Technology Stocks : KVH Industries, Inc.
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KVH Q3 CC Transcript part 1:

KVH Industries

Q3 2002 Earnings Conference Call, 10/17/2002

Pat Spratt, CFO

Good morning and thank you for joining us. I’m Pat Spratt, CFO for KVH Industries, and with us today is Martin Kits van Heyningen, our President and CEO. This call will address the 3rd quarter 2002 earnings release which we issued early this morning.

Standard risks and uncertainties and forward-looking statements disclaimer.

[Martin:] Thanks, Pat

We have a lot to talk about today, including some recent products and contract announcements. We begin with a recap of our quarterly and YTD operations and our key business areas, and then Pat will elaborate on the financial results of the quarter, and after that, of course we will take your questions.

All right, let’s get started.

Q3 was a breakthrough quarter, in what we believe is a breakthrough year for KVH. We entered 2002 with the goals of returning to profitability in the second half, doubling our defense revenues for the year, and achieving annual growth of 30%-40%, and we’ve made excellent progress on all three. Thanks to the successful execution of our long-term plan, we returned to profitability with earnings of one cent per share, up from a 14-cent loss in the same quarter last year. Overall, revenues for the 3rd quarter were $12.4 million, and was up 57% from the same period last year, and that’s a record for 3rd quarter sales. Revenues for the first 9 months of the year were $34.7 million and that’s up 45% over last year. In fact we’ve already surpassed our total revenues for all of 2001 by $2 million.

These quarterly gains were driven by the continued strength of our satellite communications business, as well as several new contracts for military navigation systems. During the 3rd quarter, operating expenses also decreased by $600,000, versus the 2nd quarter of this year. So looking ahead, we are well positioned for continued profitability and solid revenue growth in Q4.

I’d now like to go through each of our business segments, beginning with our Satellite Communications area and our Mobile Broadband group. Sales of our satellite communications products were $6.3 million for the quarter, and that’s a 55% increase from the same quarter a year ago. The continued resurgence in the North American market drove our sales up 78% over the prior year, expanding our market share, and more than offsetting a small decline in our European market sales. In our last conference call I mentioned that we had signed OEM agreements with three major RV and Coach manufacturers. I’m pleased to report that we have signed three more during the 3rd quarter. We’ve already announced our new contract with Marathon Coach, but we’ve also signed up Bluebird and Monaco as major customers.

All three of these OEM customers selected our TracVision antennas as standard or optional equipment for their vehicles. This represents the potential sale of several thousand additional units during the next 12 months. KVH’s TracVision is now offered as standard or optional equipment by 8 of the top 10 RV manufacturers. Now winning 6 OEM contracts in the last two quarters is a clear indication that our products continue to gain market share, but perhaps more importantly, it’s an indication that satellite television has crossed the threshold from being a nice to have gadget, to becoming a must have product for mobile consumers.

In addition to our OEM sales, our strong aftermarket campaign continued to expand. Aftermarket sales of TracVision antennas through the first 9 months of the year were more than double those of the same period last year, illustrating our ongoing success in addressing the existing RV customer base. We expect that strong sales in both the OEM and after market channels will continue in both the 4th quarter and into 2003.

We are also now seeing the initial benefits of our airtime services program, as we completed the first full quarter of airtime sales. This program was launched with the addition of minimal internal resources, thanks to extensive usage of web based billing and tracking systems. While it’s still early in the airtime services program, and revenues to date are very small, we’re building a solid base of customers that represent an ongoing, service driven revenue stream. I’m confident that airtime subscriptions will become an increasingly valuable component of our sat-com revenues.

In the North American Marine market 3rd quarter sales saw a 48% increase over last year, despite the continuing uncertainty in the Marine industry caused by the stock market decline. The Marine market is more susceptible to changes in overall consumer wealth, since boats are a luxury item that is often funded by capital gains from other investments, but we were able to grow despite the declining sales of new boats, through the addition of several new Inmarsat products, as well as our TracNet mobile Internet system. These new products are selling to the aftermarket in increasing numbers, making up for lower sales to new boats.

Since new products are driving our growth in a flat Marine market, we’re going to continue to introduce new ones at a fairly aggressive pace. In fact, we’ll be introducing an updated mobile broadband system at the Ft. Lauderdale International Boat show in two weeks. This new version, called TracNet 2.0, offers greater geographic range, faster upload and download speeds, and significantly lower airtime rates than our first generation product. TracNet 2.0 should help maintain the momentum we’ve created with the successful launch of the system earlier this year.

Our primary R&D efforts remain focused on our low profile satellite TV antenna system for the automotive market. We continue to make good progress on this breakthrough technology, and we expect to be able to announce a product introduction in the coming months.

Moving on to the Defense area, entering 2002, we set a goal to double our military revenues, and I’m very happy to say that we are still on track to do so. Third quarter military revenues were $4.3 million, up 81% from the same quarter last year. YTD our Defense related sales totaled $9.8 million, an increase of 118% over the first nine months of 2001.

Recently there has been lots of public speculation about the vulnerability of the GPS based navigation system. It’s even been reported that Iraq has been testing GPS jammers. And one of the key benefits of KVH’s TACNAV technology is that it includes both Inertial and magnetic field sensors and cannot be jammed. Our TACNAV navigation systems are currently in use in combat in Afghanistan and elsewhere in the Middle East. And our systems continue to prove themselves in the field, though the growing recognition by the military that uninterrupted precision navigation is critical to successful military operations.

The most compelling example of this is our recently announced contract to provide TACNAV for all US. Military Special Forces vehicles. We began planning for this contract shortly after September 11th last year, and built the initial inventory of systems, so that we would be prepared to ship them immediately if required. In the intervening months, the U.S. Special Operations command decided that the benefits offered by TACNAV should be made available to the entire Special Forces fleet. As a result, the scope of the contract expanded, and now has a potential value in excess of $10 million over the life of the program. We shipped the first few hundred systems at the end of the 3rd quarter, within 24 hours of receiving the order. We’re very proud that KVH equipment will be aiding our elite Special Forces. They’ve been on the front line in the war against terrorism, and they would be the first to be called upon for any conflicts in the Middle East.

Now the uneven nature of military procurement cycles will always result in some difficulty in projecting revenue patterns on a quarterly basis, but the overall trend of increasing Defense sales is clear. We continue to pursue a number of opportunities for TACNAV sales, both domestically and internationally. In addition to Special Forces, we also received a significant follow-on order for the TACNAV FOG system, used in the GroundProphet vehicle, which is used to pinpoint the source of enemy radio or cell phone transmissions. These orders should be shipped in the 4th quarter, which is why I am confident that we will double our Defense related revenues for the year, as we had anticipated.

Our Fiber Optics business also continued to grow, with quarterly revenues of $1.2 million, a 60% increase from the 3rd quarter of 2001. We are pleased with the results thus far, but continue our efforts to establish our fiber optic products as a more significant source of revenue. To date, military applications remain the number one market for our Fiber Optic Gyros. Our FOGs are the heart of our TACNAV FOG system and our TACNAV II navigation systems, and our recently patented Digital Gyro technology also continues to draw interest for use in a wider array of applications, such as the Inertial Measurement Unit for precision guided munitions that we are developing in cooperation with L-3 Communications.

In late July, we announced that an agreement was in place for KVH to partner with the ABB group to develop a new, high voltage optical Current Sensor, using the same digital DSP gyro technology. Working together with ABB, we’re making good progress towards bringing the Current Sensor to market. We’re very confident that ABB’s position as one of the leaders in the International Power industry will enable us to successfully address this exciting new market.

Now as you may recall from our last conference call, in response to the continuing collapse of the optical telecom market, we began to reduce the R&D funding directed toward our ActiveFiber technology during the 2nd quarter. And this process continued throughout the 3rd quarter, through the lack of a near term or even medium term opportunity to generate revenues from a 40GIG optical modulator. Instead, we are placing a greater emphasis on near term applications for our in-fiber technology, such as in our military gyros, Current Sensors, and potentially in Phased-Array antennas. This will allow us to benefit from our research, as well as increase the opportunities to drive revenues from the ActiveFiber in the near term. At the same time, we will continue to refine this technology to prepare for the eventual re-emergence of a viable optical telecommunications market, even though this may not be for a year or more.

So, looking ahead, KVH is in an extremely strong position as we enter the 4th quarter. The successful execution of our strategic plan generated record revenues over the first 9 months of the year, and returned us to profitability as planned, and despite the overall decline in the economy. Thanks to our strong Defense backlog, new OEM customers for the RV markets, and the addition of new products and services, I expect that we will remain profitable in the 4th quarter, and meet our goals for both quarterly and yearly revenue growth.

I’d now like to turn the call over to Pat, who will provide a more detailed financial picture. Pat.

[13:00] Pat Spratt, CFO

Thank you Martin. During the 3rd quarter we experienced significant growth in each of our key markets. The improvements in the operating model resulted in positive cash flow and a stronger balance sheet. While there is still work to be done, we believe that KVH has turned the corner. It has the structure in place to sustain the momentum we have been building over the past several quarters. I’d now like to review the numbers.

First, 3rd quarter sales increased 57% to $12.4 million. This has been a record number for the 3rd quarter, which traditionally has been a low point in the annual revenue cycle. Thanks to this revenue growth and continuing improvements in our business model, the result was a net profit of $150,000, or one cent per share.

Third quarter satellite communication sales grew to $6.3 million, a 55% increase. YTD satellite communication shipments rose to $20.1 million, a 45% increase.

Third quarter Defense revenues grew to $4.3 million, an 81% increase, while YTD Defense shipments were $9.8 million, a 118% increase. The award of the long anticipated Special Forces contract was an important contributor to our 3rd quarter results. Defense backlog rose to roughly $6.3 million at the end of the 3rd quarter, approximately 2/3 of which is scheduled to ship in the 4th quarter. We are very pleased with the strength of this business area. It helps to establish a very solid foundation for growth and profit improvement. However, the uneven nature of the military procurement process also makes it more difficult to project future revenue patterns.

Fiber Optic sales increased to $1.2 million, up 60% for the 3rd quarter. On a YTD basis, we are now on a par with last year.

During the 3rd quarter, legacy products, which include OEM sensors and Marine navigation sales, declined approximately 17%. Quarterly revenue for this product family was just under $600,000. YTD revenues are $2.2 million, but this reflects a 25% decline from the same period last year.

[15:10] Now to the cost side of our results. We made excellent progress in our product cost initiatives.

Third quarter Gross Profit dollars doubled Y-Y to $5.6 million. As a percentage of net sales, Gross Margin increased to 45%, up 10 points from last year’s 35%. Our YTD Gross Profit was 44% of sales, up from 37% in 2001. The quarterly and YTD Gross Profit improvements resulted from increased efficiencies in our manufacturing operations, and a beneficial shift in our product mix toward higher margin military systems. To date in 2002, our manufacturing team has reduced direct unit costs for communications products by more than 5%, and manufacturing overhead costs have been reduced in absolute terms, while revenue has grown 45%.

We are also working hard to tighten up operating expenses. While overall operating expenses for the quarter were up 21% Y-Y to $5.4 million, this reflects a 13 point reduction as a percentage of sales, to 43%. We’ve managed to reduce operating expenses by $600,000 when compared to the second quarter of this year.

Third quarter R&D expense increased to $2.2 million, a 30% increase over last year. However, on a sequential basis, R&D expenses actually declined 8%, or $200,000. This was due in part to a higher level of customer-funded research, but it also reflects a refocus. As Martin noted during his comments, we are scaling back on the total investment in PhotonicFiber research.

From the start of the PhotonicFiber project, a significant amount of the research was conducted by external consulting resources, providing us with an immediate reservoir of experience, as well as the flexibility to adjust our level of investment. We are now capitalizing on this flexible model to help manage the level of R&D going forward. We anticipate that R&D spending will, on a sequential basis, be somewhat lower in the 4th quarter.

Third quarter Sales and Marketing expense increased to $2.3 million, a 15% increase from last year. We were able to grow revenues in the quarter at a rate 3 times that of the growth rate of S&M expenses. On a sequential basis S&M actually declined 17%, a good portion of this due to a lower level of commissions associated with the mix of sales.

Third quarter G&A expense increased to $850,000, a 20% Y-Y increase, while YTD spending came in at $2.4 million, which also reflects a 20% increase. Much of the increase in G&A is related to additions to the management staff, and for professional service expense associated with the launch of new products and services.

Consistent with accounting standards, we did not recognize any income tax expense for the 3rd quarter, because we were able to use the tax effects of previous losses.

As I mentioned at the start, our Balance Sheet profile also improved. The Cash balance as of September 30th was $7.6 million. This reflects a $1 million increase over the balance at the end of June.

In addition to the improvement in earnings, another key factor that contributed was Inventory, at $4.3 million, was $800,000 lower than it was as of June 2002. This level of inventory is only slightly higher than the average inventory for all of 2001, but it is supporting much higher revenues. As a result, Inventory turns are now up to 5.8 times.

Offsetting these somewhat was the $900,000 increase in Accounts Receivable, to $8.6 million. Days Sales Outstanding, or DSO increased to 62 days from 55 days at the end of June. This increase is primarily the result of the unusual skew of revenue that we experienced late in the quarter. Because of the large TACNAV order for the U.S. Army shipped late in September, well over 50% of 3rd quarter shipments occurred in that month. We expect that DSO will return to a lower level during the 4th quarter.

Cash flow from operations was positive, $1.3 million for the 3rd quarter. Capital Expenditures were approximately $400,000. Net cash flow for the quarter was $1 million. We anticipate that cash flow from operations in the 4th quarter will be approximately neutral. When adjusted for expected Capital Expenditures and other non operating items, The year ending cash balance will likely reflect a modest decline from the September level.

Based upon our current operating forecast, our cash balances and bank line of credit are sufficient to fully fund planned operating and Capital requirements going forward. We continue to confident that we will be able to sustain strong year over year growth. Full year growth for 2002 is on track to exceed 40%.

Thanks to the ongoing improvements in our business operating model and asset utilization, and with established and strong sales momentum, we expect to sustain very solid revenue growth and improved profitability in the 4th quarter. KVH is in a solid position financially, operationally and competitively in each of our key markets. We intend to build on this success as we move forward.

Now we’d like to take your questions. I’d like to ask that each person restrict their initial questions to a few. If any individuals have additional questions, they are welcome to get back into the queue for a second turn. This will help insure that everyone has a chance to participate.

Operator, please open the call.
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