These forward-looking statements include, without limitation, any and all statements or implications regarding:
| · | The ability of EMCORE Corporation (EMCORE) to remain competitive and a leader in its industry and the future growth of the company, the industry, and the economy in general; |
| · | Difficulties in integrating recent or future acquisitions into our operations; |
| · | The expected level and timing of benefits to EMCORE from on-going cost reduction efforts, including (i) expected cost reductions and their impact on our financial performance, (ii) our continued leadership in technology and manufacturing in its markets, and (iii) our belief that the cost reduction efforts will not impact product development or manufacturing execution; |
| · | Expected improvements in our product and technology development programs; |
| · | Whether our products will (i) be successfully introduced or marketed, (ii) be qualified and purchased by our customers, or (iii) perform to any particular specifications or performance or reliability standards: and/or |
| · | Guidance provided by EMCORE regarding our expected financial performance in current or future periods, including, without limitation, with respect to anticipated revenues, income, or cash flows for any period in fiscal 2005 and subsequent periods. |
These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected, including without limitation, the following:
| · | EMCORE’s cost reduction efforts may not be successful in achieving their expected benefits, or may negatively impact our operations; |
| · | The failure of our products (i) to perform as expected without material defects, (ii) to be manufactured at acceptable volumes, yields, and cost, (iii) to be qualified and accepted by our customers, and (iv) to successfully compete with products offered by our competitors; and/or |
| · | Other risks and uncertainties described in EMCORE’s filings with the Securities and Exchange Commission (SEC) such as: cancellations, rescheduling, or delays in product shipments; manufacturing capacity constraints; lengthy sales and qualification cycles; difficulties in the production process; changes in semiconductor industry growth; increased competition; delays in developing and commercializing new products; and other factors. |
We assume no obligation to update the matters discussed in this Quarterly Report on Form 10-Q or our Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on December 14, 2004, except as required by applicable law or regulation.
Company Overview
EMCORE Corporation (EMCORE), a New Jersey corporation established in 1984, offers a broad portfolio of compound semiconductor-based components and subsystems for the broadband, fiber optic, satellite, and wireless communications markets. EMCORE continues to expand its comprehensive product portfolio to enable the transport of voice, data, and video over copper, hybrid fiber/coax (HFC), fiber, satellite, and wireless networks. EMCORE is building upon its leading-edge compound semiconductor materials and device expertise to provide cost-effective components and subsystems for the cable television (CATV), fiber-to-the-premise, business, curb or home (FTTP), telecommunications, data and storage, satellite, and wireless communications markets.
| · | CATV and FTTP Networks - The communications industry in which we participate continues to be dynamic. Cable operators and telephone companies compete with each other to offer the lowest price for unlimited "triple play" (voice, data, and video) communications through a single network connection. As a market leader in radio frequency (RF) transmission over fiber products for the CATV industry, EMCORE enables cable companies to offer multiple forms of communications to meet the expanding demand for high-speed Internet, on-demand and interactive video, and other new services (such as Voice over IP, or VoIP). In response to this triple play strategy from the cable companies, the telephone companies plan to offer competing voice, data, and video services through the deployment of new fiber-based systems. These growing applications should increase demand for EMCORE’s FTTP products and subsystems. Our CATV and FTTP products include broadcast analog and digital fiber optic transmitters, Quadrature Amplitude Modulation (QAM) transmitters, video receivers, Passive Optical Network (PON) transceivers, avalanche photodetectors (APD), PIN (P-type, intrinsic, and N-type semiconductor materials) photodetectors, and Distributed Feedback (DFB) and Fabry-Perot (FP) 1310 nanometer (nm) and 1550 nm analog and digital lasers. |
| · | Telecommunications- Our state-of-the-art optical components and modules enable high-speed (up to an aggregate 40 gigabits per second or Gb/s) optical interconnections that drive architectures in next-generation carrier class switching and routing networks. Our parallel optical modules facilitate high channel count optical interconnects in multi-shelf central office equipment. These systems sit in the network core and in key metro nodes of voice telephony and Internet infrastructures, and are highly expandable with pay-as-you-grow capacity scaling. EMCORE sells its recently acquired OptoCubeTM transceiver product and other 4- and 12-channel parallel optics products to the telecom equipment industry. |
| · | Data Communications- EMCORE’s leading-edge optical components and modules for data applications include 10G Ethernet LX4, 10G Ethernet CX4, SmartLinkTM optical Infiniband, and parallel optical modules for enterprise Ethernet and High Performance Computing (HPC), also called "Super Computing" applications. These high speed modules enable switch-to-switch, router-to-router, and server-to-server backbone connections at aggregate speeds of 10 Gb/s and above. Pluggable LX4 modules in X2 or XENPAK form factors provide a "pay-as-you-populate" cost structure during installation. The LX4 can transmit data over both multi-mode and single-mode optical fiber, and currently is the only available option to transmit optical 10G Ethernet signals over 300 meters of legacy multi-mode fiber or 10 km of single-mode fiber. CX4 modules similarly allow the cost-effective transmission of Ethernet signals over legacy copper cable. EMCORE’s parallel optical modules also are used in switched bus architectures that are needed for next-generation Super Computers and large servers. |
| · | Storage Are Networks -Our optical components also are used in the high-end data storage market, and include high-speed, 850 nm vertical cavity surface emitting lasers (VCSELs) and PIN photodiode components, and 10 Gb/s transmit and receive optical subassemblies (TOSAs/ROSAs). In the future, EMCORE anticipates selling our integrated pluggable X2 or XENPAK form factor modules into the emerging 10G Fibre Channel segment. These products provide optical interfaces for switches and storage systems used in large enterprise mission-critical applications, such as inventory control or financial systems. |
| · | Satellite Communications- EMCORE manufactures high-efficiency solar cells and solar panels for global satellite communications (satcom), and expect to see increased applications for solar cells in terrestrial power products in fiscal 2005. EMCORE also manufactures satellite communications fiber optics products, including transmitters, receivers, subsystems, and systems, that transport wideband microwave signals between satellite hub equipment and antenna dishes. |
| · | Wireless Communications- EMCORE manufactures compound semiconductor RF materials for the wireless handset, cell phone, and base station markets. Our products include 4-inch and 6-inch InGaP Hetero-junction Bipolar Transistor (HBT), AlGaAs pseudomorphic high electron mobility transistors (pHEMT), and E-mode transistor wafers that are used for power amplifiers and switches within next-generation wireless networks. We also produce GaN high electron mobility transistors (HEMT) RF materials that are designed to meet future wireless base station infrastructure requirements for higher power and frequency, along with high temperature operation at industry-leading efficiencies. |
EMCORE also is involved in a joint venture with General Electric Lighting to address the solid-state lighting market with High Brightness Light Emitting Diode-based (HB-LED) lighting systems. Through its 49% ownership in GELcore, LLC. (GELcore), EMCORE participates in the development and commercialization of next-generation LED technology for use in the general and specialty illumination markets. GELcore's products include traffic lights, channel letters, and other signage and display products that incorporate HB-LEDs. In the near term, GELcore expects to deploy its HB-LED products in the commercial and industrial markets, including medical, aerospace, commercial refrigeration, transportation, appliance, and general and specialty illumination applications. GELcore financial reportin g is on a calendar year basis and anticipates revenues in the $90.0 million range for 2005. GELcore is profitable, has experienced an annual revenue growth of 23% per year, and expects similar growth for 2005.
The table below sets forth the revenues and percentage of total revenues attributable to each of EMCORE's product lines for the three months ended December 31, 2004 and 2003.
| (in thousands) | | For the three months ended December 31, | |
Product Revenue | | | 2004 | | | % of revenue | | | 2003 | | | % of revenue | |
| | | | | | | | | | | | | | |
| Fiber Optics | | $ | 17,689 | | | 65.6 | % | $ | 15,493 | | | 67.0 | % |
| Photovoltaics | | | 7,448 | | | 27.6 | | | 4,526 | | | 19.6 | |
| Electronic Materials and Devices | | | 1,827 | | | 6.8 | | | 3,106 | | | 13.4 | |
Total revenue | | $ | 26,964 | | | 100.0 | % | $ | 23,125 | | | 100.0 | % |
EMCORE's customer base includes many of the largest semiconductor, telecommunications, data communications, consumer goods, and computer manufacturing companies in the world. For the three months ended December 31, 2004, revenues from Cisco Systems, Inc. represented 26% of our consolidated quarterly revenue. For the three months ended December 31, 2003, revenues from Motorola, Inc. and the Indian Space Research Organization (ISRO) represented 23% and 10% of our consolidated quarterly revenue, respectively.
The following chart contains a breakdown of EMCORE's consolidated revenues by geographic region. North American sales include sales to Canada, which historically have not been material.
| (in thousands) | | For the three months ended December 31, | |
Revenue by Region | | | 2004 | | | % of revenue | | | 2003 | | | % of revenue | |
| | | | | | | | | | | | | | |
| North America | | $ | 20,699 | | | 76.8 | % | $ | 16,251 | | | 70.3 | % |
| Asia | | | 4,326 | | | 16.0 | | | 5,176 | | | 22.4 | |
| Europe | | | 1,939 | | | 7.2 | | | 1,698 | | | 7.3 | |
Total revenue | | $ | 26,964 | | | 100.0 | % | $ | 23,125 | | | 100.0 | % |
Backlog
As of December 31, 2004, EMCORE had a backlog it believes to be firm of approximately $34.3 million. This compares favorably to a backlog of $28.8 million as reported at September 30, 2004. The quarterly increase in backlog is primarily attributable to increased demand for EMCORE’snew 10G CWDM fiber optic communications transceiver, the LX4 module. A majority of EMCORE’s products typically ship within the same quarter as the purchase order is received. We believe that substantially all of our backlog can be shipped during the next 12 months. But given the current market environment, customers may delay shipment of certain orders. Backlog also could be adversely affected i f customers unexpectedly cancel purchase orders accepted by us.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results may differ from those estimates. Critical accounting policies include those policies that are reflective of significant judgments and uncertainties, which potentially could produce materially different results under different assumptions and conditions. EMCORE's most significant estimates relate to accounts receivable bad debt reserves, inventory valuation reserves specif ically relating to excess and obsolete inventory, product warranty accruals, the valuation of goodwill, intangibles and other long-lived assets, and revenue recognition on contracts utilizing the percentage-of-completion method.
| · | Bad Debt Reserves - EMCORE regularly evaluates its accounts receivable and accordingly maintains allowances for doubtful accounts for estimated losses resulting from the inability of our customers to meet their financial obligation to us. The allowance for doubtful accounts at December 31, 2004 and September 30, 2004 was $0.7 million, respectively. If the financial condition of our customers were to deteriorate, additional allowances may be required. |
| · | Inventory Reserves - EMCORE reserves against inventory once it has been determined that conditions exist which may not allow it to be sold for its intended purpose, the inventory’s value is determined to be less than cost or it is determined to be obsolete. The charge for the inventory reserves is recorded in cost of revenue. EMCORE evaluates inventory levels at least quarterly against sales forecasts on a part-by-part basis, in addition to determining its overall inventory risk. Reserves are adjusted to reflect inventory values in excess of forecasted sales, as well as overall inventory risk assessed by management. Total inventory reserves at December 31, 2004 and September 30, 2004 were $3.6 million and $4.1 million, re spectively. If future demand or market conditions are less favorable than our estimates, additional inventory write-downs may be required. |
| · | Product Warranty Reserves - EMCORE provides its customers with limited rights of return for non-conforming shipments and warranty claims for up to 5 years for certain products. EMCORE makes estimates using historical data and accrues estimated warranty expense as a cost of revenue. Total warranty expense amounted to approximately $0.1 million and $0.2 million for the three months ended December 31, 2004 and 2003, respectively. Total warranty reserves at December 31, 2004 and September 30, 2004 were $2.3 million and $2.2 million, respectively. If our product reliability assessments change in the future, additional allowances may be required. |
| · | Valuation of Goodwill and Intangible Assets - EMCORE evaluates its goodwill for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that are considered important in making this determination include, but are not limited to, the following: (a) an anticipated or historic decline in revenue or operating profit; (b) significant negative industry trends; and (c) adverse legal or regulatory developments. During fiscal 2004 and 2003, EMCORE had no impairment of any of its patents, other intangibles assets, or goodwill. During the quarter ended March 31, 2005, management will perform its annual valuation review of its goodwill and intangible assets. |
| · | Valuation of Long-lived Assets - EMCORE reviews long-lived assets on an annual basis or whenever events or circumstances indicate that the assets may be impaired. A long-lived asset is considered impaired when its anticipated undiscounted cash flow is less than its carrying value. In making this determination, EMCORE uses certain assumptions, including, but not limited to: (a) estimates of the fair market value of these assets; and (b) estimates of future cash flows expected to be generated by these assets, which are based on additional assumptions such as asset utilization, length of service that assets will be used in our operations, and estimated salvage values. EMCORE determined that there was no such impairment in fiscal 2004 a nd 2003. During the quarter ended March 31, 2005, management will perform its annual valuation review of its long-lived asssets. |
| · | Revenue Recognition - Revenue is recognized upon shipment provided persuasive evidence of a contract exists, such as when a purchase order or contract is received from a customer, the price is fixed, the product meets the customers' requirements, title and ownership have transferred to the customer, and there is reasonable assurance of collection of the sales proceeds. The majority of our products have shipping terms that are free on board (FOB) or free carrier alongside (FCA) shipping point, which means that EMCORE fulfills its delivery obligation when the goods are handed over to the freight carrier at our shipping dock. This means the buyer bears all costs and risks of loss of or damage to the goods from that point. In certain ca ses, EMCORE ships its products cost insurance and freight (CIF). Under this arrangement, revenue is recognized under FCA shipping point terms, but EMCORE pays (and bills the customer) for the cost of shipping and insurance to the customer's designated location. EMCORE accounts for shipping and related transportation costs by recording the charges that are invoiced to customers as revenue, with the corresponding cost recorded as cost of revenue. In those instances where inventory is maintained at a consigned location, revenue is recognized only when our customer pulls product for its use and title and ownership have transferred to the customer. EMCORE records revenues from solar panel contracts using the percentage-of-completion method. Revenue is recognized in proportion to actual costs incurred compared to total anticipated costs expected to be incurred for each contract. If estimates of c osts to complete long-term contracts indicate a loss, a provision is made for the total loss anticipated. EMCORE has numerous contracts that are in various stages of completion. Such contracts require estimates to determine the appropriate cost and revenue recognition. EMCORE uses all available information in determining dependable estimates of the extent of progress towards completion, contract revenues, and contract costs. Estimates are revised as additional information becomes available. At December 31, 2004 and September 30, 2004, EMCORE's accrued program losses totaled $0.3 million and $0.1 million, respectively. Contract revenue represents reimbursement by various U.S. Government entities to aid in the development of new technology. The applicable contracts generally provide that EMCORE may elect to retain ownership of inventions made in performing the work, subject to a non-exc lusive license retained by the government to practice the inventions for government purposes. The contract funding may be based on a cost-plus, cost reimbursement, cost-share, or a firm fixed price arrangement. The amount of funding under each contract is determined based on cost estimates that include direct costs, plus an allocation for research and development, general and administrative, and the cost of capital expenses. Cost-plus funding is determined based on actual costs plus a set margin. For cost-share contracts, the actual costs of performance are divided between the U.S. Government and EMCORE based on the contract terms. A contract is considered complete when all significant costs have been incurred, milestones have been reached, and any reporting obligations to the customer have been met. Revenues from Government contracts amounted to approximately $1.2 million and $0.8 million for the three months ended December 31, 2004 and 2003, respectively. |
Recent Financial Accounting Pronouncements.
In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151 (SFAS No. 151),Inventory Costs, an amendment of Accounting Research Bulletin No. 43. SFAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material costs to be recognized as a current period charge. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 200 5. We are currently evaluating the provisions of SFAS No. 151 and do not expect adoption will have a material impact on our financial position, results of operations, or cash flows.
In December 2004, the FASB issued SFAS No. 123R (Revised 2004),Share- Based Payment. SFAS No.123R requires all share-based payments to employees, including grants of employee stock options and shares issued under employee stock purchase plans, to be recognized in the income statement based on their grant-date fair values. SFAS No. 123R requires us to adopt the new accounting provision beginning in our fourth quarter of fiscal 2005. We are currently evaluating the provisions of SFAS No. 123R and do not expect adoption will have a material impact on our financial position, results of operations, or cash flows.
Results of Operations
The following table sets forth the condensed consolidated statements of operations data of EMCORE expressed as a percentage of total revenues for the three months ended December 31, 2004 and 2003:
| | | For the three months ended
December 31, | |
| | | | 2004 | | | 2003 | |
| | | | | | | | |
| Revenue | | | 100.0 | % | | 100.0 | % |
| Cost of revenue | | | 92.3 | | | 86.2 | |
Gross profit | | | 7.7 | | | 13.8 | |
| | | | | | | | |
| Operating expenses: | | | | | | | |
Selling, general and administrative | | | 18.9 | | | 23.0 | |
Research and development | | | 18.8 | | | 26.1 | |
Severance charges | | | 1.7 | | | - | |
Total operating expenses | | | 39.4 | | | 49.1 | |
| | | | | | | | |
Operating loss | | | (31.7 | ) | | (35.3 | ) |
| | | | | | | | |
| Other (income) expenses: | | | | | | | |
Interest income | | | (0.9 | ) | | (0.7 | ) |
Interest expense | | | 4.5 | | | 8.8 | |
Equity in net income of GELcore | | | (1.4 | ) | | (1.1 | ) |
Total other expenses | | | 2.2 | | | 7.0 | |
| | | | | | | | |
Loss from continuing operations | | | (33.9 | ) | | (42.3 | ) |
| | | | | | | | |
| Discontinued operations: | | | | | | | |
Loss from discontinued operations | | | - | | | (7.3 | ) |
Gain on disposal of discontinued operations | | | - | | | 84.7 | |
Income from discontinued operations | | | - | | | 77.4 | |
| | | | | | | | |
Net (loss) income | | | (33.9 | )% | | 35.1 | % |
Comparison of the three months ended December 31, 2004 and 2003
Revenue. For the three months ended December 31, 2004 and 2003, EMCORE’s consolidated revenue increased $3.9 million or 17% to $27.0 million from $23.1 million, respectively. On a product line basis, fiber optics revenues increased $2.2 million or 14%, photovoltaics revenues increased $2.9 million or 65%, and electronic materials and devices revenues decreased $1.2 million or 41% from the prior year. International sales accounted for 23% of revenues for the three months ended December 31, 2004 and 30% of revenues for the three months ended December 31, 2003. Government contract revenue represents reimbursement by various U.S. Government entities to aid in the development of new technology.& nbsp; Revenue from government contracts increased $0.4 million to $1.2 million from $0.8 million. With increased government focus on energy conservation, national security, and fiber optic communications, we expect revenues from government contracts to increase in fiscal 2005 compared to fiscal 2004.
Fiber Optics - Fiber Optics revenues are derived primarily from sales of optical components and subsystems for CATV and FTTP, VCSEL and PIN photodiode components, 10G Ethernet LX4 and CX4, TOSA/ROSA packaged parts and modules, and satcom transmitter and receiver components.
EMCORE manufactures its digital fiber optics products in Albuquerque, New Mexico. For the three months ended December 31, 2004 and 2003, revenues from digital fiber optics products increased $6.5 million or 189% to $10.0 million from $3.5 million. New transceiver module product launches were the reason for this significant increase in quarterly revenues. During the quarter ended December 31, 2004, EMCORE announced that as the leading supplier in the 10GBASE-LX4 segment, it has shipped over ten thousand LX4 modules for 10 Gigabit Ethernet XENPAK applications. In 2005 EMCORE expects to continue expanding its sales of this product and anticipates continuing its market leadership in this industry segment. Also during the quarter ended December 31, 2004, EMCORE experienced increased demand for its exist ing parallel optical products: SNAP-12, CX4 and SmartlinkTMtransceivers. As a result of business consolidation in the optoelectronic industry, EMCORE has experienced a decrease in demand for its legacy VCSEL chip products as customers are moving to produce these chips in-house. Management is carefully reviewing this product market to identify other applications for its laser products. Digital fiber optics revenue represented 37% and 15% of EMCORE's total revenues for the three months ended December 31, 2004 and 2003, respectively.&nb sp;Key customers for the digital fiber optics product line include Cisco Systems, Inc., Agilent Technologies, Inc., Intel Corporation, Sycamore Networks, Inc., and JDS Uniphase Corporation. As a result of successful customer product qualifications and EMCORE’s order backlog, digital fiber optics revenues are expected to remain in the $9.0 million to $10.0 million range in the second quarter of fiscal 2005.
EMCORE’s Ortel division and part of the fiber optic group, supports thefiber optic transmitter and receiver CATV products, satcom transmission links and PON and FTTP systems. For the three months ended December 31, 2004 and 2003, revenues from Ortel’s product lines decreased $4.3 million or 36% to $7.7 million from $12.0 million. The first quarter of fiscal 2004 experienced an unexpected increase in sales volumes due to one-time buys from our customers. The decrease in the first quarter of fiscal 2005 was expected as a result of reduced customer demand for Ortel’s products . Based upon a recently increased order backlog for Ortel products, Ortel’s revenues are expected to increase to the $8.0 million to $9.0 million range in the second quarter of fiscal 2005. Sales of Ortel's products represented 29% and 52% of EMCORE's total revenues for the three months ended December 31, 2004 and 2003, respectively. Key customers for Ortel’s product line include Motorola and Scientific-Atlanta, Inc. The communications industry in which Ortel participates continues to be dynamic. Cable operators and telephone companies compete to offer the lowest price for unlimited "triple play" (voice, data, and video) communications through a single network connection. As a market leader in radio frequency (RF) transmission over fiber products for the CATV industry, EMCORE enables cable companies to offer multiple forms of communications to meet the expanding demand for high-speed Internet, on-demand and interactive video, and other new services. In response t o this threat from the cable companies, telephone companies also plan to offer competing services over the deployment of new FTTP systems. These growing applications should increase demand for FTTP subsystems that are manufactured and marketed by Ortel.
Photovoltaics - Photovoltaics revenues include the sale of epi wafers, solar cells, covered interconnect solar cells (CICs), and solar panels. For the three months ended December 31, 2004 and 2003, revenues from our Photovoltaics product line increased $2.9 million or 65% to $7.4 million from $4.5 million. This improvement to Photovoltaics revenue was attributable to an increase in solar panel and solar cell revenue. The space power generation market continues to depend on government programs as a result of the continued weakness in commercial satellite infrastructure spending and significant sales price erosion for commercial solar products. Commercial satellite awards decreased from 19 in 2003 to 13 in 2004. However, there have been indications that the commercial satellite market is stabilizing, with future awards expected for high definition TV and satellite radio. Military procurement remains steady, and we are focusing on gaining market share in that area. Private equity groups also have acquired a number of the satellite operators, and it is unclear what impact this will have on satellite procurement in the near term. In addition, on July 15, 2003, SS/L together with its parent corporation, Loral Space & Communications, Ltd., filed for bankruptcy. On October 22, 2004, SS/L filed an amended plan of reorganization to emerge from bankruptcy. The plan is subject to approval by SS/L's bankruptcy court. SS/L has stated that it believes it will emerge from bankruptcy in the first calendar quarter of 2005. During the pendency of SS/L's bankruptcy, EMCORE has continued to do business with SS/L. We do not believe that the SS/L bankruptcy or reorganization will have a material adverse effect on our business. Sales of our Photovoltaics products represented 28% and 20% of EMCORE's total revenues for the three months ended December 31, 2004 and 2003, respectively. In fiscal 2005, we expect to see increased applications for our solar cells in terrestrial products, as well as the satellite industry continuing to develop a communications backbone for voice, data, and video communications. Given the projected timing for completion of certain solar p aneling contracts, Photovoltaics revenues are expected to remain in the $7.0 million to $8.0 million range in the second quarter of fiscal 2005.
Electronic Materials and Devices - Sales of electronic materials and devices (EMD) include RF materials and MR sensors. For the three months ended December 31, 2004 and 2003, revenues from our EMD product line decreased $1.3 million, or 41% to $1.8 million from $3.1 million. This decrease is the result of reduced customer demand for RF materials. This market is highly competitive, raw materials are extremely expensive, and average selling prices have been declining over the past several years. Our contract with General Motors for MR sensors expired in the first quarter of fiscal 2004, however EMCORE has offered GM a “last time buy” opportunity, which is expected to occur during the second qu arter of fiscal 2005. Management expects the introduction of GaN RF materials to drive revenue growth in fiscal 2005 as major RF product manufacturers roll out new commercial infrastructure devices.
Gross Profit (Loss). Gross profit decreased $1.1 million to $2.1 million for the three months ended December 31, 2004 from $3.2 million for the three months ended December 31, 2003. Compared to the prior year, gross margins decreased from 14% to 8% of revenue. On a product line basis, quarterly margins for fiber optics decreased from 23% to 12% for the three months ended December 31, 2003 and 2004, respectively. This decrease was due to unabsorbed overhead at Ortel, the result of Ortel’s revenues decreasing by $4.3 million from the prior year. Quarterly margins for photovoltaics improved from (25%) to 5% due to manufacturing yield improvements and other operational efficiencies. Margins for the E MD product line decreased from 26% to (22)% as a result of unabsorbed overhead costs due to lower revenues.
Improvement to gross margins is highly dependent upon the amount of revenue EMCORE earns. Gross margins continue to be negatively impacted by the underutilization of fixed costs and overhead resulting from expansions previously deployed through fiscal 2001. As revenues increase, our margins should increase as well since a significant portion of our facility costs is fixed, so higher throughput should result in lower costs per unit produced. Management does expect gains in gross margins to be somewhat offset by lower sales prices due to competitive pricing pressures. Fiscal 2005 gross margins should also increase as product lines continue to be transferred to contract manufacturers for high volume production and as management implements additional programs to improve manufacturing process yields.
Selling, General and Administrative. SG&A expenses decreased $0.2 million or 4% to $5.1 million for the three months ended December 31, 2004 from $5.3 million for the three months ended December 31, 2003. As a percentage of revenue, SG&A decreased from 23% to 19%. Assuming no further non-recurring charges and acquisitions, management expects annual SG&A expenses in fiscal year 2005 to continue to decrease as a percentage of revenue due to cost reduction measures being undertaken and projected revenue growth.
Research and Development. R&D expenses decreased $0.9 million or 15% to $5.1 million for the three months ended December 31, 2004 from $6.0 million for the three months ended December 31, 2003. The decrease was primarily due to completion of R&D projects that resulted in recent new product launches that occurred in the later half of fiscal 2004. As a percentage of revenue, R&D decreased from 26% to 19%. Management expects R&D to decline as a percentage of revenue in the second quarter of fiscal 2005 as products previously under development are released to production. Additionally, in t he second quarter of fiscal 2005, EMCORE intends to either spin-off or eliminate its Gallium Nitride (GaN) Schottky diode R&D program. This program is directed towards the development of 200-600 volt GaN-based Schottky diode devices for power conversion applications in consumer electronics. This program currently incurs between $700,000-$800,000 in quarterly losses. While EMCORE expects to save a significant portion of these ongoing costs, management does not believe that this decision will result in any material impairment charges.
Severance Charges.In fiscal 2005, EMCORE continued its focus on cutting corporate overhead expenses and the realignment of certain shared service operations. As a result, EMCORE incurred $0.5 million in severance and fringe benefit charges related to the employee termination costs for 7 employees. Management expects the restructuring program to continue in fiscal 2005.
Interest Expense, net. Interest expense, net decreased $0.9 million, or 47%, to $1.0 million for the three months ended December 31, 2004 from $1.9 million for the three months ended December 31, 2003. This decrease is due to the retirement of approximately $65.7 million of EMCORE’s subordinated debt through the debt exchange accomplished in February 2004. As a result of this debt exchange, net interest expense will decrease by approximately $3.3 million for fiscal year 2005 when compared to the prior year.
Equity in Net Income of GELcore. EMCORE's share of GELcore's net income increased $0.1 million, or 33%, to net income of $0.4 million for the three months ended December 31, 2004 from net income of $0.3 million for the three months ended December 31, 2003. Management believes GELcore's results will continue to improve in fiscal 2005 when compared to fiscal 2004 as a result of increased unit volumes, changes in LED product mix and less manufacturing inefficiencies associated with newer product introductions.
Income Taxes.As a result of its losses, EMCORE did not incur any income tax expense in either the three months ended December 31, 2004 or 2003 and we do not expect to generate a tax liability in excess of our net operating loss carryforwards.
Discontinued Operations. In November 2003, EMCORE sold its TurboDisc systems business to Veeco Instruments Inc. Accordingly, the operating results from this business were reported as discontinued operations in our condensed consolidated statements of operations. For the three months ended December 31, 2 003 EMCORE recognized anet loss from discontinued operations of $1.7 million and recognized a gain on the disposal of the systems business of $19.6 million.
Liquidity and Capital Resources
Working Capital
At December 31, 2004, EMCORE had working capital of approximately $51.1 million. Cash, cash equivalents, and marketable securities at December 31, 2004 and September 30, 2004 totaled $38.3 million and $51.6 million, respectively. This reflects a net cash decrease of $13.3 million for the three months ended December 31, 2004.
Cash Flow
Net Cash Used For Operations — Net cash used for operations decreased $2.3 million or 18% to $10.5 million for the three months ended December 31, 2004 from $12.8 million for the three months ended December 31, 2003. Following is a summary of the major items accounting for the increase in cash used in operations:
| | | For the three months ended December 31, | | | | |
(in thousands) | | | 2004 | | | 2003 | | | Favorable (Unfavorable) | |
| | | | | | | | | | | |
| (Loss) income from continuing operations | | $ | (9,141 | ) | $ | 8,114 | | $ | (17,255 | ) |
| Adjustments (non cash items): | | | | | | | | | | |
Depreciation | | | 3,600 | | | 4,056 | | | (456 | ) |
Loss from discontinued operations | | | - | | | 1,697 | | | (1,697 | ) |
Gain on disposal of discontinuedoperations | | | - | | | (19,584 | ) | | 19,584 | |
| Other non-cash items | | | (47 | ) | | 228 | | | (275 | ) |
| | | | | | | | | | | |
| Adjusted loss from continuing operations | | | (5,588 | ) | | (5,489 | ) | | (99 | ) |
| Other adjustments: | | | | | | | | | | |
Changes in working capital | | | (4,925 | ) | | (3,459 | ) | | (1,466 | ) |
Discontinued operations | | | - | | | (3,870 | ) | | 3,870 | |
| | | | | | | | | | | |
| Cash used in operations | | $ | (10,513 | ) | $ | (12,818 | ) | $ | 2,305 | |
| | | | | | | | | | | |
As mentioned above, in November 2004, EMCORE sold its TurboDisc capital equipment business to Veeco. EMCORE owned this product line for approximately 35 days in fiscal 2004. As a result, expenses exceeded revenues and a loss of $3.9 million was incurred for the period during which EMCORE still owned the TurboDisc business. Revenues during this 35-day period werede minimis since, historically, the majority of our TurboDisc revenues were generated in the latter part of each fiscal quarter. Excluding the non-cash effect of the discontinued operations, net cash used for operations increased by $1.5 mill ion as a result of changes in working capital. The $1.5 million increase resulted from the reduction of liabilities of $6.0 million, an increase in inventory of $1.0 million offset by a decrease in accounts receivable by $5.5 million.
Net Cash Provided By Investing Activities — For the three months ended December 31, 2004 net cash provided by investing activities decreased $34.0 million to $2.5 million from $36.5 million. Changes in cash flow consisted of:
• Divestiture - The sale of the TurboDisc business generated $62.0 million in cash in fiscal 2004. In addition to the initial cash payment, EMCORE will also receive in either cash or stock, 50% of all revenues from the TurboDisc capital equipment business that exceed $40.0 million in each of the next two years, beginning January 1, 2004. Management expects to receive between $15 million to $17 million in the second quarter of fiscal 2005 as part of the additional payout for this divesture.
• Capital expenditures — Capital expenditures increased to $1.2 million from $0.3 million. As part of our ongoing effort to manage cash, management carefully scrutinizes all capital purchases.
• Acquisitions —In October 2003, EMCORE acquired Molex’s 10G Ethernet transceiver business for an initial $1.0 million in cash. In accordance with the agreement, EMCORE paid an additional $1.1 million in cash earn out based upon LX4 unit shipments during the first quarter of fiscal 2005.
• Marketable securities — For the three months ended December 31, 2004, EMCORE’s net investment in marketable securities decreased by $5.8 million in order to fund acquisitions and operations. In the prior year, EMCORE’s net investment in marketable securities increased by $24.1 million due to the investment of proceeds received from the sale of the TurboDisc capital equipment business.
• Investment in K2 — In October 2004, EMCORE invested $1.0 million in K2 Optronics, Inc., a California-based company specializing in the design and manufacture of external cavity lasers, to strengthen its partnership in designing next-generation long wavelength components for the CATV and FTTP markets. EMCORE does not exercise significant influence over financial and operating policies, and the investment represents approximately 6.6% ownership.
Net Cash Provided By Financing Activities — For the three months ended December 31, 2004, net cash provided by financing activities decreased $1.6 million to $0.6 million from $2.2 million in the prior year. Proceeds received from the exercise of common stock options amounted to $0.1 million and $1.8 million in the three months ended December 31, 2004 and 2003, respectively.
Conclusion
We believe that our current liquidity should be sufficient to meet our cash needs for working capital through the next 12 months. If cash generated from operations and cash on hand are not sufficient to satisfy EMCORE's liquidity requirements, EMCORE will seek to obtain additional equity or debt financing. Additional funding may not be available when needed, or on terms acceptable to EMCORE. If EMCORE is required to raise additional financing and if adequate funds are not available or not available on acceptable terms, our ability to continue to fund expansion, develop and enhance products and services, or otherwise respond to competitive pressures may be severely limited. Such a limitation could have a material adverse effect on EMCORE's business, financial condition, results of operati ons, and cash flow.
