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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 29, 2003

OR

o

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: 0-23081

FARO TECHNOLOGIES, INC.

(Exact name of Registrant as specified in its charter)

Registrant’s Telephone Number, including area code: 407-333-9911

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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes o    No x

The number of shares outstanding of the registrant’s common stock as of March 29, 2003 was 11,900,391.

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FARO TECHNOLOGIES, INC.

Form 10-Q

For the Quarter Ended March 29, 2003

INDEX

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
UNAUDITED

See accompanying notes to consolidated financial statements.

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

See accompanying notes to consolidated financial statements.

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED

See accompanying notes to consolidated financial statements.

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FARO TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the three months ended March 29, 2003 and March 31, 2002

(Unaudited)

NOTE A - DESCRIPTION OF BUSINESS

FARO Technologies, Inc. and subsidiaries develops, manufactures, markets and supports Computer Aided Design (CAD)-based quality assurance products and CAD-based inspection and statistical process control software.

The consolidated financial statements include the accounts of FARO Technologies, Inc. and all wholly owned subsidiaries (collectively, the “Company”). All significant intercompany transactions and balances have been eliminated. The financial statements of foreign subsidiaries have been translated into U.S. dollars using the current exchange rate in effect at each balance sheet date, for assets and liabilities, and the average exchange rates during each reporting period, for results of operations. Adjustments resulting from translation of the financial statements are reflected as a separate component of comprehensive loss in shareholder’s equity.

NOTE B - BASIS OF PRESENTATION

In the opinion of management, the accompanying consolidated balance sheets and related interim consolidated statements of operations, cash flows and shareholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States (“GAAP”). Preparing financial statement requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Actual results and outcomes may differ from these estimates and assumptions.

The consolidated results of operations for the three months ended March 29, 2003 are not necessarily indicative of results that may be expected for the year ending December 31, 2003. The information included in this Form 10-Q (including the interim consolidated financial statements and notes that accompany these financial statements) should be read in conjunction with the audited consolidated financial statements reported as of December 31, 2002 and 2001, and for each of the three years included in the Company’s 2002 Annual Report on Form 10-K.

In November 2002, the FASB issued FASB interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements of this interpretation are effective for interim and annual periods ending after December 15, 2002. The initial recognition and initial measurement requirements of this interpretation are effective prospectively for guarantees issued or modified after December 31, 2002. The interpretations’s expanded disclosures will not have a material impact on the Company’s financial position or results of operations.

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At the November 21, 2002 EITF meeting the Task Force reached a consensus on Issue 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor (Issue 02-16). Issue 02-16 addresses the accounting by a vendor for consideration given to a customer, including both a reseller of the vendor’s products and an entity that purchases the vendor’s products from a reseller. Issue 02-16 provides accounting guidance on how a vendor should characterize consideration given to a customer and when to recognize and how to measure that consideration in its income statement. It should be applied to new arrangements, including modifications of existing arrangements, entered into after December 31, 2002. The Company is assessing, but at this point does not believe the adoption of Issue 02-16 will have a material impact on our financial position, cash flows or results of operations.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (FAS 148). FAS 148 amends an earlier standard on accounting for stock-based compensation, FAS 123, Accounting for Stock-Based Compensation (FAS 123), to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure requirements of FAS 123 to require more prominent disclosure about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The additional disclosure requirements of FAS 148 are effective for fiscal years ending after December 15, 2002.

The Company continues to follow the intrinsic value method of accounting as prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, to account for employee stock options issued.

The following table illustrates the effects on net income (loss) and earnings per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46), which clarifies the applicability of Accounting Research Bulletin No. 52, Consolidated Financial Statements, to certain entities which equity investors do not have the

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characteristics of controller financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Company does not expect it to have a material impact on the Company’s financial position or results of operations.

On January 1, 2003, the Company modified its accounting calendar in which the reporting quarters end on the last Saturday nearest to the calendar month-end, with the exception of the year end date. Consequently the first quarter ended on March 29, 2003. This change did not materially impact the first quarter. The ending dates for all subsequent quarters in the reporting year of 2003 are as follows:

2nd Quarter       June 28, 2003
3rd Quarter       September 27, 2003
4th Quarter       December 31, 2003

NOTE C - CASH AND CASH EQUIVALENT AND INVESTMENTS

Cash and cash equivalents - We consider cash on hand, and amounts on deposit with financial institutions, which have original maturities of three months or less, to be cash and cash equivalents. All short-term investments in debt securities which have maturities of three months or less are classified as cash and equivalents, which are carried at market value based upon the quoted market prices of those investments at each respective balance sheet date.

Investments - Investments ordinarily consist of debt securities acquired with cash not immediately needed in operations. Such amounts have maturities exceeding one year. At December 31, 2002 investments consisted of corporate bonds with a market value of $427,478.

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Supplemental Cash Flow Information - Selected cash payments and non cash activities were as follows:

NOTE D - INVENTORIES

NOTE E - EARNINGS (LOSS) PER SHARE

A reconciliation of the number of common shares used in the calculation of basic and diluted earnings (loss) per share (“EPS”) is presented below:

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NOTE F - INCOME TAX EXPENSE

The tax provision for the three months ended March 29, 2003 is not comparable to the tax provision s for the three months ended March 31, 2002, due to the realization of certain tax loss carry-forwards previously not recognized.

NOTE G - SEGMENT GEOGRAPHIC DATA

The Company develops, manufactures, markets and supports Computer Aided Design (CAD)-based quality assurance products and CAD-based inspection and statistical process control software. This one line of business represents more than 98% of consolidated sales. Operating through sales teams established in geographic regions, each team is equipped to deliver the entire line of FARO products to customers within its geographic area. We have aggregated the sales teams into a single operating segment as a result of the similarities in the nature of products sold, the type of customers and the methods used to distribute our products.

The following table presents sales information by the geographic region of the customer:

Locations of the Long-lived assets is shown below:

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PART I.  FINANCIAL INFORMATION

Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following information should be read in conjunction with the Consolidated Financial Statements, including the notes thereto, included elsewhere in this Form 10-Q, and the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s 2002 Annual Report, Form 10-K, for the year ended December 31, 2002.

The Company has made forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) in this report that are subject to risks and uncertainties, such as statements about our plans, objectives, projections, expectations, assumptions, strategies, or future events. Other written or oral statements, which constitute forward-looking statements, also may be made from time to time. Words such as “may,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “will,” “should,” “could,” variations of such words, and similar expressions are intended to identify such forward-looking statements. Statements that are not historical facts or that describe our future plans, objectives, or goals also are forward-looking statements. These statements are not guarantees of future performance and are subject to a number of known and unknown risks, uncertainties, and other factors, including those discussed below and elsewhere in this report, that could cause actual results to differ materially from future results, performances, or achievements expressed or implied by such forward-looking statements. Consequently, undue reliance should not be placed on these forward-looking statements. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Factors that could cause actual results to differ materially from what is expressed or forecasted in such forward-looking statements include, but are not limited to: (i) the potential loss of material customers; (ii) the failure to properly manage growth and successfully integrate acquired businesses; (iii) inability of the Company’s products to attain broad market acceptance or increased length of the Company’s sales cycle; (iv) inability of the Company to maintain or reduce expenses; (v) the impact of competitive products and pricing; (vi) delays in shipping products , (vii) fluctuations in quarterly operating results as a result of the size, timing and recognition of revenue from significant orders, increases in operating expenses required for product development and marketing, the timing and market acceptance of new products and product enhancements; customer order deferrals in anticipation of new products and product enhancements; the Company’s success in expanding its sales and marketing programs, and general economic conditions; (viii) the financial condition of the Company’s clients; (ix) adverse consequences of exchange rate fluctuations; (x) inability to protect our intellectual property and other proprietary rights; (xi) dependence on Simon Raab and Gregory A. Fraser and other key personnel; and (xii) the cyclical nature of both the Company’s business and the industries of the Company’s customers.

The consolidated financial statements include the accounts of FARO Technologies, Inc. and all wholly-owned subsidiaries (collectively, the “Company”). All significant inter-company transactions and balances have been eliminated. The financial statements of the foreign subsidiaries have been translated into U.S. dollars using current exchange rates in effect at each balance sheet date, for assets and liabilities and average exchange rates during each reporting period for results of operations. Adjustments resulting from translation of financial statements are reflected as a separate component of comprehensive loss in shareholders’ equity.

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Results of Operations

Three Months Ended March 29, 2003 Compared to Three Months Ended March 31, 2002

Sales. Sales increased by $4.7 million or 54.0%, from $8.7 million for the three months ended March 31, 2002 to $13.4 million for three months ended March 29, 2003. The increase resulted from higher sales in all regions: Europe ($2.6 million), United States ($1.2 million), and Japan ($466,000), as well as increases in other foreign countries ($530,000). Increases in the United States were attributable mainly to laser trackers, whereas Europe and Japan saw increases in both articulated arms and laser tracker sales.

Gross profit. Gross profit increased by $2.6 million or 53.0%, from $4.9 million for the three months ended March 31, 2002 to $7.5 million for the three months ended March 29, 2003 due to higher sales volumes, as stated above in “Sales”. Gross margin remained virtually constant, decreasing only slightly to 56.0% for the three months ended March 29, 2003 from 56.1% for the three months ended March 31, 2002.

Selling expenses. Selling expenses increased by $561,000 or 17.5%, from $3.2 million for the three months ended March 31, 2002 to $3.8 million for the three months ended March 29, 2003. This increase was due primarily to increased sales commissions and related payroll expenses ($658,000) and increased trade show expenses ($106,000), partially offset by decreased salaries in Europe ($209,000) due to a restructuring of the compensation plan for sales persons. While an increase in selling expenses was experienced for the three months ended March 29, 2003 compared to the three months ended March 31, 2002, this amount represents a decrease in the percentage of sales from 37.0% to 28.3%.

General and administrative expenses. General and administrative expenses increased by $193,000 or 12.4 %, from $1.6 million for the three months ended March 31, 2002 to $1.8 million for the three months ended March 29, 2003. The increase was due primarily to increases in administrative expenses to support the higher sales volume. The increases in the United States were attributable to bad debt expense ($76,000), travel ($8,000), information technology/network ($26,000), and insurances ($17,000). Increases in Europe consisted of salaries ($34,000), telecommunications ($19,000) and rent expense ($13,000). While an increase in general and administrative expenses was experienced for the three months ended March 29, 2003 compared to the three months ended March 31, 2002, this amount represents a decrease in the percentage of sales from 17.9% to 13.1%.

Depreciation and amortization expenses. Depreciation and amortization expenses decreased by $72,000 or 10.9% from $661,000 for the three months ended March 31, 2002 to $589,000 for the three months ended March 29, 2003, due primarily to certain assets becoming fully depreciated during the prior year.

Research and development expenses. Research and development expenses decreased by $345,000, or 28.2%, from $1.2 million for the three months ended March 31, 2002 to $877,000 for the three months ended March 29, 2003 principally as a result of reduced research and development salaries relating to the development of the laser tracker in the United States ($293,000), and reductions in Europe for salaries ($42,000) and travel ($10,000).

Interest income and expense.Interest income decreased by $203,000, or 98.5%, from $206,000 for the three months ended March 31, 2002, to $3,000 for the three months ended March 29, 2003. The decrease was primarily attributable to lower interest bearing cash balances in 2003 resulting from an early 2002 acquisition of SMX. Interest expense increased by $15,000 from $1,000 for the three months ended March 31, 2002 to $16,000 for the three months ended March 29, 2003. This was

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due to the use of a credit line previously established for short term needs (see Liquidity and Capital Resources below).

Other income (expense). Other income increased by $144,000 from an expense of $28,000 for the three months ended March 31, 2002 to income of $116,000 for the three months ended March 29, 2003 due primarily to gains on currency translation.

Income tax expense. Income tax expense increased by $32,000 from $40,000 for the three months ended March 31, 2002, to $72,000 for the three months ended March 29, 2003. The company’s effective tax rate for the three months ended March 29, 2003 reflects the realization of certain tax loss carry-forwards not recognized previously.

Net income (loss). Net income increased by $2.1 million from a loss of $1.7 million for the three months ended March 31, 2002 to income of $489,000 for the three months ended March 29, 2003 as a result of the factors described above.

Liquidity and Capital Resources

Since 1997, the Company has financed its operations primarily from cash provided by operating activities and from the proceeds of its 1997 initial public offering of common stock (approximately $31.7 million). Total marketable securities (cash and cash equivalents, short-term investments and investments) at March 29, 2003 were approximately $6.8 million compared with approximately $5.9 million on December 31, 2002. This represents an increase of approximately $900,000 during the three months ended March 29, 2003 due primarily to the collection of the accounts receivable generated during the later portion of the year ended December 31, 2002.

Principal commitments at March 29, 2003 consisted of leases on the Company’s offices and manufacturing facilities, and purchase orders for goods related to manufacturing. There were no material commitments for capital expenditures as of that date. The Company is pursuing a larger line of credit for additional operating cash. However, even without obtaining a larger line of credit, the Company believes that its cash, investments, borrowings and cash flows from operations will be sufficient to satisfy its working capital and capital expenditure needs in the foreseeable future.

Critical Accounting Policies

In response to the SEC’S financial reporting release, FR-60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, we have selected our most subjective accounting estimation processes for purposes of explaining the methodology used in calculating the estimate in addition to any inherent uncertainties pertaining to the estimate and the possible effects on the Company’s financial condition. The estimation processes discussed below are the Company’s process of recognizing research and development expenditures, the allowance for obsolete and slow-moving inventory, and the allowance for doubtful accounts. These estimation processes affect current assets and operating results and are therefore critical in assessing the financial and operating status of the Company. These estimates involve certain assumptions that if incorrect, could create an adverse impact on the Company’s operations and financial position.