Their was a small increase in RD&E for the third quarter and first nine months of fiscal 2006 as compared with the prior year periods. In the third quarter of fiscal 2006 the increase in RD&E expenses was primarily due to the opening of our Oregon engineering and product development office earlier in the year. For the first nine months of fiscal 2006, RD&E expenses increased as compared with the prior year period due to the Oregon office. Additionally, RD&E expenses for the year were reduced by a reimbursement from a customer of $0.7 million for research costs incurred. Current year initiatives are focused in the semiconductor segment, most notably in the display and packaging markets, and include the opening of our Oregon office as mentioned above. Share-based compensation expense included in RD&E for the first nine months of fiscal 2006 was $0.2 million.
Income tax expense for both the three and nine months ended March 31, 2006 was favorably impacted by the Company’s redetermination of deductions attributable to foreign trading income, also referred to as an Extraterritorial Income Exclusion (“EIE”), related to the current fiscal year and to fiscal 2004. The impact of the EIE reduced the effective tax rate for the three months ended March 31, 2006 to 19% from 30% in the prior year period. The tax rate for the nine months ended March 31, 2006 decreased to 30% from 33% in the comparable prior year period. The EIE had the effect of lowering the estimated annual effective tax rate for the first nine months of fiscal 2006 from 38% to 35%. An additional EIE, which was related to fiscal 2004, further reduced the tax rate from 35% to 30%. Income tax expense for the nine months ended March 31, 2006 was also affected by increased income in foreign jurisdictions, which operate in higher tax jurisdictions and an increase in tax upon additional monies repatriated from these foreign operations, which were partially offset by the release of tax reserves in a foreign jurisdiction that occurred in the second quarter.
Sales to Canon Inc., one of our significant stockholders, and Canon Sales Co., Inc., a distributor of certain of our products in Japan and a subsidiary of Canon Inc., amounted to $16.4 million (38% of net sales) and $44.4 million (37% of net sales) for the third quarter and nine months ended March 31, 2006, as compared with $12.8 million (38% of net sales) and $38.2 million (40% of net sales) for the comparable prior year periods. These sales include revenues generated from the development agreements referenced below. Selling prices of products sold to Canon Inc. and Canon Sales Co., Inc. are based, generally, on the terms customarily given to distributors. Revenues generated from the development agreements are recorded on a cost-plus basis. At March 31, 2006 and June 30, 2005, there were, in the aggregate, $5.1 million and $4.0 million, respectively, of trade accounts receivable from Canon Inc. and Canon Sales Co., Inc.
In September 2002, we entered into a contract with Canon Inc. related to the development of certain interferometers. In March 2004, we signed a preliminary agreement to begin further add-on work; the definitive agreement for this additional work was signed in December 2004. In February 2005, we entered into two additional agreements with Canon Inc. related to the development of prototype production tools and accessories. During the three and nine month ended March 31, 2006, we recognized revenue in the semiconductor segment of $5.2 million and $14.8 million, respectively, from these contracts as compared with $5.4 million and $9.6 million, respectively, for the comparable prior year periods. According to the terms of the agreements, we also receive progress payments during the course of the contract. As of March 31, 2006 and June 30, 2005, we received $5.1 million and $11.3 million, respectively, of progress payments in excess of services performed.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2006, working capital was $75.3 million, an increase of $11.9 million from $63.4 million at June 30, 2005. We maintained cash, cash equivalents, and marketable securities at March 31, 2006 totaling $63.1 million, an increase of $6.2 million, from $56.9 million at June 30, 2005. Cash flow from operations contributed $10.4 million in the nine months ended March 31, 2006, with the benefit derived primarily from our results of operations of $10.0 million, which included non-cash expenses of $9.4 million, along with a decrease in our receivables of $2.1 million. Offsetting these incoming cash flows were an increase in inventories of $3.5 million and a decrease in accounts payable, accrued expenses, and taxes payable of $8.3 million.
Acquisitions of property, plant, and equipment totaled $1.5 million and $4.5 during the three and nine months ended March 31, 2006. Management believes that cash generated from operations, together with the liquidity provided by existing cash balances, will be sufficient to satisfy our liquidity requirements for the next 12 months.
CRITICAL ACCOUNTING POLICIES, SIGNIFICANT JUDGMENTS, AND ESTIMATES
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures at the date of our consolidated financial statements. On an on-going basis, management evaluates its estimates and judgments, including those related to bad debts, inventories, warranty obligations, income taxes, long-lived assets, and share-based payments. Management bases its estimates and judgments on historical experience and current market conditions and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We consider certain accounting policies related to revenue recognition and allowance for doubtful accounts, inventory valuation, warranty costs, accounting for income taxes, valuation of long-lived assets, and valuation of share-based payments to be critical policies due to the estimates and judgments involved in each.
Revenue Recognition and Allowance for Doubtful Accounts
We recognize revenue based on guidance provided in SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition” and in accordance with the Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, our price is fixed or determinable, and collectibility is reasonably assured. We recognize revenue on our standard products when title passes to the customer upon shipment. While our standard products generally require installation, the installation is considered a perfunctory performance obligation. Standard products do not have customer acceptance criteria. Generally, software is a component of our standard product and, as such, is not separately recognized as revenue. We have standard rights of return that we account for as a warranty provision under SFAS No. 5, “Accounting for Contingencies.” We do not have any price protection agreements or other post shipment obligations. For custom equipment where customer acceptance is part of the sales agreement, revenue is recognized when the customer has accepted the product. In cases where custom equipment does not have customer acceptance as part of the sales agreement, we recognize revenue upon shipment as long as the system meets the specifications as agreed upon with the customer. Certain transactions have multiple deliverables, with the deliverables clearly defined. To the extent that the secondary deliverables are other than perfunctory, we recognize the revenue on each deliverable, if separable, or on the completion of all deliverables, if not separable, all in a manner consistent with SAB No. 104 and EITF 00-21. Standalone software products are recognized as revenue when they are shipped. Revenue generated from development contracts are recorded on a cost-plus basis in the period services are rendered.
We maintain an allowance for doubtful accounts based on a continuous review of customer accounts, payment patterns, and specific collection issues. We perform on-going credit evaluations of our customers and do not require collateral from our customers. For many of our international customers, we require an irrevocable letter of credit to be issued by the customer before a shipment is made. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required.
Inventory Valuation
Inventories are valued at the lower of cost or market, cost being determined on a first-in, first-out basis. Management evaluates the need to record adjustments for impairment of inventory on a monthly basis. Our policy is to assess the valuation of all inventories, including raw materials, work-in-process, and finished goods. Obsolete inventory or inventory in excess of management’s estimated future usage is written down to estimated market value, if less than its cost. Contracts with fixed prices are evaluated to determine if estimated total costs will exceed revenues. A loss provision is recorded when the judgment is made that actual costs incurred plus estimated costs remaining to be incurred will exceed total revenues from the contract. Inherent in
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the estimates of market value are management’s estimates related to current economic trends, future demand for our products, and technological obsolescence. Significant management judgments must be made when providing for obsolete and excess inventory and losses on contracts. If actual market conditions are different than those projected by management, additional inventory write-downs and loss accruals may be required.
Warranty Costs
We provide for the estimated cost of product warranties at the time revenue is recognized. We consider historical warranty costs actually incurred and specifically identified circumstances to establish the warranty liability. The warranty liability is reviewed on a quarterly basis. Should actual costs or revised estimated costs differ from management’s prior estimates, revisions to the estimated warranty liability would be required.
Accounting for Income Taxes
Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective income tax bases, and operating loss and tax credit carryforwards. SFAS No. 109, “Accounting for Income Taxes,” requires the establishment of a valuation allowance to reflect the likelihood of the realization of deferred tax assets. We record a valuation allowance to reduce our deferred tax assets to an estimated realizable amount based on historical and forecasted results. While management has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event management were to determine that ZYGO would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the valuation allowance would increase income in the period such determination was made. Likewise, should management determine that ZYGO would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the valuation allowance would be charged to income in the period such determination was made. Our effective tax rate may vary from period to period, generally based on changes in estimated taxable income or loss for domestic and foreign locations, changes to the valuation allowance, changes to federal, state or foreign tax laws, and deductibility of certain costs and expenses by jurisdiction.
Valuation of Long-Lived Assets
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the carrying value of intangible assets and other long-lived assets is reviewed on a regular basis for the existence of facts or circumstances, both internally and externally, that may suggest impairment. Some factors we consider important, which could trigger the impairment review, include a significant decrease in the market value of an asset, a significant change in the extent or manner in which an asset is used, a significant adverse change in the business climate that could affect the value of an asset, an accumulation of costs for an asset in excess of the amount originally expected, a current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection that demonstrates continuing losses, and a current expectation that, more likely than not, a long-lived asset will be disposed of significantly before the end of its estimated useful life.
If such circumstances exist, we evaluate the carrying value of long-lived assets to determine if impairment exists based upon estimated undiscounted future cash flows over the remaining useful life of the assets and comparing that value with the carrying value of the assets. If the carrying value of the assets is greater than the estimated future cash flows, the assets are written down to the estimated fair value. We determine the estimated fair value of the assets based on a current market value of the assets. If a current market value is not readily available, a projected discounted cash flow method is applied using a discount rate determined by management to be commensurate with the risk inherent in the current business model. Our cash flow estimates are based upon management’s best estimates, using appropriate and customary assumptions and projections at the time.
Share-Based Payments
In December 2004, FASB issued SFAS No. 123(R), “Share-Based Payment (as amended).” SFAS No. 123(R) eliminates the alternative to use the intrinsic value method of accounting that was provided in SFAS No. 123, which generally resulted in no compensation expense recorded in the financial statements related to the issuance of equity awards to employees. SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all companies to apply a fair-value-based measurement method in accounting for generally all share-based payment transactions with employees. This method includes estimates and judgments pertaining to term, volatility, risk-free interest rates, dividend yields and forfeiture rates.
Health Insurance
We are self-insured for the majority of our group health insurance. We rely on claims experience in determining an adequate liability for claims incurred, but not reported. To the extent actual claims exceed estimates; we may be required to record additional expense. A one percent change in actual claims would have an annual impact of approximately $25,000 on our financial condition and results of operations.
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Off-Balance Sheet Arrangements
We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt, or operating parts of our business that are not consolidated into our financial statements. We have not guaranteed any obligations of a third party.
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RISK FACTORS THAT MAY IMPACT FUTURE RESULTS
Risk factors that may impact future results include those disclosed in our Form 10-K, as amended, for the year ended June 30, 2005.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
There have been no material changes that have occurred in our quantitative and qualitative market risk disclosures during the first nine months of fiscal 2006. In the third quarter of fiscal 2005, we began hedging certain intercompany transactions by entering into forward contracts to reduce the impact of adverse fluctuations on earnings associated with foreign currency exchange rate changes. We do not enter into any derivative transactions for speculative purposes. These contracts are entered into for periods consistent with the currency transaction exposures, generally three to six months. Generally, any gains and losses on the fair value of these contracts are expected to be largely offset by losses and gains on the underlying transactions.
For discussion of our exposure to market risk, refer to Item 7a., “Quantitative and Qualitative Disclosures about Market Risk”, presented in our Annual Report on Form 10-K, as amended, for the year ended June 30, 2005 filed with the Securities and Exchange Commission.
Item 4. Controls and Procedures
As previously disclosed in a Current Report on Form 8-K which we filed on March 29, 2006 and as described in our Explanatory Note to this Form 10-Q and note 2 to our accompanying consolidated financial statements included herein, in connection with conducting an internal review of our tax return, we determined that inadvertent accounting errors were made in the consolidation of our intercompany revenues from certain of our foreign operations. The errors are the result of our failure to identify and eliminate certain intercompany revenues attributed to our Singapore and Taiwan offices, which resulted in our overstating reported revenues, from fiscal 2001 through the second quarter of fiscal 2006. Based on the impact of the aforementioned accounting errors, we determined to restate our financial statements as of June 30, 2005 and 2004 and for each of the years in the three-year period ended June 30, 2005, as well as interim financial statements for the quarters ended September 30, 2005 and December 31, 2005. Our restated consolidated financial statements for fiscal years 2005, 2004, and 2003 included in Form 10-K/A also include disclosure of restated quarterly results for 2005 and 2004.
Management has determined that the internal control deficiency that resulted in the aforementioned accounting errors is a material weakness, as defined by the Public Company Accounting Oversight Board’s Auditing Standard No. 2. We have determined that the material weakness was that we did not maintain adequate controls and procedures to ensure that intercompany accounts were properly reconciled and intercompany transactions were properly identified and eliminated in the consolidation process. The Public Company Accounting Oversight Board has defined a material weakness as “a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.”
In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
In response to this material weakness, management performed additional analyses and other post-closing procedures to ensure our consolidated financial statements included in this Form 10-Q were prepared in accordance with generally accepted accounting principles. During the period from April to May 2006, we implemented remedial measures to address the identified material weakness. We improved procedures related to the recording and reporting of our intercompany transactions, including dedicating additional resources to our consolidation process and the procedures and controls surrounding the consolidation process, and increased review and approval controls by senior financial personnel over the personnel that perform the consolidation. These improved procedures included ensuring that the inter-company activity is properly identified and eliminated in consolidation.
Accordingly, management, including our Chief Executive Officer and Chief Financial Officer, believes the consolidated financial statements included in this report fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented.
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PART II - Other Information |
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Item 6. | Exhibits | |
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(a) | Exhibits: | |
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| 31.1 | Certification of Chief Executive Officer under Rule 13a-14(a) |
| 31.2 | Certification of Chief Financial Officer under Rule 13a-14(a) |
| 32.1 | Certification of Chief Executive Officer and Chief Financial Officer |
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SIGNATURE
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.
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| Zygo Corporation | |
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| (Registrant) | |
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| /s/ J. Bruce Robinson | |
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| J. Bruce Robinson | |
| President, Chairman, and Chief Executive Officer |
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| /s/ Walter A. Shephard | |
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| Walter A. Shephard | |
| Vice President, Finance, Chief Financial Officer, and Treasurer |
Date: June 26, 2006
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