Westell Technologies 10-Q 2006
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File Number 0-27266
Westell Technologies, Inc.
(Exact name of registrant as specified in its charter)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check or mark whether the registrant (1) has filed all reports required to be filed by Sections 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 o.
Indicate by check mark whether the registrant is a large filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large filer in Rule 12b-2 of the Exchange Act.
Large accelerated filer o Accelerated filer x Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o No x
Indicate the number of shares outstanding of each of the issuers classes of common stock as of a October 24, 2006:
Class A Common Stock, $0.01 Par Value 55,680,773 shares
Class B Common Stock, $0.01 Par Value 14,741,872 shares
WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES
PART II OTHER INFORMATION
Safe Harbor Statement
Certain statements contained in this Quarterly Report of Form 10-Q regarding matters that are not historical facts or that contain the words believe, expect, intend, anticipate or derivatives thereof and other words of similar meaning, are forward-looking statements. Such forward-looking statements include risks and uncertainties, and actual results may differ materially from those expressed in or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, those discussed under Risk Factors set forth in Westell Technologies, Inc.s Annual Report on Form 10-K for the fiscal year ended March 31, 2006. Our actual results may differ from these forward-looking statements. Westell Technologies, Inc. undertakes no obligation to publicly update these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or otherwise.
WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these Consolidated Financial Statements.
WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these Consolidated Financial Statements
WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these Consolidated Financial Statements
Note 1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the year ended March 31, 2006.
In the opinion of management, the unaudited interim financial statements included herein reflect all adjustments, consisting of normal recurring adjustments, necessary to present fairly the Companys consolidated financial position and the results of operations and cash flows at September 30, 2006 and for all periods presented. The results of operations for the three and six month periods ended September 30, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2007 (fiscal year 2007).
Note 2. Computation of Income Per Share
The computation of basic earnings per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share includes the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. The following table sets forth the computation of basic and diluted earnings per share:
Options to purchase 5,985,350 and 5,025,588 shares of common stock for the three months ended September 30, 2006 and September 30, 2005, respectively and options to purchase 5,960,272 and 4,723,041 shares of common stock for the six months ended September 30, 2006 and September 30, 2005, respectively, were not included in the computation of diluted shares because the options exercise prices were greater than the average market price of the common shares.
Note 3. Revolving Credit Agreements:
The Company entered into a Second Amended and Restated Credit Agreement dated as of June 30, 2006 (the Credit Agreement). The Credit Agreement is a three-year revolving credit facility in an amount up to $40 million. The obligations of the Company under the Credit Agreement are secured by a guaranty from certain direct and indirect domestic subsidiaries of the Company, and substantially all of the assets of the Company. The interest rate spread in the case of LIBOR and Base Rate loans and the payment of the non-use fees is dependent on the Companys leverage ratio. Currently the revolving loans under the Credit Agreement bear interest, at the Companys option, at the London Interbank Offered Rate (LIBOR) plus 1.5% or an alternative base rate. The alternative base rate is the greater of the LaSalle Bank National Association prime rate or the Federal Funds rate plus 0.50%. The Company is also required to pay a non-use fee of 0.2% per annum on the unused portion of the revolving loans. The Credit Agreement contains financial covenants that include a minimum Fixed Charge
Coverage Ratio, a minimum tangible net worth test, a total leverage ratio test (consolidated total debt to EBITDA), and a limitation on capital expenditures for any fiscal year as well as other non financial covenants. The Company was in compliance with these covenants on September 30, 2006 and expects to comply with these covenants for the term of the debt. There were no borrowings under this facility at September 30, 2006.
Note 4. Restructuring Charge
The Company recognized a restructuring expense of $443,000 in the third quarter of fiscal year 2006. This charge included personnel costs relating to the termination of 17 employees at Westell Inc. As of September 30, 2006, all of these costs have been paid.
On December 29, 2005, the Company acquired 100% of the stock of HyperEdge Corporation. The Company has implemented a restructuring plan to combine and streamline the operations of the companies to achieve synergies related to the manufacture and distribution of common NSA product lines. The Company estimates the costs of employee terminations, which were recorded as liabilities assumed in the acquisition, to be $400,000. Approximately 20 employees were impacted by this plan. Any adjustments to this plan will be accounted for in accordance with SFAS No. 141. As of September 30, 2006, $182,000 of these costs have been paid leaving an unpaid balance of $218,000.
The restructuring charges and their utilization are summarized as follows:
Note 5. Interim Segment Information
Westells reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and market strategies. They consist of:
Performance of these segments is evaluated utilizing revenue, operating income and total asset measurements. The accounting policies of the segments are the same as those for Westell Technologies, Inc. Segment information for the three and six month periods ended September 30, 2005 and 2006 are as follows:
Reconciliation of Operating income for the reportable segments to income before income taxes and minority interest:
Note 6. Comprehensive Income
The disclosure of comprehensive income, which encompasses net income and foreign currency translation adjustments, is as follows:
Note 7. Inventories
The components of inventories are as follows:
Note 8. Stock-based Compensation
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R). This statement requires that the costs of all employee share-based payments be measured at fair value on the awards grant date and be recognized in the financial statements over the requisite service period. SFAS No. 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, (APB No. 25) and its related interpretations, and eliminates the alternative use of the intrinsic value method of accounting under APB No. 25, which the Company previously used.
On April 1, 2006, the Company adopted SFAS No. 123R using the modified prospective method. As a result, the Companys income before income taxes for the three and six months ended September 30, 2006 is $277,000 and $572,000 lower than if it had continued to account for share-based compensation under APB No. 25. The $572,000 of expense is inclusive of a $62,000 reduction of expense resulting from the application of an estimated forfeiture rate to its existing unvested awards which is included in the accompanying Consolidated Statement of Operations for the six months ended September 30, 2006. The Company previously recognized forfeitures as they were incurred. Additionally, under SFAS No. 123R, the Company has elected to recognize compensation expense for all share-based awards with service periods beginning subsequent to the adoption of SFAS No. 123R over the service period of the award, unless the award has a performance condition in which case compensation expense will be recognized using a graded vesting attribution method. Also, under SFAS No. 123R the benefits of tax deductions in excess of recognized compensation cost are now reported as a financing cash flow instead of as an operating cash flow as required under previous accounting literature.
Prior to the adoption of SFAS No. 123R, the Company applied the intrinsic-value-based method of accounting prescribed by APB No. 25 and related interpretations to account for its fixed-plan stock options. Under this method, compensation expense was recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Pro forma net earnings as if the fair value based method had been applied to all awards are as follows:
On February 24, 2006, the Company accelerated the vesting of approximately 1.4 million unvested out of the money stock options held by current employees and certain executive officers of the Company. No options were accelerated for board members or the Chief Executive Officer. The immediate vesting included a restriction on the resale of the underlying shares of common stock. The acceleration of vesting was made to reduce compensation expense that otherwise would be recorded in future periods. For pro forma disclosure purposes, these options were treated as if they were expensed in the fourth quarter of fiscal 2006.
Non-qualified stock options
Stock options granted by the Company generally have an exercise price that is equal to the fair value of the Companys stock on the grant date. Options vest over period from two to five years, or upon the earlier of the achievement of Company and individual goals established, or 8 years. The Company recorded expense of $218,000 and $446,000 in the three and six month periods ended September 30, 2006 related to stock options. The excess tax benefit of $39,000 was reflected as a cash flow from financing activities in the consolidated statement of cash flows. Total cash received from options exercised was $137,000 and $1.7 million in the six months ended September 30, 2006 and 2005, respectively. The option activity for the six months ended September 30, 2006 is as follows:
As of September 30, 2006, there was $1.4 million pre-tax stock option compensation expense related to non-vested awards not yet recognized, which is expected to be recognized over a weighted average period of 2.6 years.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
Non-qualified subsidiary stock options
The Companys Conference Plus subsidiary has a stock option plan for the purchase of Conference Plus stock. Stock options granted under this plan have an exercise price that is equal to the fair value of Conference Plus stock on the grant date. Options can not be exercised until the earliest of the following to occur; an initial public offering, a spin off, a change in control of Conference Plus, or the fifth anniversary of the option grant date. The Company recorded expense of $55,000 and $112,000 in the three and six month periods ended September 30, 2006 related to these stock options. The option activity for the three months ended September 30, 2006 is as follows:
As of September 30, 2006, there was $352,000 pre-tax stock option compensation expense related to non-vested awards not yet recognized, which is expected to be recognized over a weighted average period of 2.5 years.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
Vesting of restricted stock is subject to continued employment with the Company. Restricted stock awards granted in fiscal year 2006 will vest in full on March 31, 2007. The restricted stock awards granted in fiscal year 2005 will vest in full on June 1, 2008 with the exception of 20,000 awards that will vest on March 31, 2007. Each restricted stock award is subject to partial vesting in the event of death, disability or involuntary termination other than for cause, as defined in the restricted stock award, based upon the number of months worked prior to the vesting date of the stock award. The Company recognizes compensation expense on a straight-line basis over the vesting period based on the market value of Westell Technologies stock on the date of grant. The Company recorded $200,000 and $206,000 of expense in the three months ended September 30, 2006 and 2005, respectively, and $250,000 and $412,000 of expense in the six months ended September 30, 2006 and 2005, respectively, related to these grants. The following table sets forth restricted stock activity for the six months ended September 30, 2006:
As of September 30, 2006, there was $1.1 million of unrecognized compensation expense related to restricted stock expected to be recognized over a weighted-average period of 1.4 years.
Employee Stock Purchase Plan
There were 45,189 and 34,219 shares of common stock purchased under the employee stock purchase plan (ESPP) during the six months ended September 30, 2006 and 2005, respectively. The ESPP allows employees to purchase
stock through payroll deductions each quarter end at a 15% discount from the market price on that day. The Company recorded $4,000 and $14,000 of expense in the three and six months ended September 30, 2006 related to stock purchased under this plan.
Stock-Based Compensation Expense
The following table sets forth the total stock-based compensation expense resulting from stock options, restricted stock and the employee stock purchase plan:
Note 9. Warranty Reserve
Most of the Companys products carry a limited warranty ranging from one to seven years. The specific terms and conditions of those warranties vary depending upon the product sold. Factors that enter into the estimate of the Companys warranty reserve include the number of units shipped historical and anticipated rates of warranty claims, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the reserve as necessary. The Company reports warranty reserve as both current and long term liabilities. The following table presents the changes in the Companys product warranty reserve:
Note 10. Deferred Compensation
The Company has a deferred compensation program with its Chief Executive Officer that is funded through a rabbi trust. The rabbi trust qualifies as a Variable Interest Entity under FASB Interpretation No. 46, Consolidation of Variable Interest Entities and as such is consolidated in the Companys financial statements. Approximately $1.9 million of cash has been funded into the rabbi trust as September 30, 2006. The Company has recorded a $2.4 million short-term liability to accrue for the deferred compensation liability as of September 30, 2006. The rabbi trust is subject to the creditors of the Company. All amounts deferred under this compensation program vested on March 31, 2006.
Note 11. Sale of Product Line
On July 1, 2004, the Company sold its Data Station Termination product lines and specified fixed assets for $2.2 million to Enginuity Communications Corporation (Enginuity). The Company received $2.0 million in cash, $200,000 in the form of a note receivable and provided an unconditional guarantee in the amount of $1.6 million relating to a 10 year term Enginuity note payable to a third party lender that financed the transaction. The balance of
the term loan is $1.4 million as of September 30, 2006. Certain owners of Enginuity pledged assets with a fair market value of $1.5 million and personally guaranteed the note payable. These guarantees will stay in place until the note is paid in full. The Company must pay all amounts due under the note payable upon demand from the lender.
The Company evaluated FIN 46R Consolidation of Variable Interest Entities and concluded that Enginuity was a variable interest entity as a result of the debt guarantee. The Company is not considered the primary beneficiary of the variable interest entity therefore consolidation is not required.
The Company assessed its obligation under this guarantee pursuant to the provisions of FIN 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others and recorded a $300,000 liability for the value of the guarantee. The Company evaluates the liability each quarter and reduced the liability to $200,000 in the quarter ended June 30, 2006 based on Enginuity operating performance and current status of the guaranteed debt obligation.
Note 12. Acquisition
On December 29, 2005, the Company acquired 100% of the common stock of HyperEdge Corporation, a manufacturer of network service access products, for $14.0 million in cash. The Company has accrued $649,000 in estimated transaction costs, including costs for employee severance. The Company paid $112,000 of transaction costs consisting of legal fees and accounting fees for intangible valuation in the six months ended September 30 2006. The acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141 Business Combinations (SFAS No. 141) and accordingly the operating results of HyperEdge have been included in the consolidated financial statements from the acquisition date.
In accordance with SFAS No. 141, the total purchase price was allocated to the tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values at the acquisition date with excess purchase price allocated to goodwill. The purchase price allocation for HyperEdge has not been finalized pending completion of final adjustments to liabilities assumed in the acquisition and the completion of integration plans.
Note 13. New Accounting Pronouncements
In June 2006, the FASB issued FASB Interpretation (FIN) No 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109. FIN No. 48 prescribes a recognition threshold and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN No. 48 is effective for the Company beginning on April 1, 2007. The Company is currently evaluating the impact that the adoption of FIN No. 48 will have on its financial condition and results of operations, which will be required to be adopted in the June 30, 2007 quarter.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement addresses how to calculate fair value measurements required or permitted under other accounting pronouncements. Accordingly, this statement does not require any new fair value measurements. However, for some entities, the application of this statement will change current practice. SFAS No. 157 is effective for the Company beginning April 1, 2008. The Company is currently evaluating the impact of this standard.
In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, to address diversity in practice in quantifying financial statement misstatements. SAB 108 provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 is effective for the Company in its year ended March 31, 2007, and allows a one-time transitional cumulative effect adjustment to retained earnings for errors that were not previously deemed material, but are material under the guidance in SAB 108. The Company is in the process of determining the effects, if any, that SAB 108 will have on its financial statements.
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
The Company is comprised of two segments: telecommunications equipment manufacturer and teleconference services bureau. The equipment manufacturing segment consists of two product lines: Customer Networking Equipment (CNE) products and Network Service Access (NSA) products. The CNE product line includes broadband and digital subscriber line (DSL) technology products that allow the transport of high-speed data over the local loop and enable telecommunications companies to provide broadband services over existing copper infrastructure. The Companys NSA product line consists of manageable and non-manageable T1 transmission equipment, associated mountings and special service plugs for the legacy copper telephone network. Westell realizes the majority of its revenues from the North American market.
The Companys teleconference service segment is comprised of a 91.5% owned subsidiary, Conference Plus, Inc. Conference Plus provides audio, video, and web conferencing services. Businesses and individuals use these services to hold voice, video or web conferences with many people at the same time. Conference Plus sells its services directly to large customers, including Fortune 1000 companies, and serves other customers indirectly through its private label reseller program.
The equipment manufacturing segment of the Companys business consists of two product lines, offering a broad range of products that facilitate the broadband transmission of high-speed digital and analog data between a telephone companys central office and end user customers. These two product lines are:
The prices for the products within each market group vary based upon volume, customer specifications and other criteria and are subject to change due to competition among telecommunications manufacturers and service providers. Increasing competition, in terms of the number of entrants and their size, and increasing size of the Companys customers because of past mergers, continues to exert downward pressure on prices for the Companys products. The Company expects average selling prices on its VersaLinkTM and modem products to decline 20% or less in fiscal year 2007.
On November 18, 2005, SBC (now AT&T Inc.) acquired AT&T Corp. In the fiscal year ended March 31, 2006, sales to AT&T Inc. generated approximately 7.9% of the Companys total revenues. The largest customer of Conference Plus is AT&T Inc. which offers services similar to Conference Plus. AT&T accounted for 46.2% of the service segment revenue in the fiscal year ended March 31, 2006. The Company is unable to predict at this time how the merger will impact the Companys results of operations in the future.
On July 21, 2006 AT&T Inc. and BellSouth stockholders approved the acquisition of BellSouth by AT&T. Subject to approval of regulatory authorities and other customary closing conditions, the merger is expected to close in 2006.
BellSouth is the Companys second largest customer. The Company is unable to predict at this time how the merger will impact the Companys results from operations in the future.
In September 2006 the Company announced an end to joint development of the Verizon One product with Verizon Communications Inc. The Company will complete its orders for Verizon One, and the companies will each pursue independent development and marketing strategies for their respective multimedia terminal product programs. Westell continues as Verizons primary supplier of DSL modems and gateway products and continues to be engaged on video and convergence product opportunities at Verizon.
The Companys customer base is highly concentrated and comprised primarily of the Regional Bell Operating Companies (RBOCs), independent domestic local exchange carriers and public telephone administrations located outside the U.S. Due to the stringent quality specifications of its customers and the regulated environment in which its customers operate, the Company must undergo lengthy approval and procurement processes prior to selling its products. Accordingly, the Company must make significant up front investments in product and market development prior to actual commencement of sales of new products.
To remain competitive, the Company must continue to invest in new product development and invest in targeted sales and marketing efforts to cover new product lines. Failure to increase revenues from new products, whether due to lack of market acceptance, competition, technological change or otherwise, would have a material adverse effect on the Companys business and results of operations. The Company expects to continue to evaluate new product opportunities and engage in extensive research and development activities.
The Company is focusing on expanding its product offerings in the equipment segment from basic high speed broadband to more sophisticated applications such as VoIP, in-premise networking; wireless/wireline convergence, IMS (IP Multimedia Subsystem) and FMC (Fixed Mobile Convergence); video / IPTV and multifunctional broadband appliances. This will require the Company to continue to invest in research and development and sales and marketing, which could adversely affect short-term results of operations. The Company expects to increase spending in research and development and sales and marketing and technical support by approximately 25% in fiscal year 2007 compared to fiscal year 2006 to take advantage of these market opportunities. In view of the Companys reliance on the broadband CPE for revenues and the unpredictability of orders and pricing pressures, the Company believes that period-to-period comparisons of its financial results are not necessarily meaningful and should not be relied upon as an indication of future performance.
In the CNE equipment manufacturing segment, the Company is focusing on the evolving broadband demand, which includes increased bandwidth, richer application sets, converged capabilities and higher complexity. The Company has introduced products including the UltraLineTM , ProLineTM VersaLinkTM and TriLinkTM, which are targeted at the broadband access, home networking, small office/home office (SOHO) and small business markets. The Company has multiple evaluations and its entering trials for TriLinkTM, TriLinkTMIMS and UltraLineIITM The Company continues to focus on expanding existing and new products into the international market consisting primarily of Europe and Canada.
The Company expects the overall NSA market to decline annually by approximately 10% as the transition to high-speed digital service continues. This decline could impact the Companys future revenue. The Company acquired 100% of the common stock of HyperEdge Corporation, on December 29, 2005 with the goal of strengthening the NSA business by improving margin through economies of scale. With the addition of HyperEdge the Company hopes to increase its market share in mountings and NIUs. The Company also plans to invest in new product areas to complement wireless and fiber applications.
Results of Operations
The Company adopted SFAS No. 123R on April 1, 2006 using the modified prospective method. As a result, the Companys income before income taxes for the three and six months ended September 30, 2006 is $277,000 and $572,000 lower due to the adoption of this statement. See Note 8 to the consolidated financial statements for further discussion on stock based compensation.
CNE revenue for the three months ended September 30, 2006 increased due to a 21% increase in unit volume compared to the three month period ended September 30, 2005 offset in part by an 8% decrease in average selling price per unit. CNE revenue decreased 13% in the six months ended September 30, 2006 compared to September 30, 2005 due to a 16% decrease in average selling price per unit offset in part by a 9% increase in units sold. NSA revenue increased in the three and six months ended September 30, 2006 by 37% and 35%, respectively, compared to same periods ended September 30, 2005 due to the acquisition of HyperEdge, which occurred in December of 2005. Revenue in the services segment was increased 5% and 2% in the three and six month periods ended September 30, 2006 compared to the same periods ended September 30, 2005.
Gross margin increased as a percent of revenue in the equipment segment in both the three and six month periods ended September 30, 2006 compared to the same periods ended September 30, 2005 primarily due to a higher mix of NSA revenue resulting from the acquisition of HyperEdge as well as benefit received from product cost reductions on ProlineTM and VersalinkTM products offset in part by a $646,000 excess and obsolete inventory charge in the second quarter. Margins in the services segment increased slightly in the three and six months ended September 30, 2006 when compared to the same periods ended September 30, 2005.
The sales and marketing expense increase in the equipment segment in the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due primarily to $192,000 of less billable warranty repair work, $140,000 of increased health insurance expense, $129,000 of bonus expense and $129,000 of media gateway test and evaluation units. The sales and marketing expense increase in the equipment segment in the six months ended September 30, 2006 compared to the six months ended September 30, 2005 was due primarily to $737,000 of less billable warranty repair work, $176,000 of increased bonus expense and $143,000 of higher product certification expense. Sales and marketing expense increased in the Companys services segment in the
three and six month period ended September 30, 2006 compared to the same period last year due primarily to a 10% increase in the number of employees at Conference Plus. The Company believes that sales and marketing expense in the future will continue to be a significant percent of revenue and will be required to expand its product lines, bring new products to market and service customers.
Engineering expenses have increased in the three and six months ended September 30, 2006 compared to the same periods in fiscal year 2006. A portion of this increase was due to an increase in external consulting expense of $901,000 and $1.4 million in the three and six month ended September 30, 2006 compared to the same periods ended September 30, 2005. In addition, there was a 15% increase in the number of employees in the fiscal year 2007 periods resulting in $350,000 and $706,000 more compensation and employee related expenses. The increase in engineering consulting and employees was primarily to support the development of the media gateway and video transport products and to a lesser extent the acquisition of HyperEdge. The Company believes that research and development expenses will increase in fiscal year 2007 as the Company continues to focus on VoIP, in-premise networking, wireless/wireline convergence including IMS (IP Multimedia Subsystem) and FMC (Fixed Mobile Convergence), video / IPTV and multifunctional broadband appliances, user interfaces and other broadband applications.
The increase in general and administrative expense in the equipment segment in the six months ended September 30, 2006 compared to the same period ended September 30, 2005 is due primarily to a $256,000 fee paid to an executive search firm for the purpose of conducting a search for the successor CEO. The increase in general and administrative expense in the services segment in the quarter ended September 30, 2006 compared to the same period ended September 30, 2005 is due primarily to increased information technology costs.
Intangible amortization Intangible amortization was $415,000 and $324,000 for the three months and $830,000 and $648,000 for the six months ended September 30, 2006 and 2005, respectively. The intangibles consist of product technology related to the March 17, 2000 acquisition of Teltrend Inc. and product technology and customer relationships related to the December 29, 2005 HyperEdge Inc. acquisition.
Other income net Other income, net was $772,000 and $192,000 in the three months and $1.4 million and $14,000 in the six months ended September 30, 2006 and 2005, respectively. Interest income was $722,000 and $1.3 million in the three and six months ended September 30, 2006 compared to $301,000 and $472,000 in the three and six months ended September 30, 2005. The increase in the current year interest income is due to higher cash balances on hand in addition to higher interest rates. The September 30, 2005 quarter and six months contained $121,000 and $496,000 of expense for unrealized losses on intercompany balances denominated in foreign currency.
Interest expense Interest expense decreased to $1,000 and $2,000 in the three and six months ended September 30, 2006 from $5,000 and $9,000 in the three and six months ended September 30, 2005. The decrease in interest expense during the current period is a result of lower net obligations outstanding during the period.
Income taxes The Company recorded $2.4 million and $4.1 million of income tax expense based on an estimated tax rate of 39% in the three and six months ended September 30, 2006 and $2.1 million and $4.8 million in the three and six months ended September 30, 2005, respectively.
Liquidity and Capital Resources
The Company entered into a Second Amended and Restated Credit Agreement dated as of June 30, 2006 (the Credit Agreement). The Credit Agreement, which has improved terms over the prior agreement, is a three-year revolving credit facility in an amount up to $40 million. The obligations of the Company under the Credit Agreement are secured by a guaranty from certain direct and indirect domestic subsidiaries of the Company, and substantially all of the assets of the Company. Any proceeds from the revolving loans would be used for working capital purposes and for other general corporate purposes. The interest rate spread in the case of LIBOR and Base Rate loans and the payment of the non-use fees is dependent on the Companys leverage ratio. Currently the revolving loans under the Credit Agreement bear interest, at the Companys option, at the London Interbank Offered Rate (LIBOR) plus 1.5% or an alternative base rate. The alternative base rate is the greater of the LaSalle Bank National Association prime rate or the Federal Funds rate plus 0.50%. The Company is also required to pay a non-use fee of 0.2% per annum on the unused portion of the revolving loans.
The Credit Agreement contains financial covenants that include a minimum Fixed Charge Coverage Ratio, a minimum tangible net worth test, a total leverage ratio test (consolidated total debt to EBITDA), and a limitation on capital expenditures for any fiscal year. Other covenants include limitations on lines of business, additional indebtedness, liens and negative pledge agreements, incorporation of other debt covenants, guarantees, investments and advances, cancellation of indebtedness, restricted payments, modification of certain agreements and instruments, inconsistent agreements, leases, consolidations, mergers and acquisitions, sale of assets, subsidiary dividends, and transactions with affiliates. The Company was in compliance with these covenants on September 30, 2006 and expects to comply with these covenants for the term of the debt.
At September 30, 2006, the Company had $66.1 million in cash and cash equivalents consisting primarily of the highest rated grade corporate commercial paper. At September 30, 2006, the Company had no amounts outstanding and $40.0 million available under its secured revolving credit facility.
The Companys operating activities generated cash of $27.5 million in the six month period ended September 30, 2006. Cash generated by operations resulted primarily from net income, non-cash depreciation and amortization and reductions in accounts receivable and deferred taxes and an increase in accounts payable and accrued expenses in both segments.
The Companys investing activities used $2.7 million for the six month period ended September 30, 2006. Capital expenditures for the six month period ended September 30, 2006 were $1.9 million. The capital expenditures in the equipment segment were $1.4 million and were primarily for machinery and research and development equipment purchases. The services segment capital expenditures were $477,000. These expenditures were primarily for computer and telecom bridge equipment.
At September 30, 2006 the Companys principle sources of liquidity were $66.1 million of cash and the secured revolving credit facility under which the Company was eligible to borrow up to an additional $40 million. Cash in excess of operating requirements, if any, will be invested on a short-term basis in the highest rated grade commercial paper. The Company believes cash on hand and generated from operations will satisfy its future cash requirements for the foreseeable future.
The Company had deferred tax assets of approximately $64.1 million at September 30, 2006. The Company has recorded a valuation allowance reserve of $9.5 million to reduce the recorded net deferred tax asset to $54.6 million. The net operating loss carryforwards begin to expire in 2012. Realization of deferred tax assets associated with the Companys future deductible temporary differences, net operating loss carryforwards and tax credit carryforwards is dependent upon generating sufficient taxable income prior to their expiration. The Company uses estimates of future taxable income and tax planning strategies by specific jurisdiction to access the valuation allowance required against deferred tax assets. Management periodically evaluates the recoverability of the deferred tax assets and will adjust the valuation allowance against deferred tax assets accordingly.
Critical Accounting Policies
The Company accounts for stock-based compensation in accordance with SFAS No. 123R using the fair value of awards at grant date and recognizing compensation expense over the vesting period of the award. The determination of fair value of share-based awards at the grant date requires several assumptions including expected stock volatility, risk-free interest rate, expected option term and expected forfeitures of awards. See footnote 8 for more detailed information on these assumptions. For a description of our other critical accounting policies, see our Annual Report on Form 10-K for the fiscal year ended March 31, 2006.
Westell is subject to certain market risks, including foreign currency and interest rates. The Company has foreign subsidiaries in the United Kingdom and Ireland that develop and sell products and services in those respective countries. The Company is exposed to potential gains and losses from foreign currency fluctuations affecting net investments and earnings denominated in foreign currencies. Market risk is estimated as the potential decrease in pretax earnings resulting from a hypothetical decrease in the ending exchange rate of 10%. If such a decrease occurred, the Company would incur approximately $31,000 in additional other expense based on the ending intercompany balance outstanding at September 30, 2006 that is expected to repaid in the foreseeable future. The Companys future primary exposure is to changes in exchange rates for the U.S. dollar versus the British Pound Sterling and the Euro. The Company does not currently use any derivative financial instruments relating to the risk associated with changes in foreign currency rates.
As of September 30, 2006, the balance in the cumulative foreign currency translation adjustment account, which is a component of stockholders equity, was an unrealized loss of $70,000.
The Company does not have significant exposure to interest rate risk related to its debt obligations, which are primarily U.S. Dollar denominated. The Company does not currently use any derivative financial instruments relating to the risk associated with changes in interest rates.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures.
Under the supervision and with the participation of our senior management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of the end of the period covered by this quarterly report (the Evaluation Date). Based on this evaluation, our chief executive officer and chief financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, including consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (SEC) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to the Companys management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting.
There have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2006 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
Part II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
The Company is involved in various legal proceedings incidental to the Companys business. In the ordinary course of our business, we are routinely audited and subject to inquiries by governmental and regulatory agencies. Management believes that the outcome of such proceedings will not have a material adverse effect on our consolidated operations or financial condition.
On September 21, 2006, the Company held its annual meeting of stockholders.
The following directors were re-elected to serve until the annual meeting of stockholders in 2007:
The stockholders voted to approve the proposal to ratify the appointment of Ernst &Young LLP, independent auditors as auditors for fiscal year ending March 31, 2007:
ITEM 6. EXHIBITS
Items 1A, 2, 3 and 5 are not applicable and have been omitted.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.