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STALWART TANKERS INC. 10-Q 2005
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
Form 10-Q
For the Quarterly Period Ended July 3, 2005
or
For the Transition period from ___to ___
Commission
File Number 000-08193
ARGON ST, INC.
(Exact name of registrant as specified in its charter)
12701 Fair Lakes Circle, Suite 800, Fairfax, Virginia 22033
(Address of principal executive offices)
Registrant’s telephone number (703) 322-0881
Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and
(2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act.)
As of August 1, 2005, there were 19,947,288 shares of the Registrant’s Common Stock, par
value $.01 per share, outstanding.
ARGON ST, INC. AND SUBSIDIARIES
FORM 10-Q QUARTERLY REPORT
FOR THE QUARTER ENDED JULY 3, 2005
TABLE OF CONTENTS
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ARGON ST, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
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ARGON ST, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS (unaudited)
The accompanying notes are an integral part of these consolidated financial statements.
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ARGON ST, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
The accompanying notes are an integral part of these consolidated financial statements.
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ARGON ST, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with generally accepted accounting principles of the United States of America for
interim financial information and the instructions to Form 10-Q. Accordingly, they do not include
all of the information and disclosures required by generally accepted accounting principles for
complete financial statements. In the opinion of management, all adjustments (consisting of normal
recurring items) considered necessary for fair presentation have been included. Operating results
for the period ended July 3, 2005 are not necessarily indicative of the results that may be
expected for the fiscal year ending September 30, 2005. Inter-company accounts and transactions
have been eliminated in consolidation. For further information, refer to the consolidated financial
statements and footnotes thereto included in Argon ST, Inc.’s Annual Report on Form 10-K for the
fiscal year ended September 30, 2004. Reclassifications are made to the prior year financial
statements when appropriate, to conform to the current year presentation.
Argon ST maintains a September 30 fiscal year-end for annual financial reporting purposes.
Argon ST presents its interim periods ending on the Sunday closest to the end of the month for each
quarter consistent with labor and billing cycles. As a result, each quarter of each year may
contain more or less days than other quarters of the year. Management does not believe that this
practice has a material effect on quarterly results or on the comparison of such results.
Argon ST records contract revenues and costs of operations for interim reporting purposes based on annual targeted indirect rates.
At year-end, the revenues and costs are adjusted for actual indirect rates. During our interim reporting periods, variances
may accumulate between the actual indirect rates and the annual targeted rates. Timing-related indirect spending variances
are not applied to contract costs, research and development, and general and administrative expenses, but are included
in unbilled receivables during these interim reporting periods. These rates are reviewed regularly, and the Company
records adjustments for any material, permanent variances in the period they become determinable.
Argon ST accounting policy for recording indirect rate variances is
based on management’s
belief that variances accumulated during interim reporting periods will be absorbed by management actions to control costs
during the remainder of the year. The Company considers the rate variance to be unfavorable when the actual
indirect rates are greater than the Company’s
annual targeted rates. During interim reporting periods, unfavorable rate variances are recorded as reductions to operating expenses
and increases to unbilled receivables. Favorable rate variances are recorded as increases to
operating expenses and decreases to unbilled receivables.
As further described in Note 3, on September 29, 2004, Argon Engineering Associates, Inc.
(“Argon Engineering”) merged with a wholly owned subsidiary of Sensytech, Inc. (“Sensytech”). As a
result of this merger, each outstanding share of Argon Engineering stock was converted into two
shares of Sensytech common stock. Immediately following the merger, the combined company was
renamed Argon ST, Inc. (“Argon ST”).
While Sensytech was the legal acquirer, the merger was accounted for as a reverse acquisition,
whereby Argon Engineering was deemed to have acquired Sensytech for financial reporting purposes.
This determination was based on factors including relative stock ownership and voting rights, board
control, and senior management composition. Consistent with the reverse acquisition accounting
treatment, the historical financial statements presented for periods prior to the acquisition date
are the financial statements of Argon Engineering. Earnings per share have been adjusted to
reflect the two for one exchange ratio. The operations of the former Sensytech businesses have
been included in the financial statements from the date of acquisition.
Stockholders’ equity has been restated to give retroactive recognition to the exchange ratio
for all periods presented by reclassifying additional paid in capital and retained earnings to
reflect the additional shares. Argon Engineering’s class A and class B shares have been combined
to report a single class of common stock for all periods presented.
The names Argon ST, Sensytech, and Argon Engineering are used throughout this report. Argon
ST, also the Company, refers to the entity created by the merger of Argon Engineering and
Sensytech. Argon Engineering refers to Argon Engineering Associates, Inc. which operated as a
stand alone private company until the September 29, 2004 merger with Sensytech. Sensytech refers
to Sensytech Inc., which, combined with its wholly-owned
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subsidiaries, made up the publicly held entity Sensytech until the September 29, 2004 merger with
Argon Engineering.
Argon Engineering historically operated in a single business segment. Subsequent to the
merger, Argon ST management reviewed its business operations and has determined that it operates in
a single homogeneous business segment. The Company’s financial information is reviewed and
evaluated by the chief operating decision maker on a consolidated basis relating to the single
business segment. Argon ST sells similar products and services that exhibit similar economic
characteristics to similar classes of customers, primarily the US Government. Revenue is
internally reviewed monthly by management on an individual contract basis as a single business
segment.
2. EARNINGS PER SHARE
Basic earnings per share is computed by dividing the net income by the weighted average number
of common shares outstanding during each period. Diluted earnings per share is computed by dividing
the net income by the weighted average number of common and common equivalent shares outstanding
during each period. The following summary of basic and diluted shares is presented for the periods
indicated.
3. MERGER
On September 29, 2004, a wholly owned subsidiary of Sensytech merged with and into Argon
Engineering in an acquisition whereby each outstanding share of Argon Engineering common stock was
exchanged for two shares of Sensytech common stock. As a result of the merger, the former Argon
Engineering stockholders acquired approximately 65.6% of the issued and outstanding shares of
Sensytech common stock. In accordance with SFAS No. 141 “Business Combinations” the merger was
accounted for as a reverse acquisition, whereby Argon Engineering was deemed to have acquired
Sensytech for financial reporting purposes. Consistent with the reverse acquisition accounting
treatment, the historical financial statements presented for periods prior to the acquisition date
are the statements of Argon Engineering, except for stockholders’ equity which has been
retroactively restated for the equivalent number of shares of the legal acquirer.
The Company has followed the guidance of SFAS No. 141 to record this purchase. SFAS No. 141
requires that the purchase method of accounting be used for all business combinations initiated
after June 1, 2001 and that goodwill, as well as any intangible assets believed to have an
indefinite life, not be amortized for financial accounting purposes. The Company has recognized
goodwill in the amount of $107,776,000 (none of which is tax deductible) in connection with this
acquisition. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the goodwill
will be reviewed periodically to determine if there has been any impairment to its value. The
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Company will perform its annual impairment test in September of each fiscal year, unless
circumstances or events indicate that an impairment test should be performed sooner.
The following unaudited condensed pro forma results of operations reflect the pro forma
combination of Argon Engineering and Sensytech as if the combination had occurred at the beginning
of the period presented, compared with the actual results of operations of Argon Engineering for
the same period.
Pro forma revenues attributable to Sensytech were $17,280,000 and $43,964,000 for the third
quarter and nine months ended June 27, 2004, respectively. Pro forma income from operations
attributable to Sensytech was $2,436,000 and $5,541,000 for the third quarter and nine months ended
June 27, 2004, respectively. Pro forma net income attributable to Sensytech was $1,510,000 and
$3,414,000, for the third quarter and nine months ended June 27, 2004, respectively. Pro forma
depreciation and amortization on the write up of tangible and intangible assets, in accordance with
SFAS 141, was $279,000 and $995,000 for the third quarter and nine months ended June 27, 2004,
respectively, and the after tax effect was $172,000 and $614,000, respectively.
4. STOCK-BASED COMPENSATION
Argon ST accounts for stock-based employee compensation arrangements in accordance with
provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to
Employees,” (APB No. 25) and related interpretations using the intrinsic value method. Argon ST
complies with the disclosure provisions of Financial Accounting Board Statement No. 123,
“Accounting for Stock-based Compensation,” (“SFAS No. 123”) and Statement of Financial Accounting
Standards No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure. The Company
currently uses the Black-Scholes model to estimate the fair value of options under SFAS No. 123.
Had compensation cost been determined based on the fair value at the grant dates for awards under
the plans consistent with the method of SFAS No. 123, net earnings per share for the periods
presented would have been reduced to the pro forma amounts indicated below.
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5. REVOLVING LINE OF CREDIT
The Company has a $15,000,000 line of credit with Bank of America, which expires on February
28, 2006. The total borrowing base generally cannot exceed the sum of 90% of qualified government
accounts receivable and 80% of qualified non-government accounts receivable. The line of credit
is available to finance the performance of government contracts, to support the issuance of
stand-by letters of credit, and for short-term working capital purposes. At July 3, 2005, there
were no borrowings under the line of credit. Stand-by letters of credit are issued to certain
foreign customers in lieu of posting a performance bond. Letters of credit are also used to cover
certain contract prepayments received from foreign customers and to satisfy domestic financial
obligations. Total letters of credit at July 3, 2005 were $1,554,000. The line of credit less the
letters of credit outstanding provided loan availability of $13,446,000 at July 3, 2005.
The bank agreement establishes the interest rate at the LIBOR plus 200 to 285 basis points,
determined by Argon ST’s ratio of funded debt to earnings before interest, taxes, depreciation and
amortization. All borrowings under the line of credit are collateralized by all tangible assets of
Argon ST. The agreement also contains various covenants as to dividend restrictions, working
capital, tangible net worth, earnings and debt-to-equity ratios. Unused commitment fees of one
quarter of one percent per annum are required. At July 3, 2005, the Company was in compliance with
all covenants.
6. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 154
(“Statement No. 154”) Accounting Changes and Error Corrections — a replacement of APB Opinion No.
20 and FASB Statement No. 3. Opinion No. 20 previously required that most voluntary changes in
accounting principle be recognized by including in net income of the period of the change the
cumulative effect of the change to the new accounting principle. Statement No. 154 requires
retrospective application to prior periods’ financial statements of changes in accounting
principle, unless it is impracticable to determine either the period-specific effects or the
cumulative effect of the change. Statement No. 154 is effective for the accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005. The Company will
adopt Statement No. 154 in the fiscal year beginning October 1, 2006.
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In December 2004, FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment
(“Statement No. 123(R)”), which is a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. Statement No. 123(R) requires that the compensation cost related to share-based
payment transactions be recognized in financial statements. In April 2005, the Securities and
Exchange Commission issued Release 33-8568 which allows companies to implement Statement No. 123(R)
at the beginning of the annual reporting period that begins after June 15, 2005. Consistent with
the new rule, the Company intends to adopt Statement No. 123(R) in the first quarter of its 2006
fiscal year, and to implement the standard on a prospective basis. The Company has not yet
concluded what impact the adoption of Statement No. 123(R) may have on its results of operations or
financial position.
The effects of the adoption of Statement No. 123(R) on our results of operations and
financial position are dependent upon a number of factors, including the number of employee stock
options outstanding and unvested, the number of employee options that may be granted in the future,
the future market value and volatility of our stock price, movements in the risk-free rate of
interest, stock option exercise and forfeiture patterns, and the stock option valuation model used
to estimate the fair value of each option. As a result of these variables, it is not yet possible
to reliably estimate the effect of the adoption of Statement No. 123(R) on our results of
operations and earnings per share. Note 4 of the Notes to Condensed Consolidated Financial
Statements provides an indication of the effects of adoption assuming the use of the Black-Scholes
option pricing model to estimate the fair value of employee stock options and employee stock
purchase plan awards upon the results of operations for the nine months ended July 3, 2005 and June
27, 2004. We, however, have not determined whether the adoption will result in amounts that are
similar to the current pro forma disclosures under Statement No. 123(R).
7. RELATED PARTY TRANSACTIONS
An individual who is a director, executive officer and significant shareholder of Argon ST is
also a director and significant shareholder of James Monroe Bank. At July 3, 2005, the Company had
$22,112,000 on deposit at James Monroe Bank.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The names Argon ST, Sensytech, and Argon Engineering are used throughout this discussion.
Argon ST, also the Company, refers to the entity created by the merger of Argon Engineering and
Sensytech. Argon Engineering refers to Argon Engineering Associates, Inc. which operated as a
stand alone private company until the September 29, 2004 merger with Sensytech. Sensytech refers
to Sensytech Inc., which, combined with its wholly-owned subsidiaries made up the publicly held
entity Sensytech until the September 29, 2004 merger with Argon Engineering.
The following discussion provides information which management believes is relevant to an
assessment and an understanding of the Company’s operations and financial condition. This
discussion should be read in conjunction with the attached unaudited condensed consolidated
financial statements and accompanying notes as well as our annual report on Form 10-K for the
fiscal year ended September 30, 2004.
Forward-looking Statements
Statements in this filing which are not historical facts are forward-looking statements under
the provision of the Private Securities Litigation Reform Act of 1955. Such forward-looking
statements include, without limitation, statements with respect to total estimated remaining
contract values and the Company’s expectations regarding the U.S. government’s procurement
activities. All forward-looking statements involve risks and uncertainties. These statements are
based upon numerous assumptions about future conditions that could prove not to be accurate.
Actual events, transactions or results may materially differ from the anticipated events,
transactions or results described in such statements. The Company’s ability to consummate such
transactions and achieve such events or results is subject to certain risks and uncertainties. In
addition to those risks specifically mentioned in this report and in the other reports filed by the
Company with the Securities and Exchange Commission (including the Company’s Form 10-K for the
fiscal year ended September 30, 2004), such risks and uncertainties include, but are not limited
to: the availability of U.S. government funding for the Company’s products and services; changes in
the U.S. federal government procurement laws, regulations, policies and budgets (including changes
to respond to budgetary constraints and cost-cutting initiatives); the number and type of contracts
and task orders awarded to the Company; the exercise by the government of options to extend the
Company’s contracts; the Company’s ability to retain contracts during any rebidding process;
difficulties in developing and producing operationally advanced technology systems; the timing and
customer acceptance of contract deliverables; the Company’s ability to attract and retain qualified
personnel, including technical personnel; charges from any future impairment reviews; the future
impact of any acquisitions or divestitures the Company may make; the competitive environment for
defense and intelligence information technology products and services; general economic, business
and political conditions domestically and internationally; and other factors affecting the
Company’s business that are beyond the Company’s control. All of the forward-looking statements
should be considered in light of these factors. You should not put undue reliance on any
forward-looking statements. The Company undertakes no obligation to update these forward-looking
statements to reflect new information, future events or otherwise, except as provided by law.
Overview
General
Argon ST designs, develops, and manufactures systems and sensors for the Intelligence,
Surveillance, and Reconnaissance markets including signals intelligence (SIGINT), electronic
support measures (ESM), electronic warfare (EW), imaging and acoustic systems serving domestic and
worldwide markets. These systems are used for threat warning and monitoring, simulation, force
protection, and communication. Recently, Argon ST has begun to use the technology developed for
these systems in other applications, such as software radios, high accuracy targeting,
counter-terrorism, and wideband communications.
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Basis of Discussion/Acquisition
On September 29, 2004, a wholly owned subsidiary of Sensytech merged with and into Argon
Engineering in an acquisition whereby each outstanding share of Argon Engineering common stock was
converted into two shares of Sensytech common stock. As a result of the merger, the former Argon
Engineering stockholders acquired approximately 65.6% of the issued and outstanding shares of
Sensytech common stock. As part of the overall transaction, Sensytech changed its name to ARGON
ST, Inc. While Sensytech was the legal acquirer, the acquisition was accounted for as a reverse
acquisition, whereby Argon Engineering was deemed to have acquired Sensytech for financial
reporting purposes.
Management’s discussion and analysis addresses the Company’s historical results of operations
and financial condition as shown in its consolidated financial statements for the third quarter and
nine months ended July 3, 2005 and June 27, 2004, respectively. Consistent with the reverse
acquisition accounting treatment applied to the merger, the historical financial statements of the
Company presented in this Form 10-Q for periods prior to the acquisition date are the statements of
Argon Engineering (except for stockholders’ equity which has been retroactively restated for the
equivalent number of shares of the Company as the legal acquirer). Therefore, the consolidated
historical financial statements included in this Form 10-Q differ from the consolidated historical
financial statements of the Company as previously reported. The operations of the former Sensytech
businesses have been included in the financial statements and other financial information from the
date of acquisition.
Revenues
Argon ST’s revenues are primarily generated from the design, development, installation and
support of complex sensor systems under contracts primarily with the U.S. Government and major
domestic prime contractors, as well as with foreign governments, agencies and defense contractors.
Argon ST’s contracts can be divided into three major types: cost reimbursable contracts, fixed
price contracts, and time and material contracts. Cost reimbursable contracts are primarily used
for system design and development activities involving considerable risks to the contractor,
including risks related to cost estimates on complex systems, performance risks associated with
real time signal processing, embedded software, high performance hardware requirements that are not
fully understood by the customer or the company, the development of technology that has never been
used, and interfaces with other systems that are in development or are obsolete without adequate
documentation. Fees under these contracts are usually fixed at the time of negotiation; however, in
some cases the fee is an incentive or award fee based on cost, schedule, and performance or a
combination of those factors. Although the government customer assumes the cost risk on these
contracts, the contractor is not allowed to exceed the cost ceiling on the contract without the
approval of the customer.
Fixed price contracts are typically used for the production of systems. Development activities
similar to activities performed under previous contacts are also usually covered by fixed price
contracts, due to the low risk involved. In these contracts, cost risks are borne entirely by the
contractor. Some fixed price contracts include an award fee or an incentive fee as well as the
negotiated profit. Most foreign customers, and some U.S. customers, use fixed price contracts for
design and development work even when the work is considered high risk. Time and material
contracts are based on hours worked, multiplied by approved labor rates, plus other costs incurred
and allocated.
The following table represents the Company’s revenue concentration by contract type for the
periods indicated:
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Generally, the Company experiences revenue growth when systems move from the development stage
to the production stage due to increases in sales volumes from production of multiple systems and
when the Company adds new customers or is successful in selling new systems to existing customers.
Argon ST’s current production work has been derived from programs for which the Company has
performed the initial development work. These programs are next generation systems replacing
existing, obsolete systems that were developed by other companies. Argon ST was able to displace
these companies primarily on the basis of technological capability. Argon ST believes that the
current state of world affairs and the U.S. government’s emphasis on protecting U.S. citizens will
cause funding of these programs to continue.
Backlog
Argon ST defines backlog as the funded and unfunded amount provided in contracts less
previously recognized revenue and excludes all unexercised options on contracts. Some contracts
where work has been authorized carry a funding ceiling that does not allow Argon ST to continue
work on the contract once the customer obligations have reached the funding ceiling. In such cases,
the Company is required to stop work until additional funding is added to the contract. Argon ST’s
experience in this case is very rare and therefore it generally carries the entire amount that the
customer intends to execute as backlog when it is confident that the customer has access to the
required funding for the contract.
In general, most of Argon ST’s backlog results in sales in subsequent fiscal years, as the
Company maintains very minimal inventory and therefore the lead time on ordering and receiving
material and increasing staff to execute programs has a lag time of several months from the receipt
of order.
At the dates indicated, the Company’s backlog consisted of the following:
Of the total unfunded backlog, $63,400,000 pertains to a new airborne program signed in April
2005. The contract is scheduled to be funded incrementally through fiscal year 2008, and
$3,500,000 was funded following the end of the third quarter of fiscal year 2005.
Cost of Revenues
Cost of revenues consist of direct costs incurred on contracts such as labor, materials,
travel, subcontracts and other direct costs and indirect costs associated with overhead expenses
such as facilities, fringe benefits and other costs that are not directly related to the execution
of a specific contract. Argon ST plans indirect costs on an annual basis and on cost reimbursable
contracts receives government approval to bill those costs as a percentage of Argon ST’s direct
labor, other direct costs and direct materials as the Company executes its contracts. The
government approves the planned indirect rates as provisional billing rates near the beginning of
each fiscal year.
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General and Administrative Expenses
Argon ST’s general and administrative expenses include administrative salaries, costs related
to proposal activities, internally funded research and development, and other administrative costs.
Interest Income, net
Net interest income is derived solely from interest earned on cash reserves maintained in
short term bank accounts and are therefore subject to short-term interest rates that have minimal
risk.
Research and Development
Argon ST conducts internally funded research and development into complex signal processing,
system and software architectures, and other technologies that are important to continued
advancement of its systems and are of interest to its current and prospective customers. For the
nine months ended July 3, 2005 and June 27, 2004, internal research and development expenditures
were $4,034,000 and $1,160,000, representing 2.1% and 1.3% of revenues in those periods,
respectively. The increase of $2,874,000 is reflective of the Company’s emphasis on increasing its
technical advantage in a number of key technology areas.
Internal research and development is a small portion of Argon ST’s overall research and
development, as government funded research and development constitutes the majority of the
Company’s activities in this area. Most of Argon ST’s cost type contracts are research and
development contracts, and historically more than 30% of Argon ST’s fixed price contract work has
been of a research and development nature.
Critical Accounting Practices and Estimates
General
Argon ST’s discussion and analysis of its financial condition and results of operations are
based upon its financial statements. These financial statements are prepared in accordance with
accounting principles generally accepted in the United States, which require management to make
estimates and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ significantly from those estimates. Argon ST
believes that the estimates, assumptions, and judgments involved in the accounting practices
described below have the greatest potential impact on Argon ST’s financial statements and,
therefore, consider these to be critical accounting practices.
Revenue and Cost Recognition
General
The majority of Argon ST’s contracts, which are with the U.S. government, are accounted for in
accordance with the American Institute of Certified Public Accountants Statement of Position 81-1,
Accounting for Performance of Construction-Type and Production-Type Contracts. These contracts are
transacted using written contractual arrangements, most of which require Argon ST to design,
develop, manufacture and/or modify complex products and systems, and perform related services
according to specifications provided by the customer. Argon ST accounts for fixed-price contracts
by using the percentage-of-completion method of accounting. Under this method, contract costs are
charged to operations as incurred. A portion of the contract revenue, based on estimated profits
and the degree of completion of the contract as measured by a comparison of the actual and
estimated costs, is recognized as revenue each period. In the case of contracts with materials
requirements, revenue is recognized as those materials are applied to the production process in
satisfaction of the contracts’ end objectives. Argon ST accounts for cost reimbursable contracts by
charging contract costs to operations as incurred and recognizing contract revenues and profits by
applying the negotiated fee rate to actual costs on an individual contract basis. Management
reviews contract performance, costs incurred, and estimated completion costs regularly and adjusts
revenues and profits on contracts in the period in which changes become determinable
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Anticipated losses on contracts are also recorded in the period in which they become
determinable. Unexpected increases in the cost to develop or manufacture a product, whether due to
inaccurate estimates in the bidding process, unanticipated increases in material costs,
inefficiencies, or other factors are borne by Argon ST on fixed-price contracts, and could have a
material adverse effect on results of operations and financial condition. Unexpected cost increases
in cost reimbursable contracts may be borne by Argon ST for purposes of maintaining customer
relationships. If the customer agrees to fund cost increases on cost type contracts, the additional
work does not have any profit and therefore dilutes margin.
AN/SLQ-25A Contract
Argon ST historically recorded the AN/SLQ-25A Surface Ship Torpedo Defense System (SSTD)
contract at zero margin. Revenue from this contract amounted to approximately 5.1% of Argon ST’s
revenues for the third quarter ending July 3, 2005 and approximately 6.0% of the pro forma revenues
for the third quarter ending June 27, 2004. Revenue from this contract amounted to approximately
4.8% of Argon ST’s revenues for the nine months ending July 3, 2005 and approximately 6.5% of the
pro forma revenues for the nine months ending June 27, 2004 (see “Pro Forma Financial Results of
Operation” below). This contract was acquired as part of Sensytech’s acquisition of certain assets
of FEL Corporation during 2002 and was performing at a potential loss at the date of acquisition.
Based on the historical experience of awarded change orders on the SSTD contract and Argon ST’s
ongoing discussions with the customer, Argon ST has deemed future change orders probable to enable
the contract to break even (i.e., eliminating any potential loss on the contract). Argon ST has
favorably performed under the contract since the date the contract was acquired from FEL
Corporation and management has worked with the customer to reduce any potential loss through change
orders approved to date. As of July 3, 2005 there have been 28 change orders awarded for a total
contract value of $59,264,000. While management currently estimates that the contract will be
profitable, the profitability is dependent upon future change orders, expected by management, but
that have not yet been finalized. Based upon the current funding of the contract, should no
additional funding be received, a loss of approximately $288,000 would be recognized. However,
after considering the effect of anticipated change orders, the Company projects the contract to
complete at a modest profit. Change orders are under continuous negotiation with the customer.
When these change orders are received, Argon ST will reassess the contract based on current
estimates, and such reassessments are currently expected to result in increases to the margins
recorded on the contract. Such increases would impact operations in the period such change orders
are finalized as well as future periods. If such change orders are not finalized under currently
expected terms, or if Argon ST does not perform as expected under the contract, contract losses may
be required to be accrued. During the third quarter of fiscal year 2005, the Company received
change orders in the amount of $20,839,000, which management had expected would be sufficiently
profitable to enable the contract to realize a marginal profit. However, because of delays in the
award of the change orders and the consequential effect on indirect cost recovery, the projected
profit was not sufficient to eliminate the loss in total. Management expects that additional
change orders will be received during the fourth quarter of fiscal year 2005 or the first quarter
of fiscal year 2006 which will be sufficient to enable the contract to realize a marginal profit
through the completion date in fiscal year 2008. Until such time, Argon ST will continue to
recognize zero margin on the contract.
Indirect rate variance
Argon ST records contract revenues and costs of operations for interim reporting purposes
based on annual targeted indirect rates. At year-end, the revenues and costs are adjusted for
actual indirect rates. During our interim reporting periods, variances may accumulate between the
actual indirect rates and the annual targeted rates. Timing-related indirect spending
variances are not applied to contract costs, research and development, and general and administrative
expenses, but are included in unbilled receivables during these interim reporting periods. These
rates are reviewed regularly, and the Company records adjustments for any material, permanent
variances in the period they become determinable.
Argon ST accounting policy for
recording indirect rate variances is based on management’s
belief that variances accumulated during interim reporting periods will be absorbed by management actions to control costs during the remainder of the year. The Company considers the rate variance to
be unfavorable when the actual indirect rates are greater than the Company’s annual targeted rates.
During interim reporting periods, unfavorable rate variances are recorded as reductions to
operating expenses and increases to unbilled receivables. Favorable rate variances are recorded as
increases to operating expenses and decreases to unbilled receivables.
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If the Company anticipates that actual contract activities will be different than planned
levels, there are alternatives the Company can utilize to absorb the variance: the Company can
adjust planned indirect spending during the year, modify its billing rates to its customers, or
record adjustments to expense based on estimates of future contract activities.
If the Company’s rate variance is unfavorable, the modification of our billing rates will
likely increase revenue and operating expenses. Profit percentages on fixed-price
contracts will generally decline as a result of an increase to indirect costs. Profit percentages will generally decline as a percentage of total
costs as a result of an increase in indirect costs even if the cost increase is funded by the customer.
If the Company’s rate variance is favorable, the modification of our billing rates will decrease
revenue and operating expenses. In this event, profit percentages on fixed-price contracts will
generally increase. Profit percentages on cost-reimbursable contracts will generally be unaffected as
a result of any reduction to indirect costs, due to the fact that programs will typically expend
all of the funds available. Any impact on operating income, however, will depend on a number of
other factors, including mix of contract types, contract terms and anticipated performance on
specific contracts.
At July 3, 2005, the
unfavorable rate variance was approximately $3,000,000. Actions taken by management to reduce the unfavorable rate variance beginning in the third quarter are expected to have
a continued favorable impact in the fourth quarter. Based on the additions the Company has already made to the engineering staff and the improved utilization of that staff in program
performance, management expects the unfavorable rate variance to be eliminated by the end of the fourth quarter.
Award Fee Recognition
Argon ST’s practice for recognizing interim fee on its cost-plus-award-fee contracts is based
on management’s assessment as to the likelihood that the award fee or an incremental portion of the
award fee will be earned on a contract-by-contract basis. Management’s assessments are based on
numerous factors including contract terms, nature of the work performed, Argon ST’s relationship
and history with the customer, Argon ST’s history with similar types of projects, and Argon ST’s
current and anticipated performance on the specific contract. No award fee is recognized until
management determines that it is probable that an award fee or portion thereof will be earned.
Actual fees awarded are typically within management’s estimates. However, changes could arise
within an award fee period causing management to either lower or raise the award fee estimate in
the period in which it occurs.
Goodwill
Costs in excess of the fair value of tangible and identifiable intangible assets acquired and
liabilities assumed in a business combination are recorded as goodwill. In accordance with SFAS
No. 142, “Goodwill and Other Intangible Assets” companies no longer amortize goodwill, but instead
test for impairment at least annually using a two-step approach. Impairment of goodwill is tested
at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill,
to the fair value of the reporting unit. The fair value of the reporting units is estimated using
a combination of the income, or discounted cash flows approach and the market approach, which
utilizes comparable companies’ data. If the carrying amount of the unit exceeds its fair value,
goodwill is considered impaired and a second step is performed to measure the amount of impairment
loss, if any. The Company performs its annual impairment test in September of each fiscal year,
unless circumstances or events indicate that an impairment test should be performed sooner.
Accounts Receivable
Argon ST is required to estimate the collectibility of its accounts receivables. Judgment is
required in assessing the realization of such receivables, and the related reserve requirements are
based on the best facts available to Argon ST. Since most of Argon ST’s revenue is generated under
U.S. Federal Government contracts, its current accounts receivable reserve is not significant.
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Historical Operating Results
Third Quarter Ended July 3, 2005 compared to Third Quarter Ended June 27, 2004
The following table sets forth certain items, including consolidated revenues, cost of
revenues, general and administrative expenses, income tax expense and net income, and the changes
in these items for the periods indicated:
Revenues:
Revenues increased approximately 94% for the third quarter ended July 3, 2005, as compared to
the third quarter ended June 27, 2004. The increase is primarily attributable to additional
revenues generated from the merger with Sensytech (see pro forma data below), increased
international contract activity, increased activity on a new airborne program, and the continued
transition to full rate production on three major systems programs in the third quarter ended July
3, 2005. These three production programs contributed 53% of the revenue during this period.
Cost of Revenues:
Cost of revenues increased approximately
93% for the third quarter ended July 3, 2005 as
compared to the third quarter ended June 27, 2004. The increase is attributable to the merger with
Sensytech (see pro forma data below) and the related material and labor costs associated with the
increased business volume from the Company’s fixed price production contracts. Cost of revenues as
a percentage of revenues was 83% and 83% for the third quarters ended July 3, 2005 and June 27,
2004, respectively. We continue to be successful in controlling labor cost increases, as the
Company has leveraged its growing software product line across a broader base of programs, thereby
enabling it to achieve cost efficiencies in satisfying its program requirements for software
deliveries. Material cost savings have been achieved as a result of improved pricing from vendors
through the practice of purchasing in higher volumes across multiple programs. We have increased
the rate of systems production and have experienced efficiencies in our production processes,
resulting in lower costs.
During the fiscal quarter ended July 3, 2005, the Company’s percentage of revenue from fixed
price contracts increased to 79% from 74% for the fiscal quarter ended June 27, 2004. In the
present quarter and historically, we have derived higher margins in fixed price work then we
experience with cost reimbursable work, which ultimately results in a lower cost as a percentage of
revenue.
General and Administrative Expenses:
General and administrative expenses increased
approximately 173% for the third quarter ended
July 3, 2005, as compared to the third quarter ended June 27, 2004. The increase was due to an
increase in internal research and development of $1,011,000 and costs of $665,000 associated with
financial systems consolidation related to the Sensytech merger and Sarbanes-Oxley Section 404
compliance. The Section 404 costs were comprised primarily of external consulting expenses.
17
Interest Income and Interest Expense:
Interest income increased approximately $153,000 for the third quarter ended July 3, 2005, as
compared to the third quarter ended June 27, 2004. During the quarter ended July 3, 2005, the
Company maintained an average cash balance of $27,033,000, compared to $6,729,000 maintained during
the quarter ended June 27, 2004. This, combined with higher interest rates on short term
investments, resulted in higher interest income. Interest expense was not significant in the third
quarters ended July 3, 2005 and June 27, 2004.
Income Tax Expense:
The Company’s effective income tax rate increased to 40.1% for the third quarter ended July 3,
2005, compared to an effective rate of 36.9% for the third quarter ended June 27, 2004. This
increase is due primarily to an increase in the federal statutory rate from 34% to 35%; an increase
in the effective state tax rate of approximately 1.2%; and an anticipated decrease in the R&D tax
credit effective rate of approximately 1%.
Net Income:
As a result of the above, net income increased approximately $2,428,000, or 71%, for the third
quarter ended July 3, 2005 compared to the third quarter ended June 27, 2004. The effect of
increased sales volume, the merger with Sensytech and operational cost savings noted above has
yielded increased efficiencies.
Nine Months Ended July 3, 2005 compared to Nine Months Ended June 27, 2004
The following table sets forth certain items, including consolidated revenues, cost of
revenues, general and administrative expenses, income tax expense and net income, and the changes
in these items for the periods indicated:
Revenues:
Revenues increased approximately 111% for the nine months ended July 3, 2005, as compared to
the nine months ended June 27, 2004. The increase is primarily attributable to the additional
revenues generated from the merger with Sensytech (see pro forma data below), increased
international contract activity, the increased activity on a new airborne program, and the
continued transition to full rate production on three major systems programs in the nine months
ended July 3, 2005. As production has increased, the material content has increased by 206% over
the prior year period. These three production programs contributed 50% of the revenue during this
period.
Cost of Revenues:
Cost of revenues increased approximately 106% for the nine months ended July 3, 2005 as
compared to the nine months ended June 27, 2004. The increase is attributable to the merger with
Sensytech (see pro forma data below) and the related material and labor costs associated with the
increased business volume from the Company’s fixed price production contracts. Cost of revenues as
a percentage of revenues was 81% and 83% for the nine
18
months ended July 3, 2005 and June 27, 2004, respectively. We continue to be successful in
controlling labor cost increases, as the Company has leveraged its growing software product line
across a broader base of programs, thereby enabling it to achieve cost efficiencies in satisfying
its program requirements for software deliveries. Material cost savings have been achieved as a
result of improved pricing from vendors through the practice of purchasing in higher volumes across
multiple programs. In addition, as we have increased the rate of systems production, we have
experienced efficiencies in our production processes, resulting in lower costs. During the nine
months ended July 3, 2005, the Company’s percentage of revenue from fixed price contracts increased
to 79% from 72% for the prior year nine month period. Historically, fixed price contracts produce
higher margins than cost reimbursable contracts, resulting in a lower percentage of cost to
revenue.
General and Administrative Expenses:
General and administrative expenses increased approximately
138% for the nine months ended
July 3, 2005, as compared to the nine months ended June 27, 2004. The increase was due to an
increase in internal research and development costs of $2,876,000, costs of $1,288,000 associated
with financial systems consolidation related to the Sensytech merger and Sarbanes-Oxley Section 404
compliance, and an increase in salaries expense of $822,000 as a result of increased staff.
Interest Income and Interest Expense:
Interest income increased approximately $448,000 for the nine months ended July 3, 2005, as
compared to the nine months ended June 27, 2004. During the nine months ended July 3, 2005, the
company maintained an average cash balance of $30,938,000, compared to $8,338,000 maintained during
the nine months ended June 27, 2004. This, combined with higher interest rates on short term
investments, resulted in higher interest income. Interest expense was not significant in the nine
months ended July 3, 2005 and June 27, 2004.
Income Tax Expense:
The Company’s effective income tax rate increased to 39.0% for the nine months ended July 3,
2005, compared to an effective rate of 36.9% for the nine months ended June 27, 2004. The
increased is due primarily to an increase in the federal statutory rate from 34% to 35%; an
increase in the effective state tax from 3.9% to 4.4% and an anticipated decrease in the R&D tax
credit effective rate of approximately 1%.
Net Income:
As a result of the above, net income increased approximately $8,886,000, or 130%, for the nine
months ended July 3, 2005 compared to the nine months ended June 27, 2004. The effect of increased
sales volume, the merger with Sensytech and operations cost savings noted above has yielded greater
efficiencies contributing to this increase. In addition, the Company successfully met critical
milestones on two fixed price programs, enabling increases to the profit rates on those programs.
Pro forma Financial Results of Operations
The following unaudited condensed combined pro forma results of operations reflect the pro
forma combination of Argon Engineering and Sensytech as if the combination had occurred at the
beginning of the periods presented, compared with the historical results of operations for Argon
Engineering for the same periods.
These unaudited pro forma condensed combined results of operations were prepared based on the
historical financial statements of Argon Engineering, and the historical financial statements of
Sensytech, adjusted in accordance with SFAS No. 141 as presented in note 3 of the accompanying
financial statements. The unaudited pro forma condensed combined results of operations do not
purport to represent what Argon ST’s results of operations would have been if such transaction had
occurred at the beginning of the periods presented, and are not necessarily indicative of Argon
ST’s future results.
19
Pro forma revenues attributable to Sensytech were $17,280,000 and $43,964,000 for the third
quarter and nine months ended June 27, 2004, respectively. Pro forma income from operations
attributable to Sensytech was $2,436,000 and $5,541,000 for the third quarter and nine months ended
June 27, 2004, respectively. Pro forma net income attributable to Sensytech was $1,510,000 and
$3,414,000, for the third quarter and nine months ended June 27, 2004, respectively. Pro forma
depreciation and amortization on the write up of tangible and intangible assets, in accordance with
SFAS 141, was $279,000 and $995,000 for the third quarter and nine months ended June 27, 2004,
respectively, and the after tax effect was $172,000 and $614,000, respectively.
Analysis of Liquidity and Capital Resources
Argon ST’s primary source of liquidity is cash used in operations. On July 3, 2005, Argon ST
had cash of $25,652,000 compared to cash of $29,732,000 on September 30, 2004. This decrease in
cash of $4,080,000 was the result of an increase in billed and unbilled receivables of $14,380,000
(including approximately $3,000,000 in unbilled receivables related to indirect rate variances),
and a decrease in deferred revenue of $16,994,000; partially offset by net income earned during the
nine months ending July 3, 2005 of $15,719,000 and an increase in accounts payable and accrued
expense of $14,042,000.
While billed and unbilled receivables continue to increase over the prior year, the percentage
of receivables to revenue actually has decreased. At July 3, 2005, the percent of receivable to
annualized revenue was 30.0% compared to 32.5% at June 27, 2004. Based on pro forma numbers, which
include Sensytech receivables and revenues at June 27, 2004, the percent of receivables to revenues
was 37.2%
Argon ST has a $15,000,000 line of credit with Bank of America. The line of credit is for two
years and is scheduled to expire on February 28, 2006. The total borrowing base generally cannot
exceed the sum of 90% of qualified government accounts receivable and 80% of qualified
non-government accounts receivable. Total letters of credit at July 3, 2005 were $1,554,000. The
line of credit is available to finance the performance of government contracts, to support the
issuance of stand-by letters of credit, and for short-term working capital purposes. At April 3,
2005, there were no borrowings under the line of credit. The line of credit less the letters of
credit provided loan availability of $13,446,000 at July 3, 2005. Based on current backlog, planned
contract revenue, and planned capital expenditures, Argon ST does not anticipate the need for any
cash other than cash generated from operations during the next twelve months. This planning does
not assume any acquisitions that would require cash.
The bank agreement establishes the interest rate at the LIBOR plus 200 to 285 basis points,
determined by Argon ST’s ratio of funded debt to earnings before interest, taxes, depreciation and
amortization. All borrowings under the line of credit are collateralized by all personal property
of Argon ST. The agreement also contains various
20
covenants as to dividend restrictions, working capital, tangible net worth, earnings and
debt-to-equity ratios. Unused commitment fees of one quarter of one percent per annum are required.
Net cash used in operating activities was $4,581,000 for the nine months ending July 3, 2005,
compared to net cash provided by operating activities of $3,708,000 for the nine months ending June
27, 2004. The decrease in net cash from operating activities for the nine months ending July 3,
2005 period compared to the nine months ending June 27, 2004 was primarily caused by a decrease in
deferred revenues of $24,096,000 and a decrease in income taxes payable of $2,111,000, partially
offset by an increase in net income of $8,886,000 and a decrease in accounts receivable billed and
unbilled of $8,393,000, and an increase in accounts payable and accrued expense of $4,743,000.
Deferred revenue occurs when event or time based payments on fixed price contracts exceed the
amount of revenue recognized on those contracts as of the applicable measurement date. As the
Company continues work on those contracts and the excess billing amount decreases, the Company
recognizes additional revenue on those contracts. During the nine months ended July 3, 2005, the
Company made tax payments of $10,989,000.
Net cash used by investing activities was $3,852,000 in the nine months ending July 3, 2005,
compared to $1,876,000 in the nine months ending June 27, 2004. The increase in cash used by
investing activities was due to the acquisition of test equipment, computer resources and software,
and completion of the Company’s Systems Engineering Test Center (SETC) in Fayette County,
Pennsylvania. It is expected that the equipment acquisition and related costs will continue as
Argon ST replaces older equipment and will increase in approximately the same proportion as Argon
ST’s employee base increases.
Net cash provided by financing activities was $4,353,000 in nine months ending July 3, 2005 as
compared to net cash used in financing activities of $304,000 in nine months ending June 27, 2004.
The increase in cash provided by financing activities is primarily the result of proceeds from
exercises of stock options and purchases of common stock under the Company’s employee stock plans.
During the nine months ended June 27, 2004, Argon ST purchased and retired $664,000 of common stock
and in connection with the repurchase, issued a note payable of $451,000 of which $113,000 is
outstanding as of July 3, 2005.
Contractual Obligations and Commitments
Contractual Cash Obligations:
Other Commercial Commitments:
Argon ST has no long-term debt obligations, capital lease obligations, other operating lease
obligations, contractual purchase obligations, or other long-term liabilities other than those
shown above. Argon ST also has no off-balance sheet arrangements of any kind.
21
Recent Accounting Pronouncements
In June 2005, the FASB issued FASB Statement No. 154 (“Statement No. 154”) Accounting Changes
and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3. Opinion No.
20 previously required that most voluntary changes in accounting principle be recognized by
including in net income of the period of the change the cumulative effect of the change to the new
accounting principle. Statement No. 154 requires retrospective application to prior periods’
financial statements of changes in accounting principle, unless it is impracticable to determine
either the period-specific effects or the cumulative effect of the change. Statement No. 154 is
effective for the accounting changes and corrections of errors made in fiscal years beginning after
December 15, 2005. The Company will adopt Statement No. 154 in the fiscal year beginning October
1, 2006.
In December 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment
(“Statement No. 123(R)”), which is a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. Statement No. 123(R) requires that the compensation cost related to share-based
payment transactions be recognized in financial statements. In April 2005, the Securities and
Exchange Commission issued Release 33-8568 which allows companies to implement Statement No. 123(R)
at the beginning of the annual reporting period that begins after June 15, 2005. Consistent with
the new rule, the Company intends to adopt Statement No. 123(R) in the first quarter of its 2006
fiscal year, and to implement the standard on a prospective basis. The Company has not yet
concluded what impact the adoption of Statement No. 123(R) may have on its results of operations or
financial position.
The effects of the adoption of Statement No. 123(R) on our results of operations and financial
position are dependent upon a number of factors, including the number of employee stock options
outstanding and unvested, the number of employee options that may be granted in the future, the
future market value and volatility of our stock price, movements in the risk-free rate of interest,
stock option exercise and forfeiture patterns, and the stock option valuation model used to
estimate the fair value of each option. As a result of these variables, it is not yet possible to
reliably estimate the effect of the adoption of Statement No. 123(R) on our results of operations
and earnings per share. Note 4 of the Notes to Condensed Consolidated Financial Statements
provides an indication of the effects of adoption assuming the use of the Black-Scholes option
pricing model to estimate the fair value of employee stock options and employee stock purchase plan
awards upon the results of operations for the nine months ended July 3, 2005 and June 27, 2004.
We, however, have not determined whether the adoption will result in amounts that are similar to
the current pro forma disclosures under Statement No. 123(R).
Market Risks
In addition to the risks inherent in its operations, Argon ST is exposed to financial, market,
political and economic risks. The following discussion provides additional detail regarding its
exposure to credit, interest rates and foreign exchange rates.
Cash and Cash Equivalents:
All unrestricted, highly liquid investments purchased with a remaining maturity of three
months or less are considered to be cash equivalents. Argon ST maintains cash and cash equivalents
with various financial institutions in excess of the amount insured by the Federal Deposit
Insurance Corporation. It believes that any credit risk related to these cash and cash equivalents
is minimal.
Interest Rates:
Argon ST’s line of credit financing provides available borrowing to it at a variable interest
rate tied to the bank’s prime interest rate or the LIBOR rate. There were no outstanding borrowings
under this line of credit at July 3, 2005. Accordingly, Argon ST does not believe that any movement
in interest rates would have a material impact on future earnings or cash flows
22
Foreign Currency:
Argon ST has contracts to provide services to U.S. approved foreign countries. Argon ST’s
foreign sales contracts require payment in U.S. dollars, and therefore are not affected by foreign
currency fluctuations. Argon ST occasionally issues orders or subcontracts to foreign companies in
local currency. The current obligations to foreign companies are of an immaterial amount and the
Company believes the associated currency risk is also immaterial.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The information called for by this item is provided under Item 2 — “Management’s Discussion
and Analysis of Financial Condition and Results of Operations – Market Risks.”
ITEM 4. CONTROLS AND PROCEDURES
23
PART
II — OTHER INFORMATION
ITEM 5. OTHER INFORMATION
On July 8, 2005, the Company announced that Donald F. Fultz resigned as Chief Financial
Officer, effective July 9, 2005. Victor F. Sellier, formerly the Company’s Vice President,
Business Operations and Secretary, was appointed to assume the duties of Chief Financial Officer
upon Mr. Fultz’s resignation. Mr. Sellier will retain the office of Secretary. Under the February
2004 retention agreement between Mr. Fultz and the Company entered into prior to the merger of
Argon Engineering and Sensytech, Mr. Fultz will be paid $320,000 within 60 days of August 5, 2005,
the date of his departure from the Company.
ITEM 6. EXHIBITS
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: August 11, 2005
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