-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, TiAEvVGgFJaWt7g4k6KkECGH+4C3jzKaeu8NRke/CRJ2b2euxB9ZbfXVUFG7ZA7Y J3zqxYTdCvBJz9UzrzWYpw== 0000352956-98-000004.txt : 19980331 0000352956-98-000004.hdr.sgml : 19980331 ACCESSION NUMBER: 0000352956-98-000004 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980330 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: FAFCO INC CENTRAL INDEX KEY: 0000352956 STANDARD INDUSTRIAL CLASSIFICATION: HEATING EQUIPMENT, EXCEPT ELECTRIC & WARM AIR FURNACES [3433] IRS NUMBER: 942159547 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-10120 FILM NUMBER: 98577284 BUSINESS ADDRESS: STREET 1: 2690 MIDDLEFIELD RD CITY: REDWOOD CITY STATE: CA ZIP: 94063 BUSINESS PHONE: 4153632690 MAIL ADDRESS: STREET 1: 2690 MIDDLEFIELD ROAD CITY: REDWOOD CITY STATE: CA ZIP: 94063 10-K 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 1997 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ________________ to _______________. Commission file number 0-10120 FAFCO, Inc. (Exact name of registrant as specified in its charter) California 94-2159547 (State or other jurisdiction of incorporation or organization) (IRS Employer Identification No.) 2690 Middlefield Road, Redwood City, California 94063 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 650/363-2690 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.125 par value (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____ Indicate by check mark if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X ] The aggregate market value of the registrant's. Common Stock held by non-affiliates of the registrant as of __ _ __was , based upon the average of the bid and ask prices reported for such date by the National Quotation Bureau. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 5% of the outstanding shares of Common Stock and shares held by executive officers and directors of the registrant have been excluded in that such persons may be deemed to be "affiliates" as that term is defined under the rules and regulations promulgated under the Securities Act of 1933. This determination is not necessarily conclusive for other purposes. The number of shares of the registrant's Common Stock outstanding as of December 31, 1997, was 3,298,311. Documents Incorporated by Reference Document Description Form 10-K Part Portions of Exhibit 13.1 (the Company's 1997 Annual Report to Shareholders (the "Annual Report") ................................................................. ................................I, II, IV The Company's Definitive Proxy Statement (the "Proxy Statement") for the 1998 Annual Meeting of Stockholders to be held on May 14, 1998 (the Proxy Statement is expected to be filed pursuant to Regulation 14A on or before April 30, 1998) .................... III _____________________________ With the exception of the information specifically incorporated by reference in Parts I, II, III and IV of this Form 10-K, neither the Company's Annual Report nor the Company's Proxy Statement is to be deemed filed as part of this report. PART I Item 1. Business Introduction FAFCO, Inc. ("FAFCO," the "Company" or "Registrant") designs, develops, manufactures, and markets solar heating systems for swimming pools and thermal energy storage systems for commercial and industrial cooling. Pool product sales amounted to 56% of net sales in 1997 compared to 58% of net sales in 1996 and 62% of net sales in 1995. Thermal energy storage sales amounted to 44% of net sales in 1997 compared to 42% of net sales in 1996 and 38% of net sales in 1995. The Company manufactures products for the solar heating of water for low and medium temperature applications. From the inception of the Company's predecessor as a sole proprietorship in 1969 until 1976, efforts were largely devoted to the refinement of the Company's initial product, a solar heating system for swimming pools - a low temperature solar application. Since that time, the Company has focused on increasing its share of the pool heating market by extending its network of independent distributors, decreasing its manufacturing costs, and improving its initial product. In 1983, a passive domestic hot water heating system, the 444, was introduced (this product was discontinued in early 1994). In 1987, the Company introduced a thermal energy storage system based on the same heat exchanger technology as is used in its swimming pool heating systems. In 1993, the Company introduced a state-of-the-art control system for swimming pool solar heating systems (this product was discontinued in December 1996). FAFCO, Inc. was incorporated under the laws of the State of California in 1972. Its principal executive offices are located at 2690 Middlefield Road, Redwood City, California. Its telephone number at that address is (650) 363-2690. Safe Harbor Language for Form 10-K This Annual Report of Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth on page 19 of the Annual Report under the heading "Factors Affecting Future Results" and elsewhere in this Form 10-K. Markets Swimming Pool Heating Low temperature solar applications developed because of the cost effectiveness of solar systems in heating a large volume of water to produce a small temperature change. The market for swimming pool heating developed for several reasons. First, pool owners normally use their pools when solar energy is abundant (during daylight hours and the summer swimming season). Second, pools already have two elements needed for low temperature water heating: storage (the pool water) and circulation (the existing pool pump and associated plumbing). Third, pool owners are an easily identifiable market. Thermal Energy Storage FAFCO also designs, develops, manufactures, and markets a static, glycol ice builder for the thermal storage market. Since the product's introduction, FAFCO has sold "ice banks" primarily to the commercial air conditioning market for use in off-peak air conditioning systems. Products Swimming Pool Heating The FAFCO solar pool heating system is composed of six to twelve solar collectors, a sun sensor, an automatic control, and associated accessories. The collectors and sensor are typically mounted on the roof of a pool owner's home and connected to the pool pump and automatic control. The customer sets the automatic control for the desired water temperature and, when the sensor detects that there is sufficient solar energy for the system to function efficiently, the automatic control directs the flow of water from the pool to the collectors. The water absorbs heat as it passes through the collectors and then flows back to the pool. When the desired water temperature is achieved or when there is insufficient solar energy, the automatic control redirects the flow of water back to the pool and water is drained from the collectors. When the water temperature drops and there is sufficient solar energy, the system is reactivated automatically. In February 1996, the Company introduced a version of its solar pool heating system specifically designed for above-ground swimming pools. This system is composed of one or two solar collectors optimized for use in heating above-ground swimming pools and designed to lie flat on the ground or to be mounted on a rack on the ground. In May 1996, the Company introduced a new and improved version of its solar collector that has a higher thermal performance due to its unique heat exchanger tube design. The tube design incorporates molded indentations, which enhance the heat transfer coefficient by increasing fluid turbulence. The Company's solar collectors are composed entirely of a polyolefin material (a high molecular weight polymer compound) and made up of small round tubes formed side by side in a rectangular shape either one-by-two meters, four-by-eight feet, four-by-ten feet, four-by-twelve feet or four-by-twenty feet in size, with submanifolds and header pipes thermoformed on each end. This design provides for a maximum heating surface and even water flow in order to transfer 75% to 90% of the available solar energy to the pool water. The polyolefin material, which has been specially formulated by the Company, is black in color (to optimize solar energy absorption) and has the inherent advantages over other possible materials of lower cost, lighter weight, and higher resistance to the corrosive effects of pool chemicals and degradation resulting from ultraviolet radiation, heat, and other environmental effects. In May 1993, the Company introduced a proprietary microprocessor- based control (AutoPool) for its solar pool heating systems. Prior to May 1993, the Company had a private label arrangement with an automatic control manufacturer. AutoPool has built-in "intelligence" that allows it to optimize the heating and filtration time for the swimming pool and can also control non- conventional solar swimming pool heaters. Because of lack of demand for the Company's AutoPool Control, this product was discontinued effective January 1, 1997. The Company has ongoing obligations to service and provide spare parts for AutoPool controls sold prior to that time. Thermal Energy Storage The Company's thermal energy storage ("IceStor?") systems utilize nighttime electric capacity to create stored cooling energy. This is normally done by storing inexpensive "off- peak" energy in the form of either chilled water or ice. The next day this stored cooling capacity is used in conjunction with a building's air conditioning equipment to significantly reduce electrical power requirements for cooling during times of high power demand and high electrical cost. Cool storage systems offer power utilities a solution to a fundamental, long-term problem: increasing peak demand for power during periods of limited available capacity (i.e., during business hours). IceStor? technology shifts consumption to off- peak periods when there is available capacity and lower demand. Marketing and Sales Solar Systems FAFCO markets its solar systems and controls in the United States through independent distributors who sell directly to end users. Distributors generally have sales, installation, and service personnel who are supported by extensive FAFCO marketing and technical materials as well as in-depth factory and field training programs. The majority of sales personnel employed by the typical distributor are assigned to retrofit sales, which are sales to existing pool owners. Retrofit sales are generated through direct mail, customer referrals, canvassing, and, to a lesser extent, selected media advertising. The balance of the typical distributor's sales personnel are generally assigned to contractor accounts and seek referrals for new construction sales. FAFCO usually provides direct mail literature and other advertising materials to distributors and mails or places these materials with local advertisers on the distributors' behalf and partially at the distributors' expense. In certain instances, distributors will also engage in direct mailing and advertising. In the past, the Company has canceled several distributor agreements for reasons of inadequate performance by the distributor, primarily for failure to provide adequate sales, installation and service support for the Company's products. In such instances, the Company has generally been able to find qualified replacements. All work relating to the installation of FAFCO solar systems is covered by a full one-year warranty provided by the distributor. The Company's solar collectors used to be covered by a ten-year limited warranty, which was changed to a ten-year full warranty beginning in 1991. Its automatic controls, pumps, and drain-down valves are covered by a three-year limited warranty. FAFCO warranties cover defects in materials and workmanship provided that the related products are used for their intended purpose. FAFCO solar systems are designed to require only minimal maintenance, which can be performed either by the consumer using an owner's manual or by the distributor's service personnel. Thermal Energy Storage Systems The Company markets its IceStor? products through independent contractors who design and build heating and cooling systems for commercial and industrial applications. The Company has also licensed its IceStor? products for sale overseas, to design-and- build, heating, ventilating, and air-conditioning companies in Taiwan, Korea, Japan, and The Peoples Republic of China. These licensing agreements provide for licensees' assembly and sale of IceStor? products in those countries. Sales by Geographic Area The Company's net sales during 1997, 1996 and, 1995 were geographically distributed approximately as follows: 1997 1996 1995 California 22% 17% 21% Florida 31% 34% 37% Oklahoma 3% 0% 7% Other U.S. 16% 35% 20% Foreign Countries 28% 14% 15% 100% 100% 100%
One of the Company's customers, Ebara Corporation, accounted for 18.6% of the Company's fiscal 1997 net sales. Three of the Company's customers, Kailay International (now known as FAPCO), Ebara Corporation, and Florida Solar, accounted for 13.8%, 11.9%, and 11.8% of the Company's fiscal 1996 net sales. Kailay International also accounted for 10.0% of the Company's fiscal 1995 net sales. During 1995, 1996 and 1997, Kailay International and Ebara Corporation were the licensees for the Company's IceStorT products in Taiwan and Japan, respectively, and, as such, purchased IceStorT products and components for assembly into products for resale to end users in Taiwan and Japan, respectively. During 1996, Florida Solar was a distributor of the Company's pool products and, as such, purchased pool panels and components for resale to end users in Florida. No other customer accounted for 10% or more of the Company's net sales in fiscal 1995, 1996 or 1997. Any material cancellation, reduction or rescheduling of orders from these major customers, or the loss of any such customer, would have a material adverse effect in the Company's financial condition and operation results. Foreign sales of the Company's products are made through independent foreign distributors and licensees. Sales to foreign distributors and licensees are shipped directly from the Company's facilities in California and invoiced in U.S. dollars. Export sales are subject to certain controls and restrictions, including tariffs and import duties, and are subject to certain risks, including changing regulatory requirements of foreign jurisdictions and transportation delays and interruptions; however, the Company has not experienced any material difficulties in the past relating to such limitations. The financial crisis in Southeast Asia has not had any noticeable negative effect on sales; however, there is no assurance that sales will not be negatively affected if the crisis worsens or is prolonged. Backlog Sales to solar distributors are made against individual purchase orders rather than through volume purchase arrangements. The Company typically ships its products within one to five days of receipt of an order; therefore, the Company's backlog at any date is usually insignificant and is not a meaningful indicator of future sales. FAFCO distributors tend to order frequently in small quantities in order to minimize their inventory levels and match inventory levels with current installation schedules. Sales of IceStor? products are made against individual purchase orders to general contractors or Heating, Ventilating, and Air Conditioning (HVAC) contractors for specific new construction projects or for retrofit in existing buildings. The Company typically ships these products within six weeks or less of receipt of an order; therefore, the Company's backlog with respect to IceStor? products at any date is also usually insignificant and not a meaningful indicator of future sales. Government Tax Incentives Although the Company's operations are not directly subject to extensive governmental regulations, the existence or lack of federal, state, and local tax incentives for the sale and installation of solar systems would have a substantial impact on the Company's business. There is currently no federal tax credit for solar heating systems and state solar tax credits are available only in a few states. The Company does not anticipate that solar tax credits will become available for solar heating systems in any additional states, nor does it anticipate a significant increase in sales due to existing or future tax credits. Manufacturing FAFCO's manufacturing activities consist primarily of the production of polyolefin solar collectors and IceStor? heat exchangers, automatic controls, components for its solar systems, and IceStor? containers. A total system approach is emphasized in order to ensure the effectiveness and reliability of the Company's products after they have been installed, eliminating the need for distributors to rely upon materials from other suppliers. The Company's solar pool heating system utilizes collectors produced from polyolefin resins using a patented extrusion and thermoforming process. The Company's IceStor? system utilizes heat exchangers, which are also made from polyolefin resins using a patented extrusion and thermoforming process. Substantially all equipment used in these processes has been designed and built by the Company's research and development engineers. The resins employed by the Company are a petroleum by-product. The market price of these resins has fluctuated over the years with an increase in 1990 and early 1991 due to tensions in the Middle East, followed by a stabilization after the completion of Desert Storm. It is expected that the price of the resins will continue to fluctuate as a result of domestic and international political and economic conditions. FAFCO has qualified multiple sources of supply for all of its resins, materials, and subassemblies. However, certain materials and subassemblies are currently obtained from single sources. The Company believes these items could be supplied by the Company's other qualified sources if sufficient lead-time were provided. The Company attempts to maintain additional inventory of such materials to mitigate the risk of supply shortages; however, any prolonged inability to obtain such items would have a material adverse effect on the Company's results of operations. To date, the Company has not experienced any significant manufacturing problems or delays due to shortages of materials. Quality assurance is performed by FAFCO at its manufacturing facility. Test and inspection procedures are a part of substantially all production and assembly operations. In addition, the Company uses it own diagnostic equipment and laboratory to continually test and inspect raw materials, work in process, and finished goods. Competition The Company's solar heating products currently compete directly with solar heating products offered by less than ten other domestic and international manufacturers of solar heating systems, and indirectly with conventional heating systems. The Company believes that the principal competitive factors in the markets for FAFCO solar products are (i) product performance and reliability; (ii) marketing and technical support from the manufacturer for distribution channels; (iii) selling, installation, and service capabilities of distribution channels; and (iv) price. The Company believes that it competes favorably with respect to all of these factors. However, certain of its competitors may have greater financial, marketing, and technological resources than those of the Company. A number of companies in the United States manufacture thermal energy storage systems of various types similar to the Company's IceStor? product. The industry is in the early stages of development and additional competitors are expected to enter the market over time. At the present time, the Company believes that the main competitive factors in the thermal energy storage market are performance, reliability, and price. The Company believes that it competes favorably with respect to these factors. However, several of its competitors have greater financial, marketing, and technological resources than those of the Company. Research and Development For the years ended December 31, 1997, 1996, and 1995, the Company's research and development expenses were $202,800, $116,000, and $460,100, respectively. The majority of the research and development costs incurred in 1995 related to an improved solar heating product for in-ground pools, which was introduced in April 1996. The Company currently uses consulting engineers, in addition to staff engineers, who are responsible for existing product improvement, applications engineering, and new product research and development. The Company is exploring other potential revenue-producing uses for its polyolefin extrusions. Patents, Trademarks and Licenses FAFCO currently holds two United States patents and one foreign patent relating to certain aspects of its products and manufacturing technology. These patents expire at various times between March 1998 and July 2003. However, the Company believes that patent protection is secondary to such factors as ongoing product development and refinement, the knowledge and experience of its personnel, and their ability to design, manufacture, and successfully market the Company's products. From time to time, the Company has registered as trademarks certain product names and marks in order to preserve its right to those product names and marks. The Company has granted licenses to assemble and sell IceStor? in Taiwan, Korea, Japan, and the Peoples Republic of China to a Taiwanese company, a Korean company, a Japanese company, and a Peoples Republic of China company, respectively. See "Marketing and Sales" above. Employees At December 31, 1997, the Company had a total of 52 full-time employees, including eight in marketing, two in research and development, 32 in manufacturing, and 10 in general management and administration. The Company also uses temporary employees from agencies to fill seasonal needs. The Company has never had a work stoppage. No employees are represented by a labor organization. Seasonality Information regarding the seasonality of the Company's business is set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Seasonality" on page 18 of the Annual Report, which information is incorporated herein by reference. Segment Information Following the sale of the business of the Company's subsidiary, The Gregory Company, in 1988, the Company has only had continuing operations in the energy products segment. Environmental Regulations The Company is subject to a number of environmental regulations concerning potential air and water pollution. However, such regulations have not in the past had, and are not expected to have, any material adverse effect on the Company's business. However, there can be no assurance that compliance with existing or future regulations will not require the expenditure of funds or the modification of the Company's manufacturing process, which could have a material adverse effect on the Company's business or financial condition. Item 2. Properties The Company's principal executive offices and manufacturing facilities for its products are located in a single 42,500 square foot facility in Redwood City, California. A lease expiring in the year 2000 covers this facility. See Note 11 of Notes to Consolidated Financial Statements on page 13 of the Annual Report, which information is incorporated herein by reference. The Company believes that its current facilities are adequate to meet its requirements for space in the near future. Manufacturing space is being fully utilized at the present time. However, additional demand can be accommodated by adding additional employee shifts. Item 3. Legal Proceedings There are presently no material pending legal proceedings to which the Company is a party or to which any of its property is subject, except for ordinary routine legal proceedings incidental to the Company's business. Item 4. Submission of Matters to a Vote of Security Holders The Company did not submit any matter to a vote of security holders during the fourth quarter of its fiscal year ended December 31, 1997. ART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Information regarding the market for and market prices of the Company's Common Stock, the number of shareholders of record, and information regarding dividends is set forth under the heading "Common Stock Data" on page 16 of the Annual Report, which information is incorporated herein by reference. Item 6. Selected Financial Data Selected financial data for the Company is set forth in the table entitled "Five-Year Summary of Operations" on page 16 and in the last sentence of the text under the table entitled "Common Stock Data" on page 16 of the Annual Report, which information is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Information regarding Management's Discussion and Analysis of Financial Condition and Results of Operations is set forth under the heading "Management's Discussion and Analysis," on pages 17 through 19 of the Annual Report, which information is incorporated herein by reference. Item 7A. Quantitative and Qualitative Disclosures about Market Risk Not applicable. Item 8. Financial Statements and Supplementary Data The consolidated financial statements of the Company are set forth on pages 4 through 15 of the Annual Report, which information is incorporated herein by reference. The supplementary financial information requirements of Regulation S- K Item 302 do not apply to the Company, because the Company does not meet the tests set forth therein. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On December 11, 1996, FAFCO, Inc. dismissed Price Waterhouse LLP as its independents accounts. The reports of Price Waterhouse LLP on the financial statements for the past two fiscal years contain no adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principles. The Registrant's Audit Committee and Board of Directors participated in and approved the decision to change independent accountants. In connection with its audits for fiscal year 1995 through December 11, 1996, there were no disagreements with Price Waterhouse LLP on any matter of accounting principles or practices, financial statements disclosure, or auditing scope of procedure, which disagreements if not resolved to the satisfaction of Price Waterhouse LLP would have caused them to make reference thereto in their report on the financial statemetns for such years. During fiscal year 1995 through December 11, 1996, there were no reportable events as defined in Regulation S-K Item 304 (a)(1)(v). The Registrant requested that Price Waterhouse LLP furnish it with a letter addressed to the SEC stating whether or not it agrees with the above statements. A copy of such letter, dated December 11, 1996, was filed as Exhibit 16.1 of a Current Report on Form 8-K of the Company dated as of such date. The Registrant engaged Burr, Pilger & Mayer as its new independent accountants as of December 11, 1996. PART III Item 10. Directors and Executive Officers of the Registrant Information regarding directors is to be set forth under the heading "Election of Directors - Nominees" in the Company's Proxy Statement, which information is incorporated herein by reference. Information regarding the filing of reports by insiders under Section 16(a) of the Exchange Act is to be set forth under the heading "Election of Directors - Beneficial Ownership Reporting Compliance Section 16(a) of the Exchange Act" in the Company's Proxy Statement, which information is incorporated herein by reference. The executive officers of the Company are set forth below. All officers serve at the pleasure of the Board of Directors. There are no family relationships between any executive officers or directors. Freeman A. Ford, age 57, serves as Chairman of the Board, President, and Chief Executive Officer. Mr. Ford, a co-founder of the Company, has served as Chairman of the Board since 1972, as Chief Executive Officer of the Company since May 1979, and as President since September 1984. Mr. Ford is also a Director of H.B. Fuller Company. Alex N. Watt, age 56, serves as Vice President of Finance and Administration, Chief Financial Officer, and Secretary. Mr. Watt joined the Company as its Vice President-Finance and Chief Financial Officer in July 1984, and has served as Secretary since March 1985. David Harris, age 42, serves as Vice President, Pool Products. Mr. Harris joined the Company in August 1981 as a sales representative and has held the positions of Pool Builder Manager, National Sales Manager-Pool Products, Pacific Northwestern Region Sales Manager, National Sales Manager-Solar Division, National Sales Manager, Vice President-Sales and Marketing (from June 1988 until April 1993) and President-Pool Products Division (from May 1993 until May 1995). Item 11. Executive Compensation Information regarding the Company's remuneration of its executive officers and directors is to be set forth under the headings "Election of Directors - Executive Compensation" and "Election of Directors - Director Compensation" in the Company's Proxy Statement, which information is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management Information regarding the security ownership of certain beneficial owners and management is to be set forth under the headings "Election of Directors - Security Ownership" and "Information Concerning Solicitation and Voting - Record Date and Outstanding Shares" in the Company's Proxy Statement, which information is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is to be set forth under the headings "Election of Directors - Nominees" and "Election of Directors - Certain Transactions" in the Company's Proxy Statement, which information is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as part of this report: 1. Financial Statements The consolidated balance sheets for the years ended December 31, 1997 and 1996, the Consolidated Statement of Operations, of Shareholders' Equity and Cash Flows for each of the three years in the period ended December 31, 1997, and the notes thereto appear on pages 4 through 15 of the Annual Report. 2. Financial Statement Schedules The following schedule for the years ended December 31, 1997, 1996, and 1995 is included in this report. Such schedule should be read in conjunction with the consolidated financial statements in the Annual Report. Report of Independent Accountants on Financial Statement Schedule (see page 18). Schedule II - Valuation and Qualifying Accounts and Reserves (see page 19). Schedules not included in these financial statement schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Index to Exhibits The following exhibits are filed as part of or incorporated by reference, to the extent indicated herein, in this Annual Report on Form 10-K. Exhibit No. Description (footnotes appear at the end of the exhibit list) 3.1(1) Articles of Incorporation, as amended. 3.2(3) Bylaws, as amended. 4.1(1) Stock Purchase Agreement dated April 14, 1977, between Registrant and certain investors. 4.2(3) 10% Convertible Subordinated Notes Purchase Agreement dated March 27, 1984, between Registrant and certain investors. 4.2(a)(2) Amendment to Subordinated Note Purchase Agreement dated March 27, 1990. 4.2(b)(9) Amendment to 10% Subordinated Note Agreement dated March 25, 1991. 4.3(4)* Security and Guaranty Agreement and Common Stock Purchase Warrant between the Registrant and Freeman A. Ford dated February 16, 1987. 4.3(a)(5)* Amendment to the Security and Guaranty Agreement between the Registrant and Freeman A. Ford dated December 8, 1987. 4.3(b)(6)* Amendment to the Security and Guaranty Agreement between the Registrant and Freeman A. Ford dated February 1, 1988. 4.3(c)(7)* Second Amendment to the Promissory Notes between the Registrant and Freeman A. Ford dated March 26, 1991. 4.3(d)(9)* Form of Common Stock Purchase Warrant issued March 25, 1993 by the Registrant to Freeman A. Ford. 4.3(e)(9) Amendment to the Promissory Notes between the Registrant and Freeman A. Ford dated March 25, 1993. 4.4(10) Common Stock Warrant issued January 19, 1994 to B. Severns. 4.5 Reference Exhibits 3.1 and 3.2. 10.1 Reference Exhibit 4.1. 10.2 Reference Exhibit 4.2, 4.2(a), and 4.2(b). 10.3(7)* 1981 Incentive Stock Option Plan. 10.4(7)* Form of 1981 Incentive Stock Option Agreement. 10.8(1) Standard Form of Distributor Agreement. 10.9(7) Lease Agreement and Addenda for 2690 Middlefield Road, Redwood City, California, between Registrant, as Lessee, and Beals Martin and Associates, as Lessor, dated January 18, 1990. 10.10(3) FAFCO Solar Partners II Certificate of Limited Partnership and Limited Partnership Agreement. 10.11 Reference Exhibits 4.3, 4.3(a), 4.3(b), 4.3(c), 4.3(d), and 4.3(e). 10.12(6) Licensing Agreement between the Registrant, as Licensor, and Enercon Engineering, as Licensee, dated May 20, 1988. 10.13(6)* Form of Director's Warrant issued February 1988 to directors Berry and Selig. 10.14(11)* 1991 Stock Option Plan, as amended. 10.14(a)(8)* Form of Stock Option Agreement used under the 1991 Stock Option Plan. 10.15(8)* 1991 Directors' Stock Option Plan. 10.15(a)(8)* Form of Nonstatutory Stock Option Agreement used under 1991 Director's Stock Option Plan. 10.16(8)* Employee Stock Purchase Plan. 10.16(a)(8)* Form of Subscription Agreement used under Employee Stock Purchase Plan. 10.17(9) Licensing Agreement and Addendum between the Registrant, as Licensor, and Jang-Han Systems Engineering, as Licensee, dated January 1, 1993. 10.18(10) Export - Import and Technical License Agreement between the Registrant, as Licensor, and Ebara Corporation, as Licensee, dated October 22, 1993. 10.19(10) Business Loan Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated June 10, 1992. 10.19(a)(10) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated March 8, 1994. 10.19(b)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated June 5, 1995. 10.19(c)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated August 7, 1995. 10.19(d)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated September 22, 1995. 10.19(e)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated February 8, 1996. 10.19(f)(13) Loan Modification agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated October 30, 1996. 10.19(g)(13) Loan Modification Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated December 11, 1996. 10.19(h)(13) Loan Modification Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated January 6, 1997. 10.19(i)(13) Loan Modification Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated January 21, 1997. 10.20(11) Agency/Distributorship Agreement between Registrant as Manufacturer and Jabria Establishment, as Agent/Distributorship, dated December 10, 1994. 11.1 Computation of Earnings Per Share (see Note 12 of Notes to Consolidated Financial Statements on the 1997 Annual Report). 13.1 Registrant's 1997 Annual Report to Shareholders. 16.1(14) Letter from Price Waterhouse LLP dated December 11, 1996 re change in Registrant's Certifying Accountants. 18.1(15) Letter re change in Accounting Principle from Burr, Pilger & Meyer dated November 5, 1997. 21.1 Subsidiaries of Registrant. 23.1 Consent of Independent Accountants (see page 20) 24.1 Power of Attorney (see page 19). 27.1 Financial Data Schedule. Denotes a management contract or compensatory plan or arrangement. (1) Incorporated by reference to exhibit filed with Registrant's Registration Statement on Form S-1 (File No. 2-72297) filed May 14, 1981. (2) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. (3) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1983. (4) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. (5) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. (6) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. (7) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. (8) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. (9) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (10) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993. (11) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994 (12) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1995. (13) Incorporated by reference to exhibit filed with Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1996. (14) Incorporated by reference to exhibit filed with Registrant's Report on Form 8-K for the quarter ended December 31, 1996. (15) Incorporated by reference to exhibit filed with Registrant's Quarterly Report on Form 10Q for the fiscal quarter ended September 30, 1997. (b) Reports on Form 8-K: No Reports on Form 8-K were filed by the Company during the fourth quarter of 1997 . (c) Exhibits: See subsection (a) (3) above. (d) Financial Statement Schedules: See subsection (a) (2) above. Report of Independent Accountants on Financial Statement Schedule To the Board of Directors of FAFCO, Inc. Our audits of the consolidated financial statements referred to in our report dated March 17, 1998 appearing on page 15 of the 1997 Annual Report to Shareholders of FAFCO, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule listed in Item 14(a) of this Form 10-K. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Burr, Pilger & Mayer LLP San Francisco, California March 17, 1998 FAFCO, Inc. Schedule II Valuation and Qualifying Accounts and Reserves Balance at Additions Balance Begining of to Costs and at End Period Expenses Deductions of Period 1997: Allowance for doubtful accounts current accounts receivable $ 512,600 $ 172,600 $ 145,100(1) $ 540,100 short-term receivable 28,800 97,600 126,400 long-term receivable 34,000 4,700(4) 29,300 Warranty reserve 234,100 85,600 108,700(2) 211,000 Deferred tax asset valuation allowance 1,191,800 483,800 708,000 1996: Allowance for doubtful accounts current accounts receivable $ 463,900 $ 50,400 $ 1,700 $ 512,600 short-term receivable 28,800 28,800 long-term receivable 39,100 5,100(4) 34,000 Warranty reserve 216,000 94,100 76,000(2) 234,100 Deferred tax asset valuation allowance 600,900 782,900 1,383,800 1995: Allowance for doubtful accounts current accounts $ 5,700(1) receivable $ 469,100 $ 39,600 39,100(3) $ 463,900 long-term receivable 39,100 39,100 Warranty reserve 247,000 10,500 41,500(2) 216,000 Deferred tax asset valuation allowance 600,900 782,900 1,383,800 (1) Write-off of uncollectible accounts. (2) Cost of warranty claims processed. (3) Reclassification to allowance for long-term notes receivable. (4) Reclassification to allowance for short-term notes receivable. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: ______________ FAFCO, Inc. /s/Freeman A. Ford Freeman A. Ford, Chairman of the Board, President and Chief Executive Officer POWER OF ATTORNEY Each person whose signature appears below constitutes and appoints Freeman A. Ford and Alex N. Watt, or either of them, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that either of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date Chairman of the Board, President and Chief executive Officer (Principal /s/Freeman A. Ford Chief Executive Officer (Principal Freeman A. Ford Executive Officer) and Director Vice President, Finance & Administration /s/Alex N. Watt and Chief Financial Officer (Principal Alex N. Watt Financial and Accounting Officer) /s/William A. Berry Director William A. Berry /s/Robert W. Selig, Jr. Director Robert W. Selig, Jr. CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 2-75201, 2-86299, 2- 95390 and 33-76220) and related prospectuses of FAFCO, Inc. of our report dated March 17, 1998, appearing on page 15 of the 1997 Annual Report to Shareholders, which is incorporated by reference in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedule, which appears on page 17 of this Form 10-K. Burr, Pilger & Mayer San Francisco, California March 17, 1998 ITEMS Exhibit No. Description 3.1(1) Articles of Incorporation, as amended. 3.2(3) Bylaws, as amended. 4.1(1) Stock Purchase Agreement dated April 14, 1977, between Registrant and certain investors. 4.2(3) 10% Convertible Subordinated Notes Purchase Agreement dated March 27, 1984, between Registrant and certain investors. 4.2(a)(2) Amendment to Subordinated Note Purchase Agreement dated March 27, 1990. 4.2(b)(9) Amendment to 10% Subordinated Note Agreement dated March 25, 1991. 4.3(4)* Security and Guaranty Agreement and Common Stock Purchase Warrant between the Registrant and Freeman A. Ford dated February 16, 1987. 4.3(a)(5)* Amendment to the Security and Guaranty Agreement between the Registrant and Freeman A. Ford dated December 8, 1987. 4.3(b)(6)* Amendment to the Security and Guaranty Agreement between the Registrant and Freeman A. Ford dated February 1, 1988. 4.3(c)(7)* Second Amendment to the Promissory Notes between the Registrant and Freeman A. Ford dated March 26, 1991. 4.3(d)(9)* Form of Common Stock Purchase Warrant issued March 25, 1993 by the Registrant to Freeman A. Ford. 4.3(e)(9) Amendment to the Promissory Notes between the Registrant and Freeman A. Ford dated March 25, 1993. 4.4(10) Common Stock Warrant issued January 19, 1994 to B. Severns. 4.5 Reference Exhibits 3.1 and 3.2. 10.1 Reference Exhibit 4.1. 10.2 Reference Exhibit 4.2, 4.2(a), and 4.2(b). 10.3(7)* 1981 Incentive Stock Option Plan. 10.4(7)* Form of 1981 Incentive Stock Option Agreement. 10.8(1) Standard Form of Distributor Agreement. 10.9(7) Lease Agreement and Addenda for 2690 Middlefield Road, Redwood City, California, between Registrant, as Lessee, and Beals Martin and Associates, as Lessor, dated January 18, 1990. 10.10(3) FAFCO Solar Partners II Certificate of Limited Partnership and Limited Partnership Agreement. 10.11 Reference Exhibits 4.3, 4.3(a), 4.3(b), 4.3(c), 4.3(d), and 4.3(e). 10.12(6) Licensing Agreement between the Registrant, as Licensor, and Enercon Engineering, as Licensee, dated May 20, 1988. 10.13(6)* Form of Director's Warrant issued February 1988 to directors Berry and Selig. 10.14(11)* 1991 Stock Option Plan, as amended. 10.14(a)(8)* Form of Stock Option Agreement used under the 1991 Stock Option Plan. 10.15(8)* 1991 Directors' Stock Option Plan. 10.15(a)(8)* Form of Nonstatutory Stock Option Agreement used under 1991 Director's Stock Option Plan. 10.16(8)* Employee Stock Purchase Plan. 10.16(a)(8)* Form of Subscription Agreement used under Employee Stock Purchase Plan. 10.17(9) Licensing Agreement and Addendum between the Registrant, as Licensor, and Jang-Han Systems Engineering, as Licensee, dated January 1, 1993. 10.18(10) Export - Import and Technical License Agreement between the Registrant, as Licensor, and Ebara Corporation, as Licensee, dated October 22, 1993. 10.19(10) Business Loan Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated June 10, 1992. 10.19(a)(10) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated March 8, 1994. 10.19(b)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated June 5, 1995. 10.19(c)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated August 7, 1995. 10.19(d)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated September 22, 1995. 10.19(e)(12) Loan Modification Agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated February 8, 1996. 10.19(f)(13) Loan Modification agreement between Registrant as Borrower, and Silicon Valley Bank, as Lender, dated October 30, 1996. 10.19(g)(13) Loan Modification Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated December 11, 1996. 10.19(h)(13) Loan Modification Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated January 6, 1997. 10.19(i)(13) Loan Modification Agreement between Registrant, as Borrower, and Silicon Valley Bank, as Lender, dated January 21, 1997. 10.20(11) Agency/Distributorship Agreement between Registrant as Manufacturer and Jabria Establishment, as Agent/Distributorship, dated December 10, 1994. 11.1 Computation of Earnings Per Share (see Note 12 of Notes to Consolidated Financial Statements on the 1997 Annual Report). 13.1 Registrant's 1997 Annual Report to Shareholders. 16.1(14) Letter from Price Waterhouse LLP dated December 11, 1996 re change in Registrant's Certifying Accountants. 18.1(15) Letter re change in Accounting Principle from Burr, Pilger & Meyer dated November 5, 1997. 21.1 Subsidiaries of Registrant. 23.1 Consent of Independent Accountants (see page 20) 24.2 Power of Attorney (see page 19). 27.1 Financial Data Schedule. 2 D:\BRUCE_J\10KFORM.DOC D:\BRUCE_J\10KFORM.DOC Revised: 1/30/97
EX-2 2 ANNUAL REPORT FAFCO, Inc. 1997 Annual Report The Company This Annual Report to Shareholders contains for- ward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below under the heading "Management's Discussion and Analysis - Factors Affecting Future Results" and elsewhere in this Annual Report to Shareholders FAFCO, Inc. designs, manufactures and markets heat exchangers made primarily of polymers for use in solar swimming pool heating and for thermal energy storage. FAFCO markets its swimming pool products in the United States and overseas through independent distributors who sell directly to end-users. The Company markets its IceStor(tm) products in the United States through independent manufacturers' representatives. The Company also licenses its IceStor(tm) products overseas. FAFCO has manufactured over one million polymer heat exchangers since its incorporation in 1972. The heat exchangers are made using proprietary and patented processing technology. The Company is the largest manufacturer of solar pool heating systems in the United States. In 1987, FAFCO introduced IceStor(tm), a static glycol ice builder for the thermal storage market. The FAFCO IceStor(tm) utilizes a variation of the Company's polymer heat exchanger placed in a galvanized steel container. The IceStor(tm) products, a demand-side management for electric utilities, use chilled glycol flowing through the heat exchanger to convert a static volume of water in the container to ice. The ice is made at night using less expensive "off-peak" power. The cooling energy stored in the ice is then reclaimed the next day during "peak periods" to provide space or process cooling. The result is lowered cooling costs. FAFCO's products are manufactured and marketed with a common guiding strategy outlined below: Targeting markets where high market share or growth are likely. A high value-added manufacturing process that minimizes direct labor in favor or proprietary processes. An effort to maximize gross margin based on sophisticated manufacturing in high volume to enable economies of scale. Experienced management whose capabilities exceed the immediate demands of the business. A resolution to combine the foregoing to build a large and successful enterprise Letter to Shareholders FAFCO is a manufacturer of polymer heat exchangers used principally for solar and thermal energy storage applications. Net sales grew by 19% to $10,551,500 in 1997. Net profit increased to $866,900, up 178% compared with 1996. Despite record-setting rains in California and adverse weather in Florida, 1998 promises to be another good year for FAFCO. FAFCO's solar business increased 14.8% in 1997 due to the execution of product and market strategies introduced in 1995. Specifically, the new Revolution(tm) solar technology has been well received by our customers. In addition, FAFCO has taken a leadership position in the aboveground pool heating market as a result of new technology and a focus on increased market share. Finally, the solar business has benefited strongly from targeted sales outside the tra-ditional California and Florida markets. FAFCO's thermal energy storage business uses our unique polymer heat exchanger technology to shift peaking electrical loads to off peak. This significantly increases the effective capacity of the electrical supplier without the expense of adding new capacity. FAFCO's IceStor(tm) technology is sold principally in the United States, Asia and in the emerging Middle Eastern market. Domestic and foreign sales were up 100% and 17%, respectively in 1997. As of December 31, 1997, FAFCO's million-dollar credit line was unused and there was $46,300 of cash on hand. Working capital increased to $2,006,800 at December 31, 1997 from $1,284,700 at December 31, 1996. In addition to our solar Revolution(tm) and aboveground pool technologies, FAFCO is accelerating certain new technologies that are expected to positively influence sales and profitability starting next year. Furthermore, we believe that FAFCO's polymer heat exchanger technology is ideally suited to enter certain formerly untargeted large domestic thermal energy storage markets. A focus on these markets is expected to yield significant results in 1999 and thereafter. FAFCO's increased sales and profitability in 1997 resulted directly from the long hours, increased effciency, and dedication of each and every FAFCO employee. My thanks to each and every one of you. Sincerely, Freeman A. Ford President Financial Highlights 1997 1996 % Change Net Sales $ 10,551,500 $ 8,868,600 19% Net Income 866,000 $ 311,400 178% Diluted Earnings Per Common Share $ 0.22 $ 0.10 120% Shareholders' Equity $ 2,042,300 $ 1,176,30 74% Working Capital $ 2,006,800 $ 1,284,700 56%
Consolidated Balance Sheet December 31, 1997 1996* Assets Current assets: Cash and cash equivalents $ 46,300 $ 88,200 Accounts receivable, less allowancefor doubtful accounts of $540,100 in 1997 and $512,600 in 1996 1,833,400 1,890,700 Current portion of long-term notes receivable (net) 88,800 229,100 Inventories 1,082,900 917,400 Prepaid expenses and other current assets 174,000 150,800 Other accounts receivable, net of allowance 12,200 4,500 Total current assets 183,300 221,500 Plant and equipment, at cost 3,420,900 3,502,200 Less accumulated depreciation and amortization 2,614,900 2,465,800 Notes receivable and other assets (net) (2,236,300) (2,116,200) Deferred tax asset, net of allowance 378,600 349,600 Total assets 151,200 65,500 Liabilities and shareholders' equity 485,800 427,900 Current liabilities: 4,436,500 4,345,200 Bank line of credit $ $ 758,600 Accounts payable and other accrued expenses 850,900 1,037,800 Accrued compensation and benefits 331,600 187,000 Accrued warranty expense 211,000 234,100 Income taxes payable 20,600 Total current liabilities 1,414,100 2,217,500 Convertible subordinated notes ($600,000 was owed to related parties in 1997 and 1996) 925,000 925,000 Other non-current liabilities 55,100 26,400 Total liabilities $2,394,200 $3,168,900 Shareholders' equity: Preferred Stock-authorized 1,000,000 shares of $1.00 par value, none of which has been issued Common Stock-authorized 10,000,000 shares of $0.125 par value; 3,298,311 issued and outstanding in 1997 and in 1996 412,200 412,200 Capital in excess of par value 5,105,200 5,105,200 Notes receivable secured by Common Stock 75,100 75,100 Accumulated deficit (3,400,000) (4,266,000) Total shareholders' equity $2,042,300 $1,176,300 Commitments and contingent liabilities Total liabilities and shareholders' equity $4,436,500 $4,345,200
CONSOLIDATED STATEMENT OF OPERATIONS Year ended December 31, 1997 1996 1995 Net Sales $10,551,500 $ 8,868,600 $ 7,876,100 Other income (net) 171,800 54,000 39,700 Total revenues 10,723,300 8,922,600 7,915,800 Cost of goods sold 5,956,500 5,500,300 5,578,000 Marketing and selling expense 1,770,000 1,575,400 2,137,200 General and administrative expense 1,776,100 1,286,300 1,502,000 Research and development expense 202,800 116,000 460,100 Net interest expense 128,700 169,900 95,300 Total costs and expenses 9,834,100 8,647,900 9,772,600 Income (loss) before income taxes 889,200 274,700 (1,856,800) Provision for (benefit from) income taxes. 23,200 (36,700) 1,600 Net income (loss) 866,000 311,400 $(1,858,400) Basic net income (loss) per share $ 0.26 $ 0.10 (0.60) Diluted net income (loss per share 0.22 0.10 (0.60) *Restated for change in accounting principle (see Note 2).
Consolidated Statement of Shareholders' Equity Notes Number Capital in Receivable Retained of Common Excess of Secured by Earnings Shares Stock Par Value Common StockDeficit* Balance at December 31, 1994 3,100,8870$387,600$5,034,100$(75,100)$2,719,000) Net loss for the year Cancellation of shares in satisfaction of other notes receivable (3,000)(400) (4,100) Issuance of shares under the 1981 Employee Incentive Stock Option Plan 8,800 1,100 3,300 Issuance of shares under the 1991 Employee Incentive Stock Option Plan 6,000 700 2,300 Balance at December 31, 1995 3,112,687$389,000$5,035,600$75,100 $(4,577,400) Net income for the year 311,400 Issuance of shares upon conversion of subordinated note 185,624 23,200 69,600 Balance at December 31, 19963,298,311$412,200$5,105,200$75,100 $4,266,000 Net income for the year 866,000 Balance at December 31, 19973,298,311$412,200 $(75,100) $(3,400,000)
*Restated for change in accounting principle (see Note 2). The accompanying notes are an integral part of this statement Consolidated Statement of Cash Flows Year Ended December 31, 1997 1996*** 1995** $866,000 $311,400 $(1,858,400) Net income (loss) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation 130,700 121,200 178,700 Allowance for doubtful accounts and notes 120,300 72,400 33,900 Provision for inventory reserve (90,500) 72,400 105,800 (Gain) loss on disposition of fixed assets (18,700) 22,700 Change in assets and liabilities: Change in receivables 22,100 (794,300) 1,367,800 Change in inventories (75,000) (85,200) (39,700) Change in prepaid expenses (23,200) (5,300) (28,600) Change in deferred tax assets (19,700) (38,400) Change in other assets (38,200) (73,400) (333,000) Change in payables and accrued expenses (44,800) 104,900 (288,900) Change in other non-current liabilites 28,700 (54,000) (27,800) Net cash provided by (used in) operations 876,400 (270,200) (867,500) Cash flow from investing activities: Purchase of fixed assets (159,700) (211,600) (81,300) Proceeds from sale of fixed assets 18,700 Net cash used in investing activities (159,700) (192,900) (81,300) Cash flow from financing activities: Proceeds of subordinated debt issuance 325,000 Proceeds from sale of common stock 92,800 Payments on line of credit (1,493,900)(1,350,000)(490,000) Borrowings on line of credit 735,300 1,357,300 1,241,300 Miscellaneuous borrowings (21,700) Net cash (used in) provided by financing activities (758,600) 425,100 737,000 Net (decrease) in cash and cash equivalents (41,900) (38,000) (21,800) Cash and cash equivalents, beginning of year 88,200 126,200 338,000 Cash and cash equivalents, end of year $46,300 $88,200 $126,200 Supplemental disclosures of cash flow information: Cash paid during the year for interest $142,100 $159,300 $ 89,800 Cash paid during the year for interest $ 10,000 $ 7,500 49,000 Net cash paid duringthe year for income taxes
*Reclassified for comparative purposes. **Restated for change in accounting principle (see Note 2). The accompanying notes are an integral part of this statement. Notes to Consolidated Financial Statements 1) Organization and Summary of Significant Accounting Policies The Company designs, develops, manufactures and markets solar heating systems for swimming pools and thermal energy storage systems for commercial and industrial cooling. The solar heating systems are sold to wholesalers and distributors primarily in California and Florida and in other locations in the United States and overseas. Thermal energy storage systems are marketed through manufacturers' representatives throughout the United States and internationally. One of the Company's customers accounted for more than 10% of the Company's fiscal 1997 net sales. Three of the Company's customers each accounted for more than 10% of the Company's fiscal 1996 net sales. One of the Company's customers accounted for 10% of the Company's fiscal 1995 net sales. During 1997, the Company had sales to unaffiliated customers in foreign countries amounting to 28% of total net sales. During 1996 and 1995, the Company had sales to unaffiliated customers in foreign countries amounting to 14% and 15%, respectively, of total net sales. A summary of significant accounting policies follows: Principles of Consolidation: The consolidated financial statements include the accounts of FAFCO, Inc. and its wholly- owned subsidiary. All significant inter-company balances and transactions have been eliminated in consolidation. Revenue Recognition: Revenues on sales of products are recognized at the time of shipment of goods or performance of service. Use of Estimates: 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 materially from those estimates. Cash and Cash Equivalents: For purposes of reporting cash flows, cash and cash equivalents include highly liquid investments with a maturity of three months or less. Inventories: Inventories are stated at the lower of cost or market determined using the first-in, first-out (FIFO) method. Plant and Equipment: Plant and equipment are stated based on historical cost adjusted for accumulated depreciation. Depreciation and amortization of plant and equipment, excluding vehicles and leasehold improvements, are determined using accelerated methods. For vehicles and leasehold improvements, the straight line method is used. The estimated useful lives of the assets range between three and ten years. Minor replacements, improvements, maintenance and repairs are expensed as incurred. Major replacements and improvements are capitalized and depreciated over the remaining useful life of the related asset. Gains and losses on sales and retirement of plant and equipment are credited or charged to income. Accounting for the Impairment of Long-lived Assets and for Long- lived Assets to be Disposed of: As required by generally accepted accounting principles (GAAP), effective January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of." The new standard provides guidance on when to recognize and how to measure impairment losses of long-lived assets and certain identifiable intangibles and how to value long-lived assets to be disposed of. The new standard had no material effect on the Consolidated Balance Sheets for 1997 and 1996 nor the Consolidated Statements of Operations for 1997, 1996 or 1995. Income Taxes: Deferred tax assets and liabilities are recognized for the tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities. (See Note 8.) Earnings per Common Share: FAFCO adopted Statement of Financial Accounting Standard No. 128 ("FAS 128"), Earnings per Share, beginning with FAFCO's fourth quarter of 1997. All prior period earnings per common share data have been restated to conform to the provisions of this statement. Basic earnings per common share is computed using the weighted average number of shares outstanding. Diluted earnings per common share is computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to outstanding options and warrants to purchase common stock and shares issuable upon conversion of certain convertible securities. (See Note 12.) Concentration of Credit Risk: Most of the Company's business activity is with customers located in California, Florida and foreign countries. As of December 31, 1997, unsecured trade accounts receivable from customers in California, Florida and foreign countries were $481,100, $841,400, and $915,000, respectively. Warranties: In the normal course of business, the Company makes certain warranties as to workmanship and materials. Product warranty periods range from two to ten years for full coverage. The estimated future expense of these warranties is accrued at the time of sale. The estimates inherent in accounting for such warranties are reviewed and revisions to previous estimates are made as required to reflect the most current information available. Accounting for Stock-Based Compensation: The FASB issued a new standard, FAS No. 123, "Accounting for Stock-Based Compensation," which contains a fair value-based method for valuing stock-based compensation that entities may use, which measures compensation cost at the grant date based on the fair value of the award. Compensation is then recognized over the service period. Alternatively, the standard permits entities to continue accounting for employee stock options and similar equity instruments under APB Opinion 25, "Accounting for Stock Issued to Employees." Entities that continue to account for stock options using APB Opinion 25 are required to make pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in FAS No. 123 had been adopted. The Company has decided to continue accounting for employee stock options and similar equity instruments under APB Opinion 25, "Accounting for Stock Issued to Employees." (see Note 7.) Disclosures About Fair Value of Financial Instruments: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. Current Assets and Current Liabilities: The carrying value of cash equivalents, accounts receivable, notes receivable, short- term borrowings, accounts payable, and accrued expenses approximate fair value because of their short maturity. Long-Term Debt: The fair value of the Company's long-term debt is estimated based on the borrowing rates currently available to the Company for loans with similar terms. At December 31, 1997, the carrying amount approximates estimated fair value of long- term debt. 2) Inventories Effective in 1997 the Company changed its method of accounting for inventories from last in, first out (LIFO) to first in, first out (FIFO), a change in accounting principle. The reason for this change is that LIFO is difficult and costly for the Company to administer and the effect on the Consolidated Statement of Operations has not been material over the past several years due to the relatively low rates of inflation in the economy as a whole. The cumulative effect on Shareholders' Equity at December 31, 1996 was to increase Shareholders' Equity by $82,000. The financial statements have been restated for this change in accounting method for all periods presented. December 31, 1997 1996 Net income (loss) as previously as reported $ 386,800 $ (1,918,300) Adjustment for effect of a change in accounting principle that is applied retroactively $ (75,400) $ 59,900 Net income (loss) as adjusted $ 311,400 $ (1,858,400) Per share amounts Basic earnings per common share: Net income (loss) as previously reported $ 0.12 $ (0.62) Adjustment for effect of a change in accounting principle that is applied retroactively $ (0.02) $ (0.02) Net income (loss) as adjusted $ 0.10 $ (0.60) Diluted earnings per common share: Net income (loss) as previously reported $ 0.12 $ (0.62) Adjustment for effect of a change in accounting principle that is applied retroactively $ (0.02) $ 0.02 Net income (loss) as adjusted $ 0.10 $ (0.60)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Inventories consist of the following: December 31, 1997 1996 Raw materials $ 462,800 $ 413,800 Work in progress 114,000 111,900 Finished goods 506,100 391,700 $1,082,900 $ 917,400
3) Plant and Equipment Plant and equipment consists of the following: December 31, 1997 1996 Machinery and equipment $ 1,957,600 $ 1,902,800 Office and computer equipmen $ 466,900 $ 372,600 Leasehold improvements 88,600 88,600 Vehicles 101,800 101,800 $ 2,614,900 $ 2,465,800 Less accumulated depreciation and amortization (2,236,300) (2,116,200) $ 378,600 $ 349,600
4) Notes Receivable During 1997, the Company converted $126,400 of accounts receivable from a customer into a note receivable. During 1996, the Company converted $4,700 of accounts receivable from a customer into a note receivable. 5) Convertible Subordinated Notes At December 31, 1997 and 1996, convertible subordinated notes consisted of $925,000 of notes bearing interest at 11% per annum payable quarterly and warrants to purchase Common Stock. The exercise price of the warrants is $0.125 per share, the maximum aggregate number of shares issuable upon exercise of the warrants is 555,000, and the unexercised warrants expire March 27, 2000 (see Note 9). 6) Bank Line of Credit The Company has a bank line of credit secured by substantially all the assets of the Company. The line of credit allows the Company to borrow the lesser of $1,000,000 or an amount determined by a formula applied to net accounts receivable, inventories, and net lant and equipment. Amounts borrowed bear interest at the bank's prime rate plus 1.5%. The line of credit contains certain covenants relating to working capital, current ratio, and tangible net worth, prohibits the payment of cash dividends and expires on March 30, 1999. At December 31, 1997 and 1996, the Company had complied with the loan covenants. As of December 31, 1997 and 1996, the Company had outstanding balances of $0 and $758,600, respectively, under this facility. 7) Shareholders' Equity The Board of Directors, without shareholder approval, may determine the rights, preferences, privileges, and restrictions of the Company's unissued Preferred Stock. Such shares may be issued in one or more series. In 1980, the Company issued 202,300 shares of Common Stock at a price of $2.43 per share in exchange for non-interest bearing promissory notes, which have a balance due of $75,100 at December 31, 1997 and 1996. The notes are due and payable and the Company intends to pursue collection of these notes. In the event that any of the notes are uncollectible, the Company will demand surrender of the related shares issued and will cancel and write off the related notes receivable balance. Under the Company's Employee Stock Purchase Plan, 150,000 shares of Common Stock have been reserved for issuance at 85% of fair market value as of specified dates. The Plan was suspended in 1991 and no shares have been issued thereunder since 1991. The Company had a 1981 Incentive Stock Option Plan under which 310,000 shares of Common Stock are reserved for issuance. During 1991, options were granted for 5,000 shares exercisable at $0.625 per share which were forfeited during 1997. The plan expired by its terms in 1991. The Company has a 1991 Incentive Stock Option Plan under which 250,000 shares of Common Stock were initially reserved for issuance to employees and consultants. During November 1994, the Board of Directors approved an increase in the number of shares of Common Stock reserved for issuance to a total of 500,000 shares subject to shareholder approval, which was obtained in April 1995. During 1995, options were granted to purchase 124,000 shares exercisable at $0.56 per share, the fair market value on the date of grant, and options to purchase 6,000 shares were exercised. During 1996, options were granted to purchase 236,950 shares exercisable at $0.125 per share, the fair market value on the date of grant. During 1997, options were granted to purchase 21,000 shares exercisable at $0.125 per share, the fair market value on the date of grant. The Company has a 1991 Director's Stock Option Plan under which 50,000 shares of Common Stock are reserved for issuance. No options were granted or exercised during 1995, 1996, or 1997. Options granted under these plans become exercisable at a rate of 20% per year for five years from date of grant and expire six years or ten years from date of grant. During 1995, the Company granted nonqualified options to purchase 20,000 shares at $0.56 per share to a consultant. These options were fully vested at the date of grant and expire six years from date of grant. None of these options have been exercised. During 1995, options to purchase 234 shares were canceled. A summary of activity under the 1981 and 1991 Incentive Stock Option Plans follows: Shares Exercise Subject Price to Option Per Share Outstanding at December 31, 1994 332,550 $ 0.50-0.625 Granted 124,000 $ 0.560 Canceled (166,300) $ 0.50-0.560 Exercised (14,800) $ 0.500 Outstanding at December 31, 1995 275,450 $ 0.50-0.625 Granted 236,950 $ 0.125 Canceled (126,950) $ 0.50-0.560 Exercised 0 Outstanding at December 31, 1996 385,450 $ 0.125-0.625 Granted 21,000 $ 0.0125 Canceled (31,500) $ 0.125-0.625 Exercised 0 Outstanding at December 31, 1997 374,950 $ 0.125-0.50
The Company applies APB Opinion 25 in accounting for its stock option plans. Accordingly, no compensation cost has been recognized for the plan in 1995 or 1996. Had compensation cost been determined on the basis of fair value pursuant to FASB Statement No. 123, net income and earnings per share would have been reduced as follows: 1997 199 1995 Net income (loss) As reported $ 866,000 $ 311,400 $(1,858,400) Pro forma $ 860,200 $ 293,600 $(1,857,600) Basic earnings (loss) per share As reported $ 0.26 $ 0.10 $ (0.60) Pro forma 0.26 0.09 (0.60) Diluted earnings (loss) per share As reported $ 0.22 $ 0.10 $ (0.60) Pro forma $ 0.2 $ 0.09 $ (0.60)
The fair value of each option granted was estimated on the grant date using the Black-Scholes model. The following assumptions were made in estimating fair value: Assumption 1997 1996 Dividend yield 0% 0% Risk-free interest rate 5.55% 6.5% Expected life 10 years 6 years Expected volatility 141.1% 96.74%
Following is a summary of the status of the plans during 1997, 1996, and 1995. Weighted Average Number of Excercise Shares Price Outstanding at January 1, 1997 385,450 $ 0.258 Granted 21,000 0.125 Exercised 0 0 Forfeited (31,500) 0.460 Outstanding at December 31, 1997 374,950 0.250 Options exercisable at December 31,1997 231,150 0.282 Weighted average fair value of options granted during 1997 $0.123
Weighted Average Number of Exercise Shares Price Outstanding at January 1, 1996 275,450 $ 0.485 Granted 236,950 0.125 Exercised 0 0 Forfeited (126,950) 0.502 Outstanding at December 31, 1997 385,450 0.258 Options exercisable at December 31,1996 199,650 0.297 Weighted average fair value of options granted during 1996 $0.101
Weighted Average Number of Exercise Shares Price Outstanding at January 1, 1995 332,550 $0.5020 Granted 124,000 0.5100 Exercised (14,800) 0.5000 Forfeited (166,300) 0.0536 Outstanding at December 31, 1995 275,450 0.4850 Options exercisable at December 31,1995 163,750 0.5030 Weighted average fair value of options granted during 1995 $ 0.410
Following is a summary of the status of options outstanding at December 31, 1997: Outstanding Exercisable Weighted Average Weighted Weighted Remaining Average Average Exercise Contractual Exercise Price Number Life Price Number Price $0.500 118,000 1 $0.500 94,400 $0.500 $0.250 20,000 4 $0.250 8,000 $0.250 $0.125 236,950 5 $0.125 128,750 $0.125 374,950 4 231,150
The range of exercise prices for the options outstanding at December 31, 1997 is $0.125-$0.50 with a weighted average contractual life of 5 years. The Company estimates that based on vesting at 20% per year at December 31, 1997, approximately 100% of options will eventually vest. 8 Income Taxes The provisions for income taxes consist of the following: Years Ended December 31, 1997 1996 1995 Taxes on income: U.S. Federal Current $ 12,000 $ 0 $ 0 Deferred (28,400) (40,300) 0 (16,400) (40,300) 0 State Current 20,000 1,600 1,600 Deferred 9,600 2,000 29,600 3,600 1,600 Foreign Current 10,000 0 0 Deferred 0 0 0 $ 10,000 $ 0 $ 0 Net income tax (benefit) provision $ 23,200 $ (36,700) $ 1,600
A reconciliation of the statutory federal income tax rate with the effective tax rate reported in the financial statements follows: Years Ended December 31, 1997 1996 1995 Statutory federal income tax (benefit) rate 34.0% 34.0% (34.0%) Effect on tax rate resulting from: State and foreign income taxes, net of federal tax benefit 2.2% 7.7% (1.4%) Tax effect of change in valuation allowance (36.6%) (54.8%) 40.9% Expiration of tax credits 1.7% 2.0% 0.7% Other 1.3% 0.6% (6.2%) Effective tax rate 2.6% (10.5%) 0%
The Company records its deferred taxes on a tax jurisdiction basis and, with the adoption of FAS No. 109 in 1993, classifies those net amounts as current or noncurrent based on the balance sheet classifications. Deferred tax assets are comprised of the following: December 31, 1997 1996 Allowance for doubtful accounts $ 227,700 $ 215,600 Accrued expenses 132,500 184,300 Loss carryforwards 837,400 1,157,800 Tax credits 71,200 175,700 Other 108,300 107,800 1,377,100 1,841,200 Deferred tax asset valuation allowance (708,000) (1,191,800) Total deferred taxes, net $ 669,100 $ 649,400
The Company had unused federal net operating loss carryforwards of approximately $2,394,000 and $3,191,500, Florida loss carryforwards of approximately $611,000 and $1,083,000 and investment and other federal tax credits of approximately $71,200 and $175,700 available to offset future tax liabilities at December 31, 1997 and December 31, 1996, respectively. The net operating losses and credits expire in varying amounts until 2010. The use of the tax credits has been limited by the provisions of the Tax Reform Act of 1986 to reflect the benefit associated with an overall reduction in the corporate tax rate. The Company believes that the "total deferred taxes, net" in the amount of $669,100 is more likely than not to be realized. 9) Transactions with Related Parties At December 31, 1997 and 1996, $600,000 of the Company's convertible subordinated notes (see Note 5) were held by Mr. Freeman A. Ford, an officer, director, and major shareholder of the Company, and his immediate family members. In April 1996, the Company granted Mr. Ford a warrant to purchase 123,950 shares of Common Stock. 10) Employee Benefit Plans The Company has a 401(k) retirement savings plan for all eligible employees who have completed one year of service. Eligible employees have the option to contribute up to 15% of their eligible salary. The Company contributes an amount equal to 25% of the employee contribution, up to a maximum of $400 per employee. 11) Lease Commitments The Company's rental expense, relating primarily to a lease for its office and manufacturing facility, amounted to $393,400 in 1997, $380,300 in 1996, and $359,400 in 1995. At December 31, 1997, minimum annual lease commitments under non-cancelable leases were as follows: 1998 $ 391,900 1999 405,400 2000 138,900 Total $ 936,200
The Company is required to pay property taxes, utilities, and insurance under certain of these leases, some of which provide for renewal options at the end of the initial lease term in the year 2000. 12) Net Income Per Share Basic earnings per share were calculated as follows: Years ended December 31, 1997 1996 1995 Net income (loss) $ 866,000 $ 311,400 $ (1,858,400) Average common shares outstanding 3,298,311 3,254,066 3,102,564 Earnings (loss) per share $ 0.26 $ 0.10 $ (0.60)
Basic earnings per share are calculated by dividing net income (loss) by the weighted average number of shares issued and outstanding. Diluted earnings per share were calculated as follows: Years ended December 31, 1997 1996 1995 Adjusted Net income (loss) $ 921,700 $ 311,400 $(1,858,400) Average com- mon shares outstanding 3,298,311 3,254,066 3,102,564 Add: Exercise of options re- duced by the number of shares pur- chased with proceeds 186,026 N/A N/A Add: Exercise of warrants re- duced by the number of shares purchased with proceeds 63,173 N/A N/ Add: Conversion of convertible debt into shares 555,000 Adjusted weighted average shares outstanding 4,102,510 3,254,066 3,102,564 Earnings (loss) per common share assuming full dilution $ 0.22 $ 0.10 $ (0.60)
13) Licensing Income During 1997, the Company entered into a licensee agreement with a third party in the Far East under which the Company received and recognized license fee income net of foreign income taxes of $90,000. The agreement allows for the licensee to assemble and sell the IceStor(tm) product in certain countries using the Company's technology and design specifications. For the term of the agreement (eight years), the Company is required to provide parts and technical services to the licensee at prices and rates equivalent to normal list prices. 14) Litigation The Company is involved in certain litigation matters. Management believes resolution of these disputes will not have a material adverse effect on the Company's financial condition and results of operation. Report of Independent Auditors To the Board of Directors of FAFCO, Inc. We have audited the consolidated balance sheets of FAFCO, Inc. and its subsidiary as of December 31, 1997 and 1996 and the related consolidated statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The Consolidated Statements of Income, Retained Earnings and Cash Flows for the year ended December 31, 1995 were audited by other auditors whose report dated March 27, 1996 expressed an unqualified opinion on those statements. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of FAFCO, Inc. and its subsidiary as of December 31, 1997 and 1996 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. As discussed in Notes 1 and 2 respectively to the consolidated financial statements, the Company adopted SFAS 128 "Earnings per Share" during the fourth quarter of 1997 and changed its method of accounting for inventories from last-in, first-out (LIFO) to first-in, first-out (FIFO) effective January 1, 1997. Burr, Pilger & Mayer Palo Alto, California March 17, 1998 Summary of Operations Five-Year Summary of Operations (in thousands, except per share data) Year Ended December 31, 1997 1996 1995 1994 1993 Net sales $10,552 $8,869 $7,876 $10,526 $9,352 Income (loss) before income taxes and changes in accounting principles $ 889 $ 350 $(1,917)$ 504 $ 254 Provision for income taxes 23 (37) 1 49 116 Income (loss) before changes in accounting principles 866 387 (1,918) 455 138 Effect of change in method of accounting for inventories applied retroactively 0 (74) 60 43 (2) Cumulative effect of change in method of accounting for income taxes 717 Net income (loss) $ 866 $ 311 $ (1,858)$ 498 $ 853 Basic net income (loss) per share before changes in accounting principles $ 0.26 $ 0.12 $ (0.62) $ 0.13 $ 0.04 Basic net income (loss) per share from effect of change in method of accounting for inventories applied retroactively 0 (0.02) 0.02 0.01 0 Basic net income per share from cumulative effect of change in method of accounting for income taxes 0.22 Basic net income (loss) per share $ 0.26 $ 0.10 $ (0.60) $ 0.14 $ 0.26 Diluted net income (loss) per share before changes in accounting principles $ 0.22 $ 0.12 $(0.62) $ 0.13 $ 0.05 Diluted net income (loss) per share from effect of change in method of accounting for inventories applied retroactively 0 (0.02) 0.02 0.01 0 Diluted net income per share from cumulative effect of change in method of accounting for income taxes 0.19 Diluted net income (loss) per share $ 0.22 $ 0.10 $(0.60) $ 0.14 $ 0.24 At December 31, 1997 1996* 1995* 1994* 1993* Working capital $ 2,007 $ 1,285 $379 $2,469 $ 1,839 Total assets 4,437 4,345 3,557 5,001 4,428 Long-term obligations 980 951 680 725 751 Shareholders' equity 2,042 1,176 772 2,628 2,093
*Restated for change in accounting principle (see Note 2). Common Stock Data FAFCO, Inc. Common Stock is traded on the over-the-counter market but is not listed on an exchange or quoted on any automated quotation system. The high and low closing bid quotations for each quarter during 1997 and 1996 were as follows: Quarter Ended March 31 June 30 September 30 December 31 1997 High $0.125 $0.125 $0.125 $0.750 1997 Low $0.125 $0.125 $0.125 $0.125 1996 High $0.250 $0.125 $0.125 $0.125 1996 Low $0.125 $0.125 $0.125 $0.125
The quotations above were provided by the National Quotation Bureau. All quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. At March 6, 1998, the Company had 710 shareholders of record. FAFCO, Inc. has never paid dividends on its Common Stock and has no plans to do so in the foreseeable future and is prohibited from so doing (see Note 6). Management's Discussion and Analysis This Annual Report to Shareholders contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below under the heading Factors Affecting Future Results and elsewhere in this Annual Report to Shareholders. 1997 Compared with 1996 Net sales for 1997 increased by 19% from $8,868,600 in 1996 to $10,551,500 in 1997. This increase was due primarily to increased unit sales of the Company's pool panel products, along with increased unit sales of the Company's IceStor(tm) products partially offset by the effect of discontinuance of the company's automated swimming pool controls. Net sales of the Company's pool products were 14.8% higher in 1997 than 1996 due mainly to increased sales of its Revolution model inground pool panels, along with increased sales of its Sunsaver(tm) model inground pool panels and increased sales of its Sunsaver(tm) model aboveground pool panels. These increases were partially offset by the effect of discontinuance of its proprietary line of automated swimming pool controls, which was phased out as of January 1, 1997. Net sales of the Company's IceStor(tm) products were 25.1% higher in 1997 than in 1996 due mainly to increased domestic sales along with higher foreign sales. Pool product sales amounted to 56% of net sales in 1997 compared to 58% of net sales in 1996. IceStor(tm) sales amounted to 44% of net sales in 1997 compared to 42% of net sales in 1996. There were no significant price changes in any of the Company's products during 1997. Cost of goods sold increased in absolute dollars from $5,500,300 in 1996 to $5,956,500 in 1997 while decreasing from 62.0% of net sales in 1996 to 56.5% of net sales in 1997. This decrease as a percent of net sales was due primarily to the fixed costs being allocated over higher sales along with a continued increase of sales of higher margin products in both the pool and the IceStor(tm) lines. Marketing and selling expenses increased in absolute dollars from $1,575,400 in 1996 to $1,770,000 in 1997 while decreasing from 17.8% of net sales in 1996 to 16.8% of net sales in 1997. These decreases as a percent of net sales were due mainly to the increased level of sales experienced in 1997 as compared to 1996. General and administrative expenses increased from $1,286,300 (14.5% of net sales) in 1996 to $1,776,100 (16.8% of net sales) in 1997. These increases were due mainly to increased bad debt write-offs along with bonus and profit-sharing expenses incurred in 1997 which were not incurred in 1996. Research and development expenses increased from $116,000 (1.3% of net sales) in 1996 to $202,800 (1.9% of net sales) in 1997. This increase was due mainly to an increase in the number of projects designed to improve current products and to develop potential new products, along with an increase in personnel to implement those projects. Net interest expense decreased from $169,900 (1.9% of net sales) in 1996 to $128,700 (1.2% of net sales) in 1997. This decrease was due mainly to lower average daily borrowing in 1997 along with lower interest rates. 1996 Compared with 1995 Net sales for 1996 increased by 12.6% from $7,876,100 in 1995 to $8,868,600 in 1996. This increase was due primarily to increased unit sales of the Company's IceStor(tm) and pool panel products. Net sales of the Company's pool products were 5.9% higher in 1996 than in 1995 due mainly to increased sales of its SunSaver(tm) model inground and aboveground pool panels partially offset by decreased sales of its Revolution(tm) model inground pool panels and decreased sales of its proprietary line of automatic controls, which was phased out as of January 1, 1997. Net sales of the Company's IceStor(tm) products were 24.0% higher in 1996 than in 1995 due mainly to increased foreign sales partially offset by decreased domestic sales. The Company believes the decreased domestic sales were due mainly to potential customers' beliefs that lower energy prices in the domestic market place will result from planned deregulation of energy prices. Pool product sales amounted to 58% of net sales in 1996 compared to 62% of net sales in 1995. IceStor(tm) sales amounted to 42% of net sales in 1996 compared to 38% of net sales in 1995. There were no significant price changes in any of the Company's products during 1996. Cost of goods sold decreased from $5,578,000 (70.8% of net sales) in 1995 to $5,500,300 (62.0% of net sales) in 1996. This was due mainly to the fixed costs being allocated over higher sales along with increased sales of higher margin products in both the pool product line and IceStor(tm) product line. Marketing and selling expenses decreased from $2,137,200 (27.1% of net sales) in 1995 to $1,575,400. (17.8% of net sales) in 1996. This decrease is due mainly to reduced promotional expenses for pool products along with reduction in support personnel for IceStor(tm) products. General and administrative expenses decreased from $1,502,000 (19.1% of net sales) in 1995 to $1,286,300 (14.5% of net sales) in 1996. This decrease is due mainly to decreased personnel costs along with decreased legal and accounting expenses. Research and development expenses decreased from $460,100 (5.8% of net sales) in 1995 to $116,000 (1.3% of net sales) in 1996. This decrease was due entirely to the reduction in personnel in late 1995 and the continued low level of personnel in 1996. Net interest expense increased from $95,300 (1.2% of net sales) in 1995 to $169,900 (1.9% of net sales) in 1996. This increase is due primarily to the higher average daily borrowing in 1996 at higher interest rates than in 1995. Seasonality Historically, the Company has experienced lower sales during the first quarter than during other quarters of each year. In addition, sales typically have increased significantly during the second quarter, declined slightly, and then remained relatively constant during the third and fourth quarters, respectively. The Company believes that this pattern derives primarily from the sales of solar heating products. As the Company's product mix shifts to include a larger proportion of other products, such as the thermal energy storage products, the traditional seasonality is being mitigated. Net income is affected by the seasonality of sales as well as by significant marketing and selling expenses typically incurred during the first quarter of each year. These expenses are incurred to develop programs and materials for use throughout the remainder of the year. In 1997 sales and net income experienced their typical seasonality, except that sales of pool panel products in the first quarter were increased as a result of the unusually dry and warm weather in both California and Florida. As a result of the increased sales of pool panel products the traditional first quarter loss was not experienced. The traditional seasonality may be exaccerbated in 1998 because of the effect on sales due to the El Nino weather pattern. In 1996, sales and net income experienced their traditional seasonality, except that sales in the fourth quarter were increased due to sales of IceStor(tm) product. As a result of the ice storage sales, the traditional fourth quarter loss was not experienced. In 1995, sales experienced the traditional seasonality except that the decline in sales in the third and fourth quarters was more pronounced than normal due to weak sales in both pool products and IceStor(tm) during the second half of the year. There were net losses in all four quarters due to sales being below the planned levels in all four quarters. Liquidity and Capital Resources The Company's cash position decreased from $88,200 at 1996 fiscal year end to $46,300 at 1997 fiscal year end, principally due to the repayment of the bank line of credit and the purchase of fixed assets. At December 31, 1997, the Company's net accounts receivable had decreased slightly to $1,833,400 from $1,890,700 at December 31, 1996, primarily as a result of faster collection of accounts receivable partially offset by increased sales in late 1997. At December 31, 1997, the Company's accounts payable and other accrued expenses had decreased to $850,900 from $1,037,800 at December 31, 1996. This decrease is primarily due to faster payment of accounts payable because of cash availability from profits. At December 31, 1997, the Company's inventories had increased to $1,082,900 from $917,400 at December 31, 1996. This increase was due entirely to the buildup of inventories for a specific order that shipped in the first quarter of 1998. As described in Note 2 of the Financial Statements, during 1997 the Company changed its inventory accounting principle from LIFO to FIFO, after discussions with Burr, Pilger and Mayer (the Company's independent auditors) as to the appropriate method. The Company adopted SFAS 109 effective January 1, 1993. This resulted in the recognition of a deferred tax asset, net of valuation allowance, at year-end of $669,100 in 1997 and $649,400 in 1996. The Company believes that it is more likely than not that this asset will be fully realized. This belief is based upon the Company's recent history of profitable operations prior to 1995, its return to profitability in 1996 and 1997, and the Company's expectation that operating results will allow it to realize the net deferred tax asset. However, there can be no assurance that the Company will continue profitability or, if it does, that profits will be sufficient to utilize the net deferred tax asset. At December 31, 1997, the Company's current ratio was 2.42 to 1 compared with 1.58 to 1 at December 31, 1996 and working capital increased over the same period to $2,006,800 from $1,284,700. Total assets exceeded total liabilities by $2,042,300 at December 31, 1997 compared with $1,176,300 at December 31, 1996. The Company believes that its cash flow from operations, together with bank borrowings, will be sufficient to support operations during the next twelve months. The foregoing statement of how long the Company's capital resources are expected to last is a forward-looking statement involving risks and uncertainties, including the amount of the Company's sales and the ability of the Company to control its operating expenses and the need to invest in sales and marketing activities in 1998. However, if sales decline from current levels, additional debt or equity financing may be required. There can be no assurance that financing, if required, would be available on favorable terms or at all or that such financing will not significantly dilute the ownership interests and rights of existing shareholders. The Company has a line of credit, of which none had been utilized and $1,000,000 remained available under the formula applied to net accounts receivable at December 31,1997. This line of credit expires on March 30, 1999. Factors Affecting Future Results During 1997 26.6% of the Company's net sales were to Japan, Taiwan and South Korea. Although the financial crisis in that region of the world has not yet had any noticeable negative effect on the Company's sales, there is no assurance that sales will not be negatively affected if the crisis worsens, or is prolonged. Sales of pool panel products have slowed somewhat in January and February of 1998 due to severe weather conditions in both California and Florida as a consequence of El Nino. However, the Company does not expect that the El Nino weather pattern will significantly affect sales of pool panel products over the long term. However, if this weather pattern becomes more severe and/or lasts into the peak pool panel selling season of March through July, there is no assurance that sales will not be substantially negatively affected. In addition, the effect on a particular quarter's results of operations could be substantial. The Company has reviewed its internal computer systems for year 2000 compliance and is satisfied that all of its internal computer systems are either already year-2000 compliant or can be made year-2000 compliant through simple, inexpensive upgrades. The Company does not expect the costs of achieving full year-2000 compliance to be material. However, there can be no assurance that coding errors or other defects will not be discovered in the future. Export sales are subject to certain controls and restrictions, including tariffs and import duties and are subject to certain risks, including changing regulatory requirements of foreign jurisdictions and transportation delays and interruptions; however, the Company has not experienced any material difficulties in the past relating to such limitations. The financial crisis in Southeast Asia has not had any noticeable negative effecct on sales; however, there is no assurance that sales will not be negatively affected if the crisis worsens or is prolonged. Corporate Directory and Information Board of Directors Freeman A. Ford Chairman of the Board, President, and Chief Executive Officer FAFCO, Inc. William A. Berry* Senior Vice President and Chief Financial Officer Electric Power Research Institute a private, nonprofit, research organization doing collaborative research for the electricity industry. Robert W. Selig, Jr.* President Davis Instruments Corporation a manufacturer of marine and weather equipment. _________________________ *Audit Committee Member Executive Officers Freeman A. Ford Chairman of the Board, President, and Chief Executive Officer Alex N. Watt Vice President, Finance and Administration, Chief Financial Officer, and Secretary David K. Harris Vice President, Pool Products Transfer Agent and Registrar Continental Stock Transfer & Trust Company 2 Broadway New York, NY 10004 Telephone: (212) 509-4000 Legal Counsel Wilson, Sonsini, Goodrich & Rosati A Professional Corporation 650 Page Mill Road Palo Alto, California 94304 Independent Accountants Burr, Pilger & Mayer A Professional Corporation 261 Hamilton Avenue Palo Alto, California 94301 Form 10-K A copy of the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission, including financial statement schedules but excluding exhibits, is available without charge upon written request to: FAFCO, Inc. 2690 Middlefield Road Redwood City, California 94063-3455 Attention: Alex N. Watt Annual Shareholders' Meeting The Annual Shareholders' Meeting will be held at 3:00 p.m. on May 14, 1998 at FAFCO, Inc., 2690 Middlefield Road, Redwood City, California 94063-3455, Telephone: (650) 363-2690 -----END PRIVACY-ENHANCED MESSAGE-----