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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549-1004

 

Form 10-Q

 

(Mark One)

 

ý 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

 

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 0-21681

 

EFJ, INC.

(Exact name of registrant as specified in its charter)

 

 

DELAWARE

47-0801192

(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer Identification No.)

 

 

 1232 22nd STREET NW, SUITE 600
WASHINGTON, D.C. 20037
(202) 833-7742

(Address, including zip code, and telephone number,
including area code, of registrant’s
principal executive office)

 

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 Exchange Act).

 

YES o                NO ý

 

As of October 18, 2004, 18,066,962 shares of the Registrant’s Common Stock were outstanding.

 

 



 

PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

EFJ, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

September 30, 2004 and December 31, 2003

(in thousands, except share data)

 

 

 

SEPTEMBER 30,
2004

 

DECEMBER 31,
2003

 

 

 

(unaudited)

 

 

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

7,967

 

$

4,644

 

Accounts receivable, net of allowance for returns and doubtful accounts of $142 and $104, respectively

 

9,863

 

19,754

 

Receivables – other

 

178

 

157

 

Cost in excess of billings on uncompleted contracts

 

1,371

 

869

 

Inventories

 

14,531

 

18,040

 

Deferred income taxes

 

2,000

 

1,500

 

Prepaid expenses

 

3,262

 

587

 

Total current assets

 

39,172

 

45,551

 

 

 

 

 

 

 

Property, plant and equipment, net

 

3,546

 

2,779

 

Deferred income taxes

 

6,000

 

6,500

 

Intangible assets, net of accumulated amortization

 

6,748

 

6,753

 

Other assets

 

542

 

686

 

TOTAL ASSETS

 

$

56,008

 

$

62,269

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Revolving line of credit

 

$

 

$

7,500

 

Current portion of long-term debt obligations

 

131

 

127

 

Accounts payable

 

6,719

 

8,582

 

Billings in excess of cost on uncompleted contracts

 

25

 

30

 

Deferred revenue – current

 

277

 

1,191

 

Accrued expenses

 

3,867

 

3,406

 

Total current liabilities

 

11,019

 

20,836

 

 

 

 

 

 

 

Long-term debt obligations, net of current portion

 

323

 

426

 

Deferred revenue, net of current portion

 

737

 

601

 

TOTAL LIABILITIES

 

12,079

 

21,863

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock ($0.01 par value; 3,000,000 shares authorized; none issued)

 

 

 

Common stock ($0.01 par value; 50,000,000 voting shares authorized, 17,972,432 and 17,359,973 issued and outstanding as of September 30, 2004 and December 31, 2003; 600,000 non-voting shares authorized, 217,542 issued and outstanding at December 31, 2003, which shares were converted to voting shares in 2004)

 

180

 

176

 

Additional paid-in capital

 

102,046

 

100,845

 

Accumulated deficit

 

(58,297

)

(60,615

)

TOTAL STOCKHOLDERS’ EQUITY

 

43,929

 

40,406

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

 

$

56,008

 

$

62,269

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

2



 

EFJ, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

For the three and nine months ended September 30, 2004 and 2003
(Unaudited and in thousands, except share and per share data)

 

 

 

THREE MONTHS ENDED
SEPTEMBER 30,

 

NINE MONTHS ENDED
SEPTEMBER 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

15,430

 

$

13,089

 

$

55,245

 

$

32,803

 

Cost of sales

 

8,161

 

7,853

 

30,401

 

18,974

 

Gross profit

 

7,269

 

5,236

 

24,844

 

13,829

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

2,572

 

1,939

 

7,842

 

5,154

 

Sales and marketing

 

2,709

 

1,756

 

7,045

 

4,590

 

General and administrative, inclusive of non-cash  stock option repricing (benefit) expense adjustment  of $(1,425) and $886 for the three and nine months  ended September 30, 2004 and $1,890 and $2,186  for the same periods ended September 30, 2003

 

1,221

 

3,327

 

7,580

 

6,523

 

Total operating expenses

 

6,502

 

7,022

 

22,467

 

16,267

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from operations

 

767

 

(1,786

)

2,377

 

(2,438

)

 

 

 

 

 

 

 

 

 

 

Other income (expense)

 

34

 

35

 

29

 

62

 

Interest income

 

11

 

5

 

31

 

26

 

Interest expense

 

(28

)

(41

)

(119

)

(133

)

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

784

 

(1,787

)

2,318

 

(2,483

)

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

784

 

$

(1,787

)

$

2,318

 

$

(2,483

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share – Basic

 

$

0.04

 

$

(0.10

)

$

0.13

 

$

(0.14

)

Net income (loss) per share – Diluted

 

$

0.04

 

$

(0.10

)

$

0.12

 

$

(0.14

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares – Basic

 

17,887,457

 

17,577,315

 

17,779,443

 

17,577,315

 

Weighted average common shares – Diluted

 

18,672,301

 

17,577,315

 

18,784,281

 

17,577,315

 

 

See accompanying notes to the condensed consolidated financial statements.

 

 

3



 

EFJ, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine months ended September 30, 2004 and 2003

(Unaudited and in thousands, except share data)

 

 

 

Nine months ended September 30,

 

 

 

2004

 

2003

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

2,318

 

$

(2,483

)

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

1,041

 

827

 

Non-cash compensation expense – intrinsic value of repriced options

 

886

 

2,186

 

Gain on sale of fixed assets

 

(76

)

(58

)

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

9,870

 

(3,623

)

Cost in excess of billings on uncompleted contracts

 

(502

)

829

 

Inventories

 

3,509

 

(1,778

)

Prepaid expenses

 

(2,675

)

(318

)

Accounts payable

 

(1,863

)

1,445

 

Billings in excess of cost on uncompleted contracts

 

461

 

(26

)

Deferred revenues

 

(5

)

(480

)

Accrued and other liabilities

 

(778

)

(126

)

Total adjustments

 

9,868

 

(1,122

)

Net cash provided by (used in) operating activities

 

12,186

 

(3,605

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Proceeds from sale of fixed assets

 

79

 

53

 

Purchase of property, plant and equipment

 

(1,806

)

(553

)

Other assets

 

144

 

167

 

Net cash used in investing activities

 

(1,583

)

(333

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Payments on revolving line of credit, net

 

(7,500

)

(5,000

)

Principal payments on long-term debt

 

(99

)

(82

)

Other

 

319

 

(5

)

Net cash used in financing activities

 

(7,280

)

(5,087

)

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

3,323

 

(9,025

)

 

 

 

 

 

 

Cash and cash equivalents, beginning of period

 

4,644

 

11,333

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

7,967

 

$

2,308

 

 

Summary of non-cash transactions:

 

In the nine months ending September 30, 2003, the Company acquired $374 of fixed assets in exchange for long-term debt.

 

See accompanying notes to the condensed consolidated financial statements

 

4



 

EFJ, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 Three and nine months ended September 30, 2004 and 2003

(Unaudited and in thousands, except share and per share data)

 

1. GENERAL

 

The condensed consolidated balance sheet of EFJ, Inc. (“EFJ” or the “Company”) at December 31, 2003, presented within this Report on Form 10-Q filing, has been derived from audited consolidated financial statements at that date.  The condensed consolidated financial statements as of September 30, 2004 and for the three and nine months ended September 30, 2004 and 2003 are unaudited.  The condensed consolidated financial statements reflect all normal and recurring accruals and adjustments that, in the opinion of management, are necessary for a fair presentation of the financial position, operating results, and cash flows for the interim periods presented in this quarterly report.  The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.  The results of operations and cash flows for the nine months ended September 30, 2004 are not necessarily indicative of the results for any other period or the entire fiscal year ending December 31, 2004.  Where appropriate, items within the condensed consolidated financial statements have been reclassified from the previous period’s presentation to conform to the current presentation.

 

2.  ORGANIZATION AND CONSOLIDATION

 

The Company is a provider of land mobile radio (“LMR”) wireless communications products and systems, which are sold to: (1) domestic public safety / public service and other governmental users; (2) domestic commercial users; and (3) international customers.  Through its wholly-owned subsidiaries, E.F. Johnson Company (“EFJohnson”) and Transcrypt International, Inc. (“Transcrypt”), the Company designs, develops, manufactures and / or markets:

                  mobile and portable LMR radios (“subscriber units”);

                  stationary LMR transmitters / receivers (base stations or repeaters);

                  LMR systems;

                  information security products, based on a wide range of analog scrambling and digital encryption technologies; and

                  LMR services.

 

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries.  All significant intercompany accounts and transactions have been eliminated in the consolidation.

 

3.  NET INCOME (LOSS) PER SHARE

 

Basic income (loss) per share (“EPS”) is calculated based upon the weighted average number of common shares outstanding during the period.  The diluted EPS calculation reflects the potential dilution from common stock equivalents such as stock options.  For the three and nine months ended September 30, 2004 and 2003, substantially all outstanding stock options granted as of such dates had exercise prices lower than the average market price of the common stock for the respective periods and are, thereby, considered common stock equivalents in the calculation of the diluted weighted average common shares.  The Company uses the treasury stock method to calculate diluted weighted average common shares, as if all such options were outstanding for the periods presented.

 

For the three and nine months ended September 30, 2003, the impact of outstanding stock options on diluted EPS was anti-dilutive as the Company incurred net losses during these periods.  Accordingly, basic EPS is used for both basic and diluted EPS for the respective periods.  If the Company had not incurred net losses for these periods, the diluted weighted average common shares would have been: 18,779,341 and 18,580,437, respectively, for the three and nine months ended September 30, 2003.

 

5



 

4.  ACCOUNTING FOR STOCK-BASED COMPENSATION

 

The Company applies the intrinsic value-based method of accounting for stock options issued to employees.   When both the number of shares that an individual employee is entitled to receive and the option price are known at the grant date, total compensation cost for the Company’s grants of stock options is measured at the grant date (“fixed plan awards”).  However, when either or both of these factors are not known at the grant date, the Company estimates total compensation cost each accounting period from the date of grant based on the estimated fair value of the Company’s common stock at the end of each period (“variable plan awards”).  Changes, either increases or decreases, in the estimated fair value of the shares between the date of grant and the final exercise or expiration of the options result in a change in the measure of compensation cost for variable plan awards.  Compensation cost is recognized as expense over the periods in which the employee performs the related services, which is generally presumed to be the vesting period.

 

If compensation cost for the Company’s stock option plans had been determined based on the fair value at the grant date for awards for the three and nine months ended September 30, 2004 and 2003, the Company’s pro forma net income (loss) and pro forma net income (loss) per share would have been as follows:

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) — as reported

 

$

784

 

$

(1,787

)

$

2,318

 

$

(2,483

)

General and administrative expenses for management stock option compensation

 

122

 

(115

)

1,932

 

320

 

Pro forma net income (loss)

 

$

662

 

$

(1,672

)

$

386

 

$

(2,803

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share, basic — as reported

 

$

0.04

 

$

(0.10

)

$

0.13

 

$

(0.14

)

Net income (loss) per share, diluted — as reported

 

0.04

 

(0.10

)

0.12

 

(0.14

)

Pro forma net income (loss) per share, basic

 

0.04

 

(0.10

)

0.11

 

(0.16

)

Pro forma net income (loss) per share, diluted

 

0.03

 

(0.10

)

0.10

 

(0.16

)

 

The weighted average fair value per option at date of grant during the three months ended September 30, 2004 and 2003 was $1.55 and $1.47.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for options granted:

 

 

 

Nine months ended September 30,

 

 

 

2004

 

2003

 

Expected option life

 

10 years

 

10 years

 

Expected annual volatility

 

75

%

92

%

Risk-free interest rate

 

4.40

%

3.99

%

Dividend yield

 

0

%

0

%

 

5. INVENTORIES

 

The following is a summary of inventories:

 

 

 

September 30, 2004

 

December 31, 2003

 

Raw materials and supplies

 

$

8,164

 

$

8,069

 

Work in progress

 

1,487

 

1,350

 

Finished goods

 

6,245

 

9,250

 

 

 

15,896

 

18,669

 

Reserve for obsolescence

 

1,365

 

629

 

Total inventories

 

$

14,531

 

$

18,040

 

 

6



 

6.  INTANGIBLE ASSETS

 

As required by Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, the Company does not amortize its goodwill and tradename, both of which relate solely to the Company’s EFJohnson segment, but instead reviews such assets for impairment, at least annually.  The Company performed fair value-based impairment tests, in accordance with SFAS No. 142, at December 31, 2003 and 2002, concluding that no impairment of goodwill or tradename had occurred as of these dates.  No events occurred during the three and nine months ended September 30, 2004 and 2003 that would indicate that an impairment of such assets had taken place as of such dates.  As of January 1, 2002, certain of the Company’s intangible assets (primarily acquired workforce) were reclassified to goodwill, as these assets, per SFAS No. 141, Business Combinations, were not deemed separable from goodwill.

 

Amortization expense, related to intangible assets which are subject to amortization, was $2 and $4 for the three and nine months ended September 30, 2004 and 2003.  Amortization expense of intangible assets subject to amortization is anticipated to be $7 for 2004 and annually thereafter through 2012.  Intangible assets consist of the following as of the dates indicated:

 

 

 

September 30, 2004

 

December 31, 2003

 

Intangible assets not subject to amortization:

 

 

 

 

 

 

 

 

 

Goodwill

 

 

 

$

5,126

 

 

 

$

5,126

 

Tradename

 

 

 

1,564

 

 

 

1,564

 

 

 

 

 

 

 

 

 

 

 

Intangible assets subject to amortization:

 

 

 

 

 

 

 

 

 

Proprietary and core technology

 

1,290

 

 

 

1,290

 

 

 

Less: accumulated amortization

 

1,290

 

 

1,290

 

 

Patents

 

113

 

 

 

113

 

 

 

Less: accumulated amortization

 

55

 

58

 

50

 

63

 

Total

 

 

 

$

6,748

 

 

 

$

6,753

 

 

7.  REVOLVING LINE OF CREDIT

 

The Company renewed it line of credit agreement with Bank of America in September 2004.  The secured $15,000 line of credit bears interest at a rate of LIBOR plus 150 basis points, which rate may be increased to LIBOR plus 225 basis points dependent upon certain debt ratios.  The effective rate at September 30, 2004 was 3.2%.  The line of credit is collateralized by substantially all of the Company’s assets, and borrowings available under the line of credit are calculated as a percentage of eligible inventory and receivables.  The agreement, which expires September 30, 2007, includes certain covenants, including financial covenants, with which the Company was in compliance as of September 30, 2004 and December 31, 2003.  At September 30, 2004 and December 31, 2003, the Company had zero and $7,500, respectively, outstanding on its line of credit.  The total available credit under the line of credit was $8,160 as of September 30, 2004.

 

7



 

8.  WARRANTY COSTS

 

        The Company substantially provides a one-to-two year warranty on its product sales, dependent upon certain terms and conditions of the sale, and estimates future warranty claims based on historical experience and anticipated costs to be incurred over the life of the warranty.  Warranty expense is accrued at the time of sale with an additional accrual for specific items after the sale when their existence is known and amounts are both extraordinary and determinable.  A reconciliation of changes in the Company’s accrued warranty as of September 30, 2004 is as follows:

 

 

 

Balance at
December 31, 2003

 

Charged to
Expenses

 

Deduction /
Expenditures

 

Balance at
September 30, 2004

 

 

 

 

 

 

 

 

 

 

 

Allowance for Warranty Reserve

 

$

727

 

1,883

 

825

 

$

1,785

 

 

9.  REPRICED STOCK OPTIONS

 

In 2000 and 2001, the Company effectively cancelled and reissued stock options in order to lower the exercise price of those options to $0.656 per share, an amount approximating 150% of the then prevailing market value of the Company’s common stock (the “repricing”).  The repricing of the stock options resulted in a new measurement date for accounting purposes and the reclassification of these options as variable plan awards beginning on the date of the repricing.  The Company had previously accounted for these option grants as fixed plan awards.  The market value of the Company’s common stock was $6.71 and $3.90 per share at September 30, 2004 and 2003, respectively; this compared to market values of $5.90 and $1.25 per share at December 31, 2003 and 2002, respectively.  Aggregate non-cash compensation charges, therefore, resulted to the extent that the market value at the respective period ending date exceeded the repriced exercise price of $0.656 per share.  In the three and nine months ended September 30, 2004, the amounts of compensation (benefit) expense relating to these repriced options were $(1,425) and $886.  In the three and nine months ended September 30, 2003, the amounts of compensation expense relating to these repriced options were $1,890 and $2,186.  These amounts are included in general and administrative expenses.

 

As of September 30, 2004, approximately 555,000 of these repriced options, in various stages of vesting, were outstanding, of which approximately 492,000 related to options issued to the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).  In the first quarter of 2004, the CEO and CFO adopted pre-arranged stock selling plans, pursuant to Rule 10b5-1 of the Securities and Exchange Act of 1934, in regards to the repriced option shares held by them which are subject to variable accounting treatment.  Under the pre-arranged stock selling plans, stock options will be exercised contemporaneously with the sales of the resulting shares.  The respective selling of the stock commenced in the second quarter of 2004 and will continue over a period at least through the second quarter of 2005.  Any non-cash compensation related to these options will become fixed at the time the options are exercised; prior to exercise, the options will continue to be subject to variable accounting treatment.  The CEO and CFO, in aggregate, exercised approximately 308,000 options during the nine months ended September 30, 2004.

 

10.  COMMITMENTS AND CONTINGENCIES

 

On or about February 5, 2001, ASRC Communication (“ASRC”) filed a complaint in United States District Court for the District of Alaska, against EFJohnson seeking damages against EFJohnson on claims arising out of EFJohnson’s sale of radio products to ASRC.  ASRC purchased, and resold to the State of Alaska, approximately $500 of products from EFJohnson since 1999.  ASRC’s claims against EFJohnson include breach of contract, breach of express warranty, breach of implied warranty of merchantability, breach of implied warranty of fitness for a particular purpose, breach of duty of good faith and fair dealing, equitable estoppel, misrepresentation, and violations of the Racketeer Influenced and Corrupt Organizations Act.  The complaint anticipated that the State of Alaska would formally prosecute its administrative claim under the Alaska State Procurement Code against ASRC for damages associated with alleged malfunctions of EFJohnson manufactured radios. Under the May 21, 2003

 

8



 

agreement between ASRC and EFJohnson (the “ASRC Agreement”), EFJohnson agreed to defend ASRC, at EFJohnson’s expense, against any State’s claim alleging non-performance of the EFJohnson radios.  In the event the State prevailed in its claim EFJohnson and ASRC agreed to allocate any award in favor of the State in accordance with formula in the ASRC Agreement.  In addition, the parties agreed to resolve any issue or dispute remaining between them after the conclusion of the State administrative proceeding through mediation and binding arbitration.  Based upon the ASRC Agreement, ASRC and EFJohnson dismissed the claims against each other.  On or about April 6, 2004, the State of Alaska’s Department of Administration, Information Technology Group filed an administrative claim under the State Procurement Code against ASRC for damages associated with the EFJohnson radios.  The State of Alaska claim alleges damages in excess of $900.  Subsequently, ASRC has tendered, and EFJohnson has accepted, the State’s administrative claim in accordance with the ASRC Agreement. EFJohnson will undertake to defend ASRC under the terms and conditions of the ASRC Agreement.  The Company is unable to predict the likelihood of the outcome or potential liability that may arise from this action.

 

In June 2004, Mace, Incorporated (“Mace”) filed a complaint in United States District Court for the Eastern District of Virginia, against EFJohnson seeking damages against EFJohnson on claims for third-party commissions allegedly due in conjunction with certain product sales to the federal government. Mace has alleged protected damages of $400 and an unspecified percentage of past and future federal government sales.  The Company has provided for its estimated liability relating to this matter.  The Company believes that it has meritorious contractual defenses against such demand and intends to vigorously contest such allegation.  Due to the fact that the assertion is undefined, the Company is unable to predict the likelihood of the outcome or potential liability that may arise from this request for payment.

 

The Company is presently disputing certain state tax liabilities totaling approximately $350.  The Company believes the basis for the states’ assessment of the amounts owed is incorrect and intends to vigorously contest such assessments.  At September 30, 2004, the Company has recorded a liability related to these assessments, which amount reflects the Company’s evaluation of the eventual conclusion of these matters.

 

The Company is presently involved in a dispute regarding the computation of certain royalty liabilities.  The Company believes the basis for its royalty computation is correct and consistent with the terms of the royalty agreement.  However, if the Company’s method of computation proves to be wrong, accrued royalties could be understated at September 30, 2004 by approximately $400.  The Company is presently unable to predict the outcome and eventual liability related to this matter.

 

The Company is involved in certain other legal proceedings incidental to the normal conduct of its business.  The Company does not believe that any liabilities relating to such other legal proceedings are likely to be, individually or in the aggregate, material to the Company’s business, financial condition, results of operations, or cash flows.

 

In the normal course of its business activities, the Company is required under a contract with various governmental authorities to provide letters of credit and bonds that may be drawn upon if the Company fails to perform under its contracts.  The letters of credit, which expire on various dates in 2004, have a total undrawn balance of $250 at September 30, 2004.  Bonds, which expire on various dates, totaled $7,300 on September 30, 2004.  As of that date, no bonds have been drawn upon.

 

At September 30, 2004, the Company had posted a $2,559 cash deposit in regards to an LMR statewide system bid.  The cash deposit was made in lieu of a bid bond.  The deposit was returned in October 2004.  The amount is included in prepaid expenses on the balance sheet as of September 30, 2004.

 

9



 

11.  SEGMENT AND RELATED INFORMATION

 

                The Company operates in the following two reporting segments, both of which operate in the LMR industry.  These segments are the Company’s two operating subsidiaries: EFJohnson and Transcrypt.  Although both segments have product offerings which have some market similarity, EFJohnson’s operations primarily entail the design, development, manufacture and sale of LMR transmitters/receivers, mobile and portable LMR radios, and LMR communication systems, while Transcrypt’s operations primarily entail the design, manufacture and sale of devices that prevent the unauthorized interception of sensitive voice and data communication.  The Company evaluates segment results based on gross margin and income from operations.  Corporate expenses, exclusive of charges or benefits associated with variable accounting for repriced stock options, are allocated to the operating segments based upon estimated usage of corporate resources.  The following table is a summary of the unaudited operating results for the three and nine months ended September 30, 2004 and 2003.

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

In thousands

 

2004

 

2003

 

2004

 

2003

 

Revenues:

 

 

 

 

 

 

 

 

 

Wireless Communication

 

$

11,300

 

$

11,992

 

$

44,418

 

$

28,139

 

Information Security

 

4,130

 

1,097

 

10,827

 

4,664

 

 

 

$

15,430

 

$

13,089

 

$

55,245

 

$

32,803

 

Gross Profit:

 

 

 

 

 

 

 

 

 

Wireless Communication

 

$

3,914

 

$

4,448

 

$

16,125

 

$

10,428

 

Information Security

 

3,355

 

788

 

8,719

 

3,401

 

 

 

$

7,269

 

$

5,236

 

$

24,844

 

$

13,829

 

Operating Profit (Loss):

 

 

 

 

 

 

 

 

 

Wireless Communication

 

$

(2,647

)

$

110

 

$

(2,131

)

$

(1,242

)

Information Security

 

1,989

 

(6

)

5,394

 

990

 

Income (Loss) from Operations

 

(658

)

104

 

3,263

 

(252

)

 

 

 

 

 

 

 

 

 

 

Stock Option Repricing Adjustment, net

 

1,425

 

(1,890

)

(886

)

(2,186

)

Other Expense, net

 

17

 

(1

)

(59

)

(45

)

 

 

 

 

 

 

 

 

 

 

Income (Loss) before Income Taxes

 

$

784

 

$

(1,787

)

$

2,318

 

$

(2,483

)

 

 

 

 

 

 

 

 

 

 

Depreciation & Amortization:

 

 

 

 

 

 

 

 

 

Wireless Communication

 

$

312

 

$

252

 

$

940

 

$

730

 

Information Security

 

34

 

34

 

101

 

97

 

 

 

$

346

 

$

286

 

$

1,041

 

$

827

 

 

 

 

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

 

 

 

 

Wireless Communication

 

$

37,042

 

 

 

 

 

 

 

Information Security

 

12,951

 

 

 

 

 

 

 

Corporate

 

6,015

 

 

 

 

 

 

 

 

 

$

56,008

 

 

 

 

 

 

 

 

10



 

12.  PLANNED MOVES OF THE COMPANY’S OPERATING FACILITIES

 

During the second quarter of 2004, Transcrypt’s operations moved from its previous facility in Lincoln, Nebraska to a similar 18,000 square-foot facility located a short distance from its previous operations.  The Company incurred $45 and $190 in relation to this move for the three and nine months ended September 30, 2004.  The new facility was obtained pursuant to a ten-year lease with anticipated facility costs approximating those of the departed facility.  The move was precipitated by the May 31, 2004 termination of the lease agreement on the segment’s previous facility and was complete by September 30, 2004.

 

On April 14, 2004, the Company announced its decision to move EFJohnson’s operations, to include the outsourcing of its manufacturing, from its current facility in Waseca, Minnesota to the Dallas, Texas area.  The Company expects to incur costs of $1,900 in relation to this move of EFJohnson.  The timing of the recognition of costs associated with this move will be determined in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, and other relevant guidance, which provide that a liability for a cost associated with an exit or disposal activity shall be recognized at its fair value in the period in which the liability is incurred.  In particular, employee-related termination costs associated with the relocation are generally recognized ratably over the period that the employees are required to provide services in order to earn the respective termination benefit.  This move is expected to be completed by April 2005 and is not expected to cause significant disruption of the business; however, a significant portion of EFJohnson’s workforce may be replaced or otherwise terminated in relation to this move.

 

EFJohnson and Transcrypt Operating

Facility Relocation Costs (in 000’s):

 

 

 

Total amount
expected to be
incurred

 

Amount incurred
in the three
months ended
September 30, 2004

 

Cumulative amount
incurred as of
September 30,
2004

 

Remaining amount
to be incurred

 

Description of Costs

 

 

 

 

 

 

 

 

 

Employee related costs

 

$

900

 

$

410

 

$

528

 

$

372

 

Furniture and equipment relocation costs

 

490

 

90

 

242

 

248

 

Manufacturing outsourcing set-up costs

 

400

 

128

 

246

 

154

 

Other

 

300

 

110

 

123

 

177

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

2,090

 

$

738

 

$

1,139

 

$

951

 

 

11



 

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

AND RESULTS OF OPERATIONS

 

Discussions of certain matters contained in this Quarterly Report on Form 10-Q may constitute forward-looking statements under Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). These forward-looking statements relate to, among other things, the results of the Company’s product development efforts, future sales and expense levels, the Company’s future financial condition, liquidity and business prospects generally, relocation of operating facilities, outsourcing of EFJohnson’s manufacturing, perceived opportunities in the marketplace for the Company’s products, and the Company’s other business plans for the future.  These forward-looking statements are subject to certain risks and uncertainties that could cause the actual results, performance and outcomes to differ materially from those expressed or implied in these forward-looking statements due to a number of risk factors including, but not limited to, the risks detailed in “ITEM 1. BUSINESS — Summary of Business Considerations and Certain Factors That May Affect Future Results of Operations and/or Stock Price” contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

The following discussion is intended to provide a better understanding of the significant changes in trends relating to the Company’s financial condition and results of operations.  Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying Condensed Consolidated Financial Statements and Notes thereto.

 

The following table presents certain Condensed Consolidated Statements of Operations information as a percentage of revenues during the periods indicated:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

100.0

%

100.0

%

100.0

%

100.0

%

Cost of sales

 

52.9

 

60.0

 

55.0

 

57.8

 

Gross profit

 

47.1

 

40.0

 

45.0

 

42.2

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

16.7

 

14.8

 

14.2

 

15.7

 

Sales and marketing

 

17.5

 

13.5

 

12.7

 

14.0

 

Facility relocation expenses

 

4.8

 

 

2.1

 

 

Stock option repricing (benefit) expense

 

(9.2

)

14.4

 

1.6

 

6.7

 

General and administrative

 

12.3

 

11.0

 

10.1

 

13.3

 

Total operating expenses

 

42.1

 

53.7

 

40.7

 

49.7

 

Income (loss) from operations

 

5.0

 

(13.7

)

4.3

 

(7.5

)

Interest expense - net

 

(0.1

)

(0.3

)

(0.2

)

(0.3

)

Other expense

 

0.2

 

0.3

 

0.1

 

0.2

 

Income (loss) before income taxes

 

5.1

 

(13.7

)

4.2

 

(7.6

)

Income tax provision

 

 

 

 

 

Net income (loss)

 

5.1

%

(13.7

)%

4.2

%

(7.6

)%

 

12



 

Revenues

 

Revenues increased 8% to $15.4 million in the third quarter of 2004, as compared to $13.1 million during the same period in 2003.  Of total revenues in the third quarter of 2004, the wireless communication segment comprised $11.3 million, representing a 6% decrease over revenues of $12.0 million during the same period in 2003.  Information security segment revenues of $4.1 million in the third quarter of 2004 represent a 276% increase over revenues of $1.1 million during the same period in 2003.

 

Revenues increased 68% to $55.2 million in the nine months ended September 30, 2004, as compared to $32.8 million during the same period in 2003.  Of total revenues in the nine months ended September 30, 2004, the wireless communication segment comprised $44.4 million, representing a 58% increase over revenues of $28.1 million during the same period in 2003.  Information security segment revenues of $10.8 million in the nine months ended September 30, 2004 represent a 132% increase over revenues of $4.7 million during the same period in 2003.

 

The Company’s sales, as per its customer markets, are shown below for the nine months ended September 30, 2004 and 2003.

 

 

 

2004

 

2003

 

Revenues (in ‘000’s):

 

Amount

 

%

 

Amount

 

%

 

Domestic public safety / public service

 

$

41,854

 

76

%

$

26,078

 

80

%

International

 

11,696

 

21

 

5,085

 

16

 

Domestic commercial

 

1,695

 

3

 

1,640

 

4

 

 

 

 

 

 

 

 

 

 

 

Total Sales

 

$

55,245

 

 

 

$

32,803

 

 

 

 

The increase in EFJohnson’s revenues for the first nine months of 2004 related primarily to a substantial increase in sales to the domestic government sector.  This is consistent with EFJohnson’s market strategy to emphasize federal, state and local governmental customers.

 

The increase in revenues of the information security segment primarily results from increased marketing in certain parts of the world where LMR systems are primarily analog and perceived security risks are high.  Transcrypt’s sales are primarily to international customers because of the analog nature of its products.

 

Gross Profit

 

Cost of sales includes materials, labor, depreciation, and overhead costs associated with the production of the Company’s products, as well as shipping, royalty and warranty product costs.

 

Consolidated gross profit was $7.3 million (47% gross margin) for the third quarter of 2004, as compared to $5.2 million (40% gross margin) for the same period in 2003.  Gross margin for the wireless communication segment was 35% in the third quarter of 2004 versus 37% for the same period in 2003.  Gross margin for the information security segment was 81% in the third quarter of 2004 versus 72% for the same period in 2003.

 

Consolidated gross profit was $25.0 million (45% gross margin) for the nine months ended September 30, 2004, as compared to $13.8 million (42% gross margin) for the same period in 2003.  Gross margin for the wireless communication segment was 36% for the nine months ended September 30, 2004, as compared to 37% for the same period in 2003.  Gross margin for the information security segment was 80% in the first nine months of 2004 versus 73% for the same period in 2003.

 

The increase in overall gross margin percentage relates primarily to Transcrypt being a larger percentage of the overall sales mix, 20% for the nine months ended September 30, 2004, as compared to 14% for the same period in 2003.  Additionally, Transcrypt’s margin has increased in 2004, as compared to 2003, as a result of economies of scale created by the higher sales volume in 2004.  EFJohnson’s gross margin percentage for the three months ended September 30, 2004 was negatively impacted approximately 2% by higher warranty costs resulting from certain software upgrades to its digital line of radios.  The Company does not anticipate this higher warranty rate to recur in the fourth quarter of 2004.  Additionally, $3.6 million of sales in the first quarter of 2004 involved proprietary

 

13



 

encryption modules for which the Company charged no mark-up over the cost of procurement due to competitive market reasons.  Excluding the impact of these proprietary modules, gross margin for the wireless communication segment would have been 40% for the nine months ended September 30, 2004.  The Company does not anticipate such proprietary encryption module factor to recur during the remainder of 2004.

 

Management intends to make adjustments to its product offerings, where deemed appropriate, to include elimination of marginally profitable products and product lines.  Management is also continuing to review its manufacturing procedures to create efficiencies.  While management continues to review pricing and product strategy, gross margins for both industry segments are likely to vary in the future, based primarily upon the mix of products and the amount of revenues recognized in the respective periods.  Further, as noted in Note 12 to the accompanying Notes to Condensed Consolidated Financial Statements, the Company is presently engaged in outsourcing its manufacturing of wireless communication products; the Company does not anticipate that this event will have any significant impact on future gross margins.

 

Research and Development

 

Research and development expenses consist primarily of the costs associated with research and development personnel, materials, and the depreciation of research and development equipment and facilities.

 

Research and development expenses increased 33% in the third quarter of 2004, to $2.6 million (17% of revenues) as compared to $2.0 million during the same period in 2003 (15% of revenues).  Further, research and development expenses increased 52% for the nine months ended September 30, 2004, to $7.8 million (14% of revenues) as compared to $5.2 million for the same period in 2003 (16% of revenues).  The increase related primarily to Project 25 LMR infrastructure development at EFJohnson, along with the Company’s development efforts towards new digital subscriber units, upon which the Company’s 2004 research and development efforts will be substantially concentrated.  Certain of the Company’s anticipated future sales are dependent upon successful and timely completion of its on-going research and development projects.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of salaries and related costs of sales personnel, including sales commissions and travel expenses, and costs of advertising, public relations, and trade show participation.

 

Sales and marketing expenses increased 54% in the third quarter of 2004, $2.7 million (18% of revenues) as compared to $1.8 million during the same period in 2003 (13% of revenues).  Further, sales and marketing expenses increased 53% for the nine months ended September 30, 2004, to $7.0 million (13% of revenues) as compared to $4.6 million for the same period in 2003 (14% of revenues).  The expenditure level, as a percentage of revenues, was higher in the third quarter of 2004 as a result of the lower sales volume at EFJohnson and a build-up in fixed sales resources in concert with management’s anticipation of future sales opportunities in the wireless communication segment.

 

General and Administrative

 

General and administrative expenses consist primarily of salaries and other expenses associated with the Company’s management, finance, accounting, and administration; it also includes (benefit) expense relating to repriced stock options, as well as costs incurred in 2004 to move the operations of both EFJohnson and Transcrypt.

 

Excluding any benefit or expense resulting from the repriced stock options adjustment and excluding facility relocation expenses, general and administrative expenses increased 43% in the third quarter of 2004, to $1.9 million (12% of revenues) as compared to $1.4 million in the same period in 2003 (11% of revenues).  Further, excluding the repriced stock option adjustment and facility relocation expenses, general and administrative expenses increased 25% for the nine months ended September 30, 2004, to $5.6 million (10% of revenues) as compared to $4.3 million for the same period in 2003 (13% of revenues).  See also “Net Income (Loss) section below.  The

 

14



 

increases result from: 1) increased support requirements related to the Company’s increased sales; 2) increased investor relations efforts; and 3) efforts associated with ongoing implementation of §404 of the Sarbanes-Oxley Act.

 

The repriced stock option adjustment was a benefit of $1.4 million for the three months ended September 30, 2004, as compared to an expense of $1.9 million during the same period in 2003.  The repriced stock option adjustment was an expense of $0.9 million for the nine months ended September 30, 2004, as compared to an expense of $2.2 million for the same period in 2003.  The amount of (benefit) or expense recorded relates substantially to the change in the Company’s common stock price, as explained in Note 9 of the accompanying Notes to the Condensed Consolidated Financial Statements.

 

In relation to the planned move of its operating facilities, as described in Note 12 to the accompanying Notes to Condensed Consolidated Financial Statements, the Company incurred $0.7 million for the third quarter of 2004, as compared to zero during the same period in 2003.  The Company incurred $1.1 million for the nine months ended September 30, 2004, as compared to zero for the same period in 2003.

 

The Company will be an accelerated filer as of December 31, 2004 as a result of its market capitalization at June 30, 2004.  Accordingly, periodic reports due during the fiscal year ended December 31, 2005 will be subject to an accelerated filing schedule.

 

Other Income (Expense)

 

Other income (expense), net for the three months ended September 30, 2004 was $34,000, as compared to $35,000 for the same period in 2003.  Further, other income (expense), net for the nine months ended September 30, 2004 was $29,000, as compared to $62,000 for the same period in 2003.  The Company would expect other income (expense) to remain at an insignificant level during the remainder of 2004.

 

Interest Income / Interest Expense

 

Interest income consists of interest income earned on cash and invested funds; interest expense related to the Company’s loans and bank line of credit.  Interest income and interest expense were $11,000 and $28,000, respectively, for the three months ended September 30, 2004, as compared to $5,000 and $41,000 in the same period in 2003.  Further, interest income and interest expense were $31,000 and $119,000, respectively, for the nine months ended September 30, 2004, as compared to $26,000 and $133,000 in the same period in 2003.  Interest income and expense vary based on the relative interest rates earned or incurred, and the relative cash and loan balances.  The Company’s interest expense includes monthly expense of $12,000 related to amortization of loan fees and bank line of credit availability fees.  Future interest income and expense will vary according to the Company’s use of cash, interest rates, and operating results.

 

Provision / Benefit for Income Taxes

 

The Company did not record a tax benefit or provision for the three and nine months ended, respectively, September 30, 2004 and 2003.  As of September 30, 2004, the Company had approximately $25.2 million in deferred tax assets primarily comprised of net operating loss carryforwards (“NOL’s”), which asset was reduced by a valuation allowance of $17.2 million.  The Company’s tax asset is chiefly composed of NOL’s.  These NOL’s total approximately $57.0 million at September 30, 2004 and do not begin to expire until 2011.  The Company’s deferred tax asset of $8.0 million at September 30, 2004 and December 31, 2003, respectively, is approximately comprised of the following components:

 

Tax asset components (in millions):

 

September 30, 2004

 

December 31, 2003

 

 

 

 

 

 

 

Net operating loss carryforwards

 

$

19.9

 

$

20.4

 

Timing differences - book to tax

 

2.9

 

3.3

 

General business tax credits

 

2.4

 

2.4

 

 

 

25.2

 

26.1

 

Less: valuation allowance

 

17.2

 

18.1

 

 

 

$

8.0

 

$

8.0

 

 

15



 

The valuation allowance is based upon management’s conclusions regarding, among other considerations, the Company’s historical operating results, management’s estimates of future earnings based on information currently available, and certain technological and competitive factors impacting the Company’s current products.  Current financial accounting standards require that organizations analyze all positive and negative evidence relating to deferred tax asset realization.

 

The Company cannot presently estimate what changes to the deferred tax asset valuation allowance may be deemed appropriate, or to what extent the Company may record a tax benefit (expense), during the remainder of 2004.  If the Company continues its recent trend of profitability in 2004, some portion, if not all, of the deferred tax asset valuation allowance may be reduced in 2004 or beyond, and a net tax benefit may subsequently be recorded.  However, if the Company incurs future losses, it may be necessary to provide an additional allowance against some, or all, of the $8.0 million deferred tax asset recorded at September 30, 2004.

 

Net Income (Loss)

 

The Company had a net income of $0.8 million during the three months ended September 30, 2004, as compared to a net loss of $1.8 million during the same period in 2003.  Further, the Company had a net income of $2.3 million during the nine months ended September 30, 2004, as compared to a net loss of $2.5 million during the same period in 2003.  Operating results for the three and nine months ended September 30, 2004 and 2003 were affected by non-cash compensation resulting from variable accounting treatment required for certain of the Company’s stock options repriced in the fourth quarter of 2000 and the first quarter of 2001.  Additionally, the operating results for the three and nine months ended September 30, 2004 were affected by costs incurred to move the operations of both EFJohnson and Transcrypt, as discussed in Note 12 to the accompanying Notes to Condensed Consolidated Financial Statements.

 

The table below illustrates the operating results for the three and nine months ending September 30, 2004 and 2003, adjusting for the non-cash stock option repricing and for the non-recurring facility relocation effects discussed above.  The Company believes that such presentation offers a more comparative measurement of the Company’s operating results.

 

Operating Results (in thousands)

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

784

 

$

(1,787

)

$

2,318

 

$

(2,483

)

 

 

 

 

 

 

 

 

 

 

Facility relocation expenses

 

738

 

 

1,139

 

 

 

 

 

 

 

 

 

 

 

 

Stock option repricing non-cash compensation expense (benefit).

 

(1,425

)

1,890

 

886

 

2,186

 

 

 

 

 

 

 

 

 

 

 

Proforma income (loss) - comparative basis

 

$

97

 

$

103

 

$

4,343

 

$

(297

)

 

 

 

 

 

 

 

 

 

 

Proforma income (loss) as a percentage of total revenues

 

0.6

%

0.8

%

7.9

%

(0.9

)%

 

Liquidity and Capital Resources

 

Historically, the Company has financed its operations and met its capital requirements primarily through short-term borrowings, long-term debt, and stock offerings completed on January 22, 1997 and October 15, 1997.  However, the Company’s operations have consistently provided positive cash since the second quarter of 2001, and operations provided positive cash of $12.6 million for the nine months ended September 30, 2004.

 

The Company’s operating activities provided (used) cash of $12.2 million and $(3.6) million in the nine months ended September 30, 2004 and 2003, respectively.  Cash provided by operating activities in the first three quarters of 2004 consisted primarily of: net income of $2.3 million; depreciation and amortization expenses of $1.0 million; non-cash compensation of $0.9 million; and a net change in the various components of working capital of $8.0 (principally $9.9 million and $3.5 million provided by decreases, respectively, in accounts receivable and inventories, offset by $1.9 million decrease in accounts payable and $2.7 million increase in prepaid expenses).

 

16



 

Cash used by operating activities in the first nine months of 2003 consisted primarily of: net loss of $(2.5) million; depreciation and amortization expenses of $0.8 million; non-cash compensation of $2.1 million; and a net change in the various components of working capital of $(3.2) million.

 

Cash used by investing activities was $1.6 million for the first nine months of 2004; this compared to cash used by investing activities of $0.3 million for the same period in 2003.  The difference between 2004 and 2003 related primarily to cash flows used in the purchase of property.  Total capital expenditures in 2004 were $1.8 million, as compared to $0.6 million of capital expenditures in 2003.  Additionally, $0.4 million of capital expenditures in 2003 were acquired through the exchange of debt and are, thus, excluded from the Statement of Cash Flows.

 

Cash used by financing activities was $7.3 million for the first nine months of 2004; this compared to cash used by investing activities of $5.1 million for the same period in 2003.  The line of credit balance of $7.5 million at December 31, 2003 was paid off during the three months ended March 31, 2004, and the line of credit balance remained zero throughout the period ended September 30, 2004.  In the previous year, the December 31, 2002 line balance of $5.0 million was paid off prior to June 30, 2003, at which time the line of credit balance was zero and remained such through September 30, 2003.

 

The Company’s cash availability position and overall working capital position were significantly improved as of September 30, 2004, as compared to December 31, 2003, primarily as the result of cash collection of December 31, 2003 accounts receivable, as well as of revenues recognized in the first nine months of 2004.  The Company’s cash balance, at any given point in time, is substantially dependent upon fluctuations in receivables which increase and decrease commensurate with the timing and volume of sales orders.  Further, the Company had zero borrowings under its $15.0 million secured line of credit with Bank of America as of September 30, 2004, as compared to borrowings of $7.5 million at December 31, 2003.  Accordingly, at September 30, 2004, the Company had unrestricted cash of $8.0 million, an additional $8.2 million available credit under its line of credit, and a $2.5 million cash deposit which was returned to the Company in October 2004.

 

In the normal course of its business activities, the Company is required under contracts with various government authorities to provide letters of credit or bonds that may be drawn upon if the Company fails to perform under its contracts.  The Company’s current bonding arrangement calls for zero-collateral bonding, with a single bond limitation of $2.0 million.  The Company has approximately $6.2 million of bonding availability under its current bonding agreement.  The Company believes its present bonding arrangements provide it with sufficient bonding availability through 2004; however, the Company continues to seek improved bonding alternatives with increased limits.

 

The Company’s backlog of unfilled orders at September 30, 2004 was $14.6 million, compared to a backlog of $22.2 million at December 31, 2003 and $32.0 million at September 30, 2003.  Due to the unpredictable timing of major domestic governmental orders, the Company does not believe that its backlog figures, and variations from period to period therein, are necessarily indicative of sales of products in future periods.

 

The Company does not anticipate paying cash dividends in the foreseeable future.

 

Critical Accounting Policies

 

The preparation of the Company’s consolidated financial statements in conformity with accounting principles generally accepted in the United States (“USGAAP”) requires management to make judgments, estimates and assumptions in certain circumstances that affect the amounts reported in the consolidated financial statements and related footnotes.  The Company regularly evaluates the accounting policies and estimates used to prepare its financial statements.  Estimates are used for, but not limited to: the accounting for allowance for doubtful accounts and sales returns; application of the percentage of completion accounting for long-term contract revenues, inventory reserves, income taxes, long-lived assets, and contingencies.  These estimates are based on historical experience and various assumptions that the Company believes to be reasonable under the particular applicable facts and circumstances.  Actual results could differ from those estimates.

 

The Company considers its critical accounting policies to be those that (i) involve significant judgments and

 

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uncertainties, (ii) require estimates that are more difficult for management to determine and (iii) have the potential to result in materially different outcomes under varying assumptions and conditions.  The application of USGAAP may require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying results.  Listed below are those policies the Company believes are critical and require the use of complex judgment in their application.

 

Revenue

 

The Company’s revenue recognition policy is in accordance with the criteria put forth in Staff Accounting Bulletins 101 and 104.  Revenues are recognized when the earnings process is complete, less an estimate for an allowance for returns, if applicable, and collection is reasonably assured.  The earnings process is generally complete when the product is shipped, or received by the customer, depending upon whether the title to the goods, as well as the risks and benefits of ownership, are transferred to the customer at point of shipment or point of delivery.  For sales where collection is not reasonably assured, the Company recognizes revenue as cash is received.  If collection is contingent on a future event, the Company recognizes revenue when the contingency lapses, generally upon cash collection.

 

System sales under long-term contracts are accounted for under the percentage-of-completion method.  Under this method, revenues are recognized as work on a contract progresses.  The recognized revenue is that percentage of estimated total revenue that incurred costs to date bear to estimated total costs to complete the contract.  Revisions in cost and profit estimates are made when conditions requiring such revisions become known.  Anticipated losses on contracts are recognized in operations as soon as such losses are determined to be probable and reasonably estimable.

 

Deferred revenue includes unearned services provided under systems maintenance contracts.  The Company recognizes the maintenance fees based upon a straight-line method over the life of the contract.  The Company no longer defers revenue generated from extended warranties on its digital LMR radio sales, as the Company believes the earnings process is complete at time of sale, and the Company presently has sufficient history on its digital products to reasonably estimate any future warranty costs related to such extensions.

 

The Company periodically reviews its revenue recognition procedures to assure that such procedures are in accordance with the provisions of Staff Accounting Bulletins 101 and 104.

 

Inventory

 

Inventory is recorded at the lower of cost or market with cost determined by the first-in, first-out (FIFO) method.  The Company periodically assesses its inventory for potential obsolescence and lower-of-cost-or-market issues.  The Company makes estimates of inventory obsolescence, providing reserves when necessary, based on, among other factors, demand for inventory based on backlog, product pricing, the ability to liquidate or sell older inventory, and the impact of introducing new products.  Charges associated with providing for inventory obsolescence, or revisions to related reserves, have historically correlated with selling activity and have had a consistent impact on the Company’s gross margins over the last three fiscal years.

 

Goodwill

 

SFAS No. 142 requires that goodwill and other indefinite-lived intangible assets no longer be amortized to earnings, but instead be reviewed for impairment, on at least an annual basis, by applying a fair value-based test.  The Company adopted the provisions SFAS No. 142 effective January 1, 2002.  At least annually, the Company assesses its goodwill and tradename, using a fair value-based test, consistent with SFAS No. 142.  If the carrying amounts exceed the computed fair values, goodwill and/or tradename, as appropriate, is considered to be impaired.  In evaluating impairment, the Company estimates the sum of the expected future cash flows derived from its goodwill and tradename.  Such evaluations for impairment are significantly impacted by estimates of future revenues, costs and expenses and other factors.  The estimates use assumptions about the Company’s market segment share in the future and about future expenditures by government entities for wireless communications products.  The

 

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Company continually evaluates whether events and circumstances have occurred that indicate the remaining carrying values of goodwill and tradename may not be recoverable.  If the Company fails to deliver new products, if the products fail to gain expected market acceptance, or if the Company fails to achieve assumed revenue growth rates or assumed gross margin, the Company may incur charges for impairment of goodwill and/or tradename in the future.

 

Income Taxes

 

The Company accounts for income taxes using the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using current enacted tax rates.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date.  Valuation allowances are provided to the extent that recoverability of tax assets is not considered likely.  In determining whether a tax asset is recoverable, the Company considers estimates of future revenues, costs and expenses and other factors.  If the Company fails to achieve revenue growth rates or gross margins assumed in the calculation of the deferred tax asset, the Company may be required to reduce its deferred tax assets in the future.

 

Long-Lived Assets

 

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company reviews its long-lived assets, to include intangible assets subject to amortization, for recoverability whenever events or changes in circumstances indicate that the carrying amount of such long-lived asset or group of long-lived assets (collectively referred to as “the asset”) may not be recoverable.  Such circumstances include, but are not limited to:

                  significant decrease in the market price of the asset;

                  significant change in the extent or manner in which the asset is being used;

                  significant change in the business climate that could affect the value of the asset;

                  current period losses combined with projection of continuing losses associated with the use of the asset;

                  current expectation that, more likely than not, the asset will be sold or otherwise disposed of before the end of its previously estimated useful life.

 

The Company continually evaluates whether events and circumstances have occurred.  When such events or circumstances exist, the recoverability of the asset’s carrying value shall be determined by estimating the undiscounted future cash flows (cash inflows less associated cash outflows) that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset.  To date, no such impairment has occurred.  To the extent such events or circumstances occur that could affect the recoverability of the Company’s long-lived assets, the Company may incur charges for impairment in the future.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Although all of the Company’s sales are denominated in U.S. dollars, fluctuations in the value of international currencies relative to the U.S. dollar may affect the price, competitiveness and profitability of the Company’s products sold in international markets.  Furthermore, the uncertainty of monetary exchange values has caused, and may in the future cause, some foreign customers to delay new orders or delay payment for existing orders.  Additionally, troubled economic conditions, such as that recently experienced in Asia and in Latin America, could result in lower revenues for the Company.  While most international sales are supported by letters of credit, the purchase of Company products by international customers presents increased risks, which include:

                  unexpected changes in regulatory requirements;

                  tariffs and other trade barriers;

                  political and economic instability in foreign markets;

                  difficulties in establishing foreign distribution channels;

                  longer payment cycles;

                  uncertainty in the collection of accounts receivable;

 

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                  increased costs associated with maintaining international marketing efforts;

                  difficulties in protecting intellectual property; and

                  susceptibility to orders being cancelled as a result of foreign currency fluctuations (since all the Company quotations and invoices are denominated in U.S. dollars).

 

ITEM 4. CONTROLS AND PROCEDURES

 

In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934 (“Exchange Act”), the Company evaluated the effectiveness of the design and operation of its disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act (“Disclosure Controls”) as of the quarter ended September 30, 2004.  This evaluation (the “Controls Evaluation”) was done under the supervision and with the participation of management, including the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).  The effectiveness of the Company’s Disclosure Controls, as determined by this evaluation, is disclosed in the Chief Executive Officer’s Certification of Report on Form 10-Q for the Quarter Ending September 30, 2004 and the Chief Financial Officer’s Certification of Report on Form 10-Q for the Quarter Ending September 30, 2004 (together, “Certifications”).

 

Disclosure Controls are procedures that are designed with the objective of ensuring that information required to be disclosed in the Company’s reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission (“SEC”) rules and forms.  Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

 

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any system of controls also 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; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected, and, thus, the Company’s management cannot provide absolute assurance that the Company’s Disclosure Controls will prevent all errors and all fraud.

 

The Company’s Disclosure Controls are also evaluated on an ongoing basis by its Finance organization.  The overall goals of these various evaluation activities are to monitor the Company’s Disclosure Controls and to make modifications as necessary.  The Company’s intent in this regard is that the Disclosure Controls will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant.

 

Based upon the Controls Evaluation, the Company’s CEO and CFO have concluded that, subject to the limitations noted above, the Company’s Disclosure Controls are effective as of the quarter ended September 30, 2004 to ensure that material information relating to the Company and its consolidated subsidiaries was made known to management, including the CEO and CFO, particularly during the period when periodic reports are being prepared, and that the Company’s Disclosure Controls are effective to provide reasonable assurance that its financial statements are fairly presented in conformity with USGAAP.

 

Due to the Company’s market capitalization at June 30, 2004, the Company will be required to comply with §404 of the Sarbanes-Oxley Act (internal control over financial reporting) as of December 31, 2004, as explained in Item 2 above, in management’s General and Administrative discussion.

 

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PART II.  OTHER INFORMATION

 

 

ITEMS 1 – 5.

 

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

(a)  Exhibits

 

The following exhibits are filed herewith:

 

Exhibit No.

 

Description

 

 

 

11.1

 

Computation of income (loss) per share

 

 

 

31.1

 

Chief Executive Officer’s Certification of Report on Form 10-Q
For the Quarter Ending September 30, 2004

 

 

 

31.2

 

Chief Financial Officer’s Certification of Report on Form 10-Q
For the Quarter Ending September 30, 2004

 

 

 

32.0

 

Written certification of Chief Executive Officer and Chief Financial Officer, dated October 28, 2004, pursuant to 18 U.S.C. Section 1350.

 

(b)  Reports on Form 8-K:

 

On August 03, 2004, the Company filed its press release announcing financial results for the quarter ended June 30, 2004 as a report on Form 8-K, under Items 7 and 12.

 

On September 16, 2004, the Company filed its press release announcing that the Company had entered into an amendment of its line of credit agreement with Bank of America, as a report on Form 8-K, under Item 2.02, Entry into Material Definitive Agreements.

 

On September 16, 2004, the Company filed its press release announcing an update of previous forward-looking earnings guidance, as a report on Form 8-K, under Item 2.02, Results of Operations and Financial Condition.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

EFJ, INC.

 

 

 

 

 

 

 

 

Date:

October 28, 2004

By:

/s/ Massoud Safavi

 

 

 

 

 

 

 

 

Massoud Safavi

 

 

 

Senior Vice President and

 

 

 

Chief Financial Officer

 

 

 

(Principal Financial and Accounting Officer)

 

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