Channell Commercial 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File Number 0-28582
CHANNELL COMMERCIAL CORPORATION
(Exact name of registrant as specified in its charter)
26040 Ynez Road
Temecula, CA 92591
(Address of principal executive offices, including zip code)
Registrants telephone number, including area code: (951) 719-2600
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.
Yes o No ý
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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
On March 27, 2006, the registrant had 9,543,584 shares of Common Stock outstanding with a par value of $.01 per share. The aggregate market value of the 4,678,495 shares held by non-affiliates of the registrant was $35,088,713 computed by reference to the price at which the shares were last sold, as of the last business day of the registrants most recently completed second fiscal quarter. Shares of Common Stock held by each officer and director and by each person who may be deemed to be an affiliate have been excluded.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Form 10-K incorporates by reference certain information from the registrants definitive proxy statement for its 2006 annual meeting of stockholders.
TABLE OF CONTENTS
Channell Commercial Corporation (the Company) was incorporated in Delaware on April 23, 1996, as the successor to Channell Commercial Corporation, a California corporation. The Companys executive offices are located at 26040 Ynez Road, Temecula, California 92591, and its telephone number at that address is (951) 719-2600.
The Company is a designer and manufacturer of telecommunications equipment supplied to broadband and telephone network providers worldwide. Major product lines include a complete line of thermoplastic and metal fabricated enclosures, advanced copper termination and connectorization products, fiber optic cable management systems for fiber to the premise (FTTP) networks, and heat shrink products. The Companys enclosure products house, protect and provide access to advanced telecommunications hardware, including both radio frequency (RF) electronics and photonics, and transmission media, including coaxial cable, copper wire and optical fibers, used in the delivery of voice, video and data services. The enclosure products are deployed within the access portion of the local signal delivery network, commonly known as the outside plant, local loop or last mile, that connects the network providers signal origination point or local office with its residential and business customers. The Companys connectivity products provide critical network connection points between cables or network transmission devices.
The Company also designs, manufactures and markets polyethylene water tanks for rural and residential markets in Australia. The Companys primary product line of rotational molded tanks is used in the agricultural sector where water shortages require storage of rain and ground water. The Company also markets a range of water storage tanks for use in residential and rural-residential markets. The Company operates out of six leased facilities in Australia. The facilities are located in Sydney, Dalby, Orange, Terang, Townsville, and Adelaide.
The Company entered the Australian water storage tank market in August 2004 with the acquisition of Bushman Tanks. Bushman Tanks is Australias largest manufacturer and distributor of rotational molded polyethylene water storage tanks.
The Companys enclosure product line accounted for 44%, 59% and 79% of the Companys net sales in 2005, 2004 and 2003, respectively. The Company has recently diversified a portion of its business with the acquisition of Bushman Tanks. The Companys water related products product line accounted for 48% of the Companys net sales in 2005 and 30% of the Companys net sales in 2004. The Company has long-lived assets in Australia that were $5.3 million, $5.5 million and $2.4 million as of December 31, 2005, 2004 and 2003, respectively. For financial segment and geographic information, see Note O to the Companys Consolidated Financial Statements included herein.
The Company operates primarily in two industries, the global telecommunications industry and the Australian water storage tank industry.
In the telecommunications industry, broadband and local telephone operators are building, rebuilding or upgrading signal delivery networks around the world. These networks are designed to deliver video, voice and/or data transmissions to individual residences and businesses. Operators deploy a variety of network technologies and architectures, such as HFC, VoIP, DLC, ADSL and FTTP (see Glossary of Terms) to carry broadband and narrowband signals. These architectures are constructed of electronic hardware connected via coaxial cables, copper wires and/or optical fibers, including various access devices, amplifiers, nodes, hubs and other signal transmission and powering electronics. Many of these devices in the outside plant require housing in secure, protective enclosures and cable management connectivity systems, such as those manufactured by the Company.
As critical components of the outside plant, enclosure products provide (i) protection against weather and vandalism, (ii) ready access for technicians who maintain and manage the outside plant and, (iii) in some cases, dissipation of heat generated by the active electronic hardware. Broadband and local telephone network operators place great reliance on manufacturers of protective enclosures because any material damage to the signal delivery networks is likely to disrupt communications services. Connectivity products provide critical broadband data-rated connection points which support cost effective service deployment and ensure signal integrity is maintained throughout the network.
The primary drivers of demand for enclosures in the communications industry are the construction, rebuilding, upgrading and maintenance of signal delivery networks by broadband operators and local telephone companies. For example, broadband networks are being upgraded and prepared for advanced two-way services such as high-speed Internet access via cable modems, traditional wireline telephony and xDSL transport. Local telephone service providers are employing advanced technologies, such as a variety of digital subscriber line (DSL) technologies, which utilize installed copper wires for broadband services. These local loop copper wire systems often require significant upgrading and maintenance to provide the optimal throughput necessary to carry high-speed broadband signals, increasing the need for data-rated fully sealed outside plant facilities in order to sustain network reliability and longevity. Local telephone service providers are also employing various fiber to the premise (FTTP) technologies to deliver higher bandwidth services to customers. FTTP utilizes outside plant enclosures to protect the networks as well as fiber cable management devices that are both manufactured by the Company. Similar architectures are deployed world-wide which utilize multiple configurations of enclosure and connectivity products.
In the Australian water storage tank industry, consumers utilize plastic, steel or concrete tanks for the storage of water. Australia is an arid climate with limited water resources. The combination of a growing population, a movement of people away from urban areas and limited rainfall has resulted in water shortages in most geographic areas. Water storage tanks are used to store rain and ground water in residential and commercial properties. The water is used for outside the home purposes such as gardening, pumped into the home for non potable uses such as washing machines and toilets and may often be used as a source of drinking water. Local, state and national governments have implemented several regulations intended to conserve water. These include restrictions on the use of potable water and requirements to install water storage tanks or other conservancy products in new residential dwellings in selected areas.
The Companys strategy is to capitalize on its core strengths in the design and manufacture of thermoplastic products, metal products and connectivity products and to use these strengths to be a leading company in the markets in which it operates as well as to enter new markets.
The Company pursues opportunities in the global communications industry by providing enclosures, connectivity products and other complementary components to meet the evolving needs of its customers communications networks. The Companys wide range of products, manufacturing expertise, application-based sales and marketing approach and reputation for high quality products address key requirements of its customers.
In addition to the communications industry, the Company seeks to leverage its expertise in plastics and metal manufacturing technologies to diversify into other industries. The Companys acquisition of the Bushman Tanks business is an example of this diversification. Bushman Tanks utilizes plastic rotational molding technology to produce water tanks, a process similar to that used by the Company to manufacture thermoplastic enclosures for the communications industry. The Company believes it can apply its advanced rotational manufacturing technologies to the Bushman Tanks operations to improve performance.
Principal elements of the Companys strategy include the following:
Focus on Core Telecommunications Business. The Company will continue to seek to capitalize on its position as a leading designer, manufacturer and marketer of enclosures, grade level boxes, and copper wire connectors for the broadband/CATV and local telephone industries in the North America, Europe, Middle East, Africa, Australia and Asia markets through direct marketing and new product development. The Company believes it currently supplies a substantial portion of the enclosure product requirements of a number of major broadband network operators.
The Company has invested in the development of a broad range of products designed specifically for telecom applications. These include connectivity and enclosure products for DSL and FTTP based networks. The Company has successfully marketed its traditional broadband products to local telephone companies that have been designing and deploying broadband networks to deliver competitive video and data services. The Company will continue to target this market for growth, both with telephone network operators and with major system OEMs.
Expand International Presence in Communications Industry. Management believes international markets offer significant opportunities for increased sales to both broadband and telephone companies. The Companys principal international markets currently include Canada, Mexico, Asia, the Pacific Rim, the Middle East, Africa and Europe. Trends expected to result in international growth opportunities include the on-going deregulation and privatization of telecommunications in many nations around the world and the focus of numerous countries on building, expanding and enhancing their communications systems to deliver broadband services in order to participate fully in the information-based global economy. The Company will concentrate on expansion in international markets that are characterized by deregulation or privatization of telecommunications and by the availability of capital for the construction of signal delivery networks.
Develop New Products and Enter New Markets. The Company continues to leverage its core capabilities in developing innovative products that meet the evolving needs of its customers. Innovative products offered by the Company include its MAH Series free-breathing telephony enclosures, GLBTM grade level box sub surface enclosures, the Mini-Rocker insulation displacement copper connectivity products, and a range of Rhino metal fabricated enclosures. The Company continually invests in ongoing improvement and enhancement projects for the existing products developed by the Company, several of which have received U.S. and international patent protection. The Companys products are designed to improve the performance of its customers outside plant systems. The Company has a proven record in designing, developing and manufacturing next generation products that provide solutions for its customers and offer advantages over those offered by other suppliers to the industry. The Company also believes its core capabilities are applicable to markets outside the telecommunications industry.
The Company is expanding its product offering of water storage tanks to include underground tanks and related products primarily for the residential markets in Australia. The Companys principal customers are currently in rural areas. The Company continues to develop innovative products to expand its presence in the residential and rural-residential markets of Australia. The Company may also pursue water storage tank markets beyond Australia in the future.
Concentrate on Core Capabilities to Diversify into Other Industries. The Company believes its core competencies are in the design and manufacture of plastic and metal enclosure products for industrial infrastructure applications and copper wire connectivity. The Company is pursuing a strategy to utilize these core competencies to diversify into other industries to grow profitably. Relevant industries that the Company may pursue include water, irrigation, power utility and other outside plant infrastructure products. The acquisition of Bushman Tanks to operate in the water industry is an example of this diversification strategy.
The Company currently markets over 60 product families, with several thousand optional product configurations. The primary functions of the Companys products designed for the telecommunications industry are cable routing and management, equipment access, heat dissipation and security. The Company believes that it offers one of the most complete lines of outside plant infrastructure products in the telecommunications industry. The primary functions of the Companys products designed for the water industry are the filtration, storage and distribution of water for both outside and inside rural and suburban residences.
Enclosures. The Company manufactures precision-molded, highly engineered and application-specific thermoplastic and metal fabricated enclosures for the communications industry that are considered state-of-the-industry, having been field tested and received approvals and standardization certifications from major broadband/CATV and telephone company operators. Most of the Companys products are designed for buried and underground network applications. The Companys enclosure products provide technicians access to network equipment for maintenance, upgrades and installation of new services. Buried and underground networks and enclosures are generally preferred by broadband operators for increased network reliability, lower maintenance, improved security, reduced utility right-of-way conflicts, and aesthetic appeal. The enclosure products, particularly the thermoplastic versions, must provide advanced heat dissipation characteristics increasingly required for the protection of active electronics in many network installations. The Company is also a designer and manufacturer of metal fabricated enclosures that house advanced electronics, fiber optic cable and power systems for broadband telecommunications networks (branded as Rhino Enclosures). The Company designs and manufactures a series of termination blocks, brackets and cable management devices for mounting inside its enclosure products. The Company is recognized in the industry for its differentiated product designs and the functionality, field performance and service life of its products.
Copper Connectivity. The Company is a designer and manufacturer of innovative telephone connectivity devices. The Companys Insulation Displacement Connector (IDC) technology provides advanced tool-less termination systems for copper wires, the predominant medium used in the Last Mile for telephone services worldwide. These proprietary IDC products environmentally seal network termination points with a high level of reliability. The Companys DSLink TM modular terminal block offers telephone service providers a Category 5 (Cat-5) solution to the rising costs of DSL deployment in the local loop. The Companys Mini-Rocker line of copper connectivity modules, blocks and accessories offer environmentally sealed and Cat-5 data rated IDC tool-less circuit installation and have been accepted as a universal connectivity platform for network applications worldwide, including xDSL and VoIP services.
Fiber Optic Products. The Company offers a range of fiber optic cable management products designed for use in telephone and broadband networks. These products are particularly well suited for fiber to the premises (FTTP) network architectures. Fiber optic electronic enclosures house optical electronics, power supplies and cables. The Companys fiber optic splice cases are used for organizing, managing and protecting the connection points between separate lengths of fiber optic cable in the outside plant network. Fiber optic cable assemblies and interconnect hardware are used to connect fiber
optic electronics and fiber optic cables primarily for in-building applications. All of these products are designed and manufactured by the Company and marketed worldwide.
Grade Level Boxes. The Company is a designer and supplier of grade level boxes used for sub-surface network access. Storage of underground cables, irrigation valves, and power utility distribution points represent some of the leading cross industry applications. A series of these products have been designed specifically for, and are widely deployed in, FTTP networks.
OEM Programs. The Company has OEM marketing programs through which other manufacturers incorporate the Companys products as components of their telecommunications systems. These OEM programs generally include exchanges of technical information that the Company can use in developing new products and improvements and enhancements to existing designs. The Company has established additional relationships with systems integrators and innovative end users that provide valuable product improvement information.
Water Products. The Company offers a range of water tank products for the storage of potable and non potable water. These products typically store rain water collected from the roofs of homes or other buildings or water pumped from underground wells. These products are primarily used by residential homes, agricultural properties and commercial buildings. Accessory products for these water tanks include filtration systems, connection devices and pumps.
In addition to water storage tanks, the Companys water product line includes enclosures for various access applications. The Companys line of grade level boxes are designed and configured for water distribution and irrigation applications.
Marketing and Sales
The Company markets its products primarily through a direct sales force of technically trained salespeople. The Company employs an application-specific, systems approach to marketing its products, offering the customer a complete, cost-effective system solution to meet its outside plant requirements. All sales personnel have technical expertise in the products they market and are supported by the Companys engineering and technical marketing staff. Product marketing specialists are assigned to provide technical support and commercial direction for the Companys strategic product groups.
Internal sales/customer service departments administer and schedule incoming orders, handle requests for product enhancements and service inquiries and support the Companys direct sales force. This department maintains direct communications with customers and the Companys field sales and operations personnel.
By engaging in public relations activities, product literature development, market research and advertising, the marketing department also promotes and positions the Company within both domestic and international markets. The Company regularly attends, participates and exhibits its products at industry trade shows and conferences within domestic and international markets throughout the year.
Specific to the Companys water tank products, a network of agents and distributors are utilized to market the Companys products in addition to the use of a direct sales force.
The Company participates in agricultural field days in Australia to market water storage products. Agricultural field days are held in most rural areas once or twice per year and are used by rural customers to purchase a variety of hardware products by attending a single event. The Company uses radio and television advertising to promote its water storage tank products throughout Australia.
The Companys vertically integrated manufacturing operations enable the Company to control each step in the manufacturing process, including product design and engineering; design and production of many of its own dies, tools, molds and fixtures. This vertically integrated manufacturing strategy applies to both the communications equipment and water product lines.
The Companys manufacturing expertise enables it to modify its product lines to meet changing market demands, rapidly and efficiently produce large volumes of products, control expenses and ensure product quality. Management considers the Companys manufacturing expertise a distinct and significant competitive advantage, providing it with the ability to satisfy the requirements of major customers with relatively short lead-times by promptly booking and shipping orders.
The Company owns a majority of its manufacturing equipment. Manufacturing processes are performed by trained Company personnel. These manufacturing processes include injection molding, structural foam molding, rotational molding, metal fabrication, automated discrete connector fabrication, rubber injection, transfer and compression molding, and
termination block fabrication. The Company has implemented several comprehensive process and quality assurance programs, including continuous monitoring of key processes, regular product inspections and comprehensive testing.
The Companys manufacturing and distribution facilities as of December 31, 2005, include approximately 367,000 square feet in Temecula, California; 7,000 square feet in Mississauga, Ontario, Canada; 34,000 square feet in Sydney, 43,000 square feet in Dalby, 22,000 square feet in Orange, 16,000 square feet in Terang, 5,000 square feet in Townsville, and 13,000 square feet in Adelaide. The Company operates a leased distribution, sales and marketing facility in the UK serving Europe, Middle East and Africa.
Product Development and Engineering
The Companys product development and engineering staff has designed and tested the Companys products and has developed core competencies in telecommunications outside plant and water storage products. As a direct result, the Company has been able to develop a broad series of superior products designed to meet the specific needs of customers. Distinguishing characteristics of the Companys products include:
Advanced mechanical innovations providing unique application specific performance and feature sets;
Sub-surface network access systems;
Modular metal fabricated enclosure product line covering multiple applications;
Effective heat dissipation qualities for enclosure products;
Advanced copper IDC connectivity products;
A superior environmental sealing and protection system in enclosure products that, unlike many competitors products, does not require gels, compounds or other methods to maintain the required seal;
Product designs allowing communications equipment technicians easy access through covers that can be removed to fully expose the enclosed electronics;
Compatibility with a variety of communications equipment signal delivery network architectures;
Versatility of design to accommodate communications network growth through custom hardware and universal mounting systems that adapt to a variety of new electronic hardware;
Excellent protection and management of optical fibers and cables;
Thermoplastic Epoxy Coating that bonds directly to metal hardware and protects against rust and deterioration;
High strength and UV protected water storage products;
Underground water storage products; and
A complete line of water storage accessories products including filtration, pumps and connection devices.
The Companys product development approach is applications-based and customer driven. A team comprised of engineering, marketing, manufacturing and direct sales personnel work together to define, develop and deliver comprehensive systems solutions to customers, focusing on the complete design cycle from product concept through tooling and high-volume manufacturing. The Company is equipped to conduct many of its own product testing requirements for performance qualification purposes, enabling it to accelerate the product development process. The Company spent $2.7 million in 2005, $2.3 million in 2004, and $1.9 million in 2003 on research and development.
The Company sells its telecommunications related products directly to broadband operators and telephone companies throughout the world, principally within developed nations. The Company sells its products to OEMs on a global basis. The Company sells its water storage products in Australia directly to end users as well as to retailers, wholesalers, distributors and agents. During 2005, the Companys five largest customers accounted for 34.4% of total net sales. In 2005, the Companys five largest customers by sales in the United States were Verizon, Comcast, Cox, Power and Telephone Supply, and Time Warner. The majority of sales to Verizon in 2005 occurred in the first six months of the fiscal year. Verizon and Comcast accounted for 17.5% and 7.3%, respectively, of the Companys net sales in 2005. Verizon and Comcast accounted for 21.7% and 14.6%, respectively, of the Companys net sales in 2004. In international markets, the Companys five largest customers in 2005 by sales were Telstra (Australia), Rogers (Canada), British Telecom (UK), Middendorp Electric (Australia), and Uni Telco (Malaysia).
The Company has historically operated with a relatively small backlog. Sales and operating results in any quarter are primarily dependent upon orders booked and products shipped in the quarter. The Companys customers generally do not enter into long-term supply contracts providing for future purchase commitments of the Companys products. Rather, the Company believes that many of its customers periodically review their supply relationships and adjust buying patterns based upon their current assessment of the products and pricing available in the marketplace. From fiscal period to fiscal period, significant changes in the level of purchases of the Companys products by specific customers can and do result from this
periodic assessment. Customers of water products in Australia are typically individual users that may keep their product for several years before making a repeat purchase, as well as distributors that are used to market the Companys products.
The Company owns substantially all of the patents and other technology employed by it in the manufacture and design of its products. The Companys patents, which expire through the year 2010, cover various aspects of the Companys products. In addition, the Company has certain trade secrets, know-how and trademarks related to its technology and products.
Management does not believe any single patent or other intellectual property right is material to the Companys success as a whole. The Company maintains an intellectual property protection program designed to preserve its intellectual property assets.
The telecommunications industry is highly competitive. The Companys competitors include companies that are much larger than the Company, such as Tyco, 3M, Emerson, Arris and Corning in addition to competitors similar in size to the Company such as Carson Industries. The Company believes its competitive advantages include its ability to service national and multi-national customers, its direct sales force, its specialized engineering resources and its vertically integrated manufacturing operations.
Management believes the principal competitive factors in the telecommunications equipment market are customer service, new product capabilities, price, product availability, and product performance.
Competitive price pressures are common in the industry. In the past, the Company has responded effectively to competition with cost controls through vertical integration utilizing advanced manufacturing techniques, cost-effective product designs and material selection, and an aggressive procurement approach.
In the past, certain of the Companys telecommunications customers have required relatively lengthy field testing of new products prior to purchasing such products in quantity. While field testing can delay the introduction of new products, it can also act as a competitive advantage for those products tested and approved because to a certain extent it creates a barrier to new product introduction and sales by competitors.
The water storage products industry in Australia is characterized by a few large competitors, including ARI Industries and Clark Tanks, and a high number of smaller, regional competitors. The Company believes its competitive advantages include its low cost structure, manufacturing expertise, product design, marketing and sales expertise and its nationwide coverage.
Management believes that the principle competitive factors in the water storage industry are product quality, manufacturing capacity, and geographic location for logistics support, technical support and customer service. The multiple manufacturing plant locations provide nationwide market coverage in the industry.
Competitive price pressures are prevalent in this industry. The Company has responded to these with ongoing process improvements, design optimization and targeted procurement programs.
The existing customer base is widely dispersed throughout the rural market areas. Promotion and awareness of the Companys products and services is strongly reinforced. Long term direct marketing programs including media advertising, radio and television, and high profile promotion at exhibitions have been developed by the Company over many years. These marketing programs have established strong brand equity which creates a competitive advantage/barrier to entry for other suppliers in several significant market areas.
Raw Materials; Availability of Complementary Products
The principal raw materials used by the Company are thermoplastic resins, neoprene rubbers, hot and cold rolled steel, stainless steel, copper and brass. The Company also uses certain other raw materials, such as fasteners, packaging materials and communications cable. Management believes the Company has adequate sources of supply for the raw materials used in its manufacturing processes and it attempts to develop and maintain multiple sources of supply in order to extend the availability and encourage competitive pricing of these materials.
Most plastic resins are purchased under annual or multi-year purchase agreements to stabilize costs and improve supplier delivery performance. Neoprene rubbers are manufactured using the Companys proprietary formulas. Metal products are supplied in standard stock shapes, coils and custom roll forms.
The Company also relies on certain other manufacturers to supply products that complement the Companys own product line, such as grade level boxes. The Company believes there are multiple sources of supply for these products.
As of December 31, 2005, the Company employed 512 people, of whom 85 were in sales, 353 were in manufacturing operations, 26 were in research and development and 48 were in administration. The Company considers its employee relations to be good and recognizes its ability to attract and retain qualified employees is an important factor in its growth and development. None of the Companys employees is subject to a collective bargaining agreement, and the Company has not experienced any business interruption as a result of labor disputes within the past five years.
The telecommunications industry is subject to regulations in the United States and other countries. Federal and state regulatory agencies regulate most of the Companys domestic customers. On February 1, 1996, the United States Congress passed the Telecommunications Act of 1996 that the President signed into law on February 8, 1996. The Telecommunications Act lifted certain restrictions on the ability of companies, including RBOCs and other customers of the Company, to compete with one another and generally reduced the regulation of the communications industry.
The Company is also subject to a wide variety of federal, state and local environmental laws and regulations. The Company utilizes, principally in connection with its thermoplastic manufacturing processes, a limited number of chemicals or similar substances that are classified as hazardous. It is difficult to predict what impact these environmental laws and regulations may have on the Company in the future. Restrictions on chemical uses or certain manufacturing processes could restrict the ability of the Company to operate in the manner that it currently operates or is permitted to operate. Management believes that the Companys operations are in compliance in all material respects with current environmental laws and regulations. Nevertheless, it is possible that the Company may experience releases of certain chemicals to environmental media which could constitute violations of environmental law (and have an impact on its operations) or which could cause the Company to incur material cleanup costs or other damages. For these reasons, the Company might become involved in legal proceedings involving exposure to chemicals or the remediation of environmental contamination from past or present operations. Because certain environmental laws impose strict joint and several retrospective liability upon current owners or operators of facilities from which there have been releases of hazardous substances, the Company could be held liable for remedial measures or other damages (such as liability in personal injury actions) at properties it owns or utilizes in its operations, even if the contamination were not caused by the Companys operations.
The water storage products industry in Australia is also subject to regulation. National, state and local regulatory agencies regulate and in some cases mandate the use of water storage products to conserve water usage. Examples include restrictions on the use of potable water for gardening, the washing of cars and other non-essential uses. In addition, several agencies have offered rebates to those who purchase water storage products to conserve water. Most recently, government agencies have mandated that new residential dwellings in the states of New South Wales and Victoria require a water conservation device such as water storage tanks. The city of Sydney is located in New South Wales and the city of Melbourne is located in Victoria. The affect of these regulations has been to increase the demand for water storage tanks in Australia. There can be no guarantee that these regulations and rebates will remain in existence.
The Companys Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports are available as soon as reasonably practicable after they are filed or furnished to the Securities and Exchange Commission (SEC), through our Internet website, www.channellcomm.com. Company filings are also available through a database maintained by the SEC at www.sec.gov.
Forward Looking Statements
Certain statements contained in this Annual Report on Form 10-K are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the Act), which provides certain safe harbor provisions for forward-looking statements. All forward-looking statements made in this Annual Report on Form 10-K are made pursuant to the Act. Forward-looking statements include statements that are predictive in nature; that depend upon or refer to future events or conditions; or that include words such as expects, anticipates, intends, plans, believes, estimates, or variations or negatives thereof or by similar or comparable words or phrases. In addition, any statements that may be provided by our management concerning future financial performance, ongoing business strategies or prospects or our
possible future actions are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about us; and economic and market factors in the countries in which we do business, among other things. These statements are not guarantees of future performance, and we have no specific intentions to update these statements. References to we us or our are references to the Company.
Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. The principal important risk factors that could cause our actual performance and future events and actions to differ materially from such forward-looking statements include, but are not limited to, the risk factors discussed below.
Obsolescence and Technological Change. The communications industry is in a state of rapid technological change. The introduction of new technologies, network architectures or changes in industry standards can render our existing products or products under development obsolete or unmarketable. For example, satellite, wireless and other communication technologies under development or currently being deployed may represent a threat to copper, coaxial and fiber optic-based systems by reducing the need for wire-line networks. Further, while we anticipate that a number of factors, including network capacity requirements, existing investments in wire-line networks, security and long-term cost effectiveness, will result in growth of wire-line networks, there can be no assurance that future advances or further development of these or other new technologies will not have a material adverse effect on our business. Our growth strategies are designed, in part, to take advantage of opportunities that we believe are emerging as a result of the development of enhanced voice, video, data and other transmission networks, and high-speed Internet access in the telecommunications industry. There can be no assurance that demand resulting from these emerging trends will continue or that our products will be met with market acceptance.
Importance of New Product Development to Growth. A significant factor in our ability to grow and remain competitive will be our ability to anticipate changes in technology, industry standards and customer preferences, and to successfully develop and introduce new products on a timely basis. New product development often requires long-term forecasting of market trends, development and implementation of new designs and processes, and substantial capital commitment. Trends toward consolidation of the communications industry and convergence of technologies may require us to quickly adapt to rapidly changing market conditions and customer requirements. Trends in consumer preferences in Australia for the aesthetic design of water storage tanks may require us to redesign or develop new water tanks and accessory products.
Our manufacturing and marketing expertise has enabled us to successfully develop and market new products in the past. However, any failure by us to anticipate or respond in a cost-effective and timely manner to technological developments or changes in industry standards or customer requirements, or any significant delays in product development or introduction, could have a material adverse effect on our business, operating results and financial condition.
Concentration of Customers. The telecommunications industry is the largest industry in which we operate and is highly concentrated. A relatively small number of customers account for a large percentage of our available market. Consequently, our five largest customers accounted for 34.4% and 48.7% of our total net sales in 2005 and 2004, respectively. Verizon accounted for 17.5% of our total net sales in 2005 and 21.7% of our total net sales in 2004. Comcast accounted for 14.6% of our total net sales in 2004 and 7.3% of our total net sales in 2005. Mergers and acquisitions in the telecommunications industry, which are expected to continue, not only increase the concentration of the industry and of our customer base, but also from time to time delay customers capital expenditures as newly merged service providers consolidate operations. In the event one of our major customers were to terminate purchases of our products, our operating results would be adversely affected.
Dependence on the Telecommunications Industry. Although we have recently diversified a portion of our business with the acquisition of Bushman Tanks, a manufacturer of water storage tanks, we expect that sales to the telecommunications industry will continue to represent a substantial portion of our total sales. Demand for products within this industry depends primarily on capital spending by service providers for constructing, rebuilding, maintaining or upgrading their systems. The amount of capital spending and, therefore, our sales and profitability, are affected by a variety of factors, including general economic conditions, access by service providers to financing, government regulation of service providers, demand for services and technological developments in the telecommunications technology. While the industry generally experienced above average growth in the late 1990s, since 2001 the telecommunications equipment industry has been materially adversely affected by service providers reductions of their capital expenditures.
Our success is dependent upon continued demand by the communications industry for products used in signal transmission systems, which may be affected by factors beyond our control, including the convergence of video, voice, and data transmission systems occurring within the broadband and telephone markets, continuing consolidation of companies within those markets and the provision of Internet access by broadband operators and local telephone companies.
Limited Backlog. Our customers typically require prompt shipment of our products within a narrow timeframe. As a result, we have historically operated with a relatively small backlog. Sales and operating results in any quarter are principally dependent upon orders booked and products shipped in that quarter. Further, our customers generally do not enter into long-term supply contracts providing for future purchase commitments for our products. These factors, when combined with our operating leverage (see Operating Leverage below) and the need to incur certain capital expenditures and expenses in part based upon the expectation of future sales, may place our operating results at risk to changing customer buying patterns. If sales levels in a particular period do not coincide with our expectations, operating results for that period may be materially and adversely affected.
Price Fluctuations of Raw Materials; Availability of Complementary Products. Our cost of sales may be materially affected by increases in the market prices of the raw materials, including resins, used in our manufacturing processes. We do not engage in hedging transactions for such materials, although we periodically enter into purchase agreements for certain raw materials for as much as one year or more. There can be no assurance that price increases in raw materials can be passed on to our customers through increases in product prices. In addition, in order to position ourselves as a full-line product supplier, we rely on certain manufacturers to supply products, including grade level boxes that complement the products manufactured by us. Although we believe there are multiple sources of supply for these products, disruptions or delays in the supply of such products could have a material adverse effect on sales of our own products.
Energy Costs and Availability. Our cost of sales may be materially affected by increases in the market prices of electricity, natural gas and water used in our manufacturing processes. California is the site of our largest manufacturing operation. The energy costs of California manufacturing firms may increase. There exists the possibility of interruption(s) in the supply of energy to Californias manufacturing firms. There can be no assurance that our energy costs can be passed on to our customers through increases in product prices. Further, disruptions or delays in the supply of electricity, natural gas and water to us could have a material adverse effect on sales of our products.
Acquisitions and Failure to Integrate Acquired Businesses. In the event of any acquisition by us, there can be no assurance that we will be able to identify and acquire attractive acquisition candidates, profitably manage any such acquired businesses or successfully integrate such acquired businesses into our business without substantial costs, delays or other problems. Acquisitions involve a number of special risks, including, but not limited to, adverse short-term effects on our reported financial condition or results of operations, diversion of managements attention, dependence on retention, hiring and training of key personnel, risks associated with unanticipated problems or liabilities and amortization of acquired intangible assets, some or all of which could have a material adverse effect on our business, financial condition or results of operations.
We acquired Bushman Tanks in August 2004. The successful integration of this business into our business requires among other things the retention of key personnel, the implementation of the Oracle information system used by all of our other businesses, the implementation of financial accounting and internal controls required by all U.S. publicly owned corporations, the time and attention of our executive management, the integration of management styles and culture as well as the hiring of people necessary to implement the aforementioned items and to expand the business. By the end of 2006, management expects this integration effort to be completed.
In addition, there can be no assurance that any businesses acquired in the future will be profitable at the time of acquisition or will achieve sales and profitability justifying our investment therein or that we will realize the synergies expected from such acquisitions.
The failure to obtain any or all of the desired results from acquisitions could have a material adverse effect on our business, financial condition and results of operations.
Operating Leverage. Because the fixed costs of facilities, product development, engineering, tooling and manufacturing are a relatively high percentage of total costs, our ability to operate profitably is dependent on generating a sufficient volume of product sales, thereby spreading fixed costs over the sales base. Due to this operating leverage, a reduction in sales or the rate of sales growth has had in the past and could have in the future a disproportionately adverse effect on our financial results.
Seasonality and Fluctuations in Operating Results. Our business is seasonal in nature, with the first and fourth quarters generally reflecting lower sales due to the impact of adverse weather conditions on construction projects that may alter or postpone the needs of customers for delivery of our telecommunications products. In addition, first quarter sales may also reflect telecommunication customer delays in implementation of their annual capital expenditure plans. The water storage tank business in Australia is traditionally slow during the fourth quarter due to holidays and restrictions on the number of days in which large trucks can utilize major roads to deliver water storage tanks to customers. Our operating results may also fluctuate significantly from quarter to quarter due to several other factors, including the volume and timing of orders from and shipments to major customers, the timing of new product introductions and deployment as well as the
availability of products by us or our competitors, weather conditions in Australia, which may affect the sales of water storage tanks as a large percentage of sales occur at outdoor agricultural farm fairs, the overall level of capital expenditures by broadband operators and telephone companies, market acceptance of new and enhanced versions of our products, variations in the mix of products we sell, and the availability and costs of raw materials.
Risks Associated with International Operations. International sales, including export sales from U.S. operations, accounted for 48.5%, 33.9%, and 21.2% of our net sales in 2005, 2004 and 2003, respectively. The percentage of international sales to our total sales has increased with the acquisition of the Bushman Tanks business. Due to our international sales, we are subject to the risks of conducting business internationally, including unexpected changes in or impositions of legislative or regulatory requirements, fluctuations in the U.S. dollar, which could materially adversely affect U.S. dollar revenues or operating expenses, tariffs and other barriers and restrictions, longer collection cycles, greater difficulty in accounts receivable collection, potentially adverse taxes and the burdens of complying with a variety of international laws and communications standards. We are also subject to general geopolitical risks, such as political and economic instability and changes in diplomatic and trade relationships, in connection with our international operations. There can be no assurance that these risks of conducting business internationally will not have a material adverse effect on our business.
Competition. The industries in which we operate are highly competitive. The level and intensity of competition may increase in the future. Our competitors in the telecommunications industry include companies that are much larger than us, such as Tyco, 3M, Marconi, Arris and Corning. Our business strategy includes increased focus on telephone connectivity. There can be no assurance that we will be able to compete successfully against our competitors, most of whom have access to greater financial resources than we do. Our competitors in the Australian water storage tank business includes Nylex, which is much larger than us, as well as smaller companies that have market position in specific geographic regions. There can be no assurances that we will be able to successfully compete against these competitors or increase our sales by obtaining a higher market share.
Disruptions at Our Manufacturing Facility; Leases with Related Party. The majority of our manufacturing operations are currently located at our facilities in Temecula, California, which also includes our principal warehouse and corporate office operations. Our success depends in large part on the orderly operation of these facilities. Because our manufacturing operations and administrative departments are concentrated at this facility, a fire, earthquake, power interruption or other disaster at this facility could materially and adversely affect our business and results of operations. We maintain property and business interruption insurance on this facility.
We currently lease a portion of our Temecula facilities from The Channell Family Trust, an affiliate of William H. Channell, Sr., our principal stockholder and Chairman of the Board, and Jacqueline M. Channell, a director and our corporate secretary. We believe the terms of these leases are no less favorable than would be available from an unrelated third party after arms length negotiations. Although these leases expire in, or have renewal options through, the year 2015, there can be no assurance that we will be able to agree on additional renewal terms for the properties currently leased by us. Our failure to renew the leases would require us to relocate our existing facilities, which could have a material adverse effect on our business, financial condition or results of operations.
We currently lease four facilities in Australia from the former owners of Bushman Tanks. Although we believe these leases are in total in excess of fair market value by $27,000 per year, we do not believe that amount is significant compared to total manufacturing costs and thus does not place us of a competitive disadvantage. Although we also have renewal options through the year 2015 under these leases, there can be no assurance that we and the former owners will be able to agree on additional renewal terms for the properties currently leased by us. Our failure to renew the leases would require us to relocate our existing facilities, which could have a material adverse effect on our business, financial condition or results of operations.
Dependence on Key Personnel. Our future success depends in part on our ability to attract and retain key executive, engineering, marketing and sales personnel. Our key personnel includes William H. Channell, Sr., Chairman of the Board, William H. Channell, Jr., President and Chief Executive Officer and our other executive officers. The market for qualified personnel in the communications industry is competitive and the loss of certain key personnel could have a material adverse effect on us. We have employment contracts with William H. Channell, Jr. and William H. Channell, Sr.
Changing Regulatory Environment. The communications industry is subject to regulation in the United States and other countries. Federal and state agencies regulate most of our domestic customers. Changes in current or future laws or regulations, in the United States or elsewhere, could materially adversely affect our business. Government regulation in Australia has increased demand for water storage tanks by requiring the installation of water storage tanks or other water conservation products in new homes built in selected regions. There can be no assurances that these regulations will remain in affect. A lessening of these regulations most likely would lead to lower demand for water storage products and thus negatively affect our sales.
Uncertain Ability to Manage Industry Volatility. Our business has required and is expected to continue to require significant resources in terms of personnel, management and other infrastructure. Our ability to manage effectively the volatility of the telecommunications industry requires us to attract, train, motivate and manage new employees successfully, to integrate new employees into our overall operations and to continue to improve our operational, financial and management information systems.
Environmental Matters. We are subject to a wide variety of federal, state and local environmental laws and regulations and use a limited number of chemicals that are classified or could be classified as hazardous or similar substances. Although we believe that our operations are in compliance in all material respects with current environmental laws and regulations, our failure to comply with such laws and regulations could have a material adverse effect on us.
Weather Matters. Our business may be affected by adverse changes in weather patterns in Australia that may affect the demand for water storage tanks. Prior to 2005 Australia experienced a severe water shortage for several years due to less rainfall, inadequate national infrastructure to store water for use during drought periods and the growth in population in non urban areas. In 2005, Australia received a significant amount of rainfall. A change in the weather pattern which provides additional rainfall and lessens the effect of the drought could have a negative impact on the demand for water storage tanks.
The Companys facilities approximate 509,000 square feet, of which approximately 60%, 25% and 15% were used for manufacturing, warehouse and office space, respectively. In Temecula, California, 261,000 square feet of the total 367,000 square feet are leased from the Channell Family Trust, an affiliate of William H. Channell, Sr., the Companys principal stockholder and Chairman of the Board, and Jacqueline M. Channell, a director and the Company secretary. The Company also leases an aggregate of approximately 325,000 square feet of manufacturing, warehouse and office space in Canada, Australia and the United Kingdom. In Australia, 94,000 square feet of manufacturing and distribution space in Orange, Dalby, Terang, and Adelaide are leased from the former owners of Bushman Tanks. In December, 2002, the Company announced steps to rationalize international manufacturing operations to consolidate operations. The Company has completed the facilities reduction program. In 2002, the Company completed a sale and leaseback of approximately 103,000 square feet of manufacturing, warehouse and office space in Temecula, California. The Company sold approximately 43,000 square feet of manufacturing, warehouse and office space in the United Kingdom in January, 2003. In the fourth quarter of 2003, the Company further evaluated International operations to improve profitability. A manufacturing facility in the United Kingdom was closed in June 2004. The Company considers its current facilities, and its facilities following the completion of the foregoing restructuring activities, to be adequate for its operations.
Carson Industries LLC v. Channell Commercial Corporation (Calif. Superior Court Case No. BC334759). For a number of years, the Company has purchased grade level boxes from Carson Industries LLC (Carson) for resale to the Companys customers. In 2004, the Companys customers began to report failure of Carson boxes in the field. The Company has determined that certain boxes sold to the Company by Carson in 2004 and thereafter did not conform to certain specifications and/or did not perform properly in the field. On June 9, 2005, Carson filed the above-captioned lawsuit against the Company, principally seeking approximately $360,000 for product sold to the Company but not yet paid for. On July 26, 2005, the Company cross-complained against Carson for, among other things, breach of contract, breach of express and implied warranties, fraud and intentional interference with contractual relations. The Company has not stated a specific dollar remedy that it is seeking from Carson. Carson demurred to many of the claims in the Companys cross-complaint, and the demurrer was overruled by the court. Carson has subsequently denied the allegations of the cross-complaint. Discovery in this case is ongoing, and trial has been set for June 7, 2006.
Subsequent to December 31, 2005, the parties have tentatively agreed to settle the lawsuit. Upon final agreement, the Company will pay to Carson $360,000, less the value of inventory returned to Carson, which is approximately $70,000. In addition, Carson will indemnify the Company against certain product warranty claims for five years from the date of sale.
In addition, the Company is from time to time involved in ordinary routine litigation incidental to the conduct of its business. The Company regularly reviews all pending litigation matters in which it is involved and establishes reserves deemed appropriate for such litigation matters. Management believes that no presently pending litigation matters are likely to have a material adverse effect on the Companys financial statements or results of operations, taken as a whole.
The Companys common stock is listed on the NASDAQ National Market and is traded under the symbol CHNL. The following table sets forth, for the periods indicated, the high and low sale prices for the Companys Common Stock, as reported on the NASDAQ National Market.
The Company has not declared any dividends subsequent to its initial public offering in July 1996.
The Company currently anticipates it will retain all available funds to finance its business. The Company does not intend to pay cash dividends in the foreseeable future. Under the terms of the Companys Loan and Security Agreement, the Company has agreed not to pay any dividends (see Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources).
As of March 27, 2006, the Company had 9,543,584 shares of its Common Stock outstanding, held by approximately 1,060 shareholders of record.
The selected consolidated financial data presented below for each of the five years in the period ended December 31, 2005, have been derived from the Companys audited consolidated financial statements, which for the most recent three years appear elsewhere herein. The data should be read in conjunction with the financial statements, related notes and other financial information included therein (amounts in thousands, except per share data).
(1) Includes all interest bearing debt and capital lease obligations.
(2) Gross margin is gross profit as a percentage of net sales.
(3) Operating margin is income (loss) from operations as a percentage of net sales.
The Company is a designer and manufacturer of telecommunications equipment supplied to telephone and broadband network providers worldwide and of water storage products marketed primarily in Australia. In addition to Company manufactured products, the Company markets complementary products manufactured by third parties. The Company sells products directly to broadband operators and telephone companies throughout the United States, Canada, Australia, Asia, Europe, the Middle East and Africa and certain other international markets, principally within developed nations. The Companys customers of water storage products in Australia are typically individual users who will keep the product for several years without a repeat purchase. The Company believes that many of its customers periodically review their supply relationships and consequently the Company can experience significant changes in buying patterns from specific customers between fiscal periods. The Company has historically operated with a relatively small backlog with sales and operating results in any quarter principally dependent upon orders booked and products shipped in that quarter. The Companys customers generally do not enter into long-term supply contracts providing for future purchase commitments for the Companys products. These factors, when combined with the Companys operating leverage and the need to incur certain capital expenditures and expenses in part based upon the expectation of future sales, causes the Companys operating results to be at risk to changing customer buying patterns. If sales levels in a particular period do not meet the Companys expectations, operating results for that period may be materially and adversely affected.
The Company uses numerous raw materials in its manufacturing processes. Although management believes that the Company has adequate sources of supply for such raw materials, increases in the market prices of the Companys raw materials could significantly increase the Companys cost of goods sold and materially adversely affect the Companys profitability. The Companys profitability may also be materially and adversely affected by decreases in its sales volume because many of the costs associated with the Companys facilities, product development, engineering, tooling and other manufacturing processes are essentially fixed in nature and must be spread over its sales base in order to maintain historical levels of profitability.
Critical Accounting Policies
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management bases its estimates on historical experience and on assumptions that are believed to be reasonable under the circumstances and revises its estimates, as appropriate, when changes in events or circumstances indicate that revisions may be necessary. Although these estimates are based on managements knowledge of and experience with past and current events and on managements assumptions about future events, it is possible that they may ultimately differ materially from actual results.
The critical accounting policies requiring estimates and assumptions that management believes have the most significant impact on the Companys consolidated financial statements are:
Accounts receivables reserves
Allowances for excess and obsolete inventory
Valuation of goodwill and long-lived assets
Accounting for income taxes
Foreign currency translation
Accounts receivable reserves and estimated sales returns. Allowances for doubtful accounts are maintained for estimated losses expected to result from the inability of our customers to make required payments. Provisions for uncollectible accounts are made based upon specific percentages of the past due outstanding accounts receivable aging categories. The specific percentages are based on historical experience and are applied to the categories of accounts that are past due by 60, 90, 180 and 360 days. An adverse change in financial condition of a significant customer or group of customers could materially affect managements estimate of percentages required for the provisions for doubtful accounts. Provisions for estimated sales returns are made based on the Companys historical sales returns experience.
Allowances for excess and obsolete inventory. The estimates of excess and obsolete inventory are based on managements assumptions about and analysis of relevant factors including historical sales and usage of items in inventory, current levels of orders and backlog, forecasted demand, product life cycle and market conditions. If actual market conditions become less favorable than anticipated by management, additional allowances for excess and obsolete inventory could be required. In the event management adjusts estimates such as forecasted sales or expected product lifecycles, the
value of the Companys inventory may become understated or overstated and recognition of such understatement or overstatement will affect cost of sales in a future period, which could materially affect the Companys operating results and financial position.
Valuation of goodwill and long-lived assets. Management reviews goodwill and long-lived assets for impairment when events or changes in circumstances indicate the carrying values may not be fully recoverable. Management assesses potential impairment of the carrying values of these assets based on market prices, if available, and/or assumptions about and estimates of future cash flows expected to be generated from these assets. Future cash flows may be adversely impacted by operating performance, market conditions and other factors. An impairment charge would be based on the amount by which the carrying value exceeds fair value. Fair value is estimated by management based on market prices, if available, and/or forecasted discounted cash flows, using a discount rate commensurate with the risks involved. Assumptions related to future cash flows and discount rates involve management judgment and are subject to significant uncertainty. If future cash flows, discount rates and other assumptions used in the assessment and measurement of impairment differ from managements estimates and forecasts, additional impairment charges could be required. As of December 31, 2005, there was no impairment in the Companys valuation of goodwill.
Restructuring costs. Restructuring costs are recorded in accordance with Financial Accounting Standards Board (FASB) Statement 146, Accounting for Costs Associated With Exit or Disposal Activities. One-time severance benefits for employees terminated are recorded at the time management commits to the plan to reduce the work force, knows the amount of the termination benefit, is unlikely to change the plan and has communicated to employees the intended work force reduction. Liabilities for costs that will continue to be incurred under a contract for its remaining term without an economic benefit, such as for facility lease payments for premises vacated, are recorded when the Company ceases to use the right conveyed by the contract. In the case of vacated leased facilities, the liability is based on the future lease payments required under the contract less the estimated future rental income the Company may earn by subletting the facilities or estimates of costs incurred to terminate a lease with a landlord. These estimates of future sublet income are based on current economic conditions, current condition of the local leasing market, past experience and judgments supplied by professionals in the local real estate market. These estimates are subject to significant uncertainty and may change. Additional charges could be required as a result in the changes in estimates.
Accounting for income taxes. Income taxes are recorded for each of the jurisdictions in which the Company operates. Management records the actual current income tax payable and assesses the temporary differences resulting from differing treatment of items, such as reserves and accruals, for tax and accounting purposes. These differences result in deferred tax assets and liabilities which are included within the consolidated balance sheet. In addition, Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes requires recognition of future tax benefits attributable to tax net loss carryforwards and deductible temporary differences between financial statement and income tax bases of assets and liabilities.
Deferred tax assets must be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the benefits will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible. Management has determined, based on historical profit trends, that in the Companys domestic operations, there is not sufficient evidence to support the position that it is more likely than not that some portion or all of the benefits will be realized. As such, management has provided a full valuation allowance to the extent of net deferred assets on the domestic operations. With regard to the Companys foreign operations, management has determined, based on historical profit trends, that it is more likely than not that all of the benefits will be realized. Significant management judgment is involved in assessing the Companys ability to realize any future benefit from deferred tax assets. In the event that actual results differ from management estimates and management adjusts these estimates in future periods, the Companys operating results and financial position could be materially affected.
Foreign currency translation. The Company has foreign subsidiaries that together accounted for 48.3% of the Companys net revenues and 57.9% of the Companys assets as of and for the year ended December 31, 2005. In preparing the Companys consolidated financial statements, the Company is required to translate the financial statements of its foreign subsidiaries from the currencies in which they keep their accounting records into United States dollars. This process results in exchange gains and losses which, under relevant accounting guidance, are either included within the Companys statement of operations or as a separate part of the Companys net equity under the caption accumulated other comprehensive income.
Under relevant accounting guidance, the treatment of these translation gains or losses depends upon managements determination of the functional currency of each subsidiary. This determination involves consideration of relevant economic facts and circumstances affecting the subsidiary. Generally, the currency in which the subsidiary transacts a majority of its transactions, including billings, financing, payroll and other expenditures, would be considered the functional currency.
However, management must also consider any dependency of the subsidiary upon the parent and the nature of the subsidiarys operations.
If management deems any subsidiarys functional currency to be its local currency, then any gain or loss associated with the translation of that subsidiarys financial statements is included in accumulated other comprehensive income. However, if management deems the functional currency to be United States dollars, then any gain or loss associated with the translation of these financial statements would be included within the Companys statement of operations.
If the Company disposes of any of its subsidiaries, any cumulative translation gains or losses would be realized into the Companys statement of operations. If management determines that there has been a change in the functional currency of a subsidiary to United States dollars, then any translation gains or losses arising after the date of the change would be included within the Companys statement of operations.
Based on managements assessment of the factors discussed above, the Company considers the functional currency of each of its international subsidiaries to be each subsidiarys local currency. Accordingly, the Company had cumulative translation gains of ($0.1) million that were included as part of accumulated other comprehensive gain within the Companys balance sheet at December 31, 2005. During the year ended December 31, 2005, the Company included translation adjustments of a loss of approximately $0.7 million under accumulated other comprehensive income and loss.
If the Company had determined that the functional currency of its subsidiaries was United States dollars, these gains or losses would have decreased or increased the Companys loss for the year ended December 31, 2005. The magnitude of these gains or losses depends upon movements in the exchange rates of the foreign currencies in which the Company transacted business as compared to the value of the United States dollar. These currencies primarily include the British pound, the Canadian dollar and the Australian dollar. Any future translation gains or losses could be significantly higher than those the Company recorded for the year ended December 31, 2005.
Recent Accounting Pronouncements
In May 2005, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 154, Accounting Changes and Error Corrections a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS No. 154 replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements and changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. We do not believe the adoption of SFAS No. 154 will have a material effect on the Companys consolidated financial position, results of operations or cash flows.
In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143. This Interpretation clarifies that the term conditional asset retirement obligation as used in FASB No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation, when incurred, if the fair value of the liability can be reasonably estimated. The Interpretation is effective for the Company no later than the end of the fiscal year ending on December 31, 2005. The implementation of this Interpretation did not have a material effect on the Companys consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued Statement 123 (revised 2004), Share-Based Payment (Statement 123(R)). This Statement is a revision to Statement 123, Accounting for Stock-Based Compensation, and supersedes Opinion 25, Accounting for Stock Issued to Employees. Statement 123(R) requires the measurement of the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The cost will be recognized over the period during which an employee is required to provide service in exchange for the award. No compensation cost is recognized for equity instruments for which employees do not render service. The Company adopted Statement 123(R) on January 1, 2006, using the modified prospective method, requiring compensation cost to be recognized as expense for the portion of outstanding unvested awards, based on the grant-date fair value of those awards calculated using the Black-Scholes option pricing model under Statement 123 for pro forma disclosures. The effect of adopting Statement 123(R) will decrease the Companys pretax net income by approximately $420 during 2006.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an Amendment of ARB No. 43, Chapter 4. SFAS No. 151 retains the general principle of ARB No.43, Chapter 4, Inventory Pricing, that inventories are presumed
to be stated at cost; however, it amends ARB No. 43 to clarify that abnormal amounts of idle facilities, freight, handling costs and spoilage should be recognized as current period expenses. Also, SFAS No. 151 requires fixed overhead costs be allocated to inventories based on normal production capacity. The guidance in SAFS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company believes that implementing SFAS No. 151 should not have a material impact on its financial condition or results of operations.
Results of Operations
The following table sets forth the Companys operating results for the periods indicated expressed as a percentage of net sales.
Comparison of Year Ended December 31, 2005 with Year Ended December 31, 2004
In August of 2004 the Company acquired 75% of the Bushman Tanks business (the acquired company). Bushman Tanks is Australias largest manufacturer of plastic water storage tanks. The Bushman Tanks financial results have been consolidated in the Companys financial statements for the twelve months ended December 31, 2004 and 2005. The consolidated results include five months of business activity of Bushman Tanks for 2004 and twelve months for 2005. A minority interest has been recorded for the 25% equity owned by ANZ Private Equity, a unit of Australia and New Zealand Banking Group Ltd.
Net Sales. Net sales increased $13.4 million or 13.4% from $100.1 million in 2004 to $113.5 million in 2005. The increase was due to the addition of the acquired business for a full year and partially offset a decline in revenues in the Americas Segment.
Americas net sales decreased $9.6 million or 13.3% from $72.4 million in 2004 to $62.8 million in 2005. The decrease was due to lower sales of thermoplastic enclosures, primarily to Verizon.
International net sales increased $23.0 million or 82.7% from $27.8 million in 2004 to $50.8 million in 2005. The increase was primarily due to sales of the acquired company.
Sales to Verizon of $19.9 million in 2005 represented 17.5% of Company sales in the period. Sales to Verizon were $16.2 million in the first six months of the fiscal year. Sales to Verizon have historically fluctuated from year to year. Accordingly, the Company cannot accurately predict what sales to Verizon will be in 2006. Sales to Verizon of $21.8
million in 2004 represented 21.7% of Company sales in the period. The second largest customer in 2005 was Comcast, with sales of $8.3 million representing 7.3% of the total sales in the period. Sales to Comcast in 2004 were $14.6 million representing 14.6% of the Company sales in the period.
Gross Profit. Gross profit increased $4.5 million from $28.0 million in 2004 to $32.5 million in 2005. The increase was primarily due to the addition of gross profit earned by the acquired company. Gross profit dollars in the Americas segment decreased by $4.2 million due to lower sales volume. Gross profit dollars in the International segment increased by $8.7 million due to the addition of the acquired company.
As a percentage of net sales, gross profit increased from 27.9% in 2004 to 28.6% in 2005. The overall increase is due to an increase in the International segment that outweighed a decrease in the America segment. Gross profit as a percentage of net sales increased in the International segment due to the addition of the acquired company, which has a higher gross profit percentage than the Companys other businesses. The decrease in the Americas segment resulted primarily from unabsorbed costs from lower volumes.
Selling. Selling expenses increased $5.6 million or 39.2% from $14.3 million in 2004 to $19.9 million in 2005. The increase is due to the addition of selling expenses of the acquired company as well as increased freight costs across all segments.
As a percentage of net sales, selling expense increased from 14.3% in the 2004 period to 17.5% in the 2005 period. The higher percentage is primarily due to the increase in freight costs and the addition of selling expenses for the acquired company. The acquired company has a higher percentage of selling expense to net sales than the other Channell businesses primarily due to the freight costs incurred to transport water storage tanks to customers.
General and Administrative. General and administrative expenses increased $2.8 million or 32.6% from $8.6 million in 2004 to $11.4 million in 2005. The increase is due to the addition of the acquired company, partially offset by lower general and administrative expense in the Americas segment.
As a percentage of net sales, general and administrative expenses increased from 8.6% in the 2004 period to 10.0% in the 2005 period. The increase is due to the lower volumes in the Americas segment.
Research and Development. Research and development expenses increased $0.4 million or 17.4% from $2.3 million in 2004 to $2.7 million in 2005. The increase is due to spending on new product development programs, primarily for telephone connectivity products and thermoplastic enclosures for both telephone and cable customers.
As a percentage of net sales, research and development expenses increased from 2.3% in 2004 to 2.4% in 2005.
Restructuring charge. There were no restructuring charges in 2005 compared to ($0.7) million in 2004. In 2004, a credit to restructuring charge of ($0.7) million was recorded primarily due to the subletting of a vacated facility in the United Kingdom at a cost less than previously estimated by management.
Impairment of Fixed Assets. There was no impairment of fixed assets in 2004. In 2005, there was an impairment charge of $0.1 million due to the writedown of some manufacturing equipment in the Americas segment.
Income from Operations. As a result of the items discussed above, income (loss) from operations decreased $5.0 million or 142.9% from $3.5 million in 2004 to ($1.5) million in 2005. Operating margin as a percent of sales decreased from 3.5% in 2004 to (1.4%) in 2005.
Interest Expense, Net. Net interest expense remained the same at $0.5 million in 2004 and 2005.
Income Taxes. There was an income tax benefit of ($0.8) million in 2004 compared to an income tax expense of $5.0 million in 2005. The effective tax rate was (26.5%) in 2004 and 246.0% in 2005. The 2004 benefit was primarily due to an ordinary worthless stock deduction, whereas the expense in 2005 was primarily the result of an increase in the valuation allowance on the realization of the net deferred tax asset.
Comparison of Year Ended December 31, 2004 with Year Ended December 31, 2003
In August of 2004 the Company acquired 75% of the Bushman Tanks business (the acquired company). Bushman Tanks is Australias largest manufacturer of plastic water storage tanks. The Bushman Tanks financial results have been consolidated in the Companys financial statements for the twelve months ended December 31, 2004. The consolidated results include five months of business activity of Bushman Tanks. A minority interest has been recorded for the 25% equity owned by ANZ Private Equity, a unit of Australia and New Zealand Banking Group Ltd.
Net Sales. Net sales increased $23.6 million or 30.8% from $76.5 million in 2003 to $100.1 million in 2004. The increase was due to the addition of the acquired business and growth in both the core Americas and International segments.
Americas net sales increased $7.6 million or 11.7% from $64.8 million in 2003 to $72.4 million in 2004. The increase was due to higher sales to a major telephone customer and due to growth in connectivity and metal enclosure sales. The major telephone customer purchased plastic enclosures for a construction project to install fiber communication lines to customer premises.
International net sales increased $16.0 million or 136.3% from $11.7 million in 2003 to $27.7 million in 2004. The increase was primarily due to sales of the acquired company. In addition, higher sales to telephone customers in the Asian market contributed to the sales growth.
Sales to Verizon of $21.8 million in 2004 represented 21.7% of Company sales in the period. Sales to Verizon in 2003 were $8.0 million representing 10.5% of the Company sales in the period. The second largest customer in 2004 was Comcast with sales of $14.6 million representing 14.6% of the total sales in the period. Sales to Comcast in 2003 were $20.7 million representing 27.1% of the Company sales in the period.
Gross Profit. Gross profit increased $5.4 million from $22.6 million in 2003 to $28.0 million in 2004. The increase was primarily due to the addition of gross profit earned by the acquired company. Gross profit dollars in the Americas segment decreased due to higher raw material costs for plastic and steel. Gross profit dollars in the International segment increased due to the addition of the acquired company and the closure of a manufacturing facility in the United Kingdom. The closure of the United Kingdom facility lowered the overhead cost structure of International operations primarily due to the elimination of facility lease costs, middle management and indirect support costs.
As a percentage of net sales, gross profit decreased from 29.5% in 2003 to 27.9% in 2004. The decline is due primarily to increased raw material costs for plastic and steel in the Americas segment. Gross profit as a percentage of net sales increased in the International segment due to the addition of the acquired company, which has a higher gross profit percentage than the other Channell businesses and savings associated with the closure of the manufacturing facility in the United Kingdom.
Selling. Selling expenses increased $4.8 million or 50.9% from $9.5 million in 2003 to $14.3 million in 2004. The increase is due to the addition of selling expenses of the acquired company and higher commissions and freight costs as a result of the increased sales level. The freight cost increase is also due to an increase in full truckload shipments to customers in which the Company pays the freight cost.
As a percentage of net sales, selling expense increased from 12.4% in the 2003 period to 14.3% in the 2004 period. The higher percentage is primarily due to the increase in freight costs and the addition of selling expenses for the acquired company. The acquired company has a higher percentage of selling expense to net sales than the Companys other businesses primarily due to the freight costs incurred to transport water storage tanks to customers.
General and Administrative. General and administrative expenses increased $0.9 million or 11.3% from $7.7 million in 2003 to $8.6 million in 2004. The increase is due to the addition of the acquired company partially offset by lower general and administrative expense in the Americas segment. In December of 2004 the Company sold its receivable owed from Adelphia at a discount for $1.4 million. The receivable had previously been written off and thus the $1.4 million proceeds were recorded as a reduction to general and administrative expenses in the Americas segment in 2004. Partially offsetting this credit to expense in the fourth quarter of 2004 were additional accruals and charges for management incentive bonus $0.5 million, state sales tax $0.4 million, expenses to evaluate an acquisition candidate that the Company decided not to further pursue $0.2 million and audit and consulting fees mostly related to the worthless stock deduction associated with the United Kingdom operations and costs associated with review and modification of internal controls in response to the disclosure requirements of the Sarbanes Oxley Act $0.1 million.
As a percentage of net sales, general and administrative expenses decreased from 10.1% in the 2003 period to 8.6% in the 2004 period. The decrease is due to the lower costs in the Americas segment as well as the increased sales level without a corresponding increase in general and administrative costs.
Research and Development. Research and development expenses increased $0.4 million or 22.8% from $1.9 million in 2003 to $2.3 million in 2004. The increase is due to spending on new product development programs, primarily for telephone connectivity products and thermoplastic enclosures for both telephone and cable customers.
As a percentage of net sales, research and development expenses decreased from 2.5% in 2003 to 2.3% in 2004 due to the addition of the acquired company, which has a lower level of research and development spending as compared to the Companys other businesses.
Restructuring charge. Restructuring charges of ($0.7) million in 2004 compare to $1.6 million in 2003.
In 2003, the Company evaluated International operations to improve profitability. A plan was developed to close a manufacturing facility in International operations by mid-year 2004. Additional restructuring charges of $1.6 million were recorded in the fourth quarter of 2003 for employee severance and facility closure cost.
In 2004, a credit to restructuring charge of ($0.7) million was recorded primarily due to the subletting of a vacated facility in the United Kingdom at a cost less than previously estimated by management.
Impairment of Fixed Assets. In 2003, an asset impairment charge of $1.2 million was recorded for production equipment in International operations as part of the closure of a manufacturing facility. There was no impairment of fixed assets in 2004.
Income from Operations. As a result of the items discussed above, income from operations increased $2.8 million or 398.4% from $0.7 million in 2003 to $3.5 million in 2004. Operating margin as a percent of sales increased from 0.9% in 2003 to 3.5% in 2004.
Interest Expense, Net. Net interest expense decreased from $0.6 million in 2003 to $0.5 million in 2004. The decrease was attributable to lower amortization of prepaid bank origination fees in 2004. Total debt and interest expense increased in August due to the acquisition of Bushman Tanks.
Income Taxes. Income tax expense decreased from $0.2 million in 2003 to ($0.8) million in 2004. The effective tax rate of 159% in 2003 compares to (26.5%) in 2004. The decline is due to an ordinary worthless stock deduction in 2004 offset by an increase in the valuation allowance. The worthless stock deduction is associated with the United Kingdom operations. As a result of the decision to close the manufacturing facility in the United Kingdom, an independent party was commissioned to appraise the value of the legal entity. The appraisal concluded that the entity was financially insolvent. Being insolvent, the entity therefore met the requirements for a worthless stock deduction.
Liquidity and Capital Resources
Cash and cash equivalents on December 31, 2005 were $3.1 million, a decrease of $2.4 million from the December 31, 2004 balance of $5.5 million. The decrease was primarily due to cash used for capital expenditures, as well as cash used to reduce notes payable.
Net cash provided by operating activities was $1.7 million and $9.4 million in 2005 and 2004, respectively. In 2005, the net loss of $6.9 million was offset by non-cash charges of $9.3 million, further reduced by a period to period increase in net working capital of $0.7 million. In 2004, the net income of $3.6 million was increased by $5.0 million of non-cash charges, increased further by a period to period decrease in net working capital of $0.8 million.
Net cash used in investing activities was ($4.3) million and ($20.0) million in 2005 and 2004, respectively. In the 2005 period, the Company purchased property and equipment. In the 2004 period, the Company acquired the Bushman Tanks business.
Net cash provided by financing activities in 2005 was $201 compared to net cash provided by financing activities of $7.4 million in 2004. In the 2004 period, the Company acquired the Bushman Tank business and financed the purchase with a term loan from The National Australia Bank Ltd and equity provided by ANZ Private Equity.
Accounts receivable decreased from $13.9 million at December 31, 2004 to $8.3 million at December 31, 2005 primarily through improved collection efforts and lower sales levels. In terms of days sales outstanding, accounts receivable decreased from 37 days at December 31, 2004 to 33 days at December 31, 2005.
Inventories decreased from $14.2 million at December 31, 2004, to $11.4 million at December 31, 2005. The decrease is the result of managing inventory in line with lower sales levels. Days inventory on hand increased from 52 days at December 31, 2004 to 60 days at December 31, 2005.
Accounts payable decreased from $16.1 million at December 31, 2004 to $8.7 million at December 31, 2005. Days payables decreased from 59 days to 46 days, respectively. The decrease is due to lower sales levels, as well as a higher percentage of product being produced in house versus being purchased.
The Company and its subsidiaries have entered into the following financing arrangements:
1. On September 25, 2002, the Company entered into a three-year Loan and Security Agreement with an asset-based lender in the United States. In September, 2005 this agreement was extended to December 31, 2005, and in December 2005, it was further extended until February 28, 2006. In February 2006, it was amended and extended to March 31, 2007.
The Loan and Security Agreements initial term loan balance of $4.7 million and initial revolver balance of $2.1 million as well as $9.6 million in cash were used to repay, in full, the Companys prior credit agreement. The term loan was repayable in quarterly payments based on a five-year amortization schedule with a balloon repayment at maturity. At December 31, 2005, the outstanding balance of the term loan was $1.9 million, with no outstanding balance in the revolver.
Under the Loan and Security Agreement, the outstanding balance bears interest payable monthly at a variable rate based on either LIBOR or the lenders base rate. The weighted average interest rate under the Loan and Security Agreement at December 31, 2005 was 4.03%.
The Loan and Security Agreement contains various financial and operating covenants that impose limitations on the Companys ability, among other things, to incur additional indebtedness, merge or consolidate, sell assets except in the ordinary course of business, make certain investments, enter into leases and pay dividends. The Company was also required to comply with a fixed charge coverage ratio financial covenant. The Company received a waiver of compliance of the fixed charge coverage ratio financial covenant for December 31, 2005. The loans under the Loan and Security Agreement are secured by all the assets of the Company.
On February 28, 2006, the Loan and Security Agreement was amended, and the fixed charge coverage ratio financial covenant was eliminated. In addition, the amendment, among other things, reduced the revolving credit maximum amount from $25 million to $10 million, made the domestic term loan a stand-alone facility, rather than a subfacility of the domestic revolving credit loan facility and extended the Agreement through March 31, 2007. The term loan continues to be amortized over the original five-year amortization schedule with a balloon payment now due March 31, 2007.
2. In July 2004, a subsidiary of the Company located in Australia, Channell Pty Ltd, entered into a one-year Loan and Security Agreement with a commercial bank in Australia.
Under the Loan and Security Agreement, the balance bears interest payable monthly at a variable rate based on the lenders base rate. Since no borrowings under the revolver were made in 2005, no interest was paid. The Agreement was terminated in 2005.
3. On August 2, 2004, Channell Bushman Pty Ltd and controlled entities, collectively known as Bushmans Group Pty Ltd, entered into a five-year Loan and Security Agreement with a commercial bank in Australia. Channell Bushman Pty Ltd is the holding company established to acquire the Bushman Tanks business. The Loan and Security Agreements initial term loan balance of $5.8 million was used to fund part of the consideration paid to acquire the Bushman Tanks business. The five-year term loan is repayable in quarterly payments based on a five-year amortization schedule. The Loan and Security Agreement also includes a revolving credit facility, reviewed annually, for working capital needs in the amount of $1.5 million, a capital expenditure line of credit in the amount of $3.3 million and a $1.3 million facility to fund future earn out payments to the seller if the Bushman Tanks business achieves specified performance targets in 2005 and 2006. The Loan and Security Agreement is guaranteed by Channell Pty Ltd, a subsidiary of the Company in Australia. At December 31, 2005, the outstanding balance of the term loan was $4.08 million and $1.0 million on the revolving line of credit. The outstanding balance on the capital expenditure line of credit was $0.2 million and the outstanding balance on the earn out facility was $0.4 million. The loans under the Loan and Security Agreement are secured by all the assets of Channell Bushmans Pty Ltd and controlled entities, and Channell Pty Ltd.
Under the Loan and Security Agreement, the outstanding balance bears interest payable monthly at a variable rate based on the lenders base rate. The weighted average interest rate under the Loan and Security Agreement at December 31, 2005 was 5.7%.
The Loan and Security Agreement contains various financial and operating covenants that impose limitations on Channell Bushman Pty Ltd.s ability, among other things, to incur additional indebtedness, merge or consolidate, sell assets except in the ordinary course of business, make certain investments, enter into leases and pay dividends. Channell Bushman Pty Ltd is also required to comply with a Debt/EBIT ratio, capital adequacy ratio, debit service coverage ratio and interest coverage ratio. As of December 31, 2005, Channell Bushman Pty Ltd was not in compliance with the Debt/EBIT ratio, debt service coverage ratio and interest coverage ratio financial covenants. The Company has not received a waiver of noncompliance from the bank. The Company has, however, received a notice dated April 10, 2006 from the bank stating that at this time, the bank does not intend to
cancel the facilities nor accelerate the debt under the facilities. The Company is currently renegotiating the terms and financial covenants of the facility. As the Company has not received a formal waiver for its breach of the aforementioned bank covenants and has not completed renegotiations for new loan facilities, the Company is reclassifying approximately $3.1 million of long term debt to short term debt. If the Company successfully completes such renegotiations with the bank, the debt will be reclassified to long term.
4. On August 2, 2004, the Company and Channell Bushman Pty Ltd entered into an Investment and Shareholders Agreement with a private equity firm in Australia. The private equity investment was obtained as part of the financing of the Bushman Tanks acquisition. The private equity party invested $2.6 million, the net amount received after paying a capital raising fee, for ownership of 25% of the outstanding and voting shares of Channell Bushman Pty Ltd As part of the agreement, the private equity party has the right to appoint one member of the Board of Directors of Channell Bushman Pty Ltd with the Company appointing the remaining three members. The agreement specifies that certain actions taken by the Board of Directors require unanimous approval, among other things, a proposal to sell all or substantially all of the assets of Channell Bushman Pty Ltd, material asset acquisitions or disposals not included in the annual business plan, any plan to limit or dissolve the business, the issuance of any securities, capital restructuring, granting of a security interest on assets and related party transactions.
It is the intent of the private equity party to exit from its investment in Channell Bushman Pty Ltd within 5 years. The Agreement contains clauses to facilitate the exit of the private equity party. The Agreement specifies that after two years, the Company has an option to acquire all of the shares owned by the private equity party. The Agreement specifies that the value of the shares is to be fair market value as determined by an independent appraiser. There are no minimum or maximum amounts specified in the Agreement. After five years, both the Company and the private equity party have the right to initiate a sale of Channell Bushman Pty Ltd At such time, the other party may elect to buy out the shares of the party initiating the sale at the fair market value as determined by an independent appraiser. Otherwise, Channell Bushman Pty Ltd would be offered for sale with the assistance of a financial advisor.
Contractual obligations consist principally of payment for noncancellable operating lease obligations, long term debt and capital leases. Future payments required under these contractual obligations have been summarized in the notes to the Consolidated Financial Statements as follows: (i) lease commitments Note M, (ii) long term debt Note F, and (iii) capital lease obligations Note G.
The Company believes that cash flow from operations should be sufficient to fund the Companys capital expenditure and working capital requirements through 2006.
Contractual Obligations and Other Commitments
The following table summarizes the Companys contractual obligations and other commitments as of December 31, 2005:
(1) The Company has a Loan and Security Agreement which includes a term loan and revolver line of credit with an asset-based lender in the United States which has been extended through March 31, 2007. The Company entered into a one-year Loan and Security Agreement which includes a revolver line of credit with a commercial bank in Australia in July 2004. The Company also entered into a five-year Loan and Security Agreement which includes a term loan and revolver line of credit with a commercial bank in Australia in August 2004. See Note F to the Consolidated Financial Statements.
(2) The Company leases manufacturing and office space and machinery & equipment under several operating leases expiring through 2015. See Note M to the Consolidated Financial Statements.
(3) The Company has employment agreements with its Chairman of the Board expiring July 7, 2006 and its President and Chief Executive Officer expiring December 8, 2008. Both contracts are renewable every 5 years. The Chairman of the Boards salary is set at $50,000 per
annum for the remainder of the term. The President and Chief Executive Officers base salary is $745,616 per year effective July 2004, and is subject to an annual cost of living increase based on the consumer price index. Base salary may also be increased at the discretion of the Board of Directors. In the event the President and Chief Executive Officer is terminated the Company will be obligated to make a lump sum severance payment equal to three times his then current base salary.
(4) The Company believes it has adequate sources of supply for the raw materials used in its manufacturing processes and it attempts to develop and maintain multiple sources of supply in order to extend the availability and encourage competitive pricing of these materials. Most plastic resins are purchased under annual or multi-year pricing agreements to stabilize costs and improve supplier delivery performance. The Company is not contractually obligated to purchase product over the life of these agreements.
Off-Balance Sheet Arrangements
Our off-balance sheet arrangements consist of operating leases, employment contracts and purchase obligations as described above. In addition, as discussed in Note L to the Consolidated Financial Statements, the Company guaranteed debt of the Companys principal stockholder and Chairman of the Board of approximately $0.8 million in 1997. The guaranteed debt was incurred in connection with construction of the facilities leased to the Company and is collateralized by said facilities. The loan amount subject to the unsecured guarantee is expected to decline before expiring in 2017. It is not practicable to estimate the fair value of the guarantee; however, the Company does not anticipate that it will incur losses as a result of this guarantee. The Company has not recorded a liability for this guarantee. If the principal stockholder were to default on the outstanding loan balance, the Company may be required to repay the remaining principal balance. The maximum potential amount the Company would be required to pay is equal to the outstanding principal and interest balance of the loan to the stockholder. At December 31, 2005, the outstanding loan balance subject to the guarantee totaled $0.55 million.
The market risk inherent in the Companys market risk sensitivity instruments is the potential loss arising from adverse changes in interest rates and foreign currency exchange rates. All financial instruments held by the Company and described below are held for purposes other than trading.
The Company and its subsidiaries have entered into three financing agreements. In September 2002, the Company entered into a three-year Loan and Security Agreement with an asset based lender in the United States. The agreement contains a term loan and a revolver line of credit. In July 2004, the Company entered into a one-year Loan and Security Agreement which contains a revolver line of credit with a commercial bank in Australia. In August 2004, the Company entered into a five-year Loan and Security Agreement which contains a term loan and revolver line of credit with a commercial bank in Australia. The loan and security agreements allow for the outstanding balance to bear interest at a variable rate based on the lenders base rate. The credit facility exposes operations to changes in short-term interest rates since the interest rates on the credit facility are variable.
If the variable rates on the Companys loan and security agreements were to increase by 1% from the rate at December 31, 2005, and if the Company had borrowed during all of fiscal 2005 the maximum amount (approximately $34.5 million) at any time in 2005 under its credit facility at the increased interest rate, the Companys interest expense would have increased, and net income would have decreased by $0.2 million. A marginal income tax rate of 38.0% was used in this analysis. This analysis does not consider the effects of economic activity on the Companys sales and profitability in such an environment.
Foreign Exchange Risk
The Company has assets and liabilities outside the United States that are subject to fluctuations in foreign currency exchange rates. Assets and liabilities outside the United States are primarily located in the United Kingdom, Australia and Canada. The Companys investment in foreign subsidiaries with a functional currency other than the U.S. dollar are generally considered long-term. Accordingly, the Company does not hedge these net investments. The Company also purchases a limited portion of its raw materials from foreign countries. These purchases are generally denominated in U.S. dollars and are accordingly not subject to exchange rate fluctuations. The Company has not engaged in forward foreign exchange and other similar contracts to reduce its economic exposure to changes in exchange rates because the associated risk is not considered significant.
Selected Quarterly Financial Data
Set forth below is certain unaudited quarterly financial information. (See also Note P to the Consolidated Financial Statements included elsewhere herein.) The Company believes that all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly, and in accordance with generally accepted accounting principles, the selected quarterly information when read in conjunction with the Consolidated Financial Statements.
All remaining schedules are omitted because they are not applicable, or the required information is included in the financial statements or the notes thereto.
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934 (the Exchange Act), that are designed to ensure that information required to be disclosed in the Companys Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in rules and forms of the Securities and Exchange Commission regulations, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. As of December 31, 2005, the management of the Company carried out an assessment concluding that the Companys disclosure controls and procedures were not effective as of December 31, 2005, because of the material weaknesses described below.
Due to the material weaknesses described below, the Companys management performed additional analyses and other post-closing procedures including reviewing all significant account balances and disclosures in the consolidated financial statements contained in this Annual Report on Form 10-K, to ensure the Companys consolidated financial statements are in accordance with accounting principles generally accepted in the United States of America. Accordingly, management believes that the consolidated financial statements included in this Annual Report, fairly present in all material respects, the Companys financial condition, results of operations, and cash flows for all periods presented.
Managements Report on Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Companys assets that could have a material effect on the interim or annual consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The Companys management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2005. In performing its assessment of the effectiveness of the Companys internal control over financial reporting, management applied the criteria described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management identified the following control deficiencies which represent material weaknesses in the Companys internal control over financial reporting as of December 31, 2005. The Company did not maintain effective controls over the accuracy of its accounting for income taxes and the determination of the income tax provision. Specifically, the Company did not have effective controls to accurately calculate current income tax expense and the effect on additional paid in capital for the exercise of non-qualified stock options. This control deficiency could result in a misstatement of deferred taxes and tax accruals that would result in a material misstatement of the Companys interim or annual consolidated financial statements that would not be prevented or detected. In addition, due to the limited tenure of the Companys domestic and Australian accounting staff, additional reconciliations and post closing adjustments were necessary to properly account for certain items of income and expense that the staff was not fully aware of. The most significant manifestations of this material weakness involved the accounting of the Companys workers compensation liability as well as the Companys unvouchered accounts payable balance. Accordingly, management has determined that these control deficiencies constitute a material weakness.
Management has also identified control deficiencies that relate to the Companys acquired Australian subsidiary, Bushmans. Bushmans was previously a closely held, family run business with mostly manual controls in place. During the process of assessing the status of the internal control infrastructure, the Company has identified significant deficiencies in internal controls that rise to the level of material weaknesses in the revenue and purchasing cycles. Management has also identified other significant deficiencies in the payroll cycle, capital asset purchasing cycle, information technology and governance.
The control deficiencies described above could result in a misstatement of the aforementioned accounts or disclosures that would result in a material misstatement to the Companys interim or annual consolidated financial statements that would not be prevented or detected. Accordingly, management has determined that the control deficiencies described above constitutes a material weakness. Management does not believe that either of these material weaknesses resulted in material errors in the Companys December 31, 2005 financial results, as reported in this filing.
Changes in Internal Control Over Financial Reporting
During the fourth quarter of the year ended December 31, 2005, there were changes in the Companys internal control over financial reporting with regard to the accounting for income taxes and the determination of income taxes payable, deferred income tax assets and liabilities and the related income tax provision. Specifically, the Company did not have effective
controls to accurately calculate current income tax expense. In addition, the Company did not have effective controls to monitor the difference between the income tax basis and the financial reporting basis of assets and liabilities and reconcile the difference to its deferred income tax asset and liability balances. This control deficiency resulted in restatements to the Companys 2002, 2003, and 2004 annual consolidated financial statements to correct deferred taxes and the tax provisions. Additionally, this control deficiency could result in a misstatement of deferred taxes, tax accruals and the tax provision that would result in a material misstatement to the Companys interim or annual consolidated financial statements that would not be prevented or detected. Accordingly, management had determined that this control deficiency constitutes a material weakness. During the fourth quarter of the year ended December 31, 2005, the Company identified and gathered the necessary financial information and set up a procedure to accurately prepare and review its accounting for income taxes and the determination of income taxes payable, deferred income tax assets and liabilities and the related income tax provision. The Company has also hired additional personnel qualified as Certified Public Accountants to assist in the preparation of the Companys income tax provision as well as general accounting matters.
Recent Developments Relating to the Companys Internal Control Over Financial Reporting
The Company continues to implement enhancements and changes to its internal control over financial reporting to remediate the material weaknesses described above. This remediation began in 2005.
These improvements include further formalization of policies and procedures, improved segregation of duties, improved information technology system controls, and additional monitoring controls.
The Company has enhanced the competence of the organization by hiring staff competent in accounting principles generally accepted in the United States of America, and the Company will continue to enhance its financial accounting and reporting competencies by recruiting additional qualified staff and further developing its existing staff by reinforcing existing continuing education programs.
The Companys Audit Committee meets regularly with management and the independent accountants to review accounting, auditing, financial matters and internal control structure. The Audit Committee and the independent accountants have free access to each other, with or without management being present.
The information required by this item is incorporated by reference to the Companys definitive proxy statement for its 2006 Annual Meeting of Stockholders.
The information required by this item is incorporated by reference to the Companys definitive proxy statement for its 2006 Annual Meeting of Stockholders.
The information required by this item is incorporated by reference to the Companys definitive proxy statement for its 2006 Annual Meeting of Stockholders.
(a) The following financial statements and schedules are filed as a part of this report:
Financial Statement Schedules
(a)(3) and (c). The following exhibits are filed herewith:
* Management contract or, compensatory plan or arrangement.
(1) Incorporated by reference to the indicated exhibits filed in connection with the Companys Registration Statement on Form S-1 (File No. 333-03621).
(2) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on May 18, 1998.
(3) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-K on March 31, 1999.
(4) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-K on April 2, 2001.
(5) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-Q on August 12, 2002.
(6) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on October 1, 2002.
(7) Incorporated by reference to Appendix B filed in connection with the Companys Definitive Proxy Statement on March 26, 2003.
(8) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-K on March 5, 2004.
(9) Incorporated by reference to Appendix B filed in connection with the Companys Definitive Proxy Statement on April 16, 2004.
(10) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on August 6, 2004.
(11) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-Q on November 15, 2004.
(12) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on June 15, 2005.
(13) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on June 28, 2005.
(14) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-Q on August 15, 2005.
(15) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on September 9, 2005.
(16) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-Q on November 21, 2005.
(17) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 10-K/A on November 21, 2005.
(18) Incorporated by reference to the indicated exhibits filed in connection with the Companys Form 8-K on March 6, 2006.
(19) Filed herewith.
ADSL (Asymmetric Digital Subscriber Line): A standard allowing digital broadband signals and standard telephone service to be transmitted up to 12,000 feet over a twisted copper pair.
Broadband: Transmission rates in excess of 1.544 mega bits per second typically deployed for delivery of high-speed data, video and voice services. Also, a system for distributing television programming by a cable network rather than by broadcasting electromagnetic radiation.
Cat-5 (Category 5): Network cabling that consists of four twisted pairs of copper wire terminated by data rated connectors. Cat-5 cabling supports frequencies up to 100 MHz and speeds up to 1000 Mbps.
Cable Modem: Electronic transmission device placed on the broadband network, located at end user locations, providing two-way, high-speed data service capability, including internet access for subscribers.
Coaxial Cable: The most commonly used means of transmitting cable television signals. It consists of a cylindrical outer conductor (shield) surrounding a center conductor held concentrically in place by an insulating material.
DLC (Digital Loop Carrier): Telecommunications transmission technology which multiplexes multiple individual voice circuits onto copper or fiber cables.
DSL (Digital Subscriber Line): Generic descriptor covering various versions of DSL services delivered over copper wires. Included are HDSL and ADSL services.
Fiber Optics: The process of transmitting infrared and visible light frequencies through a low-loss glass fiber with a transmitting laser or LED and a photo diode receiver.
FTTP (Fiber-To-The-Premise): In a long distance network consisting of fiber optics, fiber-to-the-premise refers to the fiber optics running from the distribution plant to the customer premise, which may be the curb or the outside wall of the premise, at which point copper is used for the remaining connection.
HDSL (High bit rate Digital Subscriber Line): By using sophisticated coding techniques, a large amount of information may be transmitted over copper. The HDSL scheme uses such coding over four copper wires and is primarily intended for high capacity bi-directional business services.
HFC (Hybrid Fiber Coax): A type of distribution plant that utilizes fiber optics to carry service from a CO to the carrier serving area, then coaxial cable within the CSA to or close to the individual residences.
RBOC (Regional Bell Operating Company): A term for the regional holding companies created when AT&T divested the Bell operating companies.
RF (Radio Frequency): An electromagnetic wave frequency intermediate between audio frequencies and infrared frequencies used especially in wireless telecommunications and broadband transmission.
VoIP (Voice over Internet Protocol): A technology that allows you to make telephone calls using a broadband Internet connection instead of a regular (or analog) phone line.
xDSL (Digital Subscriber Line): Represents Generic description of DSL covering higher bandwidth.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Form 10-K Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K Annual Report has been signed by the following persons on behalf of the registrant and in the capacities indicated below as of April 17, 2006.
Board of Directors and Stockholders
Channell Commercial Corporation
We have audited the accompanying consolidated balance sheets of Channell Commercial Corporation (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of operations and comprehensive income (loss), stockholders equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Channell Commercial Corporation as of December 31, 2005 and 2004, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
We have also audited Schedule II of Channell Commercial Corporation for each of the three years in the period ended December 31, 2005. In our opinion, this schedule presents fairly, in all material respects, the information required to be set forth therein.
CHANNELL COMMERCIAL CORPORATION
(amounts in thousands)
The accompanying notes are an integral part of these financial statements.
Year ended December 31,
(amounts in thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
CHANNELL COMMERCIAL CORPORATION
Years ended December 31, 2003, 2004 and 2005
(amounts in thousands)