experience with customers that have trucking fleets. This operation is part of our mobile data communications segment.
Sales and marketing strategies vary with particular markets served and include direct sales through sales, marketing and engineering personnel, sales through independent representatives, value-added resellers or a combination of the foregoing. We intend to continue to expand international marketing efforts by engaging additional independent sales representatives, distributors and value-added resellers and by establishing additional Comtech foreign sales offices. As appropriate and as guided by corporate senior management, our three business segments capitalize on manufacturing, technology, sales, marketing and customer support synergies between them.
Our management, technical and marketing personnel establish and maintain relationships with customers. Our strategy includes a commitment to provide ongoing customer support for our systems and equipment. This support involves providing direct access to engineering staff or trained technical representatives to resolve technical or operational issues.
Over-the-horizon microwave systems, mobile data tracking and messaging products and services and a portion of our solid-state high-power, broadband RF microwave amplifier product line have long sales cycles. Once a product is designed into a system, customers may be reluctant to change the incumbent supplier due to the extensive qualification process and potential redesign required in using alternative sources. Accordingly, senior management is actively involved in key aspects of relations with our major customers.
Sales by geography and customer type, as a percentage of consolidated net sales, are as follows:
International sales include sales to U.S domestic companies for inclusion in products that will be sold to international customers. In fiscal 2005, except for sales to the U.S. government, one customer, a prime contractor, represented 10.2% of consolidated net sales. In fiscal 2004 and 2003, except for sales to the U.S. government, one customer, another prime contractor, represented 12.5% and 19.8% of consolidated net sales, respectively.
Our backlog as of July 31, 2005 and 2004 was approximately $153.3 million and $83.5 million, respectively. We expect that a majority of the backlog as of July 31, 2005 will be recognized as sales during fiscal 2006. We received advance payments and deposits aggregating approximately $5.3 million as of July 31, 2005 in connection with orders included in the backlog at that date. At July 31, 2005, approximately 37.7% of the backlog consisted of U.S. government contracts, subcontracts and government funded programs, approximately 51.9% consisted of orders for use by foreign customers (including sales to prime contractors’ international customers) and approximately 10.4% consisted of orders for use by domestic commercial customers.
Our backlog consists solely of firm orders. In the case of contracts with departments or agencies of the U.S. government, including our MTS contract discussed above, orders are only included in backlog to the extent funding has been obtained for such orders. All of the contracts in our backlog are subject to cancellation at the convenience of the customer or for default in the event that we are unable to perform under the contract.
Variations in backlog from time to time are attributable, in part, to the timing of contract proposals, the timing of contract awards and the delivery schedules on specific contracts. Our satellite earth station equipment, forward error correction product lines, turnkey employee mobility solutions and a portion of our RF microwave amplifiers business operate under short lead times and usually generate sales out of inventory. As a result, we believe our
backlog at any point in the fiscal year is not necessarily indicative of the total sales anticipated for any particular future period.
Manufacturing and Service
Our manufacturing operations consist principally of the assembly and testing of electronic products that we design and build from purchased fabricated parts, printed circuits and electronic components.
We consider our facilities to be well maintained and adequate for current and planned production requirements. All of our manufacturing facilities, including those that serve the military market, must comply with stringent customer specifications. We employ formal quality management programs and other training programs, including the International Standard Organization’s (“ISO-9000”) quality procedure registration programs.
Our ability to deliver products to customers on a timely basis is dependent, in part, upon the availability and timely delivery by subcontractors and suppliers of the components and subsystems that we use in manufacturing our products. Electronic components and raw materials used in our products are generally obtained from independent suppliers. Some components are standard items and are available from a number of suppliers. Others are manufactured to our specifications by subcontractors. Although we obtain certain components and subsystems from a single source or a limited number of sources, we believe that most components and equipment are available from multiple sources.
Research and Development
We reported research and development expenses for financial reporting purposes of $21.2 million, $15.9 million and $12.8 million in fiscal 2005, 2004 and 2003, respectively, representing 6.9%, 7.1% and 7.4% of total net sales, respectively, for these periods.
A portion of our research and development efforts relates to the adaptation of our basic technology to specialized customer requirements and is recoverable under contracts, and such expenditures are not included in our research and development expenses for financial reporting purposes. During fiscal 2005, 2004 and 2003, we were reimbursed by customers for such activities in the amounts of $3.0 million, $5.7 million and $3.7 million, respectively. Our aggregate research and development expenditures (internal and customer funded) were $24.2 million, $21.7 million and $16.5 million or 7.8%, 9.7% and 9.5% of total net sales in fiscal 2005, 2004 and 2003, respectively.
Intellectual Property
We rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. The products we sell require significant engineering design and manufacturing expertise. The majority of these technological capabilities, however, are not protected by patents and licenses. We rely on the expertise of our employees and our learned experiences in both the design and manufacture of our products and the delivery of our services.
Some of our telecommunications transmission technology is protected by patents, which are significant to protecting our proprietary technology. We have been issued several U.S. patents relating to forward error correction technology that is utilized in our TPC-enabled satellite modems. The earliest of these patents expires in 2012.
Competition
Our businesses are highly competitive and are characterized by rapid technological change. A significant technological breakthrough by others, including new companies or our customers, could have a material adverse effect on our business. Our growth and financial condition depend on, among other things, our ability to keep pace with such changes and developments and to respond to the sophisticated requirements of an increasing variety of electronic equipment users and transmission technologies.
Certain of our competitors are substantially larger, have significantly greater financial, marketing, research and development, technological and operating resources and broader product lines than we do. The principal competitors in our telecommunications transmission segment include ViaSat, Inc., Radyne Corporation, Miteq, Inc., iDirect, Inc. and Marconi Corporation plc. The principal competitors in our mobile data communications segment include Qualcomm, Inc. and EMS Technologies, Inc. The principal competitors in our RF microwave amplifiers segment include Herley Industries, Inc., Zeta (a division of DRS Technologies, Inc.) and ARKalmus. In addition, certain of our customers, such as prime contractors who currently outsource their engineering and manufacturing
9
requirements to us, have technological capabilities in our product areas and could choose to replace our products with their own. In some cases, we partner or team with companies (both large or mid-tier) to compete against other teams for large defense programs. In some cases, these same companies may be competitors as it relates to certain aspects of our business.
We believe that competition in all of our markets is based primarily on technology innovation, product performance, reputation, delivery times, customer support and price. Due to our flexible organizational structure and proprietary know-how, we believe we have the ability to develop, produce and deliver products on a cost-effective basis faster than many of our competitors.
Employees
At July 31, 2005, we had 1,090 employees (including temporary employees and contractors), 589 of whom were engaged in production and production support, 289 in research and development and other engineering support and 212 in marketing and administrative functions. None of our employees are represented by a labor union. We believe that our employee relations are good.
Regulatory Matters
We are subject to a variety of local, state and federal governmental regulations. Our products that are incorporated into wireless communications systems must comply with various governmental regulations, including those of the Federal Communications Commission (“FCC”). Our manufacturing facilities, which may store, handle, emit, generate and dispose of hazardous substances that are used in the manufacture of our products, are subject to a variety of local, state and federal regulations, including those issued by the Environmental Protection Agency. Our international sales are subject to U.S. and foreign regulations and may require licenses from U.S. government agencies or require the payment of certain tariffs. In addition, we are subject to recent directives buy the European Union related to the recycling of electrical and electronic equipment. Our financial reporting, corporate governance, public disclosure and compliance practices are governed by laws such as the Sarbanes-Oxley Act of 2002 and rules and regulations issued by the Securities and Exchange Commission (“SEC”). As a U.S. government contractor and subcontractor, we are subject to a variety of rules and regulations, such as the Federal Acquisition Regulations.
To date, we have incurred costs in connection with compliance with these regulations in the normal course of business. We have not experienced material changes to our earnings, capital expenditures or competitive position caused by unexpected expenditures in connection with complying with such regulations.
ITEM 2. PROPERTIES
Our corporate offices are located in a portion of a 46,000-square foot engineering and manufacturing facility on more than two acres of land in Melville, New York. This facility is primarily used by our RF microwave amplifiers segment. We lease this facility from a partnership controlled by our Chairman, Chief Executive Officer and President. The lease, as amended, provides for our use of the premises as they now exist for a term of ten years through December 2011. We have a right of first refusal in the event of a sale of the facility. The base annual rental under the lease is subject to customary adjustments.
Although primarily used for our satellite earth station product lines which are part of our telecommunications transmission segment, all three of our business segments utilize our recently expanded 126,000 square foot, high-volume manufacturing center located in Tempe, Arizona. This manufacturing center utilizes state-of-the-art design and production techniques, including analog, digital and RF microwave production, hardware assembly and full service engineering. The lease for this facility expires in fiscal 2011 and we have the option to extend the term of the lease for an additional five-year period.
Our telecommunications transmission segment leases an additional ten facilities, five of which are located in the U.S. The U.S. facilities (excluding our Tempe, Arizona facility) aggregate 112,000 square feet and are primarily utilized for manufacturing, engineering, and general office use. Our telecommunications transmission segment also operates five small offices in China, North Africa, Thailand, the United Kingdom and Canada that are primarily utilized for customer support, engineering and sales. Our mobile data communications segment operates in a 31,000 square foot facility located in Germantown, Maryland and a 13,000 square foot facility located in Gig Harbor, Washington. The lease terms for all of these facilities are generally for multi-year periods and we believe that we will be able to renew these leases or find comparable facilities elsewhere.
10
ITEM 3. LEGAL PROCEEDINGS
We are subject to certain legal actions, which arise in the normal course of business. Although the ultimate outcome of litigation is difficult to accurately predict, we believe that the outcome of these actions will not have a material effect on our consolidated financial position or results of operations.
During fiscal 2005, two of our leased facilities located in Florida experienced hurricane damage to both leasehold improvements and personal property. As of July 31, 2005, we have substantially completed all restoration efforts relating to the hurricane damage. We have a written agreement with our general contractor which we believe limits our liability to the amount of insurance proceeds ultimately received. Our general contractor is in a dispute with certain of its subcontractors. As a result, we placed approximately $1.4 million, which represents the amount of insurance proceeds still payable to the general contractor, into an escrow account with the 9th Judicial Circuit Court in Orange County, Florida. We are awaiting the Court’s direction as to how these funds should be disbursed. We are also continuing our efforts to work with the insurance carrier and the general contractor and its subcontractors to finalize the amount of any additional insurance proceeds. We do not expect that the outcome of this matter will have a material effect on our consolidated financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to our stockholders during the fourth quarter of the fiscal year ended July 31, 2005.
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock trades on the Nasdaq National Market under the symbol “CMTL.” The following table shows the quarterly range of the high and low sale prices for our common stock as reported by the Nasdaq National Market, as adjusted to reflect the three-for-two stock split effected in April 2005. Such prices do not include retail markups, markdowns or commissions.
| | | | | | | |
| | Common Stock | |
| |
| |
| | High | | Low | |
| |
| |
| |
Fiscal Year Ended July 31, 2004 | | | | | | | |
First Quarter | | $ | 21.93 | | $ | 9.73 | |
Second Quarter | | | 26.35 | | | 17.78 | |
Third Quarter | | | 22.80 | | | 10.60 | |
Fourth Quarter | | | 15.92 | | | 9.95 | |
| | | | | | | |
Fiscal Year Ended July 31, 2005 | | | | | | | |
First Quarter | | | 19.71 | | | 10.85 | |
Second Quarter | | | 25.63 | | | 17.87 | |
Third Quarter | | | 36.65 | | | 22.07 | |
Fourth Quarter | | | 39.70 | | | 31.80 | |
Dividends
We have never paid cash dividends on our common stock and we intend to continue this policy for the foreseeable future. We expect to use earnings to finance the development and expansion of our businesses. Our Board of Directors reviews our dividend policy periodically. The payment of dividends in the future will depend upon our earnings, capital requirements, financial condition and other factors considered relevant by our Board of Directors.
Recent Sales of Unregistered Securities
On July 16, 2003, we sold 3.2 million shares of our common stock to a limited number of accredited investors in a private placement transaction for an aggregate price of approximately $40.6 million (or $12.89 per share). We used a portion of the net proceeds of $38.2 million from the sale of shares to prepay long-term debt and will use the balance for other corporate purposes.
11
The securities offered and sold in the private placement were not registered with the SEC and were sold without registration in reliance upon the exemption from securities registration afforded by the provisions of Regulation D under the Securities Act of 1933, as amended. We registered for resale the shares sold in the private placement by filing a registration statement with the SEC, which became effective in August 2003.
In addition to the private placement, we sold, in the aggregate, 47,370 and 82,104 shares of our common stock to holders of warrants who exercised purchase rights during fiscal 2004 and 2003, respectively. These warrants for the purchase of shares of our common stock were issued in connection with our acquisition of Mobile Datacom Corporation in September 1998 and were issued with an exercise price of $2.92 per share.
On January 27, 2004, we issued $105.0 million of 2.0% convertible senior notes in a private offering pursuant to Rule 144A under the Securities Act of 1933, as amended. During certain periods, the notes are convertible into shares of our common stock at an initial conversion price of $31.50 per share (a conversion rate of 31.7460 shares per $1,000 original principal amount of notes), subject to adjustment in certain circumstances. The notes may be converted if, during a conversion period on each of at least 20 trading days, the closing sale price of our common stock exceeds 120% of the conversion price in effect. Upon conversion of the notes, in lieu of delivering common stock, we may, in our discretion, deliver cash or a combination of cash and common stock. We may, at our option, redeem some or all of the notes on or after February 4, 2009. Holders of the notes will have the right to require us to repurchase some or all of the outstanding notes on February 1, 2011, February 1, 2014 and February 1, 2019 and upon certain events, including a change in control. If not redeemed by us or repaid pursuant to the holders’ right to require repurchase, the notes mature on February 1, 2024.
The 2.0% interest is payable in cash, semi-annually, through February 1, 2011. After such date, the 2.0% interest will be accreted into the principal amount of the notes. Also, commencing with the six month period beginning February 1, 2009, if the average note price for the applicable trading period equals 120% or more of the accreted principal amount of such notes, we will pay contingent interest at an annual rate of 0.25%.
The notes are general unsecured obligations of Comtech, ranking equally in right of payment with all of our other existing and future unsecured senior indebtedness and senior in right of payment to any of our future subordinated indebtedness. All of our subsidiaries have issued full and unconditional guarantees in favor of the holders of our 2.0% convertible senior notes, except for our subsidiary that purchased certain assets and assumed certain liabilities of Memotec (the “Memotec Subsidiary”). The Memotec Subsidiary’s total assets, equity, sales, income from continuing operations before income taxes and cash flows from operating activities were less than 3% of the corresponding consolidated amount. These full and unconditional guarantees are joint and several. Other than supporting the operations of its subsidiaries, Comtech Telecommunications Corp. (the “Parent”) has no independent assets or operations and there are currently no significant restrictions on its ability, or the ability of the guarantors, to obtain funds from each other by dividend or loan.
The net proceeds of the offering are being used for working capital and general corporate purposes and potentially may be used for future acquisitions of businesses or technologies or repurchases of our common stock. We filed a registration statement with the SEC, which became effective in April 2004, for the resale of the notes and the shares of common stock issuable upon conversion of the notes.
Issuer Purchases of Equity Securities
We did not repurchase any of our equity securities during fiscal 2005.
Approximate Number of Equity Security Holders
As of September 14, 2005, there were approximately 786 holders of our common stock. Such number of record owners was determined from our shareholder records and does not include beneficial owners of our common stock held in the name of various security holders, dealers and clearing agencies.
12
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table shows selected historical consolidated financial data for our Company. During the fiscal quarter ended January 31, 2005, the Company adopted Emerging Issues Task Force (“EITF”) Issue No. 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings Per Share.” The Company has restated, for comparative purposes, the historical share and per share data, including earnings per share (“EPS”), to reflect the impact of the assumed conversion of the Company’s 2.0% convertible senior notes in calculating diluted EPS. No restatement of EPS for periods prior to fiscal 2004 was required since the convertible senior notes were not outstanding during these periods. All share and per share amounts have also been adjusted to reflect the three-for-two stock splits of the Company’s common shares that occurred in April 2005 and July 2003. Detailed historical financial information is included in the audited consolidated financial statements for fiscal 2005, 2004 and 2003.
| | | | | | | | | | | | | | | | |
| | Fiscal Years Ended July 31,
(In thousands, except per share amounts) | |
| | 2005 | | | 2004 | | | 2003 | | | 2002 | | | 2001 | |
| |
| | |
| | |
| | |
| | |
| |
Consolidated Statement of
Operations Data: | | | | | | | | | | | | | | | | |
Net sales | | $ | 307,890 | | | 223,390 | | | 174,035 | | | 119,357 | | | 135,931 | |
Cost of sales | | | 180,524 | | | 135,858 | | | 114,317 | | | 78,780 | | | 87,327 | |
| |
|
| | |
| | |
| | |
| | |
| |
Gross profit | | | 127,366 | | | 87,532 | | | 59,718 | | | 40,577 | | | 48,604 | |
| | | | | | | | | | | | | | | | |
Expenses: | | | | | | | | | | | | | | | | |
Selling, general and administrative | | | 51,819 | | | 36,016 | | | 28,045 | | | 22,512 | | | 22,707 | |
Research and development | | | 21,155 | | | 15,907 | | | 12,828 | | | 11,041 | | | 10,190 | |
In-process research and development | | | — | | | 940 | | | — | | | 2,192 | | | — | |
Amortization of intangibles | | | 2,328 | | | 2,067 | | | 2,039 | | | 1,471 | | | 2,552 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | 75,302 | | | 54,930 | | | 42,912 | | | 37,216 | | | 35,449 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | | | | | | | | | | | | | | |
Operating income | | | 52,064 | | | 32,602 | | | 16,806 | | | 3,361 | | | 13,155 | |
| | | | | | | | | | | | | | | | |
Other expenses (income): | | | | | | | | | | | | | | | | |
Interest expense | | | 2,679 | | | 1,425 | | | 2,803 | | | 3,061 | | | 4,015 | |
Interest income | | | (4,072 | ) | | (921 | ) | | (275 | ) | | (452 | ) | | (2,303 | ) |
Other (income) expense, net | | | — | | | — | | | — | | | (28 | ) | | 841 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | | | | | | | | | | | | | | |
Income before provision (benefit) for
income taxes | | | 53,457 | | | 32,098 | | | 14,278 | | | 780 | | | 10,602 | |
| | | | | | | | | | | | | | | | |
Provision (benefit) for income taxes | | | 16,802 | | | 10,271 | | | 4,569 | | | (368 | ) | | 3,888 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | | | | | | | | | | | | | | |
Net income | | $ | 36,655 | | | 21,827 | | | 9,709 | | | 1,148 | | | 6,714 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | | | | | | | | | | | | | | |
Net income per share: | | | | | | | | | | | | | | | | |
Basic | | $ | 1.69 | | | 1.03 | | | 0.57 | | | 0.07 | | | 0.41 | |
| |
|
| | |
| | |
| | |
| | |
| |
Diluted | | $ | 1.42 | | | 0.92 | | | 0.53 | | | 0.07 | | | 0.38 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | | | | | | | | | | | | | | |
Weighted average number of common
shares outstanding - basic | | | 21,673 | | | 21,178 | | | 17,168 | | | 16,788 | | | 16,533 | |
| |
|
| | |
| | |
| | |
| | |
| |
| | | | | | | | | | | | | | | | |
Weighted average number of common and common equivalent shares outstanding assuming dilution - diluted | | | 27,064 | | | 24,781 | | | 18,290 | | | 17,562 | | | 17,798 | |
| |
|
| | |
| | |
| | |
| | |
| |
(continued)
13
| | | | | | | | | | | | | | | | |
| | Fiscal Years Ended July 31,
(In thousands) | |
| | 2005 | | | 2004 | | | 2003 | | | 2002 | | | 2001 | |
| |
| | |
| | |
| | |
| | |
| |
Other Consolidated Operating Data: | | | | | | | | | | | | | | | | |
Backlog at period-end | | $ | 153,314 | | | 83,549 | | | 100,142 | | | 44,121 | | | 50,094 | |
New orders | | | 377,655 | | | 206,797 | | | 230,056 | | | 113,384 | | | 135,487 | |
Research and development expenditures
- internal and customer funded | | | 24,156 | | | 21,656 | | | 16,504 | | | 13,070 | | | 11,846 | |
| | | | | | | | | | | | | | | | |
| | As of July 31,
(In thousands) | |
| | 2005 | | | 2004 | | | 2003 | | | 2002 | | | 2001 | |
| |
| | |
| | |
| | |
| | |
| |
Consolidated Balance Sheet Data: | | | | | | | | | | | | | | | | |
Total assets | | $ | 382,403 | | | 306,390 | | | 164,250 | | | 126,586 | | | 146,988 | |
Working capital | | | 254,690 | | | 201,218 | | | 74,801 | | | 51,577 | | | 67,089 | |
Long-term debt | | | — | | | — | | | — | | | 28,683 | | | 42,000 | |
Convertible senior notes | | | 105,000 | | | 105,000 | | | — | | | — | | | — | |
Other long-term obligations | | | 396 | | | 158 | | | 393 | | | 1,294 | | | 2,157 | |
Stockholders’ equity | | | 196,629 | | | 142,398 | | | 117,568 | | | 67,288 | | | 65,565 | |
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
We design, develop, produce and market innovative products, systems and services for advanced communications solutions. We conduct our business through three complementary segments: telecommunications transmission, mobile data communications and RF microwave amplifiers. We sell our products into commercial and government markets where we believe we have technological, engineering, systems design or other expertise that differentiate our product offerings. We believe we are leaders in the market segments that we serve.
Our telecommunications transmission segment, our largest business segment, provides specialized products and systems for satellite, over-the-horizon microwave and wireless line-of-sight microwave telecommunications systems. Our mobile data communications segment provides satellite-based mobile location, tracking and messaging services and mobile satellite transceivers primarily for defense applications, including logistics, support and battlefield command and control, as well as turnkey employee mobility solutions. Our RF microwave amplifiers segment designs, manufactures and markets solid-state, high-power, broadband RF microwave amplifier products.
A substantial portion of our sales may be derived from a limited number of relatively large customer contracts, the timing of revenues from which cannot be predicted. Quarterly sales and operating results may be significantly affected by one or more of such contracts. Accordingly, we can experience significant fluctuations in sales and operating results from quarter-to-quarter and period-to-period comparisons may not be indicative of future performance.
Revenue from the sale of our products is generally recognized when the earnings process is complete, upon shipment or customer acceptance. Revenue from contracts relating to the design, development or manufacturing of complex electronic equipment to a buyer’s specification or to provide services relating to the performance of such contracts is recognized using the percentage-of-completion method. Revenue from contracts that contain multiple elements that are not accounted for under the percentage-of-completion method are accounted for in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” Revenue from these contracts is allocated to each respective element based on each element’s relative fair value and is recognized when the respective revenue recognition criteria for each element are met.
Our contract with the United States (“U.S.”) Army for the Movement Tracking System (“MTS”) is for an eight-year period and revenue recognition is based on the percentage-of-completion method. The gross margin is based on the estimated sales and expenses for the entire eight-year contract. The amount of revenue recognized has been limited to the amount of funded orders received from the U.S. Army. Through the end of our fiscal quarter ended October 31, 2004, we recognized revenue on the portion of such orders that relate to prepaid service time when the time was
14
used by the customer. As a result of changes to the manner in which our technology is being deployed and used, commencing November 1, 2004, we are recognizing service time revenue based on a network availability method which recognizes prepaid service time on a straight-line basis from the date of shipment through the end of the contract term in July 2007.
Our gross profit is affected by a variety of factors, including the mix of products, systems and services sold, production efficiencies, estimates of warranty expense, price competition and general economic conditions. Our gross profit may also be affected by the impact of any cumulative adjustments to contracts that are accounted for under the percentage-of-completion method.
Selling, general and administrative expenses consist primarily of salaries, commissions and benefits for marketing, sales and administrative employees, advertising and trade show costs, professional fees and other administrative costs.
Our research and development expenses relate to both existing product enhancements and new product development. A portion of our research and development effort is related to specific contracts and is recoverable under those contracts because they are funded by the customers. Such customer funded expenditures are not included in research and development expenses for financial reporting purposes, but are reflected in cost of sales.
As more fully described below under“Recent Accounting Pronouncements – Impact of SFAS No. 123(R), Share- Based Payments,”beginning in the first quarter of fiscal 2006, we will be required to recognize compensation expense for previously issued and new share-based compensation awards. Accordingly, the future reported amounts of cost of sales, research and development expenses and selling, general and administrative expenses will include the incremental expense relating to such awards.
In May 2004, we acquired certain assets and assumed certain liabilities of Memotec, Inc. (“Memotec”), a subsidiary of Kontron AG, and at the same time, purchased related inventory owned by Kontron Canada Inc., for an aggregate purchase price of approximately $5.2 million in cash. Commencing in May 2004, Memotec’s results of operations have been included in our telecommunications transmission segment.
In February 2005, we acquired certain assets and assumed certain liabilities of Tolt Technologies, Inc. (“Tolt”) for an aggregate purchase price of $3.7 million, including transaction costs of $0.2 million. Based on Tolt’s achievement of fiscal 2006 sales goals, we may be required to pay an earn-out of $0.5 million. Commencing in February 2005, Tolt’s results of operations have been included in our mobile data communications segment.
Critical Accounting Policies
We consider certain accounting policies to be critical due to the estimation process involved in each.
Revenue Recognition on Long-Term Contracts.Revenues and related costs from long-term contracts relating to the design, development or manufacturing of complex electronic equipment to a buyer’s specification or to provide services relating to the performance of such contracts are recognized using the percentage-of-completion method. Revenue is recognized based on the relationship of total costs incurred to total projected costs, or, alternatively, based on output measures, such as units delivered. Profits expected to be realized on such contracts are based on total estimated sales for the contract compared to total estimated costs, including warranty costs, at completion of the contract. These estimates are reviewed and revised periodically throughout the lives of the contracts, and adjustments to profits resulting from such revisions are made cumulative to the date of the change. The impact of any such adjustments discussed in“Management’s Discussion and Analysis of Financial Condition and Results of Operations”represents the cumulative impact of the adjustment on the relevant financial statement amount as of the beginning of the period being discussed. Estimated losses on long-term contracts are recorded in the period in which the losses become evident.
Some of our largest contracts, including our MTS contract with the U.S. Army, are accounted for using the percentage-of-completion method. We have been engaged in the production and delivery of goods and services on a continual basis under contractual arrangements for many years. Historically, we have demonstrated an ability to accurately estimate revenues and expenses relating to our long-term contracts. However, there exist inherent risks and uncertainties in estimating revenues, expenses and progress toward completion, particularly on larger or longer-term contracts. If we do not accurately estimate the total sales, related costs and progress towards completion on such contracts, the estimated gross margins may be significantly impacted or losses may need to be recognized in future periods. Any such resulting changes in margins or contract losses could be material to our results of operations and financial position.
15
In addition, most government contracts have termination for convenience clauses that provide the customer with the right to terminate the contract at any time. Such terminations could impact the assumptions regarding total contract revenues and expenses utilized in recognizing profit under the percentage-of-completion method of accounting. Changes to these assumptions could materially impact our results of operations and financial position. Historically, we have not experienced material terminations of our long-term contracts.
We also address customer acceptance provisions in assessing our ability to perform our contractual obligations under long-term contracts. Our inability to perform on our long-term contracts could materially impact our results of operations and financial position. Historically, we have been able to perform on our long-term contracts.
Impairment of Intangible Assets.As of July 31, 2005, our company’s intangible assets, including goodwill, aggregated $31.4 million. In assessing the recoverability of goodwill and other intangibles, we must make various assumptions regarding estimated future cash flows and other factors in determining the fair values of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets in future periods. Any such resulting impairment charges could be material to our results of operations.
Provisions for Excess and Obsolete Inventory.We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based on historical and future usage trends. Several factors may influence the sale and use of our inventories, including decisions to exit a product line, technological change and new product development. These factors could result in a change in the amount of excess and obsolete inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if we determine that our inventory was overvalued, we would be required to recognize such costs in our financial statements at the time of such determination. Any such charges could be material to our results of operations and financial position.
Allowance for Doubtful Accounts.We perform ongoing credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness, as determined by our review of our customers’ current credit information. Generally, we will require cash in advance or payment secured by irrevocable letters of credit before an order is accepted from an international customer that we do not do business with regularly. In addition, we seek to obtain insurance for certain international customers. We continuously monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the allowances established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and financial health of specific customers. Changes to the estimated allowance for doubtful accounts could be material to our results of operations and financial position.
Accounting for Stock-Based Compensation. Through July 31, 2005, we accounted for our stock option and employee stock purchase plans under the intrinsic value method of Accounting Principles Board (“APB”) Opinion No. 25, and as a result no compensation costs to date have been recognized in our historical consolidated statements of operations. As discussed further below under“Recent Accounting Pronouncements – Impact of SFAS No. 123(R), Share-Based Payments,” on August 1, 2005 we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R) using the modified prospective method.
We have used and expect to continue to use the Black-Scholes option-pricing model to compute the estimated fair value of stock-based awards. The Black-Scholes option pricing model includes assumptions regarding dividend yields, expected volatility, expected lives, and risk-free interest rates. The assumptions used in computing the fair value of stock-based awards reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. As a result, if other assumptions had been used, the stock-based compensation expense that will be recorded beginning in the first quarter of fiscal 2006 could have been materially different. Furthermore, if different assumptions are used in future periods, stock-based compensation expense could be materially impacted in the future.
16
Results of Operations
The following table sets forth, for the periods indicated, certain income and expense items expressed as a percentage of our consolidated net sales:
| | | | | | | | | | |
| | | Fiscal Years Ended July 31, |
| | |
|
| | | 2005 | | 2004 | | 2003 |
| | |
| |
| |
|
Net sales | | | 100.0 | % | | 100.0 | % | | 100.0 | % |
Gross margin | | | 41.4 | | | 39.2 | | | 34.3 | |
Selling, general and administrative expenses | | | 16.8 | | | 16.1 | | | 16.1 | |
Research and development expenses | | | 6.9 | | | 7.1 | | | 7.4 | |
In-process research and development | | | — | | | 0.4 | | | — | |
Amortization of intangibles | | | 0.8 | | | 0.9 | | | 1.2 | |
Operating income | | | 16.9 | | | 14.6 | | | 9.7 | |
Interest expense (income), net | | | (0.5 | ) | | 0.2 | | | 1.5 | |
Income before provision for income taxes | | | 17.4 | | | 14.4 | | | 8.2 | |
Net income | | | 11.9 | | | 9.8 | | | 5.6 | |
Comparison of Fiscal 2005 and 2004
Net Sales.Consolidated net sales were $307.9 million and $223.4 million for fiscal 2005 and 2004, respectively, representing an increase of $84.5 million, or 37.8%. The increase in net sales was driven by increased demand for our products in all three business segments.
Net sales in our telecommunications transmission segment were $174.5 million and $141.5 million for fiscal 2005 and 2004, respectively, an increase of $33.0 million, or 23.3%. The growth in this segment resulted primarily from a significant increase in demand for our satellite earth station products and incremental sales of our over-the-horizon microwave systems. In addition, favorable cumulative gross margin adjustments, resulting from lower than anticipated costs on two large over-the-horizon microwave system contracts, contributed $4.0 million and $0.8 million in net sales for fiscal 2005 and 2004, respectively. Memotec, which we acquired in May 2004, contributed $6.3 million and $1.3 million to net sales for fiscal 2005 and 2004, respectively. Our telecommunications transmission segment represented 56.7% of consolidated net sales for fiscal 2005 as compared to 63.3% for fiscal 2004.
Net sales in our mobile data communications segment were $86.1 million and $59.8 million for fiscal 2005 and 2004, respectively, an increase of $26.3 million, or 44.0%. The increase in net sales was due, in part, to increased demand and continued deployment of our MTS system by the U.S. Army and higher sales of battlefield command and control applications to the U.S. military. Tolt, which we acquired in February 2005, contributed $11.3 million of net sales for fiscal 2005. Also, included in net sales for fiscal 2005 is a $3.8 million cumulative adjustment associated with the aforementioned change from the usage method to the straight-line method of accounting for MTS prepaid service time revenue. During fiscal 2005, at the request of the U.S. Army, we migrated our technology to the next generation. This migration included modifying our satellite transceivers to incorporate radio frequency identification (“RFID”) and a selected availability anti-spoofing module (“SAASM”). We also began enhancing our network and related software to provide increased speed and performance. In August 2005, we received the first orders from the U.S. Army for our next generation transceiver, known as the MT 2012. We currently expect to complete the technology migration during the first half of fiscal 2006 and expect to begin shipments of the MT 2012 during the first quarter of fiscal 2006. In addition to the normal quarterly funding fluctuations experienced in this segment, we may also see significant quarter-to-quarter fluctuations in the deployment of our MTS products during this product transition.Our mobile data communications segment represented 27.9% of consolidated net sales for fiscal 2005 as compared to 26.8% for fiscal 2004.
Net sales in our RF microwave amplifiers segment were $47.3 million for fiscal 2005 compared to $22.1 million for fiscal 2004, an increase of $25.2 million, or 114.0%. The significant increase in net sales was primarily the result of increased demand for our defense related products. In particular, we experienced a marked increase in demand for our RF microwave amplifiers that are incorporated into improvised explosive device jamming systems. The sustainability of the defense related revenue base in this segment will be dependent upon the receipt of additional orders for improvised explosive device jamming system amplifiers or participation in additional large electronic warfare programs. Our RF microwave amplifiers segment represented 15.4% of consolidated net sales for fiscal 2005 as compared to 9.9% for fiscal 2004.
17
International sales (which include sales to domestic companies for inclusion in products which are sold to international customers) represented 44.0% and 45.4% of consolidated net sales for fiscal 2005 and 2004, respectively. Domestic commercial sales represented 13.9% and 14.5% of consolidated net sales for fiscal 2005 and 2004, respectively. Sales to the U.S. government (including sales to prime contractors to the U.S. government) represented 42.1% and 40.1% of consolidated net sales for fiscal 2005 and 2004, respectively.
During fiscal 2005, except for sales to the U.S. government, one customer, a prime contractor, represented 10.2% of consolidated net sales. During fiscal 2004, except for sales to the U.S. government, one customer, another prime contractor, represented 12.5% of consolidated net sales. Direct and indirect sales to a North African country, including certain sales to the prime contractors mentioned above, during fiscal 2005 and 2004 represented 13.2% and 14.1%, respectively, of consolidated net sales.
Gross Profit.Gross profit was $127.4 million and $87.5 million for fiscal 2005 and 2004, respectively, representing an increase of $39.9 million, or 45.6%. The increase in gross profit was primarily attributable to the increase in net sales and the gross profit percentage, which increased from 39.2% for fiscal 2004 to 41.4% for fiscal 2005. Fiscal 2005 includes favorable cumulative gross margin adjustments on two large over-the-horizon microwave system contracts and the MTS contract (including the MTS prepaid service time adjustment as discussed above), which had an aggregate impact of $5.8 million on gross profit compared to favorable cumulative gross margin adjustments during fiscal 2004 of $1.9 million. Excluding the sales and gross profit relating to prior periods from these adjustments, our gross margin percentage still improved significantly due to increased operating efficiencies.
As mentioned above, in fiscal 2005, we continued to realize increased operating efficiencies. In our telecommunications transmission segment, such efficiencies were achieved, in part, by our continuing efforts to expand the usage of our high-volume manufacturing facility in Tempe, Arizona. The increased utilization and resulting operating efficiencies were the result of higher demand for our satellite earth station products, as well as the continued use of the facility by our other two segments for certain high-volume manufacturing requirements. In addition, as part of our strategy to leverage the high-volume manufacturing center and further develop a diversified customer base, we produced and currently have on-hand $1.6 million of inventory relating to a contract from a third-party commercial customer to outsource its manufacturing. We currently expect to realize sales associated with this inventory during early fiscal 2006.
In our mobile data communications segment, operating efficiencies were the result of incremental MTS and battlefield command and control applications funding from the U.S. Army. If the current levels of MTS and battlefield command and control applications funding are maintained or increased and if our transition to the next generation product line occurs without major unanticipated costs or delays, we believe we may continue to realize increased operating efficiencies.
Our RF microwave amplifiers segment experienced increased operating efficiencies associated with significant operating leverage driven by the increase in sales and a more favorable product mix.
Included in cost of sales for fiscal 2005 and 2004 are provisions for excess and obsolete inventory of $2.1 million and $1.2 million, respectively. As discussed under“Critical Accounting Policies – Provisions for Excess and Obsolete Inventory,” we regularly review our inventory and record a provision for excess and obsolete inventory based on historical and projected usage assumptions.
Selling, General and Administrative Expenses.Selling, general and administrative expenses were $51.8 million and $36.0 million for fiscal 2005 and 2004, respectively, representing an increase of $15.8 million, or 43.9%. The increase in expenses is primarily attributable to (i) the increased level of net sales in all three of our business segments, (ii) expenses associated with the Memotec and Tolt acquisitions in May 2004 and February 2005, respectively, and (iii) costs of compliance with recent corporate governance regulations. As a percentage of consolidated net sales, selling, general and administrative expenses were 16.8% and 16.1% for fiscal 2005 and 2004, respectively.
Research and Development Expenses.Research and development expenses were $21.2 million and $15.9 million for fiscal 2005 and 2004, respectively representing an increase of $5.3 million or 33.3%. Approximately $17.7 million and $14.2 million of such amounts, respectively, related to our telecommunications transmission segment. As an investment for the future, we are continually enhancing our existing products and developing new products and technologies. Whenever possible, we seek customer funding for research and development to adapt our products to specialized customer requirements. During fiscal 2005 and 2004, customers reimbursed us $3.0 million and $5.7 million, respectively, which is not reflected in the reported research and development expenses, but is included in net sales with the related costs included in cost of sales.
18
In-Process Research and Development Expense.In connection with the purchase of certain assets and liabilities of Memotec in fiscal 2004, we recorded a charge of $0.9 million for the write-off of in-process research and development. There was no in-process research and development expense in fiscal 2005.
Amortization of Intangibles.Amortization of intangibles for fiscal 2005 and 2004 was $2.3 million and $2.1 million, respectively. The increase was attributable to the Memotec and Tolt acquisitions.
Operating Income.Operating income for fiscal 2005 and 2004 was $52.1 million and $32.6 million, respectively. The $19.5 million or 59.8% increase was the result of the higher sales and gross profit, discussed above, partially offset by higher operating expenses.
Operating income in our telecommunications transmission segment increased to $40.2 million for fiscal 2005 from $29.2 million for fiscal 2004 as a result of increased sales and associated operating efficiencies. Fiscal 2005 operating income included favorable cumulative gross margin adjustments on two large over-the-horizon microwave system contracts which aggregated $3.1 million, compared to $0.6 million in 2004.
Our mobile data communications segment generated operating income of $11.9 million for fiscal 2005 compared to $9.5 million for fiscal 2004 as a result of increased sales and associated operating efficiencies. In addition, fiscal 2005 operating income included a $2.0 million favorable impact of the cumulative MTS contract adjustments discussed above in“Gross Profit,”compared to $1.0 million in fiscal 2004. This was partially offset by increased operating costs, including expenses associated with Tolt and our continued initiation of commercial marketing efforts.
Operating income in our RF microwave amplifiers segment increased to $8.2 million for fiscal 2005 from $0.3 million for fiscal 2004 primarily as a result of the significant increase in net sales and improved operating efficiencies.
Unallocated operating expenses increased to $8.2 million for fiscal 2005 from $6.4 million for fiscal 2004, due primarily to increased compensation expense and increased costs in connection with recent corporate governance regulations.
Interest Expense.Interest expense increased from $1.4 million for fiscal 2004 to $2.7 million for fiscal 2005. Interest expense primarily represents interest expense associated with our 2.0% convertible senior notes issued in January 2004.
Interest Income.Interest income for fiscal 2005 was $4.1 million, as compared to $0.9 million for fiscal 2004. The $3.2 million increase was due primarily to a higher average cash position resulting from the proceeds received from the issuance of our 2.0% convertible senior notes in January 2004 and cash provided by our operating activities, as well as an increase in interest rates.
Provision for Income Taxes.The provision for income taxes was $16.8 million and $10.3 million for fiscal 2005 and 2004, respectively. The increase was the result of the significant increase in pre-tax profit in fiscal 2005. The effective tax rate was 31.4% and 32.0% in fiscal 2005 and 2004, respectively. The fiscal 2005 provision for income taxes was offset by a tax benefit of $1.1 million primarily relating to the reduction in the valuation allowance that was established for the extended write-off period of acquired in-process research and development. During fiscal 2005, it became more likely than not that the related deferred tax asset would be recoverable. Excluding the tax benefit, the effective tax rate for fiscal 2005 was 33.5%.
Comparison of Fiscal 2004 and 2003
Net Sales.Consolidated net sales were $223.4 million and $174.0 million for fiscal 2004 and 2003, respectively, representing an increase of $49.4 million, or 28.4%. The increase was driven by significant growth in our telecommunications transmission and mobile data communications segments, as described below.
Net sales in our telecommunications transmission segment were $141.5 million for fiscal 2004, as compared to sales of $102.6 million for fiscal 2003, an increase of $38.9 million, or 37.9%. The significant sales growth in this segment resulted primarily from (i) increased demand for our satellite earth station products and (ii) incremental sales of over-the-horizon microwave systems relating to two contract awards received in fiscal 2003. Our telecommunications transmission segment represented 63.3% of consolidated net sales for fiscal 2004 as compared to 59.0% for fiscal 2003.
19
Net sales in our mobile data communications segment increased $11.7 million, or 24.3%, from $48.1 million for fiscal 2003 to $59.8 million for fiscal 2004. The significant sales growth in this segment was primarily the result of (i) increased demand for battlefield command and control applications by the U.S. Army and (ii) the continued rollout of our MTS system to the U.S. Army. Our mobile data communications segment represented 26.8% of consolidated net sales for fiscal 2004 as compared to 27.6% for fiscal 2003.
Net sales from our RF microwave amplifiers segment were $22.1 million for fiscal 2004 compared to $23.3 million for fiscal 2003, representing a decrease of $1.2 million, or 5.2%. The decrease was the result of continued softness in certain of our commercial product lines, partially offset by increasing demand for our defense-related products. Our RF microwave amplifiers segment represented 9.9% of consolidated net sales for fiscal 2004 as compared to 13.4% for fiscal 2003.
International sales (including sales to domestic companies for inclusion in products which are sold to international customers) represented 45.4% and 39.7% of consolidated net sales for fiscal 2004 and 2003, respectively. Domestic commercial sales represented 14.5% and 16.1% of consolidated net sales for fiscal 2004 and 2003, respectively. Sales to the U.S. government (including sales to prime contractors to the U.S. government) represented 40.1% and 44.2% of consolidated net sales for fiscal 2004 and 2003, respectively.
During fiscal 2004 and 2003, sales to one customer, a prime contractor, represented 12.5% and 19.8% of consolidated net sales, respectively. Direct and indirect sales to a North African country, including certain sales to the prime contractor mentioned above, during fiscal 2004 and 2003 represented 14.1% and 10.2%, respectively, of consolidated net sales.
Gross Profit.Gross profit was $87.5 million and $59.7 million for fiscal 2004 and 2003, respectively, representing an increase of $27.8 million, or 46.6%. The increase in gross profit was due to the significant increase in net sales, as well as an increase in the gross profit percentage. Gross profit, as a percentage of net sales, was 39.2% for fiscal 2004, as compared to 34.3% for fiscal 2003.
The increase in the gross profit, as a percentage of sales, was primarily due to (i) the higher proportion of our sales being in the telecommunications transmission segment, which typically realize higher margins than sales in our other two segments, (ii) a more favorable product mix within the mobile data communications segment, and (iii) increased operating efficiencies and overhead absorption in both the telecommunications transmission and mobile data communications segments. These increases were partially offset by a decrease in gross profit in our RF microwave amplifiers segment due to higher than anticipated costs to complete two contracts.
As mentioned above, in fiscal 2004, we realized increased operating efficiencies in our two largest segments. In our telecommunications transmission segment, such efficiencies were achieved, in part, by our continuing efforts to expand the usage of our high-volume manufacturing facility in Tempe, Arizona. The increased utilization and resulting operating efficiencies were the result of higher demand for our satellite earth station products, as well as the continued use of the facility by our other two segments for certain high-volume manufacturing requirements. In our mobile data communications segment, such efficiencies were the result of incremental MTS and battlefield command and control application funding from the U.S. Army.
As discussed above under “Critical Accounting Policies – Revenue Recognition on Long-term Contracts,” we periodically review and adjust total estimated contract revenues and costs on long-term contracts. In fiscal 2004, we adjusted the estimated margins at completion on certain large contracts. In the telecommunications transmission segment, we increased the estimated margins at completion on two large over-the-horizon microwave system contracts as they draw nearer to completion. In the mobile data communications segment, we increased the estimated margins at completion on the MTS contract with the U.S. Army as a result of increased funding. These adjustments resulted in an aggregate $1.9 million cumulative increase to the gross profits recognized on these contracts in prior years. Such amount is included in the fiscal 2004 results of operations.
Included in cost of sales for fiscal 2004 and 2003 are provisions for excess and obsolete inventory of $1.2 million and $2.5 million, respectively. As discussed under“Critical Accounting Policies – Provisions for Excess and Obsolete Inventory,”we regularly review our inventory and record a provision for excess and obsolete inventory based on historical and projected usage assumptions. The provision for fiscal 2003 includes $0.4 million relating to certain product line discontinuances in our telecommunications transmission segment.
Selling, General and Administrative Expenses.Selling, general and administrative expenses were $36.0 million and $28.0 million for fiscal 2004 and 2003, respectively, representing an increase of $8.0 million, or 28.6%. The
20
increase was due to higher expenses relating to the significant increases in sales and profitability during fiscal 2004, including expenses related to recent acquisitions. Also contributing to the increase were higher insurance costs and compliance costs incurred in connection with recently enacted corporate governance regulations. As a percentage of consolidated net sales, selling, general and administrative expenses were 16.1% for fiscal 2004 and 2003.
Research and Development Expenses.Research and development expenses were $15.9 million and $12.8 million for fiscal 2004 and 2003, respectively. Approximately $14.2 million and $11.6 million of such amounts, respectively, related to our telecommunications transmission segment. As an investment for the future, we are continually enhancing our existing products and developing new products and technologies. Whenever possible, we seek customer funding for research and development to adapt our products to specialized customer requirements. During fiscal 2004 and 2003, customers reimbursed us $5.7 million and $3.7 million, respectively, which amounts are not reflected in the reported research and development expenses, but are included in net sales with the related costs included in cost of sales.
In-Process Research and Development Expense.In connection with the purchase of certain assets and liabilities of Memotec in fiscal 2004, we recorded a charge of $0.9 million for the write-off of in-process research and development. There was no in-process research and development expense in fiscal 2003.
Amortization of Intangibles.Amortization of intangibles for fiscal 2004 and 2003 was $2.1 million and $2.0 million, respectively. The amortization relates to intangibles with definite lives which we acquired in connection with various acquisitions.
Operating Income.Operating income for fiscal 2004 and 2003 was $32.6 million and $16.8 million, respectively. The $15.8 million increase was the result of the higher sales and gross profit, discussed above, partially offset by higher operating expenses.
Operating income in our telecommunications transmission segment increased to $29.2 million for fiscal 2004 from $14.2 million for fiscal 2003 as a result of significantly higher sales combined with increased operating efficiencies and overhead absorption. Our mobile data communications segment generated operating income of $9.5 million for fiscal 2004 compared to $5.2 million for fiscal 2003 due primarily to the increase in sales, more favorable product mix and the impact of the cumulative gross margin adjustment discussed above under “Gross Profit.” Operating income in our RF microwave amplifiers segment decreased to $0.3 million for fiscal 2004 from $1.8 million for fiscal 2003 primarily as a result of the decrease in sales and higher than anticipated costs to complete two contracts. Unallocated operating expenses increased to $6.4 million for fiscal 2004 from $4.4 million for fiscal 2003 due primarily to higher incentive compensation expense, increased costs associated with recent corporate governance regulations and higher insurance costs.
Interest Expense.Interest expense decreased from $2.8 million for fiscal 2003 to $1.4 million for fiscal 2004. The decrease was due to the prepayment of our term loan, which bore interest at approximately 9.0%, in July 2003. Interest expense for fiscal 2004 primarily represents interest expense associated with our 2.0% convertible senior notes issued in January 2004.
Interest Income.Interest income for fiscal 2004 was $0.9 million, as compared to $0.3 million for fiscal 2003. The $0.6 million increase was due primarily to a higher average cash position resulting from the proceeds received from our private placement of common stock in July 2003 and issuance of our 2.0% convertible senior notes in January 2004.
Provision for Income Taxes.The provision for income taxes was $10.3 million and $4.6 million for fiscal 2004 and 2003, respectively, as a result of the significant increase in pre-tax profit. The effective tax rate was 32.0% in both periods.
Liquidity and Capital Resources
Our unrestricted cash and cash equivalents increased to $214.4 million at July 31, 2005 from $163.3 million at July 31, 2004, representing an increase of $51.1 million. The increase in cash was driven by strong cash flow from operations, partially offset by capital expenditures necessary to support our anticipated future growth and the acquisition of Tolt.
Net cash provided by operating activities, net of effects of acquisitions, was $56.1 million for fiscal 2005. Such amount primarily reflects (i) net income of $36.7 million plus the impact of depreciation, amortization, the provisions for doubtful accounts and inventory reserves, and the income tax benefit from stock-related transactions
21
aggregating $20.5 million, (ii) deferred income tax expense of $2.8 million, and (iii) changes in working capital balances.
Net cash used in investing activities for fiscal 2005 was $12.3 million, primarily representing capital expenditures and the acquisition of Tolt. During the year, our mobile data communications segment completed the move to its new facility in Germantown, Maryland, including the construction of a state-of-the-art network operations center, and we expanded our high-volume manufacturing center located in Tempe, Arizona. We currently expect capital expenditures for fiscal 2006 to be between $12.0 million and $14.0 million.
Net cash provided by financing activities for fiscal 2005 was $7.4 million, due primarily to the proceeds from stock option exercises and the sale of shares under our employee stock purchase plan.
Financing Arrangement
On January 27, 2004, we issued $105.0 million of our 2.0% convertible senior notes in a private offering pursuant to Rule 144A under the Securities Act of 1933, as amended. The net proceeds from this transaction were $101.2 million after deducting the initial purchaser’s discount and other transaction costs. For further information concerning this financing, see“Notes to Consolidated Financial Statements – Note 8(a) 2.0% Convertible Senior Notes due 2024.”
Commitments
In the normal course of business, we routinely enter into binding and non-binding purchase obligations primarily covering anticipated purchases of inventory and equipment. We do not expect that these commitments as of July 31, 2005 will materially adversely affect our liquidity.
At July 31, 2005, we had contractual cash obligations to repay our 2.0% convertible senior notes, capital lease and operating lease obligations (including satellite lease expenditures relating to our mobile data communications segment contracts) and the financing of a purchase of proprietary technology. Payments due under these long-term obligations are as follows:
| | | | | | | | | | | | | | | | | |
| | | | Obligations due by fiscal years | |
| | |
| |
| | | Total | | 2006 | | 2007
and
2008 | | 2009
and
2010 | | After
2010 | |
| | |
|
|
|
|
|
|
|
|
| |
| | | | | | | | | | | | | | | | | |
2.0% convertible senior notes | | $ | 105,000,000 | | | — | | | — | | | — | | | 105,000,000 | |
| | | | | | | | | | | | | | | | | |
Operating lease commitments | | | 17,562,000 | | | 8,492,000 | | | 4,503,000 | | | 3,356,000 | | | 1,211,000 | |
| | | | | | | | | | | | | | | | | |
Other obligations | | | 719,000 | | | 276,000 | | | 330,000 | | | 113,000 | | | — | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | | | | | |
Total contractual cash obligations | | $ | 123,281,000 | | | 8,768,000 | | | 4,833,000 | | | 3,469,000 | | | 106,211,000 | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
We have entered into standby letter of credit agreements with financial institutions relating to the guarantee of future performance on certain contracts. At July 31, 2005, the balance of these agreements was $1.3 million. Cash we have pledged against such agreements aggregating $1.0 million has been classified as restricted cash in the consolidated balance sheet.
We believe that our cash and cash equivalents will be sufficient to meet our operating cash requirements for the foreseeable future. In the event that we identify a significant acquisition that requires additional cash, we would seek to borrow funds or raise additional equity capital.
Legal Proceedings
We are subject to certain legal actions, which arise in the normal course of business. Although the ultimate outcome of litigation is difficult to accurately predict, we believe that the outcome of these actions will not have a material effect on our consolidated financial position or results of operations.
22
During fiscal 2005, two of our leased facilities located in Florida experienced hurricane damage to both leasehold improvements and personal property. As of July 31, 2005, we have substantially completed all restoration efforts relating to the hurricane damage. We have a written agreement with our general contractor which we believe limits our liability to the amount of insurance proceeds ultimately received. Our general contractor is in a dispute with certain of its subcontractors. As a result, we placed approximately $1.4 million, which represents the amount of insurance proceeds still payable to the general contractor, into an escrow account with the 9th Judicial Circuit Court in Orange County, Florida. We are awaiting the Court’s direction as to how these funds should be disbursed. We are also continuing our efforts to work with the insurance carrier and the general contractor and its subcontractors to finalize the amount of any additional insurance proceeds. We do not expect that the outcome of this matter will have a material effect on our consolidated financial position or results of operations.
Recent Accounting Pronouncements
Impact of SFAS No. 123(R),“Share-Based Payments”
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), which requires companies to expense the estimated fair value of employee stock options and similar awards. SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB Opinion No. 25. In March 2005, the Securities Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”) which generally provides the SEC staff’s views regarding SFAS No. 123(R). SAB 107 provides guidance on how to determine the expected volatility and expected term inputs into a valuation model used to determine the fair value of share-based payments. SAB 107 also provides guidance related to numerous aspects of the adoption of SFAS No. 123(R) such as income taxes, capitalization of compensation costs, modification of share-based payments prior to adoption and the classification of expenses. We will apply the principles of SAB 107 in conjunction with our adoption of SFAS No. 123(R).
Beginning with the first quarter of fiscal 2006, we will adopt the provisions of SFAS No. 123(R) using a modified prospective application. Under the modified prospective application, SFAS No. 123(R), which provides certain changes to the methodology for valuing share-based compensation among other changes, will apply to new awards and to awards outstanding on the effective date that are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service had not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under SFAS No. 123.
At July 31, 2005, the total unamortized compensation expense related to the 2,328,690 unvested options that were outstanding, as determined in accordance with SFAS No. 123, was approximately $8.5 million before income taxes. This amount will be amortized over the remaining vesting periods. In addition, during the first quarter of fiscal 2006 (through September 22, 2005), our Executive Compensation Committee granted a total of 606,000 nonqualified stock options. Based on the total number of outstanding options (through September 22, 2005), we expect to record amortization of stock compensation expense in fiscal 2006 of approximately $5.3 million before income taxes, of which $1.3 million is expected to be recognized during the first quarter of fiscal 2006.
SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as prescribed under current accounting rules. This requirement will reduce net operating cash flow and increase net financing cash flow in periods after adoption. Total cash flow will remain unchanged.
Impact of Other Recent Accounting Pronouncements
In October 2004, the FASB ratified the consensus reached by the EITF with respect to Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings Per Share.” The EITF’s consensus states that shares of common stock contingently issuable pursuant to contingent convertible securities should be included in diluted earnings per share computations (if dilutive) regardless of whether their market price triggers (or other contingent features) have been met. EITF No. 04-8 was effective for reporting periods ending after December 15, 2004. As further discussed in Note 1 to the Consolidated Financial Statements, we have (i) included the impact of the assumed conversion of our 2.0% convertible senior notes in calculating diluted EPS commencing in the fiscal quarter ended January 31, 2005 and (ii) restated prior periods’ diluted EPS for comparative purposes.
23
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs - an amendment of Accounting Research Bulletin No. 43, Chapter 4. SFAS No. 151 requires all companies to recognize a current period charge for abnormal amounts of idle facility expense, freight, handling costs and wasted materials. This statement also requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. We adopted this statement on August 1, 2005 and it has not had a material impact on our consolidated financial statements.
In January 2003, as revised in December 2003, the FASB issued FASB Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities (“VIE”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional financial support from other parties. In March 2005, the FASB issued FASB Staff Position FIN 46 (R)-5, which addresses whether a reporting enterprise should consider whether it holds an implicit variable interest in a VIE or a potential VIE when specific conditions exist. The guidance, which applies to certain leases between related parties, became effective during the fourth quarter of fiscal 2005. As discussed in Note 13(a) to the Consolidated Financial Statements, we lease our corporate headquarters and Melville, New York manufacturing facility from a partnership controlled by our Chairman, Chief Executive Officer and President. We evaluated the relationship between us and this partnership and determined that we do not have an implicit variable interest in the partnership. Accordingly, there was no impact on our consolidated financial statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principles, as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 eliminates the requirement to include the cumulative effect of changes in accounting principle in the income statement and instead requires that changes in accounting principle be retroactively applied. A change in accounting estimate continues to be accounted for in the period of change and future periods if necessary. A correction of an error continues to be reported by restating prior period financial statements. SFAS No. 154 applies to accounting changes and corrections of errors made on or after January 1, 2006.
In June 2005, the FASB issued FASB Staff Position No. 143-1, “Accounting for Electronic Equipment Waste Obligations,” to address the accounting for obligations associated with Directive 2002/96/EC on Waste Electrical and Electronic Equipment adopted by the European Union (“EU”). This guidance is effective beginning on the later of the first reporting period ending after June 8, 2005 or the date of adoption of the law by the applicable EU member country. As of July 31, 2005, the EU member countries where the majority of our sales within the EU are made have not yet implemented the Directive. The impact of this guidance for the fiscal year ended July 31, 2005 for our “historical waste” (as defined by the EU) was not material and we continue to evaluate these new laws and the related financial impact in the countries in which our products are sold.
Forward-Looking Statements and Risk Factors
This Form 10-K contains “forward-looking statements” including statements concerning the future of our industry, product development, business strategy, continued acceptance of our products, market growth, and dependence on significant customers. These statements can be identified by the use of forward-looking terminology such as “may,” “expect,” “anticipate,” “estimate,” “continue,” or other similar words. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this Form 10-K. The risk factors noted below and other factors noted throughout this Form 10-K could cause our actual financial condition or results to differ significantly from those contained in any forward-looking statement.
Due to many factors, including the amount of business represented by large contracts, new orders, net sales and our operating results are difficult to forecast and may be volatile.
We have experienced, and will experience in the future, significant fluctuations in new orders, net sales and operating results, including our net income and earnings per share, from quarter-to-quarter. One reason for this is that a significant portion of our business — primarily the over-the-horizon microwave systems of our telecommunications transmission segment, a portion of our RF microwave amplifiers segment and the majority of our mobile data communications segment — is derived from a limited number of relatively large customer contracts, the timing of which cannot be predicted. Our new orders, net sales and operating results, including our net income and earnings per share, also may vary significantly from period-to-period because of the following factors: product
24
mix sold; fluctuating market demand; price competition; new product introductions by our competitors; fluctuations in foreign currency exchange rates; unexpected changes in delivery of components or subsystems; political instability; regulatory developments; and general economic conditions. Accordingly, you should not rely on period-to-period comparisons as indications of our future performance because these comparisons may not be meaningful.
Our business, results of operations, liquidity and financial position depend on our ability to maintain our level of government business.
In recent years, we have increased our dependence on U.S. government business. Our sales to the U.S. government (including sales to prime contractors to the U.S. government) accounted for approximately 42.1%, 40.1% and 44.2% of our consolidated net sales for the fiscal years ended July 31, 2005, 2004 and 2003, respectively. Approximately 37.7% of our backlog at July 31, 2005 consisted of orders from the U.S. government. We expect such business to represent a significant portion of our consolidated net sales for the foreseeable future. U.S. government business exposes us to various risks, including:
| | |
| • | unexpected contract or project terminations or suspensions; |
| | |
| • | unpredictable order placements, reductions or cancellations; |
| | |
| • | reductions in government funds available for our projects due to government policy changes, budget cuts and other spending priorities; |
| | |
| • | penalties arising from post-award contract audits; |
| | |
| • | cost audits in which the value of our contracts may be reduced; |
| | |
| • | higher-than-expected final costs, particularly relating to software and hardware development, for work performed under contracts where we commit to specified deliveries for a fixed price; and |
| | |
| • | unpredictable cash collections of unbilled receivables that may be subject to acceptance of contract deliverables by the customer and contract close-out procedures, including government approval of final indirect rates. |
All of our U.S. government contracts can be terminated by the U.S. government for its convenience. Termination for convenience provisions provide only for our recovery of costs incurred or committed, settlement expenses and profit on work completed prior to termination. In addition to the right of the U.S. government to terminate, U.S. government contracts are conditioned upon the continuing approval by Congress of the necessary spending. Congress usually appropriates funds for a given program on a fiscal year basis even though contract performance may take more than one year. Consequently, at the beginning of a major program, the contract may not be fully funded, and additional monies are normally committed to the contract only if, as and when appropriations are made by Congress for future fiscal years.
The U.S. government may review our costs and performance on certain contracts, as well as our accounting and general business practices. Based on the results of such audits, the U.S. government may adjust our contract-related costs and fees.
We obtain U.S. government contracts through a competitive bidding process. We cannot assure you that we will continue to win competitively awarded contracts or that awarded contracts will generate sufficient net sales to result in profitability.
All of our businesses are subject to rapid technological change; we must keep pace with changes to compete successfully.
We are engaged in businesses characterized by rapid technological change, evolving industry standards, frequent new product announcements and enhancements, and changing customer demands. The introduction of products and services embodying new technologies and the emergence of new industry standards could render our products and services obsolete or non-competitive. The technology used in our products and services evolves rapidly, and our business position depends, in large part, on the continuous refinement of our scientific and engineering expertise and the development, either through internal research and development or acquisitions, of new or enhanced products and technologies. We may not have the economic or technological resources to be successful in such efforts and we may not be able to identify and respond to technological improvements made by our competitors in a timely or cost-effective fashion. A significant technological breakthrough by others, including smaller competitors or new firms, could have a material adverse impact on our business, results of operations and financial condition.
25
Our dependence on international sales may adversely affect us.
Sales for use by international customers (including sales to prime contractors’ international customers) represented approximately 44.0%, 45.4% and 39.7% of our consolidated net sales for the fiscal years ended July 31, 2005, 2004 and 2003, respectively. Approximately 51.9% of our backlog at July 31, 2005 consisted of orders for use by foreign customers. Direct and indirect sales to a North African country during the fiscal year ended July 31, 2005 were 13.2% of consolidated net sales. We expect that international sales will continue to be a substantial portion of our consolidated sales.
These sales expose us to certain risks, including barriers to trade, fluctuations in foreign currency exchange rates (which may make our products less price-competitive), political and economic instability, exposure to public health epidemics, availability of suitable export financing, tariff regulations, and other U.S. and foreign regulations that may apply to the export of our products and the generally greater difficulties of doing business abroad. We attempt to reduce the risk of doing business in foreign countries by seeking subcontracts with large systems suppliers, contracts denominated in U.S. dollars, advance or milestone payments and irrevocable letters of credit in our favor. However, we may not be able to reduce the economic risk of doing business in foreign countries, in all instances. In such cases billed and unbilled receivables relating to international sales are subject to increased collectibility risk and may result in significant write-offs, which could have a material adverse impact on our business, results of operations and financial condition.
Foreign defense contracts generally contain provisions relating to termination at the convenience of the government. In addition, certain of our products and systems may require licenses from U.S. government agencies for export from the U.S., and some of our products are not permitted to be exported. We cannot be sure of our ability to gain any licenses that may be required to export our products, and failure to receive required licenses could materially reduce our ability to sell our products outside the U.S.
Reductions in telecommunications equipment and systems spending may negatively affect our revenues, profitability and the recoverability of our assets, including intangible assets.
From the second half of fiscal 2001 through fiscal 2003, our revenues from commercial customers were negatively affected by the uncertain economic environment both in the overall market, and more specifically in the telecommunications and aviation sectors. Since 2003, the telecommunications and aviation sectors have stabilized and are starting to grow again; however, if the economy slows some of our customers may reduce their budgets for spending on telecommunications and aviations equipment and systems. As a consequence, our current customers and other prospective customers may postpone, reduce or even forego the purchase of our products and systems, which could adversely affect our revenues, profitability and the recoverability of our assets, including intangible assets, particularly in our telecommunications transmission and RF microwave amplifiers segments, which are exposed to the telecommunications and aviation sectors.
Our mobile data communications business is subject to unique risks.
Although sales and earnings have increased significantly in the past few years, our mobile data communications business has a relatively limited operating history compared to our other business segments. It is subject to many of the risks inherent in the operation of a new business enterprise. In addition to the other risk factors described in this section, the risk factors applicable to our mobile data communications business include the following:
| | |
| • | Our contract for the U.S. Army logistics command’s MTS system currently obligates us to provide (i) hardware, including mobile satellite transceivers, through July 2006, and (ii) satellite and other services, through July 2007, at fixed prices and other terms set forth in the contract. The U.S. Army is not obligated to purchase any equipment or services under the contract. Orders and related sales relating to this contract are subject to unpredictable funding and deployment decisions. |
| | |
| • | The MTS contract is not subject to automatic renewal or extension upon its scheduled expiration in July 2007. As such, the U.S. Army may decide to recompete the contract in which case all or a portion of our efforts relating to MTS could be awarded to another party in the future. If the MTS contract is not renewed, extended or if we fail to succeed in a recompete process, our business, results of operations and financial condition would be materially and adversely impacted. |
| | |
| • | Certain components that we need have purchasing lead-time of four months or longer, and the U.S. Army contract requires us to provide mobile terminals within 90 days after we receive an order. |
26
| | |
| • | Our success in commercial markets will depend on, among other things, our ability to access the best distribution channels, the development or licensing of applications which create value for the customer and our ability to attract and retain qualified personnel. Delays in delivering terminals could also adversely affect our ability to obtain and retain commercial customers. |
| | |
| • | In general, as we seek to grow our mobile data communications business, we anticipate that we will need to maintain a substantial inventory in order to provide terminals to our customers on a timely basis. If forecasted orders are not received, we might be left with large inventories of slow moving or unusable parts or terminals. This could result in an adverse effect on our business, results of operations and financial position. |
| | |
| • | We lease the satellite capacity necessary to operate our system from third party satellite networks. Our ability to grow and remain profitable depends on the ability of our satellite network providers to provide sufficient network capacity, reliability and security to our customers. If our satellite network providers were to increase the prices of their services, or to suffer operational or technical failures, our business, results of operation and financial condition could be adversely affected. |
| | |
| • | There are several existing competitors in the mobile data communications market that have established systems with sizable customer bases and much greater financial resources than us. The largest of these competitors is Qualcomm, Inc. Existing competitors, including terrestrial-based service providers, are also aggressively pricing their products and services and may continue to do so in the future. Competitors continue to offer new value added products and services, which we may be unable to match on a timely or cost effective basis. Increased competition may impact margins throughout the industry. We anticipate that new competitors will enter the mobile data communications market in the future. This could impact our penetration into the commercial market in a significant way. |
| | |
| • | All satellite communications are subject to the risk that a satellite or ground station failure or a natural disaster may interrupt service. Interruptions in service could have a material adverse impact on our business, results of operations and financial condition. Should we be required to restore service on another system in the event of a satellite failure, our costs could increase which would have an adverse effect on our business, results of operations and financial condition. |
Our backlog is subject to customer cancellation or modification.
We currently have a backlog of orders, mostly under contracts that the customer may modify or terminate. We cannot assure you that our backlog will result in net sales.
Our dependence on component availability, subcontractor availability and performance and key suppliers may adversely affect us.
We do not generally maintain a substantial inventory of components and subsystems. We obtain certain components and subsystems from a single source or a limited number of sources, but believe that most components and subsystems are available from alternative suppliers and subcontractors. A significant interruption in the delivery of such items, however, could have a material adverse impact on our business, results of operations and financial condition.
Our fixed price contracts subject us to risk.
Almost all of our products and services are sold under fixed price contracts. This means that we bear the risk of unanticipated technological, manufacturing, supply or other problems, price increases or other increases in the cost of performance.
Adverse regulatory changes could impair our ability to sell products.
Our products are incorporated into wireless communications systems that must comply with various government regulations, including those of the Federal Communications Commission (“FCC”). Regulatory changes, including changes in the allocation and availability of frequency spectrum, and in the military standards and specifications that define the current satellite networking environment, could materially harm our business by (i) restricting development efforts by us and our customers, (ii) making our current products less attractive or obsolete, or (iii) increasing the opportunity for additional competition.
27
Changes in, or our failure to comply with, applicable regulations could materially harm our business. In addition, the increasing demand for wireless communications has exerted pressure on regulatory bodies worldwide to adopt new standards and reassign bandwidth for these products and services. The reduced number of available frequencies for other products and services and the time delays inherent in the government approval process of new products and services have caused and may continue to cause our customers to cancel, postpone or reschedule their installation of communications systems including their satellite, over-the-horizon microwave, or terrestrial line-of-sight microwave communication systems. This, in turn, could have a material adverse effect on our sales of products to our customers.
In addition, the EU has adopted two directives to facilitate the recycling of electrical and electronic equipment sold in the EU. The first of these is the Waste Electrical and Electronic Equipment directive, which directs EU member states to enact laws, regulations, and administrative provisions to ensure that producers of electrical and electronic equipment are financially responsible for the collection, recycling, treatment, and environmentally sound disposal of certain products placed on the market after August 13, 2005, and from products in use prior to that date that are being replaced. The EU has also adopted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) directive. The RoHS directive restricts the use of lead, mercury, and certain other substances in electrical and electronic products placed on the market in the EU after July 1, 2006.
Similar laws and regulations have been or may be enacted in other regions, including in the U.S., China, and Japan. Other environmental regulations may require us to reengineer our products to utilize components that are more environmentally compatible, and such reengineering and component substitution may result in additional costs to us. There can be no assurance that such existing or future laws will not have a material adverse effect on our business.
We face risks from the uncertainty of prevailing economic and political conditions.
Current global political and economic conditions are uncertain. As a result, it is difficult to estimate the level of expansion, if any, for the global or U.S. economies generally or the markets in which we participate. Because our budgeting and forecasting process relies on estimates of growth in the markets we serve, the current economic environment renders estimates of future income and expenses even more difficult than usual to formulate. The future direction of the domestic and global economies and political environment could have a material adverse impact on our business, results of operations and financial condition.
Acquisitions and strategic investments may divert our resources and management attention; results may fall short of expectations.
We intend to continue pursuing selected acquisitions of and investments in businesses, technologies and product lines as a key component of our growth strategy. Any future acquisition or investment may result in the use of significant amounts of cash, potentially dilutive issuances of equity securities, incurrence of debt and amortization expenses or in process research and development charges related to intangible assets. Acquisitions involve numerous risks, including:
| | |
| • | difficulties in the integration and assimilation of the operations, technologies, products and personnel of an acquired business; |
| | |
| • | diversion of management’s attention from other business concerns; |
| | |
| • | increased expenses associated with the acquisition; and |
| | |
| • | potential loss of key employees or customers of any acquired business. |
We cannot assure you that our acquisitions will be successful and will not adversely affect our business, results of operations or financial condition.
The loss of key technical or management personnel could adversely affect our business.
Our success depends on the continued contributions of key technical management personnel, including the key corporate and operating unit management at each of our subsidiaries. Many of our key personnel, particularly the key engineers of our subsidiaries, would be difficult to replace, and are not subject to employment or noncompetition agreements. Our growth and future success will depend in large part upon our ability to attract and retain highly qualified engineering, sales and marketing personnel. Competition for such personnel from other companies, academic institutions, government entities and other organizations is intense. Although we believe that we have been successful to date in recruiting and keeping key personnel, we may not be successful in attracting and
28
retaining the personnel we will need to continue to grow and operate profitably. Also, the management skills that have been appropriate for us in the past may not continue to be appropriate if we continue to grow and diversify.
Our markets are highly competitive.
The markets for our products are highly competitive. We cannot assure you that we will be able to successfully compete or that our competitors will not develop new technologies and products that are more commercially effective than our own. We expect the Department of Defense’s increased use of commercial off-the-shelf products and components in military equipment will encourage new competitors to enter the market. Also, although the implementation of advanced telecommunications services is in its early stages in many developing countries, we believe competition may intensify as businesses and foreign governments realize the market potential of telecommunications services. Many of our competitors have financial, technical, marketing, sales and distribution resources greater than ours.
Protection of our intellectual property is limited; we are subject to the risk of third party claims of infringement.
Our businesses rely in large part upon our proprietary scientific and engineering “know-how” and production techniques. Historically, patents have not been an important part of our protection of our intellectual property rights. We rely upon the laws of unfair competition, restrictions in licensing agreements and confidentiality agreements to protect our intellectual property. We limit access to and distribution of our proprietary information. These efforts allow us to rely upon the knowledge and experience of our management and technical personnel to market our existing products and to develop new products. The departure of any of our key management and technical personnel, the breach of their confidentiality and non-disclosure obligations to us or the failure to achieve our intellectual property objectives may have a material adverse impact on our business, results of operations and financial condition.
Our ability to compete successfully and achieve future revenue growth will depend, in part, on our ability to protect our proprietary technology and operate without infringing upon the rights of others. We may fail to do so. In addition, the laws of certain countries in which our products are or may be sold may not protect our products and intellectual property rights to the same extent as the laws of the U.S.
We believe that we own or have licensed all intellectual property rights necessary for the operation of our businesses as currently contemplated. If the technology we use is found to infringe on protected technology, we could be required to change our business practices, license the protected technology, and/or pay damages or other compensation to the infringed party. If we are unable to license protected technology used in our business or if we were required to change our business practices, we could be prohibited from making and selling our products or providing certain telecommunications services.
Our operations are subject to environmental laws and regulations and we may be subject to environmental liabilities.
We engage in manufacturing and are subject to a variety of local, state and federal governmental regulations relating to the storage, discharge, handling, emission, generation, manufacture and disposal of toxic or other hazardous substances used to manufacture our products, particularly in the fabrication of fiberglass antennas by our Comtech Antenna Systems, Inc. subsidiary. The failure to comply with current or future environmental requirements could result in the imposition of substantial fines, suspension of production, alteration of our manufacturing processes or cessation of operations that could have a material adverse impact on our business, results of operations and financial condition.
In addition, the handling, treatment or disposal of hazardous substances by us or our predecessors may have resulted or could in the future result in contamination requiring investigation or remediation, or leading to other liabilities, any of which could have a material adverse impact on our business, results of operations and financial condition.
Recently enacted and proposed changes in securities laws and regulations are increasing our costs.
The Sarbanes-Oxley Act of 2002 that became law in July 2002 requires changes in some of our corporate governance, public disclosure and compliance practices. The Act also requires the Securities and Exchange Commission to promulgate new rules on a variety of subjects. In addition, the Nasdaq National Market has revised its requirements for companies, such as us, that are listed on the Nasdaq National Market. These developments are increasing our legal and financial compliance costs. We expect these developments to make it more difficult and
29
more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers.
We are subject to the ongoing internal control provisions of Section 404 of the Sarbanes-Oxley Act of 2002. Identification of material weaknesses in internal controls, if identified, could indicate a lack of proper controls to generate accurate financial statements.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and related SEC rules, we are required to furnish a report of management’s assessment of the effectiveness of our internal controls as part of our Annual Report on Form 10-K. Our auditors are required to attest to and report on management’s assessment, as well as provide a separate opinion. To issue our report, we document our internal control design and the testing processes that support our evaluation and conclusion, and then we test and evaluate the results. There can be no assurance, however, that we will be able to remediate material weaknesses, if any, that may be identified in future periods, or maintain all of the controls necessary for continued compliance. There likewise can be no assurance that we will be able to retain sufficient skilled finance and accounting personnel, especially in light of the increased demand for such personnel among publicly traded companies.
Terrorist attacks and threats, and government responses thereto, and threats of war elsewhere may negatively impact all aspects of our operations, revenues, costs and stock price.
The terrorist attacks in the U.S. and against U.S.’ interests overseas, the U.S. government’s response thereto, and threats of war may negatively affect our business, financial condition and results of operations. Any escalation in these events or similar or future events may disrupt our operations or those of our customers and may affect the availability of materials needed to manufacture our products or the means to transport those materials to manufacturing facilities and finished products to customers. In addition, these events have had and could in the future have an adverse impact on the U.S. and world economy in general.
Provisions in our corporate documents, stockholder rights plan, and Delaware law could delay or prevent a change in control of Comtech.
We have taken a number of actions that could have the effect of discouraging, delaying or preventing a merger or acquisition involving Comtech that our stockholders may consider favorable. For example, we have a classified board and the employment contract of our chief executive officer provides for a substantial payment in the event of a change of control of Comtech. We also adopted a stockholder rights plan that could cause substantial dilution to a stockholder, and substantially increase the cost paid by a stockholder, who attempts to acquire us on terms not approved by our board of directors. These could prevent us from being acquired. In addition, our certificate of incorporation grants the board of directors the authority to fix the rights, preferences and privileges of and issue up to 2,000,000 shares of preferred stock without stockholder action. Although we have no present intention to issue shares of preferred stock, such an issuance of any class or series of our preferred stock could have rights which would adversely affect the voting power of the common stock or which could delay, defer, or prevent a change in control of Comtech. In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, an anti-takeover law. In general, this statute provides that except in certain limited circumstances a corporation shall not engage in any “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. A “business combination” includes mergers, asset sales and other transactions resulting in a financial benefit to the interested stockholder. Subject to certain exceptions, for purposes of Section 203 of the Delaware General Corporation Law, an “interested stockholder” is a person who, together with affiliates, owns, or within three years did own, 15% or more of the corporation’s voting stock. This provision could have the effect of delaying or preventing a change in control of Comtech.
Our debt service obligations may adversely affect our cash flow.
The higher level of indebtedness resulting from the issuance of our 2.0% convertible senior notes increases the risk that we may default on our debt obligations. We cannot assure you that we will be able to generate sufficient cash flow to pay the interest on our debt or that future working capital, borrowings or equity financing will be available to pay or refinance such debt.
The level of our indebtedness, among other things, could:
| | |
| • | make it difficult for us to make payments on our debt; |
30
| | |
| • | make it difficult for us to obtain any necessary financing in the future for working capital, acquisitions, capital expenditures, debt service requirements or other purposes; |
| | |
| • | limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete; and |
| | |
| • | make us more vulnerable in the event of a downturn in our business. |
Changes in financial accounting standards related to stock option expenses are expected to have a significant effect on our reported results.
The FASB recently issued SFAS No. 123(R), a revised standard that requires that we record compensation expense in the statement of operations for employee stock options using the fair value method. The adoption of the new standard is expected to have a significant effect on our reported earnings, although it will not affect our total cash flows, and could adversely impact our ability to provide accurate guidance on our future reported financial results due to the variability of the factors used to establish the value of stock options. As a result, the adoption of the new standard in fiscal 2006 could impact the value of our common stock and may result in greater stock price volatility.
Our stock price is volatile.
The stock market in general, and the stock prices of technology-based companies in particular, have experienced extreme volatility that often has been unrelated to the operating performance of any specific public company. The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate significantly in the future as well. Factors that may have a significant impact on the market price of our stock include:
| | |
| • | future announcements concerning us or our competitors; |
| | |
| • | receipt or non-receipt of substantial orders for products and services; |
| | |
| • | results of technological innovations; |
| | |
| • | new commercial products; |
| | |
| • | changes in recommendations of securities analysts; |
| | |
| • | government regulations; |
| | |
| • | proprietary rights or product or patent litigation; |
| | |
| • | changes in economic conditions generally, particularly in the telecommunications sector; |
| | |
| • | changes in market conditions generally, particularly in the market for small cap stocks; and |
| | |
| • | limited public float. |
Shortfalls in our sales or earnings in any given period relative to the levels expected by securities analysts could immediately, significantly and adversely affect the trading price of our common stock.
We have never declared or paid cash dividends.
We have never declared or paid a cash dividend and do not intend to declare any cash dividends on our common stock in the foreseeable future.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our earnings and cash flows are subject to fluctuations due to changes in interest rates primarily from our investment of available cash balances. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. If the interest rate we receive on our investment of available cash balances were to change by 10%, our interest income would be impacted by approximately $0.4 million.
Our 2.0% convertible senior notes bear a fixed rate of interest. As such, our earnings and cash flows are not sensitive to changes in interest rates on our long-term debt.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reports of Independent Registered Public Accounting Firm, Consolidated Financial Statements, Notes to Consolidated Financial Statements and Related Financial Schedule are listed in the Index to Consolidated Financial Statements and Schedule annexed hereto.
31
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this Annual Report on Form 10-K, an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures was carried out by the Company under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures have been designed and are being operated in a manner that provides reasonable assurance that the information required to be disclosed by the Company in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. A system of controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
Management’s Report on Internal Control Over Financial Reporting
Management of Comtech is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accounted accounting principles.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of July 31, 2005. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. Based on our assessment, we determined that, as of July 31, 2005, the Company’s internal control over financial reporting was effective based on those criteria.
The Company acquired certain assets and assumed certain liabilities of Tolt in February 2005. Excluded from the Company’s assessment of internal controls over financial reporting as of July 31, 2005, is the internal control over financial reporting of Tolt. Tolt had total assets of $9.8 million and net sales of $11.3 million as of and for the fiscal year ended July 31, 2005.
KPMG LLP (“KPMG”), our independent registered public accounting firm, has performed an audit of our assessment of the effectiveness of the Company’s internal control over financial reporting as of July 31, 2005. This audit is required to be performed in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our independent auditors were given unrestricted access to all financial records and related data. KPMG’s audit reports appear on pages F-2 and F-3 of this annual report.
Changes In Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act that occurred during our fiscal quarter ended July 31, 2005, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
32
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
Certain information concerning directors and officers is incorporated by reference to our Proxy Statement for the Annual Meeting of Stockholders to be held December 6, 2005 (the “Proxy Statement”) which will be filed with the Securities and Exchange Commission no more than 120 days after the close of our fiscal year.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation is incorporated by reference to the Proxy Statement, which will be filed with the Securities and Exchange Commission no more than 120 days after the close of our fiscal year.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information regarding securities authorized for issuance under equity compensation plans and certain information regarding security ownership of certain beneficial owners and management is incorporated by reference to the Proxy Statement, which will be filed with the Securities and Exchange Commission no more than 120 days after the close of our fiscal year.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions is incorporated by reference to the Proxy Statement, which will be filed with the Securities and Exchange Commission no more than 120 days after the close of our fiscal year.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information regarding principal accountant fees and services is incorporated by reference to the Proxy Statement, which will be filed with the Securities and Exchange Commission no more than 120 days after the close of our fiscal year.
33
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
| | |
(a) | (1) | The Registrant’s financial statements together with a separate index are annexed hereto. |
| (2) | The Financial Statement Schedule listed in a separate index is annexed hereto. |
| (3) | Exhibits required by Item 601 of Regulation S-K are listed below. |
| | | | | |
Exhibit
Number | | Description of Exhibit | | Incorporated By
Reference to Exhibit |
| |
| |
|
| 3(a) | | Certificate of Incorporation of the Registrant | | Exhibit 3(a) to the Registrant’s 1987 Form 10-K |
| | | | | |
| 3(b) | | Amendment of the Certificate of Incorporation effecting the 5 to 1 reverse stock split | | Exhibit 3(b) to the Registrant’s 1991 Form 10-K |
| | | | | |
| 3(c) | | Amended and restated By-Laws of the Registrant | | Exhibit 3(c) to Registrant’s 1998 Form 10-K |
| | | | | |
| 3(d) | | Amendment to the Certificate of Incorporation increasing authorized shares to 12 million | | Exhibit 3(d) to the Registrant’s 1994 Form 10-K |
| | | | | |
| 3(e) | | Amendment to the Certificate of Incorporation increasing the authorized shares to 17 million | | Exhibit 3(e) to Registrant’s 1998 Form 10-K |
| | | | | |
| 3(f) | | Form of Certificate of Designation of the Series A Junior Participating Preferred Stock | | Exhibit 4(1) to the Registrant’s Form 8-A/A dated December 23, 1998 |
| | | | | |
| 3(g) | | Amendment to the Certificate of Incorporation increasing the authorized shares to 32 million | | Exhibit 3(g) to Registrant’s 2000 Form 10-K |
| | | | | |
| 4(a) | | Rights Agreement dated as of December 15, 1998 between the Registrant and American Stock Transfer and Trust Company, as Rights Agent | | Exhibit 4(1) to the Registrant’s Form 8-A/A dated December 23, 1998 |
| | | | | |
| 4(b) | | Indenture by and between the Registrant and The Bank of New York, as trustee, dated as of January 27, 2004, including form of Note | | Exhibit 4.2 to the Registrant’s Form S-3 (File No. 333-114268) |
| | | | | |
| 4(c) | | Registration Rights Agreement dated as of January 27, 2004, between the Registrant and Bear, Stearns & Co. Inc., as Initial Purchaser | | Exhibit 4.4 to the Registrant’s Form S-3 (File No. 333-114268) |
| | | | | |
| 10(a) | | Amended and restated Employment Agreement dated June 2, 2003, between the Registrant and Fred Kornberg | | Exhibit 10(a) to the Registrant’s Form 10-Q for quarter ended April 30, 2003 |
| | | | | |
| 10(b) | | Amended and restated Employment Agreement dated June 2, 2003, between the Registrant and Robert G. Rouse | | Exhibit 10(b) to the Registrant’s Form 10-Q for quarter ended April 30, 2003 |
| | | | | |
| 10(c) | | Lease and amendment thereto on the Melville, New York Facility | | Exhibit 10(k) to the Registrant’s 1992 Form 10-K |
| | | | | |
| 10(d) | | Amended and restated 1993 Incentive Stock Option Plan | | Appendix A to the Registrant’s Proxy Statement dated November 3, 1997 |
| | | | | |
| 10(e) | | Movement Tracking System Contract between Comtech Mobile Datacom Corp. and U.S. Army’s CECOM Acquisition Center dated June 24, 1999 (certain portions of this agreement have been omitted and filed separately with the Securities and Exchange Commission pursuant to a request for confidential treatment) | | Exhibit 10(g) to the Registrant’s 1999 Form 10-K |
| | | | | |
| 10(f)(1) | | 2000 Stock Incentive Plan | | Appendix A to the Registrant’s Proxy Statement dated November 8, 1999 |
| | | | | |
| 10(f)(2) | | Amendment to the 2000 Stock Incentive Plan | | Appendix A to the Registrant’s Proxy Statement dated November 6, 2000 |
34
Exhibits to this Annual Report on Form 10-K are available from the Company upon request and payment to the Company for the cost of reproduction.
35
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | |
| COMTECH TELECOMMUNICATIONS CORP. |
| |
September 22, 2005 | | By: /s/Fred Kornberg |
| |
|
(Date) | | Fred Kornberg, Chairman of the Board
and Chief Executive Officer |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| | | | |
| | Signature | | Title |
| |
| |
|
| | | | |
| | | | |
September 22, 2005 | | /s/Fred Kornberg | | Chairman of the Board |
| |
| | Chief Executive Officer and President |
(Date) | | Fred Kornberg | | (Principal Executive Officer) |
| | | | |
| | | | |
September 22, 2005 | | /s/Robert G. Rouse | | Executive Vice President and |
| |
| | Chief Financial Officer |
(Date) | | Robert G. Rouse | | (Principal Financial and Accounting Officer) |
| | | | |
| | | | |
September 22, 2005 | | /s/George Bugliarello | | Director |
| |
| | |
(Date) | | George Bugliarello | | |
| | | | |
| | | | |
September 22, 2005 | | /s/Richard L. Goldberg | | Director |
| |
| | |
(Date) | | Richard L. Goldberg | | |
| | | | |
| | | | |
September 22, 2005 | | /s/Edwin Kantor | | Director |
| |
| | |
(Date) | | Edwin Kantor | | |
| | | | |
| | | | |
September 22, 2005 | | /s/Ira Kaplan | | Director |
| |
| | |
(Date) | | Ira Kaplan | | |
| | | | |
| | | | |
September 22, 2005 | | /s/Gerard R. Nocita | | Director |
| |
| | |
(Date) | | Gerard R. Nocita | | |
36
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
Index to Consolidated Financial Statements and Schedule
Schedules not listed above have been omitted because they are either not applicable or the required information has been provided elsewhere in the consolidated financial statements or notes thereto.
F-1
| |
| KPMG LLP |
| Suite 200 |
| 1305 Walt Whitman Road |
| Melville, NY 11747-4302 |
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Comtech Telecommunications Corp.:
We have audited the accompanying consolidated balance sheets of Comtech Telecommunications Corp. and subsidiaries as of July 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended July 31, 2005. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule listed in the accompanying index. These consolidated financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Comtech Telecommunications Corp. and subsidiaries as of July 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended July 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Comtech Telecommunications Corp.’s internal control over financial reporting as of July 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated September 22, 2005, expressed an unqualified opinion on management’s assessment of, and the effective operation of, the Company’s internal control over financial reporting. Such report contains an explanatory paragraph relating to the exclusion of internal control over financial reporting associated with one entity acquired during 2005 from management’s assessment and our assessment of the effectiveness of internal control over financial reporting of the Company as of July 31, 2005.
Melville, New York
September 22, 2005
F-2
| |
| KPMG LLP |
| Suite 200 |
| 1305 Walt Whitman Road |
| Melville, NY 11747-4302 |
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Comtech Telecommunications Corp.:
We have audited management’s assessment, included in the accompanyingManagement’s Report on Internal Control Over Financial Reporting,that Comtech Telecommunications Corp. maintained effective internal control over financial reporting as of July 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).Comtech Telecommunications Corp’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Comtech Telecommunications Corp. maintained effective internal control over financial reporting as of July 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Comtech Telecommunications Corp. maintained, in all material respects, effective internal control over financial reporting as of July 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Comtech Telecommunications Corp. acquired certain assets and assumed certain liabilities of Tolt Technologies, Inc. during 2005, and management excluded from its assessment of the effectiveness of Comtech Telecommunications Corp’s internal control over financial reporting as of July 31, 2005, internal control over financial reporting associated with this entity comprising aggregate total assets of $9,827,000 and net sales of $11,344,000 included in Comtech Telecommunications Corp’s consolidated financial statements as of and for the year ended July 31, 2005. Our audit of internal control over financial reporting of Comtech Telecommunications Corp. also excluded an evaluation of the internal control over financial reporting of Tolt Technologies, Inc.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Comtech Telecommunications Corp. and subsidiaries as of July 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended July 31, 2005, and our report dated September 22, 2005, expressed an unqualified opinion on those consolidated financial statements.
Melville, New York
September 22, 2005
F-3
COMTECH TELECOMMUNICATIONS CORP.
AND SUBSIDIARIES
Consolidated Balance Sheets
July 31, 2005 and 2004
| | | | | | | |
| | 2005 | | 2004 | |
| |
| |
| |
Assets | | | | | |
Current assets: | | | | | | | |
Cash and cash equivalents | | $ | 214,413,000 | | | 163,292,000 | |
Restricted cash | | | 1,034,000 | | | 4,054,000 | |
Accounts receivable, net | | | 56,052,000 | | | 43,002,000 | |
Inventories, net | | | 45,103,000 | | | 39,758,000 | |
Prepaid expenses and other current assets | | | 4,387,000 | | | 1,817,000 | |
Deferred tax asset - current | | | 8,092,000 | | | 6,501,000 | |
| |
|
| |
|
| |
Total current assets | | | 329,081,000 | | | 258,424,000 | |
| | | | | | | |
Property, plant and equipment, net | | | 18,683,000 | | | 14,652,000 | |
Goodwill | | | 22,244,000 | | | 18,721,000 | |
Intangibles with definite lives, net | | | 9,123,000 | | | 10,706,000 | |
Deferred financing costs, net | | | 2,995,000 | | | 3,541,000 | |
Other assets, net | | | 277,000 | | | 346,000 | |
| |
|
| |
|
| |
Total assets | | $ | 382,403,000 | | | 306,390,000 | |
| |
|
| |
|
| |
| | | | | | | |
Liabilities and Stockholders’ Equity | | | | | | | |
Current liabilities: | | | | | | | |
Accounts payable | | $ | 23,577,000 | | | 9,566,000 | |
Accrued expenses and other current liabilities | | | 34,497,000 | | | 20,515,000 | |
Customer advances and deposits | | | 5,282,000 | | | 7,290,000 | |
Deferred service revenue | | | 8,210,000 | | | 13,716,000 | |
Current installments of other obligations | | | 235,000 | | | 234,000 | |
Interest payable | | | 1,050,000 | | | 1,073,000 | |
Income taxes payable | | | 1,540,000 | | | 4,812,000 | |
| |
|
| |
|
| |
Total current liabilities | | | 74,391,000 | | | 57,206,000 | |
| | | | | | | |
Convertible senior notes | | | 105,000,000 | | | 105,000,000 | |
Other obligations, less current installments | | | 396,000 | | | 158,000 | |
Deferred tax liability – non-current | | | 5,987,000 | | | 1,628,000 | |
| |
|
| |
|
| |
Total liabilities | | | 185,774,000 | | | 163,992,000 | |
| | | | | | | |
Commitments and contingencies (See Note 13) | | | | | | | |
| | | | | | | |
Stockholders’ equity: | | | | | | | |
Preferred stock, par value $.10 per share; shares authorized and unissued 2,000,000 | | | — | | | — | |
Common stock, par value $.10 per share; authorized 30,000,000 shares, issued 22,781,678 shares and 21,557,002 shares at July 31, 2005 and 2004, respectively | | | 2,278,000 | | | 2,156,000 | |
Additional paid-in capital | | | 127,170,000 | | | 109,716,000 | |
Retained earnings | | | 67,366,000 | | | 30,711,000 | |
| |
|
| |
|
| |
| | | 196,814,000 | | | 142,583,000 | |
Less: | | | | | | | |
Treasury stock (210,937 shares) | | | (185,000 | ) | | (185,000 | ) |
| |
|
| |
|
| |
Total stockholders’ equity | | | 196,629,000 | | | 142,398,000 | |
| |
|
| |
|
| |
Total liabilities and stockholders’ equity | | $ | 382,403,000 | | | 306,390,000 | |
| |
|
| |
|
| |
See accompanying notes to consolidated financial statements.
F-4
COMTECH TELECOMMUNICATIONS CORP.
AND SUBSIDIARIES
Consolidated Statements of Operations
Years ended July 31, 2005, 2004 and 2003
| | | | | | | | | | |
| | 2005 | | 2004 | | 2003 | |
| |
| |
| |
| |
| | | | | | | |
Net sales | | $ | 307,890,000 | | | 223,390,000 | | | 174,035,000 | |
Cost of sales | | | 180,524,000 | | | 135,858,000 | | | 114,317,000 | |
| |
|
| |
|
| |
|
| |
Gross profit | | | 127,366,000 | | | 87,532,000 | | | 59,718,000 | |
| | | | | | | | | | |
Expenses: | | | | | | | | | | |
Selling, general and administrative | | | 51,819,000 | | | 36,016,000 | | | 28,045,000 | |
Research and development | | | 21,155,000 | | | 15,907,000 | | | 12,828,000 | |
In-process research and development | | | — | | | 940,000 | | | — | |
Amortization of intangibles | | | 2,328,000 | | | 2,067,000 | | | 2,039,000 | |
| |
|
| |
|
| |
|
| |
| | | 75,302,000 | | | 54,930,000 | | | 42,912,000 | |
| |
|
| |
|
| |
|
| |
| | | | | | | | | | |
Operating income | | | 52,064,000 | | | 32,602,000 | | | 16,806,000 | |
| | | | | | | | | | |
Other expenses (income): | | | | | | | | | | |
Interest expense | | | 2,679,000 | | | 1,425,000 | | | 2,803,000 | |
Interest income | | | (4,072,000 | ) | | (921,000 | ) | | (275,000 | ) |
| |
|
| |
|
| |
|
| |
| | | | | | | | | | |
Income before provision for income taxes | | | 53,457,000 | | | 32,098,000 | | | 14,278,000 | |
Provision for income taxes | | | 16,802,000 | | | 10,271,000 | | | 4,569,000 | |
| |
|
| |
|
| |
|
| |
Net income | | $ | 36,655,000 | | | 21,827,000 | | | 9,709,000 | |
| |
|
| |
|
| |
|
| |
| | | | | | | | | | |
Net income per share (See Note 1): | | | | | | | | | | |
Basic | | $ | 1.69 | | | 1.03 | | | 0.57 | |
| |
|
| |
|
| |
|
| |
Diluted | | $ | 1.42 | | | 0.92 | | | 0.53 | |
| |
|
| |
|
| |
|
| |
| | | | | | | | | | |
Weighted average number of common shares outstanding - basic | | | 21,673,000 | | | 21,178,000 | | | 17,168,000 | |
| |
|
| |
|
| |
|
| |
| | | | | | | | | | |
Weighted average number of common and common equivalent shares outstanding assuming dilution - diluted | | | 27,064,000 | | | 24,781,000 | | | 18,290,000 | |
| |
|
| |
|
| |
|
| |
See accompanying notes to consolidated financial statements.
F-5
