Item 1. Business
Overview
We were founded in 1971 and our shares began trading on The Nasdaq Stock Market in 1995. We are a leading supplier of instruments for nanoscale imaging, analysis and prototyping to enable research, development and manufacturing in a range of industrial, academic and research institutional applications. We report our revenue based on a market-focused organization: the NanoElectronics market, the NanoResearch and Industry market, the NanoBiology market and the Service and Components market.
Our products include focused ion beam systems, or FIBs; scanning electron microscopes, or SEMs; transmission electron microscopes, or TEMs; and DualBeam systems, which combine a FIB and SEM on a single platform.
Our DualBeam systems include models that have wafer handling capability and are purchased by semiconductor and data storage manufacturers (“wafer-level DualBeam systems”) and models that have small stages and are sold to customers in several markets (“small-stage DualBeam systems”).
We have research, development and manufacturing operations in Hillsboro, Oregon; Eindhoven, the Netherlands; and Brno, Czech Republic.
Our sales and service operations are conducted in the U.S. and approximately 50 other countries around the world. We also sell our products through independent agents, distributors and representatives in additional countries.
To date, we have a total worldwide installed base of over 6,800 systems. The development of these solutions has been driven by our strong technology base that includes patented and proprietary technologies and the technical expertise and knowledge base of research and development personnel worldwide.
The NanoElectronics market consists of customers in the semiconductor, data storage and related industries such as printers and microelectromechanical systems (“MEMs”). For the semiconductor market, our growth is driven by shrinking line widths and process nodes of 65 nanometers and smaller, the use of multiple layers of new materials such as copper and low-k dielectrics, the increase in wafer size to 300 millimeters in diameter and increasing device complexity. Our products are used primarily in laboratories to speed new product development and increase yields by enabling three-dimensional (“3D”) wafer metrology, defect analysis, root cause failure analysis and circuit edit for modifying device structures. In the data storage market, factors affecting our business include the transition from longitudinal to perpendicular recording heads, rapidly increasing storage densities that require smaller recording heads, thinner geometries and materials that increase the complexity of device structures. Our products offer 3D metrology for thin film head processing and root cause failure analysis.
The NanoResearch and Industry market includes universities, public and private research laboratories and a wide range of industrial customers, including automobiles, aerospace, metals, mining and petrochemicals. Growth in these markets is driven by global corporate and government funding for research and development in materials science and by development of new products and processes based on innovations in materials at the nanoscale. Our solutions provide researchers and manufacturers with atomic-level resolution images and permit development, analysis and production of advanced products. Our products are also used in root cause failure analysis and quality control applications.
The NanoBiology market includes universities and research institutes engaged in biotech and life sciences applications, as well as pharmaceutical, biotech, medical device and hospital companies. Our products’
ultra-high resolution imaging allows cell biologists and drug researchers to create detailed 3D reconstructions of complex biological structures, enabling them to map proteins within cells.
Our service division provides support for products and customers for the entire life cycle of a tool from installation through the warranty period, and after warranty period through contract coverage or on a time and materials basis. We believe strong technical support is an important part of the value proposition that we offer customers when a tool is sold. Our service division provides support across all markets and all regions.
Core Technologies
We use several core technologies to deliver a range of value-added customer solutions. Our core technologies include:
· focused ion beams, which allow modification of structures in sub-micron geometries;
· focused electron beams, which allow imaging, analysis and measurement of structures at sub-micron and even atomic levels;
· beam gas chemistries, which increase the effectiveness of ion and electron beams and allow etching and deposition of materials on structures at sub-micron levels; and
· system automation and sample management tools, which provide faster access to data and improved ease of use for operators of our systems.
Particle beam technologies-focused ion beams and electron beams. The emission and focusing of ions, which are positively or negatively charged atoms, or electrons from a source material, is fundamental to many of our products. Particle beams are accelerated and focused on a sample for purposes of high resolution imaging and sample processing. The fundamental properties of ion and electron beams permit them to perform various functions. The relatively low mass subatomic electrons interact with the sample and release secondary electrons. When collected, these secondary electrons can provide high quality images at nanometer-scale resolution. In previously thinned samples, collection of high energy electrons transmitted through the sample can yield image resolution at the atomic scale. The much greater mass ions dislodge surface particles, also resulting in displacement of secondary ions and electrons. Through the use of FIBs, the surface can be modified or milled with sub-micron precision by direct action of the ion beam or in combination with gases. Secondary electrons and ions may also be collected for imaging and compositional analysis. Our ion and electron beam technologies provide advanced capabilities and applications when coupled with our other core technologies.
Beam gas chemistry. Beam gas chemistry plays an important role in enabling our electron and ion beam based products to perform many tasks successfully. Beam gas chemistry involves the interaction of the primary ion beam with an injected gas near the surface of the sample. This interaction results in either the deposition of material or the enhanced removal of material from the sample. Both of these processes are critical to optimizing and expanding FIB and SEM applications. Our markets have growing needs for gas chemistry technologies, and we have aimed our development strategy at meeting these requirements.
· Deposition: Deposition of materials enables our FIBs to connect or isolate features electrically on, for example, an integrated circuit. A deposited layer of metal also can be used before FIB milling to protect surface features for more accurate cross-sectioning or sample preparation.
· Etching: The fast, clean and selective removal of material is the most important function of our FIBs. Our FIBs have the ability to mill specific types of material faster than other surrounding material. This process is called selective etching and is used to enhance image contrast or aid in the modification of various structures.
System automation and sample management. Drawing on our knowledge of application needs, and using robotics and image recognition and reconstruction software, we have developed automation capabilities that allow us to increase system performance, speed and precision. These capabilities have been especially important to our development efforts for in-line products and applications in the NanoElectronics market and are expected to be increasingly important in emerging production and
process control applications in NanoResearch and Industry and NanoBiology markets. Two important areas where we have developed significant automation technologies are TEM sample preparation and 3D process control. TEMs are widely used in the semiconductor and data storage markets to obtain valuable high-resolution images of extremely small, even atomic-level, structures. TEM sample preparation has traditionally been a slow and difficult manual process. With our DualBeam systems and proprietary software, we have automated this process, significantly improving the sample consistency and overall throughput. Similarly, by automating 3D process control applications, we allow customers to acquire previously unobtainable subsurface process metrics directly from within the production line, improving process management.
Research and Development
We have research, development and manufacturing operations in Hillsboro, Oregon; Eindhoven, the Netherlands; and Brno, Czech Republic.
Our research and development staff at December 31, 2007 consisted of 345 employees, including scientists, engineers, designer draftsmen, technicians and software developers.
In the last year, we introduced several new and improved products, including the:
· Quanta 3D FEG small-stage DualBeam;
· Phenom low-cost imaging tool;
· Titan3 80-200, with environmental enhancements to our base Titan system;
· V600CE Upgrade circuit edit system;
· Nova NanoSEM 30 scanning electron microscope;
· Vitrobot Mark IV cryo sample preparation tool;
· Expida 1255S, enhancement to our wafer-level DualBeam line; and
· Titan Krios TEM for high-resolution, automated life sciences applications.
We believe our knowledge of field emission technology and products incorporating focused ion beams remain critical to our performance in the focused charged particle beam business. Drawing on this technology, we have developed a number of product innovations, including:
· the scanning transmission electron microscope (“S/TEM”) system platform with unprecedented stability coupled with aberration correction and monochromator technology, enabling sub-angstrom resolution;
· enhanced robotics, processes and tool connectivity enabling in-line sample liftout and S/TEM imaging from semiconductor wafers for defect analysis and process control applications;
· advanced environmental scanning electron microscope (“ESEM”) detector (the “Helix Detector”) and immersion lens technology, enabling ultra-high resolution SEM imaging at low pressure in the new Nova NanoSEM;
· advanced image processing hardware and software enabling high performance 3D tomographic, TEM based imaging; and
· advanced cryogenic fixation technology and subsequent imaging of aqueous samples at cryo temperatures in a TEM for aqueous biological, and colloidal polymer, pigment and nanoparticle samples.
From time to time, we engage in joint research and development projects with some of our customers and other parties. In Europe, our electron microscope development is conducted in collaboration with universities and research institutions, often supported by European Union research and development programs. We periodically have received public funds under Dutch government and European Union-funded research and development programs, and expect to continue to leverage these funding opportunities in the future. However, these funds have decreased over the past several years and we are not able to predict the amount of future funding. We also maintain other informal collaborative relationships with universities and other research institutions, and we work with several of our customers to evaluate new products.
The markets into which we sell our principal products are subject to rapid technological development, product innovation and competitive pressures. Consequently, we have expended substantial amounts of money on research and development. We generally intend to continue investing in research and development at approximately the current percentage of our net sales and believe that continued investment will be important to our ability to address the needs of our customers and to develop additional product offerings. Research and development efforts continue to be directed toward development of next generation product platforms, new ion and electron columns, beam chemistries, system automation and new applications. We believe these areas hold promise of yielding significant new products and existing product enhancements. Research and development efforts are subject to change due to product evolution and changing market needs. Often, these changes cannot be predicted.
Net research and development expense was $66.0 million in 2007, $57.5 million in 2006 and $56.6 million in 2005.
Manufacturing
We have manufacturing operations located in Hillsboro, Oregon; Eindhoven, the Netherlands; and Brno, Czech Republic. Our system manufacturing operations consist largely of final assembly and the testing of finished products. Product performance is documented and validated with factory acceptance and selective customer witness acceptance tests before these products are shipped. We also fabricate electron and ion source materials and manufacture component products at our facilities in Oregon and the Czech Republic.
We currently use numerous vendors to supply parts, components and subassemblies for the manufacture and support of our products. Some key parts, however, may only be obtained from a single supplier or a limited group of suppliers. In particular, we rely on: VDL Enabling Technologies Group, or ETG, Frencken Mechatronics B.V. and AZD Praha STR for our supply of mechanical parts and subassemblies; Gatan, Inc. for critical accessory products; and Neways Electronics, N.V. for some of our electronic subassemblies. Some of the subcomponents that make up the components and sub-assemblies supplied to us are proprietary in nature and are provided to our suppliers only from single sources. We monitor those parts subject to single or a limited source supply to minimize factory down time due to unavailability of such parts, which could impact our ability to meet manufacturing schedules.
Sales, Marketing and Service
Sales, marketing and service operations are conducted in the U.S. and approximately 50 other countries around the world. We also sell our products through independent agents, distributors and representatives in various additional countries.
Our sales and marketing staff at December 31, 2007 consisted of 358 employees, including account managers, direct salespersons, sales support management, administration, demo lab personnel, marketing support, product managers, product marketing engineers, applications specialists and technical writers. Applications specialists identify and develop new applications for our products, which we expect to further expand our markets. Our sales force and marketing efforts are organized through three geographic sales and services divisions: North America, Europe and the Asia-Pacific region.
We require sales representatives to have the technical expertise and understanding of the businesses of our principal and potential customers to meet the requirements for selling our products. Normally, a sales representative will have the knowledge of, and experience with, our products or similar products, markets or customers at the time the sales representative is hired. We also provide additional training to our sales force on an ongoing basis. Our marketing efforts include presentations at trade shows, advertising in trade journals, development of printed collateral materials, customer forums, public relations efforts in trade media and our website. In addition, our employees publish articles in scientific journals and make presentations at scientific conferences.
In a typical sale, a potential customer is provided with information about our products, including specifications and performance data, by one of our sales representatives. The customer then often participates in a product demonstration at our facilities, using samples provided by the customer. The sales cycle for our systems typically ranges from three to 12 months, but can be longer when our customers are evaluating new applications of our technology.
Our products are sold generally with a 12 month warranty. Customers may purchase service contracts for our products of one year or more in duration after expiration of any warranty. We employ service engineers in each of the three regions in which we have sales and service divisions. We also contract with independent service representatives for product service in some foreign countries.
Competition
The markets for our products are highly competitive. Some of our competitors and potential competitors have greater financial, marketing and production resources than we do. In addition, some of our competitors may cooperate with each other. Additionally, markets for our products are subject to constant change, due in part to evolving customer needs. As we respond to this change, the elements of competition as well as the specific competitors may change. Moreover, one or more of our competitors might achieve a technological advance that would put us at a competitive disadvantage.
Our significant competitors, with respect to the manufacture and sale of equipment, include: JEOL Ltd., Hitachi Ltd., Seiko Instruments Inc., Carl Zeiss SMT A.G. and Orsay Physics S.A. In addition, some of our competitors have formed collaborative relationships and otherwise may cooperate with each other. We believe the key competitive factors are performance, range of features, reliability and price. We believe that we are competitive with respect to each of these factors. Our ability to remain competitive depends in part upon our success in developing new and enhanced systems and introducing these systems at competitive prices on a timely basis.
Our service business faces little significant third-party competition. Because of the highly specialized nature of our products and technology, and because of the critical mass necessary to support a worldwide field service capability, few competitors have emerged to provide service to our installed base of systems. Some of our older, less sophisticated equipment, particularly in the NanoResearch and Industry market, is serviced by independent field service engineers who compete directly with us. We believe we will continue to provide most of the field service for our products.
Patents and Intellectual Property
We rely on a combination of trade secret protection (including use of nondisclosure agreements), trademarks, copyrights and patents to establish and protect our proprietary rights. These intellectual property rights may not have commercial value or may not be sufficiently broad to protect the aspect of our technology to which they relate or competitors may design around the patents. We own, solely or jointly, approximately 138 patents in the U.S. and approximately 188 patents outside of the U.S., many of which correspond to the U.S. patents. Further, we have licenses for additional patents. Our patents expire over a period of time from 2008 to 2027.
Several of our competitors hold patents covering a variety of focused ion beam products and applications and methods of use of focused ion and electron beam products. Some of our customers may use our products for applications that are similar to those covered by these patents. As the number and sophistication of focused ion and electron beam products in the industry increase through the continued introduction of new products by us and others, and the functionality of these products further overlaps, manufacturers and users of ion and electron beam products may become increasingly subject to infringement claims.
We also depend on trade secrets used in the development and manufacture of our products. We endeavor to protect these trade secrets but the measures we have taken to protect these trade secrets may be inadequate or ineffective.
We claim trademarks on a number of our products and have registered some of these marks. Use of the registered and unregistered marks, however, may be subject to challenge with the potential consequence that we would have to cease using marks or pay fees for their use.
Our automation software incorporates software from third-party suppliers, which is licensed to end users along with our proprietary software. We depend on these outside software suppliers to continue to develop automation capacities. The failure of these suppliers to continue to offer and develop software consistent with our automation efforts could undermine our ability to deliver product applications.
Employees
At December 31, 2007, we had 1,820 full-time equivalent, permanent employees and 46 temporary employees worldwide. Some of the 1,219 employees who are employed outside of the U.S. are covered by national, industry-wide agreements or national work regulations that govern various aspects of employment conditions and compensation. None of our U.S. employees are subject to collective bargaining agreements, and we have never experienced a work stoppage, slowdown or strike in any of our worldwide operations. We believe we maintain good employee relations.
Backlog
At December 31, 2007, our total backlog was $310.8 million, which consisted of product and service and components backlog of unfilled orders of $256.1 million and $54.7 million, respectively, compared to $259.1 million and $46.8 million, respectively, at December 31, 2006. Orders received in a particular period that cannot be built and shipped to the customer in that period represent backlog. We only recognize backlog for purchase commitments for which the terms of the sale have been agreed upon, including price, configuration, options and payment terms. Product backlog consists of all open orders meeting these criteria. Service and Components backlog consists of open orders for service, unearned revenue on service contracts and open orders for spare parts. U.S. government backlog is limited to contracted amounts. In addition, some of the U.S. government backlog represents uncommitted funds.
Of our total backlog at December 31, 2007, approximately 90% is expected to be shippable within 12 months and approximately 10% - 15% requires some incremental development. Customers may cancel or delay delivery on previously placed orders, although our standard terms and conditions include penalties for cancellations made close to the scheduled delivery date. As a result, the timing of the receipt of orders or the shipment of products could have a significant impact on our backlog at any date. Historically, cancellations have been minor. From time to time, we have experienced difficulty in shipping our product from backlog due to single-sourcing issues and problems in securing electronic components from a certain vendor. In addition, product shipments have been delayed due to delays in completing certain application development, by our customers pushing out shipments because their facilities are not ready to install our systems and by our own manufacturing delays due to the technical complexity of our products and supply chain issues. For example, a large order from a Canadian university that was announced in 2006, and was planned to ship in the first quarter of 2007, is now expected to ship in the first quarter of 2008. For these and other reasons, the amount of backlog at any date is not necessarily indicative of revenue to be recognized in future periods.
Geographic Revenue and Assets
The following table summarizes sales by geographic region in 2007 (in thousands):
Sales to countries which totaled 10% or more of our total net sales in 2007 were as follows (dollars in thousands):
Our long-lived assets were geographically located as follows at December 31, 2007 (in thousands):
Seasonality
Our history shows that our revenues and bookings normally peak in the fourth quarter. Bookings are normally the lowest in the second quarter and revenues are normally lowest in the third quarter.
In addition, our sales have tended to grow more rapidly from the third to the fourth quarter of the year than in other sequential quarterly periods, primarily because our NanoResearch and Industry customers budget their spending on an annual basis. Correspondingly, the NanoResearch and Industry market has tended to record declines in revenue from the fourth quarter of one year to the first quarter of the next year. These seasonal trends can be offset by numerous other factors, including our introduction of new products, the overall economic cycle and the business cycles in the semiconductor and data storage industries.
Where You Can Find More Information
Our principal executive offices are located at 5350 NE Dawson Creek Drive, Hillsboro, Oregon 97124. Our website is at http://www.fei.com. We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 as amended (“Exchange Act”). We make available free of charge on our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports as soon as reasonably practicable after we file such material with, or furnish it to, the SEC. You can inspect and copy our reports, proxy statements and other information filed with the SEC at the offices of the SEC’s Public Reference Room located at 100 F Street, NE, Washington D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the operation of Public Reference Rooms. The SEC also maintains an Internet website at http://www.sec.gov/ where you can obtain most of our SEC filings. You can also obtain copies of these materials free of charge by contacting our investor relations department at 503-726-7500.
Item 1A.
Item 1A. Risk Factors
A description of the risks and uncertainties associated with our business is set forth below. You should carefully consider such risks and uncertainties, together with the other information contained in this report and in our other public filings. If any of such risks and uncertainties actually occurs, our business, financial condition or operating results could differ materially from the plans, projections and other forward-looking statements included in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report and in our other public filings. In addition, if any of the following risks and uncertainties, or if any other risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which could cause the market price of our stock to decline, perhaps significantly.
Gross margins on our products vary between product lines and markets and, accordingly, changes in product mix will affect our results of operations.
If a higher portion of our net sales in any given period have lower gross margins, our overall gross margins and earnings would be negatively affected. For example, during the second half of 2007, our net sales contained a smaller portion of sales from our relatively higher margin NanoElectronics segment, which contributed to a decrease in our overall gross margins in the second half of 2007 compared to the first half of 2007.
Our business is complex, and changes to the business may not achieve their desired benefits.
Our business is based on a myriad of technologies, encompassed in multiple different product lines, addressing various markets in different regions of the world. A business of our breadth and complexity requires significant management time, attention and resources. In addition, significant changes to our business, such as changes in manufacturing, operations, product lines, market focus or organizational structure or focus, can be distracting, time-consuming and expensive. These changes can have short-term adverse effects on our financial results and may not provide their intended long-term benefits. Failure to achieve these benefits would have a material adverse impact on our financial position, results of operations or cash flow.
We operate in highly competitive industries, and we cannot be certain that we will be able to compete successfully in such industries.
The industries in which we operate are intensely competitive. Established companies, both domestic and foreign, compete with us in each of our product lines. Some of our competitors have greater financial, engineering, manufacturing and marketing resources than we do and may price their products very aggressively. Our significant competitors include: JEOL Ltd., Hitachi Ltd., Seiko Instruments Inc., Carl Zeiss SMT A.G. and Orsay Physics S.A. In addition, some of our competitors have formed collaborative relationships and otherwise may cooperate with each other.
A substantial investment by customers is required for them to install and integrate capital equipment into their laboratories and process applications. As a result, once a manufacturer has selected a particular vendor’s capital equipment, the manufacturer generally relies on that equipment for a specific production line or process control application and frequently will attempt to consolidate its other capital equipment requirements with the same vendor. Accordingly, if a particular customer selects a competitor’s capital equipment, we expect to experience difficulty selling to that customer for a significant period of time.
Our ability to compete successfully depends on a number of factors both within and outside of our control, including:
· price;
· product quality;
· breadth of product line;
· system performance;
· ease of use;
· cost of ownership;
· global technical service and support;
· success in developing or otherwise introducing new products; and
· foreign currency movements.
We cannot be certain that we will be able to compete successfully on these or other factors, which could negatively impact our revenues, gross margins and net income in the future.
Because many of our shipments occur in the last month of a quarter, we are at risk of one or more transactions not being delivered according to forecast.
We have historically shipped approximately 75% of our products in the last month of each quarter. As any one shipment may be significant to meeting our quarterly sales projection, any slippage of shipments into a subsequent quarter may result in our not meeting our quarterly sales projection, which may adversely impact our results of operations for the quarter.
Because we have significant operations outside of the U.S., we are subject to political, economic and other international conditions that could result in increased operating expenses and regulation of our products and increased difficulty in maintaining operating and financial controls.
Since a significant portion of our operations occur outside of the U.S., our revenues and expenses are impacted by foreign economic and regulatory conditions. Approximately 61% and 65%, respectively, of our revenues in the years ended December 31, 2007 and 2006 came from outside of the U.S. We have manufacturing facilities in Brno, Czech Republic and Eindhoven, the Netherlands and sales offices in many other countries.
Moreover, we operate in 50 countries, 29 with a direct presence and an additional 21 via sales agents. Some of our global operations are geographically isolated, are distant from corporate headquarters and/or have little infrastructure support. Therefore, maintaining and enforcing operating and financial controls can be difficult. Failure to maintain or enforce controls could have a material adverse effect on our control over service inventories, quality of service, customer relationships and financial reporting.
Our exposure to the business risks presented by foreign economies will increase to the extent we continue to expand our global operations. International operations will continue to subject us to a number of risks, including:
· longer sales cycles;
· multiple, conflicting and changing governmental laws and regulations;
· protectionist laws and business practices that favor local companies;
· price and currency exchange rates and controls;
· taxes and tariffs;
· export restrictions;
· difficulties in collecting accounts receivable;
· travel and transportation difficulties resulting from actual or perceived health risks (e.g., SARS and avian influenza);
· changes in the regulatory environment in countries where we do business could lead to delays in the importation of products into those countries;
· the implementation of China RoHS regulations could lead to delays in the importation of products into China;
· political and economic instability; and
· risk of failure of internal controls and failure to detect unauthorized transactions.
If our customers cancel or reschedule orders or if an anticipated order for even one of our systems is not received in time to permit shipping during a certain fiscal period, our operating results for that fiscal period may fluctuate and our business and financial results for such period could be materially and adversely affected.
Our customers are able to cancel or reschedule orders, generally with limited or no penalties, depending on the product’s stage of completion. The amount of purchase orders at any particular date, therefore, is not necessarily indicative of sales to be made in any given period. Our build cycle, or the time it takes us to build a product to customer specifications, typically ranges from one to six months. During this period, the customer may cancel the order, although generally we will be entitled to receive a cancellation fee based on the agreed-upon shipment schedule. In addition, we derive a substantial portion of our net sales in any fiscal period from the sale of a relatively small number of high-priced systems, with a large portion in the last month of the quarter. Further, in some cases, our customers have to make changes to their facilities to accommodate the site requirements for our systems and may reschedule their orders because of the time required to complete these facility changes. This is particularly true of the high-performance TEMs. As a result, the timing of revenue recognition for a single transaction could have a material effect on our revenue and results of operations for a particular fiscal period.
Due to these and other factors, our net revenues and results of operations have fluctuated in the past and are likely to fluctuate significantly in the future on a quarterly and annual basis. It is possible that in some future quarter or quarters our results of operations will be below the expectations of public market analysts or investors. In such event, the market price of our common stock may decline significantly.
Due to our extensive international operations and sales, we are exposed to foreign currency exchange rate risks that could adversely affect our revenues, gross margins and results of operations.
A significant portion of our sales and expenses are denominated in currencies other than the U.S. dollar, principally the euro. For the year ended December 31, 2007 and the year ended December 31, 2006, approximately 30% to 40% of our revenue was denominated in euros, while more than half of our expenses were denominated in euros or other foreign currencies. Particularly as a result of this imbalance, changes in the exchange rate between the U.S. dollar and foreign currencies, especially the euro, can impact our revenues, gross margins, results of operations and cash flows. We undertake hedging transactions to limit our exposure to changes in the dollar/euro exchange rate. The hedges are designed to protect us as the dollar weakens but also provide us with some flexibility if the dollar strengthens.
We enter into various forward extra contracts, which are a combination of a foreign forward exchange contract and an option, as well as standard option contracts, to partially mitigate the impact of changes in the euro against the dollar on our European operating results. We are evaluating the use of other forms of contracts in addition to, or as a substitute to, the forward extra contracts as we move into 2008. These contracts are considered derivatives. We are required to carry all open derivative contracts on our balance sheet at fair value. When specific accounting criteria have been met, derivative contracts can be designated as hedging instruments and changes in fair value related to these derivative contracts are recorded in other comprehensive income, rather than net income, until the underlying hedged transaction affects net income. When the designated hedges mature, they are recorded in cost of goods sold. We are required to record changes in fair value for derivatives not designated as hedges in net income in the current period. Prior to the second quarter of fiscal 2004, none of our derivative contracts were designated as hedges and all realized and unrealized gains and losses were recognized in net income in the current period. Our ability to designate derivative contracts as hedges significantly reduces the volatility in our operating results due to changes in the fair value of the derivative contracts.
Achieving hedge designation is based on evaluating the effectiveness of the derivative contracts’ ability to mitigate the foreign currency exposure of the linked transaction. We are required to monitor the effectiveness of all new and open derivative contracts designated as hedges on a quarterly basis. Based
on our evaluation in 2005, we recorded charges totaling $0.5 million in other income (expense) related to hedge dedesignations and ineffectiveness. We did not record any charges for hedge dedesignations or ineffectiveness in 2007 or 2006. Failure to meet the hedge accounting requirements could result in the requirement to record deferred and current realized and unrealized gains and losses into net income in the current period. This failure could result in significant fluctuations in operating results. In addition, we will continue to recognize unrealized gains and losses related to the changes in fair value of derivative contracts not designated as hedges in the current period net income. Accordingly, the related impact to operating results may be recognized in a different period than the foreign currency impact of the linked asset, liability or transaction.
We also enter into foreign forward exchange contracts to partially mitigate the impact of specific cash, receivables or payables positions denominated in foreign currencies. Foreign currency losses recorded in other income (expense), inclusive of the impact of derivatives which are not designated as hedges, totaled $3.1 million and $1.9 million, respectively, in 2007 and 2006.
We rely on a limited number of parts, components and equipment manufacturers. Failure of any of these suppliers to provide us with quality products in a timely manner could negatively affect our revenues and results of operations.
Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business, including our ability to convert backlog into revenue. We currently use numerous vendors to supply parts, components and subassemblies for the manufacture and support of our products. Some key parts, however, may only be obtained from a single supplier or a limited group of suppliers. In particular, we rely on: VDL Enabling Technologies Group, or ETG, Frencken Mechatronics B.V. and AZD Praha STR for our supply of mechanical parts and subassemblies; Gatan, Inc. for critical accessory products; and Neways Electronics, N.V. for some of our electronic subassemblies. In addition, some of our suppliers rely on sole suppliers. As a result of this concentration of key suppliers, our results of operations may be materially and adversely affected if we do not timely and cost-effectively receive a sufficient quantity of quality parts to meet our production requirements or if we are required to find alternative suppliers for these supplies. We may not be able to expand our supplier group or to reduce our dependence on single suppliers. If our suppliers are not able to meet our supply requirements, constraints may affect our ability to deliver products to customers in a timely manner, which could have an adverse effect on our results of operations. In addition, world wide restrictions governing the use of certain hazardous substances in electrical and electronic equipment (Restrictions on Hazardous Substances, or “RoHS,” regulations) may impact parts and component availability or our electronics suppliers’ ability to source parts and components in a timely and cost-effective manner. Overall, because we only have a few equipment suppliers, we may be more exposed to future cost increases for this equipment.
Our acquisition and investment strategy subjects us to risks associated with evaluating and pursuing these opportunities and integrating these businesses.
In addition to our efforts to develop new technologies from internal sources, we also may seek to acquire new technologies or operations from external sources. As part of this effort, we may make acquisitions of, or make significant debt and equity investments in, businesses with complementary products, services and/or technologies. Acquisitions can involve numerous risks, including management issues and costs in connection with the integration of the operations and personnel, technologies and products of the acquired companies, the possible write-downs of impaired assets and the potential loss of key employees of the acquired companies. The inability to effectively manage any of these risks could seriously harm our business. Additionally, difficulties in integrating any potential acquisitions into our internal control structure could result in a failure of our internal control over financial reporting, which, in turn, could create a material weakness.
During the fourth quarter of 2006, we sold one such investment, Knights Technology. During the third quarter of 2006, we sold a cost-method investment for a gain of $5.2 million and wrote-off the remaining such investments, incurring an aggregate charge of $3.9 million.
To the extent we make investments in entities that we control, or have significant influence in, our financial results will reflect our proportionate share of the financial results of the entity.
The industries in which we sell our products are cyclical, which may cause our results of operations to fluctuate.
Our business depends in large part on the capital expenditures of customers within our NanoElectronics, NanoResearch and Industry and NanoBiology market segments, which, along with Service and Components sales, accounted for the following amounts (in thousands) and percentages of our net sales for the periods indicated:
The largest sub-parts of the NanoElectronics market are the semiconductor and data storage industries. These industries are cyclical and have experienced significant economic downturns at various times in the last decade. Such downturns have been characterized by diminished product demand, accelerated erosion of average selling prices and production overcapacity. A downturn in one or both of these industries, or the businesses of one or more of our customers, could have a material adverse effect on our business, prospects, financial condition and results of operations. In the second half of 2007, we experienced a significant decline in bookings and revenue in our NanoElectronics segment due to a general decline in semiconductor and data storage capital equipment spending. Global economic conditions continue to be volatile and slower growth or reduced demand for our customers’ products in the future would cause our business to decline. During downturns, our sales and gross profit margins generally decline.
The NanoResearch and Industry market is also affected by overall economic conditions, but is not as cyclical as the NanoElectronics market. However, NanoResearch and Industry customer spending is highly dependent on governmental and private funding levels and timing, which can vary depending on budgetary or economic constraints.
The NanoBiology market is a smaller and emerging market, and the tools we sell into that market often have average selling prices of over $1.0 million. Consequently, loss of demand among a relatively small group of potential customers can have a material impact on the overall demand for our products. As a result, movement of a small number of sales from one quarter to the next could cause significant variability in quarter-to-quarter growth rates, even as we believe that this market has the potential for long-term growth.
As a capital equipment provider, our revenues depend in large part on the spending patterns of our customers, who often delay expenditures or cancel orders in reaction to variations in their businesses or general economic conditions. Because a high proportion of our costs are fixed, we have a limited ability to reduce expenses quickly in response to revenue shortfalls. In a prolonged economic downturn, we may not be able to reduce our significant fixed costs, such as manufacturing overhead, capital equipment or research and development costs, which may cause our gross margins to erode and our net loss to increase or earnings to decline.
Our history shows that our revenues and bookings normally peak in the fourth quarter. Bookings are normally the lowest in the second quarter and revenues are normally lowest in the third quarter.
The loss of one or more of our key customers would result in the loss of significant net revenues.
A relatively small number of customers account for a large percentage of our net revenues, although no customer has accounted for more than 10% of total net revenues in the recent past. Our business will be seriously harmed if we do not generate as much revenue as we expect from these key customers, if we experience a loss of any of our key customers or if we suffer a substantial reduction in orders from these customers. Our ability to continue to generate revenues from our key customers will depend on our ability to introduce new products that are desirable to these customers.
Because we do not have long-term contracts with our customers, our customers may stop purchasing our products at any time, which makes it difficult to forecast our results of operations and to plan expenditures accordingly.
We do not have long-term contracts with our customers. Accordingly:
· customers can stop purchasing our products at any time without penalty;
· customers may cancel orders that they previously placed;
· customers may purchase products from our competitors;
· we are exposed to competitive pricing pressure on each order; and
· customers are not required to make minimum purchases.
If we do not succeed in obtaining new sales orders from existing customers, our results of operations will be negatively impacted.
Many of our projects are funded under federal, state and local government contracts and if we are found to have violated the terms of the government contracts or applicable statutes and regulations, we are subject to the risk of suspension or debarment from government contracting activities, which could have a material adverse effect on our business and results of operations.
Many of our projects are funded under federal, state and local government contracts worldwide. Government contracts are subject to specific procurement regulations, contract provisions and requirements relating to the formation, administration, performance and accounting of these contracts. Many of these contracts include express or implied certifications of compliance with applicable laws and contract provisions. As a result of our government contracting, claims for civil or criminal fraud may be brought by the government for violations of these regulations, requirements or statutes. Further, if we fail to comply with any of these regulations, requirements or statutes, our existing government contracts could be terminated, we could be suspended or debarred from government contracting or subcontracting, including federally funded projects at the state level. If one or more of our government contracts are terminated for any reason, or if we are suspended from government work, we could suffer the loss of the contracts, which could have a material adverse effect on our business and results of operations.
Changes and fluctuations in government spending priorities could adversely affect our revenue.
Because a significant part of our overall business is generated either directly or indirectly as a result of worldwide federal and local government regulatory and infrastructure priorities, shifts in these priorities due to changes in policy imperatives or economic conditions, which are often unpredictable, may affect our revenues.
Political instability in key regions around the world coupled with the U.S. government’s commitment to military related expenditures put at risk federal discretionary spending, including spending on nanotechnology research programs and projects that are of particular importance to our business. Also, changes in U.S. Congressional appropriations practices could result in decreased funding for some of our customers. At the state and local levels, the need to compensate for reductions in federal matching funds,
as well as financing of federal unfunded mandates, creates strong pressures to cut back on research expenditures as well. A potential reduction of federal funding may adversely affect our business.
We have long sales cycles for our systems, which may cause our results of operations to fluctuate and could negatively impact our stock price.
Our sales cycle can be 12 months or longer and is unpredictable. Variations in the length of our sales cycle could cause our net sales and, therefore, our business, financial condition, results of operations, operating margins and cash flows, to fluctuate widely from period to period. These variations could be based on factors partially or completely outside of our control.
The factors that could affect the length of time it takes us to complete a sale depend on many elements, including:
· the efforts of our sales force and our independent sales representatives;
· changes in the composition of our sales force, including the departure of senior sales personnel;
· the history of previous sales to a customer;
· the complexity of the customer’s manufacturing processes;
· the introduction, or announced introduction, of new products by our competitors;
· the economic environment;
· the internal technical capabilities and sophistication of the customer; and
· the capital expenditure budget cycle of the customer.
Our sales cycle also extends in situations where the sale involves developing new applications for a system or technology. As a result of these and a number of other factors that could influence sales cycles with particular customers, the period between initial contact with a potential customer and the time when we recognize revenue from that customer, if we ever do, may vary widely.
The loss of key management or our inability to attract and retain managerial, engineering and other technical personnel could have a material adverse effect on our business, financial condition and results of operations.
Attracting qualified personnel is difficult, and our recruiting efforts may not be successful. Specifically, our product generation efforts depend on hiring and retaining qualified engineers. The market for qualified engineers is very competitive. In addition, experienced management and technical, marketing and support personnel in the technology industry are in high demand, and competition for such talent is intense. The loss of key personnel, or our inability to attract key personnel, could have an adverse effect on our business, financial condition or results of operations.
Our customers experience rapid technological changes, with which we must keep pace, but we may be unable to introduce new products on a timely and cost-effective basis to meet such changes.
Customers in each of our market segments experience rapid technological change and new product introductions and enhancements. Our ability to remain competitive depends in large part on our ability to develop, in a timely and cost-effective manner, new and enhanced systems at competitive prices and to accurately predict technology transitions. In addition, new product introductions or enhancements by competitors could cause a decline in our sales or a loss of market acceptance of our existing products. Increased competitive pressure also could lead to intensified price competition, resulting in lower margins, which could materially adversely affect our business, prospects, financial condition and results of operations.
Our success in developing, introducing and selling new and enhanced systems depends on a variety of factors, including:
· selection and development of product offerings;
· timely and efficient completion of product design and development;
· timely and efficient implementation of manufacturing processes;
· effective sales, service and marketing functions; and
· product performance.
Because new product development commitments must be made well in advance of sales, new product decisions must anticipate both the future demand for products under development and the equipment required to produce such products. We cannot be certain that we will be successful in selecting, developing, manufacturing and marketing new products or in enhancing existing products. On occasion, certain product and application development has taken longer than expected. These delays can have an adverse affect on product shipments and results of operations.
The process of developing new high technology capital equipment products and services is complex and uncertain, and failure to accurately anticipate customers’ changing needs and emerging technological trends, to complete engineering and development projects in a timely manner and to develop or obtain appropriate intellectual property could significantly harm our results of operations. We must make long-term investments and commit significant resources before knowing whether our predictions will result in products that the market will accept. For example, we have invested substantial resources in our new Phenom desk top imaging tool and the Titan scanning electron microscope (“S/TEM”), and further development may be required to take full advantage of these products. If the completion of further development is delayed, potential revenue growth could be deferred or may not happen at all.
To the extent that a market does not develop for a new product, we may decide to discontinue or modify the product. These actions could involve significant costs and/or require us to take charges in future periods. If these products are accepted by the marketplace, sales of our new products may cannibalize sales of our existing products. Further, after a product is developed, we must be able to manufacture sufficient volume quickly and at low cost. To accomplish this objective, we must accurately forecast production volumes, mix of products and configurations that meet customer requirements. If we are not successful in making accurate forecasts, our business and results of operations could be significantly harmed.
If third parties assert that we violate their intellectual property rights, our business and results of operations may be materially adversely affected.
Several of our competitors hold patents covering a variety of technologies that may be included in some of our products. In addition, some of our customers may use our products for applications that are similar to those covered by these patents. From time to time, we and our respective customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. To date, none of these allegations has resulted in litigation. Our competitors or other entities may, however, assert infringement claims against us or our customers in the future with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. Additionally, if claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur.
If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, these potential infringement claims could have a material adverse effect on our business, prospects, financial condition and results of operations.
We may not be able to enforce our intellectual property rights, especially in foreign countries, which could materially adversely affect our business.
Our success depends in large part on the protection of our proprietary rights. We incur significant costs to obtain and maintain patents and defend our intellectual property. We also rely on the laws of the U.S. and other countries where we develop, manufacture or sell products to protect our proprietary rights. We may not be successful in protecting these proprietary rights, these rights may not provide the competitive advantages that we expect or other parties may challenge, invalidate or circumvent these rights.
Further, our efforts to protect our intellectual property may be less effective in some countries where intellectual property rights are not as well protected as they are in the U.S. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. We derived approximately 61% and 65%, respectively, of our sales from foreign countries in the years ended December 31, 2007 and 2006. If we fail to adequately protect our intellectual property rights in these countries, our business may be materially adversely affected.
Infringement of our proprietary rights could result in weakened capacity to compete for sales and increased litigation costs, both of which could have a material adverse effect on our business, prospects, financial condition and results of operations.
We are substantially leveraged, which could adversely affect our ability to adjust our business to respond to competitive pressures and to obtain sufficient funds to satisfy our future manufacturing capacity and research and development needs.
We have significant indebtedness. As of December 31, 2007, we had total convertible long-term debt of approximately $195.9 million due in 2008 and $115.0 million due in 2013. In January 2008, we paid off $45.9 million of the indebtedness due in 2008 and have funds available to pay off the additional $150.0 million that is due in June 2008. The degree to which we are leveraged could have important consequences, including but not limited to the following:
· our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate or other purposes may be limited;
· our shareholders would be diluted if we elect to settle all or a portion of our zero coupon convertible notes in shares, up to a maximum aggregate of 5,528,527 shares of our common stock, upon the bondholders’ election to convert the notes once certain stock price metrics are met. These shares were included in our diluted share count for the years ended December 31, 2007 and 2006;
· our shareholders would be diluted if holders of all or a portion of our 2.875% subordinated convertible notes elect to convert their notes, up to a maximum aggregate of 3,918,395 shares of our common stock. These shares were included in our diluted share count for the year ended December 31, 2007;
· a substantial portion of our cash and short-term investments as of December 31, 2007 will be dedicated to the payment of the principal of, and interest on, our indebtedness; and
· we may be more vulnerable to economic downturns, less able to withstand competitive pressures and less flexible in responding to changing business and economic conditions.
Our ability to pay interest and principal on our debt securities, to satisfy our other debt obligations and to make planned expenditures will be dependent on our future operating performance, which could be affected by changes in economic conditions and other factors, some of which are beyond our control. A failure to comply with the covenants and other provisions of our debt instruments could result in events of default under such instruments, which could permit acceleration of the debt under such instruments and in some cases acceleration of debt under other instruments that contain cross-default or cross-acceleration provisions. If we are at any time unable to generate sufficient cash flow from operations to service our indebtedness, we may be required to attempt to renegotiate the terms of the instruments relating to the indebtedness, seek to refinance all or a portion of the indebtedness or obtain additional
financing. We cannot assure you that we will be able to successfully renegotiate such terms, that any such refinancing would be possible or that any additional financing could be obtained on terms that are favorable or acceptable to us.
At December 31, 2007, we held $118.1 million in auction rate securities (“ARS”) which we classified as current assets. The ARS held by us have long-term stated maturities for which the interest rates are reset through a Dutch auction generally every 28 days. The auctions have historically provided a liquid market for these securities as investors could readily sell their investments at auction. Subsequent to December 31, 2007, we began to exit our position in these securities. As of February 25, 2008, we had successfully liquidated $8.0 million of these securities, leaving us with $110.1 million invested in ARS.
With the liquidity issues experienced in global credit and capital markets, the ARS held by us have experienced multiple failed auctions, beginning on February 19, 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders. We expect additional auction failures during the remainder of February and March 2008, which will require us to hold the securities until liquidity is restored to the credit markets or the securities are redeemed or mature.
If uncertainties in the credit and capital markets continue, these markets deteriorate further or there are any ratings downgrades on any ARS we hold, we may be required to reclassify these investments from short-term to long-term investments. In addition, if the failed auctions or any downgrades are deemed to cause an “other than temporary impairment” of our ARS, we may be required to re-value the ARS at some amount below par. Any re-valuation of ARS that are other than temporarily impaired will flow through our operations statement and affect our earnings.
We may have exposure to income tax rate fluctuations as well as to additional tax liabilities, which would impact our financial position.
As a corporation with operations both in the U.S. and abroad, we are subject to income taxes in both the U.S. and various foreign jurisdictions. Our effective tax rate is subject to fluctuation as the income tax rates for each year are a function of the following factors, among others:
· the effects of a mix of profits or losses earned by us and our subsidiaries in numerous foreign tax jurisdictions with a broad range of income tax rates;
· our ability to utilize recorded deferred tax assets;
· changes in uncertain tax positions, interest or penalties resulting from tax audits; and
· changes in tax laws or the interpretation of such laws.
Changes in the mix of these items and other items may cause our effective tax rate to fluctuate between periods, which could have a material adverse effect on our financial results.
We are also subject to non-income taxes, such as payroll, sales, use, value-added, net worth, property and goods and services taxes, in both the U.S. and various foreign jurisdictions.
We are regularly under audit by tax authorities with respect to both income and non-income taxes and may have exposure to additional tax liabilities as a result of these audits.
Significant judgment is required in determining our provision for income taxes and other tax liabilities. Although we believe that our tax estimates are reasonable, we cannot assure you that the final determination of tax audits or tax disputes will not be different from what is reflected in our historical income tax provisions and accruals.
Many of our current and planned products are highly complex and may contain defects or errors that can only be detected after installation, which may harm our reputation.
Our products are highly complex, and our extensive product development, manufacturing and testing processes may not be adequate to detect all defects, errors, failures and quality issues that could impact customer satisfaction or result in claims against us. As a result, we could have to replace certain components and/or provide remediation in response to the discovery of defects in products after they are shipped. The occurrence of any defects, errors, failures or quality issues could result in cancellation of orders, product returns, diversion of our resources, legal actions by our customers and other losses to us or to our customers. These occurrences could also result in the loss of, or delay in, market acceptance of
our products and loss of sales, which would harm our business and adversely affect our revenues and profitability.
Issues arising from our enterprise resource planning system could affect our operating results and ability to manage our business effectively.
Our ability to design, manufacture, market and service products and systems is dependent on information technology systems that encompass all of our major business functions. In 2005, we abandoned the implementation of an Oracle-based enterprise resource planning (“ERP”) software system.
In lieu of the abandoned project, we have undertaken to update and upgrade certain components of our existing system and to add additional functionality. Updating our existing system presents the potential for additional difficulties. Moreover, if the existing system, as updated, is not sufficient to meet our needs, it could adversely affect our ability to do the following in a timely manner: manage and replenish inventory; fulfill and process orders; manufacture and ship products in a timely manner; invoice and collect receivables; place purchase orders and pay invoices; coordinate sales and marketing activities; prepare our financial statements and manage our accounting systems and controls; and otherwise carry on our business in the ordinary course. Any such disruption could adversely affect our business, prospects, financial condition and results of operations. Moreover, difficulties arising from the ERP system could result in a failure of our internal control over financial reporting, which, in turn, could result in a material weakness and a qualified report from our independent registered public accounting firm.
We may have underestimated past restructuring charges or we may incur future restructuring and asset impairment charges, either of which may adversely impact our results of operations.
In 2006, we recorded restructuring, reorganization, relocation and severance charges of $12.6 million, of which $3.3 million was for facilities and severance charges related to the closure of certain of our European field offices, the closure of our Tempe, Arizona research and development facility, as well as residual costs related to the Peabody, Massachusetts plant closure and the downsizing of the related semiconductor businesses, and $9.3 million was related to the termination of our former Chief Executive Officer. Of the $9.3 million charge, $2.2 million was cash compensation and $7.1 million was non-cash stock-based compensation. We may incur additional restructuring and related expenses, which may have a material adverse effect on our business, financial condition or results of operations. The charges in connection with these restructurings are only estimates and may not be accurate. As part of these restructurings, we ceased to use certain of our leased facilities and, accordingly, we have negotiated, and are continuing to negotiate, certain lease terminations and/or subleases of our facilities. We cannot predict when or if we will be successful in negotiating lease termination agreements or subleases of our facilities on terms acceptable to us. If we are not successful in negotiating terms acceptable to us, or at all, we may be required to materially increase our restructuring and related expenses in future periods. Further, if we have additional reductions to our workforce or consolidate additional facilities in the future we may incur additional restructuring and related expenses, which could have a material adverse effect on our business, financial condition or results of operations.
In addition, we test our goodwill and other intangible assets for impairment annually or when an event occurs indicating the potential for impairment. If we record an impairment charge as a result of this analysis, it could have a material impact on our results of operations. We could also incur material charges as a result of write-downs of inventories or other tangible assets.
Any failure by us to execute planned cost reductions successfully could result in total costs and expenses that are greater than expected.
We have undertaken restructuring plans to bring operational expenses to appropriate levels for our business. In 2005, we took significant restructuring charges in connection with the closing of our Peabody, Massachusetts plant and otherwise. We may have further workforce reductions or rebalancing actions in the future. Significant risks associated with these actions and other workforce management
issues that may impair our ability to achieve anticipated cost reductions or that may otherwise harm our business include delays in implementation of anticipated workforce reductions in highly regulated locations outside of the U.S., particularly in Europe and Asia, redundancies among restructuring programs, decreases in employee morale and the failure to meet operational targets due to the loss of employees, particularly sales and service employees and engineers.
Changes in accounting pronouncements or taxation rules or practices may affect how we conduct our business.
Changes in accounting pronouncements or taxation rules or practices can have a significant effect on our reported results. Other new accounting pronouncements or taxation rules and varying interpretations of accounting pronouncements or taxation practices have occurred and may occur in the future. New rules, changes to existing rules, if any, or the questioning of current practices may adversely affect our reported financial results or change the way we conduct our business.
Terrorist acts, acts of war and natural disasters may seriously harm our business and revenues, costs and expenses and financial condition.
Terrorist acts, acts of war and natural disasters, wherever located around the world, may cause damage or disruption to us or our employees, facilities, partners, suppliers, distributors and customers, any and all of which could significantly impact our revenues, expenses and financial condition. This impact could be disproportionately greater on us than on other companies as a result of our significant international presence. The potential for future terrorist attacks, the national and international responses to terrorist attacks and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations in ways that cannot presently be predicted. We are largely uninsured for losses and interruptions caused by terrorist acts, acts of war and natural disasters, including at our headquarters located in Oregon, which is in a region subject to earthquakes.
Some of our systems use hazardous gases and emit x-rays, which, if not properly contained, could result in property damage, bodily injury and death.
A hazardous gas or x-ray leak could result in substantial liability and could also significantly damage customer relationships and disrupt future sales. Moreover, remediation could require redesign of the tools involved, creating additional expense, increasing tool costs and damaging sales. In addition, the matter could involve significant litigation that would divert management time and resources and cause unanticipated legal expense. Further, if such a leak involved violation of health and safety laws, we may suffer substantial fines and penalties in addition to the other damage suffered.
Unforeseen health, safety and environmental costs could impact our future net earnings.
Some of our operations use substances that are regulated by various federal, state and international laws governing health, safety and the environment. We could be subject to liability if we do not handle these substances in compliance with safety standards for storage and transportation and applicable laws. It is our policy to apply strict standards for environmental protection to sites inside and outside the U.S., even when not subject to local government regulations. We will record a liability for any costs related to health, safety or environmental remediation when we consider the costs to be probable and the amount of the costs can be reasonably estimated.
We may not be successful in obtaining the necessary export licenses to conduct operations abroad, and the U.S. Congress may prevent proposed sales to foreign customers.
We are subject to export control laws that limit which products we sell and where and to whom we sell our products. Moreover, export licenses are required from government agencies for some of our products in accordance with various statutory authorities, including the Export Administration Act of 1979, the International Emergency Economic Powers Act of 1977, the Trading with the Enemy Act of 1917 and the
Arms Export Control Act of 1976. We may not be successful in obtaining these necessary licenses in order to conduct business abroad. Failure to comply with applicable export controls or the termination or significant limitation on our ability to export certain of our products would have an adverse effect on our business, results of operations and financial condition.
Provisions of our charter documents, our shareholder rights plan and Oregon law could make it more difficult for a third party to acquire us, even if the offer may be considered beneficial by our shareholders.
Our articles of incorporation and bylaws contain provisions that could make it harder for a third party to acquire us without the consent of our Board of Directors. Our Board of Directors has also adopted a shareholder rights plan, or “poison pill,” which would significantly dilute the ownership of a hostile acquirer. In addition, the Oregon Control Share Act and the Oregon Business Combination Act limit the ability of parties who acquire a significant amount of voting stock to exercise control over us. These provisions may have the effect of lengthening the time required for a person to acquire control of us through a proxy contest or the election of a majority of our Board of Directors, may deter efforts to obtain control of us and may make it more difficult for a third party to acquire us without negotiation. These provisions may apply even if the offer may be considered beneficial by our shareholders.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Our corporate headquarters is located in a facility we own in Hillsboro, Oregon. This facility totals approximately 180,000 square feet and houses a range of activities, including manufacturing, research and development, corporate finance and administration and sales and marketing.
We also maintain a major facility in Eindhoven, the Netherlands, consisting of 244,169 square feet of space. The lease for this space expires in 2018. Present lease payments are approximately $290,000 per month. This facility is used for research and development, manufacturing, sales, marketing and administrative functions.
We maintain a manufacturing and development facility in Brno, Czech Republic, which consists of 92,570 square feet of space, and is leased for approximately $140,000 per month. The lease expires in 2012.
We operate sales and service offices in leased facilities in the People’s Republic of China (“PRC”), Japan, Hong Kong, Singapore, the Netherlands, the United Kingdom and the U.S., as well as other smaller offices in the other countries where we have direct sales and service operations. In some of these locations, we lease space directly. In other locations, we obtain space through service agreements with affiliates of Koninklijke Philips Electronics N.V. (“Philips”). We closed several European sales offices and consolidated these operations into our offices in the Netherlands in the first half of 2006. We expect that our facilities arrangements will be adequate to meet our needs for the foreseeable future and, overall, believe we can meet increased demand for facilities that may be required to meet increased demand for our products. In addition, we believe that if product demand increases, we can use outsourced manufacturing of spare parts, additional manufacturing shifts and currently underutilized space as a means of adding capacity without increasing our direct investment in additional facilities.
Item 3.
Item 3. Legal Proceedings
As of the date hereof, there is no material litigation pending against us. From time to time, we become party to litigation and subject to claims arising in the ordinary course of our business. To date, these actions have not had a material adverse effect on our business, financial position, results of operations or cash flows, and although the results of litigation and claims cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our business, financial position, results of operations or cash flows.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our shareholders during the fourth quarter ended December 31, 2007.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Stock Prices, Issuances of Common Stock and Dividends
Our common stock is quoted on the Nasdaq Global Market under the symbol FEIC. The high and low sales prices on the Nasdaq Global Market for the past two years were as follows:
The approximate number of beneficial shareholders and shareholders of record at February 26, 2008 was 11,400 and 101, respectively.
In February 1997, we acquired the electron optics business of Philips pursuant to a combination agreement between us and a subsidiary of Philips. We issued shares of our common stock to Philips at the time of the combination and agreed to issue additional shares of our common stock when stock options that were outstanding on the date of the closing of the combination (February 21, 1997) are exercised. The additional shares are issued at a rate of approximately 1.22 shares to Philips for each share issued on exercise of these options. During 2007, we did not issue any shares of our common stock to Philips in connection with this agreement and, as of December 31, 2007, 185,000 shares of our common stock remained issuable under this agreement.
We did not pay or declare any cash dividends in 2007 or 2006. We intend to retain any earnings for use in our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future.
Equity Compensation Plans
Information regarding securities authorized for issuance under equity compensation plans will be included in the section titled “Securities Authorized for Issuance Under Equity Compensation Plans” in the proxy statement for our 2008 Annual Meeting of Shareholders and is incorporated by reference herein.
Stock Performance Graph
The following line-graph presentation compares cumulative five-year shareholder returns on an indexed basis, assuming a $100 initial investment and reinvestment of dividends, of (a) FEI Company, (b) a broad-based equity market index and (c) an industry-specific index. The broad-based market index used is the Nasdaq Stock Market Total Return Index - U.S. and the industry-specific index used is the Nasdaq Non-Financial Index.
Item 6.
Item 6. Selected Financial Data
The selected consolidated financial data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.
(1) Included in 2005 cost of sales was $14.2 million of inventory write-downs related to the closure of our Peabody, Massachusetts facility, the relocation and refocus of the product lines that were at that facility, a price adjustment on a product sale from that operation and capitalized software impairment charges related to certain semiconductor products.
(2) Included in 2006 operating expenses were the following:
· restructuring, reorganization, relocation and severance charges of $12.6 million;
· merger costs of $0.5 million;
· asset impairment charges of $0.5 million; and
· a $1.5 million gain related to the sale of certain intellectual property rights to a privately-held company.
Included in 2005 operating expenses were the following:
· $25.4 million of asset impairment charges primarily related to semiconductor products and the write-off of all costs related to our ERP system as we determined that the future cost required to complete the ERP system did not justify the potential return; and
· $8.5 million of restructuring charges, primarily for severance, lease terminations and relocation expenses for the closure of our Peabody facility and consolidation of certain of our European facilities.
Included in 2004 operating expenses was a $0.6 million charge for restructuring, reorganization and relocation.
Included in 2003 operating expenses was a $1.7 million charge for restructuring, reorganization and relocation related to our fourth quarter 2002 and second quarter 2003 restructuring and reorganization plans, plus $1.2 million for the write-off of in-process purchased technology.
(3) Included in other income (expense), net in 2007 were a $0.5 million gain related to the disposal of one of our cost-based investments and a $0.5 million gain on the sale of a minority interest in a small technology company.
Included in other income (expense), net in 2006 were the following that affect comparability:
· interest expense of $0.5 million in the first half of 2006 related to the repurchase of $29.0 million face value of our 5.5% convertible notes;
· a $5.2 million gain related to the sale of our entire ownership interest in a privately-held company in the third quarter of 2006; and
· a $3.9 million charge related to the write-off of our equity and debt investment in a privately-held company in the third quarter of 2006.
Included in 2005 other income (expense), net was $6.4 million for realized losses on investments in privately-held companies and the write-down of certain of these investments for which we concluded an “other-than-temporary” impairment existed.
Included in 2003 other income (expense), net was $3.5 million related to currency and hedging gains.
(4) Our 2007 tax provision on income from continuing operation reflected taxes on foreign earnings offset by a $4.7 million release of unrecognized tax benefits, including interest and penalties, as a result of the settlement of foreign tax audits and a tax benefit of $5.3 million related to the release of valuation allowance recorded against net operating loss deferred tax assets utilized to offset income earned in the U.S. . Our 2006 tax provision consisted primarily of taxes accrued in foreign jurisdictions and reflects a benefit of $1.5 million related to the release of valuation allowances against a portion of U.S. deferred tax assets utilized during the period. Our 2005 tax expense primarily consisted of $15.1 million in expense related to the establishment of valuation allowances against the United States deferred tax assets, which offset the benefit from U.S. net operating losses generated in 2005. Additionally, we had approximately $10.9 million of foreign tax expense, which was offset by a net current tax benefit of $4.1 million primarily related to tax audit settlements in the U.S.
(5) Represents the gain on the sale of our Knights Technology assets.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Factors That May Affect Future Results
This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectations of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; factors that may affect our 2007 operating results; any statements concerning proposed new products, services, developments, changes to our restructuring reserves or anticipated performance of products or services; any statements related to future capital expenditures; any statements related to the needs or expected growth of our target markets; any statements regarding future economic conditions or performance; statements of belief; and any statement of assumptions underlying any of the foregoing. You can identify these statements by the fact that they do not relate strictly to historical or current facts and use words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe” and other words and terms of similar meaning. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public. The risks, uncertainties and assumptions referred to above include, but are not limited to, those discussed here and the risks discussed from time to time in our other public filings. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us as of the date of this report, and we assume no obligation to update these forward-looking statements. You are advised, however, to consult any further disclosures we make on related subjects in our Forms 10-Q and 8-K filed with, or furnished to, the SEC. You also should read Item 1A. “Risk Factors” for factors that we believe could cause our actual results to differ materially from expected and historical results. Other factors also could adversely affect us.
Summary of Products and Segments
We are a leading supplier of instruments for nanoscale imaging, analysis and prototyping to enable research, development and manufacturing in a range of industrial, academic and research institutional applications. We report our revenue based on a market-focused organization: the NanoElectronics market, the NanoResearch and Industry market, the NanoBiology market and the Service and Components market.
Our products include focused ion beam systems, or FIBs; scanning electron microscopes, or SEMs; transmission electron microscopes, or TEMs; and DualBeam systems, which combine a FIB and SEM on a single platform.
Our DualBeam systems include models that have wafer handling capability and are purchased by semiconductor and data storage manufacturers (“wafer-level DualBeam systems”) and models that have small stages and are sold to customers in several markets (“small-stage DualBeam systems”).
The NanoElectronics market consists of customers in the semiconductor, data storage and related industries such as printers and microelectromechanical systems (“MEMs”). For the semiconductor market, our growth is driven by shrinking line widths and process nodes of 65 nanometers and smaller, the use of multiple layers of new materials such as copper and low-k dielectrics, the increase in wafer size to 300 millimeters in diameter and increasing device complexity. Our products are used primarily in laboratories to speed new product development and increase yields by enabling 3D wafer metrology, defect analysis, root cause failure analysis and circuit edit for modifying device structures. In the data storage market, factors affecting our business include the transition from longitudinal to perpendicular recording heads, rapidly increasing storage densities that require smaller recording heads, thinner geometries and materials that increase the complexity of device structures. Our products offer 3D metrology for thin film head processing and root cause failure analysis.
The NanoResearch and Industry market includes universities, public and private research laboratories and customers in a wide range of industries, including automobiles, aerospace, metals, mining and petrochemicals. Growth in these markets is driven by global corporate and government funding for research and development in materials science and by development of new products and processes based on innovations in materials at the nanoscale. Our solutions provide researchers and manufacturers with atomic-level resolution images and permit development, analysis and production of advanced products. Our products are also used in root cause failure analysis and quality control applications.
The NanoBiology market includes universities and research institutes engaged in biotech and life sciences applications, as well as pharmaceutical, biotech, medical device and hospital companies. Our products’ ultra-high resolution imaging allows cell biologists and drug researchers to create detailed 3D reconstructions of complex biological structures. Our products are also used in particle analysis and a range of pathology and quality control applications.
Overview
Net sales increased to $592.5 million in 2007 compared to $479.5 million in 2006. Revenue growth in each of our product segments contributed to our growth in 2007 compared to 2006.
At December 31, 2007, our total backlog was $310.8 million compared to $305.9 million at December 31, 2006. Backlog consisted of product and service and components backlog of unfilled orders of $256.1 million and $54.7 million, respectively, at December 31, 2007 compared to $259.1 million and $46.8 million, respectively, at December 31, 2006.
Outlook for 2008
After achieving revenue growth of 23.6% in 2007 compared to 2006, we expect slower growth in 2008.
We expect our NanoResearch and Industry business to continue to grow as governments, institutions and corporations globally continue to invest in nanotechnology research and product development. If the U.S. experiences a consumer-led recession in 2008, as many observers expect, a portion of our NanoResearch and Industry business could be somewhat affected. However, we believe the global reach of our products and the multi-year budget cycles of many of our customers will be sufficient to provide further growth in 2008. We also expect continued growth in our NanoBiology business in 2008, although it will vary from quarter to quarter. This is an emerging, research-oriented market for us, and we expect our revenue to be positively affected by the introduction of the Titan Krios TEM in early 2008. We experienced a significant slow-down in bookings in our NanoElectronics business in the second half of 2007, mainly due to a cyclical slow-down in the semiconductor capital equipment industry. That weakness relative to the first half of 2007 is expected to persist in 2008. While revenue for this segment is likely to decline in 2008, we believe we have the potential to demonstrate better performance than the semiconductor capital equipment industry as a whole, because of increased demand for higher-resolution images as manufacturers move to smaller line widths and new processes, among other factors. Demand for service of our products is expected to grow modestly as our installed base of products grows.
We believe we hold leadership positions, both technologically and in the markets in which we compete, with our TEM and DualBeam products. While some competitors introduced new products in these areas in 2007, we expect to maintain our leadership in 2008. In the SEM product line, we expect to introduce new products in 2008 that will improve our competitive position, with the goal of obtaining technological leadership in that product line as well.
Our gross margins improved in 2007 compared with 2006. While our plan is to continue that trend in 2008, we face a number of challenges. Factors that may contribute to increased margins include the introduction of new products and planned operational improvements in our supply chain, manufacturing operations and service organization. However, product mix and a weaker U.S. dollar will likely reduce margins early in 2008. The product mix pressure includes the potential decline in the relative size of our
higher-margin NanoElectronics business, as well as the sale of relatively fewer DualBeam products within NanoElectronics. The weaker U.S. dollar adversely affects us because our euro-denominated expenses are greater than our euro-denominated revenue. Our cash flow hedging program can delay or mitigate the effect of the weaker U.S. dollar, but it cannot counteract the multi-year trend we have seen in recent years. We have programs in place to offset these negative forces on our margins, including new product introductions and better operational balance between euro expenses and euro revenues, but they are likely to offset only part of the impact of the downward mix and currency fluctuations on margins in 2008.
Growth in research and development and marketing spending is also negatively affected by the stronger euro, as well as increases in personnel, because a large percentage of our research and development operations are located in Europe. Total employment growth is planned to be significantly below the 11% growth rate of 2007, but we do plan to selectively add to critical positions during 2008. Overall operating spending is expected to grow in 2008 compared with 2007, but at a significantly lower rate of growth than in 2007.
Non-operating income is expected to decline in 2008 due to lower market interest rates and the repayment of part of our outstanding debt. Our annual tax rate is also expected to be somewhat higher for 2008, because 2007’s expense for income taxes was lowered by the settlement of several international tax audits.
Our goal for 2008 is to increase net income over 2007 levels. However, the combination of more modest growth and improvement in gross margins, offset by increased operating expenses, lower non-operating income and a higher tax rate, could result in net income in 2008 that is below 2007 levels.
Results of Operations
The following table sets forth our statement of operations data in thousands of dollars.
The following table sets forth our statement of operations data as a percentage of net sales.
(1) Percentages may not add due to rounding.
Net sales increased $113.0 million, or 23.6%, to $592.5 million, in 2007 compared to $479.5 million in 2006. The increase in net sales reflects increases in all of our market segments, as discussed in more detail below.
Net sales increased $59.4 million, or 14.1%, to $479.5 million, in 2006 compared to $420.1 million in 2005. The increase in net sales was driven by improvements in all of our segments, primarily related to increases in our TEM and small-stage DualBeam sales.
Net Sales by Segment
Net sales include sales in the NanoElectronics market, the NanoResearch and Industry market, the NanoBiology market and the Service and Components market. Net sales by market segment (in thousands) and as a percentage of net sales were as follows:
NanoElectronics
The $44.0 million, or 28.5%, increase in NanoElectronics sales in 2007 compared to 2006 was due to increases in the number of TEM and small-stage DualBeam system units sold. We achieved increased penetration of TEM sales due to higher resolution image requirements from customers. The increase in small-stage DualBeam systems was due to continued adoption of new products. Sales in the NanoElectronics segment moderated in the third and fourth quarters of 2007 as compared to the first two quarters of 2007 due to a cyclical decline in semiconductor capital spending. We expect this trend to continue in the first quarter of 2008 and perhaps beyond.
The $8.7 million, or 6.0%, increase in NanoElectronics sales in 2006 compared to 2005 was primarily due to improvements in our wafer-level DualBeam, SEM and small-stage DualBeam system unit sales, which
resulted primarily from general demand in the semiconductor capital equipment and data storage markets. These improvements were partially offset by volume declines related to products in our semiconductor businesses that were deemphasized during our restructuring activities in the second half of 2005.
NanoResearch and Industry
The $49.5 million, or 30.0%, increase in NanoResearch and Industry sales in 2007 compared to 2006 was due primarily to increases in the number of SEM and small-stage DualBeam system units sold as nanotechnology research strengthens. In addition, we have seen strong customer demand in this market for our high-end TEMs, including the Titan, other new SEM products and small-stage DualBeam products introduced in the last two years.
The $35.0 million, or 26.9%, increase in NanoResearch and Industry sales in 2006 compared to 2005 was due primarily to an approximately $33.6 million increase related to sales of our TEMs, due primarily to a shift in mix to our higher-priced TEMs, including the Titan, as well as a slight increase in unit sales. In addition, sales of our small-stage DualBeam systems increased by $3.0 million in 2006 compared to 2005 as a result of increased unit sales.
NanoBiology
The $10.9 million, or 26.7%, increase in NanoBiology sales in 2007 compared to 2006 was due primarily to an increase in the number of TEM units sold as the adoption of TEM technology increased in life sciences research applications. NanoBiology is an emerging market for our equipment, and a significant portion of the tools we sell in this market have relatively high per unit prices. As a result, quarter-to-quarter growth rates in this market are likely to fluctuate, although we expect long-term growth.
The $5.6 million, or 15.8%, increase in NanoBiology sales in 2006 compared to 2005 was due primarily to a shift in mix to higher-priced TEMs. We also realized an increase in the number of TEMs sold in 2006 compared to 2005.
Service and Components
The $8.6 million, or 7.2%, increase in Service and Component sales in 2007 compared to 2006 was due primarily to a larger installed base and the fact that the installed base has newer, higher-priced tools, which typically carry higher-priced service contracts. Component sales include sales of individual components as well as refurbished equipment and decreased $0.6 million, or 7.9%, in 2007 compared to 2006. This decrease was primarily due to weakness in NanoElectronics in the second half of 2007 and the timing of orders and shipments.
The $10.1 million, or 9.3%, increase in Service and Component sales in 2006 compared to 2005 was due primarily to a larger installed base and strong service contract renewals in the second half of 2006. Component sales contributed $0.8 million to the increase in 2006 compared to 2005.
Net Sales by Geographic Region
A significant portion of our net sales has been derived from customers outside of the U.S., which we expect to continue. The following table shows our net sales by geographic location (dollars in thousands):
North America
Sales in North America increased $63.0 million, or 37.7%, in 2007 compared to 2006. This increase was primarily due to strong bookings in 2006, which resulted in increased shipments in 2007, improved sales efforts in North America in 2007 following the reorganization of our sales management team in North America in 2005, as well as a generally strong market for our tools. In addition, 2007 sales were positively affected by the utilization of backlog during the year.
Sales in North America increased $41.5 million, or 33.0%, in 2006 compared to 2005. This increase was primarily due to increased data storage sales as the conversion to perpendicular recording accelerated, as well as increased TEM sales, including the Titan, and increased small-stage DualBeam sales. These improvements were partially driven by improvements in the semiconductor capital equipment and data storage markets in 2006 compared to 2005. The reorganization of our sales management team in North America in 2005 also contributed to the improved net sales in 2006 compared to 2005.
Europe
Sales in Europe increased $30.9 million, or 16.5%, in 2007 compared to 2006. Several nanoresearch centers are being developed in the European region, which has contributed to an increase in NanoResearch and Industry and NanoBiology sales. We are also focusing on increasing the number of indirect sales agents and distributors, which has contributed to the increase in sales in both existing and emerging markets. The change in the valuation of the European currencies in relation to the U.S. dollar during 2007 increased European sales in 2007 by approximately $17.1 million.
Sales in Europe increased $26.3 million, or 16.4%, in 2006 compared to 2005. This increase was primarily due to increased TEM sales, including the Titan, partially offset by unusually high volume sales of our small-stage DualBeam systems in the first half of 2005 compared to 2006. In 2005, we reorganized our sales management team in Europe, which also contributed to the improved net sales in 2006 compared to 2005. European sales were also increased by the strength of the euro compared with the U.S. dollar.
Asia-Pacific Region
Sales in the Asia-Pacific region increased $19.1 million, or 15.3%, in 2007 compared to 2006. This increase was primarily due to higher unit sales, primarily in Japan and China. We are also realizing initial benefits from our investment in additional sales and service resources in 2007 in the Asia-Pacific region.
Sales in the Asia-Pacific region decreased $8.5 million, or 6.3%, in 2006 compared to 2005. This decrease resulted from lower volume sales of our wafer-level DualBeam systems and small-stage DualBeam systems in 2006 due to unusually high volumes in 2005 and a decrease in SEM sales, partially offset by an increase in TEM sales, including the Titan.
Cost of Sales and Gross Margin
Our gross margin (gross profit as a percentage of net sales) by segment was as follows:
Cost of sales includes manufacturing costs, such as materials, labor (both direct and indirect) and factory overhead, as well as all of the costs of our customer service function such as labor, materials, travel and overhead. We see five primary drivers affecting gross margin: product mix (including the effect of price competition), volume, cost reduction efforts, competitive pricing pressure and currency fluctuations.
Cost of sales increased $63.1 million, or 22.3%, to $346.1 million in 2007 compared to $283.0 million in 2006. This increase was primarily due to the increase in revenue discussed above, although cost of sales as a percentage of revenue decreased slightly, partially offsetting these increases. In addition, the change in the valuation of European currencies in relation to the U.S. dollar during 2007 increased cost of sales by approximately $19.6 million in 2007.
The net effect on our gross margin from the effect of the change in valuation of currencies on our net sales and cost of sales was an approximately $2.6 million decrease, which decreased our gross margin percentage by approximately 1.7 percentage points. Offsetting the negative currency effects were approximately $5.0 million of cash flow hedge gains recorded in cost of sales, which improved gross margins by approximately one percentage point.
Cost of sales increased $8.1 million, or 3.0%, to $283.0 million in 2006 compared to $274.9 million in 2005. This increase was primarily due to the increased sales in 2006 compared to 2005 and $0.8 million of stock-based compensation in 2006 compared to none for 2005. These increases were partially offset by $14.2 million of charges incurred to write-off inventory and capitalized software related to the closure of our Peabody, Massachusetts facility in 2005, as well as an increase in our overall gross margin as detailed above.
Overall gross margins were decreased in 2005 by approximately 3.4 percentage points due to the $14.2 million of charges related to the write-down of inventory and capitalized software as discussed above and the NanoElectronics margins were decreased by approximately 9.7 percentage points.
NanoElectronics
The increase in NanoElectronics gross margins in 2007 compared to 2006 was due primarily to the sale of more high-end systems, such as the data storage Certus DualBeam product, high-end TEM units and new small-stage DualBeam products.
The NanoElectronics gross margin improved significantly in 2006 compared to 2005, primarily due to the impact in 2005 of the inventory and capitalized software write-offs discussed above. Additionally, gross margins in 2006 increased due to improvements in our product mix for both DualBeam systems and TEM products, including the Titan.
NanoResearch and Industry
The decrease in the NanoResearch and Industry gross margin in 2007 compared to 2006 was primarily due to pricing pressure on our SEM and lower-end TEM systems and costs to ramp production of our new Phenom product, partially offset by a shift in product mix to more high-end TEMs and small-stage DualBeam units.
The increase in the NanoResearch and Industry gross margin in 2006 compared to 2005 was primarily due to improvements in the TEM product mix, partially offset by the shift to the lower-margin small-stage DualBeam systems.
NanoBiology
The decrease in the NanoBiology gross margin in 2007 compared to 2006 was primarily due to pricing pressures on our lower-end TEM and SEM systems. These factors were partially offset by the sale of more high-end TEM products, which have higher gross margins than other products within this segment.
The increase in the NanoBiology gross margin in 2006 compared to 2005 was primarily due to improvements in margins achieved on our TEMs, due in part to sales of the Titan.
Service and Components
The decrease in the Service and Components gross margin in 2007 compared to 2006 was primarily due to increased headcount and travel costs, partially offset by higher revenues from a larger installed base.
The increase in the Service and Components gross margin in 2006 compared to 2005 was primarily due to efficiencies gained as net sales increased and a reduction in inventory write-downs in 2006 compared to 2005, partially offset by higher repair costs and material usage.
Research and Development Costs
Research and development (“R&D”) costs include labor, materials, overhead and payments third parties for research and development of new products and new software or enhancements to existing products and software and are presented net of subsidies received for such efforts. During 2007, we received subsidies from European governments for technology developments specifically in the areas of semiconductor and life science equipment.
R&D costs were $66.0 million (11.1% of net sales) in 2007, $57.5 million (12.0% of net sales) in 2006 and $56.6 million (13.5% of net sales) in 2005.
R&D costs are reported net of subsidies and were as follows (in thousands):
The $8.5 million increase in R&D costs in 2007 compared to 2006 was due to a $1.2 million increase in project spending in North America and Europe, a $4.2 million increase in labor and related costs, including stock-based compensation, due to headcount additions, increased contractors, annual pay raises and increased bonus accruals and a $3.2 million increase related to currency fluctuations.
The $1.0 million increase in R&D costs in 2006 compared to 2005 was primarily due to a $0.9 million increase in stock-based compensation, a $1.6 million increase in employee cash bonuses and a $0.7 million decrease in subsidies received, partially offset by $2.5 million in savings from restructuring activities, mainly due to the closing of our Peabody, Massachusetts operations and $0.5 million in project cost savings. Subsidies have decreased as the projects available for subsidies, primarily in the Netherlands and the U.S., have decreased.
We anticipate that we will continue to invest in R&D at a similar percentage of revenue for the foreseeable future. Accordingly, as revenues increase, we currently anticipate that R&D expenditures also will increase. Actual future spending, however, will depend on market conditions.
Selling, General and Administrative Costs
Selling, general and administrative (“SG&A”) costs include labor, travel, outside services and overhead incurred in our sales, marketing, management and administrative support functions. SG&A costs also include sales commissions paid to our employees as well as to our agents.
SG&A costs were $124.2 million (21.0% of net sales) in 2007, $100.3 million (20.9% of net sales) in 2006 and $97.5 million (23.2% of net sales) in 2005.
The $23.9 million increase in SG&A costs in 2007 compared to 2006 was due primarily to a $12.8 million increase in labor and related costs, which includes stock-based compensation expense, a $4.8 million increase in agent commissions and other selling costs and a $2.8 million increase in legal and accounting expenses. These increases were primarily due to increases in headcount, as we are adding to our global sales force, and higher sales in 2007 compared to 2006. SG&A in 2007 was also affected by a $3.5 million increase related to currency fluctuations.
The $2.8 million increase in SG&A costs in 2006 compared to 2005 was primarily due to $5.6 million of profit sharing and management incentive pay as a result of the achievement of corporate profitability targets in 2006 compared to none in 2005. In addition, commissions increased approximately $0.8 million due to the increase in net sales and stock-based compensation increased $4.0 million. These increases were partially offset by a $1.5 million gain related to the sale of certain intellectual property rights to a privately-held company, approximately $2.1 million of savings related to our 2005 restructuring activities, a $1.6 million decrease in legal and audit fees, excluding the merger costs discussed below, a $0.9 million decrease in bad debt expense and a $1.2 million decrease in labor and related costs due primarily to lower headcount.
Merger Costs
Merger costs of $0.5 million in 2006 related to legal expenses and Board of Directors’ costs incurred for activities related to a merger proposal. The discussions related to the proposed transaction were terminated in the first quarter of 2006.
Amortization of Purchased Technology
Amortization of purchased technology was $1.8 million in 2007, $2.0 million in 2006 and $3.8 million in 2005.
In 2005, we recorded an impairment charge of $9.3 million against our purchased technology balance, which led to the decrease in amortization in 2006 compared to 2005. See also Note 5 of Notes to Consolidated Financial Statements.
Our purchased technology balance at December 31, 2007 was $2.9 million and current amortization of purchased technology is approximately $0.4 million per quarter, which could increase if we acquire additional technology.
Asset Impairment
We had no asset impairment charges in 2007.
Asset impairment charges of $0.5 million in 2006 were primarily for the write-off of the remaining costs related to the abandonment of our ERP system, which were incurred during the first quarter of 2006.
In 2005, we took certain actions to align our cost structure with the current prevailing market conditions, primarily in the semiconductor markets. The actions taken to date, which were necessary as a result of reduced business volumes, have resulted in decreases in our global workforce and also required us to evaluate our goodwill and other long-lived assets for impairment.
We recorded asset impairment charges and write-offs totaling $25.4 million in 2005. These charges are summarized as follows (in thousands):
Our goodwill impairment analysis was focused on goodwill related to our former microelectronics segment, which we sold to the semiconductor market. Based on our analysis of current and projected operating results, we concluded that the goodwill allocated to this segment was not impaired. However, we evaluated the recoverability of the segment’s long-lived assets and concluded impairments existed.
Accordingly, we recorded impairment charges based on the amounts by which the carrying amounts of these assets exceeded their fair value. Additionally, certain assets were abandoned and, accordingly, written off, including a charge for costs capitalized for the terminated ERP project.
Restructuring, Reorganization, Relocation and Severance
The net $0.3 million expense reversal of restructuring, reorganization, relocation and severance costs in 2007 related to favorable buyouts of our Peabody lease, offset by changes in estimates incorporated into our restructuring accrual related to our ability to sublease certain abandoned facilities under lease.
Restructuring, reorganization, relocation and severance in 2006 included a charge of $3.3 million for facilities and severance charges related to the closure of certain of our European field offices, closure of a research and development facility in Tempe, Arizona, as well as residual costs related to the Peabody, Massachusetts plant closure and the downsizing of the related semiconductor businesses.
Effective April 1, 2006, our Chairman, President and Chief Executive Officer (“CEO”) was terminated. Our CEO was a party to an existing Executive Severance Agreement dated February 1, 2002. In accordance with this agreement, in the first quarter of 2006, we recorded a charge of $9.3 million, of which $2.2 million related to the cash severance payments and $7.1 million related to the non-cash expense associated with the fair market value of modified stock options.
During 2005, we initiated global restructuring activities to realign our cost structure with current prevailing market conditions. These actions included reductions in workforce, reorganization and relocation of employees as well as closure of our Peabody, Massachusetts facility and certain field offices around the world. Some of these actions were initiated in the second quarter of 2005 with the remainder continuing through the first half of 2006. These costs were accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Under SFAS No. 146, liabilities for costs associated with exit or disposal activities are recognized and measured at fair value in the period the liability is incurred.
In 2005, we also expensed $4.6 million in severance and relocation costs related to workforce reductions and reallocation of personnel geographically. We also incurred $3.9 million of restructuring expense for facility closures, largely related to the Peabody, Massachusetts facility (inclusive of $0.2 million in reserve releases related to prior accruals for another facility lease that was terminated).
For information regarding the related accrued liability, see Note 14 of Notes to Consolidated Financial Statements.
Other Income (Expense), Net
Other income (expense) items include interest income, interest expense, foreign currency gains and losses and other miscellaneous items.
Interest income represents interest earned on cash and cash equivalents, investments in marketable securities and, in 2004, a shareholder note receivable. Interest income was $22.4 million in 2007, $13.2 million in 2006 and $7.8 million in 2005.
These increase in 2007 compared to 2006, as well as the increase in 2006 compared to 2005, resulted from increases in our invested balances, primarily due to cash generated by operations, as well as from the net proceeds from our sale of $115.0 million principal amount of 2.875% convertible debt in May 2006.
Interest expense for 2007, 2006 and 2005 included interest related to our 5.5% convertible debt issued in August 2001, which we retired in January 2008. Interest expense in 2007 and 2006 also included interest related to our $115.0 million principal amount of 2.875% convertible debt, which was issued in May 2006.
The amortization of capitalized note issuance costs related to our convertible note issuances is also included as a component of interest expense in all periods.
Interest expense in 2006 and 2005 included premiums and commissions paid on the repurchase of a portion of our 5.5% convertible subordinated notes as well as the write-off of deferred note issuance costs totaling $0.5 million and $1.8 million, respectively.
Assuming no additional note repurchases, amortization of our remaining convertible note issuance costs, including those related to our 2.875% convertible notes, will total approximately $0.3 million per quarter through 2008 and $0.1 million per quarter thereafter through the second quarter of 2013.
Other, net primarily consists of foreign currency gains and losses on transactions and realized and unrealized gains and losses on the changes in fair value of derivative contracts entered into to hedge these transactions.
Other, net in 2007 included a $0.5 million gain related to the disposal of one of our cost-based investments and a $0.5 million gain for the final escrow payment on the sale of a minority interest in a small technology company.
Other, net included charge of $3.9 million and $6.4 million in 2006 and 2005, respectively, related to impairment charges and realized losses of certain of our cost-method investments. Additionally, in 2006, we recorded a $5.2 million gain related to the sale of one of our cost-method investments. Our cost-method investments are minority-interest holdings in small, privately-held entities where it is not practical to estimate fair values. We evaluate our cost-method investments for impairment whenever events indicate that the carrying amount of the investment may not be recoverable within a reasonable period of time. This evaluation is based on review of interim financial statements and informal discussions with the senior management of the investee entities.
At December 31, 2007 and 2006, all cost-method investments have been written down to zero on our balance sheet.
Income Tax Expense
We recorded a tax provision of $8.1 million, $10.5 million and $22.1 million, respectively, in 2007, 2006 and 2005, which reflected an effective tax rate of 12.2%, 37.2% and 39.1%, respectively.
Our 2007 tax provision on income from continuing operation reflected taxes on foreign earnings offset by a $4.7 million release of unrecognized tax benefits, including interest and penalties, as a result of the settlement of foreign tax audits and a tax benefit of $5.3 million related to the release of valuation allowance recorded against net operating loss deferred tax assets utilized to offset income earned in the U.S.
We adopted the provisions of Interpretation No. 48 in the first quarter of 2007 and, accordingly, increased the opening balance of retained earnings by $4.1 million to reflect those tax positions that are more likely than not to be sustained. As of December 31, 2007, unrecognized tax benefits were $15.7 million and related primarily to uncertainty surrounding intercompany pricing and permanent establishment. All unrecognized tax benefits would decrease the effective tax rate if recognized.
Our 2006 tax provision consisted primarily of taxes accrued in foreign jurisdictions and reflects a benefit of $1.5 million related to the release of valuation allowances against a portion of U.S. deferred tax assets utilized during the period.
Our 2005 tax provision primarily consisted of $15.1 million in expense related to the establishment of valuation allowances against the U.S. deferred tax assets, which offset the benefit from U.S. net operating losses generated in 2005. Additionally, we had approximately $10.9 million of foreign tax expense, which was offset by a net current tax benefit of $4.1 million primarily related to tax audit
settlements in the U.S. For 2005, we experienced an abnormally high effective tax rate as we had profits and related tax expense from our international operations, but losses in the U.S. for which we did not record a tax benefit.
Valuation allowances on deferred tax assets totaled $39.5 million and $33.5 million as of December 31, 2007 and 2006, respectively.
Our effective tax rate may differ from the U.S. federal statutory tax rate primarily as a result of the effects of state and foreign income taxes, research and experimentation tax credits earned in the U.S. and foreign jurisdictions, adjustments to our unrecognized tax benefits and our ability or inability to utilize various carry forward tax items. In addition, our effective income tax rate may be affected by changes in statutory tax rates and laws in the U.S. and foreign jurisdictions and other factors.
Discontinued Operations
In the fourth quarter of 2006, we sold the assets and operations related to Knights Technology, which was a consolidated subsidiary, and recognized a gain on the disposal of the discontinued operations of $3.3 million and received cash proceeds of $7.8 million. In the first quarter of 2007, we recognized an additional $0.1 million gain related to post-closing adjustments for working capital items. In addition, in the fourth quarter of 2007, we recognized an additional $0.3 million gain related to the release of certain acquisition contingency accruals, as well as to amounts that had been held in escrow and subsequently paid to us once all contingencies surrounding the transaction were resolved. All historical statement of operations data has been restated to reflect the discontinued operations.
Certain financial information related to discontinued operations was as follows (in thousands):
LIQUIDITY AND CAPITAL RESOURCES
Our sources of liquidity and capital resources as of December 31, 2007 consisted of $453.6 million of cash, cash equivalents, short-term restricted cash and short-term investments, $12.8 million in non-current investments, $24.6 million of long-term restricted cash, as well as potential future cash flows from operations. Restricted cash relates to deposits to secure bank guarantees for customer prepayments that expire through 2013.
At December 31, 2007, we held $118.1 million in auction rate securities (“ARS”) which we classified as current assets. The ARS held by us have long-term stated maturities for which the interest rates are reset through a Dutch auction generally every 28 days. The auctions have historically provided a liquid market for these securities as investors could readily sell their investments at auction. Subsequent to December 31, 2007, we began to exit our position in these securities. As of February 25, 2008, we had successfully liquidated $8.0 million of these securities, leaving us with $110.1 million invested in ARS.
A chart showing the amounts of each of our ARS, the issuers and whether the underlying collateral for the notes are guaranteed by the U.S. Department of Education (“USDE”) is set out below. At the time of issuance, each of the ARS was purported to be at least 100% collateralized. All of the notes come up for auction by March 24, 2008.
With the liquidity issues experienced in global credit and capital markets, the ARS held by us have experienced multiple failed auctions, beginning on February 19, 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders. We expect additional auction failures during the remainder of February and March 2008, which will require us to hold the securities until liquidity is restored to the credit markets or the securities are redeemed or mature.
All of the ARS held by us carry AAA ratings, have not experienced any payment defaults and are backed by student loans, some of which are guaranteed under the Federal Family Education Loan Program of the USDE. Nonetheless, if uncertainties in the credit and capital markets continue, these markets deteriorate further or there are any ratings downgrades on any ARS we hold, we may be required to reclassify these investments from short-term to long-term investments. In addition, if the failed auctions or any downgrades are deemed to cause an “other than temporary impairment” of our ARS, we may be required to re-value the ARS at some amount below par. Any re-valuation of ARS that are other than temporarily impaired will flow through our operations statement and affect our earnings.
We believe that, even allowing for the reclassification of these securities to long-term and the possible requirement to hold such securities for an indefinite period of time, our remaining cash and cash equivalents, short-term restricted cash, short-term investments and cash expected to be generated from operations will be sufficient to meet our expected operational and capital needs for at least the next twelve months from December 31, 2007, including our upcoming convertible note repayment obligations.
In 2007, cash and cash equivalents and short-term restricted cash increased $170.4 million to $301.6 million as of December 31, 2007 from $130.8 million as of December 31, 2006 primarily as a result of $51.5 million provided by operations, $40.9 million of proceeds from the exercise of employee stock options and employee stock purchases, $105.7 million of net maturities of marketable securities and a $8.8 million favorable effect of exchange rate changes. These increases were partially offset by $18.5 million used for the purchase of property, plant and equipment.
Accounts receivable increased $12.1 million to $157.1 million as of December 31, 2007 from $145.0 million as of December 31, 2006, primarily due to increased sales in the fourth quarter of 2007 compared with the fourth quarter of 2006. The December 31, 2007 balance was also affected by a $9.3 million increase related to changes in currency exchange rates. Our days sales outstanding, calculated on a quarterly basis, was 95 days at December 31, 2007 compared to 94 days at December 31, 2006.
Inventories increased $41.3 million to $138.8 million as of December 31, 2007 compared to $97.5 million as of December 31, 2006. The increase primarily was due to purchasing of raw materials as sales continue to increase, as well as an increase related to currency movements of approximately $11.6 million. Our annualized inventory turnover rate, calculated on a quarterly basis, was 2.6 times for the quarter ended December 31, 2007 and 3.5 times for the quarter ended December 31, 2006.
Other assets, net increased $9.3 million to $16.8 million as of December 31, 2007 compared to $7.5 million as of December 31, 2006 primarily due to increased long-term lease receivables, increased taxes receivable and approximately $3.5 million of intangible asset additions.
Expenditures for property, plant and equipment of $18.5 million in 2007 primarily consisted of expenditures for machinery and equipment, including instruments used for demonstration as part of our marketing programs. We expect to continue to invest in capital equipment, customer evaluation systems and R&D equipment for applications development. We estimate our total capital expenditures in 2008 to be approximately $29.5 million, primarily for the development and introduction of new products, demonstration equipment and upgrades and incremental improvements to our enterprise resource planning (“ERP”) system.
Accounts payable decreased $13.9 million to $31.2 million as of December 31, 2007 compared to $45.1 million as of December 31, 2006. The decrease resulted primarily from lower material purchases as part of inventory reduction programs. Additionally, primarily in our European locations, we have decreased the number and amount of invoices on hold after negotiations with our suppliers on open issues. We have also noted in price negotiations with suppliers a trend that suppliers request shorter payment terms or better adhered to payment terms in exchange for more favorable pricing.
Accrued payroll liabilities increased $5.4 million to $26.1 million as of December 31, 2007 compared to $20.7 million as of December 31, 2006. The increase resulted primarily from profit sharing and variable compensation programs for management personnel for 2007 being partially offset by the payment of amounts earned in 2006 in the first quarter of 2007. Additionally, accrued wages and related payroll taxes increased from prior year due to headcount and wage increase.
Other liabilities increased $33.1 million to $38.7 million as of December 31, 2007 compared to $5.6 million as of December 31, 2006. The increase resulted primarily from the reclassification of $9.1 million of unrecognized tax benefits from income taxes payable to other long-term liabilities for the impact of the adoption of Interpretation No. 48, as well as current year accruals of $6.3 million related to unrecognized tax benefits. Additionally, long-term liabilities increased $15.6 million related to deferred revenue not expected to be taken into revenue within the next twelve months.
We have a 50.0 million yen unsecured and uncommitted bank borrowing facility in Japan and various limited facilities in select foreign countries. As part of our contracts with certain customers, we are required to provide letters of credit or bank guarantees which these customers can draw against in the event we do not perform in accordance with our contractual obligations. At December 31, 2007, we had $46.0 million of these guarantees and letters of credit outstanding, of which approximately $45.6 million were secured by restricted cash deposits. Restricted cash balances securing bank guarantees that expire within 12 months of the balance sheet date are recorded as a current asset on our consolidated balance sheets. Restricted cash balances securing bank guarantees that expire beyond 12 months from the balance sheet date are recorded as long-term restricted cash on our consolidated balance sheet.
CONTRACTUAL PAYMENT OBLIGATIONS
A summary of our contractual commitments and obligations as of December 31, 2007 was as follows (in thousands):
We also have other liabilities of $15.7 million relating to uncertain tax positions. However, as we are unable to reliably estimate the timing of future payments related to the uncertain tax positions, we have excluded this amount from the table above.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
See Note 2 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K.
CRITICAL ACCOUNTING POLICIES AND THE USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period.
Significant accounting policies and estimates underlying the accompanying consolidated financial statements include:
· the timing of revenue recognition;
· the allowance for doubtful accounts;
· valuations of excess and obsolete inventory;
· valuation of investments in privately-held companies;
· the lives and recoverability of equipment and other long-lived assets such as goodwill and existing technology intangibles;
· restructuring, reorganization, relocation and severance costs;
· accounting for income taxes;
· warranty liabilities;
· stock-based compensation; and
· accounting for derivatives.
It is reasonably possible that the estimates we make may change in the future.
Revenue Recognition
We recognize revenue when persuasive evidence of a contractual arrangement exits, delivery has occurred or services have been rendered, the seller’s price to buyer is fixed and determinable, and collectibility is reasonably assured.
For products demonstrated to meet our published specifications, revenue is recognized when the title to the product and the risks and rewards of ownership pass to the customer. The portion of revenue related to installation and final acceptance, of which the estimated fair value is generally 4% of the total revenue of the transaction, is deferred until such installation and final customer acceptance are completed. For products produced according to a particular customer’s specifications, revenue is recognized when the product meets the customer’s specifications and when the title and the risks and rewards of ownership have passed to the customer. In each case, the portion of revenue applicable to installation and customer acceptance is recognized upon meeting specifications at the installation site. For new applications of our products where performance cannot be assured prior to meeting specifications at the installation site, no revenue is recognized until such specifications are met.
For sales arrangements containing multiple elements (products or services), revenue relating to undelivered elements is deferred at the estimated fair value until delivery of the deferred elements. To be considered a separate element, the product or service in question must represent a separate unit under accounting rules and fulfill the following criteria: the delivered item(s) has value to the customer on a standalone basis; there is objective and reliable evidence of the fair value of the undelivered item(s); and, if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all criteria above, the entire amount of the transaction is deferred until all elements are delivered.
We provide maintenance and support services under renewable, term maintenance agreements. Maintenance and support fee revenue is recognized ratably over the contractual term, which is generally 12 months, and commences from contract date.
Revenue from time and materials based service arrangements is recognized as the service is performed. Spare parts revenue is generally recognized upon shipment.
Deferred revenue represents customer deposits on equipment orders, orders awaiting customer acceptance and prepaid service contract revenue. Deferred revenue is recognized in accordance with our revenue recognition policies described above.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is estimated based on collection experience and known trends with current customers. The large number of entities comprising our customer base and their dispersion across many different industries and geographies somewhat mitigates our credit risk exposure and the magnitude of our allowance for doubtful accounts. Our estimates of the allowance for doubtful accounts are reviewed and updated on a quarterly basis. Changes to the reserve may occur based upon changes in revenue levels and associated balances in accounts receivable and estimated changes in individual customers’ credit quality. Historically, we have not incurred significant write-offs of accounts receivable, however, an individual loss could be significant due to the relative size of our sales transactions. Our bad debt expense totaled $0.9 million, $0.7 million and $1.7 million, respectively, in 2007, 2006 and 2005. Our
allowance for doubtful accounts totaled $3.8 million and $4.2 million, respectively, at December 31, 2007 and 2006.
Valuation of Excess and Obsolete Inventory
Inventory is stated at the lower of cost or market, with cost determined by standard cost methods, which approximate the first-in, first-out method. Inventory costs include material, labor and manufacturing overhead. Inventory is reviewed for obsolescence and excess quantities on a quarterly basis, based on estimated future use of quantities on hand, which is determined based on past usage, planned changes to products and known trends in markets and technology. Changes in support plans or technology could have a significant impact on obsolescence. Because of the long-lived nature of many of our products, we maintain a substantial supply of parts for possible use in future repairs and customer field service. As these service parts become older, we apply a higher percentage of reserve against the recorded balance, recognizing that the older the part, the less likely it is ultimately to be used. Provision for inventory valuation adjustments totaled $1.0 million in 2007, were immaterial in 2006 and totaled $10.1 million in 2005. Provision for service inventory valuation adjustments totaled $4.0 million, $4.2 million and $2.9 million, respectively, in 2007, 2006 and 2005.
Valuation of Investments in Privately-Held Companies
We made investments in several small, privately held technology companies in which we hold less than 20% of the capital stock or hold notes receivable. We account for these investments at their cost unless their value has been determined to be other than temporarily impaired, in which case, we write the investment down to its estimated fair value. We review these investments periodically for impairment and make appropriate reductions in carrying value when an “other-than-temporary” decline is evident; however, for non-marketable equity securities, the impairment analysis requires significant judgment. We evaluate the financial condition of the investee, market conditions and other factors providing an indication of the fair value of the investments. During 2005, we recorded impairments and losses on liquidation related to these investments totaling $6.4 million. During 2006, we wrote off certain of our investments, incurring a charge of $3.9 million, and sold our remaining investments, resulting in a gain of $5.2 million, and, accordingly, as of December 31, 2007 and December 31, 2006, the carrying value of our investments in privately-held companies was zero on our balance sheet. See also Note 3 of Notes to Consolidated Financial Statements.
Lives and Recoverability of Equipment and Other Long-Lived Assets
We evaluate the remaining life and recoverability of equipment and other assets, including intangible assets, whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” If there is an indication of impairment, we prepare an estimate of future, undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If these cash flows are less than the carrying value of the asset, we adjust the carrying amount of the asset to its estimated fair value.
For information on impairments recognized in 2006 and 2005, see Note 5 of Notes to Consolidated Financial Statements. No such adjustments were made in 2007.
Goodwill
Goodwill represents the excess purchase price over fair value of net assets acquired. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill and other identifiable intangible assets with indefinite useful lives are no longer amortized, but, instead, a two-step impairment test is performed at least annually, in accordance with the provisions of SFAS No. 142. We test goodwill for impairment annually in the fourth quarter. First, the fair value of each reporting unit is compared to its carrying value. We have defined our reporting units to be our operating segments as disclosed under SFAS No. 131,
“Disclosures about Segments of an Enterprise and Related Information.” If the fair value of the reporting unit exceeds the carrying value, goodwill is not impaired and no further testing is performed. The second step is performed if the carrying value exceeds the fair value. The fair value of the reporting unit’s goodwill must be determined based on, and compared to, the carrying value of the goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, an impairment loss equal to the difference will be recorded. No impairments were identified in the first step of our goodwill impairment analyses performed during 2007, 2006 or 2005.
Existing Technology Intangible Assets
Existing technology intangible assets purchased in business combinations, which represent the estimated value of products utilizing technology existing as of the combination date discounted to their net present value, are amortized on a straight-line basis over the estimated useful life of the technology. We currently are using amortization periods ranging from 5 to 12 years for these assets. Changes in technology could affect our estimates of the useful lives of such assets. We test our technology intangible assets for impairment whenever events or circumstances indicate that the carrying amount of assets may not be recoverable in accordance with SFAS No. 144. We evaluate recoverability by comparing the carrying amount to future net undiscounted cash flows to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Such reviews assess the fair value of the assets based upon estimates of future cash flows that the assets are expected to generate. We review the estimated useful lives of the assets on an annual basis. During 2005, we recorded impairment charges related to these assets totaling $9.3 million, which were included as a component of asset impairment on our consolidated statement of operations. For additional information on these impairments, see Note 5 of Notes to Consolidated Financial Statements. We did not change estimated useful lives or recognize impairment charges related to our technology intangible assets during 2007 or 2006.
Restructuring, Reorganization, Relocation and Severance Costs
Restructuring, reorganization, relocation and severance costs are recognized and recorded at fair value as incurred in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Such costs include severance and other costs related to employee terminations as well as facility costs related to future abandonment of various leased office and manufacturing sites. Changes in our estimates could occur, and have occurred, due to fluctuations in exchange rates, the sublease of unused space, unanticipated voluntary departures before severance was required and unanticipated redeployment of employees to vacant positions.
Income Taxes
We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of the assets and liabilities. In accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes,” we record a valuation allowance to reduce deferred tax assets to the amount expected to “more likely than not” be realized in our future tax returns. During 2007 and 2006, we released approximately $5.3 million and $1.5 million, respectively, in valuation allowance relating to U.S. deferred tax assets utilized during the year to offset U.S. taxable income generated during the respective periods. During 2005, we recorded valuation allowances against deferred tax assets that existed prior to January 1, 2005 and U.S. deferred tax assets originated in 2005. Should we determine that we would not be able to realize all or part of our remaining net deferred tax assets in the future, additional increases to the valuation allowance for deferred tax assets may be required. Conversely, if we determine that certain tax assets that have been reserved for may be realized in the future, we may reduce our valuation allowance in future periods. Our net deferred tax assets totaled $2.6 million and $0.5 million, respectively, at December 31, 2007 and 2006 and our valuation allowance totaled $39.5 million and $33.5 million, respectively.
In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109.” This statement clarifies the criteria that an individual tax position must satisfy for some or all of the benefits of that position to be recognized in a company’s financial statements. Interpretation No. 48 prescribes a recognition threshold of more likely than not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements. Effective January 1, 2007, we adopted the provisions of Interpretation No. 48 and recorded a $4.1 million increase to the opening balance of retained earnings to account for the cumulative effect of applying the new standard to previously unrecognized tax benefits. The increase to retained earnings was attributable to the resolution of a U.S. federal tax audit where the result was considered more likely than not under the recognition and measurement standards of Interpretation No. 48.
On January 1, 2007, total unrecognized tax benefits were $17.6 million, of which $9.1 million would have an impact on the effective tax rate. Interest and penalties accrued on unrecognized tax benefits were $1.5 million and were treated as tax expense in the consolidated statement of operations. Unrecognized tax benefits relate mainly to uncertainty surrounding intercompany pricing, permanent establishment and the capitalization of certain costs. See Note 13 of Notes to Consolidated Financial Statements for additional information.
Significant income tax exposures include potential challenges to intercompany pricing and permanent establishment. In the ordinary course of business, there is inherent uncertainty in quantifying our income tax positions. We assess our income tax positions and record tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. When applicable, associated interest and penalties have been recognized as a component of income tax expense.
Warranty Liabilities
Our products generally carry a one-year warranty. A reserve is established at the time of sale to cover estimated warranty costs and certain commitments for product upgrades. Our estimate of warranty cost is primarily based on our history of warranty repairs and maintenance, as applied to systems currently under warranty. For our new products without a history of known warranty costs, we estimate the expected costs based on our experience with similar product lines and technology. While most new products are extensions of existing technology, the estimate could change if new products require a significantly different level of repair and maintenance than similar products have required in the past. Our estimated warranty costs are reviewed and updated on a quarterly basis. Changes to the reserve occur as volume, product mix and warranty costs fluctuate. Our warranty reserve totaled $6.6 million and $5.7 million, respectively, at December 31, 2007 and 2006. Warranty expense totaled $16.0 million, $11.7 million and $9.3 million, respectively, during 2007, 2006 and 2005. The 2005 expense is net of a $1.0 million positive adjustment to warranty expense based on an analysis of our actual warranty costs incurred compared to our reserve estimate. No such adjustments were recorded in 2007 or 2006.
Stock-Based Compensation
On January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards granted to our employees and directors, including employee stock options, non-vested stock and stock purchases related to our employee share purchase plan based on the estimated fair value of the award on the grant date. Upon the adoption of SFAS No. 123(R), we maintained our method of valuation for stock option awards using the Black-Scholes valuation model, which has historically been used for the purpose of
providing pro-forma financial disclosures in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.”
The use of the Black-Scholes valuation model to estimate the fair value of stock option awards requires us to make judgments on assumptions regarding the risk-free interest rate, expected dividend yield, expected term and expected volatility over the expected term of the award. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates at the time they are made, but these estimates involve inherent uncertainties and the application of expense could be materially different in the future.
Compensation expense is only recognized on awards that ultimately vest. Therefore, we have reduced the compensation expense to be recognized over the vesting period for anticipated future forfeitures. Forfeiture estimates are based on historical forfeiture patterns. We update our forfeiture estimates quarterly and recognize any changes to accumulated compensation expense in the period of change. If actual forfeitures differ significantly from our estimates, our results of operations could be materially impacted.
Compensation expense, net of tax, calculated pursuant to SFAS No. 123 totaled $34.4 million in 2005.
Accounting for Derivatives
We use foreign forward extra contracts (a combination of forward exchange and option contracts) and option contracts and we are looking at additional instruments in 2008 to hedge certain anticipated foreign currency exchange transactions. When specific criteria required by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” have been met, changes in fair values of hedge contracts relating to anticipated transactions are recorded in other comprehensive income rather than net income until the underlying hedged transaction affects net income. One of the criteria for this accounting treatment is that the forward exchange contract amount should not be in excess of specifically identified anticipated transactions. By their nature, our estimates of anticipated transactions may fluctuate over time and may ultimately vary from actual transactions. When anticipated transaction estimates or actual transaction amounts decrease below hedged levels, or when the timing of transactions changes significantly, we reclassify a portion of the cumulative changes in fair values of the related hedge contracts from other comprehensive income to other income (expense) during the quarter in which such changes occur.
We also use foreign forward exchange contracts to mitigate the foreign currency exchange impact of our cash, receivables and payables denominated in foreign currencies. These derivatives do not meet the criteria for hedge accounting. Changes in fair value for derivatives not designated as hedging instruments are recognized in net income in the current period.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Exchange Rate Risk
A large portion of our business is conducted outside of the U.S. through a number of foreign subsidiaries. Each of the foreign subsidiaries keeps its accounting records in its respective local currency. These local-currency-denominated accounting records are translated at exchange rates that fluctuate up or down from period to period and consequently affect our consolidated results of operations and financial position. The major foreign currencies in which we experience periodic fluctuations are the euro, the Czech koruna, the Japanese yen and the British pound sterling. For each of the last three years, more than 62% of our sales occurred outside of the U.S.
In addition, because of our substantial research, development and manufacturing operations in Europe, we incur a greater proportion of our costs in Europe than the revenue we derive from sales in that geographic region. Our raw materials, labor and other manufacturing costs are primarily denominated in
U.S. dollars, euros and Czech korunas. This situation negatively affects our gross margins and results of operations when the dollar weakens in relation to the euro or koruna. A strengthening of the dollar in relation to the euro or koruna would have a net positive effect on our gross margins and results of operations. Movement of Asian currencies in relation to the dollar and euro also can affect our reported sales and results of operations because we derive more revenue than we incur costs from the Asia-Pacific region. In addition, several of our competitors are based in Japan and a weakening of the Japanese yen has the effect of lowering their prices relative to ours.
Assets and liabilities of foreign subsidiaries are translated using the exchange rates in effect at the balance sheet date. Revenues and expenses are translated using the average exchange rate during the period. The resulting translation adjustments increased shareholders’ equity and comprehensive income in 2007 by $26.5 million. Holding other variables constant, if the U.S. dollar weakened by 10% against all currencies that we translate, shareholders’ equity would increase by approximately $24.6 million as of December 31, 2007. Holding other variables constant, if the U.S. dollar strengthened by 10% against all currencies that we translate, shareholders’ equity would decrease by approximately $20.2 million as of December 31, 2007.
Risk Mitigation
We use derivatives to mitigate financial exposure resulting from fluctuations in foreign currency exchange rates. When specific accounting criteria have been met, changes in fair values of derivative contracts relating to anticipated transactions are recorded in other comprehensive income, rather than net income, until the underlying hedged transaction affects net income. Changes in fair value for derivatives not designated as hedging instruments are recognized in net income in the current period. As of December 31, 2007, the aggregate notional amount of our outstanding derivative contracts was $68.5 million, which contracts have varying maturities through December 29, 2008. We do not enter into derivative financial instruments for speculative purposes.
Holding other variables constant, if the U.S. dollar weakened by 10%, the market value of our foreign currency contracts outstanding as of December 31, 2007 would increase by approximately $2.6 million. The increase in value relating to the forward sale or purchase contracts would, however, be substantially offset by the revaluation of the transactions being hedged. A 10% increase in the U.S. dollar relative to the hedged currencies would have a similar, but negative, effect on the value of our foreign currency contracts, substantially offset again by the revaluation of the transactions being hedged.
Balance Sheet Related
We attempt to mitigate our currency exposures for recorded transactions by using forward exchange contracts to reduce the risk that our future cash flows will be adversely affected by changes in exchange rates. We enter into forward sale or purchase contracts for foreign currencies to hedge specific cash, receivables or payables positions denominated in foreign currencies. Changes in fair value of derivatives entered into to mitigate the foreign exchange risks related to these balance sheet items are recorded in other income (expense) currently together with the transaction gain or loss from the hedged balance sheet position.
The hedging transactions we undertake are intended to limit our exposure to changes in the dollar/euro exchange rate. Foreign currency losses recorded in other income (expense), inclusive of the impact of derivatives, totaled $3.1 million, $1.9 million and $1.5 million, respectively, in 2007, 2006 and 2005.
Cash Flow Hedges
We use foreign forward extra contracts (a combination of forward exchange and option contracts) and also option contracts to hedge certain anticipated foreign currency exchange transactions. The foreign exchange hedging structure is set up generally on a twelve-month time horizon. The hedging transactions we undertake primarily limit our exposure to changes in the U.S. dollar/euro exchange rate. The forward extra contract hedges are designed to protect us as the U.S. dollar weakens, but also provide us with some flexibility if the dollar strengthens.
These derivatives meet the criteria to be designated as hedges and, accordingly, we record the change in fair value of these hedge contracts relating to anticipated transactions in other comprehensive income rather than net income until the underlying hedged transaction affects net income. We recognized realized gains of $5.0 million in 2007 in cost of sales related to hedge results, compared to realized gains of $2.0 million in 2006. As of December 31, 2007, $2.2 million of deferred unrealized net gains on outstanding derivatives have been recorded in other comprehensive income and are expected to be reclassified to net income during the next 12 months as a result of the underlying hedged transactions also being recorded in net income. We did not record any charges related to hedge dedesignations or ineffectiveness in 2007 or 2006. In 2005, we recorded charges totaling $0.5 million in other income (expense) related to hedge dedesignations and ineffectiveness. We continually monitor our hedge positions and forecasted transactions and, in the event changes to our forecast occur, we may have dedesignations of our cash flow hedges in the future.
Interest Rate Risk
Our exposure to market risk for changes in interest rates primarily relates to our investments. Since we had no variable interest rate debt outstanding at December 31, 2007, our interest expense is relatively fixed and not affected by changes in interest rates. In the event we issue any new debt in the future, increases in interest rates will increase the interest expense associated with the debt. The significant decline in U.S. interest rates in early 2008, combined with the use of cash to pay off some of our outstanding debt securities, is expected to result in lower net interest income in 2008 compared with 2007.
The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This objective is accomplished by making diversified investments, consisting only of investment grade securities.
Cash, Cash Equivalents and Restricted Cash
As of December 31, 2007, we held cash and cash equivalents of $280.6 million and short-term restricted cash of $21.0 million that consisted of cash and highly liquid short-term investments having maturity dates of no more than 90 days at the date of acquisition. Declines of interest rates over time would reduce our interest income from our highly liquid short-term investments. A decrease in interest rates of one percentage point would cause a corresponding decrease in annual interest income of approximately $3.0 million assuming our cash and cash equivalent balances at December 31, 2007 remained constant. Due to the nature of our highly liquid cash equivalents, an increase in interest rates would not materially change the fair market value of our cash and cash equivalents.
Fixed Rate Debt Securities
As of December 31, 2007, we held short- and long-term fixed rate investments of $43.9 million that consisted of corporate notes and bonds and government-backed securities. These investments are recorded on our balance sheet at fair value based on quoted market prices. Unrealized gains/losses resulting from changes in the fair value are recorded, net of tax, in shareholders’ equity as a component of other comprehensive income (loss). Interest rate fluctuations impact the fair value of these investments, however, given our ability to hold these investments until maturity or until the unrealized losses recover, we do not expect these fluctuations to have a material impact on our results of operations, financial position or cash flows. Declines in interest rates over time would reduce our interest income from our short-term investments, as our short-term portfolio is re-invested at current market interest rates. A decrease in interest rates of one percentage point would cause a corresponding decrease in our annual interest income from these items of approximately $0.4 million assuming our investment balances at December 31, 2007 remained constant.
Variable Rate-Notes
As of December 31, 2007, we held variable-rate auction notes of $118.1 million. These securities are primarily backed by government guaranteed student loans and carry the highest investment ratings. None of these notes are backed by mortgages or collateralized debt obligations. Subsequent to December 31, 2007, certain auctions of these securities have failed. See also “Liquidity and Capital Resources” above. Cost is generally considered to approximate fair value for these securities and their fair value is not significantly impacted by interest rate fluctuations. Declines in interest rates over time would reduce our interest income from our investments in variable-rate notes, as interest rates are reset periodically to current market interest rates. A decrease in interest rates of one percentage point would cause a corresponding decrease in our annual interest income from these items of approximately $1.2 million assuming our investment balances at December 31, 2007 remained constant.
Fair Value of Convertible Debt
The fair market value of our fixed rate convertible debt is subject to interest rate risk. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. The interest rate changes affect the fair market value of our long-term debt, but do not impact earnings or cash flows. At December 31, 2007, we had $310.9 million of fixed rate convertible debt outstanding. Based on open market trades, we have determined that the fair market value of our long-term fixed interest rate debt was approximately $328.8 million at December 31, 2007.
Item 8.
Item 8. Financial Statements and Supplementary Data
Unaudited quarterly financial data for each of the eight quarters in the two-year period ended December 31, 2007 is as follows:
(1) Other income, net in the second quarter of 2007 included a $0.5 million gain on the sale of a minority interest in a small technology company and the third quarter of 2007 included a $0.5 million gain related to the disposal of one of our cost-based investments.
(2) Represents the results of Knights Technology, which was classified as a discontinued operation in 2006 and sold in the fourth quarter of 2006.
(3) Included in quarterly operating expenses were the following that affect comparability:
· restructuring, reorganization, relocation and severance charges of $11.6 million, $0.8 million, $0.2 million, respectively, in the first, second and third quarters of 2006;
· merger costs of $0.5 million in the first quarter of 2006;
· asset impairment charges of $0.5 million in the first quarter of 2006; and
· a $1.5 million gain related to the sale of certain intellectual property rights to a privately-held company in the third quarter of 2006.
(4) Included in other income, net were the following that affect comparability:
· interest expense of $0.4 million and $0.1 million, respectively, in the first and second quarters of 2006 related to the repurchase of $29.0 million face value of our 5.5% convertible notes;
· a $5.2 million gain related to the sale of our entire ownership interest in a privately-held company in the third quarter of 2006; and
· a $3.9 million charge related to the write-off of our equity and debt investment in a privately-held company in the third quarter of 2006.
(5) Income tax expense (benefit) consisted primarily of taxes accrued in foreign jurisdictions and a benefit related to the release of valuation allowance against a portion of U.S. deferred tax assets utilized during each quarter of 2006.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
FEI Company
Hillsboro, Oregon
We have audited the accompanying consolidated balance sheets of FEI Company and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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 audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of FEI Company and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109,” effective January 1, 2007.
As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment,” effective January 1, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2007, based on Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 29, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
Portland, Oregon
February 29, 2008
FEI Company and Subsidiaries
Consolidated Balance Sheets
(In thousands)
See accompanying Notes to Consolidated Financial Statements.
FEI Company and Subsidiaries
Consolidated Statements of Operations
(In thousands, except per share amounts)
See accompanying Notes to Consolidated Financial Statements.
FEI Company and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss)
(In thousands)
See accompanying Notes to Consolidated Financial Statements.
FEI Company and Subsidiaries
Consolidated Statements of Shareholders’ Equity
For The Years Ended December 31, 2007, 2006 and 2005
(In thousands)
See accompanying Notes to Consolidated Financial Statements.
FEI Company and Subsidiaries
Consolidated Statements of Cash Flows
(In thousands)
See accompanying Notes to Consolidated Financial Statements.
FEI COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
We are a leading supplier of instruments for nanoscale imaging, analysis and prototyping to enable research, development and manufacturing in a range of industrial, academic and research institutional applications. We report our revenue based on a market-focused organization: the NanoElectronics market, the NanoResearch and Industry market, the NanoBiology market and the Service and Components market.
Our products include focused ion beam systems, or FIBs; scanning electron microscopes, or SEMs; transmission electron microscopes, or TEMs; and DualBeam systems, which combine a FIB and SEM on a single platform.
Our DualBeam systems include models that have wafer handling capability and are purchased by semiconductor and data storage manufacturers (“wafer-level DualBeam systems”) and models that have small stages and are sold to customers in several markets (“small-stage DualBeam systems”).
We have research, development and manufacturing operations in Hillsboro, Oregon; Eindhoven, the Netherlands; and Brno, Czech Republic.
Our sales and service operations are conducted in the U.S. and approximately 50 other countries around the world. We also sell our products through independent agents, distributors and representatives in additional countries.
Basis of Presentation
The consolidated financial statements include the accounts of FEI Company and our majority-controlled subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates in Financial Reporting
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Significant accounting policies and estimates underlying the accompanying consolidated financial statements include:
· the timing of revenue recognition;
· the allowance for doubtful accounts;
· valuations of excess and obsolete inventory;
· valuation of marketable securities;
· valuation of investments in privately-held companies;
· the lives and recoverability of equipment and other long-lived assets such as goodwill, existing technology intangibles;
· restructuring, reorganization, relocation and severance costs;
· accounting for income taxes;
· warranty liabilities;
· stock-based compensation; and
· accounting for derivatives.
It is reasonably possible that the estimates we make may change in the future.
Concentration of Credit Risk
Instruments that potentially subject us to concentration of credit risk consist principally of cash and cash equivalents, short-term investments and receivables. Our investment policy limits investments with any one issuer to 10% or less of the total investment portfolio, with the exception of money market funds and securities issued by the U.S. government or its agencies which may comprise up to 100% of the total investment portfolio. Our exposure to credit risk concentrations within our receivables balance is limited due to the large number of entities comprising our customer base and their dispersion across many different industries and geographies.
Dependence on Key Suppliers
Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business, including our ability to convert backlog into revenue. We currently use numerous vendors to supply parts, components and subassemblies for the manufacture and support of our products. Some key parts, however, may only be obtained from a single supplier or a limited group of suppliers. In particular, we rely on: VDL Enabling Technologies Group, or ETG, Frencken Mechatronics B.V. and AZD Praha STR for our supply of mechanical parts and subassemblies; Gatan, Inc. for critical accessory products; and Neways Electronics, N.V. for some of our electronic subassemblies. In addition, some of our suppliers rely on sole suppliers. As a result of this concentration of key suppliers, our results of operations may be materially and adversely affected if we do not timely and cost-effectively receive a sufficient quantity of quality parts to meet our production requirements or if we are required to find alternative suppliers for these supplies. We may not be able to expand our supplier group or to reduce our dependence on single suppliers. If our suppliers are not able to meet our supply requirements, constraints may affect our ability to deliver products to customers in a timely manner, which could have an adverse effect on our results of operations. In addition, world wide restrictions governing the use of certain hazardous substances in electrical and electronic equipment (Restrictions on Hazardous Substances, or “RoHS,” regulations) may impact parts and component availability or our electronics suppliers’ ability to source parts and components in a timely and cost-effective manner. Overall, because we only have a few equipment suppliers, we may be more exposed to future cost increases for this equipment.
In addition, we rely on a limited number of equipment manufacturers to develop and supply the equipment we use to manufacture our products. The failure of these manufacturers to develop or deliver quality equipment on a timely basis could have a material adverse effect on our business and results of operations. In addition, because we only have a few equipment suppliers, we may be more exposed to future cost increases for this equipment.
Cash and Cash Equivalents
Cash and cash equivalents include cash deposits in banks, money market funds and other highly liquid marketable securities with maturities of three months or less at the date of acquisition.
Restricted Cash
Our restricted cash balances are held in deposit accounts with banks that have issued guarantees and letters of credit to our customers for system sales transactions and customer advance deposits relating to prepayments for service contracts, mainly in Europe and Asia. This restricted cash can be drawn on by the bank if goods are not delivered or services are not properly performed. In addition, while the restricted cash is held in the bank it is earning interest. Given these deposit accounts require satisfaction of conditions other than a withdrawal demand for us to receive a return of principal, are interest bearing and are held for extended periods of time, we have concluded these balances are similar in nature to our other investments and that inclusion in investing activities on our statement of cash flows is appropriate and consistent with our treatment of other investments.
Accounts Receivable
The roll-forward of our accounts receivable allowance was as follows (in thousands):
Write-offs include amounts written off for specifically identified bad debts.
Marketable Securities
We account for our investments in marketable securities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Our investments include marketable debt securities, corporate notes and bonds and government-backed securities with maturities greater than 90 days at the time of purchase. Our fixed maturity securities are classified as available-for-sale securities and, accordingly, are carried at fair value, based on quoted market prices, with the unrealized gains or losses reported, net of tax, in shareholders’ equity as a component of accumulated other comprehensive income (loss).
Certain equity securities held in short-term and long-term investments related to the executive deferred compensation plan are classified as trading securities. Investments designated as trading securities are carried at fair value on the balance sheet, based on quoted market prices, with the unrealized gains or losses recorded in interest and other income in the period incurred.
Realized gains and losses on all investments are recorded on the specific identification method and are included in interest and other income. Investments with maturities greater than 12 months from the balance sheet date are classified as non-current investments, unless they are expected to be liquidated within the next 12 months; in which case, the investment is classified as current.
Inventories
Inventories are stated at the lower of cost or market, with cost determined by standard cost methods, which approximate the first-in, first-out method. Inventory costs include material, labor and manufacturing overhead. Service inventories that exceed the estimated requirements for the next 12 months based on recent usage levels are reported as other long-term assets. Management has established inventory reserves based on estimates of excess and/or obsolete current and non-current inventory.
Income Taxes
We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of the assets and liabilities. In accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes,” we record a valuation allowance to reduce deferred tax assets to the amount expected to “more likely than not” be realized in our future tax returns. During 2007 and 2006, we released a portion of the valuation allowance recorded against U.S. deferred tax assets which were utilized during the periods to offset 2007 and 2006 U.S. taxable income.
Should we determine that we would not be able to realize all or part of our remaining net deferred tax assets in the future, increases to the valuation allowance for deferred tax assets may be required.
Conversely, if we determine that certain tax assets that have been reserved for may be realized in the future, we may reduce our valuation allowance in future periods. Our net deferred tax assets totaled $2.6 million and $0.5 million, respectively, at December 31, 2007 and 2006 and our valuation allowance totaled $39.5 million and $33.5 million, respectively.
In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109.” This statement clarifies the criteria that an individual tax position must satisfy for some or all of the benefits of that position to be recognized in a company’s financial statements. Interpretation No. 48 prescribes a recognition threshold of more likely than not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements. Effective January 1, 2007, we adopted the provisions of Interpretation No. 48 and recorded a $4.1 million increase to the opening balance of retained earnings to account for the cumulative effect of applying the new standard to previously unrecognized tax benefits. The increase to retained earnings was attributable to the resolution of a U.S. federal tax audit where the result was considered more likely than not under the recognition and measurement standards of Interpretation No. 48.
On January 1, 2007, total unrecognized tax benefits were $17.6 million, of which $9.1 million would have an impact on the effective tax rate. Interest and penalties accrued on unrecognized tax benefits were $1.5 million and were treated as tax expense in the consolidated statement of operations. Unrecognized tax benefits relate mainly to uncertainty surrounding intercompany pricing, permanent establishment and the capitalization of certain costs. See Note 13 for additional information.
Property, Plant and Equipment
Land is stated at cost. Buildings and improvements are stated at cost and depreciated over estimated useful lives of approximately 35 years using the straight-line method. Machinery and equipment, including systems used in research and development activities, production and in demonstration laboratories, are stated at cost and depreciated over estimated useful lives of approximately three to seven years using the straight-line method. Leasehold improvements are amortized over the shorter of their economic lives or the lease term. Maintenance and repairs are expensed as incurred. See Note 5 “Asset Impairment Charges” for a discussion of property, plant and equipment impairment charges incurred in 2006 and 2005.
Demonstration systems consist primarily of internally manufactured products and related accessories that we use for marketing purposes in our demonstration laboratories (“NanoPorts”) or for trade shows. These systems are not held for sale and accordingly are recorded as a component of property, plant and equipment and depreciated using the straight-line method over their expected useful lives of approximately three to seven years with the expense being reflected as a component of selling, general and administrative.
On occasion we loan systems to customers on a temporary basis while they wait for their tool to be manufactured or for evaluation. These systems are included in our finished goods inventories and the lending/evaluation periods are typically for a time period of less than one year. The sale of disposable products or services is not typically included in these arrangements. Any expense associated with these systems is recorded as a component of cost of sales.
Additionally, we lease systems to customers as operating type leases as defined by SFAS No. 13, “Accounting for Leases,” where we are the lessor. Under the operating method, rental revenue is recognized over the lease period. The leased asset is depreciated over the life of the lease. In addition to the depreciation charge, maintenance costs and the cost of any other services rendered under the provision of the lease that pertain to the current accounting period are charged to expense.
Purchased Technology
Purchased technology represents the estimated value of products utilizing technology existing as of the purchase date, discounted to its net present value. Purchased technology is amortized on a straight-line basis over the estimated useful life of the technology, typically 5 to 12 years. See Note 5 “Asset Impairment Charges” for a discussion of purchased technology impairment charges incurred in 2005.
Long-Lived Asset Impairment
We evaluate, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the remaining life and recoverability of equipment and other assets that are to be held and used, including purchased technology and other intangible assets with definite useful lives, whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If there is an indication of impairment, we prepare an estimate of future, undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If these cash flows are less than the carrying value of the asset, we adjust the carrying amount of the asset to its estimated fair value. Long-lived assets to be disposed of by sale are valued at the lower of book value or fair value less cost to sell. See Note 5 “Asset Impairment Charges” for a discussion of long-lived asset impairment charges incurred in 2005.
Investments in Privately-Held Companies
We made investments in several small, privately held technology companies in which we hold less than 20% of the capital stock or hold notes receivable. We account for these investments at their cost unless their value has been determined to be other-than-temporarily impaired, in which case we write the investment down to its estimated fair value. We review these investments periodically for impairment and make appropriate reductions in carrying value when an “other-than-temporary” decline is evident. However, for non-marketable equity securities, the impairment analysis requires significant judgment. We evaluate the financial condition of the investee, market conditions and other factors providing an indication of the fair value of the investments. Based on these actions, in 2006 and 2005, we concluded that certain of these investments had “other-than-temporary” impairments and, accordingly, we recorded impairment charges totaling $3.9 million and $2.9 million, respectively, as a component of other income (expense). As of December 31, 2006, all cost-method investments had been written down to zero. During 2007, we recorded gains totaling $1.0 million on the disposal of two of our cost-method investments. See also Note 3 “Investments.”
Goodwill
Goodwill represents the excess purchase price over fair value of net assets acquired. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill and other identifiable intangible assets with indefinite useful lives are no longer amortized, but, instead, a two-step impairment test is performed at least annually, in accordance with the provisions of SFAS No. 142. We test goodwill for impairment annually in the fourth quarter. First, the fair value of each reporting unit is compared to its carrying value. We have defined our reporting units to be our operating segments as disclosed under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” If the fair value of the reporting unit exceeds the carrying value, goodwill is not impaired and no further testing is performed. The second step is performed if the carrying value exceeds the fair value. The implied fair value of the reporting unit’s goodwill must be determined and compared to the carrying value of the goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, an impairment loss equal to the difference will be recorded. No impairments were identified in step one of our annual analysis during the fourth quarter of 2007, 2006 or 2005 as a result of this test.
Additionally, in the second quarter of 2005, based on our then-current and projected operating results, we concluded that there were sufficient indicators to require us to assess whether the portion of our goodwill balance recorded within, what was then, our microelectronics reporting unit was impaired. We applied the two-step impairment test described above. In determining the fair value used in step one of the impairment analysis for the microelectronics reporting unit, we employed the market approach, consisting of the market comparable methodology. The market comparable methodology involves comparing the reporting unit to similar publicly held companies whose equity securities are actively traded on a public
market. Financial multiples of the comparable public companies are computed and these multiples were then applied to the reporting unit’s operating results to estimate their fair value. The estimated fair value of the reporting unit exceeded its carrying value and, accordingly, no further impairment analysis was required.
Segment Reporting
Based upon definitions contained within SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” we have determined that we operate in four reportable operating segments: NanoElectronics, NanoResearch and Industry, NanoBiology and Service and Components. There are no differences between the accounting policies used for our business segments compared to those used on a consolidated basis.
Revenue Recognition
We recognize revenue when persuasive evidence of a contractual arrangement exits, delivery has occurred or services have been rendered, the seller’s price to buyer is fixed and determinable, and collectibility is reasonably assured.
For products demonstrated to meet our published specifications, revenue is recognized when the title to the product and the risks and rewards of ownership pass to the customer. The portion of revenue related to installation and final acceptance, of which the estimated fair value is generally 4% of the total revenue of the transaction, is deferred until such installation and final customer acceptance are completed. For products produced according to a particular customer’s specifications, revenue is recognized when the product meets the customer’s specifications and when the title and the risks and rewards of ownership have passed to the customer. In each case, the portion of revenue applicable to installation and customer acceptance is recognized upon meeting specifications at the installation site. For new applications of our products where performance cannot be assured prior to meeting specifications at the installation site, no revenue is recognized until such specifications are met.
For sales arrangements containing multiple elements (products or services), revenue relating to undelivered elements is deferred at the estimated fair value until delivery of the deferred elements. To be considered a separate element, the product or service in question must represent a separate unit under accounting rules and fulfill the following criteria: the delivered item(s) has value to the customer on a standalone basis; there is objective and reliable evidence of the fair value of the undelivered item(s); and, if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all criteria above, the entire amount of the transaction is deferred until all elements are delivered.
We provide maintenance and support services under renewable, term maintenance agreements. Maintenance and support fee revenue is recognized ratably over the contractual term, which is generally 12 months, and commences from contract date.
Revenue from time and materials based service arrangements is recognized as the service is performed. Spare parts revenue is generally recognized upon shipment.
Deferred revenue represents customer deposits on equipment orders, orders awaiting customer acceptance and prepaid service contract revenue. Deferred revenue is recognized in accordance with our revenue recognition policies described above.
Deferred Revenue
Deferred revenue represents customer deposits on equipment orders, orders awaiting customer acceptance and prepaid service contract revenue. Deferred revenue is recognized in accordance with our revenue recognition policies described above.
Product Warranty Costs
Our products generally carry a one-year warranty. A reserve is established at the time of sale to cover estimated warranty costs as a component of cost of sales on our consolidated statements of operations. Our estimate of warranty cost is based on our history of warranty repairs and maintenance. While most new products are extensions of existing technology, the estimate could change if new products require a significantly different level of repair and maintenance than similar products have required in the past. Our estimated warranty costs are reviewed and updated on a quarterly basis. Historically, we have not made significant adjustments to our estimates. However, in the third quarter of 2005, we reduced our warranty reserve by approximately $1.0 million as a result of our continual review of the actual warranty repair and maintenance activity, which was below our initial reserve estimates. No significant adjustments were made to our estimates in 2007 or 2006.
A roll-forward of our warranty liability for the years ended December 31, 2007, 2006 and 2005 was as follows (in thousands):
Research and Development
Research and development costs are expensed as incurred. We periodically receive funds from various organizations to subsidize our research and development. These funds are reported as an offset to research and development expense. These subsidies totaled $4.0 million, $3.9 million and $4.6 million in 2007, 2006 and 2005, respectively. Subsidies have decreased as the projects available for subsidies, primarily in the Netherlands and the U.S., have decreased.
Advertising
Advertising costs are expensed as incurred and are included as a component of selling, general and administrative costs on our consolidated statements of operations. Advertising expense totaled $3.5 million, $2.9 million and $2.6 million in 2007, 2006 and 2005, respectively.
Computation of Per Share Amounts
Basic earnings per share (“EPS”) and diluted EPS are computed using the methods prescribed by SFAS No. 128, “Earnings per Share.” Following is a reconciliation of basic EPS and diluted EPS (in thousands, except per share amounts):
(1) Amounts may not add due to rounding.
Stock-Based Compensation
Effective January 1, 2006, we adopted SFAS No. 123R, “Share-Based Payment.” We elected to use the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-K have not been restated to reflect the fair value method of expensing stock-based compensation. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. In addition, the unrecognized expense of awards not yet vested at the date of adoption is recognized in net income in the periods after the date of adoption over the remainder the requisite service period. The cumulative effect of the change
in accounting principle from Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” to SFAS No. 123R was not material.
Prior to January 1, 2006, we accounted for stock-based compensation using the intrinsic value method as prescribed by APB Opinion No. 25 and related interpretations. We provided disclosures of net loss and net loss per share as prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” as if it had been applied in measuring compensation expense as follows (in thousands, except per share amounts):
We did not record any tax benefit for U.S. losses generated in 2005. Accordingly, the only tax benefit reflected in the pro forma stock-based employee compensation expense in 2005 was for non-U.S. based awards.
Our stock-based compensation expense was included in our statements of operations as follows (in thousands):
Compensation expense related to restricted shares and restricted stock units is based on the fair value of the underlying shares on the date of grant as if the shares were vested. Compensation expense related to options granted pursuant to our stock incentive plans and shares purchased pursuant to our employee share purchase plan was determined based on the estimated fair values using the Black-Scholes option pricing model and the following weighted average assumptions:
(1) No options granted during 2007.
The risk-free rate used is based on the U.S. Treasury yield over the estimated term of the options granted. Expected lives were estimated based on the average between the stock option awards’ vest date and their contractual life. The expected volatility is calculated based on the historical volatility of our common stock.
We amortize stock-based compensation expense related to options granted prior to the adoption of SFAS No. 123R on a ratable basis and related to options granted after the adoption of SFAS No. 123R and restricted shares and restricted stock units on a straight-line basis over the vesting period of the individual
award with estimated forfeitures considered. Vesting periods are generally four years. Shares to be issued upon the exercise of stock options will come from newly issued shares. The exercise price of issued options equals the grant date fair value of the underlying shares and the options generally have a legal life of seven years. Stock-based compensation costs related to inventory or fixed assets were not significant in the years ended December 31, 2007 or 2006.
Foreign Currency Translation
Assets and liabilities denominated in a foreign currency, where the local currency is the functional currency, are translated to U.S. dollars at the exchange rate in effect on the respective balance sheet date. Gains and losses resulting from the translation of assets, liabilities and equity are included in accumulated other comprehensive income on the consolidated balance sheet. Transactions representing revenues, costs and expenses are translated using an average rate of exchange for the period, and the related gains and losses are reported as other income (expense) on our consolidated statement of operations.
2. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
SFAS No. 141R and SFAS No. 160
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements.” SFAS Nos. 141R and 160 require most identifiable assets, liabilities, noncontrolling interests and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity, which changes the accounting for transactions with noncontrolling interest holders. Both statements are effective for periods beginning on or after December 15, 2008 and earlier adoption is prohibited. SFAS No. 141R will be applied to business combinations occurring after the effective date and SFAS No. 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date. While we are still analyzing the effects of applying SFAS Nos. 141R and 160, we believe that the adoption of SFAS Nos. 141R and 160 will not have a material effect on our financial position or results of operations.
EITF 07-3
In June 2007, the Emerging Issues Task Force (“EITF”) issued EITF 07-3, “Accounting for Advance Payments for Goods or Services to Be Used in Future Research and Development Activities,” which states that non-refundable advance payments for services that will be consumed or performed in a future period in conducting research and development activities on behalf of the company should be recorded as an asset when the advance payment is made and then recognized as an expense when the research and development activities are performed. EITF 07-3 is applicable prospectively to new contractual arrangement entered into in fiscal years beginning after December 15, 2007. While we are still analyzing the effects of applying EITF 07-3, we believe that the adoption of EITF 07-3 will not have a material effect on our financial position or results of operations.
SFAS No. 159
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. While we are still analyzing the effects of applying SFAS No. 159, we believe that the adoption of SFAS No. 159 will not have a material effect on our financial position or results of operations.
SFAS No. 157
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which establishes a single authoritative definition of fair value, sets out a framework for measuring fair value and requires additional disclosures about fair-value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. While we are still analyzing the effects of applying SFAS No. 157, we
believe that the adoption of SFAS No. 157 will not have a material effect on our financial position or results of operations.
3. INVESTMENTS
Investments held at December 31, 2007 consisted of the following (in thousands):
Investments held at December 31, 2006 consisted of the following (in thousands):
(1) Investments for which it is not practical to estimate fair value are included at cost and primarily consist of investments in privately-held companies.
Realized gains and losses on sales of marketable securities were insignificant in 2007, 2006 and 2005.
We review investments in debt and equity securities for other than temporary impairment whenever the fair value of an investment is less than amortized cost and evidence indicates that an investment’s carrying amount is not recoverable within a reasonable period of time. In the evaluation of whether an impairment is “other-than-temporary,” we consider our ability and intent to hold the investment until the market price recovers, the reasons for the impairment, compliance with our investment policy, the severity and duration of the impairment and expected future performance. As of December 31, 2007, $10.9 million of government-backed securities and $33.0 million of corporate notes and bonds had unrealized losses of $17,000 and $1,000, respectively. These unrealized losses are mainly due to interest rate movements, and no unrealized losses of any significance existed for a period in excess of 12 months. See also Note 24, “Subsequent Events,” for information regarding the liquidity of our investments in auction rate securities.
For investments in small privately-held companies, which are recorded at cost, it is often not practical to estimate fair value. In order to assess if impairments exist that are “other-than-temporary,” we reviewed recent interim financial statements and held discussions with these entities’ management about their
current financial conditions and future economic outlooks. We also considered our willingness to support future funding requirements as well as our intention and/or ability to hold these investments long-term. Based on these actions, in 2006 and 2005, we concluded that certain of these investments had “other-than-temporary” impairments and, accordingly, we recorded impairment charges totaling $3.9 million and $2.9 million, respectively, as a component of other income (expense). Additionally, we recorded a loss of $3.5 million in 2005 as a component of other income (expense) related to the liquidation of a portion of a convertible note investment.
During 2006, in addition to the $3.9 million impairment charge mentioned above, we sold one cost-based investment for a gain of $5.2 million. In 2007, we recorded an additional $0.5 million gain for the final escrow payment related to the disposal of this investment. We recorded an additional $0.5 million gain in 2007 related to the sale of another investment, which was previously written down in 2006. All remaining cost method investments were written down to zero as of December 31, 2006.
Contractual maturities or expected liquidation dates of long-term marketable securities at December 31, 2007 were as follows (in thousands):
4. FACTORING OF ACCOUNTS RECEIVABLE
In 2007 and 2006, we entered into agreements under which we sold a total of $1.2 million and $2.0 million, respectively, of our accounts receivable at a discount to unrelated third party financiers without recourse. The transfers qualified for sales treatment under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Discounts related to the sale of the receivables, which were immaterial, were recorded on our statements of operations as other expense.
5. ASSET IMPAIRMENT CHARGES
We initiated restructuring actions in the second quarter of 2005, which continued into 2006, to align our cost structure with the current prevailing market conditions, primarily in the semiconductor markets. The actions taken, which were necessary as a result of reduced business volumes, resulted in decreases in our global workforce and also required us to evaluate our goodwill and long-lived assets for impairment in components of our segment previously knows as our microelectronics segment.
As a result of these evaluations, we recorded asset impairment charges and write-downs totaling $39.6 million in 2005 as either components of asset impairment or cost of sales on our consolidated statements of operations. These charges are summarized as follows (in thousands):
In addition, in 2006, we recorded an additional $0.5 million charge as asset impairments on our consolidated statements of operations related to the write-off of additional costs for our enterprise resource planning (“ERP”) system abandonment. No impairment charges were recorded in 2007.
Inventory
Write-downs of inventory in 2005 related to portions of our semiconductor businesses and to the closure of our Peabody, Massachusetts facility, which primarily manufactured and supported products sold to semiconductor markets. In response to the declining product demand which continued throughout 2005, management decided to restructure these businesses, which included lowering demand expectations and accepting a significant price adjustment of approximately $1.0 million below cost to complete a sale on a product that we were deemphasizing in the market place.
Goodwill
We test goodwill annually in the fourth quarter, however, in the second quarter of 2005, based on our current and projected operating results, we concluded that there were sufficient indicators to require us to assess whether a portion of our recorded goodwill balance within our microelectronics segment was impaired at this interim date. The impairment review was performed in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Based on these analyses, we concluded that the goodwill allocated to this segment was not impaired.
Long-Lived Assets
As a result of the initiation of our restructuring actions and due to the weakness in the semiconductor market, our projected future revenues and cash flows for certain asset groupings were revised downward in the second quarter of 2005. These factors led to indications that the carrying value of certain of our long-lived assets, including purchased intangibles recorded in various acquisitions, property, plant and equipment and patents and other intangibles, may not be recoverable and we performed impairment reviews as of July 3, 2005. The impairment reviews were performed in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We evaluated the recoverability of the long-lived assets and concluded that impairments existed. Accordingly, we recorded impairment charges based on the amounts by which the carrying amounts of these assets exceeded their fair value. Fair value was determined based on discounted cash flows for the operating entities that had separately identifiable cash flows. In addition, in the fourth quarter of 2005, we decided to abandon our ERP system project and, accordingly, wrote off all costs related to this project. In total, impairment charges for long-lived assets were $25.4 million in 2005.
6. INVENTORIES
Inventories consisted of the following (in thousands):
Non-service inventory valuation adjustments totaled $1.0 million in 2007, were insignificant in 2006 and totaled $10.1 million in 2005 (inclusive of the write-downs discussed in Note 5). Provision for service inventory valuation adjustments totaled $4.0 million, $4.2 million and $2.9 million, respectively, in 2007, 2006 and 2005.
7. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following (in thousands):
See also Note 5 for a discussion of long-lived asset impairments.
8. GOODWILL, PURCHASED TECHNOLOGY AND OTHER INTANGIBLE ASSETS
The roll-forward of our goodwill was as follows (in thousands):
Adjustments to goodwill include translation adjustments resulting from a portion of our goodwill being recorded on the books of our foreign subsidiaries.
At December 31, 2007 and 2006, our other intangible assets included purchased technology, patents, trademarks and other and note issuance costs. The gross amount of our other intangible assets and the related accumulated amortization were as follows (in thousands):
See Note 5 for a discussion of impairment charges and write-offs related to purchased software, capitalized software and patents recognized during 2005.
See Note 10 for a discussion of note issuance cost write-offs totaling $0.3 million and $1.1 million, respectively, related to the convertible note redemptions in 2006 and 2005.
Amortization expense, excluding impairment charges and note issuance cost write-offs, was as follows (in thousands):
Expected amortization, without consideration for foreign currency effects, is as follows (in thousands):
9. CREDIT FACILITIES
We have a 50.0 million yen unsecured and uncommitted bank borrowing facility in Japan and various limited facilities in select foreign countries. As part of our contracts with certain customers, we are required to provide letters of credit or bank guarantees which these customers can draw against in the event we do not perform in accordance with our contractual obligations. At December 31, 2007, we had $46.1 million of these guarantees and letters of credit outstanding, of which approximately $45.6 million were secured by restricted cash deposits. Restricted cash balances securing bank guarantees that expire within 12 months of the balance sheet date are recorded as a current asset on our consolidated balance sheets. Restricted cash balances securing bank guarantees that expire beyond 12 months from the balance sheet date are recorded as long-term restricted cash on our consolidated balance sheet.
10. CONVERTIBLE NOTES
2.875% Convertible Subordinated Notes
On May 19, 2006, we issued $115.0 million aggregate principal amount of convertible subordinated notes. The interest rate on the notes is 2.875%, payable semi-annually. The notes are due on June 1, 2013, are subordinated to all previously existing and future senior indebtedness, are effectively subordinated to all indebtedness and other liabilities of our subsidiaries, and rank pari passu in right of payment with our zero coupon convertible subordinated notes and our 5.5% convertible subordinated notes. The cost of this transaction, including underwriting discounts and commissions and offering expenses, totaled $3.1 million and is recorded on our balance sheet in other long-term assets and is being amortized over the life of the notes. The amortization of these costs totals $0.1 million per quarter and is reflected as additional interest expense in our statements of operations. The notes are convertible into 3,918,395 shares of our common stock, at the note holder’s option, at a price of $29.35 per share.
5.5% Convertible Subordinated Notes
On August 3, 2001, we issued $175.0 million of convertible subordinated notes, due August 15, 2008, through a private placement. The notes are currently redeemable at our option. The notes bear interest at 5.5%, payable semi-annually. The notes are convertible into shares of our common stock, at the noteholder’s option, at a price of $49.52 per share.
We have made the following redemptions of these notes:
The redemption premium and write-off of related note issuance costs were included as a component of interest expense in the period of redemption.
These notes were paid off in full in January 2008. See Note 24, “Subsequent Events” for additional information.
Zero Coupon Convertible Subordinated Notes
On June 13, 2003, we issued $150.0 million aggregate principal amount of zero coupon convertible subordinated notes. The interest rate on the notes is zero and the notes will not accrete interest. The notes are due on June 15, 2023 and are first putable to us at the noteholder’s option (in whole or in part) for cash on June 15, 2008, at a price equal to 100.25% of the principal amount, and on June 15, 2013 and 2018, at a price equal to 100% of the principal amount. The notes are also putable to us at the noteholder’s option upon a change of control at a price equal to 100% of the principal amount. We can redeem the notes (in whole or in part) for cash on June 15, 2008, at a price equal to 100.25% of the principal amount, or thereafter at a price equal to 100% of the principal amount. The notes are subordinated to all previously existing and future senior indebtedness and are effectively subordinated to all indebtedness and other liabilities of our subsidiaries. The cost of this transaction, including underwriting discounts and commissions and offering expenses, totaled $4.8 million and is recorded on our balance sheet in other long-term assets and is being amortized over the life of the notes. The amortization of these costs totals $240,000 per quarter and is reflected as interest expense in our statements of operations.
The notes are convertible into shares of our common stock upon the occurrence of certain events at an initial conversion price of $27.132 per share (subject to adjustment), or 5,528,527 shares if the entire $150.0 million is converted. Upon conversion, we have the option to settle the notes in cash, shares of our common stock, or a combination of cash and shares.
11. CONVERTIBLE NOTE HEDGE AND WARRANT TRANSACTIONS
We used a portion of the net proceeds from the offering of our zero coupon convertible subordinated notes to enter into convertible note hedge and warrant transactions with respect to our common stock, the exposure for which was held at the time the notes were issued by Credit Suisse First Boston International, an affiliate of an initial purchaser of the notes. The net cost of the hedging transactions of $23.9 million was included as a reduction of common stock in shareholders’ equity in accordance with the guidance in EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”
In November 2005, we terminated the hedge and warrant in return for a cash payment of approximately $11.0 million to us from the counterparty to these instruments. The termination of the hedge and warrant eliminate the potential anti-dilutive effect of the hedge in the event of future conversions of the zero coupon notes. The receipt of the approximately $11.0 million was recorded as an increase to contributed capital and did not result in any gain or loss in our consolidated statement of operations.
12. LEASE OBLIGATIONS
We have operating leases for certain of our manufacturing and administrative facilities that extend through 2019. The lease agreements generally provide for payment of base rental amounts plus our share of property taxes and common area costs. The leases generally provide renewal options at current market rates.
Rent expense is recognized on a straight-line basis over the term of the lease. Rent expense was $7.1 million in 2007, $7.1 million in 2006 and $7.8 million in 2005.
The approximate future minimum rental payments due under these agreements as of December 31, 2007, were as follows (in thousands):
13. INCOME TAXES
Income tax expense (benefit) consisted of the following (in thousands):
The effective income tax rate applied to net income (loss) varied from the U.S. federal statutory rate due to the following (in thousands):
Our 2007 tax provision on income from continuing operations reflected taxes on foreign earnings offset by a $4.7 million release of unrecognized tax benefits, including interest and penalties, as a result of the settlement of foreign tax audits and a tax benefit of $5.3 million related to the release of valuation allowance recorded against net operating loss deferred tax assets utilized to offset income earned in the U.S.
The 2006 income tax provision on income from continuing operations consisted primarily of taxes accrued in foreign jurisdictions and reflects a benefit of $1.5 million related to the release of valuation allowance against a portion of deferred tax assets utilized during the period to offset 2006 U.S. taxable income. We continue to record a valuation allowance against the remaining U.S. deferred tax assets as we do not believe it is more likely than not that the benefit of the deferred tax assets will be realized in future periods. The 2005 income tax expense included provisions for foreign taxable income, but did not reflect a benefit for 2005 losses in the U.S. as we recorded full valuation allowances against the U.S. deferred tax assets generated from such losses. We also recorded a charge in 2005 for valuation allowances placed on our U.S. deferred tax assets recorded as of December 31, 2004.
Current taxes payable were reduced for foreign tax benefits recorded to common stock and related to stock compensation of $0.4 million and $1.4 million, respectively, in 2007 and 2006. No amounts were recorded in 2005. No tax benefits were recorded in the U.S. for excess tax benefits relating to stock-based compensation or the convertible note hedge in 2007, 2006 or 2005 due to our current valuation allowance against net operating losses in the U.S.
Deferred Income Taxes
Net deferred tax assets and liabilities were included in the following consolidated balance sheet accounts:
The tax effects of temporary differences that gave rise to significant portions of deferred tax assets and deferred tax liabilities were as follows (in thousands):
At December 31, 2007, we had approximately $57.2 million of U.S. net operating loss carryforwards that can be used to offset future income for U.S. federal income tax purposes, which expire through 2027, and approximately $34.3 million for Oregon income tax purposes, which expire through 2022. Approximately
$27.7 million of the increase in net operating loss carryforwards was primarily due to excess tax benefits relating to share-based compensation and other equity related items in 2007 offset by utilization of part of the net operating loss carryforwards against 2007 U.S taxable income. Additionally, deferred tax expense of $0.8 million, $1.6 million and $1.1 million was recorded in other comprehensive income in 2007, 2006 and 2005 respectively.
Our valuation allowances on deferred tax assets totaled $39.5 million and $33.5 million as of December 31, 2007 and 2006, respectively. In assessing the realizability of deferred tax assets, SFAS No. 109, “Accounting for Income Taxes,” establishes a more likely than not standard. If it is determined that it is “more likely than not” that deferred tax assets will not be realized, a valuation allowance must be established against the deferred tax assets. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, historical operating performance, projected future taxable income and tax planning strategies in making this assessment. Our “more likely than not” assessment was principally based upon our historical losses in the U.S., the impact of the restructuring activities discussed in Note 14 and our forecast of future profitability in certain tax jurisdictions, primarily the U.S.
Federal and state research and development tax credit carryforwards as of December 31, 2007 were $3.8 million and expire between 2008 and 2027. Federal foreign tax credits as of December 31, 2007 were $1.3 million and expire in 2010 and 2011. We also have $0.8 million of alternative minimum tax carryforwards, which do not expire.
As of December 31, 2007, U.S. income taxes have not been provided for approximately $168.9 million of cumulative undistributed earnings of several non-U.S. subsidiaries, as our current intention is to reinvest these earnings indefinitely outside the U.S. Foreign tax provisions have been provided for these cumulative undistributed earnings. Upon distribution of those earnings in the form of dividends or otherwise, we would be subject to both U.S. income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the various foreign countries. Similarly, we have not provided deferred taxes on the cumulative translation adjustment related to those non-U.S. subsidiaries.
Unrecognized Tax Benefits Under Interpretation No. 48 and Other Tax Contingencies
We adopted the provisions of FIN 48 on January 1, 2007. As of December 31, 2007, unrecognized tax benefits related mainly to uncertainty surrounding intercompany pricing and permanent establishment. A reconciliation of the beginning and ending amount of unrecognized tax benefits and related deferred tax assets was as follows (in thousands):
Current and non-current liability components of unrecognized tax benefits were classified on the balance sheet as follows (in thousands):
The entire balance of unrecognized tax benefits, if recognized, would reduce our effective tax rate.
We recognize interest and penalties related to unrecognized tax benefits in income tax expense. The liability for unrecognized tax benefits included accrued interest and penalties of $1.5 million and $1.4 million as of January 1, 2007 and December 31, 2007, respectively. Tax expense for the year ended December 31, 2007 included a benefit for interest and penalties of $0.1 million, which is comprised of a benefit of $0.9 million related to the lapse of statutes of limitation and settlements with taxing authorities and a $0.8 million offset related to interest and penalties on unrecognized tax benefits for prior years.
During 2007, we requested a bilateral Advance Pricing Agreement (“APA”) between the U.S. and The Netherlands tax authorities under the mutual agreement procedures of the tax treaty. For the years ended December 31, 2006 and 2007, the requested transfer pricing methodologies would result in a total of approximately $35.0 million of additional tax deductions in The Netherlands and $35.0 million of additional taxable income in the U.S. The additional income in the U.S. can be offset by net operating loss carryforwards. As the outcome of the requested APA is not considered more likely than not, we have not recognized the benefit resulting from the use of the net operating loss carryforwards. Due to the uncertainty surrounding the timing of a possible agreement between the taxing authorities, we believe it is reasonably possible that unrecognized tax benefits could decrease somewhere in the range of zero to $9.7 million in the next 12 months.
We believe it is reasonably possible that the remainder of the unrecognized tax benefits could decrease by approximately $0.3 million in the next 12 months as the result of lapses of statutes of limitation.
For our major tax jurisdictions, the following years were open for examination by the tax authorities as of December 31, 2007:
14. RESTRUCTURING, REORGANIZATION, RELOCATION AND SEVERANCE
Restructuring, reorganization, relocation and severance costs are accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Under SFAS No. 146, liabilities for costs associated with exit or disposal activities are recognized and measured at fair value in the period the liability is incurred.
The $0.3 million net reversal of restructuring, reorganization, relocation and severance costs in 2007 related to favorable buyouts of our Peabody lease, offset by changes in estimates incorporated into our restructuring accrual related to our ability to sublease certain other abandoned facilities under lease.
Restructuring, reorganization, relocation and severance in 2006 included charges of $3.3 million for facilities and severance charges related to the closure of certain of our European field offices, closure of a research and development facility in Tempe, Arizona, as well as residual costs related to the Peabody plant closure and the downsizing of the related semiconductor businesses.
Effective April 1, 2006, our Chairman, President and Chief Executive Officer (“CEO”) was terminated. Our CEO was a party to an existing Executive Severance Agreement dated February 1, 2002. Termination of his service was deemed a termination without cause under the agreement. Pursuant to the terms of this agreement, and following his execution and non-revocation of a standard release, our CEO was entitled to certain severance benefits. These included: (i) a lump sum payment equaling three years of base salary (approximately $1.59 million); (ii) a lump sum payment equal to 100% of his target bonus for 2006 (approximately $583,000); (iii) acceleration of all of his stock options and restricted stock awards; (iv) permitting him to exercise his options until the earlier of three years after his departure date or the option expiration date as set forth in the applicable option agreement; (v) a lump sum payment equaling two times what his reasonably expected health insurance coverage costs would be for 18 months; and (vi) life insurance premium payments not to exceed $5,000.
Accordingly, in the first quarter of 2006, we recorded a charge of $9.3 million, of which $2.2 million related to the cash severance payments and $7.1 million related to the non-cash expense associated with the fair market value of the modified stock options, which modified the original awards to (i) accelerate all unvested stock options; (ii) waive the cancellation clause upon termination of employment; and (iii) extend their legal lives as discussed above.
In 2005, we expensed $4.6 million in severance and relocation costs related to workforce reductions and reallocation of personnel geographically, which was included as a component of restructuring, reorganization, relocation and severance expense. We also incurred $3.9 million of restructuring expense for facility closures, largely related to the Peabody facility (inclusive of $0.2 million in reserve releases related to prior accruals for another facility lease that was terminated).
The following tables summarize the charges, expenditures and write-offs and adjustments in 2007, 2006 and 2005 related to our restructuring, reorganization, relocation and severance accruals (in thousands):
Restructuring, reorganization, relocation and severance in 2006 also included the $7.1 million non-cash charge for stock-based compensation discussed above.
The current estimate accrued for cash to be paid related to abandoned leases is net of estimated sublease payments to be received and will be paid over the respective lease terms.
The restructuring charges are based on estimates that are subject to change. Workforce related charges could change because of shifts in timing, redeployment or changes in amounts of severance and outplacement benefits. Facilities charges could change due to changes in expected sublease income. Our ability to generate sublease income is dependent upon lease market conditions at the time we negotiate the sublease arrangements. Variances from these estimates could alter our ability to achieve anticipated expense reductions in the planned timeframe and modify our expected cash outflows and working capital.
15. SHAREHOLDERS’ EQUITY
Preferred Stock Rights Plan
On July 21, 2005, the Board of Directors adopted a Preferred Stock Rights Plan. Pursuant to the Preferred Stock Rights Plan, we distributed Rights as a dividend at the rate of one Right for each share of our common stock held by shareholders of record as of the close of business on August 12, 2005. The Rights expire on August 12, 2015, unless redeemed or exchanged.
The Rights are not exercisable until the earlier of: (1) 10 days (or such later date as may be determined by the Board of Directors) following an announcement that a person or group has acquired beneficial ownership of 20% of our common stock or (2) 10 days (or such later date as may be determined by the Board of Directors) following the announcement of a tender offer which would result in a person or group obtaining beneficial ownership of 20% or more of our outstanding common stock, subject to certain exceptions (the earlier of such dates being called the Distribution Date). The Rights are initially exercisable for one-thousandth of a share of our Series A Preferred Stock at a price of $120 per one-thousandth share, subject to adjustment. However, if: (1) after the Distribution Date we are acquired in certain types of transactions, or (2) any person or group (with limited exceptions) acquires beneficial ownership of 20% of our common stock, then holders of Rights (other than the 20% holder) will be entitled to receive, upon exercise of the Right, common stock (or in case we are completely acquired, common stock of the acquirer) having a market value of two times the exercise price of the Right. Philips Business Electronics International B.V., or any of its affiliates, shall not be considered for the 20% calculation so long as it does not acquire 30% or more of our common shares.
We are entitled to redeem the Rights, for $0.001 per Right, at the discretion of the Board of Directors, until certain specified times. We may also require the exchange of Rights, at a rate of one share of common stock for each Right, under certain circumstances. We also have the ability to amend the Rights, subject to certain limitations.
PEO Combination
On February 21, 1997, we acquired substantially all of the assets and liabilities of the electron optics business of Koninklijke Philips Electronics N.V. (the “PEO Combination”), in a transaction accounted for as a reverse acquisition. As part of the PEO Combination, we agreed to issue to Philips additional shares of our common stock whenever stock options that were outstanding on the date of the closing of the PEO Combination are exercised. Any such additional shares are issued at a rate of approximately 1.22 shares to Philips for each share issued on exercise of these options. We receive no additional consideration for these shares issued to Philips under this agreement. We did not issue any shares in 2007, 2006 or 2005 to Philips under this agreement. As of December 31, 2007, 185,000 shares of our common stock are potentially issuable and reserved for issuance as a result of this agreement.
Stock Incentive Plans
As of December 31, 2007, a total of 5,773,598 shares of our common stock were reserved for issuance pursuant to our stock incentive plans.
16. STOCK INCENTIVE PLANS AND STOCK-BASED COMPENSATION
Stock-Based Compensation Information
Certain information regarding our stock-based compensation was as follows (in thousands):
Stock Incentive Plan and 1995 Supplemental Stock Incentive Plan
Our 1995 Stock Incentive Plan, as amended (the “1995 Plan”) allows for issuance of a maximum of 9,500,000 shares and our 1995 Supplemental Stock Incentive Plan (the “1995 Supplemental Plan”) allows for issuance of a maximum of 500,000 shares.
We maintain stock incentive plans for selected directors, officers, employees and certain other parties that allow the Board of Directors to grant options (incentive and nonqualified), stock and cash bonuses, stock appreciation rights, restricted stock units (“RSUs”) and restricted shares. The Board of Directors’ ability to grant options under either the 1995 Plan or the 1995 Supplemental Plan will terminate, if the plans are not amended, when all shares reserved for issuance have been issued and all restrictions on such shares have lapsed, or earlier, at the discretion of the Board of Directors. At December 31, 2007, there were 2,612,262 shares available for grant under these plans and 5,773,598 shares of our common stock were reserved for issuance. Activity under these plans was as follows (share amounts in thousands):
Included in the above activity tables are 100,000 options to purchase our common stock and 75,000 RSUs granted to our chief executive officer in the third quarter of 2006. These grants were made outside of our plans at an exercise price of $19.38 per share for the options and a $19.38 per share fair value at grant date for the RSUs. The stock options and 25,000 of the RSUs vest over four years and 50,000 of the RSUs vested over a one-year period. We reduced the number of shares available for grant under the 1995 Plan by a number equal to the option and RSU grants made outside the 1995 Plan.
Summary
Certain information regarding all options outstanding as of December 31, 2007 was as follows:
As of December 31, 2007, unrecognized stock-based compensation related to outstanding, but unvested stock options, restricted shares and RSUs was $17.3 million, which will be recognized over the weighted average remaining vesting period of two years.
Employee Share Purchase Plan
In 1998, we implemented an Employee Share Purchase Plan (“ESPP”). A total of 2,450,000 shares of our common stock may be issued pursuant to the ESPP, as amended. Under the ESPP, employees may elect to have compensation withheld and placed in a designated stock subscription account for purchase of our common stock. Each ESPP offering period consists of one six-month purchase period. The purchase price in a purchase period is set at a 15% discount to the lower of the market price on either the first day of the applicable offering period or the purchase date. The ESPP allows a maximum purchase of 1,000 shares by each employee during any two consecutive offering periods. A total of 211,509 shares were purchased pursuant to the ESPP during 2007 at a weighted average purchase price of $20.88 per share, which represented a weighted average discount of $9.65 per share compared to the fair market value of our common stock on the dates of purchase. At December 31, 2007, 791,967 shares of our common stock remained available for purchase and were reserved for issuance under the ESPP.
Stock Option Acceleration of Vesting
On October 19, 2005, we accelerated the vesting, effective immediately, of certain “out-of-the-money” unvested options, as determined based on the per share price of our common stock of $19.34 as of the close of market on that date. Options held by our then-Chief Executive Officer and members of our Board of Directors were excluded from acceleration.
In making the decision to accelerate the vesting of these options, our Board of Directors considered a number of factors, including the interests of our shareholders in eliminating the future amortization of compensation expense represented by unvested options, the accounting impact of vesting acceleration, the potential impact on employee morale and the potential benefit to the market value of our common stock.
As a result of the acceleration, options representing approximately 1.4 million shares, which represented approximately 26% of the total outstanding options as of that date, became immediately exercisable. No compensation expense was recognized on our consolidated statement of operations related to this modification as the options modified had exercise prices greater than the fair value of the underlying stock at the acceleration date. This action, however, did result in an additional charge of approximately $17.9 million in our stock compensation expense footnote disclosure pursuant to SFAS No. 123 in 2005. See Note 1 “Summary of Significant Accounting Policies - Stock-Based Compensation.”
In addition, the vesting of certain stock options and restricted stock was accelerated in 2006 upon the termination of our former Chief Executive Officer. See Note 14 above.
17. EMPLOYEE BENEFIT PLANS
Pension Plans
Employee retirement plans have been established in some foreign countries in accordance with the legal requirements and customs in the countries involved. The majority of employees in Europe, Asia and Canada are covered by defined benefit, multi-employer or defined contribution pension plans. The benefits provided by these plans are based primarily on years of service and employees’ compensation near retirement. Employees in the U.S. are covered by a profit sharing 401(k) plan, which is a defined contribution plan.
Employees in the Netherlands participate with other companies in making collectively-bargained payments to the Metal-Electro Industry pension fund. Pension costs relating to this multi-employer plan were $6.7 million in 2007, $6.3 million in 2006 and $5.7 million in 2005.
Outside the U.S. and the Netherlands, employees are covered under various defined contribution and defined benefit plans as required by local law.
Plan costs for our defined contribution plans outside the U.S. and the Netherlands totaled $0.8 million in 2007, $0.4 million in 2006 and $0.2 million in 2005.
Plan costs for our defined benefit pension plans were $0.9 million in 2007, $0.3 million in 2006 and $0.6 million in 2005. Obligations under the defined benefit pension plans are not funded. A liability for the projected benefit obligations of these plans of $2.5 million and $2.2 million was included in other non-current liabilities as of December 31, 2007 and 2006, respectively. Unrealized gains (losses) recorded in other comprehensive income related to the additional minimum pension liability for these plans totaled $0.2 million in 2007 and $(0.6) million in 2006. Due to the immateriality of these defined benefit pension plan costs, we have not included all disclosures required by SFAS No. 87, “Employers Accounting for Pensions,” and SFAS No. 132 (Revised 2003), “Employer’s Disclosures about Pensions and Other Postretirement Benefits.”
Profit Share and Variable Compensation Programs
In 2006, we modified the Employee Profit Share Plan that had been in place since 2000. We also have a Management Variable Compensation Plan for management-level employees to reward achievement of corporate and individual objectives. The Compensation Committee of the Board of Directors generally determines the structure of the overall incentive program at the beginning of each year. In setting the structure and the amount of the overall target incentive pool, the Compensation Committee considers potential size of the pool in relation to our earnings and other financial estimates, the achievability of the corporate targets under the plan, historical payouts under the plan and other factors. The total cost of these plans was $9.2 million in 2007, $9.3 million in 2006 and $0 in 2005.
Profit Sharing 401(k) Plan
We maintain a profit sharing 401(k) plan that covers substantially all U.S. employees. Employees may elect to defer a portion of their compensation, and we may contribute an amount approved by the Board of Directors. Beginning in 2006, we match 100% of employee contributions to the 401(k) plan up to 3% of each employee’s eligible compensation. Prior to 2006, we matched 100% of employee contributions up to 1½% with a possible supplemental match, if approved by the Board of Directors, based on our performance, up to a maximum of an additional 3% of eligible compensation. Employees must meet certain requirements to be eligible for the matching contribution. We contributed $1.4 million in 2007, $1.1 million in 2006 and $0.6 million in 2005 to this plan. Our 401(k) plan does not allow for the investment in shares of our common stock. No supplemental matching contributions were made in 2005.
Deferred Compensation Plan
We maintain a deferred compensation plan (the “Plan”) which permits certain employees to defer payment of a portion of their annual compensation. We do not match deferrals or make any additional contributions to the Plan. Distributions from the Plan are generally payable as a lump sum payment or in
multi-year installments as directed by the participant according to the Plan provisions. Undistributed amounts under the Plan are subject to the claims of our creditors. As of December 31, 2007 and 2006, the invested amounts under the Plan totaled $2.8 million and $1.9 million, respectively, and were recorded on our balance sheets as non-current investments in marketable securities and as a long-term liability to recognize undistributed amounts due to employees.
18. RELATED-PARTY ACTIVITY
Philips
Until December 2006, Philips Business Electronics International B.V. (“Philips”), a subsidiary of Koninklijke Philips Electronics N.V., owned approximately 25% of our common stock. As of December 31, 2006, Philips did not own any of our common stock. In addition, during 2006, one of our directors, Mr. Jan C. Lobbezoo served as the Executive Vice President of Philips International B.V. with responsibility for financial oversight of several minority shareholdings of Koninklijke Philips Electronics N.V. For sales to Philips prior to the divesture date, see “Other Transactions” below. We continue to purchase certain subassemblies, as well as research and development services, from Philips-related entities.
Other Transactions
We have sold products and services to LSI Corporation, Applied Materials, Inc., Nanosys, Inc. and Cascade Microtech, Inc. A director of Applied Materials, the former Chairman and Chief Executive Officer of LSI and the former Executive Chairman of Nanosys are all members of our Board of Directors. In addition, our Chief Financial Officer is currently on the board of directors of Cascade Microtech, Inc.
Sales to Philips (while they were a related party in 2006 and 2005), Applied Materials, LSI (while they were a related party prior to 2007), Nanosys and Cascade Microtech, Inc. were as follows (in thousands):
As of December 31, 2007, Applied Materials owed us $0.1 million related to its purchases.
During 2007, we purchased services totaling $157,000 from EasyStreet Online Services. One of the members of our Board of Directors, Mr. William Lattin, also serves on the Board of Directors of EasyStreet Online Services.
19. RISK MANAGEMENT AND DERIVATIVES
We are exposed to global market risks, including the effect of changes in foreign currency exchange rates. We use derivatives to manage financial exposures that occur in the normal course of business. We do not hold or issue derivatives for trading or speculative purposes. We formally document all relationships between hedging instruments and hedged items, as well as our risk-management objective and strategy for undertaking hedge transactions. This process includes linking all derivatives either to assets and liabilities recorded on the balance sheet or to forecasted transactions. Derivatives entered into by us that are linked to forecasted transactions have been designated as cash flow hedges commencing April 5, 2004.
All derivatives are recognized on the balance sheet at their fair value. Unrealized gain positions are recorded as other current assets, and unrealized loss positions are recorded as other current liabilities as all maturity dates are less than one year. Changes in fair values of outstanding derivatives that are designated as cash flow hedges and are highly effective are recorded in other comprehensive income until net income is affected by the variability of cash flows of the hedged transaction. Changes in the fair value of derivatives either not designated or effective as hedging instruments are recognized in earnings in the current period and primarily relate to derivatives linked to specific non-functional currency denominated assets and liabilities on the balance sheet.
Cash Flow Hedges
The purpose of our foreign currency hedging activities is to protect us from the risk that the eventual cash flows resulting from transactions in foreign currencies will be adversely affected by changes in exchange rates. It is our policy to utilize derivatives to reduce foreign exchange risks where internal netting strategies cannot be effectively employed.
Derivatives used by us to hedge foreign currency exchange risks are foreign forward extra contracts, which are a combination of foreign exchange contracts and options, and option contracts. These instruments protect against the risk that the eventual net cash inflows from foreign currency denominated transactions will be adversely affected by changes in exchange rates beyond a range specified at the inception of the hedging relationship. We hedge up to 90% of anticipated U.S. dollar denominated sales of our foreign subsidiaries for a rolling 12-month period.
As of April 5, 2004, all forward extra contracts entered into by us to hedge forecasted transactions qualified for, and were designated as, foreign-currency cash flow hedges. Changes in fair values of outstanding cash flow hedge derivatives that are highly effective are recorded in other comprehensive income until net income is affected by the variability of the cash flows of the hedged transaction. In most cases, amounts recorded in other comprehensive income will be released to net income in the quarter that the related derivative matures. Results of hedges are recorded as cost of sales when the underlying hedged transaction affects net income.
Actual amounts ultimately reclassified to net income are dependent on the exchange rates in effect when derivative contracts that are currently outstanding mature. As of December 31, 2007, the maximum term over which we are hedging exposures to the variability of cash flows for all forecasted and recorded transactions was 12 months. We formally assess, both at the inception of the hedge and on an ongoing basis, whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. We assess effectiveness of options based on the total cash flows method and record total changes in the options’ fair value to other comprehensive income to the degree the options are effective.
We prospectively discontinue hedge accounting when (i) we determine that the derivative is no longer highly effective in offsetting changes in the cash flows of a hedged item (including hedged items such as firm commitments or forecasted transactions); (ii) it is no longer probable that the forecasted transaction will occur; or (iii) management determines that designating the derivative as a hedging instrument is no
longer appropriate. If we discontinue hedge accounting, the gains and losses that were accumulated in other comprehensive income (loss) will be recognized immediately in net income. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, we will carry the derivative at its fair value on the balance sheet, recognizing future changes in the fair value in current-period net income (loss). Any hedge ineffectiveness is recorded in current-period net income.
Net realized gains (losses) related to cash flow hedges recorded in cost of sales were $5.0 million in 2007, $2.0 million in 2006 and $(2.2) million in 2005. As of December 31, 2007 and 2006, $2.2 million and $1.7 million, respectively, of deferred net unrealized gains on outstanding derivatives were recorded as other comprehensive income. The 2007 deferred unrealized gains are expected to be reclassified to net income during the next 12 months as a result of underlying hedged transactions also being recorded in net income.
In 2005, we recorded a charge of $0.5 million in other income (expense) related to both hedge ineffectiveness and hedge dedesignations. We did not record any gain or loss in other income/expense due to ineffectiveness of derivatives in 2007 or 2006, nor did we record any gain or loss due to discontinued hedge accounting during 2007 or 2006.
Other Derivatives
Changes in the fair value of foreign forward exchange contracts entered into to mitigate the foreign exchange risks related to non-functionally denominated cash, receivables and payables are recorded in other income (expense) currently together with the transaction gain or loss from the hedged balance sheet position. Excluding forward extra contracts and option losses, foreign exchange losses, net of the balance sheet hedge benefits, were $3.1 million, $1.9 million and $1.0 million in 2007, 2006 and 2005, respectively.
20. COMMITMENTS AND CONTINGENT LIABILITIES
From time to time, we may be a party to litigation arising in the ordinary course of business. Currently, we are not a party to any litigation that we believe would have a material adverse effect on our financial position, results of operations or cash flows.
We have commitments under non-cancelable purchase orders, primarily relating to inventory, totaling $63.0 million at December 31, 2007. These commitments expire at various times through the fourth quarter of 2008.
21. SEGMENT AND GEOGRAPHIC INFORMATION
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer.
We report our segments based on a market-focused organization. Our segments are: NanoElectronics, NanoResearch and Industry, NanoBiology and Service and Components.
The following table summarizes various financial amounts for each of our business segments (in thousands):
Nano-market segment disclosures are presented to the gross profit level as this is the primary performance measure for which the segment general managers are responsible. Selling, general and administrative, research and development and other operating expenses are managed and reported at the corporate level and, given allocation to the nano-market segments would be arbitrary, have not been allocated to the market segments. See our Consolidated Statements of Operations for reconciliations from gross profit to income before income taxes. These reconciling items are not included in the measure of profit and loss for each reportable segment.
Our long-lived assets were geographically located as follows (in thousands):
The following table summarizes sales by geographic region (in thousands):
None of our customers represented 10% or more of our total sales in 2007, 2006 or 2005.
Sales to countries which totaled 10% or more of our total sales were as follows (dollars in thousands):
22. DISCONTINUED OPERATIONS
In the fourth quarter of 2006, we sold the assets and operations related to Knights Technology that was included as part of our NanoElectronics operating segment. We recognized a gain on the disposal of the discontinued operations of $3.3 million and received cash proceeds of $7.8 million. In the first quarter of 2007, we recognized an additional $0.1 million gain related to post-closing adjustments for working capital items. In addition, in the fourth quarter of 2007, we recognized an additional $0.3 million gain related to the release of certain acquisition contingency accruals, as well as to amounts that had been held in escrow and subsequently paid to us once all contingencies surrounding the transaction were resolved. All historical balance sheet and statement of operations data has been restated to reflect the discontinued operations.
Certain financial information related to discontinued operations was as follows (in thousands):
No impairment charge was recorded related to the assets of the discontinued operations.
23. FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES
We estimate the fair value of our monetary assets and liabilities based upon comparison of such assets and liabilities to the current market values for instruments of a similar nature and degree of risk.
We believe the carrying amounts of cash and cash equivalents, receivables, accounts payable and other current liabilities are a reasonable approximation of the fair value of those financial instruments because of the nature of the underlying transactions and the short-term maturities involved.
The fair value and cost of certain financial assets and liabilities was as follows (in thousands):
As of December 31, 2007 and 2006, the aggregate notional amount of our outstanding derivative contracts was $68.5 million and $56.0 million, respectively. The fair value of these contracts represents our forward extra contracts and forward contracts. The fair value of these contracts was obtained from financial institutions.
24. SUBSEQUENT EVENTS
Redemption of 5.5% Convertible Subordinated Notes
On January 24, 2008, we redeemed the remaining outstanding balance of our 5.5% convertible subordinated notes due August 15, 2008, which totaled $45.9 million. Interest paid as part of the note redemption was approximately $1.1 million, of which $0.9 million was accrued as of December 31, 2007. Additionally, we expensed the remaining related bond issuance costs of $0.1 million.
Auction Rate Securities and Liquidity
At December 31, 2007, we held $118.1 million in auction rate securities (“ARS”) which we classified as current assets. The ARS held by us have long-term stated maturities for which the interest rates are reset through a Dutch auction generally every 28 days. The auctions have historically provided a liquid market for these securities as investors could readily sell their investments at auction. Subsequent to December 31, 2007, we began to exit our position in these securities. As of February 25, 2008, we had successfully liquidated $8.0 million of these securities, leaving us with $110.1 million invested in ARS.
A chart showing the amounts of each of our ARS, the issuers and whether the underlying collateral for the notes are guaranteed by the U.S. Department of Education (“USDE”) is set out below. At the time of issuance each of the ARS was purported to be at least 100% collateralized. All of the notes come up for auction by March 24, 2008.
With the liquidity issues experienced in global credit and capital markets, the ARS held by us have experienced multiple failed auctions, beginning on February 19, 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders. We expect additional auction failures during the remainder of February and March 2008, which will require us to hold the securities until liquidity is restored to the credit markets or the securities are redeemed or mature.
All of the ARS held by us carry AAA ratings, have not experienced any payment defaults and are backed by student loans, some of which are guaranteed under the Federal Family Education Loan Program of the USDE. Nonetheless, if uncertainties in the credit and capital markets continue, these markets deteriorate further or there are any ratings downgrades on any ARS we hold, we may be required to reclassify these investments from short-term to long-term investments. In addition, if the failed auctions or any downgrades are deemed to cause an “other than temporary impairment” of our ARS, we may be required to re-value the ARS at some amount below par. Any re-valuation of ARS that are other than temporarily impaired will flow through our operations statement and affect our earnings.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management evaluated, with the participation and under the supervision of our President and Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our President and Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting.
Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, we used the criteria set forth in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment using those criteria, our management concluded that, as of December 31, 2007, our internal control over financial reporting was effective.
Deloitte & Touche LLP has audited this assessment of our internal control over financial reporting and their report is included below.
Inherent Limitations on Effectiveness of Controls
Our management, including the CEO and CFO, does not expect that our disclosure controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
FEI Company
Hillsboro, Oregon
We have audited the internal control over financial reporting of FEI Company and subsidiaries (the “Company”) as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Reporting on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2007 of the Company and our report dated February 29, 2008 expressed an unqualified opinion on those financial statements, and included an explanatory paragraph regarding the Company’s adoption of Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109,” as of January 1, 2007 and an explanatory paragraph regarding the Company’s adoption of Statement of Financial Accounting Standards No 123R, “Share-Based Payment,” effective January 1, 2006.
DELOITTE & TOUCHE LLP
Portland, Oregon
February 29, 2008
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Information required by this item will be included under the captions Election of Directors, Meetings and Committees of the Board of Directors, Membership of the Audit Committee, Code of Ethics, Executive Officers, Governance and Section 16(a) Beneficial Ownership Reporting Compliance in our Proxy Statement for our 2008 Annual Meeting of Shareholders and is incorporated by reference herein.
On September 9, 2003, we adopted a code of business conduct and ethics that applies to all directors, officers and employees. We posted our code of business conduct and ethics on our website at www.fei.com. We intend to disclose any amendment to the provisions of the code of business conduct and ethics that apply specifically to directors or executive officers by posting such information on our website. We intend to disclose any waiver to the provisions of the code of business conduct and ethics that apply specifically to directors or executive officers by filing such information on a Current Report on Form 8-K with the SEC, to the extent such filing is required by the Nasdaq Global Market’s listing requirements; otherwise, we will disclose such waiver by posting such information on our website.
Item 11.
Item 11. Executive Compensation
Information required by this item will be included under the captions Director Compensation, Executive Compensation, Compensation Discussion and Analysis for Named Executive Officers and Compensation Committee Interlocks and Insider Participation in our proxy statement for our 2008 Annual Meeting of Shareholders and is incorporated by reference herein.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required by this item will be included under the captions Security Ownership of Certain Beneficial Owners and Management and Securities Authorized for Issuance Under Equity Compensation Plans in our proxy statement for our 2008 Annual Meeting of Shareholders and is incorporated by reference herein.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information required by this item will be included under the captions Certain Relationships and Related Transactions and Director Independence in our Proxy Statement for our 2008 Annual Meeting of Shareholders and is incorporated by reference herein.
Item 14.
Item 14. Principal Accountant Fees and Services
Information required by this item will be included under the caption Ratification of Appointment of Public Accounting Firm in our proxy statement for our 2008 Annual Meeting of Shareholders and is incorporated by reference herein.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
Financial Statements and Schedules
The Consolidated Financial Statements, together with the report thereon of our independent registered public accounting firm, are included on the pages indicated below:
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2007 and 2006
Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements
There are no schedules required to be filed herewith.
Exhibits
The following exhibits are filed herewith and this list is intended to constitute the exhibit index. A plus sign (+) beside the exhibit number indicates the exhibits containing a management contract, compensatory plan or arrangement, which are required to be identified in this report.
Exhibit No.
Description
3.1(10)
Third Amended and Restated Articles of Incorporation
3.2(13)
Articles of Amendment to the Third Amended and Restated Articles of Incorporation
3.3(15)
Amended and Restated Bylaws, as amended on August 17, 2006
4.1(5)
Indenture between FEI and BNY Western Trust Company dated August 3, 2001
4.2(5)
Form of Note for 5.5% Convertible Subordinated Notes due 2008
4.3(5)
Registration Rights Agreement between FEI and Credit Suisse First Boston dated August 3, 2001
4.4(9)
Indenture, dated as of June 13, 2003, between FEI and BNY Western Trust Company, a California state chartered banking corporation
4.5(9)
Form of Note for Zero Coupon Convertible Subordinated Notes due 2008
4.6(9)
Registration Rights Agreement, dated as of June 13, 2003, between FEI and the initial purchasers named therein
4.7(16)
Indenture, dated as of May 19, 2006, between the Company and The Bank of New York Trust Company, as trustee
4.8
Form of 2.875% Convertible Subordinated Note due 2013 (incorporated by reference to Annex A of Exhibit 4.7)
Exhibit No.
Description
4.9(17)
Registration Rights Agreement, dated as of May 19, 2006, among FEI Company, Merrill Lynch, Pierce, Fenner & Smith Incorporated, Needham & Company, LLC, Thomas Weisel Partners LLC, D.A. Davidson & Co. and Merriman Curhan Ford & Co.
4.10(13)
Preferred Stock Rights Agreement dated July 21, 2005, between FEI and Mellon Investor Services, LLC
10.1+
1995 Stock Incentive Plan, as amended effective May 17, 2007
10.2+(2)
Supplemental Stock Incentive Plan
10.3+(1)
Form of Incentive Stock Option Agreement
10.4+(1)
Form of Nonstatutory Stock Option Agreement
10.5+
1995 Employee Share Purchase Plan, as amended effective May 17, 2007
10.6(3)
Lease Agreement, dated October 27, 1997, between Philips Business Electronics International B.V., as lessor, and Philips Electron Optics B.V., a wholly owned indirect subsidiary of FEI, as lessee, including a guarantee by FEI of the lessee’s obligations thereunder
10.7+(17)
Executive Severance Agreement by and between Dr. Don Kania and FEI Company
10.8+(17)
Stand-alone Non-statutory Stock Option Agreement (for grant of 100,000 option shares outside of 1995 Stock Incentive Plan as a material inducement for Dr. Kania to accept employment)
10.9+(17)
Stand-alone Restricted Stock Unit Agreement (for grant of 25,000 units outside the 1995 Stock Incentive Plan as a material inducement for Dr. Kania to accept employment)
10.10+(17)
Stand-alone Restricted Stock Unit Agreement (for grant of 50,000 units outside of 1995 Stock Incentive Plan as a material inducement for Dr. Kania to accept employment)
10.11+(17)
Form of Restricted Stock Unit grant (for grant of 75,000 units to Dr. Kania within the 1995 Stock Incentive Plan)
10.12+(4)
FEI Company Nonqualified Deferred Compensation Plan
10.13(7)
Purchase Agreement, effective as of November 1, 2002, between FEI and Philips Enabling Technologies Group Nederland B.V.
10.14(7)
Lease Agreement, dated December 11, 2002, by and among FEI, Technologicky Park Brno, a.s. and FEI Czech Republic, s.r.o.
10.15(8)
Master Agreement for the Acht facility, dated January 14, 2003
10.16+(11)
Form of Indemnity Agreement for Directors and Executive Officers of FEI
10.17+(21)
Description of Compensation of Non-Employee Directors
10.18+(23)
2008 FEI Management Variable Compensation Plan Program Summary Description
10.19+(20)
2007 Base Salary and Target Management Variable Compensation Payment Plan for Certain Executive Officers
10.20+(14)
Form of Lock-Up Agreement between FEI and Certain of its Executive Officers and Other Members of Senior Management
10.21+(14)
Description of Accelerated Vesting of Certain Stock Options Held by Employees
Exhibit No.
Description
10.22+(18)
Employment Agreement with Robert H. J. Fastenau, dated November 28, 2006
10.23(19)
Description of Compensation for Executive Vice President and Chief Financial Officer Raymond A. Link
10.24+
Offer Letter of Employment to Benjamin Loh, dated May 5, 2007
10.25+(22)
Description of Compensation for President and Chief Executive Officer, Don R. Kania
14(11)
Code of Ethics
Subsidiaries
Consent of Deloitte & Touche, LLP
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley Act of 2002
32.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of The Sarbanes-Oxley Act of 2002
32.2
Certification of Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of The Sarbanes-Oxley Act of 2002
(1) Incorporated by reference to our Registration Statement of Form S-1, as amended, effective May 31, 1995 (Commission Registration No. 33-71146).
(2) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1995.
(3) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 28, 1997.
(4) Incorporated by reference to our Registration Statement on Form S-3, filed on April 23, 2001.
(5) Incorporated by reference to our Registration Statement of Form S-3, as amended, effective November 7, 2001.
(6) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2001.
(7) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.
(8) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended March 30, 2003.
(9) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 29, 2003.
(10) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 28, 2003.
(11) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2003.
(12) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2004.
(13) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 27, 2005.
(14) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on October 24, 2005.
(15) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 22, 2006.
(16) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on May 23, 2006.
(17) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended July 2, 2006.
(18) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 4, 2006.
(19) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on May 27, 2005.
(20) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 27, 2007.
(21) Incorporated by reference to our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 1, 2007.
(22) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 27, 2006.
(23) Incorporated by reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 26, 2008.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on February 29, 2008:
Signature
Title
/s/ DON R. KANIA
Director, President and
Don R. Kania
Chief Executive Officer
(Principal Executive Officer)
/s/ RAYMOND A. LINK
Executive Vice President and Chief Financial
Raymond A. Link
Officer (Principal Financial and Accounting Officer)
/s/ MICHAEL J. ATTARDO
Director
Michael J. Attardo
/s/ LAWRENCE A. BOCK
Director
Lawrence A. Bock
/s/ WILFRED J. CORRIGAN
Director
Wilfred J. Corrigan
/s/ THOMAS F. KELLY
Director
Thomas F. Kelly
/s/ WILLIAM W. LATTIN
Director
William W. Lattin
/s/JAN C. LOBBEZOO
Director
Jan C. Lobbezoo
/s/ GERHARD H. PARKER
Director
Gerhard H. Parker
/s/ JAMES T. RICHARDSON
Chairman of the Board
James T. Richardson
/s/ DONALD R. VANLUVANEE
Director
Donald R. VanLuvanee