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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 May 28, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______ to _______
Commission File No. 1-10655
ENVIRONMENTAL TECTONICS CORPORATION
-------------------------------------------------------
(Exact name of registrant as specified in its charter)
Pennsylvania 23-1714256
- -------------------------------- -------------------
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification No.)
COUNTY LINE INDUSTRIAL PARK
SOUTHAMPTON, PENNSYLVANIA 18966
----------------------------------------
(Address of principal executive offices)
(Zip Code)
(215) 355-9100
----------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for at least the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes No X
----- -----
The number of shares outstanding of the registrant's common stock as of
June 30, 2004 is: 7,634,910.
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
May 28, May 30,
2004 2003
------------ ------------
Net Sales $6,175 $6,130
Cost of goods sold 5,181 3,843
------- ------
Gross profit 994 2,287
------- ------
Operating expenses:
Selling and administrative 2,430 1,685
Research and development 209 82
------- ------
2,639 1,767
------- ------
Operating (loss)/income (1,645) 520
------- ------
Other expenses:
Interest expense 344 378
Other, net 85 9
------- ------
429 387
------- ------
(Loss)/income before income taxes (2,074) 133
(Benefit from)/provision for income taxes (614) 67
------- ------
(Loss)/income before minority interest (1,460) 66
Profit/(Loss) attributable to minority interest 1 (4)
------- ------
Net (loss)/income $(1,461) $70
======= ======
================================================================================
Per share information:
(Loss) applicable/income available to
common shareholders $(1,461) $70
(Loss)/income per share: basic $(0.19) $0.01
(Loss)/income per share: diluted $(0.19) $0.01
Number of shares: basic 7,635,000 7,157,000
Number of shares: diluted 7,635,000 7,751,000
The accompanying notes are an integral part of the consolidated financial
statements.
2
Environmental Tectonics Corporation
Consolidated Balance Sheets
May 28, February 27,
2004 2004
---------------------------------------------
(unaudited)
-----------------------
(amounts in thousands, except share
information)
Assets
Current assets:
Cash and cash equivalents $ 7,850 $ 1,366
Cash equivalents restricted for letters of credit 1,517 784
Accounts receivable, net 10,546 19,233
Costs and estimated earnings in excess of billings on uncompleted
long-term contracts 5,123 5,333
Inventories 8,875 9,843
Deferred tax asset 1,337 1,337
Prepaid expenses and other current assets 2,481 1,949
--------- --------
Total current assets 37,729 39,845
--------- --------
Property, plant and equipment, at cost, net of accumulated
depreciation of $10,825 at May 28, 2004 and $10,651 at
February 27, 2004 5,363 4,886
Software development costs, net of accumulated amortization of $7,714
at May 28, 2004 and $7,494 at February 27, 2004 3,248 3,089
Goodwill and intangibles 477 477
Other assets, net 320 399
--------- --------
Total assets $ 47,137 $ 48,696
========= ========
Liabilities and Stockholders' Equity
Liabilities
Current liabilities:
Current portion of long-term debt $ 313 $ 317
Accounts payable - trade 1,744 2,431
Billings in excess of costs and estimated earnings on uncompleted
long-term contracts 1,762 945
Customer deposits 3,080 3,657
Accrued liabilities 2,500 2,588
--------- --------
Total current liabilities 9,399 9,938
--------- --------
Long-term debt, and capitalized lease obligations, less current portion:
Credit facility payable to banks - 30
Long-term bonds, net 4,095 4,370
Subordinated debt 7,743 7,666
Capitalized lease obligations 82 91
--------- --------
11,920 12,157
--------- --------
Deferred income taxes 1,502 1,502
--------- --------
Total liabilities 22,821 23,597
--------- --------
Minority interest 46 45
Stockholders' Equity
Common stock; $.05 par value; 20,000,000 shares authorized; 7,634,910 and
7,176,552 issued and outstanding at May 28, 2004 and February
27, 2004, respectively 381 359
Capital contributed in excess of par value of common stock 10,132 9,430
Accumulated other comprehensive loss (376) (329)
Retained earnings 14,133 15,594
--------- --------
Total stockholders' equity 24,270 25,054
--------- --------
Total liabilities and stockholders' equity $ 47,137 $ 48,696
========= ========
The accompanying notes are an integral part of the consolidated financial
statements.
3
Environmental Tectonics Corporation
Consolidated Statements of Cash Flows
(unaudited)
Thirteen Weeks Ended
----------------------------------
May 27, May 30,
2004 2003
----------- ----------
(amounts in thousands)
Cash flows from operating activities:
Net (loss)/income $(1,461) $70
Adjustments to reconcile net (loss)/income to net cash
provided by operating activities:
Depreciation and amortization 474 415
Non-cash interest expense 77 65
Provision for losses on accounts receivable and
inventories 1 50
Minority interest 1 (4)
Changes in operating assets and liabilities:
Accounts receivable 8,687 884
Costs and estimated earnings in excess of billings on
uncompleted long-term contracts 210 (1,165)
Inventories 374 (1,084)
Prepaid expenses and other current assets (532) (945)
Other assets (1) -
Accounts payable (687) 772
Billings in excess of costs and estimated earnings on
uncompleted long-term contracts 817 30
Customer deposits (577) 949
Accrued income taxes - 1
Other accrued liabilities (88) 7
------- -------
Net cash provided by operating activities 7,295 45
------- -------
Cash flows from investing activities:
Acquisition of equipment (58) (95)
Capitalized software development costs (379) (233)
------- -------
Net cash used in investing activities (437) (328)
------- -------
Cash flows from financing activities:
Payments under credit facility (30) (600)
Repayment of long-term bonds (275) (275)
Cash equivalents restricted for letters of credit (733) (709)
Proceeds from issuance of common stock / warrants 724 -
Deferred finance charges/other (13) (28)
------- -------
Net cash used in financing activities (327) (1,612)
------- -------
Effect of exchange rate changes on cash (47) (109)
------- -------
Net increase/(decrease) in cash and cash equivalents 6,484 (2,004)
Cash and cash equivalents at beginning of period 1,366 4,305
------- -------
Cash and cash equivalents at end of period $7,850 $2,301
======= =======
Supplemental schedule of cash flow information:
Interest paid 220 19
Income taxes paid 1 56
Supplemental information on noncash operating and investing activities:
During the thirteen weeks ended May 28,2004, the Company reclassified
$593 from inventory to fixed assets.
The accompanying notes are an integral part of the consolidated financial
statements.
4
Environmental Tectonics Corporation
Notes to Consolidated Financial Statements
(amounts in dollars, except where noted and share and
per share information)
1. Basis of Presentation
The accompanying consolidated financial statements include the accounts
of Environmental Tectonics Corporation ("ETC" or the "Company"), Entertainment
Technology Corporation ("EnTCo"), ETC International Corporation and
ETC-Delaware, its wholly-owned subsidiaries, ETC Europe, its 99% owned
subsidiary and ETC-PZL Aerospace Industries, Ltd. ("ETC-PZL"), its 95% owned
subsidiary.
The accompanying consolidated financial statements have been prepared
by ETC, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission, and reflect all adjustments which, in the opinion of
management, are necessary for a fair presentation of the results for the interim
periods presented. All such adjustments are of a normal recurring nature.
Certain information in footnote disclosures normally included in
financial statements prepared in conformity with accounting principles generally
accepted in the United States of America has been condensed or omitted pursuant
to such rules and regulations and the financial results for the periods
presented may not be indicative of the full year's results, although the Company
believes the disclosures are adequate to make the information presented not
misleading. These financial statements should be read in conjunction with the
financial statements and the notes thereto included in the Company's Annual
Report on Form 10-K for the year ended February 27, 2004. Certain
reclassifications have been made to the fiscal 2004 financial statements to
conform with the fiscal 2005 presentation.
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 May 28, 2004 Thirteen weeks ended May 30, 2003
------------------------------------------------ --------------------------------------------
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) applicable/
earnings available
to common stockholders $(1,461) 7,635,000 $(0.19) $70 7,157,000 $0.01
Effect of dilutive
securities
Options - - 11,000
Warrants - - 583,000
Diluted EPS
Net(loss) applicable/
earnings available
to common stockholders
plus assumed
conversions $(1,461) 7,635,000 $(0.19) $70 7,751,000 $0.01
At May 28, 2004 there were stock options to purchase the Company's common stock
totaling 357,802 shares which were not included in the computation of diluted
earnings per share, as the effect of such would be anti-dilutive. Additionally,
there was subordinated debt with a face value of $10,000,000 which was
convertible at an exercise price of $6.05 per share, equating to 1,652,893
shares if fully converted to common shares. Upon each conversion of the
subordinated 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 was converted
into common shares, then warrants to purchase an additional 165,289 shares would
be issued, bringing the total shares to be issued to 1,818,182. Additionally, at
May 28, 2004, there were outstanding warrants to purchase the Company's stock
totaling 803,048 shares. None of these shares were included in the computation
of diluted earnings per share as the effect would be anti-dilutive.
At May 30, 2003, there were employee stock options to purchase the Company's
stock totaling 331,764 shares which were not included in the computation of
diluted earnings per share, as the effect of such options would be
6
anti-dilutive. Additionally, there was subordinated debt with a face value of
$10,000,000 which was convertible at an exercise price of $6.05 per share,
equating to 1,652,893 shares if fully converted to common shares. Upon each
conversion of the subordinated 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, then warrants to purchase an
additional 165,289 shares would be issued, bringing the total shares to be
issued to 1,818,182. Additionally, there were outstanding warrants to purchase
the Company's stock totaling 1,240,868 shares. None of these shares were
included in the computation of diluted earnings per share as the effect would be
anti-dilutive.
3. Stock Options
The Company accounts for stock options under SFAS No. 123, "Accounting
for Stock-Based Compensation," as amended by SFAS No. 148, which contains a fair
value-based method for valuing stock-based compensation that entities may use,
which measures compensation cost at the grant date based on the fair value of
the award. Compensation is then recognized over the service period, which is
usually the vesting period. Alternatively, SFAS No. 123 permits entities to
continue accounting for employee stock options and similar equity instruments
under Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued
to Employees." Entities that continue to account for stock options using APB
Opinion 25 are required to make pro forma disclosures of net income and earnings
per share, as if the fair value-based method of accounting defined in SFAS No.
123 had been applied.
At May 28, 2004, the Company had one stock-based employee compensation
plan. The Company accounts for this plan under the recognition and measurement
principles of APB Opinion 25, "Accounting for Stock Issued to Employees," and
related interpretations. Stock-based employee compensation costs are not
reflected in net income, as all options granted under the plan had an exercise
price equal to the market value of the underlying common stock on the date of
grant. The following table illustrates the effect on net income and earnings per
share if the Company had applied the fair value recognition provisions of SFAS
No. 123, to stock-based employee compensation (in thousands, except per share
amounts).
7
Thirteen Weeks Ended
-----------------------------------------
May 28, 2004 May 30, 2003
----------------- -----------------
Net (loss)/income,
as reported $(1,461) $ 70
Less: stock-based compensation costs
determined under fair market value based
methods for all awards -- (5)
------- -----
Net (loss)/income, pro forma $ (1,461) $ 65
(Loss)/earnings per share of common stock-basic:
As reported $ (0.19) $ .01
Pro forma $ (0.19) $ .01
(Loss)/earnings per share of common stock-diluted:
As reported $ (0.19) $ .01
Pro forma $ (0.19) $ .01
There were no grants of stock options during the thirteen weeks ended May 28,
2004 or May 30, 2003.
4. Accounts Receivable
The components of accounts receivable are as follows:
May 28, February 27,
2004 2004
--------- ------------
(amounts in thousands)
U.S. Government receivables billed and unbilled contract costs
subject to negotiation $ 3,460 $ 3,128
U.S. commercial receivables billed 2,451 1,508
International receivables billed and unbilled contract costs
subject to negotiation 5,014 14,976
------- -------
10,925 19,612
Less allowance for doubtful accounts (379) (379)
------- -------
$10,546 $19,233
======= =======
U.S. Government receivables billed and unbilled contract costs subject to
negotiation:
Unbilled contract costs subject to negotiation as of May 28, 2004 and
February 27, 2004 respectively, 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 $833,000 recorded 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 U.S. Government has
agreed to issue a final decision on September 15, 2004. The Company considers
the recorded costs to be realizable due to the fact that the costs relate to
customer caused delays, errors and changes in specifications and designs,
disputed liquidated damages and other out of scope items. In the fiscal quarter
ended May 28, 2004, the Company submitted a supplement to the claim
incorporating additional cost items. During the third quarter of fiscal 2004 the
U.S. Government, citing failure to deliver the product within contract terms,
began assessing liquidated damages by offsetting progress payments due the
Company under the contract. However, during the fiscal quarter ended May 28,
2004, citing "substantial material progress" on the project, the U.S. Government
agreed to release all outstanding invoice payments which had previously been
8
withheld for liquidated damages. The Company disputes the basis for these
liquidated damages, noting that applicable U.S. Government purchasing
regulations allow for a waiver of these charges if the delay is beyond the
control and not due to the fault or negligence of the Company. However,
following accounting principles generally accepted in the United States of
America, the Company has reduced contract values and corresponding revenue
recognition for an estimated amount of $330,000 to cover a delay through the
extended delivery period.
International receivables billed and unbilled contract costs subject to
negotiation:
International receivables billed includes $700,000 at May 28, 2004 and
February 27, 2004, respectively, related to a contract with the Royal Thai Air
Force ("RTAF").
In October 1993, the Company was notified by the RTAF that the RTAF was
terminating a $4,600,000 simulator contract with the Company. Although the
Company had performed in excess of 90% of the contract, the RTAF alleged a
failure to completely perform. In connection with this termination, the RTAF
made a call on a $230,000 performance bond, as well as a draw on an
approximately $1,100,000 advance payment letter of credit. Work under this
contract had stopped while under arbitration, but on October 1, 1996, the Thai
Trade Arbitration Counsel rendered its decision under which the contract was
reinstated in full and the Company was given a period of nine months to complete
the remainder of the work. Except as noted in the award, the rights and
obligations of the parties remained as stated in the original contract including
the potential invoking of penalties or termination of the contract for delay. On
December 22, 1997, the Company successfully performed acceptance testing and the
unit passed with no discrepancy reports. Although the contract was not completed
in the time allotted, the Company has requested an extension on the completion
time due to various extenuating circumstances, including allowable "force
majeure" events, one of which was a delay in obtaining an export license to ship
parts required to complete the trainers. On August 30, 2001, the Company
received a payment of $230,000 representing the amount due on the performance
bond.
The open balance of $700,000 due on the contract represents the total
net exposure to the Company on this contract. On June 16, 2003, the Company'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. 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.
Citing a conflict of interest on the part of the RTAF's arbitrator, the Company
was successful in having the RTAF's arbitrator disqualified and the RTAF is
currently in the process of appointing an alternative. 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
9
unappealable legal decision is rendered by a competent Thai tribunal. The
Company continues to enjoy a favorable relationship with the RTAF. It currently
has a maintenance contract with the RTAF and has performed upgrades for the
trainers that are the subject of the dispute. Additionally, the Company has sold
a significant amount of additional equipment to the RTAF since this dispute
began, therefore 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 a claim
($2,600,000 recorded as of May 28, 2004) made against an international customer
for a contract covering the period from 1997 to the present. Claim costs have
been incurred in connection with customer caused delays, errors in
specifications and designs, other out-of-scope items and exchange losses and may
not be received in full during fiscal 2005. In conformity with accounting
principles generally accepted in the United States of America, revenue recorded
by the Company from a claim does not exceed the incurred contract costs related
to the claim. The Company and the customer are currently in the discovery phase
of the arbitration process. The Company has filed its "Points of Claim" to which
the customer has replied. Additionally, the customer has filed a counterclaim
which the Company answered subsequent to the fiscal quarter end. The customer,
citing failure to deliver product within contract terms, has assessed liquidated
damages totaling approximately $400,000 on the contract. The Company disputes
the basis for these liquidated damages and is vigorously contesting them.
However, following accounting principles generally accepted in the United States
of America, the Company has reduced contract values and corresponding revenue
recognition by approximately $400,000.
Effective February 27, 2004, the Company reached an agreement totaling
$10.5 million with the same international customer on another claim, thus
resolving all outstanding amounts related to that claim. These proceeds were
received on March 16, 2004. (See also the Liquidity and Capital Resources
section of the Management's Discussion and Analysis of Results of Operations and
Financial Condition following.)
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
$565,000 at May 28, 2004 and February 27, 2004):
May 28, February 27,
2004 2004
------------ ---------------
(amounts in thousands)
Raw materials $ 315 $ 311
Work in Process 7,191 7,803
Finished Goods 1,369 1,729
------ ------
Total $8,875 $9,843
====== ======
10
6. Stockholders' Equity
The components of stockholders' equity at February 27, 2004 and May 28,
2004 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 27, 2004 7,176,552 $359 $9,430 $(329) $15,594 $25,054
Net loss for the thirteen weeks ended
May 28, 2004 - - - - (1,461) (1,461)
Foreign currency translation
adjustment - - - (47) - (47)
-------
Total comprehensive loss - - - (47) - (1,508)
-------
Shares issued in connection with
exercise of warrants 437,820 21 565 - - 586
Shares issued upon exercise of
employee stock options 20,538 1 137 - - 138
---------- ----- ------- ----- ------- -------
Balance at May 28, 2004 7,634,910 $381 $10,132 $(376) $14,133 $24,270
========== ===== ======= ===== ======= =======
7. Long Term Debt
The following table lists the long-term debt and other long-term
obligations of the Company as of May 28, 2004.
PAYMENTS DUE BY PERIOD
Obligation Total Less than 1 Year 1-3 Years 4-5 Years After 5 Years
- ---------- ----- ---------------- --------- --------- -------------
Current Portion of
Long Term Debt $ 275 $ 275 $ - $ - $ -
Long-term Debt - - - - -
Capital Leases 120 38 82 - -
Subordinated debt, net of
unamortized discount of
$2,257 7,743 - - 7,743 -
Long term bonds 4,095 - 825 550 2,720
--------- ------- -------- -------- --------
Total Obligations $ 12,233 $ 313 $ 907 $ 8,293 $ 2,720
========= ======= ======== ======== ========
As part of our bank and subordinated debt agreements, the Company must
also meet certain financial covenants including a Leverage Ratio, a Fixed Charge
Ratio and a Tangible Net Worth Ratio. At May 28, 2004, the Company failed to
meet most of these covenants but has obtained waivers of such violations from
both of its lenders. The waivers are solely for the period specified, namely the
fiscal quarter ended May 28, 2004. Except as specified, the waiver does not
constitute a modification or alteration of any other terms or conditions in the
respective agreements, or a release of any of the lender's rights or remedies,
all of which are reserved, nor does it release the Company or any guarantor from
any of its duties, obligations, covenants or agreements including the
consequences of any Event of Default, except as specified.
As a result of the Company's operating performance during fiscal 2004 and
its violation of its financial covenants, during the first quarter of fiscal
2005 PNC Bank advised the Company that it was instituting certain changes to the
revolving credit facility. The changes included reducing the facility to
$6,000,000 and requiring the Company to cash collateralize the full facility.
Although no formal agreements have yet been signed, these changes place
effective June 2, 2004. Given the bank's actions, we may need to obtain
11
additional sources of capital in order to continue growing our business. We
believe that we will be able to locate such additional sources of capital and
that these changes to the existing facility will not have a long-term material
adverse effect on our business. The financing alternatives currently include
applying for Pennsylvania State business development funds and seeking
additional financial support from the Company's current subordinated lender
including guarantees for the Company's international letters of credit and a
revolving line of credit.
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 MAY 28, 2004
Net Sales $4,401 $1,774 $6,175
Interest Expense 237 107 344
Depreciation and Amortization 327 147 474
Operating loss (744) (632) (1,376)
Income Tax Benefit 320 224 544
Goodwill and Intangibles 477 - 477
Identifiable Assets 19,541 8,251 27,792
Expenditures For Segment Assets 41 17 58
THIRTEEN WEEKS ENDED MAY 30, 2003
Net Sales $2,985 $3,145 $6,130
Interest Expense 294 84 378
Depreciation and Amortization 217 263 480
Operating Income/(Loss) 181 647 828
Income Tax (Benefit)/Provision (57) 282 225
Goodwill and Intangibles 477 - 477
Identifiable Assets 26,219 7,499 33,718
Expenditures For Segment Assets 74 21 95
Reconciliation to consolidated amounts 2004 2003
---- ----
Corporate Assets $19,345 $ 14,409
------- --------
Total Assets $47,137 $48,604
Segment operating (loss)/income $(1,376) $ 828
Less interest expense (344) (378)
Income taxes benefit/(expense) 544 (225)
------- --------
Total (loss)/profit for segments (1,176) 225
Corporate home office expenses (269) (308)
Interest and other expenses (85) (9)
Income tax benefit 70 158
Minority interest (1) 4
------- --------
Net (loss)/income $(1,461) $ 70
======= ========
=========================================================================================================================
12
Segment operating income consists of net sales less applicable costs
and expenses relating to these revenues. Unallocated general corporate expenses,
letter of credit fees, interest expense and income taxes have been excluded from
the determination of the total profit/loss for segments. Corporate home office
expenses are primarily central administrative office expenses. Interest and
other expenses include banking and letter of credit fees. Property, plant and
equipment are not identified with specific business segments, as these are
common resources shared by all segments.
Approximately 44% of sales totaling $2,688,000 in the thirteen weeks
ended May 28, 2004 were made to three international customers in the ATS
segment. Approximately 37% of sales totaling $2,253,000 in the thirteen weeks
ended May 30, 2003 were made to one domestic and one international customer in
the sterilizer and ATS segments respectively.
Included in the segment information for the thirteen weeks ended May
28, 2004 are export sales of $3,678,000. Of this amount, there are sales to or
relating to governments or commercial accounts in Malaysia ($1,225,000),
Australia ($745,000), and Egypt ($718,000). Sales to the U.S. Government and its
agencies aggregated $447,000 for the period.
Included in the segment information for the thirteen weeks ended May
30, 2003 are export sales of $2,971,000. Of this amount, there are sales to or
relating to governments or commercial accounts in Malaysia ($815,000), Norway
($495,000), and Greece ($484,000). Sales to the U.S. Government and its agencies
aggregated $335,000 for the period.
9. Recent Accounting Pronouncements
Consolidation of Variable Interest Entities:
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 this
statement did not have a significant impact on the Company's consolidated
financial position, results of operations, or cash flows since the Company
currently has no VIEs. In December 2003, the FASB issued FIN 46R with respect to
VIEs created before January 31, 2003, which, among other things, revised the
implementation date to the first fiscal year or interim period ending after
13
March 15, 2004, with the exception of Special Purpose Entities (SPE). The
consolidation requirements apply to all SPEs in the first fiscal year or interim
period ending after December 15, 2003. The Company adopted the provision of FIN
46R effective February 27, 2004, and such adoption did not have a material
impact on the consolidated financial statements since the Company currently has
no SPEs.
Accounting for Certain Financial Instruments
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.
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
14
known and unknown risks, uncertainties and assumptions about the Company and its
subsidiaries that may cause actual results, levels of activity, performance or
achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by these
forward-looking statements.
These forward-looking statements include statements with respect to the
Company's vision, mission, strategies, goals, beliefs, plans, objectives,
expectations, anticipations, estimates, intentions, financial condition, results
of operations, future performance and business of the Company, including but not
limited to, (i) projections of revenue, costs of raw materials, income or loss,
earnings or loss per share, capital expenditures, growth prospects, dividends,
capital structure, other financial items and the effects of currency
fluctuations, (ii) statements of plans and objectives of the Company or its
management or Board of Directors, including the introduction of new products, or
estimates or predictions of actions of customers, suppliers, competitors or
regulatory authorities, (iii) statements of future economic performance, (iv)
statements of assumptions and other statements about the Company or its
business, and (v) statements preceded by, followed by or that include the words
"may", "could", "should", "looking forward", "would", "believe", "expect",
"anticipate", "estimate", "intend", "plan", or the negative of such terms or
similar expressions. These forward-looking statements involve risks and
uncertainties which are subject to change based on various important factors.
Some of these risks and uncertainties, in whole or in part, are beyond the
Company's control. Factors that might cause or contribute to such a material
difference include, but are not limited to, those discussed in the Company's
Annual Report on Form 10-K for the fiscal year ended February 27, 2004, in the
section entitled "Risks Particular to Our Business." Shareholders are urged to
review these risks carefully prior to making an investment in the Company's
common stock.
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.
The following factors had an adverse impact on our performance for the
fiscal quarter ended May 28, 2004:
o Unfavorable global economic and political conditions;
o Technical and other issues which delayed completion of some
projects; and
o Higher costs of capital.
15
Our new sales bookings performance continued to be hampered by unfavorable
global economic and political conditions. Many new projects continue to face
budget constraints and other governmental delays by our customers throughout the
world. While we have seen some heightened proposal activity in some of our
businesses, most notably sterilizers, and have booked some significant projects
in the ATS area in the first quarter of fiscal 2005, we still remain cautious
about the volume of new contracts which will be awarded in the near term.
Many of our products, especially in the ATS and environmental lines,
incorporate new state-of-the-art or unproven technologies. Occasionally, given
the difficult logistics of installation and acceptance requirements in foreign
locations, we experience delays in the final completion and receipt of final
payment for a project. This can have a negative impact on revenue recognition
and gross margin performance, especially if additional spending is required or
if customer induced delays occur. Although some significant long-standing
contracts were closed in the first quarter of fiscal 2005, additional contracts
continued to experience various delays. This situation unfortunately is
applicable to many of our product lines and tends to create an element of
unpredictability to our financial performance.
The Company's relatively high average cost of capital continues to have a
negative impact on its financial results. Although the Company's cash
collections were very strong during this quarter (including the collection of
$10.5 million under a settlement of an international claim), due to the
requirement by the Company's bank to cash collateralize outstanding facility
usage, no repayment of the Company's subordinated debt could be effected, nor is
any anticipated in the near future. Given the bank's recent actions, we may need
to obtain additional sources of capital in order to continue growing our
business, and the cost of any additional funds may be relatively high. We
believe that we will be able to locate such additional sources of capital and
that these actions by our bank will not have a long-term material adverse effect
on our business. The financing alternatives currently include applying for
Pennsylvania State business development funds and seeking additional financial
support from the Company's current subordinated lender including guarantees for
the Company's international letters of credit and a revolving line of credit.
The Company faces various challenges in order to make fiscal 2005 a
successful year. The following is a list of the major issues we face. (The
reader is referred to the Management's Discussion and Analysis of Financial
Condition and Results of Operations included in the Company's Annual Report on
Form 10-K for the fiscal year ended February 27, 2004.)
o Sell through all of the products we technologically enhanced in
fiscal 2004.
o Continue to evolve Advanced Tactical Flight Simulation (ATFS).
o Re-engineer the products in our ATS group to remain competitive.
16
o Standardize the environmental line of products.
o Expand the entertainment line by repeat sales and the introduction
of story line enhancements.
o Settle at least one major claim.
o Balance overhead and sales, general and administrative (SG&A)
spending levels to be more in line with the current level of sales
volume.
A significant portion of the Company's SG&A spending is related to
three activities: 1. legal and claims costs associated with the
Company's ongoing contract claims, 2. outside agent and sales
personnel commissions on booked contracts and 3. additional
accounting, legal, and stockholder's costs required to comply with
applicable statutes, rules and regulations as a public company.
The Company faces a challenge to continuously review and adjust
the operating expense portion of overhead spending.
o Rejuvenate the sales force and sales booking level
The Company has recently both added professional sales personnel
and re-arranged sales duties in certain business units in an
effort to address the difficult global economic conditions facing
our businesses.
o Prioritize and focus our product development
To remain competitive and maintain our niche position, the nature
of our products and markets requires us to continuously invest in
product enhancements and, occasionally, new products. Also, the
product development and selling cycles for most of our products
extend beyond one year. The cost of this development is not always
covered in our selling prices and consequently has a negative
impact on current operating performance, since the results of our
efforts will not be seen until future contracts are obtained.
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
17
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.
Effective with the beginning of this fiscal year, the Company is
changing the parameters for application of the percentage of completion method
of revenue recognition. The minimum contract value is being raised to include
all contracts over $250,000 and the minimum completion period is being shortened
to six months for a contract to apply for this method. (The criteria in prior
years was contracts over $100,000 in value with a completion period of one year
or more.) This change applies to contracts entered into or started after
February 27, 2004. Given the nature and mix of contracts booked in the recent
years, the Company feels adjusting the criteria in this way will allow for a
more representative reporting of the production flow and earnings process. The
Company is unable to quantify the impact this change would have had on prior
years.
Revenue for contracts under $250,000, or to be completed in less than
six months, and where there are no post-shipment services included in the
contract, is recognized on the date that the finished product is shipped to the
customer.
Revenue derived from the sale of parts and services is also recognized
on the date that the finished product is shipped to the customer. Revenue on
contracts under $250,000, or to be completed in less than six months, and where
post-shipment services (such as installation and customer acceptance) are
required, is recognized following customer acceptance. 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 of America, recognizing revenue on contract claims and disputes
related to customer caused delays, errors in specifications and designs, and
other unanticipated causes, and for amounts in excess of contract value, is
generally appropriate if it is probable that the claim will result in additional
contract revenue and if 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 the 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 of America. The preparation of these
financial statements requires the Company to make estimates and judgments that
affect the reported amount of assets and liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities at the date of the
Company's financial statements. Actual results may differ from these estimates
under different assumptions or conditions.
Critical accounting policies are defined as those that reflect
significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. The Company
believes that its critical accounting policies include those described below.
For a detailed discussion on the application of these and other accounting
policies, see Note 1 to the Consolidated Financial Statements, Summary of
Significant Accounting Policies in the Company's Annual Report on Form 10-K for
the fiscal year ended February 27, 2004, which was filed with the Securities and
Exchange Commission on May 27, 2004.
Revenue Recognition on Long-Term Contracts
When the performance of a contract requires a customer to pay the
Company more than $250,000 and will extend beyond a six-month period, revenue
and related costs are recognized on the percentage-of-completion method of
accounting. Profits expected to be realized on such contracts are recognized
based on total estimated sales for the contract compared to total estimated
costs at completion of the contract. These estimates are reviewed periodically
throughout the lives of the contracts, and adjustments to profits resulting from
any revisions are made cumulative to the date of the change. Estimated losses on
long-term contracts are recorded in the period in which the losses become known
to 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.
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
19
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 MAY 28, 2004 COMPARED TO THIRTEEN WEEKS ENDED MAY 30, 2003.
Net Loss.
- --------
The Company had a net loss of $1,461,000, or ($0.19) per share
(diluted), during the first quarter of fiscal 2005 versus net income of $70,000,
or $.01 per share (diluted), for the first quarter of fiscal 2004, representing
a negative variance of $1,531,000. This decrease was due primarily to a
significant decrease in gross profit margin and an increase in selling, general
and administrative expenses partially offset by an income tax benefit.
Sales ($000 except for %)
Domestic Government International Total
--------------- ------------- ----------------- -------------
$ % $ % $ % $ %
FY05 Q1 2,050 33.2 447 7.2 3,678 59.6 6,175 100.0
FY04 Q1 2,824 46.1 335 5.5 2,971 48.4 6,130 100.0
Sales.
- -----
Sales for the first quarter of fiscal 2005 were $6,175,000 as compared
to $6,130,000 for the first quarter of fiscal 2004, an increase of $45,000 or
0.7%. The slight sales increase reflected significant increases in Aircrew
Training Systems (ATS) and environmental sales, up $2,008,000 (91.4%) and
$744,000 (338.2%), respectively, partially offset by decreases across the board
in the other business units, most notably sterilizers, which decreased
$1,567,000 (92.1%). The increase in ATS sales reflected higher sales for a
centrifuge project for Malaysia and the sale of two Gyro-IPTs in the current
period. Higher environmental sales resulted from additional projects in both the
domestic and international markets. The decrease in sterilizers reflected
reduced activity for a large domestic Ethylene Oxide ("ETO") sterilizer project.
Domestic Sales.
- --------------
Overall, domestic sales in the first quarter of fiscal 2005 were
$2,050,000 as compared to $2,824,000 in the first quarter of fiscal 2004, a
decrease of $774,000 or 27.4%, as a significant reduction in sterilizer sales
(down $1,567,000 (92.1%)) was only partially offset by increases in ATS (up
20
$776,000 (611.0%) and environmental (up $475,000 (399.2%)). Domestic sales
represented 33.2% of the Company's total sales in the first quarter of fiscal
2005, down from 46.1% for the first quarter of fiscal 2004. U.S. Government
sales in the first quarter of fiscal 2005 were $447,000 as compared to $335,000
in the first quarter of fiscal 2004. U.S. Government sales represented 7.2% of
total sales in the first quarter of fiscal 2005 versus 5.5% for the first
quarter of fiscal 2004.
International Sales.
- -------------------
International sales for the first quarter of fiscal 2005 were
$3,678,000 as compared to $2,971,000 in the first quarter of fiscal 2004, an
increase of $707,000 or 23.8%, and represented 59.6% of total sales, as compared
to 48.4% in the first quarter of fiscal 2004. Throughout the Company's history,
most of the sales for ATS have been made to international customers. In the
first quarter of fiscal 2005 international sales totaling at least ten percent
of total international sales were made to Malaysia ($1,225,000), Australia
($745,000) and Egypt ($718,000). In the first quarter of fiscal 2004
international sales totaling at least ten percent of total international sales
were made to Malaysia ($815,000). 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 first quarter of fiscal 2005 was $994,000 as
compared to $2,287,000 in the first quarter of fiscal 2004, a decrease of
$1,293,000 or 56.5%. This decrease reflected a 21.2 percentage point decrease in
the gross profit rate as a percent of sales. The reduced gross profit rate as a
percent of sales reflected across the board reductions in all business areas,
most notably simulation and hyperbaric. Installation cost overruns for three
projects in China and Italy generated negative gross margins totaling $333,000
in environmental, although one of these contracts was completed subsequent to
year end. ATS experienced unbudgeted expenses totaling $163,000 to complete an
upgrade of an airplane simulator in Egypt. And simulation expended additional
development funds totaling $131,000 for two international projects. It is
anticipated that the extra functionality added to these two simulation products
will make them marketable to fire schools and academies throughout Europe.
Selling and Administrative Expenses.
- -----------------------------------
Selling and administrative expenses for the first quarter of fiscal
2005 were $2,430,000 as compared to $1,685,000 in the first quarter of fiscal
2004, an increase of $745,000 or 44.2%. Most of the variance reflected the fact
that the first quarter of fiscal 2004 included a significant reimbursement of
legal and claim expenses associated with an arbitration hearing.
Research and Development Expenses.
- ---------------------------------
Research and development expenses, which are charged to operations as
incurred, were $209,000 for the first quarter of fiscal 2005 as compared to
$82,000 for the first quarter of fiscal 2004, reflecting an increase of $127,000
or 154.9%. The increase primarily reflected additional activity in the Company's
21
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.
Interest Expense.
- ----------------
Interest expense for the first quarter of fiscal 2005 was $344,000 as
compared to $378,000 for the first quarter of fiscal 2004, representing a
decrease of $34,000 or 9.0%. This decrease primarily reflected a reduced
interest rate for the Company's subordinated debt borrowed in February 2003.
Other Income/Expense, Net.
- -------------------------
Other income/expense, net, was a net expense of $85,000 for the first
quarter of fiscal 2005 versus a net expense of $9,000 for the first quarter of
fiscal 2004, an increase of $76,000. The first quarter of fiscal 2004 included a
significant foreign exchange gain on the collection of some foreign denominated
receivables.
Provision for Income Taxes.
- --------------------------
The Company's tax benefit for the first quarter of fiscal 2005
reflected an estimated 30% rate domestically and a consolidated estimated rate
of 29.6%. The domestic tax rate reflected the estimated impact of timing
differences and foreign sales and domestic research and development tax credits.
The international rate reflects no tax benefit for ETC Europe, a subsidiary of
the Company, since we are not assured there will be future tax liabilities to
utilize any current tax benefits.
LIQUIDITY AND CAPITAL RESOURCES
During the thirteen weeks ended May 28, 2004, the Company generated
$7,295,000 from operating activities. This was primarily the result of the
collection in March 2004 of a $10.5 million settlement on an international claim
coupled with a slight reduction in inventory and cash from non-cash expenses.
Acting as partial offsets were an increase in prepaid expenses and a decrease in
accounts payable and customer deposits.
The Company's investing activities used $437,000 during the thirteen
weeks ended May 28, 2004, which consisted of purchases of capital equipment and
capitalized software.
The Company's financing activities used $327,000 during the thirteen
weeks ended May 28, 2004, consisting primarily of a payment on the Company's
long-term bonds and an increase in the Company's cash collateral restricted cash
account. Acting as a partial offset was cash from the issuance of common stock
for exercised stock options and warrants. 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.
22
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 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 real estate 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 were used by the Company
for working capital and general corporate purposes.
As a result of the Company's operating performance during fiscal 2004
and its violation of certain financial covenants contained in the Bank
Agreement, during the first quarter of fiscal 2005 PNC Bank advised the Company
that it was instituting certain changes to the revolving credit facility. The
changes included reducing the facility to $6,000,000 and requiring the Company
to cash collateralize the full facility. Although no formal amendments have yet
been signed, these changes took place effective June 2, 2004. Given the bank's
actions, we may need to obtain additional sources of capital in order to
continue growing our business. We believe that we will be able to locate such
additional sources of capital and that these changes to the existing facility
will not have a long-term material adverse effect on our business. The financing
alternatives currently include applying for Pennsylvania State business
development funds and seeking additional financial support from the company's
current subordinated lender including guarantees for the Company's international
letters of credit and a revolving line of credit.
In accordance with the terms of an amendment dated April 30, 2003, the
PNC Bank facility was increased and, prior to the aforementioned change on June
2, 2004 included: (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.
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 May 28, 2004, the Company had no cash
borrowings from its bank.
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.
23
As part of our Bank and subordinated agreements, the Company must also
meet certain financial covenants including a Leverage Ratio, a Fixed Charge
Ratio and a Tangible Net Worth Ratio. At May 28, 2004 the Company failed to meet
each of these covenants and has obtained waivers of such violations from both of
its lenders. The waivers are solely for the period specified, namely the fiscal
quarter ended May 28, 2004. Except as specified, the waiver does not constitute
a modification or alteration of any other terms or conditions in the respective
agreements, or a release of any of the lender's rights or remedies, all of which
are reserved, nor does it release the Company or any guarantor from any of its
duties, obligations, covenants or agreements including the consequences of any
Event of Default, except as specified.
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.
Prior to the consummation of the February, 2003 refinancing, Advanced
Technology Asset Management, LLC, ("ATAM"), 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, ATAM waived, solely in
connection with such issuance, the anti-dilution rights contained in its
warrant. In exchange for ATAM's consent, the Company issued to ATAM warrants to
purchase an additional 105,000 shares of common stock. Except for the number of
shares issuable upon exercise of the warrants, the new ETC Asset Management
warrants have substantially the same terms as the warrants issued to Mr.
Lenfest. In March 2004 ATAM exercised all of its warrants and received a total
of 437,820 shares of common stock of the Company. The Company received proceeds
of $586,410 from the exercise of these warrants.
To fund its operations, the Company plans to utilize cash from
operations and potential proceeds from arbitration proceedings. The Company
believes that cash generated from these two sources will be sufficient to meet
its future obligations for the foreseeable future.
24
The following table presents our contractual cash flow commitments on
long-term debt and operating leases.
PAYMENTS DUE BY PERIOD (IN THOUSANDS)
-----------------------------------------------------------------------------------
TOTAL LESS THAN 1 YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS
---------- ------------------ ----------- ------------- -----------------
Long-term debt, including
current maturities $12,233 $313 $907 $8,293 $2,720
Operating leases 216 118 98 - -
------- ---- ------ ------ ------
Total 12,449 $431 $1,005 $8,293 $2,720
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 May 28, 2004, claims recorded against the U.S. Government totaled
$2,899,000 and claims recorded against an international customer totaled
$2,600,000.
Claim costs have been incurred in connection with customer caused
delays, errors in specifications and designs, other out-of-scope items and
exchange losses and may not be received in full during fiscal 2005. In
conformity with accounting principles generally accepted in the United States of
America, revenue recorded by the Company from a claim may not exceed the
incurred contract costs related to the claim.
In November 2003, the U.S. Government completed an audit of the
submarine rescue decompression chamber project claim, rejecting most of the
items due to audit or engineering reasons. The Company was not provided a copy
of the Government's Technical Report which 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 U.S. government
has agreed to issue a final decision on September 15, 2004. The Company
considers the recorded costs to be reasonable 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. During the first
quarter of fiscal 2005 the Company submitted a supplement to the claim
incorporating additional cost items. During the fiscal 2004 third quarter, the
U.S. government, citing failure to deliver product within contract terms, began
assessing liquidated damages by offsetting progress payments due the Company
under the contract. However, during the first quarter of fiscal 2005, citing
"substantial material progress" on the project, the U.S. Government agreed to
release all outstanding invoice payments which had previously been withheld for
liquidated damages. 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, in accordance with accounting principles
generally accepted in the United States of America, the Company has reduced
contract values and corresponding revenue recognition for an estimated amount of
$330,000 to cover a delay through the extended delivery period.
With respect to the claims filed against an international customer, the
Company is currently in the discovery phase of the arbitration process. The
Company has filed its "Points of Claim" to which the customer has replied.
Additionally, the customer has filed a counterclaim which the Company answered
subsequent to fiscal quarter end. The customer, citing failure to deliver
25
product within contract terms, has assessed liquidated damages totaling
approximately $400,000 on the contract. The company disputes the basis for these
liquidated damages and is vigorously contesting them. However, following
generally accepted accounting principles in the United States of America, the
Company has reduced contract values and corresponding revenue recognition by
approximately $400,000. At this time, the Company is unable to assess the
ultimate impact of the arbitration on current operations and financial
condition.
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. 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.
Citing a conflict of interest on the part of the RTAF's arbitrator, the Company
was successful in having their arbitrator disqualified and the RTAF is currently
in the process of appointing an alternative. 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, therefore 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.
Backlog
- -------
The Company's sales backlog at May 28, 2004 and February 27, 2004, for
work to be performed and revenue to be recognized under written agreements after
such dates was approximately $16,776,000 and $16,914,000 respectively. In
addition, the Company's training, maintenance and upgrade contracts backlog at
May 28, 2004, and February 27, 2004, for work to be performed and revenue to be
recognized after that date under written agreements was approximately $1,655,000
and $2,637,000 respectively. Of the May 28, 2004 backlog, approximately
$7,743,000 was under contracts for ATS products including $2,574,000 for the
Royal Malaysian Air Force.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The company is exposed to various market risks, including changes
interest rates. Market risk is the potential loss arising from adverse changes
in market rates and prices, such as interest rates and foreign currency exchange
26
rates. The Company does not enter into derivatives or other financial
instruments for trading or speculative purposes. The Company also has not
entered into financial instruments to manage and reduce the impact of changes in
interest rates and foreign currency exchange rates although we may enter into
such transactions in the future. A portion of the Company's indebtedness bears
interest at rates that vary with the prime rate of interest. Accordingly, any
increases in the applicable prime rate of interest will reduce the Company's
earnings. With respect to currency risk, where the Company has a contract which
is denominated in a foreign currency, it often establishes local in-country bank
accounts and funds in-country expenses in the local currency, thus creating a
"natural" currency hedge for a portion of the contract.
ITEM 4. CONTROLS AND PROCEDURES.
Under the supervision and with the participation of the Company's
management, including the Company's chief executive officer and chief financial
officer, the Company has evaluated the effectiveness of the design and operation
of the Company's disclosure controls and procedures as of May 28, 2004 (the
"Evaluation Date"), and, based on this evaluation, the Company's chief executive
officer and chief financial officer have concluded that these controls and
procedures were effective as of the Evaluation Date. There were no significant
changes in 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 chief executive officer and chief financial officer, as
appropriate to allow timely decisions regarding required disclosure.
27
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In April 2003, Boenning & Scattergood, Inc. ("B&S") filed suit against
the Company in the Court of Common Pleas in Philadelphia, Pennsylvania, seeking
payment of $901,843.46 for financing fees allegedly due to B&S pursuant to the
terms of an agreement for investment banking services, which was entered into
with a predecessor of B&S (the "B&S Agreement"). B&S alleges that it contacted
the investors in the Company's February 2003 financing transaction and that it
earned the claimed financing fees pursuant to the terms of the B&S Agreement.
The Company has responded to the complaint and also filed a counterclaim for
breach of contract and professional malpractice. The Company believes that it
has valid defenses to each of the claims of B&S and intends to vigorously defend
itself against these claims. At this time, however, discovery is ongoing and the
Company is unable to predict the outcome of this matter.
In June 2003, 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. In March 2004 this suit
was settled without any material impact on the Company's results of operations.
In June 2003, EnTCo, our 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 EnTCo and the Company (under a guarantee) for,
among other things, alleged failures in performance and design in the contract.
Disney is seeking damages in excess of $150,000. EnTCo and the Company believe
that they have valid defenses to each of Disney's counterclaims and intend to
vigorously defend against these counterclaims. At this time, the parties are
engaged in the discovery process. The parties have exchanged self-executing
disclosures, responses to interrogatories and documents and depositions will
begin soon. Accordingly, as of this date, EnTCo and the Company are unable to
predict the outcome of this matter.
28
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
None.
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 July 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 July 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 July 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 May 28, 2004, the Company filed a Current Report on Form 8-K
reporting its financial results for the fourth quarter of fiscal 2004 as well as
its financial results for fiscal 2004.
29
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: July 12, 2004 By: /s/ William F. Mitchell
---------------------------------
William F. Mitchell
President and Chief
Executive Officer
(Principal Executive Officer)
Date: July 12, 2004 By: /s/ Duane Deaner
-----------------------------------
Duane Deaner,
Chief Financial Officer
(Principal Financial and
Accounting Officer)