Nanometrics 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
For the quarterly period ended July 2, 2005
For the transition period from to
Commission file number 0-13470
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (408) 435-9600
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 x NO ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES ¨ NO x
As of July 21, 2005, there were 12,798,207 shares of common stock, no par value, issued and outstanding.
ITEM 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands except share amounts)
See Notes to Condensed Consolidated Financial Statements
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands except per share amounts)
See Notes to Condensed Consolidated Financial Statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
See Notes to Condensed Consolidated Financial Statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Condensed Consolidated Financial Statements
In the opinion of management, the accompanying Unaudited Condensed Consolidated Interim Financial Statements (financial statements) of Nanometrics Incorporated and its wholly-owned subsidiaries (collectively, Nanometrics or the Company) have been prepared on a consistent basis with the January 1, 2005 audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly present the information set forth therein. The financial statements have been prepared in accordance with the regulations of the U.S. Securities and Exchange Commission (SEC), and, therefore, omit certain information and footnote disclosure necessary to present the statements in accordance with accounting principles generally accepted in the United States of America. The operating results for interim periods are not necessarily indicative of the operating results that may be expected for the entire year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended January 1, 2005, which were included in the Companys Annual Report on Form 10-K, which was filed with the SEC on March 23, 2005.
Fiscal Period Nanometrics uses a 52/53 week fiscal year ending on the Saturday nearest to December 31. All references to the quarter refer to Nanometrics fiscal quarter. The fiscal quarters presented herein include 13 weeks.
Note 2. Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, (SFAS No. 123(R)). This statement replaces SFAS No. 123, Accounting for Stock-Based Compensation, amends SFAS No. 95, Statement of Cash Flows and supersedes Accounting Principles Board (APB) Opinion No. 25 Accounting for Stock Issued to Employees, (APB No. 25). SFAS No. 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted, and to awards modified, repurchased or cancelled after the required effective date. In addition, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS No. 123(R) will be effective for fiscal years beginning after June 15, 2005, which is the Companys fiscal 2006. This statement will have a significant impact on the Companys results of operations as the Company will be required to record compensation expense rather than disclose the impact on the Companys results of operations within its footnotes (see Note 4 below).
In March 2005, the SEC staff issued guidance on SFAS No. 123(R). Staff Accounting Bulletin (SAB) No. 107 (SAB No. 107) was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123(R) while enhancing the information that investors receive. SAB No. 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS No. 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB No. 107 include: (a) valuation models SAB No. 107 reinforces the flexibility allowed by SFAS No. 123(R) to choose an option-pricing model that meets the standards fair value measurement objective; (b) expected volatility SAB No. 107 provides guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term the new guidance includes examples and some simplified approaches to determining the expected term under certain circumstances. The Company will apply the principles of SAB No. 107 in conjunction with its adoption of SFAS No. 123(R).
In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on recognition and measurement guidance under EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments which clarifies the meaning of other-than-temporary impairment and its application to investments in debt and equity securities. In particular, investments within the scope of SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, and investments accounted for under the cost method are addressed. In September 2004, the FASB delayed the requirements to record impairment losses under EITF 03-1 until the January 1, 2005 effective date. The Company adopted this consensus and the adoption did not have a material affect on its consolidated results of operations.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, An Amendment of ARB No. 43, Chapter 4. This Statement amends ARB No. 43, Chapter 4, to clarify that abnormal amount of idle facility, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that
allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The provisions of SFAS No. 151 should be applied prospectively. The Company does not believe SFAS No. 151 will have a material impact on its financial position or results of operations.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154) which replaces APB 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial StatementsAn Amendment of APB Opinion. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted in the first fiscal quarter of 2006. The Company does not anticipate any impact on its consolidated results of operations and financial condition upon adoption of SFAS 154.
Note 3. Merger Termination
On January 21, 2005, Nanometrics and August Technology Corporation entered into a definitive merger agreement. On June 28, 2005, August Technology Corporation and the Company announced the termination of the merger agreement. In accordance with the terms of the merger agreement, August Technology paid Nanometrics a merger termination fee of $8.3 million on June 28, 2005. Also in accordance with the terms of the merger agreement, August Technology paid to the Company approximately $2.6 million as reimbursement of the Companys expenses associated with the merger agreement on the same date.
Note 4. Stock-Based Compensation
The Company accounts for stock-based employee compensation arrangements using the intrinsic-value-based method in accordance with the provisions of APB No. 25, as interpreted by FASB Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation, and complies with the disclosure provisions of SFAS No. 148, Accounting for Stock-based Compensation Transition and Disclosure, an amendment of SFAS No. 123.
The following table illustrates the effect on net income (loss) and net income (loss) per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to employee stock option plans including shares issued under the Companys Employee Stock Purchase Plan, collectively called options for all periods presented. For purposes of pro forma disclosures, the estimated fair value of the options is assumed to be amortized to expense over the options vesting periods. Pro forma information follows (in thousands, except per share amounts):
SFAS No. 123 requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option pricing model, used by the Company, was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option pricing
models require the input of highly subjective assumptions, including the options expected life and the price volatility of the underlying stock. Because the Companys options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable measure of the fair value of the Companys options.
The fair value of options granted for the period presented below under the 1991, 2000 and 2002 Option Plans and the 1991 and 2000 Directors Plans were estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
Note 5. Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):
Note 6. Intangible Assets
Intangible assets are recorded at cost, less accumulated amortization. Intangible assets as of July 2, 2005 and January 1, 2005 consist of (in thousands):
Amortization expense for each of the three month and six month periods ended July 2, 2005 and July 3, 2004 was $0.1 million and $0.2 million, respectively.
The estimated future amortization expense as of July 2, 2005 is as follows (in thousands):
Note 7. Line of Credit
During the second quarter 2005, the Company renewed a revolving line of credit with a Japanese bank. This revolver is an unsecured line of credit, and the Company may borrow up to ¥400 million through June 2006. Borrowings under the Line of Credit bear interest at a rate of 1.5%. There are no restrictive covenants under the line of credit agreement. As of July 2, 2005, outstanding borrowing was ¥200 million, or approximately $1.79 million translated at spot rate effective as of end of the second quarter 2005. As of January 1, 2005, there were no amounts drawn under the previous line of credit arrangement with the same bank.
Note 8. Other Current Liabilities
Other current liabilities consist of the following (in thousands):
Note 9. Shareholders Equity
Net Income (Loss) Per Share - Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income per share gives effect to all potentially dilutive common shares outstanding during the period, which include certain stock options, calculated using the treasury stock method. A reconciliation of the share denominator of the basic and diluted net income (loss) per share computations is as follows (in thousands):
At July 2, 2005 and July 3, 2004, respectively, diluted net income per share excludes common equivalent shares outstanding of 1.1 million and 0.8 million, respectively, as their effect was anti-dilutive.
Note 10. Comprehensive Income
The Companys comprehensive income was as follows (in thousands):
Substantially all of the accumulated other comprehensive income reflected as a separate component of shareholders equity consists of accumulated foreign currency translation adjustment for all periods presented.
Note 11. Guarantees
Product Warranty- Nanometrics sells the majority of its products with a one-year repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by sales volumes, product failure rates, material usage and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage or replacement costs differ from the Companys estimates, revisions to the estimated warranty obligations would be required. For new product introductions where limited or no historical information exists, the Company may use warranty information from other previous product introductions to guide it in estimating its warranty accrual. The warranty accrual represents the best estimate of the amount necessary to settle future and existing claims on products sold as of the balance sheet date. The Company periodically assesses the adequacy of its reported warranty reserve and adjusts the amounts in accordance with changes in these factors. Components of the warranty accrual, which was included in the accompanying consolidated balance sheets with other current liabilities, were as follows (in thousands):
Intellectual Property Indemnification Obligations- In addition to product warranties, the Company will, from time to time, in the normal course of business, indemnify certain customers with whom it enters into contractual relationships. The Company has agreed to hold these customers harmless against third party claims that Nanometrics products, when used for their intended purpose(s), infringe the intellectual property rights of such third parties or other claims made against the customer. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in each particular claim. Historically, the Company has not made payments under these obligations and believes that the estimated fair value of these agreements is minimal. Accordingly, no liabilities have been recorded for these obligations on the condensed consolidated balance sheets as of July 2, 2005 and January 1, 2005.
Note 12. Income Taxes
Income tax provisions for interim periods are based on the Companys estimated annual income tax rate. In the second quarter of fiscal 2005, the Company recorded an income tax provision of $0.3 million on pre-tax income of $5.0 million. The estimated annual tax rate differs from the combined United States federal and state statutory income tax rate of 40% primarily due to estimated utilization of the Companys net operating losses and various tax credits and reduction of the associated deferred tax valuation allowance.
Note 13. Asset Impairment
During the three month period ended July 2, 2005 Nanometrics recorded an asset impairment charge of $2.2 million related to certain assets in our Japanese operations. Under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, The Company should assess the recoverability of assets when events become known which would indicate potential impairment. The Company evaluated the estimated future cash flows of certain assets groups in our Japanese operations and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets. The impairment charge was measured based on the excess carrying value of the asset group in excess of the associated discounted future cash flows. Accordingly, we recorded an asset impairment charge during the quarter.
Note 14. Contingency
On March 9, 2005, Nova Measuring Instruments Ltd. (Nova) filed suit against Nanometrics. The complaint alleges certain Company products infringe a Nova patent and seeks a preliminary and permanent injunction against their sale and unspecified damages. The Company does not believe any of its products infringe any valid claim of the Nova patent. Nanometrics intends to vigorously and aggressively defend itself in the litigation. While the results of such litigation matters and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse impact on its financial position or results operations.
In August 2005, Nanometrics was served with a complaint alleging that certain Company products infringe the intellectual property of a third party. The complaint seeks a preliminary and permanent injunction against the sale of these products and unspecified damages. The Company does not believe any of its products infringe any intellectual property of a third party and intends to vigorously and aggressively defend itself in the litigation.
Note 15. Geographic and Significant Customer Information
Nanometrics has operations in four primary geographic operating locations: the United States, Japan, South Korea and Taiwan. All such operating locations have similar economic characteristics, as defined in SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, and accordingly, Nanometrics operates in one reportable segment: the sale, design, manufacture, marketing and support of thin film, optical critical dimension and overlay dimension metrology systems. The following table summarizes total net revenues and long-lived assets attributed to significant countries (in thousands):
At July 2, 2005, three customers each, accounted for 10% or more of total accounts receivable. At January 1, 2005, only one customer did so, accounting for 11% of total accounts receivable.
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this document that are not purely historical are 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, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding our business, including, but not
limited to, the level of our expenditures and savings for various expense items and our liquidity in future periods. We may identify these statements by the use of words such as anticipate, believe, continue, could, estimate, expect, intend, may, might, plan, potential, predict, project, should, will, would and other similar expressions. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements, except as may otherwise be required by law.
Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risk factors set forth in the Factors That May Affect Future Operating Results section and elsewhere in this document. In evaluating our business, current and prospective investors should carefully consider these factors in addition to the other information set forth in this document. We believe that it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. You should be aware that the occurrence of the events described in such risk factors and elsewhere in this report could materially and adversely affect our business, operating results and financial condition. While management believes that the discussion and analysis in this report is adequate for a fair presentation of the information presented, we recommend that you read this discussion and analysis in conjunction with the audited consolidated financial statements and notes thereto for the year ended January 1, 2005, which were included in the Companys Annual Report on Form 10-K filed with the Securities Exchange Commission on March 23, 2005.
We are an innovator in the field of metrology systems for the semiconductor and flat panel display manufacturing industries. Our systems are designed to precisely monitor film thickness and critical dimensions that are necessary to control the manufacturing process and provide increased production yields and performance.
Capital expenditures by manufacturers of semiconductors and flat panel displays, especially in Asia, and their suppliers are critical to our success. The demand by these manufacturers and suppliers is driven by the expected market demand for new products and new applications. The increasing complexity of the 300mm manufacturing processes for semiconductors and larger flat panel displays is an important factor in the demand for our innovative metrology systems. The incorporation of smaller features sizes, copper interconnect technology and optical critical dimension technology are expected to result in increased demand. Our strategy is to continue to innovate organically as well to evaluate strategic acquisitions in order to address business challenges and opportunities.
Our revenues are derived from product sales and customer service, which include sales of accessories and service for the installed base of our products. For the year ended January 1, 2005, we derived 89% of our total net revenues from product sales and 11% of our total net revenues from services.
Important Themes and Significant Trends
The semiconductor equipment industry is characterized by cyclical growth. Recently, the industry emerged from an exceptionally long, cyclical downturn. Changing trends in the semiconductor and flat panel display manufacturing industries are increasing the need for metrology as a major component of manufacturing systems. These trends include:
Critical Accounting Policies
The preparation of our financial statements conforms with accounting principles generally accepted in the United States of America, which requires management to make estimates and judgments in applying our accounting policies that have an important impact on our reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of our financial statements. On an on-going basis, management evaluates its estimates including those related to bad debts, inventory valuations, warranty obligations and income taxes. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from managements estimates. We believe that the application of the following accounting policies requires significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including those discussed below, see Note 1 to The Consolidated Financial Statements included in our Annual Report on Form 10-K filed with the SEC on March 23, 2005.
Revenue Recognition Nanometrics recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sellers price is fixed or determinable, and collectibility is reasonably assured. Product revenue includes hardware and software that is incidental to the products. For product sales to existing customers, revenue recognition generally occurs at the time of shipment, as our terms are FOB shipping point, if we have met defined customer acceptance experience levels with both the customer and the specific type of equipment. All other product revenues are recognized upon customer acceptance. In Japan, where risk of loss and title transfer to the customer upon customer acceptance, revenue is recognized upon customer acceptance.
All of our products are assembled prior to shipment to our customers. We often perform limited installation for our customers; such installation, however, is inconsequential and perfunctory as it is also performed by third parties. Revenue related to spare parts sales is recognized on shipment and is included as part of service revenue. Service revenue also includes service contracts and non-warranty repairs of systems. Whereas service revenue related to service contracts is recognized ratably over the period under contract, service revenue related to repairs of systems is recognized as services are performed. Unearned maintenance and service contract revenue is included in deferred revenue. Furthermore, we do not provide our customers with any return rights. Service contracts may be purchased by the customer when the warranty period expires.
In limited situations we have multiple deliverables in our customer arrangements. Those situations include the sale of repair services and parts together where revenues are recognized when both the services and parts have been delivered. We also provide technical support to our customers as part of our warranty program. Upon recognition of product revenue, a liability is recorded for anticipated warranty costs.
Allowance for Doubtful Accounts We maintain allowances for estimated losses resulting from the nonpayment by our customers of required payments. Credit limits are established through a process of reviewing the financial history and stability of our customers. Where appropriate and available, we obtain credit rating reports and financial statements of customers when determining or modifying their credit limits. We regularly evaluate the collectibility of our trade receivable balances based on a combination of factors such as the length of time the receivables are past due, customary payment practices in the respective geographies and our historical collection experience with customers. We believe that our doubtful
accounts allowance reflects our risk associated with smaller rather than larger customers and that our reported allowances are adequate. If however, the financial conditions of customers were to deteriorate, resulting in their inability to make payments, we may need to record additional allowances which would result in additional general and administrative expenses being recorded for the period in which such a determination was made.
Inventories We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in our market, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components from our suppliers. We have established inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our assumptions about future demand for our products and market conditions. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales of usage, product end-of-life dates, estimated current and future market values and new product introductions. For demonstration inventory, we also consider the potential cost to refurbish the inventory prior to sale. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value. If actual demand for our products deteriorates, or market conditions are less favorable than those that we project, additional reserves may be required. Inventories are stated at the lower of cost, using the first-in, first-out method, or market value.
Product Warranties We sell the majority of our products with a twelve month repair or replacement warranty from the date of shipment. We provide an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to revenues. The estimated future warranty obligations related to product sales are reported in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by sales volumes, product failure rates, material usage and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage or replacement costs differ from our estimates, revisions to the estimated warranty obligations would be required. For new product introductions where limited or no historical information exists, we may use warranty information from other previous product introductions to guide us in estimating our warranty accrual. The warranty accrual represents our best estimate of the amount necessary to settle future and existing claims on products sold as of the balance sheet date. We periodically assess the adequacy of our recorded warranty reserve and adjust the amounts in accordance with changes in these factors.
Income Tax Assets and Liabilities We account for income taxes based on Statement of Financial Accounting Standards (SFAS) No. 109 Accounting for Income Taxes, whereby deferred tax assets and liabilities must be recognized using enacted tax rates for the effect of temporary differences between the book and tax accounting for assets and liabilities. Also, deferred tax assets must be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized in the future. We evaluate the deferred tax assets on a quarterly basis to determine whether or not a valuation allowance is appropriate. Factors used in this determination include future expected income and the underlying asset or liability which generated the temporary tax difference. Our income tax provision is primarily impacted by federal statutory rates, state and foreign income taxes and changes in our valuation allowance.
Stock-Based Compensation We currently account for stock-based compensation issued to employees using the intrinsic value method in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), as allowed by SFAS No. 123, Accounting for Stock Based Compensation as amended by SFAS No. 148, Accounting for Stock Based CompensationTransition and Disclosures, an Amendment of FASB Statement No. 123. Under the intrinsic value method, we do not recognize any compensation expense, as the exercise price of all stock options is equal to the fair market value at the time the options are granted. We disclose the pro forma effect of recognizing compensation expense on stock options granted to employees in the footnotes to the consolidated financial statements. These pro forma effects are based on the fair value of the options using the Black-Scholes valuation model using assumptions which are based on our historical experience.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R) Share-Based Payment. This statement replaces SFAS No. 123, amends SFAS No. 95, Statement of Cash Flows and supersedes APB No. 25. SFAS No. 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted, and to awards modified, repurchased or cancelled after the required effective date. In addition, we are required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS No. 123(R) will be effective for fiscal years beginning after June 15, 2005, which is our fiscal 2006. This statement will have a significant impact on our results of operations as we will be required to record compensation expense rather than disclose the impact on our results of operations within our footnotes.
In March 2005, the SEC staff issued guidance on SFAS No. 123(R). Staff Accounting Bulletin (SAB) No. 107 (SAB No. 107) was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123(R) while enhancing the information that investors receive. SAB No. 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS No. 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB No. 107 include: (a) valuation models SAB No. 107 reinforces the flexibility allowed by SFAS No. 123(R) to choose an option-pricing model that meets the standards fair value measurement objective; (b) expected volatility SAB No. 107 provides guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term the new guidance includes examples and some simplified approaches to determining the expected term under certain circumstances. We will apply the principles of SAB No. 107 in conjunction with its adoption of SFAS No. 123(R).
In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on recognition and measurement guidance under EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments which clarifies the meaning of other-than-temporary impairment and its application to investments in debt and equity securities. In particular, investments within the scope of SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, and investments accounted for under the cost method are addressed. In September 2004, the FASB delayed the requirements to record impairment losses under EITF 03-1 until the January 1, 2005. We adopted this consensus and the adoption did not have a material affect on our consolidated results of operations.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, An Amendment of ARB No. 43, Chapter 4. This Statement amends ARB No. 43, Chapter 4, to clarify that abnormal amount of idle facility, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The provisions of SFAS No. 151 should be applied prospectively. The Company does not believe SFAS No. 151 will have a material impact on its financial position or results of operations.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154) which replaces APB 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial StatementsAn Amendment of APB Opinion. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted in the first fiscal quarter of 2006. We are currently evaluating the effect that the adoption of SFAS 154 will have on our consolidated results of operations and financial condition but do not expect it to have a material impact.
Results of Operations
Periods ended July 2, 2005 and July 3, 2004
Net revenues: Our net revenues were comprised of the following categories (in thousands):
Net revenues for the three months ended July 2, 2005 were $18.8 million, an increase of $2.6 million or 16% from the comparable period in 2004. For the six months ended July 2, 2005, net revenues of $42.3 million increased $12.4 million or 42% from the comparable period in 2004. Product sales of $16.7 million and $37.8 million for the three months and six months ended July 2, 2005, respectively, increased $2.5 million or 17% and $12.0 million or 46%, respectively, as compared with the
same periods during 2004. Sales of automated, integrated and tabletop systems increased in the second quarter of 2005 from their second quarter 2004 levels. The increase in product sales resulted from demand for semiconductor process control equipment, primarily in Asia. We believe that increased consumer demand for high performance electronics drives technology advancement in semiconductor design and manufacturing which has in turn promoted the purchase of semiconductor capital equipment featuring the latest advances in technology. Service revenue of $2.2 million and $4.5 million for the three months and six months ended July 2, 2005, respectively, increased $0.1 million or 7% and $0.4 million or 11%, respectively, as compared to the same periods in 2004 primarily due to higher sales of parts and services, particularly in Asia, due in part to a large installed base of systems that have passed their warranty periods.
Cost of sales: As a percentage of product sales, cost of product sales increased to 50% in the second quarter of 2005 from 42% in the second quarter of 2004 and increased to 48% in the six months ended July 2, 2005 from 44% for the same period in 2004 due primarily to a mix of lower margin sales and increased inventory reserves taken on older products. Cost of service as a percentage of service revenue increased to 120% in the second quarter of 2005 from 81% in the second quarter of 2004 and increased to 115% in the six months ended July 2, 2005 from 81% for the same period in 2004 primarily as a result of higher service costs from an increase in headcount and related overhead to provide additional support for our growing customer base, particularly in Asia. We could not fully recoup these costs due to higher service demands from our customer base.
Research and development expenses: Our research and development expenses for the three month and six month periods ended July 2, 2005 increased by $1.0 million or 37% and $0.7 million or 11%, respectively, compared to the same periods in 2004 resulting primarily from increased headcount and materials expenses. In the United States, our research and development efforts are focused on semiconductor metrology. In South Korea, our research and development efforts are focused on the overlay metrology market. In Japan, our research and development efforts are focused on tabletop and flat panel display metrology. We are committed to the development of new and enhanced products and believe that new product introductions are required for us to maintain our competitive position.
Selling expenses: Our selling expenses for the three month and six month periods ended July 2, 2005 decreased by $0.3 million or 9% and $0.2 million or 3%, respectively, compared to the same periods in 2004 primarily due to lower headcount levels.
General and administrative expenses: Our general and administrative expenses for the three month and six month periods ended July 2, 2005 increased $1.0 million or 76% and $1.7 million or 65%, respectively, compared to the same periods in 2004 due primarily to higher regulatory compliance expenses. We expect the trend with respect to regulatory expenses to continue in the future.
Asset impairment: During the three month period ended July 2, 2005 we recorded an asset impairment charge of $2.2 million for certain assets in our Japanese operations. Under SFAS No. 144, we should assess the recoverability of assets when events become known which would indicate potential impairment. The Company evaluated the estimated future cash flows of certain assets groups in our Japanese operations and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets. The impairment charge was measured based on the excess carrying value of the asset group in excess of the associated discounted future cash flows. Accordingly, we recorded an asset impairment charge during the quarter.
Merger termination fee: During the second quarter of 2005, we announced the termination of our merger agreement with August Technology Corporation. In accordance with the terms of the merger agreement, August Technology paid us a merger termination fee of $8.3 million and approximately $2.6 million as reimbursement of the Companys expenses.
Total other expense, net: Our total other expense, net, for the three month and six month periods ended July 2, 2005 decreased $0.1 million and increased $0.1 million, respectively, from the comparable periods in 2004.
Income tax provision: The effective tax rates of 6% and 5% for the three months and six months ended July 2, 2005, respectively, primarily reflect the Companys obligation for foreign taxes and U.S. Federal alternative minimum taxes. The estimated annual tax rate differs from the combined U.S. Federal and state statutory tax rates of 40% primarily due to the utilization of net operating loss carryforwards and the release of the related valuation allowance. We have established significant valuation allowances for our deferred tax assets arising from our operating losses of the past two years. We will continue to assess the realizability of our deferred tax assets particularly if we establish a pattern of profitability in future quarters.
Liquidity and Capital Resources
At July 2, 2005, our cash, cash equivalents and short-term investments totaled $45.2 million. The short-term investments consist primarily of U.S. Treasury Bills. At July 2, 2005, we had working capital of $80.5 million compared to $69.9 million at January 1, 2005. Our current ratio at July 2, 2005 was 6.2 to 1.
Operating activities in the second quarter of 2005 provided cash of $9.1 million primarily from net income of $7.3 million which includes the $8.3 million cash received from August Technology for the merger termination fee, and non-cash charges for an asset impairment of $2.2 million and depreciation and amortization of $1.2 million as well as higher levels of current liabilities. These inflows of cash were partially offset by higher accounts receivable resulting from the timing of shipments and receipt of payments.
Investing activities used $1.0 million primarily due to purchases of short-term investments of $18.9 million offset to some extent by sales of short-term investments in the amount of $18.0 million.
Financing activities provided $2.2 million primarily due to borrowing under our line of credit in Japan and the sale of stock from the exercise of stock options by offset to some extent by repayment of long-term debt in Japan.
We have evaluated and will continue to evaluate the acquisition of products, technologies or businesses that are complementary to our business. These activities may result in product and business investments, which may affect our cash position and working capital balances. Some of these activities might require significant cash outlays. However, we believe working capital including cash, cash equivalents and short-term investments will be sufficient to meet our needs through at least the next twelve months.
The following table summarizes our contractual cash obligations as of July 1, 2005, and the effect such obligations are expected to have on liquidity and cash flow in future periods (in thousands):
We have no off-balance sheet financing arrangements.
Factors That May Affect Future Operating Results
You should carefully consider the risks described below together with all of the other information included in this Quarterly Report on Form 10-Q before making an investment decision. The risks and uncertainties described below are not the only ones that we face. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. In such case, the trading price of our common stock could decline, and you could lose all or part of your investment.
Risks Related to Our Business
Cyclicality in the semiconductor and flat panel display industries has led to substantial fluctuations in demand for our systems and may, from time to time, continue to do so.
Our operating results have varied significantly from period to period due to the cyclical nature of the semiconductor and flat panel display industries. The majority of our business depends upon the capital expenditures of semiconductor device and equipment manufacturers. These manufacturers capital expenditures, in turn, depend upon the current and anticipated market demand for semiconductors and products using semiconductors. The semiconductor industry is cyclical and has historically experienced periodic downturns. These downturns have often resulted in substantial decreases in the demand for
semiconductor manufacturing equipment, including metrology systems. We have found that the resulting decrease in capital expenditures has typically been more pronounced than the downturn in semiconductor device industry revenues. We expect the cyclical nature of the semiconductor industry, and therefore, our business, to continue in the foreseeable future. Recently, the semiconductor industry emerged from a sustained downturn, which had existed for the past few years. Should this trend reverse and the downturn resume, our business and results of operations would suffer.
Because we derive a significant portion of our revenues from sales in Asia, our revenues and results of operations could be adversely affected by the instability of Asian economies.
Revenues from customers in Asian markets represented 63.3%, 72.7% and 68.1% of our total net revenues in 2002, 2003 and 2004, respectively. Countries in the Asia Pacific region, including Japan, South Korea and Taiwan, each of which accounted for a significant portion of our business in that region, had experienced general economic weaknesses in 2002 and 2003, which adversely affected our revenues at that time.
We depend on Applied Materials and other OEM suppliers for sales of our integrated metrology systems, and the loss of Applied Materials or any of our other OEM suppliers as a customer could harm our business.
We believe that sales of integrated metrology systems will continue to be an important source of our revenues. Sales of our integrated metrology systems depend upon the ability of Applied Materials to sell semiconductor equipment products that include our metrology systems as components. If Applied Materials is unable to sell such products, or if Applied Materials chooses to focus its attention on products that do not integrate our systems, our business could suffer. If we were to lose Applied Materials as a customer for any reason, our ability to realize sales from integrated metrology systems would be significantly diminished, which would harm our business.
Our largest customers account for a substantial portion of our revenue, and our revenue would materially decline if one or more of these customers were to purchase significantly fewer of our systems or if they delayed or cancelled a large order.
Historically, a significant portion of our revenues in each quarter and each year has been derived from sales to a relatively few number of customers, and we expect this trend to continue. There are only a limited number of large companies operating in the semiconductor and flat panel display industries. Accordingly, we expect that we will continue to depend on a small number of large customers for a significant portion of our revenues for at least the next several years. If any of our key customers were to purchase significantly fewer systems, or if a large order were delayed or cancelled, our revenues would significantly decline. In 2004, sales to Applied Materials accounted for 22.0% and sales to Samsung accounted for 14.6% of our total net revenues, respectively. In 2003, sales to Applied Materials accounted for 15.4% and sales to Hynix accounted for 12.0% of our total net revenues, respectively. In 2002, sales to Applied Materials accounted for 13.8% and sales to TSMC accounted for 10.9% of our total net revenues, respectively.
The success of our product development efforts depends on our ability to anticipate market trends and the price, performance and functionality requirements of semiconductor device manufacturers. In order to anticipate these trends and ensure that critical development projects proceed in a coordinated manner, we must continue to collaborate closely with our customers. Our relationships with our customers provide us with access to valuable information regarding industry trends, which enables us to better plan our product development activities. If our current relationships with our large customers are impaired, or if we are unable to develop similar collaborative relationships with important customers in the future, our long-term ability to produce commercially successful systems could be adversely affected.
We may have difficulty meeting the requirements described in Section 404 of the Sarbanes-Oxley Act of 2002, including addressing certain significant deficiencies in our internal controls identified in connection with our fiscal 2004 year-end audit, and failure to meet such requirements could materially affect our stock price.
We may be required to file a report on internal accounting controls, in accordance with Section 404 of the Sarbanes-Oxley Act, with our Annual Report on Form 10-K for the year ending December 31, 2005. Accordingly, we will be required to increase the amount of documentation surrounding our internal control systems and provide evidence that our systems have been properly tested to support our managements conclusions. While we continue to improve our internal control systems, including through the companywide implementation of a new Enterprise Resource Planning System or ERP System, there can be no assurance that our report will not disclose a material weakness. Even if we do not identify such a material weakness, our auditors may identify a material weakness in their attestation. In the event that a material weakness is identified, our stock price may be adversely affected.
In connection with the audit conducted by our independent registered public accounting firm BDO Seidman, LLP (BDO Seidman) of our 2004 consolidated financial statements, BDO Seidman advised our management and our Audit
Committee of certain significant deficiencies in our internal controls (none of which individually, or in the aggregate, constituted a material weakness) and made certain recommendations. Under the auditing standards of the Public Company Accounting Overnight Board (PCAOB), a significant deficiency represents a deficiency in the design or operation of internal controls in which there is a more than remote likelihood that a misstatement that is more than inconsequential but less than material could occur. Please refer to our Annual Report on Form 10-K for the year ending January 1, 2005, Item 9A, Management Report on Internal Control Over Financial Reporting, for details.
We are currently in the process of implementing the recommendations of BDO Seidman. Additionally, we are also in the process of augmenting our current control processes, repositioning current finance and accounting personnel and recruiting additional personnel to ensure consistently complete and accurate reporting of financial information. We believe we will satisfactorily address most of the significant deficiencies referenced above by the end of the third fiscal quarter of 2005, although there can be no assurance that we will do so. Furthermore, remediation of our internal controls, required to fully comply with the Section 404 internal control assessment, may require more significant efforts by our management than initially anticipated.
Our current and potential competitors have significantly greater resources than we do, and increased competition could impair sales of our products.
We operate in the highly competitive semiconductor and flat panel display industries and face competition from a number of companies, many of which have greater financial, engineering, manufacturing, marketing and customer support resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or market developments by devoting greater resources to the development, promotion and sale of products, which could impair sales of our products. Moreover, there has been merger and acquisition activity among our competitors and potential competitors. These transactions by our competitors and potential competitors may provide them with a competitive advantage over us by enabling them to rapidly expand their product offerings and service capabilities to meet a broader range of customer needs. Many of our customers and potential customers in the semiconductor and flat panel display industries are large companies that require global support and service for their metrology systems. Some of our larger or more geographically diverse competitors might be better equipped to provide this global support.
If any of our systems fail to meet or exceed our internal quality specifications, we cannot ship them until such time as they have met such specifications. If we experience significant delays or are unable to ship our products to our customers as a result of our internal processes, or for any other reason, our business and reputation may suffer.
Our products are complex and require technical expertise to design and manufacture properly. Various problems occasionally arise during the manufacturing process that may cause delays and/or impair product quality. We must actively monitor our manufacturing processes to ensure that our products meet our internal quality specifications. Any significant delays stemming from the failure of our products to meet or exceed our internal quality specifications, or for any other reasons, would delay our shipments. Shipment delays could harm our business and reputation in the industry.
If we deliver systems with defects, our credibility will be harmed, revenue from, and market acceptance of, our systems will decrease and we could expend significant capital and resources as a result of such defects.
Notwithstanding our internal quality specifications, our systems have sometimes contained errors, defects and bugs when introduced. If we deliver systems with errors, defects or bugs, our credibility and the market acceptance and sales of our systems would be harmed. Further, if our systems contain errors, defects or bugs, we may be required to expend significant capital and resources to alleviate such problems. Defects could also lead to product liability as a result of product liability lawsuits against us or against our customers. We have agreed to indemnify our customers in some circumstances against liability arising from defects in our systems. In the event of a successful product liability claim, we could be obligated to pay damages significantly in excess of our product liability insurance limits.
Successful infringement claims by third parties could result in substantial damages, lost product sales and the loss of important intellectual property rights by us.
Our commercial success depends in part on our ability to avoid infringing or misappropriating patents or other proprietary rights owned by third parties. From time to time we may receive communications from third parties asserting that our metrology systems may contain design features which are claimed to infringe on their proprietary rights. For example, we announced on March 14, 2005 that we had received notice of a patent infringement lawsuit brought by Nova Measuring Instruments, Ltd., alleging infringement of a patent. There can be no assurance that Nanometrics new or current products do not infringe any valid intellectual property rights. Even if our products do not infringe, we may be required to expend significant sums of money to defend against infringement claims, as in the Nova Measuring Instruments, Ltd. lawsuit described above, or to actively protect our intellectual property rights through litigation.
We obtain some of the components and subassemblies included in our systems from a single source or a limited group of suppliers, and the partial or complete loss of one of these suppliers could cause production delays and significant loss of revenue.
We rely on outside vendors to manufacture many components and subassemblies. Certain components, subassemblies and services necessary for the manufacture of our systems are obtained from a sole supplier or limited group of suppliers. We do not maintain any long-term supply agreements with any of our suppliers. We have entered into arrangements with J.A. Woollam Company for the purchase of the spectroscopic ellipsometer component incorporated in our advanced measurement systems. Our reliance on a sole or a limited group of suppliers involves several risks, including the following:
Some of our suppliers have relatively limited financial and other resources. Because the manufacturing of certain of these components and subassemblies involves extremely complex processes and requires long lead times, we may experience delays or shortages caused by our suppliers. If we were forced to seek alternative sources of supply or to manufacture such components or subassemblies internally, we could be forced to redesign our systems, which could cause production delays and prevent us from shipping our systems to customers on a timely basis. Any inability to obtain adequate deliveries from our suppliers, or any other circumstance that would restrict our ability to ship our products, could damage relationships with current and prospective customers, harm our business and result in significant loss of revenue.
Variations in the amount of time it takes for us to sell our systems may cause fluctuations in our operating results, which could adversely affect our stock price.
Variations in the length of our sales cycles could cause our revenues to fluctuate widely from period to period. Our customers generally take long periods of time to evaluate our metrology systems. We expend significant resources educating and providing information to our prospective customers regarding the uses and benefits of our systems. The length of time that it takes for us to complete a sale depends upon many factors, including:
Because of the number of factors influencing the sales process, the period between our initial contact with a customer and the time at which we recognize revenue from that customer, if at all, varies widely. Our sales cycles, including the time it takes for us to build a product to customer specifications after receiving an order, typically range from three to six months. Occasionally our sales cycles can be much longer, particularly with customers in Asia who may require longer evaluation periods. During the sales cycles, we commit substantial resources to our sales efforts in advance of receiving any revenue, and we may never receive any revenue from a customer despite our sales efforts.
If we do complete a sale, customers often purchase only one of our systems and then evaluate its performance for a lengthy period of time before purchasing additional systems. The purchases are generally made through purchase orders rather than through long-term contracts. The number of additional products that a customer purchases, if any, depends on many factors, including a customers capacity requirements. The period between a customers initial purchase and any subsequent purchases is unpredictable and can vary from three months to a year or longer. Variations in the length of this period could cause fluctuations in our operating results, which could adversely affect our stock price.
Relatively small fluctuations in our system sales volume may cause our operating results to vary significantly each quarter.
During any quarter, a significant portion of our revenue is derived from the sale of a relatively small number of systems. Our automated metrology systems range in price from approximately $200,000 to over $1,000,000 per system, our integrated metrology systems range in price from approximately $80,000 to $300,000 per system and our tabletop metrology systems range in price from approximately $50,000 to $200,000 per system. Accordingly, a small change in the number or types of systems that we sell could cause significant changes in our operating results.
We may experience material payment delays as a result of customer acceptance issues and such delays could negatively affect our results of operations.
As a result of customer acceptance issues, we may, from time to time, experience payment delays on some of our systems. Because a significant portion of our revenue is derived from the sale of a relatively small number of our systems, substantial payment delays by our customers could materially and adverse affect our results of operations.
We depend on orders that are received and shipped in the same quarter, and therefore our results of operations may be subject to significant variability from quarter to quarter.
Our net sales in any given quarter depend upon a combination of orders received in that quarter for shipment in that quarter and shipments from backlog. Our backlog at the beginning of each quarter does not include all systems sales needed to achieve expected revenues for that quarter. Consequently, we are dependent on obtaining orders for systems to be shipped in the same quarter that the order is received. Moreover, customers may reschedule shipments, and production difficulties could delay shipments. Accordingly, we have limited visibility into future product shipments, and our results of operations may be subject to significant variability from quarter to quarter.
Because of the high cost of switching equipment vendors in our markets, it is sometimes difficult for us to attract customers from our competitors even if our metrology systems are superior to theirs.
We believe that once a semiconductor or flat panel display customer has selected one vendors metrology system, the customer generally relies upon that system and, to the extent possible, subsequent generations of the same vendors system, for the life of the application. Once a vendors metrology system has been installed, a customer must often make substantial technical modifications and may experience downtime in order to switch to another vendors metrology system. Accordingly, unless our systems offer performance or cost advantages that outweigh a customers expense of switching to our systems, it will be difficult for us to achieve significant sales from that customer once it has selected another vendors system for an application.
If we are not successful in developing new and enhanced metrology systems we will likely lose market share to our competitors.
We operate in an industry that is subject to technological changes, changes in customer demands and the introduction of new, higher performance systems with short product life cycles. To be competitive, we must continually design, develop and introduce in a timely manner new metrology systems that meet the performance and price demands of semiconductor and flat panel display manufacturers and suppliers. We must also continue to refine our current systems so that they remain competitive. We may experience difficulties or delays in our development efforts with respect to new systems, and we may not ultimately be successful in developing them. Any significant delay in releasing new systems could adversely affect our reputation, give a competitor a first-to-market advantage or cause a competitor to achieve greater market share.
Lack of market acceptance for our new products may affect our ability to generate revenue and may harm our business.
We have recently introduced several new products to market including the Nano OCD/DUV 9010, the Nanometrics Atlas, Atlas-M, Orion and the Nano OCD 9010M. We have invested substantial time and resources into the development of the products. However, we cannot accurately predict the future level of acceptance of our new products by our customers. As a result, we may not be able to generate anticipated revenue from sales of these products. While we anticipate that our new products will become an increasingly larger component of our business, their failure to gain acceptance with our customers could materially harm our business. Additionally, if our new products do gain market acceptance, our ability to sell our existing products may be impeded. As a result, there can be no assurance that the introduction of these products will be commercially successful or that these products will result in significant additional revenues or improved operating margins in future periods.
Our intellectual property may be infringed upon by third parties despite our efforts to protect it, which could threaten our future success and competitive position and adversely affect our operating results.
Our future success and competitive position depend in part upon our ability to obtain and maintain proprietary technology for our principal product families, and we rely, in part, on patent, trade secret and trademark law to protect that technology. If we fail to adequately protect our intellectual property, it will be easier for our competitors to sell competing products. We own or have licensed a number of patents relating to our metrology systems, and have filed applications for additional patents. Any of our pending patent applications may be rejected, and we may not in the future be able to develop additional proprietary technology that is patentable. In addition, the patents we do own or that have been issued or licensed to us may not provide us with competitive advantages and may be challenged by third parties. Third parties may also design around these patents.
In addition to patent protection, we rely upon trade secret protection for our confidential and proprietary information and technology. We routinely enter into confidentiality agreements with our employees. However, in the event that these agreements may be breached, we may not have adequate remedies. Our confidential and proprietary information and technology might also be independently developed by or become otherwise known to third parties. We may be required to initiate litigation in order to enforce any patents issued to or licensed by us, or to determine the scope or validity of a third partys patent or other proprietary rights. Any such litigation, regardless of outcome, could be expensive and time consuming, and could subject us to significant liabilities or require us to re-engineer our product or obtain expensive licenses from third parties, any of which would adversely affect our business and operating results.
If we choose to acquire new and complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or may not be able to successfully integrate an acquired business in a cost-effective and non-disruptive manner.
Our success depends on our ability to continually enhance and broaden our product offerings in response to changing technologies, customer demands and competitive pressures. To achieve this, from time to time we have acquired complementary businesses, products, or technologies instead of developing them ourselves and may choose to do so in the future. We recently announced the termination of our definitive merger agreement with August Technology, a leader in macro defect inspection. As highlighted by this example, we do not know if we will be able to complete any acquisitions, or whether, if we were able to do so, we will be able to successfully integrate any acquired business, operate it profitably or retain its key employees. Integrating any business, product or technology that we acquire could be expensive and time consuming, disrupt our ongoing business and distract our management. In addition, in order to finance any acquisitions, we may be required to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on terms that are not favorable to us and, in the case of an equity financing, that result in dilution to our shareholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer.
We must attract and retain key personnel with relevant industry knowledge to help support our future growth.
Our success depends to a significant degree upon the continued contributions of our key management, engineering, sales and marketing, customer support, finance and manufacturing personnel. We generally do not enter into employment contracts with any of our key personnel. The loss of any of these key personnel, who would be difficult to replace, could harm our business and operating results. To support our future growth, we will need to attract and retain additional qualified employees. Competition for such personnel in our industry is ongoing, and we may not be successful in attracting and retaining qualified employees.
We manufacture all of our systems at a limited number of facilities, and any prolonged disruption in the operations of those facilities could reduce our revenues.
We produce all of our systems in our manufacturing facilities located in Milpitas, California and through our subsidiaries in Japan and South Korea. Our manufacturing processes are highly complex and require sophisticated, costly equipment and specially designed facilities. As a result, any prolonged disruption in the operations of our manufacturing facilities, such as those resulting from a fire or severe earthquake, could seriously harm our ability to satisfy our customer order deadlines. A significant portion of our operations is located in Japan and South Korea, which may be subject to regional political and economic instability.
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.
In 2002, 2003 and 2004, 69.0%, 74.8% and 71.0%, respectively, of our total net revenues were derived from sales to customers in foreign countries, including certain countries in Asia, such as Taiwan, South Korea and Japan. The laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States, and many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in such countries. If we fail to adequately protect our intellectual property in these countries, it would be easier for our competitors to sell competing products.
We will incur increased costs as a result of recent changes in laws and regulations affecting public companies.
Compliance with recent changes in laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, has resulted in, and may result in additional, increased accounting, legal and administrative costs. In particular, Section 404 of the Sarbanes-Oxley Act and the rules of the Securities and Exchange Commission and the PCAOB impose new requirements with respect to the evaluation of the effectiveness of our internal controls. The cost of complying with these new requirements is substantial.
Our quarterly operating results have varied in the past and probably will continue to vary significantly in the future, which will cause volatility in our stock price.
Our quarterly operating results have varied significantly in the past and are likely to vary in the future, which volatility could cause our stock price to decline. Some of the factors that may influence our operating results and subject our stock to extreme price and volume fluctuations include:
If our operating results in any period fall below the expectations of securities analysts and investors, the market price of our common stock would likely decline.
We are highly dependent on international sales and operations, which exposes us to foreign political and economic risks.
Sales to customers in foreign countries accounted for approximately 69.0%, 74.8% and 71.0% of our total net revenues in 2002, 2003 and 2004, respectively. We maintain facilities in Japan and South Korea. We anticipate that international sales will continue to account for a significant portion of our revenues. International sales and operations carry inherent risks such as: regulatory limitations imposed by foreign governments, obstacles to the protection of our intellectual property, political, military and terrorism risks, disruptions or delays in shipments caused by customs brokers or other
government agencies, unexpected changes in regulatory requirements, tariffs, customs, duties and other trade barriers, difficulties in staffing and managing foreign operations, and potentially adverse tax consequences resulting from changes in tax laws. If any of these risks materialize and we are unable to manage them, our international sales and operations would suffer.
We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition.
Some of our operations use substances regulated under various federal, state, local, and international laws governing the environment, including those relating to the storage, use, discharge, disposal, labeling, and human exposure to hazardous and toxic materials. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws. Liability under environmental laws can be joint and several and without regard to comparative fault. Compliance with current or future environmental laws and regulations could restrict our ability to expand our facilities or require us to acquire additional expensive equipment, modify our manufacturing processes, or incur other significant expenses. There can be no assurance that violations of environmental laws or regulations will not occur in the future as a result of the inability to obtain permits, human error, equipment failure or other causes.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information concerning market risk is incorporated herein by reference to Item 7A Quantitative and Qualitative Disclosures About Market Risk contained in Part II of our Annual Report on Form 10-K for the year ended January 1, 2005. Our exposure to market risk does not differ materially from that discussed in our Annual Report as Form 10-K for the year ended January 1, 2005. However, we cannot give any assurance as to the effect that future changes in interest rates or foreign currency rates will have on our consolidated financial position, results of operations or cash flows.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (Exchange Act)), as of July 2, 2005, the end of the period covered by this Quarterly Report on Form 10-Q. Based upon that evaluation, our management, including our CEO and CFO, concluded that the design and operation of our disclosure controls and procedures are effective and that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.
While there were no changes in our internal controls over financial reporting that occurred in the second fiscal quarter of 2005 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, we are in the process of documenting, evaluating and remediating our internal controls in anticipation of filing a report on internal accounting controls, in accordance with Section 404 of the Sarbanes Oxley Act with our Annual Report on Form 10-K for the year ending December 31, 2005. Additionally, during the quarter ended July 2, 2005, we hired Quentin Wright as our Chief Accounting Officer as part of this effort.
While we believe our disclosure controls and procedures and our internal control over financial reporting are effective, no system of controls can prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected.
These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
ITEM 1. LEGAL PROCEEDINGS
On March 9, 2005, Nova Measuring Instruments Ltd. (Nova) filed suit against Nanometrics. The complaint alleges that certain of our products infringe a Nova patent and seeks a preliminary and permanent injunction against their sale and unspecified damages. We do not believe any of our products infringe any valid claim of the Nova patent. We intend to vigorously and aggressively defend ourselves in the litigation. While the results of such litigation matters and claims cannot be predicted with certainty, we believe the final outcome of such matters will not have a material adverse impact on our financial position or results operations.
In August 2005, we were served with a complaint alleging certain of our products infringe the intellectual property of a third party. The complaint seeks a preliminary and permanent injunction against the sale of these products and unspecified damages. We do not believe any of our products infringe any intellectual property of a third party and we intend to vigorously and aggressively defend ourselves in the litigation.
ITEM 6. EXHIBITS
The following exhibits are filed or incorporated by reference with this Quarterly Report on Form 10-Q:
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.
Dated: August 15, 2005