Jeffrey Lucas - CFO Andrew Sculley - CEO

Dennis Van Zelfden - Brazos Research Tom Rat - Soldier Valley Asset Management

Good afternoon, everyone, and welcome to the eMagin First Quarter 2016 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please also note that today’s event is being recorded. At this time, I’d like to turn the conference over to Mr. Jeffrey Lucas, Chief Financial Officer. Sir, please go ahead.

Thank you. Good afternoon, everyone. We’re very glad to have you join us today for our first quarter 2016 earnings conference call. As always, before we begin, please note that we will be referring to the numbers that are part of our quarterly Form 10-Q for the quarter ended March 31, 2016. 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 2015 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 the call over to eMagin’s Chief Executive Officer, Andrew Sculley. Andrew?

Thank you, Jeff. In Q1 we made further progress in advancing our business on several fronts and remain very enthusiastic about the broad market applicability of our leading OLED technologies. During the quarter we grew revenue by 17% year-over-year, including the recognition of $1 million from the commercial licensing deal we signed in Q4. We remain encouraged by the potential display sales to this company. We also made progress on our yield and throughput improvement initiatives. A comparison of Q1 2016, versus the prior quarter Q4 2015, shows an outstanding improvement. As a result we now have the ability to more efficiently ramp inventory levels ahead of anticipated customer demand. We also believe as we more predictably ramp production volumes, we have the potential to reduce unit cost. These initiatives including replacement of some old equipment, continued support of our statistical process control and best practices initiatives and example of these efforts was the review of our replenishment procedures on our main OLED deposition tool with the operator. We came away with ideas that cut down this time significantly. These changes are now part of our standard operating procedures. On the business development front, we signed several notable, new and follow-on orders in Q1. We've been awarded contracts for both enhanced night-vision Goggle 3 that’s ENVG III and family of Weapons Sight’s individual or FWS I by a major prime contractor and we continued to support the qualification testing phase of both programs. Each of these multiyear programs has scored several million dollars to us, which we expect to begin recognizing when we enter the production phase of the program in 2017. We are working with multiple prime contractors for proposed IPs and display solutions for our Family of Weapons Sight, FWS, Crew Served that’s CS and Sniper or S variance. We have also been awarded a contract with a prime contractor on a laser ranger finder system and we have the gun delivering in the production phase. We have three new R&D programs worth over $800,000 one in Q1. The first project is focused on continuing improvements in our direct pattering, ultra high brightness technology. The second is focused on the development of a new display backplane that has electronic features for lower power and higher frame rate attributes that are in great demand by both the military and consumer markets. This new backplane will be used in both the defense and consumer headset markets. The last project is focused on building display samples that further display technology for consumer VR headsets. We are partnering with a virtual reality headset company on this new display technology. We received production orders for two new projects one for U.S. Marine Corps application and the other with a large Asian company using our WUXGA full color display in a new product. We shipped the customer a new version of the WUXGA micro display product with qualification schedule to be completed by July 2016. Our discussions with potential high volume manufacturing partners continue. These are complex negotiations and each one takes a great deal of time. As a result we'll update you when we have something more definitive. With our R&D investments during Q1, we made steady progress on our very high brightness display development. The end result of our work produced displays, which we finished recently that measured over 4,000 candela per meter squared or net. Recall, your Smartphone is likely under 500 niche, this is significantly above the minimum we have been told we need for a significant augmented reality potential customer. We're now crossing the brightness threshold that can truly bring augmented reality to the mainstream commercial market. The need for OLED here is power and high contrast. This landmark is also on the path we need for the next generation of the avionic full color displays. Here the need for OLED in a helicopter or airplane is contrast. In fact the poor contrast of LCD displays is why the Navy asked with development of high brightness monochrome OLED displays. This step we are now doing is high brightness color. We completed a key product development in April for our WUXGA display. These are 1920/1200 resolution; this work was to improve the operation and manufacturability of the display. They are well suited for both augmented and virtual reality applications and avionics application. The 2kx2k display enhancement initiative for the development of a full color display for the consumer virtual reality market continues to make substantive progress. We expect to have prototype samples to customers in Q4. This is important to our virtual reality HMD and anyone who wants a similar virtual reality HMD with 4 million pixels per eye. Recall, current HMDs have about 1 million pixels per eye. We're also looking to build the prototype display that is 35 millimeters by 35 millimeters, which we could design with a resolution up to 4,000 by 4,000. We're discussing this display with potential foundry partners and we’ll bring the proposal to a half dozen likely customers who are looking for displays of this type. The customers with whom we've discussed this display are very interested in our proposal. This is a longer term project that because of our excitement about it we wanted to give you an update today. Before turning the call over to Jeff to discuss the financials, I wanted to comment briefly on two key topics; one our military business and two entry into a brand new revenue segment. First on the military business, the overall temple of our military business remains risk most particularly a new product development. During the quarter we received additional positive evaluations from ongoing military avionics testing of the eMagin OLEDs. Since the start of the second quarter 2016 eMagin has delivered displays for installation in two additional aviation helmet prototypes. We are working closely with the prime contractors and integrators providing support as required. We continue to receive indications that our OLEDs will be selected for production in applications during the calendar year 2016. In terms of revenue, while military product sales held steady in the quarter, we believe future growth will largely be driven, when the new programs that are currently in qualification move into production for the next generation technology such as the new helmet prototypes I just mentioned or ENVG III and the three Family of Weapons Sight programs. Our military contract R&D efforts where we worked closely with the U.S. government and international companies on designing next generation requirements and specifications, positions us well to capture these new production contract vehicles when awarded. Overall, we feel eMagin's breadth of presence in both domestic and international military markets remains quite strong. In terms of expanding our end market reach, we are already underway in designing and developing product in our HMD Group, leveraging our OLED technology in both the headset and mobile device format. We believe our product development efforts could result in revenue in this new segment within Calendar 2016. We look forward to updating you with more detailed information on this product launch as we progress throughout the year. With that, I'll turn it over to Jeff.

Thank you, Andrew. Turning to the company's financial performance, I'll start with the first quarter income statement. Revenue for the first quarter were $7 million, up 17% from the same quarter last year and included $1 million of licensing revenue from the agreement signed in late December. Product revenue of $5.3 million was up 4% over last year. The increase in product sales reflected a higher average selling price per unit, partially offset by lower volumes. The higher price per unit is primarily due to product mix as customers purchase more of the company’s technically advanced macro display. Contract revenues were about $700,000, 20% lower than the prior year quarter. The lower revenues in the quarter reflect a late award of a key R&D contract, which will be performed in Q2 instead of Q1. Turning to profitability. Gross margin for the first quarter was 48% from gross profit of $3.3 million, compared to 39% gross profit of $2.4 million in Q1 of last year. Excluding the profit contribution for the license revenues for which there were no associated costs of revenues during the quarter, the gross margin for the first quarter would have been 39% comparable to the prior year quarter. Product gross margin was 38% in comparison to 40% in the prior year. Our yields were slightly higher than those achieved during the first quarter of 2015 and significantly improved over the yields of the last two quarters of 2015. The yield improvement was offset by higher production costs during the quarter, resulting in a lower year-over-year margin comparison. Contract revenue gross margins were 46% in comparison to 35% in the prior year quarter, reflecting higher profitability projects we performed during the quarter in a low allocation of R&D expense. Turing to expenses, total operating expenses for the first quarter increased to $3.3 million from $2 million a year ago. R&D expenses comprised about $320,000 of the increase and SG&A comprised the balance. R&D expense for the quarter increased by 32% to $1.3 million with $903,000 in the first quarter of 2015. This is due to higher material costs, lower allocation of R&D expense to contract-specific projects into our investment in HMD product development. SG&A expenses for the first quarter were $2 million as compared to $1 million in the first quarter of last year. The prior year's quarter expenses include approximately $500,000 of favorable adjustments for the reduction in the allowance for doubtful accounts and a reduction in the employ vacation accrual due to a change in policy at that time. This year's SG&A expense for the first quarter reflects higher personnel costs including those in our HMD Group, higher legal expenses versus last year in administrative transition costs. Adjusted EBITDA for the first quarter, which excludes non-cash stock compensation charges was $606,000 in comparison to $873,000 in the prior year. Operating income for the first quarter decreased to $22,000 from $329,000 in the first quarter last year. For comparative purposes, please bear in mind of last year's adjusted EBITDA figure includes the benefit of the $500,000 of favorable adjustments although they are noncash items. Looking at the balance sheet, at March 31, 2015, we had cash and cash equivalent of $9.1 million, compared to $9.3 million at year end. Our inventory levels at March 31, while about $240,000 lower than a year earlier, increased from December 31 reflecting a higher yield in our selective build-up of inventory to meet anticipated demand and shorten customer response time. We continue to have no outstanding debt. Finally regarding our thoughts for 2016, we are confident in our position for the next generation of military contracts that are currently under review. And as Andrew mentioned in the earning release, we have several key objectives in place to further drive shareholder value from putting potential implementation of our leading display and headset technologies into new commercial and consumer products. We expect to make progress in these business development initiatives while achieving stable revenue performance over the short term. As always, we appreciate your continued support. We're pleased with our progress for 2016 and excited about extending markets and increasing opportunities for our leading edge OLED technology. With that I'll turn it back over to Andrew for final comments before we take your questions.

Thank you, Jeff. Before we open the call up for Q&A, I just wanted to reiterate that we are laying a strong foundation for our future growth. Our technology is leading edge and continues to be so. We have a strategic roadmap for our R&D and believe that our OLED micro-display technology and product are years ahead of the competition. And I believe that 2016 will be the year when we really begin to see commercialization into the consumer market. With that, I'll turn the call over to the operator to begin the Q&A session.

Thank you. We'll now begin the question-and-answer session. [Operator Instructions] And our first question will come from Dennis Van Zelfden of Brazos Research.

Good afternoon, Andrew and Jeff.

Hi Dennis.

Hi Dennis.

Have you all completed the installation of all the manufacturing and yield enhancing machinery you alluded to in the press release and in prior calls?

No, there are a number of things, three of which are really significant who will take some time. So the smaller things that we're doing and have done a number of them, the three tougher ones are going to take a little time. For example we have the one tool align order that's a more expensive tool about $1 million and that will not be end until late New Year.

Okay. So we can -- but we could probably still expect continued maybe even if it's gradual improvements in yields going forward?

Yes and there are really two things here that we're talking about. One is yield in terms of equipment, but also downtime is an issue that one tool I just mentioned about $1 million that there are two similar tools that do different processes and when that one tool goes down, we can run both processes in the other tool, but that takes time to make it happen. It cuts your output by more than half and the yield is impaired during that time. So that's the kind of thing that we're doing many little things like that. So throughput is very important too. The other things that I may have mentioned the statistical process control and some of the other best practices, that's actually turning over some great improvements too and that will continue.

By the way, just to add to Andrew’s comment a little bit, we are in a process of continual yield improvement and the program we have in place here is going to take about 12 months at least to unfold. So there is lot that's going to be happening further improvements that you’d be seeing over the coming year, year and a half.

With that 12 months saw also significant improvement is our goal.

Yes. Okay, but you also mentioned increased production costs, is that people, do have more engineers running this stuff or is it just…

Yeah in this case, there are two real items. One of them was a wafer issue that we had and therefore those wafers are not usable for us. And the other one we do have some chemicals that were costing us more as well, but no more people in this case. However we are looking for a few key positions to move this yield of improvement and throughput improvement faster.

So some of the higher production costs this quarter are unique to the quarter that just happened, will not be repeated, but to add to Andrew’s point, we aren’t making some additions in terms of engineers and technicians. It’s going to helping our yields and our throughput and that will result in a higher production cost overall, but a lower unit cost as the volumes increase.

Okay. One last question going forward are the dollar amount of R&D and SG&A that you recorded in this quarter is that about what they’re going to be going forward?

Yeah I understand. We are and we had mentioned in the script, we're going to launch a significant product that we expect some revenue this year and that is actually causing some product development cost in R&D and the same thing in SG&A. The higher legal expenses that Jeff mentioned, we have a number of IP costs in that with respect to this new program. So some of that will not keep ongoing but some of the development cost will.

Now we also did mentioned there though, there is sort of a non-recurring cost or its administrative transition cost. We’ve got an operation here bunch of terrific focus here. In their view outside of Seattle and we’re going to bring them over to -- bringing that function over to proper junction where we have our manufacturing, production and business development and sales functions. And so that’s going incur some non-recurring cost that we're going to see for another quarter or two as well.

Okay. Thanks guys. Good luck.

Thank you.

[Operator Instructions] And our next question will come from Tom Rat of Soldier Valley Asset Management.

Hi, Andrew and Jeff.

Hi, Tom.

Hi, just a couple, first I want to follow up on Dennis' previous question about yields and gross margin. So, taking that discussion as a whole, it sounds like we should see some modest continued improvement in gross margin over the next couple quarters is that fair?

Yes, yes, that is our plan.

Okay. Great. And then this new revenue segment you are talking about is that related to display-only revenue or is that more related to your HMD?

In this case, we’ve mentioned it's from the HMD Group. So it does have display and other components to.

Okay. Great. And then you made a statement about your update on your high volume manufacturing partner effort and it sounded like you don’t really want to talk about it, but that I guess that could indicate to me that may be you're getting closer is that is that fair?

Well, yeah the word here is that anything like this takes a loan time. I just have to look back to my background when we formed the joint venture between Kodak and Sanyo to produce direct view displays using OLED technology and that took a long time, but we did a good job.

I think the point we want to make is we don’t want to unrealistically set expectations because these things are very complex. There is a lot of moving process to them and they can take time and we're not always necessarily in the driver's seat in terms of dictating that time. So given the fact that we're working with other companies that are much larger than ours, they may have their own administrative and bureaucratic issue that they have to wrestle with. We just don't want people to be expecting something to happen in the very near future and immediate future because it may take longer than that.

Okay. Got you. And then my final question is on the 2Kx2K full color direct pattern display, you said again today that you'll that out for sampling within six months. It sounds like are there any technical hurdles remaining?

No, and let me just clarify one thing, we’re going to do two things with that. First it's going to be out at the end of the year. No technical hurdles. I’m sure we’re designing new silicon, but it's very similar to the WUXGA silicon. It's higher resolution, little smaller pixel pitch, but let me correct just one thing. This display will both have the ability to do right with color filters and we will be able to direct pattern it in the future. So, I didn’t want to tie this to direct patterning.

Okay. So this is, this uses color filters for now?

No, and the reason I say that is because this is for virtual reality applications, which are included. So, you don’t need a very bright display. Otherwise your eyes can't take it. But I also want to mention that its possible for us to use direct patterning for it, but as you recall the Mantech program, which is brining that to manufacturing readiness, doesn’t until 2017. I don’t want to give anyone on the phone the impression that this will not be done until direct patterning is finished.

Got it. Okay. That’s it from me. Appreciate your time. Thank you.

Great, Tom.

[Operator Instructions] And with no further questions, this will conclude the question-and-answer session. I would like to turn the conference back over the Andrew Sculley for any closing remarks.

I just want to thank you all for, first of all the questions are very good and helpful for us and for being with us. This is going to be an exciting time for us in the display world as well as the headset group. So, I think this is a good time and we'll -- you should look for markers over the year that tell us -- tell you that we're performing. So, I just want to thank you all very much. Stay tuned for what’s going to happen and I also want to thank the Management Team because they're doing an outstanding job. So, thank you all at eMagin and thank you shareowners until next time.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.