Item 1. BUSINESS
Axsys Technologies, Inc. (together with our subsidiaries, unless the context suggests otherwise, “Axsys”, “Company”, “we”, “us” or “our”) was originally incorporated in the State of New York in 1959 and reincorporated in the State of Delaware in 1968. We are a leading designer and manufacturer of precision optical solutions for defense, aerospace, homeland security and high-performance commercial applications. These sophisticated solutions are typically found in applications that demand the finest optical surfaces, highest accuracy and tightest motion control tolerances. Application examples include weapon systems, long-range surveillance cameras and highly precise medical imagers. We are also a technology leader in the supply of infrared surveillance solutions to homeland security market customers such as the U.S. Border Patrol, Army, Navy, Air Force, Coast Guard and various port authorities.
Our solutions are often embedded in larger systems that depend on precise optical control for accurate operation of critical functions. We are involved in many large-scale programs including the,, Apache, Stryker, M1A2 Abrams and Bradley Fighting Vehicle. Many of the applications with which we are involved include the continuing development of next-generation targeting, navigation and imaging systems for fighter aircraft, helicopters, aircraft carriers and armored vehicles. We also supply critical guidance and seeker components for platforms such as the Minuteman intercontinental ballistic missile and the AIM-9X Sidewinder missile. Our products are included on many platforms within the U.S. National Missile Defense program, or NMD. Our defense products are often used in sophisticated stabilized optical platforms, or SOPs, which are highly accurate optical positioning mechanisms. The SOPs are essential in applications such as military targeting and imaging systems.
In addition to optical solutions, we distribute precision ball bearings used in a variety of industrial and commercial applications. We sell our components, sub-systems and bearings to a variety of original equipment manufacturers, or OEMs.
We are organized into two businesses: the Optical Systems Group and the Distributed Products Group. Financial information by business segment can be found in Note 15 to the consolidated financial statements included elsewhere in this annual report.
Optical Systems Group
The Optical Systems Group designs, manufactures and sells highly precise systems, sub-systems and components that are typically used in surveillance, long-range observation, tracking and targeting and high-performance imaging applications.
Our products can be grouped into four primary areas: reflective optical products, infrared products, motion control products and precision optical and mechanical structures. However, customer requirements sometimes demand an optical solution that combines products from several of these areas. Our defense products are often designed to be integrated into stabilized optical platforms, which are highly accurate optical positioning mechanisms. Stabilized optical platforms are essential in applications such as military targeting and imaging systems.
The focus markets for our Optical Systems Group are aerospace, defense and homeland security. Our products are typically sold to OEMs, which in turn supply a variety of government and commercial end-customers. Our thermal camera systems are typically used for border surveillance, perimeter security and public safety, while sub-systems and components are usually designed for integration into our customers’ high-performance optical systems.
The core technologies and manufacturing techniques that we use to supply the aerospace and defense industry are transferable to commercial markets. The commercial markets that we serve include the
semiconductor, high-performance graphic arts and medical imaging industries. In all of these markets, highly precise optical and motion control systems are required.
The Optical Systems Group has design and manufacturing facilities in San Diego, California, Cullman, Alabama, Rochester Hills, Michigan and Nashua, New Hampshire.
For the fiscal year ended December 31, 2006, the Optical Systems Group generated $129.9 million, or approximately 83.1%, of our total revenues.
Distributed Products Group
The Distributed Products Group distributes precision ball bearings, spherical plain bearings and bushings, which are acquired from various domestic and international sources, to OEMs and maintenance, repair and overhaul companies, or MROs. The bearings and bushings are used in a variety of industrial automation and commercial markets. Additionally, the Distributed Products Group designs, manufactures and sells mechanical bearing subassemblies for a variety of customers. The Distributed Products Group is comprised of the AST Bearings Division located in Montville, New Jersey, with a satellite distribution center in Irvine, California. For the fiscal year ended December 31, 2006, the Distributed Products Group generated $26.4 million, or approximately 16.9%, of our total revenues.
Market Overview
Our products are sold mainly to OEMs in a variety of markets that demand the precision and performance that our products and capabilities provide.
Optical Systems Group
Military Surveillance and Targeting. Surveillance and Targeting represents one of the largest growth sectors in the U.S. Department of Defense budget. This sector includes optical sensors and thermal imaging equipment. We have a substantial heritage in this market and continue to focus on protecting and building upon this position. We are involved in many large-scale programs including the,, Apache, Stryker MIA2 Abrams and Bradley Fighter Vehicle. Many of the applications with which we are involved include the continuing development of the next-generation targeting, night vision, navigation and imaging systems for military applications. We are a major supplier of optical systems for night-vision optical systems, which are an important component of the U.S. Army’s strategy to “Own the night”.
Optical sensors and thermal imaging equipment are vitally necessary for the U.S. military to maintain its battlefield superiority. Planned upgrade and improvement of such optical and thermal imaging equipment is not dependent upon spending on new platforms. Even as new platform spending is projected to be challenging over the next few years, we expect that spending to upgrade the sensors on existing platforms will continue to thrive.
We have the opportunity to provide value-added solutions by integrating our technologies into sophisticated optical systems. We have recently developed motorized pan and tilt gimbal systems, which are often used to support and position thermal cameras and other sensors.
Homeland Security. Since September 11, 2001, government officials have increased their focus on designing plans to reduce the risk of terrorist attacks and prepare for the consequences of terrorist attacks. Many of the preventative efforts of these initiatives involve surveillance and imaging of people, baggage, cargo and vehicles. We are well positioned to participate in this emerging market with our imaging and infrared solutions, including the expected increase in spending on border security, as the U.S. Border Patrol upgrades and supplements existing systems on the nation’s borders to bolster homeland security efforts.
National Missile Defense. Restructuring the country’s defense and deterrence capabilities to correspond to emerging threats remains a high priority for the United States. The deployment of missile defenses is an essential component of this effort. We are an integral member of the contractor teams involved in the rollout of key NMD programs from development to production, including EKV, THAAD, PAC-3, SBIRS-High and Airborne Laser.
Other Aerospace and Defense Opportunities. In connection with the U.S. government’s efforts to continually enhance aging weaponry, we have the opportunity to be involved in retrofitting the nuclear missile arsenal with advanced gas bearings. We were chosen as the U.S. Air Force’s Center of Excellence for gas bearing production. We also have a long history of involvement with space-based telescopes for use in U.S.-based surveillance applications, as well as weather and astronomical research. We expect to benefit from the future growth in satellite programs.
Semiconductor Capital Equipment. Our products are used in the precise inspection of semiconductor wafers. These products include complete auto-focus assemblies, motion control stages and precise distance measuring devices. We have the opportunity to expand our position in this industry by introducing new products and marketing to new customers.
Graphic Arts. We were a pioneer in the development of airbearing laser scanners used for digital imaging of film within the graphic arts market in the early 1990’s. While declining advertising revenues have negatively impacted the graphic arts market, we have expanded our product offering to include marker engines, which can increase our average selling price to a customer over six-fold. Although we anticipate a moderate decline in the overall graphic arts market, we expect to mitigate some of this decline with the introduction of marker engines to our customer base.
Thermal Imaging. Advancements in cooled and uncooled focal plane array technology have improved the quality of infrared images and drastically reduced the costs of producing thermal imaging camera systems. The development of uncooled focal plane array technology during the mid-1990s has resulted in a pronounced reduction in the cost of infrared cameras. The market has responded with a number of infrared related products designed for a variety of applications, including firefighting, surveillance, preventive maintenance and other commercial night vision needs. Furthermore, the availability of more moderately priced alternatives enables manufacturers to employ the same infrared systems or components for both commercial and military applications. The enhanced total market size accumulated thereby is sufficient to create the economies of scale that permit broad deployment. We have been at the forefront of developing both cooled and uncooled camera product offerings and, like much of the rest of the infrared market, we have experienced a broad increase in thermal imaging demand as the cost effectiveness of employing infrared capabilities has escalated.
Distributed Products Group
Ball Bearings. The markets we serve include industrial automation, semi-conductor capital equipment, aerospace and defense and consumer products. The market for the distribution of ball bearings and related products generally follows worldwide economic trends. In order to position us for growth, we are introducing new products, lower cost products and value-added services.
Technologies, Products and Capabilities
We utilize several key manufacturing technologies and have developed software and systems integration capabilities that enable us to design, manufacture and assemble a wide variety of high-performance precision optical and motion control solutions. Our core competencies include:
Thermal Imaging Cameras. We have leveraged our turnkey optical design, manufacturing and integration capabilities into an extensive and growing line of world-class thermal imaging cameras. We
currently have a product line of seven integrated thermal imaging systems, approximately 20 cooled and uncooled cameras and five clip-on weapon night sights. Our success in thermal cameras is integrally tied to our coating processes and ability to produce industry-leading optical lens assemblies. Our cameras, including surveillance systems, clip-on weapon night sights and handheld imagers, fill a variety of requirements of the federal and military customers, municipal first responders, firefighters and commercial entities. We have expanded into the design and manufacture of thermal cameras and systems intended for a wide range of surveillance requirements in the military, homeland security and commercial sectors. We sell weapons sights, both image intensified and uncooled thermal imagers, that are designed to clip onto a soldier’s existing day sight, eliminating the need to change over from a day scope to a dedicated night sight while allowing the weapon to retain its boresight after repeated use. We also manufacture a line of handheld thermal cameras that we market and sell to first responders in municipal fire, law enforcement and security departments, as well as to the U.S. Border Patrol and the U.S. military. We also manufacture and sell a line of complementary products, which are thermal imaging cameras designed specifically for firefighting.
We have designed our entire line of thermal cameras using a consistent architecture and are therefore able to easily construct exactly the combination of product features that best meet a customer’s needs. For example, we essentially use the same electronics processing architecture and optics across our suite of different cameras. The common design elements of our thermal imagers permit us to offer a wide variety of thermal cameras to satisfy specific customer demand. This approach has allowed us to adapt cutting edge focal plane array technologies for both high-end and low-end market opportunities. Additionally, our software engineering team has made significant strides in proprietary designs that drive our complex thermal camera integration and allow us to respond to a variety of customer requirements.
Precision Optics. We believe we are a leading designer and manufacturer of custom precision reflective and transmissive optical solutions and components. We provide complete design, fabrication and testing of glass and metal optics ranging from single and multi-faceted scan mirrors, plano and aspheric mirrors to complex telescope assemblies and thermal camera lenses. We have designed and/or manufactured numerous optical products for a variety of military and astronomical applications over the past 40 years.
We specialize in the manufacture of diamond-machined aspheric metal optics that are significantly enhanced for optical figure and optical finish by post polishing, typically while using custom engineered interferometric null tests. “Bolt together” assemblies with post polished metal aspheres are routine. We produce a variety of aspheric surfaces including conic aspheres, general case aspheres, cylindrical aspheres and toric aspheres with up to 0.80-meter aperture. Our precision metal optic products are used in applications where performance requirements cannot be met with glass optics. The advantages of our optics include lighter weight, thermal stability and ease of mechanical interface with housing and actuation devices. We sell our precision metal optical components for use in high speed electro-mechanical scanners, weapon fire control systems, forward-looking infrared, or FLIR, night vision weapon systems and high-performance space-borne instruments used on weather, mapping and scientific satellites.
We also specialize in the production of precision glass lenses using infrared materials through the use of conventional grinding and polishing techniques. We produce aspheric lenses in glass by hand polishing and produce aspheric and diffractive lenses in infrared materials by diamond turning. Surfaces are tested using null test and profilometry. These glass lenses are integrated into sophisticated lens assemblies for use with thermal cameras or imaging systems, or sold as components for use by OEM suppliers in various infrared applications. Our infrared lens assemblies are tested using infrared interferometry.
Precision Motion Control. We design a complete line of brushless and brush type torque motors and servomotors that can be customized to meet customers’ unique specifications. The direct drive motor replaces conventional servomotor-gearhead configurations improving the response characteristics of the
unit. Motors incorporate rare earth magnets with outer diameters ranging from 0.5” to 48” and provide peak torques up to 1,650 ft-lbs.
The gearless DC motor drive is ideally suited for high acceleration applications requiring improved response for rapid start/stop actions such as missile seekers, optical stabilization and turret control. The absence of gearing also eliminates errors caused by friction and backlash creating high threshold sensitivity. These motors achieve accuracies of one arc-second in a high performance positioning system. Our DC torque motors are designed using premium materials that offer unique space and weight saving properties while generating maximum power output. Limited angle torque motors do not require commutation electronics and have near zero cogging.
We also manufacture highly reliable multi-speed and segmented positioning sensors, such as resolvers and induction potentiometers, which provide a high degree of angular accuracy and resolution. These devices typically accompany our motors to provide position feedback within a high performance system.
Resolvers are available with transmitter, differential or receiver functions. These resolvers are specifically designed to withstand high-impact shock and environments containing dirt, grease, oil or other contaminants, and are available housed or un-housed in a variety of configurations. Resolvers are either single or multi-speed (up to 64-speed), with outer diameters ranging from 0.7” to 15”, and provide accuracies to 5 arc seconds.
Induction potentiometers, also defined as linear transmitters, provide high linearity output over a wide angular range. Induction potentiometers are available in frameless and housed configurations and brush and brushless designs.
Electronics. We design and manufacture several key electronic components for the semiconductor capital equipment and high-end digital imaging markets, including laser interferometers and electronic controllers and drives. Our electronics components control the speed and position of electro-mechanical systems, such as precision motors, actuators, X-Y positioning stages and laser scanners. Laser interferometers, which are designed to permit precise linear position sensing, are sold to customers principally in the semiconductor capital equipment market. Electronic controllers coordinate the positioning and speed of electro-mechanical systems by interfacing with other motion control components. Drives provide power to a motor based on input from the controller in order to achieve a designated position or to achieve a specific speed.
Precision Machining. We are a leading fabricator of precision machined and processed exotic materials. These include beryllium, AlBeMet, titanium, halfnium, quartz and glass used in the defense, space and high-performance commercial markets. Operating within a 120,000 square foot environmentally-controlled manufacturing facility, we provide complete fabrication services including manual and CNC milling, turning, EDM, lapping and grinding, chemical and special processing and mechanical assembly. Using these technologies, we are able to meet our customers’ extremely high tolerance requirements. Applications include precision optics, airbearings, heat sinks, structural housings and gimbals. Our airbearings provide high-speed precision positioning and are used in high-speed scanners for digital imaging and weapon guidance systems. Our heat sinks are used to dissipate heat in high-performance avionics and satellite electronics, and our gimbals are used in various applications, including positioning optical sensors in FLIR night vision systems. We also manufacture optical substrates used internally and by our customers in a variety of precision metal optical applications such as weapon fire control systems and space-borne instruments.
Utilizing these core technologies, we have developed an array of solutions to create value-added, vertically integrated solutions for the aerospace, defense and high-performance commercial equipment industries. Examples of these solutions include:
Infrared Zoom Lenses: We design and manufacture sophisticated zoom and multi-field-of-view thermal lenses for use in a variety of military applications. These lenses are sold to OEMs who subsequently integrate them with infrared cameras and imagers for military and intelligence purposes.
Infrared Cameras and Systems. We have developed a broad range of cooled and uncooled camera systems, culminating in the recently released Electro Optical Sensor Suite, a state-of-the-art integrated system comprised of a cooled or uncooled thermal imager, pan/tilt mounting, joystick controller, optional visible camera and numerous other features.
Motion-Control Solutions. We provide precision micro-positioning systems. These high-performance systems are used in a diverse array of high-end commercial applications such as stabilized optical platforms, semiconductor and flat panel process and inspections systems, as well as laser imaging systems.
Fast Steering Mirrors. We have applied extensive experience designing and building opto-mechanical systems to develop fast steering mirror, or FSM, technology. The single-axis and two-axis, flexure mounted FSM represents a compact, low cost, high-performance design solution for a variety of emerging optical scanning and beam stabilization applications. Such devices may be used to correct for polygon cross scan errors, acquire and lock beams within free space laser systems, modulate tilt and cavity control in interferometers, maintain beam stabilization in the presence of thermal drift and vibration, and provide general two-axis beam scanning.
Marker Engines. We have leveraged our experience providing high-speed airbearing scanners with our precision optics and electronics capabilities to produce ultra-high performance flat bed marker engines. Each engine is self-contained, pre-aligned and ready to integrate into a customer’s system.
Rotary Airbearing Scanners. We design and manufacture rotary airbearing scanners for use in high precision graphic arts and medical imaging applications, semiconductor mask production and inspection applications, as well as defense applications. Airbearing scanners provide numerous advantages over mechanical bearings due to their low noise characteristics, repeatability and ability to rotate at high speeds (up to 100,000 RPMs). When combined with our electronic controllers, our airbearing scanners provide extremely high cross-scan accuracy and extremely low jitter.
Integrated Systems. Part of our product strategy is to develop systems that incorporate multiple products. Our integration capabilities create value for the prime contractors by reducing the number of suppliers and collapsing the supply chain. One notable example of this strategy is our recent introduction of pan and tilt positioners that are compatible with our infrared cameras as well as other payloads.
The following table summarizes our core engineering and manufacturing capabilities:
Backlog and Orders
Axsys recognized, in 2006, bookings of $174.1 million, ending the year with record backlog of $130.4 million, of which 14.8% will be shipped beyond 12 months. Our backlog increased by $17.7 million, or 15.7%, compared to our ending backlog of $112.7 million as of December 31, 2005.
Competition
The markets for our products are competitive. We compete primarily on the basis of our ability to design and engineer products to meet performance specifications set by our customers. Most of our customers are OEMs that purchase component parts or subassemblies, which they incorporate into their end products. Although most of our customers are OEMs, our thermal imaging cameras and clip-on night sights are typically sold directly to equipment integrators, as well as government, military and commercial end users. Product pricing, quality, customer support, experience, reputation and financial stability are also important competitive factors.
There are a limited number of competitors in each of the markets for the various types of precision optical, infrared and motion control systems and components that we design, manufacture and sell. Our competitors are often well entrenched, particularly in the aerospace and defense markets. Some of these competitors have substantially greater resources than we do. We believe that the breadth of our technologies and product offerings provides us with a competitive advantage over certain manufacturers that supply only discrete components or who are not vertically integrated with enabling technologies.
There are numerous competitors in markets to which we distribute our precision ball bearings. These competitors vary in size and include bearing manufacturers and other distributors. We believe that our product breadth and availability, combined with the value-added services we supply, provide competitive advantages.
We expect our competitors to continue to improve the design and performance of their products. We cannot assure you that our competitors will not develop enhancements to, or future generations of, competitive products that will offer superior price or performance features, or that new technology or processes will not emerge that render our products less competitive or obsolete. Increased competitive pressure could lead to lower prices for our products, thereby adversely affecting our business, financial condition and results of operations. We cannot assure you that we will be able to compete successfully in the future.
Customers
Our customers include OEMs, equipment integrators and end-users that design or utilize high-precision, performance and throughput equipment. We sell our products primarily to OEM customers in the aerospace and defense, homeland security, high-end graphic art, medical imaging, semiconductor capital equipment and industrial automation markets.
BAE Systems, an aerospace and defense systems supplier, represented 12.1% of our total sales during 2006. Raytheon Company, an aerospace and defense systems supplier, represented 12.3% and 18.9% of our total sales during 2005 and 2004, respectively. Our accounts receivable from BAE Systems was $2.4 million as of December 31, 2006, and our accounts receivable from Raytheon was $1.0 million at December 31, 2005 and $4.5 million at December 31, 2004. We participate with BAE Systems on multiple programs, with the majority of our sales to BAE Systems relating to an armored vehicle program and a thermal weapons sight program. Both programs are ultimately dependent on U.S. Department of Defense spending and could be canceled. However, night vision systems are a high priority for the U.S. military and, therefore, we do not foresee any weakening of demand for these products in the short term.
We had aggregate sales, both military and non-military, directly to the U.S. government, including its agencies and departments, of approximately $4.8 million in 2006, $4.6 million in 2005, and $2.4 million in 2004. These sales accounted for approximately 3.0% of total sales in 2006, 3.4% in 2005 and 2.3% in 2004. Approximately 57.3% of total sales in 2006, 56.3% in 2005 and 46.0% in 2004 were derived from subcontracts with U.S. government contractors. The majority of these contracts are subject to termination at the convenience of the U.S. government, and certain contracts are also subject to renegotiation. Currently, we are not aware of any proposed termination or renegotiation of such contracts that would have a material adverse effect on our business.
Because a substantial part of our business is derived directly from contracts with the U.S. government, U.S. government agencies or departments, or indirectly through subcontracts with U.S. government contractors, our operational results could be materially affected by changes in U.S. government expenditures for projects or programs using our products. However, we believe that the broad number and diversity of the programs with which we are involved and the breadth of our product applications may lessen our exposure to such risk.
Sales, Marketing and Customer Support
As of December 31, 2006, we employed 67 sales, marketing and customer support personnel throughout our organization, compared to 69 employees in similar functions at the end of 2005. We utilize two OEM sales organizations, one focused on aerospace and defense customers and the other focused on high-performance commercial customers. We have a separate distributed products sales force that is focused on selling ball bearings, bushings and assemblies, principally to commercial and industrial oriented OEMs as well as MRO distributors.
Our sales organization included 25 direct sales field personnel, most of whom have engineering backgrounds, with the remainder involved in inside sales, customer service, program management, contract administration and applications engineering. We believe that our sales effort is enhanced by having engineering-trained sales personnel available to meet with our customers’ engineering personnel. Our application and design engineers are also involved in the sales process.
We also sell our products through a significant number of manufacturers’ sales representatives and agents. Although we believe that we have satisfactory relationships with these sales representatives and agents, we cannot assure you that these relationships will continue to be satisfactory or will continue at all.
Domestic and Foreign Sales
The table below presents sales from continuing operations to specific geographic regions. Substantially all of our assets are located within the United States.
Research, Development and Engineering
We seek to develop new products and improve existing products in order to keep pace with the increasing performance requirements of our customers. We devote significant resources, a portion of which is reimbursed by customers, to development programs directed at creating new products and product enhancements, as well as developing new applications for existing products. Because we believe
that our ability to compete effectively depends in part on maintaining and enhancing our expertise in applying new technologies and developing new products, we dedicate substantial resources to engineering, research and development. As of December 31, 2006, we employed 95 individuals in engineering, research and development functions. We cannot assure you that our product development efforts will be successful in producing products that respond to technological changes or new products introduced by others.
Our costs associated with research, development and engineering expenses were $4.5 million in 2006, $3.8 million in 2005 and $2.7 million in 2004. We intend to direct our research and development activities toward integrating our various technologies and continuing to develop sub-systems.
Raw Materials Suppliers
The raw materials and components that we purchase are generally available from multiple suppliers. However, Brush Wellman, Inc. is the only U.S. source for beryllium, which is a material used extensively by our Company. Historically, we have had an excellent relationship with Brush Wellman and have not encountered problems in obtaining our supply requirements. While there is an alternative source in Kazakhstan, most of our military contracts preclude the use of non-US material. We believe that a partial or complete loss of Brush Wellman as a supplier of beryllium, or production shortfalls or interruptions that otherwise impair the supply of beryllium, would have a material adverse effect on our business, financial condition and results of operations.
In addition, we purchase a substantial amount of ball bearings that we distribute from two foreign suppliers. While we believe that we could obtain alternate sources of supply, any interruption in the flow of products from these suppliers, or significant increases in the cost of these products, could have an adverse effect on our business, financial condition and results of operations.
Patents and Trademarks
We are not dependent upon any single patent or trademark. We have a combination of patents, trademarks and trade secrets, non-disclosure agreements and other forms of intellectual property protection covering our proprietary technology. Although we believe that our patents and trademarks may have value, we believe that our future success will depend primarily on the innovation, technical expertise, manufacturing and marketing abilities of our personnel. We cannot assure you as to the degree of protection offered by our patents. We cannot assure you that we will be able to maintain the confidentiality of our trade secrets or that our non-disclosure agreements will provide meaningful protection of our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or other disclosure.
Competitors in the United States and foreign countries, many of which have substantially greater resources, may have applied for or obtained, or may in the future apply for and obtain, patents that will prevent, limit or interfere with our ability to make and sell some of our products. Although we believe that our products do not infringe on the patents or other proprietary rights of third parties, we cannot assure you that third parties will not assert infringement claims against us or that such claims will not be successful.
Environmental Regulation
We believe that we are currently in compliance, in all material respects, with federal, state and local laws and regulations governing the use and discharge of hazardous substances and other pollutants into the environment or otherwise relating to the protection of the environment and that any non-compliance with such laws will not have a material adverse effect upon our business, financial condition, results of operations, capital expenditures, earnings or competitive position. We cannot assure you, however, (1) that changes in federal, state or local laws, regulations or regulatory policy or the discovery of unknown problems or conditions will not in the future require substantial expenditures or (2) as to the extent of our liabilities, if any, for past failures, if any, to comply with applicable environmental laws, regulations and permits, any of which also could have a materially adverse effect on our business, financial condition or results of operations.
We have incurred, and may in the future incur, costs and liabilities under the Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, or similar state laws for the investigation and cleanup of hazardous waste or contamination at third party waste disposal sites or at current or former facilities, related in part to historical practices or waste disposed of prior to the purchase of facilities by us. We are in the process of remediating two formerly owned sites in Bedford, Ohio and St. Petersburg, Florida and we are participating as a potentially responsible party, or PRP, at a third-party waste disposal site in Norwalk, Connecticut. Although liability under CERCLA is joint and several, meaning that liability can exceed a PRP’s pro rata share of cleanup costs, we believe, based on currently available information, that costs associated with these sites will not have a material adverse effect on our business and financial condition. It is possible, however, that our results of operations for a particular fiscal period could be materially affected.
As of December 31, 2006, we have an accrual of $666 thousand for future costs related to the Ohio and Florida sites. These estimates have been developed in consultation with outside environmental and legal consultants handling these matters and are based upon an analysis of the anticipated remediation plans. We do not anticipate these matters will have a material adverse effect on our consolidated financial position. It is possible, however, that future results of operations could be materially affected by changes in our assumptions.
In addition, in 2001, we were notified by the United States Environmental Protection Agency, or the EPA, that it considers us a PRP for the US Cap and Jacket site in Prospect, Connecticut. Our former subsidiary, which was merged into us in 1979, operated a screw machine shop at this location from 1961 to 1978. The EPA demanded reimbursement for its costs incurred in connection with a time-critical removal action at the site in 2001. In April 2004, the EPA notified us that the total amount of these costs was approximately $650 thousand, including indirect costs and interest accrued through that date. We advised the EPA of our position that the contamination must have occurred after our ownership of the site and that, accordingly, we are not responsible for the EPA’s costs or the remediation of the site. The EPA continued its investigation of the site, including serving us with a formal request for information under Section 104(e) of CERCLA in July 2004 (to which we responded). The EPA designated no other PRPs. The EPA informed us that it was prepared to commence a CERCLA cost-recovery action against us if we were unable to amicably resolve the matter. On July 18, 2005, we signed a settlement agreement with the EPA, settling this matter for $175 thousand, plus accrued interest from this date through the date of payment. We have no further responsibility to the EPA as it relates to the EPA’s 2001 removal action at this site. During 2005, we recognized an after tax charge of $150 thousand in discontinued operations for the settlement costs and legal expenses associated with the settlement of this matter.
We use or generate certain hazardous substances in our manufacturing and engineering facilities. We believe that our handling of these substances is in compliance with, and exceeds what is required by, applicable local, state and federal environmental, safety and health regulations at each operating location. We invest in protective equipment, process controls and specialized training to minimize risks to
employees, surrounding communities and the environment due to the presence and handling of these hazardous substances. We regularly conduct employee physical examinations and workplace air monitoring related to these substances. When potential or actual exposure problems have been indicated, we implement corrective actions. In general, re-occurrence has been minimal or non-existent. We do not carry environmental impairment insurance. Accordingly, any failure by us to properly manage exposure to hazardous substances could have a materially adverse effect on our business, financial condition and our operations.
Employees
As of December 31, 2006, we employed 765 persons, including 536 in manufacturing, 67 in sales, 95 in engineering and 67 in administration. Currently, none of our employees are represented by unions and we consider our relationship with our employees to be satisfactory. There has been no significant interruption of operations due to labor disputes.
Available Information
Our Internet website is http://www.axsys.com. We make available free of charge on our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file or furnish such materials to the Securities and Exchange Commission. In addition, we have posted the charters for our Audit Committee, Compensation Committee, and Nominating and Governance Committee on our website under the heading “Investors.” These charters are not incorporated herein by reference. We will also provide a copy of these documents to shareholders upon request.
Item 1A.
Item 1A. RISK FACTORS
You should carefully consider each of the risks and uncertainties we describe below and all of the other information in this annual report. The risk and uncertainties we describe below are not the only ones we face. Additional risks and uncertainties of which we are currently unaware or that we currently believe to be immaterial may also adversely affect our business.
We depend on contracts with the U.S. federal government for a significant portion of our sales. Most of these contracts are subject to termination and renegotiation by the U.S. federal government at any time.
The aerospace and defense industry, which represents the majority of our sales, is largely dependent upon government contracts. A significant portion of our business and business development efforts is concentrated in the aerospace and defense industry. Our business depends, in significant part, upon the U.S. government’s continued demand in the area of defense for high-end, high-performance products of the type that we manufacture. Approximately 60% of our sales in 2006 and 2005 and 48% in 2004 were derived directly from contracts with the U.S. government, or its agencies or departments, or indirectly from subcontracts with U.S. government contractors.
The majority of these government contracts are subject to termination and renegotiation. Generally, government contracts and subcontracts are subject to oversight audits by government representatives and contain provisions permitting termination, in whole or in part, without prior notice at the government’s convenience upon the payment of compensation only for work done and commitments made at the time of termination. We can give no assurance that one or more of our government contracts or subcontracts will not be terminated under these circumstances. Also, we can give no assurance that we would be able to procure new government contracts or subcontracts to offset the revenues lost as a result of any termination of our contracts. Because our revenues are dependent on our procurement, performance and payment under our contracts, the loss of one or more critical contracts could have a materially adverse effect on our business, financial condition and results of operations.
The loss of BAE Systems as a customer or a significant reduction in sales to BAE Systems could have a materially adverse effect on our business, financial condition and results of operations.
We rely on key customers. We currently have one customer that represents a significant portion of our sales. During 2006, approximately 12.1% of our sales were to BAE Systems. The loss of BAE Systems as a customer or a significant reduction in sales to BAE Systems could have a materially adverse effect on our business, financial condition and results of operations.
If BAE Systems or any of our other key customers becomes insolvent or files for bankruptcy, our ability to recover accounts receivable from that customer would be adversely affected and any payments we received in the preference period prior to a bankruptcy filing may be potentially recoverable, which could have a materially adverse effect on our business, financial condition and results of operations.
U.S. federal government spending priorities may change in a manner adverse to our business.
We act as a subcontractor for many different government programs. The funding of government programs is subject to congressional appropriations. Although multi-year contracts may be authorized in connection with major procurements, Congress generally appropriates funds on a fiscal year basis even though a program may continue for several years. Consequently, programs are often only partially funded initially, and additional funds are committed only as Congress makes further appropriations. The termination of funding for a government program would result in a loss of anticipated future revenues attributable to that program, which could have a materially adverse effect on our business, financial condition and results of operations. In addition, the termination of a program or failure to commit additional funds to a program already started could increase our overall costs of doing business. Among the factors that could materially adversely affect our federal government contracting business are:
· budgetary constraints affecting federal government spending generally, or defense and intelligence spending in particular, and annual changes in fiscal policies or available funding;
· changes in federal government programs, priorities, procurement policies or requirements;
· new legislation, regulations or government union pressures, on the nature and amount of services the government may obtain from private contractors;
· federal governmental shutdowns (such as during the government’s 1996 fiscal year) and other potential delays in the government appropriations process; and
· delays in the payment of our invoices by government payment offices due to problems with, or upgrades to, government information systems, or for other reasons.
These or other factors could cause federal governmental agencies, or prime contractors where we are acting as a subcontractor, to reduce their purchases under contracts, to exercise their right to terminate contracts or to not exercise options to renew contracts, any of which could have a materially adverse effect on our business, financial condition and results of operations.
We could be suspended or debarred from contracting with the federal government.
We could be debarred or suspended from contracting with the federal government generally, or any significant agency in the intelligence community or Department of Defense, for, among other things, actions or omissions that are deemed by the government to be so serious or compelling that they affect our contractual responsibilities. For example, we could be debarred for committing a fraud or criminal offense in connection with obtaining, attempting to obtain or performing a contract, or for embezzlement, fraud, forgery, falsification or other causes identified in Subpart 9.4 of the Federal Acquisition Regulation. In addition, our reputation or relationship with the government agencies could be impaired. If we were
suspended or debarred, or if our relationship or reputation were impaired, our business, financial condition and results of operations could be materially adversely affected.
The failure to obtain, or any delays in obtaining, export authorizations from the federal government in connection with the export of our products, or the imposition of sanctions for failing to comply with the export control laws and regulations, could have a materially adverse effect on our business, financial condition and results of operations.
We must often obtain the prior review and approval of the federal government in connection with the export of our products and technology. Such approvals are provided via licenses or other authorizations issued by government agencies under the Arms Export Control Act, the International Traffic in Arms Regulations, the Export Administration Regulations and other laws and regulations that control exports of hardware and technology to foreign countries and the transfer of technology to foreign persons wherever located. We can give no assurance that we will be successful in obtaining and maintaining the necessary licenses or other authorizations required to conduct business in foreign countries or with foreign persons. Recently, heightened government enforcement of the export control laws and regulations, and an increasingly restrictive federal government policy with respect to the export licensing of certain technologies including infrared and night vision systems, has resulted in lengthened review periods for our license applications and increased risks that such requests for licenses or other authorizations could be denied. The failure to comply with such export control laws and regulations can result in the imposition of sanctions, which may include monetary penalties and the loss of export privileges. The imposition of such sanctions, or the failure to obtain or delays in obtaining export licenses or other necessary authorizations that would prevent or delay us from selling our products outside the United States, could have a materially adverse effect on our business, financial condition and results of operations.
We must comply with complex procurement laws and regulations.
We must comply with and are affected by laws and regulations relating to the formation, administration and performance of federal government contracts, which affect how we do business with our customers and may impose added costs on our business. Among the most significant regulations are:
· the Federal Acquisition Regulation, and agency regulations supplemental to the Federal Acquisition Regulation, which comprehensively regulate the formation, administration and performance of government contracts;
· the Truth in Negotiations Act, which requires certification and disclosure of all cost and pricing data in connection with contract negotiations;
· the Cost Accounting Standards and Cost Principles, which impose accounting requirements under certain government contracts; and
· laws, regulations and executive orders restricting the use and dissemination of information classified for national security purposes and the exportation of certain products and technical data.
Moreover, we are subject to industrial security regulations of the Department of Defense and other federal agencies that are designed to safeguard against foreigners’ access to classified information. If we were to come under foreign ownership, control or influence, our federal government customers could terminate or decide not to renew our contracts, and it could impair our ability to obtain new contracts.
We may not be able to implement our business plan effectively because the industries in which we operate are subject to fluctuations and other factors that are difficult to forecast.
Our operating results may vary substantially due to factors that are difficult to forecast. Factors such as announcements of technological innovations or new products by us or our competitors, domestic and
foreign general economic conditions and the cyclical nature of the industries that we serve could cause substantial variations in our operating results. The aerospace and defense, semiconductor capital equipment, high-performance graphic art, medical imaging capital equipment and industrial automation OEM and MRO industries, each of which represents a significant market for our products, have historically been subject to substantial economic fluctuations due to changing demands for their products and services, introduction of new products and product obsolescence. Any future fluctuations arising from these or other conditions could have a materially adverse impact on our business, financial condition and results of operations. We have experienced, and expect to continue to experience, significant fluctuations in our quarterly and annual operating results due to a variety of factors, including:
· market acceptance of new and enhanced versions of our products;
· timing and shipment of significant orders;
· mix of products sold;
· length of sales cycles;
· plant openings and closings;
· the timing of acquisitions or dispositions;
· delays in raw materials shipments, as well as other manufacturing delays and disruptions;
· completion of large projects;
· the level of backlog of orders;
· domestic and foreign general economic conditions; and
· demand in the markets that we serve.
To some extent, primarily in our bearing distribution division, our net sales and operating results for a specific quarter will depend upon generating orders to be shipped in the same quarter in which the order is received. The failure to receive anticipated orders or delays in shipments near the end of a particular quarter, due, for example, to unanticipated rescheduling or cancellations of shipments by our customers or unexpected manufacturing difficulties, may cause our net sales in a particular quarter to fall significantly below expectations, which could have a materially adverse effect on our business, financial condition and results of operations for such quarter.
If we are unable to adapt to technological change, demand for our products may be reduced.
The rapid pace of technological change will require continuous new product development. Our success will continue to depend in substantial part upon our ability to introduce new products that keep pace with technological developments and evolving industry standards and to apply appropriate levels of engineering, research and development resources necessary to keep pace with these developments. In addition, our success will depend on how well we respond to changes in customer requirements and achieve market acceptance for our products and capabilities. Any failure by us to anticipate or respond adequately to technological developments and customer requirements could have a materially adverse effect on our business, financial condition and results of operations. In order to develop new products successfully, we are dependent upon close relationships with our customers and their willingness to share proprietary information about their requirements and participate in collaborative efforts with us. We cannot assure you that our customers will continue to provide us with timely access to information or that we will be successful in developing and marketing new products and services or their enhancements. In addition, we cannot assure you that the new products and services or their enhancements, if any, that we develop will achieve market acceptance.
We operate in highly competitive markets with competitors who may have greater resources than we possess, which could reduce the volume of products we can sell and our operating margins.
Our markets are extremely competitive. We compete primarily on the basis of our ability to design and engineer our products to meet performance specifications set by our customers, most of whom are OEMs who purchase component parts or sub-systems for inclusion in their end products. Product pricing and quality, customer support, experience, reputation and financial stability are also important competitive factors.
There are a limited number of competitors in each of the markets for the various types of precision optical and positioning products that we sell. Our competitors, especially those in the precision optical and positioning product lines, are typically focused on a smaller number of product offerings than we are, and they are often well entrenched. Some of our competitors have substantially greater resources than we do. Our competitors could develop enhancements to or future generations of competitive products that will offer superior price or performance features to ours. In addition, new processes or technologies could emerge that render our products less competitive or obsolete.
In addition, a substantial investment is required by an existing or potential customer to integrate components and sub-systems into their product design. We believe that once a customer has selected particular components or sub-systems from one vendor, the customer generally relies upon that vendor to provide equipment for the specific product application and may seek to rely upon that vendor to meet other component or sub-system requirements. Accordingly, we may be at a competitive disadvantage with respect to a prospective customer that chooses to utilize a competitor’s components or sub-systems.
Further, there are numerous competitors in markets to which we distribute precision ball bearings. Our competitors, who vary in size, include other ball bearings distributors as well as ball bearings manufacturers.
The basis of competition in the industries in which we compete could shift and we may not be able to compete successfully.
Our backlog is subject to reduction and cancellation.
Backlog represents products or services that our customers have committed by contract to purchase from us. Our backlog as of December 31, 2006 was $130.4 million. Our backlog is subject to fluctuations and is not necessarily indicative of future sales. Moreover, cancellations of purchase orders or reductions of product quantities in existing contracts could materially reduce our backlog and, consequently, future revenues. Our failure to replace canceled or reduced backlog could result in lower revenues.
We operate internationally, which exposes us to the risks of doing business abroad.
Our levels of international sales and purchases could pose risks to our operating results. Our international sales accounted for approximately 9.3% of our sales in 2006, 11.5% in 2005 and 12.0% in 2004. In addition, our products are sold to domestic customers who use them in products that they sell into international markets. Also, we purchase a substantial portion of our ball bearing products from two foreign suppliers and certain other products from other foreign suppliers. Our international sales and purchases are subject to a number of risks generally associated with international operations, including the following:
· general economic conditions;
· import and export duties and restrictions;
· currency fluctuations;
· changes in regulatory requirements;
· the imposition of tariffs and other barriers;
· political and economic instability;
· potentially adverse income tax consequences;
· transportation delays and interruptions;
· labor unrest and current and changing regulatory environments;
· our ability to comply with regulations governing foreign government contracts;
· difficulties in staffing and managing multi-national operations; and
· limitations on our ability to enforce legal rights and remedies.
Any of these factors could have a materially adverse effect on our business, financial condition and results of operations. We cannot assure you that we will continue to operate in compliance with applicable customs, currency exchange control regulations, transfer pricing regulations or any other laws or regulations to which we may be subject. We also cannot assure you that these laws will not be modified.
Our sales growth and earnings may be reduced if we cannot implement our acquisition strategy.
We may not be able to successfully manage acquisitions. As part of our business development strategy, we plan to pursue acquisitions in order to expand our product offerings, add to or enhance our base of technical and sales personnel or provide desirable customer relationships. This growth could result in a significant strain on our managerial, financial, engineering and other resources. The rate of our future expansion, if any, in combination with the complexity of the technologies involved in our businesses, may demand an unusually high level of managerial effectiveness in anticipating, planning, coordinating and meeting our operational needs as well as the needs of our customers.
We may not successfully acquire the most complementary businesses. We cannot assure you that we will be able to acquire complementary businesses on a cost-effective basis, integrate acquired operations into our organization effectively, retain and motivate key personnel, or retain customers of acquired firms. We compete for attractive acquisition candidates with other companies or investors, and that competition could increase the cost of pursuing our acquisition strategy or reduce the number of attractive candidates to be acquired.
We may be unable to integrate our acquired companies successfully.
If we fail to integrate acquired businesses successfully or to manage our growth, that failure could have a materially adverse effect on our business, financial condition and results of operations. Further, there can be no assurance that we will be able to maintain or enhance the profitability of any acquired business or consolidate operations to achieve cost savings.
In addition, there may be liabilities that we fail, or are unable, to discover in the course of performing due diligence investigations on each company or business we have already acquired or may acquire in the future. Such liabilities could include those arising from employee benefits contribution obligations of a prior owner or non-compliance with applicable federal, state or local environmental requirements by prior owners for which we, as a successor owner, may be responsible. In addition, there may be additional costs relating to acquisitions including, but not limited to, possible purchase price adjustments. We cannot assure you that rights to indemnification by sellers of assets to us, even if obtained, will be enforceable, collectible or sufficient in amount, scope or duration to fully offset the possible liabilities associated with
the business or property acquired. Any such liabilities, individually or in the aggregate, could have a materially adverse effect on our business, financial condition and results of operations.
We may experience production delays if suppliers fail to deliver materials to us.
Many key product components come from single source suppliers. A significant portion of our precision machining business depends on the adequate supply of specialty metals, such as beryllium, at competitive prices and on reasonable terms. We currently procure all of our beryllium from Brush Wellman, the sole U.S. supplier, and expect to continue to rely on Brush Wellman for beryllium for the foreseeable future. Although we have not experienced significant problems with our supplier in the past, we cannot assure you that such relationship will continue or that we will continue to obtain such supplies at cost levels that would not adversely affect our gross profit. The partial or complete loss of Brush Wellman as a supplier of beryllium, or production shortfalls or interruptions that otherwise impair our supply of beryllium, could have a materially adverse effect on our business, financial condition and results of operations. It is uncertain whether alternative sources of supply could be developed without a material disruption in our ability to provide beryllium products to our customers.
In addition, we purchase a substantial amount of the ball bearings that we distribute from two foreign suppliers. Although we have not experienced significant problems with our other suppliers in the past, we cannot assure you that such relationships will continue or that, in the event of the termination of one or more of our relationships with those other suppliers, we would be able to obtain alternative sources of supply without a material disruption in our ability to provide products to our customers. Any material disruption in our supply of products could have a materially adverse effect on our business, financial condition and results of operations.
Our future growth and continued success are dependent on our key personnel.
Our success depends to a significant extent on the continued services of our key executive officers and senior management personnel. The loss of the services of one or more of these individuals could have a materially adverse effect on our business, financial condition and results of operations. We do not maintain key man life insurance on our executive officers. In addition, since our continued success is largely dependent upon our ability to design, manufacture and sell high-performance solutions for the high-performance technology market, we are particularly dependent upon our ability to identify, attract, motivate and retain qualified technical personnel, including engineers and skilled machinists, with the requisite educational background and industry experience. Our employees may voluntarily terminate their employment with us at any time, and competition for personnel is intense. Accordingly, we cannot assure that we will be successful in retaining our existing personnel. The loss of the services of a significant number of our technical or skilled personnel, or the future inability to attract technical or skilled personnel, could have a materially adverse effect on our business, financial condition and results of operations.
Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand.
We must protect our intellectual property rights. Our ability to compete effectively with other companies will depend, in part, on our ability to maintain the proprietary nature of our technology. We rely upon a combination of patents, trademarks and trade secrets, non-disclosure agreements and other forms of intellectual property protection to safeguard our proprietary technology. We cannot assure you as to the degree of protection offered by these patents. We also cannot assure you that we will be able to maintain the confidentiality of our trade secrets or that our non-disclosure agreements will provide meaningful protection of our trade secrets, know-how or other proprietary information in the event of any
unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information.
The patents of competitors could impact our business. Competitors in the United States and foreign countries, many of which have substantially greater resources than we do and have made substantial investments in competing technologies, may have applied for or obtained, or may in the future apply for and obtain, patents that will prevent, limit or interfere with our ability to make and sell some of our products. Although we believe that our existing products do not infringe on the patents or other proprietary rights of third parties, third parties could assert infringement claims against us and such claims could be successful.
In addition, we do not have the right to prohibit the U.S. government from using certain technologies developed by us or to prohibit third-party companies, including our competitors, from using those technologies in providing products and services to the U.S. government. The U.S. government has the right to royalty-free use of technologies that we have developed under U.S. government contracts. We are free to commercially exploit those government-funded technologies and may assert our intellectual property rights to seek to block other non-government users thereof, but we cannot assure you that we could successfully do so.
We are subject to significant environmental, health and safety laws and regulations and related compliance expenditures and liabilities.
We are subject to a variety of federal, state and local laws, rules and regulations relating to the use, storage, discharge and disposal of hazardous substances and wastes used or generated during our engineering, research and development and manufacturing activities. Failure to comply with applicable environmental requirements could result in substantial liability to us, including civil or criminal penalties, suspension or cessation of our operations, restrictions on our ability to expand our operations or requirements for the acquisition of additional equipment or other significant expense, any of which could have a materially adverse effect on our business, financial condition and results of operations. In addition, environmental laws also impose obligations and liability for the cleanup of properties affected by hazardous substance spills or releases. These liabilities can be imposed on the parties generating or disposing of such substances or on the owner or operator of the affected property, often without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous substances. Accordingly, we may become liable, either contractually or by operation of law, for remediation costs even if the contaminated property is not presently owned or operated by us, or if the contamination was caused by third parties. We cannot assure you (1) that changes in federal, state or local laws, regulations or regulatory policy, or the discovery of unknown problems or conditions, will not in the future require substantial expenditures or (2) as to the extent of our liabilities, if any, for past failures, if any, to comply with applicable environmental laws, regulations and permits, any of which also could have a materially adverse effect on our business, financial condition and results of operations.
We have made and continue to make investments in protective equipment, process controls, manufacturing procedures and training in order to minimize the risks to our employees, surrounding communities and the environment due to the presence and handling of hazardous materials. The failure to properly handle these materials could lead to harmful exposure for employees or to the discharge of certain hazardous waste materials. Since we do not carry environmental impairment insurance, such a failure could have a materially adverse effect on our business, financial condition and results of operations.
As a result of processing beryllium, we are subject to liability and compliance costs.
The processing of beryllium, one of the materials used in some of our products, may result in the release of beryllium into the workplace and the environment and in the creation of beryllium oxide as a
by-product. Beryllium is classified as a hazardous air pollutant, a toxic substance and a hazardous substance under environmental, safety and health laws and regulations. Various acute and chronic health effects may result from exposure to beryllium, including the development of a chronic lung disease known as chronic beryllium disease, or CBD. Because of the health risks associated with beryllium, we may be subject to product liability claims and third-party lawsuits and increased levels of scrutiny from federal, state, foreign and international regulatory authorities. Concerns over CBD and other potential adverse health effects relating to beryllium, as well as concerns regarding potential liability from the use of beryllium, may discourage our customers’ use of our beryllium-containing products and significantly reduce demand for our products.
In addition, we are required to comply with certain regulatory requirements to process beryllium. In response to these regulatory requirements, we have incurred, and continue to incur, costs for employee training as well as monitoring and protective equipment. Any future changes in these regulatory requirements may increase our cost of compliance, which could have a materially adverse effect on our business, financial condition and results of operations.
If we are unable to maintain and upgrade our manufacturing capabilities, our ability to compete could be materially and adversely impacted.
We must continue to invest significant resources to maintain and upgrade our manufacturing capabilities. We have invested, and intend to continue to invest, in state-of-the-art equipment in order to increase, expand, update or relocate our manufacturing capabilities and facilities. Changes in technology or sales growth beyond currently established manufacturing capabilities would require that we make further investment. We cannot assure you that we will generate sufficient funds from operations to finance any required investment or that other sources of funding will be available on terms acceptable to us, if at all. In addition, any further expansion could have a materially adverse effect on our business, financial condition and results of operations.
Failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed-price contract may reduce our profit or cause a loss.
We provide our services primarily through firm fixed-price contracts. Substantially all of our net sales for 2006 were derived from firm fixed-price contracts, which require us to perform services under a contract at a stipulated price. We assume greater financial risk on firm fixed-price contracts. Failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed-price contract will reduce our profit or cause a loss. Although we believe that adequate provision for our costs of performance is reflected in our financial statements, we can give no assurance that this provision is adequate or that losses on firm fixed-price contracts will not occur in the future.
We are dependent in part upon our relationships and strategic alliances with industry participants in order to generate revenue.
We rely on the strength of our relationships with military industry organizations to form strategic alliances. If any of our existing relationships with our strategic partners were impaired or terminated, we could experience significant delays in the development of our new products ourselves and we would incur additional development costs. We would need to fund the development of our new products internally or identify new strategic partners.
Some of our likely partners are also potential competitors, which may impair the viability of new strategic relationships. While we must compete effectively in the marketplace, our future alliances may depend on our strategic partners’ perception of us. As a result, our ability to win new and/or follow-on contracts may be dependent upon our relationships within the military industry.
Restrictive covenants under our credit facility may reduce our operating and financial flexibility.
Our credit facility requires us to maintain compliance with certain covenants, including covenants regarding minimum EBITDA, a minimum fixed charge coverage ratio and a maximum leverage ratio. Our ability to comply with these covenants may be affected by events beyond our control. Our inability to comply with the required financial covenants could result in a default under our credit facility. In the event of any such default, the lenders under our credit facility could elect to declare all outstanding debt, accrued interest and fees under the facility to be due and immediately payable. If we are unable to repay any of this debt when due, the lenders under our credit facility could foreclose on our assets pledged to them as security. If the indebtedness under our credit facility were to be accelerated, our assets may not be sufficient to repay such indebtedness in full.
A portion of our business is dependent upon obtaining and maintaining required security clearances.
Some of our federal government contracts require our employees to maintain various levels of security clearances, and at three of our manufacturing facilities, we are required to maintain certain facility security clearances complying with federal government requirements. Obtaining and maintaining security clearances for employees involves a lengthy process, and it is difficult to identify, recruit and retain employees who already hold security clearances. If our employees are unable to obtain or retain security clearances or if our employees who hold security clearances terminate employment with us, any customer whose work requires cleared employees could terminate its contract or decide not to renew its contract upon its expiration. In addition, we expect that some of the contracts on which we will bid will require us to demonstrate our ability to obtain facility security clearances and perform work with employees who hold specified types of security clearances. To the extent we are not able to obtain facility security clearances or engage employees with the required security clearances for a particular contract, we may not be able to bid on or win new contracts, or effectively re-compete on expiring contracts.
The concentration of our common stock ownership with our Chairman of the Board and Chief Executive Officer may limit our ability to influence corporate matters.
Our Chairman of the Board and Chief Executive Officer beneficially owned approximately 18.3% of our common stock outstanding as of December 31, 2006. As a result, he will have the ability to exert influence with respect to corporate actions, including the election of directors and certain sales or mergers and acquisitions. In addition, the interests of our Chairman of the Board and Chief Executive Officer may conflict with the interests of the other holders of our common stock.
Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable.
Certain anti-takeover provisions could cause harm to our stockholders. Our Restated Certificate of Incorporation, as amended, our By-Laws and the General Corporation Law of the State of Delaware, which we refer to as the DGCL, contain various provisions that could delay or impede the removal of incumbent directors and could make a merger, tender offer or proxy contest involving us more difficult, even if such a transaction would be beneficial to the interests of the stockholders, or could discourage a third party from attempting to acquire control of us.
We have authorized 4,000,000 shares of our preferred stock, none of which is currently outstanding, and which we could issue without further stockholder approval and upon terms and conditions, and having rights, privileges and preferences, as the Board of Directors may determine. We have no current plans to issue any preferred stock.
Our By-Laws include provisions establishing advance notice procedures with respect to stockholder proposals and director nominations, and permitting the calling of special stockholder meetings only by the
written consent of three-quarters of the Board of Directors or the Chairman of the Board. Our Restated Certificate of Incorporation provides that in lieu of a meeting, action may be taken by written consent of our stockholders only by unanimous consent. These provisions could have the effect of delaying, deterring or preventing a change in control of Axsys, and may adversely affect the voting and other rights of holders of common stock.
In addition, we are subject to section 203 of the DGCL, which, among other things and subject to various exceptions, restricts certain business transactions between a corporation and a stockholder owning 15% or more of the corporation’s outstanding voting stock, which we refer to as an interested stockholder in this prospectus, for a period of three years from the date the stockholder becomes an interested stockholder. These provisions may have the effect of delaying or preventing a change of control of Axsys without action by the stockholders and, therefore, could adversely affect the price of our common stock. In the event of a change of control of Axsys, the vesting of outstanding options issued under our stock incentive plan may be accelerated at the discretion of the committee administering the plan or may be required to be accelerated under certain circumstances provided for in incentive agreements.
Item 1B.
Item 1B. UNRESOLVED STAFF COMMENTS
None.
Item 2.
Item 2. PROPERTIES
We lease approximately 4,740 square feet of office space, located at 175 Capital Boulevard in Rocky Hill, Connecticut, for our corporate headquarters. This lease expires in 2012. The principal plants and other significant properties at December 31, 2006 are:
We believe that our facilities are generally sufficient to meet our current and reasonably anticipated manufacturing, distribution and related requirements. We, however, periodically review space requirements to ascertain whether our facilities are sufficient to meet our needs. All properties are used by the Optical Systems group except Montville, New Jersey, which is used by our Distributed Products group.
Item 3.
Item 3. LEGAL PROCEEDINGS
Axsys is a defendant in various lawsuits, none of which are expected to have a material adverse effect on Axsys’ business or financial position. It is possible, however, that our results of operations for a particular fiscal period could be materially affected.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None during the quarter ended December 31, 2006.
PART II
Item 5.
Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Axsys’ common stock trades on the Nasdaq Global Select Market under the symbol “AXYS.” The following table sets forth the range of high and low sales prices as reported by Nasdaq during the fiscal years 2006 and 2005:
On February 16, 2007, the high sales price was $17.30 and the low sales price was $17.04.
On February 16, 2007, the approximate number of holders of record of Axsys’ common stock was 434. In addition, we believe that as of that date, there were approximately 2,200 beneficial owners.
Dividend Policy
Axsys has applied and currently intends to continue to apply the retained and current earnings toward the development of its business and to finance growth. Axsys did not pay cash dividends on the common stock during the three years ended December 31, 2006 and does not anticipate paying cash dividends in the foreseeable future. Our ability to declare and make dividends payments is restricted under our credit facility.
Issuer Purchases of Equity Securities
None during the quarter ended December 31, 2006.
Item 6.
Item 6. SELECTED FINANCIAL DATA
The following selected financial data for the five fiscal years presented below is derived from Axsys’ audited Consolidated Financial Statements as adjusted to reflect the discontinuance of the Automation Group in 2002. The data should be read in conjunction with the consolidated financial statements and the related notes thereto included elsewhere in this annual report.
(1) On September 27, 2005, we issued and sold 3,450,000 shares of our common stock at a public offering price of $18.00 per share. The proceeds of this offering were used to prepay our existing credit facilities in 2005. This prepayment triggered a charge of $480 thousand for the loss on extinguishment of debt.
(2) On May 2, 2005, we acquired Diversified Optical Products, or DiOP. We accounted for this acquisition under the purchase method of accounting and, accordingly, results of DiOP’s operations have been included in our Consolidated Statements of Operations since the date of acquisition.
(3) On April 8, 2004, we acquired Telic Optics, Inc., or Telic. We accounted for this acquisition under the purchase method of accounting and, accordingly, the results of Telic’s operations have been included in our Consolidated Statements of Operations since the date of acquisition.
(4) In the second quarter of 2004, the Board of Directors announced the declaration of a 3:2 stock split effected as a stock dividend payable on June 30, 2004 to stockholders of record on June 15, 2004. Stockholders received a dividend of one additional share our common stock for every two shares
owned on the record date. Fractional shares were cashed out, and payments were made to stockholders in lieu of fractional shares on June 30, 2004. Share and per share information for all prior periods have been restated to reflect the stock split.
(5) For 2002, certain engineering costs have been reclassified from cost of goods sold to operating expenses to conform to the current presentation.
(6) In the third quarter of 2002, the Automation Group was divested, which included the Fiber Automation division and Automation Engineering, Inc., a wholly owned subsidiary. Accordingly, the Automation Group has been accounted for as discontinued operations and the operating results have been reported separately from continuing operations for all applicable periods. Sales applicable to these discontinued operations were $1.2 million in 2002.
(7) In accordance with SFAS No. 109, we established a $4.6 million valuation allowance against our deferred income tax asset in 2002. As we reported income, we reduced the valuation allowance and utilized $3.2 million in 2004 and $1.4 million in 2003 as deferred income tax assets were realized.
Item 7.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following table sets forth selected financial data on a consolidated basis (in thousands):
The following table sets forth the percent of sales by segment:
Overview
Axsys is a leading designer and manufacturer of precision optical solutions for defense, aerospace, homeland security and high-performance commercial applications. These sophisticated solutions are typically found in applications that demand the finest optical surfaces, highest accuracy and tightest motion
control tolerances. Application examples include weapon systems and long-range surveillance cameras. We are also a technology leader in the supply of infrared surveillance solutions to homeland security market customers, such as the U.S. Border Patrol, Army, Navy, Air Force, Coast Guard and various port authorities.
Our solutions are often embedded in larger systems that depend on precise optical control for accurate operation of critical functions. For example, our products are embedded in several next generation thermal imaging and targeting systems for platforms such as the,, Bradley Fighting Vehicle, M1A2 Abrams and Stryker. We also supply critical guidance and seeker components for platforms such as the Minuteman intercontinental ballistic missile and the AIM-9X Sidewinder missile. Our products are included on several platforms within the U.S. National Missile Defense program. We are well positioned within this market, with strong positions on a diverse array of high-profile military programs.
In addition to optical solutions, we also distribute precision ball bearings used in a variety of industrial and commercial applications. We sell our components, sub-systems and bearings to a variety of OEMs.
We are organized into two businesses: the Optical Systems Group and the Distributed Products Group.
Optical Systems Group
The Optical Systems Group designs, manufactures and sells highly precise systems, sub-systems and components that are typically used in surveillance, long-range observation, tracking and targeting and high-performance imaging applications. Customers include both governmental and commercial organizations. The Optical Systems Group has design and manufacturing facilities in San Diego, California, Cullman, Alabama, Rochester Hills, Michigan, and Nashua, New Hampshire.
Distributed Products Group
The Distributed Products Group distributes precision ball bearings, spherical plain bearings, and bushings, acquired from various domestic and international sources, to OEMs and MROs. Additionally, the Distributed Products Group designs, manufactures and sells mechanical-bearing subassemblies for a variety of customers. The Distributed Products Group is comprised of the AST Bearings Division located in Montville, New Jersey, with a satellite distribution center in Irvine, California.
Facilities
On April 26, 2006, we purchased a 78,000 square foot building and 10.5 acres of land in Nashua, New Hampshire for $4.0 million. This facility serves as the consolidated manufacturing facility for our Axsys Technologies IR Systems division, formerly operating at two facilities in New Hampshire and Massachusetts. The relocation and the closure of the two existing facilities was completed in the fourth quarter of 2006. During 2006, total pre-tax costs associated with the relocation and facilities’ closures were approximately $325 thousand, with an additional $2.5 million of capital expenditures. These costs included equipment relocation, employee training and facility improvements. In addition, we recognized a $106 thousand in expense for the cancellation of the existing Salem facility lease.
Share-Based Compensation Expense
Beginning in the first quarter of 2006, we were required to record the expense of share-based payment transactions pursuant to Statement of Financial Accounting Standards No. 123 (revised ), “Share-Based Payment”, or SFAS 123(R). Under the modified prospective method, we were not required to restate the
prior year financial statements or include in the current year any expenses related to stock option grants vested as of December 31, 2005.
During the first quarter of 2006, we reviewed our equity compensation program to determine the most appropriate equity award vehicles based on our objectives and new accounting and regulatory rules. Stock ownership guidelines, award types and award amounts were also reviewed to ensure market competitiveness. As a result of this review, we began granting a mix of restricted stock and stock options to all eligible employees and Directors. Prior to January 1, 2006, only stock option awards were granted.
As of December 31, 2006, there was $2.1 million of unrecognized compensation cost related to stock option awards, which is expected to be recognized over a weighted-average period of 1.7 years. As of December 31, 2006, we had unamortized compensation expense of $936 thousand associated with restricted stock awards, which will be amortized over the weighted-average remaining life of 3.9 years.
The impact of SFAS 123(R) on the statement of operations was as follows:
Public Stock Offering
On September 27, 2005, we issued and sold 3,450,000 shares of common stock at the public offering price of $18.00 per share. We received all of the net proceeds from the offering after payment of underwriting discounts and commissions. Gross proceeds from the stock offering were $62.1 million. After underwriting discounts and commissions, we received $57.6 million. We utilized $54.6 million to repay all of the amounts outstanding under our credit facility, including accrued interest and fees, and $791 thousand to pay expenses related to the stock offering, and we used the remaining $2.2 million for working capital and general corporate purposes.
Significant Customers
BAE Systems, an aerospace and defense systems supplier, represented 12.1% of our net sales in 2006. Raytheon Company, an aerospace and defense systems supplier, represented 12.3% of our net sales in 2005 and 18.9% in 2004. While BAE, a prime contractor with the U.S. government, does constitute a significant portion of our business, we do not currently believe that this is at-risk business.
Backlog and Orders
Axsys recognized, in 2006, bookings of $174.1 million, ending the year with record backlog of $130.4 million, of which 14.8% will be shipped beyond 12 months. Our backlog increased by $17.7 million, or 15.7%, compared to our ending backlog of $112.7 million as of December 31, 2005. As we look forward, we expect continued growth in the Optical Systems Group, which is supported by the segment’s backlog of $115.9 million at the end of 2006. This group will continue to target orders that require highly precise optical and motion control solutions. Examples include surveillance, military navigation and targeting, ‘smart’ weapons, and medical imaging.
Acquisition of Diversified Optical Products, Inc.
On May 2, 2005, we acquired all of the stock of DiOP, a manufacturer of high-end thermal camera systems and lenses, for $55.2 million in cash plus $1.9 million of legal, audit and other acquisition related costs incurred in connection with the acquisition. The acquisition of DiOP brought us new, high value technologies, leveraged our existing infrared and motion control technologies, and provided us with a new base of customers. Further, the combination of DiOP and Axsys positioned us as a leading independent infrared lens manufacturer. At the time of the acquisition, DiOP employed approximately 120 people at its Salem, New Hampshire headquarters. DiOP is doing business as Axsys Technologies IR Systems and the financial results are included in our Optical Systems Group’s results.
In connection with the acquisition of DiOP, on May 2, 2005, we also entered into a new $70.0 million credit facility with Fleet Bank. The credit facility consisted of a five-year term loan A in the amount of $20.0 million, a two-year term loan B in the amount of $35.0 million and a three-year revolving line of credit in the maximum amount of $15.0 million. Borrowings under this credit facility provided a portion of the consideration used to acquire DiOP.
Pursuant to the terms of the credit facility, we used the net proceeds from the 2005 stock offering to repay all of the amounts outstanding under the term loan B. In addition to repaying term loan B, we also repaid in full the amounts outstanding under the term loan A with the net proceeds of the stock offering.
At December 31, 2006, there were no borrowings outstanding under the revolving credit facility; however, $1.1 million of the revolving credit facility was utilized for outstanding letters of credit
Acquisition of Telic Optics, Inc.
On April 8, 2004, we acquired all of the stock of Telic, a manufacturer of infrared optical products. The financial results of Telic are included in our Optical Systems Group’s results.
Telic’s broad infrared optics capabilities increase our product offerings and complement our strong position in reflective optical solutions. In addition, Telic’s products are typically used in ground- and sea-based programs. This complements our historical focus on air- and space-based programs and expands our overall market and program penetration. Finally, the complementary addition of Telic’s technical capabilities to our core technical strengths broadens our technical offering to prime contractors who are seeking to outsource the fulfillment of their optical requirements.
The initial purchase price of this acquisition, after a working capital adjustment of $15 thousand, was $14.4 million with an additional earn out payment of up to $4.0 million over 36 months following the closing date based on the achievement of certain revenue goals. Of this additional earn out payment, $1.2 million was earned in 2006 and will be paid out in 2007 and $2.8 million was earned in 2005 and subsequently paid in 2006. This increased the purchase price to $18.4 million at December 31, 2006. Included in the purchase price was $438 thousand of legal, audit and other acquisition related expenses that were incurred in connection with the acquisition. We funded the purchase price and associated transaction costs through a combination of existing cash balances and outside bank financing.
James Webb Space Telescope
Since 2004, we received $21.0 million of orders from Ball Aerospace and Technology Corporation, including the original contract and change orders, to produce the optical mirror substrates for the James Webb Space Telescope, or JWST. The contract contains $12.4 million of production sales and $8.6 million for facilitization. We recognized revenue of $3.9 million in 2006, $4.0 million in 2005 and $1.0 million in 2004 under the percentage of completion method of accounting related to the JWST project.
The JWST, which is currently expected to launch in 2013, will replace the Hubble as NASA’s premier space telescope. Northrop Grumman is the prime contractor. The primary mirror is comprised of 18 individual lightweight beryllium segments, all of which will be fabricated by Axsys. Because of the large size of the primary mirror, JWST will be significantly more sensitive than ground-based infrared telescopes, enabling it to search for the first stars and galaxies formed in the universe billions of years ago.
Our contract includes the production of optical substrates for an engineering development unit, 18 primary mirror segments, 2 spare mirrors and support structures. As of December 31, 2006, we delivered 16 of the primary mirror segments. We expect to ship the final units in 2007.
Results of Segment Operations
The following tables and discussion set forth selected financial information from continuing operations on a segment basis for the years ended December 31, 2006, 2005 and 2004. The segment tables, shown below, exclude one-time charges, which are shown separately.
Optical Systems Group Segment
(table in thousands and as a percentage of sales)
Sales in the Optical Systems Group segment increased 19.6% for the year ended December 31, 2006 compared to 2005, while sales in this segment increased 39.0% for the year ended December 31, 2005 compared to 2004. The increase in 2006 sales compared to 2005 was primarily due to increased demand for our infrared product lines. The success of our thermal imaging cameras and lenses in military and homeland security surveillance and targeting applications continues to drive our revenue growth.
The increase in 2005 sales compared to 2004 sales was due to both the addition of a new revenue stream related to the acquisition of DiOP and continued organic growth year over year, primarily from our infrared product lines.
Gross profit as a percent of sales for the year ended December 31, 2006 remained comparable to 2005. The higher sales volume during 2006 did not generate incremental margin as we continued to increase our participation on large military programs, which generally carry lower than average margins. Gross profit as a percentage of sales for 2005 compared to 2004 increased mainly due to increased volume, improved sales mix related to our infrared business and improved efficiencies in comparison to the prior year.
The Optical Systems Group, as of December 31, 2006, had a backlog of definitive orders of $115.9 million, of which 14.1% is expected to ship beyond the 2007 fiscal year.
Distributed Products Group Segment
(table in thousands and as a percentage of sales)
Sales in the Distributed Products Group increased 6.2% for the year ended December 31, 2006 compared to 2005, while sales decreased 1.8% for the year ended December 31, 2005 comparable to 2004. Sales increased during 2006 compared to 2005 mainly due to increased activity of new and existing products from some of our larger customers. During 2005, revenues remained consistent when compared to 2004 despite increased pricing pressures and competition.
Gross profit, as a percent of sales, for 2006 was slightly higher than gross profit in the same period in the prior year mainly due to favorable product mix and a reduction in anti-dumping duty rates. For 2005, gross profit, as a percentage of sales, was lower than gross profit in the comparable period in 2004 year mainly due to competitive pricing pressures, continued increasing freight costs and increased anti-dumping duty rates that were not reflected in our pricing, which was include in our backlog coming into the year.
Operating Expenses
(table in thousands and as a percentage of sales)
Selling, general and administrative expenses. Selling, general and administrative expenses, or SG&A, were $28.2 million in 2006 compared to $24.0 million in 2005 and $18.6 million in 2004. SG&A spending during 2006 was 17.6% higher than spending during 2005. Several factors contributed to the increases. During 2006, we implemented SFAS 123(R) for share-based compensation expensing, which cost totaled $1.1 million. Additional costs associated with having DiOP for a full year compared to eight months in 2005 were estimated to be $1.0 million. We incurred $431 thousand of move-related expenses associated with the consolidation of our IR Systems divisions. We incurred $500 thousand of additional professional costs in 2006 compared to 2005 as a result of anti-dumping duty issues associated with our Distributed Products Group and other legal matters associated with the ordinary course of business. Lastly, we spent an additional $1.3 million across several expense categories associated with the general growth of the business.
The spending increase from 2004 to 2005 was primarily due to the acquisition of DiOP and the incremental expenses associated with a full year of expense for Telic compared to nine months of expense in 2004. DiOP incurred $3.3 million of SG&A expenses in 2005, while Telic incurred an incremental $400 thousand of SG&A costs compared to the prior year as a result of a full year of operation. Amortization expense totaled $816 thousand in 2005 as compared to $73 thousand in 2004.
SG&A spending, as a percentage of sales, remained comparable to spending in the prior years despite the adoption of FAS123(R) and the move-related costs associated with consolidation of our IR Systems division.
Research, development and engineering expenses. Research, development and engineering expenses in 2006 increased by $697 thousand and $1.1 million compared to 2005 and 2004, respectively. This was primarily a result of our infrared product line. This product line is research intensive as we continuously make improvements on products to ensure competitiveness in the imaging market place. Our legacy product lines are primarily manufactured and sold to OEMs based on their unique design specifications.
Other Income and Expenses
Interest expense. Interest expense was $80 thousand in the year ended December 31, 2006, compared to $1.7 million in 2005 and $254 thousand in 2004. The lower interest expense was due to lower overall borrowings on our revolving credit facility during 2006 compared to borrowings in 2005. The increase in
expense in 2005 compared to 2004 was primarily due to interest on our $55 million term loan incurred in conjunction with the acquisition of DiOP, which was partially offset by lower interest paid on capital leases compared to 2004.
Interest income. Interest income was $290 thousand in the year ended December 31, 2006 compared to $167 thousand in 2005 and $98 thousand in 2004. Interest income was primarily composed of income from cash and cash equivalents and short-term investments. The increase year-over year was primarily due to overall higher interest rates on higher than average cash on hand.
Loss on extinguishment of debt. In conjunction with our prepayment of the principal and accrued interest on the $20.0 million term loan A and the $35.0 million term loan B during 2005, we incurred a charge of $421 thousand for the write off of loan origination fees and a charge of $59 thousand for the early termination of the related interest rate swap agreement.
Other income and expense, net. Net other expense in 2006 was $2 thousand compared to net other income of $33 thousand in 2005 and net other expense of $38 thousand in 2004. Other income and expense were composed primarily of the gains and losses incurred as a result of foreign exchange gains and losses and the disposal of capital equipment.
Income Taxes. The consolidated effective income tax rate was 37.0% for the year ended December 31, 2006 compared to 37.5% in 2005 and (0.1)% in 2004. The effective rate for 2004 was impacted by the reversal of a previously-established valuation allowance. A valuation allowance is not required at December 31, 2006 as it is more likely than not that the net deferred income tax asset will be realized in the future.
Discontinued operations. In 2006, we recognized an after-tax charge of $202 thousand related to legal and consulting expenses in conjunction with an environmental clean-up site of a discontinued operation. During 2002, Axsys disposed of the Automation Group, which included facilities in Wilmington, Massachusetts and Pittsburgh, Pennsylvania. At the time of the sale, Axsys continued to be responsible for fulfilling the remaining terms of the leases. As of December 31, 2006, we fulfilled all of our contractual obligations related to these sites and we recognized an after-tax gain of $85 thousand on the reversal of an accrual associated with these leases.
In 2005, we incurred an after-tax charge of $150 thousand from the settlement of the Prospect, Connecticut environmental claim related to a previously divested operation. As of December 31, 2005, we had no further responsibility to the EPA as it relates to this site.
In 2004, we recognized an additional loss reserve in conjunction with the 2002 sale of the Automation Group. The after-tax charge of $421 represents rental expenses for the two facilities within the Automation Group. In addition, during 2004, we recognized an after tax charge $74 thousand for an environmental-related expense for previously divested operations.
Net income. We had net income of $10.3 million, or $0.94 per diluted share, in 2006, net income of $7.3 million, or $0.88 per diluted share, in 2005 and net income of $8.7 million, or $1.19 per diluted share, in 2004. In addition, we issued 3,450,000 shares of common stock through a public stock offering in September 2005, which impacted earnings per share.
Liquidity and Capital Resources
We fund our operations primarily from cash on hand and cash flow from operations. As of December 31, 2006, cash and cash equivalents totaled $6.0 million. We have maintained a high level of liquidity as evidenced by our current ratio (current assets divided by current liabilities), which was 2.2 as of December 31, 2006 and 2.1 as of December 31, 2005. Maintaining this current ratio supports our goal to maintain a high level of liquidity to seek growth opportunities.
During 2006, we borrowed and subsequently repaid $8.0 million under our revolving credit facility. The weighted-average interest rate on these borrowings was 6.3%. The $15.0 million revolving credit facility remains available through May 2008, subject to optional prepayment in accordance with its terms. Up to $2.0 million of the revolving credit facility may be utilized to issue letters of credit. We may elect to have any borrowing under the revolving credit facility bear interest either at the bank’s prime rate or the LIBOR rate plus a margin of 100 to 275 basis points, depending on our consolidated funded debt-to-consolidated EBITDA ratio. We have the option of selecting the 1-month, 2-month, 3-month or 6-month LIBOR rate. As of December 31, 2006, there were no borrowings outstanding under the revolving credit facility. However, as of December 31, 2006, $1.1 million of the revolving credit facility was utilized for outstanding letters of credit. Our credit facility requires us to maintain compliance with certain covenants, including covenants regarding minimum EBITDA, a minimum fixed charge coverage ratio and a maximum leverage ratio.
Net cash provided by operations was $12.7 million in 2006, $7.6 million in 2005 and $7.6 million in 2004. In 2006, our primary sources of operating cash were $10.3 million of net income plus non-cash expenses, which primarily consisted of $4.5 million of depreciation and amortization, $1.1 million of share-based compensation expense, $823 thousand decrease in our net deferred income tax asset and $102 thousand of other non-cash items. In addition, we spent $292 thousand on discontinued operations primarily for leases and environmental clean-up activities.
In 2006, we utilized $3.8 million of cash to fund changes in our operating assets and liabilities. We utilized $2.5 million of cash to fund an increase in accounts receivable primarily as a result of increased sales volume. We used $6.3 million of cash to fund an increase in our inventories, which resulted from long lead-time orders and increased sales by our Optical Systems Group, which was partially offset by the timing of vendor invoices and payments resulting in a $3.9 million increase to accounts payable and accrued liabilities. Accrued liabilities increased an additional $2.3 million as a result of higher excess of billings over costs of $1.8 million associated with percentage of completion accounting and additional compensation-related expenses of $1.2 million. Accrued liabilities decreased during 2006 by $700 thousand as a result of lower income tax payable, warranty reserves, accrued professional fees and other miscellaneous accruals. Additional cash outflows of $956 thousand were for the reduction of deferred income as we completed some long lead-time orders.
In 2005, our primary sources of operating cash were $7.3 million of net income plus non-cash expenses, which primarily consisted of $4.0 million of depreciation and amortization, $1.3 million decrease in our net deferred income tax asset and $69 thousand of other non-cash items. In addition, we spent $907 thousand on discontinued operations primarily for leases and environmental clean-up activities.
In 2005, we utilized $4.2 million of cash to fund changes in our operating assets and liabilities. We used $2.6 million of cash to fund an increase in our inventories, which resulted from long lead-time orders and increased sales from our Optical Systems Group. We also utilized $809 thousand of cash to fund an increase in accounts receivable primarily as a result of unbilled receivables generated by service contracts and excess of cost over billings on percentage of completion accounting. Additional cash outflows of $800 thousand were primarily for the utilization of loss contract reserves, legal and consulting costs associated with environmental activities and the reduction of deferred income as we completed some long lead-time orders.
In 2004, our primary sources of operating cash were $8.7 million of net income plus non-cash expenses, which primarily consisted of $2.7 million of depreciation and amortization and a $242 thousand non-cash charge related to the modification of stock option grants for a terminated employee. These non-cash charges were partially offset by non-cash benefits, including a $1.7 million increase in our net deferred income tax assets, due to the utilization and reversal of a valuation allowance for these assets. We also paid
out $902 thousand for liabilities related to discontinued operations, which was offset by an additional accrual for discontinued operations of $762 thousand.
In 2004, we utilized $2.2 million of cash to fund changes in our operating assets and liabilities. We used $4.5 million of cash to fund an increase in our accounts receivable, which resulted from sales growth and higher deferred income billings in our Optical Solutions Group. We also utilized $4.1 million to fund inventory growth in 2004. The inventory growth was related to certain large long-term programs in our Optical Systems Group. The increases in accounts receivable and inventory were partially offset by a $2.1 million increase in accounts payable and a $2.6 million increase in deferred income. The increase in deferred income was the result of our strategy to actively negotiate progress payments into certain large dollar contracts for long lead-time products and long-term programs. This strategy helps to mitigate the near-term negative cash impact of these contracts. The net change in accrued expenses and other liabilities and other long-term liabilities was a $784 thousand increase. The increase was related to increased accruals for compensation-related expenses and an accrual for capital equipment that was received but not invoiced, which were partially offset by the liquidation of an inactive pension plan and the utilization of the reserve for loss contracts. During 2004, we also received a $566 thousand federal income tax refund and a $224 thousand decrease in current assets primarily due to the timing of insurance payments.
Net cash used in investing activities was $14.0 million in 2006, $60.7 million in 2005 and $11.0 million in 2004. During 2006, we utilized $4.0 million of cash to purchase a new facility for our IR Systems division and invested an additional $2.0 million in capital improvements for the new facility. We had additional capital expenditures of $5.2 million in 2006 primarily for manufacturing machinery and equipment used to support sales growth. We also utilized $2.8 million of cash in 2006 for the Telic earn-out payment. During 2006, we also received $93 thousand of proceeds from the sale of fully depreciated machinery.
We utilized $57.1 million to acquire DiOP in 2005 and $13.7 million to acquire Telic in 2004. The purchase of Telic was partially funded by the sale of $7.0 million of short-term investment securities. Capital expenditures were $3.5 million during 2005 and $ 4.2 million during 2004. In 2004, we constructed a 20,000 square foot, climate-controlled manufacturing facility in Cullman, Alabama.
Financing activities provided $199 thousand of cash in 2006, $54.1 million in 2005 and $4.1 million in 2004. During 2006, we borrowed and subsequently repaid $8.0 million under our revolving credit facility. We also received $140 thousand in proceeds from the exercise of stock options and recorded a tax benefit of $59 thousand related to the exercise of non-qualified stock options. During 2005, we borrowed $55.0 million to purchase DiOP and paid off $4.4 million of financing related to the acquisition of Telic in April 2004. In addition, we completed a public stock offering of 3,450,000 shares of common stock, which generated net proceeds of $57.6 million during the third quarter of 2005. In 2005, we made a $1.0 million principal payment and utilized a portion of the net proceeds from the public stock offering to prepay the remaining $54.0 million outstanding under our credit facility. During 2005, we also received $1.3 million in proceeds from the exercise of stock options and paid off the remaining $518 thousand of capital lease obligations. During 2004, we obtained a $5.0 million term loan for the acquisition of Telic and received $360 thousand in proceeds from the exercise of stock options. These sources of funds were partially offset by repayments of $667 thousand on the term loan and $473 thousand on our capital leases.
With our existing cash balance, anticipated cash flows from operations and the $15.0 million revolving credit facility, management believes that Axsys has sufficient liquidity to finance its operations, capital expenditures, and working capital requirements for at least the next twelve months.
Shareholders’ equity was $131.2 million, or $12.33 per common share issued, at December 31, 2006 compared to $119.5 million, or $11.24 per common share issued, at December 31, 2005. The increase in shareholders’ equity was due primarily to net income of $10.3 million. Most of the remaining increase in shareholders’ equity was related to share-based compensation and the exercise of stock options.
Off-Balance Sheet Arrangements
As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2006, we are not involved in any unconsolidated single-purpose entities.
Contracts and Commitments
We have entered into certain contractual obligations, which will result in material cash outlays over the next several years. A summary of our contractual obligations and commitments for capital leases, minimum lease payment obligations under non-cancelable operating leases and other obligations as of December 31, 2006 are as follows (in thousands):
As of December 31, 2006, we had operating lease commitments for all of our facilities, with the exception of our Cullman, Alabama and Nashua, New Hampshire facilities, which are owned. In addition, our operating lease commitments included leases on some office equipment.
As of December 31, 2006, we had various purchase obligations, which include uninvoiced inventory receipts, capital equipment commitments, long-distance phone service and other commitments.
Incorporated in other long-term obligations are commitments related to environmental remediation plans and building leases associated with discontinued operations and employee benefit obligations.
We are involved in various stages of investigation and cleanup related to environmental remediation matters at three sites, which include one site that is in the final stage of monitoring. The ultimate cost of site cleanup is difficult to predict given the uncertainties regarding the extent of cleanup, the interpretation of applicable laws and regulations and alternative cleanup methods. As of December 31, 2006, we determined that it was probable that we would incur approximately $748 thousand of remediation and monitoring costs, of which $182 thousand is included in current liabilities and $566 thousand is in other long-term liabilities.
As of December 31, 2006, we were contingently liable for $1.1 million under outstanding letters of credit. We have issued letters of credit for certain business transactions including insurance programs and customer deposits.
As of December 31, 2006, we had one pension plan for which benefits and participation have been frozen. Pension benefits under this plan are generally based upon years of service and compensation. The plan is an unfunded plan with an annual payout of approximately $104 thousand.
In December of 2006, we signed an agreement to lease an additional 1,291 square feet of office space in Rocky Hill, Connecticut for our corporate headquarters. The lease is contingent upon the completion of certain renovations, which are scheduled to be completed in February 2007.
Critical Accounting Estimates
The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts for revenues and expenses during the reporting period. On an ongoing basis, management evaluates estimates, including those related to inventory allowances, contingencies, bad debts, warranties, environmental remediation efforts and income taxes. We base our estimates on historical data, when available, experience, and on various other assumptions that are believed to be reasonable under the circumstances, the combined results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
Critical Accounting Policies
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to inventory valuation and the adequacy of allowances for doubtful accounts, long-term loss contract reserves and environmental contingencies. Actual amounts could differ significantly from these estimates.
Revenue recognition. We manufacture or distribute products, which are either components or subassemblies that are sold to other manufacturers or OEMs. We do not sell any finished products directly to consumers. Therefore, we are generally not responsible for any installation or customer training. However, some of our contracts are subject to customer acceptance and generally the customer will inspect and accept the product at our facility prior to shipment. Generally, legal title passes to the customer upon shipment. However, occasionally product is shipped FOB destination. When the product is shipped FOB destination, revenues are not recognized until the customer receives the product.
Our policy is to recognize revenues when a product is either shipped to or received by the customer based on the terms of the specific sale. However, certain long-term contracts are accounted for under the percentage-of-completion model. Revenues and estimated gross profit are recognized as work is performed based on the percentage that incurred costs bear to estimated total costs. Cost estimates include direct and indirect costs such as labor, materials and overhead. These contracts require judgment relative to assessing risks, estimating, and making assumptions for schedule and technical issues. Contract changes are included when the costs can be reasonably estimated. We may receive progress payments that exceed costs incurred on these long-term contracts. Such advances are recognized as billings in excess of costs and are included in accrued expenses and other current liabilities on our consolidated balance sheets.
Deferred income primarily results from the advance billings to our customers for the cost of beryllium, known as material only billings. These material only billings are deferred and subsequently recognized as revenue only when the associated finished product is shipped.
Certain contracts are accounted for under the service contract model. Under these contracts, revenues are deferred and recognized on a straight-line basis over the contract period.
Due to the build-to-order nature of our products, except for the distribution of ball bearings and the manufacture of infrared cameras, we do not offer price protection and generally do not offer discounts. To the extent discounts are offered, they are reflected at the time of the sale as a reduction in revenues. The price is fixed upon acceptance of the purchase order. When customer change orders occur, any pricing changes are reflected in a revised purchase order.
Allowance for doubtful accounts. We periodically review the aging of our accounts receivable over ninety days to identify potentially uncollectible accounts and establish an allowance based on experience and discussion with customers. Historically, our estimated allowance has approximated actual write-offs. However, actual write-offs could differ from our allowance for doubtful accounts. If circumstances change (for example, higher than expected defaults or an unexpected material adverse change in a customer’s ability to meet its financial obligations), our estimates of recoverability of amounts due to us could be reduced by a material amount. Accounts receivable are written off only when all reasonable collection efforts are exhausted.
Inventory valuation. We value our inventory at the lower of the actual cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory. We regularly review inventory quantities on hand and record a provision for excess or obsolete inventory based on current requirements and historical usage. A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess or obsolete inventory quantities on hand. In addition, some of our markets are characterized by rapid technological change or frequent new product development that could result in an increase in the amount of obsolete inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess or obsolete inventory.
In the future, if we determine our inventory to be overvalued, we would be required to recognize those costs in our cost of goods sold at the time of such determination. Likewise, if our inventory is undervalued, we may have over-reported our costs of goods sold in previous periods and would be required to recognize additional operating income at the time of sale. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results. Historically, our estimate of inventory reserves has approximated actual results.
Goodwill and Identifiable Intangible Assets. In accordance with SFAS No. 141, Business Combinations, we allocate the cost of acquired businesses to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. As part of the purchase price allocation for our acquired businesses, identifiable intangible assets are recognized as assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired business and sold, transferred, licensed, rented or exchanged.
The values assigned to acquired identifiable intangible assets are determined, as of the date of acquisition, based on estimates and judgments regarding expectations for the estimated future after-tax cash flows from those assets over their lives, including the probability of expected future contract renewals and sales, less a cost-of-capital charge, all of which is discounted to present value. The value assigned to goodwill equals the amount of the purchase price of the business acquired in excess of the sum of the amounts assigned to identifiable acquired assets, both tangible and intangible, less liabilities assumed.
We review goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also review goodwill annually in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, or SFAS 142. SFAS 142 requires that goodwill be tested, at a minimum, annually for each reporting unit. We estimate the fair value of a reporting unit using a discounted cash flow valuation approach, which is dependent on estimates for future operating results, working capital changes, and capital expenditures, as well as expected growth rates for cash flows and long-term interest rates. A decline in future operating results or a change in our discount rate (11.5% in 2006) in the future could result in a change in the estimated fair value of a reporting unit and result in an impairment charge to goodwill, which could have a material adverse effect on our business, financial condition and results of operations.
Loss contract reserves. Generally, our customer contracts are completed within one year of receiving the order. However, occasionally, longer lead-time orders are received and we monitor these contracts periodically to determine if our actual costs are comparable to our cost estimates used at the time of order acceptance. If we determine that our actual costs are significantly exceeding our original estimates, we will record a loss contract reserve. Currently, one long-term contract is covered by a loss contract reserve. We accrued for this contract based on the contract price and the current cost structure, including estimated cost increases.
Environmental contingencies. We are currently involved in two environmental remediation projects and one site that is in the final stage of monitoring. We accrue for environmental contingencies when (1) responsibility for cleanup is determined and (2) costs are probable and can be reasonably estimated. When costs are not probable and cannot be reasonably estimated, no accrual is made. We have accrued our estimate of the probable costs for the resolution of these claims. These estimates have been developed in consultation with outside environmental consultants handling these matters and are based upon an analysis of the anticipated remediation plans. We do not anticipate these projects will have a material adverse effect on our consolidated financial position. Although our estimates to date have proven to be accurate, it is possible that future results of operations could be materially affected by changes in our assumptions.
Self-insurance. We are self-insured for certain losses related to general liability, workers’ compensation and medical claims. Our liability represents an estimate of the ultimate cost of claims incurred as of the balance sheet date. The estimated liability is established based on an analysis of historical data and is reviewed by management on a quarterly basis to ensure that the liability is appropriate. While we believe that our estimates are reasonable based on the information currently available, if actual trends, including the severity and frequency of claims, medical cost inflation or fluctuations in premiums, differ from our estimates, our results from operations could be impacted
Share-based compensation. We elected to use a Black-Scholes-Merton option-pricing model to value stock options that were granted subsequent to our adoption of Statement 123(R). The model includes various assumptions including expected life, expected volatility, expected dividend yield and risk-free interest rates. The assumptions are based on historical information regarding grants, exercises and cancellations. We believe each assumption used in the valuation is reasonable because it takes into account the experience of the plan and reasonable expectations. The assumptions, however, involve inherent uncertainties based on market conditions generally outside the control of Axsys. As a result, if other assumptions had been used, stock-based compensation expense could have varied.
Accounting for income taxes. As part of the process of preparing the consolidated financial statements, we are required to estimate the income taxes in each jurisdiction in which we operate. This process involves estimating the actual current tax liabilities together with assessing temporary differences resulting from the differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheet. We must then assess the likelihood that the deferred tax assets will be recovered, and to the extent that we believe that recovery is not more than likely, we are required to establish a valuation allowance. If a valuation allowance is established or increased during any period, we are required to include this amount as an expense within the tax provision in the Consolidated Statements of Operations. Significant judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recognized against net deferred assets. The valuation allowance is based on our estimates of the taxable income in the jurisdictions in which we operate and the period over which the deferred tax assets will be recoverable. In the event that actual results differ from these estimates or management adjusts these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our results of operations.
Recently Issued Accounting Standards
In June 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, or FIN 48, which prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return (including a decision whether to file a return in a particular jurisdiction). Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities’ full knowledge of the position and all relevant facts, but without considering time values. FIN 48 substantially changes the applicable accounting model and is likely to cause greater volatility in income statements as more items are recognized discretely within income tax expense. FIN 48 also revises disclosure requirements and introduces a prescriptive, annual tabular rollfoward of the unrecognized tax benefits. FIN 48 must be adopted no later than January 1, 2007. Early adoption is permitted. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial position and results of operations and expect to adopt FIN 48 effective January 1, 2007.
In December 2004, the FASB issued SFAS 123(R), “Share-Based Payment”, which requires us to expense share-based payments, including employee stock options, based on their fair value. We adopted SFAS 123(R) on January 1, 2006. We discuss our adoption of SFAS 123(R) and the adoption’s effects in Note 9 to our consolidated financial statements in this annual report.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costing”, or SFAS 151, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS 151 requires that those amounts, if abnormal, be recognized as expenses in the period incurred. In addition, SFAS 151 requires the allocation of fixed production overheads to the cost of conversion based upon the normal capacity of the production facilities. We adopted SFAS 151 during the first quarter of 2006. The adoption did not have a material impact on our earnings or financial position.
Cautionary Factors That May Affect Future Results
This annual report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act, including, without limitation, statements regarding our ability to reduce design and manufacturing lead times and manufacturing costs, our ability to integrate existing technologies, our ability to implement our strategy to develop and sell, among other things, higher level sub-systems, the changes to be achieved from our cost reduction efforts, our objective to grow through strategic acquisitions and anticipated expenditures for environmental remediation. One can identify these forward-looking statements by the use of the words such as “expect,” “anticipate,” “plan,” “may,” “will,” “estimate” or other similar expressions. Discussion containing such forward-looking statements is found in the material set forth under “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as within the filing generally. One should understand that many factors could cause actual results to differ from those expressed or implied in the forward-looking statements. These factors include those discussed below as well as inaccurate assumptions. We caution the reader that this list of factors may not be exhaustive. Because these forward-looking statements involve risks and uncertainties, you should be aware that there are important factors that could cause our actual results, level of activity, performance or achievements to differ materially from the results, level of activity, performance or achievements expressed or implied by these forward-looking statements including, but not limited to:
· our dependence on sales to the U.S. federal government and BAE Systems;
· changes to U.S. federal government spending priorities;
· our ability to continue to contract with the federal government or Department of Defense;
· our ability to comply with complex procurement laws and regulations;
· our ability to implement effective business plans in the industries in which we operate;
· our ability to adapt to technological change;
· our ability to compete in the industries in which we operate;
· the potential for our backlog to be reduced or cancelled;
· the risks of doing business internationally;
· our ability to implement our acquisition strategy and integrate our acquired companies successfully;
· the availability and timely delivery of materials to us by our suppliers;
· our ability to manage costs under our fixed-price contracts effectively;
· our ability to attract and retain qualified personnel;
· the ability to protect our intellectual property rights;
· fluctuations in workers’ compensation and health care costs for our employees;
· our ability to comply with environmental, health and safety laws and regulations;
· our ability to maintain and upgrade our manufacturing capabilities to stay competitive;
· our ability to comply with restrictive covenants under our credit facility;
· our ability to maintain security clearances for classified government systems; and
· the other factors that we describe in Item 1A of this annual report.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Axsys’ market risk sensitive instruments do not subject it to material risk exposures. During the year ended December 31, 2006, we borrowed and subsequently repaid $8.0 million under our revolving credit facility. We paid a weighted-average interest rate of 6.3% on the borrowings, resulting in $46 thousand in interest expense. Our $15.0 million revolving credit facility remains available through May 2008, subject to optional prepayment in accordance with its terms. Up to $2.0 million of the revolving credit facility may be utilized to issue letters of credit. We may elect to have any borrowing under the revolving credit facility bear interest either at the bank’s prime rate or the LIBOR rate plus a margin of 100 to 275 basis points, depending on our consolidated funded debt-to-consolidated EBITDA ratio. We have the option of selecting the 1-month, 2-month, 3-month or 6-month LIBOR rate. On December 31, 2006, there were no borrowings outstanding under the revolving credit facility. However, as of December 31, 2006, $1.1 million of the revolving credit facility was utilized for outstanding letters of credit.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Axsys’ consolidated financial statements, together with the Report of Independent Registered Public Accounting Firm thereon dated February 16, 2007, is included in this annual report and listed in the index to financial information on page.
The selected quarterly information required by this item is included under the caption “Selected Quarterly Financial Data (Unaudited)” in Note 18 to the consolidated financial statements included in this annual report.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
Management’s Responsibility for Financial Statements
Management is responsible for the integrity and objectivity of the consolidated financial statements and other financial information presented in this annual report. These statements have been prepared in accordance with generally accepted accounting principles and necessarily include amounts based on judgments and estimates by management.
The Audit Committee of the Board of Directors, which is composed solely of independent directors, meets regularly with the independent auditors and representatives of management to review accounting, financial reporting, internal control and audit matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent auditors. The independent auditors and internal auditor have unrestricted access to the Audit Committee.
Disclosure Controls and Procedures
As of the end of the period covered by this annual report, management, including our principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of the Axsys’ disclosure controls and procedures.
The principal executive officer and principal financial officer have concluded, based on their review, that the Axsys’ disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e), were, as of the end of the period covered by this annual report, effective to ensure that information required to be disclosed by the Axsys in reports it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in the rules promulgated under the Exchange Act of 1934. Under the supervision and with the participation of its management, including its principal executive, financial and accounting officers, Axsys has conducted an evaluation of the effectiveness of its 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. The evaluation included a review of the documentation of controls, evaluation of the design effectiveness of controls, and testing of the operating effectiveness of controls.
Based on this evaluation, management has concluded that as of December 31, 2006, Axsys did not have any material weaknesses in its internal control over financial reporting and its internal control over financial reporting was effective. Management’s assessment of the effectiveness of its internal control over financial reporting on December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is included below in this annual report.
Changes in Internal Control over Financial Reporting
No change to the Company’s internal control over financial reporting occurred during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, Axsys’ internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders of Axsys Technologies, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, included at Item 9A, that Axsys Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Axsys Technologies, Inc.’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 opinion.
A company’s internal control over financial reporting is a process designed 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 its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Axsys Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Axsys Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2006, of Axsys Technologies, Inc. and subsidiaries and our report dated February 16, 2007 expressed an unqualified opinion thereon.
ERNST & YOUNG LLP
Hartford, Connecticut
February 16,
Item 9B.
Item 9B. OTHER INFORMATION
None.
PART III
The information required by items 10, 11, 12, 13 and 14 of Part III, other than the disclosure regarding the adoption of our Code of Ethics as required by Item 406(a) of Regulation S-K and the table required by Item 201(d) of Regulation S-K, is incorporated by reference to Axsys’ definitive proxy statement for its 2007 Annual Meeting of Stockholders, or 2007 Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days following the end of Axsys’ fiscal year ended December 31, 2006. If such proxy statement is not so filed, that information will be filed as an amendment to this Form 10-K within 120 days following the end of Axsys’ fiscal year ended December 31, 2006.
Item 10.
Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Except for the information concerning our Code of Ethics, the information required by this item is incorporated by reference from our 2007 Proxy Statement.
Code of Ethics
Axsys adopted a code of ethics applicable to our Chief Executive Officer and Chief Financial Officer, which is a “code of ethics” as defined by applicable rules of the Securities and Exchange Commission. This code of ethics is publicly available on our website, www.axsys.com. The information on our website is not part of this annual report. If we make any amendments to this code of ethics other than technical, administrative, or other non-substantive amendments, or grant any waivers, including implicit waivers, from a provision of this code of ethics to our Chief Executive Officer or Chief Financial Officer, we will disclose the nature of the amendment or waiver, the effective date and to whom it applies in a report on Form 8-K filed with the Securities and Exchange Commission.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from our 2007 Proxy Statement
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Except for the information concerning equity compensation plans, the information required by this item is incorporated by reference from our 2007 Proxy Statement under the caption, “Securities Ownership of Directors and Officers.” The following table gives information about our equity securities that may be issued under equity compensation plans as of December 31, 2006. Those securities are shares of common stock that can be issued under our existing Long-Term Stock Incentive Plan.
Equity Compensation Plan Information
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is incorporated by reference from our 2007 Proxy Statement.
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference from our 2007 Proxy Statement.
PART IV
Item 15.
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements
See accompanying index to consolidated financial statements and schedule on page of this annual report.
(a)(2) Financial Statement Schedules
See accompanying index to consolidated financial statements and schedule on page of this annual report.
(a)(3) Exhibits
10.2
Severance Protection Agreement between Axsys and Stephen W. Bershad dated as of February 11, 1999 (filed as Exhibit 10(1) to Axsys’ Form 10-Q, dated May 11, 1999, for the fiscal quarter ended March 31, 1999 (File No. 000-16182) and incorporated herein by reference).*
10.3
Amendment to Axsys Technologies, Inc. Long-Term Stock Incentive Plan (filed as Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 (File No. 000-16182) and incorporated herein by reference).*
10.4
Employment Agreement, dated as of October 12, 2000, between Axsys and Stephen W. Bershad (filed as Exhibit 10(27) to the December 31, 2000 Form 10-K (File No. 000-16182) and incorporated herein by reference). *
10.5
Form of Indemnification Agreement for all Directors and Officers of Axsys (filed as Exhibit 10(17) to the December 31, 2001 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.6
Letter Agreement between David A. Almeida and Axsys dated as of November 14, 2001 (filed as Exhibit 10(18) to the December 31, 2001 Form 10-K (File No. 000-16182) and incorporated herein by reference). *
10.7
Severance Protection Agreement between Axsys and David A. Almeida dated as of May 13, 2003 (filed as Exhibit 10.2 to the June 28, 2003 Form 10-Q (File No. 000-16182) and incorporated herein by reference).*
10.8
Severance Protection Agreement between Axsys and Scott B. Conner dated as of December 3, 2004 (filed as Exhibit 10.9 to the December 31, 2004 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.9
Summary of Management Incentive Plan. (filed as Exhibit 10.10 to the December 31, 2004 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.10
Purchase and Sale Agreement dated February 15, 2006 (filed as Exhibit 99.1 to Axsys’ Form 8-K filed on February 16, 2006 (File No. 000-16182) and incorporated herein by reference).
10.11
Letter Agreement between Stephen W. Bershad and Axsys Technologies, Inc. extending the term of the initial period of Mr. Bershad’s Employment Agreement (filed as Exhibit 10.1 to Axsys’ Form 8-K, filed August 8, 2006 (File No. 000-16182) and incorporated herein by reference).
10.12
Amended and Restated Long-Term Stock Incentive Plan (filed as Exhibit 10.1 to Axsys’ Form 8-K, filed May 5, 2006 (File No. 000-16182) and incorporated herein by reference).
10.13
Credit Agreement, dated May 2, 2005, by and among Axsys, its subsidiaries and Fleet National Bank (filed as Exhibit 10.1 to Axsys’ Form 10-Q, filed July 26, 2005 (File No. 000-16182) and incorporated herein by reference.)
Subsidiaries of the Registrant
Consent of Ernst & Young LLP
31.1
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Executive Officer
31.2
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Financial Officer
32.1
Certification pursuant to 18 U.S.C. Section 1350-Chief Executive Officer
32.2
Certification pursuant to 18 U.S.C. Section 1350-Chief Financial Officer
* Indicates management contracts or compensatory plans or arrangements.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated this the 21st day of February 2007.
/s/ STEPHEN W. BERSHAD
Chairman of the Board of Directors and Chief Executive Officer
Stephen W. Bershad
(Principal Executive Officer)
/s/ DAVID A. ALMEIDA
Vice President, Chief Financial Officer, Treasurer
David A. Almeida
(Principal Financial and Accounting Officer)
/s/ ANTHONY J. FIORELLI, Jr.
Director
Anthony J. Fiorelli, Jr.
/s/ ELIOT M. FRIED
Director
Eliot M. Fried
/s/ RICHARD F. HAMM, Jr.
Director
Richard F. Hamm, Jr.
/s/ ROBERT G. STEVENS
Director
Robert G. Stevens
ANNUAL REPORT ON FORM 10-K
ITEM 8, ITEM 15(a)(1) and (2)
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE
FINANCIAL STATEMENTS
YEAR ENDED DECEMBER 31, 2006
AXSYS TECHNOLOGIES, INC.
AXSYS TECHNOLOGIES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE
The following consolidated financial statements of Axsys Technologies, Inc. are included in Item 8:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets-December 31, 2006 and 2005
Consolidated Statements of Operations-For the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows-For the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)-For the years ended December 31, 2006, 2005 and 2004
Notes to the consolidated financial statements
The following consolidated financial statement schedule of Axsys Technologies, Inc. is included in Item 15(a)(2):
Schedule II-Valuation and qualifying accounts
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders of
Axsys Technologies, Inc.
We have audited the accompanying consolidated balance sheets of Axsys Technologies, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Axsys Technologies, Inc. and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 9 to the consolidated financial statements, effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Axsys Technologies, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 16, 2007, expressed an unqualified opinion thereon.
ERNST & YOUNG LLP
Hartford, Connecticut
February 16, 2007
AXSYS TECHNOLOGIES, INC.
Consolidated Balance Sheets
(Dollars in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
AXSYS TECHNOLOGIES, INC.
Consolidated Statements of Operations
(Dollars in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
AXSYS TECHNOLOGIES, INC.
Consolidated Statements of Cash Flows
(Dollars in thousands)
See accompanying notes to consolidated financial statements.
AXSYS TECHNOLOGIES, INC.
Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)
(Dollars in thousands)
See accompanying notes to consolidated financial statements.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share and per share data)
December 31,
Note 1-Summary of Significant Accounting Policies
Business overview. The accompanying consolidated financial statements include the accounts of Axsys Technologies, Inc. and its wholly-owned subsidiaries (collectively “Axsys”, “Company”, “we”, “our” or “us”).
Axsys is a leading designer and manufacturer of precision optical solutions for defense, aerospace, homeland security and high-performance commercial applications. These sophisticated solutions are typically found in applications that demand the finest optical surfaces, highest accuracy and tightest motion control tolerances. In addition to optical solutions, we distribute precision ball bearings used in a variety of industrial and commercial applications.
Principles of consolidation. The consolidated financial statements include the results of Axsys and its wholly-owned subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.
Revenue recognition. Revenue is recognized in accordance with the Securities and Exchange Commission Staff Accounting Bulletin, or SAB, No. 104. SAB No. 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Shipping and handling costs, such as freight to customers, are classified in cost of sales.
Our policy is to recognize revenues when product is either shipped to or received by the customer based on the terms of the specific sale. However, certain long-term contracts are accounted for under the percentage-of-completion model. Revenues and estimated gross profit are recognized as work is performed based on the percentage that incurred costs bear to estimated total costs. Cost estimates include direct and indirect costs such as labor, materials and overhead. These contracts require judgment relative to assessing risks, estimating, and making assumptions for schedule and technical issues. Contract changes are included when the costs can be reasonably estimated. We may receive progress payments that exceed costs incurred on these long-term contracts. Such advances are recognized as billings in excess of costs and are included in accrued expenses and other current liabilities on our consolidated balance sheet. When incurred costs exceed progress payments received, the net of costs in excess of billings are included in accounts receivable on our consolidated balance sheet.
Certain contracts are accounted for under the service contract model. Under these contracts, revenues are deferred and recognized on a straight-line basis over the contract period, as services are performed.
Due to the build-to-order nature of our products, except for the distribution of ball bearings, we do not offer price protection and generally do not offer discounts. To the extent discounts are offered, they are reflected at the time of the sale as a reduction in revenues. The price is fixed upon acceptance of the purchase order. When customer change orders occur, any pricing changes are reflected in a revised purchase order.
Provisions for estimated losses on contracts are recognized when losses become evident. These estimates are subject to change and could result in adjustments to contracts in progress.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 1-Summary of Significant Accounting Policies (Continued)
Cash and cash equivalents. Cash and cash equivalents include highly liquid investments with a maturity of three months or less at the date of purchase.
Financial instruments. We may use derivative instruments, in the form of forward exchange contracts and interest rate swap agreements, to manage certain foreign currency and interest rate exposures. We view derivative instruments as risk management tools, and we do not use them for trading or speculative purposes. Derivatives used for hedging purposes are designated as an effective hedge of the identified risk exposure at the inception of the contract. Accordingly, changes in fair value of the derivative contract must be highly correlated with changes in the fair value of the underlying hedged item at inception of the hedge and over the life of the hedge contract.
All derivative instruments are recorded in the balance sheet at fair value. Derivatives used to hedge forecasted cash flows associated with foreign currency sales and interest rate fluctuations are accounted for as cash flow hedges. Gains and losses on derivatives designated as cash flow hedges are recognized in accumulated other comprehensive income (loss) and in earnings in a manner that matches the timing of the earnings impact of the hedged transactions. The ineffective portion of all hedges, if any, is recognized currently in earnings. At December 31, 2006, we did not have any forward exchange contracts or interest rate swap agreements outstanding. At December 31, 2005, we had one forward exchange contract outstanding with a total gain position of $3, which was included in other current assets. We did not have any interest rate swap agreements outstanding at December 31, 2006 or 2005.
The table below presents the fair value of those derivative instruments at December 31:
The carrying amounts of our other financial instruments, which include cash equivalents, accounts receivable and accounts payable approximate their fair value due to the short-term nature of such instruments.
Accounts receivable. Receivables consist of amounts billed and currently due from customers, and unbilled costs and accrued profits primarily related to revenues on long-term contracts that have been recognized for accounting purposes but not yet billed to customers. Credit is extended to customers, typically on net 30-day terms. We do not require collateral.
Allowance for doubtful accounts. We periodically review the aging of our accounts receivable over 90 days to identify potentially uncollectible accounts and establish reserves based on experience and discussion with customers. Actual write-offs could differ from our allowance for doubtful accounts. If circumstances change (for example, higher than expected defaults or an unexpected materially adverse change in a customer’s ability to meet its financial obligations), our estimates of recoverability of amounts due to us, could be reduced by a material amount. Accounts receivable are written off only when all reasonable collection efforts are exhausted.
Inventory. We value our inventory at the lower of the actual cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory with cost generally determined using the
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 1-Summary of Significant Accounting Policies (Continued)
first in, first out method. A provision for excess or obsolete inventory is recorded based upon an analysis that considers current inventory levels, historical usage patterns and future sales expectations.
In November 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 151, “Inventory Costs”, or SFAS 151, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS 151 requires that those amounts, if abnormal, be recognized as expenses in the period incurred. In addition, SFAS 151 requires the allocation of fixed production overheads to the cost of conversion based upon the normal capacity of the production facilities. We adopted SFAS 151 on January 1, 2006. The adoption did not have a material impact on our earnings or financial position.
Property, plant and equipment. Property, plant and equipment are stated at cost, less accumulated depreciation and amortization, which includes the depreciation of assets recognized under capital leases. Depreciation is provided primarily by the straight-line method using estimated lives for buildings and improvements of 20 to 40 years and from 3 to 8 years for machinery and equipment. Repair and maintenance costs are expensed as incurred.
Goodwill and other intangibles. Goodwill (representing the excess of the amount paid to acquire a company over the estimated fair value of the net assets acquired) and intangible assets with indefinite useful lives are not amortized but instead are tested for impairment annually, or when events or circumstances indicate that its value may have declined. Impairment exists when the carrying amount of goodwill exceeds its fair market value. The Company’s goodwill impairment test is performed by comparing the net present value of projected cash flows to the carrying value of the reporting unit. The Company utilizes discount rates determined by management to be similar with the level of risk in its current business model. The Company performs the annual impairment testing during the second quarter of each fiscal year and has determined that, to date, no impairment of goodwill exists. Although no changes are expected, if the actual results of the Company are less favorable than the assumptions the Company makes regarding estimated cash flows, the Company may be required to record an impairment charge in the future.
Definite-lived intangible assets acquired as part of business combinations are amortized over their estimated useful lives. For material business combinations, amounts recognized related to purchased intangibles are determined with the assistance of independent valuations.
Commitments and contingencies. We are self-insured for certain losses related to general liability, workers’ compensation and medical claims. Our liability represents an estimate of the ultimate cost of claims incurred as of the balance sheet date. The estimated liability is established based on an analysis of historical data and is reviewed by management on a quarterly basis to ensure that the liability is appropriate. While we believe that our estimates are reasonable based on the information currently available, if actual trends, including the severity and frequency of claims, medical cost inflation or fluctuations in premiums, differ from our estimates, our results from operations could be impacted.
Deferred income. Deferred income primarily results from the advance billings to our customers for milestone payments for either progress billings or for material billings. Material billings primarily occur when customers advance us the cost of beryllium on long lead-time orders.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 1-Summary of Significant Accounting Policies (Continued)
Warranty. We provide warranties for certain of our products. Provisions for estimated expenses related to product warranties are made at the time products are sold. These estimates are established using historical information on the nature, frequency, and average cost of warranty claims.
The following table summarizes product warranty activity:
Loss contract reserves. Generally, our customer contracts are completed within one year of receiving the order. However, occasionally, longer lead-time orders are received and we monitor these contracts periodically to determine if our actual costs are comparable to our cost estimates used at the time of order acceptance. If we determine that our actual costs are exceeding our original estimates, we will record a loss contract reserve. Currently, one contract is covered by a loss contract reserve. We accrued for this contract based on the contract price and the current cost structure, including estimated cost increases.
Environmental contingencies. We are currently involved in three environmental remediation projects. We accrue for environmental contingencies when (1) responsibility for cleanup is determined and (2) costs are probable and can be reasonably estimated. When costs are not probable or cannot be reasonably estimated, no accrual is made. We have accrued our estimate of the costs for the resolution of the open claims. These estimates have been developed in consultation with outside environmental consultants handling these matters and are based upon an analysis of the anticipated remediation plans. We do not anticipate these projects will have a material adverse effect on our consolidated financial position. It is possible, however, that future results of operations could be materially affected by changes in our assumptions.
Research, development and engineering. Significant costs are incurred each year in connection with research and development programs and administrative engineering costs, or R&D. Such costs are included in operating expenses as incurred. In situations where the customer reimburses the cost of the R&D effort, the revenue generated is recognized as sales and the expense is included in cost of sales. Research and development expenses, exclusive of engineering costs, were $2,987 in 2006, $2,730 in 2005 and $1,571 in 2004.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 1-Summary of Significant Accounting Policies (Continued)
Share-based compensation. During the first quarter of 2006, Axsys adopted Statement No. 123(R), “Share Based Payment”, or SFAS 123(R). Prior to 2006, we accounted for stock awards under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, or APB 25, and related interpretations. Prior to 2006, generally no compensation expense was recognized for stock options granted to employees because all stock options granted generally had exercise prices equal to the market price of the underlying common stock on the date of the grant. However, during 2004, we modified the stock option grants of a former officer upon his termination from Axsys, which resulted in compensation expense of $242.
SFAS 123(R) requires all share-based payments, including grants of stock options, to be recognized in the Consolidated Statement of Operations as an operating expense, based on their fair values on the grant date, over the requisite service period. We elected to adopt SFAS 123(R) under the modified-prospective transition method. Prior period stock option financial information was valued using the Black-Scholes-Merton option pricing model. Axsys was not required to restate prior periods. Under this transition method, share-based compensation expense for the year ended December 31, 2006 includes:
(a) Compensation expense for all stock option awards granted prior to, but not vested as of, December 31, 2006 based on the fair value estimated at grant date in accordance with the original provisions of Statement No. 123, “Accounting for Stock-Based Compensation”;
(b) Compensation expense for all stock option awards granted subsequent to January 1, 2006, based on the fair value estimated at grant date in accordance with SFAS 123(R); and
(c) Compensation expense for all restricted stock awards in accordance with the provisions of SFAS 123(R).
Compensation expense for share-based awards is recognized in the Consolidated Statement of Operations in cost of sales and general and administrative expenses. Total pre-tax share-based compensation expense was $1,093 in 2006, $0 in 2005 and $242 in 2004.
We recognize compensation expense, net of an estimated forfeiture rate, on a straight-line basis over the requisite service period of the award. The estimated forfeiture rate was based on historical experience. We applied the forfeiture rate in calculating the expense related to stock-based compensation for both the stock option awards granted prior to, but not vested as of, December 31, 2005, as well as stock option awards granted subsequent to December 31, 2005. Per the provisions of SFAS 123(R), expense is recognized only for those awards expected to fully vest. If actual forfeitures differ from the estimates, a revision to the forfeiture rate will be necessary.
Prior to adopting SFAS 123(R), we presented all tax benefits resulting from the exercise of stock options as operating cash flows in the Consolidated Statement of Cash Flows. SFAS 123(R) requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow. As a result of adopting SFAS 123(R), $59 of excess tax benefits for the year ended December 31, 2006 have been classified as a financing cash inflow.
Income taxes. We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes”. As such, deferred income taxes are determined based on the differences between the financial statement and tax basis of assets and liabilities at enacted income tax rates in effect in the year in
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 1-Summary of Significant Accounting Policies (Continued)
which the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce deferred income tax assets to estimated amounts expected to be realized. Realizability of net deferred income tax assets are evaluated on an ongoing basis. We consider future taxable income, our most recent operating results and various income tax planning strategies in assessing the need for a valuation allowance.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, or FIN 48, which prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return (including a decision whether to file or not file a return in a particular jurisdiction). Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities’ full knowledge of the position and all relevant facts, but without considering time values. FIN 48 substantially changes the applicable accounting model and is likely to cause greater volatility in income statements as more items are recognized discretely within income tax expense. FIN 48 also revises disclosure requirements and introduces a prescriptive, annual tabular roll-forward of the unrecognized tax benefits. FIN 48 must be adopted no later than January 1, 2007. Early adoption is permitted. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial position and results of operations and expect to adopt FIN 48 effective January 1, 2007.
Earnings per share. Basic earnings per share have been computed by dividing net income or loss by the weighted-average number of common shares outstanding. The dilutive effect of stock options on the weighted-average number of common shares outstanding was 259,847 shares for the year ended December 31, 2006, 349,371 shares for the year ended December 31, 2005 and 269,253 shares for the year ended December 31, 2004.
Diluted earnings per share for 2006 and 2005 exclude 244,160 and 131,538, respectively, potential common shares related to our stock compensation plans because they were anti-dilutive. There were no anti-dilutive common shares related to our stock compensation plans in 2004.
Estimates and assumptions. The preparation of financial statements in conformity with generally accepted accounting principles 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.
Certain amounts in previously issued annual financial statements were reclassified to conform to the 2006 presentation.
Note 2-Acquisitions
On May 2, 2005, Axsys acquired all of the capital stock of Diversified Optical Products, Inc., or DiOP, a manufacturer of high-end thermal camera systems and lenses, for $55,200 in cash plus $1,900 of legal, audit and other acquisition-related costs incurred in connection with the acquisition. Goodwill of $45,218 resulted from this acquisition.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 2-Acquisitions (Continued)
On April 8, 2004, we acquired all of the capital stock of Telic Optics, Inc. , or Telic, a manufacturer of infrared optics and optical assemblies. The initial purchase price of this acquisition, after a working capital adjustment of $15, was $14,423 with an additional earn out payment of up to $4,000 over 36 months following the closing date based on the achievement of certain revenue goals. Of this additional earn out payment, $1,183 was earned in 2006 and will be paid out in 2007 and $2,817 was earned in 2005 and was paid in 2006. This has resulted in a final purchase price of $18,423 at December 31, 2006.
Note 3-Balance Sheet Information
The details of certain balance sheet accounts are as follows:
All of the December 31, 2006 unbilled costs and accrued profits are expected to be billed in 2007.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 3-Balance Sheet Information (Continued)
Note 4-Goodwill and Intangible Assets
Goodwill increased during 2004, 2005 and 2006 as follows:
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 4-Goodwill and Intangible Assets (Continued)
The components of amortizable intangible assets are as follows:
Amortization expense of $954 in 2006, $816 in 2005 and $73 in 2004 was included in selling, general and administrative expenses. Estimated amortization expense for each of the five succeeding years is as follows:
Note 5-Long-Term Debt
Financing Activities: During the year ended December 31, 2006, we borrowed and subsequently repaid $8,000 from our revolving credit facility. We paid a weighted-average interest rate of 6.3% on the borrowings. As of December 31, 2006, there were no borrowings outstanding under the revolving credit facility. However, as of December 31, 2006, $1,060 of the revolving credit facility was utilized for outstanding letters of credit.
2005 Financing Activities: On May 2, 2005, we entered into a credit facility with Fleet Bank in conjunction with the acquisition of DiOP. The credit facility included a $20,000 five-year term loan facility, or term loan A, a $35,000 two-year term loan facility, or term loan B, and a $15,000 three-year revolving credit facility. On September 27, 2005, we prepaid the two term loans in full and terminated the related interest rate swap. We continue to maintain the revolving credit facility. Amounts borrowed under the credit facility were secured by a lien on all of our assets and the assets of our subsidiaries, including a pledge of the stock of all of our subsidiaries.
In conjunction with our prepayment of the principal and accrued interest on the $20,000 term loan A and the $35,000 term loan B during 2005, we incurred a charge of $421 for the loss on extinguishment of debt related to the write off of loan origination fees and $59 for the early termination of the related interest rate swap agreement.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 5-Long-Term Debt (Continued)
The $15,000 revolving credit facility remains available through May 2008, subject to optional prepayment in accordance with its terms. Up to $2,000 of the revolving credit facility may be utilized to issue letters of credit. We may elect to have any borrowing under the revolving credit facility bear interest either at the bank’s prime rate or the LIBOR rate plus a margin of 100 to 275 basis points, depending on our consolidated funded debt-to-consolidated EBITDA ratio. We have the option of selecting the 1-month, 2-month, 3-month or 6-month LIBOR rate. On December 31, 2005, there were no borrowings outstanding under the revolving credit facility. However, as of December 31, 2005, $1,007 of the revolving credit facility was utilized for outstanding letters of credit.
Note 6-Environmental Contingencies
We are currently involved in two environmental remediation projects and a third site, which is in the final stage of monitoring. We accrue for environmental contingencies on an undiscounted basis when responsibility for clean up is determined and costs, including legal fees, are probable and can be reasonably estimated. We are the primary responsible party, or PRP, at sites located in Bedford, Ohio and St. Petersburg, Florida. Pursuant to remediation plans approved by each state’s environmental protection agency, we investigated soils and groundwater and conducted certain remedial work, including soil removal. The clean up of each site is currently in process. We have incurred costs of $107 in 2006 and approximately $1,799 to date related to these sites. During 2006, we recognized a charge of $202, net of tax of $109, in discontinued operations related to future costs associated with these sites. We anticipate remediation costs for theses sites to continue through 2011, including estimated expenditures of $120 in 2007.
As of December 31, 2006, we have an accrual of $666 for future costs related to the Ohio and Florida sites. These estimates have been developed in consultation with outside environmental and legal consultants handling these matters and are based upon an analysis of the anticipated remediation plans. We do not anticipate these matters will have a material adverse effect on our consolidated financial position. It is possible, however, that future results of operations could be materially affected by changes in our assumptions.
In addition, in 2001, we were notified by the United States Environmental Protection Agency, or the EPA, that it considered us a PRP for the US Cap and Jacket site in Prospect, Connecticut. The EPA designated no other PRPs. The EPA informed us that it was prepared to commence a CERCLA cost-recovery action against us if we were unable to amicably resolve the matter. On July 18, 2005, we signed a settlement agreement with the EPA, settling this matter for $175, plus accrued interest from this date through the date of payment. We have no further responsibility to the EPA as it relates to the EPA’s 2001 removal action at this site. During 2005, we recognized an after tax charge of $150 in discontinued operations for the settlement costs and legal expenses associated with the settlement of this matter.
Note 7-Litigation
During 2004, we settled an action, which was filed in the Court of Chancery in the State of Delaware on May 30, 1997, against us and three of our directors on behalf of a purported class of persons who purchased our preferred stock. The plaintiff challenged our decision to redeem all of our outstanding shares of the preferred stock. The plaintiff claimed that the defendants (1) breached fiduciary duties in
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 7-Litigation (Continued)
setting the redemption price too low and unfairly seeking to advantage holders of common stock and (2) breached contractual duties as set forth in the Certificate of Designation governing the preferred stock, as well as an implied covenant of good faith and fair dealing. In 2004, we paid $201 to settle this claim and reflected the charge as a reduction to paid-in-capital in 2003. During the first quarter of 2005, the settlement fund was closed and $76 of unpaid claims was returned to us. The cash received is reflected as an increase to paid-in-capital in 2005.
Note 8-Shareholders’ Equity
Public Stock Offering: On September 27, 2005, Axsys issued and sold 3,450,000 shares of common stock at the public offering price of $18.00 per share. We received net proceeds of $57,620 from the offering after payment of underwriting discounts and commissions.
Stock Repurchase: In May 2004, our Board of Directors authorized the repurchase, from time to time, on the open market or otherwise, of up to 200,000 shares of the Axsys common stock at prevailing market prices or at negotiated prices. We plan to use the repurchased shares for general corporate purposes, including the satisfaction of commitments under our employee benefit plans and the exercise of stock option grants. As of December 31, 2006, we repurchased 77 shares under this authorization.
Stock Split: The Board of Directors declared, on June 1, 2004, a 3:2 stock split to be effected as a stock dividend payable on June 30, 2004 to stockholders of record on June 15, 2004. Stockholders received a dividend of one additional share of Axsys $0.01 par value common stock for every two shares owned on the record date. Fractional shares were not issued; rather cash payments were made to shareholders in lieu of fractional shares on June 30, 2004. The cash paid for fractional shares was de-minimus.In conjunction with the stock split, we issued an additional 2,395,578 shares resulting in a total of 7,186,734 issued shares of Axsys $0.01 par value stock on June 30, 2004. We reclassified an amount equal to the par value of the number of shares issued to common stock from retained earnings. All share information, including the basic and diluted weighted-average number of shares and net income per share information, for all reporting periods has been restated retroactively to reflect the effects of the stock split.
Paid in Capital: During 2004, we recognized $242 of compensation expense related to the modification of certain existing stock options, pursuant to the terms of a severance arrangement.
Treasury Stock: We use treasury stock shares for general corporate purposes, including the satisfaction of commitments under the employee benefit plans and the exercise of stock options. During 2006, we received 12,444 shares of Axsys common stock as payment in lieu of cash for the exercise of incentive stock options.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 8-Shareholders’ Equity (Continued)
Changes in treasury stock were as follows:
Common Stock: Shares of common stock authorized and issued were 10,643,934 at the end of 2006 and 10,636,734 at the end of 2005. Changes in common stock were as follows:
Note 9-Share-Based Compensation
Our Amended and Restated Long-Term Stock Incentive Plan (“Stock Incentive Plan”), as approved by our stockholders, is administered by the Compensation Committee of the Board of Directors, which selects persons eligible to receive awards and determines the number of shares subject to each award and the terms, conditions, performance measures and other provisions of each award.
Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment”, or SFAS 123(R), utilizing the modified prospective approach. As a result of adopting SFAS 123(R) on January 1, 2006, our income before taxes, income from continuing operations, net income and basic and diluted earnings per share for the year ended December 31, 2006 were $1,093, $689, $689, $0.06 and $0.06 lower, respectively, than if we had continued to account for share-based compensation under APB No. 25 for our stock option grants.
Net cash proceeds from the exercise of stock options were $140 and the tax benefit realized from stock option exercises was $59 for the year ended December 31, 2006. Common stock issued in conjunction with
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 9-Share-Based Compensation (Continued)
share-based awards is issued from our treasury stock. If we do not have a sufficient number of treasury stock shares available, new shares of common stock are issued.
The following table illustrates the effect on operating results and per share information as if Axsys had accounted for share-based compensation in accordance with SFAS 123(R) for all periods presented:
We used the Black-Scholes-Merton option-pricing model to estimate the fair value of share-based awards with the following weighted-average assumptions for the indicated periods:
The assumptions above are based on multiple factors, including historical patterns by employees in relatively homogeneous groups with respect to exercise and post-vesting employment termination behaviors, expected future exercising patterns for these same homogeneous groups and the volatility of our stock price. The volatility assumption used in the Black-Scholes-Merton pricing model uses historical changes in the market value of Axsys common stock over a period of five years, which we believe represents the future volatility of our common stock. The expected life represents the weighted average period of time that stock options are expected to remain outstanding and is based on historical experience. Stock options are generally granted with a five-year vesting schedule and a ten-year life.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 9-Share-Based Compensation (Continued)
The following table presents stock option activity for the years ended December 31, 2006, 2005 and 2004:
At December 31, 2006, there was $2,149 of unrecognized compensation cost related to share-based payments, which is expected to be recognized over a weighted-average period of 1.7 years. We recognize compensation expense, net of an estimated forfeiture rate, on a straight-line basis over the requisite service period of the award.
Shares available for future share-based grants to employees and directors under existing plans were 220,902 at December 31, 2006. At December 31, 2006, the aggregate intrinsic value of options outstanding was $5,851, and the aggregate intrinsic value of options exercisable was $3,927. The total intrinsic value of
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 9-Share-Based Compensation (Continued)
options exercised was $218 for the year ended December 31, 2006. The total intrinsic value of options vested was $1,194 for the year ended December 31, 2006.
Of the total stock options outstanding as of December 31, 2006, 511,383 are fully vested. The weighted average exercise price of these options is $10.26, and the aggregate intrinsic value is $3,927 with a weighted-average contractual term of 5.4 years.
Restricted Stock
Our Stock Incentive Plan allows for the issuance of restricted stock awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned share-based compensation related to these awards is amortized to compensation expense over the period the restrictions lapse (generally five years). The share-based expense for these awards is determined based on the market price of our stock at the date of grant applied to the total numbers of shares that are anticipated to fully vest, which is then amortized over the vesting period. Axsys first issued restricted stock during 2006.
The following table presents the restricted stock activity for the year ended December 31, 2006:
As of December 31, 2006, we had unamortized compensation expense of $936 associated with these awards, which will be amortized over the weighted-average remaining life of 3.9 years.
Note 10-Supplemental Cash Flow Information
Supplemental cash flow information from continuing operations for the years ended December 31, 2006, 2005 and 2004 is summarized as follows:
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 11-Income Taxes
The income tax provision (benefit) from continuing operations consists of:
In 2004, the deferred federal and state income tax benefit reflected the utilization of a valuation allowance.
The difference between the provision (benefit) for income taxes and the amount computed by applying the statutory federal income tax rate to Income from Continuing Operations Before Income Taxes is as follows:
We reduced the previously recorded valuation allowance of $3,236 in 2004 as deferred income tax assets were realized. As of December 31, 2006 and 2005, we have determined that a valuation allowance was not required as it is more likely than not that the net deferred income tax assets will be realized in the future.
At December 31, 2006, we had reserves totaling $4,103, primarily for various state income tax issues.
Deferred income taxes reflect the net federal and state tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 11-Income Taxes (Continued)
Significant components of deferred income taxes are as follows:
Deferred income taxes are included in the Consolidated Balance Sheets as follows:
Note 12-Pension Arrangements (Continued)
As of December 31, 2006, we had one pension plan for which benefits and participation have been frozen. The plan, which has an accrued benefit cost of $407 at December 31, 2006, is an unfunded plan with an annual payout of approximately $104 until such time as the sole participant becomes ineligible.
We also sponsor a 401(k) plan under which eligible employees may elect to contribute a percentage of their earnings. We match employee contributions to this plan in amounts ranging from 3% to 5% of the employees’ gross earnings. Our matching contributions were $1,234 in 2006, $1,118 in 2005 and $918 in 2004, of which a portion was provided in Axsys stock.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 13-Commitments and Contingencies
Future minimum payments under non-cancelable operating leases (exclusive of property expenses and net of sublease rental income) as of December 31, 2006, are as follows:
Rent expense under such leases, net of sublease rental income, amounted to $1,932 in 2006, $1,849 in 2005 and $1,598 in 2004. As of December 31, 2006, we were contingently liable for $1,060 under outstanding letters of credit. We have issued letters of credit for certain business transactions including insurance programs and customer deposits.
Note 14-Discontinued Operations
We recognized an after-tax charge of $202 in 2006, $150 in 2005 and $74 in 2004 related to legal and consulting expenses in conjunction with an environmental clean-up site of a discontinued operation. (See Note 6 of the consolidated financial statements.)
During 2002, Axsys disposed of the Automation Group, which included facilities in Wilmington, Massachusetts and Pittsburgh, Pennsylvania. At the time of the sale, Axsys continued to be responsible for fulfilling the remaining terms of the leases. As of December 31, 2006, we fulfilled all of our contractual obligations related to these sites and we recognized an after-tax gain of $85 during 2006 on the reversal of an accrual associated with the leases. In 2004, we recognized an additional accrual in conjunction with the 2002 sale of the Automation Group. The after-tax charge of $421 represented rental expenses for these two facilities.
The loss from discontinued operations, net of tax, recognized in the consolidated statements of operations includes the following:
We had cash outflows of $292 in 2006, $907 in 2005 and $140 in 2004 related to legal, consulting and lease commitment expenses for our discontinued operations.
Note 15-Segment Data
We are organized into two businesses: the Optical Systems Group and the Distributed Products Group.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 15-Segment Data (Continued)
The Optical Systems Group designs, manufactures and sells highly precise systems, sub-subsystems and components that are typically used in surveillance, long-range observation, tracking and targeting and high-performance imaging applications. Customers include both government and commercial organizations. Our thermal camera systems are typically used for border surveillance, perimeter security and public safety, while sub-systems and components are usually designed for integration into our customers’ high-performance optical systems. Products can be grouped into four primary areas: reflective optical products, infrared products, motion control products and precision optical and mechanical structures. However, customer requirements sometimes demand an optical solution that combines products from several of these areas. Our defense products are often designed to be integrated into stabilized optical platforms, which are highly accurate optical positioning mechanisms. Stabilized optical platforms are essential in applications such as military targeting and imaging systems. The Optical Systems Group has design and manufacturing facilities in San Diego, California, Cullman, Alabama, Rochester Hills, Michigan and Nashua, New Hampshire.
The Distributed Products Group distributes precision ball bearings, spherical plain bearings and bushings, which are acquired from various domestic and international sources, to OEMs and maintenance repair organizations, or MROs. The bearings and bushings are used in a variety of industrial automation and commercial markets. Additionally, the Distributed Products Group designs, manufactures and sells mechanical-bearing subassemblies for a variety of customers. The Distributed Products Group is comprised of the AST Bearings Division located in Montville, New Jersey, with a satellite distribution center in Irvine, California.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 15-Segment Data (Continued)
The following tables present financial data for each segment:
Included in non-allocated expenses are general corporate expense, interest expense, and other income and expense. Identifiable assets by segment consist of those assets that are used in the segment’s operations. Non-allocated assets are comprised primarily of short-term investments, cash and cash equivalents, corporate assets and deferred income tax assets.
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 15-Segment Data (Continued)
The following table presents the non-allocated identifiable assets:
The table below presents sales from continuing operations for specific geographic regions. Substantially all of our assets are located within the United States.
Sales to BAE Systems represented 12.1% of our consolidated sales and 14.6% of sales within the Optical Systems Group in 2006. Sales to Raytheon represented 12.3% of our consolidated sales in 2005 and 18.9% in 2004. Sales to Raytheon also represented 15.2% in 2005 and 25.0% in 2004 of our sales within the Optical Systems Group. BAE Systems also represented 11.1% of our consolidated accounts receivable balance as of December 31, 2006. As of December 31, 2005, no individual customer represented more than 10% of our accounts receivable balance. As of December 31, 2004, Raytheon accounted for 28.9% of our outstanding accounts receivable.
Within our Optical Systems Group, we had aggregate sales, both military and non-military, directly to the U.S. government, including its agencies and departments, of $4,760 in 2006, $4,564 in 2005 and $2,367 in 2004. In addition, sales of $89,568 in 2006, $75,118 in 2005 and $47,574 in 2004 were derived from subcontracts with U.S. government contractors. The majority of these contracts are subject to termination at the convenience of the U.S. government, and certain contracts are also subject to renegotiation. Currently, we are not aware of any proposed termination or renegotiation of such contracts that would have a material adverse effect on our business.
The raw materials and components that we purchase are generally available from multiple suppliers. However, beryllium, a material we use extensively within our Optical Systems Group, is only available from Brush Wellman, Inc., the sole U.S. supplier. Historically, we have had an excellent relationship with Brush Wellman and have not encountered problems in obtaining our supply requirements. However, the partial or complete loss of Brush Wellman as a supplier of beryllium, or production shortfalls or interruptions that otherwise impair the supply of beryllium, would have a material adverse effect on our business, financial
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 15-Segment Data (Continued)
condition and results of operations. If such conditions were to occur, it is uncertain whether alternative sources could be developed. We paid Brush Wellman $5,314 in 2006, $6,500 in 2005 and $9,660 in 2004.
In addition, within our Distributed Products Group, we purchase a substantial amount of ball bearings from two foreign suppliers. While we believe that we could obtain alternate sources of supply, any interruption in the flow of products from these suppliers, or significant increases in the cost of these products, could have an adverse effect on our business, financial condition and results of operations. We paid these two suppliers $6,463 in 2006, $5,820 in 2005 and $6,406 in 2004.
Note 16-Facilities
On April 26, 2006, Axsys purchased a 78,000 square foot building and 10.5 acres of land in Nashua, New Hampshire for $4,000. This facility serves as the consolidated manufacturing facility for our Axsys Technologies IR Systems division, formerly operating at two facilities in New Hampshire and Massachusetts. The relocation and the closure of the two existing facilities were completed in the fourth quarter of 2006. The total pre-tax costs associated with the relocation and facilities closures were approximately $325, with an additional $2,500 of capital expenditures. These costs included equipment relocation, employee training and facility improvements. In addition, we recognized a $106 in expense for the cancellation of the existing Salem facility lease.
Note 17-Related Party
A senior management employee is a major partner in KFN Realty, Inc., the previous landlord for our manufacturing facility in Salem, New Hampshire, which was acquired on May 2, 2005. The current lease expired in December 2006. The aggregate rent paid, including real estate taxes, to the related party amounted to $120 from the date of acquisition through November 26, 2005. KFN Realty sold the building to an unrelated party in November 2005.
Note 18-Selected Quarterly Financial Data (Unaudited)
Selected quarterly financial data for the years ended December 31, 2006 and 2005 is summarized as follows (in thousands, except per share data):
AXSYS TECHNOLOGIES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except share and per share data)
Note 18-Selected Quarterly Financial Data (Unaudited) (Continued)
(1) Diluted net income per share is computed independently for each of the quarters presented. Therefore, the sum of the quarterly amounts may not necessarily equal the total for the year.
(2) In conjunction with our prepayment of the principal and accrued interest on our former credit facility, we incurred a charge of $421 for the loss on extinguishment of debt related to the write-off of loan origination fees and $59 for the early termination of the related interest rate swap agreement in the third quarter of 2005.
AXSYS TECHNOLOGIES, INC.
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(a) Uncollectible accounts written off, net of recoveries.
(b) Relates to adjustments to cost accounting standards, which increased gross inventory as well as inventory reserve.
EXHIBIT INDEX
3.1
Restated Certificate of Incorporation of Axsys (filed as Exhibit 3(4) to Axsys’ Amendment No. 2 to Registration Statement on Form S-1, dated October 17, 1997 (File No. 333-36027) (the “Form S-1”) and incorporated herein by reference).
3.2
By-Laws of Axsys (filed as Exhibit 2 to the Form 8-A dated August 8, 1991(file No. 000-16182) and incorporated herein by reference).
10.1
Form of Incentive Stock Option Agreement, dated as of September 30, 1991 (filed as Exhibit 10(17) to Axsys’ Annual Report on Form 10-K for the fiscal year ended December 30, 1991 (File No. 000-16182)and incorporated herein by reference).*
10.2
Severance Protection Agreement between Axsys and Stephen W. Bershad dated as of February 11, 1999 (filed as Exhibit 10(1) to Axsys’ Form 10-Q, dated May 11, 1999, for the fiscal quarter ended March 31, 1999 (File No. 000-16182) and incorporated herein by reference).*
10.3
Amendment to Axsys Technologies, Inc. Long-Term Stock Incentive Plan (filed as Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 (File No. 000-16182) and incorporated herein by reference).*
10.4
Employment Agreement, dated as of October 12, 2000, between Axsys and Stephen W. Bershad (filed as Exhibit 10(27) to the December 31, 2000 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.5
Form of Indemnification Agreement for all Directors and Officers of Axsys (filed as Exhibit 10(17) to the December 31, 2001 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.6
Letter Agreement between David A. Almeida and Axsys dated as of November 14, 2001 (filed as Exhibit 10(18) to the December 31, 2001 Form 10-K (File No. 000-16182) and incorporated herein by reference). *
10.7
Severance Protection Agreement between Axsys and David A. Almeida dated as of May 13, 2003 (filed as Exhibit 10.2 to the June 28, 2003 Form 10-Q (File No. 000-16182) and incorporated herein by reference).*
10.8
Severance Protection Agreement between Axsys and Scott B. Conner dated as of December 3, 2004 (filed as Exhibit 10.9 to the December 31, 2004 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.9
Summary of Management Incentive Plan. (filed as Exhibit 10.10 to the December 31, 2004 Form 10-K (File No. 000-16182) and incorporated herein by reference).*
10.10
Purchase and Sale Agreement dated February 15, 2006 (filed as Exhibit 99.1 to Axsys’ Form 8-K filed on February 16, 2006 (File No. 000-16182) and incorporated herein by reference).
10.11
Letter Agreement between Stephen W. Bershad and Axsys Technologies, Inc. extending the term of the initial period of Mr. Bershad’s Employment Agreement (filed as Exhibit 10.1 to Axsys’ Form 8-K, filed August 8, 2006 (File No. 000-16182) and incorporated herein by reference).
10.12
Amended and Restated Long-Term Stock Incentive Plan (filed as Exhibit 10.1 to Axsys’ Form 8-K, filed May 5, 2006 (File no. 000-16182) and incorporated herein by reference).
10.13
Credit Agreement, dated May 2, 2005, by and among Axsys, its subsidiaries and Fleet National Bank (filed as Exhibit 10.1 to Axsys’ Form 10-Q, filed July 26, 2005 (File No. 000-16182) and incorporated herein by reference.)
Subsidiaries of the Registrant
Consent of Ernst & Young LLP
31.1
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Executive Officer
31.2
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Financial Officer
32.1
Certification pursuant to 18 U.S.C. Section 1350-Chief Executive Officer
32.2
Certification pursuant to 18 U.S.C. Section 1350-Chief Financial Officer
* Indicates management contracts or compensatory plans or arrangements.