Electro Scientific Industries 10-Q 2005
WASHINGTON, D.C. 20549
ý QUARTERLY REPORT PURSUANT TO SECTION 13
OR 15(d) OF THE SECURITIES
For the quarterly period ended August 27, 2005
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
For the transition period from to
Commission File Number: 0-12853
ELECTRO SCIENTIFIC INDUSTRIES, INC.
Registrants telephone number: (503) 641-4141
Registrants web address: www.esi.com
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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
Indicate by check mark whether the registrant is shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
The number of shares outstanding of the Registrants Common Stock at September 21, 2005 was 28,675,704 shares.
ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
The accompanying notes are an integral part of these statements.
ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
(In thousands, except per share data)
The accompanying notes are an integral part of these statements.
ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
The accompanying notes are an integral part of these statements.
ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
These unaudited interim consolidated condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted in these interim statements. Accordingly, these interim statements include all adjustments (consisting of only normal recurring adjustments and accruals) necessary for a fair presentation of results for the interim periods presented. These consolidated condensed financial statements are to be read in conjunction with the financial statements and notes included in the Companys Annual Report on Form 10-K.
Results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.
Note 2 - Inventories
Inventories are principally valued at standard costs, which approximate the lower of cost (on a first-in, first-out basis) or market. Components of inventories are as follows (in thousands):
Note 3 Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
See Note 4 for a discussion of the accrual for product warranty.
Note 4 Product Warranty
The Company evaluates obligations related to product warranties quarterly. A standard one-year warranty is provided on products. Warranty charges are comprised of costs to service the warranty, including labor to repair the system and replacement parts for defective items, as well as other costs incidental to the repairs. Inventory credits resulting from the return of repaired parts to inventory and any cost recoveries from warranties offered by suppliers for defective components are recorded as a credit to the warranty accrual. Using historical data, the Company estimates average warranty cost per system or part type and record the provision for such charges as an element of cost of goods sold. Additionally, the overall warranty accrual balance is separately analyzed using the remaining warranty periods outstanding on systems and items under warranty, and any resulting changes in estimates are recorded as an adjustment to cost of sales. If circumstances change, or if a material change in warranty-related incidents occurs, the estimate of the warranty accrual could change significantly. Accrued product warranty is included on the balance sheet as a component of accrued liabilities.
Following is a reconciliation of the change in the aggregate accrual for product warranty for the three months ended August 27, 2005 and August 28, 2004 (in thousands):
Note 5 Deferred Revenue
Revenue is deferred pending title transfer and fulfillment of acceptance criteria, which frequently occur at the time of delivery to a common carrier. Shipments for which title transfer has not occurred and/or acceptance criteria cannot be demonstrated at the Companys factory include sales to Japanese end-user customers and shipments of substantially new products. In sales involving multiple element arrangements, the fair value of any undelivered elements, including installation services, is deferred until the elements are delivered and acceptance criteria are met. Revenue related to maintenance and service contracts is deferred and recognized ratably over the duration of the contracts.
The following is a reconciliation of the changes in deferred revenue for the three months ended August 27, 2005 and August 28, 2004 (in thousands):
Note 6 - Earnings Per Share
The following is a reconciliation of weighted average shares outstanding and adjustments to net income used in the calculation of basic and diluted earnings per share (EPS) for the three months ended August 27, 2005 and August 28, 2004 (in thousands):
In the diluted EPS calculation for the three months ending August 28, 2005 and August 27, 2004, employee stock options equal to 2,875,000 and 3,744,000 common stock equivalent shares, respectively, were excluded because inclusion would have had an antidilutive effect.
The components of comprehensive income, net of tax, are as follows (in thousands):
Note 8 Stock-Based Compensation Plans
The Company has elected to use the intrinsic value method under APB No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation, subsequently amended by SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, to account for stock options, stock bonuses, restricted stock or performance-based restricted stock units issued to its employees under its stock compensation plans, and amortizes deferred compensation, if any, ratably over the vesting period of the awards.
Compensation expense resulting from the issuance of fixed term stock option awards is measured as the difference between the exercise price of the option and the fair market value of the underlying share of company stock subject to the option on the measurement date, which is typically the awards grant date. Compensation expense, if any, is included in operating results over the vesting period of the underlying options using the straight-line method. Compensation expense resulting from the issuance of time-based restricted stock and restricted stock units is calculated based on the fair market value on the date of grant and is included in operating results over the related vesting period using the straight line method. Compensation expense resulting from the issuance of performance-based restricted stock units is recorded when performance is probable and can be reasonably estimated, and is calculated based upon current fair market values (adjusted each period) until such time as the number of units an employee is entitled to receive is fixed or determinable. During the first quarter of fiscal 2006 and fiscal 2005, the Company recorded $0.7 million and $0.2 million, respectively, of compensation expense related to grants of restricted stock and restricted stock units on a pre-tax basis. No compensation cost has been recognized for employee stock purchase plan (ESPP) shares which are issued at a fifteen percent discount of the lower of the market price on either the first day of the applicable offering period or the purchase date.
Pro forma fair value disclosures required by SFAS No. 123 are presented below and reflect the impact on net income (loss) and net income (loss) per share as if the fair value of stock-based awards to employees had been applied (in thousands, except per share data):
The Black-Scholes option pricing model is utilized to determine the fair value of stock options under SFAS No. 123. The following weighted average assumptions were made in calculating the value of all options granted during the periods presented:
The following weighted average assumptions were made in calculating the value of all shares issued under the ESPP during the periods presented:
Note 9 Legal Proceedings
On August 24, 2005, the Company executed a Provisional Attachment Order (the Order) issued by the Kaohsiung District Court of Taiwan directed against All Ring Tech Co., Ltd. (All Ring) of Taiwan. In its petition requesting the Order, the Company alleges that All Rings Capacitor Tester Model RK-T6600 infringes the Companys Taiwan Patent No. 207469, entitled Circuit Component Handler (the 207469 patent). This patent corresponds to the Companys U.S. Patent No. 5,842,579. The patented technology is used in the Companys Model 3340 Multifunction MLCC Tester. The Company filed in support of the petition a copy of a patent infringement assessment report issued by Yen Tjing Ling Industrial Research Institute, a professional organization appointed by the judicial branch of the Taiwan government, that concludes that the RK-T6600 infringes the 207469 patent. A copy of the assessment report and an English language translation of the assessment report are available on the Companys website. All Ring has filed a bond with the court to obtain relief from the attachment of its assets. The bond provides security to the Company with respect to its patent infringement claim against All Ring. The Company intends to vigorously pursue this patent infringement claim against All Ring.
Note 10 New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (Revised 2004), Share-Based Payments. (SFAS 123R). The scope of SFAS 123R includes a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. SFAS 123R replaces FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS 123), and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (Opinion 25). SFAS 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements and rescinds the ability of companies to elect the intrinsic value method prescribed under Opinion 25. That cost will be measured based on the fair value of the equity or liability instruments issued. The Company will be required to implement SFAS 123R for the fiscal year beginning June 4, 2006. The Company has not completed its analysis of the impact of the adoption of SFAS 123R on its financial position or results of operations.
In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision with the American Jobs Creation Act of 2004. FSP No. 109-2 provides guidance under SFAS No. 109, Accounting for Income Taxes, with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act) on enterprises income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. Accordingly, the Company will continue to analyze and assess its options under this provision.
Note 11 Subsequent Event
In September 2005, an Oregon tax law changed resulting in a limitation on the Companys future use of certain state tax operating losses which were generated in prior years. Accordingly, the Company will record a charge of $1.1 million to the provision for income taxes in the second quarter of fiscal 2006, representing its estimate of the valuation allowance required to reduce these operating losses to the amount expected to be realized.
Forward Looking Statements
The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words believes, expects and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. From time to time we may make other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ as a result of many factors, including the risks described below under the heading Factors That May Affect Future Results.
Electro Scientific Industries, Inc. and its subsidiaries (ESI) provide high-technology manufacturing equipment to the global electronics market, including advanced laser systems that are used to microengineer electronic device features in high-volume production environments. Our customers are primarily manufacturers of semiconductors, passive components and electronic interconnect devices. Our equipment enables these manufacturers to achieve the yield and productivity gains in their manufacturing processes that can be critical to their profitability. The components and devices manufactured by our customers are used in a wide variety of end products in the computer, consumer electronics and communications industries.
We supply advanced laser microengineering systems that allow electronics manufacturers to physically alter select device features during high-volume production in order to heighten performance and boost production yields of semiconductor devices, passive components and circuitry, high-density interconnect (HDI) circuit boards and advanced semiconductor packaging. Laser microengineering comprises a set of precise fine-tuning processes (laser trimming, link cutting and via drilling) that require application-specific laser systems able to meet semiconductor and microelectronics manufacturers exacting performance and productivity requirements.
Additionally, we produce high-speed test, inspection and termination equipment used in the high-volume production of multi-layer ceramic capacitors and other passive components, as well as original equipment manufacturer machine vision products.
During the first quarter of fiscal 2006, order volume of $34.8 million decreased 33.1% compared to orders of $52.0 million in the fourth quarter of fiscal 2005. The decrease in orders in the current quarter compared to the prior quarter was largely influenced by the timing of semiconductor orders.
Shipments were $44.6 million in the first quarter of fiscal 2006, representing an 11.2% decline from shipments of $50.2 million in the fourth quarter of fiscal 2005. Deferred revenue remained essentially unchanged at approximately $13 million. Accordingly, net sales for the quarter were $44.5 million, declining slightly from $45.7 million in the fourth quarter of fiscal 2005.
Gross margin on first quarter sales of $44.5 million was 44.1%, representing a decrease of one percentage point from the prior quarter margin on sales of $45.7 million. Margins were impacted by lower overhead absorption on reduced production levels. Second quarter shipments and net sales are currently estimated to be in the range of $45 million to $55 million and related gross margins are expected to remain in the low to mid-40% range.
Operating expenses were $18.9 million for the first quarter of fiscal 2006, compared to $18.7 million in the fourth quarter of fiscal 2005, resulting in operating income of $0.7 million in the first quarter. We anticipate operating expenses in the second quarter of fiscal 2006 to be in the range of $19 million to $20 million.
Net other income was $1.2 million in the first quarter of fiscal 2006, compared to net other expense of $3.0 million in the fourth quarter of fiscal 2005. Included in the fourth quarter of fiscal 2005 was a $4.1 million charge resulting from the redemption of all of our outstanding 4 ¼% convertible subordinated notes.
The income tax provision recorded for the first quarter of fiscal 2006 was $0.6 million on pretax income of $2.0 million, compared to a tax benefit of $0.3 million on pretax loss of $1.0 million for the fourth quarter of 2005. The effective tax rate for the second quarter of fiscal 2006 is expected to be approximately 25%, which excludes an income tax charge of approximately $1.1 million to be recorded in the second quarter relating to a recent change in Oregon tax law.
Net income for the first quarter of fiscal 2006 was $1.3 million, or $0.05 per share on a basic and fully diluted basis, compared to a net loss of $0.8 million, or ($0.03) per share on a basic and fully diluted basis, respectively, in the fourth quarter of fiscal year 2005.
Results of Operations
The following table sets forth results of operations data as a percentage of net sales.
Certain information regarding our net sales by product group is as follows (net sales in thousands):
Net sales were $44.5 million for the quarter ended August 27, 2005, a decrease of $28.1 million or 38.7% compared to net sales of $72.6 million for the same quarter of the prior year. Sales decreased $16.1 million or 36.6% for SG, $9.6 million or 46.4% for PCG and $2.4 million or 30.6% for EIG, compared to the same period in the prior year. Sales decreases in SG for the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005 resulted primarily from a decrease in system sales volumes. Net sales in the first quarter of the prior year benefited from a trend of major DRAM manufacturers increasing capacity, primarily in the memory repair product line, which peaked in the fourth quarter of fiscal 2004. SG net sales in the fourth quarter of 2004 were $54.1 million followed by volume decreases resulting in net sales of $44.0 million in the first quarter of fiscal 2005. Volume declines continued throughout fiscal 2005 ending with SG net sales of $29.2 million in the fourth quarter of that year. This decreasing capital investment trend is consistent with the trend in the overall semiconductor market. The decrease in PCG sales is due to continuing caution by component manufacturers, who are evaluating the sustainability of utilization rates before placing equipment orders. In the first quarter of the prior year, PCG sales reached a four-quarter peak, driven by demand for passive components processed by our laser trim and passive test systems. EIG sales levels decreased compared to the prior year as a result of industry softness and resulting sales volume decreases.
Net sales by geographic region were as follows (net sales in thousands):
Total net sales to Asia decreased $27.6 million in the first quarter of fiscal 2006 from the comparative quarter of fiscal 2005. This decrease in sales volume to Asia was the primary cause of the overall net sales decrease of $28.1 million. Shipments to Asia in the first quarter of fiscal 2006 decreased $33.8 million from the same comparative period as a result of volume decreases consistent with overall semiconductor market trends described above. Net sales to the United States increased modestly due to sales volume increases of SG systems to customers in that region. Regional net sales as a percentage of total sales depends heavily upon net sales to SG customers in Asia for any given quarter and can vary depending on the timing of orders, shipments, and product acceptance.
Gross profit was $19.6 million (44.1% of net sales) for the first quarter of fiscal 2006 compared to $36.9 million (50.8% of net sales) for the first quarter of fiscal 2005. Shipments in the first quarter of fiscal 2006 decreased 42.8% compared to the same quarter in fiscal 2005. Decreased shipment levels resulted in lower volume-based manufacturing efficiencies, reduced overhead absorption and higher costs per unit.
Selling, Service and Administrative Expenses
The primary items included in selling, service and administrative expenses are labor and other employee-related expenses, travel expenses, professional fees and facilities costs. Selling, service and administrative expenses were $11.1 million (24.9% of net sales) in the first quarter of fiscal 2006, a decrease of $3.8 million compared to $14.9 million (20.5% of net sales) in the first quarter of fiscal 2005.
The first quarter of fiscal 2005 includes $0.4 million in special charges for professional fees related to the 2003 audit committee investigation and securities litigation. Exclusive of these special charges, selling, service and administrative expenses decreased $3.4 million in the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005. The decrease is primarily due to a reduction in payroll and related costs resulting from restructuring and other cost containment initiatives implemented in fiscal 2005. Additionally, commission expenses decreased due to the reduction in revenue compared to the first quarter of fiscal 2005.
Research, Development and Engineering Expenses
Research, development and engineering expenses are primarily comprised of labor and other employee-related expenses, professional fees, project materials, equipment and facilities costs. Expenses associated with research, development and engineering totaled $7.8 million (17.6% of net sales) for the first quarter of fiscal 2006, representing a $1.2 million increase from expenses of $6.6 million (9.0% of net sales) for the first quarter of fiscal 2005. This is primarily due to an increase in subcontracted and professional services and increased purchases of materials used in research and development of new products in existing and emerging markets.
Other Income (Expense)
Interest income was $1.5 million in the first quarter of 2006, compared to $1.6 million in the first quarter of 2005, a decrease of $0.1 million. The decrease is partly due to the liquidation of marketable securities on March 10, 2005 to fund the $145 million redemption of our 4 ¼% convertible subordinated notes due 2006. The resulting lower amount invested was offset by increased yields on invested assets, consistent with increases in market interest rates on debt securities over the past year.
Interest expense decreased by $1.8 million or 98% in the first quarter of 2006, compared to the first quarter of fiscal 2005, due to the redemption of our convertible subordinated notes.
The income tax provision recorded for the first quarter of fiscal 2006 was $0.6 million on pretax income of $2.0 million, an effective rate of 32%. The effective tax rate is lower than our statutory tax rate of 36%, primarily due to incentives for export sales and research credits.
In October 2003 the Internal Revenue Service (IRS) began an audit of the fiscal tax years ending in 1996 through 2003. During fiscal 2005 we reached an agreement with the IRS on the tax return years under review. The examination required a special report to be submitted by the IRS for congressional approval from the Joint Committee on Taxation. During the first quarter of fiscal 2006, we received notice from the IRS that the Joint Committees review was completed without exception. As a result, we will receive approximately $7.2 million in tax refunds. Additionally, we are subject to numerous ongoing state and foreign tax audits. Although the final outcome of these audits is uncertain, based on currently available information we believe the ultimate resolutions will not have a materially adverse effect on the Companys financial position or results of operations.
Net income for the first quarter of fiscal 2006 was $1.3 million (3.0% of net sales), or $0.05 per share on a basic and fully diluted basis, compared to a net income of $10.6 million (14.7% of net sales), or $0.38 and $0.36 per share on a basic and fully diluted basis, respectively, in the first quarter of fiscal year 2005.
Financial Condition and Liquidity
At August 27, 2005, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $221.4 million and accounts receivable of $37.2 million. At August 27, 2005, we had a current ratio of 7.4:1 and no long-term debt. Working capital increased to $284.1 million at August 27, 2005 from $275.7 million at May 28, 2005. We believe that our existing cash, cash equivalents and marketable securities are adequate to fund our operations for at least the next twelve months.
Cash flows from operating activities totaled $6.8 million in the first quarter of fiscal 2006. Cash totaling $4.0 million was provided by net income adjusted for non-cash items. Other significant factors impacting cash flows from operations included increases in trade receivables, receipt of income tax refunds, decreases in inventories, and decreases in current liabilities.
Net inventories decreased 9.8% to $53.7 million at August 27, 2005, compared to $59.5 million at May 28, 2005. The decrease is comprised primarily of decreases in finished goods due to the implementation of a targeted inventory management program designed to reduce inventory levels.
Net trade receivables were $37.2 million at August 27, 2005 compared to $36.2 million at May 28, 2005, an increase of $1.0 million. The increase is primarily due to the timing of acceptances on shipped systems.
Payables and current liabilities were $31.5 million at August 27, 2005 compared to $33.4 million at May 28, 2005. The decrease in other liabilities is due primarily to the payment of accrued amounts for annual payroll-related liabilities.
Cash flows from investing activities totaled $19.2 million for the first quarter of fiscal 2006. Capital expenditures totaled $4.7 million during this period and were principally comprised of costs related to the implementation of a new enterprise resource planning system and a major refurbishment of research and development clean rooms and laboratories. We also generated $24.3 million net in cash and cash equivalents through the maturity and sale of investments in our portfolio of marketable securities offset by certain reinvestments. We anticipate remaining capital expenditures related to the implementation of the new enterprise resource planning system in fiscal 2006 will total approximately $7 million.
Cash flows from financing activities of $0.9 million were comprised of proceeds from the exercise of stock options and ESPP purchases for the quarter ended August 27, 2005.
Critical Accounting Policies and Estimates
We reaffirm the critical accounting policies and our use of estimates as reported in our annual report on Form 10-K for our fiscal year ended May 28, 2005 as filed with the Securities and Exchange Commission on July 27, 2005.
Factors That May Affect Future Results
The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words believes, expects and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. From time to time we may make other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ. The following information highlights some of the factors that could cause actual results to differ materially from the results expressed or implied by our forward-looking statements. Forward-looking statements should be considered in light of these factors. Factors that may result in such variances include, but are not limited to, the following:
The industries that comprise our primary markets are volatile and unpredictable.
Our business depends upon the capital expenditures of manufacturers of components and circuitry used in wireless communications, computers and other electronic products. In the past, the markets for electronic devices have experienced sharp downturns. During these downturns, electronics manufacturers, including our customers, have delayed or canceled capital expenditures, which has had a negative impact on our financial results.
After experiencing a significant increase in orders in fiscal 2004, we experienced reduced demand beginning in the first quarter of fiscal 2005. Net sales decreased from $81.8 million in the fourth quarter of fiscal 2004 to $72.6 million, $66.0 million, $49.1 million and $45.7 million in the first, second, third and fourth quarters of fiscal 2005, respectively. Net income (loss) during those periods decreased from $16.2 million in the fourth quarter of fiscal 2004 to $10.6 million, $7.9 million, $2.0 million and ($0.8 million) in the first, second third and fourth quarters of fiscal 2005, respectively. In the first quarter of fiscal 2006, net sales remained fairly level with the prior quarter at $44.5 million and net income increased to $1.3 million. We cannot assure you when, or if, demand for our products will increase or that demand will not further decrease. Even if demand for our products does increase, there may be significant fluctuations in our profitability and net sales.
During any downturn, it will be difficult for us to maintain our sales levels. As a consequence, to maintain profitability we will need to reduce our operating expenses. For example, in December 2004 we announced an operational restructuring and reduction in force to reduce our expenses in connection with the current downturn. Our ability to quickly reduce operating expenses is dependent upon the nature of the actions we take to reduce expense and our subsequent ability to implement those actions and realize expected cost savings. Additionally, we may be unable to defer capital expenditures and we will need to continue to invest in certain areas such as research and development. An economic downturn may also cause us to incur charges related to impairment of assets and inventory write-offs and we may also experience delays in payments from our customers, which would have a negative effect on our financial results.
Delays in manufacturing, shipment or customer acceptance of our products could substantially decrease our sales for a period.
We depend on manufacturing flexibility to meet the changing demands of our customers. Any significant delay or interruption in receiving raw materials or in our manufacturing operations as a result of software deficiencies, natural disasters, or other causes could result in reduced manufacturing capabilities or delayed product deliveries, any or all of which could materially and adversely affect our results of operations.
In addition, we derive a substantial portion of our revenue from the sale of a relatively small number of products. Consequently, shipment and/or customer acceptance delays could significantly impact our recognition of revenue and could be further magnified by announcements from us or our competitors of new products and technologies, which announcements could cause our customers to defer purchases of our systems or purchase products from our competitors. Any of these delays could result in a material adverse change in our results of operations for any particular period.
Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business.
We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers for those materials. We generally do not have guaranteed supply arrangements with our suppliers. We seek to reduce the risk of production and service interruptions and shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key suppliers and maintaining appropriate inventories of key parts. Although we make reasonable efforts to ensure that parts are available from multiple suppliers, some key parts are available only from a single supplier or a limited group of suppliers in the short term. Operations at our suppliers facilities are subject to disruption for a variety of reasons, including changes in business relationships, competitive factors, work stoppages, and fire, earthquake, flooding or other natural disasters. Such disruption could interrupt our manufacturing. Our business may be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner.
We depend on a few significant customers and we do not have long-term contracts with any of our customers.
Our top ten customers for fiscal 2005 accounted for approximately 51% of total net sales in fiscal 2005, with one customer, Samsung, accounting for approximately 13% of total net sales in fiscal 2005. No other customer in fiscal 2005 accounted for more than 10% of total net sales. In addition, none of our customers has any long-term obligation to continue to buy our products or services, and any customer could delay, reduce or cease ordering our products or services at any time.
Our markets are subject to rapid technological change, and to compete effectively we must continually introduce new products that achieve market acceptance.
The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes as well as current and potential customer requirements. The introduction by us or by our competitors of new and enhanced products may cause our customers to defer or cancel orders for our existing products, which may harm our operating results. In the past we have also experienced delays in new product development. Similar delays may occur in the future. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or, where necessary, to license these technologies from others.
Product development delays may result from numerous factors, including:
Changing product specifications and customer requirements;
Difficulties in hiring and retaining necessary technical personnel;
Difficulties in reallocating engineering resources and overcoming resource limitations;
Difficulties with contract manufacturers;
Changing market or competitive product requirements; and
Unanticipated engineering complexities.
The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Any failure to respond to technological change that may render our current products or technologies obsolete could significantly harm our business.
Our ability to reduce costs is limited by our need to invest in research and development.
Our industry is characterized by the need for continued investment in research and development. Because of intense competition in the industries in which we compete, if we were to fail to invest sufficiently in research and development, our products could become less attractive to potential customers, and our business and financial condition could be materially and adversely affected. As a result of our need to maintain our spending levels in this area, our operating results could be materially harmed if our net sales fall below expectations. In addition, as a result of our emphasis on research and development and technological innovation, our operating costs may increase further in the future, and research and development expenses may increase as a percentage of total operating expenses and as a percentage of net sales.
We are exposed to the risks that others may violate our proprietary rights, and our intellectual property rights may not be well protected in foreign countries.
Our success is dependent upon the protection of our proprietary rights. In the high technology industry, intellectual property is an important asset that is always at risk of infringement. We incur substantial costs to obtain and maintain patents and defend our intellectual property. For example, we have initiated litigation alleging that certain parties have violated various patents of ours. We rely upon the laws of the United States and of foreign countries in which we develop, manufacture or sell our products to protect our proprietary rights. However, these proprietary rights may not provide the competitive advantages that we expect or other parties may challenge, invalidate or circumvent these rights.
Further, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. If we fail to adequately protect our intellectual property in these countries, it could be easier for our competitors to sell competing products in foreign countries, which could result in reduced sales and gross margins.
We may be subject to claims of intellectual property infringement.
Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products. From time to time, we and our customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. Competitors or others have in the past and may in the future assert infringement claims against our customers or us with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur.
If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, our financial condition and results of operations could be materially and adversely affected.
Our business is highly competitive, and if we fail to compete effectively, our business will be harmed.
The industries in which we operate are highly competitive. We face substantial competition from established competitors, some of which have greater financial, engineering, manufacturing and marketing resources than we do. If we are unable to compete effectively with these companies, our market share may decline and our business could be harmed. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. New companies may enter the markets in which we compete, or industry consolidation may occur, further increasing competition in those markets. Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors.
Our competitors greater resources in the areas described above may enable them to:
Better withstand periodic downturns;
Compete more effectively on the basis of price and technology; and
More quickly develop enhancements to and new generations of products.
We believe that our ability to compete successfully depends on a number of factors, including:
Performance of our products;
Quality of our products;
Reliability of our products;
Cost of using our products;
Consistent availability of critical components;
Our ability to ship products on the schedule required;
Quality of the technical service we provide;
Timeliness of the services we provide;
Our success in developing new products and enhancements;
Existing market and economic conditions; and
Price of our products as compared to our competitors products.
We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins and loss of market share.
The loss of key personnel or our inability to attract, retain and assimilate sufficient numbers of managerial, financial, engineering and other technical personnel could have a material effect upon our results of operations.
Our continued success depends, in part, upon key managerial, financial, engineering and technical personnel as well as our ability to continue to attract, retain and assimilate additional personnel. The loss of key personnel could have a material adverse effect on our business or results of operations. We may not be able to retain our key managerial, financial, engineering and technical employees. Attracting qualified personnel may be difficult and our efforts to attract and retain these personnel may not be successful. In addition, we may not be able to assimilate qualified personnel, including any new members of senior management, which could disrupt our operations.
Our worldwide direct sales and service operations expose us to employer-related risks in foreign countries.
We have established direct sales and service organizations throughout the world. A worldwide direct sales and service model in foreign countries involves certain risks. We are subject to compliance with the labor laws and other laws governing employers in the countries where our operations are located and as a result we may incur additional costs to comply with these local regulations. Additionally, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell, market and service our products. If we cannot effectively manage the risks related to employing persons in foreign countries, our operating results could be adversely affected.
We may make acquisitions in the future, and these acquisitions may subject us to risks associated with integrating these businesses into our current business.
Although we have no commitments or agreements for any acquisitions, in the future we may make acquisitions of, or significant investments in, businesses with complementary products, services or technologies.
Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including:
Difficulties and increased costs in connection with integration of the personnel, operations, technologies and products of acquired companies;
Diversion of managements attention from other operational matters;
The potential loss of key employees of acquired companies;
Lack of synergy, or inability to realize expected synergies, resulting from the acquisition; and
Acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company.
Our inability to effectively manage these acquisition risks could materially and adversely affect our business, financial condition and results of operations. In addition, if we issue equity securities to pay for an acquisition the ownership percentage of our existing shareholders would be reduced and the value of the shares held by our existing shareholders could be diluted. If we use cash to pay for an acquisition the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. In addition, the accounting for future acquisitions could result in significant charges resulting from amortization of intangible assets related to such acquisitions.
We are exposed to the risks of operating a global business, including risks associated with exchange rate fluctuations, legal and regulatory changes and the impact of regional and global economic disruptions.
International shipments accounted for 85% of net sales in fiscal 2005, with 77% of our net sales to customers in Asia. We expect that international shipments will continue to represent a significant percentage of net sales in the future. Our non-U.S. sales, purchases and operations are subject to risks inherent in conducting business abroad, many of which are outside our control, including the following:
Periodic local or geographic economic downturns and unstable political conditions;
Price and currency exchange controls;
Fluctuation in the relative values of currencies;
Difficulties protecting intellectual property;
Local labor disputes;
Shipping delays and disruptions;
Increases in shipping costs, caused by increased fuel costs or otherwise, which we may not be able to pass on to our customers;
Unexpected changes in trading policies, regulatory requirements, tariffs and other barriers; and
Difficulties in managing a global enterprise, including staffing, collecting accounts receivable, managing distributors and representatives and repatriation of earnings.
Our business and operating results are subject to uncertainties arising out of the possibility of regional or global economic disruptions (including those resulting from natural disasters), the economic consequences of military action or terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. In particular, due to these uncertainties we are subject to:
The risk that future tightening of immigration controls may adversely affect the residence status of non-U.S. engineers and other key technical employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities;
The risk of more frequent instances of shipping delays; and
The risk that demand for our products may not increase or may decrease.
Failure to achieve and maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.
In connection with our fiscal 2005 audit, we documented and tested our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. If we fail to achieve and maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Our ability to maintain internal controls may be negatively impacted by our planned implementation of new enterprise management software and systems in fiscal 2006. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.
Enterprise resource planning system (ERP) implementation could have a material adverse effect on our business.
We are highly dependent on our systems infrastructure in order to process orders, track inventory, ship products in a timely manner, prepare invoices to our customers and otherwise carry on our business in the ordinary course. Key to the success of our strategy to drive greater productivity and cost savings is the implementation of a new worldwide ERP system expected in fiscal 2006. If we experience problems with the implementation of this system, the resulting disruption could adversely affect our business, sales, results of operations and financial condition. The transition to our new ERP system involves numerous risks, including:
difficulties in integrating the system with our current operations;
diversion of managements attention away from normal daily operations of our business;
initial dependence on an unfamiliar system while training personnel in its use;
increased demand on our support operations; and
potential delay in the processing of customer orders for shipment of products.
Further, we may experience difficulties in the transition to the new software that could affect our internal control systems, processes, procedures and related documentation. The ERP implementation will require significant effort in a compressed timeframe, as well as result in our incurring costs to comply with Section 404 of the Sarbanes-Oxley Act by documenting all business processes that have been revised as a result of the implementation. This will result in compliance costs that will be in addition to the implementation costs of our new ERP system. There can be no assurances that the evaluation required by Section 404 of the Sarbanes-Oxley Act for fiscal 2006 will not result in the identification of significant control deficiencies or that our auditors will be able to attest to the effectiveness of our internal control over financial reporting subsequent to the implementation of the new ERP system.
The Companys tax rates are subject to fluctuation, which could impact our financial position
Our effective tax rates are subject to fluctuation as the income tax rates for each year are a function of: (a) the effects of a mix of profits (losses) earned by ESI and our subsidiaries in numerous tax jurisdictions with a broad range of income tax rates, (b) our ability to utilize recorded deferred tax assets, (c) taxes, interest or penalties resulting from tax audits and (d) changes in tax laws or the interpretation of such tax laws. Changes in the mix of these items may cause our effective tax rates to fluctuate between periods, which could have a material adverse effect on our financial position.
There have been no material changes in the market risk disclosure contained in our 2005 Annual Report on Form 10-K for our fiscal year ended on May 28, 2005.
Attached to this quarterly report as exhibits 31.1 and 31.2 are the certifications of our President and Chief Executive Officer and our Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302 Certifications). This portion of our quarterly report on Form 10-Q is our disclosure of the conclusions of our management, including our President and Chief Executive Officer and our Chief Financial Officer, regarding the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report based on managements evaluation of those disclosure controls and procedures. You should read this disclosure in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.
Disclosure Controls and Procedures
Our management has evaluated, under the supervision and with the participation of our President and Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (Exchange Act). Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to our management, including our President and Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting that occurred during our fiscal quarter ended August 27, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
On August 24, 2005, we executed a Provisional Attachment Order (the Order) issued by the Kaohsiung District Court of Taiwan directed against All Ring Tech Co., Ltd. (All Ring) of Taiwan. In the petition requesting the Order, ESI alleges that All Rings Capacitor Tester Model RK-T6600 infringes our Taiwan Patent No. 207469, entitled Circuit Component Handler (the 207469 patent). This patent corresponds to our U.S. Patent No. 5,842,579. The patented technology is used in our Model 3340 Multifunction MLCC Tester. We filed in support of the petition a copy of a patent infringement assessment report issued by Yen Tjing Ling Industrial Research Institute, a professional organization appointed by the judicial branch of the Taiwan government, that concludes that the RK-T6600 infringes the 207469 patent. A copy of the assessment report and an English language translation of the assessment report are available on ESIs website. All Ring has filed a bond with the court to obtain relief from the attachment of its assets. The bond provides security to us with respect to our patent infringement claim against All Ring. We intend to vigorously pursue this patent infringement claim against All Ring.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.