Freshpet, Inc.
Q3 2008 Earnings Call Transcript

Published: 10 Nov 2008

[Operator:]

Greetings and welcome to the Force Protection third quarter investor conference call. (Operator Instructions) It is now my pleasure to introduce your host, Mr. James Palczynski of Integrated Corporate Relations.

[James Palczynski:]

Before we get started with this morning’s conference call, I’d just like to read the company’s Safe Harbor language. Certain statements in today’s call, including without limitation, statements relating to the company’s business expectations for the remainder of 2008 and fiscal year 2009, statements relating to the beliefs of management of Force Protection, expectations, or opinions, and all other statements in this conference call other than historical facts, are forward-looking statements as such term is defined in the Securities and Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. The numbers presented for the three month and nine months ended September 30, 2008, reflect the numbers included in the company’s quarterly reports on Form 10-Q for the third quarter 2008. Forward-looking statements are subject to risks and uncertainties, are subject to change at any time, and may be affected by various factors that may cause actual results to differ materially from expected or planned results. In addition to the statements discussed above, certain other statements are forward-looking, including, without limitation, our expectations regarding profitability, our ability to address or identify material weaknesses, and the progress made with respect to our internal controls, our expectations for the Cougar, Cheetah, and Buffalo and their variants, and additional orders for foreign military customers. These statements are subject to numerous risks and uncertainties that are fully described in our Form 10-K for the 2007 fiscal year and the Form 10-Q for the period ended September 30, 2008, as filed with the Securities and Exchange Commission. With that out of the way, I would now like to turn the call over to Michael Moody, Force Protection’s Chief Executive Officer.

[Michael Moody:]

Good morning and thank you for joining us to review our third quarter results. With me on the call today are Charles Mathis, our Chief Financial Officer, and Damon Walsh, our Executive Vice President of Customer Operations. Our third quarter results demonstrate that when we are operating well we can produce good operating margins. The quarter’s results were driven by strong delivery of vehicles under the MRAP program, substantial improvements in operating efficiency, particularly in the more efficient use of labor in our manufacturing activities, and significant service and support revenues where margins are somewhat higher than those for vehicles. As we move forward we expect to continue to reduce our production-related expenses, as well as overhead expenses, to appropriate levels consistent with the business we have and the orders we reasonably expect to win. We are moving towards being a leaner, more capable, and more efficient organization. I believe I advised shareholders on a recent call that in September we were able to produce vehicles at near record numbers with a significantly reduced headcount. In terms of operating income this third quarter of 2008 was the best ever recorded by the company. Our operating income was $31.7 million and our earnings reached $0.29 per share. Our shareholders might also note another important milestone for Force Protection in these financial reports. We have turned the corner and the total shareholders’ equity no longer records accumulated deficit, but retained earnings, which stood at $9.6 million at September 30, 2008. As we review these third quarter results, there’s one important point I wanted to make. Force Protection has not been in the practice of providing guidance. However, I would like investors and analysts to follow the company, to recognize that Force Protection is continuing to move through its transition to a more broadly-based business with a wider range of products and a wider range of customers. The United States government hosted an important ceremony at our Ladson, South Carolina, facility less than two weeks ago, thanking us for all the work, our excellent results, and for igniting the MRAP program by developing the first vehicles and then for the delivery and very successful deployment of thousands of them. The timing of the event was to recognize the completion of deliveries under MRAP. The company is actively pursuing sales of existing vehicles, enhanced versions of those vehicles, and new products and services, and we are looking to generate revenues from many of those initiatives. Even so, we do not expect to see vehicle production rates at the levels seen in this past quarter. We do, however, expect the company to generate significant revenue and look to be profitable going forward. However, I would caution against a straight-line projection of the revenues and earnings for the third quarter of the third quarter of 2008 to future quarters. We are proud to the fact that over 95% of the vehicles that we have shipped are still in operation after literally thousands of attacks and nearly constant use. We believe that we have the most survivable, sustainable vehicles on the battlefield. They are extremely tough and very capable and we are dedicated to keeping operational readiness at a very high level. We have seen strong validation of the quality and the capability of the Cougar over the past quarter. As our military’s operational focus shifts to Afghanistan from Iraq, we believe we are in a very good position to support the needs that will arise. The Army, which has you know, has long favored other vehicles platforms for Iraq, is borrowing hundreds of Cougars from other services for operations in Afghanistan. We believe that this reflects recognition of the suitability of the Cougar to these conditions. As we do with our existing customers, we are very focused on the service and support work for the Army so that they achieve the best results and have the best experience possible with our vehicles. We are confident that feedback from the commanders and troops on the ground will be very positive. As I believe you are aware, the U.K. Ministry of Defense has shared very positive feedback with respective to their active views for the [masted] vehicles, particularly in Afghanistan. In addition, we are enhancing the performance of our Cougar vehicles in many ways to take the capability of our vehicles to an even higher level. As you know, we were granted an award for five Cougar Restricted Terrain vehicles. These variants of the Cougar feature, amongst a large number of enhancements, improved suspension, lighter weight, greater powder weight ratios, and enhanced survivability packages. We will deliver these test vehicles in the fourth quarter so the government can begin the testing process. These are the best Cougars Force Protection has ever built and it is important to note that almost all the improvements incorporated in these latest test vehicles can be retro-fitted to the existing Cougar fleet. We see this of great value to our existing customers but it is also likely to generate additional revenues for Force Protection. There is also significant activity in regard to the Cheetah that I can report to you. We believe that there is an urgent requirement for up to 2,000 vehicles for deployment in Afghanistan, for which the latest development of the Cheetah is ideally suited. This latest version of the Cheetah incorporates independent suspension, significant weight reduction, power upgrades, and greater internal useable space. All these improvements are directly responsive to customer requirements. In addition, we have been undertaking blast testing of the Cheetah at the Aberdeen Proving Grounds and those tests are going well. We have also been working hard to address what we see as a developing need for a heavy tactical support vehicle, or TSV Heavy. This vehicle is a flat-bed version of the Cougar that can carry S cargo up to four NATO pallets. We see a demand for this type of vehicle from the United Kingdom Ministry of Defense and potentially elsewhere. I am very proud that we went from concept in July of this year to a driving, operable prototype in a matter of only 90 days. While an order has yet to be granted for TSV, we are optimistic about an initial order for approximately 100 vehicles. It is also good to see a continuing, robust need for the Buffalo. As you may have seen, we recently received an order within the primary IDIQ contract for 27 Buffalo vehicles. The government is conducting first article testing for the new A2 version of the Buffalo. As that variant comes into production we continue to have multi-year visibility to production and sale of approximately 120 vehicles per year. We are also now in a position to offer improved protection packages for any tactical-wheeled vehicles. We are ramping up our sales effort and our production capability for Force Armor. Our product is fully certified by Aberdeen Proving Grounds to address the threat from explosively formed projectiles. Compared to a very limited number of other solutions, we believe our compass odometer is lighter weight and the materials are more readily available. We are working hard to ensure that the latest delivery order for Cougars incorporate this improvement and that the customer and other vehicle manufacturers consider and adopt our armor kits for deployment on other vehicles. As of September 30, 2008, we had a total funded backlog of 335 vehicles, 116 under the MRAP program, 212 Cougar variants for delivery under other programs, the majority of which are for foreign military customers, and 7 Buffalos, which did not include the most recent order I just mentioned. This production will be completed in the first quarter of 2009, so as you can imagine we are acutely focused on turning our opportunities, which are both significant and relatively close at hand, into funded backlog. As I previously stated, our goal is to create an infrastructure that reflects the business we have and reasonably expect to win. For Force Protection this will translate into sustainable, lower rates of vehicle production. In the event of larger vehicle orders, our plan is to supplement this by utilizing our relationships and partnerships. We will continue to work to right-size our infrastructure to this model and we will be making significant decisions in the regard prior to the year end. We have an ability to further adjust our labor base and our facilities as we look to deliver profitability and positive cash flow next year. Our balance sheet at the end of the quarter continued to be strong. Our cash balance we $79.4 million and we continue to have no debt. Our working capital needs expanded, due to the increase in receivables associated with vehicles and revenue growth, but we are pleased to continue to reduce our inventory level. Our shareholders’ equity at the end of the quarter was $266.9 million, which I would contrast with our recent equity market capitalization of approximately $190.0 million. I am going to reserve some comments for closing but I would like to turn the call over now to Charles Mathis to give you some detail on the numbers for the third quarter.

[Charles Mathis:]

I would like to start by walking you through the income statement for the third quarter. Net sales for the quarter were $343.3 million, an increase of 66% versus the $206.8 million reported in the third quarter of 2007. Of this total, $255.5 million was associated with Cougar vehicle production. Cougar revenues grew 44% versus the year ago period. We also recorded $72.2 million in spare parts and services for the quarter, which compared to $14.3 million in the third quarter of 2007. This was a significant increase over last year and we anticipate this revenue to remain strong in the fourth quarter. During the first nine months of this year we have recognized approximately $155.9 million in spare parts and service revenue. We remain comfortable that fiscal 2009 service and support revenues will exceed $200.0 million. As discussed, spare parts and service includes spare parts, field service and support, training, new sales of Force Armor external ballistic kits, eye lab services, and sales related to the modernization of the existing fleet. The remainder of approximately $15.6 million of revenues in the quarter was due to Buffalo production, which is flat to the year ago total of $15.7 million, but 28% higher versus the 2007 nine-month period. Lastly, I should note that GDLS subcontract vehicle revenue for the quarter was approximately $106.9 million compared to $33.3 million in the year-ago quarter. Unlike the year-ago period, we did recognize some gross profit on these revenues. Gross margin improved by nearly 8% to 18.6% versus year-ago quarter’s level of 10.9%. This improvement was the result of several factors

[Michael Moody:]

I would like to conclude these comments by saying a little more about the strategic direction of Force Protection. I said earlier that Force Protection is continuing to move through the transition to a more broadly-based business with a wider range of products and a wider range of customers. Within the context of that comment, I believe it would be valuable for me to set out what the management team at Force Protection is committed to as we make this transition. First, that we will serve our current customers to the best of our ability. Second, that we will focus on having the production capability to deliver the highest quality products efficiently, on time, and at a reasonable price. Third, that we will ensure their spares and sustainment deliveries match the performance of our vehicles. Our troops want to use these vehicles. The vehicles take battle damage. We need to ensure that spare parts and field service representatives are there so that the operational readiness of the vehicles continues to exceed 90%. Fourth, that we are actively engaged with our customers to enhance modified developmental vehicles so that they continue to meet the customers’ needs for decades into the future and remain the most survivable and sustainable vehicles on the battlefield. Finally, we will continue to introduce new products and solutions that continually recognize the evolving threats and to leverage our strong research capabilities. In addition to that particular focus on our current customers, we are committed to developing and seeking out complimentary products and businesses that will broaden our business space and look to address the cyclical nature and narrow focus of our current business. Although Force Protection is a relatively small company, we have excellent products, a strong brand name, very capable employees and executives, and a strong balance sheet with no borrowing. We are changing our organization from within. We will also be engaging in activities to add to and change from outside. I will talk more to our shareholders about the strategic direction at the company’s annual shareholders’ meeting next week, but for now I will be happy to entertain questions.

[Operator:]

(Operator Instructions) Your first question comes from Chris Donaghey – SunTrust Robinson Humphrey.

[Chris Donaghey:]

First of all, on the support and sustainment revenue, obviously very strong in the quarter. Is that $72.2 million just the Force Protection component of support and sustainment, or is there GD component in there as well?

[Michael Moody:]

It is all of the spares and sustainment, which includes the spares delivered by GD under subcontract.

[Chris Donaghey:]

And in the press release it says that you were able to get some gross margin on the General Dynamics-related revenue. Can you talk about that a little bit?

[Michael Moody:]

We are getting some margin in regard to that spares business. In regard to the vehicles, I think you understand there’s just a small royalty fee that is payable. But in regard to the spares there is a margin that Force Protection earns on that subcontract.

[Chris Donaghey:]

And obviously in the quarter operating margin was very strong, certainly versus my expectation. As we start to think about the business going forward, can you kind of walk us through how you are going to structure the company and what kind of target margin structure you may be looking for, say a year from now, when things may be in a more normalized, non-MRAP program type of environment?

[Michael Moody:]

In general terms I think I’ve indicated in my comments that we look to structuring the company with a real focus on getting the best results for our existing customers out of the current products, out of the services and sustainment enhancement, out of those vehicles, so that’s a whole activity where there will be significant focus. And my belief is enhanced improvement. And as I said, we are looking at a broader range of products, a broader range of customers, which is complimentary to what we’re doing. In terms of margins, I think that Charles has made the comment before, and he might like to speak here, we have generally looked at our initial targets as industry averages, and certainly that is what we are looking at initially in terms of what we expect to achieve. I think that this quarter has demonstrated that we are able to enhance performance at the gross profit line and the bottom line. And certainly we have made some significant progress, but I don’t believe that is the end of the progress we can make.

[Chris Donaghey:]

In terms of the Army borrowing the hundreds of Cougars to take to Afghanistan, can you talk a little bit about, to the extent that you can, their decision-making process? Are they seeing this as just a way to get vehicles into the theater faster or is this a recognition that the Cougar is a better vehicle?

[Damon Walsh:]

I think it is a couple of things. One, they are looking for a vehicle that has greater utility in Afghanistan and they are all Cougar 4x4s that are going to the Army. The Cougar 4x4 is one a small number of variants to appear to give them the mobility that they want, matched with the survivability that you get that comes with a Cougar. So in terms of your question, the decision-making process, as we understand it, is they wanted the vehicles that would fit and would provide the mobility and still provide MRAP survivability. Obviously, we think they are taking the ones that provide the best MRAP survivability, but that’s our view.

[Chris Donaghey:]

And timing on the interim vehicle program, do you have any insight into how long this is going to play out? I know this came in under an urgency type of request. Based on where you stand with your testing program for the Cheetah, do you have any kind of insight into how the government can proceed with orders going into this interim vehicle decision?

[Michael Moody:]

Our understanding is that is likely to move very rapidly. I think within a month we are likely to see a short-term RFP, which we are certainly ready and enthusiastic about responding to. And I think that our view is that it is likely to move recently rapidly after that.

[Damon Walsh:]

And just to clarify, when you say interim vehicle program, you are talking about the [ju-ons] for the MRAP Light?

[Chris Donaghey:]

Yes.

[Damon Walsh:]

Early December is what we’re hearing is when they are planning to issue an RFP. It sounds like it will be very similar to MRAP1, an urgent RFP, a quick turn on proposals, and then going into testing.

[Chris Donaghey:]

And just like we saw with MRAP1, is there any potential to see an early order ahead of the actual formal RFP process?

[Michael Moody:]

Certainly we would encourage that. We have undertaken, as I have indicated, testing of that vehicle and that’s information that we are providing to the customer, so certainly from our point of view, we believe that a lot of testing the customer believes they need to do we will be able to demonstrate has been undertaken and will meet their requirements.

[Damon Walsh:]

But you said ahead of the RFP. I think that’s unlikely that they will order before they issue the RFP.

[Chris Donaghey:]

I guess I meant before the actual awards are made under that RFP process.

[Michael Moody:]

As I indicated, certainly we are encouraging the customer to think that way.

[Operator:]

Your next question comes from James McIlree – Collins Stewart.

[James McIlree:]

The operating expenses, relative to Q2, were up fairly substantially and I’m wondering why.

[Charles Mathis:]

The primary reason was because we were at the peak of the restatement and the audit work that was taking place there, it was probably up to $5.0 million or more in additional expenses related to those from Q2 to Q3.

[James McIlree:]

So presumably that will come down in Q4? About $5.0 million?

[Charles Mathis:]

Those expenses will come down in Q4.

[James McIlree:]

And what was headcount at the end of Q3? And what is headcount now?

[Michael Moody:]

We are continuing to reduce the headcount. I think we had indicated on the last investor call, which was about the end of Q3, that it was somewhat less than 1,500. The number is now less than 1,400, so there have been some reductions since then.

[James McIlree:]

The gross margin increase, again relative to Q2, is that primarily because of the greater mix of spares revenue or is there something else going on there?

[Michael Moody:]

There are a few things. Obviously the spares revenue has some impact to gross margins somewhat higher, but I think the significant area where our labor reduction is taking place is in directly chargeable labor. So I think that some of the significant impact is in terms of the actual cost of the input into our production. I think I may have indicated to you that not only have we seen those significant reductions, some of those have been in terms of Force Protection employees, but the company also engaged a large number of contractors and that was an expensive element which we have largely reduced. So I think a lot of it is also just related to our expense reduction activities.

[James McIlree:]

And going forward, presumable the revenues fall off in Q4 and beyond from the peak Q3 levels, and then presumably you would not have as much overhead absorption in the forward quarter. So again, presumably you would have reduced margins. Is that reduction presumption correct? And if so, how much?

[Michael Moody:]

I don’t know that I would work on an assumption that the margins are reducing. I think that we had indicated, on this call and on previous calls, that the management is very committed here to reducing our expenses to our business and the business we reasonably expect to win. So, sure, there are some overheads we need to address. We are relatively fortunate in that we have some reasonable flexibility, not only in terms of our labor cost, but some other costs related to our facilities we are evaluating at the moment. And so I think it’s not unreasonable that we continue to see that we can make expense reductions which are commensurate with reductions in our revenues.

[James McIlree:]

And on the receivables and inventory, I am assuming that both of those of come down rather sharply in Q4. Is that a good assumption?

[Michael Moody:]

They should start to come down pretty significantly. One of the things that happened, we had indicated on a previous call that we had very substantial levels of production in September and of course the impact of that is that the receivables are sitting on the books for a large part of that production. So I think as the number of vehicles we produce each month goes down, you can expect that to reduce. There is also a reasonably significant amount of work in process at the end of the third quarter. And I think you will see that start to impact as well. So it’s not unreasonable to see those numbers coming down.

[James McIlree:]

Michael, in your comments you were talking about the Cheetah as a solution for Afghanistan. This is the first time where you actually made it sound like it had more than just an outside chance of getting orders for Afghanistan. Did I misunderstand you? It sounds like you are highly confident that Cheetah will be chosen as an Afghanistan vehicle. Did I misunderstand you? And if I didn’t can you tell me why?

[Michael Moody:]

What I would best say is this

[James McIlree:]

So you are expressing confidence in the vehicle. You weren’t nudging and winking that you’ve got an order coming?

[Michael Moody:]

No, I was not saying that.

[Operator:]

Your next question comes from Joe Maxa – Dougherty & Company.

[Joe Maxa:]

Is the opportunity for your restricted vehicle Cougar and the Cheetah, are you really looking at the same opportunity in Afghanistan?

[Michael Moody:]

There are similar requirements in terms of the rugged terrain environment in terms of the requirements for protection. I think that there are complimentary requirements for our Cougar and the Cheetah. There are some specific requirements that are coming out, as we discussed, related to this much lighter, protected vehicle that has the same performance as a Humvee but the protection of an MRAP. But I think there is also an opportunity for a vehicle that is larger, that is more of the traditional MRAP size. So two related, but I think they are distinct requirements. The second point I wanted to make is it is also important to the company that we demonstrate to the customer that there is a lot of enhancement to the Cougar, which can go on new orders but is also available to the existing fleet.

[Joe Maxa:]

So the order for the potential request for 2,000 urgent vehicles, that’s targeting the Cheetah.

[Michael Moody:]

Right.

[Joe Maxa:]

And then the MRAP light certainly is targeting the other vehicle?

[Michael Moody:]

The 2,000 vehicles I think is being represented as the MRAP light. The other vehicle was an order for test vehicles which we received a few months ago. It was an MRAP order, it wasn’t specifically designated as MRAP light. It was designated as a restricted terrain. So there is a slight distinction here. I think one of the things that’s happened is various constituents within the customer have recognized requirements and have reached out to industry certainly to ask. But our view is certainly there is value in the requirements for both of these solutions.

[Joe Maxa:]

Can you give us a ballpark ASP range on what you would expect the Cheetah or the MRAP light Cougar to be in?

[Michael Moody:]

I think it’s probably in the $400,000 range, something of that order.

[Joe Maxa:]

And then the Buffalo. You have seven in funded but you have the order for 27. What would be a reasonable number to think about for Q4? Are you going to stick in the 20 range, will you be able to produce those additional 27 this quarter or is that more something next year, given lead times.

[Michael Moody:]

I think it’s better to look at those numbers in terms of the 120 a year in terms of 2009. One of the things that’s happening in this quarter is that we have the A2 Buffalo in testing, as I indicated. And what we’re doing is that are certainly some other orders for Buffalos that we are fulfilling, but I don’t think that you could look in the fourth quarter at that same production level.

[Joe Maxa:]

And then your ILS, we should expect to see some lumpiness in those quarter-to-quarter?

[Michael Moody:]

It’s possible. Certainly this year it has ramped up very significantly. As Charles indicated, we see substantial revenues from this whole area next year. It may be lumpy but there are reasonable fly of orders that we expect to fall during the whole year.

[Joe Maxa:]

On the TSV, heavy cargo Cougar, any idea when we should be thinking about potentially getting that order?

[Damon Walsh:]

We expect to get their version of a letter contract in the next 30 days or so and then the formal contract after the beginning of the year.

[Operator:]

Your next question comes from Josephine Millworth – Stanford Group.

[Josephine Millworth:]

Can you give us an update on Force Armor? Previously I believe you said you might hear something before year end. Is that still on track?

[Michael Moody:]

Yes, absolutely. As I indicated in my comments, we are actively pursuing this, but only in terms of it being fitted to our most recent delivery of vehicles. But we have the highest level of confidence. But also in regard to other of our vehicles and we are certainly in active discussions with other OEMs and the customer in regard to fitting it on a broader basis. But absolutely we expect something before year end.

[Josephine Millworth:]

Are you also looking at the long-term armoring strategy with Force Armor? Is [Al Tact] something that would be suitable for Force Armor?

[Damon Walsh:]

Absolutely. We are talking to all of the, I mean the bottom line is Force Armor potentially could be applied to anything in the tactical wheel and non-tactical wheel vehicle fleet. So anything that drives down the road is a potential opportunity for the Force Armor package. Across all of the customers, they are looking at how to enhance the survivability of all of their vehicles.

[Josephine Millworth:]

I know it might be a bit early to say, but can you help us quantify this market opportunity and how we should think about it going forward?

[Damon Walsh:]

At this point, we’re still to get our arms around everybody that is interested and potentially has, bear in mind that a requirement has to line up with funding from the customer and that’s still a little dynamic. I think it will take us a little time to get a good handle on what the size of the market, bearing in mind the market is defined as requirement and funding, before we could really talk to it.

[Michael Moody:]

But initially we’re obviously focusing on this latest delivery of vehicles from Force Protection, and then to expand it beyond that, as Damon indicated.

[Josephine Millworth:]

Michael, is that what you mean when you talked about the opportunity to retrofit existing Cougars? So that’s the initial opportunity you’re looking at?

[Michael Moody:]

It’s part of the initial opportunity. The restricted terrain Cougar, the five vehicles which we have completed and are now delivering, incorporate a number of enhancements. It’s obviously the Force Armor and the improved protection, but it also relates to suspensions, it relates to power, it relates to weight reduction. There are a series of improvements across the board and almost every one of those improvements, including this armor, can be retrofitted to the existing fleet.

[Josephine Millworth:]

When do you think the Marines will make a decision on that? Because doesn’t that involve bringing the vehicles back to retrofit? It seems like a pretty job logistically.

[Michael Moody:]

About the first thin g I should say is that we understand in active discussions with the customer that this may be looked at in terms of different compartments and different time frames. There are some enhancements and improvements that can be made relatively quickly in or near theater. And a lot of those are around suspension and potentially additional armor protection. In terms of a more substantial remanufacture and refit, that would be a longer-term program, which could very well involve the vehicles coming back. But certainly in terms of significant enhancements of the vehicles and some modifications which assist with the mobility and the operational effectiveness in Afghanistan, many of those improvements can be made in theater or near theater.

[Josephine Millworth:]

If you were to receive an MRAP light production order, how soon can you turn around and start shipping the vehicles?

[Michael Moody:]

We’re looking to make the best response possible in all ways to this opportunity. We could be producing vehicles in the first quarter of next year.

[Josephine Millworth:]

Can you help us think about your R&D spending going forward? Do you expect that to remain at the same level or is that going to increase next year?

[Charles Mathis:]

We basically indicated that R&D spending will be at around $10.0 million to $12.0 million on an annual basis and that’s what we’re looking at.

[Operator:]

There are no further questions at this time.

[Michael Moody:]

Thank you for joining this call. And thank you for those questions. I would like to invite all of our shareholders to our annual shareholder meeting which is being held on Friday, November 21 at 10

[Operator:]

This concludes today’s conference call.