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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 August 27, 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
September 30, 2004 is: 7,640,686.
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 Twenty-six Weeks Ended
August 27, August 29, August 27, August 29,
2004 2003 2004 2003
----------- ------------ ----------- -----------
Net sales $6,523 $4,752 $12,698 $10,882
Cost of goods sold 5,502 2,966 10,683 6,809
------- ------- ------- -------
Gross profit 1,021 1,786 2,015 4,073
------- ------- ------- -------
Operating expenses:
Selling and administrative 3,121 2,231 5,551 3,916
Research and development 292 (50) 501 32
------- ------- ------- -------
3,413 2,181 6,052 3,948
------- ------- ------- -------
Operating (loss)/income (2,392) (395) (4,037) 125
------- ------- ------- -------
Other expenses:
Interest expense, net 387 389 731 767
Other, net 40 78 125 87
------- ------- ------- -------
427 467 856 854
------- ------- ------- -------
Loss before income taxes (2,819) (862) (4,893) (729)
Benefit from income taxes (835) (238) (1,450) (171)
------- ------- ------- -------
Loss before minority interest (1,984) (624) (3,443) (558)
Loss (income) attributable to
Minority interest - 2 (2) 6
------- ------- ------- -------
Net loss (1,984) $(622) $(3,445) $(552)
======= ======= ======= =======
Per share information:
Loss applicable to common shareholders $(1,984) $(622) $(3,445) $(552)
Loss per share:
basic $(0.26) $(0.09) $(0.45) $(0.08)
Loss per share:
diluted $(0.26) $(0.09) $(0.45) $(0.08)
Number of shares: basic 7,641,000 7,157,000 7,590,000 7,157,000
Number of shares: diluted 7,641,000 7,157,000 7,590,000 7,157,000
The accompanying notes are an integral part of the
consolidated financial statements.
2
Environmental Tectonics Corporation
Consolidated Balance Sheets
August 27, February 27,
2004 2004
unaudited
----------------------- ----------------------
(amounts in thousands, except share
information)
Assets
Current assets:
Cash and cash equivalents $ 1,572 $ 1,366
Cash equivalents restricted for letters of credit 6,183 784
Accounts receivable, net 9,081 19,233
Costs and estimated earnings in excess of billings on uncompleted
long-term contracts 6,121 5,333
Inventories 8,045 9,843
Deferred tax asset 1,337 1,337
Prepaid expenses and other current assets 3,341 1,949
---------- ----------
Total current assets 35,680 39,845
---------- ----------
Property, plant and equipment, at cost, net of accumulated
depreciation of $10,995 at August 27, 2004 and $10,651 at
February 27, 2004 5,687 4,886
Software development costs, net of accumulated amortization of $7,921
at August 27, 2004 and $7,494 at February 27, 2004 3,504 3,089
Goodwill and intangibles 477 477
Other assets, net 240 399
---------- ----------
Total assets $ 45,588 $ 48,696
========== ==========
Liabilities and Stockholders' Equity
Liabilities
Current liabilities:
Current portion of long-term debt $ 442 $ 317
Accounts payable - trade 2,876 2,431
Billings in excess of costs and estimated earnings on uncompleted
long-term contracts 2,125 945
Customer deposits 1,820 3,657
Accrued liabilities 1,985 2,588
---------- ----------
Total current liabilities 9,248 9,938
---------- ----------
Long-term debt, less current portion:
Credit facility payable to banks - 30
Long-term bonds, net 4,095 4,370
Subordinated debt 7,822 7,666
Other 420 91
---------- ----------
12,337 12,157
---------- ----------
Deferred income taxes 1,502 1,502
---------- ----------
Total liabilities 23,087 23,597
---------- ----------
Minority interest 47 45
Stockholders' Equity
Common stock; $.05 par value; 20,000,000 shares authorized; 7,640,686 and
7,176,552 issued and outstanding at August 27, 2004 and
February 27, 2004, respectively 381 359
Capital contributed in excess of par value of common stock 10,157 9,430
Accumulated other comprehensive loss (233) (329)
Retained earnings 12,149 15,594
---------- ----------
Total stockholders' equity 22,454 25,054
---------- ----------
Total liabilities and stockholders' equity $ 45,588 $ 48,696
========== ==========
The accompanying notes are an integral part of the
consolidated financial statements.
3
Environmental Tectonics Corporation
Consolidated Statements of Cash Flows
(unaudited)
Twenty-six Weeks Ended
-------------------------------------------
August 27, August 29,
2004 2003
-------------- -------------
(amounts in thousands)
Cash flows from operating activities:
Net loss $(3,445) $(552)
Adjustments to reconcile net loss to net cash
provided by/(used in) operating activities:
Depreciation and amortization 990 670
Non-cash interest expense 156 255
Provision for losses on accounts receivable
and inventories 76 100
Minority interest 2 (6)
Changes in operating assets and liabilities:
Accounts receivable 10,152 498
Costs and estimated earnings in excess of
billings on uncompleted long-term contracts (788) (2,077)
Inventories 1,129 (2,166)
Prepaid expenses and other assets (1,392) (730)
Accounts payable 445 527
Billings in excess of costs and estimated
earnings on uncompleted long-term contracts 1,180 (822)
Customer deposits (1,837) 1,047
Other accrued liabilities (604) 216
------- -------
Net cash provided by/(used in) operating activities 6,064 (3,040)
------- -------
Cash flows from investing activities:
Acquisition of equipment (92) (207)
Capitalized leases (520) -
Capitalized software development costs (842) (484)
------- -------
Net cash used in investing activities (1,454) (691)
------- -------
Cash flows from financing activities:
Borrowings under credit facility - 200
Payments under credit facility (30) (600)
Repayment of long-term bonds (275) (275)
Cash equivalents restricted for letters of credit (5,399) 562
Proceeds from issuance of common stock / warrants 749 -
Deferred finance charges - (49)
------- -------
Capital leases 455 (3)
------- -------
Net cash used in financing activities (4,500) (165)
------- -------
Effect of exchange rate changes on cash 96 (25)
------- -------
Net increase/(decrease) in cash and cash equivalents 206 (3,921)
Cash and cash equivalents at beginning of period 1,366 4,305
------- -------
Cash and cash equivalents at end of period $1,572 $384
======= =======
Supplemental schedule of cash flow information:
Interest paid 444 309
Income taxes paid 4 63
Supplemental information on noncash
operating and investing activities:
During the twenty-six weeks ended
August 27,2004, 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 statement of the results for the interim
periods presented. All such adjustments are of a normal recurring nature.
Certain information in footnote disclosures normally included in
financial statements prepared in conformity with accounting principles generally
accepted in the United States of America has been condensed or omitted pursuant
to such rules and regulations and the financial results for the periods
presented may not be indicative of the full year's results, although the Company
believes the disclosures are adequate to make the information presented not
misleading. These financial statements should be read in conjunction with the
financial statements and the notes thereto included in the Company's Annual
Report on Form 10-K for the year ended February 27, 2004. Certain
reclassifications have been made to the fiscal 2004 financial statements to
conform with the fiscal 2005 presentation.
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 August 27, 2004 Thirteen Weeks Ended August 29, 2003
-------------------------------------------------- -----------------------------------------------
Loss Shares Per Share Loss Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
------------ -------------- ------------- ------------ ------------- ------------
(amounts in thousands, except share and per share information)
Basic EPS
Net loss applicable to
common stockholders $(1,984) 7,641,000 $(0.26) $(622) 7,157,000 $(0.09)
Effect of dilutive
securities
Options - - -
Warrants - - -
Diluted EPS
Net loss applicable to
common stockholders
plus assumed
conversions $(1,984) 7,641,000 $(0.26) $(622) 7,157,000 $(0.09)
Twenty-six Weeks Ended August 27, 2004 Twenty-six Weeks Ended August 29, 2003
-------------------------------------------------- ------------------------------------------------
Loss Shares Per Share Loss Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- -------------- ------------- ------------ ------------- ------------
(amounts in thousands, except share and per share information)
Basic EPS
Net loss applicable to
common stockholders $ (3,445) 7,590,000 $(0.45) $(552) 7,157,000 $(0.08)
Effect of dilutive
securities
Options - - -
Warrants - - -
Diluted EPS
Net loss applicable to
common stockholders
plus assumed
conversions $ (3,445) 7,590,000 $(0.45) $(552) 7,157,000 $(0.08)
5
At August 27, 2004 there were stock options to purchase the Company's common
stock totaling 323,752 shares which were not included in the computation of
diluted earnings per share, as the effect of such would be anti-dilutive.
Additionally, there was subordinated debt with a face value of $10,000,000 which
was convertible at an exercise price of $6.05 per share, equating to 1,652,893
shares if fully converted to common shares. Upon each conversion of the Note,
the holder would be entitled to receive a warrant to purchase additional shares
of common stock equal to ten percent of the shares issued pursuant to such
conversion. If the entire face value of the Note were to be converted into
common shares, warrants for an additional 165,289 shares would be issued,
bringing the total shares to be issued to 1,818,182. Additionally, at August 27,
2004, there were outstanding warrants to purchase the Company's stock totaling
803,048 shares. None of these shares have been included in the computation of
diluted earnings per share as the effect would be anti-dilutive.
At August 29, 2003 there were stock options to purchase the Company's common
stock totaling 412,064 shares which were not included in the computation of
diluted earnings per share, as the effect of such would be anti-dilutive.
Additionally, there was subordinated debt with a face value of $10,000,000 which
was convertible at an exercise price of $6.05 per share, equating to 1,652,893
shares if fully converted to common shares. Upon each conversion of the Note,
the holder would be entitled to receive a warrant to purchase additional shares
of common stock equal to ten percent of the shares issued pursuant to such
conversion. If the entire face value of the Note were to be converted into
common shares, warrants for an additional 165,289 shares would be issued,
bringing the total shares to be issued to 1,818,182. Additionally, at August 29,
2003, there were outstanding warrants to purchase the Company's stock totaling
1,240,868 shares. None of these shares have been included in the computation of
diluted earnings per share as the effect would be anti-dilutive.
3. Stock Options
The Company accounts for stock options under SFAS No. 123, "Accounting
for Stock-Based Compensation," as amended by SFAS No. 148, which contains a fair
value-based method for valuing stock-based compensation that entities may use,
which measures compensation cost at the grant date based on the fair value of
the award. Compensation is then recognized over the service period, which is
usually the vesting period. Alternatively, SFAS No. 123 permits entities to
continue accounting for employee stock options and similar equity instruments
under Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued
to Employees." Entities that continue to account for stock options using APB
Opinion 25 are required to make pro forma disclosures of net income and earnings
per share, as if the fair value-based method of accounting defined in SFAS No.
123 had been applied.
At August 27, 2004, the Company had one stock-based employee
compensation plan. The Company accounts for this plan under the recognition and
measurement principles of APB Opinion 25, "Accounting for Stock Issued to
Employees," and related interpretations. Stock-based employee compensation costs
are not reflected in net income, as all options granted under the plan had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net income and
earnings per share if the Company had applied the fair value recognition
provisions of SFAS No. 123, to stock-based employee compensation (in thousands,
except per share amounts).
Thirteen Weeks Ended
----------------------------------------
August 27, 2004 August 29, 2003
----------------- -----------------
Net loss,
as reported $(1,984) $ (622)
Less: stock-based compensation costs
determined under fair market value based
methods for all awards - (10)
-------- ------
Net loss, pro forma $(1,984) $ (632)
Loss per share of common stock-basic:
As reported $ (0.26) $ (.09)
Pro forma $ (0.26) $ (.09)
Loss per share of common stock--diluted:
As reported $ (0.26) $ (.09)
Pro forma $ (0.26) $ (.09)
Twenty-six Weeks Ended
----------------------------------------
August 27, 2004 August 29, 2003
----------------- -----------------
Net loss,
as reported $(3,445) $(552)
Less: stock-based compensation costs
determined under fair market value based
methods for all awards - (20)
------- -----
Net loss, pro forma $(3,445) $(572)
Loss per share of common stock-basic:
As reported $ (0.45) $ (.08)
Pro forma $ (0.45) $ (.08)
Loss per share of common stock--diluted:
As reported $ (0.45) $ (.08)
Pro forma $ (0.45) $ (.08)
There were no grants of stock options during the twenty-six weeks ended August
27, 2004 or August 29, 2003.
6
4. Accounts Receivable
The components of accounts receivable are as follows:
August 27,
2004 February 27,
unaudited 2004
----------- -------------
(amounts in thousands)
U.S. Government receivables billed and unbilled contract costs subject to
negotiation $ 3,159 $ 3,128
U.S. commercial receivables billed 2,026 1,508
International receivables billed and unbilled contract costs subject to
negotiation 4,274 14,976
------- -------
9,459 19,612
Less allowance for doubtful accounts (378) (379)
------- -------
$ 9,081 $19,233
======= =======
U.S. Government receivables billed and unbilled contract costs subject to
negotiation:
Unbilled contract costs subject to negotiation as of August 27, 2004
and February 27, 2004, primarily represent claims made against the U.S.
Government under a contract for a submarine rescue decompression chamber
project. These costs totaling $3,004,000 were recorded beginning in fiscal year
2002 and include $833,000 recorded during fiscal year 2004 and $105,000 recorded
during the current fiscal quarter. In November 2003, the U.S. Government
completed an audit of the claim, rejecting most of the items due to audit or
engineering reasons. The Company was not provided a copy of the Government's
Technical Report that questioned approximately half of the claim costs. The
Company has submitted a written rebuttal to the draft report and has formally
requested a copy of the Technical Report. On July 22, 2004 the U.S. Government's
Contracting Officer issued a final decision on the claim, denying the claim in
full. In response, the Company plans to file a complaint in the Court of Federal
Claims in the near future.
This U. S. Government claim has followed the typical process of claim
notification, preparation, submittal, government audit and review by the
contracting officer. Historically, most claims are initially denied in part or
in full by the contracting officer (or no decision is forthcoming, which is then
taken to be a deemed denial) which then forces the company to seek relief in a
court of law.
The Company considers the recorded costs to be realizable due to the
fact that the costs relate to customer caused delays, errors and changes in
specifications and designs, disputed liquidated damages and other out of scope
items. In the fiscal quarter ended May 28, 2004, the Company submitted a
supplement to the claim incorporating additional cost items. The U.S.
Government, citing failure to deliver the product within contract terms, has
assessed liquidated damages but has not offset or withheld any progress payments
due to the Company under the contract. The Company disputes the basis for these
liquidated damages, noting that applicable U.S. Government purchasing
regulations allow for a waiver of these charges if the delay is beyond the
control and not due to the fault or negligence of the Company. However,
following accounting principles generally accepted in the United States of
America, the Company has reduced contract values and corresponding revenue
recognition for an estimated amount of $330,000 to cover a delay through the
extended delivery period.
International receivables billed and unbilled contract costs subject to
negotiation:
International receivables billed include $700,000 at August 27, 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 selected 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 earlier this fiscal year in having the RTAF's first choice for
the arbitrator disqualified. They have since chosen another candidate, whom the
Company also feels is not a disinterested party and thus, on August 3, 2004, we
formally protested his appointment on the grounds of a conflict of interest.
7
Since the circumstances that caused a delay are commonly considered
"force majeure" events, and since the contract under question allows for
consideration of "force majeure" events, the Company believes that the open
balance related to this contract is collectible and will continue to treat this
balance as collectible until a final unappealable legal decision is rendered by
a competent Thai tribunal. The Company continues to enjoy a favorable
relationship with the RTAF. It currently has both maintenance and upgrade
contracts with the RTAF for trainers that are the subject of the dispute and has
sold a significant amount of additional equipment to the RTAF since this dispute
began. Thus, we do not feel the initiation of legal action against the RTAF has
affected our ability to obtain additional contracts with the RTAF. At this
point, the Company is not able to determine what, if any, impact the extended
completion period will ultimately have upon the receipt of final payment.
Unbilled contract costs subject to negotiation represent a claim
($2,600,000 recorded as of August 27, 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 to
which the Company answered in the second quarter of fiscal 2005. The customer,
citing failure to deliver the 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. At this point, the Company is
unable to assess the ultimate impact of the arbitration on current operations
and financials.
Effective February 27, 2004, the Company reached an agreement totaling
$10.5 million with the same international customer on another claim, thus
resolving all outstanding amounts related to that claim. These proceeds were
received on March 16, 2004 (See also the Liquidity and Capital Resources section
of the Management's Discussion and Analysis of Results of Operations and
Financial condition following).
Historically, the Company has had positive experience with regard to
its contract claims in that recoveries have exceeded the carrying value of
claims.
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
$640,000 and $564,000 at August 27, 2004 and February 27, 2004, respectively):
August 27,
2004 February 27,
unaudited 2004
----------- ------------
(amounts in thousands)
Raw materials $313 $311
Work in process 6,233 7,803
Finished goods 1,499 1,729
------ ------
Total $8,045 $9,843
====== ======
6. Stockholders' Equity
The components of stockholders' equity at February 27, 2004 and August
27, 2004 were as follows:
(amounts in thousands, except share information)
Capital
contributed
in excess of Accumulated
Common Stock par value of Other Comp. Retained
Shares Amount common stock Loss Earnings Total
--------- -------- ------------ ----------- ---------- --------
Balance at February 27, 2004 7,176,552 $359 $9,430 $(329) $15,594 $25,054
Net loss for the twenty-six weeks
ended August 27, 2004
- - - - (3,445) (3,445)
Foreign currency translation
adjustment - - - 96
-------
Total comprehensive loss - - - 96 - (3,349)
=======
Shares issued in connection
with exercise of warrants 437,820 21 565 - - 586
Shares issued under exercise
of employee stock options
and Director compensation 26,314 1 162 - - 163
--------- ---- ------- ----- ------- -------
Balance at August 27, 2004 7,640,686 $381 $10,157 $(233) $12,149 $22,454
========= ==== ======= ===== ======= =======
8
7. Long Term Debt
The following table lists the long-term debt and other long-term
obligations of the Company as of August 27, 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 $ 442 $ 442 $ - $ - $ -
Long-term Debt - - - - -
Capital Leases 420 - 420 - -
Subordinated debt, net of
unamortized discount of $2,178 7,822 - - - 7,822
Long term bonds 4,095 - 825 550 2,720
--------- ---------- ------ ------- -------
Total Obligations $ 12,779 $ 442 $1,245 $ 550 $10,542
========= ========== ====== ======= =======
The Company has historically financed operations through a combination
of cash generated from operations, and bank and other debt. On February 19,
2003, the Company signed a Credit Agreement (the "Agreement") with PNC Bank,
National Association ("PNC") and a Convertible Note and Warrant Purchase
Agreement (the "Note") with H.F. Lenfest, an individual, in the aggregate amount
of $29,800,000. The Company used a portion of the proceeds from the financing to
satisfy its existing debt obligations to Wachovia Bank, the Company's former
lender, and to permit PNC 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 Company used the
net proceeds for working capital and general corporate purposes.
On April 30, 2003, the Agreement was amended to include: (i) a revolving
credit facility in the maximum aggregate principal amount of $14,800,000 to be
used for the Company's working capital and general corporate purposes, including
capital expenditures, with a sublimit for issuances of letters of credit in the
maximum aggregate face amount of $10,300,000, and (ii) a standby letter of
credit in the face amount of $4,750,000 as credit support for the Company's
bonds. Additionally, on July 9, 2003, a second amendment to the Agreement was
executed which formed an additional $1,010,000 credit facility for use in
financing export contracts which qualify for an EXIM (the Export-Import Bank of
the United States) Bank guarantee.
During the first quarter of fiscal 2005, as a result of the Company's
recent operating losses and its violation of certain financial covenants
contained in the Agreement, PNC advised the Company that it was instituting
certain changes to the revolving credit facility. The changes included reducing
the facility to $6,000,000 and requiring the Company to cash collateralize the
full facility. These changes became effective on June 2, 2004.
On August 24, 2004, the Agreement was amended to substantially reduce the
operating facility and eliminate the associated monthly borrowing base reporting
requirements. The revolving facility was reduced from $14,800,000 to $5,000,000
and use of the facility was restricted to the issuance of letters of credit,
which are frequently a requirement of international contracts. Under the amended
Agreement, the Company could no longer borrow cash loans. The Company's
long-term bonds were left intact. As additional collateral for the revised
facility, PNC required the Company to keep $2,500,000 in a restricted cash
account. The annual fee for letters of credit was reduced from 1.75% to 1.0% per
annum. Additionally, three of the financial covenants, the Leverage Ratio, the
Fixed Charge Ratio and the requirement not to report a net loss in any annual
period were eliminated and the Tangible Net Worth requirement was reduced. All
other terms and conditions of the revolving loan and the line of credit as set
forth in the Agreement remained in effect.
Under the amended Agreement, the Company must maintain a minimum Tangible
Net Worth. At August 27, 2004, the Company dropped below this minimum and thus
was in violation of this financial covenant. The Company has obtained a waiver
from PNC for this violation. Additionally, under the Note, which covers the
Company's subordinated debt, the Company must meet certain financial covenants
including a Leverage Ratio, a Fixed Charge Ratio and a Tangible Net Worth Ratio.
At August 27, 2004 the Company failed to meet any of these financial covenants
but has obtained a waiver from its subordinated lender. Both of these waivers
are solely for the period specified, namely the fiscal quarter ended August 27,
2004. Except as specified, these waivers do 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.
Going forward, the Bank has agreed to review and reduce the minimum
Tangible Net Worth requirement to be more in line with the Company's operating
performance. Specific terms and conditions for this modification had not been
finalized as of the filing date of this report. Based on the annual forecast
and the indicated actions described above, the Company does not believe it is
probable that it will fail future covenant tests.
Given the Company's inability to borrow cash under the amended Agreement,
the Company may need to obtain additional sources of capital in order to
continue growing our business. This capital may be difficult to obtain and the
cost of this additional capital is likely to be relatively high. However, we
believe that we will be able to locate such additional capital and that these
actions by our bank will not have a long-term material adverse effect on our
business.
Under the August 24, 2004 amendment the EXIM Line was reduced from
$1,010,000 to $995,000, with all other terms and conditions remaining unchanged.
Availability under the EXIM facility is determined based on a borrowing base
consisting of a portion of the Company's receivables and inventory.
As a condition of amending the Agreement, Mr. Lenfest, holder of the
Company's subordinated debt, agreed to issue to PNC on the Company's behalf a
limited guarantee to secure up to $5,000,000 in principal amount of any letters
of credit issued under the amended facility. In consideration for issuing this
guarantee, Mr.Lenfest will receive a fee of 0.75% per annum of the average
amount of letters of credit outstanding, payable on a quarterly basis, and a
warrant to purchase 200,000 shares of stock under the same terms and conditions
as his existing warrant for 803,048 shares (see the Liquidity and Capital
Resources section following in this report).
9
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 AUGUST 27, 2004
Net Sales $4,013 $2,510 $6,523
Interest Expense 288 113 401
Depreciation and Amortization 291 165 456
Operating loss (2,014) (164) (2,178)
Income Tax Benefit 698 83 781
Goodwill and Intangibles 477 - 477
Identifiable Assets 18,882 7,869 26,751
Expenditures For Segment Assets 548 6 554
THIRTEEN WEEKS ENDED AUGUST 29, 2003
Net Sales $2,676 $2,076 $4,752
Interest Expense 300 89 389
Depreciation and Amortization 232 213 445
Operating Income/(Loss) 54 (131) (77)
Income Tax Benefit (68) (61) (129)
Goodwill and Intangibles 477 - 477
Identifiable Assets 28,009 8,139 36,148
Expenditures For Segment Assets 86 26 112
Reconciliation to consolidated amounts 2004 2003
Segment Assets $26,751 $36,148
Corporate Assets 18,837 11,389
------- -------
Total Assets $45,588 $47,537
======= =======
Segment operating loss $(2,178) $ (77)
Less interest expense (401) (389)
Less income taxes benefit 781 129
------- -------
Total loss for segments (1,798) (337)
Corporate home office expenses (214) (318)
Interest and other expenses (26) (78)
Income tax benefit 54 109
Minority interest - 2
-------- --------
Net loss $ (1,984) $ (622)
======== ========
Industrial
ATS Group Total
-------- ---------------- ---------
(amounts in thousands)
TWENTY-SIX WEEKS ENDED AUGUST 27, 2004
Net Sales $8,414 $4,284 $12,698
Interest Expense 525 220 745
Depreciation and Amortization 618 312 930
Operating Loss (2,758) (796) (3,554)
Income Tax Benefit 1,018 307 1,325
Goodwill and Intangibles 477 - 477
Identifiable Assets 18,882 7,869 26,751
Expenditures For Segment Assets 589 23 612
TWENTY-SIX WEEKS ENDED AUGUST 29, 2003
Net Sales $5,661 $5,221 $10,882
Interest Expense 594 173 767
Depreciation and Amortization 449 476 925
Operating Income 235 516 751
Income Tax (Benefit)/Provision (125) 221 96
Goodwill and Intangibles 477 - 477
Identifiable Assets 28,009 8,139 36,148
Expenditures For Segment Assets 160 47 207
Reconciliation to consolidated amounts 2004 2003
Segment Assets $26,751 $36,148
Corporate Assets 18,837 11,389
-------- -------
Total Assets $45,588 $47,537
======== ========
Segment operating (loss)/income $(3,554) $ 751
Less interest expense (745) (767)
Less income taxes benefit/(exp) 1,325 (96)
-------- -------
Total loss for segments (2,974) (112)
Corporate home office expenses (483) (626)
Interest and other expenses (111) (87)
Income tax benefit 125 267
Minority interest (2) 6
-------- -------
Net loss $ (3,445) $ (552)
======== =======
10
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 28% of sales totaling $1,827,000 in the thirteen weeks
ended August 27, 2004 were made to two international customers in the ATS
segment. Approximately 43% of sales totaling $2,020,000 in the thirteen weeks
ended August 27, 2003 were made to one domestic and one international customer
in the sterilizer and ATS segments respectively.
Approximately 17% of sales totaling $2,140,000 in the twenty-six weeks
ended August 27, 2004 were made to one international customer in the ATS
segment. Approximately 37% of sales totaling $3,992,000 in the thirty-nine weeks
ended August 29, 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 August
27, 2004 are export sales of $2,599,000. Of this amount, there are sales to or
relating to governments or commercial accounts in Malaysia ($915,000) and the
Czech Republic ($912,000). Sales to the U.S. Government and its agencies were
$619,000 for the period.
Included in the segment information for the thirteen weeks ended August
29, 2003 are export sales of $2,665,000. Of this amount, there are sales to or
relating to governments or commercial accounts in Malaysia ($1,280,000), Nigeria
($474,000), and Korea ($275,000). Sales to the U.S. Government and its agencies
aggregated $330,000 for the period.
Included in the segment information for the twenty-six weeks ended
August 27, 2004 are export sales of $6,277,000. Of this amount, there are sales
to or relating to commercial accounts in Malaysia ($2,140,000), the Czech
Republic ($912,000), Australia ($752,000) and Egypt ($752,000). Sales to the
U.S. Government and its agencies aggregated $1,067,000 for the period.
Included in the segment information for the twenty-six weeks ended
August 29, 2003 are export sales of $5,636,000. Of this amount, there are sales
to or relating to commercial or government accounts in Malaysia of $2,094,000.
Sales to the U.S. Government and its agencies aggregated $665,000 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", "VIEs"). 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 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 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 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.
11
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
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
We are principally engaged in the design, manufacture and sale of
software driven products used to create and monitor the physiological effects of
motion on humans and equipment and to control, modify, simulate and measure
environmental conditions. These products include aircrew training systems,
entertainment products, sterilizers, environmental and hyperbaric chambers and
other products that involve similar manufacturing techniques and engineering
technologies.
The following factors had an adverse impact on our performance for the
fiscal quarter and the twenty-six weeks ended August 27, 2004:
o Unfavorable global economic and political conditions;
Our new sales bookings continued to be hampered by unfavorable global
economic and political conditions. Many new projects continue to face
budget constraints and other governmental delays by our customers
throughout the world. Additionally, sentiment against purchasing
American-made goods has heightened since September 11, 2001. Proposal
activity in some of our businesses, most notably in the ATS and
environmental areas, remains strong: the probability of being awarded
some significant potential projects has recently increased: we have
booked some large projects in the ATS area this fiscal year; however,
we have not been able to materially increase the backlog and our
resulting sales volume. Thus, we still remain cautious about the volume
of new contracts that may be awarded in the near term.
o Technical and other issues which delayed completion of some
projects;
12
Many of our products, especially in the ATS and environmental lines,
incorporate new state-of-the-art or unproven technologies.
Occasionally, given the engineering effort to design, develop and test
these technologies and the difficult logistics of installation and
acceptance requirements in foreign locations, we experience delays in
the final completion and receipt of final payment for a project. This
can have a negative impact on revenue recognition, gross margin
performance, and cash flow from operations, especially if additional
spending is required or if customer induced delays occur. Historically,
we have charged the cost of developing new product technologies to
individual contracts and occasionally only a portion of these costs is
covered by customer payments. Although some significant long-standing
contracts have been closed in fiscal 2005, additional contracts have
continued to experience various delays, and these delays are expected
to have a continued negative impact on our gross margins. This
situation is applicable to many of our product lines and tends to add
an element of unpredictability to our financial performance.
o Limited borrowing availability and higher costs of capital.
Cash collections have been very strong in fiscal 2005 primarily due to
the receipt of $10.5 million in March 2004 under a settlement agreement
of an international claim, and there are currently some sizable open
customer receivables. However, given our inability to borrow cash from
PNC under the August 24, 2004 amendment to the Bank Agreement, and the
requirement to restrict the use of $2.5 million of cash, we may need to
obtain additional sources of capital in order to grow our business. We
currently have a relatively high average cost of capital and this
continues to have a negative impact on our financial results. New
capital may be difficult to obtain and the cost of this additional
capital is likely to be relatively high.
o Higher cost of litigation and contract claims activity.
A significant portion of our selling and administrative spending is
related to costs associated with litigation and our ongoing contract
claims activities. Two litigation matters, an international contract
claim and the legal suit against Walt Disney World Company, were in the
discovery phase in the fiscal quarter ended August 27, 2004 and
required high outside legal effort. Although some decrease in the rate
of expenditure is expected going forward, these matters are expected to
continue to require material legal expenditures for the foreseeable
future.
Our goal is to be the premier supplier of low-cost, high-performance
and technologically advanced simulation equipment in the markets we
serve. To that end we face various challenges in order to make fiscal
2005 a successful year. In order to overcome the factors adversely
impacting our performance and to meet this goal, we need to take the
following actions. (The reader is referred to the Management's
Discussion and Analysis of Financial Condition and Results of
Operations included in the Company's Annual Report on Form 10-K for the
fiscal year ended February 27, 2004.)
o Sell through all of the products we technologically enhanced in
fiscal 2004.
o Stimulate interest in the U.S. Government Armed Forces to purchase
ATFS technology.
o Allocate the resources and find the funding to continue to evolve
Advanced Tactical Flight Simulation (ATFS).
o Re-engineer the products in our ATS and environmental lines to
remain competitive.
o Complete some large international projects which have negative
margins and continue to monopolize our limited installation
personnel.
o Continue to reduce the environmental business operating losses by
utilizing the skills of additional personnel acquired from a former
competitor.
o Expand the entertainment line by repeat sales and the introduction
of story line enhancements.
o Settle at least one major claim.
o Balance overhead and selling and administrative spending levels to
be more in line with the current level of sales volume.
o Rejuvenate the sales force and sales booking level.
o Prioritize and focus our product development.
o Tightly manage our cash to compensate for the reduced booking level
and inability to borrow from our bank.
o Minimize the financial cost of implementing the new requirements
under the Sarbanes-Oxley act.
Our failure to complete some or all of these steps may have a material
adverse effect on our future operating results.
We recognize revenue when it is realized or realizable and earned. We
consider revenue realized or realizable and earned when there exists persuasive
evidence of an arrangement, the product has been shipped or the services have
been provided to the customer, the sales price is fixed or determinable and
collectability is reasonable assured. In addition to the aforementioned general
policy, the following are the specific revenue recognition policies we utilize:
13
Revenue on long-term contracts that require us to design, develop or
manufacture a product or modify an existing unit is recognized using the
percentage-of-completion method. Percentage of completion is measured based on
the ratio of costs incurred to date compared to the total estimated costs. This
percentage is multiplied by the total estimated revenue under a contract to
calculate the amount of revenue recognized in an accounting period. Total
estimated costs are based on several factors, including estimated labor hours to
complete certain tasks and the estimated cost of purchased items at future
dates. Revenue recognized in excess of amounts billed to customers on
uncompleted long-term contracts under the percentage of completion method is
reflected as an asset. Amounts billed to customers in excess of revenue
recognized on uncompleted long-term contracts under the percentage of completion
method are reflected as a liability. When it is estimated that a contract will
result in a loss, the entire amount of the loss is accrued. The effect of
revisions in cost and profit estimates for long-term contracts is reflected in
the accounting period in which we learn the facts that require us to revise the
cost and profit estimates. Contract progress billings are based upon contract
provisions for customer advance payments, contract costs incurred, and
completion of specified contract milestones. Contracts may provide for customer
retainage of a portion of amounts billed until contract completion. Retainage is
generally due within one year of completion of the contract. Revenue recognition
under the percentage-of-completion method involves significant estimates which
may need to be adjusted from quarter to quarter which would impact revenue and
margins on a cumulative basis.
Effective with the beginning of fiscal year 2005, we changed the
parameters for application of the percentage of completion method of revenue
recognition. The minimum contract value has been raised to include all contracts
over $250,000 and the minimum completion period has been shortened to six months
for a contract to apply for this method. The criteria in prior years was
contracts over $100,000 in value with a completion period of one year or more.
This change applies to contracts entered into or started after February 27,
2004. Given the nature and mix of contracts booked in recent years, the we
believe adjusting the criteria in this way will allow for a more representative
reporting of the production flow and earnings process. We are unable to quantify
the impact this change would have had on prior years operating results.
Revenue for contracts under $250,000, or to be completed in less than
six months, and where there are no post-shipment services included in the
contract, is recognized on the date that the finished product is shipped to the
customer.
Revenue derived from the sale of parts or as-needed repair services is
recognized on the date that the product is shipped to the customer or that the
services are completed. Revenue on contracts under $250,000, or to be completed
in less than six months, and where post-shipment services (such as installation
and customer acceptance) are required, is recognized following customer
acceptance. Contracted maintenance services are provided under separate
maintenance contracts with our customers. Revenue for contracted maintenance
contracts is recognized ratably over the life of the contract with related
material costs expensed as incurred.
In accordance with accounting principles generally accepted in the
United States of America, recognizing revenue on contract claims and disputes
related to customer caused delays, errors in specifications and designs, and
other unanticipated causes, and for amounts in excess of contract value, is
generally appropriate if it is probable that the claim will result in additional
contract revenue and if we can reliably estimate the amount of additional
contract revenue which may be received. However, revenue recorded on a contract
claim cannot exceed the incurred contract costs related to that claim. Claims
involve significant judgments and estimates and are subject to negotiation,
arbitration and audit by the customer or governmental agency.
We have operating subsidiaries in the United Kingdom and Poland,
maintain regional offices in the Middle East, and Asia, and use the services of
approximately 100 independent sales organizations and agents throughout the
world. ETC International Corporation is a holding company established for
federal income tax purposes and is not an operating subsidiary. We consider our
business activities to be divided into two segments: Aircrew Training Systems
(ATS) and the Industrial Group.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and
results of operation are based upon the Company's consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these
financial statements requires the Company to make estimates and judgments that
affect the reported amount of assets and liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities at the date of the
Company's financial statements. Actual results may differ from these estimates
under different assumptions or conditions.
Critical accounting policies are defined as those that reflect
significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. The Company
believes that its critical accounting policies include those described below.
For a detailed discussion on the application of these and other accounting
policies, see Note 1 to the Consolidated Financial Statements, Summary of
Significant Accounting Policies in our Annual Report on Form 10-K for the fiscal
year ended February 27, 2004, which was filed with the Securities and Exchange
Commission on May 27, 2004.
14
Revenue Recognition on Long-Term Contracts
When the performance of a contract requires a customer to pay the
Company more than $250,000 and will extend beyond a six-month period, revenue
and related costs are recognized on the percentage-of-completion method of
accounting. Profits expected to be realized on such contracts are recognized
based on total estimated sales for the contract compared to total estimated
costs at completion of the contract. These estimates are reviewed periodically
throughout the lives of the contracts, and adjustments to profits resulting from
any revisions are made cumulative to the date of the change. Estimated losses on
long-term contracts are recorded in the period in which the losses become known
to us.
We account for some of our largest contracts, including our contracts
with the U.S. Government and foreign governments, using the
percentage-of-completion method. If we do not accurately estimate the total cost
to be incurred on this type of contract, or if we are unsuccessful in the
ultimate collection of any associated contract claims, 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 our results of operations and financial position.
Accounts Receivable
We perform ongoing credit evaluations of our customers and adjust
credit limits based on payment history and the customer's current credit
worthiness. We continuously monitor collections and payments from our customers
and maintain a provision for estimated credit losses based on historical
experience and any specific customer collection issues that have been
identified. While our credit losses have historically been within our
expectations and the provisions established, we cannot guarantee that we will
continue to experience the same credit loss rates that we have in the past.
Additionally, as a result of the concentration of international receivables, we
cannot predict the effect, if any, which geopolitical risk and uncertainty will
have on the ultimate collection of our international receivables.
RESULTS OF OPERATIONS
THIRTEEN WEEKS ENDED AUGUST 27, 2004 COMPARED TO THIRTEEN WEEKS ENDED AUGUST 29,
2003.
We have historically experienced significant variability in our
quarterly revenue, earnings and other operating results, and our performance may
fluctuate significantly in the future.
15
($000) SUMMARY TABLE OF RESULTS
- -------------------------------------------------
FY 05 Q2 FY 04 Q2 $ VAR % VAR
( )=UNFAVORABLE
SALES
DOMESTIC 3,304 1,757 1,547 88.1
US GOV'T 619 330 289 87.6
INT'L 2,600 2,665 (65) (2.4)
------ ------ ----- -----
TOTAL SALES 6,523 4,752 1,771 37.3
GROSS PROFIT 1,021 1,786 (765) (42.8)
SG&A EXPENSES 3,121 2,231 (890) (39.9)
R&D EXPENSES 292 (50) (342) (784.0)
INTEREST EXP. 387 389 2 0.5
OTHER EXP.,NET 40 78 38 48.7
INCOME TAXES (835) (238) 597 250.8
------ ------ ----- -----
NET LOSS (1,984) (622) (1,362) (219.0)
NET LOSS PER SHARE
(DILUTED) $(0.26) $(0.09) $(0.17) (188.9)
Net Loss.
- --------
The Company had a net loss of $(1,984,000), or ($0.26) per share
(diluted), during the second quarter of fiscal 2005 versus a net loss of
$(622,000), or ($.09) per share (diluted), for the second quarter of fiscal
2004, representing a decrease of $1,362,000 or 219.0%. This increase in net loss
was due to a significantly reduced gross profit margin coupled with increases in
selling and administrative and research and development expenses, partially
offset by increased sales and a larger income tax benefit.
Sales.
- -----
Sales for the second quarter of fiscal 2005 were $6,523,000 as compared
to $4,752,000 for the second quarter of fiscal 2004, an increase of $1,771,000
or 37.3%. Sales increases were evidenced in all product lines except
sterilizers. The most significant increases occurred in the entertainment and
environmental areas. ATS sales benefited from the shipment, which had been
delayed for over a year due to U.S. Government paperwork issues, of a gyro to
the Czech Republic. The environmental group experienced increased domestic sales
for automotive testing and HVAC applications. Entertainment experienced
significant quarter over quarter growth as new products were introduced to the
market.
We have historically experienced significant variability in our sales
performance. This reflects the existing sales backlog, product and the nature of
contract (size and performance time) mix, the manufacturing cycle and amount of
time to effect installation and customer acceptance, and certain factors not in
our control such as customer delays and the time required to obtain U.S.
Government export licenses. One or a few contract sales may account for a
substantial percentage of our quarterly revenue.
Domestic Sales.
- --------------
Overall, domestic sales in the second quarter of fiscal 2005 were
$3,304,000,000 as compared to $1,757,000 in the second quarter of fiscal 2004,
an increase of $1,547,000 or 88.1%, as all product lines except sterilizers and
ATS showed significant increases. Entertainment and environmental products
evidenced the most significant increases resulting from the aforementioned
activities. Domestic sales represented 50.7% of the Company's total sales in the
second quarter of fiscal 2005, up from 37.0% for the second quarter of fiscal
2004. Sales to the U.S. Government in the second quarter of fiscal 2005 were
$619,000 as compared to $330,000 in the second quarter of fiscal 2004, and
represented 9.5% of total sales in the second quarter of fiscal 2005 versus 6.9%
for the second quarter of fiscal 2004.
International Sales.
- -------------------
International sales for the second quarter of fiscal 2005 were
$2,600,000 as compared to $2,665,000 in the second quarter of fiscal 2004, a
decrease of $65,000 or 2.4%, and represented 39.8% of total sales as compared to
56.1% in the second quarter of fiscal 2004. Throughout our history, most of the
sales for Aircrew Training Systems have been made to international customers. In
the second quarter of fiscal 2005 international sales totaling at least ten
percent of total international sales were made to Malaysia ($915,000) and the
Czech Republic ($912,000). In the second quarter of fiscal 2004 international
sales totaling at least ten percent of total international sales were made to
government or commercial accounts in Malaysia ($1,280,000), Nigeria ($474,000),
and Korea ($275,000). 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.
16
Gross Profit.
- ------------
Gross profit for the second quarter of fiscal 2005 was $1,021,000 as
compared to $1,786,000 in the second quarter of fiscal 2004, a decrease of
$765,000 or 42.8%. This decrease resulted from a 21.9 percentage point decrease
in the gross profit rate as a percent of sales partially offset by an increase
in sales. The quarter-to-quarter reduction resulted primarily from a
significantly reduced gross margin rate in the pilot training systems (PTS)
group of ATS, which comprised 41.0% of total sales in the current period. This
reduction resulted from a budget cost increase for the Malaysia centrifuge
project reflecting additional testing and an extended installation period and
the shipment of the aforementioned gyro for the Czech Republic at a cost above
sales value, which resulted in a negative gross margin for the project.
Historically we have charged the cost of developing new product technologies to
individual contracts and occasionally only a portion of these costs are covered
by customer payments. Relatively speaking, the gross profit rate as a percent of
sales for the PTS group in the second quarter of fiscal 2004 was high reflecting
a few lost cost projects.
We have historically experienced significant fluctuations in gross
profit margins and, consequently, our operating results, and we expect such
fluctuations to continue. Gross margins are routinely affected by selling
prices, the engineering cost of product enhancements, the amount of new product
development required to meet contract specifications, the mix of materials,
labor content and engineering effort in manufacturing costs, labor difficulties
in field work including installation and customer acceptance, and the impact of
claims settlements. We face a challenge to reduce costs and improve gross
margins while implementing innovative new technologies.
Selling and Administrative Expenses.
- -----------------------------------
Selling and administrative expenses for the second quarter of fiscal
2005 were $3,121,000 as compared to $2,231,000 in the second quarter of fiscal
2004, an increase of $890,000 or 39.9% primarily reflecting significantly higher
costs associated with litigation and the Company's ongoing contract claims
activities. Two litigation matters, an international contract claim and the
legal suit against Walt Disney World Company, etc., were in the discovery phase
in the fiscal quarter ended August 27, 2004 and required high outside legal
effort. Although some decrease in the rate of expenditure is expected going
forward, these matters are expected to continue to require material legal
expenditures for the foreseeable future.
A significant portion of our selling and administrative spending is
related to three activities: 1. legal and contract claims costs, 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. We have recently instituted
a series of cost cutting measures and plan to continue to review all spending
categories.
Research and Development Expenses.
- ---------------------------------
Research and development expenses, which are charged to operations as
incurred, were $292,000 for the second quarter of fiscal 2005 as compared to a
credit of $50,000 for the second quarter of fiscal 2004, reflecting an increase
of $342,000 or 784.0%. Most of the increase resulted from a delay in obtaining
local government grant funding for spending in our Turkish subsidiary for two
projects currently in progress. We are currently evaluating the level of
spending required to support this operation.
Most of our research efforts, which were and continue to be a
significant cost of our business, are included in cost of sales for applied
research for specific contracts, as well as research for feasibility and
technology updates. Most of our products require a significant amount of
continued development effort to implement new applications, design product
extensions, and integrate new technology into existing products.
Interest Expense.
- ----------------
Interest expense for the second quarter of fiscal 2005 approximated the
prior period level. Interest expense includes interest on our debt, amortization
of debt discount resulting from the beneficial conversion option of the our
subordinated debt and associated warrants issued with the debt, and amortization
of deferred financing costs for our February 2003 refinancing.
Other Income/Expense, Net
- -------------------------
Other income/expense, net, was an expense of $40,000 for the second quarter
of fiscal 2005 versus a net expense of $78,000 for the second quarter of fiscal
2004, a decrease of $38,000 or 48.7%. The reduction in other income/expenses
reflected higher miscellaneous income in the current quarter.
Provision for Income Taxes.
- --------------------------
Given our pre-tax loss for the fiscal period, we recognized a tax
benefit for the second quarter of fiscal 2005 estimated at a 30% rate
domestically and a consolidated estimated rate of 29.6%. The consolidated rate
for the second quarter of fiscal 2004 reflected an estimated rate of 27.6%,
reflecting additional research and development tax credits.
17
RESULTS OF OPERATIONS
TWENTY-SIX WEEKS ENDED AUGUST 27, 2004 COMPARED TO TWENTY-SIX WEEKS ENDED
AUGUST 29, 2003.
We have historically experienced significant variability in our revenue,
earnings and other operating results, and our performance may fluctuate
significantly in the future.
$000) SUMMARY TABLE OF RESULTS
- ------------------------------------------------
FIRST SIX MONTHS FIRST SIX MONTHS $ VAR % VAR
FISCAL 2005 FISCAL 2004
( )=UNFAVORABLE
SALES
DOMESTIC 5,354 4,581 773 16.9
US GOV'T 1,067 665 402 60.5
INT'L 6,277 5,636 641 11.4
------ ------ ------ -------
TOTAL SALES 12,698 10,882 1,816 16.7
GROSS PROFIT 2,015 4,073 (2,058) (50.5)
SG&A EXPENSES 5,551 3,916 (1,635) (41.8)
R&D EXPENSES 501 32 (469) (1,465.6)
INTEREST EXP. 731 767 36 4.7
OTHER EXP.,NET 125 87 (38) (43.7)
INCOME TAXES (1,450) (171) 1,279 748.0
------ ------ ------ -------
NET LOSS (3,445) (552) (2,893) (524.1)
NET LOSS PER SHARE
(DILUTED) $(0.45) $(0.08) $(0.37) (462.5%)
Net Loss.
- ---------
The Company had a net loss of $(3,445,000), or ($0.45) per share
(diluted), during the first half of fiscal 2005 versus a net loss of $(552,000),
or ($.08) per share (diluted), for the first half of fiscal 2004, representing a
decrease of $2,893,000 or 524.1%. This increase in net loss was due to a
significantly reduced gross profit margin coupled with increases in selling and
administrative and research and development expenses, partially offset by
increased sales and a larger income tax benefit.
18
Sales.
- ------
Sales in the first half of fiscal 2005 were $12,698,000 as compared to
$10,882,000 for the first half of fiscal 2004, an increase of $1,816,000 or
16.7%. Sales increases were evidenced in the environmental, ATS and
entertainment lines. Environmental sales were higher for automotive testing
domestically and for HVAC applications in China. ATS benefited from the shipment
of a Gyro for the Czech Republic. Entertainment experienced significant period
over period growth as new products were introduced to the market. Acting as a
partial offset were significantly reduced sterilizer sales as the prior period
included revenue for a large multi-unit order.
We have historically experienced significant variability in our sales
performance. This reflects the existing sales bookings backlog, product and the
nature of contract (size and performance time) mix, the manufacturing cycle and
amount of time to effect installation and customer acceptance, and certain
factors not in our control such as customer delays and the time required to
obtain U.S. Government export licenses. One or a few contract sales may account
for a substantial percentage of our quarterly revenue.
Domestic Sales.
- --------------
Overall, domestic sales in the first half of fiscal 2005 were
$5,354,000 as compared to $4,581,000 for the first half of fiscal 2004, an
increase of $773,000 or 16.9%. The increase in domestic sales resulted from
significant growth in most product areas. Domestic sales represented 42.2% of
our total sales in the first half of fiscal 2005, up slightly from 42.1% for the
first half of fiscal 2004. Sales to the U.S. Government in the first half of
fiscal 2005 were $1,067,000 as compared to $665,000 for the first half of fiscal
2004, an increase of $402,000, 60.5%, and represented 8.4% of total sales in the
first half of fiscal 2005 versus 6.1% for the first half of fiscal 2004.
International Sales.
- -------------------
International sales in the first half of fiscal 2005 were $6,277,000 as
compared to $5,636,000 for the first half of fiscal 2004, an increase of
$641,000 or 11.4%, and represented 49.4% of total sales in the first half of
fiscal 2005, as compared to 51.8% for the first half of fiscal 2004. Throughout
our history, most of the sales for ATS have been made to international
customers. In the first half of fiscal 2005, international sales totaling at
least ten percent of total international sales were made to government or
commercial accounts in Malaysia ($2,140,000), the Czech Republic ($912,000),
Australia ($752,000) and Egypt ($752,000). In the first half of fiscal 2004,
international sales totaling at least ten percent of total international sales
were made to commercial or governmental accounts in Malaysia ($2,094,000).
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 first half of fiscal 2005 was $2,015,000 as
compared to $4,073,000 for the first half of fiscal 2004, a decrease of
$2,058,000 or 50.5%. This decrease resulted from a 21.5 percentage point drop in
the gross profit rate as a percent of sales partially offset by the
aforementioned sales increase. The period-to-period decrease reflected gross
profit rate reductions most notably in the simulation, PTS and hyperbaric
product areas. Simulation was negatively affected by additional development
funds for both domestic and international projects. PTS suffered from a budget
increase for the Malaysia centrifuge project reflecting additional testing and
an extended installation period due to customer delays and the shipment of two
gyros with net negative gross margins. Historically we have charged the cost of
developing new product technologies to individual contracts and occasionally
only a portion of these costs are covered by customer payments. Hyperbaric
products reflected cost overruns on the Navy SDC project which is the subject of
a claim.
We have historically experienced significant fluctuations in gross
profit margins and, consequently, our operating results, and we expect such
fluctuations to continue. Gross margins are routinely affected by selling
prices, the amount of new product development required to meet contract
specifications, the mix of materials, labor content and engineering effort in
manufacturing costs, and labor difficulties in field work including installation
and customer acceptance, and the impact of claims settlements.
Selling and Administrative Expenses.
- -----------------------------------
Selling and administrative expenses in the first half of fiscal 2005
were $5,551,000 as compared to $3,916,000 for the first half of fiscal 2004, an
increase of $1,635,000 or 41.8%. During the first half of fiscal 2005 we
incurred significant legal costs and claims expenses to support two litigation
matters that were in the discovery phase of the legal process, an international
contract claim and the suit against Walt Disney World Company. Additionally, the
first quarter of fiscal 2004 included a reimbursement of prior period legal and
claim expenses associated with an arbitration hearing in January 2003. Although
some decrease in the rate of expenditure is expected going forward, these
matters are expected to continue to require material legal expenditures for the
foreseeable future.
A significant portion of our selling and administrative spending is
related to three activities; 1. legal and contract claims costs, 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. We have recently instituted
a series of cost cutting measures and plans to continue to review all spending
categories.
19
Research and Development Expenses.
- ---------------------------------
Research and development expenses, which are charged to operations as
incurred, were $501,000 in the first half of fiscal 2005 as compared to $32,000
for the first half of fiscal 2004, reflecting an increase of $469,000 or
1465.6%. Most of the increase in research and development expenses resulted from
a delay in obtaining local government grant funding for spending in our Turkish
subsidiary for two projects currently in progress. The Company is currently
evaluating the level of spending required to support this operation.
Most of our research efforts, which were and continue to be a
significant cost of our business, are included in cost of sales for applied
research for specific contracts, as well as research for feasibility and
technology updates. Most of our products require a significant amount of
continued development effort to implement new applications, design product
extensions, and integrate new technology into existing products
Interest Expense.
- ----------------
Interest expense in the first half of fiscal 2005 was $731,000 as
compared to $767,000 for the first half of fiscal 2004, representing a decrease
of $36,000 or 4.7%. The reduction in interest expense primarily reflected a
temporary reduction in the interest rate for our subordinated debt borrowed in
February 2003. Interest expense includes interest on our debt, amortization of
debt discount resulting from the beneficial conversion option of our
subordinated debt and associated warrants issued with the debt, and amortization
of deferred financing costs for our February 2003 refinancing.
Other Income/Expense, Net
- -------------------------
Other income/expense, net, was a net expense of $125,000 for the first half
of fiscal 2005 versus a net expense of $87,000 for the first half of fiscal
2004, an increase of $38,000 or 43.7%. The current period included higher bank
and letter of credit charges.
Provision for Income Taxes.
- --------------------------
Given our pre-tax loss for the fiscal period, we recognized a tax
benefit in the first half of fiscal 2005 estimated at a 30.0% rate domestically
and a consolidated estimated rate of 29.6%. The consolidated rate for the first
half of fiscal 2004 reflected an estimated rate of 23.5% reflecting additional
research and development tax credits.
LIQUIDITY AND CAPITAL RESOURCES
Our cash flow is subject to significant fluctuations due to many factors.
The timing of new orders and associated advance and milestone deposits; the
complicated logistics of collecting payments from international customers under
letters of credit; customer induced schedule changes which could delay
shipments, final acceptance and release of final contract payments; the
variability and availability of funding for foreign government defense
purchases; changes in levels of customer capital spending; international
conflicts or economic crises; these and other factors not under our control may
have a material impact on the timing and amount of cash generation or usage.
During the first half of fiscal 2005 we generated $6,064,000 from
operating activities. This was primarily the result of the collection in March
2004 of a $10.5 million settlement on an international claim (The reader is
referred to the Notes to the Consolidated Financial Statements, Note 4,
"Accounts Receivable" for a discussion of claims.) coupled with non-cash
expenses, a decrease in inventory and an increase in billings in excess of costs
and estimated earnings on uncompleted long-term contracts. Acting as partial
offsets were the net loss, an increase in prepaid expenses and a decrease in
customer deposits. Generally speaking, the cash generation reflected significant
claims collections and the completion of some large non-POC (percentage of
completion) jobs.
Our investing activities used $1,454,000 during the first half of
fiscal 2005 which consisted of purchases of capital equipment, capitalized
leases, and capitalized software.
Our financing activities used $4,500,000 during the first half of
fiscal 2005 primarily reflecting an increase in our cash collateral restricted
cash account. The cash collateral account serves as additional collateral for
our bank facility.
We have historically financed operations through a combination of cash
generated from operations, and bank and other debt. On February 19, 2003, we
signed a Credit Agreement (the "Agreement") with PNC Bank, National Association
("PNC") and a Convertible Note and Warrant Purchase Agreement (the "Note") with
H.F. Lenfest, an individual, in the aggregate amount of $29,800,000. We used a
portion of the proceeds from the financing to satisfy our existing debt
obligations to Wachovia Bank, our former lender, and to permit PNC Bank to issue
a letter of credit to support outstanding bonds that we had issued in a previous
financing transaction. The transaction resulted in net proceeds (after
transaction expenses and payment of existing debt) to the Company of
approximately $3,600,000. We used the net proceeds for working capital and
general corporate purposes.
Our obligations to PNC under the Agreement are secured by a first priority lien
on and senior security interest in all of our assets, including all real
property that we own.
20
The Note issued to Mr. Lenfest included (i) a senior subordinated
convertible promissory note in the original principal amount of $10,000,000 and
(ii) warrants to purchase 803,048 shares of our common stock. Upon the
occurrence of certain events, we will be obligated to issue additional warrants
to Mr. Lenfest. The Note accrues interest at the rate of 10% per annum and
matures on February 18, 2009. The Note entitles Mr. Lenfest to convert all or a
portion of the outstanding principal of plus accrued and unpaid interest on the
Note into shares of common stock at a conversion price of $6.05 per share. The
warrants may be exercised into shares of common stock at an exercise price equal
to the lesser of $4.00 per share or two-thirds of the average of the high and
low sale prices of the common stock for the 25 consecutive trading days
immediately preceding the date of exercise.
Our obligations to Mr. Lenfest under the Note are secured by a second
priority lien on and security interest in all of our assets, junior in rights to
the liens and security interests in favor of PNC, including all real property
that we own.
On April 30, 2003, the Agreement was amended to include: (i) a
revolving credit facility in the maximum aggregate principal amount of
$14,800,000 to be used for our working capital and general corporate purposes,
including capital expenditures, with a sublimit for issuances of letters of
credit in the maximum aggregate face amount of $10,300,000, and (ii) a standby
letter of credit in the face amount of $4,750,000 as credit support for our
bonds. Additionally, on July 9, 2003, a second amendment to the Agreement was
executed which formed an additional $1,010,000 credit facility for use in
financing export contracts which qualify for an EXIM (the Export-Import Bank of
the United States) Bank guarantee.
During the first quarter of fiscal 2005, as a result of our recent
operating losses and our violation of certain financial covenants contained in
the Agreement, PNC advised us that it was instituting certain changes to the
revolving credit facility. The changes included reducing the facility to
$6,000,000 and requiring us to cash collateralize the full facility. These
changes became effective on June 2, 2004.
On August 24, 2004 the Agreement was amended to substantially reduce
the operating facility and eliminate the associated monthly borrowing base
reporting requirements. The revolving facility was reduced from $14,800,000 to
$5,000,000 and use of the facility was restricted to the issuance of letters of
credit, which are frequently a requirement of international contracts. We could
no longer borrow cash loans. Our long-term bonds were left intact. As additional
collateral for the revised facility, PNC required us to keep $2,500,000 in a
restricted cash account. The fee for letters of credit was reduced from 1.75% to
1.0% per annum. Additionally, three of the financial covenants, the Leverage
Ratio, the Fixed Charge Ratio and the requirement not to report a net loss in
any annual period were eliminated and the Tangible Net Worth requirement was
reduced. All other terms and conditions of the revolving loan and the line of
credit as set forth in the Agreement remained in effect.
Under the amended Agreement, we must maintain a minimum Tangible Net
Worth. At August 27, 2004 we dropped below this minimum and were in violation of
this financial covenant. We have obtained a waiver from PNC for this violation.
Additionally, under the Note, which covers our subordinated debt, we must meet
certain financial covenants including a Leverage Ratio, a Fixed Charge Ratio,
and a Tangible Net Worth Ratio. At August 27, 2004 we failed to meet any of
these financial covenants but have obtained a waiver from the subordinated
lender. These waivers are solely for the period specified, namely the fiscal
quarter ended August 27, 2004. Except as specified, these waivers do 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 us or any guarantor from any of
its duties, obligations, covenants or agreements including the consequences of
any Event of Default, except as specified.
Going forward, the Bank has agreed to review and reduce the minimum
Tangible Net Worth requirement to be more in line with our operating
performance. Specific terms and conditions for this modification had not yet
been finalized as of the filing date of this report. Based on the annual
forecast and the indicated actions described above, the Company does not
believe it is probable that it will fail future covenant tests.
Under the August 24, 2004 amendment, the EXIM Line was reduced from
$1,010,000 to $995,000, with all other terms and conditions remaining as per the
Agreement. Availability under the EXIM facility is determined based on a
borrowing base consisting of a portion of our receivables and inventory.
As a condition of amending the Agreement, Mr. Lenfest, holder of our
subordinated debt, agreed to issue to PNC on our behalf a limited guarantee to
secure up to $5,000,000 in principal amount of any letters of credit issued
under the amended revolving line of credit. In consideration for issuing this
guarantee, Mr. Lenfest will receive a fee of 0.75% per annum of the average
amount of letters of credit outstanding, payable on a quarterly basis, and a
warrant to purchase 200,000 shares of stock under the same terms and conditions
as his existing warrant for 803,048 shares (see discussion following).
Prior to the consummation of the February 2003 refinancing, Advanced
Technology Asset Management, LLC, ("ATAM"), a shareholder and a holder of
warrants to purchase 332,820 shares of our common stock, consented to the
transactions contemplated under the Agreement and the financing provided by Mr.
Lenfest, including the below market issuance of warrants to Mr. Lenfest. As a
result of its consent, ATAM waived, solely in connection with the issuance of
warrants to Mr. Lenfest, the anti-dilution rights contained in its warrant. In
exchange for ATAM's consent, we issued to ATAM warrants to purchase an
additional 105,000 shares of common stock. Except for the number of shares
issuable upon exercise of the warrants, the new ATAM warrants have substantially
the same terms as the warrants issued to Mr. Lenfest. In March 2004 ATAM
exercised all of its warrants and received a total of 437,820 shares of our
common stock. We received proceeds of $586,410 from the exercise of these
warrants.
21
Going forward, our significant cash requirements will relate to
salaries and other operational expenses, continued spending for product
enhancements and technology and the costs of litigating claims and lawsuits. To
fund these items, we plan to utilize cash from operations and proceeds from
potential arbitration proceeds as well as additional cash which was restricted
by the Bank but which will become available under the August 24, 2004 amended
agreement. We have recently instituted a series of cost cutting measures and
plans to continue to review all spending categories.
Given our inability to borrow cash under the amended Agreement, we may
need to obtain additional sources of capital in order to continue growing our
business. This capital may be difficult to obtain and the cost of this
additional capital is likely to be relatively high. However, we believe that we
will be able to locate such additional capital and that these actions by our
bank will not have a long-term material adverse effect on our business.
The following table presents our contractual cash flow commitments on
long-term debt and operating leases as of August 27, 2004.
PAYMENTS DUE BY PERIOD (IN THOUSANDS)
-----------------------------------------------------------------------------------
LESS THAN 1
TOTAL YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS
---------- ------------ ------------ ----------- ---------------
Long-term debt, including
current maturities $12,779 $442 $1,245 $550 $10,542
Operating leases 694 139 86 83 386
------- ---- ------ ---- -------
Total 13,473 $581 $1,331 $633 $10,928
Contract Claims
- ---------------
Historically, we have had positive experience with regard to our
contract claims in that recoveries have exceeded the carrying value of claims.
As of August 27, 2004, claims recorded against the U.S. Government totaled
$3,004,000 and claims recorded against an international customer totaled
$2,600,000.
Claim costs have been incurred in connection with customer caused
delays, errors in specifications and designs, other out-of-scope items and
exchange losses and may not be received in full during fiscal 2005. In
conformity with accounting principles generally accepted in the United States of
America, revenue that we record from a claim may not exceed the incurred
contract costs related to the claim.
In November 2003, the U.S. Government completed an audit of the
submarine rescue decompression chamber project claim, rejecting most of the
items due to audit or engineering reasons. We were not provided a copy of the
Government's Technical Report that questioned approximately half of the claim
costs. We have submitted a written rebuttal to the draft report and have
formally requested a copy of the Technical Report. On July 22, 2004 the U.S.
Government' Contracting Officer issued a final decision on the claim, denying
the claim in full. We plan to file a complaint in the Court of Federal Claims in
the near future.
This U. S. Government claim has followed the typical process of claim
notification, preparation, submittal, government audit, and review by the
contracting officer. Historically, most claims are initially denied in part or
in full by the contracting officer (or no decision is forthcoming, which is then
taken to be a deemed denial) which then forces us to seek relief in a court of
law.
We consider the recorded costs to be realizable due to the fact that
they relate to customer caused delays, errors and changes in specifications and
designs, disputed liquidated damages and other out of scope items. The U.S.
Government, citing failure to deliver the product within contract terms, has
assessed liquidated damages but has not offset or withheld any progress payments
due to us under the contract. We dispute the basis for these liquidated damages,
noting that applicable U.S. Government purchasing regulations allow for a waiver
of these charges if the delay is beyond our control and not due to our fault or
negligence. However, following accounting principles generally accepted in the
United States, we have reduced contract values and corresponding revenue
recognition for an estimated amount of $330,000 to cover a delay through the
extended delivery period.
With respect to the claims filed against an international customer, we
are currently in the discovery phase of the arbitration process. We have filed
our "points of Claim" to which the customer has replied. Additionally, the
customer has filed a counterclaim, which we answered, in the fiscal quarter
ended August 27, 2004. The customer, citing failure to deliver product within
contract terms, has assessed liquidated damages totaling approximately $400,000
on the contract. We dispute the basis for these liquidated damages and are
vigorously contesting them. However, following accounting principles generally
accepted in the United States of America, we have reduced contract values and
corresponding revenue recognition by approximately $400,000. At this time we are
unable to assess the ultimate impact of the arbitration on current operations
and financials.
The open balance of $700,000 due on the contract represents the total
net exposure to us on this contract. On June 16, 2003, our 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. In December 2003 we and the RTAF both
picked arbitrators to represent each of us respectively in the dispute, although
no date has yet been set for the Arbitration proceedings. Citing a conflict of
interest on the part of the RTAF's arbitrator, we were successful earlier this
fiscal year in having the RTAF's first choice for arbitrator disqualified. They
have since chosen another candidate, whom we also feels is not a disinterested
party and thus on August 3, 2004 we formally protested his appointment on the
grounds of a conflict of interest.
22
Since the circumstances that caused a delay are commonly considered
"force majeure" events, and since the contract under question allows for
consideration of "force majeure" events, we believe that the open balance
related to this contract is collectible and will continue to treat this balance
as collectible until a final unappealable legal decision is rendered by a
competent Thai tribunal. We continue to enjoy a favorable relationship with the
RTAF. We currently have both maintenance and upgrade contracts with the RTAF for
trainers that are the subject of the dispute and have sold a significant amount
of additional equipment to the RTAF since this dispute began, and the initiation
of legal action against the RTAF has not affected our ability to obtain future
contracts with the RTAF. At this point, we are not able to determine what, if
any, impact the extended completion period will ultimately have upon the receipt
of final payment under this contract.
Backlog
Our sales backlog at August 27, 2004 and February 27, 2004, for work to
be performed and revenue to be recognized under written agreements after such
dates was approximately $14,470,000 and $16,914,000 respectively. In addition,
our training, maintenance and upgrade contracts backlog at August 27, 2004, and
February 27, 2004, for work to be performed and revenue to be recognized after
that date under written agreements was approximately $1,190,000 and $2,637,000
respectively. Of the August 27, 2004 backlog, approximately $5,358,000 was under
contracts for ATS products including $3,450,000 for Egypt and $1,659,000 for the
Royal Malaysian Air Force.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risk, including changes in interest
rates. Market risk is the potential loss arising from adverse changes in market
rates and prices such as interest rates and foreign exchange rates. We do not
enter into derivatives or other financial instruments for trading or speculative
purposes. Also, we have not entered into financial instruments to manage and
reduce the impact of interest rates and foreign currency exchange rates although
we may enter into such transactions in the future. A portion of our indebtedness
bears interest at rates that vary with the prime rate of interest. Accordingly,
any applicable increases in the applicable prime rate of interest will reduce
our earnings. With respect to currency risk, where we have a contract that is
denominated in a foreign currency, we often establish local in-country bank
accounts and fund in-country expenses in the local currency, thus creating a
"natural" currency hedge for a portion of the contract.
ITEM 4. CONTROLS AND PROCEDURES.
Under the supervision and with the participation of our management,
including our chief executive officer and chief financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of August 27, 2004 (the "Evaluation Date"), and,
based on this evaluation, our chief executive officer and chief financial
officer have concluded that these controls and procedures were effective as of
the Evaluation Date. There were no significant changes in our internal controls
or in other factors that could significantly affect these controls during the
fiscal quarter ended on the Evaluation Date.
Disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended) are our
internal controls and other procedures that are designed to ensure that
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commission's rules and
forms. Disclosure controls and procedures include, without limitation, controls
and procedures designed to ensure that information that we are required to
disclose in the reports that we file under the Exchange Act is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate to allow timely decisions regarding required
disclosure.
23
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In April 2003, Boenning & Scattergood, Inc. ("B&S") filed suit against
the Company in the Court of Common Pleas in Philadelphia, Pennsylvania, seeking
payment of $901,843.46 for financing fees allegedly due to B&S pursuant to the
terms of an agreement for investment banking services, which was entered into
with a predecessor of B&S (the "B&S Agreement"). B&S alleges that it contacted
the investors in the Company's February 2003 financing transaction and that it
earned the claimed financing fees pursuant to the terms of the B&S Agreement.
The Company has responded to the complaint and also filed a counterclaim for
breach of contract and professional malpractice. The Company believes that it
has valid defenses to each of the claims of B&S and intends to vigorously defend
itself against these claims. At this time, however, discovery is ongoing and the
Company is unable to predict the outcome of this matter.
In June 2003, Entertainment Technology Corporation ("EnTCo"), our
wholly-owned subsidiary, filed suit against Walt Disney World Co. and other
entities ("Disney") in the United States District Court for the Eastern District
of Pennsylvania, alleging breach of contract for, among other things, failure to
pay all amounts due under contract for the design and production of the
amusement park ride "Mission: Space" located in Disney's Epcot Center. In
response, in August 2003, Disney filed counterclaims against both 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. EnTCo and the Company believe that they
have valid defenses to each of Disney's counterclaims and intend to vigorously
defend against these counterclaims. At this time, the parties are engaged in the
discovery process. The parties have exchanged self-executing disclosures and
responses to interrogatories, have produced documents, and have started
depositions. EnTCo and the Company are unable to predict the outcome of this
matter.
Certain claims, suits and complaints arising in the ordinary course of
business have been filed or are pending against us. In the opinion of
management, all such matters are reserved for or are adequately covered by
insurance or, if not so covered, are without merit or are of such kind, or
involve such amounts as would not have a material adverse effect on our
financial position if resolved unfavorably.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The constituent instruments defining the rights of the holders of any
class of securities were not modified nor were the rights evidenced by any class
of registered securities materially limited or qualified during the period
covered by this report.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None.
24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Number Item
- ------ ----
3.1 Registrant's Articles of Incorporation, as amended, were filed
as Exhibit 3.1 to Registrant's Form 10-K for the year ended
February 28, 1997 and are incorporated herein by reference.
3.2 Registrant's By-Laws, as amended, were filed as Exhibit 3 (ii)
to Registrant's Form 10-K for the year ended February 25,
1994, and are incorporated herein by reference.
10.1 Amendment to Credit Agreement, dated as of August 24, 2004,
between ETC and PNC Bank, National Association (incorporated
by reference to the Company's Current Report on Form 8-K filed
on September 10, 2004).
10.2 Second Amended and Restated Revolving Credit Note, dated
August 24, 2004, issued by ETC in favor of PNC Bank, National
Association (incorporated by reference to the Company's
Current Report on Form 8-K filed on September 10, 2004).
10.3 Limited Guaranty Agreement, dated as of August 24, 2004, of
H.F. Lenfest in favor of PNC Bank, National Association
(incorporated by reference to the Company's Current Report on
Form 8-K filed on September 10, 2004).
31.1 Certification dated October 11, 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 October 11, 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 October 11, 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 July 19, 2004, the Company filed a Current Report on Form 8-K
reporting its financial results for the first quarter of fiscal 2005.
25
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: October 12, 2004 By: /s/ William F. Mitchell
------------------------------------
William F. Mitchell
President and Chief
Executive Officer
(Principal Executive Officer)
Date: October 12, 2004 By: /s/ Duane D. Deaner
-------------------------------------
Duane D. Deaner,
Chief Financial Officer
(Principal Financial and
Accounting Officer)