United States Form 10-K (Mark One) [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended October 31, 2007 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Transition Period from ____________________ to ____________________. Commission file number 0-21236 |
Applied Signal Technology, Inc. |
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California |
77-0015491 |
400 West California Ave., Sunnyvale, CA 94086 |
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(408) 749-1888 |
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| Securities registered pursuant to Section 12(b) of the Act: Not Applicable. | ||
| Securities registered pursuant to Section 12(g) of the Act: Common Stock, without par value. | ||
| Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. | ||
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| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. | ||
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| 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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. | ||
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| 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. [ ] | ||
| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one): | |||
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Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act). |
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| Aggregate market value of the voting common stock held by non-affiliates of the registrant: | |
Common stock, without par value – $204,242,383 as of May 4, 2007, based on the closing price on such date for the registrant’s common stock reported by the NASDAQ National Market System. For purposes of this disclosure, shares of common stock held by persons who held more than 5% of the outstanding shares of common stock and shares held by officers and directors of the registrant have been excluded in that such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes. |
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| Number of shares of registrant’s common stock outstanding: | |
Common stock, without par value – 12,388,422 shares as of October 31, 2007. |
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Documents Incorporated by Reference
The registrant has incorporated by reference into Part II, Item 5 and Part III of this Form 10-K portions of its proxy statement for the registrant’s Annual Meeting of Shareholders to be held on March 18, 2008.
Index
Applied Signal Technology Inc.
This annual report on Form 10-K contains forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on management’s current expectations and beliefs, including estimates and projections about our industry. Forward-looking statements may be identified by the use of terms such as “anticipates,” “expects,” “intends,” “plans,” “seeks,” “estimates,” “believes,” and similar expressions, although some forward-looking statements are expressed differently. Statements concerning financial position, business strategy, and plans or objectives for future operations are forward-looking statements. These statements are not guarantees of future performance, are subject to certain risks, uncertainties, and assumptions that are difficult to predict, and may cause actual results to differ materially from management’s current expectations. Such risks and uncertainties include those set forth under “Item 1A: Risk Factors” and “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The forward-looking statements in this report speak only as of the time they are made and do not necessarily reflect management’s outlook at any other point in time. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or for any other reason. However, readers should carefully review the risk factors set forth in other reports or documents we file from time to time with the Securities and Exchange Commission (SEC) after the date of the Annual Report. These SEC filings, as well as our latest annual report, can be obtained through our website at www.appsig.com. In addition, hard copies can be obtained free of charge through our investor relations department.
Description of the Business
Applied Signal Technology, Inc. (AST) provides advanced digital signal processing products, systems, and services in support of intelligence, surveillance, and reconnaissance (ISR) for global security. We provide processing of both man-made and naturally occurring signals. The processing of man-made signals includes communications intelligence (COMINT) and electronic intelligence (ELINT). The processing of natural signatures includes the use of sonar, radar, magnetic, and chemical sensors to detect changes in the environmental phenomenology. Our primary customer is the United States Government. We develop and manufacture equipment for both the collection and processing of signals.
COMINT derives intelligence from telecommunications signals. Our COMINT signal collection equipment consists of sophisticated receivers that scan through potentially thousands of cellular telephone, microwave, ship-to-shore, and military transmissions in the radio frequency (RF) spectrum with the goal of collecting certain specific signals. Our COMINT signal processing equipment uses advanced software and hardware to evaluate characteristics of the collected signals and selects those most likely to contain relevant information. At inception, our efforts were primarily focused on COMINT processing equipment. Over time, we have broadened our scope to add specialized collection equipment and complete signal processing systems and related services.
ELINT derives intelligence from signals associated with weapons systems. Our investment in ELINT is directed toward the development of equipment for the collection and processing of weapons systems signals. This equipment will be able to scan the radar bands associated with weapons systems and determine the type of system and its precise location for battlefield characterization and force protection. The equipment will also analyze the command and control signals associated with these weapons systems to provide information about battlefield readiness. Our ELINT initiatives are new, and to date we have derived no revenue from the sale of ELINT products or services.
Sensor signal processing observes changes in physical phenomena that can provide an indication of activities of concern to global security. Examples of these phenomena are detection of chemicals that might be used for explosive devices or the detection of sub-terrain ferrous materials that might indicate an underground facility for weapon manufacturing. Our sensor processing equipment provides automatic detection of physical abnormalities in both marine and terrestrial environments.
Substantially all of our revenues are from contracts with the United States Government or prime contractors to the United States Government.
We are incorporated in California. Our principal executive offices are located at 400 West California Ave., Sunnyvale, CA, 94086, and our telephone number at that address is (408) 749-1888. Our website address is www.appsig.com. The information posted on our website is not incorporated into this annual report. However, investors can obtain a copy of this annual report on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports filed or furnished with the SEC, as well as a copy of our Code of Ethics, on our website free of charge.
Communications Intelligence (COMINT)
Accurate and comprehensive information regarding foreign affairs and developments affecting international security has become increasingly important to the United States Government. The political instability in certain regions such as the Middle East, Eastern Europe, Africa, and Central and South America and the ongoing counterterrorism campaign have heightened the United States Government’s need to be able to monitor activities in foreign countries. In order to obtain information about activities within foreign countries, the United States Government gathers and analyzes telecommunications signals emanating from those countries.
The ever-increasing commercial development of telecommunications equipment has led to a significant increase in the overall quantity of information communicated and an increase in the density of signals transmitted throughout the RF spectrum. This increase can be seen in the proliferation of facsimile, cellular, and digital signal telecommunications equipment and in the global information network (such as the Internet) in recent years, resulting in a significant increase in the amount of information being communicated. Consequently, the need to develop COMINT equipment capable of collecting and processing an increasing quantity of signals, as well as new types of signals, has grown significantly.
We devote significant resources toward understanding the United States Government’s COMINT goals, capabilities, and perceived future needs. We obtain information about these signal reconnaissance needs through frequent marketing contact between our employees and technical and contracting officials of the United States Government. In addition, we invest in research and development (R&D) activities that we anticipate will enable us to develop signal reconnaissance equipment that meets the future needs of the United States Government.
Our COMINT products can be used, with or without further modification, to satisfy requirements of a variety of customers. Our products can be deployed readily in a wide variety of circumstances to meet current United States Government signal reconnaissance requirements.
In addition, we believe that the United States Government is continuing to increase funding for counterterrorism. Counterterrorism is focused on individuals and groups of individuals, and relies heavily on intelligence gathering. A key source for intelligence is COMINT. We are a resource to the United States Government, providing COMINT products, systems, and services.
Electronic Intelligence (ELINT)
The same countries that have political instability and terrorist activities are modifying older Soviet-developed weapons systems as well as developing new weapons systems. Accordingly, the United States Government must invest in new ELINT technologies to gather intelligence about these weapons systems. There is also a need to advance ELINT technology to provide battlefield mapping and force protection against these new weapons systems.
We are investing to develop a state-of-the-art ELINT processor that will provide information concerning the characterization and location of these new weapons systems. We expect that this investment will result in a product that will also be applicable to unmanned aerial vehicles, which we believe will be the platform of choice for future ELINT missions.
Sensor Processing
In the current counterterrorism campaign, the United States Government has determined that the collection of signature information is very important in aiding the detection and location of terrorist activities. We believe that sensor detection of chemicals that might be used for explosives or ferrous materials that might indicate installations of improvised explosive devices (IEDs) is a high-priority information source to the United States Government.
Our sensor processing products can aid anti-submarine warfare, as well as mine countermeasures. We also have products that can detect land-based mines and IEDs.
Homeland security requires a robust system that quickly conducts covert or overt inspection of containers, vehicles, packages, and facilities anywhere in the world, on land or sea, by using tools that reach beyond the fixed site border security systems. In particular, United States security forces need to have a portable capability to “see” through walls and other barriers to non-intrusively identify dangerous materials on the other side.
To address this need, Applied Signal Technology is developing neu-VISION™—a portable neutron imaging and material identification system designed to provide through-barrier detection and classification of explosives, chemical agents, radiological or nuclear materials, and other hazardous materials in a variety of operational settings. The innovative neutron imaging technology serves an important role in the nation’s integrated security capability with its unique combination of barrier penetration, three-dimensional representation, material identification, and operational flexibility. We have obtained a license to operate neutron-imaging equipment at our non-intrusive inspection test facility in Torrance, California.
Segments
We have reviewed our business operations and determined that we operate in a single homogeneous business segment. We sell similar products and services with similar economic characteristics to similar classes of customers, primarily to the United States Government, its agencies, or prime contractors for the United States Government. Our technologies and the operations of our divisions are highly integrated. Revenues and costs are reviewed monthly by management on an individual contract basis as a single business segment.
Strategy
Our objective is to anticipate the needs of the global security marketplace and to invest in research and development so we can provide solutions to ISR needs before our competitors. In some cases, our solution is to develop equipment or services that address new telecommunications technologies or detection of new phenomena of importance. In other cases, our solution is to develop equipment that offers smaller size, lower power consumption, and lower cost than potentially competitive products. Our strategy to accomplish these objectives focuses on the following elements.
Anticipate marketplace needs. We devote significant resources in order to anticipate future global security needs. We monitor technological and commercial advances in telecommunications as well as trends in terrorist activities to identify what we believe are new opportunities for the development of our products. We obtain information about marketplace needs through frequent contact with technical and contracting officials of pertinent government agencies within the intelligence community.
Many times, the United States Government grants sole-source contracts when a single contractor is deemed to have expertise or technology that is superior to that of competing contractors. Since our inception, a significant portion of our revenues has been from sole-source contracts.
Invest in research and development. We invest in research and development (R&D) that we believe will enable us to develop equipment and services that will satisfy the future global security needs of our customers. This, in turn, often enables us to introduce products that meet marketplace demands before our competitors. An important aspect of our R&D efforts is the understanding of information sources that could enhance global security in order to anticipate the future signal processing needs of our customers. Not only does this allow us to direct R&D engineering efforts to produce solutions promptly once a customer expresses a requirement, but it often allows us to educate the customer about potential requirements and simultaneously present a conceptual solution to those requirements.
Develop flexible products. We develop products that can be used as originally designed or, with further customization, to satisfy the needs of a variety of customers. We use prior product development efforts to offer customers cost-effective solutions and to offer these solutions promptly.
Develop highly integrated products. We design our products to use advanced circuitry and highly integrated components. This enables us to offer products that are smaller, consume less power, and cost customers less when multiple units are built than equipment of similar functionality that uses fewer advanced designs and materials. The lower cost of many of our products appeals to customers with budget constraints, and the small size and low power consumption of many of our products appeal to customers with physical installation constraints.
Focus on signal processing. Since inception, we have focused our attention on developing signal processing equipment and services. We believe that there have been and will continue to be opportunities to develop specialized signal processing equipment and services to satisfy emerging technological requirements.
Increase business with existing customers and broaden customer base. We believe that our current intelligence agency and military customers offer opportunities for sales growth through sales of additional units of developed products and through contracts to develop new products. Accordingly, we direct much of our marketing efforts toward these customers in order to increase our penetration of these markets. Additionally, we continue to try to broaden our customer base by increasing marketing efforts toward other agencies and military customers.
Products
Communications Intelligence Products
Our COMINT products consist of signal collection and processing equipment that use software and hardware that we developed over many years. This software and hardware enables our processing equipment to evaluate large numbers of radio frequency signals and to select the relatively small portion that contains information likely to be useful to the United States Government. We offer a variety of COMINT products that can be categorized as follows.
Voice grade channel processors. These processors are designed to process voice grade channels (VGCs), which carry audio and other signals. The standard telecommunication systems used throughout the world put a large number of VGCs on a single carrier channel to increase the number of signals that can be transmitted at a particular frequency. Our VGC processors can scan thousands of signals in less than one second, evaluate their characteristics, and use sophisticated processing technology to detect and record relevant data that is then analyzed by United States Government personnel. Our VGC processors currently range in price from approximately $3,000 to approximately $700,000.
Wideband processors. These processors “clean” telecommunication signals for further processing by VGC processors by adjusting for signal distortions that commonly occur during transmission. The two primary types of distortions that these processors correct are multipath interference (caused by the reception of a signal and its reflections) and co-channel interference (caused by the reception of multiple interfering signals). Commercial telecommunication companies overcome these distortions with careful alignment and tuning that requires interruption of the telecommunication signals. Our wideband processors perform this alignment independently and automatically by using proprietary adaptive algorithms that let the processors “learn” how to adjust their parameters to process the incoming signals. One of our wideband products processes signals that carry thousands of VGCs in a globally used digital format that is particularly susceptible to distortions. Our wideband processors currently range in price from approximately $8,000 to approximately $90,000.
Collection products. We offer a limited number of signal collection products designed to complement some of our processing products. Our collection products include a low-cost, small receiver that collects very complex signaling formats, and a receiver that optimizes multiple antenna inputs to overcome co-channel interference and certain forms of multi-path interference. Our collection products currently range in price from approximately $20,000 to approximately $40,000.
Software products. Software products are based upon the use of commercial off-the-shelf hardware processors. With current state-of-the-art computer and component technologies (for example, field-programmable gate arrays, Pentium processors, G4 processors), global security requirements can often be met by utilizing off-the-shelf “compute engines.” We develop our software products so the signal processing can be performed on these engines when applicable. Our software products, utilizing our proprietary licenses, range in price from approximately $2,000 to approximately $100,000.
Sensor Processing Products
Our sensor processing products consist of advanced digital signal processing hardware and software. These products automatically process the results of physical phenomena sensors to detect abnormalities of interest. These products can be categorized as follows.
Marine processors. These processors are designed to detect abnormalities in the marine environment such as the presence of a submarine, mines tethered to the ocean floor, and terrorist activities such as attempts to destruct a telecommunication cable on the ocean floor. These processors consist of active sensing such as synthetic aperture sonar and radar detection of periscopes as well as passive sensing such as magnetic detection of submarines. These processors can range in price from approximately $200,000 to approximately $500,000.
Terrestrial processors. These processors are designed to detect terrestrial abnormalities such as buried land mines, IEDs, and underground structures. These processors can be active sensors such as associated particle imaging or passive sensors such as electro-magnetic sensing. These processors can range in price from approximately $500,000 to approximately $2,000,000.
Systems
Systems development. We also develop and deliver entire systems in situations where the capabilities of our products formulate the majority of the system capability. These systems include our custom developed system software, and the integration of the appropriate compilation of our products as well as, at times, the integration of other vendors’ products. Pricing for processing systems can vary widely depending on systems requirements and may range from approximately $300,000 to tens of millions of dollars.
Systems integration. In recent years, we have applied our expertise to integrate signal processing systems comprised mainly of other vendors’ products. These system integration efforts are usually performed at a customer’s facility or site (many times in foreign countries). These contracts may include the development of system software, the physical integration of other vendors’ products, and the final system testing to verify performance. These contracts may require us to perform on-going maintenance and mission management efforts.
ELINT systems. We are currently investing to develop an airborne ELINT processing system capable of being installed in either manned or unmanned aerial vehicles. This system will be capable of identifying modern weapons systems of foreign countries and precisely geo-locating their position in the battlefield.
Services
We perform engineering services for current operational systems. Examples of these services are: 1) evaluation of current performance, 2) engineering improvements for performance enhancement, 3) evaluation of signals being processed to develop system operation techniques that can improve the intelligence gathering, 4) on-going mission management of a system, and 5) customer training in the usage of our standard products. Contracts for these services range in price up to several hundred thousand dollars.
Customers, Contracts, and Marketing
Customers
Since our inception, purchases by the United States Government have accounted for almost all of our revenues. These purchases occur in two ways: through contracts directly with the government and subcontracts to prime contractors. Direct contracts with the United States Government accounted for approximately 69%, 60%, and 67% of revenues in fiscal years 2007, 2006, and 2005, respectively. The subcontracts under which we supply products or services to prime contractors that have contracts with the United States Government accounted for approximately 29%, 37%, and 28% of revenues in fiscal years 2007, 2006, and 2005, respectively.
Our United States Government customers consist of military and intelligence agencies that have signal reconnaissance needs. Within our primary customer agencies, we have contracts with approximately 40 different offices, each with separate budgets and contracting authority.
The following table identifies the source of our revenues for fiscal years 2007, 2006, and 2005 by customer type.
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FY07 |
FY06 |
FY05 |
Intelligence agencies |
78% |
74% |
72% |
Military |
20% |
23% |
23% |
Foreign |
— |
1% |
2% |
Commercial |
2% |
2% |
3% |
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100% |
100% |
100% |
Contracts with all offices of two intelligence agencies accounted for approximately 26% and 47% of revenues in fiscal year 2007, approximately 24% and 46% of revenues in fiscal year 2006, and approximately 28% and 44% of revenues in fiscal year 2005, respectively. Contracts with one branch of the military accounted for approximately 15%, 17%, and 21% of revenues in fiscal years 2007, 2006, and 2005, respectively.
Contracts
Most of our business is conducted under contracts that include United States Government security requirements. Our contracts with United States Government agencies are of two types, as described below.
Sole-source contracts are awarded by the United States Government when a single contractor is deemed to have an expertise or technology that is superior to that of competing contractors. Potential suppliers compete informally for sole-source contracts through R&D investment and marketing efforts. This competition requires a contractor to identify the United States Government’s requirements early and invest in developing potential solutions so that the contractor can demonstrate a distinguishing expertise or technology promptly after the United States Government has identified a requirement. Sole-source contracts are awarded without a formal competition.
Competitive-bid contracts are awarded based on formal proposal evaluation criteria established by the procuring agency. Interested contractors prepare a bid and proposal in response to the agency’s request. A bid and proposal is usually prepared in a short time period (for example, 45 days) in response to a deadline, and requires the extensive involvement of numerous technical and administrative personnel. Competitive-bid contracts are awarded after a formal bid and proposal competition among suppliers.
The following table identifies the allocation of revenues we generated for fiscal years 2007, 2006, and 2005 between contracts awarded on a sole-source basis and contracts awarded on a competitive-bid basis.
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FY07 |
FY06 |
FY05 |
Sole-source contracts |
76% |
70% |
82% |
Competitive-bid contracts |
24% |
30% |
18% |
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100% |
100% |
100% |
Sole-source and competitive-bid contracts can be fixed-price contracts, where we agree to deliver equipment for a fixed price and we assume the risk of cost overruns; cost-reimbursement contracts, where we are reimbursed for our direct and indirect costs and paid a negotiated profit; or time-and-materials contracts, where we recognize revenue by applying a negotiated billing rate to the level of effort. Historically, we achieve greater profit margins from our fixed-price contracts than from our cost-reimbursement and time-and-materials contracts. In recent years, our significant contracts have been cost-reimbursement contracts. The following table represents our revenue concentration during the respective periods by contract type.
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FY07 |
FY06 |
FY05 |
Cost-reimbursement contracts |
71% |
79% |
76% |
Fixed-price contracts |
15% |
17% |
21% |
Time-and-materials contracts |
14% |
4% |
3% |
|
100% |
100% |
100% |
Most of our fixed-price contracts are for the manufacture of multiple units of our established products, rather than the development of new products. We believe that the risk of cost overruns is much less in the case of fixed-price manufacturing contracts, where the product has already been developed and at least a prototype made, than in the case of fixed-price development contracts.
Six contracts represented an aggregate of 56.3% of revenues for fiscal year 2007. Five contracts represented an aggregate of 42.1% of revenues for fiscal year 2006, and four contracts represented an aggregate of 29.4% of revenues for fiscal year 2005. One of the six significant contracts in fiscal year 2007 was a time-and-materials contract. All of the other contracts referenced were cost-reimbursement contracts.
We are subject to price redetermination on certain fixed-price United States Government contracts if it is determined that we did not price our products and services consistent with the requirements of the Federal Acquisition Regulations. During fiscal years 2007, 2006, and 2005, we did not have claims against us for noncompliance with these regulations, although, during fiscal year 2005 we did settle one dispute with the United States Government relating to earlier contracts.
Almost all of our contracts contain termination clauses that permit contract termination by the customer for cause upon our default or without cause for the convenience of the other contracting party. In either case, terminations could adversely affect our operating results. Under contracts terminable at the convenience of the United States Government, a contractor is generally entitled to receive payments for its allowable costs and, in general, the proportionate share of fees or earnings for the work done. Contracts that are terminable for default generally provide that the United States Government only pay for the work it has accepted and may require the contractor to pay for the incremental cost of reprocurement and may hold the contractor liable for damages incurred by the customer.
Marketing
Our primary marketing efforts consist of personal contact between our technical personnel and technical representatives of existing and potential customers. We involve all technically qualified staff members in our marketing program. We believe that it is extremely important to have technically knowledgeable staff make marketing contacts since an initial system concept is often developed during the first marketing contact.
In addition to our primary technical marketing, we also conduct marketing activities designed to increase our visibility with existing and potential customers. Each year, we conduct equipment shows in the Washington, D.C. area, demonstrating the operation of many of our products, and participate in shows sponsored by professional organizations. Additionally, we use direct mail and magazine advertising from time to time to inform potential customers of available products. We also produce a product summary catalog.
Backlog
Our backlog, which consists of anticipated revenues from the uncompleted portions of existing contracts and excludes unexercised options, was $126,708,000, $104,952,000, and $140,193,000, at October 31, 2007, 2006, and 2005, respectively. Anticipated revenues included in backlog may be realized over a multi-year period and include expected revenues from contracts that are fully funded as well as from contracts that are only partially funded. We include expected revenues from a contract in backlog when the contract is signed by us and by our customer. We believe the backlog figures are firm, subject only to the cancellation and modification provisions contained in our contracts. (See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations – New Orders and Backlog.”) Because of possible future changes in delivery schedules and cancellations of orders, backlog at any particular date is not necessarily representative of actual revenue to be expected for any succeeding period, and actual revenue for the year may not meet or exceed the backlog represented. We may experience significant contract cancellations that were previously booked and included in backlog.
Research and Development
We conduct R&D pursuant to United States Government R&D contracts and as part of our own R&D investment. We believe that our investment in R&D provides us with a significant competitive advantage. Research and development expenses incurred by us were approximately $14,204,000, $19,165,000, and $16,125,000 in fiscal years 2007, 2006, and 2005, respectively. As a percent of revenue, R&D equated to 8.3%, 11.8%, and 10.3% in fiscal years 2007, 2006, and 2005, respectively.
In fiscal years 2007, 2006, and 2005, our R&D program was funded entirely by the billing rates charged to our customers.
We seek to develop technology capable of addressing new global security signal processing requirements before our competitors. In addition, we focus R&D on developing products and services that can be used, with or without further modification, to satisfy various needs of a variety of customers, thereby permitting us to offer a prompt solution.
Company Technical Operations
Our technical business operations consist of a Multichannel Systems Division, a Wireless Communication Systems Division, an Ocean Systems Division, a National Security Systems Division, an Electronic Systems Division, and an Operations Division. All of these organizations report to our Chief Operating Officer. Because of the integral technologies and operations of our divisions to date, as well as the joint product development and common customers for our divisions, we have determined that we have only one corporate-wide reporting entity.
The Multichannel Systems Division and Wireless Communications Systems Division provide our COMINT products and services, and research and development for COMINT collection and processing solutions.
The Ocean Systems Division and the National Security Systems Division provide advanced sensor signal processing solutions for space-based, airborne, terrestrial, and undersea sensor technologies.
The Electronic Systems Division provides research and development for solutions to ELINT requirements.
The Operations Division is primarily responsible for manufacturing multiple units of products for all our divisions.
As of December 7, 2007, we had 496 employees in technical operations. (See “Item 1: Business – Employees” on page 12.)
Competition
The global security market is highly competitive and we expect that competition will continue to increase in the future. Some of our current and potential competitors have significantly greater technical, manufacturing, financial, and marketing resources than we do. Our current competitors include L-3 Communications, BAE Systems, Boeing, Raytheon Corporation, General Dynamics, Harris Corporation, Lockheed Martin, Northrop Grumman, Argon ST, Digital Receiver Technology, EDO Corporation, QinetiQ, Sierra Nevada Corporation, Science Applications International Corporation, and Thales. Substantial competition could impose pricing pressure on sales of our products, could develop and introduce new products meeting market demand more quickly than we can, and could result in lower revenue and decreased sales, which would have a materially adverse effect on our financial condition and operating results.
The competition for competitive-bid contracts differs from the competition for sole-source contracts. Companies competing for competitive-bid contracts prepare bids and proposals in response to either commercial or government requests and typically compete on price. Potential suppliers compete informally for sole-source contracts through R&D investment and marketing efforts. Companies competing for sole-source contracts attempt to identify the customer’s requirements early and invest in solutions so that they can demonstrate a distinguishing expertise or technology promptly after the customer has identified a signal processing requirement. The principal factors of competition for sole-source contracts include investments in R&D; the ability to respond promptly to government needs; and product price relative to performance, quality, and customer support. We believe that we compete favorably on each of these factors.
Proprietary Rights
The United States Government has rights to most of the technology that we have developed under government contracts, including rights to permit other companies, including our competitors, to use this technology to develop products for the United States Government. To our knowledge, the United States Government has not exercised these rights related to our products.
As of October 31, 2007, we had five issued patents.We believe that, given the rapidly changing nature of signal collection and processing technology, our future success will depend primarily upon the technical competence and creative skills of our personnel, rather than the legal protection afforded by patents. We attempt to protect our trade secrets and other proprietary information through agreements with customers, employees, and consultants, and through other security measures. To the extent we wish to assert our patent rights, we cannot be sure that any claims of our patents will be sufficiently broad to protect our technology. In addition, there can be no assurance that any patents issued to us will not be challenged, invalidated, or circumvented; that any rights granted under these patents will provide us adequate protection; or that there will be sufficient resources to protect and enforce our rights. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as do the laws of the United States. Although we do not believe that we are infringing upon the intellectual property rights of others, it is possible that such a claim will be asserted against us in the future. In the event any third party makes a claim against us for infringement of patents or other intellectual property rights of a third party, such claims, with or without merit, could be time-consuming and result in costly litigation. In addition, we could experience loss or cancellation of customer orders, could experience product shipment delays, or could be subject to significant liabilities to third parties. If our products were found to infringe on a third party’s proprietary rights, we could be required to enter into royalty or licensing agreements to continue selling our products. Royalty or licensing agreements, if required, may not be available under acceptable terms or at all, which could seriously harm our business. Our involvement in any patent dispute or other intellectual property dispute or action to protect trade secrets and expertise could have a materially adverse effect on our business.
Government Regulations
We must comply with regulatory requirements of federal, state, and municipal authorities applicable to companies contracting with the United States Government and its agencies, including regulations concerning employment obligations and affirmative action, workplace safety, and protection of the environment. Most importantly, we must comply with detailed government procurement and contracting regulations and with United States Government security regulations, certain of which carry substantial penalties for noncompliance or misrepresentation in the course of negotiations. Failure to comply with our government procurement or contracting obligations or security obligations could result in penalties imposed on us or suspension from government contracting, which would prevent us from selling our products to the United States Government, severely limiting our ability to operate our business and generate revenue, resulting in a materially adverse effect on our financial condition and operating results. (See “Item 1: Business – Customers, Contracts, and Marketing” on page 8.)
While compliance with applicable regulations has not adversely affected our operations in the past, we cannot be sure that we will continue to be in compliance in the future or that these regulations will not change, resulting in increased operational costs.
Employees
As of December 7, 2007, we had 635 employees. Our business requires that a large number of our technical employees obtain security clearances from the United States Government, which limits the available pool of eligible candidates for such positions to those who can satisfy the prerequisites to obtaining these clearances. In particular, the personnel involved in marketing require the appropriate clearances to meet with government technical representatives and discuss the government’s needs. We have a United States Government-sanctioned security program that allows staff members to obtain appropriate clearances. Approximately 76% of our staff has security clearances. Our success is dependent on attracting, retaining, and motivating qualified key management and technical personnel, the loss of whom could adversely affect our business materially. We believe we maintain a good relationship with our employees.
Our future performance is subject to a variety of risks. If any of the following risks actually occurs, our business could be harmed and the trading price of our common stock could decline. In addition to the following disclosures, please refer to the other information contained in this report, including consolidated financial statements and the related notes.
We may not be successful in our expansion of our products and markets, and may not realize the benefits of our investments in these new markets. Over the last several years, we have made investments in other areas complementary to our historic COMINT offerings. As a result of these investments, including our acquisition of Dynamics Technology, Inc. (DTI) in July 2005, and our research and development into the ELINT market, we have expanded our product offerings, approached new customers, and entered into new markets for advanced digital signal processing products, systems, and services in support of intelligence, surveillance, and reconnaissance (ISR) for global security. Our operations during fiscal year 2007 were, and are expected to continue to be, substantially influenced by the operations of the businesses we acquired from DTI as well as from our continued investment in products and markets complementary to our existing and new businesses. Our entry into new markets, and introduction of new products, subjects us to a number of risks and uncertainties, including the following:
- We are entering markets in which we have no or limited prior experience, and marketing to new customers in addition to our historic customer relationships. We may not be successful in these markets, and we may be unable to successfully enter into contracts with new or existing customers for these new business lines. We may not achieve the strategic objectives and other anticipated potential benefits of the acquisition of DTI or the investment in other products and complementary technologies. Our failure to achieve these strategic objectives could have a material, adverse effect on our ability to grow our business.
- As a result of the acquisition of DTI, we incurred debt in the amount of $10 million, of which $6.8 million remains outstanding as of October 31, 2007. Our failure to repay this debt when due would materially, adversely affect our financial condition and results of operations.
- Our diversification into ELINT, and into new signal processing capabilities, requires us to invest additional capital, open new facilities, and incur additional R&D expenditures. In addition, diversification results in diversion of management’s attention from our historic business. Although we believe that entering into these new business areas will be important to remaining competitive in the defense electronics marketplace, there can be no assurance that we will derive benefits from this diversification, our core business could suffer, and we could incur significant unanticipated costs, which could have a material impact on our results of operations.
Any decrease in expected product sales during a period could adversely impact our revenues, results of operations, and financial condition. From time to time, we have derived a significant portion of our revenue from product sales. In recent periods, however, we have been focusing on sales of systems and software, and targeting larger programs. In addition, we have experienced some seasonality in product sales to the United States Government, with more product sales occurring in the second half of the fiscal year than in the first. The amount and timing of Government purchases of products is unpredictable, and fluctuates significantly from period to period, making it difficult for us to predict the amount of revenue we will generate from product sales in any particular period, and causing our revenues to fluctuate from period to period. If we are not able to generate revenues from product sales as expected in a particular period, we may fail to meet our revenue expectations and the expectations of industry analysts and investors, which could cause our stock price to decline.
If we are unable to recruit, train, and retain key personnel with required security clearances, our ability to develop, introduce, and sell our products may be adversely impacted. Our ability to execute our business plan is contingent upon successfully attracting and retaining qualified employees who obtain, or are able to obtain and retain, necessary government security clearances. If we fail to attract and retain qualified employees who can obtain the necessary security clearances, our business could be significantly harmed. The loss of the services of our qualified employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel could negatively impact our ability to develop, introduce, and sell our products. In addition, employees may leave us and subsequently compete against us.
Many of the personnel we hire will need United States Government security clearances in order to perform tasks required on our government contracts, and without such clearances, employees cannot work on the majority of our projects. We have found that there is a shortage of qualified personnel possessing the necessary clearances, and new security clearances are taking longer to be granted. If we are not able to obtain security clearances for our personnel where required, they will be unable to perform tasks requiring clearances, and we may be unable to satisfy the terms of our contracts, resulting in customer dissatisfaction and possible loss of current or future contracts.
Stop-work orders could negatively impact our operating results and financial condition. Almost all of our contracts contain stop-work clauses that permit the Government or other contracting party, at any time, by written order, to stop work on all or any part of the work called for by the contract for a period of ninety days. Within the ninety-day period, the other contracting party may cancel the stop-work order and resume work or terminate all or part of the work covered by the stop-work order. There can be no assurance that stop-work orders will not be received in future periods. If we receive stop work orders, our orders and backlog may be reduced, and we may fail to achieve anticipated revenues.
Any reduction in government spending on ISR could materially adversely impact our revenues, results of operations, and financial condition. Historically, defense and intelligence agencies of the United States Government have accounted for almost all of our revenues. There are risks associated with programs that are subject to appropriation by Congress, which could be potential targets for reductions in funding to pay for other programs. Future reductions in United States Government spending on global security or future changes in the kind of products or services required by the United States Government agencies could limit demand for our products and services, which could result in failure to achieve anticipated revenues, resulting in a materially adverse effect on our operating results and financial condition.
In the event there are shifts in responsibilities and functions among the government agencies responsible for United States defense and intelligence, it could result in a reduction of orders for global security by the defense and intelligence agencies that have historically been our major customers. Our relationships with other Government agencies to which responsibilities and functions for our contracts have shifted may not be as strong as our relationships with current customer agencies. Accordingly, a reduction in contracts from our customer agencies may not be offset by contracts from other United States Government agencies. Even if other agencies increase spending for global security, we may not secure the same amount of work from these agencies. As a result, demand for our products and services could decline, resulting in a decrease in revenues, and could adversely affect our operating results and financial condition materially.
If we are unable to comply with complex government regulations governing security and contracting practices, we could be disqualified as a supplier to the United States Government. As a supplier to United States Government defense and intelligence agencies, we must comply with numerous regulations, including those governing security and contracting practices. Failure to comply with these procurement regulations and practices could result in fines being imposed against us or our suspension for a period of time from eligibility for bidding on, or for award of, new government contracts. If we are disqualified as a supplier to government agencies, we will lose most, if not all, of our customers, revenues from sales of our products would decline significantly, and our ability to continue operations would be seriously jeopardized. Among the causes for disqualification are violations of various statutes, including those related to procurement integrity, export control, United States Government security regulations, employment practices, protection of the environment, accuracy of records in the recording of costs, and foreign corruption. The government may investigate and make inquiries of our business practices and conduct audits of contract performance and cost accounting. The government audits and investigations can take several years to complete. Depending on the results of these audits and investigations, the government may make claims against us or take exception to certain costs we determined to be recoverable. In the period management determines recoverability is not likely, operating income would be reduced.
We depend on revenues from a few significant contracts, and any loss, cancellation, reduction, or delay in these contracts could harm our business. From time to time, including recent periods, we have derived a material portion of our revenue from one or more individual contracts that could be terminated by the customer in full or in part at the customer’s discretion. We have in the past experienced a significant reduction of, and stop work order on, one of our largest contracts. We expect that in future periods we may again enter into individual contracts with significant revenue concentrations. In addition, the majority of our contracts are with a limited number of government agencies. If our individually large contracts were terminated or substantially reduced, we could fail to achieve expected revenues and net income.
United States Government contracts are generally not fully funded at inception and funding may be terminated or reduced at any time. We act as a prime contractor or subcontractor for many different United States Government programs. Department of Defense and intelligence contracts typically involve long lead times for design and development and are subject to significant changes in contract scheduling. Programs can be partially funded initially, and additional funds may or may not be allocated. The termination or reduction of funding for a government program would result in a loss of anticipated future revenues attributable to that program.
Our backlog as of October 31, 2007, was approximately $126.7 million and includes orders under awards that in some cases extend several years. The actual receipt of revenues on awards included in backlog may never occur or may change because a program schedule could change or the program could be canceled, or a contract could be reduced, modified, or terminated early.
Our business depends upon our relationships with, and the performance of, our prime contractors. We expect to continue to depend on relationships with other contractors for a substantial portion of our revenues in the foreseeable future. Our business, prospects, financial condition, or operating results could be adversely affected if other contractors terminate or reduce their subcontracts or relationships with us, either because they choose to establish relationships with our competitors or because they choose to directly offer services that compete with our business. Our business also suffers if the prime contractor fails to win the contract, or if the Government terminates or reduces these other contractors’ programs or does not award them new or additional contracts.
In addition, on those contracts for which we are not the prime contractor, the United States Government could terminate a prime contract under which we are subcontractor, regardless of the quality of our performance as a subcontractor. A prime contractor’s performance deficiencies could adversely affect our status as a subcontractor on the program, jeopardize our ability to collect award or incentive fees, cause customers to delay payments, and result in contract terminations.
We depend on revenues from a few significant customers; the loss of any significant customer could have an adverse effect on our business. Our success will depend on our continued ability to develop and manage relationships with significant customers. The markets in which we sell our products are dominated by a relatively small number of governmental agencies and allies of the United States Government, thereby limiting the number of potential customers. Our dependence on large orders from a relatively small number of customers makes our relationship with each customer critical to our business. We cannot be sure that we will be able to retain our largest customers, that we will be able to attract additional customers, or that our customers will continue to buy our products and services in the same amounts as in prior years. The loss of one or more of our largest customers, any reduction or delay in sales to these customers, our inability to successfully develop relationships with additional customers, or future price concessions that we may have to make could significantly harm our business.
Continued competition in ISR may lead to a reduction in our revenues and market share. The global security market is highly competitive and we expect that competition will continue to increase in the future. Our current competitors have significantly greater technical, manufacturing, financial, and marketing resources than we do. We expect that more companies will enter the market for global security, possibly resulting in pricing pressures on our products and services. We may not be able to compete successfully against either current or future competitors. Increased competition could result in reduced revenue, lower margins, or loss of market share, any of which could significantly harm our business. Our competitors may introduce improved products with lower prices, and we would have to do the same to remain competitive.
Unexpected increases in the cost to develop or manufacture our products under fixed-price contracts may cause us to experience unreimbursed cost overruns resulting in reduced profit margins or increased loss provisions. A significant portion of our revenue is derived from fixed-price contracts. Under fixed-price contracts, unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in materials costs, unfavorable indirect rate variances, inefficiencies, or other factors, are borne by us. We have experienced cost overruns in the past that have resulted in losses on certain contracts, and may experience additional cost overruns in the future. Such cost overruns would increase our operating expenses, reduce our net income and earnings per share, and could have a material, adverse effect on our future results of operations and financial condition.
Fixed price contracts use percentage-of-completion accounting to determine profit margins. Under generally accepted accounting principles unexpected cost over-runs can change the percentage completion estimates and result in reduced profit margins and the reversal of previously recognized profits in addition to reducing future period profits. Although we believe that our profit margins are fairly stated and that adequate provisions for losses for our fixed-price contracts are recorded in our financial statements as required under accounting principles generally accepted within the United States, there can be no assurance that our contract profit margins will not decrease or our loss provision will not increase in the future.
Unexpected contract terminations could negatively impact our operating results and financial condition Almost all of our contracts contain termination clauses that permit contract termination upon our default or for the convenience of the other contracting party. In either case, termination could adversely affect our operating results and financial condition; however, we received no such terminations in fiscal years 2007 or 2006.
Our future revenues are inherently unpredictable, our operating results are likely to fluctuate from period to period, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly. Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include conditions inherent in government contracting and our business such as the timing of cost and expense recognition for contracts, the United States Government contracting and budget cycles, and contract closeouts. Because we base our operating expenses on anticipated revenue trends and a high percentage of our expenses are fixed in the short term, any delay in generating or recognizing forecasted revenues could significantly harm our business. Fluctuations in quarterly results, competition, or announcements of extraordinary events such as acquisitions or litigation may cause earnings to fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock could significantly decline. In addition, there can be no assurance that an active trading market will be sustained for our common stock. The stock market in recent years has experienced extreme price and volume fluctuations that have particularly affected the market prices of many technology companies. These fluctuations, as well as general economic and market conditions, may adversely affect the future market price of our common stock.
Our market is subject to rapid technological change, and to compete effectively, we must continually introduce new signal processing solutions that achieve market acceptance. The market for our products is characterized by rapidly changing technology, frequent new product introductions, changes in customer requirements, and evolving industry standards. We believe that we have been successful to date in identifying certain global security needs early, investing in research and development to meet these needs, and delivering products before our competitors. We believe that our future success will depend upon continued development and timely introduction of products capable of satisfying emerging global security needs. However, we expect that new requirements will continue to emerge. Our future performance will depend on the successful development, introduction, and market acceptance of new and enhanced products that address these new requirements. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. There can be no assurance that we will be able to develop and market new products successfully in the future or respond effectively to new requirements, or that new products introduced by others will not render our products or technologies noncompetitive or obsolete.
We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or to license these technologies from third parties. Product development delays may result from numerous factors, including:
- Changing product specifications and customer requirements
- Difficulties in hiring and retaining necessary technical personnel
- Difficulties in reallocating engineering resources and overcoming resource limitations
- Difficulties with contract manufacturers
- Changing market or competitive product requirements
- Unanticipated engineering complexities
The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot ensure that we will be able to identify, develop, manufacture, market, or support new or enhanced products successfully, or on a timely basis, if at all. Further, we cannot ensure that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes, or emerging industry standards. Any failure to respond to technological change would significantly harm our business.
Our results of operations could be negatively impacted if we are required to write off inventory deemed not saleable or usable. Some of our products or raw materials may become obsolete or unusable while in inventory. This could be due to changing customer specifications, decreases in demand for existing products, or changes in government spending on signal intelligence. Work in process deemed not saleable is written off to contract costs in our statement of operations, while unusable raw materials are written off to general and administrative expenses.
We may lose sales if our suppliers fail to meet our needs. Although we procure most of our parts and components from multiple sources or believe that these components are readily available from numerous sources, certain components are available only from sole sources or from a limited number of sources. While we believe that substitute components or assemblies could be obtained, use of substitutes would require development of new suppliers or would require us to re-engineer our products, or both, which could delay shipment of our products and could have a materially adverse effect on our operating results and financial condition.
Delays in the receipt of contracts could negatively impact our business. During our history, the receipt of certain final contracts has periodically been delayed to periods later than originally expected. Delays in the receipt of such orders could result in revenues falling short of estimates. On some of these contracts, we will make expenditures in advance of receipt of the final contract in anticipation of meeting the expected timetables, and will from time to time hire personnel in anticipation of receipt of the contract. If the contract is delayed, these costs are not covered. In addition, gross margins and net income will decrease if we elect to hold our cost structure in place while awaiting the award of delayed contracts.
Our failure to protect our intellectual property may significantly harm our business. Our success and ability to compete is dependent in part on our proprietary technology. We rely on a combination of patent, copyright, trademark, and trade secret laws, as well as confidentiality agreements to establish and protect our proprietary rights. We license certain of our proprietary technology to customers, and we rely largely on provisions of our licensing agreements to protect our intellectual property rights in this technology. To date, we have relied primarily on proprietary processes and know-how to protect our intellectual property. Although we have filed applications for several patents, five of which we currently hold, we cannot ensure that any patents will be issued as a result of pending patent applications or that our issued patents will be upheld. Any infringement of our proprietary rights could result in significant litigation costs, and any failure to adequately protect our proprietary rights could result in our competitors offering similar products, potentially resulting in loss of a competitive advantage and decreased revenues. Despite our efforts to protect our proprietary rights, existing patent, copyright, trademark, and trade secret laws afford only limited protection. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, we may not be able to prevent misappropriation of our technology or deter others from developing similar technology. Furthermore, policing the unauthorized use of our products is difficult. Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. This litigation could result in substantial costs and diversion of resources, and could significantly harm our business.
The U.S. Government has rights to our technology that limits our intellectual property rights. Although we seek to protect the competitive benefits we derive from our patents, proprietary information, and other intellectual property, we do not have the right to prohibit the U.S. Government from using certain technologies developed or acquired by us or to prohibit third party companies, including our competitors, from using those technologies in providing products and services to the U.S. Government. The U.S. Government has the right to royalty-free use of technologies that we have developed under U.S. Government contracts. We may commercially exploit those government-funded technologies and may assert our intellectual property rights against other non-government users of technology developed by us, but we may not be successful in our efforts to do so.
Claims that we infringe third-party intellectual property rights could result in significant expenses or restrictions on our ability to sell our products. It is possible that from time to time, other parties may assert patent, copyright, trademark, and other intellectual property rights to technologies and in various jurisdictions that are important to our business. Any claims asserting that our products infringe or may infringe proprietary rights of third parties, if determined adverse to us, could significantly harm our business. Any claims, with or without merit, could result in costly litigation, divert the efforts of our technical and management personnel, cause product shipment delays, or require us to enter into royalty or licensing agreements, any of which could significantly harm our business. Royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all. In addition, our agreements with our customers typically require us to indemnify our customers from any expense or liability resulting from claimed infringement of third-party intellectual property rights. In the event a claim against us was successful and we could not obtain a license to the relevant technology on acceptable terms, license a substitute technology, or redesign our products to avoid infringement, our business would be significantly harmed.
Item 1B: Unresolved Staff Comments
None.
Our corporate offices, located in Sunnyvale, California, also serve as our primary research and development, engineering, production, marketing, and administrative center. As of October 31, 2007, we leased five buildings in Sunnyvale, California, totaling approximately 266,077 square feet under a lease that expires in March 2012.
In addition, we maintain ten additional offices within the United States. As of October 31, 2007, we lease the following properties: 61,038 square feet in Annapolis Junction, Maryland (lease expires April 2016); 15,250 square feet in Herndon, Virginia (lease expires March 2011); 10,962 square feet in Hillsboro, Oregon (lease expires October 2009); 27,345 square feet in Salt Lake City, Utah (lease expires October 2009); 32,000 square feet in Allen, Texas (lease expires February 2011); 19,383 square feet in Torrance, California (lease expires February 2008); 2,008 square feet in Torrance, California (lease expires October 2010); an additional 39,692 square feet in Torrance, California (lease expires June 2015); 9,785 square feet in Anaheim, California (lease expires May 2010); 14,090 square feet in Arlington, Virginia (lease expires June 2013); and 2,309 square feet in Tampa, Florida (lease expires April 2010).
Our business requires that we maintain a facility clearance, sponsored and approved by the United States Government, at most of our offices. This approval could be suspended or revoked if we are found not to have complied with security regulations applicable to such facilities. Any revocation or suspension of such approval that materially delayed delivery of our products to customers would have a material, adverse impact on our ability to manufacture and sell our products and operate our business. Although we have adopted policies directed at assuring our compliance with relevant regulations, there can be no assurance that the approved status of our facilities will continue without interruption.
We are subject to litigation, from time to time, in the ordinary course of business including, but not limited to, allegations of wrongful termination or discrimination, or governmental agency investigations. As a government contractor, we may also be subject to investigations by the United States Government for alleged violations of procurement or other federal laws. Under present government procurement regulations, if judged in violation of procurement or other federal civil laws, we could be suspended or barred from eligibility for awards of new government contracts.
On March 11 and July 19, 2005, purported securities class action complaints were filed in the United States District Court, Northern District of California. The cases were considered as In re Applied Signal Technology Inc. Securities Litigation, Master File No. 4:05-cv-1027 (SBA). The amended consolidated complaint is brought on behalf of a putative class of persons who purchased our Company’s securities during a class period of August 24, 2004, through February 22, 2005. The complaints name us, our Chief Executive Officer, and our Chief Financial Officer as defendants, and allege that false and misleading statements regarding us were issued during the class period. On February 8, 2006, the Court dismissed the case with prejudice and entered judgment in defendants’ favor. Plaintiffs appealed the judgment of dismissal on March 23, 2006, and the appeal was heard on December 6, 2007; any future unfavorable outcome of the litigation could have an adverse impact on our business, financial condition, and results of operation. At this time we cannot estimate the amount of possible loss or range of loss that might be incurred as a result of this proceeding.
Item 4: Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year.
Item 5: Market for Registrant’s Common Equity, Related Shareholder Matters, and Issuer Purchases of Equity Securities
Selected Common Stock Data
Our common stock trades on the NASDAQ National Market under the symbol “APSG.” As of October 31, 2007, the closing price of our common stock, as reported on NASDAQ, was $14.37, and we had approximately 502 registered shareholders of record with our transfer agent. The following table sets forth the high and low closing prices for our common stock over the eight quarters ending October 31, 2007.
Closing prices, as reported on NASDAQ |
High |
Low |
Fiscal year ended October 31, 2006 |
|
|
First quarter |
$23.50 |
$16.80 |
Second quarter |
$24.02 |
$17.95 |
Third quarter |
$18.69 |
$14.43 |
Fourth quarter |
$15.70 |
$14.23 |
|
|
|
First quarter |
$16.25 |
$13.45 |
Second quarter |
$18.57 |
$15.13 |
Third quarter |
$18.19 |
$13.89 |
Fourth quarter |
$15.40 |
$12.56 |
The company pays dividends at the rate of $0.50 per share per annum, payable quarterly. However, the dividend is subject to approval by the Board of Directors, and is reviewed quarterly. Dividends are expected to be paid on February 15, 2008, May 16, 2008, August 15, 2008, and November 14, 2008, to shareholders of record at February 1, 2008, May 2, 2008, August 1, 2008, and October 31, 2008.
The continued payment of dividends and the amount thereof in the future will depend on a number of factors, including our financial condition, capital requirements, results of operations, future business prospects, and other factors that our Board of Directors may deem relevant.
We did not repurchase any of our equity securities during the fourth quarter of fiscal year 2007 nor issue any securities that were not registered under the Securities Act of 1933.
Comparison of Shareholder Return
Set forth below is a line graph comparing the annual percentage in the cumulative total return on our common stock with the cumulative total return for the Standard & Poor’s MIDCAP 400 Index (S&P MIDCAP 400) and the Standard and Poor’s Aerospace and Defense Index (S&P Aerospace and Defense) for the five-year period commencing October 31, 2002, and ending on October 31, 2007.
|
10/02 |
10/03 |
10/04 |
10/05 |
10/06 |
10/07 |
Applied Signal Technology, Inc. |
100.00 |
232.22 |
345.59 |
200.42 |
178.51 |
178.66 |
S&P Midcap 400 |
100.00 |
130.73 |
145.16 |
170.78 |
193.72 |
226.69 |
S&P Aerospace & Defense |
100.00 |
114.26 |
137.93 |
158.00 |
203.04 |
263.38 |
| *
Assumes that $100.00 was invested on 10/31/02 in our common stock and
in each index, and that all dividends have been reinvested. Shareholder returns over the indicated period should not be considered indicative of future shareholder returns. |
||||||
This stock performance graph does not constitute soliciting material, and should not be deemed filed or incorporated by reference into any other company filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate this stock performance graph by reference therein.
Item 6: Selected Financial Data
(In thousands, except per share data)
Summary of Operations: |
2007 |
2006 |
2005 |
2004 |
2003 |
Revenues from contracts |
$170,375 |
$161,913 |
$156,061 |
$142,836 |
$95,384 |
Operating expenses: |
|
|
|
|
|
Contract costs |
116,133 |
107,898 |
102,938 |
94,727 |
63,338 |
Research and development |
14,204 |
19,165 |
16,125 |
14,166 |
7,526 |
General and administrative |
28,734 |
25,978 |
22,167 |
16,694 |
15,376 |
Total operating expenses |
159,071 |
153,041 |
141,230 |
125,587 |
86,240 |
Operating income |
11,304 |
8,872 |
14,831 |
17,249 |
9,144 |
Interest income (expense), net |
683 |
315 |
648 |
576 |
510 |
Income before provision for income taxes |
11,987 |
9,187 |
15,479 |
17,825 |
9,654 |
Provision (benefit) for income taxes |
5,175 |
4,860 |
6,235 |
5,559 |
911 |
Net income |
$6,812 |
$4,327 |
$9,244 |
$12,266 |
$8,743 |
Cash dividends declared per common share |
$0.50 |
$0.50 |
$0.50 |
$0.50 |
$0.1875 |
Net income per common share: |
|
|
|
|
|
Basic |
$0.56 |
$0.37 |
$0.81 |
$1.11 |
$0.84 |
Diluted |
$0.55 |
$0.36 |
$0.79 |
$1.05 |
$0.80 |
Number of shares used in calculating net income per common share: |
|
|
|
|
|
Basic |
12,100 |
11,739 |
11,400 |
11,042 |
10,459 |
Diluted |
12,314 |
11,994 |
11,759 |
11,638 |
10,863 |
|
|
||||
Financial Position at End of Fiscal Year: |
2007 |
2006 |
2005 |
2004 |
2003 |
Working capital |
$75,337 |
$67,188 |
$63,188 |
$76,659 |
$64,640 |
Total assets |
142,733 |
136,532 |
134,621 |
111,750 |
89,947 |
Long term debt |
5,357 |
6,786 |
8,215 |
— |
— |
Retained earnings |
52,953 |
52,272 |
53,853 |
50,327 |
43,608 |
Shareholders’ equity |
114,836 |
105,630 |
98,129 |
89,563 |
76,199 |
Note: The financial results in fiscal years 2007 and 2006 include stock-based compensation expense as a result of adopting SFAS 123 (revised 2004), Share-Based Payment. The fiscal year 2005 financial results include the results of DTI, since its acquisition in July 2005.
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion contains forward-looking statements that involve risks and uncertainties, as discussed in the introduction to “Item 1: Business.” Actual results could differ substantially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Item 1A: Risk Factors.”
Overview
We believe that there continues to be an interest in ISR by the United States Government to respond to the threat of terrorist activities and the war against terrorism, and that we are well positioned to benefit from the spending that might result. We believe that our COMINT and sensor processing markets have strong growth potential and that our move into the ELINT marketplace provides us an opportunity to diversify into a complementary business. As a result of this anticipated growth, we expect to make additional investments of capital and management resources, including additional personnel and facilities.
We continue to focus our operations on assuring program performance, meeting staffing requirements, maintaining a competitive cost structure, and diversifying our marketplace. Our customers continue to come to us with new requirements for ISR solutions, weighted heavily toward new developments. A significant portion of our revenue continues to be generated by cost-reimbursable contracts that tend to be developmental in nature, and require highly specialized, technical skill sets. We believe that this trend will continue in fiscal year 2008.
Critical Accounting Policies and Estimates
General. Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. These consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. We believe that the estimates, assumptions, and judgments involved in the accounting policies described below have the greatest potential impact on our consolidated financial statements and, therefore, consider these to be critical accounting policies. See “Notes to Consolidated Financial Statements, Note 1: Summary of Significant Accounting Policies,” included elsewhere in this report for more information about these critical accounting policies, as well as descriptions of other significant accounting policies.
Revenue and cost recognition. The majority of our contracts are accounted for in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Opinion 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts. These contracts are executed by using written contractual arrangements, most of which require us to design, develop, manufacture, and/or modify our complex products, and perform related services according to specifications provided by the customer. A limited number of standalone software contracts are recognized in accordance with the AICPA Statement of Opinion 97-2, Software Revenue Recognition (SOP 97-2). In accordance with SOP 97-2, we may, at times, record an amount of deferred revenue associated with contracts that are billed and for which customers have paid in advance of performance requirements set forth in these contracts.
We account for cost-reimbursement contracts by charging actual labor, materials, and other direct costs, plus estimated indirect costs of operations as incurred, including overhead, research and development, and general and administrative expenses (incurred costs). Stock compensation expense recognized in fiscal year 2007 is not reimbursable under these contracts. We do not apply indirect costs to subcontract costs that are in excess of $250,000 and that meet certain other predetermined criteria.
We recognize contract revenues and profits on cost-reimbursement contracts by applying an estimated fee rate to all incurred costs on an individual contract basis. Fee calculations are based on either negotiated fee amounts or management’s assessment of the fee amounts that are likely to be earned. On cost-reimbursement contracts, we may bear unexpected cost increases for purposes of maintaining customer relationships. Historically, the effect on operating results and financial condition from cost-reimbursement losses has been minimal.
Our policy for recognizing interim fees on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion of the award fee will be earned, on a contract-by-contract basis. Management bases its assessments on numerous factors, including contract terms, nature of the work to be performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized until management determines that it is probable that an award fee or a portion thereof will be earned. Historically, management’s estimates have generally been consistent with actual fees awarded. However, changes in facts and circumstances could arise within an award fee period causing management to either lower or raise the award fee estimate in the period in which the changes occur.
Some of our engineering services are performed under time-and-materials contracts on a level-of-effort basis. We recognize revenue for these contracts by applying a negotiated billing rate to the level-of-effort.
We account for fixed-price contracts by using the percentage-of-completion method. Under this method, we charge labor, materials, and other direct costs, plus estimated indirect costs of operations as they are incurred. Each period, we recognize as revenue a portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual costs incurred and the estimated total costs to complete. On fixed-price contracts, we bear the risk of any unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors, and these costs could have a materially adverse effect on our results of operations
For those contracts in which all of the terms have not yet been finalized, revenue does not include an estimated fee rate on cost.
Management reviews contract performance, costs incurred, and estimated completion costs regularly. We adjust revenues and profits on all contracts in the period in which changes, including anticipated losses, become determinable.
Precontract costs represent costs incurred in anticipation of specific expected future contract awards and costs incurred in connection with ongoing contracts for which contract modifications have not been defined or completed as of the end of the reporting date. These costs are included in other current assets on the balance sheet. Precontract costs for the periods ending October 31, 2007, and October 31, 2006, were approximately $4,465,000 and $5,667,000, respectively.
We anticipate that at least $2.6 million of these pre-contract costs will be recognized as revenue during the first quarter of fiscal year 2008 due to the fact that we received additional contract funding during the first quarter of fiscal year 2008. Approximately $5,502,000 of the October 31, 2006, balance was recognized as revenue during fiscal year 2007. At the end of fiscal year 2006, approximately $569,000 that was included in pre-contract costs was associated with an individual contract for which we had filed a formal claim against the U.S. Government. This was a formal request for reimbursement for work performed on this contract. During the second quarter of fiscal year 2007, the claim was rejected and we reduced the balance of pre-contract costs and operating income by $569,000. This claim was ultimately settled and we recovered approximately $404,000 during the fourth quarter of fiscal year 2007. As a result of this settlement, we increased revenues and operating income accordingly.
Indirect rate variance adjustment to operations. We record contract revenues and costs of operations for interim reporting purposes based on annual targeted indirect rates. During our interim reporting periods, variances may accumulate between the actual indirect rates and the annual targeted rates. We remove timing-related indirect spending variances from contract costs, research and development, and general and administrative expenses, and we include them in inventory as part of work in process during these interim reporting periods. We review these rates regularly, and record adjustments for any material, permanent variances in the period they become determinable. We believe that this estimate is the preferred practice used within our industry. At year-end, we adjust the revenues and costs for actual indirect rates.
Our accounting policy for recording the indirect rate variance is based on management’s belief that variances accumulated during interim reporting periods will be absorbed by expected contract activities during the remainder of the year. We consider the rate variance to be unfavorable when our actual indirect rates are greater than our annual targeted rates. In contrast, a favorable rate variance occurs when our actual indirect rates are lower than our annual targeted rates. During interim reporting periods, we record unfavorable rate variances as reductions to operating expenses and increases to work in process inventory. We record favorable rate variances as increases to operating expenses and decreases to work in process inventory.
If we anticipate that actual indirect rates will be different than planned levels, there are alternatives we can utilize to reduce the variance: we can adjust some of our planned indirect spending during the year; request a modification of our billing rates to our customers through the Defense Contract Audit Agency any time during the fiscal year, in accordance with Federal Acquisition Regulations; or record adjustments to expense based on estimates of future contract activities for the remainder of the fiscal year.
If our rate variance is unfavorable at the end of our fiscal year, the modification of our billing rates will likely increase revenue and operating expenses, and decrease inventory. Fee percentages on fixed-price and cost-reimbursement contracts will generally decline as a result of any increase to indirect costs. If our rate variance is favorable at the end of our fiscal year, the modification of our billing rates will decrease revenue and operating expenses, and increase inventory. In this event, fee percentages on fixed-price contracts will generally increase. Fee percentages on cost-reimbursable contracts will generally be unaffected as a result of any reduction to indirect costs, because programs will typically expend all of the funds available. Any impact on operating income, however, depends on a number of other factors, including mix of contract types, contract terms, anticipated performance on specific contracts, and anticipated changes in inventory.
At the end of fiscal year 2007, we absorbed an unfavorable indirect rate variance that accumulated during the fiscal year by modifying our billing rates to our customers, which increased revenues by approximately $958,000 and operating expenses by approximately $2,224,000, which represented a reduction to operating income of approximately $1,266,000. As of the end of the third quarter of fiscal year 2007, we had anticipated a reduction to operating income and recorded a profit reserve of $1,300,000.
At the end of fiscal year 2006, we absorbed an unfavorable indirect rate variance that accumulated during the fiscal year by modifying our billing rates to our customers, which increased revenues by approximately $3,387,000 and operating expenses by approximately $5,725,000, which represented a reduction to operating income of approximately $2,338,000. As of the end of the third quarter of fiscal year 2006, we had anticipated a reduction to operating income and recorded a profit reserve of $1,000,000.
At the end of fiscal year 2005, we absorbed an unfavorable indirect rate variance that accumulated during the fiscal year by modifying our billing rates to our customers, which increased revenues by approximately $3,949,000 and operating expenses by approximately $4,935,000, which represented a reduction to operating income of approximately $986,000. As of the end of the third quarter of fiscal year 2005, we had anticipated a reduction to operating income and recorded a profit reserve of $750,000.
Income taxes. Our income tax expense at interim reporting periods is based on our estimated annual effective tax rate and any discrete items that occur during any interim period. We calculate this estimated tax rate based on the projected net income at the end of the fiscal year, and review it at each reporting period. At the end of the fiscal year, we adjust income tax expense for actual results. Our effective tax rate can differ from the statutory rate primarily due to the non-tax-deductible nature of certain types of stock-based compensation expense. Please refer to “Notes to Consolidated Financial Statements, Note 8: Income Taxes” for the current year effective tax rate.
Allowance for bad debt. Since the majority of our revenues are generated from the United States Government, its agencies, or prime contractors for the United States Government, we regard the credit risk of our business to be minimal. We record allowances for bad debt as a reduction to accounts receivable and an increase to bad debt expense. These allowances are recorded in the period a specific collection problem is identified. Once the receivable is deemed uncollectible, the allowance is reversed and the receivable is written off. Charges to bad debt expense were not significant during fiscal years 2007, 2006, and 2005.
Inventory valuation and disposal. We provide advanced digital signal processing products and systems to the United States Government. Typical life cycles of our equipment are eight to ten years or more. In addition, we maintain spare parts in order to repair the equipment. We evaluate our inventory quarterly, at interim reporting periods, and assess our ability to sell our products, which includes raw materials. Historically, we have sold our inventory at or above cost, so there is typically limited decrement in valuation. In addition, when we determined that a product has reached the end of its life cycle or there is no longer a need for a certain product, we would dispose of any remaining inventory, and recorded the associated reduction to inventory. At the end of fiscal year 2007, however, we recorded a write-down of approximately $415,000, inventory against one inventoried product for which we consider future sales remote. The charges associated with these reductions to work in process and finished goods are included in contract costs in our statement of operations. Disposals associated with our raw material represent a minor amount and is included in general and administrative expenses on the statement of operations due to the fact that raw materials could be used in a variety of situations other than contract costs, including R&D.
Inventory activities during fiscal year 2007 included a write-down of approximately $415,000 and disposals of obsolete products of approximately $187,000. Fiscal year 2006 activity included disposals of approximately $237,000. The disposals included items that were in various stages of completion.
Price redetermination. As a government contractor, we are subject to price redetermination on certain fixed-price contracts if it is determined that we did not price our products and services consistent with the requirements of the Federal Acquisition Regulations. We did not incur any price redeterminations on any of our contracts during fiscal years 2007, 2006, or 2005, although in fiscal year 2005, we did settle an outstanding contract dispute relating to older contracts with the United States Government for approximately $500,000.
Goodwill valuation. We test goodwill for possible impairment on an annual basis and at any other time if events occur or circumstances indicate that the current carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include, but are not limited to, a significant adverse change in the business climate or legal factors, an adverse action or assessment by a regulator, unanticipated competition, and loss of key personnel.
To perform the goodwill impairment test, we determine the fair value of the reporting unit and compare the fair value to the reporting unit’s carrying value. We believe AST is one reporting unit, and therefore, we compare the fair value of AST to the total net asset value on our balance sheet. If our total net asset value were to exceed our fair value, we would perform the second step of the impairment test. In the second step, we would compare the implied fair value of our goodwill to our carrying amount. If no impairment exists under step one, then step two is not necessary.
Based on our analysis, we concluded no impairment existed at October 31, 2007.
Long-lived asset valuation (property, plant and equipment, and intangible assets). We will test long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances that could trigger a review include, but are not limited to: significant decreases in the market price of the asset, significant adverse changes in the business climate or legal considerations, accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset, current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset, and current expectation that the asset will more likely than not be sold or discarded significantly before the end of its estimated useful life.
We assess recoverability based on the carrying amount of the asset and its fair value, which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset. We recognize an impairment loss when the carrying amount is not recoverable and exceeds the fair value.
No indicators of impairment existed at October 31, 2007.
Share-based payment. We adopted SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R), effective at the beginning of fiscal year 2006. Applying this complex standard to value equity-based compensation requires us to use significant judgment and to make estimates, particularly for the assumptions used in the Black-Scholes valuation model, such as stock price volatility and expected option lives, as well as for the expected option forfeiture rates.
We elected to use the modified prospective transition method as permitted by SFAS 123R. Stock-based compensation expense for all stock-based compensation awards granted subsequent to November 1, 2005, was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. For awards granted prior to, but not yet vested, as of November 1, 2005, stock-based compensation expense was based on the grant-date fair value previously estimated, by using the Black-Scholes valuation model, in accordance with the original provisions of SFAS 123. We recognize the stock compensation expense on a straight-line basis over the requisite service period of the award, which generally equals the vesting period of each grant.
Assumptions used in the Black-Scholes model are the expected stock price volatility over the expected life of the awards, the projected employee stock option’s life, the expected dividend yield, and the risk-free interest rate. Changes in the subjective assumptions can materially affect the estimated value of the stock awards. Historical volatility, market-based implied volatility, or a combination of both will be considered when projecting the expected stock price volatility for both stock options and purchases under our employee stock purchase plan (ESPP). For fiscal years 2007 and 2006, we determined that the combination of historical and market-based implied volatility provides a more accurate reflection of our market conditions and is more representative of future stock price trends than employing solely historical volatility. For stock options granted to non-officer employees in fiscal year 2006, we used a five-year expected life. We estimated the expected life of the options based on historical observations of our stock, considering the average years of options actually exercised, vested and cancelled options, and outstanding and exercisable options. For offering periods beginning prior to June 1, 2007, the expected life used for our ESPP was based on the six-month purchase periods within each twenty-four-month offering period. Offering periods beginning after that date have a single six-month purchase period and we used an expected life of six months. The risk-free interest rate is based on the Federal Reserve Bank’s constant maturities daily interest rate in effect at the time of the option grant or ESPP offering date.The expected dividend yield for both stock options and purchases under the ESPP is calculated by taking the total expected annual dividend payout divided by the average stock price per share.
We have an ESPP that allows employees to purchase shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. For offering periods beginning prior to June 1, 2007, our ESPP had a twenty-four-month offering period with four six-month purchase periods within each offering period. If the fair market value on the purchase date was lower than the fair market value on the offering date, all participants were withdrawn from the offering period and re-enrolled into a new offering period. Effective, May 31, 2007, we modified our ESPP such that the length of all offering periods, beginning June 1, 2007, is six months. Consequently, there is no reset feature associated with these new six-month offering periods. As a result of the modification to the ESPP, the December 1, 2006, offering period, ending November 30, 2008, was the final twenty-four-month offering. On November 30, 2007, this offering was reset to a six-month offering period beginning on December 1, 2007. Therefore, the unrecognized compensation cost at December 1, 2007, will be recognized over a six-month period ending on May 31, 2008, instead of the remaining twelve months of the original offering period. There will be additional participants in the six-month offering beginning June 1, 2008. The additional participation is attributable to the reenrollment of those individuals who were included in the final twenty-four month offering. As a result, we anticipate that stock-based compensation could increase in excess of $500,000 in fiscal year 2008.
The fair value of our restricted stock is based on our closing stock price on the date of grant.
Operating Results – Fiscal Years Comparison
The following table sets forth, for the periods indicated, statements of operations data as a percentage of revenues from contracts, and, at the end of each period indicated, our backlog.
|
2007 |
2006 |
2005 |
Revenues from contracts |
100.0% |
100.0% |
100.0% |
Operating expenses: |
|
|
|
Contract costs |
68.2% |
66.6% |
66.0% |
Research and development |
8.3% |
11.8% |
10.3% |
General and administrative |
16.9% |
16.1% |
14.2% |
Total operating expenses |
93.4% |
94.5% |
90.5% |
Operating income |
6.6% |
5.5% |
9.5% |
Interest income (expense), net |
0.4% |
0.2% |
0.4% |
Income before provision (benefit) for income taxes |
7.0% |
5.7% |
9.9% |
Provision (benefit) for income taxes |
3.0% |
3.0% |
4.0% |
Net income |
4.0% |
2.7% |
5.9% |
|
|
|
|
Backlog (thousands of dollars) |
$126,708 |
$104,952 |
$140,193 |
Results
Revenues for fiscal year 2007 were $170,375,000, up 5.2% from revenues of $161,913,000 recorded during fiscal year 2006. In fiscal year 2007, new orders increased 53.6% and ending backlog increased 20.7% compared to fiscal year 2006.
Operating income for fiscal year 2007 was $11,304,000 compared to operating income of $8,872,000 recorded during fiscal year 2006. Operating income was higher for fiscal year 2007 when compared to fiscal year 2006 due to improved program profitability.
Net income for fiscal year 2007 was $6,812,000, or $0.55 per diluted share, compared to net income of $4,327,000, or $0.36 per diluted share, for fiscal year 2006. Our tax rates for fiscal years 2007 and 2006 were approximately 43% and 53%, respectively.
In fiscal year 2006, revenues increased 3.7%, new orders declined 2.5%, and ending backlog declined 25.1% compared to fiscal year 2005. Operating income for fiscal year 2006 was $8,872,000 compared to operating income of $14,831,000 recorded during fiscal year 2005. Operating income was lower for fiscal year 2006 when compared to fiscal year 2005 primarily due to the impact of our stock-based compensation expense. In addition, our expenditures for R&D, marketing, and proposal efforts increased.
At the beginning of fiscal year 2006, we adopted the provisions of SFAS 123R, requiring us to recognize expense related to the fair value of our stock-based compensation awards that are ultimately expected to vest.
The following table sets forth the total stock-based compensation expense resulting from stock options, restricted stock, and ESPP included in our condensed consolidated statements of operations (in thousands).
|
2007 |
2006 |
Contract costs |
$2,388 |
$2,493 |
Research and development |
177 |
229 |
General and administrative |
1,585 |
1,561 |
Stock-based compensation expense before income taxes |
4,150 |
4,283 |
Income taxes |
(850) |
(804) |
Stock-based compensation expense after income taxes |
$3,300 |
$3,479 |
Reduction to basic net income per share |
$0.27 |
$0.30 |
Reduction to diluted net income per share |
$0.27 |
$0.29 |
Please refer to “Notes to Consolidated Financial Statements, Note 1: Summary of Significant Accounting Policies, Stock-Based Compensation” for further information.
Revenues
Revenues were approximately $170,375,000, $161,913,000, and $156,061,000 for fiscal years 2007, 2006, and 2005, respectively. Revenues increased by 5.2% during fiscal year 2007 over fiscal year 2006 and increased by 3.7% during fiscal year 2006 over fiscal year 2005. The primary reason for the continued increase in revenues in recent years is an increase in engineering development efforts designed to provide a variety of global security solutions to the United States Government. These solutions have helped to support the United States Government’s global security counterterrorism efforts. In fiscal year 2007, we recognized approximately $5,502,000 of pre-contract costs incurred during fiscal year 2006.
In fiscal year 2006, revenues increased due to the result of the full-year impact related to the acquisition of DTI entered into during the third quarter of fiscal year 2005.
The following table identifies the source of our revenues (as a percentage of total revenues) for fiscal years 2007, 2006, and 2005 by customer type.
|
FY07 |
FY06 |
FY05 |
Intelligence agencies |
78% |
74% |
72% |
Military |
20% |
23% |
23% |
Foreign |
— |
1% |
2% |
Commercial |
2% |
2% |
3% |
|
100% |
100% |
100% |
Within the customer types, contracts with two intelligence agencies and one branch of the military represented a significant portion of revenues.
The table below identifies the revenue concentration (as a percentage of total revenues) from all contracts with each significant customer.
|
FY07 |
FY06 |
FY05 |
First intelligence agency |
26% |
24% |
28% |
Second intelligence agency |
47% |
46% |
44% |
One branch of the military |
15% |
17% |
21% |
|
88% |
87% |
93% |
Revenues from the United States Government can also be categorized as direct purchases and subcontracts, where we are the supplier to another contractor. The following table distinguishes revenue (as a percentage of total revenues) between those two categories.
|
FY07 |
FY06 |
FY05 |
Direct purchases |
69% |
60% |
67% |
Subcontracts |
29% |
37% |
28% |
|
98% |
97% |
95% |
Our contracts can be either fixed-price contracts, where we agree to deliver equipment for a fixed price and assume the risk of cost overruns; cost-reimbursement, where we are reimbursed for our direct and indirect costs and paid a negotiated profit; or time-and-materials contracts, where we recognize revenue for these contracts by applying a negotiated billing rate to the level of effort. Cost-reimbursement and time-and-materials contracts typically do not return as high a profit margin as fixed-price contracts, and accordingly, our profit margin will be affected by the mix of our orders by contract type. The following table represents our revenue concentration (as a percentage of total revenues) during the respective periods by contract type.
|
FY07 |
FY06 |
FY05 |
Cost-reimbursement contracts |
71% |
79% |
76% |
Fixed-price contracts |
15% |
17% |
21% |
Time-and-materials contracts |
14% |
4% |
3% |
|
100% |
100% |
100% |
Six contracts represented an aggregate of 56.3% of revenues for fiscal year 2007. Five contracts represented an aggregate of 42.1% of revenues for fiscal year 2006, and four contracts represented an aggregate of 29.4% of revenues for fiscal year 2005. One of the six significant contracts in fiscal year 2007 is a time-and-materials contract. All of the other contracts referenced are cost-reimbursement contracts.
New Orders and Backlog
We received new orders of approximately $191,193,000, $124,481,000, and $127,663,000 during fiscal years 2007, 2006, and 2005, respectively. New orders increased in fiscal year 2007 due to what we believe to be the continued interest in ISR by the U.S. Government. During fiscal year 2006, new orders declined due to the fact that negotiations of an indefinite delivery/indefinite quantity (IDIQ) type contract with one of our government agency customers was not awarded until the first quarter of fiscal year 2007 and a decline in product orders. New orders for fiscal year 2005 included a reduction of approximately $12 million because the company completed negotiations of a stop-work order related to a portion of its largest contract.
Our backlog consists of the uncompleted portions of existing contracts (excluding unexercised contract options). At the end of fiscal year 2007, ending backlog was approximately $126,708,000. Reported backlog includes both funded and unfunded portions of contract values. There is no assurance or obligation that contracts will be fully funded. To the extent that contracts are not fully funded, there will be a reduction to backlog in a future period. The fiscal year 2007 backlog represents a 20.7% increase to the backlog of $104,952,000 at the end of fiscal year 2006. The fiscal year 2006 backlog represents a 25.1% decrease to fiscal year 2005.
Contract Costs
Contract costs consist of direct costs incurred in the performance of contracts, including labor, materials, and overhead costs. Contract costs were approximately $116,133,000, or 68.2% of revenues, in fiscal year 2007, compared to approximately $107,898,000, or 66.6% of revenues, in fiscal year 2006, and approximately $102,938,000, or 66.0% of revenues, in fiscal year 2005. Contract costs increased in absolute dollars during fiscal year 2007 primarily due to increased contract activity related to our development contracts and our ability to recognize pre-contract costs incurred during fiscal year 2006. Contract costs increased as a percentage of revenues during fiscal year 2007 due to our ability to recognize pre-contract costs incurred during fiscal year 2006. Contract costs increased as a percentage of revenues during fiscal year 2006 primarily due to the impact of SFAS 123R on reported expenses. The impact of the stock compensation expense was partially offset by a reduction of our subcontract costs. Contract costs increased in absolute dollars during fiscal year 2006 compared to fiscal year 2005 due to the increase in contract activities as well as the impact of SFAS 123R on reported expenses.
Research and Development Expenses
Company-directed investment in research and development consists of expenditures recoverable from customers through billing rates and expenditures funded by us from operations. Research and development expenses were approximately $14,204,000, or 8.3% of revenues, in fiscal year 2007 compared to approximately $19,165,000, or 11.8% of revenues, in fiscal year 2006 and approximately $16,125,000, or 10.3% of revenues, in fiscal year 2005. We manage the combination of company-directed R&D, proposal, and marketing expenditures as a total investment and as part of our indirect rate structure. Our proposal expenditures were high during fiscal year 2007. In addition, our analysis during the second and third quarters of fiscal year 2007 indicated that our indirect rates at the end of fiscal year 2007 would be higher than planned levels. In order to minimize the impact of the projected indirect rate increase, we reduced R&D activities. During fiscal year 2006, R&D expenses were higher than in fiscal year 2005 in absolute dollars and as percentage of revenues as a result of increased efforts toward new and existing R&D projects precipitated by a delay in anticipated orders.
General and Administrative Expenses
General and administrative expenses include administrative salaries, costs related to marketing and proposal activities, costs related to product warranties, and other administrative costs. General and administrative expenses were approximately $28,734,000, or 16.9% of revenues, in fiscal year 2007 compared to approximately $25,978,000, or 16.1% of revenues, in fiscal year 2006 and approximately $22,167,000, or 14.2% of revenues, in fiscal year 2005. G&A expenses were higher in absolute dollars and as a percentage of revenues during fiscal year 2007 compared to fiscal year 2006 due an overall increase in contract activities and bid and proposal expenditures during fiscal year 2007. General and administrative expenses increased in absolute dollars and as a percentage of revenues during fiscal year 2006 as a result of the impact of SFAS 123R on reported expenses, an increase in marketing and proposal expenditures, and the full-year impact of personnel added during fiscal year 2005 to support business growth.
Interest Income and Other, Net
Interest income and other, net for fiscal year 2007, was approximately $1,356,000 compared to approximately $1,024,000 and $1,027,000 of interest income in fiscal years 2006 and 2005, respectively. Interest income increased fiscal year 2007 due to higher yields within our investment portfolio and higher investment balances.
Interest Expense
Interest expense for fiscal year 2007 was approximately $673,000 compared to approximately $709,000 and $379,000 of interest expense in fiscal years 2006 and 2005, respectively. Interest expense increased in fiscal years 2007 and 2006 primarily due to interest payments and accruals related to our $10 million Term Loan entered into in connection with our acquisition of DTI during the third quarter of fiscal year 2005.
Provision for Income Taxes
Our provision for income taxes for fiscal years 2007, 2006, and 2005 resulted in income tax expense of approximately $5,175,000, $4,860,000, and $6,235,000, respectively. The effective tax rate for fiscal years 2007, 2006, and 2005 were approximately 43%, 53%, and 40%, respectively. The decrease in our tax rate in fiscal year 2007 from fiscal year 2006 was primarily due to an increase in our pre-tax income, which reduced the impact of non-deductible stock-based compensation expense. In addition, a greater portion of our investments was in tax-free municipal securities. The increase in our tax rate in fiscal year 2006 from fiscal year 2005 was primarily related to the tax impact of stock-based compensation expense for our employee stock purchase plan and stock option plans.
Analysis of Liquidity and Capital Resources
Our primary sources of liquidity during fiscal year 2007 were the cash flows generated from operations and the issuance of common stock through our employee stock purchase plans.
Cash by operating activities. Net cash from operating activities has fluctuated significantly from year to year. Net cash provided by operating activities was approximately $14,096,000, $10,787,000, and $13,603,000 in fiscal years 2007, 2006, and 2005, respectively. The year-to-year variances are primarily the result of changes in net income, accounts receivable, inventories held by us, contract risk activity, and accounts payable and accrued liabilities.
Net income for fiscal year 2007 was approximately $6,812,000, a $2,485,000 increase from fiscal year 2006. The increase was due to improved program profitability and a reduction in our effective tax rate. Net income for fiscal year 2006 was approximately $4,327,000, a decrease of $4,917,000 from fiscal year 2005 that was due, primarily, to the impact of our stock-based compensation expense of approximately $4,283,000. While the stock-based compensation expense materially impacted net income, it had no impact on operating cash.
Accounts receivable balances increased by approximately $3,897,000 during fiscal year 2007, decreased by approximately $7,887,000 during fiscal year 2006, and increased by approximately $2,272,000 during fiscal year 2005. During fiscal year 2007, we generated revenues of approximately $170,375,000 and collected approximately $166,478,000. In fiscal year 2006, we generated revenues of approximately $161,914,000 and collected approximately $169,801,000. In fiscal years 2005, increased revenues caused the accounts receivable balances to increase.
Inventories, prepaid expenses, and other current assets decreased by approximately $2,680,000 in fiscal year 2007 and increased by approximately $7,867,000 and $850,000 in fiscal years 2006 and 2005, respectively. The decrease during fiscal year 2007 is primarily due to a decrease of prepaid income taxes of approximately $1,690,000 and a decrease in pre-contract costs of approximately $1,202,000.The leading factor for the increase in fiscal year 2006 was the increase in precontract costs of approximately $4,621,000, which was due to the timing of our contract activities in fiscal year 2006. Prepaid income taxes increased in fiscal year 2006 by approximately $1,690,000 and prepaid expenses increased approximately $666,000. In addition, 2006 inventory balances increased by approximately $809,000. The increase in fiscal year 2005 is primarily due to the increase in precontract costs of approximately $1,023,000.
Accounts payable and accrued liabilities balances decreased in fiscal year 2007 by approximately $1,692,000, decreased in fiscal year 2006 by approximately $4,151,000, and increased in fiscal year 2005 by approximately $2,951,000. During fiscal year 2007, accounts payable balances decreased by approximately $1,405,000 and accrued payroll liabilities decreased approximately $709,000. The primary reason for the decline in fiscal year 2006 was the decrease in accounts payable of approximately $3,308,000 due to the overall decrease in our subcontract costs in fiscal year 2006. In addition, income taxes payable decreased by approximately $605,000 and accrued payroll balances decreased by approximately $383,000.
Fiscal year 2005 accrued payroll liabilities increased by approximately $1,151,000 due, primarily, to the increase in staffing, offset by a reduction in accrued bonus accrual in fiscal year 2005. Fiscal year 2005 accrued bonus was approximately $2,851,000, and was paid during the first quarter of fiscal year 2006. Other accrued liabilities decreased by approximately $843,000 in fiscal year 2005 primarily due to the payment of $500,000 to the United States Government in settlement of a contract dispute over certain older contracts.
Cash from investing activities. Net cash used in investing activities during fiscal years 2007, 2006, and 2005 was approximately $9,985,000, $22,890,000, and $14,135,000, respectively.
During fiscal years 2007 and 2006 we increased our investment in tax-exempt securities that were classified as short-term or long-term investments. Fiscal year 2007 property and equipment purchases of approximately $4,451,000 included leasehold improvement efforts of approximately $1,901,000 associated with our new facilities in Torrance, California,approximately $1,456,000 in computer equipment, and approximately $515,000 in test equipment. Fiscal year 2006 property and equipment purchases were approximately $5,037,000, which included approximately $3,008,000 in equipment purchases and approximately $1,804,000 in leasehold improvements, primarily to support the new facility in Annapolis Junction, Maryland, and to improve the existing facilities in Sunnyvale, California, and Arlington, Virginia.
The primary use of cash in fiscal year 2005 was for the acquisition of DTI. In the third quarter of fiscal year 2005, the Board of Directors approved a change in our investment policy to include tax-exempt securities. We purchased approximately $25,471,000 in available-for-sale securities, while approximately $47,491,000 matured. In addition, property and equipment purchases during fiscal year 2005 were approximately $6,887,000. We purchased property for the increased facilities and equipment to support the increase in our staff.
Cash from financing activities. Net cash used in financing activities during fiscal year 2007 and 2006 was approximately $3,055,000 and $2,623,000, respectively. Financing activities provided cash of approximately $8,225,000 during fiscal years 2005.
The sources of cash from financing activities for fiscal years 2007 and 2006 were from the purchase of common stock under our employee stock purchase plan and the cash received from stock option exercises. The sources of cash from financing activities during fiscal year 2005 were the $10 million Term Loan from Wells Fargo and the purchase of common stock under our stock option and employee stock purchase plans.
The primary fluctuations in financing activities between fiscal years 2006 and 2005 were a result of the $10 million Term Loan. We obtained the loan from Wells Fargo Bank, National Association (Wells Fargo), during the third quarter of fiscal year 2005 in connection with the acquisition of DTI. The receipt of loan proceeds was offset by loan payments of approximately $357,000 in fiscal year 2005. Loan payments totaled approximately $1,429,000 during fiscal years 2007 and 2006.
Dividend payments in fiscal year 2007 were the same as for fiscal years 2006 and 2005, at $0.50 per share per annum. Dividend payments were approximately $6,074,000, $5,858,000, and $5,678,000 in fiscal years 2007, 2006, and 2005, respectively. The year-over-year increases are due to increases in common stock outstanding resulting from the purchases of common stock under our stock compensation plans.
Cash is generated primarily from operating activities, employee stock activities, and investing activities. We believe the primary risk to liquidity is the potential decrease in demand for our products and services. Historically, this demand has been influenced by the needs of the United States Government intelligence community.
We believe that the funds generated from operations, existing working capital, and the amount available under our existing line of credit will be sufficient to meet our cash needs for the next twelve months.
Borrowing Arrangements
Revolving line of credit. At October 31, 2007, we had a revolving line of credit (the Line of Credit) under which Wells Fargo will advance funds to us from time to time up to and including March 1, 2008, not to exceed at any time the maximum principal amount of $3 million. Under the Line of Credit, we had two standby letters of credit totaling approximately $1,370,000. One letter of credit, related to our Sunnyvale, California, facilities lease, had a committed balance of approximately $1,220,000 at October 31, 2007, and October 31, 2006. The second letter of credit was a requirement of our workers compensation insurance, and the committed balance was approximately $150,000 at October 31, 2007, and October 31, 2006. We do not pay interest on the amounts associated with the standby letters of credit.
As a result of the committed but unused funds associated with the two letters of credit, the total amount under the Line of Credit available for borrowing was approximately $1,630,000. No fees or interest were associated with this unused portion. Borrowings under the Line of Credit bear interest at Wells Fargo’s reference rate (7.5% at October 31, 2007) and interest on those borrowings are payable monthly. As security for its indebtedness under the Line of Credit, we have granted to Wells Fargo a security interest in our cash and marketable securities maintained with an affiliate of Wells Fargo.
Term loan and interest rate swap. Effective July 1, 2005, and in connection with the acquisition of DTI, we entered into a term loan with Wells Fargo, in the principal amount of $10 million, plus interest, the proceeds of which were used for acquisition financing (Term Loan). The Term Loan bears interest at a rate per annum equal to 1.750% above the London Inter-Bank Offered Rate (LIBOR) (5.12% at October 31, 2007). Our Term Loan is for a seven-year term ending on July 1, 2012. The loan terms require us to make monthly payments of principal and interest.
As security for our indebtedness under the Term Loan, we have granted to Wells Fargo a security interest in our accounts receivable, general intangibles, inventory, and equipment.
We are required to maintain certain financial covenants setting forth minimum ratios for quick ratio and fixed charge coverage and maximum ratios for total liabilities to tangible net worth. As of October 31, 2007, we were in compliance with these covenants.
We are exposed to market risk from changes in interest rates on the Term Loan, and manage this exposure by using an interest rate swap agreement with Wells Fargo, designated as a cash flow hedge. By locking in a fixed rate for the entire term of the loan, this strategy decreases the variability of earnings and cash flows resulting from interest rate fluctuations and lowers the overall borrowing costs should interest rates rise. The interest rate swap is considered a cash flow hedge and is accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133).
At October 31, 2007, we had one interest rate swap agreement outstanding, with Wells Fargo, related to our Term Loan. We do not anticipate any losses on the agreement due to counterparty credit issues. Under this swap, we pay a fixed interest rate of 4.33% over the seven-year term of the loan and receive an average floating rate of LIBOR on the notional amount of the loan. The combined interest amounts on the Term Loan and the swap reflect our total monthly interest obligation, which is fixed at 6.08%.
The effective portion of the cash flow hedge is reported as other comprehensive income and reclassified into earnings in the same period during which the hedged transaction affects earnings. At October 31, 2007, the effective portion of the cash flow hedge was a deferred gain of approximately $16,000, net of taxes. Over the next twelve months, we expect to reclassify approximately $8,000 of the gain to interest expense as principle on the Term Loan is repaid and the related swap-instrument notional amount is reduced.
The ineffective portion of the gain or loss, if there is one, impacts earnings as it occurs. There is no ineffective portion of the outstanding swap as of October 31, 2007.
Contractual Obligations
The following table sets forth our contractual obligations as of October 31, 2007 (in thousands).
Fiscal Year |
Total |
Less than |
1 –3 |
3 –5 |
More than |
Operating lease obligations |
$44,324 |
$7,517 |
$14,998 |
$11,732 |
$10,077 |
Loan obligations – principal |
6,786 |
1,429 |
2,858 |
2,499 |
— |
Loan obligations – interest |
977 |
373 |
475 |
129 |
— |
Purchase obligations |
4,159 |
4,159 |
— |
— |
— |
Total |
$56,246 |
$13,478 |
$18,331 |
$14,360 |
$10,077 |
Our operating lease obligations consist of non-cancelable lease agreements for our facilities, which expire at various dates between fiscal years 2008 and 2016.
Certain leases contain escalation clauses and requirements for the payment of property taxes, insurance, and maintenance expenses. During fiscal year 2007, we entered into a new operating lease agreement with a total lease obligation of approximately $8,104,000 for our new facility in Torrance, California. In addition, we amended our operating lease agreements for our facilities in Anaheim, California, and Salt Lake City, Utah. These amendments increased our total lease obligation by approximately $93,000 and $71,000, respectively.
Product warranties. Our products are warranted against defective workmanship and materials for a period of one year from the date of acceptance by the original purchaser. Warranty costs were approximately $306,000, $279,000, and $263,000 for fiscal years 2007, 2006, and 2005, respectively.
We do not have any off-balance sheet arrangements with unconsolidated entities or related parties, and, accordingly, our liquidity and capital resources are not subject to off-balance sheet risks from unconsolidated entities.
Recent Accounting Pronouncements
In June 2005, the FASB issued SFAS 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized through a cumulative effect adjustment within net income of the period of the change. SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effect or the cumulative effect of the change. We adopted SFAS 154 at the beginning of fiscal year 2007. The adoption of SFAS 154 did not have a material impact on our financial statements.
In May 2006, the FASB issued SFAS 155, Accounting for Certain Hybrid Instruments, which amends SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. We adopted SFAS 155 at the beginning of fiscal year 2007. The adoption of SFAS 155 did not have a material impact on our financial statements.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides guidance on the SEC’s views regarding quantifying the materiality of financial statement misstatements, including misstatements that were not material to prior years’ financial statements. We adopted SAB 108 at the beginning of fiscal year 2007. The adoption of SAB 108 did not have a material impact on our financial statements.
In June 2006, the FASB issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109 (FIN 48). The interpretation clarifies the accounting for uncertainty in income taxes. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken on a return. The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure, and transition. FIN 48 utilizes a two-step approach. The first step is to determine whether it is more likely than not that a tax position accounted for under SFAS 109 will be sustained upon examination, with the presumption that the position will be examined. The second step is to measure the amount of benefit to recognize in the financial statements. The provisions are effective for us for our fiscal year beginning November 1, 2007. Based on a preliminary evaluation of the impact of adopting FIN 48, we believe that it will not a have a material effect on our financial position or results of operations in 2008.
In September 2006, the FASB issued SFAS 157, Fair Value Measurement. SFAS 157 defines fair value, establishes a framework for measuring fair value, and enhances disclosures about fair value measurements. The statement will be effective for our fiscal year beginning November 1, 2008. We are evaluating the impact adopting SFAS 157 will have on our financial statements.
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements to facilitate comparisons between companies using different measurement attributes for similar types of assets and liabilities. The statement will be effective for our fiscal year beginning November 1, 2008. We are evaluating the impact adopting SFAS 159 will have on our financial statements.
In June 2007, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities (EITF 07-3). EITF 07-3 requires non-refundable advance payments for goods, services to be used in future research, and development activities to be recorded as an asset, with the payments expensed when the research and development activities are performed. EITF 07-3 applies to new contractual arrangements entered into in fiscal years beginning after December 15, 2007. We believe that adoption of EITF 07-3 will not have a material effect on our financial position, results of operations, or cash flows.
In December 2007, the FASB issued SFAS 141R, Business Combinations. SFAS 141R replaces SFAS 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. The statement will apply prospectively to business combinations occurring in our fiscal year beginning November 1, 2009. We are evaluating the impact adopting SFAS 141R will have on our financial statements.
Quarterly Results
The following table sets forth certain unaudited quarterly consolidated financial data for the eight quarters ending October 31, 2007. In the opinion of management, the unaudited information set forth below has been prepared on the same basis as the audited information and includes all adjustments necessary to present fairly the information set forth herein. The operating results for any quarter are not indicative of results for any future period. All data is in thousands except for common share and per common share data.
|
Q1 |
Q2 |
Q3 |
Q4 |
Total |
Q1 |
Q2 |
Q3 |
Q4 |
Total |
Revenues from contracts |
$33,553 |
$43,525 |
$39,450 |
$45,385 |
$161,913 |
$43,544 |
$41,054 |
$39,542 |
$46,235 |
$170,375 |
Operating expenses: |
|
|
|
|
|
|
|
|
|
|
Contract costs |
22,068 |
29,253 |
27,258 |
29,319 |
107,898 |
28,860 |
28,583 |
27,062 |
31,628 |
116,133 |
Research and development |
3,589 |
4,698 |
3,986 |
6,892 |
19,165 |
3,585 |
3,410 |
3,756 |
3,453 |
14,204 |
General and administrative |
5,370 |
6,834 |
6,429 |
7,345 |
25,978 |
7,959 |
6,585 |
7,101 |
7,089 |
28,734 |
Total operating expenses |
31,027 |
40,785 |
37,673 |
43,556 |
153,041 |
40,404 |
38,578 |
37,919 |
42,170 |
159,071 |
Operating income |
2,526 |
2,740 |
1,777 |
1,829 |
8,872 |
3,140 |
2,476 |
1,623 |
4,065 |
11,304 |
Interest income (expense), net |
22 |
49 |
107 |
137 |
315 |
160 |
105 |
189 |
229 |
683 |
Income before provision (benefit) for income taxes |
2,548 |
2,789 |
1,884 |
1,966 |
9,187 |
3,300 |
2,581 |
1,812 |
4,294 |
11,987 |
Provision (benefit) for income taxes |
1,236 |
1,266 |
960 |
1,398 |
4,860 |
1,437 |
1,001 |
835 |
1,902 |
5,175 |
Net income |
$1,312 |
$1,523 |
$924 |
$568 |
$4,327 |
$1,863 |
$1,580 |
$977 |
$2,392 |
$6,812 |
Net income, per common share |
|
|
|
|
|
|
|
|
|
|
Basic |
$0.11 |
$0.13 |
$0.08 |
$0.05 |
$0.37 |
$0.16 |
$0.13 |
$0.08 |
$0.20 |
$0.56 |
Diluted |
$0.11 |
$0.13 |
$0.08 |
$0.05 |
$0.36 |
$0.15 |
$0.13 |
$0.08 |
$0.19 |
$0.55 |
Number of shares used in calculating net income per common share |
|
|
|
|
|
|
|
|
|
|
Basic |
11,617 |
11,712 |
11,784 |
11,848 |
11,739 |
11,973 |
12,039 |
12,171 |
12,218 |
12,100 |
Diluted |
11,919 |
12,012 |
12,019 |
12,040 |
11,994 |
12,171 |
12,285 |
12,381 |
12,397 |
12,314 |
At times, we have experienced fluctuations in our quarterly results. Management believes that these fluctuations are an inherent part of the business and could continue into the future. These have included costs associated with uneven flows of incoming material, the level of research and development spending during any given quarter, the use of target indirect rates at interim reporting periods, fee recognition on development contracts in the early phases of contract performance where the financial risk is not entirely known until the contract is further along in the development cycle, the United States Government contracting and budget cycles, the timing of contract awards, and changes in estimates that impact our effective tax rate.
Item 7A: Quantitative and Qualitative Disclosures about Market Risk
Interest rate risk. Our interest income is sensitive to changes in the general level of United States interest rates. The average days to maturity of our investment portfolio is 153 days, as of October 31, 2007.
Due to the short-term nature of our investments, we do not believe that there is a material interest rate risk. As of October 31, 2007, our total cash and investments balance that was sensitive to interest rate risk was approximately $39,047,000. As a measurement of the sensitivity of our portfolio, if yields were to fluctuate by 100 basis points, the total effect to the investment portfolio balance would be approximately $152,000.
The following table summarizes our cash and cash equivalents, and short-term securities, at fair value, that are sensitive to interest rate risk (in thousands).
|
2007 |
2006 |
Cash and cash equivalents |
$5,250 |
$4,194 |
Available-for-sale securities: |
|
|
Short-term tax-exempt |
29,683 |
25,651 |
Long-term tax-exempt |
4,114 |
2,802 |
|
$39,047 |
$32,647 |
Term loan and interest rate swap. Effective July 1, 2005, and in connection with the acquisition of DTI, we entered into a Term Loan agreement in the principal amount of $10 million with Wells Fargo, the proceeds of which were used for acquisition financing. The Term Loan bears interest at an annual rate of 1.75% above LIBOR (5.12% at October 31, 2007).
We manage potential market risk from changes in interest rates on the Term Loan through the use of an interest rate swap agreement designated as a cash flow hedge. By locking in a fixed rate for the entire term of the loan, this strategy decreases the variability of earnings and cash flows resulting from interest rate fluctuations and lowers our overall borrowing costs should interest rates rise.
Coincident with the Term Loan transaction, we also entered into an interest rate swap agreement with Wells Fargo whereby we pay interest to Wells Fargo at a fixed rate of 4.33% and Wells Fargo pays interest to us at a floating rate tied to the LIBOR index. The combined interest amounts on the Term Loan and the swap reflect our total monthly interest obligation, which is locked in at 6.08%.
Item 8: Consolidated Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of
Applied Signal Technology, Inc.
We have audited the accompanying consolidated balance sheets of Applied Signal Technology, Inc. as of October 31, 2007, and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended October 31, 2007, 2006, and 2005. These financial statements are the responsibility of Applied Signal Technology, Inc. management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board ( United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Applied Signal Technology, Inc. at October 31, 2007, and 2006, and the consolidated results of its operations and its cash flows for the years ended October 31, 2007, 2006, and 2005, in conformity with United States generally accepted accounting principles.
As discussed in Note 1 to the Notes to Consolidated Financial Statements, under the heading Stock-Based Compensation, in fiscal 2006 Applied Signal Technology, Inc. changed its method of accounting for stock-based compensation to adopt the provision of FASB Statement No. 123R, Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Applied Signal Technology, Inc.’s internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 9, 2008, expressed an unqualified opinion thereon.
| /s/ Ernst & Young LLP | |
| San Jose, California January 9, 2008 |
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
The Board of Directors and Shareholders of
Applied Signal Technology, Inc.
We have audited Applied Signal Technology, Inc.’s internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Applied Signal Technology, Inc. management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board ( United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Applied Signal Technology, Inc. maintained, in all material respects, effective internal control over financial reporting as of October 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Applied Signal Technology, Inc. as of October 31, 2007, and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended October 31, 2007, and our report dated January 9, 2008, expressed an unqualified opinion thereon.
| /s/ Ernst & Young LLP | |
| San Jose, California January 9, 2008 |
Consolidated Statements of Operations
(in thousands, except per share data)
|
2007 |
2006 |
2005 |
Revenues from contracts |
$170,375 |
$161,913 |
$156,061 |
Operating expenses: |
|
|
|
Contract costs |
116,133 |
107,898 |
102,938 |
Research and development |
14,204 |
19,165 |
16,125 |
General and administrative |
28,734 |
25,978 |
22,167 |
Total operating expenses |
159,071 |
153,041 |
141,230 |
Operating income |
11,304 |
8,872 |
14,831 |
Interest income and other, net |
1,356 |
1,024 |
1,027 |
Interest expense |
(673) |
(709) |
(379) |
Income before provision for income taxes |
11,987 |
9,187 |
15,479 |
Provision for income taxes |
5,175 |
4,860 |
6,235 |
Net income |
$6,812 |
$4,327 |
$9,244 |
Net income per common share |
|
|
|
Basic |
$0.56 |
$0.37 |
$0.81 |
Diluted |
$0.55 |
$0.36 |
$0.79 |
Number of shares used in calculating net income per common share |
|
|
|
Basic |
12,100 |
11,739 |
11,400 |
Diluted |
12,314 |
11,994 |
11,759 |
See accompanying notes. |
|
|
|
Consolidated Balance Sheets
(in thousands)
|
2007 |
2006 |
Assets |
|
|
Current assets: |
|
|
Cash and cash equivalents |
$5,250 |
$4,194 |
Short-term investments |
29,683 |
25,651 |
Total cash, cash equivalents, and short-term investments |
34,933 |
29,845 |
Accounts receivable: |
|
|
Billed |
25,097 |
20,766 |
Unbilled |
19,379 |
19,813 |
Total accounts receivable |
44,476 |
40,579 |
Inventory |
5,944 |
6,078 |
Refundable income taxes |
647 |
647 |
Prepaid and other current assets |
9,760 |
12,306 |
Total current assets |
95,760 |
89,455 |
Property and equipment, at cost: |
|
|
Machinery and equipment |
41,075 |
39,224 |
Furniture and fixtures |
4,676 |
4,614 |
Leasehold improvements |
14,584 |
14,278 |
Construction in process |
2,230 |
195 |
|
62,565 |
58,311 |
Accumulated depreciation and amortization |
(46,096) |
(41,496) |
Property and equipment, net |
16,469 |
16,815 |
Long-term investment |
4,114 |
2,802 |
Goodwill |
19,964 |
19,964 |
Intangible assets, net of accumulated amortization |
616 |
1,260 |
Long-term deferred tax asset |
5,021 |
5,455 |
Other assets |
789 |
781 |
Total assets |
$142,733 |
$136,532 |
Consolidated Balance Sheets (continued)
(in thousands)
|
2007 |
2006 |
Liabilities and Shareholders’ Equity |
|
|
Current liabilities: |
|
|
Accounts payable |
$3,848 |
$5,253 |
Accrued payroll and related benefits |
13,135 |
13,844 |
Note payable |
1,429 |
1,429 |
Income taxes payable |
14 |
— |
Other accrued liabilities |
1,997 |
1,741 |
Total current liabilities |
20,423 |
22,267 |
Long-term note payable |
5,357 |
6,786 |
Accrued rent |
1,658 |
1,354 |
Other long-term liabilities |
459 |
495 |
Shareholders’ equity: |
|
|
Preferred stock, no par value: 2,000,000
shares authorized; |
— |
— |
Common stock, no par value: 20,000,000 shares
authorized; |
61,849 |
53,295 |
Retained earnings |
52,953 |
52,272 |
Accumulated comprehensive income |
34 |
63 |
Total shareholders’ equity |
114,836 |
105,630 |
Total liabilities and shareholders’ equity |
$142,733 |
$136,532 |
See accompanying notes. |
|
|
Consolidated Statements of Cash Flows
(in thousands)
|
2007 |
2006 |
2005 |
Operating activities: |
|
|
|
Net income |
$6,812 |
$4,327 |
$9,244 |
Adjustments to reconcile net income to net cash provided by operating activities: |
|
|
|
Depreciation and amortization |
5,649 |
5,279 |
3,994 |
Stock-based compensation |
4,150 |
4,283 |
— |
Tax benefit related to stock plans |
68 |
379 |
629 |
Excess tax benefits from stock-based |
|
|
|
Changes in: |
|
|
|
Accounts receivable |
(3,897) |
7,887 |
(2,272) |
Income tax receivable |
— |
513 |
— |
Inventory, prepaid expenses and other |
|
|
|
Other assets |
380 |
317 |
(93) |
Accounts payable and accrued liabilities |
(1,692) |
(4,151) |
2,951 |
Net cash provided by operating activities |
14,096 |
10,787 |
13,603 |
Investing activities: |
|
|
|
Cash paid for business acquired, net |
— |
— |
(29,273) |
Purchases of available-for-sale securities |
(76,411) |
(77,853) |
(25,471) |
Maturities of available-for-sale securities |
70,877 |
60,000 |
47,491 |
Additions to property and equipment |
(4,451) |
(5,037) |
(6,882) |
Net used in investing activities |
(9,985) |
(22,890) |
(14,135) |
Financing activities: |
|
|
|
Issuances of common stock |
4,394 |
4,484 |
4,259 |
Excess tax benefits from stock-based |
|
|
|
Term loan |
(1,429) |
(1,429) |
9,644 |
Dividends paid |
(6,074) |
(5,858) |
(5,678) |
Net cash (used in) provided by financing activities |
(3,055) |
(2,623) |
8,225 |
Net increase (decrease) in cash and cash equivalents |
1,056 |
(14,726) |
7,693 |
Cash and cash equivalents at beginning of year |
4,194 |
18,920 |
11,227 |
Cash and cash equivalents at end of year |
$5,250 |
$4,194 |
$18,920 |
|
|
|
|
Interest paid |
$556 |
$586 |
$232 |
Income taxes paid |
$3,873 |
$5,997 |
$4,466 |
See accompanying notes. |
|
|
|
Consolidated
Statement of Shareholders’ Equity
(in thousands, except share data)
|
Number of Outstanding Shares |
Common Stock |
Retained Earnings |
Accumulated Comprehensive Income (Loss) |
Total Shareholders’ Equity |
Balance at October 31, 2004 (as reported) |
11,210,738 |
$39,261 |
$50,327 |
($25) |
$89,563 |
Issuance of common shares to employees |
317,580 |
4,259 |
— |
— |
4,259 |
Dividends declared |
— |
— |
(5,718) |
— |
(5,718) |
Tax benefit related to stock plans |
— |
629 |
— |
— |
629 |
Other comprehensive income |
— |
— |
— |
152 |
152 |
Net income |
— |
— |
9,244 |
— |
9,244 |
Balance at October 31, 2005 (as reported) |
11,528,318 |
$44,149 |
$53,853 |
$127 |
$98,129 |
Issuance of common shares to employees |
393,785 |
4,484 |
— |
— |
4,484 |
Stock-based compensation expense |
— |
4,283 |
— |
— |
4,283 |
Dividends declared |
— |
— |
(5,908) |
— |
(5,908) |
Tax benefit related to stock plans |
— |
379 |
— |
— |
379 |
Other comprehensive income |
— |
— |
— |
(64) |
(64) |
Net income |
— |
— |
4,327 |
— |
4,327 |
Balance at October 31, 2006 (as reported) |
11,922,103 |
$53,295 |
$52,272 |
$63 |
$105,630 |
Issuance
of common shares to employees |
466,319 |
4,336 |
— |
— |
4,336 |
Stock-based compensation expense |
— |
4,150 |
— |
— |
4,150 |
Dividends declared |
— |
— |
(6,131) |
— |
(6,131) |
Tax benefit related to stock plans |
— |
68 |
— |
— |
68 |
Other comprehensive income |
— |
— |
— |
(29) |
(29) |
Net income |
— |
— |
6,812 |
— |
6,812 |
Balance at October 31, 2007 |
12,388,422 |
$61,849 |
$52,953 |
$34 |
$114,836 |
See accompanying notes. |
|
|
|
|
|
Notes to Consolidated Financial Statements, October 31, 2007
Note 1: Organization and Summary of Significant Accounting Policies
Organization
Applied Signal Technology, Inc. (AST) provides advanced digital signal processing products, systems, and services in support of intelligence, surveillance, and reconnaissance (ISR) for global security. We provide processing of both man-made and naturally occurring signals. The processing of man-made signals includes communications intelligence (COMINT) and electronic intelligence (ELINT). The processing of natural signatures includes the use of sonar, radar, magnetic, and chemical sensors to detect changes in the environmental phenomenology. Our primary customer is the United States Government. We develop and manufacture sophisticated receivers and signal processing equipment that use advanced software.
Substantially, all of our revenues were from contracts with the United States Government or prime contractors for the United States Government.
Use of Estimates
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates.
Principles of Consolidation
The financial statements include the accounts of AST and its wholly owned subsidiary, DTI. All significant intercompany transactions have been eliminated.
Revenues and Contract Accounting
Revenues and cost recognition. The majority of our contracts are accounted for in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Opinion 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts. These contracts are executed by using written contractual arrangements, most of which require us to design, develop, manufacture, and/or modify our complex products and perform related services according to specifications provided by the customer. A limited number of standalone software contracts are recognized in accordance with the AICPA Statement of Opinion 97-2, Software Revenue Recognition (SOP 97-2). In accordance with SOP 97-2, we may, at times, record an amount of deferred revenue associated with contracts that are billed and for which customers have paid in advance of performance requirements set forth in these contracts.
We account for cost-reimbursement contracts by charging actual labor, materials, and other direct costs, plus estimated indirect costs of operations as incurred (incurred costs), including overhead, research and development, and general and administrative expenses. We do not apply indirect costs to subcontract costs that are in excess of $250,000 and meet certain other predetermined criteria.
We recognize contract revenues and profits on cost-reimbursement contracts by applying an estimated fee rate to all incurred costs on an individual contract basis. Fee calculations are based on either negotiated fee amounts or management’s assessment of the fee amounts that are likely to be earned. On cost-reimbursement contracts, we may bear unexpected cost increases for purposes of maintaining customer relationships. Historically, the effect on operating results and financial condition from cost-reimbursement losses has been minimal.
Our policy for recognizing interim award fees on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion thereof will be earned, on a contract-by-contract basis. Management bases its assessments on numerous factors including contract terms, nature of the work to be performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized in whole or in part until management determines that it is probable that the award fee or portion thereof will be earned. Historically, management’s estimates have generally been consistent with the actual fees awarded. However, changes in facts and circumstances could arise within an award fee period, causing management to either lower or raise the award fee estimate in the period in which the changes occur.
Some of our engineering services are performed under time-and-materials contracts on a level-of-effort basis. We recognize revenue for these contracts by applying a negotiated billing rate to the level of effort.
We account for fixed-price contracts by using the percentage-of-completion method. Under this method, we charge labor, materials, and other direct costs, plus estimated indirect costs of operations, as they are incurred. Each period, we recognize as revenue a portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual costs incurred and the estimated costs to complete. On fixed-price contracts, we bear the risk of any unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors, and these costs could have a materially adverse effect on our results of operations.
The following table represents our revenue concentration during the respective periods by contract type.
|
FY07 |
FY06 |
FY05 |
Cost-reimbursement contracts |
71% |
79% |
76% |
Fixed-price contracts |
15% |
17% |
21% |
Time-and-materials contracts |
14% |
4% |
3% |
|
100% |
100% |
100% |
Six contracts represented an aggregate of 56.3% of revenues for fiscal year 2007. Five contracts represented an aggregate of 42.1% of revenues for fiscal year 2006 and four contracts represented an aggregate of 29.4% of revenues for fiscal year 2005. One of the six significant contracts in fiscal year 2007 was a time-and-materials contract. All of the other contracts referenced were cost-reimbursement contracts.
For those contracts in which all of the terms have not yet been finalized, revenue does not include an estimated fee rate on cost.
Management reviews contract performance, costs incurred, and estimated completion costs regularly. Revenues and profits are adjusted on all contracts in the period in which changes, including anticipated losses, become determinable.
Precontract costs represent costs incurred in anticipation of specific expected future contract awards and costs incurred in connection with ongoing contracts for which contract modifications have not been defined or completed at the end of the reporting date. These costs are included in other current assets on the balance sheet. For further information please refer to “Note 3: Inventory and Precontract Costs.”
Indirect rate variance adjustments to operations. We record contract revenues and costs of operations for interim reporting purposes based on annual targeted indirect rates. At year-end, the revenues and costs are adjusted for actual indirect rates. During our interim reporting periods, variances may accumulate between the actual indirect rates and the annual targeted rates. All timing-related indirect spending variances are removed from contract costs, research and development, and general and administrative expenses, and are included in inventory as part of work in process during these interim reporting periods. These rates are reviewed regularly, and we record adjustments for any material, permanent variances in the period they become determinable.
Our accounting policy for recording indirect rate variances is based on management’s belief that variances accumulated during interim reporting periods will be absorbed by expected contract activities during the remainder of the year. We consider the rate variance to be unfavorable when our actual indirect rates are greater than our annual targeted rates. In contrast, a favorable rate variance occurs when our actual indirect rates are lower than our annual targeted rates. During interim reporting periods, unfavorable rate variances are recorded as reductions to operating expenses and increases to work in process inventory. Favorable rate variances are recorded as increases to operating expenses and decreases to work in process inventory.
If we anticipate that actual contract activities will be different than planned levels, there are alternatives we can utilize to absorb the variance: we can adjust our planned indirect spending during the year, modify our billing rates to our customers through the Defense Contract Audit Agency in accordance with Federal Acquisition Regulations, or record adjustments to expense based on estimates of future contract activities for the remainder of the fiscal year.
If our rate variance is unfavorable, the modification of our billing rates will likely increase revenue and operating expenses, and decrease inventory. Fee percentages on fixed-price and cost-reimbursement contracts will generally decline as a result of any increase to indirect costs. If our rate variance is favorable, the modification of our billing rates will decrease revenue and operating expenses, and increase inventory. In this event, fee percentages on fixed-price contracts will generally increase. Fee percentages on cost-reimbursable contracts will generally be unaffected as a result of any reduction to indirect costs, due to the fact that programs will typically expend all of the funds available. Any impact on operating income, however, will depend on a number of other factors, including mix of contract types, contract terms, anticipated performance on specific contracts, and anticipated changes in inventory.
During fiscal year 2007, we absorbed an unfavorable indirect rate variance that accumulated during the fiscal year, by modifying our billing rates to our customers, which increased revenues by approximately $958,000 and operating expenses by approximately $2,224,000.
During fiscal year 2006, we absorbed an unfavorable indirect rate variance that accumulated during the fiscal year, by modifying our billing rates to our customers, which increased revenues by approximately $3,387,000 and operating expenses by approximately $5,725,000.
During fiscal year 2005, we absorbed an unfavorable indirect rate variance that accumulated during the fiscal year by modifying our billing rates to our customers, which increased revenues by approximately $3,949,000 and operating expenses by approximately $4,935,000.
Accounts receivable and allowance for bad debt. Accounts receivable are segregated between billed and unbilled accounts. For cost-reimbursement contracts, we bill incurred costs and a portion of our fees on a regular basis. Under fixed-price contracts, we either regularly progress bill 90% of incurred costs or bill contract costs on a milestone or unit of delivery basis. Unbilled amounts result from our recognition of contract revenue in advance of contractual billing or progress billing terms.
When evaluating our need for a bad debt allowance, we consider our customer base and their payment history. The majority of our revenues are generated from the United States Government, and therefore credit risk is minimal. We record allowances for bad debt as a reduction to accounts receivable and an increase to bad debt expense. These allowances are recorded in the period a specific collection problem is identified. Once the receivable is deemed uncollectible, the allowance is reversed and the receivable is written off to bad debt expense. Charges to bad debt expense were not significant during fiscal years 2007, 2006, and 2005.
Inventory valuation and disposal. Typical life cycles of our equipment are eight to ten years or more. In addition, we maintain spare parts in order to repair the equipment. We evaluate our inventory quarterly at interim reporting periods, and assess our ability to sell our products, which includes raw materials. Historically, we have sold our inventory at or above cost, so there is typically no decrement in valuation. In addition, when we determined that a product has reached the end of its life cycle or there is no longer a need for a certain product, we would dispose of any remaining inventory, and recorded the associated reduction to inventory. At the end of fiscal year 2007, however, we recorded a write-down of approximately $415,000, inventory against one inventoried product for which we consider future sales remote. The charges associated with these reductions to work in process and finished goods are included in contract costs in our statement of operations. Disposals associated with our raw material represent a minor amount and is included in general and administrative expenses on the statement of operations due to the fact that raw materials could be used in a variety of situations other than contract costs, including R&D.
For inventory disposal activities for fiscal years 2007 and 2006, please refer to “Note 3: Inventory.”
Income Taxes
Our income tax expense at interim reporting periods is based on our estimated annual effective tax rate. This estimated tax rate is calculated based on the projected net income at the end of the fiscal year, and is reviewed at each reporting period. At the end of the fiscal year, income tax expense is adjusted for actual results. Our effective tax rate can differ from the statutory rate primarily due to the non-deductible nature of certain types of stock-based compensation expense. Please refer to “Note 8: Income Taxes” for the current year effective tax rate.
Price Redetermination
As a government contractor, we are subject to price redetermination on certain fixed-price contracts if it is determined that we did not price our products and services consistent with the requirements of the Federal Acquisition Regulations. We did not incur any price redeterminations on any of our contracts during fiscal years 2007, 2006, or 2005, although, during fiscal year 2005 we did settle an outstanding dispute with the United States Government for approximately $500,000 relating to older contracts. This settlement did not result in a negative impact to our fiscal year 2005 earnings because the amount paid by us was fully reserved in prior years.
Cash, Cash Equivalents, and Investments
We consider all highly liquid debt instruments purchased with an original maturity date of three months or less to be cash equivalents.
Our remaining securities are classified as available for sale and are carried at fair market value in short-term and long-term investments. At October 31, 2007, all of our short-term and long-term investments consist of tax-exempt securities. At the time of purchase, management determines the appropriate classification of these securities and re-evaluates such designation as of each balance sheet date. Unrealized gains and losses, net of tax, are reported in shareholders’ equity as part of comprehensive income. The cost of securities sold is based on the specific identification method. The fair value of short-term and long-term investments is determined based on quoted market prices for the respective securities. Realized gains and losses on sales of available-for-sale securities were not material for fiscal years 2007, 2006, and 2005.
The following tables summarize our cash and cash equivalents, short-term securities, and long-term securities (in thousands).
|
Amortized Cost |
Gross Unrealized Gains |
Estimated Fair Market Value |
Cash and cash equivalents |
$5,250 |
$— |
$5,250 |
Available-for-sale securities: |
|
|
|
Short-term tax exempt |
29,671 |
12 |
29,683 |
Long–term tax exempt |
4,108 |
6 |
4,114 |
|
$39,029 |
$18 |
$39,047 |
|
Amortized Cost |
Gross Unrealized Gains |
Estimated Fair Market Value |
Cash and cash equivalents |
$4,194 |
$— |
$4,194 |
Available-for-sale securities: |
|
|
|
Short-term tax exempt |
25,651 |
— |
25,651 |
Long-term tax exempt |
2,801 |
1 |
2,802 |
|
$32,646 |
$1 |
$32,647 |
The following table summarizes the maturities of our available-for-sale investments (in thousands).
|
October 31, 2007 |
October 31, 2006 |
Due in one year or less |
$29,683 |
$25,651 |
Due in one to two years |
4,114 |
2,802 |
|
$33,797 |
$28,453 |
Restricted Cash
We had restricted cash balances of approximately $562,000 and $582,000 at October 31, 2007, and October 31, 2006, respectively. These balances include contributions made by our employees residing in California for disability funds. These contributions were paid in lieu of participating in the state-sponsored disability program.
Approximately $194,000 and $177,000 was included in prepaids and other current assets on October 31, 2007, and October 31, 2006, respectively. Approximately $368,000 and $405,000 was included in other assets on October 31, 2007, and October 31, 2006, respectively.
Property and Equipment
Machinery and equipment as well as furniture and fixtures are depreciated by using the straight-line method over the estimated useful lives of the assets, ranging up to five years. Leasehold improvements are amortized by using the straight-line method over the lesser of the useful life of the assets or the lease term. Construction in process includes costs incurred to build a portion of our leasehold improvements and test equipment.
Goodwill and Long-Lived Asset Valuation
Goodwill valuation. We test goodwill for possible impairment on an annual basis and at any other time if events occur or circumstances indicate that the current carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include, but are not limited to, a significant adverse change in the business climate or legal factors, an adverse action or assessment by a regulator, unanticipated competition and loss of key personnel.
To perform the goodwill impairment test, we determine the fair value of the reporting unit and compare the fair value to the reporting unit’s carrying value. We believe AST is one reporting unit, and therefore, we compare the fair value of AST to the total net asset value on our balance sheet. If our total net asset value were to exceed our fair value, we would perform the second step of the impairment test. In the second step, we would compare the implied fair value of our goodwill to our carrying amount. If no impairment exists under step one, then step two is not necessary.
Based on our analysis, we concluded no impairment existed at October 31, 2007.
Long-lived asset valuation (property, plant and equipment, and intangible assets). We test long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances that could trigger a review include, but are not limited to, significant decreases in the market price of the asset, significant adverse changes in the business climate or legal factors, accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset, current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset, and current expectation that the asset will more likely than not be sold or disposed of significantly before the end of its estimated useful life.
We assess recoverability based on the carrying amount of the asset and its fair value, which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset. We recognize an impairment loss when the carrying amount is not recoverable and exceeds fair value.
No indicators of impairment existed at October 31, 2007.
Net Income Per Share Data
Basic net income per share is determined by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the weighted average number of common shares used in the basic earnings per share calculation, plus the number of common shares that would be issued assuming conversion of all potentially dilutive securities outstanding under the treasury stock method. Per share data is as follows (in thousands, except per share amounts).
|
2007 |
2006 |
2005 |
Numerator: |
|
|
|
Net income |
$6,812 |
$4,327 |
$9,244 |
|
|
|
|
Shares
used to compute net income per |
12,100 |
11,739 |
11,400 |
Effect of dilutive stock options and non-vested shares |
214 |
255 |
359 |
Shares
used to compute net income per |
12,314 |
11,994 |
11,759 |
|
|
|
|
Net income per common share – diluted |
$0.55 |
$0.36 |
$0.79 |
We excluded approximately 971,000; 860,000; and 584,000 potential common shares for fiscal years 2007, 2006, and 2005 from the diluted net income per common share computation for the respective periods, as their effect would be antidilutive.
Comprehensive Income
The components of our annual comprehensive income, net of tax, are as follows (in thousands).
|
2007 |
2006 |
2005 |
Net income |
$6,812 |
$4,327 |
$9,244 |
Unrealized gain on securities |
17 |
6 |
20 |
Unrealized gain (loss) on derivative |
(46) |
(70) |
132 |
Comprehensive income |
$6,783 |
$4,263 |
$9,396 |
The balance of accumulated comprehensive income on securities as of October 31, 2007, and October 31, 2006, was approximately $18,000 and $1,000, respectively. Derivative accumulated comprehensive income balance as of October 31, 2007, and October 31, 2006, was approximately $16,000 and $62,000, respectively. Accumulated comprehensive income was $127,000 as of October 31, 2005. The derivative gain was not booked net of the tax effect during fiscal year 2005.
Dividends
We pay dividends at the rate of $0.50 per share per annum, payable quarterly. However, the dividend is subject to approval by the Board of Directors and is reviewed quarterly. Dividends were paid on February 16, 2007, May 18, 2007, August 17, 2007, and November 16, 2007, to shareholders of record at February 2, 2007, May 4, 2007, August 3, 2007, and October 31, 2007.
Total dividends paid during fiscal years 2007, 2006, and 2005 were approximately $6,074,000, $5,858,000, and $5,678,000, respectively.
At October 31, 2007, and October 31, 2006, accrued dividends of approximately $1,549,000 and $1,491,000, respectively, were included in other accrued liabilities on the accompanying balance sheet.
Stock-Based Compensation
We have the following stock-based compensation programs that provide our Board of Directors discretion in creating employee equity incentives. As of October 31, 2007, there were a total of 1,158,941 shares reserved for future issuance under all of our equity incentive plans and our ESPP.
Employee Stock Purchase Plan. We maintain our 1993 Employee Stock Purchase Plan (ESPP), and have reserved 4,900,000 shares of common stock for issuance to employees under the ESPP. The ESPP was adopted by the Board of Directors on January 22, 1993, and approved by the shareholders on February 22, 1993. Under this plan, eligible employees purchase common stock through payroll deductions (which cannot exceed 10% of any employee’s compensation) at 85% of the lower of its fair market value at the beginning of an offering period or the end of a six-month purchase period. For offering periods beginning prior to June 1, 2007, our ESPP had a twenty-four month offering period with four six-month purchase periods within each offering period. If the fair market value on the purchase date was lower than the fair market value on the offering date, all participants were withdrawn from the offering period and re-enrolled into a new offering period. Effective, May 31, 2007, we modified our ESPP such that the length of all offering periods, beginning June 1, 2007, is six months. Consequently, there is no reset feature associated with the new offering periods. As a result of the modification to the ESPP, the December 1, 2006, offering period, originally scheduled to end on November 30, 2008, was the final twenty-four month offering. As of October 31, 2007, 674,272 shares remain reserved for issuance and eligible for purchase under the 1993 Plan.
Stock Option Plan – 1991. Our 1991 Stock Option Plan (1991 Plan) provided for the granting of incentive stock options and non-qualified stock options to our employees, directors, and consultants at exercise prices ranging from 85% to 110% (depending on the type of grant) of the fair market value of the common stock on the date of grant. The exercise price of the options granted under this plan were 100% or greater than the fair market value on the date of grant. Some options are exercisable only at the end of a two-year vesting period and some options are exercisable at the rate of 20% per year over five years. The 1991 Plan expired on January 19, 2001, and all remaining shares reserved for issuance expired. Options to purchase an aggregate of 160,875 shares of our common stock remain outstanding under the 1991 Plan as of October 31, 2007.
Stock Option Plan – 2000. Our 2000 Stock Option Plan (2000 Plan) was adopted by the Board of Directors on May 11, 2000, and provides for the granting of non-qualified stock options to our employees and consultants at exercise prices ranging from 85% to 100% of the fair market value of the common stock on the date of grant. Options granted prior to 2004 vest over five years, at the rate of 20%, on the first anniversary of the date of grant and in equal monthly installments over the remaining 48 months, and have a maximum term of 10 years. Options granted in 2004 and beyond vest at the rate of 20% per year over five years, on the anniversary date of the grant date. Options to purchase an aggregate of 569,617 shares of our common stock were outstanding and 357,557 shares were available for grant under the 2000 Plan as of October 31, 2007. In November 2007, the Board of Directors voted to terminate the 2000 Plan.
Stock Option Plan – 2001. Our 2001 Stock Option Plan (2001 Plan) was adopted by the Board of Directors on November 16, 2000, and approved by the shareholders on March 15, 2001. The 2001 Plan provides for the granting of incentive stock options and non-qualified stock options to our employees, directors, and consultants at exercise prices ranging from 85% to 100% of the fair market value of the common stock on the date of grant. Options granted prior to 2004 vest over five years, at the rate of 20%, on the first anniversary of the date of grant and in equal monthly installments over the remaining 48 months, and have a maximum term of 10 years. Options granted in 2004 and beyond vest at the rate of 20% per year over five years, on the anniversary date of the grant date. Options to purchase an aggregate of 346,232 shares of our common stock are outstanding and 35,635 shares remain available for grant under the 2001 Plan as of October 31, 2007.
Stock Incentive Plan – 2004. Our 2004 Stock Incentive Plan (2004 Plan) was adopted by the Board of Directors on November 20, 2003 and approved by the shareholders on March 10, 2004. The 2004 Plan provides for the granting of incentive stock options, non-qualified stock options, restricted stock, and restricted stock unit awards to our employees, directors, and consultants. The exercise price for an option is equal to 100% of the fair market value of the common stock on the date of grant. No monetary payment is required as a condition of receiving a restricted stock or restricted stock unit award, since the consideration for the award shall be services actually rendered to us or for our benefit. Some options vest over five years, at the rate of 20%, one year after the date of grant and in equal monthly installments over the remaining 48 months, and have a maximum term of eight years. Other options vest over five years, at the rate of 20% per year. Options to purchase an aggregate of 333,000 shares of our common stock are outstanding, the common stock balance includes 163,266 shares of restricted stock, and 91,477 shares remain available for grant under the 2004 Plan as of October 31, 2007.
Prior to fiscal year 2006, we used stock options as the primary component of our stock-based incentive plans for officers, directors, and employees. In fiscal year 2006, we began granting restricted stock to our officers and directors. During 2007, we granted restricted stock to officers as part of their annual compensation review and we granted restricted stock to newly-hired and existing non-officer employees. The restrictions typically will lapse in four equal annual installments, on each anniversary of the grant date, conditioned on continued employment. During the fourth quarter of fiscal year 2007, we granted restricted stock to our directors. The restrictions for the majority of the grants will lapse in three equal annual installments.
In fiscal year 2006, we adopted the provisions of SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R), requiring us to recognize expense related to the fair value of our stock-based compensation awards that are ultimately expected to vest. We elected to use the modified prospective transition method as permitted by SFAS 123R and therefore have not restated our financial results for 2005. Stock-based compensation expense for all stock-based compensation awards granted subsequent to November 1, 2005, was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. For stock-based compensation awards granted prior to, but not yet vested as of November 1, 2005, stock-based compensation expense was based on the grant-date fair value previously estimated, by using the Black Scholes valuation model, in accordance with the original provisions of SFAS 123. We recognize expense for stock-based compensation awards on a straight-line basis over the requisite service period of the award, which generally equals the vesting period of each grant.
The following table sets forth the total stock-based compensation expense resulting from stock option grants, restricted stock awards, and shares purchased under our ESPP included in our condensed consolidated statements of operations (in thousands).
|
Fiscal Year 2007 |
Fiscal Year 2006 |
Contract costs |
$2,388 |
$2,493 |
Research and development |
177 |
229 |
General and administrative |
1,585 |
1,561 |
Stock-based compensation expense before income taxes |
4,150 |
4,283 |
Income taxes |
(850) |
(804) |
Stock-based compensation expense after income taxes |
$3,300 |
$3,479 |
Reduction to basic net income per share |
$0.27 |
$0.30 |
Reduction to diluted net income per share |
$0.27 |
$0.29 |
Prior to the adoption of SFAS 123R, we applied SFAS 123, amended by SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure, which allowed companies to apply existing accounting rules under APB 25. In general, if the exercise price of options granted under these plans was equal to the market price of the underlying common stock on the grant date, no stock-based employee compensation cost was recognized in our net income for periods prior to the adoption of SFAS 123R. As required by SFAS 123 and 148 prior to the adoption of SFAS 123R, we provided pro forma net income (loss) and pro forma net income (loss) per common share disclosures for stock-based awards as if the fair-value method defined in SFAS 123 had been applied.
SFAS 123R requires us to present pro forma information for the comparative periods prior to the adoption as if we had accounted for all of our employee stock options and ESPP under the fair value method of the original SFAS 123. The following table illustrates the effect on net income after tax and net income per common share as if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation during fiscal year 2005 (in thousands, except per-share amounts).
|
Fiscal Year 2005 |
Net income – As reported |
9,244 |
Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of tax |
|
|
|
Net income – Pro forma |
5,783 |
Net income per share |
|
Basic – As reported |
$0.81 |
– Pro forma |
$0.51 |
Diluted – As reported |
$0.79 |
– Pro forma |
$0.49 |
We estimated the fair value of options granted and shares issued under our ESPP by using the Black-Scholes valuation model using the following weighted average assumptions.
|
2006 |
2005 |
2007 |
2006 |
2005 |
Risk-free interest rate |
5.0% |
3.9% |
4.6% |
4.9% |
3.2% |
Expected life (years) |
5.0 |
5.0 |
1.9 |
1.6 |
1.3 |
Expected volatility |
44% |
63% |
39% |
39% |
43% |
Expected dividends |
2.8% |
1.3% |
2.5% |
2.2% |
1.8% |
Weighted average fair value |
$6.42 |
$12.93 |
$5.59 |
$6.35 |
$6.83 |
We did not grant options during fiscal year 2007.
Our determination of the grant-date fair value of stock-based compensation using an option pricing model and the resulting compensation expense that is recognized are affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These factors include, but are not limited to, our expected stock price volatility, the projected life of the stock option, the expected dividend yield, and the risk-free interest rate. Changes in the subjective assumptions can materially affect the estimated value of the stock options and the expense recognized.
The risk-free interest rate is based on the Federal Reserve Bank’s constant maturities daily interest rate in effect at the time of the option grant or at the beginning of the ESPP offering period.
The expected life of the options represents the period that we expect the stock-based awards will be outstanding and is determined based on historical experience of similar awards, considering contractual terms, exercise patterns, and vesting schedules. The expected life used for our ESPP offering periods prior to June 1, 2007, was based on the six-month purchase periods within each twenty-four-month offering period.
Our computation of expected volatility for the ESPP in fiscal year 2007 and for both stock options and the ESPP for fiscal year 2006, reflects a combination of historical and market-based implied volatility consistent with SFAS 123R and Staff Accounting Bulletin 107. We determined that the combination of historical and market-based implied volatility provides a more accurate reflection of our market conditions and is more representative of future stock price trends than employing solely historical volatility. For grants in fiscal year 2005, we calculated our volatility based solely on historical volatility in accordance with SFAS 123 for purposes of our pro forma information.
The expected dividend yield is calculated by taking the total expected annual dividend payout divided by the average stock price.
Stock-based compensation expense recognized in the consolidated statement of operations for fiscal years 2007 and 2006 reflects estimated forfeitures that are based on historical option forfeitures. In the pro forma information required under SFAS 123 for fiscal year 2005, we included forfeitures as they occurred.
Net cash proceeds from the exercise of stock options were approximately $863,000, $1,119,000, and $1,320,000, for fiscal years 2007, 2006, and 2005, respectively. The net cash proceeds associated with our ESPP were $3,531,000, $3,365,000, and $2,939,000 for fiscal years 2007, 2006, and 2005, respectively. The income tax benefit realized from stock option exercises during fiscal years 2007, 2006, and 2005 was approximately $68,000, $379,000, and $629,000, respectively. In accordance with SFAS 123R, we present excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.
The following table summarizes the option activity under all stock option plans.
|
Number of Shares |
Weighted Average Exercise Price |
Weighted Average Remaining Contractual Term |
Aggregate Intrinsic Value |
Outstanding at October 31, 2004 |
1,216,392 |
$14.37 |
|
|
Granted |
418,000 |
$25.02 |
|
|
Exercised |
(110,432) |
$11.95 |
|
|
Forfeitures or expirations |
(44,656) |
$22.47 |
|
|
Outstanding at October 31, 2005 |
1,479,304 |
$17.32 |
|
|
Granted |
217,000 |
$17.90 |
|
|
Exercised |
(108,375) |
$10.32 |
|
|
Forfeitures or expirations |
(40,150) |
$19.54 |
|
|
Outstanding at October 31, 2006 |
1,547,779 |
$17.83 |
|
|
Exercised |
(90,091) |
$9.58 |
|
|
Forfeitures or expirations |
(47,964) |
$18.65 |
|
|
Outstanding at October 31, 2007 |
1,409,724 |
$18.33 |
5.55 |
$2,487,038 |
|
|
|
|
|
Vested or expected to vest at October 31, 2007 |
1,381,159 |
$17.41 |
5.50 |
$2,486,878 |
|
|
|
|
|
Exercisable at October 31, 2007 |
959,758 |
$16.47 |
3.26 |
$2,474,165 |
The aggregate intrinsic value in the table above represents the total pre-tax value (that is, the difference between our closing stock price on the last trading day of fiscal year 2007 and the exercise price for those options in the money, multiplied by the number of shares) that would have been received by the option holders had all option holders exercised their options on October 31, 2007. This amount changes based on the fair market value of our stock. Total intrinsic value of options exercised was approximately $584,000, $971,000, and $1,701,000 for fiscal years 2007, 2006, and 2005, respectively.
As of October 31, 2007, approximately $3,729,000 of total unrecognized compensation costs related to unvested stock options is expected to be recognized over a weighted average period of 2.60 years.
The following table summarizes our restricted stock grant activity.
Nonvested Shares |
Shares |
Weighted Average Grant Date Fair Value Per Share |
Nonvested at October 31, 2005 |
0 |
|
Grants |
61,875 |
$19.58 |
Nonvested at October 31, 2006 |
61,875 |
$19.58 |
Grants |
118,813 |
$17.64 |
Vested |
(15,472) |
$19.58 |
Forfeitures |
(1,950) |
$18.06 |
Nonvested at October 31, 2007 |
163,266 |
$17.35 |
The total fair value of restricted stock grants vested in fiscal year 2007 is $303,000. Our unrecognized compensation cost related to nonvested (restricted) stock is approximately $2,197,000, and is expected to be recognized over a weighted average period of 2.99 years.
As of October 31, 2007, our unrecognized compensation cost related to the shares to be purchased under our ESPP was approximately $1,360,000, and was expected to be recognized over a weighted average period of 1.08 years. However, on the November 30, 2007 purchase date, our fair market value was lower than the December 1, 2006 offering date, and therefore, all participants were re-enrolled into a new six-month offering period, beginning December 1, 2007. Therefore, the unrecognized compensation cost at December 1, 2007, will be recognized over a six-month period ending on May 31, 2008, instead of the remaining twelve-months of the original offering period.
On November 30, 2006, the closing stock price on our ESPP purchase date was lower than the closing stock price on the participants’ enrollment dates; therefore, 411 participants were withdrawn from their current offering period and re-enrolled into a new twenty-four month offering period beginning on December 1, 2006. Consequently, approximately $758,000 of incremental compensation expense was added to our unrecognized compensation expense at December 1, 2006.
On May 31, 2006, the closing stock price on the ESPP purchase date was lower than the closing stock price on the participant’s enrollment dates; therefore, 429 participants were withdrawn from their current offering period, and re-enrolled into a new twenty-four-month offering period beginning on June 1, 2006. In accordance with SFAS 123R, this is considered a modification, and an incremental compensation cost of approximately $1,323,000 was added to our unrecognized compensation expense at June 1, 2006.
Recent Accounting Pronouncements
In June 2005, the FASB issued SFAS 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized through a cumulative effect adjustment within net income of the period of the change. SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effect or the cumulative effect of the change. We adopted SFAS 154 at the beginning of fiscal year 2007. The adoption of SFAS 154 did not have a material impact on our financial statements.
In May 2006, the FASB issued SFAS 155, Accounting for Certain Hybrid Instruments, which amends SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. We adopted SFAS 155 at the beginning of fiscal year 2007. The adoption of SFAS 155 did not have a material impact on our financial statements.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides guidance on the SEC’s views regarding quantifying the materiality of financial statement misstatements, including misstatements that were not material to prior years’ financial statements. We adopted SAB 108 at the beginning of fiscal year 2007. The adoption of SAB 108 did not have a material impact on our financial statements.
In June 2006, the FASB issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109 (FIN 48). The interpretation clarifies the accounting for uncertainty in income taxes. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken on a return. The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure, and transition. FIN 48 utilizes a two-step approach. The first step is to determine whether it is more likely than not that a tax position accounted for under SFAS 109 will be sustained upon examination, with the presumption that the position will be examined. The second step is to measure the amount of benefit to recognize in the financial statements. The provisions are effective for us for our fiscal year beginning November 1, 2007. Based on a preliminary evaluation of the impact of adopting FIN 48, we believe that it will not a have a material effect on our financial position or results of operations in 2008.
In September 2006, the FASB issued SFAS 157, Fair Value Measurement. SFAS 157 defines fair value, establishes a framework for measuring fair value, and enhances disclosures about fair value measurements. The statement will be effective for our fiscal year beginning November 1, 2008. We are evaluating the impact adopting SFAS 157 will have on our financial statements.
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. It also establishes presentation and disclosure requirements to facilitate comparisons between companies using different measurement attributes for similar types of assets and liabilities. The statement will be effective for our fiscal year beginning November 1, 2008. We are evaluating the impact adopting SFAS 159 will have on our financial statements.
In June 2007, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities (EITF 07-3). EITF 07-3 requires non-refundable advance payments for goods and services to be used in future research and development activities to be recorded as an asset, with the payments expensed when the research and development activities are performed. EITF 07-3 applies to new contractual arrangements entered into in fiscal years beginning after December 15, 2007. We currently record a prepaid asset for any non-refundable advance payments and recognize the expense when the activities are performed. We believe that adoption of EITF 07-3 will not have a material effect on our financial position, results of operations, or cash flows.
In December 2007, the FASB issued SFAS 141R, Business Combinations. SFAS 141R replaces SFAS 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. The statement will apply prospectively to business combinations occurring in our fiscal year beginning November 1, 2009. We are evaluating the impact adopting SFAS 141R will have on our financial statements.
Note 2: Customer Concentration
The following table identifies the source of our revenues for fiscal years 2007, 2006, and 2005 by customer type.
|
FY07 |
FY06 |
FY05 |
Intelligence agencies |
78% |
74% |
72% |
Military |
20% |
23% |
23% |
Foreign |
— |
1% |
2% |
Commercial |
2% |
2% |
3% |
|
100% |
100% |
100% |
Within the customer types, two intelligence agencies and one branch of the military represented a significant portion of revenues.
The table below identifies the revenue concentration (as a percentage of total revenues) from each significant customer.
|
FY07 |
FY06 |
FY05 |
First intelligence agency |
26% |
24% |
28% |
Second intelligence agency |
47% |
46% |
44% |
One branch of the military |
15% |
17% |
21% |
|
88% |
87% |
93% |
Revenues from the United States Government can also be categorized as direct purchases and subcontracts, where we are the supplier to another contractor. The following table distinguishes revenue (as a percentage of total revenues) between those two categories.
|
FY07 |
FY06 |
FY05 |
Direct purchases |
69% |
60% |
67% |
Subcontracts |
29% |
37% |
28% |
|
98% |
97% |
95% |
Note 3: Inventory and Precontract Costs
Inventories are stated at the lower of average cost or market and consisted of the following (in thousands).
|
2007 |
2006 |
Raw materials |
$904 |
$768 |
Work in process |
4,597 |
5,060 |
Finished goods |
443 |
250 |
|
$5,944 |
$6,078 |
Inventory activities during fiscal year 2007 included a write-down of approximately $415,000 and disposals of obsolete products of approximately $187,000. Fiscal year 2006 activity included disposals of approximately $237,000. The disposals included items in various stages of completion.
Precontract costs are classified on the balance sheets as other current assets for all periods presented. Precontract costs represent costs incurred in anticipation of specific expected future contract awards and costs incurred in connection with ongoing contracts for which contract modifications have not been defined or completed at the end of the reporting date. Precontract costs for the periods ending October 31, 2007, and October 31, 2006, were approximately $4,465,000 and $5,667,000, respectively. Approximately $5,502,000 of the October 31, 2006, balance was recognized as revenue during fiscal year 2007. At the end of fiscal year 2006, approximately $569,000 that was included in pre-contract costs was associated with an individual contract for which we had filed a formal claim against the U.S. Government. This was a formal request for reimbursement for work performed on this contract. During the second quarter of fiscal year 2007, the claim was rejected and we reduced pre-contract costs and operating income by $569,000. This claim was ultimately settled and we recovered approximately $404,000 during the fourth quarter of fiscal year 2007.
Note 4: Business Combination
In order to diversify into phenomenological sensor signal processing, AST acquired Dynamics Technology, Inc. (DTI) on July 1, 2005. DTI was a privately held California corporation headquartered in Torrance, California with offices in Anaheim, California and Arlington, Virginia. DTI provided advanced sensor and signal processing products for advanced space-based, airborne, terrestrial, and undersea sensor technologies. The combined company provides signal processing products and services in support of intelligence, surveillance, and reconnaissance for global security.The purchase price of the acquisition was approximately $30.1 million in cash, plus an estimated $1.3 million in transaction costs. AST did not assume any options of DTI. Approximately ten percent (10%) of the merger consideration that would otherwise be distributed to the holders of DTI’s securities at the closing of the acquisition were deposited into an escrow account for twelve (12) months following the closing for the purpose of providing a fund against which AST may assert claims for damages, if any, based on breaches of the representations and warranties made by DTI in the agreement. However, no such claims were made and the funds in the escrow account were released in full in July 2006. The acquisition was accounted for under the purchase method of accounting and, accordingly, the results of operations of the acquisition are included in the accompanying statement of operations since the acquisition date. AST has funded the purchase price from its current investments and from a $10-million term loan from Wells Fargo Bank.The aggregate purchase price for the acquisition was preliminarily allocated to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The fair values assigned to the intangible assets acquired are based on estimates, assumptions, and other information compiled by management, including independent valuations that utilize established valuation techniques. The amounts allocated to customer relationships and existing technology were determined based on discounted cash flows. Goodwill represents the excess of purchase consideration over the fair value of the assets, including identifiable intangible assets, net of the fair value of liabilities assumed. Intangible assets related to the acquisition, excluding goodwill, are amortized to expense on a straight-line basis over their estimated useful lives ranging from 1 to 18 years.Our deferred net tax assets increased in connection with the purchase of DTI. See “Note 8: Income Taxes” for further details.
The aggregate preliminary purchase price for the acquisition consists of the following (in thousands).
Cash |
$30,074 |
Transaction costs |
1,339 |
Total purchase price |
$31,413 |
We allocated the aggregate preliminary purchase price for the acquisition to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values as follows (in thousands).
Current assets |
$6,058 |
Property and equipment |
715 |
Non-current assets |
5,646 |
Current liabilities |
(327) |
Non-current liabilities |
(2,913) |
Net tangible assets assumed |
9,179 |
Amortizable intangible assets |
2,270 |
Goodwill |
19,964 |
Total purchase price |
$31,413 |
During fiscal year 2006, we increased the portion of the purchase price allocated to goodwill by approximately $179,000, primarily due to a change in the estimate of deferred tax assets related to DTI’s net operating loss. As of October 31, 2006, the purchase price allocation was final.
Note 5: Goodwill and Intangible Assets
Goodwill
Under SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is not subject to amortization. Rather, we evaluate goodwill for impairment at least annually or more frequently if events and changes in circumstances suggest that the carrying amount may not be recoverable. No impairment was recognized in fiscal year 2007.
Intangible Assets
The tables below present information on our identifiable intangible assets that are subject to amortization (in thousands).
|
Useful Life |
Gross Carrying Amount |
Accumulated Amortization |
Net Carrying Amount |
Customer relationships |
3 years |
$1,720 |
$(1,338) |
$382 |
Existing technology |
5 years |
340 |
(158) |
182 |
Patent |
18 years |
60 |
(8) |
52 |
Total |
|
$2,120 |
$(1,504) |
$616 |
|
Useful Life |
Gross Carrying Amount |
Accumulated Amortization |
Net Carrying Amount |
Customer relationships |
3 years |
$1,720 |
$(765) |
$955 |
Existing technology |
5 years |
340 |
(91) |
249 |
Non-compete agreements |
1 year |
60 |
(60) |
0 |
Patent |
18 years |
60 |
(4) |
56 |
Trade name |
1 year |
90 |
(90) |
0 |
Total |
|
$2,270 |
$(1,010) |
$1,260 |
All of our acquired identifiable intangible assets are subject to amortization and have approximate original estimated useful lives as noted in the table above. Amortization expense associated with our intangible assets was approximately $644,000, $745,000, and $265,000, during fiscal years 2007, 2006, and 2005, respectively.
As of October 31, 2007, the estimated future amortization expense for acquired identifiable intangible assets is as follows (in thousands).
Fiscal Years |
|
2008 |
454 |
2009 |
71 |
2010 |
49 |
2011–2023 |
42 |
Total |
$616 |
Note 6: Borrowing Arrangements
Revolving Line of Credit
At October 31, 2007, we had a revolving line of credit (the Line of Credit) under which Wells Fargo will advance funds to us from time to time up to and including March 1, 2008, not to exceed at any time the maximum principal amount of $3 million.
At October 31, 2007, we had two standby letters of credit under the Line of Credit, totaling approximately $1,370,000. One letter of credit, related to our Sunnyvale, California, facilities lease, had a committed balance of approximately $1,220,000 at October 31, 2007, and October 31, 2006. The second letter of credit was a requirement of our workers compensation insurance, and had a committed balance of approximately $150,000 at October 31, 2007, and October 31, 2006. We do not pay interest on the amounts associated with the standby letters of credit.
As a result of the committed but unused funds associated with the two letters of credit, the total amount under the Line of Credit available for borrowing was approximately $1,630,000. No fees or interest were associated with this unused portion. Borrowings under the Line of Credit bear interest at Wells Fargo’s reference rate (7.5% at October 31, 2007) and interest on those borrowings are payable monthly. No fees were associated with the unused portion of the committed amount. As security for its indebtedness under the Line of Credit, we have granted to Wells Fargo a security interest in our cash and marketable securities maintained with an affiliate of Wells Fargo.
Term Loan and Interest Rate Swap
Effective July 1, 2005, and in connection with the acquisition of DTI, we entered into a term loan with Wells Fargo in the principal amount of $10 million, plus interest, the proceeds of which were used for acquisition financing (the Term Loan).
The Term Loan bears interest at a rate per annum equal to 1.750% above the London Inter-Bank Offered Rate (LIBOR) (5.12% at October 31, 2007). The Term Loan is for a seven-year term ending on July 1, 2012. Payment terms of the loan agreement include monthly payments of principal and interest.
As security for our indebtedness under the Term Loan, we have granted to Wells Fargo a security interest in our accounts receivable, general intangibles, inventory, and equipment.
We are required to maintain certain financial covenants setting forth minimum ratios for quick ratio and fixed charge coverage and maximum ratios for total liabilities to tangible net worth. As of October 31, 2007, we were in compliance with these covenants.
The following table sets forth our scheduled debt maturities under the Term Loan (in thousands).
Year |
Debt Maturities |
2008 |
1,429 |
2009 |
1,429 |
2010 |
1,429 |
Thereafter |
2,499 |
Total |
$6,786 |
We are exposed to market risk from changes in interest rates on the Term Loan, and manage this exposure through the use of derivatives. A derivative contract references an underlying variable, such as an interest rate index, a foreign currency exchange rate, or a commodity value. The payment, or settlement, obligation arising from a derivative is calculated by applying the terms of the contract to changes in the value of the reference variable during a calculation period. Derivatives may trade on exchanges, such as most common stock options, or may be private (over the counter) arrangements between two parties.
We entered into an over the counter interest rate swap contract with Wells Fargo designed to operate as a cash flow hedge for the Term Loan. The use of an interest rate swap in this situation locks the variable interest expense associated with the debt and results in a fixed interest expense that is typically immune from subsequent market rate fluctuations. Since there is a high correlation between the hedged instrument (the swap) and the underlying interest variable, gains and losses on the interest exposure are usually eliminated by offsetting changes in the swap, making it a highly effective instrument in hedging variability.
At October 31, 2007, we had one interest rate swap agreement outstanding with Wells Fargo designated as a cash flow hedge under FASB Statement 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133) related to our Term Loan. No losses on the agreement due to counterparty credit issues are anticipated. Under this swap, we pay an interest rate of 4.33% over the seven-year term of the loan and receive an average floating rate of LIBOR on the notional amount of the loan. Thus, we exchanged a variable rate obligation for a fixed interest obligation, resulting in an effective interest rate of 6.08%. The effective portion of the cash flow hedge is reported as other comprehensive income and reclassified into earnings in the same period during which the hedged transaction affects earnings. At October 31, 2007, the effective portion of the hedge was a deferred gain of approximately $16,000, net of taxes. Over the next twelve months, we expect to reclassify approximately $8,000 of the gain to interest expense as principle on the Term Loan is repaid and the related swap-instrument notional amount is reduced.
The ineffective portion of the gain or loss, if there is one, would impact earnings when it occurs. There is no ineffective portion of the outstanding swap as of October 31, 2007.
We assess effectiveness of the hedge instrument regularly. The ineffective portion of the gain or loss, if there were any, would impact earnings as it occurs. There was no ineffective portion of the outstanding swap as of October 31, 2007.
Note 7: Commitments
The following table sets forth our contractual obligations, excluding interest payments on our debt, as of October 31, 2007 (in thousands).
Fiscal Year |
Total |
Less than |
1 –3 |
3 –5 |
More than |
Operating lease obligations |
$44,324 |
$7,517 |
$14,998 |
$11,732 |
$10,077 |
Loan obligations – principal |
6,786 |
1,429 |
2,858 |
2,499 |
— |
Purchase obligations |
4,159 |
4,159 |
— |
— |
— |
Total |
$55,269 |
$13,105 |
$17,856 |
$14,231 |
$10,077 |
Our operating lease obligations consist of non-cancelable lease agreements for our facilities, which expire at various dates between fiscal years 2008 and 2016. Certain leases contain escalation clauses and requirements for the payment of property taxes, insurance, and maintenance expenses. During the first quarter of fiscal year 2007, we entered into a new operating lease agreement with a total lease obligation of approximately $8,104,000 for our new facility in Torrance, California. In addition, we amended our operating lease agreements for our facilities in Anaheim, California, and Salt Lake City, Utah during the second and third quarter, respectively. These amendments increased our total lease obligation by approximately $93,000 and $71,000, respectively. Rent expense under operating leases was approximately $7,208,000, $6,252,000, and $4,987,000 in fiscal years 2007, 2006, and 2005, respectively.
Note 8: Income Taxes
The provision for income taxes for the years ended October 31, 2007, 2006, and 2005 consists of the following (in thousands).
|
2007 |
2006 |
2005 |
Federal |
|
|
|
Current |
$4,589 |
$3,617 |
$5,712 |
Deferred |
(374) |
272 |
(717) |
|
4,215 |
3,889 |
4,995 |
State |
|
|
|
Current |
994 |
930 |
824 |
Deferred |
(34) |
41 |
416 |
|
960 |
971 |
1,240 |
Total |
$5,175 |
$4,860 |
$6,235 |
The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes as follows (in thousands).
|
2007 |
2006 |
2005 |
Computed expected tax provision |
$4,196 |
$3,215 |
$5,418 |
State income tax, net of federal benefit |
626 |
481 |
764 |
Stock-based compensation |
778 |
920 |
— |
Meals and entertainment |
213 |
218 |
118 |
Tax liability adjustment |
— |
369 |
— |
Tax-exempt interest |
(463) |
(184) |
(21) |
Other items |
(175) |
(159) |
(44) |
Total |
$5,175 |
$4,860 |
$6,235 |
Effective tax rate |
43.17% |
52.90% |
40.28% |
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities are as follows (in thousands).
|
2007 |
2006 |
Deferred tax assets: |
|
|
Accrued expenses and reserves |
$3,012 |
$2,638 |
Net operating loss carryforward |
2,314 |
3,616 |
Stock-based compensation |
1,603 |
956 |
Depreciation and amortization |
1,352 |
931 |
Other items |
339 |
416 |
Total deferred tax assets |
8,620 |
8,557 |
Deferred tax liabilities: |
|
|
Accrued expenses and reserves |
(704) |
(855) |
DTI – Intangibles |
(248) |
(441) |
Other items |
— |
— |
Total deferred tax liabilities |
(952) |
(1,296) |
Total deferred tax assets/(liabilities) |
$7,668 |
$7,261 |
Current deferred tax asset balances at October 31, 2007, and 2006 were approximately $2,647,000 and $1,806,000, respectively, and included in prepaids and other current assets in the accompanying balance sheets. Long-term deferred tax assets balances at October 31, 2007, and 2006 were approximately $5,021,000 and $5,455,000, respectively, and are included in long-term deferred tax assets in the accompanying balance sheets.
Deferred tax assets includes a net operating loss (NOL) carryforward incorporated as a result of the DTI acquisition in fiscal year 2005 and accounted for in the purchase of DTI. The utilization of the NOL carryforward against our taxable income is limited each year and may be carried forward up to fiscal year 2025. The DTI NOL available as of October 31, 2007, is approximately $6.1 million, $2.8 million, and $6.1 million for federal, California, and Virginia state purposes, respectively.
As of October 31, 2007, management has determined that our deferred tax assets are “more likely than not” to be realized in future periods and, therefore, we have not provided a valuation allowance on the deferred tax asset.
Our income tax receivables balance was acquired from DTI. At October 31, 2007, this balance was approximately $647,000.
Note 9: Retirement Plan
All employees who perform at least 1,000 hours of service per year are covered under our retirement plan (the Retirement Plan). Company contributions to the Retirement Plan, maintained by an outside administrator, are discretionary and currently are at the rate of 4% of qualified compensation up to a maximum of $225,000 per employee per annum. We accrue the accumulated contributions, which are payable biweekly to the Retirement Plan’s administrator. We have incurred approximately $2,925,000, $2,916,000, and $2,473,000 in expense under the Retirement Plan for fiscal years 2007, 2006, and 2005, respectively.
Note 10: Segment Reporting
We have reviewed our business operations and determined that we operate in a single homogeneous business segment. We sell similar products and services with similar economic characteristics to similar classes of customers, primarily to the United States Government, its agencies, or prime contractors for the United States Government. The technologies and the operations of our divisions are highly integrated. Revenues and costs are reviewed monthly by management on an individual contract basis as a single business segment.
Note 11: Contingencies
Product warranties. Our products are warranted against defective workmanship and materials for a period of one year from the date of acceptance by the original purchaser. Warranty costs were approximately $306,000, $279,000, and $263,000 for fiscal years 2007, 2006, and 2005, respectively.
Guarantees. From time to time, we enter into certain types of contracts that contingently require us to indemnify parties against third-party claims. These contracts primarily relate to 1) certain real estate leases under which we may be required to indemnify property owners for environmental and other liabilities, and other claims arising from our use of the applicable premises and 2) certain agreements with our officers, directors, and employees under which we may be required to indemnify such persons for liabilities arising out of their employment relationship. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for these obligations, and no liabilities have been recorded for these obligations on the balance sheet as of October 31, 2007, or 2006.
Legal proceedings. We are subject to litigation, from time to time, in the ordinary course of business including, but not limited to, allegations of wrongful termination or discrimination, or governmental agency investigations. As a government contractor, we may also be subject to investigations by the United States Government for alleged violations of procurement or other federal laws. Under present government procurement regulations, if judged in violation of procurement or other federal civil laws, we could be suspended or barred from eligibility for awards of new government contracts.
On March 11 and July 19, 2005, purported securities class action complaints were filed in the United States District Court, Northern District of California. The cases were considered as In re Applied Signal Technology Inc. Securities Litigation, Master File No. 4:05-cv-1027 (SBA). The amended consolidated complaint is brought on behalf of a putative class of persons who purchased our Company’s securities during a class period of August 24, 2004, through February 22, 2005. The complaints name us, our Chief Executive Officer, and our Chief Financial Officer as defendants, and allege that false and misleading statements regarding us were issued during the class period. On February 8, 2006, the Court dismissed the case with prejudice and entered judgment in defendants’ favor. Plaintiffs appealed the judgment of dismissal on March 23, 2006, and the appeal was heard on December 6, 2007; any future unfavorable outcome of the litigation could have an adverse impact on our business, financial condition, and results of operation. At this time, we cannot estimate the amount of possible loss or range of loss that might be incurred as a result of this proceeding.
Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A: Controls and Procedures
Conclusions regarding disclosure controls and procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
Management’s report on internal control over financial reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting by using the criteria established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on our evaluation under the framework in Internal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of October 31, 2007.
The effectiveness of our internal control over financial reporting as of October 31, 2007, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is included in “Part II, Item 8: Consolidated Financial Statements and Supplementary Data” of this annual report on Form 10-K.
Changes in internal control over financial reporting. There was no change in our internal control over financial reporting during the fourth quarter of fiscal year 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Limitations of the effectiveness of internal control. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the internal control system are met. Because of the inherent limitations of any internal control system, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Notwithstanding these limitations, our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. Our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are, in fact, effective at the “reasonable assurance” level.
None.
The information required by Part III is incorporated by reference from the information identified below contained in the Applied Signal Technology, Inc. Proxy Statement for the Annual Meeting of Shareholders to be held on March 18, 2008 (the Proxy Statement). The Proxy Statement is to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Exchange Act, no later than 120 days after the end of the fiscal year covered by this annual report.
Item 10: Directors, Executive Officers, and Corporate Governance
The information required by this item concerning our Board of Directors, our audit committee and audit committee financial expert is incorporated by reference to the information in the section entitled “Information About our Directors” and “Corporate Governance” in the Proxy Statement. Information concerning our executive officers is incorporated by reference to the information in the section of our Proxy Statement entitled “Executive Compensation and Other Information—Information About the Executive Officers.”
The information required by this item concerning executive officers is incorporated by reference to the section entitled “Executive Officers of the Registrant” in the Proxy Statement.
The information required by this item concerning compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is incorporated by reference to information in the section entitled “Security Ownership of Certain Holders – Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.
The Board of Directors of Applied Signal Technology, Inc. has adopted a code of ethics that applies to our principal executive officers, principal financial officer, and controller, as well as all other employees. A copy of this code of ethics has been posted on our Internet website at www.appsig.com. In addition, hard copies can be obtained free of charge through our investor relations department. Any amendments to, or waivers from, a provision of our code of ethics that applies to our principal executive officer, principal financial officer, controller, or persons performing similar functions and that relate to any element of the code of ethics enumerated in paragraph (b) of Item 406 of Regulation S-K shall be disclosed by posting such information on our website.
Item 11: Executive Compensation
The information required by this item is incorporated by reference to the sections in the Proxy Statement entitled “Director Compensation,” “Executive Compensation and Other Matters” and “Corporate Governance—Compensation Committee Interlocks and Insider Participation.
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 403 of Regulation S-K is incorporated by reference to the section entitled “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement.
The information required by Item 201(d) of Regulation S-K is incorporated by reference to the section entitled “Equity Compensation Plan Information” in the Proxy Statement.
Item 13: Certain Relationships and Related Transactions, and Director Independence
Not applicable.
Item 14: Principal Accountant Fees and Services
The information required by this item is herein incorporated by reference to the section entitled “Proposal No. 3, Ratification of Selection of Independent Auditors” in the Proxy Statement.
Item 15: Exhibits and Consolidated Financial Statement Schedules
(a) (1) and (2) The following consolidated financial statements of Applied Signal Technology, Inc. are filed as part of this report under Item 8:
- Balance Sheets – October 31, 2007, and 2006
- Statements of Operations – Years ended October 31, 2007, 2006, and 2005
- Statement of Shareholders’ Equity – Years ended October 31, 2007, 2006, and 2005
- Statements of Cash Flows – Years ended October 31, 2007, 2006, and 2005
- Notes to Consolidated Financial Statements – October 31, 2007
All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
(b) Listing of Exhibits – See Exhibit Index on page 68 of this report on Form 10-K.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, therewith duly authorized.
| Applied
Signal Technology Inc. (Registrant) |
|
| Dated January 11, 2008 | /s/ Gary L. Yancey Gary L. Yancey, President, Chief Executive Officer, and Chairman of the Board |
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Gary L. Yancey and James E. Doyle, and each of them, his or her true and lawful attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign any amendments to this report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or their substitute or substitutes may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature |
Date |
Title |
/s/ Gary L. Yancey |
January 11, 2008 |
President, Chief Executive Officer, and Chairman of the Board (Principal Executive Officer) |
/s/ James E. Doyle |
January 11, 2008 |
Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting Officer) |
/s/ Milton E. Cooper |
January 11, 2008 |
Director |
/s/ John P. Devine |
January 11, 2008 |
Director |
/s/ David D. Elliman |
January 11, 2008 |
Director |
/s/ Marie S. Minton |
January 11, 2008 |
Director |
/s/ Robert Richardson |
January 11, 2008 |
Director |
/s/ John R. Treichler |
January 11, 2008 |
Director |
Annual Report on Form 10-K
Item 15(b)
Exhibits
Year Ended October 31, 2007
Applied Signal Technology Inc.
400 West California Avenue
Sunnyvale, CA 94086
Exhibit Number |
Description of Document |
2.1(19) |
Agreement of Merger of Mercury Acquisition Corporation, a California Corporation, and Dynamics Technology, Inc., a California Corporation, dated July 1, 2005 |
3.1(1) |
Second Amended and Restated Articles of Incorporation |
3.2(1) |
Amended and Restated Bylaws |
4.1(1) |
Specimen Common Stock Certificate |
10.1(1) |
Form of Indemnification Agreement for directors and officers* |
10.3(6) |
1991 Stock Option Plan and forms of agreements thereunder* |
10.4(1) |
1993 Employee Stock Purchase Plan |
10.6(1) |
Summary Plan Description of 401(k) Retirement Plan* |
10.7(2) |
Lease Agreement, dated August 21, 1985, with Lincoln Mathilda Associates, Ltd. and Patrician Associates, Inc., and amendments thereto |
10.8(3) |
Lease Agreements, dated November 23, 1994, with Lincoln Property Company Management Services, Inc. for Buildings H and I |
10.9(4) |
Lease Agreement, dated May 31, 1996, with Constellation Real Estate, Inc., for 135 National Business Parkway |
10.10(5) |
Amendments to Lease Agreements, dated November 23, 1994, with Lincoln Property Company Management Services, Inc. |
10.11(9) |
2000 Stock Option Plan and forms and agreements thereunder |
10.16(8) |
Amendments to Lease Agreements, dated July 30, 2001, with Sunnyvale Business Park |
10.17(7) |
2001 Stock Option Plan and forms of agreements thereunder* |
10.18(8) |
Amendments to Lease Agreements, dated September 20, 2000, with Eden Roc Partnership |
10.19(8) |
Amendments to Lease Agreements, dated April 19, 2001, with Sunnyvale Business Park |
10.20(10) |
2001 Stock Option Plan (as amended through January 20, 2003)* |
10.21(10) |
Line of Credit Agreement, dated January 27, 2003, with Wells Fargo Bank, National Association |
10.22(10) |
Security Agreement, dated January 27, 2003, with Wells Fargo Bank |
10.23(12) |
Second Amendment to Lease Agreement, dated December 31, 2003, with Constellation Real Estate, Inc. |
10.24(12) |
Third Amendment to Lease Agreement, dated January 20, 2004, with Carr America Realty Corp. |
10.25(12) |
Annual Incentive Plan* |
10.26(13) |
Amendment to the Line of Credit Agreement, dated February 12, 2004, with Wells Fargo Bank, National Association |
10.27(13) |
Security Agreement, dated February 12, 2004, with Wells Fargo Bank, National Association |
10.28(13) |
Stock Incentive Plan* |
10.29(14) |
Second Amendment to Lease Agreement, dated May 18, 2004, with Eden Roc Partnership |
10.30(14) |
Executive Retention and Severance Plan* |
10.31(15) |
Revised Notice of Option Grant Form for the 2000 Stock Option Plan* |
10.32(15) |
Revised Notice of Option Grant Form for the 2001 Stock Option Plan* |
10.33(15) |
Revised Notice of Grant Form for the 2004 Stock Incentive Plan* |
10.34(20) |
Executed Interest Rate Master Agreement, dated June 2, 2005 |
10.36(20) |
Lease Agreement Between the Platt Corporation and Dynamics Technology, Inc. Dated April 4, 1984 |
10.37(20) |
First Amendment to Lease Agreement Between the Platt Corporation and Dynamics Technology, Inc., dated June 30, 1985 |
10.38(20) |
Second Amendment to Lease Agreement Between the Platt Corporation and Dynamics Technology, Inc., dated July 14, 1989 |
10.39(20) |
Third Amendment to Lease Agreement Between the DABP Associated and Dynamics Technology, Inc., dated October 29, 1990 |
10.40(20) |
Fourth Amendment to Lease Agreement Between the Del Amo Business Plaza and Dynamics Technology, Inc., dated September 2, 1992 |
10.41(20) |
Fifth Amendment to Lease Agreement Between the Del Amo Business Plaza Partners, L.P. and Dynamics Technology, Inc., dated September 15, 1997 |
10.42(20) |
Sixth Amendment to Lease Agreement Between the Realty Associates Fund V, L.P. and Dynamics Technology, Inc., dated May 30, 2002 |
10.43(20) |
Seventh Amendment to Lease Agreement Between the Realty Associates Fund V, L.P. and Dynamics Technology, Inc., dated August 29, 2003 |
10.44(20) |
Eighth Amendment to Lease Agreement Between the Realty Associates Fund V, L.P. and Dynamics Technology, Inc., dated October 29, 2004 |
10.45(20) |
Ninth Amendment to Lease Agreement Between the Realty Associates Fund V, L.P. and Dynamics Technology, Inc., dated April 27, 2005 |
10.46(20) |
Lease Agreement Between 1555 Wilson Boulevard Limited Partnership and Dynamics Technology, Inc., dated May 16, 2003 |
10.47(20) |
First Amendment to Lease Agreement Between 1555 Wilson Boulevard Limited Partnership and Dynamics Technology, Inc., dated June 4, 2004 |
10.48(20) |
Amendment to Executed Loan Agreement, dated June 8, 2005 |
10.49(20) |
Fourth Amendment to Lease Between Eden Roc Partnership and Applied Signal Technology, Inc., dated May 3, 2005 |
10.50(16) |
Second Amendment to Line of Credit Agreement, dated February 25, 2005, with Wells Fargo Bank, National Association |
10.51(17) |
Lease Agreement, dated January 31, 2003, with Tom M. Lacey Family Limited Partnership. |
10.52(18) |
Executed Loan Agreement, dated June 8, 2005 |
10.53(21) |
Second Amendment to Deed of Lease, dated August 31, 2005, with RREEF America Reit II Corp |
10.54(22) |
Second Amendment to Line of Credit Agreement, dated March 1, 2006, with Wells Fargo Bank, National Association |
10.55(23) |
First Amendment to Lease Termination and Mutual Release Agreement with NBP, 131-133-141, LLC |
10.56(23) |
Second Amendment to Agreement of Lease with NBP306, LLC |
10.57(25) |
Lease agreement with Hamilton Associates, LLC, dated December 15, 2006 |
10.58(26) |
Amendment to Line of Credit Agreement, dated March 1, 2007, with Wells Fargo Bank, National Association |
10.59(26) |
Amendment to 1993 Employee Stock Purchase Plan, dated May 31, 2007 |
14.1(11) |
Code of Business Conduct and Ethics |
21.1(24) |
Subsidiaries of the Registrant |
23.1 |
Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm |
24. |
Power of Attorney (included on signature page) |
31.1 |
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
31.2 |
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
32.1 |
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
32.2 |
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
* Management contract or compensatory plan, contract, or arrangement
(1) Incorporated by reference to corresponding Exhibit filed as an Exhibit to Registrant’s Registration Statement on Form S-1 filed January 28, 1993 (File No. 33-58168).
(2) Incorporated by reference to Exhibit 10.10 filed with the Registrant’s Registration Statement on Form S-1 filed January 28, 1993 (File No. 33-58168).
(3) Incorporated by reference to Exhibit 10.11 filed with the Registrant’s Form 10-K for fiscal year 1994 dated January 27, 1995.
(4) Incorporated by reference to Exhibit 10.15 filed with the Registrant’s Form 10-K for fiscal year 1996 dated January 29, 1997.
(5) Incorporated by reference to Exhibit 10.16 filed with the Registrant’s Form 10-K for fiscal year 1996 dated January 29, 1997.
(6) Incorporated by reference to Exhibit 10.17 filed with the Registrant’s Form 10-Q filed on June 16, 1997, for the quarter ended May 2, 1997.
(7) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Definitive Proxy Statement for the 2001 Annual Meeting of Shareholders held on March 15, 2001, filed on February 5, 2001.
(8) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-K/A No. 1 for fiscal year 2001 dated January 29, 2002.
(9) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-K for fiscal year 2002 dated January 28, 2003.
(10) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the first quarter of fiscal year 2003 dated January 31, 2003.
(11) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-K for fiscal year 2003 dated January 27, 2004.
(12) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the first quarter of fiscal year 2004 dated March 9, 2004.
(13) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the second quarter of fiscal year 2004 dated June 9, 2004.
(14) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the third quarter of fiscal year 2004 dated September 9, 2004.
(15) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-K for fiscal year 2004 dated January 14, 2005.
(16) Incorporated by reference to Exhibit 10.31 filed with the Registrant’s Form 10-Q for the first quarter of fiscal year 2005 dated March 8, 2005.
(17) Incorporated by reference to Exhibit 10.32 filed with the Registrant’s Form 10-Q for the first quarter of fiscal year 2005 dated March 8, 2005.
(18) Incorporated by reference to Exhibit 10.33 filed with the Registrant’s Form 10-Q for the third quarter of fiscal year 2005 dated September 7, 2005.
(19) Incorporated by reference to Exhibit 10.35 filed with the Registrant’s Form 10-Q for the third quarter of fiscal year 2005 dated September 7, 2005.
(20) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the third quarter of fiscal year 2005 dated September 7, 2005.
(21) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-K for fiscal year 2005 dated January 17, 2006.
(22) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the first quarter of fiscal year 2006 dated March 7, 2006.
(23) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the second quarter of fiscal year 2006 dated June 1, 2006.
(24) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-K for fiscal year 2006 dated January 29, 2007
(25) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the first quarter of fiscal year 2007 dated March 9, 2007.
(26) Incorporated by reference to corresponding Exhibit filed with the Registrant’s Form 10-Q for the second quarter of fiscal year 2007 dated June 11, 2007.