Steve Gitlin - Vice President Corporate Strategy, Investor Relations and Communication Wahid Nawabi - President and Chief Executive Officer Teresa Covington - Senior Vice President and Chief Financial Officer.

Ken Herbert - Canaccord Genuity Jon Ladewig - Stifel, Nicolaus & Co Peter Arment - Robert W. Baird & Co.

Good day, ladies and gentlemen, and welcome to the AeroVironment, Incorporated Second Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. We will conduct a question answer session after the management’s remarks. As a reminder, this conference is being recorded for replay purposes.

With us today from the Company is the President and Chief Executive Officer, Mr. Wahid Nawabi; Senior Vice President and Chief Financial Officer, Ms. Teresa Covington; and Vice President of Investor Relations, Mr. Steve Gitlin. And now at this time, I would like to turn the conference over to Mr. Gitlin. Please go ahead, sir..

Thank you, Adrian, and it’s good to be with you today. Please note that on today’s call, certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements; and may contain words such as believe, anticipate, expect, estimate, intend, project, plan or words or phrases with similar meaning.

Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties, including but not limited to, economic, competitive, governmental and technological factors outside of our control that may cause our business strategy or actual results to differ materially from the forward-looking statements.

For further information on these risks, we encourage you to review the risk factors discussed in AeroVironment’s periodic reports on Form 10-K and Form 10-Q filed with the SEC and the Form 8-K filed today with the SEC along with the associated earnings release and the Safe Harbor statement contained therein.

The content of this conference call contains time-sensitive information that is accurate only as of today, November 29, 2018. The Company undertakes no obligation to make any revision to any forward-looking statements contained in our remarks today or to update them to reflect the events or circumstances occurring after this conference call.

We will now begin with remarks from Wahid Nawabi..

a $5.9 million NATO support and procurement agency contract for Raven systems for the Portuguese Army, our first contract with Portugal; a $13 million U.S.

Air Force IDIQ contract to support Raven Systems to multiple Caribbean nations; a $9 million Puma Systems award for a Baltic Nation and a $3.2 million Puma Systems award for an ally in the DoD’s Indo-Pacific Command Region. We believe small UAS and TMS are in the early stages of market adoption.

We envision a future in which unmanned systems deliver increasingly valuable capabilities across defense and commercial markets and well beyond their contributions today. Achieving these broader and deeper penetration of unmanned systems requires continued innovation across hardware and software domains.

It also involves the implementation of unmanned solutions in new integrated approaches in which they work together to deliver more significant benefits to our customers. In October, we announced a teaming agreement with General Dynamics Land Systems that serves as a powerful example of this new integration approach.

We are working with General Dynamics to integrate small UAS Switchblade Tactical Missile Systems into armored combat vehicles for new upcoming U.S. Army and Marine Corp’s acquisition programs and for potential retrofit of existing vehicles.

Essentially, we are establishing a new paradigm for air power in which armored vehicle commanders would possess their own aerial capabilities for reconnaissance and precision strike while stationery or on the move.

Working together, our small UAS and Switchblade for example, can deliver game-changing situational awareness and precision strike capabilities directly to the commander of an unarmed – unarmored vehicle. This represents a new channel for us to enable and protect the war fighter.

It can also generate additional demand for our solutions through our other programs of record. This also represents an important new way to integrate our unmanned systems into other platforms to enhance our customers’ battlefield capabilities across multiple domains.

While development of this integrated solution is at a very early stage, we are confident in its superior ability to enable and protect the war fighter. In our nascent commercial businesses, we remain focused on executing our design, development and demonstration program for HAPS.

We consider the ongoing announcements of new competing solutions emerging from multiple new players in this market as the recognition of the potential of this large global opportunity. In Commercial Information Solutions, we continue to expand our reach into the large agricultural market.

We continue to believe in the compelling value proposition of our unique solution. However, the overall market adoption rate is lower than most anticipated as we have previously communicated. We continue to seek strategic partners to help us capitalize on this potentially large long-term value creation opportunity.

Now, Teresa will review our second quarter financials.

Teresa?.

Small UAS was $83.4 million, TMS was $37.8 million, HAPS was $24.4 million and other was $5.4 million. Gross margin for the first half of fiscal 2019 was $61 million or 40% as compared to $38.8 million or 39% for the first half of fiscal 2018.

The increase was due to an increase in product margins of $20 million and an increase in service margins of $2.2 million. Gross margin as a percentage of revenue increased from 39% to 40% due primarily to higher gross margin and product sales, partially offset by lower gross margins and service revenue.

SG&A expense for the first half of fiscal 2019 was $25.6 million or 17% of revenue compared to SG&A expense of $24.1 million or 24% of revenue for the first half of fiscal 2018.

R&D expense for the first half of fiscal 2019 was $14.5 million or 10% of revenue, compared to R&D expense of $12.4 million or 12% of revenue for the first half of fiscal 2018.

Income from continuing operations for the first half of fiscal 2019 was $20.8 million or 14% of revenue, compared to a $2.4 million or 2% of revenue for the first half of fiscal 2018.

The increase in income from operations was primarily due to an increase in gross margins of $22.2 million, partially offset by an increase in R&D expense of $2.2 million and an increase in SG&A expense of $1.6 million. Net other income for the first half of fiscal 2019 was $11.7 million, compared to the prior year net other income of $0.9 million.

The net other income increase was primarily due to a litigation settlement income earned under a transition services agreement with Webasto Charging Systems and an increase in interest income resulting from higher short-term interest rates in fiscal 2019.

The effective income tax rate from continuing operations was 11.6% for the first half of fiscal 2019, as compared to an effective income tax rate of 4.2% for the first half of fiscal 2018.

The increase in effective income tax rate was due to higher income before taxes, partially offset by a reduced federal statutory rate from the Tax Cut and Jobs Act.

Equity method investment activity, net of tax, for the first half of fiscal 2019 was a loss of $1.4 million or $0.06 per diluted share, compared to no equity method investment activity, net of tax, for the first half of fiscal 2018.

Net income from continuing operations attributable to AeroVironment for the first half of fiscal 2019 was $27.4 million or $1.14 per diluted share, compared to a $3.4 million or $0.14 per diluted share for the first half of fiscal 2018.

Our funded backlog as of October 27, 2018 was $163.9 million, an increase of $50.3 million or 44% from the second quarter of fiscal 2018 and an increase of $6.8 million or 4% from the first quarter of fiscal 2019.

Turning to our balance sheet, cash, cash equivalents and investments at the end of the second quarter of fiscal 2019 totaled $320.3 million, an increase of $22.5 million from the end of fiscal 2018 cash, cash equivalents and investments of $297.8 million.

Net accounts receivable including unbilled receivables and retention at the end of the second quarter of fiscal 2019 totaled $80.3 million. The unbilled receivables and retentions balance of $45.7 million inclusive of $7.8 million related party amounts.

The unbilled receivables and retention balances arise due to timing differences between revenue recognition and billings. All revenue from Tactical Missile Systems contracts is now recognized over time which generally accelerates the timing of when revenue is recognized and results in an increase to unbilled receivables.

Total days sales outstanding from continuing operations for the second quarter of fiscal year 2019 was approximately 95 days, compared to 48 days for the fourth quarter of fiscal year 2018.

Net inventory at the end of the second quarter of fiscal year 2019 was $46.1 million, compared to $37.4 million at the end of the fourth quarter of fiscal year 2018. Days and inventory outstanding for the second quarter of fiscal year 2019 was approximately 89 days, compared to 79 days for the fourth quarter of fiscal year 2018.

Accounts payable at the end of the second quarter of fiscal year 2019 was $14.1 million, compared to $21.3 million at the end of the fourth quarter of fiscal year 2018. Total days payable outstanding for the second quarter of fiscal year 2019 was approximately 27 days, compared to 24 days for the fourth quarter of fiscal year 2018.

Turning to capital expenditures, in the second quarter of fiscal year 2019, we invested approximately $2.7 million in property improvements and capital equipment and recognized $1.8 million of depreciation and amortization expense. Now an update to our fiscal 2019 visibility. As of today, we have year-to-date revenue in fiscal 2019 of $151 million.

Second quarter ending backlog that we expect to execute in fiscal 2019 of $127 million. Q3 quarter-to-date bookings that we anticipate to execute in fiscal 2019 of $0.3 million. Unfunded backlog from incrementally-funded contracts that we anticipate to recognize revenue during the balance of the year up $17 million.

This adds up to $296 million or 97% at the midpoint of revenue guidance. We anticipate a full year effective tax rate for continuing operations in the range of 12% to 14%. Now, I’d like to turn things back to Wahid to discuss AV's expectations for fiscal year 2019..

Thanks, Teresa. We are executing our plan effectively and enhancing our position for long-term value creation. Customer demand for our solutions remains robust supported by strong DoD appropriations for those solutions.

With strong and steady performance so far this year, we now have 97% visibility to the midpoint of our revised revenue guidance range as Teresa described. This represents historically high visibility for us at this point in the fiscal year.

The term visibility in this context refers to converting funded backlog and unfunded commitments and revenue in the current fiscal year. So, while visibility tells us much about the front-end of the business, there remains timing and execution risks to fulfilling those orders on the back-end in achieving our full year guidance.

With respect to our earnings, year-to-date, we have also generated earnings per share from continuing operations of $1.14 which places us within our EPS guidance range already.

While this as context – with this as context, we are narrowing our revenue guidance within the upper portion of our range to between $300 million and $310 million and we are raising and narrowing our earnings per diluted share from continuing operations guidance range to between $1.30 and $1.50.

As we indicated earlier this fiscal year, we expect first half revenue to be similar to second half revenue and fairly evenly distributed across all four quarters. This represents a significant change from prior years when historically our fourth quarter produced the largest quarterly revenue.

We also expect lower profitability in the second half mainly due to higher planned operating expenses and a shift in our revenue mix with higher services sales compared to product sales. We continue to expect research and development investments to total 10% to 11% of full year revenue. These factors drive the revised guidance which I just outlined.

We are confident in our ability to extend our record of delivering on our objectives and achieving these revised targets. In summary, to reiterate our main points for today’s call, first, our team is successfully executing our plan as reflected in our strong first half results.

Second, continued strong backlog and visibility keep us on track to achieve our fiscal year 2019 objectives and third, robust customer demand for our innovative solutions coupled with our strategy, support our long-term value creation goals. Thank you to AeroVironment’s team members for your relentless drive to serve our customers and stockholders.

Thank you to our customers who placed their trust in AeroVironment to support their critical missions. And thank you to our stockholders for recognizing the value creation potential of our people and our company. Teresa, Steve, and I will now take your questions..

[Operator Instructions] And our first question comes from Ken Herbert of Canaccord. Please go ahead. Your line is open. .

Hi, good afternoon. .

Good afternoon, Ken. .

Hey, Wahid, I first wanted to ask about the LMAMS, the $110 million in the fiscal 2019 budget, I am curious, have you seen any of that? I mean, is that – any of that yet under contract? I know you talked about timing and I know we are very early in the fiscal year, but can you just update us on where we are in the contract? Have you seen any of that yet? And then, maybe, how we should expect? Or how much of that potential in the budget do you see in your fiscal 2019 just considering the timing?.

Sure, so, Ken, the $110 million appropriated and authorized budget dollar amounts that are in the government fiscal year 2019 which I mentioned earlier is not under contract with us yet. We are already working on that. We are aware of it as I mentioned.

And we continue to work towards the definitization and finalization of that contract with the customer and once we do that, we will obviously update you as we go forward. At this time we are in that position. .

Okay.

So, is it possible, Wahid, that you can just give an estimate of maybe how much of that is factored into the guidance this year versus how much maybe falls into your fiscal 2020?.

So, unfortunately, because we are still in contract negotiations and definitization process, I am not in a position to be able to comment on that specifically.

Historically speaking, it always have taken us a certain amount of time for us to negotiate the contract, definitize it, finalize it and then, we have to produce the product and then obviously test them and then get approval from the customer to be able to deliver them. All of that activity is obviously planned and underway, but still to be done. .

And our next question comes from Jon Ladewig from Stifel. Please go ahead. Your line is open. .

Hey guys. Thanks for taking my call.

I was hoping you guys could first start off with updating us on your capital allocation plans these days and kind of give us some color on what’s the latest thoughts are around HAPSMobile?.

Yes, hi there, Jon. So, in terms of capital allocation, we currently in our financial outlook that we provided assume a 5% ownership in the joint venture with HAPS. You mentioned specifically HAPS.

But, per contract terms, we have the ability and the option to increase our joint venture ownership up to 19% during this step two contract with certain terms and conditions that are within the contract. And we have not to-date executed that or implemented that. So, as we progress through this process, we will keep you updated.

And so, as I’ve said before, the initial joint venture was a $100 million joint venture which contributed up to 5% of that for the ownership piece.

That’s one piece and then obviously besides that we have our ordinary capital consumption and investments in various parts of our business such as tooling and fixtures and operations that we do and Teresa usually provides an update on that and that’s the primary status of our capital expenditures year-to-date for this year. .

All right. Thank you. The two other ones here, just real quick. Can you kind of update us on the impact to change in the export laws have had on your sales to-date? You talked about a bunch of the international sales.

But has it fundamentally changed since the White House made that transition for allowing for additional exports? And then, can you kind of give us some color on the breakout for sales between TMS, international, small and HAPS?.

Sure. So, in terms of export licensing Jon, we really haven’t noticed a significant or meaningful change in the way that export license are being processed or authorized.

Having said that, historically speaking, we have a very strong track record of obtaining and complying with all the requirements with the state department for obtaining those licenses. And as you heard from my comments, we are up to over 45 allied countries now in terms of international customers for our small UAS products and solutions.

And it’s a growing list and I mentioned the number of new awards that we have achieved in the second quarter earlier in my remarks. In terms of the breakdown of the revenue, Teresa can actually help you through with those numbers now. .

Hi, Jon. As I had talked about in my prepared remarks, for the first six months of fiscal 2019, small UAS was $83.4 million, Tactical Missile Systems was $37.8 million, HAPS was $24.4 million, other was $5.4 million. For the first half of fiscal 2018, small UAS was $67.1 million, TMS was $18.9 million, HAPS was $9.6 million, other was $4.5 million.

For the first six months of fiscal 2019, our domestic sales were $82.1 million, international sales were $68.9 million and for the six months in fiscal 2018, domestic sales were $60.7 million, international sales were $39.4 million. .

And your next question comes from Ken Herbert of Canaccord. Your line is open..

Yes, hi, good afternoon. I just wanted to follow-up..

Hi, Ken..

Yes, hi, Wahid. You had mentioned part of the headwind in the second half of the year, at least from a margin or maybe gross margin standpoint was going to be a step-up in some corporate expenses.

And I am just wondering if you could maybe just provide the magnitude of that and is that something we should think about a sort of one-time as we think about sort of moving out of the second half of 2019?.

Sure, Ken. So, I can – generally speaking, as I mentioned in my remarks, our second half profitability profile looks obviously slightly lower than our first half to achieve the results that I provided in my guidance, the revised guidance. And there is two primary reasons for that.

First is, our revenue mix and in the revenue mix given any quarter, because our revenue is made up of large sums of projects and solutions deliveries, the profile of those contracts and profitability [Inaudible] could vary, such as services contracts versus product contracts and cost plus contracts, firm fixed price contracts, et cetera, et cetera.

So that's one category of impact for the second half. The second one is we also expect and plan higher operating expenditures both on the R&D side, as well as on the SG&A side.

And those two factors are the primary factors that’s affecting the profitability for the second half and yes, to your second question, we – this is really, what I refer to based on the timeframe that you look at this kind of a number.

In other words, I don’t foresee it as a systemic issue, I see this as a unique to the second half of the year as we are today and it may change in different directions in the future, Ken. .

Okay, that’s very helpful. And if I could just one final follow-up. You had also mentioned that the $6.5 million I believe was expected payment in this quarter from the purchaser of the EES business was in dispute.

Is that – do you think there is risk to that number or is that just sort of timing? I mean, how do we think about that potential cash payment for that final transaction?.

Sure, Ken. So, yes, as Teresa mentioned, that is in dispute right now with us and the purchaser of the assets and as you know, in different transactions, there is always issues related to deep contract terms and how new negotiate those things. We are obviously working with them on that.

We are still currently providing transitional support services to them in multiple fashions. However there is a risk to that and we are working through that and as we have more updates throughout the next several months and quarters, we will update you and let you know. .

[Operator Instructions] And our next question comes from Peter Arment from Baird. Please go ahead. Your line is open. .

Yes, good afternoon, Wahid. .

Hi, Peter. Good afternoon. .

Hey, so, the question I guess is around, you’ve got 45 countries I guess, the international mix continues to grow.

Can you talk us a little bit about how – are all those countries come with service contracts? Is that potentially a longer tail or the revenue stream as this grows with the international mix? And then, just as a follow-up unrelated, but when do you expect to deliver the two prototype aircraft for HAPS? Thanks..

Sure. Peter, so, in terms of our international market and customer adoption, we are now up to over 45 countries. The types of contracts that we have with those customers all vary. But overwhelming majority, yes, they have both initial hardware sales.

In addition to that, we also have logistics support services and training services to help our customers train and using our products and then also maintaining and operating our products and solutions. So that is definitely true.

And secondly, in general, the when we acquire a new international or domestic customer, there is always historically and in the future as well, continues to be a long tail in terms of sustainment and maintenance and upgrades.

And in general, the international markets – I have said this before that we still believe it is about five plus years behind the adoption curve of our U.S. domestic customers in terms of maturity and adoption.

So, as I said before, we continue to believe that the international markets for our small UAS is strong and remains robust and we are working to not only grow the number of international customers, but also our share of their spend and our solution portfolio within those customers can grow as a family of solutions for those customers as we go forward.

In terms of HAPS, we have not specified the specific timing of the deliveries of the two airplanes. What we said before, we continue to say that, we are right now focused on executing our step two design, development and demonstration program which includes the delivery of two airplanes in that process.

And as we have updates, we will obviously keep you notified..

[Operator Instructions] And we have no questions in the queue. This will conclude today's teleconference. Thanks for participating and you may now disconnect..

Thank you. .

Thank you. .

Thank you..