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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 28, 2003
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, 2003 is: 7,168,613.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Environmental Tectonics Corporation
Consolidated Income Statements
(unaudited)
(amounts in thousands, except share and per share information)
Thirteen Weeks Ended Thirty-nine Weeks Ended
November 28, November 22, November 28, November 22,
2003 2002 2003 2002
-------- -------- -------- --------
Net Sales $ 7,115 $ 12,162 $ 17,997 $ 34,410
Cost of goods sold 5,341 8,583 12,150 23,985
-------- -------- -------- --------
Gross profit 1,774 3,579 5,847 10,425
-------- -------- -------- --------
Operating expenses:
Selling and administrative 2,330 2,437 6,246 6,881
Research and development 144 268 176 487
-------- -------- -------- --------
2,474 2,705 6,422 7,368
-------- -------- -------- --------
Operating (loss)/income (700) 874 (575) 3,057
-------- -------- -------- --------
Other expenses/(income):
Interest expense 425 116 1,192 382
Other, net (138) 174 (51) 324
-------- -------- -------- --------
287 290 1,141 706
-------- -------- -------- --------
(Loss)/income before income taxes (987) 584 (1,716) 2,351
(Benefit from)/provision
for income taxes (280) 154 (451) 631
-------- -------- -------- --------
(Loss)/income before
minority interest (707) 430 (1,265) 1,720
Loss attributable to
minority interest (3) (6) (9) (37)
-------- -------- -------- --------
Net (loss)/income (704) $ 436 $ (1,256) $ 1,757
======== ======== ======== ========
========================================================================================================================
Per share information:
(Loss)/income available to
common shareholders $(704) $436 $(1,256) $1,757
(Loss)/income per share: basic $(0.10) $0.06 $(0.18) $0.25
(Loss)/income per share: diluted $(0.10) $0.06 $(0.18) $0.23
Number of shares: basic 7,168,000 7,153,000 7,168,000 7,153,000
Number of shares: diluted 7,168,000 7,481,000 7,168,000 7,493,000
The accompanying notes are an integral part of the consolidated financial
statements.
2
Environmental Tectonics Corporation
Consolidated Balance Sheets
November 28, February 28,
2003 2003
-------- --------
(unaudited)
(amounts in thousands, except share
information)
Assets
Current assets:
Cash and cash equivalents $ 1,171 $ 4,305
Cash equivalents restricted for letters of credit 569 3,189
Accounts receivable, net 20,284 16,193
Costs and estimated earnings in excess of billings on uncompleted
long-term contracts 5,516 5,441
Inventories 9,134 8,494
Deferred tax asset 689 689
Prepaid expenses and other current assets 2,297 983
-------- --------
Total current assets 39,660 39,294
-------- --------
Property, plant and equipment, at cost, net of accumulated
depreciation of $10,468 at November 28, 2003 and $9,976 at
February 28, 2003 4,850 5,086
Software development costs, net of accumulated amortization of $7,321
at November 28, 2003 and $6,819 at February 28, 2003 3,048 2,224
Goodwill and intangibles 477 477
Other assets, net 479 617
-------- --------
Total assets $ 48,514 $ 47,698
======== ========
Liabilities and Stockholders' Equity
Liabilities
Current liabilities:
Current portion of long-term debt $ 281 $ 281
Accounts payable - trade 2,363 1,778
Billings in excess of costs and estimated earnings on uncompleted
long-term contracts 1,098 1,463
Customer deposits 3,419 3,000
Accrued liabilities 2,439 1,556
-------- --------
Total current liabilities 9,600 8,078
-------- --------
Long-term debt, less current portion:
Credit facility payable to banks 1,200 600
Long-term bonds, net 4,370 4,645
Subordinated debt 7,593 7,391
Other 3 7
-------- --------
13,166 12,643
-------- --------
Deferred income taxes 1,022 1,022
-------- --------
Total liabilities 23,788 21,743
-------- --------
Minority interest 39 48
Stockholders' Equity
Common stock; $.05 par value; 20,000,000 shares authorized; 7,168,239 and
7,157,239 issued and outstanding at November 28, 2003 and
February 28, 2003, respectively 359 358
Capital contributed in excess of par value of common stock 9,381 9,331
Accumulated other comprehensive loss (184) (169)
Retained earnings 15,131 16,387
-------- --------
Total stockholders' equity 24,687 25,907
-------- --------
Total liabilities and stockholders' equity $ 48,514 $ 47,698
======== ========
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 28, November 22,
2002 2003
-------- --------
(amounts in thousands)
Cash flows from operating activities:
Net (loss)/income $ (1,256) $ 1,757
Adjustments to reconcile net (loss)/income to net cash
(used in)/provided by operating activities:
Depreciation and amortization 1,009 1,105
Non-cash interest expense 443 8
Provision for losses on accounts receivable and
inventories (198) 801
Minority interest (9) (37)
Changes in operating assets and liabilities:
Accounts receivable (4,025) 1,829
Costs and estimated earnings in excess of billings on
uncompleted long-term contracts (75) 3,578
Inventories (861) (2,536)
Prepaid expenses and other assets (1,150) (84)
Other assets -- 23
Accounts payable 585 (1,522)
Billings in excess of costs and estimated earnings on
uncompleted long-term contracts (365) 379
Customer deposits 419 1,249
Accrued income taxes -- (654)
Other accrued liabilities 884 204
-------- --------
Net cash (used in)/provided by operating activities (4,599) 6,100
-------- --------
Cash flows from investing activities:
Acquisition of equipment (271) (212)
Capitalized software development costs (973) (326)
-------- --------
Net cash used in investing activities (1,244) (538)
-------- --------
Cash flows from financing activities:
Borrowings under credit facility 1,200 24,024
Payments under credit facility (600) (25,417)
Repayment of long-term bonds (275) (275)
Cash equivalents restricted for letters of credit 2,620 (5,241)
Proceeds from issuance of common stock / warrants 51 20
Deferred finance charges/other (272) (6)
-------- --------
Net cash provided by/(used in) financing activities 2,724 (6,895)
-------- --------
Effect of exchange rate changes on cash (15) 150
-------- --------
Net decrease in cash and cash equivalents (3,134) (1,183)
Cash and cash equivalents at beginning of period 4,305 2,261
-------- --------
Cash and cash equivalents at end of period $ 1,171 $ 1,078
======== ========
Supplemental schedule of cash flow information:
Interest paid 582 351
Income taxes paid 64 1,567
Supplemental information on noncash operating and investing activities:
=================================================================
During the thirty-nine weeks ended November 28,2003, the Company reclassified
$353 from inventory to capitalized software.
During the thirty-nine weeks ended November 22, 2002, the Company
reclassified $226 from inventory to property, plant and equipment and $624
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, 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 28, 2003. Certain
reclassifications have been made to the fiscal 2003 financial statements to
conform with the fiscal 2004 presentation.
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 28, 2003 Thirteen Weeks Ended November 22, 2002
-------------------------------------- --------------------------------------
Loss Shares Per Share Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------
(amounts in thousands, except share and per share information)
Basic EPS
Net (loss)/earnings
available to common
stockholders $(704) 7,168,000 $(0.10) $436 7,153,000 $0.06
Effect of dilutive
securities
Options - - 23,000
Warrants - - 305,000
Diluted EPS
Net (loss)/earnings
available to common
stockholders
plus assumed
conversions $(704) 7,168,000 $(0.10) $436 7,481,000 $0.06
Thirty-nine Weeks Ended November 28, 2003 Thirty-nine Weeks Ended November 22, 2002
----------------------------------------- -----------------------------------------
Loss Shares Per Share Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------
(amounts in thousands, except share and per share information)
Basic EPS
Net (loss)/earnings
available to common
stockholders $ (1,256) 7,168,000 $(0.18) $1,757 7,153,000 $0.25
Effect of dilutive
securities
Options - - 32,000
Warrants - - 308,000
Diluted EPS
Net (loss)/earnings
available to common
stockholders
plus assumed
conversions $ (1,256) 7,168,000 $(0.18) $1,757 7,493,000 $0.23
6
At November 28, 2003 there were stock options to purchase the Company's common
stock totaling 412,000 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 1,653,000
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 165,000 shares would be issued,
bringing the total shares to be issued to 1,818,000. Additionally, at November
28, 2003, there were warrants to purchase the Company's stock totaling 1,241,000
shares. None of these shares were included in the computation of diluted
earnings per share as the effect would be anti-dilutive.
At November 22, 2002, there were employee stock options to purchase the
Company's stock totaling 329,000 shares which were not included in the
computation of diluted earnings per share, as the effect of such options 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.
At November 28, 2003, 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).
7
Thirteen Weeks Ended
--------------------
November 28, 2003 November 22, 2002
----------------- -----------------
Net (loss)/income,
as reported $ (704) $ 436
Less: stock-based compensation costs
determined under fair market value based
methods for all awards (10) (69)
------- ------
Net (loss)/income, pro forma $ (714) $ 367
(Loss)/earnings per share of common stock-basic:
As reported $ (0.10) $ .06
Pro forma $ (0.10) $ .05
(Loss)/earnings per share of common stock--diluted:
As reported $ (0.10) $ .06
Pro forma $ (0.10) $ .05
Thirty-nine Weeks Ended
------------------------
November 28, 2003 November 22, 2002
----------------- -----------------
Net (loss)/income,
as reported $(1,256) $1,757
Less: stock-based compensation costs
determined under fair market value based
methods for all awards (30) (206)
------- ------
Net (loss)/income, pro forma $(1,286) $1,551
(Loss)/earnings per share of common stock-basic:
As reported $ (0.18) $ .25
Pro forma $ (0.18) $ .22
(Loss)/earnings per share of common stock--diluted:
As reported $ (0.18) $ .23
Pro forma $ (0.18) $ .21
- -------------------------------------------------------------------------------------------------------------------
There were no grants of stock options during the thirty-nine weeks ended
November 28, 2003 or November 22, 2002.
4. Accounts Receivable
The components of accounts receivable are as follows:
November 28, February 28,
2003 2003
------------ ------------
(amounts in thousands)
U.S. Government receivables billed and unbilled contract costs subject to
negotiation $ 4,060 $ 2,719
U.S. commercial receivables billed 1,342 2,002
International receivables billed and unbilled contract costs subject to
negotiation 15,262 11,918
-------- --------
20,664 16,639
Less allowance for doubtful accounts (380) (446)
-------- --------
$ 20,284 $ 16,193
======== ========
8
U.S. Government receivables billed and unbilled contract costs subject to
negotiation:
Unbilled contract costs subject to negotiation as of November 28, 2003
and February 28, 2003, primarily represent claims made against the U.S.
Government under a contract for a submarine rescue decompression chamber
project. These costs totaling $2,899,000 were recorded beginning in fiscal year
2002 and include $1,691,000 recorded during fiscal year 2003 and $833,000 during
fiscal year 2004. 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. The Company considers 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. Additionally, the Company is currently preparing an update to the claim
to incorporate additional spending related to the claim items. During the
thirteen weeks ended November 28, 2003, this customer, citing failure to deliver
product within contract terms, began assessing liquidated damages by offsetting
progress payments due 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 to cover a delay through the extended
delivery period.
International receivables billed and unbilled contract costs subject to
negotiation:
International receivables billed includes $700,000 at November 28, 2003
and February 28, 2003, 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.
9
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's
Thai attorneys 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. This
document is currently being translated into English. In December 2003 the
Company and the RTAF both picked arbitrators to represent them in the dispute,
although no date has yet been set for the Arbitration proceedings. 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 the
trainers that are the subject of the dispute and has sold a significant amount
of additional equipment to the RTAF since this dispute began, so it is not
anticipated that the initiation of legal action against the RTAF will have any
material adverse impact on future sales to 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.
Unbilled contract costs subject to negotiation represent claims made or
to be made against an international customer for two contracts covering 1997 to
the present. Trade and claims receivables and resulting revenue aggregating
$10,269,000 have been recorded, including $819,000 recorded in the current
quarter. 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 2004. 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. As a related item, during the
third quarter of fiscal 2000, this international customer, citing failure to
deliver product within contract terms, assessed liquidated damages totaling
approximately $1,600,000 on the two contracts. The Company disputes the basis
for these liquidated damages and plans to contest them vigorously. However,
following generally accepted accounting principles, the Company has reduced
contract values and corresponding revenue recognition by approximately
$1,600,000.
On July 20, 2001, the Company was notified by the international
customer that it was terminating the centrifuge contract, which was
approximately 90% complete. The termination included a request for the refund of
advance milestone payments made to date.
10
The Company is currently mediating and arbitrating the disputes which
have arisen under the two contracts in the United Kingdom but is unable to
assess the ultimate impact of either the termination or the balance due on the
contracts on its operations and financial condition.
With respect to the centrifuge contract, based on witness statements,
expert reports and other facts, the Company believes that it has a reasonable
basis to refute the concerns of the U.K. Ministry of Defense. The Company has
installed seven centrifuges in the last 15 years at various locations throughout
the world and the Company is unaware of any accidents or injuries caused by the
operation of these centrifuges. The Company does not plan to reduce the carrying
value of the trade and claims receivables until all unresolved matters have been
properly adjudicated in the arbitration proceedings.
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
$514,000 and $646,000 at November 28, 2003 and February 28, 2003, respectively):
November 28, February 28,
2003 2003
------------ ------------
(amounts in thousands)
Raw materials $ 336 $ 322
Work in Process 6,667 5,629
Finished Goods 2,131 2,543
------ ------
Total $9,134 $8,494
====== ======
6. Stockholders' Equity
The components of stockholders' equity at February 28, 2003 and
November 28, 2003 were as follows:
(amounts in thousands, except share information)
Common Stock Additional Accumulated
Paid in Other Comp. Retained
Shares Amount Capital Loss Earnings Total
------ ------ ---------- ----------- -------- -----
Balance at February 28, 2003 7,157,239 $358 $9,331 $(169) $16,387 $25,907
Net loss for the thirty-nine weeks
ended November 28, 2003 - - - - (1,256) (1,256)
Foreign currency translation
adjustment - - - (15) - (15)
Total comprehensive loss - - - (15) (1,256) (1,271)
Shares issued in connection with
employee stock option plans 11,000 1 50 - - 51
--------- ---- ------ ----- ------- -------
Balance at November 28, 2003 7,168,239 $359 $9,381 $(184) $15,131 $24,687
========= ==== ====== ===== ======= =======
11
7. Long Term Debt
The following table lists the long-term debt and other long-term
obligations of the Company as of November 28, 2003.
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 1,200 - 1,200 - -
Capital Leases 9 6 3 - -
Subordinated debt, net of
unamortized
discount of $2,477 7,593 - - - 7,593
Long term bonds 4,370 - 825 550 2,995
--------- ------------- -------- -------- -------
Total Obligations $ 13,447 $ 281 $ 2,028 $ 550 $10,588
========= ============= ======== ======== =======
At November 28, 2003, the Company was in violation of three of its
financial covenants in connection with its Bank Credit Agreement and two of its
covenants in connection with its Convertible Note and Warrant Purchase
Agreement. These violations occurred as a result of the second and third quarter
fiscal 2004 net losses. As of the date of this Quarterly Report on Form 10-Q,
the Company has obtained waivers for these covenant violations from both the
Bank and the Note holder.
12
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 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
Thirteen weeks ended November 22, 2002
Net Sales $ 10,137 $ 2,025 $ 12,162
Interest Expense 87 29 116
Depreciation and Amortization 330 98 428
Operating Income/(Loss) 1,730 (489) 1,241
Income Tax Provision/(Benefit) 427 (135) 292
Goodwill and Intangibles 477 -- 477
Identifiable Assets 26,350 7,579 33,929
Expenditures For Segment Assets 82 21 103
Reconciliation to consolidated amounts 2003 2002
Segment Assets $ 38,459 $ 34,406
Corporate Assets 10,055 13,948
-------- --------
Total Assets $ 48,514 $ 48,354
======== ========
Segment operating (loss)/income $ (439) $ 1,241
Less interest expense (427) (116)
Less income taxes benefit/(expense) 246 (292)
-------- --------
Total (loss)/profit for segments (620) 833
Corporate home office expenses (261) (367)
Interest and other expenses 140 (174)
Income tax benefit 34 138
Minority interest 3 6
-------- --------
Net (loss)/income $ (704) $ 436
======== ========
13
Industrial
ATS Group Total
--- ---------- -----
(amounts in thousands)
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
Thirty-nine weeks ended November 22, 2002
Net Sales $ 27,255 $ 7,155 $ 34,410
Interest Expense 319 63 382
Depreciation and Amortization 788 272 1,060
Operating Income/(Loss) 4,735 (764) 3,971
Income Tax Provision/(Benefit) 1,192 (219) 973
Goodwill and Intangibles 477 -- 477
Identifiable Assets 26,350 7,579 33,929
Expenditures For Segment Assets 174 38 212
Reconciliation to consolidated amounts 2003 2002
Segment Assets $ 38,459 $ 34,406
Corporate Assets 10,055 13,948
-------- --------
Total Assets $ 48,514 $ 48,354
======== ========
Segment operating income $ 312 $ 3,971
Less interest expense (1,194) (382)
Less income taxes benefit/(expense) 150 (973)
-------- --------
Total (loss)/profit for segments (732) 2,616
Corporate home office expenses (781) (914)
Interest and other expenses (53) (324)
Income tax benefit 301 342
Minority interest 9 37
-------- --------
Net (loss)/income $ (1,256) $ 1,757
======== ========
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.
14
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 72% of sales totaling $8,815,000 in the thirteen weeks
ended November 22, 2002 were made to one domestic and 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 customer and one international
customer in the sterilizer and ATS segments respectively. Approximately 67% of
sales totaling $23,198,000 in the thirty-nine weeks ended November 22, 2002 were
made to one domestic and one international customer in the ATS segment.
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 thirteen weeks ended
November 22, 2002 are export sales of $8,113,000. A significant portion of this
amount consisted of sales to a government account in Malaysia of $6,345,000. In
addition, sales to the U.S. Government and its agencies aggregated $1,150,000
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 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.
Included in the segment information for the thirty-nine weeks ended
November 22, 2002 are export sales of $12,150,000. Of this amount, there are
sales to or relating to commercial or government accounts in Malaysia of
$6,345,000 and China of $2,301,000. In addition, sales to the U.S. Government
and its agencies aggregated $2,585,000 for the period.
9. Recent Accounting Pronouncements
Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB No. 13, and
Technical Corrections:
In April 2002, the Financial Accounting Standards Board (FASB) issued
SFAS No. 145, "Rescission of FASB statements No. 4, 44, and 64, Amendment of
FASB No. 13, and Technical Corrections." SFAS No. 145 changes the accounting
principles governing extraordinary items by clarifying, and to some extent,
modifying, the existing definition and criteria, specifying disclosure for
extraordinary items and specifying disclosure requirements for other unusual or
infrequently occurring events and transactions that are not extraordinary items.
SFAS No. 145 is effective for financial statements issued for fiscal years
beginning after June 15, 2002, with early adoption encouraged. The adoption of
SFAS No. 145 did not have a significant impact on the financial condition or
results of operations of the Company.
Accounting for Costs Associated with Exit or Disposal Activities:
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." This statement provides financial
accounting and reporting guidance for costs associated with exit or disposal
activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity including Certain Costs Incurred in a Restructuring." SFAS
No. 146 is effective for exit or disposal activities initiated after December
31, 2002. The adoption of the statement did not have a significant impact on the
financial condition or results of operations of the Company.
15
In November 2002, FASB Interpretation 45, Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others (FIN 45), was issued. FIN 45 requires a guarantor entity,
at the inception of a guarantee covered by the measurement provisions of the
interpretation, to record a liability for the fair value of the obligation
undertaken in issuing the guarantee. The Company previously did not record a
liability when guaranteeing obligations unless it became probable that the
Company would have to perform under the guarantee. FIN 45 applies prospectively
to guarantees the Company issues or modifies subsequent to December 31, 2002,
but has certain disclosure requirements effective for interim and annual periods
ending after December 15, 2002. The Company has not historically issued
guarantees and does not anticipate FIN 45 will have a material effect on its
fiscal 2004 consolidated financial statements.
In January 2003, the FASB issued FASB Interpretation 46 (FIN 46),
Consolidation of Variable Interest Entities. FIN 46 clarifies the application of
Accounting Research Bulletin 51, Consolidated Financial Statements, for certain
entities that do not have sufficient equity at risk for the entity to finance
its activities without additional subordinated financial support from other
parties or in which equity investors do not have the characteristics of a
controlling financial interest ("variable interest entities"). Variable interest
entities within the scope of FIN 46 will be required to be consolidated by their
primary beneficiary. The primary beneficiary of a variable interest entity is
determined to be the party that absorbs a majority of the entity's expected
losses, receives a majority of its expected returns, or both. FIN 46 applies
immediately to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise acquires an interest after
that date. It applies in the first fiscal year or interim period beginning after
June 15, 2003, to variable interest entities in which an enterprise holds a
variable interest that it acquired before February 1, 2003. The adoption of FIN
46 did not have a material effect on the Company's consolidated financial
position, results of operations, or cash flows.
On May 15, 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS
No. 150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). Many of those instruments
were previously classified as equity.
SFAS No. 150 affects the issuer's accounting for three types of
freestanding financial instruments:
o mandatorily redeemable shares, which the issuing company is obligated
to buy back in exchange for cash or other assets;
o instruments that do or may require the issuer to buy back some of its
shares in exchange for cash or other assets, including put options and
forward purchase contracts; and
o obligations that can be settled with shares, the monetary value of
which is fixed, tied solely or predominantly to a variable such as a
market index, or varies inversely with the value of the issuers'
shares.
SFAS No. 150 does not apply to features embedded in a financial
instrument that is not a derivative in its entirety.
Most of the guidance in SFAS No. 150 is effective for all financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. The adoption of SFAS No. 150 did not have a material effect on the
Company's consolidated financial position, results of operations or cash flows.
16
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 28, 2003, 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.
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
The Company is 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.
17
The Company recognizes revenue using three methods:
On long-term contracts, the percentage-of-completion method is applied
based on costs incurred as a percentage of estimated total costs. This
percentage is multiplied by the total estimated revenue under a contract to
calculate the amount of revenue recognized in an accounting period. Revenue
recognized on uncompleted long-term contracts in excess of amounts billed to
customers is reflected as an asset. Amounts billed to customers in excess of
revenue recognized on uncompleted long-term contracts 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
the Company learns the facts which require it 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.
Revenue for contracts under $100,000, or to be completed in less than
one year, 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 and services is also recognized
on the date that the finished product is shipped to the customer. Revenue on
contracts under $100,000, or to be completed in less than one year, and where
post-shipment services (such as installation and customer acceptance) are
required, is recognized following customer acceptance. Revenue for service
contracts is recognized ratably over the life of the contract with related
material costs expensed as incurred.
In accordance with accounting principles generally accepted in the
United States, 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 the Company can reliably estimate the amount of additional
contract revenue the Company may receive. However, revenue recorded on a
contract claim cannot exceed the incurred contract costs related to that claim.
Claims are subject to negotiation, arbitration and audit by the customer or
governmental agency.
The Company has operating subsidiaries in the United Kingdom and
Poland, maintains regional offices in the Middle East, Asia and Canada, and uses
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.
The Company considers its business activities to be divided into two segments:
Aircrew Training Systems (ATS) and Industrial Group.
18
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. 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 the Company's Annual Report on Form 10-K for
the fiscal year ended February 28, 2003, which we filed with the Securities and
Exchange Commission on May 29, 2003.
Revenue Recognition on Long-Term Contracts
When the performance of a contract requires a customer to pay the
Company more than $100,000 and will extend beyond a 12-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 the Company.
The Company accounts for some of its largest contracts, including its
contracts with the U.S. Government and foreign governments, using the
percentage-of-completion method. If the Company does not accurately estimate the
total cost to be incurred on this type of contract, or if the Company is
unsuccessful in the ultimate collection of associated contract claims, the
estimated gross margins may be significantly impacted or losses may need to be
recognized in future periods. Any resulting reductions in margins or contract
losses could be material to the Company's results of operations and financial
position.
19
Accounts Receivable
The Company performs ongoing credit evaluations of its customers and
adjusts credit limits based on payment history and the customer's current credit
worthiness. The Company continuously monitors collections and payments from its
customers and maintains a provision for estimated credit losses based on
historical experience and any specific customer collection issues that have been
identified. While the Company's credit losses have historically been within its
expectations and the provisions established, the Company cannot guarantee that
it will continue to experience the same credit loss rates that it has in the
past. Additionally, as a result of the concentration of international
receivables, the Company cannot predict the effect, if any, which geopolitical
risk and uncertainty will have on the ultimate collection of its international
receivables.
Results of Operations
Thirteen weeks ended November 28, 2003 compared to thirteen weeks ended November
22, 2002.
Net Income.
The Company had a net loss of $704,000, or ($0.10) per share (diluted),
during the third quarter of fiscal 2004 versus a net income of $436,000, or $.06
per share (diluted), for the third quarter of fiscal 2003, representing a
decrease of $1,140,000 or 261.5%. This decrease was due to a significant
decrease in sales and gross profit margin partially offset by reduced selling,
general and administrative and research and development expenses and an income
tax benefit.
Sales.
Sales for the third quarter of fiscal 2004 were $7,115,000 as compared
to $12,162,000 for the third quarter of fiscal 2003, a decrease of $5,047,000 or
41.5%. The primary contributors to the sales decrease were reduced revenues for
international ATS (down $3,731,000) as the prior year quarter included a
significant amount of start-up revenue for a centrifuge project in Malaysia, and
reduced sales of entertainment products(down $2,389,000) due to the completion
of a major entertainment project. Providing partial offsets were increased
domestic sterilizer sales, which benefited from a new Ethylene Oxide ("ETO")
sterilizer project and increased domestic and international environmental sales
from various projects.
Domestic Sales.
Overall, domestic sales in the third quarter of fiscal 2004 were
$2,775,000 as compared to $2,899,000 in the third quarter of fiscal 2003, a
decrease of $124,000 or 4.3%, as a significant reduction in entertainment sales
was only partially offset by increases across the board in all businesses with
the strongest performance in sterilizers and environmental. Domestic sales
represented 39.0% of the Company's total sales in the third quarter of fiscal
2004, up from 23.8% for the third quarter of fiscal 2003. Sales to the U.S.
Government in the third quarter of fiscal 2004 were negligible as compared to
$1,150,000 in the third quarter of fiscal 2003, and represented 0.0% of total
sales in the third quarter of fiscal 2004 versus 9.5% for the third quarter of
fiscal 2003.
20
International Sales.
International sales for the third quarter of fiscal 2004 were
$4,382,000 as compared to $8,113,000 in the third quarter of fiscal 2003, a
decrease of $3,731,000 or 46.0%, and represented 61.0% of total sales, as
compared to 66.7% in the third quarter of fiscal 2003. Throughout the Company's
history, most of the sales for Aircrew Training Systems have been made to
international customers. In the thirteen weeks ended November 28, 2003,
international sales totaling at least ten percent of total international sales
were made to Venezuela ($1,050,000), the United Kingdom ($818,000), and Malaysia
($793,000). In the thirteen weeks ended November 22, 2002, international sales
totaling at least ten percent of total international sales were made to Malaysia
($6,345,000). 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 for the third quarter of fiscal 2004 was $1,774,000 as
compared to $3,579,000 in the third quarter of fiscal 2003, a decrease of
$1,805,000 or 50.4%. This decrease reflected the decrease in sales coupled with
a 4.5 percentage point decrease in the gross profit rate as a percent of sales.
The reduced gross profit rate as a percent of sales reflected reductions
primarily in entertainment, simulation and ATS sales coupled with a higher mix
of lower margin environmental sales.
Selling and Administrative Expenses.
Selling and administrative expenses for the third quarter of fiscal
2004 were $2,330,000 as compared to $2,437,000 in the third quarter of fiscal
2003, a decrease of $107,000 or 4.4% primarily reflecting decreased advertising,
trade show and legal costs.
Research and Development Expenses.
Research and development expenses, which are charged to operations as
incurred, were $144,000 for the third quarter of fiscal 2004 as compared to
$268,000 for the third quarter of fiscal 2003, reflecting a decrease of $124,000
or 46.3%. The reduction primarily reflected reduced activity in the Company's
Turkish subsidiary. Most of the Company's research efforts, which were and
continue to be a significant cost of its business, are included in cost of sales
for applied research for specific contracts, as well as research for feasibility
and technology updates.
21
Interest Expense.
Interest expense for the third quarter of fiscal 2004 was $425,000 as
compared to $116,000 for the third quarter of fiscal 2003, representing an
increase of $309,000 or 266.4%. This increase reflected interest charges at a
higher effective interest rate for the Company's subordinated debt borrowed in
February 2003 (including amortization of debt discounts arising out of the
beneficial conversion option and associated warrants issued) and amortization of
deferred financing costs for the Company's February 2003 refinancing.
Other Income/Expense, Net
Other income/expense, net, was income of $138,000 for the third quarter of
fiscal 2004 versus a net expense of $174,000 for the third quarter of fiscal
2003, a decrease of $312,000 or 179.3%. The current period reflected the
positive net impact of $283,000 for an insurance reimbursement partially offset
by international letter of credit and domestic bank charges.
Provision for Income Taxes.
The Company's tax benefit for the third quarter of fiscal 2004
reflected an estimated 30% rate domestically and a consolidated estimated rate
of 28.4%. The lower than statutory effective tax rate domestically reflects the
ongoing effect of offsetting research and development tax credits. The
international rate reflects a recalculation in ETC Europe, a subsidiary of the
Company, of the estimated tax loss carry-forward which will be used to offset
any current year tax liability. The consolidated rate for the third quarter of
fiscal 2003 reflected an estimated rate of 26.3%, reflecting additional research
and development tax credits.
Results of Operations
Thirty-nine weeks ended November 28, 2003 compared to thirty-nine weeks ended
November 22, 2002.
Net Income.
The Company had a net loss of $1,256,000, or ($0.18) per share
(diluted), during the thirty-nine weeks ended November 28, 2003, versus net
income of $1,757,000, or $.23 per share (diluted), for the thirty-nine weeks
ended November 22, 2002, representing a decrease of $3,013,000 or 171.5%. This
decrease was due to a significant decrease in sales and gross profit margin
partially offset by reduced selling, general and administrative and research and
development expenses and an income tax benefit.
Sales.
Sales in the thirty-nine weeks ended November 28, 2003 were $17,997,000
as compared to $34,410,000 for the thirty-nine weeks ended November 22, 2002, a
decrease of $16,413,000 or 47.7%. The primary contributor to the sales decrease
was reduced revenues for domestic entertainment (down $16,595,000) due to the
completion of a major entertainment project. The Company also experienced
reduced international revenues for environmental and ATS sales. The prior period
included a significant amount of sales in environmental for projects in China
and start-up revenue in ATS for a centrifuge project in Malaysia. Providing
partial offsets were increased domestic sterilizer sales (up $3,222,000), which
benefited from a new ETO sterilizer project, and increased domestic simulation
sales for various projects.
22
Domestic Sales.
Overall, domestic sales in the thirty-nine weeks ended November 28,
2003, were $7,355,000 as compared to $19,675,000 for the thirty-nine weeks ended
November 22, 2002, a decrease of $12,320,000 or 62.6%. This decrease was
primarily due to the decrease in entertainment sales. Domestic sales represented
40.9% of the Company's total sales in the thirty-nine weeks ended November 28,
2003, down from 57.2% for the thirty-nine weeks ended November 22, 2002. Sales
to the U.S. Government in the thirty-nine weeks ended November 28, 2003 were
$624,000 as compared to $2,585,000 for the thirty-nine weeks ended November 22,
2002, a decrease of $1,961,000, 75.9%, and represented 3.5% of total sales in
the thirty-nine weeks ended November 28, 2003 versus 7.5% for the thirty-nine
weeks ended November 22, 2002.
International Sales.
International sales in the thirty-nine weeks ended November 28, 2003
were $10,019,000 as compared to $12,150,000 for the thirty-nine weeks ended
November 22, 2002, a decrease of $2,131,000 or 17.5%, and represented 55.6% of
total sales in the period ended November 28, 2003, as compared to 35.3% for the
thirty-nine weeks ended November 22, 2002. Throughout the Company's history,
most of the sales for Aircrew Training Systems have been made to international
customers. In the thirty-nine weeks ended November 28, 2003, international sales
totaling at least ten percent of total international sales were made to
government or commercial accounts in Malaysia ($2,887,000) and Venezuela
($1,050,000). In the thirty-nine weeks ended November 22, 2002, international
sales totaling at least ten percent of total international sales were made to
commercial or governmental accounts in Malaysia ($6,345,000) and China
($2,301,000). 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 28, 2003 was
$5,847,000 as compared to $10,425,000 for the thirty-nine weeks ended November
22, 2002, a decrease of $4,578,000 or 43.9%. This decrease reflected the
decrease in sales which was only partially offset by a 2.2 percentage point
increase in the gross profit rate as a percent of sales. Increased gross profit
rates as a percent of sales were evidenced in domestic sterilizer and simulation
and international ATS sales.
23
Selling and Administrative Expenses.
Selling and administrative expenses in the thirty-nine weeks ended
November 28, 2003 were $6,246,000 as compared to $6,881,000 for the thirty-nine
weeks ended November 22, 2002, a decrease of $635,000 or 9.2% as compared to the
first half of fiscal 2003, primarily reflecting a reimbursement in the first
quarter of fiscal 2004 of prior period legal and claim expenses associated with
an arbitration hearing in January 2003. Additional savings were evidenced in the
Company's European subsidiary.
Research and Development Expenses.
Research and development expenses, which are charged to operations as
incurred, were $176,000 in the thirty-nine weeks ended November 28, 2003 as
compared to $487,000 for the thirty-nine weeks ended November 22, 2002,
reflecting a decrease of $311,000 or 63.9%. This decrease reflected government
grants in our Turkish subsidiary under a government research award for work on
our multi-axis centrifuge tactical flight simulator. Most of the Company's
research efforts, which were and continue to be a significant cost of its
business, are included in cost of sales for applied research for specific
contracts, as well as research for feasibility and technology updates.
Interest Expense.
Interest expense in the thirty-nine weeks ended November 28, 2003 was
$1,192,000 as compared to $382,000 for the thirty-nine weeks ended November 22,
2002, representing an increase of $810,000 or 212.0%. This increase reflected
interest charges at a higher effective interest rate for the Company's
subordinated debt borrowed in February 2003 (including amortization of debt
discounts arising out of the beneficial conversion option and associated
warrants issued) and amortization of deferred financing costs for the Company's
February 2003 refinancing.
Other Income/Expense, Net
Other income/expense, net, was income of $51,000 for the thirty-nine weeks
ended November 28, 2003 versus a net expense of $324,000 for the thirty-nine
weeks ended November 22, 2002, a decrease of $375,000 or 115.7%. The current
period reflected the positive net impact of $283,000 for an insurance
reimbursement partially offset by international letter of credit and domestic
bank charges.
Provision for Income Taxes.
The Company's tax provision in the thirty-nine weeks ended November 28,
2003 reflected an estimated 30.0% rate domestically and a consolidated estimated
rate of 26.3%. The lower than statutory effective tax rate domestically reflects
the ongoing effect of offsetting research and development tax credits. The
international rate reflects a recalculation in ETC Europe, a subsidiary of the
Company, of the estimated tax loss carry-forward which will be used to offset
any current year tax liability. The consolidated rate for the thirty-nine weeks
ended November 22, 2002 reflected an estimated rate of 26.8% reflecting
additional research and development tax credits.
24
Liquidity and Capital Resources
During the thirty-nine weeks ended November 28, 2003, the Company used
$4,599,000 to support operating activities. This was primarily the result of the
net loss coupled with an increase in accounts receivable, prepaid expenses and
inventory. Acting as partial offsets were non-cash expenses and an increase in
accrued liabilities, accounts payable and customer deposits. Generally speaking,
the cash usage reflected significant period end billings on large international
contracts and a build-up in inventory of costs for contracts that were not
finished by the end of the period, partially offset by an increase in various
liability accounts.
The Company's investing activities used $1,244,000 during the
thirty-nine weeks ended November 28, 2003, which consisted of purchases of
capital equipment and capitalized software.
The Company's financing activities generated $2,724,000 during the
thirty-nine weeks ended November 28, 2003, consisting of a reduction in the
Company's cash collateral restricted cash account and net borrowings on the
Company's bank line. The cash collateral account serves as security for any of
the Company's international letters of credit that are not covered under the
Company's bank facility.
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 completed a refinancing of its indebtedness with PNC Bank,
National Association and H.F. Lenfest 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 Bank 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 net proceeds have been used by the
Company for working capital and general corporate purposes.
In accordance with the terms of an amendment dated April 30, 2003, the
PNC Bank facility was increased and, as of the date of this Quarterly Report on
Form 10-Q, includes: (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 bank 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.
25
The terms and conditions of the revolving loan and the line of credit
are set forth in a Credit Agreement, as amended, between the Company and PNC
Bank. Availability under both the main facility and the EXIM facility are
determined each month based on a borrowing base consisting of a portion of the
Company's receivables, inventory and costs and estimated earnings in excess of
billings, net of billings in excess of costs and estimated earnings on
uncompleted long-term contracts. As of November 28, 2003, availability under the
$14,800,000 revolving facility was $7,626,000, of which the Company had utilized
$7,157,000, and availability under the EXIM facility was $328,000, which was
fully available.
The obligations of the Company to PNC Bank under the Credit Agreement
are secured by a first priority lien on and senior security interest in all of
the assets of the Company, including all real property owned by the Company.
At November 28, 2003, the Company was in violation of three of its
financial covenants in its Bank Credit Agreement and two of its covenants in its
Convertible Note and Warrant Purchase Agreement. These violations occurred as a
result of the second and third quarter fiscal 2004 net losses. As of the date of
this Quarterly Report on Form 10-Q, the Company has obtained waivers for these
covenant violations from both the Bank and the Note holder. Notwithstanding the
covenant violations at November 28, 2003, it is the opinion of management based
on the current sales backlog, forecasted new contract bookings and claim
arbitration discussions that it is not probable that the Company will have
additional covenant violations going forward. However, should there be
unforeseen delays in completing existing contracts, should the receipt of new
contracts be delayed, or should arbitration discussions be delayed or extended,
it is possible that additional covenant violations may occur.
In connection with the financing provided by Mr. Lenfest, the Company
entered into a Convertible Note and Warrant Purchase Agreement with Mr. Lenfest,
pursuant to which the Company issued to Mr. Lenfest (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 the Company's common stock. Upon the
occurrence of certain events, the Company 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.
The obligations of the Company to Mr. Lenfest under the Convertible
Note and Warrant Purchase Agreement are secured by a second priority lien on and
security interest in all of the assets of the Company, junior in rights to the
liens and security interests in favor of PNC Bank, including all real property
owned by the Company.
26
Prior to the consummation of the refinancing, ETC Asset Management,
LLC, a shareholder of the Company and a holder of warrants to purchase 332,820
shares of the Company's common stock, consented to the transactions contemplated
under the Credit Agreement and the financing provided by Mr. Lenfest, including
the below market issuance of warrants to Mr. Lenfest. As a result of its
consent, ETC Asset Management waived, solely in connection with such issuance,
the anti-dilution rights contained in its warrant. In exchange for ETC Asset
Management's consent, the Company issued to ETC Asset Management 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 ETC Asset Management
warrants have substantially the same terms as the warrants issued to Mr.
Lenfest.
To fund its operations, the Company plans to utilize cash from
operations, potential arbitration proceeds as well as additional cash available
under the revolving and EXIM facilities as the borrowing base expands and
international letters of credit expire. The Company believes that cash generated
from operating activities as well as future availability under its credit
agreement will be sufficient to meet its future obligations for the foreseeable
future.
The following table presents our contractual cash flow commitments on
long-term debt and operating leases.
Payments Due by Period (in thousands)
-------------------------------------
Less Than
Total 1 Year 1-3 Years 4-5 Years After 5 Years
----- ------ --------- --------- -------------
Long-term debt, including
current maturities $13,447 $281 $2,028 $550 $10,588
Operating leases 343 168 175 - -
------- ---- ------ ---- -------
Total $13,790 $449 $2,203 $550 $10,588
Contract Claims
Historically, the Company has had positive experience with regard to
its contract claims in that recoveries have exceeded the carrying value of
claims. As of November 28, 2003, claims recorded against the U.S. Government
totaled $2,899,000 and claims recorded against an international customer totaled
$10,269,000.
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 2004. In
conformity with accounting principles generally accepted in the United States,
revenue recorded by the Company from a claim may not exceed the incurred
contract costs related to the claim.
27
In November 2003, the U.S. Government completed an audit of one of the
company's claims, 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. The Company considers 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. Additionally the Company is currently preparing an update to
the claim to incorporate additional spending related to the claim items. During
the 13 weeks ended November 28, 2003 this customer, citing failure to deliver
product within contract terms, began assessing liquidated damages by offsetting
progress payments due 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, the Company has reduced contract values and corresponding revenue
recognition for an estimated amount to cover a delay through the extended
delivery period.
With respect to the claims filed against an international customer, the
Company is currently mediating and arbitrating the disputes that have arisen
under two contracts with one of its international customers in the United
Kingdom but is unable to assess the ultimate impact of either the termination or
the arbitration on current operations and financial condition.
Based on witness statements, expert reports and other facts, the
Company believes that it has a reasonable basis to refute the concerns of the
U.K. Ministry of Defense. The Company has installed seven centrifuges in the
last 15 years at various locations throughout the world and the Company is
unaware of any accidents or injuries caused by the operation of these
centrifuges. To the extent the Company is unsuccessful in further recovery of
contract costs, such an event could have a material adverse effect on the
Company's liquidity and results of operations. The Company does not plan to
reduce the carrying value of the claim until all unresolved matters have been
properly adjudicated in the arbitration proceedings.
The Company has an open receivable balance of $700,000 due from the
RTAF. This amount represents the total net exposure to the Company on this
contract. On June 16, 2003, the Company's Thai attorneys 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. This document is currently being translated into
English. In December 2003 the Company and the RTAF both picked arbitrators to
represent them in the duspute, although no date has yet been set for the
Arbitration proceedings. 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 has enjoyed 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, and it is not anticipated that the initiation of legal action
against the RTAF will have any material adverse impact on future 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 under this contract.
28
Backlog
The Company's sales backlog at November 28, 2003 and February 28, 2003,
for work to be performed and revenue to be recognized under written agreements
after such dates was approximately $11,968,000 and $21,454,000 respectively. In
addition, the Company's training, maintenance and upgrade contracts backlog at
November 28, 2003, and February 28, 2003, for work to be performed and revenue
to be recognized after that date under written agreements was approximately
$3,582,000 and $3,931,000 respectively. Of the November 28, 2003 backlog,
approximately $6,513,000 was under contracts for ATS products including
$3,785,000 for the Royal Malaysian Air Force.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not Applicable.
Item 4. Controls and Procedures.
Under the supervision and with the participation of the Company's
management, including the Company's principal executive officer and principal
financial officer, the Company has evaluated the effectiveness of the design and
operation of the Company's disclosure controls and procedures as of November 28,
2003 (the "Evaluation Date"), and, based on their evaluation, the Company's
principal executive officer and principal financial officer have concluded that
these controls and procedures were effective as of the Evaluation Date. There
were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls subsequent to 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 the
Company's internal controls and other procedures that are designed to ensure
that information required to be disclosed by the Company in the reports that it
files or submits 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
required to be disclosed by the Company in the reports that it files under the
Exchange Act is accumulated and communicated to the Company's management,
including the Company's principal executive officer and principal financial
officer, as appropriate to allow timely decisions regarding required disclosure.
29
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 has just begun and
the Company is unable to predict the outcome of this matter.
In June 2003, Associated Mezzanine Investors, LLC ("AMI") filed suit
against the Company in the United States District Court for the Eastern District
of Pennsylvania seeking payment of $195,682.86 for costs, fees and expenses
allegedly due to AMI pursuant to the terms of an agreement which the Company
entered into with AMI (the "AMI Agreement"). AMI claims that it located suitable
investors for the Company's February 2003 financing transaction and that it
earned the claimed fees and is entitled to reimbursement of the claimed costs
and expenses pursuant to the terms of the AMI Agreement. The Company has
responded to the complaint. The Company believes that it has valid defenses to
each of the claims of AMI and intends to vigorously defend itself against these
claims. At this time, however, the Company is unable to predict the outcome of
this matter.
In June 2003, Entertainment Technology Corporation, a wholly-owned
subsidiary of the Company, 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 Entertainment
Technology Corporation 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 $150,000. Entertainment Technology Corporation 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, however, discovery is still ongoing and Entertainment Technology
Corporation and the Company are unable to predict the outcome of this matter.
30
Certain claims, suits and complaints arising in the ordinary course of
business have been filed or are pending against the Company. 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 the
Company's 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.
Item 4. Submission of Matters to Vote of Security Holders
At the Company's Annual Meeting of Stockholders held on September 11,
2003 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 6,026,023 2,200 0
Howard W. Kelley 6,026,023 2,200 0
H.F."Gerry"Lenfest 6,026,023 2,200 0
William F. Mitchell 5,736,928 293,515 0
Pete L. Stephens 6,026,023 2,200 0
31
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.
31.1 Certification dated January 12, 2004 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 12, 2004 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 12, 2004 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 15, 2003, the Company filed a Current Report on Form 8-K
reporting its financial results for the second quarter of fiscal 2004.
32
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 12, 2004 By: /s/ William F. Mitchell
-------------------------------------
William F. Mitchell
President and Chief
Executive Officer
(Principal Executive Officer)
Date: January 12, 2004 By: /s/ Duane Deaner
-------------------------------------
Duane Deaner,
Chief Financial Officer
(Principal Financial and
Accounting Officer)
33