FAFCO, Inc.
1997 Annual Report
The Company
This Annual Report to Shareholders contains for- ward-looking
statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of
1934. Actual results could differ materially from those
projected in the forward-looking statements as a result of the
risk factors set forth below under the heading "Management's
Discussion and Analysis - Factors Affecting Future Results" and
elsewhere in this Annual Report to Shareholders
FAFCO, Inc. designs, manufactures and markets heat exchangers
made primarily of polymers for use in solar swimming pool heating
and for thermal energy storage. FAFCO markets its swimming pool
products in the United States and overseas through independent
distributors who sell directly to end-users. The Company markets
its IceStor(tm) products in the United States through independent
manufacturers' representatives. The Company also licenses its
IceStor(tm) products overseas.
FAFCO has manufactured over one million polymer heat exchangers
since its incorporation in 1972. The heat exchangers are made
using proprietary and patented processing technology. The
Company is the largest manufacturer of solar pool heating systems
in the United States.
In 1987, FAFCO introduced IceStor(tm), a static glycol ice
builder for the thermal storage market. The FAFCO IceStor(tm)
utilizes a variation of the Company's polymer heat exchanger
placed in a galvanized steel container. The IceStor(tm)
products, a demand-side management for electric utilities, use
chilled glycol flowing through the heat exchanger to convert a
static volume of water in the container to ice.
The ice is made at night using less expensive "off-peak" power.
The cooling energy stored in the ice is then reclaimed the next
day during "peak periods" to provide space or process cooling.
The result is lowered cooling costs.
FAFCO's products are manufactured and marketed with a common
guiding strategy outlined below:
Targeting markets where high market share or growth are
likely.
A high value-added manufacturing process that minimizes
direct labor in favor or proprietary processes.
An effort to maximize gross margin based on sophisticated
manufacturing in high volume to enable economies of scale.
Experienced management whose capabilities exceed the
immediate demands of the business.
A resolution to combine the foregoing to build a large
and successful enterprise
Letter to Shareholders
FAFCO is a manufacturer of polymer heat exchangers used
principally for solar and thermal energy storage applications.
Net sales grew by 19% to $10,551,500 in 1997. Net profit
increased to $866,900, up 178% compared with 1996. Despite
record-setting rains in California and adverse weather in
Florida, 1998 promises to be another good year for FAFCO.
FAFCO's solar business increased 14.8% in 1997 due to the
execution of product and market strategies introduced in 1995.
Specifically, the new Revolution(tm) solar technology has been
well received by our customers. In addition, FAFCO has taken a
leadership position in the aboveground pool heating market as a
result of new technology and a focus on increased market share.
Finally, the solar business has benefited strongly from targeted
sales outside the tra-ditional California and Florida markets.
FAFCO's thermal energy storage business uses our unique polymer
heat exchanger technology to shift peaking electrical loads to
off peak. This significantly increases the effective capacity
of the electrical supplier without the expense of adding new
capacity. FAFCO's IceStor(tm) technology is sold principally in
the United States, Asia and in the emerging Middle Eastern
market. Domestic and foreign sales were up 100% and 17%,
respectively in 1997.
As of December 31, 1997, FAFCO's million-dollar credit line was
unused and there was $46,300 of cash on hand. Working capital
increased to $2,006,800 at December 31, 1997 from $1,284,700 at
December 31, 1996.
In addition to our solar Revolution(tm) and aboveground pool
technologies, FAFCO is accelerating certain new technologies that
are expected to positively influence sales and profitability
starting next year. Furthermore, we believe that FAFCO's polymer
heat exchanger technology is ideally suited to enter certain
formerly untargeted large domestic thermal energy storage
markets. A focus on these markets is expected to yield
significant results in 1999 and thereafter.
FAFCO's increased sales and profitability in 1997 resulted
directly from the long hours, increased effciency, and dedication
of each and every FAFCO employee. My thanks to each and every
one of you.
Sincerely,
Freeman A. Ford
President
Financial Highlights 1997 1996 % Change
Net Sales $ 10,551,500 $ 8,868,600 19%
Net Income 866,000 $ 311,400 178%
Diluted Earnings Per Common
Share $ 0.22 $ 0.10 120%
Shareholders' Equity $ 2,042,300 $ 1,176,30 74%
Working Capital $ 2,006,800 $ 1,284,700 56%
Consolidated Balance Sheet
December 31, 1997 1996*
Assets
Current assets:
Cash and cash equivalents $ 46,300 $ 88,200
Accounts receivable, less allowancefor doubtful
accounts of $540,100 in 1997 and $512,600 in 1996 1,833,400 1,890,700
Current portion of long-term notes receivable (net) 88,800 229,100
Inventories 1,082,900 917,400
Prepaid expenses and other current assets 174,000 150,800
Other accounts receivable, net of allowance 12,200 4,500
Total current assets 183,300 221,500
Plant and equipment, at cost 3,420,900 3,502,200
Less accumulated depreciation and amortization 2,614,900 2,465,800
Notes receivable and other assets (net) (2,236,300) (2,116,200)
Deferred tax asset, net of allowance 378,600 349,600
Total assets 151,200 65,500
Liabilities and shareholders' equity 485,800 427,900
Current liabilities: 4,436,500 4,345,200
Bank line of credit $ $ 758,600
Accounts payable and other accrued expenses 850,900 1,037,800
Accrued compensation and benefits 331,600 187,000
Accrued warranty expense 211,000 234,100
Income taxes payable 20,600
Total current liabilities 1,414,100 2,217,500
Convertible subordinated notes ($600,000 was owed
to related parties in 1997 and 1996) 925,000 925,000
Other non-current liabilities 55,100 26,400
Total liabilities $2,394,200 $3,168,900
Shareholders' equity:
Preferred Stock-authorized 1,000,000 shares of $1.00
par value, none of which has been issued
Common Stock-authorized 10,000,000 shares of
$0.125 par value; 3,298,311 issued and
outstanding in 1997 and in 1996 412,200 412,200
Capital in excess of par value 5,105,200 5,105,200
Notes receivable secured by Common Stock 75,100 75,100
Accumulated deficit (3,400,000) (4,266,000)
Total shareholders' equity $2,042,300 $1,176,300
Commitments and contingent liabilities
Total liabilities and shareholders' equity $4,436,500 $4,345,200
CONSOLIDATED STATEMENT OF OPERATIONS
Year ended December 31, 1997 1996 1995
Net Sales $10,551,500 $ 8,868,600 $ 7,876,100
Other income (net) 171,800 54,000 39,700
Total revenues 10,723,300 8,922,600 7,915,800
Cost of goods sold 5,956,500 5,500,300 5,578,000
Marketing and selling expense 1,770,000 1,575,400 2,137,200
General and administrative expense 1,776,100 1,286,300 1,502,000
Research and development expense 202,800 116,000 460,100
Net interest expense 128,700 169,900 95,300
Total costs and expenses 9,834,100 8,647,900 9,772,600
Income (loss) before income taxes 889,200 274,700 (1,856,800)
Provision for (benefit from) income
taxes. 23,200 (36,700) 1,600
Net income (loss) 866,000 311,400 $(1,858,400)
Basic net income (loss) per share $ 0.26 $ 0.10 (0.60)
Diluted net income (loss per share 0.22 0.10 (0.60)
*Restated for change in accounting principle (see Note 2).
Consolidated Statement of Shareholders' Equity
Notes
Number Capital in Receivable Retained
of Common Excess of Secured by Earnings
Shares Stock Par Value Common StockDeficit*
Balance at December 31, 1994 3,100,8870$387,600$5,034,100$(75,100)$2,719,000)
Net loss for the year
Cancellation of shares in
satisfaction of other notes
receivable (3,000)(400) (4,100)
Issuance of shares under the
1981 Employee Incentive Stock
Option Plan 8,800 1,100 3,300
Issuance of shares under the
1991 Employee Incentive Stock
Option Plan 6,000 700 2,300
Balance at December 31, 1995 3,112,687$389,000$5,035,600$75,100 $(4,577,400)
Net income for the year 311,400
Issuance of shares upon
conversion of subordinated
note 185,624 23,200 69,600
Balance at December 31, 19963,298,311$412,200$5,105,200$75,100 $4,266,000
Net income for the year 866,000
Balance at December 31, 19973,298,311$412,200 $(75,100) $(3,400,000)
*Restated for change in accounting principle (see Note 2).
The accompanying notes are an integral part of this statement
Consolidated Statement of Cash Flows
Year Ended December 31, 1997 1996*** 1995**
$866,000 $311,400 $(1,858,400)
Net income (loss)
Adjustments to reconcile net income
(loss) to net cash provided by (used in)
operating activities:
Depreciation 130,700 121,200 178,700
Allowance for doubtful accounts and notes 120,300 72,400 33,900
Provision for inventory reserve (90,500) 72,400 105,800
(Gain) loss on disposition of fixed assets (18,700) 22,700
Change in assets and liabilities:
Change in receivables 22,100 (794,300) 1,367,800
Change in inventories (75,000) (85,200) (39,700)
Change in prepaid expenses (23,200) (5,300) (28,600)
Change in deferred tax assets (19,700) (38,400)
Change in other assets (38,200) (73,400) (333,000)
Change in payables and accrued expenses (44,800) 104,900 (288,900)
Change in other non-current liabilites 28,700 (54,000) (27,800)
Net cash provided by (used in) operations 876,400 (270,200) (867,500)
Cash flow from investing activities:
Purchase of fixed assets (159,700) (211,600) (81,300)
Proceeds from sale of fixed assets 18,700
Net cash used in investing activities (159,700) (192,900) (81,300)
Cash flow from financing activities:
Proceeds of subordinated debt issuance 325,000
Proceeds from sale of common stock 92,800
Payments on line of credit (1,493,900)(1,350,000)(490,000)
Borrowings on line of credit 735,300 1,357,300 1,241,300
Miscellaneuous borrowings (21,700)
Net cash (used in) provided by financing
activities (758,600) 425,100 737,000
Net (decrease) in cash and cash equivalents (41,900) (38,000) (21,800)
Cash and cash equivalents, beginning of year 88,200 126,200 338,000
Cash and cash equivalents, end of year $46,300 $88,200 $126,200
Supplemental disclosures of cash flow information:
Cash paid during the year for interest $142,100 $159,300 $ 89,800
Cash paid during the year for interest $ 10,000 $ 7,500 49,000
Net cash paid duringthe year for income taxes
*Reclassified for comparative purposes.
**Restated for change in accounting principle (see Note 2).
The accompanying notes are an integral part of this statement.
Notes to Consolidated Financial Statements
1) Organization and Summary of
Significant Accounting Policies
The Company designs, develops, manufactures and markets solar
heating systems for swimming pools and thermal energy storage
systems for commercial and industrial cooling. The solar heating
systems are sold to wholesalers and distributors primarily in
California and Florida and in other locations in the United
States and overseas. Thermal energy storage systems are marketed
through manufacturers' representatives throughout the United
States and internationally. One of the Company's customers
accounted for more than 10% of the Company's fiscal 1997 net
sales. Three of the Company's customers each accounted for more
than 10% of the Company's fiscal 1996 net sales. One of the
Company's customers accounted for 10% of the Company's fiscal
1995 net sales. During 1997, the Company had sales to
unaffiliated customers in foreign countries amounting to 28% of
total net sales. During 1996 and 1995, the Company had sales to
unaffiliated customers in foreign countries amounting to 14% and
15%, respectively, of total net sales. A summary of significant
accounting policies follows:
Principles of Consolidation: The consolidated financial
statements include the accounts of FAFCO, Inc. and its wholly-
owned subsidiary. All significant inter-company balances and
transactions have been eliminated in consolidation.
Revenue Recognition: Revenues on sales of products are
recognized at the time of shipment of goods or performance of
service.
Use of Estimates: The preparation of financial statements in
conformity with generally accepted accounting principles 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 reporting period. Actual results could differ
materially from those estimates.
Cash and Cash Equivalents: For purposes of reporting cash flows,
cash and cash equivalents include highly liquid investments with
a maturity of three months or less.
Inventories: Inventories are stated at the lower of cost or
market determined using the first-in, first-out (FIFO) method.
Plant and Equipment: Plant and equipment are stated based on
historical cost adjusted for accumulated depreciation.
Depreciation and amortization of plant and equipment, excluding
vehicles and leasehold improvements, are determined using
accelerated methods. For vehicles and leasehold improvements,
the straight line method is used. The estimated useful lives of
the assets range between three and ten years. Minor
replacements, improvements, maintenance and repairs are expensed
as incurred. Major replacements and improvements are capitalized
and depreciated over the remaining useful life of the related
asset. Gains and losses on sales and retirement of plant and
equipment are credited or charged to income.
Accounting for the Impairment of Long-lived Assets and for Long-
lived Assets to be Disposed of: As required by generally
accepted accounting principles (GAAP), effective January 1, 1996,
the Company adopted Statement of Financial Accounting Standards
No. 121, "Accounting for the Impairment of Long-lived Assets and
for Long-lived Assets to be Disposed of." The new standard
provides guidance on when to recognize and how to measure
impairment losses of long-lived assets and certain identifiable
intangibles and how to value long-lived assets to be disposed of.
The new standard had no material effect on the Consolidated
Balance Sheets for 1997 and 1996 nor the Consolidated Statements
of Operations for 1997, 1996 or 1995.
Income Taxes: Deferred tax assets and liabilities are recognized
for the tax consequences of temporary differences between the
financial reporting and tax basis of assets and liabilities.
(See Note 8.)
Earnings per Common Share: FAFCO adopted Statement of
Financial Accounting Standard No. 128 ("FAS 128"), Earnings per
Share, beginning with FAFCO's fourth quarter of 1997. All prior
period earnings per common share data have been restated to
conform to the provisions of this statement. Basic earnings per
common share is computed using the weighted average number of
shares outstanding. Diluted earnings per common share is
computed using the weighted average number of shares outstanding
adjusted for the incremental shares attributed to outstanding
options and warrants to purchase common stock and shares issuable
upon conversion of certain convertible securities. (See Note
12.)
Concentration of Credit Risk: Most of the Company's business
activity is with customers located in California, Florida and
foreign countries. As of December 31, 1997, unsecured trade
accounts receivable from customers in California, Florida and
foreign countries were $481,100, $841,400, and $915,000,
respectively.
Warranties: In the normal course of business, the Company makes
certain warranties as to workmanship and materials. Product
warranty periods range from two to ten years for full coverage.
The estimated future expense of these warranties is accrued at
the time of sale. The estimates inherent in accounting for such
warranties are reviewed and revisions to previous estimates are
made as required to reflect the most current information
available.
Accounting for Stock-Based Compensation: The FASB issued a new
standard, FAS No. 123, "Accounting for Stock-Based Compensation,"
which contains a fair value-based method for valuing stock-based
compensation that entities may use, which measures compensation
cost at the grant date based on the fair value of the award.
Compensation is then recognized over the service period.
Alternatively, the standard permits entities to continue
accounting for employee stock options and similar equity
instruments under APB Opinion 25, "Accounting for Stock Issued to
Employees." Entities that continue to account for stock options
using APB Opinion 25 are required to make pro forma disclosures
of net income and earnings per share, as if the fair value-based
method of accounting defined in FAS No. 123 had been adopted.
The Company has decided to continue accounting for employee stock
options and similar equity instruments under APB Opinion 25,
"Accounting for Stock Issued to Employees." (see Note 7.)
Disclosures About Fair Value of Financial Instruments: The
following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is
practicable to estimate that value.
Current Assets and Current Liabilities: The carrying value of
cash equivalents, accounts receivable, notes receivable, short-
term borrowings, accounts payable, and accrued expenses
approximate fair value because of their short maturity.
Long-Term Debt: The fair value of the Company's long-term debt
is estimated based on the borrowing rates currently available to
the Company for loans with similar terms. At December 31, 1997,
the carrying amount approximates estimated fair value of long-
term debt.
2) Inventories
Effective in 1997 the Company changed its method of accounting
for inventories from last in, first out (LIFO) to first in, first
out (FIFO), a change in accounting principle. The reason for
this change is that LIFO is difficult and costly for the Company
to administer and the effect on the Consolidated Statement of
Operations has not been material over the past several years due
to the relatively low rates of inflation in the economy as a
whole. The cumulative effect on Shareholders' Equity at December
31, 1996 was to increase Shareholders' Equity by $82,000. The
financial statements have been restated for this change in
accounting method for all periods presented.
December 31, 1997 1996
Net income (loss) as
previously as reported $ 386,800 $ (1,918,300)
Adjustment for effect of
a change in accounting
principle that is applied
retroactively $ (75,400) $ 59,900
Net income (loss) as
adjusted $ 311,400 $ (1,858,400)
Per share amounts
Basic earnings per
common share:
Net income (loss) as
previously reported $ 0.12 $ (0.62)
Adjustment for effect of
a change in accounting
principle that is applied
retroactively $ (0.02) $ (0.02)
Net income (loss) as
adjusted $ 0.10 $ (0.60)
Diluted earnings per
common share:
Net income (loss) as
previously reported $ 0.12 $ (0.62)
Adjustment for effect
of a change in accounting
principle that is applied
retroactively $ (0.02) $ 0.02
Net income (loss) as
adjusted $ 0.10 $ (0.60)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Inventories consist of the following:
December 31, 1997 1996
Raw materials $ 462,800 $ 413,800
Work in progress 114,000 111,900
Finished goods 506,100 391,700
$1,082,900 $ 917,400
3) Plant and Equipment
Plant and equipment consists of the following:
December 31, 1997 1996
Machinery and
equipment $ 1,957,600 $ 1,902,800
Office and computer
equipmen $ 466,900 $ 372,600
Leasehold
improvements 88,600 88,600
Vehicles 101,800 101,800
$ 2,614,900 $ 2,465,800
Less accumulated
depreciation and
amortization (2,236,300) (2,116,200)
$ 378,600 $ 349,600
4) Notes Receivable
During 1997, the Company converted $126,400 of accounts
receivable from a customer into a note receivable. During 1996,
the Company converted $4,700 of accounts receivable from a
customer into a note receivable.
5) Convertible Subordinated Notes
At December 31, 1997 and 1996, convertible subordinated notes
consisted of $925,000 of notes bearing interest at 11% per annum
payable quarterly and warrants to purchase Common Stock. The
exercise price of the warrants is $0.125 per share, the maximum
aggregate number of shares issuable upon exercise of the warrants
is 555,000, and the unexercised warrants expire March 27, 2000
(see Note 9).
6) Bank Line of Credit
The Company has a bank line of credit secured by substantially
all the assets of the Company. The line of credit allows the
Company to borrow the lesser of $1,000,000 or an amount
determined by a formula applied to net accounts receivable,
inventories, and net
lant and equipment. Amounts borrowed bear interest at the bank's
prime rate plus 1.5%. The line of credit contains certain
covenants relating to working capital, current ratio, and
tangible net worth, prohibits the payment of cash dividends and
expires on March 30, 1999. At December 31, 1997 and 1996, the
Company had complied with the loan covenants.
As of December 31, 1997 and 1996, the Company had outstanding
balances of $0 and $758,600, respectively, under this facility.
7) Shareholders' Equity
The Board of Directors, without shareholder approval, may
determine the rights, preferences, privileges, and restrictions
of the Company's unissued Preferred Stock. Such shares may be
issued in one or more series. In 1980, the Company issued 202,300
shares of Common Stock at a price of $2.43 per share in exchange
for non-interest bearing promissory notes, which have a balance
due of $75,100 at December 31, 1997 and 1996. The notes are due
and payable and the Company intends to pursue collection of these
notes. In the event that any of the notes are uncollectible, the
Company will demand surrender of the related shares issued and
will cancel and write off the related notes receivable balance.
Under the Company's Employee Stock Purchase Plan, 150,000 shares
of Common Stock have been reserved for issuance at 85% of fair
market value as of specified dates. The Plan was suspended in
1991 and no shares have been issued thereunder since 1991.
The Company had a 1981 Incentive Stock Option Plan under which
310,000 shares of Common Stock are reserved for issuance. During
1991, options were granted for 5,000 shares exercisable at $0.625
per share which were forfeited during 1997. The plan expired by
its terms in 1991.
The Company has a 1991 Incentive Stock Option Plan under which
250,000 shares of Common Stock were initially reserved for
issuance to employees and consultants. During November 1994, the
Board of Directors approved an increase in the number of shares
of Common Stock reserved for issuance to a total of 500,000
shares subject to shareholder approval, which was obtained in
April 1995. During 1995, options were granted to purchase
124,000 shares exercisable at $0.56 per share, the fair market
value on the date of grant, and options to purchase 6,000 shares
were exercised. During 1996, options were granted to purchase
236,950 shares exercisable at $0.125 per share, the fair market
value on the date of grant. During 1997, options were granted to
purchase 21,000 shares exercisable at $0.125 per share, the fair
market value on the date of grant.
The Company has a 1991 Director's Stock Option Plan under which
50,000 shares of Common Stock are reserved for issuance. No
options were granted or exercised during 1995, 1996, or 1997.
Options granted under these plans become exercisable at a rate of
20% per year for five years from date of grant and expire six
years or ten years from date of grant.
During 1995, the Company granted nonqualified options to
purchase 20,000 shares at $0.56 per share to a consultant. These
options were fully vested at the date of grant and expire six
years from date of grant. None of these options have been
exercised. During 1995, options to purchase 234 shares were
canceled.
A summary of activity under the 1981 and 1991 Incentive Stock
Option Plans follows:
Shares Exercise
Subject Price
to Option Per Share
Outstanding at
December 31, 1994 332,550 $ 0.50-0.625
Granted 124,000 $ 0.560
Canceled (166,300) $ 0.50-0.560
Exercised (14,800) $ 0.500
Outstanding at
December 31, 1995 275,450 $ 0.50-0.625
Granted 236,950 $ 0.125
Canceled (126,950) $ 0.50-0.560
Exercised 0
Outstanding at
December 31, 1996 385,450 $ 0.125-0.625
Granted 21,000 $ 0.0125
Canceled (31,500) $ 0.125-0.625
Exercised 0
Outstanding at
December 31, 1997 374,950 $ 0.125-0.50
The Company applies APB Opinion 25 in accounting for its stock
option plans. Accordingly, no compensation cost has been
recognized for the plan in 1995 or 1996. Had compensation cost
been determined on the basis of fair value pursuant to FASB
Statement No. 123, net income and earnings per share would have
been reduced as follows:
1997 199 1995
Net income (loss)
As reported $ 866,000 $ 311,400 $(1,858,400)
Pro forma $ 860,200 $ 293,600 $(1,857,600)
Basic earnings (loss)
per share
As reported $ 0.26 $ 0.10 $ (0.60)
Pro forma 0.26 0.09 (0.60)
Diluted earnings
(loss) per share
As reported $ 0.22 $ 0.10 $ (0.60)
Pro forma $ 0.2 $ 0.09 $ (0.60)
The fair value of each option granted was estimated on the grant
date using the Black-Scholes model.
The following assumptions were made in estimating fair value:
Assumption 1997 1996
Dividend yield 0% 0%
Risk-free interest rate 5.55% 6.5%
Expected life 10 years 6 years
Expected volatility 141.1% 96.74%
Following is a summary of the status of the plans during 1997,
1996, and 1995.
Weighted
Average
Number of Excercise
Shares Price
Outstanding at
January 1, 1997 385,450 $ 0.258
Granted 21,000 0.125
Exercised 0 0
Forfeited (31,500) 0.460
Outstanding at
December 31, 1997 374,950 0.250
Options exercisable
at December 31,1997 231,150 0.282
Weighted average
fair value of options
granted during 1997 $0.123
Weighted
Average
Number of Exercise
Shares Price
Outstanding at
January 1, 1996 275,450 $ 0.485
Granted 236,950 0.125
Exercised 0 0
Forfeited (126,950) 0.502
Outstanding at
December 31, 1997 385,450 0.258
Options exercisable
at December 31,1996 199,650 0.297
Weighted average
fair value of options
granted during 1996 $0.101
Weighted
Average
Number of Exercise
Shares Price
Outstanding at
January 1, 1995 332,550 $0.5020
Granted 124,000 0.5100
Exercised (14,800) 0.5000
Forfeited (166,300) 0.0536
Outstanding at
December 31, 1995 275,450 0.4850
Options exercisable
at December 31,1995 163,750 0.5030
Weighted average
fair value of options
granted during 1995 $ 0.410
Following is a summary of the status of options outstanding at
December 31, 1997:
Outstanding Exercisable
Weighted
Average Weighted Weighted
Remaining Average Average
Exercise Contractual Exercise
Price Number Life Price Number Price
$0.500 118,000 1 $0.500 94,400 $0.500
$0.250 20,000 4 $0.250 8,000 $0.250
$0.125 236,950 5 $0.125 128,750 $0.125
374,950 4 231,150
The range of exercise prices for the options outstanding at
December 31, 1997 is $0.125-$0.50 with a weighted average
contractual life of 5 years. The Company estimates that based on
vesting at 20% per year at December 31, 1997, approximately 100%
of options will eventually vest.
8 Income Taxes
The provisions for income taxes consist of the following:
Years Ended December 31, 1997 1996 1995
Taxes on income:
U.S. Federal
Current $ 12,000 $ 0 $ 0
Deferred (28,400) (40,300) 0
(16,400) (40,300) 0
State
Current 20,000 1,600 1,600
Deferred 9,600 2,000
29,600 3,600 1,600
Foreign
Current 10,000 0 0
Deferred 0 0 0
$ 10,000 $ 0 $ 0
Net income tax
(benefit)
provision $ 23,200 $ (36,700) $ 1,600
A reconciliation of the statutory federal income tax rate with
the effective tax rate reported in the financial statements
follows:
Years Ended
December 31, 1997 1996 1995
Statutory federal
income tax
(benefit) rate 34.0% 34.0% (34.0%)
Effect on tax rate
resulting from:
State and foreign
income taxes,
net of federal
tax benefit 2.2% 7.7% (1.4%)
Tax effect of change
in valuation
allowance (36.6%) (54.8%) 40.9%
Expiration of
tax credits 1.7% 2.0% 0.7%
Other 1.3% 0.6% (6.2%)
Effective tax rate 2.6% (10.5%) 0%
The Company records its deferred taxes on a tax jurisdiction
basis and, with the adoption of FAS No. 109 in 1993, classifies
those net amounts as current or noncurrent based on the balance
sheet classifications.
Deferred tax assets are comprised of the following:
December 31, 1997 1996
Allowance for doubtful
accounts $ 227,700 $ 215,600
Accrued expenses 132,500 184,300
Loss carryforwards 837,400 1,157,800
Tax credits 71,200 175,700
Other 108,300 107,800
1,377,100 1,841,200
Deferred tax asset
valuation allowance (708,000) (1,191,800)
Total deferred taxes,
net $ 669,100 $ 649,400
The Company had unused federal net operating loss carryforwards
of approximately $2,394,000 and $3,191,500, Florida loss
carryforwards of approximately $611,000 and $1,083,000 and
investment and other federal tax credits of approximately $71,200
and $175,700 available to offset future tax liabilities at
December 31, 1997 and December 31, 1996, respectively. The net
operating losses and credits expire in varying amounts until
2010. The use of the tax credits has been limited by the
provisions of the Tax Reform Act of 1986 to reflect the benefit
associated with an overall reduction in the corporate tax rate.
The Company believes that the "total deferred taxes, net" in the
amount of $669,100 is more likely than not to be realized.
9) Transactions with Related Parties
At December 31, 1997 and 1996, $600,000 of the Company's
convertible subordinated notes (see Note 5) were held by Mr.
Freeman A. Ford, an officer, director, and major shareholder of
the Company, and his immediate family members.
In April 1996, the Company granted Mr. Ford a warrant to purchase
123,950 shares of Common Stock.
10) Employee Benefit Plans
The Company has a 401(k) retirement savings plan for all eligible
employees who have completed one year of service. Eligible
employees have the option to contribute up to 15% of their
eligible salary. The Company contributes an amount equal to 25%
of the employee contribution, up to a maximum of $400 per
employee.
11) Lease Commitments
The Company's rental expense, relating primarily to a lease for
its office and manufacturing facility, amounted to $393,400 in
1997, $380,300 in 1996, and $359,400 in 1995. At December 31,
1997, minimum annual lease commitments under non-cancelable
leases were as follows:
1998 $ 391,900
1999 405,400
2000 138,900
Total $ 936,200
The Company is required to pay property taxes, utilities, and
insurance under certain of these leases, some of which provide
for renewal options at the end of the initial lease term in the
year 2000.
12) Net Income Per Share
Basic earnings per share were calculated as follows:
Years ended December 31, 1997 1996 1995
Net income
(loss) $ 866,000 $ 311,400 $ (1,858,400)
Average
common
shares
outstanding 3,298,311 3,254,066 3,102,564
Earnings
(loss)
per share $ 0.26 $ 0.10 $ (0.60)
Basic earnings per share are calculated by dividing net income
(loss) by the weighted average number of shares issued and
outstanding.
Diluted earnings per share were calculated as follows:
Years ended December 31, 1997 1996 1995
Adjusted Net
income (loss) $ 921,700 $ 311,400 $(1,858,400)
Average com-
mon shares
outstanding 3,298,311 3,254,066 3,102,564
Add: Exercise
of options re-
duced by the
number of
shares pur-
chased with
proceeds 186,026 N/A N/A
Add: Exercise of
warrants re-
duced by the
number of shares
purchased with
proceeds 63,173 N/A N/
Add: Conversion of
convertible debt
into shares 555,000
Adjusted weighted
average shares
outstanding 4,102,510 3,254,066 3,102,564
Earnings (loss) per
common share
assuming full
dilution $ 0.22 $ 0.10 $ (0.60)
13) Licensing Income
During 1997, the Company entered into a licensee agreement with a
third party in the Far East under which the Company received and
recognized license fee income net of foreign income taxes of
$90,000. The agreement allows for the licensee to assemble and
sell the IceStor(tm) product in certain countries using the
Company's technology and design specifications. For the term of
the agreement (eight years), the Company is required to provide
parts and technical services to the licensee at prices and rates
equivalent to normal list prices.
14) Litigation
The Company is involved in certain litigation matters.
Management believes resolution of these disputes will not have a
material adverse effect on the Company's financial condition and
results of operation.
Report of Independent Auditors
To the Board of Directors of FAFCO, Inc.
We have audited the consolidated balance sheets of FAFCO, Inc.
and its subsidiary as of December 31, 1997 and 1996 and the
related consolidated statements of income, retained earnings, and
cash flows for the years then ended. These financial statements
are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial
statements based on our audit. The Consolidated Statements of
Income, Retained Earnings and Cash Flows for the year ended
December 31, 1995 were audited by other auditors whose report
dated March 27, 1996 expressed an unqualified opinion on those
statements.
We conducted our audit in accordance with generally accepted
auditing standards. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above
present fairly, in all material respects, the financial position
of FAFCO, Inc. and its subsidiary as of December 31, 1997 and
1996 and the results of its operations and its cash flows for the
years then ended in conformity with generally accepted accounting
principles.
As discussed in Notes 1 and 2 respectively to the consolidated
financial statements, the Company adopted SFAS 128 "Earnings per
Share" during the fourth quarter of 1997 and changed its method
of accounting for inventories from last-in, first-out (LIFO) to
first-in, first-out (FIFO) effective January 1, 1997.
Burr, Pilger & Mayer
Palo Alto, California
March 17, 1998
Summary of Operations
Five-Year Summary of Operations (in thousands, except per share
data)
Year Ended December 31, 1997 1996 1995 1994 1993
Net sales $10,552 $8,869 $7,876 $10,526 $9,352
Income (loss) before income
taxes
and changes in accounting
principles $ 889 $ 350 $(1,917)$ 504 $ 254
Provision for income taxes 23 (37) 1 49 116
Income (loss) before changes
in accounting principles 866 387 (1,918) 455 138
Effect of change in method of
accounting for inventories
applied retroactively 0 (74) 60 43 (2)
Cumulative effect of change in
method of accounting for income
taxes 717
Net income (loss) $ 866 $ 311 $ (1,858)$ 498 $ 853
Basic net income (loss) per
share before changes in
accounting principles $ 0.26 $ 0.12 $ (0.62) $ 0.13 $ 0.04
Basic net income (loss) per
share from effect of change
in method of accounting for
inventories applied retroactively 0 (0.02) 0.02 0.01 0
Basic net income per share from
cumulative effect of change in
method of accounting for income
taxes 0.22
Basic net income (loss) per
share $ 0.26 $ 0.10 $ (0.60) $ 0.14 $ 0.26
Diluted net income (loss) per
share before changes in
accounting principles $ 0.22 $ 0.12 $(0.62) $ 0.13 $ 0.05
Diluted net income (loss) per
share from effect of change in
method of accounting for
inventories applied retroactively 0 (0.02) 0.02 0.01 0
Diluted net income per share from
cumulative effect of change in
method of accounting for income
taxes 0.19
Diluted net income (loss) per
share $ 0.22 $ 0.10 $(0.60) $ 0.14 $ 0.24
At December 31, 1997 1996* 1995* 1994* 1993*
Working capital $ 2,007 $ 1,285 $379 $2,469 $ 1,839
Total assets 4,437 4,345 3,557 5,001 4,428
Long-term obligations 980 951 680 725 751
Shareholders' equity 2,042 1,176 772 2,628 2,093
*Restated for change in accounting principle (see Note 2).
Common Stock Data
FAFCO, Inc. Common Stock is traded on the over-the-counter market
but is not listed on an exchange or quoted on any automated
quotation system. The high and low closing bid quotations for
each quarter during 1997 and 1996 were as follows:
Quarter Ended March 31 June 30 September 30 December 31
1997 High $0.125 $0.125 $0.125 $0.750
1997 Low $0.125 $0.125 $0.125 $0.125
1996 High $0.250 $0.125 $0.125 $0.125
1996 Low $0.125 $0.125 $0.125 $0.125
The quotations above were provided by the National Quotation
Bureau. All quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission and may not necessarily
represent actual transactions. At March 6, 1998, the Company had
710 shareholders of record. FAFCO, Inc. has never paid dividends
on its Common Stock and has no plans to do so in the foreseeable
future and is prohibited from so doing (see Note 6).
Management's Discussion and Analysis
This Annual Report to Shareholders contains forward-looking
statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of
1934. Actual results could differ materially from those
projected in the forward-looking statements as a result of the
risk factors set forth below under the heading Factors Affecting
Future Results and elsewhere in this Annual Report to
Shareholders.
1997 Compared with 1996
Net sales for 1997 increased by 19% from $8,868,600 in 1996 to
$10,551,500 in 1997. This increase was due primarily to
increased unit sales of the Company's pool panel products, along
with increased unit sales of the Company's IceStor(tm) products
partially offset by the effect of discontinuance of the company's
automated swimming pool controls.
Net sales of the Company's pool products were 14.8% higher in
1997 than 1996 due mainly to increased sales of its Revolution
model inground pool panels, along with increased sales of its
Sunsaver(tm) model inground pool panels and increased sales of
its Sunsaver(tm) model aboveground pool panels. These increases
were partially offset by the effect of discontinuance of its
proprietary line of automated swimming pool controls, which was
phased out as of January 1, 1997. Net sales of the Company's
IceStor(tm) products were 25.1% higher in 1997 than in 1996 due
mainly to increased domestic sales along with higher foreign
sales.
Pool product sales amounted to 56% of net sales in 1997 compared
to 58% of net sales in 1996. IceStor(tm) sales amounted to 44%
of net sales in 1997 compared to 42% of net sales in 1996. There
were no significant price changes in any of the Company's
products during 1997.
Cost of goods sold increased in absolute dollars from $5,500,300
in 1996 to $5,956,500 in 1997 while decreasing from 62.0% of net
sales in 1996 to 56.5% of net sales in 1997. This decrease as a
percent of net sales was due primarily to the fixed costs being
allocated over higher sales along with a continued increase of
sales of higher margin products in both the pool and the
IceStor(tm) lines.
Marketing and selling expenses increased in absolute dollars from
$1,575,400 in 1996 to $1,770,000 in 1997 while decreasing from
17.8% of net sales in 1996 to 16.8% of net sales in 1997. These
decreases as a percent of net sales were due mainly to the
increased level of sales experienced in 1997 as compared to 1996.
General and administrative expenses increased from $1,286,300
(14.5% of net sales) in 1996 to $1,776,100 (16.8% of net sales)
in 1997. These increases were due mainly to increased bad debt
write-offs along with bonus and profit-sharing expenses incurred
in 1997 which were not incurred in 1996.
Research and development expenses increased from $116,000 (1.3%
of net sales) in 1996 to $202,800 (1.9% of net sales) in 1997.
This increase was due mainly to an increase in the number of
projects designed to improve current products and to develop
potential new products, along with an increase in personnel to
implement those projects.
Net interest expense decreased from $169,900 (1.9% of net sales)
in 1996 to $128,700 (1.2% of net sales) in 1997. This decrease
was due mainly to lower average daily borrowing in 1997 along
with lower interest rates.
1996 Compared with 1995
Net sales for 1996 increased by 12.6% from $7,876,100 in 1995 to
$8,868,600 in 1996. This increase was due primarily to increased
unit sales of the Company's IceStor(tm) and pool panel products.
Net sales of the Company's pool products were 5.9% higher in 1996
than in 1995 due mainly to increased sales of its SunSaver(tm)
model inground and aboveground pool panels partially offset by
decreased sales of its Revolution(tm) model inground pool panels
and decreased sales of its proprietary line of automatic
controls, which was phased out as of January 1, 1997. Net sales
of the Company's IceStor(tm) products were 24.0% higher in 1996
than in 1995 due mainly to increased foreign sales partially
offset by decreased domestic sales. The Company believes the
decreased domestic sales were due mainly to potential customers'
beliefs that lower energy prices in the domestic market place
will result from planned deregulation of energy prices.
Pool product sales amounted to 58% of net sales in 1996 compared
to 62% of net sales in 1995. IceStor(tm) sales amounted to 42%
of net sales in 1996 compared to 38% of net sales in 1995. There
were no significant price changes in any of the Company's
products during 1996.
Cost of goods sold decreased from $5,578,000 (70.8% of net sales)
in 1995 to $5,500,300 (62.0% of net sales) in 1996. This was
due mainly to the fixed costs being allocated over higher sales
along with increased sales of higher margin products in both the
pool product line and IceStor(tm) product line.
Marketing and selling expenses decreased from $2,137,200 (27.1%
of net sales) in 1995 to $1,575,400. (17.8% of net sales) in
1996. This decrease is due mainly to reduced promotional
expenses for pool products along with reduction in support
personnel for IceStor(tm) products.
General and administrative expenses decreased from $1,502,000
(19.1% of net sales) in 1995 to $1,286,300 (14.5% of net sales)
in 1996. This decrease is due mainly to decreased personnel
costs along with decreased legal and accounting expenses.
Research and development expenses decreased from $460,100 (5.8%
of net sales) in 1995 to $116,000 (1.3% of net sales) in 1996.
This decrease was due entirely to the reduction in personnel in
late 1995 and the continued low level of personnel in 1996.
Net interest expense increased from $95,300 (1.2% of net sales)
in 1995 to $169,900 (1.9% of net sales) in 1996. This increase
is due primarily to the higher average daily borrowing in 1996 at
higher interest rates than in 1995.
Seasonality
Historically, the Company has experienced lower sales during the
first quarter than during other quarters of each year. In
addition, sales typically have increased significantly during the
second quarter, declined slightly, and then remained relatively
constant during the third and fourth quarters, respectively. The
Company believes that this pattern derives primarily from the
sales of solar heating products. As the Company's product mix
shifts to include a larger proportion of other products, such as
the thermal energy storage products, the traditional seasonality
is being mitigated. Net income is affected by the seasonality of
sales as well as by significant marketing and selling expenses
typically incurred during the first quarter of each year. These
expenses are incurred to develop programs and materials for use
throughout the remainder of the year.
In 1997 sales and net income experienced their typical
seasonality, except that sales of pool panel products in the
first quarter were increased as a result of the unusually dry and
warm weather in both California and Florida. As a result of the
increased sales of pool panel products the traditional first
quarter loss was not experienced. The traditional seasonality
may be exaccerbated in 1998 because of the effect on sales due to
the El Nino weather pattern.
In 1996, sales and net income experienced their traditional
seasonality, except that sales in the fourth quarter were
increased due to sales of IceStor(tm) product. As a result of
the ice storage sales, the traditional fourth quarter loss was
not experienced.
In 1995, sales experienced the traditional seasonality except
that the decline in sales in the third and fourth quarters was
more pronounced than normal due to weak sales in both pool
products and IceStor(tm) during the second half of the year.
There were net losses in all four quarters due to sales being
below the planned levels in all four quarters.
Liquidity and Capital Resources
The Company's cash position decreased from $88,200 at 1996 fiscal
year end to $46,300 at 1997 fiscal year end, principally due to
the repayment of the bank line of credit and the purchase of
fixed assets.
At December 31, 1997, the Company's net accounts receivable had
decreased slightly to $1,833,400 from $1,890,700 at December 31,
1996, primarily as a result of faster collection of accounts
receivable partially offset by increased sales in late 1997.
At December 31, 1997, the Company's accounts payable and other
accrued expenses had decreased to $850,900 from $1,037,800 at
December 31, 1996. This decrease is primarily due to faster
payment of accounts payable because of cash availability from
profits.
At December 31, 1997, the Company's inventories had increased to
$1,082,900 from $917,400 at December 31, 1996. This increase was
due entirely to the buildup of inventories for a specific order
that shipped in the first quarter of 1998. As described in Note
2 of the Financial Statements, during 1997 the Company changed
its inventory accounting principle from LIFO to FIFO, after
discussions with Burr, Pilger and Mayer (the Company's
independent auditors) as to the appropriate method.
The Company adopted SFAS 109 effective January 1, 1993. This
resulted in the recognition of a deferred tax asset, net of
valuation allowance, at year-end of $669,100 in 1997 and $649,400
in 1996. The Company believes that it is more likely than not
that this asset will be fully realized. This belief is based
upon the Company's recent history of profitable operations prior
to 1995, its return to profitability in 1996 and 1997, and the
Company's expectation that operating results will allow it to
realize the net deferred tax asset. However, there can be no
assurance that the Company will continue profitability or, if it
does, that profits will be sufficient to utilize the net deferred
tax asset.
At December 31, 1997, the Company's current ratio was 2.42 to 1
compared with 1.58 to 1 at December 31, 1996 and working capital
increased over the same period to $2,006,800 from $1,284,700.
Total assets exceeded total liabilities by $2,042,300 at December
31, 1997 compared with $1,176,300 at December 31, 1996.
The Company believes that its cash flow from operations, together
with bank borrowings, will be sufficient to support operations
during the next twelve months. The foregoing statement of how
long the Company's capital resources are expected to last is a
forward-looking statement involving risks and uncertainties,
including the amount of the Company's sales and the ability of
the Company to control its operating expenses and the need to
invest in sales and marketing activities in 1998. However, if
sales decline from current levels, additional debt or equity
financing may be required. There can be no assurance that
financing, if required, would be available on favorable terms or
at all or that such financing will not significantly dilute the
ownership interests and rights of existing shareholders. The
Company has a line of credit, of which none had been utilized and
$1,000,000 remained available under the formula applied to net
accounts receivable at December 31,1997. This line of credit
expires on March 30, 1999.
Factors Affecting Future Results
During 1997 26.6% of the Company's net sales were to Japan,
Taiwan and South Korea. Although the financial crisis in that
region of the world has not yet had any noticeable negative
effect on the Company's sales, there is no assurance that sales
will not be negatively affected if the crisis worsens, or is
prolonged.
Sales of pool panel products have slowed somewhat in January and
February of 1998 due to severe weather conditions in both
California and Florida as a consequence of El Nino. However, the
Company does not expect that the El Nino weather pattern will
significantly affect sales of pool panel products over the long
term. However, if this weather pattern becomes more severe
and/or lasts into the peak pool panel selling season of March
through July, there is no assurance that sales will not be
substantially negatively affected. In addition, the effect on a
particular quarter's results of operations could be substantial.
The Company has reviewed its internal computer systems for year
2000 compliance and is satisfied that all of its internal
computer systems are either already year-2000 compliant or can be
made year-2000 compliant through simple, inexpensive upgrades.
The Company does not expect the costs of achieving full year-2000
compliance to be material. However, there can be no assurance
that coding errors or other defects will not be discovered in the
future.
Export sales are subject to certain controls and restrictions,
including tariffs and import duties and are subject to certain
risks, including changing regulatory requirements of foreign
jurisdictions and transportation delays and interruptions;
however, the Company has not experienced any material
difficulties in the past relating to such limitations. The
financial crisis in Southeast Asia has not had any noticeable
negative effecct on sales; however, there is no assurance that
sales will not be negatively affected if the crisis worsens or is
prolonged.
Corporate Directory and Information
Board of Directors
Freeman A. Ford
Chairman of the Board, President, and
Chief Executive Officer
FAFCO, Inc.
William A. Berry*
Senior Vice President and
Chief Financial Officer
Electric Power Research Institute
a private, nonprofit, research organization
doing collaborative research for the
electricity industry.
Robert W. Selig, Jr.*
President
Davis Instruments Corporation
a manufacturer of marine and weather
equipment.
_________________________
*Audit Committee Member
Executive Officers
Freeman A. Ford
Chairman of the Board, President, and
Chief Executive Officer
Alex N. Watt
Vice President, Finance and Administration,
Chief Financial Officer, and Secretary
David K. Harris
Vice President, Pool Products
Transfer Agent and Registrar
Continental Stock Transfer & Trust Company
2 Broadway
New York, NY 10004
Telephone: (212) 509-4000
Legal Counsel
Wilson, Sonsini, Goodrich & Rosati
A Professional Corporation
650 Page Mill Road
Palo Alto, California 94304
Independent Accountants
Burr, Pilger & Mayer
A Professional Corporation
261 Hamilton Avenue
Palo Alto, California 94301
Form 10-K
A copy of the Company's Annual Report on Form 10-K filed with the
Securities and Exchange Commission, including financial statement
schedules but excluding exhibits, is available without charge
upon written request to:
FAFCO, Inc.
2690 Middlefield Road
Redwood City, California 94063-3455
Attention: Alex N. Watt
Annual Shareholders' Meeting
The Annual Shareholders' Meeting will be held at 3:00 p.m. on May
14, 1998 at FAFCO, Inc., 2690 Middlefield Road, Redwood City,
California 94063-3455, Telephone: (650) 363-2690