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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, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission file 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
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
--- ---
As of November 7, 2003 there were 15,024,409 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, 2003 (unaudited)
and December 31, 2002 3
Consolidated Statements of Operations for the three- and nine-month
periods ended September 30, 2003 and 2002 (unaudited) 4
Consolidated Statements of Cash Flows for the nine-month periods
ended September 30, 2003 and 2002 (unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6 - 10
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10 - 15
Item 3. Quantitative and Qualitative Disclosure About Market Risk 16
Item 4. Controls and Procedures 16
Part II. Other Information
Items 1 - 5. 17
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits 17
(b) Reports on Form 8-K 17
Signatures 17
-2-
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
APPLIED INNOVATION INC.
Consolidated Balance Sheets
(Unaudited)
Assets September 30, 2003 December 31, 2002
- ------ ---------------------- ---------------------
Current assets:
Cash and cash equivalents $ 10,159,484 $ 8,986,292
Short term investments 5,759,917 8,028,510
Accounts receivable, net 5,450,581 5,240,248
Inventory, net 2,823,101 3,409,842
Income taxes receivable - 3,079,534
Other current assets 302,805 668,975
Deferred income taxes 2,037,000 2,050,000
---------------------- ---------------------
Total current assets 26,532,888 31,463,401
Property, plant and equipment, net 7,215,633 7,793,014
Investments 10,398,019 6,949,215
Intangible assets, net 183,750 341,250
Goodwill 3,525,801 3,477,001
Deferred income taxes 226,000 226,000
Other assets 1,573,834 135,027
---------------------- ---------------------
$ 49,655,925 $ 50,384,908
====================== =====================
Liabilities and Stockholders' Equity
- ------------------------------------
Current liabilities:
Accounts payable $ 1,092,668 $ 1,621,148
Accrued expenses:
Warranty 613,970 542,651
Income taxes payable 117,029 -
Payroll and related expenses 902,941 647,149
Restructuring 49,831 582,811
Other accrued expenses 1,095,920 1,039,227
Deferred revenue 2,344,389 1,902,556
Note payable 750,000 -
---------------------- ---------------------
Total current liabilities 6,966,748 6,335,542
Note payable - 750,000
---------------------- ---------------------
Total liabilities 6,966,748 7,085,542
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 15,013,909 shares in 2003 and
14,950,749 shares in 2002 150,139 149,507
Additional paid-in capital 6,057,447 5,845,740
Note receivable for common stock - (382,783)
Retained earnings 36,455,540 37,680,937
Accumulated other comprehensive income, net 26,051 5,965
---------------------- ---------------------
Total stockholders' equity 42,689,177 43,299,366
---------------------- ---------------------
$ 49,655,925 $ 50,384,908
====================== =====================
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,
2003 2002 2003 2002
------------------- -------------------- --------------------- -------------------
Sales:
Products $ 7,970,142 $ 5,578,271 $ 20,226,442 $ 27,792,461
Services 1,990,012 1,668,293 4,854,768 5,387,611
------------------- -------------------- --------------------- -------------------
Total sales 9,960,154 7,246,564 25,081,210 33,180,072
Cost of sales:
Cost of sales - products 3,786,118 3,616,466 10,021,579 15,840,944
Cost of sales - services 948,770 963,873 2,318,803 3,664,972
------------------- -------------------- --------------------- -------------------
Total cost of sales 4,734,888 4,580,339 12,340,382 19,505,916
Gross profit 5,225,266 2,666,225 12,740,828 13,674,156
Operating expenses:
Selling, general and administrative 3,341,194 4,381,026 10,540,707 15,040,084
Research and development 1,414,882 1,520,080 4,211,135 5,812,095
Restructuring charges - 2,468,953 (32,237) 2,876,683
------------------- -------------------- --------------------- -------------------
Income (loss) from operations 469,190 (5,703,834) (1,978,777) (10,054,706)
Interest income and other income, net 92,713 111,820 279,380 472,665
------------------- -------------------- --------------------- -------------------
Income (loss) before income taxes 561,903 (5,592,014) (1,699,397) (9,582,041)
Income taxes (22,000) (2,444,000) (474,000) (3,641,000)
------------------- -------------------- --------------------- -------------------
Net income (loss) $ 583,903 $ (3,148,014) $ (1,225,397) $ (5,941,041)
=================== ==================== ===================== ===================
Earnings (loss) per share:
Basic earnings (loss) per share $ 0.04 $ (0.21) $ (0.08) $ (0.39)
=================== ==================== ===================== ===================
Diluted earnings (loss) per share $ 0.04 $ (0.21) $ (0.08) $ (0.39)
=================== ==================== ===================== ===================
Weighted-average shares outstanding
for basic earnings (loss) per share 15,005,851 14,952,515 14,985,366 15,139,311
=================== ==================== ===================== ===================
Weighted-average shares outstanding
for diluted earnings (loss) per share 15,142,144 14,952,515 14,985,366 15,139,311
=================== ==================== ===================== ===================
See accompanying notes to consolidated financial statements.
-4-
APPLIED INNOVATION INC.
Consolidated Statements of Cash Flows (Unaudited)
Nine Months Ended September 30,
2003 2002
----------------- -------------
Cash flows from operating activities:
Net loss $ (1,225,397) $ (5,941,041)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation 909,973 1,356,784
Amortization of intangible assets 157,500 157,500
Other 8,533 80,481
Effects of changes in operating assets and liabilities:
Accounts receivable (210,333) 3,824,450
Inventory 586,741 3,354,260
Income taxes 3,196,563 (2,606,666)
Other current assets 366,170 283,411
Other assets (1,438,807) 26,426
Accounts payable (528,480) (787,916)
Accrued expenses (197,976) 116,177
Deferred revenue 441,833 (1,256,729)
------------------ -------------------
Net cash provided by (used in) operating activities 2,066,320 (1,392,863)
------------------ -------------------
Cash flows from investing activities:
Purchases of property, plant and equipment (348,587) (909,020)
Proceeds from sales of property, plant and equipment 16,792 33,741
Purchases of investments (14,256,548) (4,388,825)
Maturities of investments 12,908,607 8,615,086
Sales of investments 200,816 756,533
------------------ -------------------
Net cash (used in) provided by investing activities (1,478,920) 4,107,515
------------------ -------------------
Cash flows from financing activities:
Common stock repurchased - (2,834,891)
Proceeds from payment on note receivable 382,783 112,088
Proceeds from issuance of common stock 203,009 15,219
------------------ -------------------
Net cash provided by (used in) financing activities 585,792 (2,707,584)
------------------ -------------------
Increase in cash and cash equivalents 1,173,192 7,068
Cash and cash equivalents - beginning of period 8,986,292 15,698,594
------------------ -------------------
Cash and cash equivalents - end of period $ 10,159,484 $ 15,705,662
================== ===================
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,
2003, the consolidated statements of operations for the three- and nine-month
periods ended September 30, 2003 and 2002, and the consolidated statements of
cash flows for the nine-month periods ended September 30, 2003 and 2002 have
been prepared by the Company without audit. In the opinion of management, all
adjustments necessary to present fairly, in accordance with generally accepted
accounting principles in the U.S., 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, 2002 Annual Report on Form 10-K.
The results of operations for the period ended September 30, 2003 are not
necessarily indicative of the results for the full year.
2. Stock-based compensation plans - The Company accounts for stock option grants
under its stock option plans and for stock purchases under its employee stock
purchase plan in accordance with Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations.
Accordingly, no compensation cost has been recognized in the consolidated
financial statements for stock option grants or for shares purchased under the
employee stock purchase plan.
The following table illustrates the effect on net income (loss) and earnings
(loss) per share if the Company had applied the fair value recognition
provisions of Statement of Financial Accounting Standards ("SFAS") No. 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation
using the Black-Scholes model:
Three months ended September 30, Nine months ended September 30,
2003 2002 2003 2002
---- ---- ---- ----
Net income (loss), as reported $ 583,903 $ (3,148,014) $ (1,225,397) $ (5,941,041)
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax (307,399) (125,771) (991,924) (1,430,212)
effects
-------------- --------------- --------------- --------------
Pro forma net income (loss) $ 276,504 $ (3,273,785) $ (2,217,321) $ (7,371,253)
============== =============== ================ =============
Earnings (loss) per share:
Basic - as reported $ 0.04 $ (0.21) $ (0.08) $ (0.39)
Basic - pro forma $ 0.02 $ (0.22) $ (0.15) $ (0.49)
Diluted - as reported $ 0.04 $ (0.21) $ (0.08) $ (0.39)
Diluted - pro forma $ 0.02 $ (0.22) $ (0.15) $ (0.49)
-6-
3. 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, 2003 and December 31, 2002 are summarized below:
September 30, 2003 December 31, 2002
------------------ -----------------
Raw materials $ 1,717,990 $ 3,508,806
Work-in-process 102,816 15,004
Finished goods 1,866,295 993,191
----------- -----------
3,687,101 4,517,001
Reserve for obsolescence (864,000) (1,107,159)
----------- -----------
$ 2,823,101 $ 3,409,842
=========== ===========
4. Warranty - During the quarter ended March 31, 2003, the Company initiated a
product recall after a manufacturing defect was identified in a power supply
component that was purchased from a third party manufacturer, integrated into
the Company's products, and shipped to customers in 1997 and 1998. The Company
estimated the number of units that it expected customers to return in the recall
and recorded the associated costs of $450,000 in the first quarter to recall and
replace those units. During the quarter ended September 30, 2003, the Company
recorded an adjustment of $127,000 to decrease the reserve balance based on
revisions to the estimated number of units to be returned and the associated
costs. In addition, costs associated with the product recall totaling $17,000
and $203,000 for the three- and nine-month periods ended September 30, 2003,
respectively, were recorded against the reserve. At September 30, 2003, the
remaining reserve balance was $120,000.
The Company's warranty activity for the three- and nine-month periods ended
September 30, 2003 is summarized below:
Three months ended Nine months ended
September 30, 2003 September 30, 2003
------------------ ------------------
Beginning balance $ 685,846 $ 542,651
Warranty provision 288,000 1,279,710
Warranty costs incurred (359,876) (1,208,391)
------------------- ------------------
Ending balance $ 613,970 613,970
=================== ==================
5. Income taxes - The Company has recorded its interim income tax provision
based on estimates of the Company's effective tax rate and income tax credits
expected to be applicable for the full fiscal year. Estimated taxes and credits
recorded during interim periods may be periodically revised, if necessary, to
reflect revised estimates for the full fiscal year.
6. Comprehensive income (loss) - Comprehensive income (loss) for the three- and
nine-month periods ended September 30, 2003 was $577,698 and ($1,205,311),
respectively. The sole adjustment necessary to reconcile net income (loss) with
comprehensive income (loss) is the net
-7-
unrealized gain (loss), net of taxes, on investment securities, which was
($6,205) for the three months ended September 30, 2003 and $20,086 for the nine
months ended September 30, 2003.
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 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.
7. Earnings (loss) per share - Basic earnings (loss) 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 for the nine months ended September 30, 2003 and
2002, no common equivalent shares were included in the calculation of diluted
loss per share for either period because their effect would have been
anti-dilutive. The Company's weighted-average number of stock options which were
in-the-money and, therefore, potentially dilutive for the nine months ended
September 30, 2003 and 2002 were 514,642 and 167,375, respectively.
Stock options which were out-of-the money and, therefore, anti-dilutive under
the treasury stock method have also been excluded from the calculation of
diluted loss per share. The Company's stock options outstanding at September 30,
2003 and 2002 which were excluded because they were out-of-the-money were
1,313,120 and 1,666,400, respectively.
Shares of common stock used in calculating earnings (loss) per share differed
from outstanding shares reported in the consolidated financial statements as
follows:
Three months ended Three months ended
September 30, 2003 September 30, 2002
------------------- ------------------
Basic earnings Diluted earnings Basic loss Diluted loss
per share per share per share per share
---------- ---------- ---------- ----------
Outstanding shares 15,013,909 15,013,909 14,950,749 14,950,749
Effect of weighting changes
in outstanding shares (8,058) (8,058) 1,766 1,766
Stock options - - 136,293 - - - -
----------- ------------ ----------- -----------
Adjusted shares 15,005,851 15,142,144 14,952,515 14,952,515
=========== ============ =========== ===========
Nine months ended Nine months ended
September 30, 2003 September 30, 2002
------------------- ------------------
Basic loss Diluted loss Basic loss Diluted loss
per share per share per share per share
---------- ---------- ---------- ----------
Outstanding shares 15,013,909 15,013,909 14,950,749 14,950,749
Effect of weighting changes
in outstanding shares (28,543) (28,543) 188,562 188,562
Stock options - - - - - - - -
----------- ------------ ----------- -----------
Adjusted shares 14,985,366 14,985,366 15,139,311 15,139,311
=========== ============ =========== ===========
-8-
8. Restructuring costs - During 2002, the Company enacted two restructuring
plans resulting in restructuring charges related primarily to workforce
reductions throughout all departments as well as charges related to excess
equipment and leased offices. Those charges totaled $2,468,953 for the quarter
ended September 30, 2002 and $2,876,683 for the nine months ended September 30,
2002. At December 31, 2002, the remaining restructuring accrual was $582,811.
In the second quarter of 2003, certain adjustments totaling $32,237 were made to
decrease the accrual because the planned headcount reduction was not fully
enacted and certain fringe benefit costs were less than originally estimated. At
September 30, 2003, the remaining restructuring accrual was $49,831. The
remaining accrued restructuring costs represent lease payments (net of estimated
sublease receipts) extending to 2005.
Activity in the restructuring accrual for the nine months ended September 30,
2003 is summarized below:
December 31, Cash Non-cash September 30,
2002 accrual deductions adjustments 2003 accrual
------------ ------------- -------------- ------------
Employee separations $ 458,021 $ (425,784) $ (32,237) $ - -
Lease commitments, net of sublease 124,790 (74,959) - - 49,831
------------ ------------- -------------- ------------
$ 582,811 $ (500,743) $ (32,237) $ 49,831
============ ============= ============== ============
9. Major customers and geographic data - Because of the Company's concentration
of sales to the Regional Bell Operating Companies, large domestic wireline and
wireless service providers and one foreign service provider, a small number of
customers typically represent substantial portions of total sales. For the first
nine months of 2003, sales to three companies comprised 75% of total sales. Each
of the three customers contributed between 12% and 34% of total sales. For the
first nine months of 2002, sales to three companies comprised 76% of total
sales. Each of the three customers contributed between 17% and 32% of total
sales.
The Company's sales by geographic areas for the three- and nine-month periods
ended September 30, 2003 and 2002 are summarized below:
Three months ended September 30, Nine months ended September 30,
2003 2002 2003 2002
---- ---- ---- ----
United States $ 9,907,280 $ 6,677,685 $ 24,502,742 $ 27,532,936
International 52,874 568,879 578,468 5,647,136
------------ ------------- -------------- --------------
$ 9,960,154 $ 7,246,564 $ 25,081,210 $ 33,180,072
============ ============= ============== ==============
10. Employee Stock Purchase Plan - The Applied Innovation Inc. Employee Stock
Purchase Plan ("ESPP") was approved and adopted by the stockholders on April 25,
2002. The ESPP authorizes the Company to issue up to 500,000 shares of common
stock to eligible employees The ESPP has semi-annual offering periods commencing
January 1 and July 1 during which eligible employees may purchase shares at a
price equal to 90% of fair market value on the first
-9-
or last business day of the offering period, whichever is lower. On January 3,
2003, the Company issued 24,318 shares of common stock at a price of $2.73 per
share based on employee payroll deductions for the six-month offering period
ended December 31, 2002. On July 2, 2003, the Company issued 20,442 shares of
common stock at a price of $2.66 per share based on employee payroll deductions
for the six-month offering period ended June 30, 2003.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Applied Innovation Inc. is a network management solutions company that
simplifies and enhances the operation of complex, distributed voice and data
networks. Building on a deep knowledge of network architecture, elements and
management, the Company delivers unique hardware, software and service solutions
that provide greater connectivity, visibility and control of network elements
and the systems that support them. The Company's largest customers are the four
Regional Bell Operating Companies ("RBOCs") and other large domestic and foreign
wireline and wireless service providers.
Continued improvement in domestic wireline and wireless markets in the third
quarter of 2003 contributed to the increase in the Company's quarterly sales as
compared to the first and second quarters. The Company's ongoing commitment to
controlling operating expenses, coupled with the sequential increase in sales,
resulted in net income of $584,000 for the three months ended September 30,
2003. During the quarter, the Company launched a new product, AIextend, and the
Company has two additional new product introductions planned for the fourth
quarter of 2003. The Company anticipates that this focus on new product
development and its market expansion initiatives will permit it to capitalize on
improving industry conditions as its core customers return to more normal levels
of capital spending for the remainder of 2003 and into 2004.
RESULTS OF THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2003 COMPARED
TO THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2002
Sales for the third quarter of 2003 were $9,960,000, a 37% increase over sales
of $7,246,000 during the third quarter of 2002. Year-to-date sales of
$25,081,000 for 2003 decreased 24% from 2002 year-to-date sales of $33,180,000.
The increase in quarterly sales was largely attributable to the increased
capital spending by the Company's largest domestic wireline and wireless
customers, while the decrease in year-to-date sales reflected the lingering
effects of the capital spending postponements that have impacted the
telecommunications industry over the past year. Additionally, international
sales have decreased significantly based on sharp declines in quarterly and
year-to-date sales to the Company's largest international customer. For the
three- and nine-month periods ended September 30, 2003, sales to this customer
were $0 and $380,000, respectively, compared to sales for the comparable periods
in the prior year of $516,000 and $5,563,000, respectively. Although annual
volumes are expected to be less than in the prior year, the Company anticipates
increased orders from this customer in the last quarter of 2003 as compared to
earlier quarters in the year.
-10-
Gross profit as a percentage of total sales was 52% for the third quarter of
2003, versus 37% for the third quarter of 2002. Year-to-date gross profit
percentages were 51% and 41% for 2003 and 2002, respectively. The increase in
gross profit as a percentage of total sales was partially attributable to an
improved mix of higher margin core products, as well as increased utilization of
installation services personnel in the current year as compared to the prior
year. In addition, the current year included inventory charges to write down
certain inventory totaling $425,000 for the quarter and $597,000 year-to-date,
while similar quarterly and year-to-date charges in the prior year were $350,000
and $2,167,000, respectively. The Company also established specific warranty
reserves associated with a product recall in the first quarter of 2003, with a
subsequent adjustment in the third quarter to reduce the reserve by $127,000. In
the third quarter of 2002, the Company established specific warranty reserves
totaling $200,000 for warranty 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, 2003 For the Quarter Ended September 30, 2002
---------------------------------------- ----------------------------------------
Products Services Total Products Services Total
-------- -------- ----- -------- -------- -----
Sales $7,970,000 $1,990,000 $9,960,000 $5,578,000 $1,668,000 $7,246,000
Gross Profit 4,184,000 1,041,000 5,225,000 1,962,000 704,000 2,666,000
Gross Profit % 52% 52% 52% 35% 42% 37%
Product sales of $7,970,000 were 80% of 2003 third quarter sales, versus product
sales of $5,578,000, or 77% of 2002 third quarter sales. This represented a 43%
increase in product sales over the comparable quarter in the prior year.
Year-to-date product sales of $20,226,000 were 81% of total sales in 2003,
versus $27,792,000 or 84% of total sales in 2002. This represented a 27%
decrease in product sales from the previous year. On a quarterly basis, product
sales in 2003 continued to improve sequentially as a result of improved domestic
spending, including significant increases in wireless sales. However, on a
year-to-date basis, total sales still reflect the overall spending slowdown in
the industry over the last twelve months as well as the decreased spending by
the Company's largest international customer. Product sales include revenues
from the sales of AIswitch, AIscout, AIbadger and other products, as well as
third-party hardware and software licensing revenues.
Gross profit on product sales was 52% of total product sales for the third
quarter of 2003, compared with 35% of total product sales for the same period
last year. The increase in gross profit in 2003 was primarily attributable to an
overall increase in sales volume leading to better fixed cost coverage and an
improved mix of higher margin core products. In addition, the comparable quarter
in the prior year quarter included lower margin third-party network management
system equipment. The Company recorded approximately $425,000 of inventory
charges in the third quarter of 2003, related to potentially obsolete, older
line card products. Also in the quarter, the Company recorded a $127,000
adjustment to reduce its warranty reserve associated with a product recall, as
discussed above. In the third quarter of last year, the Company recorded
$350,000 of similar inventory charges, as well as specific warranty reserves of
$200,000.
-11-
Services sales of $1,990,000 were 20% of 2003 third quarter sales, versus
services sales of $1,668,000, or 23% of 2002 third quarter sales. This
represented a 19% increase in services sales over the comparable quarter of the
prior year. Year-to-date services sales of $4,855,000 were 19% of total sales in
2003, compared to $5,388,000, or 16% of total sales in 2002. This represented a
10% decrease in services sales from the previous year. The quarterly increase
and the year-to-date decrease in services sales were consistent with the
fluctuations in product sales between years. Services sales consist of network
planning and design, installation services, project management, engineering
services, training and maintenance.
Services gross profit for the three-month period ended September 30, 2003 was
52% of services sales, versus 42% of services sales a year ago. The increase in
gross profit on services sales was primarily attributable to increased
utilization of services personnel during the third quarter of 2003 and a greater
mix of maintenance contract revenues, which typically generate higher gross
profit than network management system services and installation work.
Because of the Company's concentration of sales to RBOCs, large domestic
wireline and wireless service providers and one foreign service provider, a
small number of customers typically represent substantial portions of total
sales. For the first nine months of 2003, sales to three companies comprised 75%
of total sales. Each of the three customers contributed between 12% and 34% of
total sales. For the first nine months of 2002, sales to three companies
comprised 76% of total sales. Each of the three customers contributed between
17% and 32% of total sales.
Selling, general and administrative ("SG&A") expenses decreased to $3,341,000 in
the third quarter of 2003, from $4,381,000 in the third quarter of 2002. As a
percentage of total quarterly sales, this represented 34% in 2003 and 60% in
2002. Year-to-date SG&A expenditures were $10,541,000 for 2003 and $15,040,000
for 2002, which represented 42% of total sales in 2003 and 45% in 2002. The
significant decreases in quarterly and year-to-date SG&A expenditures from the
previous year were largely attributable to headcount reductions in sales,
marketing and other administrative functions and reductions in bonuses and
commissions, advertising, trade show expenditures and travel expenses. The
Company anticipates SG&A expenses for the fourth quarter of 2003 to be generally
consistent with those in the first three quarters, although certain SG&A
expenses such as commissions and other variable compensation, will vary
proportionately with changes in sales volumes.
Research and development ("R&D") expenses decreased to $1,415,000 for the third
quarter of 2003, versus $1,520,000 for the same period in 2002. As a percentage
of total sales, this represented 14% for the third quarter of 2003 and 21% for
the same period in 2002. Year-to-date R&D expenses were $4,211,000 for 2003 and
$5,812,000 for 2002, representing 17% of total sales in 2003 and 18% in 2002.
The decreases in quarterly and year-to-date R&D expenses from the previous year
were primarily due to reduced personnel and consulting costs, as well as lower
materials costs. These cost savings resulted from streamlining the Company's R&D
focus to target only those development projects with the greatest potential for
acceptance in our current wireline and wireless markets. The Company expects to
continue to invest in product enhancements and new product development to
support changing customer and industry needs and product introductions. The
Company introduced one new product in the third quarter of 2003 and two new
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product introductions are expected in the fourth quarter. The Company expects
R&D expenditures for the fourth quarter of 2003 to be generally consistent with
those in the first three quarters.
During 2002, the Company enacted two restructuring plans resulting in
restructuring charges related primarily to workforce reductions throughout all
departments as well as charges related to excess equipment and leased offices.
Those charges totaled $2,469,000 for the quarter ended September 30, 2002 and
$2,877,000 for the nine months ended September 30, 2002. In the second quarter
of 2003, certain adjustments totaling $32,237 were made to decrease the
restructuring accrual because the planned headcount reduction was not fully
enacted and certain fringe benefit costs were less than originally estimated.
As a result of the above factors, the Company recorded income from operations of
$469,000 in the third quarter of 2003, versus a loss from operations of
$5,704,000 in the third quarter of 2002. Year-to-date loss from operations was
$1,979,000 in 2003, versus a loss from operations of $10,055,000 in 2002.
Year-to-date loss from operations represented 8% and 30% of total sales in 2003
and 2002, respectively.
Interest income and other income, net decreased to $93,000 in the third quarter
of 2003 from $112,000 in the comparable quarter last year. Year-to-date interest
income and other income, net decreased to $279,000 in 2003 from $473,000 in the
prior year. The overall decrease resulted primarily from lower interest income
due to lower yields on cash and investment balances.
In the third quarter of 2003, the Company increased its 2003 year-to-date
effective tax benefit rate to 28% from 20%, the estimated rate utilized for the
first six months of the year. This increase was due to revised estimates of the
Company's full-year operating results and the impact on taxes from research and
experimentation credits. The change in effective tax rate from 20% to 28% for
the year resulted in a $22,000 tax benefit during the quarter.
LIQUIDITY AND CAPITAL RESOURCES
The Company had $26,317,000 of cash and cash equivalents and short- and
long-term investments at September 30, 2003, an increase of $2,353,000 from the
December 31, 2002 balance of $23,964,000.
Despite the net loss of $1,225,000 for the nine-month period ended September 30,
2003, operating activities provided $2,066,000 of cash due to certain non-cash
operating expenses and favorable changes in working capital. Operating expenses
not requiring the use of cash included $1,067,000 of depreciation and
amortization. Significant changes in working capital which provided cash
included decreased income taxes receivable of $3,197,000 due primarily to
receipt of income tax refunds from prior years, decreased inventory of $587,000
and increased deferred revenue of $442,000. Partially offsetting those changes
were other working capital changes that used cash, including increased accounts
receivable of $210,000, increased other assets of $1,439,000 related primarily
to the purchase of key-man life insurance contracts, and decreased accounts
payable and accrued expenses of $726,000. During the same period, investing
activities used $1,479,000 due to investment purchases (net of maturities and
sales) of $1,147,000 and purchases of equipment (net of
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proceeds received from the sales of equipment) of $332,000. Financing activities
provided $586,000 during the nine-month period ending September 30, 2003 due to
proceeds from the payment on a shareholder note receivable of $383,000 and
proceeds from the issuance of common stock of $203,000.
During the nine-month period ended September 30, 2002, operating activities used
only $1,393,000 of cash despite the net loss of $5,941,000 for the period.
Operating expenses not requiring the use of cash included $1,514,000 of
depreciation and amortization, as well as $2,167,000 of inventory charges. Other
working capital changes included decreased accounts receivable of $3,824,000,
decreased inventory of $1,187,000 (net of non-cash charges), increased income
taxes receivable of $2,607,000 and decreased deferred revenue of $1,257,000.
Also during the nine-month period, investing activities provided $4,108,000 of
cash primarily as a result of investment maturities and sales (net of purchases)
of $4,983,000, offset by $875,000 of equipment purchases (net of proceeds
received from the sales of equipment). Also during the period, the Company used
$2,835,000 to repurchase common stock.
Net working capital was $19,566,000 at September 30, 2003, compared to
$25,128,000 at December 31, 2002. At September 30, 2003, the current ratio was
3.8:1 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.
The Company's credit facility for a line of credit up to $10,000,000 expired in
August 2003. The Company does not intend to renew or replace the credit
facility.
The Company believes that its existing cash, cash equivalents, investments and
cash to be generated from future operations will provide sufficient capital to
meet the business needs of the Company for the next twelve months. In addition,
the Company believes it could generate additional 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 resulting in decreased demand for the Company's
products and services and operating losses; faster than expected growth
resulting in increased accounts receivable and inventory; additional investment
or acquisition activity; or significant research and development efforts.
However, there can be no assurance that additional financing will be available
on terms favorable to the Company or at all.
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IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
On July 31, 2003, the Emerging Issues Task Force ("EITF") reached a consensus on
Issue 03-5, Applicability of AICPA Statement of Position ("SOP") 97-2, Software
Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software. The EITF indicates that software and software
related items are within the scope of SOP 97-2, as well as any non-software
deliverable for which a software deliverable is essential to the functionality
of the non-software deliverable. The EITF Issue is effective on a prospective
basis to all arrangements entered into during the first reporting period after
ratification by the Financial Accounting Standards Board, which occurred in
August 2003. The Company adopted the provisions of the EITF Issue on October 1,
2003. The adoption did not have a material impact on the Company's financial
condition or results of operations.
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 forward-looking 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 any statements regarding new product development and
market expansion initiatives (paragraph 2), improving industry conditions and
capital spending by core customers (paragraph 2), anticipated orders from the
Company's largest international customer (paragraph 3), future SG&A expenditures
(paragraph 11), future R&D expenditures (paragraph 12), and sufficiency of
capital resources (paragraph 22). These forward-looking statements involve
numerous risks and uncertainties, including, without limitation, fluctuations in
demand for the Company's products and services, the impact of competitive
products and services, general economic and business conditions, the Company's
ability to develop new products as planned and on budget, 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 that could
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 for the fiscal year ended December 31,
2002. 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 this Form 10-Q will
prove to be accurate. In light of the significant uncertainties inherent in the
forward-looking statements included 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.
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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 fluctuation, or similar market risks.
The Company invests in various debt obligations, primarily U.S. government and
agency obligations and high quality commercial paper, with maturities generally
less than three years. Although the yields on such investments are subject to
changes in interest rates, the potential impact to the Company and its future
earnings as a result of customary interest rate fluctuations is immaterial.
Furthermore, the Company has not entered into any derivative contracts. Related
to an acquisition in 2001, the Company has a $750,000 note payable due in August
2004, bearing interest at a fixed rate of 8% annually.
Item 4. Controls and Procedures
As of the end of the period covered by this report, the Company's management
carried out an evaluation, with the participation of the Company's principal
executive officer and principal financial officer, of the effectiveness of the
Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) promulgated under the Securities Exchange Act of 1934). Based upon
that evaluation, the Company's principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures were effective as of the end of the period covered by this report. 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.
There were no changes in the Company's internal controls over financial
reporting that occurred during the Company's most recent fiscal quarter that
have materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
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PART II. OTHER INFORMATION
Items 1 - 5. Inapplicable
Item 6. (a) Exhibits
Exhibit 31.1 - Rule 13a-14(a) Certification of Principal
Executive Officer
Exhibit 31.2 - Rule 13a-14(a) Certification of Principal
Financial Officer
Exhibit 32.1 - Section 1350 Certification of Principal
Executive Officer
Exhibit 32.2 - Section 1350 Certification of Principal
Financial Officer
(b) Reports on Form 8-K
On July 16, 2003, the Company filed a Current Report on Form
8-K (Items 7 and 9), dated July 16, 2003, regarding its
consolidated financial results of operations for its second
quarter ended June 30, 2003.
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 10, 2003 /s/ Gerard B. Moersdorf, Jr.
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Date Gerard B. Moersdorf, Jr.
Chairman, President and Chief Executive
Officer (Principal Executive Officer)
November 10, 2003 /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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