Item 1. Business
Information contained in this Report contains forward-looking statements such as statements of the Company's plans, objectives, expectations and intentions, that can often be identified by the use of forward-looking terminology, such as "may," "will," "expect," "anticipate," "believe," "plan," "intend," "could," "estimates," "is being" or "goal" or other variations of these terms or comparable terminology. Such statements, which include statements relating to the anticipated growth of the market for explosives detection equipment, the Company's ability to develop and market new products and the Company's ability to enter new markets, and other matters are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. The cautionary statements made in this Report should be read as being applicable to all forward- looking statements wherever they appear in this Report. The forward- looking statements contained herein speak only as of the date of this Report. Vivid expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any such statement or reflect any change in Vivid's expectations or any change in events, conditions or circumstances on which any such statement is based. Factors that could cause or contribute to such differences include those discussed in the risk factors set forth in Item 7 below (the "Risk Factors") as well as those discussed elsewhere herein.
Vivid Technologies, Inc. ("Vivid" or the "Company") is a leading developer, manufacturer and marketer of automated inspection systems that detect explosives in airline checked baggage. The Company also offers a system that can be used to screen carry-on baggage and enhance building security. The Company's family of advanced explosives detection systems identify targeted materials by analyzing the physical characteristics of each item in a bag or parcel, including the atomic number and mass, using patented composition analysis techniques and proprietary dual energy X-ray technology. These systems automatically (without the use of an operator) isolate and identify targeted materials within a bag or parcel, thereby preventing a suspect bag or parcel from being loaded into an aircraft or entering a building until cleared by operator inspection. The Company's systems can also be used to identify a wide variety of other substances, including drugs, currency and agricultural products.
In 1993, the Company's automated systems were successfully deployed in airports as part of an integrated multi-level checked baggage screening approach that is being adopted in many countries throughout the world. As of September 30, 1998, the Company had sold 289 systems worldwide including 30 Model APS for hand baggage and parcel inspection. Airports at which the Company's systems are deployed include JFK International Airport in New York, London Heathrow and London Gatwick, Paris Charles de Gaulle and Paris Orly, Hong Kong International Airport at Chek Lap Kok, Malaysia's Kuala Lumpur International Airport, Malpensa in Milan, King Khalid International Airport in Riyadh, Amsterdam Airport Schiphol, Zurich Airport, Brussels Airport, and Spain.
The Company was incorporated as a Massachusetts corporation in May 1989 under the name of QDR Security, Inc. The Company changed its name to Vivitech, Inc. in June 1989 and was renamed Vivid Technologies, Inc. in September 1989. In October 1996, the Company changed its state of incorporation to Delaware.
Industry Background
Markets. There are over 600 commercial airports worldwide providing scheduled service to more than 2.5 billion passengers per year. Of these airports, over 400 are located in the United States, 150 in Europe and 50 in the Asia-Pacific region. Based upon the installations of the Company's systems, the Company believes that one integrated multi-level checked baggage screening system can serve up to approximately one million passengers per year in mid-size and large airports. The capabilities of each integrated multi-level system at each airport, as well as the number of systems required, will vary depending upon a variety of factors, including the explosives detection equipment deployed, the configuration of the airport's baggage handling systems, the nature of the integration of the explosives detection equipment with the airport's baggage handling systems and the profile of the airport's passenger traffic flow. Airports deploying advanced explosives detection equipment, including smaller airports, may choose to implement freestanding systems in addition to or as an alternative to integrated systems.
The Company believes that the implementation of effective checked baggage screening will highlight the ineffectiveness of conventional X-ray systems to identify explosives in carry-on baggage. The United Nations International Civil Aviation Organization ("ICAO") requires all 185 contracting states to inspect 100% of international carry-on baggage for the detection of weapons, and virtually all airports use conventional X-ray systems for this purpose. The Company believes that several thousand of these conventional X-ray systems are installed in airports throughout the world, and that these systems are candidates for replacement with more sophisticated systems.
Market Evolution and Government Initiatives. In the 1970s, in response to hijackings, airports worldwide began to install X-ray systems to screen carry-on baggage for weapons such as guns and knives. When combined with walk-through metal detectors, these systems substantially reduced the number of airplane hijackings. The success of these systems in airports also fostered their adoption for use by governmental agencies and private companies. As the threat to civil aviation evolved in the early 1980's from hijackings to bombings, many countries required checked baggage on international flights to be inspected. Most equipment initially deployed for this purpose has been conventional X-ray systems that only provide an operator with an image for interpretation. Although conventional X- ray systems are effective for the detection of weapons made from dense materials with defined shapes, such as guns and knives, they are ineffective in detecting explosive materials that are not as dense and can be molded into virtually any shape.
In response to the December 1988 bombing of Pan American Flight 103 over Lockerbie, Scotland, many countries began the installation of systems that could detect plastic and other explosives in airline baggage. Europe, led by the United Kingdom, has been at the forefront of deploying advanced automated explosives detection equipment. The United Kingdom's commercial airports have achieved 100% screening of international checked baggage in response to a mandate from the UK Department of the Environment Transport and the Regions (formerly Department of Transport). The European Civil Aviation Conference ("ECAC"), an organization of 37 member states, has resolved to implement 100% screening of international checked baggage. Several of those countries, including Belgium, France, Germany, Italy, Spain and Switzerland, have begun to implement checked baggage screening approaches similar to that adopted by the United Kingdom.
In 1993, BAA plc ("BAA"), formerly the British Airport Authority and one of the first airport operators to implement 100% checked baggage screening using automated explosives detection equipment, developed a multi-level automated screening approach that integrates the explosives detection equipment directly into the airport baggage handling systems. The multi-level approach, which is being adopted throughout Europe and the Asia-Pacific region, separates the screening process into multiple steps, and permits the use of equipment at each stage that is most suitable for the requirements of that particular stage.
Under the multi-level approach, a fully-automated Level 1 explosives detection system is integrated into the existing airport baggage handling system to screen rapidly all baggage without an operator in attendance. Bags rejected by the Level 1 system are subjected to Level 2 inspection. Level 2 inspection equipment allows an operator to review and manipulate images of the contents of the rejected bags provided by a Level 1 system. If the operator rejects the bag, it is forwarded for Level 3 inspection. Level 3 inspection is the slowest and most detailed process. Bags rejected at Level 3 are then opened and inspected by hand in the presence of the passenger. Bags not rejected at any inspection level are conveyed by the baggage handling system for loading into the aircraft. This multi-level approach, when implemented with rapid automated explosives detection equipment, can maintain the processing rates of existing baggage handling systems. The multi-level approach also significantly reduces operating costs by reducing staffing requirements.
Level 1 inspection systems, which must inspect all baggage on a conveyor line, are often required to inspect baggage during peak periods at the rate of 900 to 1,500 bags per hour (2.4 to 4.0 seconds per bag) in order to avoid delays in the baggage handling process. Level 2 inspection systems are often required to process baggage at the rate of 180 to 360 bags per hour (10 to 20 seconds per bag). Level 3 systems can be slower to accommodate the greater precision required for the operator to fully inspect the bag in order to avoid the undesirable and expensive final inspection process, which requires the bag to be reunited with the passenger and inspected by hand.
In the Asia/Pacific region, two major new airports in Malaysia and Hong Kong purchased integrated systems and commenced operations in 1998 with 100% checked baggage screening in place. Other new airports and terminals in the region, including those in Singapore, South Korea and Thailand, are being designed to include 100% screening of international checked baggage using advanced automated explosives detection systems. Australia and New Zealand intend to implement checked baggage screening in advance of the Sydney Olympic games in 2000. Other countries in the region, including Japan and the Philippines are also studying the implementation of these systems at existing airports.
Following the Pan American Flight 103 bombing, the United States enacted the Aviation Security Improvement Act of 1990 (the "Aviation Security Act"). The Aviation Security Act directed the Federal Aviation Administration (the "FAA") to develop a standard for explosives detection systems and required airports in the United States to deploy systems meeting this standard by 1993. The FAA certified a prototype computed tomography ("CT") system in November 1998. The commercial production model of this system will require further certification. Other CT systems were certified in December 1994 and April 1998, but, thus far, have failed to demonstrate that they meet the requirements for 100% checked baggage screening under realistic operating conditions. As a result, there have been only limited purchases and installations of automated explosives detection systems in the United States. Although ECAC has adopted a standard similar to the FAA standard as a long-term goal, they have allowed and promoted the deployment of effective systems even though they do not meet the performance standards that have been adopted.
In response to the crash of TWA Flight 800 off Long Island, New York in July 1996, President Clinton formed the White House Commission on Aviation Safety and Security, chaired by Vice President Gore (the "Gore Commission"), to review airline and airport security and oversee aviation safety. The Gore Commission released its initial and final reports in September 1996 and February 1997, respectively, and in October 1996, the United States enacted the Federal Aviation Re-Authorization Act of 1996 (the "Re-Authorization Act") which included an allocation for the purchase of explosives detection systems and other advanced security equipment by air carriers and airport authorities. The Re-Authorization Act requires that, until such time that the FAA determines that the equipment certified by the FAA is commercially available and has successfully completed operational testing, the FAA shall facilitate the deployment of other commercially available explosives detection devices which the FAA determines will enhance aviation security. During 1997 and 1998, the FAA purchased a variety of state-of-the-art explosives detection devices from several manufacturers, including eight systems from the Company.
In October 1998, Congress approved and the president signed the fiscal 1999 budget, which includes $100 million for the purchase and installation of explosive detection systems and other advanced security equipment. This level of funding is consistent with the Gore Commission's recommendation that $100 million be spent annually for several years to upgrade the nation's aviation security. Included in the $100 million for fiscal 1999 is a recommendation to purchase operator assist X-ray systems for the screening of carry-on luggage.
Implementation of Checked Baggage Systems. Effective screening of checked baggage for explosives and other contraband is a complex task. To accomplish this task while meeting the operational requirements of airports, a screening system must be flexible, accurate, fast, reliable and cost-effective. The screening system must have the ability to effectively identify a wide range of explosives, including plastic explosives that can be molded into virtually any shape. In addition, the system must have an acceptable false alarm rate, rejecting only a limited percentage of explosive- free luggage. The system must also process baggage rapidly and have limited downtime to avoid delays. Costs associated with installation include the cost of modifying the airport's baggage handling system to accommodate the explosives detection equipment and the cost of integrating that equipment with the baggage handling system. A key component of the cost of operation is the staffing associated with operating these systems.
Several advanced explosives detection systems have been developed to address these requirements, each with its own inherent advantages and limitations. These systems include dual energy X-ray, trace detection and CT systems. Dual energy X-ray systems measure the X-ray absorption properties of a bag's contents at two different X-ray energies to determine if any of the items have the physical characteristics of explosive materials. Trace detection equipment, known as "sniffers," detects particulate and chemical traces of explosive materials collected by manually wiping or vacuuming the bag under inspection. CT systems use hundreds of partial X-ray images, referred to as slices, to analyze the contents of a bag.
Implementation of Carry-on Baggage Systems. There are currently no requirements for the use of automated explosives detection systems to screen carry-on baggage. However, the presence of explosives in carry-on baggage poses a serious threat to civil aviation. A published industry source estimated that approximately one quarter of bombs smuggled on board aircraft were hidden in carry-on baggage. As the global implementation of hold baggage systems continues, regulators are shifting their focus to the detection of explosives in carry-on baggage. The final report of the Gore Commission recommended that the FAA begin conducting feasibility studies with regard to the use of advanced explosives detection equipment for carry-on baggage systems. Included in the $100 million federal budget for fiscal 1999 is a recommendation to purchase operator assist X-ray systems for the screening of carry-on luggage.
Non-aviation Hand Baggage Inspection Systems. A number of governmental agencies and private sector organizations in the United States and abroad are interested in utilizing advanced explosive detection equipment to enhance facility security. Recent terrorist attacks including the August 1998 bombings of two U.S. embassies in Africa have spurred the agencies request additional funding to upgrade security at domestic and international facilities. The General Services Administration has approved the Company's Model APS for building protection. Through September 30, 1998 the Company had sold 21 systems for facility protection.
Products
The Company develops, manufactures and markets a family of advanced automated systems that can detect explosives and other contraband in airline baggage and other parcels. The first market to emerge for these systems has been explosives detection for airline baggage. The Company's product line includes Level 1 and Level 2 integrated automated explosives detection systems for checked baggage, freestanding automated explosives detection systems for Level 3, terminal and baggage hall inspection of checked baggage, and an automated explosives detection system for carry-on baggage, hand baggage and parcels. As of September 30, 1998, the Company had shipped and installed approximately 260 systems for use in airports and high-security facilities throughout Europe, the Asia-Pacific region, the Middle East and North America.
Each of the Company's automated checked baggage explosives detection systems uses a proprietary instrumentation quality power supply that generates alternating high (150kV) and low (75kV) energy pulses at film safe levels of exposure. The power supply is driven by an X-ray controller that uses both current and source voltage feedback to maintain a stable, repeatable fan shaped X-ray beam. As the X-ray beam passes through the bag and its contents, a portion of the beam is absorbed (referred to as X-ray absorption or attenuation) and a portion is scattered. The beam that passes through the bag without being absorbed or scattered is referred to as the transmitted beam and contains information regarding the X-ray absorption properties of the objects within the bag at each of the two levels of energy generated by the X-ray tube. This information can be used to analyze the atomic number, mass and other physical characteristics of the objects within the bag. The transmitted beam also contains information that can be used to make high quality images of the contents of a bag.
The Company's automated checked baggage explosives detection systems incorporate a high resolution detector array that collects high quality data from the transmitted X-ray beam consisting of more than one million pixels of information per bag. The systems then employ the Company's patented composition analysis software algorithms to identify and separate the individual objects within a bag, including objects between other items or within a container. These algorithms also analyze the atomic number, mass and other characteristics of each of those objects to determine whether they match those of a targeted item, such as explosives or other contraband. Additional algorithms detect materials such as lead that could be used to shield an explosive device from this analysis.
X-ray absorption analysis techniques are less effective for detecting certain configurations of explosives which only absorb a very small fraction of the transmitted beam. However, these materials tend to scatter X-rays more than other materials. The Company has developed proprietary scatter detection enhancement ("SDE") technology that enhances its systems' ability to detect these configurations. The Company's SDE technology, which includes a combination of additional detector arrays and software, measures and analyzes the scattered X-ray intensity emitted from baggage in both the forward and backward direction. If the scatter levels indicate the possible presence of a suspect material in a bag, the affected area is further analyzed to determine if a threat is present. The Company has incorporated SDE technology in most of its checked baggage inspection products, either as an option or a standard feature, and also offers this technology as an upgrade for existing systems.
Both the Company's composition and scatter analysis techniques result in a computer-generated decision regarding the contents of the baggage screened. Any bag that is determined to contain a suspect object will cause the system to reject the bag. In the case of an operator-attended system, such as a Level 2 or Level 3 system, an image of the rejected bag is presented to an operator for detailed inspection. The bag image is presented in high-resolution gray scale, with the suspect object highlighted in color. The system can be programmed to sound an alarm, as well as require the operator to acknowledge the alarm by pressing a designated button to either reject or clear the bag.
The Company has integrated its products into a wide range of airport baggage handling systems. These products make use of an effective control software developed by the Company to facilitate communication between the explosives detection system and the airport baggage handling system. If no suspect object is detected by the automated system, a "clear" status is sent to the baggage handling system, allowing the bag to continue directly to the aircraft. If a suspect object is detected, a "reject" message is sent to the baggage handling system, requiring the next level of inspection. The Company has gained broad acceptance of its control software by working closely with many of the major baggage handling systems and control systems contractors.
The Company's systems are offered in a variety of configurations depending on the application or installation requirements.
Integrated Models. The Company's first integrated products were the VIS Level 1 inspection system and the VDS Level 2 inspection system. The VIS Level 1 system is used to inspect 100% of the baggage on a baggage conveyor line. The system is capable of automatically inspecting up to 1,500 bags per hour without an operator. The VDS Level 2 system is designed to provide an operator with a high quality image in addition to automatically highlighting suspicious objects as an aid to the operator to inspect bags rejected by the automated Level 1 system. The system also allows the operator to view the contents of a bag using various imaging modes and magnifications to determine whether the bag should be cleared or sent to Level 3 for additional investigation.
The VIS-W was the Company's first single system alternative to discrete Level 1 and Level 2 systems. The VIS-W combines a VIS Level 1 X-ray system ("VIS mainframe") with a single remote Level 2 operator workstation. The VIS mainframe transmits images of rejected bags to the Level 2 operator workstation. Level 2 inspection is then performed by an operator at a workstation in the same manner as an operator of a discrete Level 2 VDS system, thereby eliminating the need for a separate Level 2 explosives detection system to re-scan all bags rejected at Level 1.
The VIS-M, introduced in April 1996, further extends the capability of the workstation concept by allowing several VIS mainframes to be interconnected ("Matrixed") with multiple Level 2 operator workstations. During off-peak periods, workstations can be switched off, thereby significantly reducing staffing requirements and operating costs. The efficiency gained by the additional workstations combined with enhanced baggage control software allows an operator to review images of the contents of a bag while the bag continues en route to the aircraft. This eliminates the need and associated costs of a secondary conveyor system to hold the bags while Level 2 inspection is taking place. These costs can be a significant portion of the total cost of purchase and installation of a multi-level integrated explosives detection approach. The baggage handling systems in the new airports in Malaysia and Hong Kong and the new Terminal One at JFK International Airport in New York were designed to capitalize on the VIS-M's Matrixing capability by interconnecting several of the Company's VIS-M systems with multiple workstations to achieve 100% checked baggage screening. Several other new airports or terminals are being designed to utilize networked screening systems.
The Company has begun commercial production of its newest system for screening checked baggage, the Model MVT. This system utilizes a revolutionary approach to dual energy X-ray enabling improved explosive detection while preserving the high-speed inspection necessary to screen large amounts of baggage. This approach gathers significantly more data than our current generation of systems by obtaining three different views of each bag. This multi-view tomography (MVT) technique allows better measurements of both effective atomic number and density of each item inside a suitcase than single view dual energy X-ray systems.
In addition to its performance characteristics, MVT has several other features that the Company believes will make it appealing to potential customers. The MVT has similar dimensions to the Model VIS and Model VDS can easily be integrated into baggage handling lines. For those customers currently utilizing a Vivid system, installing MVT is a "drop in" upgrade. The existing Vivid system can be removed and the MVT installed in the same space with virtually no changes to the conveyor belts entering and exiting the system. MVT also will communicate with the airport's baggage handling control system the same way as our current equipment. Additionally, MVT is film safe meaning that the X-ray dosage is below the threshold for damaging film unlike competing CT technologies that utilize a significantly higher dose of X-ray, resulting in systems that damage film. The Company believes that this feature is important to the airlines that want to avoid installing screening equipment that could result in passenger complaints.
Freestanding Models. The Company's freestanding checked baggage explosives detection systems are intended to be installed in an airport terminal, such as in front of airline check-in counters or in a baggage handling hall. The H-1 inspects bags in the upright position, as they tend to be carried by a passenger. The VDS series of systems, which can be used as freestanding systems, inspect baggage lying flat as they are transported on a conveyor belt.
In 1996, the Company introduced a modified version of the operator-attended VDS system to serve as a Level 3 inspection system. Since less than 1% of the bags reach Level 3, additional time is available for bag inspection. This version, the VDS-II, combines the Company's SDE capability with a high-resolution image to enhance detection capability. The system is a low cost alternative to CT scanners for Level 3 inspection. It is also faster and less labor intensive than trace detection systems. This system can be integrated into a baggage handling system or used as a freestanding system in a baggage handling hall or terminal.
In 1996, the Company also introduced a modified version of the VDS-II to serve as an inspection system for the inspection of baggage that exceeds the maximum dimensions that can be accommodated by standard baggage handling conveyor lines. The system can be integrated into a baggage handling system or used as a freestanding system in a baggage hall or terminal.
Carry-on Model. The Company offers its Model APS system to inspect carry-on baggage, hand baggage and parcels for explosives or contraband material. The Model APS is similar in configuration to conventional X-ray systems used to screen for concealed weapons currently installed in airports and government and private facilities. While an operator is required to inspect each bag for weapons, the Model APS automatically alerts the operator to the presence of suspect explosive materials. The Model APS incorporates an advanced proprietary operator interface that allows the operator to view the contents of a bag using various imaging modes and magnifications to determine whether the bag should be cleared or rejected for further inspection.
The Company developed the APS system with Gilardoni, S.p.A. ("Gilardoni"), a manufacturer of conventional X-ray weapons screening systems and X-ray based equipment for the medical field. The system combines many of the advanced detection algorithms developed by the Company for its automated checked baggage explosives detection systems with an X-ray main frame using conventional dual energy X-ray technology. The arrangement with Gilardoni reduced the time-to- market of the Company's APS carry-on baggage inspection system. In March 1998, the Company began full manufacturing of the Model APS at its U.S. facility, using components purchased from Gilardoni under the agreement. Through September 30, 1998 the Company had sold a total of 30 Model APS to screen carry-on luggage in an airport environment and examine hand baggage for facility protection. Examples of customers that have purchased Model APS systems include Turkey, Billund Airport Denmark, King Khalid International Airport, Riyadh, Saudi Arabia, Terminal One at JFK International Airport in New York and the Pentagon. The General Services Administration has approved the Model APS for building protection.
Other Products and Applications
The Company believes that installations of advanced automated explosives detection systems at airports will accelerate the adoption of this technology for other security applications, including the protection of government and private facilities, and the screening of mail. The Company is also exploring opportunities with various governmental authorities and agencies in the United States and internationally to use its equipment for the detection of illicit drugs, the illegal export of currency and detection of agricultural products. Further, the Company believes that its technology can expand the traditional role of X-ray technology in process control applications by providing enhanced or new value-added functions such as material analysis, segregation and sorting of materials, and quality control. In addition, during fiscal 1998 the Company entered into an exclusive technology license agreement for the development of complimentary explosive detection technology. Under the agreement, the Company paid $1,250,000 for the exclusive right to manufacture, use or sell the licensed technology for a three-year period, with an option to extend the exclusive rights. See "Risk Factors - Developing Market; Uncertainty of Market Acceptance" and "- Uncertainty of Product Development."
Products under Development
The Company's product development efforts are focused on developing new products for the explosives and contraband detection system market and further enhancing the functionality, reliability and performance of its existing product line. The Company is continuing to develop the MVT to meet FAA certification requirements. This development effort was being funded in part by a $3.4 million research grant from the FAA awarded in May 1997. The Company cannot assure that it will be able to develop a system that will meet FAA certification requirements on a timely basis, if at all, or that if developed, the system will be commercially successful. See "Risk Factors - Dependence on Government Regulation" and " - Uncertainty of Product Development."
Marketing and Sales
The company sells and markets its products through its direct sales force as well as independent sales representatives and distributors in certain foreign countries, including Spain, France, Hong Kong, Japan and Malaysia. As of September 30, 1998, the Company had a 12 person marketing and sales staff. Two members of this staff are located in the United Kingdom and one in Switzerland. The Company also has a director of business development for the United States based in New Jersey with a primary focus on the non-aviation applications for the Company's systems. The remainder of the marketing and sales staff is headquartered at the Company's offices in Woburn, Massachusetts.
In the United States, the Company is working actively with the FAA, other government agencies, airlines, airport operators and congressional committees to promote the efficacy and cost- effectiveness of its products for deployment in United States airports. The Company is also working with United States and foreign governmental agencies to promote its products for non-aviation applications. In addition, the Company markets its products through participation in trade shows, publication of articles and advertising in trade journals, participation in industry forums and standard setting organizations, and distribution of sales literature. The Company benefits from customer referrals and the use of certain customer installations as demonstration sites for its systems. In fiscal 1996,1997 and 1998, international sales accounted for approximately 95%, 97%, 78%, respectively, of the Company's revenues. See "Risk Factors - Reliance on International Sales" and "Note 6 in Notes to Consolidated Financial Statements."
The selling process for the Company's products often involves a team comprised of individuals from sales and marketing, engineering, operations and senior management. This team frequently engages in a multi-level sales effort directed toward a variety of constituents which may include government regulators, the local airport operator or authority, systems integrators and airlines. The Company's sales effort with certain of its customers has extended over several years. Potential customers frequently require the Company's products to be tested against various performance standards and competitive products. The Company maintains demonstration units for this purpose and intends to increase its investment in demonstration units in order to accelerate the introduction of its products to new customers. Delays in anticipated purchase orders by the Company's customers and potential customers could have a material adverse effect on the Company's business. See "Risk Factors - Lengthy Sales Cycle."
In 1997, the Company entered into an arrangement with Gilardoni for the manufacture and sale of the Model APS carry-on baggage explosives detection system. Under this arrangement, the Company has the exclusive right to manufacture and sell this system in the United States, the United Kingdom, certain other European countries and Mexico. In addition, the Company has agreed not to sell any competitive X-ray-based system within its territory unless manufactured by Gilardoni or the Company. The Company intends to pursue strategic alliances, acquisitions and licenses of complementary technologies to further enhance its growth. See "Risk Factors - Management of Growth."
In fiscal 1996, 1997 and 1998, sales to BAA accounted for approximately 79%, 39% and 42%, respectively, of the Company's revenues. Additionally, in fiscal 1997 and 1998 Airport Authority Hong Kong accounted for 19% and 12%, respectively, and Toyo Kanetsu K.K., the baggage-handling contractor for Malaysia's Kuala Lumpur International Airport, accounted for 27% and 2%, respectively, of the Company's revenues. Revenues from the FAA including $2.7 million in research and development funding accounted for 16% of the Company's revenues in fiscal 1998. See "Risk Factors - Customer Concentration."
Customer Service and Support
The Company provides a high level of customer support to assist in the installation and integration of the Company's products into its customers' facilities and to assist in maintaining the reliability of the Company's products once installed. The Company offers a number of customer support services, including applications support, training, system preventative and corrective maintenance, and upgrades. The Company generally provides one-year parts warranty and offers primary and back-up service contracts to its customers. The Company's customer support staff currently includes six support engineers at its headquarters in Massachusetts, seven support engineers operating out of the Company's offices in the United Kingdom and two support engineers in the Asia-Pacific region.
Regulation
The explosives detection systems manufactured and marketed by the Company for use in airports are subject to regulation by the FAA, corresponding foreign governmental authorities and ICAO, the United Nations organization for establishing standard practices for the aviation industry on a worldwide basis. Sales of the Company's explosives detection systems for use in airports have been and will continue to be dependent upon governmental initiatives to require or support the screening of baggage with advanced explosives detection systems. Substantially all of such systems have been installed at airports in countries in which the applicable governmental or regulatory authority overseeing the operations of the airport has mandated such screening. Such mandates are influenced by many factors outside of the control of the Company, including political and budgetary concerns of governments, airlines and airports. See "Risk Factors - Dependence on Government Regulation; FAA Certification; and FAA Appropriations."
The FAA currently requires all carry-on baggage and international checked baggage to be inspected by hand search or with conventional X-ray equipment. United States airlines operating at airports outside of the United States are required to meet FAA security requirements in addition to the requirements of the local authorities. The FAA permits the use of the Company's systems by United States airlines at foreign airports as an alternative to conventional X-ray equipment.
Under the Aviation Security Act, the FAA was required to develop a standard for explosives detection systems and to certify equipment that met this standard under realistic airport operating conditions. None of the Company's systems have been certified by the FAA. A prototype of the Company's recently introduced MVT was submitted to the FAA for precertification readiness testing and data collection. As of the filing date, the MVT had not been through the FAA's official certification test. The Company plans to make further refinements to the system before proceeding to the formal certification testing. The Company cannot assure that the MVT or any other products that may be developed by the Company will ever meet the FAA or any other United States certification standard. See "Risk Factors - Dependence on Government Regulation; FAA Certification; and FAA Appropriations."
In response to the crash of TWA Flight 800, President Clinton formed the Gore Commission to review airline and airport security and oversee aviation safety. The Gore Commission released its initial and final reports in September 1996 and February 1997, respectively, and in October 1996, the United States enacted the Re-Authorization Act which included an allocation for the purchase of explosives detection systems and other advanced security equipment by air carriers and airport authorities. The FAA has ordered initial quantities of the CT-based system, trace detection systems and dual energy X-ray based systems, including eight systems from the Company. The deployment of these systems will allow the U.S. airlines, which are the main users of the equipment, to gain experience with the various technologies enabling them to determine which systems work best in busy U.S. airport environments.
In October 1998, Congress approved and the president signed the fiscal 1999 federal budget, which includes $100 million for the purchase and installation of explosive detection systems and other advanced security equipment. This level of funding is consistent with the Gore Commission's recommendation that $100 million be spent annually for several years to upgrade the nation's aviation security.
The UK DOT has mandated 100% screening of international checked baggage in the United Kingdom. Similarly, the other ECAC member states have resolved to implement 100% screening of international checked baggage. The Company's Level 1, Level 2 and Level 3 systems, as well as the Company's SDE technology, have been allowed for use by the UK DOT. In most other ECAC member states, the Company's systems either must be tested and approved or procured by governmental authorities overseeing the operation of airports within the country. In addition to the United Kingdom, the Company's systems have been purchased or approved for use in airports in many European countries including Belgium, France, The Netherlands, Italy, Spain and Switzerland.
Governmental authorities overseeing the construction of new airports in the Asia-Pacific region are defining requirements for the use of advanced explosives detection systems to achieve 100% screening of international checked baggage at those airports. As a result, the Company's systems are also being evaluated by the applicable regulatory authorities in countries in the Asia-Pacific region for purchases at new airports and have been installed for use at the new airports in Malaysia and Hong Kong. The Company cannot assure that its systems will be purchased for installation in any of the other new airports or terminals under construction or proposed for construction in that region.
ICAO has adopted various recommendations and requirements for screening of checked and carry-on baggage. Currently, ICAO requires the screening of all international carry-on bags and recommends the screening of international checked baggage. This requirement and recommendation relates only to the screening of baggage and does not require any specific technology to be used. It cannot be assured that additional countries will mandate the implementation of effective explosives screening or airline baggage, or that, if mandated, the Company's systems will meet the certification or other requirements of the applicable governmental authority. Even if the Company's systems meet the applicable requirements, it cannot be assured that the Company would be able to market its systems effectively.
Research and Development
The Company's research and development efforts are focused on developing new products for the explosives and contraband detection system market and further enhancing the functionality, reliability and performance of its existing product line. The Company's research and development personnel also are involved in establishing protocols, monitoring and interpreting and submitting test data to the FAA and other domestic and foreign regulatory agencies to obtain the requisite certifications, clearances and approvals for its products. During fiscal 1998, the main focus of the Company's research and development personnel was on the development of the Model MVT.
At September 30, 1998, the Company had 46 employees engaged in research and development and engineering, including 14 employees engaged in software development. During fiscal 1996, 1997 and 1998, the Company's research and development expenses were approximately $3.5 million, $4.4 million and $5.9 million, respectively. In addition, during each of these years certain of the Company's research and development expenses related to work performed under the Company's FAA research and development grants were included under costs of goods sold.
Intellectual Property
The Company relies upon trade secrets and patents to protect its technology. Due to the rapid technological change that characterizes the explosives detection system industry, the Company believes that the improvement of existing technology, reliance upon trade secrets and unpatented proprietary know-how and the development of new products are generally as important as patent protection in establishing and maintaining a competitive advantage. Nevertheless, the Company has obtained patents and will continue to make efforts to obtain patents, when available, in connection with its product development program. The Company has obtained five patents and has pending two patent applications in the United States. In addition, for certain foreign countries the Company has pending patent applications that correspond to the subject matter of certain United States patents and patent applications. Three of the Company's United States patents relate to applications of its dual X-ray technology and the Company's software algorithms used to implement the Company's screening analysis techniques. The Company's fourth patent relates to the Company's operator workstations. The Company's fifth patent relates to the Company's SDE technology. These patents have expiration dates ranging from 2011 to 2015. It cannot be assured that any of the Company's unallowed patent applications will be granted, that any patent or patent application will provide significant protection for the Company's products or technology, be of commercial benefit to the Company, or that its validity will not be challenged. Moreover, it cannot be assured that foreign intellectual property laws will protect the Company's intellectual property rights. In the absence of significant patent protection, the Company may be vulnerable to competitors who attempt to copy or use the Company's products, processes or technology. See "Risk Factors - Limited Protection of Intellectual Property Rights; Patent Litigation."
The Company has an exclusive perpetual license to use certain patents and technology developed by Hologic, Inc. ("Hologic") for the development, manufacture and sale of X-ray screening security systems for explosives, drugs, currency and other contraband (subject to termination by either party for certain defined defaults). The Company also has a nonexclusive license to use this technology for the development, manufacture and sale of X-ray-based products for process control applications in the food and beverage industries. Hologic and the Company have also granted to the other a non- exclusive, royalty-free license to use any unpatented technology developed by the other in connection with such party's research and development activities. In addition, Hologic and the Company have the right to obtain from the other an exclusive license, on commercially reasonable terms to be negotiated, for any patented new developments. See "Risk Factors - Limited Protection of Intellectual Property Rights; Patent Litigation."
The Company also licenses certain other technologies used in its products, often on an exclusive or semi-exclusive basis, for a defined field of use. These licenses involve eight United States patents and certain foreign patents relating to X-ray and complimentary technology. The United States patents have expiration dates ranging from 2002 to 2007. The Company's arrangement with Gilardoni relating to the Company's Model APS automated explosives detection system for screening of carry-on baggage contains cross licenses of intellectual property rights associated with each party's technology incorporated into the system. This license expires in 1999, subject to certain early termination and extension options. The Company is currently negotiating an extension to the license with Gilardoni. In addition, during fiscal 1998 the Company entered into an exclusive technology license agreement for the development of complimentary explosive detection technology. Under the agreement, the Company paid $1,250,000 for the exclusive right to manufacture, use or sell the licensed technology for a three-year period, with an option to extend the exclusive rights.
The Company was involved in patent litigation with EG&G Astrophysics Research Corporation ("EG&G"), in which each party claimed that the other was infringing certain patents held by the other. On November 6, 1996, the Company and EG&G signed a settlement agreement pursuant to which, among other things, each party agreed not to sue the other for patent infringement for nonmedical uses of X- ray technology covered by each other's existing patents or by patent applications which claim priority from such patents or, for products existing as of September 12, 1996, covered by patents that may be issued pursuant to existing patent applications. As a result, each party will have broad rights to use the other's existing X-ray technology for an unlimited period of time. It cannot be assured that EG&G will not use the Company's technology in a manner that would materially and adversely affect the Company's business, results of operations and financial condition.
The Company is also involved in certain patent litigation with American Science and Engineering, Inc. ("AS&E"), whereby the Company was seeking a declaratory judgement that it is not infringing any AS&E patent. In connection with this litigation, AS&E filed a counterclaim alleging that the Company is infringing one or more of eight AS&E patents. In October 1996, the court dismissed AS&E's infringement counterclaims, but allowed AS&E to raise more specific infringement counterclaims upon asserting factual support for such claims. In December 1996, AS&E filed a motion for leave to file an amended counterclaim asserting that the Company was violating one AS&E patent. The court subsequently dismissed AS&E's motion, but again allowed AS&E to raise more specific infringement counterclaims upon AS&E's asserting factual support for such claims. In February 1997, AS&E filed a further memorandum in support of its motion for leave to file an amended counterclaim. In April 1997, the Court denied AS&E's motion and dismissed its counterclaim without granting leave to file an amended counterclaim. In April 1998, AS&E filed a motion in the Federal Court of Appeals for the First Circuit to appeal this decision. This appeal is still pending. See "Risk Factors - Limited Protection of Intellectual Property Rights; Patent Litigation" and "Item 3. Legal Proceedings."
Competition
The markets for the Company's products are highly competitive. Certain of the Company's competitors have substantially greater manufacturing, marketing and financial resources than the Company. Other major corporations have announced their intention to enter the security screening market. Competitors may develop superior products or products of similar quality for sale at the same or lower prices. Moreover, the Company cannot assure that its products will not be rendered obsolete by new industry standards or changing technology. It cannot be assured that the Company will be able to compete successfully with existing or new competitors. See "Risk Factors - Rapid Technological Change."
While certain of the Company's competitors currently market automated checked baggage explosives detection products that use dual energy X-ray technology, the Company believes that it is able to compete favorably with these products based upon the overall cost effectiveness of the Company's systems as measured by a combination of factors including effective automated explosives detection, throughput, low cost of operation, installation and integration, price, reliability, and their proven operation in a variety of airports.
The Company's systems also compete with systems employing other technologies including CT scanner technology and trace detection technology. A product based upon CT scanner technology currently detects a wider range of explosives than does the Company's systems. In 1994, the FAA first certified this CT-based system and a new model was certified in April 1998. These systems operate at a significantly lower throughput rate and significantly higher expense than the Company's systems. In November 1998 the FAA certified a new CT-based system developed by another company. This certification will not apply to the commercial production model of this system, which is still under development. The Company believes that the CT systems also are more expensive and operate at a significantly lower throughput rate compared to the Company's systems. Additionally, the two newer systems have not been tested over extended periods of time in actual airport operating conditions. None of the Company's products have been certified by the FAA. Products based upon trace detection technology have throughput rates lower than those based on dual energy X-ray or CT technology and generally have been installed as Level 3 systems. See "Risk Factors - Dependence on Government Regulation; FAA Certification; and FAA Appropriations."
The Company's Model APS system, which is intended to detect explosives in carry-on bags and personal effects at airports and other installations, has recently been evaluated by various government agencies. This system competes against conventional X-ray systems, which are lower in price, as well as advanced explosives detection systems being adapted by the Company's competitors for this use. The Model APS system competes on the basis of price, detection capabilities, ease of use, expense of operation and reliability.
Manufacturing
The Company's manufacturing operations consist primarily of assembly, test, burn-in and quality control. The Company has adopted stringent quality assurance procedures that include standard design practices, component selection procedures, vendor control procedures, and comprehensive reliability testing and analysis. As a result of these efforts, the Company has received ISO 9001 certification. The Company's manufacturing facility is currently producing approximately eight of the Company's checked baggage systems and five hand baggage systems per month and has the capability to accommodate production of over 20 checked baggage systems and 15 hand baggage systems per month. In September 1998, the Company began production of its next generation system MVT. In anticipation of future growth, the Company entered into a five-year lease agreement for additional space of approximately 18,500 square feet in a building adjacent to its existing location. Should market conditions warrant, the Company may choose to establish overseas manufacturing operations.
The Company purchases a major portion of the parts and peripheral components for its products, and manufactures certain subsystems, such as the high voltage power supply, from raw materials. Most parts and materials are readily available from several supply sources. In 1997, the Company entered into a joint marketing and royalty agreement with Gilardoni for the Model APS system. In March 1998, the Company began full manufacturing of the Model APS at its U.S. facility, using components purchased from Gilardoni per the agreement. Under the current arrangement Gilardoni is the sole source for certain components to be manufactured with the Model APS. There can be no assurance that Gilardoni will supply these components in a cost effective or timely manner. The failure of Gilardoni to provide acceptable quality and timely components at an acceptable price, or an interruption of supplies from such a supplier as a result of fire, nature calamity, strike or other significant event could materially and adversely affect the Company's business, financial condition and results of operations. The Company is currently in discussions with Gilardoni to allow the Company a second source for these components.
Backlog
Backlog for the Company's products as of September 30, 1997 and 1998 totaled approximately $15 million and $4 million, respectively. Backlog consists of purchase orders for which a customer has scheduled delivery within the next twelve months. In certain circumstances, orders included in backlog may be canceled or rescheduled by customers without significant penalty. Backlog as of any particular date should not be relied upon as indicative of the Company's revenues for any future period.
Employees
As of September 30, 1998, the Company had 125 full-time employees, including 35 in manufacturing operations and quality assurance, 46 in research, development and engineering, 27 in marketing, sales and customer support, and 17 in finance and administration and information systems. None of the Company's employees is represented by a union. The Company considers its employee relations to be good.
Executive Officers of the Registrant
The executive officers of the Company and their ages are as follows:
Name Age Position S. David Ellenbogen 60 Chairman of the Board and Chief Executive Officer
Dr. Jay A. Stein 56 Senior Vice President, Technical Director and Director
William J. Frain 32 Chief Financial Officer and Treasurer
James J. Aldo 47 Vice President of Marketing and Sales
Daniel J. Silva 46 Vice President of Operations
S. David Ellenbogen, a co-founder of the Company, has served as its Chief Executive Officer and a director since its organization in June 1989 and served as its President from June 1989 until February 1997. Mr. Ellenbogen was also a co-founder of Hologic, a developer, manufacturer and seller of X-ray and other bone densitometers, served as its President from October 1985 until May 1994, and is currently its Chairman of the Board and Chief Executive Officer. Prior to founding Hologic, Mr. Ellenbogen served as President, Treasurer and a director of Diagnostic Technology, Inc. ("DTI"), which he co-founded in 1981. DTI, which developed an X-ray product for digital angiography, was acquired in 1982 by Advanced Technology Laboratories, Inc. ("ATL"), a wholly-owned subsidiary of Squibb Corporation. Mr. Ellenbogen was involved in the management of the digital angiography group of ATL from 1982 to 1985. Mr. Ellenbogen is employed by Hologic and performs part-time management services for the Company pursuant to a management agreement between the Company and Hologic. See "Item 13. Certain Relationships and Related Transactions."
Dr. Jay A. Stein, a co-founder of the Company and Hologic, has served as Senior Vice President, Technical Director and a director for both companies since their organization. Dr. Stein co-founded DTI with Mr. Ellenbogen in 1981, served as Vice President and Technical Director of DTI and was Technical Director of the digital angiography group of its successor, ATL, from 1982 to 1985. Dr. Stein received a Ph.D. in Physics from The Massachusetts Institute of Technology. He is the principal author of fifteen patents pertaining to X-ray technology. Dr. Stein is employed by Hologic and performs part-time management services for the Company pursuant to a management agreement between the Company and Hologic. See "Item 13. Certain Relationships and Related Transactions."
William J. Frain, a Certified Public Accountant, has served as Chief Financial Officer and Treasurer since October 1996. Prior to that, Mr. Frain served as Controller from August 1993 until October 1996. Prior to joining the Company, Mr. Frain served as an auditor at Arthur Andersen LLP from September 1988 to August 1993.
James J. Aldo has served as Vice President of Marketing and Sales since July 1993. Prior to that, Mr. Aldo served as Director of Sales and Marketing since joining the Company in July 1989. Prior to joining the Company, Mr. Aldo held positions in marketing, sales, engineering and field service management at AS&E and served as Eastern Regional Manager at Tegal, Inc., a subsidiary of Motorola, Inc., a manufacturer of capital equipment for the semiconductor industry.
Daniel J. Silva has served as Vice President of Operations since April 1994. Prior to that, Mr. Silva served as the Company's Director of Operations from June 1992 to April 1994. Mr. Silva was hired as an Operations Manager in June 1991. Prior to joining the Company, Mr. Silva held positions in manufacturing, project management and program management at AS&E.
Significant Employees
Certain key employees of the Company who are not also executive officers or directors are as follows:
Name Age Position
Kristoph D. Krug 45 Chief Technical Officer
Jeremy M. Attree 39 Director of Operations, Europe
Kristoph D. Krug joined the Company in July 1989 as a Project Engineer, was promoted to Director of Research and Development Engineering in 1992 and became Chief Technical Officer in January 1997. Mr. Krug is the author of two of the Company's patents for X- ray screening. Prior to joining the Company, Mr. Krug was Engineering Manager at Teradyne, Inc., a manufacturer of automated test equipment.
Jeremy M. Attree has served as Director of Operations, Europe since joining the Company in October 1993. From September 1991 to October 1993, Mr. Attree served as Marketing Manager for EA Technology Ltd, a primary research and development center for the electricity industry in the United Kingdom. Prior to joining EA Technology, Mr. Attree served as Marketing Director and Development Manager for Schlumberger Industries, Security Division, where he was engaged primarily in the development of new products in the airport security field.
Shareholder Rights Plan
On October 13, 1998, the Board of Directors of Vivid Technologies, Inc. (the "Company") declared a dividend of one preferred share purchase right (a "Right") for each outstanding share of common stock, par value $0.01 per share (the "Common Shares") on October 27, 1998 (the "Record Date") to the stockholders of record on that date. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share (the "Preferred Shares"), of the Company, at a price of $60.00 per one one- thousandth of a Preferred Share (the "Purchase Price"), subject to adjustment. The description and terms of the Rights are set forth in a Rights Agreement (the "Rights Agreement") between the Company and American Stock Transfer & Trust Company, as Rights Agent (the "Rights Agent").
Subject to certain limited exceptions, until the earlier to occur of (i) 10 days following a public announcement that a person or group of affiliated or associated persons (an "Acquiring Person") has acquired beneficial ownership of 15% or more of the outstanding Common Shares, or (ii) 10 business days (or such later date as may be determined by action of the Board of Directors prior to such time as any Person becomes an Acquiring Person) following the commencement of, or announcement of an intention to make, a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person or group of 15% or more of such outstanding Common Shares (the earlier of such dates being called the "Distribution Date"), the Rights will be evidenced, with respect to any of the Common Share certificates outstanding as of the Record Date, by such Common Share certificate with a copy of the Summary of Rights attached thereto.
The Agreement provides that, until the Distribution Date, the Rights will be transferred with and only with the Common Shares. Until the Distribution Date (or earlier redemption or expiration of the Rights), new Common Share certificates issued after the Record Date or upon transfer or new issuance of Common Shares will contain a notation incorporating the Agreement by reference. Until the Distribution Date (or earlier redemption or expiration of the Rights), the surrender for transfer of any certificates for Common Shares outstanding as of the Record Date, even without such notation or a copy of the Summary of Rights being attached thereto, will also constitute the transfer of the Rights associated with the Common Shares represented by such certificate. As soon as practicable following the Distribution Date, separate certificates evidencing the Rights ("Right Certificates") will be mailed to holders of record of the Common Shares as of the Close of Business on the Distribution Date and such separate Right Certificates alone will evidence the Rights.
The Rights are not exercisable until the Distribution Date. The Rights will expire on October 13, 2008 (the "Final Expiration Date"), unless the Final Expiration Date is extended or unless the Rights are earlier redeemed by the Company, in each case, as described below.
The Purchase Price payable, and the number of Preferred Shares or other securities or property issuable, upon exercise of the Rights are subject to adjustment from time to time to prevent dilution (i) in the event of a stock dividend on, or a subdivision, combination or reclassification of, the Preferred Shares, (ii) upon the grant to holders of the Preferred Shares of certain rights or warrants to subscribe for or purchase Preferred Shares at a price, or securities convertible into Preferred Shares with a conversion price, less than the then current market price of the Preferred Shares or (iii) upon the distribution to holders of the Preferred Shares of evidences of indebtedness or assets (excluding regular periodic cash dividends paid out of earnings or retained earnings or dividends payable in Preferred Shares) or of subscription rights or warrants (other than those referred to above).
The number of outstanding Rights and the number of one one- thousandths of a Preferred Share issuable upon exercise of each Right are also subject to adjustment in the event of a stock split of the Common Shares or a stock dividend on the Common Shares payable in Common Shares or subdivisions, consolidations or combinations of the Common Shares occurring, in any such case, prior to the Distribution Date.
Preferred Shares purchasable upon exercise of the Rights will not be redeemable. Each Preferred Share will be entitled to a quarterly dividend payment of 1000 times the dividend declared per Common Share. In the event of liquidation, the holders of the Preferred Shares will be entitled to an aggregate payment of 1000 times the aggregate payment made per Common Share. Each Preferred Share will have 1000 votes, voting together with the Common Shares. In the event of any merger, consolidation or other transaction in which Common Shares are exchanged, each Preferred Share will be entitled to receive 1000 times the amount received per Common Share. These rights are protected by customary antidilution provisions.
Because of the nature of the Preferred Shares' dividend, liquidation and voting rights, the value of the one one-thousandth interest in a Preferred Share purchasable upon exercise of each Right should approximate the value of one Common Share.
In the event that any person becomes an Acquiring Person, proper provision shall be made so that each holder of a Right, other than Rights beneficially owned by the Acquiring Person and its Affiliates and Associates (which will thereafter be void), will thereafter have the right to receive upon exercise that number of Common Shares having a market value of two times the exercise price of the Right. In the event that, at any time after a Person becomes an Acquiring Person, the Company is acquired in a merger or other business combination transaction or 50% or more of its consolidated assets or earning power are sold, proper provision will be made so that each holder of a Right will thereafter have the right to receive, upon the exercise thereof at the then current exercise price of the Right, that number of shares of common stock of the acquiring company which at the time of such transaction will have a market value of two times the exercise price of the Right.
If the Company does not have sufficient Common Shares to satisfy such obligation to issue Common Shares, or if the Board of Directors so elects, the Company shall deliver upon payment of the exercise price of a Right an amount of cash or securities equivalent in value to the Common Shares issuable upon exercise of a Right; provided that, if the Company fails to meet such obligation within 30 days following the later of (x) the first occurrence of an event triggering the right to purchase Common Shares and (y) the date on which the Company's right to redeem the Rights expires, the Company must deliver, upon exercise of a Right but without requiring payment of the exercise price then in effect, Common Shares (to the extent available) and cash equal in value to the difference between the value of the Common Shares otherwise issuable upon the exercise of a Right and the exercise price then in effect. The Board of Directors may extend the 30-day period described above for up to an additional 60 days to permit the taking of action that may be necessary to authorize sufficient additional Common Shares to permit the issuance of Common Shares upon the exercise in full of the Rights.
At any time after any Person becomes an Acquiring Person and prior to the acquisition by any person or group of a majority of the outstanding Common Shares, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such person or group which have become void), in whole or in part, at an exchange ratio of one Common Share per Right (subject to adjustment).
With certain exceptions, no adjustment in the Purchase Price will be required until cumulative adjustments require an adjustment of at least 1% in such Purchase Price. No fractional Preferred Shares will be issued (other than fractions which are integral multiples of one one-thousandth of a Preferred Share, which may, at the election of the Company, be evidenced by depository receipts) and in lieu thereof, an adjustment in cash will be made based on the market price of the Preferred Shares on the last trading day prior to the date of exercise.
At any time prior to the time any Person becomes an Acquiring Person, the Board of Directors of the Company may redeem the Rights in whole, but not in part, at a price of $0.001 per Right (the "Redemption Price"). The redemption of the Rights may be made effective at such time, on such basis and with such conditions as the Board of Directors in its sole discretion may establish. Immediately upon any redemption of the Rights, the right to exercise the Rights will terminate and the only right of the holders of Rights will be to receive the Redemption Price.
The terms of the Rights may be amended by the Board of Directors of the Company without the consent of the holders of the Rights, except that from and after such time as any person becomes an Acquiring Person no such amendment may adversely affect the interests of the holders of the Rights (other than the Acquiring Person and its Affiliates and Associates).
Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends.
Item 2.
Item 2. Properties
The Company leases its administrative headquarters and manufacturing facility located in Woburn, Massachusetts. The facility consists of approximately 43,000 square feet, including 21,000 square feet dedicated to the Company's manufacturing operations. In July 1998, the Company entered into a five-year lease agreement for additional space of approximately 18,500 square feet in a building adjacent to its existing location in Woburn, Massachusetts. Approximately 10,000 square feet of this new facility will be used for manufacturing. The Company also leases 3,600 square feet of office and manufacturing space in San Diego, California for a research and development facility. The Company also has two offices in the United Kingdom, leasing approximately 1,000 square feet of space for sales and service. In addition, the Company has sales offices located in Moudon, Switzerland and New Jersey, USA and a sales and customer support office in Kuala Lumpur, Malaysia. The Company believes that its facilities will be adequate for its needs for the foreseeable future and that suitable additional space will be available at commercially reasonable prices as needed. Should market conditions warrant, the Company may expand its presence in Europe and the Asia-Pacific region by establishing a manufacturing operation or expanding its sales and support offices in one or more of those regions.
Item 3.
Item 3. Legal Proceedings
In May 1996, the Company commenced an action in the United States District Court for the District of Massachusetts against AS&E seeking a declaration that the Company does not infringe AS&E patents related to back scattered X-rays. This followed AS&E's allegations of infringement to third parties. No discovery has been taken to date. Following a court decision in July 1997 construing the claims of the AS&E patent, which decision the Company considers favorable, in September 1997 the Company filed a motion for summary judgment of non-infringement. AS&E has not yet filed its papers in opposition to the Company's motion but is seeking discovery. If granted, the Company's motion will resolve all issues remaining in the case in favor of the Company. Earlier, in April 1997, the Court dismissed AS&E's proposed counterclaim seeking to allege patent infringement, so that the only remaining issue in the case is the Company's request for declaration of non-infringement of two claims of a single AS&E patent. In April 1998, AS&E filed a motion in the Federal Court of Appeals for the First Circuit to appeal this decision, and the appeal is still pending.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Part II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market Information - The Company's Common Stock is quoted on the Nasdaq National Market under the symbol "VVID." The following table sets forth the quarterly high and low sales prices per share of Common Stock since the Company's initial public offering on December 11, 1996, as reported by the Nasdaq National Market.
Fiscal year Ended September 30, 1998 High Low First Quarter 16 1/2 10 3/8 Second Quarter 16 3/8 12 Third Quarter 15 3/4 10 1/2 Fourth Quarter 12 6 7/8
Fiscal Year Ended September 30, 1997 High Low First Quarter 12 3/4 10 Second Quarter 24 1/2 11 7/8 Third Quarter 19 3/4 13 1/4 Fourth Quarter 18 3/8 14 1/4
Number of Holders - As of December 14, 1998, there were approximately 146 holders of record of the Company's Common Stock, including multiple beneficial holders at depositaries, banks and brokers listed as a single holder in the street name of each respective depositary, bank or broker.
Dividend Policy - The Company has never declared or paid cash dividends on its capital stock and does not plan to pay any cash dividends in the foreseeable future. The Company's current policy is to retain all of its earnings to finance future growth. The Company's bank line of credit prohibits the payment of cash dividends without prior bank approval.
Recent Sales of Unregistered Securities - None
Use of Proceeds of Initial Public Offering -On December 10, 1996, the Securities and Exchange Commission declared effective the Company's Registration Statement on Form S-1, Commission file number 333-14311, relating to the initial public offering of the Company's Common Stock, $.01 par value. The offering commenced on December 11, 1996 and all shares covered by the Registration Statement were sold. The managing underwriters for the offering were Lehman Brothers Inc., Cowen & Company and Needham & Company. The following sets forth certain information regarding the offering and the Companys' application of the net proceeds therefrom through September 30, 1998:
INFORMATION RELATING TO THE OFFERING
Number of shares registered 2,300,000 Number of shares sold by the Company 2,300,000
Aggregate price of the offering amount registered and sold $27,600,000 Offering Expenses: Underwriting discounts and commissions $1,932,000 Finders' fees -- Expenses paid to or for underwriters -- Other expenses $845,000 Total expenses $2,777,000 (1) Net offering proceeds $24,823,000 ------------------------- (1) No such expenses were paid directly or indirectly to directors, officers, general partners of the Company or their associates; to persons owning ten percent or more of any class of equity securities of the Company, or to affiliates of the Company.
USE OF PROCEEDS
Category Amount Construction of plant, building and facilities $63,300 Purchase and installation of machinery and equipment $800,000 Purchase of real estate -- Acquisition of technology/license $1,750,000 Repayment of indebtedness -- Redemption of redeemable preferred stock (1) $5,780,650 Working capital $6,021,841 Temporary investments, net $10,407,209 Notes, drafts, bills of exchange or bankers' acceptances which mature not later than one year from the date of issuance Long-term investments __ Investment-grade commercial paper, with an average maturity period of 15 months Total investments $10,407,209 Total $24,823,000 ----------------------- (1) Of this amount, approximately $900,000 was paid to Beta Partners Limited Partnership. Frank Kenny, a director of the Company, is a general partner of this partnership. No other proceeds of the offering were paid directly or indirectly to directors, officers, general partners of the Company or their associates; to persons owning ten percent or more of any class of equity securities of the Company; or to affiliates of the Company.
Item 6.
Item 6. Selected Financial Data
The following table contains certain selected consolidated financial data of the Company and is qualified in its entirety by the more detailed Consolidated Financial Statements included herein. This data should be read in conjunction with "Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with "Item 1. Business," "Item 6. Selected Financial Data," the Company's Consolidated Financial Statements and Notes thereto and the information described under the caption "Risk Factors" below.
Overview
The Company was founded in 1989 to develop, manufacture and market automated explosives detection systems following the bombing of Pan American Flight 103 over Lockerbie, Scotland. Following its organization, the Company undertook extensive research and development, introducing its first free standing automated explosives detection system, the H-1, in 1991, and its first integrated automated explosives detection systems for Level 1 and Level 2 screening, the VIS and VDS, in 1993. The Company commenced commercial shipments of its VIS and VDS systems in January 1994. As of September 30, 1998, the Company had shipped and installed 259 checked baggage systems for use in airports throughout Europe, the Asia/Pacific region, the United States and Canada. Also, the Company shipped 30 Model APS, a freestanding system to screen carry-on baggage for explosives and weapons for use in airports and protection of public, private, and government facilities. The General Services Administration has approved the Company's Model APS for building protection. During fiscal 1998 the Company completed shipments to, and celebrated the opening of the new airports in Hong Kong and Malaysia. These two airports are the first in Asia to implement 100% screening for explosives utilizing a total of 52 Vivid systems. In addition, JFK Terminal One opened in May 1998 deploying 13 Vivid systems (7 APS and 6 checked luggage systems) and is the first terminal in the United States to automatically inspect 100% of passenger baggage for explosives.
The Company's sales are primarily to owners and operators of airports, including foreign governments and regulatory authorities, and other government agencies and departments, specifically for the purchase of non-aviation equipment. The Company's revenues are derived primarily from product sales. The Company recognizes revenue from product sales upon shipment to the customer, provided that no significant Company obligations remain outstanding and collection of the related receivable is deemed probable by management. The Company accrues for anticipated warranty and installation costs upon shipment. The Company's revenues also include government research and development grants and revenues from service, the sale of spare parts and training, which have comprised less than 10% of revenues in the periods presented. The Company recognizes revenues under its development grants as services are rendered. In May 1997, the Company received a $3.5 million research and development grant from the FAA to fund, in part, the development of a cost effective, high speed explosive detection system, based upon the Company's current proprietary technology, that is intended to meet FAA certification requirements. The Company completed work under this grant in the first quarter of fiscal 1999. In fiscal 1996, 1997, and 1998 the Company recognized $0.7 million, $0.8 million, and $2.7 million respectively, in development revenue from FAA grants.
The Company's cost of revenues includes a royalty payable with respect to product sales and other revenues derived from the license with Hologic. Under the terms of this exclusive agreement, this royalty was reduced from 5% to 3% of revenues derived from such license in January 1997 upon the Company reaching $50 million in cumulative revenues subject to the exclusive license. Upon the Company reaching $200 million of cumulative revenues subject to this exclusive license, the royalty will be eliminated entirely. As of September 30, 1998, the Company had reached approximately $118 million in cumulative revenues. See "Item 1. Business-Intellectual Property" and "Item 13. Certain Relationships and Related Transactions."
In fiscal 1996, 1997 and 1998, sales to BAA accounted for approximately 79%, 39% and 42%, respectively, of the Company's revenues. Additionally, in fiscal 1997 and 1998 Airport Authority Hong Kong and accounted for 19% and 12%, respectively, and Toyo Kanetsu K.K., the baggage-handling contractor for Malaysia's Kuala Lumpur International Airport, accounted for 27% and 2%, respectively, of the Company's revenues. The Company expects that its revenues from these customers will decrease and will become increasingly dependent upon sales of upgrades, replacement equipment and services. The failure of the Company to obtain orders from customers other than these customers would have a material adverse effect on the Company's business, results of operations and financial condition. See "Risk Factors-Customer Concentration." Revenues from the FAA including $2.7 million in research and development funding accounted for 16% of the Company's revenues in fiscal 1998.
Substantially all of the Company's revenues have been generated by sales to customers outside the United States. The Company's foreign sales have occurred principally in the United Kingdom, other Western European countries and more recently in the Asia/Pacific region and the Middle East. In fiscal 1998, the Company sold, shipped, and installed 80 checked baggage systems and 28 hand baggage systems, worldwide. The Company has sales and service offices in the United Kingdom and Malaysia to support its European and Asia/Pacific operations, respectively, and has expanded its presence in Europe and the Middle East. The Company expects international sales to remain an important component of its business.
The Company's export sales generally have been denominated in United States dollars. During fiscal 1997 and 1998 approximately 25% and 20%, respectively, of the Company's revenues were denominated in foreign currencies. The Company on occasion has hedged its foreign currency exposure by entering into forward foreign exchange contracts to hedge against foreign currency fluctuations. It cannot be assured that these hedging efforts will be successful. At September 30, 1998, the Company had no exchange contracts. Gains and losses on forward foreign exchange commitments are deferred and recognized in revenue in the same period as the hedged transactions. The net gain (loss) was not material in 1997 or 1998. See "Risk Factors-Reliance on International Sales."
Results of Operations
For the periods indicated, the following table sets forth the percentage of revenues represented by the respective line items in the Company's consolidated statement of operations:
Year Ended September 30, 1996 1997 1998 Revenues 100% 100% 100% Cost of revenues 44 42 42 Gross margin 56 58 58 Operating expenses: Research and development 22 14 15 Selling and marketing 9 11 11 General and administrative 10 9 10 Litigation expenses 8 1 1 Total operating expenses 49 35 37
Income from operations 7 23 21 Interest and other income, net -- 3 3 Income before income taxes 7 26 24 Provision for income taxes -- 7 7 Net income 7% 19% 17%
Fiscal Year Ended September 30, 1998 Compared to Fiscal Year Ended September 30, 1997
Revenues. Revenues increased by approximately 22% to $38.7 million in fiscal 1998, from $31.7 million in fiscal 1997. This increase in revenues primarily was the result of an increase in product sales of checked baggage systems and the newly introduced hand baggage system. The increase in product sales was primarily attributable to the total number of product shipments to Europe, the Middle East, and the United States, including installations at JFK Terminal One, partially offset by slightly lower average selling prices of the Company's products and a change in product mix. During fiscal 1998, the Company shipped and installed 80 checked baggage units and 28 hand baggage units compared to 76 units and 2 units, respectively, in fiscal 1997. The Company also recognized approximately $2.7 million of revenue under a FAA research grant, compared to $0.8 million in fiscal 1997 under the same grant. For the fourth quarter of fiscal 1998 revenues decreased by approximately 18% to $8.8 million when compared to $10.7 million for the third quarter of fiscal 1998. The decrease was primarily related to the Company's transition to the next generation system, MVT, and delays in purchase decisions by potential Asian customers.
Gross Margin. Gross margin was 58% of revenues in fiscal 1998 and fiscal 1997. The increase in unit sales, revenue associated with the Company's FAA development grant, service contracts and improved manufacturing efficiencies, which increased margins, were offset by lower average selling prices and initial sales of the Company's hand baggage unit which had lower margins than the Company's checked baggage units.
Research and Development Expenses. Research and development expenses increased by approximately 33% to $5.9 million (15% of revenues) in fiscal 1998 from $4.4 million (14% of revenues) in fiscal 1997. The increase in research and development expenses in fiscal 1998 was primarily due to the addition of engineering personnel and outside consultants working on the development of new products, mainly the development of a second generation explosives detection system in an effort to reach FAA certification, and enhancements to existing products, including enhancements to the Model APS system for carry-on baggage and the VIS-M. Certain expenses in connection with the development of the Company's next generation system have been included in costs of goods sold in connection with the most recent FAA research and development grant.
Selling and Marketing Expenses. Selling and marketing expenses increased approximately 22% to $4.3 million (11% of revenues) in fiscal 1998 from $3.6 million (11% of revenues) in fiscal 1997. The increase in selling and marketing expenses in fiscal 1998 primarily was due to additional sales and support personnel as a result of the expansion of operations in Europe and the United States, and to a lesser extent an increase in advertising, consulting and public relations, trade shows and related travel costs.
General and Administrative Expenses. General and administrative expenses increased approximately 35% to $3.9 million (10% of revenues) in fiscal 1998 from $2.9 million (9% of revenues) in fiscal 1997. The increase in general and administrative expenses in fiscal 1998 was primarily attributable to an increase in personnel and related costs, patent amortization, and license fees, as well as additional overhead costs as the headcount for the Company increased approximately 14%.
Litigation Expenses. The Company incurred $220,000 and $427,000 of litigation expenses in fiscal 1998 and 1997, respectively, primarily in connection with the Company's patent litigation with AS&E and to a lesser extent EG&G. See "Item 3. Legal Proceedings."
Interest Income. The Company recognized net interest income of approximately $1.3 million in fiscal 1998 compared to net interest income of $813,000 in fiscal 1997. The increase in fiscal 1998 was primarily attributable to higher average cash balances resulting from the receipt of proceeds from the Company's initial public offering in fiscal 1997, and the generation of cash from operations in fiscal 1998.
Provision for Income Taxes. The Company's effective tax rate for fiscal 1998 was 30% compared to 27% in fiscal 1996. The Company's effective tax rate in fiscal 1998 was lower than the statutory tax rates primarily due to the use of tax credits and the tax benefits associated with the Company's foreign sales corporation and Massachusetts securities corporation. The increase in the provision for income taxes in fiscal 1998 is primarily attributable to increased product sales in the United States, which offset the benefit from the foreign sales corporation.
Fiscal Year Ended September 30, 1997 Compared to Fiscal Year Ended September 30, 1996
Revenues. Revenues increased by approximately 104% to $31.7 million in fiscal 1997, from $15.6 million in fiscal 1996. This increase in revenues primarily was the result of an increase in product sales. The increase in product sales was primarily attributable to the total number of product shipments to Europe as well as the commencement of shipments to Chek Lap Kok Airport in Hong Kong and shipments to Kuala Lumpur International Airport in Malaysia, partially offset by slightly lower average selling prices of the Company's products. During fiscal 1997, the Company shipped and installed 76 units compared to 30 units in fiscal 1996.
Gross Margin. Gross margin increased to 58% of revenues in fiscal 1997 compared to 56% of revenues in fiscal 1996. The increase in gross margin in fiscal 1997 was primarily attributable to the decrease, commencing in January 1997, in royalties due to Hologic for the exclusive license of certain patents and technology from 5% to 3%, as well as decreased costs attributable to improved manufacturing efficiencies recognized during the year. These decreases were partially offset by lower average selling prices.
During the second half of fiscal 1996, the Company's product sales consisted primarily of sales of the newly introduced VIS-M and VDS-II as well as SDE upgrades. During fiscal 1997, the Company was able to reduce certain component costs and achieve other manufacturing efficiencies in the design of the VIS-M and VDS-II, which substantially offset lower average selling prices. The Company also had a significant increase in sales of upgrades, parts and maintenance in fiscal 1997. During the third quarter of fiscal 1997 the Company began recognizing revenue under the $3.5 million FAA research grant. This grant did not have a material impact on gross margins during fiscal 1997.
Research and Development Expenses. Research and development expenses increased by approximately 27% to $4.4 million (14% of revenues) in fiscal 1997 from $3.5 million (22% of revenues) in fiscal 1996. The increase in research and development expenses in fiscal 1997 was primarily due to the addition of engineering personnel and outside consultants working on the development of new products and enhancements to existing products, including enhancements to the Model APS system for carry-on baggage and the VIS- M (Matrix configuration). Certain expenses in connection with the development of the Company's next generation system have been included in costs of goods sold in connection with the most recent FAA research and development grant. As a percentage of revenues, research and development expenses declined in the current year, reflecting increased revenues in fiscal 1997.
Selling and Marketing Expenses. Selling and marketing expenses increased approximately 155% to $3.6 million (11% of revenues) in fiscal 1997 from $1.4 million (9% of revenues) in fiscal 1996. The increase in selling and marketing expenses in fiscal 1997 primarily was due to additional sales and support personnel, as a result of the expansion of operations in Europe and the establishment of operations in the Asia/Pacific region, the payment of commissions to sales representatives in the Asia/Pacific region, and to a lesser extent an increase in advertising, consulting, trade shows and related travel costs.
General and Administrative Expenses. General and administrative expenses increased approximately 93% to $2.9 million (9% of revenues) in fiscal 1997 from $1.5 million (10% of revenues) in fiscal 1996. The increase in general and administrative expenses in fiscal 1997 was primarily attributable to an increase in personnel and related costs (including non-recurring costs related to relocation fees) as well as additional overhead costs as the headcount for the Company increased approximately 42%.
Litigation Expenses. The Company incurred $427,000 and $1.2 million of litigation expenses in fiscal 1997 and 1996, respectively, primarily in connection with the Company's patent litigation with EG&G and to a lesser extent AS&E.
Interest Income. The Company recognized net interest income of approximately $813,000 in fiscal 1997 compared to net interest income of $8,000 in fiscal 1996. The increase in fiscal 1997 was primarily attributable to higher average cash balances resulting from the receipt of proceeds from the Company's initial public offering.
Provision for Income Taxes. The Company's effective tax rate for fiscal 1997 was 27% compared to no provision for income taxes in fiscal 1996. The Company's effective tax rate in fiscal 1997 was lower than the statutory tax rates primarily due to the use of tax credits and the tax benefits associated with the Company's foreign sales corporation. The provision for income taxes in fiscal 1996 was a result of the Company's recognition of a deferred tax asset, which reflected management's determination, in accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 109, that it was more likely than not that this deferred tax asset would be utilized.
Liquidity and Capital Resources
Since inception, the Company has funded its operations and capital expenditures through internally generated cash flow, proceeds from sales of securities and the availability of a working capital line of credit. At September 30, 1998, the Company had working capital of $36.3 million, including approximately $26.0 million in cash and cash equivalents and short-term investments. The Company also has a $5.0 million bank line of credit, which expires in February 1999. The Company's bank line of credit bears interest at the bank's prime rate (8.25% as of September 30, 1998). The line of credit is unsecured and contains certain financial and other covenants. At September 30, 1998, the Company had no amounts outstanding under this line of credit. See "Item 5. Market for Registrant's Common Equity and Related Stockholder Matters" and "Item 13. Certain Relationships and Related Transactions."
During the fiscal year ended September 30, 1998, the Company's net cash provided by operating activities was approximately $8.3 million and was comprised of net income adjusted for non-cash expenses including depreciation and amortization totaling $7.4 million, a decrease of $2.2 million in accounts receivable and an increase in deferred revenue of $1.7 million offset by a $1.7 million increase in inventories, an $850,000 million increase in other current assets and a decrease of $724,000 in accounts payable. The increase in inventories were primarily attributable to the Company's increased product sales, the commercial introduction of the new Model APS system, and initial production of the Model MVT.
During the fiscal year ended September 30, 1998, the Company's net cash used in investing activities was approximately $4.9 million, primarily reflecting the net purchase of approximately $2.8 million of short-term investments. Cash used in investing activities also included capital expenditures for fiscal 1998 of approximately $840,000 and an increase of $1.3 million in other assets related to the licensing of certain technologies. While the Company does not have any significant commitments for capital expenditures, the Company anticipates that it will continue to purchase equipment to support its anticipated growth.
During the fiscal year ended September 30, 1998, net cash provided by financing activities was $558,000, primarily attributable to approximately $473,000 of proceeds from the exercise of stock options and $85,000 from the exercise of stock purchase warrants.
The Company does not currently have any significant capital commitments and believes that existing sources of liquidity, including the net proceeds of its initial public offering, funds expected to be generated from operations and its line of credit will provide adequate cash to fund the Company's anticipated operational and other cash needs through at least the next twelve months. However, for a brief discussion of the factors that could adversely affect the Company's financial position and results of operations, see "Risk Factors."
Year 2000 Readiness Disclosure
The year 2000 issue is the potential for system and processing failure of date-related data and the result of computer-controlled systems using two digits rather than four to define the applicable year. For example, computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities.
The Company may be affected by year 2000 issues related to non- compliant information technology ("IT") systems or non-IT systems operated or sold by the Company or by third parties. The Company has substantially completed assessment of its internal IT systems and non- IT systems. The Company has tested all products internally and has adopted a Year 2000 Qualification Test Procedure to ensure that all products operate properly through the year 2000 and beyond. In addition to internal testing the Company has received compliance certificates from the FAA and BAA confirming that the Company's existing products are year 2000 compliant. The Company has also submitted a survey to all vendors subject to year 2000 compliance. In addition to the survey, the Company has internally tested components supplied by outside vendors. The Company has also performed an internal review of in-house computers, network, operating system and financial reporting package confirming year 2000 compliance. At this point in its assessment, the Company is not currently aware of any year 2000 problems relating to systems operated or sold by the Company that would have a material adverse effect on the Company's business, results of operations or financial condition.
Although the Company believes that its systems are year 2000 compliant, the Company utilizes third-party equipment and software that may not be year 2000 compliant. In addition, the Company's products and software are often sold to be integrated into or interface with third party equipment or software. Failure of third- party equipment or software to operate properly with regard to the year 2000 and thereafter could require the Company to incur unanticipated expenses to remedy any problems, which could have a material adverse effect on the Company business, results of operations and financial condition. The Company may also be vulnerable to any failures by its major suppliers, service providers and customers to remedy their own internal IT and non-IT system year 2000 issues which could, among other things, have a material and adverse affect on the Company's supplies and orders. The Company is unable to estimate the nature or extent of any potential adverse impact resulting from the failure of third parties, such as its suppliers, service providers and customers, to achieve year 2000 compliance. Moreover, such third parties, even if year 2000 compliant, could experience difficulties resulting from year 2000 issues that may affect their suppliers, service providers and customers. As a result, although the Company does not currently anticipate that it will experience any material shipment delays from their major product suppliers or any material sales delays from its major customers due to year 2000 issues, these third parties may experience year 2000 problems. Any such problems could have a material adverse effect on the Company's business, results of operations and financial condition.
Other than its activities described above, the Company does not have and does not plan to develop a contingency plan to address year 2000 issues. Should any unanticipated significant year 2000 issues arise, the Company's failure to implement such a contingency plan could have a material adverse affect on its business, financial condition and results of operations.
To the extent that the Company does not identify any material non- compliant IT systems or non-IT systems operated by the Company or by third parties, such as the Company's suppliers, service providers and customers, the most reasonably likely worst case year 2000 scenario is a systemic failure beyond the control of the Company, such as a prolonged telecommunications or electrical failure, or a general disruption in United States or global business activities that could result in a significant economic downturn. The Company believes that the primary business risks, in the event of such failure or other disruption, would include but not be limited to, loss of customers or orders, increased operating costs, inability to obtain inventory on a timely basis, disruptions in product shipments, or other business interruptions of a material nature, as well as claims of mismanagement, misrepresentation, or breach of contract, any of which could have a material adverse effect on the Company's business, results of operations and financial condition.
Recent Accounting Pronouncements
In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 requires disclosure of all components of comprehensive income on an annual and interim basis. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997.
In July 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 requires certain financial and supplementary information to be disclosed on an annual and interim basis for each reportable segment of an enterprise, as defined. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997. Unless impracticable, companies would be required to disclose similar prior period information upon adoption.
In March 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires computer software costs associated with internal-use software to be charged to operations as incurred until certain capitalization criteria are met. SOP 98-1 is effective beginning January 1, 1999. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial position or results of operations.
Risk Factors
This Report contains forward-looking statements that involve risks and uncertainties, such as statements of the Company's plans, objectives, expectations and intentions. The cautionary statements made in this Report should be read as being applicable to all forward- looking statements wherever they appear in this Report. The Company's actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed elsewhere in this Report.
Customer Concentration. In fiscal 1996, 1997 and 1998, sales to BAA accounted for approximately 79%, 39% and 42%, respectively, of the Company's revenues. Additionally, in fiscal 1997 and 1998 Airport Authority Hong Kong accounted for 19% and 12%, respectively, and Toyo Kanetsu K.K., the baggage-handling contractor for Malaysia's Kuala Lumpur International Airport, accounted for 27% and 2%, respectively, of the Company's revenues. In fiscal 1998, revenues from the FAA constituted 16% of the Company's revenues. The BAA, the Airport Authority Hong Kong and Toyo Kanetsue K.K., have either completed or nearly completed deployment of checked baggage explosives detection systems at their respective airports. As a result, the Company expects that its revenues from these customers will decrease and will become increasingly dependent upon sales of upgrades, replacement equipment and services. Revenues from the FAA included $2.7 million received under a research and development contract which the Company substantially completed in fiscal 1998. The inability of the Company to replace the revenue from these projects would have a material adverse effect on the Company's business, results of operations and financial condition.
Dependence on Government Regulation; FAA Certification; and FAA Appropriations. The Company's sales of its explosives detection systems for use in airports has been and will continue to be dependent upon governmental initiatives to require or support the screening of baggage with advanced explosives detection systems. Substantially all of such systems have been installed at airports in countries in which the applicable governmental or regulatory authority overseeing the operations of the airport has mandated such screening. Such mandates are influenced by many factors outside of the control of the Company, including political and budgetary concerns of governments, airlines and airports. The Company cannot assure that additional countries will mandate the implementation of effective explosives screening of airline baggage, or that, if mandated, the Company's systems will meet the certification or other requirements of the applicable governmental authority.
In the United States, the Aviation Security Act of 1990 directed the FAA to develop a standard for explosives detection systems and required airports in the United States to deploy systems meeting this standard by 1993. The standard adopted by the FAA is more comprehensive than standards adopted in most other countries. The FAA first certified a computed tomography ("CT") system in December 1994. A second CT based system from the same manufacturer was certified in April 1998. A third CT-based system was certified by the FAA in November 1998. None of the Company's systems have been certified by the FAA. A prototype of the Company's recently introduced MVT was submitted to the FAA for precertification readiness testing and data collection. As of the filing date, the MVT had not been through the FAA's official certification test. The Company plans to make further refinements to the system before proceeding to the formal certification testing. The Company cannot assure that the MVT or any other products that may be developed by the Company will ever meet the FAA or any other United States certification standard. See "Item 1. Business-Regulation."
In October 1996, the United States enacted the Re-Authorization Act, which included an allocation for the purchase of explosives detection systems and other advanced security equipment by air carriers and airport authorities. Utilizing this allocation, the FAA has ordered initial quantities of the CT-based system, trace detection systems and dual energy X-ray based systems, including eight systems from the Company. In October 1998, Congress approved and the president signed the fiscal 1999 budget, which includes $100 million for the purchase and installation of explosive detection systems and other advanced security equipment. This level of funding is consistent with the Gore Commission's recommendation that $100 million be spent annually for several years to upgrade the nation's aviation security. However, any additional funding will be subject to approval in future budgets. Included in the $100 million for fiscal 1999 is a recommendation to purchase operator assist X-ray systems for the screening of carry-on luggage. The FAA has informally advised the Company that it expects to allocate these funds in the beginning of calendar 1999. The FAA is not required to allocate any funds to purchase the Company's systems. In the past, the FAA's allocation of funds has favored those systems that have received FAA certification. As a result, the failure of the Company to have obtained FAA certification for the MVT by the time all or a portion of the fiscal 1999 funds are allocated could have an adverse effect on the number of Company systems that the FAA may order, if any. The failure of the Company to obtain significant orders from the FAA could have a material adverse effect on its business, results of operations and financial condition.
Significant Fluctuations and Unpredictability of Operating Results. Significant annual and quarterly fluctuations in the Company's results of operations may be caused by several factors, including the overall demand for explosives detection systems, market acceptance of the Company's and its competitors products, the timing of regulatory approvals for the Company's systems and government initiatives to promote the use of explosives detection systems such as those manufactured and sold by the Company and economic conditions in the Company's targeted markets. Other factors that may cause fluctuations in operating results include the timing of the announcement, introduction and delivery of new products and product enhancements by the Company and its competitors, variations in the Company's product mix and component costs, timing of customer orders, adjustments of delivery schedules to accommodate customers' programs, the availability of materials and labor necessary to produce the Company's products, the availability of components from suppliers, the timing and level of expenditures in anticipation of future sales, and pricing and other competitive conditions. Customers may also cancel or reschedule shipments and production difficulties could delay shipments. Relatively few system sales to relatively few customers comprise a significant portion of the Company's revenues in each quarter. Therefore, small variations in the number of systems sold could have a significant effect on the Company's results of operations. The Company believes that period to period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance.
Developing Market; Uncertainty of Market Acceptance. The explosives detection system market is at a relatively early stage of development. Acceptance of explosives detection systems on a broad basis will be dependent upon the acceptance and adoption of explosives detection systems by airlines and airports throughout the world, the expansion of applications for explosives detection technology, government initiatives to support the expansion of this market, the performance and price of the Company's and its competitors' products, customer reaction to those products and continued cost and performance improvements in explosives detection technology. The Company cannot assure that the explosives detection market will develop further or that the Company will be successful in marketing its products effectively and obtaining broader market acceptance for its products. Failure to do so would have a material adverse effect on the Company's business, results of operations and financial condition. Further, if one of the Company's or a competitor's systems were to fail to detect explosives and such failure resulted in an airline bombing, the ability of the Company to market its products could be materially adversely affected.
Lengthy Sales Cycle. As a result of the significant capital and other commitments required to install and integrate the Company's products into an airport baggage handling system, foreign regulatory approval requirements, and the developing nature of the explosives detection market, the Company has experienced extended sales cycles with its customers. The Company's sales efforts with certain existing and potential customers have extended over several years. Customers may initially purchase one or a few units for extensive testing and evaluation before making a decision regarding volume purchases and, in certain circumstances, the Company may provide a potential customer with a demonstration unit for regulatory testing and evaluation free of charge. Delays in anticipated purchase orders could have a material adverse effect on the Company's business, results of operations and financial condition.
Reliance on International Sales. . In fiscal 1996,1997 and 1998, international sales accounted for approximately 95%, 97%, 78%, respectively, of the Company's revenues. The Company anticipates that international sales will continue to account for a significant percentage of the Company's revenues. Risks associated with international sales include, among other things, international regulatory requirements and policy changes, political and economic instability, possible foreign currency controls, intellectual property protection, currency exchange rate fluctuations, tariffs or other barriers, staffing and management of foreign operations, inventory management, accounts receivable collection and the management of distributors or representatives. In particular, recent economic instability in the Asia/Pacific region may further delay or reduce airport capital projects in that region which could have a material adverse effect on the Company's business, results of operations and financial condition. In addition, most foreign countries have their own regulatory approval requirements for sales of the Company's products. As a result, the Company's introduction of new products into international markets can be costly and time consuming. Moreover, the Company cannot assure that it will be able to obtain the required regulatory approvals on a timely basis, if at all. Furthermore, the Company's international sales have been denominated primarily in United States dollars. The Company anticipates that its international sales may increasingly be denominated in foreign currencies. The Company on occasion has hedged its foreign currency exposure by entering into forward foreign exchange contracts to hedge against foreign currency fluctuations. The Company's hedging efforts may not be successful, and other risks associated with international sales and operations may have a material adverse effect on the Company's business, results of operations and financial condition.
Uncertainty of Product Development. The Company's success will depend upon its ability to enhance its existing products, and to develop new products to meet regulatory and customer requirements and to achieve market acceptance. The enhancement and development of these products will be subject to all of the risks associated with new product development, including unanticipated delays, expenses, technical problems or other difficulties that could result in the abandonment or substantial change in the commercialization of these enhancements or new products. Given the uncertainties inherent with product development and introduction, there is a risk that the Company will not be successful in introducing products or product enhancements, including products that meet FAA certification standards, on a timely basis, if at all, and that the Company will not be able to market successfully these products and product enhancements once developed.
Rapid Technological Change. The market for the Company's products is characterized by rapid technological change and evolving industry requirements. The Company believes that its future success will depend in large part upon its ability to enhance its existing products and to successfully develop new products that meet regulatory and customer requirements and gain market acceptance. The Company's products may be rendered obsolete by new industry standards or changing technology.
Competition. The markets for the Company's products are highly competitive. The Company's systems compete against dual energy X-ray as well as other competing technologies, including CT and trace detection. Certain of the Company's competitors have substantially greater manufacturing, marketing and financial resources than the Company. In addition, other major corporations have recently announced their intention to enter the security screening market and currently have systems in development. Two of the Company's competitors has developed products based upon CT scanner technology that was certified by the FAA. The FAA has certified none of the Company's products. Competitors may develop superior products or products of similar quality for sale at the same or lower prices. Other technical innovations may impair the Company's ability to market its products. The Company cannot assure that it will be able to compete successfully with existing or new competitors.
Limited Protection of Intellectual Property Rights; Patent Litigation. The Company's success depends significantly upon proprietary technology. The Company relies on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect its proprietary rights, all of which afford only limited protection. The Company has obtained five patents and has pending two patent applications in the United States. In addition, for certain foreign countries the Company has pending patent applications that correspond to the subject matter of certain United States patents and patent applications. The Company cannot assure that its unallowed patent applications will be granted, that any patent or patent application will provide significant protection for the Company's products and technology, or that the Company's current or future products, processes or technology will not be challenged under patents held by competitors or potential competitors. Moreover, foreign intellectual property laws may not protect the Company's intellectual property rights. In the absence of significant patent protection, the Company may be vulnerable to competitors who attempt to copy the Company's products, processes or technology.
The Company has an exclusive perpetual license to use certain patent rights and technology developed by Hologic for the development, manufacture and sale of X-ray screening security systems for explosives, drugs, currency and other contraband (subject to termination by either party for certain defined defaults). The Company also has a nonexclusive license to use this technology for the development, manufacture and sale of X-ray-based products for process control applications in the food and beverage industries. If the Company desires to develop products for other applications, it must either use alternative technology or obtain an additional license from Hologic. The Company may not be able to develop or license alternative technology for any additional applications, or that the Company would be able to license Hologic's technology for these applications on favorable terms, if at all. In addition, Hologic could develop or license its technology to others for applications competitive with those that may be developed by the Company outside of areas for which the Company has an exclusive license.
The Company was involved in patent litigation with EG&G Astrophysics Research Corporation ("EG&G"), in which each party claimed that the other was infringing certain patents held by the other. On November 6, 1996, the Company and EG&G signed a settlement agreement pursuant to which, among other things, each party agreed not to sue the other for patent infringement for nonmedical uses of X- ray technology covered by each other's existing patents or by patent applications which claim priority from such patents, or, for products existing as of September 12, 1996, covered by patents that may be issued pursuant to existing patent applications. As a result, each party will have broad rights to use the other's existing X-ray technology for an unlimited period of time. There is a risk that EG&G will use the Company's technology in a manner that would materially and adversely affect the Company's business, results of operations and financial condition.
In May 1996, the Company commenced an action in the United States District Court for the District of Massachusetts against AS&E seeking a declaration that the Company does not infringe AS&E patents related to back scattered X-rays. This followed AS&E's allegations of infringement to third parties. No discovery has been taken to date. Following a court decision in July 1997 construing the claims of the AS&E patent, which decision the Company considers favorable, in September 1997 the Company filed a motion for summary judgment of non- infringement. AS&E has not yet filed its papers in opposition to the Company's motion but is seeking discovery. If granted, the Company's motion will resolve all issues remaining in the case in favor of the Company. Earlier, in April 1997, the Court dismissed AS&E's proposed counterclaim seeking to allege patent infringement, so that the only remaining issue in the case is the Company's request for declaration of non-infringement of two claims of a single AS&E patent. In April 1998, AS&E filed a motion in the Federal Court of Appeals for the First Circuit to appeal this decision. This appeal is still pending. Although the Company does not believe that it is infringing any valid patent of AS&E, AS&E could make a new counterclaim in which it raises more specific infringement allegations. Failure of the Company to prevail in this litigation could have a material adverse effect on the Company's business, results of operations and financial condition.
Management of Growth. The Company has undergone a period of growth, and any continued expansion may significantly strain the Company's management, financial and other resources. Due to the level of technical and marketing expertise necessary to support its existing and new customers, the Company must attract and retain highly qualified and well-trained personnel. There are a limited number of persons with the requisite skills to serve in these positions, and it may become increasingly difficult for the Company to hire such personnel. The Company's expansion may also significantly strain the Company's management, manufacturing, financial and other resources. The Company cannot assure that its systems, procedures, and controls will be adequate to support the Company's operations or that the Company will be able to successfully integrate its new personnel. Failure to manage the Company's growth properly could have a material adverse effect on the Company's business, results of operations and financial condition.
Risks Associated with Possible Acquisitions. The Company intends to pursue potential acquisitions of businesses, products and technologies that could complement or expand the Company's business. The Company may not be able to identify any appropriate acquisition candidate. If the Company identifies an acquisition candidate, the Company may not be able to successfully negotiate the terms of any such acquisition, finance such acquisition or integrate such acquired business, products or technologies into the Company's existing business and products. Furthermore, the negotiation of potential acquisitions as well as the integration of an acquired business could cause diversion of management's time and resources, and require the Company to use working capital to consummate a potential acquisition. Any acquisition, whether or not consummated, could have a material adverse effect on the Company's business, results of operations or financial condition. If the Company consummates one or more significant acquisitions in which consideration consists of Common Stock, stockholders of the Company could suffer significant dilution of their interests in the Company.
Potential for Product Liability Claims. The Company's business involves the risk of product liability claims inherent to the explosives detection industry. There are many factors beyond the control of the Company that could result in the failure of the Company's products to detect explosives, such as the reliability of a customer's operators, the ongoing training of such operators and the maintenance of the Company's products by its customers. For these and other reasons, the Company's products may not detect all explosives concealed in screened bags. The failure to detect an explosive could give rise to product liability claims and result in negative publicity that could have a material adverse effect on the Company's business, results of operations and financial condition. The Company currently maintains aviation product liability insurance with an aggregate coverage limit of $150 million per year, subject to certain deductibles and exclusions. This insurance may be insufficient to protect the Company from product liability claims. Moreover, there is a risk that product liability insurance will not continue to be available to the Company at a reasonable cost, if at all.
Euro Conversion. On January 1, 1999, 11 of the 15 member countries of the European Union are scheduled to establish fixed conversion rates between their existing sovereign currencies and the euro. As of January 1, 2002, the transition to the euro will be complete. The Company has operations within the European Union and is currently preparing for the euro conversion. The issues that the Company is addressing include analyzing exchange rate risk in cross boarder transactions involving participating countries and assessing the potential impact of increased price transparency. In addition, the euro may impact general economic conditions such as interest and foreign exchange rates within the participating countries or in other areas where the Company operates, including the United Kingdom and Switzerland. The Company is analyzing the impact of the euro with view to minimize the effects on the Company's operations. The Company does not expect the costs associated with this transition to be material. The Company's functional currency for accounting purposes is the U.S. Dollar. The overall effect of the transition to the euro may have a material adverse affect on the Company's business, financial condition and financial results.
Concentration of Ownership; Control by Management. As of December 14, 1998, the Company's executive officers, directors and their affiliates and members of their immediate families beneficially owned approximately 14% of the outstanding shares of Common Stock, excluding shares issuable upon exercise of options and warrants. As a result, these stockholders, if acting together, will be able to exert substantial influence over actions requiring stockholder approval, including the election of directors, amendments to the Company's Restated Certificate of Incorporation, mergers, sales of assets or other business acquisitions or dispositions.
Antitakeover Provisions. The Company's Restated Certificate of Incorporation contains certain provisions that may discourage bids for the Company. On October 15, 1998 the Board of Directors of the Company adopted a shareholder purchase rights plan and declared a distribution of one Right for each outstanding share of the Company's Common Stock. This could limit the price that certain investors might be willing to pay in the future for shares of the Common Stock.
Volatility of Stock Price. The market price of the Common Stock has been and may continue to be highly volatile. The Company believes that a variety of factors could cause the price of the Common Stock to fluctuate, perhaps substantially, including: announcements of developments related to the Company's business, including announcements of certification by the FAA or other regulatory authorities of the Company's or its competitors products; quarterly fluctuations in the Company's actual or anticipated operating results and order levels; general conditions in the worldwide economy; announcements of technological innovations; new products or product enhancements by the Company or its competitors; developments in patents or other intellectual property rights and litigation; and developments in the Company's relationships with its customers and suppliers. In addition, in recent years the stock market in general and the markets for shares of small capitalization and "high-tech" companies in particular, have experienced extreme price fluctuations which have often been unrelated to the operating performance of affected companies. Any such fluctuations in the future could adversely affect the market price of the Common Stock and the market price of the Common Stock may decline.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Foreign Exchange Hedging. The accounts of the foreign subsidiary, Vivid Technologies UK Ltd., are translated in accordance with SFAS No. 52, Foreign Currency Translation. In translating the accounts of the foreign subsidiary into U.S. dollars, assets and liabilities are translated at the rate of exchange in effect at year-end, while stockholders' equity is translated at historical rates. Revenue and expense accounts are translated using the weighted average exchange rate in effect during the year. Foreign currency transaction gains or losses for Vivid Technologies UK Ltd. are included in the accompanying consolidated statements of operations since the functional currency for this subsidiary is the U.S. dollar.
The Company had sales of approximately $8,044,000 and $6,804,000 denominated in foreign currencies during 1997 and 1998, respectively. The Company recognized a loss of approximately $47,000 and a gain of approximately $36,000, related to such foreign currency transactions in 1997 and 1998, respectively, which is included in other income (loss) in the accompanying consolidated statements of income.
During fiscal 1997, the Company entered into forward foreign exchange contracts to hedge certain receivables denominated in a foreign currency. The purpose of this hedging activity was to protect the Company from the risk that dollar cash flows from such receivables would be adversely affected by changes in exchange rates. The Company does not engage in speculative hedging practices. As of September 30, 1997, the Company had forward foreign exchange contracts maturing through February 2, 1998 to purchase $5,393,000 in Hong Kong dollars. In accordance with SFAS No. 105, the contract was marked to market. At September 30, 1998, the Company had no exchange contracts. Gains and losses on forward foreign exchange commitments are deferred and recognized in revenue in the same period as the hedged transactions. The net gain (loss) was not material in 1997 or 1998. See "Risk Factors-Reliance on International Sales" under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
Investment Portfolio. The Company does not use derivative financial instruments that meet high credit quality standards, as specified in the Company's investment policy guidelines; the policy also limits the amount of credit exposure to any one issue, issuer, and type of instrument. See "Note 1 - Operations and Significant Accounting Policies" in the Consolidated Financial Statements.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated Financial Statements and Supplementary Data of the Company are listed under Part IV, Item 14, in this Report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by this Item 10 is hereby incorporated by reference to the text appearing under Part I, Item 1 - Business under the caption "Executive Officers of the Registrant" in this Report, and by reference to the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year.
Item 11.
Item 11. Executive Compensation
The information required by this Item 11 is hereby incorporated by reference to the information under the heading "Executive Compensation" in the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item 12 is hereby incorporated by reference to the information under the heading "Securities Beneficially Owned by Directors, Officers and Principal Stockholders" in the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this Item 13 is hereby incorporated by reference to the information under the heading "Certain Transactions," if any, in the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as part of this report:
(1) Financial Statements Page Report of Independent Public Accountants
Consolidated Balance Sheets as of September 30, 1997 and 1998
Consolidated Statements of Income for the years ended September 30, 1996, 1997 and 1998
Consolidated Statements of Stockholders' Equity for the years ended September 30, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the years ended September 30, 1996, 1997 and 1998
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
Supplemental schedules are not provided because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto.
(3) Listing of Exhibits
Exhibit No. Reference
2.01 Merger Agreement between the Company A** and the Company's Massachusetts predecessor
3.01 Restated Certificate of Incorporation A**
3.02 By-laws of the Company A**
4.01 Specimen Certificate for shares of A** the Company's Common Stock
4.02 Description of Capital Stock A** (contained in the Restated Certificate of Incorporation of the Company, filed as Exhibit 3.01)
4.03 Description of Registration Rights A** (contained in Exhibits 10.05, 10.11 and 10.13)
4.04 Rights Agreement between the C** Registrant and American Stock Transfer & Trust Company, as Rights Agent, dated as of October 13, 1998
10.01 Contract for the Manufacture, Supply, A** Installation and Commissioning of Hold Baggage Screening Equipment between the Company and BAA plc.
10.02 Distribution and Development A** Agreement between the Company and Gilardoni S.p.A.
10.02a Memorandum of Understanding between B** Gilardoni S.p.A. and the Company
10.03 First Amended and Restated Line of A** Credit Loan and Security Agreement between the Company and BayBank, N.A. and corresponding Note of the Company in favor of BayBank, N.A.
10.04 Form of Warrant to purchase Common A** Stock issued to certain investors.
10.05 Warrant to purchase Common Stock A** issued to Dominion Fund II, L.P.
10.06 1989 Combination Stock Option Plan of A** the Company*
10.07 1996 Non-Employee Director Stock A** Option Plan of the Company*
10.08 1996 Equity Incentive Plan of the A** Company*
10.09 Facility lease between the Company A** and Cummings Properties Management, Inc.
10.09a Facility lease between the Company Filed herewith and Cummings Properties Management, Inc.
10.10 Form of Indemnification Agreement for A** directors and officers of the Company*
10.11 Series A and Series B Preferred Stock A** Purchase Agreement
10.12 Series C and Series D Preferred Stock A** Purchase Agreement
10.13 Conversion Agreement between the A** Company and certain investors
10.14 Amended Shareholder Agreement among A** the Company's Massachusetts predecessor, S. David Ellenbogen, Jay A. Stein and certain investors
10.15 Management Services Agreement between A** the Company and Hologic, Inc.*
10.16 License and Technology Agreement A** between Company and Hologic, Inc., together with First Amendment to such License and Technology Agreement
10.17 Description of Bonus Plan* A**
10.18 Demand Line of Credit Loan and B** Security Agreement between the Company and BankBoston, N.A. and corresponding Note of the Company in favor of BankBoston, N.A.
10.19 Amended and Restated Demand Line of Filed herewith Credit Note
21.01 Subsidiaries of the Company A**
23.01 Consent of Arthur Andersen LLP Filed herewith
27.01 Financial Data Schedule Filed herewith ____________________
A Incorporated by reference to the Company's registration statement on Form S-1 (Registration No. 333-14311). The number set forth herein is the number of the Exhibit in said registration statement.
B Incorporated by reference to the Company's Form 10-K for the fiscal year ended September 30, 1997. The number set forth herein is the number of the Exhibit in said Form 10-K.
C Incorporated by reference to the Company's Form 8-K dated October 13, 1998 filed as exhibit number 4 therein.
* Management contract or compensatory plan or arrangement.
** In accordance with Rule 12b-32 under the Securities Exchange Act of 1934, as amended, reference is made to the documents previously filed with the Securities and Exchange Commission, which documents are hereby incorporated by reference.
(b) REPORTS ON FORM 8-K
The Company did not file any current reports on Form 8-K during the quarter ended September 30, 1998.
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.
VIVID TECHNOLOGIES, INC.
Dated: December 29, 1998 By: /s/ S. David Ellenbogen S. David Ellenbogen Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.
Signature Title Date
/s/ S. David Ellenbogen Director and Chief December 29, 1998 S. David Ellenbogen Executive Officer
/s/ William J. Frain Chief Financial December 29, 1998 William J. Frain Officer, Treasurer and Principal Accounting Officer
/s/ Jay A. Stein Director December 29, 1998 Jay A. Stein
/s/ L. Paul Bremer III Director December 29, 1998 L. Paul Bremer III
/s/ Frank Kenny Director December 29, 1998 Frank Kenny
/s/ Glenn P. Muir Director December 29, 1998 Glenn P. Muir
/s/ Gerald Segel Director December 29, 1998 Gerald Segel
Report of Independent Public Accountants
To Vivid Technologies, Inc.:
We have audited the accompanying consolidated balance sheets of Vivid Technologies, Inc. (a Delaware corporation) and subsidiaries as of September 30, 1997 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended September 30, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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 Vivid Technologies, Inc. and subsidiaries as of September 30, 1997 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1998, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Boston, Massachusetts November 3, 1998
VIVID TECHNOLOGIES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
September 30, 1997 1998 Assets Current Assets: Cash and cash equivalents $11,571,630 $15,555,189 Short-term investments 6,432,405 10,407,209 Accounts receivable 9,493,519 7,316,863 Inventories 6,195,096 7,874,036 Deferred tax asset 606,790 606,790 Other current assets 742,729 1,593,021
Total current assets 35,042,169 43,353,108
Property and Equipment, at cost: Machinery and equipment 2,166,867 2,347,896 Equipment under capital leases 198,580 198,580 Leasehold improvements 165,995 228,374 Furniture and fixtures 84,462 129,479 2,615,904 2,904,329 Less-Accumulated depreciation and amortization 1,531,709 1,488,893 1,084,195 1,415,436
Other Assets, net 1,330,233 1,155,945
$37,456,597 $45,924,489
Liabilities and Stockholders' Equity
Current Liabilities: Accounts payable $1,571,197 $ 846,457 Accrued expenses 2,418,431 2,766,268 Deferred revenue 1,755,788 3,411,864
Total current liabilities 5,745,416 7,024,589
Commitments and Contingencies (Note 9)
Stockholders' Equity: Common stock, $.01 par value- Authorized-30,000,000 shares Issued and outstanding-9,496,684 and 9,904,666 shares in 1997 and 1998, respectively 94,967 99,047 Capital in excess of par value 26,190,785 26,745,142 Retained earnings 5,425,429 12,055,711
Total stockholders' equity 31,711,181 38,899,900
$37,456,597 $45,924,489
The accompanying notes are an integral part of these consolidated financial statements.
VIVID TECHNOLOGIES, INC. AND SUBSIDIARIES
Consolidated Statements of Income
Year Ended September 30, 1996 1997 1998
Revenues $15,578,326 $31,702,188 $38,718,041
Cost of Revenues (includes approximately $775,000, $988,000 and $1,014,000, respectively, of royalties to Hologic; see Note 7) 6,899,433 13,202,925 16,360,872
Gross profit 8,678,893 18,499,263 22,357,169
Operating Expenses (includes approximately $325,000, $112,000 and $138,000, respectively, of management service expenses to Hologic; see Note 7): Research and development 3,461,555 4,390,446 5,858,883 Selling and marketing 1,394,880 3,556,006 4,334,823 General and administrative 1,515,420 2,928,658 3,952,431 Litigation expenses 1,149,889 427,000 220,000
Total operating expenses 7,521,744 11,302,110 14,366,137
Income from Operations 1,157,149 7,197,153 7,991,032
Interest Income 7,615 812,926 1,270,759
Other Income, net -- 48,834 206,880
Income before income taxes 1,164,764 8,058,913 9,468,671
Provision for Income Taxes -- 2,193,335 2,838,389
Net income $1,164,764 $5,865,578 $6,630,282
Net Income per Share: Basic $ .69 $ .78 $ .68 Diluted $ .15 $ .60 $ .65
Weighted Average Number of Shares Outstanding: Basic 1,682,109 7,547,964 9,684,975 Diluted 7,868,853 9,838,300 10,251,429
The accompanying notes are an integral part of these consolidated financial statements.
VIVID TECHNOLOGIES, INC. AND SUBSIDIARIES
The accompanying notes are an integral part of these consolidated financial statements.
VIVID TECHNOLOGIES, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Year Ended September 30, 1996 1997 1998
Cash Flows from Operating Activities: Net income $1,164,764 $5,865,578 $6,630,282 Adjustments to reconcile net income to net cash provided by (used in) operating activities- Depreciation and amortization 344,894 441,072 759,420 Issuance of common stock for services 45,000 -- -- Changes in assets and liabilities- Accounts receivable (2,552,354) (5,773,041) 2,176,656 Inventories (1,557,190) (1,453,438) (1,678,940) Deferred tax asset (181,000) (425,790) -- Other current assets (387,520) (297,827) (850,292) Accounts payable 767,303 72,957 (724,740) Accrued expenses 1,156,031 (1,014,483) 347,837 Deferred revenue 1,042,085 713,703 1,656,076
Net cash (used in) provided by operating activities (157,987) (1,871,269) 8,316,299 Cash Flows from Investing Activities: Purchase of property and equipment (427,053) (533,034) (836,893) Purchases of investments -- (11,650,261) (12,384,948) Maturities of investments -- 3,999,000 9,629,000 (Increase) decrease in other assets (37,581) 109,620 (1,298,336)
Net cash used in investing activities (464,634) (8,074,675) (4,891,177)
Cash Flows from Financing Activities: Net proceeds from sale of common stock -- 24,823,493 -- Proceeds from exercise of stock purchase warrants -- 32,960 84,756 Redemption of Series A and Series C preferred stock -- (5,780,650) -- Proceeds from exercise of stock options (including tax benefit) 11,395 812,569 473,681 Payments on capital lease obligations (161,962) (32,522) -- Deferred financing costs (127,000) -- --
Net cash provided by (used in) financing activities (277,567) 19,855,850 558,437
Net (Decrease) Increase in Cash and Cash Equivalents (900,188) 9,909,906 3,983,559
Cash and Cash Equivalents, beginning of year 2,561,912 1,661,724 11,571,630
Cash and Cash Equivalents, end of year $1,661,724 11,571,630 15,555,189
Supplemental Disclosure of Cash Flow Information: Cash paid during the year for- Interest $53,001 $2,040 -- Income taxes $351,000 $1,772,500 $2,325,033
Supplemental Disclosure of Noncash Investing and Financing Activities: Assets acquired under capital leases $198,850 $ -- $ -- Conversion of Series B and D preferred stock into common stock $ -- $5,045,850 $ --
The accompanying notes are an integral part of these consolidated financial statements.
VIVID TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Operations and Significant Accounting Policies
Vivid Technologies, Inc. (the Company) is a leading developer, manufacturer and marketer of automated inspection systems that detect plastic and other explosives in airline baggage.
The accompanying consolidated financial statements reflect the application of the accounting policies as described below.
(a)Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Vivid Technologies UK Ltd., Vivid Foreign Sales Corporation and Vivid Securities Corporation. All material intercompany transactions and balances have been eliminated in consolidation.
(b)Revenue Recognition
The Company recognizes product revenue upon shipment. The Company's product sales are not conditioned upon satisfactory installation by the Company. Installation is typically performed by the customer or a systems integrator of the airport's baggage handling system. However, the Company has typically assisted the systems integrator and accrues for estimated installation costs, in addition to estimated warranty costs, at the time of shipment. The Company recognizes revenue from the sale of extended warranty agreements ratably over the extended warranty period.
During fiscal 1996, 1997 and 1998, the Company recognized revenue of approximately $716,000, $821,000 and $2,699,000, respectively, under two separate research and development grants from an agency of the U.S. government to pursue certain explosives detection research. The Company recognizes revenue under these grants as services are rendered, provided that the government has appropriated sufficient funds for the work. The Company retains rights to all technological discoveries and products resulting from these efforts.
Deferred revenue represents amounts received from customers for products and services in advance of revenue recognition.
(c)Cash and Cash Equivalents and Investments
The Company accounts for investments in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. In accordance with SFAS No. 115, investments that the Company has the positive intent and ability to hold to maturity are reported at amortized cost, which approximates fair market value, and are classified as held- to-maturity. The Company has deemed all of its investments to be held-to-maturity, which total approximately $18,371,000 and $25,477,000 at September 30, 1997 and 1998, respectively. Cash equivalents are highly liquid investments with original maturities of three months or less at the time of acquisition. As of September 30, 1997 and 1998, there was approximately $10,720,000 and $15,070,000, respectively, in cash equivalents consisting of funds held in money market accounts, certificates of deposit, municipal bonds and repurchase agreements with overnight maturities. Short-term investments have maturities of greater than three months but less than one year. Investments with maturities of greater than one year have been classified as long-term investments. As of September 30, 1997, the Company had long-term investments of approximately $1,219,000 consisting of commercial paper, with an average maturity period of 15 months. As of September 30, 1998 the Company had no long- term investments.
(d)Concentration of Credit Risk and Significant Customers
SFAS No. 105, Disclosure of Information About Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, requires disclosure of any significant off-balance-sheet and credit risk concentrations. Financial instruments that subject the Company to credit risk consist primarily of cash and cash equivalents, investments and trade accounts receivable. The Company places its investments in several financial institutions. The Company has not experienced any material losses on these investments to date. The Company has not experienced any material losses related to receivables from individual customers or groups of customers, from any geographic region or in the baggage security and inspection industry.
During fiscal 1997, the Company entered into forward foreign exchange contracts to hedge certain receivables denominated in a foreign currency. The purpose of this hedging activity was to protect the Company from the risk that dollar cash flows from such receivables would be adversely affected by changes in exchange rates. The Company does not engage in speculative hedging practices. As of September 30, 1997, the Company had forward foreign exchange contracts maturing through February 2, 1998 to purchase $5,393,000 in Hong Kong dollars. In accordance with SFAS No. 105, the contract was marked to market. At September 30, 1998, the Company had no exchange contracts. Gains and losses on forward foreign exchange commitments are deferred and recognized in revenue in the same period as the hedged transactions. The net gain (loss) was not material in 1997 or 1998.
The Company received greater than 10% of total revenues from the following customers during the years ended September 30, 1996, 1997 and 1998:
September 30, Customer 1996 1997 1998
A 79% 39% 42% B * 19 12 C * 27 * D * * 16
*Revenues derived from these customers were less than 10% of the Company's total.
The Company had accounts receivable balances greater than 10% of total accounts receivable from the following customers as of September 30, 1997 and 1998:
September 30, Customer 1997 1998
A * 26% B 61% * C 12 * D * * E 15 19 F * 11 G * 19
*Accounts receivable balances from these customers were less than 10% of the Company's total.
(e)Disclosure of Fair Value of Financial Instruments
The Company's financial instruments consist mainly of cash and cash equivalents, investments, accounts receivable and accounts payable. The carrying amounts of the Company's cash and cash equivalents, investments, accounts receivable and accounts payable approximate fair value due to the short- term nature of these instruments.
(f) Translation of Foreign Currencies
The accounts of the foreign subsidiary are translated in accordance with SFAS No. 52, Foreign Currency Translation. In translating the accounts of the foreign subsidiary into U.S. dollars, assets and liabilities are translated at the rate of exchange in effect at year-end, while stockholders' equity is translated at historical rates. Revenue and expense accounts are translated using the weighted average exchange rate in effect during the year. Foreign currency transaction gains or losses for Vivid Technologies UK Ltd. are included in the accompanying consolidated statements of operations since the functional currency for this subsidiary is the U.S. dollar.
The Company had sales of approximately $8,044,000 and $6,804,000 denominated in foreign currencies during 1997 and 1998, respectively. The Company recognized a loss of approximately $47,000 and a gain of approximately $36,000, related to such foreign currency transactions in 1997 and 1998, respectively, which is included in other income (loss) in the accompanying consolidated statements of income.
(g)Inventories
Inventories are stated at the lower of cost (first-in, first- out) or market and consist of the following:
September 30, 1997 1998
Raw materials $3,175,211 $4,061,775 Work-in-process 1,743,746 1,440,435 Finished goods 1,276,139 2,371,826
$6,195,096 $7,874,036
Finished goods and work-in-process inventories consist of materials, labor and overhead.
(h)Depreciation and Amortization
The Company provides for depreciation and amortization by charges to operations using the straight-line and declining- balance methods, which allocate the cost of property and equipment over their estimated useful lives, as follows:
Assets Estimated Classification Useful Life
Machinery and equipment 5 years Equipment under capital leases Life of lease Leasehold improvements Life of lease Furniture and fixtures 7 years
(i)Other Assets
During 1998, the Company entered into an exclusive technology license agreement. Under the agreement, the Company paid $1,250,000 for the exclusive right to manufacture, use or sell the licensed technology for a three- year period, with a nonexclusive right for the remainder of the life of the patents. The Company also has the option to extend the exclusive rights beyond three years. Upon the ultimate commercialization of the technology, the Company will be required to pay royalties on sales of products incorporating the licensed technology, as defined. The license fee is included in other assets in the accompanying consolidated balance sheets and is being amortized over a period of five years. At September 30, 1998, the Company has recorded accumulated amortization of approximately $250,000 related to this asset.
Other assets also consists of long-term investments, deposits and patent costs, which are being amortized over 10 years using the straight-line method. The Company periodically assesses the realizability of long-lived assets, including intangible assets such as patent costs and license fees, in accordance with SFAS No. 121, Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of. The Company has not recorded any impairment of its intangible assets to date.
(j)Net Income per Share
In March 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 128, Earnings per Share. This statement established standards for computing and presenting earnings per share and applies to entities with publicly traded common stock or potential common stock. In February 1998, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 98. This bulletin revises the SEC's guidance for calculating earnings per share with respect to equity security issuances before an initial public offering (IPO). These statements are effective for fiscal years ending after December 15, 1997. The prior years' earnings per share have been retroactively restated to reflect the adoption of SFAS No. 128 and SAB No. 98.
Basic net income per share was determined by dividing net income by the weighted average common shares outstanding during the period. Diluted net income per share was determined by dividing net income by diluted weighted average shares outstanding. Diluted weighted average shares reflects the dilutive effect, if any, of potential common stock. Potential common stock includes common stock options, warrants to purchase common stock and convertible preferred stock to the extent their effect is dilutive. Nominal issuances arise when a registrant issues common stock, options or warrants to purchase common stock or other potentially dilutive instruments for nominal consideration, as defined by SAB No. 98, in the periods preceding an IPO. During the period preceding the Company's IPO, the Company did not have any nominal issuances.
The calculations of basic and diluted weighted average shares outstanding are as follows:
Year Ended September 30, 1996 1997 1998
Basic weighted average shares outstanding 1,682,109 7,547,964 9,684,975
Weighted average potential common stock 6,186,744 2,290,336 566,454
Diluted weighted average shares outstanding 7,868,853 9,838,300 10,251,429
Diluted weighted average shares outstanding do not include 113,726 and 503,347 common equivalent shares for the years ended September 30, 1997 and 1998, respectively, as their effect would be antidilutive.
(k)Management Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company is subject to risks and uncertainties, in particular, dependence on key customers and international sales, rapid technological change, dependence on government regulations and significant fluctuations and unpredictability of operating results.
(l)Research and Development and Software Development Costs
Research and development costs have been charged to operations as incurred. SFAS No. 86, Accounting for the Costs of Computer Software To Be Sold, Leased or Otherwise Marketed, requires the capitalization of certain computer software development costs incurred after technological feasibility is established. The Company believes that once technological feasibility of a software product has been established, the additional development costs incurred to bring the product to a commercially acceptable level are not significant.
(m)New Accounting Standards
In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 requires disclosure of all components of comprehensive income on an annual and interim basis. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997.
In July 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 requires certain financial and supplementary information to be disclosed on an annual and interim basis for each reportable segment of an enterprise, as defined. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997. Unless impracticable, companies would be required to disclose similar prior period information upon adoption.
In March 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires computer software costs associated with internal-use software to be charged to operations as incurred until certain capitalization criteria are met. SOP 98-1 is effective beginning January 1, 1999. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial position or results of operations.
In April 1998, the AICPA issued SOP 98-5, Reporting on the Costs of Start-Up Activities. SOP 98-5 provides guidance on the financial reporting of start-up costs and organization costs. It requires costs of start-up activities and organization costs to be expensed as incurred. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998. Initial application of this SOP will require that the Company take a one-time charge for any capitalized start-up or organization costs remaining on the balance sheet. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The Company does not expect the adoption of this statement to have a material impact on its consolidated financial position or results of operations.
(2) Income Taxes
The Company accounts for income taxes under SFAS No. 109, Accounting for Income Taxes, the objective of which is to recognize the amount of current and deferred income taxes at the date of the financial statements as a result of all differences in the tax basis and financial statement carrying amount of assets and liabilities, as measured by enacted tax laws.
The approximate income tax effect of each type of temporary difference and carryforward is as follows:
September 30, 1997 1998
Research and development credit carryforwards $32,000 $32,000 Nondeductible accruals 27,000 331,000 Nondeductible reserves 543,000 223,000 Other temporary differences 4,790 20,790
Net deferred tax asset $606,790 $606,790
Under SFAS No. 109, the Company recognizes a deferred tax asset for the future benefit of its temporary differences if it concludes that it is more likely than not that the deferred tax asset will be realized.
A reconciliation of the federal statutory rate to the Company's effective tax rate is as follows:
September 30, 1996 1997 1998
Income tax provision at federal statutory rate 34.0% 34.0% 34.0% Increase (decrease) in tax resulting from- State tax provision, net of federal benefit 8.1 3.2 1.9 Foreign sales corporation benefit (7.5) (5.0) (3.5) Foreign net operating losses not benefited 4.1 -- -- Reduction in valuation allowance (15.5) (1.2) -- Research and development tax credit utilized (24.1) (3.8) (3.3) Other 0.9 (0.2) 0.9
Effective tax rate --% 27.0% 30.0%
The provision for income taxes in the accompanying consolidated statements of operations consists of the following:
September 30, 1996 1997 1998 Federal- Current $179,000 $2,173,335 2,767,389 Deferred (179,000) (224,000) --
-- 1,949,335 2,767,389 State- Current 2,000 271,000 71,000 Deferred (2,000) (27,000) --
-- 244,000 71,000
$ -- $2,193,335 $2,838,389
(3) Line of Credit
The Company has an unsecured demand line of credit with a bank for $5,000,000. Borrowings under the line are available through February 28, 1999 and bear interest at one of several interest rates, including the bank's prime rate (8.25% at September 30, 1998) and a LIBOR index rate. There were no amounts outstanding under this line at September 30, 1997 and 1998.
(4) Redeemable Preferred Stock
The Company had previously authorized 578,065 shares of redeemable preferred stock, par value $.01 per share, of which 234,375 shares and 343,690 shares had been designated as Series A and Series C redeemable preferred stock, respectively. In connection with the Company's initial public offering during 1997, the Company redeemed all outstanding shares of Series A and Series C redeemable preferred stock for approximately $5,781,000, which represents a redemption value of $10.00 per share.
(5) Stockholders' Equity
(a) Preferred Stock
In December 1996, the Company's Board of Directors authorized the issuance of up to 1,000,000 shares of undesignated $.01 par value preferred stock, the rights and privileges of which are to be determined by the Company's Board of Directors. The Series A, B, C and D preferred stock were retired in connection with the Company's initial public offering (see Note 5(b) and (c)). There are no preferred shares outstanding as of September 30, 1997 or 1998.
(b) Series B and D Convertible Preferred Stock
The Company had previously authorized 504,585 shares of convertible preferred stock, par value $.01 per share, of which 250,000 shares and 254,585 shares had been designated as Series B and Series D convertible preferred stock, respectively. In connection with the Company's initial public offering in fiscal 1997, all shares of Series B and Series D convertible preferred stock were converted into an aggregate 5,045,850 shares of common stock.
(c)Initial Public Offering
During fiscal 1997, the Company completed its initial public offering of 2,300,000 shares of the Company's common stock at $12.00 per share. The Company received net proceeds of approximately $24,823,000 after deducting the underwriters' commission and issuance costs. The Company used approximately $5,781,000 of the net proceeds to redeem all of its outstanding shares of redeemable Series A and Series C preferred stock. In connection with the initial public offering, all of the Company's Series B and Series D preferred stock was converted into an aggregate of 5,045,850 shares of common stock.
(d)Common Stock
The Company has authorized 30,000,000 shares of $.01 par value common stock. The Company has reserved the following number of common shares as of September 30, 1998:
Exercise of stock purchase warrants 53,678 Exercise of stock options 1,406,570 1,460,248
In July 1996, the Company issued 15,000 shares of common stock to a customer at no cost in lieu of fees on certain sales of the Company's products for which the customer provided substantial assistance through access to the customer's facilities and liaison activities. The Company recorded a $45,000 charge to selling and marketing expenses for the issuance of these shares during fiscal 1996.
(e)Stock Plans
1989 Combination Stock Option Plan
The Company's 1989 Combination Stock Option Plan (the 1989 Plan) provides for the grant to key employees incentive stock options to purchase shares of the Company's common stock at a price not less than fair market value as determined by the Board of Directors, or nonqualified options at a price specified by the Board of Directors. Under the 1989 Plan, the Company has reserved shares for the granting of options to purchase up to 1,250,000 shares of the Company's common stock.
The 1996 Equity Incentive Plan
In October 1996, the Company approved the 1996 Equity Incentive Plan (the Equity Plan) for which the Company reserved shares for the granting of options to purchase up to 750,000 shares of the Company's common stock.
The 1996 Nonemployee Director Stock Option Plan
In October 1996, the Company approved the 1996 Nonemployee Director Stock Option Plan (the Director Plan) for which the Company has reserved shares for the granting of options to purchase up to 125,000 shares of the Company's common stock.
As of September 30, 1998, there were 595,220 options available for future grants under all plans. A summary of stock option activity under all plans is as follows:
Shares Price per Weighted Share Average Exercise Price
Outstanding, September 30, 1995 757,420 $ .10-1.00 $ .46 Granted 157,750 1.00-3.00 2.22 Exercised (51,170) .10-1.00 .85 Terminated (7,100) .50-1.00 .87
Outstanding, September 30, 1996 856,900 .10-3.00 .78 Granted 386,050 9.50-17.00 14.27 Exercised (333,800) .10-3.00 .46 Terminated (20,450) .50-3.00 1.15
Outstanding, September 30, 1997 888,700 .10-17.00 6.75 Granted 225,950 .01-14.88 12.77 Exercised (159,110) .01-11.00 .60 Terminated (148,890) .50-16.75 11.08
Outstanding, September 30, 1998 806,650 $ .10-17.00 $ 8.85
Exercisable, September 30, 1998 276,580 $ .10-17.00 $ 4.33
During fiscal 1998, the Company issued an option to purchase 10,000 shares of common stock to an employee at a price below fair market. All other options were issued at the fair market value at the grant date. The Company recorded the difference between the grant price and fair market value in the statement of income.
The range of exercise prices for options outstanding and options exercisable at September 30, 1998 are as follows:
Options Outstanding Options Exercisable Range of Weighted Number Weighted Number Weighted Exercise Average Average Average Price Remaining Exercise Exercise Contractual Price Price Life (in years)
$0.10-$1.00 4.7 269,600 $ 0.61 184,050 $ 0.48 $3.00-$9.50 8.0 105,300 4.77 32,940 4.31 $10.75-$15.50 9.1 213,900 13.71 5,940 14.71 $15.88-$17.00 8.5 217,850 16.25 53,650 16.38
Total 7.33 806,650 $ 8.85 276,580 $ 4.33
The Company accounts for its stock-based compensation plans under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation, which established a fair-value-based method of accounting for stock-based compensation plans. The Company has adopted the disclosure-only alternative under SFAS No. 123 which requires disclosure of the pro forma effects on net income and earnings per share as if SFAS No. 123 had been adopted, as well as certain other information.
The Company has computed the pro forma disclosures required under SFAS No. 123 for all stock options and warrants granted to employees of the Company in fiscal 1996, 1997 and 1998 using the Black Scholes option pricing model prescribed by SFAS No. 123. The assumptions used to calculate the SFAS No. 123 pro forma disclosure and the weighted average information for 1996, 1997 and 1998 are as follows:
Year Ended September 30, 1996 1997 1998
Risk-free interest rate 6.04% 6.01% 5.52% Expected dividend yield -- -- -- Expected lives (in years) 4.7 4.9 4.7 Expected volatility 53% 52% 67% Weighted-average grant date fair value of options granted during the year $1.10 $7.16 $8.08
The pro forma effect of applying SFAS No. 123 for all options and granted to employees of the Company in 1996, 1997 and 1998 would be as follows:
Year Ended September 30, 1996 1997 1998
Net Income- As reported $1,164,764 $5,865,578 $6,630,282 Pro forma 1,125,371 5,104,357 5,382,540
Net income per share- Basic- As reported $0.69 $0.78 $0.68 Pro forma 0.67 0.68 0.56 Diluted- As reported $0.15 $0.60 $0.65 Pro forma 0.14 0.52 0.53
The resulting pro forma compensation expense may not be representative of the amount to be expected in future years, as the pro forma expense may vary based on the number of options granted. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
(f)Stock Purchase Warrants
In conjunction with a $400,000 promissory note issued in fiscal 1992 and repaid in fiscal 1993, the Company sold a warrant, at nominal value, to purchase 42,667 shares of the Company's common stock at $1.50 per share. This stock purchase warrant was exercised during fiscal 1997, resulting in a net issuance of 39,789 shares of common stock.
In conjunction with the issuance of certain convertible notes in fiscal 1993, the Company sold, at nominal value, warrants to purchase 361,002 shares of the Company's common stock for $1.50 per share. The warrants expire in December 2001. During fiscal 1997 and 1998, warrants to purchase 37,792 and 269,530 shares, respectively, were exercised resulting in the net issuance of 36,725 and 248,872 shares of common stock, respectively.
(g)Shareholder Purchase Rights Plan
In October 1998, the Company's Board of Directors adopted a Shareholder Protection Rights Plan declaring a dividend of one right for each share of the Company's common stock outstanding at the close of business on October 27, 1998. The rights entitle the Company's shareholders to purchase one one-thousandth of a share of a series of junior participating preferred stock of the Company at an exercise price of $60.00, subject to adjustment. The rights will not be exercisable until a subsequent distribution date which will occur if a person or group acquires beneficial ownership of 15% or more of the Company's common stock or announces a tender or exchange offer that would result in a group owning 15% or more of the Company's common stock. Subject to certain limited exceptions, if a person or group acquires beneficial ownership of 15% or more of the Company's outstanding common stock, each holder of a right (other than the 15% holder whose rights become void once such holder reaches the 15% threshold) will thereafter have a right to purchase, upon payment of the purchase price of the right, that number of shares of the Corporation's common stock, which at the time of such transaction will have a market value equal to two times the purchase price of the right. In the event that, at any time after a person or group acquires 15% or more of the Company's common stock, the Company is acquired in a merger or other business combination transaction of 50% or more of its consolidated assets or earning power are sold, each holder of a right will thereafter have the right to purchase, upon payment of the purchase price of the right, that number of shares of common stock of the acquiring company which at the time of such transaction will have a market value of two times the purchase price of the right. The Board of Directors of the Company may exchange the rights (other than rights owned by such person or group which have become void), in whole or in part, at an exchange ratio of one share of common stock per right (subject to adjustment). At any time prior to the time any person or group acquires 15% or more of the Company's common stock, the Board of Directors of the Company may redeem the rights in whole, but not in part, at a price of $0.001 per right. The rights will expire on October 13, 2008 unless earlier redeemed or exchanged.
(6) Geographical Sales Data
A summary of the Company's revenues by geographic region is as follows:
September 30, 1996 1997 1998
Europe 95.0% 51.5% 57.3% United States 4.6 2.6 22.5 Asia 0.3 45.7 14.3 Middle East -- -- 5.9 Other 0.1 0.2 --
Total 100% 100% 100%
Substantially all of the Company's assets are located in the United States.
(7) Related Party Transactions
(a)Management Services Agreement
The Company has an agreement with Hologic, Inc. (Hologic), an affiliated company, whereby Hologic provides management, administrative and support services. In addition, the Company subleased its facilities from Hologic under a sublease agreement, which was terminated in February 1996, for approximately $15,000 per month. The Company paid Hologic for all direct costs incurred, as well as a portion of Hologic's overhead costs, as defined, representing a pro rata portion of costs attributable to the Company. Expenses charged to operations under these agreements were approximately $325,000, $112,000 and $138,000 in fiscal 1996, 1997 and 1998, respectively. Approximately $20,000 and $27,000 had not been paid as of September 30, 1997 and 1998, respectively, under the management services agreement.
(b)License and Technology Agreement
The Company has an agreement with Hologic whereby the Company has a perpetual, exclusive, worldwide license to utilize certain of Hologic's technology and patents for the purpose of developing the Company's x-ray screening security systems for explosives, drugs, currency and other contraband (the Exclusive License). In September 1996, this license was amended to grant the Company a nonexclusive license to utilize these patents and technology for certain new product development for other applications (the Nonexclusive License). Royalty payments to Hologic under the Exclusive License are 5% of revenues, as defined, on the first $50 million in sales; thereafter, payments are 3% on revenues up to $200 million, with no royalty payments on aggregate revenues in excess of $200 million. During 1997, the Company reduced its royalty payments to 3% under the Exclusive License upon achievement of cumulative revenues in excess of $50 million. Royalty payments under the Nonexclusive License are 3% on sales up to $200 million, with no royalty payments on aggregate revenues in excess of $200 million. The agreement terminates by mutual agreement of the two parties or upon certain other defined circumstances. During fiscal 1996, 1997 and 1998, the Company incurred royalty expenses under the Exclusive License of approximately $775,000, $988,000 and $1,014,000, respectively, of which approximately $753,000 and $504,000 had not been paid as of September 30, 1997 and 1998, respectively. To date, the Company has not incurred any royalty expenses under the Nonexclusive License.
(8) Profit-Sharing 401(k) Plan
The Company has a qualified profit-sharing plan covering substantially all of its employees. Contributions to the plan are at the discretion of the Company's Board of Directors. The Company has recorded approximately $65,000, $74,000 and $133,000 as a provision for profit-sharing contribution for fiscal 1996, 1997 and 1998, respectively.
(9) Commitments and Contingencies
(a)Operating Leases
The Company is renting the facilities under operating leases which expire through February 2003. The Company's future minimum lease payments under all operating leases as of September 30, 1998 are as follows:
Year Amount
1999 $553,000 2000 688,000 2001 331,000 2002 262,000 2003 207,000
$2,041,000
Rent expense charged to operations for fiscal 1996, 1997 and 1998 was approximately $302,000, $438,000 and $525,000, respectively.
(b)Patent Infringement Claims
Litigation expense in the accompanying statements of income represents costs incurred related to certain patent infringement claims which have been settled or dismissed as of September 30, 1998. From time to time, the Company is party to various types of litigation. The Company believes it has meritorious defenses to all claims, and in its opinion, all litigation currently pending or threatened will not have a material effect on the Company's financial position or results of operations.
(c)Patent License Agreement
During fiscal 1996, the Company entered into a patent license agreement for the exclusive license of certain explosives detection technology. Under this agreement, the Company is required to pay aggregate royalties of up to $1,000,000 based on net sales, as defined. During fiscal 1996, 1997 and 1998, the Company incurred approximately $28,000, $97,000 and $112,000, respectively, of royalty expense related to this agreement.
(d)Joint Development and Royalty Agreement
During fiscal 1997, the Company entered into a joint development and royalty agreement for the development of certain explosives detection technology. Under the terms of the agreement, the Company is required to pay a royalty of $3,000 per unit sold of the developed product, as defined. During 1998, the Company prepaid royalties in the amount of approximately $500,000, which are being amortized as the royalties are incurred. At September 30, 1998, approximately $414,000 of prepaid royalties are included in other current assets in the accompanying consolidated balance sheets. For the year ended September 30, 1998, the Company incurred $87,000 in royalty expenses. No royalty expenses were incurred for the year ended September 30, 1997.
(10) Accrued Expenses
Accrued expenses in the accompanying consolidated balance sheets consist of the following:
September 30, 1997 1998
Payroll and payroll-related $601,959 $907,959 Accrued warranty 798,000 798,000 Accrued royalties 789,684 537,782 Accrued legal 75,954 50,323 Other 152,834 79,564 Accrued taxes -- 392,640 $2,418,431 $2,766,268