Electro Scientific Industries 10-Q 2005
WASHINGTON, D.C. 20549
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
The number of shares outstanding of the Registrants Common Stock at March 18, 2005 was 28,554,530 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
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these statements.
ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
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. Certain prior year amounts have been reclassified to conform to current year presentation.
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 were as follows (in thousands):
Note 3 Accrued Liabilities
Accrued liabilities consisted of the following (in thousands):
See Note 4 for a discussion of the accrual for product warranty. The legal settlement accrual of $3.8 million related to the class action and derivative lawsuit and was paid during the second quarter of fiscal 2005.
Note 4 Product Warranty
The Company evaluates obligations related to product warranties quarterly. The Company provides a standard one-year warranty on its 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 our suppliers for defective components are recorded as a credit to the warranty accrual. Using historical data, we estimate 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 nine months ended February 26, 2005 and February 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 delivery of such elements. 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 nine months ended February 26, 2005 and February 28, 2004 (in thousands):
Note 6 - Earnings Per Share
Following is a reconciliation of weighted average shares outstanding and adjustments to net income (loss) used in the calculation of basic and diluted earnings (loss) per share (EPS) for the three months and nine months ended February 26, 2005 and February 28, 2004 (in thousands):
The following common stock equivalents were excluded from the diluted EPS calculations because inclusion would have had an antidilutive effect (in thousands):
The components of comprehensive income (loss), 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 and restricted stock 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 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 is recorded when performance 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. However, no compensation expense related to performance-based stock units has been recorded to date because probability cannot be assessed that the related three-year performance criteria will be met. Additionally, 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:
On January 25, 2005, the Compensation Committee of the Board of Directors (the Compensation Committee) accelerated the vesting, effective immediately, of all the Companys unvested stock options awarded to employees, other than those awarded to the President and Chief Executive Officer at his time of hire (which are discussed in the next paragraph), having an exercise price greater than $20.24. Except as noted in the following paragraph, no options were accelerated for members of the Board of Directors. The closing price of the Companys common stock on the NASDAQ National Market on January 25, 2005 was $17.14. As a result of the acceleration, options to acquire approximately 220,000 shares of the Companys common stock, which otherwise would have vested from time to time over the next 42 months, became immediately exercisable.
On January 25, 2005, the Compensation Committee accelerated the vesting of 315,000 shares of the Companys common stock subject to an option granted to Nicholas Konidaris, the Companys President and Chief Executive Officer, so that the option will become fully exercisable on August 26, 2005. The option has an exercise price of $25.71. Under the terms of the original option agreement, 105,000 shares would have vested on each of January 7, 2006, January 7, 2007 and January 7, 2008. For book reporting purposes, the Company will be required to accelerate approximately $1.5 million of unamortized expense related to this award ratably over the remaining vesting period, which ends August 26, 2005. This expense would otherwise have been expensed ratably through December 2007. Additionally, a stock option granted to Mr. Konidaris to purchase 40,000 shares of the Companys common stock was accelerated effective January 25, 2005. The option has an exercise price of $25.50. Under the terms of the original option agreement, 10,000 shares would have vested on each of July 13, 2005, July 13, 2006, July 13, 2007 and July 13, 2008. In connection with both of these accelerations, Mr. Konidaris has agreed that the shares underlying the accelerated options may not be sold by him until the dates those shares would otherwise have been vested under the terms of the original option agreements.
On June 28, 2004, the Compensation Committee of the Board of Directors approved an acceleration of the vesting of those employee stock options, excluding stock options granted to the Board of Directors and Chief Executive Officer, with an option price equal to or greater than the closing sale price of $23.38
per share on that date, as reported on the NASDAQ National Market. Options to purchase approximately 1.2 million shares of stock with varying remaining vesting schedules were subject to the acceleration provision and became immediately exercisable.
The total pro forma stock-based employee compensation expense stated above of $19.6 million for the nine months ended February 26, 2005 includes $4.0 million resulting from the January 25, 2005 accelerations and $10.1 million resulting from the June 28, 2004 acceleration, as calculated under SFAS No. 123. No compensation has been recorded in the statement of operations related to this modification as the market price of the common stock on the date of the modification was lower than the exercise price of the accelerated options.
The Company has decided to follow the modified prospective method in implementing recent amendments by the Financial Accounting Standards Board in Accounting for Stock-Based Compensation upon their effective date (see Note 10). The Company believes the acceleration of the stock option vesting schedules as described above will reduce the future amortization of the Companys stock option compensation expense for fiscal 2006 and beyond and will enhance comparability of its financial statements with those of prior and future fiscal periods. Additionally, the Compensation Committee has decided to rely less on stock options for equity-based compensation and evaluate other alternatives for such compensation in the future. It believes that the amended vesting provisions will partially mitigate the effect of this reduction in future stock option grants on employee retention and incentive.
Note 9 Restructuring and Cost Management Plans
In December 2004, the Company announced a restructuring plan to streamline its infrastructure. This plan, which was effective in early January 2005, resulted in a decrease in workforce of 57 employees in the United States and impacted manufacturing, sales, marketing and administration and research, development and engineering. Charges incurred of approximately $1.2 million related to the plan were primarily comprised of severance and other employee-related charges. These amounts were paid during the third quarter of fiscal 2005 and are included in the consolidated condensed statements of operations for the three and nine months ended February 26, 2005 as follows (in thousands):
The Company also initiated restructuring and other cost management plans in each of the prior three fiscal years. The fiscal 2004 plan consisted of a headcount reduction to reduce expenditures. The fiscal 2003 actions primarily related to relocating the manufacturing of our electronic component product line from Escondido, California to our headquarters in Portland, Oregon. The fiscal 2002 actions included a reducing headcount, exiting the mechanical drill business and discontinuing the manufacture of certain other products and vacating related facilities. All expenses related to the fiscal 2004 and fiscal 2003 plans have been paid. As of February 26, 2005, we had a remaining amount accrued of approximately $0.4 million for future payments, net of estimated sublease rentals, for a property in Ann Arbor, Michigan that is leased and sublet through December 2006 and was vacated as a part of the 2002 restructuring plan. A detail of expenses by business function for the three months and nine months ended February 28, 2004 for all plans is presented below (in thousands):
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 interim reporting period ending November 26, 2005. If SFAS 123R had been adopted for the three and nine months ending February 26, 2005, net income would have been reduced by $5.3 million ($0.19 per basic and fully diluted share) and $19.1 million ($0.68 per basic share and $0.67 per fully diluted share), respectively (see Note 8).
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. The Company has not yet completed evaluation of the impact of the repatriation provisions.
Note 11 Subsequent Events
On March 10, 2005, the Company redeemed the $145.0 million aggregate principal value of the outstanding 4 ¼ % convertible subordinated notes due 2006 (the Convertible Notes). In accordance with the terms of the Convertible Note indenture, the redemption price was 101.70% of the principal amount of the Convertible Notes, plus accrued and unpaid interest to the redemption date. In connection with the redemption, the Company will record expenses of approximately $4.2 million in the fourth quarter of fiscal 2005, consisting of the redemption premium, a non-cash charge for unamortized debt issuance costs of approximately $1.6 million and other related costs.
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 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 passives (MLCPs) and other passive components, as well as original equipment manufacturer (OEM) machine vision products.
During the first nine months of fiscal 2005, market demand lessened for our products compared to the levels experienced in the latter half of fiscal 2004. Order volume was $67.6 million in the first quarter of fiscal 2005, representing a significant decline from orders of $104.7 million in the fourth quarter of fiscal 2004. Orders decreased further to $39.8 million in each of the second and third quarters of fiscal 2005. Although order levels for the third quarter were consistent with the second quarter, the mix between product groups changed slightly; decreased orders for passive component products were offset by increased orders for semiconductor and electronic interconnect group products.
Shipments were $48.3 million in the third quarter of fiscal 2005, representing a 16.8% decline from shipments of $58.1 million in the second quarter of fiscal 2005 and a 38.0% decline from shipments of $77.9 million in the first quarter. Accordingly, net sales for the quarter decreased to $49.1 million from $66.0 million in the second quarter and $72.6 million in the first quarter of fiscal 2005.
Gross margin on sales of $49.1 million was 44%, representing a decrease of 6 percentage points from the prior quarter margin on sales of $66.0 million. Margins were impacted by lower overhead absorption on reduced production volumes as well as a change in sales mix. Sales in the current quarter were more heavily weighted towards established products as customers build capacity on existing technologies. Fourth quarter shipments and revenues are currently estimated to be in the range of $40 million to $50 million and related gross margins are expected to remain in the mid-40% range.
Operating expenses were $18.7 million for the third quarter compared to $23.1 million in the second quarter of fiscal 2005, resulting in operating income of $2.7 million in the third quarter. Operating expenses in the third quarter include $0.9 million of a total $1.2 million in charges related to a restructuring and cost management plan announced in December 2004 and are primarily comprised of severance and other employee-related costs. The previous quarters operating expenses included $2.2 million for legal and settlement fees related to a patent infringement lawsuit. We anticipate operating expenses in the fourth quarter to be in the range of $18 million to $19 million.
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 $49.1 million for the quarter ended February 26, 2005, a decrease of $9.7 million or 16.5% compared to net sales of $58.8 million for the quarter ended February 28, 2004. Sales decreased 20% and 25% for SG and EIG respectively, while sales for PCG in the third quarter of fiscal 2005 were comparable with the same period in the prior year. Sales decreases in SG for the third quarter of fiscal 2005 compared to the third quarter of fiscal 2004 resulted primarily from a decrease in system sales volumes. Shipments and related revenues have decreased sequentially by quarter during fiscal 2005 after a peak in sales in the fourth quarter of fiscal 2004. This decreasing capital equipment investment trend is consistent with the
trend in the overall semiconductor market. PCG sales remained consistent with the same quarter of the prior year as component manufacturers remained cautious about equipment purchases and ran factories at less than full capacity. EIG sales levels decreased in the third quarter of fiscal 2005 compared to the same period in the prior year as a result of industry softness and fewer integrated circuit (IC) packaging systems sold.
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 our factory include sales to Japanese end-user customers and shipments of substantially new products. Due to these factors, as well as the timing of their occurrence in any given quarter, deferred revenue balances may fluctuate significantly from quarter to quarter. In sales involving multiple element arrangements, the fair value of any undelivered elements, including installation services, is deferred until delivery of such elements. Revenue related to maintenance and service contracts is deferred and recognized ratably over the duration of the contracts.
The detail of the activity in deferred revenue for the first three quarters of fiscal 2005 is presented in the table below (in thousands). Deferred revenue recognized in the third quarter of fiscal 2005 consisted primarily of systems shipped to Japanese customers in prior quarters gaining acceptance in the current quarter. These sales are generally associated with PCG customers.
Net sales were $187.7 million for the nine months ended February 26, 2005, an increase of $62.3 million or 49.7% compared to net sales of $125.4 million for the nine months ended February 28, 2004. Of the increase, $38.4 million resulted from increased sales in the SG product lines and is attributed to major DRAM manufacturers increasing capacity, primarily in the memory repair product line. This trend with DRAM manufacturers began in the second quarter of fiscal 2004 and reached its highest level in the fourth quarter of fiscal 2004. An additional $19.9 million or 32% of the increase resulted from PCG sales generated by demand for passive components processed by our laser trim and passive test systems. This growth in demand began in the second half of fiscal 2004 and has since softened as PCG manufacturers delay building capacity until factory utilization reaches desired levels. The remaining increase of $4.0 million was generated by EIG resulting from acceptance of new products in the IC package segment shipped in prior quarters.
Net sales by geographic region were as follows (net sales in thousands):
Regional sales results in the third quarter of fiscal 2005 shifted slightly from the third quarter of fiscal 2004. The percentage of total net sales to Asia increased 4 percentage points and the percentage of total net sales to the United States increased 2 percentage points, while total net sales to Europe decreased 6 percentage points. The decrease in Europe can be attributed to fewer SG system sales into the region in the current quarter, which is consistent with the general trend of semiconductor manufacturing moving from Europe to Asia. For the nine months ended February 26, 2005, compared to the nine months ended February 28, 2004, sales by region were also more heavily weighted to Asia and particularly to Taiwan. This increase in sales resulted from volume increases of both SG and PCG products over the prior year.
Gross profit was $21.4 million (43.7% of net sales) for the third quarter of fiscal 2005 compared to $23.3 million (39.7% of net sales) for the third quarter of fiscal 2004. Although shipments in the third quarter of fiscal 2005 decreased 12.8% compared to the same quarter in fiscal 2004, we were able to maintain improved margin rates through volume-based manufacturing efficiencies and lower overhead costs per unit.
Gross profit for the nine month period ended February 26, 2005 was $91.2 million (48.6% of net sales) compared to $43.8 million (35.0% of net sales) for the same nine month period in the prior fiscal year. This represents a 13.6% improvement in gross margin rates. Shipments of $184.3 million in the first nine months of fiscal 2005 were 43.2% higher than the $128.7 million of shipments for the same nine months in fiscal 2004. Increased shipment levels resulted in volume-based manufacturing efficiencies and lower 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 $12.3 million (25.1% of net sales) in the third quarter of fiscal 2005, a decrease of $1.2 million compared to $13.5 million (23.0% of net sales) in the third quarter of fiscal 2004. For the nine months ended February 26, 2005, selling, service and administrative expenses increased $1.1 million to $42.5 million (22.7% of net sales) compared to $41.4 million (33.0% of net sales) for the nine months ended February 28, 2004.
Other special charges included in this category consist of charges relating to restructuring actions, patent litigation settlement and related legal fees and professional fees related to the 2003 audit committee investigation and securities litigation. The amounts and timing of these special charges are detailed above for comparative purposes. Exclusive of these special charges, selling, service and administrative expenses decreased $0.9 million in the third quarter of fiscal 2005 compared to the third quarter of fiscal 2004 and increased $2.3 million for the first nine months of fiscal 2005 compared to the first nine months of fiscal 2004.
The decrease in selling, service and administrative expenses of $0.9 million, exclusive of the special charges detailed above, for the three months ended February 26, 2005 compared to the same period in the prior year is primarily due to a decrease in professional fees. Additionally, expenses decreased due to a one-week plant shutdown in December 2004 and cost containment initiatives implemented in fiscal 2005.
The increase in selling, service and administrative expenses of $2.3 million, exclusive of the special charges detailed above, for the nine months ended February 26, 2005 compared to the same period in the prior year is primarily due to increased compensation costs resulting from a higher average headcount in fiscal 2005 year-to-date compared to fiscal 2004 year-to-date and an increase in sales commissions, offset by a decrease in professional fees.
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 $6.4 million (13.0% of net sales) for the third quarter of fiscal 2005, representing a $1.0 million increase from expenses of $5.4 million (9.2% of net sales) for the third quarter of fiscal 2004. For the nine months ended February 26, 2005, research, development and engineering expenses increased $4.1 million to $20.7 million (11.0% of net sales) compared to $16.6 million (13.3% of net sales) for the nine months ended February 28, 2004.
Exclusive of special charges for previous restructuring and cost management plans detailed in the table above, research, development and engineering costs increased $0.7 million and $4.0 million, respectively, for the three and nine month periods ended February 26, 2005 compared to the same periods in the prior year.
The $0.7 million increase in research and development costs, exclusive of the special charges detailed above, for the three months ended February 26, 2005 compared to the same period in fiscal 2004 is primarily due to an increase in subcontracted and professional services and materials used in research and development activities.
The $4.0 million increase in research and development costs, exclusive of the special charges detailed above, for the nine months ended February 26, 2005 compared to the same period in fiscal 2004 is primarily due an increase in compensation costs due to a higher average headcount in fiscal 2005 year-to-date compared to fiscal 2004 year-to-date, an increase in legal fees related to patent registration and maintenance, an increase in subcontracted services and materials used in research and development activities and numerous other cost increases related to our continued investment in funding for development projects, new technical capabilities and initiatives.
Restructuring and Cost Management Plans
In December 2004, we initiated a restructuring plan designed to streamline our technology development efforts and enhance our customer-centric focus through several actions, including centralizing our research, development and engineering function, creating a technical marketing solutions group and creating a customer-centric manufacturing organization. In conjunction with the restructuring, 57 positions were eliminated in our U.S. operations, impacting all employee groups. The restructuring actions were completed in early January 2005 and we incurred and paid approximately $1.2 million in charges related to the fiscal 2005 restructuring plan during the third quarter, as detailed below. Ongoing annual savings related to this restructuring are currently estimated to be approximately $6.0 million, of which approximately $4.7 million will impact operating expenses.
We also initiated restructuring and other cost management plans in fiscal 2004 and the two previous fiscal years. The fiscal 2004 plan consisted of a headcount reduction to reduce expenditures. The fiscal 2003 actions primarily related to relocating the manufacturing of our electronic component product line
from Escondido, California to our headquarters in Portland, Oregon. The fiscal 2002 actions included a reducing headcount, exiting the mechanical drill business and discontinuing the manufacture of certain other products and vacating related facilities. All expenses related to the fiscal 2005, fiscal 2004 and fiscal 2003 plans have been paid. As of February 26, 2005, we had a remaining amount accrued of approximately $0.4 million for future payments, net of estimated sublease rentals, for a property in Ann Arbor, Michigan that is leased and sublet through December 2006 and was vacated as a part of the 2002 restructuring plan. A detail of expenses by business function for the three months and nine months ended February 26, 2005 and February 28, 2004 is presented below (in thousands):
The income tax provision recorded for the third quarter of fiscal 2005 was $0.7 million on pretax income of $2.7 million, an effective rate of 25%. The fiscal year-to-date provision for income taxes at February 26, 2005 is $6.7 million on pretax income of $27.3 million, an effective annual rate of 25%. The estimated effective annual tax rate for fiscal 2005 of 25% is lower than our statutory tax rate of 36%, primarily due to incentives for export sales and research credits.
The income tax benefit for the third quarter of fiscal year 2004 was $5.8 million despite recording pre-tax income of $4.2 million for the quarter. The tax benefit recorded was a result of the dollar amount of permanent income tax deductions and tax credits relative to estimated pre-tax earnings. The income tax benefit rate for the nine months ended February 28, 2004 was 70%. This effective rate was higher than the statutory tax rate as a result of the inclusion of certain export tax incentives and increased research and development tax credits as a result of tax returns filed in fiscal 2004.
We currently have an outstanding examination by the Internal Revenue Service for our tax returns for the tax years ending in 1996 through 2003. Although the examination is substantially complete, the final outcome of the federal tax audit is uncertain. We believe the ultimate results will not have a materially adverse effect on our results of operations or financial position.
Net Income (Loss)
Net income for the three months ended February 26, 2005 was $2.0 million (4.1% of net sales) or $0.07 per share on a basic and fully diluted basis and for the nine months ended February 26, 2005 was $20.6 million (11.0% of net sales) or $0.73 and $0.72 per share on a basic and fully diluted basis, respectively. For the three months ended February 28, 2004, we recorded net income of $10.0 million (17.0% of net sales) or $0.36 and $0.34 per share on a basic and fully diluted basis, respectively. For the nine months ended February 28, 2004, we recorded a net loss of $4.3 million (3.4% of net sales) or $0.15 per share on a basic and fully diluted basis.
Liquidity and Capital Resources
At February 26, 2005, our principal sources of liquidity consisted of existing cash, cash equivalents and marketable securities of $355.5 million and accounts receivable of $36.8 million. At February 26, 2005, we had a current ratio of 2.3 and no long-term debt. The principal value of our convertible subordinated notes is classified as a short-term liability at February 26, 2005 as the notes were redeemed on March 10, 2005. As a result, working capital decreased to $247.8 million at February 26, 2005 from $369.9 million at May 29, 2004. We believe that our existing cash, cash equivalents and marketable securities are adequate to fund the redemption of our notes and our operations for at least the next twelve months.
Cash flows from operating activities for the nine months ended February 26, 2005 totaled $18.3 million. Factors impacting cash flows from operations included increases in inventories, decreases in trade receivables, estimated income tax payments and decreases in payables and current liabilities.
Net inventories increased 13.9% to $66.8 million at the end of the third quarter compared to $58.6 million at May 29, 2004. The increase is comprised primarily of additions to finished goods due to delayed timing of shipments previously anticipated in the first three quarters of fiscal 2005 and increases in raw materials due to anticipated production requirements in the fourth quarter of fiscal 2005.
Net trade receivables were $36.8 million at February 26, 2005 compared to $51.7 million at May 29, 2004, a decrease of $14.9 million inclusive of an increase of $2.0 million due to non-cash currency translation adjustments resulting from the weakening of the U.S. dollar. The increase due to currency translation is substantially offset by currency translation adjustments to current liabilities discussed below, with the difference included as a component of other comprehensive income. The remaining decrease is due to lower revenue levels in the third quarter combined with strong collection activities.
Payables and current liabilities, exclusive of the convertible subordinated notes, were $38.4 million at February 26, 2005 compared to $55.6 million at May 29, 2004, decreasing by $17.2 million, inclusive of an increase of $1.1 million due to non-cash currency translation adjustments resulting from the weakening of the U.S. dollar. Approximately $7.6 million of the decrease was due to a reduction in purchases in response to a softening of demand for our products. The remaining decrease in other liabilities is due primarily to the litigation settlement and legal fee payments, reductions in estimated income taxes payable, decreased payroll liabilities and various other reductions in operating accruals.
Cash flows from investing activities totaled $43.4 million for the nine months ended February 26, 2005. Capital expenditures totaled $3.4 million during this period and were comprised of computer equipment
and systems upgrades, and investments in production and test equipment and facilities. We generated $2.4 million in cash in June of 2004 from the sale of an undeveloped parcel of land in Taiwan classified as an asset held for sale at May 29, 2004. We also generated $45.2 million in cash and cash equivalents through the liquidation of restricted investments and sales of investments in our portfolio of marketable securities. These investment transactions were undertaken primarily to fund regularly scheduled semi-annual interest payments on the convertible subordinated notes and the redemption of the notes on March 10, 2005.
Cash flows from financing activities of $5.7 million were comprised of proceeds from the exercise of stock options for the nine months ended February 26, 2005.
At February 26, 2005 we had $143.4 million recorded on our balance sheet related to our 4¼% convertible subordinated notes due December 21, 2006 (the Convertible Notes). The $1.6 million difference between the $145.0 million face value and the $143.4 million balance at February 26, 2005 relates to underwriting discounts, which originally totaled $4.5 million. These discounts are being amortized as additional interest expense over the life of the Convertible Notes at a rate of $0.9 million per year, resulting in a corresponding accretion to the recorded amount of the notes. During the first and third quarters of fiscal 2005, we made semi-annual interest payments of $3.1 million each which were fully funded by the liquidation of restricted securities.
Subsequent to the end of the third quarter, on March 10, 2005, we redeemed the $145.0 million aggregate principal value of the outstanding Convertible Notes. In accordance with the terms of the Convertible Note indenture, the redemption price was 101.70% of the principal amount of the Convertible Notes, plus accrued and unpaid interest to the redemption date. In connection with the redemption, we will record expenses of approximately $4.2 million in the fourth quarter of fiscal 2005, consisting of the redemption premium, a non-cash charge for unamortized debt issuance costs of approximately $1.6 million and other related costs.
Additionally, as a result of the Convertible Notes redemption, quarterly interest income is expected to decrease due to the related liquidation of marketable securities. As a result of that impact combined with the $4.2 million in redemption expenses described above and the partial offset by the reduction in related interest expense, net other expense is expected to increase by approximately $3.2 million in the fourth quarter of fiscal 2005. Beginning in fiscal year 2006, we expect the impact of the redemption will increase net other income by approximately $1 million per quarter.
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 29, 2004 as filed with the Securities and Exchange Commission on July 29, 2004.
Factors That May Affect Future Results
Described below are some of the factors that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. See Forward Looking Statements at the beginning of this Item 2.
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 and $49.1 million in the first, second and third quarters of fiscal 2005, respectively. Net income during those periods decreased from $16.2 million in the fourth quarter of fiscal 2004 to $10.6 million, $7.9 million and $2.0 million in the first, second and third quarters of fiscal 2005, respectively. 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, including the current 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 fixed 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 with high average selling prices, some with prices in excess of $1 million per unit. 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 existing 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.
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, 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 2004 accounted for approximately 61% of total net sales in fiscal 2004, with one customer accounting for approximately 26% of total net sales in fiscal 2004. No other customer in fiscal 2004 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. We have in the past experienced and are currently experiencing a slowdown in demand for our products. In the past we have also experienced delays in new product development. Similar slowdowns and 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.
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 in the future 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.
Their greater resources in these areas 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 management 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 is 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 additional 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;
The risk that the issuance of our common stock in a transaction could be dilutive to our shareholders if anticipated synergies are not realized; 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 83% of net sales for the first nine months of fiscal 2005, with 76% 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 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;
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.
We are in the process of documenting and testing 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. During the course of our testing, we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, 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. 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.
We face risks relating to governmental inquiries and the results of our internal investigation of accounting matters.
On March 20, 2003, we contacted the SEC in connection with our issuance of a press release announcing the need to restate our financial results for the quarters ended August 31, 2002 and November 30, 2002. In March 2003, the audit committee of our board of directors, with the assistance of outside legal counsel and independent forensic accountants, commenced an internal investigation of certain accounting matters. The investigation involved the review of (1) the circumstances surrounding the reversal of an accrual for employee benefits, (2) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (3) certain other areas where potential accounting errors could have occurred, including revenue recognition and restructuring reserves. As a result of the investigation, we determined that our unaudited consolidated condensed financial statements for the three months ended August 31, 2002 and November 30, 2002, and our audited consolidated financial statements for the year ended June 1, 2002 (and the quarters contained therein) required restatement. We have cooperated with all government investigations into the matters addressed by the internal investigation, and the SEC has announced that because of our swift and extensive cooperation in the SECs investigation the SEC will not bring any enforcement action against us. Depending on the scope, timing and result of any other governmental investigation, managements attention and our resources could be diverted from operations, which could adversely affect our operating results and contribute to future stock price volatility.
We have entered into indemnification agreements in the ordinary course of business with our current and former officers and directors, some of whom may be the subject of any governmental investigation or party to proceedings brought as a result of any investigation. In addition, our bylaws contain indemnification provisions with respect to our directors, officers, and employees. Two of our former employees are currently party to proceedings brought by the SEC as a result of its investigation. We may be obligated throughout any investigation or proceeding to advance payment of legal fees and costs incurred by any current and former directors, officers, employees and agents pursuant to the indemnification agreements, our bylaws and applicable Oregon law. We may also be obligated to indemnify any former and/or current directors, officers, employees and agents for judgments, fines and amounts paid in settlement if the person acted in good faith and in a manner reasonably believed to be in or not opposed to our best interests. Payments made by us under these obligations, to the extent not reimbursed by insurance carriers, could have a material adverse impact on our financial condition.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the market risk disclosure contained in our 2004 Annual Report on Form 10-K for our fiscal year ended on May 29, 2004.
Item 4. Controls and Procedures
Attached to this annual 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 pro