Cost of sales consists primarily of material, production overhead and labor. Since our IPO in 1997, gross margin has been in the range 54-64%. We expect to maintain gross margin at or near 60% going forward. Selling expenses consist primarily of salaries and commissions to sales and marketing personnel, and promotion, advertising, travel and telecommunications. Selling expenses as a percentage of sales dropped significantly in the first six months of 2004 compared to the same period in 2003, to 26.2% from 27.9%. The addition of new sales personnel in Asia has kept selling expenses as a percentage of sales above 25% in the first half of 2004 while the additional sales people become fully trained and productive. Having selling expenses as a percentage of sales at 25% or less will be our long-term goal.
General and administrative expenses consist primarily of salaries for administrative personnel, rent, utilities and professional and legal expenses. We expect general and administrative expenses to drop as a percentage of sales as higher sales should not require a proportionate increase in these expenses. Research and development expenses represent salaries, equipment and third-party services. We have a commitment to support ongoing research and development and intend to continue to fund these efforts at the level of 5-7% of sales going forward.
We have received a favorable income tax rate commitment from the Swiss government as an incentive to establish a manufacturing plant in Switzerland. As a result we expect the blended (consolidated) tax rate to be in a range between 25% and 30% of consolidated taxable income for at least 2004 and 2005.
Accounting for wholly owned foreign subsidiaries is maintained in the currency of the respective foreign jurisdiction and, therefore, fluctuations in exchange rates may have an impact on inter-company accounts reflected in our consolidated financial statements. We are aware of the availability of off-balance sheet financial instruments to hedge exposure to foreign currency exchange rates, including cross-currency swaps, forward contracts, and foreign currency options (see Foreign Exchange Exposure below). However we do not regularly use such instruments.
During fiscal years 2002 and 2001, our sales growth was adversely affected by the economic slowdown, which began in 2001 in the United States and Europe. This effect, however, was offset by sales growth resulting from the acquisition in January 2002 of SpatialMetrix Corporation (SMX), which manufactured the predecessor to the Faro Laser Tracker, and the introduction in September and October 2002 of the latest generation of our traditional Faro Arm product. In 2003 sales growth resulted primarily from strong customer response to the new Faro Arm and Laser Tracker products, and an increase in worldwide sales and marketing activities, including an increase in headcount from 106 in 2002 to 120 at the end of 2003. In the first half of 2004 sales growth resulted from demand for the new Faro Gage and Scan Arm products, and from a further increase in Faro Arm and Laser T racker product sales as a result of an increase in the sales and marketing staff. Sales and marketing headcount was 141 at July 3, 2004.
Sales increased by $7.8 million or48.1%, from $ 16.2 million for the three months ended June 28, 2003 to $ 24.0 million for the three months ended July 3, 2004. This increase resulted primarily from higher unit sales of the Faro Arm, Scan Arm, Faro Gage and Laser Tracker products. Sales increased $ 2.2 million in the Americas, $ 3.9 million in Europe/Africa and $ 1.7 million in the Asia Pacific region.
Gross profit increased by $ 5.2 million or, 52% from $10.0 million for the three months ended June 28, 2003 to $ 15.2 million for the three months ended July 3, 2004. Gross margin percentage increased to 63.2% for the three months ended July 3, 2004 from 61.9% for the three months ended June 28, 2003. Gross margin increased primarily from lower service costs as a result of improved reliability of the Faro Arm and Laser Tracker products, the effect of higher sales volume on fixed overhead and smaller price discounts.
Selling expenses increased by $ 1.7 million or37.8%, from $ 4.5 million for three months ended June 28, 2003 to $ 6.2 million for the three months ended July 3, 2004. This increase wasdue primarily to increased sales commissions, salaries and benefits (worldwide sales and marketing headcount increased from 101 to 141 between June 28, 2003 and July 3, 2004), and marketing expenses.As a percentage of sales, selling expenses dropped to25.9% of sales in the three months ended July 3, 2004 from 27.6% in the three months ended June 28, 2003.
General and administrative expenses increased by $ 324,000 or 14.1%, from $ 2.3 million for the three months ended June 28, 2003 to $ 2.6 million for the three months ended July 3, 2004. The increase is mainly due to higher salaries and benefits as a result of additional IT and back office employees due to higher volume of transactions and Asia Pacific expansion, and higher professional fees. General and administrative expenses as a percentage of sales fell to10.9% for the three months ended July 3, 2004 from14.1% for the three months ended June 28, 2003.
Depreciation and amortization expenses remained relatively unchanged for the three months ended July 3, 2004 as compared to the three months ended June 28, 2003.
Research and development expenses increased by $ 140,000 or14.0%, from $ 1.0 million for the three months ended June 28, 2003 to $ 1.2 million for the three months ended July 3, 2004.Increased costs were due primarily to higher salaries and material and other project expenses.
Employee stock option expenses decreased by$96,000from $ 108,000 for the three monthsended June 28, 2003 to$ 11,000 for the 3 months ended July 3, 2004 due to fewer options accounted for under variable accounting method being outstanding.
Interest income increased by $ 41,000 from $ 33,000 for the three months ended June 28,2003, to $74,000 for the three months ended July 3, 2004.The variance was primarily attributable to an increase of $18.6 million in interest earning investments from $ 1.6 million at June 28, 2003 to $ 20.2 million at July 3, 2004. Interest expense decreased by $ 16,000 from $ 19,000 for the three months ended June 28,2003, to $3,000 for the three months ended July 3, 2004 due to lower interest bearing debt.
Other income decreased by $ 46,000 from $ 219,000 for the three months ended June 28, 2003 to $173,000 for the three months ended July 3, 2004 due primarily to unfavorable foreign exchange conversion.
Income tax expense increased by $ 520,000 from$ 240,000 for the three months ended June28, 2003to $ 760,000 for the three months ended July 3, 2004. This increase is primarily due to significant increases in taxable income in the United States, partially offset by the utilization of net operating losses in Europe, for which an allowance had previously been recorded.
Net income increased by $ 2.5 million from$ 1.6 million for the three months ended June 28,2003to $ 4.1 million for the three months ended July 3, 2004 as a result of the factors described above.
Six Months Ended July 3, 2004 Compared to Six Months Ended June 28, 2003
Sales increased by $15.5 million or 52.4%, from $29.6 million for the six months ended June 28, 2003 to $ 45.1 million for the six months ended July 3, 2004. The increase resulted from higher sales in the Americas Region $5.1 million, the Europe/Africa Region $8.1 million, and Asia Pacific Region $2.3 million. Sales increased primarily due to increased unit sales of the new Faro Gage and Scan Arm products, and increased unit sales of the Faro Arm and Laser Tracker products.
Gross profit increased by $11.1 million or 63.1%, from $17.6 million for the six months ended June 28, 2003 to $28.7 million for the six months ended July 3, 2004 due to higher sales. Gross margin increased to 63.6% for the six months ended July 3, 2004 compared to 59.2% for the six months ended June 28, 2003. Gross margin increased primarily from lower service costs, the effect of higher sales volume on fixed overhead and smaller price discounts.
Selling expenses increased by $3.5 million or 42.2%, from $8.3 million for the six months ended June 28, 2003 to $11.8 million for the six months ended July 3, 2004. This increase wasdue primarily to increased sales commissions and salaries (worldwide sales and marketing headcount increased from 101 to 141 between June 28, 2003 and July 3, 2004) and marketing expenses. As a percentage of sales, selling expenses dropped to 26.2% of sales in the six months ended July 3, 2004 from 27.9% in the six months ended June 28, 2003.
General and administrative expenses increased by $1.1 million or 27.5%, from $4.0 million for the six months ended June 28, 2003 to $5.1 million for the six months ended July 3, 2004. The increase is mainly due to higher salaries and benefits as a result of additional IT and back office employees due to higher volume of transactions and opening of the China office, and professional fees. General and administrative expenses as a percentage of sales fell to11.4% for the six months ended July 3, 2004 from13.7% for the six months ended June 28, 2003.
Depreciation and amortization expenses decreased by $33,000 or 3% from $1,128,000 for the six months ended June 28, 2003 to $1,095,000 for the six months ended July 3, 2004 due to a reduction in amortization of existing product technology, offset by increases in depreciation of new equipment and amortization of newly acquired intangibles.
Research and development expenses increased by $704,000, or 36.2%, from $1.9 million for the six months ended June 28, 2003 to $2.6 million for the six months ended July 3, 2004 principally as a result of higher salaries and bonuses as well as material and other project costs.
Employee stock option expenses decreased by $101,000, from $150,000 for the six months ended June 28, 2003 to $49,000 for the six months ended July 3, 2004 due to fewer options accounted for under the variable accounting method being outstanding.
Interest income increased by $112,000 from $36,000 for the six months ended June 28, 2003, to $148,000 for the six months ended July 3, 2004. The variance was primarily attributable to an increase of $18.6 million in interest earning investments from $1.6 million at June 28, 2003 to $ 20.2 million at July 3, 2004. Interest expense decreased by $30,000 from $35,000 for the six months ended June 28, 2003, to $5,000 for the six months ended July 3, 2004 mainly due to lower interest bearing debt.
Other income increased by $45,000 from $334,000 for the six months ended June 28, 2003 to $379,000 for the six months ended July 3, 2004 due primarily to gains on currency translation.
Income tax expense increased by $1.2 million from $313,000 for the six months ended June 28, 2003, to $1.5 million for the six months ended July 3, 2004. This increase is primarily due to the significant increase in US earnings in 2004, partially offset by the utilization of net operating losses in Europe, for which an allowance had previously been recorded.
Net income increased by $5.0 million from $2.0 million for the six months ended June 28, 2003 to $7.0 million for the six months ended July 3, 2004 as a result of the factors described above.
Liquidity and Capital Resources
On November 12, 2003, we sold 1,158,000 shares of common stock to certain institutional investors in a private placement. The shares were sold for $21.50 per share, resulting in total proceeds before placement agent fees and other offering expenses of $24.9 million. Total marketable securities (cash and cash equivalents, short-term investments and investments) were approximately $32.9 million at July 3, 2004 compared with approximately $33.5 million on December 31, 2003.
Cash flow from operations was approximately $290,000 in the first six months of 2004, a decrease of approximately $1.0 million from the first six months of the prior year. The decrease was primarily due to the increases in account receivable and inventory, and the decrease in accounts payable and accrued expenses.
Cash used in investing activities was approximately $ 5.6 million in the first six months of 2004, an increase of approximately $ 4.8 million from the first six months of the prior year, primarily reflecting the purchase of capital equipment ($1 million) and the deployment of cash balances to short-term commercial paper ($4 million).
Cash provided by financing activities was approximately $1.1 million in the first six months of 2004, an increase of approximately $720,000 from the first six months of the prior year, reflecting the proceeds from the exercise of stock options.
Principal commitments at July 3, 2004 consisted of leases on our offices and manufacturing facilities, and purchase orders for goods related to manufacturing. There were no material commitments for capital expenditures as of that date.
We believe our cash, investments, borrowings and cash flows from operations should be sufficient to satisfy our working capital and capital expenditure needs for the foreseeable future. We have no material long-term debt. On September 17, 2003, we established a new $5 million revolving credit facility with SunTrust Bank. This agreement is due to mature on September 17, 2004 and bears an interest rate, at the borrower’s option, of either the bank’s Base rate or the adjusted LIBOR rate, plus 1.75%. No amounts were outstanding under this line of credit on July 3, 2004.
Critical Accounting Policies
In response to the SEC’s financial reporting release, FR-60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, we have selected our most subjective accounting estimation processes for purposes of explaining the methodology used in calculating the estimate in addition to any inherent uncertainties pertaining to the estimate and the possible effects on our financial condition. The estimation processes discussed below are our processes of recognizing research and development expenditures, the allowance for obsolete and slow-moving inventory, the allowance for doubtful accounts, and the reserve for warranties. These estimation processes affect current assets and operating results and are therefore critical in assessing our financial and operating status. These estimates involve certain assumptions that if incorrect, could create an adver se impact on our operations and financial position.
Research And Development
Costs are incurred in the discovery of new knowledge and the resulting translation of this new knowledge into plans and designs for new products. Prior to the attainment of the related products’ technological feasibility, these costs are recorded as expenses in the period incurred. Product design costs incurred in the development of products after technological feasibility is attained are capitalized and amortized using the straight-line method over the estimated economic lives of the related products, not to exceed three years. We consider technological feasibility to be established when we have completed all planning, designing, coding and testing activities that are necessary to establish design specifications including function, features and technical performance requirements. Capitalization of product design costs ceases and amortization of such costs begins when the product is available for general release to customers. We periodically assess the value of capitalized product design costs and record a reserve for obsolescence or impairment when, in the circumstances (including the discontinuance or probable discontinuance of the related products from the market), we deem the asset to be obsolete or impaired.
The Reserve For Obsolete And Slow-Moving Inventory
Since the amount of inventoriable cost that we will truly recoup through sales cannot be known with exact certainty, we rely upon both past sales experience and future sales forecasts. Inventory is considered obsolete if we have withdrawn those products from the market or if we had no sales of the product for the past 12 months, and have no sales forecasted for the next 12 months. Accordingly, an allowance in an amount equal to 100% of the average cost of such inventory is recorded. We classify as “slow-moving”, inventory with on-hand quantities greater than the amounts sold in the past 12 months or which have been forecasted to sell in the next 12 months, and reserve such an amount adequate to reduce the carrying value to net realizable value.
The Reserve For Doubtful Accounts
We perform ongoing evaluations of our customers and adjust their credit ratings accordingly. We continuously monitor collections and payments from our customers and maintain a provision for un-collectible amounts based on its historical experience and any other issues it has identified. While such credit losses have historically been within its expectations, we cannot guarantee this will continue in the future.
The Reserve For Warranties
We rely upon our service data to determine the adequacy of our warranty reserve. We use the service frequencies and history to evaluate the future service requirements. We continuously monitor this data to ensure that the reserve is sufficient. While such expenses have historically been within its expectations, we cannot guarantee this will continue in the future.
Transactions with Related and Other Parties
We lease our headquarters from Xenon Research, Inc. (“Xenon”), all of the issued and outstanding capital stock of which is owned by Simon Raab, our President and Chief Executive Officer, and Diana Raab, his spouse. The term of the lease expires on February 28, 2006, with two five-year renewal options. The base rent during renewal periods will reflect changes in the U.S. Bureau of Labor Statistics, Consumer Price Index for all Urban Consumers.
Inflation
We believe inflation has not had a material impact on our results of operations in recent years and do not expect inflation to have a material impact on our operations in 2004.
Foreign Exchange Exposure
We conduct a significant portion of our business outside the United States. At present, approximately 50% of our revenues are invoiced, and a significant portion of our operating expenses paid, in foreign currencies. Fluctuations in exchange rates between the U.S. dollar and such foreign currencies may have a material adverse effect on our business, results of operations and financial condition, and could specifically result in foreign exchange gains and losses. The impact of future exchange rate fluctuations on the results of our operations cannot be accurately predicted. To the extent that the percentage of our non-U.S. dollar revenues derived from international sales increases (or decreases) in the future, our exposure to risks associated with fluctuations in foreign exchange rates may increase (or decrease).
Item 3. - Quantitative And Qualitative Disclosures About Market Risk
The information required by this item is incorporated by reference herein from the section of this Report in Part I, Item 2, under the captions “Inflation” and “Foreign Exchange Exposure”, above.
Item 4. - Controls And Procedures
As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in our periodic SEC reports.
PART II. OTHER INFORMATION
Item 1. - Legal Proceedings
We are not involved in any pending legal proceedings other than routine litigation arising in the ordinary course of business. We do not believe that the results of such litigation, even if the outcome were unfavorable to us, would have a material adverse effect on our business, financial condition or results of operations.
The Company's Annual Meeting of Shareholders was held on May 11 2004. At such meeting, Messrs. Norman Schipper and John Caldwell were elected, each to serve on the Company's Board of Directors for a term of three years. The terms of office of Messrs. Stephen R. Cole, Hubert D'Amours, Gregory A. Fraser, Andre Julien, and Simon Raab continued after the meeting. The number of votes cast for, the number of votes withheld, and the number of broker non-votes with respect to the directors elected at the meeting were as follows:
| | For | Withheld | Broker Non-Votes |
| Norman Schipper | 11,649,871 | 281,671 | 1,600,741 |
| John Caldwell | 11,649,871 | 281,671 | 1,600,741 |
At the same meeting shareholders approved the adoption of the Company’s new 2004 Equity Incentive Plan. The number of votes cast for, the number of votes against, the number of abstentions, and the number of broker non-votes with respect to the 2004 Equity Incentive plan approved at the meeting were as follows:
| | For | Against | Abstain | Broker Non-Votes |
| 2004 Equity Incentive Plan | 2,633,690 | 2,004,515 | 22,755 | 8,871,323 |
Item 6. - Exhibits And Reports On Form 8-K
| a.) | Exhibits: |
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| | 31(a) | Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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| | 31(b) | Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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| | 32(a) | Certification of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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| | 32(b) | Certification of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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| b.) | Reports on Form 8-K |
| | | |
| | On April 28, 2004, we filed a Current Report on Form 8-K to set forth additional information concerning fees for services rendered to FARO by Ernst & Young LLP for each of the years 2002 and 2003. |
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| | On May 7, 2004, we filed a Current Report on Form 8-K in connection with a press release announcing its results of operations for the quarter ended April 3, 2004. |
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| | On July 15, 2004, we filed a Current Report on Form 8-K in connection with a press release announcing its sales results for the quarter ended July 3, 2004. |
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.
| | | |
| Date: August 5, 2004 | FARO TECHNOLOGIES, INC. |
| | (Registrant) |
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| | By: | /s/ |
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| | Gregory A. Fraser |
| | Executive Vice President, Secretary and Treasurer (Duly Authorized Officer and Principal Financial Officer) |
