ITEM 2 - PROPERTIES
The following table sets forth certain information about our principal facilities:
(A)
The Galion, Ohio new Corporate office shell and manufacturing facility is also listed for sale and is included in the fixed assets section of the accompanying consolidated balance sheet. The portion listed for sale is 186,000 sq. ft.
(B)
The Denver facility is currently listed in the asset section as assets held for sale in the accompanying consolidated balance sheets.
We also lease sales and service offices in or near the following cities: Kansas City, Kansas, Nashua, New Hampshire, and Audubon, Pennsylvania. Our Denver facility was financed with industrial revenue bonds. In February of 2004, we signed a lease with Mesa Systems in which they agreed to lease 117,000 sq. ft. of this facility. We continue to believe that we have excess capacity for our current operations and continue to attempt to sell or sublease portions of our facilities in Galion and Denver.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
We are party to several legal proceedings and litigation arising in the ordinary course of business. Although the outcome of such items cannot be determined with certainty, management is of the opinion that the final outcome of these matters should not have a material effect on our results of operations or financial position.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2003.
ITEM 4A - EXECUTIVE OFFICERS
Set forth below is certain information concerning our executive officers:
Name
Age
Position
Matthew P. Smith
Chairman of the Board
Sandra A. Frankhouse
Secretary, Treasurer and Chief Financial Officer
James L. Green
President and Chief Executive Officer
Miles A. McIntosh
Vice President of Power Systems
Henk F. Vande Wetering
Vice President of Sales and Service Operations
The following is a biographical summary of the business experience of our executive officers:
Matthew P. Smith has been employed by PECO II since 1989, and has served as the Chairman of the Board since June 2001. Matt served as Chief Executive Officer from 1998 to June 2002. He served as our President from 1998 to June 2001. From 1996 to 1998, he served as Secretary, Treasurer and Executive Vice President. From 1991 to 1998, he served as Secretary and Treasurer, and from 1990 to 1998, Mr. Smith served as Treasurer. Mr. Smith has been a director since 1994. He holds a B.S. in mechanical engineering from Purdue University.
Sandra A. Frankhouse has been employed by PECO II since 1989, and has served as the Chief Financial Officer and Treasurer since July 2003. She served as Vice President of Customer Care from May 2002 to July 2003. She served as our Treasurer from 1998 to May 2002 and as our Secretary since 1999. From 1996 to 1998,
she served as Vice President and Controller. From 1995 to 1996, she served as Director of Accounting. Ms. Frankhouse holds a B.S. in education from Central Michigan University, and a B.S. in business management from Ashland University.
James L. Green founded PECO II in 1988, served as our Chairman of the Board of Directors until July 2001, served as Chief Executive Officer from 1988 to 1990, and as our President from 1989 to 1990. In April 2003, Mr. Green agreed to rejoin PECO II as our President and Chief Executive Officer. Mr. Green holds a B.S. in electrical engineering from the University of Illinois.
Miles A. McIntosh has been employed by PECO II since 2001, and has served as the Vice President of Power Systems since February 2004. From December 2002 to July 2003, he served as Vice President of Quality and Engineering. From July 2002 to December 2002, he served as Vice President of Quality. He served as Director of Quality from February 2001 to July 2002. Mr. McIntosh holds an associate degree from United Electronics Institute. He also is an ASQ-CQM “Certified Quality Manager” with over twenty years experience in quality and engineering in electronic and electro-mechanical industries.
Henk F. Vande Wetering has been employed by PECO II since 1998, and has served as the Vice President of Sales and Service Operations since December 2003. He served as Vice President of Service Operations from May 2003 to December 2003. From January 2002 to May 2003, he served as General Manager of Field Service. From 1998 to January 2002, he served as International Sales and Marketing. Mr. Vande Wetering holds a degree in electronics from Sheridan College and is pursuing additional MBA coursework at Regis University.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our, common shares have been traded on the Nasdaq National Market under the symbol “PIII” since our initial public offering on August 18, 2000. On June 27, 2003, PECO II common shares moved to the Nasdaq SmallCap Market to take advantage of the extended grace period for compliance with the minimum bid price requirement afforded by the Nasdaq SmallCap Market. We were notified by the Nasdaq Listing Qualifications Section that as of October 22, 2003, that we have regained compliance with the minimum bid price requirement for the Nasdaq SmallCap Market. . We have decided to remain on the Nasdaq SmallCap Market for the foreseeable future. The high and low sales prices for our common shares are set forth in the table below:
As of February 1, 2004, there were 666 holders of record of our common shares.
We did not pay dividends in 2000, 2001, 2002 or 2003. We do not currently plan to pay dividends. Any future determination to pay dividends will be at the discretion of the board of directors and will depend upon our financial condition, operating results, capital requirements and other factors the board of directors deems relevant. Our current loan agreement restricts our ability to pay cash dividends of more than $100,000 in any fiscal year.
Recent Sales of Unregistered Securities
During the fourth quarter of 2003, no unregistered securities were sold.
Use of Proceeds
On August 17, 2000, the SEC declared effective a Registration Statement on Form S-1 (File No. 333-37566) filed by us in connection with an initial public offering of our common shares.
From the date of receipt of the proceeds through December 31, 2003, of the $78.3 million in net proceeds, $14.4 million was used to repay bank indebtedness, $5.2 million was used in connection with the acquisitions of Thornton Communications and JNB Communications, $16.5 million was used for capital expenditures, excluding the purchase of the Denver regional service center in February 2001 which is being financed through industrial revenue bonds, $7.1 million has been restricted by the Company’s bank to secure outstanding borrowings, and approximately $17.7 million was used for general working capital purposes. The remaining net proceeds have been invested in short-term, interest-bearing investment grade securities or guaranteed obligations of the U.S. government.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The selected data in this section should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, the consolidated financial statements and notes to consolidated
financial statements. We derived the statement of operations data for the five years ended December 31, 2003 and balance sheet data as of December 31, 2003, 2002, 2001, 2000, and 1999 from the audited financial statements. Certain items that impact 2003 only have been reclassified as further described on page 17.
ITEM 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
You should read this discussion together with the consolidated financial statements and other financial information elsewhere in this Form 10-K.
Overview
We provide E&I on-site services, and design, produce, manufacture and market a broad line of power systems and equipment for the communications industry. Our products and services are used by communication access providers in the local exchange, long distance, wireless, internet and broadband communications markets.
PECO II was formed by management in May 1988. In December 1988, we purchased certain assets of the Power Equipment division of ITT, including the Galion, Ohio manufacturing facility and surrounding land, machinery, product designs and other business property. The ITT Power Equipment division, and its predecessors, had been engaged in the manufacturing and sale of power equipment for the communications industry since 1934, including continuous operations at the Galion, Ohio manufacturing facility from 1955 through 1988, just prior to our acquisition.
Our operating results during 2003 continued to be adversely affected by the extended downturn in the communications industry and by the global economic recession. In this depressed industry and general economic environment, many of our customers deferred capital spending and reduced their equipment purchases. Several of our customers have announced increased CAPEX budgets for 2004. While we are more optimistic than previously, we remain cautious. If industry or economic conditions do not improve, or if they worsen, we may continue to experience adverse effects on our business, operating results, and financial condition.
During 2003, our focus was to align the business with current market conditions and work towards positive cash flow. Revenues from our services business decreased to 47.0% of total revenue while the demand for our power systems, power distribution, and systems integration products increased to 53.0%. While product demand improved in the fourth quarter of 2003, we continued to take actions to evaluate, make strategic investments and realignments to our business model to reflect the reality of the market environment. We made work force reductions in early 2003. Our Denver, Colorado facility remains for sale, and we have listed a portion of our expanded Galion, Ohio facilities for sale. We sold our Worthington, Ohio Engineering facility in May 2003 and our Nashua, New Hampshire Manufacturing facility in August 2003, and eliminated support systems that were no longer in line with our plans going forward. We continue to work on our business model so that we can provide shareholder value in the current environment, and when demand returns, our capacity can accommodate it with healthy margins.
After three brutal years, the telecom market appears to be coming out of a long lasting industry slump. PECO II has been focused on streamlining its operations so as to be prepared for the opportunities when and if the industry did take a turn for the better. We have developed new products and completed product cost reductions to improve our margins and align us with our customers, the local, long distance, wireline and wireless carriers. In addition, we have been diligent in obtaining customer approvals for our product line which has increased our customer base. Should the economy take a turn for the worse, it would prolong the financial strain we have experienced the past three years.
We continue to witness a spending reluctance from our customer base. Despite the market announcements such as Verizon’s announcement to increase CAPEX spending by $1.0 billion and SBC announcing a $400 million increase, there is still a conservative mind set in our customer’s procurement operations that will take some time to change. We are reorganizing our sales operations and key national account structure to better focus on whom and where are the appropriate customer personnel to be contacted concerning what we can offer, for a competitive price, and in a short period of time. There is a risk that this conservative spending mind set that we are witnessing in the industry, could slow the announced CAPEX increases, and thus impacting the revenue increment we are projecting.
Our customer base has not been fundamentally impacted as a result of the telecom debacle, but a loss of any significant customer continues to be a risk to PECO II. It is typical for the Company to have a minimum of three customers with total sales of each over 10% of total revenues per quarter. The loss of any one of these would have a detrimental financial impact on the operations of the Company.
Critical Accounting Policies
The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates and assumptions are based on management’s judgment and available information and consequently, actual results could be different from these estimates.
In response to the SEC’s Release No. 33-8040, “Cautionary Advice Regarding Disclosure about Critical Accounting Policies,” we consider certain accounting policies related to revenue recognition, inventory valuation and impairment of long lived assets to be critical policies due to the estimation processes involved in each. We state these accounting policies on the notes to the consolidated financial statements and at relevant sections in this discussion and analysis.
Revenue Recognition
Revenue is recognized in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101 (Revenue Recognition in Financial Statements). Revenues are recognized when customer orders are completed and shipped. Sales of equipment where the Company also performs installation are deferred until installation is complete. Revenues on engineering and installation contracts and the costs for services performed are recorded as the work progresses on a percentage of completion basis. Accruals for the cost of product warranties are maintained for anticipated future claims.
Inventory Valuation
In light of the continued slump in the telecommunication industry, during the second quarter of 2003 the Company performed an evaluation of its existing operations. As a result of this evaluation the Company has provided for a write-off of approximately $8.6 million of inventory.
Impairment of Long Lived Assets
In the first quarter of 2003, the Company determined there was still additional excess capacity and a portion of the Galion, Ohio facility was listed for sale. The current value of the land, building and building improvements were classified as assets held for sale in first quarter 2003. The Company recorded an asset impairment charge in 2003 of $1.1 million to reflect the assets held for sale at their estimated realizable values based upon market conditions. After further review in the fourth quarter of 2003, it was determined that the Galion, Ohio facilities are unlikely to sell until Route 30 is completed in 2005. Therefore, the asset was reclassified to the fixed asset section of the consolidated balance sheet, but will remain as assets held for sale.
During the second quarter of 2003, the Company reviewed the current value of the fixed assets and determined they were impaired. The company recognized a $3.3 million machinery and equipment impairment.
The Denver, Colorado facility was reviewed again in the fourth quarter of 2003 as there have been discussions with a potential buyer. The Company signed a purchase agreement in March 2004, which will allow the buyer 180 days due diligence. As a result of the purchase agreement, we recognized an impairment of $107,000 in the fourth quarter of 2003 to properly state the assets at fair market value.
The Company had an independent third party review goodwill attributed to the service segment in the second quarter of 2003. The result was a $5.7 million impairment. An annual review of goodwill is required at
the end of October of each year. An independent third party performed a review as of October 31, 2003 and determined that there was no further impairment of goodwill.
The Company’s assessment of goodwill is based on the requirements of Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and other Intangible Assets,” which requires management to estimate the fair value of the Company and its reporting units. Determination of fair value is dependent upon many factors including management’s estimate of future cash flows, appropriate discount rates, identification and evaluation of comparable businesses and amounts paid in market transactions for the sale of comparable businesses. For goodwill, any one of a number of future events, including a continued telecommunication industry downturn, could cause the Company to conclude that impairment indicators exist and the carrying value of these assets cannot be recovered.
Results of Operations
The following table shows, for the periods indicated, selected items from our consolidated statement of operations, as a percentage of net sales. Certain items that impact 2003 only have been reclassified as further described on page 17.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
Net Sales. Net sales declined $23.5 million, or 37.8%, to $38.6 million for the year ended December 31, 2003 from $62.1 million for the year ended December 31, 2002. This decline was primarily due to the continued industry downturn in 2003, which resulted in a decrease by $9.5 million in sales of power systems, power distribution equipment and systems integration along with a decrease of $14 million in service sales. Net sales of our product and services segments were $20.5 million and $18.1 million, respectively, for the year ended December 31, 2003 compared $29.9 million and $32.1 million, respectively, for the year ended December 31, 2002. As of December 31, 2003, our sales backlog, which represents total dollar volume of firm sales orders not yet recognized as revenue, had declined to $2.1 million from $3.9 million at December 31, 2002. We do not
anticipate this decline going forward as year end is typically a budgeting period for our customer base and our customers’ field personnel are awaiting the CAPEX numbers for their region in the upcoming year.
Gross Margin. Gross margin dollars increased $1.3 million to a negative margin of $15.4 million in 2003 as compared to a negative margin of $14.1 million in 2002. Gross margin as a percentage of net sales declined to a negative 39.8% in 2003 compared to a negative 22.7% in 2002. The negative gross margin is also attributed primarily to the lower sales volume due to the continuing downturn in the communications industry, which significantly increased our unabsorbed capacity. In addition, in the second quarter of 2003, the current fair market value of machinery and equipment was reviewed and determined that it was impaired per SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Asset.” As a result, an impairment of $3.3 million was recognized and is included in the gross margin. This was reclassified to Cost of Goods Sold from Operating Expense where it previously appeared as a single line item. The Company also recognized an $8.6 million inventory impairment in the second quarter of 2003 as compared with an $8.0 million impairment in the third quarter of 2002. The focus on cost cutting measures and the elimination of facilities, have had an impact resulting in a positive gross margin in the fourth quarter of 2003. Gross margin dollars of our product and services segments were a negative $12.1 million and a negative $3.2 million, respectively, during 2003 compared to a negative $14.4 million and a positive $290,000, respectively, during 2002.
Research, Development and Engineering. Research, development and engineering expense decreased to $3.8 million in 2003 from $9.7 million in 2002, representing a decrease of $5.9 million. As a percentage of net sales, research, development and engineering expense decreased to 9.8% in 2003 from 15.7% in 2002. This percentage decrease is largely the result of the continued effort to align costs with the lower sales volume in the last half of 2003. Fourth quarter 2003 research, development, and engineering expenses were $708,000, compared to $1.5 million in the fourth quarter 2002. This represents a 53.9% decrease.
Selling, General and Administrative. Selling, general and administrative expense decreased to $10.4 million in 2003 from $21.3 million in 2002, representing a decrease of $10.9 million. As a percentage of net sales, selling, general and administrative expense decreased to 26.8% in 2003 from 34.2% in 2002. Included in the 2002 SG&A number was approximately $2.0 million in selling, general and administrative expense resulted from an impairment charge related to the writedown of excess real estate. This property is currently held for sale in the accompanying consolidated balance sheets. The product segment also abandoned certain manufacturing software during the fourth quarter of 2002, which resulted in a $2.4 million charge. Excluding the afore mentioned non-recurring items, totaling $4.4 million, 2002 selling, general and administrative expense was $20.9 million as compared to $10.4 million in 2003.
Interest Income. Interest income, net, was $91,000 in 2003 compared to $308,000 in 2002. The decrease in interest income, net, in the current year is due primarily to the increased use of cash for operations and less cash available for investment purposes as well as lower interest rates.
Income Taxes. As a result of our significant operating losses in 2003 and 2002, we determined a valuation allowance for our net deferred tax assets was required. As such, our effective income tax rate was 0.1% in 2003, compared to a benefit of 14.8% in 2002.
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001
Net Sales. Net sales declined $44.7 million, or 42%, to $62.1 million for the year ended December 31, 2002 from $106.7 million for the year ended December 31, 2001. This decline was primarily due to the industry downturn and depressed economic conditions in 2002, which resulted in a decrease by $45.1 million in sales of power systems, power distribution equipment and systems integration, offset by an increase of $0.4 million in service sales. Net sales of our product and services segments were $29.9 million and $32.1 million, respectively, for the year ended December 31, 2002 compared to $75.1 million and $31.2 million, respectively, for the year ended December 31, 2001. As of December 31, 2002, our sales backlog, which represents total dollar volume of firm sales orders not yet recognized as revenue, had declined to $3.9 million from $10.5 million at December 31, 2001.
Gross Margin. Gross margin dollars declined $32.5 million to a negative margin of $14.1 million in 2002 as compared to a margin of $18.4 million in 2001. Gross margin as a percentage of net sales declined to 22.7% in 2002 compared to 17.2% in 2001. Gross margin declined in 2002, due in part, to a write off and liquidation of obsolete and excess inventory of $8 million in the product segment of the business attributed to our product rationalization review. Additionally, the negative gross margin was also attributed to lower sales volume due to the downturn in the communications industry, which significantly increased our unabsorbed capacity. Gross margin dollars of our product and services segments were $14.4 million and $290,000, respectively, during 2002 compared to $13.8 million and $4.6 million, respectively, during 2001.
Research, Development and Engineering. Research, development and engineering expense decreased to $9.7 million in 2002 from $11.2 million in 2001, representing a decrease of $1.5 million. As a percentage of net sales, research, development and engineering expense increased to 15.7% in 2002 from 10.5% in 2001. This percentage increase was strictly due to the lower sales volume, as we continued to decrease these expenses in the last half of 2002. For instance, fourth quarter 2002 research, development, and engineering expense was $1.5 million, compared to $2.8 million in the fourth quarter 2001. This represented a 45.7% decrease, which demonstrated an effort to align costs with the lower sales volume.
Selling, General and Administrative. Selling, general and administrative expense increased to $23.3 million in 2002 from $18.8 million in 2001, representing an increase of $4.5 million. During the third quarter of 2002, approximately $2.0 million in selling, general and administrative expense resulted from an impairment charge related to the writedown of excess real estate. This property is still currently held for sale in the accompanying consolidated balance sheets. The product segment also abandoned certain manufacturing software during the fourth quarter of 2002, which resulted in a $2.4 million charge. As a percentage of net sales, selling, general and administrative expense increased to 37.4% in 2002 from 17.6% in 2001. Excluding the afore mentioned non-recurring items, totaling $4.4 million, 2002 selling, general and administrative expense was $20.9 million. Cost cutting strategies continued during the third and fourth quarters of 2002. If not for the real estate impairment charge, third quarter expense would have been $4.7 million and excluding the software write off, fourth quarter expense was $4.0 million.
Interest Income. Interest income, net, was $300,000 in 2002 compared to $1.3 million in 2001. The decrease in interest income, net, in the current year was due primarily to the increased use of cash for operations and less cash available for investment purposes as well as lower interest rates.
Income Taxes. As a result of our significant operating losses in 2002, we determined a valuation allowance for our net deferred tax assets was required and accordingly our effective benefit income tax rate was 14.8% in 2002, compared to a benefit of 35.6% in 2001.
Liquidity and Capital Resources
Our primary liquidity needs for the foreseeable future will be for working capital and operations. In August 2000, we completed an initial public offering of 5.75 million common shares at $15.00 per share, generating net proceeds of approximately $78.3 million. A portion of these net proceeds was used to reduce bank indebtedness. We received tax refunds of approximately $12.5 million in the second quarter of 2003. At December 31, 2003, available cash equivalents approximated $17.4 million.
Working capital was $28.1 million at December 31, 2003, which represented a working capital ratio of 2.8 to 1, compared to $52.0 million, or 3.3 to 1, at December 31, 2002. Our investment in inventories and accounts receivables was $14.5 million and $26.5 million at December 31, 2003 and 2002, respectively. Our capital expenditures were $0.3 million, $0.9 million and $17.3 million in 2003, 2002 and 2001, respectively. Our budgeted capital expenditures for 2004 remains the same at $0.5 million as we remain focused on conserving cash. Accounts receivable days sales outstanding stood at 57 days at December 31, 2003, as compared to 66 days at December 31, 2002. At December 31, 2003 inventory days on hand were 150 days, as compared to 120 days on hand at December 31, 2002.
Cash flows used by operating activities were $1.8 million in 2003, a decline of $22.0 million, from a negative cash flow from operating activities of $23.8 million in comparison with 2002. This use of cash was primarily the result of operating losses and the reduction in accounts payables and accrued expenses, offset by the income tax refund, and reductions in accounts receivable and inventories. Many cost cutting measures were implemented in 2003 to conserve cash.
In August 2001, we entered into adjustable rate industrial revenue bonds for $6.5 million from the County of Arapahoe, Colorado in connection with the opening of our Denver service center. The $2.0 million Series A Bonds bear interest at 1.45% at December 31, 2003. The $4.5 million Series B Bonds bear interest at 1.3% at December 31, 2003. We intend to sell the Denver, Colorado facility to pay down these bonds, and we signed a purchase agreement in March 2004. As a result, the Denver facilities and related bonds will remain classified as a current asset and current liability in the accompanying consolidated financial statements.
In September 2001, the Board of Directors authorized the repurchase of up to one million common shares in the open market or in private transactions. As of December 31, 2001, we had acquired 408,000 shares at a cost of $1.6 million. During the second quarter of 2002 we acquired 181,112 shares at a cost of $604,000. On July 26, 2002, the Board approved a one million share increase in the program. During the third quarter of 2002 we acquired 795,600 shares at a cost of $1.5 million, and in the fourth quarter of 2002, we acquired 1,000 shares at a cost of $1,470. As of December 31, 2003, the Company’s aggregate of 1,385,712 shares repurchased at an average price of $2.70 per share remained the same. There were no additional shares repurchased in 2003.
During the fourth quarter of 2002, we executed a fourth amendment to our second amended and restated loan and security agreement (the “Loan Agreement”) and reduced our bank loan facility to $2.0 million, due to the limited need to finance capital expenditures. The amendment included the option for the bank to obtain a security interest in cash accounts, accounts receivable, and inventories in the event that tangible net worth falls below $78.0 million. Since our tangible net worth was below $78.0 million at December 31, 2002, the bank exercised its option to obtain a security interest. The amendment also required us to maintain liquidity of not less than $10.0 million. The Loan Agreement also contains certain other restrictive covenants.
We executed a fifth amendment to the Loan Agreement effective as of January 1, 2003, which waived the tangible net worth covenant non-compliance and further reduced our bank loan facility to $750,000. The amendment also modified the tangible net worth covenant and required that we maintain liquidity of not less than $13.0 million through and including May 30, 2003 and not less than $15.0 million beginning May 31, 2003 and continuing thereafter. As a condition of entering into the amendment, we were required to deposit $10.3 million into a pledge account with the bank. The pledge will be reduced as the obligations to the bank with respect to the industrial revenue bond agreements are reduced.
We executed a sixth amendment to the Loan Agreement effective as of August 14, 2003 which waived the tangible net worth covenant non-compliance once again. The amendment modified the tangible net worth covenant, and required that we maintain liquidity of not less than $43.2 million as of September 30, 2003 and shall maintain at all times a tangible net worth of not less than $41.0 million for the period beginning December 31, 2003.
During August 2003, the Nashua, New Hampshire manufacturing facility was sold and the respective industrial revenue bond related to that facility was paid in full. As of December 31, 2003, the balance in our pledge account with the bank was $7.1 million. At December 31, 2003, we complied with all other covenants under the Loan Agreement and there were no borrowings on our secured $750,000 loan agreement.
We do not currently plan to pay dividends, but rather to retain earnings for use in the operation of our business and to fund future growth.
We believe that cash and cash equivalents, anticipated cash flow from operations, and our credit facilities will be sufficient to fund our working capital and capital expenditure requirements for at least the next
12 months. The Company will attempt to increase its credit line in 2004. While we expect secured financing to be available to us on commercially reasonable terms, in the current business environment access to financing cannot be assured.
We have capital lease agreements for computer, machinery and office equipment that expire through 2007. Future minimum annual lease payments required during the years ending in 2004 through 2007 are $209,000, $121,000, $121,000, and $389,000, respectively.
We have operating leases covering certain office facilities, and equipment that expire at various dates through 2006. Future minimum annual lease payments required during the years ending in 2004 through 2006 under non-cancelable operating leases having an original term of more than one year are, $480,000, $394,000, and $188,000, respectively.
The following table provides a summary of our debt obligations, capital lease obligations, operating lease payments, and certain other material purchase obligations as of December 31, 2003.
(1)
These amounts are included on our Consolidated Balance Sheets. These amounts are for the industrial revenue bonds which are backed by standby letter or credits totaling $6.2 million at December 31, 2003, which expire on August 7, 2020. This schedule displays the contractual payment amounts even though the entire amount is classified as a current liability at December 31, 2003. See Note 4 of the Notes to Consolidated Financial Statements for additional information about our debt and related matters.
(2)
The present value of these obligations, excluding interest, is included on our Consolidated Balance Sheets. See Note 6 of the Notes to Consolidated Financial Statements for additional information about our capital lease obligations.
(3)
Our operating lease obligations are described in Note 6 of the Notes to Consolidated Financial Statements. A portion of these obligations is backed by a letter of credit totaling $194,000 at December 31, 2003, which expire on October 31, 2006.
Recent Accounting Pronouncements
The Financial Accounting Standards Board (FASB) recently issued SFAS No. 141, “Business Combinations” and SFAS No. 142. The statements were effective for us on January 1, 2002. These statements resulted in modifications relative to our accounting for goodwill and other intangible assets. Specifically, we ceased goodwill and certain intangible asset amortization beginning January 1, 2002. Additionally, intangible assets including goodwill are now subject to new impairment testing criteria. Impairment charges of $1.8 million associated with goodwill were recognized in the first quarter of 2002 as a cumulative effect of accounting change. Impairment charges of $5.7 million were recognized in the second quarter of 2003 as additional operating expense.
In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This standard addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement cost. The standard applies to legal obligations associated
with the retirement of long-lived assets that result from acquisition, construction, development and/or the normal operation of long-lived asset, except for certain obligations of lessees. This standard requires entities to record the fair value of a liability for an asset retirement obligation in the period incurred. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. The Company has adopted this standard on January 1, 2003. The adoption of this standard does not have a material impact on the Company’s financial position or results of operations.
In September 2001, the FASB issued SFAS No. 144. This statement superceded SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets to be Disposed of” and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, “Reporting Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” related to the disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted this statement during 2002.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and replaces Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF No. 94-3”). SFAS No. 146 requires that a liability for costs associated with an exit or disposal activity to be recognized when the liability is incurred. Under EITF No. 94-3, a liability for exit costs as defined in EITF No. 94-3 is recognized at the date of an entity’s commitment to an exit plan. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an Amendment of FASB Statement No. 123.” This statement amends SFAS No.123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years beginning after December 15, 2002. The Company has adopted the additional disclosure provisions in the fourth quarter of 2002. The Company has continued following the intrinsic value based method when the entire standard was adopted on January 1, 2003.
Off-Balance Sheet Financings
We do not have any off balance sheet entities or arrangements. All of our subsidiaries are reflected in our financial statements. We do not have any interests in or relationships with any special-purpose entities that are not reflected in our financial statements.
ITEM 7A
ITEM 7A - QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
We are exposed to the impact of interest rate changes and, to a lesser extent, foreign currency fluctuations. We have not entered into interest rate or foreign currency transactions for speculative purposes or otherwise. Our foreign currency exposure was immaterial as of December 31, 2003 and 2002, respectively.
Our primary interest rate risk exposure results from our revolving loan facility. We had no borrowings under our revolving loan facility at December 31, 2003. We currently do not hedge our exposure to floating interest rate risk.
Forward-Looking Statements
We are making this statement in order to satisfy the “safe harbor” provisions contained in the Private Securities Litigation Reform Act of 1995. This Form 10-K includes forward-looking statements relating to our business, which involve risks and uncertainties. Forward-looking statements contained herein or in other statements made by us are made based on our management’s expectations and beliefs concerning future events impacting us and are subject to uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond our control, that could cause our actual results to differ materially from those matters expressed or implied by forward-looking statements. We believe that the following factors, among others, could affect our future performance and cause our actual results to differ materially from those expressed or implied by forward-looking statements made by us or on our behalf:
•
general economic, business and market conditions;
•
competition;
•
decreases in spending by our communications industry customers;
•
the loss of a major customer or customers;
•
our ability to identify, consummate and integrate the operations of suitable acquisition targets;
•
the impact of changing global, political and economic conditions;
•
our ability to expand our international operations;
•
our relations with our employees;
•
our ability to meet the high standards of quality and reliability that communications service providers expect from communications equipment suppliers;
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variability in our operating results;
•
our ability to attract and retain key personnel;
•
our ability to keep up with the rapid technological changes, evolving industry standards, changing customer needs and frequent new equipment and service introductions in the communications industry; and
•
our ability to protect our proprietary information.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
PECO II, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and Board of Directors of PECO II, Inc.
We have audited the accompanying consolidated balance sheet of PECO II, Inc. (an Ohio Corporation) as of December 31, 2003 and 2002, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years then ended. 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 audit. The financial statements of PECO II, Inc. as of December 31, 2001 and the year ended December 31, 2001 were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated January 23, 2002.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 audit provides 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 PECO II, Inc. as of December 31, 2003 and 2002, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets in 2002 to conform to Statement of Financial Accounting Standards No. 142.
As discussed above, the consolidated financial statements of PECO II, Inc. as of December 31, 2001 and for the year then ended were audited by other auditors who have ceased operations. These consolidated financial statements have been revised as follows:
1. As described in Note 1, these consolidated financial statements have been revised to include the disclosures required by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an Amendment of FASB Statement No. 123, which was adopted by the Company in the fourth quarter of 2002. Our audit procedures with respect to 2001 included (a) agreeing the adjustments to reported net income representing stock compensation expense (including any related tax effects) to the Company’s underlying records obtained from management, and (b) testing the mathematical accuracy of the reconciliation of pro forma net income to reported net income, and the related earnings-per-share amounts.
2. As described in Note 2, these consolidated financial statements have been revised to include the transition disclosures required by Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, which was adopted by the Company as of January 1, 2002. Our audit procedures with respect to 2001 included (a) agreeing previously reported net loss to the previously issued consolidated financial statements and the adjustments to reported net loss representing amortization expense (including any related tax effects) recognized in those periods relating to goodwill to the Company’s underlying records obtained from management, and (b) testing the mathematical accuracy of the reconciliation of adjusted net loss to reported net loss, and the related earnings-per-share amounts.
3. The consolidated statements of operations for each of the year ending December 31, 2001 have been revised to further detail net sales, cost of goods sold and gross margin by business segment. Our audit
procedures with respect to 2001 included (a) agreeing the reported amounts to the Company’s underlying records obtained from management, and (b) testing the mathematical accuracy of the break-out.
4. In addition, the information in Note 14, “Business Segments”, for the year ending December 31, 2001 has been revised to present this segment disclosure. Our audit procedures with respect to 2001 included (a) agreeing the reported amounts to the Company’s underlying records obtained from management, and (b) testing the mathematical accuracy of the additional disclosure.
In our opinion, such disclosures and reclassifications are appropriate and have been properly applied. However, we were not engaged to audit, review, or apply any procedures to the 2001 consolidated financial statements of the Company other than with respect to such disclosures and reclassifications, and accordingly, we do not express an opinion or any other form of assurance on the 2001 consolidated financial statements taken as a whole.
/s/ GRANT THORNTON LLP
Cleveland, Ohio
January 28, 2004
The following is a copy of the previous issued Report of Independent Public Accountants
The predecessor auditor (who has ceased operations) has not reissued the report.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and Board of Directors of PECO II, Inc.:
We have audited the accompanying consolidated balance sheets of PECO II, Inc. as of December 31, 2001 and 2000, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2001. 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 auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of PECO II, Inc. as of December 31, 2001 and 2000, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP
Cleveland, Ohio,
January 23, 2002
PECO II, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated balance sheets.
PECO II, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
The accompanying notes are an integral part of these consolidated statements.
PECO II, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated statements.
PECO II, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated statements.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except for share and per share data)
1. Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of PECO II, Inc. (the “Company”), and its wholly owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.
Nature of Business
The Company provides engineering and installation on-site services and designs, manufactures and markets communications power systems and equipment, and offers systems integration products and related services for the communications industry. The Company operates in two business segments: product and services. The products and services offered include power systems, power distribution equipment, engineering and installation services, and system integration products.
Cash and Cash Equivalents
Cash equivalents consist of commercial paper and state and municipal securities that are readily convertible into cash and have original maturities of three months or less.
Accounts Receivable
Accounts receivable are net of the allowance for doubtful accounts of $576 and $677 at December 31, 2003 and 2002, respectively.
Inventories
Inventories are stated at the lower of cost or market with cost determined by the first-in, first-out method. Inventory costs consist of purchased product, internal and external manufacturing costs, and freight. The Company sells its products as component replacement parts or on a build to-order basis and ships to the customer upon completion.
Property and Equipment
Property and equipment are stated at cost, net of accumulated depreciation. Property and equipment under capital leases are stated at the lower of the present value of minimum lease payments at the beginning of the lease term or fair value at the inception of the lease. Expenditures for improvements that extend the useful life of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.
Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used for computing depreciation for financial statement purposes are:
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
Equipment under capital leases is amortized using the straight-line method over the shorter of the lease terms or the estimated useful lives of the assets. The provision for depreciation for the years ended December 31, 2003, 2002, and 2001 is $2,234, $3,799, and $3,079, respectively.
Assets Held for Sale
In March of 2003, the Company listed the new corporate headquarters shell and new manufacturing facility for sale. An impairment of $1,096 was recognized to reflect the assets held for sale at their estimated realizable values based upon market conditions. On December 31, 2003, it was determined that these buildings will probably not sell until the four-lane highway extension of U.S. 30 within a half mile of the facility is completed, which is expected in 2005. The buildings were reclassified to long-term assets at December 31, 2003 and depreciation expense was adjusted accordingly. The Company will continue to market the buildings as held for sale.
During the fourth quarter of 2002, the Company listed their Nashua, New Hampshire, Denver, Colorado and Worthington, Ohio facilities for sale. The land, building and building improvements have been classified as assets held for sale as of December 31, 2002. The Company recorded an asset impairment charge in 2002 of $2,000 to reflect the assets held for sale at their estimated realizable values based upon market conditions.
The Worthington, Ohio and the Nashua, New Hampshire facilities were sold in May 2003 and August 2003, respectively. In March 2004, we signed a purchase agreement related to our Denver, Colorado facility. The buyer has requested approximately 180 days to perform due diligence. Based on the purchase agreement, we have written down our Denver facility by $107 to reflect the asset at its estimated fair market value.
Goodwill
Goodwill represents the excess purchase price over the fair value of assets acquired through acquisition. In accordance with SFAS No. 142 “Goodwill and other Intangible Assets,” we have ceased goodwill amortization.
Other Accrued Expenses
Other accrued expenses at December 31, 2003 and 2002 consist of the following:
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
Warranties
The Company records a liability for an estimate of costs that it expects to incur under its basic limited warranty when revenue is recognized. Factors affecting the Company’s warranty liability include the number of units sold and historical and anticipated rates of claims and costs per claim. The Company periodically assesses the adequacy of its warranty liability based on changes in these factors.
The changes in the Company’s accrued product warranty costs are as follows:
Revenue Recognition
Revenue is recognized in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101 (Revenue Recognition in Financial Statements). Revenues are recognized when customer orders are completed and shipped. Sales of equipment where the Company also performs installation are deferred until installation is complete. Revenues on engineering and installation contracts and the costs for services performed are recorded as the work progresses on a percentage of completion basis. Accruals for the cost of product warranties are maintained for anticipated future claims.
Research and Product Development Costs
Expenses associated with the development of new products and changes to existing products are charged to expense as incurred.
Financial Instruments
Financial instruments held by the Company include cash and cash equivalents, trade accounts receivable, accounts payable, borrowings under lines of credit and long-term debt. The Company does not hold or issue financial instruments for trading purposes. All financial instruments are considered to have a fair value, which approximates carrying value at December 31, 2003 and 2002. Financial instruments that potentially subject the Company to concentration of credit risk consist of trade accounts receivable. Trade accounts receivable due from three customers at December 31, 2003 and 2002 was $3,090 and $4,416, respectively, which accounted for $51.8% and 56.6% of total accounts receivable due at these dates.
Stock-Based Compensation
The Company has two stock-based employee compensation plans, which are described more fully in Note 8. The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations in accounting for its plans. Stock expense in 2002 and 2001 is the result of stock options issued prior to the Company’s IPO in August 2000 with an exercise price below the underlying stock’s market price. The following table illustrates the effect on net income and earnings per share if
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
the Company had applied the fair value recognition provisions of FASB Statement 123, “Accounting for Stock-Based Compensation,” using the assumptions described in Note 8, to its stock-based employee plans.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Liquidity
The consolidated financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company sustained net losses of $36,367 in 2003 and $41,703 in 2002 and $6,681 in 2001 and at December 31, 2003 had a retained deficit of $62,327. The Company utilized $1,753 of cash for operating activities in 2003 and $23,792 in 2002. As of December 31, 2003, the Company has $24,514 of cash of which $7,148 is restricted for its outstanding industrial revenue bonds and as collateral on the Company’s line-of-credit agreement. The Company has a financing agreement, which includes a $750 line-of-credit agreement through June, 2004. There was no outstanding balance on this line-of-credit as of December 31, 2003. The Company believes they can remain in compliance with the agreement, as amended throughout 2004. Additionally, management expects to obtain additional asset based lending during 2004. The Company has taken steps to reduce expenses, improve cash flow and return to profitability, including the consolidation of its manufacturing operations. This consolidation includes the closing and sale of its Nashua, New Hampshire production operations. The Company leased back a portion of the facility to provide a location for its service operations. Additionally, management continues to pursue the sale of other facilities held for sale and signed a purchase agreement with a potential buyer, whom has been given 180 day due diligence, for the Denver, Colorado facility.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
Based on available funds, current plans and business conditions, management believes that the Company’s available cash, borrowings and amounts generated from operations, will be sufficient to meet the Company’s cash requirements for the next 12 months. The assumptions underlying this belief include, among other things, that there will be no material adverse developments in the business or market in general. There can be no assurances however that those assumed events will occur. If management’s plans are not achieved, there may be further negative effects on the results of operations and cash flows, which could have a material adverse effect on the Company.
Impact of New Accounting Standards
The FASB recently issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.” The statements are effective for us on January 1, 2002. These statements resulted in modifications relative to our accounting for goodwill and other intangible assets. Specifically, we ceased goodwill and certain intangible asset amortization beginning January 1, 2002. Additionally, intangible assets including goodwill are now subject to new impairment testing criteria. Impairment charges of $1,835 associated with goodwill were recognized in the first quarter of 2002 as a cumulative effect of accounting change.
In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This standard addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement cost. The standard applies to legal obligations associated with the retirement of long-lived assets that result from acquisition, construction, development and/or the normal operation of long-lived asset, except for certain obligations of lessees. This standard requires entities to record the fair value of a liability for an asset retirement obligation in the period incurred. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. The Company has adopted this standard on January 1, 2003. The adoption of this standard does not have a material impact on the Company’s financial position or results of operations.
In September 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This statement superceded SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets to be Disposed of” and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, “Reporting Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” related to the disposal of a segment of a business. This statement amends certain provisions of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted this statement during 2002.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and replaces Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF No. 94-3”). SFAS No. 146 requires that a liability for costs associated with an exit or disposal activity to be recognized when the liability is incurred. Under EITF No. 94-3, a liability for exit costs as defined in EITF No. 94-3 is recognized at the date of an entity’s commitment to an exit plan. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an Amendment of FASB Statement No. 123.” This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition for a voluntary change
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years beginning after December 15, 2002. The Company has adopted the additional disclosure provisions in the fourth quarter of 2002. The Company has continued following the intrinsic value based method when the entire standard was adopted on January 1, 2003.
Reclassifications
Certain amounts in prior years have been reclassified to conform to the 2003 consolidated financial statements presentation.
2. Goodwill
On June 6, 2001, the Company acquired all of the common stock of Thornton Communications Co., Inc. of Bristol, Tennessee, a telecommunications provider of contract and engineering, furnishing and installation services for approximately $13,000 of which $3,400 was cash and the remaining consideration was 886,000 shares of the Company’s common stock at $10.76 per share. The investment in excess of the fair market value of assets purchased was approximately $12,400 and was being amortized over 7-15 years.
On August 7, 2001, the Company acquired the assets of JNB Communications Inc., a South Carolina-based provider of telecommunications installation services for $1,800. The investment in excess of the fair market value of assets purchased was approximately $1,800 and was being amortized over 15 years.
On January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is the excess of cost of an acquired entity over the amounts specifically assigned to assets acquired and liabilities assumed in purchase accounting for business combinations. Effective January 1, 2002, with the adoption of SFAS No. 142, goodwill is no longer amortized. Prior to January 1, 2002, goodwill was being amortized on a straight-line basis over a period of 15 years. As a result of the adoption of SFAS No. 142, the $13,542 carrying value of remaining goodwill will be tested for impairment annually, and will be tested for impairment between annual tests if an event occurs or circumstances change that would indicate the carrying amount may be impaired.
Impairment testing for goodwill is done at a reporting unit level. Currently, we have identified two reporting units (product and services) under the criteria set forth by SFAS No. 142. An impairment loss may be recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit. Prior to January 1, 2002, goodwill was tested for impairment in a manner consistent with property, plant and equipment and intangible assets with a definite life.
As of January 1, 2002, the carrying value of goodwill was $15,377 and was assigned to the product ($1,835) and the service ($13,542) reporting units. The Company performed the goodwill impairment test subsequent to the end of the first quarter of 2002 by comparing the carrying value of the reporting units (as of January 1, 2002) to fair value and concluded that there was impairment of the goodwill of the product reporting unit. However, the impairment test for the service reporting unit, which was acquired in 2001, indicated that there was no impairment of the goodwill for this reporting unit.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
The Company had an independent third party review goodwill attributed in the second quarter of 2003. The result was a $5,700 impairment. An annual review of goodwill is required at the end of October of each year. An independent third party performed a review as of October 31, 2003 and determined that there was no further impairment of goodwill.
The Company’s assessment of goodwill is based on the requirements of SFAS No. 142, which requires management to estimate the fair value of the company and its reporting units. Determination of fair value is dependent upon many factors including management’s estimate of future cash flows, appropriate discount rates, identification and evaluation of comparable businesses and amounts paid in market transactions for the sale of comparable businesses. For goodwill, any one of a number of future events, including a continued telecommunication industry downturn, could cause the Company to conclude that impairment indicators exist and the carrying value of these assets cannot be recovered.
Net income (loss) and earnings (loss) per share, adjusted to include the non-amortization provisions of SFAS No. 142, net of tax, are as follows:
3. Inventories
Inventories are summarized as follows:
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
4. Line of Credit and Long-Term Debt
During the fourth quarter of 2002, we executed a fourth amendment to our second amended and restated loan and security agreement (the “Loan Agreement”) and reduced our bank loan facility to $2,000, due to the limited need to finance capital expenditures. The amendment included the option for the bank to obtain a security interest in cash accounts, accounts receivable, and inventories in the event that tangible net worth falls below $78,000. Since our tangible net worth was below $78,000 at December 31, 2002, the bank exercised its option to obtain a security interest. The amendment also required us to maintain liquidity of not less than $10,000. The Loan Agreement also contains certain other restrictive covenants.
We executed a fifth amendment to the Loan Agreement effective as of January 1, 2003, which waived the tangible net worth covenant non-compliance and further reduced our bank loan facility to $750. The amendment also modified the tangible net worth covenant and required that we maintain liquidity of not less than $13,000 through and including May 30, 2003 and not less than $15,000 beginning May 31, 2003 and continuing thereafter. As a condition of entering into the amendment, we were required to deposit $10,300 into a pledge account with the bank. The pledge will be reduced as the obligations to the bank with respect to the industrial revenue bond agreements are reduced.
We executed a sixth amendment to the Loan Agreement effective as of August 14, 2003 which waived the tangible net worth covenant non-compliance once again. The amendment modified the tangible net worth covenant, and required that we maintain tangible net worth of not less than $43,200 as of September 30, 2003 and shall maintain at all times a tangible net worth of not less than $41,000 for the period beginning December 31, 2003. At December 31, 2003, the Company complied with all covenants under the Loan Agreement. As of December 31, 2003, there were not borrowings on the Company’s $750 Loan Agreement.
A summary of the Company’s long-term debt outstanding is as follows:
In the fourth quarter 2002 in conjunction with the Company’s analysis of their ongoing operations, it was determined that the Nashua, New Hampshire and Denver, Colorado facilities would be placed on the market and held for sale. As such, the related debt and deferred costs of these two facilities have been presented as a current obligation as of December 31, 2002.
During the third quarter of 2003, the Company sold the Nashua, New Hampshire facility for $3,850. In connection with the sale, the Company has agreed to leaseback 25,000 square feet of this facility through August 31, 2006. This transaction results in a gain of $280 that has been deferred and will be recognized over the
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
term of the lease. The sale of the Nashua, New Hampshire facility also resulted in the pay off of the $3,500 State of New Hampshire industrial revenue bonds and the release of $3,100 of restricted cash. The debt and deferred costs of the Denver, Colorado facility is presented as a current obligation as of December 31, 2003.
5. Asset Impairment Charges
During the third quarter of 2002 the Company performed an evaluation of its existing operations, the result of this evaluation was to consolidate certain production facilities and streamline its product offerings. In connection with this action the Company has provided for a write-off and disposed of approximately $8,000 of inventory. Due to the continued slump in the telecommunications industry, during the second quarter of 2003, the Company recognized an additional impairment charge of $8,633 of inventory. In the second quarter of 2003, machinery and equipment was reviewed, SFAS No. 144. It was determined that the current fair value was impaired, and an impairment of $3,300 was recognized.
The Company also provided a $1,200 impairment charge related to certain excess real estate to reflect the property at current fair value based upon conditions in the first quarter of 2003.
6. Commitments
The Company leases computers, machinery and office equipment under capital lease agreements that expire through the year 2007. The amount of the capital leases included in property and equipment at December 31, 2003 and 2002 is summarized as follows:
Future minimum payments under the capital leases are as follows:
The Company has operating leases covering certain office facilities, and equipment that expire at various dates through 2006. Future minimum annual lease payments required during the years ending in 2004 through 2006 under noncancelable operating leases having an original term of more than one year are $480, $394 and $188, respectively. Aggregate rental expense on noncancelable operating leases for the years ended in 2003, 2002, and 2001 approximated $595, $769, and $563, respectively.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
7. Contingencies
The Company is a party to several legal proceedings and litigation, which have arisen in the ordinary course of business or assumed in connection with an acquisition. Although the outcome of such items cannot be determined with certainty, management believes the amount of additional costs in excess of recorded amounts should not materially affect the financial position or results of operations of the Company.
8. Stock Option Plans
In June 2000, the 2000 Performance Plan was adopted and approved by our shareholders for the issuance of up to 2,500,000 common shares. In addition, the Company has two non-qualified stock option plans for employees, which each reserve 2,500,000 shares of the Company’s stock for issuance under the plans. These Plans provide for awarding stock options to employees and contains provisions under which employees may be granted stock options in lieu of a portion of their compensation, subject to the discretion of the Compensation Committee of the Board of Directors. Options are granted at the fair market value of the Company’s common stock at the date of grant, generally vest over three to four years, and must be exercised within five years from the grant date.
Prior to the completion of the initial public offering, the Company allowed the employees to receive the net proceeds from the exercise of the options in cash, in lieu of stock. Concurrent with the initial public offering, the cash option was terminated. There was no compensation expense related to an increase in value of the options recorded in 2003. Accordingly, the Plan is considered compensatory up to the initial public offering and compensation expense related to the increase in value of the options was recorded as follows:
The Company has recorded additional compensation expense with a corresponding increase to additional paid-in capital for all unexercised stock options and shares issued to a director and certain employees. The expense represents the options valued at the offering price in excess of the value of the shares pursuant to the Company’s repurchase obligation. There was no additional compensation expense recorded in 2003. Total compensation expense was recorded as follows:
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
Information relating to the Company’s outstanding option plans is as follows:
Under the 2000 plan, 1,042,114 shares are available for issuance.
The Company has elected to use the disclosure only method of complying with SFAS No. 123, “Accounting for Stock-Based Compensation.” The fair value of each option granted under the Company’s Plans are estimated as of the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions used for stock options granted in fiscal years 2003, 2002, and 2001, respectively: dividend yield of 0%, expected volatility of 109.16%, 76.53%, and 95.23%, risk-free interest rates of 2.22%, 4.02%, and 4.23%, and an expected life of the options of 5 years for 2003, 2.3 years for 2002, and 2.2 years for 2001. The weighted average fair value on the date of grant for options granted during fiscal years 2003, 2002, and 2001 were $1.29, $9.03, and $11.97, respectively.
9. Employee Benefit Plans
The Company has a 401(k)/Profit Sharing Plan. Under the Plan, eligible employees, as defined, may contribute up to 15% of their compensation subject to certain limitations. In addition, the Company may make contributions to the Plan at the discretion of the Compensation Committee of the Board of Directors. No contributions were made by the Company in 2003, 2002, and 2001.
In April 2001 the shareholders approved the 2000 Employee Stock Purchase Plan and reserved for issuance an aggregate of one million common shares. The Plan allows eligible employees to purchase common shares through payroll deductions, at prices equal to 85% of fair market value on the first or last business day of the offering period, whichever is lower. The Plan will terminate when all or substantially all of the common shares reserved for purposes of the plan have been purchased. During 2003, 2002 and 2001, 193,197, 194,471 and 151,330 shares, respectively, have been issued under the plan and 461,002 shares were available for future issuance.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
10. Income Taxes
The Company accounts for income taxes using the provisions of SFAS No. 109, “Accounting For Income Taxes.” Deferred income taxes reflect the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. The components of the provision (benefit) for income taxes for the years ended December 31 are as follows:
A reconciliation of the federal statutory and effective income tax for the years ended December 31, follows:
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
A detailed summary of the total deferred tax assets and liabilities in the Company’s Consolidated Balance Sheets at December 31 resulting from differences in the book and tax basis of assets and liabilities follows:
At December 31, 2003, the Company has a federal tax loss carryforwards of $26,463. The federal tax loss carryforwards expire in 2022 and 2023. The Company also has federal tax credit carryforwards of approximately $800.
The Company periodically reviews the need for a valuation allowance against certain deferred tax assets and recognizes these assets to the extent that realization is more likely than not. As a result of operating losses during 2003 and 2002, trends and forecasted earnings, management determined that it is more likely than not that some portion or all of its net deferred tax asset may not be recognized and a valuation allowance was required for deferred tax assets.
11. Treasury Shares
In September 2001, the Board of Directors authorized the repurchase of up to one million shares in the open market or in private transactions. As of December 31, 2001, the Company had acquired 408,000 shares at a cost of $1,642. During the second quarter of 2002 the Company acquired 181,112 shares at a cost of $604. On July 26, 2002, the Board approved a one million share increase in the program. During the third quarter of 2002 the Company acquired 795,600 shares at a cost of $1,500, and in the fourth quarter the Company acquired 1,000 shares at a cost of $1. During 2003, no additional purchases were made. As of December 31, 2003 the Company has repurchased an aggregate of 1,385,712 shares at an average price of $2.70 per share.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
12. Significant Customers
Sales to the top four customers amounted to $7,005, $5,170, $4,927, and $ 4,551 and comprised approximately 18%, 13%, 13% and 12%, respectively, of consolidated net sales for 2003.
Sales to the top three customers amounted to $23,401, $10,799 and $4,080 and comprised approximately 38%, 17% and 7%, respectively, of consolidated net sales for 2002.
Sales to the top three customers amounted to $30,547, $15,973 and $10,820 and comprised approximately 29%, 15% and 10%, respectively, of consolidated net sales for 2001.
There were no other customers individually comprising more than 10% of consolidated net sales.
13. Quarterly Results of Operations-(Unaudited)
The following table shows unaudited quarterly results of operations for the period indicated. We have prepared this quarterly information on a basis consistent with the audited consolidated financial statements and management believes it includes all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the information shown.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
The current fair value of machinery and equipment was reviewed in the second quarter of 2003 and was determined that it was impaired per SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” As a result, an impairment of $3,300 was recognized and is included in the gross margin. This was reclassified to Cost of Goods Sold from Operating Expense where it previously appeared as a single line item.
14. Business Segments
In accordance with the requirements of SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” the Company has identified two reportable segments: product and service. These two segments reflect the organization used by our management for internal reporting. The product segment consists of manufacturing operations and the production of power plants, rectifiers and power distribution equipment. The service segment consist primarily of telecommunications contract, engineering, and installation services.
The accounting policies of the segments are the same as those described in Note 1. Revenue and costs are recognized for contract engineering and installation as the work progresses on a percentage of completion basis.
Earnings of industry segments exclude interest income and expense and provision or benefit for income taxes on our consolidated statements of operations.
Identifiable assets consist of cash, plant and equipment used in the operations of the segment as well as inventory, receivables and other assets directly related to the segment. The Company has no significant assets located outside of the United States.
PECO II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except for share and per share data)
The following table summaries certain information regarding segments of the Company’s operations for the years ended December 31, 2003, 2002, and 2001:
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
On June 24, 2002, our Board of Directors, upon recommendation of its Audit Committee, dismissed Arthur Andersen LLP as our independent public accountants, and engaged Grant Thornton LLP to serve as our independent auditors for the year ended December 31, 2002. For more information, see our Current Report on Form 8-K filed with the Securities and Exchange Commission on June 24, 2002. As mentioned in the Form 8-K filed, there were no disagreements with Arthur Andersen LLP prior to their dismissal.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
As of December 31, 2003, PECO II carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation such officers concluded that our disclosure controls and procedures required by Rules 13a-15 and 15d-15 under
the Exchange Act are effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the commission’s rules and forms.
There were no changes in our internal controls over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information appearing under the captions “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive proxy statement relating to our 2004 Annual Meeting of Shareholders, to be held on April 29, 2004 (the “2004 Proxy Statement”), is incorporated herein by reference. Information regarding our executive officers is included in Part I of this Annual Report on Form 10-K.
We have adopted the PECO II, Inc. Code of Conduct and Ethics, which is a code of ethics as defined by applicable rules of the Securities and Exchange Commission, that applies to all of our directors, officers and employees. Our code is publicly available on our website at www.peco2.com. If we make any substantive amendments to our code or grant any waivers, including any implicit waivers, from a provision of our codes to any director or executive officer, we will disclose the nature of such amendment on our website and any waiver in a Current Report on Form 8-K.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this item is incorporated herein by reference to “Board of Directors and Corporate Governance Matters” and “Executive Compensation” in the 2004 Proxy Statement.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated herein by reference to “Share Ownership of Principal Holders and Management” in the Proxy Statement.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by reference to “Certain Relationships and Related Transactions” in the 2004 Proxy Statement.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this items is incorporated herein by reference to “Independent Auditors” in the 2004 Proxy Statement.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The following documents are filed as part of this report:
(a) (1) Financial Statements-See Index to Financial Statements at Item 8 of this report.
(a) (2) Financial Statement Schedules.
Schedule II: Valuation and Qualifying Accounts-See page S-1 of this report.
(a) (3) Exhibits.
See the “Exhibit Index” at page E-1 of this Form 10-K.
(b) Reports on Form 8-K.
On October 23, 2003 we filed a Current Report on Form 8-K furnishing the Company’s press release for Nasdaq relisting under Item 9.
On November 5, 2003 we filed a Current Report on Form 8-K furnishing the Company’s financial results for third quarter 2003 under Item 12.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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 Registrant and in the capacities and on the dates indicated.
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON SCHEDULE II
To the Shareholders and Board of Directors of PECO II, Inc.:
In connection with our audit of the consolidated financial statements of PECO II, Inc. referred to in our report dated January 28, 2004, which is incorporated in this form 10-K, we have also audited Schedule II for the year ended December 31, 2003 and 2002. In our opinion, this schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. The financial statements of PECO II, Inc. as of December 31, 2001 and the year December 31, 2001, were audited by other auditors who have ceased operations and whose report dated January 23, 2002, stated that the information in Schedule II as of December 31, 2001 and for year ended December 31, 2001 is fairly stated, in all material respects, in relation to the basic financial statements taken as a whole.
GRANT THORNTON LLP
Cleveland, Ohio
January 28, 2004
The following is a copy of the previous issued Report of Independent Public Accountants.
The predecessor auditor (who has ceased operations) has not reissued the report.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and Board of Directors of PECO II, Inc.:
We have audited in accordance with auditing standards generally accepted in the United States, the consolidated financial statements of PECO II, Inc. included in Form 10-K, and have issued our report thereon dated January 23, 2002. Our audits were made for the purpose of forming an opinion on those basic consolidated financial statements taken as a whole. The financial statement schedule is the responsibility of the Company’s management and is presented for purposes of complying with the Securities and Exchange Commission’s rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Cleveland, Ohio
January 23, 2002
PECO II, INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
(In thousands)
S-1
EXHIBIT INDEX
E-1
*
Management contract or compensation plan or arrangement identified pursuant to Item 14 (c) of this Form 10-K.
(A)
Incorporated by reference to the appropriate exhibit to the Company’s Registration Statement on Form S-1 (File No. 333-37566) and the amendments thereto.
(B)
Incorporated by reference to the appropriate exhibit to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 and filed on March 19, 2001.
(C)
Incorporated by reference to the appropriate exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001 and filed on November 5, 2001.
(D)
Incorporated by reference to the appropriate exhibit to the Company’s Current Report on Form 8-K dated June 24, 2002.
(E)
Incorporated by reference to the appropriate exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 and filed on November 14, 2002.
(F)
Incorporated by reference to the appropriate exhibit to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002 and filed on March 31, 2003.
(G)
Incorporated by reference to the appropriate exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and filed on August 14, 2003.
(H)
Incorporated by reference to the appropriate exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 and filed on November 7, 2003.
E-2