Good day, and welcome to the KVH Industries, Inc. Q2 2021 Earnings Conference Call. Today's conference is being recorded. And at this time, I would like to turn the conference over to Mr. Roger Kuebel, please go ahead, sir.

Thank you, operator. Good morning, everyone, and thank you for joining us today for KVH Industries second quarter results, which are included in the earnings release we published this morning. Joining me on the call are the Company's Chief Operating Officer, Brent Bruun; and CEO, Martin Kits van Heyningen. Before we dive in, a couple of quick announcements. First, if you would like a copy of the earnings release, it is available on our website and from our Investor Relations team. If you would like to listen to a recording of today's call, it will be available on our website. If you are listening via the web, feel free to submit questions to [email protected].

Thanks, Roger, and good morning, everyone. Thank you for joining us today. The first quarter was a tough one to follow given the strength of our results, but I'm pleased to report that our second quarter was, in many ways, even better, both sequentially as well as compared to Q2 of last year. Total revenues were $43.4 million. That's up 17% from $36.9 million in Q2 last year. Non-GAAP adjusted EBITDA in Q2 was $1.5 million compared to breakeven in Q2 of 2020. We achieved these results thanks to record VSAT shipments, double-digit airtime increases, and solid year-over-year growth in inertial navigation product sales. I believe that our success in Q2, along with the momentum over the last four quarters, validates our business model and our long-term strategic initiatives. Each of these priorities is at a different stage within its life cycle and contributes to our results differently. AgilePlans, for example, is a successful product line with an expanding subscriber base and strong revenue growth, now aided by the launch of regional services for smaller commercial vessels. At the same time, our new photonic chip technology is revitalizing our established inertial navigation product line. We're integrating this groundbreaking technology across our existing product portfolio. Doing so enables us to boost product reliability, performance, and realize new cost savings in our manufacturing processes while establishing a technological foundation for new products. And finally, our IoT Connectivity as a Service solution, KVH Watch, is still in its early days, much like AgilePlans was four years ago. We've launched a disruptive new service for a new market and a new customer base within the commercial maritime industry. We've made good progress assembling a team of solution partners who offer some of the most innovative IoT applications in the maritime industry. Together, we're building a foundation for dynamic growth.

Thanks, Martin. As Martin mentioned earlier, our second quarter revenue came in at $43.4 million compared to $36.9 million recorded in the second quarter of 2020. Our consolidated gross profit margin was up slightly to 35.4%. Revenue from our mobile connectivity segment increased $4.6 million with a gross margin of 34%, lower by less than 1 percentage point. Revenue from our inertial navigation segment increased $1.9 million year-over-year with gross margin increasing over 2 percentage points to 39%. Product revenue for the second quarter was $17.3 million, an increase of $3.3 million or 24% from $13.9 million in the second quarter of last year. By segment, our mobile connectivity product revenue increased by $1.3 million or 20% while our inertial navigation product revenue increased by $2 million or 27%. The increase in the mobile connectivity product sales was primarily due to a $0.8 million increase in TVRO product sales. Within our inertial navigation segment, TACNAV sales increased by $0.5 million this quarter compared to last year's second quarter while our FOG revenues increased by $1.5 million.

A couple of questions. One, we get a lot of questions in from folks about supply chain. Can you talk to us a little bit about what you're seeing in your supply chain and also how COVID reopenings are occurring? Or are there any closings as we look at the Delta variant out there?

Sure. On the supply chain side, Q2 was extremely challenging. So as we ramp production for our new product, which is the V30, and we had record demand in shipments, it was very challenging to get the material that we needed. It seemed like every day, there was a different crisis. But our team was able to do a great job, and we were able to ship everything that we needed to get out. It continues to be a challenge. I think that over the next six months, it's probably not going to improve. So I think that's sort of an ongoing risk factor, especially as demand is increasing. But right now, there are no showstoppers where we have any specific parts that we know we can't get, but it is a daily crisis. As far as the second part of your question, in terms of closings, we haven't seen any new closings, but the pushout of our media business, which is hotels in Europe and cruise ships, that, I think, is going to be slower than we had anticipated. We kind of thought July 1 initially would be sort of a recovery day for that business.

Okay. I appreciate the comments on the revenue growth and the solid adjusted EBITDA in the first half of the year. Should we consider this migration issue as the main factor that will impact the second half? Additionally, how should we approach the timing and scale of incentives and installations to help transition people from the legacy systems to the new ones?

Yes. So some of the equipment, it's a pretty easy upgrade. It requires a new modem basically. Other equipment is so old, 10, 13 years old, it just needs to be replaced. And some of those customers are moving directly to AgilePlans, some are buying the new product like the V30. So we had very good unit purchases this quarter as well. So the migrations are a combination of incentives, equipment subsidies, and move to Agile. So I think it will be similar to what we saw in Q2, but it will be accelerating in Q3 and Q4. We already saw the impact of some of those migration costs in the Q2 results we just reported.

Okay. And did some of that show up in cost of product sales or as higher cost of product? Or how should we expect it to flow through the income statement?

Yes. I'll let Roger answer that.

Yes. You will notice the points that Martin highlighted regarding incentives. Additionally, the ArcLight network needs to remain operational until the end of the year. To put it simply, if we had already migrated everyone, we would still incur costs for ArcLight while those customers would be serviced on the HTS network. This presents a challenge for us. We anticipate experiencing lower margins in the second half of the year as we work to transition as many customers as possible from the ArcLight network to the new HTS network, all while still incurring expenses related to ArcLight.

Right. So those migration costs end up in the hardware margins typically. So you'll see that the hardware margins are not as strong as they would be without the migrations.

Right. I think we saw some of that in this quarter, it seemed to us.

Yes, yes.

Yes.

Okay. And last one for me. How is visibility as you look into '22 now that we're sitting here days away from August of '21?

Well, as more and more of our business is subscription-based and recurring, the visibility gets better every quarter. So we feel pretty good about the airtime business continuing to grow. And the churn rate on the HTS network is much lower than on the legacy network, and AgilePlans' churn is lower than both of them. So we feel pretty good about that. The FOG business is growing, and we've got a huge backlog now. As Roger mentioned, it was $24 million. So we're starting to get good visibility on the FOG side of the business as well. Probably the only part of the business that doesn't have great visibility is the one we always talk about, which is TACNAV, which is purely military. And those orders tend to be binary, so the visibility on those outside of what's in backlog is not as good.

And then also, as Martin had mentioned, media, there's still kind of a question mark out there as to when that's going to recover. People keep thinking it's going to happen, but it keeps being delayed. And it's really hard to predict because nobody knows exactly what's going to happen with the pandemic.

We'll now move on to our next question over the phone which comes from Chris Quilty from Quilty Analytics.

I know it's sort of early on the V30 given that it just started shipping, but do you have any early indications of whether those are competitive wins or totally new installs or OpenPort swaps?

It appears that we are entering a new market. Most of the time, it's individuals who have not previously used a VSAT, so there is a substantial new opportunity. The product is smaller, easier to install, powered by DC, and lower in price, indicating a clear new market presence. Additionally, there are some upgrades from customers who had previously used a VSAT or an old V3-IP on the legacy network. We are encouraged by the number of new market opportunities we are seeing, which aligns perfectly with our goal of reaching an underserved segment.

And it sounds like a lot of your strength recently has been on the leisure side. What are you seeing in some of the other verticals?

No, actually, most of the strength has been in commercial. So 70%, 80% of our sales are in the commercial markets today. So we continue to be strong in leisure, but the commercial market is really the growth driver.

Got you. And the V30s, are they going both commercial and leisure?

They're going both. Initially, we launched it as a product sale first in the leisure market, and then we've added it as an AgilePlans component. So we're seeing more of that in the fishing markets and international fisheries, those types of applications. We don't see the V30 as a replacement for the V7 on commercial ships because they also need enterprise functions like the CommBox and server and those other features, which are part of V7.

Understand. Shifting over to the KVH Watch service, you seem to have made several announcements in the last six months. How do you feel about your progress on the growth plan for that service?

It's progressing more slowly than we anticipated in terms of actual subscribers, but it's advancing quicker than we expected regarding design wins and partnerships. We've realized that this situation resembles our FOG business where you secure the bid and get designed in, but you only see revenue once your customers' products are shipped. As our customers launch their products and we play a role in that, this is what is driving the subscriber and revenue growth in the latter half of this year.

Great. Speaking of FOGs, can you give us an update on where you are in terms of the cost savings? It sounds like you're bringing on new capacity. So probably no big pickup here in at least the current quarter, but where do you think margins can go on that product line as you transition over?

I will let Roger address specific margins, but I want to explain the source of our cost savings. One major advantage of the new photonic chip is that it eliminates the need for the specialty fiber and unique components required by the older gyros. A significant portion of our cost savings comes from our ability to cease fiber production, particularly deep fiber production, which has been a major overhead expense. This will occur in the current quarter and will result in considerable overhead savings. While we are already experiencing cost savings on a per unit basis, additional savings will arise from reducing overhead by eliminating entire departments.

And to Martin's point, I think year-to-year, we're expecting to see a nice bump in the margin next year. I don't want to give specific numbers, but we are definitely expecting to see a bump in the margin and then some gradual improvement after that. But yes, we definitely do expect to see some improvement.

And a final question related to PIC. Have you engaged with any customers who are designing new products that incorporate PIC due to its size and performance attributes, potentially revealing new market opportunities?

Yes. So we're getting specific customers who want a smaller product, which we are developing, which enables use in smaller products like smaller drones and missiles and things like that. So those products, we expect to launch at the end of this year.

We have no further questions queued at this time.

Operator, if there are no further questions, we'll wrap up. And we'll be available to speak to any interested parties directly after this call.

Thanks, everyone. Appreciate everyone joining.

Ladies and gentlemen, this does conclude today's call. Thank you very much for your participation. You may now disconnect.