SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-Q

 

 

Commission file number 0-26946

 

INTEVAC, INC.

(Exact name of registrant as specified in its charter)

 

 

 

3560 Bassett Street

Santa Clara, California 95054

(Address of principal executive office, including Zip Code)

 

Registrant’s telephone number, including area code: (408) 986-9888

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

 

On November 3, 2006, 21,151,314 shares of the Registrant’s Common Stock, no par value, were outstanding.

 

 

INTEVAC, INC.

 

INDEX

 

 

 

INTEVAC, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

Note:  Amounts as of December 31, 2005 are derived from the December 31, 2005 audited consolidated financial statements.

 

See accompanying notes.

INTEVAC, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

AND COMPREHENSIVE INCOME

 

 

See accompanying notes.

INTEVAC, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.  Business Activities and Basis of Presentation

 

We are the world’s leading supplier of sputtering equipment used to manufacture magnetic media used in hard disk drives and a developer and provider of advanced extreme low light imaging sensors, cameras and systems. We operate two businesses: Equipment and Imaging.

 

Our Equipment business designs, manufactures, markets and services complex capital equipment that deposits, or sputters, highly engineered thin-films onto magnetic disks used in hard disk drives. Hard disk drives are the primary storage medium for digital data and function by storing data on magnetic disks. These thin-film disks are created in a sophisticated manufacturing process involving many steps, including plating, annealing, polishing, texturing, sputtering and lubrication.

 

Our Imaging business develops and manufactures electro-optical sensors, cameras, and systems that permit highly sensitive detection of photons in the visible and near infrared portions of the spectrum, allowing vision in extreme low light situations. We currently develop night-vision technology and equipment for military and commercial applications.

 

The financial information at September 30, 2006 and for the three- and nine-month periods ended September 30, 2006 and October 1, 2005 is unaudited, but includes all adjustments (consisting only of normal recurring accruals) that we consider necessary for a fair presentation of the financial information set forth herein, in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, it does not include all of the information and footnotes required by U.S. GAAP for annual financial statements. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

 

The results for the three- and nine-month periods ended September 30, 2006 are not considered indicative of the results to be expected for any future period or for the entire year.

 

“Intevac^®,” “LIVAR^®,” and “200 Lean^®” are trademarks of Intevac, Inc.

 

2.  Concentrations

 

Historically, a significant portion of our revenues in any particular period has been attributable to sales to a limited number of customers. Our largest customers tend to change from period to period.

 

We evaluate the collectibility of trade receivables on an ongoing basis and provide reserves against potential losses when appropriate.

 

3.  New Accounting Pronouncements

 

In March 2004, the Emerging Issues Task Force (“EITF”) issued EITF No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which provides new guidance for assessing impairment losses on debt and equity investments. The new impairment model applies to investments accounted for under the cost or equity method and investments accounted for under FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” EITF No. 03-01 also includes new disclosure requirements for cost method investments and for all investments that are in an unrealized loss position. In September 2004, the FASB delayed the accounting provisions of EITF No. 03-01; however, the disclosure requirements remain effective

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and the applicable disclosures have been included in our consolidated financial statements and related notes thereto. We do not expect the adoption of this EITF to have an effect on our consolidated financial position, results of operations and cash flows.

 

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 will be effective beginning January 1, 2007. We are currently evaluating this interpretation to determine if it will have a material impact on our consolidated financial position, results of operations and cash flows.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within that fiscal year. We are currently evaluating the impact of adopting SFAS 157.

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. It requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company’s financial statements and the related financial statement disclosures. The provisions of SAB 108 must be applied to annual financial statements no later than the first fiscal year ending after November 15, 2006. We do not expect the adoption of SAB 108 to have an effect on our consolidated financial position, results of operations and cash flows.

 

4.  Inventories

 

Inventories are priced using standard costs, which approximate cost under the first-in, first-out method and are stated at the lower of cost or market. Inventories consist of the following:

 

 

Finished goods inventory consists primarily of completed systems awaiting shipment to customer sites for installation and acceptance testing.

 

Inventory reserves included in the above numbers were $8.8 million and $11.0 million at September 30, 2006 and December 31, 2005, respectively. Each quarter, we analyze our inventory (raw materials, work-in-progress and finished goods) against the forecast demand for the next 12 months. Raw materials with no forecast requirements in that period are considered excess and inventory provisions are established to write those items down to zero net book value. Work-in-progress and finished goods inventories with no forecast requirements in that period are typically written down to the lower of cost or market. During this process, some inventory is identified as having no future use or value to us and is disposed of against the reserves.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table displays the activity in the inventory provision account for the nine-month periods ending September 30, 2006 and October 1, 2005:

 

 

5.  Stock-Based Compensation

 

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including equity awards related to the 2004 Equity Incentive Plan (the “2004 Plan”) and employee stock purchases related to the 2003 Employee Stock Purchase Plan (the “ESPP”) based on estimated fair values. SFAS 123(R) supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).

 

We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our Condensed Consolidated Financial Statements as of and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the three months and nine months ended September 30 was $878,000 and $2.0 million, respectively, which consisted of stock-based compensation expense related to the grant of stock options under the 2004 Plan and stock purchase rights under the ESPP. There was $19,000 of stock-based compensation expense related to the grant of stock options or stock purchase rights recognized during the three and nine months ended October 1, 2005.

 

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in our Condensed Consolidated Statement of Income. Prior to the adoption of SFAS 123(R), we accounted for employee equity awards and employee stock purchases using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, no stock-based compensation expense had been recognized in our Condensed Consolidated Statement of Income, because the exercise price of our stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.

 

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in our Condensed Consolidated Statement of Income for the three and nine months ended September 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the Condensed Consolidated Statement of Income for the first nine months of fiscal 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In our pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

 

Descriptions of Plans

 

2004 Equity Incentive Plan

 

Our 2004 Plan is a broad-based, long-term retention program intended to attract and retain qualified management and technical employees, and align stockholder and employee interests. The 2004 Plan permits the grant of incentive or non-statutory stock options, restricted stock, stock appreciation rights, performance units and performance shares. Option price, vesting period, and other terms are determined by the Administrator of the 2004 Plan, but the option price shall generally not be less than 100% of the fair market value per share on the date of grant. During the nine months ended September 30, 2006, we granted 868,600 stock options with an estimated total grant-date fair value of $9.6 million. Of this amount, we estimated that the stock-based compensation for the awards not expected to vest was $3.2 million.

 

2003 Employee Stock Purchase Plan

 

Our ESPP provides that eligible employees may purchase our common stock through payroll deductions at a price equal to 85% of the lower of the fair market value at the beginning of the applicable offering period or at the end of each applicable purchase interval. Offering periods are generally two years in length, and consist of a series of six-month purchase intervals. Eligible employees may join the ESPP at the beginning of any six-month purchase interval. During the three and nine months ended September 30, 2006, we granted purchase rights with an estimated total grant-date value of $1.5 million and $1.6 million, respectively.

 

Impact of the Adoption of SFAS 123(R)

 

The effect of recording stock-based compensation for the three- and nine-month periods ended July 1, 2006 was as follows:

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Approximately $85,000 of stock-based compensation is included in inventory as of September 30, 2006. No stock-based compensation was capitalized to inventory prior to our adoption of the provisions of SFAS 123(R) in the first quarter of 2006.

 

Valuation Assumptions

 

The fair value of share-based payment awards is estimated at the grant date using the Black-Scholes Merton option valuation model. The determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual employee stock option exercise behavior.

 

In connection with the adoption of SFAS 123(R), we reassessed our valuation technique and related assumptions. We estimate the fair value of stock options using a Black-Scholes Merton valuation model, consistent with the provisions of SFAS 123(R), SAB No. 107 and our prior period pro forma disclosures of net earnings, including stock-based compensation expense (determined under a fair value method as prescribed by SFAS 123). The weighted-average estimated fair value of employee stock options granted during the three and nine months ended September 30, 2006 was $9.77 per share and $11.05 per share, respectively. The weighted-average estimated fair value of employee stock purchase rights granted pursuant to the ESPP during the three and nine months ended September 30, 2006 was $9.94 per share and $9.68 per share, respectively. The fair value of each option and employee stock purchase right grant is estimated on the date of grant using the Black-Scholes Merton option valuation model with the following weighted-average assumptions:

 

 

 

The computation of the expected volatility assumptions used in the Black-Scholes Merton calculations for new grants and purchase rights is based on the historical volatility of our stock price, measured over a period equal to the expected term of the grant or purchase right. The risk-free interest rate is based on the yield available on U.S. Treasury Strips with an equivalent remaining term. The expected life of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards and vesting schedules. The expected life of purchase rights is the period of time remaining in the current offering period. The dividend yield assumption is based on our history of not paying dividends and the assumption of not paying dividends in the future.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

As the stock-based compensation expense recognized in the Condensed Consolidated Statement of Income for the first nine months of 2006 is based on awards ultimately expected to vest, such amount has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on our historical experience.

 

Expense Information Under SFAS 123(R)

 

2004 Equity Incentive Plan

 

A summary of activity under the above captioned plan is as follows:

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing stock price of $16.80 as of September 29, 2006, which would have been received by the option holders had all option holders exercised their options as of that date.

 

The options outstanding and currently exercisable at September 30, 2006 were in the following exercise price ranges:

 

 

As of September 30, 2006, the unrecorded deferred stock-based compensation balance related to stock options was $9.8 million and will be recognized over an estimated weighted average amortization period of 2.1 years. The amortization period is based on the expected term of the option, which is defined as the period from grant date to exercise date.

 

2003 Employee Stock Purchase Plan

 

During the three months ended September 30, 2006, 84,368 shares were purchased at an average per share price of $5.60. At September 30, 2006, there were 387,937 shares available to be issued under the ESPP.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Prior to the Adoption of SFAS No. 123(R)

 

Prior to the adoption of SFAS No. 123(R), we provided the disclosures required under SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures.” Consistent with the disclosure provisions of SFAS 148, our net loss and basic and diluted loss per share for the three and nine months ended October 1, 2005 would have been adjusted to the pro forma amounts indicated below:

 

 

The weighted-average fair value of stock options granted was $8.67 and $6.79 for the three and nine months ended October 1, 2005, respectively. The weighted-average fair value of purchase rights granted was $6.00 and $5.14 for the three and for the nine months ended October 1, 2005, respectively. The fair value of each option grant and purchase right was estimated on the date of grant using the Black-Scholes Merton option valuation model with the following weighted average assumptions:

 

 

Prior to fiscal 2006, the expected forfeitures of employee stock options were accounted for on an as-incurred basis.

 

 

We provide for the estimated cost of warranty when revenue is recognized. Our warranty is per contract terms and for our systems the warranty typically ranges between 12 and 24 months from customer acceptance. During this warranty period any defective non-consumable parts are replaced and installed at no charge to the customer. The warranty period on consumable parts is limited to their reasonable usable life. We use estimated repair or

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

replacement costs along with our actual warranty experience to determine our warranty obligation. We exercise judgment in determining the underlying estimates.

 

On the condensed consolidated balance sheet, the short-term portion of the warranty is included in other accrued liabilities, while the long-term portion is included in other long-term liabilities.

 

The following table displays the activity in the warranty provision account for the three- and nine-month periods ending September 30, 2006 and October 1, 2005:

 

 

The following table displays the balance sheet classification of the warranty provision account at September 30, 2006 and at December 31, 2005:

 

 

 

We have entered into agreements with customers and suppliers that include limited intellectual property indemnification obligations that are customary in the industry. These obligations generally require us to compensate the other party for certain damages and costs incurred as a result of third party intellectual property claims arising from these transactions. The nature of the intellectual property indemnification obligations prevents us from making a reasonable estimate of the maximum potential amount we could be required to pay our customers and suppliers. Historically, we have not made any significant indemnification payments under such agreements, and no amount has been accrued in the accompanying consolidated financial statements with respect to these indemnification obligations.

 

8.  Cash, Cash Equivalents and Investments

 

Our investment portfolio consists of cash, cash equivalents and investments in debt securities and municipal bonds. We consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Investments in debt securities and municipal bonds consist principally of highly rated debt instruments with maturities generally between one and 25 months.

 

We account for our investments in debt securities and auction rate securities in accordance with Statement of Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities,” which requires certain securities to be categorized as either trading, available-for-sale or held-to-maturity. Available-for-sale securities are carried at fair value, with unrealized gains and losses recorded within other comprehensive income

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(loss) as a separate component of shareholders’ equity. Held-to-maturity securities are carried at amortized cost. We have no trading securities. The cost of investment securities sold is determined by the specific identification method. Interest income is recorded using an effective interest rate, with the associated premium or discount amortized to interest income. Realized gains and losses and declines in value judged to be other than temporary, if any, on available-for-sale securities are included in earnings. The table below presents the amortized principal amount, major security type and maturities for our investments in debt securities and auction rate securities.

 

 

The decline in the fair value of our investments from the principal amount is attributable to changes in interest rates and not credit quality. In accordance with EITF 03-01, we have the ability and intent to hold these investments until fair value recovers, which may be maturity, and we do not consider these investments to be other-than-temporarily impaired at September 30, 2006.

 

Cash and cash equivalents represent cash accounts and money market funds. Included in accounts payable are $5.6 million and $988,000 of book overdraft at September 30, 2006 and December 31, 2005, respectively.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table sets forth the data used in the computations of basic and diluted earnings per share:

 

 

 

 

 

Segment Description

 

We have two reportable operating segments: Equipment and Imaging. Our reportable segments are business units that offer different products and are each managed separately, under the direction of our Chief Executive Officer. Our Equipment business designs, manufactures, markets and services complex capital equipment that deposits, or sputters, highly engineered thin-films onto magnetic disks used in hard disk drives. Our Imaging business develops and manufactures electro-optical sensors, cameras and systems that permit highly sensitive detection of photons in the visible and near infrared portions of the spectrum, allowing vision in extreme low light situations.

 

Included in corporate activities are general corporate expenses, less an allocation of corporate expenses to operating units equal to 3% of net revenues. Assets of corporate activities include unallocated cash and investments, deferred income tax assets and other assets.

 

Segment Profit or Loss and Segment Assets

 

We evaluate performance and allocate resources based on a number of factors including, profit or loss from operations and future revenue potential. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Business Segment Net Revenues

 

 

Business Segment Profit & Loss

 

 

Business Segment Assets

 

 

Geographic Area Net Trade Revenues

 

 

 

For the nine- month period ended September 30, 2006, we accrued income tax using an effective tax rate of 10.0% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. We have substantial net

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

operating loss carry-forwards and deferred credits, which are being used to limit the taxes paid this year and to reduce our effective tax rate to less than the statutory income tax rates in effect. We expect our effective tax rate to significantly increase after our net operating losses and deferred credits have been fully utilized. Our deferred tax asset is mostly offset by a valuation allowance, resulting in a net deferred tax asset of $2.5 million at September 30, 2006.

 

For the three-and nine-month periods ended October 1, 2005, we accrued income tax using an effective tax rate of 2.5% of pretax income. Our tax rate differs from the applicable statutory rates due to the utilization of net operating loss carry-forwards and deferred credits.

 

 

During the nine-month period ending September 30, 2006, we sold stock to our employees under Intevac’s Stock Option and Employee Stock Purchase Plans. A total of 454,309 shares were issued under these plans, for which Intevac received $3.0 million.

 

 

Certain prior year amounts in the Condensed Consolidated Financial Statements have been reclassified to conform to 2006 presentation. The reclassification involved combining interest expense, interest income and other income, net, into a single line on the Condensed Consolidated Statements of Income and Comprehensive Income. The reclassifications had no material effect on total assets, liabilities, equity, revenue, net income or comprehensive income as previously reported.

 

This Quarterly Report on Form 10-Q contains forward-looking statements, which involve risks and uncertainties. Words such as “believes,” “expects,” “anticipates” and the like indicate forward-looking statements. These forward looking statements include comments related to our shipments, projected revenue recognition, product costs, gross margin, operating expenses, interest income, cash balances and financial results in 2006; our projected customer requirements for new capacity and for technology upgrades for their installed base of our thin-film disk sputtering equipment, and when, and if, our customers will place orders for these products; Imaging’s ability to proliferate its technology into major military weapons programs and to develop and introduce commercial imaging products; and the timing of delivery and/or acceptance of the systems and products that comprise our backlog for revenue. Our actual results may differ materially from the results discussed in the forward-looking statements for a variety of reasons, including those set forth under “Risk Factors” and in other documents we file from time to time with the Securities and Exchange Commission, including Intevac’s Annual Report on Form 10-K filed in March 2006, Form 10-Q’s and Form 8-K’s.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“US GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported. Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of our Annual Report on Form 10-K. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below.

 

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial conditions and results of operations. Specifically, critical accounting estimates have the following attributes: 1) We are required to make assumptions about matters that are highly uncertain at the time of the estimate; and 2) different estimates we could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on our financial condition or results of operations.

 

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they become known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. Many of these uncertainties are discussed in the section below entitled “Risk Factors.” Based on a critical assessment of our accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that our consolidated financial statements are fairly stated in accordance with US GAAP, and provide a meaningful presentation of our financial condition and results of operation.

 

We believe the following critical accounting policies affect the more significant judgments and estimates we make in preparing our consolidated financial statements. We also have other key accounting policies and accounting estimates related to the collectibility of trade receivables and prototype product costs. We believe that these other accounting policies and other accounting estimates either do not generally require us to make estimates and judgments that are as difficult or subjective, or are less likely to have a material impact on our reported results of operation for a given period.

 

Revenue Recognition

 

Certain of our system sales with customer acceptance provisions are accounted for as multiple-element arrangements. If we have previously met defined customer acceptance levels with the specific type of system, then we recognize revenue for the fair market value of the system upon shipment and transfer of title, and recognize revenue for the fair market value of installation and acceptance services when those services are completed. We estimate the fair market value of the installation and acceptance services based on our actual historical experience. For systems that have generally not been demonstrated to meet a particular customer’s product specifications prior

to shipment, revenue recognition is typically deferred until customer acceptance. For example, while initial shipments of our 200 Lean^®system were recognized for revenue upon customer acceptance during 2004, revenue was recognized upon shipment for the majority of 200 Leans shipped in 2005 and 2006. Most of the systems in backlog at September 30, 2006 are for customers where we have met defined customer acceptance levels and we expect to recognize revenue upon shipment for those systems.

 

In some instances, hardware that is not essential to the functioning of the system may be delivered after acceptance of the system. In these cases, we estimate the fair market value of the non-essential hardware as if it had been sold on a stand-alone basis, and defer recognizing revenue on that value until the hardware is delivered.

 

In certain cases, we sell limited rights to our intellectual property. Revenue from the sale of any intellectual property license will generally be recognized at the inception of the license term.

 

We perform best efforts research and development work under various government-sponsored research contracts. These contracts are a mixture of cost-plus-fixed-fee (“CPFF”) and firm fixed-price (“FFP”). Revenue on CPFF contracts is recognized in accordance with contract terms, typically as costs are incurred. Revenue on FFP contracts is generally recognized on the percentage-of-completion method based on costs incurred in relation to total estimated costs. Provisions for estimated losses on government-sponsored research contracts are recorded in the period in which such losses are determined.

 

Inventories

 

Inventories are priced using standard costs, which approximate cost under the first-in, first-out method, and are stated at the lower of cost or market. The carrying value of inventory is reduced for estimated excess and obsolescence by the difference between its cost and the estimated market value based on assumptions about future demand. We evaluate the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional inventory adjustments would be required, which could have a material adverse effect on our business, financial condition and results of operation. A cost-to-market reserve is established for work-in-progress and finished goods inventories when the value of the inventory plus the estimated cost to complete exceeds the net realizable value of the inventory.

 

Warranty

 

We provide for the estimated cost of warranty when revenue is recognized. Our warranty is per contract terms and for our systems the warranty typically ranges between 12 and 24 months from customer acceptance. We use estimated repair or replacement costs along with our actual warranty experience to determine our warranty obligation. We exercise judgment in determining the underlying estimates. Should actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on our business, financial condition and results of operations.

 

Income Taxes

 

We account for income taxes in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes,” (“SFAS 109”) which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Based on our history of losses through 2004, our deferred tax asset was fully offset by a valuation allowance as of December 31, 2005.

 

On a quarterly basis, we provide for income taxes based upon an annual effective income tax rate. The effective tax rate is highly dependent upon the level of our projected earnings, the geographic composition of worldwide earnings, tax regulations governing each region, net operating loss carry-forwards, availability of tax credits and the effectiveness of our tax planning strategies. We carefully monitor the changes in many factors and adjust our effective income tax rate on a timely basis. If actual results differ from the estimates, this could have a material

effect on our business, financial condition and results of operations. For example, as our projected level of earnings increased throughout 2006, we increased the annual effective tax rate from 3.0% at the end of the first quarter, to 8.8% at the end of the second quarter and to 10.0% at the end of the third quarter.

 

The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material effect on our business, financial condition and results of operations.

 

Results of Operations

 

Three Months Ended September 30, 2006 and October 1, 2005.

 

Net revenues

 

 

Net revenues consist primarily of sales of equipment used to manufacture thin-film disks, related equipment and system components, flat panel equipment technology license fees, contract research and development related to the development of electro-optical sensors, cameras and systems and low light imaging products.

 

Equipment revenue for the three months ending September 30, 2006 included revenue recognition for nine 200 Lean systems and three disk lubrication systems, and a significant quarter over quarter increase in revenue from disk equipment technology upgrades and spare parts. Revenue for the three months ended October 1, 2005 included seven 200 Lean systems, two MDP-250B systems, nine disk lubrication systems and one flat panel manufacturing system. Our outlook for the Equipment business continues to be positive and we expect our revenues will increase significantly in the fourth quarter of 2006.

 

Imaging revenue for the three months ending September 30, 2006 consisted of $2.7 million of contract research and development and $465,000 of product sales. Revenue for the three months ended October 1, 2005 consisted of $1.7 million of contract research and development and $343,000 of product sales. The increase in contract research and development revenue was the result of a better mix of fully funded vs. partially funded programs. Substantial growth in future Imaging revenues is dependent on proliferation of our technology into major military weapons programs, the ability to obtain export licenses for foreign customers, obtaining production subcontracts for these programs, and development and sale of commercial products.

 

Our backlog of orders at September 30, 2006 was $129.7 million, as compared to $84.5 million at December 31, 2005 and $65.4 million at October 1, 2005. The increase in backlog was primarily the result of orders for disk sputtering systems. We include in backlog the value of purchase orders for our products that have scheduled delivery dates. We do not recognize revenue on this backlog until we have met the criteria contained in our revenue recognition policy, including customer acceptance of newly developed systems.

 

International sales increased by 32% to $49.2 million for the three months ended September 30, 2006 from $37.2 million for the three months ended October 1, 2005. International revenues include products shipped to overseas operations of U.S. companies. The increase in international sales was primarily due to an increase in net revenues from disk equipment technology upgrades and spare parts. Substantially all of our international sales are to customers in Asia. International sales constituted 90% of net revenues for the three months ended September 30, 2006 and 86% of net revenues for the three months ended October 1, 2005.

Gross margin

 

 

Cost of net revenues consists primarily of purchased materials and costs attributable to contract research and development, and also includes fabrication, assembly, test and installation labor and overhead, customer-specific engineering costs, warranty costs, royalties, provisions for inventory reserves and scrap. Cost of net revenues for the three months ended September 30, 2006 included $70,000 of equity-based compensation expense.

 

Equipment gross margin improved during the three months ended September 30, 2006 as compared to the three months ended October 1, 2005. Our product mix, cost reduction programs and increased volume all contributed to the higher gross margin for the quarter. We expect the gross margin for the Equipment business in the fourth quarter of 2006 to be better than the fourth quarter of 2005, but lower than the margin achieved in the third quarter of 2006. Gross margins in the Equipment business will vary depending on a number of factors, including product mix, product cost, system configuration and pricing, factory utilization, and inventory provisions.

 

The increase in Imaging gross margin resulted from a higher percentage of contract research and development revenue being derived from fully funded contracts, favorable adjustments related to closing our prior year government rate audits and increased product shipments. We expect Imaging gross margin in the fourth quarter of 2006 to be lower than the third quarter of 2006, due primarily to the elimination of the one-time favorable adjustments recognized in the three months ended September 30, 2006.

 

Research and development

 

 

Research and development expense consists primarily of prototype materials, salaries and related costs of employees engaged in ongoing research, design and development activities for disk sputtering equipment and Imaging products.

 

Research and development spending increased in both Equipment and in Imaging during the three months ended September 30, 2006 as compared to the three months ended October 1, 2005. The increase in Equipment was due to spending on the development of a new product line and spending for continuing development of our disk sputtering products. The increase in Imaging was due primarily to increased spending on the development of our commercial Imaging products. Engineering headcount increased from 86 at October 1, 2005 to 115 at September 30, 2006. Included in research and development spending for the three months ended September 30, 2006 was $376,000 of equity-based compensation expense. We expect that research and development spending will increase in the fourth quarter of 2006 due primarily to expenditures related to our new Equipment product line, provisions for employee profit-sharing and bonus plans, and equity-based compensation expense.

 

Research and development expenses do not include costs of $1.7 million and $1.4 million for the three-month periods ended September 30, 2006 and October 1, 2005, respectively, which are related to contract research and development and included in cost of net revenues.

Selling, general and administrative

 

 

Selling, general and administrative expense consists primarily of selling, marketing, customer support, financial and management costs and also includes production of customer samples, travel, liability insurance, legal and professional services and bad debt expense. All domestic sales and international sales of disk sputtering products in Asia, with the exception of Japan, are typically made by Intevac’s direct sales force, whereas sales in Japan of disk sputtering products and other products are typically made by our Japanese distributor, Matsubo, who provides services such as sales, installation, warranty and customer support. We also have subsidiaries in Singapore and in Hong Kong, along with field offices in Japan, Malaysia, Korea and Shenzhen, China to support our equipment customers in Asia.

 

The increase in selling, general and administrative spending in the three months ended September 30, 2006 as compared to the three months ended October 1, 2005 was primarily the result of increases in costs related to business development, customer service and support in the Equipment business and provisions for employee profit sharing and bonus plans. Included in selling, general and administrative spending for the three months ended July 1, 2006 was $432,000 of equity-based compensation expense. Our selling, general and administrative headcount increased from 59 at October 1, 2005 to 71 at September 30, 2006. We expect that selling, general and administrative expenses will increase in the fourth quarter of 2006 due primarily to a projected increase in costs related to business development, customer service and support for the Equipment business, provisions for employee profit-sharing and bonus plans, and stock-based compensation expense.

 

Interest income and other, net

 

 

Interest income and other, net consists primarily of interest and dividend income on investments and foreign currency transaction gains and losses. The increase in the three months ended September 30, 2006 was driven by higher interest rates on our investments and a higher average invested balance.

 

Provision for income taxes

 

 

For the three months ended September 30, 2006, we accrued income tax using an effective tax rate of 12.1% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. We have substantial net operating loss carry-forwards and deferred credits, which are being used to limit the taxes paid this year and to reduce our effective tax rate to less than the statutory income tax rates in effect. We expect our effective tax rate to significantly increase after our net operating losses and deferred credits have been fully utilized. Our deferred tax asset is mostly offset by a valuation allowance, resulting in a net deferred tax asset of $2.5 million at September 30, 2006.

For the three months ended October 1, 2005, we accrued income tax using an effective tax rate of 2.5% of pretax income. Our tax rate differs from the applicable statutory rates due to the utilization of net operating loss carry-forwards and deferred credits.

 

Nine Months Ended September 30, 2006 and October 1, 2005

 

Net revenues

 

 

The increase in Equipment revenue was the result of higher sales of disk sputtering systems, disk equipment technology upgrades and spare parts. The increase in Imaging revenues was the result of both higher product sales and higher contract research and development revenues.

 

International sales increased by 106% to $141.7 million for the nine months ended September 30, 2006 from $68.6 million for the nine months ended October 1, 2005. The increase in international sales was due to higher shipments of disk sputtering systems to customers in Asia. International sales constituted 86% of net revenues for the nine months ended September 30, 2006 and 81% of net revenues for the nine months ended October 1, 2005. International revenues include products shipped to overseas operations of US companies.

 

Gross margin

 

 

Gross margin for the nine months ended September 30, 2006 increased relative to the comparable 2005 period primarily due to lower manufacturing costs and higher average selling prices for the 200 Lean systems recognized for revenue and increased sales of disk equipment technology upgrades and spare parts in the period relative to the nine months ended October 1, 2005. The increase in Imaging gross margin was primarily a result of favorable adjustments related to closing our prior year rate audits and a higher percentage of revenue being derived from fully funded development contracts and product sales. Cost of net revenues for the nine months ended September 30, 2006 included $242,000 of equity-based compensation expense.

 

Gross margin for the nine months ended October 1, 2005 was favorably impacted by $908,000 of flat panel equipment related activities. The $908,000 included $1.5 million of gross profit from the technology license sale less $592,000 for costs related to obtaining final customer acceptance of a flat panel manufacturing system shipped in 2003. Gross margin for the nine months ended October 1, 2005 was adversely impacted by the recognition of revenue on a 200 Lean system that was built early in 2004, prior to the completion of a number of cost reduction activities.

Research and development

 

 

Research and development spending increased in both Equipment and in Imaging during the nine months ended September 30, 2006 as compared to the nine months ended October 1, 2005. The increase in Equipment was due to spending on the development of a new product line and spending for continuing development of our disk sputtering products. The increase in Imaging was due primarily to spending on the development of our commercial Imaging products. Included in research and development spending for the nine months ended September 30, 2006 was $908,000 of equity-based compensation expense.

 

Research and development expenses do not include costs of $4.5 million and $4.2 million, respectively, for the nine-month periods ended September 30, 2006 and October 1, 2005 related to Imaging contract research and development. These expenses are included in cost of net revenues.

 

Selling, general and administrative

 

 

The increase in selling, general and administrative expense for the nine months ending September 30, 2006 was primarily the result of increases in costs related to business development, customer service and support in the Equipment business and provisions for employee profit sharing and bonus plans. Included in selling, general and administrative spending for the nine months ended September 30, 2006 was $883,000 of equity-based compensation expense.

 

Interest income and other, net

 

 

Interest income and other, net in both 2006 and 2005 consisted primarily of interest and dividend income on investments. The increase in the nine months ended September 30, 2006 was the driven by higher interest rates on our investments and a higher average invested balance.

 

Provision for income taxes

 

 

For the nine months ended September 30, 2006, we accrued income tax using an effective tax rate of 10.0% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”.

Income tax expense for the nine months ending October 1, 2005 consists of a 2.5% provision on net pretax income, minimum Franchise Tax payment of $2,400 to the State of California and a $7,000 accrual related to a claim we received from the California Franchise Tax Board.

 

Stock-Based Compensation

 

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including equity awards related to the 2004 Equity Incentive Plan (“employee equity awards”) and employee stock purchases related to the 2003 Employee Stock Purchase Plan (“employee stock purchases”) based on estimated fair values. SFAS 123(R) supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).

 

We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our Condensed Consolidated Financial Statements as of and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

 

During the three and nine months ended September 30, 2006, we recorded stock-based compensation expense related to stock options of $791,000 and $1,687,000 respectively. As of September 30, 2006, the unrecorded deferred stock-based compensation balance related to stock options was $9.8 million and will be recognized over an estimated weighted average amortization period of 2.1 years.

 

The compensation cost associated with the employee stock purchase plan for the three and nine months ended September 30, 2006 was $148,000 and $432,000 respectively. There were 158,859 shares purchased under the employee stock purchase plan during the nine months ended September 30, 2006.

 

Approximately $61,000 and $85,000 of stock-based compensation was capitalized as inventory at the three- and nine-month periods ended September 30, 2006. No stock-based compensation was capitalized to inventory prior to our adoption of the provisions of SFAS 123(R) in the first quarter of 2006.

 

Liquidity and Capital Resources

 

During the first nine months of 2006, cash, cash equivalents, and investments increased by $40.2 million, from $49.7 million at December 31, 2005 to $89.9 million as of September 30, 2006.

 

Operating activities provided cash of $42.4 million during the nine months ended September 30, 2006. The cash provided was due primarily to net income, adjusted to exclude the effect of non-cash charges including depreciation and equity-based compensation, and to an increase in accounts payable. This was partially offset by increases in inventory and other prepaid expenses. Accounts receivable totaled $34.0 million at September 30, 2006 compared to $42.8 million at December 31, 2005. Net inventories increased by $16.6 million during the nine months ended September 30, 2006 due to increases in raw materials, work-in-progress and finished goods, which will be used to support the September 30, 2006 backlog. Accounts payable totaled $17.9 million at September 30, 2006 compared to $7.0 million at December 31, 2005. The increase of $10.9 million relates to the increase in inventory purchases and the general growth of our business. Accrued payroll and related liabilities increased by $2.5 million during the nine months ended September 30, 2006 due primarily to increases in headcount and accruals for bonuses and employee profit sharing. Other accrued liabilities totaled $7.3 million at September 30, 2006 compared to $6.9 million at December 31, 2005. The minimal net increase relates to an increase in accruals for warranty obligations, partially offset by decreases in accruals for taxes and deferred income. Customer advances increased by $10.7 million during the nine months ended September 30, 2006. The increase was due to advances billed or received for orders that will be shipped during the balance of 2006 and in 2007.

Investing activities in the first nine months of 2006 used cash of $50.8 million. Purchases of investments, net of proceeds from sales and maturities, totaled $45.3 million. Capital expenditures for the nine months ended September 30, 2006 were $5.5 million.

 

Financing activities provided cash of $3.0 million during the nine months ended September 30, 2006 due to the sale of Intevac common stock to our employees through our employee benefit plans.

 

We have generated operating income each of the last six quarters, after incurring annual operating losses from 1997 through 2004. We believe the upturn in demand for the type of disk manufacturing equipment we produce is continuing, and we expect our Equipment business to be profitable for the balance of 2006 and into 2007.

 

We believe that our existing cash, cash equivalents and short-term investments, combined with the cash we anticipate generating from operating activities will be sufficient to meet our cash requirements for the foreseeable future. We intend to undertake approximately $5 to $6 million in capital expenditures during the reminder of 2006.

 

Contractual Obligations

 

In the normal course of business, we enter into various contractual obligations that will be settled in cash. These obligations consist primarily of operating lease and purchase obligations. The expected future cash flows required to meet these obligations as of September 30, 2006 are shown in the table below.

 

 

Interest rate risk.  Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We place our investments with high quality credit issuers and, by policy, limit the amount of credit exposure to any one issuer. Short-term investments typically consist of investments in commercial paper, auction rate securities and debt instruments issued by the US government and its agencies.

 

The table below presents principal amounts and related weighted-average interest rates by year of maturity for our investment portfolio at September 30, 2006.