Ultralife Corp (ULBI) 2007 Q3 法說會逐字稿

Good day, and welcome to this Ultralife Batteries third 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 and Associates. Thank you for joining us this morning for the Ultralife Batteries earnings conference call for the third 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 [Ultralife] website at www.ultralifebatteries.com, where you will find the release under Investor News in the Investor Relations section.

In a minute, I'll turn the call over to John Kavazanjian, Ultralife's President and Chief Executive Officer who, along with Bob Fishback, Ultralife's Chief Financial Officer, will provide the formal remarks. Management will then take questions until eleven o'clock Eastern 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 based on current expectations. Actual results could differ materially from those projected as a result of various risks and uncertainties, including continued acceptance of and demand for the Company's product; changes in the Company's products and changes in customer's purchasing plans. For a detailed description of these 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 ending December 31, 2007. 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 the corresponding GAAP figures.

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

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

Today we reported revenue of $33.3 million for the third quarter of 2007 with an operating profit of $200,000. Included in this, our non-cash expenses of $1.1 million and the amortization of intangible assets and the expensing of stock-based compensation. These results are in line with the preliminary results we disclosed on October 23. But to recap, we fell short of our guidance, due primarily to higher than expected expenses stemming from professional fees and other costs associated with acquisitions in the McDowell settlement and from manufacturing overhead under absorption.

We had another strong quarter for communication accessories with $6.7 million in sales. And in addition, gross margins showed significant improvement, coming in over 24%, up from 19% in the second quarter. With our recently announced $24 million Satcom-on-the-Move order, we expect sales growth to continue and our material sourcing improvements to lead to further margin expansion. We are on track to achieve our objective of pushing margins from this business into the 30% range by the first quarter of 2008.

Our rechargeable segment was steady relative to the second quarter with $3.3 million in sales, but gross margin remained below our target margins as we continued to sell through the remaining premium price inventory in our charger line. We are on track to be through this inventory by the end of the year.

Our biggest unfavorable swing was in the nonrechargeable segment where margins were $2 million lower than the second quarter on substantially the same sales volume. About half of this was due to a lower margin product mix, primarily connected with the increased sale of lower margin, BA-5590 batteries that we sell to the UK Ministry of Defense. And about half of the difference was due to lower production rates and the unplanned shutdown arising from the power outages.

The move of the McDowell operations from Waco, Texas to Newark, New York is virtually finished. Due to the large order for Satcom systems, however, we've modified this plan and we'll keep a small operation in Waco into the first quarter of next year. We do not expect this change to have any adverse effect on operations and it affords us the capacity and flexibility to execute on this increased business.

In September we closed on the purchase of Innovative Solutions Consulting of Hollywood, Maryland. We've known ISC for several years now as a company with excellent capability and systems engineering of complex communication systems and in services connected with the design and installation of secure vehicle-based systems. In the past, we have utilized ISC to perform on some situations that involve the installation of equipment we supplied. Just last week, we announced $2.3 million in orders from the U.S. Air Force that demonstrated the value that we are creating in combining the McDowell line of communications accessories with ISC's design capability. After several years of sales growth and profitability, ISC was slightly unprofitable in the first half of the year; but by leveraging our distribution capability, we expect ISC to be profitable again, though we don't expect its results to be a material factor in our financials at this point in time.

Yesterday we announced a definitive agreement to acquire Stationary Power Services and Reserve Power Systems of Clearwater, Florida. Stationary Power is a leading supplier of design, installation and maintenance services in the standby and backup power market. Reserve Power is an affiliated company that supplies sealed lead acid batteries and associated accessories for this market. We've previously mentioned that we're already working on the applications of our lithium-ion technology to this market. And this acquisition will be instrumental in our gaining both knowledge and distribution capability in the standby power market. Stationary Power is a profitable enterprise and we expect it to be accretive to our financials. We see the standby power market as a major area for growth for our commercial business, both in a traditional lead acid battery segment and in the nascent lithium-ion segment.

In other commercial markets we continue to see increases in demand for our product; notably, in telematics and medical markets. In telematics, our business with General Motors has expanded to two new international platforms. In new customer activity, we are in prequalification on two platforms with two new customers in Europe. We expect those new customers to start taking product in the second quarter of 2008.

In medical products, we have fourth quarter orders for custom battery packs for two new medical pump products. And in addition, we started development of a new SmartCircuit pack for an emerging medical application that should go into trial in the second half of next year.

In safety and security and automated meter reading, our ABLE product line is growing revenue. The products we've acquired with ABLE are very good in performance with very competitive pricing. They represent an excellent value brand in the markets that they supply. In 2008, we'll be developing high performance, Ultralife branded versions of these products which will bring a world-class performance product to these markets and an excellent price, thereby covering the two important price performance corners of these markets.

In the government and defense sectors, we see strong demand. Our current offering of batteries and accessories are seeing steady growth, both domestically and internationally. We see even more opportunities for dramatic growth coming in the sales of some of our newer high value offerings, including Satcom-on-the-Move system, increased sales of rechargeable battery systems and thermal site batteries, and sales of our new portable tactical repeater system. In the fourth quarter, we're expecting revenues of $41 million to $44 million and operating income between $2.7 million and $3.5 million. Based on bookings and demand, and continued improvement in our accessories gross margin, we are in a strong position to continue posting revenue gains and gross margin improvements.

Now I'd like to turn it over to Bob, after which I'll have some comments and then we'll open it up for questions.

Thank you, John, and good morning. Earlier this morning we released our third quarter results for the period ended September 29, 2007. Consolidated revenues totaled $33.3 million; a $9.6 million increase or 40% over the same quarter last year. This revenue increase was the result of growing sales in our communications accessory segment, higher sales to international defense organizations, and increased shipments of backup batteries to automotive telematics customers.

Gross margin was $6.9 million, an increase of $2.9 million from the third quarter last year. As a percentage of total revenue, gross margins improved to 21% from 17% in the third quarter of '06, mainly due to improvements in operating efficiencies in our nonrechargeable operations as well as higher production volumes. During the third quarter, we relocated most of our McDowell operation from Waco, Texas to our Newark, New York manufacturing facility. And as a result, we incurred approximately $100,000 in costs. Margins in the third quarter of '07 continued to be constrained by purchasing decisions at McDowell made in the latter half of '06 that resulted in the procurement of high cost materials. But we did realize some margin improvements in the McDowell operations during the quarter, as we had been expecting.

Operating expenses in the third quarter totaled $6.7 million versus $6.1 million in the same quarter of '06, mainly as a result of higher professional fees from acquisition-related activities as well as increased corporate costs necessary to run a more diverse business. Included in total operating costs are approximately $1.1 million of non-cash expenses related to intangible asset amortization and stock compensation expenses.

Operating income in the third quarter of '07 was $200,000 compared with an operating loss of $2.1 million last year. Our preannouncement last week highlighted the fact that our third quarter 2007 results were lower than our prior guidance due to the reasons that John has previously highlighted.

Net interest expense for the quarter was $500,000; up $100,000 from a year earlier due to higher levels of revolver debt. Income taxes were not provided for in the third quarter of '07 due to our decision in the fourth quarter of last year to fully reserve for our deferred tax asset due to the uncertainty at that time of our ability to fully utilize our existing net operating loss carryforwards. We continue to monitor this situation each quarter and will look to re-establish our deferred tax asset when we have greater certainty in our ability to utilize the NOLs in compliance with GAAP standards.

On the bottom line we reported a modest net loss of $100,000 or $0.01 per common share compared with a net loss of $1.7 million last year or $0.11 per share. Average shares outstanding were 15.2 million shares, up 200,000 from last year due to stock option exercises and restricted stock grants.

With respect to cash flows for the third quarter, we generated a positive adjusted EBITDA of $2.4 million, adjusted for the add-back of $500,000 in non-cash stock-based compensation. Changes in working capital generated approximately $700,000 as inventory levels were reduced during the quarter, offset in part by an increase in accounts payable balances. We spent approximately $300,000 on capital expenditures during the quarter and we used $500,000 of cash to reduce the principal balance on our term loan. We also spent $1 million in cash to acquire ISC, which closed on September 28, 2007. And we used approximate $900,000 to reduce ISC's working capital debt that was being used to finance their receivables and inventory.

As a result, we ended the quarter with an outstanding balance on our revolving credit facility, net of cash, of approximately $8 million, down modestly from $8.2 million at the end of June. Our inventory levels are still higher than where we would like them to be and we are continuing to focus on improving asset utilization in this area. We expect to continue to bring these levels down during the fourth quarter, which will help us to reduce our need for borrowing under our revolver.

In mid-August we amended our credit facility with our primary lending banks and ended the forbearance period that we had been operating under for several months. As part of the amendment, certain covenant metrics were reset and a new fixed charge coverage ratio was added to replace the EBIT to interest covenant. In addition, the facility was extended to January of '09.

We are very pleased with the ongoing relationship with JPMorgan Chase and M&T Bank, not only with their assistance as we've worked through some operational issues during the last year, but also with their keen understanding of and support for the acquisitions we have recently completed and those that we are now working to finance.

Looking ahead to the fourth quarter of '07, we anticipate breaking the $40 million revenue mark for the first time with consolidated revenues projected to be in the range of $41 million to $44 million. This is based largely on our strong backlog position, most notably, our recent Satcom-on-the-Move order. In line with this revenue outlook, we anticipate reporting operating income in the range of $2.7 million to $3.5 million, resulting in an adjusted EBITDA ranging from $4.7 million to $5.5 million as we continue to improve gross margins and put the third quarter one-time issues behind us. We expect to continue to realize ongoing improvements in gross margins in our communications accessories segment as we further reduce material costs.

We'll also be including a full quarter's worth of activity for ISC in the fourth quarter P&L. At this time, we are not anticipating any significant impacts from the Stationary Power and Reserve Power acquisitions in the fourth quarter, but we fully expect to close these transactions before the end of the year. Also, as a result of the favorable settlement agreement that was negotiated with the sellers of McDowell Research, we expect to report a one-time non-operating gain in Q4 of approximately $7.5 million.

We are in an exciting time right now. Our sales activity is very strong and we're realizing the synergies that we had originally expected with the McDowell acquisition. In addition, we continue to broaden and diversify our product and service offerings with the acquisition of ISC and the pending acquisitions of Stationary Power Services and Reserve Power Systems, extending our reach in the markets and applications that benefit from our technology and expertise. We remain confident in our ability to grow successfully and profitably.

That concludes my remarks and I'll turn it back to John.

Thank you, Bob. With the acquisitions of ISC and Stationary Power, they represent major milestones in the transformation of our Company. We now provide not only batteries and communications accessories, but we've expanded our product offerings and our addressable markets, and have added key services that differentiate us in the value we bring to our markets and customers.

I'd like now to open it up for any questions.

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

A couple of questions on Stationary Power. Just generally, the growth and operating margins, how are they tracking in '07 versus '06?

We'll have those numbers out but they've been running kind of at least $1 million a month in business run rate. They did $9 million in '06, I think we said; '07 has been running in the ballpark of $1 million a month in revenue.

Okay. And then can you give some detail or at least some color on product versus service revenues and margins for them? I'm assuming that the service side is pretty attractive for you going forward. If that's true, how do we think about building out that network and that opportunity?

Let's see. Product and service. It varies depending on how much replacement work is done versus initial installations. There's more service on the initial installation work in terms of mix of batteries and services. It ranges anywhere from two-thirds hardware, one-third service of installations, but it could be 50/50 sometimes. So it does vary, in a reasonably wide range.

All I can say is that the margins appear to be -- we're kind of looking at the model more and more closer and closer -- the margins appear to be fairly consistent, because when they do more hardware intensive work, some of that -- or I'd say, sell more batteries themselves, those tend to be replacement product which go for a little better margin than the initial installation. So, call it anywhere from 50/50 -- call it 50/50, Steve, but sometimes it runs two-thirds hardware if they do a lot of replacement work.

Okay. And then you guys obviously have expertise on the lithium-ion side, the SmartCircuitry, et cetera. They've got an established business that's based more on the lead acid batteries. So as you think about what I would assume to be a premium offering, where you take their products and incorporate your lithium-ion batteries, where is that attractive versus a lead acid solution? In other words, what customers or niches might be interested in that premium solution and why?

Sure. First, in their core business their -- after installation, maintenance is limited to where they can geographically cover, which is in a small area. So we think in a very targeted way. We're not going to build a national service organization; we believe in a very targeted way. Where they do installations away from their home base, we can -- in some geographies, for example, they've started already in Atlanta, away from the Tampa area, to be able to pick up service contracts. So we want to be able to get the contract work afterwards, because we believe they do a very good job of installation and the after-installation service should be very attractive if you do a good job.

But most of the service with lead acid batteries is really based on people going in, testing, checking, et cetera. The real attractive piece comes in where you're in either a remote location or lots of small installations where you can't go necessarily and every day -- every month go out to a curbside box, open it up and test the batteries. And when they fail on you, they fail pretty fast.

With lithium-ion batteries and those kinds of installations, we can do remote diagnosis. We can tell almost down to the individual cell level where we have problems. And so the real attractive -- the attractive part of that market is really the more distributed sites. A cell site might be able to bear somebody going there every month to check it out, but on a more distributed site, we think lithium-ion has got a real value proposition.

The second thing is in portable type applications. I mean, we've said, we're in development of a battery that's going to be in the market next year that's a very portable cell site, where if you have a problem or trouble you can drop the cell service in pretty fast. The military has need for backup portable power, for example. And lithium-ion is very attractive there just because of its size and weight.

The proposition for us is, we could make 100 sales calls in the communications business and maybe sell 1% to 5% of them lithium-ion batteries, well, what about those other 95 sales calls? And so the synergy for us is if they're making 100 sales calls, the percentage of those that went lithium-ion, it's just another product in the portfolio. We think in some of these markets, again, distributed markets and where people want -- where weight and size makes a big difference, we think that's a real proposition for lithium-ion.

And then Satcom-on-the-Move, I assume you didn't get much in this quarter, if anything. Do we look for the $24 million to flow in pretty evenly over the next couple of quarters?

Right now we have it projected to flow pretty evenly. The demand is for it as fast as possible. We've just got the order and so we are very supply line gated. And I think we were very prudent in our guidance in terms of being real careful of supply lines; it really just is how fast we can get materials in. That's really the issue for us. So yes, our assumption is fairly smooth over the next couple quarters. But frankly, it's -- we're ramping up a lot in November and December. There's a lot of stuff that's got to get out.

Okay. And then last, just a couple of questions on the gross margin. On the primary side, I think you highlighted bad mix and overhead absorption in the quarter. Do we look for that business to get back into the mid-20s kind of gross margin by fourth quarter?

And then second, just bring us up-to-date on the high cost inventory at McDowell, just a little more specifics there.

Yes. We'll be back in the mid-20s. We had some underutilization, mostly connected with the fact that we were shut down and then when we went to recover, the areas that we had some lots that we couldn't get enough testing time in for the military because we were out for basically a week -- three day shut down -- but then getting test stations and stuff started back on, we had brown-out situations. We'll be back in the mid-20s pretty comfortably.

And in terms of mix, we have a much better mix this quarter. Demand is back up. We had a little -- in the military area, there was a lot of funding that was diverted from programs to funding MRAP program. We were the beneficiary of that on the Satcom-on-Demand side, but we had decent orders but not at the run rate we have this quarter from our standard battery stuff.

On getting through premium inventory, we are in pretty good shape. We got back at about 24% gross margin. We ought to have that. We're pretty confident it will be at least that, hopefully a little better. I'd like to be -- I'd love to be at 30%. It's just, again, the mix will be heavily weighted to how many Satcom systems we get in. And we also -- the accessories product line, I'd say kind of a $4 million, $5 million piece of that comes in at a fairly steady basis through the quarter and there's some mix associated with that. But most of that we have resourced and we're in pretty good shape there.

The big -- the one that we highlighted is, in our rechargeable segment, the 6-Bay chargers. We've got -- we'll be pretty much -- we'll be through them by the end of this quarter. We might have 40 or 50 units more to go but we sell hundreds of those in a quarter. So we are just about there.

Jim McIlree, Collins Stewart.

In times past, you guys have talked about an operating model of 10% to 14% margins on a $40 million quarterly revenue rate. But your guidance for Q4 has much lower margins on that kind of revenue rate. What's the delta there?

Well, we have a start -- we're right now in a startup situation in a couple of different areas. We've only now started getting the volume of building some of the batteries we've built for some different batteries, like the stuff we do for Harris, for example. We've got new workforce coming in that we are training on some of the new things, like the Satcom systems and building chargers. So we have some learning curve there. I mean it's simple as that. We also have some over-hanging costs, as I said, we have some cost overhang in the rechargeable area to get through to get there.

Can you estimate how much the rechargeable overhang is costing you in terms of gross margin percentage in Q4?

It would be -- we've done this before -- it's probably worth -- depending on how many of these systems we sell, I don't know, it could be worth 5% to 6%, somewhere in there?

In that segment, yes.

Yes. That sound right?

Yes.

5% to 6% just for the rechargers?

Yes.

So what does that work out to be, 100, 200 basis points for the Company as a whole?

If that's about a quarter of our business right now, yes. 1% and 2% on the Company line.

And kind of on the same track, given all the acquisitions that you've made plus the two that are pending, what changes does that make to your operating model? Does it make the margins go higher, lower? Stay the same?

Well, they at least stay the same. And what we're trying to do is get to a model where we have some repetitive revenue. The big issue we have had has been having a steady stream of repetitive revenue. And the commercial business has been very good for that. But as the military business has gone, there is lumpiness associated with it. It has to do with order patterns, budgets, et cetera. As much as we grow in that business, it's been very hard for us to forecast because of some of the ordering patterns.

You've even highlighted in your own thing that -- take Satcom-on-Demand. We thought we'd get this order back in July but it took time to get stuff worked out and by the time we got, we were scrambling for supply lines. You've written about [DECRUZ] and further Satcom-on-Demand systems, we think there's business out there. We don't know in the budget cycle, procurement cycle, priority cycle, when those things are going to happen. So it's been tough.

So we're trying to get some established market repetitive business out there. So that we are not dominated in our model by counting on getting our fixed overhead spread over a business that -- 60%, 70% of our business is really lumpy. We'd like to get to where, where at least half of our business is very predictable, profitable, and easily covers our expenses.

I think this really gets us to be there. The installation systems business at ISC is very healthy business. And it just suffers from a lack of marketing and sales, which we bring it. And then the Stationary Power business, it is an adjustable market that is bigger than any single adjustable market we've gone after before. And they have a good steady growth. Lead acid batteries are going to keep growing, right? But we probably wouldn't have done this if we didn't think we had a real good value proposition to bring in addition to that marketplace.

We've got a company that they really know what they're doing. They're first class and they do it in our style which is not in a fragmented way. They bring a total solution to the customer. They want to do it all; meaning, the design, the installation, bringing them the batteries and then the aftermarket service.

And they were a little frustrated, because it's a small company, being able to have the wherewithal and the management capability to grow in order to have multiple stocking locations in the country, which we have already. To have the wherewithal to put a couple of people in Atlanta or maybe a couple of people in Dallas to be able to service customers after they do the installations for them. And that's -- so it worked out really well for everybody.

Okay. And last one, I think is -- what are you doing differently with these acquisitions that you learned from McDowell -- from the McDowell experience, if anything?

Yes. No -- if anything --

Good question.

Just about everything. Good question is right. We've put our management team and finance staff in day one. So we already, Phil Meek is already -- our Vice President of Manufacturing has moved to a new assignment. He's going to be managing Stationary Power and Reserve Power down in Florida. He's there already working along with Bill Maher and Ed Bellamy. He's there. We have a Controller in there already. We happen to have had a top Accounting Manager in Bob [Staff], who moved to Florida over a year ago who we really liked but for family reasons had to move. And turns out she's right there in Florida. So she's now our Controller.

In ISC, Jose [Salazar], one of our top field people who has a lot of experience in vehicle work and in this kind of engineering, he's moved in. He's running as COO for ISC. He was there day one; the day we bought it and we have our finance people in day one. I think that's really been the lesson for us, is to be in there day one. And on day one to have them working with our management reporting, our monitoring systems and our management team. And we've done that for both of them.

Ted Kundtz, Needham & Co.

John or Bob, I want to go back to the gross margin issue again. One, you mentioned in your opening comments that it was impacted by the BA-5590. Maybe you can give a little more clarity on that.

And then I just wanted to go through to see what -- if you could break down the gross margin improvement that you're looking for from the current level to where your target is of 30%, what exactly -- what programs, what areas does that represent? If you could sort of segment that for us, that would be helpful, how to get to another 9 percentage points out of gross margin. What programs are those going to come from? And if you could tell us how much from each program, that will give us a sense of the magnitude that you're looking --.

Yes, I can give you a general sense of it. First of all, the BA-5590 is a product that's not made by us. It's made by EaglePicher. We represent them overseas selling the product. So the margins we have associated with that are in the teens. And so it does not pick up kind of the classical manufacturing overhead costs that you'd want it to pick up of power, depreciation, capital equipment, et cetera, when we sell it. We sold a pretty decent volume of that this quarter to the UK Ministry of Defense.

That's just a mix issue. Because that's always been the case --

Yes, it is --

That wouldn't really change the gross margin but --

Well, it's a mix issue, but --

-- you sell a lot more of it.

It's a mix issue, yes, and we accounted for it. There's no question about it. But we also anticipated having three, four more days of production in our facility of products that we do put overhead into in our product costs. And without being able -- by losing that production, we lose that overhead absorption. It's a big effect on us.

And where we had products that we could substitute in for us, meaning products that didn't need heavy compressors running that you could do on backup power or didn't have the long testing qualification cycles that got interrupted that we have with the military products, the shift in product mix was to shift other products that didn't pick up those kinds of overheads. The McDowell product -- the accessories product line and the rechargeable product line don't carry as much overhead because there's not as much infrastructure dedicated to them. It's a manufacturing costing problem issue that you have.

Now the good news about that issue is when you overship in those areas, you pick up much better incremental margins. But it went the wrong way on us last quarter. And the stuff that we could pick it up with wasn't stuff that carried -- we could pick up the revenue but we couldn't pick up the overhead absorption. So, there are (multiple speakers) --

[Could you] go back and just sort of tell us how you can get to this 30%. Which programs you need to -- how that mix needs to --

Yes. In the accessory business it's purely getting all of our new sources kicked in. We went from 19% to 24% this quarter. We are anticipating we will be higher than that in the fourth quarter. And we've said, pretty straightforwardly we'll be at 30% by the first quarter. We are getting through inventory. It is both getting through inventory and resourcing more economically some of the parts that we have. And we have done that. So I think we're on a good track there.

In the rechargeable product line, it is getting through a charger -- an overhanging charger inventory. We've got probably 350 -- I think at the beginning of this quarter, ballpark, 350 chargers worth of parts that were bought at a significant premium. We've got to get through those. We will be through those this quarter. We sell anywhere from 250 to 400 chargers a quarter in this line, without a big order. So, in just a normal course of business. We'll be through that and get there.

And we also had learning curve because it was the first quarter we started really building batteries for people like Harris. We had a couple of projects, Harris is one example of one that we've announced that's getting to significant volume that we're getting through a learning curve on.

Okay. And that's a couple of gross margin percentage points right there, right?

Yes. And you've got to remember, the other thing, Ted, we moved this quarter. We moved from Waco to Rochester -- to Newark here this quarter. And that's -- it's done. That's behind us.

Yes. Well, that's the accessory thing. So, yes, we've got that already.

And then that's rechargeable. And then in nonrechargeable, like I said, it is really utilizing our production. We suffered from two things -- number one was volume in areas that we could get things done in. And the second thing was with the shutdown we couldn't even utilize the volume --

Power outages.

The power outages, I mean. We couldn't utilize what we had there. And we had some chances to over achieve and produce parts and stuff in some areas that we had the resources to do it in and then we couldn't get the parts. Because, for example, we just couldn't get -- we build all the 9-volts we could build with the parts we had. And we could have built -- we would have liked to have built more, for example. So I think we're lined up in pretty good shape. And it was purely because we were counting on a different mix that just threw us -- we got thrown off on.

The things -- we had some orders that we did not get enough qualification time on that carried good margins, that we couldn't get out because of test time. Those are shipped already. So we're very well utilized in all of our factories right now. UK, U.S. and -- we're in pretty good shape there.

Okay. Terrific.

But that's what it takes. We know in each area what it takes to get it back.

Okay. Great. Just speaking in general on the commercial side, you went through a bunch of the programs there. But that business looks overall pretty healthy and more predictable, I would think. Right?

It is a much more predictable business. There is no question about it. People would tell us that the auto business, oh, they have their ups and downs. Well, every so often we will get a call saying we don't need shipments this week. And every so often we'll get a call saying we need double shipments this week. But it is very predictable. Much more so than -- it doesn't have the lumpiness of other business and it really keeps us -- very steady demand. Automotive, medical -- it all is -- it's pretty steady.

Ted Bade, 150 LLC.

I just have a quick questions on this power added to your Newark, New York facility. Just wondering when that happened and then when you guys realized that would hurt volumes and margins?

It happened in the last week of August, just before Labor Day. And we knew that it was an underutilization issue, but right up to the end of the quarter had a chance to get materials in for things like Satcom systems that we had orders for and some of the rechargeable things that we had orders for, it didn't have long test times. It didn't require dry rooms and pre-discharge and some of the other things we have to do in our nonrechargeable. And we just ran out of runway at the end of the quarter.

We also had test time on some of the military batteries that we were just a little short on the test time on that sometimes we get waivers for. And we just couldn't get waivers for it.

And then lastly, I forget your guy's long-term gross margin target?

Our goal is to get gross margin up in the high 20s, 27%, 28% in a very short term and a long-term to be a 30% gross margin business. It's there -- 30% plus, it's there to be had.

Greg Weaver, Kern Capital.

On the BA-5590, in terms of the orders from the UK MoD, where you surprised at the volume there in this quarter?

No, we had planned for it. We knew it was there all along. That was not a surprise in the volume there. But we would have, Greg, just to be clear on this, we planned -- my comment was all about the second quarter to the third quarter -- we planned that we would have a margin drop from second to third quarter because we had a higher mix of DA-5590. That's my comment. And if you look at the margin drop, it was $2 million. That's much more than the part of our miss that would be attributable to volume. So we accounted for a good part of that already that we thought was going to happen.

Right. So the 8% drop in that segment margin, what portion of that would you attribute to overhead versus mix?

It was probably -- half of it was probably mix. Is that about right, Bob?

Yes, that's right.

So that was a known quantity?

That was known. That was built into our numbers.

We had a supply chain of higher margin products in our accessories business to overcome that.

But the real mix problem came in when we couldn't -- with not being able to get out, not being able to produce because we didn't have enough production days. When you produce a part -- I don't want to get too esoteric on manufacturing cost accounting -- but when you produce a part in our nonrechargeable operation, it brings with it into inventory or into the sale, it absorbs overhead costs, which goes into the cost sales number. And if you can't produce you don't absorb that overhead, that cost is a bigger number across the board. You have an unfavorable (multiple speakers) -- I'm sorry?

I'm just saying, I'm happy to see the inventories down as opposed to you loading up some overhead in there.

Well, that's right. But frankly, we would have liked to have gotten some more of these things built and get the inventories down more by shipping stuff out the door, too.

So the communications accessories, nice margin improvement there. I'm just trying to -- did you say that you felt in Q4 that that would be relatively flat sequentially?

We think we will improve that in Q4. I mean I'd love to tell you it's going to be back at 30%, but I just don't know because of the mix sensitivity there. But we will improve that in Q4. Every projection we have says we will improve that.

Okay, because you're doing supposedly 30% in Q1, right? So I just wanted to --

Yes. We'll be right in the 30% range in Q1.

All right. How about a little bit more on the Stationary Power here? How did you end up finding those guys? Why are they selling? And in terms of financing the acquisition here, a little more detail there?

Yes, we've been looking at this market for quite a while and looking at ways to get into the market and the business, or channel to get in there. We found it to be a very fragmented market. In other words, there are people who design, there are people who make batteries for it, there are people who install and there are people who maintain. We couldn't find a lot of people who did it all in an integrated way. And they were one of the few that we found.

They have a fantastic reputation in the business. They've pretty much -- while they've grown some, they have much more demand for their services than they can fulfill. And a lot of that comes because it's hard for small businesses, especially people-based businesses, to finance themselves. And finance -- make those forward investments, get financing to finance the growth. Because when you want to get in a service business, the growth is not toward buying tangible things that people can see but by hiring people and putting them in place; office space and people.

And it's not a huge number, but for them it was relatively a pretty good number. To do an office is maybe three people in a location. And so we started talking and spending time with them, and we found that they had kind of hit the wall in terms of growth rate. They have grown but they had the potential to grow much further -- much faster with some help in a partner.

And that's how we found each other. We started talking about them as a channel. And then it came to the point of well, let's just -- maybe we ought to get ourselves together here.

So nobody was shopping them.

No. Nobody was shopping them. We came upon each other honestly. Very much in the same way we met the people from McDowell and very much in the same way ISC. It wasn't by chance. These were areas that we'd been looking in.

And even then when you do get together and talk about it, we've had discussions with people and sometimes you can't get together and come to an agreement on price or structure or whatever. And we were able to do that.

So will they need additional capital here to expand these offices, et cetera?

It is not a capital intensive business. It is people services. And to put an office in play literally as office space -- you know, a van, some tools and three people. It's not a big investment. But it's a forward investment that small companies can't do. And we're not going willy-nilly into this. We have a very sane segmented plan here so -- to be able to grow what they do.

(OPERATOR INSTRUCTIONS). Matt Williams, Columbia Partners.

Nice quarter, guys. Congratulations on the acquisitions. The ISC -- what sort of revenues are you incorporating in your Q4 guidance from the ISC acquisition?

It will be very modest. They'd done -- we noted that they did about $4 million in revenues in '06. It will probably be an incremental amount of $1 million or so in this quarter.

Right now I think, yes, we've got about a $1 million in the plan for it. (multiple speakers) There's a $2.3 million order we took where we're probably -- we're pretty much planning that that will happen. A little bit will happen this quarter, it will happen in the first quarter. We have some material supply to get in place for that.

Okay. And then the Stationary Power and Reserve Power acquisitions, what's the cost of those deals?

It's $10 million for Stationary Power. And it's $1 million plus an earnout. And then Reserve Power is $1 million --

100,000 shares.

100,000 shares.

Current market is $1.3 million or thereabouts. And then there's an earnout component for cash on that one.

Okay. And can you share anything with regard to the earnout? What it is based on and how much it could be?

It is based on -- go ahead, Bob.

It's based on achieving, or overachieving revenue targets that we set for each of those entities.

Okay. And not margin but just revenue?

Primarily revenue but there is an assumption built in that there will be ongoing margins that we expect in those businesses.

It has to exceed a certain margin to qualify.

Okay. And then so -- did you -- are the earnouts capped or are they not?

They are capped in the area of -- go ahead, Bob.

For Stationary Power it's capped on the max -- there's 100,000 shares that could potentially be earned over a five year time horizon, if they exceed the revenue target that we've pre-established. On the Reserve Power, there is not a cap. It is over a three year period. It is based on exceeding the revenue targets that we've established.

And the Reserve Power, I think of it more as a royalty than anything. They designed and built a product line that didn't have any substantial revenue. And so basically it's a royalty if they make certain goals.

Okay. And then the recovery from the McDowell purchase that you will have in Q4, will any of that go to reduce purchased inventory?

No. What we have discussed and what the appropriate accounting is with our accountants is that that purchase price adjustment, virtually all of it will be flowthrough as a one-time gain through the P&L. Based on accounting standards, we don't go back at this time, kind of past the year, past the acquisition date. We won't go back and adjust goodwill or any of the intangible assets at all.

Okay. And that's going to be in the form of a cash payment -- that gain?

No, the gain is based on a reduction in the overall purchase price which there's a $6 million reduction in the note, which was a $20 million convertible note that will be adjusted down to $14 million. And then there was a $1.9 million liability related to working capital adjustments for a purchase price adjustment that we had factored into the agreement. And that has been eliminated as a result of the settlement agreement.

Okay. So we'll recognize the gain and we'll be reducing your debt and liabilities?

That's correct.

Exactly.

And then, so as we look forward into '08 and just based on your guidance for the fourth quarter, you're really going to start to be generating decent amounts of cash. What's the right amount of debt to carry for this business? I don't know if in terms of debt to capital that you think about? And once you get to that point, how do you think about using that cash?

Well, I'll answer this one and maybe Bob has a different answer. My answer is it depends what the debt costs and what the capital costs. So there's a point at which it is attractive to finance with capital. And there is a point where it's attractive to finance with debt. And right now in conjunction with the Board, we think we have a fair amount of debt capability here. But if capital got attractive, we would use that.

Jim McIlree, Collins Stewart.

What kind of amortization of intangible charges do you think the Stationary Power acquisition will result in?

We've engaged an appraisal firm to help us sort that out at this point. So I don't have really precise numbers. But based on the prior two acquisitions that we completed with ABLE and McDowell, the access purchase price over the net assets we acquire, we would probably -- my assumption would be that we'd split that 50/50 between goodwill and intangible assets. And it's the intangible assets we'll get amortized over a, say, on average, a five to seven year time horizon. And that's as good of an assumption or set of assumptions that we have got to go on right now. But we are working through the details with the appraisal firm.

It is a little sensitive to the time you put on the amortization, because it is slightly -- it's weighted to the front a little (multiple speakers) --

Because you get the benefit earlier in the time horizon (multiple speakers) --

Yes. They get it a little more earlier than later. So, that's why we've -- that's about as good as we can tune it right now.

Okay. That's good. And Bob, the comments that you made regarding taxes, I'm assuming that at some point in '08 you're expecting to begin accruing for taxes again? Is that -- am I hearing that correctly?

No, don't jump to that conclusion yet. Because we need to establish a track record based on the guidelines that we have gone through in the past. And typically if you look back over the prior three year time horizon to determine whether you have got positive earnings, and probably -- we will be looking at this very carefully at year end, but my sense is that because we have a favorable year in '07, it won't necessarily offset the couple of years of losses from the prior two years. So I'm not expecting at this point to kind of put the deferred tax asset back on the books this year. But we've got a long way to go, but talking to our accountants and going through that process before the end of the year.

Okay. That's terrific. And just the last one. As you fold in ISC for the December quarter, does that result in any significant changes to the operating expense levels? Are we just talking maybe $100,000 or so for those guys, even if that much?

Yes. I mean, they have some modest operating expenses at that level and we're working to consolidate back office functions and the like. But it's not going to be substantial from that addition, no.

Okay. Terrific. Thanks again.

We have no additional questions at this time. I would like to turn the call back over to Mr. John Kavazanjian for any closing remarks.

Thank you very much. Well, I'd like to thank everybody for participating. Our fourth quarter is now shaping up to be the strongest in the Company's history. The acquisitions we've done are going to add to a strong and growing business in ways that we think will accelerate our growth. And so we really look forward to sharing further progress with you next quarter. Thanks for everybody participating and we'll talk to you again.

This concludes today's conference. We thank everyone for their participation. And you may now disconnect your lines.