Jim Byers - MKR Group Joe Bergera - President and CEO Andy Schmidt - CFO

Jeff Van Sinderen - B. Riley Mike Latimore - Northland Capital Markets Joseph Osha - JMP Securities

Good day, and welcome to the Iteris Fiscal Second Quarter 2018 Financial Results Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Jim Byers, MKR Group. Please go ahead.

Thank you, Operator, and good afternoon everyone, and thank you for participating in today's conference call to discuss Iteris' financial results for its fiscal 2018 second quarter ended September 30, 2017. Joining us today are Iteris' President and CEO, Mr. Joe Bergera, and the company's CFO, Mr. Andy Schmidt. Following their remarks, we'll open the call for your questions. Before we continue, we'd like to remind all participants that during the course of this call, we may make forward-looking statements regarding future events or the future performance of the company, which are based on current information, are subject to change and are not guarantees of future performance. Iteris is not undertaking an obligation to provide updates to these forward-looking statements in the future. Actual results may differ substantially from what is discussed today, and no one should assume that at a later date, the company's comments from today will still be valid. Iteris refers you to the documents that the company files from time to time with the SEC, specifically the company's most recent Forms 10-K, 10-Q and 8-K, which contain and identify important risk factors that could cause actual results to differ materially from those that are contained in any of the forward-looking statements. I'd like to remind everyone that a webcast replay of today's call will be available via the Investor Relation section of the company's website at www.iteris.com. Now I'd like to turn the call over to Iteris' President and CEO, Mr. Joe Bergera.

Thank you, Jim, and good afternoon everyone. Thanks for joining us today. As you saw at the close of the market we issued a press release announcing the financial results for our fiscal second quarter ended September 30, 2017. In Q2, Iteris recorded 25.2 million in total revenue representing 5% year-over-year growth. The result which is below our original expectation was due largely to the impact of hurricanes Harvey and Irma that hit Texas and Florida, two of our most strategic markets. In a few minutes I'll provide more detail regarding how these storms affected our transportation systems and roadway sensors segments to varying degrees. Notwithstanding these unprecedented storms, our transportation systems and agriculture and weather analytics segments achieved record second quarter revenue results. And for the first half of FY '18 we reported total consolidated revenue of 52.4 million which represents 9% year-over-year. In Q2, the transportation system segment recognized 13.1 million in revenue representing 6% growth versus the same prior year quarter. We believe that hurricanes Harvey and Irma had a modest impact on the segment second quarter revenue. However, the storms delayed some procurement processes and it is possible there could be future knock on consequences as agencies across the state of Texas in particular continue to reprioritize projects in favor of hurricane recovery efforts. For the first half of FY '18, the transportation system segment recognized revenue of 27.8 million representing 13% growth over the same prior-year period. During Q2, the transportation system segment continued to win new business producing approximately 10.8 million in net new added backlog. On a half over half basis, net new added backlog increased 2%. Recent notable wins included a communications infrastructure design project for Abilene, Texas, the renewal of a large business process outsourcing contract for the Virginia Department of Transportation and several orders for both our IPAMS and ATIS software applications. The transportation systems segment ended the second quarter with 50.5 million in backlog. Additionally, you may have seen that today we announced a new IDIQ contract with the Federal Highway Administration worth up to 9.5 million. We do not include the value of IDIQ contracts in our backlog until we receive a firm task order. Therefore, this award is not included in the 50.5 million Q2 backlog figure. Over the course of FY '18, we expect our focus on project mix to continue to benefit the financial performance of the transportation systems segment. That said, we may encounter project timing issues that produce material margin fluctuation within a given period. This occurred in Q2 with the segment's operating income declining 600,000 year-over-year due to one, the timing of two sizable projects and two, a high-level business development activity that reduced the segments utilization rate. Unlike the transportation systems that realized only modest financial impact from hurricanes Harvery and Irma, our roadway sensor segment experienced considerable direct and indirect project disruptions in both Texas and Florida, which had a material effect on the segments revenue. Fortunately, strong product sales in the northwest Canada and Latin America provided some revenue offset. We also continue to experience favorable adoption of VantageLive!, a software as a service solution that we released in May. VantageLive! allows customers to view and analyze data collected by our sensors at intersections across the country. For Q2, sensors segment recorded 11.3 million in revenue versus 10.9 million in the same prior year quarter, which represents 3% year-over-year growth. During Q2, the roadway sensors segment realized an 80 basis point increase in gross margin and 50 basis point increase in a segment level operating income margin. The margin expansion is due to the lower portion of revenue contribution from the state of Texas. As discussed on prior calls, our gross margin tends to be lower in Texas due to the mix of third party distribution revenue in that state. In Q2, ClearAg continued to experience strong year-over-year growth. However, ClearPath weather revenue declined year-over-year due to a delay in a large contract renewal that prevented us from recognizing revenue in the quarter. As a result, our agriculture and weather analytics segment recognized approximately 0.9 million in revenue versus 0.8 million in the same prior year quarter. This represents a 7% year-over-year increase. We have subsequently received the ClearPath weather renewal, we'll begin to see some revenue catch up in Q3. During Q2, we closed several net new ClearAg deals. To give you a flavor, I'll briefly highlight three of these deals. EFC Systems, a leading provider of technology solutions to Ag retailers committed to an OEM agreement with Iteris. Under the terms of the agreement, EFC will provide if customers with access to our ClearAg spray advisor. The Toro Company selected ClearAg to provide global environmental content through Toro's turf management platform and applications. Toro's irrigation solutions are used worldwide for golf courses, public green spaces, commercial and residential properties, and agricultural crops. As you may recall, we only just announced the availability of our ClearAg irrigation APIs on July 25. And Syngenta, one of the world's largest crop science companies committed to a new project that will continue to expand the company's use of ClearAg. As we previously noted, we believe the single biggest near-term lever for ClearAg growth will come from increasing our penetration in our largest crop science accounts. Looking forward, we remain very enthusiastic about the opportunity for agriculture and whether analytics segment and we continue to see solid pipeline growth and opportunity conversion for both ClearAg and ClearPath weather. So now I'd like to turn the call over to Andy to walk through our financial results.

Thank you and good afternoon everyone. Joe's financial introduction outlines that while we had externally driven challenges this quarter that impacted our ability to meet revenue expectations; our first half year performance provides a more balanced view of our overall business. Going forward, we expect that we may experience quarter-to-quarter fluctuations in our financial performance. However, our half year and full year performance should normalize these fluctuations. With that mind I'll address both our first two quarters of fiscal 2018 and how our first half year perspective provides a clear picture of our business. As Joe covered our Q2 and half year revenue, I won't repeat the numbers, but we'll note that our first half year revenue has shown 9% year-over-year growth. In terms of gross margin, our first half year performance normalizes our quarter-to-quarter fluctuations in our business segments. Starting with our systems business, our first quarter showed lower than typical gross margins of 29.6%. That was due to a higher than typical subcontract revenue component which carries a lower gross margin than internal Iteris labor. For our second fiscal quarter, gross margins were at 32.7% which lands within a typical range for the system segment. That brings our first half year gross margin up to 31.1%. We expect our gross margin in the segment to continue with modest improvements over the next two quarters which should normalize the total year gross margins which typically are at 32% to 33%. In regard to our sensors group, gross margins in Q1 were 44.7% and in Q2 47.8%. First half year gross margins of 46.2% is within our expected range of 45% to 47%. The primary gross margin influencer is our mix of Iteris product revenue versus distribution of third-party product, which can average between 8% and 15% of total revenue in a given period. Looking at our ag and weather segment, gross margins of 34.1% for the current period and 39.4% for the first half of fiscal '18 are difficult to compare directly with last year's margins. This business continues to mature in scale. As such it's difficult to take gross margin at face value at the current level of revenue. There are several components of costs of sales which rely on revenue scale. For example, at this stage of development, we are capitalizing and amortizing certain software development that is not tied to revenue. Essentially, the business needs to be operating closer to a $10 million annualized revenue level that leverage the cost of sales elements which include Iteris labor, amortization of capitalized software development and the cost of our third-party hosting costs for example Amazon Web Services or AWS. As a big data business, the cost of processing in approximate 1.5 plus terabyte databases to our AWS framework is a significant component of our cost of sales. We continue to find leverage opportunities to bring this cost down and expect such cost savings to be reflected in our Q3 and Q4 cost of sales figures. Moving to operating expenses, operating expenses consist of business segments, sales and marketing, R&D and G&A as well as corporate level operating expenses, which are not allocated to the business segments, which allows us to measure segment contribution margins. Operating expenses are more consistent quarter-to-quarter for each operating segment. Completing the contribution margin to you, let me start with the systems business. As noted above, our systems business starts with a current period gross margin of 32.7% and year-to-date gross margin of 31.1%. Total operating expenses of 2.35 million for the quarter compares to 1.4 million for the comparable period last year. As Joe noted in his opening comments, our systems business was in engaged in a high level of business development activity this period, which was the primary driver to the operating expense increase. Of key note, the current spend does not represent a structural increase in operating expenses. In this business, most of our employees are billable to specific contracts. As such our labor is utilized each period will drive operating expense. And our second quarter contribution margin in our systems business was 1.9 million or 14.8% as compared to 2.5 million or 20.7% in the previous year second quarter. For the first half of fiscal '18, operating expenses were 4.4 million as compared to 3.1million last year. Contribution margin was 4.3 million or 15.3% for the first half of fiscal '18 as compared to 4.9 million or 19.8% in fiscal '17. Regarding our sensor segment, we start with the fiscal second quarter gross margin of 47.8% and year-to-date gross margin of 46.2%. Total operating expenses of 2.6 million for the second quarter compares to 2.5 million for the comparable quarter last year. From a first half year perspective, total operating expenses of 5.1 million are flat with fiscal 2017. Second quarter contribution margin of 2.8 million or 24.8% compares to 2.6 million or 24.3% for the previous year second quarter. From a first half year perspective, contribution margin of 5.3 million or 23.7% compares to 5 million or 23.1% for the prior year first half. Certainly, this business segment is very stable when considering operating expenses. We continue to invest in our product development and software business opportunities including the VantageLive! in a very disciplined manner and expect such opportunities to create financial leverage over the coming years. In regard to ag and weather, as we have noted in past calls, while essentially an early stage business, we do not see a need to meaningfully increase our investment in R&D or our sales and marketing efforts at this time. As we continue to focus our go-to market efforts, we feel that we can leverage our existing resources to drive growth. Considering our operating expenses, our second fiscal quarter expenses were 2.5 million compared to 2.1 million for the same period last year. First half year operating expenses of 4.9 million compared to 4.5 million in fiscal '17. Our second fiscal quarter contribution margin of minus 2.2 million compares to minus 2.1 million for the previous year second quarter. From a first half year perspective, contribution margin of minus 4.1 million compares to minus 3.7 million for the prior year first half. In terms of corporate expenses, which include corporate IT, HR, accounting, legal, administration, executive and public company related expenses, we saw expenses of 3.55 million for a second quarter, which is flat with our Q1 fiscal 2018 period. Our prior year second quarter corporate expenses were 3.2 million. The year-over-year increase was due to planned headcount additions and subcontract expense associated with an overall strengthening of our infrastructure. As we discussed during our last call, we noted that we expect our corporate expenses of being to $3.5 million to $3.7 million range and will vary given the seasonal nature of audits, proxy filings, new accounting rule changes and so forth. First half year corporate expense was 7.1 million as compared to 6.3 million for the prior year first half. Regarding earnings, our second quarter fiscal 2018 loss was $0.03 as compared to $0.00 per share last year or breakeven. Our first half year fiscal 2018 loss totaled $0.04 as compared to breakeven or $0.00 for the first half of last year. From a balance sheet perspective, we ended the quarter with cash at 14.9 million, a decrease of 2.6 million from last quarter and 3.3 million from the beginning of the fiscal year. Current period cash was affected by several timing issues, notably we had three payrolls in the month of September including the payroll payment on September 30. This timing variance should normalize over the next period, otherwise we have also invested approximately 0.7 million year-to-date on CapEx which includes about $650,000 on upgrading our corporate ERP system. Finally, deferred revenue increased slightly to 4.7 million at September 30, 2017 versus 4 million at the beginning of the year. This concludes my prepared remarks and as a final note we expect to file our 10-Q today at the close of the business. At this point I'll turn the call back to Joe.

All right thank you Andy. So Iteris continues to benefit from solid execution and from favorable trends in both transportation and agriculture. Also, the team continues to deliver compelling business and technology innovations in our transportation segments, while we develop a highly meaningful high margin subscription model in agriculture market. Therefore, despite some second quarter challenges, we expect our business to normalize in the second half of the fiscal year. This should support revenue growth similar to our first half consolidated results albeit the growth mix is likely to vary for reasons that I'll discuss momentarily. Our transportation system segment continues to experience an increase in demand for programs related to smart cities, data analytics, connected vehicle advisory services and vehicle to infrastructure planning and design. We believe that Iteris is uniquely qualified to address this market demand. Therefore, we expect the transportation system segment to benefit from a favorable shift in transportation infrastructure spending for at least the next four to six quarters. That said, while we continue to develop our still relatively small portfolio of multimillion dollar projects, we will bear some risk exposure associated with the timing of complex procurement cycles. And during H2 we expect the Virginia Department of Transportation to issue a new contract that will encompass the activity we currently perform for VDOT's five transportation operation centers. Due to the structure of the new contract, Iteris will need to compete as a sub-contractor rather than a prime contractor as is the current case. This will reduce our annual revenue from this contract by about 5 million assuming we win the new contract. Accordingly, we would anticipate a temporary deceleration in the rate of revenue growth for the transportation system segment during H2. This is the normal course of business. By law, public agencies must rebid contracts regularly and it is common for the contract scope to change at these renewal periods. VDOT remains our largest customer and as mentioned we just won another large contract renewal with the agency. Also, we continue to develop new business opportunities to offset contracts that don't renew. However as stated previously we're not able to control the timing of these new contract awards and the timing of contract renewals which will cause the revenue line for the transportation system segment to move in a stair-step function rather than a linear function for the foreseeable future. While we anticipate some near-term pressure on our transportation systems growth rate, we expect some acceleration in the rate of growth for roadway sensors segment through the balance of the fiscal year. As you may recall, we re-platformed our sensor portfolio, introduced several highly innovative product capabilities throughout FY '17. While our market can be cautious about adopting new technology, we now have a large number of successful field deployment and as a result we're experiencing an increase in market demand. Also, the introduction of VantageLive! is helping us create an interesting virtuous cycle. Our VantageLive! customers want to collect and analyze as many data elements as possible. In order to maximize the number of data elements they often need to upgrade their sensors. Thus, the introduction of VantageLive! is driving product upgrade revenue and we'll begin to provide net new recurring revenue in our second half. And finally, we expect to release two additional applications or modules on the VantageLive! platform in H2, which will create further differentiation for Iteris and reinforce this virtuous cycle. With revenue growth anticipated to be in the low-double digits for H2, we would expect the roadway sensor segment to realize an increase in segment level operating income dollars. However, as discussed on prior calls, we are making some modest investments in customer success activities to enhance customer on-boarding for VantageLive! This investment may put some near-term pressure on the segment's operating income margin rate. Still we continue to believe the VantageLive! product line will realize substantially higher gross margins than we realized on our sensors as the new SaaS product reaches maturity. Now let's discuss our agriculture and weather analytics business. Segment continues to experience growth and adoption of ClearAg particularly at the operating company level of some of the world's largest seed and crop protection companies. And through the second half of FY '18 we expect to continue to secure additional orders at the operating company level of these camps. This activity should continue to generate solid segment level revenue growth similar to our FY '17 growth rate notwithstanding the impact of timing on ClearPath whether revenue in Q2. Additionally, we continue to anticipate the ClearAg will realize considerable future revenue acceleration as we transition our crop science customers to enterprise agreements. Given the current timelines for various M&A activity and the associated swapping of assets across the crop science industry, we continue to expect to begin to realize the potential of some enterprise agreements in FY '19. While we maintain our strategic focus on the crop science market, we will continue to develop our OEM business with allied providers, irrigation solution providers and ag integrators who embed ClearAg into their solutions and we will continue to respond opportunistically to demand in other segments. As Andy mentioned, we believe our scientific and engineering capacity remains sufficient to meet current product roadmap requirements and likewise, we believe our current total sales and marketing resource level is sufficient to support our near to medium term requirements. Therefore, with the exception of the segment's new general manager who joined Iteris in Q2, we do not anticipate any growth in the segment's cost base through at least FY '18. So, in summary, Iteris continued to execute well in Q2 despite each segment encountering some unanticipated challenges, including unprecedented natural disasters in two of our strategic markets. We continue to believe that market conditions will remain generally favorable in all our end markets through at least a medium-term horizon. Therefore, we continue to anticipate full year organic revenue growth from each of our reporting segments and believe second half consolidated revenue growth should remain in the high single digits. Further, we believe operational enhancements made over the previous quarters will enable us to contain expense growth through at least fiscal year end, even while we continue to implement business model and technology innovations that will continue to create long term shareholder value. Now, I'd be delighted to respond to your questions and comments. Operator?

[Operator Instructions] And we'll take our first question from Jeff Van Sinderen with B. Riley.

You know what might be helpful, could you give us a better sense of how, I guess, how much the hurricanes impacted the sensor segment compared to the systems segment and how that materialized. I know you walked through some of it in your prepared comments, but anything else you could add there.

Yeah. Sure. So, in the case of the sensors segment, the impact would be measured in seven figures. In the case of the systems segment, it would be measured in six figures. What happened with respect to the sensors business is that we had projects that were planned for implementation in the Houston area, which were obviously delayed as a result of the storms, but in addition, we had projects elsewhere in Texas that were deferred when that state requested that large municipal agencies move resources from those local areas into the Houston area to do an immediate assessment of their hurricane damage and to assist with immediate relief work. And so that brought not only the projects planned for Houston to a standstill, but projects across the entire state to a standstill. In the case of the systems business, it wasn't as much sort of emergency related, but there were projects that were deferred and there were some procurements which we were expecting to have consummated in September, which were delayed and pushed into the current quarter.

Jeff, this is Andy. Something to keep in mind though as we discuss this topic, we don't view any of the disruption to be lost revenue. It's basically going to be revenue that pushes to the right. But as Joe mentioned in his comments, it's not going to be basically a rebound in one period. It's going to be basically some number of periods going forward that we see these orders basically get back on schedule. So that one's going to be hard to predict. So, we expect to see the revenue recovered, it's going to be over a number of quarters.

And then just I guess as a follow-up to that, maybe you can break down, I know, Houston is a substantial area for you. Any idea kind of, I guess, how many sensors may have been damaged in Houston due to the hurricane and then also Florida I think was less damage, although it's still an important market for you, maybe you can just touch on what happened there?

Yeah. It was similar, but not as dramatic in Florida. Florida is a large important market to us, but not as large as the Texas market is today. So just think about what happened in Florida as being kind of a fraction of what happened in Texas, but it was essentially the same kind of scenario.

So, some of the work -

Yeah. I'm sorry Jeff. I was just kind of thinking here about the number of sensors, the second part of your question. I don't know that we have an official number as to the number of units that were destroyed or damaged and need replacement. I would assume that it's in the 100s, if not 1000s of units that we're talking about.

So, it's not just some delays and push out to the right, but also those hundreds or even into the thousands of units, you would think at some point are going to need to be replaced. Is that correct.

That is true, but I - we don't know how this is going to work, but it's not as if there's an infinite amount of budget dollars. And so, there is unfortunately the possibility that other projects like perhaps modernization initiatives that we were planning to win, those may be reprioritized in order to pay to replace units that were destroyed. So, at this point, we just don't know what the net impact is going to be in the short term. As Andy said, over the medium to long term, we would expect to get all this business back, but I'm just not sure how it's all - what all the trade-offs are going to amount to in the short term.

And then one last one if I could just, maybe you could just touch on ag and if, I think, you said that you're still looking for that to get going in terms of the enterprise agreements in the out year and I'm just wondering if anything has really changed around that or if you feel like that's pretty much status quo in terms of the M&A activity and the timing of enterprise.

Yes. So, there has been some progress, so that DowDuPont merger has been completed. There is still post-acquisition integration work going on that is causing some delays, but that merger is generally by and large behind us. The ChemChina merger, ChemChina Syngenta merger is also largely behind us. The Bayer Monsanto merger seems to have been delayed. I think the current expectation is that there's going to be some EU determination sometime early part of next year, but I'm not certain of the schedule. I have been told that they have delayed the announcement of the new organization post acquisition. I believe that DowDuPont announced their kind of pro forma organization prior to receiving EU approval and that resulted in some delays. And so, Bayer Monsanto has elected to defer making any kinds of announcements. So that is actually kind of protracting some of our discussions with Bayer, who as you know is a major customer, but I do expect that will eventually be resolved, the other combinations were ultimately approved and moved forward. With respect to the comment as to next year, why we would anticipate it beyond just sort of the overall state of the activity, we are getting requests for budget information from these organizations, which is indicative of increasing their level of engagement with Iteris.

And we'll take our next question from Mike Latimore with Northland Capital Markets.

So, I just wanted a clarification, just to make sure I got it right. You said you think the second half revenue growth will be in the high single digit percent range sort of for the entire company. Was that what you said?

Yes. That's correct. So, what we're saying is that the mix of the contribution is likely to change. As I mentioned, we would expect to see some deceleration in the rate of growth on a half over half basis for our systems business, I would expect to see some acceleration in the rate of growth for our sensors segment and that's again on a half over half basis.

And then the Toro deal, how does there - is there a specific annual bookings number attached to that or how do you get a sense of the revenue levels that are there over the next year or so.

Yeah. So, in that case, they're embedding ClearAg into their technology platform, so that's a firm order. It's a subscription model, so we take the booking and then we recognize the revenue on that booking monthly going forward. We are, I don't know if you're specifically asking this, but I'm going to assume you are, Mike. We are anticipating some additional orders from Toro and as you may know, Toro has - the nature of the business is such that there is, we have talked them about the possibility of essentially reselling ClearAg in addition to directly embedding us into their solution as they did in the initial - this initial order that we just talked about. So, if we were to proceed with some of these other opportunities, that would not necessarily be a firm subscription order, but it would be more of a reseller model.

And then on the ClearPath contract renewal, you said that was delayed, how much revenue might have that affected that segment of the business?

I'm not sure and it's very - I'll let Andy talk about that, but ClearPath revenue recognition is complicated. And with that, I'll hand it over to you Andy.

Yes. So that one, you're basically - we shift between quarters, let's say, around the $100,000 level, right. So, it's not massive, but it's significant enough on the lower base when you're doing 900,000 a quarter in revenue. But like Joe said, it's - every municipality is a little bit different in terms of how their contracts work. They're annual contracts, but they tend to behave differently in different periods, but the key was a very large one basically shifted one quarter from a comparative last year. So, the year over year doesn't look quite right, but again it's - that business is still growing and when we look at it year-over-year, it's going to be bigger than it was last year.

And Mike, we have subsequently received that order, just not in time to recognize it last quarter.

And then on VantageLive, I'm sure there is a lot of different ways that that data can be used, but can you talk a little bit about your visibility into the most likely way that data will be used over next year. Is that data that you Iteris will take in providing value to your customers or the data that goes directly to your customers for them to use or just trying to get a sense of who's kind of owning and looking at the data?

Yes. So, the way that our contracts work that personally identifiable data remains owned by that various agencies, but the derivative and metadata is owned by Iteris and we would be able to repackage that and monetize it. However, in the short term, the VantageLive is targeted at the agency market, the same agencies that have purchased the sensors and that owned personally identifiable information. So, there's no data re-monetization going on. But what is happening is we've worked with a number of agencies to help them figure out, first of all, how to aggregate and cleanse that data and then visualize that in a way that's going to be meaningful and it today addresses two business use cases. One, it's being used by agencies to do longitudinal planning or long term planning that longitudinal analysis. That is critical for all agencies in order to provide performance measures, which are necessary for that annual budgeting process at both the state and at the federal level. And then in addition, agencies are using the data to do real time optimization work in their operation centers.

And we'll go next to Joseph Osha with JMP Securities.

I wanted to return if I might to some of the comments about the gross margin in ag and whether. It sounded like you were saying that there were still a fairly long way away from sort of optimal scale, if I understood the comments correctly, but maybe if you could describe in terms of what the incremental fall through might look like at this point at the gross margin level and how that changes say if it gets to a couple of million dollar run rate and then I have another follow up.

Sure. So again, this is Andy. If you consider the key components of cost of sales for that business, of course, there is one part that's internal labor. There is going to be another part which is the AWS, the Amazon Web Services pipe, which again we'd use to process the big databases. And then finally, there's actually capitalized software and so what we're seeing right now is if you consider our past calls and as we described the development of that particular off frame, for instance, we have an irrigation advisor that's now being put to use with Toro and so on, other customers. We've got a harvest advisor. These are basically - consider those products. As we develop those products, we're capitalizing that development, putting on the balance sheet and then basically we start to amortize that over three years. That's starting to kick in. So, what we're seeing is, over the last couple of years, we've been heavy in development, but now we're complete, but now we're going to start seeing some charges come in in an even manner over three years, not tied to revenue. So, what we need to see is at a $10 million level, you're going to start seeing 50%, 60% gross margins and as we get up to 15 million, probably 70%. It's going to continue to get better as we go forward. We're finding some great efficiencies in their AWS deployment. So, we expect those costs probably to drop 25% to 40% starting in a next number of quarters. So, we'll start seeing improvements, but as I noted, given where we sit today, the margins just don't necessarily, they are not indicative of how the business runs, they are just a little bit awkward.

And that when you talk about obviously that $10 million number, that would most likely manifest these enterprise level contracts that we talked about.

Yes. I mean that's our fastest path we feel.

And then just I wasn't absolutely sure I understood. It seemed pretty clear that you were unambiguously saying that operating costs were going to be flat in ag and weather. What are you saying about that trajectory of operating costs for your other two areas for the second half of the year?

Sure. So, let's considered the two different BUs. Sensors is the most predictable and essentially year over year, they're flat. Again, they're built where they want to be built. They are highly leveraged. Again, as we look at the different opportunities, especially VantageLive and the different software opportunities, there may be some good reasons to say, let's add some go to market strength and that be you, but that would be modest increases, very small. But when we look at the systems business, that business is actually really unique. As I noted in my remarks, essentially everyone in that BU is capable of being charged directly to a project, in other words, they're revenue generating. However, under certain circumstances and probably the biggest driver is business development as we go after very large pursuits, we pull some of these people out of direct labor booking, if you will, to actually go on market. And so that basically drops down into an operating expense. So that one is fairly fluid. As we look going forward, we did had, let's say, we had a usually high bit of marketing going on in the last quarter. That will probably normalize going forward where we don't necessarily see consistent very, very large pursuits that require quite a bit of effort. So that basically will normalize as we get into the second half of this year.

[Operator Instructions] And we'll take a follow-up from Mike Latimore with Northland Capital Markets.

Yeah. Just on the business development activity you mentioned there, in transportation systems, I guess can you just talk a little bit about what types of projects you're looking at there? It sounds like that's a marketing function and you're pursuing new business, but maybe a little more detail around that would be great.

Yes. So - Mike, this is Joe and we're pursuing actually a huge number of opportunities. As I've been saying, we are in a pretty fortunate spot where our unique competencies are in high demand and, so we've just seen a tremendous number of requests for proposals. It is difficult to really characterize opportunities other than they fall into the different buckets that I mentioned in my prepared remarks. The total number of opportunities that we're looking at right now are actually at historical highs and the total value of the pipeline is also at historical highs. To give you a sense, we've also seen a significant increase in the average size of the opportunities. A couple of years ago when I first joined the average new project that we were pursuing had a value of about 50,000. Now, almost all of the opportunities we're pursuing have at least a couple of hundred-thousand-dollar value and many of them are in excess of 500,000. There is not one enormous, like opportunity that we're pursuing other than that new contract with the Virginia Department of Transportation, in case that's part of what you're asking. Most of these are in the range of several hundred thousand to a couple of million as opposed to tens of millions of dollars. However, that one re-compete that we are pursuing does have a value in excess of 20 million.

And over what time frame is that being?

That would be over a five to ten-year timeframe. They are optional periods.

And there are no further questions at this time. I'd like to turn the call back to Joe Bergera, CEO, for closing remarks.

All right. Great. Thank you, operator. I appreciate it and I also appreciate everybody's support and also the question. This was obviously very unusual quarter. There are a lot of puts and takes. It was complicated, and I appreciate you bearing with us. On the Investor Relations front, I also want to let you know that we'll be presenting at the Seventh Annual Craig-Hallum Alpha Select Conference which takes place in New York on November 16 through 17. So, if you're attending this conference, we'd love to see you. Please come and see our presentation. In the meantime, as always, we look forward to updating you again on our continued progress and we hope to hear from you when we report our results for our third quarter of FY'18. So, with that, we'll conclude today's call. Thank you.

Thank you everyone. That does conclude today's conference. We thank you for your participation.