United States SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ( X ) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year end December 31, 1998 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ___________ Commission file number: 0-28082 KVH Industries, Inc. (Exact name of Registrant as specified in its charter) Delaware 05-0420589 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 50 Enterprise Center, Middletown, RI 02842 (Address of principal executive offices) (Zip code) (401) 847-3327 (Registrant's telephone number including area code) Securities registered pursuant to Section 12(b) of the Act: None. Securities registered pursuant to section 12(g) of the Act: Common Stock, $0.01 par value, per share. (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No __ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ( ). As of March 23, 1999, the aggregate market value of the voting stock held by non-affiliates of the Registrant was $7,096,642 based upon a total of 4,125,955 shares held by non-affiliates and the last sale price on that date of $1.72. As of March 23, 1999, the number of shares outstanding of the Registrant's common stock was 7,205,928. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Company's definitive Proxy Statement relating to the 1999 Annual Meeting of Shareholders are incorporated by reference into Part III of this Report on Form 10-K. The Company anticipates that its definitive Proxy Statement will be filed with the Securities and Exchange Commission within 120 days after the end of the Company's fiscal year end December 31, 1998.
INDEX TO FORM 10-K <TABLE> <CAPTION> <S> <C> PART I <C> Page Item 1. Business 3 Item 2. Properties 8 Item 3. Legal Proceedings 9 Item 4. Submission of Matters to a Vote of Security Holders 9 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters 9 Item 6. Selected Financial Data 10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 7A. Market Risk Disclosure 16 Item 8. Financial Statements and Supplementary Data 16 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 16 PART III Item 10. Directors and Executive Officers of the Registrant 16 Item 11. Executive Compensation 16 Item 12. Security Ownership of Certain Beneficial Owners and Management 16 Item 13. Certain Relationships and Related Transactions 16 PART IV Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K 17 </TABLE> "Safe Harbor" statement under the Private Securities Litigation Reform Act of 1995 With the exception of historical information, the matters discussed in this Annual Report on Form 10-K include certain forward-looking statements that involve risks and uncertainties. Among the risks ands uncertainties to which the Company is subject are product life cycles, technological change, the Company's relationship with its significant customers, market acceptance of new product offerings, reliance on outside resources such as satellite networks, dependence on key personnel, fluctuations in annual and quarterly performance and worldwide economic conditions. As a result the actual results realized by the Company could differ materially from the statements made herein. Shareholders of the Company are cautioned not to place undue reliance on forward-looking statements made in the Annual Report on Form 10-K or in any document or statement referring to this Annual Report on Form 10-K. For a more detailed discussion of risks and uncertainties, see "Management's Discussion and Analysis of Financial Condition and Results of Operations--Forward Looking Statements."
PART I Item 1. Business. Overview KVH Industries, Inc. ("KVH" or the "Company") was organized in Rhode Island in 1978 and was reincorporated in Delaware on August 16, 1985. The Company completed its initial public offering in April 1996. The Company's executive offices are located at 50 Enterprise Center, Middletown, RI, and its telephone number is (401) 847-3327. Unless the context otherwise requires, references to KVH or the Company include KVH Industries, Inc. and its Danish sales subsidiary. KVH utilizes its proprietary fiber optic, autocalibration and fluxgate technologies to produce sensor systems with multiple market applications. The Company currently sells its sensors as integrated components of navigation and satellite communications systems for mobile marine and land applications in the commercial, military and original equipment manufacturers ("OEM") markets. KVH's digital navigation systems provide accurate, real-time heading, orientation, position and pointing information. The Company's satellite communications systems provide two-way voice, fax and data connections and deliver television and certain data via direct broadcast satellite (DBS) services. Since introducing the world's first commercial digital fluxgate compass in 1982, KVH has demonstrated a commitment and the ability to continually advance the capabilities and applications of its sensors and the systems into which they are integrated. KVH first enhanced its stand-alone compass for sailing vessels by developing proprietary software that automatically calibrated the system. The Company further increased its marine product capabilities by incorporating Global Positioning System ("GPS") compatibility for precise location data, adding gyroscopes to measure pitch, roll and yaw, enhancing display readability and designing compact, integrated systems that interface with other navigation devices and sensors. By continually advancing product applications and designing components to meet the needs of new customer groups, such as powerboat owners, the Company broadened its reach in the marine market. To support its international marketing of marine navigation products, the Company has established a broad network of international distributors and in 1991 established KVH Europe A/S in Hoersholm, Denmark. In its first foray into the land navigation market, KVH developed militarized versions of its electronic compasses and began supplying them to the United States Navy for amphibious vehicles in 1988. To expand its land navigation product capabilities and market depth, the Company combined its sensor and autocalibration technologies into fully integrated systems. In 1991, the United States Marine Corps used KVH self-calibrating compasses for on-board military land vehicle navigation during the Persian Gulf War. Subsequently, the Company achieved increased accuracy and capabilities in its land mobile navigation systems through GPS integration, incorporating navigation capabilities for turreted armored vehicles and, ultimately, producing a fully integrated tactical navigation system that provides heading, location and targeting data to military vehicle commanders. Tactical navigation and digital compass systems are sold directly to the United States Department of Defense and the armed forces of other countries in Europe and the Middle East. Major defense contractors, including United Defense LP and General Motors Corporation, also incorporate KVH navigation products in manufacturing military land vehicles. Sensor technologies were further leveraged when the Company created and introduced in 1993 an active-stabilized antenna-aiming system that maintains a continuous satellite link from moving platforms. KVH combined its sensors and software to integrate real-time heading, orientation and position data and then position the antenna to compensate for the ongoing, often severe directional changes that vessels experience at sea. Initially, the antennas were used for mobile marine voice transmission via Inmarsat M satellites. Ongoing advances in satellite capabilities provide KVH with a continual flow of product opportunities, as demonstrated by Inmarsat's launch of its mini-M satellite constellation. The higher-powered mini-M satellites made it possible for the Company to develop and in 1997 launch a system that is significantly smaller and costs less per minute than earlier products while delivering mobile voice, fax and data access worldwide. Further technological advances led to the 1998 introduction of one of the smallest and lowest-cost fully stabilized marine telephony systems available for Inmarsat mini-M service. In a parallel expansion of its stabilized antenna technology, in 1994 the Company introduced its first TracVision(R) system to enable mobile television reception via direct broadcast satellite ("DBS") providers. Additional development efforts led to the 1998 launch of the world's smallest fully stabilized antenna for mobile marine television reception with systems designed for reception in North America and Europe. Also in 1998, the Company exploited its TracVision capabilities and took a major step in enabling broadband data delivery by offering users access to real-time stock market and weather information. Most recently, KVH developed an advanced TracVision system that incorporates the Company's newest digital gyro compass to provide vessel navigation capabilities in addition to antenna control. The Company also has developed a system for mobile television reception from land vehicles such as recreational vehicles (RVs) and motor coaches. Mobile communications products are marketed through the Company's third-party distributor network. KVH enhanced its sensor capabilities in 1997 by acquiring the assets of the fiber optic sensor group of Andrew Corporation. With no moving parts, fiber optic sensors offer the benefits of long and stable operation and a lack of sensitivity to shock and acceleration that makes them valuable in a broad range of environments. For example, integrated fiber optic gyroscopes (FOGs) have the ability to significantly increase heading and location accuracy at a lower cost than comparable tactical navigation systems. Combining FOGs and the TracVision control system can potentially enable highly accurate antenna pointing for the impending X-, K- or Ka-band communication systems that will provide ultra-high data rate transmissions. FOGs also have potential applications in military navigation, turret stabilization, merchant vessel navigation, precision agriculture, aviation flight control and positive train control. Fiber optic products are manufactured at the Company's Tinley Park, Illinois, facility and some development efforts are conducted at a St. Petersburg, Florida, facility. Company Products KVH has determined that there are significant opportunities for its sensor-based systems in the mobile communications market where the worldwide growth in demand for audio, data and video accessibility is eliciting significant growth in satellite availability. Advantages that satellites offer over land-based communications technologies include rapid service implementation, broad market reach that is independent of customer density, global access for mobile travelers throughout the world and broadband capabilities. Bandwidth on demand is required for delivering television, high-speed data and multimedia (e.g., Internet access, corporate networking and video conferencing) services. KVH is using its core sensor, robotic and software technologies to develop systems that are synergistic with the escalating demand for mobile communications applications and that benefit from the related growth in satellite availability. The Company also recognizes that mobile users need, and are seeking, integrated, simplified access to those capabilities. As a result, the Company focuses on designing turnkey and OEM systems in the areas of broadcast, datacast and telephony. A key component of KVH communications products is the Company's proprietary three-axis, fully stabilized antenna, which maintains satellite contact with geostationary satellites when a vessel or vehicle platform is in motion. The antennas use a KVH digital gyro compass and inclinometer to measure precisely the pitch, roll and yaw of an antenna platform in relation to the earth. The Company's proprietary stabilization and control software and on-board microprocessors use that data to compute the antenna movement necessary to maintain satellite contact and then transmit precise motor control instructions to aim the antenna. KVH has designed its antennas to permit rapid initial acquisition of the satellite signal without operator intervention. KVH sells two telephony systems, Tracphone 25 and Tracphone 50, to mobile users worldwide. The Company introduced Tracphone 25 in 1998 and that year the system was named Best Satellite Telephone System by the National Marine Electronics Association ("NMEA"). Tracphone 50, which was introduced in 1997, is used primarily on larger vessels such as fishing boats and bulk carrier fleets. Basic prices for the systems are $7,000 and $8,000, respectively. Tracphones deliver voice, fax and data via the mini-M satellite constellation operated by Inmarsat (the International Maritime Satellite Organization), a consortium of 79 countries that operate a network of geostationary satellites providing worldwide communications services through mobile terminals on air, sea and land. The per-minute airtime rates for mini-M service, which average $2.40 compared to Iridium's voice-only service for $5.00-$9.00 and Inmarsat's A/B services for $7.00, gives the Company an additional competitive edge. Under a new 1998 co-marketing agreement with American Mobile Satellite Corporation ("AMSC"), the Company also offers customers AMSC's cost-effective SKYCELL services with certain Tracphone sales. As a result of the collaborative agreement, KVH has become an authorized SKYCELL Agent and is supporting both hardware sales and services for AMSC Tracphones. The Tracphones covered by the agreement were produced under an earlier $10.2-million contract with AMSC and these units have been incorporated into KVH's telephony line. AMSC Tracphones range in price from $5,500 to $6,900 and SKYCELL service covers as far north as the Bering Sea and as far south as the northern tip of South America, including all of the Caribbean. Since SKYCELL service costs are significantly lower than global Inmarsat service, KVH telephone customers can benefit from a more cost-effective service for North American coverage and use mini-M service for global coverage. Distributors in the KVH network sell AMSC packages for SKYCELL Satellite Telephone Services and the Company is using its dealer base to promote Tracphone and service package sales. A three-year agreement between KVH and Station 12 to co-market Tracphone 50 and Altus service will end in August 2000. KVH markets all of its communication products through a broad network of more than 260 national and international dealers. KVH also sells DBS antenna systems for mobile television and data reception. Marine systems include TracVision II, which was named Best Satellite Television System by NMEA in 1998, for coverage in North America and TracVision(R) 45 for coverage in a range of European countries. In North America, TracVision II users can choose to subscribe to a variety of services from any of three DBS providers: DIRECTV(R), a subsidiary of GM Hughes Electronics, U.S. Satellite Broadcasting, Inc. ("USSB(R)") and EchoStar(R). TracVision 45 provides television reception via Astra and Hotbird satellite service to mariners in Europe, primarily in the coastal waterways of Germany, The Netherlands, Belgium, France and sections of the United Kingdom. With TracVision antennas, mariners can access such provider services as laser disc quality television, subscription programming, pay-per-view services and CD-quality audio channels. KVH introduced TracVision II in 1997 and launched TracVision 45 in 1998. The Company is developing a TracVision II upgrade that incorporates an optional KVH GyroTrac that controls antenna pointing and integrates with other electronic systems such as radar and autopilots. TracVision turnkey systems range in price from $5,000 to $7,100. Service activation capabilities are built in and costs depend upon which packages a user selects when establishing service with the provider. KVH plans to introduce TracVision LM, its first land mobile satellite communications product and another evolution in the Company's stabilized antenna product line, in 1999 at a cost of $2,995. TracVision LM is designed to integrate with television systems to deliver DBS channels to on-the-move recreational and sports utility vehicles, motor coaches, vans, mini-vans and long-haul trucks. KVH also sells sensor-based products into marine and military markets. Compass systems utilize the Company's digital fluxgate heading sensor to sample the surrounding magnetic field and output precise heading data. These signals are relayed to an on-board microprocessor, where filtering and averaging algorithms developed by the Company translate the output to stable heading information. The Company's proprietary autocalibration software continuously and automatically compensates for the effects of magnetic interference. In highly dynamic applications where greater accuracy and fully stabilized heading output is required, KVH integrates the sensor with one or more angular rate gyros and inclinometers. This integration provides three-dimensional error correction and stabilization capabilities previously available only from more costly systems. The Company is integrating FOG sensors into its navigation and communication product lines to create enhanced systems with broader market potential. The Azimuth GyroTrac introduced in 1998 is the successor to the Company's Azimuth Digital Gyro Compass, which the NMEA named Best Gyro Compass in 1998. The newly designed system incorporates in one package multiple navigation capabilities that previously were available as options, thereby reducing the overall cost to customers and making installation easier and more efficient. NMEA also selected the Company's Azimuth 1000 as Best Electronic Compass in 1998. In addition to its Azimuth product line, the Company sells Sailcomp digital compass systems, the Quadro line of integrated instrument systems and DataScope, a hand-held compass and rangefinder that also is used in outdoor, military, technical, sporting and commercial applications. In the military market, KVH sells TACNAV systems in a variety of configurations ranging from a simple GPS-compatible compass system with a single commander's display to a complete, integrated system that provides full tactical navigation and targeting capabilities and includes up to three separate commander's, gunner's and driver's displays. TACNAV systems are installed in a variety of light-armored fleets, including the United States AAV-7, LAV-25 and Bradley ODS, the Swedish Army's CV90 fleet and the Canadian Army's RECCE and APC. Several new TACNAV orders that contributed modest revenues in 1998 have potential for more significant sales going forward. The United States Army extended its TACNAV use by installing systems in National Guard vehicles, the first deployment that expanded upon the initial contracted applications. TACNAV systems also were selected in 1998 as a key component for testing in the U.S. Army's Task Force XXI Battle Command Brigade and Below (FBCB2) program. FBCB2 is the digital battlefield effort that the Army has underway to provide battlefield commanders with comprehensive, real-time digital information, electronic coordination and situational awareness through an integrated tactical computer system. Also in 1998, the United States Marine Corps selected TACNAV Light systems for a rebuild of AAV-7's. With the aid of Small Business Innovation Research (SBIR) grants awarded in 1998, the Company is integrating fiber-optic components to enhance the performance of TACNAV systems. KVH is developing ToFOG Navigator, a next-generation upgrade to TACNAV, to offer the military increased accuracy in pointing and targeting over the TACNAV system. ToFOG Navigator also is designed to solve the problem of GPS jamming, which the United States military has identified as an existing and growing problem with potentially serious consequences in battlefield situations. The Company is integrating GPS, FOGs and accelerometer sensors to create a three-axis, non-magnetic fiber optic gyroscope that will deliver reliable, highly accurate navigation and targeting capabilities in mobile environments. The system is designed to increase bandwidth, improve accuracy and ensure the continuous delivery of attitude and azimuth functions even when GPS is blocked at less cost than existing inertial systems. KVH also sells its FOG sensors and a variety of digital heading sensors, stabilized gyro compasses, rate sensors, inclinometers, sensing coils and other standard sensors and sensor systems to a variety of commercial OEMs. Sales and Marketing. The Company sells its sensor products and systems through a variety of channels, including a direct sales force and a network of dealers, value-added resellers, distributors and sales representatives. KVH's commercial and recreational marine navigation products are sold through a domestic dealer network of more than 400 catalog chain outlets, including West Marine, Boaters' World and Boat U.S., more than 200 technical marine electronics value-added resellers, over 60 overseas distributors, and are supported through an independent manufacturer's sales representative network in all domestic sales regions. KVH markets its military navigation products to the armed forces of the United States and other countries and to OEM manufacturers through a direct sales force, distributors and sales representatives. The Company also uses its direct sales force, distributors and sales representatives to sell embedded sensors and sensor systems to a broad range of OEM manufacturers, including Lockheed, Harris and Raytheon. A world-wide network of technical dealers and distributors established by KVH sells the Company's antenna-aiming systems directly to both OEM manufacturers of satellite telephone transceivers and as turnkey systems to end-users. FOG sensors are sold directly to OEM customers through the same distribution system that the Company utilizes to sell its commercial digital sensors. The Company's agreements with its dealers, value added resellers, distributors and sales representatives generally are non-exclusive. The Company's products are sold in Europe through KVH Europe A/S and elsewhere in the world through a network of distributors. Until recently, a significant portion of the Company's sales depended on a small number of customers placing large orders. During 1998 the Company made significant progress in shifting its communication revenues towards stronger direct sales and away from a predominance of OEM sales, a strategy that the Company initiated in 1997. The Company expects this strategy to replace sporadic and notable variances in sales revenues with a more level revenue stream from repeat orders and a broader customer base, particularly in the communications industry. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations Forward Looking Statements-Risk Factors.") Backlog. The Company includes in its backlog only firm orders for which it has accepted a written purchase order. Many of the Company's orders are subject to cancellation, generally without penalties. In particular, the Company's military orders can generally be canceled at any time for the convenience of the customer, without penalty other than recovery of the Company's actual costs incurred through the date of cancellation. The Company's revenue from commercial and recreational marine markets is derived primarily from sales to non-stocking distributors, retail chains, OEMs and other resellers who require short lead times for delivery of products to end-users. The Company manufactures its products on a just-in-time basis. Customers may cancel or reschedule orders without significant penalty and the prices of products may be adjusted between the time the purchase order is booked into backlog and the time the product is shipped to the customer. For these reasons, the Company believes that its backlog in general, and its backlog of commercial and recreational marine orders in particular, are not necessarily meaningful in predicting the Company's actual revenue for any future period. The Company's backlog at December 31 was $3.0 million in both 1998 and 1997. The Company expects to ship all its backlog at December 31, 1998, during 1999. The Company's total backlog at December 31, 1998 includes $2.0 million in military navigation system orders and $1.0 million in mobile satellite communication and FOG product orders. The Company's total backlog at December 31, 1997 included $1.4 million in military navigation system orders and $1.6 million in mobile satellite communication and FOG product orders. Research and Development. The Company's research and development efforts are based on its core sensor technologies and focused on developing new products that will have broad application across existing and anticipated strategic markets while improving performance and reducing manufacturing costs for products in the market. A substantial portion of the Company's research and development expenditure is devoted to basic research for core technology development projects. The Company's research and development activities fall into two categories: internally funded research and development and customer-funded research and development. The Company has financed virtually all of the cost of developing the Company's marine navigation and satellite communications products. However, much of the funding used to develop KVH's products for the military navigation market, in which a significant engineering effort to develop enhanced features requested by the customer is frequently involved, has been derived from government sources. Development of the Company's core sensor technologies has also been subsidized to a large extent by grants under the United States government's SBIR program. Customer-funded research and development is included in cost of sales. The Company's total expenditures for research and development during 1998, 1997 and 1996 were as follows: Year ended December 31, 1998 1997 1996 ( in thousands) Internally funded research and development $3,991 3,175 2,431 Customer funded research and development 936 630 869 Total research and development $4,927 3,805 3,300 Manufacturing. The Company's manufacturing operations consist primarily of final assembly and test of products, materials procurement management and quality assurance. The Company manufactures a unique, proprietary optical fiber and certain subassemblies and components, such as fluxgate and fiber optic sensor coils. The Company contracts with third parties for some services, such as the fabrication and assembly of printed circuit boards, injection-molded plastic parts and machined metal components. KVH believes there are a number of acceptable vendors for most components and third-party services used in manufac-turing its products and the Company actively evaluates and selects suppliers for quality, dependability and cost effective-ness. In some instances where KVH has obtained certain components and services from a sole source to maintain quality control or develop a strategic supplier relationship supplier, the Company has experienced production delays due to insufficient supplies, delivery delays, poor quality control or failure to meet design requirements. Future shortages, delays or other problems could adversely affect production and, consequently, Company operating results. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Statements-Risk Factors.") Competition. The Company encounters significant competition in each of its markets. In the mobile satellite antenna-aiming market, the Company faces competition with its antenna systems primarily from SeaTel Corporation, which manufactures and markets a broad line of marine satellite communications and satellite tracking equipment, including antenna systems for Inmarsat and DBS-TV applications. For large dish marine satellite systems, SeaTel has greater marketing experience and a larger installed base than the Company. A second competitor, Datron Corporation, provides a stabilized antenna design for RV and marine reception of DBS-TV that competes with the company's turnkey DBS products. Other competitors include Nera Corporation and Westinghouse, plus a few smaller manufacturers of active stabilized antenna-aiming systems that may in the future develop antenna-aiming systems or other mobile satellite communications systems or equipment. The Company's satellite phone products also could be affected adversely by the advent of hand-held worldwide satellite voice, data and fax services provided by companies such as Iridium World Communications, Ltd., Globalstar Telecommunications Ltd. and ICO Global Communications. Iridium, the only hand-held system currently on the market, offers voice service only and the costs per minute exceed those available through KVH's Inmarsat service by as much as 75 percent. KVH believes that there are certain mobile applications where hand-held systems will be ineffective and that the Company's antennas will be required. The Company has determined that the principal bases of competition in the satellite communications market are system performance, reliability, antenna size, cost and customer support. In the market for military vehicle tactical navigation systems, the Company competes with a large number of domestic and international companies that produce dead-reckoning, inertial, GPS-based, or radio-based navigation systems and systems that provide integrated magnetic heading and GPS navigation capabilities. Most of these competitors have more experience than the Company in manufacturing and marketing products for the military marketplace. The Company believes that the principal bases of competition in the market for military land vehicle navigation systems are: product performance; field reliability; ease and flexibility of installation, maintenance and field modification; size and weight of the unit; size and stability of the vendor; and price. In the commercial and recreational marine navigation market, the Company's principal competitors include a large number of domestic and international companies that manufacture and market stand-alone digital compasses, digital heading sensors and integrated instrument systems. The Company believes that the principal bases of competition in the commercial and recreational marine navigation market include product design and performance; flexibility and ease-of-use; product quality and the quality of customer support; and vendor reputation. The Company's fiber optic gyro and embedded sensors compete with products of a large number of companies that pro-duce magnetic sensors and gyroscopic rate sensors for sale in the OEM market. A number of these sensors are less accurate and substantially less expensive than the Company's products. Some larger competitors in the gyroscopic rate sensor market are Litton Corporation and Honeywell Corporation. Intellectual Property The Company's ability to compete effectively depends to a significant extent on its ability to protect its proprietary information. The Company relies primarily on trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. The technology licenses on which the Company relies include an angular rate gyro license from Etak, Inc. and a license from Thomson Consumer Electronics, Inc. relating to certain consumer electronic components. The Company has 27 issued United States patents covering the Company's core sensor and fiber optic technologies. The Company intends to seek further patents on its technology, if appropriate. In addition to patents, the Company registers its product brand names and trademarks in the U.S. and other key markets where the company does business around the world. Expiration of the Company's patents and trademarks range from March 3, 2000, to April 7, 2015. The Company generally enters into confidentiality agreements with its consultants, key employees and sales representatives and generally controls access to and distribution of its technology, software and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's products or technology without authorization, or to develop similar technology independently. Also, the Company has delivered certain technical data and information to the United States government under procurement contracts, and the United States government may have unlimited rights to use such technical data and information or to authorize others to use such technical data and information. Employees As of December 31, 1998, the Company employed 154 full-time employees. The decline in total employees from 191 at December 31, 1997, is due primarily to a 1998 restructuring when the Company reduced staff levels, reengineered processes and streamlined job responsibilities. KVH utilizes the services of temporary or contract personnel within all functional areas to assist on project-related activities. The Company generally enters into non-disclosure agreements with temporary or contract personnel or firms to protect the confidentiality of its proprietary technology. The Company believes its future success will depend in large part upon the continued service of its key technical and senior management personnel and upon the Company's continuing ability to attract and retain highly qualified technical and managerial personnel. None of the Company's employees are represented by a labor union. The Company has not experienced any work stoppage and considers its relationship with its employees to be good. Government Regulation The Company's manufacturing operations are subject to various laws governing the protection of the environment. These laws and regulations are subject to change, and such change may require the Company to improve technology or incur expenditures to comply with such laws and regulation. The Company believes that it complies in all material respects with applicable environmental laws and regulations and does not expect that any costs in connection with complying with such laws or regulations will have a material effect on the Company's results of operations, financial position or liquidity. The Company is subject to compliance with the United States Export Administration Regulations. Because some of the Company's products have military or strategic applications, some products are on the Munitions List of the International Trafficking in Arms Regulations ("ITAR") or are subject to a requirement for an individual validated license from the Department of Commerce in order to be exported to certain jurisdictions. Under the Exon-Florio Amendment to the Defense Production Act of 1950, the United States President has authority to investigate and unwind any investment by foreign persons that could result in foreign control of an entity, if the President determines that foreign control would threaten national security. Item 2. Properties. The Company's executive offices, administration, product development and manufacturing facilities are housed in two adjacent buildings in Middletown, Rhode Island containing approximately 75,000 and 6,000 square feet. The Company occupies the smaller of the two facilities under a lease that expires in September 1999 and purchased the larger facility in May 1996. KVH relocated operations into the wholly owned, larger facility in 1997 and subsequently made a one-time payment of $210,000 to reduce the leased space in its smaller facility to 6,000 square feet from approximately 30,000 square feet. The smaller facility is being used as a warehouse for Tracphone inventory and may be rendered idle as product ships. The Company utilized approximately $4.0 million of the proceeds of its 1996 public offering to purchase and build out the wholly owned 75,000-square-foot building to accommodate manufacturing and operations needs. The Company's fiber optic sensor group occupies approximately 23,000 square feet in a Tinley Park, Illinois, facility under a seven-year lease agreement that began April 1, 1998. The cost to build out the facility was approximately $800,000 and the initial annual rent is $152,121 with a 3% escalation each year thereafter. Item 3. Legal Proceedings. In the ordinary course of business, the Company is a party to legal proceedings and claims. In addition, from time to time, the Company has contractual disagreements with certain customers concerning the Company's products and services. In the opinion of the Company's management, none of the current matters or proceedings, when ultimately concluded, are likely to have a material adverse effect on the results of operations or financial position of the Company and its subsidiary taken as a whole. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise. PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's common stock has traded on the NASDAQ National Market under the symbol KVHI since April 8, 1996. As of [ ??], 1999, there were [ ] holders of record of the Company's Common Stock. The Company has never declared or paid any cash dividends on its Common Stock and does not intend to pay cash dividends on its Common Stock in the foreseeable future. The Company intends to retain earnings for reinvestment in its business. The Company's stock commenced trading on April 2, 1996 at $6.50. On March 23, 1999, the closing sale price for the Company's Common Stock was $1.75. 1998 1997 ---------------------- ---------------------- High Low High Low First Quarter 6.25 3.25 8.00 6.25 Second Quarter 4.00 2.13 10.00 5.00 Third Quarter 3.50 1.75 9.50 7.13 Fourth Quarter 2.06 0.88 8.13 3.75
Item 6. Selected Financial Data. The following selected financial data is derived from the Company's financial statements. This data should be read in conjunction with Item 8, Financial Statements and Supplementary Data, and with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. <TABLE> <CAPTION> Year Ended December 31, <S> <C> <C> <C> <C> <C> 1998 1997 1996 1995 1994 (in thousands, except per share data) Consolidated Statement of Operations: Net sales $ 20,630 25,570 25,687 14,150 8,565 Cost of goods sold 14,100 14,085 14,607 8,447 5,082 ------------ ------------ ------------ ------------ -------------- Gross profit 6,530 11,485 11,080 5,703 3,483 Operating expenses: Research and development 3,991 3,175 2,431 1,279 727 Sales and marketing 4,470 3,738 3,040 2,494 1,652 General and administrative 2,225 1,895 1,624 1,058 763 ------------ ------------ ------------ ------------ -------------- Operating (loss) profit (4,156) 2,677 3,985 872 341 Other (income) expense: Interest (income) expense, net (57) (327) (278) 27 60 Other (income) expense (27) (95) 14 20 (172) (Gain) loss on currency translation (198) (138) 50 (4) (44) ------------ ------------ ------------ ------------ -------------- (Loss) income before income tax (benefit) expense (3,874) 3,237 4,199 829 497 Income tax (benefit) expense (1,608) 1,020 1,743 (365) (48) ------------ ------------ ------------ ------------ -------------- Net (loss) income $ (2,266) 2,217 2,456 1,194 545 ============ ============ ============ ============ ============== Per share information (1): Net (loss) income per common share - basic $ (0.32) 0.31 0.39 0.25 0.11 ============ ============ ============ ============ ============== Net (loss) income per common share - diluted $ (0.32) 0.30 0.35 0.21 0.09 ============ ============ ============ ============ ============== Weighted average number of shares outstanding: Basic 7,124 7,049 6,370 4,862 4,970 ============ ============ ============ ============ ============== Diluted 7,124 7,498 7,055 5,710 5,851 ============ ============ ============ ============ ============== December 31, 1998 1997 1996 1995 1994 (dollars in thousands) Consolidated Balance Sheet Data: Working capital $ 8,486 12,410 12,570 3,214 2,110 Total assets 18,746 21,805 21,544 7,931 3,644 Long-term obligations (2) 0 7 61 113 579 Total shareholders' equity 17,070 19,194 16,563 3,654 2,451 </TABLE> (1) See note 1 of Notes to Consolidated Financial Statements for an explanation of the method of calculation. (2) Includes obligations under capital leases. See notes 6 and 15 of Notes to Consolidated Financial Statements.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Overview KVH Industries, Inc. (the "Company") derives its revenues from sensor products and systems sold to a range of commercial, military and OEM markets in the communications and navigation industries. The Company's products include: stabilized antenna systems for mobile satellite applications such as voice, fax and data transmission and television reception; positional and heading systems for tactical military applications in amphibious and land vehicles and for commercial applications in land vehicles; digital compasses and instrument systems for recreational, commercial and military applications; and embedded fiber optic sensors. The Company's in-house sales and marketing groups have established a worldwide network of independent sales representatives and distributors to market the Company's products. The majority of the Company's sales, product distribution and customer service is conducted at the Company's headquarters in Middletown, Rhode Island, and the European market is managed through the Company's subsidiary in Hoersholm, Denmark. The Company's manufacturing process consists primarily of light assembly and final test, which is conducted at its facilities in Middletown, Rhode Island, and Tinley Park, Illinois. There was a notable impact on sales in 1998 as the Company completed its first full fiscal year following a strategic marketing shift towards direct sales with repeat orders and away from dependence upon large, one-time OEM sales. The Company implemented the new strategy in mid-1997 to replace the significant revenue fluctuations caused by non-recurring large sales, particularly of its sensor-based products for communications applications, with repeat sales that would provide a more consistent revenue stream. A decrease in military orders during 1998 was related to customary funding procedures that commonly cause periodic sales fluctuations in the defense industry. Fiber optic gyro (FOG) sales did not meet internal expectations, primarily because the Company withdrew its CPS(TM)-based BusNav(TM) system from the mass transportation market when the cost of supplying full-service support to customers buying product at OEM prices became financially counter-productive. The Company has determined that there are greater opportunities for CPS systems in other markets such as precision agriculture, power sensors, trains and robotics. Results of Operations The following table sets forth, for the periods indicated, certain financial data as a percentage of total revenues: Year Ended December 31, 1998 1997 1996 Net sales 100.0% 100.0% 100.0% Gross profit 31.7 45.0 43.2 Research and development 19.3 12.4 9.5 Sales and marketing 21.7 14.6 11.8 General and administrative 10.8 7.4 6.3 Operating (loss) profit (20.1) 10.6 15.6 Interest income, net (0.3) (1.3) (1.0) Other income, net (0.1) (0.3) 0.0 (Gain) loss on currency translation ( 1.0) (0.5) 0.2 (Loss) income before income tax (benefit) expense (18.7) 12.7 16.4 Income tax (benefit) expense (7.8) 4.0 6.8 Net (loss) income (10.9)% 8.7% 9.6% Years Ended December 31, 1998 and 1997 Net Sales. Net sales decreased to $20.6 million in 1998 from $25.6 million in 1997, primarily due to an anticipated fluctuation in military orders and an unexpected lack of FOG revenues that would have offset lower defense sales. FOG revenues were adversely affected by KVH's decision to remove its CPS products from the bus navigation market and focus on other markets that the Company believes have significantly more sales potential. Product sales were $19.6 million in 1998 and $24.6 million in 1997 with customer-funded research at $1.0 million in both 1998 and 1997. Communications revenues increased 27% in 1998 to $6.6 million from $5.2 million in 1997 as strong growth in direct sales of turnkey mobile satellite systems continued to supplant previous non-recurring OEM sales. Navigation sales were $14.0 million in 1998 compared to $20.3 million in 1997, a 31% decrease attributable to a decline in high-margin military contracts that adversely affected gross profits. Fiber optic sensor sales constituted $1.7 million or 12% of 1998 navigation revenues. This compares to fiber optic revenues of $0.4 million for the two-month period in 1997 following the Company's October 30 acquisition of the fiber optic group assets from Andrew Corporation. Cost of Goods Sold. The Company's cost of goods sold consists primarily of direct labor, material and indirect manufacturing costs and includes customer-funded research and development costs of $0.9 million in 1998 and $0.6 million in 1997. Cost of goods sold as a percentage of net sales increased to 68% in 1998 from 55% in 1997 due to a proportional decrease in higher-margin military product sales. In addition, fiber optic manufacturing costs exceeded fiber optic revenues to negatively impact gross margins by $0.7 million. Manufacturing overheads increased to $3.8 million in 1998 from $2.8 million in 1997 as the company moved its fiber optic group from the former Andrew Corporation site to a new facility in Tinley Park, Illinois. Excluding fiber optic facility and manufacturing costs of $1.5 million, overhead would have decreased 11 percent in 1998 from 1997. The Company anticipates that cost of goods sold will be level or decrease slightly in 1999 as a result of increased manufacturing efficiencies and expected sales increases in high-margin military products. Research and Development Expense. Research and development expense consists primarily of direct labor and material, labor and material overhead and other direct costs associated with the Company's internally funded product development efforts. The Company expenses all of its software development costs in the period incurred. Research costs increased 25 percent to $4.0 million in 1998 from $3.2 million in 1997 due to costs for developing new directional antenna systems and $1.4 million for fiber optic sensor integration and development. Total research and development expenditures, including customer-funded product development expenditures included in cost of goods sold, were $4.9 million in 1998 and $3.8 million in 1997, a 29% increase that reflects general growth in Company-funded research expenditures. The Company expects ongoing growth in research and development expenses as it continues to develop advanced-capability products for tactical navigation and broadband communications. Sales and Marketing Expense. Sales and marketing expense consists primarily of salaries and related expenses for sales and marketing personnel, sales commissions, travel expenses, cooperative advertising, sales literature, advertising and trade shows. Sales and marketing costs grew 22% to $4.5 million in 1998 from $3.7 million in 1997. Major factors contributing to the growth of sales expenses were staffing, travel and new product introduction costs. The Company anticipates that sales and marketing expense will continue to grow to promote expected new-product introductions. General and Administrative Expense. General and administrative expense consists primarily of costs attributable to the Company's management, finance, accounting and human resources operations and legal and other professional services. Administrative costs increased 16% to $2.2 million in 1998 from $1.9 million in 1997, primarily due to staffing and increased professional fees related to maintaining the Company's patent portfolio. Interest income. Interest income reflects the interest earned by investing excess cash in Federal short-term obligations. Gain on Foreign Currency Translation. The results of operations of the Company's foreign subsidiary, KVH Europe, are determined by re-measuring its foreign currency-denominated operations as if they had taken place in United States dollars. Gains and losses resulting from this translation are included in the Company's net income. The translation gain increase to $0.2 million in 1998 from $0.1 million in 1997 reflects changes in the relative strength of the United States dollar in relation to the Danish krone. Income Tax (Benefit) Expense. The Company realized an income tax benefit in the amount of $1.6 million in 1998 as compared with income tax expense of $1.0 million in 1997, due to the Company's 1998 operating loss. The Company's effective tax rate in both years was positively affected by the utilization of state and Federal research and development and investment tax credits.
Years Ended December 31, 1997 and 1996 Net Sales. Net sales decreased slightly to $25.6 million in 1997 from $25.7 million in 1996. Product sales were$24.6 million in both 1997 and 1996 while customer-funded research was $1.0 and $1.1 million in 1997 and 1996, respectively. Navigation sales grew 28% to $20.3 million in 1997 from $15.9 million in 1996. Navigation sales increases resulted primarily from a $3.8 million or 40% increase in navigation defense shipments. Communications sales were $5.2 million in 1997, a decrease of 47% from $9.8 million in 1996. The anticipated decreases in communication revenues reflected a large non-recurring OEM sale amounting to $5.6 million in 1996 that was somewhat off-set by direct sales of turnkey mobile satellite communications systems that increased to just under $1.0 million in 1997 from $0.1 million in 1996. Cost of Goods Sold. Cost of goods sold includes customer-funded research and development costs of $0.6 million in 1997 and $0.9 million in 1996. Cost of goods sold decreased to 55% as a percentage of net sales in 1997 from 57% as a percentage of net sales in 1996 due to a 17% mix shift to higher-margin navigation sales. Manufacturing overheads increased to $2.8 million in 1997 from $1.9 million in 1996 somewhat off-setting the gains in product cost of sales. Factors contributing to the manufacturing overhead increase included fiber optic sensor start-up costs and a one-time lease modification charge. Research and Development Expense. Research costs increased to $3.2 million or 33% in 1997 from $2.4 million in 1996. Costs of Company-funded product development accounted for $0.6 million of the 1997 increase while fiber optic start-up costs accounted for the remainder of the increase. Total research and development expenditures, including customer-funded product development expenditures included in cost of goods sold, were $3.8 million in 1997 and $3.3 million in 1996, reflecting the expected decline in customer-funded research. Sales and Marketing Expense. Sales and marketing costs grew to $3.7 million or 23% in 1997 from $3.0 million in 1996. Major factors contributing to the growth of sales expenses were staffing, travel and new product introduction costs. General and Administrative Expense. Administrative costs increased to $1.9 million or 19% from 1996 spending of $1.6 million, in response to fiber optic start-up costs, increased professional fees and staffing costs. Interest income. The proceeds of the public offering in April 1996 fully funded the Company's operating and capital requirements in 1997. Other (Income) Expense. Other income increased $0.1 million in 1997 from 1996 primarily due to the award of a new-hire training grant from the state of Rhode Island. (Gain) Loss on Foreign Currency Translation. The translation gain of $0.1 million in 1997 and the loss of $0.05 million in 1996 reflect changes in the relative strength of the United States dollar in relation to the Danish krone. Income Tax Expense. The Company's income tax expense decreased to $1.0 million in 1997 from $1.7 million in 1996. The decrease in income taxes was attributable to the utilization of state and federal research and development and investment tax credits. The Company's effective tax rate in 1997 was 31.5% as a percentage of taxable income versus 41.5% in 1996. Liquidity and Capital Resources <TABLE> <CAPTION> Year ended December 31, ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> 1998 Change 1997 Change 1996 (in thousands) Cash and cash equivalents $ 1,239 (74%) 4,758 (32%) 7,006 Working capital 8,486 (32%) 12,410 (1%) 12,570 </TABLE> The Company financed its 1998 operations and fixed asset acquisitions of approximately $1.6 million dollars through a combination of short-term bank revolving lines of credit and the remaining proceeds from its public offering. In January 1999, the Company borrowed approximately $3 million pursuant to a 10-year mortgage note agreement and mortgage on its facility at 50 Enterprise Center, Middletown, Rhode Island (see note 15 of Notes to Consolidated Financial Statements).
The Company believes that existing cash balances, amounts available under its revolving credit facility and funds generated from the mortgage will be sufficient to meet anticipated liquidity and working capital requirements for 1999. If the Company decides to expand more rapidly, to broaden or enhance its products more rapidly, to acquire businesses or technologies or to make other significant expenditures to remain competitive, then it may need to raise additional funds. Other Matters Recent Accounting Pronouncements. The Financial Accounting Standards Board ("FASB") recently issued Statement of Financial Accounting Standards Number 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 establishes accounting and reporting standards for derivative instruments and hedging, requiring recognition of all derivatives as either assets or liabilities in the statement of financial position measured at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The effect of adopting SFAS 133 is not expected to have a material impact on the Company's financial condition, results of operations or cash flows. Year 2000 - The Company has evaluated the impact of the year 2000 issue as it relates to its navigation and communications products, both sold or intended to sell, and has concluded that the Company's products are not affected by year 2000 operating issues. The Company has also assessed its software and computer systems ensuring that its computer software and hardware are year 2000 compliant. The most significant element of this process is the upgrading of its enterprise resource planning system at a cost estimated at less than $1 million, of which approximately $0.4 million has been spent to date. The Company is contacting its customers, suppliers, and financial institutions, with which it does business, to ensure that any year 2000 issue is resolved. While there can be no assurance that the systems of other companies will be year 2000 compliant, the Company has no knowledge of any such third party year 2000 issues that would result in a material adverse affect on its operations. Should the Company become aware of any such situation, contingency plans will be developed. The Company could be adversely affected should the Company or other entities with whom the Company conducts business be unsuccessful in resolving year 2000 issues in a timely manner. The Company estimates that it was 90% complete at December 31, 1998, in implementing its new system and believes it will be year 2000 compliant by the first half of 1999. The Company believes the cost of becoming year 2000 compliant will not have a material adverse effect on the Company's financial condition, results of operations or liquidity. Inflation. The Company believes that inflation has not had a material effect on its results of operations. Forward Looking Statements - Risk Factors This "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements that are subject to a number of risks and uncertainties. Among the important factors that could cause actual results to differ materially from those anticipated by the statements made above are the following: The Company's products target two industries that are subject to volatility, risks and uncertainties. The communications industry is experiencing rapid growth fueled by strong worldwide demand and buffeted by competing formats and rapid, unpredictable technology changes. The defense industry historically experiences variability in supply and demand related to international conditions, national politics, budget decisions and technology changes, all of which are difficult or impossible to predict. Factors in both industries could affect the Company's ability to effectively meet prevailing market conditions. To position itself in these uncertain industries, the Company has taken a number of steps that include, but are not limited to: acquisition of the fiber optic technology and development of new related products; ongoing analysis of potential technology advances; staff reductions and reallocations; improved operational efficiencies; inventory reduction; recruiting key personnel and implementing cost controls. There can be no assurance that the objectives of these development and cost-reduction activities will be achieved. Other factors that could cause actual results to differ materially from the results anticipated by management include: Dependence on New Products and the Marine Mobile Satellite Communications Market. The Company's future sales growth will depend to a considerable extent upon the successful introduction of new mobile satellite communications products for use in marine and land applications, and those introductions will be affected by a number of variables including, but not limited to: market potential and penetration; reliability of outside vendors; satellite communications service providers' financial abilities and products; regulatory issues; maintaining appropriate inventory levels; disparities between forecast and realized sales; and design delays and defects. The occurrence of any of these factors could have a material adverse effect on the Company's business, financial condition and results of operations. FOG Acquisition. The additional personnel and operating expenses associated with the acquisition of FOG technology and assets from Andrew Corporation in October 1997 added significant costs to the Company's 1998 operations. As the Company continues the process of integrating FOG sensors into current product offerings and identifying new, untapped markets for existing FOG products, it expects FOG-related costs to remain level or increase. Although the Company believes these opportunities show great promise, to date the Company has been successful in marketing only small quantities of products and it does not anticipate that FOG-enhanced products will provide significant revenues for the next 9 to 12 months. The Company is designing its FOG-enhanced products to meet what it believes are customer performance and price criteria; however, at this early stage of product development and market introduction the Company can provide no assurance that these objectives will be met or that competing technologies will not be developed that may supercede FOG technology. The occurrence of any of these factors could have a material adverse effect on the Company's business, financial condition and results of operations. Variability of Quarterly Operating Results. The Company's quarterly operating results have varied in the past and may vary significantly in the future depending upon all the foregoing risk factors and including: the size and timing of significant orders; the ability of the Company to control costs; changes in Company strategy and the Company's ability to attract and retain key personnel. Competition. Competitors in the communications market include SeaTel Corporation, Datron Corporation and Nera Corporation, any of which could challenge the Company's pricing or technology platforms. The Company's satellite phone products could be negatively impacted when Iridium World Communications, Ltd., Globalstar Telecommunications Ltd. and ICO Global Communications (all offering hand-held worldwide, satellite voice, data and fax services) commence operations, scheduled from late 1998 through to 2000. The Company may be faced with increased competition from the Hitachi Corporation's newly introduced closed-loop FOG sensor that is targeted at applications and market segments similar to those the Company is pursuing. Possibility of Common Stock Price Volatility. The trading price of the Company's Common Stock has been subject to wide fluctuations. The trading price of the Company's Common Stock could be subject to wide fluctuations in the future in response to quarterly variations in operating results, announcement of new products by the Company or its competitors, changes in the financial estimates by securities analysts and other events or factors. In addition, the stock market volatility that affects the market price of many high technology companies often is unrelated to the operating performance of such companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. Market Dynamics. KVH's key markets for its sensors and integrated systems are particularly volatile. In the communications industry, there are many technologies and large, well-funded companies competing to provide a single-source solution for broadband voice, fax, data and video access. There are significant political, economic and business forces that are restraining near-term growth and influencing how the communications consumer market ultimately will resolve such issues as technology transfers, diverse and incompatible encryption standards and the needs of underdeveloped countries. New initiatives such as the Iridium worldwide, handheld telephone system, the advent of low earth orbit (LEO) satellites for low-cost messaging and data communication and developments underway at Teledesic, Alcatel and Motorola may pose a threat to the Company's products. In the military navigation industry where governments are the customers, defense funding, equipment focus and performance criteria are continually evolving in reaction to international politics, economic conditions and technological changes. A number of companies in the military navigation industry have established extensive relationships with United States and foreign defense departments and have the size and capital to develop new technologies. In the marine navigation industry, there are a number of companies competing for a portion of a relatively small market. The Company's future growth also depends upon expanding sales of its antenna-aiming and navigation products. Antenna-aiming systems rely upon DBS providers DIRECTV, EchoStar, ASTRA and HotBird and telephony providers Inmarsat and SKYCELL. The Company's business, financial condition and results of operation could be adversely affected if any of these satellite networks experience operating, financial or regulatory problems. Revenues from communications products increased in 1998 from 1997 and the Company expects continued growth in 1999 as new products penetrate the market. Sales cycles for the Company's TACNAV and TACNAV Light systems for military navigation applications are long and difficult to predict, resulting in a variable revenue stream from this market. Military revenues decreased in 1998 from 1997 and the Company anticipates that 1999 revenues will remain relatively flat. Research and Development Efforts. The Company's future success depends on its ability to achieve technological advances that lead to marketable new products and this requires continued substantial investment in research and development. A large portion of the Company's product development strategy for the near future relies upon FOGs and success in product integration, new development, marketing, increasing manufacturing capabilities, market acceptance, and the Company's continued ability to fund the fiber optic effort. Prior to the 1997 acquisition of the fiber optic group from Andrew Corporation, the Company had no experience with fiber optic manufacturing or applications and the learning and integration curve to date has taken longer than the Company initially anticipated. There can be no assurance that the Company will succeed in achieving its FOG technological and manufacturing goals or continue to have funds available for developing and marketing fiber optic products. Item 7A. Market Risk Disclosure. Not applicable. Item 8. Financial Statements and Supplementary Data. The Company's consolidated financial statements and supplementary data, together with the report of KPMG LLP, independent auditors, are included in Part IV of this Report on Form 10-K. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. Not applicable PART III Item 10. Directors and Executive Officers of the Registrant. Reference is made to the information set forth in the definitive Proxy Statement relating to the Fiscal 1998 Annual Meeting of Stockholders (to be filed with the Securities and Exchange Commission within 120 days after December 31, 1998) (the "Proxy Statement"), under the caption "Directors and Executive Officers". Item 11. Executive Compensation. Reference is made to the information in the Proxy Statement under "Remuneration of Executive Officers and Directors". Item 12. Security Ownership of Certain Beneficial Owners and Management. Reference is made to the information set forth in the Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management". Item 13. Certain Relationships and Related Transactions. None. PART IV <TABLE> <CAPTION> Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K. (a) Documents filed as part of this report: Page 1. Financial Statements: <S> <C> Report of Independent Auditors 19 Consolidated Balance Sheets as of December 31, 1998, and 1997 20 Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996 21 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996 22 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 23 Notes to Consolidated Financial Statements 24 2. Financial Statement Schedule. See "Independent Auditors Report" and "Schedule II - Valuation and Qualifying Accounts" included on pages 34 and 35. All other schedules have been omitted since the information is not required to be presented, or because the information required is included in the consolidated financial statements or notes thereto. (b) Reports on Form 8-K: Report on Form 8-K was filed on November 14, 1997. The report contains the asset purchase agreement between the Company and Andrew Corporation and a Common Stock Warrant both dated October 30,1997. (c) Exhibit Number Description Page 3.1 Restated Certificate of Incorporation of the Company (1) 3.5 Amended and Restated By-laws of the Company 10.1 1986 Executive Incentive Stock Option Plan (1) 10.2 Amended and Restated 1995 Incentive Stock Option Plan of the Company (1) 10.3 1996 Employee Stock Purchase Plan (1) 10.5 Credit Agreement dated September 8, 1993 between the Company and Fleet National Bank (1) 10.6 $500,000 Revolving Credit Note dated September 8, 1993 between the Company and Fleet National Bank (1) 10.7 Security Agreement dated September 8, 1993 between the Company and Fleet National Bank (1) 10.8 Modification to Security Agreement dated May 30, 1994 between the Company and Fleet National Bank (1) 10.9 Second Modification to Credit Agreement and Revolving Credit Note dated May 30, 1994 between the Company and Fleet National Bank (1) 10.10 Second Modification to Security Agreement dated March 17, 1995 between the Company and Fleet National Bank (1) 10.11 Third Modification to Credit Agreement and Revolving Credit Note dated March 17, 1995 between the Company and Fleet National Bank (1) 10.12 Third Modification to Security Agreement dated December 12, 1995 between the Company and Fleet National Bank (1) 10.13 Fourth Modification to Credit Agreement and Revolving Credit Note dated December 12, 1995 between the Company and Fleet National Bank (1) 10.14 Lease dated February 27, 1989 between the Company and Middletown Technology Associates IV (1) 10.17 Registration Rights Agreement dated May 20, 1986 by and among the Company and certain stockholders of the Company (1) 10.18 Amendment to Registration Rights Agreement dated January 25, 1988, by and among the Company, Fleet Venture Resources, Inc., and Fleet Venture Partners I and certain stockholders of the Company (1) 10.19 Amendment to Registration Rights Agreement dated October 25, 1988 by and among the Company and certain stockholders of the Company (1) 10.20 Amendment to Registration Rights Agreement dated July 21, 1989 by and among the Company and certain stockholders of the Company (1) 10.21 Third Amendment to Registration Rights Agreement dated November 3, 1989 by and among the Company and certain stockholders of the Company (1) 10.28 Technology License Agreement dated December 22, 1992 between the Company and Etak, Inc. (1) 10.29 Agreement dated September 28, 1995 between the Company and Thomson Consumer Electronics, Inc. (1) 10.30 Agreement dated September 28, 1995 between the Company and Thomson Consumer Electronics, Inc. (1) 10.31 Agreement regarding Technology Affiliates Program between Jet Propulsion Laboratory and the Company (1) 10.32 Purchase and Sale Agreement dated March 18, 1996, 50 Enterprise Center, Middletown, Rhode Island between the Company and SKW Real Estate Limited Partnership (2) 10.33 Fifth Modification to Credit Agreement and Revolving Note dated August 8, 1996 between the Company and Fleet National Bank (c) Exhibit Number Description Page 10.34 Andrew Corporation Asset Purchase and Warrant Agreement (3) 11.1 Computation of (Loss) Earnings per Share (2) 36 21.1 List of Subsidiaries of the Company (1) 23.1 Consent of KPMG LLP 37 27.1 Financial Data Schedule 38 99.1 Open End Mortgage, and Security Agreement 39 99.2 Tinley Park, Illinois, lease 70 </TABLE> (1) Incorporated by Reference to Exhibit Index on Form S-1 filed with the Securities and Exchange Commission dated March 28, 1996, Registration No. 333-01258. (2) Filed by paper with the Securities and Exchange Commission.. (3) Incorporated by reference to Exhibits 1 & 2 on Form 8-K filed with the Securities and Exchange Commission dated November 14, 1997.
SIGNATURES Pursuant to the requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934 the registrant has the duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. KVH Industries, Inc. DATE: March 23, 1999 By: /s/ Martin A. Kits van Heyningen Martin A. Kits van Heyningen President & CEO Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated. <TABLE> <CAPTION> <S> <C> <C> Signature Title Date /s/ Martin A. Kits van Heyningen President (Chief Executive Officer) March 24, 1999 Martin A. Kits van Heyningen /s/ Richard C. Forsyth Chief Financial Officer March 24, 1999 Richard C. Forsyth (Principal Financial and Accounting Officer) /s/ Arent H. Kits van Heyningen Chairman of the Board March 24, 1999 Arent H. Kits van Heyningen /s/ Robert W. B. Kits van Heyningen Director March 24, 1999 Robert W. B. Kits van Heyningen /s/ Werner Trattner Director March 24, 1999 Werner Trattner </TABLE>
INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders KVH Industries, Inc. and Subsidiary: We have audited the accompanying consolidated balance sheets of KVH Industries, Inc. and subsidiary as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of KVH Industries, Inc. and subsidiary at December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles. /s/ KPMG LLP Providence, Rhode Island February 10, 1999
<TABLE> <CAPTION> KVH INDUSTRIES, INC. AND SUBSIDIARY Consolidated Balance Sheets December 31, 1998 and 1997 Assets (note 5) 1998 1997 Current assets: <S> <C> <C> Cash and cash equivalents $ 1,239,227 4,757,614 Accounts receivable, less allowance for doubtful accounts of $91,604 in 1998 and $73,909 in 1997 (note 12) 3,106,414 4,338,992 Income taxes receivable (note 9) 1,062,494 Contract receivables - 156,777 Costs and estimated earnings in excess of billings on uncompleted contracts 768,156 406,014 Inventories (note 3) 3,390,787 4,751,792 Prepaid expenses and other deposits 360,346 222,015 Deferred income taxes (note 9) 234,158 387,567 Total current assets 10,161,582 15,020,771 Property and equipment, net (notes 4 and 15) 7,186,539 5,974,635 Other assets, less accumulated amortization of $107,254 in 1998 and $0 in 1997 (note 2) 972,365 731,000 Deferred income taxes (note 9) 425,150 78,535 $ 18,745,636 21,804,941 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 853,238 1,618,295 Accrued expenses (note 7) 822,533 992,834 Total current liabilities 1,675,771 2,611,129 Total liabilities 1,675,771 2,611,129 Stockholders' equity (note 8): Preferred stock, $.01 par value. Authorized 1,440,390 shares; none issued. - - Common stock, $.01 par value. Authorized 7,490,582 shares; issued 7,205,928 shares in 1998 and 7,086,046 in 1997 72,059 70,860 Additional paid-in capital 15,439,421 15,298,558 Retained earnings 1,558,385 3,824,394 Total stockholders' equity 17,069,865 19,193,812 Commitment and other information (notes 6, 10 and 15) $ 18,745,636 21,804,941 </TABLE> See accompanying Notes to Consolidated Financial Statements.
<TABLE> <CAPTION> KVH INDUSTRIES, INC. AND SUBSIDIARY Consolidated Statements of Operations Years ended December 31, 1998, 1997 and 1996 1998 1997 1996 <S> <C> <C> <C> <C> Net sales (note 12) $ 20,630,648 25,570,347 25,687,495 Cost of goods sold 14,100,398 14,085,463 14,607,584 Gross profit 6,530,250 11,484,884 11,079,911 Operating expenses: Research and development 3,991,193 3,175,181 2,430,755 Sales and marketing 4,469,654 3,738,605 3,039,483 General and administrative 2,225,370 1,895,031 1,624,270 Operating (loss) profit (4,155,967) 2,676,067 3,985,403 Other (income) expense: Interest income (58,735) (336,157) (293,494) Interest expense 2,023 8,893 15,938 Other (income) expense (27,392) (95,083) 14,303 (Gain) loss on foreign currency translation (197,663) (138,272) 50,087 (Loss) income before income tax (benefit) expense (3,874,200) 3,236,686 4,198,569 Income tax (benefit) expense (note 9) (1,608,191) 1,020,185 1,742,538 Net (loss) income $ (2,266,009) 2,216,501 2,456,031 Per share information (notes 8 and 14): Net (loss) income per common share - basic $ (0.32) 0.31 0.39 Net (loss) income per common share - diluted $ (0.32) 0.30 0.35 Weighted average number of shares outstanding: Basic 7,124,023 7,049,125 6,370,272 Diluted 7,124,023 7,497,695 7,055,309 </TABLE> See accompanying Notes to Consolidated Financial Statements.
KVH INDUSTRIES, INC. AND SUBSIDIARY Consolidated Statements of Stockholders' Equity Years ended December 31, 1998, 1997 and 1996 <TABLE> <CAPTION> Additional Retained Total Preferred Common Paid-in Earnings Stockholders' Stock Stock Capital (Deficit) Equity <S> <C> <C> <C> <C> <C> Balances at December 31, 1995 $ 12,982 16,160 4,473,045 (848,138) 3,654,049 Net income - - - 2,456,031 2,456,031 Exercise of stock options and warrants- - 3,274 457,203 - 460,477 Initial public offering of common stock, net of issuance costs of $1,736,555 (note 8) - 18,000 9,945,445 - 9,963,445 Conversion of 1,298,182 shares of preferred stock to 3,245,500 shares of common stock (12,982) 32,455 (19,473) - - Issuance of common stock under benefit plans - 43 28,586 - 28,629 Balances at December 31, 1996 - 69,932 14,884,806 1,607,893 16,562,631 Net income - - - 2,216,501 2,216,501 Issuance of common stock under benefit plan - 127 67,404 - 67,531 Exercise of stock options - 801 151,913 - 152,714 Issuance of warrants (notes 2 and 8) - - 194,435 - 194,435 - 194,435 Balances at December 31, 1997 - 70,860 15,298,558 3,824,394 19,193,812 Net (loss) - - - (2,266,009) (2,266,009) Issuance of common stock under benefit plan - 797 118,620 - 119,417 Exercise of stock options - 402 22,243 - 22,645 Balances at December 31, 1998 $ - 72,059 15,439,421 1,558,385 17,069,865 </TABLE> See accompanying Notes to Consolidated Financial Statements.
<TABLE> <CAPTION> KVH INDUSTRIES, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended December 31, 1998, 1997 and 1996 1998 1997 1996 Cash flows from operating activities: <S> <C> <C> <C> Net (loss) income $ (2,266,009) 2,216,501 2,456,031 Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 767,289 797,761 285,049 Provision for doubtful accounts 17,695 284 (45,000) Provision for deferred taxes (193,206) (242,688) 315,381 Decrease (increase) in accounts and contract receivables (note 11) 1,208,198 1,827,202 (2,932,821) Increase in income taxes receivable (1,062,494) - - (Increase) decrease in costs and estimated earnings in excess of billings on uncompleted contracts (362,142) 429,706 80,474 Decrease (increase) in inventories (note 11) 923,345 (649,213) (1,489,098) Increase in prepaid expenses and other deposits (138,331) (42,310) (23,030) (Decrease) increase in accounts payable (765,057) 586,986 72,802 (Decrease) increase in accrued expenses (170,301) (554,922) 1,035,297 Decrease in customer deposits - 2,502,432) (342,095) Net cash (used in) provided by operating activities (2,041,013) 1,866,875 (587,010) Cash flows from investing activities: Acquisition (note 2) - (1,946,026) - Capital expenditures (note 11) (1,619,436) (2,335,423) (3,703,327) Net cash used in investing activities (1,619,436) (4,281,449) (3,703,327) Cash flows from financing activities: Repayments of obligations under capital lease - (53,739) (52,209) Stock option and benefit plan transactions 142,062 220,245 489,106 Proceeds from initial public offering (note 8) - - 9,963,445 Net cash provided by financing activities 142,062 166,506 10,400,342 Net (decrease) increase in cash and cash equivalents (3,518,387) (2,248,068) 6,110,005 Cash and cash equivalents at beginning of year 4,757,614 7,005,682 895,677 Cash and cash equivalents at end of year $ 1,239,227 4,757,614 7,005,682 Supplemental disclosure of cash flow information (note 11): Cash paid during the year for interest $ 2,023 8,589 15,938 Cash paid during the year for income taxes $ 137,784 1,872,049 20,250 </TABLE> See accompanying Notes to Consolidated Financial Statements.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements December 31, 1998, 1997 and 1996 (1) Summary of Significant Accounting Policies (a) Description of Business KVH Industries, Inc. (the "Company") develops, manufactures and markets proprietary fiber optic, autocalibration and sensor technologies to produce navigation and mobile satellite communications systems for commercial, military and marine applications. (b) Principles of Consolidation The consolidated financial statements include the financial statements of KVH Industries, Inc. and its wholly-owned subsidiary, KVH Europe A/S ("KVH Europe"). All significant intercompany accounts and transactions have been eliminated in consolidation. (c) Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity, at the purchase date, of three months or less to be cash equivalents. (d) Revenue Recognition Revenue is recognized when a product is shipped and services are performed. Revenues on long-term contracts are recognized using the percentage of completion method. Under this method, income is recognized as work progresses on the contracts. The percentage of work completed is determined principally by comparing the accumulated costs incurred to date with management's current estimate of total costs to be incurred at contract completion. On certain contracts where the delivery of equipment is separable from development and other aspects of the contract, the Company segments the contract and recognizes revenue on each segment individually. Revisions of costs and income estimates are reflected in the period in which the facts that require the revisions become known. If estimated total costs on a contract indicate a loss, the entire amount of the estimated loss is provided for currently. (e) Inventories Inventories of finished goods for sale and raw materials are stated at the lower of cost or market using the first-in first-out costing method. Work in process is valued at production cost represented by material, labor and overhead, and is not recorded in excess of net realizable values. (f) Property and Equipment Property and equipment are stated at cost. Depreciation and amortization is computed on the straight-line method over the estimated useful lives of the respective assets. The principal lives, in years, used in determining the depreciation rates of various assets are: buildings and improvements, 40 years; leasehold improvements, over term of lease; machinery and equipment, 5 years; office and computer equipment, 5-7 years; and motor vehicles, 4 years. Amortization of property and equipment under capital lease is provided using the straight-line method over the lease terms. (g) Other Assets Other assets consist of patents and capitalized costs of workforce resulting from the Company's October 1997 acquisition (see note 2). These costs are being amortized on a straight-line basis over periods ranging from 5-12 years. The Company continually reviews intangible assets to assess recoverability from estimated future results of operations and estimated future cash flows.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued (h) Progress Payments Progress payments received from customers are offset against inventories associated with the contracts for which the payments were received. Under contractual arrangements by which progress payments are received from the United States Government, the United States Government has a lien on the inventories identified with related contracts. (i) Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. (j) Research and Development Expenditures for research and development, including customer-funded research and development, are expensed in the year incurred. Revenue from customer-funded research and development is included in net sales, and the related product development costs are included in cost of goods sold. Revenues from customer-funded research and development totaled approximately $1,169,000, $957,000 and $1,050,000, respectively, in 1998, 1997 and 1996, and related costs included in cost of goods sold totaled approximately $936,000, $630,000 and $869,000 in such years, respectively. (k) Foreign Currency Translation The financial statements of the Company's foreign subsidiary are re-measured into the United States dollar functional currency for consolidation and reporting purposes. Current exchange rates are used to re-measure monetary assets and liabilities. Historical exchange rates are used for nonmonetary assets and related elements of expense. Revenue and other expense elements are re-measured at rates, which approximate the rates in effect on the transaction dates. Gains and losses resulting from this re-measurement process are recognized currently in the consolidated statements of operations. (l) Stock-based Compensation The Company applies APB Opinion 25 and related interpretations in accounting for its stock option plans. No compensation cost has been recognized for these plans in the accompanying consolidated financial statements. (m) Use of 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 at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (n) Long-lived Assets The Company reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (o) Net (Loss) Income per Common Share In 1997 the Company adopted the provisions of SFAS No. 128, Earnings Per Share. Under the provisions of SFAS 128, basic earnings per share replaces primary earnings per share and the dilutive effect of stock options and warrants are excluded from the calculation. Fully diluted earnings per share are replaced by diluted earnings per share and include the dilutive effect of stock options and warrants, using the treasury stock method. All prior period earnings per share data have been restated to conform to the requirements of SFAS 128. A reconciliation of the weighted average number of shares outstanding used in the computation of the basic and diluted earnings per share for the three years ended December 31, 1998 is as follows: 1998 1997 1996 Weighted average shares (basic) 7,124,023 7,049,125 6,370,272 Effect of dilutive stock options - 448,570 685,037 Weighted average shares (diluted) 7,124,023 7,497,695 7,055,309 The net (loss) income used in the calculation for basic and diluted earnings per share calculations agrees with the net (loss) income appearing in the financial statements. (p) Fair Value of Financial Instruments The carrying amounts of accounts receivable, contracts receivable, costs and estimated earnings in excess of billings on uncompleted contracts, accounts payable and accrued expenses approximate fair value due to the short maturity of these instruments. (2) Acquisition On October 30, 1997 the Company purchased certain operating assets and assumed certain liabilities of the Sensor Products Group of the Andrew Corporation for approximately $1.9 million of cash (including acquisition costs) and warrants to purchase the Company's common stock, valued at approximately $0.2 million. The assets acquired will provide the Company with the ability to produce fiber optic rate sensors that will advance the Company's existing product performance. The acquisition has been accounted for as a purchase and the allocation resulted in intangibles, primarily patents and workforce, of approximately $1.1 million that are being amortized on a straight-line basis over periods of 5-12 years. In 1998 the Company revalued certain current acquisition assets downward by $0.6 million, increasing the valuation of property and equipment and intangibles by approximately $0.3 million each. (3) Inventories Inventories at December 31, 1998 and 1997 consist of the following: 1998 1997 Raw materials $ 2,178,265 3,242,580 Work in process 461,798 356,211 Finished goods 750,724 1,153,001 $ 3,390,787 4,751,792 Project inventories totaling $139,930 and $39,408, respectively, in 1998 and 1997 have been offset against related progress payments and included as a component of costs and estimated earnings in excess of billings on uncompleted contracts.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued (4) Property and Equipment Property and equipment, net, at December 31, 1998 and 1997 consist of the following: 1998 1997 Land $ 806,774 806,774 Building and improvements 3,227,336 3,181,986 Leasehold improvements 712,666 - Machinery and equipment 2,912,705 1,838,603 Office and computer equipment 2,494,878 2,455,057 Motor vehicles 92,348 92,348 10,246,707 8,374,768 Less accumulated depreciation 3,060,168 2,400,133 $ 7,186,539 5,974,635 Depreciation for the years ended December 31, 1998, 1997 and 1996 amounted to $660,035, $771,783 and $246,081, respectively. (5) Notes Payable to Bank On September 29, 1998, the Company renewed a revolving credit agreement with its bank. Under the terms of the agreement, the Company may borrow up to $2.5 million during the term of the loan at an interest rate equal to the bank's prime rate of interest plus 125 basis points. The credit agreement expires on June 30, 1999. Borrowings are secured by substantially all of the assets of the Company, except for land, building and improvements. At December 31, 1998, the Company had $2.5 million of unused borrowings with its bank to be drawn upon as needed. The credit agreement contains various covenants pertaining to the maintenance of certain financial ratios and maximum operating losses. At December 31, 1998, the Company's operating loss exceeded the maximum loss provided for in the loan agreement, a breach of the credit agreement. The bank has waived that requirement as of December 31, 1998. (6) Leases The Company has certain operating leases for facilities, automobiles, and various equipment. The following is a summary of future minimum payments under operating leases that have initial or remaining non-cancelable lease terms in excess of one year at December 31, 1998: Operating Year ending December 31, Leases 1999 $ 223,421 2000 160,210 2001 165,016 2002 169,967 2003 175,066 Subsequent to 2003 225,728 Total minimum lease payments $1,119,408 Total rent expense incurred under operating leases for the years ended December 31, 1998, 1997 and 1996 amounted to, $196,780, $433,908 and $435,124, respectively. In 1997 the Company reduced the amount of square feet under a facility lease from 30,000 to 6,000. The Company paid $210,000 in the fourth quarter of 1997 to modify the lease agreement. As a consequence of reducing the leased square footage the Company's lease liability decreased to $78,000 and $56,000 in 1998 and 1999, respectively.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued (7) Accrued Expenses Accrued expenses for the period ended December 31, 1998 and 1997 consist of the following: 1998 1997 Accrued payroll, bonus and other related expenses payable $ 417,406 709,544 State income tax payable - 57,601 Professional fees 110,803 162,133 Accrued sales commissions 120,045 - Other 174,279 63,556 $ 822,533 992,834 (8) Stockholders' Equity (a) Sale of Common Stock On March 28, 1996, the Company's registration statement for an initial public offering of common stock was declared effective. An aggregate of 1,800,000 shares of common stock were issued by the Company on April 8, 1996 at an initial public offering of $6.50 per share that resulted in net proceeds of approximately $9.9 million. (b) Employee Stock Options and Warrants The Company has a 1986 Executive Incentive Stock Option Plan, a 1995 Incentive Stock Option Plan, and a 1996 Incentive and Non-Qualified Stock Option Plan (the "Plans"). The Company has reserved 915,000 shares of its common stock for issuance upon exercise of options granted or to be granted under the Plans. These options generally vest in equal annual amounts over four years beginning on the date of the grant. The Plans provide that options be granted at exercise prices not less than market value on the date the option is granted and options are adjusted for such changes as stock splits and stock dividends. No options are exercisable for periods of more than ten years after date of grant. The per share weighted-average fair value of stock options granted during 1998, 1997 and 1996 was $2.74, $4.12 and $1.80 on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 1998 1997 1996 Expected dividend yield 0% 0% 0% Risk-free interest rate 5.84% 5.36% 6.4% Expected volatility 115.48% 82.71% 3% Expected life (years) 3 3 4 The Company applies APB Opinion No. 25 in accounting for its Plans and, accordingly, no compensation cost has been recognized for its stock options in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's net (loss) income would have been reduced to the pro forma amounts indicated below: 1998 1997 1996 Net (loss) income As reported $ (2,266,009) 2,216,501 2,456,031 Pro forma (3,013,785) 1,942,467 2,109,142 Net (loss) income per As reported $ (0.32) 0.30 0.35 common share-diluted Pro forma $ (0.42) 0.26 0.30 Pro forma net (loss) income reflects only options granted in 1998, 1997 and 1996. The full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net (loss) income amounts presented above because compensation cost is reflected in the year of grant.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued At December 31, 1998, warrants, issued in conjunction with the acquisition of the Sensor Products Group of the Andrew Corporation (note 2), to purchase 50,000 common shares were outstanding. Each warrant allows the holder thereof to acquire one share of common stock for a purchase price of $8.00. The warrants are exercisable through October 30, 2002. The changes in outstanding employee stock options for the three years ended December 31, 1998, 1997 and 1996 is as follows: Number of Weighted-Average Shares Exercise Price Outstanding at December 31, 1995 1,065,139 $ 1.11 Granted 362,000 7.91 Exercised (327,400) 0.75 Forfeited (66,080) 0.60 Expired and canceled (12,332) 5.72 Outstanding at December 31, 1996 1,021,327 3.83 Granted 66,250 7.13 Exercised (86,728) 0.76 Expired and canceled (70,446) 5.93 Outstanding at December 31, 1997 930,403 4.28 Granted 687,950 3.97 Exercised (40,195) 0.60 Expired and canceled (383,525) 7.58 Outstanding at December 31, 1998 1,194,633 $ 3.14 On March 2, 1998, the Compensation Committee of the Board of Directors approved a stock option repricing program in which all employees and directors of the company could elect to exchange certain previously granted incentive and non-qualifying stock options for a "New Option" granted under the 1996 Plan. The Company repriced the options because the exercise prices of such options were significantly higher than the fair market value of the Company's common stock and therefore did not provide the desired incentive to employees. Under the terms of the exchange, employees had the option to surrender all outstanding previously granted options with exercise prices of $5.00 per share or more for a New Option amounting to 80 percent of the previously granted options at new exercise prices ranging from $4.125 to $4.538 per share. Options to purchase 361,500 shares of common stock, with an average exercise price per share of $7.77, were surrendered and exchanged for 289,200 shares repriced at exercise prices ranging from $4.125 to $4.538 per share, based upon the fair market closing price on March 2, 1998. The vesting schedule and all other terms and conditions of the options remained unchanged.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued The following table summarizes information about employee stock options at December 31, 1998: <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> <C> Average Weighted- Number Exercisable Weighted- Range of Outstanding Remaining Average As of Average Exercise Prices 12/31/98 Life Exercise Price 12/31/98 Exercise Price $0.60 - $0.60 73,245 1.53 $0.60 67,818 $0.60 $1.70 - $1.70 400,000 1.82 $1.70 400,000 $1.70 $2.50 - $3.50 120,000 4.53 $2.67 20,000 $3.50 $4.13 - $4.13 452,366 3.30 $4.13 215,948 $4.13 $4.54 - $9.13 149,022 3.67 $5.67 78,782 $6.68 $0.60 - $9.13 1,194,633 2.86 $3.14 782,548 $2.82 </TABLE> At December 31, 1998, 1997 and 1996 the number of options exercisable was 782,548, 646,576 and 983,828, respectively, and the weighted average exercise price of those options was $2.82, $3.87 and $3.83, respectively. (c) Employee Stock Purchase Plan The Employee Stock Purchase Plan (the "ESPP") covers substantially all employees in the United States and Denmark. The ESPP allows eligible employees the right to purchase common stock on a semi-annual basis at the lower of 85% of the market price at the beginning or end of each six-month offering period. During 1998 and 1997, 80,510 and 12,700 shares, respectively, were issued under this plan. As of December 31, 1998, 52,439 shares were reserved for future issuance under the plan. (9) Income Taxes Income tax (benefit) expense for the years ended December 31, 1998, 1997 and 1996 are presented below. Current Deferred Total 1998: Federal $(1,237,981) (233,226) (1,471,207) State (208,595) 40,020 (168,575) Foreign 31,591 - 31,591 $(1,414,985) (193,206) (1,608,191) 1997: Federal $ 1,037,954 (212,586) 825,368 State 157,997 (30,102) 127,895 Foreign 66,922 - 66,922 $ 1,262,873 (242,688) 1,020,185 1996: Federal $ 1,062,392 246,986 1,309,378 State 285,148 68,395 353,543 Foreign 79,617 - 79,617 $ 1,427,157 315,381 1,742,538
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued The actual tax (benefit) expense differs from the "expected" tax (benefit) expense computed by applying the U.S. Federal corporate tax rate of 34% to (loss) income before income taxes as follows: <TABLE> <CAPTION> 1998 1997 1996 <S> <C> <C> <C> Computed "expected" tax (benefit) expense $ (1,317,228) 1,100,473 1,427,513 Increase (decrease) in income taxes resulting from: Non-deductible expenses 15,699 26,262 25,025 Utilization of tax credits (176,982) (215,411) - State income tax (benefit) expense, net of Federal income tax benefit (168,575) 84,411 233,674 Other 38,895 24,450 56,326 Net income tax (benefit) expense $ (1,608,191) 1,020,185 1,742,538 The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities at December 31, 1998 and 1997 are as follows: 1998 1997 Deferred tax assets: Accounts receivable, due to allowance for doubtful accounts $ 39,810 24,126 Inventories, due to valuation reserve 30,923 204,451 Inventories, due to differences in costing for tax purposes 2,138 4,334 Inventories, due to unrealized gain 48,315 130,416 Property and equipment, due to differences in depreciation - 5,812 Intangibles due to differences in amortization 14,695 - Dislodged tax credits from prior years 460,000 - Accrued warranty costs 42,882 96,963 Accrued vacation 98,822 - Gross deferred tax assets $ 737,585 466,102 Deferred tax liability: Property and equipment, due to differences in depreciation 78,277 - Net deferred tax asset $ 659,308 466,102 </TABLE> The recognition of the net deferred tax asset of $659,308 is supported by the Company's history of earnings and the expectation that it will have future taxable income in 1999 and beyond in order to realize the benefit of these future tax deductions. Research and development tax credit carryforwards in the amounts of $154,000 and $255,000 relating to 1997 and 1996 expire in 2012 and 2011, respectively. An Alternative Minimum Tax credit of $51,000 from 1996 has no expiration date. (10) 401(k) Profit Sharing Plan The Company has a 401(k) Profit Sharing Plan (the Plan) for all eligible employees. All employees with a minimum of one year of service who have attained age 21 are eligible to participate. Participants can contribute up to 15% of total compensation, subject to the annual IRS dollar limitation. Participants become fully vested in Company contributions after 7 years of continuous service. Company contributions to the plan are discretionary. During 1998, 1997 and 1996, the Company did not make any contributions to the Plan.
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued (11) Supplemental Cash Flow Information As discussed in Note 2, the Company purchased certain operating assets and assumed certain liabilities of Andrew Corporation's Sensor Products Group in 1997. During 1998 the Company revalued accounts receivable and inventory to reflect actual fair values. As a consequence of the revaluation, accounts receivable and inventory were reduced by $163,462 and $437,660, respectively, while property and equipment and other assets were increased by $252,503 and $348,619, respectively. (12) Business and Credit Concentrations In September 1995 the Company entered into an agreement with AMSC to design and manufacture mobile satellite telephone systems for use at sea. The agreement provided for AMSC to purchase 5,000 systems, for a total contract value of $10.2 million. The Company received an advance from AMSC of $2.5 million to be applied to the purchase price of the last of the systems covered by the agreement. The Company shipped approximately 70% of the order in 1996 and the remainder in 1997. The Company derives a substantial portion of its revenues from the armed forces of the United States and foreign governments. The Company estimates that approximately 39%, 52% and 37% of the Company's revenues were derived from United States and foreign military and defense related sources in fiscal 1998, 1997 and 1996, respectively. A significant portion of the Company's revenues are also derived from customers outside the U.S. Revenues from foreign customers accounted for 30%, 31% and 42% of total revenues in fiscal 1998, 1997 and 1996, respectively. Historically, a significant portion of the Company's sales in any particular period has been attributable to sales to a limited number of customers. There were no sales in 1998 to AMSC, which accounted for approximately 12% and 27% of net sales in 1997 and 1996, respectively. Sales to the United States Army Tank and Automotive Command accounted for approximately 17% and 28% of net sales in 1998 and 1997, respectively. Sales to the Government of Sweden did not occur in 1998 and accounted for approximately 13% of the Company's net sales in 1997. Sales to General Motors Corporation of Canada accounted for approximately 14% of the Company's net sales in both 1998 and 1997. (13) Segment Reporting During 1998 the Company adopted Financial Accounting Standards Board Statement of Financial Accounting Standards Number 131 ("SFAS 131"), "Disclosures About Segments of an Enterprise and Related Information." Under SFAS 131, the Company's operations are classified into one reportable segment. The Company designs, manufactures and markets sensor systems for a wide variety of applications under common management which oversees the Company's marketing production and technology strategies. (a) Products and Services The Company's sensor systems are primarily marketed in the communication and navigation industries. Revenues attributed to each of these industries is as follows: 1998 1997 1996 Navigation $13,985,623 20,328,191 15,877,721 Communication 6,645,025 5,242,156 9,809,774 $20,630,648 25,570,347 25,687,495 (b) Geographic Information The Company's operations are located in the United States and Europe, and substantially all long-lived assets reside in the United States. Inter-region sales are not significant to total revenue of any geographic region. Information about the Company's revenues in different geographic regions for each of the three-year periods ended December 31, 1998, 1997 and 1996 is as follows:
KVH INDUSTRIES, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements, Continued 1998 1997 1996 Net revenues: United States $ 17,461,608 23,258,557 23,809,807 Europe 3,169,040 2,311,790 1,877,688 $ 20,630,648 25,570,347 25,687,495 United States revenues include export sales to unaffiliated customers, located primarily in Europe and Canada, and totaled $6,112,627, $7,813,138 and $9,051,291, respectively, in 1998, 1997 and 1996. (14) Selected Quarterly Financial Results (Unaudited) Financial information for interim periods was as follows: <TABLE> <CAPTION> First Second Third Fourth Quarter Quarter Quarter Quarter 1998 <S> <C> <C> <C> <C> Net sales $ 4,128,601 6,470,240 5,307,323 4,724,484 Gross profit 1,130,182 2,390,607 2,164,348 845,113 Net (loss) income (896,719) (247,329) 258,089 (1,380,050) (Loss) income per share (a): Basic $ (0.13) (0.03) 0.04 (0.19) Diluted $ (0.13) (0.03) 0.04 (0.19) 1997 Net sales $ 5,916,329 5,770,505 7,025,976 6,857,537 Gross profit 2,737,300 2,519,762 3,546,897 2,680,925 Net income 603,989 402,167 1,018,799 191,546 Earnings per share (a): Basic $ 0.09 0.06 0.14 0.03 Diluted 0.08 0.05 0.14 0.03 1996 Net sales $ 4,780,659 5,113,602 7,147,270 8,645,964 Gross profit 2,088,270 2,284,354 2,918,469 3,788,818 Net income 187,568 320,099 920,513 1,027,851 Earnings per share (a): Basic $ 0.04 0.05 0.13 0.15 Diluted $ 0.03 0.04 0.12 0.14 </TABLE> (a) Earnings (loss) per share are computed independently for each of the quarters. Therefore, the earnings (loss) per share for the four quarters may not equal the annual earnings per share data. (15) Subsequent Event On January 11, 1999, the Company entered into a mortgage loan in the amount of $3,000,000 with a life insurance company. The note term is 10 years, with a principal amortization of 20 years at a fixed rate of interest of 7%. Due to the difference in the term of the note and the amortization of principal, a balloon payment is due on February 1, 2009, in the amount of $2,014,716.
INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders KVH Industries, Inc. and Subsidiary: Under the date of February 10, 1999, we reported on the consolidated balance sheets of KVH Industries, Inc., and subsidiary as of December 31, 1998 and December 31, 1997 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the fiscal years in the three-year period ended December 31, 1998, as contained in the annual report on Form 10-K for the year 1998. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedule listed in Item 14(a)(2). This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Providence, Rhode Island February 10, 1999
Schedule II KVH INDUSTRIES, INC. AND SUBSIDIARY Valuation and Qualifying Accounts <TABLE> <CAPTION> Additions Balance at Charged to Beginning of Cost or Deductions Balance at Description Year Expense from Reserve End of Year ---------------------------------------------------------------------------------------- (in thousands) Deducted from accounts receivable for doubtful accounts <S> <C> <C> <C> <C> <C> 1998 74 26 (8) 92 1997 50 24 - 74 1996 95 - (45) 50 Deducted from inventory for estimated obsolescence 1998 511 50 (484) 77 1997 105 556 (150) 511 1996 60 60 (15) 105 </TABLE>