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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2006
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 0-27234
PHOTON DYNAMICS, INC.
(Exact name of registrant as specified in its charter)
California | 94-3007502 | |
(State or other jurisdiction of | (I.R.S. Employer | |
incorporation or organization) | Identification No.) |
5970 Optical Court
San Jose, California 95138-1400
(Address of principal executive offices including zip code)
San Jose, California 95138-1400
(Address of principal executive offices including zip code)
(408) 226-9900
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo
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 filero Accelerated filerþ Non-accelerated filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ
As of July 31, 2006, there were 17,055,363 shares outstanding of the Registrant’s Common Stock, no par value.
INDEX
Page | ||||||||
Item 1 | ||||||||
3 | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
Item 2 | 21 | |||||||
Item 3 | 43 | |||||||
Item 4 | 44 | |||||||
Item 1 | 45 | |||||||
Item 1A | 45 | |||||||
Item 2 | 45 | |||||||
Item 3 | 45 | |||||||
Item 4 | 45 | |||||||
Item 5 | 45 | |||||||
Item 6 | 45 | |||||||
Signatures | 46 | |||||||
EXHIBIT 10.1 | ||||||||
EXHIBIT 31.1 | ||||||||
EXHIBIT 31.2 | ||||||||
EXHIBIT 32.1 |
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PART I. FINANCIAL INFORMATION
ITEM 1.Financial Statements
PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS*
June 30, | September 30, | |||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 22,483 | $ | 20,288 | ||||
Short-term investments | 68,147 | 72,738 | ||||||
Accounts receivable, net of allowance for doubtful accounts of $424 and $153 at June 30, 2006 and September 30, 2005, respectively | 57,253 | 27,067 | ||||||
Inventories | 19,754 | 32,545 | ||||||
Other current assets | 4,379 | 3,932 | ||||||
Total current assets | 172,016 | 156,570 | ||||||
Land, property and equipment, net | 16,867 | 19,366 | ||||||
Other assets | 4,197 | 4,390 | ||||||
Intangible assets, net | 2,088 | 3,205 | ||||||
Goodwill | 153 | 153 | ||||||
Total assets | $ | 195,321 | $ | 183,684 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 10,337 | $ | 13,005 | ||||
Warranty | 5,367 | 5,346 | ||||||
Other current liabilities | 13,126 | 8,618 | ||||||
Deferred gross margin | 10,016 | 13,113 | ||||||
Total current liabilities | 38,846 | 40,082 | ||||||
Other non-current liabilities | 19 | 1,008 | ||||||
Commitments and contingencies | ||||||||
Shareholders’ equity: | ||||||||
Common stock, no par value | 291,554 | 287,765 | ||||||
Accumulated deficit | (135,355 | ) | (145,489 | ) | ||||
Accumulated other comprehensive income | 257 | 318 | ||||||
Total shareholders’ equity | 156,456 | 142,594 | ||||||
Total liabilities and shareholders’ equity | $ | 195,321 | $ | 183,684 | ||||
* | Amounts as of June 30, 2006 are unaudited. Amounts as of September 30, 2005 are derived from the September 30, 2005 audited financial statements. |
See accompanying notes to condensed consolidated financial statements.
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PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(unaudited) | ||||||||||||||||
(in thousands, except per share data) | ||||||||||||||||
Revenue | $ | 51,658 | $ | 39,096 | $ | 143,613 | $ | 101,061 | ||||||||
Cost of revenue | 32,178 | 25,966 | 87,629 | 67,515 | ||||||||||||
Gross margin | 19,480 | 13,130 | 55,984 | 33,546 | ||||||||||||
Operating expenses: | ||||||||||||||||
Research and development | 8,508 | 8,618 | 25,139 | 27,906 | ||||||||||||
Selling, general and administrative | 6,968 | 7,352 | 20,803 | 18,143 | ||||||||||||
Restructuring charge | — | 951 | 30 | 951 | ||||||||||||
Impairment of property and equipment | 50 | 174 | 50 | 556 | ||||||||||||
Gain on sale of fixed assets | — | (143 | ) | — | (143 | ) | ||||||||||
Amortization of intangible assets | 372 | 380 | 1,117 | 1,175 | ||||||||||||
Total operating expenses | 15,898 | 17,332 | 47,139 | 48,588 | ||||||||||||
Income (loss) from operations | 3,582 | (4,202 | ) | 8,845 | (15,042 | ) | ||||||||||
Interest income and other, net | 999 | 472 | 2,518 | 1,891 | ||||||||||||
Income (loss) from continuing operations before income taxes and discontinued operations | 4,581 | (3,730 | ) | 11,363 | (13,151 | ) | ||||||||||
Provision for income taxes | 205 | 167 | 756 | 565 | ||||||||||||
Income (loss) from continuing operations before discontinued operations | 4,376 | (3,897 | ) | 10,607 | (13,716 | ) | ||||||||||
Income (loss) from discontinued operations | (127 | ) | 268 | (473 | ) | 258 | ||||||||||
Net income (loss) | $ | 4,249 | $ | (3,629 | ) | $ | 10,134 | $ | (13,458 | ) | ||||||
Income (loss) per share from continuing operations: | ||||||||||||||||
Basic | $ | 0.26 | $ | (0.23 | ) | $ | 0.62 | $ | (0.81 | ) | ||||||
Diluted | $ | 0.26 | $ | (0.23 | ) | $ | 0.62 | $ | (0.81 | ) | ||||||
Income (loss) per share from discontinued operations: | ||||||||||||||||
Basic | $ | (0.01 | ) | $ | 0.02 | $ | (0.03 | ) | $ | 0.02 | ||||||
Diluted | $ | (0.01 | ) | $ | 0.02 | $ | (0.03 | ) | $ | 0.02 | ||||||
Net income (loss) per share: | ||||||||||||||||
Basic | $ | 0.25 | $ | (0.21 | ) | $ | 0.60 | $ | (0.79 | ) | ||||||
Diluted | $ | 0.25 | $ | (0.21 | ) | $ | 0.59 | $ | (0.79 | ) | ||||||
Weighted average number of shares: | ||||||||||||||||
Basic | 17,047 | 16,984 | 17,023 | 16,934 | ||||||||||||
Diluted | 17,077 | 16,984 | 17,065 | 16,934 |
See accompanying notes to condensed consolidated financial statements.
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PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended | ||||||||
June 30, | ||||||||
2006 | 2005 | |||||||
(unaudited) | ||||||||
(in thousands) | ||||||||
Cash flows from operating activities: | ||||||||
Income (loss) from continuing operations | $ | 10,607 | $ | (13,716 | ) | |||
Adjustments to reconcile income (loss) from continuing operations to net cash provided by (used in) operating activities from continuing operations: | ||||||||
Depreciation | 4,326 | 4,331 | ||||||
Amortization of intangible assets | 1,117 | 1,175 | ||||||
Impairment of property and equipment | 50 | 556 | ||||||
Loss (gain) on sale of property and equipment | — | (143 | ) | |||||
Non-cash stock-based compensation | 2,954 | — | ||||||
Non-employee stock ownership expense | 14 | 44 | ||||||
Restructuring charge | 30 | 171 | ||||||
Accretion of non-interest bearing notes payable | 31 | 53 | ||||||
Changes in operating assets and liabilities: | ||||||||
Accounts receivable | (30,186 | ) | 19,687 | |||||
Inventories | 13,084 | 8,762 | ||||||
Other current assets | (622 | ) | (324 | ) | ||||
Other assets | (319 | ) | 109 | |||||
Accounts payable | (2,589 | ) | (9,786 | ) | ||||
Other current liabilities | 4,109 | 252 | ||||||
Deferred gross margin | (3,097 | ) | (1,281 | ) | ||||
Other liabilities | (40 | ) | (66 | ) | ||||
Net cash provided by (used in) operating activities from continuing operations | (531 | ) | 9,824 | |||||
Net cash used in operating activities from discontinued operations | (1,169 | ) | (589 | ) | ||||
Net cash provided by (used in) operating activities | (1,700 | ) | 9,235 | |||||
Cash flows from investing activities: | ||||||||
Purchase of property and equipment | (1,887 | ) | (5,070 | ) | ||||
Proceeds from disposal of property and equipment | — | 270 | ||||||
Purchase of short-term investments | (100,288 | ) | (51,481 | ) | ||||
Maturities and sales of short-term investments | 105,103 | 33,678 | ||||||
Net cash provided by (used in) investing activities from continuing operations | 2,928 | (22,603 | ) | |||||
Cash flows from financing activities: | ||||||||
Issuance of common stock | 1,785 | 1,756 | ||||||
Net repayment of short-term borrowings | (533 | ) | (532 | ) | ||||
Net cash provided by financing activities from continuing operations | 1,252 | 1,224 | ||||||
Net cash used in financing activities from discontinued operations | — | (198 | ) | |||||
Net cash provided by financing activities | 1,252 | 1,026 | ||||||
Effect of exchange rate changes on cash and cash equivalents | (285 | ) | (42 | ) | ||||
Net increase (decrease) in cash and cash equivalents from continuing operations | 3,364 | (11,597 | ) | |||||
Net decrease in cash and cash equivalents from discontinued operations | (1,169 | ) | (787 | ) | ||||
Net increase (decrease) in cash and cash equivalents | 2,195 | (12,384 | ) | |||||
Cash and cash equivalents at beginning of period | 20,288 | 25,483 | ||||||
Cash and cash equivalents at end of period | $ | 22,483 | $ | 13,099 | ||||
See accompanying notes to condensed consolidated financial statements.
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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Unaudited)
NOTE 1 — Basis of Presentation and Summary of Significant Accounting Policies
Basis of Presentation.The accompanying unaudited condensed consolidated financial statements of Photon Dynamics, Inc. (“Photon Dynamics” or the “Company”) have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods indicated.
These financial statements and notes should be read in conjunction with “Item 8. Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2005, filed with the Securities and Exchange Commission on December 14, 2005. Operating results for the three and nine month periods ended June 30, 2006, are not necessarily indicative of the results that may be expected for any other interim period or for the full fiscal year ending September 30, 2006.
The condensed consolidated balance sheet as of September 30, 2005, is derived from the Company’s audited consolidated financial statements as of September 30, 2005, included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2005 filed with the Securities and Exchange Commission, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Certain prior year amounts in these condensed consolidated financial statements and notes thereto have been reclassified to conform to the current period’s presentation.
Description of Operations and Principles of Consolidation.Photon Dynamics is a supplier of integrated yield management solutions for the flat panel display industry. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated. The Company currently operates in one segment: the manufacture and servicing of test equipment for the flat panel display industry. The Company’s test, repair and inspection systems are used by manufacturers to collect data, analyze product quality and identify and repair product defects at critical steps in the active matrix liquid crystal display manufacturing process.
Through January 14, 2003, the Company conducted business in three operating segments: flat panel display products, cathode ray tube display and high quality glass inspection products and printed circuit board assembly inspection products. In January 2003, the Company implemented a plan to exit the printed circuit board assembly inspection business. In June 2003, the Company implemented a plan to exit the cathode ray tube display and high quality glass inspection businesses. Accordingly, the operating results of these former business segments have been presented as discontinued operations in accordance with the provisions of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” (“SFAS No. 144”). Accordingly, in the condensed consolidated statements of operations, the net operating results of these former businesses have been classified as “Income (loss) from discontinued operations,” for all periods presented. The cash flows from these businesses have been presented as net cash flows from discontinued operations, as applicable, in the operating, investing and financing sections of the condensed consolidated statements of cash flows. The Company continues to incur charges to discontinued operations primarily due to costs associated with the Amtower v. Photon Dynamics, Inc. lawsuit (see Note 9).
Management Estimates.The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by management include revenue recognition, the allowance for doubtful accounts, inventory write-downs, warranty accruals, other acquired intangible assets and long-lived assets and litigation and contingency assessments.
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Fair Value of Financial Instruments.The Company evaluates the estimated fair value of financial instruments using available market information and certain valuation methodologies. The use of different market information and/or estimation techniques could have a negative effect on the estimated fair value amounts. The fair value of the Company’s cash, cash equivalents, accounts receivable, accounts payable and other current liabilities approximates the carrying amounts due to the relatively short maturity of these items.
Inventories.Inventories, consisting of raw materials, work-in-process and finished goods, are stated at the lower of cost (first-in, first-out) or market. Inventory which is obsolete (defined as inventory that will no longer be used in the manufacturing process) or in excess of the forecasted usage is written down to its estimated market value based on projected demand, historical usage and other known factors. Photon Dynamics reviews the appropriate valuation of its inventories on a quarterly basis. If actual demand were to decline below the Company’s forecasts, the Company may need to record additional inventory write-downs.
Concentration of Credit and Other Risk.Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of available for sale securities and trade accounts receivable.
The Company invests excess cash not required for use in operations in securities that the Company believes bear minimal risk of loss. These investments are of a short-term nature and include investments in auction rate preferred securities, commercial paper and government and corporate debt securities. The Company has not experienced any losses due to institutional failure or bankruptcy.
The Company’s customers are located in Korea, Taiwan, Japan and China. The Company’s sales to these customers may be adversely affected by the overall health of these economies, including the effects of currency exchange rate fluctuations. The Company generally does not require collateral for its trade accounts receivable. The Company maintains a provision for potential credit losses based upon expected collectibility of all accounts receivable. For sales to some of its customers in certain geographic regions, the Company requires letters of credit. The majority of the Company’s revenue is invoiced in U.S. dollars although approximately $716,000 and $727,000 of revenue that was recognized in the three months ended June 30, 2006 and 2005, respectively, and approximately $1.9 million and $18.3 million of revenue that was recognized in nine months ended June 30, 2006 and 2005, respectively, were invoiced in currencies other than the U.S. dollar, primarily Japanese yen. The Company believes its credit evaluation prior to shipment, credit instruments such as letters of credit, and subsequent monitoring of customer status mitigate credit risk.
The Company’s products include certain components that are currently single-sourced. The Company believes that other vendors would be able to provide similar components; however, the qualification of such vendors may require start-up time. In order to mitigate any adverse impacts from a disruption of supply, the Company attempts to maintain an adequate inventory of critical single-sourced components.
Revenue Recognition.Photon Dynamics derives revenue primarily from the sale and installation of equipment and spare part sales. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured. Persuasive evidence of an arrangement exists when a sales quotation outlining the terms and conditions of the arrangement has been issued to the customer and a purchase order has been received from the customer accepting the terms of the sales quotation and stating, at a minimum, the number of systems ordered and the value of the overall arrangement.
The Company accounts for certain of its product sales, as arrangements with multiple deliverables in accordance with Emerging Issues Task Force Issue 00-21, “Revenue Arrangements with Multiple Deliverables.” For arrangements with multiple deliverables, the Company recognizes revenue for the delivered items if the delivered items have value to the customer on a standalone basis, the amount of revenue for delivered elements is not subject to refund, and delivery or performance of the undelivered items is considered probable and substantially in the control of the Company, the Company has met defined customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. The Company allocates revenue to the delivered items based on the lesser of the amount due and billable upon shipment and the difference between the total amount due at time of shipment and the allocated fair value of the undelivered elements, with the remaining amount recognized after installation and acceptance when the final amount becomes due. Installation and other services are not essential to the functionality of the products as these services do not alter the product capabilities, do not require specialized skills or tools and can be performed by other vendors.
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For new products that have not been demonstrated to meet product specifications, 100% of revenue is deferred until customer acceptance. The Company recognizes revenue from the sale of spare parts generally upon shipment.
The Company has a policy to record a provision as necessary based on historical rates for estimated sales returns in the same period the related revenue is recorded. This provision is netted against revenue.
Shipping Costs.The Company’s shipping and handling costs are included under cost of revenue for all periods presented. In those instances where the Company charges its customers for shipping and handling, the amounts billed are classified as revenue.
Research and Development Cost.Costs to develop the Company’s products, which include both hardware and software components are expensed as incurred. Software incorporated in the Company’s products is an integral part of the overall product design process and costs to develop software, which is deemed to be incidental, are not tracked separately. The Company does not sell or market any software product on a standalone basis.
Interest Income.Interest income was approximately $966,000 and $648,000 for the three months ended June 30, 2006 and 2005, respectively, and approximately $2.5 million and $1.5 million for the nine months ended June 30, 2006 and 2005, respectively.
Variable Interest Entity. In November 2005, Photon Dynamics entered into agreements which commit the Company to provide funding to an early-stage development company subject to certain conditions and milestones. The funding is in the form of a convertible note. In addition, in exchange for providing a limited use license to certain of the Company’s intellectual property, the Company received a minority equity interest. For accounting purposes, Photon Dynamics is considered to be the primary beneficiary within the provisions of FASB Financial Interpretation No. 46 (revised 2003) “Consolidation of Variable Interest Entities.” Due to the nature of the agreement, the Company determined that since Photon Dynamics is essentially providing 100% of the funding, there is no offset for minority interest and so the Company consolidates 100% of the entity’s operations until such time as the entity obtains funding from other sources. As of June 30, 2006, the consolidation of this entity did not have a material impact on the Company’s results of operations or financial position.
Recent Accounting Pronouncements.In July 2006, the Financial Accounting Standard Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosures. It will be effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. The provisions of this Interpretation apply to all tax positions upon initial adoption of this Interpretation. Only tax positions that meet the recognition threshold criteria at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year, presented separately. The Company is currently evaluating the accounting and disclosure requirements of this Interpretation and expects to adopt it as required at the beginning of its fiscal year 2008.
In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”). SFAS No. 154 replaces APB No. 20 (“APB 20”) and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of change a cumulative effect of changing to the new accounting principle whereas SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle, unless it is impracticable. SFAS No. 154 enhances the consistency of financial information between periods. SFAS No. 154 will be effective beginning with the Company’s first quarter of fiscal year 2007. The Company does not expect that the adoption of SFAS No. 154 will have a material impact on its results of operations, financial position or cash flows.
In March 2005, the FASB published FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” which clarifies that the term, conditional asset retirement obligations, as used in SFAS No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. The interpretation also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. This interpretation is effective no later than the end of the Company’s fiscal 2006. The adoption of this Interpretation is not expected to have a material effect on the Company’s consolidated financial position or results of operations.
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NOTE 2 — Financial Statement Components
June 30, | September 30, | |||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
Inventories: | ||||||||
Raw materials | $ | 9,933 | $ | 12,476 | ||||
Work-in-process | 9,558 | 19,327 | ||||||
Finished goods | 263 | 742 | ||||||
Total | $ | 19,754 | $ | 32,545 | ||||
Other current liabilities: | ||||||||
Compensation | $ | 5,242 | $ | 3,838 | ||||
Commissions | 346 | 295 | ||||||
Vendor obligations | 1,836 | 286 | ||||||
Professional fees | 1,284 | 1,314 | ||||||
Employee notes payable | 1,026 | 490 | ||||||
Customer deposits | 1,500 | — | ||||||
Other accrued expenses | 1,892 | 2,395 | ||||||
Total | $ | 13,126 | $ | 8,618 | ||||
Deferred gross margin: | ||||||||
Deferred system sales | $ | 17,977 | $ | 25,481 | ||||
Deferred cost of revenue related to system sales | (7,961 | ) | (12,368 | ) | ||||
Total | $ | 10,016 | $ | 13,113 | ||||
Accumulated other comprehensive income: | ||||||||
Foreign currency translation adjustments | $ | 358 | $ | 643 | ||||
Unrealized losses on available for sale securities | (101 | ) | (325 | ) | ||||
Total | $ | 257 | $ | 318 | ||||
NOTE 3 — Discontinued Operations
Printed Circuit Board Assembly Inspection Business
The Company formerly had a business which sold printed circuit board assembly inspection products. In January 2003, the Company implemented a plan to exit this business. Accordingly, the operating results of this former business segment have been reclassified as a discontinued operation for all periods presented.
The following table summarizes the results of discontinuing the printed circuit board assembly inspection products former reporting segment for the three and nine months ended June 30, 2006 and 2005:
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(in thousands) | ||||||||||||||||
Cost of revenue | $ | — | $ | 5 | $ | — | $ | (127 | ) | |||||||
Gross margin | — | (5 | ) | — | 127 | |||||||||||
Operating expenses: | ||||||||||||||||
Selling, general and administrative | 127 | — | 501 | 139 | ||||||||||||
Total operating expenses | 127 | — | 501 | 139 | ||||||||||||
Loss from discontinued operations | $ | (127 | ) | $ | (5 | ) | $ | (501 | ) | $ | (12 | ) | ||||
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Loss from discontinued operations for the three months ended June 30, 2006 consists primarily of approximately $127,000 of additional legal charges related to the Amtower v. Photon Dynamics, Inc. lawsuit (see Note 9). Loss from discontinued operations for the nine months ended June 30, 2006 consists primarily of legal charges related to the Amtower v. Photon Dynamics, Inc. lawsuit, offset by deferred rent charges that were reversed in the quarter ended December 31, 2005 when the Company successfully renegotiated its remaining lease obligations for its Austin, Texas facility.
Loss from discontinued operations for the three months ended June 30, 2005 includes approximately $132,000 for the reversal of a liability related to the settlement of vendor obligations, net of approximately $113,000 of additional legal charges related to the Amtower v. Photon Dynamics Inc. lawsuit.
The following summarizes the assets and liabilities of the printed circuit board assembly inspection products discontinued operations:
June 30, | September 30, | |||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
ASSETS | ||||||||
Current assets: | ||||||||
Other current assets | $ | 494 | $ | 175 | ||||
Total current assets | 494 | 175 | ||||||
Other assets: | ||||||||
Other non-current assets | — | 1,016 | ||||||
Total assets | $ | 494 | $ | 1,191 | ||||
LIABILITIES | ||||||||
Current liabilities: | ||||||||
Other current liabilities | $ | 534 | $ | 579 | ||||
Total current liabilities | 534 | 579 | ||||||
Other liabilities: | ||||||||
Other non-current liabilities | — | 42 | ||||||
Total liabilities | $ | 534 | $ | 621 | ||||
Other current assets at June 30, 2006, include approximately $494,000 related to insurance receivable for reimbursable legal costs associated with the Amtower v. Photon Dynamics, Inc. lawsuit (see Note 9). Other current liabilities at June 30, 2006, include accrued legal charges related to Amtower v Photon Dynamics, Inc. lawsuit (see Note 9) and a liability related to potential vendor obligations.
Other current assets at September 30, 2005 included approximately $175,000 in security deposits on the Austin, Texas facility lease, while Other current liabilities and Other non-current liabilities included approximately $79,000 and $42,000, respectively, related to lease obligations associated with this lease. In December 2005, the Company settled its lease obligations on its Austin, Texas facility.
Other non-current assets at September 30, 2005, included a receivable of approximately $1.0 million against shares that were being held in escrow related to the Company’s acquisition of Intelligent Reasoning Systems, Inc (“IRSI”). An aggregate of 57,195 shares of Photon Dynamics, Inc. common stock, issued in July 2001 as part of a share purchase agreement with IRSI, were held in an escrow account pending resolution of the Company’s claim against the escrow related to the Austin facility lease. During the quarter ended December 31, 2005, the Company settled its lease obligations and filed a claim against the escrow. During the quarter ended March 31, 2006, the Company’s claim against the escrow was accepted and the Company received 50,319 shares, while the remaining 6,876 shares were distributed to the former shareholders of IRSI. The Company cancelled the 50,319 shares and the balance of the escrow account at the time of share cancellation of approximately $1.3 million was recorded as a reduction of common stock in the condensed consolidated financial statements.
In the second quarter of fiscal 2003, in accordance with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), the Company recorded a liability of approximately $2.0 million for costs associated with the discontinuation of the business, including termination benefits of approximately $700,000 and approximately $1.3 million of purchase obligations to suppliers. The following summarizes the liability since inception:
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One-Time | ||||||||||||
Termination | ||||||||||||
Benefits | Other Costs | Total | ||||||||||
(in thousands) | ||||||||||||
Inception of liability | $ | 696 | $ | 1,326 | $ | 2,022 | ||||||
Cash payments | (614 | ) | (652 | ) | (1,266 | ) | ||||||
Adjustments to the liability | (82 | ) | (474 | ) | (556 | ) | ||||||
Balance at September 30, 2005 | — | 200 | 200 | |||||||||
Cash payments | — | — | — | |||||||||
Adjustments to the liability | — | — | — | |||||||||
Balance at June 30, 2006 | $ | — | $ | 200 | $ | 200 | ||||||
The balance of $200,000 remaining at June 30, 2006, consists primarily of potential vendor obligations.
Cathode Ray Tube Display and High Quality Glass Inspection Business
The Company formerly had a business which sold cathode ray tube display and high quality glass inspection products. In June 2003, the Company implemented a plan to exit this business. Accordingly, the operating results of this former business segment have been reclassified as a discontinued operation for all periods presented.
The following table summarizes the results of discontinuing the cathode ray tube display and high quality glass inspection products former reporting segment for the three and nine months ended June 30, 2006 and 2005:
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
(in thousands) | (in thousands) | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Cost of revenue | $ | — | $ | (150 | ) | $ | (34 | ) | $ | (150 | ) | |||||
Gross margin | 150 | 34 | 150 | |||||||||||||
Operating expenses: | ||||||||||||||||
Selling, general and administrative | — | (123 | ) | 7 | (120 | ) | ||||||||||
Total operating expenses | — | (123 | ) | 7 | (120 | ) | ||||||||||
Income from discontinued operations | $ | — | $ | 273 | $ | 28 | $ | 270 | ||||||||
Income from discontinued operations for the nine months ended June 30, 2006, includes approximately $34,000 of adjustments to reduce the estimated warranty liability.
Income from discontinued operations for the three and nine months ended June 30, 2005, includes approximately $270,000 for the reduction of certain reserves related to contingent warranty and lease obligations settled at amounts less than originally estimated.
The following summarizes the assets and liabilities of the cathode ray tube display and high quality glass inspection discontinued operations:
June 30, | September 30, | |||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
LIABILITIES | ||||||||
Other current liabilities: | $ | 27 | $ | 74 | ||||
Other current liabilities at June 30, 2006, relate to operating lease obligations. Future minimum lease payments, due by fiscal year, are approximately $5,000, $21,000 and $1,000 for the remainder of fiscal 2006, fiscal 2007 and fiscal 2008, respectively.
In the third quarter of fiscal 2003, in accordance with SFAS No. 146, the Company recorded a liability of approximately $1.9 million for costs associated with the discontinuation of the business. The following summarizes the liability since inception:
One-Time | Contract | |||||||||||||||
Termination | Termination | |||||||||||||||
Benefits | Costs | Other Costs | Total | |||||||||||||
(in thousands) | ||||||||||||||||
Inception of liability | $ | 1,116 | $ | 771 | $ | 11 | $ | 1,898 | ||||||||
Cash payments | (1,116 | ) | (393 | ) | (61 | ) | (1,570 | ) | ||||||||
Adjustments to the liability | — | (304 | ) | 50 | (254 | ) | ||||||||||
Balance at September 30, 2005 | — | 74 | — | 74 | ||||||||||||
Cash payments | — | (13 | ) | — | (13 | ) | ||||||||||
Adjustments to the liability | — | (34 | ) | — | (34 | ) | ||||||||||
Balance at June 30, 2006 | $ | — | $ | 27 | $ | — | $ | 27 | ||||||||
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NOTE 4 — Goodwill and Other Purchased Intangible Assets
Goodwill
The carrying value of goodwill was approximately $153,000 at both June 30, 2006, and September 30, 2005. There were no additions or adjustments to goodwill during the nine months ended June 30, 2006. There have been no significant events or circumstances negatively affecting the valuation of goodwill subsequent to the Company’s impairment test performed during the fourth quarter of fiscal 2005.
Goodwill of $153,000 as of June 30, 2006, relates entirely to the Company’s purchase of assets from Summit Imaging in May 2003.
Intangible Assets
The components of intangible assets as of June 30, 2006 were as follows:
Non | ||||||||||||||||||||
Developed | Core | License | Compete | |||||||||||||||||
Technology | Technology | Agreement | Contract | Total | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Gross carrying amount at June 30, 2006 | $ | 1,006 | $ | 2,408 | $ | 1,138 | $ | 968 | $ | 5,520 | ||||||||||
Accumulated amortization | (515 | ) | (1,353 | ) | (853 | ) | (711 | ) | (3,432 | ) | ||||||||||
Net carrying amount at June 30, 2006 | $ | 491 | $ | 1,055 | $ | 285 | $ | 257 | $ | 2,088 | ||||||||||
The components of intangible assets as of September 30, 2005 were as follows:
Non | ||||||||||||||||||||
Developed | Core | License | Compete | |||||||||||||||||
Technology | Technology | Agreement | Contract | Total | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Gross carrying amount at September 30, 2005 | $ | 1,006 | $ | 2,408 | $ | 1,138 | $ | 968 | $ | 5,520 | ||||||||||
Accumulated amortization | (326 | ) | (902 | ) | (568 | ) | (519 | ) | (2,315 | ) | ||||||||||
Net carrying amount at September 30, 2005 | $ | 680 | $ | 1,506 | $ | 570 | $ | 449 | $ | 3,205 | ||||||||||
The following table summarizes the activity during the nine months ended June 30, 2006:
Non | ||||||||||||||||||||
Developed | Core | License | Compete | |||||||||||||||||
Technology | Technology | Agreement | Contract | Total | ||||||||||||||||
Net carrying amount at September 30, 2005 | $ | 680 | $ | 1,506 | $ | 570 | $ | 449 | $ | 3,205 | ||||||||||
Amortization during the period | (189 | ) | (451 | ) | (285 | ) | (192 | ) | (1,117 | ) | ||||||||||
Net carrying amount at June 30, 2006 | $ | 491 | $ | 1,055 | $ | 285 | $ | 257 | $ | 2,088 | ||||||||||
Based on intangible assets recorded at June 30, 2006, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining estimated amortization expense relating to intangible assets at June 30, 2006, is approximately $372,000, $1.2 million and $558,000 in the remainder of fiscal 2006, fiscal 2007 and fiscal 2008, respectively.
In assessing the recoverability of its intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. It is reasonably possible that these estimates, or their related assumptions, may change in the future, in which case the Company may be required to record additional impairment charges for these assets.
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NOTE 5 — Restructuring Charges
During the third quarter of fiscal 2005, the Company implemented a restructuring plan to relocate all activities in its Markham, Canada location — consisting of research and development related to the Company’s PanelMasterTM inspection systems — to the Company’s Daejon, Korea and San Jose, California locations. The Company recorded this restructuring plan in accordance with Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”).
The restructuring plan included reducing its workforce and closing its Markham, Canada location. Management approved and implemented the plan and determined the benefits that would be offered to the employees being terminated. Management determined that terminations affecting up to 32 employees would take place in three phases through March 31, 2006. Certain of these employees were offered permanent employment elsewhere in the Company and those that accepted were provided with certain relocation benefits in lieu of severance benefits. In the third quarter of fiscal 2005, all 32 of the affected employees were notified of their termination and the benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits they were entitled to receive.
The Company recorded an initial restructuring charge of approximately $676,000 in its third quarter of fiscal 2005, which was comprised of approximately $430,000 for employee severance and related benefits and approximately $246,000 related to contract termination costs associated with excess facilities. The charge for excess facilities relates to rent obligations under long term operating lease agreements which are to be paid in cash through October 2007, net of a sublease agreement the Company entered into in April 2005, and to costs associated with the book value of leasehold improvements. The Company recorded a total restructuring charge of approximately $1.2 million in the fiscal year ended September 30, 2005. The Company recorded an additional restructuring charge of approximately $107,000 during the six months ended March 31, 2006, which represented the ratable charges for employee severance and related retention benefits that were to be paid through March 31, 2006. This charge was offset by approximately $77,000 of adjustments to the liability for bonuses not paid. These charges were reflected in “Restructuring charge” in the Company’s Condensed Consolidated Statements of Operations.
The following table summarizes the liability since inception:
One-Time | Contract | |||||||||||
Termination | Termination | |||||||||||
Benefits | Costs | Total | ||||||||||
(in thousands) | ||||||||||||
Inception of liability | $ | 430 | $ | 246 | $ | 676 | ||||||
Cash payments | (526 | ) | (21 | ) | (547 | ) | ||||||
Costs incurred and charged to expense | 521 | — | 521 | |||||||||
Adjustments to the liability | 24 | (166 | ) | (142 | ) | |||||||
Balance at September 30, 2005 | 449 | 59 | 508 | |||||||||
Cash payments | (483 | ) | (10 | ) | (493 | ) | ||||||
Costs incurred and charged to expense | 107 | — | 107 | |||||||||
Adjustments to the liability | (73 | ) | (4 | ) | (77 | ) | ||||||
Balance at June 30, 2006 | $ | — | $ | 45 | $ | 45 | ||||||
As of June 30, 2006, the remaining liability of approximately $45,000 is reflected in “Other current liabilities” in the Company’s Consolidated Balance Sheets and relates primarily to the lease, which continues through October 2007. All termination benefits were paid out by March 31, 2006. Adjustments to the liability represent an adjustment to bonus amounts accrued and to foreign currency translation effects on the liability.
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NOTE 6 — Comprehensive Income
The components of comprehensive income were as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(in thousands) | ||||||||||||||||
Net income (loss) | $ | 4,249 | $ | (3,629 | ) | $ | 10,134 | $ | (13,458 | ) | ||||||
Other comprehensive income (loss): | ||||||||||||||||
Net change in unrealized gain (loss) on investments | 40 | 94 | 223 | (163 | ) | |||||||||||
Change in foreign currency translation | (25 | ) | (121 | ) | (284 | ) | (42 | ) | ||||||||
Other comprehensive income (loss) | 15 | (27 | ) | (61 | ) | (205 | ) | |||||||||
Total comprehensive income (loss) | $ | 4,264 | $ | (3,656 | ) | $ | 10,073 | $ | (13,663 | ) | ||||||
NOTE 7 — Stock-Based Compensation
Effective October 1, 2005, Photon Dynamics adopted the provisions of SFAS No. 123 (revised 2004) “Share-Based Payments” (SFAS No. 123R). SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured on the grant date, based on the fair value of the award, and is recognized as an expense over the employee requisite service period. Prior to October 1, 2005, the Company accounted for its stock-based awards under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations as permitted by SFAS No. 123.
At June 30, 2006, the Company had an Equity Incentive program and an Employee Stock Purchase Plan, which are described in more detail below.
Prior to the Adoption of SFAS No. 123R.Prior to the adoption of SFAS No. 123R, the Company provided disclosures required under SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”) as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosures.” No employee stock-based compensation was reflected in net income for the three and nine month periods ended June 30, 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
The proforma information under SFAS No. 123 for the three and nine months ended June 30, 2005 was as follows:
Three Months Ended | Nine Months Ended | |||||||
June 30, 2005 | June 30, 2005 | |||||||
(in thousands, except per share data) | ||||||||
Net loss — as reported | $ | (3,629 | ) | $ | (13,458 | ) | ||
Less: total stock-based employee compensation expense determined under fair value based method for all awards | (959 | ) | (4,886 | ) | ||||
Net loss — pro forma | $ | (4,588 | ) | $ | (18,344 | ) | ||
Basic net loss per share — as reported | $ | (0.21 | ) | $ | (0.79 | ) | ||
Diluted net loss per share — as reported | $ | (0.21 | ) | $ | (0.79 | ) | ||
Basic net loss per share — pro forma | $ | (0.27 | ) | $ | (1.08 | ) | ||
Diluted net loss per share — pro forma | $ | (0.27 | ) | $ | (1.08 | ) | ||
Impact of the adoption of SFAS No. 123R. The Company elected to adopt the modified prospective transition method as provided by SFAS No. 123R. Under that transition method, compensation cost recognized in the three and nine months ended June 30, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of October 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123; and (b) compensation cost for all share-based payments granted subsequent to October 1, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.
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Previously reported amounts have not been restated. The effect of recording stock-based compensation for the three and nine months ended June 30, 2006 was as follows:
Three Months Ended | Nine Months Ended | |||||||
June 30, 2006 | June 30, 2006 | |||||||
(in thousands, except per share data) | ||||||||
Stock-based compensation expense included in continuing operations: | ||||||||
Cost of revenue | $ | 34 | $ | 86 | ||||
Research and development | 169 | 502 | ||||||
Selling, general and administrative | 749 | 2,366 | ||||||
Total stock-based compensation expense after income taxes (1) | $ | 952 | $ | 2,954 | ||||
Stock-based compensation expense by type of award: | ||||||||
Employee stock options | $ | 970 | $ | 2,892 | ||||
Employee stock purchase plan | 116 | 355 | ||||||
Amounts capitalized as inventory and deferred gross margin | (134 | ) | (293 | ) | ||||
Net effect on net income (1) | $ | 952 | $ | 2,954 | ||||
Effect on net income per share: | ||||||||
Basic | $ | 0.06 | $ | 0.17 | ||||
Diluted | $ | 0.06 | $ | 0.17 | ||||
(1) | The income tax benefit on stock-based compensation for all periods presented was not material. |
Equity Incentive Program. The Company’s equity incentive program is a long-term retention program that is intended to attract and retain qualified management and technical employees and align stockholder and employee interests. At June 30, 2006, the equity incentive program consisted of: the 2005 Non-Employee Directors’ Stock Option Plan, under which non-employee directors may be granted options to purchase shares of the Company’s stock; and the 2005 Equity Incentive Plan, under which officers, key employees, consultants and all other employees may be granted options to purchase shares of the Company’s stock, restricted stock units, and other types of equity awards. The 2005 Non-Employee Directors’ Stock Option Plan permits the grant of share options for up to 400,000 shares of common stock, while the 2005 Equity Incentive Plan permits the grant of share options for up to 1,450,000 shares of common stock. Under the equity incentive program, stock options generally have a vesting period of 50 to 60 months are generally exercisable for a period of seven to ten years from the date of issuance and are granted at prices not less than the fair market value of the Company’s common stock at the grant date. Certain option awards provide for accelerated vesting if there is a change of control. Restricted stock units may be granted with varying criteria such as time-based or performance-based vesting. No restricted stock units have been granted under the equity incentive program.
The following table provides certain information with respect to all of Photon Dynamics’ equity compensation plans in effect as of June 30, 2006:
Number of Securities | ||||||||||||
Remaining Available for | ||||||||||||
Future Issuance Under | ||||||||||||
Number of Securities | Equity | |||||||||||
to be Issued upon | Weighted-Average | Compensation Plans | ||||||||||
Exercise of | Exercise Price of | (Excluding Securities | ||||||||||
Outstanding Options | Outstanding Options | Reflected in Column (a)) | ||||||||||
Plan Category | (a) | (b) | (c) | |||||||||
Equity compensation plans approved by security holders | 2,060,735 | $ | 23.31 | 714,021 | ||||||||
Equity compensation plans not approved by security holders | 625 | $ | 16.88 | — | ||||||||
Total | 2,061,360 | $ | 23.31 | 714,021 | ||||||||
The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model using a multiple options approach, consistent with the provisions of SFAS No. 123R, Securities and Exchange Commissions SAB No. 107 and the Company’s prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123). All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. The Black-Scholes valuation model requires the input of the following assumptions:
Expected Volatility. The Company estimates the volatility of its stock options at the date of grant using implied volatilities. In connection with the adoption of SFAS No. 123R, the Company reassessed its valuation technique and related assumptions. Expected volatilities used in fiscal 2006 are based on implied volatilities from traded options on the Company’s stock. Prior
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to the adoption of SFAS No. 123R, the Company primarily used historical volatility in deriving its expected volatility assumption. The Company determined that the use of implied volatility is more reflective of market conditions and a better indicator of expected volatility than a historical volatility.
Expected Term. The expected term of options granted is derived from a numerical model of the Company’s stock price and represents the period of time that options granted are expected to be outstanding. The Company uses historical data to estimate option exercise and employee termination within the valuation model.
Risk-Free Interest Rate. The risk-free rate for periods within the contractual life of the option is based on a risk-free zero-coupon spot interest rate at the time of grant.
Expected Dividends. The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes valuation model.
Forfeitures. The Company uses historical data and future expectations of employee turnover to estimate pre-vesting forfeitures. As required by SFAS No. 123R, the Company records stock-based compensation expense only for those awards that are expected to vest.
The fair value of each option grant in the three and nine month periods ended June 30, 2006 and 2005 used the following weighted-average valuation assumptions:
Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Stock option plan: | ||||||||||||||||
Expected volatility | 42 | % | 71 | % | 44 | % | 74 | % | ||||||||
Risk free rate | 4.9 | % | 3.9 | % | 4.5 | % | 3.1 | % | ||||||||
Expected term (in years) | 3.8 | 4.0 | 3.7 | 5.4 |
SFAS No. 123R requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock.
The following table summarizes the combined activity under the equity incentive plans for the indicated periods:
Weighted- | Weighted-Average | Aggregate | ||||||||||||||||||
Available | Options | Average | Remaining Contract | Intrinsic Value | ||||||||||||||||
for Grant | Outstanding | Exercise Price | Term (in years) | (in thousands) | ||||||||||||||||
Balances at September 30, 2005 | 1,663,308 | 1,946,274 | $ | 24.64 | ||||||||||||||||
Plan shares expired | (763,768 | ) | — | — | ||||||||||||||||
Options granted | (443,150 | ) | 443,150 | 18.83 | ||||||||||||||||
Options canceled/expired | 257,631 | (257,631 | ) | 27.72 | ||||||||||||||||
Options exercised | — | (70,433 | ) | 15.10 | ||||||||||||||||
Balances at June 30, 2006 | 714,021 | 2,061,360 | $ | 23.31 | 7.4 | $ | 246 | |||||||||||||
Vested and expected to vest at June 30, 2006 | 1,881,801 | $ | 23.71 | 7.3 | $ | 246 | ||||||||||||||
Exercisable at June 30, 2006 | 1,226,005 | $ | 26.12 | 6.8 | $ | 246 | ||||||||||||||
The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $12.52 as of June 30, 2006, which would have been received by the option holders had all option holders with in-the-money options exercised their options as of that date.
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The weighted average grant date fair value of options granted during the nine months ended June 30, 2006 was $7.10 per share. The total intrinsic value of options exercised during the nine month period ended June 30, 2006 was approximately $295,000. The total cash received from employees as a result of stock option exercises during the nine months ended June 30, 2006 was approximately $1.1 million. In connection with these exercises, the tax benefits realized by the Company for the nine months ended June 30, 2006 was minimal.
The Company settles employee stock option exercises with newly issued common shares.
As of June 30, 2006, the unrecorded deferred stock-based compensation balance related to stock options was $3.7 million and will be recognized over an estimated remaining weighted average amortization period of 1.6 years.
Employee Stock Purchase Plan.The Company’s employee stock purchase plan provides that eligible employees may contribute up to 10% of their eligible earnings, through accumulated payroll deductions, toward the semi-annual purchase of the Company’s common stock. Participants purchase shares on the last day of each offering period. The price at which shares are purchased is equal to 85% of the lower of the fair market value of a share of common stock on the first day of the offering period or the purchase date. Offering periods are six months in length.
The fair value of the stock purchase plan is estimated on the date of grant using the Black-Scholes valuation model, consistent with the provisions of SFAS No. 123R, SEC SAB No. 107 and the Company’s prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123). The fair value in the three and nine month periods ended June 30, 2006 and 2005 used the following weighted-average assumptions:
Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Stock purchase plan: | ||||||||||||||||
Expected volatility | 44 | % | 58 | % | 44 | % | 65 | % | ||||||||
Risk free rate | 4.9 | % | 2.9 | % | 4.6 | % | 2.5 | % | ||||||||
Expected term (in years) | 0.5 | 1.2 | 0.5 | 1.3 |
The compensation cost in connection with the employee stock purchase plan for the nine months ended June 30, 2006 was approximately $355,000. There were 45,309 shares purchased under the employee stock purchase plan during the nine months ended June 30, 2006. Total cash received from employees for the issuance of shares under the employee stock purchase plan was approximately $722,000 during the nine months ended June 30, 2006.
The Plan shares are replenished through shareholder approval at the Annual Shareholder meeting. At June 30, 2006, a total of 954,691 shares were reserved and available for issuance under this Plan.
NOTE 8 — Net Income Per Share
Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to give effect to all dilutive potential common shares outstanding during the period. Common equivalent shares consist of stock options issued to employees under employee stock option plans.
The following table sets forth the computation of basic and diluted net income per share:
Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(in thousands, except per share data) | ||||||||||||||||
Numerator: | ||||||||||||||||
Net income (loss) from continuing operations | $ | 4,376 | $ | (3,897 | ) | $ | 10,607 | $ | (13,716 | ) | ||||||
Net income (loss) from discontinued operations | (127 | ) | 268 | (473 | ) | 258 | ||||||||||
Net income (loss) | $ | 4,249 | $ | (3,629 | ) | $ | 10,134 | $ | (13,458 | ) | ||||||
Denominator: | ||||||||||||||||
Weighted average shares for basic net income per share | 17,047 | 16,984 | 17,023 | 16,934 |
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Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(in thousands, except per share data) | ||||||||||||||||
Effect of dilutive securities: Employee stock options | 29 | — | (1) | 42 | — | (1) | ||||||||||
Weighted average shares for diluted net income per share | 17,076 | 16,984 | 17,065 | 16,934 | ||||||||||||
Earnings per share: | ||||||||||||||||
Basic net income (loss) per share: | ||||||||||||||||
Net income (loss) from continuing operations | $ | 0.26 | $ | (0.23 | ) | $ | 0.62 | $ | (0.81 | ) | ||||||
Net income (loss) from discontinued operations | (0.01 | ) | 0.02 | (0.03 | ) | 0.02 | ||||||||||
Net income (loss) per share | $ | 0.25 | $ | (0.21 | ) | $ | 0.60 | $ | (0.79 | ) | ||||||
Diluted net income (loss) per share: | ||||||||||||||||
Net income (loss) from continuing operations | $ | 0.26 | $ | (0.23 | ) | $ | 0.62 | $ | (0.81 | ) | ||||||
Net income (loss) from discontinued operations | (0.01 | ) | 0.02 | (0.03 | ) | 0.02 | ||||||||||
Net income (loss) per share | $ | 0.25 | $ | (0.21 | ) | $ | 0.59 | $ | (0.79 | ) | ||||||
(1) | The effect of potentially dilutive securities from employee stock options to purchase 95,096 and 132,667 shares of common stock for the three and nine months periods ended June 30, 2005 were not included in the computation of diluted net loss per share as the effect is anti-dilutive. |
During the three and nine month periods ended June 30, 2006, options to purchase 2,031,836 and 1,817,141 shares, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of common shares for the respective periods and hence, their effect would have been anti-dilutive. During the three and nine month periods ended June 30, 2005, options to purchase 1,241,597 and 1,238,574 shares, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of common shares for the respective periods and hence, their effect would have been anti-dilutive.
NOTE 9 — Commitments and Contingencies
Purchase Agreements
The Company maintains certain open inventory purchase commitments with suppliers to ensure a smooth and continuous supply chain for key components. The Company’s liability in these purchase commitments is generally restricted to a forecasted time horizon as mutually agreed upon between the parties. The Company’s open inventory purchase commitments were approximately $27.5 million as of June 30, 2006 and $33.8 million as of September 30, 2005.
Warranty Obligations
The Company generally offers warranty coverage for a period of one year from the date of final customer acceptance. Upon product shipment, the Company records the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment. Factors that affect the Company’s warranty liability include the number of installed units under warranty, product failure rates, material usage rates and the efficiency by which the product failure is corrected. The Company assesses the adequacy of its recorded warranty liability quarterly and adjusts the amount as necessary.
Changes in the Company’s product liability during the nine month period ended June 30, 2006 and 2005 were as follows:
Nine Months Ended | ||||||||
June 30, | ||||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
Beginning balance | $ | 5,346 | $ | 6,194 | ||||
Estimated warranty cost of new shipments during the period | 4,947 | 3,975 | ||||||
Warranty costs during the period | (2,824 | ) | (3,556 | ) | ||||
Changes in liability for pre-existing warranties, including expirations | (2,102 | ) | (279 | ) | ||||
Ending balance | $ | 5,367 | $ | 6,334 | ||||
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Legal Proceedings
The Company and certain of its directors and former officers were named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The trial of this case commenced on April 3, 2006. On a motion for non-suit, the court dismissed all claims against all directors on April 20, 2006. On May 5, 2006, judgments were entered in favor of the Company and its former officers. The plaintiff, a former officer of the Company, had asserted several causes of action arising out of alleged misrepresentations made to the plaintiff regarding the existence and enforcement of the Company’s insider trading policy. The plaintiff had sought damages in excess of $6 million for defendants’ alleged refusal to allow plaintiff to sell shares of the Company’s stock in May of 2000, plus unspecified emotional distress and punitive damages. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded the Company approximately $445,000 in fees and costs. The award bears interest at the statutory rate of 10% simple interest per annum. Collection of the award will be stayed during the plaintiff’s appeal of the verdict. The Company has recorded an accrual for legal charges incurred, as well as committed but unpaid expenses, related to this litigation.
From time to time, Photon Dynamics is subject to certain other legal proceedings and claims that arise in the ordinary course of business. Additionally, the Company in the ordinary course of business may potentially be subject to future legal proceedings that could individually, or in the aggregate, have a material adverse effect on its financial condition, liquidity or results of operations. Litigation in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.
NOTE 10 — Geographic Information
The Company operates in one segment: the manufacture and servicing of test equipment for the flat panel display industry. The Company sells its products for the flat panel display industry directly to customers in Korea, Taiwan, China and Japan. For geographical reporting, revenue is attributed to the geographic location to which the product was shipped. Long-lived assets consist primarily of property, plant and equipment, goodwill and intangibles and are attributed to the geographic location in which they are located.
The following is a summary of revenue by geographic area based on location where the product was shipped:
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(in thousands) | ||||||||||||||||
Revenue: | ||||||||||||||||
Korea | $ | 37,388 | $ | 19,550 | $ | 103,563 | $ | 30,585 | ||||||||
Taiwan | 13,577 | 18,420 | 37,927 | 40,994 | ||||||||||||
Japan | 693 | 1,126 | 2,123 | 16,200 | ||||||||||||
China | — | — | — | 13,282 | ||||||||||||
Total | $ | 51,658 | $ | 39,096 | $ | 143,613 | $ | 101,061 | ||||||||
The following is a summary of revenue by product line (as a percentage of total revenue):
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenue: | ||||||||||||||||
ArrayCheckerTM | 75 | % | 71 | % | 68 | % | 63 | % | ||||||||
ArraySaverTM | 12 | % | 21 | % | 17 | % | 27 | % | ||||||||
PanelMasterTM | 6 | % | — | 7 | % | 1 | % | |||||||||
Customer spares and other | 7 | % | 8 | % | 8 | % | 9 | % | ||||||||
Total | 100 | % | 100 | % | 100 | % | 100 | % | ||||||||
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Sales to individual unaffiliated customers in excess of 10% of total revenue were as follows:
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Customer A | 52 | % | 42 | % | 44 | % | 26 | % | ||||||||
Customer B | 20 | % | * | 28 | % | * | ||||||||||
Customer C | 19 | % | 15 | % | 11 | % | * | |||||||||
Customer D | * | * | * | 15 | % | |||||||||||
Customer E | * | * | * | 14 | % | |||||||||||
Customer F | * | * | * | 12 | % | |||||||||||
Customer G | * | 14 | % | * | * | |||||||||||
Customer H | * | 12 | % | * | * |
* | Customer accounted for less than 10% of total revenue for the period. |
Accounts receivable from individual unaffiliated customers in excess of 10% of total gross accounts receivable were as follows:
June 30, | September 30, | |||||||
2006 | 2005 | |||||||
Customer A | 45 | % | 29 | % | ||||
Customer B | * | 19 | % | |||||
Customer C | 11 | % | 19 | % | ||||
Customer D | * | 10 | % | |||||
Customer E | 11 | % | * |
* | Customer accounted for less than 10% of total gross accounts receivable for the period. |
Long-lived assets by geographical area are as follows:
June 30, | September 30, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
United States | $ | 17,534 | $ | 21,022 | ||||
Canada | — | 519 | ||||||
Other | 1,574 | 1,183 | ||||||
Total | $ | 19,108 | $ | 22,724 | ||||
NOTE 11 — Related Party Transactions
During the three and nine month periods ended June 30, 2006, the Company recorded approximately $0 and $14,000, respectively, in stock ownership expense related to options granted to a board member in his role as a consultant. During the three and nine month periods ended June 30, 2005, the Company recorded approximately $9,000 and $44,000, respectively, in stock ownership expense related to options granted to this board member in his role as a consultant.
During the three and nine month periods ended June 30, 2005, the Company paid $24,000 and $96,000, respectively to a member of the Company’s board of directors for consulting services rendered to the Company.
NOTE 12 — Provision for Income Taxes
For the three and nine month periods ended June 30, 2006, the Company recorded a provision for income taxes of approximately $205,000 and $756,000, respectively. The effective tax rate for the three and nine month periods ended June 30, 2006 is lower than the statutory rate due to tax benefits arising from net operating loss carryforwards. For the three and nine month periods ended June 30, 2005, the Company recorded a provision for income taxes of approximately $167,000 and $565,000, respectively. The Company had a provision for income taxes despite a net loss position in both the three and nine month periods ended June 30, 2005 due primarily to foreign income taxes.
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ITEM 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth in this discussion, especially under the caption “Factors Affecting Operating Results” in this Form 10-Q. Financial projections for future periods are forward-looking statements, and generally other statements using the words “anticipate”, “expect”, “intend”, “believe” and similar expressions identify forward-looking statements. The forward-looking statements made in thisForm 10-Q are made as of the filing date with the Securities and Exchange Commission and future events or circumstances could cause results that differ significantly from the forward-looking statements included here. Accordingly, we caution readers not to place undue reliance on these statements. We expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise.
The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto in Item 1 above and with our financial statements and notes thereto for the year ended September 30, 2005, contained in our Annual Report onForm 10-K filed with the SEC on December 14, 2005.
Overview
Our Company
We are a leading provider of yield management solutions to the flat panel display industry. Our customers use our systems to increase manufacturing yields of high performance flat panel displays used in a number of products, including notebook and desktop computers, televisions and advanced mobile electronic devices such as cellular phones, personal digital assistants and portable video games. Our test, repair and inspection systems are used by manufacturers to collect data, analyze product quality and identify and repair product defects at critical steps in the active matrix liquid crystal display manufacturing process.
We sell our products to manufacturers in the flat panel display industry. Our flat panel display customers are located in Korea, Taiwan and Japan, where flat panel display production is concentrated, and in China. We derive most of our revenue from a small number of customers, and we expect this to continue for the foreseeable future.
Our products are primarily manufactured in San Jose, California. Our manufacturing activities consist primarily of final assembly and test of components and subassemblies, which are purchased from third party vendors. We schedule production based upon customer purchase orders and anticipated orders during the planning cycle. We generally expect to be able to accept a customer order, build the required machinery and ship to the customer within 26 to 39 weeks.
The success of our business depends upon numerous factors, including, but not limited to:
• | The level of capital expenditures of flat panel display manufacturers, which in turn depends on the current and anticipated market demand for products utilizing flat panel displays, and | ||
• | The relative competitiveness of our products and services. |
We do not consider our business to be seasonal in nature, but it is cyclical with respect to the capital equipment procurement practices of flat panel display manufacturers and is impacted by the investment patterns of these manufacturers in different global markets. We do consider consumer demand for flat panel display products to be seasonal, with peak demand occurring in the latter half of each calendar year. This end-user seasonality has an influence on capacity decisions by flat panel display manufacturers and, has a limited influence on the flat panel display manufacturers overall investment patterns. However, because new fabrication facilities and upgrades to existing facilities represent significant investments and take time to implement, flat panel display manufacturers have cyclical investment patterns.
A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from approximately $300,000 to $2.8 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results.
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Focus on Flat Panel Display Industry
We have not always focused solely on the flat panel display industry. Previously, we also produced printed circuit board assembly inspection products and cathode ray tube display and high quality glass inspection products. However, we exited these businesses during fiscal 2003 as we believed that they did not have the potential to be profitable for us. Accordingly, the operating results of these former businesses are reclassified as discontinued operations for all periods presented.
In the first quarter of fiscal 2004, we suspended operations in the low temperature poly-silicon (“LTPS”) technology and the inverter markets. Although we did not actively pursue new LTPS business opportunities, we continued to support LTPS systems in the field with parts and service through March 31, 2005. Having completed substantially all our customer commitments, we wrote off the remaining assets associated with the LTPS technology in second quarter of fiscal 2005. In our third quarter of fiscal 2004, we sold all assets related to the inverter business.
Our transition to the singular focus on our core business of developing yield management solutions for the flat panel display industry has given us a clear strategy and direction. Our management team has been focused on several imperatives to support these objectives:
• | Product Focus:We continue to improve our product performance in defect detection, repair success, cost of ownership, ease of use and throughput for each of our product generations. We seek to couple this improved system performance with our expert applications engineering services to provide the best possible business solutions to our customers. | ||
• | Quality Focus:We continue to implement processes to drive product quality improvement and ease of use for our customers. | ||
• | Technology Leadership:We continue to emphasize our research and development to maintain our technology leadership in our products. | ||
• | Financial Improvement:We continue our efforts to improve financial performance. To achieve these goals, we will continue to look for vertical integration opportunities, source certain raw materials and certain system integration in Asia, and expand sales and marketing of our service product offerings. |
Furthermore, we have focused additional resources to strengthen our reporting structure, processes, and corporate governance within our organization.
In fiscal 2006, we are focusing on three key areas to improve our results of operations:
• | Gross margin improvement; | ||
• | New product introduction execution; and | ||
• | Strengthening market leadership in our yield management portfolio of products. |
Industry
Continuous innovations in microelectronics and materials science have enabled manufacturers, including our customers, to produce flat panel displays with sharper resolution, brighter pixels and faster imaging in varying sizes for differing applications. Growth in the mobile electronic devices market, the desktop computer market and the television market have driven the demand for flat panel displays, which offer reduced footprint, weight, power consumption and heat emission and better picture quality as compared to cathode ray tube displays, the current standard technology for televisions.
Active matrix liquid crystal display (“AMLCD”) is the most prevalent and one of the highest performance flat panel displays available today. The manufacture of active matrix liquid crystal displays is an extremely complex process, which has been developed and refined for different substrate glass panel sizes. Each progressive increase in initial substrate panel size is referred to by its “generation.” Manufacturing an active matrix liquid crystal display involves a series of three principal phases — the Array Phase, the Cell Phase and the Module Assembly Phase. At various points in the manufacturing process, the flat panel display manufacturer uses test and inspection equipment to identify defects to permit repair and to avoid wasting costly materials on continued manufacturing of a defective product. Our yield management products include our test and repair equipment that are used primarily in the Array phase of production, and our inspection equipment that is used primarily in the Cell phase of production.
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In the last half of calendar year 2005, market indicators showed that AMLCD demand rose and continued rising into calendar 2006 as a result of significantly reduced panel prices. However, at the end of the first half of calendar 2006, we once again saw an oversupply. Flat Panel Display manufacturers had been ramping capacity in anticipation that the World Cup soccer tournament would generate additional consumer demand to offset the typical first half seasonal demand dip. Unfortunately the additional demand did not materialize creating oversupply and causing inventories to build. Flat Panel Display manufacturers have responded by scaling back factory utilization rates and dropping panel average selling prices which have eroded the manufacturers’ profits. However, given television and information technology end-user market seasonality, industry forecasts show consumer demand for AMLCD products picking up again in the second half of calendar 2006.
The recent inventory levels and profitability issues have resulted in delays in some, but not all, of our customers’ investment plans. There is an element of uncertainty in terms of timing, particularly with respect to new factory investments for manufacturers in Taiwan, China and Korea and plans for expansion have not solidified. As a result, we currently expect both lower levels of bookings for the next several quarters due to factory investment delays and lower revenue in our fourth quarter of fiscal 2006. In addition, delivery dates for certain of our current orders could be rescheduled into the future to meet customer demands. However, these investment patterns could change dramatically if current inventory levels decrease rapidly. Industry forecasts show the current consumer market conditions to be seasonal in nature and increasingly driven by the fact that the industry is still in the early adoption phase of LCD televisions. Based on industry forecasts, we believe that demand for our Generation 7 test and repair equipment will pick up again as the market works through the current oversupply. In addition, we have installed our first Generation 8 systems which are now testing customer production glass. Also, we continue to see interest in our automated inspection systems; however, customer adoption has been slower than we expected.
Growth in the AMLCD television market is expected to continue to fuel the overall growth in the flat panel display market. While there is a current oversupply in the market, overall consumer demand for AMLCD television is projected to accelerate during the latter half of calendar year 2006. We expect TV panel prices to stabilize in the near future and peak panel demand to occur towards the end of the last half of calendar 2006. Overall, calendar year 2006 AMLCD television panel demand is still forecasted to be roughly double that of calendar 2005. This increased demand has been driven primarily by larger sized AMLCD televisions; and, in addition, we have also seen consumer demand for monitors increase and, as a result, we are seeing an increase in panel prices. There are many factors that will dictate how successful AMLCD manufacturers are in penetrating the television market, including display performance, price reduction and the ability to maintain profitability.
We believe continued growth in demand for AMLCD products will, in the long term, fuel investments in Generation 6, 7 and 8 factories to keep pace and that inspection, test and repair systems will continue to represent a significant percentage of our customers’ capital spending, driving increased demand for our products and services.
Backlog
Our backlog, consisting of unshipped system orders, unearned revenue and systems in deferred gross margin, as of June 30, 2006, was approximately $69.5 million, a majority of which we expect to ship, or to recognize for revenue, within the next six to twelve months. This compares to a backlog of $100.9 million as of September 30, 2005. All orders are subject to delay or cancellation with minimal penalty or no penalty to the customer. Because of possible changes in product delivery schedules and cancellation of product orders and the cyclical nature of our customers’ capital equipment procurement practices, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period. As discussed earlier, we are currently expecting lower levels of bookings for the next several quarters due to recently announced factory investment delays.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of our financial statements and the related disclosures requires our management to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Note 1 of the “Notes to Condensed Consolidated Financial Statements” describes significant accounting policies used in the preparation of our consolidated financial statements. Some of these significant accounting policies are considered to be critical accounting policies.
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A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations.
Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions that are believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties are discussed in the section below entitled “Factors Affecting Operating Results.”
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition.Note 1 of our “Notes to Condensed Consolidated Financial Statements” provides a description of our revenue recognition policy. For each arrangement, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or the services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured, the latter of which is subject to judgment. If we determine that any of these criteria are not met, we defer revenue recognition until such time as we determine that all of the criteria are met.
In addition, for arrangements with multiple deliverables, we make additional judgments as to whether each item has value to the customer on a stand-alone basis, the amounts of revenue for each element that are not subject to refund, that all defined customer acceptance experience levels have been met and the fair values of any undelivered items have been reliably determined.
We have a policy to record a provision as necessary for estimated sales returns in the same period as the related revenue is recorded. This provision, if any, is netted against revenue. Estimates applied to determine the provision are based on historical sales returns and other known factors which have not varied widely in the past and which we do not reasonably expect to significantly change in the foreseeable future. If the historical data we use to calculate these estimates does not properly reflect future returns, additional provisions may be required. Historically, we have not experienced the return of any of our systems upon which we have recognized revenue and do not expect this to change in the foreseeable future. However, due to the relatively high prices of our systems, the return of one of these systems would have a material adverse effect on our results of operations.
Allowance for Doubtful Accounts.Our trade receivables are derived from sales to flat panel display manufacturers located in Korea, Taiwan, Japan and China. In order to monitor potential credit losses, we perform periodic evaluations of our customer’s financial condition. We maintain an allowance for doubtful accounts for the potential inability of our customers to make required payments based upon our assessment of the expected collectibility of all accounts receivable. In estimating the provision, we consider (i) historical experience, (ii) the length of time the receivables are past due, (iii) any circumstances of which we are aware regarding a customer’s inability to meet its financial obligations, and (iv) other known factors. We review this provision periodically to assess the adequacy of the provision.
Our allowance for doubtful accounts was approximately $424,000 and $153,000 at June 30, 2006 and September 30, 2005, respectively. These balances each represent less than 1% of each period’s accounts receivable balance. Historically, losses due to customer bad debts in our flat panel display business have been immaterial, and we expect that this will not change in the foreseeable future. However, if a single customer was unable to make payments, additional allowances may be required. Due to the relatively high prices of our systems, the inability of even a single customer to make required payments could have a material adverse effect on our results of operations.
Inventories. The valuation of inventory requires us to estimate obsolete or excess inventory and inventory that is not saleable. The determination of obsolete or excess inventory requires us to estimate the future demand for our products within specific time horizons, generally twelve months or less. If our demand forecast for specific products is greater than actual demand and we fail to reduce manufacturing output accordingly, we could be required to record additional inventory write-offs, which would have a negative impact on our gross margin.
We review the adequacy of our inventory valuation on a quarterly basis. For production inventory, our methodology involves matching our on-hand inventory with our demand forecast over the next twelve months on a part-by-part basis. We then evaluate the parts found to be in excess of the twelve-month demand and take appropriate write-downs and write-offs to reflect the risk of obsolescence. This methodology is significantly affected by the demand forecast assumption. Using a longer time period of estimated
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demand could result in reduced inventory adjustment requirements. Based on our past experience, we believe the twelve-month time period to best reflect the reasonable and relative obsolescence risks. If actual demand or usage were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory may be required.
Warranty.Our warranty policy generally states that we will provide warranty coverage for a period of one year from final acceptance. We record the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment when the related revenue is recognized. Our warranty obligation is affected by product failure rates, consumption of field service parts and the efficiency by which the product failure is corrected. We estimate our warranty cost based on historical data related to these factors.
Our liability for warranty coverage was approximately $5.4 million and $5.3 million at June 30, 2006 and September 30, 2005, respectively. Should actual product failure rates, material usage or labor efficiencies differ from our estimates, revisions to the estimated warranty liability and related provision would be required.
Goodwill and Intangible Assets.We have accounted for goodwill and other intangible assets resulting from our acquisitions in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). SFAS No. 142 prohibits the amortization of goodwill and intangible assets with indefinite useful lives and requires that these assets be reviewed for impairment at least annually and more frequently if there are indicators of impairment. The process for evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. Should actual results differ from our estimates, revisions to the recorded amount of goodwill could be reported.
We amortize intangible assets with finite lives and other long-lived assets over their estimated useful lives and also subject them to evaluation for impairment. We review long-lived assets including intangible assets with finite lives for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable, such as a significant industry downturn, significant decline in the market value of the company, or significant reductions in projected future cash flows. We would recognize an impairment loss when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. We determine impairment, if any, using discounted cash flows. In assessing the recoverability of long-lived assets, including intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record additional impairment charges for these assets.
Goodwill at both June 30, 2006 and September 30, 2005, was approximately $153,000, and related entirely to our purchase of assets from Summit Imaging in fiscal 2003. Intangible assets, net of accumulated amortization, as of June 30, 2006 and September 30, 2005 were approximately $2.1 million and $3.2 million, respectively, related to patents and acquired core technology resulting from our purchase of assets from Summit Imaging in fiscal 2003, the assignment and license agreement signed with IHI in fiscal 2004, the purchase of Quantum Composers in fiscal 2004 and the purchase of Tucson Optical Research Corporation in fiscal 2004.
Stock-Based Compensation. We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS No. 123R, SEC SAB No. 107 and our prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123). The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock.
We determined the expected stock price volatility assumption using the implied volatility of our common stock. Prior to the adoption of SFAS No. 123R, we primarily used historical volatility in deriving our expected volatility assumption. We determined that implied volatility is more reflective of market conditions and a better indicator of expected volatility than a historical rate.
Contingencies and Litigation.We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We accrue the cost of an adverse judgment if, in our estimation and based on the advice of legal counsel, the adverse judgment is probable and we can reasonably estimate the ultimate cost of such a judgment. We were engaged in one significant litigation matter as of June 30, 2006 – Amtower v. Photon Dynamics, Inc. On May 5, 2006, judgments were entered in favor of our company and former officers. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded us approximately $445,000 in fees and costs. The award bears interest at the statutory rate of 10% simple interest per annum. Collection of the award will be stayed during the plaintiff’s appeal of the verdict. As of June 30, 2006, we recorded an accrual for legal charges incurred, as well as committed but unpaid expenses, related to this litigation.
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Results of Operations
Selected Financial Data
The percentage of net revenue represented by certain line items in our condensed consolidated statement of operations for the periods indicated are set forth in the table below.
Three Months Ended | Nine Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenue | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | ||||||||
Cost of revenue | 62.3 | 66.4 | 61.0 | 66.8 | ||||||||||||
Gross margin | 37.7 | 33.6 | 39.0 | 33.2 | ||||||||||||
Operating expenses: | ||||||||||||||||
Research and development | 16.5 | 22.0 | 17.5 | 27.6 | ||||||||||||
Selling, general and administrative | 13.5 | 18.8 | 14.5 | 18.0 | ||||||||||||
Restructure charge | — | 2.5 | 0.0 | 0.9 | ||||||||||||
Impairment of property and equipment | 0.1 | 0.5 | 0.0 | 0.6 | ||||||||||||
Gain on sale of fixed assets | — | (0.4 | ) | — | (0.1 | ) | ||||||||||
Amortization of intangible assets | 0.7 | 1.0 | 0.8 | 1.2 | ||||||||||||
Total operating expenses | 30.8 | 44.4 | 32.8 | 48.1 | ||||||||||||
Income (loss) from operations | 6.9 | (10.8 | ) | 6.2 | (14.9 | ) | ||||||||||
Interest income and other, net | 1.9 | 1.2 | 1.8 | 1.9 | ||||||||||||
Income (loss) from continuing operations before income taxes and discontinued operations | 8.8 | (9.6 | ) | 7.9 | (13.0 | ) | ||||||||||
Provision for income taxes | 0.4 | 0.4 | 0.5 | 0.6 | ||||||||||||
Income (loss) from continuing operations | 8.4 | (10.0 | ) | 7.4 | (13.6 | ) | ||||||||||
Income (loss) from discontinued operations | (0.2 | ) | 0.7 | (0.3 | ) | 0.3 | ||||||||||
Net income (loss) | 8.2 | % | (9.3 | )% | 7.1 | % | (13.3 | )% | ||||||||
Revenue
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Revenue | $ | 51.7 | 32 | % | $ | 39.1 | $ | 143.6 | 42 | % | $ | 101.1 |
Revenue increased 32% for the three months ended June 30, 2006 over the same period of the prior fiscal year and increased 3% sequentially from the three months ended March 31, 2006, as our customers continue their expansion of manufacturing capacity. Revenue increased 42% for the nine months ended June 30, 2006 over the same period of the prior fiscal year also reflecting our customers’ continued expansion of manufacturing capacity. However, as discussed earlier, the recent oversupply of end-user products has caused Flat panel display manufacturers to scale back utilization of existing capacity and to re-assess the timing of new factory investments. This oversupply has resulted in delays in some, but not all of our customers’ investment plans, which will affect our revenues in the next few quarters.
We generate revenue from the sales of our ArrayCheckerTM and ArraySaverTM test and repair equipment, our PanelMasterTM inspection equipment, and customer support, which includes the sales of spare parts.
ArrayCheckerTMand ArraySaverTMProduct Revenue
Our ArrayCheckerTM and ArraySaverTM test and repair equipment operate in the Array phase of AMLCD production and are built to handle the different generation sizes of substrate glass. Total revenue from our Generation 6 and earlier generation test and repair products represented approximately 32% and 93% of revenue in the three month periods ended June 30, 2006 and 2005, respectively, and approximately 31% and 91% of revenue in the nine month periods ended June 30, 2006 and 2005, respectively. The period-over-period decrease as a percentage of total revenue was due primarily to the shift in flat panel display manufacturers demand to our Generation 7 products as they move to a larger size glass substrate in the manufacturing process. Revenue from our Generation 7 products represented approximately 55% of revenue in each of the three and nine month periods ended June 30, 2006, and approximately 0% of revenue in each of the three and nine month periods ended June 30, 2005. Our products in each new generation
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contain new performance and control features designed specifically to enhance yield improvement and process control. As a result, historically we generally have experienced increases in our average selling prices of between 20% and 50% in each new generation product. As with prior generation products, our Generation 6 and 7 ArrayCheckerTM products have greater average selling prices than previous generations. However, the average selling prices of our Generation 6 and 7 ArraySaverTM products were relatively flat as compared to the prior generations due primarily to a more competitive environment in the array repair market. There is no assurance that we will be successful at achieving or sustaining average selling price increases on our Generation 7 and future generation products.
Revenue from our ArrayCheckerTM products represented approximately 75% and 71% of our total revenue for the three months ended June 30, 2006 and 2005, respectively, and approximately 68% and 63% of our total revenue for the nine months ended June 30, 2006 and 2005. Revenue from our test products increased as a percentage of revenue primarily due to the varying levels of capital expenditures of our customers as they invest in manufacturing capacity, which resulted in a higher mix of ArrayCheckerTM products in the three and nine months ended June 31, 2006 as compared to the same periods in the prior year.
Revenue from our ArraySaverTM products represented approximately 12% and 21% of our total revenue for the three months ended June 30, 2006 and 2005, respectively, and approximately 17% and 27% of our total revenue for the nine months ended June 30, 2006 and 2005, respectively. Revenue from our repair products decreased as a percentage of total revenue primarily due to the higher mix of ArrayCheckerTM products ordered by our customers.
Revenue from our ArrayCheckerTM and ArraySaverTM products includes revenue recognized upon final customer acceptance. Our sales terms are typically 80% to 90% of the sales price due upon shipment with that portion of the remaining amount due after installation and upon final customer acceptance. Revenue for the three and nine month periods ended June 30, 2006 included a lower absolute dollar value of revenue related to the receipt of final customer acceptances following completed installation of our products compared with the same periods in the prior fiscal year.
PanelMasterTMProduct Revenue
Our PanelMasterTM inspection equipment operates primarily in the Cell phase of AMLCD production, inspecting glass that has been cut down to the size of the needed application. As such, our PanelMasterTM product is not dependent on the initial glass substrate size and can function on either Generation 6 or Generation 7 fabrication lines. Consequently, we do not classify this product by generations.
Revenue from our PanelMasterTM products represented approximately 5% and 0% of total revenue for the three month periods ended June 30, 2006 and 2005, respectively, and approximately 6.8% and less than 1% in the nine month periods ended June 30, 2006 and 2005, respectively. Our inspection equipment was introduced in fiscal 2004 and the first production units were shipped in our fourth quarter of fiscal 2004. Because this was a new product line, we deferred 100% of the revenue until we received customer final acceptance, which we began receiving in the first quarter of our fiscal 2006. The revenue recognized in the nine months ended June 30, 2005 was revenue on an older, pre-production machine for which we received final acceptance.
Customer Support and Spare Parts Revenue
Revenue from customer support and spare parts represented approximately 7% and 8% of total revenue for the three month periods ended June 30, 2006 and 2005, respectively, and approximately 8% and 9% in the nine month periods ended June 30, 2006 and 2005, respectively. Revenue in both the three and nine months period ended June 30, 2006 was relatively flat as a percentage of total revenue compared to the same periods in the prior year. Revenues in both the three and nine month periods ended June 30, 2006, were higher in absolute dollars than in the comparative prior year periods due in part to increased sales of spare parts as we increase the installed base of tools at our customers’ facilities.
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International Revenue
Revenue by region for the periods indicated were as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Korea | $ | 37.4 | 91 | % | $ | 19.6 | $ | 103.6 | 239 | % | $ | 30.6 | ||||||||||||
Taiwan | 13.6 | (26 | )% | 18.4 | 37.9 | (8 | )% | 41.0 | ||||||||||||||||
Japan | 0.7 | (39 | )% | 1.1 | 2.1 | (87 | )% | 16.2 | ||||||||||||||||
China | — | 0 | % | — | — | (100 | )% | 13.3 | ||||||||||||||||
Total Revenue | $ | 51.7 | 32 | % | $ | 39.1 | $ | 143.6 | 42 | % | $ | 101.1 | ||||||||||||
The changes in revenue from the three and nine months ended June 30, 2006 as compared to the same periods in the prior fiscal year are a result of the investment patterns of flat panel display manufacturers, which in turn depends on the current and anticipated market demand for products utilizing flat panel displays.
In the three and nine months ended June 30, 2006, we invoiced revenue of approximately $716,000 and $1.9 million, respectively, in currencies other than U.S. dollars, primarily Japanese yen. In the three and nine months ended June 30, 2005, we invoiced revenue of approximately $727,000 and $18.3 million, respectively, in currencies other than U.S. dollars, primarily Japanese yen.
Revenue Outlook
We expect total revenue for the fourth quarter of fiscal 2006 to be between $30 and $35 million. As discussed earlier, the recent oversupply in end-user products has resulted in delays in some of our customers’ investment plans, and may cause delays in deliveries of current orders, all of which will reduce our revenues. As stated above, forward looking statements such as these and the ones below regarding our expected financial results for fiscal 2006 are subject to risks and uncertainties. Please see “Factors Affecting Operating Results” below for factors that could cause these forward looking statements not to come true.
Gross Margin
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2006 | |||||||||||||||||||
Gross Margin | 38 | % | 12 | % | 34 | % | 39 | % | 18 | % | 33 | % |
Gross margins increased in the three and nine month periods ended June 30, 2006, as compared to the same periods in the prior fiscal year. Gross margins in the current periods increased primarily due to:
• | A high mix of higher-margin ArrayCheckerTM systems in both the three and nine month periods; and, | ||
• | In the nine month period, a favorable warranty adjustment related to the increased reliability and serviceability of our tools. |
This increase in gross margins was offset by a lower mix of revenue related to the receipt of final customer acceptances following completed installation, which have higher margins associated with this portion of the sales price as compared to the same periods in the prior year, to costs associated with SFAS No. 123R for which there were no comparable charges in the same periods of the prior fiscal year, and to an additional write-down of excess inventory in our third quarter as a result of anticipated lower bookings and revenues.
We anticipate that our gross margin for our fourth quarter of fiscal 2006 will decrease due to the expected change in mix of lower gross margin products and to costs associated with the under-utilization of our San Jose facilities in connection with our expected lower fourth quarter revenues.
Key factors that may impact our future gross margin include:
• | Our revenue mix between higher margin ArrayCheckerTM systems and lower margin ArraySaverTM and PanelMasterTM systems; | ||
• | The costs of increasing customer service staff to support the increased demands of our customers; | ||
• | The additional costs in connection with inefficiencies of manufacturing newly-introduced products; | ||
• | Competitive pricing pressures, particularly in the array repair market; | ||
• | Reduced production levels as a consequence of either industry slowdown, order cancellations or customer-initiated changes in delivery schedules by our customers; and | ||
• | Fluctuations in the level of revenue due to the cyclical nature of customers’ capital expenditures. |
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Research and Development
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Expense | $ | 8.5 | (1 | )% | $ | 8.6 | $ | 25.1 | (10 | )% | $ | 27.9 | ||||||||||||
Percent of Revenue | 17 | % | 22 | % | 18 | % | 28 | % |
Our research and development expenses consisted primarily of salaries, related personnel costs, depreciation, prototype materials and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and improvement of our products. Our overall research and development spending decreased in the three and nine month periods ended June 30, 2006, in both absolute dollars and as a percentage of revenue over the same periods of the prior fiscal year due to lower spending on Generation 6 and 7 test, repair and inspection product development programs and to savings from the restructuring associated with the closing of our Markham, Canada location. This decrease in research and development expenses occurred despite the impact of SFAS No. 123R in the three and nine months ended June 30, 2006, for which there were no comparable charges in the same periods of the prior fiscal year.
We expect our research and development expenses to increase slightly in absolute dollars during our fourth quarter of fiscal 2006 as compared to research and development expenses of approximately $8.5 million in our third quarter due to expected levels of spending on new generation product lines. During the last three months of fiscal 2006, we will continue our research and development efforts to address four areas:
• | Ramp up our automated inspection program to address mass production requirements; | ||
• | Focus on product enhancements and improving cost of ownership on our Generation 7, 7.5 and 8 products; | ||
• | Accelerate development of our next-generation products; and | ||
• | Invest funds in reliability and cost reduction initiatives. |
We will continue to invest in research and development to maintain technology leadership in our products. Our customers must continually improve their display quality performance and production costs in order to be successful in the display market. To meet our customers’ needs, we must improve our product performance in defect detection, repair success, cost of ownership, ease of use and throughput for each of our product generations.
Selling, General and Administrative
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Expense | $ | 7.0 | (5 | )% | $ | 7.4 | $ | 20.8 | 15 | % | $ | 18.1 | ||||||||||||
Percent of Revenue | 14 | % | 19 | % | 15 | % | 18 | % |
Our selling, general and administrative expenses consisted primarily of salaries and related expenses for marketing, sales, finance, administration and human resources personnel, as well as costs for auditing, commissions, insurance, legal and other corporate expenses. Selling, general and administrative expenses were relatively flat in the three months ended June 30, 2005 and 2006, respectively and higher in absolute dollars in the nine month periods ended June 30, 2006 as compared to the same period of the prior fiscal year. The increase in the nine month period was primarily due to costs associated with SFAS No. 123R, to higher costs associated with audit and legal fees and to increased headcount.
We expect these expenses in our fourth quarter of fiscal 2006 to remain flat to slightly lower compared to selling, general and administrative expenses of approximately $7.0 million in our third quarter of fiscal 2006.
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Stock-Based Compensation
Effective October 1, 2005, we adopted the provisions of SFAS No. 123R, “Share-Based Payments.” SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award which is computed using the Black-Scholes option valuation model, and is recognized as expense over the employee requisite service period.
We previously applied Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations and provided the required pro forma disclosures of SFAS No. 123. No employee stock-based compensation was reflected in net income/loss for the three and nine month periods ended June 30, 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
Prior to adoption of SFAS No. 123R, in the fourth quarter of fiscal 2005, our Board of Directors approved the accelerated and full vesting of all unvested outstanding stock options to purchase shares of common stock of Photon Dynamics, Inc. that were held by current employees, including executive officers, but excluding non-employee members of our Board of Directors, that had an exercise price greater than $25.00 issued under our Amended and Restated 1995 Stock Option Plan and 2001 Equity Incentive Plan. Options to purchase 340,718 shares were subject to this acceleration, which was effective as of September 1, 2005. The decision to accelerate the vesting of these options was made primarily to reduce future financial impact to our results of operations, since after analysis it was determined that the retention value of the underwater options was relatively small compared to the income charge to continue vesting these options following the adoption of SFAS No. 123R.
We elected to adopt the modified prospective application method as provided by SFAS No. 123R. Accordingly, during the three and nine month periods ended June 30, 2006, we recorded stock-based compensation cost totaling the amount that would have been recognized had the fair value method been applied since the effective date of SFAS No. 123. We did not restate previously reported amounts.
During the three and nine month periods ended June 30, 2006, we recorded stock-based compensation related to our stock option plans of approximately $970,000 and $2.9 million, respectively, and compensation cost in connection with our employee stock purchase plan of approximately $116,000 and $355,000, respectively. Approximately $293,000 of stock-based compensation was capitalized as inventory and deferred gross margin during the nine months ended June 30, 2006.
The compensation expense related to share-based payments is charged to cost of revenue, research and development and selling, general and administrative categories based upon employees who receive the awards. The following table summarizes the stock-based compensation expense in our results from continuing operations:
Three Months Ended | Nine Months Ended | |||||||
June 30, 2006 | June 30, 2006 | |||||||
(in thousands) | ||||||||
Stock-based compensation expense included in continuing operations: | ||||||||
Cost of revenue | $ | 34 | $ | 86 | ||||
Research and development | 169 | 502 | ||||||
Selling, general and administrative | 749 | 2,366 | ||||||
Total stock-based compensation expense after income taxes (1) | $ | 952 | $ | 2,954 | ||||
(1) | The income tax benefit on stock-based compensation for all periods presented was not material. |
As of June 30, 2006, the unrecorded stock-based compensation balance related to stock options was $3.7 million and will be recognized over an estimated remaining weighted average amortization period of 1.6 years.
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Restructuring Charge
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Expense | $ | 0 | (100 | )% | $ | 951,000 | $ | 30,000 | (97 | )% | $ | 951,000 | ||||||||||||
Percent of Revenue | 0 | % | 2 | % | 0 | % | 1 | % |
In April, 2005, we recorded a restructuring charge associated with a reduction in workforce and consolidation and closing of our facilities at our Markham, Canada location. The charge was comprised of expenses for employee severance and related benefits as a result of planned terminations of employees and expenses for contract termination costs associated with excess facilities under a long-term operating lease agreement for facilities we vacated in June 2005.
Under the restructuring plan, certain employees were offered additional severance amounts and retention bonuses to stay through either September 2005 or March 2006. We accrued charges for these benefits ratably over the related service periods. We recorded additional restructuring charges of approximately $107,000 during the six months ended March 31, 2006 related to these severance and retention amounts, which was offset by an adjustment to the liability of approximately $77,000 related to bonuses. No additional amounts were charged in our third quarter of 2006. All termination benefits were paid out by March 31, 2006 and we do not expect to incur any additional restructure charges.
Under the restructuring plan, we expect annual savings in salary and benefits costs, amortization and rent expense of approximately $1.6 million to $2.0 million per fiscal year primarily in research and development. Rent savings were partially offset through March of 2006 by costs to sublease a smaller location in Markham, Ontario, Canada for the employees who were offered retention benefits to complete specific projects and assist in the transition of technology. To date, our actual savings have approximated our expected savings.
Impairment of Property and Equipment
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Expense | $ | 50,000 | (71 | )% | $ | 174,000 | $ | 50,000 | (91 | )% | $ | 556,000 | ||||||||||||
Percent of Revenue | 0 | % | 0 | % | 0 | % | 1 | % |
As discussed in the overview and critical accounting policies above, we have exited all business lines other than the flat panel display products market and have suspended operations in the LTPS and inverter markets. In the three months ended June 30, 2006 we wrote off certain amounts related to the Company’s test bed equipment. In the three months ended June, 30, 2005, we wrote off approximately $174,000 related to our test bed equipment. In the nine months ended June 30, 2005, we wrote off an additional $382,000, representing the remaining production assets related to our LTPS product line, as substantially all our customer commitments were fulfilled.
Gain on Sale of Property and Equipment
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Expense | $ | 0 | (100 | )% | $ | 143,000 | $ | 0 | (100 | )% | $ | 143,000 | ||||||||||||
Percent of Revenue | 0 | % | 0 | % | 0 | % | 0 | % |
In the three months ended June 30, 2005, we recorded approximately $143,000 as a gain on the sale of fixed assets for the sale of a demonstration tool.
Amortization of Intangibles
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Expense | $ | 372,000 | (2 | )% | $ | 380,000 | $1.1 million | (5 | )% | $1.2 million | ||||||||||||||
Percent of Revenue | 1 | % | 1 | % | 1 | % | 1 | % |
Amortization of intangibles remained relatively flat in absolute dollars in the three and nine months ended June 30, 2006 as compared to the same periods in the prior fiscal year.
Based on intangible assets recorded at June 30, 2006, and assuming no subsequent additions to, or impairment of, the underlying assets, we expect our fourth quarter amortization to be approximately $370,000.
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Interest Income and Other, Net
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Expense | $ | 999,000 | 112 | % | $ | 472,000 | $2.5 million | 33 | % | $1.9 million | ||||||||||||||
Percent of Revenue | 2 | % | 1 | % | 2 | % | 2 | % |
Interest income and other, net consisted primarily of interest income, foreign currency exchange gains and losses and other miscellaneous income and expense. The higher level of interest income and other, net, in the three and nine month periods ended June 30, 2006 as compared to the same periods of the prior fiscal year, was primarily attributable to an increase in interest income due to higher interest rates on invested cash compared to rates in effect in the prior year periods and to a decreased effect of transaction gains and losses.
Provision for Income Taxes
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Expense | $ | 205,000 | 23 | % | $ | 167,000 | $ | 756,000 | 34 | % | $ | 565,000 | ||||||||||||
Percent of Revenue | 0 | % | 0 | % | 1 | % | 1 | % |
The effective tax rates for the three and nine month periods ended June 30, 2006 were approximately 4% and 7%, respectively. The effective tax rate for the three and nine month periods ended June 30, 2006 is lower than the statutory rate due to tax benefits arising from net operating losses.
The effective tax rates for the three and nine month periods ended June 30, 2005 were approximately 4% in each period. We had a provision for income taxes despite a net loss position in both the three and nine month periods ended June 30, 2005 due primarily to foreign income taxes.
Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income, amount of and access to tax loss carryforwards, expenses incurred in connection with acquisitions that are not deductible for tax purposes, amounts of tax-exempt interest income and research and development credits as a percentage of aggregate pre-tax income, and the effectiveness of our tax planning strategies.
Discontinued Operations
Three Months Ended | Nine Months Ended | |||||||||||||||||||||||
June 30 | June 30 | |||||||||||||||||||||||
2006 | Change | 2005 | 2006 | Change | 2005 | |||||||||||||||||||
Income (loss) | $ | (127,000 | ) | na | $ | 268,000 | $ | (473,000 | ) | na | $ | 258,000 |
Discontinued operations consist of our former printed circuit board assembly inspection business and our former cathode ray tube display and high quality glass inspection business. Loss from discontinued operations for the three months ended June 30, 2006 consists primarily of approximately $127,000 of additional legal charges related to the Amtower v. Photon Dynamics, Inc. lawsuit. Loss from discontinued operations for the nine months ended June 30, 2006 consists primarily of legal charges related to the Amtower v. Photon Dynamics, Inc. lawsuit (see Note 9), offset by deferred rent charges that were reversed in the quarter ended December 31, 2005 when we successfully renegotiated our remaining lease obligations for our Austin, Texas facility.
Income from discontinued operations for the three months ended June 30, 2005 includes approximately $270,000 for the reduction in certain reserves related to contingent warranty and lease obligations settled at amount less than originally estimated in the former cathode ray tube and high quality glass inspection business. Income from discontinued operations for the nine months ended June 30,
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2005 includes additional amounts of approximately $132,000 for the reversal of a liability related to the settlement of vendor obligations, offset by approximately $113,000 of additional legal charges related to the Amtower v. Photon Dynamics, Inc. lawsuit, both of which are related to the printed circuit board assembly inspection business.
We do not expect losses from these businesses to be material in the foreseeable future; however, the former executive officer in the Amtower v. Photon Dynamics, Inc. has filed a notice of appeal, and an adverse judgment in an appeal could have a material adverse effect on the results of operations from discontinued operations.
Liquidity and Capital Resources
We have financed our growth primarily by a combination of cash flows from operations and public stock offerings. Working capital was $133.2 million as of June 30, 2006, compared to $116.5 million as of September 30, 2005. A major component of working capital is $90.6 million of cash, cash equivalents and short-term investments as of June 30, 2006, compared to $93.0 million as of September 30, 2005.
Operating Activities of Continuing Operations
Cash used in operating activities from continuing operations was approximately $531,000 in the first nine months of fiscal 2006. Cash was used in continuing operations in the nine months ending June 30, 2006, despite our net income, adjusted for non-cash related items, because of our use of approximately $19.7 million of cash in changes in working capital, the primary source being an increase in accounts receivable of approximately $30.2 million, offset in part by a decrease in inventory of approximately $13.1 million. In addition, we saw a net decrease of approximately $3.1 million in our deferred gross margin. Our accounts receivable increased due primarily to the non-linearity of shipments, with a large percentage of product shipments occurring in June. The decrease in inventories is due primarily to timing of delivery of products in our backlog and to lower levels of third quarter bookings due to the market oversupply. Deferred gross margin fluctuates based upon the timing of acceptance on our tools by our customers.
Investing Activities of Continuing Operations
Cash provided by investing activities from continuing operations was approximately $2.9 million in the first nine months of fiscal 2006. Cash provided by investing activities was primarily the result of approximately $4.8 million of net maturities and sales of short-term investments, offset by capital expenditures of approximately $1.9 million.
Financing Activities of Continuing Operations
Cash provided by financing activities from continuing operations was approximately $1.3 million in the first nine months of fiscal 2006 resulting from approximately 1.8 million in sales of our common stock under our employee equity compensation plans, offset by approximately $533,000 of repayments of short term borrowings.
The timing of and amounts received from employee stock option exercises are dependent upon the decisions of the respective option holders, and are not controlled by us. Therefore, funds raised from the issuance of common stock upon the exercise of employee stock options should not be considered an indication of additional funds to be received in future periods.
We have a bank line of credit (“line of credit”) that currently has a $4.0 million borrowing capacity with an interest rate of floating prime with an expiration date of October 2007. The line of credit is secured by substantially all of our assets and contains certain financial and other covenants. At June 30, 2006, no amounts were outstanding under the line of credit.
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Operating, Investing and Financing Activities of Discontinued Operations
Discontinued operations consist of our former printed circuit board assembly inspection business and our former cathode ray tube display and high quality glass inspection business. Net cash used in discontinued operations during the nine month periods ended June 30, 2006 and 2005 is as follows:
Nine Months Ended | ||||||||
June 30, | ||||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Printed circuit board business | $ | (1,149 | ) | $ | (523 | ) | ||
Cathode ray tube display and high quality glass inspection business | (20 | ) | (264 | ) | ||||
Net cash used in discontinued operations | $ | (1,169 | ) | $ | (787 | ) | ||
Cash used in discontinued operations for the nine months ended June 30, 2006 consists primarily of cash paid for legal expenses in the Amtower v. Photon Dynamics, Inc. lawsuit and, to a lesser extent, changes in other working capital balances.
Contractual Obligations
The following table summarizes the approximate contractual obligations that we have at June 30, 2006. Such obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited conditions.
Payments Due by Fiscal Year | ||||||||||||||||||||||||||||
Contractual Obligations | Total | 2006(1) | 2007 | 2008 | 2009 | 2010 | Thereafter | |||||||||||||||||||||
(In thousands) | ||||||||||||||||||||||||||||
Notes payable | $ | 1,050 | $ | 50 | $ | 1,000 | $ | — | $ | — | $ | — | $ | — | ||||||||||||||
Operating lease obligations | 12,421 | 748 | 2,984 | 2,667 | 2,624 | 2,714 | 684 | |||||||||||||||||||||
Purchase obligations | 27,517 | 12,111 | 15,278 | 128 | — | — | — | |||||||||||||||||||||
Total | $ | 40,988 | $ | 12,909 | $ | 19,262 | $ | 2,795 | $ | 2,624 | $ | 2,714 | $ | 684 | ||||||||||||||
(1) | Remaining three months |
Notes payable consist primarily of promissory notes issued in connection with the acquisition of Quantum Composers, Inc. These notes mature through fiscal 2007.
Operating lease obligations consist primarily of our lease agreement for our headquarters in San Jose, California, which is leased under a non-cancelable operating lease that expires in 2010, with two renewal options at fair market value for additional five year periods.
We maintain certain open inventory purchase commitments with our suppliers to help provide a smooth and continuous supply chain for key components. Our liability in these purchase commitments is generally restricted to purchase commitments over a forecasted time horizon as mutually agreed upon between the parties and is reflected in “purchase obligations” in the table above. The majority of these purchase commitments are related to our backlog of unshipped orders.
Working Capital
We believe that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to meet our operating and capital requirements and obligations for at least the next twelve months.
However, this forward-looking statement is based upon our current plans and assumptions, which may change, and our capital requirements may increase in future periods. In addition, we believe that success in our industry requires substantial capital in order to maintain the flexibility to take advantage of opportunities as they may arise. We may, from time to time, invest in or acquire complementary businesses, products or technologies and may seek additional equity or debt financing to fund such activities. There can be no assurance that such funding will be available to us on commercially reasonable terms, if at all, and if we were to proceed with acquisitions without this funding or with limited funding it would decrease our capital resources. The sale of additional equity or convertible debt securities could result in dilution to our existing shareholders.
Impact of Accounting Pronouncements
In July 2006, the Financial Accounting Standard Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and
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penalties, accounting in interim periods and disclosures. It will be effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. The provisions of this Interpretation apply to all tax positions upon initial adoption of this Interpretation. Only tax positions that meet the recognition threshold criteria at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year, presented separately. We are currently evaluating the accounting and disclosure requirements of this Interpretation and we expect to adopt it as required at the beginning of our fiscal year 2008.
In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”). SFAS No. 154 replaces APB No. 20 (“APB 20”) and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of change a cumulative effect of changing to the new accounting principle whereas SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle, unless it is impracticable. SFAS No. 154 enhances the consistency of financial information between periods. SFAS No. 154 will be effective beginning with our first quarter of fiscal year 2007. We do not expect that the adoption of SFAS No. 154 will have a material impact on our results of operations, financial position or cash flows.
In March 2005, the FASB published FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” which clarifies that the term, conditional asset retirement obligations, as used in SFAS No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. The interpretation also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. This interpretation is effective no later than the end of our fiscal 2006. We do not expect the adoption of this Interpretation to have a material effect on our consolidated financial position or results of operations.
Factors Affecting Operating Results
We have sustained losses and we may sustain losses in the future.
Although we reported net income for the nine months ended June 30, 2006, we reported a net loss for the fiscal year ended September 30, 2005, as well as net losses for each of the fiscal years ended September 30, 2003 and 2002. In addition, we expect to report a net loss in the fourth quarter of fiscal 2006, due primarily to decreased revenue due to some customers rescheduling current orders to later delivery dates and delaying placing additional orders as they re-assess the timing of their capital expenditures in light of the current end-product market oversupply. In the future our revenue may decline, remain flat or grow at a rate slower than expected. Our ability to achieve and maintain profitability is dependent in part on the success of our efforts to increase revenues and to reduce operating expenses as a percentage of revenue through our ongoing cost-cutting measures and our gross margin improvement programs. Although we expect the current oversupply to correct and our customers to resume increasing manufacturing capacity, if demand for our products is not sustained and we do not react quickly to reduce discretionary and variable spending, this would impair our ability to again achieve profitability. For all of these reasons, there is no assurance that we will be successful in achieving or maintaining increased revenue, reduced operating expenses, positive cash flows or profitability.
Our operating results are difficult to predict and may vary from investors’ expectations, which could cause our stock price to fall.
We have experienced, and expect to continue to experience, significant fluctuations in our quarterly results. Consequently, past financial results may not be indicative of future financial results. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from $300,000 to $2.8 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results. After we ship our products, customers may reject or delay acceptance, which would adversely impact our revenues. Moreover, customers may cancel or reschedule shipments, and production difficulties could delay shipments.
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Other factors which may influence our operating results in a particular quarter include:
• | the timing of the receipt of orders from major customers; | ||
• | our product mix; | ||
• | competitive pricing pressures; | ||
• | our ability to obtain components from our single or limited source suppliers in a timely manner; | ||
• | global economic uncertainty; | ||
• | changing international economic conditions; | ||
• | the outcome of the appeal of our litigation with a former executive officer; | ||
• | worldwide political instability; | ||
• | our ability to design, manufacture and introduce new products on a cost-effective and timely basis; | ||
• | the delay between expenses to further develop marketing and service capabilities and the realization of benefits from those improved capabilities; and | ||
• | the introduction of new products by our competitors. |
Our operating results also could be affected by sudden changes in customer requirements, currency exchange rate fluctuations and other economic conditions affecting customer demand and the cost of operations in the global markets in which we do business. As a result of these or other factors, our operating results could be significantly and adversely affected and our stock price could decline. In addition, it is possible that in some future quarter our operating results may be below the expectations of public market analysts and investors, which could cause our stock price to fall.
If our products experience performance, reliability or quality problems, our customers may reduce their orders.
We believe that future orders of our products will depend in part on our ability to satisfy the performance, reliability and quality standards required by our customers. Particularly as customers seek increased yields, greater throughput and higher quality end products, we must continually redesign our products to meet the needs of our customers. As with the introduction of any new product, our products may experience design and reliability issues. For example, our original Generation 7 ArrayCheckerTM and ArraySaverTM systems required longer than anticipated time periods to bring them to full production due to design and reliability issues. If our products have performance, reliability or quality problems, then we may experience:
• | delays in collecting accounts receivable; | ||
• | reduced orders; | ||
• | additional service expenses; and | ||
• | higher manufacturing costs. |
If we are unable to meet the requirements of our customers, our revenue may decrease and our business could be harmed.
In addition, we typically provide a limited warranty on our products for a period of one year from final acceptance by customers. Warranty claim experience may, at times, exceed the estimated cost of warranty coverage we record in our warranty provision. In the future, we may incur substantial warranty claim expenses on our products and actual warranty claims may exceed recorded provisions, resulting in harm to our business.
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Capital investment by manufacturers of flat panel display products can be highly cyclical and may decline in the future.
Our business depends in large part on capital expenditures by manufacturers of flat panel display products, which in turn depends on the current and anticipated market demand for the end products in that industry. The market for flat panel display products is highly cyclical and has experienced periods of oversupply resulting in significantly reduced demand for capital equipment. In the last half of calendar year 2005, market indicators showed that AMLCD consumer demand rose and continued rising into calendar 2006 as a result of significantly reduced panel prices. However, at the end of the first half of calendar 2006, we once again saw an oversupply, causing manufacturers to respond by scaling back factory utilization rates and dropping panel average selling prices which have eroded the manufacturers’ profits.
If the flat panel display markets in which we sell our products experience further slowdowns in the future, it could cause our revenue to decrease significantly. We do not control the timing or volume of orders placed by our customers. Whether and to what extent our customers place orders for any specific products, as well as the mix and quantities of products included in those orders, are factors beyond our control. Insufficient orders will result in under-utilization of our manufacturing facilities and infrastructure and will negatively affect our operating results and financial condition. In addition, the need to invest in the engineering, research and development, and marketing required to penetrate targeted foreign markets and maintain extensive service and support capabilities limits our ability to reduce expenses during these downturns.
We depend on sales to a few large customers in the flat panel display industry, and if we lose any of our large customers our revenue could decrease significantly.
The flat panel display industry is extremely concentrated with a small number of manufacturers producing the majority of the world’s flat panel displays. If one or more of our major customers ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be unable to replace sales to these customers. Sales to our greater than 10% customers in the first nine months of fiscal 2006 and all of fiscal 2005 were as follows: our top three customers accounted for 83% of our revenue in the first nine months of fiscal 2006, while our top five customers accounted for 67% of our revenue in fiscal 2005.
We rely upon sales of a limited range of products, and if demand for one product decreases for any reason it could cause our revenue to decline significantly.
All of our revenue is expected to come from a limited range of products for the flat panel display industry. As a result, we are solely reliant on the flat panel display industry. Any decline in demand for, or failure to achieve continued market acceptance of, our primary products or any new version of these products could harm our business. Continued market acceptance of our array test, array repair and cell inspection products is critical to our success.
We may not be able to develop and introduce new products that respond to evolving industry requirements in a timely manner, which could reduce our ability to compete effectively.
The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The failure to develop new products and introduce them successfully and in a timely manner could harm our competitive position and results of operations. We believe that our future success will depend in part upon our ability to continue to enhance our existing products and to develop and manufacture new products. For example, the size of glass plates for flat panel displays and the resolution of flat panel displays have changed frequently and may continue to change, requiring us to redesign or reconfigure our flat panel display products.
We expect to continue to incur significant research and development costs. There can be no assurance that we will be successful in the introduction, marketing and cost effective manufacture of any of our new products, that we will be able to timely develop and introduce new products and enhance our existing products and processes to satisfy customer needs or achieve market acceptance, or that the new markets for which we are developing new products or expect to sell current products will develop sufficiently.
In addition, we depend on close relationships with our customers and the willingness of those customers to share information with us, and the failure to maintain these relationships could harm our product development efforts.
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If we are not able to obtain critical components from our single or limited source suppliers, we may experience significant delays in producing our products, which could decrease our revenue for an extended period of time.
We obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain materials handling platforms from a single source supplier. Although we seek to reduce dependence on our sole and limited source suppliers, alternative sources of supply for this equipment may not be available or may be available on unfavorable terms. The partial or complete loss of our sole and limited source suppliers could significantly delay our shipments or otherwise harm our results of operations and damage customer relationships. Further, a significant increase in the price of one or more of these pieces of equipment could harm our results of operations.
All of our revenue is derived from sales to companies located outside the United States, which exposes us to risks that we would not experience with domestic sales.
We expect sales to customers in foreign countries to continue to represent 100% of our revenue in the foreseeable future. A number of factors may adversely affect our international sales and operations, including:
• | political instability and the possibility of hostilities, terrorist attacks, or war; | ||
• | imposition of governmental controls; | ||
• | fluctuations in interest and currency exchange rates; | ||
• | export license requirements; | ||
• | restrictions on the export of technology; | ||
• | limited foreign protection of intellectual property rights; | ||
• | trade restrictions; | ||
• | periodic or local international downturns; | ||
• | decreases in productivity, temporary plant shutdowns or infrastructure service disruptions resulting from widespread health alerts including SARS and warnings of an Avian Flu pandemic; | ||
• | changes in tariffs; and | ||
• | difficulties in staffing and managing international operations. |
If any of these factors occur, our operating results and revenue could be materially and adversely affected.
Compliance with new reporting requirements may strain our resources and we may be unable to implement in a timely manner additional finance and accounting systems, procedures and controls in the future to satisfy new reporting requirements, which could cause our stock price to fall.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to perform an evaluation of our internal control over financial reporting and have our independent registered public accounting firm publicly attest to such evaluation. During fiscal 2005, we had one material weakness in our internal control over financial reporting that we are working to remediate. However, there is no guarantee that once we remediate this material weakness, our internal control over financial reporting will continue to be adequate to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements in accordance with generally accepted accounting standards, or that our independent registered public accounting firm will concur with our assessments in the future. Preparation for and compliance with these requirements has been, and we expect it will continue to be, expensive and time-consuming. This is especially true because we have had a number of material weaknesses in the past that we have remediated, which was expensive and time consuming to do. In the future, if we are unable to complete the required assessment as to the adequacy of our internal control over financial reporting or if our independent registered public accounting firm is unable to provide us with an unqualified report as to the effectiveness of our internal control over financial reporting, we could be subject to further regulatory scrutiny and a further loss of public confidence in our internal control over financial reporting. In addition, any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligation and potentially result in a decline of our stock price.
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We have previously disclosed material weaknesses in our internal control over the financial close process and sales order fulfillment and revenue recognition process, and additionally, restated our quarterly results of operations and financial condition for both the first and the third quarters of fiscal 2005. Although we committed significant resources to remediate these weaknesses, we encountered an additional material weakness in the fourth quarter of fiscal 2005 and there can be no assurances that material weaknesses will not occur in the future. Accordingly, to the extent these material weaknesses may occur in the future or new material weaknesses may be found to exist, these material weaknesses may have a material effect on our company, or our results of operations, or result in a failure to meet our reporting obligations.
We may have difficulty integrating the businesses or assets we have acquired and may acquire in the future, and we may not realize the benefits that we expect from these acquisitions.
In addition to our efforts to develop new technologies from internal sources, we also may seek to acquire new technologies from external sources. As a part of this effort, we may make additional acquisitions of, or significant investments in, businesses with complementary products, services and/or technologies. Integrating a business can be a complex, time-consuming and expensive process. If we are not able to do so effectively, we will not be able to realize the benefits that we expect to receive from either our past or future acquisitions. For each acquisition, we must integrate separate technologies, product lines, business cultures and practices, employees and systems. Acquisitions are subject to numerous risks, including:
• | difficulty in the assimilation of the technologies and products of the acquired company; | ||
• | entering markets in which we have no or limited direct prior experience; | ||
• | loss of key customers of the acquired company; | ||
• | diversion of management resources from the business of the combined company; | ||
• | incompatibility of business cultures or practices; | ||
• | loss of key employees of the acquired company; | ||
• | costs and delays in implementing common systems and procedures; | ||
• | potential inefficiencies in delivering services to the customers of the combined company; and | ||
• | assumption of unknown or undisclosed liabilities. |
Any of these difficulties could increase our operating costs or result in impairment of purchased assets, which could harm our financial performance.
In addition, we may also elect to change our strategic direction and may no longer have need for the acquired businesses or technologies. For example, in 2004 we determined not to pursue new business for RTP Systems acquired in November 2002. In the third quarter of fiscal 2004, we sold all of our assets related to our TFT-LCD backlight inverter business acquired in September 2002. In 2003, we exited the printed circuit board assembly inspection and high quality glass inspection businesses. As a result, some or all of the technologies acquired in connection with certain of our prior acquisitions have been abandoned. Future acquisitions may also result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities and amortization expenses related to acquired intangible assets, which could harm our profitability.
Any failure of, or other problems at or with, our third party manufacturers could delay shipments of our flat panel display products, harm our relationships with our customers or otherwise negatively impact our business.
We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. If any third party that we use to manufacture our products is unable to satisfy our quality requirements or provide us with the products and services in a timely manner, our shipments of these products may be delayed, our customer relationships may be harmed and our results of operations may be adversely impacted. There can be no assurance that our relationship with any third party that we use to manufacture our products will result in a reduction of our expenses or enable us to satisfy our customers’ quality requirements or to deliver our products to our customers in a timely manner.
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If we do not compete effectively in our target markets, we will lose market share.
The markets for yield management systems in the flat panel display industry are highly competitive. We face substantial competition from established competitors that have greater financial, engineering and manufacturing resources than us and have larger service organizations and long-standing customer relationships. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Competitive pressures may force price reductions that could harm our results of operations. Our customers may also develop technology and equipment that may reduce or eliminate their need to purchase our products. Although we believe we have certain technological and other advantages over our competitors, maintaining and capitalizing on these advantages will require us to continue a high level of investment in engineering, research and development, marketing and customer service support. There can be no assurance that we will have sufficient resources to continue to make these investments or that we will be able to make the technological advances necessary to maintain our competitive advantages.
Our success depends in large part on the strength of the active matrix liquid crystal display in the flat panel display industry.
While our technology is applicable to other flat panel display technologies, our experience has been focused on applications for active matrix liquid crystal displays, the most prevalent and one of the highest performance flat panel displays available today. We derive 100% of our revenue from flat panel display products, substantially all of which were based on the active matrix liquid crystal display technology. An industry shift away from active matrix liquid crystal display technology to existing or new competing technologies could reduce the demand for our existing products and require significant expenditures to develop new products, each of which could harm our business. As an example, if the emerging AMLCD Television market has a significant shift to plasma technology, LCD manufacturers’ fab planning and Photon Dynamics business would be negatively impacted.
Our business could be harmed if we fail to properly protect our intellectual property.
Our success depends largely on our ability to protect our intellectual property. While we attempt to protect our intellectual property through patents, copyrights and trade secrets in the United States and other countries, there can be no assurance that we will successfully protect our technology or that competitors will not be able to develop similar technology independently. We cannot assure you that the claims allowed on any patents held by us will be sufficiently broad to protect our technology against competition from third parties with similar technologies or products. In addition, we cannot assure you that any patents issued to us will not be challenged, invalidated or circumvented or that the rights granted there-under will provide competitive advantages to us. Moreover, the laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States, and we could experience various obstacles and high costs in protecting our intellectual property rights in foreign countries. If we are unable to obtain or maintain these protections, we may not be able to prevent third parties from using our intellectual property.
We also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive. We have taken measures to protect our trade secrets and know-how, including the use of confidentiality agreements with our employees. It is possible that these agreements may be breached and that the available remedies for any breach will not be sufficient to compensate us for damages incurred.
Litigation may be necessary to enforce or defend against claims of intellectual property infringement, which could be expensive and, if we lose, could prevent us from selling our products.
Litigation may be necessary in the future to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical personnel.
Our domestic and international competitors, many of which have substantially greater resources and have made substantial investments in competing technologies, may have patents that will prevent, limit or interfere with our ability to manufacture and sell our products. We have not conducted a comprehensive independent review of patents issued to third parties. Third parties may assert infringement claims, successful or otherwise, against us, and litigation may be necessary to defend against claims of infringement or invalidity. An adverse outcome in the defense of a patent suit could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease selling our products. Even successful defenses of patent suits can be costly and time-consuming.
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We must attract and retain key employees and our management team and employees must work effectively together to maintain and grow our business.
Our future success depends in part on our ability to retain key personnel, particularly senior management and engineers. We also need to attract additional skilled personnel in significant areas of our business to grow. There can be no assurance that we will be able to retain our existing personnel or attract additional qualified employees in the future. We generally do not have employment contracts with our employees and do not maintain key person life insurance on any of our employees.
Terrorism and international political instability may negatively affect our operations.
The threat of terrorism targeted at the regions of the world in which we do business increases the uncertainty in our markets and may delay any recovery in the general economy, which could threaten our business.
Increased international political instability, particularly resulting from the threat of terrorist attacks, and further enhanced security measures as a result of the threat of terrorist attacks may hinder our ability to do business and may increase our costs of operations. Such continuing instability could cause us to incur increased costs in transportation, make such transportation unreliable, increase our insurance costs and cause international markets to fluctuate. This instability could have the same effects on our suppliers and their ability to timely deliver their products to us. If this international political instability continues or increases, our business and results of operations could be harmed.
Our manufacturing facilities may be subject to disruption from natural disasters.
Operations at our manufacturing facilities are subject to disruption for a variety of reasons, including work stoppages, acts of war, terrorism, fire, earthquake, energy shortages, flooding or other natural disasters. Our corporate and manufacturing facilities in California are located near major earthquake faults, which have experienced earthquakes in the past. Such disruption could cause delays in shipments of products to our customers. We cannot ensure that alternate production capacity would be available if a major disruption were to occur or that, if it were available, it could be obtained on favorable terms. Such disruption could result in cancellation of orders or loss of customers and could seriously harm our business. It could also significantly delay our research and engineering efforts for the development of new products, most of which is conducted at our California facilities.
In addition, a major earthquake in Asia near one of our customers could disrupt our operations or the operations of our customers, which could reduce demand for our products.
Exposure to various risks related to the regulatory environment.
We are subject to various risks related to new, different, inconsistent or even conflicting laws, rules and regulations that may be enacted by legislative bodies and/or regulatory agencies in the countries in which we operate and with which we must comply.
Computer viruses may disrupt our operations.
Despite our network security measures, our tools and servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems and our tools. Any such event could have an adverse effect on our business, operating results, and financial condition.
Additional Risks in Owning our Common Stock
Our stock price may fluctuate significantly.
The market price of our common stock could fluctuate significantly in response to variations in quarterly operating results and other factors, such as:
• | announcements of technological innovations or new products by us or by our competitors; |
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• | government regulations; | ||
• | developments in patent or other property rights; and | ||
• | developments in our relationships with our customers. |
In addition, the stock market has in recent years experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Broad market fluctuations, general economic condition and specific conditions in the flat panel display industry may adversely affect the market price of our common stock.
Some anti-takeover provisions may affect the price of our common stock.
Our Amended and Restated Articles of Incorporation authorize our board of directors to issue up to 5,000,000 shares of preferred stock. The board also has the authority to determine the price, rights, preferences and privileges, including voting rights, of those shares without any further vote or action by the shareholders. The rights of our shareholders will be subject to, and may be impaired by, the rights of the holders of any preferred stock that may be issued in the future. These and other provisions contained in our charter documents and applicable provisions of California law could serve to depress our stock price or discourage a hostile bid in which shareholders could receive a premium for their shares. In addition, these provisions could make it more difficult for a third party to acquire a majority of our outstanding voting stock or otherwise effect a change in control of us.
We do not anticipate paying cash dividends.
We have never declared or paid any cash dividends on our capital stock and do not anticipate paying cash dividends in the foreseeable future. We have also agreed not to pay cash dividends under our current bank line of credit. Instead, we intend to apply any earnings to the expansion and development of our business.
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ITEM 3.Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Exchange Rate Risk
We are exposed to changes in foreign currency exchange rates primarily related to the operating results of our foreign affiliates. Actual changes in foreign exchange rates could adversely affect our operating results or financial condition. The potential impact depends upon the magnitude of the rate change. In fiscal 2005, approximately $19.3 million of our revenue was denominated in currencies other than U.S. dollars, primarily in Japanese yen, and, at September 30, 2005, approximately $243,000 of our accounts receivable was denominated in currencies other than U.S. dollars, all of which was in Japanese yen. In the nine month period ended June 30, 2006, approximately $1.9 million of our revenue was denominated in currencies other than U.S. dollars, primarily in Japanese yen. At June 30, 2006, approximately $10.8 million of our accounts receivable was denominated in currencies other than U.S. dollars, primarily in Japanese yen. Our accounts receivable are subject to exchange rate risk and will fluctuate with the changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in all currency exchange rates affecting our accounts receivable from the rates at June 30, 2006 would decrease the fair value of the accounts receivable by approximately $986,000.
Although a relatively considerable portion of our revenue in fiscal 2005 was denominated in currencies other than U.S. dollars, we expect that our cash, accounts receivable and accounts payable generally will be denominated in U.S. dollars and, therefore, our exposure to changes in foreign currency exchange rates for our cash, accounts receivable and accounts payable is minimal.
Market Risk
Our market risk as described under the heading “Interest Rate Risk” in Item 7A of our Annual Report on form 10-K for the fiscal year ended September 30, 2005, has not changed significantly.
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ITEM 4.Controls and Procedures
Photon Dynamics maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
As described in our fiscal 2005 Annual Report on Form 10-K, we reported a material weakness in our financial reporting process arising from not contemporaneously documenting and evaluating complex and unusual transactions of a material nature and communicating such evaluation to our Audit Committee on a timely basis. During the first quarter of fiscal 2006, we started a process for contemporaneously documenting and evaluating material, complex and unusual transactions and reporting to the Audit Committee those transactions which involve a significant level of management judgment or which, by the nature of the transaction, rise to the level of communication to the Audit Committee. During the second quarter of fiscal 2006, we enhanced this process by incorporating into our quarterly financial close process formal procedures in order to accomplish, in a systematic fashion, the following:
• | Identification of those transactions that warrant timely documentation and evaluation, | ||
• | Assessment to ensure that such identified transactions are appropriately documented and evaluated, | ||
• | Identification of those transactions, if any, that rise to the level of communication to the Audit Committee, and | ||
• | Communication to the Audit Committee those transactions, if any, that, by the nature of the transaction, were identified as rising to the level of communication to the Audit Committee. |
Although we maintained this enhanced process during the period covered by this report, we require additional time and testing to ensure that this material weakness has been completely remediated, and the revised controls as described above are operating effectively. Consequently, we have not yet been able to conclude that this material weakness no longer exists. Based on the foregoing and our management’s evaluation (with the participation of our chief executive officer and chief financial officer), our chief executive officer and chief financial officer have concluded that, as of June 30, 2006, our disclosure controls and procedures were not effective to provide reasonable assurance that the 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 management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
In light of this determination and as part of the work undertaken in connection with this report, we have applied compensating procedures and processes as necessary to ensure the reliability of our financial reporting. Accordingly, management believes, based on its knowledge, that (i) 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 they were made, not misleading with respect to the periods covered by this report, and (ii) the financial statements, and other financial information included in this report, fairly present in all material respects our financial condition, results of operations and cash flows as of and for the periods presented in this report.
Changes in Control Over Financial Reporting in the Third Quarter of Fiscal 2006
During the period covered by this report, we have not implemented any significant changes in our internal control over financial reporting, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial Reporting.
Our management, including the chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all error and all fraud. A control system no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within a company are detected. The inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
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PART II. OTHER INFORMATION
ITEM 1.Legal Proceedings
We and certain of our directors and former officers were named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The trial of this case commenced on April 3, 2006. On a motion for non-suit, the court dismissed all claims against all directors on April 20, 2006. On May 5, 2006, judgments were entered in favor of our Company and our former officers. The plaintiff, a former officer of the Company, had asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of our insider trading policy. The plaintiff had sought damages in excess of $6 million for defendants’ alleged refusal to allow plaintiff to sell shares of our stock in May of 2000, plus unspecified emotional distress and punitive damages. The plaintiff has the right to appeal the judgments. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded us approximately $445,000 in fees and costs. The award bears interest at the statutory rate of 10% simple interest per annum. Collection of the award will be stayed during the plaintiff’s appeal of the verdict.. We have recorded an accrual for current charges incurred, as well as committed but unpaid expenses, related to this litigation.
This lawsuit was previously reported in our Annual Report on Form 10-K for the fiscal year ended September 30, 2005, as well as in our Quarterly Reports on Form 10-Q for the quarters ended December 31, 2005 and March 31, 2006.
From time to time, we are subject to certain other legal proceedings and claims that arise in the ordinary course of business. Additionally, in the ordinary course of business we may potentially be subject to future legal proceedings that could individually, or in the aggregate, have a material adverse effect on our financial condition, liquidity or results of operations. Litigation in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.
ITEM 1A.Risk Factors
The requirement to include the risk factors called by this item of Form 10-Q will not become effective until the Form 10-Q is filed for the first quarter of fiscal 2007. However, please refer to the information set forth under “Part I, Item 2 – Management Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting Operating Results” for a discussion of risk factors facing Photon Dynamics.
ITEM 2.Unregistered Sales of Equity Securities and Use of Proceeds
None.
ITEM 3.Defaults Upon Senior Securities
None.
ITEM 4.Submission of Matters to a Vote of Security Holders
None.
ITEM 5.Other Information
None.
ITEM 6.Exhibits
Exhibits
See the Exhibit Index which follows the signature page of this Quarterly Report on Form 10-Q, which is incorporated herein 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.
PHOTON DYNAMICS, INC. | ||||||
By: | /s/ Maureen L. Lamb | |||||
Chief Financial Officer and Secretary | ||||||
(Duly authorized and principal financial officer) | ||||||
Dated: August 9, 2006 |
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Exhibit Index
Number | Exhibit | |
3.1(1) | Amended and Restated Articles of Incorporation of the Registrant. | |
3.2(1) | Certificate of Amendment to Articles of Incorporation of the Registrant. | |
3.3(2) | Bylaws of the Registrant. | |
4.1 | Reference is made to Exhibits 3.1, 3.2 and 3.3. | |
10.1 | Compensation for Outside Directors, Effective May 24, 2006. | |
31.1 | Certification required by Rule 13a-14(a) or Rule 15d-14(a). | |
31.2 | Certification required by Rule 13a-14(a) or Rule 15d-14(a). | |
32.1** | Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350). |
Key to Exhibits:
(1) | Previously filed as the like-numbered exhibit to the Registrant’s Registration Statement on Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission on January 14, 2002, as amended, and incorporated herein by reference. | |
(2) | Previously filed as the like-described exhibit to the Registrant’s Quarterly Report on Form 10Q for the quarter ended December 31, 2005 as filed with the Securities and Exchange Commission on February 9, 2006, and incorporated herein by reference. | |
** | The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. |
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