UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: April 30, 2006
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or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 0-5411
HERLEY INDUSTRIES, INC.
-----------------------
(Exact name of registrant as specified in its charter)
DELAWARE #23-2413500
-------- -----------
(State or other jurisdiction (I.R.S. Employer Identification
of incorporation or organization) Number)
101 North Pointe Boulevard, Lancaster, Pennsylvania 17601
- --------------------------------------------------- -----
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, including Area Code: (717) 735-8117
--------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
[X] Yes [ ] No
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
[ ] Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
[ ] Yes [X] No
As of June 5, 2006 - 14,649,916 shares of Common Stock.
EXPLANATORY NOTE
As explained in a press release issued on June 6, 2006, the U.S. Attorney's
office for the Eastern District in Pennsylvania has indicted the Company and its
former Chairman, Lee N. Blatt on multiple charges in connection with purported
activities resulting in alleged excessive profits by the Company on three
contracts with the U.S. Department of Defense. The Company's Board of Directors
has retained outside counsel who has conducted an independent investigation and
review of the allegations. The Board of Directors believes that, based on
information currently available to it, no criminal conduct has occurred and the
Company will vigorously contest the charges.
The Company has been advised by BDO SEIDMAN, LLP, the Company's Independent
Registered Public Accountants, that, due to their need to complete review
procedures in connection with the Board's investigation, BDO SEIDMAN, LLP is
unable at this time to complete its review of Herley Industries, Inc.'s
consolidated financial statements set forth herein in accordance with
established professional standards and procedures for conducting such reviews,
as established by generally accepted auditing standards, which review is
required by Rule 10-01(d) of Regulation S-X.
The Company understands that the staff of the Securities and Exchange Commission
(the "staff") has taken the position that this report is deficient because the
interim financial statements contained in this report have not been reviewed by
an independent registered public accountant as required by Rule 10-01(d) of
Regulation S-X. Pursuant to the position taken by the staff, the Company is
deemed not to be current in its filings required under the Securities Exchange
Act of 1934, as amended. The Company understands that completion of a review of
its interim financial statements and the filing of an amendment will make this
report current, although it will not be deemed timely for purposes of the rules
governing eligibility to use registration statements on Forms S-2 and S-3. When
the review is complete, the Company will file an amendment to this report which
will include the required certifications of the Company's Chief Executive
Officer and Acting Chief Financial Officer as required by Sections 302 and 906
of the Sarbanes-Oxley Act.
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
INDEX TO FORM 10-Q
PAGE
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PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements:
Consolidated Balance Sheets -
April 30, 2006 and July 31, 2005 2
Consolidated Statements of Income -
For the Thirteen and Thirty-nine weeks ended
April 30, 2006 and May 1, 2005 3
Consolidated Statement of Shareholders' Equity-
For the Thirty-nine weeks ended April 30, 2006 4
Consolidated Statements of Cash Flows -
For the Thirty-nine weeks ended
April 30, 2006 and May 1, 2005 5
Notes to Consolidated Financial Statements 6
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 16
Item 3 - Quantitative and Qualitative Disclosures About Market Risk 20
Item 4 - Controls and Procedures 20
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings 20
Signatures 22
Part I - Financial Information
Item 1 - Financial Statements
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(In thousands, except share data)
April 30, July 31,
2006 2005
---------- ----------
ASSETS
Current Assets:
Cash and cash equivalents $ 27,364 $ 20,331
Trade accounts receivable 30,148 27,258
Costs incurred and income recognized in excess
of billings on uncompleted contracts 18,494 16,058
Other receivables 1,131 1,414
Inventories, net of allowance of $5,168
in fiscal 2006 and $4,492 in fiscal 2005 53,639 53,668
Deferred taxes and other 4,317 3,782
---------- ----------
Total Current Assets 135,093 122,511
Property, Plant and Equipment, net 30,133 29,461
Goodwill 73,500 70,831
Intangibles, net of accumulated amortization of $3,021
in fiscal 2006 and $1,680 in fiscal 2005 20,525 20,554
Other Assets 650 744
---------- ----------
$ 259,901 $ 244,101
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Current portion of long-term debt $ 221 $ 797
Accounts payable and accrued expenses 22,877 23,678
Billings in excess of costs incurred and
income recognized on uncompleted contracts 410 538
Income taxes payable 2,953 3,760
Accrual for contract losses 3,158 630
Accrual for warranty costs 715 799
Advance payments on contracts 5,109 3,966
---------- ----------
Total Current Liabilities 35,443 34,168
Long-term Debt 4,756 5,000
Other Long-term Liabilities 1,246 1,042
Deferred Income Taxes 7,182 6,254
---------- ----------
48,627 46,464
---------- ----------
Commitments and Contingencies
Shareholders' Equity:
Common stock, $.10 par value; authorized
20,000,000 shares; issued and outstanding
14,634,916 in fiscal 2006 and 14,389,625 in fiscal 2005 1,463 1,439
Additional paid-in capital 112,899 109,118
Retained earnings 95,573 85,932
Accumulated other comprehensive income 1,339 1,148
---------- ----------
Total Shareholders' Equity 211,274 197,637
---------- ----------
$ 259,901 $ 244,101
========== ==========
The accompanying notes are an integral part of these financial statements.
2
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(In thousands except per share data)
Thirteen weeks ended Thirty-nine weeks ended
-------------------- -----------------------
April 30, May 1, April 30, May 1,
2006 2005 2006 2005
------------ -------- ------------ ----------
Net sales $ 45,689 $ 41,266 $ 133,466 $ 108,610
------------ -------- ------------ ----------
Cost and expenses:
Cost of products sold 34,736 27,845 94,900 75,034
Selling and administrative expenses 8,960 8,865 25,785 21,541
------------ -------- ------------ ----------
43,696 36,710 120,685 96,575
------------ -------- ------------ ----------
Operating Income 1,993 4,556 12,781 12,035
------------ -------- ------------ ----------
Other income (expense), net:
Investment income 269 253 578 769
Interest expense (68) (74) (242) (211)
Foreign exchange gain 170 79 273 264
------------ -------- ------------ ----------
371 258 609 822
------------ -------- ------------ ----------
Income before income taxes 2,364 4,814 13,390 12,857
Provision for income taxes 662 1,187 3,749 3,600
------------ -------- ------------ ----------
Net income $ 1,702 $ 3,627 $ 9,641 $ 9,257
============ ======== ============ ==========
Earnings per common share - Basic $ .12 $ .25 $ .67 $ .65
============ ======== ============ ==========
Basic weighted average shares 14,569 14,313 14,497 14,300
============ ======== ============ ==========
Earnings per common share - Diluted $ .11 $ .24 $ .63 $ .62
============ ======== ============ ==========
Diluted weighted average shares 15,398 14,936 15,230 14,972
============ ======== ============ ==========
The accompanying notes are an integral part of these financial statements.
3
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED)
Thirty-nine weeks ended April 30, 2006
(In thousands except share data)
Accumulated
Additional Other
Common Stock Paid-in Retained Comprehensive
Shares Amount Capital Earnings Income Total
------------- -------- ---------- --------- ------------- ----------
Balance at July 31, 2005 14,389,625 $ 1,439 109,118 85,932 1,148 $ 197,637
Exercise of stock options 245,291 24 2,775 2,799
Stock option compensation 333 333
Tax benefit upon exercise of stock
options 673 673
------------- -------- ---------- --------- ------------- ----------
Subtotal 14,634,916 $ 1,463 112,899 85,932 1,148 $ 201,442
------------- -------- ---------- --------- ------------- ----------
Net income 9,641 9,641
Other comprehensive income, net of tax:
Unrealized gain on interest rate swap 33 33
Foreign currency translation gain 158 158
----------
Comprehensive income 9,832
------------- -------- ---------- --------- ------------- ----------
Balance at April 30, 2006 14,634,916 $ 1,463 112,899 95,573 1,339 $ 211,274
============= ======== ========== ========= ============= ==========
The accompanying notes are an integral part of these financial statements.
4
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
Thirty-nine weeks ended
-----------------------
April 30, May 1,
2006 2005
------------ -----------
Cash flows from operating activities:
Net income $ 9,641 $ 9,257
------------ -----------
Adjustments to reconcile net income to
net cash provided by operations:
Depreciation and amortization 5,266 3,825
Stock-based compensation expense 333 -
Increase in deferred tax assets (127) -
Increase in deferred tax liabilities 913 -
Foreign exchange (gain) loss (55) 31
Gain on sale of securities - (22)
Equity in income of limited partnership (49) (54)
Changes in operating assets and liabilities:
(Increase) decrease in trade accounts receivable (2,890) 4,996
(Increase) in costs incurred and income
recognized in excess of billings on
uncompleted contracts, and claims (2,436) (3,569)
Decrease (Increase) in other receivables 283 (269)
Decrease (Increase) in inventories 29 (3,341)
(Increase) in deferred taxes and other (535) (400)
(Decrease) increase in accounts payable
and accrued expenses (801) 1,677
(Decrease) in billings in excess of
costs incurred and income recognized
on uncompleted contracts (128) (1,206)
(Decrease) increase in income taxes payable (807) 2,842
Increase (decrease) in accrual for contract losses 24 (377)
Increase (decrease) in advance payments on contracts 1,143 (1,410)
Other, net 205 293
------------ -----------
Total adjustments 368 3,016
------------ -----------
Net cash provided by operating activities 10,009 12,273
------------ -----------
Cash flows from investing activities:
Acquisition of businesses, net of cash acquired - (51,391)
Acquisition of technology license (1,256) (2,000)
Proceeds from sale of securities - 165
Partial distribution from limited partnership 111 109
Capital expenditures (4,525) (4,948)
------------ -----------
Net cash used in investing activities (5,670) (58,065)
------------ -----------
Cash flows from financing activities:
Borrowings under bank line of credit 12,000 -
Proceeds from exercise of stock options 2,799 1,803
Payments of long-term debt (779) (780)
Purchase of treasury stock - (1,770)
Payments under bank line of credit (12,000) -
Income tax benefit from exercise of stock options 674 345
------------ -----------
Net cash provided by (used in) financing activities 2,694 (402)
------------ -----------
Net increase in cash and cash equivalents 7,033 (46,194)
Cash and cash equivalents at beginning of period 20,331 66,181
------------ -----------
Cash and cash equivalents at end of period $ 27,364 $ 19,987
============ ===========
The accompanying notes are an integral part of these financial statements.
5
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED)
1. Interim Reporting
The accompanying unaudited consolidated financial statements have been
prepared in accordance with instructions to Form 10-Q and do not include
all of the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial
statements. The Company's independent registered public accountants were
unable to complete their review of the accompanying unaudited consolidated
financial statements at this time due to their need to complete review
procedures in connection with the indictments discussed in Note 14 to the
consolidated financial statements. In the opinion of management, all
adjustments (consisting of normal recurring accruals) considered necessary
for a fair presentation have been included. Operating results for interim
periods are not necessarily indicative of the results of operations that
may be expected for a full year. These statements should be read in
conjunction with the consolidated financial statements and notes thereto,
and the Company's description of critical accounting policies, included in
the Company's 2005 Annual Report on Form 10-K/A Amendment 1 for the fiscal
year ended July 31, 2005, as filed with the Securities and Exchange
Commission.
The Company understands that the staff of the Securities and Exchange
Commission (the "staff") has taken the position that this report is
deficient because the interim financial statements contained in this report
have not been reviewed by an independent registered public accountant as
required by Rule 10-01(d) of Regulation S-X. Pursuant to the position taken
by the staff, the Company is deemed not to be current in its filings
required under the Securities Exchange Act of 1934, as amended. The Company
understands that completion of a review of its interim financial statements
and the filing of an amendment will make this report current, although it
will not be deemed timely for purposes of the rules governing eligibility
to use registration statements on Forms S-2 and S-3.
The unaudited consolidated financial statements include the accounts of
Herley Industries, Inc. and its wholly-owned subsidiaries, collectively
referred to as the "Company." All significant intercompany accounts and
transactions have been eliminated.
Certain prior period balances have been reclassified to conform to the
current period's financial statement presentation.
2. Acquisitions
The Company entered into an agreement as of September 1, 2004 to purchase
the majority of the assets and assume the majority of the liabilities of
Reliable System Services Corporation of Melbourne, Florida for $3,725,000
in cash, plus acquisition costs of approximately $28,000. The results of
operations of RSS are included in the consolidated financial statements
from September 1, 2004. The Company operates the business as a wholly-owned
subsidiary under the name Herley-RSS, Inc. ("RSS"). RSS was acquired by
Herley in order to capitalize on its synergies with Herley's other product
lines, particularly in "over the horizon" command and control (C2) systems
for drones and targets. RSS designs, develops and produces satellite-based
command and control systems for prime defense contractors and entities
worldwide.
The Company entered into an agreement as of February 1, 2005 to acquire all
of the capital stock of Micro Systems, Inc. ("MSI"), Fort Walton Beach,
Florida for payments of $21,473,328 in cash, plus acquisition costs accrued
of approximately $16,000, and the assumption of certain liabilities. The
results of operation of MSI are included in the consolidated financial
statements from February 1, 2005. MSI was acquired by Herley in order to
capitalize on its synergies with Herley's legacy product lines, consolidate
operations, addition of engineers and increase its capabilities in the area
of control avionics, and target control systems. MSI is a market leader in
the design and manufacturing of command and control systems for operation
of unmanned aerial, seaborne and ground targets and missiles.
The Company entered into an agreement as of April 1, 2005 to acquire all of
the capital stock of Innovative Concepts, Inc. ("ICI"), McLean, Virginia
for cash payments of $24,378,330, the assumption of certain liabilities,
and a cash advance of $3,250,000 for the repayment of debt assumed. The
results of operations of ICI are included in the consolidated financial
statements from April 1, 2005. ICI was acquired by Herley in order to
capitalize on its tactical data link technology for exchange of digital
information. ICI has a successful history of developing and providing
wireless communications technology and real-time embedded systems,
software, hardware and high-speed processing in support of the defense
industry.
All of the acquisitions completed by the Company are accounted for in
accordance with the provisions of SFAS No. 141, "Business Combinations",
which requires that all business combinations be accounted for using the
purchase method.
6
For the three acquisitions outlined above, the allocation of the aggregate
purchase price (net of cash acquired of approximately $1,463,000), based on
a review of the fair value of the assets acquired and liabilities assumed,
is as follows (in thousands):
Acquisition RSS MSI ICI
Effective Date September 1, 2004 February 1, 2005 April 1, 2005
-------------- ----------------- ---------------- --------------
Current assets $ 483 $1,534 $8,759
Property, plant and equipment 72 2,038 681
Other assets - 1 -
Intangible assets - 4,400 10,200
Goodwill 3,456 15,148 19,693
Current liabilities (258) (2,436) (12,364)
-------- -------- --------
Aggregate purchase price $ 3,753 $ 20,685 $ 26,969
======== ======== ========
The Company adjusted its valuation of the assets acquired and liabilities
assumed in the acquisition of ICI in accordance with the provisions of SFAS
No. 141 during the second quarter of fiscal 2006. Accordingly, the
Company's consolidated financial statements reflect an adjustment of
$2,504,000 to the reserve for contract losses relating to a contract in
ICI's backlog at the date of acquisition.
Prior to the acquisition of MSI, MSI had leased one of its two buildings in
Fort Walton Beach, Florida from MSI Investments, a Florida General
Partnership. MSI Investments is owned by four individuals, three of whom
are currently employees of MSI. This lease has an original term of 15
years, ending December 31, 2012. The lease costs currently are
approximately $287,000 on an annual basis, including the tenant's
obligation to pay for insurance and property taxes. The base lease rate is
adjusted every January for changes in the consumer price index, using 1997
as the base year.
3. Claims on Major Contracts
Claims include amounts in excess of the original contract price (as it may
be adjusted for approved change orders) that we seek to collect from our
customers for delays, errors in specifications and designs, contract
terminations, change orders in dispute or unapproved as to both scope and
price, or other causes of unanticipated additional costs and are included
in estimated revenues when recovery of the amounts is probable and the
costs can be reasonably estimated. Claims receivable in the amount of $2.2
million at April 30, 2006 are included in costs incurred and income
recognized in excess of billings on uncompleted contracts on the
accompanying Consolidated Balance Sheets.
4. Inventories
Inventories at April 30, 2006 and July 31, 2005 are summarized as follows
(in thousands):
April 30, 2006 July 31, 2005
-------------- -------------
Purchased parts and raw materials $ 25,124 $ 23,838
Work in process 31,414 32,026
Finished products 2,269 2,296
-------- --------
58,807 58,160
Less reserve for excess and obsolete materials 5,168 4,492
-------- --------
$ 53,639 $ 53,668
======== ========
5. Goodwill and Other Intangible Assets
The Company adopted the provisions of SFAS No. 142 "Goodwill and Other
Intangible Assets" on July 30, 2001. SFAS No. 142 requires the use of a
non-amortization approach to account for purchased goodwill and certain
intangibles. Under a non-amortization approach, goodwill and certain
intangibles are not amortized into results of operations, but instead are
reviewed for impairment and written down and charged to results of
operations in the periods in which the recorded value of goodwill and
certain intangibles is more than its fair value. The adoption of SFAS No.
142 resulted in the Company's discontinuation of amortization of its
goodwill and certain intangible assets. An annual impairment test is
performed in the fourth quarter of each fiscal year and any future
impairment of goodwill will be charged to operations.
7
The change in the carrying amount of goodwill for the nine months ended
April 30, 2006 is as follows (in thousands):
Balance at July 31, 2005 $ 70,831
Change in fair value of liabilities assumed
in connection with the ICI acquisition (Note 2) 2,504
Foreign currency translation adjustment 165
--------
Balance at April 30, 2006 $ 73,500
========
Intangible Assets consist of the following (in thousands):
April 30, July 31, Estimated
2006 2005 useful life
--------- --------- -----------
Trademarks (acquired with MSI and ICI) $ 2,800 $ 2,800 Indefinite
Technology (acquired with EWST and MSI) 12,421 12,421 10-15 years
Drawings 800 800 15 years
Patents 568 568 14 years
Backlog 3,125 3,125 2-5 years
Non-compete 31 31 5 years
Foreign currency translation adjustment 245 189
------- -------
19,990 19,934
Accumulated amortization 3,021 1,680
------- -------
16,969 18,254
Technology license (for millimeter wave applications; purchased from Xytrans) 3,556 2,300 (see below)
------- -------
$20,525 $20,554
======= =======
The Company entered into a license and development agreement ("agreement")
on April 7, 2005 to license millimeter wave technology for military
applications from Xytrans, Inc. Xytrans focuses on providing high-frequency
transceiver and outdoor unit design for the wireless broadband network
market. The technology acquired includes exclusive access to a portfolio of
patents and trade secrets that improve the cost and performance of
millimeter wave subsystems that are used in weapons and radar systems.
In January 2005, the Company had made a deposit payment of $1,000,000 in
connection with this proposed transaction. The deposit payment was secured
by a note receivable, which was cancelled upon execution of the agreement.
The agreement provided for an additional payment on execution of
$1,000,000, and for certain additional contingent payments, of up to
$4,500,000. These contingent payments are subject to achievement of a
series of development milestones on a US Government missile program, and /
or receipt by the Company of a single contract award using millimeter wave
technology valued at a minimum of $6,000,000, amongst other requirements.
The agreement also provides for the payment of royalties ranging from 1% to
4% of sales of products including relevant millimeter wave technology,
starting at the earliest January 1, 2006, and generally ending 4 years
later. No royalties have been earned as of April 30, 2006.
As of April 30, 2006, Xytrans had achieved the development milestones on
the missile program discussed above and the Company made additional
contingent payments totaling $1,500,000. Additional development costs as a
result of a scope change were paid in the net amount of $56,000.
The investment in this licensed technology of $3,556,000 as of April 30,
2006 is included in the accompanying Consolidated Balance Sheets under the
caption "Intangibles." After further development of this technology, and /
or at the commencement of sales of products using the millimeter wave
technology, the Company will begin to amortize the costs associated with
this agreement based on the estimated economic life of the technology
acquired.
The carrying amount of intangibles is reviewed for recoverability when
events or changes in circumstances occur that indicate that the carrying
value of the assets may not be recovered.
8
Amortization expense for the thirteen weeks ended April 30, 2006 and May 1,
2005 was approximately $447,000 and $232,000, respectively, and for the
thirty-nine weeks ended April 30, 2006 and May 1, 2005 was approximately
$1,341,000 and $410,000, respectively.
Estimated aggregate amortization expense for each of the next five fiscal
years, is as follows (in thousands):
2006 $ 1,788
2007 1,788
2008 1,782
2009 1,782
2010 1,502
6. Product Warranties
The Company warrants its products generally for a period of one year.
Product warranty costs are accrued based on historical claims expense.
Accrued warranty costs are reduced as warranty repair costs are incurred.
The following table presents the change in the accrual for product warranty
costs for the quarter and nine months ended April 30, 2006 (in thousands):
Thirteen weeks ended Thirty-nine weeks ended
-------------------- -----------------------
April 30, May 1, April 30, May 1,
2006 2005 2006 2005
-------- ------- -------- --------
Balance at beginning of period $ 746 $ 583 $ 799 $ 580
Provision for warranty obligations 98 449 347 762
Warranty costs charged to the reserve (129) (246) (431) (556)
---------- ---------- ---------- ---------
Balance at end of period $ 715 $ 786 $ 715 $ 786
========== ========== ========== =========
7. Litigation
As previously reported, there has been a continuing investigation by the
U.S. Attorneys' Office in Pennsylvania which, inter alia, involves pricing
under contracts with the U.S. Department of Defense relating to voltage
control oscillators and powerheads. The contracts aggregate approximately
$3.9 million in total revenue.
On June 6, 2006 an indictment was returned against the Company and Lee
Blatt, its former Chairman. No other officer or director of the Company was
named in the indictment. The indictment alleges 29 counts of violations of
the wire fraud statute (18 U.S.C. Section 1343); 2 counts of violations of
the obstruction of a federal audit statute (18 U.S.C. Section 1516); 1
count of violating the major fraud against the United States statute (18
U.S.C. Section 1031); 3 counts of violating the false statements to the
government statute (18 U.S.C. Section 1001) and a notice of forfeiture. The
Company believes that no criminal conduct has occurred and will vigorously
contest the charges.
The Company is involved in various other legal proceedings and claims which
arise in the ordinary course of its business. While any litigation contains
an element of uncertainty, management believes that the outcome of such
other litigation will not have a material adverse effect on the Company's
financial position or results of operations.
8. Comprehensive Income
The components of comprehensive income are as follows (in thousands):
Thirteen weeks ended Thirty-nine weeks ended
-------------------- -----------------------
April 30, May 1, April 30, May 1,
2006 2005 2006 2005
--------- ------- ---------- -------
Net income $ 1,702 $ 3,627 $ 9,641 $ 9,257
Unrealized gain on interest rate swap 15 17 33 4
Foreign currency translation gain 152 115 158 394
----------- -------- ----------- ----------
Comprehensive income $ 1,869 $ 3,759 $ 9,832 $ 9,655
=========== ======== =========== ==========
The components of accumulated other comprehensive income is as follows (in
thousands):
9
April 30, 2006 July 31, 2005
-------------- -------------
Unrealized loss on interest rate swap $ (22) $ (55)
Foreign currency translation gain 1,361 1,203
-------- --------
Accumulated other comprehensive income $ 1,339 $ 1,148
======== ========
9. Stock-Based Compensation
The Company has various fixed stock option plans which are described in
Note M of the Company's 2005 Annual Report on Form 10-K/A Amendment 1 that
provide for the grant of stock options to eligible employees and directors.
Effective August 1, 2005, the Company adopted the fair value recognition
provisions of Statement of Financial Accounting Standard 123R ("SFAS 123R")
using the modified prospective application method. This standard requires
the Company to measure the cost of employee services received in exchange
for equity share options granted based on the grant-date fair value of the
options. The cost is recognized as compensation expense over the requisite
service period for each separately vesting portion of the options. Under
the modified prospective application method, compensation cost included in
operating expenses in the thirteen and thirty-nine weeks ended April 30,
2006 is approximately $120,000 and $333,000, respectively, and includes:
(a) compensation cost of stock options granted prior to but not yet vested
as of August 1, 2005 (based on grant-date fair value estimated in
accordance with the provisions of SFAS 123), and (b) compensation cost for
all options granted subsequent to July 31, 2005 (based on grant-date fair
value estimated in accordance with the new provisions of SFAS 123R).
Operating income and income before taxes were reduced for the quarter and
nine months by approximately $120,000 and $333,000, respectively, while net
income was reduced by approximately $86,000 and $240,000 respectively, or
approximately $0.01 and $0.02 for the quarter and nine months respectively,
per basic and diluted share.
Income tax benefits relating to the exercise of stock options during the
thirty-nine weeks ended April 30, 2006 and May 1, 2005 amounting to
$673,000 and $345,000 respectively are classified as a financing cash
inflow in the Company's Consolidated Statements of Cash Flows. Prior to the
adoption of SFAS 123R the Company presented all income tax benefits related
to stock-based compensation as an operating cash inflow.
As of April 30, 2006, there were 3,495,880 stock options outstanding. The
aggregate value of unvested options, as determined using a Black-Scholes
option valuation model was approximately $682,000 (net of estimated
forfeitures). During the quarter ended April 30, 2006, the Company granted
9,000 non-qualified stock options, with a fair value of approximately
$49,000. Options for 157,279 shares of common stock were exercised, and
4,021 options were forfeited during the third quarter. New option grants
made after July 31, 2005, as well as option grants issued prior to that
date have been valued using a Black-Scholes option valuation model.
Prior to adopting SFAS 123R on August 1, 2005, the Company's equity based
employee compensation expense under the various stock option plans was
accounted for under the recognition and measurement principles of APB
Opinion No. 25, "Accounting for Stock Issued to Employees", and related
interpretations. Under the modified prospective application method, results
for prior periods have not been restated to reflect the effects on
implementing SFAS 123R. Therefore, for the thirteen and thirty-nine weeks
ended May 1, 2005, no option based employee compensation cost is reflected
in net income, as all options granted under those plans had an exercise
price equal to the underlying common stock price on the date of grant. The
following table which is presented for comparative purposes, provides the
pro forma information as required by SFAS No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure, an amendment of FASB
Statement No. 123," and illustrates the effect on net income and earnings
per common share for the period presented as if the Company had applied the
fair value recognition provisions of FASB Statement No. 123, "Accounting
for Stock-Based Compensation", to stock based employee compensation prior
to August 1, 2005:
Thirteen weeks ended Thirty-nine weeks ended
May 1, 2005 May 1, 2005
----------- ------------
Net income - as reported $ 3,627 $ 9,257
Deduct: total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (207) (985)
------------- -------------
Net income - pro forma $ 3,420 $ 8,272
============= =============
Earnings per share - as reported
Basic $ 0.25 $ 0.65
Diluted 0.24 0.62
Earnings per share - pro forma
Basic $ 0.24 $ 0.58
Diluted 0.23 0.55
10
The weighted average fair value of stock options on the date of grant, and
the assumptions used to estimate the fair value of stock options issued
during the periods presented using the Black-Scholes option valuation model
are as follows:
Thirteen weeks ended Thirty-nine weeks ended
-------------------- -----------------------
April 30, May 1, April 30, May 1,
2006 2005 2006 2005
--------- -------- ---------- ---------
Weighted average fair value of options granted $ 5.45 $ 4.00 $ 6.50 $ 4.00
Expected life (years) 1.95 3.69 3.23 3.69
Expected volatility 0.44 0.44 0.44 0.44
Risk-free interest rate 4.28 3.80 4.28 3.80
Expected dividend yield zero zero zero zero
The expected life of options granted during the periods presented above is
based on the Company's historical share option exercise experience using
the historical expected term from vest date. The expected volatility of the
options granted is determined using historical volatilities based on
historical stock prices. The risk-free interest rate is determined using
the yield available for zero-coupon U.S. government issues with a remaining
term equal to the expected life of the options. The Company has never paid
a dividend, and as such the dividend yield is zero.
The following table summarizes the non-qualified stock option activity
during the thirty-nine weeks ended April 30, 2006:
Weighted Aggregate
Average Intrinsic
Number Price Range Exercise Value (1)
of shares per share Price (in thousands)
--------- ------------ ------------- --------------
Outstanding July 31, 2005 3,735,530 $ 4.06 - 20.45 $ 14.41
Granted 10,500 18.57 18.57
Exercised (79,250) 4.31 - 19.83 11.33
Cancelled (2,000) 19.83 19.83
-------------- ---------------- -------------
Outstanding October 30, 2005 3,664,780 $ 4.06 - 20.45 $ 14.49 $ 11,394
Exercisable October 30, 2005 3,481,280 $ 14.28 $ 11,394
Granted 19,500 17.11 - 20.85 18.59
Exercised (10,100) 8.38 - 13.10 10.00
Cancelled (26,000) 19.03 - 19.83 19.26
-------------- ---------------- -------------
Outstanding January 29, 2006 3,648,180 $ 4.06 - 20.85 $ 14.49 $ 12,104
Exercisable January 29, 2006 3,445,180 $ 14.28 $ 12,104
Granted 9,000 20.09 20.09
Exercised (157,279) 8.38 - 19.83 11.60
Cancelled (4,021) 17.98 - 18.39 17.98
-------------- ---------------- -------------
Outstanding April 30, 2006 3,495,880 $ 4.06 - 20.85 $ 14.63 $ 22,899
Exercisable April 30, 2006 3,287,880 $ 14.41 $ 22,270
Vested and expected to vest 3,466,752 $ 14.60 $ 22,810
<FN>
(1) There are no vested options with an exercise price greater than the closing stock price of $21.18 as of April 30, 2006.
</FN>
11
Options outstanding and exercisable by price range as of April 30, 2006,
with expiration dates ranging from January 3, 2007 to May 2, 2015 are as
follows:
Options Outstanding Options Exercisable
------------------- -------------------
Weighted
Average Weighted Weighted
Range of Exercise Number Remaining Average Number Average
Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
- --------------------------------------------------------------------------------------------------------------------
4.06 - 10.46 1,132,780 3.9 $ 9.26 1,132,780 $ 9.26
10.50 - 17.50 678,100 4.9 13.32 666,100 13.25
17.98 859,000 6.4 17.98 690,000 17.98
18.57 - 19.83 779,500 5.1 19.54 769,000 19.55
19.94 - 20.85 46,500 5.0 20.34 30,000 20.28
--------------- --------- ---- ------------ ---------- -------------
4.06 - 20.85 3,495,880 5.0 $ 14.63 3,287,880 $ 14.41
========= ==========
As of April 30, 2006, the total future compensation cost related to
nonvested options not yet recognized in the consolidated statement of
income was approximately $883,000 ($682,000 net of estimated forfeitures)
and the weighted average period over which these options are expected to be
recognized was 2.0 years.
10. Earnings Per Share ("EPS")
The following table shows the components used in the calculation of basic
earnings per share and earnings per share assuming dilution (in thousands):
Thirteen weeks ended Thirty-nine weeks ended
-------------------- -----------------------
April 30, May 1, April 30, May 1,
2006 2005 2006 2005
--------- ------ ---------- ------
Numerator:
Net Income $1,702 $3,627 $9,641 $9,257
====== ====== ====== ======
Denominator:
Basic weighted-average shares 14,569 14,313 14,497 14,300
Effect of dilutive securities:
Employee stock options 829 623 733 672
------ ------ ------ ------
Diluted weighted-average shares 15,398 14,936 15,230 14,972
====== ====== ====== ======
Stock options not included in computation 376 875 1,015 787
====== ====== ====== ======
Expercise Price Range $17.11 - $20.85 $18.39 - $20.45 $17.11 - $20.85 $18.85 - $20.45
The number of stock options not included in the computation of diluted EPS
relates to stock options having exercise prices which are greater than the
average market price of the common shares during the periods presented, and
therefore, are anti-dilutive. The options which were outstanding as of April 30,
2006 expire at various dates through February 4, 2015.
12
11. Geographic Information
The Company operates as a single integrated business and as such has one
operating segment. Geographic net sales for the third quarter, based on
place of contract performance, were as follows (in thousands):
Thirteen weeks ended Thirty-nine weeks ended
-------------------- -----------------------
April 30, May 1, April 30, May 1,
2006 2005 2006 2005
--------- --------- --------- ---------
United States $ 40,069 $ 35,378 $ 117,677 $ 92,353
Israel 3,887 3,350 10,307 9,534
England 1,733 2,538 5,482 6,723
------------- ------------- ------------- -------------
45,689 41,266 133,466 108,610
============= ============= ============= =============
Net property, plant and equipment by geographic area was as follows (in
thousands):
April 30, 2006 July 31, 2005
-------------- -------------
United States $ 24,927 $ 24,318
Israel 4,592 4,376
England 614 767
-------------- -------------
$ 30,133 $ 29,461
12. Supplemental cash flow information is as follows (in thousands):
Thirty-nine weeks ended
-----------------------
April 30, 2006 May 1, 2005
-------------- -----------
Net cash paid during the period for:
Interest $ 219 $ 229
Income taxes 2,960 296
13. New Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 151, "Inventory Costs, an
amendment of APB No. 43, Chapter 4" ("SFAS 151.") SFAS 151 clarifies that
abnormal inventory costs such as costs of idle facilities, excess freight
and handling costs, and wasted materials (spoilage) are required to be
recognized as current period charges. The provisions of SFAS 151 are
effective for fiscal years beginning after June 15, 2005. Management
adopted this standard on August 1, 2005, and has determined that the
adoption of SFAS 151 did not have a material impact on the consolidated
financial position, result of operations or cash flows of the Company.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary
Assets - An Amendment of APB Opinion No. 29". SFAS No. 153 eliminates the
exception from fair value measurement for nonmonetary exchanges of similar
productive assets in paragraph 21(b) of APB Opinion No. 29, "Accounting for
Nonmonetary Transactions," and replaces it with an exception for exchanges
that do not have commercial substance. SFAS No 153 specifies that a
nonmonetary exchange has commercial substance if the future cash flows of
the entity are expected to change significantly as a result of the
exchange. SFAS No. 153 is effective for fiscal periods beginning after June
15, 2005. Management adopted this standard on August 1, 2005, and has
determined that the adoption of SFAS 153 did not have a material impact on
the consolidated financial position, result of operations or cash flows of
the Company.
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment,"
which is a revision of SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123(R).") SFAS 123(R) is effective for publicly-traded
companies for interim or annual periods beginning after June 15, 2005,
supersedes Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash
Flows." Management adopted this standard on August 1, 2005. See Note 9 for
a discussion of the impact on the consolidated financial position, result
of operations and cash flows of the Company upon adoption of SFAS 123(R).
13
In March of 2005, the SEC issued Staff Accounting Bulletin No. 107,
"Share-Based Payment," ("SAB 107"), which provides interpretive guidance
related to the interaction between SFAS 123R and certain SEC rules and
regulations, as well as provides the SEC staff's views regarding the
valuation of share-based payment arrangements. The Company has incorporated
SAB 107 in the implementation and adoption of SFAS 123R.
In March 2005, the FASB issued FASB Interpretation No. 47, "Accounting for
Conditional Asset Retirement Obligations - An Interpretation of SFAS No.
143." This Interpretation provides additional guidance as to when companies
should record the fair value of a liability for a conditional asset
retirement obligation when there is uncertainty about the timing and (or)
method of settlement of the obligation. This Interpretation is effective no
later than the end of fiscal years ending after December 15, 2005. The
Company does not expect the adoption of FASB Interpretation No. 47 to have
a material impact on its consolidated financial position, results of
operations or cash flows.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections" ("SFAS 154.") SFAS 154 replaces APB Opinion No. 20 "Accounting
Changes" and FASB Statement No. 3 "Reporting Accounting Changes in Interim
Financial Statements." SFAS 154 requires that a voluntary change in
accounting principle be applied retrospectively with all prior period
financial statements presented on the new accounting principle, unless it
is impracticable to do so. SFAS 154 also provides that a correction of
errors in previously issued financial statements should be termed a
"restatement." This new standard will be effective for accounting changes
and correction of errors for fiscal years beginning after December 15,
2005. The Company does not expect that the adoption of SFAS 154 will have a
material impact on its consolidated financial position, results of
operations or cash flows.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments," ("SFAS 155") an amendment of FASB Statements
No. 133 and 140. SFAS 155 permits a fair value remeasurement for any hybrid
financial instrument that contains an embedded derivative that otherwise
would require bifurcation; clarifies which interest-only strips and
principal-only strips are not subject to the requirements of Statement 133;
establishes a requirement to evaluate interests in securitized financial
assets to identify interests that are freestanding derivatives or that are
hybrid financial instruments that contain an embedded derivative requiring
bifurcation; clarifies that concentrations of credit risk in the form of
subordination are not embedded derivatives; and amends Statement 140 to
eliminate the prohibition on a qualifying special-purpose entity from
holding a derivative financial instrument that pertains to a beneficial
interest other than another derivative financial instrument. This new
standard will be effective for all financial instruments acquired or issued
after the beginning of the Company's first fiscal year that begins after
September 15, 2006. The Company does not expect the adoption of SFAS 155 to
have a material impact on its consolidated financial position, results of
operations or cash flows.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets, an amendment of FASB Statements No. 140" ("SFAS 156".)
SFAS 156 requires that servicing assets and servicing liabilities be
recognized at fair value, if practicable, when the Company enters into a
servicing agreement. This new standard will be effective as of the start of
the Company's first fiscal year that begins after September 15, 2006. The
Company does not expect the adoption of SFAS 156 to have a material impact
on its consolidated financial position, results of operations or cash
flows.
13. Subsequent Events
As previously reported, there has been a continuing investigation by the
U.S. Attorneys' Office in Pennsylvania which, inter alia, involves pricing
under contracts with the U.S. Department of Defense relating to voltage
control oscillators and powerheads. The contracts aggregate approximately
$3.9 million in total revenue.
On June 6, 2006 an indictment was returned against the Company and Lee
Blatt, its former Chairman. No other officer or director of the Company was
named in the indictment. The indictment alleges 29 counts of violations of
the wire fraud statute (18 U.S.C. Section 1343); 2 counts of violations of
the obstruction of a federal audit statute (18 U.S.C. Section 1516); 1
count of violating the major fraud against the United States statute (18
U.S.C. Section 1031); 3 counts of violating the false statements to the
government statute (18 U.S.C. Section 1001) and a notice of forfeiture. The
Company believes that no criminal conduct has occurred and will vigorously
contest the charges. If convicted, Mr. Blatt and the Company could be fined
up to approximately $13 million each and the Company could be required to
forfeit approximately $2.9 million paid under the contracts. Under the
terms of an indemnification agreement with Mr. Blatt, the Company has
agreed to provide indemnification with regard to certain legal proceedings
so long as he has acted in good faith and in a manner believed to be in, or
not opposed to, the Company's best interest with respect to any criminal
proceeding and had no reasonable cause to believe his conduct was unlawful.
14
In accordance with FASB Statement No. 5, "Accounting for Contingencies,"
the Company determines whether an estimated loss from a loss contingency
should be accrued by assessing whether a loss is deemed probable and can be
reasonably estimated. Litigation is inherently unpredictable and due to the
uncertainty of the outcome of the matter discussed above, a reasonable
estimate of any liability can not be made. If an unfavorable ruling were to
occur in any specific period, there exists the possibility of a material
adverse impact on the results of operations for that period.
In connection with the legal matter discussed above, the Company was
notified that certain of its operations have been suspended from receiving
new contract awards from the U. S. Government. The affected operations
include facilities in Lancaster, Pennsylvania, Woburn, Massachusetts,
Chicago, Illinois and Herley's subsidiary in Farmingdale, New York. The
Chicago, Illinois location is a two-person marketing office. The result of
this suspension is that these facilities will not be solicited for or
awarded new contracts or contract extensions without special exceptions,
pending the outcome of the legal proceedings. The suspended facilities may
receive contract awards or subcontracts from the Federal Government if the
head of the agency states in writing the compelling reason to do so. A
significant portion of Herley's business is received where the company is
the only qualified supplier on critical defense programs. For this reason
the effect of the suspension on these manufacturing facilities cannot
easily be determined at this time. Currently, the Company has a funded
backlog of approximately $142 million, which is not affected by this
action, and which will be delivered to customers within the next year or
two.
The Company's facilities which are not included in the action and who are
free to contract with the U.S. Government are our facilities in Whippany,
NJ (Herley-CTI), Jerusalem (Herley-Israel), McLean, Virginia, (Innovative
Concepts, Inc.), Ft. Walton Beach, Florida, (Micro Systems, Inc.),
Farnborough, U.K. (EW Simulation Systems), and Melbourne, Florida,
(Herley-RSS).
15
Item 2: Management's Discussion and Analysis of Financial Condition and Results
of Operations
Explanatory Note
As explained in a press release issued on June 6, 2006, the U.S. Attorney's
office for the Eastern District in Pennsylvania has indicted the Company and its
former Chairman, Lee N. Blatt on multiple charges in connection with purported
activities resulting in alleged excessive profits by the Company on three
contracts with the U.S. Department of Defense. The Company's Board of Directors
has retained outside counsel who has conducted an independent investigation and
review of the allegations. The Board of Directors believes that, based on
information currently available to it, no criminal conduct has occurred and the
Company will vigorously contest the charges.
The Company has been advised by BDO SEIDMAN, LLP, The Company's Independent
Registered Public Accountants, that, due to their need to complete review
procedures in connection with the Board's investigation, BDO SEIDMAN, LLP is
unable at this time to complete its review of the consolidated financial
statements set forth herein in accordance with established professional
standards and procedures for conducting such reviews, as established by
generally accepted auditing standards, which review is required by Rule 10-01(d)
of Regulation S-X.
The Company understands that the staff of the Securities and Exchange Commission
(the "staff") has taken the position that this report is deficient because the
interim financial statements contained in this report have not been reviewed by
an independent registered public accountant as required by Rule 10-01(d) of
Regulation S-X. Pursuant to the position taken by the staff, the Company is
deemed not to be current in its filings required under the Securities Exchange
Act of 1934, as amended. The Company understands that completion of a review of
its interim financial statements and the filing of an amendment will make this
report current, although it will not be deemed timely for purposes of the rules
governing eligibility to use registration statements on Forms S-2 and S-3.
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
Certain statements contained in this report are "forward-looking statements"
that involve various important assumptions, risks, uncertainties and other
factors which could cause the Company's actual results to differ materially from
those expressed in such forward-looking statements. Forward-looking statements
can be identified by terminology such as "may", "will", "should" , "expects",
"intends", "anticipates", "believes", "estimates", "predicts", "continue", or
the negative of these terms or other comparable terminology. These important
factors include, without limitation, a large percentage of sales are under
government contracts, cost overruns under fixed price contracts, doing business
in foreign markets, customer concentration, competitive factors and pricing
pressures, effective integration of acquired businesses, management of future
growth, recruiting and retaining qualified technical personnel, general economic
conditions, as well as other risks previously disclosed in the Company's
securities filings and press releases. Although the Company believes that the
expectations reflected in the forward-looking statements are reasonable, it
cannot guarantee future results, performance or achievements. Further, the
Company is under no duty to update any of the forward-looking statements after
the date of this quarterly report to conform such statements to actual results.
Business Overview
We are a leading supplier of microwave products and systems to defense and
aerospace entities worldwide. Our primary customers include large defense prime
contractors (including Raytheon, Northrop Grumman, General Dynamics, Lockheed
Martin and Boeing), the U.S. Government (including the Department of Defense,
NASA and other U.S. Government agencies) and international customers (including
the German, Japanese, Turkish, British, Norwegian and South Korean militaries,
and suppliers to international militaries). We are a leading provider of
microwave technologies for use in command and control systems, flight
instrumentation, weapons sensors, high power amplifiers, electronic warfare
systems, wireless data communications products and services, and radar threat
and electronic countermeasure simulation systems. We have served the defense
industry since 1965 by designing and manufacturing microwave devices and systems
for use in high technology defense electronics applications. Our products and
systems are currently deployed on a wide range of high profile military
platforms, including the F-16 Falcon, the F/A-18E/F Super Hornet, the EA-6B
Prowler, the EA-18 Growler, the AH-64D Apache Longbow, AEGIS class destroyers,
the AMRAAM missile, unmanned aerial vehicles (UAVs), as well as high priority
national security programs such as National Missile Defense and the Trident II
D-5 missile.
Results of Operations
Thirty-nine weeks ended April 30, 2006 and May 1, 2005
- ------------------------------------------------------
Net sales for the thirty-nine weeks ended April 30, 2006 were approximately
$133,466,000 compared to $108,610,000 in the first nine months of fiscal 2005,
an increase of $24.9 million (22.9%). Net sales through the acquisitions of MSI
and ICI completed in the third quarter of fiscal 2005 accounted for an increase
of approximately $22.4 million, or 90% of the increase in net sales for the
thirty-nine weeks ended April 30, 2006. We also experienced an approximate $2.5
million net increase in sales at our other operations as follows:
- -- An increase in sales at our Lancaster operation of $1.0 million, which
includes $2.2 million in revenue in connection with a claim due to customer
delays and changes in specifications and designs under a major program
offset by decreases in overall sales volume; and
- -- A net increase in sales at our GMC facility of approximately $1.7 million,
including $2.5 million in power amplifier sales to the Government of Israel
for multiplatform communications;
Offset by
- -- A decline of $1.2 million at EWST as they near completion of certain major
contracts.
16
The gross profit margin in the thirty-nine weeks ended April 30, 2006 was 28.9%
compared to 30.9% in the three quarters of fiscal 2005, a decrease of 2.0%.
Contributing to the reduction in gross profit for the nine months are the
following items:
- -- Engineering development costs overruns on certain contracts in excess of
billings to customers;
- -- startup production costs on certain programs; and
- -- the cumulative effects of changes in contract costs estimates on certain
programs accounted for under the percentage completion method of
accounting.
Selling and administrative expenses for the thirty-nine weeks ended April 30,
2006 increased approximately $4.2 million over fiscal 2005 and were 19.3% of net
sales as compared to 19.8% in fiscal 2005. Significant changes during the period
included:
- -- An increase of approximately $4.2 million attributable to selling and
administrative expenses related to the two acquisitions completed in the
third quarter of fiscal 2005 (MSI and ICI);
- -- Legal expenses in fiscal 2006 were $1,450,000 primarily attributable to
legal costs associated with a continuing investigation by the U.S.
Attorneys' office in Pennsylvania which, inter alia, involves pricing under
two contracts with the U.S. Department of Defense relating to voltage
control oscillators and a contract relating to powerheads. Legal costs
incurred in fiscal 2005 were $1,965,000, of which $1,236,000 relates to the
current investigation by the U.S. Attorneys' office, and the balance
relates primarily to the litigation involving Robinson Laboratories, Inc.
and Ben Robinson which was settled in fiscal 2005;
- -- Stock compensation costs in connection with the adoption of SFAS 123R as of
August 1, 2005 of $0.3 million.
Operating income for the nine months was $12,781,000 or 9.6% of net sales, as
compared to $12,035,000 or 11.1% of net sales in 2005. The decrease in operating
income as a percentage of net sales is primarily attributable to the reduction
in gross margins discussed above. Our foreign operations contributed
approximately $2,018,000 in operating income for the nine months as compared to
$1,653,000 in fiscal 2005.
Investment income decreased by $191,000 in the nine months of fiscal 2006
because of a decline on average of approximately $38 million in funds invested,
offset by an increase of approximately 76% in the rate of interest earned on the
investment of excess cash reserves during the period as compared to interest
rates in the prior year. The reduction in the average balance of funds invested
in the first three quarters of fiscal 2006 versus the prior year was caused by
the investments in capital expenditures and recent acquisitions financed out of
our investment funds.
The Company recognized a net foreign exchange gain of $273,000 through the third
quarter of fiscal 2006, versus a gain of $264,000 in fiscal 2005. The foreign
exchange gains are attributable to our UK subsidiary primarily in connection
with temporary advances we have made to them.
Provision for income taxes for the first nine months of fiscal 2006 was
$3,749,000 representing an effective tax rate of approximately 28%, comparable
to the effective tax rate of 28% in the first nine months of fiscal 2005. The
favorable effective rate in fiscal 2006 is due to various favorable tax
benefits, including a lower effective tax rate on foreign source income, the tax
benefit attributable to extra territorial income, research and development tax
credits, the Section 199 manufacturing deduction, and tax exempt interest
income.
Thirteen weeks ended April 30, 2006 and May 1, 2005
- ---------------------------------------------------
Net sales for the thirteen weeks ended April 30, 2006 were approximately
$45,689,000, as compared to $41,266,000 in the thirteen weeks ended May 1, 2005,
an increase of $4.4 million (10.7%). Net sales through the acquisition of ICI
completed in the third quarter of fiscal 2005 accounted for an increase of
approximately $3.7 million, or 83% of the increase in net sales for the quarter
ended April 30, 2006. We experienced an approximate $1.1 million increase in net
sales related primarily to microwave components, which sales were depressed in
the prior year's third quarter. Offsetting these increases was a decline of $0.8
million at EWST as they near completion of certain major contracts.
The gross profit margin in the thirteen weeks ended April 30, 2006 was 24.0%
compared to 32.5% in the third quarter of fiscal 2005, a decrease of 8.5%.
Contributing to the reduction in gross profit for the quarter are the following
items:
- -- Engineering development costs overruns on certain contracts in excess of
billings to customers;
- -- startup production costs on certain programs;
- -- the cumulative effects of changes in contract costs estimates on certain
programs accounted for under the percentage completion method of
accounting; and
17
- -- engineering development costs in connection with the Xytrans development
agreement.
Selling and administrative expenses for the thirteen weeks ended April 30, 2006
increased approximately $95,000 over the third quarter of fiscal 2005 and were
19.6% of net sales as compared to 21.5% in fiscal 2005. Significant changes
during the period included:
- -- An increase of approximately $822,000 attributable to selling and
administrative expenses related to the acquisition of ICI completed in the
third quarter of fiscal 2005, and
- -- Stock compensation costs in connection with the adoption of SFAS 123R as of
August 1, 2005 of $120,000,
Offset by
- -- A decrease in legal costs from $1,285,000 in the third quarter of fiscal
2005 to $425,000 in the third quarter of fiscal 2006. Legal costs in fiscal
2006 are primarily attributable to the continuing investigation by the U.S.
Attorneys' office in Pennsylvania which, inter alia, involves pricing under
two contracts with the U.S. Department of Defense relating to voltage
control oscillators and a contract relating to powerheads.
Operating income for the third quarter of fiscal 2006 was $1,993,000 or 4.4% of
net sales, as compared to $4,556,000 or 11.0% of net sales in the prior year.
The decrease in operating income as a percentage of net sales is primarily
attributable to the reduction in gross margins discussed above. Our foreign
operations contributed $881,000 in operating income for the quarter as compared
to $541,000 in the third quarter of fiscal 2005.
Investment income increased by $16,000 in the third quarter of fiscal 2006 due
to an increase of approximately 56% in the rate of interest earned on the
investment of excess cash reserves as compared to the prior year, despite the
decline on average of approximately $17 million in funds invested. The reduction
in the average balance of funds invested versus the prior year is due to the
funding of the acquisitions of MSI and ICI during the third quarter of fiscal
2005.
In the thirteen weeks ended April 30, 2006, the Company recognized a foreign
exchange gain of $170,000 versus a gain of $79,000 in the third quarter of
fiscal 2005. The foreign exchange gains are attributable to our UK subsidiary
primarily in connection with temporary advances we have made to them.
Provision for income taxes for the third quarter of fiscal 2006 was $662,000
representing an effective tax rate of approximately 28%, as compared to an
effective tax rate of 25% in the prior year's third quarter. The lower effective
tax rate in the third quarter of fiscal year 2005 is due to the cumulative
recognition of research and development credits that were realized in the prior
year third quarter. The overall effective rate for the quarter ended April 30,
2006 is due to various favorable tax benefits, including a lower effective tax
rate on foreign source income, the tax benefit attributable to extra territorial
income, research and development tax credits, the Section 199 manufacturing
deduction, and tax exempt interest income.
Liquidity and Capital Resources
- -------------------------------
As of April 30, 2006 and July 31, 2005, working capital was $99,650,000 and
$88,343,000, respectively, and the ratio of current assets to current
liabilities was 3.8 to 1 and 3.6 to 1, respectively.
As is customary in the defense industry, inventory is partially financed by
customer deposits and progress payments. The un-liquidated balance of these
deposits and payments was approximately $5,109,000 at April 30, 2006, and
$3,966,000 at July 31, 2005.
Net cash provided by operations during the thirty-nine weeks ended April 30,
2006 was approximately $10,009,000 as compared to $12,273,000 during the
comparable period in the prior year, a decrease of approximately $2,264,000.
Income from operations (adjusted for depreciation, amortization, and foreign
exchange (gain) loss) was $14,852,000 in the first nine months of the current
fiscal year versus $13,113,000 in the similar period in the prior year, an
increase of approximately $1,739,000. Significant items contributing to the
overall decrease in cash provided by operations of $2,264,000 include the
following:
1. A decrease of approximately $7.9 million in cash generated from collection
of accounts receivable during the first nine months of fiscal 2006 versus
fiscal 2005. The largest impact was from a major contract at our Lancaster
facility in connection with an upgrade for US Navy aircraft. This job was
largely shipped during fiscal 2004 and early in fiscal 2005, which resulted
in increased collections of accounts receivable in the first quarter of
fiscal 2005. Additionally, an increase in shipments of approximately 11%
during the third quarter of fiscal 2006 versus the third quarter of fiscal
2005 resulted in higher accounts receivable at the close of the quarter;
2. a decrease of approximately $2.5 million generated through amounts due to
vendors and accrued expenses; and
18
3. a reduction in income taxes payable of approximately $3.6 million.
Offset primarily by
1. a reversal in the growth of inventory since the beginning of the current
fiscal year resulting in an improvement in cash flow of approximately $3.4
million;
2. an increase of approximately $1.1 million in cash generated from billings
in excess of costs incurred and income recognized on uncompleted contracts
during the course of the nine-month period;
3. a reduction of approximately $1.1 million in the amount of cash invested in
costs incurred and income recognized in excess of billings on uncompleted
contracts, after including $2.2 million of estimated costs incurred in
connection with a claim due to customer delays and changes in specification
and designs under a major program; and
4. an increase of approximately $2.6 million in advanced payments from
customers on contracts in progress.
Net cash used in investing activities includes capital expenditures of
$4,525,000 including $584,000 at the Company's CTI facility for the purchase of
equipment used for the production of millimeter wave products relating to the
Xytrans license agreement during the first nine months of the current fiscal
year.
In June 2002, the Company entered into a new $50,000,000 Revolving Credit Loan
Agreement with two banks on an unsecured basis which may be used for general
corporate purposes, including business acquisitions. The revolving credit
facility requires the payment of interest only on a monthly basis and payment of
the outstanding principal balance on March 31, 2008 (as amended). The Company
may elect to borrow up to a maximum of $5,000,000 with interest based on the
Federal Funds Target Rate plus a margin of 1.50% to 1.80%, or up to a maximum of
$45,000,000 with interest based on LIBOR plus a margin of 1.35% to 1.65%. The
applicable incremental margin is based on the ratio of total liabilities to
tangible net worth, as those terms are defined in the agreement. The Federal
Funds Target Rate and the LIBOR rate was 4.75% and 5.04%, respectively, at April
30, 2006. There is a fee of 15 basis points per annum on the unused portion of
the $45,000,000 LIBOR based portion of the credit facility payable quarterly.
There are no borrowings under the credit line at April 30, 2006 and July 31,
2005. Stand-by letters of credit were outstanding in the amount of approximately
$11,479,000 under the credit facility at April 30, 2006, and $10,703,000 at July
31, 2005.
The agreement contains various financial covenants, including, among other
matters, minimum tangible net worth, total liabilities to tangible net worth,
debt services coverage, and restrictions on other borrowings. The company is in
compliance with all covenants at April 30, 2006.
The Company believes that presently anticipated future cash requirements will be
provided by internally generated funds, its existing unsecured credit facility,
and existing cash reserves. A significant portion of our revenue for fiscal 2006
will be generated from our existing backlog of sales orders. The backlog of
orders at April 30, 2006 was approximately $143 million of which $136 million
are orders covered by funded signed contracts or purchase orders. The remaining
$7 million of backlog is "unfunded" and consists of the portion of a contract
expected to be recognized as our customer increases the funding allotment for
completion of the aggregate firm contract award. Contracts involving government
programs may be terminated at the discretion of the government. In the event of
the cancellation of a significant amount of government contracts included in the
Company's backlog, the Company will be required to rely more heavily on cash
reserves and its existing credit facility to fund its operations. The Company is
not aware of any events which are reasonably likely to result in any
cancellation of its government contracts. As of April 30, 2006, the Company has
approximately $38,521,000 available under its bank credit facility, net of
outstanding stand-by letters of credit of approximately $11,479,000, and cash
reserves of approximately $27,364,000.
19
Disclosure Regarding Contractual Obligations and Commitments
- ------------------------------------------------------------
Accounting standards require disclosure concerning the Company's obligations and
commitments to make future payments under contracts, including interest, such as
debt and lease agreements, and other contingent commitments, such as stand-by
letters of credit. The following table summarizes the Company's contractual
obligations and other contingent commitments, including interest, at July 31,
2005 (in thousands):
Within 2-3 4-5 After 5
Obligations Total 1 Year Years Years Years
----------- ----- ------ ----- ----- -------
Mortgage Note $ 2,571 $ 124 $ 270 $ 308 $ 1,869
Industrial Revenue Bonds 3,811 220 442 442 2,707
EWST Note 606 606 - - -
Operating Lease Obligations 17,095 2,876 5,629 3,655 4,935
Purchase Obligations 22,038 17,739 3,106 1,063 130
--------- --------- --------- --------- ---------
46,121 21,565 9,447 5,468 9,641
Standby Letters of Credit 10,703 2,327 7,989 325 62
--------- --------- --------- --------- ---------
Total Contractual Obligations $ 56,824 $ 23,892 $ 17,436 $ 5,793 $ 9,703
========= ========= ========= ========= =========
Other than the ordinary course fulfillment of open purchase orders and placement
of new purchase orders, there have been no other significant changes to the
Company's contractual obligations table since July 31, 2005.
New Accounting Pronouncements
- -----------------------------
See Note 13 of Notes to Consolidated Financial Statements - (Unaudited) for the
discussion on recent accounting pronouncements.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
The Company's exposures to market risk have not changed significantly since July
31, 2005.
Item 4: Controls and Procedures
(a) Evaluation of disclosure controls and procedures. The term "disclosure
controls and procedures" is defined in Rules 13a-15(e) and 15d-15(e) of the
Securities Exchange Act of 1934 as amended (the "Exchange Act"). These
rules refer to the controls and other procedures of a company that are
designed to ensure that information required to be disclosed by the company
in the reports that it files under the Exchange Act is recorded, processed,
summarized and reported within the required time periods. The Company's
management, with participation of the Company's Chief Executive Officer and
Chief Financial Officer, has evaluated the design, operation and
effectiveness of the Company's disclosure controls and procedures and have
concluded, based on such evaluation, that such controls and procedures were
effective at providing reasonable assurance that required information will
be disclosed in the Company's reports filed under the Exchange Act as of
April 30, 2006.
(b) Changes in internal controls. There were no changes in the Company's
internal controls over financial reporting (as such term is defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal
quarter ended April 30, 2006 that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings:
As previously reported, there has been a continuing investigation by the U.S.
Attorneys' Office in Pennsylvania which, inter alia, involves pricing under
contracts with the U.S. Department of Defense relating to voltage control
oscillators and powerheads. The contracts aggregate approximately $3.9 million
in total revenue.
On June 6, 2006, an indictment was returned against the Company and Lee Blatt,
its former Chairman. No other officer or director of the Company was named in
the indictment. The indictment alleges 29 counts of violations of the wire fraud
statute (18 U.S.C. Section 1343); 2 counts of violations of the obstruction of a
federal audit statute (18 U.S.C. Section 1516); 1 count of violating the major
fraud against the United States statute (18 U.S.C. Section 1031); 3 counts of
violating the false statements to the government statute (18 U.S.C. Section
1001) and a notice of forfeiture. The Company believes that no criminal conduct
has occurred and will vigorously contest the charges.
The Company is involved in various other legal proceedings and claims which
arise in the ordinary course of its business. While any litigation contains an
element of uncertainty, management believes that the outcome of such other
litigation will not have a material adverse effect on the Company's financial
position or results of operations.
20
Item 2 - Changes In Securities:
None
Item 3 - Defaults Upon Senior Securities:
None
Item 4 - Submission Of Matters To A Vote Of Security Holders:
None
Item 5 - Other Information:
None
Item 6 - Exhibits
None
21
FORM 10-Q
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.
HERLEY INDUSTRIES, INC.
-----------------------------------
Registrant
BY: /S/ Myron Levy
-----------------------------------
Myron Levy, Chief Executive Officer
BY: /S/ Anello C. Garefino
-------------------------------------------------
Anello C. Garefino, Acting Chief Financial Officer
DATE: June 14, 2006
22