UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------------------
FORM 10-Q
(Mark One)
[x] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended November 26, 2004
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 No. 1-10655
ENVIRONMENTAL TECTONICS CORPORATION
-----------------------------------------------------
(Exact name of registrant as specified in its charter)
Pennsylvania 23-1714256
-------------------------------- -------------------
(State or other jurisdiction (IRS Employer
of incorporation or organization Identification No.)
COUNTY LINE INDUSTRIAL PARK
SOUTHAMPTON, PENNSYLVANIA 18966
----------------------------------------
(Address of principal executive offices)
(Zip Code)
(215) 355-9100
----------------------------------------------------
(Registrant's telephone number, including area code)
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 at least the past 90 days.
Yes x No
--- ---
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes No x
--- ---
The number of shares outstanding of the registrant's common stock as of
December 31, 2004 is: 7,640,686.
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Environmental Tectonics Corporation
Consolidated Statements of Operations
(unaudited)
(amounts in thousands, except share and per share information)
Thirteen Weeks Ended Thirty-nine Weeks Ended
--------------------------------- ---------------------------------
November 26, November 28, November 26, November 28,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net sales $7,751 $7,115 $20,449 $17,997
Cost of goods sold 6,114 5,341 16,797 12,150
------- ------- ------- -------
Gross profit 1,637 1,774 3,652 5,847
------- ------- ------- -------
Operating expenses:
Selling and administrative 4,224 2,330 9,775 6,246
Research and development 170 144 671 176
------- ------- ------- -------
4,394 2,474 10,446 6,422
------- ------- ------- -------
Operating loss (2,757) (700) (6,794) (575)
------- ------- ------- -------
Other expenses:
Interest expense, net 440 425 1,171 1,192
Other, net 57 (138) 182 (51)
------- ------- ------- -------
497 287 1,353 1,141
------- ------- ------- -------
Loss before income taxes (3,254) (987) (8,147) (1,716)
Benefit from income taxes (4) (280) (1,453) (451)
------- ------- ------- -------
Loss before minority interest (3,250) (707) (6,694) (1,265)
Loss attributable to
minority interest (1) (3) - (9)
------- ------- ------- -------
Net loss $(3,249) $(704) $(6,694) $(1,256)
======= ======= ======= =======
Per share information:
Loss applicable to common shareholders $(3,249) $(704) $(6,694) $(1,256)
Loss per share: basic $(0.43) $(0.10) $(0.88) $(0.18)
Loss per share: diluted $(0.43) $(0.10) $(0.88) $(0.18)
Number of shares: basic 7,641,000 7,168,000 7,604,000 7,168,000
Number of shares: diluted 7,641,000 7,168,000 7,604,000 7,168,000
The accompanying notes are an integral part of the consolidated
financial statements.
2
Environmental Tectonics Corporation
Consolidated Balance Sheets
November 26,
2004 February 27,
unaudited 2004
----------------------- ----------------------
(amounts in thousands, except share
information)
Assets
Current assets:
Cash and cash equivalents $ 5,832 $ 1,366
Cash equivalents restricted for letters of credit 2,850 784
Accounts receivable, net 9,044 19,233
Costs and estimated earnings in excess of billings on uncompleted
long-term contracts 3,015 5,333
Inventories 7,412 9,843
Deferred tax asset 1,337 1,337
Prepaid expenses and other current assets 2,111 1,949
------------ ------------
Total current assets 31,601 39,845
------------ ------------
Property, plant and equipment, at cost, net of accumulated
depreciation of $11,263 at November 26, 2004 and $10,651 at
February 27, 2004 5,509 4,886
Software development costs, net of accumulated amortization of $8,125
at November 26, 2004 and $7,494 at February 27, 2004 3,524 3,089
Goodwill and intangibles 477 477
Other assets, net 612 399
------------ ------------
Total assets $ 41,723 $ 48,696
============ ============
Liabilities and Stockholders' Equity
Liabilities
Current liabilities:
Current portion of long-term debt $ 452 $ 317
Accounts payable - trade 3,767 2,431
Billings in excess of costs and estimated earnings on uncompleted
long-term contracts 961 945
Customer deposits 1,163 3,657
Accrued liabilities 1,774 2,588
------------ ------------
Total current liabilities 8,117 9,938
------------ ------------
Long-term debt, less current portion:
Credit facility payable to banks - 30
Long-term bonds, net 4,095 4,370
Subordinated debt 7,905 7,666
Capital leases/Other 374 91
------------ ------------
12,374 12,157
------------ ------------
Deferred income taxes 1,502 1,502
------------ ------------
Total liabilities 21,993 23,597
------------ ------------
Minority interest 46 45
Stockholders' Equity
Common stock; $.05 par value; 20,000,000 shares authorized; 7,640,686 and
7,176,552 issued and outstanding at November 26, 2004 and
February 27, 2004, respectively 381 359
Capital contributed in excess of par value of common stock 10,728 9,430
Accumulated other comprehensive loss (325) (329)
Retained earnings 8,900 15,594
------------ ------------
Total stockholders' equity 19,684 25,054
------------ ------------
Total liabilities and stockholders' equity $ 41,723 $ 48,696
============ ============
The accompanying notes are an integral part of the consolidated
financial statements.
3
Environmental Tectonics Corporation
Consolidated Statements of Cash Flows
(unaudited)
Thirty-nine Weeks Ended
--------------------------------------------
November 26, November 28,
2004 2003
------------ ------------
(amounts in thousands)
Cash flows from operating activities:
Net loss $(6,694) $(1,256)
Adjustments to reconcile net loss to net cash
provided by/(used in) operating activities:
Depreciation and amortization 1,405 1,009
Non-cash interest expense 239 443
Provision for losses on accounts receivable
and inventories 172 (198)
Minority interest 1 (9)
Changes in operating assets and liabilities:
Accounts receivable 10,168 (4,025)
Costs and estimated earnings in excess of
billings on uncompleted long-term contracts 2,318 (75)
Inventories 1,687 (861)
Prepaid expenses and other assets (68) (1,150)
Accounts payable 1,336 585
Billings in excess of costs and estimated
earnings on uncompleted long-term contracts 16 (365)
Customer deposits (2,494) 419
Other accrued liabilities (814) 884
------ ------
Net cash provided by/(used in) operating activities 7,272 (4,599)
------ ------
Cash flows from investing activities:
Acquisition of equipment (122) (271)
Capitalized software development costs (1,066) (973)
------ ------
Net cash used in investing activities (1,188) (1,244)
------ ------
Cash flows from financing activities:
Borrowings under credit facility - 1,200
Payments under credit facility (30) (600)
Repayment of long-term bonds (275) (275)
Cash equivalents restricted (2,066) 2,620
Proceeds from issuance of common stock / warrants 1,320 51
Deferred finance charges (571) (272)
------ ------
Net cash (used in)/provided by financing activities (1,622) 2,724
------ ------
Effect of exchange rate changes on cash 4 (15)
------ ------
Net increase/(decrease) in cash and cash equivalents 4,466 (3,134)
Cash and cash equivalents at beginning of period 1,366 4,305
------ ------
Cash and cash equivalents at end of period $5,832 $1,171
====== ======
Supplemental schedule of cash flow information:
Interest paid 670 582
Income taxes paid 5 64
Supplemental information on noncash
operating and investing activities:
During the thirty-nine weeks ended
November 26,2004, the Company
reclassified $593 from inventory to
fixed assets.
During the thirty-nine weeks ended
November 28, 2003 the Company
reclassified $353 from inventory to
capitalized software.
The accompanying notes are an integral part of the consolidated
financial statements.
4
Environmental Tectonics Corporation
Notes to Consolidated Financial Statements
(amounts in dollars, except where noted and share and per
share information)
1. Basis of Presentation
The accompanying consolidated financial statements include the accounts
of Environmental Tectonics Corporation ("ETC" or the "Company"), Entertainment
Technology Corporation ("EnTCo"), ETC International Corporation and
ETC-Delaware, its wholly-owned subsidiaries, ETC Europe, its 99% owned
subsidiary and ETC-PZL Aerospace Industries, Ltd. ("ETC-PZL"), its 95% owned
subsidiary.
The accompanying consolidated financial statements have been prepared
by ETC, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission, and reflect all adjustments which, in the opinion of
management, are necessary for a fair statement of the results for the interim
periods presented. All such adjustments are of a normal recurring nature.
Certain information in footnote disclosures normally included in
financial statements prepared in conformity with accounting principles generally
accepted in the United States of America has been condensed or omitted pursuant
to such rules and regulations and the financial results for the periods
presented may not be indicative of the full year's results, although the Company
believes the disclosures are adequate to make the information presented not
misleading. These financial statements should be read in conjunction with the
financial statements and the notes thereto included in the Company's Annual
Report on Form 10-K for the year ended February 27, 2004. Certain
reclassifications have been made to the fiscal 2004 financial statements to
conform with the fiscal 2005 presentation.
As a result of the Company's recent financial performance, PNC, the
Company's main bank, has taken certain actions to substantially reduce the
Company's operating facility. The facility is currently limited to the issuance
of international letters of credit and the Company can no longer borrow cash
under the facility. PNC has required the Company to keep $2.8 million in a
restricted cash account as collateral and has indicated that additional changes
may be required to our Bank Agreement including increasing the amount of cash
collateral. Given the Company's inability to borrow cash from its bank, the
Company may need to obtain additional sources of capital in order to continue
growing and operating the business. The reader is referred to the discussions in
Footnote 7, Long Term Debt, and the Liquidity and Capital Resources Section of
the Management's Discussion and Analysis of Results of Operations and Financial
Condition later in this Form 10-Q.
5
2. Earnings Per Share
Our calculation of earnings per share in accordance with SFAS No. 128,
"Earnings Per Share", is as follows:
Thirteen Weeks Ended November 26, 2004 Thirteen Weeks Ended November 28, 2003
------------------------------------------------- ----------------------------------------------
Loss Shares Per Share Loss Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ----------- ----------- ------------- -----------
(amounts in thousands, except share and per share information)
Basic EPS
Net loss applicable to
common stockholders $(3,249) 7,641,000 $(0.43) $(704) 7,168,000 $(0.10)
Effect of dilutive
securities
Options - -
Warrants - -
Diluted EPS
Net loss applicable to
common stockholders
plus assumed conversions $(3,249) 7,641,000 $(0.43) $(704) 7,168,000 $(0.10)
Thirty-nine Weeks Ended November 26, 2004 Thirty-nine Weeks Ended November 28,2003
---------------------------------------------- -----------------------------------------------
Loss Shares Per Share Loss Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------------ ------------ ------------- -----------
(amounts in thousands, except share and per share information)
Basic EPS
Net loss applicable to
common stockholders $ (6,694) 7,604,000 $(0.88) $(1,256) 7,168,000 $(0.18)
Effect of dilutive
securities
Options - -
Warrants - -
Diluted EPS
Net loss applicable to
common stockholders
plus assumed conversions $ (6,694) 7,604,000 $(0.88) $(1,256) 7,168,000 $(0.18)
6
At November 26, 2004, there were stock options to purchase the Company's common
stock totaling 299,779 shares which were not included in the computation of
diluted earnings per share, as the effect of such would be anti-dilutive.
Additionally, there was subordinated debt with a face value of $10,000,000 which
was convertible at an exercise price of $6.05 per share, equating to 1,652,893
shares if fully converted to common shares. Upon each conversion of the Note,
the holder would be entitled to receive a warrant to purchase additional shares
of common stock equal to ten percent of the shares issued pursuant to such
conversion. If the entire face value of the Note were to be converted into
common shares, warrants for an additional 165,289 shares would be issued,
bringing the total shares to be issued to 1,818,182. Additionally, at November
26, 2004, there were outstanding warrants to purchase the Company's stock
totaling 1,003,048 shares. None of these shares have been included in the
computation of diluted earnings per share as the effect would be anti-dilutive.
At November 28, 2003, there were stock options to purchase the Company's common
stock totaling 412,064 shares which were not included in the computation of
diluted earnings per share, as the effect of such would be anti-dilutive.
Additionally, there was subordinated debt with a face value of $10,000,000 which
was convertible at an exercise price of $6.05 per share, equating to 1,652,893
shares if fully converted to common shares. Upon each conversion of the Note,
the holder would be entitled to receive a warrant to purchase additional shares
of common stock equal to ten percent of the shares issued pursuant to such
conversion. If the entire face value of the Note were to be converted into
common shares, warrants for an additional 165,289 shares would be issued,
bringing the total shares to be issued to 1,818,182. Additionally, at November
28, 2003, there were outstanding warrants to purchase the Company's stock
totaling 1,240,868 shares. None of these shares have been included in the
computation of diluted earnings per share as the effect would be anti-dilutive.
3. Stock Options
The Company accounts for stock options under SFAS No. 123, "Accounting
for Stock-Based Compensation," as amended by SFAS No. 148, which contains a fair
value-based method for valuing stock-based compensation that entities may use,
which measures compensation cost at the grant date based on the fair value of
the award. Compensation is then recognized over the service period, which is
usually the vesting period. Alternatively, SFAS No. 123 permits entities to
continue accounting for employee stock options and similar equity instruments
under Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued
to Employees." Entities that continue to account for stock options using APB
Opinion 25 are required to make pro forma disclosures of net income and earnings
per share, as if the fair value-based method of accounting defined in SFAS No.
123 had been applied.
7
At November 26, 2004, the Company had one stock-based employee
compensation plan. The Company accounts for this plan under the recognition and
measurement principles of APB Opinion 25, "Accounting for Stock Issued to
Employees," and related interpretations. Stock-based employee compensation costs
are not reflected in net income, as all options granted under the plan had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net income and
earnings per share if the Company had applied the fair value recognition
provisions of SFAS No. 123, to stock-based employee compensation (in thousands,
except per share amounts).
Thirteen Weeks Ended
--------------------------------------------
November 26, 2004 November 28, 2003
----------------- -----------------
Net loss,
as reported $(3,249) $ (704)
Less: stock-based compensation costs
determined under fair market value based
methods for all awards (2) (10)
-------- ------
Net loss, pro forma $ (3,251) $ (714)
Loss per share of common stock-basic:
As reported $ (0.43) $ (.10)
Pro forma $ (0.43) $ (.10)
Loss per share of common stock-diluted:
As reported $ (0.43) $ (.10)
Pro forma $ (0.43) $ (.10)
Thirty-nine Weeks Ended
--------------------------------------------
November 26, 2004 November 28, 2003
----------------- -----------------
Net loss,
as reported $(6,694) $(1,256)
Less: stock-based compensation costs
determined under fair market value based
methods for all awards (2) (30)
-------- ------
Net loss, pro forma $(6,696) $(1,286)
Loss per share of common stock-basic:
As reported $ (0.88) $ (.18)
Pro forma $ (0.88) $ (.18)
Loss per share of common stock-diluted:
As reported $ (0.88) $ (.18)
Pro forma $ (0.88) $ (.18)
Stock options to purchase a total of 33,586 shares of the Company's common stock
were granted during the thirteen weeks ended November 26, 2004.
There were no grants of stock options during the thirty-nine weeks ended
November 28, 2003.
8
4. Accounts Receivable
The components of accounts receivable are as follows:
November 26,
2004 February 27,
unaudited 2004
------------ ------------
(amounts in thousands)
U.S. Government receivables billed and unbilled contract
costs subject to negotiation $ 3,167 $ 3,128
U.S. commercial receivables billed 2,132 1,508
International receivables billed and unbilled contract
costs subject to negotiation 4,145 14,976
------- -------
9,444 19,612
Less allowance for doubtful accounts (400) (379)
------- -------
$ 9,044 $19,233
======= =======
U.S. Government receivables billed and unbilled contract costs subject to
negotiation:
Unbilled contract costs subject to negotiation as of November 26, 2004,
and February 27, 2004, primarily represent claims made against the U.S.
Government under a contract for a submarine rescue decompression chamber
project. These costs totaling $3,004,000 were recorded beginning in fiscal year
2002 and include $833,000 recorded during fiscal year 2004 and $105,000 recorded
during fiscal year 2005. In November 2003, the U.S. Government completed an
audit of the claim, rejecting most of the items due to audit or engineering
reasons. The Company was not provided a copy of the Government's Technical
Report that questioned approximately half of the claim costs. The Company has
submitted a written rebuttal to the draft report and has formally requested a
copy of the Technical Report. On July 22, 2004, the U.S. Government's
Contracting Officer issued a final decision on the claim, denying the claim in
full. In response, the Company plans to file a complaint in the Court of Federal
Claims in the near future.
This U. S. Government claim has followed the typical process of claim
notification, preparation, submittal, government audit and review by the
contracting officer. Historically, the Company's experience has indicated that
most claims are initially denied in part or in full by the contracting officer
(or no decision is forthcoming, which is then taken to be a deemed denial) which
then forces the Company to seek relief in a court of law.
The Company considers the recorded costs to be realizable due to the
fact that the costs relate to customer caused delays, errors and changes in
specifications and designs, disputed liquidated damages and other out of scope
items. In the first quarter of fiscal 2005, the Company submitted a supplement
to the claim incorporating additional cost items. The U.S. Government, citing
failure to deliver the product within contract terms, has assessed liquidated
damages but has not offset or withheld any progress payments due to the Company
under the contract. The Company disputes the basis for these liquidated damages,
noting that applicable U.S. Government purchasing regulations allow for a waiver
of these charges if the delay is beyond the control and not due to the fault or
negligence of the Company. However, following accounting principles generally
accepted in the United States of America, the Company has reduced contract
values and corresponding revenue recognition for an estimated amount of $330,000
to cover a delay through the extended delivery period.
9
International receivables billed and unbilled contract costs subject to
negotiation:
International receivables billed include $700,000 at November 26, 2004
and February 27, 2004, respectively, related to a contract with the Royal Thai
Air Force ("RTAF").
In October 1993, the Company was notified by the RTAF that the RTAF was
terminating a $4,600,000 simulator contract with the Company. Although the
Company had performed in excess of 90% of the contract, the RTAF alleged a
failure to completely perform. In connection with this termination, the RTAF
made a call on a $230,000 performance bond, as well as a draw on an
approximately $1,100,000 advance payment letter of credit. Work under this
contract had stopped while under arbitration, but on October 1, 1996, the Thai
Trade Arbitration Counsel rendered its decision under which the contract was
reinstated in full and the Company was given a period of nine months to complete
the remainder of the work. Except as noted in the award, the rights and
obligations of the parties remained as stated in the original contract including
the potential invoking of penalties or termination of the contract for delay. On
December 22, 1997, the Company successfully performed acceptance testing and the
unit passed with no discrepancy reports. Although the contract was not completed
in the time allotted, the Company has requested an extension on the completion
time due to various extenuating circumstances, including allowable "force
majeure" events, one of which was a delay in obtaining an export license to ship
parts required to complete the trainers. On August 30, 2001, the Company
received a payment of $230,000 representing the amount due on the performance
bond.
The open balance of $700,000 due on the contract represents the total
net exposure to the Company on this contract. On June 16, 2003, the Company
filed for arbitration in Thailand seeking recovery of the open balance of
$700,000 due on this contract. On October 8, 2003, the Thai government filed
their defense with the Thai Arbitration Institute (TAI). In December 2003 the
Company and the RTAF both selected arbitrators to represent them in the dispute,
although no date has yet been set for the arbitration proceedings. To choose the
third (umpire) arbitrator, the RTAF, TAI and the Company will each nominate
three candidates for a total of nine. The RTAF and the Company will then rank
the candidates and the one receiving the highest rank will be asked to serve as
the (umpire) arbitrator. It is expected that this approach will avoid any
conflict of interest issues.
Since the circumstances that caused a delay are commonly considered
"force majeure" events, and since the contract under question allows for
consideration of "force majeure" events, the Company believes that the open
balance related to this contract is collectible and will continue to treat this
balance as collectible until a final unappealable legal decision is rendered by
a competent Thai tribunal. The Company continues to enjoy a favorable
relationship with the RTAF. It currently has both maintenance and upgrade
contracts with the RTAF for trainers that are the subject of the dispute and has
sold a significant amount of additional equipment to the RTAF since this dispute
began. Thus, we do not feel the initiation of legal action against the RTAF has
affected our ability to obtain additional contracts with the RTAF. At this
point, the Company is not able to determine what, if any, impact the extended
completion period will ultimately have upon the receipt of final payment.
10
Unbilled contract costs subject to negotiation represent a claim
($2,600,000 recorded as of November 26, 2004) made against an international
customer for a contract covering the period from 1997 to the present. Claim
costs have been incurred in connection with customer caused delays, errors in
specifications and designs, other out-of-scope items and exchange losses and may
not be received in full during fiscal 2005. In conformity with accounting
principles generally accepted in the United States of America, revenue recorded
by the Company from a claim does not exceed the incurred contract costs related
to the claim. The Company is currently in discussions with this customer to
finalize all open issues. At this point, the Company is unable to assess the
ultimate impact of discussions or arbitration on current operations and
financials.
Effective February 27, 2004, the Company reached an agreement totaling
$10.5 million with the same international customer on another claim, thus
resolving all outstanding amounts related to that claim. These proceeds were
received on March 16, 2004 (See also the Liquidity and Capital Resources section
of the Management's Discussion and Analysis of Results of Operations and
Financial Condition following).
Historically, the Company has had positive experience with regard to
its contract claims in that recoveries have exceeded the carrying value of
claims. However, there is no assurance that the Company will always have
positive experience with regard to recoveries for its contract claims.
5. Inventories
Inventories are valued at the lower of cost or market using the first
in, first out (FIFO) method and consist of the following (net of reserves of
$715,000 and $564,000 at November 26, 2004 and February 27, 2004, respectively):
November 26,
2004 February 27,
unaudited 2004
------------- ------------
(amounts in thousands)
Raw materials $308 $311
Work in process 5,461 7,803
Finished goods 1,643 1,729
------ ------
Total $7,412 $9,843
====== ======
11
6. Stockholders' Equity
The components of stockholders' equity at February 27, 2004 and
November 26, 2004 were as follows:
(amounts in thousands, except share information)
Capital
contributed
Common Stock in excess of Accumulated
------------------------ par value of Other Comp. Retained
Shares Amount common stock Loss Earnings Total
----------- -------- ------------- ------------- --------- -------
Balance at February 27, 2004 7,176,552 $359 $9,430 $(329) $15,594 $25,054
Net loss for the thirty-nine weeks
ended November 26, 2004 - - - - (6,694) (6,694)
Foreign currency translation
adjustment - - - 4
Total comprehensive loss - - - 4 - (6,690)
Shares issued in connection
with exercise of warrants 437,820 21 565 - - 586
Value of warrants issued 571 571
Shares issued under exercise
of employee stock options
and Director compensation 26,314 1 162 - - 163
--------- ---- ------- ----- ------ -------
Balance at November 26, 2004 7,640,686 $381 $10,728 $(325) $8,900 $19,684
========= ==== ======= ===== ====== =======
7. Long Term Debt
The following table lists the long-term debt and other long-term
obligations of the Company as of November 26, 2004.
PAYMENTS DUE BY PERIOD
Obligation Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years
---------- ----- ---------------- --------- --------- -------------
Current Portion of
Long Term Debt $ 275 $ 275 $ - $ - $ -
Long-term Debt - - - - -
Capital Leases 551 177 374 - -
Subordinated debt, net of
unamortized discount
of $2,095 7,905 - - 7,905 -
Long term bonds 4,095 - 825 550 2,720
--------- -------- -------- ------- --------
Total Obligations $ 12,826 $ 452 $ 1,199 $ 8,455 $ 2,720
========= ======== ======== ======= ========
Expected Interest Expense $ 5,006 $ 917 $ 3,309 $ 409 $ 371
The Company has historically financed operations through a combination
of cash generated from operations, and bank and other debt. On February 19,
2003, the Company signed a Credit Agreement (the "Agreement") with PNC Bank,
National Association ("PNC") and a Convertible Note and Warrant Purchase
Agreement (the "Note") with H.F. Lenfest, an individual, in the aggregate amount
of $29,800,000. The Company used a portion of the proceeds from the financing to
satisfy its existing debt obligations to Wachovia Bank, the Company's former
lender, and to permit PNC to issue a letter of credit to support outstanding
bonds issued by the Company in a previous financing transaction. The transaction
resulted in net proceeds (after transaction expenses and payment of existing
debt) to the Company of approximately $3,600,000. The Company used the net
proceeds for working capital and general corporate purposes.
12
On April 30, 2003, the Agreement was amended to include: (i) a revolving
credit facility in the maximum aggregate principal amount of $14,800,000 to be
used for the Company's working capital and general corporate purposes, including
capital expenditures, with a sublimit for issuances of letters of credit in the
maximum aggregate face amount of $10,300,000, and (ii) a standby letter of
credit in the face amount of $4,750,000 as credit support for the Company's
bonds. Additionally, on July 9, 2003, a second amendment to the Agreement was
executed which formed an additional $1,010,000 credit facility for use in
financing export contracts which qualify for an EXIM (the Export-Import Bank of
the United States) Bank guarantee.
During the first quarter of fiscal 2005, as a result of the Company's
recent operating losses and its violation of certain financial covenants
contained in the Agreement, PNC advised the Company that it was instituting
certain changes to the revolving credit facility. The changes included reducing
the facility to $6,000,000 and requiring the Company to cash collateralize the
full facility. These changes became effective on June 2, 2004.
On August 24, 2004, the Agreement was amended to substantially reduce the
operating facility and eliminate the associated monthly borrowing base reporting
requirements. The revolving facility was reduced from $14,800,000 to $5,000,000
and use of the facility was restricted to the issuance of letters of credit,
which are frequently a requirement of international contracts. Under the amended
Agreement, the Company could no longer borrow cash under the facility. The
Company's long-term bonds were left intact. As additional collateral for the
revised facility, PNC required the Company to keep $2,500,000 in a restricted
cash account. The annual fee for letters of credit was reduced from 1.75% to
1.0% per annum. Additionally, three of the financial covenants, the Leverage
Ratio, the Fixed Charge Ratio and the requirement not to report a net loss in
any annual period were eliminated and the Tangible Net Worth requirement was
reduced. All other terms and conditions of the revolving loan and the line of
credit as set forth in the Agreement remained in effect.
Under the August 24, 2004, amendment the EXIM Bank credit facility was
reduced from $1,010,000 to $995,000, with all other terms and conditions
remaining unchanged. Availability under the EXIM facility is determined based on
a borrowing base consisting of a portion of the Company's receivables and
inventory.
As a condition of amending the Agreement, Mr. Lenfest, holder of the
Company's subordinated debt, agreed to issue to PNC on the Company's behalf a
limited guarantee to secure up to $5,000,000 in principal amount of any letters
of credit issued under the amended facility. In consideration for issuing this
guarantee, Mr. Lenfest will receive a fee of 0.75% per annum of the average
amount of letters of credit outstanding, payable on a quarterly basis, and
received a warrant to purchase 200,000 shares of stock under the same terms and
conditions as his existing warrant for 803,048 shares (see the Liquidity and
Capital Resources section following in this report).
13
On October 18, 2004, the Agreement was again modified. This amendment
required the Company to deposit in a restricted cash account an additional
amount of $285,000 to cover the next scheduled payment of principal and interest
due April 1, 2005 on the Company's long-term bonds. The Tangible Net Worth
covenant requirement was reduced to a) $14,500,000 for the periods ended
November 26, 2004 and February 25, 2005 and b) on the last day of any fiscal
quarter ending after February 25, 2005, to be at least equal to the actual
Tangible Net Worth on February 25, 2005. Additionally, the fee for the PNC
Letter of Credit, which backs the Company's long-term bonds, was increased from
2.0% to 2.5% annually.
Under the October 18, 2004 amendment to the Agreement, the Company must
maintain a minimum Tangible Net Worth. At November 26, 2004, the Company's
Tangible Net Worth dropped below this minimum and thus was in violation of this
financial covenant. The Company has obtained a waiver from PNC for this
violation.
Additionally, under the Note, which covers the Company's subordinated
debt, the Company must meet certain financial covenants including a Leverage
Ratio, a Fixed Charge Ratio and a Tangible Net Worth Ratio. At November 26, 2004
the Company failed to meet any of these financial covenants but has obtained a
waiver from its subordinated lender. This waiver applies to the period through
November 30, 2005. Except as specified, the waiver does not constitute a
modification or alteration of any other terms or conditions in the Note, or a
release of any of the lender's rights or remedies, all of which are reserved,
nor does it release the Company or any guarantor from any of its duties,
obligations, covenants or agreements including the consequences of any Event of
Default, except as specified.
Going forward, PNC has alerted the Company that additional changes may be
required to the Agreement and that an increase in the cash collateral account
may be required. Specific terms and conditions for any additional modifications
had not been finalized as of the filing date of this report. Based on the annual
forecast and the indicated actions described above, the Company does not believe
it is probable that it will fail future covenant tests.
Given the Company's inability to borrow cash under the amended Agreement,
the Company may need to obtain additional sources of capital in order to
continue growing and operating our business. This capital may be difficult to
obtain and the cost of this additional capital is likely to be relatively high.
However, we believe that we will be able to locate such additional capital and
that these actions by PNC will not have a long-term material adverse effect on
our business.
14
8. Business Segment Presentation:
The Company primarily manufactures under contract various types of
high-technology equipment that it has designed and developed. The Company
considers its business activities to be divided into two segments: Aircrew
Training Systems (ATS) and the Industrial Group. The ATS business segment
produces devices which create and monitor the physiological effects of motion,
including spatial disorientation and centrifugal forces for the medical,
training, research and entertainment markets. The Industrial Group produces
chambers that create environments that are used for sterilization, research, and
medical applications. The following segment information reflects the accrual
basis of accounting:
Industrial
ATS Group Total
------ ---------- -----
(amounts in thousands)
THIRTEEN WEEKS ENDED NOVEMBER 26, 2004
Net Sales $3,368 $4,383 $7,751
Interest Expense 305 135 440
Depreciation and Amortization 174 302 476
Operating loss (2,257) (299) (2,556)
Income Tax Benefit 4 - 4
Goodwill and Intangibles 477 - 477
Identifiable Assets 15,103 7,892 22,995
Expenditures For Segment Assets 601 41 642
THIRTEEN WEEKS ENDED NOVEMBER 28, 2003
Net Sales $4,029 $3,086 $7,115
Interest Expense 343 84 427
Depreciation and Amortization 282 246 528
Operating loss (286) (153) (439)
Income Tax Benefit 179 67 246
Goodwill and Intangibles 477 - 477
Identifiable Assets 30,491 7,491 37,982
Expenditures For Segment Assets 55 9 64
Reconciliation to consolidated amounts 2004 2003
Segment Assets $22,995 $ 38,459
Corporate Assets 18,728 10,055
------- --------
Total Assets $41,723 $ 48,514
======= ========
Segment operating loss $(2,556) $ (439)
Less interest expense (440) (427)
Less income tax benefit 4 246
------- --------
Total loss for segments (2,992) (620)
Corporate home office expenses (201) (261)
Interest and other expenses (56) 140
Income tax benefit - 34
Minority interest - 3
------- --------
Net loss $(3,249) $ (704)
======= ========
15
Industrial
ATS Group Total
-------- ---------------------- -------
(amounts in thousands)
THIRTY-NINE WEEKS ENDED NOVEMBER 26, 2004
Net Sales $11,782 $8,667 $20,449
Interest Expense 830 355 1,185
Depreciation and Amortization 792 614 1,406
Operating Loss (5,015) (1,095) (6,110)
Income Tax Benefit 1,022 307 1,329
Goodwill and Intangibles 477 - 477
Identifiable Assets 15,103 7,892 22,995
Expenditures For Segment Assets 1,190 64 1,254
THIRTY-NINE WEEKS ENDED NOVEMBER 28, 2003
Net Sales $ 9,690 $8,307 $17,997
Interest Expense 937 257 1,194
Depreciation and Amortization 731 722 1,453
Operating Income (51) 363 312
Income Tax (Benefit)/Provision (304) 154 (150)
Goodwill and Intangibles 477 - 477
Identifiable Assets 30,491 7,491 37,982
Expenditures For Segment Assets 215 56 271
Reconciliation to consolidated amounts 2004 2003
Segment Assets $22,995 $38,459
Corporate Assets 18,728 10,055
------- -------
Total Assets $41,723 $48,514
======= =======
Segment operating (loss)/income $(6,110) $ 312
Less interest expense (1,185) (1,194)
Less income tax benefit 1,329 150
------- -------
Total loss for segments (5,966) (732)
Corporate home office expenses (684) (781)
Interest and other expenses (168) (53)
Income tax benefit 124 301
Minority interest - 9
------- -------
Net loss $(6,694) $(1,256)
======= =======
Segment operating income consists of net sales less applicable costs
and expenses relating to these revenues. Unallocated general corporate expenses,
letter of credit fees, interest expense and income taxes have been excluded from
the determination of the total profit/loss for segments. Corporate home office
expenses are primarily central administrative office expenses. Interest and
other expenses include banking and letter of credit fees. Property, plant and
equipment are not identified with specific business segments, as these are
common resources shared by all segments.
Approximately 41% of sales totaling $3,189,000 in the thirteen weeks
ended November 26, 2004 were made to two international customers and one
domestic customer in the ATS segment. Approximately 23% of sales totaling
$1,611,000 in the thirteen weeks ended November 28, 2003 were made to two
international customers in the ATS segment.
Approximately 16% of sales totaling $3,343,000 in the thirty-nine weeks
ended November 26, 2004 were made to one international customer in the ATS
segment. Approximately 30% of sales totaling $5,318,000 in the thirty-nine weeks
ended November 28, 2003 were made to one domestic and one international customer
in the sterilizer and ATS segments respectively.
16
Included in the segment information for the thirteen weeks ended
November 26, 2004 are export sales of $3,276,000. Of this amount, there are
sales to or relating to governments or commercial accounts in Malaysia
($1,203,000) and Italy ($525,000). Sales to the U.S. Government and its agencies
were $1,157,000 for the period.
Included in the segment information for the thirteen weeks ended
November 28, 2003 are export sales of $4,382,000. Of this amount, there are
sales to or relating to governments or commercial accounts in Venezuela
($1,050,000), the United Kingdom ($818,000), and Malaysia ($793,000). Sales to
the U.S. Government and its agencies were negligible for the period.
Included in the segment information for the thirty-nine weeks ended
November 26, 2004 are export sales of $9,554,000. Of this amount, there are
sales to or relating to commercial accounts in Malaysia ($3,343,000). Sales to
the U.S. Government and its agencies aggregated $2,225,000 for the period.
Included in the segment information for the thirty-nine weeks ended
November 28, 2003 are export sales of $10,019,000. Of this amount, there are
sales to or relating to commercial or government accounts in Malaysia
($2,887,000) and Venezuela ($1,050,000). Sales to the U.S. Government and its
agencies aggregated $624,000 for the period.
9. Recent Accounting Pronouncements
ACCOUNTING FOR SHARE-BASED PAYMENTS
In December 2004, the Financial Accounting Standards Board (FASB)
issued FASB Statement No. 123 (revised 2004), Share-Based Payments. This
statement replaces FASB Statement No. 123, Accounting for Stock-Based
compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees. This statement requires companies to recognize in financial
statements the compensation cost relating to share-based transactions including
share options, restricted share plans, performance-based awards, share
appreciation rights and employee share purchase plans. The cost of these
arrangements will be measured based on the fair value of the equity or liability
instruments issued. Public companies will be required to apply Statement 123(R)
as of the first interim or annual reporting period that begins after June 15,
2005. The Company is not able at this time to determine what impact, if any,
adoption of Statement 123(R) will have on the results of operations.
ACCOUNTING FOR INVENTORY COSTS
In November 2004, the FASB issued FASB Statement 151, Inventory Costs,
an amendment of ARB No. 43, Chapter 4. While retaining the general principle
that inventories are presumed to be stated at cost, Statement 151 amends ARB No.
43 to clarify that:
o abnormal amounts of idle facilities, freight, handling costs, and
spoilage should be recognized as charges of the current period.
o allocation of fixed production overheads to inventories should be
based on the normal capacity of the production facilities.
The Statement defines normal capacity as the production expected to be
achieved over a number of periods or seasons under normal
circumstances, taking into account the loss of capacity resulting from
planned maintenance.
17
Statement 151 is effective for inventory costs incurred during fiscal
years beginning after June 15, 2005 and should be applied
prospectively. Early application is permitted. The Company is not able
at this time to determine what impact, if any, adoption of statement
151 will have on the results of operations.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION (AMOUNTS IN DOLLARS, EXCEPT WHERE NOTED AND SHARE AND PER
SHARE AMOUNTS)
Forward Looking Statements
This Quarterly Report on Form 10-Q includes 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. These
forward-looking statements are based on the Company's current expectations and
projections about future events. These forward-looking statements are subject to
known and unknown risks, uncertainties and assumptions about the Company and its
subsidiaries that may cause actual results, levels of activity, performance or
achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by these
forward-looking statements.
These forward-looking statements include statements with respect to the
Company's vision, mission, strategies, goals, beliefs, plans, objectives,
expectations, anticipations, estimates, intentions, financial condition, results
of operations, future performance and business of the Company, including but not
limited to, (i) projections of revenue, costs of raw materials, income or loss,
earnings or loss per share, capital expenditures, growth prospects, dividends,
capital structure, other financial items and the effects of currency
fluctuations, (ii) statements of plans and objectives of the Company or its
management or Board of Directors, including the introduction of new products, or
estimates or predictions of actions of customers, suppliers, competitors or
regulatory authorities, (iii) statements of future economic performance, (iv)
statements of assumptions and other statements about the Company or its
business, and (v) statements preceded by, followed by or that include the words
"may", "could", "should", "looking forward", "would", "believe", "expect",
"anticipate", "estimate", "intend", "plan", or the negative of such terms or
similar expressions. These forward-looking statements involve risks and
uncertainties which are subject to change based on various important factors.
Some of these risks and uncertainties, in whole or in part, are beyond the
Company's control. Factors that might cause or contribute to such a material
difference include, but are not limited to, those discussed in the Company's
Annual Report on Form 10-K for the fiscal year ended February 27, 2004, in the
section entitled "Risks Particular to Our Business." Shareholders are urged to
review these risks carefully prior to making an investment in the Company's
common stock.
18
The Company cautions that the foregoing list of important factors is
not exclusive. The Company does not undertake to update any forward-looking
statement, whether written or oral, that may be made from time to time by or on
behalf of the Company.
OVERVIEW
We are principally engaged in the design, manufacture and sale of
software driven products used to create and monitor the physiological effects of
motion on humans and equipment and to control, modify, simulate and measure
environmental conditions. These products include aircrew training systems,
entertainment products, sterilizers, environmental and hyperbaric chambers and
other products that involve similar manufacturing techniques and engineering
technologies.
The following factors had an adverse impact on our performance for the
fiscal quarter and the thirty-nine weeks ended November 26, 2004:
o Unfavorable global economic and political conditions;
Our new sales bookings continued to be hampered by unfavorable global
economic and political conditions. Many new projects continue to face
budget constraints and other governmental delays by our customers
throughout the world. Additionally, sentiment against purchasing
American-made goods has heightened since September 11, 2001. Proposal
activity in some of our businesses, most notably in the ATS and
environmental areas, remains strong: the probability of being awarded
some significant potential projects has recently increased: we have
booked some large projects in the ATS area in fiscal 2005; however, we
have not been able to materially increase the backlog and our resulting
sales volume. Thus, we still remain cautious about the volume of new
contracts that we may be awarded in the near term.
o Technical and other issues which delayed completion of some
projects;
Many of our products, especially in the ATS and environmental lines,
incorporate new state-of-the-art or unproven technologies.
Occasionally, given the engineering effort to design, develop and test
these technologies and the difficult logistics of installation and
acceptance requirements in foreign locations, we experience delays in
the final completion and receipt of final payment for a project. This
can have a negative impact on revenue recognition, gross margin
performance, and cash flow from operations, especially if additional
spending is required or if customer induced delays occur. Historically,
we have charged the cost of new product technologies to individual
contracts and occasionally only a portion of these costs is covered by
customer payments. Although some significant long-standing contracts
have been closed in fiscal 2005, additional contracts have continued to
experience various delays, and these delays are expected to have a
continued negative impact on our gross margins. This situation is
applicable to many of our product lines and tends to add an element of
unpredictability to our financial performance.
19
o Limited borrowing availability and higher costs of capital.
Cash collections have been very strong in fiscal 2005 primarily due to
the receipt of $10.5 million in March 2004 under a settlement agreement
of an international claim, and there are currently some sizable open
customer receivables. However, given our inability to borrow cash from
PNC under the August 24, 2004, amendment to the Bank Agreement, the
requirement to restrict the use of $2.8 million of cash, and the
potential that PNC will require additional cash to be deposited in a
restricted account as collateral, we may need to obtain additional
sources of capital in order to grow our business. We currently have a
relatively high average cost of capital and this continues to have a
negative impact on our financial results. New capital may be difficult
to obtain and the cost of this additional capital is likely to be
relatively high.
o Higher cost of litigation and contract claims activity.
A significant portion of our selling and administrative spending is
related to costs associated with litigation and our ongoing contract
claims activities. Two litigation matters, an international contract
claim and the legal suit against Walt Disney World Company, were in the
discovery phase in the fiscal quarter ended November 26, 2004 and
required extensive outside legal effort. Although some decrease in the
rate of expenditure is expected in future periods, these matters are
expected to continue to require material legal expenditures for the
foreseeable future. The Company plans to utilize collections from other
outstanding claims and cash from operations to pay for these costs.
Our goal is to be the premier supplier of low-cost, high-performance
and technologically advanced simulation equipment in the markets we
serve. To that end, we face various challenges in order to make fiscal
2005 a successful year. In order to overcome the factors adversely
impacting our performance and to meet this goal, we need to take the
following actions. (The reader is referred to the Management's
Discussion and Analysis of Financial Condition and Results of
Operations included in the Company's Annual Report on Form 10-K for the
fiscal year ended February 27, 2004.)
o Sell through all of the products we technologically enhanced in
fiscal 2004.
20
o Stimulate interest in the U.S. Government Armed Forces to purchase
Advanced Tactical Flight Simulation (ATFS) technology. This effort
may require the use of scarce operating funds to manufacture a
prototype device for demonstration purposes.
o Allocate the resources and find the funding to continue to evolve
ATFS.
o Re-engineer the products in our ATS and environmental lines to
remain competitive.
o Complete some large international projects which have negative
margins and continue to monopolize our limited installation
personnel.
o Continue to reduce the environmental business operating losses by
utilizing the skills of additional personnel acquired from a
former competitor.
o Expand the entertainment line by repeat sales and the introduction
of story line enhancements.
o Settle at least one major claim.
o Balance overhead and selling and administrative spending levels to
be more in line with the current level of sales volume.
o Rejuvenate the sales force and sales booking level.
o Prioritize and focus our product development.
o Tightly manage our cash to compensate for the reduced booking
level and inability to borrow from our bank.
o Minimize the financial cost of implementing the new requirements
under the Sarbanes-Oxley Act of 2002 and related regulations.
Our failure to complete some or all of these steps may have a material
adverse effect on both our cash availability and our future operating results.
We recognize revenue when it is realized or realizable and earned. We
consider revenue realized or realizable and earned when there exists persuasive
evidence of an arrangement, the product has been shipped or the services have
been provided to the customer, the sales price is fixed or determinable and
collectability is reasonably assured. In addition to the aforementioned general
policy, the following are the specific revenue recognition policies we utilize:
Revenue on long-term contracts that require us to design, develop or
manufacture a product or modify an existing unit is recognized using the
percentage-of-completion method. Percentage of completion is measured based on
the ratio of costs incurred to date compared to the total estimated costs. This
21
percentage is multiplied by the total estimated revenue under a contract to
calculate the amount of revenue recognized in an accounting period. Total
estimated costs are based on several factors, including estimated labor hours to
complete certain tasks and the estimated cost of purchased items at future
dates. Revenue recognized in excess of amounts billed to customers on
uncompleted long-term contracts under the percentage of completion method is
reflected as an asset. Amounts billed to customers in excess of revenue
recognized on uncompleted long-term contracts under the percentage of completion
method are reflected as a liability. When it is estimated that a contract will
result in a loss, the entire amount of the loss is accrued. The effect of
revisions in cost and profit estimates for long-term contracts is reflected in
the accounting period in which we learn the facts that require us to revise the
cost and profit estimates. Contract progress billings are based upon contract
provisions for customer advance payments, contract costs incurred, and
completion of specified contract milestones. Contracts may provide for customer
retainage of a portion of amounts billed until contract completion. Retainage is
generally due within one year of completion of the contract. Revenue recognition
under the percentage-of-completion method involves significant estimates which
may need to be adjusted from quarter to quarter which would impact revenue and
margins on a cumulative basis.
Effective with the beginning of fiscal year 2005, we changed the
parameters for application of the percentage of completion method of revenue
recognition. The minimum contract value has been raised to include all contracts
over $250,000 and the minimum completion period has been shortened to six months
for a contract to apply for this method. The criteria in prior years was
contracts over $100,000 in value with a completion period of one year or more.
This change applies to contracts entered into or started after February 27,
2004. Given the nature and mix of contracts booked in recent years, we believe
adjusting the criteria in this way will allow for a more representative
reporting of the production flow and earnings process. We are unable to quantify
the impact this change would have had on prior years' operating results.
Revenue for contracts under $250,000, or to be completed in less than
six months, and where there are no post-shipment services included in the
contract, is recognized on the date that the finished product is shipped to the
customer.
Revenue derived from the sale of parts or as-needed repair services is
recognized on the date that the product is shipped to the customer or that the
services are completed. Revenue on contracts under $250,000, or to be completed
in less than six months, and where post-shipment services (such as installation
and customer acceptance) are required, is recognized following customer
acceptance. Contracted maintenance services are provided under separate
maintenance contracts with our customers. Revenue for contracted maintenance
contracts is recognized ratably over the life of the contract with related
material costs expensed as incurred.
22
In accordance with accounting principles generally accepted in the
United States of America, recognizing revenue on contract claims and disputes
related to customer caused delays, errors in specifications and designs, and
other unanticipated causes, and for amounts in excess of contract value, is
generally appropriate if it is probable that the claim will result in additional
contract revenue and if we can reliably estimate the amount of additional
contract revenue which may be received. However, revenue recorded on a contract
claim cannot exceed the incurred contract costs related to that claim. Claims
involve significant judgments and estimates and are subject to negotiation,
arbitration and audit by the customer or governmental agency.
We have operating subsidiaries in the United Kingdom and Poland,
maintain regional offices in the Middle East, and Asia, and use the services of
approximately 100 independent sales organizations and agents throughout the
world. ETC International Corporation is a holding company established for
federal income tax purposes and is not an operating subsidiary. We consider our
business activities to be divided into two segments: Aircrew Training Systems
(ATS) and the Industrial Group.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and
results of operation are based upon the Company's consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these
financial statements requires the Company to make estimates and judgments that
affect the reported amount of assets and liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities at the date of the
Company's financial statements. Actual results may differ from these estimates
under different assumptions or conditions.
Critical accounting policies are defined as those that reflect
significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. The Company
believes that its critical accounting policies include those described below.
For a detailed discussion on the application of these and other accounting
policies, see Note 1 to the Consolidated Financial Statements, Summary of
Significant Accounting Policies in our Annual Report on Form 10-K for the fiscal
year ended February 27, 2004, which was filed with the Securities and Exchange
Commission on May 27, 2004.
Revenue Recognition on Long-Term Contracts
When the performance of a contract requires a customer to pay the
Company more than $250,000 and will extend beyond a six-month period, revenue
and related costs are recognized on the percentage-of-completion method of
accounting. Profits expected to be realized on such contracts are recognized
based on total estimated sales for the contract compared to total estimated
costs at completion of the contract. These estimates are reviewed periodically
throughout the lives of the contracts, and adjustments to profits resulting from
any revisions are made cumulative to the date of the change. Estimated losses on
long-term contracts are recorded in the period in which the losses become known
to us.
23
We account for some of our largest contracts, including our contracts
with the U.S. Government and foreign governments, using the
percentage-of-completion method. If we do not accurately estimate the total cost
to be incurred on this type of contract, or if we are unsuccessful in the
ultimate collection of any associated contract claims, our actual gross margins
may be significantly less than our estimates or losses may need to be recognized
in future periods. Any resulting reductions in margins or contract losses could
be material to our results of operations and financial position.
Accounts Receivable
We perform ongoing credit evaluations of our customers and adjust
credit limits based on payment history and the customer's current credit
worthiness. We continuously monitor collections and payments from our customers
and maintain a provision for estimated credit losses based on historical
experience and any specific customer collection issues that have been
identified. While our credit losses have historically been within our
expectations and the provisions established, we cannot guarantee that we will
continue to experience the same credit loss rates that we have in the past.
Additionally, as a result of the concentration of international receivables, we
cannot predict the effect, if any, which geopolitical risk and uncertainty will
have on the ultimate collection of our international receivables.
RESULTS OF OPERATIONS
THIRTEEN WEEKS ENDED NOVEMBER 26, 2004 COMPARED TO THIRTEEN WEEKS ENDED NOVEMBER
28, 2003.
We have historically experienced significant variability in our
quarterly revenue, earnings and other operating results, and our performance may
fluctuate significantly in the future.
24
($000) SUMMARY TABLE OF RESULTS
--------------------------------------------------
FY 05 Q3 FY 04 Q3 $ VARIANCE % VARIANCE
( )=UNFAVORABLE
SALES
DOMESTIC $ 3,318 $ 2,775 $ 543 19.6%
US GOV'T 1,157 (42) 1,199 N/A
INT'L 3,276 4,382 (1,106) (25.2)
------- ------- --------
TOTAL SALES 7,751 7,115 636 8.9
GROSS PROFIT 1,637 1,774 (137) (7.7)
SG&A EXPENSES 4,224 2,330 (1,894) (81.3)
R&D EXPENSES 170 144 (26) (18.1)
INTEREST EXP. 440 425 (15) (3.5)
OTHER EXP.,NET 57 (138) (195) (241.3)
INCOME TAXES (4) (280) (276) (98.6)
MINORITY INTEREST (1) (3) (2) (66.7)
------- ------- --------
NET LOSS $ (3,249) $ (704) $ (2,545) (361.5%)
======== ======= ======== =======
NET LOSS PER SHARE
(DILUTED) $(0.43) $ (0.10) (0.33) (330.0%)
======== ======= ======== =======
Net Loss.
--------
The Company had a net loss of $(3,249,000), or ($0.43) per share
(diluted), during the third quarter of fiscal 2005 versus a net loss of
$(704,000), or ($.10) per share (diluted), for the third quarter of fiscal 2004,
representing a decrease of $2,545,000 or 361.5%. This increase in net loss was
primarily due to a significant increase in litigation expenses associated with
the Company's international contract claims and other litigation and a lower
income tax benefit.
25
Sales.
-----
Sales for the third quarter of fiscal 2005 were $7,751,000 as compared
to $7,115,000 for the third quarter of fiscal 2004, an increase of $636,000 or
8.9%. Sales increases were evidenced in the environmental, hyperbaric and
entertainment lines. Environmental benefited from higher international sales
primarily in Italy. Hyperbaric, which evidenced the most significant increase
(domestic hyperbaric sales were up $940,000), benefited from the production on
two large multi-man hyperbaric chambers. Entertainment benefited from work on
Wild Earth units being produced for the Philadelphia Zoo.
We have historically experienced significant variability in our sales
performance. This reflects the existing sales backlog, product and the nature of
contract (size and performance time) mix, the manufacturing cycle and amount of
time to effect installation and customer acceptance, and certain factors not in
our control such as customer delays and the time required to obtain U.S.
Government export licenses. One or a few contract sales may account for a
substantial percentage of our quarterly revenue.
Domestic Sales.
--------------
Overall, domestic sales in the third quarter of fiscal 2005 were
$3,318,000 as compared to $2,775,000 in the third quarter of fiscal 2004, an
increase of $543,000 or 19.6%, reflecting increases in hyperbaric, service, and
entertainment sales. Hyperbaric and entertainment sales benefited from the
aforementioned activity while service benefited from work on domestic
sterilizers. Domestic sales represented 42.8% of the Company's total sales in
the third quarter of fiscal 2005, up from 39.0% for the third quarter of fiscal
2004. Sales to the U.S. Government in the third quarter of fiscal 2005 were
$1,157,000 as compared to a negligible amount in the third quarter of fiscal
2004, and represented 14.9% of total sales in the third quarter of fiscal 2005
versus a negligible amount for the third quarter of fiscal 2004.
International Sales.
-------------------
International sales for the third quarter of fiscal 2005 were
$3,276,000 as compared to $4,382,000 in the third quarter of fiscal 2004, a
decrease of $1,106,000 or 25.2%, and represented 42.3% of total sales as
compared to 61.6% in the third quarter of fiscal 2004. Throughout our history,
most of the sales for ATS have been made to international customers. In the
third quarter of fiscal 2005 international sales totaling at least ten percent
of total international sales were made to Malaysia ($1,203,000) and Italy
($525,000). In the third quarter of fiscal 2004 international sales totaling at
least ten percent of total international sales were made to government or
commercial accounts in Venezuela ($1,050,000), the United Kingdom ($818,000),
and Malaysia ($793,000). Fluctuations in sales to international countries from
year to year primarily reflect revenue recognition on the level and stage of
development and production on multi-year long-term contracts.
26
Gross Profit.
------------
Gross profit for the third quarter of fiscal 2005 was $1,637,000 as
compared to $1,774,000 in the third quarter of fiscal 2004, a decrease of
$137,000 or 7.7%. This decrease resulted from a 3.8 percentage point decrease in
the gross profit rate as a percent of sales partially offset by an increase in
sales. The quarter-to-quarter reduction reflected reduced manufacturing
performance in all groups except hyperbaric (on favorable costing for the
aforementioned large chamber contracts) and ATS which benefited from a large
multi-product contract sold through the U.S. Government. On the negative side,
sterilizers suffered from the completion in the prior period of a large
multi-unit contract at higher margins while the environmental group continued to
suffer cost overruns both domestically and internationally. This group has
recently revised its proposal and project management procedures in an effort to
improve margins. Historically we have charged the cost of new product
technologies to individual contracts and occasionally only a portion of these
costs are covered by customer payments, resulting in negative gross
manufacturing margins.
We have historically experienced significant fluctuations in gross
profit margins and, consequently, our operating results, and we expect such
fluctuations to continue. Gross margins are routinely affected by selling
prices, the engineering cost of product enhancements, the amount of new product
development required to meet contract specifications, the mix of materials,
labor content and engineering effort in manufacturing costs, labor difficulties
in field work including installation and customer acceptance, our ability to
negotiate change orders for additional work scope, and the impact of claims
settlements. We face a continuous challenge to reduce costs and improve gross
margins while implementing innovative new technologies.
Selling and Administrative Expenses.
-----------------------------------
Selling and administrative expenses for the third quarter of fiscal
2005 were $4,224,000 as compared to $2,330,000 in the third quarter of fiscal
2004, an increase of $1,894,000 or 81.3% primarily reflecting significantly
higher costs associated with litigation and the Company's ongoing contract
claims activities. Two litigation matters, an international contract claim and
the legal suit against Walt Disney World Company, etc., were in the discovery
phase in the fiscal quarter ended November 26, 2004 and required extensive
outside legal effort. The Company is currently in discussions with the
international customer to finalize all open issues. Although some decrease in
the rate of expenditure is expected in future periods, these matters are
expected to continue to require material legal expenditures for the foreseeable
future.
A significant portion of our selling and administrative spending is
related to three activities: i. legal and contract claims costs, ii. outside
sales agent and sales personnel commissions on booked contracts and iii.
additional accounting, legal and stockholder's costs required to comply with
applicable statutes, rules and regulations as a public company. We have recently
instituted a series of cost cutting measures and plan to continue to review all
spending categories.
27
Research and Development Expenses.
---------------------------------
Research and development expenses, which are charged to operations as
incurred, were $170,000 for the third quarter of fiscal 2005 as compared to
$144,000 for the third quarter of fiscal 2004, reflecting an increase of $26,000
or 18.1%. Most of the increase resulted from a delay in obtaining local
government grant funding for spending in our Turkish subsidiary for two projects
currently in progress. We are currently evaluating the level of spending
required to support this operation.
Most of our research efforts, which were and continue to be a
significant cost of our business, are included in cost of sales for applied
research for specific contracts, as well as research for feasibility and
technology updates. Most of our products require a significant amount of
continued development effort to implement new applications, design product
extensions, and integrate new technology into existing products.
Interest Expense.
----------------
Interest expense for the third quarter of fiscal 2005 was $440,000
versus $425,000 for the third quarter of fiscal 2004. Interest expense includes
interest on our debt, amortization of debt discount resulting from the
beneficial conversion option of our subordinated debt and associated warrants
issued with the debt, amortization expense associated with the recent issuance
of additional warrants, and amortization of deferred financing costs for our
February 2003 refinancing.
Other Income/Expense, Net
-------------------------
Other income/expense, net, consisted of an expense of $57,000 for the third
quarter of fiscal 2005 versus income of $138,000 for the third quarter of fiscal
2004, an increase of $195,000 or 241.3%. The increase resulted from the positive
net impact in the prior period of $283,000 from an insurance reimbursement.
Provision for Income Taxes.
--------------------------
During the current fiscal period, the Company applied for refunds for
tax loss carry-backs from the fiscal 2004 operating losses and received refunds
totaling approximately $900,000 from the Internal Revenue Service and the
Commonwealth of Pennsylvania. During the first two quarters of fiscal 2005, the
Company recognized approximately $1.4 million as income tax receivables
reflecting the two quarter's operating losses, approximately $800,000 of which
will be filed as refunds applied to income earned in prior years. During the
current fiscal quarter, the Company did not record any additional deferred tax
asset related to the current period loss, although it is possible income will be
generated in future periods which could be used to offset these third quarter
losses. The consolidated rate for the third quarter of fiscal 2004 reflected an
estimated rate of 28.4%, reflecting additional research and development tax
credits.
28
RESULTS OF OPERATIONS
THIRTY-NINE WEEKS ENDED NOVEMBER 26, 2004 COMPARED TO THIRTY-NINE WEEKS
ENDED NOVEMBER 28, 2003.
We have historically experienced significant variability in our revenue,
earnings and other operating results, and our performance may fluctuate
significantly in the future.
($000) SUMMARY TABLE OF RESULTS
FIRST NINE MONTHS FIRST NINE MONTHS $ VARIANCE % VARIANCE
FISCAL 2005 FISCAL 2004 ( )=UNFAVORABLE
SALES
DOMESTIC $ 8,670 $ 7,354 $ 1,316 17.9%
US GOV'T 2,225 624 1,601 256.6
INT'L 9,554 10,019 (465) (4.6)
------- ------- -------
TOTAL SALES 20,449 17,997 2,452 13.6
GROSS PROFIT 3,652 5,847 (2,195) (37.5)
SG&A EXPENSES 9,775 6,246 (3,529) (56.5)
R&D EXPENSES 671 176 (495) (281.3)
INTEREST EXP. 1,171 1,192 21 1.8
OTHER EXP.,NET 182 (51) (233) (456.9)
INCOME TAXES (1,453) (451) 1,002 222.2
MINORITY INTEREST - (9) (9) N/A
------- ------- -------
NET LOSS $(6,694) $(1,256) $(5,438) (433.0%)
======= ======= ======= =======
NET LOSS PER SHARE
(DILUTED) $(0.88) $(0.18) $(0.70) (388.9%)
======= ======= ======= =======
29
Net Loss.
--------
The Company had a net loss of $(6,694,000), or ($0.88) per share
(diluted), during the thirty-nine weeks ended November 26, 2004 versus a net
loss of $(1,256,000), or ($.18) per share (diluted), for the thirty-nine weeks
ended November 28,2004 representing a decrease of $5,438,000 or 433.0%. This
increase in net loss was primarily due to a significantly reduced gross profit
margin coupled with increases in legal costs associated with the Company's
litigation and claims activity.
Sales.
-----
Sales in the thirty-nine weeks ended November 26, 2004 were $20,449,000
as compared to $17,997,000 for the thirty-nine weeks ended November 28, 2003, an
increase of $2,452,000 or 13.6%. Sales increases were evidenced in all business
areas except sterilizers. Environmental benefited from additional activity both
domestically for automotive testing equipment and internationally for a project
in Italy and for HVAC applications in China. Hyperbaric benefited from the
production of three large chambers. ATS benefited from the shipment of a Gyro
for the Czech Republic and continued work on a pilot selection system purchased
through the U.S. Government. Entertainment experienced significant period over
period growth as new products were introduced to the market. Acting as a partial
offset were significantly reduced sterilizer sales as the prior period included
revenue for a large multi-unit order.
We have historically experienced significant variability in our sales
performance. This reflects the existing sales bookings backlog, product and the
nature of contract (size and performance time) mix, the manufacturing cycle and
amount of time to effect installation and customer acceptance, and certain
factors not in our control such as customer delays and the time required to
obtain U.S. Government export licenses. One or a few contract sales may account
for a substantial percentage of our quarterly revenue.
Domestic Sales.
--------------
Overall, domestic sales in the thirty-nine weeks ended November 26,
2004 were $8,670,000 as compared to $7,354,000 for the thirty-nine weeks ended
November 28, 2003, an increase of $1,316,000 or 17.9%. The increase in domestic
sales resulted from significant growth in most product areas except sterilizers.
Domestic sales represented 42.4% of our total sales in the thirty-nine weeks
ended November 26, 2004, up slightly from 40.9% for the thirty-nine weeks ended
November 28, 2004. Sales to the U.S. Government in the thirty-nine weeks ended
November 26, 2004 were $2,225,000 as compared to $624,000 for the thirty-nine
weeks November 28, 2004, an increase of $1,601,000, 256.6%, and represented
10.9% of total sales in the thirty-nine weeks ended November 26, 2004 versus
3.5% for the thirty-nine weeks ended November 28, 2003.
International Sales.
-------------------
International sales in the thirty-nine weeks ended November 26, 2004
were $9,554,000 as compared to $10,019,000 for the thirty-nine weeks ended
November 28, 2003, an increase of $465,000 or 4.6%, and represented 46.7% of
total sales in the thirty-nine weeks ended November 26, 2004, as compared to
30
55.7% for the thirty-nine weeks ended November 28, 2003. Throughout our history,
most of the sales for ATS have been made to international customers. In the
thirty-nine weeks ended November 26, 2004, international sales totaling at least
ten percent of total international sales were made to government or commercial
accounts in Malaysia ($3,343,000). In the thirty-nine weeks ended November 28,
2003, international sales totaling at least ten percent of total international
sales were made to commercial or governmental accounts in Malaysia ($2,887,000)
and Venezuela ($1,050,000). Fluctuations in sales to international countries
from year to year primarily reflect revenue recognition on the level and stage
of development and production on multi-year long-term contracts.
Gross Profit.
------------
Gross profit in the thirty-nine weeks ended November 26, 2004 was
$3,652,000 as compared to $5,847,000 for the thirty-nine weeks ended November
28, 2003, a decrease of $2,195,000 or 37.5%. This decrease resulted from a 14.6
percentage point drop in the gross profit rate as a percent of sales partially
offset by the aforementioned sales increase. The period-to-period decrease
reflected gross profit rate reductions in all categories except environmental
and hyperbaric areas. Sterilizers suffered from the completion in the prior
period of a large multi-unit project. ATS margin decrease reflected the sale of
a gyro to the Czech Republic at a cost above sales value and an addition to the
budget for the Malaysia centrifuge project reflecting additional testing and an
extended installation period due to customer delays. Historically, we have
charged the cost of new product technologies to individual contracts and
occasionally only a portion of these costs are covered by customer payments. The
simulation group evidenced additional development costs to enhance and expand
product functionality.
We have historically experienced significant fluctuations in gross
profit margins and, consequently, our operating results, and we expect such
fluctuations to continue. Gross margins are routinely affected by selling
prices, the amount of new product development required to meet contract
specifications, the mix of materials, labor content and engineering effort in
manufacturing costs, and labor difficulties in field work including installation
and customer acceptance, and the impact of claims settlements.
Selling and Administrative Expenses.
-----------------------------------
Selling and administrative expenses in the thirty-nine weeks ended
November 26, 2004, were $9,775,000 as compared to $6,246,000 for the thirty-nine
weeks ended November 28, 2003, an increase of $3,529,000 or 56.5%. During the
thirty-nine weeks ended November 26, 2004, we incurred significant legal costs
and claims expenses to support an international contract claim and the suit
against Walt Disney World Company, each of which was in the discovery phase.
Additionally, the first quarter of fiscal 2004 included a reimbursement of prior
period legal and claim expenses associated with an arbitration hearing in
January 2003. The Company is currently in discussions with the international
customer to finalize all open issues. Although some decrease in the rate of
expenditure is expected in future periods, these matters are expected to
continue to require material legal expenditures for the foreseeable future.
31
A significant portion of our selling and administrative spending is
related to three activities: i. legal and contract claims costs, ii. outside
agent and sales personnel commissions on booked contracts, and iii. additional
accounting, legal and stockholder's costs required to comply with applicable
statutes, rules and regulations as a public company. We have recently instituted
a series of cost cutting measures and plans to continue to review all spending
categories.
Research and Development Expenses.
---------------------------------
Research and development expenses, which are charged to operations as
incurred, were $671,000 in the thirty-nine weeks ended November 26, 2004 as
compared to $176,000 for the thirty-nine weeks ended November 28, 2003,
reflecting an increase of $495,000 or 281.3%. Most of the increase in research
and development expenses resulted from a delay in obtaining local government
grant funding for spending in our Turkish subsidiary for two projects currently
in progress. The Company is currently evaluating the level of spending required
to support this operation.
Most of our research efforts, which were and continue to be a
significant cost of our business, are included in cost of sales for applied
research for specific contracts, as well as research for feasibility and
technology updates. Most of our products require a significant amount of
continued development effort to implement new applications, design product
extensions, and integrate new technology into existing products.
Interest Expense.
----------------
Interest expense in the thirty-nine weeks ended November 26, 2004 was
$1,171,000 as compared to $1,192,000 for the thirty-nine weeks ended November
28, 2003, representing a decrease of $21,000 or 1.8%. The reduction in interest
expense primarily reflected a temporary reduction in the interest rate for our
subordinated debt borrowed in February 2003. Interest expense includes interest
on our debt, amortization of debt discount resulting from the beneficial
conversion option of our subordinated debt and associated warrants issued with
the debt, amortization expense associated with the recent issuance of additional
warrants, and amortization of deferred financing costs for our February 2003
refinancing.
Other Income/Expense, Net
-------------------------
Other income/expense, net, was a net expense of $182,000 for the
thirty-nine weeks ended November 26, 2004 versus income of $51,000 for the
thirty-nine weeks ended November 28, 2003, an increase of $233,000 or 456.9%.
The increase resulted from the positive net impact in the prior period of
$283,000 from an insurance reimbursement.
32
Provision for Income Taxes.
--------------------------
During the current fiscal period, the Company applied for refunds for
tax loss carry-backs from the fiscal 2004 operating losses and received refunds
totaling approximately $900,000 from the Internal Revenue Service and the
Commonwealth of Pennsylvania. During the first two quarters of the current
fiscal year, the company recognized approximately $1.4 million as income tax
receivables reflecting the two quarter's operating losses, approximately
$800,000 of which will be filed as refunds applied to income earned in prior
years. During the current fiscal quarter, the Company did not record any
additional deferred tax asset related to the current period loss, although it
is possible income will be generated in future periods which could be used to
offset these third quarter losses. The consolidated rate for the thirty-nine
weeks ended November 28, 2003, reflected an estimated rate of 23.5% reflecting
additional research and development tax credits.
LIQUIDITY AND CAPITAL RESOURCES
Our cash flow is subject to significant fluctuations due to many factors.
The timing of new orders and associated advance and milestone deposits; the
complicated logistics of collecting payments from international customers under
letters of credit; customer induced schedule changes which could delay
shipments, final acceptance and release of final contract payments; the
variability and availability of funding for foreign government defense
purchases; changes in levels of customer capital spending; and international
conflicts or economic crises. These and other factors not under our control may
have a material impact on the timing and amount of cash generation or usage.
During the thirty-nine weeks ended November 26, 2004 we generated
$7,272,000 from operating activities. This was primarily the result of the
collection in March 2004 of a $10.5 million settlement on an international claim
(Please refer to the Notes to the Consolidated Financial Statements, Note 4,
"Accounts Receivable" for a discussion of claims.) coupled with non-cash
expenses, a decrease in inventory and costs and estimated earnings in excess of
billings on uncompleted long-term contracts and an increase in accounts payable.
Acting as partial offsets were the net loss and decreases in customer deposits
and other accrued liabilities. Generally speaking, the cash generation reflected
significant claims collections and collections on contracts accounted for by the
percentage of completion method.
Our investing activities used $1,188,000 during the thirty-nine weeks
ended November 26, 2004 which consisted of purchases of capital equipment and
capitalized software.
Our financing activities used $1,622,000 during the thirty-nine weeks
ended November 26, 2004 primarily reflecting an increase in our cash collateral
restricted cash account. The cash collateral account serves as additional
collateral for our bank facility. Providing a partial offset was proceeds from
the issuance of common stock and warrants.
33
We have historically financed operations through a combination of cash
generated from operations, and bank and other debt. On February 19, 2003, we
signed a Credit Agreement (the "Agreement") with PNC Bank, National Association
("PNC") and a Convertible Note and Warrant Purchase Agreement (the "Note") with
H.F. Lenfest, an individual, in the aggregate amount of $29,800,000. We used a
portion of the proceeds from the financing to satisfy our existing debt
obligations to Wachovia Bank, our former lender, and to permit PNC to issue a
letter of credit to support outstanding bonds that we had issued in a previous
financing transaction. The transaction resulted in net proceeds (after
transaction expenses and payment of existing debt) to the Company of
approximately $3,600,000. We used the net proceeds for working capital and
general corporate purposes.
Our obligations to PNC under the Agreement are secured by a first priority lien
on and senior security interest in all of our assets, including all real
property that we own.
The Note issued to Mr. Lenfest included (i) a senior subordinated
convertible promissory note in the original principal amount of $10,000,000 and
(ii) warrants to purchase 803,048 shares of our common stock. Upon the
occurrence of certain events, we will be obligated to issue additional warrants
to Mr. Lenfest. The Note accrues interest at the rate of 10% per annum and
matures on February 18, 2009. The Note entitles Mr. Lenfest to convert all or a
portion of the outstanding principal of plus accrued and unpaid interest on the
Note into shares of common stock at a conversion price of $6.05 per share. The
warrants may be exercised into shares of common stock at an exercise price equal
to the lesser of $4.00 per share or two-thirds of the average of the high and
low sale prices of the common stock for the 25 consecutive trading days
immediately preceding the date of exercise.
Our obligations to Mr. Lenfest under the Note are secured by a second
priority lien on and security interest in all of our assets, junior in rights to
the liens and security interests in favor of PNC, including all real property
that we own.
Prior to the consummation of the February 2003 refinancing, Advanced
Technology Asset Management, LLC, ("ATAM"), a shareholder and a holder of
warrants to purchase 332,820 shares of our common stock, consented to the
transactions contemplated under the Agreement and the financing provided by Mr.
Lenfest, including the below market issuance of warrants to Mr. Lenfest. As a
result of its consent, ATAM waived, solely in connection with the issuance of
warrants to Mr. Lenfest, the anti-dilution rights contained in its warrant. In
exchange for ATAM's consent, we issued to ATAM warrants to purchase an
additional 105,000 shares of common stock. Except for the number of shares
issuable upon exercise of the warrants, the new ATAM warrants have substantially
the same terms as the warrants issued to Mr. Lenfest. In March 2004 ATAM
exercised all of its warrants and received a total of 437,820 shares of our
common stock. We received proceeds of $586,410 from the exercise of these
warrants.
34
On April 30, 2003, the Agreement was amended to include: (i) a revolving
credit facility in the maximum aggregate principal amount of $14,800,000 to be
used for our working capital and general corporate purposes, including capital
expenditures, with a sublimit for issuances of letters of credit in the maximum
aggregate face amount of $10,300,000, and (ii) a standby letter of credit in the
face amount of $4,750,000 as credit support for our bonds. Additionally, on July
9, 2003, a second amendment to the Agreement was executed which formed an
additional $1,010,000 credit facility for use in financing export contracts
which qualify for an EXIM (the Export-Import Bank of the United States) Bank
guarantee.
During the first quarter of fiscal 2005, as a result of our recent
operating losses and our violation of certain financial covenants contained in
the Agreement, PNC advised us that it was instituting certain changes to the
revolving credit facility. The changes included reducing the facility to
$6,000,000 and requiring us to cash collateralize the full facility. These
changes became effective on June 2, 2004.
On August 24, 2004 the Agreement was amended to substantially reduce
the operating facility and eliminate the associated monthly borrowing base
reporting requirements. The revolving facility was reduced from $14,800,000 to
$5,000,000 and use of the facility was restricted to the issuance of letters of
credit, which are frequently a requirement of international contracts. We could
no longer borrow cash under the facility. Our long-term bonds were left intact.
As additional collateral for the revised facility, PNC required us to keep
$2,500,000 in a restricted cash account. The fee for letters of credit was
reduced from 1.75% to 1.0% per annum. Additionally, three of the financial
covenants, the Leverage Ratio, the Fixed Charge Ratio and the requirement not to
report a net loss in any annual period were eliminated and the Tangible Net
Worth requirement was reduced. All other terms and conditions of the revolving
loan and the line of credit as set forth in the Agreement remained in effect.
Under the August 24, 2004 amendment, the EXIM Bank credit facility was
reduced from $1,010,000 to $995,000, with all other terms and conditions
remaining as per the Agreement. Availability under the EXIM facility is
determined based on a borrowing base consisting of a portion of our receivables
and inventory.
As a condition of amending the Agreement, Mr. Lenfest, holder of our
subordinated debt, agreed to issue to PNC on our behalf a limited guarantee to
secure up to $5,000,000 in principal amount of any letters of credit issued
under the amended revolving line of credit. In consideration for issuing this
guarantee, Mr. Lenfest will receive a fee of 0.75% per annum of the average
amount of letters of credit outstanding, payable on a quarterly basis, and
received a warrant to purchase 200,000 shares of stock under the same terms and
conditions as his existing warrant for 803,048 shares.
35
On October 18, 2004, the Agreement was again modified. This amendment
required the company to deposit in a restricted cash account an additional
amount of $285,000 to cover the next scheduled payment of principal and interest
due April 1, 2005 on the Company's long-term bonds. The tangible Net Worth
covenant requirement was reduced to a. $14,500,000 for the periods ending
November 26, 2004 and February 25, 2005 and b. on the last day of any fiscal
quarter ending after February 25, 2005, to be at least equal to the actual
tangible Net Worth on February 25, 2005. Additionally, the fee for the PNC
Letter of Credit which backs the Company's long-term bonds was increased from
2.0% to 2.5% annually.
Under the October 18, 2004 amendment to the Agreement, the Company must
meet a minimum Tangible Net Worth. At November 26, 2004 the Company's Tangible
Net Worth dropped below this minimum and thus was in violation of this financial
covenant. The Company has obtained a waiver from PNC for this violation.
Additionally, under the Note, which covers our subordinated debt, we
must meet certain financial covenants including a Leverage Ratio, a Fixed Charge
Ratio, and a Tangible Net Worth Ratio. At November 26, 2004, we failed to meet
any of these financial covenants but have obtained a waiver from our
subordinated lender. This waiver applies to the period through November 30,
2005. Except as specified, the waiver does not constitute a modification or
alteration of any other terms or conditions in the Note, or a release of any of
the lender's rights or remedies, all of which are reserved, nor does it release
us or any guarantor from any of its duties, obligations, covenants or agreements
including the consequences of any Event of Default, except as specified.
Our bank has alerted us that additional changes may be required to the
Agreement and that an increase in the cash collateral account may be required.
Specific terms and conditions for any additional modifications had not been
finalized as of the filing date of this report. Based on the annual forecast and
the indicated actions described above, we do not believe it is probable that we
will fail future covenant tests.
Going forward, our significant cash requirements will relate to
salaries and other operational expenses, continued spending for product
enhancements and technology and the costs of litigating claims and lawsuits. To
fund these items, we plan to utilize cash from operations and proceeds from
potential arbitration proceeds and collections. However, given our inability to
borrow cash under the amended Agreement, we may need to obtain additional
sources of capital in order to continue growing and operating our business. This
capital may be difficult to obtain and the cost of this additional capital is
likely to be relatively high. However, we believe that we will be able to locate
such additional capital and that these actions by our bank will not have a
long-term material adverse effect on our business.
36
The following table presents our contractual cash flow commitments on
long-term debt and operating leases as of November 26, 2004.
PAYMENTS DUE BY PERIOD (IN THOUSANDS)
-----------------------------------------------------------------------------
LESS THAN 1
TOTAL YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS
------ ----------- --------- --------- -------------
Long-term debt, including
current maturities $12,826 $452 $1,199 $8,455 $2,720
Operating leases 686 147 83 83 373
------- ---- ------ ------ ------
Total
$13,512 $599 $1,282 $8,538 $3,093
======= ==== ====== ====== ======
Expected Interest Expense $ 5,006 $917 $3,309 $ 409 $ 371
Contract Claims
---------------
Historically, we have had positive experience with our contract claims
in that recoveries have exceeded the carrying value of claims. As of November
26, 2004, claims recorded against the U.S. Government totaled $3,004,000 and
claims recorded against an international customer totaled $2,600,000.
Claim costs have been incurred in connection with customer caused
delays, errors in specifications and designs, other out-of-scope items and
exchange losses and may not be received in full during fiscal 2005. In
conformity with accounting principles generally accepted in the United States of
America, revenue that we record from a claim may not exceed the incurred
contract costs related to the claim.
In November 2003, the U.S. Government completed an audit of the
submarine rescue decompression chamber project claim, rejecting most of the
items due to audit or engineering reasons. We were not provided a copy of the
Government's Technical Report that questioned approximately half of the claim
costs. We have submitted a written rebuttal to the draft report and have
formally requested a copy of the Technical Report. On July 22, 2004 the U.S.
Government' Contracting Officer issued a final decision on the claim, denying
the claim in full. In response, we plan to file a complaint in the Court of
Federal Claims in the near future.
This U. S. Government claim has followed the typical process of claim
notification, preparation, submittal, government audit, and review by the
contracting officer. Historically, most claims are initially denied in part or
in full by the contracting officer (or no decision is forthcoming, which is then
taken to be a deemed denial) which then forces us to seek relief in a court of
law.
We consider the recorded costs to be realizable due to the fact that
they relate to customer caused delays, errors and changes in specifications and
designs, disputed liquidated damages and other out of scope items. The U.S.
Government, citing failure to deliver the product within contract terms, has
assessed liquidated damages but has not offset or withheld any progress payments
due to us under the contract. We dispute the basis for these liquidated damages,
noting that applicable U.S. Government purchasing regulations allow for a waiver
of these charges if the delay is beyond our control and not due to our fault or
negligence. However, following accounting principles generally accepted in the
United States, we have reduced contract values and corresponding revenue
recognition for an estimated amount of $330,000 to cover a delay through the
extended delivery period.
37
With respect to the claims filed against an international customer, we
are currently in the discovery phase of the arbitration process. We have filed
our "Points of Claim" to which the customer has replied. Additionally, the
customer has filed a counterclaim, which we answered, in the fiscal quarter
ended August 27, 2004. The customer, citing failure to deliver product within
contract terms, has assessed liquidated damages totaling approximately $400,000
on the contract. We dispute the basis for these liquidated damages and are
vigorously contesting them. However, following accounting principles generally
accepted in the United States of America, we have reduced contract values and
corresponding revenue recognition by approximately $400,000. The Company is
currently in discussions with this customer to finalize all open issues. At this
time we are unable to assess the ultimate impact of any discussions or
arbitration on current operations and financials.
The open balance of $700,000 due on the contract represents the total
net exposure to us on this contract. On June 16, 2003, we filed for arbitration
in Thailand seeking recovery of the open balance of $700,000 due on the
contract. On October 8, 2003, the Thai government filed their defense with the
Thai Arbitration Institute. In December 2003 we and the RTAF both picked
arbitrators to represent each of us respectively in the dispute, although no
date has yet been set for the Arbitration proceedings. To choose the third
(umpire) arbitrator, the RTAF, TAI, and the Company will each nominate three
candidates for a total of nine. The RTAF and the Company will then rank the
candidates and the one receiving the highest rating will be asked to serve as
the (umpire) arbitrator. It is felt this approach will avoid any conflict of
interest issues.
Since the circumstances that caused a delay are commonly considered
"force majeure" events, and since the contract under question allows for
consideration of "force majeure" events, we believe that the open balance
related to this contract is collectible and will continue to treat this balance
as collectible until a final unappealable legal decision is rendered by a
competent Thai tribunal. We continue to enjoy a favorable relationship with the
RTAF. We currently have both maintenance and upgrade contracts with the RTAF for
trainers that are the subject of the dispute and have sold a significant amount
of additional equipment to the RTAF since this dispute began, and the initiation
of legal action against the RTAF has not affected our ability to obtain future
contracts with the RTAF. At this point, we are not able to determine what, if
any, impact the extended completion period will ultimately have upon the receipt
of final payment under this contract.
Backlog
-------
Our sales backlog at November 26, 2004 and February 27, 2004, for work
to be performed and revenue to be recognized under written agreements after such
dates was approximately $16,029,000 and $16,914,000 respectively. In addition,
our training, maintenance and upgrade contracts backlog at November 26, 2004,
and February 27, 2004, for work to be performed and revenue to be recognized
after that date under written agreements was approximately $1,200,000 and
$2,637,000 respectively. Of the November 26, 2004 backlog, approximately
$9,716,000 was under contracts for ATS products including $2,404,000 for Egypt
and $6,600,000 for a contract in the Company's Polish subsidiary for simulators
for L-3 Communications.
38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risk, including changes in interest
rates. Market risk is the potential loss arising from adverse changes in market
rates and prices such as interest rates and foreign exchange rates. We do not
enter into derivatives or other financial instruments for trading or speculative
purposes. Also, we have not entered into financial instruments to manage and
reduce the impact of interest rates and foreign currency exchange rates although
we may enter into such transactions in the future. A portion of our indebtedness
bears interest at rates that vary with the prime rate of interest. Accordingly,
any applicable increases in the applicable prime rate of interest will reduce
our earnings. With respect to currency risk, where we have a contract that is
denominated in a foreign currency, we often establish local in-country bank
accounts and fund in-country expenses in the local currency, thus creating a
"natural" currency hedge for a portion of the contract.
ITEM 4. CONTROLS AND PROCEDURES.
Under the supervision and with the participation of our management,
including our chief executive officer and chief financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of November 26, 2004 (the "Evaluation Date"), and,
based on this evaluation, our chief executive officer and chief financial
officer have concluded that these controls and procedures were effective as of
the Evaluation Date. There were no significant changes in our internal controls
or in other factors that could significantly affect these controls during the
fiscal quarter ended on the Evaluation Date.
Disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended) are our
internal controls and other procedures that are designed to ensure that
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commission's rules and
forms. Disclosure controls and procedures include, without limitation, controls
and procedures designed to ensure that information that we are required to
disclose in the reports that we file under the Exchange Act is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate to allow timely decisions regarding required
disclosure.
39
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In April 2003, Boenning & Scattergood, Inc. ("B&S") filed suit against
the Company in the Court of Common Pleas in Philadelphia, Pennsylvania, seeking
payment of $901,843.46 for financing fees allegedly due to B&S pursuant to the
terms of an agreement for investment banking services, which was entered into
with a predecessor of B&S (the "B&S Agreement"). B&S alleges that it contacted
the investors in the Company's February 2003 financing transaction and that it
earned the claimed financing fees pursuant to the terms of the B&S Agreement.
The Company has responded to the complaint and also filed a counterclaim for
breach of contract and professional malpractice. The Company believes that it
has valid defenses to each of the claims of B&S and intends to vigorously defend
itself against these claims. At this time, however, discovery is ongoing and the
Company is unable to predict the outcome of this matter.
In June 2003, Entertainment Technology Corporation ("EnTCo"), our
wholly-owned subsidiary, filed suit against Walt Disney World Co. and other
entities ("Disney") in the United States District Court for the Eastern District
of Pennsylvania, alleging breach of contract for, among other things, failure to
pay all amounts due under contract for the design and production of the
amusement park ride "Mission: Space" located in Disney's Epcot Center. In
response, in August 2003, Disney filed counterclaims against both EnTCo and the
Company (under a guarantee) for, among other things, alleged failures in
performance and design in the contract. Disney is seeking damages in excess of
$22 million plus punitive damages. EnTCo and the Company believe that they have
valid defenses to each of Disney's counterclaims and intend to vigorously defend
against these counterclaims. At this time, the parties are engaged in the
discovery process. The parties have exchanged self-executing disclosures and
responses to interrogatories, have produced documents, and have conducted
depositions. EnTCo and the Company are unable to predict the outcome of this
matter.
Certain claims, suits and complaints arising in the ordinary course of
business have been filed or are pending against us. In the opinion of
management, all such matters are reserved for or are adequately covered by
insurance or, if not so covered, are without merit or are of such kind, or
involve such amounts as would not have a material adverse effect on our
financial position if resolved unfavorably.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The constituent instruments defining the rights of the holders of any
class of securities were not modified nor were the rights evidenced by any class
of registered securities materially limited or qualified during the period
covered by this report.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
40
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
At the Company's Annual Meeting of Stockholders held on September 20, 2004
the following proposal was adopted by the vote specified below. No other matters
were submitted to a vote of security holders at the Annual Meeting.
Proposal One: To elect five directors to serve until successors have been
elected and qualified.
Abstentions and
Nominee For Withheld Broker Non-votes
George K. Anderson 5,635,499 49,312 0
Howard W. Kelley 5,634,499 50,312 0
H.F. Lenfest 5,625,317 59,494 0
William F. Mitchell 5,635,437 49,374 0
Pete L. Stephens 5,634,499 50,312 0
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Number Item
------ ----
3.1 Registrant's Articles of Incorporation, as amended, were filed
as Exhibit 3.1 to Registrant's Form 10-K for the year ended
February 28, 1997 and are incorporated herein by reference.
3.2 Registrant's By-Laws, as amended, were filed as Exhibit 3 (ii)
to Registrant's Form 10-K for the year ended February 25, 1994,
and are incorporated herein by reference.
10.1 Amendment to Credit Agreement, dated as of October 18, 2004,
between ETC and PNC Bank, National Association.
31.1 Certification dated January 10, 2005 pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 made by William F. Mitchell, Chief
Executive Officer.
31.2 Certification dated January 10, 2005 pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 made by Duane D. Deaner, Chief
Financial Officer.
32 Certification dated January 10, 2005 pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 made by William F. Mitchell, Chief
Executive Officer, and Duane D. Deaner, Chief Financial
Officer.
(b) Reports on Form 8-K
On October 20, 2004, the Company filed a Current Report on Form 8-K
reporting its financial results for the second quarter of fiscal 2005.
41
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.
ENVIRONMENTAL TECTONICS CORPORATION
(Registrant)
Date: January 10, 2005 By: /s/ William F. Mitchell
---------------------------------
William F. Mitchell
President and Chief
Executive Officer
(Principal Executive Officer)
Date: January 10, 2005 By: /s/ Duane D. Deaner
----------------------------------
Duane D. Deaner,
Chief Financial Officer
(Principal Financial and
Accounting Officer)