--------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 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 Quarter Ended September 30, 2006
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 0-27460
PERFORMANCE TECHNOLOGIES, INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 16-1158413
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
205 Indigo Creek Drive, Rochester, New York 14626
(Address of principal executive offices) (Zip Code)
-----------------
Registrant's telephone number, including area code: (585) 256-0200
-----------------
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. Yes [X] 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 [ ] Accelerated filer [X]
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 [ ] No [X]
The number of shares outstanding of the registrant's common stock was
13,270,690 as of November 1, 2006.
--------------------------------------------------------------------------------
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 2006 and
December 31, 2005 (unaudited) 3
Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2006 and 2005 (unaudited) 4
Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 2006 and 2005 (unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 25
Item 4. Controls and Procedures 25
PART II. OTHER INFORMATION
Item 6. Exhibits 25
Signatures 26
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(unaudited)
ASSETS
September 30, December 31,
2006 2005
------------- -------------
Current assets:
Cash and cash equivalents $ 11,793,000 $ 11,803,000
Investments 23,425,000 21,150,000
Accounts receivable, net 8,189,000 9,523,000
Inventories 6,989,000 7,148,000
Prepaid income taxes 44,000
Prepaid expenses and other assets 405,000 470,000
Deferred taxes 3,609,000 3,272,000
------------- -------------
Total current assets 54,454,000 53,366,000
Property, equipment and improvements, net 2,286,000 2,004,000
Software development costs, net 3,383,000 3,182,000
Investment in unconsolidated company 248,000 248,000
Goodwill 4,143,000 4,143,000
------------- -------------
Total assets $ 64,514,000 $ 62,943,000
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,438,000 $ 1,836,000
Income taxes payable 244,000
Accrued expenses 4,956,000 4,438,000
------------- -------------
Total current liabilities 6,394,000 6,518,000
Deferred taxes 1,252,000 1,138,000
------------- -------------
Total liabilities 7,646,000 7,656,000
------------- -------------
Stockholders' equity:
Preferred stock - $.01 par value;
1,000,000 shares authorized; none issued
Common stock - $.01 par value;
50,000,000 shares authorized;
13,260,038 shares issued 133,000 133,000
Additional paid-in capital 14,642,000 13,903,000
Retained earnings 42,217,000 42,601,000
Treasury stock - at cost; 6,235 and
171,757 shares held at September 30,
2006 and December 31, 2005, respectively (124,000) (1,350,000)
------------- -------------
Total stockholders' equity 56,868,000 55,287,000
------------- -------------
Total liabilities and
stockholders' equity $ 64,514,000 $ 62,943,000
============= =============
The accompanying notes are an integral part of
these consolidated financial statements.
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---------- ----------- ----------- -----------
Sales $10,828,000 $12,343,000 $36,048,000 $36,302,000
Cost of goods sold 5,615,000 6,153,000 17,715,000 18,531,000
Non RoHS inventory charge
(Note C) 801,000
----------- ----------- ----------- -----------
Gross profit 5,213,000 6,190,000 17,532,000 17,771,000
----------- ----------- ----------- -----------
Operating expenses:
Selling and marketing 1,581,000 1,342,000 4,404,000 4,187,000
Research and development 2,561,000 2,677,000 8,342,000 7,550,000
General and administrative 1,452,000 1,131,000 4,198,000 3,658,000
Restructuring charges
(Note H) 792,000 53,000 1,786,000 249,000
----------- ----------- ----------- -----------
Total operating expenses 6,386,000 5,203,000 18,730,000 15,644,000
----------- ----------- ----------- -----------
(Loss) income from operations(1,173,000) 987,000 (1,198,000) 2,127,000
Other income, net 385,000 333,000 1,090,000 958,000
----------- ----------- ----------- -----------
(Loss) income before
income taxes (788,000) 1,320,000 (108,000) 3,085,000
Income tax (benefit)
provision (408,000) 383,000 (346,000) 895,000
----------- ----------- ----------- -----------
Net (loss) income $ (380,000) $ 937,000 $ 238,000 $ 2,190,000
=========== =========== =========== ===========
Basic (loss) earnings
per share $ (.03) $ .07 $ .02 $ .17
=========== =========== =========== ===========
Diluted (loss) earnings
per share $ (.03) $ .07 $ .02 $ .17
=========== =========== =========== ===========
Weighted average number of
common shares used in
basic earnings per share 13,252,012 12,872,126 13,178,107 12,848,264
Potential common shares 207,314 166,900 276,238
Weighted average number of
common shares used in ----------- ----------- ----------- -----------
diluted earnings per share 13,252,012 13,079,440 13,345,007 13,124,502
=========== =========== =========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Ended
September 30,
2006 2005
------------- -------------
Cash flows from operating activities:
Net income $ 238,000 $ 2,190,000
Non-cash adjustments:
Depreciation and amortization 1,713,000 1,838,000
Tax benefit from stock option exercises 231,000 143,000
Stock-based compensation expense 482,000 17,000
Deferred income taxes (223,000) 367,000
Loss on disposal of assets 102,000 2,000
Other 37,000
Changes in operating assets and liabilities:
Accounts receivable 1,334,000 316,000
Inventories 159,000 (180,000)
Prepaid expenses and other assets 65,000 305,000
Accounts payable and accrued expenses 120,000 840,000
Income taxes payable and prepaid
income taxes (288,000) 511,000
------------- -------------
Net cash provided by operating
activities 3,933,000 6,386,000
------------- -------------
Cash flows from investing activities:
Purchases of property, equipment and
improvements (945,000) (480,000)
Capitalized software development costs (1,353,000) (1,987,000)
Purchases of investments (75,175,000) (57,325,000)
Proceeds from sales of investments 72,900,000 53,250,000
------------- -------------
Net cash used by investing activities (4,573,000) (6,542,000)
------------- -------------
Cash flows from financing activities:
Tax windfall benefit from stock option
exercises 25,000
Exercise of stock options 605,000 394,000
------------- -------------
Net cash provided by financing
activities 630,000 394,000
------------- -------------
Net (decrease) increase in cash and
cash equivalents (10,000) 238,000
Cash and cash equivalents at beginning
of period 11,803,000 10,361,000
------------- -------------
Cash and cash equivalents at end of
period $ 11,793,000 $ 10,599,000
============= =============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Non-cash financing activity:
Exercise of stock options using 57,484
shares of common stock $ 426,000 $
============= =============
Noncash investing activity - During the third quarter 2005, the Company received
preferred stock of InSciTek Microsystems, Inc., in satisfaction of an interest
payment of $248,000 due to the Company from InSciTek Microsystems, Inc.
The accompanying notes are an integral part of
these consolidated financial statements.
PERFORMANCE TECHNOLOGIES, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note A - Basis of Presentation
---------------------
The unaudited Consolidated Financial Statements of Performance Technologies,
Incorporated and Subsidiaries (the "Company") have been prepared in accordance
with generally accepted accounting principles in the United States of America
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X of the Securities and Exchange Commission.
Accordingly, the Consolidated Financial Statements do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all adjustments
considered necessary for a fair statement have been included. The results for
the interim periods are not necessarily indicative of the results to be expected
for the year. The accompanying Consolidated Financial Statements should be read
in conjunction with the audited Consolidated Financial Statements of the Company
as of December 31, 2005, as reported in its Annual Report on Form 10-K filed
with the Securities and Exchange Commission.
Note B - Stock-Based Compensation and Earnings Per Share
-----------------------------------------------
The Company has stock options outstanding from three stock-based employee
compensation plans, the Amended and Restated 1986 Incentive Stock Option Plan,
the 2001 Incentive Stock Option Plan, and the 2003 Omnibus Incentive Plan.
Effective January 1, 2006, the provisions of Statement of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment", and related
interpretations, were adopted to account for stock-based compensation using the
modified prospective transition method and therefore, prior period results were
not restated. SFAS No. 123(R) supersedes Accounting Principles Board Opinion
(APB) No. 25, "Accounting for Stock Issued to Employees", and revises guidance
of SFAS No. 123, "Accounting for Stock-Based Compensation". Among other things,
SFAS No. 123(R) requires that compensation expense be recognized in the
financial statements for share-based awards based on the grant-date fair value
of those awards. The modified prospective transition method applies to (a) stock
options granted prior to December 31, 2005 which had unrecognized compensation
expense at January 1, 2006, calculated under SFAS No. 123, and (b) any new
share-based awards granted subsequent to December 31, 2005, based on the
grant-date fair value estimated in accordance with the provisions of SFAS No.
123(R). Additionally, stock-based compensation expense includes an estimate for
pre-vesting forfeitures and is recognized over the requisite service periods of
the awards on a straight-line or graded vesting basis, which is generally
commensurate with the vesting term. Stock-based compensation expense associated
with stock option grants of $194,000 and $482,000 was recorded during the third
quarter and the first nine months of 2006, respectively, as a result of the
adoption of SFAS No. 123(R).
Prior to January 1, 2006, stock-based compensation plans were accounted for in
accordance with APB No. 25 and related interpretations. Stock options may be
granted to any officer or employee at not less than the fair market value at the
date of grant (not less than 110% of the fair market value in the case of
holders of more than 10% of the Company's common stock). Options granted under
the plans generally expire between five and ten years from the date of grant and
vest in periods ranging from one to six years. Prior to the adoption of SFAS No.
123(R), as required under the disclosure provisions of SFAS No. 123, as amended,
pro forma net income (loss) and earnings (loss) per common share were provided
for each period as if the fair value method were applied to measure stock-based
compensation expense.
The table below summarizes the impact of outstanding stock options and
restricted stock on the results of operations for the three and nine months
ended September 30, 2006 under the provisions of SFAS No. 123(R):
Three Months Nine Months
Ended Ended
September 30, September 30,
2006 2006
------------- -------------
Stock based compensation expense:
Stock options $ 188,000 $ 465,000
Restricted stock 6,000 17,000
Income tax benefit (67,000) (165,000)
------------- -------------
Net decrease in net income $ 127,000 $ 317,000
============= =============
Decrease in earnings per share:
Basic $ .01 $ .02
============= =============
Diluted $ .01 $ .02
============= =============
The Black-Scholes-Merton option pricing model was used to estimate the fair
value of share-based awards under SFAS No. 123(R) as well as for pro forma
disclosures under SFAS No. 123. The Black-Scholes-Merton option pricing model
incorporates various and highly subjective assumptions, including expected term
and expected volatility. For valuation purposes, stock option awards were
categorized into two groups, stock option grants to employees and stock option
grants to members of the Board of Directors.
The expected term of options granted prior to January 1, 2006 equaled the
vesting period. The expected term of options granted in 2006 was the average of
the vesting term and the contractual life. The expected volatility at the grant
date is estimated using historical stock prices based upon the expected term of
the options granted. The risk-free interest rate assumption is determined using
the rates for U.S. Treasury zero-coupon bonds with maturities similar to those
of the expected term of the award being valued. Cash dividends have never been
paid and are not anticipated to be paid in the foreseeable future. Therefore,
the assumed expected dividend yield is zero.
SFAS No. 123(R) requires pre-vesting option forfeitures at the time of grant be
estimated and periodically revised in subsequent periods if actual forfeitures
differ from those estimates. Stock-based compensation expense is recorded only
for those awards expected to vest using an estimated forfeiture rate based on
historical pre-vesting forfeiture data. Previously, forfeitures were accounted
for as they occurred under the pro forma disclosure provisions of SFAS No. 123
for periods prior to 2006.
The following table shows the detailed assumptions used to compute the fair
value of stock options granted during the nine months ended September 30, 2006:
Nine Months
Ended
September 30,
2006
-------------------
Expected term (years) 2 to 6.5
Volatility 56% to 66%
Risk free interest rate 4.6% to 5.0%
The weighted average grant date fair value of options granted during the nine
months ended September 30, 2006 was $3.93 per option. Unrecognized stock-based
compensation expense was approximately $1,727,000 as of September 30, 2006,
relating to a total of 551,000 unvested stock options under the Company's stock
option plans. This stock-based compensation expense is expected to be recognized
over a weighted average period of approximately four years.
The following table summarizes stock option activity for the nine months ended
September 30, 2006:
Weighted
Average
Number of Exercise Exercise Price
Shares Price Range
------------------------- ---------------
Outstanding at December 31, 2005 2,118,164 $ 9.71 $3.40 - $18.13
Granted 245,000 $ 6.82 $6.64 - $7.50
Exercised (223,006) $ 4.62 $3.40 - $7.25
Expired (237,798) $13.22 $3.80 - $18.13
-------------
Outstanding at September 30, 2006 1,902,360 $ 9.55 $3.40 - $18.13
=============
The following table summarizes stock option information at September 30, 2006:
Options outstanding Options exercisable
-----------------------------------------
Weighted Weighted Weighted Weighted
average average average average
Range of remaining exercise remaining exercise
exercise price Shares life (yrs) price Shares life (yrs) price
--------------------------------------------------------------------------------
$3.40 to $5.94 405,411 2.93 $ 4.56 321,749 1.95 $ 4.25
$5.95 to $8.60 864,360 5.03 $ 7.69 399,360 1.79 $ 8.06
$8.61 to $11.40 65,500 2.42 $10.27 65,330 2.42 $10.27
$11.41 to $14.24 286,564 .30 $13.74 284,864 .29 $13.74
$14.25 to $18.13 280,525 2.55 $18.06 280,525 2.55 $18.06
--------------------------------------------------------------------------------
1,902,360 3.41 $ 9.55 1,351,828 1.70 $10.53
===============================================================
The total intrinsic value of all outstanding options and all exercisable options
at September 30, 2006, whose exercise price was less than the Company's closing
stock price at September 30, 2006, was $933,000 and $822,000 respectively. The
total intrinsic value, determined as of the date of exercise, of options
exercised in the first nine months of 2006 and 2005 was $599,000 and $444,000,
respectively. Cash received from option exercises for the nine months ended
September 30, 2006 and 2005, amounted to $605,000 and $394,000, respectively.
The total fair value of options that vested during the nine months ended
September 30, 2006 was $220,000. In 2005 and 2006, shares of common stock were
issued from treasury for stock option exercises.
The following table illustrates the effect on net income and earnings per common
share for the three months and nine months ended September 30, 2005, as if the
provisions of SFAS No. 123 were applied using the fair value method to measure
stock-based compensation:
Three Months Nine Months
Ended Ended
September September
30, 2005 30, 2005
-------------- --------------
Net income, as reported $ 937,000 $ 2,190,000
Add: Restricted stock compensation expense,
net of tax 4,000 11,000
Deduct: Total stock-based compensation expense
determined under fair value based method for
all awards, net of related tax effects (150,000) (2,440,000)
-------------- --------------
Pro forma net income (loss) $ 791,000 $ (239,000)
============== ==============
Earnings (loss) per share:
Basic - as reported $ .07 $ .17
============== ==============
Basic - pro forma $ .06 $ (.02)
============== ==============
Diluted - as reported $ .07 $ .17
============== ==============
Diluted - pro forma $ .06 $ (.02)
============== ==============
During the nine months ended September 30, 2005, the Company granted options to
purchase 204,000 shares of common stock. The assumption for vesting of the stock
options granted was generally 33% per year. The following weighted-average
assumptions were used for these 2005 grants: Dividend yield of 0%; expected
volatility ranges of 65% to 70%, risk-free interest rate ranges of 3.3% to 3.7%,
and expected life ranges of one to three years.
During the fourth quarter 2005 and the first quarter 2006, stock options to
purchase 225,000 and 185,000 shares of common stock, respectively, were granted
that are subject to accelerated vesting based upon the achievement of certain
milestones, as defined in the option agreements. Subsequent to September 30,
2006, the option to purchase 225,000 shares of common stock terminated in
connection with the resignation of the Company's former president and chief
executive officer.
During 2003, 17,720 shares of restricted stock were granted at prices ranging
from $6.89 to $12.54. During 2003, 1,740 shares of restricted stock were
forfeited, without vesting. In January 2004, 10,524 shares vested and were
issued. The remaining shares vest in November 2006. The value of restricted
stock is charged to compensation expense over the vesting period of the grant.
Unrecognized compensation expense totaled approximately $3,000 at September 30,
2006, related to restricted stock.
Basic earnings per share is computed by dividing net income by the weighted
average number of common shares outstanding for the period. Diluted earnings per
share calculations reflect the assumed exercise and conversion of dilutive stock
options and unvested restricted stock, applying the treasury stock method. Due
to the net loss incurred in the third quarter 2006, there were no dilutive
options. Diluted earnings per share calculations exclude the effect of
approximately 1,263,000 options for the three months ended September 30, 2005,
and 1,325,000 and 1,184,000 options for the nine months ended September 30, 2006
and 2005, respectively, since such options have an exercise price in excess of
the average market price of the Company's common stock.
Note C - Inventories
-----------
Inventories consisted of the following:
September 30, December 31,
2006 2005
-------------- --------------
Purchased parts and components $ 2,737,000 $ 2,884,000
Work in process 2,995,000 3,378,000
Finished goods 1,257,000 886,000
-------------- -------------
Net $ 6,989,000 $ 7,148,000
============== ==============
The Restriction of Certain Hazardous Substances ("RoHS") Directive issued by the
European Union (EU) became effective on July 1, 2006. This directive restricts
the distribution of products within the EU that exceed very low maximum
concentration values of certain substances, including lead. In the second
quarter 2006, the Company recorded a charge to cost of goods sold for excess
non-compliant "RoHS" inventory, which is not expected to be sold, in the amount
of $801,000.
Note D - Investments
-----------
At September 30, 2006 and December 31, 2005, investments consisted of high
grade, auction rate municipal securities which were classified as
available-for-sale. As of September 30, 2006, the contractual maturity of one
security held by the Company, which totaled $1,000,000, was in 2008. The
contractual maturities of all other investments held by the Company at September
30, 2006 exceeded five years.
These investments are recorded at cost, which approximates fair market value due
to their variable interest rates. These investments typically reset on
approximately a monthly basis, and despite the long-term nature of their stated
contractual maturities, these securities historically had the ability to be
quickly liquidated. All income generated from these investments was recorded as
interest income.
Note E - Warranty Obligations
--------------------
Warranty obligations are incurred in connection with the sale of certain
products. The warranty period is generally one year. The costs incurred to
provide for these warranty obligations are estimated and recorded as an accrued
liability at the time of sale. Future warranty costs are estimated based on
product-based historical performance rates and related costs to repair. Changes
in accrued warranty obligations for the nine months ended September 30, 2006 and
2005 were as follows:
2006 2005
-------------- --------------
Accrued warranty obligations, January 1, $ 310,000 $ 288,000
Actual warranty experience (136,000) (95,000)
Warranty provisions 135,000 117,000
-------------- --------------
Accrued warranty obligations, September 30, $ 309,000 $ 310,000
============== ==============
Note F - Stock Repurchase Program
------------------------
On July 11, 2005, a plan to repurchase shares of common stock for an aggregate
amount not to exceed $10,000,000 was authorized by the Board of Directors. In
July 2006, this program was extended by the Board of Directors through July 13,
2007. Under this program, shares of common stock may be repurchased through open
market or private transactions, including block purchases. Repurchased shares
can be used for stock option plans, potential acquisition initiatives and
general corporate purposes. Through September 30, 2006, there have been no
repurchases of shares under the original or the extended program.
Note G - Income Taxes
------------
The Company's effective income tax rate is a combination of federal, state and
foreign tax rates and is generally lower than statutory rates because it
includes benefits derived from international operations, research activities,
tax exempt interest and foreign sales. For the third quarter 2006, the income
tax benefit amounted to $408,000, which included an income tax benefit of
$68,000 and discrete income tax benefit items of $340,000. The discrete income
tax benefit items realized during the third quarter 2006 primarily related to
the release of a reserve for income tax uncertainties of $383,000, partially
offset by the recording of an income tax provision uncertainty adjustment of
$47,000. The tax uncertainties were released based upon the lapsing of the
statute of limitations related to these uncertainties.
For the nine months ended September 30, 2006, the income tax benefit amounted to
$346,000, which included an income tax provision of $54,000 and discrete income
tax benefit items totaling $400,000. The discrete income tax benefit items
included a previously unused tax credit of $60,000 and the release of a reserve
for income tax uncertainties of $383,000, partially offset by the recording of
an income tax provision uncertainty adjustment of $47,000. The effective tax
rate was 29% for both the third quarter and the first nine months of 2005.
Note H - Restructuring Costs
-------------------
Restructuring charges amounted to $792,000 and $53,000 in the third quarter 2006
and 2005, respectively, and $1,786,000 and $249,000 for the nine months ended
September 30, 2006 and 2005, respectively.
During the third quarter 2006, the Company terminated seven employees and
recorded $139,000 of severance costs related to these terminations. In addition,
during the third quarter 2006, the Company relocated its San Luis Obispo
engineering center to a less expensive facility which resulted in lease
termination costs amounting to $653,000. Restructuring charges in the first and
second quarter of 2006 primarily related to severance and facility expenses
incurred for the closing of the Company's Norwood, Massachusetts engineering
center. Substantially all actions under these programs were completed as of
September 30, 2006, although payments for the severance reserve will occur in
the fourth quarter 2006 and payments for certain lease obligations will continue
through 2008.
A summary of the activity with respect to the 2006 restructuring charges is as
follows:
Lease
Number of Severance commitments
employees Reserve and other Total
------------------------ ------------- ----------
Balance at January 1, 2006
2006 restructuring charges 29 $970,000 $816,000 $1,786,000
2006 utilization (29) (831,000) (230,000) (1,061,000)
------------------------ ------------- ----------
Balance at September 30, 2006 $139,000 $586,000 $ 725,000
======================== ============= ==========
Restructuring charges in 2005 related primarily to severance payments associated
with the Company's efforts to centralize its operations.
Note I - Lease Commitments
-----------------
During the second quarter 2006, the Company entered into a lease for a facility
in Kanata, Ontario, Canada. The lease term extends from August 1, 2006 to
October 31, 2011. The Company's Ottawa operation relocated to this facility
during the third quarter 2006.
In July 2006, the Company entered into a two-year lease for a facility in the
San Luis Obispo area which commenced on September 1, 2006. During the third
quarter 2006, the Company's San Luis Obispo engineering center relocated to this
facility.
For both lease agreements, the Company is required to pay the pro rata share of
the real property taxes and assessments, expenses and other charges associated
with these facilities.
Future combined minimum payments under these two new leases as of September 30,
2006, are as follows:
Amount
--------------
2006 $ 55,000
2007 244,000
2008 224,000
2009 169,000
2010 181,000
Thereafter 151,000
--------------
Total $ 1,024,000
==============
Note J - Recent Accounting Pronouncements
--------------------------------
On January 1, 2006, the Company adopted SFAS No. 151, "Inventory Costs - An
Amendment of ARB No. 43, Chapter 4." SFAS No. 151 states that abnormal amounts
of idle facility expense, freight, handling costs, and wasted material
(spoilage) should be recognized as current-period charges. This adoption did not
have a material impact on the Company's consolidated results of operations and
financial condition.
In July 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" (FIN 48).
FIN 48 clarifies the accounting and reporting for income taxes recognized in
accordance with SFAS No. 109, "Accounting for Income Taxes." This Interpretation
prescribes a comprehensive model for the financial statement recognition,
measurement, presentation and disclosure of uncertain tax positions taken or
expected to be taken in income tax returns. The Company is currently evaluating
the impact of FIN 48. The Company will adopt this Interpretation in the first
quarter of 2007.
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin ("SAB") No. 108, Considering the Effects of Prior Year
Misstatements when Quantifying Current Year Misstatements. SAB No. 108 requires
analysis of misstatements using both an income statement (rollover) approach and
a balance sheet (iron curtain) approach in assessing materiality and provides
for a one-time cumulative effect transition adjustment. The Company will adopt
this SAB in the first quarter of 2007. The Company is currently assessing the
potential impact that the adoption of SAB No. 108 will have on its financial
statements; the impact is not expected to be material.
Note K - Subsequent Event
----------------
In October 2006, the Company and Michael P. Skarzynski, the Company's former
president and chief executive officer, agreed to a consulting agreement in
connection with Mr. Skarzynski's resignation. Under the terms of the agreement,
Mr. Skarzynski will assist the Company with the transition of his former duties
through March 31, 2007. In exchange for the transition services, the Company
will make initial payment of $50,000 to Mr. Skarzynski on or by November 1,
2006; an additional payment of $40,000 on December 31, 2006; and a final
payment of $10,000 on March 31, 2007.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Matters discussed in Management's Discussion and Analysis of Financial Condition
and Results of Operations and elsewhere in this Form 10-Q include
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended, and are subject to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Actual results could differ materially
from those discussed in the forward-looking statements.
Critical Accounting Estimates and Assumptions
In preparing the financial statements in accordance with GAAP, estimates and
assumptions are required to be made that have an impact on the assets,
liabilities, revenue and expense amounts reported. These estimates can also
affect supplemental information disclosures, including information about
contingencies, risk and financial condition. Estimates are generally not made
until preliminary results for a financial quarter are known and analyzed. It is
believed that given the current facts and circumstances, these estimates and
assumptions are reasonable, adhere to GAAP, and are consistently applied.
Inherent in the nature of an estimate or assumption is the fact that actual
results may differ from estimates, and estimates may vary as new facts and
circumstances arise. The critical accounting policies, judgments and estimates
that we believe have the most significant effect on our financial statements are
set forth below:
o Revenue Recognition
o Software Development Costs
o Valuation of Inventories
o Income Taxes
o Product Warranty
o Carrying Value of Goodwill
o Stock-Based Compensation
o Restructuring Costs
Revenue Recognition: Revenue is recognized from product sales in accordance with
the SEC Staff Accounting Bulletin No. 104, "Revenue Recognition." Product sales
represent the majority of our revenue and include both hardware products and
hardware products with embedded software. Revenue is recognized from these
product sales when persuasive evidence of an arrangement exists, delivery has
occurred or services have been provided, the sale price is fixed or
determinable, and collectability is reasonably assured. Additionally, products
are sold on terms which transfer title and risk of loss at a specified location,
typically the shipping point. Accordingly, revenue recognition from product
sales occurs when all factors are met, including transfer of title and risk of
loss, which typically occurs upon shipment. If these conditions are not met,
revenue recognition is deferred until such time as these conditions have been
satisfied.
Revenue earned from arrangements for software is accounted for under the
provisions of Statement of Position 97-2, "Software Revenue Recognition" and
EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables." Revenue
from software requiring significant production, modification, or customization
is recognized using the percentage of completion method of accounting. Any
anticipated losses on contracts are charged to operations as soon as such losses
are determined. If all conditions of revenue recognition are not met, revenue
recognition is deferred and revenue will be recognized when all obligations
under the arrangement are fulfilled. Revenue from software maintenance contracts
is recognized ratably over the contractual period.
Revenue from consulting and other services is recognized at the time the
services are rendered. Certain products are sold through distributors who are
granted limited rights of return. Potential returns are accounted for at the
time of sale.
The accounting estimate related to revenue recognition is considered a "critical
accounting estimate" because terms of sale can vary, and judgment is exercised
in determining whether to defer revenue recognition. Such judgments may
materially affect net sales for any period. Judgment is exercised within the
parameters of GAAP in determining when contractual obligations are met, title
and risk of loss are transferred, sales price is fixed or determinable and
collectability is reasonably assured.
Software Development Costs: All software development costs incurred in
establishing the technological feasibility of computer software products to be
sold are research and development costs. Software development costs incurred
subsequent to the establishment of technological feasibility of a computer
software product to be sold and prior to general release of that product are
capitalized. Amounts capitalized are amortized commencing after general release
of that product over the estimated remaining economic life of that product,
generally three years, or using the ratio of current revenues to current and
anticipated revenues from such product, whichever provides greater amortization.
If the technological feasibility for a particular project is judged not to have
been met or recoverability of amounts capitalized is in doubt, project costs are
expensed as research and development or charged to cost of goods sold, as
applicable. The accounting estimate related to software development costs is
considered a "critical accounting estimate" because judgment is exercised in
determining whether project costs are expensed as research and development or
capitalized as an asset. Such judgments may materially affect expense amounts
for any period. Judgment is exercised within the parameters of GAAP in
determining when technological feasibility has been met and recoverability of
software development costs is reasonably assured.
Valuation of Inventories: Inventories are stated at the lower of cost or market,
using the first-in, first-out method. Inventory includes purchased parts and
components, work in process and finished goods. Provisions for excess, obsolete
or slow moving inventory are recorded after periodic evaluation of historical
sales, current economic trends, forecasted sales, estimated product lifecycles
and estimated inventory levels. Purchasing practices, electronic component
obsolescence, accuracy of sales and production forecasts, introduction of new
products, product lifecycles, product support and foreign regulations governing
hazardous materials are the factors that contribute to inventory valuation
risks. Exposure to inventory valuation risks is managed by maintaining safety
stocks, minimum purchase lots, managing product end-of-life issues brought on by
aging components or new product introductions, and by utilizing certain
inventory minimization strategies such as vendor-managed inventories. The
accounting estimate related to valuation of inventories is considered a
"critical accounting estimate" because it is susceptible to changes from
period-to-period due to the requirement for management to make estimates
relative to each of the underlying factors, ranging from purchasing, to sales,
to production, to after-sale support. If actual demand, market conditions or
product lifecycles differ from estimates, inventory adjustments to lower market
values would result in a reduction to the carrying value of inventory, an
increase in inventory write-offs and a decrease to gross margins.
Income Taxes: Income taxes are accounted for using the asset and liability
approach, which requires recognition of deferred tax liabilities and assets for
the expected future tax consequences of the temporary differences between the
carrying amounts and the tax basis of such assets and liabilities. A valuation
allowance is recorded to reduce deferred tax assets to the amount that is more
likely than not to be realized. The accounting estimate related to income taxes
is considered a "critical accounting estimate" because judgment is exercised in
estimating future taxable income, including prudent and feasible tax planning
strategies, and in assessing the need for any valuation allowance. If it should
be determined that all or part of a net deferred tax asset is not able to be
realized in the future, an adjustment to the deferred tax asset would be charged
to income in the period such determination was made. Likewise, in the event that
it should be determined that all or part of a deferred tax asset in the future
is in excess of the net recorded amount, an adjustment to the deferred tax asset
would increase income in the period such determination was made.
Product Warranty: Warranty obligations are incurred in connection with the sale
of certain products. The warranty period for these products is generally one
year. The costs incurred to provide for these warranty obligations are estimated
and recorded as an accrued liability at the time of sale. Future warranty costs
are estimated based on historical performance rates and related costs to repair
given products. The accounting estimate related to product warranty is
considered a "critical accounting estimate" because judgment is exercised in
determining future estimated warranty costs. Should actual performance rates or
repair costs differ from estimates, revisions to the estimated warranty
liability would be required.
Carrying Value of Goodwill: Tests for impairments of goodwill are conducted
annually, at year end, or more frequently if circumstances indicate that the
asset might be impaired. The accounting estimate related to impairment of
goodwill is considered a "critical accounting estimate" because these impairment
tests include estimates of future cash flows that are dependent upon subjective
assumptions regarding future operating results including growth rates, discount
rates, capital requirements and other factors that impact the estimated fair
value. An impairment loss is recognized to the extent that the goodwill's
carrying amount exceeds its fair value.
Stock-Based Compensation: Stock options are granted to purchase our common
stock. Under the provisions of SFAS No. 123(R), stock compensation expense is
recorded based upon the fair value of the stock option at the date of grant. The
accounting estimate related to stock-based compensation is considered a
"critical accounting estimate" because estimates are made in calculating
compensation expense including: expected option lives, forfeiture rates and
expected volatility. Expected option lives are estimated using vesting terms and
contractual lives. Expected forfeiture rates and volatility are calculated using
historical information. Actual option lives and forfeiture rates may be
different from estimates and may result in potential future adjustments which
would impact the amount of stock-based compensation expense recorded in a
particular period.
Restructuring Costs: Restructuring costs consist of employee-related severance
costs, lease termination costs and other facility-related closing expenses.
Employee-related severance benefits are recorded either at the time an employee
is severed or is estimated and recorded pro-rata over the period of each
planned restructuring activity. Lease termination costs are calculated using
remaining lease obligation amounts and estimates for sublease receipts. The
accounting estimate related to restructuring costs is considered a "critical
accounting estimate" because estimates are made in calculating the amount of
employee-related severance benefits that will ultimately be paid and the amount
of sublease receipts that will ultimately be received in future periods. Actual
amounts paid for employee-related severance benefits can vary from these
estimates depending upon the number of employees actually receiving severance
payments.
Overview
The following contains forward-looking statements within the meaning of the
Securities Act of 1933 and Securities Exchange Act of 1934 and these
forward-looking statements are subject to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995.
The Company is a leading developer of platforms, blades and software solutions
for the communications market. It targets three vertical markets:
telecommunications, defense and homeland security, and commercial. Of the three
vertical markets served, telecommunications is the largest and represents
approximately 80% of the Company's business. An approximate breakdown of
telecommunications applications utilizing the Company's products is as follows:
Voice-over-IP (VoIP) represents 40%, wireless infrastructure represents 40%, and
the remaining 20% is spread across IP multimedia and other applications.
The Company's products are marketed through a direct worldwide sales force under
a variety of brand names including IPnexus(TM), SEGway(TM), NexusWare(TM) and
Advanced Managed Platforms(TM). These products are based on open standards and
are sold as fully-integrated, purpose-built, application ready platforms, or as
individual blade components for the embedded communications marketplace. A key
differentiation of the Company's products is the internally developed software
available with each product. When sold as platforms, known as our Advanced
Managed Platform products, our customers can quickly move to the enhanced value
steps of their products while realizing distinct cost advantages, increased
overall system reliability and performance, and improved time-to-market. Since
its introduction in 2003, our Advanced Managed Platform product line has
realized more than 34 new design wins. If successfully implemented by our
customers, each design win is expected to generate greater than $.5 million of
annualized revenue when reaching production volumes. In addition, we also
realized more than 36 new design wins for blade solutions in this same time
period. Design wins are subject to risks and uncertainties and, therefore, not
all design wins are expected to result in production orders.
A company-wide transformation began in early 2006, which management believes
will establish the foundation upon which the Company can reach its growth goals.
This transformation is balancing the Company's traditional engineering and
technology focus with a stronger emphasis on sales and marketing. Since the
beginning of the year, we have hired ten senior salespeople, including sales
executives for global sales, signaling sales and European sales, to expand,
bolster and partially replace our direct, world-wide sales organization.
We recognize the need to balance investments in sales and marketing with
projected revenue growth and expense reductions in other areas of the business.
Since the beginning of the year, we have instituted a number of expense
reduction initiatives, including closing our Norwood engineering facility,
relocating our San Luis Obispo engineering center to a less expensive facility
and implementing reductions-in-force. The relocation of the San Luis Obispo
engineering center and a 3% company-wide reduction-in-force were completed in
the third quarter 2006. Restructuring costs primarily associated with these
activities amounted to $.8 million and $1.8 million in the third quarter and for
the nine months ended September 30, 2006, respectively.
The telecommunications market served by the Company depends upon carrier
spending to upgrade network infrastructure to next-generation equipment. During
the third quarter 2006, investments by U.S. wireless carriers in third
generation mobile networks continued to be selective and this trend adversely
impacted the Company's revenue. The Company's largest customer during the first
nine months of 2006 sells directly into the U.S. wireless market, and third
quarter shipments to this customer amounted to $.8 million, compared to $2.2
million in the preceding quarter and $3.0 million in the comparable quarter in
2005. The third quarter revenue shortfall was also attributable to several
signaling customers in North America and Europe that delayed product deployments
beyond the third quarter. Management believes these signaling deployment delays
are customer specific, rather than due to any lack of demand for the Company's
signaling products.
On October 13, 2006, Michael P. Skarzynski resigned as president, chief
executive officer and as a member of the Board of Directors, for personal
reasons. Mr. Skarzynski's resignation was accepted by the Company and the
Company's current chairman, John M. Slusser, was appointed to serve as interim
president and chief executive officer until a successor can be found. During the
transition period, Mr. Slusser will continue in his role as chairman. The Board
of Directors has established an Executive Transition Committee, which will
oversee the process through which a new chief executive officer will be
selected. Subsequent to September 30, 2006, the Company entered into a
short-term consulting arrangement with Mr. Skarzynski to assist with the
transition of his former responsibilities to Mr. Slusser.
Strategy
The Company has a history of successfully adapting its products and services to
a constantly changing technology-driven marketplace. This adaptation has been
demonstrated through the course of several business cycles that have occurred
since the Company's founding in 1981.
A new product strategy was adopted in 2003. This strategy repositioned the
Company to deliver fully managed, system-level platform products to the embedded
communications marketplace and resulted in the Company's ability to address over
60% of the served available market. Today, our line of platform products
specifically addresses equipment manufacturers' requirements for an increased
level of system integration and services from suppliers, thus allowing them to
focus on their value-added stages of product development, which in most cases is
application software. The Company's strategy also enables its customers to
replace proprietary or legacy platforms with the latest generation of platform
products.
The Company's goal is to drive sustained and profitable revenue growth. A
company-wide transformation began in early 2006, which management believes will
establish the foundation upon which the Company can reach its growth goals. This
transformation is balancing the Company's traditional engineering and technology
focus with a stronger emphasis on sales and marketing. Management believes that
its current products and product pipeline can support a substantially higher
revenue base. With the Company's new sales organization now in place, management
expects to replicate key customer sales successes and aggressively pursue new
sales opportunities as the basis for the Company's future earnings and revenue
growth.
There are identifiable risks associated with carrying out the Company's strategy
in the current uncertain economic climate. Many of the Company's end markets are
forecasted to show only modest growth in the near term. In order to realize
growth in this environment, the Company will have to gain market share from
competitors, many of which are larger, more established companies with greater
resources than the Company's. Management believes that its strategy to increase
emphasis on sales and marketing, while continuing to invest in new product
development, will enable the Company to successfully compete in this economic
environment.
Financial Information
Revenue:
--------
Revenue in the third quarter 2006 amounted to $10.8 million, compared to $12.3
million in the corresponding quarter a year earlier. Revenue for the nine months
ended September 30, 2006 amounted to $36.0 million, compared to $36.3 million
during the corresponding period in 2005.
Earnings and Loss:
------------------
Net loss for the third quarter 2006 totaled $.4 million, or $.03 per basic
share, based on 13.3 million shares outstanding and included:
o Restructuring charges of $.8 million, or $.06 per basic share,
primarily related to the relocation of our San Luis Obispo
engineering center and severance costs related to a Company-wide
reduction in force;
o Stock compensation expense of $.2 million, or $.02 per basic share;
and
o Discrete income tax benefits amounting to $.3 million, or $.03 per
basic share.
Net income for the third quarter 2005 amounted to $.9 million, or $.07 per
diluted share and included restructuring charges of $.1 million, or $.00 per
diluted share, based on 13.1 million shares outstanding.
Net income for the nine months ended September 30, 2006 amounted to $.2 million,
or $.02 per diluted share, based on 13.3 million shares outstanding and
included:
o A charge for non-compliant RoHS inventory of $.8 million, or $.05
per diluted share;
o Restructuring charges of $1.8 million, or $.10 per diluted share,
related to severance and facilities costs associated with the
closing of our Norwood engineering center, the relocation of our
San Luis Obispo engineering center and severance costs related to
Company-wide reductions in force;
o Stock compensation expense of $.5 million, or $.03 per diluted share;
and
o Discrete income tax benefits amounting to $.4 million, or $.03 per
diluted share.
Net income for the nine months ended September 30, 2005 amounted to $2.2
million, or $.17 per diluted share, including restructuring charges related to
centralization efforts amounting to $.2 million, or $.01 per diluted share,
based on 13.1 million shares outstanding.
Liquidity:
----------
Cash, cash equivalents and investments amounted to $35.2 million and $33.0
million at September 30, 2006 and December 31, 2005, respectively. We had no
long-term debt at either date.
Centralization and Relocation of Functions:
-------------------------------------------
In January 2006, we announced a plan to close our engineering center in Norwood,
Massachusetts, and transfer product development and customer support functions
for the voice technology products to our other engineering centers. This program
was completed in May 2006.
During the third quarter 2006, our engineering center in San Luis Obispo,
California was relocated to a new facility in the same city and our signaling
engineering organization in Ottawa, Ontario, Canada was relocated to a new
facility in Kanata, Ontario, outside of Ottawa.
Key Performance Indicators:
The Company works closely with customers to incorporate its platforms, blades
and software solutions into their product designs. Such "design wins" have been
a useful metric for management to judge the Company's product acceptance in its
marketplace. Design wins, if successfully implemented by our customers, reach
production volumes at varying rates, generally beginning twelve to eighteen
months after the design win occurs. A variety of risks such as schedule delays,
cancellations, changes in customer markets and economic conditions can adversely
affect a design win before production is reached or during deployment. Beginning
in 2006, our sales organization is targeting higher revenue major accounts which
may lower the total number of design wins reported in the future, although
management expects such design wins will generate higher value design wins.
During the third quarter 2006, we realized two design wins for our Advanced
Managed Platform (with multiple products) (1), and individual communications
products (1). During the third quarter 2005, the Company realized six design
wins comprised of Advanced Managed Platform (with multiple products) (1), and
individual communications products (5). Each design win is expected to generate
at least $.5 million of annualized revenue when reaching production volumes. Not
all design wins are expected to result in production orders.
We believe that another key indicator for our business is the volume of orders
received from our customers. During weak or uncertain economic periods,
visibility of customer orders is limited, which frequently causes delays in the
placement of orders with the Company. These factors often result in a
substantial portion of the Company's revenue being derived from orders placed
within a quarter and shipped in the final month of the same quarter.
Forward-looking visibility of customer orders continues to be very limited.
Shipments to customers in the third quarter 2006 amounted to $10.8 million,
compared to $12.3 million in the third quarter 2006. The Company's largest
customer during the first nine months of 2006 sells directly into the U.S.
wireless market and third quarter shipments to this customer amounted to $.8
million, compared to $3.0 million in the comparable quarter in 2005. In
addition, several signaling customers in North America and Europe delayed
anticipated product deployments beyond the third quarter 2006. Management
believes the signaling deployment delays are customer specific, rather than due
to any lack of demand for the Company's signaling products.
More in-depth discussions of our strategy and financial performance can be found
in our Annual Report on Form 10-K and other filings with the Securities and
Exchange Commission.
Three and Nine Months Ended September 30, 2006, compared with
the Three and Nine Months Ended September 30, 2005
The following table presents the percentage of sales represented by each item in
our consolidated statements of income for the periods indicated.
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
-------- -------- -------- -------
Sales 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 51.9 49.9 49.1 51.0
Non RoHS inventory charge 2.2
-------- -------- -------- -------
Gross profit 48.1 50.1 48.7 49.0
-------- -------- -------- -------
Operating expenses:
Selling and marketing 14.6 10.9 12.2 11.5
Research and development 23.7 21.6 23.2 20.8
General and administrative 13.4 9.2 11.6 10.1
Restructuring charges 7.3 0.4 5.0 0.7
-------- -------- -------- -------
Total operating expenses 59.0 42.1 52.0 43.1
-------- -------- -------- -------
(Loss) income from operations (10.9) 8.0 (3.3) 5.9
Other income, net 3.6 2.7 3.0 2.6
-------- -------- -------- -------
(Loss) income before income taxes (7.3) 10.7 (0.3) 8.5
Income tax (benefit) provision (3.8) 3.1 (1.0) 2.5
-------- -------- -------- -------
Net (loss) income (3.5)% 7.6% 0.7% 6.0%
======== ======== ======== =======
Sales. Total revenue for the third quarter 2006 amounted to $10.8 million,
compared to $12.3 million for the corresponding quarter in 2005. Revenue for the
nine months ended September 30, 2006 totaled $36.0 million, compared to $36.3
million for the comparable period in 2005.
In the third quarter 2006, one customer represented 21% of sales and our four
largest customers represented 41% of sales. In the third quarter 2005, two
customers represented 25% and 14% of sales, and our four largest customers
represented 48% of sales. For the nine months ended September 30, 2006, two
customers represented 16% and 12% of sales, and our four largest customers
represented 39% of sales. For the nine months ended September 30, 2005, two
customers represented 21% and 12% of sales, and our four largest customers
represented 44% of sales.
Sales to customers outside of the United States represented 60% and 46% of our
sales during the third quarter 2006 and 2005, respectively. During this
comparative period, although overall Company sales decreased, sales to customers
outside the United States increased slightly, resulting in the percentage
increase described above. This increase in sales to customers outside the United
States was attributable to increased sales to the Company's largest integrated
platform customer. Sales to customers based in the United Kingdom represented
25% and 15% of revenue in the third quarter 2006 and 2005, respectively.
For the nine months ended September 30, 2006 and 2005, sales to customers
outside of the United States represented 48% and 42% of sales, respectively.
Sales to customers based in the United Kingdom represented 15% and 13% of
revenue for the nine months ended September 30, 2006 and 2005, respectively.
Beginning in 2006, our products are grouped into three distinct categories in
one market segment: Communications (network access, signaling and voice)
products, Computing products and Switching products. Revenue from each product
category is expressed as a percentage of sales for the periods indicated:
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
-------- -------- -------- -------
Communications 45% 43% 49% 47%
Computing 34% 25% 26% 25%
Switching 21% 31% 25% 27%
Other 1% 1%
-------- -------- -------- -------
Total 100% 100% 100% 100%
======== ======== ======== =======
Communications products:
Communications products are comprised of network access, SEGway signaling and
Voice Technology products. Network access products provide a connection between
a variety of voice, data and signaling networks and embedded systems platforms
that are used to control the network and/or process information being
transported over networks. This family includes a complete line of
communications protocols. Many of our signaling products provide a signaling
bridge between traditional telephone networks and the growing IP packet-switched
network, and enable the transport of signaling messages over IP networks. Voice
Technology products enable voice, data and fax processing for communications
applications.
Revenue from Communications products amounted to $4.9 million and $5.3 million
in the third quarter of 2006 and 2005, respectively. This decrease of $.4
million, or 8%, was the result of decreased demand from a variety of our
customers across this product category.
Revenue from Communications products amounted to $17.5 million and $17.0 million
in the nine months ended September 30, 2006 and 2005, respectively. This
increase in business of $.5 million, or 3%, reflects a combination of factors
including one major customer in 2005 that, due to market conditions,
unexpectedly decreased product requirements after the second quarter 2005, which
was offset by a greater demand from a variety of customers across this product
category.
Computing products:
Computing products include integrated platform solutions, a range of single
board computers, a variety of embedded system chassis and associated chassis
management products.
Computing products revenue amounted to $3.7 million and $3.1 million in the
third quarter 2006 and 2005, respectively. The increase in revenue of $.6
million, or 19%, for these comparative periods is primarily a result of
increased sales to the Company's largest integrated platform customer.
For the nine months ended September 30, 2006 and 2005, Computing products
revenue totaled $9.5 million, compared to $9.2 million, respectively. The
increase in revenue of $.3 million, or 3%, was primarily attributable to
fluctuations in sales to various customers during the comparative periods.
Switching products:
Our Ethernet switch components operate as the "nexus" of the IP packet switching
functionality of the Advanced Managed Platforms.
Revenue from Switching products amounted to $2.2 million and $3.8 million in the
third quarter 2006, and 2005, respectively. This decrease of $1.6 million, or
42%, is primarily the result of decreased shipments to one customer amounting to
$2.2 million who purchased less due to their decreased customer demand,
partially offset by increased sales to several other switch customers.
Switch revenue totaled $9.0 million and $9.6 million for the nine months ended
September 30, 2006 and 2005, respectively. This decrease of $.6 million, or 6%,
is a result of a combination of decreased sales to one customer of $2.0 million
who purchased less due to their decreased customer demand, partially offset by
increased sales to several other customers in this product category.
Gross profit. Gross profit consists of sales, less cost of goods sold including
material costs, manufacturing expenses, depreciation, amortization of software
development costs, and expenses associated with engineering contracts and the
technical support function. Gross margin was 48.1% and 50.1% of sales for the
third quarter 2006 and 2005, respectively. The decrease in gross margin
primarily resulted from a change in sales mix from higher margin products (e.g.,
Switching) to lower margin products (i.e., Computing). Gross margin for the
quarter was also negatively impacted by lower production volumes. Offsetting
these decreases were benefits resulting from our centralization efforts that
took place in 2005. Included in cost of goods sold is the amortization of
software development costs which totaled $.4 million and $.3 million in the
third quarter 2006 and 2005, respectively.
Gross margin was 48.7% and 49.0% of sales for the first nine months of 2006 and
2005, respectively. The Restriction of Certain Hazardous Substances ("RoHS")
Directive issued by the European Union (EU) became effective on July 1, 2006.
Gross margin for the first nine months of 2006 was impacted by a charge recorded
in the second quarter to cost of goods sold for excess non-compliant RoHS
inventory in the amount of $.8 million, or 2.2% of revenue. Excluding this
charge, the increase in gross margin was attributable to benefits realized from
the Company's centralization efforts. Also included in cost of goods sold is the
amortization of software development costs which totaled $1.2 million for both
the nine months ended September 30, 2006 and 2005.
Total Operating Expenses. Total operating expenses in the third quarter 2006
amounted to $6.4 million, compared to $5.2 million for the corresponding period
in 2005. Total operating expenses in the third quarter 2006 included
restructuring charges amounting to $.8 million and stock compensation expense
related to the adoption of SFAS 123(R) amounting to $.2 million. Total operating
expenses in the third quarter 2005 included restructuring charges amounting to
$.1 million.
Total operating expenses for the nine months ended September 30, 2006 amounted
to $18.7 million, compared to $15.6 million for the corresponding period in
2005. Total operating expenses for the nine months ended September 30, 2006
included restructuring charges amounting to $1.8 million and stock compensation
expense amounting to $.5 million. Total operating expenses for the nine months
ended September 30, 2005 included restructuring charges amounting to $.2
million.
Selling and marketing expenses were $1.6 million and $1.3 million for the third
quarter 2006 and 2005, respectively, and $4.4 million and $4.2 million for the
first nine months of 2006 and 2005, respectively. The increases in expenses in
both comparative periods are primarily related to additional sales personnel
hired in 2006 as a key component of the Company's transformation program.
Research and development expenses were $2.6 million and $2.7 million in the
third quarter 2006 and 2005, respectively. We capitalize certain software
development costs, which reduces the amount charged to research and development
expenses. Amounts capitalized were $.4 million and $.7 million during the third
quarter 2006 and 2005, respectively. The decrease in gross research and
development expenditures for the comparable periods is primarily the result of
the closing of the Norwood engineering center during the second quarter 2006.
Research and development expenses totaled $8.3 million and $7.6 million for the
nine months ended September 30, 2006 and 2005, respectively. Amounts capitalized
were $1.4 million and $2.0 million for the nine month periods in 2006 and 2005,
respectively. Gross expenditures for the comparative periods were generally
comparable.
General and administrative expenses were $1.5 million and $1.1 million in the
third quarter 2006 and 2005, respectively. General and administrative expenses
totaled $4.2 million and $3.7 million for the nine months ended September 30,
2006 and 2005, respectively. The increase in expenses for both comparative
periods is primarily related to higher personnel costs, higher corporate
governance costs and stock based compensation expense in 2006.
Restructuring charges amounted to $.8 million and $.05 million in the third
quarter 2006 and 2005, respectively, and $1.8 million and $.2 million for the
nine months ended September 30, 2006 and 2005, respectively.
During the third quarter 2006, the Company terminated seven employees and
recorded $.1 million of severance costs related to these terminations. In
addition, during the third quarter 2006, the Company relocated its San Luis
Obispo engineering center to a less expensive facility which resulted in lease
termination costs amounting to $.7 million. Restructuring charges in first and
second quarter of 2006 primarily related to severance and facility expenses
incurred for the closing of the Company's Norwood, Massachusetts engineering
center. Substantially all actions under these programs were completed as of
September 30, 2006, although payments for the severance reserve will occur in
the fourth quarter 2006 and payments for certain lease obligations will continue
through 2008.
A summary of the activity with respect to the 2006 restructuring charges is as
follows:
Lease
Number of Severance commitments
employees Reserve and other Total
---------------------- ------------ -----------
Balance at January 1, 2006
2006 restructuring charges 29 $970,000 $816,000 $1,786,000
2006 utilization (29) (831,000) (230,000) (1,061,000)
---------------------- ------------ -----------
Balance at September 30, 2006 $139,000 $586,000 $ 725,000
====================== ============ ===========
Restructuring charges in 2005 related primarily to severance payments associated
with the Company's efforts to centralize its operations.
The Company is not expecting to incur any restructuring charges in the fourth
quarter 2006.
Other Income, net. Other income consists primarily of interest income. The
Company's funds are primarily invested in high quality auction rate municipal
securities. An increase in the funds available for investment as well as higher
interest rates in 2006 resulted in an increase in interest income. Interest
income in 2005 also included interest income from a note receivable from an
unconsolidated company.
Income taxes. The effective income tax rate is a combination of federal, state
and foreign tax rates and is generally lower than statutory rates because it
includes benefits derived from our international operations, research
activities, tax exempt interest and foreign sales. For the third quarter 2006,
the income tax benefit amounted to $.4 million, which included an income tax
benefit of $.1 million and discrete income tax benefit items of $.3 million. The
discrete income tax benefit items realized during the third quarter 2006
primarily related to the release of a reserve for income tax uncertainties of
$.4 million, partially offset by the recording of an income tax provision
uncertainty adjustment of $.05 million. The tax uncertainties were released
based upon the lapsing of the statute of limitations related to these
uncertainties.
For the nine months ended September 30, 2006, the income tax benefit amounted to
$.3 million, which included an income tax provision of $.1 million and discrete
income tax benefit items totaling $.4 million. The discrete income tax benefit
items included a previously unused tax credit of $.1 million and the release of
a reserve for income tax uncertainties of $.4 million, partially offset by the
recording of an income tax provision uncertainty adjustment of $.05 million. The
effective tax rate was 29% for both the third quarter and the first nine months
of 2005.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of liquidity are cash, cash equivalents and investments,
which together totaled $35.2 million at September 30, 2006. The Company had
working capital of $48.1 million and $46.8 million at September 30, 2006 and
December 31, 2005, respectively.
Cash provided by operating activities amounted to $3.9 million for the nine
months ended September 30, 2006. This amount included net income of $.2 million,
a depreciation and amortization charge of $1.7 million and stock-based
compensation expense of $.5 million. Cash provided by operations due to changes
in operating assets and liabilities included an increase in cash associated with
a decrease in accounts receivable of $1.3 million. The decrease in accounts
receivable is primarily related to lower sales in the final month of the third
quarter 2006.
On July 1, 2006, the RoHS Directive issued by the EU became effective. This
directive restricts the distribution of products within the EU that exceed very
low maximum concentration values of certain substances, including lead. During
the second quarter 2006, a charge was recorded in the amount of $.8 million for
non-compliant RoHS inventory not expected to be sold in the future.
Cash used by investing activities during the first nine months of 2006 totaled
$4.6 million. This utilization was primarily the result of capital asset
purchases of $.9 million, the capitalization of software development costs
amounting to $1.4 million and a net increase in investments of $2.3 million.
Cash provided by financing activities for the first nine months of 2006 amounted
to $.6 million, primarily resulting from the exercise of stock options. On July
11, 2005, our Board of Directors authorized the Company to repurchase shares of
our common stock for an aggregate amount not to exceed $10.0 million. In July
2006, this program was extended to July 13, 2007. Under this program, shares of
our common stock may be repurchased through open market or private transactions,
including block purchases. Repurchased shares can be used for our stock option
plans, potential acquisition initiatives and general corporate purposes. Through
September 30, 2006, there have been no repurchases of shares under the original
or the extended program.
Off-Balance Sheet Arrangements:
No off-balance sheet arrangements were entered into during the first nine months
of 2006.
Contractual Obligations:
During the second quarter 2006, a lease agreement was entered into for a new
facility in Kanata, Ontario, Canada. The term of this lease extends from August
1, 2006 to October 31, 2011. During the third quarter 2006, our Ottawa operation
relocated to this facility.
In July 2006, the Company entered into a two-year lease for a facility in the
San Luis Obispo area which commenced on September 1, 2006. During the third
quarter 2006, our San Luis Obispo engineering center relocated to this facility.
For both lease agreements, the Company is required to pay the pro rata share of
the real property taxes and assessments, expenses and other charges associated
with these facilities.
As of September 30, 2006, combined future minimum payments under these two new
leases are as follows:
Amount
--------------
2006 $ 55,000
2007 244,000
2008 224,000
2009 169,000
2010 181,000
Thereafter 151,000
--------------
Total $ 1,024,000
==============
No other significant contractual obligations were entered into during the first
nine months of 2006.
In October 2006, the Company and Michael P. Skarzynski, the Company's former
president and chief executive officer, agreed to a consulting agreement in
connection with Mr. Skarzynski's resignation. Under the terms of the agreement,
Mr. Skarzynski will assist the Company with the transition of his former duties
through March 31, 2007. In exchange for the transition services, the Company
will make an initial payment of $50,000 to Mr. Skarzynski on or by November 1,
2006; an additional payment of $40,000 on December 31, 2006; and a final
payment of $10,000 on March 31, 2007.
Current Position:
Assuming there is no significant change in our business, we believe that the
Company's current cash, cash equivalents and investments, together with cash
generated from operations should be sufficient to meet our anticipated cash
requirements, including working capital and capital expenditure requirements,
for at least the next twelve months. However, we are continuing to evaluate
strategic acquisitions to further accelerate our growth and market penetration
efforts. These strategic acquisition efforts could have an impact on our working
capital, liquidity or capital resources and we may raise additional capital to
facilitate these efforts.
RECENT ACCOUNTING PRONOUNCEMENTS
On January 1, 2006, the Company adopted SFAS No. 151, "Inventory Costs - An
Amendment of ARB No. 43, Chapter 4." SFAS No. 151 states that abnormal amounts
of idle facility expense, freight, handling costs, and wasted material
(spoilage) should be recognized as current-period charges. This adoption did not
have a material impact on the Company's consolidated results of operations and
financial condition.
In July 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" (FIN 48).
FIN 48 clarifies the accounting and reporting for income taxes recognized in
accordance with SFAS No. 109, "Accounting for Income Taxes." This Interpretation
prescribes a comprehensive model for the financial statement recognition,
measurement, presentation and disclosure of uncertain tax positions taken or
expected to be taken in income tax returns. The Company is currently evaluating
the impact of FIN 48. The Company will adopt this Interpretation in the first
quarter of 2007.
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin ("SAB") No. 108, Considering the Effects of Prior Year
Misstatements when Quantifying Current Year Misstatements. SAB No. 108 requires
analysis of misstatements using both an income statement (rollover) approach and
a balance sheet (iron curtain) approach in assessing materiality and provides
for a one-time cumulative effect transition adjustment. The Company will adopt
this SAB in the first quarter of 2007. The Company is currently assessing the
potential impact that the adoption of SAB No. 108 will have on its financial
statements; the impact is not expected to be material.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
This quarterly report on Form 10-Q contains forward-looking statements, which
reflect our current views with respect to future events and financial
performance, within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 and is subject to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements are subject to certain risks and uncertainties,
including those identified below, which could cause actual results to differ
materially from historical results or those anticipated. The words "believes,"
"anticipates," "plans," "may," "intend," "estimate," "will," "should," "could,"
"feels," "is optimistic," "expects," and other expressions which indicate future
events and trends also identify forward-looking statements. However, the absence
of such words does not mean that a statement is not forward-looking.
The future operating results of the Company are subject to various risks and
uncertainties and could differ materially from those discussed in the
forward-looking statements and may be affected by various trends and factors
which are beyond our control. These risks and uncertainties include, among other
factors, general business and economic conditions, rapid technological changes
accompanied by frequent new product introductions, competitive pressures,
dependence on key customers, the attainment of design wins and obtaining orders
as a result, fluctuations in quarterly and annual results, the reliance on a
limited number of third party suppliers, limitations of our manufacturing
capacity and arrangements, the protection of our proprietary technology, the
dependence on key personnel, changes in critical accounting estimates, potential
impairments related to goodwill and investments, and foreign regulations. These
statements should be read in conjunction with the audited Consolidated Financial
Statements, the Notes thereto, and Management's Discussion and Analysis of
Financial Condition and Results of Operations of the Company as of December 31,
2005, as reported in its Annual Report on Form 10-K, and other documents filed
with the Securities and Exchange Commission. Additional information related to
risk factors can be found in the Company's Annual Report on Form 10-K for the
year ended December 31, 2005.
Stockholders are cautioned not to place undue reliance on the forward-looking
statements which speak as of the date of this quarterly report or the date of
the documents incorporated by reference in this quarterly report.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's assets are exposed to various market risks in the normal course of
business, primarily interest rate risk and changes in the market value of our
investments and we believe the exposure to such risk is minimal. Investments are
made in accordance with the investment policy and primarily consist of auction
rate municipal securities. The Company's assets are also subject to foreign
exchange risk related to our operations in Canada. We believe that the exposure
to foreign currency risk is minimal for the first nine months of 2006.
Management does not enter into the investment of derivative financial
instruments.
ITEM 4. CONTROLS AND PROCEDURES
A. Evaluation of Disclosure Controls and Procedures
The Company's Chief Executive Officer and its Chief Financial Officer
have evaluated the Company's disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of
the period covered by this quarterly report. Based on this evaluation,
the Chief Executive Officer and Chief Financial Officer concluded that
the Company's disclosure controls and procedures were effective as of
such date.
B. Changes in Internal Control Over Financial Reporting
There has been no change in the Company's internal control over
financial reporting that occurred during the fiscal quarter covered by
this report that has materially affected, or is reasonably likely to
materially affect, the Company's internal controls over financial
reporting.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Section 1350 Certification
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.
PERFORMANCE TECHNOLOGIES, INCORPORATED
November 7, 2006 By: /s/ John M. Slusser
-------------------------
John M. Slusser
Chairman of the Board, Interim President and
Chief Executive Officer
November 7, 2006 By: /s/ Dorrance W. Lamb
--------------------------
Dorrance W. Lamb
Chief Financial Officer and
Senior Vice President
Exhibit 31.1
Certification of Chief Executive Officer
I, John M. Slusser, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Performance
Technologies, Incorporated;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
a. Designed such disclosure controls and procedures, or
caused such disclosure controls and procedures to be
designed under our supervision, to ensure that material
information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in
which this report is being prepared;
b. Designed such internal control over financial reporting,
or caused such internal control over financial reporting
to be designed under our supervision, to provide
reasonable assurance regarding the reliability of
financial reporting and the preparation of financial
statements for external purposes in accordance with
generally accepted accounting principles;
c. Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure
controls and procedures, as of the end of the period
covered by this report based on such evaluation; and
d. Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred
during the registrant's most recent fiscal quarter (the
registrant's fourth fiscal quarter in the case of an
annual report) that has materially affected, or is
reasonably likely to materially affect, the registrant's
internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
the registrant's board of directors (or persons performing the
equivalent functions):
a. All significant deficiencies and material weaknesses in
the design or operation of internal control over financial
reporting which are reasonably likely to adversely affect
the registrant's ability to record, process, summarize and
report financial information; and
b. Any fraud, whether or not material, that involves
management or other employees who have a significant role
in the registrant's internal control over financial
reporting.
Date: November 7, 2006 By:/s/ John M. Slusser
------------------------
John M. Slusser
Interim Chief Executive Officer
Exhibit 31.2
Certification of Chief Financial Officer
I, Dorrance W. Lamb, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Performance
Technologies, Incorporated;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) for the registrant and have:
a. Designed such disclosure controls and procedures, or
caused such disclosure controls and procedures to be
designed under our supervision, to ensure that material
information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in
which this report is being prepared;
b. Designed such internal control over financial reporting,
or caused such internal control over financial reporting
to be designed under our supervision, to provide
reasonable assurance regarding the reliability of
financial reporting and the preparation of financial
statements for external purposes in accordance with
generally accepted accounting principles;
c. Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure
controls and procedures, as of the end of the period
covered by this report based on such evaluation; and
d. Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred
during the registrant's most recent fiscal quarter (the
registrant's fourth fiscal quarter in the case of an
annual report) that has materially affected, or is
reasonably likely to materially affect, the registrant's
internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
the registrant's board of directors (or persons performing the
equivalent functions):
a. All significant deficiencies and material weaknesses in
the design or operation of internal control over financial
reporting which are reasonably likely to adversely affect
the registrant's ability to record, process, summarize and
report financial information; and
b. Any fraud, whether or not material, that involves
management or other employees who have a significant role
in the registrant's internal control over financial
reporting.
Date: November 7, 2006 By:/s/ Dorrance W. Lamb
-------------------------
Dorrance W. Lamb
Chief Financial Officer
Exhibit 32.1
Section 1350 Certification
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 ("Section 906"), John M. Slusser and Dorrance W.
Lamb, the Interim Chief Executive Officer and Chief Financial Officer,
respectively, of Performance Technologies, Incorporated, certify that (i) the
quarterly report on Form 10-Q for the quarter ended September 30, 2006 fully
complies with the requirements of Section 13(a) or 15(d) of the Securities
Exchange Act of 1934 and (ii) the information contained in such report fairly
presents, in all material respects, the financial condition and results of
operations of Performance Technologies, Incorporated.
A signed original of this written statement required by Section 906 has been
provided to Performance Technologies, Incorporated and will be retained by
Performance Technologies, Incorporated and furnished to the Securities and
Exchange Commission or its staff upon request.
Date: November 7, 2006 By:/s/ John M. Slusser
--------------------------
John M. Slusser
Chairman of the Board, Interim President
and Chief Executive Officer
Date: November 7, 2006 By:/s/ Dorrance W. Lamb
--------------------------
Dorrance W. Lamb
Chief Financial Officer and
Senior Vice President