UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934

 

For Quarter Ended June 30, 2004

Commission File No. 0-8828

 

 

 

Registrant’s telephone number, including area code: (301) 444-2200.

 

Securities registered pursuant to Section 12(b) of the Act: None.

 

Securities registered pursuant to Section 12(g) of the Act: Common Stock $0.03 Par Value.

 

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 ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

 

Yes o    No ý

 

At August 12, 2004, the registrant had outstanding 3,166,918 shares of Common Stock, $.03 Par Value.

 

 

OPTELECOM, INC.

FORM 10-Q

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
	Consolidated Balance Sheets at June 30, 2004 and December 31, 2003
	Consolidated Statements of Income and Comprehensive Income for the three months ended June 30, 2004 and 2003
	Consolidated Statements of Income and Comprehensive Income for the six months ended June 30, 2004 and 2003
	Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003
	Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
SIGNATURES.

 

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

 

OPTELECOM, INC.

CONSOLIDATED BALANCE SHEETS

AS OF JUNE 30, 2004 and DECEMBER 31, 2003

(Unaudited)

 

		2004			2003
ASSETS
CURRENT ASSETS
Cash and cash equivalents		$	1,864,856		$	1,387,866
Accounts and contracts receivable, net		2,518,653			2,834,956
Inventories, net		3,123,502			2,661,000
Deferred tax asset—current		762,793			1,069,479
Prepaid expenses and other current assets		267,000			340,078
Total current assets		8,536,804			8,293,379
Property and equipment, net		1,597,804			1,350,366
Restricted certificate of deposit		134,759			129,368
Deferred tax asset—non-current		682,585			658,784
Other assets		36,419			—
TOTAL ASSETS		$	10,988,371		$	10,431,897
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable		$	987,356		$	1,052,410
Accrued payroll		365,808			315,889
Commissions payable		158,727			287,767
Current portion of notes payable		45,000			67,500
Other current liabilities		450,676			587,835
Total current liabilities		2,007,567			2,311,401
Notes and leases payable		90,000			90,000
Security deposits payable		11,526			11,526
Deferred rent liability		125,191			62,494
Total liabilities		2,234,284			2,475,421
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY
Common stock, $.03 par value—shares authorized, 15,000,000; issued and outstanding, 3,166,818 and 3,114,898 shares as of June 30, 2004 and December 31, 2003, respectively		95,004			93,446
Additional paid-in capital		11,140,462			10,942,206
Other comprehensive loss		(28,731		)	(19,672		)
Treasury stock, 162,672 shares, at cost		(1,265,047		)	(1,265,047		)
Accumulated deficit		(1,187,601		)	(1,794,457		)
Total stockholders’ equity		8,754,087			7,956,476
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	10,988,371		$	10,431,897

 

See notes to unaudited consolidated financial statements.

 

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OPTELECOM, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

FOR THE THREE MONTHS ENDED JUNE 30,

(Unaudited)

 

		2004			2003
Revenues		$	4,264,704		$	4,176,293
Cost of goods sold		1,831,514			1,686,437
Gross profit		2,433,190			2,489,856
Operating expenses:
Engineering		345,664			324,966
Selling and marketing		850,448			661,231
General and administrative		788,326			959,704
Total operating expenses		1,984,438			1,945,901
Income from operations		448,752			543,955
Other income (expense):
Interest income (expense), net		591			909
Income before income taxes		449,343			544,864
Provision for income taxes		145,912			8,540
Net income		$	303,431		$	536,324
Basic earnings per share		$	0.10		$	0.18
Diluted earnings per share		$	0.09		$	0.17
Weighted average common shares outstanding-basic		3,160,425			2,978,943
Weighted average common shares outstanding-diluted		3,287,450			3,170,891
Net income		$	303,431		$	536,324
Foreign currency translation		1,032			(91,724		)
Comprehensive income		$	304,463		$	444,600

 

See notes to unaudited consolidated financial statements.

 

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OPTELECOM, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

FOR THE SIX MONTHS ENDED JUNE 30,

(Unaudited)

 

		2004			2003
Revenues		$	8,444,827		$	7,664,679
Cost of goods sold		3,600,530			3,208,672
Gross profit		4,844,297			4,456,007
Operating expenses:
Engineering		717,163			626,971
Selling and marketing		1,538,785			1,174,385
General and administrative		1,698,105			1,734,855
Total operating expenses		3,954,053			3,536,211
Income from operations		890,244			919,796
Other income (expense):
Interest income (expense), net		8,469			(6,410		)
Income before income taxes		898,713			913,386
Provision for income taxes		291,857			8,540
Net income		$	606,856		$	904,846
Basic earnings per share		$	0.19		$	0.31
Diluted earnings per share		$	0.19		$	0.29
Weighted average common shares outstanding-basic		3,143,972			2,936,057
Weighted average common shares outstanding-diluted		3,272,020			3,112,977
Net income		$	606,856		$	904,846
Foreign currency translation		(9,059		)	(54,795		)
Comprehensive income		$	597,797		$	850,051

 

See notes to unaudited consolidated financial statements.

 

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OPTELECOM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30,

(Unaudited)

 

		2004			2003
Cash Flows From Operating Activities
Net income		$	606,856		$	904,846
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		207,397			151,223
Accounts receivable provision / (benefit)		217			(7,038		)
Inventory benefit		(85,612		)	(5,150		)
Stock based compensation		8,850			—
Deferred rent		62,697			28,406
Deferred tax asset		282,885			—
Change in assets and liabilities:
Accounts and contracts receivable		316,086			1,012.596
Inventories		(376,889		)	(358,216		)
Prepaid expenses and other current assets		73,078			(59,396		)
Other assets		(36,419		)	126,063
Accounts payable		(65,054		)	(215,648		)
Other current liabilities		(216,282		)	(261,584		)
Net cash provided by operating activities		777,810			1,316,102
Cash Flows From Investing Activities
Capital expenditures		(454,462		)	(784,556		)
Net cash used in investing activities		(454,462		)	(784,556		)
Cash Flows From Financing Activities
Borrowings on bank line-of-credit payable		—			2,020,551
Payments on bank line-of-credit payable		—			(2,596,630		)
Borrowings on notes payable		—			180,000
Payments on notes payable and capital leases		(22,500		)	(1,006		)
Increase in certificate of deposit		(5,391		)	—
Proceeds from issuance of common stock		36,839			34,500
Proceeds from exercise of stock options		154,126			347,779
Net cash provided by (used in) financing activities		163,074			(14,806		)
Effect of exchange rates on cash and cash equivalents		(9,432		)	(54,795		)
Net increase in cash and cash equivalents		476,990			461,945
Cash and cash equivalents—beginning of period		1,387,866			46,012
Cash and cash equivalents—end of period		$	1,864,856		$	507,957
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for interest		$	—		$	11,549
Cash paid during the period for income taxes		$	7,500		$	15,200

 

See notes to unaudited consolidated financial statements.

 

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OPTELECOM, INC.

 

Notes to Consolidated Financial Statements (Unaudited)

 

1.               Basis of Presentation

 

The accompanying unaudited financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and note disclosures normally included in the annual financial statements, prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to those rules and regulations, although Optelecom, Inc. (the Company) believes that the disclosures made are adequate to make the information presented not misleading.

 

In the opinion of management, the accompanying unaudited financial statements reflect all necessary adjustments and reclassifications (all of which are of a normal, recurring nature) that are necessary for fair presentation for the periods presented.  It is suggested that these financial statements be read in conjunction with the financial statements and the notes thereto included in the Company’s latest annual report to the Securities and Exchange Commission on Form 10-K for the year ended December 31, 2003.

 

The results for the interim periods are not necessarily indicative of the results to be expected for future quarters or the year.

 

2.               Inventory

 

Inventories consisted of the following:

 

		June 30, 2004			December 31, 2003
Production materials		$	1,579,021		$	1,637,331
Work in process		333,860			414,639
Finished goods		1,405,000			889,022
Allowance for obsolescence		(194,379		)	(279,992		)
Net		$	3,123,502		$	2,661,000

 

3.               Earnings Per Share

 

Basic earnings per share is computed using the weighted average number of common shares outstanding.  Diluted earnings per share is computed using the weighted average number of shares outstanding and the treasury stock computation method for stock options and warrants, provided they are not antidilutive.  The following is a reconciliation of the basic and diluted earnings per share.

 

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		Three Months ended June 30,
		2004			2003
Basic Earnings per Share:
Income available to common stockholders		$	303,431		$	536,324
Weighted average common shares – basic		3,160,425			2,978,943
Basic income per share		$	0.10		$	0.18
Diluted Earnings per Share:
Income available to common stockholders		$	303,431		$	536,324
Weighted average common shares – basic		3,160,425			2,978,943
Assumed conversion of:
Stock options		127,025			151,810
Warrants		—			40,138
Weighted average common shares – diluted		3,287,450			3,170,891
Diluted income per share		$	0.09		$	0.17

 

		Six Months ended June 30,
		2004			2003
Basic Earnings per Share:
Income available to common stockholders		$	606,856		$	904,846
Weighted average common shares – basic		3,143,972			2,936,057
Basic income per share		$	0.19		$	0.31
Diluted Earnings per Share:
Income available to common stockholders		$	606,856		$	904,846
Weighted average common shares – basic		3,143,972			2,936,057
Assumed conversion of:
Stock options		128,048			139,220
Warrants		—			37,700
Weighted average common shares – diluted		3,272,020			3,112,977
Diluted income per share		$	0.19		$	0.29

 

4.               Stock-based Compensation

 

The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations, in accounting for its employee stock options and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation” (FAS 123). APB 25 provides that the compensation expense relative to the Company’s employee stock options is measured based on the intrinsic value of the stock option. FAS 123 requires companies that continue to follow APB 25 to provide a pro forma disclosure of the impact of applying the fair value method of FAS 123.

 

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (FAS 148). FAS 148 amends 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, this Statement amends the disclosure requirements of FAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

 

The following table illustrates the effect on net income and net income per common share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation.

 

8

 

		Three Months ended June 30,
		2004			2003
Net income, as reported		$	303,431		$	536,324
Deduct:  Total stock-based compensation expense determined under fair value based method for all awards		(245,134		)	(109,136		)
Pro-forma net income		$	58,297		$	427,188
Net income per share:
Basic, as reported		$	0.10		$	0.18
Basic, pro-forma		$	0.02		$	0.14
Diluted, as reported		$	0.09		$	0.17
Diluted, pro-forma		$	0.02		$	0.13

 

		Six Months ended June 30,
		2004			2003
Net income, as reported		$	606,856		$	904,846
Deduct:  Total stock-based compensation expense determined under fair value based method for all awards		(462,009		)	(197,525		)
Pro-forma net income		$	144,847		$	707,321
Net income per share:
Basic, as reported		$	0.19		$	0.31
Basic, pro-forma		$	0.05		$	0.24
Diluted, as reported		$	0.19		$	0.29
Diluted, pro-forma		$	0.04		$	0.23

 

The effect of applying SFAS No. 123 on a pro forma net loss as stated above is not necessarily representative of the effects on reported net loss for future years due to, among other things, the vesting period of the stock options and the fair value of additional options to be granted in the future years.

 

5.               Business Unit Information

 

The Company manages its operations in three segments:  the Communication Products Division which develops, manufactures, and sells optical fiber-based data communications equipment to both commercial and government customers; the Electro-Optics Division which is focused on Interferometric Fiber Optic Gyro coils and the manufacture of innovative optical devices under contract, primarily to government and defense industry customers; and the Integrated Systems Division which concentrates on the delivery of video content management solutions to both new and existing customers.  The Integrated Systems Division began operating in 2003 but Management currently views it as a reportable segment.

 

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		Quarter ended June 30, 2004
		Communication Products Division			Integrated Systems Division		Electro- Optics Division			Total
Revenues		$	3,697,348		—		$	567,356		$	4,264,704
Depreciation and amortization		104,509			—		—			104,509
Income (loss) from operations		251,221			(39,587	)	237,118			448,752
Assets		10,581,115			—		407,256			10,988,371
Capital expenditures		170,976			—		—			170,976

 

		Quarter ended June 30, 2003
		Communication Products Division			Integrated Systems Division		Electro- Optics Division			Total
Revenues		$	3,747,300		—		$	428,993		$	4,176,293
Depreciation and amortization		84,304			—		—			84,304
Income from operations		400,920			—		143,035			543,955
Assets		6,634,114			—		379,528			7,013,642
Capital expenditures		513,864			—		—			513,864

 

		Six Months ended June 30, 2004
		Communication Products Division			Integrated Systems Division			Electro- Optics Division			Total
Revenues		$	7,483,157		$	14,370		$	947,300		$	8,444,827
Depreciation and amortization		207,397			—			—			207,397
Income (loss) from operations		635,415			(85,053		)	339,882			890,244
Assets		10,581,115			—			407,256			10,988,371
Capital expenditures		454,462			—			—			454,462

 

		Six Months ended June 30, 2003
		Communication Products Division			Integrated Systems Division		Electro- Optics Division			Total
Revenues		$	6,502,825		—		$	1,161,854		$	7,664,679
Depreciation and amortization		151,223			—		—			151,223
Income from operations		426,960			—		492,836			919,796
Assets		6,634,114			—		379,528			7,013,642
Capital expenditures		784,556			—		—			784,556

 

Optelecom is engaged primarily in the development, manufacture, and sale of integrated multi-media products for communicating video, audio, and other data over both copper wire and optical network systems.  Revenues represent shipments and services provided to third parties. Contract costs and operating expenses directly traceable to individual segments were deducted from revenues to arrive at income from operations.  Identifiable assets by segment are those assets that are used in the Company’s operations in each segment.  Geographically the majority of our revenues come from sales in the United States.  During the six months ended June 30, 2004 and 2003 revenue by geographic region was as follows:

 

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		2004			2003
United States		$	6,031,357		$	5,190,062
Europe		1,257,799			1,695,518
Asia - Pacific		390,659			531,083
Other		765,012			248,016
Total		$	8,444,827		$	7,664,679

 

The increase in the U.S. region is due to higher CPD sales resulting from the Company’s expanding integrator and reseller sales channels along with increased penetration of the security and surveillance marketplace.  The decline in the European region is mainly due to lower contract R&D revenues associated with the Electro-Optics division.

 

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

 

Except for the historical financial information contained herein, the following discussion and analysis may contain “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.  Such statements include declarations regarding the intent, belief or current expectations of the Company and its management.  Prospective investors are cautioned that any such forward looking statements are not guarantees of future performance and involve a number of risks and uncertainties; actual results could differ materially from those indicated by such forward looking statements.

 

The following discussion should be read in conjunction with the Financial Statements and Notes thereto.

 

OVERVIEW

 

Optelecom offers integrated multi-media products for communicating video, audio, and other data over both copper wire and optical network systems.  Optelecom currently manages its operations under three business segments: the Communication Products Division (CPD), the Electro-Optics Division (EOD), and the Integrated Systems Division (ISD).  The primary focus of the CPD is the design, manufacture and sale of optical fiber-based data communication equipment to commercial and Government clients as well as the delivery and distribution of video systems over Category5 (CAT5) copper cabling as the transmission medium.  This Division is now managing the processes previously reported under the Optical Products Unit and the Copper Products Unit.  The EOD is focused on Interferometric Fiber Optic Gyro coils and the manufacture of innovative optical devices under contract, primarily to government and defense industry customers.  The ISD is focused on delivering video content management solutions to both new and existing customers.  Initial product offerings in this segment will include rich media communications and networked security systems.

 

The CPD addresses business opportunities in the worldwide optical communication equipment marketplace, specializing in optical fiber transmission technologies. The majority of its current and future revenues is and will be derived from several niche markets that apply the advantages of fiber optic telecommunications to their transmission requirements. Presently, the vertical markets we serve include communications systems for highway traffic monitoring, advanced air traffic control video monitor displays, security surveillance and control systems, and manufacturing process and control communications.  The Company plans to develop products that will take advantage of the bandwidth capacity of fiber, primarily in the area of Gigabit Ethernet and Redundant Self-Healing Ring Networks.  A common characteristic of these systems is the capability to deliver a large quantity of video feeds over a single fiber.  These products are targeted at the security and surveillance and traffic markets.

 

In the EOD, emphasis has been placed on fabrication of precision-wound coils of optical fiber used as the sensing elements of fiber optic gyroscopes.  During the past decade, Optelecom has received U.S. Government contracts to investigate advanced manufacturing technology related to gyro coil winding. Optelecom currently pursues this tradition of business development and continues to seek out technology development opportunities with potential for production follow-on.  The EOD also produces precision wound coils for applications ranging from optical fiber dispensers used in remote vehicle control systems to precision optical fiber coils for communications systems.

 

Integrated Systems Division offers solutions in the areas of video storage, retrieval, and rich media communications. Solutions in video storage and retrieval are targeted for the surveillance and security markets.  Rich media communications solutions are targeted for the general corporate communications, engineering and scientific, and healthcare markets.

 

RESULTS OF OPERATIONS

 

Optelecom, Inc. designs, develops, manufactures and markets high-bandwidth fiber optic-based communications systems for traffic monitoring, security / surveillance, and business video systems. Over the past two years the company has aggressively pursued several operational objectives including: 1) the expansion of a distribution network both in the United States and worldwide, 2) realization of manufacturing and process improvements and 3) implementation of a cost and asset management program.

 

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The successful execution of these initiatives along with increased demand in our core markets has enabled the Company to significantly improve its financial condition in 2002, 2003 and 2004, as evidenced by increasing levels of profitability and positive cash flow.

 

The Company will continue in 2004 to work at broadening its sales channels, sustaining gross profit margins and controlling costs. To supplement the growth expected in its core business, the Company in 2003 established a new business unit called Integrated Systems. This unit will focus on delivering video content management solutions to both existing and new customers and is beginning to generate revenue in 2004.

 

THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30, 2003

 

REVENUES

 

		2004			2003
Communication Products Division		$	3,697,348		$	3,747,300
Electro-Optics Division		567,356			428,993
Integrated Systems Division		—			—
Total Revenue		$	4,264,704		$	4,176,293

 

Consolidated revenues for the three months ended June 30, 2004 of $4,264,704 were $88,411 or 2% higher than 2003. Revenue for the Communication Products Division decreased by $49,952 or 1%. This slight decrease is attributed to the decline in sales in the traffic sector.  We believe this decline is a near-term issue related to the timing of contract awards and not indicative of a long-term trend.  The decline in our traffic market sector was almost entirely offset by increases in the security and surveillance markets.  Electro-Optics revenues increased $138,363 to $567,356 for the second quarter of 2004 from $428,993 in 2003 as a result of an increase in contract services revenues as well as an increase in coil winding revenues from 2003 to 2004.  Integrated Systems, a new business unit, did not report any revenues from rich media services during the second quarter of 2004.

 

GROSS PROFIT

 

Consolidated gross profit was $2,433,190, or 57% for the three months ended June 30, 2004 as compared to $2,489,856, or 60% for the second quarter of 2003.  The Communication Products Division’s gross profit was $2,113,957 for the second quarter of 2004 compared to $2,259,065 in the second quarter of 2003.  Gross profit for the Communications Products Division as a percent of revenue was 57% and 60% for the three months ended June 30, 2004 and 2003, respectively.  The decrease of $145,108 or 6% was due to slightly lower sales and higher labor and materials costs.  The gross profit of the Electro-Optics Division increased from $230,792 in the second quarter of 2003 to $319,234 in the second quarter of 2004 primarily as a result of the higher than average revenues realized in 2004 and tighter cost controls in the second quarter of 2004.  Gross profit for the Electro-Optics Division as a percent of revenue increased to 56% for the second quarter of 2004 from 54% for the second quarter of 2003.

 

OPERATING EXPENSES

 

Operating expenses were $1,984,438 for the quarter ended June 30, 2004 compared to $1,945,901 in 2003. This increase of $38,537, or 2% is mainly due to the increased costs associated with supporting higher sales volumes.  Engineering expenses increased from $324,966 in the second quarter of 2003 to $345,664 for the second quarter of 2004 due to increases in engineering personnel.  The addition of engineering personnel will allow the Company to more effectively respond to product development requirements.  Selling and marketing expenses increased from $661,231 in the second quarter of 2003 to $850,448 for the second quarter of 2004.  This 29% increase of $189,217 results from higher personnel, commissions, advertising costs and trade show expenses incurred.  General and administrative costs decreased from $959,704 in the second quarter of 2003 to $788,326 for the second quarter of 2004.  This 18% decrease of $171,378 is primarily attributable to decreases in fringe benefits, consulting costs and other professional fees.  The Company’s

 

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management expects operating expenses to increase as revenues continue to grow and the Company develops and delivers new products to the marketplace.

 

OTHER INCOME (EXPENSE)

 

Other income for the quarter ended June 30, 2004 consisted of net interest income of $591.  Other income for the prior year quarter consisted of net interest income of $909.

 

SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDED JUNE 30, 2003

 

REVENUES

 

		2004			2003
Communication Products Division		$	7,483,157		$	6,502,825
Electro-Optics Division		947,300			1,161,854
Integrated Systems Division		14,370			—
Total Revenue		$	8,444,827		$	7,664,679

 

Consolidated revenues for the six months ended June 30, 2004 of $8,444,827 were $780,148 or 10% higher than 2003. Revenue for the Communication Products Division increased by $980,332 or 15%. This increase is attributed to the Company’s continued focus of increasing sales channels both domestically and internationally. Sales to integrators and end users increased substantially over the prior year quarter. While product pricing remained relatively stable between 2003 and 2004, the sales growth was attributable to increased sales orders and increased units sold.    Electro-Optics revenues decreased to $947,300 for the first six months of 2004 from $1,161,854 in 2003 as a result of a decline in contract services revenues related to the delivery of product associated with a major contract realized during the first quarter of 2003.  This decline was partially offset by an increase in coil winding revenues from 2003 to 2004 from $489,870 to $612,516.  Integrated Systems, a new business unit, reported modest revenues from rich media services during the six months ended June 30, 2004.

 

GROSS PROFIT

 

Consolidated gross profit was $4,844,297, or 57% for the six months ended June 30, 2004 as compared to $4,456,007, or 58% for the first six months of 2003.  The Communication Products Division’s gross profit was $4,351,435 for the six months ended June 30, 2004 compared to $3,743,522 for 2003.  Gross profit for the Communications Products Division as a percent of revenue was 58% for the six months ended June 30, 2004 and 2003.  The increase of $607,913 or 16% was due to higher sales, selective price increases and the shift from analog to digital products.  This shift from analog to digital enables the Company to focus on the sale and manufacture of leading edge product technology which are more efficiently produced than analog products.  The gross profit of the Electro-Optics Division decreased from $712,486 for the first two quarters of 2003 to $495,742 for the same period in 2004 primarily as a result of a decline in contract services revenues related to the delivery of product associated with a major contract realized during the first quarter of 2003.   Gross profit for the Electro-Optics Division as a percent of revenue decreased to 52% for the six months ended June 30, 2004 from 61% for the six months ended June 30, 2003.

 

OPERATING EXPENSES

 

Operating expenses were $3,954,053 for the six months ended June 30, 2004 compared to $3,536,211 in 2003. This increase of $417,842 or 12% is generally indicative of the need to increase the Company’s infrastructure in order to support higher sales levels.  Engineering expenses increased from $626,971 for the first two quarters of 2003 to $717,163 for the first two quarters of 2004 due to increases in engineering personnel.  The addition of engineering personnel will allow the

 

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Company to more effectively respond to product development requirements.  Selling and marketing expenses increased from $1,174,385 for the six months ended June 30, 2003 to $1,538,785 for the same period of 2004.  This 31% increase of $364,400 results from higher personnel, commissions and advertising costs incurred.  General and administrative costs decreased from $1,734,855 for the six months ended June 30, 2003 to $1,698,105 for the same period of 2004.  This 2% decrease of $36,750 is primarily attributable to the Company’s tight cost controls in personnel and professional fees.  The Company’s management expects operating expenses to increase as revenues continue to grow and the Company develops and delivers new products to the marketplace.

 

OTHER INCOME (EXPENSE)

 

Other income for the six months ended June 30, 2004 consisted of net interest income of $8,469.  Other income (expense) for the prior year period consisted of net interest expense of $6,410.

 

FINANCIAL CONDITION

 

The Company’s Stockholders’ equity increased from $8.0 million at December 31, 2003 to $8.75 million at June 30, 2004 due primarily to our recording net income and to the exercise of stock options by employees and purchase of shares pursuant to the employee stock purchase plan.

 

Other key components of Optelecom’s financial condition include accounts receivable, inventory, fixed assets and accounts payable. The Company’s current ratio has increased to 4.25 at June 30, 2004 compared to 3.59 at December 31, 2003. This increase is attributed primarily to the $0.48 million increase in cash and the $0.46 million increase in the Company’s balance in inventory.  Current liabilities overall decreased by $0.30 million due to decreases in accounts payable, commissions payable and other current liabilities.

 

Inventory increased slightly from $2.7 million at December 31, 2003 to $3.1 million at June 30, 2004 primarily due to increases in finished goods inventories. This increase was due to the Company’s decision to increase stocking levels to meet customer requirements, primarily for the growing security and surveillance market and the pre-building of finished goods expected to ship subsequent to June 30, 2004.  As the demand for Optelecom’s products from the security marketplace continues to increase, the Company expects to increase the quantity of certain finished goods products to facilitate its ability to meet the quick delivery requirements of that marketplace.

 

During the first two quarters of 2004 fixed asset additions were $0.45 million, compared to $0.78 million in 2003.  During 2003, as the Company’s profitability continued to improve over prior year levels, capital spending was increased in order to improve and expand on engineering and manufacturing capabilities. This trend continues into 2004.  While the Company does not currently have any capital asset purchase commitments, we anticipate an overall investment in capital expenditures of approximately $0.75 million in 2004.

 

The Company’s current liabilities decreased $0.30 million from $2.3 million at December 31, 2003 to $2.0 million at June 30, 2004 primarily as a result of a decrease of $0.13 million in commissions payable and $0.14 million in other current liabilities.  The Company’s deferred rent liability was increased by $0.06 million as a result of the lease term on the Company’s U.S. office space.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash provided by operating activities was $0.78 million for the six months ended June 30,2004 compared to cash provided of $1.32 million in the first six months of the prior year.  Our cash from operations is the result of our net income, adjustment for depreciation, amortization and other non-cash items and changes in our operating assets and liabilities.  As noted above, we increased our inventory levels in order to have items on hand to meet the delivery needs of our customers.  Should this market continue to increase, we expect to continue to increase inventory levels to meet this need.  While the increase in inventory was not the only item that impacted our operating cash flows, it was one significant component.

 

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Cash used in investing activities was $0.78 million for the first two quarters of 2003 and $.48 million for the same period of 2004.  The Company has maintained a relatively comparable level of spending during the current year in its efforts to improve and expand manufacturing capabilities and our information system infrastructure.

 

During the first two quarters of 2004, financing activities provided $0.16 million in cash compared to $0.015 million used in financing activities during the first six months of 2003.  The current year increase resulted primarily from the proceeds from the exercise of stock options and common stock issued from the employee stock purchase plan.  The use of cash in financing activities for the prior year is attributed primarily to the elimination of the bank line-of-credit of $0.58 million.  These uses were offset by borrowings on notes of $0.18 million and proceeds from the exercise of stock options and common stock issued from the employee stock purchase plan totaling $0.38 million during the first two quarters of 2003.

 

The Company has the ability to borrow up to $3.5 million under its existing bank line-of-credit as of June 30, 2004, provided there are sufficient accounts receivable and inventory. This facility consists of two components:  (a) a demand working capital line of credit which will enable the Company to borrow up to the lesser of $3.0 million or the borrowing base; and (b) a $500,000 transaction specific revolving demand export line of credit for short-term financing.  The Company’s borrowing base under the first facility equals the sum of 90% of eligible government billed accounts receivable, 80% of the eligible commercial billed accounts receivable and 20% of eligible related inventory capped at $500,000. The Company’s borrowing base under the second facility equals the sum of 75% of the eligible export-related inventory and 90% of the eligible export-related accounts receivable. This facility is guaranteed 90% by the Export-Import Bank of the United States (“Ex-Im Bank”) under Ex-Im Bank’s Working Capital Guarantee Program.

 

The first facility carries interest at the rate of LIBOR (1.36% at June 30, 2004) plus 3.5%. The second facility carries interest at the rate of PRIME (4.25% at June 30, 2004) plus 1.25%, floating.

 

Optelecom is required to comply with certain financial ratios including maintaining a minimum current ratio, a maximum debt to worth ratio, a maximum funded debt to EBITDA ratio and a minimum tangible net worth ratio. The Company was in compliance with all of these covenants at June 30, 2004.

 

Optelecom’s future working capital needs will be financed by our operating cash flow and continued use of the line-of-credit. In the event that operating cash flows become insufficient to meet funding needs, the Company may be required to scale back or eliminate product research and development and overhead costs. Additionally, the Company would look to increase its line of credit and/or pursue equity financing. The Company’s strategy will focus on identifying new products that meet the demands of our core markets, expanding our distribution channels and implementing processes which will increase manufacturing efficiencies. Management fully understands the costs required to execute this strategy and will pursue these initiatives in a timely and fiscally prudent manner.

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

Market risk is the potential change in an instrument’s value caused by, for example, fluctuations in interest and currency exchange rates. The Company has not purchased any futures contracts nor purchased or held any derivative financial instruments for trading purposes during the six months ended June 30, 2004 and 2003. The primary market risk exposure is the risk that interest rates on our outstanding borrowings may increase. Optelecom also faces market risk exposure as a result of foreign currency translation adjustments of the Company’s foreign subsidiary, Optelecom Europe Limited. The Company believes this risk is immaterial.

 

Optelecom currently has no borrowings under its available bank lines-of-credit.  Optelecom has not entered into any hedging arrangements with respect to any prior interest obligations under these lines of credit.

 

Item 4.  Controls and Procedures

 

As of June 30, 2004, under the direction and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company reviewed and evaluated the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based on that

 

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evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are adequate and effective.

 

In connection with the evaluation by management, including the Chief Executive Officer and Chief Financial Officer, of our internal controls over financial reporting, pursuant to Exchange Act Rule 13a-15(d), no changes during the quarter ended June 30, 2004 were identified that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.  The Company is currently reviewing the new internal controls documentation and attestation requirements regarding Rule 404 of the Sarbanes Oxley Act of 2002 and is confident that it will fully comply with such requirements.

 

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PART II - OTHER INFORMATION

 

ITEM 1 - LEGAL PROCEEDINGS

 

From time to time, the Company is involved in legal proceedings and litigation arising in the ordinary course of business.  As of the date of this report, except as described above, the Company is not a party to any litigation or other legal proceeding that, in the opinion of management, could have a material adverse effect on the Company’s business, financial condition or results of operations.

 

ITEM 2 - CHANGES IN SECURITIES

 

None.

 

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

Optelecom’s Annual Meeting of Stockholders was held on May 3, 2004 at which time the stockholders elected Edmund D. Ludwig and David R. Lipinski as directors of Optelecom to hold office until the 2007 annual meeting of stockholders (subject to the election and qualification of their successors or their earlier death, resignation or removal) and approved an increase in the number of shares available under the Optelecom, Inc. 2002 Stock Option Plan from 300,000 shares to 500,000 shares.  The votes were as follows:

 

		Votes for		Votes against		Withheld/Abstain
(1) Election of directors:
Edmund D. Ludwig		2,637,452		n/a		30,527
David R. Lipinski		2,637,417		n/a		30,562
(2) Increase the number of shares available under the Optelecom, Inc. 2002 Stock Option Plan from 300,000 shares to 500,000 shares.		529,654		160,770		9,233

 

ITEM 5 - OTHER INFORMATION

 

None

 

ITEM 6A - EXHIBITS

 

Exhibits are incorporated by reference to the Company’s December 31, 2003 Form 10-K

 

ITEM 6B - REPORTS ON FORM 8-K

 

None

 

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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.

 

 

		OPTELECOM, INC.
Date:	August 13, 2004	/s/  Edmund Ludwig
		Edmund Ludwig,
		Director, President and Chief Executive Officer
Date:	August 13, 2004	/s/  James Armstrong
		James Armstrong,
		Director, Chief Financial Officer

 

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