Form 10KSB for INTERNATIONAL ELECTRONICS INC
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28-Nov-2005
Annual Report
Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with our consolidated financial statements and notes to those statements. The following discussion contains forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of a number of factors, including the matters discussed in "Risk Factors" and elsewhere in this report.
Critical Accounting Policies
The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Note 1 to the consolidated financial statements in this Annual Report on Form 10-KSB for the year ended August 31, 2005 describes the significant accounting policies used in the preparation of our consolidated financial statements. Management bases its estimates and judgments on historical experience, market trends, and other factors that are believed to be reasonable under the circumstances. Estimates are used for, but not limited to, the accounting for allowance for doubtful accounts and sales returns, inventory reserves, warranty reserves, income taxes and contingencies. Actual results could materially differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.
Revenue recognition - Revenue from product sales is recognized upon shipment provided there are no uncertainties regarding customer acceptance, persuasive evidence of an arrangement exists, the sales price is fixed or determinable, and collection of the related receivable is probable. If uncertainties exist, IEI recognizes revenue when these uncertainties are resolved. An allowance for estimated future returns is recorded at the time revenue is recognized based on IEI's historical experience. Estimated product warranty costs are recorded at the time of product revenue recognition.
Allowance for Doubtful Accounts and Sales Returns - The allowance for doubtful accounts and sales returns is based on our assessment of the collectibility of specific customer accounts, the aging of our accounts receivable and trends in product returns. While we believe that our allowance for doubtful accounts and sales returns is adequate and that the judgment applied is appropriate, if there is a deterioration of a major customer's credit worthiness, actual defaults are higher than our previous experience, or actual future returns do not reflect historical trends, our estimates of the recoverability of the amounts due us and our sales would be adversely affected.
Inventory Obsolescence Reserve - Inventory purchases and commitments are based upon future demand forecasts for our products and our current level of inventory. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and requirements, we may be required to increase our inventory reserve and as a result, our gross profit margin would be adversely affected.
Warranty Reserve - We accrue for warranty costs based on the historical rate of claims and costs to provide warranty services as the sale is recognized. While we believe the accrual for warranty costs is adequate to address known warranty issues, if we experience an increase in warranty claims that are higher than our historical experience or our costs to provide warranty services increase, we may be required to increase our warranty accrual and as a result, our gross profit margin would be adversely affected.
Deferred Income Taxes - SFAS No. 109, "Accounting for Income Taxes", requires the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We evaluate all available evidence to determine whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. Our effective income tax rate may vary from period to period based on changes in estimated taxable income or loss, changes to the valuation allowance, changes to federal, state or foreign tax laws and deductibility of certain costs and expenses.
Loss Contingencies - We are subject to the possibility of various loss contingencies arising in the ordinary course of business. An estimated loss contingency is accrued when it is probable that a liability has been incurred or an asset has been impaired and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be recognized or adjusted.
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Results of Operations
Fiscal years ended August 31, 2005, 2004 and 2003
Net Sales. Net sales in both 2005 and 2004 increased 11% from the previous year. The increase in net sales for 2005 compared to 2004 is primarily due to increases in our OEM custom and keypad product lines. The increase in net sales for 2004 compared to 2003 is primarily due to increases in demand for our access control product line. In 2005, 2004 and 2003, one customer contributed more than 10% of our net sales, representing 32%, 35% and 38%, respectively.
Cost of Sales/Gross Profit. Our cost of sales primarily consists of purchased materials, manufacturing salaries and related personnel expenses, facility overhead and amounts paid to third-party manufacturers. The ratios of gross profit to net sales were 45% in 2005, 42% in 2004, and 44% in 2003. The decrease in the gross profit ratio for 2004 from the prior year is primarily due to product mix and an increase in manufacturing overhead costs. The increase in gross profit ratio for 2005 is primarily due to product mix. Our gross profit as a percentage of net sales in a particular quarter is highly variable due to many factors such as sales volume. Gross profit may also be adversely affected by increases in manufacturing costs, excess and obsolete inventory, warranty costs, increased price competition, geographic mix, and changes in sales channels or product mix.
Research and Development Expenses. Research and development expenses primarily consist of salaries and related personnel expenses, consulting fees and prototype costs. Research and development expenses were $1,228,920 in 2005, $1,177,463 in 2004 and $1,090,604 in 2003. The 2005 expenditures included $135,000 related to a contract IEI entered into with S2 Security Corporation. The purpose of the contract was to reengineer the eMerge™ 5000 product. The increase in costs in 2004 from the prior year is primarily due to additional salaries and related expenses, and consulting fees due to the increased development efforts for the industrial access control product line. We believe that research and development is critical to our strategic product development objectives and we intend to continue to enhance our products. We expect future research and development expenses to decrease slightly in absolute dollars from its current level.
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Selling, General and Administrative Expenses. Selling, general and administrative expenses primarily consist of salaries and related personnel expenses, commissions, travel and entertainment expenses, trade shows, advertising, telephone, bad debts and professional fees. As a percentage of net sales, selling, general and administrative expenses were 41% in 2005, 37% in 2004 and 33% in 2003. The aggregate increase in dollars in 2005 was approximately $906,000, with the largest increase attributed to payroll of $339,000. Other contributing factors were travel, sales and marketing, trade shows, and legal costs resulting from the delisting from NASDAQ. The increase in expenses as a percentage of net sales in 2004 from the prior year is primarily due to an increase in the hiring of additional management personnel, increases in advertising, trade shows and consulting fees and a reduction in bad debt expense. We expect future selling, general and administrative expenses to increase in absolute dollars from its current level as we introduce new products to the market and expand our sales organization.
Other Income. Other income primarily consists of interest earned on our cash balances, and to a lesser extent, sundry other non-operating items. Other income was $25,867 in 2005, $18,228 in 2004 and $23,578 in 2003. The increase in 2005 is primarily due to an increase in interest rates on invested balances. The decrease in 2004 from 2003 was the result of a reduction in interest rates and invested balances.
Interest Expense. Interest expense consists of interest incurred on equipment financing. Interest expense was $20,097 in 2005, $24,929 in 2004 and $27,462 in 2003. These decreases are the result of a reduction in outstanding debt.
Income Taxes. IEI's effective income tax rate was .3% in 2005, 67% in 2004 and 28% for 2003. In the fourth quarter of 2005, upon completion of IEI's 2006 operating plan and 2005 financial results, we decided to maintain a full valuation allowance against the calculated deferred tax asset due to the uncertainty of realizing the benefit of the assets. See Note 8 to the Consolidated Financial Statements. The difference between the effective tax rate and the federal statutory rate is primarily due to the valuation allowance in 2005 and the utilization of net operating loss carryforwards in 2003.
Off-Balance Sheet Arrangements.
We have no off-balance sheet arrangements that are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Liquidity and Capital Resources
As of August 31, 2005, IEI had $1,564,245 in working capital as compared to $2,312,446 at August 31, 2004. The ratio of current assets to current liabilities as of August 31, 2005 was 1.6 as compared to 2.1 for 2004 and 2.8 for 2003. The debt to equity ratio, which is a measure of a company's financial leverage and is computed by dividing total liabilities over shareholder's equity, was 1.1 at August 31, 2005 as compared to 0.8 at August 31, 2004 and 0.5 at August 31, 2003. The decrease in working capital and current ratio in 2005 from 2004 is primarily due to a reduction in cash and equivalents, and an increase in accounts payable, partially offset by an increase in accounts receivable. The increase in the debt to equity ratios in 2005 from 2004 is primarily due to an increase in accounts payable and IEI's net loss.
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Net cash flows used in operating activities were $652,207 in 2005, compared with net cash flows provided by operating activities of $179,420 in 2004, and cash flows used in operating activities of $323,409 in 2003. The decrease in operating cash flows in 2005 is primarily due to the net loss, and increases in accounts receivable and inventory, partially offset by an increase in accounts payable and accrued expenses.
Net capital expenditures were $107,225, $404,621, and $229,311 for 2005, 2004 and 2003, respectively. In 2004, IEI purchased certain expensive manufacturing equipment. These capital investments were aimed at decreasing the manual labor costs and increasing the quality of the product. The total purchases for production equipment in 2004 totaled $266,000. As a result of these capital expenditures, there was a significant decrease in net capital expenditures in 2005 and a significant increase in 2004. IEI anticipates having up to $300,000 in total capital expenditures in fiscal 2006 primarily for the purchase of production, engineering, and office equipment. We expect our 2006 capital expenditures to be financed from cash flow from operations.
Net cash flows used in financing activities were $217,247 in 2005, while net cash flows provided by financing activities were $99,642 in 2004, and net cash flows used in financing activities were $97,562 in 2003. The increase in cash flows used in financing activities in 2005 was primarily due to a reduction in the availability of the equipment and demand lines of credit. The increase in net cash flows provided by financing activities in 2004 compared to the prior year is primarily the result of additional long-term obligations for equipment financing and proceeds from the exercise of stock options and warrants.
The following table summarizes our future contractual cash obligations as of August 31, 2005:
2006 2007 2008 Total
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Equipment line of credit $ 238,385 $ - $ - $ 238,385
Employment agreement 184,641 184,641 184,641 553,923
Purchase commitments 1,944,066 96,013 6,400 2,046,479
Operating lease obligations 124,437 5,280 - 129,717
- --------- - ------- - ------- - ---------
$ 2,491,529 $ 285,934 $ 191,041 $ 2,968,504
- --------- - ------- - ------- - ---------
In February 2005 the equipment line of credit expired and was not renewed, and therefore the debt was classified as a current liability on the balance sheet. Eastern Bank agreed to the original repayment schedule as dictated by the equipment line of credit. The outstanding balance of $238,385 is scheduled to be paid as follows: $167,691 in fiscal 2006, $62,252 in fiscal 2007 and $8,442 in fiscal 2008.
Purchase commitments in the table above, represents outstanding purchase orders on materials, services and supplies. Some of these purchase orders are extending over several years. The supplier's production is solely dependent on IEI's forecasted requirements which may vary over an extended period of time. Therefore, IEI's liability is limited to the releases of those forecasted requirements that are scheduled within the next three to six months.
Based on our current expectations, we believe that our current cash position, together with internally generated funds at present sales levels, will provide adequate cash reserves to satisfy our cash requirements for the next twelve months. Although it is difficult to predict future liquidity requirements with certainty, the rate at which we will consume cash will be dependent on the cash needs of future operations, including changes in working capital, which will, in turn, be directly affected by the levels of demand for our products, the timing and rate of expansion of our business and the resources we devote to developing our products. We anticipate devoting substantial capital resources to continue our research and development efforts, to maintain our sales and marketing, and for other general corporate activities. We may periodically review strategic and operational alternatives to improve our operating results and financial position. In this regard, we may consider, among other things, changes in our capital structure, adjustment to our capital expenditures and overall spending and the restructuring of our operations. We cannot be assured that we will be successful in implementing any new strategic or operational initiatives or, if implemented, that they will have the effect of improving our operating results and financial position. We may seek to sell additional equity or debt securities that could result in additional dilution to our shareholders, and we cannot be certain that additional financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and sales and marketing efforts, which could harm our business, financial condition and operating results.
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Recent Accounting Pronouncement
In November 2004, the Financial Accounting Standards Board ("FASB") issued SFAS Statement No. 151, Inventory Costs, an Amendment of Accounting Principles Board Opinion No. 43, Chapter 4, or SFAS 151. SFAS 151 requires that items such as idle facility expense, freight, handling costs and wasted materials be recognized as current-period charges rather than being included in the inventory regardless of whether the costs meet the criterion of abnormal as defined in Accounting Principles Board Opinion No. 43. SFAS 151 is applicable for inventory costs incurred during fiscal years beginning after June 15, 2005. We will adopt this pronouncement on September 1, 2005 and we do not expect the adoption will have a material impact on our financial condition or results of operation.
In December 2004, the FASB issued Statement No. 123R, "Share-Based Payment" ("FAS 123R"). FAS 123R is a revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"). IEI is required to adopt the provisions of FAS 123R as of the beginning of its first fiscal quarter of 2007, beginning September 1, 2006. This statement establishes standards for and requires the recognition of the cost of employment-related services settled in share-based payment.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107") regarding the SEC's interpretation of FAS 123R and the valuation of share-based payments for public companies. IEI will be evaluating the requirements of FAS 123R and SAB 107. The impact of FAS 123R and SAB 107 cannot be predicted at this time because it will depend on the fair-market value of the awards issued and the amount of the share based awards granted in the future.
Risk Factors
Information provided by IEI in writing and orally, from time to time may contain certain "forward-looking" information as this term is defined by: (1) the Private Securities Litigation Reform Act of 1995 (the "Act") and (2) in releases made by the Securities and Exchange Commission. These risk factors are being described pursuant to the provisions of the Act and with the intention of obtaining the benefits of the "safe harbor" provisions of the Act. IEI cautions investors that any forward-looking statements made by IEI involve risks and uncertainties, which could cause actual results to differ materially from those projected.
IEI has identified certain risks and uncertainties as factors, which may have an impact on its operating results that are detailed below. All of these factors are difficult for IEI to forecast, and these or other factors can materially adversely affect IEI's business and operating results for one quarter or a series of quarters.
Concentration of Customers. IEI has a substantial number of customers but sells a large majority of its products to a small number of large customers. This concentration of customers may cause net sales and operating results to fluctuate from quarter to quarter based on major customers' requirements and the timing of their orders and shipments. Sales to IEI's largest customer accounted for approximately 32% and 35% of IEI's total net sales for the fiscal year ended August 31, 2005 and 2004, respectively. IEI's industry has experienced significant consolidation, which may further increase IEI's concentration among its major customers. There can be no assurance that IEI's major customers will place additional orders, or that IEI will obtain orders of similar magnitude from other customers. IEI's operating results could be materially and adversely affected if any present or future major customer were to choose to reduce its level of orders, were to experience financial, operational or other difficulties that resulted in such a reduction in orders to IEI or were to delay paying or fail to pay IEI's receivables from such customer.
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Reliance on Distribution Partners. We have historically sold the majority of our products through distribution. We believe that our future success is dependent upon retaining successful relationships with a variety of distribution partners. We have no long-term agreements with these partners and certain distribution partners also manufacture and sell products that compete with some of our products. We cannot be certain that we will be able to retain our current distribution partners or that these partners will devote adequate resources to selling our products. If we are unable to maintain our distribution partners or the partners do not devote adequate resources to the sale of our products, our operating results could be materially and adversely affected.
General Economic Conditions. Our business is subject to the effects of general economic conditions in the United States and globally. If the economic conditions in the United States and globally do not improve, or if we experience a worsening in the global economic slowdown, we may experience adverse impacts on our business, operating results and financial condition.
Limited Financial Resources. IEI has limited financial resources. It is therefore subject to all the risks generally associated with a small business having limited financial resources. For the year ended August 31, 2005 and 2004, IEI had net losses of approximately ($720,000) and ($1,125,000), respectively and for the year ended August 31, 2003 had net income of $23,000. There can be no assurance that IEI will return to profitable operations. Continued operations after the expenditure of IEI's existing cash reserves may require additional working capital to be generated by profitable operations and/or additional financing. There can be no assurance that profits will return or that additional external funding will be obtainable, if such a need should arise.
Dependence on Key Employees. The business of IEI is dependent upon the efforts of John Waldstein and certain other key management and technical employees. The loss or prolonged disability of such personnel could have a significant adverse effect on the business of IEI. IEI presently maintains a key man life insurance policy of $1,000,000 on John Waldstein, President, Chief Executive Officer, Chief Financial Officer and Treasurer.
Lack of New Product Development. IEI is engaged in an industry, which, as a result of extensive research and development, introduces new products on a regular basis. Current competitors or new market entrants may develop new products with features that could adversely affect the competitive position of IEI's products. There can be no assurance that IEI will be successful in selecting, developing, manufacturing and marketing new products or enhancing its existing products or that IEI will be able to respond effectively to technological changes or product announcements by competitors. Any failure or delay in these goals could have a material adverse effect on IEI.
Fluctuations in Sales and Operating Results. Operating results may fluctuate due to factors such as the timing of new product announcements and introductions by IEI, its major customers and its competitors, market acceptance of new or enhanced versions of IEI's products, changes in the product mix of sales, changes in the relative proportions of sales among distribution channels or among customers within each distribution channel, changes in manufacturing costs, competitive pricing pressures, the gain or loss of significant customers, increased research and development expenses associated with new product introductions and
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general economic conditions. A limited number of customers have accounted for a significant portion of sales in any particular quarter. In addition, IEI typically operates with a relatively small backlog. As a result, quarterly sales and operating results generally depend on the volume, timing of, and ability to fulfill orders received within the quarter which are difficult to forecast. In this regard, IEI may recognize a substantial portion of its sales in a given quarter from sales booked and shipped in the last weeks of that quarter. A delay in customer orders, resulting in a shift of product shipment from one quarter to another, could have a significant effect on IEI's operating results in a quarter. In addition, competitive pressure on pricing in a given quarter could adversely affect IEI's operating results, or such price pressure over an extended period could adversely affect IEI's long-term profitability.
IEI establishes its expenditure levels for sales and marketing and other expenses based, in large part, on its expected future results. As a result, if sales fall below expectations, there would likely be a material adverse effect on operating results because only a small portion of IEI's expenses vary with its sales in the short-term.
Competition. Other companies in the industry offer products in competition with those of IEI. Many of the companies with which IEI competes are substantially larger, have greater resources and market a larger line of products. IEI expects competition to increase significantly in the future from existing competitors and new companies that may enter IEI's existing or future markets. IEI competes with a number of large multinational companies including: Assa Abloy, Bosch, General Electric, Honeywell International, Ingersoll Rand, Kaba and Tyco, some of whom have recently expanded their position in the marketplace by acquiring companies that design competing products. We also compete against a number of smaller companies. Some of our competitors sell significant amounts of other products to our current and prospective customers.
Our competitors' broad product portfolios, coupled with already existing relationships, may cause our customers to buy our competitors' products or harm our ability to attract new customers. Increased competition could adversely affect IEI's sales and profitability. There can be no assurance that IEI will be able to continue to compete successfully with its existing competitors or with new competitors.
Investments and Acquisitions. Although we have no current agreements to do so, we intend to consider investing in or acquiring products, technologies or businesses. In the event of future investments or acquisitions, we could:
• issue stock that would dilute our current shareholders' percentage ownership; incur debt or assume liabilities;
• incur significant impairment charges related to the write-off of goodwill and purchased intangible assets;
• incur significant amortization expenses related to purchased intangible assets; or
• incur large and immediate write-offs for in-process research and development and stock-based compensation.
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Our integration of any acquired products, technologies or businesses may also involve numerous risks including:
• problems and unanticipated costs associated with combining the purchased products, technologies, or businesses;
• diversion of management's attention from our core business;
• adverse effects on existing business relationships with suppliers and customers; |
