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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
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 number 0-21352
APPLIED INNOVATION INC.
(Exact name of registrant as specified in its charter)
DELAWARE 31-1177192
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) identification no.)
5800 INNOVATION DRIVE, DUBLIN, OHIO 43016
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (614)-798-2000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ___
As of November 8, 2002 there were 14,950,749 shares of common stock outstanding.
APPLIED INNOVATION INC.
Table of Contents
Page
----
Facing Page 1
Table of Contents 2
Part I. Financial Information
- ----------------------------
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2002
(unaudited) and December 31, 2001 3
Consolidated Statements of Operations for the three- and nine-month
periods ended September 30, 2002 and 2001 (unaudited) 4
Consolidated Statements of Cash Flows for the nine-month
periods ended September 30, 2002 and 2001 (unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6 - 9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 9 - 15
Item 3. Quantitative and Qualitative Disclosure About Market Risk 15
Item 4. Controls and Procedures 15
Part II. Other Information
- --------------------------
Items 1 - 5. 15
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits 15
(b) Reports on Form 8-K 16
Signatures 16
Certifications 17 - 19
-2-
PART I. FINANCIAL INFORMATION
- ------- ---------------------
Item 1. Financial Statements
APPLIED INNOVATION INC.
Consolidated Balance Sheets
(Unaudited)
September 30, 2002 December 31, 2001
-------------------- --------------------
Assets
- ------
Current assets:
Cash and cash equivalents $ 15,705,662 $ 15,698,594
Short term investments 6,082,953 6,067,770
Accounts receivable, net 3,872,553 7,697,003
Inventory, net 3,968,056 7,322,316
Income taxes 3,509,935 903,269
Other current assets 347,182 630,593
Deferred income taxes 2,703,000 2,678,000
-------------------- --------------------
Total current assets 36,189,341 40,997,545
Property, plant and equipment, net 8,261,709 8,823,355
Investments 1,786,933 6,849,766
Intangible assets, net 393,750 551,250
Goodwill 3,466,201 3,423,201
Other assets 176,261 202,687
-------------------- --------------------
$ 50,274,195 $ 60,847,804
==================== ====================
Liabilities and Stockholders' Equity
- ------------------------------------
Current liabilities:
Accounts payable $ 2,319,496 $ 3,107,412
Accrued expenses:
Warranty 765,047 819,166
Payroll and related expenses 676,528 1,512,229
Accrued restructuring 1,122,001 -
Other accrued expenses 306,884 379,888
Deferred revenue 2,118,468 3,375,197
-------------------- --------------------
Total current liabilities 7,308,424 9,193,892
Note payable 750,000 750,000
-------------------- --------------------
Total liabilities 8,058,424 9,943,892
Stockholders' equity:
Preferred stock; $.01 par value; authorized 5,000,000 shares;
none issued and outstanding - -
Common stock; $.01 par value; authorized 55,000,000 shares; issued and
outstanding 14,950,749 shares in 2002 and 15,512,899 shares in 2001 149,507 155,129
Additional paid-in capital 5,845,740 8,659,450
Note receivable for common stock (382,783) (494,871)
Retained earnings 36,594,676 42,535,717
Accumulated other comprehensive income 8,631 48,487
-------------------- --------------------
Total stockholders' equity 42,215,771 50,903,912
-------------------- --------------------
$ 50,274,195 $ 60,847,804
==================== ====================
See accompanying notes to consolidated financial statements.
-3-
APPLIED INNOVATION INC.
Consolidated Statements of Operations (Unaudited)
Three Months Ended September 30, Nine Months Ended September 30,
2002 2001 2002 2001
------------ ------------ ------------ ------------
Sales:
Products and integration $ 5,578,271 $ 15,628,473 $ 27,792,461 $ 50,339,853
Services 1,668,293 4,006,095 5,387,611 11,924,044
------------ ------------ ------------ ------------
Total sales 7,246,564 19,634,568 33,180,072 62,263,897
Cost of sales:
Cost of sales - products and integration 3,616,466 6,524,316 15,840,944 24,582,396
Cost of sales - services 963,873 2,599,880 3,664,972 7,185,799
------------ ------------ ------------ ------------
Total cost of sales 4,580,339 9,124,196 19,505,916 31,768,195
Gross profit 2,666,225 10,510,372 13,674,156 30,495,702
Operating expenses:
Selling, general and administrative 4,381,026 5,974,961 15,040,084 17,523,288
Research and development 1,520,080 2,190,239 5,812,095 7,106,695
Restructuring charges 2,468,953 - 2,876,683 292,330
------------ ------------ ------------ ------------
(Loss) income from operations (5,703,834) 2,345,172 (10,054,706) 5,573,389
Interest income and other income, net 111,820 340,494 472,665 1,126,574
------------ ------------ ------------ ------------
(Loss) income before income taxes (5,592,014) 2,685,666 (9,582,041) 6,699,963
Income taxes (2,444,000) 913,744 (3,641,000) 2,278,644
------------ ------------ ------------ ------------
Net (loss) income $ (3,148,014) $ 1,771,922 $ (5,941,041) $ 4,421,319
============ ============ ============ ============
(Loss) earnings per share:
Basic (loss) earnings per share $ (0.21) $ 0.11 $ (0.39) $ 0.28
============ ============ ============ ============
Diluted (loss) earnings per share $ (0.21) $ 0.11 $ (0.39) $ 0.27
============ ============ ============ ============
Weighted-average shares outstanding
for basic (loss) earnings per share 14,952,515 15,909,600 15,139,311 15,898,632
============ ============ ============ ============
Weighted-average shares outstanding
for diluted (loss) earnings per share 14,952,515 16,082,922 15,139,311 16,208,898
============ ============ ============ ============
See accompanying notes to consolidated financial statements.
-4-
APPLIED INNOVATION INC.
Consolidated Statements of Cash Flows (Unaudited)
Nine Months Ended September 30,
2002 2001
-------------------- --------------------
Cash flows from operating activities:
Net (loss) income $ (5,941,041) $ 4,421,319
Adjustments to reconcile net (loss) income to net cash
(used in) provided by operating activities:
Depreciation 1,356,784 1,273,522
Amortization of intangible assets 157,500 93,750
Loss (gain) on disposal of assets 80,141 (9,193)
Deferred income tax expense - 400,000
Tax benefit of options exercised 340 587,600
Effects of changes in operating assets and liabilities:
Accounts receivable 3,824,450 17,393,175
Inventory 3,354,260 4,739,550
Income taxes (2,606,666) -
Other current assets 283,411 214,421
Other assets 26,426 57,067
Accounts payable (787,916) (16,011,252)
Accrued expenses 116,177 (4,126,285)
Deferred revenue (1,256,729) (1,067,849)
-------------------- --------------------
Net cash (used in) provided by operating activities (1,392,863) 7,965,825
-------------------- --------------------
Cash flows from investing activities:
Purchases of property, plant and equipment (909,020) (1,312,474)
Acquisition of Badger - (3,584,167)
Purchases of investments (4,388,825) (21,352,556)
Maturities of investments 8,615,086 13,335,931
Sales of investments 756,533 5,325,093
Proceeds from sales of property, plant and equipment 33,741 30,938
-------------------- --------------------
Net cash provided by (used in) investing activities 4,107,515 (7,557,235)
-------------------- --------------------
Cash flows from financing activities:
Common stock repurchased (2,834,891) (452,000)
Proceeds from payment on note receivable 112,088 -
Proceeds from issuance of common stock 15,219 822,750
-------------------- --------------------
Net cash (used in) provided by financing activities (2,707,584) 370,750
-------------------- --------------------
Increase in cash and cash equivalents 7,068 779,340
Cash and cash equivalents - beginning of period 15,698,594 14,020,080
-------------------- --------------------
Cash and cash equivalents - end of period $ 15,705,662 $ 14,799,420
==================== ====================
See accompanying notes to consolidated financial statements.
-5-
APPLIED INNOVATION INC.
Notes to Consolidated Financial Statements
(Unaudited)
1. Basis of presentation - The consolidated balance sheet as of September 30,
2002, the consolidated statements of operations for the three- and nine-month
periods ended September 30, 2002 and 2001, and the consolidated statements of
cash flows for the nine-month periods ended September 30, 2002 and 2001, have
been prepared by the Company without audit. In the opinion of management, all
adjustments, which consist solely of normal recurring adjustments, necessary to
present fairly, in accordance with generally accepted accounting principles in
the United States of America, the financial position, results of operations and
cash flows for all periods presented have been made.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These consolidated financial statements should
be read in conjunction with the consolidated financial statements and notes
thereto included in the Company's December 31, 2001 Annual Report on Form 10-K.
The results of operations for the period ended September 30, 2002 are not
necessarily indicative of the results for the full year.
2. Inventory - Inventory is stated at the lower of cost or market. Cost is
computed using standard cost, which approximates actual cost on a first-in,
first-out method, net of allowances for estimated obsolescence. Major classes of
inventory at September 30, 2002 and December 31, 2001 are summarized below:
September 30, 2002 December 31, 2001
------------------ -----------------
Raw materials $ 3,535,913 $ 7,104,242
Work-in-process 320,814 181,552
Finished goods 1,099,682 1,806,808
----------- -----------
4,956,409 9,092,602
Reserve for obsolescence (988,353) (1,770,286)
----------- -----------
$ 3,968,056 $ 7,322,316
=========== ===========
3. Income taxes - The Company has recorded its interim income tax provision
based on estimates of the Company's effective tax rate expected to be applicable
for the full fiscal year. Estimated effective rates recorded during interim
periods may be periodically revised, if necessary, to reflect current estimates.
4. Comprehensive income - Comprehensive loss for the three- and nine-month
periods ended September 30, 2002 was $3,141,789 and $5,980,897, respectively.
The sole adjustment necessary to reconcile net loss with comprehensive loss is
the net unrealized gain (loss), net of taxes, on available-for-sale investment
securities, which was $6,225 for the three months ended September 30, 2002 and
($39,856) for the nine months ended September 30, 2002.
-6-
Comprehensive income for the three- and nine-month periods ended September 30,
2001 was $1,806,167 and $4,445,133, respectively. The sole adjustment necessary
to reconcile net income with comprehensive income is the net unrealized gain,
net of taxes, on available-for-sale investment securities, which was $34,245 for
the three months ended September 30, 2001 and $23,814 for the nine months ended
September 30, 2001.
5. Earnings per share - Basic (loss) earnings per share is calculated using the
weighted-average number of common shares outstanding during the periods. Diluted
earnings per share is calculated using the weighted-average number of common and
common equivalent shares outstanding during the periods. Due to the Company's
net loss, no common equivalent shares were included in the calculation of
diluted loss per share for the three and nine months ended September 30, 2002
because their effect would have been anti-dilutive. For the three months ended
September 30, 2002, the Company had no stock options which were in-the-money
and, therefore, potentially dilutive. For the nine months ended September 30,
2002, the Company's weighted-average number of stock options which were
in-the-money and, therefore, potentially dilutive, was 167,375. For the three
and nine months ended September 30, 2002, the Company had 2,468,462 and
2,477,505, respectively, of weighted-average stock options which were
out-of-the-money.
Shares of common stock used in calculating earnings per share differed from
those amounts reported in the consolidated financial statements as follows:
Three months ended Three months ended
September 30, 2002 September 30, 2001
------------------- ------------------
Basic earnings Diluted earnings Basic earnings Diluted earnings
per share per share per share per share
---------- ---------- ---------- ----------
Outstanding shares 14,950,749 14,950,749 15,850,959 15,850,959
Effect of weighting changes
in outstanding shares 1,766 1,766 58,641 58,641
Stock options -- -- -- 173,322
---------- ---------- ---------- ----------
Adjusted shares 14,952,515 14,952,515 15,909,600 16,082,922
========== ========== ========== ==========
Nine months ended Nine months ended
September 30, 2002 September 30, 2001
------------------- ------------------
Basic earnings Diluted earnings Basic earnings Diluted earnings
per share per share per share per share
---------- ---------- ---------- ----------
Outstanding shares 14,950,749 14,950,749 15,850,959 15,850,959
Effect of weighting changes
in outstanding shares 188,562 188,562 47,673 47,673
Stock options -- -- -- 310,266
---------- ---------- ---------- ----------
Adjusted shares 15,139,311 15,139,311 15,898,632 16,208,898
========== ========== ========== ==========
6. Goodwill and intangible assets - Effective January 1, 2002, the Company
adopted the provisions of Statement of Financial Accounting Standards (SFAS) No.
142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill
and intangible assets with indefinite
-7-
useful lives no longer be amortized, but instead be tested for impairment at
least annually in accordance with the provisions of SFAS No. 142. It also
requires that the Company complete a transitional goodwill impairment test
within six months from the date of adoption and reassess the useful lives of
other intangible assets within the first interim quarter after adoption. Any
impairment losses that arise due to the initial adoption of the standard must be
reported as a cumulative effect of a change in accounting principle.
The Company had no previously recorded goodwill or other intangible assets
accounted for under standards other than SFAS No. 142. In accordance with SFAS
No. 142, the Company completed the transitional goodwill impairment test during
the second quarter of 2002 and the annual impairment test during the third
quarter of 2002 and determined that no impairment charges were necessary.
The Company's goodwill relates to an acquisition made in 2001. As part of the
acquisition, the Company agreed to pay up to $750,000 in contingent
consideration based on certain product sales in the two years subsequent to the
acquisition. For the three- and nine-months ended September 30, 2002, the
Company recorded additional goodwill of $10,400 and $43,000, respectively, based
on actual product sales and contingent amounts owed.
7. Equity - On September 14, 2002, the twelve-month stock repurchase program
authorized by the Company's Board of Directors ended. During the three months
ended September 30, 2002, the Company paid $18,366 to repurchase 5,800 shares
under this program. During the nine months ended September 30, 2002, the Company
paid $2,834,891 to repurchase 566,150 shares under this program. For the twelve
months since inception of the repurchase program, the Company paid $5,863,019 to
repurchase 1,011,450 shares.
8. Restructuring costs - On August 14, 2002, the Company announced a
restructuring plan, including management changes and a reduction in workforce of
approximately 40%, or approximately 100 employees, throughout all departments.
Management changes included Gerard B. Moersdorf, Jr., Chairman and Founder,
resuming his previous role as President and Chief Executive Officer. Robert L.
Smialek vacated those positions, which he held since July 2000, and no longer
serves on the Company's Board of Directors. As a result of the restructuring
plan, the Company recorded restructuring charges of $2,469,000 during the third
quarter of 2002, relating primarily to severance and other fringe benefits for
affected employees, as well as charges related to excess equipment and leased
offices. As of September 30, 2002, the Company has paid out $1,350,000 of such
restructuring costs and has accrued restructuring costs of $1,119,000. The
Company expects to pay out approximately half of the accrued restructuring costs
prior to December 31, 2002. With the exception of approximately $112,000 related
to lease payments extending to 2005, the remaining accrued restructuring costs
are expected to be paid out in 2003.
On February 5, 2002, the Company announced a reduction in workforce of
approximately 16%, or approximately 50 employees, throughout all departments.
The Company recorded a workforce reduction charge of approximately $634,000 in
the first quarter of 2002 relating primarily to severance and fringe benefits.
The Company has paid out $405,000 of such costs as of
-8-
September 30, 2002 and reversed $226,000 of accrued restructuring costs in the
second quarter of 2002, resulting in accrued restructuring costs of $3,000 as of
September 30, 2002.
9. Employee Stock Purchase Plan - At the April 25, 2002 Annual Meeting of
Stockholders, the Applied Innovation Inc. Employee Stock Purchase Plan ("the
Plan") was approved and adopted. The Plan authorizes the sale of up to 500,000
shares of Applied Innovation Inc. common stock to eligible employees, pursuant
to the terms and conditions outlined in the Plan.
10. Credit facility - On August 7, 2002, the Company entered into an agreement
with The Huntington National Bank ("the Bank") for a credit facility. The term
of the credit facility is 364 days and provides for a line of credit up to
$10,000,000, with interest payable monthly and principal due at maturity.
Borrowings on the line are subject to a borrowing base which will be limited to
$5,000,000 on real estate, plus 75% of eligible accounts receivable and 40% of
eligible inventory, as defined in the agreement. Borrowings will bear interest
at the London Interbank Offered Rate ("LIBOR") plus 1.65%, or the Bank's Prime
Commercial Rate less 1.00%, at the option of the Company. Borrowings will be
collateralized by the Company's receivables, inventory, certain investments,
equipment, real estate and general intangibles. The credit facility contains
certain financial covenants, including, but not limited to, restrictions on the
payment of dividends, minimum tangible net worth and a minimum liquidity ratio.
At September 30, 2002, the Company has no outstanding borrowings under this
credit facility.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Applied Innovation Inc. develops, manufactures, and markets network mediation
and bridging products and related services to the telecommunications industry.
The products and services support the operation, maintenance, administration and
provisioning of a variety of switching and transmission devices used by wireline
and wireless telecommunications providers to assist in the management of their
customer service networks. The Company's primary emphasis is on providing
integrated hardware, software, service and turnkey network management solutions.
The Company's largest customers are the four Regional Bell Operating Companies
("RBOCs"), as well as other large domestic and foreign phone companies. In
recent months, sales focus has increased related to domestic Independent
Operating Carriers ("IOCs"), also known as Independent Local Exchange Carriers
("ILECs"), which are operating companies in local and rural markets.
The Company's order flow and product and services sales continue to be
negatively impacted by the prolonged spending slowdown in the telecommunications
industry. The Company continues to experience weakness in its core markets as
its large domestic customers continue to reduce their capital spending and delay
network maintenance projects. Prompted by these industry conditions, the Company
took further cost cutting actions in the third quarter of 2002, resulting in
restructuring charges of $2,469,000 in the quarter. Because of the continued
uncertainty in the industry, the Company remains unable to provide revenue
estimates or other guidance for the remainder of 2002. The Company continues to
view the international and wireless markets as areas of opportunity and
continues its efforts in those areas, including a number of international field
trials currently underway. The Company also continues to explore the possibility
of new markets for its products within the United States government.
-9-
RESULTS OF THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2002 COMPARED
TO THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2001
Sales for the third quarter of 2002 were $7,246,000, a decrease of 63% from
prior year third quarter sales of $19,634,000. Year-to-date sales of $33,180,000
for 2002 decreased 47% from 2001 year-to-date sales of $62,264,000. The 2001
year-to-date sales include $5,830,000 of integration sales from the first
quarter of 2001 which the Company identified as non-recurring in nature. The
overall decrease in year-to-date sales is largely attributable to overall weak
demand for telecommunications equipment and related services, evidenced by much
lower order activity and project delays from the Company's largest customers.
Gross profit as a percentage of total sales was 37% for the third quarter of
2002, versus 54% for the third quarter of 2001. Year-to-date gross profit
percentages were 41% and 49% for 2002 and 2001, respectively. Current year gross
profit as a percentage of total sales continues to lag the prior year based
primarily on the overall decrease in demand for both products and services.
Overall lower demand results in less fixed cost absorption and, therefore,
decreased margins. In addition, as further discussed below, the Company took
additional inventory charges in the third quarter of 2002 to further writedown
certain of its inventory and also established specific warranty reserves for
exposure associated with a single product line.
The following table summarizes sales and gross profit for products and services:
For the Quarter Ended September 30, 2002 For the Quarter Ended September 30, 2001
---------------------------------------- ----------------------------------------
Products Services Total Products Services Total
-------- -------- ----- -------- -------- -----
Sales $ 5,578,000 $1,668,000 $ 7,246,000 $15,628,000 $ 4,006,000 $19,634,000
Gross Profit 1,962,000 704,000 2,666,000 9,104,000 1,406,000 10,510,000
Gross Profit % 35% 42% 37% 58% 35% 54%
Product sales of $5,578,000 were 77% of 2002 third quarter sales, versus product
sales of $15,628,000, or 80% of 2001 third quarter sales. Year-to-date product
sales of $27,792,000 were 84% of total sales in 2002, versus $44,510,000, or 71%
of total sales in 2001. Product sales for the quarter decreased 64% from the
comparable quarter in the prior year and 37% on a year-to-date basis from the
prior year, attributable to overall reduced capital spending in the
telecommunications industry. Product sales include revenues from the sales of
AIswitch, AIscout, and other products, as well as third-party hardware and
software licensing revenues.
Gross profit on product sales was 35% of total product sales for the third
quarter of 2002, compared with 58% of total product sales for the same period
last year. The overall reduced product sales volume in 2002 resulted in
decreased margins due to lower absorption of certain fixed manufacturing costs.
Additionally, the Company recorded $350,000 in inventory charges during the
third quarter of 2002 related to price reductions of certain materials in stock,
slow-moving stock and scrap inventory associated with the termination of a
contract manufacturer. The Company also reserved approximately $200,000 for a
specific warranty exposure associated with a single product line. The Company
believes this exposure is limited to specific products shipped to a single
customer and will be fully resolved in the fourth quarter of 2002. Finally,
product sales for the quarter included
-10-
approximately $750,000 of third-party computer equipment for a network
management system (NMS) deployment and such third-party equipment sales yield
lower margins than the Company's core products.
Services sales of $1,668,000 were 23% of 2002 third quarter sales, versus
services sales of $4,006,000, or 20% of 2001 third quarter sales. Year-to-date
services sales of $5,388,000 were 16% of total sales in 2002, compared to
$11,924,000, or 19% of total sales in 2001. Services sales for the quarter
decreased 58% from the comparable quarter in the prior year and 55% on a
year-to-date basis from the prior year. Demand for installation services has
decreased, corresponding with the overall decrease in product sales from the
previous year and consistent with the overall reduced spending in the industry.
Services sales consists of network planning and design, installation, project
management and engineering services, training and maintenance.
Service gross profit for the three-month period ended September 30, 2002 was 42%
of services sales, versus 35% for the same period in 2001. The increase in
margin in 2002 is primarily attributable to a reduction in lower margin
installation work and an increased mix of higher margin NMS services.
Because of the Company's concentration of sales to RBOCs, long distance phone
companies, and large CLECs, a small number of customers have represented
substantial portions of net sales. For the nine months ended September 30, 2002,
sales to three companies comprised 76% of net sales. Each of the three customers
contributed between 17% and 32% of net sales.
Selling, general and administrative ("SG&A") expenses decreased to $4,381,000 in
the third quarter of 2002, from $5,975,000 in 2001. As a percentage of total
quarterly sales, this represented 60% in 2002 and 30% in 2001. Year-to-date SG&A
expenses were $15,040,000 for 2002 and $17,523,000 for 2001, which represented
45% of total sales in 2002 and 28% in 2001. The decrease in quarterly and
year-to-date SG&A was primarily related to lower sales commissions and
travel-related expenses, headcount reductions in sales, marketing and other
administrative functions and reductions in marketing-related spending on
discretionary items such as advertising and trade show expenditures. The
increase in quarterly and year-to-date SG&A spending as a percentage of total
sales is primarily a result of lower total sales in 2002 than in 2001. The
Company anticipates SG&A expenses for the remainder of 2002 will continue to be
less than the prior year due to decreased staffing and other cost-saving
measures.
Research and development ("R&D") expenses were $1,520,000 for the third quarter
of 2002, versus $2,190,000 for the same period in 2001. R&D expenses as a
percentage of total sales increased to 21% for the third quarter of 2002, up
from 11% for the same period in 2001. Year-to-date R&D expenses were $5,812,000
for 2002 and $7,107,000 for 2001. As a percentage of total sales, this
represented 18% for 2002 and 11% for 2001. The decrease in R&D expenses is
primarily attributed to reduced staffing and decreased consulting costs, as well
as lower materials costs. The Company has realigned its engineering group to
focus on a smaller number of projects that are strategic enhancements to the
Company's core product line. The increase in quarterly and year-to-date R&D
expenses as a percentage of total sales is primarily a result of lower total
sales in 2002 than in 2001. While the Company expects to continue to invest in
product enhancements and new product
-11-
development, the Company expects R&D expenditures for the remainder of 2002 to
continue to be less than 2001.
In the third quarter of 2002, the Company announced a restructuring plan,
including management changes and a reduction in workforce of approximately 40%,
or approximately 100 employees, throughout all departments. Management changes
included Gerard B. Moersdorf, Jr., Chairman and Founder, resuming his previous
role as President and Chief Executive Officer. Robert L. Smialek vacated those
positions, which he held since July 2000, and no longer serves on the Company's
Board of Directors. As a result of the restructuring plan, the Company recorded
restructuring charges of $2,469,000 during the third quarter of 2002, relating
primarily to severance and other fringe benefits for affected employees, as well
as charges related to excess equipment and leased offices. As of September 30,
2002, the Company has paid out $1,350,000 of such restructuring costs and has
accrued restructuring costs of $1,119,000. The Company expects to pay out
approximately half of the accrued restructuring costs prior to December 31,
2002. With the exception of approximately $112,000 related to lease payments
extending to 2005, the remaining accrued restructuring costs are expected to be
paid out in 2003.
On February 5, 2002, the Company announced a reduction in workforce of
approximately 16%, or approximately 50 employees, throughout all departments.
The Company recorded a workforce reduction charge of approximately $634,000 in
the first quarter of 2002 relating primarily to severance and fringe benefits.
The Company has paid out $405,000 of such costs as of September 30, 2002 and
reversed $226,000 of accrued restructuring costs in the second quarter of 2002,
resulting in accrued restructuring costs of $3,000 as of September 30, 2002.
As a result of the above factors, the Company recorded a loss from operations of
$5,704,000 in the third quarter of 2002 versus income from operations of
$2,345,000 in the third quarter of 2001. Year-to-date loss from operations was
$10,055,000 for 2002, versus income from operations of $5,573,000 in 2001.
Year-to-date loss from operations represents 30% of total sales in 2002, versus
income from operations of 9% of total sales in 2001.
Interest income and other income, net decreased to $112,000 in the third quarter
of 2002, versus $340,000 in the third quarter of 2001. On a year-to-date basis,
interest income and other income, net was $473,000 in 2002 and $1,127,000 in
2001. The overall decreases were primarily due to lower cash and investment
balances, as well as lower average yields on those balances.
In the third quarter of 2002, the Company revised its 2002 year-to-date
effective tax benefit rate to 38%, based on revised expectations of the full
year effective tax benefit rate. For the first six months of 2002, the Company
had been utilizing an effective tax benefit rate of 30%. As a result, the
effective tax benefit rate for the third quarter of 2002 was 44% compared to 34%
used in the third quarter and full year 2001.
LIQUIDITY AND CAPITAL RESOURCES
The Company had $23,576,000 of cash and cash equivalents and short- and
long-term investments at September 30, 2002, a decrease of $5,040,000 from the
December 31, 2001 balance of $28,616,000.
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Despite the net loss of $5,941,000 for the nine-month period ended September 30,
2002, operating activities used only $1,393,000 of cash due to certain operating
expenses that did not require the use of cash and changes in operating assets
and liabilities. Operating expenses that did not require the use of cash
included $1,514,000 of depreciation and amortization and $2,167,000 of inventory
charges. Significant changes in operating assets and liabilities which provided
cash included decreased accounts receivable of $3,824,000 and decreased
inventory of $1,187,000 (net of non-cash charges), offset by changes in income
taxes of $2,607,000 and deferred revenue of $1,257,000. Accounts receivable and
inventory balances decreased as a result of the Company's efforts to reduce the
amount of working capital invested in those assets, as well as the decline in
overall business volume in 2002. Income taxes receivable increased due to tax
refunds resulting from current year operating losses. The decrease in deferred
revenue resulted from the timing of several large customer maintenance and
support agreements entered into in late 2001. Advance customer payments are
initially recorded as deferred revenue and the corresponding revenue is then
recognized over the terms of the related agreements. Investing activities
provided $4,108,000 of cash primarily due to $4,983,000 of maturities and sales
of investments (net of purchases) offset by $909,000 of equipment purchases.
Also during the period, the Company used $2,835,000 to repurchase common stock.
During the nine-month period ended September 30, 2001, operating activities
provided $7,966,000 of cash. During the same period, the Company used $2,692,000
to purchase investments (net of sales and maturities), $1,312,000 to purchase
equipment and $3,584,000 related to an acquisition.
Net working capital was $28,881,000 at September 30, 2002, compared to
$31,804,000 at December 31, 2001. At September 30, 2002, the current ratio was
5.0:1 and the Company's only debt outstanding was a $750,000 note payable issued
in conjunction with an acquisition that occurred in 2001. The note payable bears
interest at the annual rate of 8%, with interest payments due semi-annually and
principal due at maturity in August 2004.
On August 7, 2002, the Company entered into an agreement with The Huntington
National Bank ("the Bank") for a credit facility. The term of the credit
facility is 364 days and provides for a line of credit up to $10,000,000, with
interest payable monthly and principal due at maturity. Borrowings on the line
are subject to a borrowing base which will be limited to $5,000,000 on real
estate, plus 75% of eligible accounts receivable and 40% of eligible inventory,
as defined in the agreement. Borrowings will bear interest at the London
Interbank Offered Rate ("LIBOR") plus 1.65%, or the Bank's Prime Commercial Rate
less 1.00%, at the option of the Company. Borrowings will be collateralized by
the Company's receivables, inventory, certain investments, equipment, real
estate and general intangibles. The credit facility contains certain financial
covenants, including, but not limited to, restrictions on the payment of
dividends, minimum tangible net worth and a minimum liquidity ratio. At
September 30, 2002, the Company has no outstanding borrowings under this credit
facility.
The Company believes that its existing cash, cash equivalents, investments, and
cash to be generated from future operations and available credit facility will
provide sufficient capital to meet the business needs of the Company for the
next twelve months. However, the Company could generate additional
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funding through issuance of debt or equity or through the sale of land if the
Company's working capital needs significantly increase due to circumstances such
as sustained weakness in the telecommunications industry which results in
decreased demand for the Company's products and services and operating losses;
faster than expected growth which results in increase accounts receivable and
inventory; additional investment or acquisition activity; or significant
research and development efforts.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 2002, the Financial Accounting Standards Board issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal Activities. This Statement
addresses financial accounting and reporting for costs associated with exit or
disposal activities by requiring that expenses related to the exit of an
activity or disposal of long-lived assets will be recorded when they are
incurred and measurable. Prior to SFAS No. 146, these charges were accrued at
the time of commitment to exit or dispose of an activity. The Company will adopt
SFAS No. 146 on January 1, 2003, and it is not expected to have a material
effect on the Company's financial position, results of operation, or cash flows.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The foregoing Management's Discussion and Analysis of Financial Condition and
Results of Operations contains certain 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, which are intended to be
covered by the safe harbors created thereby. These statements include, but may
not be limited to, all statements regarding intent, beliefs, expectations,
projections, forecasts, and plans of the Company and its management, and include
statements regarding exposure for warranty claims (paragraph 7), future SG&A
expenditures (paragraph 11), future R&D expenditures (paragraph 12), payment of
restructuring costs (paragraph 13), sufficiency of capital resources (paragraph
22), and impact of recently issued accounting standards (paragraph 23).
These forward-looking statements involve numerous risks and uncertainties,
including, without limitation, fluctuations in demand for the Company's products
and services, general economic and business conditions, the Company's ability to
develop new products as planned and on budget, the impact of competitive
products and services, the fact that the Company may decide to substantially
increase R&D expenditures to meet the needs of its business and customers,
currently unforeseen circumstances which require the use of capital resources,
current and future mergers of key customers and the various risks inherent in
the Company's business and other risks and uncertainties detailed from time to
time in the Company's periodic reports filed with the Securities and Exchange
Commission, including, the Company's Annual Report on Form 10-K, as amended, for
the fiscal year ended December 31, 2001. One or more of these factors have
affected, and could in the future affect, the Company's business and financial
results and could cause actual results to differ materially from plans and
projections. Therefore, there can be no assurance that the forward-looking
statements included in the MD&A will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements included
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herein, the inclusion of such information should not be regarded as a
representation by the Company, or any other person, that the objectives and
plans of the Company will be achieved. All forward-looking statements are based
on information presently available to the management of the Company. The Company
assumes no obligation to update any forward-looking statements.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
The Company does not have any material exposure to interest rate changes,
commodity price changes, foreign currency fluctuations, or similar market risks.
Furthermore, the Company has not entered into any derivative contracts. Related
to an acquisition in 2001, the Company has a $750,000 note payable, bearing
interest at a fixed rate of 8% annually and due in August 2004.
Item 4. Controls and Procedures
Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer along with our Chief Financial Officer, of
the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, our
Chief Executive Officer along with our Chief Financial Officer concluded that
our disclosure controls and procedures are effective in timely alerting them to
material information relating to us (including our consolidated subsidiaries)
required to be included in our periodic SEC filings. It should be noted that the
design of any system of controls is based in part upon certain assumptions about
the likelihood of future events, and there can be no assurance that any design
will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote.
Since the date of our evaluation to the filing date of this Quarterly Report,
there have been no significant changes in our internal controls or in other
factors that could significantly affect internal controls subsequent to the date
we carried out this evaluation.
Part II. OTHER INFORMATION
- -------- -----------------
Items 1 - 5. Inapplicable
Item 6. (a) Exhibits
Exhibit 10.1 - Loan and Security Agreement by and
between Applied Innovation Inc., as Borrower,
and Huntington National Bank, as Lender, dated
August 7, 2002
Exhibit 99.1 - Certification by Chief Executive Officer
Exhibit 99.2 - Certification by Chief Financial Officer
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(b) Reports on Form 8-K
The Company filed a Report on Form 8-K dated August 14, 2002
announcing a restructuring plan to significantly reduce its
cost structure, changes in management associated with the
restructuring plan and revenue guidance for its third quarter
ending September 30, 2002.
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.
APPLIED INNOVATION INC.
-----------------------
(Registrant)
November 13, 2002 /s/ Gerard B. Moersdorf, Jr.
- ----------------- -----------------------------
Date Gerard B. Moersdorf, Jr.
Chairman, President and Chief Executive Officer
(Principal Executive Officer)
November 13, 2002 /s/ Michael P. Keegan
- ----------------- ----------------------
Date Michael P. Keegan
Vice President, Chief Financial Officer and
Treasurer
(Principal Financial Officer and Principal
Accounting Officer)
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CERTIFICATION
I, Gerard B. Moersdorf, Jr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Applied
Innovation Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made,
not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries,
is made known to us by others within those entities,
particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date
within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls
and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or
operation of internal controls which could adversely
affect the registrant's ability to record, process,
summarize and report financial data and have
identified for the registrant's auditors any material
weaknesses in internal controls; and
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b) any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weaknesses.
Date: November 13, 2002
-----------------
/s/ Gerard B. Moersdorf, Jr.
----------------------------
Gerard B. Moersdorf, Jr.
Chairman, President and Chief Executive Officer
CERTIFICATION
I, Michael P. Keegan, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Applied
Innovation Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made,
not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries,
is made known to us by others within those entities,
particularly during the period in which this
quarterly report is being prepared;
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b) evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date
within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls
and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or
operation of internal controls which could adversely
affect the registrant's ability to record, process,
summarize and report financial data and have
identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weaknesses.
Date: November 13, 2002
-----------------
/s/ Michael P. Keegan
--------------------------
Michael P. Keegan,
Vice President, Chief Financial Officer and
Treasurer
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