Item 1. BUSINESS.
American Bank Note Holographics, Inc. (“ABNH” or the “Company”) originates, produces, markets and sells holograms and products incorporating holograms. Our mission is to address the escalating global problem of product and document counterfeiting with high quality authentication devices and related products and services for brand owners and governments. Our products are used primarily in security applications including authentication of transaction cards, identity documents, documents of value and various consumer products. We operate in one reportable industry segment. Our ability to create distinctive, secure optically variable devices, to reproduce them with high quality and to distribute them securely has enabled us to become a market leader in security holography. Our products are used by over 200 companies worldwide, including MasterCard, VISA, American Express, Discover, Diners Club, Citicorp, Sears, Nordstrom, Janssen-Cilag, Eli Lilly, Genomma, Quaker State, Roshfrans, Sony, Oki Data, Raytheon, Nike, Reebok and Prince as well as the United States government and other governments and companies. We also produce non-secure holograms for design and promotional applications.
We believe we have a number of strengths that provide us with a competitive advantage in the security sector of the holography industry, including:
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our reputation as a quality supplier of secure holograms with over 20 years of experience in the industry,
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our expertise in holographic technology and production techniques which enables us to offer effective security solutions for a variety of end use markets and application environments,
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our secure production and distribution processes and capabilities which qualify us to meet the stringent requirements of security conscious customers,
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our origination laboratories, which enable us to produce distinctive holograms with a variety of security features that make them difficult to counterfeit, and
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our integrated manufacturing facilities, which allow us to mass produce our products in accordance with the highest quality standards.
The Holography Industry
A hologram is a unique type of image that is created through the diffraction of light at pre-determined angles to create various visual effects. Holograms are created with special laser configurations and do not use ink, thereby enabling a holographic image to be easily distinguished from a traditionally printed or copied image. When a hologram is viewed from different angles, the viewer is able to see features such as depth and movement, which would not typically be possible in most two-dimensional images. Holograms can also include information that is detectable only with the aid of special devices.
The holography industry is divided into two main sectors: security and non-security.
Security
The security sector of the holography industry includes products that protect and authenticate transaction cards, documents of value, consumer and industrial products and identification cards. Using holography, and other techniques, we can develop a unique holographic security device for each customer with which to identify and protect the customer’s products. Holograms provide the following major benefits as security devices:
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difficult to copy-holograms cannot be copied with conventional copying equipment such as color copiers or scanners. The unique properties and high resolution of a security hologram make it extremely difficult to replicate even with specialized equipment and expertise.
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overt features-the unique visual aspects of a hologram are easily recognizable, making authentication of products and documents practical for the general public without special machinery, equipment or training. Overt features that we offer include:
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3-D Imagery-an image that has three dimensions and gives the illusion of depth or varying distances.
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TrueColor-a holographic image that gives the illusion of color.
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Parallax-images created on different planes that move in relation to one another when viewed from different angles.
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Secondary Flip Image-an image that appears and disappears when viewed at certain angles.
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Diffractive Mercurial-a bright, sharp, color shifting two-dimensional image.
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Animation-a two or three-dimensional image that gives the illusion of motion.
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covert features-hidden features that can only be detected with high-powered microscopes or specialized readers can be incorporated into a hologram to make it more difficult to counterfeit, facilitate verification in the field and support forensic investigation. Covert features that we offer include:
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Hidden Latent Image-a hidden element within a holographic image that is machine-readable only with a proprietary reader.
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HoloScan™-our hidden machine readable code within a holographic image that can be read with special readers.
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Micro Imagery-text or a logo within a holographic image that is visible only under magnification.
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Nano Imagery-microscopic text or a logo within a holographic image that is visible only with high-powered magnification.
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physical features-features that can be combined with holographic materials to increase the security of the holographic product. Physical features that we offer include:
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HoloMagTM-an integrated hologram and magnetic stripe.
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Micro-demetallization-a feature whereby a designed portion of the vacuum deposited aluminum materials are removed from the holographic film to create additional unique features that can be used to differentiate and authenticate the materials. This can be used to create see through screens, additional micro text in the metallization layer, and images that are only visible under magnification.
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Tamper Apparent-an invisible feature used in labels which when combined with the holographic image will act as a self destructive layer and produce a predictable release pattern that indicates that a product has been tampered with or altered. This release pattern can be in the form of a customized or generic design.
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Taggants-unique features which are added during the manufacturing process to the holographic films or coatings that are verifiable by specialized equipment.
The security sector of the holography industry addresses concerns relating to counterfeiting, diversion, tampering and fraud. The cost of the hologram is generally relatively small compared to the value of the item being protected and the risk of loss. Consequently, customers typically select suppliers primarily based on the effectiveness of their security solutions, quality, reliability and price.
Our research, product development, marketing and sales activities are primarily focused on the security sector of the holography industry. We offer a diverse set of security, authentication and design features. Based on
customer specific needs and applications, we can combine these techniques creating a unique set of effects in a well-constructed and effective holographic security product.
Non-Security
The non-security sector of the holography industry includes design, packaging and other decorative applications.
The unique visual appeal of holograms makes them attractive for use on consumer products. Holograms are used to enhance the design of a wide variety of products including greeting cards, decorative clothing, point-of-purchase displays, and for other promotional uses. Holograms are also used for packaging of food and other products. These holograms are generally used on consumer product packaging for their eye-catching appeal, including packaging for candy, beer, toothpaste, soft drinks and other consumer products. Non-secure holograms are generally not as complex, secure or proprietary as security holograms. Since there are more companies capable of producing non-secure holograms than there are qualified to produce and market security holograms, the competition is more intense in the non-security sector, and the margins are typically lower than in the security market. Customers in the non-security sector of the holographic industry typically distinguish between suppliers primarily based upon price, quality and production capacity.
Markets and Products
We have five target markets, and we market various products to meet the needs of these markets:
Transaction Cards. In the early 1980’s, we began marketing our secure holograms for use on transaction cards and, as a result, helped to create and expand the security sector of the holography market. Since that time, holograms have been established as an important fraud prevention device on transaction cards. They are also commonly used to enhance the brand image of a transaction card issuer. Our products include:
Holographic Hot-Stamp Patch. Our largest source of revenue since our inception has been security holograms embossed into hot-stamp foil for transaction card authentication. Holographic hot-stamp patches can also enhance the design and branding of a card. Our customers for this product include the issuers or manufacturers of MasterCard, VISA, American Express, Diners Club, Sears and various other retail and payment cards. We are the market leader in this segment and have developed a secure, global distribution system for secure holograms to the payment card industry.
HoloMagTM. HoloMag is an integrated holographic magnetic stripe. HoloMag significantly enhances the security of a card with overt, covert and machine readable security features. HoloMag also can support the branding objectives of card issuers with attractive imagery on the magnetic stripe while freeing up space on the front of cards.
HoloCardTM. HoloCard incorporates a hologram on a card’s entire face, creating a customized marketing tool and a counterfeit deterrent. A full-faced hologram can support brand recognition, product enhancement campaigns, customer retention and overall product differentiation efforts.
Identification Documents. We provide secure holographic laminates and patches for identity documents such as national ID cards, passports, government credentials, military credentials and drivers’ licenses. We have patents on demetallized holograms which are transparent and used to see printed information under the holograms.
We believe there are significant security advantages for demetallized holograms used on ID cards and other documents. We currently supply demetallized laminates for certain secure U.S. government credentials as well as national IDs for certain foreign countries. We believe there is a need to improve the security of many identity
documents used in the United States and other countries, and we are proposing security holograms as a component of the security enhancements that are being considered by major issuers of identification documents.
Product Authentication and Security Packaging. The use of holograms for product authentication and security packaging is driven by concerns regarding counterfeiting, piracy, pilfering, diversion and other infractions that can result in lost sales, lost goodwill and product liability claims. Holograms are used as authentication devices in, among others, pharmaceuticals, licensed consumer products and high value consumer and industrial products. Product authentication holograms are either machine or hand-applied to individual products. A holographic label that is tampered with can become permanently damaged, leaving a visible footprint on the product. Our products for this market segment include:
Holographic Labels. Our pressure-sensitive label is available with a broad array of authenticating features such as demetallizing, latent imagery, machine readability and other overt and covert features. By combining multiple security techniques, we achieve higher levels of security and make the entire product or package easier to authenticate and difficult to simulate.
HoloSealTM. HoloSeal integrates several key security features into one innovative device. A high security hologram, customized tamper-apparent break pattern, black light verification system and machine-readable embedded code are all features of this security label. In addition, HoloSeal can be manufactured to be transparent or semi-transparent so that printed regulatory or marketing copy can be seen through the hologram.
HoloCapTM. HoloCap is our innovative approach to sealing bottles or containers with a higher level of security. Utilizing an induction seal process, this application provides for authentication, tamper-resistance and branding. A holographic layer becomes part of the seal itself. HoloCap can be combined with other security features to create an effective approach for the security needs of a wide range of sealed products.
Holographic Shrink Sleeves. We have developed a heat-shrink seal with an integrated holographic stripe that can be applied to the lids of bottles to deter product fraud and tampering. By including overt and covert security features within the hologram, a customized tamper-apparent break pattern and an embedded black light verification system, our holographic shrink sleeves provide manufacturers of bottled goods with a tool to combat criminals that, at the same time, can be easily integrated into a customer’s existing manufacturing operations.
Documents of Value. Concerns over counterfeiting and copying have led to an increased use of holograms produced by international suppliers for international markets for currency, checks, gift certificates, tax stamps and other financial instruments. While this market may provide a future growth opportunity for the Company, we have had minimal sales in this market to date. Holographic products for paper documents of value include:
Holographic Thread. A holographic thread is a security device made up of a narrow-strip hologram, approximately 2-5 millimeters wide, and is typically incorporated into the paper substrate at the security paper mill. The hologram is often partially embedded into the paper creating a window or serpentine-thread. This holographic product offers both visual and covert security features and helps raise the recognition and perceived value of the document it is embedded into. We produce holographic material for security threads with our proprietary process, which we believe provides significant advantages for brighter and more durable holographic threads compared to other methods of holographic replication.
Holographic Ribbons. A holographic ribbon is an anti-counterfeiting device that can be used on documents of value such as checks and currency. The system is comprised of a narrow strip hologram made of hot-stamp foil and slit into ribbons that are applied on security paper by either the paper maker or the printer.
Holographic Patch. A holographic patch is created by embossing a hologram into hot-stamp foil, and is used for authenticating currency and other secure documents. It is machine applied for registered placement and
quality. Depending on the design of the document, patches can be created to meet specific size, shape, creative and security requirements. A holographic patch is applied with heat and pressure forming a distinctly recognizable, security component of the document.
Commercial. We also produce holographic imagery for decorative and promotional purposes. Our products for this market include pressure sensitive labels with a rich array of designs and wide web holographic patterns for flexible packaging applications.
Strategy
Protect and Enhance Our Position in Our Core Transaction Card Business. We hold a leadership position in the market for holograms on transaction cards as a result of our relationships with leading transaction card companies and many of the major security card manufacturers. We intend to maintain our leadership position in the card industry through excellent customer service and the distribution of new products that address the security needs and design objectives of this market.
Focus Sales and Marketing. We have narrowed the focus of our sales and marketing efforts to those specific applications within our target markets in which we can establish and sustain competitive advantages through a combination of product differentiation, intellectual property and market position.
Broaden and Enhance Our Security Offerings. We are developing better security solutions for our target markets which incorporate innovative applications of holography and other complementary technologies.
Control Costs. We have invested in more efficient operations and prudently manage our expenses to strengthen our competitive position and enhance profitability.
Strengthen Operational Capabilities. We have made significant investments in our facilities and our manufacturing capabilities and intend to continue to invest in enhancing our production and operational capabilities to broaden our product range, improve the products and services we provide to our customers, become more vertically integrated in our manufacturing operations and to gain operational efficiencies.
Acquire Strategic Companies and Assets. We will be pursuing prospective strategic acquisitions and partnerships in order to diversify our product line and customer base, achieve scale efficiencies, and strengthen our position as an integrated supplier of products and services that authenticate, protect and enhance critical and valuable documents, products and brands.
Production Processes
We are one of the most experienced security production companies in the holographic industry. In our high-security facility in Robbinsville, New Jersey we operate a holographic design studio, seven holographic origination laboratories, a recombining operation, electroforming, plate making, twenty-two mass replication lines, converting and finishing operations as well as extensive quality control and security procedures. Additionally the facility houses our high security warehouse and shipping and receiving areas.
Our production process is integrated to handle most aspects of production, including materials sourcing, processing, finishing, packaging, storage and logistics. We generally design and originate our own holograms in our facility in Robbinsville, New Jersey. We subcontract certain production functions or products, including HoloMag, to third parties. The production process for holograms produced by us consists of the following steps:
Design
The first step of the production process is the design of the hologram. In our art department, our experienced personnel work with the customer to develop a conceptual design that incorporates the necessary features, both security and non-security, to satisfy the customer’s requirements.
Origination
After the design has been completed, various laser-ready components (digital data, three-dimensional sculpture, flat art, etc., referred to as “information”) are delivered to our holographic origination studios.
The conversion from information to hologram is based on our ability to record light in an organized format. Coherent light, which is delivered by a laser, is best understood as light, which has one wavelength of the visible spectrum and possesses a high degree of organization. The coherent light is split into two beams (the object beam and the reference beam) and directed toward photo-resist treated glass. The object beam is interfered with by the information before continuing its travel toward the photo-resist treated glass. The reference beam is not interfered with and travels directly toward the photo-resist treated glass.
The object beam then interferes with the reference beam, creating an interference pattern, which is recorded on the light sensitive photo-resist glass. After developing the photo-resist glass, the film is re-illuminated approximating the original angle(s) of the reference beam. The resulting interference pattern within the film reflects some of the light, striking it into a re-creation of the pattern of light that originally came from the object beam, due to a property of light called diffraction. The reflected light, now organized and containing all information that the object beam once carried, allows the viewer to see all of the information in three dimensions, true color or with other desired effects. There are less complex methods of creating a hologram origination than the process described above. However, in our opinion, the above process produces the clarity, depth perception, movement and mass replication properties that are essential components of our secure holograms. We believe that certain competitors in the security sector may use similar processes among others.
We have invented and patented a novel method of holographic origination that produces high resolution images and unique features which complement our deep capabilities in classical laser interference holography. This method uses state of the art complex computer algorithms and proprietary equipment to generate unique visual and security features that cannot be obtained with classical holography. This method enables us to provide greater flexibility in security features and design, particularly when combined with other imaging techniques we deploy.
Plate Making
Once the origination process is completed, a plate is created in order to permit mass production. The “one-up” image is “step and repeated” to a pre-determined size with multiple identical images recorded on a photo-resist glass. We have designed and built a proprietary step and repeat process to create very precise plates for mass production of tightly registered images. The glass is then converted to a production plate in an electrolytic process where nickel is grown on the surface of the glass. Nickel is used because its molecular nature allows for an exact transfer of the origination to the production plate. We believe that our plate making process is an important component of our ability to mass-produce our secure holograms with high precision.
The electrolytic process creates different “generations” of plates prior to the production phase. Each generation, identical to the last, creates a more wear resistant plate for use in a mass production environment, thereby extending the useful life of the plate. The production plate will have varying degrees of hardness, depending upon the processes used in production.
The step and repeat process may be achieved through either optical replication or mechanical replication. Optical replication is accomplished by repeatedly exposing the original image one by one into the photo sensitive resist plate along with any registration marks. The image and mark are placed onto the plate with a high degree of accuracy. Mechanical replication is accomplished by forming surface relief copies of a one-up master in an ultraviolet light curing system and then repeating the process for each required image in a multi-image version.
Mass Production
Manufacturing specifications are determined in collaboration with the customer. We typically enter into production planning with the customer where drawings and overall specifications are written and distributed to the various production and quality control departments.
We employ three methods of mass-production of holograms. Hard embossing transfers images to an aluminum foil/polyester substrate through heat and pressure using steel cylinders. Heat and pressure on the holographic plate force the holographic image into the foil, which is then further processed into the final product. Soft or compliant embossing generally permits embossing into coated, pre-metallized films with heat and pressure re-forming the surface of the coating using one steel and one compliant cylinder to replicate the imagery. The material is then metallized using a vacuum deposition process and further processed into final product.
The other method of mass production we employ is casting. We developed a proprietary casting method involving ultraviolet curing, which we refer to as In-Situ Polymeric Replication. Using this method, a polymer is transferred to a substrate (polyester, polypropylene, etc.) which is then put in contact with the holographic plate and cured using ultraviolet light so that holographic imagery is captured in the polymer and replicated. The material is then metallized using a vacuum deposition process.
Finishing for each of these methods may include some combination of metallization or other vacuum deposition, demetallization, application of coatings and adhesives, magnetic coating, slitting, sheeting, die-cutting, lamination and custom printing, encoding or numbering. The completed holographic material may then be applied to the customer’s product.
We perform the above processes through a combination of our internal production resources and outside subcontractors.
Procurement of Key Materials and Products
We purchase certain key materials used in the manufacture of our products, and subcontract certain production functions or products from third parties some of which are sole suppliers. In some cases, we do not have supply contracts with our suppliers, and operate on a purchase order basis. In the case of HoloMag, we have a single supplier, CFC International, Inc. an ITW Company, with whom we have a supply contract. We may not be able to find alternative sources in a timely manner if our suppliers or subcontractors become unwilling or unable to supply us, or if they increase their prices. Our inability to obtain key product components or to have certain processes performed on our behalf could cause delays or reduce product shipments, which could cause our relationship with customers to suffer and materially and adversely affect our financial condition, results of operations and cash flows.
Quality
Through an extensive quality assurance program, we continually make improvements to our processes through the use of an effective and efficient business management system.
In 2005, we moved and consolidated our ISO-certified facilities from Elmsford, New York and Huntingdon Valley, Pennsylvania into a new facility in Robbinsville, New Jersey. (See “Manufacturing Facilities” below and “Item 2. Properties”). We have continued to employ the same quality policies and procedures in our facility in Robbinsville, New Jersey, and we have introduced additional management systems to comply with new ISO requirements. After the facility consolidation was complete, we began preparing for the ISO 9001-2000 certification process for our Robbinsville, New Jersey facility and have scheduled our 3rd party ISO recertification audit for April 2007.
We are also planning to implement Six Sigma, a process of continuous improvement that involves all of our functional areas, as well as the use of and role of statistics. We will be training certain employees on Six Sigma,
which will be followed by black belt and green belt certification for certain employees. These employees will then further drive and support our Six Sigma initiatives well into 2008.
Information Technology
We have an integrated Enterprise Resource Planning (ERP) system that provides essential information for management decision making. Since systems such as ERP are integrated in the initiating, authorizing, processing and reporting of financial data, key IT projects that we are focusing on in 2007 include ERP System improvements, compliance with the Sarbanes-Oxley (SOX) 404 Act, implementation and integration of a Warehouse Management System, implementation and integration of a Customer Relationship Management System and enhancement to our corporate e-mail messaging system including e-mail archiving.
Research and Product Development
We have devoted significant attention to research and product development to continue to enhance our origination, replication and mass production capabilities as well as the features and performance of our products. Our research and development has enabled us to create new technologies and proprietary production processes and to deliver innovative products to the marketplace. We intend to continue to make on-going investments in research and development in order to develop better solutions for our customers’ requirements, create features which differentiate our products from those of our competitors and develop and improve processing techniques to improve the quality and reduce the costs of our products.
Research and development expense amounted to $1.6 million in 2006 and $1.3 million in each of 2005 and 2004.
Manufacturing Facilities
We lease a 134,000 square foot modern manufacturing and office building in Robbinsville, New Jersey. The facility is a high-security building and has undergone substantial construction to meet our specialized operational and security requirements. The Robbinsville, New Jersey facility is the site for our primary operations. We have also acquired and installed additional equipment and technology in the Robbinsville facility in order to broaden our capabilities to serve our target customers, expand capacity, become more vertically integrated and improve efficiency. The facility provides substantial room for expansion. Additionally we lease a 30,000 square foot facility in Huntingdon Valley, Pennsylvania as a secondary manufacturing and secure storage facility. See “Item 2. Properties.”
Sales and Marketing
In 2006, we provided holographic products to over 200 customers worldwide. The majority of these customers are manufacturers of secure transaction cards. We are the exclusive supplier of holograms to MasterCard and an authorized manufacturer of VISA Dove holograms for sale to approved manufacturers of VISA cards. In 2006, we supplied holographic magnetic stripes for VISA, MasterCard, American Express and Diners Club cards. See Item 1A.
Item 1A. RISK FACTORS
Important Factors Regarding Forward-Looking Statements
In addition to other information in this Annual Report on Form 10-K, the following risk factors should be carefully considered in evaluating our business and us because these factors currently have a significant impact or may have a significant impact on our business, operating results or financial condition. This Form 10-K contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below and elsewhere in this Form 10-K.
We depend on sales to transaction card companies for a substantial portion of our revenue, the loss of which would have a material adverse effect on our business.
A significant portion of our business is derived from orders placed by certain transaction card companies and manufacturers of transaction cards, and variations in the timing of such orders can cause significant fluctuations in our sales. Sales to transaction card companies and manufacturers of transaction cards accounted for approximately 84% and 86% of our total sales in 2006 and 2005, respectively. The traditional hot stamp hologram that we have supplied for many transaction cards has been our primary source of revenue for over twenty years. Certain customers began to transition from the hot stamp hologram to an integrated holographic magnetic stripe (“HoloMag”) that we supply and have cancelled plans to make this transition, due to a small number of incidents in which certain card terminals had been affected by electro-static discharge (“ESD”) from static electricity carried on cards incorporating the first generation of HoloMag. These customers have continued to purchase the traditional hot stamp hologram we supply. As a result of being advised of the ESD issue and in response to requests from customers we developed a second generation HoloMag product that addresses ESD. We are currently offering to customers a second generation version of HoloMag and began shipping the product in limited quantities in early 2007, although no assurance can be given that such second generation version of HoloMag will be accepted by our customers. Further there can be no assurance that a competitor of ours will not develop an acceptable product that is adopted by our customers. To the extent that our sales of the traditional hot stamp patch holograms decline without replacing such sales with sales of new products, our business, operating results and financial condition would be materially and adversely affected.
VISA terminated the HoloMag program in 2006 and we do not expect any HoloMag sales to VISA in 2007. Additionally, we depend on sales of hot stamp holograms to VISA authorized card manufactures for a substantial portion of our revenue, the loss of which would have a material adverse effect on our business.
Sales to manufacturers of VISA transaction cards were approximately 35% and 37% of sales for the years ended December 31, 2006 and 2005, respectively. Currently we are an authorized supplier of the VISA Dove hot stamp holograms to manufacturers of VISA brand transaction cards. On March 15, 2005, VISA announced its intention to phase out the Dove hot stamp hologram that we supply for the VISA card, and to replace it with an integrated holographic magnetic stripe. On April 8, 2005, we entered into an Agreement with VISA, pursuant to which we were authorized to supply HoloMag to VISA approved card manufacturers. We began shipping HoloMag to VISA authorized card manufacturers in the second half of 2005. On March 14, 2006, we were informed by VISA that, as a result of the ESD issue, VISA was effectively ceasing the HoloMag program (the “VISA Decision”). VISA then moved to include either the Dove hot stamp hologram or the Mini Dove hot stamp hologram, both of which we supply, as the security device on VISA cards. By letter dated November 7, 2006, we were advised by VISA that VISA was terminating the VISA HoloMag Agreement. Sales of VISA products to VISA authorized card manufacturers in 2006 and 2005 were as follows:
Sales of HoloMag to VISA authorized card manufacturers are not expected to continue in 2007.
Sales of the hot stamp holograms to VISA authorized card manufacturers are expected to continue in 2007. If we were to lose a substantial portion of our hot stamp hologram business with VISA without replacing it with new product sales, our business, operating results and financial condition would be materially and adversely affected. In addition, if we fail to obtain anticipated orders from VISA authorized card manufactures or if we experience delays or cancellations of orders from card manufacturers, our business and financial performance will be materially and adversely affected.
VISA informed us that they would seek indemnification for costs incurred for a remediation program they implemented when ceasing the HoloMag program.
In VISA’s March 2006 correspondence to us at the time it ceased the HoloMag program, VISA stated its view that “a remediation program for impacted stakeholders may be necessary” and that VISA would seek indemnification from us for such costs and/or claims. We have been evaluating VISA’s actions and claims and continue to discuss the matter with VISA. We believe that we have complied with the VISA HoloMag Agreement and that the HoloMag product complied with all standards and specifications contained in such agreement and we are continuing to evaluate VISA’s actions and claims and discuss the matter with VISA. In the event that VISA or other third parties assert claims against us our financial condition and results of operations may be adversely affected.
We depend on sales to MasterCard for a substantial portion of our revenue, the loss of which would have a material adverse effect on our business.
Sales to MasterCard were approximately 35% and 31% of sales for the years ended December 31, 2006 and 2005, respectively. We have an agreement with MasterCard, as amended, pursuant to which the Company is the exclusive supplier of MasterCard holograms and holographic magnetic stripes, HoloMag™. In the quarter ended September 30, 2005, MasterCard advised its member financial institutions around the world that it will allow
them to choose among card designs that incorporate either the traditional hot stamp patch hologram or HoloMag, both of which are supplied by the Company. Sales of HoloMag to MasterCard were not significant in 2006. On February 9, 2007, MasterCard advised its certified card manufacturers and us that effective immediately they were no longer offering the first generation HoloMag product on newly issued cards due to a decrease in the demand for the product. To date, MasterCard has not approved the second generation HoloMag product. MasterCard has informed us that they are continuing to test the second generation HoloMag product. The agreement with MasterCard expires on February 28, 2013, subject to automatic renewal thereafter.
If we were to lose a substantial portion of our business with MasterCard without replacing it with new product sales, our business, operating results and financial condition would be materially and adversely affected. In addition, if we fail to obtain anticipated orders from MasterCard or if we experience delays or cancellations of orders from MasterCard, our business and financial performance will be materially and adversely affected.
Our quarterly and annual operating results may fluctuate and the price of our common stock may change in response to those fluctuations.
Our quarterly and annual operating results have varied in the past and may vary significantly in the future depending on factors such as:
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market acceptance of second generation HoloMag,
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timing of customer orders,
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customer business cycles,
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cancellation or expiration of customer contracts or programs,
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card expiration patterns,
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inventory replenishment,
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increased competition,
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changes in our and our competitors’ pricing policies,
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changes in the cost of materials or labor,
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cost and availability of the services of subcontractors,
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costs of recruiting or relocating personnel,
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increased research and development expenses,
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expenses associated with litigation,
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market acceptance of our products,
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the time required for customer testing and evaluation,
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costs associated with implementing changes in operations,
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investments in new technology and equipment,
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changes in facility requirements,
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changes in our business strategy,
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changes in reserve levels, and
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general economic factors.
Because our revenues and operating results may fluctuate, it is possible that in some future quarter, our revenues or operating results will be below the expectations of public market analysts and investors, which could cause our stock price to decrease.
We are in a competitive, highly-fragmented industry with many companies competing to deliver a highly-specialized product, which may lead to declining sales or reduced prices for our products.
The holographic, magnetic tape and product security industries are highly competitive and highly fragmented. Our competitors, many of which are larger than us, may have greater financial and other resources than we do and may take away market share or compete with us on the basis of price, which may erode our prices and margins. Our industry has become increasingly competitive over the past several years as low cost foreign producers have entered our target markets, and low cost holographic producers that previously focused on non-security applications are increasingly competing in security applications. The holographic industry has also experienced consolidation, which has increased the breadth and scale of some of our competitors. Increasing competition in the market for our security holograms has resulted in declining sales prices for certain products including hot stamp holograms for transaction cards and certain product authentication labels. Competitive pressures may force us to reduce prices, which can adversely affect our results of operations.
Competition is based on a number of factors, such as:
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price,
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technology,
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product quality, and
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customer service.
In addition, an increased use of non-holographic methods or devices in place of our products could reduce demand for our products. We cannot assure you that we will have sufficient resources to make the technological advances necessary to maintain any competitive advantages. We also cannot assure you that the bases of competition in the industries in which we compete will not shift.
If we are not able to successfully protect our intellectual property our business could be materially and adversely affected.
Our business is dependent to some extent upon our proprietary technology. We utilize a combination of patents, trade secrets and confidentiality agreements, as well as restricted access and other forms of intellectual property protection to safeguard certain of our proprietary technology and processes. We also hold certain trademarks with respect to certain products and services. We cannot be certain as to the degree of protection offered by any of our patents or as to the likelihood that patents will be issued for any of our pending applications. Certain of our patents have expired and others have been declared invalid in the past. Other patents will expire over the next several years. We can not assure you that we will be able to maintain the confidentiality of our trade secrets or that our confidentiality agreements will provide meaningful protection of our trade secrets or other proprietary information. In addition, litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of our patents or of the proprietary rights of others. Such litigation might result in substantial costs and diversion of resources and management attention.
If our products infringe on the intellectual property rights of third-parties, our business may suffer if we are sued for infringement or cannot obtain licenses to these rights on commercially acceptable terms.
We are subject to the risk of adverse claims and litigation alleging infringement by us of the intellectual property rights of others. In the past, third-parties have claimed, and may in the future claim, infringement by our products. Any such claims, with or without merit, could result in significant litigation costs and diversion of management attention, and could require us to enter into royalty and license agreements that may be disadvantageous to us or cause other harm to our business. If litigation is successful against us, it could result in invalidation of our proprietary rights and liability for damages, which could have a material adverse effect on our business and financial condition.
We depend on third-party suppliers and subcontractors for some key products and processes, and we may not be able to find alternative sources in a timely manner if those suppliers or subcontractors fail to supply us.
We purchase certain key materials used in the manufacture of our products, and subcontract certain production functions or products from third parties some of which are sole suppliers. In some cases, we do not have supply contracts with our suppliers, and operate on a purchase order basis. In the case of HoloMag, we have a single supplier, CFC International, Inc., an ITW Company, with whom we have a supply contract which was amended on July 26, 2006. Also at that time we negotiated a settlement with CFC International, Inc. that resulted in a reduction of our payable to them of approximately $1.0 million. We may not be able to find alternative sources in a timely manner if our suppliers or subcontractors become unwilling or unable to supply us, or if they increase their prices. Our inability to obtain key product components or to have certain processes performed on our behalf could cause delays or reduce product shipments, which could cause our relationship with customers to suffer and materially and adversely affect our financial condition, results of operations and cash flows.
Our common stock trades on the OTC Bulletin Board, which may adversely affect the price of our common stock.
Our common stock trades on the over-the-counter bulletin board (OTCBB), an electronic quotation service. The OTCBB does not impose listing standards or requirements, does not provide automatic trade executions and does not maintain relationships with quoted issuers. Stocks traded on the OTCBB may experience:
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a loss of market makers,
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a lack of readily available bid and ask prices,
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a greater spread between the bid and ask prices of its stock, and
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a general loss of liquidity compared to established stock exchanges or the NASDAQ National Market.
In addition, many investors have policies against purchasing or holding OTCBB securities. Both trading volume and the market value of our stock have been, and will continue to be, affected by trading on the OTCBB, which may adversely affect the price of our stock and make it difficult for our stockholders to resell their shares.
If we were unable to continue to attract and retain qualified employees, our business, operating results and financial condition could be materially and adversely affected.
While we have added significantly to our talent pool in recent years our future success continues to depend on our ability to attract and retain qualified:
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management,
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engineering,
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manufacturing,
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research and development,
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sales and marketing, and
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customer support personnel.
Competition for these individuals is intense, and we cannot assure you that we will be able to retain our existing personnel or attract and retain additional personnel.
We may be subject to significant product liability in connection with the products which we provide to our customers.
We provide holograms in connection with a wide range of our customers’ products, in which case it is possible that we are subjecting ourselves to product liabilities in association with those products or in connection
with the holograms used with those products. Although we maintain product liability insurance, there can be no assurance that such insurance would be available to cover any such claim or available in amounts sufficient to cover all potential liabilities.
Since a significant percentage of our sales are derived from overseas customers, our exports and business may be subject to some risks related to doing business internationally.
Sales derived from customers outside the United States were 35% and 34% of our total sales in 2006 and 2005, respectively. All of our export sales are presently billed in U.S, dollars. Our international sales are subject to risks, including:
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U.S. and international regulatory requirements and policy changes,
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exchange rate fluctuations,
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political and economic instability,
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difficulties in accounts receivable collection,
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tariffs and other barriers, and
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difficulty in attracting, retaining and managing international representatives.
These factors may have a material adverse effect on our future international sales, and consequently our business, financial condition or results of operations.
Our business is subject to environmental regulation and is always subject to environmental liability.
Our operations are subject to federal, state and local environmental laws and regulations. If we fail to comply with applicable rules and regulations, we could be subject to monetary damages and injunctive action, which could materially and adversely affect our business, financial condition or results of operations. To the extent future laws and regulations are adopted or interpretations of existing laws and regulations change, new requirements may be imposed on our future activities or may create liability retroactively.
The issuance of shares of our common stock upon exercise of outstanding options, together with the potential sales of such shares in the public market, could result in substantial dilution of your investment, a detrimental effect on our liquidity and ability to raise additional capital, and a significant decline in the market value of our common stock.
As of March 23, 2007, we had 19,034,138 shares of our common stock issued and outstanding and 3,033,722 additional shares of common stock reserved for issuance upon exercise of outstanding stock options. If the holders of shares of common stock acquired upon the exercise of outstanding options or the lapse of the sale restrictions on restricted stock grants were to sell a significant amount of their shares into the open market, the market price of our common stock could be adversely affected. The sales might also make it more difficult for us to sell equity or equity-related securities in the future at a price we deem appropriate.
Crane & Co. Inc. has certain rights which could adversely affect the market price of our common stock.
On June 30, 2000, we entered into a stock purchase agreement with Crane & Co., Inc. (“Crane”) under which Crane purchased 3,387,720 shares of our common stock. This stock is not currently registered for public resale, but may be sold (i) in privately negotiated transactions, (ii) pursuant to Rule 144 in the public market, and subject to the volume restrictions of Rule 144, or (iii) pursuant to a registration statement filed by the Company. Crane has the right to demand registration on Form S-3 in the event we are eligible to register securities on a Form S-3. Since our stock trades on the OTC Bulletin Board we are not currently eligible to register our securities on a Form S-3. Crane also has piggy-back registration rights which require us to register its stock in the
event we file a registration statement to sell common stock. On November 30, 2005 we were informed by Crane & Co., Inc. of their intention to sell a portion or all of their shares in an orderly manner. If the sale of these shares is not conducted in an orderly fashion it could have a negative impact on the price of our common stock. If we are required to register Crane’s common stock, we will incur legal, accounting and other expenses associated with the registration and sale, and the registration and sale of Crane’s common stock may have an impact on the market for our common stock. As of March 23, 2007, Crane had not sold any of its shares of our common stock.
Effects of anti-takeover provisions could inhibit the acquisition of ABNH.
Our certificate of incorporation permits our board of directors to issue up to 5,000,000 shares of preferred stock and to fix the rights, preferences, privileges and restrictions of such shares without any further vote or action by our stockholders. Although we have no current plans to issue shares of preferred stock, the potential issuance of preferred stock may have the effect of:
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discouraging potential acquisitions proposals,
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delaying or preventing a change in control, and
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limiting the price that investors might be willing to pay in the future for shares of our common stock.
We are also subject to Section 203 of the Delaware General Corporation Law which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with any interested stockholder for a period of three years following the date on which the stockholder became an interested stockholder.
Future acquisitions may entail certain operational and financial risks.
Our growth strategy includes expanding our products and services, and we may seek acquisitions to strategically expand our business. We review from time to time potential acquisitions of businesses, technologies, or products complementary to our business and periodically engage in discussions regarding such possible acquisitions. Acquisitions involve numerous risks, including some or all of the following: substantial cash expenditures and capital investments; potentially dilutive issuance of equity securities; incurrence of debt and contingent liabilities; amortization of certain intangible assets; difficulties in assimilating the operations and products of the acquired companies; diverting our management’s attention away from other business concerns; risks of entering markets in which we have limited or no direct experience; the inability to manage the growth expected for various acquisitions; potential loss of key employees of the acquired companies in the process of integrating personnel with disparate business backgrounds; and combining different corporate cultures.
We cannot assure you that any acquisition will result in long-term benefits to us or that our management will be able to effectively manage the acquired businesses. We may also incorrectly judge the value or worth of an acquired company or business.
Item 1B.
Item 1B. UNRESOLVED STAFF COMMENTS.
Not applicable.
Item 2.
Item 2. PROPERTIES.
We maintain our principal secure hologram manufacturing facility in Robbinsville, New Jersey and a secondary facility is located in Huntingdon Valley, Pennsylvania. During 2005 we moved our headquarters and substantially all of our principal operations, including our design, engineering, research and development, holographic origination, plate making, manufacturing, distribution and quality control for numerous holographic products to our 134,000 square foot leased facility at Robbinsville, New Jersey. The initial lease term for this
facility is through May 2017 and at the expiration of the lease, we have options to renew the lease for three consecutive five year periods and we also have an option to make an offer to purchase the building.
Our 30,000 square foot leased facility at Huntingdon Valley, Pennsylvania was vacated as part of the move and consolidation of operations in 2005. We re-opened this facility for certain manufacturing and secure storage during 2006. The lease on this facility expires in July 2007 and we are currently negotiating a potential extension.
From 2000 and until October 31, 2006 we maintained a 2,400 square foot leased facility at Dalton, Massachusetts dedicated to the production of security holograms. The facility was closed in 2006 and the production was transferred to our facility in Huntingdon Valley, Pennsylvania.
Our 57,200 square foot leased facility at Elmsford, New York was vacated and all operations previously conducted in the facility were transferred to Robbinsville, New Jersey in 2005. The lease on the facility expires in December 2007. During the quarter ended September 30, 2006 we entered into an amendment to the lease on the Elmsford, New York facility. Under the terms of the amendment, we and the building’s owner agreed to (i) a ten percent (10%) reduction of the fixed annual rent retroactive to April 1, 2006, (ii) the payment of $100,000 in full satisfaction of any obligation we had regarding the cost of demolition and restoration of the facility, (iii) we provided a letter of credit in favor of the owner in the amount of $789,606.80 in the event of an un-cured default of payments under the lease agreement, and (iv) acceleration of payments by us under the lease agreement in the event the facility is sub-leased.
Our Robbinsville, New Jersey facility is constantly monitored for security, and has uniformed security personnel on site, 24 hours a day, seven days a week. Our Director of Security is responsible for the physical security of each facility, access and egress, monitoring employee integrity, and safeguarding of machinery, materials, work-in-process and finished product until shipping. The security department witnesses material destruction and supervises the transfer of security shipments. Each facility is equipped with full perimeter alarms enhanced by window glass break sensors, internal motion detectors and closed circuit video monitoring of security sensitive areas. Our Huntingdon Valley, Pennsylvania facility is video-monitored remotely from Robbinsville on a 24 hour, seven days per week basis.
Item 3.
Item 3. LEGAL PROCEEDINGS.
We currently, and from time to time, are involved in litigation (as both plaintiff and defendant) incidental to the conduct of our business; however, we are not a party to any lawsuit or proceeding which, in our opinion, is likely to have a material impact on our financial position, results of operations or cash flows.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
Part II
Item 5.
Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Our common stock has been quoted on the NASD’s Over-the-Counter Bulletin Board quotation service under the symbol “ABHH,” since March 31, 2000. Our securities are not listed or quoted on any exchange or other quotation system.
The following table sets forth the high and low closing prices of our common stock for each quarter of 2005, 2006 and the period from January 1 to March 23 of 2007.
As of March 23, 2007, there were approximately 550 holders of record of our common stock. Because many of our shares of common stock are held of record by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of beneficial stockholders represented by these record holders.
We have not paid cash dividends during the past two fiscal years. We have no plans or intentions of paying dividends in the foreseeable future.
COMPARATIVE STOCK PERFORMANCE
The Stock Price Performance Graph below shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended or otherwise subject to the liabilities under that Section, and shall not be deemed to be incorporated by reference into any of our filings under the Securities Act of 1933, as amended, or under the Securities Exchange Act of 1934, as amended.
The graph compares our performance from December 31, 2001 through December 31, 2006, against the performance of the Russell 2000 Index and our peer group for the same period. The peer group represented in the graph includes the corporations (other than the Company) that are in the Metal Heat Treating Group and who make up our SIC Code Index, a published index of which our group code is 3398.
Equity Compensation Plan Information
The following table sets forth information as of December 31, 2006 with respect to shares of our common stock which may be issued under our equity compensation plans.
(1) Represents our 2000 and 2005 Stock Incentive Plans.
(2) Represents our 1998 Stock Incentive Plan.
Material Terms of the 1998 Stock Incentive Plan
On July 20, 1998, we adopted the 1998 Stock Incentive Plan (as amended, the “1998 Plan”). The 1998 Plan was adopted for the purpose of granting various stock incentives to our officers, directors, employees and consultants. The board of directors (or a committee appointed by the board of directors) has discretionary authority, subject to certain restrictions, to administer the 1998 Plan. The total number of shares reserved for issuance under the 1998 Plan are 1,863,000 shares of common stock. Options to purchase 1,604,500 shares of common stock were outstanding under the 1998 Plan at December 31, 2006. The exercise price of options granted under the 1998 Plan may not be less than 100% of the fair market value of the common stock on the date such option was granted. Options granted under the 1998 Plan generally become vested and exercisable for up to either 25% or 33 1/3% of the total optioned shares upon each succeeding anniversary of the date of grant. Generally, the unexercised portion of any option automatically terminates upon the termination of the optionee’s employment with us, unless otherwise determined by the board of directors; provided however, that any extension shall not extend beyond the expiration of the option, generally ten years. Upon a change in control, outstanding options will generally become fully vested.
Material Terms of the 2000 Stock Incentive Plan
On August 4, 2000, we adopted the American Bank Note Holographics, Inc. 2000 Stock Incentive Plan (as amended, the “2000 Plan”), which was subsequently approved by our stockholders at our annual meeting on September 12, 2000. In August 2001, our stockholders approved an amendment to the 2000 Plan increasing the shares available for issuance thereunder by 600,000 to 1,350,000 shares. The 2000 Plan was adopted for the purpose of granting various stock incentives to our directors, employees and consultants. The board of directors (or a committee appointed by the board of directors) has discretionary authority, subject to certain restrictions, to administer the 2000 Plan. The total number of shares reserved for issuance under the 2000 Plan is 1,350,000 shares of common stock. Options to purchase 1,173,556 shares of common stock were outstanding under the 2000 Plan at December 31, 2006. The exercise price of options granted under the 2000 Plan may not be less than 100% of the fair market value of the common stock on the date such option was granted. Options granted under the 2000 Plan generally become vested and exercisable for up to either 25% or 33 1/3% of the total optioned shares upon each succeeding anniversary of the date of grant. Generally, the unexercised portion of any option automatically terminates upon the termination of the optionee’s employment with us, unless otherwise determined by the board of directors; provided however, that any extension shall not extend beyond the expiration of the option, generally ten years. Upon a change in control, outstanding options will generally become fully vested.
Material Terms of the 2005 Stock Incentive Plan
On August 8, 2005, we adopted the American Bank Note Holographics, Inc. 2005 Stock Incentive Plan (the “2005 Plan”), which was subsequently approved by our stockholders at our annual meeting on September 22, 2005. The 2005 Plan was adopted for the purpose of granting various stock incentives to our officers, directors, employees and consultants. The board of directors (or a committee appointed by the board of directors) has discretionary authority, subject to certain restrictions, to administer the 2005 Plan. The total number of shares reserved for issuance under the 2005 Plan is 1,600,000 shares of common stock. Options to purchase 255,666 shares of common stock were outstanding under the 2005 Plan at December 31, 2006. Also at December 31, 2006 we had issued and outstanding 133,500 shares of restricted stock under the 2005 Plan. The exercise price of options granted under the 2005 Plan may not be less than 100% of the fair market value of the common stock on the date such option was granted. Options granted under the 2005 Plan generally become vested and exercisable for up to 33 1/3% of the total optioned shares upon each succeeding anniversary of the date of grant. Generally, the unexercised portion of any option automatically terminates upon the termination of the optionee’s employment with us, unless otherwise determined by the board of directors; provided however, that any extension shall not extend beyond the expiration of the option, generally ten years. Upon a change in control, outstanding options will generally become fully vested.
Item 6.
Item 6. SELECTED FINANCIAL DATA.
(a) We adopted FAS 123 (R) under the modified prospective method effective January 1, 2006 resulting in stock based compensation expense amounting to $1.0 million in 2006. Under the modified prospective method, we were not required to restate the prior year financial statements.
(b) In the quarter ended December 31, 2005, as a result of the VISA Decision, we recorded a pre-tax charge amounting to approximately $5.0 million relating primarily to the value of our HoloMag inventory. Also included in the charge were increases in our provisions for accounts receivable and warranty.
(c) As a result of our annual test for impairment of goodwill, we recorded an impairment charge of $7.4 million during the quarter ended December 31, 2002. As a result of our review of long-lived assets for impairment during the quarter ended December 31, 2002, we recorded an impairment charge of $1.9 million (see Note 1 of the Notes to the Financial Statements).
(d) Diluted earnings (loss) per share would have been anti-dilutive for the years ended December 31, 2002 and 2005, if based on fully diluted shares adjusted to reflect stock options exercised.
Item 7.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis should be read in conjunction with “Item 6. Selected Financial Data” and our financial statements, including the notes thereto, which appear elsewhere in this report.
Overview
ABNH was, until July 20, 1998, a wholly-owned subsidiary of American Banknote Corporation (“ABN”). On that date, ABN completed the sale of 13,636,000 shares of our common stock in an initial public offering (the “Offering”), representing ABN’s entire investment in ABNH. We did not receive any proceeds from the Offering.
We originate, produce, market and sell secure holograms and products incorporating secure holograms. Our products are used primarily in security applications including authentication of transaction cards, identity documents, value documents and various consumer products. We operate in one reportable industry segment. Our ability to create distinctive, secure optically variable devices, to reproduce them with high quality and to distribute them securely has enabled us to become a market leader in security holography. Our products are sold to over 200 companies worldwide, including MasterCard, VISA, American Express, Discover, Diners Club, Citicorp, Sears, Nordstrom, Janssen-Cilag, Eli Lilly, Genomma, Quaker State, Roshfrans, Sony, Oki Data, Raytheon, Nike, Reebok and Prince as well as the United States government and other governments and companies. We also produce non-secure holograms for design and promotional applications.
Concerns regarding counterfeiting, piracy and other infractions that can result in lost sales, lost goodwill and product liability claims drive the use of product authentication holograms. Companies in various industries utilize holograms as authentication devices.
A significant portion of our business is derived from orders placed by certain transaction card companies and manufacturers of transaction cards, and variations in the timing of such orders can cause significant fluctuations in our sales. Sales to transaction card companies and manufacturers of transaction cards accounted for approximately 84% and 86% of our total sales in 2006 and 2005, respectively. The traditional hot stamp hologram that we have supplied for many transaction cards has been our primary source of revenue for over twenty years. Certain customers began to transition from the hot stamp hologram to an integrated holographic magnetic stripe (“HoloMag”) that we supply and have cancelled plans to make this transition, reverting back to the traditional hot stamp hologram due to a small number of incidents in which certain card terminals had been affected by electro-static discharge (“ESD”) from static electricity carried on cards incorporating the first generation of HoloMag. As a result of being advised of the ESD issue and in response to requests from customers we developed a second generation HoloMag product that addresses ESD. We are currently offering to customers a second generation version of HoloMag and began shipping the product in limited quantities in early 2007.
Sales to manufacturers of VISA transaction cards were approximately 35% and 37% of sales for the years ended December 31, 2006 and 2005, respectively. Currently we are an authorized supplier of the VISA Dove hot stamp holograms to manufacturers of VISA brand transaction cards. On March 15, 2005, VISA announced its intention to phase out the Dove hot stamp hologram that we supply for the VISA card, and to replace it with an integrated holographic magnetic stripe. On April 8, 2005, we entered into an Agreement with VISA, pursuant to which we were authorized to supply HoloMag to VISA approved card manufacturers. We began shipping HoloMag to VISA authorized card manufacturers in the second half of 2005. On March 14, 2006, we were informed by VISA that, as a result of the ESD issue, VISA was effectively ceasing the HoloMag program (the “VISA Decision”). VISA then moved to include either the Dove hot stamp hologram or the Mini Dove hot stamp hologram, both of which we supply, as the security device on VISA cards. By letter dated November 7, 2006, we
were advised by VISA that VISA was terminating the VISA HoloMag Agreement. Sales of VISA products to VISA authorized card manufacturers in 2006 and 2005 were as follows:
Sales of HoloMag to VISA authorized card manufacturers are not expected to continue in 2007.
Sales of the hot stamp holograms to VISA authorized card manufacturers are expected to continue in 2007. If we were to lose a substantial portion of our hot stamp hologram business with VISA without replacing it with new product sales, our business, operating results and financial condition would be materially and adversely affected. In addition, if we fail to obtain anticipated orders from VISA authorized card manufactures or if we experience delays or cancellations of orders from card manufacturers, our business and financial performance will be materially and adversely affected.
Sales to MasterCard were approximately 35% and 31% of sales for the years ended December 31, 2006 and 2005, respectively. We have an agreement with MasterCard, as amended, pursuant to which the Company is the exclusive supplier of MasterCard holograms and holographic magnetic stripes, HoloMag™. In the quarter ended September 30, 2005, MasterCard advised its member financial institutions around the world that it will allow them to choose among card designs that incorporate either the traditional hot stamp patch hologram or HoloMag, both of which are supplied by the Company. Sales of HoloMag to MasterCard were not significant in 2006. On February 9, 2007, MasterCard advised its certified card manufacturers and us that effective immediately they were suspending the use of the first generation HoloMag product due to a decrease in the demand for the product. To date, MasterCard has not approved the second generation HoloMag product. MasterCard has informed us that they are continuing to test the second generation HoloMag product. The agreement with MasterCard expires on February 28, 2013, subject to automatic renewal thereafter.
If we were to lose a substantial portion of our business with MasterCard without replacing it with new product sales, our business, operating results and financial condition would be materially and adversely affected. In addition, if we fail to obtain anticipated orders from MasterCard or if we experience delays or cancellations of orders from MasterCard, our business and financial performance will be materially and adversely affected.
Our products are sold on a fixed price basis under purchase orders and contracts with customers. Sales and the related cost of goods sold are generally recognized at the latter of the time of shipment or when title passes to customers. In some situations, we have shipped product where the sale is contingent upon the customers’ use of the product. In these situations, we do not recognize sales upon product shipment, but rather when the buyer of the product informs us that the product has been used. Additionally, pursuant to the request of and agreement with a certain customer, completed items are stored on behalf of this customer at our on-site secured facility, and in that instance, sales are recognized when all of the following have occurred: the customer has ordered the goods pursuant to a fixed price purchase order, the manufacturing process is complete, the goods have been transferred to the on-site secured facility and are ready for shipment, the risk of ownership has passed to the customer, the customer has been billed for the order and collection of the invoice is considered reasonably assured. At December 31, 2006 and 2005, accounts receivable from this customer totaled $2.4 million and $1.5 million, respectively. In certain cases we have agreed to maintain an inventory of products for a customer to ensure quick turn around of deliveries. We only accept returns of product sold to customers when the product is determined to not be in conformance with the specifications previously agreed upon with such customers in accordance with the terms of its warranty policy and generally replaces the product. We generally provide replacement product for up to 180 days from original shipment as a warranty for defective product. Shipping and handling amounts
billed to customers are included in sales and amounted to $0.9 million, $0.9 million and $0.4 million in 2006, 2005 and 2004, respectively.
We purchase certain key materials used in the manufacture of our products, and subcontract certain production functions or products from third parties some of which are sole suppliers. In some cases, we do not have supply contracts with our suppliers, and operate on a purchase order basis. In the case of HoloMag, we have a single supplier, CFC International, Inc., an ITW Company, with whom we have a supply contract which was amended on July 26, 2006. Also at that time we negotiated a settlement with CFC International, Inc. that resulted in a reduction of our payable to them of approximately $1.0 million. We may not be able to find alternative sources in a timely manner if our suppliers or subcontractors become unwilling or unable to supply us, or if they increase their prices. Our inability to obtain key product components or to have certain processes performed on our behalf could cause delays or reduce product shipments, which could cause our relationship with customers to suffer and materially and adversely affect our financial condition, results of operations and cash flows.
During 2006, 2005 and 2004, export sales accounted for approximately 35%, 34% and 21%, respectively, of total sales. All of our export sales are presently denominated in U.S. dollars.
Sales may fluctuate from quarter to quarter due to changes in customers’ ordering patterns. Customers do not typically provide us with precise forecasts of future order quantities. Quarterly demand for our products may be materially influenced by customers’ promotions, inventory replenishment, card expiration patterns, delivery schedules and other factors, such as the VISA Decision, which may be difficult for us to anticipate.
Cost of goods sold includes raw materials such as nickel, foils, films and adhesives; labor costs; manufacturing overhead; and hologram origination costs (which represent costs of a unique master hologram that is made to customer specifications and is an integral part of the production process). Cost of goods sold also includes the cost of certain processes that we outsource to third parties. As a result, costs of goods sold are affected by product mix, manufacturing yields, supplier prices and changes in the cost of raw materials and labor.
Selling and administrative expenses primarily consist of salaries, benefits and commissions for our corporate, sales, customer service, marketing and administrative personnel, marketing and promotion expenses, legal and accounting expenses and expenses associated with being a public company. We also include the cost of shipping and handling product deliveries that are billed to customers in selling and administrative expenses. These costs amounted to $1.1 million, $1.0 million and $0.5 million in 2006, 2005 and 2004, respectively.
Critical Accounting Policies
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make use of estimates and assumptions that impact the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to bad debts, stock-based compensation, inventories, intangible assets and taxes. These estimates and assumptions are based on historical results and trends as well as our forecasts as to how these estimates and assumptions might change in the future.
We believe the following critical accounting policies impact the significant judgments and estimates we use in the preparation of our financial statements:
Revenue Recognition
We recognize revenue in accordance with the provisions of the SEC’s Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition (an amendment of SAB 101, “Revenue Recognition in Financial Statements”).” Our products are sold on a fixed price basis under purchase orders and contracts with customers. Sales and the
related cost of goods sold are generally recognized at the latter of the time of shipment or when title passes to customers. In some situations, we have shipped product where the sale is contingent upon the customers’ use of the product. In these situations, we do not recognize sales upon product shipment, but rather when the buyer of the product informs us that the product has been used. Additionally, pursuant to the request of and agreement with a certain customer, completed items are stored on behalf of this customer at our on-site secured facility, and in that instance, sales are recognized when all of the following have occurred: the customer has ordered the goods pursuant to a fixed price purchase order, the manufacturing process is complete, the goods have been transferred to the on-site secured facility and are ready for shipment, the risk of ownership has passed to the customer, the customer has been billed for the order and collection of the invoice is considered reasonably assured. In certain cases we have agreed to maintain an inventory of products for a customer to ensure quick turn around of deliveries. We only accept returns of product sold to customers when the product is determined to not be in conformance with the specifications previously agreed upon with such customers in accordance with the terms of its warranty policy (typically within 180 days of such sale) and generally replaces the product.
Customer advances represent payments received from customers for products which have not yet been shipped. These customer advances are classified as current liabilities on our balance sheets.
Shipping and handling amounts billed to customers are included in sales. Shipping and handling costs are included in selling and administrative expenses and amounted to $1.1 million, $1.0 million and $0.5 million in 2006, 2005 and 2004, respectively.
Allowance for Doubtful Accounts
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make the required payments. We recognize an allowance for doubtful accounts based on the length of time the receivables are past due, the current general business environment, the credit worthiness and current specific business conditions of our customers, and our historical experience. If the financial condition of our customers were to deteriorate or if economic conditions were to worsen, additional allowances may be required in the future.
Inventory Valuation
Inventories are stated at the lower of cost or market with cost being determined on the first-in, first-out (FIFO) method. At each balance sheet date, we evaluate our ending inventory for excess quantities and obsolescence. We provide reserves for estimated obsolescence equal to the difference between the cost of the inventory and its estimated market value. We fully reserve for inventories deemed obsolete. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required.
Impairment of Long-lived Assets
We account for long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”). SFAS No. 144 requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value
under Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after December 15, 2007. The Company is currently in the process of evaluating the impact that the adoption of SFAS No. 157 will have on its financial position, results of operations and cash flows.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that the Company quantifies misstatements based on their impact on each of its financial statements and related disclosures. We adopted the provisions of SAB 108 during the fourth quarter of 2006 and the adoption had no effect on our financial statements.
In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of SFAS no. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income tax positions that we have taken or expects to take with respect to a tax return. The pronouncement prescribes a more-likely-than-not threshold for recognition as well as measurement criteria for changes in such tax positions for financial statement purposes. In addition, FIN 48 also requires additional qualitative and quantitative disclosures on unrecognized tax benefits to be included in the notes to the financial statements. We will adopt the provisions of FIN 48 in the quarter ending March 31, 2007. We have reviewed our accounting for income taxes in light of the provisions of FIN 48 and do not expect that adoption will materially affect our consolidated financial statements.
In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R) (FAS 123R), Share-Based Payment, revising FAS 123 and requiring that all share-based payments to employees be recognized in the financial statements. Generally, the approach to accounting for share-based payments in FAS 123R is similar to the approach described in FAS 123, however, pro forma footnote disclosure will no longer be an alternative to financial statement recognition. We adopted the new statement effective January 1, 2006, using the modified-prospective transition method described in the statement. Under this method, we recognize compensation expense over the remaining vesting period for all awards that remain unvested at January 1, 2006. As permitted by FAS 123, we previously accounted for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognized no compensation cost for employee stock options. The impact on 2006 results is shown below in Results of Operations and in Note 8.,”Stock-based Compensation”, in the Financial Statements.
In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 151 (“FAS 151”), Inventory Costs, an amendment of ARB No. 43, Chapter 4. FAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs and wasted materials should be recognized as current period charges. In addition, FAS 151 requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. FAS 151 was effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We adopted FAS 151 during 2006. As a result of the impact of the VISA Decision we recorded approximately $0.8 million of overhead expenses as period expenses in 2006.
In March 2005, the FASB issued interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS No. 143. This interpretation clarifies that the term of conditional asset retirement obligation refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The provisions of Interpretation 47 are effective for fiscal years ending after December 15, 2005. We adopted Interpretation No. 47 in 2006. Adoption of this statement had no impact on our financial statement presentation since we had no conditional asset retirement obligations.
Stock-based compensation expense
Beginning in the first quarter of 2006, we were required to record the expense of share-based payment transactions pursuant to Statement of Financial Accounting Standards No. 123 (R) (“FAS 123R”). Under the modified prospective method, we were not required to restate the prior year financial statements or include in the current year any expenses related to stock option grants vested as of December 31, 2005.
We use the Black-Scholes option pricing model to calculate the fair value of options. The key assumptions for this valuation method include the expected term of the option, stock price volatility, risk-free interest rate, dividend yield, exercise price, and forfeiture rate. Many of these assumptions are judgmental and highly sensitive in the determination of compensation expense. In the first quarter of 2006 we modified our assumption of the expected term from that used under FAS 123 to reflect an estimated reduction in the amount of time that options granted will remain outstanding as a result of our historical trends. We increased our expected volatility based on recent events which resulted in significantly higher volatility than in previous periods. Under FAS 123R we are required to estimate forfeitures rather than recording forfeitures when they occur as previously permitted. Our estimated forfeiture rate was determined by reviewing historical trends. In the fourth quarter of 2006 we again modified our assumptions of expected term and forfeitures based upon our actual experience in 2006. We will continue to review our Black-Scholes assumptions and modify them as needed in the future. Changes in these assumptions may lead to variations in the compensation expense that we record in future periods.
In 2006, operating income was reduced by $980,000 for stock-based payment compensation expense for both stock options and restricted stock. Stock-based compensation in 2006 affected cost of goods sold by $225,000, selling, general and administrative expenses by $639,000 and research and development expenses by $116,000. Stock-based compensation expense reduced our 2006 net income by $638,000 and our basic and fully diluted earnings per share by $0.03.
FAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under previous accounting literature, which has the effect of reducing net operating cash flows and increasing financing cash flows in periods after adoption. For the year ended December 31, 2006, we recognized financing cash flows amounting to $58,000 for such excess tax deductions. FAS 123R also requires the computation of an APIC pool which is the amount of excess tax benefits that are available for offset against future “shortfalls”. We calculated the beginning APIC pool using the “long-form” method. The APIC pool will be used subsequent to the adoption of FAS 123R in determining whether or not amounts of deferred tax assets related to stock options in excess of the tax deductions realized (short falls) will need to be recorded as an expense.
Impact of the VISA Decision
On February 23, 2006 we reported that we had learned that there had been a small number of incidents in which certain card terminals had been affected by electro-static discharge (“ESD”) from static electricity carried on cards incorporating HoloMag. We also reported at that date that we had been advised by customers of a need to develop a second generation holographic magnetic tape product that addresses the ESD issue, and that we had commenced such development, but that there could be no assurance that we would be successful in developing such a product that would be acceptable to our customers.
On March 14, 2006, we were informed by VISA that, as a result of the ESD issue, VISA was effectively ceasing the HoloMag program (the “VISA Decision”). VISA then moved to include either the Dove hot stamp hologram or the mini hot stamp hologram, both of which we supply, as the security device on VISA cards. By letter dated November 7, 2006, we were advised by VISA that VISA was terminating the VISA HoloMag Agreement. In VISA’s March 2006 correspondence to us VISA stated its view that “a remediation program for impacted stakeholders may be necessary” and that VISA would seek indemnification from us for such costs and/or claims. We have been evaluating VISA’s actions and claims and continue to discuss the matter with VISA.
We believe that we have complied with the VISA HoloMag Agreement and that the HoloMag product complied with all standards and specifications contained in such agreement.
Accordingly, in the quarter ended December 31, 2005, as a result of the VISA Decision, we recorded a pre-tax charge amounting to approximately $5.0 million of which $4.8 million was recorded in cost of goods sold and was principally related to the value of our HoloMag inventory. Also included in the charge were increases in our provisions for accounts receivable and potential non-ESD related warranty claims. Also shipments totaling approximately $2.3 million of VISA HoloMag that were completed and invoiced during the quarter ended March 31, 2006 were not recognized as revenue as the collection of these amounts was not considered probable as a result of the VISA Decision. During 2006 and subsequent to completing and filing our financial statements for the quarter ended March 31, 2006, substantially all of the amounts outstanding relating to prior shipments of VISA HoloMag were collected, and accordingly revenue of approximately $0.9 million, $0.2 million and $1.2 million was recorded in the quarters ended June 30, 2006, September 30, 2006, and December 31, 2006, respectively. Also during 2006 we wrote-off the value of our VISA HoloMag inventory and reversed the reserve for obsolescence that was recorded in the quarter ended December 31, 2005. Additionally as a result of the VISA Decision, in the twelve months ended December 31, 2006 we wrote-off approximately $0.8 million of idle facility costs that were not absorbed into inventory and approximately $0.3 million of costs that were capitalized on the balance sheet at December 31, 2005 relating to a terminated manufacturing project. During 2006 we also analyzed the provision levels for warranty liability and accounts receivable and recorded necessary adjustments.
We have invented a technology and methods of significantly reducing ESD and we have filed patent applications on these inventions. We have incorporated our invention into our HoloMag product and our testing shows that our second generation HoloMag product generally exhibits no more ESD than a standard black magnetic stripe. We are currently offering to customers a second generation version of HoloMag and began shipping the product in limited quantities in early 2007, although no assurance can be given that such second generation version of HoloMag will be accepted by our customers.
Results of Operations
Comparison of the Year Ended December 31, 2006 to the Year Ended December 31, 2005
Sales. Sales increased by $0.2 million, or 1%, from $32.3 million in 2005 to $32.5 million in 2006. The increase was achieved despite the cessation of sales of VISA HoloMag as a result of the VISA Decision. Sales of VISA HoloMag amounted to $6.1 million in 2005 and $5.4 million in 2006. Excluding the decline in VISA HoloMag sales in 2006 sales to the transaction card market increased slightly as a result of expansion of existing products and new customer programs. During 2006 we also experienced sales growth in the product authentication and security identification markets.
Royalty Income. Royalty income was immaterial and declined from 2005.
Cost of Goods Sold, excluding Depreciation and Amortization. Cost of goods sold, excluding depreciation and amortization decreased by $3.6 million, from $19.4 million in 2005 to $15.8 million in 2006. The decrease was primarily the result of increases in inventory and warranty reserves for HoloMag in 2005 which did not recur in 2006 and the recognition of approximately $2.3 million of VISA HoloMag revenue in 2006 with no corresponding cost of goods sold which will not recur in future periods. Also reducing Cost of Goods Sold in 2006 as compared to 2005 was the full year affect of the cost reductions associated with the consolidation of our facilities in Robbinsville, New Jersey which occurred during 2005. We expect further cost reductions to be realized in future periods as a result of the efficiencies we are gaining from the facility consolidation. Partially offsetting these decreases was approximately $0.8 million of idle facility costs that were not absorbed into inventory as well as approximately $0.2 million of stock-based compensation expense. As a percentage of sales, cost of goods sold excluding depreciation and amortization decreased from 60.0% in 2005 to 48.5% in 2006. As a result of the VISA Decision, in the fourth quarter of 2005, we recorded a charge to cost of goods sold of $4.8
million to reserve the value of the HoloMag inventory and provide for additional, non-ESD related warranty claims for products sold in 2005. We believe that there is a reasonable likelihood that approximately $0.7 million of non-VISA related reserves on the balance sheet at December 31, 2006 will be reversed into income during 2007 as the periods for potential claims under the programs will expire.
Selling and Administrative Expenses. Selling and administrative expenses increased $0.1 million from $8.9 million in 2005 to $9.0 million in 2006. As a percentage of sales, selling and administrative expenses increased from 27.4% in 2005 to 27.7% in 2006. The increase in expenses was primarily due to higher professional fees, salaries and wages in support of the growth of the business as well as addressing HoloMag related matters and increased costs associated with being a public company as well as approximately $0.6 million of stock-based compensation expense partially offset by a reduction in bad debt expense resulting from a reduction in the allowance for doubtful accounts. The increase in costs as a percentage of sales was primarily due to higher general and administrative costs.
Research and Development. Research and development expenses increased $0.3 million from $1.3 million in 2005 to $1.6 million in 2006 primarily as a result of higher research and development costs associated with the invention to reduce ESD, development of the second generation HoloMag product and the development of other complementary products as well as approximately $0.1 million of stock-based compensation expense.
Depreciation and Amortization. Depreciation and amortization decreased $0.5 million from $1.3 million in 2005 to $0.8 million in 2006. Higher depreciation expenses resulting from additions to fixed assets during the year at the Robbinsville, New Jersey facility were offset by the reversal of a portion of the anticipated costs previously recorded for renovation of the vacated facility in Elmsford, New York as a result of a settlement with the buildings owner.
Facility Consolidation Expenses. Facility consolidation expenses of $0.1 million were recorded in 2006 as compared to $2.8 million recorded in 2005. Expense recorded in 2006 resulted from expenses related to employee relocations and additional expenses incurred on the abandoned facility rent which were partially offset by the impact of a settlement with the owner of the abandoned facility in Elmsford, New York that reduced the remaining rent owed under our lease by 10%. Costs recorded in 2005, which include the majority of costs incurred for the relocation and consolidation project, consist primarily of future amounts of rent due on the abandoned facility in Elmsford, New York, moving costs for equipment and inventory and employee severance costs.
Interest Income. Interest income increased $0.2 million from $0.3 million in 2005 to $0.5 million in 2006 primarily as a result of higher average cash balances and higher interest rates in effect during 2006.
Income Taxes. The provision for income taxes increased $2.6 million from $(0.4) million in 2005 to $2.2 million in 2006. As a percentage of Income before taxes, the provision for income taxes decreased from 40.0% in 2005 to 37.6% in 2006. The decrease in the effective tax rate was due to the reduction of permanent timing differences in 2006 as well as adjustments to the provision for the actual deductions and tax credits that we recorded in 2006 when filing our 2005 income tax returns which differed from those in the income tax provision at September 30, 2005. We believe that there is a reasonable likelihood that a portion of a reserve on the balance sheet at December 31, 2006 will be reversed into income during 2007.
Comparison of the Year Ended December 31, 2005 to the Year Ended December 31, 2004
Sales. Sales increased by $11.0 million, or 52%, from $21.3 million in 2004 to $32.3 million in 2005. The increase was primarily due to the roll-out of the HoloMag program in the transaction card market. HoloMag sales accounted for approximately $8.4 million of the increase from 2004 to 2005 and included sales of approximately $6.1 million to manufacturers of VISA transaction cards which sales began in the second half of the year. HoloMag was also sold to manufacturers of American Express and Diners Club cards throughout the entire year
and to MasterCard beginning in the fourth quarter. Sales growth was also affected by the value of the HoloMag product which sells for substantially higher prices than a conventional hot stamp hologram due to its unique design and high security features. We also created new product solutions in the identity document and product authentication markets and expanded existing customer relationships in each of our markets.
Royalty Income. Royalty income remained relatively unchanged.
Cost of Goods Sold, excluding Depreciation and Amortization. Cost of goods sold, excluding depreciation and amortization increased by $10.2 million, from $9.2 million in 2004 to $19.4 million in 2005 primarily as a result of the volume increase due to the ramp up of HoloMag in the second half of 2005 and increases in inventory and warranty reserves for HoloMag. As a percentage of sales, cost of goods sold excluding depreciation and amortization increased from 43.1% in 2004 to 60.0% in 2005. As a result of the VISA Decision, in the fourth quarter of 2005, we recorded a charge to cost of goods sold of $4.8 million to reserve the value of the HoloMag inventory and provide for additional, non-ESD related warranty claims for products sold in 2005.
Selling and Administrative Expenses. Selling and administrative expenses increased $1.8 million from $7.1 million in 2004 to $8.9 million in 2005. As a percentage of sales, selling and administrative expenses decreased from 33.3% in 2004 to 27.4% in 2005. The increase in expenses was primarily due to higher professional fees, salaries and wages in support of the growth of the business and the facility consolidation and shipping charges which increased due to higher product shipments as well as an increase in the allowance for doubtful accounts relating to the VISA Decision. The decrease in percentage of sales was primarily due to the volume increase in sales, partially offset by higher general and administrative costs.
Research and Development. Research and development expenses amounted to $1.3 million in both 2004 and 2005 as lower testing expenses in 2005 were partially offset by higher salaries and wages due to manpower additions and consulting costs in connection with the HoloMag program.
Depreciation and Amortization. Depreciation and amortization increased $0.5 million from $0.8 million in 2004 to $1.3 million in 2005. The increase was primarily due to the acceleration of depreciation on equipment and leasehold improvements from the Company’s abandoned facility in Elmsford, New York of $0.4 million and the increase in fixed assets in connection with the leasehold improvements and new equipment in the Company’s new facility in Robbinsville, New Jersey.
Facility Consolidation Expenses. Facility consolidation expenses of $2.8 million were recorded in 2005 as compared to $0.2 million recorded in 2004. All amounts recorded in facilities consolidation expenses pertain to expenses incurred for the Company’s move and consolidation into its new facility in Robbinsville, New Jersey and in 2005 consist primarily of future amounts of rent due on the abandoned facility in Elmsford, New York, moving costs for equipment and inventory and employee severance costs, while expenses incurred in 2004 consist primarily of legal fees, real estate commissions and employee relocation and severance expenses.
Interest Income. Interest income increased $0.2 million from $0.1 million in 2004 to $0.3 million in 2005 primarily as a result of higher interest rates in effect during 2005.
Other Income. Other income decreased $0.2 million from $0.2 million in 2004 to $0 million in 2005. The decrease was primarily due to income from a patent settlement agreement with a competitor in 2004 which did not recur in 2005.
Income Taxes. The Company recorded a benefit from income taxes of $.4 million in 2005 as a result of the pre-tax loss as compared to income tax expense of $1.2 million in 2004.
Seasonality
Our sales have not generally exhibited substantial seasonality. However, our sales and operating results to date have, and future sales and therefore operating results may, continue to fluctuate from quarter to quarter. The degree of fluctuation will depend on a number of factors, including the timing and level of sales, and any change in the pricing of our products and the mix of products sold. Because a significant portion of our business is expected to be derived from orders placed by a limited number of large customers, variations in the timing of such orders could cause significant fluctuations in our operating results. Customers do not typically provide us with precise forecasts of future order quantities. Quarterly demand for our products may be materially influenced by customers’ promotions, inventory replenishment, transaction card expiration patterns, delivery schedules and other factors which may be difficult for us to anticipate. Other factors that may result in fluctuations in operating results include the impact of the VISA Decision, the timing of new product announcements and the introduction of new products and new technologies by us or our competitors, delays in research and development of new products, increased research and development expenses, availability and cost of materials from our suppliers, and competitive pricing pressures.
Liquidity and Capital Resources
At December 31, 2006, we had $15.3 million of cash and cash equivalents and working capital of $19.1 million.
Our operating activities provided cash of $6.0 million in 2006 and $0.3 million in 2005. The substantial increase in cash in 2006 was primarily the result of net income of $3.6 million adjusted for non-cash costs of $3.8 million and changes in operating assets and liabilities of $(1.4) million.
The $3.8 million of non-cash adjustments primarily related to (i) a $1.8 million change in net deferred taxes primarily due to the disposal of VISA HoloMag inventories previously reserved for, (ii) $1.0 million of share-based compensation expense due to the adoption of FAS 123 (R), (iii) depreciation expense totaling $0.8 million and (iv) a $0.3 million write-off of certain fixed assets as a result of the VISA Decision.
The $(1.4) million of cash usage as a result of changes in asset and liability accounts was primarily the result of (i) a $1.6 million decrease in accounts payable primarily as a result of a $1.0 million settlement with a vendor, (ii) a $0.8 million decrease in long-term liabilities principally as a result of accrued facility consolidation costs becoming a current liability, (iii) a $0.6 million reduction in income taxes receivable/payable as a result of overpaying estimated income taxes in 2005, and (iv) a $0.5 million reduction of accrued liabilities partially offset by (i) a $1.2 million reduction of accounts receivable primarily as a result of the collection of VISA HoloMag receivables and a $0.8 million reduction in inventories.
Investing activities in 2006 neither provided nor used cash primarily as a result of the return of $0.4 million of progress payments made to the manufacturer of a special machine that was not accepted by the Company offset by capital expenditures of $0.4 million in the year.
Financing activities in 2006 provided cash of $0.2 million due to the exercise of stock options. FAS 123R requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under previous accounting literature, which has the effect of reducing net operating cash flows and increasing financing cash flows in periods after adoption. For the year ended December 31, 2006, we recognized financing cash flows amounting to $0.1 million for such excess tax deductions.
Our operating activities provided cash of $0.3 million in 2005, compared to $3.4 million of cash provided in 2004. The decrease was primarily due to an increase in accounts receivable and inventories in connection with the increase in sales partially offset by an increase in accounts payable and accrued liabilities due to the growth
of the business. Investing activities in 2005 used cash of $3.1 million including $5.1 million as a result of capital expenditures, primarily associated with leasehold improvements and new equipment in the new facility partially offset by sales of short-term investments of $2.0 million. Financing activities in 2005 provided cash of $0.6 million due to the exercise of stock options.
On December 14, 2004, we entered into agreements to lease a 134,000 square foot modern manufacturing and office building in Robbinsville, New Jersey, which is the site of its primary operations following the closure, relocation and consolidation of its operations in Elmsford, New York and Huntingdon Valley, Pennsylvania into the Robbinsville, New Jersey site. We completed the relocation and consolidation of its operations during 2005. The Robbinsville facility provides substantial room for expansion as our consolidated its operations that were being conducted within a 58,000 square foot facility in Elmsford, New York and a 30,000 square foot facility in Huntingdon Valley, Pennsylvania into the new facility. During 2006 we re-opened the Huntingdon Valley facility for certain manufacturing and secure storage. We also acquired and installed additional equipment and technology in the new facility to broaden its capabilities to serve its target customers, expand capacity, become more vertically integrated and improve efficiency.
The base rent on the lease for the Robbinsville, New Jersey facility is $555,000 per year, increasing by 1.9% per year, and the first seven months of the lease were rent-free. We recorded deferred rent of $0.4 million in 2004 and 2005. The term of the lease for the Robbinsville facility extends through May 31, 2017, and at the expiration of the term, we have options to renew the lease for three consecutive five year periods at the then fair market value and also have an option to purchase the building after the end of the original lease term for the adjusted fair market value as defined in the lease agreement. The base rent on the lease in Huntingdon Valley, Pennsylvania is $144,000 per year. The lease on this facility expires on June 30, 2007. We are currently negotiating a potential extension to the lease on the Huntingdon Valley, Pennsylvania facility. The base rent on the lease in Elmsford, New York is $746,000 per year. The lease on this facility expires on December 31, 2007. As this facility was abandoned as part of our move and consolidation in 2005 the remaining rent, net of estimated sublease income, through the end of the lease term was charged to Facility Consolidation Expense in 2005. During the quarter ended September 30, 2006 we entered into an amendment to the lease on the Elmsford, New York facility. Under the terms of the amendment, we and the buildings owner agreed to (i) a ten percent (10%) reduction of the fixed annual rent retroactive to April 1, 2006 which was recorded as a reduction to facility consolidation expense, (ii) the payment of $100,000 as a contribution towards the cost of demolition and restoration of the facility, which was recorded as a reduction of depreciation expense (iii) we provided a letter of credit in favor of owner in the amount of $789,606.80 in the event of an un-cured default of payments under the lease agreement, and (iv) acceleration of payments by us under the lease agreement in the event the facility is sub-leased.
We invested approximately $6.0 million through 2005 in capital additions at the Robbinsville, New Jersey facility in conjunction with the consolidation of our operations, of which approximately $5.1 million was expended in 2005 and $.9 million was expended in 2004. These expenditures were for facility upgrades to customize the Robbinsville, New Jersey facility for our operational and security requirements as well as the acquisition of new equipment to upgrade and expand our production capabilities.
We believe that cash flows from operations and cash balances will be sufficient to meet working capital needs and fund capital expenditures for the foreseeable future. In 2007 we will be pursuing prospective strategic acquisitions and partnerships in order to diversify our product line and customer base, achieve scale efficiencies, and strengthen our position as an integrated supplier of products and services that authenticate, protect and enhance critical and valuable documents, products and brands. The funding of these acquisitions and partnerships will be determined on a case by case basis and could include any combination of cash, debt and equity.
The following table quantifies our future obligations, which consist primarily of lease obligations (in thousands):
Impact of Inflation
In recent years, inflation has not had a significant impact on our historical operations. There can be no assurance that inflation will not adversely affect our operations in the future, particularly in emerging markets where inflationary conditions tend to be more prevalent.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Unaudited Quarterly Results of Operations for the Years Ended December 31, 2006 and 2005.
(1) We adopted FAS 123 (R) under the modified prospective method effective January 1, 2006 resulting in stock based compensation expense which impacted net income by $146,000, $178,000, $171,000 and $116,000 in the quarters ended March 31, June 30, September 30 and December 31, 2006, respectively. Under the modified prospective method, we were not required to restate the prior year financial statements.
(2) The quarter ended December 31, 2005 includes $5.0 million of additional charges for the HoloMag inventory adjustment, an additional warranty provision and an increase in the allowance for doubtful accounts. Net Income (loss) in the quarter was also impacted by facility consolidation expense of $2.2 million.
(3) Diluted income (loss) per share would have been anti-dilutive for the quarter ended December 31, 2005 if based on fully diluted shares adjusted to reflect stock options.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We do not engage in significant activity with respect to market risk sensitive instruments. Accordingly, our risk with respect to market risk sensitive instruments is immaterial.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Financial Statements and Supplementary Data required by this item are filed as part of this Form 10-K. See Index to Financial Statements on page of this Form 10-K.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
On April 27, 2005, Ernst & Young LLP (“Ernst & Young”) notified us that it would be resigning as our independent auditors upon completion of their SAS No. 100 review for the quarter ended March 31, 2005. Ernst & Young subsequently completed its SAS No. 100 review and by letter dated May 17, 2005 confirmed its resignation. Ernst & Young advised us that it was resigning because of Ernst & Young’s resource constraints, and that its resignation was not related to any matter concerning us including our selection or application of accounting policies or judgments, the scope of audit, internal controls or integrity of management.
Ernst & Young audited our financial statements for the fiscal year ended December 31, 2004.
During the fiscal year ended December 31, 2004 and for the period from January 1, 2005 through the date of resignation, there were no disagreements with Ernst & Young on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Ernst & Young would have caused them to make reference to the subject matter of their disagreement in their report.
During the fiscal year ended December 31, 2004 and for the period from January 1, 2005 through the date of resignation, there were no reportable events as such term is defined by paragraph (a)(1)(iv) of Item 304 of Regulation S-K promulgated by the Securities and Exchange Commission.
The report of Ernst & Young accompanying the audit for the fiscal year ended December 31, 2004 did not contain any adverse opinion or disclaimer or opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles.
The Company provided Ernst & Young with a copy of the above disclosures on May 18, 2005, and requested that Ernst & Young furnish a letter addressed to the Securities and Exchange Commission stating whether it agrees with the statements made by the Company and, if not, stating the respects in which it does not agree. A copy of such letter is attached as exhibit 16.1 to the Form 8-K filed by the Company on May 20, 2005.
On, August 1, 2005 we engaged PricewaterhouseCoopers, LLP as our independent registered public accounting firm for 2005. During our fiscal year ended December 31, 2004 and through August 1, 2005, neither we, nor anyone acting on our behalf, consulted with PricewaterhouseCoopers, LLP with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on our financial statements, or any other matters or events set forth in Item 304(a)(2)(i) and (ii) of Regulation S-K.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation
of the Company’s disclosure controls and procedures as of the end of the period covered by this report pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective in timely alerting them to material information relating to the Company required to be included in the Company’s periodic Securities and Exchange Commission filings and ensure information required to be included by the Company in reports it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC rules and forms. There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that would have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. OTHER INFORMATION
None.
Part III
Item 10.
Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The information required by this item concerning our executive officers, directors and key employees is set forth under the headings “Executive Officers and Directors” and “Other Key Employees” in Part I of this Annual Report on Form 10-K.
The information required by this item not set forth herein will be filed with the SEC within 120 days after the fiscal year ended December 31, 2006.
Item 11.
Item 11. EXECUTIVE COMPENSATION.
The information required by this item not set forth herein will be filed with the SEC within 120 days after the fiscal year ended December 31, 2006.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by this item not set forth herein will be filed with the SEC within 120 days after the fiscal year ended December 31, 2006.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The information required by this item not set forth herein will be filed with the SEC within 120 days after the fiscal year ended December 31, 2006.
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required by this item not set forth herein will be filed with the SEC within 120 days after the fiscal year ended December 31, 2006.
Part IV
Item 15.
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
(1) Financial Statements
The financial statements required by this item are submitted in a separate section beginning on page of this report.
(2) Financial Statement Schedules
The financial statement schedule required by this item is submitted in a separate section on page S-1 of this report.
Schedules other than that included at page S-1 of this report have been omitted because of the absence of conditions under which they are required or because the required information is included in our financial statements or notes thereto.
(3) Exhibits
The following exhibits are filed as part of this report or are incorporated herein by reference. Exhibit Nos. 10.4, 10.5, 10.6, 10.7, 10.8, 10.9, 10.10, 10.11, 10.12, 10.25, 10.30, 10.34, 10.35, 10.36, 10.37 and 10.38 are management contracts, compensatory plans or arrangements.
(1) Incorporated by reference from the Registration Statement on Form S-1 (Registration No. 333-51845).
(2) Incorporated by reference from the Proxy Statement on Schedule 14A filed on July 3, 2001.
(3) Incorporated by reference from the Quarterly Report on Form 10-Q filed on August 14, 2000.
(4) Incorporated by reference from the Annual Report on Form 10-K for 2000.
(5) Incorporated by reference from the Registration Statement on Form S-8 (Registration No. 333-61602).
(6) Incorporated by reference from the Proxy Statement on Schedule 14A filed on August 11, 2000.
(7) Incorporated by reference from the Annual Report on Form 10-K for 1998.
(8) Incorporated by reference from the Annual Report on Form 10-K for 1999.
(9) Incorporated by reference from the Annual Report on Form 10-K for 2001.
(10) Incorporated by reference from the Quarterly Report on Form 10-Q filed on August 13, 2002.
(11) Incorporated by reference from the Annual Report on Form 10-K for 2002.
(12) Incorporated by reference from the Quarterly Report on Form 10-Q filed on August 12, 2003.
(13) Incorporated by reference from the Quarterly Report on Form 10-Q filed on November 13, 2003.
(14) Incorporated by reference from the Current Report on Form 8-K filed on December 20, 2004.
(15) Incorporated by reference from the Quarterly Report on Form 10-Q filed on August 15, 2005.
(16) Incorporated by reference from the Current Report on Form 8-K filed on September 22, 2005.
(17) Incorporated by reference from the Registration Statement on Form S-8 (Registration No. 333-129686).
(18) Incorporated by reference from the Quarterly Report on Form 10-Q filed on November 13, 2005.
(19) Incorporated by reference from the Annual Report on Form 10-K for 2005.
(20) Incorporated by reference from the Quarterly Report on Form 10-Q filed on August 11, 2006.
(21) Incorporated by reference from the Quarterly Report on Form 10-Q filed on November 14, 2006.
(+) Portions have been omitted pursuant to a request for confidential treatment.
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
BALANCE SHEETS
DECEMBER 31, 2006 AND 2005
(In Thousands, Except Share Data)
The accompanying notes are an integral part of these financial statements.
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
(In Thousands, Except Per Share Data)
The accompanying notes are an integral part of these financial statements.
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
STATEMENTS OF STOCKHOLDERS’ EQUITY
YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004
(In Thousands)
The accompanying notes are an integral part of these financial statements.
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
(In Thousands)
The accompanying notes are an integral part of these financial statements.
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
American Bank Note Holographics, Inc. (the “Company” or “ABNH”) was incorporated in the state of Delaware in August 1985. The Company was, until July 20, 1998, a wholly-owned subsidiary of American Banknote Corporation (the “Former Parent” or “ABN”).
ABNH originates, produces, markets and sells holograms and products incorporating holograms. The Company’s products are used primarily in security applications including authentication of transaction cards, identity documents, value documents and various consumer products. The Company operates in one reportable industry segment.
Use of Estimates-The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make use of estimates and assumptions that impact the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to bad debts, stock-based compensation, inventories, and taxes. These estimates and assumptions are based on historical results and trends as well as our forecasts as to how these estimates and assumptions might change in the future. In addition, these estimates and assumptions have been influenced by our current assumptions of the potential impact of the VISA Decision (see Note 11. VISA Decision). Actual results may differ materially from our estimates.
Cash and Cash Equivalents-All highly liquid investments (primarily government bonds) with a maturity of three months or less, when purchased, are considered to be cash equivalents and are stated at cost, which approximates market.
Short-Term Investments-Short-term investments consists of a government bond which matured February 22, 2005. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” management determines the appropriate classification of marketable securities at the time of purchase and reevaluates such designations as of each balance sheet date. This investment was classified as held to maturity and carried at its amortized cost until its maturity date.
Inventories-Inventories are stated at the lower of cost or market with cost being determined on the first-in, first-out (FIFO) method.
Revenue Recognition-The Company recognizes revenue in accordance with the provisions of the SEC’s Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition (an amendment of SAB 101, “Revenue Recognition in Financial Statements”).” Our products are sold on a fixed price basis under purchase orders and contracts with customers. Sales and the related cost of goods sold are generally recognized at the latter of the time of shipment or when title passes to customers. In some situations, the Company has shipped product where the sale is contingent upon the customers’ use of the product. In these situations, the Company does not recognize sales upon product shipment, but rather when the buyer of the product informs the Company that the product has been used. Additionally, pursuant to the request of and agreement with a certain customer, completed items are stored on behalf of this customer at the Company’s on-site secured facility, and in that instance, sales are recognized when all of the following have occurred: the customer has ordered the goods pursuant to a fixed price purchase order, the manufacturing process is complete, the goods have been transferred to the on-site secured facility and are ready for shipment, the risk of ownership has passed to the customer, the customer has been billed for the order and collection of the invoice is considered reasonably assured. At December 31, 2006
and 2005, accounts receivable from this customer totaled $1.5 million and $1.5 million, respectively. In certain cases the Company has agreed to maintain an inventory of products for a customer to ensure quick turn around of deliveries. The Company only accepts returns of product sold to customers when the product is determined to not be in conformance with the specifications previously agreed upon with such customers in accordance with the terms of its warranty policy and generally replaces the product. The Company generally provides replacement product for up to 180 days from original shipment as a warranty for defective product. Shipping and handling amounts billed to customers are included in sales and amounted to $0.9 million, $0.9 million and $0.4 million in 2006, 2005 and 2004, respectively. Shipping and handling costs are included in selling and administrative expenses.
Royalty Income-The Company enters into licensing agreements with certain manufacturers under which the Company receives royalty payments. Royalty payments due under licensing agreements are recognized as income either based upon shipment reports from licensees, where available, or estimated shipments by such licensees.
Depreciation and Amortization-Machinery and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful life of the asset. Estimated useful lives are generally as follows: Machinery and production equipment-5 to 15 years; Furniture and fixtures-5 to 7 years and Computer equipment-3 to 5 years. Amortization of leasehold improvements is computed using the straight-line method based upon the remaining term of the applicable lease, or the estimated useful life of the asset, whichever is shorter, currently 12 years.
Long-Lived Assets-Long-lived assets used in operations are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable. For long-lived assets to be held and used, the Company recognizes an impairment loss only if its carrying amount is not recoverable through its undiscounted cash flows and measures the impairment loss based on the difference between the carrying amount and fair value.
Warranty Costs-The Company provides for warranty costs in amounts it estimates will be needed to cover future warranty obligations for products sold. Estimates of warranty costs are based on historical experience and are periodically reviewed and adjusted, when necessary. The Company’s product warranty provision is included in accrued expenses in the accompanying balance sheets.
Research and Development-Research and development costs are expensed as incurred. Research and development expense amounted to $1.6 million in 2006 and $1.3 million in each of 2005 and 2004.
Income Taxes-The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” The provision for income taxes includes deferred income taxes resulting from items reported in different periods for income tax and financial statement purposes. Deferred tax assets and liabilities represent the expected future tax consequences of the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of SFAS no. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income tax positions that the Company has taken or expects to take with respect to a tax return. The pronouncement prescribes a more-likely-than-not threshold for recognition as well as measurement criteria for changes in such tax positions for financial statement purposes. In addition, FIN 48 also requires additional qualitative and quantitative disclosures on unrecognized tax benefits to be included in the notes to the financial statements. We will adopt the provisions of FIN 48 in the quarter ending March 31, 2007. We have reviewed our accounting for income taxes in light of the provisions of FIN 48 and do not expect that adoption will materially affect our consolidated financial statements.
Stock-Based Compensation-In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R) (FAS 123R), Share-Based Payment, revising FAS 123 and requiring that all share-based
payments to employees be recognized in the financial statements. We adopted the new statement effective January 1, 2006, using the modified-prospective transition method described in the statement. Under this method, we are required to recognize compensation expense for all awards granted after the adoption based on the grant date fair value estimated in accordance with FAS 123R and for the unvested portion of previously granted options that remain outstanding as of the adoption date based on the grant date fair value in accordance with the original provisions of FAS 123. Prior periods have not been adjusted. Unearned compensation on restricted shares has been reclassified to additional paid in capital beginning January 1, 2006. Prior to adopting FAS 123R, we applied the intrinsic value-based method of accounting prescribed in APB Opinion No. 25 and, accordingly, did not recognize compensation expense for stock option grants made at an exercise price equal to or in excess of the fair market value of the stock at the date of grant. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under previous accounting literature, which has the effect of reducing net operating cash flows and increasing financing cash flows in periods after adoption. FAS 123R also requires the computation of an APIC pool which is the amount of excess tax benefits that are available for offset against future “shortfalls”. We calculated the beginning APIC pool using the “long-form” method. The APIC pool will be used subsequent to the adoption of FAS 123R in determining whether or not amounts of deferred tax assets related to stock options in excess of the tax deductions realized (short falls) will need to be recorded as an expense.
Earnings Per Share
Basic and diluted earnings per share are calculated in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share.”
The following table sets forth the reconciliation of basic weighted average shares outstanding and diluted weighted average shares outstanding:
Basic and Diluted Net (Loss) Income per Share-Basic net (loss) income per share is computed based on the weighted average number of outstanding shares of common stock. As the Company was in a loss position for the year ended December 31, 2005 dilutive stock options were excluded from the calculation of dilutive earnings per share as the shares would have had an anti-dilutive effect.
Business Concentration Risks-A significant portion of our business is derived from orders placed by certain transaction card companies and manufacturers of transaction cards, and variations in the timing of such orders can cause significant fluctuations in our sales. Sales to transaction card companies and manufacturers of transaction cards accounted for approximately 84% and 86% of our total sales in 2006 and 2005, respectively. The traditional hot stamp hologram that we have supplied for many transaction cards has been our primary source of revenue for over twenty years. Certain customers began to transition from the hot stamp hologram to an integrated holographic magnetic stripe (“HoloMag”) that we supply and have cancelled plans to make this transition, reverting back to the traditional hot stamp hologram due to a small number of incidents in which certain card terminals had been affected by electro-static discharge (“ESD”) from static electricity carried on cards incorporating the first generation of HoloMag. As a result of being advised of the ESD issue and in response to requests from customers we developed a second generation HoloMag product that addresses ESD. We are currently offering to customers a second generation version of HoloMag and began shipping the product in limited quantities in early 2007, although no assurance can be given that such second generation version of HoloMag will be accepted by our customers. Further there can be no assurance that a competitor of ours will not develop an acceptable product that is adopted by our customers. To the extent that our sales of the traditional hot
stamp patch holograms decline without replacing such sales with sales of new products, our business, operating results and financial condition would be materially and adversely affected.
Concentrations of Credit Risk-A significant portion of the Company’s accounts receivable are due from credit card issuers and related credit card manufacturers located throughout the United States and Europe. At December 31, 2006 each of three customers accounted for 28%, 15% and 15%, respectively, of the Company’s accounts receivable and 35%, 8% and 5%, respectively, of its sales for the year then ended. At December 31, 2005 two customers each accounted for 22% of the Company’s accounts receivable and 30% and 11%, respectively of its sales for the year then ended. The Company establishes its credit policies based on an ongoing evaluation of its customers’ creditworthiness and competitive market conditions and does not require collateral.
Sales to manufacturers of VISA transaction cards were approximately 35% and 37% of sales for the years ended December 31, 2006 and 2005, respectively. Currently we are an authorized supplier of the VISA Dove hot stamp holograms to manufacturers of VISA brand transaction cards. On March 15, 2005, VISA announced its intention to phase out the Dove hot stamp hologram that we supply for the front of the VISA card, and to replace it with an integrated holographic magnetic stripe. On April 8, 2005, we entered into an Agreement with VISA, pursuant to which we are authorized to supply HoloMag to VISA approved card manufacturers. We began shipping HoloMag to VISA authorized card manufacturers in the second half of 2005. On March 14, 2006, we were informed by VISA that, as a result of the ESD issue, VISA was effectively ceasing the HoloMag program (the “VISA Decision”). VISA then moved to include either the Dove hot stamp hologram or the mini hot stamp hologram, both of which we supply, as the security device on VISA cards. By letter dated November 7, 2006, we were advised by VISA that VISA was terminating the VISA HoloMag Agreement. Sales of VISA products to VISA authorized card manufacturers in 2006 and 2005 were as follows:
Sales of HoloMag to VISA authorized card manufacturers are not expected to continue in 2007.
Sales of the hot stamp holograms to VISA authorized card manufacturers are expected to continue in 2007. If we were to lose a substantial portion of our hot stamp hologram business with VISA without replacing it with new product sales, our business, operating results and financial condition would be materially and adversely affected. In addition, if we fail to obtain anticipated orders from VISA authorized card manufactures or if we experience delays or cancellations of orders from card manufacturers, our business and financial performance will be materially and adversely affected.
In VISA’s March 2006 correspondence to us at the time it ceased the HoloMag program, VISA stated its view that “a remediation program for impacted stakeholders may be necessary” and that VISA would seek indemnification from us for such costs and/or claims. We have been evaluating VISA’s actions and claims and continue to discuss the matter with VISA. We believe that we have complied with the VISA HoloMag Agreement and that the HoloMag product complied with all standards and specifications contained in such agreement and we are continuing to evaluate VISA’s actions and claims and discuss the matter with VISA. In the event that VISA or other third parties assert claims against us our financial condition and results of operations may be adversely affected.
Sales to MasterCard were approximately 35% and 31% of sales for the years ended December 31, 2006 and 2005, respectively. We have an agreement with MasterCard, as amended, pursuant to which the Company is the
exclusive supplier of MasterCard holograms and holographic magnetic stripes, HoloMag™. In the quarter ended September 30, 2005, MasterCard advised its member financial institutions around the world that it will allow them to choose among card designs that incorporate either the traditional hot stamp patch hologram or HoloMag, both of which are supplied by the Company. Sales of HoloMag to MasterCard were not significant in 2006. On February 9, 2007, MasterCard advised its certified card manufacturers and us that effective immediately they were suspending the use of the first generation HoloMag product due to a significant decrease in the demand for the product. To date, MasterCard has not approved the second generation HoloMag product. MasterCard has informed us that they are continuing to test the second generation HoloMag product. The agreement with MasterCard expires on February 28, 2013, subject to automatic renewal thereafter.
If we were to lose a substantial portion of our business with MasterCard without replacing it with new product sales, our business, operating results and financial condition would be materially and adversely affected. In addition, if we fail to obtain anticipated orders from MasterCard or if we experience delays or cancellations of orders from MasterCard, our business and financial performance will be materially and adversely affected.
Export Sales-During 2006, 2005 and 2004, export sales accounted for approximately 35%, 34% and 21%, respectively, of total sales. All of our export sales are presently billed in U.S. dollars. At December 31, 2006 and 2005, accounts receivable from these customers approximated $1.2 million and $2.0 million, respectively.
We purchase certain key materials used in the manufacture of our products, and subcontract certain production functions or products from third parties some of which are sole suppliers. In some cases, we do not have supply contracts with our suppliers, and operate on a purchase order basis. In the case of HoloMag, we have a single supplier, CFC International, Inc., that was acquired by ITW during 2006, with whom we have a supply contract which was amended on July 26, 2006. Also at that time we negotiated a settlement with CFC International, Inc. that resulted in a reduction of our payable to them of approximately $1.0 million. We may not be able to find alternative sources in a timely manner if our suppliers or subcontractors become unwilling or unable to supply us, or if they increase their prices. Our inability to obtain key product components or to have certain processes performed on our behalf could cause delays or reduce product shipments, which could cause our relationship with customers to suffer and materially and adversely affect our financial condition, results of operations and cash flows.
Fair Value of Financial Instruments-The Company’s financial instruments consist of cash and cash equivalents, short-term investments, accounts receivables, accounts payable and accrued expenses. The carrying amounts reported in the balance sheets approximate their fair value at both December 31, 2006 and 2005.
Comprehensive Income-Comprehensive income is equal to net income in all periods.
Reclassifications-Certain prior year amounts have been reclassified to conform with the current year’s presentation.
Impact of Recently Issued Accounting Standards
In September 2006, the Financial Accounting Standards Board issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value under Generally Accepted Accounting Principles, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after December 15, 2007. The Company is currently in the process of evaluating the impact that the adoption of SFAS No. 157 will have on its financial position, results of operations and cash flows.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), to
address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that the Company quantifies misstatements based on their impact on each of its financial statements and related disclosures. The Company adopted the provisions of SAB 108 during the fourth quarter of 2006 and the adoption had no effect on the Company’s financial statements.
In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of SFAS no. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income tax positions that the Company has taken or expects to take with respect to a tax return. The pronouncement prescribes a more-likely-than-not threshold for recognition as well as measurement criteria for changes in such tax positions for financial statement purposes. In addition, FIN 48 also requires additional qualitative and quantitative disclosures on unrecognized tax benefits to be included in the notes to the financial statements. We will adopt the provisions of FIN 48 beginning in the quarter ending March 31, 2007. We have reviewed our accounting for income taxes in light of the provisions of FIN 48 and do not expect that adoption will materially affect our consolidated financial statements.
In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R) (FAS 123R), Share-Based Payment, revising FAS 123 and requiring that all share-based payments to employees be recognized in the financial statements. Generally, the approach to accounting for share-based payments in FAS 123R is similar to the approach described in FAS 123, however, pro forma footnote disclosure will no longer be an alternative to financial statement recognition. This statement, as amended, becomes effective in the first annual period beginning after June 15, 2005. The Company adopted the new statement effective January 1, 2006, using the modified-prospective transition method described in the statement. Under this method, the Company will be required to recognize compensation expense over the remaining vesting period for all awards that remain unvested as of January 1, 2006. As permitted by FAS 123, the Company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognized no compensation cost for employee stock options. The impact on 2006 results is shown below in Results of Operations and in Note 8.,”Stock-based Compensation”, in the Financial Statements.
In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 151 (“FAS 151”), Inventory Costs, an amendment of ARB No. 43, Chapter 4. FAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs and wasted materials should be recognized as current period charges. In addition, FAS 151 requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. FAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company adopted FAS 151 during 2006. As a result of the impact of the VISA Decision the Company recorded approximately $0.8 million of overhead expenses as period expenses in 2006.
In March 2005, the FASB issued interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS No. 143. This interpretation clarifies that the term of conditional asset retirement obligation refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The provisions of Interpretation 47 are effective for fiscal years ending after December 15, 2005. The Company adopted Interpretation No. 47 in 2006. Adoption of this statement had no impact on the Company’s financial statement presentation since the Company had no conditional asset retirement obligations.
2. INVENTORIES, NET
Inventories are stated at the lower of cost or market (first-in, first-out method). As a result of the VISA Decision (see Note 12, VISA Decision) in the quarter ended December 31, 2005, we adjusted the value of HoloMag inventory by $4,018,000 reflecting the lower of cost or market value at December 31, 2005. During 2006, following the termination of the VISA HoloMag program we wrote-off all remaining VISA HoloMag inventory, reducing finished goods inventory and the inventory reserve by a like amount.
3. MACHINERY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Depreciation of machinery and equipment and leasehold improvements for the years ended December 31, 2006, 2005 and 2004 were $843,000, $1,291,000, and $824,000, respectively.
4. ACCRUED EXPENSES
The significant change in warranties provided in 2005 is principally due to increased volume in the quarter ended December 31, 2005 and an additional provision recorded in the quarter ended December 31, 2005 for potential non-ESD related warranty claims as a result of the VISA Decision. (see Note 11. VISA Decision). Changes in the Company’s warranty provision during the years ended December 31, 2006, 2005 and 2004 are displayed in the following table.
5. INCOME TAXES
Provision for income taxes are as follows:
A reconciliation of the taxes on income in 2006, 2005 and 2004 is as follows:
The tax effects of the items comprising the Company’s deferred income tax assets and liabilities are as follows:
Deferred income taxes arise from temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. The net non-current deferred tax liability is included in Long Term Liabilities on the Balance Sheet.
6. STOCKHOLDERS’ EQUITY
On June 11, 1998, the Company increased its authorized common stock to 30,000,000 shares and its authorized preferred stock to 5,000,000 shares. On July 20, 1998, the Former Parent completed the sale of 13,636,000 shares of the Company’s common stock in a public offering (the “Offering”), representing its entire investment in the Company. During 2001 and 2002 the Company issued and distributed 1,460,000 shares of its common stock as well as warrants to purchase 863,647 shares of the Company’s common stock, at an exercise price of $6.00 per share in settlement of the class action lawsuit filed against the Company in 1999. The warrants expired on June 18, 2003. None of the warrants were exercised. On August 10, 2001, the Company’s stockholders approved an amendment to the Company’s Amended and Restated Articles of Incorporation increasing the number of authorized shares of its common stock to 40,000,000 shares.
On June 30, 2000, the Company entered into a Stock Purchase Agreement (the “Agreement”) with Crane & Co., Inc. (“Crane”). Under the Agreement, the Company sold 3,387,720 shares of the Company’s common stock to Crane for an aggregate purchase price of $9,316,230. The Agreement also provides that the Board of Directors of the Company and the audit committee of the Board of Directors each be expanded by one position, which was filled by Douglas A. Crane, a representative of Crane. Mr. Crane resigned from our Board of Directors on November 29, 2005 and on November 30, 2005 we were informed by Crane & Co., Inc. of their intention to sell a portion or all of their shares in an orderly manner. Crane has not sold any of its shares as of March 23, 2007.
The Agreement also contains a standstill provision, whereby Crane agreed, that, among other things, neither it nor its affiliates, except as otherwise provided for in the Agreement, will acquire more than its current
proportionate share of the outstanding securities of the Company. The standstill provision also provides that Crane will not offer, sell or transfer any of its voting securities of the Company during a tender or exchange offer if such offer is opposed by the Company’s Board of Directors.
During 2000, we entered into agreements with Crane under which we rented factory space and leased employees for our facility in Dalton, MA. The arrangement was ended in October 2006 and all leased facilities and employees were turned over to Crane at that time. For the years ended December 31, 2006, 2005 and 2004, we paid Crane under these agreements $60,000, $72,000 and $72,000, respectively, for the rental of the factory space and $62,000, $153,000 and $169,000, respectively, for the leased employees.
7. FACILITY CONSOLIDATION
On December 14, 2004, the Company entered into agreements to lease a 134,000 square foot modern manufacturing and office building in Robbinsville, New Jersey, which is the site of its primary operations following the closure, relocation and consolidation of its operations in Elmsford, New York and Huntingdon Valley, Pennsylvania into the Robbinsville site. The Company completed the relocation and consolidation of its operations during 2005. The Robbinsville facility provides substantial room for expansion as the Company consolidated its operations that were being conducted within a 58,000 square foot facility in Elmsford, New York and a 30,000 square foot facility in Huntingdon Valley, Pennsylvania into the new facility. During 2006 we re-opened the Huntingdon Valley facility for certain manufacturing and secure storage. The Company has also acquired and installed additional equipment and technology in the new facility to broaden its capabilities to serve its target customers, expand capacity, become more vertically integrated and improve efficiency.
The base rent on the lease for the Robbinsville, New Jersey facility is $555,000 per year, increasing by 1.9% per year, and the first seven months of the lease were rent-free. We recorded deferred rent of $0.4 million in 2004 and 2005, respectively. The term of the lease for the Robbinsville facility extends through May 31, 2017, and at the expiration of the term, we have options to renew the lease for three consecutive five year periods at the then fair market value and also have an option to purchase the building after the end of the original lease term for the adjusted fair market value as defined in the lease agreement. The base rent on the lease in Huntingdon Valley, Pennsylvania is $144,000 per year. The lease on this facility expires on June 30, 2007. We are currently negotiating an extension to the lease on this facility. The base rent on the lease in Elmsford, New York is $746,000 per year. The lease on this facility expires on December 31, 2007. As this facility was abandoned as part of our move and consolidation in 2005 the remaining rent, net of estimated sublease income, through the end of the lease term was charged to Facility Consolidation Expense in 2005. During the quarter ended September 30, 2006 we entered into an amendment to the lease on the Elmsford, New York facility. Under the terms of the amendment, we and the buildings owner agreed to (i) a ten percent (10%) reduction of the fixed annual rent retroactive to April 1, 2006, which was recorded as a reduction to facility consolidation expense, (ii) the payment of $100,000 as a contribution towards the cost of demolition and restoration of the facility, which was recorded as a reduction of depreciation expense (iii) the Company provided a letter of credit in favor of owner in the amount of $789,606.80 in the event of an un-cured default of payments under the lease agreement, and (iv) acceleration of payments by the Company under the lease agreement in the event the facility is sub-leased.
We invested approximately $6.0 million through 2005 in capital additions at the Robbinsville, New Jersey facility in conjunction with the consolidation of our operations, of which approximately $5.1 million was expended in 2005 and $0.9 million was expended in 2004. These expenditures were for facility upgrades to customize the Robbinsville, New Jersey facility for the Company’s operational and security requirements as well as the acquisition of new equipment to upgrade and expand our production capabilities.
The following table illustrates the liability balance and activity related to the relocation and consolidation in the in 2006, 2005 and 2004.
(a) Of the $2,058,000 balance at December 31, 2005, $1,182,000 was included in accrued liabilities and $876,000 was included in other long-term liabilities.
The following table illustrates the costs incurred in the relocation and consolidation of facilities through December 31, 2006 and anticipated in 2007 when all cash payments and expenses are expected to be completed.
8. STOCK-BASED COMPENSATION PLANS
On August 8, 2005, we adopted the 2005 Stock Incentive Plan (the “2005 Plan”), which was approved by our stockholders at the annual meeting on September 22, 2005. The number of shares available for issuance under the 2005 Stock Incentive Plan is 1,600,000. On August 4, 2000, we adopted the American Bank Note Holographics, Inc. 2000 Stock Incentive Plan (as amended, the “2000 Plan”), which was approved by our stockholders at our annual meeting on September 12, 2000. In August 2001, our stockholders approved an amendment to the 2000 Plan increasing the shares available for issuance thereunder by 600,000 to 1,350,000 shares. On July 20, 1998, we adopted the 1998 Stock Incentive Plan (as amended, the “1998 Plan”, and collectively with the 2000 Plan and the 2005 Plan, the “Plans”). The number of shares available for issuance under the 1998 Plan is 1,863,000. The Plans were adopted for the purpose of granting various stock incentives to
officers, directors, employees and consultants of ABNH. The board of directors (or a committee appointed by the board of directors) has discretionary authority, subject to certain restrictions, to administer the Plans. The total number of shares reserved for issuance under the Plans is 4,813,000 shares of common stock. Options to purchase 3,033,722 shares of common stock were outstanding under the Plans at December 31, 2006. The exercise price of options granted under the Plans may not be less than 100% of the fair market value of the common stock on the date such option was granted. Options granted under the Plans generally become vested and exercisable for up to either 25% or 33 1/3% of the total optioned shares upon each succeeding anniversary of the date of grant. Generally, the unexercised portion of any option automatically terminates upon the termination of the optionee’s employment with us, unless otherwise determined by the board of directors; provided however, that any extension shall not extend beyond the expiration of the option, generally ten years. Upon a change in control, outstanding options will generally become fully vested. Prior to 2005 we only granted non-qualified stock options. Beginning in 2005 we began granting restricted shares in addition to stock options. At December 31, 2006, 133,500 shares of restricted stock had been issued. Restricted stock will fully vest three years from the date of issuance if the grantee is employed at that time. On January 19, 2007 we granted options to purchase an aggregate of 137,500 shares of common stock to our employees at an exercise price equal to the fair value of the common stock at the date of the grant. Additionally we issued 98,500 restricted shares to employees on that date. On January 26, 2007, we granted options to purchase an aggregate of 15,000 shares of common stock to our outside directors at an exercise price equal to the fair value of the common stock at the date of the grant. Beginning in 2007 stock based compensation awards to Executive officers will be granted following the release of year end earnings therefore no options or restricted shares have been granted to Executive Officers as of this date.
In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R) (“FAS 123R”), Share-Based Payment, revising FAS 123 and requiring that all share-based payments to employees be recognized in the financial statements. We adopted the new statement effective January 1, 2006, using the modified-prospective transition method described in the statement. Under this method, we are required to recognize compensation expense for all awards granted after the adoption based on the grant date fair value estimated in accordance with FAS 123R and for the unvested portion of previously granted options that remain outstanding as of the adoption date based on the grant date fair value in accordance with the original provisions of FAS 123. In 2006, operating income was reduced by $980,000 for stock-based payment compensation expense for both stock options and restricted stock. Stock-based compensation in 2006 affected cost of goods sold by $225,000, selling, general and administrative expenses by $639,000 and research and development expenses by $116,000. Stock-based compensation expense reduced our 2006 net income by $611,000 and our basic and fully diluted earnings per share by $0.03. Prior periods have not been adjusted. Unearned compensation on restricted shares has been reclassified to additional paid in capital beginning January 1, 2006.
FAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under previous accounting literature, which has the effect of reducing net operating cash flows and increasing financing cash flows in periods after adoption. For the year ended December 31, 2006, we recognized financing cash flows amounting to $58,000 for such excess tax deductions. FAS 123R also requires the computation of an APIC pool which is the amount of excess tax benefits that are available for offset against future “shortfalls”. We calculated the beginning APIC pool using the “long-form” method. The APIC pool will be used subsequent to the adoption of FAS 123R in determining whether or not amounts of deferred tax assets related to stock options in excess of the tax deductions realized (short falls) will need to be recorded as an expense.
Prior to adopting FAS 123R, we applied the intrinsic value-based method of accounting prescribed in APB Opinion No. 25 and, accordingly, did not recognize compensation expense for stock option grants made at an exercise price equal to or in excess of the fair market value of the stock at the date of grant.
The following table details the effect on the Company’s net income and basic and diluted net income per share had compensation expense for stock-based awards been recorded in 2005 and 2004 based on the fair-value method under SFAS 123.
We use the Black-Scholes option pricing model to calculate the fair value of options. The key assumptions for this valuation method include the expected term of the option, stock price volatility, risk-free interest rate, dividend yield, exercise price, and forfeiture rate. Many of these assumptions are judgmental and highly sensitive in the determination of compensation expense. Under the assumptions, indicated below, the weighted average fair value of the stock option grants in 2006 and 2005 were $5.69 and $2.97, respectively. The table below indicates the key assumptions used in the valuation calculations for options granted in 2006 and 2005 and a discussion of our methodology for developing each of the assumptions used in the valuation model:
Term-This is the period of time over which the options granted are expected to remain outstanding. Options granted have a maximum term of ten (10) years. An increase in the expected term will increase compensation expense.
Volatility-This is the measure of the amount by which a stock price has fluctuated or is expected to fluctuate. Volatilities are based on historical volatility of ABNH’s shares, and other factors such as expected volatility arising from planned changes in our business operations. An increase in the expected volatility will increase compensation expense.
Risk-free interest rate-This is the U.S. Treasury rate for the week of the grant having a term equal to the expected term of the options granted. An increase in the risk-free interest rate will increase compensation expense.
Dividend yield-We did not make any dividend payments during the last five years and we have no plans to make any dividend payments in the foreseeable future
Forfeiture Rate-This is the estimated percentage of options granted that are expected to be forfeited or canceled before becoming vested. An increase in the forfeiture rate will decrease compensation expense. A
summary of the status of the Company’s outstanding stock options as of December 31, 2006, 2005 and 2004 and changes during the years then ended follows:
The following table summarizes information concerning outstanding and exercisable options at December 31, 2006:
As of December 31, 2006 there was $1,354,000 of total unrecognized compensation cost, net of estimated forfeitures, related to stock options. These costs are expected to be recognized over a weighted average period of 0.9 years.
The total intrinsic value of stock options exercised during the year ended December 31, 2006 was $238,000. The total intrinsic value of all stock options outstanding at December 31, 2006 was $1,972,000. The total intrinsic value of all vested stock options at December 31, 2006 was $1,884,000.
Cash received from stock option exercises in the year ended December 31, 2006 was $158,000. The income tax benefit from stock based arrangements totaled $86,000 all of which was attributable to stock option exercises and was credited to additional paid in capital.
The following table summarizes information about restricted stock awards for 2006:
Restricted stock awards were made under the 2005 Stock Incentive Plan and generally vest 100% three years from the grant date.
As of December 31, 2006 there was $559,000 of unrecognized compensation costs, net of estimated forfeitures, related to restricted stock awards. These costs are expected to be recognized over a weighted average period of 2.0 years.
As of December 31, 2006 an aggregate of 1,326,360 shares remained available for future grants and awards under our stock incentive plans, which cover stock options and restricted stock awards. We issue shares to satisfy stock option exercises and restricted stock awards.
9. EMPLOYEE BENEFITS PLANS
Retirement Plans-On October 1, 1999, the Company implemented defined contribution plans for its employees. Aggregate contributions to such plans, which have been charged to the Company’s operations, were approximately $58,000, $57,000 and $59,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
10. COMMITMENTS AND CONTINGENCIES
The Company currently, and from time to time, is involved in litigation (as both plaintiff and defendant) incidental to the conduct of its business; however, the Company is not a party to any lawsuit or proceeding which, in the opinion of management of the Company, is likely to have a material impact on the Company’s financial position, results of operations or cash flows.
Product Liability Matters-The Company provides holograms in connection with a wide range of its customers’ products, in which case it is possible that the Company is subject to product liabilities in association with those products or in connection with the holograms used with those products. Although the Company maintains product liability insurance, there can be no assurance that such insurance would be available to cover any such claim or available in amounts sufficient to cover all potential liabilities. As a result, product liability claims could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows.
Warranty and Contracts Reserves-The Company believes that there is a reasonable likelihood that approximately $0.7 million of reserves on the balance sheet at December 31, 2006 will be reversed into income during 2007 as the periods for potential claims under the programs will expire.
Leases-The Company has long-term operating leases for offices, manufacturing facilities and equipment, which expire through 2017. The Company has three five year renewal options on its Robbinsville location, which provides for renewal rents based upon the adjusted fair market rental value, as defined in the lease agreement.
The Company is currently negotiating an extension to the lease on the facility in Huntingdon Valley, PA as the current lease will expire on June 30, 2007.
Rental expense was approximately $1.3 million, $1.3 million and $1.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.
At December 31, 2005, future minimum lease payments under non-cancelable operating leases, expiring through 2017, are as follows: $1.8 million in 2007; $0.7 million in 2008; $0.8 million in 2009; $0.6 million in 2010 and $3.9 million, thereafter.
Employment Agreements-The Company entered into employment agreements with certain of its current executive officers, which provide for, among other matters, minimum compensation of approximately $0.8 million in 2007 and $0.8 million in 2008. The agreements also provide for bonuses.
11. VISA DECISION
On February 23, 2006 we reported that we had learned that there had been a small number of incidents in which certain card terminals had been affected by electro-static discharge (“ESD”) from static electricity carried on cards incorporating HoloMag. We also reported at that date that it had been advised by customers of a need to develop a second generation holographic magnetic tape product that addresses the ESD issue, and that we had commenced such development, but that there could be no assurance that we would be successful in developing such a product that would be acceptable to our customers.
On March 14, 2006, we were informed by VISA that, as a result of the ESD issue, VISA was effectively ceasing the HoloMag program (the “VISA Decision”). VISA then moved to include either the Dove hot stamp hologram or the mini hot stamp hologram, both of which we supply, as the security device on VISA cards. By letter dated November 7, 2006, we were advised by VISA that VISA was terminating the VISA HoloMag Agreement. In VISA’s March 2006 correspondence to us VISA stated its view that “a remediation program for impacted stakeholders may be necessary” and that VISA would seek indemnification from us for such costs and/or claims. We have been evaluating VISA’s actions and claims and continue to discuss the matter with VISA. We believe that we have complied with the VISA HoloMag Agreement and that the HoloMag product complied with all standards and specifications contained in such agreement.
Accordingly, in the quarter ended December 31, 2005, as a result of the VISA Decision, we recorded a pre-tax charge amounting to approximately $5.0 million of which $4.8 million was recorded in cost of goods sold and was principally related to the value of our HoloMag inventory. Also included in the charge were increases in our provisions for accounts receivable and potential non-ESD related warranty claims. Also shipments totaling approximately $2.3 million of VISA HoloMag that were completed and invoiced during the quarter ended March 31, 2006 were not recognized as revenue as the collection of these amounts was not considered probable as a result of the VISA Decision. During 2006 and subsequent to completing and filing our financial statements for the three months ended March 31, 2006 approximately $0.9 million, $0.2 million and $1.2 million was collected and accordingly the revenue was recorded in the quarter ended June 30, 2006, September 30, 2006, and December 31, 2006, respectively. Also during 2006 we wrote-off the value of our VISA HoloMag inventory and reversed the reserve for obsolescence that was recorded in the quarter ended December 31, 2005. Additionally as a result of the VISA Decision, in the twelve months ended December 31, 2006 we wrote-off approximately $0.8 million of idle facility costs that were not absorbed into inventory and approximately $0.3 million of costs that were capitalized on the balance sheet at December 31, 2005 relating to a terminated manufacturing project. During 2006 we also analyzed the provision levels for warranty liability and accounts receivable and recorded necessary adjustments.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders
of American Bank Note Holographics, Inc.:
In our opinion, the 2006 and 2005 financial statements listed in the accompanying index present fairly, in all material respects, the financial position of American Bank Note Holographics, Inc. at December 31, 2006 and 2005 and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index for each of the two years in the period ended December 31, 2006 present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 and 8 to the consolidated financial statements, respectively, the Company changed the manner in which it accounts for inventory costs and stock-based compensation in 2006.
/s/ PricewaterhouseCoopers, LLP
Florham Park, New Jersey
March 26, 2007
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
American Bank Note Holographics, Inc.
We have audited the accompanying the statements of operations, stockholders’ equity, and cash flows of American Bank Note Holographics, Inc. for the year ended December 31, 2004. Our audit also included the information for the year ended December 31, 2004 included in the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether 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 financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of American Bank Note Holographics, Inc. for the year ended December 31, 2004 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the information for the year ended December 31, 2004 in the related financial statement schedule when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
New York, New York
March 10, 2005
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.
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
By:
/S/ KENNETH H. TRAUB
Kenneth H. Traub
President and Chief Executive Officer
March 30, 2007
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.
Schedule II
AMERICAN BANK NOTE HOLOGRAPHICS, INC.
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
(1) Accounts deemed to be uncollectible.
(2) Destruction of obsolete inventory.