FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended August 31, 2005. 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: 000-22893. AEHR TEST SYSTEMS (Exact name of registrant as specified in its charter) CALIFORNIA 94-2424084 - -------------------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 400 KATO TERRACE FREMONT, CA 94539 - -------------------------------------- ------------------------------------ (Address of principal (Zip Code) executive offices) (510) 623-9400 - ------------------------------------------------------------------------------ (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT. N/A Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period as the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. (Item 1) YES X NO --- --- (Item 2) YES X NO --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES NO X --- --- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES NO X --- --- 1
Number of shares of Common Stock, $0.01 par value, outstanding at September 30, 2005 was 7,481,829. 2
FORM 10-Q FOR THE QUARTER ENDED AUGUST 31, 2005 INDEX PART I. FINANCIAL INFORMATION ITEM 1. Condensed Consolidated Financial Statements (Unaudited) Condensed Consolidated Balance Sheets as of August 31, 2005 and May 31, 2005 . . . . . . . . . . . . 4 Condensed Consolidated Statements of Operations for the three months ended August 31, 2005 and 2004. . . . . . . 5 Condensed Consolidated Statements of Cash Flows for the three months ended August 31, 2005 and 2004. . . . . . . 6 Notes to Condensed Consolidated Financial Statements. . . . . 7 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. . . . . . . . . . . . . . . . 12 ITEM 3. Quantitative and Qualitative Disclosures about Market Risks. . 27 ITEM 4. Controls and Procedures. . . . . . . . . . . . . . . . . . . . 28 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . 28 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds . 28 ITEM 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . . 28 ITEM 4. Submission of Matters to a Vote of Security Holders . . . . . 28 ITEM 5. Other Information . . . . . . . . . . . . . . . . . . . . . . 28 ITEM 6. Exhibits . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 SIGNATURE PAGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Index to Exhibits . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 3
PART I. FINANCIAL STATEMENTS Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AEHR TEST SYSTEMS CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except per share data) <TABLE> <CAPTION> August 31, May 31, 2005 2005 (Unaudited) ----------- ----------- <S> <C> <C> ASSETS Current assets: Cash and cash equivalents . . . . . . . . . . . $ 3,983 $ 4,952 Short-term investments. . . . . . . . . . . . . 2,341 3,813 Accounts receivable, net of allowances for doubtful accounts of $105 and $80 at August 31, 2005 and May 31, 2005, respectively. . . . . . . . . . . . . . . . . 4,628 2,537 Inventories . . . . . . . . . . . . . . . . . . 7,815 7,140 Prepaid expenses and other. . . . . . . . . . . 433 585 ----------- ----------- Total current assets . . . . . . . . . . . . 19,200 19,027 Property and equipment, net . . . . . . . . . . . 1,381 1,232 Long-term investments . . . . . . . . . . . . . . -- 409 Goodwill. . . . . . . . . . . . . . . . . . . . . 274 274 Other assets, net . . . . . . . . . . . . . . . . 526 527 ----------- ----------- Total assets . . . . . . . . . . . . . . . . $21,381 $21,469 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable. . . . . . . . . . . . . . . . $ 1,222 $ 1,050 Accrued expenses. . . . . . . . . . . . . . . . 1,782 1,943 Deferred revenue. . . . . . . . . . . . . . . . 835 692 ----------- ----------- Total current liabilities . . . . . . . . . . 3,839 3,685 Deferred revenue. . . . . . . . . . . . . . . . . 20 21 Accrued lease commitment. . . . . . . . . . . . . 309 311 ----------- ----------- Total liabilities . . . . . . . . . . . . . . 4,168 4,017 ----------- ----------- Shareholders' equity: Common stock, $0.01 par value: Issued and outstanding: 7,482 shares at August 31, 2005 and May 31, 2005, respectively. . . . . . . . . . 75 75 Additional paid-in capital. . . . . . . . . . . 37,568 37,568 Accumulated other comprehensive income. . . . . 1,255 1,250 Accumulated deficit . . . . . . . . . . . . . . (21,685) (21,441) ----------- ----------- Total shareholders' equity . . . . . . . . . 17,213 17,452 ----------- ----------- Total liabilities and shareholders' equity. . $21,381 $21,469 =========== =========== </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 4
AEHR TEST SYSTEMS CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (Unaudited) <TABLE> <CAPTION> Three Months Ended August 31, ---------------------- 2005 2004 ---------- ---------- <S> <C> <C> Net sales. . . . . . . . . . . . . . . . . . . $4,646 $ 5,936 Cost of sales. . . . . . . . . . . . . . . . . 2,458 4,869 ---------- ---------- Gross profit . . . . . . . . . . . . . . . . . 2,188 1,067 ---------- ---------- Operating expenses: Selling, general and administrative. . . . . 1,452 1,432 Research and development . . . . . . . . . . 1,034 1,025 ---------- ---------- Total operating expenses . . . . . . . . 2,486 2,457 ---------- ---------- Loss from operations . . . . . . . . . . . . . (298) (1,390) Interest income. . . . . . . . . . . . . . . . 46 24 Other income, net . . . . . . . . . . . . . . -- 24 ---------- ---------- Loss before income taxes . . . . . . . . . . . (252) (1,342) Income tax benefit . . . . . . . . . . . . . . (8) (18) ---------- ---------- Net loss . . . . . . . . . . . . . . . . . . . $ (244) $(1,324) ========== ========== Net loss per share (basic and diluted) . . . . $(0.03) $ (0.18) Shares used in per share calculation: Basic and diluted. . . . . . . . . . . . . . 7,482 7,393 </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 5
AEHR TEST SYSTEMS CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited) <TABLE> <CAPTION> Three Months Ended August 31, ---------------------- 2005 2004 ---------- ---------- <S> <C> <C> Cash flows from operating activities: Net loss...................................... $ (244) $(1,324) Adjustments to reconcile net loss to net cash used in operating activities: Provision for doubtful accounts............. 25 24 Depreciation and amortization............... 85 37 Loss on disposal of property and equipment.. 25 -- Changes in operating assets and liabilities: Accounts receivable....................... (2,130) (1,071) Inventories............................... (915) 366 Accounts payable.......................... 266 769 Accrued expenses and deferred revenue..... 20 231 Accrued lease commitment.................. (2) 4 Other current assets...................... 151 42 ---------- ---------- Net cash used in operating activities.................. (2,719) (922) ---------- ---------- Cash flows from investing activities: Purchase of investments..................... (4,590) (4,847) Proceeds from sales and maturity of investments................... 6,475 5,740 Purchase of property and equipment.......... ( 32) (52) (Increase) decrease in other assets......... (1) 1 ---------- ---------- Net cash provided by investing activities.................. 1,852 842 ---------- ---------- Cash flows from financing activities: Proceeds from issuance of common stock and exercise of stock options............. -- 19 ---------- ---------- Net cash provided by financing activities.................. -- 19 ---------- ---------- Effect of exchange rates on cash................ (102) (8) ---------- ---------- Net decrease in cash and cash equivalents...................... (969) (69) Cash and cash equivalents, beginning of period.. 4,952 4,041 ---------- ---------- Cash and cash equivalents, end of period........ $3,983 $ 3,972 ========== ========== Supplementary disclosure of non-cash item: Transfer of inventory to rental equipment....... $ 231 -- ========== ========== </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 6
AEHR TEST SYSTEMS NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED AUGUST 31, 2005 (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying condensed consolidated financial information has been prepared by Aehr Test Systems, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC") and therefore does not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in accordance with generally accepted accounting principles. In the opinion of management, the unaudited condensed consolidated financial statements for the interim periods presented reflect all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the consolidated financial position and results of operations as of and for such periods indicated. These condensed consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 2005. Results for the interim periods presented herein are not necessarily indicative of results which may be reported for any other interim period or for the entire fiscal year. PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of Aehr Test Systems and its subsidiaries (collectively, the "Company," "we," "us," and "our"). All significant intercompany balances have been eliminated in consolidation. ACCOUNTING ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. 2. STOCK-BASED COMPENSATION The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25") and related interpretations and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company's shares and the exercise price of the option. Stock-based compensation for consultants or other third parties are accounted for in accordance with SFAS 123 and Emerging Issues Task Force No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Service." For purposes of pro forma disclosures, the estimated fair value of the stock options and grants under the Company's Employee Stock Purchase Plan are amortized to expense over the vesting period. The Company's pro forma information follows (in thousands, except per share amounts): 7
<TABLE> <CAPTION> Three Months Ended August 31, --------- --------- 2005 2004 --------- --------- (unaudited) <S> <C> <C> Net loss, as reported:...................... $ (244) $(1,324) Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects......................... (193) (201) --------- --------- Pro forma net loss.......................... $ (437) $(1,525) ========= ========= Net loss per share: Basic and diluted, as reported.............. $(0.03) $ (0.18) ========= ========= Basic and diluted, pro forma................ $(0.06) $ (0.21) ========= ========= </TABLE> The above pro forma effects on loss may not be representative of the effects on net income (loss) for future years as option grants typically vest over several years and additional options are generally granted each year. The fair value of each option and stock purchase plan grant has been estimated on the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions: <TABLE> <CAPTION> Three Months Ended August 31, --------- --------- 2005 2004 --------- --------- <S> <C> <C> Risk-free Interest Rate .................... 3.96% 3.70% Expected Life............................... 5 years 5 years Expected Volatility......................... 78% 82% Dividend Yield.............................. -- -- </TABLE> SFAS 123R is now effective for public companies for annual reporting periods beginning after June 15, 2005 (the first quarter of fiscal 2007 for the Company). The impact of SFAS 123R on the Company in fiscal 2007 and beyond will depend upon various factors, among them being the Company's future compensation strategy. The pro forma compensation costs presented in the table above and in prior filings for the Company have been calculated using the Black-Scholes option pricing model and may not be indicative of amounts which should be expected in future years. As of the date of this filing, no decisions have been made as to the selection of an option pricing model and a transition method for adoption. The Company expects that the adoption of SFAS 123R will have an adverse impact on the Company's consolidated statements of operations. 8
3. EARNINGS PER SHARE EARNINGS PER SHARE. Earnings per share is computed based on the weighted average number of common and common equivalent shares (common stock options) outstanding, when dilutive, during each period using the treasury stock method. <TABLE> <CAPTION> Three Months Ended August 31, ---------- ---------- 2005 2004 ---------- ---------- (in thousands, except per share amounts) (unaudited) <S> <C> <C> Net loss available to common shareholders: Numerator: Net loss................................ $ (244) $(1,324) ---------- ---------- Denominator for basic loss per share: Weighted-average shares outstanding ............. 7,482 7,393 ---------- ---------- Shares used in basic loss per share calculation.... 7,482 7,393 Effect of dilutive securities: Employee stock options......................... -- -- ---------- ---------- Denominator for diluted loss per share............. 7,482 7,393 ---------- ---------- Basic and diluted loss per share................... $(0.03) $ (0.18) ========== ========== </TABLE> Stock options to purchase 1,408,000 and 1,352,000 shares of common stock were outstanding on August 31, 2005 and August 31, 2004, respectively, but were not included in the computation of diluted loss per share because the inclusion of such shares would be anti-dilutive. 4. INVENTORIES Inventories are comprised of the following (in thousands): <TABLE> <CAPTION> August 31, May 31, 2005 2005 (unaudited) ----------- ----------- <S> <C> <C> Raw materials and sub-assemblies $2,635 $2,939 Work in process 4,765 3,694 Finished goods 415 507 ----------- ----------- $7,815 $7,140 =========== =========== </TABLE> 5. SEGMENT INFORMATION The Company operates in one reportable segment; the design, manufacture and marketing of advanced test and burn-in products to the semiconductor manufacturing industry. 9
The following presents information about the Company's operations in different geographic areas (in thousands): <TABLE> <CAPTION> United Adjust- States Asia Europe ments Total --------- --------- --------- --------- --------- <S> <C> <C> <C> <C> <C> Three months ended August 31, 2005: Net sales...................... $ 3,961 $ 583 $ 195 $ (93) $ 4,646 U.S. net sales................. 683 79 -- (79) 683 Portion of net sales from export sales............ 3,278 -- -- -- 3,278 Income (loss) from operations.. (287) (3) (43) 35 (298) Identifiable assets............ 29,826 1,171 883 (10,499) 21,381 Long-lived assets.............. 1,156 195 30 -- 1,381 Fiscal year ended May 31, 2005: Net sales...................... $14,128 $1,112 $2,353 $(1,513) $16,080 U.S. net sales................. 3,022 390 50 (440) 3,022 Portion of net sales from export sales............ 11,106 -- -- -- 11,106 Income (loss) from operations.. (4,825) (469) 323 (4) (4,975) Identifiable assets............ 29,621 1,272 1,155 (10,579) 21,469 Long-lived assets.............. 970 230 32 -- 1,232 Three months ended August 31, 2004: Net sales...................... $ 5,911 $ 238 $ 187 $ (400) $ 5,936 U.S. net sales................. 508 100 17 (117) 508 Portion of net sales from export sales............ 5,403 -- -- -- 5,403 Loss from operations........... (1,180) (133) (46) (31) (1,390) Identifiable assets............ 34,686 1,590 816 (10,583) 26,509 Long-lived assets.............. 1,006 289 11 -- 1,306 </TABLE> The Company's foreign operations are primarily those of its Japanese and German subsidiaries. Substantially all of the sales of the subsidiaries are made to unaffiliated Japanese or European customers. Net sales and income (loss) from operations from outside the United States include the operating results of Aehr Test Systems Japan K.K. and Aehr Test Systems GmbH. Adjustments consist of intercompany eliminations. Identifiable assets are all assets identified with operations in each geographic area. 6. PRODUCT WARRANTIES The Company provides for the estimated cost of product warranties at the time the products are shipped. While the Company engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its component suppliers, the Company's warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from the Company's estimates, revisions to the estimated warranty liability would be required. Following is a summary of changes in the Company's liability for product warranties during the three months ended August 31, 2005 and 2004: 10
<TABLE> <CAPTION> Three months ended August 31, ------------------------ 2005 2004 ----------- ----------- (in thousands, unaudited) <S> <C> <C> Balance at the beginning of the period ........... $213 $146 (Reversal) accruals for warranties issued during the period................................. (11) 65 Settlements made during the period (in cash or in kind)............................. (60) (73) ----------- ----------- Balance at the end of the period.................. $142 $138 =========== =========== </TABLE> 7. OTHER COMPREHENSIVE LOSS Other comprehensive loss, net of tax are comprised of the following: <TABLE> <CAPTION> Three months ended August 31, ------------------------ 2005 2004 ----------- ----------- (in thousands, unaudited) <S> <C> <C> Net loss......................................... $(244) $(1,324) Foreign currency translation adjustments......... 1 (19) Unrealized holding gains arising during period ................................. 4 6 ----------- ----------- Comprehensive loss............................... $(239) $(1,337) =========== =========== </TABLE> 8. RECENT ACCOUNTING PRONOUNCEMENTS In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an Amendment of ARB No. 43, Chapter 4". This statement clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) to require them to be recognized as current-period charges and to require the allocation of fixed production overhead to inventory based on the normal capacity of a production facility. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted. The adoption of this statement is not expected to have a material impact on the Company's financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), "Share- Based Payment" ("SFAS 123R"), which is a revision SFAS 123 and supersedes APB 25. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their grant-date fair values. Pro forma disclosure is no longer an alternative. In April 2005, the Securities and Exchange Commission delayed the effective date of SFAS 123R, which is now effective for the annual reporting period that begins after June 15, 2005. The Company will apply SFAS 123 beginning in the Company's first quarter of fiscal 2007. We are currently evaluating the impact of adopting this statement on our financial position and results of operations. The impact on our financial statements will be dependent on the transition method, the option pricing model used to compute fair value and the inputs to that model such as volatility and expected life. The pro forma disclosures of the impact of SFAS 11
123 provided earlier in Note 2 may not be representative of the impact of adopting this statement. The Company expects that the adoption of SFAS 123R will have an adverse impact on the Company's consolidated statements of operations. On March 29, 2005, the SEC staff issued Staff Accounting Bulletin (SAB) No. 107, "Share-Based Payment" to express the views of the staff regarding the interaction between SFAS no. 123R and certain SEC rules and regulations and to provide the staff's views regarding the valuation of share-based payment arrangements for public companies. The Company is currently in the process of implementing SFAS No. 123R, effective as of June 1, 2007, and will take into consideration the additional guidance provided by SAB No. 107 in connection with the implementation of SFAS No. 123R. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29." This statement amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier application is permitted. The adoption of this standard is not expected to have a material impact on the Company's financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No. FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FSP FAS 109-2"). The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP FAS 109-2 provides accounting and disclosure guidance for the repatriation provision. The deduction is subject to a number of limitations and, as of today, uncertainty remains as to how to interpret numerous provisions in the Act. As such, we are not yet in a position to decide on whether, and to what extent, we might repatriate foreign earnings that have not yet been remitted to the U.S. and cannot reasonably estimate the income tax effect of the Foreign Earnings Repatriation Provision. The Company has yet to complete its evaluation of the Foreign Earnings Repatriation Provision within the Act and plans to complete its evaluation in the first half of fiscal 2006. In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS No. 154), a replacement of APB Opinion No. 20, Accounting Changes (APB 20), and FASB SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements (SFAS No. 3). SFAS No. 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. SFAS No. 154 also requires that a change in method of depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is affected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections or errors made occurring in fiscal years beginning after June 1, 2005. SFAS No. 154 does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of this Statement. The Company does not believe the adoption of SFAS No. 154 will have a material impact on its financial statements. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Condensed 12
Consolidated Financial Statements and the related notes that appear elsewhere in this document and with our Annual Report on Form 10-K for the fiscal year ended May 31, 2005 and the consolidated financial statements and notes thereto. In addition to historical information, this report contains forward- looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Act of 1934. These statements typically may be identified by the use of forward-looking words or phrases such as "believe," "expect," "intend," "anticipate," "should," "planned," "estimated," and "potential," among others and include, but are not limited to, statements concerning our expectations regarding our operations, business, strategies, prospects, revenues, expenses, costs and resources. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those the anticipated results or other expectations reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this report and other factors beyond our control, and in particular, the risks discussed below and under the heading "Factors that May Affect Future Results of Operations" and those discussed in other documents we file with the Securities and Exchange Commission. All forward-looking statements included in this document are based on our current expectations, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. CRITICAL ACCOUNTING POLICIES The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to customer programs and incentives, product returns, bad debts, inventories, investments, intangible assets, income taxes, financing operations, warranty obligations, long-term service contracts, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. For a discussion of the critical accounting policies, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies" in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 2005. RESULTS OF OPERATIONS The following table sets forth items in the Company's Condensed Consolidated Statements of Operations as a percentage of net sales for the periods indicated. 13
<TABLE> <CAPTION> Three Months Ended August 31, --------------------- 2005 2004 ---------- ---------- <S> <C> <C> Net sales. . . . . . . . . . . . . . . . . 100.0 % 100.0 % Cost of sales. . . . . . . . . . . . . . . 52.9 82.0 ---------- ---------- Gross profit . . . . . . . . . . . . . . . 47.1 18.0 ---------- ---------- Operating expenses: Selling, general and administrative. . . 31.3 24.1 Research and development . . . . . . . . 22.3 17.3 ---------- ---------- Total operating expenses . . . . 53.6 41.4 ---------- ---------- Loss from operations . . . . . . . . . . . (6.5) (23.4) Interest income. . . . . . . . . . . . . . 1.0 0.4 Other income, net. . . . . . . . . . . . . -- 0.4 ---------- ---------- Loss before income taxes . . . . . . . . . (5.5) (22.6) Income tax benefit . . . . . . . . . . . . (0.2) (0.3) ---------- ---------- Net loss. . . . . . . . . . . .. . . . . . (5.3)% (22.3)% ========== ========== </TABLE> THREE MONTHS ENDED AUGUST 31, 2005 COMPARED TO THREE MONTHS ENDED AUGUST 31, 2004 NET SALES. Net sales decreased to $4.6 million in the three months ended August 31, 2005 from $5.9 million in the three months ended August 31, 2004, a decrease of 21.7%. The decrease in net sales in the three months ended August 31, 2005 resulted primarily from a decrease in the Company's MTX pass-through products, partially offset by increases in net sales of the Company's dynamic burn-in products and of the Company's MTX products. Net sales of the Company's MTX pass-through products for the three months ended August 31, 2004 were $2.3 million, and decreased to zero in the three months ended August 31, 2005. Net sales of the Company's dynamic burn-in products for the three months ended August 31, 2005 were $2.5 million, and increased approximately $712,000 from the three months ended August 31, 2004. Net sales of the Company's MTX products for the three months ended August 31, 2005 were $2.1 million, and increased approximately $373,000 from the three months ended August 31, 2004. GROSS PROFIT. Gross profit consists of net sales less cost of sales. Cost of sales consists primarily of the cost of materials, assembly and test costs, and overhead from operations. Gross profit increased to $2.2 million in the three months ended August 31, 2005 from $1.1 million in the three months ended August 31, 2004, an increase of 105.1%. Gross profit margin increased to 47.1% in the three months ended August 31, 2005 from 18.0% in the three months ended August 31, 2004. Approximately 40% of the increase in gross profit margin was the result of manufacturing efficiencies related to increased production levels in the first quarter of fiscal 2006. Approximately 30% of the increase in gross profit margin was the result of very low gross profit margins related to MTX pass-through products which shipped in the first quarter of fiscal 2005, but not in the first quarter of fiscal 2006, as discussed below. Beginning in January 2004, the Company received turnkey MTX system orders from a single customer, which included certain very low margin products not typically sold directly by the Company which are used in conjunction with the Company's systems. At the customer's request, these products were included as part of the order. These products were priced at or near the Company's cost and are referred to here as "MTX pass-through" products. There was a reduction in net sales of MTX pass-through products of 14
$2.3 million from the first quarter of fiscal 2005 to the first quarter of fiscal 2006. Since the Company does not typically accept orders for pass- through products, it has requested that, going forward, the customer purchases these pass-through products directly through the vendors that currently manufacture such products. The customer has already ordered some of these products directly from the vendors. The customer has not advised the Company of its intent to purchase any additional pass-through products from the Company. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative ("SG&A") expenses consist primarily of salaries and related costs of employees, commission expenses to independent sales representatives, product promotion and other professional services. SG&A expenses increased to $1.5 million in the three months ended August 31, 2005 from $1.4 million in the three months ended August 31, 2004, an increase of 1.4%. The increase in SG&A expenses was primarily due to an increase in employment related costs. As a percentage of net sales, SG&A expenses increased to 31.3% in the three months ended August 31, 2005 from 24.1% in the three months ended August 31, 2004, reflecting lower net sales. RESEARCH AND DEVELOPMENT. Research and development ("R&D") expenses consist primarily of salaries and related costs of employees engaged in ongoing research, design and development activities, costs of engineering materials and supplies, and professional consulting expenses. R&D expenses remained flat at $1.0 million in the three months ended August 31, 2005 and 2004. As a percentage of net sales, R&D expenses increased to 22.3% in the three months ended August 31, 2005 from 17.3% in the three months ended August 31, 2004, reflecting lower net sales. INTEREST INCOME. Interest income increased to $46,000 in the three months ended August 31, 2005 from $24,000 in the three months ended August 31, 2004, an increase of 91.7%. The increase in interest income was primarily attributable to higher interest rates earned on the Company's cash investments. OTHER INCOME (EXPENSE), NET. Other income, net decreased to zero in the three months ended August 31, 2005 from $24,000 in the three months ended August 31, 2004. INCOME TAX EXPENSE (BENEFIT). Income tax benefit was $8,000 in the three months ended August 31, 2005 and $18,000 in the three months ended August 31, 2004. The income tax benefits in the three months ended August 31, 2005 and 2004 were primarily due to the tax benefit recorded by the Company as a result of losses incurred in the Company's German subsidiary. The Company's U.S. operations and its Japanese subsidiary have experienced significant cumulative losses and thus generated certain net operating losses available to offset future taxes payable in the U.S. and Japan. As a result of the cumulative operating losses in the Company's U.S. operations and its Japanese subsidiary, a valuation allowance was established for the full amount of its net deferred tax assets for both its U.S. operations and its Japanese subsidiary. LIQUIDITY AND CAPITAL RESOURCES Net cash used in operating activities was $2.7 million for the three months ended August 31, 2005 and was approximately $922,000 for the three months ended August 31, 2004. For the three months ended August 31, 2005, net cash used in operating activities was due primarily to increases in accounts receivable of $2.1 million and inventories of $915,000, and the net loss of $244,000, partially offset by an increase in accounts payable of $266,000. Of the increase in accounts receivable, approximately 60% of the increase was due to higher shipment levels than in the quarter ended May 31, 2005 and approximately 40% of the increase is related to a higher level of shipments to Asian locations, for which payments were not timely made, than in the quarter ended May 31, 2005. The increases in inventories and accounts payable were due primarily to the higher shipment levels than in the quarter ended May 31, 2005 and higher production levels related to the increased MTX and MAX orders 15
received. For the three months ended August 31, 2004, net cash used in operating activities was due primarily to the net loss of $1.3 million and an increase in accounts receivable of $1.1 million, partially offset by an increase in accounts payable of $769,000 and a decrease in inventories of $366,000. Net cash provided by investing activities was approximately $1.9 million for the three months ended August 31, 2005 and approximately $842,000 for the three months ended August 31, 2004. The cash provided by investing activities during the three months ended August 31, 2005 and August 31, 2004 was primarily due to the net proceeds from sales and maturity of investments, partially offset by the purchase of investments. Financing activities neither used nor provided cash in the three months ended August 31, 2005. Financing activities provided cash of $19,000 in the three months ended August 31, 2004. Net cash provided by financing activities during the three months ended August 31, 2004 was due to proceeds from issuance of common stock and exercise of stock options. As of August 31, 2005, the Company had working capital of $15.4 million. Working capital consists of cash and cash equivalents, short-term investments, accounts receivable, inventory and other current assets, less current liabilities. The Company announced in August 1998 that its board of directors had authorized the repurchase of up to 1,000,000 shares of its outstanding common shares. The Company may repurchase the shares in the open market or in privately negotiated transactions, from time to time, subject to market conditions. The number of shares of common stock actually acquired by the Company will depend on subsequent developments and corporate needs, and the repurchase program may be interrupted or discontinued at any time. Any such repurchase of shares, if consummated, may use a portion of the Company's working capital. As of August 31, 2005, the Company had repurchased 523,700 shares at an average price of $3.95 per share. Shares repurchased by the Company are cancelled. The Company leases most of its manufacturing and office space under operating leases. The Company entered into a non-cancelable operating lease agreement for its United States manufacturing and office facilities, which commenced in December 1999 and expires in December 2009. Under the lease agreement, the Company is responsible for payments of utilities, taxes and insurance. From time to time, the Company evaluates potential acquisitions of businesses, products or technologies that complement the Company's business. Any such transactions, if consummated, may use a portion of the Company's working capital or require the issuance of equity. The Company has no present understandings, commitments or agreements with respect to any material acquisitions. The Company anticipates that the existing cash balance together with cash provided by operations, if any, are adequate to meet its working capital and capital equipment requirements through calendar year 2006. After calendar year 2006, depending on its rate of growth and profitability, the Company may require additional equity or debt financing to meet its working capital requirements or capital equipment needs. There can be no assurance that additional financing will be available when required, or, if available, that such financing can be obtained on terms satisfactory to the Company. OFF-BALANCE SHEET ARRANGEMENTS The Company has not entered into any off-balance sheet financing arrangements and has not established any special purpose entities. 16
OVERVIEW OF CONTRACTUAL OBLIGATIONS There have been no material changes in the composition, magnitude or other key characteristics of the Company's contractual obligations or other commitments as disclosed in the Company's Form 10-K for the year ended May 31, 2005. RECENT ACCOUNTING PRONOUNCEMENTS In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an Amendment of ARB No. 43, Chapter 4". This statement clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) to require them to be recognized as current-period charges and to require the allocation of fixed production overhead to inventory based on the normal capacity of a production facility. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted. The adoption of this statement is not expected to have a material impact on the Company's financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), "Share- Based Payment" ("SFAS 123R"), which is a revision SFAS 123 and supersedes APB 25. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their grant-date fair values. Pro forma disclosure is no longer an alternative. In April 2005, the Securities and Exchange Commission delayed the effective date of SFAS 123R, which is now effective annual reporting period that begins after June 15, 2005. The Company will apply SFAS 123 beginning in the Company's first quarter of fiscal 2007. We are currently evaluating the impact of adopting this statement on our financial position and results of operations. The impact on our financial statements will be dependent on the transition method, the option pricing model used to compute fair value and the inputs to that model such as volatility and expected life. The pro forma disclosures of the impact of SFAS 123 provided earlier in Note 2 may not be representative of the impact of adopting this statement. The Company expects that the adoption of SFAS 123R will have an adverse impact on the Company's consolidated statements of operations. On March 29, 2005, the SEC staff issued Staff Accounting Bulleting (SAB) No. 107, "Share-Based Payment" to express the views of the staff regarding the interaction between SFAS No. 123R and certain SEC rules and regulations and to provide the Staff's views regarding the valuation of share-based payment arrangements for public companies. The Company is currently in the process of implementing SFAS No. 123R, effective as of June 1, 2007, and will take into consideration the additional guidance provided by SAB No. 107 in connection with the implementation of SFAS No. 123R. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29." This statement amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier application is permitted. The adoption of this standard is not expected to have a material impact on the Company's financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No. FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FSP FAS 109-2"). The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP FAS 17
109-2 provides accounting and disclosure guidance for the repatriation provision. The deduction is subject to a number of limitations and, as of today, uncertainty remains as to how to interpret numerous provisions in the Act. As such, we are not yet in a position to decide on whether, and to what extent, we might repatriate foreign earnings that have not yet been remitted to the U.S. and cannot reasonably estimate the income tax effect of the Foreign Earnings Repatriation Provision. The Company has yet to complete its evaluation of the Foreign Earnings Repatriation Provision within the Act and plans to complete its evaluation in the first half of fiscal 2006. In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS No. 154), a replacement of APB Opinion No. 20, Accounting Changes (APB 20), and FASB SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements (SFAS No. 3). SFAS No. 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. SFAS No. 154 also requires that a change in method of depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is affected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections or errors made occurring in fiscal years beginning after June 1, 2005. SFAS No. 154 does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of this Statement. The Company does not believe the adoption of SFAS No. 154 will have a material impact on its financial statements. FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS Set forth below and elsewhere in this Quarterly Report on Form 10-Q and in other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements in this Quarterly Report on Form 10-Q. We believe that these risks and uncertainties are the principal material risks facing the Company as of the date of this Form 10-Q. In the future, we may become subject to additional risks that are not currently known to us. If any of these risks actually occur, our business, financial condition and operating results could be seriously harmed. As a result, the trading price of our common stock could decline, and you could lose all or part of the value of your investment. FLUCTUATIONS IN OPERATING RESULTS. The Company has experienced and expects to continue to experience significant fluctuations in its quarterly and annual operating results. During fiscal 2005, 2004 and 2003, quarterly net sales have been as low as $2.1 million and as high as $5.9 million, and gross margins for quarterly sales have fluctuated between 18.0% and 44.4%. The Company's future operating results will depend upon a variety of factors, including sales volume, the timing of significant orders, the mix of products sold, changes in pricing by the Company, its competitors, customers or suppliers, the length of sales cycles for the Company's products, timing of new product announcements and releases by the Company and its competitors, market acceptance of new products and enhanced versions of the Company's products, capital spending patterns by customers, manufacturing inefficiencies associated with new product introductions by the Company, the Company's ability to produce systems and products in volume and meet customer requirements, product returns and customer acceptance of product shipments, volatility in the Company's targeted markets, political and economic instability, natural disasters, regulatory changes, possible disruptions caused by expanding existing facilities or moving into new facilities, expenses associated with acquisitions and alliances, and various competitive factors, including price-based competition, competition from vendors employing other technologies, and the quantity of products sold under volume purchase 18
arrangements, which tend to have lower selling prices. Accordingly, past performance may not be indicative of future performance. DEPENDENCE ON TIMING AND SIZE OF SALES ORDERS AND SHIPMENT. The Company derives a substantial portion of its revenues from the sale of a relatively small number of systems which typically range in purchase price from approximately $200,000 to over $1 million per system. As a result, the loss or deferral of a limited number of system sales could have a material and adverse effect on the Company's net sales and operating results in a particular period. All customer purchase orders are subject to cancellation or rescheduling by the customer with limited penalties, and, therefore, backlog at any particular date is not necessarily indicative of actual sales for any succeeding period. From time to time, cancellations and rescheduling of customer orders have occurred, and delays by the Company's suppliers in providing components or subassemblies to the Company have caused delays in the Company's shipments of its own products. There can be no assurance that the Company will not be materially and adversely affected by future cancellations and rescheduling. A substantial portion of net sales typically are realized near the end of each quarter. A delay or reduction in shipments near the end of a particular quarter, due, for example, to unanticipated shipment rescheduling, cancellations or deferrals by customers, customer credit issues, unexpected manufacturing difficulties experienced by the Company, or delays in deliveries by suppliers, could cause net sales in a particular quarter to fall significantly below the Company's expectations. As the Company incurs expenses in anticipation of future sales levels, the Company's results of operations may be adversely affected if such sales levels are not achieved. RECENT OPERATING LOSSES. Although the Company reported operating income in fiscal 2001 as a whole, beginning in the second half of fiscal 2001, the Company experienced the result of a sharp and severe industry downturn and recorded operating losses of $4.7 million, $4.5 million and $5.0 million in fiscal 2003, 2004 and 2005, respectively. There can be no assurance that the Company's net sales and operating results will not continue to be further impacted by any prolonged downturn in the semiconductor equipment market and global economy. Failure to become profitable may further depress the market price of the Company's common stock and its ability to raise capital, if necessary. DEPENDENCE ON MARKET ACCEPTANCE OF FOX SYSTEM. One element of the Company's business strategy is to capture an increasing share of the test equipment market through sales of its FOX wafer-level burn-in and test system. The FOX system is newly designed to simultaneously burn-in and functionally test all of the die on a wafer. The market for the FOX systems is in the very early stages of development. The FOX-14 full wafer contact burn-in and parallel test system was introduced in July 2001 and the FOX-1 full wafer parallel test system was introduced in June 2005. The Company's strategy depends, in part, upon its ability to persuade potential customers that the FOX system can successfully contact and functionally test all of the die on a wafer simultaneously, and that this method of testing is cost-effective for the customer. There can be no assurance that the Company's strategy will be successful. The failure of the FOX system to achieve market acceptance would have a material and adverse effect on the Company's future operating results and long-term prospects. The Company's stock price may also decline. Market acceptance of the FOX system is subject to a number of risks. The Company must complete development of the FOX system and the manufacturing processes used to build it. Before a customer will incorporate the FOX system into a production line, lengthy qualification and correlation tests must be performed. The Company anticipates that potential customers may be reluctant to change their procedures in order to transfer burn-in and test functions to the FOX system. Initial purchases are expected to be limited to systems used for these qualifications and for engineering studies. Market acceptance of the FOX system also may be affected by a reluctance of IC manufacturers to rely on relatively small suppliers such as the Company. As is common with new complex products incorporating leading-edge technologies, the Company may 19
encounter reliability, design and manufacturing issues as it begins volume production and initial installations of FOX systems at customer sites. While the Company places a high priority on addressing these issues as they arise, there can be no assurance that they can be resolved to the customer's satisfaction or that the resolution of such problems will not cause the Company to incur significant development costs or warranty expenses or to lose significant sales opportunities. DEPENDENCE ON MARKET ACCEPTANCE OF MTX SYSTEM. A principal element of the Company's business strategy is to capture an increasing share of the memory test equipment market through sales of the MTX massively parallel test system. The MTX system is designed to perform both burn-in and many of the final test functions currently performed by high-cost memory testers. The Company's strategy depends, in part, upon its ability to persuade potential customers that the MTX system can successfully perform a significant portion of such final test functions and that transferring such tests to MTX systems will reduce their overall capital and test costs. There can be no assurance that the Company's strategy will be successful. The failure of the MTX system to achieve market acceptance would have a material and adverse effect on the Company's business, financial condition and operating results. Market acceptance of the MTX system is subject to a number of risks. Through the end of fiscal 2005, several companies purchased evaluation units of the MTX system, but only four customers have purchased production quantities. There are no long-term volume purchase commitments with any of these customers. There can be no assurance that these customers will continue to purchase MTX systems for their production facilities. Since most potential customers have successfully relied on memory testers for many years and their personnel understand the use and maintenance of such systems, the Company anticipates that they may be reluctant to change their procedures in order to transfer test functions to the MTX system. Before a customer will transfer test functions to the MTX, the test programs must be translated for use with the MTX system and lengthy correlation tests must be performed. Correlation testing may take up to six months or more. Furthermore, MTX system sales are expected to be primarily limited to new facilities and to existing facilities being upgraded to accommodate new product generations, such as the transition to new memory technologies, including the Double Data Rate DRAMs, DDR II DRAMs and newer generation flash memories. Construction of new facilities and upgrades of existing facilities have in some cases been delayed or canceled during periodic semiconductor industry downturns. Other companies have purchased MTX systems which are being used only in quality assurance and engineering applications. Market acceptance of the MTX system may also be affected by a reluctance of IC manufacturers to rely on relatively small suppliers such as the Company. CUSTOMER CONCENTRATION. The semiconductor manufacturing industry is highly concentrated, with a relatively small number of large semiconductor manufacturers and contract assemblers accounting for a substantial portion of the purchases of semiconductor equipment. Sales to the Company's five largest customers accounted for approximately 73.1%, 70.5% and 73.0% of its net sales in fiscal 2005, 2004 and 2003, respectively. Sales to the Company's five largest customers accounted for approximately 88.1% of its net sales in the three months ended August 31, 2005. During fiscal 2005, Spansion Inc. (formerly FASL LLC.) and Texas Instruments Incorporated accounted for 43.1% and 16.9% of the Company's net sales, respectively. During fiscal 2004, Texas Instruments Incorporated and FASL LLC. accounted for 33.8% and 17.8% of the Company's net sales, respectively. During fiscal 2003, Texas Instruments Incorporated and First International Computer, Inc. accounted for 45.3% and 10.7% of the Company's net sales, respectively. No other customers represented more than 10% of the Company's net sales for any of such periods. The Company expects that sales of its products to a limited number of customers will continue to account for a high percentage of net sales for the foreseeable future. In addition, sales to particular customers may fluctuate significantly from quarter to quarter. The loss of or reduction or delay in orders from a significant customer, or a delay in collecting or failure to 20
collect accounts receivable from a significant customer could adversely affect the Company's business, financial condition and operating results. LIMITED MARKET FOR BURN-IN SYSTEMS. Historically, a substantial portion of the Company's net sales were derived from the sale of dynamic burn-in systems. The management believes that the market for burn-in systems is mature and does not expect to have significant long-term growth. In general, process control improvements in the semiconductor industry have tended to reduce burn-in times. In addition, as a given IC product generation matures and yields increase, the required burn-in time may be reduced or eliminated. IC manufacturers, which historically have been the Company's primary customer base, increasingly outsource test and burn-in to independent test labs which often build their own systems. There can be no assurance that the market for burn-in systems will grow, and sales of the Company's burn-in products could decline. LENGTHY SALES CYCLE. Sales of the Company's systems depend, in significant part, upon the decision of a prospective customer to increase manufacturing capacity or to restructure current manufacturing facilities, either of which typically involve a significant commitment of capital. In addition, the approval process for MTX and FOX system and DiePak carrier sales may require lengthy qualification and correlation testing. In view of the significant investment or strategic issues that may be involved in a decision to purchase MTX and FOX systems or DiePak carriers, the Company may experience delays following initial qualification of the Company's systems as a result of delays in a customer's approval process. For these reasons, the Company's systems typically have a lengthy sales cycle during which the Company may expend substantial funds and management effort in securing a sale. Lengthy sales cycles subject the Company to a number of significant risks, including inventory obsolescence and fluctuations in operating results, over which the Company has little or no control. The loss of individual orders due to the lengthy sales and evaluation cycle, or delays in the sale of even a limited number of systems could have a material and adverse effect on the Company's business, operating results and financial condition and, in particular, could contribute to significant fluctuations in operating results on a quarterly basis. DEPENDENCE ON INTERNATIONAL SALES AND OPERATIONS. Approximately 81.2%, 84.5% and 73.0% of the Company's net sales for fiscal 2005, 2004 and 2003, respectively, were attributable to sales to customers for delivery outside of the United States. Approximately 85.3% of the Company's net sales in the three months ended August 31, 2005 were attributable to sales for customers for delivery outside the United States. The Company operates sales, service and limited manufacturing organizations in Japan and Germany and a sales and support organization in Taiwan. The Company expects that sales of products for delivery outside of the United States will continue to represent a substantial portion of its future revenues. The future performance of the Company will depend, in significant part, upon its ability to continue to compete in foreign markets which in turn will depend, in part, upon a continuation of current trade relations between the United States and foreign countries in which semiconductor manufacturers or assemblers have operations. A change toward more protectionist trade legislation in either the United States or such foreign countries, such as a change in the current tariff structures, export compliance or other trade policies, could adversely affect the Company's ability to sell its products in foreign markets. In addition, the Company is subject to other risks associated with doing business internationally, including longer receivable collection periods and greater difficulty in accounts receivable collection, the burden of complying with a variety of foreign laws, difficulty in staffing and managing global operations, risks of civil disturbance or other events which may limit or disrupt markets, international exchange restrictions, changing political conditions and monetary policies of foreign governments. A substantial portion of the Company's sales has been in Asia. Turmoil in the Asian financial markets has resulted, and may result in the future, in 21
dramatic currency devaluations, stock market declines, restriction of available credit and general financial weakness. In addition, DRAM, and other memory device, prices in Asia have on occasion declined dramatically, and will likely do so again in the future. These developments may affect the Company in several ways. The Company believes that many international semiconductor manufacturers limited their capital spending (including the purchase of MTXs) in fiscal years 2003 and 2002, and that the uncertainty of the memory market may cause some manufacturers in the future to again delay capital spending plans. The economic conditions in Asia may also affect the ability of the Company's customers to meet their payment obligations, resulting in cancellations or deferrals of existing orders and the limitation of additional orders. In addition, Asian governments have subsidized some portion of fabrication construction. Financial turmoil may reduce these governments' willingness to continue such subsidies. Such developments could have a material and adverse effect on the Company's business, financial condition and results of operations. Because a substantial portion of the Company's net sales is from sales of products for delivery outside the United States, an increase in the value of the U.S. Dollar relative to foreign currencies would increase the cost of the Company's products compared to products sold by local companies in such markets. Approximately 87.2%, 4.4% and 8.4% of the Company's net sales for fiscal 2005 were denominated in U.S. Dollars, Japanese Yen and Euros. Although a large percentage of sales to European customers is denominated in U.S. Dollars, substantially all sales to Japanese customers are denominated in Yen. Since the price is determined at the time a purchase order is accepted, the Company is exposed to the risks of fluctuations in the Yen-U.S. Dollar exchange rate during the lengthy period from the date a purchase order is received until payment is made. This exchange rate risk is partially offset to the extent the Company's Japanese subsidiary incurs expenses payable in Yen. To date, the Company has not invested in instruments designed to hedge currency risks. In addition, the Company's Japanese subsidiary typically carries debt or other obligations due to the Company that may be denominated in either Yen or U.S. Dollars. A substantial portion of the world's manufacturers of memory devices are in Korea, Japan, Taiwan and China and growth in the Company's net sales depends in large part upon its ability to penetrate these markets. Both the Korean and Japanese markets are difficult for foreign companies to penetrate. The Company has served the Japanese market through its Japanese subsidiary, which has experienced limited success and has incurred operating losses in recent years. Sales into Korea have not been significant in recent years. Taiwan and China represent an increasingly important portion of the memory manufacturer market. The Company established a support organization in Taiwan in fiscal 2001 and subsequently added a sales function. The lack of local manufacturing may impede the Company's efforts to develop the Japanese, Korean, Taiwanese and Chinese markets. There can be no assurance that the Company's efforts in Japan, Korea, Taiwan or China will be successful or that the Company will be able to achieve and sustain significant sales to, or be able to successfully compete in, these markets. RAPID TECHNOLOGICAL CHANGE; IMPORTANCE OF TIMELY PRODUCT INTRODUCTION. The semiconductor equipment industry is subject to rapid technological change and new product introductions and enhancements. The Company's ability to remain competitive will depend in part upon its ability to develop new products and to introduce these products at competitive prices and on a timely and cost-effective basis. The Company's success in developing new and enhanced products depends upon a variety of factors, including product selection, timely and efficient completion of product design, timely and efficient implementation of manufacturing and assembly processes, product performance in the field and effective sales and marketing. Because new product development commitments must be made well in advance of sales, new product decisions must anticipate both future demand and the technology that will be available to supply that demand. Furthermore, introductions of new and complex products typically involve a period in which design, engineering 22
and reliability issues are identified and addressed by the Company and its suppliers. This process in the past required and in the future is likely to require the Company to incur unreimbursed engineering expenses, and from time to time to experience warranty claims or product returns. There can be no assurance that the Company will be successful in selecting, developing, manufacturing and marketing new products that satisfy market demand. Any such failure would materially and adversely affect the Company's business, financial condition and results of operations. Because of the complexity of the Company's products, significant delays can occur between a product's introduction and the commencement of volume production of such product. The Company has experienced, from time to time, significant delays in the introduction of, and technical and manufacturing difficulties with, certain of its products and may experience delays and technical and manufacturing difficulties in future introductions or volume production of new products. The Company's inability to complete new product development, or to manufacture and ship products in volume and in time to meet customer requirements would materially and adversely affect the Company's business, financial condition and results of operations. As is common with new complex and software-intensive products, the Company has encountered reliability, design and manufacturing issues as it began volume production and initial installations of certain products at customer sites. The Company places a high priority on addressing these issues as they arise. Certain of these issues in the past have been related to components and subsystems supplied to the Company by third parties which have in some cases limited the ability of the Company to address such issues promptly. In the early stages of product development, there can be no assurance that reliability, design and manufacturing issues will not be discovered or, that if such issues arise, they can be resolved to the customers' satisfaction or that the resolution of such problems will not cause the Company to incur significant development costs or warranty expenses or to lose significant sales opportunities. Future improvements in semiconductor design and manufacturing technology may reduce or eliminate the need for the Company's products. For example, the introduction of viable wafer-level burn-in and test systems, improvements in BIST technology, and improvements in conventional test systems, such as reduced cost or increased throughput, may significantly reduce or eliminate the market for one or more of the Company's products. If the Company is not able to improve its products or develop new products or technologies quickly enough to maintain a competitive position in its markets, the Company may not be able to grow its business. INTENSE COMPETITION. In each of the markets it serves, the Company faces competition from established competitors and potential new entrants, many of which have greater financial, engineering, manufacturing and marketing resources than the Company. The Company expects its competitors will continue to improve the performance of their current products and to introduce new products with improved price and performance characteristics. In addition, continuing consolidation in the semiconductor equipment industry, and potential future consolidation, could adversely affect the ability of smaller companies, such as the Company, to compete with larger, integrated competitors. New product introductions by the Company's competitors or by new market entrants could cause a decline in sales or loss of market acceptance of the Company's existing products. Increased competitive pressure could also lead to intensified price-based competition, resulting in lower prices which could adversely affect the Company's business, financial condition and operating results. The Company believes that to remain competitive it must invest significant financial resources in new product development and expand its customer service and support worldwide. There can be no assurance that the Company will be able to compete successfully in the future. The semiconductor equipment industry is intensely competitive. Significant competitive factors in the semiconductor equipment market include 23
price, technical capabilities, quality, delivery lead-time, flexibility, automation, cost of ownership, reliability, throughput and customer service. In each of the markets it serves, the Company faces competition from established competitors and potential new entrants, many of which have greater financial, engineering, manufacturing and marketing resources than the Company. Because the Company's MTX system performs burn-in and many of the functional tests performed by traditional memory testers, the MTX system faces intense competition from burn-in system suppliers and traditional memory tester suppliers. The market for burn-in systems is highly fragmented, with many domestic and international suppliers. Some users, such as independent test labs, build their own burn-in systems, and some other users, particularly large Japanese IC manufacturers, acquire burn-in systems from captive or affiliated suppliers. Competing suppliers of burn-in and functional test systems include Advantest Corporation, Reliability Incorporated and Dong-Il Corporation. The Company's MAX monitored and dynamic burn-in systems have faced and are expected to continue to face, increasingly severe competition, especially from several regional, low cost manufacturers and from systems manufacturers that offer higher power dissipation per device under test. The Company's FOX full wafer contact system is expected to face competition from larger systems manufacturers that have sufficient technological know-how and manufacturing capability. Competing suppliers of full wafer contact systems include Matsushita Electric Industrial Co., Ltd. and Delta V Instruments, Incorporated. The Company expects that its DiePak products will face significant competition. The Company believes that several companies have developed or are developing products which are intended to enable burn-in and test of bare die. As the bare die market develops, the Company expects that other competitors will emerge. The DiePak products also face severe competition from other alternative test solutions. The Company expects that the primary competitive factors in this market will be cost, performance, reliability and assured supply. Competing suppliers of DiePak products include Yamaichi Electronics Co., Ltd. The Company's test fixture products face numerous competitors. There are limited barriers to entry into the burn-in board ("BIB") market, and as a result, many small companies design and manufacture BIBs, including BIBs for use with the Company's MAX system. The Company's strategy is to provide only certain high performance BIBs, and the Company generally does not compete to supply low cost, low performance BIBs. The Company has a partnership with Pycon, Inc. whereby Pycon, Inc. designs, manufactures and sells the BIBs and the Company provides Pycon, Inc. with system know-how. Both companies jointly market and sell the BIBs and performance test boards ("PTBs"). There can be no assurance that the partnership will be successful. The Company has granted royalty-bearing licenses to several companies to make PTBs for use with the Company's MTX systems, in order to assure customers a second source of supply, and the Company may grant additional licenses as well. Sales of PTBs by licensees result in royalties to the Company but reduce the Company's own sales of PTBs. The Company expects its competitors to continue to improve the performance of their current products and to introduce new products with improved price and performance characteristics. New product introductions by the Company's competitors or by new market entrants could cause a decline in sales or loss of market acceptance of the Company's products. Increased competitive pressure could also lead to intensified price-based competition, resulting in lower prices which could adversely affect the Company's business, financial condition and operating results. The Company believes that to remain competitive it must invest significant financial resources in new product development and expand its customer service and support worldwide. There can 24
be no assurance that the Company will be able to compete successfully in the future. CYCLICALITY OF SEMICONDUCTOR INDUSTRY AND CUSTOMER PURCHASES; RISK OF CANCELLATIONS AND RESCHEDULINGS. The Company's operating results depend primarily upon the capital expenditures of semiconductor manufacturers, semiconductor contract assemblers and burn-in and test service companies worldwide, which in turn depend on the current and anticipated market demand for ICs and products utilizing ICs. The semiconductor and semiconductor equipment industries in general, and the market for DRAMs and other memory devices in particular, historically have been highly volatile and have experienced periodic downturns and slowdowns, which have had severe negative effects on the semiconductor industry's demand for semiconductor capital equipment, including test and burn-in systems manufactured and marketed by the Company. These downturns and slowdowns have adversely affected the Company's operating results in the past. In addition, the purchasing patterns of the Company's customers are also highly cyclical because most customers purchase the Company's products for use in new production facilities or for upgrading existing test lines for the introduction of next generation products. Construction of new facilities and upgrades of existing facilities have in some cases been delayed or canceled during the most recent semiconductor industry downturn. A large portion of the Company's net sales are attributable to a few customers and therefore a reduction in purchases by one or more customers could materially and adversely affect the Company's financial results. There can be no assurance that the semiconductor industry will grow in the future at the same rates as it has grown historically. Any downturn or slowdown in the semiconductor industry would have a material and adverse effect on the Company's business, financial condition and operating results. In addition, the need to maintain investment in research and development and to maintain customer service and support will limit the Company's ability to reduce its expenses in response to any such downturn or slowdown period. The semiconductor equipment manufacturing industry has historically been subject to a relatively high rate of purchase order cancellation by customers as compared to other high technology industry sectors. Manufacturing companies that are the customers of semiconductor equipment companies frequently revise, postpone and cancel capital facility expansion plans. In such cases, semiconductor equipment companies may experience a significant rate of cancellations and reschedulings of purchase orders. There can be no assurance that the Company will not be materially and adversely affected by future cancellations and reschedulings. DEPENDENCE ON SUBCONTRACTORS; SOLE OR LIMITED SOURCES OF SUPPLY. The Company relies on subcontractors to manufacture many of the components or subassemblies used in its products. The Company's MTX, MAX and FOX systems and DiePak carriers contain several components, including environmental chambers, power supplies, wafer and die contactors, signal distribution substrates and certain ICs, which are currently supplied by only one or a limited number of suppliers. The Company's reliance on subcontractors and single source suppliers involves a number of significant risks, including the loss of control over the manufacturing process, the potential absence of adequate capacity and reduced control over delivery schedules, manufacturing yields, quality and costs. In the event that any significant subcontractor or single source supplier was to become unable or unwilling to continue to manufacture subassemblies, components or parts in required volumes, the Company would have to identify and qualify acceptable replacements. The process of qualifying subcontractors and suppliers could be lengthy, and no assurance can be given that any additional sources would be available to the Company on a timely basis. Any delay, interruption or termination of a supplier relationship could have a material and adverse effect on the Company's business, financial condition and operating results. POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the Company's Common Stock has been, and may continue to be, extremely volatile. The 25
Company believes that factors such as announcements of developments related to the Company's business, fluctuations in the Company's operating results, failure to meet securities analysts' expectations, general conditions in the semiconductor and semiconductor equipment industries and the worldwide economy, announcement of technological innovations, new systems or product enhancements by the Company or its competitors, fluctuations in the level of cooperative development funding, acquisitions, changes in governmental regulations, developments in patents or other intellectual property rights and changes in the Company's relationships with customers and suppliers could cause the price of the Company's Common Stock to fluctuate substantially. In addition, in recent years the stock market in general, and the market for small capitalization and high technology stocks in particular, has experienced extreme price fluctuations which have often been unrelated to the operating performance of affected companies. Such fluctuations could adversely affect the market price of the Company's Common Stock. MANAGEMENT OF CHANGING BUSINESS. If the Company is to be successful, it must expand its operations. Such expansion will place a significant strain on the Company's administrative, operational and financial resources. Further, such expansion will result in a continuing increase in the responsibility placed upon management personnel and will require development or enhancement of operational, managerial and financial systems and controls. If the Company is unable to manage the expansion of its operations effectively, the Company's business, financial condition and operating results will be materially and adversely affected. DEPENDENCE ON KEY PERSONNEL; ABILITY TO ATTRACT AND RETAIN SKILLED PERSONNEL. The Company's success depends to a significant extent upon the continued service of Rhea Posedel, its Chief Executive Officer, as well as other executive officers and key employees. The Company does not maintain key person life insurance for its benefit on any of its personnel, and none of the Company's employees is subject to a non-competition agreement with the Company. The loss of the services of any of its executive officers or a group of key employees could have a material and adverse effect on the Company's business, financial condition and operating results. The Company's future success will depend in significant part upon its ability to attract and retain highly skilled technical, management, sales and marketing personnel. There is a limited number of personnel with the requisite skills to serve in these positions, and it has become increasingly difficult for the Company to hire such personnel. Competition for such personnel in the semiconductor equipment industry is intense, and there can be no assurance that the Company will be successful in attracting or retaining such personnel. The Company's inability to attract and retain the executive management and other key personnel it requires will limit its ability to expand its business and would have a material and adverse effect on the Company's business, financial condition and operating results. INTELLECTUAL PROPERTY PROTECTION AND INFRINGEMENT. The Company's ability to compete successfully is dependent in part upon its ability to protect its proprietary technology and information. Although the Company attempts to protect its proprietary technology through patents, copyrights, trade secrets and other measures, there can be no assurance that these measures will be adequate or that competitors will not be able to develop similar technology independently. These competitors would then be able to offer services and develop, manufacture and sell products, which compete directly with the Company's services and products. In that case, the Company's revenues and operating results could decline. Further, there can be no assurance that claims allowed on any patent issued to the Company will be sufficiently broad to protect the Company's technology, that any patent will issue from any pending application or that foreign intellectual property laws will protect the Company's intellectual property. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the U.S., and many companies have encountered significant problems in protecting their proprietary rights in 26
these foreign countries. These problems can be caused by, for example, a lack of rules and processes allowing for meaningfully defending intellectual property rights. If the Company does not adequately protect its intellectual property, competitors may be able to practice the Company's technologies and erode the Company's competitive advantage, and the Company's business and operating results could be harmed. Litigation may be necessary to enforce or determine the validity and scope of the Company's proprietary rights, and there can be no assurance that the Company's intellectual property rights, if challenged, will be upheld as valid. Such litigation could result in substantial costs and diversion of resources and could have a material and adverse effect on the Company's business, financial condition and operating results, regardless of the outcome of the litigation. In addition, there can be no assurance that any of the patents issued to the Company will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide competitive advantages to the Company. The Company will be able to protect its proprietary rights from unauthorized use by third parties only to the extent that the Company's proprietary technologies are covered by valid and enforceable patents or are effectively maintained trade secrets. There are no pending claims against the Company regarding infringement of any patents or other intellectual property rights of others. However, the Company may receive, in the future, communications from third parties asserting intellectual property claims against the Company. Such claims could include assertions that the Company's products infringe, or may infringe, the proprietary rights of third parties, requests for indemnification against such infringement or suggestions that the Company may be interested in acquiring a license from such third parties. There can be no assurance that any such claim made in the future will not result in litigation, which could involve significant expense to the Company, and, if the Company is required or deems it appropriate to obtain a license relating to one or more products or technologies, there can be no assurance that the Company would be able to do so on commercially reasonable terms, or at all. ENVIRONMENTAL REGULATIONS. Federal, state and local regulations impose various controls on the use, storage, discharge, handling, emission, generation, manufacture and disposal of toxic or other hazardous substances used in the Company's operations. The Company believes that its activities conform in all material respects to current environmental and land use regulations applicable to its operations and its current facilities and that it has obtained environmental permits necessary to conduct its business. Nevertheless, the failure to comply with current or future regulations could result in substantial fines being imposed on the Company, suspension of production, alteration of its manufacturing processes or cessation of operations. Such regulations could require the Company to acquire expensive remediation equipment or to incur substantial expenses to comply with environmental regulations. Any failure by the Company to control the use, disposal or storage of, or adequately restrict the discharge of, hazardous or toxic substances could subject the Company to significant liabilities. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS The Company considered the provisions of Financial Reporting Release No. 48 "Disclosures of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments, and Disclosures of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Commodity Instruments." The Company had no holdings of derivative financial or commodity instruments at August 31, 2005. The Company is exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. The Company invests excess cash in a managed portfolio of corporate and government bond instruments with maturities of 18 months or less. The Company does not use 27
any financial instruments for speculative or trading purposes. Fluctuations in interest rates would not have a material effect on the Company's financial position, results of operations and cash flows. A majority of the Company's revenue and capital spending is transacted in U.S. Dollars. The Company, however, enters into transactions in other currencies, primarily Japanese Yen. Substantially all sales to Japanese customers are denominated in Yen. Since the price is determined at the time a purchase order is accepted, the Company is exposed to the risks of fluctuations in the Yen-U.S. Dollar exchange rate during the lengthy period from purchase order to ultimate payment. This exchange rate risk is partially offset to the extent that the Company's Japanese subsidiary incurs expenses payable in Yen. To date, the Company has not invested in instruments designed to hedge currency risks. In addition, the Company's Japanese subsidiary typically carries debt or other obligations due to the Company that may be denominated in either Yen or U.S. Dollars. Since the Japanese subsidiary's financial statements are based in Yen and the Company's financial statements are based in U.S. Dollars, the Japanese subsidiary and the Company recognize foreign exchange gain or loss in any period in which the value of the Yen rises or falls in relation to the U.S. Dollar. A 10% decrease in the value of the Yen as compared with the U.S. Dollar would not be expected to result in a significant change in the net income or loss. Item 4. CONTROLS AND PROCEDURES Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. Changes in internal controls over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART II - OTHER INFORMATION Item 1. LEGAL PROCEEDINGS None. Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None. Item 3. DEFAULTS UPON SENIOR SECURITIES None. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Item 5. OTHER INFORMATION None. 28
Item 6. EXHIBITS The Exhibits listed on the accompanying "Index to Exhibits" are filed as part hereof, or incorporated by reference into, the report. 29
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Aehr Test Systems (Registrant) Date: October 14, 2005 /s/ RHEA J. POSEDEL --------------- Rhea J. Posedel Chief Executive Officer and Chairman of the Board of Directors Date: October 14, 2005 /s/ GARY L. LARSON -------------- Gary L. Larson Vice President of Finance and Chief Financial Officer 30
AEHR TEST SYSTEMS INDEX TO EXHIBITS Exhibit No. Description - ---------- ------------ 31.1 Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002. 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 31