RESULTS OF OPERATIONS

Net sales increased 1 % to $7,709,000 for the quarter ended June 30, 2006, as compared to the same quarter a year ago.  The increase was primarily the result of increasing EFO sales and completion of the first milestone for the US navy ship project described in the next paragraph. EFO sales were $938,000 for the second quarter compared to $456,000 for the second quarter of 2005.  Net sales for the first six months of 2006 were $13,037,000 compared to net sales of $14,465,000 for the same period in 2005, a decrease of 10%.  The decrease is due to a 15% decline in the traditional commercial lighting business and a 12% decline in the pool business offset by a 57% increase in EFO sales which were $1,201,000 for the first six months compared to $766,000 for the same period in 2005. We expect net sales for 2006 to be comparable to 2005 as a result of an increase in EFO sales offsetting a decline in traditional fiber optic sales.  However, the market for our products is highly dependent upon general economic conditions.

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On March 31, 2006, we announced that we had received funding from DARPA for $2.1 million to develop and install our high efficiency distributed lighting systems as a “commercial” product on three US Navy ships.  This project will result in revenue being recognized on a percentage of completion basis as milestones are completed over the next two years.

Gross profit was $2,328,000 in the second quarter of fiscal 2006, a 20% decrease compared to the same period in the prior year.  The gross profit margin as a percentage of sales decreased from 38% for the second quarter of fiscal 2005 to 30 % for the second quarter of 2006.  Gross profit margin declined primarily due to lower gross profit margins on commercial lighting sales due to EFO introduction, increased competition in Europe requiring more competitive pricing and new product start-up costs.  Gross profit for the first six months of 2006 was $3,931,000, a decrease of 28% over gross profit margins for the same period in 2005.   This represents gross profit margins of 30% for the first six months of 2006 compared to 38% in 2005.  The decline was expected due to the introduction of EFO, which has lower margins.  It was also a result of lower margins in Europe due to increased competition and new product start-up costs.  We expect gross profit margins for the full 2006 year, to be lower than 2005, assuming general economic conditions remain consistent.

Research and development expenses were $ 436,000 in the second quarter of fiscal 2006, an increase of $36,000 compared with the second quarter of fiscal 2005.  Our research and development expense are reduced by credits received for achieving milestones under a development contract with the Department of Energy, “DOE” that was signed in 2005 for a total of $1.5 million.  In addition, further awards were taken for a Small Business Innovative Research award with the Defense Advanced Research Projects Agency, “DARPA” totaling $199,000 signed in October, 2005.   Gross research and development expenses were $1,656,000 in the first 6 months of 2006, nearly equal to research and development expense for the same period in 2005.  The gross research and development spending along with credits from government contracts is shown in the table:

 

		Three months ended June 30, 2006						Six months ended June 30, 2006
		(in thousands)						(in thousands)
		2006			2005			2006			2005
Gross expenses for research and development		$	777		$	780		$	1,656		$	1,661
Deduct:  credits from DARPA & DOE contracts			(341	)		(380	)		(765	)		(784	)
Net  research and development expense		$	436		$	400		$	891		$	877

We expect research and development expense to increase for the full year 2006 compared to 2005 due to reduced DARPA credits and recording option expense under FAS 123R.

Sales and marketing expenses increased by 9% to $2,609,000  in the second quarter of fiscal 2006 as compared to $2,388,000  for the same period in fiscal 2005.  This increase was largely due to increased spending on Pools and EFO sales and marketing ($307,000).  Sales and marketing expense increased by 3% to $4,853,000 in the first six months of 2006 as compared to the same period in 2005.  This was due to lower commissions ($222,000) offset by higher spending on EFO and Pools sales and marketing ($368,000).  We expect sales and marketing expenses to increase for the full year 2006 as we anticipate increasing our sales and marketing efforts for our new products.

General and administrative expenses were $1,537,000 in the second quarter of fiscal 2006, an increase of 106% compared to the second quarter of fiscal 2005.  The increase was primarily due to the impact of expense recognized under FAS123R ($351,000) and Sarbanes Oxley ($258,000).  We will be required to comply with Section 404 of the Sarbanes-Oxley Act of 2002 for December 31, 2006. Estimates of costs required in order to comply with Section 404 for a company of our size range in the order of $600,000 or higher, independent of additional audit fees.  These additional expenses will be incurred in the remainder of fiscal year 2006. General and administrative expenses were $2,615,000 for the first six months of 2006 compared to $1,558,000 for the same period in 2005.  The increase is for the same reasons described above for the second quarter.  We expect general and administrative expenses to continue to increase in 2006 as compared to 2005 due to anticipated higher administration accounting costs and expenses associated with the impact of the Sarbanes- Oxley Act of 2002 and option expense under FAS123R.

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In June 2005, we announced our plans to close our Fremont office and consolidate most of our operations in Solon, Ohio, where we have a local sales office and a manufacturing facility. The relocation resulted in a restructuring charge of approximately $3.1 million for severance payments, redundancy, and lease and inventory write-offs for the fiscal year 2005. During the first half of 2006, we charged to operations $636,000 for costs associated with this restructuring.  We expect to spend an additional $200,000 for restructuring in the third quarter of 2006 bringing our final total restructuring cost to $4,000,000.  We expect the total restructuring to produce cost savings of between $1.5 million and $2 million on an annual basis, with the savings beginning in Q3 of 2006.  These savings will be reflected largely in reduced cost of sales with a lesser amount in operating expenses.  These savings are being offset by expense increases as a result of building capacity and increasing expenses for development, sales and marketing of new products, primarily EFO, and also new pool lighting products.

 

We recorded a net loss of $2,299,000 in the second quarter of fiscal 2006 as compared to a net loss of $763,000 in the second quarter of fiscal 2005. The net loss for the six months ending June 30, 2006 and 2005 was $4,741,000 and $1,813,000, respectively. The net loss in 2006 was due primarily to soft sales, reduced margin from changes in product mix, and higher operating expenses.

 

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents

At June 30, 2006, our cash and cash equivalents were $589,000 as compared to $5,554,000 at December 31, 2005, a net cash decrease of $4,965,000 during the first six months of 2006.  This compares to a net cash decrease of $260,000 for the same period in 2005, and an ending cash balance of $3,349,000 as of June 30, 2005

Due to seasonality in the sales of our pool lighting products, our cash balances tend to decrease in the first half of the year and increase in the second half of the year.  This year we expect there to be some cash utilization in the second half of the year due to increased investment in new products, however at a slower rate than in the first half.  This is subject to the condition that the market for our products is highly dependent upon general economic conditions.

Cash was used in the period to purchase fixed assets and pay other accruals from December 31, 2005 relating to costs incurred in 2005 for our restructuring and resolution of legal commitments.

Cash Used in Investing Activities

Investing activities used cash of $1,797,000 during the first six months of 2006, compared to a use of cash of $464,000 for the same period of 2005.  During both periods, cash was used for the acquisition of fixed assets. Fixed asset purchases from ADLT were $1,325,000 in the first six months of 2006 and $1,092,000 in 2005.  The increase was due to additional fixed assets required in order to move forward with the EFO product line and future R & D efforts.

Cash Provided by Financing Activities

Financing activities contributed $2,651,000 to cash during the first six months of 2006.  This net contribution was due primarily from long and short term borrowings of $2,325,000 and the exercise of employee stock options for $473,000.  For the same period in 2005, financing activities, from the exercise of warrants and employee stock options, were $1,356,000. 

The Company had a $5,000,000 Loan and Security Agreement (Accounts Receivable and Inventory) dated August 15, 2005, with Silicon Valley Bank bearing interest equal to prime plus 1.75% per annum computed daily.   Borrowings under this Loan and Security Agreement were collateralized by its assets and intellectual property.  Specific borrowings were tied to accounts receivable and inventory balances, and the Company is required to comply with certain covenants with respect to effective net worth. The Company had $1,000,000 of borrowings against this facility as of June 30, 2006 and no borrowings at December 31, 2005.  The Company had total borrowings of $2,252,000 under the term-loan agreement as of June 30, 2006 and $1,092,000 as of December 31, 2005.  The Company was in conformity with the bank covenants of the Silicon Valley Bank agreement as of June 30, 2006.  

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Through our U.K. subsidiary, we maintain a $462,000 (in UK pounds sterling based on the exchange rate at June 30, 2006) bank overdraft agreement with Lloyds Bank Plc through its UK subsidiary.  There were no borrowings against this facility as of June 30, 2006 and December 31, 2005.  The facility is renewed annually on January 1 and bears an interest rate of 7%.

Through our German subsidiary, we maintain a credit facility under an agreement with Sparkasse Neumarkt Bank.  This credit facility is in place to finance, and is secured by, our offices owned and occupied by our German subsidiary.   As of June 30, 2006, we had total borrowings of $389,000 (in Euros, based on the exchange rate at June 30, 2006) against this credit facility.  As of December 31, 2005, we had $331,000 (in Euros, based on the exchange rate at December 31, 2005) borrowed against this facility.    Additionally, we have a revolving line of credit of $192,000 (in Euros, based on the exchange rate at June 30, 2006) with Sparkasse Neumarkt Bank.  As of June 30, 2006, there were no borrowings against this facility, and there were $47,000 of borrowings against this facility as of December 31, 2005(in Euros, based on the exchange rate at December 31, 2005).  The facility is renewed annually on January 1 and bears an interest rate of 8.75%.

We believe that our existing cash balances and funds available to us through our bank lines of credit together with funds that we anticipate generating from our operations, will be sufficient to finance our currently anticipated working capital requirements and capital expenditure requirements for the next twelve months.   However, a sudden increase in product demand requiring a significant increase in manufacturing capability, or unforeseen adverse competitive, economic or other factors may impact our cash position, and thereby affect operations.   From time to time we may be required to raise additional funds through public or private financing, strategic relationships or other arrangements.   There can be no assurance that such funding, if needed, will be available on terms acceptable to us, or at all.   Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants.  Strategic arrangements, if necessary to raise additional funds, may require that we relinquish rights to certain of our technologies or products.   Failure to generate sufficient revenues or to raise capital when needed could have an adverse impact on our business, operating results and financial condition, as well as our ability to achieve intended business objectives.

Recently Issued Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004) or SFAS 123R, “Share-Based Payments.”  SFAS 123R requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. We applied SFAS 123R on a modified prospective method. Under this method, we recorded compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption.

In December 2004, the FASB issued SFAS No.151, “Inventory Costs,” which amends part of ARB 43, “Inventory Pricing,” concerning the treatment of certain types of inventory costs.  The provisions of ARB No. 43 provided that certain inventory-related costs, such as double freight, re-handling, might be “so abnormal” that they should be charged against current earnings rather than be included in the cost of inventory and, that is capitalized to future periods. As amended by SFAS No. 151, the “so-abnormal” criterion has been eliminated. Thus, all such “abnormal” costs are required to be treated as current-period charges under all circumstances. In addition, fixed production overhead should be allocated based on the normal capacity of the production facilities, with unallocated overhead charged to expense when incurred.  SFAS 151 is required to be adopted for fiscal years beginning after June 15, 2005. The impacts of adopting SFAS No.15 did not have a material impact on our overall financial position.

In July, 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” providing guidance on the accounting for and reporting of accounting changes and error corrections.  The standard is effective for fiscal years beginning after December 15, 2006. The impact of adopting SFAS 154 did not have a material impact on our financial reporting.

In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement 109. FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements pretax positions taken or expected to be taken on a tax return, including the decision whether to file or not to file in a particular jurisdiction. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of FIN 48 on its consolidated financial position and results of operations.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of June 30, 2006, we had $588,000 in cash held in foreign currencies based on the exchange rates at June 30, 2006. The balances for cash held overseas in foreign currencies are subject to exchange rate risk. We have a policy of maintaining cash balances in local currencies unless an amount of cash is occasionally transferred in order to repay inter-company debts.

As of June 30, 2006, we had no borrowings against a credit facility secured by real property owned by our German subsidiary.  As of December 31, 2005, we had $47,000 (in Euros, based on the exchange rate at December 31, 2005) borrowed against this credit facility.

 

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures.  

 

We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet, and management believes they meet, reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.

 

(b) Changes in internal control over financial reporting.  

 

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II  -  OTHER INFORMATION

 

Item 1. Legal Proceedings

On March 6, 2006, Ohms Electric, Inc. filed a complaint against Fiberstars, Inc. with the 30th Judicial Circuit Court in the State of Michigan.  The complaint requests unspecified damages as a result of the Company’s product not working properly at Neighborhood Cinema in Lansing, Michigan.  Management does not believe the suit will have a material affect on our financial condition.

Item 1A.  Risk Factors

There are no significant changes in risk factors from our December 31, 2005 filed 10-K.

Item 4. Submission of  Matters to a Vote of Security Holders

The Company held its annual meeting on June 15, 2006.  The meeting was adjourned until July 6, 2006, when it was completed.  The matters considered at the meeting and the shareholder votes, were as follows:

Proposal 1:  Election of Directors		For			Withheld
John M Davenport			9,995,598			178,216
John B Stuppin			10,009,329			164,485
Jeffrey H Brite			9,923,729			250,085
Ronald A Casentini			9,945,645			228,172
Michael Kasper			9,936,088			237,726
Paul von Paumgartten			9,999,913			173,901
David N Ruckert			9,999,275			174,539
Philip E Wolfson			9,426,979			746,835
Proposal 2:  Increase number of shares			For			Against			Abstain
available in Company's 2004
Stock Incentive Plan to
500,000 shares			5,146,696			1,009,936			4,017,183
Proposal 3:  Increase number of			For			Against			Abstain
Shares available in Company's 1994
Employee Stock Purchase
Plan by 50,000 shares			5,752,143			411,085			4,010,586
Proposal 4:   Proposal to reincorporate			For			Against			Abstain
the Company from the State
of California to the State
of Delaware			5,806,476			358,986			4,008,352
Proposal 5:  Ratify the appointment of			For			Against			Abstain
Grant Thornton, LLC, as the
Company's independent
auditors for fiscal year 2006			10,155,499			5,000			13,315

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Item 6. Exhibits

 

Exhibit Number		Description of Documents
10.1		Equipment and Supply Agreement entered into May 25,  2006 between Fiberstars, Inc. and Deposition Sciences, Inc.
10.2		Modification to sublease between Fiberstars, Inc. and Keystone Ruby, LLC.
31.1		Rule 13a-14(a) Certification of Chief Executive Officer.
31.2		Rule 13a-14(a) Certification of Chief Financial Officer.
32.1**		Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
32.2**		Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).

 

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** In accordance with item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986,  Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act.  Such certications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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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.

 

 

	FIBERSTARS, INC.
Date: August 11, 2006	By:	/s/ John M. Davenport
		John M. Davenport
		Chief Executive Officer

 

	By:	/s/ Robert A. Connors
		Robert A. Connors
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

 

 

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 Exhibit Index

 

Exhibit Number		Description of Documents
10.1		Equipment and Supply Agreement entered into May 25, 2006 between Fiberstars, Inc. and Deposition Sciences, Inc.
10.2		Modification to sublease between Fiberstars, Inc. and Keystone Ruby, LLC.
31.1		Rule 13a-14(a) Certification of Chief Executive Officer.
31.2		Rule 13a-14(a) Certification of Chief Financial Officer.
32.1**		Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
32.2**		Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).

 

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** In accordance with item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986,  Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act.  Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

 

 

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