ITEM 1. BUSINESS
Introduction
II-VI Incorporated (“II-VI” or the “Company”) was incorporated in Pennsylvania in 1971. Our executive offices are located at 375 Saxonburg Boulevard, Saxonburg, Pennsylvania 16056. Our telephone number is 724-352-4455. Reference to the “Company” or “II-VI” in this Form 10-K, unless the context requires otherwise, refers to II-VI Incorporated, its wholly-owned subsidiaries and its majority-owned subsidiary. The Company’s name is pronounced “Two Six Incorporated.” The majority of our revenues are attributable to the sale of (i) infrared and near-infrared optical components for laser applications, (ii) infrared products for military applications and (iii) thermoelectric cooling and power generation products.
In December 2004, the Company acquired all the outstanding shares of Marlow Industries, Inc. (Marlow), a global leader in the design and manufacturer of thermoelectric products for cooling and power generation. Marlow is an operating unit within the Company’s Compound Semiconductor Group segment.
In July 2005, the Company exercised its call option and purchased the remaining 25% interest of II-VI Deutschland GmbH from L.O.T.-Oriel Laser Optik GmbH & Co. KG.
Our internet address is www.ii-vi.com. On this web site we post the following filings as soon as reasonably practical after they are electronically filed with or furnished to the Securities and Exchange Commission: our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. In addition, we post our proxy statements on Schedule 14A related to our annual shareholders’ meeting as well as reports filed by our directors, officers and ten-percent beneficial owners pursuant to Section 16 of the Securities Exchange Act of 1934. All such filings are located on the Investor Relations page of our web site and are available free of charge.
Information Regarding Market Segments and Foreign Operations
Financial data regarding our revenues, results of operations, industry segments and international sales for the three years ended June 30, 2006 is set forth in the consolidated statements of earnings and in Note M to the Company’s consolidated financial statements included in Item 8 of this Form 10-K. We also discuss certain Risk Factors set forth in Item 1A
ITEM 1A. RISK FACTORS
The Company cautions investors that its performance (and, therefore, any forward-looking statement) is subject to risks and uncertainties. Various important factors including, but not limited to, the following may cause the Company’s future results to differ materially from those projected in any forward-looking statement.
We Depend on Highly Complex Manufacturing Processes Which Require Products from Limited Sources of Supply
We utilize high quality, optical grade ZnSe in the production of many of our infrared optical products. We are the leading producer of ZnSe for our internal use and for external sale. The production of ZnSe is a complex process requiring production in a highly controlled environment. A number of factors, including defective or contaminated materials, could adversely affect our ability to achieve acceptable manufacturing yields of high quality ZnSe. ZnSe is available from only one outside source where quantity and qualities may be limited. The unavailability of necessary amounts of high quality ZnSe would have a material adverse effect upon us. There can be no assurance that we will not experience manufacturing yield inefficiencies which could have a material adverse effect on our business, results of operations or financial condition.
We produce Hydrogen Selenide gas which is used in our production of ZnSe. There are risks inherent in the production and handling of such material. Our inability to effectively handle Hydrogen Selenide could require us to curtail our production of Hydrogen Selenide. Hydrogen Selenide is available from only one outside source where quantities and qualities may be limited. The cost of purchasing such material is greater than the cost of internal production. As a result, purchasing a substantial portion of such material from the outside source would increase our production costs of ZnSe. Therefore, our inability to internally produce Hydrogen Selenide could have a material adverse effect on our business, results of operations or financial condition.
In addition, we produce and utilize other high purity, relatively uncommon materials and compounds to manufacture our products. Failure of our internal production processes or our suppliers to deliver sufficient quantities of these necessary materials on a timely basis could have a material adverse effect on our business, results of operations or financial condition.
International Sales Account for a Significant Portion of Our Revenues
Sales to customers in countries other than the United States accounted for approximately 41%, 40% and 41% of revenues during the years ended June 30, 2006, 2005 and 2004, respectively. We anticipate that international sales will continue to account for a significant portion of our revenues for the foreseeable future. In addition, we manufacture products in Singapore, China and Vietnam and maintain direct sales offices in Germany, Japan, Switzerland, the UK and Belgium. Sales and operations outside of the United States are subject to certain inherent risks, including fluctuations in the value of the U.S. dollar relative to foreign currencies, tariffs, quotas, taxes and other market barriers, political and economic instability, restrictions on the export or import of technology, potentially limited intellectual property protection, difficulties in staffing and managing international operations and potentially adverse tax consequences. There can be no assurance that any of these factors will not have a material adverse effect on our business, results of operations or financial condition. In particular, currency exchange fluctuations in countries where we do business in the local currency could have a material adverse affect on our business, results of operations, or financial condition by rendering us less price-competitive than foreign manufacturers. Our sales in Japan are denominated in Yen and, accordingly, are affected by fluctuations in the dollar/yen currency exchange rates. We generally reduce our exposure to such fluctuations of the Yen through forward exchange agreements which target to hedge approximately 75% of our sales in Japan. We do not engage in the speculative trading of financial derivatives. There can be no assurance, however, that our practices will reduce or eliminate the risk of fluctuation of the Yen in the U.S. dollar/Japanese Yen currency exchange rate.
We May Encounter Substantial Competition
We may encounter substantial competition from other companies in the same market, including established companies with significant resources. Some of our competitors may have financial, technical, marketing or other capabilities more extensive than ours and may be able to respond more quickly than we can to new or emerging technologies and other competitive pressures. We may not be able to compete successfully against our present or future competitors, and competition may have a material adverse effect on our business, results of operations or financial condition.
There Are Limitations on the Protection of Our Intellectual Property
We rely on a combination of trade secrets, patents, copyright and trademark laws combined with employee non-competition and nondisclosure agreements to protect our intellectual property rights. There can be no assurance that the steps taken by us will be adequate to prevent misappropriation of our technology. Furthermore, there can be no assurance that, in the future, third parties will not assert infringement claims against us. Asserting our rights or defending against third-party claims could involve substantial expense, thus materially and adversely affecting our business, results of operations or financial condition. In the event a third party were successful in a claim that one of our processes infringed its proprietary rights, we may have to pay substantial damages or royalties, or expend substantial amounts in order to obtain a license or modify processes so that it no longer infringes such proprietary rights, any of which could have a material adverse effect on our business, results of operations or financial condition.
Our Success Depends on the Ability to Retain Key Personnel
We are highly dependent upon the experience and continuing services of certain scientists, engineers, production and management personnel. Competition for the services of these personnel is intense, and there can be no assurance that we will be able to retain or attract the personnel necessary for our success. The loss of the services of our key personnel could have a material adverse effect on our business, results of operations or financial condition.
Failure to Keep Pace with Industry Developments May Adversely Affect Our Operations
We are engaged in industries which will be affected by future developments. The introduction of products or processes utilizing new developments could render existing products or processes obsolete or unmarketable. Our continued success will depend upon our ability to develop and introduce on a timely and cost-effective basis new products, processes and applications that keep pace with developments and address increasingly sophisticated customer requirements. There can be no assurance that we will be successful in identifying, developing and marketing new products, applications and processes that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of product or process enhancements or new products, applications or processes, or that our products, applications or processes will adequately meet the requirements of the marketplace and achieve market acceptance. Our business, results of operations and financial condition could be materially and adversely affected if we were to incur delays in developing new products, applications or processes or if we did not gain market acceptance for the same.
Our Success Depends on New Products and Processes
In order to meet our strategic objectives, we must continue to develop, manufacture and market new products, develop new processes and improve existing processes. As a result, we expect to continue to make significant investments in research and development and to continue to consider from time to time the strategic acquisition of businesses, products, or technologies complementary to our business. Our success in developing, introducing and selling new and enhanced products depends upon a variety of factors including product selection, timely and efficient completion of product design and development, timely and efficient implementation of manufacturing and assembly processes, effective sales and marketing, and product performance in the field. There can be no assurance that we will be able to develop and introduce new products or enhancements to our existing products and processes in a manner which satisfies customer needs or achieves market acceptance. The failure to do so could have a material adverse effect on our ability to grow our business.
We May Expand Product Lines and Markets by Acquiring Other Businesses
Our business strategy includes expanding our product lines and markets through internal product development and acquisitions. Any acquisition may result in potentially dilutive issuances of equity securities, the incurrence of debt and contingent liabilities, and amortization expense related to intangible assets acquired, any of which could have a material adverse effect on our business, results of operations or financial condition. In addition, acquired businesses may be experiencing operating losses. Any acquisition will involve numerous risks, including difficulties in the assimilation of the acquired company’s operations and products, uncertainties associated with operating in new markets and working with new customers, and the potential loss of the acquired company’s key personnel.
The following information relates to significant acquisitions made since fiscal year ended June 30, 1995.
Our Revenues May Suffer if General Economic Conditions Worsen
Our revenues and earnings may be affected by general economic factors, such as inflation, currency fluctuations and employment levels, resulting in a temporary or longer-term overall decline in demand for our products. Therefore, any significant downturn or recession in the United States or other countries could have a material adverse effect on our business, results of operations or financial condition.
A Significant Portion of Our Business is Dependent on Other Cyclical Industries
Our business is significantly dependent on the demand for products produced by end-users of industrial lasers. Many of these end-users are in industries that historically have experienced a highly cyclical demand for their products. As a result, demand for our products are subject to cyclical fluctuations. This cyclical demand could have a material adverse effect on our business, results of operations or financial condition.
Our Revenues are Subject to Potential Seasonal Fluctuations
Due to our customers’ buying patterns, particularly in Europe, revenues for our first fiscal quarter ending in September could be below those in the preceding quarter. Our first fiscal quarter results often are dependent upon the sales made in the last month of the quarter.
Exposure to Government Markets
With the acquisition of Marlow and the operations of our Military and Near-Infrared Optics businesses, sales to customers in the defense industry have increased. These customers in turn generally contract with a governmental entity, typically the U.S. government. Most governmental programs are subject to funding approval and can be modified or terminated with no warning upon the determination of a legislative or administrative body. The loss or failure to obtain certain contracts or a loss of a major government customer could have a material adverse effect on our business, results of operations or financial condition.
Our Stock Price May Fluctuate
Future announcements concerning us, our competitors or customers, quarterly variations in operating results, announcements of technological innovations, the introduction of new products or changes in product pricing policies by us or our competitors, seasonal or other variations in anticipated or actual results of operations, changes in earnings estimates by analysts or reports regarding our industries in the financial press or investment advisory publications, among other factors, could cause the market price of our stock to fluctuate substantially. In addition, stock prices may fluctuate widely for reasons which may be unrelated to operating results. These fluctuations, as well as general economic, political and market conditions such as recessions, military conflicts or market or market-sector declines, may materially and adversely affect the market price of our common stock. In addition, any information concerning us, including projections of future operating results, appearing in investment advisory publications or on-line bulletin boards or otherwise emanating from a source other than us could in the future contribute to volatility in the market price of our common stock.
Provisions in our Articles of Incorporation and By-Laws May Limit the Price that Investors May be Willing to Pay in the Future for Shares of Our Common Stock
Our articles of incorporation and by-laws contain provisions which could make us a less attractive target for a hostile takeover or make it more difficult or discourage a merger proposal, a tender offer or a proxy contest. The provisions include: classification of the board of directors into three classes; a procedure which requires shareholders or the board of directors to nominate directors in advance of a meeting to elect such directors; the ability of the board of directors to issue additional shares of common stock or preferred stock without shareholder approval; and certain provisions requiring supermajority approval (at least two-thirds of the votes cast by all shareholders entitled to vote thereon, voting together as a single class).
In addition, the Pennsylvania Business Corporation Law contains provisions which may have the effect of delaying or preventing a change in our control. All of these may limit the price that investors may be willing to pay for shares of our common stock.
We Are Subject to Stringent Environmental Regulation
We use or generate certain hazardous substances in our research and manufacturing facilities. We believe that our handling of such substances is in material compliance with applicable local, state and federal environmental, safety and health regulations at each operating location. We invest substantially in proper protective equipment, process controls and specialized training to minimize risks to employees, surrounding communities and the environment due to the presence and handling of such hazardous substances. We regularly conduct employee physical examinations and workplace monitoring regarding such substances. When exposure problems or potential exposure problems have been indicated, corrective actions have been implemented and re-occurrence has been minimal or non-existent. We do not carry environmental impairment insurance.
Relative to its generation and use of the hazardous substance Hydrogen Selenide, we have in place an emergency response plan. Special attention has been given to all procedures pertaining to this gaseous material to minimize the chances of its accidental release to the atmosphere.
With respect to the use, storage and disposal of the low-level radioactive material Thorium Fluoride, our facilities and procedures have been inspected and licensed by the Nuclear Regulatory Commission. Thorium bearing by-products are collected and shipped as solid waste to a government-approved low-level radioactive waste disposal site in Clive, Utah.
The generation, use, collection, storage and disposal of all other hazardous by-products, such as suspended solids containing heavy metals or airborne particulates, are believed by us to be in material compliance with regulations. We believe that all of the permits and licenses required for operation of our business are in place.
Although we do not know of any material environmental, safety or health problems in our properties or processes, there can be no assurance that problems will not develop in the future which could have a material adverse effect on our business, results of operations or financial condition.
Some Laser Systems Are Complex in Design and May Contain Defects that Are Not Detected Until Deployed Which Could Increase Our Costs and Reduce Our Revenues
Laser systems are inherently complex in design and require ongoing regular maintenance. The manufacture of lasers, laser products and systems involves a highly complex and precise process. As a result of the technical complexity of our products, changes in our or our suppliers’ manufacturing processes or in the use of defective or contaminated materials by us or our suppliers could result in a material adverse effect on our ability to achieve acceptable manufacturing yields and product reliability. To the extent that we do not achieve such yields or product reliability, our business, operating results, financial condition and customer relationships could be adversely affected. Our customers may discover defects in our products after the products have been fully deployed and operated under peak stress conditions. In addition, some of our products are combined with products from other vendors, which may contain defects. Should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things: loss of customers; increased costs of product returns and warranty expenses; damage to our brand reputation; failure to attract new customers or achieve market acceptance; diversion of development and engineering resources; and legal action by our customers.
The occurrence of any one or more of the foregoing factors could have a material adverse effect on our business, results of operations or financial condition.
Recently Issued Financial Accounting Standards
In May 2005, the Financial Accounting Standard Board (FASB) issued SFAS No. 154, “Accounting Changes and Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also redefines “restatement” as the revising of previously issued financial statements to reflect the correction of an error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109” (“FIN 48”) which clarifies the accounting for uncertainty in tax positions taken or expected to be taken in a tax return, including issues relating to financial statement recognition and measurement. FIN 48 provides that the tax effects from an uncertain tax position can be recognized in the financial statements only if the position is “more-likely-than-not” of being sustained if the position were to be challenged by a taxing authority. The assessment of the tax position is based solely on the technical merits of the position, without regard to the likelihood that the tax position may be challenged. If an uncertain tax position meets the “more-likely-than-not” threshold, the largest amount of tax benefit that is greater than 50 percent likely of being recognized upon ultimate settlement with the taxing authority, is recorded. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements for the fiscal year ending June 30, 2008.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Information regarding our principal properties at June 30, 2006 is set forth below:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are involved in various claims and lawsuits incidental to the business. Each of these matters is subject to various uncertainties, and it is possible that these matters may be resolved unfavorably to the Company. Management believes, after consulting with legal counsel, that the ultimate liabilities, if any, resulting from such legal proceedings will not materially affect the Company’s financial position, liquidity or results of operation. During the quarter ended September 30, 2003, the Company was awarded a jury verdict in the amount of $0.8 million in a trade secret lawsuit which it had initiated. During the quarter ended September 30, 2005, the Company received the verdict award in the amount of $0.8 million and recorded this amount in other income, net in its Consolidated Statements of Earnings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Form 10-K.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers(1) of the Company and their respective ages and positions are as follows:
Name
Age
Position
Carl J. Johnson
Chairman, Chief Executive Officer and Director
Francis J. Kramer
President, Chief Operating Officer and Director
Herman E. Reedy
Executive Vice President - Infrared Optics
James Martinelli
Vice President - Government and Military Businesses
Vincent D. Mattera, Jr.
Vice President - General Manager - Compound Semiconductor Group
Craig A. Creaturo
Chief Financial Officer and Treasurer
(1) Each executive officer listed has been appointed by the Board of Directors to serve until removed or until a successor is elected and qualified.
Carl J. Johnson, a co-founder of the Company in 1971, serves as Chairman, Chief Executive Officer, and Director of the Company. He served as President of the Company from 1971 until 1985, has served as a Director since 1971 and Chairman and Chief Executive Officer since 1985. From 1966 to 1971, Dr. Johnson was Director of Research & Development for Essex International, Inc., an automotive electrical and power distribution products manufacturer. From 1964 to 1966, Dr. Johnson worked at Bell Telephone Laboratories as a member of the technical staff. Dr. Johnson completed his Ph.D. in Electrical Engineering at the University of Illinois. He holds B.S. and M.S. degrees in Electrical Engineering from Purdue University and Massachusetts Institute of Technology (MIT), respectively.
Francis J. Kramer has been employed by the Company since 1983 and has been its President and Chief Operating Officer since 1985. Mr. Kramer has served as a Director of the Company since 1989. Mr. Kramer joined the Company as Vice President and General Manager of Manufacturing and was named Executive Vice President and General Manager of Manufacturing in 1984. Prior to his employment by the Company, Mr. Kramer was the Director of Operations for the Utility Communications Systems Group of Rockwell International Corp. Mr. Kramer graduated from the University of Pittsburgh with a B.S. degree in Industrial Engineering and from Purdue University with an M.S. degree in Industrial Administration.
Herman E. Reedy has been employed by the Company since 1977 and has been Executive Vice President - Infrared Optics since February 2003. Previously, Mr. Reedy held positions at the Company as Vice President and General Manager of Quality and Engineering, Manager of Quality and Manager of Components. Prior to his employment by the Company, Mr. Reedy was employed by Essex International, Inc., serving last as Manager, MOS Wafer Process Engineering. Prior to 1973, he was employed by Carnegie Mellon University and previously held positions with SemiElements, Inc. and Westinghouse Electric Corporation. Mr. Reedy is a graduate of the University of Pittsburgh with a B.S. degree in Electrical Engineering.
James Martinelli has been employed by the Company since 1986 and has been Vice President - Government and Military Businesses since February 2003. Previously, Mr. Martinelli served as General Manager of Laser Power Corporation since 2000 and Chief Financial Officer of II-VI Incorporated since 1994. Mr. Martinelli joined the Company as Accounting Manager, was named Corporate Controller in 1990 and named Chief Financial Officer and Treasurer in 1994. Prior to his employment by the Company, Mr. Martinelli was Accounting Manager at Tippins Incorporated and Pennsylvania Engineering Corporation from 1980 to 1985. Mr. Martinelli graduated from Indiana University of Pennsylvania with a B.S. degree in Accounting.
Vincent D. Mattera, Jr., has been employed by the Company since 2004 and has been Vice President since November 2005. Previously Dr. Mattera had served as a Director of the Company from 2000 to 2002. Dr. Mattera had been Vice President, Undersea Optical Transport, Agere Systems (formerly Lucent Technologies, Microelectronics and
Communications Technologies Group) since 2001. Previously, Dr. Mattera was Optoelectronic Device Manufacturing and Process Development Vice President with Lucent Technologies, Microelectronics and Communications Technologies Group from 2000 until 2001. He was Director of Optoelectronic Device Manufacturing and Development at Lucent Technologies, Microelectronics Group from 1997 to 2000. From 1995 to 1997 he served as Director, Indium Phosphide Semiconductor Laser Chip Design and Process Development with Lucent Technologies, Microelectronics Group. From 1984 to 1995 he held management positions with AT&T Bell Laboratories. Dr. Mattera holds B.S. and Ph.D. in Chemistry from the University of Rhode Island and Brown University, respectively.
Craig A. Creaturo has been employed by the Company since 1998 and has been Chief Financial Officer since November 2004 and Treasurer since 2000. Previously, Mr. Creaturo served as Chief Accounting Officer, Director of Finance, Accounting and Information Systems and Corporate Controller. Prior to his employment by the Company, Mr. Creaturo was employed by the Pittsburgh, Pennsylvania office of Arthur Andersen LLP from 1992 to 1998 and served in the audit and attestation division with a final position as Audit Manager. Mr. Creaturo graduated from Grove City College with a B.S. degree in Accounting. Mr. Creaturo is a Certified Public Accountant in the Commonwealth of Pennsylvania and is a member of the American Institute of Certified Public Accountants and the Pennsylvania Institute of Certified Public Accountants.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company’s Common Stock is traded on the Nasdaq Global Select Market under the symbol “IIVI.” The following table sets forth the range of high and low closing sale prices per share of the Company’s Common Stock for the fiscal periods indicated, as reported by Nasdaq.
On September 1, 2006, the last reported sale price for the Common Stock was $20.90 per share. As of such date, there were approximately 1,030 holders of record of the Common Stock.
The Company historically has not paid cash dividends and does not anticipate paying cash dividends in the foreseeable future.
The following table provides information with respect to purchases of the Company’s equity securities during the quarter ended June 30, 2006.
ISSUER PURCHASES OF EQUITY SECURITIES
(1) A share repurchase program for up to 500,000 shares was approved by the Board of Directors and announced on May 18, 2005. The repurchase program has no expiration date.
Additional repurchases of stock may occur from time to time depending upon factors such as the Company’s cash flows and general market conditions. While the Company expects to continue to repurchase shares of the Common Stock for the foreseeable future, there can be no assurance as to the timing or amount of such repurchases.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
FIVE-YEAR FINANCIAL SUMMARY
(1) Share and per share data for all periods presented were adjusted to reflect the two-for-one stock split in fiscal 2005, and restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.”
(1) As restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.”
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are forward-looking statements. Forward-looking statements are also identified by words such as “expects,” “anticipates,” “believes,” “intends,” “plans, “projects,” or similar expressions. Actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including risk factors described in the Risk Factors set forth in this Item 1A, which are incorporated herein by reference.
OVERVIEW
The Company generates revenues, earnings and cash flows from developing, manufacturing and marketing high technology materials and derivative products for precision use in industrial, medical, military, security and aerospace applications. We also generate revenue, earnings and cash flows from external customer and government funded research and development contracts relating to the development and manufacture of new technologies, materials and products.
Our customer base includes OEM, laser end users, system integrators of high-power lasers, manufacturers of equipment and devices for industrial, security and monitoring, x-ray imaging, U.S. government prime contractors, various U.S. government agencies and thermoelectric solutions. Approximately 41% of our revenues during the fiscal year ended June 30, 2006 were from product sales to customers outside the United States.
The following discussion and analysis includes the seven months financial results for the year ended June 30, 2005 of the Company’s Marlow Industries, Inc. subsidiary included in the Compound Semiconductor Group since the date of acquisition.
All per share data for this year and former periods cited in this discussion and analysis have been adjusted to reflect the two-for-one split of the Company’s common shares paid as a stock dividend to shareholders of record on March 2, 2005 and distributed on March 22, 2005.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America and the Company’s discussion and analysis of its financial condition and results of operations requires the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note A of the Notes to Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates.
Management believes the Company’s critical accounting estimates are those related to revenue recognition, allowance for doubtful accounts, warranty reserves, inventory valuation, valuation of long-lived assets including acquired intangibles and goodwill, accrual of bonus and profit sharing estimates, accrual of income tax liability estimates, accounting for share-based compensation and self-insurance for workers’ compensation. Management believes these estimates to be critical because they are both important to the portrayal of the Company’s financial condition and results of operations, and they require management to make judgments and estimates about matters that are inherently uncertain.
Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact to the financial statements.
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the price is established or determinable and collectibility is probable. Revenue for all business segments, other than for contract research and development, is recognized from the sale of products at the point of passage of title, which is generally at the time of shipment. The Company considers the provisions of Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition (SAB 104), which superseded SAB 101.
The Company performs research and development under contract agreements with customers based on cost plus fixed fee, cost reimbursable or fixed fee terms. These contracts generally require the Company to produce and provide developmental materials and/or products to those customers. Revenues from cost plus fixed fee and cost reimbursable contracts are recognized as costs are incurred.
The Company follows the guidelines of Statement of Position 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” for our fixed fee contracts. Revenue and profits on each fixed fee contract are accounted for using the percentage-of-completion method of accounting, whereby revenue and profits are recognized throughout the performance period of the contract. Percentage-of-completion is determined by relating the actual cost of work performed to date to the estimated total cost for each contract. The estimated total cost for each contract is periodically reevaluated and revised, when necessary, throughout the life of the contract. Losses on contracts are recorded in full when identified.
The Company establishes an allowance for doubtful accounts and a warranty reserve based on historical experience and believes the collection of revenues, net of these reserves, is reasonably assured. The allowance for doubtful accounts is an estimate for potential non-collection of accounts receivable based on historical experience. The Company has not experienced a non-collection of accounts receivable materially affecting its financial position or results of operations as of and for the fiscal years ended June 30, 2006, 2005 and 2004. If the financial condition of the Company’s customers were to deteriorate causing an impairment of their ability to make payments, additional provisions for bad debts may be required in future periods.
The Company records a warranty reserve as a charge against earnings based on a percentage of revenues utilizing actual returns over the last twelve months. If actual returns in the future are not consistent with the historical data used to calculate these estimates, additional warranty reserves could be required.
The Company records a slow moving inventory reserve as a charge against earnings for all products on hand more than twelve months to eighteen months depending on the products that have not been sold to customers or cannot be further manufactured for sale to alternative customers. An additional reserve is recorded for product on hand that is in excess of product sold to customers over the same periods noted above. If actual market conditions are less favorable than projected, additional inventory reserves may be required.
The Company tests goodwill and indefinite-lived intangible assets on an annual basis for impairment. Other intangible assets are amortized over their estimated useful lives. The determination of related estimated useful lives of other intangible assets and whether goodwill or indefinite-lived intangibles are impaired involves judgments based upon long-term projections of future performance. Estimates of fair value are based on our projection of revenues, operating costs, and cash flows of each reporting unit considering historical and anticipated results, general economic and market conditions as well as the impact of planned business or operational strategies. The valuations may employ a combination of present value techniques to measure fair value and consider market factors. The annual goodwill impairment analysis considers the financial projections of the reporting unit based on the most recently completed budgeting and long-term strategic planning processes and also considers the current financial performance compared to the prior projections of the reporting unit. Changes in our financial performance, judgments and projections could result in an impairment of goodwill or indefinite-lived intangible assets.
As a result of the purchase price allocations from our prior acquisitions and due to our decentralized structure, our goodwill is included in multiple reporting units. Due to the cyclical nature of our business, and the other factors described under “Risk Factors” herein, the profitability of our individual reporting units may periodically suffer from downturns in customer demands, operational challenges and other factors. These factors may have a relatively more pronounced impact on the individual reporting units as compared to the Company as a whole and might adversely affect the fair value of the reporting units. If material adverse conditions occur that impact our reporting units, our future determination of fair value may not support the carrying amount of one or more of our reporting units, and the related goodwill would need to be written down.
During the fourth quarter of fiscal 2006 after completing the Company’s annual goodwill impairment analysis, it was determined that the goodwill of our Military Infrared Optics business unit was impaired and consequently the Company recorded a goodwill impairment charge of approximately $17.6 million.
The Company records certain bonus and profit sharing estimates as a charge against earnings based on a formula percentage of the Company’s operating income. These estimates are adjusted to actual based on final results of operations achieved during the fiscal year. Certain partial bonus amounts are paid quarterly based on interim Company performance, and the remainder is paid after fiscal year end and final determination of the applicable percentage. Other bonuses are paid annually.
The Company records an estimated income tax liability to recognize the amount of income taxes payable or refundable for the current year and deferred income tax liabilities and assets for the future tax consequences of events that have been recognized in the Company’s financial statements or income tax returns. Judgment is required in estimating the future income tax consequences of events that have been recognized in the Company’s financial statements or the income tax returns.
The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), (“SFAS 123R”) “Share-Based Payment,” effective July 1, 2005. SFAS 123R requires the recognition of the fair value of share-based compensation in earnings. The Company recognizes the share-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period. Prior to July 1, 2005, the Company followed Accounting Principles Board (“APB”) Opinion 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its share-based compensation.
The Company elected the modified retrospective transition method for adopting SFAS 123R. Under this method, all prior period financial statements were restated effective July 1, 2005 to recognize share-based compensation cost in the amounts previously reported in the Notes to Consolidated Financial Statements. The
Consolidated Balance Sheet at June 30, 2005 has been restated for the modified retrospective adoption of SFAS 123R resulting in a $7.2 million increase in common stock, a $5.6 million reduction in retained earnings and a $1.6 million increase in deferred tax assets.
Under the provisions of SFAS 123R, the Company recorded $2.4 million, $2.2 million and $1.1 million in share-based compensation expense in its Consolidated Statements of Earnings for the fiscal years ended June 30, 2006, 2005 and 2004, respectively. The shared-based compensation expense is allocated 35% to cost of goods sold and 65% to selling, general and administrative expense in the Consolidated Statements of Earnings based upon the employee classification of the grantee. The Company utilized the Black-Scholes valuation model for estimating the fair value of the share-based compensation expense. During the fiscal years ended June 30, 2006, 2005 and 2004, the weighted-average fair value of options granted under the stock option plan was $10.96, $11.21 and $7.84, respectively, per option using the following assumptions:
The risk-free interest rate is derived from the average U.S. Treasury Note rate during the period, which approximates the rate in effect at the time of grant related to the expected life of the options. The risk free interest rate shown above is the weighted average rate for all options granted during the fiscal year. Expected volatility is based on the historical volatility of the Company’s common stock over the period commensurate with the expected life of the options. The expected life calculation is based on the observed time to post-vesting exercise and/or forfeitures of options by our employees. The dividend yield of zero is based on the fact the Company has never paid cash dividends and has no intention to pay cash dividends in the future. The estimated annualized forfeitures are based on the Company’s historical experience of option pre-vesting cancellations and are estimated at a rate of 22%. Under the provisions of SFAS 123R, the Company will record additional expense in future periods if the actual forfeiture rate is lower than estimated, and will record a recovery of expense in future periods if the actual forfeitures are higher than estimated.
The Company is self-insured for certain losses related to workers’ compensation. Additionally, third-party insurance is obtained to limit our exposure to these claims in excess of $0.3 million per occurrence and $1.0 million in the aggregate per policy year. When estimating the self-insurance liability, the Company considers a number of factors, including historical claims experience, demographic and severity factors and valuations provided by independent third party consultants. Periodically, management reviews its assumptions and the valuations to determine the adequacy of the self-insurance liability.
Fiscal 2006 Compared to Fiscal 2005
Overview (millions except per share data)
RESULTS OF OPERATIONS
BOOKINGS Bookings increased 29% to $242.3 million in fiscal 2006 compared to $187.8 million in fiscal 2005. Demand for the Company’s products worldwide continue to strengthen as evidenced by double-digit increases in
bookings across all of the Company’s operating segments. Numerous factors have contributed to the overall increased level of bookings during fiscal 2006, among them:
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The proliferation of laser systems worldwide continues to grow. Our Infrared and Near-Infrared Optics segments are capitalizing on this expansion by providing optics and components to both OEM and aftermarket customers worldwide.
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Rapid growth in China and Eastern Europe has opened up new markets.
•
Superior on-time delivery and quality associated with the Company’s Ultra-Violet Filter production assemblies has allowed the Company to win additional orders for this important defense system.
To address this continued demand, the majority of II-VI operating units have initiated efforts to expand capacity and capabilities at our production plants worldwide to position itself for fiscal 2007 and beyond.
REVENUES Revenues increased 20% to $232.5 million in fiscal 2006 compared to $194.0 million in fiscal 2005. The majority of the increase in revenues was attributable to the Company’s Infrared Optics segment which recorded an increase of 19% from the prior year. In addition, the increase in revenues was due to a full twelve months of revenues from Marlow in fiscal 2006 compared to just seven months in fiscal 2005 as the Company acquired Marlow in December 2004.
NET EARNINGS Net earnings decreased 54% in fiscal 2006 to $10.8 million ($0.36 per share-diluted) compared to $23.3 million ($0.78 per share-diluted) in fiscal 2005. The decrease in net earnings was primarily the result of the Company recording a pre-tax goodwill impairment charge of $17.6 million in fiscal 2006 based on annual impairment testing to write-off a portion of the goodwill attributable to its acquisition of Laser Power Corporation in fiscal 2001 which is included in the Military Infrared Optics segment. The decrease in net earnings was partially offset by the full twelve months of Marlow’s operations and the overall increase in revenues.
OUTLOOK The Company anticipates continued strengthening of its addressable markets in fiscal 2007, and is currently projecting for fiscal 2007 revenues to range from $261 million to $267 million and diluted earnings per share to range from $1.08 to $1.17.
Bookings, revenues and segment earnings (loss) for the Company’s reportable segments are discussed below. Segment earnings differs from income from operations in that segment earnings excludes certain operational expenses included in other expense - net as reported. Management believes segment earnings (loss) to be a useful measure as it reflects the results of segment performance over which management has direct control and is used by management in its evaluation of segment performance. See also Note M to the Company’s Consolidated Financial Statements for further information on the Company’s reportable segments.
Infrared Optics (millions)
Bookings for fiscal 2006 for Infrared Optics increased 20% to $122.2 million from $102.0 million in fiscal 2005. Demand from OEM and aftermarket customers continues to grow as the Company benefits from an expanding worldwide base of laser systems. In particular, rapid industrial growth in China and Eastern Europe has augmented our traditionally strong markets in United States, Western Europe and Japan. In addition, during fiscal 2006, the Company received more than twice the fiscal 2005 level of orders for zinc-based materials used in optical components for military and commercial applications. In anticipation of continued bookings growth in fiscal 2007, the Company has begun efforts to expand capacity in our Infrared Optics plants in Pennsylvania, Singapore and China.
Revenues for fiscal 2006 for Infrared Optics increased 19% to $120.4 million from $101.3 million in fiscal 2005. The increase in revenues for fiscal 2006 was driven by increased shipment volume to both OEM and aftermarket customers. Several of the largest OEM high-power laser system manufacturers increased their manufacturing outputs, resulting in higher optics consumption. Meanwhile, we received several large prototype orders as system builders continued to develop new laser system models to fill the full range of market requirements for laser cutting machines. Additionally, the segment recognized increased revenues of zinc-based materials for use as optical components in military surveillance and targeting systems.
Segment earnings for fiscal 2006 increased 13% to $34.5 million compared to $30.6 million in fiscal 2005. The increase in segment earnings was primarily driven by the increased sales volume. Segment earnings during the 2006 fiscal year increased at a rate less than that for revenues due to several factors. Among them, the segment experienced increases in raw material costs for many of the Company’s optical substrates, increased levels of overhead associated with the expansion of the Pennsylvania and Singapore manufacturing facilities and increased allocated corporate overhead all contributed to limit the growth of segment earnings.
Near-Infrared Optics (millions)
Bookings for fiscal 2006 for Near-Infrared Optics increased 25% to $41.7 million from $33.5 million in fiscal 2005. Approximately two-thirds of the bookings increase was related to the segment’s UV filter product line used to assist aircraft in the early detection of missile threats. Additionally, optics bookings grew by 20% from the prior fiscal year fueled by strong demand in the medical and instrumentation-related markets and the segment’s YAG bookings grew by 19% driven by medical and military applications.
Revenues for fiscal 2006 for Near-Infrared Optics remained flat at $34.0 million compared to $33.9 million in fiscal 2005. The lack of revenue growth in the current fiscal year despite the increase in bookings was primarily due to certain UV filter revenues being deferred into fiscal 2007 in accordance with revenue recognition principles in conjunction with a new contract entered into fiscal 2006. During most of fiscal 2006, the segment had been producing and stocking in inventory UV filter components. This inventory has begun to be shipped to the customer during the fourth quarter of fiscal 2006 and will continue to be shipped. As of June 30, 2006, the Near-Infrared Optics segment had $2.4 million of deferred revenue.
Segment earnings for fiscal 2006 decreased 10% to $2.1 million from $2.3 million in fiscal 2005. The decrease in segment earnings primarily reflects lower revenues from the YAG and crystal product lines. In addition, production yields and increased operating costs also impacted segment earnings negatively.
Military Infrared Optics (millions)
Bookings for fiscal 2006 for Military Infrared Optics increased 10% to $27.5 million from $25.0 million in fiscal 2005. The increase in bookings was driven by core military and sapphire product demands for military programs such as the Apache helicopter targeting system and the Advanced Targeting Pod (ATP) Sniper program used on and fighter jets.
Revenues for fiscal 2006 for Military Infrared Optics increased 8% to $29.4 million compared to $27.3 million in fiscal 2005. The revenue performance in core military and sapphire product lines were led by increased shipments of infrared windows for heritage programs and the next generation Arrowhead program for the Apache helicopter targeting system, and increased billings for sapphire development contracts related to the Joint Strike Fighter program.
Segment loss for fiscal 2006 was $17.5 million compared to segment earnings of $1.0 million in fiscal 2005. The segment’s goodwill was determined to be impaired based upon the completion of the annual goodwill impairment analysis resulting in a goodwill impairment charge of $17.6 million. The annual goodwill impairment analysis considers the financial projections of the Segment based on the most recently completed budgeting and long-term strategic planning processes and also considers the current financial performance compared to the prior projections of the Segment. Additionally, and, to a lesser extent, lower than normal production yields and increased scrap costs associated with the Javelin and Arrowhead Programs during fiscal 2006 contributed to the decrease in segment earnings.
Compound Semiconductor Group (millions)
The Company’s Compound Semiconductor Group includes the combined operations of Marlow for the seven months in fiscal year 2005 since the date of acquisition, the Company’s eV PRODUCTS division, the Company’s WBG group, and the Company’s Advanced Materials Development Center (AMDC).
Combined bookings for fiscal 2006 from these operations increased 86% to $50.8 million as compared to $27.3 million in fiscal 2005. Included in fiscal 2006 bookings is $37.3 million from Marlow representing a full twelve months compared to $17.3 million for the seven months in fiscal 2005 since the date of acquisition. Marlow experienced solid bookings across all of its addressable markets led by the business unit’s medical and defense markets. Bookings for the segment’s combined development businesses eV PRODUCTS and WBG group experienced an increase of approximately 35% during fiscal 2006 compared to fiscal 2005. This increase was the result of demand for nuclear medicine applications as well as certain research and development activities focusing on improvements in crystal growth and other production process improvements.
Revenues for fiscal 2006 from these operations increased 55% to $48.8 million compared to $31.5 million in 2005. Included in fiscal 2006 revenues is $35.1 million from Marlow representing a full twelve months compared to $19.8 million for the seven months in fiscal 2005 since the date of acquisition. Demand for Marlow’s products continues to strengthen, especially in the defense and medical markets. The Group’s eV PRODUCTS division experienced a 31% increase in revenues in fiscal 2006 compared to fiscal 2005. This increase was due to product demands from the Company’s core OEM customers in the medical, industrial and security markets combined with higher product pricing.
The segment earnings for fiscal 2006 were $1.9 million compared to a segment loss of $1.5 million in 2005. The improvement in segment earnings was attributed to the inclusion of Marlow’s operations for the full fiscal year as well as operational and yield improvements at the Groups’ eV PRODUCTS division and WBG Group.
Costs and Expenses
Manufacturing gross margin, which is defined as net sales less cost of goods sold, for fiscal 2006 was $91.0 million or 41% of revenues compared to $79.0 million or 43% of revenues in fiscal 2005. The increase in gross margin
dollars is a result of increased revenues. The decrease in the gross margin percentage during the current fiscal year was due to several factors. The addition of Marlow has lowered gross margins as the historical gross margins of Marlow’s product mix are lower than the overall gross margin of the Company before the Marlow acquisition. Selenium and other raw material price increases in the Company’s Infrared Optics segment negatively impacted gross margins as the price of these materials have risen and expect to continue to rise over the near term. Low production yields and high scrap costs experienced by the Military Infrared Optics segment during fiscal 2006 also contributed to the lower gross margin.
Contract research and development gross margin, which is calculated as contract research and development revenues less expenses, for fiscal 2006 was $2.6 million (27% of contract research and development revenues), compared to a gross margin of $2.6 million (28% of contract research and development revenues) for fiscal 2005. The contract research and development revenues and costs are a result of development efforts in the Near-Infrared Optics and the Military Infrared Optics segments as well as activities in Marlow, the eV PRODUCTS division and the WBG group for fiscal 2006. Contract research and development gross margin is a result of a blend of cost plus fixed fee, cost reimbursement and fixed fee contract activities.
Company-funded internal research and development expenses for fiscal 2006 were $6.9 million or 3% of revenues compared to $5.8 million or 3% of revenues, for fiscal 2005. The higher dollar amount is primarily the result of the addition of internal research and development at our Marlow subsidiary combined with increased corporate research and development activities.
Selling, general and administrative expenses for fiscal 2006 were $48.1 million or 21% of revenues compared to $43.3 million or 22% of revenues for fiscal 2005. The dollar increase reflects higher revenue combined with the addition of Marlow for a full year during fiscal 2006. Also, there was higher salary expense for the Company’s worldwide profit driven bonus programs in fiscal year 2006. From a percentage of revenue standpoint, the addition of Marlow and this business’s selling, general and administration cost structure has lowered this metric for the Company.
Interest expense for fiscal 2006 was $1.8 million compared to $0.9 million for fiscal 2005. The increase in interest expense for fiscal year 2006 was due to a full fiscal year of the Company’s debt incurred to finance the Marlow acquisition combined with higher interest rates. As of June 30, 2006, the Company’s had outstanding debt of $31.2 million compared to $45.0 million outstanding at June 30, 2005.
Other income for fiscal 2006 was $2.2 million compared to other income of $0.3 million in fiscal 2005. The increase in other income was due in part to the receipt of $0.8 million award from a jury verdict in favor of the Company in a trade secret lawsuit. The remainder of the increase is the result of foreign currency gains, interest income and other income items partially offset by the minority interest from the 25% interest of II-VI LOT Suisse S.a.r.l.
The Company’s effective income tax rate for fiscal 2006 was 49%. The increase in the effective tax rate was due to a goodwill impairment charge for which there is no tax benefit. The Company’s effective income tax rate reflects the benefit from lower tax rates from its Singapore and China operations and a favorable mix of U.S. and foreign income. In the prior fiscal year the Company entered into a Development and Expansion Initiative with the Singapore government whereby II-VI Singapore lowered its effective tax rate to approximately 16%. It is expected that this favorable tax structure will exist for the Company’s next few fiscal years. During the year ended June 30, 2006, pursuant to the provisions of the American Jobs Creation Act of 2004 (the “Act”), the Company adopted a domestic reinvestment plan for the purpose of facilitating the repatriation of foreign dividends. The Company repatriated $5.5 million during the fourth quarter of fiscal 2006 resulting in an increase in income taxes of $0.3 million.
Fiscal 2005 Compared to Fiscal 2004
Overview (millions except per share data)
RESULTS OF OPERATIONS
NET EARNINGS Net earnings increased 41% in fiscal 2005 to $23.3 million ($0.78 per share-diluted) from $16.5 million ($0.56 per share-diluted) in fiscal 2004. Net earnings increase was primarily attributed to revenue growth in all the Company’s operating segments. In particular, the Infrared Optics and Near-Infrared Optics segments achieved increases in revenues of 16% and 31% respectively from the prior year. In addition to the above, the Company’s newly acquired subsidiary, Marlow contributed to the net earnings growth. Earnings increases also resulted from operating improvements from the prior year due to production efficiencies and cost savings realized through increased manufacturing performed at the Company’s Singapore and China facilities and the lowering of the effective tax rate to 27% in fiscal 2005 from 29% in fiscal 2004.
BOOKINGS Bookings increased 15% to $187.8 million in fiscal 2005 compared to $162.8 million in fiscal 2004. Order backlog increased 9% to $75.5 million at June 30, 2005. Included in the fiscal 2005 bookings and order backlog are $17.3 million of bookings and $9.2 million of backlog at June 30, 2005 from Marlow. The Company’s Infrared Optics and Near-Infrared Optics bookings increased 13% and 11%, respectively, over the prior year. Growth in the United States CO2 laser market fueled the increase in the Infrared Optics segment. The Near-Infrared Optics segment increase was driven by the Company’s ramp up of their UV filter product line for which bookings of $6.4 million were recorded during fiscal 2005. The Company’s Military Optics segment bookings decreased 14% due to delays in the defense procurement cycle and increased competition in the military optics market. The Company’s Compound Semiconductor Group, exclusive of Marlow, experienced a decrease in bookings of approximately 23%. The majority of this decrease was due to the Company’s eV PRODUCTS division receipt of approximately $1.9 million in order cancellations from two OEM customers.
REVENUES Revenues increased 29% to $194.0 million in fiscal 2005 compared to $150.8 million in fiscal 2004. Included in the fiscal year 2005 revenues were $19.8 million of revenue contributions from Marlow. Excluding Marlow, leading this growth was the Company’s Near-Infrared Optics segment which recorded an increase in revenues of 31%. The majority of this increase was attributable to the segment’s UV Filter product line which recorded revenues of $7.1 million during fiscal 2005. The Company’s Infrared Optics and Military Optics segments increased revenues of 16% and 8%, respectively. The revenue growth in the Infrared Optics segment is due to the strong demand of our optics particularly in the aftermarket as more laser systems are being deployed. The increase in revenues in the Military Optics segment was driven by strong demand for the Company’s core military and sapphire products due to the need to repair and replace hardware expended or damaged in the war against terror.
Infrared Optics (millions)
Bookings for fiscal 2005 for Infrared Optics increased 13% to $102.0 million from $90.4 million in fiscal 2004. Strong buying patterns by CO2 laser OEM’s worldwide were experienced during the year. During fiscal 2005, our OEM customers deployed high-powered laser systems at the highest level in several years. In addition to high-powered laser system growth, the Company has experienced growth in the low-power optics markets.
Revenues for fiscal 2005 for Infrared Optics increased 16% to $101.3 million from $87.6 million in fiscal 2004. The increase was primarily attributed to increased shipment volume to both OEM and aftermarket customers as stronger order intake has translated into stronger revenues for fiscal 2005 compared to fiscal 2004.
Segment earnings for fiscal 2005 increased 37% to $30.6 million compared to $22.4 million in fiscal 2004. The improvement was the result of a combination of increased sales volume, an increased level of manufacturing at the Company’s Asian facilities in Singapore and China and productivity improvements occurring at our various manufacturing facilities.
Near-Infrared Optics (millions)
Bookings for fiscal 2005 for Near-Infrared Optics increased 11% to $33.5 million from $30.2 million in fiscal 2004. The increase in bookings was primarily driven by an increase in demand for the Company’s UV filter product line which recorded $2.4 million more bookings in fiscal 2005 as compared to fiscal 2004. In addition, YAG and other crystal product bookings increased approximately 7% in fiscal 2005 as compared to fiscal 2004.
Revenues for fiscal 2005 for Near-Infrared Optics increased 31% to $33.9 million compared to $25.8 million in fiscal 2004. The increase in revenues was primarily due to increased shipments of the Company’s UV filter product line which ramped up production during fiscal 2005. The Company recorded $7.1 million of UV filter revenue compared to $1.8 million in fiscal 2004. In addition to the increased UV filter revenue, the Company recorded approximately 15% more optic shipments during fiscal 2005.
Segment earnings for fiscal 2005 decreased 4% to $2.3 million from $2.4 million in fiscal 2004. The decrease in segment earnings reflects higher operating costs driven by a higher proportion of lower margin shipments during fiscal 2005 and the ramp up of costs associated with the UV filter product line.
Military Infrared Optics (millions)
Bookings for fiscal 2005 for Military Infrared Optics decreased 14% to $25.0 million from $29.2 million in fiscal 2004. The reduction in bookings was primarily driven by delays in the defense procurement cycle and increased competition in the military optics market.
Revenues for fiscal 2005 for Military Infrared Optics increased 8% to $27.3 million compared to $25.3 million in fiscal 2004. The increase in revenues was due primarily from strong demand for core military products due to the need to repair and replace hardware expended or damaged in the war against terror. In addition, the Company’s sapphire product line revenues increased approximately $1.1 million from fiscal 2004 as the Company continues to develop this part of its business.
Segment earnings for fiscal 2005 increased to $1.0 million from $0.9 million in fiscal 2004. The increase in segment earnings was due to overall increase in revenues and favorable product mix with higher revenues from core military products with higher gross margins.
Compound Semiconductor Group (millions)
Combined bookings for fiscal 2005 from these operations increased 110% to $27.3 million as compared to $13.0 million in fiscal 2004. Included in the current fiscal year bookings were $17.3 million from Marlow. Excluding the bookings from Marlow for the current year, bookings for the Compound Semiconductor Group decreased $3.0 million or 23%. The decrease in bookings primarily resulted from the Company’s eV PRODUCTS division receiving order cancellations of approximately $1.9 million from two OEM customers.
Revenues for fiscal 2005 from these operations increased 160% to $31.5 million compared to $12.1 million in fiscal 2004. Included in the fiscal 2005 revenues were $19.8 million from Marlow. Excluding revenues from Marlow for fiscal 2005, revenues for the Compound Semiconductor Group were consistent with fiscal 2004.
The segment loss for fiscal 2005 of $1.5 million decreased 25% from the segment loss of $2.0 million in fiscal 2004. The improvement in the segment loss was attributed to the inclusion of Marlow’s operations during fiscal 2005 which offset slightly higher segment losses at eV PRODUCTS and WBG.
Costs and Expenses
Manufacturing gross margin, which is defined as net sales less cost of goods sold, for fiscal 2005 was $79.0 million or 43% of revenues compared to $62.2 million or 44% of revenues in fiscal 2004. The increased gross margin in relative dollars was due to higher sales levels in fiscal 2005 than in fiscal 2004 while the decrease in the gross margin as a percentage of sales was primarily due to the addition of Marlow which historically has a lower gross margin than the core II-VI operating segments. Other factors impacting the gross margin of specific business segments were noted in the previous discussion of segment results.
Contract research and development gross margin, which is calculated as contract research and development revenues less expenses, for fiscal 2005 was $2.6 million (28% of research and development revenues), compared to a gross margin of $1.6 million (18% of research and development revenues), for fiscal 2004. The contract research and development revenues and costs are a result of development efforts in the Near-Infrared Optics and the Military Infrared Optics segments as well as activities in Marlow, the eV PRODUCTS division and the WBG group for fiscal 2005. The improvement in the contract research and development gross margin was due to increased contract activity in the fiscal 2005. In addition, our Military Optics segment recognized approximately $0.7 million of gross margin during fiscal 2005 related to its Large Optics Coating contract. Contract research and development gross margin is a result of a blend of cost plus fixed fee, cost reimbursement and fixed fee contract activities.
Company-funded internal research and development expenses for fiscal 2005 were $5.8 million or 3% of revenues compared to $5.0 million or 3% of revenues, for fiscal 2004. The higher dollar amount is primarily the result of the addition of internal research and development at our Marlow subsidiary combined with more corporate research and development activities.
Selling, general and administrative expenses for fiscal 2005 were $43.3 million or 22% of revenues compared to $35.1 million or 23% of revenues for fiscal 2004. The dollar increase reflects the addition of Marlow during the year and higher salary expense for the Company’s worldwide profit driven bonus program. In addition, outside professional services, including services relating to Section 404 of Sarbanes-Oxley, contributed to the increase from fiscal 2004. From a percentage of revenue standpoint, the addition of Marlow and this business’s selling, general and administration cost structure has lowered this metric for the Company.
Interest expense for fiscal 2005 was $0.9 million compared to $0.4 million for fiscal 2004. The increase in interest expense reflects an increase in the company’s debt levels from fiscal 2004 due to the financing of the acquisition of Marlow. As of June 30, 2005, the Company’s had outstanding debt of $45.0 million compared to $15.5 million outstanding at June 30, 2004. During fiscal 2005 the Company capitalized approximately $0.1 million of interest associated with its coating and administrative office expansion in Saxonburg, Pennsylvania.
The Company’s effective income tax rate for fiscal 2005 was 27% and was lower than the income tax rate for fiscal 2004 of 29%. The Company’s effective income tax rate reflects the Company’s continued benefit from lower tax rates on its Singapore and China operations and a favorable mix of U.S. and foreign income. The Company entered into a Development and Expansion Initiative with the Singapore government whereby II-VI Singapore lowered its effective tax rate to approximately 16%.
LIQUIDITY AND CAPITAL RESOURCES
Historically, our primary source of cash has been provided through operations and long-term borrowings. Other sources of cash include proceeds received from the exercise of stock options. Our historical uses of cash have been for capital expenditures, purchases of businesses, payment of principal and interest on outstanding debt obligations and purchases of treasury stock. Supplemental information pertaining to our sources and uses of cash is presented as follows:
Sources (uses) of Cash (millions):
In fiscal 2006, cash provided by operations was $40.8 million. The increase in cash from operations was driven by the Company’s net earnings of $10.8 million, depreciation and amortization expense of $15.8 million, a non-cash goodwill impairment charge of $17.6 million and share-based compensation expense of $2.4 million. The increase in cash was offset by working capital requirements of $2.9 million and a reduction of deferred taxes of $2.9 million.
Net cash used in investing activities during the fiscal year of $17.3 million was primarily for the Company’s purchase of property plant and equipment expenditures of $15.6 million and the final 25% purchase of II-VI Deutschland GmbH of $1.7 million.
Net cash used in financing activities during the fiscal year 2006 was $16.3 million and included short-term and long-term net debt payments of $13.7 million, purchases of treasury stock of $5.2 million offset by $1.4 million of proceeds from the exercise of stock options and $1.2 million of cash provided by excess tax benefits from share-based compensation.
The Company has a $60.0 million secured credit facility. This facility has a five-year term and contains a term loan in the original amount of $30.0 million and a $30.0 million line of credit. The facility is collateralized by a pledge of 65% of the stock of certain of the Company’s foreign subsidiaries. Additionally, the facility is subject to certain restrictive covenants, including those relating to minimum net worth, leverage and consolidated debt service coverage. The facility has an interest rate range of LIBOR plus 0.75% to LIBOR plus 1.50%. Principal payments of $1.9 million under the term loan are payable in quarterly installments which began January 2006. The weighted average interest rate of borrowings under the credit agreements was 4.8% and 3.4% for the fiscal years ended June 30, 2006 and 2005, respectively. The Company had available $27.4 million and $17.6 million under its line of credit as of June 30, 2006 and 2005, respectively.
On May 18, 2005, the Board of Directors authorized the Company to purchase up to 500,000 shares of its Common Stock. The repurchase program calls for shares to be purchased in the open market or in private transactions from time to time. The Company may suspend or discontinue this purchase program at any time. Shares purchased by the Company will be retained as treasury stock and will be available for general corporate purposes. The Company repurchased 283,100 shares totaling $5.2 million of common stock under the share repurchase program during the fiscal year ended June 30, 2006. To date, the Company has repurchased 294,100 shares, totaling $5.4 million, of common stock under this share repurchase program. The Company expects the repurchase of shares to at least partially offset the dilutive effect of the issuance of shares from the Company’s stock option plan.
Our cash position, borrowing capacity and debt obligations are as follows (in millions):
The Company believes cash flow from operations, existing cash reserves and available borrowing capacity will be sufficient to fund its working capital needs, capital expenditures, scheduled debt payments, treasury stock repurchases and internal growth for fiscal 2007.
OFF-BALANCE SHEET ARRANGEMENTS
The Company’s off-balance sheet arrangements include the operating leases and unconditional purchase obligations disclosed in the “Liquidity and Capital Resources” section in the contractual obligations table below as well as letters of credit as discussed in Note H to the Company’s Consolidated Financial Statements
TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS
(1) Variable rate interest obligations are based on the interest rate in effect at June 30, 2006.
(2) A “purchase obligation” is defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company and that specifies all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments to vendors for the purchase of supplies and materials.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISKS
The Company is exposed to market risks arising from adverse changes in foreign currency exchange rates and interest rates. In the normal course of business, the Company uses a variety of techniques and derivative financial instruments as part of its overall risk management strategy primarily focused on its exposure to the Japanese Yen. No significant changes have occurred in the techniques and instruments used other than those described below.
In addition, the Company has transactions denominated in Euros and Pounds Sterling. As a result of the Company’s hedging activities discussed below, changes in the foreign currency exchange rates of these currencies did not have a material impact on the results of operations for fiscal year 2006.
Foreign Exchange Risks
In the normal course of business, the Company enters into foreign currency forward exchange contracts with its financial institutions. The purpose of these contracts is to hedge ordinary business risks regarding foreign currencies on product sales. Foreign currency exchange contracts are used to limit transactional exposure to changes in currency rates. The Company enters into foreign currency forward contracts that permit it to sell specified amounts of foreign currencies expected to be received from its export sales for pre-established U.S. dollar amounts at specified dates. The forward contracts are denominated in the same foreign currencies in which export sales are denominated. These contracts provide the Company with an economic hedge in which settlement will occur in future periods and which otherwise would expose the Company to foreign currency risk. The Company monitors its positions and the credit ratings of the parties to these contracts. While the Company may be exposed to potential losses due to risk in the event of non-performance by the counterparties to these financial instruments, it does not anticipate such losses. The Company entered into a low interest rate, 300 million Yen loan with PNC Bank in September 2002 in an effort to minimize the foreign currency exposure in Japan. A change in the interest rate of 1% for this Yen loan would have changed the interest expense by approximately $27,000 and a 10% change in the Yen to U.S. dollar exchange rate would have changed revenues in the range from a decrease of approximately $1.9 million to an increase of approximately $2.3 million for the year ended June 30, 2006.
For II-VI Singapore Pte., Ltd. and its subsidiaries, and the Company’s majority-owned subsidiary II-VI LOT Suisse S.a.r.l., the functional currency is the U.S. dollar. Gains and losses on the remeasurement of the local currency financial statements are included in net earnings. Foreign currency remeasurement gains (losses) were $2.8 million, $0.2 million and $0.5 million for the years ended June 30, 2006, 2005 and 2004, respectively. The increase in the foreign currency remeasurement gain was due to the Singapore dollar strengthening against the U.S. dollar during fiscal year 2006.
For all other foreign subsidiaries, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using the period-end exchange rate while income and expenses are translated using the average exchange rates for the reporting period. Translation adjustments are recorded as accumulated other comprehensive income within shareholders’ equity.
Interest Rate Risks
As of June 30, 2006, the total borrowings of $31.2 million included a $26.3 million term loan, $2.0 million under a line of credit, $2.6 million loan denominated in Japanese Yen and a $0.3 million Pennsylvania Industrial Development Authority (PIDA) term note. As such, the Company is exposed to changes in interest rates. A change in the interest rate of 1% would have changed the interest expense by approximately $0.4 million for the fiscal year ended June 30, 2006.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF MANAGEMENT
Management’s Responsibility for Preparation of the Financial Statements
Management is responsible for the preparation of the financial statements included in this Annual Report. The financial statements were prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on the best estimates and judgments of management. The other financial information contained in this Annual Report is consistent with the financial statements.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance concerning the reliability of the financial data used in the preparation of the Company’s financial statements, as well as reasonable assurance with respect to safeguarding the Company’s assets from unauthorized use or disposition.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement presentation and other results of such systems.
Management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of June 30, 2006. In making this evaluation, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
Management’s evaluation included reviewing the documentation of its controls, evaluating the design effectiveness of controls and testing their operating effectiveness. Based on the evaluation, management concluded that as of June 30, 2006, a material weakness existed relating to the Company’s lack of internal expertise and resulting failure to properly execute control procedures designed to evaluate the annual testing for impairment of goodwill for the Company’s Military Infrared Optics business unit as required by Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets.” Specifically, management concluded that the following deficiencies constituted a material weakness in the aggregate: (a) failure to accurately interpret the valuation results obtained from an independent third party, (b) insufficient review procedures and (c) lack of internal expertise and training in the interpretation of goodwill-related valuation results. This weakness ultimately resulted in a material audit adjustment related to an impairment charge with respect to goodwill for the Company’s Military Infrared Optics business unit. Consequently, the Company’s consolidated financial statements for the fiscal year ended and as of June 30, 2006 properly reflected the results of the goodwill impairment in accordance with generally accepted accounting principles.
As a result of the material weakness identified as of June 30, 2006, management has concluded that the Company did not maintain effective internal control over financial reporting at June 30, 2006.
Deloitte & Touche LLP has issued their report on our evaluation of internal control over financial reporting. Additionally, Deloitte & Touche LLP expressed an unqualified opinion on the Company’s fiscal 2006 financial statements.
Management’s Remediation Plans
Management believes that additional training and enhanced review procedures in the area of goodwill impairment testing are appropriate to correct the material weakness. Management intends to implement these corrective measures and will continue to monitor the effectiveness of these control modifications and implement improvements as and when necessary.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of II-VI Incorporated and Subsidiaries:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that II-VI Incorporated and subsidiaries (the “Company”) did not maintain effective internal control over financial reporting as of June 30, 2006 because of the effect of the material weakness identified in management’s assessment based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organization 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. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of 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, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
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.
A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment: a material weakness existed relating to the Company’s lack of internal expertise and resulting failure to properly execute control procedures designed to evaluate the annual testing for impairment of goodwill as required by Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets.” This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and financial statement schedule as of and for the year ended June 30, 2006, of the Company and this report does not affect our report on such financial statements and financial statement schedule.
In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of June 30, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objective of control criteria, the Company has not maintained, in all material respects, effective internal control over financial reporting as of June 30, 2006, 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 and financial statement schedule as of and for the year ended June 30, 2006, of the Company and our report dated September 11, 2006 expressed an unqualified opinion on those financial statements and financial statement schedule.
/s/ Deloitte & Touche LLP
Pittsburgh, Pennsylvania
September 11, 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of II-VI Incorporated and Subsidiaries:
We have audited the accompanying consolidated balance sheets of II-VI Incorporated and subsidiaries (the “Company”) as of June 30, 2006 and 2005, and the related consolidated statements of earnings, shareholders’ equity, comprehensive income, and cash flows for each of the three years in the period ended June 30, 2006. Our audits also included the financial statement schedule listed in Item 15. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule 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 the Company as of June 30, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2006, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated September 11, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of a material weakness.
As discussed in Note A to the Consolidated Financial Statements, effective July 1, 2005, the Company changed its method of accounting for share-based compensation.
/s/ Deloitte & Touche LLP
Pittsburgh, Pennsylvania
September 11, 2006
CONSOLIDATED BALANCE SHEETS
(1) As restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.” See Note A.
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF EARNINGS
(1) As restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.” See Note A.
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(1) As restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.” See Note A.
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(1) As retrospectively adjusted to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.” See Note A.
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(1) As restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.” See Note A.
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note A NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS II-VI Incorporated and subsidiaries (the “Company”) develops, manufactures and markets infrared and near-infrared laser optical elements, military infrared optical components, x-ray and gamma-ray sensors, single crystal silicon carbide (SiC) substrates and thermoelectric cooling and power generation solutions. The Company markets its products in the United States through its direct sales force and worldwide through its wholly- or majority-owned subsidiaries, distributors and agents.
The Company uses certain uncommon materials and compounds to manufacture its products. Some of these materials are available from only one proven outside source. The continued high quality of these materials is critical to the stability of the Company’s manufacturing yields. The Company has not experienced significant production delays due to a shortage of materials. However, the Company does occasionally experience problems associated with vendor supplied materials not meeting specifications for quality or purity. A significant failure of the Company’s suppliers to deliver sufficient quantities of necessary high-quality materials on a timely basis could have a material adverse effect on the Company’s results of operations.
PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company. All intercompany transactions and balances have been eliminated.
FOREIGN CURRENCY TRANSLATION For II-VI Singapore Pte., Ltd. and its subsidiaries, and the Company’s majority-owned subsidiary II-VI LOT Suisse S.a.r.l., the functional currency is the U.S. dollar. Gains and losses on the remeasurement of the local currency financial statements are included in net earnings. Foreign currency remeasurement gains were $2.8 million, $0.2 million and $0.5 million for the years ended June 30, 2006, 2005 and 2004, respectively. The increase in the foreign currency remeasurement gain during fiscal year 2006 was due to the Singapore dollar strengthening against the U.S. dollar.
For all other foreign subsidiaries, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using period-end exchange rates while income and expenses are translated using the average exchange rates for the reporting period. Translation adjustments are recorded as accumulated other comprehensive income within shareholders’ equity in the accompanying consolidated balance sheets.
CASH AND CASH EQUIVALENTS The Company considers highly liquid investment instruments with an original maturity of three months or less to be cash equivalents. The majority of cash and cash equivalents is invested in investment grade money market type instruments. Cash of foreign subsidiaries is on deposit at banks in Singapore, China, Germany, Japan, Belgium, the Netherlands, Switzerland, the United Kingdom and Vietnam.
ACCOUNTS RECEIVABLE AND WARRANTY RESERVE The Company establishes an allowance for doubtful accounts based on historical experience.
The Company factored a portion of the accounts receivable due to its Japan subsidiary during each of the years ended June 30, 2006 and 2005. Factoring is done with large banks in Japan. During the years ended June 30, 2006 and 2005, $4.8 million and $6.6 million respectively, of accounts receivable had been factored. As of June 30, 2006 and 2005, $0.5 million and $0.6 million, respectively, was included in Other Accrued Liabilities representing the Company’s obligation to the bank for these receivables factored with recourse.
The Company records a warranty reserve as a charge against earnings based on a percentage of sales utilizing actual returns over the last twelve months. The following table summarizes the change in the carrying value of the Company’s warranty reserve as of and for the years ended June 30, 2006, 2005 and 2004.
(1) The component of “Other” relates to the warranty reserve from the acquisition of Marlow Industries, Inc. in December 2004 (see Note C).
INVENTORIES Inventories are valued at the lower of cost or market, with cost determined on the first-in, first-out basis. Inventory costs include material, labor and manufacturing overhead. The Company records a slow moving inventory reserve as a charge against earnings for all products on hand more than twelve months to eighteen months depending on the products that have not been sold to customers or cannot be further manufactured for sale to alternative customers. An additional reserve is recorded for product on hand that is in excess of product sold to customers over the same periods noted above. Inventories are net of reserves totaling $2.5 million and $1.4 million at June 30, 2006 and 2005, respectively.
PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are carried at cost or fair market value upon acquisition. Major improvements are capitalized, while maintenance and repairs are generally expensed as incurred. The Company reviews its property, plant and equipment and other long-lived assets for impairment whenever events or circumstances indicate that the carrying amounts may not be recoverable. Depreciation for financial reporting purposes is computed primarily by the straight-line method over the estimated useful lives of the assets. Depreciable useful lives range from 2 to 20 years.
GOODWILL The excess purchase price over the net assets of businesses acquired is reported as goodwill in the accompanying consolidated balance sheets. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets”, the Company tests goodwill for impairment at least annually or when events or changes in circumstances indicate that goodwill might be impaired.
INVESTMENT In July 2001, the Company acquired for $1.7 million a 25% ownership interest in 5NPlus, Inc., a supplier to the Company. In July 2002, the Company increased its ownership interest to 33% as a result of a loan conversion to equity in accordance with the original purchase agreement in the amount of $0.4 million. In April 2005, the Company increased its ownership to approximately 36% as a result of acquiring a pro-rata ownership percentage of an exiting shareholder for $0.2 million. This investment is accounted for under the equity method of accounting.
At June 30, 2006 and 2005, the Company had outstanding notes receivable of approximately $0.4 million and $0.5 million, respectively, from equipment and supply agreements with this supplier. Payments on these notes are made quarterly with interest calculated at up to the Canadian Prime Rate plus 1.50% on the unpaid balance. For the years ended June 30, 2006, 2005 and 2004, the Company purchased $1.2 million, $1.0 million and $0.3 million, respectively, of raw materials each year from this supplier. The Company’s pro rata share of the earnings from this investment and the interest received from these agreements were approximately $0.2 million, $0.2 million and $0.1 million for the years ended June 30, 2006, 2005 and 2004, respectively.
INTANGIBLES Intangible assets are carried at cost or fair market value upon acquisition. Finite-lived intangible assets are amortized for financial reporting purposes using the straight-line method over the estimated useful lives of the assets ranging from 3 years to 20 years. Indefinite-lived intangible assets are not amortized but tested annually for impairment.
OTHER ASSETS In April 2005, the Company entered into a $2.0 million note purchase agreement with SemiSouth Laboratories, Inc. (“SemiSouth”), a customer and supplier of the Company. Under the terms of the agreement, the note receivable accrues interest at Prime plus 1.00% per annum paid quarterly. The note receivable matures April 4, 2010. The note purchase agreement contains a conversion feature that permits the Company to convert the note receivable into common shares of SemiSouth at certain times upon certain situations through the maturity date.
ACCRUED BONUSES AND PROFIT SHARING CONTRIBUTION The Company records bonus and profit sharing estimates as a charge against earnings based on a formula percentage of the Company’s operating income.
These estimates are adjusted to actual based on final results of operations achieved during the fiscal year. Partial bonus amounts may be paid on an interim basis, and the remainder is paid after the fiscal year end after the final determination of the applicable percentage or amounts.
INCOME TAXES Deferred income tax assets and liabilities are determined based on the differences between the consolidated financial statement and tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred income tax assets to the amount more likely than not to be realized. Annual tax provisions include amounts considered sufficient to pay assessments that may result from examinations of prior year tax returns; however, the amount ultimately paid upon resolution of issues raised may differ from the amounts accrued.
REVENUE RECOGNITION The Company considers the provisions of Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition (“SAB 104”), which superseded SAB 101. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is established or determinable and collectibility is probable. Revenue, for all business segments, other than for contract research and development, is recognized from the sale of products at the point of passage of title, which is generally at the time of shipment.
The Company performs research and development under contract agreements with customers based on cost plus fixed fee, cost reimbursable or fixed fee terms. These contracts generally require the Company to produce and provide developmental materials and/or products to those customers. Revenues from cost plus fixed fee and cost reimbursable contracts are recognized as costs are incurred.
The Company follows the guidelines of Statement of Position 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” for its fixed fee contracts. Revenue and profits on each fixed fee contract are accounted for using the percentage-of-completion method of accounting, whereby revenue and profits are recognized throughout the performance period of the contract. Percentage-of-completion is determined by relating the actual cost of work performed to date to the estimated total cost for each contract. The estimated total cost for each contract is periodically reevaluated and revised, when necessary, throughout the life of the contract. Losses on contracts are recorded in full when identified.
SHIPPING AND HANDLING COSTS Shipping and handling costs billed to customers are included in revenues. Shipping and handling costs incurred by the Company are included in selling, general and administrative expenses in the accompanying consolidated statements of earnings. Total shipping and handling costs included in revenues and in selling, general and administrative expenses was $0.3 million for the year ended June 30, 2006 and $0.2 million for each of the years ended June 30, 2005 and 2004.
RESEARCH AND DEVELOPMENT Internal research and development costs and costs not related to customer and government funded research and development contracts are expensed as incurred.
SHARE-BASED COMPENSATION The Company adopted SFAS No. 123 (revised 2004), (“SFAS 123R”) “Share-Based Payment,” effective July 1, 2005. SFAS 123R requires the recognition of the fair value of stock compensation in net earnings. The Company recognizes the share-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period. Prior to July 1, 2005, the Company followed Accountings Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its share-based compensation.
The Company elected the modified retrospective transition method for adopting SFAS 123R. Under this method, all prior period financial statements were restated effective July 1, 2005 to recognize share-based compensation cost in the amounts previously reported in the Notes to Consolidated Financial Statements. The Consolidated Balance Sheet at June 30, 2005 has been restated for the modified retrospective adoption of SFAS 123R resulting in a $7.2 million increase in common stock, a $5.6 million reduction in retained earnings and a $1.6 million increase in deferred tax asset.
Under the provisions of SFAS 123R, the Company recorded $2.4 million, $2.2 million and $1.1 million in share-based compensation expense in its Consolidated Statements of Earnings for the fiscal years ended June 30, 2006, 2005 and 2004, respectively. The share-based compensation expense is allocated approximately 35% to cost of goods sold and 65% to selling, general and administrative expense in the Consolidated Statements of Earnings based upon the employee classification of the grantee. The Company utilized the Black-Scholes valuation model for estimating the fair
value of the share-based compensation expense. During the fiscal years ended June 30, 2006, 2005 and 2004, the weighted-average fair value of options granted under the stock option plan was $10.96, $11.21 and $7.84, respectively, per option using the following assumptions:
The risk-free interest rate is derived from the average U.S. Treasury Note rate during the period, which approximates the rate in effect at the time of grant related to the expected life of the options. The risk free interest rate shown above is the weighted average rate for all options granted during the fiscal year. Expected volatility is based on the historical volatility of the Company’s common stock over the period commensurate with the expected life of the options. The expected life calculation is based on the observed time to post-vesting exercise and/or forfeitures of options by our employees. The dividend yield of zero is based on the fact the Company has never paid cash dividends and has no intention to pay cash dividends in the future. The estimated annualized forfeitures are based on the Company’s historical experience of option pre-vesting cancellations and are estimated at a rate of 22%. Under the provisions of SFAS 123R, the Company will record additional expense in future periods if the actual forfeiture rate is lower than estimated, and will record a recovery of expense in future periods if the actual forfeitures are higher than estimated.
DERIVATIVE INSTRUMENTS The Company, from time to time, purchases foreign currency forward exchange contracts, primarily in Japanese Yen, that permit it to sell specified amounts of these foreign currencies expected to be received from its export sales for pre-established U.S. dollar amounts at specified dates. These contracts are entered into to limit transactional exposure to changes in currency exchange rates of export sales transactions in which settlement will occur in future periods and which otherwise would expose the Company, on the basis of its aggregate net cash flows in respective currencies, to foreign currency risk.
The Company recorded these contracts with a notional amount of approximately $4.9 million and $3.0 million as of June 30, 2006 and 2005, respectively, which approximated the fair value of these contracts on the statement of financial position. The Company records the change in the fair value of these contracts in the results of operations as they occur. The change in the fair value of these contracts increased net earnings by $0.1 million for the year ended June 30, 2005. The impact in fiscal years ended June 30, 2006 and 2004 was insignificant.
WORKERS’ COMPENSATION The Company is self-insured for certain losses related to workers’ compensation. Additionally, third-party insurance is obtained to limit our exposure to these claims. When estimating the self-insurance liability, the Company considers a number of factors, including historical claims experience, demographic and severity factors and valuations provided by independent third party consultants. Periodically, management reviews its assumptions and the valuations to determine the adequacy of the self-insurance liability.
COMPREHENSIVE INCOME Comprehensive income is a measure of all changes in shareholders’ equity that result from transactions and other economic events of the period other than transactions with owners. Accumulated other comprehensive income is a component of shareholders’ equity and consists of accumulated foreign currency translation adjustments of $0.7 million and $0.6 million, net of income taxes of $0.3 million and $0.2 million, as of June 30, 2006 and 2005, respectively.
FAIR VALUE OF FINANCIAL INSTRUMENTS EXCLUDING DERIVATIVE INSTRUMENTS The following methods and assumptions were used to estimate the fair value of financial instruments:
Cash and Cash Equivalents The carrying amount approximates fair value because of their short maturities.
Debt Obligations The fair values of debt obligations are estimated based upon market values of similar issues. The fair values and carrying amounts of the Company’s debt obligations are approximately equivalent.
ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS In May 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also redefines “restatement” as the revising of previously issued financial statements to reflect the correction of an error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109” (“FIN 48”) which clarifies the accounting for uncertainty in tax positions taken or expected to be taken in a tax return, including issues relating to financial statement recognition and measurement. FIN 48 provides that the tax effects from an uncertain tax position can be recognized in the financial statements only if the position is “more-likely-than-not” of being sustained if the position were to be challenged by a taxing authority. The assessment of the tax position is based solely on the technical merits of the position, without regard to the likelihood that the tax position may be challenged. If an uncertain tax position meets the “more-likely-than-not” threshold, the largest amount of tax benefit that is greater than 50 percent likely of being recognized upon ultimate settlement with the taxing authority, is recorded. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on the consolidated financial statements for the fiscal year ending June 30, 2008.
RECLASSIFICATIONS Certain amounts from prior years have been reclassified to conform to the 2006 presentation.
Note B STOCK SPLIT
On February 17, 2005, the Company’s Board of Directors declared a two-for-one stock split, in the form of a stock dividend, of the Company’s common stock for shareholders of record on March 2, 2005. The stock split was distributed on March 22, 2005 issuing one additional share of common stock for every share of common stock held. The applicable share and per share data for all periods included herein have been restated to give effect to this stock split.
Note C ACQUISITIONS
II-VI Deutschland GmbH
In July 2005, the Company exercised its call option and purchased the remaining 25% interest of II-VI Deutschland GmbH from L.O.T.-Oriel Laser Optik GmbH & Co. KG (L.O.T.) for $1.7 million. In connection with the purchase of the remaining 25% interest, the Company received a three year non-compete agreement from L.O.T. The purchase price was allocated $1.6 million to goodwill and $0.1 million to the non-compete agreement.
Marlow Industries, Inc.
In December 2004, the Company acquired all the outstanding shares of Marlow Industries, Inc. (“Marlow”) for approximately $29.7 million net of cash acquired of $2.9 million and including transaction costs of approximately $0.3 million. The financial results of Marlow are included since the date of acquisition, in the Consolidated Statements of Earnings.
This acquisition was accounted for using the purchase method in accordance with SFAS No. 141, “Business Combinations.” Accordingly, the Company recorded the net assets at their estimated fair values. The following table presents allocation of the purchase price to the assets acquired and liabilities assumed at the date of acquisition ($000’s).
Of the $11.7 million of acquired intangible assets, $6.0 million was assigned to a registered tradename that is not subject to amortization. Acquired patents totaled $2.9 million and are amortized over a period ranging from 1.5 years to 8.5 years. Customer list acquired totaled $2.3 million and is amortized over 9.5 years and the remaining non-compete agreement of $0.5 million is amortized over 3 years.
During the fiscal year ended June 30, 2006, the Company finalized its accounting for the acquisition of Marlow in accordance with SFAS No. 141, “Business Combinations” and recorded an adjustment to goodwill relating to a change in deferred income tax liability.
The following unaudited pro-forma consolidated results of operations have been prepared as if the acquisition of Marlow had occurred at July 1, 2003, the beginning of the Company’s fiscal year 2004 ($000 except per share).
The pro-forma results are not necessarily indicative of what actually would have occurred if the transaction had taken place at the beginning of the period, are not intended to be a projection of future results and do not reflect any cost savings that might be achieved from the combined operations.
Note D CONTRACT RECEIVABLES
The components of contract receivables, which are a component of accounts receivable, net, were as follows:
Note E INVENTORIES
The components of inventories were as follows:
Note F PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at cost or valuation consist of the following:
Depreciation expense was $14.3 million, $11.5 million and $9.0 million for the years ended June 30, 2006, 2005 and 2004, respectively.
Capitalized interest expense associated with the construction of buildings and improvements was $0.1 million for the years ended June 30, 2006 and 2005 and was insignificant for the year ended June 30, 2004.
Note G GOODWILL AND INTANGIBLE ASSETS
Goodwill represents the excess of the cost over the net tangible and identifiable intangible assets of acquired businesses. Identifiable intangible assets acquired in business combinations are recorded based upon fair market value at the date of acquisition.
Changes in the carrying amount of goodwill are as follows:
In accordance with SFAS No. 142, “Goodwill and Intangible Assets,” the Company reviews, the recoverability of goodwill at least annually and any time business conditions indicate a potential change in recoverability. During the fourth quarter of fiscal 2006, the Company conducted its annual impairment tests of its reporting units utilizing a combination of valuation techniques including the discounted cash flow approach and the market multiple approach. The results of these impairment tests indicated that the Company’s Exotic Electro-Optics reporting unit’s goodwill was impaired. The Company recorded approximately $17.6 million of goodwill impairment charges in the Consolidated Statements of Earnings associated with the goodwill of Exotic Electro-Optics.
In connection with the remaining 25% acquisition of II-VI Deutschland GmbH in July 2005, the Company recorded the excess purchase price over the net assets of the business acquired as goodwill in the accompanying Consolidated Balance Sheets based on the purchase price allocation.
In connection with the acquisition of Marlow in December 2004, the Company recorded the excess purchase price over the net assets of the business acquired as goodwill in the accompanying Consolidated Balance Sheet based on the purchase price allocation. The Company finalized its accounting for the acquisition of Marlow during the fiscal year ended June 30, 2006 in accordance with SFAS No. 141, “Business Combinations and recorded an adjustment to goodwill relating to a change in deferred income tax liability.
During the year ended June 30, 2005, the Company finalized its accounting for the acquisition of II-VI LOT Suisse S.a.r.l., (“II-VI LOT Suisse”) in accordance with SFAS No. 141, “Business Combinations” and recorded an adjustment to goodwill relating to a change in deferred income tax liability.
The gross carrying amount and accumulated amortization of the Company’s intangible assets other than goodwill as of June 30, 2006 and 2005 were as follows:
Amortization expense recorded on the intangible assets for the years ended June 30, 2006, 2005 and 2004 was $1.5 million, $1.2 million and $0.6 million, respectively. In connection with the acquisition of Marlow, the Company completed its valuation of certain identifiable intangible assets in accordance with SFAS No. 141, during the year end
June 30, 2005. The Company recognized approximately $11.7 million of identifiable intangibles as a result of the valuation. The carrying amount of the acquired trade name with an indefinite life not amortized but tested annually for impairment totaled $6.0 million. The Company completed its impairment test of the acquired trade name with an indefinite life in the fourth quarter of fiscal 2006. Based on the results of the test the trade name was not impaired at June 30, 2006. Included in the gross carrying amount and accumulated amortization of the Company’s customer list component of intangible assets and goodwill is the effect of the foreign currency translation of the portion relating to the Company’s German distributor. The estimated amortization expense for existing intangible assets for each of the five succeeding years is as follows:
Note H DEBT
The components of debt were as follows:
The Company has a $60.0 million secured credit facility. The facility has a five-year term through December 2009 and contains a term loan in the original amount of $30.0 million and a $30.0 million line of credit. The facility is collateralized by a pledge of 65% of the stock of certain of the Company’s foreign subsidiaries. Additionally, the facility is subject to certain restrictive covenants, including those relating to minimum net worth, leverage and consolidated debt service coverage. The facility has an interest rate range of LIBOR plus 0.75% to LIBOR plus 1.50%. Principal payments of $1.9 million under the term loan are payable in quarterly installments through October 2009. The weighted average interest rate of borrowings under the credit agreements was 4.8% and 3.4% for the fiscal years ended June 30, 2006 and 2005, respectively. The Company had available $27.4 million and $17.6 million under its line of credit as of June 30, 2006 and 2005, respectively.
At June 30, 2006 and 2005, total outstanding letters of credit supported by the credit facility were $0.6 million and $0.5 million, respectively.
The Company has a 300 million Yen loan. This loan matures in September 2007. Interest is at a rate equal to the Japanese Yen Base Rate, as defined in the loan agreement, plus 1.49%. The Japanese Yen Base Rate was 0.16% at June 30, 2006 and 0.07% at June 30, 2005.
The Company has a line of credit facility with a Singapore bank which permits maximum borrowings in the local currency of approximately $0.4 million for the fiscal years ended June 30, 2006 and 2005. Borrowings are payable upon demand with interest being charged at the rate of 1.00% above the bank’s prevailing prime lending rate. The interest rate was 5.3% at June 30, 2006 and 2005. At June 30, 2006 and 2005 there were no outstanding borrowings under this facility.
The aggregate annual amounts of principal payments required on the long-term debt are as follows:
Interest and commitment fees paid during the years ended June 30, 2006, 2005 and 2004 totaled approximately $1.6 million, $1.0 million and $0.5 million, respectively.
Note I INCOME TAXES
The components of income tax expense were as follows:
Principal items comprising deferred income taxes were as follows:
The reconciliation of income tax expense at the statutory federal rate to the reported income tax expense is as follows:
During the years ended June 30, 2006, 2005, and 2004, cash paid by the Company for income taxes was $10.8 million, $6.9 million, and $3.3 million, respectively.
Earnings before income taxes of our non-U.S. operations for June 30, 2006, 2005 and 2004 was $18.1 million, $15.0 million and $12.8 million, respectively. The Company has not recorded deferred income taxes applicable to undistributed earnings of foreign subsidiaries that are indefinitely reinvested outside the United States. If the earnings of such foreign subsidiaries were not indefinitely reinvested, an additional deferred tax liability of approximately $11.4 million and $15.3 million would have been required as of June 30, 2006 and 2005, respectively.
It is the Company’s intention to permanently reinvest undistributed earnings of its foreign subsidiaries beyond the repatriated amount; therefore, no provision has been made for future income taxes on the undistributed of foreign subsidiaries, as they are considered indefinitely reinvested.
The American Jobs Creation Act of 2004 (the “Act”) was enacted in October of 2004. The Act provided for a temporary incentive for U.S. multinational corporations to repatriate accumulated income earned abroad by providing an 85% exclusion from taxable income for certain dividends from controlled foreign corporations. As a result of this special temporary tax incentive and pursuant to the provisions of the Act, the Company repatriated $5.5 million during the year ended June 30, 2006 and recorded tax expense of $0.3 million in connection with such repatriation.
The Company’s Vietnam subsidiary operates under a tax holiday and does not pay income taxes. This subsidiary is tax exempted for four years from the first year profits are achieved.
The sources of differences resulting in deferred income tax expense (benefit) and the related tax effect of each were as follows:
As of June 30, 2006, the Company had federal and state net operating loss carryforwards of $2.1 million and $2.2 million, respectively. The net operating loss carryforwards will begin to expire in 2024 and 2010, respectively. For the years ended June 30, 2006, 2005 and 2004, the Company utilized $1.5 million, $1.6 million and $1.9 million of net operating losses, respectively, to reduce current taxable income.
Note J EARNINGS PER SHARE
The following table sets forth the computation of earnings per share for the periods indicated. Weighted average shares issuable upon the exercise of stock options that were not included in the calculation because they were antidilutive were immaterial for all periods presented.
Note K OPERATING LEASES
The Company leases certain property under operating leases that expire at various dates through the year ending June 30, 2014. Future rental commitments applicable to the operating leases at June 30, 2006 are as follows:
Rent expense was approximately $2.2 million, $1.7 million and $1.3 million for the years ended June 30, 2006, 2005 and 2004, respectively.
Note L SHARE-BASED COMPENSATION PLANS
On August 13, 2005, the Board of Directors adopted the II-VI Incorporated 2005 Omnibus Incentive Plan (the “Plan”). The Plan was approved by the shareholders of the Company on November 4, 2005, and consequently, no further stock option grants will be made under the predecessor plan. The Plan provides for the grant of non-qualified stock options, stock appreciation rights, restricted shares, deferred shares and performance units shares may be issued to employees, officers, directors and consultants of the Company. The maximum number of shares of the Company’s common stock authorized for issuance under the Plan shall not in the aggregate exceed 1,800,000 shares of common stock authorized plus any shares under the predecessor plan which were outstanding as of November 4, 2005, that expire or terminate without being exercised. All options to purchase shares of common stock granted under the Plan had been at market price at the date of grant. Generally, twenty percent of the options may be exercised one year from the date of grant with comparable annual increases on a cumulative basis each year thereafter. The stock option plan also had vesting provisions predicated upon the death, retirement or disability of the optionee. As of June 30, 2006, there were 1,738,120 shares available under the Plan.
During the fiscal year 2006, the Company issued performance shares under the Plan to certain executive officers for the performance period January 2006 to June 2006. The awards were intended to provide continuing emphasis on specified financial performance goals that the Company considers being important contributors to long-term
shareholder value. The awards were payable only if the Company achieved specified levels of revenue and cash flows from operations for the performance periods. Included in the $2.4 million share-based compensation expense for the year ended June 30, 2006 was $0.4 million of expense attributable to the performance shares. The performance shares compensation expense was calculated based on the number of shares earned multiplied by the stock price at the date the performance plan was established. There were no performance shares issued for the fiscal years ended June 30, 2005 and 2004.
The Company had a stock option plan, the II-VI Incorporated Stock Option Plan of 2001, under which stock options had been granted by the Board of Directors to directors, officers and key employees, with 7,740,000 shares of common stock reserved for use under this plan. All options to purchase shares of common stock granted under the Stock Option Plan of 2001 had been at market price at the date of grant. Generally, twenty percent of the options may be exercised one year from the date of grant with comparable annual increases on a cumulative basis each year thereafter. The stock option plan also had vesting provisions predicated upon the death, retirement or disability of the optionee. All stock options expire 10 years after the grant date.
Stock option activity relating to the plans during the years ended June 30, 2006, 2005 and 2004 were as follows:
Outstanding and exercisable options at June 30, 2006 were as follows:
Note M SEGMENT AND GEOGRAPHIC REPORTING
The Company reports its segments using the “management approach” model for segment reporting. The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure or any other manner in which management segregates a company.
The Company’s reportable segments offer similar products to different target markets. The segments are managed separately due to the production requirements and facilities that are unique to each segment. The Company has the following reportable segments: Infrared Optics, which is the Company’s infrared optics and material products businesses and remaining corporate activities, primarily corporate assets and capital expenditures; Near-Infrared Optics, which is the Company’s VLOC subsidiary, and the China and Vietnam near-infrared operations; Military Infrared Optics, which is the Company’s Exotic Electro-Optics subsidiary; and the Compound Semiconductor Group, which is the aggregation of the Company’s Marlow subsidiary, the eV PRODUCTS division, the Wide Bandgap Materials (“WBG”) group and the Advanced Material Development Center (“AMDC”) group, (which is responsible for the corporate research and development activities).
The Infrared Optics segment is divided into the geographic locations in the United States, Singapore, China, Germany, Switzerland, Japan, Belgium and the United Kingdom. An Executive Vice-President of the Company directs the segment, while each geographic location is directed by a general manager, and is further divided into production and administrative units that are directed by managers. The Infrared Optics segment designs, manufactures and markets optical and electro-optical components and materials sold under the II-VI brand name and used primarily in high-power CO2 lasers.
The Near-Infrared Optics segment is located in the United States, China, Vietnam, Germany, Japan and the U.K. The Near-Infrared Optics segment is directed by a general manager. The Near-Infrared Optics segment is further divided into production and administrative units that are directed by managers. The Near-Infrared Optics segment designs, manufactures and markets near-infrared and visible-light products for industrial, scientific, military and medical instruments and laser gain material and products for solid-state YAG, YLF lasers and UV filter components.
The Military Infrared Optics segment is located in the United States. The Military Infrared Optics segment is directed by a general manager with oversight by a Corporate Vice-President. The Military Infrared Optics segment is further divided into production and administrative units that are directed by managers. The Military Infrared Optics segment designs, manufactures and markets infrared products for military applications under the Exotic Electro-Optics brand name.
The Compound Semiconductor Group is located in the United States, the United Kingdom, Japan, China and Vietnam. The Compound Semiconductor Group segment is directed by a Corporate Vice-President. Marlow designs and manufacturers thermoelectric cooling and power generation solutions for use in defense and space, telecommunications, medical, consumer and industrial markets. eV PRODUCTS division manufactures and markets solid-state x-ray and gamma-ray sensor materials and products for use in medical, security monitoring, industrial, environmental and scientific applications. WBG group manufactures and markets single crystal silicon carbide substrates for use in solid-state lighting, wireless infrastructure, radio frequency (“RF”) electronics and power switching industries. AMDC group directs the corporate research and development initiatives.
The accounting policies of the segments are the same as those of the Company. Substantially all of the Company’s corporate expenses are allocated to the segments. The Company evaluates segment performance based upon reported segment earnings or loss, which is defined as earnings before income taxes, interest and other income or expense. Inter-segment sales and transfers have been eliminated.
The following table summarizes selected financial information of the Company’s operations by segment:
Geographic information for revenues, based on country of origin, and long-lived assets which include property, plant and equipment, goodwill and other intangibles, net of related depreciation and amortization, follows:
Note N EMPLOYEE BENEFIT PLANS
Eligible employees of the Company participate in a profit sharing retirement plan. Contributions to the plan are made at the discretion of the Company’s board of directors and were $2.6 million, $2.1 million and $2.1 million for the years ended June 30, 2006, 2005 and 2004, respectively.
The Company has an employee stock purchase plan available for employees who have completed six months of continuous employment with the Company. The employee may purchase the common stock at 5% below the prevailing market price. The amount of shares which may be bought by an employee during each fiscal year is limited to 10% of the employee’s base pay. This plan, as amended, limits the number of shares of common stock available for purchase to 800,000 shares. There were 355,897 and 370,896 shares of common stock available for purchase under the plan at June 30, 2006 and 2005, respectively.
The Company has no program for post-retirement health and welfare or post employment benefits.
The II-VI Incorporated Deferred Compensation Plan (the “Compensation Plan”) is designed to allow officers and key employees of the Company to defer receipt of compensation into a trust fund for retirement purposes. The Compensation Plan is a nonqualified, defined contribution employees’ retirement plan. At the Company’s discretion, the Compensation Plan may be funded by the Company making contributions based on compensation deferrals, matching contributions and discretionary contributions. Compensation deferrals will be based on an election by the participant to defer a percentage of compensation under the Compensation Plan. All assets in the Compensation Plan
are subject to claims of the Company’s creditors until such amounts are paid to the Compensation Plan participants. Employees of the Company made contributions to the Compensation Plan in the amount of approximately $0.3 million, $0.4 million and $0.5 million for the years ended June 30, 2006, 2005, and 2004, respectively.
Note O COMMITMENTS AND CONTINGENCIES
The Company has purchase commitments for materials and supplies as part of the ordinary conduct of business. A few of the commitments are long-term and are based on minimum purchase requirements. Due to the proprietary nature of some of the Company’s materials and processes, certain contracts may contain penalty provisions for early termination. The Company does not believe that a material amount of penalties is reasonably likely to be incurred under these commitments based upon historical experience and current expectation. Future purchases under these commitments are as follows:
Note P STOCK REPURCHASE PROGRAM
On May 18, 2005, the Board of Directors authorized the Company to purchase up to 500,000 shares of its common stock. The repurchase program calls for shares to be purchased in the open market or in private transactions from time to time. The Company may suspend or discontinue this purchase program at any time. Shares purchased by the Company will be retained as treasury stock and will be available for general corporate purposes. The Company expects the repurchase of shares to at least partially offset the dilutive effect of the issuance of shares from the Company’s stock option plan. The following are share repurchases under the Stock Repurchase Program ($000 except share data).
SCHEDULE II
II-VI INCORPORATED AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED JUNE 30, 2004, 2005, AND 2006
(IN THOUSANDS OF DOLLARS)
Uncollectible accounts written off, net of recovery
Primarily relates to the closing of manufacturing operations in Mexico and the costs related to consolidating several of the Company’s European distribution arrangements.
Primarily relates to the allowance for doubtful accounts and warranty return reserves from the acquisition of Marlow Industries, Inc. and foreign currency translations from the Company’s foreign subsidiaries.
QUARTERLY FINANCIAL DATA (unaudited)
FISCAL 2006
FISCAL 2005
(1) As restated to reflect the modified retrospective application of the fair value recognition provisions of SFAS 123(R) “Share-Based Payment.”
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
The Company’s management evaluated, with the participation of Carl J. Johnson, the Company’s Chairman and Chief Executive Officer, and Craig A. Creaturo, the Company’s Chief Financial Officer and Treasurer the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this annual report on Form 10-K. The Company’s disclosure controls were designed to provide reasonable assurance that information required to be disclosed in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the Securities and Exchange Commission. It should be noted that the design of any system of controls is based in part upon 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, regardless of how remote. However, the controls have been designed to provide reasonable assurance of achieving the controls’ stated goals. Based on that evaluation, Messrs. Johnson and Creaturo concluded that the Company’s disclosure controls and procedures were not effective for the reasons discussed below and in the Report of Management set forth under Item 8 above.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. See the “Report of Management” which is set forth under Item 8 above and is incorporated herein by reference.
Attestation Report of the Registered Public Accounting Firm
Our management’s assessment of the effectiveness of our internal control over financial reporting as of June 30, 2006 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included in Item 8.
Changes in Internal Control over Financial Reporting
There have been no changes in the Company’s internal controls over financial reporting that occurred during our most recent quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting other than the material weakness noted in the “Report of Management” which is included under Item 8.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth above in Part I under the caption “Executive Officers of the Registrant” is incorporated herein by reference. The other information required by this item is incorporated herein by reference to the information set forth under the captions “Election of Directors,” “Corporate Governance Matters-Code of Business Conduct and Ethics,” “Meetings and Committees of the Board of Directors” and “Other Matters - Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive proxy statement for the 2006 Annual Meeting of Shareholders filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated herein by reference to the information set forth in the second paragraph under the caption “Meetings and Committees of the Board of Directors” and the information set forth under the caption “Executive Compensation and Other Information” in the Company’s definitive proxy statement for the 2006 Annual Meeting of Shareholders filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Equity Compensation Plan Information
The other information required by this item is incorporated herein by reference to the information set forth under the caption “Principal Shareholders” in the Company’s definitive proxy statement for the 2006 Annual Meeting of Shareholders filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by reference to the information set forth under the caption “Meetings and Committees of the Board of Directors” in the Company’s definitive proxy statement for the 2006 Annual Meeting of Shareholders filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated herein by reference to the information set forth under the caption “Ratification of Independent Registered Public Accounting Firm” in the Company’s definitive proxy statement for the 2006 Annual Meeting of Shareholders filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Financial statements, financial statement schedules and exhibits not listed have been omitted where the required information is included in the consolidated financial statements or notes thereto, or is not applicable or required.
(3) Exhibits.
* Denotes management contract or compensatory plan, contract or arrangement.
The Registrant will furnish to the Commission upon request copies of any instruments not filed herewith which authorize the issuance of long-term obligations of the Registrant not in excess of 10% of the Registrant’s total assets on a consolidated basis.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
* Denotes management contract or compensatory plan, contract or arrangement.
The Registrant will furnish to the Commission upon request copies of any instruments not filed herewith which authorize the issuance of long-term obligations of the Registrant not in excess of 10% of the Registrant’s total assets on a consolidated basis.