UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to ______________
Commission File Number 0-29798
COMPUDYNE CORPORATION
---------------------
(Exact name of registrant as specified in its charter)
Nevada 23-1408659
------------------------------ ------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2530 Riva Road, Suite 201, Annapolis, Maryland 21401
(Address of principal executive offices)
Registrant's telephone number, including area code: (410) 224-4415
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes __X__ No____
Indicate by checkmark whether the registrant is an accelerated filer (as defined
in rule 12b-2 of the Exchange Act)
Yes __X__ No____
As of November 1, 2004, a total of 8,314,279 shares of Common Stock, $.75 par
value, were outstanding.
1
COMPUDYNE CORPORATION AND SUBSIDIARIES
INDEX
Page No.
Part I. Financial Information
Item 1. Financial Statements - Unaudited
Consolidated Balance Sheets - September 30, 2004
and December 31, 2003 3
Consolidated Statements of Operations -
Three Months and Nine Months Ended
September 30, 2004 and 2003 4
Consolidated Statement of Changes in
Shareholders' Equity - Nine Months Ended
September 30, 2004 5
Consolidated Statements of Cash Flows -
Nine Months Ended September 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7-15
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 16-29
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 30
Item 4. Controls and Procedures 31
Part II. Other Information 32
Signature 33
2
ITEM 1. FINANCIAL STATEMENTS
COMPUDYNE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(unaudited)
September 30, December 31,
ASSETS 2004 2003
--------- ---------
(in thousands)
Current Assets
Cash and cash equivalents $ 2,366 $ 1,869
Marketable securities 15,711 --
Accounts receivable, net 40,578 41,780
Contract costs in excess of billings 17,239 17,568
Inventories 5,096 6,704
Deferred tax assets 1,168 1,371
Prepaid expenses and other 4,969 2,322
--------- ---------
Total Current Assets 87,127 71,614
Property, plant and equipment, net 11,421 10,079
Goodwill 23,157 21,280
Other intangible assets, net 9,570 9,785
Other 972 904
--------- ---------
Total Assets $ 132,247 $ 113,662
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable and accrued liabilities $ 15,053 $ 21,078
Billings in excess of contract costs incurred 12,522 13,551
Deferred revenue 6,434 6,036
Current portion of notes payable 440 2,103
--------- ---------
Total Current Liabilities 34,449 42,768
Notes payable 3,565 15,555
Convertible subordinated notes payable 39,071 --
Deferred tax liabilities 1,709 1,592
Other 619 820
--------- ---------
Total Liabilities 79,413 60,735
--------- ---------
Commitments and Contingencies
Shareholders' Equity
Preferred stock, 2,000,000 shares authorized and unissued -- --
Common stock, par value $.75 per share: 50,000,000 and
15,000,000 shares authorized at September 30, 2004
and December 31, 2003, respectively; 8,943,856 and
8,567,680 shares issued at September
30, 2004 and December 31, 2003, respectively 6,707 6,426
Additional paid-in-capital 44,368 42,755
Retained earnings 5,859 7,926
Accumulated other comprehensive loss (13) (93)
Treasury stock, at cost; 594,877 shares at
September 30, 2004 and December 31, 2003 (4,087) (4,087)
--------- ---------
Total Shareholders' Equity 52,834 52,927
--------- ---------
Total Liabilities and Shareholders' Equity $ 132,247 $ 113,662
========= =========
The accompanying notes are an integral part of these financial statements.
3
COMPUDYNE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
------- ----------- --------- ---------
(in thousands, except per share data)
Revenues:
Services $ 26,242 $ 46,231 $ 87,831 $ 123,382
Products 7,118 6,905 22,339 24,059
--------- --------- --------- ---------
Total revenues 33,360 53,136 110,170 147,441
Cost of sales:
Services 16,788 35,015 59,222 92,333
Products 7,764 6,110 20,795 19,527
--------- --------- --------- ---------
Total cost of sales 24,552 41,125 80,017 111,860
--------- --------- --------- ---------
Gross profit 8,808 12,011 30,153 35,581
Selling, general and administrative expenses 9,288 8,471 26,119 24,125
Research and development 2,051 1,683 5,680 5,596
--------- --------- --------- ---------
(Loss) income from operations (2,531) 1,857 (1,646) 5,860
--------- --------- --------- ---------
Other expense (income)
Interest expense 849 366 2,443 1,079
Interest income (289) (149) (703) (159)
Other expense (income) (20) 4 43 5
--------- --------- --------- ---------
Total other expense 540 221 1,783 925
--------- --------- --------- ---------
(Loss) income before income taxes (3,071) 1,636 (3,429) 4,935
Income taxes (benefit) expense (1,221) 654 (1,362) 1,974
--------- --------- --------- ---------
Net (loss) income $ (1,850) $ 982 $ (2,067) $ 2,961
========= ========= ========= =========
Earnings (loss) per share:
Basic earnings (loss) per common share $ (.23) $ .12 $ (.26) $ .38
========= ========= ========= =========
Weighted average number of common
shares outstanding 8,171 7,923 8,085 7,881
========= ========= ========= =========
Diluted earnings (loss) per common share $ (.23) $ .12 $ (.26) $ .36
========= ========= ========= =========
Weighted average number of common
shares and equivalents 8,171 8,199 8,085 8,140
========= ========= ========= =========
The accompanying notes are an integral part of these financial statements.
4
COMPUDYNE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(unaudited)
(in thousands)
Accumulated
Additional Other
Common Stock Paid-in Retained Comprehensive Treasury Stock
Shares Amount Capital Earnings Income /(Loss) Shares Amount Total
---------------- -------- -------- ----------------- --------------- --------
Balance at
January 1, 2004 8,568 $ 6,426 $ 42,755 $ 7,926 $ (93) 595 $ (4,087) $ 52,927
Common stock issued
in connection with
acquisition of 90
Degrees, Inc. 72 54 585 -- -- -- --
639
Stock options exercised 304 227 1,028 -- -- -- -- 1,255
Net loss -- -- -- (2,067) -- -- -- (2,067)
Other comprehensive income, net of tax:
Ineffectiveness of interest
rate swap agreement -- -- -- -- 93 -- -- 93
Unrealized loss on
available for sale
marketable securities -- -- -- -- (13) -- -- (13)
----------------------------------------------------------------------------------------
Balance at
September 30, 2004 8,944 $ 6,707 $ 44,368 $ 5,859 $ (13) 595 $ (4,087) $ 52,834
======= ======== ======== ======== ======== ======== ======== ========
The accompanying notes are an integral part of these financial statements.
5
COMPUDYNE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Ended
September 30,
2004 2003
------ -------
(in thousands)
Cash flows from operating activities:
Net (loss) income $ (2,067) $ 2,961
Adjustments to reconcile net (loss) income to
net cash provided by operations:
Depreciation and amortization 2,099 2,016
Deferred tax asset 267 --
(Gain) loss from disposal of property, plant and equipment 3 5
Amortization of debt discount 129 --
Unrealized loss on interest rate swap 44 --
Amortization of discounts on marketable securities (56) --
Changes in assets and liabilities:
Accounts receivable 1,220 (4,750)
Contract costs in excess of billings 329 3,132
Inventories 1,608 715
Prepaid expenses and other current assets (2,647) (171)
Other assets (68) 6
Accounts payable and accrued liabilities (6,125) 7,356
Billings in excess of contract costs incurred (1,029) (868)
Deferred revenue 398 739
Other liabilities (46) --
-------- --------
Net cash flows (used in) provided by operating activities (5,941) 11,141
-------- --------
Cash flows from investing activities:
Purchase of marketable securities (31,195) --
Redemption of marketable securities 15,518 --
Additions to property, plant and equipment (972) (622)
Proceeds from sale of property, plant and equipment 3 9
Net payment for acquisition (3,460) (71)
-------- --------
Net cash flows used in investing activities (20,106) (684)
-------- --------
Cash flows from financing activities:
Issuance of common stock 1,255 225
Warrants exercised -- 166
Purchase of treasury stock -- (167)
Repayment of bank notes and line of credit (13,653) (8,485)
Borrowings of convertible subordinated notes payable 38,942 --
-------- --------
Net cash provided by (used in) financing activities 26,544 (8,261)
-------- --------
Net change in cash and cash equivalents 497 2,196
Cash and cash equivalents at beginning of period 1,869 1,274
-------- --------
Cash and cash equivalents at end of period $ 2,366 $ 3,470
======== ========
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest $ 1,517 $ 859
Income tax, net of refunds $ 746 $ 1,488
Common stock issued in connection with acquisition $ 639 $ --
The accompanying notes are an integral part of these financial statements.
6
COMPUDYNE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT POLICIES
Basis of Presentation:
The accompanying unaudited consolidated financial statements of CompuDyne
Corporation and its subsidiaries (the "Company") have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission. The
consolidated balance sheet as of December 31, 2003 has been derived from the
Company's December 31, 2003 audited financial statements. Certain information
and note disclosures 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 the Company believes that the disclosures made are adequate to make the
information presented not misleading.
In the opinion of management, the accompanying unaudited consolidated financial
statements reflect all necessary adjustments and reclassifications (all of which
are of a normal, recurring nature) that are necessary for the fair presentation
of the periods presented. It is suggested that these consolidated unaudited
financial statements be read in conjunction with the consolidated financial
statements and the notes thereto included in the Company's annual report filed
with the Securities and Exchange Commission on Form 10-K for the year ended
December 31, 2003. Operating results for the three and nine month periods ended
September 30, 2004 and 2003 are not necessarily indicative of operating results
for the entire fiscal year.
New Accounting Pronouncements:
In June 2004 the FASB issued an exposure draft entitled Fair Value Measurements
that provides guidance on how to measure fair value of assets and liabilities.
The objective is to increase the consistency, reliability, and comparability of
fair value measurements in applying general accepted accounting principles.
Valuation techniques consistent with the market approach, income approach and
cost approach are to be considered for purposes of estimating fair value. The
proposed standard's effective date would be applicable for awards that are
granted, modified, or settled in cash in interim or annual periods beginning
after June 15, 2005. The Company is currently evaluating the impact of the
proposed standard.
In March 2004 the Emerging Issues Task Force ("EITF") reached a final consensus
on EITF Issue No. 03-06, "Participating Securities and the Two-Class Method
under FAS 128, EARNINGS PER SHARE". Issue No. 03-06 addresses a number of
questions regarding the computation of earnings per share ("EPS") by companies
that have issued securities other than common stock that contractually entitle
the holder to participate in dividends and earnings of the company when, and if,
it declares dividends on its common stock. The issue also provides further
guidance in applying the two-class method of calculating EPS. It clarifies what
constitutes a participating security and how to apply the two-class method of
computing EPS once it is determined that a security is participating, including
how to allocate undistributed earnings to such a security. EITF 03-06 was
effective for the fiscal quarter ended June 30, 2004. The adoption of this
standard did not have a material effect on the financial position, results of
operations or cash flows of the Company.
In January 2003 the FASB issued FASB Interpretation No. 46, "Consolidation of
Variable Interest Entities" (FIN 46). In December 2003, FIN 46 was replaced by
FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities".
FIN 46(R) clarifies the application of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements", to certain entities in which equity
investors do not have the characteristics of a controlling financial interest or
do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. FIN 46(R)
requires an enterprise to consolidate a variable interest entity if that
enterprise will absorb a majority of the entity's expected losses, is entitled
to receive a majority of the entity's expected residual returns, or both. FIN
46(R) is effective for entities being evaluated under FIN 46(R) for
consolidation no later than the end of the first reporting period that ends
after March 15, 2004. The adoption of this standard did not have a material
effect on the financial position, results of operations or cash flows of the
Company.
7
Comprehensive Income:
The following table shows the components of comprehensive (loss) income, net of
income taxes, for the nine months ended September 30, 2004 and 2003, in
thousands.
For the Nine Months
Ended September 30,
2004 2003
-------- ---------
Net (loss) income $ (2,067) $ 2,961
Unrealized loss on available-for-sale securities (13) --
Ineffectiveness of interest rate swap agreement 93 --
Translation adjustment -- (7)
Loss on interest rate swap agreement -- 76
-------- ---------
Comprehensive (loss) income $ (1,987) $ 3,030
======== =========
Stock-based Compensation:
As of September 30, 2004, the Company continues to account for its stock-based
compensation plans, which are described more fully in the Company's 2003 Annual
Report, using the intrinsic value method and in accordance with the recognition
and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued
to Employees," and related Interpretations. No stock-based employee compensation
cost is reflected in net income, as all options granted had an exercise price
equal to the fair market value of the underlying common stock on the date of
grant. The following table illustrates, in accordance with the provisions of
SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure," the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation," to stock-based employee compensation.
For the Three Months
Ended September 30,
2004 2003
------------ ----------
(in thousands, except per share data)
Net (loss) income, as reported $ (1,850) $ 982
Deduct: Total stock-based employee compensation expense determined
under fair value based method for all awards net of related tax effects (277) (277)
------------ ----------
Pro forma net (loss) income $ (2,127) $ 705
============ ==========
Earnings (loss) per share:
Basic - as reported $ (.23) $ .12
Basic - pro forma $ (.26) $ .09
Diluted - as reported $ (.23) $ .12
Diluted - pro forma $ (.26) $ .09
8
For the Nine Months
Ended September 30,
2004 2003
------------ ------------
(in thousands, except per share data)
Net (loss) income, as reported $ (2,067) $ 2,961
Deduct: Total stock-based employee compensation expense determined
under fair value based method for all awards net of related tax effects (784) (853)
------------ -------------
Pro forma net (loss) income $ (2,851) $ 2,108
============ ============
Earnings (loss) per share:
Basic - as reported $ (.26) $ .38
Basic - pro forma $ (.35) $ .27
Diluted - as reported $ (.26) $ .36
Diluted - pro forma $ (.35) $ .26
The fair value of the Company's stock-based option awards to employees was
estimated using the Black-Scholes model assuming no expected dividends and the
following weighted-average assumptions:
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2004 2003 2004 2003
-------- -------- ------- -------
Expected life in years 5.3 5.6 5.4 6.8
Risk-free interest rate 3.4% 3.2% 3.3% 2.9%
Expected volatility 75.4% 78.8% 76.0% 79.9%
Reclassifications:
Certain prior period amounts have been reclassified to conform to the current
period's presentation.
2. OPERATING SEGMENT INFORMATION
The following is the operating segment information for the three months ended
September 30, 2004 and 2003, in thousands:
Pre-tax
Revenues Gross Profit (Loss) (Loss)/Income
--------------------- --------------------- --------------------
2004 2003 2004 2003 2004 2003
-------- -------- ------- -------- -------- --------
Institutional Security
Systems $ 11,783 $ 26,357 $ 1,773 $ 3,729 $ (806) $ 1,216
Attack Protection 6,510 6,036 (477) 758 (2,101) (663)
Federal Security Systems 3,296 4,549 501 934 137 223
Public Safety and Justice 11,771 16,194 7,011 6,590 370 790
CompuDyne Corporate -- -- -- -- (671) 70
-------- -------- ------- -------- -------- --------
$ 33,360 $ 53,136 $ 8,808 $ 12,011 $ (3,071) $ 1,636
======== ======== ======= ======== ========= ========
9
35
The following is the operating segment information for the nine months ended
September 30, 2004 and 2003, in thousands:
Pre-tax
Revenues Gross Profit (Loss)/Income
-------------------- --------------------- ----------------------
2004 2003 2004 2003 2004 2003
-------- -------- -------- -------- -------- --------
Institutional Security
Systems $ 41,794 $ 75,497 $ 6,522 $ 10,246 $ (683) $ 2,788
Attack Protection 20,204 20,912 1,524 4,113 (3,236) (153)
Federal Security Systems 11,242 12,299 1,602 2,059 551 726
Public Safety and Justice 36,930 38,733 20,505 19,163 1,765 1,340
CompuDyne Corporate -- -- -- -- (1,826) 234
-------- -------- -------- -------- -------- --------
$110,170 $147,441 $ 30,153 $ 35,581 $ (3,429) $ 4,935
======== ======== ======== ======== ======== ========
3. EARNINGS PER SHARE
Earnings per share are presented in accordance with SFAS No. 128, "Earnings Per
Share." This Statement requires dual presentation of basic and diluted earnings
per share on the face of the statement of operations. Basic earnings per share
is computed using the weighted average number of shares outstanding during the
period and excludes any dilutive effects of options or warrants and convertible
securities. Diluted earnings per share is computed using the weighted average
number of common and common stock equivalent shares outstanding during the
period; common stock equivalent shares are excluded from the computation if
their effect is antidilutive. Stock options and warrants to purchase 739,800 and
571,985 shares for the three month periods ended September 30, 2004 and 2003
respectively, were not dilutive and, therefore, were not included in the
computation of diluted earnings per common share. Additionally, the 2,897,768
shares issuable upon conversion of the 6.25% Convertible Subordinated Notes due
January 15, 2011 (the "2011 Notes") are excluded for the three month period
ended September 30, 2004 as the effect is antidilutive. Stock options and
warrants to purchase 673,800 and 933,670 shares for the nine month periods ended
September 30, 2004 and 2003 respectively, were not dilutive and, therefore, were
not included in the computation of diluted earnings per common share.
Additionally, the 2,897,768 shares issuable upon conversion of the 2011 Notes
are excluded for the nine month period ended September 30, 2004 as the effect is
antidilutive.
The computations of the Company's basic and diluted earnings (loss) per share
amounts for the three and nine months ended September 30, 2004 and 2003 were as
follows, in thousands, except per share data:
Three Months Ended Nine Months Ended
Ended September 30, Ended September 30,
2004 2003 2004 2003
------- -------- ------- -------
Net (loss) income $(1,850) $ 982 $(2,067) $ 2,961
======= ======= ======= =======
Weighted average common shares outstanding 8,171 7,923 8,085 7,881
Effect of dilutive stock options and warrants -- 276 -- 259
------- ------- ------- -------
Diluted weighted average common shares outstanding 8,171 8,199 8,085 8,140
======= ======= ======= =======
Net (loss) income per common share
Basic $ (.23) $ .12 $ (.26) $ .38
Diluted $ (.23) $ .12 $ (.26) $ .36
10
The 2011 Notes contain contingent participation rights. The participation rights
are contingent upon the ability, based on the undistributed earnings for the
period, of the Company to declare and distribute dividends per share equal to or
in excess of the per share fair value of the Company's common stock. The Company
does not believe this contingency was met for the three and nine months ended
September 30, 2004. Accordingly, no undistributed earnings have been allocated
to the 2011 Notes. At each reporting period, the Company assesses whether the
contingency criteria have been met and consequently if undistributed earnings
should be allocated to participating securities.
4. INVENTORIES
Inventories consist of the following, in thousands:
September 30, December 31,
2004 2003
------ ------
Raw materials $3,355 $3,745
Work in progress 1,224 2,310
Finished goods 517 649
------ ------
$5,096 $6,704
====== ======
5. GOODWILL
The September 30, 2004 unaudited consolidated financial statements include
preliminary estimates of the fair market value of the assets acquired and
liabilities assumed and the related allocations of the purchase price related to
the acquisition of 90 Degrees, Inc. (see Note 10). Final valuations and
allocations, which are expected to be completed by June 30, 2005, may differ
from the amounts included herein. Currently goodwill is estimated to be
approximately $1.9 million.
The Company reviews the carrying value of goodwill annually during the fourth
quarter of the year or whenever events or changes in circumstances indicate that
the carrying value may not be recoverable, utilizing a discounted cash flow
model. Changes in estimates of future cash flows caused by items such as
unforeseen events or changes in market conditions could negatively affect the
reporting unit's fair value and result in an impairment charge. The Company
cannot predict the occurrence of events that might adversely affect the reported
value of goodwill of $23.2 million at September 30, 2004 and of $21.3 million at
December 31, 2003.
Goodwill, by segment, consists of the following, in thousands:
September 30, December 31,
2004 2003
-------- ---------
Institutional Security Systems $ 739 $ 739
Attack Protection 728 728
Federal Security Systems -- --
Public Safety & Justice 21,690 19,813
--------- ---------
$ 23,157 $ 21,280
======== =========
6. INTANGIBLE ASSETS
The September 30, 2004 unaudited consolidated financial statements include
preliminary estimates of the fair market value of the assets acquired and
liabilities assumed and the related allocations of the purchase price related to
the acquisition of 90 Degrees, Inc. (see Note 10). Final valuations and
allocations, which are expected to be completed by June 30, 2005 may differ from
the amounts included herein. Currently, intangible assets are estimated to be
approximately $60 thousand.
11
Intangible assets include the trade name, customer relationships and backlog
from the acquisition of Tiburon, Inc. in 2002. Other intangibles include trade
names, Department of State Certifications, Underwriters Laboratories, Inc.
listings, and patents related to the acquisition of Norment and Norshield in
1998. With the exception of trade names, which have indefinite lives, the
intangible assets are being amortized using the straight-line method.
Intangible assets consist of the following, in thousands:
September 30, December 31, Amortizable
2004 2003 Lives
-------- -------- --------
(in years)
Trade name $ 6,913 $ 6,913 Indefinite
Customer relationships 2,500 2,500 14
Backlog 300 300 2
Other 1,280 1,220 2 - 20
-------- --------
10,993 10,933
Less: accumulated amortization (1,423) (1,148)
-------- --------
$ 9,570 $ 9,785
======== ========
Amortization expense for the Company's intangible assets for the three and nine
month periods ended September 30, 2004 was $75 thousand and $275 thousand,
respectively. The following schedule lists the expected amortization expense for
each of the years ending December 31, in thousands:
Year
-----
2004 (remaining) $ 80
2005 290
2006 245
2007 240
2008 225
-------
Total $ 1,080
=======
7. PRODUCT WARRANTIES
Included in accounts payable and accrued liabilities are estimated expenses
related to warranties made at the time products are sold or services are
rendered. These accruals are established using historical information on the
nature, frequency, and average cost of warranty claims. The Company warrants
numerous products, the terms of which vary widely. In general, the Company
warrants its products against defect and specific non-performance. As of
September 30, 2004, the Company had a product warranty accrual in the amount of
$402 thousand.
Product Warranty Liabilities
----------------------------
(in thousands)
-------------
Beginning balance at January 1, 2004 $ 517
Plus: accruals for product warranties 195
Less: warranty changes/claims (310)
--------
Ending balance at September 30, 2004 $ 402
=======
8. INVESTMENTS IN MARKETABLE SECURITITES
The Company's marketable securities are categorized as available-for-sale
securities, as defined by Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Investments in Debt and Equity Securities." At September
30, 2004 all of the Company's investments in marketable securities were
classified as available-for-sale, and as a result, were reported at fair value.
Unrealized gains and losses are reported as a component of accumulated other
comprehensive income in shareholders' equity. The amortized costs of debt
securities is adjusted for accretion of discounts from the date of purchase to
maturity. The accretion is included in interest income on the investments. The
cost for marketable securities was determined using the specific identification
method. The fair values of marketable securities are estimated based on the
quoted market price for these securities.
12
Marketable securities at September 30, 2004 are summarized, in thousands, as
follows:
Gross Unrealized
----------------------------
Cost Gains Losses Fair Value
---------- ----------- ----------- ----------
Collateralized mortgage obligations
(CMO's) consisting of securities
issued by Fannie Mae,
Freddie Mac, and Ginnie Mae $ 15,733 $ -- $ 22 $ 15,711
The cost and estimated fair value of current debt securities at September 30,
2004, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because the issuers of the securities may have the
right to repay obligations without prepayment penalties. It is the Company's
policy to classify available-for-sale securities that are available for use in
current operations as a current asset.
Estimated
(in thousands) Cost Fair Value
---------- -----------
Due in one year or less $ -- $ --
Due after one year and beyond 15,733 15,711
---------- -----------
Total debt securities $ 15,733 $ 15,711
========== ===========
9. NOTES PAYABLE AND LINE OF CREDIT
September 30, December 31,
2004 2003
----------- ----------
(in thousands)
Industrial revenue bond, interest payable quarterly at a variable rate of 1.14%
to 1.83% (1.83% at September 30, 2004) principal payable in quarterly
installments of $35,000. The bond is fully collateralized by a $1.4 million
letter of credit and a bond guarantee agreement $ 1,400 $ 1,540
Industrial revenue bond, interest payable quarterly at a variable rate of 1.01%
to 1.82% (1.82% at September 30, 2004) principal payable in yearly installments
of $300,000. The bond is fully collateralized by a $2.6 million letter of
credit and a bond guarantee agreement. 2,605 2,905
6.25% Convertible Subordinated Notes due January 15, 2011. The notes bear
interest at a rate of 6.25% per annum, payable semi-annually, and are
convertible into shares of common stock at a conversion price of $13.89 per
share. These notes are subordinated to all other liabilities of the Company. 40,250 --
Line of credit with a Bank, interest range from LIBOR + 2.25% to Prime + 1.00%,
weighted average rate at December 31, 2003 was 3.89%, collateralized by
virtually all of the Company's assets. -- 11,550
13
September 30, December 31,
2004 2003
----------- ----------
(in thousands)
Note payable to Bank, interest at LIBOR plus a fixed credit spread of 2.50%,
(3.62% at December 31, 2003) collateralized by virtually all of the Company's
assets, repaid in full in January 2004. -- 1,663
---------- ----------
Total notes payable and line of credit 44,255 17,658
Less convertible subordinated notes discount 1,179 --
----------- ----------
Subtotal 43,076 17,658
Less amount due within one year 440 2,103
----------- ----------
$ 42,636 $ 15,555
=========== ==========
Maturities of notes payable are as follows, in thousands:
Year Ending December 31, Amount
------------------------ ----------
2004 (remaining) $ --
2005 440
2006 440
2007 440
2008 440
Thereafter 42,495
-----------
$ 44,255
===========
On January 22, 2004, the Company completed an offering of $40.25 million
principal amount of the 2011 Notes. The offering was for $35 million principal
amount plus an underwriter's over-allotment option of $5.25 million principal
amount, which was exercised in full. The 2011 Notes bear interest at a rate of
6.25% per annum, payable semi-annually, and are convertible into shares of
common stock at a conversion price of $13.89 per share, subject to adjustments.
The 2011 Notes are subordinated to all other liabilities of the Company. The
carrying value is listed below, in thousands.
Face value $ 40,250
Underwriters discounts, net 1,179
----------
$ 39,071
==========
The 2011 Notes can be converted into the Company's common stock at the option of
the holder at any time at a conversion price of $13.89 per share, subject to
adjustments for stock splits, stock dividends, the issuance of certain rights or
warrants to the existing holders of the Company's common stock and common stock
cash dividends in excess of a stated threshold.
The 2011 Notes are redeemable at the option of the Company after January 15,
2009, at a premium of two percent of the face value plus accrued interest unless
a change in control event, as defined in the indenture dated as of January 15,
2004 between the Company and Wachovia Bank of Delaware, National Association,
relating to the 2011 Notes, occurs. If such an event does occur, the Company may
redeem the 2011 Notes in whole but not in part at face value plus a premium. If
a change in control event occurs and the Company does not elect to redeem the
2011 Notes, the holders can require the Company to repurchase the 2011 Notes at
face value plus accrued interest.
The Company incurred $452 thousand of debt issuance costs for the 2011 Notes.
These costs are recorded as non-current assets and are amortized on a straight
line basis to interest expense over the term of the 2011 Notes. In addition,
underwriters' discounts totaled $1.3 million and are amortized on a straight
line basis to interest expense over the term of the 2011 Notes. Interest expense
recorded for the total of the deferred financing costs and debt discount on the
2011 Notes totaled $63 thousand and $182 thousand for the three months and nine
months ended September 30, 2004, respectively.
During January 2004, the Company repaid all of its outstanding bank borrowings
from the proceeds of the issuance of the 2011 Notes.
14
On March 31, 2004, the Company signed an Amended and Restated Credit Agreement
for its $25.0 million secured working capital line of credit. The new agreement
provides for borrowings against eligible accounts receivable and inventories. Of
this line of credit $10.0 million matures on March 1, 2007 and $15.0 million
matures on March 1, 2005. At September 30, 2004 $5.3 million was committed
principally as letters of credit securing the Industrial Revenue Bonds. On
October 29, 2004 the Company and its banks amended its credit agreement to
eliminate the $15.0 million line of credit maturing on March 1, 2005 and to
require borrowing under its $10.0 million line of credit to be collateralized by
pledged marketable securities.
The bank borrowings contain various financial covenants, including among other
things, maintenance of fixed charge coverage ratios, interest coverage ratios,
maximum senior debt to earnings before interest, taxes, depreciation and
amortization ("EBITDA") ratios, maximum permitted capital expenditures, and a
restriction against paying dividends. The Company was not in compliance with the
fixed charge ratio of its bank covenants at September 30, 2004, and in
conjunction with the October 29, 2004 amendment received a waiver from its
banks.
The interest rate on the line of credit is variable based on the performance of
the Company and ranges from LIBOR + 1.00% to Prime + 0.75%. The Company incurs
commitment fees equal to a range of 0.20% to 0.35% on any unused balances,
defined as the difference between the total amount of its $10.0 million line of
credit less amounts borrowed, and outstanding under letters of credit.
In January 2004 the interest rate swap ceased to be a highly effective cash flow
hedge when the related debt was repaid. Consequently, the amounts previously
recorded in other comprehensive income as changes in fair value of the interest
rate swap were recognized in earnings for the nine months ended September 30,
2004. Upon determination of the hedge ineffectiveness the cumulative loss on the
fair value of the interest rate swap was $155 thousand, which was recognized in
other income. The change in fair value of the interest rate swap for the three
and nine months ended September 30, 2004 was a gain of $24 thousand and $111
thousand, respectively, resulting in a remaining liability for the investment of
$44 thousand. Future changes in the value of the interest rate swap will be
recognized in earnings.
10. ACQUISITION
On August 10, 2004 the Company acquired the net assets of 90 Degrees, Inc. In
consideration for the $3.3 million in cash and 72,278 shares of CompuDyne
Corporation restricted common stock exchanged, the Company acquired
approximately $2.2 million in software, $60 thousand of intangible assets, net
receivables and liabilities of $38 thousand and $1.9 million in goodwill. Final
valuations and allocations, which is expected to be completed by June 30, 2005,
may differ from these amounts. 90 Degrees, Inc. historical results of operations
are immaterial.
11. COMMITMENTS AND CONTINGENCIES
The Company entered into a new lease for its corporate headquarters on July 1,
2004. The lease has a term of five years and total future minimum rental
payments under the lease are $528 thousand.
15
ITEM 2
COMPUDYNE CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
CompuDyne Corporation was reincorporated in Nevada in 1996. We were originally
incorporated in 1952. We believe that we are a leading provider of products and
services to the public security markets. We operate in four distinct segments:
Institutional Security Systems; Attack Protection; Federal Security Systems; and
Public Safety and Justice.
The Institutional Security Systems ("ISS") segment is headquartered in
Montgomery, Alabama and operates under the trade name Norment Security Group
("Norment"). This segment provides physical and electronic security products and
services to the corrections industry (prisons and jails) and to the courthouse,
municipal and commercial markets. ISS serves as a contractor, responsible for
most installation work on larger projects. Installations involve hard-line
(steel security doors, frames, locking devices, etc.) and sophisticated
electronic security systems, including software, electronics, touch-screens,
closed circuit TV, perimeter alarm devices and other security monitoring
controls. ISS also developed a product called MaxWall. MaxWall is a modular
steel, concrete filled prefabricated jail cell. It allows for construction
projects to use considerably less space and can save the project owner
significant amounts of money. ISS, through its regional offices provides field
level design, installation and maintenance of both physical and electronic
security products.
Included in the Institutional Security Systems segment is the TrenTech line
which designs, manufactures and integrates electronic security systems. TrenTech
integrates generally available products and software as well as designing its
own proprietary systems. TrenTech has developed a sophisticated proprietary
video badging system, with approximately 234 systems installed at 63 facilities,
including 58 military installations.
The Institutional Security Systems segment also manufactures a complete line of
locks and locking devices under the brand name Airteq. Airteq is an industry
leader in pneumatic and electro-mechanical sliding devices used in the
corrections industry.
The Attack Protection segment is one of the country's largest original equipment
manufacturers (OEM) of bullet, blast and attack resistant windows and doors
designed for high security applications such as embassies, courthouses, Federal
buildings, banks, corporate headquarters and other facilities that insist on
having the highest level of protection currently available. We believe we are a
premier provider of Level 8 security products, the highest rating level of
commercial security products. Our attack resistant windows and doors are
integrated and structurally secure products with specifically designed frames
and encasements that are integral parts of the structure in which they are
installed. Existing product installations number in the thousands and range from
the Middle East to the White House. Working under contracts from the United
States Department of State, the segment's largest customer, Attack Protection is
a significant supplier of bullet and blast resistant windows and doors to United
States embassies throughout the world. Attack Protection products are also sold
to drug stores, convenience stores, and banks to secure drive through
facilities. Other commercial applications include guard booths, tollbooths, cash
drawers and other similar items. Additionally, this segment designs and installs
both fixed and pop-up bollards and wedge barrier security systems.
The Attack Protection segment also manufactures a sophisticated fiber optic
sensor system, known as Fiber SenSys, used to detect physical intrusion. This
application is designed to protect large perimeters including such applications
as Federal facilities, military deployments and bases, oil fields, airport
tarmacs, public utilities, nuclear reactors and water systems. In addition, it
has been installed to protect the perimeters of numerous private estates and
other similar properties.
The Federal Security Systems segment is known as Quanta Systems Corporation. Its
customer base includes the military, governmental agencies, and state and local
governmental units. Federal Security Systems provides turnkey system integration
of public security and safety systems. This segment specializes in a wide range
of customized access control and badging, intrusion detection, surveillance and
assessment, communications, command and control, fire and life safety, and asset
tracking systems. Federal Security Systems provides central station oversight
and control of multiple and separate facilities as well as security and public
life safety systems and equipment. This segment designs and manufactures
advanced digital signal processing products used in reconnaissance of foreign
telecommunications signals designed for the United States Government and its
foreign allies.
16
The Public Safety and Justice segment consists of two subsidiaries known to the
industry as CorrLogic and Tiburon. We believe that CorrLogic is a leading
developer of inmate management and institutional medical software systems.
CorrLogic specializes in the development, implementation and support of complex,
integrated inmate management software systems, including inmate medical
management that improves the efficiency and accuracy of correctional facility
operations. CorrLogic's focus is entirely on information solutions for the
corrections industry.
During the third quarter of 2004, we expanded our offerings in the Public Safety
and Justice sector by completion of our acquisition of the assets of 90 Degrees,
Inc. 90 Degrees provides a web-based fire records management system which is
being integrated into our current PS&J product offerings. 90 Degrees'
enterprise-wide records management solutions assist fire and EMS agencies in
managing responses to emergency situations. We anticipate that as we integrate
90 Degrees' product offerings into our PS&J product offerings, the open
web-based technology from 90 Degrees will advance our current fire and rescue
product offerings.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
Certain statements made in this Form 10-Q with regard to the Company's
expectations as to future revenues, expenses, financial position and industry
conditions, the Company's ability to secure new contracts, its goals for future
operations, implementation of business strategy and other future events
constitute "forward-looking statements" within the meaning of the federal
securities laws. When used in this Form 10-Q, words such as "anticipate,"
"believe," "estimate," "expect," "intend" and similar expressions, as they
relate to management, identify forward-looking statements. Although the Company
makes such statements based on current information and assumptions it believes
to be reasonable, there can be no assurance that actual results will not differ
materially from those expressed or implied by such forward-looking statements.
Actual results could differ materially from those contemplated by the
forward-looking statements as a result of certain important factors, including
but not limited to, demand for the Company's products, competitive factors and
pricing pressures, changes in legal and regulatory requirements, government
budget problems, the ability to successfully grow the Company by completing
acquisitions, the ability to remain in compliance with its bank covenants,
delays in government procurement processes, ability to obtain bid, payment and
performance bonds on various of the Company's projects, technological change or
difficulties, the ability to refinance debt when it becomes due, product
development risks, commercialization difficulties, adverse results in
litigation, the level of product returns, the amount of remedial work needed to
be performed, and general economic conditions. Risks inherent in the Company's
business and with respect to future uncertainties are further described in our
other filings with the Securities Exchange Commission.
MANAGEMENT OUTLOOK
We find ourselves in very challenging times. We now have three major areas of
emphasis: the first is increasing the amount of our backlog; the second is
migrating to a business model with a more predictable revenue stream; and the
third is finding attractive acquisition candidates to enhance our existing
businesses.
During 2003 and the first quarter of 2004, as depicted in the following chart,
we saw the amount of our backlog decline. During the second and third quarters
of 2004 we experienced increases in our backlog for the first time since the
fourth quarter of 2002. Although this increase was a relatively modest $6.5
million, or 4.9% of our March 31, 2004 backlog, we view the fact that the
backlog has stopped declining and in fact started to increase as a very
important milestone and an early indicator that the difficult economic
environment we have been operating under during the past two years appears to
have stabilized.
Institutional Federal Public
Security Attack Security Safety and Total
(in thousands) Systems Protection Systems Justice Backlog
------------------------------------------------------------------------------------
December 31, 2002 $ 99,527 $ 18,478 $ 11,440 $ 74,867 $ 204,312
March 31, 2003 $ 91,602 $ 14,827 $ 11,667 $ 66,007 $ 184,103
June 30, 2003 $ 81,916 $ 16,552 $ 10,643 $ 72,621 $ 181,732
September 30, 2003 $ 68,780 $ 14,375 $ 11,528 $ 65,962 $ 160,645
December 31, 2003 $ 57,258 $ 10,043 $ 8,326 $ 63,727 $ 139,354
March 31, 2004 $ 52,147 $ 12,905 $ 9,269 $ 57,332 $ 131,653
June 30, 2004 $ 62,765 $ 17,761 $ 6,296 $ 50,065 $ 136,887
September 30, 2004 $ 59,524 $ 19,351 $ 9,018 $ 50,215 $ 138,108
17
Historically, approximately over 75% of our revenues were generated from sources
where the ultimate customer is a state or local government unit. During the last
few years due to the general economic slowdown, state and local budgets, which
we are dependent on for our revenue sources, have come under intense pressure.
Most states are currently running in a deficit situation, as are many local
governments. This has caused many of them to delay and in some cases cancel many
infrastructure projects until such time as their economic fortunes rebound.
Until the economy has improved for several quarters and until state and local
budgets improve, we would anticipate our backlog levels continuing to remain
under pressure. To address this area of focus we are actively bidding on jobs
and keeping our offerings in front of our customers so that when or if the
current government budget cycle turns around we will be well positioned to
capitalize on new opportunities. As noted above, the modest increase in our
backlog at September 30, 2004 preliminarily indicates to us that the markets we
serve are stabilizing and we are hopeful that our future backlogs will reflect
this trend.
Our second area of focus surrounds reengineering our business model so that it
contains a greater degree of recurring revenue. As indicated in the following
table, approximately 12.9% of our revenue is generated from recurring revenue
sources (primarily maintenance revenues), and the majority of these revenues
occur in our Public Safety and Justice segment. We define one-time revenue as
revenue derived from discrete projects, from which we do not expect to generate
incremental revenue upon the completion of the project. We define recurring
revenue as sources of revenue from which we anticipate receiving revenue in the
current, as well as future periods, for example annual renewable maintenance
contracts.
Nine Months Ended September 30, 2004
--------------------------------------------
(in thousands) One-time Revenue % Recurring Revenue % Total
---------------- ----- ----------------- ----- ----------
Institutional Security Systems $37,948 34.5 $ 3,846 3.5 $41,794
Attack Protection 20,204 18.3 -- -- 20,204
Federal Security Systems 11,242 10.2 -- -- 11,242
Public Safety and Justice 26,515 24.1 10,415 9.4 36,930
------- ---- ------- ----- ----------
Total $95,909 87.1% $ 14,261 12.9% $110,170
======= ==== ======= ===== ==========
Since the majority of our revenues are one-time revenues and are non-recurring,
we must reinvent our book of business every day. This makes it very difficult
for us to project our future revenue stream and thus makes it very difficult for
us to project our earnings as well as our business outlook. Over the next two to
five years, we intend to modify our business model to rely less upon one-time
sources of revenue and more on recurring sources of revenue. In this regard, we
recently hired a Chief Operating Officer (COO). The COO position is a newly
created position within CompuDyne. Our new COO, Mr. Maurice Boukelif, brings
extensive manufacturing and operational experience to us. Relying on his
expertise, we are hopeful we will be able to make this business model shift in
the next few years.
Our third key focus area is acquisitions. With the January 2004 completion of
the 2011 Notes offering, we have significant resources with which to fund
acquisitions. We are particularly interested in three areas.
The first is a business that would either prove additive or complementary to our
current offerings in the Public Safety and Justice segment. We envision this
segment as being a growth segment for our business. Our assessment is that the
demands of our nation's first responders will grow in the foreseeable future.
Furthermore, this business is characterized by strong recurring revenues which
as discussed above is one of our key business drivers.
Second, we are continually looking for companies that have attractive security
technology-based products that we can leverage by offering the technology to our
existing customers and markets.
The third type of business we are interested in acquiring is a high-end
commercial security integrator. Our primary clientele are currently governmental
units. Throughout all our segments other than Public Safety & Justice (which is
involved in a different market), over the years we have developed significant
skills as it relates to security integration and applications. Our offerings
however are sold almost exclusively to various governmental units. We believe
that the purchase of the right high end commercial security integrator would
give us a market entree whereby we would be able to offer many of our existing
offerings into the private sector, a wholly new business arena for us, and one
that we believe is not served as well as the governmental arena to which we have
heretofore dedicated ourselves.
18
We believe that if we address and implement successfully the above three areas
of focus it will significantly enhance our future growth opportunities and will
provide for more predictable financial results.
In this regard, on August 11, 2004, we acquired the assets of 90 Degrees, Inc.
of Yakima, Washington. 90 Degrees is a provider of mission critical fire and
emergency medical information management systems for public, military and
private public safety agencies. 90 Degrees' enterprise-wide records management
solutions assist fire and EMS agencies in managing responses to emergency
situations. We anticipate that as we integrate 90 Degrees' product offerings
into our Public Safety & Justice product offerings, the open web-based
technology from 90 Degrees will advance our current fire and rescue product
offerings.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
Revenues. The Company had revenues of $33.4 million and $53.1 million for the
three months ended September 30, 2004 and 2003, respectively. This was a
decrease of $19.8 million or 37.2%.
Revenues from the Institutional Security Systems segment were $11.8 million in
the three months ended September 30, 2004, a decrease from $26.4 million for the
same period of 2003. This was a decrease of $14.6 million or 55.3%. The
Institutional Security Systems segment is largely a construction driven
business. Much of its revenue is obtained by working on new and retrofit
construction projects in the corrections industry, as opposed to sources of
recurring revenue. As such, the decrease in revenue experienced by this segment
is largely attributable to its working on less projects than it did in the
previous year. The principal reason for the decrease was backlog had decreased
from $99.5 million at December 31, 2002 to $57.3 million at December 31, 2003
thus resulting in less work available to be performed in 2004 and the third
quarter of 2004 than in 2003 and the third quarter of 2003. At September 30,
2004, the backlog for the Institutional Security System's segment was $59.5
million which was a $3.2 million decrease over the previous quarter. The bidding
in years 2003 through 2004 has been slow for the Company. Although the gross
amount of construction spending in the corrections area remained relatively flat
during 2002, 2003 and the first nine months of 2004, the types of projects that
the Company solicits, namely large-scale medium to maximum security
installations, declined in 2003 and the first nine months of 2004. This
situation was further compounded by state and local governmental budget deficits
which are causing these governmental units to rethink and delay many of their
pending corrections projects.
Revenues from the Attack Protection segment were $6.6 million in the three
months ended September 30, 2004, an increase from $6.0 million for the same
period of 2003. This was an increase of $0.6 million or 7.9%. The Company
purchased an existing 75,000 square foot factory for the Attack Protection
segment on 20 acres of land in close proximity to its existing factory in
Montgomery, Alabama. This capacity increase was largely driven by the Company's
expectation that the demands for its products, principally its bullet and blast
resistant windows and doors would accelerate significantly in the post September
11, 2001 world. Throughout 2002, 2003 and the first nine months of 2004 this
anticipated increase in demand did not materialize leaving the segment with
significant excess capacity. This segment is composed of two chief product
offerings, namely Norshield, which encompasses bullet and blast resistant
windows and doors and ancillary products, and Fiber SenSys, which encompasses
its fiber optic intrusion detection systems. During the three months ended
September 30, 2004 compared to the three months ended September 30, 2003, the
Norshield line experienced a 16.3% decline in revenues, whereas the Fiber SenSys
line experienced a 206.3% increase in revenue. The Company continues to see
heightened interest for its Fiber SenSys products and expects sales for these
items to continue to experience sustainable growth. The slow-down in the
government building process experienced during 2002 and early 2003 has appeared
to stabilize. Now it appears that projects are being released for construction,
and thus the Attack Protection segment is experiencing increased bidding
activity for its products. During the fourth quarter of 2003, the Company
furnished bids to supply its products for eight new embassy projects. At the
time, this was the largest number of embassy projects bid in a single calendar
year for this segment. As of September 30, 2004, the Company was awarded five of
these embassy projects, for a total CompuDyne contract value of $11.2 million,
lost two embassy projects and the eighth has yet to be awarded. To date during
the second half of 2004 we have bid on 13 new embassy projects for a total
CompuDyne contract value of approximately $32 million. In 2005, preliminary
indications show 20 embassy projects will be available for bid. All indications
are that this increased level of new embassy construction will continue for the
next several years.
19
Revenues from the Federal Security Systems segment were $3.3 million in the
three months ended September 30, 2004, a decrease from $4.6 million for the same
period of 2003. This was a decrease of $1.3 million or 27.5%. Substantially all
of this segment's revenue is backlog driven. The Federal Security Systems
Segment ended 2002 with a backlog level of $11.4 million. Backlog at December
31, 2003 decreased to $8.3 million and at September 30, 2004 was $9.0 million.
Revenues from the Public Safety and Justice segment were $11.8 million in the
three months ended September 30, 2004, a decrease from $16.2 million for the
same period of 2003. This was a decrease of $4.4 million or 27.3%. During the
third quarter of 2003, PS&J shipped $4.8 million of hardware to a large client.
Although PS&J ships certain hardware components to clients on an occasional
basis, shipment of this magnitude of hardware, done to accommodate our client,
is an unusual and nonroutine event.
Expenses. Cost of goods sold of $24.6 million in the three months ended
September 30, 2004 was down $16.6 million, or 40.3%, from $41.1 million during
the same period of 2003. This decrease was a result of a decreased costs of
goods sold of $12.6 million at the Institutional Security Systems segment,
largely attributable to the decreased sales of this segment. The smaller
percentage decrease in sales as compared to the percentage decrease in cost of
goods sold resulted in an increased gross profit percentage of 26.4% in the
three months ended September 30, 2004 as compared to 22.6% in 2003.
Cost of goods sold in the Institutional Security Systems segment of $10.0
million in the three months ended September 30, 2004 were down $12.6 million or
55.8% from $22.6 million for the same period of 2003. This decrease was slightly
more than the related sales decrease of this segment of 55.3% resulting in an
increase in the gross profit percentage to 15.0% from 14.1% in the three months
ended September 30, 2004. During 2002, the West Coast operations of the
Institutional Security Systems segment identified that the costs to complete its
projects were expected to be significantly higher than was previously projected.
This was a result of significant cost overruns on many of these projects. As the
work on the projects progressed and as these projects neared completion, the
Institutional Security Systems segment identified additional cost overruns which
would cause the costs to complete these projects to increase, resulting in a
higher cost of goods sold in 2003 as a result of these changes in estimate to
complete.
These increases were identified and recorded in the cost to complete
calculations in the following periods.
Second Half of 2002 $ 2,215,725
First Half of 2003 1,728,829
Third Quarter of 2003 437,717
Fourth Quarter of 2003 821,646
First Half of 2004 334,841
Third Quarter of 2004 60,913
-----------
Total West Coast Margin Reductions $ 5,599,671
===========
As a result, as these projects are being brought to completion and the final
billings made, the revenue generated by them is resulting in little margin or in
some cases losses as the additional cumulative cost overruns of $5.6 million
were being identified and realized. To address this situation, the Company
implemented more centralized controls and replaced certain personnel at its West
Coast operations. As of September 30, 2004, we believe that additional cost
overruns to complete these projects will be minimal, and as of September 30,
2004, all known probable losses have been accrued for.
20
Cost of goods sold in the Attack Protection segment of $7.0 million in the three
months ended September 30, 2004 was up $1.7 million or 32.4% from $5.3 million
during the same period of 2003. This increase was in spite of the related sales
decrease of this segment of 7.9%, resulting in a 19.9% decrease in the gross
profit percentage to (7.3%) from 12.6% in the three months ended September 30,
2003. We are actively working to better utilize the 75,000 square foot factory
the Company purchased in Montgomery, Alabama. The Airteq manufacturing operation
in Oregon was relocated and consolidated into this facility. This was done in an
effort to enhance the utilization of our owned facilities in Alabama and thus
absorb some of our excess manufacturing capacity. Although not a huge
contributor, this did in fact result in further utilization of approximately
12,000 square feet of previously unused manufacturing space in this plant in
Alabama. In addition, we identified a quality problem with the windows and doors
being installed on one active and current project. As a result of this
identified problem, we were forced to take remedial action in the field to
repair this defect. During the quarter ending September 30, 2004 we were forced
to increase our estimated cost to complete this project by $1.1 million. This
was in addition to $947 thousand write downs recorded during the first and
second quarters of 2004. We now anticipate losing $1.4 million on this project.
As this project is brought to completion, any future revenues recognized will be
without any margin.
Cost of goods sold in the Federal Security Systems segment of $2.8 million in
the three months ended September 30, 2004 were down $0.8 million or 22.7% from
$3.6 million during the same period of 2003. This decrease was less than the
related sales decrease of this segment of 27.5% resulting in a 5.3% decrease in
the gross profit percentage to 15.2% from 20.5% in the three months ended
September 30, 2003. Substantially all of the projects awarded in this segment
are discrete projects.
Cost of goods sold in the Public Safety and Justice segment of $4.8 million in
the three months ended September 30, 2004 were down $4.8 million or 50.4% from
$9.6 million during the same period of 2003. During the third quarter of 2003,
PS&J shipped $4.8 million of hardware to a large client. Although PS&J ships
certain hardware components to clients on an occasional basis, shipment of this
magnitude of hardware, done to accommodate our client, is an unusual and
nonroutine event. The absence of these hardware sales in the third quarter of
2004 contributed to the decline in cost of goods sold in 2004.
Selling, general and administrative expenses was $9.3 million for the three
months ended September 30, 2004, an increase of $0.8 million or 9.7% from $8.5
million for the same period of 2003. A significant portion of this increase is
related to additional costs incurred by the Company related to legal fees
incurred in connection with responding to a complaint filed by a Public Safety
and Justice segment customer, expenses incurred in connection with evaluating
potential acquisitions, recruiting fees incurred to fill the recently hired COO
position and other senior management positions and to comply with new
requirements mandated by the Sarbanes-Oxley Act and the SEC.
Research and Development expenses were $2.1 million for the three months ended
September 30, 2004, an increase of $0.4 million or 21.9% from $1.7 million for
the same period of 2003. Being a technology driven enterprise, the Company's
Public Safety and Justice segment is required to continually update and enhance
its software offerings causing it to incur significant research and development
costs.
Interest expense increased to $849 thousand for the three month period ending
September 30, 2004 from $366 thousand for the three month period ended September
30, 2003 due to an increase in borrowings and overall higher interest rates. The
following table compares the weighted average of the Company's three month
period ended September 30, 2004 and September 30, 2003 interest bearing
borrowings and the related rates charged thereon.
Monthly Weighted Monthly Weighted
Average - 2004 Average - 2003
Amount Rate Amount Rate
------ ---- ------ ----
(in thousands) (in thousands)
Bank borrowings $ -- -- $15,580 3.2%
Industrial revenue bonds $ 4,052 2.7% $ 4,492 4.0%
Subordinated borrowings $40,250 6.3% -- --
Swap hedge agreement $ 3,382 3.4% $ 6,088 3.9%
21
Monthly Weighted Monthly Weighted
Average - 2004 Average - 2003
Amount Rate Amount Rate
------ ---- ------ ----
(in thousands) (in thousands)
In addition the Company recorded the following
interest expense:
Amortization and write-off
of deferred financing charges $ 145 $ 77
Taxes on Income. The effective tax rate (benefit) was approximately 40% during
both the three month periods ended September 30, 2004 and September 30, 2003.
Net Income. The Company reported net (loss) income of ($1.8) million and $1.0
million in the third quarters of 2004 and 2003, respectively. Diluted earnings
per share decreased to ($.23) in the third quarter of 2004 from $.12 in the
third quarter of 2003. The weighted average number of common shares outstanding
and equivalents used in computing EPS increased in the third quarter of 2004 as
compared to the third quarter of 2003 to 8.2 million from 8.1 million in 2003.
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
Revenues. The Company had revenues of $110.2 million and $147.4 million for the
nine months ended September 30, 2004 and September 30, 2003, respectively. This
was a decrease of $37.3 million or 25.3%.
Revenues from the Institutional Security Systems segment were $41.8 million in
the nine months ended September 30, 2004, a decrease from $75.5 million for the
same period of 2003. This was a decrease of $33.7 million or 44.6%. The
Institutional Security Systems segment is largely a construction driven
business. Much of its revenue is obtained by working on new and retrofit
construction projects in the corrections industry, as opposed to sources of
recurring revenue. As such, the decrease in revenue experienced by this segment
is largely attributable to its working on less projects than it did in the
previous year. The principal reason was because its backlog had decreased from
$99.5 million at December 31, 2002 to $57.3 million at December 31, 2003 thus
resulting in less work available to be performed in the first nine months of
2004 as compared to the first nine months of 2003. At September 30, 2004, the
backlog for the Institutional Security System's segment was $59.5 million which
was a $2.3 million increase over the December 31, 2003 backlog amount. The year
2003 and 2004 has been a slow bidding period for the Company. Although the gross
amount of construction spending in the corrections area remained relatively flat
between 2002, 2003 and the first nine months of 2004, the types of projects that
the Company solicits, namely large-scale medium to maximum security
installations, declined in 2003 and the first nine months of 2004. This
situation was further compounded by the general state and local governmental
budget deficits which are causing these governmental units to rethink and delay
many of their pending corrections projects.
Revenues from the Attack Protection segment was $20.2 million in the nine months
ended September 30, 2004, a decrease from $20.9 million for the same period of
2003. This was a decrease of $0.7 million or 3.4%. The Company purchased an
existing 75,000 square foot factory for the Attack Protection segment on 20
acres of land in close proximity to its existing factory in Montgomery, Alabama.
This capacity increase was largely driven by the Company's expectation that the
demands for its products, principally its bullet and blast resistant windows and
doors would accelerate significantly in the post September 11, 2001 world.
Throughout 2002, 2003 and the first nine months of 2004 this anticipated
increase in demand did not materialize leaving the segment with significant
excess capacity. This segment is composed of two chief product offerings, namely
Norshield, which encompasses bullet and blast resistant windows and doors and
ancillary products, and Fiber SenSys, which encompasses its fiber optic
intrusion detection systems. During the nine months ended September 30, 2004
compared to September 30, 2003 the Norshield line experienced a 22.8% decline in
revenues, whereas the Fiber SenSys line experienced a 108.1% increase in
revenues. The Company continues to see heightened interest for its Fiber SenSys
products and expects sales for these items to continue to experience sustainable
growth. The slow-down in the government building process experienced during 2002
and 2003 has appeared to stabilize. It appears that projects are being released
for construction, and thus the Attack Protection segment is experiencing
increased bidding activity for its products. During the fourth quarter of 2003
the Company furnished bids to supply its products for eight new embassy
projects. At the time, this was the largest number of embassy projects bid in a
single calendar year for this segment. As of September 30, 2004, the Company was
awarded five of these embassy projects, for a total CompuDyne contract value of
$11.2 million, lost two embassy projects and the eighth has yet to be awarded.
To date during the second half of 2004, we have bid on 13 new embassy projects
for a total CompuDyne contract value of approximately $32 million. In 2005,
preliminary indications show 20 embassy projects will be available for bid. All
indications are that this increased level of new embassy construction will
continue for the next several years.
22
Revenues from the Federal Security Systems segment was $11.2 million in the nine
months ended September 30, 2004, a decrease from $12.3 million for the same
period of 2003. This was a decrease of $1.1 million or 8.6%. Substantially all
of this segment's revenue is backlog driven. The Federal Security Systems
Segment ended 2002 with a backlog level of $11.4 million. Backlog at December
31, 2003 was $8.3 million and at September 30, 2004 was $9.0 million.
Revenues from the Public Safety and Justice segment was $36.9 million in the
nine months ended September 30, 2004, a decrease from $38.7 million for the same
period of 2003. This was a decrease of $1.8 million or 4.7%. During the third
quarter of 2003, PS&J shipped $4.8 million of hardware to a large client.
Although PS&J ships certain hardware components to clients on an occasional
basis, shipment of this magnitude of hardware, done to accommodate our client,
is an unusual and nonroutine event.
Expenses. Cost of goods sold of $80.0 million in the nine months ended September
30, 2004 were down $31.8 million or 28.5% from $111.9 million during the same
period of 2003. This decrease was a result of decreased costs of goods sold of
$30.0 million at the Institutional Security Systems segment, largely
attributable to the decreased sales of this segment. The smaller percentage
decrease in sales as compared to the percentage decrease in cost of goods sold
resulted in an increased gross profit percentage of 27.4% for the nine months
ended September 30, 2004 as compared to 24.1% in 2003.
Cost of goods sold in the Institutional Security Systems segment of $35.3
million for the nine months ended September 30, 2004 were down $30.0 million or
45.9% from $65.3 million during the same period of 2003. This decrease was more
than the related sales decrease of this segment of 44.6% resulting in a 2.0%
increase in the gross profit percentage to 15.6% from 13.6% in the nine months
ended September 30, 2003. During 2002, the West Coast operations of the
Institutional Security Systems segment identified that the costs to complete its
projects was going to be significantly higher than was previously projected.
This was a result of significant cost overruns on many of these projects. As the
work on the projects progressed and as these projects neared completion the
Institutional Security Systems segment identified additional cost overruns which
would cause the costs to complete these projects to increase resulting in a
higher cost of goods sold in 2003 as a result of the charges in estimate to
complete.
These increases were identified and recorded in the cost to complete
calculations in the following periods.
Second Half of 2002 $ 2,215,725
First Half of 2003 1,728,829
Third Quarter of 2003 437,717
Fourth Quarter of 2003 821,646
First Half of 2004 334,841
Third Quarter of 2004 60,913
------------
Total West Coast
Margin Reductions $ 5,599,671
============
23
As a result, as these projects are being brought to completion and the final
billings collected, the revenue generated by them is resulting in little margin
or in some cases losses as the additional cumulative costs overruns of $5.6
million were being identified and realized. To address this situation, the
Company implemented more centralized controls and replaced certain personnel at
its West Coast operations. As of September 30, 2004 we believe that additional
cost overruns to complete these projects will be minimal, and as of September
30, 2004 all known probable losses have been accrued for.
Cost of goods sold in the Attack Protection segment of $18.7 million for the
nine months ended September 30, 2004 increased $1.9 million or 11.2% from $16.8
million during the same period of 2003. This increase occurred in spite of a
sales decrease of this segment of 3.4%, resulting in a 12.1% decrease in the
gross profit percentage to 7.5% from 19.7% during the nine months ended
September 30, 2003. We are actively working to better utilize the 75,000 square
foot factory the Company purchased in Montgomery, Alabama. The Airteq
manufacturing operation in Oregon was relocated and consolidated into this
facility. This was done in an effort to enhance the utilization of our owned
facilities in Alabama and thus absorb some of our excess manufacturing capacity.
Although not a huge contributor, this did in fact result in further utilization
of approximately 12,000 square feet of previously unused manufacturing space in
this plant in Alabama. In addition we identified a quality problem with the
windows and doors being installed on one active and current project. As a result
of this identified problem, we were forced to take remedial action in the field
to repair this defect. During the first nine months of September 30, 2004 we
were forced to increase our estimated cost to complete this project by $2.0
million thus causing this project to become a negative margin project.
Cumulative write downs on this project amount to $2.3 million. As this project
is brought to completion any future revenue recognized will be without any
margin.
Cost of goods sold in the Federal Security Systems segment of $9.6 million in
the nine months ended September 30, 2004 decreased $0.6 million or 5.9% from
$10.2 million during the same period of 2003. This decrease was more than the
related sales decrease of this segment of 8.6%, resulting in a 2.5% decrease in
the gross profit percentage to 14.3% from 16.7% in the nine months ended
September 30, 2003. Substantially all of the projects awarded in this segment
are discrete projects.
Cost of goods sold in the Public Safety and Justice segment of $16.4 million for
the nine months ended September 30, 2004 was down $3.1 million or 16.1% from
$19.6 million during the same period of 2003. This decrease was more than the
related sales decrease of this segment of 4.7%, resulting in a 6.0% increase in
the gross profit percentage to 55.5% from 49.5% in the nine months ended
September 30, 2003. During the fourth quarter of 2003 our Public Safety and
Justice segment received a complaint alleging that we breached our contract to
provide a public safety software system to a customer. As a result we recorded a
$1.6 million pre-tax charge. During the second quarter of 2004 this matter was
settled resulting in a recovery by the segment of $0.3 million of the accrued
charge, which was reflected as a reduction of its cost of sales.
Selling, general and administrative expenses was $26.1 million for the nine
months ended September 30, 2004, an increase of $2.0 million or 8.3% from $24.1
million for the same period of 2003. Much of this increase is related to
additional costs incurred by the Company related to legal fees in connection
with responding to and settling the complaint filed by a Public Safety and
Justice segment customer, expenses incurred in connection with evaluating
potential acquisitions, recruiting fees incurred to fill the recently hired COO
position and other senior management positions and to comply with new
requirements mandated by the Sarbanes-Oxley Act and the SEC.
Research and Development expenses was $5.7 million for the nine months ended
September 30, 2004, an increase of $0.1 million or 1.5% from $5.6 million for
the same period of 2003. Being a technology driven enterprise, the Company's
Public Safety and Justice segment is required to continually update and enhance
its software offerings, thus causing it to incur significant research and
development costs.
Interest expense increased to $2.4 million for the nine month period ending
September 30, 2004 from $1.1 million for the nine month period ending September
30, 2003 due to increase in borrowings and overall higher interest rates. The
following table compares the weighted average of the Company's nine month
periods ended September 30, 2004 and September 30, 2003 interest bearing
borrowings and the related rates charged thereon.
24
Monthly Weighted Monthly Weighted
Average - 2004 Average - 2003
Amount Rate Amount Rate
------ ---- ------ ----
(in thousands) (in thousands)
Bank borrowings $ 822 1.4% $17,330 2.6%
Industrial revenue bonds $ 4,214 3.2% $ 4,752 3.8%
Subordinated borrowings $40,250 6.3% -- --
Swap hedge agreement $ 4,059 3.7% $ 6,755 3.7%
In addition the Company recorded
the following interest expense:
Amortization and write-off
of deferred financing charges $ 418 $ 178
Taxes on Income. The effective tax rate (benefit) was approximately 40% during
both the nine month periods ended September 30, 2004 and September 30, 2003.
Net Income. The Company reported net (loss) income of ($2.1) million and $3.0
million in the first nine months of 2004 and 2003, respectively. Diluted
earnings per share decreased to a loss of ($.26) in the first nine months of
2004 from $.36 in the first nine months of 2003. The weighted average number of
common shares outstanding and equivalents used in computing EPS increased to 8.2
million in 2004 from 8.1 million in 2003.
LIQUIDITY AND CAPITAL RESOURCES
The Company funds its operations through cash flows generated from its
operations, bank and public financings, and the sale of its common stock. The
Company's liquidity requirements arise from cash necessary to carry its
inventories and billed and unbilled receivables, for capital expenditures, to
repurchase shares of its common stock under its share repurchase program, for
payments of principal and interest on outstanding indebtedness and for
acquisitions. The ultimate customers of the Company are primarily federal, state
and local governmental units. In the event the funding of these governmental
units is reduced for any reason, including budgetary reductions due to economic
conditions, there is a risk that the demand for the Company's goods and services
would decrease which would reduce the availability of funds to the Company.
As of September 30, 2004, the Company had working capital of $52.7 million
compared with $28.8 million as of December 31, 2003. The most significant
changes in working capital were due to the receipt of the cash proceeds from the
2011 Notes financing, offset in part by the concurrent pay down of the Company's
debt, with the balance invested in available-for-sale marketable securities.
Net cash used by operating activities was $5.9 million in the first nine months
of 2004 versus $11.1 million provided by operating activities in the first nine
months of 2003.
Net cash used for investing activities was $20.1 million in the first nine
months of 2004 compared to net cash used of $684 thousand in the first nine
months of 2003. In the first nine months of 2004, the net of marketable
securities bought and redeemed was $15.5 million.
Net cash provided by financing activities amounted to $26.6 million in the first
nine months of 2004 compared with a net cash use of $8.3 million in the first
nine months of 2003. $13.5 million of our bank borrowings were repaid from the
proceeds of the issuance of the 2011 Notes.
25
The following table summarizes the long term debt of the Company as of September
30, 2004 and the payments due by period, in thousands.
Long-Term Debt
December 31: --------------
2004 $ --
2005 440
2006 440
2007 440
2008 440
Thereafter 42,495
-------
Totals $44,255
=======
In addition, the Company enters into purchase obligations to procure equipment
and services, including subcontractor contracts, in the performance of the
day-to-day operations of its business. Substantially all of these obligations
are covered by our existing backlog and the revenues generated by these backlogs
are expected to be sufficient to meet any payment obligations resulting from
these purchase commitments.
On January 22, 2004, the Company completed the offering of the 2011 Notes. The
offering was for $35 million principal amount plus an underwriter's
over-allotment option of $5.25 million principal amount, which was exercised in
full. The 2011 Notes bear interest at the rate of 6.25% per annum, payable
semi-annually, and are convertible into shares of common stock at a conversion
price of $13.89 per share. The proceeds from the 2011 Notes were used to repay
substantially all of the Company's outstanding borrowings.
During January 2004, the Company repaid substantially all of its outstanding
bank borrowings from the proceeds of the issuance of its 2011 Notes. The Company
has decided not to repay any of its Industrial Revenue Bond ("IRB") borrowings
as it has determined that there were certain favorable tax treatments afforded
the Company when it entered into these IRB's, which it would lose in the event
these borrowings were repaid prematurely.
On March 31, 2004 the Company and its banks amended and restated its credit
agreement. Under the terms of the new agreement $10.0 million of the line of
credit matures on March 1, 2007 and $15.0 million of the line of credit matures
on March 1, 2005.
On October 29, 2004, the Company and its banks amended its credit agreement to
eliminate the $15.0 million line of credit maturing on March 1, 2005 and to
require borrowings under its $10.0 million line of credit to be collateralized
by pledged marketable securities. The Company was not in compliance with its
fixed charge coverage ratio covenant at September 30, 2004 and in conjunction
with the October 29, 2004 amendment received a waiver from its bank.
The Company's total outstanding borrowings at September 30, 2004 amounted to
approximately $44.2 million. The 2011 Notes accounted for $40.2 million of these
borrowings. The remaining amount of $4.0 million resulted from borrowings at
variable rates and consisted of two industrial revenue bonds outstanding in the
amounts of $1.4 million and $2.6 million. The interest rate charged to the
Company at September 30, 2004 for its industrial revenue bonds was 1.83% and
1.82% respectively. The variable interest rate for these borrowings fluctuated
between 1.01% and 1.83% during the first nine months of 2004 based on weekly
market conditions. These bonds are fully collateralized by bank letters of
credit issued under the Credit Agreement. The Company's banks consider letters
of credit as outstanding borrowings when considering the amount of availability
the Company has remaining under its line of credit and in determining the amount
of marketable securities needed to be pledged as collateral.
Other than the Company's letters of credit, which amounted to $5.3 million at
September 30, 2004, the Company has no other material off balance sheet
liabilities.
The Company had $4.7 million of unused availability under its line of credit
after execution of the October amendment. As a result of the variable nature of
the interest rate on the Company's bank borrowings, any increase in the amount
of outstanding borrowings and/or decreases in the Company's EBITDA (an increase
in the "leverage ratio") will result in the Company's interest rate increasing
and thus the amount of interest expense incurred also increasing.
26
The Company anticipates that cash generated from operations and borrowings under
the working capital line of credit and the cash generated from its recent
issuance of the 2011 Notes will enable the Company to meet its liquidity,
working capital and capital expenditure requirements during the next 12 months.
The Company, however, may require additional financing to pursue its strategy of
growth through acquisitions, and to meet its long-term liquidity, working
capital and capital expenditure requirements. If such financing is required,
there are no assurances that it will be available, or if available, that it can
be obtained on terms favorable to the Company. From time to time, the Company
may be party to one or more non-binding letters of intent regarding material
acquisitions, which, if consummated, may be paid for with cash or through the
issuance of a significant number of shares of the Company's common stock. The
interest rate environment earlier this year was at historic lows. In light of
this favorable environment, the Company determined that it was in its best
interests to lock in a favorable fixed interest rate for a significant amount of
borrowings. These borrowings, which were made on a subordinated basis, were used
to pay off the Company's existing bank debt and will be available to fund the
Company's future growth opportunities and also will be available to fund any
acquisitions which the Company may wish to pursue. These funds will be
instrumental in the Company's growth through acquisition strategy. Unlike the
Company's existing bank debt availability, the 2011 Notes do not contain any
restrictive covenants or ratios. As a result of securing this borrowing, the
Company renegotiated its bank lines of credit. Although the Company currently
does not see the need to borrow under its bank line, it intends to keep such
line open.
Additional Considerations
COST CONTAINMENT
Due to current economic conditions, and in light of a very strong competitive
environment, the Company recognizes that its ability to increase the prices it
charges its customers is limited. As a result, in order to enhance its
profitability, the Company recognizes the need to continue to seek ways to
reduce its costs.
TOTAL BACKLOG
CompuDyne's total backlog amounted to $138.1 million at September 30, 2004. This
was a decrease of 0.9% from the Company's December 31, 2003 backlog of $139.4
million. The break down of the Company's backlog by segment is as follows, in
thousands:
September 30, December, 31,
2004 2003
-------- --------
Institutional Security Systems $ 59,524 $ 57,258
Attack Protection 19,351 10,043
Federal Security Systems 9,018 8,326
Public Safety and Justice 50,215 63,727
-------- --------
Totals $138,108 $139,354
======== ========
Included in the backlog of the Public Safety and Justice segment at September
30, 2004 and December 31, 2003 is $6.0 million and $12.0 million, respectively,
representing awards received by the segment, for which the customers have not
yet entered into signed contracts. These awards are expected to result in signed
contracts over the next twelve months.
CRITICAL ACCOUNTING POLICIES
A complete description of the Company's significant accounting policies appears
in the Company's Annual Report to its stockholders and is incorporated by
reference in its Annual Report on Form 10-K for the year ended December 31,
2003.
PERCENTAGE OF COMPLETION ACCOUNTING AND REVENUE RECOGNITION
Approximately 75% of the Company's revenues are derived from long term contracts
where revenue is recognized under the percentage of completion method of
accounting. The Company's software related contracts utilize labor hours
incurred to date on a project, divided by the total expected project hours to
determine the completion percentage. The Company's manufacturing and
construction contracts utilize costs incurred to date on a project, divided by
the total expected project costs to determine the completion percentage. Both of
these methods require considerable judgment and, as such, the estimates derived
at any point in time could differ significantly from actual results. These
estimates affect many of the balance sheet and statement of operations accounts
including net sales, cost of goods sold, accounts receivable, contract costs in
excess of billings and billings in excess of contract costs incurred.
27
Revenues for support and maintenance contracts are deferred and recognized
ratably over the life of the contract.
Provisions for estimated losses on uncompleted contracts are recognized in the
period such losses are determined.
GOODWILL AND INTANGIBLE ASSETS
The Company reviews the carrying value of goodwill and unamortized intangible
assets either annually during the fourth quarter of the year or when events or
changes in circumstances indicate that the carrying value may not be
recoverable, utilizing a discounted cash flow model. Changes in estimates of
future cash flows caused by items such as unforeseen events or changes in market
conditions could negatively affect the reporting unit's fair value and result in
an impairment charge. The Company cannot predict the occurrence of events that
might adversely affect the reported value of goodwill and intangible assets that
totaled approximately $32.7 million, net, at September 30, 2004.
STOCK COMPENSATION POLICY
The Company accounts for its stock-based compensation using the intrinsic value
method and in accordance with the recognition and measurement principles of APB
Opinion No. 25, "Accounting for Stock Issued to Employees", and related
interpretations. No stock-based employee compensation cost is reflected in net
income, as all options granted had an exercise price equal to the fair market
value of the underlying common stock on the date of the grant.
In June 2004 the FASB issued an exposure draft entitled Fair Value Measurements
that provides guidance on how to measure fair value of assets and liabilities.
The objective is to increase the consistency, reliability, and comparability of
fair value measurements in applying general accepted accounting principles.
Valuation techniques consistent with the market approach, income approach and
cost approach are to be considered for purposes of estimating fair value. The
proposed standard's effective date would be applicable for awards that are
granted, modified, or settled in cash in interim or annual periods beginning
after June 15, 2005. The Company is currently evaluating the impact of the
proposed standard.
ECONOMIC CONDITIONS AND THE AFTER EFFECT OF THE
SEPTEMBER 11, 2001 TERRORIST ATTACKS
Much of the work CompuDyne performs is for state and local governmental units.
These entities have been severely impacted by recent economic conditions and the
resulting contraction of the tax bases of these governmental units. This has
caused these governmental units to carefully evaluate their budgets and defer
expenses and projects where possible. Much of the work of the Company's Public
Safety and Justice, and Institutional Security Systems segments is contracted
with these state and local governmental units. As a result, these segments have
seen delays in new work available to be bid and worked on. In addition, even
work that has been contracted for where possible is being deferred by the
customer into the future, presumably when the tax bases will be more robust.
After the occurrence of the tragic events of the September 11, 2001 terrorist
attacks, there was a general perception that our Federal Security Systems and
Attack Protection segments would see a significant increase in order flow. To
the contrary, in the months subsequent to the terrorist attacks these segments
saw a slowing in new work opportunities as the various federal agencies and
other customers that are the usual source of business for the Company slowed
their procurement processes waiting for definitive direction as to how to
proceed in the post September 11 world. Now further complicated by the military
action in Iraq, the Company's customers are reevaluating priorities and budgets
and are funding only their most pressing demands while also making key decisions
as to which projects can be deferred.
As a result of the above factors, during the last three years the Company has
experienced a more challenging marketplace than it experienced in several years
prior to September 11, 2001.
MARKET RISK
The Company is exposed to market risk related to changes in interest rates. The
Company entered into an interest rate swap agreement on June 26, 2001 in the
initial notional amount of $11.5 million. The notional amount of this swap
agreement declines by $676 thousand on a quarterly basis until it becomes $0 on
October 1, 2005. At September 30, 2004 the notional amount of the swap agreement
had declined to $2.7 million at a fixed rate of 4.9%. In January 2004 the
interest rate swap ceased to be a highly effective cash flow hedge when the
related debt was repaid. Consequently, the amounts previously recorded in other
comprehensive income as changes in fair value of the interest rate swap were
recognized in earnings for the nine months ended September 30, 2004. Upon
determination of the hedge ineffectiveness, the cumulative loss on the fair
value of the interest rate swap was $155 thousand, which was recognized in other
income. The change in fair value of the interest rate swap for the three months
ended September 30, 2004 was a gain of $24 thousand, and the change in fair
value of the interest rate swap for the nine months ended September 30, 2004 was
a gain of $111 thousand, resulting in a remaining liability for the investment
of $44 thousand. Future changes in the value of the interest rate swap will be
recognized in earnings.
28
On January 22, 2004, the Company completed an offering of $40.25 million
principal amount of the 2011 Notes. The offering was for $35 million principal
amount plus an underwriter's over-allotment option of $5.25 million principal
amount, which was exercised in full. The 2011 Notes bear interest at the rate of
6.25% per annum, payable semi-annually, and are convertible into shares of
common stock at a conversion price of $13.89 per share. The Company used a
portion of the proceeds of this note offering to pay down outstanding borrowings
under its variable rate bank notes. Subsequent to the pay-down of its bank notes
the only variable rate borrowings outstanding was approximately $4.4 million of
industrial revenue bonds. Since these borrowings bear interest at variable
rates, and in the event interest rates increase dramatically, the increase in
interest expense to the Company could be material to the results of operations
of the Company.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2004 the FASB issued an exposure draft entitled Fair Value Measurements
that provides guidance on how to measure fair value of assets and liabilities.
The objective is to increase the consistency, reliability, and comparability of
fair value measurements in applying general accepted accounting principles.
Valuation techniques consistent with the market approach, income approach and
cost approach are to be considered for purposes of estimating fair value. The
proposed standard's effective date would be applicable for awards that are
granted, modified, or settled in cash in interim or annual periods beginning
after June 15, 2005. The Company is currently evaluating the impact of the
proposed standard.
In March 2004 the Emerging Issues Task Force ("EITF") reached a final consensus
on EITF Issue No. 03-06, "Participating Securities and the Two-Class Method
under FAS 128, EARNINGS PER SHARE". Issue No. 03-06 addresses a number of
questions regarding the computation of earnings per share ("EPS") by companies
that have issued securities other than common stock that contractually entitle
the holder to participate in dividends and earnings of the company when, and if,
it declares dividends on its common stock. The issue also provides further
guidance in applying the two-class method of calculating EPS. It clarifies what
constitutes a participating security and how to apply the two-class method of
computing EPS once it is determined that a security is participating, including
how to allocate undistributed earnings to such a security. EITF 03-06 was
effective for the fiscal quarter ended June 30, 2004. The adoption of this
standard did not have a material effect on the financial position, results of
operations or cash flows of the Company.
In January 2003 the FASB issued FASB Interpretation No. 46, "Consolidation of
Variable Interest Entitites" (FIN 46). In December 2003, FIN 46 was replaced by
FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities".
FIN 46(R) clarifies the application of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements", to certain entities in which equity
investors do not have the characteristics of a controlling financial interest or
do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. FIN 46(R)
requires an enterprise to consolidate a variable interest entity if that
enterprise will absorb a majority of the entity's expected losses, is entitled
to receive a majority of the entity's expected residual returns, or both. FIN
46(R) is effective for entities being evaluated under FIN 46(R) for
consolidation no later than the end of the first reporting period that ends
after March 15, 2004. The adoption of this standard did not have a material
effect on the financial position, results of operations or cash flows of the
Company.
29
ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
CompuDyne has fixed and variable rate notes payable. These on-balance sheet
financial instruments expose the Company to interest rate risk, with the primary
interest rate exposure resulting from changes in the bond market used to
determine the interest rate applicable to the borrowings under the Company's IRB
borrowings.
The information below summarizes our sensitivity to market risks associated with
fluctuations in interest rates as of September 30, 2004. To the extent that the
Company's financial instruments expose the Company to interest rate risk, they
are presented in the table below. The table presents principal cash flows and
related interest rates by year of maturity of the Company's notes payable with
variable rates of interest in effect at September 30, 2004.
On January 22, 2004, the Company completed an offering of $40.25 million
principal amount of 6.25% Convertible Subordinated Notes due on January 15,
2011. The 2011 Notes bear interest at a rate of 6.25% per annum, payable
semi-annually, and are convertible into shares of common stock at a conversion
price of $13.89 per share. The Company used a portion of the proceeds of this
note offering to pay down its variable bank notes payable. The pay down of its
variable borrowings reduced the Company's interest rate risk.
Financial Instruments by Expected Maturity Date
Notes Payable
Year Ending Variable Average Variable Fixed Average Fixed
December 31 Rate ($) Interest Rate Rate ($) Interest Rate
----------- ---------- -------------- ------------- --------------
2004 (remaining) $ -- 1.82% $ -- --
2005 440,000 1.82% -- --
2006 440,000 1.82% -- --
2007 440,000 1.82% -- --
2008 440,000 1.82% -- --
Thereafter 2,245,000 1.82% 40,250,000 6.25%
--------- -------------
Total $4,005,000 1.82% $ 40,250,000 6.25%
Fair Value $4,005,000 1.82% $ 40,250,000 6.25%
Interest Rate Swaps
Year Ending Variable Average Average
December 31 Rate ($) Pay Rate Receive Rate
----------- ---------- -------- -------------
2004 (remaining) $ 676,470 4.90% 1.98%
2005 2,029,420 4.90% 1.98%
2006 -- -- --
2007 -- -- --
2008 -- -- --
Thereafter -- -- --
--------
Total $2,705,890 4.90% 1.98%
Fair Value $ (43,977)
30
ITEM 4
CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company's management, including the Company's President and Chief Executive
Officer, Executive Vice President, Chief Financial Officer and Treasurer,
conducted an evaluation as of September 30, 2004 of the effectiveness of the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and
Rule 15d-15(e)). Based on that evaluation, the President and Chief Executive
Officer, Executive Vice President, Chief Financial Officer and Treasurer
concluded that the disclosure controls and procedures were effective in ensuring
that all material information required to be disclosed in the reports the
Company files and submits under the Securities and Exchange Act of 1934 has been
made known to them on a timely basis and that such information has been properly
recorded, processed, summarized and reported, as required.
CHANGES IN INTERNAL CONTROLS
There have been no significant changes in the Company's internal controls over
financial reporting during the most recent fiscal quarter that materially
affected, or are reasonably likely to materially affect, the Company's internal
controls over financial reporting.
SARBANES-OXLEY SECTION 404 COMPLIANCE
Section 404 of the Sarbanes-Oxley Act of 2002 (the "Act") will require the
Company to include an internal control report from management in its Annual
Report on Form 10-K for the year ended December 31, 2004 and in subsequent
Annual Reports thereafter. The internal control report must include the
following: (1) a statement of management's responsibility for establishing and
maintaining adequate internal control over financial reporting, (2) a statement
identifying the framework used by management to conduct the required evaluation
of the effectiveness of the Company's internal control over financial reporting,
(3) management's assessment of the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004, including a statement
as to whether or not internal control over financial reporting is effective, and
(4) a statement that the Company's independent public accounting firm has issued
an attestation report on management's assessment of internal control over
financial reporting.
Management acknowledges its responsibility for establishing and maintaining
internal controls over financial reporting and seeks to continually improve
those controls. In addition, in order to achieve compliance with Section 404 of
the Act within the required timeframe, the Company has been conducting a process
to document and evaluate its internal controls over financial reporting since
2003. In this regard, the Company has dedicated internal resources, hired
additional staff, engaged outside consultants and adopted a detailed work plan
to: (i) assess and document the adequacy of internal control over financial
reporting; (ii) take steps to improve control processes where required; (iii)
validate through testing that controls are functioning as documented; and (iv)
implement a continuous reporting and improvement process for internal control
over financial reporting. The Company believes its process for documenting,
evaluating and monitoring its internal control over financial reporting is
consistent with the objectives of Section 404 of the Act.
During 2004, the Company continued to document, evaluate and commenced testing
of its internal controls. The Company's documentation and testing to date have
identified certain gaps in the documentation, design and effectiveness of
internal controls over financial reporting that the Company is in the process of
remediating. Given the risks inherent in the design and operation of internal
controls over financial reporting, the Company can provide no assurance as to
its, or its independent public accounting firm's conclusions at December 31,
2004 with respect to the effectiveness of its internal controls over financial
reporting.
It should be noted that any system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
objectives of the control system are met. In addition, the design of any control
system is based in part upon certain assumptions about the likelihood of future
events. Because of these and other inherent limitations of control systems,
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions, regardless of how remote.
31
PART II - OTHER INFORMATION
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds.
On August 11, 2004, the Company issued 72,278 shares of its common stock, par
value $0.75 per share to 90 Degrees, Inc. as a portion of the consideration for
the Company's acquisition of the assets of 90 Degrees, Inc. Such shares of
common stock were issued without registration under the Securities Act of 1933,
as amended, in reliance on the exemption from the Securities Act's registration
requirements provided by Section 4(2) of the Securities Act for transactions not
involving any public offering.
Item 6: Exhibits.
Exhibits -
31.1 Certification by Mr. Martin Roenigk, Chief Executive Officer pursuant to
Rule 13a-14(a), filed herewith.
31.2 Certification by Mr. Geoffrey F. Feidelberg, Chief Financial Officer
pursuant to Rule 13a-14(a), filed herewith.
32.1 Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002, 18
U.S.C. Section 1350, for Mr. Martin Roenigk, Chief Executive Officer, filed
herewith.
32.2 Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002, 18
U.S.C. Section 1350, for Mr. Geoffrey F. Feidelberg, Chief Financial
Officer, filed herewith
32
SIGNATURE
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.
COMPUDYNE CORPORATION
Date: November 8, 2004 /s/ Martin Roenigk
-------------------------
Martin Roenigk
Chief Executive Officer
/s/ Geoffrey F. Feidelberg
---------------------------
Geoffrey F. Feidelberg
Chief Financial Officer
33