Item 1. Business
FORWARD-LOOKING STATEMENTS
All statements other than statements of historical fact included in this Annual Report, including without limitation statements under, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business," regarding our financial position, business strategy and our plans and objectives of management for future operations, are forward-looking statements. Forward-looking statements involve various important assumptions, risks, uncertainties and other factors which could cause our actual results to differ materially from those expressed in such forward-looking statements. Forward-looking statements in this Annual Report can be identified by words such as "anticipate," "believe," "estimate," "expect," "plan," "intend," "may," "should" or the negative of these terms or similar expressions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance or achievement. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors including but not limited to, competitive factors and pricing pressures, changes in legal and regulatory requirements, technological change or difficulties, product development risks, commercialization and trade difficulties, and general economic conditions as well as the factors set forth in our public filings with the Securities and Exchange Commission.
You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Annual Report or the date of any document incorporated by reference, in this Annual Report. We are under no obligation, and expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise.
For these statements, we claim the protection of the safe harbor for forward-looking statements contained in Section 21E of the Securities Exchange Act of 1934.
GENERAL
The Company's corporate offices are located at 101 North Pointe Boulevard, Lancaster, Pennsylvania 17601. The telephone number of the Company at that location is (717) 735-8117. The Company's web site is located at www.herley.com. The Company makes its periodic and current reports available, free of charge, on its web site as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. The Company's Common Stock is listed on the NASDAQ national market under the symbol "HRLY."
BACKGROUND
We are a leading supplier of microwave products and systems to defense and aerospace entities worldwide. Our primary customers include large defense prime contractors (including Northrop Grumman, Lockheed Martin, Raytheon and Boeing), the U.S. Government (including the Department of Defense, NASA and other U.S. Government agencies) and international customers (including the Egyptian, German, Japanese and South Korean militaries and suppliers to international militaries). We are a leading provider of microwave technologies for use in command and control systems, flight instrumentation, weapons sensors and electronic warfare systems. We have served the defense industry since 1965 by designing and manufacturing microwave devices for use in high technology defense electronics applications. Our products and systems are currently deployed on a wide range of high profile military platforms, including the Falcon, the F/A-18E/F Super Hornet, the RC-135 Rivet Joint, the E-2C Hawkeye, the AEGIS class surface combatants, the EA-6B Prowler, the AMRAAM air to air missile, and unmanned aerial vehicles, or UAVs, as well as high priority national security programs such as National Missile Defense and the Trident II D-5.
ACQUISITIONS
We have grown internally and through strategic acquisitions and have evolved from a component manufacturer to a systems and service provider. We have successfully integrated these acquisitions by targeting microwave technology companies and focusing their strengths into our existing operations. Over the last ten years, our acquisitions have included the following:
- - In July 1995, we acquired Stewart Warner Electronics Corp. of Chicago, Illinois, a manufacturer of high frequency radio and IFF interrogator systems.
- - In August 1997, we acquired Metraplex Corporation of Frederick, Maryland, a manufacturer of airborne PCM and FM telemetry and data acquisition systems.
- - In January 1999, we acquired General Microwave Corporation of Farmingdale, New York, a manufacturer of microwave components and electronic systems.
- - In January 2000, we acquired Robinson Laboratories, Inc. of Nashua, New Hampshire, a designer, developer and manufacturer of microwave components and assemblies primarily for defense applications.
- - In September 2000, we acquired American Microwave Technology, Inc. of Anaheim, California, a manufacturer of high power, solid state amplifiers for the scientific and medical markets, which enabled us to enter these markets.
- - In September 2002, we acquired EW Simulation Technology, Limited ("EWST"), a company located in Aldershot, in the United Kingdom. EWST designs, develops and produces electronic warfare simulator systems for prime defense contractors and countries worldwide.
- - In March 2004, we acquired Communication Techniques, Inc. ("CTI"), of Whippany, New Jersey. CTI designs, develops and produces state-of-the-art signal generation components and integrated assemblies for digital radio, SONET, SatCom, test and instrumentation, datacom, and wired and wireless applications to 45 Gigahertz ("GHz") and 45 Gigabits Per Second ("Gb/s").
- - In September 2004, we acquired Reliable System Services Corporation ("RSS"), of Melbourne, Florida, a manufacturer of satellite based command and control systems for defense customers. The RSS Iridium based command and control system provides secure (encryption, anti-spoof) global service coverage, allowing multiple target operations, and is complementary with the Company's MAGIC2 command and control systems.
- - In February 2005, we acquired Micro Systems, Inc. ("MSI"), Fort Walton Beach, Florida, a market leader in the design and manufacturing of command and control systems for operation of unmanned aerial, seaborne and ground targets and missiles.
- - In April 2005, we acquired Innovative Concepts, Inc. ("ICI"), McLean, Virginia, which has a successful history of developing and providing wireless communications technology and real-time embedded systems, software, hardware and high-speed processing in support of the defense industry.
BUSINESS STRATEGY
Our goal is to continue to leverage our proprietary technology, microwave expertise and manufacturing capabilities to further expand our penetration in our market. Our strategies to achieve our objectives include:
- - INCREASE LEVELS OF COMPONENT INTEGRATION AND VALUE ADDED CONTENT. Due to growth of engineering expertise, new product development, and acquisitions, we have increased our capability to provide more component integration. Management believes component integration adds value and will enable us to increase content in defense platforms and systems, thereby increasing our revenue and profitability.
- - MAINTAIN LEADERSHIP IN MICROWAVE TECHNOLOGY. We intend to pursue further technological advances through continued investment in internally-funded and customer-funded research and product development.
- - STRENGTHEN AND EXPAND CUSTOMER RELATIONSHIPS. We have developed mutually beneficial relationships with various agencies of the U.S. Government and defense and commercial companies. We expect to continue to build and strengthen these relationships with industry leaders by anticipating and recognizing their needs and providing them with on-time and cost-effective solutions.
- - CAPITALIZE ON OUTSOURCING DYNAMICS IN THE AEROSPACE AND DEFENSE INDUSTRY. Microwave technology has traditionally been an in-house resource of the prime contractors. However, the prime contractors are beginning to outsource the design and manufacture of this specialized engineering work to system sub-contractors. We are well positioned to generate more business as prime contractors continue to focus primarily on integration of defense electronics.
- - PURSUE STRATEGIC ACQUISITIONS. We intend to continue to augment our existing technological base by acquiring specialized companies that complement or expand our product offerings and market strategies. We believe that expansion of our core competencies through the acquisition of such specialized technology companies, when combined with our current technological and manufacturing skills, will provide us with improved levels of horizontal and vertical integration, leading to the creation of subsystems and complete system products.
- - ENHANCE MANUFACTURING CAPABILITIES. We intend to continue to implement process manufacturing automation, and believe that our ability to develop a high level of automated production and test capability will help to further improve our cost effectiveness and time to market.
- - PURSUE SELECTIVE COMMERCIAL OPPORTUNITIES. We seek to identify and pursue selected commercial applications for our products and technologies where we can add value based on our microwave expertise.
COMPETITIVE STRENGTHS
Our competitive strengths include:
- - TECHNICAL EXPERTISE. We have developed a leading position in the field of microwave technology through our 40 year focus on research and development and our state-of-the-art design and production capabilities. In fiscal 2002 we completed the expansion of our facilities in Lancaster, Pennsylvania, including state-of-the-art manufacturing capacity, where we now have a full range of capabilities including long and short run production, hardware assembly and full- service engineering. In addition, we have highly capable manufacturing facilities located in Woburn, Massachusetts; Farmingdale, New York; Whippany, New Jersey; Melbourne, Florida; Fort Walton Beach FL; Farnborough, England; and Jerusalem, Israel. We continue to develop and reward our engineers in order to maintain our expertise in-house.
- - HIGH PROPORTION OF LONG-TERM SOLE-PROVIDER PRODUCTION PROGRAMS. We generate a significant proportion of our revenue from continuing, long-term programs, both in the production and upgrade phases, and continue to target high growth, high priority defense programs. Typically, on such long-term defense programs we are the sole provider of microwave equipment.
- - DIVERSE PRODUCT AND CUSTOMER BASE. We have a diverse product and customer base, with only the U.S. Government at approximately 25%, and Northrop Grumman at approximately 11%, representing 11% or more of our fiscal 2005 revenues. We are a first-tier supplier to all of the prime defense contractors, as well as a direct supplier to all of the service branches of the U.S. military, including products found on over 120 individual platforms. Foreign customers accounted for approximately 26% of our revenues in fiscal 2005.
- - LONG-STANDING INDUSTRY RELATIONSHIPS. We have established long-standing relationships with the U.S. Government and other key organizations in the aerospace and defense industry after 40 years in the defense electronic industry. Over this period, we have become recognized for our ability to develop new technologies and meet stringent program requirements.
- - SUCCESSFUL ACQUISITION TRACK RECORD. We have demonstrated that we can successfully integrate acquired companies. We are experienced at evaluating prospective operations in order to increase efficiencies and capitalize on market and technological synergies.
- - EMPHASIS ON RESEARCH AND DEVELOPMENT. In fiscal year 2005, we spent approximately $10.3 million on new product development, of which our customers funded approximately $5.3 million. Our emphasis on new product development enables us to maintain our technological leadership in current products and to develop new capabilities. This spending helps solidify and strengthen our position on different programs and may serve as a barrier to entry for competitors.
- - EXPERIENCED MANAGEMENT TEAM. Our senior management team averages over 25 years of experience in the defense electronics industry.
PRODUCTS AND SERVICES
We are a leading supplier of microwave products and systems to defense and aerospace entities worldwide. We design and manufacture microwave components and subassemblies which are embedded in a variety of radars, flight instrumentation, weapons sensors, electronic warfare systems and guidance systems. Our microwave devices are used on our subassemblies and integrated systems (e.g. command and control systems, telemetry systems, transponders, flight termination receivers and identification friend or foe, or IFF, interrogators), in addition to being sold on a component basis.
The following are descriptions of our major systems and products:
Telemetry Systems. Telemetry systems provide wireless data transmission between two or more sites for recording and analysis. Missile, UAV, or target testing on domestic and international test ranges requires flight safety and performance data transmission to maximize flight safety during the test operation. Surveillance and intelligence gathering UAVs also require a data transmission downlink and a command and control systems uplink to accomplish their mission. We have developed a telemetry system capability that can be configured to meet individual customers' needs. Various components of the system include data encoders, transmitters and flight termination receivers. Each has a distinctive role and each is the key to the success of the mission.
We are a leading manufacturer of Pulse Code Modulation, or PCM, and Frequency Modulation, or FM, telemetry and data acquisition systems for severe environment applications, and our products are used worldwide for testing space launch vehicle instrumentation, aircraft flight testing, and amphibian, industrial and automotive vehicle testing. The product portfolio ranges in size and complexity from miniature encoders to completely programmable data acquisition systems.
We offer a complete airborne data link system. With our digital capability in data encoding and acquisition elements combined with our radio frequency capability in providing telemetry transmitters and flight termination receivers, we offer a full line of narrow and wide-band airborne telemetry systems to meet a wide variety of industrial needs, both domestically and internationally.
Command and Control Systems. Our command and control ("C2") systems principally are used to fly remotely a large variety of unmanned aerial vehicles, or UAVs, typically aircraft used as target drones or Remotely Piloted Vehicles, or RPVs. Our C2 systems also control surface targets. Operations have been conducted by users on the open ocean, remote land masses, and instrumented test and training ranges. Our C2 systems are currently in service throughout the world. C2 systems permit a ground operator to fly a target or a UAV through a pre-planned mission. The mission may be for reconnaissance, where the vehicle is equipped with high definition TV sensors and the necessary data links to send information back to its C2 systems ground station. The UAV may also be used as a decoy, since the operator can direct the flight operations that will make the small drone appear to be a larger combat aircraft.
Our MONTAGE system affords over-the-horizon C2 using GPS guidance and control of multiple targets from a single ground station. The ability to control multiple targets at increased distances represents a significant product improvement. The MONTAGE is a highly flexible, multiple processor design with high resolution graphics, which can be field- configured within minutes to fly or control any selected vehicle for which it is equipped. The MONTAGE is used in support of missile, aircraft and other weapons systems development and testing. The system meets a growing requirement to test against multiple threats with the automated defense capabilities of ships like the AEGIS cruiser and the E-2C aircraft.
In September 2004, we closed on the purchase of Reliable System Services Corporation ("RSS"). In addition to complementing and adding to our capabilities in Telemetry, Electronic Warfare ("EW") Simulation Equipment, EW Jamming Equipment and Range Safety Commanding applications, RSS will significantly enhance our C2 capabilities for UAV platforms, in that RSS provides a C2 system for UAVs that operates through the Iridium satellite system. The RSS Iridium based C2 system provides secure (encryption, anti-spoof) global service coverage, allowing multiple target operations. The addition of this RSS Iridium based alternate for UAV C2 systems will enable us to provide a broader array of systems configuration solutions to our defense industry customers.
Transponders. We manufacture a variety of expendable transponders, including range safety, IFF, command and control, and range scoring systems. Transponders are small, expendable, electronic systems consisting of a transmitter, sensitive receiver and internal signal processing equipment comprised of active and passive components, including microwave subassemblies such as amplifiers, oscillators and circulators. The transponder receives signals from radars, changes and amplifies the frequency of the signals, and transmits back a reply on a different frequency and signal level. This reply is a strong, noise-free signal upon which the tracking radar can "lock," and one which is far superior to skin reflection tracking, particularly under adverse weather conditions after the launch.
In range safety applications, transponders enable accurate tracking of space launch and unmanned aerial vehicles, missiles, and target drones so that position and direction are known throughout its flight. In the case of several defense and commercial space launch vehicles (i.e., Delta, Atlas, Titan and Pegasus), our transponder is tracked by the ground launch team all the way to space orbit, and in certain instances through several orbits, as a reference location point in space to assure that the launch payload has been properly placed in orbit.
IFF transponders, which are used in conjunction with the Federal Aviation Authority Air Traffic Control System, enable ground controllers to identify the unmanned targets, drones and cruise missiles on which these units fly and to vector other manned aircraft safely away from the flight path of the unmanned aerial vehicle.
Command and control transponders provide the link through the telemetry system for relaying ground signals to direct the vehicle's flight. The uplink from the ground control station, a series of coded pulse groups, carries the signals that command the flight control guidance system of the vehicle. The downlink to the ground provides both tracking signals for range safety, as well as acknowledgment and status of the uplink commands and their implementation in the vehicle. The transponder is therefore the means to fly the vehicle. Scoring systems are mounted on both airborne and sea targets. Scoring systems enable test and evaluation engineers to determine the "miss-distance" between a projectile and the target at which it has been launched.
Flight Termination Receiver. A flight termination receiver, or FTR, is installed in a test missile, UAV, target or space launch vehicle as a safety device. The FTR has a built-in decoder that enables it to receive a complex series of audio tones which, when appropriate, will set off an explosive charge that will
destroy the vehicle. A Range Safety Officer, or RSO, using the range safety transponder will track the vehicle in flight to determine if it is performing as required. If the RSO detects a malfunction in the test or launch vehicle that causes it to veer from a planned trajectory in a manner that may endanger personnel or facilities, the RSO will transmit a coded signal to the onboard FTR to explode the vehicle.
HF Communications and IFF Interrogators. We design and manufacture high frequency radio and IFF interrogators. This high frequency communications equipment is used by the U.S. Navy and foreign navies that conduct joint military exercises with the U.S. Navy. The IFF interrogators are used as part of shipboard equipment and are also placed on coastlines, where they are employed as silent sentries. We have been a significant supplier to the Republic of Korea for over twenty years and have a large, established installed base of equipment. We have been, and continue to be, a supplier to the Republic of Korea KDX destroyer program.
High Power Amplifier. We design and manufacture high power amplifier systems with frequencies ranging from 1.5 Megahertz ("MHz") to 12 GHz with power levels from multi-kilowatts up to 15W, depending on the frequency. Our high power amplifier applications include but are not limited to defense communication, electronic warfare, radar and avionics.
Microwave Integrated Circuits. We design and manufacture complex microwave integrated circuits, or MICs, which consist of sophisticated assemblies that perform many functions, primarily involving switching of microwave signals. Our MICs are employed in many defense electronics systems and missile programs.
High/Low Power Integrated Assembly. Our high power microwave devices are used in radar system transmitters and in long-range missiles. High power devices frequently use small amounts of nuclear material to enhance breakdown of high energy pulses, and we are one of very few companies with an active nuclear license that permits the handling of these trace amounts of nuclear materials. There are relatively few companies with the expertise or facilities to design, manufacture and test high power devices. We also produce lower power, broad band microwave integrated assemblies for the defense electronics industry. These complex assemblies combine microwave functions such as amplification, attenuation, switching of multiple signals, and phase and amplitude control. Their applications include Rear Warning Receivers, or RWRs, Electronics Countermeasure, or ECM, systems and highly sensitive receiver systems.
Solid State Receiver Protector. We have become a preeminent supplier of solid-state receiver protector devices that are able to withstand high energy pulses without the use of nuclear materials. These high power devices protect a radar receiver from transient bursts of microwave energy and are employed in almost every military and commercial radar system. For our engineering efforts in designing solid-state receiver protectors for the, we received cash awards from the United States Air Force as part of the government's value engineering program.
Digitally Tuned Oscillators (DTO's). We produce microwave sources, which generate signals that are used in microwave oscillators. Our microwave sources are sold to the U.S. defense industry and to various foreign governments. We specialize in digitally tuned oscillators, or DTOs, a critical component in many ECM systems.
Simulation Equipment. EW Simulation Technology Limited ("EWST"), a U.K. company and wholly owned subsidiary, designs and manufactures radar threat and electronic countermeasures simulation equipment for electronic warfare training and test and evaluation applications. Radar threat and countermeasures simulator products include but are not limited to the following:
CHAMELEON is a real time electronic countermeasures ("ECM") jamming simulator. It uses a variety of ECM techniques and radar target modeling for training and testing of both radar and EW operators and systems. The system offers a fully programmable ECM capability using Digital RF Memories ("DRFM") technology; and offers fully coherent jamming in both range and velocity through the use of 8-bit DRFM technology together with GUI software. The CHAMELEON is suited for ground-based and airborne ECM test and training systems.
The RSS8000 Series Radar Threat Simulator generates real-time user programmable radar threats and provides output configurations in digital (On-board trainer-OBT) and RF (RSS series) formats. The system can be used for EW system test and evaluation as well as for EW operator training in laboratory and more rugged environments. The RSS8000 equipment covers the 100MHz to 40 GHz range and can be configured to suit any application from a portable single RF source unit to a multiple RF source and multiple port DF system. The DF systems are available in amplitude, DTOA and/or phase formats with the ports being capable of angular rotation.
Mobile EW and Radar Test Systems ("MERTS") is a mobile EW and radar test system providing complete jamming and radar threat test facility for field use. It provides a turnkey test and evaluation equipment for field applications and includes both the CHAMELEON and RSS8000 systems integrated into one operational unit. The MERTS equipment is housed within an air-conditioned ISO container mounted on a four-wheel drive truck that allows on-site test and evaluation of radar and EW systems as well as operator training.
Scientific Products. Our scientific products are used extensively in Nuclear Magnetic Resonance (NMR) systems. These amplifiers, which have dual mode
capability and can be operated in either a pulsed or continuous wave, cover the frequency ranges of 6 MHz to 950 MHz, with power levels as high as 2.0KW peak power at 10% duty cycle. Scientific customers include Original Equipment Manufacturers ("OEM"), system manufacturers and research centers.
Medical Products. Our medical products vary in complexity from single modules, to rack mounted amplifiers, to complete systems. The rack-mounted amplifiers and complete systems typically include detection/protection circuitry, built-in power supplies, front panel metering and digital and/or analog interface controls. Both forced air and/or water cooling are used, depending on the customer's requirements. Our medical products are used in Magnetic Resonance Imaging, or MRI, systems. All amplifiers have dual mode capability and can be operated in either a pulsed or continuous wave mode, and cover the frequency ranges of 10 MHz to 200 MHz with power levels as high as 12.0KW peak power at 10% duty cycle. Medical customers include OEM, as well as universities and research centers.
All products feature highly reliable technical solutions designed for improved production and reliability. Producibility is enhanced through the use of surface mount components and circuit designs which eliminate the need for excessive alignment during the production cycle. High reliability is achieved through the implementation of conservative thermal and RF circuit design and sophisticated self-protection schemes. Reliability is further enhanced during the design phase by employing detailed environmental testing.
CUSTOMERS
During the fiscal year ended July 31, 2005, approximately 25% of our net sales were attributable to contracts with offices and agencies of the U.S. Government, and Northrop Grumman accounted for approximately 11% of net sales. No other customers accounted for shipments of 11% or more of net sales.
We provide defense electronics equipment to major defense prime contractors for integration into larger platforms and systems. Some of our customers for defense electronics equipment include:
The Boeing Company BAE Systems Harris Corporation Lockheed Martin Corporation Northrop Grumman Corporation Raytheon Company
During fiscal 2005, sales to foreign customers accounted for approximately 26% of our net sales. Domestic sales to foreign customers accounted for 13% of net sales. Sales from England were 5%, and Israel 8% of net sales to foreign customers. The governments of Egypt, Japan, South Korea, Taiwan and the United Kingdom are all significant customers of ours. All of our domestic contracts with foreign customers are payable in U.S. dollars. Contracts with customers originating in Israel and England are either in U.S. dollars or the local functional currency. International sales are subject to numerous risks, including political and economic instability in foreign markets, currency and economic difficulties in the Pacific Rim, restrictive trade policies of foreign governments, inconsistent product regulation by foreign agencies or governments, imposition of product tariffs and burdens and costs of complying with a wide variety of international and U.S. export laws and regulatory requirements. Our international sales also are subject to us obtaining export licenses for certain products and systems.
SALES AND MARKETING
We market our products worldwide to the United States Government, prime contractors and various countries in defense markets, and to OEM, research institutions and universities in commercial markets. Sales are primarily through a sales force generally organized by geographic territory and markets. In addition, we have contracts with manufacturers' representatives in the United States and international representatives who are located in Western Europe, the Middle East and Asia. As part of our marketing efforts, we advertise in major trade publications and attend major industrial shows in the commercial, medical, satellite communications and defense markets.
After we have identified key potential customers, we make sales calls with our own sales, management and engineering personnel. In order to promote widespread acceptance of our products and provide customers with support, our sales and engineering teams work closely with our customers to develop tailored solutions to their requirements. We believe that our customer engineering support provides us with a key competitive advantage.
We also produce microwave components that are sold through our catalog, which for almost forty years has been an industry leader, and sell attenuating devices and IQ modulation and phase shifters through the microwave engineer's handbook.
MANUFACTURING
We manufacture our products from standard components, as well as from items that are manufactured by vendors to our specifications. A majority of our defense electronics and commercial assemblies and subsystems contain proprietary technology which is designed and tested by our engineers and technicians and is manufactured at our own facilities.
We continue to invest in improving our proprietary manufacturing processes and the automation of the manufacturing processes. Automation is critical in meeting our customers' demands for price competitiveness, world class quality and on- time delivery. We are also investing to enhance our responsiveness to the production demands of our customers.
We purchase electronic components and other raw materials used in our products from a large number of suppliers and all such materials are readily available from alternate sources.
We maintain minimal levels of finished products inventory, principally to meet the needs of our medical products customers. We generally purchase raw materials for specific contracts, and we purchase common components for stock based on our firm fixed backlog.
There are no significant environmental control procedures required concerning the discharge of materials into the environment that require us to invest in any significant capital equipment or that would have a material effect on our earnings or our competitive position.
Quality assurance checks are performed on manufacturing processes, purchased items, work-in-process and finished products. Due to the complexity of our products, final tests are performed on some products by highly skilled engineers and technicians.
Our primary manufacturing facilities have earned the ISO 9001 Registration. The ISO 9000 series standards are internationally recognized quality management system requirements. ISO 9001, the most comprehensive Standard in the ISO 9000 Series, covers design, manufacturing, installation, and servicing systems. Assembly, test, package and shipment of products are done at our manufacturing facilities located in the following cities:
Lancaster, Pennsylvania Farmingdale, New York Woburn, Massachusetts Whippany, New Jersey (acquired in March 2004) Melbourne, Florida (acquired in September 2004) Fort Walton Beach, Florida (acquired in February 2005) McLean, Virginia (acquired in April 2005) Jerusalem, Israel Farnborough, England
BACKLOG
Our total backlog of orders was approximately $145 million on July 31, 2005 as compared to approximately $100 million on August 1, 2004. Of our total backlog at July 31, 2005, $109 million (75%) is attributable to domestic orders and $36 million (25%) is attributable to foreign orders. Management anticipates that approximately 84% of this backlog will be shipped during the fiscal year ending July 30, 2006.
All of the orders included in backlog are covered by signed contracts or purchase orders. Backlog is not directly indicative of future sales. Accordingly, we do not believe that our backlog as of any particular date is representative of actual sales for any succeeding period.
Approximately 90% of our contracts are fixed price contracts, some of which require delivery over time periods in excess of one year. With this type of contract, we agree to deliver products at a fixed price except for costs incurred because of change orders issued by the customer.
In accordance with Department of Defense procedures, all contracts involving government programs may be terminated by the government, in whole or in part, at the government's discretion for cause or convenience. In the event of a termination for convenience, prime contractors on such contracts are required to terminate their subcontracts on the program, and the government or the prime contractor is obligated to pay the costs incurred by us under the contract to the date of termination plus a fee based on the work completed.
PRODUCT DEVELOPMENT
We believe that our growth depends, in part, on our ability to renew and expand our technology, products, and design and manufacturing processes with an emphasis on cost effectiveness. We focus our primary efforts on engineering design and product development activities rather than pure research. Our policy is to assign the required engineering and support people, on an ad hoc basis, to new product development as needs require and budgets permit. The cost of these development activities, including employees' time and prototype development, was approximately $10.3 million in fiscal 2005, $11.1 million in fiscal 2004 and $6.3 million in fiscal 2003. The portion of these costs not reimbursed by customers was approximately $5.0 million in fiscal 2005, $5.4 million in fiscal 2004 and $3.1 million in 2003. These increases in development spending were undertaken to continue to provide future business opportunities for the Company. Future product development costs will depend on the availability of appropriate development opportunities within the markets served by the Company.
COMPETITION
The microwave component and subsystems industry is highly competitive and we compete against many companies, both foreign and domestic. Many of these companies are larger, have greater financial resources and are better known. As a supplier, we also experience significant competition from the in-house capabilities of our customers.
Competition is generally based upon technology, design, past performance and price. Our ability to compete depends, in part, on our ability to offer better design and performance than our competitors and our readiness in facilities, equipment and personnel to complete the programs. Many of the programs in which we participate are long standing programs in which we are the sole provider of our product.
GOVERNMENT REGULATION
Because of our participation in the defense industry, we are subject to audits by various government agencies for our compliance with government regulations. We are also subject to a variety of local, state and federal government regulations relating to, among other things, the storage, discharge, handling, omission, generation, manufacture and disposal of toxic or other hazardous substances used to manufacture our products. We believe that we operate our business in material compliance with applicable laws and regulations. However, any failure to comply with existing or future laws or regulations could have a material adverse impact on our business, financial condition and results of operations.
INTELLECTUAL PROPERTY
We rely primarily on a combination of trade secrets and employee and third-party non-disclosure agreements to protect our intellectual property, as well as limiting access to the distribution of proprietary information. We cannot assure you that the steps taken to protect our intellectual property rights will be adequate to prevent misappropriation of our technology or to preclude competitors from independently developing such technology. Furthermore, we cannot assure you that, in the future, third parties will not assert infringement claims against us with respect to our products. Asserting our rights or defending against third party claims could involve substantial costs and diversion of resources, thus materially and adversely affecting our business, financial condition and results of operations. In the event a third party were successful in a claim that one of our products infringed its proprietary rights, we may have to pay substantial royalties or damages, remove that product from the marketplace or expend substantial amounts in order to modify the product so that it no longer infringes on such proprietary rights, any of which could have a material adverse effect on our business, financial condition and results of operations.
EMPLOYEES
As of July 31, 2005 we had 1,026 employees. We believe that our employee relations are satisfactory. None of our approximately 889 U.S. based employees are represented by a labor union. Employment by functional area as of July 31, 2005 is as follows:
Executive 15 Administration 55 Manufacturing 638 Engineering 260 Sales and Marketing 58 ----- Total 1,026 =====
We believe that our future success will depend, in part, on our continued ability to recruit and retain highly skilled technical, managerial and marketing personnel, including microwave engineers. To assist in recruiting and retaining such personnel, we have established competitive benefits programs, including a 401(k) employee savings plan for our U.S. employees, and stock option plans.
OFFICERS OF THE REGISTRANT
Item 2.
Item 2. Properties
Our facilities are as follows:
We believe that these facilities are adequate for our current and presently anticipated future needs.
Item 3.
Item 3. Legal Proceedings
On August 14, 2001, Robinson Laboratories, Inc. ("RLI") and Ben Robinson ("Robinson") filed an Amended Complaint against Herley Industries, Inc. ("Herley"). Although the Amended Complaint sets forth fifteen counts, the core allegations are (i) that Herley failed to issue 97,841 shares of common stock in connection with certain earn out requirements contained in an Asset Purchase Agreement dated February 1, 2000; (ii) that Herley breached an Employment Agreement with Robinson by terminating his employment on August 5, 2001; and (iii) that Herley breached a Stock Option Agreement dated January 31, 2000, with Robinson. RLI and Robinson asserted (i) violations of state and federal securities laws; (ii) fraud claims; (iii) breach of contract claims; and (iv) other equitable claims arising from the above core factual allegations.
On September 17, 2001, Herley filed an Answer, Affirmative Defenses and Counterclaims in this matter. In the Answer and Affirmative Defenses, Herley denied the material allegations of the Amended Complaint. Herley also filed Counterclaims against both RLI and Robinson. In these counterclaims, Herley's core allegations concern Robinson's misconduct (i) in connection with the manner he attempted to satisfy RLI's earn out requirements; (ii) misrepresentations made in connection with the Asset Purchase Agreement; (iii) wrongdoing as a Herley employee leading to his termination and (iv) post-Herley employment wrongdoing in connection with a new company known as RH Laboratories. In addition to seeking a Declaratory Judgment pursuant to 28 U.S.C. Section 2201 et. seq., Herley also asserted claims for, among other things, fraud, breach of contract, breach of fiduciary duty, unfair competition and tortious interference with actual and prospective contractual relationships.
On August 5, 2002, a jury trial commenced. A jury verdict was rendered on August 21, 2002 in which the jury determined, among other things, that (i) Herley was not required to pay any additional stock; (ii) Herley breached the Employment Agreement with Robinson and awarded Robinson $1.5 million in damages; (iii) Herley breached the Lease Agreement with Robinson and awarded Robinson approximately $552,000 in compensatory damages; (iv) Robinson breached fiduciary duties to Herley and awarded Herley $400,000 in compensatory damages; (v) Robinson and RLI breached indemnity obligations and awarded Herley $100,000 in damages; (vi) RLI breached representations and warranties given to Herley and awarded Herley $320,000 in damages.
On October 18, 2002, the Court entered a final judgment consistent with the above, and both parties filed post-trial motions. Additionally, as the prevailing party in connection with the claims asserted by RLI relating to the earn-out stock, as well as claims advanced relating to the various breaches of the Asset Purchase Agreement, Herley filed a petition for fees and costs against both RLI and Robinson on November 27, 2002 for approximately $2,000,000. RLI and Robinson also filed petitions to recover attorneys' fees of approximately $240,000 for certain claims in which they contend that they were the prevailing party. On February 5, 2003, the Court denied the post-trial motions filed by the parties, thus leaving the jury verdict undisturbed.
At a proceeding on April 28, 2003, the Court decided to delay ruling on all of the petitions for fees and costs until after appeals are exhausted. Accordingly, by Order dated May 6, 2003, the Court denied without prejudice all of the parties' petitions. On May 12, 2003, Herley filed its appeal to the United States Court of Appeals for the Second Circuit. On May 28, 2003, RLI filed a notice of cross-appeal. Robinson did not appeal. Herley filed its brief in support of its appeal before the Second Circuit on August 22, 2003. RLI timely filed its brief in response to Herley's appeal and in support of RLI's cross-appeal. Herley timely filed a response to RLI's brief and thereafter RLI timely filed a response to Herley's brief. Oral argument was held on December 18, 2003.
By Summary Order on January 26, 2004, the Second Circuit affirmed the trial court judgment in its entirety. On February 4, 2004, RLI submitted a letter request to the trial court for relief from the judgment on RLI's claim for the earn-out stock under Federal Rule of Civil Procedure 60. RLI contends that it has "newly discovered evidence," first learned in August 2003, to justify its requested relief. Herley submitted its response in opposition by letter dated February 10, 2004. On February 26, 2004, the parties appeared before the Court concerning the various applications and were directed to submit legal briefs on various legal issues. By Order dated May 28, 2004 the trial court denied RLI's Motion for a New Trial. The Court also denied Herley's request that it exercise its general equitable power to hold Ben Robinson personally liable for any fees Herley might recover against RLI.
On June 28, 2004, Herley filed suit against Ben Robinson and Frank Holt in the Superior Court of Hillsborough County, New Hampshire, asserting claims for fraudulent conveyance and piercing the corporate veil to hold Robinson personally liable for the fees incurred by Herley in defending RLI's claims discussed above. In response, Robinson took steps to collect damages awarded to him under the jury verdict. On July 21, 2004, Herley brought an Emergency Motion for Injunctive Relief and moved for an immediate order from the New Hampshire court allowing Herley to escrow the judgment owed to Robinson to be offset against any award of fees to Herley. The court entered an order denying the requested relief. On July 27, 2004, Herley paid $1,594,621 (including interest) to Ben Robinson, an amount calculated by deducting Herley's award against Robinson from the amounts awarded to Robinson on his claims under the Employment Agreement and the Lease Agreement. On July 28, 2004, the parties filed a Notice of Partial Satisfaction of Judgment.
By Order dated February 8, 2005, the Superior court of Hillsborough County, New Hampshire, granted Ben Robinson's and Frank Holt's Motion for Summary Judgment in the New Hampshire action. By Order Dated February 17, 2005, the Court ruled upon the parties' cross-petitions for attorneys' fees, granting all petitions in their entirety. Herley was awarded $2,146,882 against RLI under the Asset Purchase Agreement. RLI was awarded $54,426 against Herley for its successful defense of an indemnity by Herley. Ben Robinson was awarded $259,295 against Herley under the Lease Agreement.
On June 10, 2005, Herley reached an agreement with Robinson, RLI and Holt under which Herley agreed to pay Robinson $260,000 for the attorneys fees awarded to him by the New York Court. Further, all claims, counterclaims and appeals in Herley Industries, Inc. v. Benjamin Robinson and Frank Holt, Docket No. 04-E-0266 and Herley Industries, Inc. v. RH Laboratories, Inc., Stephen Robinson and Michael Gravelese, No. 02-11140 (D. Mass), were dismissed with prejudice. Based upon this agreement, the Company recorded a provision in the third quarter of fiscal 2005 to account for this settlement. The settlement was paid in the fourth quarter of fiscal 2005.
The Company is involved in various other legal proceedings and claims which arise in the ordinary course of its business. While any litigation contains an element of uncertainty, management believes that the outcome of such litigation will not have a material adverse effect on the Company's financial position or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.
(a) Our Common Stock is traded in the NASDAQ National Market under the symbol HRLY. The following table sets forth the high and low closing sales price as reported by the NASDAQ National Market for our Common Stock for the periods indicated.
The closing price on October 17, 2005 was $18.21.
As of October 17, 2005, there were approximately 200 holders of record and approximately 4,800 beneficial holders of our Common Stock.
There have been no cash dividends declared or paid by us on our Common Stock during the past two fiscal years.
(b) Not applicable.
Item 6.
Item 6. Selected Financial Data (in thousands except per share data):
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations
We are a leading supplier of microwave products and systems to defense and aerospace entities worldwide. Our primary customers include large defense prime contractors (including Northrop Grumman, Lockheed Martin, Raytheon and Boeing), the U.S. Government (including the Department of Defense, NASA and other U.S. Government agencies) and international customers (including the Egyptian, German, Japanese and South Korean militaries and suppliers to international militaries). We are a leading provider of microwave technologies for use in command and control systems, flight instrumentation, weapons sensors and electronic warfare systems. We have served the defense industry since 1965 by designing and manufacturing microwave devices for use in high technology defense electronics applications. Our products and systems are currently deployed on a wide range of high profile military platforms, including the Falcon, the F/A-18E/F Super Hornet, the RC-135 Rivet Joint, the E-2C Hawkeye, the AEGIS class surface combatants, the EA-6B Prowler, the AMRAAM air to air missile, and unmanned aerial vehicles, or UAVs, as well as high priority national security programs such as National Missile Defense and the Trident II D-5.
The following table sets forth for the periods indicated certain financial information derived from our consolidated statements of income expressed as a percentage of net sales. There can be no assurance that trends in sales growth or operating results will continue in the future.
Fiscal 2005 Compared to Fiscal 2004
Net sales for the 52 weeks ended July 31, 2005 were approximately $151,415,000 compared to $122,154,000 for fiscal 2004, an increase of approximately $29.3 million (24%). Net sales at our three acquisitions completed in fiscal 2005 (RSS, MSI and ICI), accounted for an increase of approximately $22.3 million, or approximately three quarters of the increase for the 52 weeks ended July 31, 2005. Approximately $11.2 million of net sales increase is attributable to CTI, which was consolidated into our results for only 4 months in fiscal 2004, versus a full 12 months in fiscal 2005. In addition to this impact of a full year results for CTI, CTI has experienced growth of greater than 20% in sales in the fourth quarter of fiscal 2005 as compared to the fourth quarter of fiscal 2004, principally due to growth at CTI in sales of military products in CTI's direct synthesizer products.
Other than these acquisition driven impacts, our other divisions experienced a net decline in sales for the year. The largest decline occurred in our Lancaster operation with the decline in 2005 versus 2004 net sales being primarily attributable to a reduction of $1.3 million in foreign sales and a reduction in revenues from the ACLS program of $1.7 million. Our UK subsidiary, EWST, experienced a reduction in revenue of approximately $1.8 million in fiscal 2005 versus fiscal 2004, principally due to revisions to (and increases in) estimated costs to complete certain contracts, which resulted in a reduction in revenue recognized on these contracts.
Our level of intercompany sales increased from approximately $6.1 million in fiscal 2004 to $7.3 million in fiscal 2005.
The gross profit margin for the 52 weeks ended July 31, 2005 was 30% as compared to the margin of 35% in fiscal 2004 a decline of 5%. Excluding the impact of our three acquisitions completed in fiscal 2005 (RSS, MSI and ICI), the decline in gross profit margins would have been larger. The decrease in gross profit margins is primarily attributable to:
- -- The transition of several new programs from engineering development to the early stage of production, with higher engineering costs not yet offset by production revenues.
- -- Decreases of gross margins at EWST, principally due to changes in contract cost estimates at that operation versus contract cost estimates in the prior fiscal year for the same projects. The changes in contract cost estimates were principally due to unanticipated delays in meeting technical requirements and delivery dates on certain EWST contracts.
offset by
- -- Higher margins contributed by signal generation components and direct sources, principally due to the fact that the prior year included only four months of results for CTI, which was acquired effective as of March 29, 2004.
Selling and administrative expenses for the fifty-two weeks ended July 31, 2005 were 20% of net sales as compared to 17% in fiscal 2004, or an increase of $7.3 million. Large increases during the period included:
- -- Increases of approximately $4.0 million attributable to our three acquisitions completed in fiscal 2005 (RSS, MSI and ICI); and
- -- An increase of approximately $2.0 million due to the fact that the prior year only included four months of results for CTI, which was acquired effective as of March 29, 2004;
- -- An increase of approximately $935,000 in legal costs associated with Robinson Laboratories and a continuing investigation by the U.S. Attorneys' office in Pennsylvania which, inter alia, involves pricing under two contracts with the U.S. Department of Defense relating to voltage control oscillators and a contract relating to powerheads.
We spent approximately $658,000 in out of pocket consulting fees in fiscal 2005 in connection with our Sarbanes-Oxley Section 404 compliance program. We expect some of these costs to continue in fiscal 2006.
As a result of the above trends, our Operating Income for fiscal year 2005 was $14,669,000 or 10% of net sales, as compared to $19,602,000 or 16% of net sales in fiscal 2004. Our foreign operations contributed $872,000 in operating income for the year as compared to $3,017,000 in fiscal 2004. Revenues from our foreign operations decreased by $1,319,000 as compared to fiscal 2004. The drop in revenue and operating income within our foreign operations was due to revisions in total cost estimates at our EWST subsidiary in the UK.
Investment income increased by $260,000 in fiscal 2005 as a result of an 89% increase in the rate of interest earned on the investment of excess cash reserves during the 2005 fiscal year as compared to interest rates in fiscal 2004, and a decrease on average of approximately $27.5 million in funds invested.
The effective income tax rate for fiscal 2005 was 28% as compared to 31% in fiscal 2004. The effective tax rate is lower than the statutory income tax rate of 35% in fiscal 2005 due to various favorable tax benefits. The largest benefit was from the recognition of multi year research and development tax credits now being realized. Other benefits included a lower effective tax rate on foreign-source income, the US tax benefits attributable to extra territorial income (i.e. -- export sales) and tax exempt interest income.
Fiscal 2004 Compared to Fiscal 2003
Net sales for the 52 weeks ended August 1, 2004 were approximately $122,154,000 compared to $110,223,000 for fiscal 2003. The net sales increase of $11,931,000 (11%) is attributable to increased revenue in defense electronics microwave systems and components of $9,426,000 (including $1,078,000 attributable to the acquisition of CTI as of March 29, 2004). This increase also includes revenue from products shipped under new programs as well as increases on legacy products and programs. Net sales in commercial technologies increased by $2,505,000, which includes revenue attributable to the acquisition of CTI of $3,045,000, offset by a decrease of $540,000 in medical and scientific products due to the decline in demand in the industry for Nuclear Magnetic Resonance systems. We expect revenues for medical products to increase and scientific products to remain relatively flat.
The gross profit margin for the 52 weeks ended August 1, 2004 was 35% as compared to the margin of 34% in fiscal 2003. Gross profit increased $5,648,000 primarily as a result of increased volume over fiscal 2003 and greater absorption of fixed costs. Margins also improved in microwave components due to production efficiencies, including the automation of certain processes. This improvement was offset by lower margins on revenue relating to engineering programs which are essential for long-term technology development and future revenue growth. In addition, consolidated gross profit margins were negatively impacted by approximately one half percent due to revisions in total cost estimates (including the effect of foreign exchange translations on non-Sterling denominated contracts) at our EWST subsidiary in the UK.
Selling and administrative expenses for the fifty-two weeks ended August 1, 2004 were 19% of net sales as compared to 16% in fiscal 2003. There was a net increase in expenses of $5,713,000 which includes:
- -- expenses of CTI of approximately $900,000;
- -- an increase of litigation costs of $777,000 directly related to the Robinson Labs litigation and include a payment of the jury award to Ben Robinson of approximately $1,595,000 in July 2004. (See Item 3. "Legal Proceedings");
- -- an increase in incentive compensation under employment contracts and discretionary bonuses of $320,000; and
- -- additional administrative and business development personnel and related costs of $2,019,000;
The Company reorganized and expanded its business development group to focus and capitalize on worldwide market opportunities for all of its products. Other increases include amortization of acquired intangibles of $90,000, sales representative fees and commissions of $623,000, and $303,000 in consulting fees primarily in connection with our Sarbanes-Oxley, Section 404 preparation which will continue in fiscal 2005.
Income from operations for the year was $19,602,000 or 16% of net sales, as compared to $19,667,000 or 18% of net sales in fiscal 2003. The decrease in operating income is primarily attributable to the increases in selling and administrative expenses and litigation costs as discussed above. In addition, our foreign operations contributed $3,017,000 in operating income for the year as compared to $4,250,000 in fiscal 2003. Revenues from our foreign operations decreased by $520,000 as compared to fiscal 2003. The drop in revenue and operating income within our foreign operations was due to revisions in total cost estimates (including the effect of foreign exchange translations on non-Sterling denominated contracts) at our EWST subsidiary in the UK.
Investment income decreased by $439,000 in fiscal 2004 as a result of a 29% decline in the rate of interest earned on the investment of excess cash reserves during the 2004 fiscal year as compared to interest rates in fiscal 2003, and a decrease on average of approximately $6,655,000 in funds invested.
The net foreign exchange loss of $194,000 in fiscal 2004 is attributable to the weaker U.S. Dollar during the fiscal year causing our foreign denominated liabilities to increase in value, and the U.S. Dollar denominated contracts in the United Kingdom to decrease in value. In addition, we recorded an unrealized gain on U.S. Dollar denominated loans to EWST which are expected to be repaid during fiscal 2005.
The effective income tax rate for fiscal 2004 was 31% as compared to 32% in fiscal 2003. The overall effective tax rate is lower than the statutory income tax rate of 35% in fiscal 2004 due to various favorable tax benefits including a lower effective tax rate on foreign-source income, the tax benefit attributable to extra territorial income, and research and development credits.
Quarterly Results (Unaudited)
The following is a summary of the unaudited quarterly results of operations for the 52 weeks ended July 31, 2005 and for the 52 weeks ended August 1, 2004 (in thousands, except for per share data).
The fourth quarter has historically been our strongest quarter for shipments. The third and fourth quarters of fiscal 2005 includes revenue attributable to the acquisitions of MSI of $5,294,000 and $2,824,000, respectively, and ICI of $3,401,000 and $8,389,000, respectively. The third and fourth quarter of fiscal 2004 includes revenue attributable to the acquisition of CTI of $1,116,000 and $3,007,000, respectively.
The gross margin percentage in the fourth quarter of 2005 was negatively impacted (as compared to 2004) due to revisions in total cost estimates on certain long term contracts at our EWST subsidiary which resulted in negative gross profit. In addition, the gross profit margin also varies from quarter to quarter due to changes in product mix.
Included in the results of the third quarter of fiscal 2005 is an accrual of $260,000, and in the fourth quarter of 2004 a payment of $1,595,000 in connection with the Robinson Labs litigation. (See Item 3. "Legal Proceedings").
Liquidity and Capital Resources
As of July 31, 2005 and August 1, 2004, working capital was $88,343,000 and $130,273,000, respectively, and the ratio of current assets to current liabilities was 3.6 to 1 and 6.5 to 1, respectively.
As is customary in the defense industry, inventory is partially financed by progress payments. In addition, it is customary for us to receive advanced payments from customers on major contracts at the time a contract is entered into. The unliquidated balance of these advanced payments was approximately $3,966,000 at July 31, 2005, and $1,180,000 at August 1, 2004.
Net cash provided by operations was approximately $12,968,000 in fiscal 2005 as compared to $3,610,000 in 2004, an increase of approximately $9.4 million. Income from operations (adjusted for depreciation and amortization) was $16,464,000 in fiscal 2005 as compared to $17,917,000 in fiscal 2004, a decrease of approximately $1.5 million. Significant items contributing to the increase in cash provided by operations include the following:
1. an increase of approximately $9.5 million in cash generated from collection of accounts receivable during fiscal 2005 versus fiscal 2004,
2. a reduction of approximately $5.6 million in the amount of cash invested in "Costs incurred and income recognized in excess of billings on uncompleted contracts",
3. a reduction of approximately $2.0 million in the amount of cash invested in inventories during fiscal 2005 versus fiscal 2004, and
4. other net sources of cash
offset by
5. a decrease of approximately $3.1 million in cash generated through advance payments from customers on contracts during the course of fiscal 2005, and
6. a decrease of approximately $2.9 million in cash generated from "Billings in excess of costs incurred and income recognized on uncompleted contracts" during the course of fiscal 2005.
Of the changes noted in (1) and (2) above, the largest impact was from a major contract at our Lancaster facility in connection with an upgrade for US Navy aircraft. This program was accounted for on a percentage of completion basis, and in last year's fourth quarter, we were accumulating significant costs into this contract. The job was largely shipped during fiscal 2004 and early in fiscal 2005, which also contributed to the increase in accounts receivable collections in fiscal 2005.
Net cash used in investing activities includes:
1. A net payment of $51.4 million in connection with the three acquisitions completed in fiscal 2005 (RSS $3.7 million, MSI $20.7 million and ICI $27 million.) (See Note B.)
2. A payment of $2.3 million in connection with the acquisition from Xytrans of certain technology to be used in missile and millimeter wave products. (See Note A-8.)
3. Capital expenditures of $5.4 million including approximately $2.1 million related to new expanded facilities occupied by our Israel and UK operations. The setup costs and capital expenditures associated with these new facilities are now substantially completed. We also invested in our engineering and test facilities throughout our U.S. operations, and expanded certain production facilities at our Lancaster plant.
Net cash provided by financing activities of $2,000 reflects the net impact of proceeds of from the exercise of stock options for $3.5 million, offset by the purchase of treasury stock for approximately $2.7 million, and the payment of the deferred purchase price of EWST.
In June 2002, we entered into a new $50,000,000 Revolving Credit Loan Agreement with two banks on an unsecured basis which may be used for general corporate purposes, including business acquisitions. The revolving credit facility requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on January 31, 2007 (as amended). We may elect to borrow up to a maximum of $5,000,000 with interest based on the Federal Funds Target Rate plus a margin of 1.50% to 1.80%, or up to a maximum of $45,000,000 with interest based on LIBOR plus a margin of 1.35% to 1.65%. The applicable incremental margin is based on the ratio of total liabilities to tangible net worth, as those terms are defined in the agreement. The Federal Funds Target Rate and the LIBOR rate was 3.25% and 3.49%, respectively, at July 31, 2005. There is a fee of 15 basis points per annum on the unused portion of the $45,000,000 LIBOR based portion of the credit facility payable quarterly. There were no borrowings under the line at July 31, 2005 and August 1, 2004. Stand-by letters of credit were outstanding in the amount of $10,703,000 under the credit facility at July 31, 2005.
We believe that presently anticipated future cash requirements will be provided by internally generated funds, our existing unsecured credit facility, and existing cash reserves. A significant portion of our revenue for fiscal 2005 will be generated from our existing backlog of sales orders. The backlog of orders at July 31, 2005 was approximately $145 million. All orders included in backlog are covered by signed contracts or purchase orders. Nevertheless, contracts involving government programs may be terminated at the discretion of the government. In the event of the cancellation of a significant amount of government contracts included in our backlog, we will be required to rely more heavily on cash reserves and our existing credit facility to fund our operations. We are not aware of any events which are reasonably likely to result in any cancellation of our government contracts. We have approximately $39,297,000 available under our bank credit facility, net of outstanding stand-by letters of credit of approximately $10,703,000, and cash reserves at July 31, 2005 of approximately $20,331,000.
Contractual Obligations and Commitments
Our obligations and commitments to make future payments under contracts, such as purchase orders, and debt and lease agreements, and under contingent commitments, such as stand-by letters of credit are as follows:
We have outstanding an aggregate of approximately $22,038,000 in open purchase orders as of July 31, 2005. These open purchase orders represent executory contracts for the purchase of goods and services which will be substantially fulfilled in the next six months.
The following table summarizes the Company=s contractual obligations and other contingent commitments at July 31, 2005 (in thousands):
In addition, we have employment agreements with certain executives of the Company which expire December 31, 2008, subject to extension for additional one-year periods annually each January 1 with a final expiration date of December 31, 2015. The agreements provide for aggregate annual salaries as of July 31, 2005 of $1,460,000 and provide for a semi- annual cost of living adjustment based on the consumer price index. The agreements also provide for incentive compensation at 7% in the aggregate of pretax income of the Company.
The agreements also provide that, in the event there is a change in control of the Company, the executives have the option to terminate the agreements and receive a lump-sum payment equal to the sum of the salary payable for the remainder of the employment term, plus the annual bonuses (based on the average of the three highest annual bonuses awarded during the ten preceding years) for the remainder of the employment term. As of July 31, 2005, the amount payable in the event of such termination would be approximately $16,797,000.
The agreements also provide for consulting periods, one for five years and one for ten years, at the end of the employment period at an annual compensation equivalent to one-half of the executive's annual salary at the end of the employment period, subject to annual cost of living adjustments.
Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 151 "Inventory Costs, an amendment of APB No. 43, Chapter 4" ("SFAS 151.") SFAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS 151 are effective for fiscal years beginning after June 15, 2005. We will adopt this pronouncement beginning with the first quarter of fiscal 2006, and do not expect that the adoption of SFAS 151 will have a material impact on our consolidated financial position or result of operations.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets - -- An Amendment of APB Opinion No. 29". SFAS No. 153 eliminates the exception
from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, "Accounting for Nonmonetary Transactions," and replaces it with an exception for exchanges that do not have commercial substance. SFAS No 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for the fiscal periods beginning after June 15, 2005, and is required to be adopted by the Company effective August 1, 2006. We do not expect SFAS No. 153 to have a material impact on the Company's consolidated financial position or results of operations.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment," which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123R.") SFAS 123R is effective for publicly-traded companies for interim or annual periods beginning after June 15, 2005, supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS 123R requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the consolidated statements of income. SFAS 123R will be effective for the Company beginning with the first quarter of fiscal 2006.
The pro forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. See Note A 14 - Summary of Significant Accounting Policies in Notes to Consolidated Financial Statements for the estimated impact on net income and net income per diluted share amounts of recording share-based payments in the Consolidated Statements of Income using a fair-value-based method similar to the methods required under SFAS 123R to measure compensation expense for employee stock options.
In March 2005, the FASB issued FASB Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations - An Interpretation of SFAS No. 143." This Interpretation provides additional guidance as to when companies should record the fair value of a liability for a conditional asset retirement obligation when there is uncertainty about the timing and (or) method of settlement of the obligation. This Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. We do not expect the adoption of FASB Interpretation No. 47 to have a material impact on the Company's consolidated financial position or results of operations.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, "Accounting Changes and Error Corrections" ("SFAS 154.") SFAS 154 replaces APB Opinion No. 20 "Accounting Changes" and FASB Statement No. 3 "Reporting Accounting Changes in Interim Financial Statements." SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS 154 also provides that a correction of errors in previously issued financial statements should be termed a "restatement." The new standard is effective for accounting changes and correction of errors for fiscal years beginning after December 15, 2005. We do not expect that the adoption of SFAS 154 will have a material impact on the Company's consolidated financial position or results of operations.
Critical Accounting Policies and Estimates
Our established policies are outlined in the footnotes to the Consolidated Financial Statements entitled "Summary of Significant Accounting Policies" (contained in Part II, Item 8 of this Form 10-K). As part of our oversight responsibilities, we continually evaluate the propriety of our accounting methods as new events occur. We believe that our policies are applied in a manner which is intended to provide the user of our financial statements a current, accurate and complete presentation of information in accordance with accounting principles generally accepted in the United States of America. Important accounting practices that require the use of assumptions and judgments are outlined below.
We generally recognize revenue when products are shipped and the customer takes ownership and assumes risk of loss, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Payments received from customers in advance of products delivered are recorded as customer advance payments until earned. Approximately 90% of our customer contracts are firm, fixed price contracts, providing for a predetermined fixed price for the products sold, regardless of the costs incurred. Approximately 14% to 16% of revenues over the last three fiscal years were derived from long-term, fixed price contracts for which revenues and estimated profits are recognized using the percentage of completion method of accounting based on estimated completion to date (the total contract amount multiplied by the percentage of performance, based on total costs incurred in relation to total estimated cost at completion). Contract costs include all direct material and labor costs and those indirect costs related to contract performance. Selling, general and administrative costs are charged to expense as incurred. Risks and uncertainties inherent in the estimation process could affect the amounts reported in our financial statements. The key assumptions used in the estimate of costs to complete relate to labor costs and indirect costs required to complete the contract. The estimate of rates and hours as well as the application of overhead costs is reviewed on a regular basis. If our business conditions were different, or if we used different assumptions in the application of this and other accounting policies, it is likely that materially different amounts would be reported on our financial statements.
Prospective losses on long-term contracts are based upon the anticipated excess of costs over the selling price of the remaining units to be delivered and are recorded in the period when first determinable. Actual losses could differ from those estimated due to changes in the ultimate costs and contract terms.
Inventories are stated at lower of cost (principally first-in, first-out) or market. A valuation allowance for obsolete and slow-moving inventory is established based upon an aging of raw material components. Current requirements for raw materials are evaluated based on current backlog of orders for products in which the components are used and anticipated future orders.
Under the non-amortization approach in accounting for goodwill under SFAS No. 142, goodwill is not amortized into results of operations but instead is reviewed for impairment and written down and charged to results of operations in the period in which the recorded value of goodwill is more than its fair value. An annual impairment test is performed in the fourth quarter of each fiscal year, or when an indication of impairment exists, and any impairment of goodwill is charged to operations.
An impairment test based on a single reporting unit was performed in the fourth quarter of fiscal 2005 using our current market capitalization, which in an active market for our common stock, we consider a reasonable indication of implied fair value. Based on this initial step in the test for impairment, we concluded there was no impairment of goodwill at July 31, 2005.
Provisions for federal, foreign, state and local income taxes are calculated on reported financial statement pretax income based on current tax law and also include the cumulative effect of any changes in tax rates from those used previously in determining deferred tax assets and liabilities. Such provisions differ from the amounts currently payable because certain items of income and expense are recognized in different time periods for financial reporting purposes than for income tax purposes.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are subject to market risk associated with foreign currency exchange and changes in interest rates. We have not entered into any market risk sensitive instruments for trading purposes.
Since the acquisitions of General Microwave Corporation and EWST, we are subject to movements in foreign currency rate changes related to our operations in Israel and in England. The movements in the Israeli Shekel versus the U.S. Dollar have not been significant. Movements in Pounds Sterling (the functional currency at EWST) have been more significant.
Based on our historical results and expected future results, EWST accounts for approximately 7% to 10% of our total revenues, based in part on the rate at which EWST's Sterling denominated financial statements have been or will be converted into U.S. dollars. Since its acquisition in fiscal year 2003, EWST has contributed approximately 2.2% to our consolidated operating income. Having a portion of our future revenue and income denominated in Sterling exposes us to market risk with respect to fluctuations in the U.S. dollar value of future Sterling denominated revenue and earnings.
We have a foreign denominated liability as of July 31, 2005 of approximately 667,000 Pounds Sterling in connection with the acquisition of EWST that is subject to foreign exchange rate fluctuations. Based on the spot rate of exchange at July 31, 2005 of 1.7593, the U.S. Dollar equivalent of the liability is approximately $586,000.
We have made inter-company advances to EWST in the aggregate amount of approximately $6 million at July 31, 2005 that were previously considered long-term advances. However, since the advances are denominated in U.S. Dollars and EWST anticipates reducing the amount of advances during fiscal year 2006, the amount outstanding is subject to foreign exchange rate fluctuations.
In October 2001, we entered into an interest rate swap with a bank pursuant to which it exchanged floating rate interest in connection with the Bonds discussed in Note H of the financial statements on a notional amount of $3,000,000 for a fixed rate of 4.07% for a 10 year period ending October 1, 2011. The notional amount reduces each year in tandem with the annual installments due on the Bonds. The fixing of the interest rate for this period offsets our exposure to the uncertainty of floating interest rates on the Bonds, and as such has been designated as a cash flow hedge. The hedge is deemed to be highly effective and any ineffectiveness will be recognized in interest expense in the reporting period. The fair value of the interest rate swap was a liability of approximately $80,000 as of July 31, 2005. There was no material hedge ineffectiveness related to cash flow hedges during the fiscal years presented to be recognized in earnings.
We also have a $50,000,000 Revolving Credit Loan Agreement with two banks on an unsecured basis which may be used for general corporate purposes, including business acquisitions. The revolving credit facility requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on January 31, 2007. We may elect to borrow up to a maximum of $5,000,000 with interest based on the Federal Funds Target Rate plus a margin of
1.50% to 1.80%, or up to a maximum of $45,000,000 with interest based on LIBOR plus a margin of 1.35% to 1.65%. The applicable incremental margin is based on the ratio of total liabilities to tangible net worth, as those terms are defined in the Agreement. The Federal Funds Target Rate and the LIBOR rate was 3.25% and 3.49%, respectively, at July 31, 2005. The credit line is reviewed on an annual basis.
There were no borrowings outstanding under our revolving credit facility as of July 31, 2005.
The table below provides information about our debt that is sensitive to changes in interest rates. Future principal payment cash flows by maturity date as required under the industrial revenue bonds, and corresponding fair value is as follows:
We do not anticipate any other material changes in its primary market risk exposures in fiscal 2006.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements and supplementary data listed in the Index on Page are filed as a part of this report.
Item 9.
Item 9. Changes in and Disagreements on Accounting and Financial Disclosure
Not applicable
Item 9A.
Item 9A. Controls and Procedures
I. Evaluation of Disclosure Controls and Procedures.
Under the supervision and with the participation of our management, including our principal executive officer (Vice Chairman of the Board/Chief Executive Officer) and principal financial officer (Vice President Finance/ Acting Chief Financial Officer), we have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of July 31, 2005 (the "Evaluation Date"). Based on such evaluation, the principal executive officer and the principal financial officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective, and are reasonably designed to ensure that all material information (including our consolidated subsidiaries) required to be included in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.
Our review of our internal controls was made within the context of the relevant professional auditing standards defining "internal controls," "significant deficiencies," and "material weaknesses." "Internal controls" are processes designed to provide reasonable assurance that our transactions are properly authorized, our assets are safeguarded against unauthorized or improper use, and our transactions are properly recorded and reported, all to permit the preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States. "Significant deficiencies" are control issues that could have a significant adverse effect on our ability to properly authorize transactions, safeguard our assets, or record, process, summarize or report financial data in the consolidated financial statements. A "material weakness" is a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the consolidated financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions. As part of our internal controls
procedures, we also address other, less significant control matters that we identify, and we determine what revision or improvement to make, if any, in accordance with our on-going procedures.
II. Changes in Internal Control over Financial Reporting.
During the quarter ended July 31, 2005, there were certain changes in the Company's internal control over financial reporting which resulted from control improvement and remediation efforts. These changes have not materially affected, and are not likely to materially affect, such internal control over financial reporting.
III. Management's Annual Report on Internal Control over Financial Reporting.
We are responsible for establishing and maintaining an adequate internal control structure and procedures over financial reporting. We have assessed the effectiveness of internal control over financial reporting as of July 31, 2005. Our assessment was based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) Internal Control-Integrated Framework.
Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that:
(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of our assets;
(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and board of directors; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on our financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Our evaluation of and conclusion on the effectiveness of internal control over financial reporting excludes Herley- RSS, Inc. ("RSS"), Micro Systems, Inc. ("MSI"), and Innovative Concepts, Inc. ("ICI"), which were acquired as of September 1, 2004, February 1, 2005 and April 1, 2005, respectively. The acquisitions of RSS, MSI and ICI contributed approximately fifteen percent of our total revenue in fiscal 2005 and accounted for approximately twenty-seven percent of our total assets at July 31, 2005. The aggregate purchase price of the acquisitions was approximately $51.4 million.
Based on the COSO criteria, we believe our internal control over financial reporting as of July 31, 2005 was effective.
Our management's assessment of the effectiveness of our internal control over financial reporting as of July 31, 2005 has been audited by BDO Seidman, LLP, independent registered public accounting firm, as stated in their report which is included below.
Important Considerations
The effectiveness of our disclosure controls and procedures and our internal control over financial reporting is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of our systems, the possibility of human error, and the risk of fraud. Moreover, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and the risk that the degree of compliance with policies or procedures may deteriorate over time. Because of these limitations, there can be no assurance that any system of disclosure controls and procedures or internal control over financial reporting will be successful in preventing all errors or fraud or in making all material information known in a timely manner to the appropriate levels of management.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
To The Board of Directors of Herley Industries, Inc. and subsidiaries:
We have audited management's assessment, included in Management's Annual Report on Internal Control Over Financial Reporting, that Herley Industries, Inc. and subsidiaries (the "Company") maintained effective internal control over financial reporting as of July 31, 2005, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As indicated in the accompanying Management's Annual Report on Internal Control over Financial Reporting and scope of management's report, management's assessment of and conclusion of the effectiveness of internal control over financial reporting did not include the internal controls of Herley-RSS, Inc. ("RSS"), Micro Systems, Inc. ("MSI"), and Innovative Concepts, Inc. ("ICI"), which were included in the fiscal 2005 consolidated financial statements of Herley Industries, Inc. and constituted $22.3 million of net revenue for the year ended July 31, 2005. The aggregate purchase price of the acquisitions was approximately $51.4 million. Management did not assess the effectiveness of internal control over financial reporting of these entities as they were acquired during fiscal 2005. Our audit of internal control over financial reporting of Herley Industries, Inc. also did not include an evaluation of internal control over financial reporting of Herley-RSS, Inc. ("RSS"), Micro Systems, Inc. ("MSI"), and Innovative Concepts, Inc. ("ICI").
In our opinion, management's assessment that Herley Industries, Inc. and subsidiaries maintained effective internal control over financial reporting as of July 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 31, 2005, based on the COSO criteria.
We have also audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Herley Industries, Inc. and subsidiaries as of July 31, 2005, and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for the year ended July 31, 2005, and our report dated October 7, 2005 expressed an unqualified opinion thereon.
/s/ BDO SEIDMAN, LLP
Philadelphia, Pennsylvania October 7, 2005
Item 9B.
Item 9B. Other Information
Not applicable
PART III
The information required by Part III is incorporated by reference to our definitive proxy statement in connection with our Annual Meeting of Stockholders scheduled to be held in February 2006, to be filed with the Securities and Exchange Commission within 120 days following the end of our fiscal year ended July 31, 2005.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Exhibits
3.1 Certificate of Incorporation, as amended (Exhibit 3(a) of Form S-1 Registration Statement No. 2-87160). 3.2 By-Laws, as amended August 7, 2001 (Exhibit 3.2 of Annual Report on Form 10-K for the fiscal year ended July 29, 2001). 10.1 1996 Stock Option Plan (Exhibit 10.1 of Annual Report on Form 10-K for the fiscal year ended July 28, 1996). 10.2 1997 Stock Option Plan (Exhibit 10.1 of Report on Form 10-Q dated June 10, 1997). 10.3 1998 Stock Option Plan (Exhibit 10.3 of Annual Report on Form 10-K for the fiscal year ended August 1, 1999). 10.4 2000 Stock Option Plan (Exhibit 4.1 of Report on Form S-8 dated October 12, 2001). 10.5 2003 Stock Option Plan (Exhibit 10.1 of Report on Form 10-Q dated June 11, 2003). 10.6 Employment Agreement between Herley Industries, Inc. and Lee N. Blatt dated as of July 29, 2002. (Exhibit 10.5 of Annual Report on Form 10-K for the fiscal year ended July 28, 2002). 10.7 Employment Agreement between Herley Industries, Inc. and Myron Levy dated as of July 29, 2002. (Exhibit 10.6 of Annual Report on Form 10-K for the fiscal year ended July 28, 2002). 10.8 Agreement and Plan of Reorganization dated as of July 8, 1997 among the Company, Metraplex Acquisition Corporation and Metraplex Corporation (Exhibit 2.1 of Registration Statement Form S-3 dated September 4, 1997). 10.9 Agreement and Plan of Merger dated as of August 21, 1998 among General Microwave Corp., Eleven General Microwave Corp., Shareholders, GMC Acquisition Corporation and Registrant (Exhibit 1 of Schedule 13D dated August 28, 1998). 10.10Lease Agreement dated September 1, 1999 between Registrant and RSK Realty LTD. (Exhibit 10.8 of Annual Report on Form 10-K for the fiscal year ended August 1, 1999). 10.11Loan Agreement dated June 19, 2002 among the Registrant, Allfirst Bank and Fulton Bank. (Exhibit 10.10 of Annual Report on Form 10-K for the fiscal year ended July 28, 2002). 10.12Amendment (dated May 2, 2003) to Loan Agreement dated June 19, 2002 among the Registrant, Manufacturers and Traders Trust Company, successor in interest to Allfirst Bank, and Fulton Bank. (Exhibit 10.12 of Annual Report on Form 10-K for the fiscal year ended August 3, 2003). 10.13Asset Purchase Agreement dated as of February 1, 2000 between Registrant and Robinson Laboratories, Inc. (Exhibit 10.2 of Form 10-Q dated March 13, 2000). 10.14Asset Purchase Agreement dated as of October 12, 2000 between Registrant and American Microwave Technology Inc. (Exhibit 10.1 of Form 10-Q dated December 12, 2000). 10.15Asset Purchase Agreement dated as of March 29, 2004 between Registrant and Communication Techniques, Inc. (Exhibit 10.15 of Annual Report on Form 10-K for the fiscal year ended August 1, 2004). 10.16Lease Agreement dated March 1, 2000 between Registrant and RSK Realty LTD (Exhibit 10.13 of Annual Report on Form 10-K for the fiscal year ended July 30, 2000). 10.17Common Stock Purchase Agreement dated as of September 20, 2002 between Registrant and EW Simulation Technology, Limited. (Exhibit 10.17 of Annual Report on Form 10-K for the fiscal year ended July 28, 2002). 10.18Trust Indenture dated as of October 19, 2001 between Registrant, and East Hempfield Township Industrial Development Authority and Allfirst Bank, as Trustee. (Exhibit 10.18 of Annual Report on Form 10-K for the fiscal year ended July 28, 2002). 10.19Amendment (dated April 2, 2004) to Loan Agreement dated June 19, 2002 among the Registrant, Manufacturers and Traders Trust Company, successor in interest to Allfirst Bank, and Fulton Bank. (Exhibit 10.19 of Annual Report on Form 10-K for the fiscal year ended August 1, 2004). 10.20Asset Purchase Agreement dated as of September 1, 2004 between Registrant and Reliable System Services Corp. (Exhibit 10.20 of Annual Report on Form 10-K for the fiscal year ended August 1, 2004). 10.21Amendment dated December 9, 2003 to Employment Agreement between Herley Industries, Inc. and Myron Levy dated as of July 29, 2002. (Exhibit 10.21 of Annual Report on Form 10-K for the fiscal year ended August 1, 2004).
10.22Amendment dated December 9, 2003to Employment Agreement between Herley Industries, Inc. and Lee N. Blatt dated as of July 29, 2002. (Exhibit 10.22 of Annual Report on Form 10-K for the fiscal year ended August 1, 2004). 10.23Common Stock Purchase Agreement dated as of February 1, 2005 between Registrant and Micro Systems, Inc. (Exhibit 2.1 of Form 8K dated February 7, 2005). 10.24Common Stock Purchase Agreement dated as of April 12, 2005 between Registrant and Innovative Concepts, Inc. (Exhibit 2.1 of Form 8K dated April 18, 2005). 10.25Amendment (dated June 9, 2005) to Loan Agreement dated June 19, 2002 among the Registrant, Manufacturers and Traders Trust Company, successor in interest to AllFirst Bank, and Fulton Bank. (Exhibit 10.1 of Form 10-Q dated June 10, 2005). 23.1 Consent of BDO Seidman, LLP. 23.2 Consent of Deloitte & Touche LLP. 31.1 Certifications pursuant to Rules 13a-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Financial Statements
(1) See Index to Consolidated Financial Statements at Page.
(2) Schedule II - Valuation and Qualifying Accounts filed as part of this Form 10-K at page 30.
SIGNATURES:
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on October 31, 2005.
HERLEY INDUSTRIES, INC.
By: /S/ Lee N. Blatt --------------------- Lee N. Blatt, Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on October 31, 2005 by the following persons in the capacities indicated:
By: /S/ Lee N. Blatt Chairman of the Board ----------------------- Lee N. Blatt
By: /S/ Myron Levy Vice Chairman of the Board ----------------------- Chief Executive Officer and Director Myron Levy (Principal Executive Officer)
By: /S/ Anello C. Garefino Vice President Finance and ------------------------ Acting Chief Financial Officer Anello C. Garefino (Principal Financial Officer)
By: /S/ John A. Thonet Secretary and Director ------------------------ John A. Thonet
By: /S/ Carlos C. Campbell Director ------------------------ Carlos C. Campbell
By: /S/ Edward K. Walker, Jr. Director --------------------------- Edward K. Walker, Jr.
By: /S/ Robert M. Moore Director ----------------------- Robert M. Moore
By: /S/ Edward A. Bogucz Director ----------------------- Edward A. Bogucz
Schedule II - Valuation and Qualifying Accounts (in thousands)
All other Schedules have been omitted since they are either not required, not applicable, or the information is otherwise included in this Annual Report on Form 10-K.
Item 8. Financial Statements and Supplementary Data
HERLEY INDUSTRIES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors Herley Industries, Inc. Lancaster, Pennsylvania
We have audited the accompanying consolidated balance sheet of Herley Industries, Inc. and subsidiaries (the "Company") as of July 31, 2005, and the related consolidated statements of income, shareholders' equity, and cash flows for the year ended July 31, 2005. We have also audited the financial statement schedule listed in the index at Item 15 as it relates to the year ended July 31, 2005. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of the Company for the years ended August 1, 2004 and August 3, 2003 were audited by other auditors who have expressed an unqualified opinion on those financial statements in their report dated October 14, 2004.
We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Herley Industries, Inc. as of July 31, 2005, and the results of its operations and its cash flows for the year ended July 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the schedule presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Herley Industries, Inc. internal control over financial reporting as of July 31, 2005, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO criteria) and our report dated October 7, 2005 expressed an unqualified opinion thereon.
/s/ BDO SEIDMAN, LLP
Philadelphia, Pennsylvania October 7, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Herley Industries, Inc. Lancaster, Pennsylvania
We have audited the accompanying consolidated balance sheet of Herley Industries, Inc. and subsidiaries (the Corporation) as of August 1, 2004, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the two years in the period ended August 1, 2004. Our audits also included the financial statement schedule for the years ended August 1, 2004 and August 3, 2003, listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Corporation's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Corporation's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Herley Industries, Inc. and subsidiaries at August 1, 2004, and the results of their operations and their cash flows for each of the two years in the period ended August 1, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule for the years ended August 1, 2004 and August 3, 2003, 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/ DELOITTE & TOUCHE LLP
Baltimore, Maryland October 14, 2004
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share data)
The accompanying notes are an integral part of these financial statements.
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
The accompanying notes are an integral part of these financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
1. Nature of Operations --------------------
The Company, a Delaware corporation, is engaged in research, engineering, product development, and manufacturing of complex microwave radio frequency (RF) and millimeter wave components and subsystems for defense and commercial customers worldwide.
2. Fiscal Year -----------
The Company's fiscal year ends on the Sunday closest to July 31. Normally each fiscal year consists of 52 weeks, but every five or six years the fiscal year will consist of 53 weeks. Fiscal year 2003 consisted of 53 weeks and all other fiscal years presented consisted of 52 weeks.
3. Basis of Financial Statement Presentation -----------------------------------------
The consolidated financial statements include the accounts of Herley Industries, Inc. and its subsidiaries, all of which are wholly-owned. All significant inter-company accounts and transactions have been eliminated in consolidation. The presentation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements as well as revenues and expenses during the period. Actual results could differ from those estimates.
4. Cash and Cash Equivalents -------------------------
The Company considers all liquid investments with an original maturity of three months or less at the date of acquisition to be cash equivalents. Short-term investments are recorded at the amortized cost plus accrued interest which approximates market value. The Company limits its credit risk to an acceptable level by evaluating the financial strength of institutions at which significant investments are made and based upon credit ratings.
5. Concentration of Credit Risk ----------------------------
Financial instruments which potentially subject the Company to credit risk consist primarily of trade accounts receivable. Accounts receivable are principally from the U.S. Government, major U.S. Government contractors, several foreign governments, and domestic customers in the defense, aerospace, and medical industries. Credit is extended based on an evaluation of the customer's financial condition and generally collateral is not required. In many cases irrevocable letters of credit accompanied by advanced payments are received from foreign customers, and progress payments are received from domestic customers. The Company performs periodic credit evaluations of its customers and maintains reserves for potential credit losses.
6. Inventories -----------
Inventories, other than inventory costs relating to long-term contracts and programs, are stated at lower of cost (principally first-in, first-out) or market. Inventory costs relating to long-term contracts and programs are stated at the actual production costs, including factory overhead, reduced by amounts identified with revenue recognized on units delivered or progress completed.
Inventory costs relating to long-term contracts and programs are reduced by any amounts in excess of estimated realizable value.
7. Property, Plant and Equipment -----------------------------
Property, plant and equipment are stated at cost. Depreciation and amortization are provided principally by the straight-line method over the estimated useful lives of the related assets. Gains and losses arising from the sale or disposition of property, plant and equipment are included in income from operations.
8. Goodwill and Other Intangible Assets ------------------------------------
The Company adopted the provisions of SFAS No. 142 "Goodwill and Other Intangible Assets" on July 30, 2001. SFAS No. 142 requires the use of a non-amortization approach to account for purchased goodwill and certain intangibles. Under a non-amortization approach, goodwill and certain intangibles are not amortized into results of operations, but instead are reviewed for impairment and written down and charged to results of operations in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value. The adoption of SFAS No.142 resulted in the Company's discontinuation of amortization of its goodwill and certain intangible assets. An annual impairment test is performed in the fourth quarter of each fiscal year and any future impairment of goodwill will be charged to operations. There was no impairment in goodwill at July 31, 2005 based on current market capitalization of the Company.
The change in the carrying amount of goodwill for the years ended July 31, 2005 and August 1, 2004, is principally based upon the fair value of assets acquired and liabilities assumed related to the acquisitions of CTI in fiscal 2004 and RSS, MSI and ICI in fiscal 2005, as follows (in thousands):
Intangibles consist of the following (in thousands):
The Company entered into a license and development agreement ("agreement") on April 7, 2005 to license millimeter wave technology for military applications from Xytrans, Inc. Xytrans focuses on providing high-frequency transceiver and outdoor unit design for the wireless broadband network market. The technology acquired includes exclusive access to a portfolio of patents and trade secrets that improve the cost and performance of millimeter wave subsystems that are used in weapons and radar systems.
In January 2005, the Company had made a deposit payment of $1,000,000 in connection with this proposed transaction. The deposit payment was secured by a note receivable, which was cancelled upon execution of the agreement. The agreement provided for an additional payment on execution of $1,000,000, and for certain additional contingent payments, of up to $4,500,000. These contingent payments are subject to achievement of a series of development milestones on a US Government missile program, and / or receipt by the Company of a single contract award using millimeter wave technology valued at a minimum of $6,000,000, amongst other requirements. The agreement also provides for the payment of royalties ranging from 1% to 4% of sales of products including relevant millimeter wave technology, starting at the earliest January 1, 2006, and generally ending 4 years later.
In the fourth quarter of fiscal 2005, Xytrans had achieved certain of the development milestones on the missile program discussed above, and the Company made additional contingent payments totaling $300,000. In the first quarter of fiscal 2006 (as of October 14, 2005), additional contingent payments totaling $375,000 were made by the Company.
The investment in this licensed technology of $2,300,000 as of July 31, 2005 is included in the Consolidated Balance Sheet under the caption "Intangibles." After further development of this technology, and / or at the commencement of sales of products using the millimeter wave technology, the Company will begin to amortize a portion of the costs associated with this agreement against the related revenues, and may allocate some of the value of this technology to the specific patents acquired. In the event that some of the value is allocated to specific patents, then that value would be amortized over the remaining life of the patent. At this point, the portion of this technology investment that should be allocated to any particular patent is not estimatable.
Amortization expense related to Intangibles for the fifty-two weeks ended July 31, 2005 and August 1, 2004, was approximately $928,000 and $349,000, respectively.
Estimated aggregate amortization expense for each of the next five fiscal years, is as follows (in thousands):
9. Marketable Securities ---------------------
The Company accounts for its investments in marketable securities in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Marketable equity securities and debt securities not classified as held-to-maturity are classified as available-for-sale. Available-for-sale securities are carried at fair market value with net unrealized holding gains or losses, net of income taxes, reported as a separate component of other comprehensive income or loss. Realized gains and losses and declines in value judged to be other-than-temporary are included in other income (expense), net. The cost of securities sold is based on the specific identification method. Interest and dividends on securities are included in other income.
10. Other Investments -----------------
The Company is a limited partner in a non-marketable limited partnership in which it owns approximately a 10% interest. The investment is accounted for under the equity method (See Note D.)
11. Revenue and Cost Recognition ----------------------------
The Company generally recognizes revenue when products are shipped and the customer takes ownership and assumes risk of loss, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Payments received from customers in advance of products delivered are recorded as customer advance payments until earned. Substantially all of our customer contracts are firm, fixed price contracts, providing for a predetermined fixed price for the products sold, regardless of the costs incurred. A certain percentage of revenues are derived from long-term, fixed price contracts. Revenues and estimated profits are recognized on these contracts using the percentage of completion method of accounting and are based on estimated completion to date (the total contract amount multiplied by the percentage of performance, based on total costs incurred in relation to total estimated cost at completion). Prospective losses on long-term contracts are based upon the anticipated excess of manufacturing costs over the selling price of the remaining units to be delivered and are recorded in the period when first determinable. Actual losses could differ from those estimated due to changes in the ultimate manufacturing costs and contract terms.
Contract costs include all direct material and labor costs and those indirect costs related to contract performance. Selling, general and administrative costs are charged to expense as incurred.
12. Product Development -------------------
The Company's primary efforts are focused on engineering design and product development activities rather than pure research. The cost of these development activities, including employees' time and prototype development, net of amounts paid by customers, was approximately $5,018,000, $5,422,000, and $3,083,000 in fiscal 2005, 2004, and 2003, respectively, and are included in cost of products sold.
13. Income Taxes ------------
Income taxes are accounted for by the asset/liability approach in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Deferred taxes represent the expected future tax consequences when the reported amounts of assets and liabilities are recovered or paid. They arise from temporary differences between the financial reporting and tax bases of assets and liabilities and are adjusted for changes in tax laws and tax rates when those changes are enacted. The provision for income taxes represents the total of income taxes paid or payable for the current year, plus the change in deferred taxes during the year.
14. Stock-Based Compensation ------------------------
The Company has various fixed stock option plans which reserve shares of common stock for issuance to executives, key employees and directors. The Company accounts for employee stock options in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock. Because the exercise price of the employee stock options granted equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS 123) provides an alternative to APB 25 in accounting for stock-based compensation issued to employees. SFAS 123 provides for a fair-value-based method of accounting for employee stock options, employee stock purchase plans and similar equity instruments. Companies that continue to account for stock-based compensation arrangements under APB 25 are required by SFAS 123 to disclose the pro forma effect on net income and net income per share as if the fair-value-based method prescribed by SFAS 123 had been applied. The Company has continued to account for stock-based compensation using the provisions of APB 25 and presents below the pro forma information required by SFAS 123 as amended by Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" (SFAS 148).
In April 2005, the Company's Board of Directors, upon recommendation of the Board's Compensation Committee, approved the accelerated vesting of all unvested and "out-of-the-money" stock options outstanding as of May 2, 2005. As a result of this action, options to purchase approximately 307,000 shares of the Company's common stock that would otherwise have vested at various times within the next four years became fully vested. The decision to accelerate the vesting, which the Company believes to be in the best interest of the Company and its shareholders, was made in lieu of certain discretionary cash bonuses, and to reduce compensation expense that might be recorded in future periods following the Company's adoption of SFAS 123(R). The Board of Directors further believes that the acceleration is consistent with possible changes to the Company's overall equity compensation approach, which is expected to include a reduced use of stock options. The SFAS 123 pro forma stock-based compensation costs of approximately $4,587,000 (net of taxes) for the year ended July 31, 2005 in the table below includes a charge of approximately $900,000 (net of taxes) as a result of the acceleration.
Pro forma Disclosures
Pro forma information regarding net income and net income per share is required by SFAS 123 as amended by SFAS 148, and has been determined as if the Company accounted for its employee stock option plans using the fair value method of SFAS 123 as amended by SFAS 148. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:
For purposes of pro forma disclosures, compensation costs for stock options granted in fiscal years 2005, 2004, and 2003, based on the fair value at the grant date consistent with the provisions of SFAS 123, the Company's net income and earnings per share would have been as follows (in thousands except per share data):
On December 16, 2004, the FASB issued SFAS 123(R), which is a revision of SFAS 123. SFAS 123(R) supersedes APB 25 and amends SFAS 95, "Statement of Cash Flows." Generally, the approach in SFAS 123(R) is similar to the approach in SFAS 123. However, SFAS 123(R) requires that the compensation cost relating to share-based payment transactions, including grants of employee stock options, be recognized in financial statements based on the estimated fair value of those options using an acceptable valuation method. Pro forma disclosure will no longer be an alternative.
SFAS 123(R) was originally effective for public companies at the beginning of the first interim or annual period beginning after June 15, 2005. However, on April 15, 2005, the SEC amended the date for compliance with SFAS 123(R) to be the first interim or annual reporting period of the registrant's first fiscal year beginning on or after June 15, 2005. Therefore, the Company will prepare its financial statements in accordance with SFAS 123(R) beginning on August 1, 2005. In accordance with SFAS 123(R), companies may elect to use either the modified- prospective or modified-retrospective transition method. The Company expects to use the modified-prospective transition method. Under this method, compensation cost is recognized for all awards granted, modified or settled after the adoption date as well as for any awards that were granted prior to the adoption date for which the requisite service has not yet been rendered.
The adoption of SFAS 123(R)'s fair value method may have a significant impact on the Company's results of operations, although it will have no impact on the Company's overall financial position. The impact of adoption of SFAS 123(R) in fiscal 2006 and beyond cannot be predicted at this time because it will depend upon various factors including levels of share-based awards granted in the future and the Company's future compensation strategy.
If the Company had adopted SFAS 123(R) in prior periods, the impact would have approximated the impact of SFAS 123 as described in the pro forma disclosure above. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption.
The pro forma compensation costs presented in the table above and in prior filings have been calculated using a Black-Scholes option pricing model and may not be indicative of amounts which should be expected in future periods. As of the date of this filing, the Company is still evaluating the option pricing model that it will use to estimate the fair value of its options when SFAS 123(R) becomes effective.
15. Foreign Currency Translation ----------------------------
Financial statements of foreign subsidiaries are prepared in their respective functional currencies and translated into United States dollars at the current exchange rates for assets and liabilities and a monthly average rate during the year for revenues, costs and expenses. Net gains or losses resulting from the translation of foreign financial statements are charged or credited directly to the 'Foreign currency translation' component of "Accumulated other comprehensive income" in the accompanying consolidated statements of shareholders' equity.
16. Derivatives -----------
The Company recognizes all derivatives on the balance sheet at fair value. On the date the derivative instrument is entered into, the Company generally designates the derivative as either (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment ("fair value hedge") or (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability ("cash flow hedge"). The Company entered into an interest rate swap in October 2001 with a bank, which it recognized as a cash flow hedge. Changes in the fair value of a derivative that is designated as, and meets all the required criteria for, a cash flow hedge are recorded in accumulated other comprehensive income (loss) and reclassified into earnings as the underlying hedged item affects earnings.
17. Comprehensive Income
The Company reports comprehensive income in the Consolidated Statements of Shareholders' Equity, which includes net income, unrealized gain (loss) on available-for sale securities, unrealized gain (loss) on interest rate swap, and foreign currency translation gain (loss), net of related income taxes. Substantially all the amount included in other comprehensive income relates to the effects of foreign exchange translation gains and losses.
18. New Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 151 "Inventory Costs, an amendment of APB No. 43, Chapter 4" ("SFAS 151.") SFAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS 151 are effective for fiscal years beginning after June 15, 2005. The Company will adopt this pronouncement beginning with the first quarter of fiscal 2006, and does not expect that the adoption of SFAS 151 will have a material impact on its consolidated financial position or result of operations.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets -- An Amendment of APB Opinion No. 29". SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, "Accounting for Nonmonetary Transactions," and replaces it with an exception for exchanges that do not have commercial substance. SFAS No 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for the fiscal periods beginning after June 15, 2005, and is required to be adopted by the Company effective August 1, 2005. The Company does not expect SFAS No. 153 to have a material impact on it consolidated financial position or results of operations.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment," which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123R.") SFAS 123R is effective for publicly-traded companies for interim or annual periods beginning after June 15, 2005, supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS 123R requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the consolidated statements of income. SFAS 123R will be effective for the Company beginning with the first quarter of fiscal 2006.
The pro forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. See Note A 14 - Summary of Significant Accounting Policies in Notes to Consolidated Financial Statements for the estimated impact on net income and net income per diluted share amounts of recording share-based payments in the Consolidated Statements of Income using a fair-value-based method similar to the methods required under SFAS 123R to measure compensation expense for employee stock options.
In March 2005, the FASB issued FASB Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations - An Interpretation of SFAS No. 143." This Interpretation provides additional guidance as to when companies should record the fair value of a liability for a conditional asset retirement obligation when there is uncertainty about the timing and (or) method of settlement of the obligation. This Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The Company does not expect the adoption of FASB Interpretation No. 47 to have a material impact on its consolidated financial position or results of operations.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, "Accounting Changes and Error Corrections" ("SFAS 154.") SFAS 154 replaces APB Opinion No. 20 "Accounting Changes" and FASB Statement No. 3 "Reporting Accounting Charges in Interim Financial Statements." SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS 154 also provides that a correction of errors in previously issued financial statements should be termed a "restatement." The new standard is effective for accounting changes and correction of errors for fiscal years beginning after December 15, 2005. The Company does not expect that the adoption of SFAS 154 will have a material impact on its consolidated financial position or results of operations.
NOTE B - ACQUISITIONS
The Company entered into an agreement as of March 29, 2004 to acquire certain assets and the business, subject to the assumption of certain liabilities, of Communication Techniques, Inc. for $14,914,000 in cash. The business operates as a wholly-owned subsidiary of the Company, Herley-CTI, Inc. ("CTI"). CTI designs, develops and produces signal generation components and integrated assemblies for digital radio, Satellite Communications, test and instrumentation, and datacom applications. CTI also recently developed a fast frequency changing direct synthesizer which, when combined with the capabilities of Herley-Israel, puts the Company at the forefront of producing broadband microwave sources for radar, communication, electronic warfare, and microwave test systems.
The Company entered into an agreement as of September 1, 2004 to purchase the majority of the assets and assume the majority of the liabilities of Reliable System Services Corporation of Melbourne, Florida for $3,725,000
in cash. The results of operations of RSS are included in the consolidated financial statements from September 1, 2004. The Company operates the business as a wholly-owned subsidiary under the name Herley-RSS, Inc. ("RSS"). RSS was acquired by Herley in order to capitalize on its synergies with Herley's other product lines, particularly in "over the horizon" command and control (C2) systems for drones and targets. RSS designs, develops and produces satellite-based command and control systems for prime defense contractors and entities worldwide.
The Company entered into an agreement as of February 1, 2005 to acquire all of the capital stock of Micro Systems, Inc. ("MSI"), Fort Walton Beach, Florida for a payment of $21,473,328 in cash and the assumption of certain liabilities. The results of operations of MSI are included in the consolidated financial statements from February 1, 2005. MSI was acquired by Herley in order to capitalize on its synergies with Herley's legacy product lines, consolidate operations, addition of engineers and increase its capabilities in the area of control avionics, and target control systems. MSI is a market leader in the design and manufacturing of command and control systems for operation of unmanned aerial, seaborne and ground targets and missiles.
The Company entered into an agreement as of April 1, 2005 to acquire all of the capital stock of Innovative Concepts, Inc. ("ICI"), McLean, Virginia for cash payments, including the assumption and payment of certain liabilities, of $24,378,330. The results of operations of ICI are included in the consolidated financial statements from April 1, 2005. ICI was acquired by Herley in order to capitalize on its tactical data link technology for exchange of digital information. ICI has a successful history of developing and providing wireless communications technology and real-time embedded systems, software, hardware and high-speed processing in support of the defense industry.
All of the acquisitions completed by the Company are accounted for in accordance with the provisions of SFAS No. 141, "Business Combinations", which requires that all business combinations be accounted for using the purchase method.
For the four acquisitions outlined above, the allocation of the aggregate purchase price (net of cash acquired), based on a review of the fair value of the assets acquired and liabilities assumed, is as follows (in thousands):
The Company's consolidated financial statements reflect preliminary estimates of the fair value of the ICI assets acquired and liabilities assumed and the related allocations of the purchase price. The final determination of the fair value of liabilities assumed and final allocation of the purchase price is expected to be completed no later than the third quarter of fiscal 2006, and may differ from the amounts included in the accompanying consolidated financial statements.
Goodwill resulting from these acquisitions is based on the excess of the amounts paid over the estimated fair value of the net assets acquired, and is tax deductible.
Prior to the acquisition of MSI, MSI had leased one of its two buildings in Fort Walton Beach Florida from MSI Investments, a Florida General Partnership. MSI Investments is owned by four individuals, three of whom are currently employees of MSI. This lease has an original term of 15 years, ending December 31, 2012. The lease costs currently are approximately $278,000 on an annual basis, including the tenant's obligation to pay for insurance and property taxes. The base lease rate is adjusted every January for changes in the consumer price index, using 1997 as the base year.
NOTE C - INVENTORIES
The major components of inventories are as follows (in thousands):
NOTE D - OTHER INVESTMENTS
In July 1994, the Company invested $1,000,000 for a limited partnership interest in M.D. Sass Municipal Finance Partners-I, a Delaware limited partnership. The objectives of the partnership are the preservation and protection of its capital and the earning of income through the purchase of certificates or other documentation that evidence liens for unpaid local taxes on parcels of real property. At July 31, 2005 and August 1, 2004 the percentage of ownership was approximately 10%. The Company's interest in the partnership may be transferred to a substitute limited partner, upon written notice to the managing general partners, only with the unanimous consent of both general partners at their sole discretion. The partnership is in the process of being liquidated and accordingly the Company received partial distributions of approximately $109,000 and $55,000 from the Partnership in fiscal 2005 and 2004, respectively. As of July 31, 2005 the Company's limited partnership interest had a carrying value of approximately $62,000, based on the equity method of accounting.
NOTE E - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are comprised of the following (in thousands):
Depreciation charges totaled approximately $4,626,000, $3,796,000, and $3,944,000 in fiscal 2005, 2004, and 2003, respectively.
NOTE F - COMMITMENTS AND CONTINGENCIES
Leases ------
The Company leases office, production and warehouse space as well as computer equipment and automobiles under non-cancelable operating leases. Rent expense for the 52 weeks ended July 31, 2005 and August 1, 2004, and the 53 weeks ended August 3, 2003, was approximately $2,834,000, $1,749,000, and $1,393,000, respectively. Minimum annual rentals under non-cancelable operating leases are as follows (in thousands):
Employment Agreements ---------------------
The Company has employment agreements with certain executives of the Company which expire December 31, 2009, subject to extension for additional one-year periods annually each January 1 with a final expiration date of December 31, 2015 (as amended December 9, 2003). The agreements provide for aggregate annual salaries as of July 31, 2005 of $1,460,000 and provide for a semi-annual cost of living adjustment based on the consumer price index. The agreements also provide for incentive compensation at 7% in the aggregate of pretax income of the Company. Incentive compensation in the amount of $1,138,000, and $2,214,000 (including a supplemental payment of $650,000 for fiscal 2003) was charged to expense in fiscal years 2005 and 2004, respectively.
The agreements also provide that, in the event there is a change in control of the Company, as defined, the executives have the option to terminate the agreements and receive a lump-sum payment equal to the sum of the salary payable for the remainder of the employment term, plus the annual bonuses (based on the average of the three highest annual bonuses awarded during the ten preceding years) for the remainder of the employment term. As of July 31, 2005, the amount payable in the event of such termination would be approximately $16,797,000. The agreements also provide for consulting periods, one for five and one for ten years, at the end of the employment period at an annual compensation equivalent to one-half of the executive's annual salary at the end of the employment period, subject to annual cost of living adjustments.
An employment contract of a retired executive provides for a consulting period which became effective October 1, 1998, and terminates December 31, 2010 at the annual rate of compensation of $100,000.
Eight officers of the Company have severance agreements providing for an aggregate lump-sum payment of $2,970,000 through September 30, 2006 in the event of a change of control of the Company as defined in the agreements.
Litigation ----------
On August 14, 2001, Robinson Laboratories, Inc. ("RLI") and Ben Robinson ("Robinson") filed an Amended Complaint against Herley Industries, Inc. ("Herley"). Although the Amended Complaint sets forth fifteen counts, the core allegations are (i) that Herley failed to issue 97,841 shares of common stock in connection with certain earn out requirements contained in an Asset Purchase Agreement dated February 1, 2000; (ii) that Herley breached an Employment Agreement with Robinson by terminating his employment on August 5, 2001; and (iii) that Herley breached a Stock Option Agreement dated January 31, 2000, with Robinson. RLI and Robinson asserted (i) violations of state and federal securities laws; (ii) fraud claims; (iii) breach of contract claims; and (iv) other equitable claims arising from the above core factual allegations.
On September 17, 2001, Herley filed an Answer, Affirmative Defenses and Counterclaims in this matter. In the Answer and Affirmative Defenses, Herley denied the material allegations of the Amended Complaint. Herley also filed Counterclaims against both RLI and Robinson. In these counterclaims, Herley's core allegations concern Robinson's misconduct (i) in connection with the manner he attempted to satisfy RLI's earn out requirements; (ii) misrepresentations made in connection with the Asset Purchase Agreement; (iii) wrongdoing as a Herley employee leading to his termination and (iv) post-Herley employment wrongdoing in connection with a new company known as RH Laboratories. In addition to seeking a Declaratory Judgment pursuant to 28 U.S.C. Section 2201 et. seq., Herley also asserted claims for, among other things, fraud, breach of contract, breach of fiduciary duty, unfair competition and tortious interference with actual and prospective contractual relationships.
On August 5, 2002, a jury trial commenced. A jury verdict was rendered on August 21, 2002 in which the jury determined, among other things, that (i) Herley was not required to pay any additional stock; (ii) Herley breached the Employment Agreement with Robinson and awarded Robinson $1.5 million in damages; (iii) Herley breached the Lease Agreement with Robinson and awarded Robinson approximately $552,000 in compensatory damages; (iv) Robinson breached fiduciary duties to Herley and awarded Herley $400,000 in compensatory damages; (v) Robinson and RLI breached indemnity obligations and awarded Herley $100,000 in damages; (vi) RLI breached representations and warranties given to Herley and awarded Herley $320,000 in damages.
On October 18, 2002, the Court entered a final judgment consistent with the above, and both parties filed post-trial motions. Additionally, as the prevailing party in connection with the claims asserted by RLI relating to the earn-out stock, as well as claims advanced relating to the various breaches of the Asset Purchase Agreement, Herley filed a petition for fees and costs against both RLI and Robinson on November 27, 2002 for approximately $2,000,000. RLI and Robinson also filed petitions to recover attorneys' fees of approximately $240,000 for certain claims in which they contend that they were the prevailing party. On February 5, 2003, the Court denied the post-trial motions filed by the parties, thus leaving the jury verdict undisturbed.
At a proceeding on April 28, 2003, the Court decided to delay ruling on all of the petitions for fees and costs until after appeals are exhausted. Accordingly, by Order dated May 6, 2003, the Court denied without prejudice all of the parties' petitions. On May 12, 2003, Herley filed its appeal to the United States Court of Appeals for the Second Circuit. On May 28, 2003, RLI filed a notice of cross-appeal. Robinson did not appeal. Herley filed its brief in support of its appeal before the Second Circuit on August 22, 2003. RLI timely filed its brief in response to Herley's appeal and in support of RLI's cross-appeal. Herley timely filed a response to RLI's brief and thereafter RLI timely filed a response to Herley's brief. Oral argument was held on December 18, 2003.
By Summary Order on January 26, 2004, the Second Circuit affirmed the trial court judgment in its entirety. On February 4, 2004, RLI submitted a letter request to the trial court for relief from the judgment on RLI's claim for the earn-out stock under Federal Rule of Civil Procedure 60. RLI contends that it has "newly discovered evidence," first learned in August 2003, to justify its requested relief. Herley submitted its response in opposition by letter dated February 10, 2004. On February 26, 2004, the parties appeared before the Court concerning the various applications and were directed to submit legal briefs on various legal issues. By Order dated May 28, 2004 the trial court denied RLI's Motion for a New Trial. The Court also denied Herley's request that it exercise its general equitable power to hold Ben Robinson personally liable for any fees Herley might recover against RLI.
On June 28, 2004, Herley filed suit against Ben Robinson and Frank Holt in the Superior Court of Hillsborough County, New Hampshire, asserting claims for fraudulent conveyance and piercing the corporate veil to hold Robinson personally liable for the fees incurred by Herley in defending RLI's claims discussed above. In response, Robinson took steps to collect damages awarded to him under the jury verdict. On July 21, 2004, Herley brought an Emergency Motion for Injunctive Relief and moved for an immediate order from the New Hampshire court allowing Herley to escrow the judgment owed to Robinson to be offset against any award of fees to Herley. The court entered an order denying the requested relief. On July 27, 2004, Herley paid $1,594,621 (including interest) to Ben Robinson, an amount calculated by deducting Herley's award against Robinson from the amounts awarded to Robinson on his claims under the Employment Agreement and the Lease Agreement. On July 28, 2004, the parties filed a Notice of Partial Satisfaction of Judgment.
By Order dated February 8, 2005, the Superior court of Hillsborough County, New Hampshire, granted Ben Robinson's and Frank Holt's Motion for Summary Judgment in the New Hampshire action. By Order Dated February 17, 2005, the Court ruled upon the parties' cross-petitions for attorneys' fees, granting all petitions in their entirety. Herley was awarded $2,146,882 against RLI under the Asset Purchase Agreement. RLI was awarded $54,426 against Herley for its successful defense of an indemnity by Herley. Ben Robinson was awarded $259,295 against Herley under the Lease Agreement.
On June 10, 2005, Herley reached an agreement with Robinson, RLI and Holt under which Herley agreed to pay Robinson $260,000 for the attorneys fees awarded to him by the New York Court. Further, all claims, counterclaims and appeals in Herley Industries, Inc. v. Benjamin Robinson and Frank Holt, Docket No. 04-E-0266 and Herley Industries, Inc. v. RH Laboratories, Inc., Stephen Robinson and Michael Gravelese, No. 02-11140 (D. Mass), were dismissed with prejudice. Based upon this agreement, the Company recorded a provision in the third quarter of fiscal 2005 to account for this settlement. The settlement was paid in the fourth quarter of fiscal 2005.
The Company is involved in various other legal proceedings and claims which arise in the ordinary course of its business. While any litigation contains an element of uncertainty, management believes that the outcome of such litigation will not have a material adverse effect on the Company's financial position or results of operations.
Stand-by Letters of Credit --------------------------
The Company maintains a letter of credit facility with a bank that provides for the issuance of stand-by letters of credit and requires the payment of a fee of 1.0% per annum of the amounts outstanding under the facility. The facility expires January 31, 2007. At July 31, 2005 stand-by letters of credit aggregating approximately $10,703,000 were outstanding under this facility.
NOTE G - INCOME TAXES
Income tax expense consisted of the following (in thousands):
The Company paid income taxes of approximately $546,000, $5,496,000, and $4,164,000 in fiscal 2005, 2004, and 2003, respectively. The following is a reconciliation of the U. S. statutory income tax rate and the effective tax rate on pretax income:
Income taxes have not been provided on undistributed earnings of foreign subsidiaries. If remitted as dividends, these earnings could become subject to additional tax. The Company's intention is to reinvest non-remitted earnings of subsidiaries outside the United States permanently.
The tax effects of significant items comprising deferred income taxes are as follows (in thousands):
As of July 31, 2005 the Company has available net operating loss carry-forwards for state income tax purposes of approximately $3,600,000 with expiration dates ranging from 2022 to 2024.
NOTE H- LONG-TERM DEBT
Long-term debt is summarized as follows (in thousands):
(a) In June 2002, the Company entered into a new $50,000,000 Revolving Credit Loan Agreement with two banks on an unsecured basis which may be used for general corporate purposes, including business acquisitions. The revolving credit facility requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on January 31, 2007 (as amended). The Company may elect to borrow up to a maximum of $5,000,000 with interest based on the Federal Funds Target Rate plus a margin of 1.50% to 1.80%, or up to a maximum of $45,000,000 with interest based on LIBOR plus a margin of 1.35% to 1.65%. The applicable incremental margin is based on the ratio of total liabilities to tangible net worth, as those terms are defined in the agreement. The Federal Funds Target Rate and the LIBOR rate was 3.25% and 3.49%, respectively, at July 31, 2005. There is a fee of 15 basis points per annum on the unused portion of the $45,000,000 LIBOR based portion of the credit facility payable quarterly. There are no borrowings under the line at July 31, 2005 and August 1, 2004.
The agreement contains various financial covenants, including, among other matters, minimum tangible net worth, total liabilities to tangible net worth, debt service coverage, and restrictions on other borrowings. The Company is in compliance with all covenants at July 31, 2005.
(b) The mortgage loan is for a term of ten years commencing February 16, 1999 with fixed monthly principal and interest installments of $23,359, including interest at a fixed rate of 7.43%, and is based upon a twenty year amortization. The loan is secured by a mortgage on the Company's land and building in Lancaster, Pennsylvania having a net book value of approximately $1,861,000.
The mortgage note agreement contains various financial covenants, including, among other matters, the maintenance of specific amounts of tangible net worth, debt to tangible net worth, debt service coverage, and restrictions on other borrowings. The Company is in compliance with all covenants at July 31, 2005. In connection with this loan, the Company paid approximately $45,000 in financing costs. Such costs are included in Other Assets in the accompanying consolidated balance sheets at July 31, 2005 and August 1, 2004, and are being amortized over the term of the loan (10 years).
(c) On October 19, 2001, the Company received $3,000,000 in proceeds from the East Hempfield Township Industrial Development Authority Variable Rate Demand/Fixed Rate Revenue Bonds Series of 2001 (the "Bonds"). The Bonds are due in varying annual installments through October 1, 2021. The initial installment of $95,000 was paid October 1, 2002 and increases each year until the final payment of $225,000 in 2021. The interest rate on the Bonds is reset weekly at the prevailing market rate of the BMA Municipal index. The initial rate of interest was 2.1%, which, after giving effect to a ten year interest rate swap agreement (See Note O) becomes a fixed rate of 4.07%. The interest rate at July 31, 2005 was 2.48%. The bond agreement requires a sinking fund payment on a monthly basis to fund the annual Bonds redemption installment. Proceeds from the Bonds were used for the construction of a 15,000 square foot expansion of the Company's facilities in Lancaster Pennsylvania, and for manufacturing equipment.
The Bonds are secured by a letter of credit expiring October 18, 2006 and a mortgage on the related properties pledged as collateral. The net book value of the land and building covered by the mortgage is approximately $1,723,000 at July 31, 2005.
(d) In connection with the acquisition of EWST as of September 1, 2002, the Company issued a note for 1,000,000 Pounds Sterling, including interest at 1.8%, payable in annual installments of 333,334 Pounds Sterling beginning October 1, 2003. Based on the spot rate of exchange at July 31, 2005 of 1.7593 the U.S. Dollar equivalent of the annual installments is approximately $586,000.
The Company paid interest in 2005, 2004 and 2003 of approximately $304,000, $314,000 and $355,000, respectively.
Future payments required on long-term debt are as follows (in thousands):
NOTE I - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses include the following (in thousands):
NOTE J - EMPLOYEE BENEFIT PLANS
In August 1985, the Board of Directors approved an Employee Savings Plan ("Plan") which qualified as a thrift plan under Section 401(k) of the Internal Revenue Code. This Plan, as amended and restated, allows employees to contribute between 2% and 30% of their salaries to the Plan. For the Plan year beginning August 1, 2005, the Plan was amended to be considered a "Safe Harbor" plan, where a contribution will be make to eligible participants in an amount equal to 100% of the amount of each participant's elective deferral that does not exceed 3% of compensation, plus 50% of the amount of the elective deferral that exceeds 3% of compensation up to a maximum contribution of 5% of compensation. Under the Safe Harbor provision, all contributions are 100% vested when made. Additional Company contributions can be made depending on profits. The aggregate benefit payable to an employee is dependent upon his rate of contribution, the earnings of the fund, and the length of time such employee continues as a participant. The Company has recognized expenses of approximately $1,038,000 (including approximately $268,000 related to the acquisitions of MSI, ICI, and RSS), $618,000 and $513,000 under the Plan for the 52 weeks ended July 31, 2005 and August 1, 2004, and 53 weeks ended August 3, 2003, respectively.
The Company's Israeli subsidiary provides for employee severance liabilities pursuant to the Israeli severance pay law and labor agreements. The Company's liability is fully provided for by monthly payments deposited with insurers and by a reserve established by the Company to cover the portion of this liability not covered by the Company's deposits. In addition to recognizing an expense for the funding to the insurance programs for this severance obligation, the Company also records as expense the net increase in its unfunded severance liability. The liability for this unfunded severance obligation is carried in Other Long-Term Liabilities on the accompanying Consolidated Balance Sheets and was $1,042,000 and $932,000 at July 31, 2005 and August 1, 2004, respectively. The total expense recognized for employee severance programs in Israel (both the funded and unfunded portion of the program) was approximately $110,000, $313,000 and $353,000 for fiscal years 2005, 2004 and 2003, respectively.
NOTE K - RELATED PARTY TRANSACTIONS
In connection with the move of the Amityville facilities of GMC in fiscal 1999, the Company entered into a 10 year lease agreement with a partnership owned by the children of certain officers of the Company. The lease provides for initial minimum annual rent of $312,000 subject to escalation of approximately 4% annually throughout the 10 year term. Additionally, in March 2000, The Company entered into another 10 year lease with the same partnership for additional space. The initial minimum annual rent of $92,000 is subject to escalation of approximately 4% annually.
Prior to the acquisition of MSI, MSI had leased one of its two buildings in Fort Walton Beach Florida from MSI Investments, a Florida General Partnership. MSI Investments is owned by four individuals, three of whom are currently employees of MSI. This lease has an original term of 15 years, ending December 31, 2012. The lease costs currently are approximately $278,000 on an annual basis, including the tenant's obligation to pay for insurance and property taxes. The base lease rate is adjusted every January for changes in the consumer price index, using 1997 as the base year.
NOTE L - COMPUTATION OF PER SHARE EARNINGS
The following table shows the components used in the calculation of basic earnings per share and earnings per share assuming dilution (in thousands except per share data):
The number of stock options not included in the computation of diluted EPS relates to stock options having exercise prices ranging from $18.65 to $20.45 which are greater than the average market price of the common shares during the period, and therefore, are anti-dilutive. The options, which were outstanding as of July 31, 2005, expire at various dates through February 4, 2015.
NOTE M - SHAREHOLDERS' EQUITY
The authorized shares of Common Stock of the Company are 20,000,000 shares.
Summary of Stock Option Plans
In March 2003, the Board of Directors approved the 2003 Stock Option Plan which covers 1,000,000 shares of the Company's common stock. Options granted under the plan are non-qualified stock options. Under the terms of the plan, the exercise price for options granted under the plan will be the fair market value at the date of grant. The nature and terms of the options to be granted are determined at the time of grant by the compensation committee or the board of directors. The options expire no later than ten years from the date of grant, subject to certain restrictions. Options for 993,500 shares were granted under the plan during fiscal year ended July 31, 2005. No options were granted under this plan during fiscal year ended August 1, 2004.
In September 2000, the Board of Directors approved the 2000 Stock Option Plan which covers 1,500,000 shares of the Company's common stock. Options granted under the plan are non-qualified stock options. Under the terms of the plan, the exercise price for options granted under the plan will be the fair market value at the date of grant. The nature and terms of the options to be granted are determined at the time of grant by the compensation committee or the board of directors. The options expire no later than ten years from the date of grant, subject to certain restrictions. Options for 53,000 shares were granted under the plan during fiscal year ended July 31, 2005. No options were granted under this plan during fiscal year ended August 1, 2004.
In April 1998, the Board of Directors approved the 1998 Stock Option Plan which covers 2,250,000 shares of the Company's common stock. Options granted under the plan may be incentive stock options qualified under Section 422 of the Internal Revenue Code of 1986 or non-qualified stock options. Under the terms of the plan, the exercise price for options granted under the plan will be the fair market value at the date of grant. Prices for incentive stock options granted to employees who own 10% or more of the Company's stock are at least 110% of market value at date of grant. The nature and terms of the options to be granted are determined at the time of grant by the compensation committee or the board of directors. The options expire no later than ten years from the date of grant, subject to certain restrictions. Non-qualified stock options for 29,500 and 40,000 shares were granted under this plan during the fiscal years ended July 31, 2005 and August 1, 2004, respectively.
In May 1997, the Board of Directors approved the 1997 Stock Option Plan which covers 2,500,000 shares of the Company's common stock. Options granted under the plan may be incentive stock options qualified under Section 422 of the Internal Revenue Code of 1986 or non-qualified stock options. Under the terms of the plan, the exercise price for options granted under the plan will be the fair market value at the date of grant. Prices for incentive stock options granted to employees who own 10% or more of the Company's stock are at least 110% of market value at date of grant. The nature and terms of the options to be granted are determined at the time of grant by the compensation committee or the board of directors. The options expire no later than ten years from the date of grant, subject to certain restrictions. Non-qualified stock options for 5,000 and 7,500 shares were granted under this plan during the fiscal years ended July 31, 2005 August 1, 2004, respectively.
A summary of stock option activity under all plans for the 52 weeks ended July 31, 2005 and August 1, 2004, and the 53 weeks ended August 3, 2003 is as follows:
Options Outstanding and Exercisable by Price Range as of July 31, 2005, with expiration dates ranging from August 18, 2005 to May 2, 2015 are as follows:
In April 2005, the Company's Board of Directors, upon recommendation of the Board's Compensation Committee, approved the accelerated vesting of all unvested and "out-of-the-money" stock options outstanding as of May 2, 2005. See Note A-14 of Notes to Consolidated Financial Statements.
NOTE N - SIGNIFICANT SEGMENTS, MAJOR CUSTOMERS, EXPORT SALES, AND GEOGRAPHIC INFORMATION
The Company's chief operating decision makers are considered to be the Chairman and the Chief Executive Officer (CEO). The Company's Chairman and CEO evaluate both consolidated and disaggregated financial information, primarily gross revenues, in deciding how to allocate resources and assess performance. The Chairman and CEO also use certain disaggregated financial information for the Company's product groups. The Company does not determine a measure of operating income or loss by product group. The Company's product groups have similar long-term economic characteristics, such as application, and are similar in regards to (a) nature of products and production processes, (b) type of customers, and (c) method used to distribute products. Accordingly, the Company operates as a single integrated business and as such has one operating segment as a provider of complex microwave radio frequency (RF) and millimeter wave components and subsystems for defense and commercial customers worldwide. All of the Company's revenues result from sales of its products.
Revenues for fiscal years 2005, 2004 and 2003 were as follows: defense electronics, $138,071,000, $113,172,000 and $103,746,000, respectively; and commercial technologies, $13,344,000, $8,982,000, and $6,477,000, respectively. In fiscal 2004 defense electronics includes revenues of $1,078,000, and commercial technologies includes revenue of $3,045,000 attributable to the CTI acquisition as of March 29, 2004. In fiscal 2005 defense electronics includes revenues of $6,660,000, and commercial technologies includes revenue of $8,633,000 attributable to the CTI acquisition. (See Note B.)
Net sales to the U.S. Government in fiscal 2005, 2004 and 2003 accounted for approximately 25%, 17% and 25% of net sales, respectively. The Northrop Grumman accounted for approximately 11% of net sales in fiscal 2005. No other customer accounted for shipments in excess of 11% of consolidated net sales during the periods presented. Foreign sales amounted to approximately $39,952,000 (including $7,351,000 in sales for EWST), $39,855,000 (including $9,262,000 in sales for EWST), and $39,646,000 in fiscal 2005, 2004 and 2003, respectively.
Geographic net sales based on place of contract performance were as follows (in thousands):
Net property, plant and equipment by geographic area was as follows (in thousands):
NOTE O - DERIVATIVE FINANCIAL INSTRUMENTS
In October 2001, the Company entered into an interest rate swap with a bank pursuant to which it exchanged floating rate interest in connection with the Bonds discussed in Note H on a notional amount of $3,000,000 for a fixed rate of 4.07% for a 10 year period ending October 1, 2011. The notional amount reduces each year in tandem with the annual installments due on the Bonds. The fixing of the interest rate for this period offsets the Company's exposure to the uncertainty of floating interest rates on the Bonds, and as such has been designated as a cash flow hedge. The hedge is deemed to be highly effective and any ineffectiveness will be recognized in interest expense in the reporting period. The fair value of the interest rate swap was a liability of $80,000 as of July 31, 2005. There was no material hedge ineffectiveness related to cash flow hedges during the period to be recognized in earnings. There was no gain or loss reclassified from accumulated other comprehensive income into earnings during the fiscal year ended July 31, 2005 as a result of the discontinuance of a cash flow hedge due to the probability of the original forecasted transaction not occurring.
NOTE P - FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amount reported in the balance sheet for cash and cash equivalents approximated its fair value.
Available-for-sale securities: The fair value of available-for-sale securities was based on quoted market prices.
Long-term debt: The fair value of the mortgage note and industrial revenue bonds (including the related interest rate swap) were estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rate for similar types of borrowing arrangements.
The carrying amounts and fair values of the Company's financial instruments are presented below (in thousands):
NOTE Q - QUARTERLY RESULTS (UNAUDITED)
The following is a summary of the unaudited quarterly results of operations for the 52 weeks ended July 31, 2005 and August 1, 2004 (in thousands, except for per share data).
The fourth quarter has historically been our strongest quarter for shipments. The third and fourth quarters of fiscal 2005 includes revenue attributable to the acquisitions of MSI of $5,294,000 and $2,824,000, respectively, and ICI of $3,401,000 and $8,389,000, respectively. The third and fourth quarter of fiscal 2004 includes revenue attributable to the acquisition of CTI of $1,116,000 and $3,007,000, respectively.
The gross margin percentage in the fourth quarter of 2005 was negatively impacted (as compared to 2004) due to revisions in total cost estimates on certain long term contracts at our EWST subsidiary which resulted in negative gross profit. In addition, the gross profit margin also varies from quarter to quarter due to changes in product mix.
Included in the results of the third quarter of fiscal 2005 is an accrual of $260,000 and in the fourth quarter of 2004 a payment of $1,595,000 in connection with the Robinson Labs litigation. (See Item 3. "Legal Proceedings").
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