We have historically experienced significant variability in our revenue, earnings and other operating results, and our performance may fluctuate significantly in the future.
Net Loss.
Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Sales.
Sales during the thirty-nine weeks ended November 24, 2006 were $13,622,000 as compared to $18,376,000 for the thirty-nine weeks ended November 25, 2005, a decrease of $4,754,000 or 25.9%. Geographically, the sales decrease was split between domestic (down $2,937,000, 40.8%) and U.S. government (down $1,925,000, 81.2%). International sales were up $108,000 or 1.2% between the periods. We have historically experienced significant variability in our sales performance. This reflects the existing sales backlog, product and the nature of contract (size and performance time) mix, the manufacturing cycle and amount of time to effect installation and customer acceptance, and certain factors not in our control such as customer delays and the time required to obtain U.S. Government export licenses. One or a few contract sales may and typically do account for a substantial percentage of our revenue.
Our combined sales backlog at November 24, 2006 for work to be performed and revenue to be recognized under written agreements after such dates was $10,545,000.
Domestic Sales.
Overall, domestic sales during the thirty-nine weeks ended November 24, 2006 were $4,270,000 as compared to $7,207,000 for the thirty-nine weeks ended November 25, 2005, a decrease of $2,937,000 or 40.8%. The decrease in domestic sales reflected declines in all product groups except simulation and entertainment, with the greatest decline being evidenced in the environmental product line (down $2,037,000, 80.0%). In general, the sales performance for fiscal 2007 has reflected the lower beginning backlog and timing of the booking of new contracts within the period. Domestic sales represented 31.4% of our total sales during the thirty-nine weeks ended November 24, 2006, compared to 39.2% for the thirty-nine weeks ended November 25, 2005. Sales to the U.S. Government during the thirty-nine weeks ended November 24, 2006 $445,000 as compared to $2,370,000 for the first half of fiscal 2006, a decrease of $1,925,000 or 81.2%, and represented 3.3% of total sales during the thirty-nine weeks ended November 24, 2006 versus 12.9% for the thirty-nine weeks ended November 25, 2005. The major decrease in U. S. Government sales in the current period represented percentage of completion revenue recognized in the prior period for a Pilot Selection System purchased by the Army Corps of Engineers for use in a foreign country.
International Sales.
International sales during the thirty-nine weeks ended November 24, 2006 were $8,907,000 as compared to $8,799,000 for the thirty-nine weeks ended November 25, 2005, an increase of $108,000 or 1.2%, and represented 65.3% of total sales during the thirty-nine weeks ended November 24, 2006, compared to 47.9% for the thirty-nine weeks ended November 25, 2005. International sales in the current period were up in ETC Southampton in all product categories except environmental and simulation. Significant increases were evidenced in PTS (up $1,272,000, 31.9%), sterilizers (up $1,046,000), and hyperbaric (up $209,000, 47.5%). These increases were nearly offset by a decrease in ETC PZL sales of $1,712,000, 53.9%, on reduced production for the L-3 simulator contract. During the thirty-nine weeks ended November 24, 2006, international sales totaling at least ten percent of total international sales were made to or relating to commercial accounts in Japan ($3,127,000) and a domestic customer purchasing from ETC-PZL ($1,195,000). In the thirty-nine weeks ended November 25, 2005, there were sales of 10% or more to or relating to a commercial account in Pakistan ($1,386,000) and a domestic customer purchasing from ETC-PZL ($3,163,000). Fluctuations in sales to international countries from year to year primarily reflect revenue recognition on the level and stage of development and production on multi-year long-term contracts.
34
Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Gross Profit.
Gross profit for the thirty-nine weeks ended November 24, 2006 was $2,538,000 as compared to $4,102,000 for the thirty-nine weeks ended November 25, 2005, a decrease of $1,564,000 or 38.1%. This decrease reflected the decrease in sales between the two periods coupled with a 3.7 percentage point decrease in the gross profit rate as a percent of sales. Gross profit rate performance by product was mixed. The primary contributor to the reduced margin was ETC Southampton PTS which experienced both a decreased sales volume and gross profit rate. By division, a decrease in ETC Southampton was partially offset by a significant improvement (up 49.4 percentage points) in ETC-PZL reflecting a favorable gross profit albeit at a lower sales volume for the L-3 simulator contract.
We have historically experienced significant fluctuations in gross profit margins and, consequently, our operating results, and we expect such fluctuations to continue. Gross margins are routinely affected by selling prices, the amount of new product development required to meet contract specifications, the mix of materials, labor content and engineering effort in manufacturing costs, and labor difficulties in field work including installation and customer acceptance, and the impact of claims settlements.
Selling and Administrative Expenses.
Selling and administrative expenses for the thirty-nine weeks ended November 24, 2006 were $6,945,000 as compared to $7,142,000 for the thirty-nine weeks ended November 25, 2005, a decrease of $197,000 or 2.8%, primarily reflecting a significant reduction in sales commissions, legal costs associated with our ongoing litigation and contract claims activities, and bad debt expense. Acting as a partial offset were increased consulting fees and start-up expenses associated with the development of the NASTAR Center in Southampton. Although reduced from the prior period, spending on legal matters is expected to continue to be significant for the foreseeable future.
A significant portion of our selling and administrative spending is related to three activities: 1. legal and contract claims costs, 2. outside agent and sales personnel commissions on booked contracts and 3. additional accounting, legal and stockholder’s costs required to comply with applicable statutes, rules and regulations as a public company. In fiscal 2006, we instituted a series of cost cutting measures and we continue to monitor these spending categories very closely.
Research and Development Expenses.
Research and development expenses, which are charged to operations as incurred, were $529,000 for the thirty-nine weeks ended November 24, 2006 as compared to $247,000 for the thirty-nine weeks ended November 25, 2005, an increase of $282,000 or 114.2%. This increase reflected less reimbursement from the Turkish government under grant programs coupled with additional projects in ETC Southampton.
Most of our research efforts, which were and continue to be a significant cost of our business, are included in cost of sales for applied research for specific contracts, as well as research for feasibility and technology updates. Most of our products require a significant amount of continued development effort to implement new applications, design product extensions, and integrate new technology into existing products.
35
Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Where appropriate under applicable accounting principles, we capitalize the qualifying costs of developing software contained in certain products.
Interest Expense.
Interest expense for the thirty-nine weeks ended November 24, 2006 was $857,000 as compared to $1,265,000 for the thirty-nine weeks ended November 25, 2005, a decrease of $408,000 or 32.3%. The decrease reflected no amortization in the current period of deferred finance expenses from our February 2003 refinancing and stock warrants issued in connection with modifications to the PNC Agreement. These amounts have been fully amortized to our Consolidated Statements of Operations as of February 24, 2006. Additionally, the prior period included cash interest payments on our long-term bonds which were redeemed on August 1, 2005.
Other Income/Expense, Net.
Other income/expense, net, was income of $36,000 for the thirty-nine weeks ended November 24, 2006 as compared to expense of $110,000 for the thirty-nine weeks ended November 25, 2005, a decrease of $146,000 or 132.7%. The current period included higher foreign exchange gain in ETC-PZL and lower bank charges.
Income Taxes
Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and operating loss and tax credit carry forwards and are measured using the enacted tax rates and laws that will be in effect when the differences and carry forwards are expected to be recovered or settled. In accordance with SFAS No. 109, Accounting for Income Taxes, a valuation allowance for deferred tax assets is provided when we estimate that it is more likely than not that all or a portion of the deferred tax assets may not be realized through future operations. This assessment is based upon consideration of available positive and negative evidence, which includes, among other things, our most recent results of operations and expected profitability. We consider our actual historical results to have stronger weight than other more subjective indicators when considering whether to establish or reduce a valuation allowance on deferred tax assets. During the current fiscal quarter, no offsetting income tax benefit and corresponding deferred tax receivable was recorded. The tax accrual of $13,000 reflected tax liability in ETC-PZL. We will recognize deferred tax benefits only as reassessment demonstrates that they are realizable. Realization is entirely dependent upon future earnings in specific tax jurisdictions.
As of February 24, 2006, we had approximately $11.7 million of federal and $4.8 million of state net loss carry forwards available to offset future income taxes, expiring in 2025. We have established a full valuation allowance of the same amount against these carry forward benefits. While the need for this valuation allowance is subject to periodic review, if the allowance is reduced, the tax benefits of the carry forwards will be recorded in future operations as a reduction of the company’s income tax expense.
The income tax accrual of $4,000 in the prior period reflected tax liability in ETC-PZL.
36
Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Liquidity and Capital Resources
During the thirty-nine weeks ended November 24, 2006, operating activities required $8,182,000 of our cash. Cash was primarily used to fund the operating loss, a build in inventories (NASTAR equipment) and receivables (a major portion of which was collected in December, 2006) and increased costs and estimated earnings in excess of billings on uncompleted long-term contracts (one large contract currently in progress does not allow for billing until the device is shipped or accepted). The major offsets to this operating usage were non-cash expenses (depreciation, software amortization and non-cash interest expense), an increase in billings in excess of costs and estimated earnings on uncompleted long-term contracts and higher customer deposits.
Our investing activities required $283,000 during the thirty-nine weeks ended November 24, 2006, consisting of purchases of capital equipment and capitalized software. This was down significantly from the prior period.
Our financing activities generated $8,831,000 during the thirty-nine weeks ended November 24, 2006, reflecting the receipt of $6,000,000 in exchange for the issuance of shares of our preferred stock under the Lenfest Equity Line and $3,000,000 from the issuance of a short-term note, which was repaid in full on December 13, 2006.
Refinancing
We have historically financed operations through a combination of cash generated from operations, equity offerings, subordinated borrowings and bank debt. On February 19, 2003, we refinanced our operations (the “Refinancing”). The Refinancing was effected through the issuance of subordinated, convertible notes to Mr. Lenfest and entering into a credit agreement (the “PNC Agreement”) with PNC Bank. The total proceeds from the Refinancing were $29,800,000.
Bank Credit and Facility
Since inception, the PNC Agreement has had numerous amendments. As of February 24, 2006, the facility total was $5,000,000 and use of this amount was restricted to the issuance of international letters of credit. This line was secured by all of our assets as well as a $5,000,000 personal guarantee by Mr. Lenfest.
On June 28, 2006, we signed an amendment to the PNC Agreement which (i) extended the agreement’s termination date to the earlier of June 30, 2007 or such date to which we and PNC Bank have agreed in writing, (ii) terminated the Security Agreement and Mortgage, thereby releasing our assets as collateral for the facility, (iii) adjusted the Tangible Net Worth covenant to a minimum of $9,000,000, and (iv) made other changes to the PNC Agreement. This $5,000,000 facility remains restricted to use for issuing letters of credit.
On November 16, 2006, we entered into a Letter Agreement with PNC Bank. This Letter Agreement amended, restated and replaced the existing PNC Credit Agreement. Pursuant to such agreement, PNC Bank (i) terminated our Credit Agreement dated as of February 18, 2003 (ii) re-approved our $5,000,000 Line of Credit for Letters of Credit, and (iii) re-affirmed the Tangible Net Worth covenant (as defined in the Letter Agreement) to be a minimum of $9,000,000. The $5 million Line of Credit for Letters of Credit will continue to be guaranteed by Mr. Lenfest. As of November 24, 2006, we had used approximately $3,200,000 million of this facility for international letters of credit.
37
Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Equity Line
On April 7, 2006, ETC entered into a Preferred Stock Purchase Agreement (the “Equity Agreement”) with Mr. Lenfest, a Director, significant shareholder and holder of our subordinated debt. The Equity Agreement permits us to unilaterally draw down up to $15 million prior to October 2007 in exchange for shares of our newly-created Series B Cumulative Convertible Preferred Stock (“Preferred Stock”). The Preferred Stock provides for a dividend equal to six percent per annum. After three years, the Preferred Stock will be convertible, at Mr. Lenfest’s request, into ETC common shares at a conversion price (the “Conversion Price”) which will be set on the day of each draw down. The Conversion Price will be equal to the closing price of our common stock on the trading day immediately preceding the day in which the draw down occurs, subject to a floor price of $4.95 per common share. Draw downs will not be permitted on any day when the Conversion Price would be less than this floor price. On the sixth anniversary of the Equity Agreement, any issued and outstanding Preferred Stock will be mandatorily converted into ETC common stock at each set Conversion Price. The Equity Agreement also allows us to redeem any outstanding Preferred Stock any time within the six-year term of the Equity Agreement. The Preferred Stock is entitled to vote with the ETC common stock on an as converted basis.
In connection with the execution of the Equity Agreement, in April 2006 we drew down $3,000,000 by issuing 3,000 shares of Preferred Stock with a Conversion Price equal to $4.95 per share. Additionally, on July 31, 2006, we drew down an additional $3,000,000 by issuing 3,000 shares of Preferred Stock at a Conversion Price equal to $6.68 per common share.
Unsecured Promissory Note
On November 16, 2006, we executed an Unsecured Promissory Note (the “Lenfest Note”) in favor of Mr. Lenfest in the aggregate principal amount of $3,000,000. Pursuant to the terms of the Lenfest Note, ETC can borrow up to $3,000,000 in increments of $1,000,000 prior to the maturity date of October 6, 2007. On November 17, 2006, ETC borrowed $3,000,000. The Lenfest Note plus all accrued interest was repaid in full on December 13, 2006.
All outstanding and unpaid interest on the Lenfest Note is due and payable on the earlier of (i) October 6, 2007 or (ii) such date as we draw down funds sufficient to repay the amount due under the Lenfest Note pursuant to the Preferred Stock Purchase Agreement.
Borrowings made pursuant to the Lenfest Note will bear interest at an annual rate of six (6%) percent with such interest beginning to accrue on the date of the funding of each loan and, to the extent not paid, compounding on the first day of each month.
The Lenfest Note provides for customary events of default including, but not limited to, the nonpayment of any amount payable when due, certain bankruptcy, insolvency or receivership events and the imposition of certain judgments. Upon the occurrence of an event of default, Mr. Lenfest has the right to accelerate the maturity date of the Lenfest Note and demand immediate payment of all amounts payable there under.
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Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Subordinated Convertible Debt
In connection with the financing provided by PNC on February 19, 2003, we entered into a Convertible Note and Warrant Purchase Agreement with Mr. Lenfest, pursuant to which we issued to Mr. Lenfest (i) a senior subordinated convertible promissory note (the “Senior Subordinated Note”) in the original principal amount of $10,000,000 and (ii) warrants to purchase 803,048 shares of our common stock. Upon the occurrence of certain events, we will be obligated to issue additional warrants to Mr. Lenfest. The Senior Subordinated Note accrues interest at the rate of 10% per annum (Mr. Lenfest reduced the rate to 8% on a temporary basis for the period December 1, 2004 through November 30, 2006) and matures on February 18, 2009. At our option, the quarterly interest payments may be deferred and added to the outstanding principal. The Senior Subordinated Note entitles Mr. Lenfest to convert all or a portion of the outstanding principal of, and accrued and unpaid interest on, the note into shares of common stock at a conversion price of $6.05 per share. The warrants could be exercised into shares of common stock at an exercise price equal to the lesser of $4.00 per share or two-thirds of the average of the high and low sale prices of the common stock for the 25 consecutive trading days immediately preceding the date of exercise.
Our obligations to Mr. Lenfest under the Convertible Note and Warrant Purchase Agreement are secured by a second lien on all of our assets, junior in rights to any lien (if any is in place) in favor of PNC Bank, including all of our real property.
As a condition of amending the PNC Agreement on August 24, 2004, Mr. Lenfest agreed to issue to PNC Bank on our behalf a limited guarantee to secure up to $5,000,000 in principal amount of any letters of credit issued under the amended facility. In consideration for issuing this guarantee, Mr.Lenfest receives a fee of 0.75% per annum of the average amount of letters of credit outstanding, payable on a quarterly basis, and received a warrant to purchase 200,000 shares of stock under the same terms and conditions as his existing warrant for 803,048 shares.
On February 14, 2005, Mr. Lenfest exercised all of his outstanding warrants and received 1,003,048 shares of common stock for approximately $3.9 million. Additionally, on February 14, 2005, Mr. Lenfest purchased 373,831 shares of common stock for approximately $2.0 million.
Under the Senior Subordinated Note, we must meet certain financial covenants including a Leverage Ratio, a Fixed Charge Ratio and a Tangible Net Worth Ratio. At November 24, 2006, we failed to meet any of these financial covenants but have obtained a waiver from Mr. Lenfest. This waiver applies to all periods through November 25, 2007. Except as specified, the waiver does not constitute a modification or alteration of any other terms or conditions in the Note, or a release of any of the lender’s rights or remedies, all of which are reserved, nor does it release us or any guarantor from any duties, obligations, covenants or agreements including the consequences of any event of default, except as specified.
Long-Term Bonds
On March 15, 2000, we issued approximately $5,500,000 of unregistered Taxable Variable Rate Demand/Fixed Rate Revenue Bonds (Series of 2000). Net proceeds from these bonds were used to repay a $4,100,000 advance taken on our revolving credit facility and to finance construction of an addition to our main plant in Southampton, Pennsylvania. The bonds were secured by a $5,000,000 irrevocable direct pay Letter of Credit issued by PNC Bank which was scheduled to expire on February 17, 2006 and which was secured by all of our assets. At February 25, 2005, the bonds were fully cash collateralized. The bonds carried a maturity date of April 1, 2020, bore a variable interest rate which adjusted each week to a rate required to remarket the bonds at full principal value with a cap of 17%, and were subject to mandatory redemption of $275,000 per year for 19 years and $245,000 for the 20th year.
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Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
On June 30, 2005, we directed the trustee for the bonds to issue a redemption notice for all of our outstanding bonds and, on August 1, 2005, we utilized the restricted cash held by PNC Bank to redeem all outstanding bonds. As of May 27, 2005, all deferred financing charges associated with this bond issue had been fully amortized to our Consolidated Statements of Operations.
Liquidity
At any particular time, our cash position is affected by the timing of cash receipts for milestone payments on open orders, product sales and maintenance services and payments we make for inventory and on account of operating expenses, including legal expenses, resulting in significant quarter-to-quarter, as well as within a quarter, fluctuations in our cash balances. We face increased liquidity risk if we do not receive cash flow from operating activities as planned. Our principal sources of liquidity are our cash balances, cash from operations and our promissory note and equity line with Mr. Lenfest. Given our inability to borrow cash under the amended PNC Agreement and certain restrictions in the Equity Agreement, we may need to obtain additional sources of capital in order to continue growing and operating our business. This capital may be difficult to obtain and the cost of this additional capital is likely to be relatively high. However, because we have established businesses in many markets, significant fixed assets including a building, and other valuable business assets which can be used as collateral for an investor or lender, we believe that we will be able to locate such additional capital and that the actions by PNC Bank will not have a long-term material adverse effect on our business.
In reference to our outstanding claims with the U.S. Navy, to the extent we are unsuccessful in recovering a significant portion of recorded claim contract costs, and to the extent that significant additional legal expenses are required to bring the dispute to resolution, such events could have a material adverse effect on our liquidity and results of operations. Historically, we have had favorable experience in that recoveries have exceeded recorded claims, including significant settlement agreements in fiscal 2003, 2004 and 2005. (See Note 2 to the Consolidated Financial Statements, Accounts Receivable).
Most of our contracts include stage or milestone payment clauses in which the customer advances funds to facilitate the cost of engineering, purchase of materials and production. These advance funds are a significant source of working capital, especially where the project is high in dollar value and requires multiple years to complete.
We are evaluating different business models to generate sales and working capital. These include providing contract training, revenue sharing and leasing our products to third parties. If successful, these alternate approaches may provide a more consistent and predictable cash flow to support our operations.
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Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
The following table presents our contractual cash flow commitments on long-term debt and operating leases.
| | Payments Due by Period | |
| |
| |
| | Total | | Less Than 1 Year | | 1-3 Years | | 4-5 Years | | After 5 Years | |
| |
| |
| |
| |
| |
| |
| | (in thousands) | |
Long-term debt, including current maturities | | $ | 8,709 | | $ | — | | $ | 8,709 | | $ | — | | $ | — | |
Operating leases | | | 567 | | | 32 | | | 338 | | | 197 | | | — | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | 9,276 | | $ | 32 | | $ | 9,047 | | $ | 197 | | $ | — | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
Long-term debt is reported net of unamortized discount of $1,291,000 on the Company’s subordinated debt.
As of December 29, 2006, the Company had available a total of $9,000,000 under the promissory note and equity line with Mr. Lenfest and approximately $1,800,000 available under the Letter of Credit line with PNC.
We believe that existing cash balances at November 24, 2006, cash generated from operating activities as well as future availability under our promissory note and equity line with Mr. Lenfest will be sufficient to meet our future obligations through at least November 25, 2007. Our plans assume customer acceptances and subsequent collections from a few large customers, as well as cash receipts on new bookings.
As of November 24, 2006, claims recorded against the U.S. Government totaled $3,004,000. To the extent we are unsuccessful in recovering a significant portion of recorded claim contract costs, and to the extent that significant additional legal expenses are required to bring the dispute to resolution, such events could have a material adverse effect on our liquidity and results of operations. Historically, we have had favorable experience in that recoveries have exceeded recorded claims, including significant settlement agreements in fiscal 2003, 2004 and 2005. However, there is no assurance that we will continue to have positive experience with regard to recoveries for our contract claims. (See Note 2 to the Consolidated Financial Statements, Accounts Receivable).
Claim costs have been incurred in connection with customer caused delays, errors in specifications and designs, other out-of-scope items and exchange losses and may not be received in full during fiscal 2007. In conformity with accounting principles generally accepted in the United States of America, revenue recorded for a claim may not exceed the incurred contract costs related to the claim.
In November 2003, the U.S. Government completed an audit of the submarine rescue decompression chamber project claim, rejecting most of the items due to audit or engineering reasons. We were not provided a copy of the Government’s Technical Report which questioned approximately half of the claim costs. We have submitted a written rebuttal to the draft report. On July 22, 2004, the U.S. Government’s contracting officer issued a final decision on the claim, basically denying the claim in full. We have updated the claim for additional costs expended on claimable items since the original submission and have converted the claim to a complaint which was filed in the Court of Federal Claims in July 2005. On November 7, 2005 the U.S. Government filed its response to our complaint, contesting each of the items.
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Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
This claim is currently in the discovery phase, including the mutual exchange of documents. Depositions are expected to last through the end of January 2007. Assuming no further delays, the case is scheduled to go to trial in July 2007.
This U. S. Government claim has followed the typical process of claim notification, preparation, submittal and government audit and review by the contracting officer. Historically, our experience has indicated that most claims are initially denied in part or in full by the contracting officer (or no decision is forthcoming, which is then taken to be a deemed denial) which then forces us to seek relief in a court of law.
We consider the recorded costs to be realizable due to the fact that the costs relate to customer caused delays, errors and changes in specifications and designs, disputed liquidated damages and other out of scope items. The U.S. Government, citing failure to deliver the product within contract terms, has assessed liquidated damages but has not offset or withheld any progress payments due to us under the contract. We dispute the basis for these liquidated damages, noting that applicable U.S. Government purchasing regulations allow for a waiver of these charges if the delay is beyond the control and not due to our fault or negligence. However, following accounting principles generally accepted in the United States of America, we have reduced contract values and corresponding revenue recognition by an estimated amount of $330,000 to cover a delay through the extended delivery period.
On June 16, 2003, we filed for arbitration in Thailand seeking recovery of the $700,000 open balance on the RTAF contract. On March 23, 2006, the Arbitration panel awarded us $314,813 plus interest from March 1, 2006 as full settlement of this dispute. Although the award is final with the arbitration panel, the RTAF has filed a motion in the Thai court to void the award, citing that the award was illegal and thus against the public order and unfair to the RTAF. On August 9, 2006, we filed our defense to this motion with the court. In September 2006, at a pre-trial session the court ordered the parties to produce witnesses to testify. This testimony has been scheduled for August and September 2007.
If the RTAF loses on its motion but does not honor the decision, the award will have to be enforced through the court system in Thailand, a process which may be time consuming and costly. The assets of the RTAF are not subject to enforcement. At this point, we are not able to determine what the ultimate result of this dispute will be. However, we have established sufficient receivable reserves so that any resolution will not have a material impact on our financial position or results of operations.
Historically, the Company has had positive experience with regard to its contract claims in that recoveries have exceeded the carrying value of claims. Although the claim with the U.S. Government was filed in the Court of Federal Appeals whereas prior claims have been filed with the Armed Services Board of Contract Appeals (ASBCA), the litigation has followed a consistent process and time frame as prior claims. The dispute with the RTAF has been outstanding for over 10 years, although the arbitration award occurred on March 23, 2006.
There is no assurance that the Company will always have positive experience with regard to recoveries for its contract claims.
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Management’s Discussion and Analysis of Results of Operations and Financial Condition, continued
Backlog
Our sales backlog at November 24, 2006 and February 24, 2006, for work to be performed and revenue to be recognized under written agreements after such dates, was $9,097,000 and $8,132,000, respectively. In addition, our training, maintenance and upgrade contracts backlog at November 24, 2006 and February 24, 2006, for work to be performed and revenue to be recognized after such dates under written agreements, was $1,448,000 and $1,774,000, respectively. Of the November 24, 2006 backlog, we have contracts totaling approximately $5,250,000 for PTS and PTS maintenance support, including $1,969,000 for Indonesia. Our order flow does not follow any seasonal pattern as we receive orders in each fiscal quarter of its fiscal year.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to various market risks, including changes in interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. We do not enter into derivatives or other financial instruments for trading or speculative purposes. We also have not entered into financial instruments to manage and reduce the impact of changes in interest rates and foreign currency exchange rates although we may enter into such transactions in the future. Although currently none of our debt bears interest at rates that vary with the prime rate of interest, it is expected that any additional debt which we might incur would carry a floating rate. If this were the case, any increases in the applicable prime rate of interest would reduce our earnings. With respect to currency risk, where we have a contract which is denominated in a foreign currency, we often establish local in-country bank accounts and fund in-country expenses in the local currency, thus creating a “natural” currency hedge for a portion of the contract.
Item 4. Controls and Procedures
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of November 24, 2006 (the “Evaluation Date”), and, based on this evaluation, our chief executive officer and chief financial officer have concluded that these controls and procedures were effective as of the Evaluation Date. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the Evaluation Date.
Disclosure controls and procedures (as defined in Rules 13a-14(c) and 15(d)-14(c) under the Securities Exchange Act of 1934, as amended) are our internal controls and other procedures that are designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the internal control system are met. Because of the inherent limitations of any internal control system, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected.
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Part II – OTHER INFORMATION
Item 1. Legal Proceedings
In April 2003, Boenning & Scattergood, Inc. (“B&S”) filed suit against ETC in the Court of Common Pleas in Philadelphia, Pennsylvania, seeking payment of $901,843.46 for financing fees allegedly due to B&S pursuant to the terms of an agreement for investment banking services, which was entered into with a predecessor of B&S (the “B&S Agreement”). B&S alleged that it contacted the investors in ETC’s February 2003 financing transaction and that it earned the claimed financing fees pursuant to the terms of the B&S Agreement. On August 17, 2005, ETC entered into an agreement to settle this litigation. The agreement was entered into for the purpose of resolving contested claims and disputes as well as avoiding the substantial costs, expenses and uncertainties associated with protracted and complex litigation, and was not an admission of fault or liability by either party. Under the guidance of FASB Statement No.5, an amount representing a probable settlement had been accrued in a prior period, so the payment under the settlement had no material impact on ETC’s results of operations for the fiscal second quarter of fiscal 2006.
In June 2003, Entertainment Technology Corporation (“EnTCo”), our wholly-owned subsidiary, filed suit against Walt Disney World Co. and other entities (“Disney”) in the United States District Court for the Eastern District of Pennsylvania, alleging breach of contract for, among other things, failure to pay all amounts due under contract for the design and production of the amusement park ride “Mission: Space” located in Disney’s Epcot Center. In response, in August 2003, Disney filed counterclaims against both EnTCo and us (under a guarantee) for, among other things, alleged failures in performance and design in the contract. Disney is seeking damages in excess of $65 million plus punitive damages. In December 2005 EnTCo filed a second suit against Disney, alleging breach of confidentiality and unfair trade practices. Both EnTCo and we believe that we have valid defenses to each of Disney’s counterclaims and intend to vigorously defend ourselves against these counterclaims. Discovery is expected to be completed in the first quarter of fiscal 2007. The parties participated in a structured mediation in early December 2005 on the first suit, with no agreement forthcoming. The case is not currently scheduled for trial. Neither EnTCo nor we are able to predict the outcome of this matter.
Certain other claims, suits, and complaints arising in the ordinary course of business have been filed or are pending against us.
In our opinion, after consultation with legal counsel handling these specific maters, all such matters are reserved for or adequately covered by insurance or, if not so covered, are without merit or are of such kind, or involve such amounts, as would not have a significant effect on our financial position or results of operations if disposed of unfavorably.
Item 1A. Risk Factors
There have been no material changes to the Company’s risk factors since fiscal 2006-year end. The reader is referred to Part I of the Company’s Annual Report on Form 10-K for the fiscal year ended February 24, 2006, in the section entitled “Risks Particular to our Business”.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Please see Note 4 to the Notes to Consolidated Financial Statements of the Company, together with the Company’s Current Report on Form 8-K, dated April 6, 2006, and the Company’s Current Report on Form 8-K, dated July 31, 2006 for further information regarding the Company’s sale of Series B Cumulative Convertible Preferred Stock to H.F. Lenfest under the Lenfest Equity Agreement.
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Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Security Holders
On September 21, 2006, the Company held its Annual Meeting to vote on proposals to elect five directors. The results of voting are as follows:
I. | | Election of Directors | | FOR | | WITHHELD |
| | | | |
| |
|
| | William F. Mitchell | | 9,038,801 | | 224,264 |
| | Alan Mark Gemmill | | 9,244,785 | | 18,280 |
| | Howard W. Kelley | | 9,244,785 | | 18,280 |
| | George K. Anderson, M.D. | | 9,038,889 | | 224,176 |
| | H. F. Lenfest | | 9,038,889 | | 224,176 |
Item 5. Other Information
None.
Item 6. Exhibits
Number | | Item |
| |
|
3.1 | | Registrant’s Articles of Incorporation, as amended, were filed as Exhibit 3.1 to Registrant’s Form 10-K for the year ended February 28, 1997 and are incorporated herein by reference. |
3.2 | | Registrant’s amended and restated By-Laws were filed as Exhibit 3.2 to Registrant’s Form 8-K dated May 25, 2005, and are incorporated herein by reference. |
31.1 | | Certification dated January 8, 2007 pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 made by William F. Mitchell, Chief Executive Officer. |
31.2 | | Certification dated January 8, 2007 pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 made by Duane D. Deaner, Chief Financial Officer. |
32 | | Certification dated January 8, 2007 pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 made by William F. Mitchell, Chief Executive Officer, and Duane D. Deaner, Chief Financial Officer. |
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | ENVIRONMENTAL TECTONICS CORPORATION (Registrant) |
Date: January 8, 2007 | |
By:
| /s/ William F. Mitchell |
| | |
|
| | | William F. Mitchell
President and Chief
Executive Officer
(Principal Executive Officer) |
Date: January 8, 2007 | |
By:
| /s/ Duane Deaner |
| | |
|
| | | Duane Deaner
Chief Financial Officer
(Principal Financial and Accounting Officer) |
No 