UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009
Commission File #0-6072

EMS TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code: (770) 263-9200

Securities registered pursuant to Section 12(b) of the Act:

 

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

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act: Yes o No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act: Yes o No x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K: o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act: Large accelerated filer  o  Accelerated filer  x
Non-accelerated filer  o   Smaller reporting company  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes o No x

 

The aggregate market value of voting stock held by persons other than directors or executive officers as of July 2, 2009 was $315 million, based on a closing price of $20.87 per share. The basis of this calculation does not constitute a determination by the registrant that all of its directors and executive officers are affiliates as defined in Rule 405.

 

As of March 26, 2010, the number of shares of the registrant’s common stock outstanding was 15,248,681 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information contained in the Company’s definitive proxy statement for the 2010 Annual Meeting of Shareholders of the registrant is incorporated herein by reference in Part III of this Annual Report on Form 10-K.

 

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EMS TECHNOLOGIES, INC. AND SUBSIDIARIES

FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2009

TABLE OF CONTENTS

 

 

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FORWARD-LOOKING STATEMENTS

 

The discussions of the Company’s business in this Report, including under the caption “Business”,“Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7, and in other public documents or statements that may from time to time incorporate or refer to these disclosures, contain various statements that are, or may be deemed to be, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “plan,” “expect,” “believe,” “anticipate,” “estimate,” “will,” “should,” “could” and other words and terms of similar meaning, typically identify such forward-looking statements. Forward-looking statements include, but are not limited to:

 

1. statements about what the Company or management believes or expects,

 

 

3. statements about potential or anticipated benefits of recent acquisitions,

 

4. statements about trends in markets that are served or pursued by the Company,

 

 

6. statements about the Company’s plans for product developments or market initiatives.

 

These statements are based on assumptions and analyses made by us in light of our experience and our perception of historical trends, current conditions and expected future developments, as well as other factors we believe are appropriate under the circumstances. Actual results could differ materially from those suggested in any forward-looking statements as a result of a variety of factors, including those risks and uncertainties set forth under Risk Factors in Item 1A. You should not place undue reliance on these forward-looking statements. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to these forward-looking statements to reflect events or circumstances that occur or arise or are anticipated to occur or arise after the date of this Report except as may be required by law.

 

 

In this report, unless the context otherwise requires, “we,” “us,” “our,” and the “Company” refer to the continuing operations of EMS Technologies, Inc. and its consolidated subsidiaries. Unless otherwise indicated, all financial and statistical information pertains solely to our continuing operations.

 

We are a leading provider of wireless connectivity solutions addressing the enterprise mobility, communications-on-the-move, tracking and in-flight connectivity markets for both commercial and government users. We focus on the needs of the mobile information user and the increasing demand for wireless broadband communications. Our products and services enable communications across a variety of coverage areas, ranging from global to regional to within a single facility.

 

During 2009, our business operated in three segments, Communications & Tracking, LXE and Defense & Space (“D&S”). In early 2010, we realigned our business segments for strategic growth and replaced Communications & Tracking with two new segments, Aviation and Global Tracking (see the section “Our New Segment Structure as of 2010” below for additional information). Each of our segments is focused on a different application of wireless technology. These segments share a common foundation in broadband and other advanced wireless technologies, which provides important technical and marketing synergies and contributes to our ability to continually develop and commercialize new products for use in a wide array of mobile communications. Our business provides product solutions and services that enable aviation in-cabin wireless and satellite-based connectivity, security, vehicle and maritime tracking, and military radar/space and

 

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communication-on-the-move applications. We also provide product solutions and support services for use in supply chain management networks for warehousing, distribution and ports, as well as new markets such as field services and agriculture.

 

Founded in 1968 as Electromagnetic Sciences, we initially concentrated on microwave components, products and technology and subsequently developed subsystems for one of the first electronically steerable antennas deployed in space. The expertise and technology we have developed during the past 41 years in this original business remain directly applicable to a range of our current defense and commercial products, including products for satellite, ground and airborne communications, as well as radar, signal intelligence and electronic countermeasure systems.

 

In the early 1980’s, we developed a line of wireless mobile computers and local-area network products for use in materials-handling applications. These products enable our industrial customers to connect mobile employees to central data networks and take advantage of sophisticated enterprise software and automatic-identification technologies such as bar-code scanning and voice recognition.

 

Beginning in the mid-1990’s and continuing through to present day, we have expanded into several new markets through the development or acquisition of additional product lines. We have established an industry-leading position in the market for high-speed, two-way satellite communications solutions for use on aircraft and other mobile platforms, and we develop and market antennas and terminals and support services for use by search-and-rescue and emergency management organizations around the world.

 

Today, our connectivity and tracking offerings serve the aeronautical, defense, maritime, commercial space and auto-identification/data capture markets making possible mobility, visibility and intelligence. For example, our Communications & Tracking segment supplies both high- and low-speed data communications equipment, which enable voice, e-mail, tracking, video conferencing and Internet capabilities on aircraft. Our D&S segment provides data links, radar and Satcom systems to give the military real-time intelligence integrated across naval, ground and air platforms. Our Communications & Tracking segment also provides the capability to track, monitor and control remote assets, regardless of whether they are fixed, semi-fixed or mobile. More than 18 governments worldwide rely on this segment’s software and hardware for search and rescue applications. Our LXE segment develops supply chain logistics solutions with our wireless network infrastructure and rugged mobile computers.

 

Technological Leadership

 

Since our founding in 1968, we have been an innovative leader in the development and commercialization of wireless communications technologies. Early in our history, we pioneered the use of ferrite materials for electronic beam forming, a practice that remains important in many sophisticated defense communications applications. Our more recent innovations include the following products, which we believe were the first in their respective markets: airborne terminals and antennas for high-speed, two-way data transmission via satellite for the communication of voice and data in the military, business and air transportation markets; airborne computer and networking systems; antenna systems allowing commercial airlines to provide satellite television to passengers, and satellite anti-jam systems to protect commercial communication satellites from jamming and transponder hijackings.

 

Commitment to Research and Development

 

We continually devote significant resources to research and development that enhances and maintains our technological advantages, and enables us to overcome the substantial technical barriers that are often encountered in the commercialization of sophisticated wireless communications equipment. Over the past three years, we have invested an aggregate of $58 million in company-sponsored research and development. In addition, our work under government and commercial contracts for new wireless communications equipment often leads to innovations that benefit us on future contracts and product development efforts. Approximately 25% of our employees hold engineering degrees, and our engineers actively participate in professional and

 

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industry technical conferences and working groups. As of December 31, 2009, our personnel have been awarded, and have assigned to us, 62 currently active U.S. patents and 28 foreign patents. In addition, as of December 31, 2009, we had pending applications for approximately 18 U.S. and 18 foreign patents covering various technology improvements and other current or potential products.

 

Technological Synergies

 

Although we conduct our businesses through separately managed segments, we have established a variety of processes that facilitate technical exchanges and cooperation among them. Our shared knowledge base and core expertise in wireless technologies create synergies among our various businesses. We believe this provides us advantages in research and development, manufacturing, and sales and marketing, and better positions us as an important supplier of connectivity and tracking systems and services to a diverse base of military and commercial customers. An example is the technical collaboration of engineering teams within our Aviation business to bring to market a new in-flight connectivity service that uses the Iridium network to reliably provide e-mail access to any WiFi-enabled smartphone or PDA.

 

Strong Customer Relationships

 

During our 41 years of operation, we have developed cooperative and on-going relationships with important commercial and government customers. We build and strengthen these relationships by anticipating and recognizing our customers’ needs, by working with them to understand how we should focus our internal innovation efforts, and by providing customers with technologically advanced and cost-effective solutions coupled with excellent customer service. We continue to receive important orders and contracts from companies that have been our customers or industrial partners for many years. Within the Communications & Tracking segment, those firms include Airbus, Rockwell Collins, Honeywell, Panasonic Avionics and Aircell.

 

We are particularly proud of our industry recognition, including a Silver Supplier Award from Northrop Grumman Space Systems and seven MobileStar Awards given to our LXE segment for customer service excellence, voted on by industry decision makers. The LXE segment also has been awarded “Best Channel Vendor” by Business Solutions magazine.

 

Diverse Global Customer Base

 

We offer multiple wireless product lines to a diverse customer base through facilities in 13 countries. Sales to no individual customer exceeded more than 10% of our annual net sales during any of the years ended December 31, 2008 or 2007. Sales to one of our customers during the year ended December 31, 2009 exceeded 10% of our annual net sales, with sales of $37.9 million, mainly due to a significant order received by our D&S segment that is not expected to reoccur. Sales to various customers for U.S. government end use accounted for 29.7% of our net sales in 2009, 26.3% of our net sales in 2008 and 24.6% of our net sales for 2007. Additionally, 29.8%, 39.6% and 38.8% of our net sales for 2009, 2008 and 2007, respectively, were derived from sales to customers outside the U.S. We believe our geographically diverse customer base and broad range of products provide us ample opportunity to grow our business and help mitigate the effects of a downturn in any one of our markets.

 

Strong Manufacturing Capabilities

 

We manufacture certain of our products in our manufacturing facilities, and for others, we source components from foreign and domestic suppliers, and primarily perform final assembly and test functions. For our defense applications, we have developed our own highly specialized domestic manufacturing capabilities. Through our continuous efforts to improve our manufacturing and sourcing processes, we have dramatically reduced the time required for us to ship products in several of the commercial markets in which a short delivery cycle for custom-manufactured products is an important competitive factor. We have also achieved major reductions in rework on highly engineered space and defense products. These efforts have enhanced our ability to compete for new business and improved our profitability.

 

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Our business is the design, manufacture and sale of advanced wireless communications products. We participate in selected markets within the broad wireless communications industry that typically require a high level of technical expertise, innovative product development and, in many cases, specialized manufacturing capabilities. Although our businesses share a common heritage and focus on wireless communications, they address a variety of markets with different technical and manufacturing requirements, distribution channels, customers and purchasing processes.

 

Accordingly, through 2009, we were organized into three separately managed reporting segments, as follows:

 

 

Communications & Tracking

 

The Communications & Tracking segment was previously reported as the Satellite Communications segment. The Communications & Tracking segment includes our SATCOM business, and the Sky Connect business acquired in August 2008, and the Formation and Satamatics businesses that were acquired in January and February 2009, respectively. In early 2010, we realigned our business segments for strategic growth and replaced Communications & Tracking with two new segments, Aviation and Global Tracking. A summary of the products and services offered by this segment, their key benefits and features, as well as the markets and customers that it serves are summarized by the new Aviation and Global Tracking businesses as follows:

 

 

 

Aviation

 

The Aviation segment includes SATCOM’s aeronautical business, and the Sky Connect and Formation businesses, which were acquired in August 2008 and January 2009, respectively. Aviation designs and develops satellite-based communications solutions through a broad array of terminals and antennas for the aeronautical market. The segment also builds in-cabin connection devices and computers to process data on board aircraft, including rugged data storage, airborne connectivity, air-to-ground connectivity, and data recording and replay equipment.

 

Aviation’s products enable customers in aircraft and other mobile platforms to communicate over satellite networks at a variety of data speeds. Most of its growth and major product expansions in these markets have occurred since 2004. Its equipment is used to safeguard and monitor cargo, personnel and fleet assets in some of the harshest environments of the world and for emergency management services.

 

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The demand for mobile communications has driven the rise of aero-connectivity system use on business and commercial jets around the world. EMS continues to lead the industry as a key supplier of Inmarsat Swift64 and SwiftBroadband products that support airborne communications at DSL speeds, as well as Iridium-based messaging and tracking for airplanes and helicopters. Aviation’s high-speed data terminals, antennas and networking products are designed for use in the aeronautical market. We believe that we are the top supplier of Swift64 high-speed data communications equipment, garnering more than an estimated 75% of the high-speed data Satcom market for military aircraft. Aviation’s eNfusion Broadband^tm line of aeronautical products enable voice, e-mail, videoconferencing and internet capabilities on a broad variety of aircraft. Aviation directly sells equipment and technology under the Forté, eNfusion and Fleet brand names, and also sells indirectly as a supplier to leading airframe and avionics manufacturers and other aviation players. Aviation customers include Fortune 100 companies and the U.S. Government’s VIP Fleet, as well as the United States’ leading airborne emergency medical service transport, air taxi, airborne firefighting and offshore oil transport companies.

 

In the air transport market, Aviation delivers its equipment and technology through partners such as Panasonic Avionics, Aircell, OnAir, Aeromobile Row44, and LiveTV. Aviation’s equipment and technology enables in-flight connectivity on more than 40 airlines, including Lufthansa, Delta Air Lines, Airtran, Continental, Emirates, Air France, Ryanair, and TAP, to name a few. In the aviation market, Aviation’s terminals, antennas and networking equipment provide a globally capable solution for a broad variety of aircraft. One variant provides office-like communications capabilities to the cabin while providing critical safety communications capabilities to the cockpit. Aviation’s CNX^® Cabin Gateway family of networking products is widely used for airborne networking equipment, and variations of this product line offer compression and acceleration of data, which significantly reduces the user’s airtime costs. Aviation’s antennas are mounted on the fuselage or on the tail to accommodate a variety of aircraft, including the Bombardier Global Express, Dassault Falcon 7X, Gulfstream G550, and Airbus A320. More than 1,300 of Aviation’s antennas have been installed on more than 35 different types of aircraft. Aviation also sells an antenna specifically for military use. This antenna is mounted in the forward hatch of a C-130 military cargo aircraft and, when connected to the transceiver, provides instant communications that can be rolled on and off the aircraft.

 

Aviation markets and sells most of its hardware through distributor channels. Third-party distributors sell directly to end — users, such as the aircraft manufacturers. One of Aviation’s most significant distribution

 

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channels relates to technology components or avionics terminal systems sold through leading airframe and avionics manufacturers, including Boeing, Airbus, Honeywell, Rockwell Collins, and Thales.

 

 

Global Tracking

 

Global Tracking includes the asset tracking and emergency management operations of our SATCOM business, and the Satamatics business which was acquired in February 2009. Global Tracking provides the capability to track, monitor and control remote assets, regardless of whether they are fixed, semi-fixed or mobile. One of only two IsatM2M providers in the world and backed by a dedicated global network, the Global Tracking segment has in excess of 150,000 terminals delivered to date. Its equipment is used to safeguard and monitor cargo, personnel and fleet assets in some of the harshest environments of the world. Additionally, SATCOM is the leading provider of ground segment equipment for the Cospas-Sarsat search and rescue system and incident management software for rescue coordination worldwide with more than 75% market share. Global Tracking revenues are derived from both product sales and recurring airtime and support services. In 2009, more than half of this segment’s revenue came from the services side of the business.

 

Tracking terminals are sold in three vertical markets — security, land tracking and maritime. The segment also offers end-to-end solutions in the various markets with the inclusion of its applications, systems integration, including tracking and mapping, multi-network communication gateways and communication devices. These products and services are sold to military for Blue Force Tracking systems used by NATO, and in the transport trucking market predominantly in the Americas, Africa and the Middle East. It provides critical logistics support to coalition forces in Afghanistan and Iraq.

 

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Global Tracking markets and sells most of its equipment and services through its value-added-reseller network, and directly markets its emergency management products to end-user organizations in governments worldwide.

 

 

LXE

 

LXE’s rugged terminals and wireless wide-area networks (“WWAN”) have been installed at more than 7,500 sites worldwide, including the facilities of many Fortune 500 companies and some of the world’s largest materials-handling installations. In 2009, 2008 and 2007, approximately 51%, 56% and 55% of LXE’s net sales were generated outside the U.S., respectively.

 

A typical LXE system consists of mobile terminals that incorporate WLAN radios, automatic-identification capabilities, network access points that provide a radio link to the wired network and associated host computers, and software that manages and facilitates the communications process. LXE’s systems generally incorporate barcode scanning or other automatic-identification capabilities, and are primarily based on the 802.11 open system standards. Uses of these systems include employment of real-time data communications in directing and tracking inventory movement in a large warehouse, manufacturing facility, or container yard.

 

In 2009, LXE began placing greater emphasis on markets outside these core warehousing, manufacturing and intermodal markets. The introduction of the ultra-rugged MX9 handheld computer, which supports WWAN in a terrestrial cellular network, and the addition of WWAN support in the VX8 and VX9 vehicle-mount computers, are the first steps to migrate the product line in this direction. These products allow LXE to sell into a wider range of potential markets including field service, transportation, forestry, agriculture, mining, utilities and public safety. LXE also began shipping a custom version of the MX9 to Itron, the leading worldwide provider of utility meters and the systems used to read them, for use in their meter reading applications. This gives LXE a significant position in the tough outdoor data collection application. LXE products normally are used in conjunction with IT infrastructure products provided by others, such as host computer systems and inventory-management or other applications software.

 

LXE generally designs and manufactures the mobile computers it sells for use in wireless systems. In addition, LXE sells certain handheld models that it jointly designed with original equipment manufacturers. LXE’s computers are grouped into three product families: handheld units, hands-free units that can be worn on the

 

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wrist or hip and operated using a keypad or voice and units that are mounted on a forklift, truck or other vehicle. LXE has also developed “hybrid” units, which easily detach from vehicle-mounting hardware to operate as a handheld device. All are ruggedized to withstand harsh conditions in warehouses, port facilities and outdoor environments. The latest generation of mobile computers has significantly more computing power than previous models, supports the Windows^® and Windows CE^® operating systems, and offers improved power-management features and superior ergonomics. Radio access points and other infrastructure products are generally acquired from third parties for resale and installation by LXE. With the acquisition of Akerstroms Trux AB, LXE has expanded its product offerings to include mobile computers for warehouse and production environments that support the Windows XP^® operating systems.

 

Over the past several years, LXE has made a substantial commitment to the use of alternative auto-identification technologies, including imaging, voice recognition, and mobile RFID, in the execution of distribution tasks. Innovations include implementation of voice-directed applications on LXE’s entire Windows CE product line through the use of sophisticated audio controls and noise reduction techniques, development of a standards-based wearable computer to enable hands-free picking and other warehousing functions, and integration of Bluetooth^® technology in demanding industrial environments.

 

In conjunction with several supply chain execution software partners, LXE has also developed concepts for the concurrent use of these technologies, which have the potential to make warehouse activities much more efficient. LXE has been recognized by leading industry analysts for its thought leadership in distribution operations.

 

Equipment is marketed directly to end-users and through distributors, and integrators (such as value-added resellers who provide inventory management software) that incorporate it with their products and services for sale and delivery to end users.

 

 

Defense & Space

 

D&S principally develops advanced microwave-based RF systems for a broad range of military and defense electronics applications. D&S provides military and defense customers with critical RF systems and subsystems for terrestrial, airborne and space-based communication; radar and electronic warfare systems; and advanced surveillance, electronic counter-measure and secure communications capabilities.

 

D&S products are also used in a number of commercial and civil ventures. D&S products are sold primarily to space and defense prime contractors or commercial communications systems integrators rather than to end-users, and are deployed on airborne, naval, terrestrial and space platforms.

 

Defense markets are vital to D&S. Secure communications as well as intelligence and surveillance systems are being developed or significantly upgraded as a part of the U.S. Department of Defense’s initiatives to

 

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transform military communications and to achieve “information dominance” over adversaries. D&S also performs research and development services directly for the U.S. Department of Defense. Our D&S facilities meet requirements for performing on classified military programs, including special access, military programs, and over 250 of our personnel hold Department of Defense security clearances.

 

 

Additional information regarding our revenues, earnings and total assets for each of our reportable operating segments, and the revenues and assets for each major geographic area for 2009, 2008 and 2007, is included in Note 5 of our consolidated financial statements included immediately following the signature page to this Annual Report on Form 10-K.

 

Formation

 

We acquired Formation, Inc. (“Formation”) of Moorestown, NJ on January 9, 2009. Formation has approximately 110 employees and designs and manufactures equipment and software products and provides related engineering services for the defense, aviation, data communications and transportation industries. Its products include rugged hard disks, advanced integrated recorders, avionics-class servers, and rugged wired and wireless networks. Formation’s fastest-growing products are its rugged servers and cabin Wireless Access Points (“WAP’s”), which enable aircraft broadband systems to extend connectivity to laptops and personal digital assistants (“PDA’s”). Formation’s equipment supports in-flight communications regardless of whether the connectivity is through terrestrial or satellite-based networks. Formation is an approved direct supplier to Airbus and also is a major supplier to Rockwell Collins, Aircell and Panasonic. Formation and other EMS businesses have common supplier relationships and complementary customer bases in the avionics, defense and transportation markets.

 

Acquiring Formation signalled our continued investment in its aero-connectivity strategy to become a more comprehensive solutions provider. Our goal is to meet the growing demand for aeronautical communications from airlines and business aircraft owners, as well as governments. With Formation, we cover the spectrum of air-connectivity solutions, delivering the platforms and systems that airlines can use across multiple satellite platforms. Since its acquisition, Formation’s financial results have been included in our Communications & Tracking segment. In 2010, its financial results will be included in our newly formed Aviation segment.

 

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Satamatics

 

Satamatics Global Limited (“Satamatics”) was acquired on February 13, 2009. Satamatics has approximately 50 employees and is a global telematics company, providing customized, end-to-end tracking and monitoring solutions that will work anywhere in the world. Operating with Inmarsat’s IsatM2M satellite service, Satamatics enables land transport, security, maritime and oil and gas organizations to locate, track and communicate with mobile assets, to safeguard fleets, cargo and personnel, and to monitor fixed assets in the world’s most hostile and remote areas. Founded in 2001, Satamatics has an extensive worldwide distribution network of value-added resellers, but also supplies direct to end users complete tracking and monitoring solutions (equipment, airtime and mapping) for land transport, oil and gas, and maritime industries.

 

The Satamatics acquisition complements our existing Iridium- and Inmarsat-based tracking solutions. Acquiring Satamatics extended our satellite capabilities into the growing M2M market using low-cost satellite data terminals, and further strengthened EMS as a market leader in satellite-based applications for tracking people and assets worldwide. We anticipate significant synergies with our current satellite-based helicopter and military-vehicle tracking businesses. In particular, we expect promising growth for security and logistics applications in the road transport market, particularly in South America, Africa and the Middle East. Since its acquisition, Satamatics’ financial results have been included in our Communications & Tracking segment. In 2010, its financial results will be included in our newly formed Global Tracking segment.

 

With these acquisitions, we believe we have the capabilities to adapt products and technologies from one aero-connectivity application to another, enabling us to get to market faster and more profitably than companies entering the market today.

 

Akerstroms Trux

 

We acquired Akerstroms Trux AB (“Trux”) of Bjorbo, Sweden in February 2008. At that time, Trux had approximately 20 employees. Trux was an international company with focus on development, sales and marketing of robust and reliable vehicle-mount computing solutions for warehousing and production environments in the Nordic region. The acquisition of Trux brought us a new, market-ready Windows XP-based product line targeted at customers running advanced wireless applications in demanding warehousing and production environments. Since its acquisition, Trux’s product line, manufacturing process, employees and financial results have been integrated into our LXE operating segment.

 

Sky Connect

 

We acquired Sky Connect, LLC (“Sky Connect”) of Takoma Park, MD in August 2008. Sky Connect has approximately 20 employees and offers a range of satellite-based tracking, text messaging, and telephone systems for airborne, ground-based, and marine applications in both the commercial and government markets. Sky Connect provides automated flight tracking with true worldwide coverage. Aircraft phone systems support headset interfaces plus corded or cordless handsets. Sky Connect uses the Iridium satellite network for complete earth coverage and mission effectiveness.

 

Sky Connect’s innovative and flexible offering provides 100 percent global coverage on the Iridium satellite network and continues to lead the industry in the development of integrated Machine-to-Machine (“M2M”) and voice applications. Iridium is the platform of choice for tracking of aviation, marine and land-mobile assets on the move, with over 50,000 M2M data units deployed.

 

Acquiring Sky Connect complemented our aero-connectivity strategy by adding Iridium hardware and a services business targeting the growing general aviation market. In addition, Sky Connect’s efforts with Qantas, Air New Zealand and El Al paralleled our similar expansion into the air transport market. Since its acquisition, Sky Connect’s financial results have been included in our Communications & Tracking segment. In 2010, its financial results will be included in our newly formed Aviation segment.

 

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Communications & Tracking markets its products and services to a variety of customers including major airframe manufacturers, avionics original equipment manufacturers (“OEM”), aircraft operators and owners. It provides products and solutions through key integrators, a network of completion centers that install aeronautical products and value-added resellers.

 

LXE markets its products and services through distributors, integrators (such as value-added resellers who provide inventory management software) that incorporate it with their products and services for sale and delivery to end users and directly to end users. LXE also markets its products and services across North America and through eight international subsidiaries (seven in Europe) through a direct sales force, all assisted by inside sales and sales support staff, and through independent marketing representatives.

 

Our D&S unit produces highly technical products that are often co-engineered with the customer. For these products, internal personnel with strong engineering backgrounds conduct significant sales efforts. D&S also utilizes independent marketing representatives, both in the U.S. and internationally, selected for their knowledge of local markets and their ability to provide technical support and on-going, direct contact with current and potential customers. The development of major business opportunities for D&S often involves significant bid-and-proposal effort. This work often requires complex pre-award engineering to determine the technical feasibility and cost-effectiveness of various design approaches.

 

The markets for space and defense electronics comprise a relatively small number of large customers, which are typically first or second-tier contractors. Our D&S marketing efforts rely on on-going communications with this base of potential customers, to determine customers’ future needs and to inform customers of our capabilities and recent developments. Technical support and service after the sale are also important factors that affect our ability to maintain strong relationships and generate additional sales.

 

We spent $18.7 million, $20.1 million and $18.8 million in 2009, 2008 and 2007, respectively, on company-sponsored research and development. In addition, our work under government and commercial contracts for new wireless communications hardware creates new intellectual property that we own, which often leads to innovations that benefit us on future contracts and product development efforts; most of the costs for this work are included with the overall manufacturing costs for specific orders.

 

We use both patents and trade-secret procedures to protect our technology and product development efforts. With respect to patents, as of December 31, 2009, we owned 62 currently active U.S. patents, expiring 2011 through 2027, and 28 foreign patents expiring 2012 through 2022. We do not expect that any impending patent expirations to have a material effect on our business. In addition, as of December 31, 2009, we had pending applications for approximately 18 U.S. and 18 foreign patents, covering various technology improvements and other current or potential products. While we expect to continue to expand our patent activities, we also believe that many of our processes and much of our know-how are more efficiently and effectively protected as trade secrets, and we seek to maintain that protection through the use of employee and third-party non-disclosure agreements, physical controls and need-to-know restrictions.

 

In some cases, we rely on licenses from third parties under patent rights that could otherwise restrict our ability to market significant products. The principal instances of such licenses involve the integration of bar code scanners in certain LXE terminals under license from Motorola, and the development and sale of laser and imager-based products by LXE under license from Intermec Corporation (“Intermec”). In each case, the licenses are non-exclusive, and are noncancelable for the lives of the relevant patents except upon default by us.

 

The backlog of firm orders related to continuing operations as of December 31, 2009, was $178.2 million, compared with $185.9 million as of December 31, 2008. We had $155.7 million of funded backlog and

 

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$22.5 million of unfunded backlog as of December 31, 2009, as compared with $137.5 million of funded backlog and $48.4 million of unfunded backlog as of December 31, 2008.

 

Backlog is very important for our D&S segment due to the long delivery cycles for its projects. The backlog for D&S as of December 31, 2009 was $89.6 million compared with $114.9 million as of December 31, 2008. Many customers of our LXE segment typically require short delivery cycles. As a result, LXE usually converts orders into revenues within a few weeks, and it generally does not build up a significant order backlog that extends substantially beyond one fiscal quarter except for annual or multi-year maintenance service agreements. Our Communications & Tracking segment has projects with both short delivery cycles, and delivery cycles that extend beyond the next twelve months. Of the orders in backlog as of December 31, 2009, the following are expected to be filled in 2010: Communications & Tracking — 70%; LXE — 80%; and D&S — 50%. LXE’s backlog as of December 31, 2009 was nearly double that of December 31, 2008 mainly due to a shortage of certain component parts from LXE’s suppliers which caused a delay in the fulfillment of LXE’s orders received late in 2009. LXE is working closely with suppliers to identify and implement ways to resolve the sourcing issues. LXE is expecting to increase critical parts inventories in 2010 to avoid further delays.

 

We have manufacturing operations in five facilities; four in the U.S., and one in Canada. We manufacture certain of our products in our manufacturing facilities, and for others, we source components from foreign and domestic suppliers, and primarily perform final assembly and test functions. For our defense applications, we perform extensive manufacturing operations, including the production of advanced integrated electronic circuitry, the formulation and fabrication of unique ferrite-based ceramic materials, and precision machining. Our manufacturing strategy is:

 

 

 

All of our production activities have been ISO 9001:2000 certified, and are AS9100 certified where applicable. Our facilities, equipment and processes enable us to meet all quality and process requirements applicable to our products under demanding military and space hardware standards, and we are also certified by the U.S. Federal Aviation Administration and Transport Canada to manufacture equipment for installation on commercial aircraft.

 

We believe we have adequate sources for the supply of raw materials and components for our manufacturing and service needs. Electronic components and other raw materials used in the manufacture of our products are generally available from several suppliers. However, LXE systems include barcode scanners in almost all orders, and a significant number of the scanners are purchased from an LXE competitor, Motorola. There are alternative suppliers that manufacture and sell barcode scanners, either independently or under license agreements with Motorola. We believe that many of LXE’s competitors also rely on scanning equipment purchased from or licensed by Motorola. In addition, LXE has a license agreement with Motorola that allows us to utilize Motorola’s patented integrated scanning technology in certain products.

 

Our advanced technology products often require sophisticated subsystems supplied or cooperatively developed by third parties having specialized expertise, production skills and economies of scale. Important examples include critical specialized components and subsystems required for successful completion of certain D&S

 

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programs, and application-specific integrated circuitry and computers incorporated into LXE products. In such cases, the performance, reliability and timely delivery of our products can be heavily dependent on the effectiveness of those third parties.

 

Materials used in D&S products consist of magnetic microwave ferrites, metals such as aluminum and brass, permanent magnet materials and electronic components. Most of the raw materials for the formulation of magnetic microwave ferrite materials are purchased from two suppliers, while permanent magnet materials and space-qualified electronic components are purchased from a limited number of suppliers. Other electronic components and metals are available from a larger number of suppliers and manufacturers.

 

We believe that the loss of any supplier or subassembly manufacturer would not have a material adverse effect on our business as a whole. Generally, shortages of supplies and delays in the receipt of necessary components have not had a material adverse effect on shipments of our established products, although in 2009 we did encounter delays in supplies of certain component parts needed to fill pending orders at LXE, a situation that we believe reflected temporary capacity reductions in response to the slow economy rather than a longer-term capacity reductions. In addition, from time to time the rollout of new standard products and our performance on certain programs at our D&S and Communications & Tracking segments have been adversely affected by quality and scheduling problems with developers/suppliers of critical subsystems. In some cases, these problems have resulted in significant additional costs to us and in difficulties with our customers. Such problems could have a material adverse effect on us if they recur in the future.

 

We believe that each of our reportable segments is an important supplier in our principal markets. However, these markets are highly competitive, and some of our competitors have substantial resources that exceed ours. We also compete against smaller, specialized firms.

 

In Communications & Tracking’s markets, our competitors include Thrane & Thrane, Chelton, Ltd., Tecom, Qualcomm, and VP Miltope. LXE’s principal competitors include Intermec, Motorola, and Psion Teklogix. D&S competes with specialized divisions of large U.S. industrial concerns, such as Boeing, Lockheed Martin, L3 Communications, DRS Technologies, Inc., Northrop Grumman, Harris Corporation and BAE, as well as with companies outside the U.S., such as COMDEV. Some of these companies, as well as others, are both potential competitors for certain contracts and potential customers on other contracts. In addition, D&S occasionally experiences competition from existing or potential customers when these customers choose to develop and manufacture products internally rather than purchasing them from us.

 

We believe that the key competitive factors in all of our reportable segments are product performance (including quality and reliability), technical expertise and on-going support to customers, time-to-market, time-to-ship and adherence to delivery schedules and price.

 

As of December 31, 2009, we had approximately 1,300 employees. Approximately 55% of our personnel are directly involved in engineering or manufacturing activities. No employees are represented by a labor union. Management believes that our relationship with our employees is good.

 

Certain of our products are subject to regulation by various agencies in the U.S. and abroad. Our airborne satellite communications products used in civil aviation applications are subject to continued compliance with applicable regulatory requirements. Our airborne products sold in the U.S. are required to comply with Federal Aviation Administration regulations, and similar agencies in other countries in which those systems are sold that govern production and quality systems, airworthiness and installation approvals, repair procedures and continuing operational safety. Some of our products, such as radio frequency transmitters and receivers, must also comply with U.S. Federal Communications Commission regulations governing authorization and operational approval of telecommunications equipment.

 

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Our products used in defense applications are subject to a variety of federal regulations. Our contract costs and accounting practices are audited periodically by the Defense Contract Audit Agency. Audits and investigations are conducted from time to time to determine if the performance and administration of our U.S. Government contracts are compliant with applicable contractual terms, including federal procurement regulations and statutes which include, in many cases, security requirements related to classified military programs.

 

Our products for use in defense applications and on satellites are subject to the U.S. State Department’s International Traffic in Arms Regulations, and as a result we must obtain licenses in order to export these products or to disclose their non-public design features to persons who are not citizens or permanent residents of the United States. We have trained internal personnel to monitor compliance, to educate our personnel on the restrictions and procedures and to process license applications. The licensing process occasionally prevents us from working with suppliers outside the U.S. on European or Asian space programs, and it also affects the extent to which we can involve our engineers from foreign locations on D&S programs, or use D&S engineers and capabilities to assist our non-U.S. operations on their products or programs.

 

Greenhouse gas emissions have increasingly become the subject of a large amount of international, national, regional, state and local attention. At this time, we do not believe that existing or pending climate change legislation, regulation, or international treaties or accords are reasonably likely to have a material effect in the foreseeable future on our business or markets that we serve or on our results of operations, capital expenditures or financial position. However, the enactment of cap-and-trade proposals would likely increase the cost of energy, including purchases of electricity, and of certain raw materials that we use. In addition, future environmental regulatory developments related to climate change, whether pursuant to future treaty obligations or statutory or regulatory changes, are possible, and could increase our operating, manufacturing and delivery costs.

 

We believe that our products and business operations are in material compliance with current standards and regulations. However, governmental standards and regulations may affect the design, cost and schedule for new products. In addition, future regulatory changes could require modifications in order to continue to market certain of our products.

 

AVAILABLE INFORMATION

 

EMS Technologies, Inc. makes available free of charge, on or through its website at www.ems-t.com, its annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the Securities and Exchange Commission. Information contained on our website is not part of this report.

 

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Information concerning the executive officers of the Company is set forth below:

 

John B. Mowell, age 75, was appointed Executive Director of the Company in December 2009. He has been serving as the Chairman of the Board of the Company since 2001. Mr. Mowell is President of Mowell Financial Group, Inc., Tallahassee, FL, an investment counseling firm, and Director and Chairman of the Board of Entegrion Inc., a privately held medical technologies company. He was formerly Chairman of the Board (1981-1990) and Chief Executive Officer (1985-1989) for Reflectone, Inc., Tampa, FL, a manufacturer of aircraft flight simulators and training systems for commercial and military markets. Mr. Mowell is past Chairman of the Florida State Board of Administration’s Investment Advisory Council for the $100 billion Florida state teacher’s retirement fund; and Founding President, past Chairman and Chairman Emeritus of The Economic Club of Florida.

 

Neilson A. Mackay, age 68, became President and Chief Executive Officer of the Company in November 2009. He served as Chief Operating Officer and Executive Vice President from July 2008, and as Executive Vice President - Strategy from December 2007. From March 2007 until December 2007, he held the positions of Vice President - Corporate Development and President of SATCOM, and from 2001 to 2007, he served as Senior Vice President and General Manager of SATCOM. He joined the Company in January 1993, when the Company acquired an Ottawa, Ontario-based space satellite communications business of which he served as President.

 

Gary B. Shell, age 55, was appointed Senior Vice President, Chief Financial Officer and Treasurer of the Company in May 2008. He previously served as Vice President, Finance from November 2007 and as Vice President, Corporate Finance (2004-2007), and in those capacities was the Company’s chief accounting officer. He had served as Director, Corporate Finance from 1998 to 2004. He joined the Company in 1983 as Corporate Financial Analyst. Mr. Shell is a certified public accountant, having formerly served on the audit staff of KPMG LLP.

 

Timothy C. Reis, age 52, became Vice President and General Counsel of the Company in August 2005. He is responsible for the legal affairs of the Company and its operating subsidiaries. Mr. Reis first joined the Company in 2001 as Assistant General Counsel. Previously, he was engaged in the private practice of law with King & Spalding and as in-house counsel for United Parcel Service and for Manufacturers Hanover, a New York bank, focusing his practice on intellectual property and technology transactions.

 

David M. Sheffield, age 48, became Vice President, Finance and Chief Accounting Officer of the Company in August 2008. From 2005 until 2008, Mr. Sheffield served as Vice President, Finance and Accounting, for Allied Systems Holdings, Inc., a vehicle-hauling company providing a range of logistics and other support services to the automotive industry. From 2003 to 2005, he served as Vice President and Chief Accounting Officer for Matria Healthcare, Inc. Mr. Sheffield, a certified public accountant, also held senior accounting and finance positions with Rubbermaid, Gulfstream Aerospace and Safety-Kleen, after beginning his career with Deloitte & Touche LLP.

 

R. Nim Evatt, age 68, was appointed Vice President and General Manager of the Company’s newly formed Aviation division in January 2010. He joined the Company in January 2009 when the Company acquired Formation, Inc. of which he had served as President and Chief Executive Officer since 1998. From 1991 to 1998 he was President and Chief Executive Officer of Liberty Technologies, a provider of condition-monitoring products and services for energy industries, and he previously led General Electric Power Systems’ installation and service engineering business for Europe, Africa and the Middle East.

 

Stephen M. Newell, age 42, was appointed Vice President and General Manager of the Company’s LXE division in April 2009. He joined the Company’s SATCOM group in January 2003, and since then has been given assignments of increasing responsibilities, including appointment as Director, Military Aeronautical Sales in 2004, Vice President, Military Sales in May 2006, and Vice President, Sales from May 2006 to March 2007 at SATCOM. Prior to joining EMS, Mr. Newell was Manager of Avionics Systems at AIRIA, Inc. from

 

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November 2000 to January 2003, where he was responsible for the development of the Company’s Inmarsat-based aeronautical television system.

 

Adoption of Shareholder Rights Plan

 

On July 27, 2009, our Board of Directors adopted a Shareholder Rights Plan (the “Plan”) to replace a similar plan adopted in 1999 that expired on August 6, 2009. Under the Plan, a dividend distribution of one right for each our outstanding common shares was made to shareholders of record at the close of business on August 7, 2009. Upon the occurrence of certain triggering events, as set forth in the Plan, the rights would become exercisable.

 

 

Our business is subject to certain risks, including the risks described below. This Item 1A does not describe all risks applicable to our business and is intended only as a summary of the most significant factors that affect our operations and the industries in which we operate. More detailed information concerning these and other risks is contained in other sections of this Annual Report on Form 10-K. The risks described below, as well as the other risks that are generally set forth in this Annual Report on Form 10-K, and other risks and uncertainties not presently known to us or that we currently consider immaterial, could materially and adversely affect our business, results of operations and financial condition. Readers of this Annual Report on Form 10-K should take such risks into account in evaluating any investment decision involving our common stock. At any point, the trading price of our common stock could decline, and investors could lose all or a portion of their investment.

 

Risks Related to Our Operations

 

In addition to general economic conditions, both domestic and foreign, which can change unexpectedly and generally affect U.S. businesses with worldwide operations, we are subject to a number of risks and uncertainties that are specific to us or the businesses we operate:

 

Decisions by our customers about the timing and scope of capital spending, particularly on major programs, can have a significant effect on our net sales and earnings.

 

Each of our businesses is dependent on our customers’ capital spending decisions, which are affected by numerous factors, such as general economic conditions, end-user demand for their particular products, capital availability, and comparative anticipated returns on their capital investments. In addition, large defense programs are an important source of our current and anticipated future net sales, especially in D&S. Customer decisions as to the nature and timing of their capital spending, and developments affecting these large defense programs, can have a significant effect on us. Our net sales and earnings would decline in the event of general reductions in capital spending by our customers, or delay in the implementation of, or significant reduction in the scope of, any of the current or major anticipated programs in which we participate.

 

Unfavorable economic or financial market conditions or other developments may affect the fair value of one or more of our business units and increase the potential for additional asset impairment charges that could adversely affect our earnings.

 

As of December 31, 2009, we had approximately $60.3 million of goodwill and $49.3 million of other intangible assets on our consolidated balance sheet, collectively representing approximately 29% of our total assets. We test goodwill for impairment on an annual basis in the fourth quarter of the year. We are also required to test goodwill and other long-lived assets on an interim basis if an event occurs or circumstances change which indicate that an asset might be impaired. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include a sustained, significant decline in our share price and market capitalization, a decline in expected future cash flows for one or more of our business units (including our recently acquired businesses), a significant adverse change in legal factors or in the business climate, unanticipated competition and/or slower-than-expected growth rates, among others. We

 

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recognized an impairment loss on the goodwill of $19.9 million associated with our LXE business in 2009 (refer to Note 3 of the consolidated financial statements for additional information). Our tests in the fourth quarter of 2009 for Formation, Satamatics and Sky Connect did not indicate an impairment. However, the estimated fair values did not exceed the carrying amount by a significant amount. If we are required to recognize an additional impairment loss in the future related to goodwill or long-lived assets, the related charge, although a noncash charge, could materially reduce reported earnings or result in a loss from continuing operations for the period in which the impairment loss is recognized.

 

If our commercial customers fail to find adequate funding for major potential programs, or our government customers do not receive necessary funding approvals, our net sales would decline.

 

To proceed with major programs, such as upgrades for satellite data-communications systems, our customers typically must obtain substantial amounts of capital, from either governmental or private sources. The availability of this capital is directly affected not only by general economic conditions, but also by political developments and by conditions in the private capital markets, which at times in recent years have been very unstable. If adequate funds are not available to our targeted customers for these programs, our expected net sales may be adversely affected. Large defense programs are often funded in multiple phases, requiring periodic further funding approvals, which may be withheld for a variety of political, budgetary or technical reasons, including the effects of defense budget pressures on near-term spending priorities. Such multi-year programs can also be terminated or modified by the government in ways adverse to us and, in many cases, with limited notice and without penalty. These developments would reduce our net sales below the levels we would otherwise expect.

 

We may encounter technical problems or contractual uncertainties, which can cause delays, added costs, lost sales and liability to customers.

 

From time to time we have encountered technical difficulties that have caused delays and additional costs in our technology development efforts. We are particularly exposed to this risk in new product development efforts and in fixed-price contracts on technically advanced programs at D&S and Communications & Tracking that require novel approaches and solutions. In these cases, the additional costs that we incur may not be covered by revenue commitments from our customers, and therefore reduce our earnings. In addition, technical difficulties can cause us to miss expected delivery dates for new product offerings, which could cause customer orders to fall short of expectations.

 

Some of our products perform mission-critical functions in space applications. If we experience technical problems and are unable to adhere to a customer’s schedule, the customer could experience costly launch delays or re-procurements from other vendors. The customer may then be contractually entitled to substantial financial damages from us. The customer would also be entitled to cancel future deliveries, which would reduce our future revenues and could make it impossible for us to recover our design, tooling or inventory costs, or our remaining commitments to third-party suppliers.

 

Due to technological uncertainties in new or unproven applications of technology, our contracts may be broadly defined in their early stages, with a structure to accommodate future changes in the scope of work or contract value as technical development progresses. In such cases, management must evaluate these contract uncertainties and estimate the future expected levels of scope of work and likely contract-value changes to determine the appropriate level of revenue associated with costs incurred. Actual changes may vary from expected changes, resulting in a reduction of net sales and earnings recognized in future periods.

 

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Our products are subject to a variety of certification requirements of the Federal Aviation Administration (FAA) and the Federal Communications Commission (FCC), including stringent standards for performance, reliability and manufacturing processes. Our failure to meet any of these standards, which may involve complex testing and technical issues, could limit our ability to market these products and thereby reduce our sales and earnings. Our sales and earnings may also be adversely affected by the costs and delays associated with meeting these standards and obtaining the required certifications.

 

Products that we sell for installation on aircraft must receive approvals and certifications from the FAA, and generally must be produced in facilities that are themselves FAA-certified. In addition, many of the products we sell require FCC approval or certification before our customers are permitted to use them. The applicable standards are rigorous, can be costly to meet, and must be met on a continuing basis. The approval and certification standards for our aviation products require that we meet standards for performance and reliability, as well as for the appropriateness of products for particular aircraft types, and our facilities must meet standards for consistent and reliable production processes. FCC certification of our products requires that we demonstrate technical performance in accordance with certain required RF characteristics. We have generally been successful in obtaining required product approvals and certifications, and the facilities in which we produce aviation products currently hold all required certifications. However, in the past we have addressed, or we currently are addressing, technical issues raised by the FAA and the FCC with respect to certain products, and such technical issues or changes in applicable standards could affect any of these certifications, or cause us to incur significant expense or delays in marketing our products.

 

If we cannot continue to rapidly develop, manufacture and market innovative products and services that meet customer requirements for performance and reliability, we may incur development costs that we cannot recover and our net sales and earnings will suffer.

 

The process of developing new wireless communications products is complex and uncertain, and failure to anticipate customers’ changing needs and emerging technological trends accurately, or to develop or obtain appropriate intellectual property, could significantly harm our results of operations. In many instances we must make long-term investments and commit significant resources before knowing whether our investments will eventually result in products that the market will accept. If our new products are not accepted by the market, our net sales and earnings will decline.

 

Competing technology could be superior to ours, and could cause customer orders and net sales to decline.

 

The markets in which we compete are very sensitive to technological advances. As a result, technological developments by competitors can cause our products to be less desirable to customers, or even to become obsolete. Those developments could cause our customer orders and net sales to decline.

 

Our competitors’ marketing and pricing strategies could make their products more attractive than ours. This could cause reductions in customer orders or our profits.

 

We operate in highly competitive technology markets, and some of our competitors have substantially greater resources and facilities than we do. As a result, our competition may be able to pursue aggressive marketing strategies, such as significant price discounting. These competitive activities could cause our customers to purchase our competitors’ products rather than ours, or cause us to increase marketing expenditures or reduce prices, in any such case, causing a reduction of net sales and earnings below expected levels.

 

Our transitions to new product offerings can be costly and disruptive, and could adversely affect our net sales or profitability.

 

Because our businesses involve constant efforts to improve existing technology, we regularly introduce new generations of products. During these transitions, customers may reduce purchases of older equipment more rapidly than we expect, or may choose not to migrate to our new products, which could result in lower net sales and excessive inventories. In addition, product transitions create uncertainty about both production costs and customer acceptance. These potential problems are generally more severe if our product introduction

 

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schedule is delayed by technical development issues. These problems could cause our net sales or profitability to be less than expected.

 

Our products may inadvertently infringe third-party patents, which could create substantial liability to our customers or the third-party patent owners.

 

As we regularly develop and introduce new technology, we face risks that our new products or manufacturing techniques may infringe valid patents held, or currently being processed, by others. The earliest that the U.S. Patent Office publishes patents is 18 months after their initial filing, and exceptions exist so that some applications are not published before they issue as patents. Thus, we may be unaware of a pending patent until well after we have introduced an infringing product. In addition, questions of whether a particular product infringes a particular patent can involve significant uncertainty. As a result of these factors, third-party patents may require us to redesign our products and to incur both added expense and delays that interfere with marketing plans. We may also be required to make significant expenditures from time to time to defend or pay damages or royalties on infringement claims, or to respond to customer indemnification claims relating to third-party patents. Such costs could reduce our earnings.

 

We may not be successful in protecting our intellectual property.

 

Our unique intellectual property is a critical resource in our efforts to produce and market technically advanced products. We primarily seek to protect our intellectual property, including product designs and manufacturing processes, through patents and as trade secrets. If we are unable to obtain enforceable patents on certain technologies, or if information we protect as trade secrets becomes known to our competitors, then competitors may be able to copy or otherwise appropriate our technology, we would lose competitive advantages, and our net sales and operating income could decline. In any event, litigation to enforce our intellectual property rights could result in substantial costs and diversion of resources that could have a material adverse effect on our operations regardless of the outcome of the litigation. We may also enter into transactions in countries where intellectual property laws are not well developed and legal protection of our rights may be ineffective.

 

Our success depends on our ability to attract and retain a highly skilled workforce.

 

Because our products and programs are technically sophisticated, we must attract and retain employees with advanced technical and program-management skills. Many of our senior management personnel also possess advanced knowledge of the business in which we operate and are otherwise important to our success. Other employers also often recruit persons with these skills, both generally and in focused engineering fields. If we are unable to attract and retain skilled employees and senior management, our performance obligations to our customers could be affected and our net sales could decline.

 

We depend on highly skilled suppliers, who may become unavailable or fail to achieve desired levels of technical performance.

 

In addition to our requirements for basic materials and electronic components, our advanced technological products often require sophisticated subsystems supplied or cooperatively developed by third parties. To meet those requirements, our suppliers must have specialized expertise, production skills and economies of scale, and in some cases there are only a limited number of qualified potential suppliers. Our ability to perform according to customer contract requirements, or to introduce new products on the desired schedule, can be heavily dependent on our ability to identify and engage appropriate suppliers, and on the effectiveness of those suppliers in meeting our development and delivery objectives. If these highly skilled suppliers are unavailable when needed, or fail to perform as expected, our ability to meet our performance obligations to our customers could be affected and our net sales and earnings could decline.

 

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Changes in regulations that limit the availability of licenses or otherwise result in increased expenses could cause our net sales or earnings to decline.

 

Many of our products are incorporated into wireless communications systems that are regulated in the U.S. by the Federal Communications Commission and internationally by other government agencies. Changes in government regulations could reduce the growth potential of our markets by limiting either the access to or availability of frequency spectrum. In addition, other changes in government regulations could make the competitive environment more difficult by increasing costs or inhibiting our customers’ efforts to develop or introduce new technologies and products. Also, changes in government regulations could substantially increase the difficulty and cost of compliance with government regulations for both our customers and us. All of these factors could result in reductions in our net sales and earnings.

 

Additional environmental regulation could increase costs and adversely affect our future earnings.

 

Greenhouse gas emissions have increasingly become the subject of a large amount of international, national, regional, state and local attention. Any enactment of cap-and-trade proposals would likely increase the cost of energy, including purchases of electricity, and of certain raw materials used by us. In addition, future environmental regulatory developments related to climate change, whether pursuant to future treaty obligations or statutory or regulatory changes, are possible, and could increase our operating, manufacturing and delivery costs.

 

The export license process for space products is uncertain, increasing the chance that we may not obtain required export licenses in a timely or cost-effective manner.

 

Our products for use on commercial satellites are included on the U.S. Munitions List of the U.S. International Traffic in Arms Regulations and are subject to U.S. State Department licensing requirements. The licensing process for our products for use on commercial satellite and many of our other products is time-consuming, and political considerations can increase the time and difficulty of obtaining licenses for export of technically advanced products. The license process may prevent particular sales, and generally has created schedule uncertainties that encourage foreign customers, such as those in Western Europe, to develop internal or other foreign sources rather than use U.S. suppliers. If we are unable to obtain required export licenses when we expect them or at the costs we expect, our net sales and earnings could be adversely affected.

 

Export controls on space technology restrict our ability to hold technical discussions with foreign customers, suppliers and internal engineering resources, which reduces our ability to obtain sales from foreign customers or to perform contracts with the desired level of efficiency or profitability.

 

U.S. export controls severely limit unlicensed technical discussions with any persons who are not U.S. citizens or permanent residents. As a result, we are restricted in our ability to hold technical discussions between U.S. personnel and current or prospective customers or suppliers outside the U.S., between Canadian personnel and current or prospective U.S. customers or suppliers, and between U.S. employees and our other employees outside the U.S. These restrictions reduce our ability to win cross-border space work, to utilize cross-border supply sources, and to deploy technical expertise in the most effective manner.

 

Economic or political conditions in other countries could cause our net sales or earnings to decline.

 

International sales significantly affect our financial performance. Approximately $107.2 million, $132.5 million and $111.7 million, or 29.8%, 39.6% and 38.8% of our net sales for 2009, 2008, and 2007, respectively, were derived from customers residing outside of the U.S. Adverse economic conditions in our customers’ countries, mainly in Western Europe, Latin America and the Pacific Rim, have affected us in the past, and could adversely affect future international revenues in all of our businesses, especially LXE. Unfavorable currency exchange rate movements can adversely affect the marketability of our products by increasing the local-currency cost. In addition to these economic factors directly related to our markets, there are risks and uncertainties inherent in doing business internationally that could have an adverse effect on us, such as potential adverse effects of political instability or changes in governments, changes in foreign income tax laws,

 

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and restrictions on funds transfers by us or our customers, as well as unfavorable changes in laws and regulations governing a broad range of business concerns, including proprietary rights, legal liability, and employee relations. All of these factors could cause significant harm to our net sales or earnings.

 

Unfavorable currency exchange rate movements could result in foreign exchange losses and cause our earnings to decline.

 

We have international operations, and we use forward currency contracts to reduce the earnings risk from holding certain assets and liabilities denominated in different currencies, but we cannot entirely eliminate those risks. In addition, Canada-based SATCOM derives a major portion of its sales from agreements in U.S. dollars; but its costs are predominately in Canadian dollars; as a result, a stronger Canadian dollar would increase our costs relative to our U.S. net sales, and we are unlikely to recover these increased costs through higher U.S. dollar prices due to competitive conditions. As a result of these factors, our financial results will continue to have an element of risk related to foreign currency exchange rates.

 

Our net sales in certain markets depend on the availability and performance of other companies with which we have marketing relationships.

 

With respect to some applications, including mobile satellite communications, we seek to develop marketing relationships with other companies that have superior direct customer access from advantages such as specialized software and established customer service systems. For example, the marketing of our line of high-speed commercial airline communications products is dependent on the success of our direct customers in the sale of our products as a complementary offering with their own lines of avionics products. In other markets, such as wireless local-area networks, a major element of our distribution channels is a network of value-added retailers and independent distributors. In foreign markets for many of our products, we are often dependent on successful working relationships with local distributors and other business personnel. If we are unable to identify and structure effective relationships with other companies that are able to market our products, our net sales could fail to grow in the ways we expect.

 

Customer orders in backlog may not result in sales.

 

Our order backlog represents firm orders for products and services. However, our customers may cancel or defer orders for products and services, in most cases without penalty. Cancellation or deferral of an order in our D&S segment typically involves penalties and termination charges for costs incurred to date, but these termination penalties would still be considerably less than what we would have expected to earn if the order could have been completed. We make management decisions based on our backlog, including hiring of personnel, purchasing of materials, and other matters that may increase our production capabilities and costs whether or not the backlog is converted into revenue. Cancellations, delays or reductions of orders could adversely affect our results of operations and financial condition.

 

We are exposed to the credit risk of some of our customers and to credit exposures in weakened markets, which could cause our earnings to decline.

 

Most of our sales are on an open credit basis, with typical payment terms of up to 60 days in the U.S. and, because of local customs or conditions, longer in some markets outside the U.S. In the past, certain of our customers have experienced credit problems, up to and including bankruptcy. Although any resulting loss has not been material to date, future losses, if incurred, could harm our business and have an adverse effect on our operating results and financial condition. Additionally, to the degree that the recent turmoil in the credit markets makes it more difficult for some customers to obtain financing, our customers’ ability to pay could be adversely impacted, which in turn could have an adverse impact on our business, operating results, and financial condition.

 

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Our products typically carry warranties, and the costs to us to repair or replace defective products could exceed the amounts we have experienced historically.

 

Most of our products carry basic warranties of between one and five years, depending on the type of product. For certain products, customers can purchase warranty coverage for specified additional periods. If our products are returned for repair or replacement under warranty or otherwise under circumstances in which we assume responsibility, particularly if at a higher rate than we expect based on historical experience, we can incur significant costs that may be in excess of the allowances that we have established based on our historical warranty cost levels, which would reduce our earnings.

 

Changes in our consolidated effective income tax rate and the related effect on our results can be difficult to predict.

 

We earn taxable income in various tax jurisdictions around the world. The rates of income tax that we pay can vary significantly by jurisdiction, due to differing income tax rates and benefits that may be available in some jurisdictions and not in others. In particular, our earnings in Canada are subject to very low income taxes due to research-related tax incentives. As a result, our overall effective income tax rate depends upon the relative annual income that we earn in each of the tax jurisdictions where we do business, and the rate reported in our quarterly financial results depends on our expectations for such relative earnings for the balance of the year. Thus, even though our actual or expected consolidated earnings before taxes could remain unchanged, our income tax expenses and net earnings may still increase or decrease, depending upon changes in the jurisdictions in which we have generated or expect to generate those earnings.

 

We may not effectively manage possible future growth, which could result in reduced earnings.

 

Historically, we have experienced broad fluctuations in demand for our products and services. These changes in demand have depended on many factors and have been difficult to predict. In recent years, there has also been an increasing complexity in the technologies and applications in certain of our businesses. These changes in our businesses place significant demands on both our management personnel and our management systems for information, planning and control. If we are to achieve further strong growth on a profitable basis, our management must identify and exploit potential market opportunities for our products and technologies, while continuing to manage our current businesses effectively. Furthermore, our management systems must support the changes to our operations resulting from our business growth. If our management and management systems fail to meet these challenges, our business and prospects will be adversely affected.

 

We may make acquisitions and investments that could adversely affect our earnings or otherwise fail to perform as expected.

 

To support growth, we have made and may continue to make acquisitions of and investments in businesses, products and technologies that could complement or expand our businesses. However, if we should be unable to successfully negotiate with a potential acquisition candidate, finance the acquisition, or effectively integrate the acquired businesses, products or technologies into our existing business and products, our net sales and earnings could be adversely affected. Furthermore, to complete future acquisitions, we may issue equity securities, incur debt, assume contingent liabilities or the risk of unknown liabilities, or we may incur amortization expenses or write-downs of acquired assets as a result of future acquisitions, all of which could cause our earnings or earnings per share to decline. In addition, under newly adopted Statement of Financial Accounting Standards No. 141(R), Business Combinations, which is now included in the FASB Accounting Standards Codification^tm (“ASC”) Topic 805, effective for us for business combinations completed after January 1, 2009, we are required to record certain acquisition-related costs and other items as current period expenses, reducing our reported earnings in the period in which an acquisition is consummated, and to reflect post-closing changes in the fair value of contingent consideration as a charge (or credit) to reported earnings. We also may acquire businesses that do not perform as we expect, are subject to undisclosed or unanticipated liabilities, or are otherwise dilutive to our earnings.

 

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We have residual liabilities under the terms of our sales of discontinued businesses.

 

We have reserved amounts we believe to be adequate to cover our potential liabilities that we consider probable and estimable on actual claims asserted under warranties and representations that we made in connection with our prior dispositions of discontinued operations. However, payment of such contingent liabilities would decrease our cash, and if the final resolution of such liabilities exceeded our reserves, our results of discontinued operations would also be adversely affected.

 

Risks Related to our Common Stock

 

In addition to risks and uncertainties related to our operations, there are investment risks that could adversely affect the return to an investor in our common stock and could adversely affect our ability to raise capital for financing future operations.

 

Our quarterly results are volatile and difficult to predict. If our quarterly performance results fall short of market expectations, the market value of our shares is likely to decline.

 

The quarterly net sales and earnings contributions of some of our segments are heavily dependent on customer orders or product shipments in the final weeks or days of the quarter. Due to some of the risks related to our business discussed above, it can be difficult for us to predict the timing of receipt of major customer orders, and we are unable to control timing decisions made by our customers. This can create volatility in quarterly results, and hinders our ability to determine before the end of each quarter whether quarterly earnings will meet prevailing expectations. The market price for our shares is likely to be adversely affected by quarterly earnings results that are below analyst and market expectations.

 

Our share price may fluctuate significantly, and an investor may not be able to sell our shares at a price that would yield a favorable return on investment.

 

The market price of our stock will fluctuate in the future, and such fluctuations could be substantial. Price fluctuations may occur in response to a variety of factors, including:

 

 

In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the stocks of technology companies, and that have been unrelated to the operating performance of particular companies.

 

Future sales of our common stock may cause our stock price to decline.

 

Our outstanding shares are freely tradable without restriction or further registration, and shares reserved for issuance upon exercise of stock options will also be freely tradable upon issuance, in each case unless held by affiliates. Sales of substantial amounts of common stock by our shareholders, including those who have acquired a significant number of shares in connection with business acquisitions or private investments, or even the potential for such sales, may depress the market price of our common stock and could impair our ability to raise capital through the sale of our equity securities.

 

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Provisions in our governing documents and law could prevent or delay a change of control not supported by our Board of Directors.

 

Our shareholder rights plan and provisions of our amended and restated articles of incorporation and amended bylaws could make it more difficult for a third party to acquire us. These documents include provisions that:

 

 

 

None.

 

 

Our corporate headquarters, and D&S’s and LXE’s domestic operations are located in four buildings, three of which we own comprising approximately 290,000 square feet of floor space on 21 acres, as well as one that is leased totaling approximately 37,000 square feet (lease expires in 2015), all located in a suburb of Atlanta, Georgia. These facilities include drafting and design facilities, engineering laboratories, assembly and test areas, materials storage and control areas, and offices.

 

We lease approximately 160,000 square feet of office and manufacturing space for our Communications & Tracking segment, with the majority located in Ottawa, Ontario (lease to expire in 2017), with other facilities located in Moorestown, NJ (lease to expire in 2013), Tewkesbury, UK (lease to expire in 2012), and in Takoma Park, MD (lease to expire in 2011).

 

We lease several small sites in the U.S., Europe, Singapore, the UAE, and China for LXE sales offices. If any of these leases are terminated, we believe we could arrange for comparable replacement facilities on similar terms.

 

 

Prior to 2007, we disposed of our S&T/Montreal, SatNet, and EMS Wireless divisions. The sales agreements for each of these disposals contained standard indemnification provisions for various contingencies that could not be resolved before the dates of closing and for various representations and warranties provided by us and the purchasers. In 2008, the purchaser of EMS Wireless asserted claims under such representations and warranties. The parties agreed to arbitration, which commenced in the third quarter of 2009. In March 2010, we received an interim decision from the arbitrator on these claims awarding the purchaser a total of approximately $9.2 million under the warranty provisions of the purchase agreement. As a result, we accrued a liability for the award costs in discontinued operations in 2009. The interim award will not become final until the arbitrator determines awards of costs and attorneys’ fees, which the parties will be briefing in the near

 

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future. It is not possible at this time to determine the amount of any additional award, but any such award would be reflected in discontinued operations when it becomes probable and estimable.

 

We are involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

 

 

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The common stock of EMS Technologies, Inc. is traded on the NASDAQ Global Select Market (symbol ELMG). At March 19, 2010, there were approximately 400 shareholders of record, we believe that there were approximately 2,900 beneficial shareholders, based upon broker requests for distribution of Annual Meeting materials. The price range of the stock is shown below:

 

 

We have never paid a cash dividend with respect to shares of our common stock, and have retained our earnings to provide cash for the operation and expansion of our business. We cannot currently declare or make any cash dividends without the consent of the lenders in our revolving credit agreement. Future dividends, if any, will be determined by the Board of Directors in light of the circumstances then existing, including our earnings and financial requirements and general business conditions.

 

The following table summarizes our repurchases of our common shares for the quarter ended December 31, 2009:

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

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The following table sets forth selected consolidated financial data with respect to our operations. The data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto, which appear immediately following the signature page of this Annual Report on Form 10-K. The statement of operations data for each of the five years ended December 31, 2009, and the related balance sheet data have been derived from the audited consolidated financial statements (in thousands, except per share data).

 

 

No cash dividends have been declared or paid during any of the periods presented.

 

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We have included forward-looking statements in management’s discussion and analysis of financial condition and results of operations. All statements, other than statements of historical fact, included in this report that address activities, events or developments that we expect or anticipate will or may occur in the future, or that necessarily depend upon future events, including such matters as our expectations with respect to future financial performance, future capital expenditures, business strategy, competitive strengths, goals, expansion, market and industry developments and the growth of our businesses and operations, are forward-looking statements.

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K. Actual results could differ materially from those anticipated in the forward-looking statements as a result of a variety of factors, including those addressed at the end of this item and those discussed under the caption “Risk Factors” in Item 1A. of this Annual Report on Form 10-K. The historical results of operations are not necessarily indicative of future results.

 

Overview

 

We are a leading innovator in the design, manufacture, and marketing of wireless communications solutions addressing the enterprise mobility, communications-on-the-move and in-flight connectivity markets for both commercial and government end-users. We focus on the needs of the mobile information user and the increasing demand for wireless broadband communications. We provide products and services that enable communications across a variety of coverage areas, ranging from global, to regional, to within a single facility.

 

As of 2009, our continuing operations include the following three reportable operating segments:

 

 

In early 2010, we realigned our business segments for strategic growth and replaced Communications & Tracking with two new segments, Aviation and Global Tracking.

 

 

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This new segment structure will be presented beginning in 2010.

 

We sell LXE products and the majority of Communications & Tracking products for commercial applications. We sell D&S products primarily for defense and space applications. Sales of products for U.S. government end-use comprised 29.7%, 26.3% and 24.6% of our net sales in 2009, 2008 and 2007, respectively.

 

Our sales to customers in the U.S. accounted for 70.3%, 60.4% and 61.2% of our consolidated net sales in 2009, 2008 and 2007, respectively. The remainder of our sales were to customers in markets outside of the U.S. Net sales from our markets outside the U.S. have generally increased when the Euro and other local functional currencies have increased in value as compared with the U.S. dollar.

 

Financial and Performance Highlights of 2009

 

Following is a summary of significant factors affecting our business in 2009:

 

 

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Description of Net Sales, Costs and Expenses

 

Net sales

 

The amount of net sales is generally the most significant factor affecting our operating income in a period. We recognize product-related net sales under most of our customer agreements when we ship completed units or complete the installation of our products. If multiple deliverables are involved in a revenue arrangement, or if software included in an offering is more than incidental to a product as a whole, we recognize revenue in accordance with ASC Subtopic 605-25, Revenue Recognition-Multiple-Element Arrangements, or ASC Subtopic 985-605, Software-Revenue Recognition, as applicable. If the customer agreement is in the form of a long-term contract (mainly at D&S and to a lesser degree at Communications & Tracking), we recognize revenue under the percentage-of-completion method, using the ratio of cost-incurred-to-date to total-estimated-cost-at-completion as the measure of performance. Estimated cost-at-completion for each of these contracts is reviewed on a routine periodic basis, and adjustments are made periodically to the estimated cost-at-completion based on actual costs incurred, progress made, and estimates of the costs required to complete the contractual requirements. When the estimated cost-at-completion exceeds the contract value, the entire estimated loss resulting from the projected cost overruns is immediately recognized. If the customer agreement is in the form of a cost-reimbursement contract, we recognize revenue based on the type of fee specified in the contract, which is typically a fixed fee, award fee or a combination of both.

 

We also generate net sales from product-related service contracts, repair services, airtime and mapping services, and engineering services projects. We recognize revenue from product-related service contracts, extended warranties ratably over the life of the contract. We recognize revenue from repair services and tracking, voice, and data services as services are rendered. We recognize revenue from contracts for engineering services using the percentage-of-completion method for fixed price contracts, or as costs are incurred for cost-type contracts.

 

Cost of sales

 

Product cost of sales includes the cost of materials, payroll and benefits for direct and indirect manufacturing labor, engineering and design costs, outside costs such as subcontracts, consulting or travel related to specific contracts, and manufacturing overhead expenses such as depreciation, utilities and facilities maintenance. We also include amortization of intangible assets for development technologies in cost of sales.

 

We sell a wide range of advanced wireless communications products into markets with varying competitive conditions, and cost of sales as a percentage of net sales varies by product. Consequently, the mix of products sold in a given period is a significant factor affecting our operating income.

 

The cost-of-sales percentage is principally a function of competitive conditions and product and customer mix, but Communications & Tracking is also affected by changes in foreign currency exchange rates, mainly because the Canadian-based SATCOM business derives most of its net sales from contracts denominated in U.S. dollars, but incurs most of its costs in Canadian dollars. When the U.S. dollar weakens against the Canadian dollar, our reported manufacturing costs for SATCOM increase relative to our net sales, which increases the cost-of-sales percentage. When the U.S. dollar strengthens, the opposite effect results. Our LXE business derives a significant portion of its net sales from international markets, mainly in Euros, but incurs most of its costs in U.S. dollars. When the U.S. dollar weakens against the Euro and other international currencies, our reported net sales generally increase relative to our costs, which decreases the cost-of-sales percentage. When the U.S. dollar strengthens, the opposite effect generally results.

 

Service cost of sales is based on labor and other costs recognized as incurred to fulfill obligations under most of our service contracts, and the cost of airtime for providing tracking, voice and data services. Cost of sales for long-term engineering services contracts are based on labor and other costs incurred.

 

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Selling, general and administrative expenses

 

Selling, general and administrative (“SG&A”) expenses include salaries, commissions, bonuses and related overhead costs for our personnel engaged in sales, administration, finance, information systems and legal functions. Also included in SG&A expenses is amortization of intangible assets for trademarks, trade names and customer lists as well as costs of engaging outside professionals for consultation on legal, accounting, tax and management information system matters, auditing and tax compliance, and general corporate expenditures to other outside suppliers and service providers.

 

Research and development expenses

 

Research and development (“R&D”) expenses represent the cost of our development efforts, net of reimbursement under specific customer-funded R&D agreements. R&D expenses include salaries of engineers and technicians and related overhead expenses, the cost of materials utilized in research, and additional engineering or consulting services provided by independent companies. R&D costs are expensed as they are incurred. We also often incur significant development costs to meet the specific requirements of customer contracts in D&S and Communications & Tracking, and we report these costs in the consolidated statements of operations as cost of sales.

 

Acquisition-related items

 

Acquisition-related items include the costs of engaging outside professionals for legal, due diligence, business valuation, and integration services related to business combinations. The category also includes adjustments related to changes in the fair value of the earn-out liability associated with one acquisition completed in 2009.

 

Impairment loss on goodwill

 

An impairment loss on goodwill is recognized to the extent that a reporting unit’s carrying amount of goodwill exceeds the implied fair value of its goodwill, determined in accordance with ASC Topic 350, Intangibles-Goodwill and Other. Goodwill is evaluated for impairment annually, and between annual tests if an event or changes in circumstances indicate that the goodwill might be impaired. We complete our annual evaluation of goodwill for impairment in the fourth quarter of each fiscal year.

 

Interest income

 

Interest income is earned primarily from our investments in government-obligations money market funds, other money market instruments, and interest-bearing deposits.

 

Interest expense

 

We incur interest expense principally related to mortgages on certain facilities and our revolving credit facility. We incurred no interest expense in 2008 and 2007 related to borrowings under revolving credit facility because during those periods we had no borrowings outstanding under this facility.

 

Foreign exchange gains and losses

 

We recognize foreign exchange gains and losses at any of our subsidiaries that have assets and liabilities that are denominated in a currency different than its local functional currency. For our Canada-based SATCOM business, most trade receivables are denominated in U.S. dollars; when the U.S. dollar weakens against the Canadian dollar, the value of SATCOM’s trade receivables decreases and foreign exchange losses result. For our LXE segment’s international subsidiaries, most trade payables are in U.S. dollars and relate to their purchases of equipment from LXE’s U.S. operations for sale in Europe; when the U.S. dollar weakens against the Euro or other international currencies, the value of the LXE subsidiaries’ trade payables decreases and foreign exchange gains result. When the U.S. dollar strengthens, the opposite effects on trade payables and foreign exchange gains and losses result.

 

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We regularly assess our exposures to changes in foreign currency exchange rates and as a result, we enter into forward currency contracts to reduce those exposures. The notional amount of each forward currency contract is based on the amount of exposure for net assets or liabilities subject to changes in foreign currency exchange rates. We record changes in the fair value of these contracts in foreign exchange gains and losses in our consolidated statements of operations.

 

Income taxes

 

Typically, the main factor affecting our effective income tax rate each year is the relative proportion of taxable income that we expect to earn in Canada, where the effective rate is lower than in the U.S. and other locations. The lower effective rate in Canada results from certain Canadian tax benefits for research-related expenditures.

 

Discontinued operations

 

Prior to 2007, we disposed of our Space & Technology/Montreal (“S&T/Montreal”), Satellite Networks (“SatNet”) and EMS Wireless divisions. The losses reported in discontinued operations relate directly to the resolution of various contingencies, representations or warranties as specified under the standard indemnification provisions of the sales agreements. We record a liability related to a contingency, representation or warranty when management considers that the liability is both probable and can be reasonably estimated.

 

Results of Operations

 

The following table sets forth the percentage relationship of each line item to net sales for each period.

 

 

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Years ended December 31, 2009 and 2008:

 

Net sales increased by 7.4% to $360.0 million from $335.0 million in 2009 as compared with 2008, reflecting growth in net sales from two of our three reportable operating segments, Communications & Tracking, and D&S, with increases of 41.3%, and 19.5%, respectively. The increase in net sales in the Communications & Tracking segment was the result of our recently acquired product lines. Such increases were partially offset by declines in net sales from Communications & Tracking organic product lines in 2009, as compared with 2008, and from the Inmarsat development project that was concluded in 2008 and therefore, not included in the 2009 results. D&S’s net sales were higher in 2009 mainly due to significant work performed on a military communications research project and increased activity on both military and commercial programs. LXE’s net sales in 2009 were $36.4 million lower than the same period in 2008, a decrease of 25.0%, with a decrease in net sales in both the Americas and International markets.

 

Product net sales increased by 2.9% to $281.2 million in 2009 as compared with 2008. This was primarily due to the product net sales generated from our recently acquired product lines and increased activity on both defense and commercial programs, including significant work to supply phase-shifter products for a military program, and antennas for systems that provide connectivity to the internet, live television programs and cellular services on-board commercial aircraft. These increases were partially offset by a lower number of terminals shipped by LXE in both the International and Americas markets and lower net sales of high-speed-data aeronautical products from the organic product lines of Communications & Tracking. Service net sales increased by 27.6% to $78.8 million in 2009 as compared with the same period in 2008, mainly due to significant work performed on a military communications research project by D&S, and the service revenue generated from our newly acquired product lines at Communications & Tracking. As a result, service net sales comprised a higher percentage of total net sales in 2009 as compared with 2008.

 

Overall cost of sales as a percentage of consolidated net sales was higher in 2009 as compared with 2008 due to higher cost-of-sales percentages reported by each of our three reportable operating segments. Product cost of sales as a percentage of net sales, was higher in 2009 as compared with 2008. The increase in product cost of sales as a percentage of net sales was mainly due to the acquisition of the new product lines in 2009 at Communications & Tracking which had a higher cost-of-sales percentages than our existing SATCOM business, primarily due to the amortization of intangible assets, and a higher percentage of net sales generated by our D&S segment, which has a higher cost-of-sales percentage than our other two reportable operating segments. Product cost of sales was also higher due to a lower production volume by our LXE segment over which fixed costs were absorbed, and an unfavorable effect of changes in foreign currency exchange rates, and additional severance costs of $1.8 million recorded in 2009 for a reduction in workforce across all divisions to realign the staffing needs of the business with current economic conditions. Service cost of sales as a percentage of net sales was lower in 2009 as compared with 2008. The decrease in the service cost-of-sales percentage was mainly due to an increase in service revenue from our newly acquired product lines at Communications & Tracking which had a lower cost-of-sales percentage than our other two operating segments. Service cost of sales as a percentage of net sales was also lower in 2009 as compared with 2008 due to lower volume of repairs experienced under existing maintenance contracts at our D&S and LXE segments in 2009.

 

SG&A expenses as a percentage of consolidated net sales increased slightly in 2009 as compared with 2008. Actual expenses grew by $6.3 million in 2009 as compared with 2008 mainly due to the additional costs related to the acquired product lines, including additional amortization of intangible assets. These additional costs were partially offset by the impact of management’s continued cost reduction efforts and the favorable effect of changes in foreign currency exchange rates on our LXE and SATCOM international operations.

 

R&D expenses were $1.4 million lower in 2009 than in 2008 mainly due to additional funding received from the Canadian government under a program to encourage technology development in areas such as satellite communications, reduced spending due to cost control measures, and the completion of certain internal development programs at SATCOM and LXE in 2009. R&D expenses were also lower due to the favorable effect of changes in foreign currency exchange rates in 2009. These decreases in expenses were partially offset by additional R&D expenses related to our recently acquired product lines.

 

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An impairment loss on goodwill of $19.9 million was recorded by our LXE segment in 2009. We completed our annual evaluation for goodwill impairment in the fourth quarter of 2009 and concluded that the goodwill of our LXE segment might be impaired, since the estimated fair value of the reporting unit was less than the carrying amount. The amount of the impairment loss was determined by comparing the carrying amount of the goodwill for the reporting unit to the implied fair value of the goodwill determined in accordance with current accounting standards. While the carrying amount exceeded the estimated fair value by only $6.0 million, the impairment loss was measured as $19.9 million. The requirements to determine the impairment loss stipulate that the estimated fair value of all assets and liabilities of the reporting unit be determined similar to the method used in a business combination. The aggregate fair value of the assets and liabilities, including those not reflected in the carrying amount, is compared to the estimated reporting unit fair value with the difference being implied goodwill. The excess of goodwill on the balance sheet and this implied goodwill is the impairment loss. For a reporting unit with unrecognized intangible assets or other assets whose fair value exceeds the carrying amount, the impairment loss will exceed the reporting unit fair value deficiency since the accounting rules do not allow for a step up in fair value for these other assets in this process.

 

Goodwill in our consolidated balance sheet as of December 31, 2009 includes the remaining goodwill of LXE of $1.8 million and the goodwill related to the acquisitions of Formation, Satamatics and Sky Connect, for which no impairment was indicated in 2009.

 

Acquisition-related charges were $7.2 million in 2009. These charges were primarily for professional fees for legal, due-diligence, valuation, and integration services for the acquisition of our Formation and Satamatics businesses, as well as increases in the estimated fair value of the earn-out liability associated with one of the acquisitions. The fair value increased by $3.2 million during 2009 primarily related to accretion in the liability from the acquisition date, changes in the expected earn-out payments based on the results of 2009, and an agreement between the Company and the sellers of the acquired entity to set the 2010 earn-out at a fixed amount, which settled the contingency.

 

Interest income was $2.2 million lower in 2009 than in 2008 mainly as a result of lower average investment balances and, to a lesser extent, lower average interest rates earned on our investment balances.

 

Interest expense was $0.5 million higher in 2009 than in 2008 mainly due to borrowings under our revolving credit facility incurred in the first quarter of 2009 to partially fund the acquisition of our new product lines.

 

Our foreign exchange net loss was $0.2 million higher in 2009 than in 2008. Included in 2009, was a $1.4 million foreign exchange loss related to the funding of the Satamatics acquisition, which was required to be paid in British pounds sterling. The loss resulted from changes in foreign currency exchange rates from the date we funded the transaction to the date the acquisition was completed. Partially offsetting this loss in the period were net gains from the conversion of assets and liabilities not denominated in the functional currency and changes in the fair value of forward contracts used to hedge against currency exposure.

 

We recognized an income tax benefit of $4.3 million for continuing operations in 2009. Earnings were generated in Canada, where we have a much lower effective rate than in the U.S. or other locations due to research-related tax benefits. Other jurisdictions incurred losses, which generated a tax benefit. In addition we recognized a change in estimate of $1.9 million for prior-year research and development credits in the U.S. after completion of an Internal Revenue Service examination. No tax benefit was recognized for the loss on impairment of goodwill. Income tax for 2008 was a net benefit of $0.7 million. A $0.9 million tax benefit was recognized in 2008 related to revised estimates for research and development costs qualifying for U.S. Federal tax credits from prior years. We also recognized a $1.3 million benefit in 2008 from the reduction of the valuation allowance against deferred tax assets based upon the expected continuing profitability of SATCOM. Our effective tax rate for 2010 is expected to be approximately 15%.

 

Years ended December 31, 2008 and 2007:

 

Net sales increased by 16.4% to $335.0 million from $287.9 million, for 2008 as compared with 2007, with net sales growth contributed by each of our three reportable operating segments. Communications & Tracking and D&S recorded the largest growth in net sales, with increases of 25.1% and 29.7%, respectively. These

 

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increases were mainly due to the strong demand for high-speed-data aeronautical products from both commercial and military markets and the revenues generated from the development of the Inmarsat global satellite/GSM phone by our Communications & Tracking segment, and the increased activity on both commercial and military programs by our D&S segment. Net sales for LXE were higher by 5.1% primarily due to growth in net sales from the international market along with a favorable effect of changes in exchange rates that increased the reported net sales from international markets.

 

Product net sales increased by 10.4% to $273.3 million in 2008 as compared with 2007 mainly due to the strong demand for high-speed-data aeronautical products from both commercial and military markets, and higher net sales of terminals and wireless data collection equipment for logistics management systems. Service net sales increased by $21.4 million to $61.8 million in 2008 as compared with 2007 mainly due to significant work performed on a military communications research project by D&S. Service net sales made up a slightly higher percentage of total net sales in 2008 compared with 2007.

 

Overall cost of sales as a percentage of consolidated net sales increased in 2008 as compared with 2007, due to higher cost-of-sales percentages recorded by each of our three reportable segments. Product cost of sales as a percentage of its respective net sales increased in 2008 as compared with 2007, mainly due to a higher percentage of net sales generated from indirect channels at LXE, and the revenues generated in 2008 by Communications & Tracking related to an agreement to develop the Inmarsat global satellite/GSM phone, that did not generate gross margin. An agreement was reached with Inmarsat in January 2009 and the project has been concluded with the full effect recognized in the fourth quarter of 2008. Service cost of sales as a percentage of its respective net sales increased in 2008 as compared with 2007, mainly due to a higher percentage of net sales generated by D&S, which has a higher cost-of-sales percentage than our LXE and Communications & Tracking segments.

 

SG&A expenses as a percentage of consolidated net sales were lower in 2008 as compared with 2007. The $6.9 million growth in actual expenses mainly related to the effect of changes in foreign currency exchange rates that increased the reported costs of the international activities at LXE, and sales-related efforts, such as selling and marketing, to support the growth in net sales. SG&A expenses also included additional costs from our Trux and Sky Connect operations which were acquired in February and August 2008, respectively, as well as approximately $1.1 million of severance costs primarily related to staff reductions in LXE’s international operations that occurred during 2008. These additional costs were partially offset by the impact of management’s cost-reduction efforts at LXE which began in the second quarter of 2008.

 

R&D expenses increased by $1.3 million mainly due to additional internal development programs for next-generation products at SATCOM, and the effect of changes in foreign currency exchange rates on its reported costs.

 

Interest income decreased by $3.0 million mainly as a result of lower average interest rates earned on our investment balances and to a lesser extent the decrease in the average investment balances.

 

Our foreign currency forward contract program was somewhat more effective in reducing the currency risk in 2008, resulting in smaller foreign currency exchange losses in 2008 as compared with 2007.

 

Income tax for 2008 was a net benefit of $0.7 million. A $0.9 million tax benefit was recognized in 2008 related to revised estimates for research and development costs qualifying for U.S. Federal tax credits from prior years. We also recognized a $1.3 million benefit in 2008 from the reduction of the valuation allowance against deferred tax assets based upon the expected continuing profitability of SATCOM. Excluding these special items, our effective income tax rate for 2008 was 7.7%. The rate was 9.8% for the year ended December 31, 2007. The decrease in the estimated annual rate is due to a higher proportion of earnings in Canada, where we have a much lower effective rate than in the U.S. or other locations due to research-related tax benefits.

 

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Segment Analysis

 

Our net sales, cost-of-sales (as a percentage of respective segment net sales), operating income (loss), and Adjusted EBITDA for the years ended December 31, 2009, 2008 and 2007 were as follows for each of our reportable operating segments (in thousands, except percentages):

 

 

⁽¹⁾ Adjusted EBITDA is considered a non-GAAP financial measure. See section entitled “Adjusted EBITDA” for an explanation of this measure and a reconciliation to net earnings (loss).

 

Communications & Tracking: Net sales were $46.4 million higher in 2009 as compared with 2008. The increase was due to the sales generated from our recently acquired product lines, which contributed $64.7 million of additional net sales in 2009. This increase in net sales was partially offset by lower net sales of high-speed-data aeronautical products into the military and air transport markets in 2009, as compared with 2008. Net sales from the business jet market were also lower in 2009 as compared with 2008. Sales of new corporate aircraft have declined in 2009 due to general economic conditions and a high level of inventory of used aircraft. Positive customer acceptance of new equipment offerings in 2009 helped to fuel sales of SwiftBroadband products. Revenues for 2008 included the development of the Inmarsat global satellite/GSM phone, which was concluded in 2008 and, therefore, had no effect on the results of 2009. Net sales of $112.5 million were reported for 2008, an increase of 25.1% as compared with 2007, mainly as a result of the strong demand for high-speed-data aeronautical products from both commercial and military markets, and revenues generated from the development of the Inmarsat global satellite/GSM phone.

 

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Cost of sales as a percentage of net sales was higher in 2009 as compared with 2008. The cost-of-sales percentage for 2009 was impacted by a change in product mix and amortization costs of intangible assets from our new product lines acquired in 2009. Cost of sales as a percentage of net sales was higher for 2008 as compared with 2007. The increase in cost of sales percentage was mainly related to cost increases on the Inmarsat global satellite/GSM phone project which was partially offset by a more favorable product mix.

 

Operating income was $2.8 million lower in 2009 as compared with 2008. This was primarily as a result of higher SG&A expenses, additional intangible asset amortization costs from our new product lines, and severance charges of approximately $0.7 million in 2009, which offset the higher margin contribution from an increase in net sales generated, and the favorable effects of foreign currency exchange rates in 2009. Operating income was $2.0 million higher in 2008 as compared with 2007 primarily due to a higher margin contribution from an increase in net sales generated in 2008. Operating income as a percentage of net sales was 7.2%, 12.6% and 13.5% in 2009, 2008 and 2007, respectively.

 

Adjusted EBITDA of $24.3 million in 2009 was $5.2 million more than 2008, primarily due to the operating income before depreciation and amortization contributed by our new product lines acquired in 2009, and a $1.5 million favorable change in foreign currency gains and losses. Adjusted EBITDA increased by $3.9 million in 2008 as compared with 2007, mainly due to higher operating income contribution by SATCOM’s organic product lines and lower foreign currency exchange losses in 2008.

 

LXE: Net sales in 2009 were $36.4 million lower as compared with 2008, reflecting the impact of the slowdown in the global economy. Net sales decreased in both the International and Americas markets in 2009, as compared with 2008, resulting primarily from a lower number of terminals shipped in both markets. It was also lower due to the foreign currency translation effect on the reported net sales for LXE’s International market. Net sales in 2008 increased as compared with the preceding year resulting from an increased number of terminals shipped in the International market, along with a favorable effect of changes in foreign currency exchange rates that increased the reported net sales from International market. Increased International sales more than offset the decline in net sales in the Americas in 2008. We believe that the softer Americas and International markets reflect slower capital spending in a sluggish economy. The economy may continue to be sluggish in both the Americas and International markets in 2010, which could continue to delay customer capital-spending decisions.

 

Cost of sales as a percentage of net sales was higher in 2009 as compared with 2008, mainly due to lower production volume over which fixed costs were absorbed, a higher percentage of net sales generated from indirect channels which have a higher cost-of-sales percentage than net sales generated from direct sales channels, and an unfavorable effect of changes in foreign currency exchange rates that affected our reported International net sales. Revenues are reported in the local functional currency but product costs are reported in the U.S. dollar, which was stronger in 2009 compared with 2008. Cost of sales as a percentage of net sales was higher in 2008 as compared with 2007 mainly as a result of a higher percentage of net sales generated from indirect channels, which has a higher cost-of-sales percentage than net sales generated from direct sales channels, partially offset by the favorable effects of changes in international currencies that increased our reported international net sales.

 

LXE reported an operating loss of $26.5 million in 2009. This was a decrease in operating income of $29.4 million as compared with 2008 mainly due to an impairment loss on goodwill recorded in 2009 of $19.9 million, lower net sales recorded in 2009 and a less favorable cost-of-sales percentage. These impacts were partially offset by lower SG&A and R&D expenses. SG&A and R&D expenses were lower in 2009 by $8.6 million as compared with the same periods in 2008 reflecting the impact of management’s efforts to control spending. Lower SG&A expenses were primarily a result of staff reductions to realign LXE’s cost structure with the expected needs of the business, and the favorable effect of changes in foreign currency exchange rates on reported costs, partially offset by higher severance expenses. Lower R&D expenses were mainly a result of controlled spending through headcount reductions, redeploying development efforts offshore and the completion of certain internal development programs in 2009. Operating income decreased by $4.2 million in 2008 as compared with 2007 primarily due to a lower margin contribution resulting from a less favorable cost-of-sales percentage, and an increase in SG&A expenses. SG&A expenses increased in 2008, as

 

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compared with 2007, mainly as a result of the unfavorable effects of changes in foreign currency exchange rates, as well as approximately $1.1 million of severance costs primarily related to staff reductions in LXE’s international operations in 2008. The increase in SG&A costs was partially offset by the impact of management’s cost reduction efforts begun in the second quarter of 2008. Operating income as a percentage of net sales was negative 24.2%, and positive 2.0% and 5.1% in 2009, 2008 and 2007, respectively.

 

Adjusted EBITDA decreased in 2009 and in 2008 by $10.1 million and $2.8 million, respectively, as compared with the previous year, mainly due to lower operating income in both 2009 and in 2008.

 

Defense & Space: Net sales increased by $14.9 million in 2009, or 19.5%, compared to 2008. Net sales for 2008 were $17.6 million higher, or 29.7%, compared to 2007. The increases were mainly due to increased work performed on military programs in 2009 and 2008, and increased activity on commercial projects, including significant work to supply phase-shifter products for a military program, and antennas for systems that provide connectivity to the internet, live television programs and cellular services on-board commercial aircraft. The work performed on a large military satellite communications research project was an individually significant contributor to the net sales increase in both 2009 and 2008, but the work was completed early in the fourth quarter of 2009, and is not expected to contribute to future net sales. As a result, D&S began an operational transition and workforce reduction in the fourth quarter of 2009 to reduce capacity; however, the extent and cost of that transition will depend upon the success of business development efforts and the timing of orders. Order backlog of long-term contracts was $89.6 million at December 31, 2009, a decrease of $25.3 million from December 31, 2008. Customer orders in 2008 were a record $125.7 million. This increased sales order volume contributed to the increase in net sales as it allowed D&S to expand its workforce to meet the order demand. The strong order volume also left D&S with a record backlog for long-term contracts of $114.9 million at December 31, 2008, a 75% increase from December 31, 2007.

 

Cost of sales as a percentage of net sales was higher in 2009 and 2008 as compared with the previous years, mainly due to an unfavorable mix of contracts and an increase in costs from a higher volume of subcontracted projects utilized to meet scheduling demands for certain military programs. Cost of sales as a percentage of net sales was also higher in 2009 as compared with 2008 due to unfavorable contract performance experienced on certain programs in 2009.

 

Operating income improved by $0.9 million in 2009 as compared with 2008. Operating income improved mainly due to the increase in net sales generated in 2009, and lower SG&A expenses, partially offset by severance charges of approximately $1.6 million in 2009. Operating income improved by $1.5 million in 2008, as compared with 2007, primarily due to a higher margin contribution from an increase in net sales generated in 2008. Operating income as a percentage of net sales was 8.0% in 2009, and was 8.3% in both 2008 and 2007.

 

Adjusted EBITDA increased in 2009 and in 2008 by $1.3 million, and $1.9 million, respectively, as compared with the previous year, due to an increase in operating income in both 2009 and in 2008.

 

Adjusted EBITDA

 

We also measure our performance based on the non-GAAP financial measure of earnings before interest expense, income taxes, depreciation and amortization, and before discontinued operations, impairment loss on goodwill, acquisition-related items and acquisition-related foreign exchange adjustment (“Adjusted EBITDA”).

 

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The following table is a reconciliation of net (loss) earnings (which is the most directly comparable GAAP operating performance measure) to Adjusted EBITDA and earnings (loss) from continuing operations before income taxes by segment, for 2009, 2008, and 2007 (in thousands):

 

 

We believe that earnings that are based on this non-GAAP financial measure provide useful information to investors, lenders and financial analysts because (i) this measure is more comparable with the results for prior fiscal periods, and (ii) by excluding the potential volatility related to the timing and extent of non operating activities, such as acquisitions or revisions of the estimated value of post-closing earn-outs, such results provide a useful means of evaluating the success of our ongoing operating activities. Also, we use this information, together with other appropriate metrics, to set goals for and measure the performance of our operating businesses, and to assess our compliance with debt covenants. Management further considers

 

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Adjusted EBITDA an important indicator of operational strengths and performance of our businesses. EBITDA measures are used historically by investors, lenders and financial analysts to estimate the value of a company, to make informed investment decisions and evaluate performance. Management believes that Adjusted EBITDA facilitates comparisons of our results of operations with those of companies having different capital structures. In addition, a measure similar to Adjusted EBITDA is a component of our bank lending agreement, which requires certain levels of Adjusted EBITDA to be achieved. This information should not be considered in isolation or in lieu of our operating and other financial information determined in accordance with generally accepted accounting principles (“GAAP”). In addition, because EBITDA and adjustments to EBITDA are not determined consistently by all entities, Adjusted EBITDA as presented may not be comparable to similarly titled measures of other companies.

 

Discontinued Operations:

 

Our discontinued operations reported a loss before income taxes of $10.9 million in 2009. The loss was mainly a result of a $9.2 million liability recorded in 2009 for costs awarded for warranty claims under the provisions of the sales agreement of our former EMS Wireless division, and for legal costs associated with the defense of these claims.

 

Prior to 2007, we disposed of our S&T/Montreal, SatNet, and EMS Wireless divisions. The sales agreements for each of these disposals contained standard indemnification provisions for various contingencies that could not be resolved before the dates of closing and for various representations and warranties provided by us and the purchasers. The purchaser of EMS Wireless asserted claims under such representations and warranties. The parties agreed to arbitration, which commenced in the third quarter of 2009. In March of 2010, we received an interim decision from the arbitrator on these claims awarding the purchaser a total of approximately $9.2 million under the warranty provisions of the purchase agreement. As a result, we accrued a liability for the awarded costs in discontinued operations in 2009. We accrue for a liability related to a contingency, representation or warranty when management considers that the liability is both probable and can be reasonably estimated. Prior to the decision by the arbitrator, we did not believe that sufficient information existed to evaluate such claims, and could not reasonably estimate the range of this liability, or determine whether such liability would be material. The interim award will not become final until the arbitrator determines awards of costs and attorneys’ fees, which the parties will be briefing in the near future. It is not possible at this time to determine the amount of any additional award, but any such award would be reflected in discontinued operations when it becomes probable and estimable. We are assessing our options in response to the interim award. Legal costs of $1.5 million associated with the defense of this claim were also reflected in discontinued operations in 2009.

 

In 2008, discontinued operations had no effect on our net earnings. Our discontinued operations reported a loss before income taxes of $0.6 million in 2007, mainly due to additional costs incurred to settle various contingent items, as well as expenses for legal, audit, and other outside services for the sale of SatNet and EMS Wireless.

 

We have an agreement with the purchaser of the former S&T/Montreal division to acquire a license for $8 million in payments over a seven-year period, beginning in December 2008, for the rights to a certain satellite territory. We have a corresponding sublicense agreement with the purchaser that granted the territory rights back to the purchaser, under which we are to receive a portion of the satellite service revenues from the specific market territory over the same period. The purchaser had previously guaranteed that the revenues derived under the sublicense would equal or exceed the acquisition cost of the license. As part of the agreement to sell the net assets of S&T/Montreal, we released the purchaser for this guarantee. Without the guarantee, we estimate that our portion of the satellite service revenues will be less that the acquisition cost, and we have accordingly reflected a liability for the net cost in our consolidated balance sheet.

 

As of December 31, 2009, we have not made any payments under this license agreement. The satellite service revenues from the specific market territory included under the sublicense agreement are considerably lower than expected. We believe that sufficient efforts are not being made by the purchaser of the former S&T/Montreal division to market this satellite service. The parties are in discussions of a possible settlement under

 

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these agreements. We believe that the net liability recorded in our consolidated balance sheet is our best estimate of the settlement amount. If a settlement is reached, it would be expected to be paid in the following twelve months, and therefore the net liability is recorded as a current liability in our consolidated balance sheet as of December 31, 2009.

 

In 2006, we completed the sale of our former SatNet division. The asset purchase agreement (“APA”) provided for the payment of $2.3 million of the aggregate consideration in an interest-bearing note to be repaid over a three-year period beginning in May 2007. As of December 31, 2009, approximately $1.1 million of this note receivable, excluding accrued interest, remained unpaid. The purchaser has indicated that it believes it has claims that offset the unpaid balance. We do not believe that these claims are valid according the terms of the APA and have filed an arbitration demand with the purchaser. We believe that the purchaser has the ability to pay the remaining balance of this note receivable, and that the receivable recorded in its consolidated balance sheet is fully collectible.

 

Backlog

 

Backlog is very important for our D&S segment due to the long delivery cycles for its projects. Many customers of our LXE segment typically require short delivery cycles. As a result, LXE usually converts orders into revenues within a few weeks, and it generally does not build up a significant order backlog that extends substantially beyond one fiscal quarter except for annual or multi-year maintenance service agreements. Our Communications & Tracking business has projects with both short delivery cycles, and delivery cycles that extend beyond the next twelve months. Our segment backlog as of December 31, 2009 and December 31, 2008 was as follows (in millions):

 

 

Included in the backlog of firm orders for our D&S segment was approximately $22.5 million and $48.4 million of unfunded orders, mainly for military contracts, as of December 31, 2009, and December 31, 2008, respectively. Of the orders in backlog as of December 31, 2009, the following are expected to be filled in 2010: Communications & Tracking – 70%; LXE – 80%; and D&S – 50%. LXE’s backlog as of December 31, 2009 was nearly double that of December 31, 2008 mainly due to a shortage of certain component parts from LXE’s suppliers which caused a delay in the fulfillment of LXE’s orders received in 2009. LXE is working closely with suppliers to identify and implement ways to resolve the sourcing issues. LXE is expecting to increase critical parts inventories in 2010 to avoid further delays.

 

Liquidity and Capital Resources

 

During 2009, cash and cash equivalents decreased by $39.8 million to $47.2 million as of December 31, 2009. The primary factor contributing to the decrease during the period was cash utilized for our Formation and Satamatics acquisitions. Of the $47.2 million of cash as of December 31, 2009, $39.3 million is held by subsidiaries outside of the U.S. These undistributed earnings are considered to be permanently reinvested and are not available for use in the U.S.

 

Operating activities from continuing operations contributed $42.3 million in positive cash flows in 2009. Although we reported a loss from continuing operations loss of $13.1 million in 2009, that loss included noncash charges for depreciation and amortization of $20.0 million and an impairment loss on goodwill of $19.9 million. We experienced good customer collections during the period and were able to lower inventory levels. Acquisition-related charges of $3.1 million paid in 2009 are included as reductions of cash provided by operating activities in the consolidated statement of cash flows. Discontinued operations used cash of

 

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$0.6 million mainly for legal fees to defend us against claims made by the purchaser of our EMS Wireless division, net of tax benefits.

 

During 2009, we used $87.3 million of cash to acquire our Formation and Satamatics businesses. These acquisitions were partially funded with approximately $33.8 million of borrowings under our revolving credit facility. We subsequently repaid approximately $15.3 million of borrowings under our revolving credit facility. We used $13.4 million for purchases of capital equipment, the expansion of D&S’s facility, and to upgrade the enterprise reporting system at LXE in 2009.

 

During 2008, cash and cash equivalents decreased by $47.0 million to $87.0 million as of December 31, 2008. The primary uses of cash during the period included $31.6 million of cash used to acquire our Trux and Sky Connect businesses, $13.9 million for purchases of capital equipment and the expansion of D&S’s facility, and $10.0 million to repurchase common shares under our share repurchase program.

 

Continuing operating activities contributed $16.5 million in positive cash flows in 2008. Net earnings of $20.5 million and noncash charges, primarily depreciation and amortization of $12.5 million and stock-based compensation of $2.3 million, were partially offset by increases in working capital.

 

During 2007, cash flow from continuing operating activities increased to $42.1 million mainly due to the net earnings reported by each of our four segments, and significant collections of receivables by D&S and LXE. The $3.3 million of net cash used in operating activities in discontinued operations was mainly for payments of working capital adjustments in accordance with the terms of the sales agreements for our former SatNet and EMS Wireless.

 

We have a revolving credit agreement with a syndicate of banks. Under the agreement, we have $60 million total capacity for borrowing in the U.S. and $15 million total capacity for borrowing in Canada. The agreement also has a provision permitting an increase in the total borrowing capacity of up to an additional $50 million with additional commitments from the current lenders or from new lenders. The existing lenders have no obligation to increase their commitments. The credit agreement provides for borrowings through February 28, 2013, with no principal payments required prior to that date. The credit agreement is secured by substantially all of our tangible and intangible assets, with certain exceptions for real estate that secures existing mortgages, other permitted liens and for certain assets in foreign countries.

 

As of December 31, 2009, we had $18.5 million of borrowings outstanding under this facility. We had $2.5 million of outstanding letters of credit at December 31, 2009, and the net total available for borrowing under our revolving credit facility was $54.0 million.

 

We expect that capital expenditures in 2010 will range from $12 million to $14 million, excluding acquisitions of businesses. These expenditures will be used to purchase equipment that increases or enhances capacity and productivity, and to upgrade the enterprise reporting system of our LXE division.

 

Management believes that existing cash and cash equivalent balances, cash provided from operations, and borrowings available under our credit agreement will provide sufficient liquidity to meet the operating and capital expenditure needs for existing operations during the next twelve months.

 

On July 29, 2008, our Board of Directors authorized a stock repurchase program for up to $20 million of our common shares. We repurchased 495,000 common shares for approximately $10.1 million under this program as of December 31, 2009.

 

We will make additional cash payments in 2010 of $13.7 million related to acquisitions completed in 2009 based upon the achievement of performance targets in 2009, and an agreement to settle the 2010 earn-out amount. Refer to Note 2 of the consolidated financial statements for additional information on these acquisitions.

 

In March of 2010, we received an interim decision from the arbitrator on claims made by the purchaser of our former EMS Wireless division. The arbitrator awarded the purchaser a total of approximately $9.2 million under the warranty provisions of the purchase agreement. We have sufficient cash resources to pay this award.

 

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Off-Balance Sheet Arrangements

 

We have $2.5 million of standby letters of credit outstanding under our revolving credit facility to satisfy performance guarantee requirements under certain customer contracts. While these obligations are not normally called, they could be called by the beneficiaries at any time before the expiration date, if we failed to meet certain contractual requirements. After deducting the outstanding letters of credit, at December 31, 2009 we had $41.5 million available for borrowing in the U.S. and $12.5 million available for borrowing in Canada under the revolving credit facility.

 

During 2009, we completed acquisitions of two entities. Of the total purchase price of these businesses, $10.2 million of cash is in escrow accounts and is payable to the sellers within specified periods following the respective dates of acquisition, subject to claims we may make against the sellers.

 

The sales agreements for the disposal of our former S&T/Montreal, SatNet, and EMS Wireless divisions contain standard indemnification provisions for various contingencies that could not be resolved before the dates of closing and for various representations and warranties by the purchasers and us. The purchaser of EMS Wireless asserted claims under such representations and warranties. The parties agreed to arbitration, which commenced in the third quarter of 2009. In March of 2010, we received an interim decision from the arbitrator on these claims awarding the purchaser a total of approximately $9.2 million under the warranty provisions of the purchase agreement. As a result, we accrued a liability for the awarded costs in discontinued operations in 2009. We accrue for a liability related to a contingency, representation or warranty when management considers that the liability is both probable and can be reasonably estimated. Prior to the decision by the arbitrator, we did not believe that sufficient information existed to evaluate such claims, and could not reasonably estimate the range of this liability, or determine whether such liability would be material. The interim award will not become final until the arbitrator determines awards of costs and attorneys’ fees, which the parties will be briefing in the near future. It is not possible at this time to determine the amount of any additional award, but any such award would be reflected in discontinued operations when it becomes probable and estimable.

 

Also as part of the agreement to sell the net assets of S&T/Montreal, we released the purchaser from a corporate guarantee, and have reported a noncurrent liability in the consolidated balance sheet as of December 31, 2009. This liability represents our estimated loss under an agreement to acquire a license from the purchaser for $8 million in payments over a seven-year period for the rights to a certain satellite territory and a corresponding sublicense agreement that granted the territory rights back to the purchaser, under which we will receive a portion of the satellite service revenues from the specific market territory over the same period. The purchaser had previously guaranteed that the revenues derived under the sublicense would equal or exceed the acquisition cost of the license; however, having released the guarantee, we currently estimate that our portion of the satellite service revenues will be less than the acquisition cost, and we have accordingly reflected a net liability as current in the consolidated balance sheet.

 

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Commitments and Contractual Obligations

 

Following is a summary of our material contractual cash commitments as of December 31, 2009 (in thousands):

 

 

 

Critical Accounting Policies

 

Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, which often require the judgment of management in the selection and application of certain accounting principles and methods. We consider the following accounting policies to be critical to understanding our consolidated financial statements, because the application of these policies requires significant judgment on the part of management, and as a result, actual future developments may be different from those expected at the time that we make these critical judgments. We have discussed these critical accounting policies with the Audit Committee.

 

Revenue recognition

 

Revenue recognition for fixed-price, long-term contracts is a critical accounting policy involving significant management estimates by D&S, and Communications & Tracking. Long-term contracts use the ratio of cost-incurred-to-date to total-estimated-cost-at-completion as the measure of performance that determines how much revenue should be recognized (“percentage-of-completion” method of accounting). Cost incurred and estimates of cost to complete include overhead expenses, which are applied at a budgeted rate; the budgeted overhead rate has historically been closely comparable with the periodic actual overhead rate, but any budget-versus-actual rate variance during an accounting period is expensed in that period, with no effect on revenues recognized.

 

The determination of total estimated cost relies on engineering estimates of the cost to complete the contract, with allowances for identifiable risks and uncertainties. If changes in engineering estimates result in an expected cost overrun but not an overall loss on the contract (i.e., the estimated cost to complete exceeds the revenue to be recognized on the remainder of the contract), then revenue recognized-to-date will be adjusted accordingly based on the application of the percentage-of-completion method. If changes in engineering estimates result in the total estimated cost-at-completion in excess of total contact value, the entire estimated loss is immediately recognized. Engineering estimates are frequently reviewed and updated; however,

 

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unforeseen problems can occur to substantially reduce the rate of future revenue recognition in relation to costs incurred.

 

Billings under a long-term contract are often subject to the accomplishment of contractual milestones or specified billing arrangements that are not directly related to the rate of costs being incurred under a contract. As a result, revenue recognized under percentage-of-completion for any particular period may vary from billings for the same period. As of December 31, 2009, we had recognized a cumulative total of $33.1 million in revenues under percentage-of-completion accounting, for which revenues were unbilled as of that date due to the billing milestones specified in the respective customer contracts. This is included in estimated earnings in excess of billings on long-term contracts and other non-current assets in our consolidated balance sheets. We had also recognized $9.6 million in billings in excess of contract costs and estimated earnings on long-term contracts. This is included in noncurrent liabilities in our consolidated balance sheets.

 

Net sales under cost-reimbursement contracts in D&S are recorded as costs are incurred and include an estimate of fees earned under specific contract terms. Costs incurred include overhead, which is applied at rates approved by the customer. Fixed fees are earned ratably over the life of a contract. Incentive fees are based upon achievement of objective criteria for technical product performance or delivery milestones, although such fees may also be based upon subjective criteria (for example, the customer’s qualitative assessment of our project management). In all cases related to incentive fee arrangements, we do not record revenue until the fee has been earned under the terms of the contract.

 

We recognize revenue from product-related service contracts, and extended warranties, ratably over the life of the contract. Amounts paid by customers at the inception of the extended warranty period are reflected as deferred revenue with the portion estimated to be recognized as revenue within the next twelve months reflected in other current liabilities in the consolidated balance sheets and the remainder reflected in noncurrent liabilities. We recognize revenue from repair services and tracking, voice and data services as services are rendered. We recognize revenue from contracts for engineering services using the percentage-of-completion method for fixed price contracts, or as costs are incurred for cost-type contracts.

 

Net sales under all arrangements are recognized when units are shipped or services are performed, unless multiple deliverables are involved or software is more than incidental to a product as a whole (mainly experienced at Communications & Tracking), in which case we recognize revenue in accordance with either ASC Subtopic 605-25, Revenue Recognition-Multiple-Element Arrangements, or ASC Subtopic 985-605, Software-Revenue Recognition, as applicable. Net sales do not include sales tax collected.

 

Inventory valuation

 

We reduce the carrying amount of our inventory for estimated obsolete and slow-moving inventory to its estimated net realizable value based on assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional adjustments could be required. Such adjustments reduce the inventory’s cost basis, and the cost basis is not increased upon any subsequent increases in estimated net realizable value.

 

Evaluation of fair value measurements

 

We adopted ASC Topic 820, Fair Value Measurements and Disclosures, for financial assets and liabilities on January 1, 2008, and for non-financial assets and liabilities on January 1, 2009. This guidance clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the new guidance establishes a three-tier fair-value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

 

 

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Business combinations

 

We account for business combinations in accordance with the provisions of ASC Topic 805, Business Combinations (“ASC 805”). The provisions of ASC 805 were previously contained in Statement of Financial Accounting Standards (“SFAS”) No. 141(R), Business Combinations. These provisions require that identifiable assets acquired and liabilities assumed be reported at fair value as of the acquisition date of a business combination. Transaction costs are expensed as incurred, and are classified within cash flows from operating activities in the consolidated statement of cash flows. Costs associated with restructuring or exit activities of an acquired entity are also expensed when incurred. Contingent consideration in a business combination is recognized at fair value at the acquisition date as a liability or as equity. Subsequent adjustments of an amount recognized as a liability, including accretion of the discounted liability, are recognized in the statement of operations.

 

ASC 805 requires that we recognize and measure deferred tax assets or liabilities arising from assets acquired and liabilities assumed to be accounted for in accordance with the provisions of ASC Topic 740, Income Taxes, with appropriate allowances for uncertain tax positions and valuation allowances against deferred tax assets. Subsequent changes to valuation allowances against deferred tax assets after the measurement period are recognized as an adjustment to income tax expense.

 

An intangible asset is recognized as an asset apart from goodwill if it arises from contractual or other legal rights or if it is separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged. Goodwill is recognized as a result of a business combination to the extent the consideration transferred exceeds the acquisition-date amounts of identifiable assets acquired and liabilities assumed, determined in accordance with the provisions of ASC 805.

 

In accordance with ASC Topic 350, Intangibles – Goodwill and Other (“ASC 350”), goodwill and intangible assets acquired in a business combination and determined to have indefinite useful lives are not being amortized, but instead are evaluated for impairment annually, and between annual tests if an event occurs or circumstances change that indicate that the asset might be impaired.

 

ASC 350 requires that if the fair value of a reporting unit is less than its carrying amount, including goodwill, further analysis is required to measure the amount of the impairment loss, if any. The amount by which the reporting unit’s carrying amount of goodwill exceeds the implied fair value of the reporting unit’s goodwill, determined in accordance with ASC 350, is to be recognized as an impairment loss. During 2009, we changed the annual impairment testing date from December 31 to the first day of our twelfth reporting period in the fiscal year. We believe this change is preferable since it provides additional time prior to our year-end to complete the goodwill impairment testing and report the results in our Annual Report on Form 10-K.

 

In accordance with ASC 350, intangible assets, other than those determined to have an indefinite life, are amortized to their estimated residual values on a straight-line basis, or on the basis of expected economic benefit, over their estimated useful lives. These intangible assets are reviewed for impairment in accordance with ASC Subtopic 360-35, Impairment or Disposal of Long-Lived Assets, whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Recoverability of an asset to be held and used is measured by comparing its carrying amount to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge would be recognized for the amount by which the carrying amount of the asset exceeds its fair value. An asset to be disposed of would be reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. Cash flow projections, although subject to a degree of uncertainty, are based on management’s estimates of future performance, giving consideration to existing and anticipated competitive and economic conditions.

 

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Evaluation of long-lived assets for impairment

 

All long-lived assets on the consolidated balance sheet are periodically reviewed for impairment. If an indication of impairment arises, we test recoverability by estimating the cash flows expected to result from the long-lived assets under several different scenarios, including the potential sale of assets, as well as continued holding of the assets under several different kinds of business conditions.

 

Evaluation of goodwill for impairment

 

We have four reporting units with goodwill from prior acquisitions reported on the balance sheet at December 31, 2009. In completing the annual test for impairment in the fourth quarter of 2009, the estimated fair value of three of our four reporting units with goodwill exceeded the carrying amount. The determination of estimated fair value includes a number of assumptions that drive the value and these assumptions inherently include a level of uncertainty. Future events, circumstances, or both, could have a negative effect on the fair value of any or all of the reporting units which could result in the fair value not exceeding the carrying amount in future tests. If this were to occur, we would be required to measure the amount, if any, of an impairment loss of goodwill.

 

For our LXE reporting unit, the estimated fair value did not exceed the carrying amount. Therefore, we completed step two of the impairment testing process to measure the amount of the impairment loss. While the carrying amount exceeded the estimated fair value by only $6.0 million, the impairment loss was measured as $19.9 million. The requirements to determine the impairment loss stipulate that the estimated fair value of all assets and liabilities of the reporting unit be determined similar to the method used in a business combination. The aggregate fair value of the assets and liabilities, including those not reflected in the carrying amount, is compared to the estimated reporting unit fair value with the difference being implied goodwill. The excess of goodwill on the balance sheet and this implied goodwill is the impairment loss. For a reporting unit with unrecognized intangible assets or other assets whose fair value exceeds the carrying amount, the impairment loss will exceed the reporting unit fair value deficiency since the accounting rules do not allow for a step up in fair value for these other assets in this process. The LXE reporting unit was last tested for impairment as of the end of the first quarter in 2009. At that time no impairment of goodwill was indicated. LXE’s results for the remainder of the year improved from the first quarter, however, they were somewhat below revised expectations. In developing the 2010 operating plan for the reporting unit, and the longer-term cash flow projections, the cash flows are now projected to be less than previously estimated. Furthermore, the discount rate used to determine the present value of the estimated future cash flows is now higher.

 

The amount of goodwill for each reporting unit that passed the initial step of the impairment test as of December 31, 2009, and the percentage by which the estimated fair value exceeded the carrying amount of the reporting unit is as follows (dollars in thousands):

 

 

Each of these reporting units was recently acquired. At the acquisition date, the carrying amount of a reporting unit is equal to its purchase price. Therefore, a significant excess would not be expected for a recently acquired reporting unit. The key assumptions that drive the estimated fair value of the reporting units include future cash flows from operations, the discount rate applied to those future cash flows, determined from a weighted-average cost of capital calculation, and EBITDA and revenue multiples using guideline comparable companies. The future cash flows include additional key assumptions relating to revenue growth rates, margins and costs. The estimated revenue growth rates for each of these reporting units are in excess of anticipated inflation and industry forecasts in general since the revenues of these reporting units have been

 

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negatively impacted by the global economic environment in recent years so we expect a recovery to impact revenues favorably. Furthermore, several of these reporting units operate in growing markets. In addition, our reporting units are introducing a number of new products in the near future that we expect to be well received in the market. In the near term, we believe that these reporting units will see the impact of a rebounding economy over the next two years that will support such growth projections. Actual future results could differ materially from these estimates which could have a negative effect on fair value. Particularly, if the markets served by these reporting units do not expand as we expect, the fair value of one or more of the reporting units could be determined to be below the carrying amount.

 

The carrying amount of consolidated net assets on our balance sheet as of the goodwill impairment testing date exceeded the market capitalization of our common stock by approximately 30% prior to recording the $19.9 million loss on impairment of goodwill for LXE. At December 31, 2009, the carrying amount of net assets exceeded the market capitalization by 7%. At March 26, 2010, the market capitalization of our common stock was 14% higher than the December 31, 2009 level.

 

Evaluation of contingencies related to discontinued operations

 

In 2005 and 2006, we disposed of S&T/Montreal, SatNet, and EMS Wireless, all of which have been reported as discontinued operations. The costs reported under discontinued operations in 2007 and 2009 mainly related to the resolution of various contingencies, representations or warranties under standard indemnification provisions in the sales agreements. We record a liability related to a contingency, representation or warranty when management considers that the liability is both probable and can be reasonably estimated. The amounts we have accrued related to the expected resolution of the dispositions of discontinued operations that could vary from the actual amounts.

 

The purchaser of EMS Wireless asserted claims under such representations and warranties. The parties agreed to arbitration, which commenced in the third quarter of 2009. In March of 2010, we received an interim decision from the arbitrator on these claims awarding the purchaser a total of approximately $9.2 million under the warranty provisions of the purchase agreement. As a result, we accrued a liability for the awarded costs in discontinued operations in 2009. We accrue for a liability related to a contingency, representation or warranty when management considers that the liability is both probable and can be reasonably estimated. Prior to the decision by the arbitrator, we did not believe that sufficient information existed to evaluate such claims, and could not reasonably estimate the range of this liability, or determine whether such liability would be material. The interim award will not become final until the arbitrator determines awards of costs and attorneys’ fees, which the parties will be briefing in the near future. It is not possible at this time to determine the amount of any additional award, but any such award would be reflected in discontinued operations when it becomes probable and estimable.

 

Income taxes

 

As part of the process of preparing our consolidated financial statements, we are required to determine income taxes related to each of the jurisdictions in which we operate. This process involves estimating current tax expense, together with assessing temporary differences resulting from differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. These differences result in deferred tax assets and liabilities in our consolidated balance sheet.

 

For all deferred tax assets that exist in relation to an uncertain tax position, we must determine the amount of that benefit to recognize in accordance with the recognition and measurement provisions of FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109 (which is now included in ASC Subtopic 740-10-05, Income Taxes). This determination requires judgments to be made regarding the likelihood that the position would be sustained upon examination based on the technical merits of the position and estimates of the amount to be realized upon settlement. A portion of the unrecognized tax benefits that exist at December 31, 2009 would affect our effective tax rate in the

 

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future if recognized. In 2009 we lowered the amount of unrecognized benefits by $1.9 million related to prior-year research and development credits in the U.S. after completion of an Internal Revenue Service examination.

 

We must also assess the likelihood that the deferred tax assets in each jurisdiction will be recovered from taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance against the deferred tax assets. In determining the required level of valuation allowance, we consider whether it is more likely than not that all or some portion of the deferred tax assets will not be realized. This assessment is based on management’s expectations as to whether sufficient taxable income of an appropriate character will be realized within tax carryback and carryforward periods. Our assessment involves estimates and assumptions about matters that are inherently uncertain, and unanticipated events or circumstances could cause actual results to differ from these estimates. Should we change our estimate of the amount of deferred tax assets that we would be able to realize, a change to the valuation allowance would result in an increase or decrease to the provision for income taxes in the period in which such change in estimate is made.

 

Our most significant amount of deferred tax assets relates to our Canadian operations, primarily from research-related tax benefits. A valuation allowance has been established for a portion of the Canadian deferred tax assets. It had been management’s expectation until 2005 that our Canadian operations would generate enough research-related tax benefits each year to offset any Canadian federal tax liability for any given year. As a result, we had reserved substantially all the net deferred tax assets associated with these research-related tax benefits because the extent to which these deferred income tax assets were to be realized in the future was uncertain. With the disposal of unprofitable operations beginning in 2005 and the improving profitability of continuing operations in Canada, we have reassessed the required amount of valuation allowance against our research-related deferred tax assets in Canada each year. We have made adjustments each year in which we concluded that it was more likely than not that additional tax benefits would be realized based on an assessment of all available evidence. The valuation allowance could be increased or decreased in the future, which would result in an income tax expense or benefit in future consolidated statements of operations. A benefit could result if profitability expectations for our Canadian operations increase.

 

We also have net deferred tax assets in the U.S., including net operating loss and research and development credit carryforwards from acquired companies. We completed our assessment in 2009 and determined that no valuation allowance was necessary for those deferred tax assets based on a consideration of all available evidence about sources of taxable income. We will make an evaluation of the likelihood of realization each reporting period in the future, and we could determine that a valuation allowance is necessary against all, or a portion, of the these deferred tax assets.

 

Stock-based compensation

 

We measure compensation expense based on estimated fair values of all share-based awards to our employees and directors. We estimate the fair value of stock options on the date of grant using the Black-Scholes option valuation model. Stock-based compensation is recognized on a straight-line basis over the requisite service period for each separately vesting portion of an award as if the award was, in substance, multiple awards. We estimate future forfeitures based on historical experience and review such estimates periodically and adjust expense recognition accordingly.

 

The Black-Scholes option valuation model requires additional estimates and assumptions, including expected stock price volatility, expected term, and forfeitures rates. Our estimated expected volatility is based on historical volatility of our stock over a period equal to the expected term. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding. Forfeitures are based on actual forfeiture rates experienced.

 

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Risk Factors and Forward-Looking Statements

 

The Company has included forward-looking statements in management’s discussion and analysis of financial condition and results of operations. Actual results could differ materially from those suggested in any forward-looking statements as a result of a variety of factors. Such factors include, but are not limited to:

 

 

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Additional information concerning these and other potential risk factors is included in Item 1A. of this Annual Report on Form 10-K under the caption “Risk Factors.”

 

Effect of New Accounting Pronouncements

 

—  Recently Issued Pronouncements Not Yet Adopted

 

In October 2009 the FASB issued two Accounting Standards Updates (“ASU”) that could result in revenue being recognized earlier in certain revenue arrangements with multiple deliverables. Both updates are effective for us in the first quarter of 2011. Early adoption is permitted. We are evaluating when to adopt the updates and the effect the adoption will have on our consolidated financial statements.

 

ASU 2009-13, Revenue Recognition – Multiple-Deliverable Revenue Arrangements, amends the accounting for revenue arrangements with multiple deliverables. Among other things, ASU 2009-13:

 

ASU 2009-14, Software – Certain Revenue Arrangements That Include Software Elements, amends the guidance for revenue arrangements that contain tangible products and software elements. ASU 2009-14 redefines the scope of arrangements that fall within software revenue recognition guidance by specifically excluding tangible products that contain software components that function together to deliver the essential functionality of the tangible product.

 

Under current guidance, products that contain software that is more than incidental to the product as a whole fall within the scope of software revenue recognition guidance, which requires, among other things, the existence of vendor-specific objective evidence of fair value of all undelivered items to allow a delivered item to be treated as a separate unit of accounting. Such tangible products excluded from the requirements of software revenue recognition requirements under ASU 2009-14 would follow the revenue recognition requirements for other revenue arrangements, including the new requirements for multiple-deliverable arrangements contained in ASU 2009-13.

 

In January 2010, the FASB issued guidance amending and clarifying requirements for fair value measurements and disclosures in ASU 2010-06, Improving Disclosures About Fair Value Measurements. The new guidance requires disclosure of transfers in and out of Level 1 and Level 2 and a reconciliation of all activity in Level 3. The guidance also requires detailed disaggregation disclosure for each class of assets and liabilities in all

 

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levels, and disclosures about inputs and valuation techniques for Level 2 and Level 3. The guidance is effective at the start of interim or annual reporting periods beginning after December 15, 2009 and the disclosure reconciliation of all activity in Level 3 is effective at the start of annual reporting periods beginning after December 15, 2010. We do not expect that the adoption of ASU 2010-06 will have a material impact on our consolidated financial statements.

 

Refer to Note 1 of our consolidated financial statements in this Annual Report for additional information on accounting changes recently adopted, and recently issued pronouncements not yet adopted.

 

 

As of December 31, 2009, we had the following market-risk sensitive instruments (in thousands):

 

 

A 100 basis point change in the interest rates of our market-risk sensitive instruments would have changed interest income by approximately $237,000 for the year based upon their respective average outstanding balances.

 

Our revolving credit agreement includes variable interest rates based on the lead bank’s prime rate or the then published LIBOR for the applicable borrowing period. As of December 31, 2009 we had approximately $18.5 million of borrowings outstanding in the U.S., and no borrowings outstanding under in Canadian under our revolving credit agreement. A 100 basis point change in the interest rate on our revolving credit agreement would have changed interest expense by approximately $227,000 for the year based upon the average outstanding borrowings under these obligations.

 

At December 31, 2009, we also had intercompany accounts that eliminate in consolidation but that are considered market-risk sensitive instruments because they are denominated in a currency other than the local functional currency. These include short-term amounts due to the parent (payable by international subsidiaries arising from purchase of the parent’s products for sale), intercompany sales of products from foreign subsidiaries to a U.S. subsidiary and cash advances to foreign subsidiaries.

 

 

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We had accounts receivable and accounts payable balances denominated in currencies other than the functional currency of the local entity at December 31, 2009 as follows: