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Edited Transcript of ARTX earnings conference call or presentation 7-Mar-19 2:00pm GMT

Q4 2018 Arotech Corp Earnings Call

Ann Arbor Mar 13, 2019 (Thomson StreetEvents) -- Edited Transcript of Arotech Corp earnings conference call or presentation Thursday, March 7, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Dean M. Krutty

Arotech Corporation - President & CEO

* Kelli L. Kellar

Arotech Corporation - VP of Finance & CFO

* Yaakov Har-Oz

Arotech Corporation - Senior VP, General Counsel & Corporate Secretary

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Conference Call Participants

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* David Wright

* Michael Roy Crawford

B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen, and thank you for joining us for this Arotech Corporation Fourth Quarter 2018 Earnings Results Conference Call. As a reminder, today's meeting is being recorded. (Operator Instructions)

And now to get us started, I'm pleased to turn the floor over to VP and General Counsel, Mr. Yaakov Har-Oz. Welcome, sir.

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Yaakov Har-Oz, Arotech Corporation - Senior VP, General Counsel & Corporate Secretary [2]

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Thank you, Jim. I'd like to welcome everyone to Arotech's Fourth Quarter 2018 Earnings Call. Hosting the call today are Dean Krutty, our Chief Executive Officer; and Kelli Kellar, our Chief Financial Officer.

By now, you should all have received the company's press release. If you have not received it, please visit the Investor Relations section of Arotech's website at www.arotech.com.

Before I turn the call over to Dean and Kelli, I'd like to remind everyone that this conference call may contain projections or other forward-looking statements regarding future events or the future performance of the company. These statements are only predictions and there could be no assurance that they will, in fact, occur. Arotech does not assume any obligation to update that information. Actual events and results may differ materially from those projected, including as a result of changing market trends, reduced demand and the competitive nature of Arotech's industry as well as other risks identified in the documents filed by the company with the Securities and Exchange Commission.

In addition, certain non-GAAP financial measures will be discussed during this call. These non-GAAP measures are used by management to make strategic decisions, forecast future results and evaluate the company's current performance. Management believes the presentation of these non-GAAP financial measures is useful to investors' understanding and assessment of the company's ongoing core operations and prospects for the future. Unless it is otherwise stated, it should be assumed that any financials discussed in this conference call will be provided on a non-GAAP basis. Full reconciliations of non-GAAP to GAAP financial measures are included in the earnings release.

And with that, I'd like to introduce Arotech's CEO, Dean Krutty. Dean, the call is yours.

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Dean M. Krutty, Arotech Corporation - President & CEO [3]

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Thank you, Yaakov. Good morning, everyone. Results for 2018 were mixed as we delivered a 5% increase in adjusted earnings despite a 2% decline in revenues year-over-year. Fourth quarter revenues were in line with our expectations, while adjusted earnings were slightly ahead of our internal forecasting, resulting in full year results of $96.6 million in revenue and nearly $8 million in adjusted EBITDA. We realized an improvement in overall gross margins for the year due, primarily, to a shift in revenue toward our more profitable Simulation division. Simulation revenues increased 13% year-over-year, with record revenue from our MILO Range product line and a resurgence of our military vehicle simulation efforts.

Power Division revenues declined 18% due primarily to the decrease in tactical battery deliveries to the Israel Defense Forces in 2018 compared to 2017.

Our Power subsidiary in Israel is benefiting from efforts to diversify its product portfolio and customer base. In 2018, we completed prototype developments on 3 different lithium-ion rechargeable batteries that replace less-capable lead acid products. We have been actively selling these in low volumes to early adopters. All 3 prototype batteries have gotten promising market reception and represent a growing part of our revenue pipeline as we enter 2019.

The military product in this segment, the 6T battery, was recently purchased by the Israel Defense Force for testing in its Merkava battle tanks, following thousands of hours of successful testing on other military vehicle platforms in 2018. We are now working to move these successful prototypes toward serial production.

In 2018, Epsilor also increased its penetration into the medical battery market with batteries for products like the cannabis inhaler produced by Syqe, a renal function monitor by RenalSense and the cancer-fighting, tumor-treating fields product Novocure. Revenue from our relationship with Novocure is becoming more meaningful as their product gains a foothold as an effective cancer treatment, and we look forward to growing our relationship with this innovative and growing company. Epsilor's sale and marketing efforts outside of Israel have resulted in a new contract in the fourth from Leonardo to develop and manufacture a battery for their new tactical radio, which is to be deployed by the Italian Army.

In addition, our continued success with the Canadian Armed Forces' Integrated Soldier Systems program has recently resulted in the purchase of additional units of our innovative tactical battery charger following a successful product review.

I highlighted in our earnings release the success of Electric Fuel and reinventing a 20-year-old market-leading, water-activated life jacket light. The new patent-pending product helped bring us record sales for water-activated lights in 2018 and puts us in a strong position to maintain our favorable market share.

Our U.S. Power subsidiary, UEC Electronics, continued to emphasize hybrid power solutions for the military in 2018. Our support for the U.S. Marine Corps' testing of the prototype Mobile Electric Hybrid Power Systems, or MEHPS, that we delivered a year ago, has concluded successfully. Our systems were the only ones tested by the Marines, and we look forward to competing for a MEHPS production early this summer.

Over the last several quarters, we developed a system very similar to MEHPS for the U.S. Army. The army intends to field a hybrid power solution for specific surveillance applications that they've already been fielded. Our prototype system is undergoing final testing and will deliver this month.

We reported in the third quarter of 2018 that the U.S. Marine Corps had canceled for convenience the Assault Amphibious Vehicle survivability upgrade program that UEC was performing on under subcontract to SAIC. This cancellation is negatively affecting our performance at UEC as we enter 2019 but we expect to offset the lost revenues with new work under the Cyber Mission Systems contract we won last August. We expect initial tests for this IDIQ to be completed over the next several months and the resultant revenue to begin for UEC in the second half of 2019.

In our Training and Simulation Division, our growth in 2018 came from broad support across all of our product areas. We are pleased to be entering the new year with improved backlog, and we are executing on 2 important programs for 2019 in our U.S. Marine Corps Combat Convoy Simulator upgrade and the U.S. Army's Virtual Clearance Training Suite program. Each of these programs has recently passed important design milestones.

We also announced recently the beginning of a new effort supporting Lockheed Martin on the Army's Simulator Maintenance Program, ATMP. Under this effort, we provide staff on location responsible for maintaining of Army training needs at Fort Leonard Wood, Camp Shelby and Camp McCain. We expect that our position as a tier 1 supplier to Lockheed will put us in a good position to win new work as existing simulator systems, in use by the army, many of which were not developed by us, require modernization.

In the fourth quarter, our military vehicle simulation group delivered to the U.S. Army our proposal in response to long-anticipated Common Driver Trainer request for proposals. The army anticipates an award in the third quarter.

Our Air Warfare Systems group provides weapon engagement queuing for all models of U.S. fighter aircraft. This software product is one of the foundations of our Simulation division. In 2018, we were awarded 3 new contracts that allowed us to enter the unpiloted aircraft arena, prototype a surface-to-air warning solution, and in the fourth quarter, add a customer that will provide aggressive squadron services to the U.S. Air Force using weapon queues provided by our software. These additions helped to push our missile simulation revenues to new highs in 2018.

Likewise, our MILO Range Training Systems group continues to grow as we benefit from our expanded relationships with the U.S. Air Force and the Department of State.

We believe that our investments and accomplishments in 2018 set the stage for growth next year, and we now provide revenue guidance for 2019 in the range of $103 million to $115 million with adjusted earnings of $8.3 million to $9.3 million.

Before I turn the call over to Kelli for a detailed review of our financial results, I'd like to remind listeners that our guidance is provided as of today, and we undertake no obligation to update our estimates in the future.

With that, I'd like now to turn the call over to Kelli.

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Kelli L. Kellar, Arotech Corporation - VP of Finance & CFO [4]

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Thank you, Dean. Good morning, everyone. Before discussing our 2018 financial results, I would like to address the restatement of our 2017 consolidated financial statements. During the preparation of our annual consolidated financial statements, we identified an error in our accounting for income taxes related to changes in the legislation as a result of the Tax Cut and Jobs Act, which was enacted on December 22, 2017. This error resulted in us recording an additional income tax benefit of $3.2 million with a corresponding reduction in our net deferred tax liabilities. Our restated financials have corrected this error, and as a result, our 2017 earnings, as restated, increased by $0.12 per share for basic and diluted. Included in our fourth quarter earnings release is a summary of the impact to our 2017 financial statements resulting from our restatement.

Now I will discuss our fourth quarter financial results. Revenues for the fourth quarter of 2018 were $23.6 million compared to $29 million for the corresponding period in 2017. This is a decrease of 18.6%. The year-over-year decrease was due to lower revenues in both of our divisions, primarily due to the decline in battery orders from the Israel Defense Forces and the timing of key programs in our Training and Simulation Division. Gross profit for the fourth quarter of 2018 was $7.6 million or 32.2% of revenues compared to $7.9 million or 27.2% of revenues for the fourth quarter of 2017. The year-over-year increase in gross profit percentage was driven primarily by higher program costs in the prior year associated with certain programs in our Power Systems Division that did not recur in 2018 as well as improved margins related to products mix in our Israeli operations.

Operating expenses were $6.9 million or 29.2% of revenues in the fourth quarter of 2018 compared to $6 million or 20.7% of revenues for the fourth quarter of 2017. The increase in operating expenses is primarily attributable to our sales and marketing efforts for both divisions as well as increased spending on research and development as we work on expanding our existing product lines. We had operating income of $634,000 for the fourth quarter of 2018 compared to $2 million in the corresponding period of 2017. The decrease in operating income for the quarter was due to lower revenues for both divisions as well as increased spending on sales and marketing and research and development.

Our net income for the fourth quarter was $450,000 or $0.02 earnings per share for basic and diluted compared to net income of $7.6 million or $0.29 for corresponding period last year. The decrease in net income is related to a deferred income tax benefit that was recorded during the fourth quarter of 2017 related to the U.S. Tax Cuts and Jobs Act, which was enacted on December 22.

Our adjusted earnings per share for the fourth quarter of 2018 was $0.04 compared to $0.08 for the prior year, and our adjusted EBITDA for the fourth quarter was approximately $1.9 million compared to $3.2 million for the corresponding period of 2017. The decrease in our quarterly adjusted earnings per share and our adjusted EBITDA is attributable to lower operating income in 2018, driven by the lower sales in both divisions with higher spending.

We believe that information concerning adjusted EBITDA and adjusted earnings per share enhances overall understanding of our current financial performance. Arotech computes adjusted EBITDA and adjusted earnings per share, which are non-GAAP financial measures, as reflected in the table of yesterday's press release.

Now on to the 2018 full year financial summary. Revenues for the full year 2018 were $96.6 million compared to $98.7 million for the full year 2017, a decrease of 2.2%. The year-over-year decrease was driven primarily by a decline in the Power Systems Division revenue as a result of the decline in battery orders from the Israeli Ministry of Defense. This was partially offset by higher revenues in our Training and Simulation Division related to our vehicle simulation and Use of Force products.

Gross profit for the year was $29.2 million or 30.2% of revenues compared to $27.6 million or 28% of revenues for the prior year. The year-over-year increase in gross profit percentage was driven primarily by higher revenues in our more profitable Training and Simulation division.

Operating expenses were $25.8 million or 26.7% of revenues for the full year 2018 compared to $24.7 million or 25% of revenues for the prior year. The increase in operating expenses for 2018 is predominantly attributable to increased spending on sales and marketing efforts, R&D and compensation expense.

The operating income for the full year 2018 was $3.4 million compared to operating income of $2.9 million for the full year 2017. The increase in operating income is driven by our Training and Simulation Division.

The company's net income for 2018 was $1.9 million or $0.07 per basic and diluted share compared to a net income, as restated, of $7 million or $0.27 for basic and diluted share for the corresponding period last year. The decrease in net income for 2018 is principally related to the onetime deferred income tax benefit of $6.4 million recorded in 2017 related to the Tax Cut and Jobs Act.

Our adjusted earnings per share for the year ended December 31, 2018, was $0.19 compared to $0.17 for 2017, and our adjusted earnings before interest, tax, depreciation and amortization, or adjusted EBITDA, for 2018 was $8 million compared to $7.6 million for 2017. The increase in our adjusted EPS and adjusted earnings per share -- EBITDA is primarily attributable to higher operating income driven by our Training and Simulation Division.

Our cash flows provided by operations was $3.3 million for the 12 months ended 2018 compared to $1.9 million for the same period in 2017. The increase in cash from operations is attributable to a significant decrease in severance payments in the current year as compared to 2017 when we paid negotiated severance related to our former CEO.

Now turning to our balance sheet. As of December 31, 2018, we had $4.4 million in cash and cash equivalents as compared to December 31, 2017, of $5.5 million.

As of December 31, 2018, we had total debt outstanding of $14.1 million, consisting of $5.5 million in short-term bank debt credit under our credit facility and $8.6 million in long-term debt. This is in -- this is compared to December 31, 2017, when we had total outstanding debt of $15.9 million, consisting of $5.1 million in short-term bank's debt under our credit facility and $10.8 million in long-term debt.

We had $8.2 million in available unused bank lines of credit with our primary bank as of December 31, 2018, under our $15 million revolving credit facility. Our current ratio remained 2.0 for the comparative periods.

As of December 31, 2018, we had net operating loss carryforwards for U.S. federal income tax purposes of $33.8 million, which is available to offset future taxable taxable income, if any, expiring in 2021 through 2037. Utilization of U.S. net operating losses is subject to annual limitations due to provisions of the internal revenue code.

At the end of the fourth quarter 2018, 2017 and 2016, we had a backlog of $64.8 million, $61.1 million and $55.4 million, respectively. The company's backlog increased by 6.1% over the same period last year and 17.1% over the period ending 2016.

Now this concludes our prepared remarks. Before we open the call up for questions and answers, I'd like to remind all participants that Dean and I are regularly available to the investment community, and throughout the year, we look to participate in relevant conferences and investor events.

Operator, you may now open the call up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take our first question from the line of Mike Crawford with B. Riley FBR.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [2]

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Just regarding some of your larger programs, has there been any change to the cadence at which you expect to hit milestones on -- regarding the phase 2 and phase 3 of your Virtual Clearance Training Suites?

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Dean M. Krutty, Arotech Corporation - President & CEO [3]

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Thanks, Mike. No, our VCTS program, as you know, we are executing on phase 2. There's actually some overlap between all 3 of the phases that are expected in the program. And we expect phase 2 to go as scheduled and phase 3 to come on as scheduled.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [4]

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Okay, great. And what about your Common Driver Training pursuit?

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Dean M. Krutty, Arotech Corporation - President & CEO [5]

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Yes, we're very pleased that the army did come out with the RFP as expected at the end of 2018. We did respond and are awaiting a decision and an award. The army is advertising it for Q3.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [6]

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Q3?

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Dean M. Krutty, Arotech Corporation - President & CEO [7]

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Yes.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [8]

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Do you know how many proposals were submitted?

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Dean M. Krutty, Arotech Corporation - President & CEO [9]

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I do not know that.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [10]

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Okay. Do you know when the 10-K will come out that will provide additional detail on these little group -- subgroups within your reportable segments?

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Kelli L. Kellar, Arotech Corporation - VP of Finance & CFO [11]

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Yes, that will come out today after the market closes.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [12]

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Okay. And do you think you've continued to take share in Use of Force group?

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Dean M. Krutty, Arotech Corporation - President & CEO [13]

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Yes, we actually set consecutive sales records in '17 and '18, and we do believe we continue to take share from the competition in that group.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [14]

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Okay. Just a couple of more questions, if you don't mind. So with Power Systems, I heard definitely you're hoping to receive interim some MEHPS production in second half of '19. At what level do you think revenue would have to be for Power Systems? I know it's a bit tricky because the mix can change depending on what products comprise that revenue. But what range of revenues do you think you would need to have the Power Systems segment EBITDA exceed unallocated corporate expense for Arotech?

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Dean M. Krutty, Arotech Corporation - President & CEO [15]

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That is tricky, Mike, due to the 2 different operations we have, one in Israel, one in South Carolina. I think it's pretty difficult to just give a number given, as you say, some very large changes in profitability, depending on the type of revenue that we put through. I think our group in Israel is fairly consistent with their battery revenues and the earnings that they churn out. But at UEC, we have some very wide variety in the margins that come with the different pieces of work they go through there. I hate to try to put a single number on it because we may get there much earlier or much later, depending on the type of work that comes through UEC.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [16]

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Yes. So like if you had a range where if you had, say, more Soldier Worn Power Systems and other high-margin-type revenue, the lower number that would enable you to hit it? Or if the mix was more towards some lower-margin revenues? I mean, it could be a wide range if you want to take a stab?

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Dean M. Krutty, Arotech Corporation - President & CEO [17]

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I would love to take a stab after some thoughtful analysis.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [18]

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Okay, that's fine. And then the last question is more about kind of capital allocation and strategic thinking. You do have -- the company, as Chairman Jon Kutler, clearly, has this aerospace and defense M&A background, and there's -- you have 2 businesses that are different from each other. Do you think there's a chance that we're going to see an acquisition in one or either side in the coming, say, 12 to 24 months? Or conversely, maybe divestiture of one to focus -- to have the company be more of a pure play?

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Dean M. Krutty, Arotech Corporation - President & CEO [19]

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Yes, you're correct in your characterization of Jon and his background. And I think it's fair to say that during his tenure, we've looked at all options repeatedly, and he certainly prevented -- presented with opportunities almost on a weekly basis that we consider. So I think you're currently identifying his bent, and I think that it would not be unreasonable to assume that -- in the future, that we will be engaging in more strategic employment of our capital.

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Operator [20]

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(Operator Instructions) And we'll take a question next from David Wright with Henry Investments.

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David Wright, [21]

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Could you expand a little bit on opportunities in the medical sector? You mentioned 3 products you were involved in. What could that segment grow to potentially? How material could it become?

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Dean M. Krutty, Arotech Corporation - President & CEO [22]

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Yes, thank you, David. So as I've covered over the last few calls, our group in Epsilor has, in the last 2 years, endeavored to remove itself from being a pure Israeli Defense Force play to being a more global provider of lithium-ion, specifically lithium-ion rechargeable batteries. And one of the efforts we made was to develop a standard battery that's sold in the medical community and start going to medical shows, particularly in Europe. And the 3 different products that I highlighted, we just try to give a sense to investors that we're having success providing specific, custom-designed batteries for new products that are coming out in the medical community. The contribution to our revenues in '18 were small. In '19, it will be more significant. And I think as we go forward, we believe that this could meaningfully impact the revenues coming out of Israel, especially when the Israeli Defense Forces are having a lull in their purchasing of tactical batteries. Putting hard numbers on it, it's millions of dollars in '19, and we certainly hope that this over the next 5 years can become tens of millions of dollars to the company.

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Operator [23]

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(Operator Instructions) We'll move next to the line of [Andreas Baxter with Solace Capital Management].

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Unidentified Analyst, [24]

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I'm sorry if you addressed this earlier on the call, but I was sort of surprised we're not seeing more of a EBITDA pickup in 2019 despite the revenue guidance you're pointing to, so especially at the high end of that revenue guidance. Could you speak to what the incremental margins are? And why we couldn't see more of an EBITDA pickup next year?

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Dean M. Krutty, Arotech Corporation - President & CEO [25]

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Yes, when you look at our forecast for 2019, the EBITDA that we project is basically a similar percentage to revenue as what we achieved in '18. As Michael was alluding to earlier with some of his questions, our product mix is very important to what we deliver in terms of EBITDA. As we execute in our Simulation division at a very high and very consistent level, I think those earnings are easily forecast or more easily forecast. And when we look at our Power Division there's quite a wide delta in what we could expect, depending on the different types of revenue that we put through '19. I don't think that we've been overly aggressive in our earnings projection, but I think that it's fair and is consistent with what we just delivered in 2018.

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Operator [26]

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(Operator Instructions) And we have no signals from the phone audience at this time. I'd like to turn it back to our leadership team for any additional or closing remarks.

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Dean M. Krutty, Arotech Corporation - President & CEO [27]

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Thank you, Jim. And thank you, everyone, for joining us this morning, and that concludes our call for today.

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Operator [28]

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Ladies and gentlemen, thank you all for joining. You may disconnect your lines, and please enjoy the rest of your day.