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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
------------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended June 30, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 0-27460
PERFORMANCE TECHNOLOGIES, INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 16-1158413
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
205 Indigo Creek Drive, Rochester, New York 14626
(Address of principal executive offices) (Zip Code)
------------------
Registrant's telephone number, including area code: (585) 256-0200
------------------
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 a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one): Large accelerated filer [ ] Accelerated filer [X]
Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The number of shares outstanding of the registrant's common stock was
13,251,378 as of August 1, 2006.
--------------------------------------------------------------------------------
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Consolidated Balance Sheets as of June 30, 2006 and
December 31, 2005 (unaudited) 3
Consolidated Statements of Income for the Three and
Six Months Ended June 30, 2006 and 2005 (unaudited) 4
Consolidated Statements of Cash Flows for the Six
Months Ended June 30, 2006 and 2005 (unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk 23
Item 4. Controls and Procedures 23
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 6. Exhibits 24
Signatures 24
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(unaudited)
ASSETS
June 30, December 31,
2006 2005
---------------- -----------------
Current assets:
Cash and cash equivalents $11,435,000 $11,803,000
Investments 21,075,000 21,150,000
Accounts receivable, net 11,180,000 9,523,000
Inventories 6,451,000 7,148,000
Prepaid expenses and other assets 413,000 470,000
Deferred taxes 3,506,000 3,272,000
---------------- -----------------
Total current assets 54,060,000 53,366,000
Property, equipment and improvements, net 2,190,000 2,004,000
Software development costs, net 3,351,000 3,182,000
Investment in unconsolidated company 248,000 248,000
Goodwill 4,143,000 4,143,000
---------------- -----------------
Total assets $63,992,000 $62,943,000
================ =================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,201,000 $ 1,836,000
Income taxes payable 322,000 244,000
Accrued expenses 4,204,000 4,438,000
---------------- -----------------
Total current liabilities 5,727,000 6,518,000
Deferred taxes 1,221,000 1,138,000
---------------- -----------------
Total liabilities 6,948,000 7,656,000
---------------- -----------------
Stockholders' equity:
Preferred stock - $.01 par value;
1,000,000 shares authorized; none
issued
Common stock - $.01 par value;
50,000,000 shares authorized;
13,260,038 shares issued 133,000 133,000
Additional paid-in capital 14,448,000 13,903,000
Retained earnings 42,605,000 42,601,000
Treasury stock - at cost; 8,660 and
171,757 shares held at June 30, 2006
and December 31, 2005, respectively (142,000) (1,350,000)
---------------- -----------------
Total stockholders' equity 57,044,000 55,287,000
-------------- -----------------
Total liabilities and stockholders'
equity $63,992,000 $62,943,000
============== =================
The accompanying notes are an integral part of these
consolidated financial statements.
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
----------- ----------- ----------- -----------
Sales $13,052,000 $10,802,000 $25,220,000 $23,959,000
Cost of goods sold 6,143,000 5,916,000 12,100,000 12,378,000
Non RoHS inventory charge
(Note C) 801,000 801,000
----------- ----------- ----------- -----------
Gross profit 6,108,000 4,886,000 12,319,000 11,581,000
----------- ----------- ----------- -----------
Operating expenses:
Selling and marketing 1,453,000 1,369,000 2,823,000 2,846,000
Research and development 2,981,000 2,327,000 5,781,000 4,872,000
General and administrative 1,462,000 1,094,000 2,746,000 2,527,000
Restructuring charges
(Note H) 559,000 139,000 994,000 196,000
----------- ----------- ----------- -----------
Total operating expenses 6,455,000 4,929,000 12,344,000 10,441,000
----------- ----------- ----------- -----------
(Loss) income from operations (347,000) (43,000) (25,000) 1,140,000
Other income, net 371,000 330,000 705,000 625,000
----------- ----------- ----------- -----------
Income before income taxes 24,000 287,000 680,000 1,765,000
Income tax (benefit)
provision (48,000) 83,000 62,000 512,000
----------- ----------- ----------- -----------
Net income $ 72,000 $ 204,000 $ 618,000 $ 1,253,000
=========== =========== =========== ===========
Basic earnings per share $ .01 $ .02 $ .05 $ .10
=========== =========== =========== ===========
Diluted earnings per share $ .01 $ .02 $ .05 $ .10
=========== =========== =========== ===========
Weighted average number of
common shares used in basic
earnings per share 13,181,034 12,863,345 13,141,358 12,836,333
Potential common shares 175,385 180,747 203,107 293,643
Weighted average number of
common shares used in ----------- ----------- ----------- -----------
diluted earnings per share 13,356,419 13,044,092 13,344,465 13,129,976
=========== =========== =========== ===========
The accompanying notes are an integral part of these consolidated
financial statements.
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Six Months Ended
June 30,
2006 2005
-------------- --------------
Cash flows from operating activities:
Net income $ 618,000 $ 1,253,000
Non-cash adjustments:
Depreciation and amortization 1,156,000 1,325,000
Tax benefit from stock option exercises 233,000 143,000
Stock-based compensation expense 289,000 12,000
Deferred income taxes (151,000) 210,000
Other 15,000 29,000
Changes in operating assets and liabilities:
Accounts receivable (1,649,000) 1,653,000
Inventories 697,000 237,000
Prepaid expenses and other assets 57,000 385,000
Accounts payable and accrued expenses (869,000) (427,000)
Income taxes payable 78,000 131,000
-------------- --------------
Net cash provided by operating activities 474,000 4,951,000
-------------- --------------
Cash flows from investing activities:
Purchases of property, equipment and
improvements (588,000) (198,000)
Capitalized software development costs (948,000) (1,308,000)
Purchases of investments (41,425,000) (32,900,000)
Proceeds from sales of investments 41,500,000 29,550,000
-------------- --------------
Net cash used by investing activities (1,461,000) (4,856,000)
-------------- --------------
Cash flows from financing activities:
Tax windfall benefit from stock option exercises 24,000
Exercise of stock options 595,000 373,000
-------------- --------------
Net cash provided by financing activities 619,000 373,000
-------------- --------------
Net (decrease) increase in cash and cash
equivalents (368,000) 468,000
Cash and cash equivalents at beginning of period 11,803,000 10,361,000
-------------- --------------
Cash and cash equivalents at end of period $ 11,435,000 $ 10,829,000
============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Non-cash financing activity:
Exercise of stock options using 57,484
shares of common stock $ 426,000 $
============== ==============
The accompanying notes are an integral part of these consolidated
financial statements.
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note A - Basis of Presentation
---------------------
The unaudited Consolidated Financial Statements of Performance Technologies,
Incorporated and Subsidiaries (the "Company") have been prepared in accordance
with generally accepted accounting principles in the United States of America
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X of the Securities and Exchange Commission.
Accordingly, the Consolidated Financial Statements do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all adjustments
considered necessary for a fair statement have been included. The results for
the interim periods are not necessarily indicative of the results to be expected
for the year. The accompanying Consolidated Financial Statements should be read
in conjunction with the audited Consolidated Financial Statements of the Company
as of December 31, 2005, as reported in its Annual Report on Form 10-K filed
with the Securities and Exchange Commission.
Note B - Stock-Based Compensation and Earnings Per Share
-----------------------------------------------
The Company has stock options outstanding from three stock-based employee
compensation plans, the Amended and Restated 1986 Incentive Stock Option Plan,
the 2001 Incentive Stock Option Plan, and the 2003 Omnibus Incentive Plan.
Effective January 1, 2006, the provisions of Statement of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment", and related
interpretations, were adopted to account for stock-based compensation using the
modified prospective transition method and therefore, prior period results were
not restated. SFAS No. 123(R) supersedes Accounting Principles Board Opinion
(APB) No. 25, "Accounting for Stock Issued to Employees", and revises guidance
of SFAS No. 123, "Accounting for Stock-Based Compensation". Among other things,
SFAS No. 123(R) requires that compensation expense be recognized in the
financial statements for share-based awards based on the grant-date fair value
of those awards. The modified prospective transition method applies to (a) stock
options granted prior to December 31, 2005 which had unrecognized compensation
expense at January 1, 2006, calculated under SFAS No. 123, and (b) any new
share-based awards granted subsequent to December 31, 2005, based on the
grant-date fair value estimated in accordance with the provisions of SFAS No.
123(R). Additionally, stock-based compensation expense includes an estimate for
pre-vesting forfeitures and is recognized over the requisite service periods of
the awards on a straight-line or graded vesting basis, which is generally
commensurate with the vesting term. Stock-based compensation expense associated
with stock option grants of $168,000 and $289,000 was recorded during the second
quarter and the first six months of 2006, respectively, as a result of the
adoption of SFAS No. 123(R). Of these amounts, for the second quarter and the
first six months of 2006, $72,000 and $177,000, respectively, were related to
stock options that were granted prior to December 31, 2005.
Prior to January 1, 2006, stock-based compensation plans were accounted for in
accordance with APB No. 25 and related interpretations. Stock options may be
granted to any officer or employee at not less than the fair market value at the
date of grant (not less than 110% of the fair market value in the case of
holders of more than 10% of the Company's common stock). Options granted under
the plans generally expire between five and ten years from the date of grant and
vest in periods ranging from one to six years. Prior to the adoption of SFAS No.
123(R), as required under the disclosure provisions of SFAS No. 123, as amended,
pro forma net income (loss) and earnings (loss) per common share were provided
for each period as if the fair value method were applied to measure stock-based
compensation expense.
The table below summarizes the impact of outstanding stock options and
restricted stock on the results of operations for the three and six months ended
June 30, 2006 under the provisions of SFAS No. 123(R):
Three Months Six Months
Ended June 30, Ended June 30,
2006 2006
---------------- ----------------
Stock based compensation expense:
Stock options $ 162,000 $ 277,000
Restricted stock 6,000 12,000
Income tax benefit (64,000) (110,000)
---------------- ----------------
Net decrease in net income $ 104,000 $ 179,000
================ ================
Decrease in earnings per share:
Basic $ .01 $ .01
================ ================
Diluted $ .01 $ .01
================ ================
The Black-Scholes-Merton option pricing model was used to estimate the fair
value of share-based awards under SFAS No. 123(R) as well as for pro forma
disclosures under SFAS No. 123. The Black-Scholes-Merton option pricing model
incorporates various and highly subjective assumptions, including expected term
and expected volatility. For valuation purposes, stock option awards were
categorized into two groups, stock option grants to employees and stock option
grants to members of the Board of Directors.
The expected term of options granted prior to January 1, 2006 equaled the
vesting period. The expected term of options granted in 2006 was the average of
the vesting term and the contractual life. The expected volatility at the grant
date is estimated using historical stock prices based upon the expected term of
the options granted. The risk-free interest rate assumption is determined using
the rates for U.S. Treasury zero-coupon bonds with maturities similar to those
of the expected term of the award being valued. Cash dividends have never been
paid and are not anticipated to be paid in the foreseeable future. Therefore,
the assumed expected dividend yield is zero.
SFAS No. 123(R) requires pre-vesting option forfeitures at the time of grant be
estimated and periodically revised in subsequent periods if actual forfeitures
differ from those estimates. Stock-based compensation expense is recorded only
for those awards expected to vest using an estimated forfeiture rate based on
historical pre-vesting forfeiture data. Previously, forfeitures were accounted
for as they occurred under the pro forma disclosure provisions of SFAS No. 123
for periods prior to 2006.
The following table shows the detailed assumptions used to compute the fair
value of stock options granted during the six months ended June 30, 2006:
Six Months Ended
June 30, 2006
-------------------
Expected term (years) 2 to 6.5
Volatility 56% to 66%
Risk free interest rate 4.6% to 5.0%
The weighted average grant date fair value of options granted during the six
months ended June 30, 2006 was $3.93 per option. Unrecognized stock-based
compensation expense was approximately $1,869,000 as of June 30, 2006, relating
to a total of 561,000 unvested stock options under the Company's stock options
plans. This stock-based compensation expense is expected to be recognized over a
weighted average period of approximately four years.
The following table summarizes stock option activity for the six months ended
June 30, 2006:
Weighted
Average
Number of Exercise Exercise Price
Shares Price Range
------------- ----------- -----------------
Outstanding at December 31, 2005 2,118,164 $9.71 $3.40 - $18.13
Granted 245,000 $6.82 $6.64 - $7.50
Exercised (220,581) $4.63 $3.40 - $7.25
Expired (220,232) $13.34 $3.80 - $18.13
-------------
Outstanding at June 30, 2006 1,922,351 $9.56 $3.40 - $18.13
=============
The following table summarizes stock option information at June 30, 2006:
Options outstanding Options exercisable
-----------------------------------------------------
Weighted Weighted Weighted Weighted
average average average average
Range of remaining exercise remaining exercise
exercise price Shares life (yrs) price Shares life (yrs) price
--------------------------------------------------------------------------------
$3.40 to $5.94 411,045 3.21 $4.57 323,811 2.21 $4.25
$5.95 to $8.60 871,727 5.30 $7.68 401,727 2.04 $8.06
$8.61 to $11.40 65,500 2.68 $10.27 65,330 2.67 $10.27
$11.41 to $14.24 287,429 .55 $13.74 283,729 .54 $13.74
$14.25 to $18.13 286,650 2.81 $18.06 286,650 2.81 $18.06
--------------------------------------------------------------------------------
1,922,351 3.68 $9.56 1,361,247 1.96 $10.55
================================================================
The total intrinsic value of all outstanding options and all exercisable options
at June 30, 2006, whose exercise price was less than the Company's closing stock
price at June 30, 2006, was $1,008,000 and $865,000 respectively. The total
intrinsic value, determined as of the date of exercise, of options exercised in
the first six months of 2006 and 2005 was $592,000 and $430,000, respectively.
Cash received from option exercises for the six months ended June 30, 2006 and
2005, amounted to $595,000 and $373,000, respectively. The total fair value of
options that vested during the six months ended June 30, 2006 was $220,000. In
2005 and 2006, shares of common stock were issued from treasury for stock option
exercises.
The following table illustrates the effect on net income and earnings per common
share for the three months and six months ended June 30, 2005, as if the
provisions of SFAS No. 123 were applied using the fair value method to measure
stock-based compensation:
Three Months Six Months
Ended June 30, Ended June 30,
2005 2005
-------------- --------------
Net income, as reported $ 204,000 $ 1,253,000
Add: Restricted stock compensation
expense, net of tax 4,000 7,000
Deduct: Total stock-based compensation
expense determined under fair value
based method for all awards, net of
related tax effects (154,000) (2,290,000)
-------------- --------------
Pro forma net income (loss) $ 54,000 $(1,030,000)
============== ==============
Earnings (loss) per share:
Basic - as reported $ .02 $ .10
============== ==============
Basic - pro forma $ .00 $ (.08)
============== ==============
Diluted - as reported $ .02 $ .10
============== ==============
Diluted - pro forma $ .00 $ (.08)
============== ==============
During the six months ended June 30, 2005, the Company granted options to
purchase 204,000 shares of common stock. The assumption for vesting of the stock
options granted was generally 33% per year. The following weighted-average
assumptions were used for these 2005 grants: Dividend yield of 0%; expected
volatility ranges of 65% to 70%, risk-free interest rate ranges of 3.3% to 3.7%,
and expected life ranges of one to three years.
During the fourth quarter 2005 and the first quarter 2006, stock options to
purchase 225,000 and 185,000 shares of common stock, respectively, were granted
that are subject to accelerated vesting based upon the achievement of certain
milestones, as defined in the option agreements.
During 2003, 17,720 shares of restricted stock were granted at prices ranging
from $6.89 to $12.54. During 2003, 1,740 shares of restricted stock were
forfeited, without vesting. In January 2004, 10,524 shares vested and were
issued. The remaining shares vest in November 2006. The value of restricted
stock is charged to compensation expense over the vesting period of the grant.
Unrecognized compensation expense totaled approximately $8,000 at June 30, 2006,
related to restricted stock.
Basic earnings per share is computed by dividing net income by the weighted
average number of common shares outstanding for the period. Diluted earnings per
share calculations reflect the assumed exercise and conversion of dilutive stock
options and unvested restricted stock, applying the treasury stock method.
Diluted earnings per share calculations exclude the effect of approximately
1,208,000 and 1,330,000 options for the three months ended June 30, 2006 and
2005, respectively, and 1,236,000 and 1,144,000 options for the six months ended
June 30, 2006 and 2005 since such options have an exercise price in excess of
the average market price of the Company's common stock.
Note C - Inventories
-----------
Inventories consisted of the following:
June 30, December 31,
2006 2005
----------------- -----------------
Purchased parts and components $ 2,434,000 $ 2,884,000
Work in process 2,667,000 3,378,000
Finished goods 1,350,000 886,000
----------------- -----------------
Net $ 6,451,000 $ 7,148,000
================= =================
The Restriction of Certain Hazardous Substances ("RoHS") Directive issued by the
European Union (EU) became effective on July 1, 2006. This directive restricts
the distribution of products within the EU that exceed very low maximum
concentration values of certain substances, including lead. In the second
quarter 2006, the Company recorded a charge to cost of goods sold for excess
non-compliant "RoHS" inventory, which is not expected to be sold, in the amount
of $801,000.
Note D - Investments
-----------
At June 30, 2006 and December 31, 2005, investments consisted of high grade,
auction rate municipal securities which were classified as available-for-sale.
The contractual maturities of the available-for-sale securities at June 30, 2006
all exceeded five years.
These investments are recorded at cost, which approximates fair market value due
to their variable interest rates. These investments typically reset on
approximately a monthly basis, and, despite the long-term nature of their stated
contractual maturities, these securities historically had the ability to be
quickly liquidated. All income generated from these investments was recorded as
interest income.
Note E - Warranty Obligations
--------------------
Warranty obligations are incurred in connection with the sale of certain
products. The warranty period is generally one year. The costs incurred to
provide for these warranty obligations are estimated and recorded as an accrued
liability at the time of sale. Future warranty costs are estimated based on
product-based historical performance rates and related costs to repair. Changes
in accrued warranty obligations for the six months ended June 30, 2006 and 2005
were as follows:
2006 2005
---------------- ----------------
Accrued warranty obligations, January 1, $310,000 $288,000
Actual warranty experience (30,000) (57,000)
Warranty provisions (4,000) 69,000
---------------- ----------------
Accrued warranty obligations, June 30, $276,000 $300,000
================ ================
Note F - Stock Repurchase Program
------------------------
On July 11, 2005, a plan to repurchase shares of common stock for an aggregate
amount not to exceed $10,000,000 was authorized by the Board of Directors. This
program was extended by the Board of Directors in July 2006. Under this program,
shares of common stock may be repurchased through open market or private
transactions, including block purchases, through July 13, 2007. Repurchased
shares can be used for stock option plans, potential acquisition initiatives and
general corporate purposes. To date, there have been no repurchases of shares
under the original or the extended program.
Note G - Income Taxes
------------
The Company's effective income tax rate is a combination of federal, state and
foreign tax rates and is generally lower than statutory rates because it
includes benefits derived from international operations, research activities,
tax exempt interest and foreign sales. For the second quarter 2006, the
effective tax rate was a benefit of 200%. The tax rate in the second quarter
2006 was the result of a combination of an adjustment to the annual expected
effective tax rate to 18% and a discrete tax benefit recorded in the first
quarter 2006 of $.1 million which related to a previously unused tax credit. The
effective rate for the six month period ended June 30, 2006 was 9%. The
effective tax rate was 29% for the second quarter and for the first six months
of 2005.
Note H - Restructuring Costs
-------------------
Restructuring charges amounted to $559,000 and $139,000 in the second quarter
2006 and 2005, respectively, and $994,000 and $196,000 for the six months ended
June 30, 2006 and 2005, respectively. Restructuring charges in 2006 are
primarily related to severance and facility expenses incurred for the closing of
the Company's Norwood, Massachusetts engineering center. During the second
quarter 2006, the Company accrued $122,000 of lease termination costs related to
the closing of this facility. Restructuring charges in 2005 relate primarily to
severance payments associated with the Company's efforts to centralize
operations.
Total cash paid related to restructuring efforts in the second quarter 2006
included $548,000 related to employee severance costs (14 employees) and $73,000
in lease and facility related closing costs. Total cash paid related to
restructuring efforts in the six months ended June 30, 2006, included $805,000
of employee severance costs (22 employees) and $84,000 of lease and facility
related closing costs. The accrued lease termination costs totaled $103,000 at
June 30, 2006.
During the third quarter 2006, the Company is planning to relocate its San Luis
Obispo operation to a new facility in the same city. In connection with that
relocation, the Company expects restructuring costs in the third quarter to be
in the range of $500,000 to $750,000.
Note I - Lease Commitments
-----------------
During the second quarter 2006, the Company entered into a lease for a facility
in the Ottawa, Canada area. The lease term extends from August 1, 2006 to
October 31, 2011. The Company's Ottawa operation is expected to relocate to this
facility during the third quarter 2006.
In July 2006, the Company entered into a two-year lease for a facility in the
San Luis Obispo area which commences on September 1, 2006. During the third
quarter 2006, the Company's San Luis Obispo operation is expected to relocate to
this facility.
For both lease agreements, the Company is required to pay the pro rata share of
the real property taxes and assessments, expenses and other charges associated
with these facilities.
Future minimum payments under these two new leases are as follows:
Amount
---------------------
2006 $ 75,000
2007 244,000
2008 224,000
2009 169,000
2010 181,000
Thereafter 151,000
---------------------
Total $1,044,000
=====================
Note J - Recent Accounting Pronouncements
--------------------------------
On January 1, 2006, the Company adopted SFAS No. 151, "Inventory Costs - An
Amendment of ARB No. 43, Chapter 4". SFAS No. 151 states that abnormal amounts
of idle facility expense, freight, handling costs, and wasted material
(spoilage) should be recognized as current-period charges. This adoption did not
have a material impact on the Company's consolidated results of operations and
financial condition.
In July 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" (FIN 48).
FIN 48 clarifies the accounting and reporting for income taxes recognized in
accordance with SFAS No. 109, "Accounting for Income Taxes." This Interpretation
prescribes a comprehensive model for the financial statement recognition,
measurement, presentation and disclosure of uncertain tax positions taken or
expected to be taken in income tax returns. The Company is currently evaluating
the impact of FIN 48. The Company will adopt this Interpretation in the first
quarter of 2007.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Matters discussed in Management's Discussion and Analysis of Financial Condition
and Results of Operations and elsewhere in this Form 10-Q include
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended, and are subject to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Actual results could differ materially
from those discussed in the forward-looking statements.
Critical Accounting Estimates and Assumptions
In preparing the financial statements in accordance with GAAP, estimates and
assumptions are required to be made that have an impact on the assets,
liabilities, revenue and expense amounts reported. These estimates can also
affect supplemental information disclosures, including information about
contingencies, risk and financial condition. Estimates are generally not made
until preliminary results for a financial quarter are known and analyzed. It is
believed that given the current facts and circumstances, these estimates and
assumptions are reasonable, adhere to GAAP, and are consistently applied.
Inherent in the nature of an estimate or assumption is the fact that actual
results may differ from estimates and estimates may vary as new facts and
circumstances arise. The critical accounting policies, judgments and estimates
that we believe have the most significant effect on our financial statements are
set forth below:
o Revenue Recognition
o Software Development Costs
o Valuation of Inventories
o Income Taxes
o Product Warranty
o Carrying Value of Goodwill
o Stock-Based Compensation
o Restructuring Costs
Revenue Recognition: Revenue is recognized from product sales in accordance with
the SEC Staff Accounting Bulletin No. 104, "Revenue Recognition." Product sales
represent the majority of our revenue and include hardware products and hardware
products with embedded software. Revenue is recognized from these product sales
when persuasive evidence of an arrangement exists, delivery has occurred or
services have been provided, the sale price is fixed or determinable, and
collectability is reasonably assured. Additionally, products are sold on terms
which transfer title and risk of loss at a specified location, typically the
shipping point. Accordingly, revenue recognition from product sales occurs when
all factors are met, including transfer of title and risk of loss, which
typically occurs upon shipment. If these conditions are not met, revenue
recognition is deferred until such time that these conditions have been
satisfied.
Revenue earned from arrangements for software is accounted for under the
provisions of Statement of Position 97-2, "Software Revenue Recognition" and
EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables." Revenue
from software requiring significant production, modification, or customization
is recognized using the percentage of completion method of accounting. Any
anticipated losses on contracts are charged to operations as soon as such losses
are determined. If all conditions of revenue recognition are not met, revenue
recognition is deferred and revenue will be recognized when all obligations
under the arrangement are fulfilled. Revenue from software maintenance contracts
is recognized ratably over the contractual period.
Revenue from consulting and other services is recognized at the time the
services are rendered. Certain products are sold through distributors who are
granted limited rights of return. Potential returns are accounted for at the
time of sale.
The accounting estimate related to revenue recognition is considered a "critical
accounting estimate" because terms of sale can vary, and judgment is exercised
in determining whether to defer revenue recognition. Such judgments may
materially affect net sales for any period. Judgment is exercised within the
parameters of GAAP in determining when contractual obligations are met, title
and risk of loss are transferred, sales price is fixed or determinable and
collectability is reasonably assured.
Software Development Costs: All software development costs incurred in
establishing the technological feasibility of computer software products to be
sold are research and development costs. Software development costs incurred
subsequent to the establishment of technological feasibility of a computer
software product to be sold and prior to general release of that product are
capitalized. Amounts capitalized are amortized commencing after general release
of that product over the estimated remaining economic life of that product,
generally three years, or using the ratio of current revenues to current and
anticipated revenues from such product, whichever provides greater amortization.
If the technological feasibility for a particular project is judged not to have
been met or recoverability of amounts capitalized is in doubt, project costs are
expensed as research and development or charged to cost of goods sold, as
applicable. The accounting estimate related to software development costs is
considered a "critical accounting estimate" because judgment is exercised in
determining whether project costs are expensed as research and development or
capitalized as an asset. Such judgments may materially affect expense amounts
for any period. Judgment is exercised within the parameters of GAAP in
determining when technological feasibility has been met and recoverability of
software development costs is reasonably assured.
Valuation of Inventories: Inventories are stated at the lower of cost or market,
using the first-in, first-out method. Inventory includes purchased parts and
components, work in process and finished goods. Provisions for excess, obsolete
or slow moving inventory are recorded after periodic evaluation of historical
sales, current economic trends, forecasted sales, estimated product lifecycles
and estimated inventory levels. Purchasing practices, electronic component
obsolescence, accuracy of sales and production forecasts, introduction of new
products, product lifecycles, product support and foreign regulations governing
hazardous materials are the factors that contribute to inventory valuation
risks. Exposure to inventory valuation risks is managed by maintaining safety
stocks, minimum purchase lots, managing product end-of-life issues brought on by
aging components or new product introductions, and by utilizing certain
inventory minimization strategies such as vendor-managed inventories. The
accounting estimate related to valuation of inventories is considered a
"critical accounting estimate" because it is susceptible to changes from
period-to-period due to the requirement for management to make estimates
relative to each of the underlying factors ranging from purchasing, to sales, to
production, to after-sale support. If actual demand, market conditions or
product lifecycles are adversely different from those estimated, inventory
adjustments to lower market values would result in a reduction to the carrying
value of inventory, an increase in inventory write-offs and a decrease to gross
margins.
Income Taxes: Income taxes are accounted for using the asset and liability
approach which requires recognition of deferred tax liabilities and assets for
the expected future tax consequences of the temporary differences between the
carrying amounts and the tax basis of such assets and liabilities. A valuation
allowance is recorded to reduce deferred tax assets to the amount that is more
likely than not to be realized. The accounting estimate related to income taxes
is considered a "critical accounting estimate" because judgment is exercised in
estimating future taxable income, including prudent and feasible tax planning
strategies, and in assessing the need for any valuation allowance. If it should
be determined that all or part of a net deferred tax asset is not able to be
realized in the future, an adjustment to the deferred tax asset would be charged
to income in the period such determination was made. Likewise, in the event that
it should be determined that all or part of a deferred tax asset in the future
is in excess of the net recorded amount, an adjustment to the deferred tax asset
would increase income in the period such determination was made.
Product Warranty: Warranty obligations are incurred in connection with the sale
of certain products. The warranty period for these products is generally one
year. The costs incurred to provide for these warranty obligations are estimated
and recorded as an accrued liability at the time of sale. Future warranty costs
are estimated based on historical performance rates and related costs to repair
given products. The accounting estimate related to product warranty is
considered a "critical accounting estimate" because judgment is exercised in
determining future estimated warranty costs. Should actual performance rates or
repair costs differ from estimates, revisions to the estimated warranty
liability would be required.
Carrying Value of Goodwill: Tests for impairments of goodwill are conducted
annually, at year end, or more frequently if circumstances indicate that the
asset might be impaired. The accounting estimate related to impairment of
goodwill is considered a "critical accounting estimate" because these impairment
tests include estimates of future cash flows that are dependent upon subjective
assumptions regarding future operating results including growth rates, discount
rates, capital requirements and other factors that impact the estimated fair
value. An impairment loss is recognized to the extent that the goodwill's
carrying amount exceeds its fair value.
Stock-Based Compensation: Stock options are granted to purchase our common
stock. Under the provisions of SFAS No. 123(R), stock compensation expense is
recorded based upon the fair value of the stock option at the date of grant. The
accounting estimate related to stock-based compensation is considered a
"critical accounting estimate" because estimates are made in calculating
compensation expense including: expected option lives, forfeiture rates and
expected volatility. Expected option lives are estimated using vesting terms and
contractual lives. Expected forfeiture rates and volatility are calculated using
historical information. Actual option lives and forfeiture rates may be
different from estimates and may result in potential future adjustments which
would impact the amount of stock-based compensation expense recorded in a
particular period.
Restructuring Costs: Restructuring costs consist of employee-related severance
costs, lease termination costs and other facility related closing expenses.
Employee-related severance benefits are estimated and recorded pro-rata over the
period of each planned restructuring activity. The accounting estimate related
to restructuring costs is considered a "critical accounting estimate" because
estimates are made in calculating the amount of employee-related severance
benefits that will ultimately be paid in future periods. Actual amounts paid for
employee-related severance benefits can vary from these estimates depending upon
the number of employees actually receiving severance payments.
Overview
The following contains forward-looking statements within the meaning of the
Securities Act of 1933 and Securities Exchange Act of 1934 and these
forward-looking statements are subject to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995.
The Company is a leading developer of communications platforms and systems for
the communications market. We target three vertical markets: telecommunications,
defense and homeland security, and commercial. Of the three vertical markets
served, telecommunications is the largest and represents approximately 80% of
our business. An approximate breakdown of the telecommunications applications
that utilize our products is as follows: Voice-over-IP (VoIP) represents 40%,
wireless infrastructure represents 40%, and the remaining 20% is spread across
IP multimedia systems and other applications.
Our products are marketed through a direct worldwide sales force under a variety
of brand names including IPnexus(TM), SEGway(TM), NexusWare(TM) and Advanced
Managed Platforms(TM). These products are based on open standards and are sold
as fully integrated, purpose built, application ready platforms, or as
individual blade components for the embedded communications marketplace. When
sold as platforms, known as our Advanced Managed Platform products, our
customers can quickly move to the enhanced value steps of their products while
realizing distinct cost advantages, increased overall system reliability and
performance, and improved time-to-market. Since its introduction in 2003, our
Advanced Managed Platform product line has realized more than 33 new design
wins. If successfully implemented by our customers, each is expected to generate
greater than $.5 million of annualized revenue when reaching production volumes.
In addition, we have realized more than 35 new design wins for blade solutions
in this same time period. Design wins are subject to risks and uncertainties,
and therefore not all design wins are expected to result in production orders.
A company-wide transformation began in early 2006 which we believe will
establish the foundation upon which the Company may reach its aggressive growth
goals. This transformation is moving the Company from its traditional
engineering and technology focus to a stronger emphasis on sales and marketing.
Since the beginning of the year, we have made investments by hiring several new
sales, marketing and sales support professionals to bolster our sales
organization. These include senior sales executives for global sales, signaling
sales and European sales. We have largely completed the transformation plan for
the sales organization with this hiring.
We recognize the need to balance investments in sales and marketing with
projected revenue growth and expense reductions in other areas of the business.
We instituted a reduction-in-force during the second quarter 2006 and tempered
hiring in departments other than sales.
During the first six months of the year, a number of expense reductions were
initiated including the closing of the Norwood engineering facility.
Restructuring costs totaled $.6 million and $1.0 million in the second quarter
and for the six months ended June 30, 2006, respectively. Savings from these
cost reduction actions (i.e., elimination of employee and facility expenses) are
expected to be realized beginning in the third quarter 2006. In addition, our
San Luis Obispo operation is expected to be relocated to a smaller more
economical facility within the same city during the third quarter 2006.
The Restriction of Certain Hazardous Substances ("RoHS") Directive issued by the
European Union (EU) became effective on July 1, 2006. This directive restricts
the distribution of products within the EU that exceed very low maximum
concentration values of certain substances, including lead. In the second
quarter 2006, a charge was recorded to cost of goods sold for excess
non-compliant "RoHS" inventory, which is not expected to be sold, in the amount
of $.8 million. No further significant non-compliant RoHS inventory charges are
expected.
The telecommunications equipment manufacturer market is dependent upon carrier
spending to upgrade network infrastructure to next-generation equipment. During
the second quarter 2006, expectations for telecom equipment suppliers moved
sharply lower amid concerns of a slowdown in capital spending by telecom
carriers and service providers. In particular, investments by U.S. wireless
carriers in third generation mobile networks continued to be selective during
the second quarter 2006 and impacted a number of our customers that sell
solutions into this market. Despite these market conditions, sales increased 21%
in the second quarter from the corresponding quarter in 2005 and 7% from the
first quarter 2006.
Strategy
The Company has a history of successfully adapting its products and services to
a constantly changing technology-driven marketplace. This adaptation has been
demonstrated through the course of several business cycles that have occurred
since the Company's founding in 1981.
Through acquisitions and internal investments since 2002, we believe the Company
has moved from a position of addressing approximately 20% of the available
potential market to a position of currently addressing over 60% of the available
potential market.
Beginning in 2003, a new product strategy was adopted. This strategy
repositioned the Company to deliver fully managed, system-level platform
solutions to the embedded communications marketplace. This line of platform
solutions specifically addresses equipment manufacturers' requirements for an
increased level of system integration and services from suppliers, thus allowing
them to focus on their value-added stages of product development, which in most
cases is application software. The Company's strategy also enables its customers
to replace proprietary or legacy platforms with the latest generation of
platform solutions.
The Company's goal is to drive sustained and profitable revenue growth. The
Company expects to achieve this objective through a combination of organic
growth and acquisitions. A company-wide transformation began in early 2006 which
will establish the foundation upon which the Company expects to reach its
aggressive growth goals. This transformation is moving the Company from its
traditional engineering and technology focus to a stronger emphasis on sales and
marketing. One key element of this plan is the Everest Account Sales Program,
which focuses on major international telecommunications companies, which the
Company refers to as "Global Tier 1" customers, using a partner and solution
selling approach. By focusing on Global Tier 1 customers, the Company believes
it can replicate its sales successes with its existing largest Global Tier 1
customers and use those sales as an engine for growth.
There are identifiable risks associated with carrying out the Company's growth
strategy in the current uncertain economic climate. Many of the Company's end
markets are forecasted to show only modest growth in the near term. In order to
realize growth in this environment, the Company will have to gain market share
from competitors, many of which are larger, more established companies with
greater resources than the Company's. The Company believes that its strategy to
increase emphasis on sales and marketing while continuing to invest in new
product development will enable the Company to compete in this economic
environment.
Financial Information
Revenue:
-------
Revenue in the second quarter 2006 amounted to $13.1 million, compared to $10.8
million in the corresponding quarter a year earlier. Revenue for the six months
ended June 30, 2006 amounted to $25.2 million, compared to $24.0 million during
the corresponding period in 2005.
Earnings:
--------
Net income for the second quarter 2006 totaled $.1 million, or $.01 per diluted
share, based on 13.4 million shares outstanding and included:
o A charge for non-compliant RoHS inventory of $.8 million, or $.04 per
diluted share.
o Restructuring charges of $.6 million, or $.03 per diluted share, primarily
related to the closing of our Norwood engineering center.
o Stock compensation expense of $.2 million, or $.01 per diluted share.
The diluted per share amounts above are calculated based upon a statutory
income tax rate of 38%.
Net income for the second quarter 2005 amounted to $.2 million, or $.02 per
diluted share and included restructuring charges of $.1 million, or $.01 per
diluted share, based on 13.0 million shares outstanding.
Net income for the six months ended June 30, 2006 amounted to $.6 million, or
$.05 per diluted share, based on 13.3 million shares outstanding and included:
o A charge for non-compliant RoHS inventory of $.8 million, or $.04 per
diluted share.
o Restructuring charges of $1.0 million, or $.05 per diluted share,
primarily related to the closing of our Norwood engineering center.
o Stock compensation expense of $.3 million, or $.01 per diluted share.
The diluted per share amounts above are calculated based upon a statutory
income tax rate of 38%.
Net income for the six months ended June 30, 2005 amounted to $1.3 million, or
$.10 per diluted share, including restructuring charges related to cost
improvement efforts amounting to $.2 million, or $.01 per diluted share, based
on 13.1 million shares outstanding.
Liquidity:
---------
Cash, cash equivalents and investments amounted to $32.5 million and $33.0
million at June 30, 2006 and December 31, 2005, respectively. We had no
long-term debt at either date.
Centralization of Functions:
---------------------------
In January 2006, a plan was announced to close our engineering center in
Norwood, Massachusetts and transfer product development and customer support for
the voice technology products to our other engineering centers. This program was
completed in May 2006. Restructuring expenses in the second quarter 2006 and for
the six months ended June 30, 2006 totaled $.6 million and $1.0 million,
respectively, primarily related to these efforts.
During the third quarter, our operation in San Luis Obispo, California, is
expected to be relocated to a new facility in San Luis Obispo and our signaling
organization in Ottawa is expected to be relocated to a new facility in Kanata,
Ontario, outside of Ottawa.
Key Performance Indicators:
Our communications products, platforms and systems are incorporated into current
and next-generation embedded systems infrastructure. Traditionally, "design
wins" have been an important metric for us to judge our product acceptance in
our marketplace. Design wins, if successfully implemented by our customers,
reach production volumes at varying rates, generally beginning twelve to
eighteen months after the design win occurs. A variety of risks such as schedule
delays, cancellations, changes in customer markets and economic conditions can
adversely affect a design win before production is reached, or during
deployment.
During the second quarter 2006, we earned two design wins for our Advanced
Managed Platform (with multiple products) (1) and switch products (1). During
the second quarter 2005, the Company earned six design wins for its advanced
managed platform solutions (with multiple products) (3), individual blade design
wins for IPnexus network access (2) and for a product that combines the
technologies of network access and voice processing (1). Each design win is
expected to generate at least $.5 million of annualized revenue when reaching
production volumes. Not all design wins are expected to result in production
orders. Beginning in 2006, our sales organization is focusing on realizing
larger, high revenue potential design wins with Global Tier 1 customers, and
therefore we expect to report fewer design wins.
We believe that another key indicator for our business is the volume of orders
received from our customers. During weak economic periods, customers' visibility
deteriorates causing delays in the placement of orders. While forward-looking
visibility of customer orders continues to be limited, sales to customers in the
second quarter 2006 amounted to $13.1 million, compared to $10.8 million in the
second quarter 2005. While sales to the Company's largest customer declined
during the second quarter 2006, sales to other customers increased contributing
to the overall sales increase.
More in-depth discussions of our strategy and financial performance can be found
in our Annual Report on Form 10-K and other filings with the Securities and
Exchange Commission.
Three and Six Months Ended June 30, 2006, compared with
the Three and Six Months Ended June 30, 2005
The following table presents the percentage of sales represented by each item in
our consolidated statements of income for the periods indicated.
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
--------- --------- --------- ---------
Sales 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 47.1 54.8 48.0 51.7
Non RoHS inventory charge 6.1 3.2
--------- --------- --------- ---------
Gross profit 46.8 45.2 48.8 48.3
--------- --------- --------- ---------
Operating expenses:
Selling and marketing 11.1 12.7 11.2 11.9
Research and development 22.8 21.5 22.9 20.3
General and administrative 11.2 10.1 10.9 10.5
Restructuring charges 4.3 1.3 3.9 0.8
--------- --------- --------- ---------
Total operating expenses 49.4 45.6 48.9 43.5
--------- --------- --------- ---------
(Loss) income from operations (2.6) (0.4) (0.1) 4.8
Other income, net 2.8 3.1 2.8 2.6
--------- --------- --------- ---------
Income before income taxes 0.2 2.7 2.7 7.4
Income tax (benefit) provision (0.4) 0.8 0.2 2.2
--------- --------- --------- ---------
Net income 0.6% 1.9% 2.5% 5.2%
========= ========= ========= =========
Sales. Total revenue for the second quarter 2006 amounted to $13.1 million,
compared to $10.8 million for the corresponding quarter in 2005. Revenue for the
six months ended June 30, 2006 totaled $25.2 million, compared to $24.0 million
for the comparable period in 2005.
In the second quarter 2006, one customer represented 17% of our sales and
another customer represented 10% of our sales. Our four largest customers
together represented 40% of sales. In the second quarter 2005, the Company had
two customers that each represented greater than 10% of sales, and the four
largest customers together represented 42% of sales. For the six months ended
June 30, 2006, one customer represented 19% of our sales and our four largest
customers together represented 40% of sales. For the six months ended June 30,
2005, there were two customers that each represented greater than 10% of revenue
and our four largest customers together contributed 45% to revenue.
Sales to customers outside of the United States represented 43% and 49% of our
sales during the second quarter 2006 and 2005, respectively. Sales to customers
based in the United Kingdom represented 12% and 18% of revenue in the second
quarter 2006 and 2005, respectively.
For the six months ended June 30, 2006 and 2005, sales to customers outside of
the United States represented 44% and 40% of sales, respectively. Sales to
customers based in the United Kingdom represented 11% and 12% of revenue for the
six months ended June 30, 2006 and 2005, respectively.
Beginning in 2006, our products are grouped into three distinct categories in
one market segment: Communications (network access, signaling and voice)
products, Computing products and Switching products. Revenue from each product
category is expressed as a percentage of sales for the periods indicated:
Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
--------- --------- --------- ---------
Communications 52% 49% 50% 49%
Computing 26% 32% 23% 26%
Switching 22% 18% 27% 24%
Other 1% 1%
--------- --------- --------- ---------
Total 100% 100% 100% 100%
========= ========= ========= =========
Communications products:
Communications products are comprised of network access, SEGway signaling and
Voice Technology products. Network access products provide a connection between
a variety of voice, data and signaling networks and embedded systems platforms
that are used to control the network and/or process information being
transported over networks. This family includes a complete line of
communications protocols. Many of our signaling products provide a signaling
bridge between traditional telephone networks and the growing IP packet-switched
network, and enable the transport of signaling messages over IP networks. Voice
Technology products enable voice, data and fax processing for communications
applications.
Revenue from Communications products amounted to $6.7 million and $5.3 million
in the second quarter of 2006 and 2005, respectively. This increase of $1.4
million, or 26%, was the result of greater demand from a variety of our
customers across this product category.
Revenue from Communications products amounted to $12.6 million and $11.7 million
in the six months ended June 30, 2006 and 2005, respectively. This increase in
business reflects a combination of factors including one major customer in 2005
that, due to market conditions, unexpectedly decreased product requirements
after the second quarter 2005, this decrease was offset by a greater demand from
a variety of customers across this product category.
Computing products:
Computing products include integrated platform solutions, a range of single
board computers, a variety of embedded system chassis and associated chassis
management products.
Computing products revenue amounted to $3.4 million and $3.5 million in the
second quarter 2006 and 2005, respectively. While the revenue in the comparative
periods was essentially consistent, there were fluctuations in sales to various
customers in this category.
For the six months ended June 30, 2006 and 2005, Computing products revenue
totaled $5.9 million, compared to $6.2 million, respectively. The decline in
revenue of $.3 million, or 5%, was primarily attributable to fluctuations in
sales to various customers in this category occurring in the first quarter 2006,
compared to the first quarter 2005.
Switching products:
Our Ethernet switch components operate as the "nexus" of the IP packet switching
functionality of the Advanced Managed Platforms.
Revenue from switching products amounted to $2.9 million in the second quarter
2006, compared to $1.9 million in the second quarter 2005. Approximately 70% of
this increase is attributable to one customer.
Switch revenue for the six months ended June 30, 2006 totaled $6.8 million,
compared to $5.8 million for the six months ended June 30, 2005. Of this
increase, one customer represented approximately 40% of this increase along with
growth from a variety of other customers.
Gross profit. Gross profit consists of sales, less cost of goods sold including
material costs, manufacturing expenses, depreciation, amortization of software
development costs, and expenses associated with engineering contracts and the
technical support function. Gross margin was 46.8% and 45.2% of sales for the
second quarter 2006 and 2005, respectively. The Restriction of Certain Hazardous
Substances ("RoHS") Directive issued by the European Union (EU) became effective
on July 1, 2006. This directive restricts the distribution of products within
the EU that exceed very low maximum concentration values of certain substances,
including lead. In the second quarter 2006, the Company recorded a charge to
cost of goods sold for excess non-compliant RoHS inventory, which is not
expected to be sold, in the amount of $.8 million, or 6.1% of revenue. Excluding
this charge, the increase in gross margin resulted from a change in sales mix
from lower margin products (e.g., Computing) to higher margin products (i.e.,
Switching and Communications). Gross margin for the quarter was also positively
impacted by higher production volumes as well as the benefits resulting from our
centralization efforts that took place in 2005. Included in cost of goods sold
is the amortization of software development costs which totaled $.4 million and
$.5 million in the second quarter 2006 and 2005, respectively.
Gross margin for the first six months of 2006 was 48.8% compared to 48.3% for
the first six months of 2005. Gross margin in 2006 was negatively impacted by
the $.8 million RoHS inventory charge described above. This charge was offset by
benefits resulting from a change in sales mix (lower margin products to higher
margin products), increased production levels, and expense reductions resulting
from our centralization efforts that took place in 2005. Included in cost of
goods sold is the amortization of software development costs which totaled $.8
million and $.9 million for the six months ended June 30, 2006 and 2005,
respectively.
Total Operating Expenses. Total operating expenses in the second quarter 2006
amounted to $6.5 million, compared to $4.9 million in the same period of 2005.
Total operating expenses included stock compensation expense related to the
adoption of SFAS 123(R) on January 1, 2006 amounting to $.2 million in the
second quarter 2006.
Total operating expenses for the six months ended June 30, 2006 totaled $12.3
million, compared to $10.4 million in the corresponding period of 2005. Total
operating expenses included stock compensation expense amounting to $.3 million
for the six months ended June 30, 2006.
Selling and marketing expenses were $1.5 million and $1.4 million for the second
quarter 2006 and 2005, respectively, and $2.8 million in each of the first six
months of 2006 and 2005. Numerous personnel changes have occurred as part of the
Company's transformation plan in 2006, compared to the respective periods in
2005, but overall costs remained relatively constant for the reported periods.
Research and development expenses were $3.0 million and $2.3 million in the
second quarter 2006 and 2005, respectively. We capitalize certain software
development costs, which reduces the amount charged to operating expenses.
Amounts capitalized were $.5 million and $.7 million during the second quarter
2006 and 2005, respectively. The increase in gross research and development
expenditures for the comparable period is primarily the result of increased
personnel costs and product development costs associated with new product
prototype builds.
For the six months ended June 30, 2006 and 2005, research and development
expenses totaled $5.8 million and $4.9 million, respectively. Amounts
capitalized were $1.0 million and $1.3 million for the six month periods in 2006
and 2005, respectively. The increase in gross expenditures for the comparative
six month periods is primarily the result of increased personnel costs and
product development costs associated with new product prototype builds.
General and administrative expenses were $1.5 million in the second quarter
2006, compared to $1.1 million in the second quarter 2005. For the six months
ended June 30, 2006 and 2005, general and administrative expenses totaled
$2.7 million and $2.5 million, respectively. The increase in expenses for both
comparative periods is primarily related to higher corporate governance costs
and the recording of stock based compensation expense.
Restructuring charges amounted to $.6 million in the second quarter 2006,
compared to $.1 million during the second quarter 2005. For the six months ended
June 30, 2006, restructuring expenses totaled $1.0 million, compared to $.2
million in the comparable 2005 period. Restructuring charges in 2006 are
primarily related to severance and facility expenses incurred for the closing of
our Norwood, Massachusetts engineering center. Restructuring charges in 2005
relate primarily to severance expenses associated with our efforts to centralize
our operations.
Other Income, net. Other income consists primarily of interest income. Our funds
are primarily invested in high quality auction rate municipal securities. An
increase in the funds available for investment as well as higher interest rates
in 2006 resulted in an increase in interest income. Interest income in 2005 also
included interest income from a note receivable from an unconsolidated company.
Income taxes. The effective income tax rate is a combination of federal, state
and foreign tax rates and is generally lower than statutory rates because it
includes benefits derived from our international operations, research
activities, tax exempt interest and foreign sales. For the second quarter 2006,
the effective tax rate was a benefit of 200%. This rate was the result
of a combination of an adjustment to the annual expected effective tax rate to
18% and a discrete tax benefit of $.1 million, which was related to a previously
unused tax credit. The effective rate for the six month period ended
June 30, 2006 was 9%. The effective tax rate was 29% for both the second quarter
and the first six months of 2005.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of liquidity are cash, cash equivalents and investments,
which together totaled $32.5 million at June 30, 2006. The Company had working
capital of $48.3 million and $46.8 million at June 30, 2006 and December 31,
2005, respectively.
Cash provided by operating activities amounted to $.5 million for the six months
ended June 30, 2006. This amount included net income of $.6 million and a
depreciation and amortization charge of $1.2 million. Cash provided by
operations due to changes in operating assets and liabilities included a
decrease in cash associated with an increase in accounts receivable of $1.6
million and a decrease in accounts payable and accrued expenses of $.9 million.
The increase in accounts receivable is related to increased sales in the final
month of the second quarter 2006. The decrease in accounts payable and accrued
expenses is related to the timing of payments. Cash from operating activities
also increased as a result of a decrease in inventory of $.7 million.
On July 1, 2006, the RoHS Directive issued by the EU became effective. This
directive restricts the distribution of products within the EU that exceed very
low maximum concentration values of certain substances, including lead. During
the second quarter 2006, a charge was recorded in the amount of $.8 million for
non-compliant RoHS inventory not expected to be sold in the future. No further
significant non-compliant RoHS inventory charges are expected.
Cash used by investing activities during the first six months of 2006 totaled
$1.5 million. This utilization was primarily the result of capital asset
purchases of $.6 million and the capitalization of software development costs
amounting to $.9 million.
Cash provided by financing activities for the first six months of 2006 amounted
to $.6 million, resulting from the exercise of stock options. On July 11, 2005,
our Board of Directors authorized the Company to repurchase shares of our common
stock for an aggregate amount not to exceed $10.0 million. In July 2006, this
program was extended to July 13, 2007. Under this program, shares of our common
stock may be repurchased through open market or private transactions, including
block purchases. Repurchased shares can be used for our stock option plans,
potential acquisition initiatives and general corporate purposes. To date, there
have been no repurchases of shares under the original or the extended program.
Off-Balance Sheet Arrangements:
No off-balance sheet arrangements were entered into during the first six months
of 2006.
Contractual Obligations:
During the second quarter 2006, a lease agreement was entered into for a new
facility in the Ottawa, Canada area. The term of this lease extends from August
1, 2006 to October 31, 2011. Our Ottawa operation is expected to relocate to
this facility during the third quarter 2006.
In July 2006, the Company entered into a two-year lease for a facility in the
San Luis Obispo area which commences on September 1, 2006. During the third
quarter 2006, our San Luis Obispo operation is expected to relocate to this
facility.
For both lease agreements, the Company is required to pay the pro rata share of
the real property taxes and assessments, expenses and other charges associated
with these facilities.
Future minimum payments under these two new leases are as follows:
Amount
-----------------
2006 $ 75,000
2007 244,000
2008 224,000
2009 169,000
2010 181,000
Thereafter 151,000
-----------------
Total $ 1,044,000
=================
No other significant contractual obligations were entered into during the first
six months of 2006.
Current Position:
Assuming there is no significant change in our business, we believe that the
Company's current cash, cash equivalents and investments, together with cash
generated from operations and a line of credit available on a bank credit
facility, should be sufficient to meet our anticipated cash requirements,
including working capital and capital expenditure requirements, for at least the
next twelve months. However, we are continuing to evaluate strategic
acquisitions to further accelerate our growth and market penetration efforts.
These strategic acquisition efforts could have an impact on our working capital,
liquidity or capital resources and we may raise additional capital to facilitate
these efforts.
RECENT ACCOUNTING PRONOUNCEMENTS
On January 1, 2006, the Company adopted SFAS No. 151, "Inventory Costs - An
Amendment of ARB No. 43, Chapter 4". SFAS No. 151 states that abnormal amounts
of idle facility expense, freight, handling costs, and wasted material
(spoilage) should be recognized as current-period charges. This adoption did not
have a material impact on the Company's consolidated results of operations and
financial condition.
In July 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" (FIN 48).
FIN 48 clarifies the accounting and reporting for income taxes recognized in
accordance with SFAS No. 109, "Accounting for Income Taxes." This Interpretation
prescribes a comprehensive model for the financial statement recognition,
measurement, presentation and disclosure of uncertain tax positions taken or
expected to be taken in income tax returns. The Company is currently evaluating
the impact of FIN 48. The Company will adopt this Interpretation in the first
quarter of 2007.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
This quarterly report on Form 10-Q contains forward-looking statements, which
reflect our current views with respect to future events and financial
performance, within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 and is subject to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements are subject to certain risks and uncertainties,
including those identified below, which could cause actual results to differ
materially from historical results or those anticipated. The words "believes,"
"anticipates," "plans," "may," "intend," "estimate," "will," "should," "could,"
"feels," "is optimistic," "expects," and other expressions which indicate future
events and trends also identify forward-looking statements. However, the absence
of such words does not mean that a statement is not forward-looking.
The future operating results of the Company are subject to various risks and
uncertainties and could differ materially from those discussed in the
forward-looking statements and may be affected by various trends and factors
which are beyond our control. These risks and uncertainties include, among other
factors, general business and economic conditions, rapid technological changes
accompanied by frequent new product introductions, competitive pressures,
dependence on key customers, the attainment of design wins and obtaining orders
as a result, fluctuations in quarterly and annual results, the reliance on a
limited number of third party suppliers, limitations of our manufacturing
capacity and arrangements, the protection of our proprietary technology, the
dependence on key personnel, changes in critical accounting estimates, potential
impairments related to goodwill and investments, and foreign regulations. These
statements should be read in conjunction with the audited Consolidated Financial
Statements, the Notes thereto, and Management's Discussion and Analysis of
Financial Condition and Results of Operations of the Company as of December 31,
2005, as reported in its Annual Report on Form 10-K, and other documents filed
with the Securities and Exchange Commission. Additional information related to
risk factors can be found in the Company's Annual Report on Form 10-K as of
December 31, 2005.
Stockholders are cautioned not to place undue reliance on the forward-looking
statements which speak as of the date of this quarterly report or the date of
the documents incorporated by reference in this quarterly report.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's assets are exposed to various market risks in the normal course of
business, primarily interest rate risk and changes in the market value of our
investments and we believe the exposure to such risk is minimal. Investments are
made in accordance with the investment policy and primarily consist of auction
rate municipal securities. The Company's assets are also subject to foreign
exchange risk related to our operations in Canada. We believe that the exposure
to foreign currency risk is minimal for the first half of 2006. Management does
not enter into the investment of derivative financial instruments.
ITEM 4. CONTROLS AND PROCEDURES
A. Evaluation of Disclosure Controls and Procedures
The Company's Chief Executive Officer and its Chief Financial Officer
evaluated the Company's disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period
covered by this quarterly report. Based on this evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective as of such date. During
the first quarter 2006, Management concluded that the Company's disclosure
controls and procedures were not effective due to a material weakness
related to the Company's internal control surrounding the accounting for
restructuring costs. Specifically, the control deficiency related to the
accounting for certain severance benefits. To address this material
weakness, the Company performed additional analysis in order to prepare
the unaudited quarterly consolidated financial statements for the first
quarter 2006 in accordance with generally accepted accounting principles
in the United States, which resulted in an adjustment to the unaudited
interim financial statements for the first quarter 2006. Accordingly,
management believes that the material weakness was remediated as of May
10, 2006 and that the financial statements for the first quarter 2006
were presented fairly.
B. Changes in Internal Control Over Financial Reporting
Except as noted above, there has been no change in the Company's internal
control over financial reporting that occurred during the fiscal quarter
covered by this report that has materially affected, or is reasonably
likely to materially affect, the Company's internal controls over
financial reporting.
PART II. OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The 2006 Annual Meeting of Stockholders was held on May 25, 2006. The Directors
elected at the meeting were as follows:
Votes Cast
Nominees For Withheld
-------- --- --------
Michael P. Skarzynski 11,776,765 352,329
Robert L. Tillman 11,858,162 270,932
John M. Slusser, Bernard Kozel, Charles E. Maginness, E. Mark Rajkowski and
Stuart B. Meisenzahl, continue as Directors until the next Annual Meeting, or
such times as their respective terms expire.
The stockholders also voted to ratify the appointment of PricewaterhouseCoopers
LLP as the Company's independent registered public accounting firm for 2006.
12,091,868 shares of common stock were voted in favor of this proposal, 30,685
shares of common stock were voted against this proposal, and 6,541 shares of
common stock abstained.
ITEM 6. EXHIBITS
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Section 1350 Certification
SIGNATURES
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.
PERFORMANCE TECHNOLOGIES, INCORPORATED
August 9, 2006 By:/s/ Michael P. Skarzynski
---------------------------------
Michael P. Skarzynski
President and
Chief Executive Officer
August 9, 2006 By:/s/ Dorrance W. Lamb
---------------------------------
Dorrance W. Lamb
Chief Financial Officer and
Senior Vice President of Finance
Exhibit 31.1
Certification of Chief Executive Officer
I, Michael P. Skarzynski, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Performance
Technologies, Incorporated;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
a. Designed such disclosure controls and procedures, or
caused such disclosure controls and procedures to be
designed under our supervision, to ensure that material
information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in
which this report is being prepared;
b. Designed such internal control over financial reporting,
or caused such internal control over financial reporting
to be designed under our supervision, to provide
reasonable assurance regarding the reliability of
financial reporting and the preparation of financial
statements for external purposes in accordance with
generally accepted accounting principles;
c. Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure
controls and procedures, as of the end of the period
covered by this report based on such evaluation; and
d. Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred
during the registrant's most recent fiscal quarter (the
registrant's fourth fiscal quarter in the case of an
annual report) that has materially affected, or is
reasonably likely to materially affect, the registrant's
internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
a. All significant deficiencies and material weaknesses in
the design or operation of internal control over financial
reporting which are reasonably likely to adversely affect
the registrant's ability to record, process, summarize and
report financial information; and
b. Any fraud, whether or not material, that involves
management or other employees who have a significant role
in the registrant's internal control over financial
reporting.
Date: August 9, 2006 By:/s/ Michael P. Skarzynski
------------------------------
Michael P. Skarzynski
Chief Executive Officer
Exhibit 31.2
Certification of Chief Financial Officer
I, Dorrance W. Lamb, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Performance
Technologies, Incorporated;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
a. Designed such disclosure controls and procedures, or
caused such disclosure controls and procedures to be
designed under our supervision, to ensure that material
information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in
which this report is being prepared;
b. Designed such internal control over financial reporting,
or caused such internal control over financial reporting
to be designed under our supervision, to provide
reasonable assurance regarding the reliability of
financial reporting and the preparation of financial
statements for external purposes in accordance with
generally accepted accounting principles;
c. Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure
controls and procedures, as of the end of the period
covered by this report based on such evaluation; and
d. Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred
during the registrant's most recent fiscal quarter (the
registrant's fourth fiscal quarter in the case of an
annual report) that has materially affected, or is
reasonably likely to materially affect, the registrant's
internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
a. All significant deficiencies and material weaknesses in
the design or operation of internal control over financial
reporting which are reasonably likely to adversely affect
the registrant's ability to record, process, summarize and
report financial information; and
b. Any fraud, whether or not material, that involves
management or other employees who have a significant role
in the registrant's internal control over financial
reporting.
Date: August 9, 2006 By:/s/ Dorrance W. Lamb
-------------------------------
Dorrance W. Lamb
Chief Financial Officer
Exhibit 32.1
Section 1350 Certification
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 ("Section 906"), Michael P. Skarzynski and Dorrance
W. Lamb, the Chief Executive Officer and Chief Financial Officer, respectively,
of Performance Technologies, Incorporated, certify that (i) the quarterly report
on Form 10-Q for the quarter ended June 30, 2006 fully complies with the
requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934
and (ii) the information contained in such report fairly presents, in all
material respects, the financial condition and results of operations of
Performance Technologies, Incorporated.
A signed original of this written statement required by Section 906 has been
provided to Performance Technologies, Incorporated and will be retained by
Performance Technologies, Incorporated and furnished to the Securities and
Exchange Commission or its staff upon request.
Date: August 9, 2006 By:/s/ Michael P. Skarzynski
-------------------------------
Michael P. Skarzynski
President and
Chief Executive Officer
Date: August 9, 2006 By:/s/ Dorrance W. Lamb
-------------------------------
Dorrance W. Lamb
Chief Financial Officer and
Senior Vice President of Finance