MOCON 10-Q 2005
Washington, D.C. 20549
ý Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarter Ended September 30, 2005
o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from to
Commission File Number 0-9273
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
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 o NO ý
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES o NO ý
5,395,146 Common Shares were outstanding as of October 31, 2005.
MOCON, INC. AND SUBSIDIARIES
INDEX TO FORM 10-Q
For the Quarter Ended September 30, 2005
In this report, references to MOCON, the Company, we, our, or us, unless the context otherwise requires, refer to MOCON, Inc. and it subsidiaries.
All trademarks or trade names referred to in this report are the property of their respective owners.
MOCON, INC. & SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements.
MOCON, INC. & SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements.
MOCON, INC. & SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements.
MOCON, INC. AND SUBSIDIARIES
Note 1 Condensed Consolidated Financial Statements
The condensed consolidated balance sheet as of September 30, 2005, the condensed consolidated statements of income for the three- and nine-month periods ended September 30, 2005 and 2004, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2005 and 2004 have been prepared by us, without audit. However, all adjustments (consisting solely of normal recurring adjustments) which are, in the opinion of management, necessary to present fairly the financial position, results of operations and cash flows at September 30, 2005, and for all periods presented, have been made. The results of operations for the three- and nine-month periods ended September 30, 2005 are not necessarily indicative of operating results for the full year.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004, previously filed with the Securities and Exchange Commission.
We operate in a single industry segment: the development, manufacturing, and marketing of measurement, analytical, monitoring, sample preparation, and consulting products used to detect, measure, and analyze gases and chemical compounds for customers in the barrier packaging, food, pharmaceutical, and other industries throughout the world.
Principles of Consolidation
The consolidated financial statements include the accounts of MOCON, Inc. and our subsidiaries after elimination of inter-company transactions and accounts.
Foreign Currency Translation
The financial statements for operations outside the United States are maintained in their local currency. All assets and liabilities of our foreign subsidiary are translated to United States dollars at period-end exchange rates, while revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. Translation adjustments arising from the use of differing exchange rates are included in accumulated other comprehensive income or loss in stockholders equity. Gains and losses on foreign currency transactions are included in other income or loss.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
We use the intrinsic-value method for employee stock-based compensation pursuant to Accounting Principles Board Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees. Under the guidelines of Opinion 25, compensation cost for stock-based employee compensation plans is recognized based on the difference, if any, between the quoted market price of the stock on the date of grant and the amount an employee must pay to acquire the stock.
We have adopted the disclosure-only provisions for employee stock-based compensation and the fair-value method for nonemployee stock-based compensation of Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation. These provisions require us to show, on a pro forma basis, our net income and income per common share as if we had recorded an expense for our stock options at the time of grant. Other than disclosure in this footnote, we do not use these pro forma results for any purpose. No stock options were granted during the three- and nine-month periods ended September 30, 2005 and 2004.
Had we recorded compensation cost based on the estimated fair value on the date of grant, as defined by SFAS No. 123, our net income and net income per common share would have been reduced to the pro forma amounts indicated below:
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payments (FAS 123(R)), which is a revision of SFAS No.123 and supersedes Opinion 25. FAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. FAS 123(R) is effective at the beginning of the first annual period beginning after June 15, 2005. We expect to adopt FAS 123(R) on January 1, 2006. The ultimate amount of increased compensation expense will be dependent on the number of options granted, their timing and vesting periods, and the method used to calculate the fair value of the awards, among other things.
Certain 2004 amounts have been reclassified to conform to the 2005 presentation.
Note 2 Inventories
Inventories consist of the following:
Note 3 Net Income Per Common Share
Basic net income per common share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted net income per common share is computed using the treasury stock method to compute the weighted average common stock outstanding assuming the conversion of potential dilutive common shares.
The following table presents a reconciliation of the denominators used in the computation of net income per common share basic, and net income per common share diluted, for the three- and nine-month periods ended September 30, 2005 and 2004:
Note 4 Goodwill and Intangible Assets
As of September 30, 2005 and December 31, 2004, unamortized goodwill amounted to $2,315,774. Other identifiable intangible assets are as follows:
Total amortization expense for the three and nine months ended September 30, 2005 was $73,655 and $220,871, respectively. Estimated amortization expense for the remainder of 2005 and each of the four succeeding fiscal years based on the intangible assets as of September 30, 2005 is as follows:
Note 5 Marketable Securities
Available-for-sale securities are recorded at fair value. Unrealized holding gains and losses on available-for-sale securities are excluded from income and are reported as a separate component of stockholders equity until realized. A decline in the market value of any available-for-sale security below cost that is deemed other than temporary is charged to income resulting in the establishment of a new cost basis for the security. At September 30, 2005 and September 30, 2004, this resulted in a net cumulative unrealized loss of $4,781 and $1,297, respectively, within stockholders equity.
Note 6 Comprehensive Income
Other comprehensive income pertains to net unrealized gains and losses on marketable securities and foreign currency translation adjustments that are not included in net income but rather are recorded directly in stockholders equity.
Note 7 Warranty
We provide a warranty for most of our products. Warranties are for periods ranging from ninety days to one year, and cover parts and labor for non-maintenance repairs, at our location. Operator abuse, improper use, alteration, damage resulting from accident, or failure to follow manufacturers directions, are excluded from warranty coverage.
Warranty expense is accrued at the time of sale based on historical claims experience. Special warranty reserves are also accrued for special rework campaigns for known major product modifications. We also offer service contracts for select products when the factory warranty period expires.
Warranty provisions and claims for the nine-month periods ended September 30, 2005 and 2004 were as follows:
Note 8 Discontinued Operations
In July 2005, we sold substantially all of the assets used in our discontinued Vaculok product line. As previously reported in the first quarter of 2005, the decision had been made to cease production of Vaculok vacuum insulated panels and exit the product line.
Pursuant to the sale agreement, we received an up-front payment of $125,000, along with the right to receive up to an additional $60,000 upon the occurrence of certain post-closing events. As a result of the sale, we recognized a pre-tax gain of approximately $69,000 in the third quarter ended September 30, 2005. When combined with additional operating expenses, this produced a pre-tax gain of $53,134 which is reported in the discontinued operations section of the condensed consolidated statements of income. After tax, we recognized a gain of approximately $34,000, or $0.01 per diluted share, in the third quarter of 2005.
This Managements Discussion and Analysis provides material historical and prospective disclosures intended to enable investors and other users to assess our financial condition and results of operations. Statements that are not historical are forward-looking and involve risks and uncertainties discussed below under the caption Forward-Looking Statements. The following discussion of the results of operations and financial condition of MOCON should be read in conjunction with our condensed consolidated financial statements and the related notes thereto.
MOCON, Inc. designs, manufactures, markets, and services products and provides consulting services primarily in the measurement and analytical instrument and services markets. Our products include instruments that detect, measure and monitor gases and chemical compounds as well as products that prepare samples of various substances for laboratory analysis. Although some of the markets for our products are maturing, we continually seek growth opportunities through technological and product improvement, by acquiring and developing new products, and by acquiring new companies.
Prior to 1998, we expanded our business primarily through internally developing new products and technologies, acquiring product lines and technology, and licensing products and technology. Since 1998, we have supplemented our internal growth through several acquisitions that have provided us with additional technologies, products and product development expertise.
We completed our most recent acquisition effective January 1, 2004, by acquiring Paul Lippke Handels GmbH Prozess- und Laborsysteme (Lippke), which is located in Germany. Lippke had been the primary distributor of our products in Europe for approximately thirty years, and also served in the capacity of distributor or agent for several companies in addition to MOCON. The acquisition of Lippke provides us with a direct presence in Europe, which we plan to leverage to benefit many of our product and service offerings. We acquired all of the shares of Lippke for a base purchase price of $802,688. In addition, based on Lippkes 2004 net profits, we made an earnout payment to Lippkes former parent company of $549,257 near the end of the first quarter of 2005 and are obligated to make two future earnout payments based on the shared net profits of Lippke in the years 2005 and 2006, with a minimum payment amount of 100,000 euros ($120,480 at September 30, 2005) per year, and no maximum. It is anticipated that these earnout payments will be made to the former parent company of Lippke at or near the end of the first quarters of 2006 and 2007.
We have three primary operating locations in the United States Minnesota, Colorado, and Texas and one in Germany. We primarily use a direct sales force to market our products and services in the United States, Canada and Germany and use a network of independent representatives to market and service our products and services in other foreign countries. Our international sales have historically accounted for a significant portion of our revenues and we expect this trend to continue for the foreseeable future, especially as a result of our acquisition of Lippke, which thus far has had, and is expected to continue to have, a positive impact on our sales in 2005.
Recently, we have begun to focus more on business development opportunities in our core product areas, including in particular our gas detection and measurement businesses. In the first quarter of 2005, we decided to exit our Vaculok vacuum insulated panel business as a result of its poor financial performance since it was acquired in November 2003, and our plan to concentrate on our core businesses. In addition, we have significantly increased research and development spending in these core areas for both the third quarter and the first nine months of 2005.
Results of Operations
The following table sets forth the relationship between various components of our results of operations, stated as a percent of sales, for the three- and nine-month periods ended September 30, 2005, and 2004.
Comparison of Financial Results for the Three and Nine Months Ended September 30, 2005 and September 30, 2004
Sales for the third quarter of 2005 were $5,670,156, down 11% compared to $6,350,000 for the same period in 2004. On a product line basis, this decrease was primarily due to decreased sales of our weighing and pharmaceutical products, permeation products and leak detection products, offset somewhat by an increase in sales of our headspace analyzer products. Year-to-date sales were $18,496,853, up 2% compared to $18,156,956 for the same period in 2004. The increase was primarily due to increased sales of our headspace analyzer and gas analyzer products, offset partially by reduced sales of sample preparation products and gas chromatography analyzer products. There were no significant price increases or decreases during the third quarter of 2005 compared to the same period in 2004.
The following table summarizes total sales by product line for the three- and nine-month periods ended September 30, 2005 and 2004.
The following table sets forth the relationship between various components of domestic and foreign sales for the three- and nine-month periods ended September 30, 2005 and 2004.
Sales of our permeation products and services which accounted for approximately 60% and 56% of our consolidated third quarter sales in 2005 and 2004, respectively, decreased 4% during the third quarter of 2005 compared to the same period in 2004. This was due to a slight decrease in demand in both our foreign and domestic markets. Sales of our gas, headspace, and other analyzer products which accounted for 33% and 35% of our consolidated third quarter sales in 2005 and 2004, respectively, decreased 15% during the third quarter of 2005 compared to the same period in 2004. Within this group, headspace analyzer products increased by 17% which was evenly spread between domestic and foreign markets. Offsetting this increase, weighing and pharmaceutical products, leak detection and gas analyzer products decreased a combined 26% during the third quarter of 2005 compared to the same period in 2004, primarily as a result of a decrease in demand in our foreign markets.
For the nine-month periods, sales of our permeation products and services, which accounted for approximately 58% and 59% of our consolidated sales in 2005 and 2004, respectively, increased by less than 1%. This increase was due primarily to an increase in sales to our domestic markets, offset by a decrease in sales to our foreign markets. Sales of our gas, headspace, and other analyzer products, which accounted for 35% and 31% of our consolidated nine-month sales in 2005 and 2004, respectively, increased 16%. Within this group, headspace analyzer, gas analyzer and leak detection products increased 33%, 16% and 13% respectively. These increases were due mostly to increased sales in our domestic markets.
On a geographical basis, total foreign sales, which accounted for 54% and 56% of our consolidated third quarter sales in 2005 and 2004, respectively, were down 14% during the third quarter of 2005 compared to the same period in 2004. This decrease was due primarily to a 69% decrease in sales of weighing and pharmaceutical products and a 46% decrease in sales of leak detection products. Total domestic sales accounted for 46% and 44% of our consolidated third quarter sales in 2005 and 2004, respectively, and were down 7%. This domestic sales decrease was primarily due to reduced sales of
permeation, gas chromatography, and gas analyzer products partially offset by an increase in headspace analyzer products.
Total foreign sales, which accounted for 51% and 56% of our consolidated sales during the first nine months of 2005 and 2004, respectively, were down 6% during the first nine months of 2005 compared to the same period in 2004. This decrease was due primarily to decreased sales of our permeation, weighing and pharmaceutical, and sample preparation products, offset partially by an increase in leak detection and headspace analyzer products. Total domestic sales accounted for 49% and 44% of our consolidated sales during the first nine months in 2005 and 2004, respectively, and were up 12% during the first nine months of 2005 compared to the same period in 2004. This domestic sales increase was primarily due to increased sales of permeation, headspace analyzer, and gas analyzer products.
Our gross profit margins were 56.8% and 55.1% for the third quarters ended September 30, 2005 and 2004, respectively. The slightly lower margin for the previous period was primarily due to increases in our inventory reserve for obsolescence and additional costs associated with moving a portion of our Baseline subsidiarys manufacturing to Minneapolis, Minnesota.
Our gross profit margins for the nine-month periods ended September 30, 2005 and 2004 were 55.8% and 54.6%, respectively. The slightly lower margin for the previous period was primarily due to costs related to the acquisition of Lippke, including the write-off of costs assigned to finished goods inventory under purchase accounting rules, costs associated with the relocation of our Lab Connections subsidiary to Texas in the first quarter of 2004, and additional costs associated with moving a portion of our Baseline subsidiarys manufacturing to Minneapolis, Minnesota. The gross profit margin for our consulting services was 46.0% and 49.6%, respectively, for the nine-month periods ended September 30, 2005 and 2004. This decrease was primarily due to the slight reduction in sales and the related fixed costs.
Selling, General and Administrative Expenses
Selling, general and administrative (SG&A) expenses in the third quarter of 2005 were $1,978,839, or 34.9% of sales, compared to $2,036,701, or 32.1% of sales in the third quarter of 2004. The increase in SG&A expenses as a percentage of sales was primarily due to the combination of reduced quarterly sales together with costs related to the Sarbanes-Oxley Act of 2002. The decrease in actual dollars for the quarter was primarily due to non-recurring sales expenses in 2004 related to the amortization of purchased intangibles associated with the Lippke acquisition, as well as lower headcount and marketing costs in 2005.
SG&A expenses in the first nine months of 2005 were $6,136,163, or 33.2% of sales, compared to $6,190,747, or 34.1% of sales in the same period of 2004. The decrease in SG&A expenses was primarily due to various non-recurring amortization costs (totaling $218,000) recorded in 2004 relating to the Lippke acquisition, as well as lower headcount and marketing costs in 2005. This decrease was partially offset by increased administrative expenses incurred, which related to the Sarbanes-Oxley Act of 2002.
Research and Development Expenses
Research and development (R&D) expenses were $434,550, or approximately 7.7% of sales, in the third quarter of 2005, compared to $293,474, or approximately 4.6% of sales, in the same period of 2004. For the first nine months of 2005, R&D expenses were $1,252,402, or 6.7% of sales, compared to $1,000,603, or 5.5% of sales, for the first nine months of 2004. This planned increase in R&D expenditures is considered necessary to develop new products to expand in our niche markets. For the foreseeable future, we expect to allocate on an annual basis approximately 6% to 8% of sales to
research and development.
Other income for the three months ended September 30, 2005 consisted of interest income of $53,081 and gain on foreign currency exchange of $9,120, offset by other losses of $228. Other income for the nine months ended September 30, 2005 consisted of interest income of $140,481, gain on foreign currency exchange of $71,810, gain on sale of fixed assets of $44,182, and other income of $3,389. Other income for the nine months ended September 30, 2004 consisted of interest income of $97,107 and gain on foreign currency exchange of $13,943. Interest income increased for the nine months ended September 30, 2005, due both to higher average yields and higher average cash balances.
Income Tax Expense
Our provision for income taxes from continuing operations was 35.6% of income before income taxes for the three months ended September 30, 2005, compared to 34.0% of income before income taxes for the three months ended September 30, 2004. The slightly higher rate for the most recent period was primarily due to a larger percentage of pre-tax income being attributable to Lippke, which is taxed at a higher effective rate.
Our provision for income taxes from continuing operations was 28.9% of income before income taxes for the nine months ended September 30, 2005, compared to 34.0% of income before income taxes for the nine months ended September 30, 2004. The rate for the first nine months of 2005 was favorably impacted by the finalization of an Internal Revenue Service examination which reduced income tax expense by approximately $156,000 in the first quarter of 2005 as well as benefiting from the newly enacted tax law. Based on current operating conditions and income tax laws, we expect the tax rate for the remaining quarter of 2005 to be in the range of 33% to 36%.
Net income was $594,003 in the third quarter of 2005, compared to $728,369 in the third quarter of 2004. Diluted net income per share was $0.11 per share in the third quarter of 2005 compared to $0.13 per share in the third quarter of 2004. For the nine months ended September 30, 2005, net income was $2,163,214, or $0.39 per diluted share, compared to net income of $1,694,362, or $0.31 per diluted share in the prior year.
Liquidity and Capital Resources
We have historically financed our operations, capital expenditures and other liquidity needs through our cash flows generated from operations. Total cash, cash equivalents and marketable securities increased $1,595,565 during the first nine months of 2005 to $9,284,284 as of September 30, 2005, compared to $7,688,719 at December 31, 2004 due in part to a significant reduction in trade accounts receivable as well as the exercise of stock options. Our working capital as of September 30, 2005 increased $1,597,410 to $13,424,682 for the nine-month period, as compared to $11,827,272 at December 31, 2004. We believe that a combination of our existing cash, cash equivalents and marketable securities, plus an expected continuation of cash flow from operations, will continue to be adequate to fund our operations, capital expenditures, dividend payments, stock repurchases, and required earnout payments to the former parent company of Lippke, for at least the next twelve months. However, one of our strategic objectives is, as market and business conditions warrant, to consider acquisitions of businesses, products or technologies. We may need to fund such activities, should they arise, with debt and/or equity financing, although no assurance can be given that such debt and/or equity financing will be available at reasonable terms or at all.
Cash Flow from Operating Activities
Our primary source of funds is cash provided by operations. Cash flow from operations totaled $2,504,743 and $3,363,797 in the first nine months of 2005 and 2004, respectively. The net cash provided by trade accounts receivable was primarily due to decreased sales in the third quarter of 2005 as compared to the fourth quarter of 2004. The net cash used for inventory was primarily due to increases in work-in-process inventory. The net cash used for accounts payable reflected the use of cash generated from the decrease in trade accounts receivable.
Cash Flow from Investing Activities
Cash used in investing activities totaled $1,485,368 and $67,574 in the first nine months of 2005 and 2004, respectively. Purchases of marketable securities, net of maturities, were $1,362,930 in the first nine months of 2005. Purchases of property, plant and equipment totaled $166,482 in the first nine months of 2005, primarily for additions of office, manufacturing and laboratory equipment, as compared to $269,876 in the first nine months of 2004.
As part of the purchase price for the acquisition of Lippke in 2004, we were obligated to make three future earnout payments to Lippkes former parent company based on the shared net profits of Lippke in each of the years 2004, 2005, and 2006, with a minimum earnout payment amount of 100,000 euros per year, and no maximum. The present value of these future minimum earnout payments was included in cash paid in acquisitions, net of cash acquired, in the investing activities section of our consolidated statements of cash flows, at the time of the acquisition. Actual earnout amounts due in excess of the minimums, if any, will be reflected as an increase in cash paid in acquisitions, net of cash acquired, in the cash flows from investing activities section of our consolidated statements of cash flows, in the fourth quarters of 2004, 2005 and 2006, respectively, when the actual earnout amount is calculated, and the related additional liability is accrued. The earnout payment related to the 2004 net profits was made in the first quarter of 2005, and it is anticipated that the remaining two earnout payments will be made in the first quarters of 2006 and 2007, respectively.
We had no material commitments for capital expenditures as of September 30, 2005. We presently do not believe that any significant property, plant and equipment expenditures are required to accommodate our current level of operations.
Cash Flow from Financing Activities
Cash provided from the exercise of stock options amounted to $341,140 and $95,263 during the first nine months of 2005 and 2004, respectively.
Cash used in financing activities consists primarily of the payment of dividends to our shareholders. During the first nine months of 2005 and 2004, we made dividend payments to our shareholders of $1,124,625 and $1,048,132, respectively.
A final dividend payment was also made to Lippkes former parent company in the first quarter of 2004 totaling $449,087. This payment was for 2003 profits earned by Lippke prior to the acquisition, was paid by Lippke to its former parent company as a dividend in 2004, and has accordingly been reflected in the financing activities section of our consolidated statements of cash flows as a dividend payment to former owners.
Our Board of Directors has authorized, depending upon market conditions and other factors, the repurchase of up to a total of $3,200,000 of our common stock at prices not exceeding prevailing market prices at the time of purchase. There were no repurchases of our common stock during the
third quarter of 2005. As of September 30, 2005, $1,672,034 was remaining in this authorization. On November 8, 2005, our Board of Directors authorized the Company to repurchase up to $2,000,000 of its common stock. This repurchase program supersedes the above-mentioned repurchase authorization.
We refer you to our Annual Report on Form 10-K for the year ended December 31, 2004 for a summary of our contractual obligations. Except for the earnout payment paid in connection with the Lippke acquisition, there has been no material change in this information.
Off-Balance Sheet Arrangements
Except for operating leases entered into in the ordinary course of business and customary indemnification obligations under certain of our agreements entered into in the ordinary course of business, we do not have any material off-balance sheet arrangements.
Critical Accounting Policies
The preparation of our consolidated financial statements requires management to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Securities and Exchange Commission has defined a companys most critical accounting policies as those that are most important to the portrayal of its financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the following critical accounting policies. Although we believe that our estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions or conditions.
Allowance for doubtful accounts and sales returns This reserve is for accounts receivable balances that are estimated to be uncollectible as well as estimated sales returns. This reserve is based on a number of factors, including: (1) an analysis of customer accounts and (2) our historical experience with accounts receivable write-offs and sales returns. The analysis includes the age of the receivable, the financial condition of a customer or industry, and general economic conditions. We believe actual results could be materially different if historical trends do not reflect actual results or if economic conditions worsened for our customers. In the event we determined that a smaller or larger allowance for doubtful accounts and sales returns is appropriate, we would record a credit or charge to selling, general and administrative expense in the period that we made such a determination. As of September 30, 2005, we had $209,495 reserved against our accounts receivable for doubtful accounts and sales returns.
Allowance for excess and obsolete inventories We perform an analysis to identify inventory shrinkage, and excess and obsolete inventory. We record a charge to cost of sales for amounts identified. Our analysis includes inventory levels, the nature of the finished product and its inherent risk of obsolescence, the gross margin of the product, and the on-hand quantities relative to the sales history of that finished product. We believe that the operating results could be materially different if historical trends do not reflect actual results or if demand for our products decreased because of economic or competitive conditions or otherwise. Our allowance for excess and obsolete inventories at September 30, 2005 was $711,021.
Recoverability of long-lived assets We assess the recoverability of goodwill and other long-lived assets annually or whenever events or changes in circumstances indicate that expected future undiscounted cash flows might not be sufficient to support the carrying amount of an asset. We deem
an asset to be impaired if a forecast of undiscounted future operating cash flows is less than an assets carrying amount. If an asset is determined to be impaired, the loss is measured as the amount by which the carrying value of the asset exceeds its fair value. During the first quarter of 2005, we incurred a non-cash asset impairment charge of $162,000 relating to equipment and inventory used in our Vaculok vacuum insulated panels business as a result of our decision during that quarter to discontinue the product line. Changes in our business strategies and/or changes in the economic environment in which we operate may result in future impairment charges.
Accrued product warranties Our products are generally covered by a warranty, with warranty periods ranging from ninety days to one year from the date of sale. Estimated warranty costs are accrued in the same period in which the related revenue is recognized, based on anticipated parts and labor costs, utilizing historical experience. Special warranty reserves are also accrued for major rework campaigns. We periodically assess the adequacy of our warranty reserves based on changes in these factors and record any necessary adjustment if actual claim experience indicates that adjustments are necessary. Although we believe the likelihood to be relatively low, our historical warranty claims experience could be materially different from actual results due to manufacturing changes that could impact product quality, a change in our warranty policy in response to industry trends, as yet unrecognized defects in products sold, or other factors. As of September 30, 2005, we had $344,096 accrued related to future estimated warranty claims.
Income taxes In the preparation of our consolidated financial statements, management is required to estimate income taxes in each of the jurisdictions in which we operate. This process involves estimating actual current tax exposures together with assessing temporary differences resulting from different treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet.
We have significant amounts of deferred tax assets. Management reviews the deferred tax assets for recoverability on a quarterly basis and assesses the need for valuation allowances. These deferred tax assets are evaluated by considering historical levels of income, estimates of future taxable income streams and the impact of tax planning strategies. A valuation allowance is recorded to reduce deferred tax assets when it is determined that it is more likely than not that we would not be able to realize all or part of its deferred tax assets. We carried no valuation allowance against our net deferred tax assets at either September 30, 2005 or 2004.
New Accounting Pronouncements
In September 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections a replacement of APB No. 20 and SFAS No. 3. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS 154 also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154. SFAS 154 is required to be adopted in fiscal years beginning after December 15, 2005. Accordingly, we will adopt SFAS 154 in our fiscal year beginning January 1, 2006. Adoption of SFAS 154 is not expected to have a material effect on our financial position, results of operations or cash flows.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No 43, Chapter 4 (SFAS 151) to clarify that abnormal amounts of idle facility expense, freight, handling costs,
and wasted material (spoilage) should be recognized as current period charges, and that fixed production overheads should be allocated to inventory based on normal capacity of production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Accordingly, we will adopt SFAS 151 in our fiscal year beginning January 1, 2006. Adoption of SFAS 151 is not expected to have a material effect on our financial position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), ShareBased Payments (FAS 123(R)), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. FAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and amends FAS Statement No. 95, Statement of Cash Flows. FAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values and the pro forma disclosure is no longer allowable. FAS 123(R) is effective at the beginning of the first annual period after June 15, 2005. Accordingly, we will adopt FAS 123(R) on January 1, 2006. We are currently evaluating the impact of our adoption of FAS 123(R), which will result in additional pre-tax compensation expense in fiscal 2006 for remaining unvested stock options and any future stock option grants. The ultimate amount of increased compensation expense will be dependent on the number of options granted, their timing and vesting periods, and the method used to calculate the fair value of the awards, among other things.
This quarterly report on Form 10-Q contains not only historical information, but also forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and are subject to the safe harbor created by those statutes. In addition, we or others on our behalf may make forward-looking statements from time to time in oral presentations, including telephone conferences and/or web casts open to the public, in press releases or reports, on our internet website or otherwise. Statements that are not historical are forward-looking and reflect expectations and assumptions. We try to identify forward-looking statements in this report and elsewhere by using words such as may, will, should, expects, anticipates, contemplates, estimates, believes, plans, projected, predicts, potential or continue or the negative of these or similar terms. Examples of forward-looking statements in this report include, but are not limited to, statements regarding our international sales continuing to account for a significant portion of our revenues, our acquisition of Lippke continuing to have a positive impact on our sales in 2005, our expected Section 404 compliance costs and increased general and administrative expenses associated with the Sarbanes-Oxley Act of 2002 and other securities and corporate governance rules and regulations compliance, our allocation of 6% to 8% of our sales to research and development expenses, our expected tax rate for the remaining quarter of 2005 being in the range of 33% to 36%, our belief that no significant future capital expenditures are required to accommodate our current level of operations, our expectations regarding future cash expenditures, and the effect of new accounting pronouncements on our financial position, results of operations and cash flows.
Forward-looking statements involve risks and uncertainties. These uncertainties include factors that affect all businesses as well as matters specific to MOCON. Below are some of the factors known to us that could cause our actual results to differ materially from what we have anticipated in our forward-looking statements. We wish to caution readers not to place undue reliance on any forward-looking statement that speaks only as of the date made and to recognize that forward-looking statements are predictions of future results, which may not occur as anticipated. Actual results could differ materially from those anticipated in the forward-looking statements and from historical results, due to the risks and uncertainties described below, as well as others that we may consider immaterial or do not anticipate at this time. The following risks and uncertainties are not exclusive and further information concerning us and our business, including factors that potentially could materially affect our financial results or condition, may emerge from time to time. We assume no obligation to update forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking
statements. We advise you, however, to consult any further disclosures we make on related subjects in our quarterly reports on Form 10-Q and current reports on Form 8-K we file with or furnish to the Securities and Exchange Commission.
If we experience any increase in the cost of raw materials or supplies, we may experience a decrease in profit margins.
In the past, the overall cost of the materials that we purchase has not risen much more than the rate of inflation, although the price of some of the components that we purchase has increased in the past several years due in part to our purchasing a fewer number of such components. Certain other material and labor costs have increased, but we believe that such increases are approximately consistent with overall inflation rates. We believe that the price of our products and the prices of our competitors products is a significant factor affecting our customers buying decisions and consequently, if we experience any increases in the cost of materials or supplies, we may not be able to pass along any cost increases in the form of price increases or sustain profit margins that we have achieved in prior years.
The markets in which we operate have experienced minimal growth in recent years, and our ability to increase our revenues will depend in part on our ability to develop new products, develop new applications for our existing products and to acquire complementary businesses and product lines.
The analytical and measurement instrument markets in which we operate have not shown significant growth in recent years. Although we have identified a number of strategies that we believe will allow us to grow our business and increase our sales, including developing new products and technologies, developing new applications for our technologies, acquiring complementary businesses and product lines, and strengthening our sales force, we cannot assure you that we will be able to successfully implement these strategies, or that these strategies will result in the growth of our business or an increase in our sales.
If we acquire businesses in the future, we may experience a decrease in our profit margins, a decrease in our net income, and other adverse consequences.
One of our growth strategies is to supplement our internal growth with the acquisition of businesses and technologies that complement or augment our existing products. Some of the businesses that we previously acquired have produced net operating losses or low levels of profitability. For example, the Vaculok vacuum insulated panel business that we acquired in November 2003 financially performed poorly, resulting in our decision to discontinue the product line during the first quarter of 2005. Businesses that we may acquire in the future may be marginally profitable or unprofitable. We will likely have to successfully change the operations of any companies that we acquire in the future and improve the market penetration of such companies in order to achieve the level of profitability that we desire. In addition, the benefits of an acquisition may take more time than expected to develop or integrate into our operations, and we cannot guarantee that our previous acquisitions or any future acquisitions will in fact produce the intended benefits. Acquisitions also involve a number of additional risks, including, but not limited to:
diversion of managements attention;
difficulties in assimilating the operations and products of an acquired business or in realizing projected efficiencies, cost savings, and revenue synergies;
potential loss of key employees or customers of the acquired businesses or adverse effects on existing business relationships with suppliers and customers;
adverse impact on overall profitability if acquired businesses do not achieve the financial results projected in our valuation models;
reallocation of amounts of capital from other operating initiatives and/or an increase in our leverage and debt service requirements to pay the acquisition purchase prices, which could in turn restrict our ability to access additional capital when needed or to pursue other important elements of our business strategy;
inaccurate assessment of undisclosed, contingent or other liabilities or problems and unanticipated costs associated with the acquisition; and
incorrect estimates made in the accounting for acquisitions, incurrence of non-recurring charges and write-off of significant amounts of goodwill that could adversely affect our operating results.
Our ability to grow through acquisitions will depend, in part, on the availability of suitable acquisition candidates at an acceptable cost, our ability to compete effectively for these acquisition candidates, and the availability of capital to complete such acquisitions. These risks could be heightened if we complete several acquisitions within a relatively short period of time. We may not be able to complete acquisitions in the future and any acquisitions that we do complete may have an adverse effect on our financial performance and liquidity. It may be necessary for us to raise additional funds either through public or private equity or debt financing in order to finance any future acquisitions. Any equity or debt financing, if available at all, may be on terms that are not favorable to us and may dilute the ownership of our existing shareholders.
We face risks of technological changes that may render our products obsolete.
The markets for our products and services are characterized by rapid and significant technological change and evolving industry standards. As a result of such changes and evolving standards, our products may become noncompetitive or obsolete and we may have to develop new products in order to maintain or increase our revenues. New product introductions that are responsive to these factors require significant planning, design, development and testing at the technological, product, and manufacturing process levels and we may not be able to timely develop new products. In addition, industry acceptance of new technologies that we may develop may be slow to develop due to, among other things, existing regulations or standards written specifically for older technologies and general unfamiliarity of users with new technologies. As a result, any new products that we may develop may not generate any meaningful revenues or profits for us for a number of years, if at all.
Any reduction in the level of capital expenditures by our customers could negatively impact our sales.
Our customers include pharmaceutical, food, medical, and chemical companies, laboratories, government agencies, and public and private research institutions. The capital spending of these entities can have a significant effect on the demand for our products. Any decrease in capital spending by any of these customer groups could have a material adverse effect on our business and results of operations.
A significant portion of our sales are generated from foreign countries and selling in foreign countries entails a number of risks which could result in a decrease in our sales or an increase in our operating expenses.
Sales outside the United States accounted for approximately 54% of our sales for the three months ended September 30, 2005 and approximately 56% of our sales for the same period in 2004. We expect that foreign sales will continue to account for a significant portion of our sales in the future. Sales to customers in foreign countries are subject to a number of risks, including the following:
agreements may be difficult to enforce;
receivables may be difficult to collect;
certain regions are experiencing political unrest and conflict;
foreign customers may have longer payment cycles;
the countries into which we sell may impose tariffs or adopt other restrictions on foreign trade;
currency fluctuations could reduce reported profitability in future periods;
fluctuations in exchange rates may affect product demand;
export licenses, if required, may be difficult to obtain and;
protection of intellectual property in foreign countries may be more difficult to enforce.
If any of these risks were to materialize, our sales into foreign countries could decline, or our operating costs could increase, which would adversely affect our financial results.
Some of our competitors have greater resources than we do, which may provide our competitors with an advantage in the development and marketing of new products.
We currently encounter, and expect to continue to encounter, competition in the sale of our products. We believe that the principal competitive factors affecting the market for our products include product quality and performance, price, reliability and customer service. Our competitors include large multinational corporations. Some of our competitors have substantially greater financial, marketing, and other resources than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the promotion and sale of their products than we can. In addition, competition could increase if new companies enter the market or if existing competitors expand their product lines or intensify efforts within existing product lines. Our current products, products under development and our ability to discover new technologies may be insufficient to enable us to compete effectively with our competitors.
Our reliance upon patents, domestic trademark laws and contractual provisions to protect our proprietary rights may not be sufficient to protect our intellectual property from others who may sell similar products.
We hold patents relating to various aspects of our products and believe that proprietary technical know-how is critical to many of our products. Proprietary rights relating to our products are protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or are maintained in confidence as trade secrets. We cannot be certain that we will be issued any patents from any pending or future patent applications owned by or licensed to us or that the claims allowed under any issued patents will be sufficiently broad to protect our technology. In the absence of patent protection, we may be vulnerable to competitors who attempt to copy our products or gain access to our trade secrets and know-how. Our competitors may initiate litigation to challenge the validity of our patents, or they may use their resources to design comparable products that do not infringe our patents. We may incur substantial costs if our competitors initiate litigation to challenge the validity of our patents or if we initiate any proceedings to protect our proprietary rights and if the outcome of any such litigation is unfavorable to us, our business and results of operations could be materially adversely affected. There may also be pending or issued patents held by parties not affiliated with us that relate to our products or technologies and we may need to acquire licenses to any such patents to continue selling some or all of our products. If we had to obtain any such license in order to be able to continue to sell some or all of our products, we may not be able to do so on terms that were favorable to us, if at all.
In addition, we rely on trade secrets and proprietary know-how that we seek to protect, in part, by confidentiality agreements with our collaborators, employees, and consultants. These agreements may be breached and we may not have adequate remedies for any such breach. Even if these confidentiality agreements are not breached, our trade secrets may otherwise become known or be independently developed by competitors.
The market price of our common stock has fluctuated significantly in the past and will likely continue to do so in the future and any broad market fluctuations may materially adversely affect the market price of our common stock.
The market price of our common stock has been volatile in the past, ranging from a high sales price of $10.10 and a low sales price of $9.08 during the third quarter of 2005, and several factors could cause the price to fluctuate substantially in the future. These factors include:
announcements of new products by us or our competitors;
quarterly fluctuations in our financial results;
customer contract awards;
developments in regulation; and
general economic and political conditions in the various markets where our products are sold.
In addition, the stock prices of instrumentation companies have experienced significant price and volume fluctuations that often have been unrelated to the operating performance of such companies. This market volatility may adversely affect the market price of our common stock.
Recently enacted and future changes in securities laws and regulations have increased and are likely to continue to increase our costs.
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules, are creating challenges for publicly-held companies including us. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our assessment of our internal control over financial reporting and our independent registered public accounting firms report on that assessment will require the commitment of significant financial and managerial resources. We currently estimate that Section 404 compliance costs will be approximately $200,000 in 2005, and expect that Section 404 compliance will require significant ongoing financial and managerial resources in 2006 and beyond.
Equity Price and Interest Rate Risk
Substantially all of our marketable securities are at fixed interest rates and virtually all of our marketable securities mature within one year or less; therefore, we believe that the market risk arising from the holding of these financial instruments is minimal.
Foreign Currency Exchange Risk
Because our products are manufactured or sourced primarily from the United States, a stronger U.S. dollar generally has a negative impact on our results from operations outside of the United States while a weaker dollar generally has a positive effect. We currently sell our products and services in United States dollars or the local currency of our foreign subsidiary (Euros). Accordingly, our foreign operations expose us to foreign currency exchange risk when the Euro currency results of operations are translated to United States dollars. While we historically have not experienced any material foreign currency translation losses, we may engage in hedging activity in the future to minimize this risk. Our net investment in foreign subsidiary translated into U.S. dollars is not hedged. Any changes in foreign currency exchange rates will be reflected as a foreign currency translation adjustment, a component of accumulated other comprehensive income in stockholders equity, and would not impact our net income.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commissions rules and forms and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and we necessarily are required to apply our judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered in this Quarterly Report on Form 10-Q. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of such period, to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SECs rules and forms, and that material information relating to our Company and our consolidated subsidiaries is made known to management, including our Chief Executive Officer, and Chief Financial Officer, particularly during the period when our periodic reports are being prepared.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting that occurred during our quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Unregistered Sales of Equity Securities
We did not sell any equity securities of MOCON, Inc. during the three months ended September 30, 2005 that were not registered under the Securities Act of 1933.
Issuer Repurchases of Equity Securities
We did not repurchase any equity securities of MOCON, Inc. during the three months ended September 30, 2005. In November 2002, our Board of Directors authorized the repurchase of up to $2,000,000 of our common stock in the open market at prices not exceeding the market price at the time of purchase. In May 2003, our Board of Directors authorized a $1,200,000 increase in our stock repurchase program, increasing the total to $3,200,000. As of September 30, 2005, we had repurchased 204,000 shares of MOCON common stock under the program at a total cumulative cost of approximately $1,527,966. The repurchase program does not have an expiration date and the Board may terminate it at any time. On November 8, 2005, our Board of Directors authorized the Company to repurchase up to $2,000,000 of its common stock. This repurchase program supersedes the above-mentioned repurchase authorization.
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.
QUARTERLY REPORT ON FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2005