Paul Campbell - Chief Financial Officer Andrew Sculley - Chief Executive Officer and President

Andrew Uerkwitz - Oppenheimer Kevin Dede - H.C. Wainwright Dennis Van Zelfden - Brazos Research Tom Rath - Davidson Investment Advisors

Good afternoon, everyone, and welcome to the eMagin first quarter 2015 conference call. [Operator Instructions] At this time, I'd like to turn the conference call over to Mr. Paul Campbell, Chief Financial Officer. Sir, please go ahead.

Thanks very much, Jamie. Welcome everyone, thanks for joining us today for our first quarter 2015 earnings conference call. It's good to be with you, and it's good to be here in soggy Seattle today as well. As always, before we begin, please note that we will be referring to numbers that are part of our quarterly report on Form 10-Q for the fiscal quarter ended March 31, 2015. During today's call, we may make forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on the company's current expectations, projections and beliefs, and are subject to a number of risks and uncertainties. Such statements include references to projections of future revenues, plans for product development and production, the company's ability to ramp up production, future contracts, product benefits, operations, liquidity and capital resources, as well as statements containing words like believe, expect, plan, target, et cetera. Our risk factors are included in the company's Form 10-K for 2014, on file with the Securities and Exchange Commission. Except where required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements for any reason. With that, I'd like to turn it over to eMagin's CEO, Andrew Sculley.

Thanks, Paul. Hi, everyone, and thanks for joining our call today. I'll begin with some corporate highlights, and then Paul will discuss our financial results. Following Paul's remark, I'll update you on a few additional items, and then we'll open the call up for questions. We believe the Virtual Reality or VR and augmented reality or AR markets will be large future markets for both our immersive headset and our displays. There are market estimates from a respected research firm that says that there will be over 38 million VR headsets sold in 2018. Another research company estimates the virtual reality market size in 2020 will be $30 billion, and the AR market will be $120 billion. The 2020 market estimate numbers include headset, software, and other hardware. These numbers tell us that the market for our outstanding headset is very promising. We have shown the headset to a number of potential partners and customers, everyone was impressed with the display resolution. It is outstanding compared to every other headset they have seen. And we had one person, and I can't mention his company, so forgive me. One person say, this is the best headset I have ever seen. The viewing angle or field of view of over 100 degrees diagonal works very well, especially when we put on head tracking on the headset. The weight is much lighter than the other large field of view HMDs, and our headset has a diopter adjustment, so it can be worn without glasses, very important, because it fits close to your face, and an inter-pupil adjustment for best fit, because people have different distances between their pupils. We've hired Dan Cui as the Vice President of Business Development for the new HMD effort. Dan has been in this space for very many years. For example, last two jobs he's been the Vice President of Business Development for Vuzix and Myvu, both prior to joining us of course. His effort to raise awareness in the market for these companies attracted investment, and all you have to do is look up what investments both Vuzix and Myvu got, and you'll see the promise that Dan holds out for us. His effort to raise awareness attracted that investment, as I mentioned, this plus his knowledge in the consumer and industrial space will enable our HMD effort to grow. He already has ideas for the next products beyond the one we just produced, and these products will go after the other markets that I mentioned. We have the HMD, the IP for that HMD, a Vice President of Business Development with new market product ideas, and the contacts. He also has the contacts to get these product ideas implemented. And finally, the HMD demonstrations have gone very well and we're still pushing additional demonstrations. On the display side of the business, 38 million headsets in 2018 is a very large market for us. Those using microdisplays of course will have two displays per headset. We're in discussions about displays with some Tier 1 companies. The market understands the need for higher resolution displays for both AR and VR devices, and this has been a key driver and the enthusiasm for our displays. The companies that we're talking to are looking for higher resolution displays, and that's why they come to us. Now, I can imagine your first question must be, if the current consumer-oriented VR headsets are using cell phone displays, why would they come to use microdisplays in the future? And the advantages of microdisplays for this market are many. The resolution capability is incomparable. OLED cell phone display companies say that they are working on resolutions, and you can look this up about 3800 x 2000, so almost 2k by 2k per eye. You might remember the cell phone display is split in half, not physically, but optically. And the current OLED cell phone displays use a PenTile approach, however. And a PenTile approach really means that the device has a green and red pixel, followed by a green and blue pixel as opposed to three subpixels in a pixel, so it's green red, green blue, green red. And the companies with which we spoke say that they don't want to use a PenTile pixel approach. And basically the issue here is it's a compromise on both resolution and color. And they can't get to the image that they want with this compromise. Now, our microdisplays have no difficulty with higher resolutions, with each pixel containing all three subpixels, red, green and blue, and so the resolution can be significantly better for the same size display, not per eye I'm talking about here, or we can make a smaller display with a much better resolution, and again the color will be the way it should be. Obviously, resolution and realistic color is best with red, green and blue subpixels in each pixel, and that's what makes an OLED microdisplay better than an OLED cell phone-size display. And again, here what I'm saying is that in order to get that resolution in a cell phone-size display, OLED cell phone-size display, they need to make compromises on the structure. We did focus group study on gaming with another company for HMDs a while back. The feedback was the cell phone, virtual reality headsets had very good field of view, but the people could see the pixels and that bothered them. This is where we learned just how important both resolution and field of view were for headset. This field of view alone, which is what the cell phone-size HMDs have today is not good enough, and that's why the companies are talking to us, and they realize that it's hard for the cell phone companies to get to the resolution they really want. OLED cell phone displays also have a very poor aperture ratio. This means there is much blank space between the pixels that light. The current cell phones have an aperture ratio of about 20%, and again that means the 20% of the space is comprised of areas that are mid-light and the other is dark space. Our displays have more than 70% aperture ratio, with much smaller pixels. This is another issue mentioned by the companies with whom we spoke. They don't want to see the space between the pixels, when they magnify the display. And of course, our microdisplays easily satisfy this, because they are made to be magnified, and they have little blank space between the pixels. And that's what people call, it's like looking through a screen door, you can actually see the dark areas in the display. Speed is also important, and what that means is that OLED displays are far superior than LCD, which is why a number of HMDs with cell phone displays have moved to OLED. Our OLED microdisplays have the speed required for all demanding applications, including night vision for our jet fighter pilot helmets, where any lag could be a disaster. Our microdisplays are designed for headsets. They have the resolution, aperture ratio, high speed, low power consumption, high contrast and dynamic range that is needed for these applications. Now, we've studied what we need to do in the VR market, and one of these items is to consider getting our cost down. Obviously, the consumer market is going to push cost down. We have explored the changes we need to make for these types of reductions. As an example, today our displays function from minus 40 degrees Celsius, and that's also minus 40 degrees Fahrenheit, to about plus 70 degrees Celsius and that's 158 Fahrenheit. Because this is not necessary for consumer markets, we have explored creative cost reduction ideas for making displays without these military requirements. We're really pleased with the results. We've gotten to where, when we talk to these customers they tell us what they are looking for in terms of cost, and they are looking for bigger displays than most of the ones we produce. And we've gotten to the point where we can meet these requirements. We filed IP on the cost reduction ideas that we have. Our potential customers are interested in lower cost displays for their applications. In addition, for potential customers we're working on plans, which show how we can scale up the higher volume production of microdisplays for these consumer applications. This work, of course, again apply to AR as well as VR markets. The bottomline is this. The VR market wants displays that make the wearer feel like she is in the environment. This means the displays have to have very high resolution, magnified by large field of view, optics with high speed, accurate color and high contrast, all of what we see in the real world is working on to see in a display. What I've just described is our OLED microdisplay technology. Without these features the wearer will not have an immersive experience, and that's what it's meant by a virtual reality. When this market begins to grow, we believe our displays will capture a significant share. Again, the companies with whom we have spoken are interested in eMagin OLED microdisplays. Hence, we're pleased to have the opportunity for both an immersive VR headset that looks good, plus plans for industrial customer headsets, and the opportunity to provide displays to both the virtual reality and augmented reality headset makers. We continue with improvement in manufacturing and our yields are ahead of the plan for the first quarter and year-to-date, and that shows up in the numbers. We have really a significant yield improvement effort continuing this year, got a large team for manufacturing, R&D, product development and quality in our New York site, and that team has done an outstanding job. It's going very well, as I mention. And as we finish our projects, we brainstorm new ideas to verify and implement. And again, that just keeps rolling on and we're actually feeling very good about our progress. Our statistical process control program was started by our VP of Manufacturing, and that is also a going well. Other promise we had in the distant past was that keeping the process under control is difficult, and now we are feeling much better about that. I am not saying that we don't have a long way to go. We're not at 100% yield. So we're working like mad to improve yield and improve our process control. We had a customer do a quality audit on us, so that we could get on their high-level approved vendor list. They were very impressed with what they saw and the improvements in manufacturing that we have made. Much thanks goes to Robert, our VP of Manufacturing; and Christine, our QA Manager for the result. They did an outstanding job leading them through what we have done. And the audit process came out looking good. I'm not saying we didn't have a few things to tweak, but the company was very happy with what they saw. Our Head of Business Development, Dr. Kohin took the job in the second half of last year, and she has made some personnel changes and improved our operation. And in addition, we've got some design wins and additional potential for companies on new non-U.S. program. So we're doing nice job here. Our high brightness work is going very well, and as a reminder we have three funded efforts here. So I'm going to talk about each one little bit, just to remind you, and I know it gets complicated. The manufacturing technology program is designed to bring our direct patterning effort to manufacturing readiness. And what that means again is instead of white with color filters, we remove the color filters, and the OLED itself provide red, green and blue light individually by pixel. And you might know that the color filters throw out, well, actually probably only allow 20% to 25% of the light to come out. And when you throw them out, obviously get a 4x to 5x improvement in brightness. And we've installed additional equipment in quarter one and had gotten better performance we expected, better color, better control. Although, we did run just some difficultly, the outstanding team has found the problems, and we're correcting them. And I thanks Rob to Prache, Ilyas, Evan, Tariq and Amal for that. Now, just think for a minute, we're debugging new tools that we design and had manufactured by outside companies for this new process, and in such a short time that it's truly impressive what the team has managed. The second item is the enhanced ultra-high brightness work, and this is meant to get as brighter than direct patterning alone. This work is really on the OLED material and structures. As you can imagine, there are quite a few steps here. The first step is going to get us quite a ways down that road, and it's actually going very well. And we're filing IP on this, so that when we invent something new, we make sure it's covered by our patent. The last project is a design of a new backplane that drives the display. This work is also progressing well. This is very important for two reasons, one is, the government wants us to use the U.S. foundry and we're doing that, but also it's going to lower the consumption of power by about 30%. So these displays are already more efficient than the ones we have today. And the ones we have today are comparable, and were better than other displays, and this new backplane is going to add another 30% reduction. This display work is going to very important for all mobile display applications. The net of these three programs means we're going to have a full color display with above 10,000 nits brightness that's candelas per meter square, and just give you a basis that's 20 times brighter than what your smartphone is rated. And you can look up, your smartphone is rated at 500 nits. I personally measured them. They're only 450, but that's okay, we'll give the company a break. And it's going to have a backplane that takes 30% less power. The power consumption of displays will be significantly better than our current displays, when run at the same luminance, even without the new backplane. I think you'll agree, the end result is very impressive quantum leap in technology. The funding of $6.8 million is helping us move this much more quickly than we could. We also have technology that we developed from monochrome high brightness. We've mentioned this before, and this we call our XLT technology. This is significantly better than other displays we've seen from other companies. The XLT is three times the brightness and 10 times the contrast at these extreme brightnesses than the other company's displays that we've seen. And in fact they have presented data on them. So we're much better. And this is very important for the customers who want to use this. Say, for example, the avionics people wanted to switch to OLED. As an example, power reduction with monochrome green XLT display uses one-fifth the power of our regular monochrome green display in a good luminance. And if you add the backplane technology, it will take another 30% out. We are selling a number of these displays of various resolutions to customers now. And all that above is why something that the augmented reality needs very much, this high brightness, and some VR applications need the ones that using efficient objects. And that's why we feel very good that OLED microdisplays from eMagin will take a big share of these new markets. Now, I'm going to turn the call over to Paul to take you through the first quarter financial results.

Thanks, Andrew. Let's start with the income statement and revenues. Revenues for the first quarter were $6 million, and that's down from $6.3 million in first quarter last year. The product revenue was down 18% actually from first quarter last year. We didn't ship as many displays. We were up against a rather strong comparative last year of $6.3 million in product revenue. But the product revenues are inherently lumpy, and as some programs end and others begin, so we expect that the product revenue will improve in the coming quarters. The R&D revenue increased nicely to $885,000 from just $19,000 in Q1 last year. And as you know, we had those awards in 2014, and this increase is due primarily to the work completed so for on those new R&D contract awards. And Andrew mentioned earlier, the largest of those is the ManTech Award. As you probably remember, most of our contract revenues are comprised of U.S. government-related spending, and in the past we've reported how we believe the R&D funding has been impacted in the past couple of years by government budget issues and sequestration, et cetera. And for years prior to 2013, our R&D revenue, contract revenue ranged from about 15% of revenue to as high as 22% of revenue. Last year in quarter one R&D revenues were just 1% of revenue in both Q1 and Q2 actually. Then we received the new awards in mid-year last year. And in Q3 last year, R&D contract revenues grew to 9% of total revenue and then in Q4 it grew to 16% of total revenue, and now Q1 is roughly 15% of revenue. So we're back in the range of where we use to be for this R&D contract revenue. It's a very important component historically of our total revenue picture. And we should continue to see this positive dynamic going forward, as we work through these contracts and additional contract awards that we might get. Gross margin for Q1 improved pretty nicely to 39%. It was 31% in Q1 last year and 23% last quarter. This improvement is due to lower manufacturing cost and some significantly better yield, and higher average selling price in the quarter. The yield in quarter one was much improved from last year and that's something that's been very exciting to see based on all the effort that the team has put into that. And labor costs were much better controlled than in Q1 last year. Our operating expenses are comprised of internal non-funded R&D expenses and selling, general and administrative or SG&A expenses. The R&D expense for the first quarter decreased about 36% from first quarter last year to about $900,000, a nice decrease. It was due to more of our R&D expense going against the funded R&D contracts, as cost of goods sold for those contracts. And this effect decreases are non-funded internal R&D operating expense. So this is one of the positive effects that we get from a large increase in our funded R&D activity. So again, this effect, we'll see that going forward as well. SG&A expenses for the first quarter were $1.1 million. And again, that's a pretty nice number, down quite a bit from $2.1 million first quarter last year. We did reduce our allowance for doubtful accounts by about $375,000, as we made progress with a slow paying customer. And there was a $116,000 one-time settlement expense in Q1 last year. So those sort of one-time items make up about half of that decrease. But the other half are true expense reductions in salaries, stock compensation expense and several other expense categories that were due to our expense reduction program that we did in mid-2014. So we went through our whole cost structure last year and we made a lot of changes, and we're seeing the benefit and the positive effects of that program. And again, we'll continue to see those positive effects in coming quarters. So we had an operating profit in Q1, and that's pretty nice. The operating profit was $329,000, and this is a strong improvement of about $1.9 million from the $1.6 million in operating loss we had in Q1 last year. Adjusted EBITDA was a profit of $873,000, and again, that's a $1.6 million improvement over Q1 last year. So we really killed it over Q1 last year. That's really nice to see. Even if we were to adjust out the bad debt expense reversal, that I mentioned, the adjusted EBITDA would still have been a profit of about $500,000 for the quarter. Taking a look at the balance sheet now. At March 31, due to the improved operational results, our cash, which is cash, cash equivalents and CDs, increased about $700,000 from last quarter, December 31. And so the total amount of cash now at March 31 is $6.7 million. And the increase is due to better operational results, and we also invested about $320,000 in the quarter on new equipment. So even after that investment, we increased our cash balance by $700,000 or so. We continue to have no debt, and we haven't done any equity raises since 2008. So there has been no associated dilution in the stock in last six-and-a-half years. So the balance sheet is looking a little better this quarter, especially with the increase in cash. A lot of the other balances are about the same, as they were last quarter. And finally regarding our guidance for 2015. Based on the current and forecasted market conditions, our expected orders and our current backlog were affirming our previous guidance that we expect revenues will total between $26 million and $29 million in 2015. So with that, I will turn it back over to Andrew for some further comments.

Thanks again, Paul. Now I'll discuss a few additional highlights for the quarter, and then we'll open up for questions. We continue to supply significant customer base. In the first quarter, we supplied microdisplays to about 65 domestic and international customers. And performed some funded R&D services for eight customers. As Paul said, we're profitable in the first quarter and I thank the eMagin team for this good work. We have started to ship VGA displays globally. They were granted EAR99 classification by the U.S. Department of Commerce. State Department before that granted us okay to ship outside the U.S., but we wanted this one additional step. And what that means is that there is no export restriction on the display, except obviously to embargo countries, we don't ship to them. The VGA displays are lowest price display, and we expect significant global demand. It's our smallest displays, so we fit more of the wafer. And as you know, the cost in the front-end is a function of per wafer. More displays you put on, the lower its cost. An example of places, where people are looking at this for hunting gun sites. We're selling our high brightness micron green and yellow XLT displays. I had mentioned them earlier, for various applications it require extreme brightness like avionics. But also other places, for ground troops in the military, these displays continue to demonstrate our capability on high brightness. New version of the SXGA120 was completed. Some of the work was funded by an avionics customer. And the new version incorporates higher current carrying capability to support very high brightness levels without compromising the quality of the display, and by current obviously I mean electrical current there. Initial samples have been evaluated favorably by an avionics customer, and product qualification is expected by the end of the second quarter. And this reminds me that avionics we actually have three different funding efforts on displays. One is the 2k by 2k, and the other two are SXGAs, all for fighter pilot applications. And we would expect, as they are qualified by the companies that they are put in the displays for the future. And obviously I think also a retrofitting would be a possibility for our displays. And just to remind you that the advantage of OLED microdisplays versus the LCD type, LCOS for example were in the helmets prior or are in the helmets now. The advantage is the high contrast of OLED displays, the pilots had complained about these are all monochrome green. Green glow on the visor, when they had to turn it up for very bright sunlight; and that green glow from LCOS is because the contrast is not very high. So when you turn it up bright, the pixels that are supposed to be off aren't. So that's when the Night Vision Lab came to us and said, hey, can you produce one without this problem, and the answer was, yes. Unfortunately, it takes a long time for it to get it in the helmets, et cetera, but we're in good shape right now for that. We also have another high brightness technology for color or to-be-used for white displays, we call this XLS. This technology is really in interim step, prior to finishing our direct patterning effort. It will have a maximum brightness, say, something like 800 nits. So you can run it at 800 nits versus the end result of our direct patterning efforts of 10,000 nits. Sample displays were delivered and are being evaluated for commercial and military applications. And as a result of further R&D efforts, we also improved the lifetime of the display technology by about 25% that was holding us back before. The interest we see in these displays confirm that they offer advantages for applications that you use either low efficiency optical systems, i.e., you have turn the display up bright, and we do actually see a number of companies that ask us for these displays for that very purpose, or displays that are in augmented reality applications that these could be with outside light such as commercial data glass applications. Samples of the SXGA096 product that's 9.6 micron pixel pitch are available and product qualification for the last of the OLED the architectures on this product is expected to be completed in July of this year, and by that I mean we're putting many different OLED architectures on the SXGA096, and we have to quality each one. The SXGA096 will provide eMagin's customers with a resolution of an SXGA display, but it's much smaller form factor, in fact it's about the size of our largest running the SVGA Plus display. And the smaller form factor means, actually it's lower cost, about the same cost as our SVGA Plus. Now, finally as we discussed above, I just want to leave you with a summary that we finished the development of the immersive headset, showed it to a number of customers, they like it, and we're working with them on doing what we need to do to get them to work with this on it. And we patented to the optics, it affords a much better look, performance, weight and size than other VR headsets that you've seen, the OLED microdisplay and the optics are fit together very, very well in this. And by the way we do use the XLS architecture in this headset. We delivered ultra-high brightness color displays in the first quarter using the equipment we put in last year. And we are debugging the new equipment we've put in this year that will make the displays better and more manufacturable. And this debugging is really going to be done about the end of the second quarter. I'm a little hopeful that it would be a little faster than that, because people are interested in seeing samples of these displays now. And we've made significant progress on each of the items I have outlined before. So we're feeling very good about both the virtual reality headset and the high brightness displays. And just another reminder, talking to companies about microdisplays, our microdisplay technology for their virtual reality headsets, because they need to go, this is them talking, not me, they need to go to a higher resolution, and that's why they are interested in our displays. So we are very, very optimistic about our future. Well, with that, I'm going to open it up to questions and thank you very much.

[Operator Instructions] And our first question comes from Andrew Uerkwitz from Oppenheimer.

You've said a lot of the comments here to start off the call around commercial opportunities, could you talk a little bit about the CapEx demands that it would take to kind of ramp up for commercial partner?

Well, we've done a few things. It depends on the volume of course. And you can imagine that -- well, I'll give you an example that has nothing to do with virtual reality, which is what I talked about. If you remember, when Google Glass came out, they invested in Himax. And why'd do that? They did that because Himax needed capital before they put in the capacity to do what Google wanted. And in this case, the same thing would apply. We've done a few things. If we needed very high volume, how would we structure the OLED seal system, that's a critical play piece, but then we backed off of that. The first step we'll do would not be a terrible amount of capital, and it would give us a significant start, and then we could move that up as time went on. So that you remember our OLED machine we put in was about $4 million that was the SNU machine. We'd need obviously the OLED machine and a seal system, so to be much higher than that, but still the first step would be a rational place. In other words, no one would choke on the numbers that I've taken.

And then secondly, you mentioned the investment in another company, when they're kind of ramping up. Could we see something similar or will we see funded R&D projects? How do you go about thinking that as you move down this road here?

Well, there are two ways to go. We've been asked things about larger size displays, and could you get us a larger size display with a high resolution, so we could see how great our optics look, and using your OLED technology. So there is two ways to do that. One is a funded R&D, and we're thinking about some very clever ways to do this to keep the cost down, so that is possible that we might see that in the near future. And we also have plans that we've put together and we are reviewing those plans with a few companies to say this is the capital we need to get there. I think that it depends on whether the company wants to take a step and put in a display in their optic. And the other thing that we've done is they want to do that in the funded R&D program first. What we have done as well is taken our HMD around to everyone and said, oh, do you want to see what a 2000 x 2000 resolution display in a headset with a wide field of view, do you want to see what that looks like, so we let him look through our HMD. Now, that's not moved their optics, but it did stir some very interesting discussion in meeting that we had with a company. They brought in, I don't know how many people to take a look at the thing, and one of them was arguing for making me look at a different set of optics and a smaller display. So I think the answer to your question is it could go either way. It may be that our headset is all the company needs for a modification of it or it could be that they want a prototype first. As you might expect, we are pushing for as soon as possible. We'd like to do the prototype.

And then last question. You mentioned in your comments that different industry expectations are for millions of VR headsets by 2018. Do you think it's possible that you could get a good share of that by 2018 or should we think about that kind of timeframe for you to be in a position to start taking share would be after that? Meaning, could you guys be a first mover here or will you be working as kind of a next-generation type of product, because your quality is better?

Well, there is two things to say there. First of all, there is a first mover already and they're cell phone displays, right?

Sure.

They exist today. You could buy one.

I don't really consider the cell phone virtual reality devices as real yet?

I understand that. And by the way, I've worn them. And I'll just describe one of them. Forgive me for that. I put one on, and this was I'm looking -- I won't say the name, but you can guess --

Oculus Rift?

Yes, it was Oculus. It was s Samsung display on it. And I was looking at -- this was kind of nice. So I was looking at Iceland from a helicopter, 360 degree view, so I could turn my head and see all sorts of things, and I looked down and there was something on the ground. I couldn't make out what it was, and then until the helicopter scared a bunch of horses over on the side running, then I realize the one under me was a horse too. So the resolution really does need to be improved. So I think that type of thing means they're not real yet. Now, maybe the cell phone guys are going to come up with a Samsung or have 3800 x 2000, and that will be better, still the space between the pixels is an issue, but I think if you look at 2018, it all depends on how fast you want to turn this on, because we could put in the capital needed in that timeframe and get the stuff running. And by the way, we've already mapped this out. I was on a phone call earlier today. I know I should have been studying for this, so forgive me, but a phone call earlier today with our guys in New York about just that looking at a plan on how fast we could go. So back up, one other thing on your prototype, there are couple of companies we've talked about prototypes too. And couple of companies we've talked about, here's what we could do in terms of the ramp. And we actually need to follow up on that. So we're working on both those angles. And I hope to be able to announce we're doing one, so that everyone including everybody in our company believes that we're on the road to success.

Our next question comes from Kevin Dede from H.C. Wainwright.

So couple of things for you. Just looking at the sales volume in the product side, guidance implies a pretty substantial step up. I mean, if you look at what one would expect given the four R&D programs that are DoD related defense program. So I'm kind of wondering -- I know you talked about increasing ASP and yields, but I think what we'll need to see is more, I guess, more product shipped that I'm kind of wondering how you're looking at that, what you see that gives you that confidence and how you might be able to relay that for us?

Q1 was not that stellar in product revenue as we talked about. The business is lumpy, programs end and programs begin and there is several programs coming this year that we feel we'll get into. We have some new products also, our Digital SVGA and SXGA096, just to mention a couple. And we have customers that are clamoring for these products, and they've just recently come out, so we renewed our -- reaffirmed our guidance on the year for revenue. And we do that because we're confident that the coming quarters will be stronger on the display revenue side than Q1.

So let's switchover little bit to contract revs. The ManTech is the biggest deal, I imagine. And if I've sort of worked through the numbers correctly, I think you still have another two years on that. But by the end of this year that starts to wither on account of other programs that should be finished up, and I am kind of wondering what you see around the corner there? And whether or not there is reason for us to believe that past the $6.8 million that you have at this point, supplementing your R&D development, what else might be coming down the pipe?

The ManTech program is the largest of the R&D program and its 30 months from last September, so we still got a couple of years on that one. And of course, we're looking at new R&D projects all the time, so we don't expect that it will go for the next two years without getting another more R&D contract. So we've got ManTech for a couple of years and that's the big one. It's over $6 million on its own. And we'll be applying for additional R&D contracts. And hopefully the number will stay where it is or it will improve. And we mentioned that now we're back to like this historic number that we've had of about 15% or 20% of our revenue being in R&D contract revenue. And we've been below that for a couple of years, but it seems like the government money is freeing up a little better. And we're back now to 15%, we were last quarter as well. So we think we've gotten back to where we should be on R&D revenue and we think that will continue on. So it looks good right now.

We do have a few examples that we can't tell you, but I'll give you just an idea. Every once in a while we do a science and technology effort that is small amount of money, $200,000 something like that, a $175,000 really. And the government will come up with an idea and they will ask us to do a study to see if we can really do it. And in this case, it was dealing with power and the need on the display, and we actually came up with a very clever idea on how to accomplish what they wanted us to do, and so the next step would be a funded effort to actually make that go through. And that would be designing a new backplane and putting the right OLED architecture on it. So that's an example of one that's right now that we're doing a $175,000 part.

So if I were to interpret that correctly, Andrew, that would be an extension -- I apologize, that would be a separate activity, but it will extend the work that you're doing in the backplane right now?

Well, the work we're doing in the backplane is something different right now. It's to be much more power efficient. And this is a study, first that says, can you do -- it's really an odd thing, that when you think of it. And I can't say what it is so forgive me, but it's an odd thing. You make a new backplane with an OLED architecture that has some power efficiency in it and that's just a little study that we're doing now for $175,000. Then if that goes forward, we got to make a new backplane. It's very different from what we're doing with the ManTech, et cetera.

And the new backplane development cost would be much, much higher. The $175,000 is just nothing. It would be probably well over $1 million.

Yes, $1 million for that. And then they want to have us to make some, et cetera. And then the next step would be, hey, we like this, now please make the bunch of displays like this. And what I'm talking about for this one, that one, in particular would fit better with the foot soldier, the one we are doing for the ManTech, et cetera, et cetera, but the first thing they want that for is avionics.

So while I have your attention, Andrew, can you talk a little bit about, obviously you're confident that the overall AR and VR market will be there?

Yes.

And clearly, you're talking to some large household names. The question that I've got for you -- and this applies to the immersive headset as well that you're developing. And my question really is more specific on timing. Now, its one thing to have a grandiose plan, some big numbers four years from now, but the question I have is what can you offer us as tangible evidence that you will be able to deliver some partner in AR, VR or with the immersive headset?

I think the question that Andrew prior asked was a good one, do you expect to have a prototype. And there is a possibility for couple of different prototypes that we've talked about. And that would be some evidence that a household name, whether they let us tell you who they are or not is another question, but that would be some evidence that it could be near-term, and that would be one. And the other is potential partnership discussions that we would have, we could announce, that would be another one. And household names, yes.

And we actually did sell to two customers.

Yes, we actually did sell a headset to a customer. They are evaluating it now. And we've got an ordering for a number of displays that are higher resolution. These aren't prototypes. They're displays that we have already. For example, you know we have a 2,000 by 2,000 resolution display in our headset. Those are company interested in buying a few of those for evaluation.

Well, that was part of the plan, if I understood it correctly was to show what was capable in your own prototype and excite demand for the displays.

Yes, it would be a wonderful thing to sell our HMDs and it would be a wonderful thing to sell displays based on how good it looks, either one of those -- actually we want both.

So more specifically, can you offer data on yield improvements specifically? I mean, obviously your numbers look good specifically in the March quarter versus, say, December and a year-ago March? I know, it's typically outside of the information that you offer, but I was wondering if -- I mean, obviously, critical component of the improved gross margin. I'm just kind of wondering how we should think about it, number one. And number two, whether or not you think it's fair to forecast that elevated yield?

Well, as you know, we don't quote the numbers and we do that for a number of reasons. But as far as the yield curves, we saw a pretty good ramp up in the Q1 yield from prior quarters. So it was fairly significant. So we aren't going to say the number, but we've been having this yield improvement program for a while, and I think this is the biggest step up that we've had. We've had some smaller successes with it, but it really looks pretty good in Q1. And hopefully, we'll continue to be able to improve from where we are.

Would it be fair to say then, Paul, I could use that sort of this gross margin number as a base of forecast? I know, it's obviously driven also by SP and product mix.

True, it is. But I think our goal is to get back to a 50% gross margin. We had 39% here and with a little more yield improvement and some little revenue improvement and maintaining control on the cost, I think we can get there. So as far as modeling all those things go together and in your model, but as far as the yield component goes, I would use -- I don't see why we couldn't duplicate yield that we had in the first quarter here.

So here is another question on that relates to it, I guess, a little bit. How many times did you changeover the deposition machines through the course of the quarter? And how do you think that compares to the December quarter versus March last year? Now, given the product mix is broader that's become a bigger issue given the time it takes to do it and yield improvement during that course.

Let me make sure I understand what you meant by changeover, you mean change from one resolution display to another?

Right, I don't know a better way or more accurate way to describe it for you, Andrew. But I guess, what I've understood is to be an issue in the past is that as you changeover your manufacturing line to produce new products, you obviously incur some downtime versus, I don't know maybe three, four years ago when your product line was much narrower, you didn't have that experience. I'm just wondering if there is anyway that you can quantify that for me in March versus a December and March year ago?

Well, I don't think we have any fewer products that we're making really. So we probably have just as many line changes as we've had a year ago and last quarter. So I don't think we picked up improvement from that aspect of it, but there is a yield hit as you bring up a new product on the line. First few wafers typically don't have as good yield, and we tweak in, and that's all we've discussed that in the past, but I don't think we have any lesser that now. I think the yield improvement that we've seen has come from actually just getting better yield on the run itself.

So my question also implies the strategy that you've executed on in terms of building inventory. Obviously, your inventory was up sequentially, probably related to lower product sales. But if I understand it correctly, part of the strategy was to develop product, make sure that you had it on shelf, so that you could execute the customer orders without having to change the manufacture line. So that concept is rolled in that question. And I'm wondering if you think that that strategy is paying off for you.

Let me do one thing, I'll back up just a step and say that if you go back in time and we talked a lot about changing product, remember we had one machine, the Satella. And then when we added the SNU, it took us a long time to get that up and running well. So the Satella, you actually have to take the machine down and break vacuum. And it'd take, if you're lucky, a day-and-a-half, if you're not lucky it depends on how long the machine been running without being clean. It'd take two days. We've got a five-day work week, and because we have to change the material on Saturday and Sunday, you need to take two days out of it. That's why it was so painful. The SNU in the design, we designed it so that wasn't necessary. We could change masks to do another product resolution in without breaking vacuum. So when the SNU is running very nicely now, we can change between one product and the other easily. Now, I don't want to complicate your life, but if you have to make a material change, i.e. you're going from XLP to the regular OLED stack, then you have to break vacuum. And that takes a little more time. And I do know that we added WIP, wafer-level WIP, so that we could respond more quickly to customers. But I think Paul's final answer there was the yield is better. And that's really responsible for how you're going. That said, the machine is running much better now than if I go back a year or so.

And on the inventory question, it was up a little in the quarter. And it will probably stay up, because we are targeting to have more finished good, and more WIP in the system, so that we can respond more readily to customer request. That is something we are consciously doing. How much that effects line changes in yield that's really hard to draw that kind of relationship.

One last question for me, I know I'm hogging the call and I apologize. Your OpEx nicely down at $2 million. Is that a fair number to figure going forward, Paul?

Well, I think we did really well in controlling expenses in the quarter. What tends to happen is, when you have a really good expense control quarter, you don't repeat it exactly, but it's probably going to stay in the same area. I don't see any particular reason why it would increase a lot in the next quarter or two. So it should be in the same ballpark. You might take Q1 and add a little bit to it just for forecasting sake.

And our next question comes from Dennis Van Zelfden from Brazos Research.

Most of my questions have been asked and answered, except I've got two quick housekeeping. Paul, in relation to the last question just answered, shouldn't the SG&A go up from Q1 to 2Q by the amount of the decrease in the accrual for that AR or whatever to get back to normal in other words?

Well, yes. We aren't going to have the $375,000 reversal again. That's a one-time hit. So that's correct. You're right.

The second housekeeping type question is on the income statement. Can you refresh us as to what the participating securities are? I mean its acting like a preferred dividend or something on the income statement after you're subtracting it from net income.

Yes, it is due to the preferred stock. They have a claim on the earnings, and that's the amount of their claim. So we have to show the total net income, and then we have to show the piece that preferred has claim to.

So the last seven or eight quarters have been losses, so we would not have seen that line item even as a negative in other words?

Correct.

And our next question comes from Tom Rath from Davidson Investment Advisors.

I guess my one remaining question. You spoke to some money you spent during the quarter on new tools for manufacturability in high brightness. Can you kind of verify -- the one thing I'm confused about is with, are you producing 10,000 nits now or you're still at sort of 7,000 level on the full color high brightness?

No. We've done 6,000 to 7,000 number of displays, so we're not at the 10,000 yet. And the reason we book that new equipment and put it in quarter one was to actually do a better job on the color and make the displays more manufacturable. I almost told you more than I wanted to. So I'll stop there. I don't want to everybody to know what the heck we're doing. So we're not at 10,000 yet. So Amal if you're listening in, these guys are interested in you getting there. He is the Head of our R&D group, our Senior Vice President of R&D. So he is got the challenge, and that group is doing an outstanding job, unbelievable, that you could do this direct patterning on these little displays.

And then in the avionics, I don't know what the contracts called, but the heads of displays in helmets, are you delivering displays for that today or what is the timing on your first deliver there?

In this case we're delivering displays that are prototypes. And it takes unfortunately, the government takes a long time before a display and a new helmet will be approved for the airplane. And there is really two different pieces, and if you look at the companies as well there is only four companies to do this type of thing, and they do both helicopters and fighter jets. And the one company I can say the name, because they publicly said they're interested in avionics for commercial and that's Elbit. And we're talking to a number of those companies about displays, and actually again we have funded projects for those. So our displays are prototypes, today in helmets are prototypes, and they would be implemented when the helmets become approved. And the military in this case, as you can imagine losing one of these jets go for now. So they are very picky at getting the qualification in the helmet. And this isn't a display issue; this is a display new helmet issue.

Do you have any thoughts about how long that qualification process does take?

That's a little bit in terms of and we're talking about end of 2016 into the next year, things like that. I think if you take a look at the quality or you could do this too, take a look at the qualification plan for military jets.

And ladies and gentlemen, at this time I'm showing no additional questions. I'd like to turn the conference call back over for any closing remarks End of Q&A

I want to thank everybody on the phone. And by the way, everyone once a while, somebody will give suggestions, and we love to hear from you, because you give us more ideas. I want to thank the group, the people in Bellevue, under our Finance Director, Dianne. Outstanding group here; pulls the stuff together with a very limited staff. And you would expect that, because they all work for Paul as well. So a very limited staff, they do an outstanding job too. Our group under Harrison Kwon in Santa Clara, designing the backplanes. Every now and again, Harrison will get an idea that, hey, we're going to start designing this, because I know you guys will need it, and in their spare time they do it. So a very small group working like that. And the East Coast contingent is much bigger, under many people in this case, Robert, Amal, Olivier and Margaret. And they have done some outstanding work and things like yield in this direct patterning and getting some new products out for people. So I couldn't be more impressed with the work that the team has done this quarter. Although, this is for all of us, I am sure you would like us to do even better next quarter and keep this stuff going. And then new hire in terms of business development for the headset Dan Cui. He's actually an outstanding person in this market space. And he's already shown with his ideas and interacting with customers for this HMD product. And the other guys under him now are Andrew and John, nice job, to everyone. Thank you very much. And I also, again, thank you for being on the call today, asking us the questions. And we look forward to talking to you again in three months. Thanks.

Ladies and gentlemen, that does conclude today's conference call. We thank you for attending. You may now disconnect your telephone lines.