UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended: October 28, 2007
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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.
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(Exact name of registrant as specified in its charter)
DELAWARE 23-2413500
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(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
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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 December 3, 2007 - 13,691,209 shares of Common Stock are outstanding.
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
INDEX TO FORM 10-Q
PAGE
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PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements:
Condensed Consolidated Balance Sheets -
October 28, 2007 (Unaudited) and July 29, 2007 2
Condensed Consolidated Statements of Operations (Unaudited) - For the
thirteen weeks ended October 28, 2007
and October 29, 2006 3
Condensed Consolidated Statement of Shareholders' Equity (Unaudited) -
For the thirteen weeks ended October 28, 2007 4
Condensed Consolidated Statements of Cash Flows (Unaudited) - For the
thirteen weeks ended October 28, 2007
and October 29, 2006 5
Notes to Condensed Consolidated Financial Statements (Unaudited) 6
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations 13
Item 3 - Quantitative and Qualitative Disclosures About Market Risk 17
Item 4 - Controls and Procedures 17
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings 17
Item 1A- Risk Factors 18
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 19
Item 3 - Defaults Upon Senior Securities 19
Item 4 - Submission of Matters to a Vote of Security Holders 19
Item 5 - Other Information 19
Item 6 - Exhibits 19
Signatures 20
Part I - Financial Information
Item 1 - Financial Statements
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
October 28,
2007 July 29,
(Unaudited) 2007
------------ ------------
ASSETS
Current Assets:
Cash and cash equivalents $ 34,643 $ 35,181
Trade accounts receivable, net 25,585 28,058
Income Taxes Receivable 819 819
Costs incurred and income recognized in excess
of billings on uncompleted contracts and claims 17,495 14,448
Other receivables 2,353 2,816
Inventories, net 53,424 51,815
Deferred income taxes 6,513 4,254
Other current assets 1,860 1,069
------------ ------------
Total Current Assets 142,692 138,460
Property, Plant and Equipment, net 30,623 29,996
Goodwill 74,102 74,044
Intangibles, net of accumulated amortization of $5,819 at October 28,
2007 and $5,256 at July 29, 2007 17,879 18,431
Other Assets 616 1,662
------------ ------------
Total Assets $ 265,912 $ 262,593
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Current portion of long-term debt $ 1,361 $ 1,346
Current portion of employment settlement agreement -
(net of imputed interest of $203 at October 28, 2007 and $245
at July 29, 2007) 1,154 1,113
Current portion of litigation settlement (net of imputed interest of $59) 3,941 -
Accounts payable and accrued expenses 20,736 19,049
Billings in excess of costs incurred and
income recognized on uncompleted contracts 641 99
Income taxes payable 158 3,518
Accrual for contract losses 889 1,564
Accrual for warranty costs 1,081 1,106
Advance payments on contracts 7,118 7,163
------------ ------------
Total Current Liabilities 37,079 34,958
Long-term Debt 5,533 5,951
Long-term Portion of Employment Settlement Agreement -
(net of imputed interest of $542 at October 28, 2007 and $580
at July 29, 2007) 3,854 4,117
Long-term portion of litigation settlement (net of imputed interest of $242) 1,758 -
Other Long-term Liabilities 1,341 1,311
Deferred Income Taxes 7,120 6,615
Accrued Income Taxes Payable 3,139 -
------------ ------------
Total Liabilities 59,824 52,952
------------ ------------
Commitments and Contingencies
Shareholders' Equity:
Common stock, $.10 par value; authorized 20,000,000 shares;
issued and outstanding 13,896,671 at October 28, 2007, and
13,977,115 at July 29, 2007 1,390 1,398
Additional paid-in capital 106,108 107,094
Retained earnings 96,813 99,404
Accumulated other comprehensive income 1,777 1,745
------------ ------------
Total Shareholders' Equity 206,088 209,641
------------ ------------
Total Liabilities and Shareholders' Equity $ 265,912 $ 262,593
============ ============
See notes to condensed consolidated financial statements.
2
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share data)
Thirteen weeks ended
--------------------
October 28, October 29,
2007 2006
------------ ------------
Net sales $ 35,133 $ 40,116
------------ ------------
Cost and expenses:
Cost of products sold 25,140 29,831
Selling and administrative expenses 8,820 9,022
Litigation settlement (Notes 2 and 6) 6,042 -
Employment contract settlement costs (Note 2) - 8,914
------------ ------------
40,002 47,767
------------ ------------
Loss from operations (4,869) (7,651)
------------ ------------
Other income (expense):
Investment income 429 216
Interest expense (25) (143)
Foreign exchange transaction gain 146 17
------------ ------------
550 90
------------ ------------
Loss before income taxes (4,319) (7,561)
Benefit for income taxes (1,728) (1,550)
------------ ------------
Net loss $ (2,591) $ (6,011)
============ ============
Loss per common share - Basic $ (0.19) $ (0.43)
============ ============
Basic weighted average shares 13,965 13,862
============ ============
Loss per common share - Diluted $ (0.19) $ (0.43)
============ ============
Diluted weighted average shares 13,965 13,862
============ ============
See notes to condensed consolidated financial statements.
3
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED)
Thirteen weeks ended October 28, 2007
(In thousands, except share data)
Accumulated
Additional Other
Common Stock Paid-in Retained Treasury Comprehensive
Shares Amount Capital Earnings Stock Income (Loss) Total
------------ ------- --------- --------- --------- -------------- ----------
Balance at July 29, 2007 13,977,115 $ 1,398 $ 107,094 $ 99,404 $ - $ 1,745 $ 209,641
Exercise of stock options 4,500 - 34 34
Purchases of 84,944 shares of
treasury stock (1,288) (1,288)
Tax benefit upon exercise of
stock options 13 13
Stock-based compensation costs 247 247
Retirement of treasury stock (84,944) (8) (1,280) 1,288 -
------------ ------- --------- --------- --------- -------------- ----------
Subtotal 13,896,671 1,390 106,108 99,404 - 1,745 208,647
----------
Net loss (2,591) (2,591)
Other comprehensive (loss) income:
Unrealized loss on interest
rate swap (10) (10)
Foreign currency translation
gain 42 42
----------
Comprehensive loss (2,559)
------------ ------- --------- --------- --------- -------------- ----------
Balance at October 28, 2007 13,896,671 $ 1,390 $ 106,108 $ 96,813 $ - $ 1,777 $ 206,088
============ ======= ========= ========= ========= ============== ==========
See notes to condensed consolidated financial statements.
4
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
Thirteen weeks ended
--------------------
October 28, October 29,
2007 2006
--------- ----------
Cash flows from operating activities:
Net Loss $ (2,591)$ (6,011)
--------- ----------
Adjustments to reconcile net loss to
net cash provided by (used in) operating activities:
Depreciation and amortization 1,846 1,751
Stock-based compensation costs 247 116
Excess tax benefit from exercises of stock options (13) -
Litigation settlement costs 5,942 -
Employment contract settlement costs (includes $196 of
stock option modification costs) - 8,914
Imputed interest related to employment settlement liability 80 19
Foreign exchange transaction gains (146) (17)
Inventory valuation reserve charges 481 287
Reduction in accrual for contract losses (826) -
Warranty reserve charges 348 266
Deferred tax benefit (1,742) (2,301)
Changes in operating assets and liabilities:
Trade accounts receivable 2,379 (330)
Costs incurred and income recognized in excess
of billings on uncompleted contracts and claims (3,047) 668
Other receivables 463 (435)
Inventories (2,173) 450
Other current assets (791) (649)
Accounts payable and accrued expenses 1,687 (1,961)
Billings in excess of costs incurred and
income recognized on uncompleted contracts 542 34
Income taxes payable (208) 677
Accrual for contract losses 151 (165)
Employment settlement agreement (302) (3,000)
Advance payments on contracts (45) 261
Other, net (188) 218
--------- ----------
Total adjustments 4,685 4,803
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Net cash provided by (used in) operating activities 2,094 (1,208)
--------- ----------
Cash flows from investing activities:
Acquisition of technology license - (179)
Capital expenditures (966) (1,016)
--------- ----------
Net cash used in investing activities (966) (1,195)
--------- ----------
Cash flows from financing activities:
Borrowings under bank line of credit 4,900 4,500
Borrowings - other - 1,746
Proceeds from exercise of stock options 34 -
Excess tax benefit from exercises of stock options 13 -
Payments of long-term debt (425) (167)
Payments under bank line of credit (4,900) (4,500)
Purchase of treasury stock (1,288) -
--------- ----------
Net cash (used in) provided by financing activities (1,666) 1,579
--------- ----------
Effect of exchange rate changes on cash - 22
--------- ----------
Net decrease in cash and cash equivalents (538) (802)
Cash and cash equivalents at beginning of period 35,181 22,303
--------- ----------
Cash and cash equivalents at end of period $ 34,643 $ 21,501
========= ==========
See notes to condensed consolidated financial statements.
5
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED)
1. Principles of Consolidation and Basis of Presentation
The unaudited condensed 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.
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with instructions to Form 10-Q and Article 10
of Regulation S-X and do not include all of the information and note
disclosures normally included in annual financial statements as required by
accounting principles generally accepted in the United States of America
for complete financial statements. In the opinion of management, all
adjustments (consisting of normal recurring items, as well as the recording
of the litigation settlement costs and employment contract settlement costs
discussed in Note 2) considered necessary for a fair presentation have been
included in the accompanying condensed consolidated financial statements.
Operating results for this quarter are not necessarily indicative of the
results of operations that may be expected for any other interim period or
for the 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 2007
Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July
29, 2007, as filed with the Securities and Exchange Commission ("SEC"). The
accounting policies used in preparing these unaudited condensed interim
financial statements are consistent with those described in the July 29,
2007 audited financial statements except for the adoption of Financial
Accounting Standards Board ("FASB") Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN 48"), which is discussed in Note 4. The consolidated balance sheet at
July 29, 2007 has been derived from the audited consolidated financial
statements at that date but does not include all of the information and
footnotes required by accounting principles generally accepted in the
United States for complete financial statements.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires that
management of the Company make certain estimates and assumptions that
affect the reported amounts of assets, liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements
and reported amounts of revenues and expenses during the reporting periods.
These judgments can be subjective and complex, and consequently actual
results could differ from those estimates and assumptions. The most
significant estimates include: valuation and recoverability of long-lived
assets; income taxes; recognition of revenue and costs on production
contracts; the valuation of inventory; and stock-based compensation costs
valued in accordance with FAS 123(R). Each of these areas requires the
Company to make use of reasoned estimates including estimating the cost to
complete a contract, the net realizable value of its inventory and the
market value of its products. Changes in estimates can have a material
impact on the Company's financial position and results of operations. The
remaining accrual for contract losses associated with the ICI acquisition
(more fully described in Note A-3 and Note B of Form 10-K/A Amendment No. 1
for the fiscal year ended July 29, 2007), in the amount of $826,000 was
eliminated in the thirteen weeks ended October 28, 2007 (which is included
as a reduction of costs of products sold) as a result of the customer not
exercising the remaining two contract options under the contract. Shipments
under the contract were completed during the thirteen weeks ended October
28, 2007 and the remaining options under the contract have now expired.
Certain prior period balances have been reclassified to conform to the
current period's financial statement presentation.
2. Significant Events
In connection with a lawsuit filed on April 10, 2007, by EADS Deutschland
GmbH ("EADS"), a German corporation, against the Company (see Note 6), the
parties have entered into an agreement effective December 5, 2007 providing
for a mutual release and dismissal, with prejudice and without costs or
attorney's fees to either party, of all claims and counterclaims filed. To
avoid further dilution of management's time and energies, as well as legal
costs on a long and protracted legal dispute, the Company agreed to pay to
EADS the sum of $6,000,000. A payment of $2,500,000 is due on or before
December 15, 2007; $1,500,000 is due by March 31, 2008; and a payment of
$1,000,000 is due on March 31, 2009 and March 31, 2010, respectively. The
agreement further provides for the transfer to EADS of all drawings in the
Company's possession, custody or control for the equipment supplied in
conjunction with a contract between the parties; providing EADS with the
use of such drawings for the exclusive purpose of fulfilling its
obligations towards its own customers under the contract. As security for
the payments due in March of 2008, 2009 and 2010, the Company will issue an
irrevocable stand-by letter of credit in the amount of $3,500,000 under its
existing credit facility by December 15, 2007. The Company recorded a
charge to operations in the thirteen weeks ended October 28, 2007 of
approximately $6,042,000 consisting of payments due under the agreement of
approximately $5,699,000, net of imputed interest of approximately $301,000
discounted at an imputed interest rate of 7.25%, plus costs and other
direct settlement expenses of approximately $343,000. The payment of
$2,500,000 was made and the stand-by letter of credit was issued on
December 5, 2007.
On June 27, 2007, the Company was notified by the Office of the General
Counsel, Acquisition Integrity Office, Department of Navy (the "Navy"),
that certain of its operations had been suspended from receiving new
contract awards from the U.S. Government as discussed in Note A-1 in the
Company's 2007 Annual Report on Form 10-K/A Amendment No. 1 for the fiscal
6
year ended July 29, 2007. The affected operations included facilities in
Lancaster, Pennsylvania; Woburn, Massachusetts and Chicago, Illinois. The
Chicago, Illinois location is a two-person marketing office. On August 15,
2007 the suspension was lifted following an amendment to the Administrative
Agreement (originally signed on October 12, 2006) with the Navy as
discussed below. While the suspension was in place, these facilities could
not be solicited for or awarded new contracts or contract extensions
without special exceptions. The suspended facilities were permitted to
receive contract awards or subcontracts from the Federal Government if the
head of the agency stated in writing the compelling reason to do so. A
significant portion of our business is received under contracts where we
are the only qualified supplier on critical defense programs.
On June 13, 2006, in connection with the legal matter discussed in Note 6
"Litigation," the Company was notified that certain of its operations had
been suspended from receiving new contract awards from the U. S.
Government. The affected operations included facilities in Lancaster,
Pennsylvania; Woburn, Massachusetts; Chicago, Illinois and the Company's
subsidiary in Farmingdale, New York. The Chicago, Illinois location is a
two-person marketing office. The result of this suspension was that these
facilities were not solicited for or awarded new contracts or contract
extensions without special exceptions, pending the outcome of the legal
proceedings. The suspended facilities were permitted to receive contract
awards or subcontracts from the Federal Government if the contracting
agency stated in writing the compelling reason to do so. A significant
portion of the Company's business is received under contracts where the
Company is the only qualified supplier on critical defense programs.
The Company's facilities which were not included in the action and who were
free at all times to contract with the U.S. Government are the facilities
in Whippany, New Jersey (Herley-CTI); Jerusalem (Herley-Israel); McLean,
Virginia (Innovative Concepts, Inc.); Fort Walton Beach, Florida (Micro
Systems, Inc. and Herley-RSS) and Farnborough, U.K. (EW Simulation
Technology, Limited).
Effective October 12, 2006, the Company entered into an Administrative
Agreement with the Department of the Navy, on behalf of the Department of
Defense that requires the Company, among other things, to implement a
comprehensive program of compliance reviews, audits and reports for a
period of four years (as amended August 15, 2007) or until settlement or
adjudication of the legal matter referenced above, whichever is later,
unless shortened or extended by written agreement of the parties. In
addition, the Company was required to sever its relationship with its
former Chairman of the Board of Directors, as an employee or consultant to
the Company. In return, the Navy, on behalf of the Department of Defense
terminated the suspension of the Company from receiving new contract awards
from the U.S. Government.
Effective October 12, 2006 and as a condition to entering into the
Administrative Agreement with the Department of the Navy noted above, the
Company entered into an agreement (the "Agreement") with its former
Chairman to terminate the Employment Agreement between him and the Company
dated as of July 29, 2002 and modified on December 9, 2003. Aggregate costs
of approximately $8,914,000 under the Agreement, including a cash payment
of $3,000,000, payments due under a Promissory Note of approximately
$5,354,000, medical and life insurance benefits of approximately $364,000
(both discounted at an imputed interest rate of 6.75%) and the fair value
of the modification of stock options of approximately $196,000 (using the
Black-Scholes option valuation model), have been recorded in the Company's
condensed consolidated financial statements in the thirteen weeks ended
October 29, 2006.
3. Inventories
The major components of inventories are as follows (in thousands):
October 28, 2007 July 29, 2007
---------------- -------------
Purchased parts and raw materials $ 28,680 $ 28,526
Work in process 29,596 27,797
Finished products 2,509 2,576
------- -------
60,785 58,899
Less:
Allowance for obsolete and slow moving inventory 5,609 5,163
Unliquidated progress payments 1,752 1,921
------- -------
$ 53,424 $ 51,815
======= =======
4. Income Taxes
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes (as amended) - an interpretation of FASB
Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in an enterprise's financial
statements in accordance with SFAS No. 109, "Accounting for Income Taxes",
and prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return, including requiring certain expanded
disclosures. FIN 48 states that a tax benefit from an uncertain tax
position may be recognized only if it is "more likely than not" that the
position is sustainable, based on its technical merits. The tax benefit of
a qualifying position is the largest amount of tax benefit that is greater
than 50% likely of being realized upon settlement with a taxing authority
7
having full knowledge of all relevant information. A tax benefit from an
uncertain tax position was previously recognized if it was "probable" of
being sustained. Under FIN 48, the liability for unrecognized tax benefits
is classified as noncurrent unless the liability is expected to be settled
in cash within 12 months of the reporting date. FIN 48 also provides
guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition. FIN 48 is
effective for fiscal years beginning after December 15, 2006 and was
adopted by the Company on July 30, 2007. The adoption of FIN 48 did not
have a material impact on the Company's consolidated financial position,
results of operations or cash flows.
On July 30, 2007, the Company adopted FIN 48. The cumulative effect of
applying the provisions of FIN 48 resulted in a reclassification of
$3,139,000 of tax liabilities from current to non-current and did not
require adjustment to retained earnings. The total amount of unrecognized
tax benefits as of July 30, 2007 was $2,405,000, excluding interest and
penalties. The total amount of unrecognized tax benefits could increase or
decrease within the next twelve months for a number of reasons including
the expiration of statutes of limitations, audit settlements, tax
examination activities and the recognition and measurement considerations
under FIN 48. As of July 30, 2007, after implementation of FIN 48, the
Company's unrecognized tax benefits, that if recognized would affect the
Company's effective tax rate, were $3,139,000 in the aggregate of which
$2,665,000 may no longer be required during the Company's fiscal year
ending August 3, 2008. This unrecognized tax benefit relates to a deduction
taken for a previously impaired investment on a prior year's tax return for
which the statute of limitations will expire in April 2008, unless
extended. The ultimate timing of the tax consequences of the other tax
benefits is uncertain. The Company has elected to retain its existing
accounting policy with respect to the treatment of interest and penalties
attributable to income taxes in accordance with FIN 48, and continues to
reflect interest and penalties attributable to income taxes, to the extent
they arise, as a component of its income tax provision or benefit as well
as its outstanding income tax assets and liabilities. At July 30, 2007,
before any tax benefits, the Company had $734,000 of accrued interest and
penalties which is included as part of its unrecognized tax benefits
described above.
The Company has identified its federal tax return and its state tax return
in Pennsylvania as major tax jurisdictions. The Company is also subject to
multiple other state and foreign jurisdictions. The Company's evaluation of
FIN 48 tax matters was performed for tax years ended 2002 through 2007, the
only periods subject to examination. The Company believes that its income
tax positions and deductions would be sustained on audit and does not
anticipate any adjustments, other than those identified above that would
result in a material change to its financial position.
The income tax benefit recognized in the first quarter of fiscal 2008 was
$1,728,000 (an effective income tax benefit rate of 40.0%) as compared to a
benefit of $1,550,000 in the prior year's first quarter. The estimated
effective income tax rate for fiscal 2008 is 24.5% which is lower than the
statutory rate of 35.0% primarily due to (a) lower domestic earnings due
primarily to the EADS litigation settlement which significantly reduces
domestic income resulting in foreign earnings being a greater percentage of
total earnings and (b) the utilization of a research and development
credit. The Company's foreign earnings are attributable primarily to our
Israeli subsidiary which is taxed at an estimated rate of 10% for fiscal
2008, thereby reducing the effective income tax rate by approximately 9%.
Other non-recurring items contributing to the tax benefit in the first
quarter of fiscal 2008 include a research and development credit carryover
and a lower estimated tax rate in Israel for fiscal 2007 which increased
the income tax benefit for the first quarter by approximately 15.5%
resulting in an overall effective rate for the quarter of 40.0%.
5. 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 thirteen weeks ended October 28, 2007 and October 29, 2006
(in thousands):
Thirteen weeks ended
--------------------
October 28, October 29,
2007 2006
---- ----
Balance at beginning of period $ 1,106 $ 986
Provision for warranty obligations 348 266
Warranty costs charged to the reserve (373) (184)
------------ --------------
Balance at end of period $ 1,081 $ 1,068
============ ==============
6. Litigation
On June 6, 2006, in connection with 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, 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 contracts aggregate approximately
$3.9 million in total revenue. The indictment as superseded on January 30,
2007 alleges 27 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); aiding and abetting (18 U.S.C. Section 2); and a notice of
forfeiture. The Company moved to dismiss the indictment and that motion was
denied on November 5, 2007. A trial is currently scheduled for May 5, 2008.
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
8
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.
In June and July 2006, the Company was served with several class-action
complaints against the Company and certain of its officers in the United
States District Court for the Eastern District of Pennsylvania. The claims
are made under Section 10(b) and 20(a) of the Securities Exchange Act of
1934 and Rule 10b-5 thereunder. All defendants in the class-action
complaints filed motions to dismiss on April 6, 2007.
On July 17, 2007, the Court issued an order denying the Company's and Mr.
Blatt's motion to dismiss and granted, in part, the other defendants'
motion to dismiss. Specifically, the Court dismissed the Section 10(b)
claim against the other defendants and denied the motion to dismiss the
Section 20(a) claim against them. On July 18, 2007, the Court granted
defendant's motion to stay these actions until after the trial of the
criminal matter referenced above.
In July and August 2006, the Company and certain of its current and former
officers and directors were also served with two separate derivative
complaints for breach of fiduciary duty brought pursuant to Rule 23.1 of
the Federal Rules of Civil Procedure. The complaints relate to the
Company's indictment in the matter discussed above and were consolidated
into one action on March 9, 2006. All defendants in the derivative
complaints filed motions to dismiss on February 26, 2007. On July 20, 2007,
the Court issued an order denying defendants' motions in part and granting
them in part. Specifically, the Court dismissed the claim that the named
officers and directors failed to oversee Mr. Blatt and denied the motions
with respect to the other alleged claims. The Court also granted
defendants' motion to stay the action until after the trial of the criminal
matter.
In addition, in June 2006, the Company was notified by representatives of
the United States Attorney's Office for the Eastern District of
Pennsylvania, Civil Division, that they intended to file a civil lawsuit
against the Company pursuant to inter alia, the False Claims Act, 31 U.S.C.
Section 3729 et. seq. The Company entered into a Tolling Agreement on June
21, 2006, and does not anticipate any further activity related to this
potential claim until after the trial of the criminal matter mentioned
above which is currently scheduled for May 5, 2008.
The Company believes it has substantial defenses to the charges alleged in
the indictment and intends to vigorously defend against these allegations.
The Company believes it is entitled to recovery of certain legal fees
associated with the above matters under its D&O insurance policy.
Accordingly, as of October 28, 2007, the Company recorded a receivable of
$2,718,000 (net of a deductible of $500,000) in anticipation of recoveries.
As of October 28, 2007, partial payments of approximately $1,348,000 have
been received leaving a receivable balance of $1,370,000. The amount is
included in other receivables in the accompanying consolidated balance
sheet at October 28, 2007. The insurance carrier may contest the claim in
whole or in part. In addition, the Company has entered into an agreement
dated January 11, 2007 with the insurance carrier whereby if it is
determined by final decision of an arbitration panel, or by final judgment
of a court, or other final decision of a tribunal having jurisdiction
thereof, that any amount paid by the insurance carrier was not a loss, as
that term is defined in the policy, the Company shall repay to the
insurance carrier any such uncovered sums previously advanced to the
Company.
On June 27, 2007, the Company was notified by the Office of the General
Counsel, Acquisition Integrity Office, Department of Navy (the "Navy"),
that certain of its operations had been suspended from receiving new
contract awards from the U.S. Government. The affected operations included
facilities in Lancaster, Pennsylvania; Woburn, Massachusetts and Chicago,
Illinois. The Chicago, Illinois location is a two-person marketing office.
On August 15, 2007 the suspension was lifted following an amendment to the
Administrative Agreement with the Navy (originally signed on October 12,
2006) extending the term of the agreement for one additional year. While
the suspension was in place, these facilities could not be solicited for or
awarded new contracts or contract extensions without special exceptions.
The suspended facilities were permitted to receive contract awards or
subcontracts from the Federal Government if the head of the agency stated
in writing the compelling reason to do so. A significant portion of our
business is received under contracts where we are the only qualified
supplier on critical defense programs.
On April 10, 2007, EADS Deutschland GmbH ("EADS"), a German corporation,
filed a lawsuit against Herley Industries, Inc., General Microwave
Corporation and General Microwave Export Corporation d/b/a Herley Power
Amplifier Systems (collectively the "Company") in the United States
District Court for the Eastern District of New York. EADS claims that the
Company breached a Transfer of Technology Agreement entered into on May 30,
2001 under which the Company was granted the right to use certain
technology owned by EADS in performing under an exclusive sales and
marketing agreement entered into on May 30, 2001. EADS asserted claims for
breach of contract and conversion, claiming that the Company was wrongfully
in possession of the intellectual property that was transferred to the
Company. EADS also sought a preliminary injunction. The Company denied any
wrongdoing and filed counterclaims against EADS. On August 2, 2007, the
Company and EADS entered into a settlement of this motion, which was
reduced to a written consent decree entered by the Court on August 29,
2007. EADS's claims for breach of contract and for conversion remained
pending, as did the Company's counterclaims. Pursuant to the consent
decree, the parties agreed to a mediation/settlement conference of all
their respective claims with the Court, and further agreed to stay all
proceedings pending the outcome of that mediation/settlement conference on
October 17, 2007. In November 2007, the Company reached a comprehensive
9
settlement agreement with EADS as discussed in Note 2.
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.
7. Comprehensive Loss
Comprehensive loss for the thirteen weeks ended October 28, 2007 and
October 29, 2006 is as follows (in thousands):
Thirteen weeks ended
--------------------
October 28, October 29,
2007 2006
---- ----
Net loss $ (2,591) $ (6,011)
Unrealized loss on interest rate swap (10) (21)
Foreign currency translation gain (loss) 42 (21)
----------- -----------
Comprehensive loss $ (2,559) $ (6,053)
=========== ===========
The foreign currency translation gain relates to the Company's investment
in its U.K. subsidiary and fluctuations in exchange rates between its local
currency and the U.S. dollar.
The components of accumulated other comprehensive income are as follows (in
thousands):
October 28, 2007 July 29, 2007
---------------- -------------
Unrealized loss on interest rate swap $ (39) $ (29)
Foreign currency translation gain 1,816 1,774
----- -----
Accumulated other comprehensive income $1,777 $ 1,745
===== =====
8. Share-Based Compensation
The Company has various fixed stock option plans which are described in
Note N of the Company's July 29, 2007 Annual Report on Form 10-K/A
Amendment No. 1 that provide for the grant of stock options to eligible
employees and directors.
The Company recorded total share-based costs related to stock options,
included as compensation costs in operating expenses, of $247,000 and
$116,000 for the thirteen weeks ended October 28, 2007 and October 29,
2006, respectively.
As of October 28, 2007, there were 3,581,350 stock options outstanding. No
stock options were granted during the thirteen weeks ended October 28,
2007. The aggregate value of unvested options as of October 28, 2007, as
determined using a Black-Scholes option valuation model was approximately
$1,629,000 (net of estimated forfeitures) which is expected to be
recognized over a weighted-average period of 2.04 years.
Options for 4,500 shares of common stock were exercised during the thirteen
weeks ended October 28, 2007 at an exercise price of $7.63 per share and
options for 54,600 shares of common stock expired or were forfeited during
the quarter.
The total intrinsic value of options exercised, based on the difference
between the Company's stock price at the time of exercise and the related
exercise price, during the thirteen weeks ended October 28, 2007 was
approximately $33,000.
10
A summary of stock option activity under all plans for the thirteen weeks
ended October 28, 2007 is as follows:
Non-Qualified Stock Options Weighted Aggregate
- --------------------------- Average Intrinsic
Number Price Range Exercise Value (1)
of shares per share Price (in thousands)
--------- --------- ----- --------------
Outstanding July 29, 2007 3,640,450 $ 7.25 - 21.18 $ 14.84
--------------
Granted - - -
Exercised (4,500) $ 7.63 $ 7.63
Cancelled (54,600) $ 17.98 - 19.52 $ 19.42
-------------- ---------------- --------------
Outstanding October 28, 2007 3,581,350 $ 7.25 - 21.18 $ 14.78 $ 7,240
========== ------------- -----------
Exercisable October 28, 2007 3,149,450 $ 14.47 $ 7,240
---------- ------------- -----------
Vested and expected to vest October 28, 2007 3,507,730 $ 14.73 $ 7,240
---------- ------------- -----------
<FN>
(1) There are 1,954,900 vested options with exercise prices greater than
the closing stock price of $15.09 as of October 28, 2007.
</FN>
9. Loss per Common Share ("EPS")
The following table shows the components used in the calculation of basic
loss per common share and loss per common share assuming dilution (in
thousands):
Thirteen weeks ended
--------------------
October 28, October 29,
2007 2006
------------------ -----------------
Numerator:
Net Loss $ (2,591) $ (6,011)
================== =================
Denominator:
Basic weighted-average shares 13,965 13,862
Effect of dilutive securities:
Employee stock options - -
------------------ -----------------
Diluted weighted-average shares 13,965 13,862
================== =================
Stock options not included in computation 3,581 3,490
================== =================
Exercise price range per share $7.25 - $21.18 $4.06 - $21.18
No employee stock options were considered in the computation of diluted net
loss per share for the thirteen weeks ended October 28, 2007 and October
29, 2006 as their effect is anti-dilutive. The options which were
outstanding as of October 28, 2007 and excluded from the computation in the
table above expire at various dates through June 8, 2017.
10. Stock Buyback Program
On October 12, 2007, the Company announced that its Board of Directors had
approved an expansion of its existing stock buyback program to make
additional purchases of up to 1,000,000 shares of its common stock in the
open market or private transactions, in accordance with applicable SEC
rules. During the thirteen weeks ended October 28, 2007 the Company
repurchased and retired 84,944 shares of its common stock, pursuant to this
program at an aggregate cost of approximately $1,288,000 including
transaction costs. Common stock at par value and additional paid-in capital
were reduced by approximately $8,000 and $1,280,000, respectively. The
timing, actual number and value of any additional shares that may be
repurchased under this program will depend on a number of factors,
including the Company's future financial performance, the Company's
available cash resources and competing uses for the cash, prevailing market
prices of the Company's common stock and the number of shares that become
available for sale at prices that the Company believes are attractive. As
of October 28, 2007, approximately 1,022,000 shares are available under the
Company's buyback program. Subsequent to October 28, 2007 the Company
purchased an additional 205,462 shares at an aggregate cost of
approximately $3,090,000.
11
11. Geographic Information and Major Customers
The Company's chief operating decision makers are considered to be the
Chairman/Chief Executive Officer, the President and the Chief Operating
Officer. These individuals evaluate both consolidated and disaggregated
financial information, primarily gross revenues, in deciding how to
allocate resources and assess performance. They also use certain
disaggregated financial information for the Company's product groups. The
Company does not determine a measure of operating income or loss by product
group. The Company's product groups have similar long-term economic
characteristics, such as application, and are similar in regards to (a)
nature of products and production processes, (b) type of customers and (c)
method used to distribute products. Accordingly, the Company operates as a
single integrated business and as such has one operating segment as a
provider of complex microwave technology solutions for the defense,
aerospace and medical industries worldwide. All of the Company's revenues
result from sales of its products.
Revenues for the thirteen weeks ended October 28, 2007 and October 29, 2006
were as follows: defense electronics, $32,197,000 and $34,973,000,
respectively; and commercial technologies, $2,936,000 and $5,143,000,
respectively.
Net sales directly to the U.S. Government in the thirteen weeks ended
October 28, 2007 and October 29, 2006 accounted for approximately 15% and
21% of net sales, respectively. Northrop Grumman and Lockheed Martin
accounted for approximately 12% and 11%, respectively of net sales in the
thirteen weeks ended October 28, 2007. No other customer accounted for 10%
or more of consolidated net sales in the periods presented. Foreign sales
amounted to approximately $11,870,000 (34%) and $12,163,000 (30%) in the
thirteen weeks ended October 28, 2007 and October 29, 2006, respectively.
Geographic net sales for the first quarter based on place of contract
performance, were as follows (in thousands):
Thirteen weeks ended
--------------------
October 28, October 29,
2007 2006
------------ -----------
United States $ 30,432 $ 33,585
Israel 4,422 4,375
England 279 2,156
----------- -----------
$ 35,133 $ 40,116
=========== ===========
Net property, plant and equipment by geographic area was as follows (in
thousands):
October 28, 2007 July 29, 2007
---------------- -------------
United States $ 25,732 $ 24,904
Israel 4,688 4,844
England 203 248
-------- --------
$ 30,623 $ 29,996
======== ========
12. Supplemental Cash Flow information is as follows (in thousands):
Thirteen weeks ended
--------------------
October 28, 2007 October 29, 2006
---------------- ----------------
Net cash paid during the period for:
Interest $ 26 $ 79
Income taxes $ 221 $ -
Non-cash financing transactions:
Retirement of 84,944 shares of treasury stock $ 1,288 $ -
13. New Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 159, "The Fair
Value Option for Financial Assets and Financial Liabilities" ("SFAS 159").
SFAS 159 provides companies with an option to report selected financial
assets and financial liabilities at fair value. Unrealized gains and losses
on items for which the fair value option has been elected are reported in
earnings at each subsequent reporting date. SFAS 159 is effective for
fiscal years beginning after November 15, 2007 (the Company's 2009 fiscal
year). The Company will evaluate the impact of adopting SFAS 159 but does
not expect that it will have a material impact on the Company's
consolidated financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
12
("SFAS 157"). SFAS 157 defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles, and
expands disclosures about fair value measurements. It codifies the
definitions of fair value included in other authoritative literature;
clarifies and, in some cases, expands on the guidance for implementing fair
value measurements; and increases the level of disclosure required for fair
value measurements. Although SFAS 157 applies to (and amends) the
provisions of existing authoritative literature, it does not, of itself,
require any new fair value measurements, nor does it establish valuation
standards. At its meeting on November 14, 2007, the FASB granted a one year
deferral for non-financial assets and liabilities to comply with the
requirements of SFAS 157. Compliance with SFAS 157 for financial assets
remains effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal
years. This statement will be effective for the Company's fiscal year and
interim periods within the fiscal year beginning August 2008. The Company
will evaluate the impact of adopting SFAS 157 but does not expect that it
will have a material impact on the Company's consolidated financial
position, results of operations or cash flows.
14. Related Party Transactions
The Company leases one of its buildings in Fort Walton Beach, Florida from
MSI Investments, a Florida General Partnership which is owned by four
individuals, two of whom are currently employees of MSI and one who serves
as a consultant. Rent expense in the thirteen weeks ended October 28, 2007
and October 29, 2006 was approximately $79,000 and $67,000, respectively.
The Company leases its facilities in Farmingdale, New York from a
partnership partially owned by the children of an officer of the Company.
Rent expense in the thirteen weeks ended October 28, 2007 and October 29,
2006 was approximately $138,000 and $126,000, respectively.
Item 2: Management's Discussion and Analysis of Financial Condition and Results
of Operations
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.
Explanatory Note
We begin Management's Discussion and Analysis of Financial Condition and Results
of Operations ("MD&A") of Herley Industries, Inc. with a business overview. This
is followed by a discussion of the critical accounting estimates that we believe
are important to understanding the assumptions and judgments incorporated in our
reported financial results, which we discuss under "Results of Operations." We
then provide an analysis of cash flows under "Liquidity and Capital Resources."
This MD&A should be read in conjunction with our unaudited condensed
consolidated financial statements, the notes thereto, the other unaudited
financial data included elsewhere in this 10-Q and our 2007 Form 10-K/A
Amendment No. 1.
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 Northrop Grumman Corporation, Lockheed Martin
Corporation, Raytheon Company, The Boeing Company, BAE Systems and Harris
Corporation), the U.S. Government (including the Department of Defense, NASA and
other U.S. Government agencies) and international customers (including the
Egyptian, German, Japanese 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
and electronic warfare systems. We have served the defense industry since 1965
by designing and manufacturing microwave devices 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 E-2C/D Hawkeye, EA-18G Growler, the
AEGIS class surface combatants, the EA-6B Prowler, the AMRAAM air to air
missile, CALCM (Conventional Air Launch Cruise Missile), Multi-mission Maritime
Aircraft and unmanned aerial vehicles, or UAVs, as well as high priority
national security programs such as National Missile Defense and the Trident II
D-5.
Critical Accounting Policies
Our significant accounting policies are described in Note A of the Notes to
Consolidated Financial Statements included in our Annual Report on Form 10-K/A
13
Amendment No. 1 for the fiscal year ended July 29, 2007. A discussion of our
critical accounting policies and estimates are included in Management's
Discussion and Analysis of Results of Operations and Financial Condition in our
Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July 29,
2007. Management has discussed the development and selection of these policies
with the Audit Committee of the Company's Board of Directors, and the Audit
Committee of the Board of Directors has reviewed the Company's disclosures of
these policies.
We adopted the provisions of Financial Accounting Standards Board (FASB)
Interpretation No. 48 (FIN 48) effective July 30, 2007. FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with SFAS No. 109, "Accounting for Income
Taxes," and prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition. We had no cumulative effect adjustment
related to the adoption. However, certain amounts have been reclassified in the
consolidated balance sheet in order to comply with the requirements of the
statement.
Other than the adoption of FIN 48, there have been no material changes to the
critical accounting policies or estimates reported in Management's Discussion
and Analysis section of the audited financial statements for the fiscal year
ended July 29, 2007 as filed with the Securities and Exchange Commission.
Results of Operations
Thirteen weeks ended October 28, 2007 and October 29, 2006
- ----------------------------------------------------------
Net sales for the thirteen weeks ended October 28, 2007 were approximately
$35,133,000, as compared to $40,116,000 in the thirteen weeks ended October 29,
2006, a decrease of $5.0 million (12.4%). This decrease is attributable to: a
decrease of $1.6 million versus the prior year quarter as certain commercial
programs ended and the transition towards military business progressed at one of
our locations; a decrease of $2.1 million due to a delay in the receipt of a
significant cost plus fixed fee contract for software development; a decrease of
$1.1 million as the result of delays in certain microwave development programs
in the first quarter of fiscal 2008; approximately $0.8 million due to the
suspension in June 2007 discussed in Note 2; and a decline in revenue from
simulation systems of $1.3 million due to the completion of certain contracts
and the delay in booking a significant contract. Offsetting these decreases was
an increase of $2.3 million in sales from the start up in production of a system
upgrade and spares under a contract for the foreign market.
Domestic and foreign sales from all locations were 66% and 34% respectively of
total net sales in the quarter, versus 70% and 30% respectively in the prior
year quarter. Bookings in the first quarter were approximately $40 million, and
were 72% domestic and 28% foreign. This compares to bookings of approximately
$45 million in the prior year first quarter which were 70% domestic and 30%
foreign.
The gross profit margin in the thirteen weeks ended October 28, 2007 was 28.4%
compared to 25.6% in the first quarter of fiscal 2007, an increase of 2.8%.
Contributing to the improvement in gross profit margin for the quarter are the
following items:
o A reversal in the accrual for contract losses of approximately $826,000 due
to the completion of a contract and the expiration of the remaining
options.
o Non-recurrence of start-up production costs from the prior year on certain
programs.
o Product mix, including an increase in foreign sales which generally yield
higher margins.
Selling and administrative expenses for the thirteen weeks ended October 28,
2007 decreased approximately $202,000 over the first quarter of fiscal 2007 and
was 25% of net sales as compared to 22% in fiscal 2007. Significant decreases
and increases during the period included:
o A decrease in legal fees, net of accrued insurance recoveries, over the
prior year quarter of $167,000. During the thirteen weeks ended October 28,
2007, gross legal costs were approximately $778,000, while legal costs net
of accrued insurance recoveries were approximately $522,000 as compared to
$689,000 in thirteen weeks ended October 29, 2006. Legal costs in both
periods are primarily attributable to pending litigation by the U.S.
Attorneys' office in Pennsylvania which, inter alia, involves pricing under
two contracts with the U.S. Department of Defense.
Offset by
o An increase in stock compensation costs recorded per SFAS 123(R) of
approximately $132,000.
We believe we are entitled to recovery of certain legal fees associated with the
recent indictment and class-action complaints under our D&O insurance policy.
Accordingly, as of October 28, 2007, we have a receivable of approximately
$1,370,000 (net of a deductible of $500,000 and payments received of
approximately $1,348,000) in anticipation of recoveries and the amount is
included in other receivables in the accompanying condensed consolidated balance
sheet at October 28, 2007. The insurance carrier may contest the claim in whole
or in part. In addition, we have entered into an agreement dated January 11,
2007 with the insurance carrier whereby if it is determined by final decision of
an arbitration panel, or by final judgment of a court, or other final decision
of a tribunal having jurisdiction thereof, that any amount paid by the insurance
14
carrier was not a loss, as that term is defined in the policy, we shall repay to
the insurance carrier any such uncovered sums previously advanced to us.
In connection with a lawsuit filed on April 10, 2007, by EADS Deutschland GmbH
("EADS"), a German corporation, against us (see Notes 2 and 6), we have entered
into an agreement with EADS effective December 5, 2007 providing for a mutual
release and dismissal, with prejudice and without costs or attorney's fees to
either party, of all claims and counterclaims filed. To avoid further dilution
of management's time and energies, as well as legal costs on a long and
protracted legal dispute, we agreed to pay to EADS the sum of $6,000,000. A
payment of $2,500,000 is due on or before December 15, 2007; $1,500,000 is due
by March 31, 2008; and a payment of $1,000,000 is due on March 31, 2009 and
March 31, 2010, respectively. The agreement further provides for the transfer to
EADS of all drawings in our possession, custody or control for the equipment
supplied in conjunction with a contract between us; providing EADS with the use
of such drawings for the exclusive purpose of fulfilling its obligations towards
its own customers under the contract. As security for the payments due in March
of 2008, 2009 and 2010, we will issue an irrevocable stand-by letter of credit
in the amount of $3,500,000 under our existing credit facility by December 15,
2007. We recorded a charge to operations in the thirteen weeks ended October 28,
2007 of approximately $6,042,000 consisting of payments due under the agreement
of approximately $5,699,000, net of imputed interest of approximately $301,000
discounted at an imputed interest rate of 7.25%, plus costs and other direct
settlement expenses of approximately $343,000. The payment of $2,500,000 was
made and the stand-by letter of credit was issued on December 5, 2007.
Loss from operations for the first quarter of fiscal 2008 was $4,869,000 or
13.9% of net sales, as compared to a loss from operations of $7,651,000 or 19.1%
of net sales in the prior year. The loss from operations for the first quarter
of fiscal 2008 was largely impacted by the $6,042,000 litigation settlement
costs. Similarly, the loss from operations for the first quarter of fiscal 2007
was largely impacted by the $8,914,000 employment contract settlement costs.
Other income (expense) improved in the first quarter of fiscal 2008 over the
prior year by approximately $460,000. Contributing to the increase were
improvements in investment income of $213,000 and foreign exchange gains of
$129,000. In addition, interest expense was approximately $118,000 lower as
certain interest costs associated with the development of software for internal
use were capitalized in accordance with FAS 34, capitalization of interest cost.
The income tax benefit recognized in the first quarter of fiscal 2008 was
$1,728,000 as compared to a benefit of $1,550,000 in the prior year's first
quarter. The estimated effective income tax rate for fiscal 2008 of 24.5% is
lower than the statutory rate of 35% primarily due to (a) the utilization of a
research and development credit and (b) lower domestic earnings due primarily to
the EADS litigation settlement which significantly reduces domestic income
resulting in foreign earnings being a greater percentage of total earnings. The
Company's foreign earnings are attributable primarily to our Israeli subsidiary
which is taxed at an estimated rate of 10% for fiscal 2008, thereby reducing the
effective income tax rate by approximately 9%. Other items contributing to the
tax benefit in the first quarter of fiscal 2008 include a research and
development credit carryover and a lower estimated tax rate in Israel for fiscal
2007.
Liquidity and Capital Resources
- -------------------------------
As of October 28, 2007 and July 29, 2007, working capital was $105,613,000 and
$103,502,000, respectively, and the ratio of current assets to current
liabilities was 3.8 to 1 and 4.0 to 1, respectively.
As is customary in the defense industry, inventory is partially financed by
progress payments. In addition, it is customary for us to receive advanced
payments from customers on major contracts at the time a contract is entered
into. The un-liquidated balance of progress payments was approximately
$1,752,000 at October 28, 2007 and $1,921,000 at July 29, 2007. The balance of
advanced payments was approximately $7,118,000 at October 28, 2007 and
$7,163,000 at July 29, 2007.
Net cash provided by operations during the thirteen weeks ended October 28, 2007
was approximately $2.1 million as compared to cash used in operations of $1.2
million during the first quarter of the prior year, a net increase of
approximately $3.3 million. We had a net loss in the first quarter of the
current fiscal year of $2.6 million versus a loss of $6.0 million in the prior
year first quarter, a decrease of approximately $3.4 million. The first quarter
of fiscal 2008 was impacted by the settlement accrual of litigation and related
costs of approximately $5.9 million and the first quarter of fiscal 2007
included employment settlement costs of approximately $8.9 million, including a
cash payment of $3.0 million (as discussed in Note 2).
Other significant increases in cash provided by operating activities during the
thirteen weeks ended October 28, 2007 include the following:
1. A decrease in trade accounts receivable of $2.4 million,
2. an increase of approximately $1.7 million generated through amounts due to
vendors and accrued expenses, and
3. the recognition of a deferred tax asset of approximately $1.4 million
attributable to the net operating loss in the period.
15
Offset primarily by the following decreases in cash provided by operating
activities:
1. An increase of approximately $3.0 million in the amount of cash invested in
costs incurred and income recognized in excess of billings on uncompleted
contracts and claims, and
2. an increase in inventory of approximately $2.2 million.
Net cash used in investing activities relates to capital expenditures of
approximately $1.0 million.
Net cash used in financing activities includes:
1. The purchase and retirement of 84,944 shares of our common stock at an
aggregate cost of approximately $1,288,000, including transaction
costs, pursuant to an expansion of a stock buyback program to make
additional purchases of up to 1,000,000 shares of our common stock in
the open market or private transactions. As of October 28, 2007,
approximately 1,022,000 shares are available for purchase under the
buyback program. Subsequent to October 28, 2007 the Company purchased
an additional 205,462 shares at an aggregate cost of approximately
$3,090,000 and intends to continue to buy back shares depending on a
number of factors, including our future financial performance,
available cash resources and competing uses for the cash, prevailing
market prices of our common stock and the number of shares that become
available for sale at prices that we believe are attractive; and .
2. payments of $0.4 million related to our long-term debt.
During the thirteen weeks ended October 28, 2007 we borrowed and repaid $4.9
million under our revolving credit facility for short-term working capital
needs.
On April 30, 2007, we replaced our existing credit facility with a new $40
million Revolving Credit Loan Agreement with two banks on an unsecured basis
which may be used for general corporate purposes, including business
acquisitions and stand-by letters of credit. The revolving credit facility
requires the payment of interest only on a monthly basis and payment of the
outstanding principal balance on March 31, 2009. We may elect to borrow with
interest based on the bank's prime rate of interest minus 0.50% or 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. There is a fee of 20 basis points per annum on the
unused portion of the credit facility payable quarterly. Stand-by letters of
credit were outstanding in the amount of approximately $11.6 million at October
28, 2007. If at any time our backlog of orders falls below $50 million, the bank
may obtain a security interest in eligible accounts receivable, as defined, and
if the outstanding advances are greater than 100% of eligible receivables, a
lien on all inventory. Funded backlog as of October 28, 2007 was approximately
$137 million out of a total backlog of approximately $142 million. During the
quarter ended October 28, 2007, we utilized the credit facility for short-term
working capital needs to the extent of $4.9 million. There are no borrowings
under the credit line at October 28, 2007 and July 29, 2007. Stand-by letters of
credit were outstanding in the amount of approximately $11.6 million under the
credit facility at October 28, 2007, and $11.5 million at July 29, 2007.
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. We are in
compliance with all covenants at October 28, 2007.
We believe that presently anticipated future cash requirements will be provided
by internally generated funds, our existing unsecured credit facility, and
existing cash reserves. A significant portion of our revenue for fiscal 2008
will be generated from our existing backlog of sales orders. The funded backlog
of orders at October 28, 2007 was approximately $137 million. In the event of
the cancellation of a significant amount of government contracts included in our
backlog, we will be required to rely more heavily on cash reserves and our
existing credit facility to fund operations. We are not aware of any events
which are reasonably likely to result in any cancellation of our government
contracts. As of October 28, 2007, we have approximately $28.4 million available
under our bank credit facility, net of outstanding stand-by letters of credit of
approximately $11.6 million and cash reserves of approximately $34.6 million. In
connection with the litigation settlement discussed in Note 2, the Company will
issue an irrevocable stand-by letter of credit for $3.5 million on or before
December 15, 2007 which will reduce the availability under the credit facility
to approximately $24.9 million.
Contractual Financial Obligations, Commitments and Off-Balance Sheet
Arrangements
Our financial obligations and commitments to make future payments under
contracts include purchase orders, debt and lease agreements, and contingent
commitments such as stand-by letters of credit. These financial obligations are
recorded in accordance with accounting rules applicable to the underlying
transaction, with the result that some are recorded as liabilities on the
Balance Sheet, while others are required to be disclosed in the Notes to
Consolidated Financial Statements and Management's Discussion and Analysis. The
Company's contractual financial obligations and other contingent commitments are
disclosed in our Annual Report on Form 10-K/A Amendment No. 1 for the fiscal
year ended July 29, 2007 under Management's Discussion and Analysis. In addition
to the financial obligations contained therein, the following payments
(including imputed interest), as well as a stand-by letter of credit, are
required under the terms of the litigation settlement discussed in Note 2 (in
thousands):
16
Stand-by
Letter
Payments of Credit
-------- ---------
Within one year $4,000 $1,500
2-3 years 2,000 2,000
----- -----
Total $6,000 $3,500
===== =====
Upon the adoption of FIN 48, the Company reclassified to long term its
liabilities for unrecognized tax benefits in the amount of approximately $3.1
million, as discussed in Note 4 to the Condensed Consolidated Financial
Statements. The Company is unable to make reasonable estimates as to the
period(s) in which cash will be paid for these liabilities.
New Accounting Pronouncements
- -----------------------------
For a discussion of new accounting standards, see Note 13 to our Condensed
Consolidated Financial Statements - (Unaudited) in Item 1.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
The Company's exposures to market risk have not changed significantly since July
29, 2007.
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 October 28, 2007.
(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
October 28, 2007 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:
On June 6, 2006, in connection with 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, 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 contracts aggregate approximately
$3.9 million in total revenue. The indictment as superseded on January 30,
2007 alleges 27 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); aiding and abetting (18 U.S.C. Section 2); and a notice of
forfeiture. The Company moved to dismiss the indictment and that motion was
denied on November 5, 2007. A trial is currently scheduled for May 5, 2008.
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.
In June and July 2006, the Company was served with several class-action
complaints against the Company and certain of its officers in the United
States District Court for the Eastern District of Pennsylvania. The claims
are made under Section 10(b) and 20(a) of the Securities Exchange Act of
1934 and Rule 10b-5 thereunder. All defendants in the class-action
complaints filed motions to dismiss on April 6, 2007.
On July 17, 2007, the Court issued an order denying the Company's and Mr.
Blatt's motion to dismiss and granted, in part, the other defendants'
motion to dismiss. Specifically, the Court dismissed the Section 10(b)
claim against the other defendants and denied the motion to dismiss the
Section 20(a) claim against them. On July 18, 2007, the Court granted
defendant's motion to stay these actions until after the trial of the
criminal matter referenced above.
17
In July and August 2006, the Company and certain of its current and former
officers and directors were also served with two separate derivative
complaints for breach of fiduciary duty brought pursuant to Rule 23.1 of
the Federal Rules of Civil Procedure. The complaints relate to the
Company's indictment in the matter discussed above and were consolidated
into one action on March 9, 2006. All defendants in the derivative
complaints filed motions to dismiss on February 26, 2007. On July 20, 2007,
the Court issued an order denying defendants' motions in part and granting
them in part. Specifically, the Court dismissed the claim that the named
officers and directors failed to oversee Mr. Blatt and denied the motions
with respect to the other alleged claims. The Court also granted
defendants' motion to stay the action until after the trial of the criminal
matter.
In addition, in June 2006, the Company was notified by representatives of
the United States Attorney's Office for the Eastern District of
Pennsylvania, Civil Division, that they intended to file a civil lawsuit
against the Company pursuant to inter alia, the False Claims Act, 31 U.S.C.
Section 3729 et. seq. The Company entered into a Tolling Agreement on June
21, 2006, and does not anticipate any further activity related to this
potential claim until after the trial of the criminal matter mentioned
above which is currently scheduled for May 5, 2008.
The Company believes it has substantial defenses to the charges alleged in
the indictment and intends to vigorously defend against these allegations.
The Company believes it is entitled to recovery of certain legal fees
associated with the above matters under its D&O insurance policy.
Accordingly, as of October 28, 2007, the Company recorded a receivable of
$2,718,000 (net of a deductible of $500,000) in anticipation of recoveries.
As of October 28, 2007 partial payments of approximately $1,348,000 have
been received leaving a balance of $1,370,000. The amount is included in
other receivables in the accompanying consolidated balance sheet at October
28, 2007. The insurance carrier may contest the claim in whole or in part.
In addition, the Company has entered into an agreement dated January 11,
2007 with the insurance carrier whereby if it is determined by final
decision of an arbitration panel, or by final judgment of a court, or other
final decision of a tribunal having jurisdiction thereof, that any amount
paid by the insurance carrier was not a loss, as that term is defined in
the policy, the Company shall repay to the insurance carrier any such
uncovered sums previously advanced to the Company.
On June 27, 2007, the Company was notified by the Office of the General
Counsel, Acquisition Integrity Office, Department of Navy (the "Navy"),
that certain of its operations had been suspended from receiving new
contract awards from the U.S. Government. The affected operations included
facilities in Lancaster, Pennsylvania; Woburn, Massachusetts and Chicago,
Illinois. The Chicago, Illinois location is a two-person marketing office.
On August 15, 2007 the suspension was lifted following an amendment to the
Administrative Agreement with the Navy (originally signed on October 12,
2006) extending the term of the agreement for one additional year. While
the suspension was in place, these facilities could not be solicited for or
awarded new contracts or contract extensions without special exceptions.
The suspended facilities were permitted to receive contract awards or
subcontracts from the Federal Government if the head of the agency stated
in writing the compelling reason to do so. A significant portion of our
business is received under contracts where we are the only qualified
supplier on critical defense programs.
On April 10, 2007, EADS Deutschland GmbH ("EADS"), a German corporation,
filed a lawsuit against Herley Industries, Inc., General Microwave
Corporation and General Microwave Export Corporation d/b/a Herley Power
Amplifier Systems (collectively the "Company") in the United States
District Court for the Eastern District of New York. EADS claims that the
Company breached a Transfer of Technology Agreement entered into on May 30,
2001 under which the Company was granted the right to use certain
technology owned by EADS in performing under an exclusive sales and
marketing agreement entered into on May 30, 2001. EADS asserted claims for
breach of contract and conversion, claiming that the Company was wrongfully
in possession of the intellectual property that was transferred to the
Company. EADS also sought a preliminary injunction. The Company denied any
wrongdoing and filed counterclaims against EADS. On August 2, 2007, the
Company and EADS entered into a settlement of this motion, which was
reduced to a written consent decree entered by the Court on August 29,
2007. EADS's claims for breach of contract and for conversion remained
pending, as did the Company's counterclaims. Pursuant to the consent
decree, the parties agreed to a mediation/settlement conference of all
their respective claims with the Court, and further agreed to stay all
proceedings pending the outcome of that mediation/settlement conference on
October 17, 2007. In November 2007, the Company reached a comprehensive
settlement agreement with EADS as discussed in Note 2 of Notes to Condensed
Consolidated Financial Statements.
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.
Item 1A - Risk Factors
In addition to the other information set forth in this report, you should
carefully consider the risk factors disclosed under Part 1 -"Item 1A. Risk
Factors" in our Annual Report on Form 10-K/A Amendment No. 1 for the year
ended July 29, 2007, which could materially adversely affect our business,
financial condition, operating results and cash flows. The risks and
18
uncertainties described in our Form 10-K/A Amendment No. 1 for the year
ended July 29, 2007 are not the only ones we face. Risks and uncertainties
not currently known to us or that we currently deem immaterial also may
materially adversely affect our business, financial condition, operating
results or cash flows.
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds:
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
31. Certifications pursuant to Rules 13a-14(a) as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32. Certifications pursuant to 18 U.S.C. Section 1350 as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
19
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/ Kevin J. Purcell
-----------------------------------------
Kevin J. Purcell, Chief Financial Officer
DATE: December 6, 2007