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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, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission file 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 8, 2004 there were 15,097,467 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, 2004 (unaudited)
and December 31, 2003 3
Consolidated Statements of Operations for the three- and nine-month
periods ended September 30, 2004 and 2003 (unaudited) 4
Consolidated Statements of Cash Flows for the nine-month periods
ended September 30, 2004 and 2003 (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 - 16
Item 3. Quantitative and Qualitative Disclosure About Market Risk 16
Item 4. Controls and Procedures 17
Part II. Other Information
Items 1 - 5. 17
Item 6. Exhibits 17
Signatures 18
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
APPLIED INNOVATION INC
Consolidated Balance Sheets
(Unaudited)
September 30, 2004 December 31, 2003
------------------ ------------------
Assets
Current assets:
Cash and cash equivalents $ 6,979,670 $ 12,030,638
Short term investments 7,522,952 5,582,325
Accounts receivable, net 5,749,927 3,449,052
Inventory, net 3,012,601 2,814,442
Income taxes receivable - 268,287
Other current assets 329,137 1,255,700
Deferred income taxes 1,640,000 1,963,000
------------------ ------------------
Total current assets 25,234,287 27,363,444
Property, plant and equipment, net 6,685,432 7,060,034
Investments 8,770,486 10,360,075
Intangible assets, net - 131,250
Goodwill 3,525,801 3,525,801
Deferred income taxes 1,643,000 127,000
Other assets 1,353,461 1,315,275
------------------ ------------------
$ 47,212,467 $ 49,882,879
================== ==================
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 992,484 $ 790,037
Accrued expenses:
Warranty 330,075 479,062
Payroll and related expenses 1,055,364 787,819
Restructuring 58,617 43,825
Income taxes 404,637 -
Taxes, other than income taxes 269,663 563,252
Other accrued expenses 563,957 723,249
Deferred revenue 1,402,202 2,268,999
Note payable - 750,000
------------------ ------------------
Total current liabilities 5,076,999 6,406,243
------------------ ------------------
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 15,088,067 shares in 2004 and 15,033,409 in 2003 150,881 150,334
Additional paid-in capital 6,357,029 6,140,540
Retained earnings 35,625,203 37,145,452
Accumulated other comprehensive gain, net 2,355 40,310
------------------ ------------------
Total stockholders' equity 42,135,468 43,476,636
------------------ ------------------
$ 47,212,467 $ 49,882,879
================== ==================
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,
2004 2003 2004 2003
------------- ------------- ------------ ------------
Sales:
Products $ 8,454,105 $ 7,970,142 $ 17,116,807 $ 20,226,442
Services 1,418,512 1,990,012 4,320,642 4,854,768
------------- ------------- ------------ ------------
Total sales 9,872,617 9,960,154 21,437,449 25,081,210
Cost of sales:
Cost of sales - products 3,790,227 3,580,292 8,077,206 9,418,265
Cost of sales - services 586,560 1,154,596 1,968,948 2,922,117
------------- ------------- ------------ ------------
Total cost of sales 4,376,787 4,734,888 10,046,154 12,340,382
Gross profit 5,495,830 5,225,266 11,391,295 12,740,828
Operating expenses:
Selling, general and administrative 3,369,340 3,341,194 10,166,642 10,540,707
Research and development 1,357,951 1,414,882 4,042,986 4,211,135
Restructuring charges - - 227,690 (32,237)
------------- ------------- ------------ ------------
Income (loss) from operations 768,539 469,190 (3,046,023) (1,978,777)
Interest and other income, net 103,067 92,713 282,774 279,380
------------- ------------- ------------ ------------
Income (loss) before income taxes 871,606 561,903 (2,763,249) (1,699,397)
Income tax expense (benefit) 66,000 (22,000) (1,243,000) (474,000)
------------- ------------- ------------ ------------
Net income (loss) $ 805,606 $ 583,903 $ (1,520,249) $ (1,225,397)
============= ============= ============ ============
Basic earnings (loss) per share $ 0.05 $ 0.04 $ (0.10) $ (0.08)
============= ============= ============ ============
Diluted earnings (loss) per share $ 0.05 $ 0.04 $ (0.10) $ (0.08)
============= ============= ============ ============
Weighted-average shares outstanding
for basic earnings (loss) per share 15,086,095 15,005,851 15,071,034 14,985,366
============= ============= ============ ============
Weighted-average shares outstanding
for diluted earnings (loss) per share 15,100,237 15,142,144 15,071,034 14,985,366
============= ============= ============ ============
See accompanying notes to consolidated financial statements.
-4-
APPLIED INNOVATION INC.
Consolidated Statements of Cash Flows (Unaudited)
Nine Months Ended September 30,
2004 2003
--------------- ---------------
Cash flows from operating activities:
Net loss $ (1,520,249) $ (1,225,397)
Adjustments to reconcile net loss to net cash
(used in) provided by operating activities:
Depreciation 848,369 909,973
Amortization of intangible assets 131,250 157,500
Loss (gain) on disposal of assets 54,494 (797)
Tax benefit of options exercised 16,329 9,330
Stock grants to non-employees 16,000 -
Provision for deferred income taxes (1,169,000) -
Effects of changes in operating assets and liabilities:
Accounts receivable (2,300,875) (210,333)
Inventory (198,159) 586,741
Income taxes 672,924 3,196,563
Other current assets 926,563 366,170
Other assets (38,186) (1,438,807)
Accounts payable 202,447 (528,480)
Accrued expenses (319,531) (197,976)
Deferred revenue (866,797) 441,833
--------------- ---------------
Net cash (used in) provided by operating activities (3,544,421) 2,066,320
--------------- ---------------
Cash flows from investing activities:
Purchases of property, plant and equipment (547,100) (348,587)
Proceeds from sales of property, plant and equipment 15,790 16,792
Purchases of investments (6,477,974) (14,256,548)
Proceeds from maturities of investments 5,318,584 12,908,607
Proceeds from sales of investments 749,446 200,816
--------------- ---------------
Net cash used in investing activities (941,254) (1,478,920)
--------------- ---------------
Cash flows from financing activities:
Payment of note payable (750,000) -
Proceeds from issuance of common stock 184,707 203,009
Proceeds from payment on note receivable - 382,783
--------------- ---------------
Net cash (used in) provided by financing activities (565,293) 585,792
--------------- ---------------
(Decrease) increase in cash and cash equivalents (5,050,968) 1,173,192
Cash and cash equivalents - beginning of period 12,030,638 8,986,292
--------------- ---------------
Cash and cash equivalents - end of period $ 6,979,670 $ 10,159,484
=============== ===============
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,
2004, the consolidated statements of operations for the three- and nine-month
periods ended September 30, 2004 and 2003, and the consolidated statements of
cash flows for the nine-month periods ended September 30, 2004 and 2003 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 United States of America, the financial position,
results of operations and cash flows for all periods presented have been made.
Expenses in the third quarter of 2004 included additional expenses of
approximately $160,000 to correct an error made in a payroll related accrual at
the end of the previous quarter.
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, 2003 Annual Report on Form 10-K.
Certain amounts in the prior year financial statements have been reclassified to
conform with current year presentation. The results of operations for the period
ended September 30, 2004 are not necessarily indicative of the results for the
full year.
2. Stock-based compensation - 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 Company accounts for stock grants to non-employees in accordance with
Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments
That are Issued to Other Than Employees for Acquiring, or in Conjunction With
Selling, Goods or Services. Accordingly, the Company recognized expense for
stock grants to non-employees of $8,000 and $16,000 for the three- and
nine-month periods ended September 30, 2004, respectively.
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:
-6-
Three months ended September 30, Nine months ended September 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net income (loss), as reported $ 805,606 $ 583,903 $ (1,520,249) $ (1,225,397)
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects (356,991) (307,399) (1,172,117) (991,924)
------------ ------------ ------------ ------------
Pro forma net income (loss) $ 448,615 $ 276,504 $ (2,692,366) $ (2,217,321)
============ ============ ============ ============
Earnings (loss) per share:
Basic - as reported $ 0.05 $ 0.04 $ (0.10) $ (0.08)
Basic - pro forma $ 0.03 $ 0.02 $ (0.18) $ (0.15)
Diluted - as reported $ 0.05 $ 0.04 $ (0.10) $ (0.08)
Diluted - pro forma $ 0.03 $ 0.02 $ (0.18) $ (0.15)
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, 2004 and December 31, 2003 are summarized below:
September 30, 2004 December 31, 2003
------------------ ------------------
Raw materials $ 2,331,693 $ 1,516,034
Work-in-process 110,870 134,874
Finished goods 759,038 1,597,534
------------------ ------------------
3,201,601 3,248,442
Reserve for obsolescence (189,000) (434,000)
------------------ ------------------
$ 3,012,601 $ 2,814,442
================== ==================
4. Warranty - The Company's warranty activity for the three- and nine-month
periods ended September 30, 2004 and 2003 is summarized below:
Three months ended September 30, Nine months ended September 30,
2004 2003 2004 2003
--------------- --------------- --------------- ---------------
Beginning balance $ 381,925 $ 685,846 $ 479,062 $ 542,651
Warranty provision 95,805 106,445 362,892 748,501
Warranty costs incurred (147,655) (178,321) (511,879) (677,182)
--------------- --------------- --------------- ---------------
Ending balance $ 330,075 $ 613,970 $ 330,075 $ 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, 2004 was $831,685 and ($1,558,204),
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
$26,079 for the three months ended September 30, 2004 and ($37,955) for the nine
months ended September 30, 2004.
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 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.
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, 2004 and
2003, 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, 2004 and 2003 were 529,285 and 514,642, 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,
2004 and 2003 which were excluded because they were out-of-the-money were
1,442,220 and 1,313,120, 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, 2004 September 30, 2003
---------------------------------- ----------------------------------
Basic earnings Diluted earnings Basic earnings Diluted earnings
per share per share per share per share
--------------- --------------- --------------- ---------------
Outstanding shares 15,088,067 15,088,067 15,013,909 15,013,909
Effect of weighting changes
in outstanding shares (1,972) (1,972) (8,058) (8,058)
Dilutive effect of
stock options - 14,142 - 136,293
--------------- --------------- --------------- ---------------
Adjusted shares 15,086,095 15,100,237 15,005,851 15,142,144
=============== =============== =============== ===============
Nine months ended Nine months ended
September 30, 2004 September 30, 2003
---------------------------------- ----------------------------------
Basic loss Diluted loss Basic loss Diluted loss
per share per share per share per share
--------------- --------------- --------------- ---------------
Outstanding shares 15,088,067 15,088,067 15,013,909 15,013,909
Effect of weighting changes
in outstanding shares (17,033) (17,033) (28,543) (28,543)
--------------- --------------- --------------- ---------------
Adjusted shares 15,071,034 15,071,034 14,985,366 14,985,366
=============== =============== =============== ===============
-8-
8. Restructuring costs - In May 2004, the Company enacted a restructuring plan
resulting in charges of $227,690 related to severance benefits for workforce
reductions in sales, services and administration. As of September 30, 2004, the
remaining restructuring accrual was $58,617, consisting of employee separation
costs of $34,313 from the May 2004 event and lease commitments of $24,304 from
an August 2002 restructuring event. The employee separation costs are scheduled
to be paid in 2004, while the lease payments (net of estimated sublease
receipts) will extend into 2005.
Activity in the restructuring accrual for the nine months ended September 30,
2004 is summarized below:
Lease
commitments, Employee
net of sublease separations Total
--------------- --------------- ---------------
Restructuring accrual - December 31, 2003 $ 43,825 $ - 43,825
=============== =============== ===============
Restructuring event - May, 2004 - 227,690 227,690
Cash deductions (19,521) (193,377) (212,898)
--------------- --------------- ---------------
Restructuring accrual - September 30, 2004 $ 24,304 $ 34,313 58,617
=============== =============== ===============
9. Major customers and geographic data - Because of the Company's concentration
of sales to the Regional Bell Operating Companies, 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
2004, sales to three companies comprised 68% of total sales. Each of the three
customers contributed between 11% and 34% 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.
The Company's sales by geographic areas for the three- and nine-month periods
ended September 30, 2004 and 2003 are summarized below:
Three months ended September 30, Nine months ended September 30,
2004 2003 2004 2003
--------------- --------------- --------------- ---------------
United States $ 9,821,677 $ 9,907,280 $ 19,782,968 $ 24,502,742
International 50,940 52,874 1,654,481 578,468
--------------- --------------- --------------- ---------------
$ 9,872,617 $ 9,960,154 $ 21,437,449 $ 25,081,210
=============== =============== =============== ===============
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 or last
business day of the offering period, whichever is lower.
-9-
On January 2, 2004, the Company issued 14,766 shares of common stock at a price
of $3.02 per share based on employee payroll deductions for the six-month
offering period ended December 31, 2003. On July 2, 2004, the Company issued
13,948 shares of common stock at a price of $3.61 per share based on employee
payroll deductions for the six-month offering period ended June 30, 2004. Since
the inception of the ESPP, 73,474 shares have been issued to eligible employees.
11. Stock repurchase program - - On April 22, 2004, the Board of Directors
authorized a twelve month stock repurchase program under which the Company may
purchase up to 1,000,000 shares of common stock through April 21, 2005. As of
September 30, 2004, the Company had not purchased any shares of stock through
the program.
12. Subsequent event - In October 2004, the Company enacted a restructuring
event affecting employees in sales, engineering, operations, services and
administration. As a result of this action, the Company expects to incur a
pre-tax charge in the fourth quarter of 2004 totaling approximately $390,000,
comprised of severance and other fringe benefits that will be paid out in cash
in the fourth quarter of 2004 and in the first two quarters of 2005.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Applied Innovation Inc. (Applied Innovation, AI, and the Company) 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, AI delivers unique hardware,
software and service solutions that provide greater connectivity, visibility and
control of network elements and the systems that support them. By providing
solutions in the areas of network mediation, aggregation and adaptation, the
Company enables its customers to more effectively and efficiently manage their
large, complex networks.
Applied Innovation's products and services help its customers to improve network
quality and uptime and, at the same time, reduce network maintenance and repair
costs. By leveraging its extensive knowledge of network infrastructure, its
vendor-neutral methodology and its customer-centric approach, AI provides
solutions which help customers better manage and control both their capital
expenditures and their operating expenditures. The Company targets three primary
markets in the U.S. and abroad: 1) telecommunications companies using wireline
networks; 2) telecommunications companies using wireless networks; and 3)
government networks. Its largest customers in those markets are the four
Regional Bell Operating Companies (RBOCs), domestic wireless service providers
and other large domestic and foreign phone companies.
Results for the third quarter of 2004 reflect a significant improvement in
domestic wireline sales and continued growth in the wireless market. After a
disappointing first six months of 2004 that fell short of expectations due
primarily to order delays and decreased capital spending from key domestic
wireline customers, the Company rebounded in the third quarter of 2004 with a
73% sequential increase in sales as compared to the second quarter. The sales
rebound, combined with
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the Company's ongoing commitment to controlling operating expenses, resulted in
net income of $806,000 for the three months ended September 30, 2004. For the
corresponding quarter of the prior year, the Company reported net income of
$584,000 on comparable sales volume.
Based on limited visibility into wireline carrier spending for the remainder of
2004, the Company is cautiously optimistic that it will not experience further
order flow interruptions for the remainder of the year. The Company also
anticipates continued wireless and international demand for the balance of the
year. While remaining strongly committed to the wireline market, the Company
continues to view its growing wireless and international markets as the primary
drivers of significant near-term growth. In addition, the Company continues
dedicating resources to business development efforts in the government market to
help further diversify its business.
In driving and measuring its diversification efforts into these new markets, the
Company has set a number of key milestones for the remainder of 2004 and early
2005. In the wireless business, the AIbadger-RFMC product will be released for
generally availability in the fourth quarter and the Company will remain focused
on converting trial activity with this product into initial orders. In addition,
growing the customer base in the wireless market remains a top priority. In the
international market, vendor selection is expected before year end on a
significant opportunity in Australia. Additionally, progress in key Central and
South American accounts is expected to lead to order flow in late 2004 or early
2005. In the government market, the Company believes its technology is
well-suited for application within sensor networks and is looking forward to
technology selection by a large systems integrator in the sensor collection and
management area.
RESULTS OF THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2004 COMPARED
TO THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2003
TOTAL SALES AND GROSS PROFIT
Sales for the third quarter of 2004 were $9,873,000, generally consistent with
sales of $9,960,000 during the third quarter of 2003. Year-to-date sales
decreased 15% to $21,437,000 in 2004 from $25,081,000 in 2003. The decrease in
year-to-date sales was largely attributable to decreased capital spending by the
Company's largest domestic wireline customers during the first two quarters of
the 2004. While orders in the third quarter rebounded sharply from the delays
experienced during the first half of the year, third quarter and year-to-date
sales from wireline customers continued to lag behind prior year sales. For the
three- and nine-month periods ended September 30, 2004, sales to wireline
customers were $7,203,000 and $13,875,000, respectively, compared to sales in
the comparable periods of the prior year of $8,446,000 and $21,920,000,
respectively.
The decline in wireline sales was partially offset by growth in the wireless and
international markets. Further penetration into the wireless market resulted in
wireless sales of $2,580,000 for the quarter ended September 30, 2004, an
increase of 85% from $1,395,000 in last year's comparable quarter. For the
nine-month periods ended September 30, 2004 and 2003, wireless sales were
$5,810,000 and $2,052,000, respectively. Additionally, improved order flow
earlier in the year from the Company's largest international customer resulted
in increased year-to-date
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international sales compared to last year, despite a low volume of international
sales in the third quarter of both years. For the quarters ended September 30,
2004 and 2003, international sales were $51,000 and $53,000, respectively, while
year-to-date international sales were $1,654,000 and $578,000 for 2004 and 2003,
respectively.
Because of the Company's concentration of sales to the Regional Bell Operating
Companies, 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 2004, sales to three companies comprised 68% of total
sales. Each of the three customers contributed between 11% and 34% 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.
Gross profit as a percentage of total sales was 56% for the third quarter of
2004, versus 52% for the third quarter of 2003. Year-to-date gross profit
percentages were 53% and 51% for 2004 and 2003, respectively. Gross profit for
the three- and nine-months ended September 30, 2004 was positively impacted by
strong services margins which primarily resulted from efficient use and high
utilization of Company personnel performing installation and other service work.
Also contributing to the increase in gross profit percentages in 2004 compared
to 2003 were prior year inventory obsolescence and product recall charges that
reduced 2003 gross profit, as discussed further below.
The following table summarizes sales and gross profit for products and services:
For the Quarter Ended September 30, 2004 For the Quarter Ended September 30, 2003
---------------------------------------- ----------------------------------------
Products Services Total Products Services Total
---------- ---------- ---------- ----------- ------------ -----------
Sales $8,454,000 $1,419,000 $9,873,000 $7,970,000 $1,990,000 $9,960,000
Gross Profit 4,664,000 832,000 5,496,000 4,390,000 835,000 5,225,000
Gross Profit % 55% 59% 56% 55% 42% 52%
PRODUCT SALES AND GROSS PROFIT
Product sales of $8,454,000 were 86% of 2004 third quarter sales, versus product
sales of $7,970,000, or 80% of 2003 third quarter sales. This represented a 6%
increase in product sales over the comparable quarter in the prior year. Third
quarter 2004 product sales improved sequentially from the second quarter as a
result of improved domestic spending, including significant increases in
wireless sales. However, on a year-to-date basis, total product sales reflect
decreased domestic wireline spending, especially during the first two quarters
of the year. Year-to-date product sales of $17,117,000 were 80% of total sales
in 2004, versus $20,226,000 or 81% of total sales in 2003. This represented a
15% decrease in product sales from the previous year.
Product sales include revenues from the sales of the Company's hardware
products, as well as third-party hardware and software licensing revenues.
Gross profit on product sales was 55% of total product sales for the third
quarter of 2004, consistent with gross profit in the same period last year.
Third quarter 2003 gross profit on product sales was
-12-
negatively impacted by inventory obsolescence and product recall charges
totaling $298,000. In the current year quarter, the impact of such charges was
minimal based on a $32,000 adjustment to reduce the product recall reserve which
offset minimal inventory charges of $14,000. However, 2004 third quarter gross
profit on product sales was impacted by a larger proportion of wireless product
sales than in the prior year quarter. In general, wireless products yield lower
gross profit than the Company's core wireline products.
SERVICES SALES AND GROSS PROFIT
Services sales of $1,419,000 were 14% of 2004 third quarter sales, versus
services sales of $1,990,000, or 20% of 2003 third quarter sales. This
represented a 29% decrease in services sales over the comparable quarter of the
prior year. Year-to-date services sales of $4,321,000 were 20% of total sales in
2004, compared to $4,855,000, or 19% of total sales in 2003. This represented an
11% decrease in services sales from the previous year. The decrease in quarter
and year-to-date services sales was primarily attributable to lower demand for
installation and other services.
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, 2004 was
59% of services sales, versus 42% of services sales a year ago. The increase in
gross profit on services sales was primarily attributable to a greater
proportion of maintenance contract revenues, which typically generate higher
gross profit than network management system services and installation work.
Additionally, increased utilization of services personnel in lieu of consultants
during the third quarter of 2004 contributed to higher gross margins.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative ("SG&A") expenses of $3,369,000 during the
third quarter of 2004 remained generally consistent with SG&A expenses of
$3,341,000 in the third quarter of 2003. As a percentage of total quarterly
sales, this represented 34% in both 2004 and 2003. Year-to-date SG&A
expenditures were $10,167,000 for 2004 and $10,541,000 for 2003, which
represented 47% of total year-to-date sales in 2004 and 42% in 2003. The slight
decrease in SG&A expenditures in 2004 compared to the prior year was primarily
attributable to reduced spending on insurance and outside consultants as well as
lower personal property taxes. Due to lower headcount as a result of an October
2004 restructuring event, the Company anticipates SG&A expenses for the fourth
quarter of 2004 will be lower than those in the first three quarters.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development ("R&D") expenses decreased to $1,358,000 for the third
quarter of 2004, versus $1,415,000 for the same period in 2003. As a percentage
of total quarterly sales, this represented 14% for both the third quarter of
2004 and 2003. Year-to-date R&D expenses were $4,043,000 for 2004 and $4,211,000
for 2003, representing 19% of total year-to-date sales in 2004 and 17% in 2003.
The slight decreases in quarterly and year-to-date R&D expenses from the
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previous year were primarily due to reduced consulting costs. The Company
expects to continue to invest in product enhancements and new product
development to support changing customer and industry needs and product
introductions. Due to lower headcount as a result of an October 2004
restructuring event, the Company anticipates R&D expenditures for the fourth
quarter of 2004 will be slightly lower than the first three quarters.
INCOME TAXES
In the third quarter of 2004, the Company increased its year-to-date effective
tax benefit rate to 45% from 36%, the estimated effective tax rate utilized for
the first six months of the year. The increase was associated primarily with
reductions in tax accruals for certain federal and state income tax items. After
analyzing changes in certain federal and state income tax items, the Company
reduced its tax contingency reserves by $261,000, resulting in an effective tax
rate of 8% for the third quarter of 2004.
NET INCOME (LOSS) AND NET INCOME (LOSS) PER SHARE
As a result of the above factors, the Company recorded net income of $806,000,
or $0.05 per share, in the third quarter of 2004, versus net income of $584,000,
or $0.04 per share, in the third quarter of 2003. Year-to-date net loss was
$1,520,000, or $.10 per share, in 2004, versus net loss of $1,225,000, or $0.08
per share, in 2003.
SUBSEQUENT EVENT
In October 2004, the Company enacted a restructuring event affecting employees
in sales, engineering, operations, services and administration. As a result of
this action, the Company expects to incur a pre-tax charge in the fourth quarter
of 2004 totaling approximately $390,000, comprised of severance and other fringe
benefits that will be paid out in cash in the fourth quarter of 2004 and in the
first two quarters of 2005.
LIQUIDITY AND CAPITAL RESOURCES
Net working capital was $20,157,000 at September 30, 2004, compared to
$20,957,000 at December 31, 2003. At September 30, 2004, the current ratio was
5.0:1 and the Company had no debt outstanding.
The Company had $23,273,000 of cash and cash equivalents and short- and
long-term investments at September 30, 2004, a decrease of $4,700,000 from the
December 31, 2003 balance of $27,973,000.
OPERATING ACTIVITIES
For the nine-month period ended September 30, 2004, operating activities used
$3,544,000 of cash, primarily as a result of the $3,046,000 operating loss for
the period. Significant non-cash operating expenses and working capital changes
included: depreciation and amortization expenses of
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$980,000; increased accounts receivable of $2,301,000 resulting from increased
sales volume near the end of the third quarter; decreased income taxes
receivable as a result of the receipt of federal income tax refunds; decreased
other current assets of $927,000 as a result of the receipt of insurance and
other refunds and the decrease of certain prepaid expenses; and decreased
deferred revenue of $867,000 primarily due to revenue recognized on projects
completed for a specific customer.
INVESTING ACTIVITIES
During the nine-months ended September 30, 2004, investing activities used cash
totaling $941,000. The Company purchased $547,000 of property, plant and
equipment primarily related to information technology infrastructure and
engineering test equipment. Purchases of investments, net of maturities and
sales, used cash of $410,000.
FINANCING ACTIVITIES
Financing activities used $565,000 of cash during the nine-months ended
September 30, 2004. During the third quarter of 2004, the Company paid a
$750,000 note payable issued in conjunction with an acquisition that occurred in
2001. Partially offsetting that use of cash were stock option exercises and
stock purchases under the Employee Stock Purchase Plan, which provided cash of
$185,000 during the first nine months of 2004.
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.
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: ongoing commitment to
controlling operating expenses (paragraph 3), limited visibility into wireline
carrier spending for the remainder of 2004 (paragraph 4), cautious optimism that
the Company will not experience further order flow interruptions for the
remainder of the year (paragraph 4), continued wireless and international demand
for the balance of the year (paragraph 4), ongoing commitment to the wireline
market
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(paragraph 4), the Company's view of its wireless and international markets as
primary drivers of significant near-term growth (paragraph 4), continued
business development efforts in the government market to help further diversify
the business (paragraph 4), general availability of the Company's AIbadger-RFMC
product in the fourth quarter and the Company's focus on converting trial
activity with this product into initial orders (paragraph 5), wireless customer
base growth as a top priority (paragraph 5), expected vendor selection before
year end on a significant opportunity in Australia (paragraph 5), progress
leading to order flow in late 2004 or 2005 from key Central and South American
accounts (paragraph 5), the Company's technology being well-suitied for
application within sensor networks (paragraph 5), technology selection by a
large systems integrator in the sensor collection and management area (paragraph
5), SG&A expenses decreasing in the fourth quarter of 2004 from the first three
quarters (paragraph 17), R&D expenses decreasing in the fourth quarter of 2004
from the first three quarters (paragraph 18), pre-tax charges of $390,000
incurred in the fourth quarter of 2004 (paragraph 21), payments for severance
and other fringe benefits in the fourth quarter of 2004 and first two quarters
of 2005 (paragraph 21), and sufficiency of capital resources (paragraph 27).
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, 2003. 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.
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.
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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.
PART II. OTHER INFORMATION
Items 1 - 5. Inapplicable
Item 6. 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
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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 12, 2004 /s/ Gerard B. Moersdorf, Jr.
-----------------------------------------
Date Gerard B. Moersdorf, Jr.
Chairman, President and Chief Executive
Officer
(Principal Executive Officer)
November 12, 2004 /s/ Michael P. Keegan
-----------------------------------------
Date Michael P. Keegan
Executive Vice President and Chief Operating
Officer
November 12, 2004 /s/ Andrew J. Dosch
-----------------------------------------
Date Andrew J. Dosch
Vice President, Chief Financial Officer
and Treasurer
(Principal Financial Officer and Principal
Accounting Officer)
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