Giga-tronics Incorporated

Traci Mitchell - Investor Relations John Regazzi - Chief Executive Officer Lutz Henckels - Executive Vice President and Chief Financial Officer Timothy Ursprung - Vice President Sales and Marketing

Frank Barresi - Ameriprise Financial Services, Inc. Daniel Hanasab - Dominion Capital LLC

Hello, everyone, and thank you for joining our quarterly earnings conference call. I'm Traci Mitchell, and I'm joined today by John Regazzi, our CEO; and Dr.

Lutz Henckels, our Chief Financial Officer and Executive VP. Before we begin, I need to remind everyone that this conference call contains forward-looking statements concerning operating performance, future orders, long-term growth and shipments.

Actual results may differ significantly due to risks and uncertainties, such as delays with manufacturing and order for our new ASG, receipt or timing of future orders, cancellations or deferrals of existing orders, the Company's potential need of additional financing, ability to be traded on the OTC market, uncertainty as to the Company's ability to continue as a going concern, the volatility in the market price of our common stock, results of pending or threatened litigation and general market conditions. For further discussion, see our most recent Annual Report on Form 10-K for the fiscal year ended March 31, 2018, Part I, under the heading Risk Factors; and Part II, under the heading Management's Discussion and Analysis of Financial Conditions and Results of Operation.

With those reminders in place, I will now pass the call on to John Regazzi, our CEO.

Thank you, Traci. Good afternoon and thank you for joining our quarterly conference call.

We will review the numbers in a few moments, but I want to first affirm that management has been driving the business with a new sales strategy, and we expect future growth in the Company with the anticipation of advanced signal generation system orders. We've reevaluated the target market and our products fit, and we have developed an even deeper understanding of the opportunity and how we can reach the customer base.

I have been personally supporting our U.S. Navy customer in using their installed Threat Emulation System, which is based upon our advanced signal generation product.

And on each subsequent visit, I hear about additional ways how our competitor systems are unable to fulfill the Navy's testing requirements. Our Threat Emulation System is increasingly being viewed as the more capable solution because of its flexibility in creating complex signal scenarios.

This is due to the platform's unique architecture, which represents our key advantage in addition to size and cost the alternatives from other suppliers. I believe the U.S.

Navy fully intends to deploy our solution more widely, which is why we are forecasting orders from them for additional Threat Emulation Systems in the fourth quarter of this fiscal year. It is clear to me that there are many similar test requirements at other U.S.

Navy installations and at Air Force bases and at U.S. prime contractors throughout the country.

I am more convinced than ever that we have the right product, the right solutions and now the right sales approach to address this market. With that, I'd like to turn the call over to Dr.

Lutz Henckels to go over the numbers. Lutz?

Hi, thank you for joining this call. I will first express the fact that during the last two conference call, we outlined the major transition that the Company has made over the last six years to transition away from product lines that had little differentiation, there were two products with poor gross margin to a highly differentiated microwave RADAR test business with, not only differentiated products, but very good gross margin.

And we achieved that by building on our strength, which is Microwave technology and Microwave RADAR test systems. We have finally completed this transition, and we will now talk about the progress that we have made during the second quarter of fiscal 2019, which ended in September 30, 2018.

Now before going into our financial results, I need to explain to you a change in our accounting standard. Effective April 1, 2018, the Company was required to adopt the accounting standard which is called ASU 2014-09.

Another way of saying it is revenue from contracts with customers, which is also commonly referred to as ASC 606. So I will be referring to ASC 606, and this may change the way the Company recognizes revenue for certain products.

So until the end of FY 2018, we recognize revenue and we ship and invoice the customer. This is a much preferred way of recognizing revenue.

That's what I would like to do, but we have no choice. Under ASC 606, we must recognize revenue based on percentage completion of contracts as it incurs cost.

So the financial results for the three months ending September 30, 2018, that we are presenting today have been adjusted for this new method of accounting. However, that makes the comparison to Q2 FY 2018 more difficult because they didn't use the new standard.

So I will try very hard in this conference call to make it clear the impact that the new standard has so that you do, indeed, get a meaningful comparison. So let's start out with sales, okay?

Net sales in the second quarter of FY 2019 ending September 30, 2018, was $2.68 million. That's a 20% increase in revenue from the year-ago quarter, the second quarter of FY 2018, which was $2.242 million.

However, that 20% increase was basically all due to this accounting change and was not due to the Company really increasing the sales. So think of sales were flat when you don't take into account the accounting change.

Now going to the gross margin, the gross margin for the second quarter of fiscal 2019 were 42%. This compares with 22% for FY 2018.

Now there is no impact from ASC 606 on the gross margin. So this is truly achieved improvement in the gross margin from 22% to 42%.

And I should point out that for the last three quarters, including this one; we have shown above 40% gross margins. And I fully expect that to go forward for the next quarters, in fact, to get above even 45% as we go forward in time.

And so we will have gross margins that are much better than what we had a year-ago, and ASC 606 had zero impact on that. Then let's go to the net operating loss, okay?

The net operating loss for the second quarter of fiscal 2019 was $117,000. This compares with a net loss of the second quarter of 2018 of $1.018 million.

So a vast improvement, okay? There are four components to the reduction in the losses of the reduction from $1.018 million to $117,000 that's $901,000.

$496,000 of that reduction is due to the improvement in the gross margins that I mentioned. $262,000 is due to the reduction in operating expenses.

$8,000 is due to a sales increase. So yes, we increased sales a little bit.

And $135,000 is due to the accounting change. That adds to $901,000.

So really, the Company performance was really fundamentally the cause for the improvement in the performance because $496,000 was gross margin improvement, $262,000 was operating expense improvement, the $8,000 was sales improvement and only $135,000 was ASC 606. Going to the bottom line, now the net earnings, we need to first look at interest on other expenses.

For the second quarter of fiscal 2019, they were $165,000. This compares with $123,000 a year-ago, the second quarter for fiscal 2018.

That $42,000 difference has really two components: one component is due to the interest expenses to PFG partner for growth; and $23,000 is due to the 6% accrued interest for the E series. I will come back to the E series, but we’ve raised money, we're paying a 6% interest on it.

However, this $165,000 that we incurred in interest and other expenses, only $50,000 of that is really cash payments. The rest is accrued and other type of payments, but not cash.

Combining the operating loss of $117,000 with the interest payment of $165,000 gives us a net loss of $282,000 for the second quarter of fiscal 2019. This compares with a net loss of over $1,081 million loss for the second quarter of fiscal 2018 last year.

Now I should point out that we made a loss of $117,000, but you also have to recognize that $81,000 is depreciation and $46,000 is stock-based compensation. So we have an EBITDA that is positive $10,000.

And so we have seen that kind of breakeven positive EBITDA for the last two quarters. Going after the balance sheet.

Our balance sheet is still weak. Our shareholder equity increased by $232,000 to $1.529 million from the prior quarter.

And we have $512,000 cash in the bank. This compares to a shareholder equity of $87,000 negative a year-ago and cash of $747,000 a year-ago.

So the cash basically decreased from $747,000 to $512,000, and so there is a decrease there. However, the shareholder equity improvement to $1.529 from a negative equity of $87,000 is all due to this ASC 606.

Because the Company has made losses, so how can you improve the equity. So it's this ASC 606 accounting that causes the equity to jump, as I have explained.

The actual decrease in cash of $235,000 was primarily due to net losses that we made during the quarter of $281,000. What stems out on the balance sheet is our net inventory of $3.211 million.

$2.75 million of this inventory is for RADAR test systems. That is way too high, and we believe that we can get easily at least $2 million cash out of this inventory in this fiscal year 2019.

And so yes, we were generating cash not only by being profitable, but also by reducing the inventory by approximately $2 million during this fiscal year. However, cash is still a concern.

And so we expect a large order from the Navy, which is 100% shippable prior to the year-end fiscal 2019, which is March 31, 2019. And then because of the profits on that and the inventory reduction, we do expect to generate substantial cash in the neighborhood of $4 million to $5 million.

However, to be – it's not a matter of if we get the order. It's more a matter of when we get the order.

To make sure that we have enough space and runway, the board has allowed us to increase the E Series from $1.75 million to $2.5 million, and so we plan to execute on that. In summary, we have showed now near breakeven performance on an EBITDA level, and that's without any sales from our RADAR test business.

This was achieved basically by improving much the gross margin and by lowering the operating expenses. The accounting change of 606 impacted the bottom line by $135,000.

So this is sort of my CFO part of the presentation. Now I come more into my Executive Vice President part, and that is where are the – I'm not supposed to use the word second, where are the orders.

Maybe let me be more polite, okay? Like I mentioned, it's not if.

It's a matter of when. And truly, we expect a profitable fiscal year with substantial growth and the fiscal year ends in March, okay?

We have the right sales team, and John mentioned that and I'd like to just explain that a little bit more. And that is there were sales people that left about a year-ago, July a year-ago, and they were not replaced with sales people.

But there's a Marketing Director and there's an Applications Director. And so fundamentally, we didn't have people in sales for a year.

What we needed to do is not only change – put the right sales team in place, but also have the right sales strategy. So we moved away from a strategy that was selling boxes to a strategy that sells true test solutions.

And we hired a sales team that comes from the military aerospace that have military experience, who have been sales people for a long time, they know the customers, they know the prime contractors, they know the bases. They have access to go into the bases.

They are secured and so we needed those kinds of people that have the relationships established with the customer. We hired those people.

We have tripled our funnel, since they came on Board, and I'm very confident that this fiscal year will be very profitable and a good growth. And that the orders for the RADAR test system will materialize.

It's not a matter of if. It's just a matter of when.

And with that, I would like to thank you, and I'm ready for questions that you may have.

Lutz, I was just wondering, what is delaying the order?

Okay. I mean, we have deep insight into it, and I'm not allowed to share the absolute detail.

However, let me give you at least a flavor, okay. And that is the procurement with our customer is limited in resources and FY 2018 budgeted – or financed orders must be completed by the end of November.

We are FY 2019 budgeted order and so we are not the first priority for them and there are limited resources within the procurement. So that's how much I can characterize it.

Okay.

But there is no – I have no concern of whether we get the order. It's just a matter of how quickly we get it.

Okay. Well, thanks.

I have a two-part question. With regards to the first question, I'd like – if you could just really elaborate and drill down on the change in accounting standards.

I believe that prior to fiscal 2018, there was one that's part of a ship and an invoice was sent. But could you please elaborate on exactly how the revenue is being recognized now?

How about, Traci, you do that one?

So certain contracts have – are now being recognized. Basically, you take the total contract value or the total order price, and you also evaluate the total costs to complete the order.

And as we incur costs related to a particular contract, it's like a percentage completion basis based on costs incurred.

So the revenue is recognized prior to the product being shipped?

It can be, that's correct. But the total at the end can only be the contract price so...

Of course, yes. So it's essentially deferred revenue?

It was just – yes. Well, it was deferred revenue.

Now we basically – as we incur the costs related to the contracts, we do that as a percentage of the total expected cost, and we recognize the revenue applying the percentages.

So essentially, the cash flows – excuse me, the revenue will predate the cash flows?

Yes, pretty – the revenues will – that's correct.

And with regards to Microsource, I think it's – I believe it accounted for entirely all of your revenues for this quarter. How much more of a backlog is less and more of that backlog is shippable within 1 year?

The backlog is about $3.3 million, and it's all shippable within the year.

I should point two things. On the backlog side, under 605, it's $7 million – $7.073 million.

So it's – we are saying, okay, it's – the revenue recognition is $3.299 million. And the ASC 605, which is when we ship, is $7 million.

So I apologize. I'm a little bit confused.

So when you say $7 million and $3 million, that's a big difference. Could you please explain where that difference comes from?

Traci, would you like to explain?

Yes. So because our revenue is no longer based on shipments, we have to adjust our backlog because we recognize revenue on products that are sitting in backlog because we've already started the production of those products.

So we've incurred the cost to start producing the project, which accelerates the cost percentage. And when you apply the percentage to the total cost to complete, we've recognized revenue on backlog that's still sitting – that hasn't been delivered to the customer, yes.

So it negatively affects your income statement, but the cash flow statement will benefit in the future?

It doesn't really – it actually positively affects our income statement right now.

But prior income statements. Yes, moving forward, it'll – or it won't hurt, but it's just the backlog in – I think I understand, yes, so it's being recognized now.

Well, I mean, by the way.

Yes, we can have product sitting in backlog that we've already recognized revenue on basically, so...

So it means this whole thing is – makes me unhappy. It costs a lot of money to do this accounting, and it doesn't help us at all either understanding the financials or helping us in some form.

But we have no choice. We must use ASC 606.

But under – in shipment revenue, backlog is $7 million.

I understand. Okay.

Thank you, sir. I appreciate that.

And under 606, it's $3.299 million, what can I say.

No, no, I'm not blaming you guys. I just want to make sure I understand the Company's financials in that new law.

I think it's a way for accountants to make money on their public firm.

Well, anyway thank you for everything. I appreciate you.

All right. Thanks Daniel.

End of Q&A

Okay. Well, I would like to thank you for being on the call, and I do believe we have a good fiscal year coming, profitable and growth with greater test business.

And it's not a matter of if, it's just when. Thank you.