1
See accompanying notes to condensed consolidated financial statements.
2
3
4
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)
(1) General
(2) Reclassifications
(3) Stock-Based Compensation
Selling, general and administrative expenses
Stock-based compensation expense before income tax benefit
5
6
(5) Acquisitions
7
Fair value of net tangible assets acquired
(6) Accounts Receivable
(7) Inventories
8
Accrued expenses and other current liabilities consist of the following:
(9) 2.0% Convertible Senior Notes
9
(10) Stock Option Plans and Employee Stock Purchase Plan
10
(11) Customer and Geographic Information
Sales by geography and customer type, as a percentage of consolidated net sales, are as follows:
11
12
13
(13) Intangible Assets
(14) Legal Proceedings
14
(15) Recent Accounting Pronouncements
15
(16) Condensed Consolidating Financial Information
16
17
18
19
20
21
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Certain information in this Quarterly Report on Form 10-Q contains forward-looking statements, including but not limited to, information relating to our future performance and financial condition, our plans and objectives and our assumptions regarding such future performance, financial condition, plans and objectives that involve certain significant known and unknown risks and uncertainties and other factors not under our control which may cause actual results, future performance and financial condition, and achievement of our plans and objectives to be materially different from the results, performance or other expectations implied by these forward-looking statements. These factors include the timing of receipt of, and our performance on, new orders that can cause significant fluctuations in net sales and operating results, the timing and funding of government contracts, adjustments to gross profits on long-term contracts, risks associated with international sales, rapid technological change, evolving industry standards, frequent new product announcements and enhancements, changing customer demands, changes in prevailing economic and political conditions, and other factors described herein and in our other filings with the Securities and Exchange Commission (“SEC”).
OVERVIEW
We design, develop, produce and market innovative products, systems and services for advanced communications solutions. We believe many of our solutions play a vital role in providing or enhancing communication capabilities when terrestrial communications infrastructure is unavailable or ineffective.
We conduct our business through three complementary segments: telecommunications transmission, mobile data communications and RF microwave amplifiers. We sell our products to a diverse customer base in the global commercial and government communications markets. We believe we are a leader in the market segments that we serve.
Our telecommunications transmission segment, which is currently our largest business segment, provides sophisticated equipment and systems that are used to enhance satellite transmission efficiency and that enable wireless communications in environments where terrestrial communications are unavailable, inefficient or too expensive. Our mobile data communications segment provides customers with an integrated solution, including mobile satellite transceivers and satellite network support, to enable global satellite-based communications when mobile, real-time, secure transmission is required for applications including logistics, support and battlefield command and control applications. Our RF microwave amplifiers segment designs, manufactures and markets solid-state, high-power, broadband RF microwave amplifier products.
A substantial portion of our sales may be derived from a limited number of relatively large customer contracts, the timing of revenues from which cannot be predicted. Quarterly and period-to-period sales and operating results may be significantly affected by one or more of such contracts. In addition, our gross profit is affected by a variety of factors, including the mix of products, systems and services sold, production efficiencies, estimates of warranty expense, price competition and general economic conditions. Our gross profit may also be affected by the impact of any cumulative adjustments to contracts that are accounted for under the percentage-of-completion method. Accordingly, we can experience significant fluctuations in sales and operating results from quarter-to-quarter and period-to-period comparisons may not be indicative of future performance.
Revenue from the sale of our products is generally recognized when the earnings process is complete, upon shipment or customer acceptance. Revenue from contracts relating to the design, development or manufacturing of complex electronic equipment to a buyer’s specification or to provide services relating to the performance of such contracts is recognized using the percentage-of-completion method. Revenue from contracts that contain multiple elements that are not accounted for under the percentage-of-completion method are accounted for in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” Revenue from these contracts is allocated to each respective element based on each element’s relative fair value and is recognized when the respective revenue recognition criteria for each element are met.
22
Our contract with the United States (“U.S.”) Army for the Movement Tracking System (“MTS”) is for an eight-year period ending in July 2007 with a warranty period that we anticipate will continue through our fiscal 2011. Revenue recognition is based on the percentage-of-completion method. The gross margin is based on the estimated sales and expenses (including warranty costs) for the entire eight-year contract. The amount of revenue recognized has been limited to the amount of funded orders received from the U.S. Army. We recognize service time revenue based on a network availability method which recognizes prepaid service time on a straight-line basis from the date of shipment through the end of the contract term in July 2007. In May 2007, the U.S. Army’s Contracting Office released a Presolicitation Notice to announce that it anticipates extending our MTS contract on a sole source basis. The Presolicitation Notice indicates that the estimated dollar value of the proposed contract extension could be $646.3 million over a three-year period. We have not yet received the customer’s proposed contract terms. If the MTS contract is ultimately not renewed or extended, or if we fail to succeed in a recompete process, should one occur, it would have a material adverse effect on our business and results of operations.
In August 2006, we acquired certain assets and assumed certain liabilities of Insite Consulting, Inc. (“Insite”), a logistics application software company, for $3.2 million, including transaction costs of $0.3 million, plus certain earn-out payments based on the achievement of future sales targets. The first part of the earn-out cannot exceed $1.4 million and is limited to a five-year period. The second part of the earn-out, which is for a ten-year period, is unlimited and based on a per unit future sales target primarily relating to new commercial satellite-based mobile data communication markets. Insite has developed the geoOps™ Enterprise Location Monitoring System, a software-based solution that allows customers to integrate legacy data systems with near-real time logistics and operational data systems. Sales and income relating to the Insite assets acquired would not have been material to our results of operations for the three and nine months ended April 30, 2006 and were not material for the three and nine months ended April 30, 2007. This operation was combined with our existing business and is part of the mobile data communications segment.
In February 2007, we acquired certain assets and assumed certain liabilities of Digicast Networks, Inc. (“Digicast”), a manufacturer of digital video broadcasting equipment, for $1.0 million. Sales and income relating to the Digicast assets acquired would not have been material to our results of operations for the three and nine months ended April 30, 2006 and were not material for the three and nine months ended April 30, 2007. This operation was combined with our existing business and is part of the telecommunications transmission segment.
CRITICAL ACCOUNTING POLICIES
We consider certain accounting policies to be critical due to the estimation process involved in each.
Revenue Recognition on Long-Term Contracts. Revenues and related costs from long-term contracts relating to the design, development or manufacturing of complex electronic equipment to a buyer’s specification or to provide services relating to the performance of such contracts are recognized using the percentage-of-completion method. Revenue is recognized based on the relationship of total costs incurred to total projected costs, or, alternatively, based on output measures, such as units delivered. Profits expected to be realized on such contracts are based on total estimated sales for the contract compared to total estimated costs, including warranty costs, at completion of the contract. These estimates are reviewed and revised periodically throughout the lives of the contracts, and adjustments to profits resulting from such revisions are made cumulative to the date of the change. Estimated losses on long-term contracts are recorded in the period in which the losses become evident.
Some of our largest contracts, including our MTS contract with the U.S. Army, are accounted for using the percentage-of-completion method. We have been engaged in the production and delivery of goods and services on a continual basis under contractual arrangements for many years. Historically, we have demonstrated an ability to accurately estimate revenues and expenses relating to our long-term contracts. However, there exist inherent risks and uncertainties in estimating revenues, expenses and progress toward completion, particularly on larger or longer-term contracts. If we do not accurately estimate the total sales, related costs and progress towards completion on such contracts, the estimated gross margins may be significantly impacted or losses may need to be recognized in future periods. Any such resulting changes in margins or contract losses could be material to our results of operations and financial position.
In addition, most government contracts have termination for convenience clauses that provide the customer with the right to terminate the contract at any time. Such terminations could impact the assumptions regarding total contract revenues and expenses utilized in recognizing profit under the percentage-of-completion method of accounting. Changes to these assumptions could materially impact our results of operations and financial position. Historically, we have not experienced material terminations of our long-term contracts.
23
We also address customer acceptance provisions in assessing our ability to perform our contractual obligations under long-term contracts. Our inability to perform on our long-term contracts could materially impact our results of operations and financial position. Historically, we have been able to perform on our long-term contracts.
Accounting for Stock-Based Compensation. As discussed further in “Notes to Condensed Consolidated Financial Statements – Note (3) Stock-Based Compensation,” we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R) on August 1, 2005 using the modified prospective method.
We have used and expect to continue to use the Black-Scholes option pricing model to compute the estimated fair value of stock-based awards. The Black-Scholes option pricing model includes assumptions regarding dividend yield, expected volatility, expected option term and risk-free interest rates. The assumptions used in computing the fair value of stock-based awards reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. We estimate expected volatility by considering the historical volatility of our stock, the implied volatility of publicly traded stock options in our stock and our expectations of volatility for the expected term of stock-based compensation awards. As a result, if other assumptions or estimates had been used for options granted to date, the stock-based compensation expense that was recorded for the three and nine months ended April 30, 2007 and 2006 could have been materially different. Furthermore, if different assumptions are used in future periods, stock-based compensation expense could be materially impacted in the future.
Impairment of Goodwill and Other Intangible Assets. As of April 30, 2007, our goodwill and other intangible assets, aggregated $30.6 million. In assessing the recoverability of goodwill and other intangibles, we must make various assumptions regarding estimated future cash flows and other factors in determining the fair values of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets in future periods. Any such resulting impairment charges could be material to our results of operations.
Provision for Warranty Obligations. We provide warranty coverage for most of our products, including products under long-term contracts. We record a liability for estimated warranty expense based on historical claims, product failure rates and other factors. Some of our warranties are provided under government contracts, the costs of which are incorporated into our estimates of total contract costs. There exist inherent risks and uncertainties in estimating warranty expenses, particularly on larger or longer-term contracts. Accordingly, if we do not accurately estimate our warranty costs, any changes to our original estimates could be material to our results of operations and financial position.
Accounting for Income Taxes. Our deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities, applying enacted tax rates expected to be in effect for the year in which the differences are expected to reverse. The provision for income taxes is based on domestic and international statutory income tax rates in the tax jurisdictions where we operate, permanent differences between financial reporting and tax reporting and available credits and incentives. Significant judgment is required in determining income tax provisions and tax positions. We may be challenged upon review by the applicable taxing authority and positions taken by us may not be sustained. We provide tax reserves for tax exposures relating to periods subject to audit. The development of reserves for these exposures requires consideration of timing and judgments about tax issues and potential outcomes, and is a subjective critical estimate. In certain circumstances, the ultimate outcome of exposures and risks involves significant uncertainties. If actual outcomes differ materially from these estimates, they could have a material impact on our results of operations and our financial position.
Provisions for Excess and Obsolete Inventory. We record a provision for excess and obsolete inventory based on historical and future usage trends. Several factors may influence the sale and use of our inventories, including decisions to exit a product line, technological change and new product development. These factors could result in a change in the amount of excess and obsolete inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if we determine that our inventory was overvalued, we would be required to recognize such costs in our financial statements at the time of such determination. Any such charges could be material to our results of operations and financial position.
24
Allowance for Doubtful Accounts. We perform credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness, as determined by our review of our customers’ current credit information. Generally, we will require cash in advance or payment secured by irrevocable letters of credit before an order is accepted from an international customer that we do not do business with regularly. In addition, we seek to obtain insurance for certain international customers. We monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the allowances established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and the financial health of specific customers. Changes to the estimated allowance for doubtful accounts could be material to our results of operations and financial position.
COMPARISON OF THE RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED APRIL 30, 2007 AND APRIL 30, 2006
Net Sales. Consolidated net sales were $119.4 million and $89.0 million for the three months ended April 30, 2007 and 2006, respectively, representing an increase of $30.4 million, or 34.2%. The increase in net sales reflects growth in the telecommunications transmission and mobile data communications segments, partially offset by lower sales, as anticipated, in the RF microwave amplifiers segment.
Net sales in our telecommunications transmission segment were $56.2 million and $46.9 million for the three months ended April 30, 2007 and 2006, respectively, an increase of $9.3 million, or 19.8%. The increase in net sales in this segment primarily reflect increased sales of our over-the-horizon microwave systems which were higher due to deliveries of our new 16 Mbps troposcatter modem upgrade kits for use on the U.S. Department of Defense’s (“DoD”) AN/TRC-170 digital troposcatter terminals. Sales of our over-the-horizon microwave systems, both direct and indirect, to a North African country end-customer were lower during the three months ended April 30, 2007 as we believe the end-customer is between major phases of a large program. Sales of our over-the-horizon microwave systems can fluctuate dramatically from period to period based on the receipt of large contracts and our performance thereon. Although sales of our satellite earth station products did increase slightly year-over-year, bookings during the three months ended April 30, 2007 were lower than expected. We believe this was most likely due to the inherent order flow fluctuations that exist in any communications technology book and ship business. Although we remain confident that long-term demand drivers for our satellite earth station products remain strong, it is currently difficult to assess whether or not future bookings will meet or exceed the levels experienced earlier in fiscal 2007. Our telecommunications transmission segment represented 47.1% and 52.7% of consolidated net sales for three months ended April 30, 2007 and 2006, respectively.
Net sales in our mobile data communications segment were $55.0 million and $32.8 million for the three months ended April 30, 2007 and 2006, respectively, an increase of $22.2 million, or 67.7%. The increase in net sales was primarily due to an increase in deliveries to the U.S. Army and Army National Guard for ongoing support of MTS program activities. This increase was partially offset by a decline in sales of $4.1 million related to the impact of our decision, made in fiscal 2006, to significantly de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. Net sales during the three months ended April 30, 2007 were also positively impacted by $4.6 million relating to the MTS gross profit adjustment discussed below. Our mobile data communications segment represented 46.1% and 36.8% of consolidated net sales for the three months ended April 30, 2007 and 2006, respectively.
Our MTS contract expires in July 2007. In May 2007, the U.S. Army’s Contracting Office released a Presolicitation Notice to announce that it anticipates extending our MTS contract on a sole source basis. The Presolicitation Notice indicates that the estimated dollar value of the proposed contract extension could be $646.3 million over a three-year period. We have not yet received the customer’s proposed contract terms. If the MTS contract is not renewed or extended, or if we fail to succeed in a recompete process should one occur, it would have a material adverse effect on our business and results of operations. Because of the uncertainty as to the ultimate amount and timing of additional U.S. Army and Army National Guard orders that we could receive, our sales and profitability can continue to fluctuate dramatically.
Net sales in our RF microwave amplifiers segment were $8.2 million for the three months ended April 30, 2007, compared to $9.3 million for the three months ended April 30, 2006, a decrease of $1.1 million, or 11.8%. The decrease in net sales is primarily attributable to orders currently in backlog which are not expected to ship until future periods, including the fourth quarter of our fiscal 2007. Our RF microwave amplifiers segment represented 6.8% and 10.5% of consolidated net sales for the three months ended April 30, 2007 and 2006, respectively.
25
International sales (which include sales to U.S. companies for inclusion in products which are sold to international customers) represented 23.0% and 33.5% of consolidated net sales for the three months ended April 30, 2007 and 2006, respectively. Domestic commercial sales represented 11.2% and 22.0% of consolidated net sales for the three months ended April 30, 2007 and 2006, respectively. Sales to the U.S. government (including sales to prime contractors to the U.S. government) represented 65.8% and 44.5% of consolidated net sales for the three months ended April 30, 2007 and 2006, respectively.
Gross Profit. Gross profit was $51.6 million and $34.2 million for the three months ended April 30, 2007 and 2006, respectively, representing an increase of $17.4 million, or 50.9%. The increase in gross profit was primarily attributable to the increase in net sales discussed above, as well as an increase in the gross profit percentage to 43.2% for the three months ended April 30, 2007 from 38.4% for the three months ended April 30, 2006. As discussed below, we recorded a favorable cumulative adjustment to our MTS contract during the three months ended April 30, 2007.
Excluding the impact of the favorable adjustment to our MTS contract, to both net sales and gross profit, as discussed below, our gross profit as a percentage of net sales for the three months ended April 30, 2007 and 2006 would have been 40.9% and 38.4%, respectively. The increase in the gross profit percentage was primarily due to (i) increased gross margins in our telecommunications transmission segment, including the benefit of higher sales of our new 16 Mbps troposcatter modem upgrade kits and (ii) increased operating efficiencies in our mobile data communications segment, including the benefit of our decision to significantly de-emphasize stand-alone sales of low margin turnkey employee mobility solutions.
In our mobile data communications segment, during the three months ended April 30, 2007, we increased the estimated gross profit at completion on the MTS contract, which resulted in a cumulative increase to the gross profit recognized in prior periods of $4.6 million. This adjustment was the result of improved operating efficiencies and increased funding from the U.S. Army and Army National Guard.
Included in cost of sales for the three months ended April 30, 2007 and 2006 are provisions for excess and obsolete inventory of $0.7 million and $0.4 million, respectively. As discussed in our “Critical Accounting Policies – Provisions for Excess and Obsolete Inventory,” we regularly review our inventory and record a provision for excess and obsolete inventory based on historical and projected usage assumptions.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $18.6 million and $15.4 million for the three months ended April 30, 2007 and 2006, respectively, representing an increase of $3.2 million, or 20.8%. The increase in expenses was primarily attributable to higher payroll-related expenses and increased other costs associated with the overall growth of our business. This increase was offset, in part, by lower expenses in our mobile data communications segment as we continue to de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. The increase in payroll-related expenses is due, in part, to the increased headcount associated with the actual year-to-date and anticipated increase in sales for fiscal 2007 compared to fiscal 2006. As a percentage of consolidated net sales, selling, general and administrative expenses were 15.6% and 17.3% for the three months ended April 30, 2007 and 2006, respectively.
Amortization of stock-based compensation expense recorded as selling, general and administrative expenses was $1.5 million and $1.1 million for the three months ended April 30, 2007 and 2006, respectively. This increase is primarily attributable to an increase in both the number and related fair value of stock-based awards that are being amortized over their respective service periods for the three months ended April 30, 2007 as compared to the three months ended April 30, 2006.
26
Research and Development Expenses. Research and development expenses were $8.1 million and $6.1 million for the three months ended April 30, 2007 and 2006, respectively. Approximately $5.0 million and $4.4 million of such amounts, respectively, related to our telecommunications transmission segment, with the remaining expenses primarily related to our mobile data communications segment and, to a lesser extent, our RF microwave amplifiers segment. As a percentage of consolidated net sales, research and development expenses were 6.8% and 6.9% for the three months ended April 30, 2007 and 2006, respectively.
As an investment for the future, we are continually enhancing our existing products and developing new products and technologies. Whenever possible, we seek customer funding for research and development to adapt our products to specialized customer requirements. During the three months ended April 30, 2007 and 2006, customers reimbursed us $1.1 million and $1.0 million, respectively, which is not reflected in the reported research and development expenses, but is included in consolidated net sales with the related costs included in cost of sales.
Amortization of stock-based compensation expense recorded as research and development expenses were $0.3 million and $0.2 million for the three months ended April 30, 2007 and 2006, respectively.
Amortization of Intangibles. Amortization of intangibles for the three months ended April 30, 2007 and 2006 was $0.7 million and $0.6 million, respectively. The amortization primarily relates to intangibles with finite lives that we acquired in connection with various acquisitions (including our acquisitions of Insite and Digicast).
Operating Income. Operating income for the three months ended April 30, 2007 and 2006 was $24.2 million and $12.1 million, respectively. The $12.1 million, or 100.0% increase, was primarily the result of higher sales and gross profit, partially offset by increased operating expenses (including research and development), as discussed above.
Operating income in our telecommunications transmission segment increased to $15.0 million for the three months ended April 30, 2007 from $10.6 million for the three months ended April 30, 2006 as a result of increased net sales and gross profit, partially offset by higher operating expenses.
Our mobile data communications segment generated operating income of $14.5 million for the three months ended April 30, 2007 compared to $4.2 million for the three months ended April 30, 2006. The increase in operating income was primarily due to the increase in net sales, and increased operating efficiencies achieved, including the benefit of lower selling, general and administrative expenses as we continue to de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. As discussed above under “Gross Profit,” included in operating income in the three months ended April 30, 2007 is the positive impact from the cumulative adjustment on our MTS contract of $3.9 million.
Operating income in our RF microwave amplifier segment decreased to $0.8 million for the three months ended April 30, 2007 from $1.1 million for the three months ended April 30, 2006, due primarily to lower net sales during the three months ended April 30, 2007.
Unallocated operating expenses increased to $6.1 million for the three months ended April 30, 2007 from $3.9 million for the three months ended April 30, 2006 due primarily to higher payroll-related expenses, as well as increased other costs associated with growing our business. Amortization of stock-based compensation expense for the three months ended April 30, 2007 and 2006 was $1.9 million and $1.4 million, respectively. This increase is primarily attributable to an increase in both the number and related fair value of stock-based awards that are being amortized over their respective service periods for the three months ended April 30, 2007 as compared to the three months ended April 30, 2006.
Interest Expense. Interest expense was $0.7 million for both the three months ended April 30, 2007 and 2006. Interest expense primarily represents interest associated with our 2.0% convertible senior notes issued in January 2004.
Interest Income. Interest income for the three months ended April 30, 2007 was $3.4 million, as compared to $2.5 million for three months ended April 30, 2006. The $0.9 million increase was due primarily to an increase in interest rates and additional investable cash since April 30, 2006.
27
Provision for Income Taxes. The provision for income taxes was $7.8 million and $5.1 million for the three months ended April 30, 2007 and 2006, respectively. Our effective tax rate was 29.0% and 37.0% for the three months ended April 30, 2007 and 2006, respectively.
The decrease in the effective tax rate was primarily attributable to (i) the passage of legislation, in fiscal 2007, extending the Federal research and experimentation credit, (ii) the approval by our stockholders of an amendment to the 2000 Stock Incentive Plan (the “Plan”) which will permit us to claim tax deductions for cash awards anticipated to be paid under the Plan without limitation under §162(m) of the Internal Revenue Code, (iii) a $1.0 million reduction of income tax reserves that we determined were no longer needed due to the expiration of applicable statutes of limitations, and (iv) $0.6 million of tax benefits primarily associated with an adjustment relating to the differences between the estimates used in the computation of the fiscal 2006 income tax provision and the actual amounts reported in the fiscal 2006 income tax returns. We estimate that our effective tax rate for fiscal 2007, excluding adjustments, will approximate 35.0%.
Our Federal income tax return for the fiscal year ended July 31, 2004 is currently being audited by the Internal Revenue Service. Additional income tax returns for other fiscal years may be examined as well. If the outcome of the audit differs materially from our original income tax provisions, it could have a material adverse effect on our results of operations and financial position.
COMPARISON OF THE RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED APRIL 30, 2007 AND APRIL 30, 2006
Net Sales. Consolidated net sales were $327.9 million and $291.3 million for the nine months ended April 30, 2007 and 2006, respectively, representing an increase of $36.6 million, or 12.6%. The increase in net sales reflects growth in the telecommunications transmission and mobile data communications segments, partially offset by lower sales in the RF microwave amplifiers segment.
Net sales in our telecommunications transmission segment were $170.8 million and $146.8 million for the nine months ended April 30, 2007 and 2006, respectively, an increase of $24.0 million, or 16.3%. The increase in net sales in this segment primarily reflect both increased sales of our satellite earth station products and our over-the-horizon microwave systems which were higher due to deliveries of our new 16 Mbps troposcatter modem upgrade kits for use on the U.S. DoD’s AN/TRC-170 digital troposcatter terminals. Sales of our over-the-horizon microwave systems, both direct and indirect, to our North African country end-customer were lower during the nine months ended April 30, 2007 as we believe the end-customer is between major phases of a large program. Net sales during the nine months ended April 30, 2007 were also positively impacted by $1.2 million relating to a gross profit adjustment on a large over-the-horizon microwave systems contract. Sales in the over-the-horizon microwave systems product line can fluctuate dramatically from period to period based on the receipt of large contracts and our performance thereon. Although sales of our satellite earth station products did increase significantly year-over-year, bookings during the three months ended April 30, 2007 were lower than expected. We believe this was most likely due to the inherent order flow fluctuations that exist in any communications technology book and ship business. Although we remain confident that long-term demand drivers for our satellite earth station products remain strong, it is currently difficult to assess whether or not future bookings will meet or exceed the levels experienced earlier in fiscal 2007. Our telecommunications transmission segment represented 52.1% and 50.4% of consolidated net sales for nine months ended April 30, 2007 and 2006, respectively.
Net sales in our mobile data communications segment were $130.4 million and $108.4 million for the nine months ended April 30, 2007 and 2006, respectively, an increase of $22.0 million, or 20.3%. The increase in net sales was due to an increase in deliveries to the U.S. Army and Army National Guard for ongoing support of MTS program activities and higher sales of battlefield command and control applications to the U.S. military. This increase was partially offset by a decline in sales of $14.3 million related to the impact of our decision, made in fiscal 2006, to significantly de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. Net sales during the nine months ended April 30, 2007 and 2006 were positively impacted by $1.1 million and $5.6 million, respectively, relating to the MTS gross profit adjustments discussed below. Our mobile data communications segment represented 39.8% and 37.2% of consolidated net sales for the nine months ended April 30, 2007 and 2006, respectively.
Our MTS contract expires in July 2007. In May 2007, the U.S. Army’s Contracting Office released a Presolicitation Notice to announce that it anticipates extending our MTS contract on a sole source basis. The Presolicitation Notice indicates that the estimated dollar value of the proposed contract extension could be $646.3 million over a three-year period. We have not yet received the customer’s proposed contract terms. If the MTS contract is not renewed or extended, or if we fail to succeed in a recompete process, should one occur, it would have a material adverse effect on our business and results of
28
operations. Because of the uncertainty as to the ultimate amount and timing of additional U.S. Army and Army National Guard orders that we could receive, our sales and profitability can continue to fluctuate dramatically.
Net sales in our RF microwave amplifiers segment were $26.7 million for the nine months ended April 30, 2007, compared to $36.1 million for the nine months ended April 30, 2006, a decrease of $9.4 million, or 26.0%. The decrease in net sales was due to lower sales, as anticipated, of our amplifiers that are incorporated into improvised explosive device jamming systems. Our RF microwave amplifiers segment represented 8.1% and 12.4% of consolidated net sales for the nine months ended April 30, 2007 and 2006, respectively.
International sales (which include sales to U.S. companies for inclusion in products which are sold to international customers) represented 26.8% and 36.7% of consolidated net sales for the nine months ended April 30, 2007 and 2006, respectively. Domestic commercial sales represented 12.7% and 16.8% of consolidated net sales for the nine months ended April 30, 2007 and 2006, respectively. Sales to the U.S. government (including sales to prime contractors to the U.S. government) represented 60.5% and 46.5% of consolidated net sales for the nine months ended April 30, 2007 and 2006, respectively.
During the nine months ended April 30, 2007 and 2006, one customer, a prime contractor, represented 6.0% and 11.2% of consolidated net sales, respectively. Direct and indirect sales to a North African country (including certain sales to the prime contractor mentioned above) during the nine months ended April 30, 2007 and 2006 represented 3.5% and 11.4% of consolidated net sales, respectively.
Gross Profit. Gross profit was $140.8 million and $115.5 million for the nine months ended April 30, 2007 and 2006, respectively, representing an increase of $25.3 million, or 21.9%. The increase in gross profit was primarily attributable to the increase in net sales discussed above, as well as an increase in the gross profit percentage to 42.9% for the nine months ended April 30, 2007 from 39.7% for the nine months ended April 30, 2006. As discussed below, we recorded favorable cumulative adjustments to certain long-term contracts, which were partially offset by a firmware-related warranty provision in both periods.
Excluding the impact of adjustments to both net sales and gross profit, as discussed below, our gross profit as a percentage of net sales for the nine months ended April 30, 2007 and 2006 would have been 41.1% and 38.9%, respectively. The increase in the gross profit percentage was primarily due to (i) a higher proportion of our consolidated net sales occurring in our telecommunications transmission segment, which typically realizes higher margins than our other two segments; (ii) increased gross margins within our telecommunications segment primarily due to the benefit of higher sales of our new 16 Mbps troposcatter modem upgrade kits, (iii) increased operating efficiencies in our mobile data communications segment, including the benefit of our decision to significantly de-emphasize stand-alone sales of low margin turnkey employee mobility solutions, and (iv) the reduction in our estimated reserve for warranty obligations by $0.7 million due to lower than anticipated claims on a large over-the-horizon microwave system contract whose warranty period has expired.
During the nine months ended April 30, 2007 and 2006, we recorded favorable cumulative gross profit adjustments of $7.5 million (of which $6.4 million related to the mobile data communications segment and $1.1 million related to the telecommunications transmission segment) and $6.1 million (of which $5.5 million related to the mobile data communications segment and $0.6 million related to the RF microwave amplifiers segment), respectively, relating to our ongoing review of total estimated contract revenues and costs, and the related gross margin at completion, on long-term contracts. The adjustments in both periods were partially offset by a firmware-related warranty provision discussed below.
In our mobile data communications segment, during the nine months ended April 30, 2007 and 2006, we increased the estimated gross profit at completion on the MTS contract, which resulted in a cumulative increase to the gross profit recognized in prior periods of $6.4 million and $5.5 million, respectively. These adjustments were the result of increased funding from the U.S. Army and Army National Guard, as well as improved operating efficiencies. Included in cost of sales for the nine months ended April 30, 2007 and 2006 is a firmware-related warranty provision related to modifying units previously shipped to non-MTS customers of $0.4 million and $1.7 million, respectively. As discussed in our “Critical Accounting Policies – Provision for Warranty Obligations,” we periodically review and update our estimate of future warranty expense.
Included in cost of sales for the nine months ended April 30, 2007 and 2006 are provisions for excess and obsolete inventory of $2.3 million and $1.4 million, respectively. As discussed in our “Critical Accounting Policies – Provisions for Excess and Obsolete Inventory,” we regularly review our inventory and record a provision for excess and obsolete inventory based on historical and projected usage assumptions.
29
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $53.5 million and $47.3 million for the nine months ended April 30, 2007 and 2006, respectively, representing an increase of $6.2 million, or 13.1%. The increase in expenses was primarily attributable to higher payroll-related expenses and increased other costs associated with the growth of our business. This increase was offset, in part, by lower expenses in our mobile data communications segment as we continue to de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. The increase in payroll-related expenses is due, in part, to the increased headcount associated with the actual year-to-date and anticipated increase in sales for fiscal 2007 compared to fiscal 2006. As a percentage of consolidated net sales, selling, general and administrative expenses were 16.3% and 16.2% for the nine months ended April 30, 2007 and 2006, respectively.
Amortization of stock-based compensation expense recorded as selling, general and administrative expenses increased to $4.1 million from $3.4 million for the nine months ended April 30, 2007 and 2006, respectively. This increase is primarily attributable to an increase in both the number and related fair value of stock-based awards that are being amortized over their respective service periods for the nine months ended April 30, 2007 as compared to the nine months ended April 30, 2006 partially offset by the favorable impact of a $0.4 million reduction associated with an increase in the estimated forfeiture rate of stock-based awards.
Research and Development Expenses. Research and development expenses were $22.8 million and $18.9 million for the nine months ended April 30, 2007 and 2006, respectively. Approximately $15.0 million and $14.0 million of such amounts, respectively, related to our telecommunications transmission segment, with the remaining expenses primarily related to our mobile data communications segment and, to a lesser extent, our RF microwave amplifiers segment. As a percentage of consolidated net sales, research and development expenses were 7.0% and 6.5% for the nine months ended April 30, 2007 and 2006, respectively.
As an investment for the future, we are continually enhancing our existing products and developing new products and technologies. Whenever possible, we seek customer funding for research and development to adapt our products to specialized customer requirements. During the nine months ended April 30, 2007 and 2006, customers reimbursed us $4.3 million and $2.1 million, respectively, which is not reflected in the reported research and development expenses, but is included in consolidated net sales with the related costs included in cost of sales.
Amortization of stock-based compensation expense recorded as research and development expenses increased to $0.8 million from $0.5 million for the nine months ended April 30, 2007 and 2006, respectively.
Amortization of Intangibles. Amortization of intangibles for the nine months ended April 30, 2007 and 2006 was $2.0 million and $1.8 million, respectively. The amortization primarily relates to intangibles with finite lives that we acquired in connection with various acquisitions (including our acquisitions of Insite and Digicast).
Operating Income. Operating income for the nine months ended April 30, 2007 and 2006 was $62.5 million and $47.6 million, respectively. The $14.9 million, or 31.3% increase, was primarily the result of higher sales and gross profit, partially offset by increased operating expenses (including research and development).
Operating income in our telecommunications transmission segment increased to $47.3 million for the nine months ended April 30, 2007 from $35.9 million for the nine months ended April 30, 2006 as a result of increased net sales and gross profit, partially offset by higher operating expenses. As discussed above under “Gross Profit,” included in operating income for the nine months ended April 30, 2007 is a cumulative adjustment related to a large over-the-horizon microwave systems contract which favorably impacted operating income by $0.9 million.
30
Our mobile data communications segment generated operating income of $28.8 million for the nine months ended April 30, 2007 compared to $16.0 million for the nine months ended April 30, 2006. The increase in operating income was primarily due to the increase in net sales, and operating efficiencies achieved, including the benefit of lower selling, general and administrative expenses as we continue to de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. As discussed above under “Gross Profit,” included in operating income for the nine months ended April 30, 2007 and 2006, are the positive impacts from the cumulative adjustments, net of the respective firmware-related warranty provisions, of $5.2 million and $3.3 million, respectively.
Operating income in our RF microwave amplifier segment decreased to $2.5 million for the nine months ended April 30, 2007 from $7.4 million for the nine months ended April 30, 2006, due primarily to lower net sales during the nine months ended April 30, 2007. As discussed above under “Gross Profit,” included in the nine months ended April 30, 2006, is a cumulative adjustment relating to certain contracts which favorably impacted operating income by $0.5 million.
Unallocated operating expenses increased to $16.2 million for the nine months ended April 30, 2007 from $11.8 million for the nine months ended April 30, 2006 due primarily to higher payroll-related expenses, as well as increased other costs associated with growing our business. Amortization of stock-based compensation expense increased to $5.3 million from $4.2 million for the nine months ended April 30, 2007 and 2006, respectively. This increase is primarily attributable to an increase in both the number and related fair value of stock-based awards that are being amortized over their respective service periods for the nine months ended April 30, 2007 as compared to the nine months ended April 30, 2006 partially offset by the favorable impact of a $0.5 million reduction associated with an increase in the estimated forfeiture rate of stock-based awards.
Interest Expense. Interest expense was $2.1 million and $2.0 million for the nine months ended April 30, 2007 and 2006, respectively. Interest expense primarily represents interest associated with our 2.0% convertible senior notes issued in January 2004.
Interest Income. Interest income for the nine months ended April 30, 2007 was $9.9 million, as compared to $6.4 million for nine months ended April 30, 2006. The $3.5 million increase was due primarily to an increase in interest rates and investable cash since April 30, 2006.
Provision for Income Taxes. The provision for income taxes was $22.2 million and $18.4 million for the nine months ended April 30, 2007 and 2006, respectively. Our effective tax rate was 31.6% and 35.5% for the nine months ended April 30, 2007 and 2006, respectively.
The decrease in the effective tax rate was primarily attributable to (i) the passage of legislation, in fiscal 2007, extending the Federal research and experimentation credit including $0.6 million of tax benefits related to the retroactive application of the credit to fiscal 2006, (ii) the approval by our stockholders of an amendment to the 2000 Stock Incentive Plan (the “Plan”) which will permit us to claim tax deductions for cash awards anticipated to be paid under the Plan without limitation under §162(m) of the Internal Revenue Code, (iii) a $1.0 million reduction of income tax reserves that we determined were no longer needed due to the expiration of applicable statutes of limitations during the three months ended April 30, 2007, and (iv) $0.8 million of tax benefits primarily associated with an adjustment relating to the differences between the estimates used in the computation of the fiscal 2006 income tax provision and the actual amounts reported in the fiscal 2006 income tax returns. Our tax rate for the nine months ended April 30, 2006 was favorably impacted by the recording of a net benefit of $0.6 million primarily relating to the favorable settlement of a state tax matter. We estimate that our effective tax rate for fiscal 2007, excluding adjustments, will approximate 35.0%.
31
LIQUIDITY AND CAPITAL RESOURCES
Our unrestricted cash and cash equivalents increased to $311.0 million at April 30, 2007 from $251.6 million at July 31, 2006.
Net cash provided by operating activities was $65.4 million for the nine months ended April 30, 2007, compared to $9.3 million for the first nine months of fiscal 2006, reflecting an increase in net income and cash collected from customers (including advanced payments received), partially offset by the timing of payments for accounts payable and a decrease in deferred service revenue.
Net cash used in investing activities for the nine months ended April 30, 2007 was $11.6 million, of which $7.7 million was for purchases of property, plant and equipment including expenditures related to the continued expansion of our high-volume technology manufacturing center located in Tempe, Arizona and the continued enhancement of our network operations facility in Germantown, Maryland. During the nine months ended April 30, 2007, we paid $3.9 million relating to our acquisitions of Insite and Digicast.
Net cash provided by financing activities was $5.6 million for the nine months ended April 30, 2007, primarily due to the exercises of stock-based awards.
FINANCING ARRANGEMENT
On January 27, 2004, we issued $105.0 million of our 2.0% convertible senior notes in a private offering pursuant to Rule 144A of the Securities Act of 1933, as amended. The net proceeds from this transaction were $101.2 million after deducting the initial purchaser’s discount and other transaction costs. For further information concerning this financing, see “Notes to Condensed Consolidated Financial Statements – Note (9) 2.0% Convertible Senior Notes.”
COMMITMENTS
In the normal course of business, we routinely enter into binding and non-binding purchase obligations primarily covering anticipated purchases of inventory and equipment. We do not expect that these commitments as of April 30, 2007 will materially adversely affect our liquidity.
At April 30, 2007, we had contractual cash obligations to repay our 2.0% convertible senior notes, capital lease and operating lease obligations (including satellite lease expenditures relating to our mobile data communications segment contracts) and the financing of a purchase of proprietary technology. Payments due under these long-term obligations, excluding interest on the 2% convertible senior notes, are as follows:
As further discussed in “Notes to Condensed Consolidated Financial Statements – Note (9) 2.0% Convertible Senior Notes,” we may, at our option, redeem some or all of the 2.0% convertible senior notes on or after February 4, 2009. Holders of our 2% convertible senior notes will have the right to require us to repurchase some or all of the outstanding notes on February 1, 2011, February 1, 2014 and February 1, 2019 and upon certain events. On the basis of the closing sale prices of our common stock through June 1, 2007, we anticipate that (i) the notes will be convertible during the conversion period of June 15, 2007 through September 14, 2007, and (ii) we will deliver shares of our common stock to note holders who exercise the right to convert during such period.
We have entered into standby letter of credit agreements with financial institutions relating to the guarantee of our future performance on certain contracts. At April 30, 2007, the balance of these agreements was $4.5 million.
32
We believe that our cash and cash equivalents will be sufficient to meet our operating cash requirements for the foreseeable future. In the event that we identify a significant acquisition that requires additional cash, we would seek to borrow funds or raise additional equity capital.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Our earnings and cash flows are subject to fluctuations due to changes in interest rates primarily from our investment of available cash balances. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. If the interest rate we receive on our investment of available cash balances were to change by 10%, our annual interest income would be impacted by approximately $1.5 million.
Our 2.0% convertible senior notes bear a fixed rate of interest. As such, our earnings and cash flows are not sensitive to changes in interest rates on our long-term debt. As of April 30, 2007, we estimate the fair market value of our 2.0% convertible senior notes to be $134.1 million based on recent trading activity.
Item 4. Controls and Procedures
As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures was carried out by the Company under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures have been designed and are being operated in a manner that provides reasonable assurance that the information required to be disclosed by the Company in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. A system of controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. There have been no changes in the Company’s internal controls over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
33
PART IIOTHER INFORMATION
Item 1. Legal Proceedings
See Note (14) of the “Notes to Condensed Consolidated Financial Statements” in Part I, Item 1 of this Form 10-Q for information regarding certain legal proceedings.
Item 1A. Risk Factors
There have been no material changes from the risk factors previously disclosed in the Company’s Form 10-K for the fiscal year ended July 31, 2006 or the Company’s Form 10-Q for the fiscal quarter ended January 31, 2007.
Item 6. Exhibits
34
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.
COMTECH TELECOMMUNICATIONS CORP.(Registrant)
35