10-Q/A 1 hrly10qa1-apr2006.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A (Amendment No. 1) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: April 30, 2006 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 0-5411 HERLEY INDUSTRIES, INC. ----------------------- (Exact name of registrant as specified in its charter) DELAWARE #23-2413500 -------- ----------- (State or other jurisdiction (I.R.S. Employer Identification Number) of incorporation or organization) 101 North Pointe Boulevard, Lancaster, Pennsylvania 17601 --------------------------------------------------- ----- (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, including Area Code: (717) 735-8117 -------------- 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. [X] Yes [ ] No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): [ ] Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No As of September 11, 2006 - 14,660,716 shares of Common Stock are outstanding. EXPLANATORY NOTE This Form 10-Q/A amends and replaces in its entirety the Form 10-Q ("Original Filing") filed by Herley Industries, Inc. (the "Company") on June 14, 2006. This amendment is being filed to comply with Rule 10-01(d) of Regulation S-X (the "Rule") which requires a review of the Company's quarterly consolidated financial statements for the quarter ended April 30, 2006 by an independent registered public accountant and to include the certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002. As previously disclosed, the Company's former auditors BDO SEIDMAN LLP were unable to complete its review of the consolidated financial statements for the quarter ended April 30, 2006 by the due date of the Original Filing. Therefore, the Company was unable to satisfy the requirements of the Rule and unable to certify that the Original Filing was in compliance with the Rule requirements. BDO SEIDMAN subsequently on July 27, 2006 informed the Company that they had resigned as the Company's auditors. At a meeting held on July 27, 2006, the Company's Audit Committee accepted the resignation of BDO SEIDMAN LLP and approved the engagement of Marcum & Kliegman LLP as the Company's independent registered public accountants. The interim consolidated financial statements for the thirteen and thirty-nine weeks ended April 30, 2006 contained in this report have now been reviewed by Marcum & Kliegman LLP. This amended Form 10-Q/A also includes the required certifications of the Company's Chief Executive Officer and Chief Financial Officer as required by Sections 302 and 906 of the Sarbanes-Oxley Act. HERLEY INDUSTRIES, INC. AND SUBSIDIARIES INDEX TO FORM 10-Q/A (Amendment No. 1) PAGE PART I - FINANCIAL INFORMATION Item 1 - Financial Statements: Review Report of Independent Registered Public Accounting Firm 2 Consolidated Balance Sheets - April 30, 2006 and July 31, 2005 3 Consolidated Statements of Income - For the Thirteen and Thirty-nine weeks ended April 30, 2006 and May 1, 2005 4 Consolidated Statement of Shareholders' Equity- For the Thirty-nine weeks ended April 30, 2006 5 Consolidated Statements of Cash Flows - For the Thirty-nine weeks ended April 30, 2006 and May 1, 2005 6 Notes to Consolidated Financial Statements 7 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 22 Item 4 - Controls and Procedures 22 PART II - OTHER INFORMATION Item 1 - Legal Proceedings 22 Item 6 - Exhibits 23 Signatures 24 Part I - Financial Information Item 1 - Financial Statements REVIEW REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Herley Industries, Inc. 101 North Pointe Boulevard Lancaster, PA 17601 We have reviewed the accompanying consolidated balance sheet of Herley Industries, Inc. and Subsidiaries (the "Company") as of April 30, 2006 and the related consolidated statements of income for the thirteen weeks and thirty-nine weeks ended April 30, 2006 and shareholders' equity and cash flows for the thirty-nine weeks ended April 30, 2006. These interim consolidated financial statements are the responsibility of the Company's management. The consolidated financial statements of Herley Industries, Inc. and Subsidiaries for the thirteen weeks and thirty- nine weeks ended May 1, 2005 were reviewed by another independent registered public accounting firm. No review report was issued by such firm. We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying fiscal 2006 interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. The consolidated balance sheet of Herley Industries, Inc. and Subsidiaries as of July 31, 2005 and the related consolidated statements of income, shareholders' equity and cash flows for the year then ended (not presented herein) were previously audited by other auditors, in accordance with standards established by the Public Company Accounting Oversight Board (United States); and their report dated October 7, 2005, expressed an unqualified opinion on those consolidated financial statements. By letter dated August 14, 2006, the predecessor independent registered public accounting firm notified the Company that it was withdrawing its opinion. In our opinion, the information set forth in the accompanying consolidated balance sheet as of April 30, 2006, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. However, we have not completed an audit or review of the 2005 financial statements of the Company and, accordingly, we do not express an opinion or any other form of assurance on the 2005 financial statements taken as a whole. Marcum & Kliegman LLP Melville, New York September 12, 2006 2 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED) (In thousands, except share data)
April 30, July 31, 2006 2005 -------------- --------------- ASSETS Current Assets: Cash and cash equivalents $ 27,364 $ 20,331 Trade accounts receivable, net 30,148 27,258 Costs incurred and income recognized in excess of billings on uncompleted contracts 18,494 16,058 Other receivables 1,131 1,414 Inventories, net of allowance of $5,168 in fiscal 2006 and $4,492 in fiscal 2005 53,639 53,668 Deferred taxes and other 4,317 3,782 -------------- --------------- Total Current Assets 135,093 122,511 Property, Plant and Equipment, net 30,133 29,461 Goodwill 73,500 70,831 Intangibles, net of accumulated amortization of $3,021 in fiscal 2006 and $1,680 in fiscal 2005 20,525 20,554 Other Assets 650 744 -------------- --------------- $ 259,901 $ 244,101 ============== =============== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Current portion of long-term debt $ 221 $ 797 Accounts payable and accrued expenses 22,877 23,678 Billings in excess of costs incurred and income recognized on uncompleted contracts 410 538 Income taxes payable 2,953 3,760 Accrual for contract losses 3,158 630 Accrual for warranty costs 715 799 Advance payments on contracts 5,109 3,966 -------------- --------------- Total Current Liabilities 35,443 34,168 Long-term Debt 4,756 5,000 Other Long-term Liabilities 1,246 1,042 Deferred Income Taxes 7,182 6,254 -------------- --------------- 48,627 46,464 -------------- --------------- Commitments and Contingencies Shareholders' Equity: Common stock, $.10 par value; authorized 20,000,000 shares; issued and outstanding 14,634,916 in fiscal 2006 and 14,389,625 in fiscal 2005 1,463 1,439 Additional paid-in capital 112,899 109,118 Retained earnings 95,573 85,932 Accumulated other comprehensive income 1,339 1,148 -------------- --------------- Total Shareholders' Equity 211,274 197,637 -------------- --------------- $ 259,901 $ 244,101 ============== =============== See notes to consolidated financial statements.
3 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (In thousands except per share data)
Thirteen weeks ended Thirty-nine weeks ended -------------------- ----------------------- April 30, May 1, April 30, May 1, 2006 2005 2006 2005 ------------ ------------- --------------- --------------- Net sales $ 45,689 $ 41,266 $ 133,466 $ 108,610 ------------ ------------- --------------- --------------- Cost and expenses: Cost of products sold 34,736 27,845 94,900 75,034 Selling and administrative expenses 8,960 8,865 25,785 21,541 ------------ ------------- --------------- --------------- 43,696 36,710 120,685 96,575 ------------ ------------- --------------- --------------- Operating Income 1,993 4,556 12,781 12,035 ------------ ------------- --------------- --------------- Other income (expense), net: Investment income 269 253 578 769 Interest expense (68) (74) (242) (211) Foreign exchange gain 170 79 273 264 ------------ ------------- --------------- --------------- 371 258 609 822 ------------ ------------- --------------- --------------- Income before income taxes 2,364 4,814 13,390 12,857 Provision for income taxes 662 1,187 3,749 3,600 ------------ ------------- --------------- --------------- Net income $ 1,702 $ 3,627 $ 9,641 $ 9,257 ============ ============= =============== =============== Earnings per common share - Basic $ .12 $ .25 $ .67 $ .65 ============ ============= =============== =============== Basic weighted average shares 14,569 14,313 14,497 14,300 ============ ============= =============== =============== Earnings per common share - Diluted $ .11 $ .24 $ .63 $ .62 ============ ============= =============== =============== Diluted weighted average shares 15,398 14,936 15,230 14,972 ============ ============= =============== =============== See notes to consolidated financial statements.
4 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED) Thirty-nine weeks ended April 30, 2006 (In thousands except share data)
Accumulated Common Stock Additional Other ----------------------- Paid-in Retained Comprehensive Shares Amount Capital Earnings Income Total ----------- --------- --------- --------- -------------- --------- Balance at July 31, 2005 14,389,625 $ 1,439 $ 109,118 $ 85,932 $ 1,148 $ 197,637 Exercise of stock options 245,291 24 2,775 2,799 Stock option compensation 333 333 Tax benefit upon exercise of stock options 673 673 ------------ ------- --------- --------- -------------- --------- Subtotal 14,634,916 1,463 112,899 85,932 1,148 201,442 --------- Net income 9,641 9,641 Other comprehensive income, net of tax: Unrealized gain on interest rate swap 33 33 Foreign currency translation gain 158 158 --------- Comprehensive income 9,832 ------------ ------- --------- --------- -------------- --------- Balance at April 30, 2006 14,634,916 $ 1,463 $ 112,899 $ 95,573 $ 1,339 $ 211,274 ============ ======= ========= ========= ============== ========= See notes to consolidated financial statements.
5 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (In thousands)
Thirty-nine weeks ended ----------------------- April 30, May 1, 2006 2005 --------------- --------------- Cash flows from operating activities: Net income $ 9,641 $ 9,257 --------------- --------------- Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 5,266 3,825 Stock-based compensation expense 333 - Excess tax benefit from exercises of stock options (673) (345) Deferred tax assets and liabilities 786 - Foreign exchange (gain) loss (55) 31 Gain on sale of securities - (22) Equity in income of limited partnership (49) (54) Changes in operating assets and liabilities: Trade accounts receivable (2,890) 4,996 Costs incurred and income recognized in excess of billings on uncompleted contracts, and claims (2,436) (3,569) Other receivables 283 (269) Inventories, net 29 (3,341) Deferred taxes and other (535) (400) Accounts payable and accrued expenses (801) 1,677 Billings in excess of costs incurred and income recognized on uncompleted contracts (128) (1,206) Income taxes payable (134) 3,187 Accrual for contract losses 24 (377) Advance payments on contracts 1,143 (1,410) Other, net 206 293 --------------- --------------- Total adjustments 369 3,016 --------------- --------------- Net cash provided by operating activities 10,010 12,273 --------------- --------------- Cash flows from investing activities: Acquisition of businesses, net of cash acquired - (51,391) Acquisition of technology license (1,256) (2,000) Proceeds from sale of securities - 165 Partial distribution from limited partnership 111 109 Capital expenditures (4,525) (4,948) --------------- --------------- Net cash used in investing activities (5,670) (58,065) --------------- --------------- Cash flows from financing activities: Borrowings under bank line of credit 12,000 - Proceeds from exercise of stock options 2,799 1,803 Payments of long-term debt (779) (780) Purchase of treasury stock - (1,770) Payments under bank line of credit (12,000) - Excess tax benefit from exercises of stock options 673 345 --------------- --------------- Net cash provided by (used in) financing activities 2,693 (402) --------------- --------------- Net increase (decrease) in cash and cash equivalents 7,033 (46,194) Cash and cash equivalents at beginning of period 20,331 66,181 --------------- --------------- Cash and cash equivalents at end of period $ 27,364 $ 19,987 =============== =============== See notes to consolidated financial statements.
6 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) 1. Interim Reporting The accompanying unaudited consolidated financial statements have been prepared in accordance with instructions to Form 10-Q and do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included in the accompanying financial statements. Operating results for interim periods are not necessarily indicative of the results of operations that may be expected for a full year. These statements should be read in conjunction with the consolidated financial statements and notes thereto, and the Company's description of critical accounting policies, included in the Company's 2005 Annual Report on Form 10-K/A Amendment 1 for the fiscal year ended July 31, 2005, as filed with the Securities and Exchange Commission ("SEC"). (See also Note 14, "Subsequent Events"). The unaudited consolidated financial statements include the accounts of Herley Industries, Inc. and its wholly-owned subsidiaries, collectively referred to as the "Company." All significant intercompany accounts and transactions have been eliminated. Certain prior period balances have been reclassified to conform to the current period's financial statement presentation. 2. Acquisitions The Company entered into an agreement as of September 1, 2004 to purchase the majority of the assets and assume the majority of the liabilities of Reliable System Services Corporation of Melbourne, Florida for $3,725,000 in cash, plus acquisition costs of approximately $28,000. The results of operations of RSS are included in the consolidated financial statements from September 1, 2004. The Company operates the business as a wholly-owned subsidiary under the name Herley-RSS, Inc. ("RSS"). RSS was acquired by Herley in order to capitalize on its synergies with Herley's other product lines, particularly in "over the horizon" command and control (C2) systems for drones and targets. RSS designs, develops and produces satellite-based command and control systems for prime defense contractors and entities worldwide. The Company entered into an agreement as of February 1, 2005 to acquire all of the capital stock of Micro Systems, Inc. ("MSI"), Fort Walton Beach, Florida for payments of $21,473,328 in cash, plus acquisition costs accrued of approximately $16,000, and the assumption of certain liabilities. The results of operation of MSI are included in the consolidated financial statements from February 1, 2005. MSI was acquired by Herley in order to capitalize on its synergies with Herley's legacy product lines, consolidate operations and add additional engineers to increase its capabilities in the area of control avionics and target control systems. MSI is a market leader in the design and manufacturing of command and control systems for operation of unmanned aerial, seaborne and ground targets and missiles. The Company entered into an agreement as of April 1, 2005 to acquire all of the capital stock of Innovative Concepts, Inc. ("ICI"), McLean, Virginia for cash payments of $24,378,330, the assumption of certain liabilities, and a cash advance of $3,250,000 for the repayment of debt assumed. The results of operations of ICI are included in the consolidated financial statements from April 1, 2005. ICI was acquired by Herley in order to capitalize on its tactical data link technology for exchange of digital information. ICI has a successful history of developing and providing wireless communications technology and real-time embedded systems, software, hardware and high-speed processing in support of the defense industry. All of the acquisitions completed by the Company are accounted for in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations", which requires that all business combinations be accounted for using the purchase method. 7 For the three acquisitions outlined above, the allocation of the aggregate purchase price (net of cash acquired of approximately $1,463,000), based on a review of the fair value of the assets acquired and liabilities assumed, is as follows (in thousands):
Acquisition RSS MSI ICI Effective Date September 1, 2004 February 1, 2005 April 1, 2005 -------------- ----------------- ---------------- ------------- Current assets $ 483 $1,534 $8,759 Property, plant and equipment 72 2,038 681 Other assets - 1 - Intangible assets - 4,400 10,200 Goodwill 3,456 15,148 19,693 Current liabilities (258) (2,436) (12,364) -------- -------- -------- Aggregate purchase price $ 3,753 $ 20,685 $ 26,969 ======== ======== ========
The Company adjusted its valuation of the assets acquired and liabilities assumed in the acquisition of ICI in accordance with the provisions of SFAS No. 141 during the second quarter of fiscal 2006. Accordingly, the Company's consolidated financial statements reflect an adjustment of $2,504,000 to the reserve for contract losses relating to a contract in ICI's backlog at the date of acquisition that consisted of an initial production order and four additional options exercisable unilaterally by the customer. Although the customer had not exercised any options as of the date of acquisition, the Company had a contractual obligation to honor the terms and conditions of the contract including the discounted pricing in the contract options, with a high probability of the options being exercised, resulting in the estimated losses under the contract. Prior to the acquisition of MSI, MSI had leased one of its two buildings in Fort Walton Beach Florida from MSI Investments, a Florida General Partnership. MSI Investments is owned by four individuals, three of whom are currently employees of MSI. This lease has an original term of 15 years, ending December 31, 2012. The lease costs currently are approximately $287,000 on an annual basis, including the tenant's obligation to pay for insurance and property taxes. The base lease rate is adjusted every January for changes in the consumer price index, using 1997 as the base year. Unaudited pro forma financial information for the three acquisitions completed by the Company in fiscal 2005 as if the acquisitions had occurred on August 2, 2004 is as follows (in thousands except per share amounts):
Thirty-nine weeks ended ----------------------- May 1, 2005 ----------- Net sales $ 130,418 Net income $ 8,850 Net Income per common share: Basic $0.62 Diluted $0.59 Weighted shares outstanding Basic 14,300 Diluted 14,972
3. Claims on Major Contracts Claims include amounts in excess of the original contract price (as it may be adjusted for approved change orders) that we seek to collect from our customers for delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price, or other causes of unanticipated additional costs and are included in estimated revenues when recovery of the amounts is probable and the costs can be reasonably estimated. Claims receivable in the amount of $2.2 million at April 30, 2006 are included in costs incurred and income recognized in excess of billings on uncompleted contracts on the accompanying Consolidated Balance Sheets. 4. Inventories Inventories at April 30, 2006 and July 31, 2005 are summarized as follows (in thousands): 8
April 30, 2006 July 31, 2005 -------------- ------------- Purchased parts and raw materials $ 25,124 $ 23,838 Work in process 31,414 32,026 Finished products 2,269 2,296 -------- -------- 58,807 58,160 Less reserve for excess and obsolete materials 5,168 4,492 -------- -------- $ 53,639 $ 53,668 ======== ========
5. Goodwill and Other Intangible Assets The Company accounts for goodwill and other intangible assets pursuant to the provisions of SFAS No. 142 "Goodwill and Other Intangible Assets". SFAS No. 142 requires the use of a non-amortization approach to account for purchased goodwill and certain intangibles. Under a non-amortization approach, goodwill and certain intangibles are not amortized into results of operations, but instead are reviewed for impairment and written down and charged to results of operations in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value. An annual impairment test is performed in the fourth quarter of each fiscal year and any future impairment of goodwill will be charged to operations. The change in the carrying amount of goodwill for the nine months ended April 30, 2006 is as follows (in thousands):
Balance at July 31, 2005 $ 70,831 Change in fair value of liabilities assumed in connection with the ICI acquisition (Note 2) 2,504 Foreign currency translation adjustment 165 -------- Balance at April 30, 2006 $ 73,500 ========
Intangible Assets consist of the following (in thousands):
April 30, July 31, Estimated 2006 2005 useful life ---------- -------- ----------- Trademarks (acquired with MSI and ICI) $ 2,800 $ 2,800 Indefinite Technology (acquired with EWST and MSI) 12,421 12,421 10-15 years Drawings 800 800 15 years Patents 568 568 14 years Backlog 3,125 3,125 2-5 years Non-compete 31 31 5 years Foreign currency translation adjustment 245 189 ------- ------- 19,990 19,934 Accumulated amortization 3,021 1,680 ------- ------- 16,969 18,254 Technology license (for millimeter wave applications; purchased from Xytrans) 3,556 2,300 (see below) ------- ------- $ 20,525 $ 20,554 ======= =======
The Company entered into a license and development agreement ("agreement") on April 7, 2005 to license millimeter wave technology for military applications from Xytrans, Inc. Xytrans focuses on providing high-frequency transceiver and outdoor unit design for the wireless broadband network market. The technology acquired includes exclusive access to a portfolio of patents and trade secrets that improve the cost and performance of millimeter wave subsystems that are used in weapons and radar systems. In January 2005, the Company had made a deposit payment of $1,000,000 in connection with this proposed transaction. The deposit payment was secured by a note receivable, which was cancelled upon execution of the agreement. The agreement provided for an additional payment on execution of $1,000,000, and for certain additional contingent payments, of up to $4,500,000. These contingent payments are subject to achievement of a series of development milestones on a US Government missile program, and / or receipt by the Company of a single contract award using millimeter wave technology valued at a minimum of $6,000,000, amongst other requirements. The agreement also provides for the payment of royalties ranging from 1% to 4% of sales of products including relevant millimeter wave technology, starting at the earliest January 1, 2006, and generally ending 4 years later. No royalties have been earned as of April 30, 2006. 9 As of April 30, 2006, Xytrans had achieved the development milestones on the missile program discussed above and the Company made additional contingent payments totaling $1,500,000. Additional development costs as a result of a scope change were paid in the net amount of $56,000. The investment in this licensed technology of $3,556,000 as of April 30, 2006 is included in the accompanying Consolidated Balance Sheets under the caption "Intangibles." After further development of this technology, and / or at the commencement of sales of products using the millimeter wave technology, the Company will begin to amortize the costs associated with this agreement based on the estimated economic life of the licensed technology. The carrying amount of intangibles is reviewed for recoverability when events or changes in circumstances occur that indicate that the carrying value of the assets may not be recovered. Amortization expense for the thirteen weeks ended April 30, 2006 and May 1, 2005 was approximately $447,000 and $232,000, respectively, and for the thirty-nine weeks ended April 30, 2006 and May 1, 2005 was approximately $1,341,000 and $410,000, respectively. Estimated aggregate amortization expense for each of the next five fiscal years, is as follows (in thousands):
2006 $ 1,788 2007 1,788 2008 1,782 2009 1,782 2010 1,502
6. Product Warranties The Company warrants its products generally for a period of one year. Product warranty costs are accrued based on historical claims expense. Accrued warranty costs are reduced as warranty repair costs are incurred. The following table presents the change in the accrual for product warranty costs for the thirteen and thirty-nine weeks ended April 30, 2006 and May 1, 2005 (in thousands):
Thirteen weeks ended Thirty-nine weeks ended April 30, May 1, April 30, May 1, 2006 2005 2006 2005 ---------- ---------- ---------- ---------- Balance at beginning of period $ 746 $ 583 $ 799 $ 580 Provision for warranty obligations 98 449 347 762 Warranty costs charged to the reserve (129) (246) (431) (556) ---------- --------- ---------- --------- Balance at end of period $ 715 $ 786 $ 715 $ 786 ========== ========= ========== =========
7. Litigation On June 6, 2006, in connection with a continuing investigation by the U.S. Attorneys' Office in Pennsylvania which, inter alia, involves pricing under contracts with the U.S. Department of Defense relating to voltage control oscillators and powerheads, an indictment was returned against the Company and Lee Blatt, its former Chairman. No other officer or director of the Company was named in the indictment. The contracts aggregate approximately $3.9 million in total revenue. The indictment alleges 29 counts of violations of the wire fraud statute (18 U.S.C. Section 1343); 2 counts of violations of the obstruction of a federal audit statute (18 U.S.C. Section 1516); 1 count of violating the major fraud against the United States statute (18 U.S.C. Section 1031); 3 counts of violating the false statements to the government statute (18 U.S.C. Section 1001) and a notice of forfeiture. The Company believes that no criminal conduct has occurred and will vigorously contest the charges. (See also Note 14, "Subsequent Events"). In connection with the Robinson Laboratories, Inc. ("RLI") litigation, by Order Dated February 17, 2005, the Company was awarded $2.1 million for attorneys' fees. The judgment has not been paid by RLI and the receivable for this award has not been recorded in the Company's consolidated financial statements because RLI has no assets. The Company is involved in various other legal proceedings and claims which arise in the ordinary course of its business. While any litigation contains an element of uncertainty, management believes that the outcome of such other litigation will not have a material adverse effect on the Company's financial position or results of operations. 8. Comprehensive Income, net of income taxes The components of comprehensive income are as follows (in thousands): 10
Thirteen weeks ended Thirty-nine weeks ended -------------------- ----------------------- April 30, May 1, April 30, May 1, 2006 2005 2006 2005 ---------- ---------- ---------- ---------- Net income $ 1,702 $ 3,627 $ 9,641 $ 9,257 Unrealized gain on interest rate swap 15 17 33 4 Foreign currency translation gain 152 115 158 394 ----------- -------- ----------- ---------- Comprehensive income $ 1,869 $ 3,759 $ 9,832 $ 9,655 =========== ======== =========== ==========
The components of accumulated other comprehensive income is as follows (in thousands):
April 30, 2006 July 31, 2005 -------------- ------------- Unrealized loss on interest rate swap $ (22) $ (55) Foreign currency translation gain 1,361 1,203 ----------- ----------- Accumulated other comprehensive income $ 1,339 $ 1,148 =========== ===========
9. Stock-Based Compensation The Company has various fixed stock option plans which are described in Note M of the Company's July 31, 2005 Annual Report on Form 10-K/A Amendment 1 that provide for the grant of stock options to eligible employees and directors. Effective August 1, 2005, the Company adopted the fair value recognition provisions of SFAS 123R using the modified prospective application method. This standard requires the Company to measure the cost of employee services received in exchange for equity share options granted based on the grant-date fair value of the options. The cost is recognized as compensation expense over the requisite service period for each separately vesting portion of the options. Under the modified prospective application method, compensation cost included in operating expenses in the thirteen and thirty-nine weeks ended April 30, 2006 is approximately $120,000 and $333,000, respectively, and includes: (a) compensation cost of stock options granted prior to but not yet vested as of August 1, 2005 (based on grant-date fair value estimated in accordance with the provisions of SFAS 123), and (b) compensation cost for all options granted subsequent to July 31, 2005 (based on grant-date fair value estimated in accordance with the new provisions of SFAS 123R). Operating income and income before taxes were reduced for the quarter and nine months by approximately $120,000 and $333,000, respectively, while net income was reduced by approximately $86,000 and $240,000 respectively, or approximately $0.01 and $0.02 for the quarter and nine months respectively, per basic and diluted share. Income tax benefits relating to the exercise of stock options during the thirty-nine weeks ended April 30, 2006 and May 1, 2005 amounting to $673,000 and $345,000 respectively are classified as a financing cash inflow in the Company's Consolidated Statements of Cash Flows. Prior to the adoption of SFAS 123R the Company presented all income tax benefits related to stock-based compensation as an operating cash inflow. As of April 30, 2006, there were 3,495,880 stock options outstanding. The aggregate value of unvested options, as determined using a Black-Scholes option valuation model was approximately $682,000 (net of estimated forfeitures). During the quarter ended April 30, 2006, the Company granted 9,000 non-qualified stock options, with a fair value of approximately $49,000. Options for 157,279 shares of common stock were exercised, and 4,021 options were forfeited during the third quarter. New option grants made after July 31, 2005, as well as option grants issued prior to that date have been valued using a Black-Scholes option valuation model. Prior to adopting SFAS 123R on August 1, 2005, the Company's equity based employee compensation expense under the various stock option plans was accounted for under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations. Under the modified prospective application method, results for prior periods have not been restated to reflect the effects on implementing SFAS 123R. Therefore, for the thirteen and thirty-nine weeks ended May 1, 2005, no option based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the underlying common stock price on the date of grant. The following table which is presented for comparative purposes, provides the pro forma information as required by SFAS No. 148, "Accounting for 11 Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123," and illustrates the effect on net income and earnings per common share for the period presented as if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", to stock based employee compensation prior to August 1, 2005:
Thirteen weeks ended Thirty-nine weeks ended May 1, 2005 May 1, 2005 --------------------- ----------------------- Net income - as reported $ 3,627 $ 9,257 Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (207) (985) ------------- ------------- Net income - pro forma $ 3,420 $ 8,272 ============= ============= Earnings per share - as reported Basic $ 0.25 $ 0.65 Diluted 0.24 0.62 Earnings per share - pro forma Basic $ 0.24 $ 0.58 Diluted 0.23 0.55
The weighted average fair value of stock options on the date of grant, and the assumptions used to estimate the fair value of stock options issued during the periods presented using the Black-Scholes option valuation model are as follows:
Thirteen weeks ended Thirty-nine weeks ended ------------------------- ----------------------- April 30, May 1, April 30, May 1, 2006 2005 2006 2005 --------- --------- ---------- ---------- Weighted average fair value of options granted $ 5.45 $ 4.00 $ 6.50 $ 4.00 Expected life (years) 1.95 3.69 3.23 3.69 Expected volatility 0.44 0.44 0.44 0.44 Risk-free interest rate 4.28 3.80 4.28 3.80 Expected dividend yield zero zero zero zero
The expected life of options granted during the periods presented above is based on the Company's historical share option exercise experience using the historical expected term from vest date. The expected volatility of the options granted is determined using historical volatilities based on historical stock prices. The risk-free interest rate is determined using the yield available for zero-coupon U.S. government issues with a remaining term equal to the expected life of the options. The Company has never paid a dividend, and as such the dividend yield is zero. 12 The following table summarizes the non-qualified stock option activity during the thirty-nine weeks ended April 30, 2006:
Weighted Aggregate Average Intrinsic Number Price Range Exercise Value (1) of shares per share Price (in thousands) ------------ -------------------- ---------- ------------- Outstanding July 31, 2005 3,735,530 $ 4.06 - 20.45 $ 14.41 Granted 10,500 18.57 18.57 Exercised (79,250) 4.31 - 19.83 11.33 Cancelled (2,000) 19.83 19.83 -------------- ------------------- ------------- Outstanding October 30, 2005 3,664,780 $ 4.06 - 20.45 $ 14.49 $ 11,394 Exercisable October 30, 2005 3,481,280 $ 14.28 $ 11,394 Granted 19,500 17.11 - 20.85 18.59 Exercised (10,100) 8.38 - 13.10 10.00 Cancelled (26,000) 19.03 - 19.83 19.26 -------------- ------------------- ------------- Outstanding January 29, 2006 3,648,180 $ 4.06 - 20.85 $ 14.49 $ 12,104 Exercisable January 29, 2006 3,445,180 $ 14.28 $ 12,104 Granted 9,000 20.09 20.09 Exercised (157,279) 8.38 - 19.83 11.60 Cancelled (4,021) 17.98 - 18.39 17.98 -------------- ------------------- ------------- Outstanding April 30, 2006 3,495,880 $ 4.06 - 20.85 $ 14.63 $ 22,899 Exercisable April 30, 2006 3,287,880 $ 14.41 $ 22,270 Vested and expected to vest 3,466,752 $ 14.60 $ 22,810 (1) There are no vested options with an exercise price greater than the closing stock price of $21.18 as of April 30, 2006.
Options outstanding and exercisable by price range as of April 30, 2006, with expiration dates ranging from January 3, 2007 to May 2, 2015 are as follows:
Options Outstanding Options Exercisable ------------------- ------------------- Weighted Average Weighted Weighted Range of Exercise Number Remaining Average Number Average Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price ---------------- ----------- ---------------- -------------- ----------- -------------- $ 4.06 - 10.46 1,132,780 3.9 $ 9.26 1,132,780 $ 9.26 10.50 - 17.50 678,100 4.9 13.32 666,100 13.25 17.98 859,000 6.4 17.98 690,000 17.98 18.57 - 19.83 779,500 5.1 19.54 769,000 19.55 19.94 - 20.85 46,500 5.0 20.34 30,000 20.28 ----------------- --------- ---- ----------- --------- ----------- $ 4.06 - 20.85 3,495,880 5.0 $ 14.63 3,287,880 $ 14.41 ========= =========
As of April 30, 2006, the total future compensation cost related to nonvested options not yet recognized in the consolidated statement of income was approximately $883,000 ($682,000 net of estimated forfeitures) and the weighted average period over which these options are expected to be recognized was 2.0 years. 13 10. Earnings Per Share ("EPS") The following table shows the components used in the calculation of basic earnings per share and earnings per share assuming dilution (in thousands):
Thirteen weeks ended Thirty-nine weeks ended ------------------------- ------------------------ April 30, May 1, April 30, May 1, 2006 2005 2006 2005 ---------- ---------- ---------- ---------- Numerator: Net Income $1,702 $3,627 $9,641 $9,257 ====== ====== ====== ====== Denominator: Basic weighted-average shares 14,569 14,313 14,497 14,300 Effect of dilutive securities: Employee stock options 829 623 733 672 ------ ------ ------ ------ Diluted weighted-average shares 15,398 14,936 15,230 14,972 ====== ====== ====== ====== Stock options not included in computation 376 875 1,015 787 ====== ====== ====== ====== Exercise price range per share $17.11-$20.85 $18.39-$20.45 $17.11-$20.85 $18.85-$20.45
The number of stock options not included in the computation of diluted EPS relates to stock options having exercise prices which are greater than the average market price of the common shares during the periods presented, and therefore, are anti-dilutive. The options which were outstanding as of April 30, 2006 expire at various dates through February 4, 2015. 11. Geographic Information Net sales to the U.S. Government in the thirteen and thirty-nine weeks ended April 30, 2006 and May 1, 2005 accounted for approximately 20% and 23% of net sales in 2006, and 27% and 23% of net sales in 2005, respectively. No other customer accounted for 10% or more of net sales during the periods presented. The Company operates as a single integrated business and as such has one operating segment. Geographic net sales for the third quarter, based on place of contract performance, were as follows (in thousands):
Thirteen weeks ended Thirty-nine weeks ended ------------------------- ------------------------- April 30, May 1, April 30, May 1, 2006 2005 2006 2005 ---------- ---------- ---------- ---------- United States $ 40,069 $ 35,378 $ 117,677 $ 92,353 Israel 3,887 3,350 10,307 9,534 England 1,733 2,538 5,482 6,723 ---------- ---------- ----------- ---------- $ 45,689 $ 41,266 $ 133,466 $108,610 ========== ========== =========== ==========
Net property, plant and equipment by geographic area was as follows (in thousands):
April 30, 2006 July 31, 2005 -------------- ------------- United States $ 24,927 $ 24,318 Israel 4,592 4,376 England 614 767 -------- -------- $ 30,133 $ 29,461 ======== ========
12. Supplemental cash flow information is as follows (in thousands):
Thirty-nine weeks ended ----------------------- April 30, 2006 May 1, 2005 -------------- ----------- Net cash paid during the period for: Interest $ 219 $ 229 Income taxes 2,960 296
14 13. New Accounting Pronouncements In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes (as amended) - an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes", and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is in the process of analyzing the impact of FIN 48, which is required to be adopted by the first quarter of fiscal 2008. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an amendment of APB No. 43, Chapter 4" ("SFAS 151.") SFAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS 151 are effective for fiscal years beginning after June 15, 2005. Management adopted this standard on August 1, 2005, and has determined that the adoption of SFAS 151 did not have a material impact on the consolidated financial position, result of operations or cash flows of the Company. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29". SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, "Accounting for Nonmonetary Transactions," and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for fiscal periods beginning after June 15, 2005. Management adopted this standard on August 1, 2005, and has determined that the adoption of SFAS 153 did not have a material impact on the consolidated financial position, result of operations or cash flows of the Company. In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment," which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123(R).") SFAS 123(R) is effective for publicly-traded companies for interim or annual periods beginning after June 15, 2005, supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows." Management adopted this standard on August 1, 2005. See Note 9 for a discussion of the impact on the consolidated financial position, result of operations and cash flows of the Company upon adoption of SFAS 123(R). In March of 2005, the SEC issued Staff Accounting Bulletin No. 107, "Share-Based Payment," ("SAB 107"), which provides interpretive guidance related to the interaction between SFAS 123R and certain SEC rules and regulations, as well as provides the SEC staff's views regarding the valuation of share-based payment arrangements. The Company has incorporated SAB 107 in the implementation and adoption of SFAS 123R. In March 2005, the FASB issued FASB Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations - An Interpretation of SFAS No. 143." This Interpretation provides additional guidance as to when companies should record the fair value of a liability for a conditional asset retirement obligation when there is uncertainty about the timing and (or) method of settlement of the obligation. This Interpretation is effective no later than the end of fiscal years ending after December 15, 2005. The Company does not expect the adoption of FASB Interpretation No. 47 to have a material impact on its consolidated financial position, results of operations or cash flows. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections" ("SFAS 154.") SFAS 154 replaces APB Opinion No. 20 "Accounting Changes" and FASB Statement No. 3 "Reporting Accounting Changes in Interim Financial Statements." SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS 154 also provides that a correction of errors in previously issued financial statements should be termed a "restatement." This new standard will be effective for accounting changes and correction of errors for fiscal years beginning after December 15, 2005. The Company does not expect that the adoption of SFAS 154 will have a material impact on its consolidated financial position, results of operations or cash flows. 15 In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments," ("SFAS 155") an amendment of FASB Statements No. 133 and 140. SFAS 155 permits a fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This new standard will be effective for all financial instruments acquired or issued after the beginning of the Company's first fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS 155 to have a material impact on its consolidated financial position, results of operations or cash flows. In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets, an amendment of FASB Statements No. 140" ("SFAS 156".) SFAS 156 requires that servicing assets and servicing liabilities be recognized at fair value, if practicable, when the Company enters into a servicing agreement. This new standard will be effective as of the start of the Company's first fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS 156 to have a material impact on its consolidated financial position, results of operations or cash flows. 14. Subsequent Events As previously reported, there has been a continuing investigation by the U.S. Attorneys' Office in Pennsylvania which, inter alia, involves pricing under contracts with the U.S. Department of Defense relating to voltage control oscillators and powerheads. The contracts aggregate approximately $3.9 million in total revenue. On June 6, 2006 an indictment was returned against the Company and Lee Blatt, its former Chairman. No other officer or director of the Company was named in the indictment. The indictment alleges 29 counts of violations of the wire fraud statute (18 U.S.C. Section 1343); 2 counts of violations of the obstruction of a federal audit statute (18 U.S.C. Section 1516); 1 count of violating the major fraud against the United States statute (18 U.S.C. Section 1031); 3 counts of violating the false statements to the government statute (18 U.S.C. Section 1001) and a notice of forfeiture. The Company believes that no criminal conduct has occurred and will vigorously contest the charges. If convicted, Mr. Blatt and the Company could be fined up to approximately $13 million each and the Company could be required to forfeit approximately $2.9 million paid under the contracts. Under the terms of an indemnification agreement with Mr. Blatt, the Company has agreed to provide indemnification with regard to certain legal proceedings so long as he has acted in good faith and in a manner believed to be in, or not opposed to, the Company's best interest with respect to any criminal proceeding and had no reasonable cause to believe his conduct was unlawful. In June and July 2006, the Company was served with several class-action complaints against the Company and certain of its officers in the United States District Court for the Eastern District of Pennsylvania. The claims are made under Section 10(b) and 20(a) of the Securities Exchange act of 1934 and Rule 10b-5 thereunder. In July 2006, the Company and its directors were also served with a derivative complaint for breach of fiduciary duty brought pursuant to Rule 23.1 of the Federal Rules of Civil Procedure. The complaints relate to the Company's indictment in the matter discussed above. In addition, in June 2006 the Company was notified by representatives of the United States Attorney's Office for the Eastern District of Pennsylvania, Civil Division, that they intended to file a civil lawsuit against the Company pursuant to inter alia, the False Claims Act, 31 U.S.C. Sec. 3729 et. seq. The Company entered into a Tolling Agreement on June 21, 2006, and does not anticipate any further activity related to this potential claim until after the trial of the criminal matter mentioned above. The Company believes it has substantial defenses to the charges alleged in the indictment and intends to vigorously defend against these allegations. In accordance with SFAS No. 5, "Accounting for Contingencies," the Company determines whether an estimated loss from a loss contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. Litigation is inherently unpredictable and due to the uncertainty of the outcome of the matters discussed above, a reasonable estimate of any liability can not be made. If an unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations for that period. 16 In connection with the legal matter discussed above, the Company was notified that certain of its operations have been suspended from receiving new contract awards from the U. S. Government. The affected operations include facilities in Lancaster, Pennsylvania, Woburn, Massachusetts, Chicago, Illinois and Herley's subsidiary in Farmingdale, New York. The Chicago, Illinois location is a two-person marketing office. The result of this suspension is that these facilities will not be solicited for or awarded new contracts or contract extensions without special exceptions, pending the outcome of the legal proceedings. The suspended facilities may receive contract awards or subcontracts from the Federal Government if the head of the agency states in writing the compelling reason to do so. A significant portion of Herley's business is received where the company is the only qualified supplier on critical defense programs. For this reason the effect of the suspension on these manufacturing facilities cannot easily be determined at this time. As of April 30, 2006 the Company has a funded backlog of approximately $136 million, which is not affected by this action, and which will be delivered to customers within the next year or two. The Company's facilities which are not included in the action and who are free to contract with the U.S. Government are our facilities in Whippany, NJ (Herley-CTI), Jerusalem (Herley-Israel), McLean, Virginia, (Innovative Concepts, Inc.), Ft. Walton Beach, Florida, (Micro Systems, Inc. and Herley-RSS), and Farnborough, U.K. (EW Simulation Systems). The Company had been advised by BDO SEIDMAN, LLP, the Company's former independent registered public accountants, that, due to their need to complete review procedures in connection with an independent investigation of the allegations by outside counsel, BDO SEIDMAN, LLP was unable to complete its review of the interim consolidated financial statements set forth herein by the due date of the Company's Form 10-Q in accordance with established professional standards and procedures for conducting such reviews, which review is required by Rule 10-01(d) of Regulation S-X. BDO SEIDMAN subsequently on July 27, 2006 informed the Company that they had resigned as the Company's auditors. In addition, by letter dated August 14, 2006 BDO SEIDMAN informed the Company that it was withdrawing its opinion on the Company's financial statements for the fiscal year ended July 31, 2005. At a meeting held on July 27, 2006, the Company's Audit Committee accepted the resignation of BDO SEIDMAN LLP and approved the engagement of Marcum & Kliegman LLP as the Company's independent registered public accountants. In addition, on August 16, 2006 the Audit Committee approved the engagement of Marcum & Kliegman LLP to also act as its independent auditors for the fiscal year ended July 31, 2005. The interim consolidated financial statements contained in this report have now been reviewed by Marcum & Kliegman LLP. By letter dated June 16, 2006, the Company received written notification from Nasdaq that since the Form 10-Q filed by the Company on June 14, 2006 had not been reviewed by its accountants and did not include the required certifications, the Company was not in compliance with Marketplace Rule 4310(c) (14). Accordingly, the Company was informed that its securities would be delisted from The Nasdaq Stock Market. On June 22, 2006, the Company requested a hearing which was held on August 3, 2006. By letter dated August 16, 2006, the Company received written notification from Nasdaq that the Company's request for continued listing on The Nasdaq Stock Market had been granted, subject to the Company's filing of a complete amended Form 10-Q by September 15, 2006. On June 15, 2006 the Company announced a resumption of the stock repurchase program initially announced in October 2002 covering 1,000,000 shares of common stock of the Company and subsequently expanded on May 30, 2003 to cover 2,000,000 shares of common stock. As of September 11, 2006 the Company acquired approximately 1,898,000 shares of common stock under this program including approximately 799,000 shares at an aggregate cost of approximately $9,044,000 subsequent to April 30, 2006. 17 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations Explanatory Note As explained in a press release issued on June 6, 2006, the U.S. Attorney's office for the Eastern District in Pennsylvania has indicted the Company and its former Chairman, Lee N. Blatt on multiple charges in connection with purported activities resulting in alleged excessive profits by the Company on three contracts with the U.S. Department of Defense. The Company's Board of Directors has retained outside counsel who has conducted an independent investigation and review of the allegations. The Board of Directors believes that, based on information currently available to it, no criminal conduct has occurred and the Company will vigorously contest the charges. In connection with the legal matter discussed above, the Company was notified that certain of its operations have been suspended from receiving new contract awards from the U. S. Government. The affected operations include facilities in Lancaster, Pennsylvania, Woburn, Massachusetts, Chicago, Illinois and Herley's subsidiary in Farmingdale, New York. The Chicago, Illinois location is a two-person marketing office. The result of this suspension is that these facilities will not be solicited for or awarded new contracts or contract extensions without special exceptions, pending the outcome of the legal proceedings. The suspended facilities may receive contract awards or subcontracts from the Federal Government if the head of the agency states in writing the compelling reason to do so. A significant portion of Herley's business is received where the Company is the only qualified supplier on critical defense programs. For this reason the effect of the suspension on these manufacturing facilities cannot easily be determined at this time. As of April 30, 2006 the Company has a funded backlog of approximately $136 million, which is not affected by this action, and which will be delivered to customers within the next year or two. The Company's facilities which are not included in the action and who are free to contract with the U.S. Government are our facilities in Whippany, NJ (Herley-CTI), Jerusalem (Herley-Israel), McLean, Virginia, (Innovative Concepts, Inc.), Ft. Walton Beach, Florida, (Micro Systems, Inc. and Herley-RSS), and Farnborough, U.K. (EW Simulation Systems). The Company had been advised by BDO SEIDMAN, LLP, the Company's former independent registered public accountants, that, due to their need to complete review procedures in connection with the Board's investigation, BDO SEIDMAN, LLP was unable to complete its review of the interim consolidated financial statements set forth herein by the due date of the Company's Form 10-Q in accordance with established professional standards and procedures for conducting such reviews, which review is required by Rule 10-01(d) of Regulation S-X. BDO SEIDMAN subsequently on July 27, 2006 informed the Company that they had resigned as the Company's auditors. In addition, by letter dated August 14, 2006 BDO SEIDMAN informed the Company that it was withdrawing its opinion on the Company's financial statements for the fiscal year ended July 31, 2005. At a meeting held on July 27, 2006, the Company's Audit Committee accepted the resignation of BDO SEIDMAN LLP and approved the engagement of Marcum & Kliegman LLP as the Company's independent registered public accountants. In addition, on August 16, 2006 the Audit Committee approved the engagement of Marcum & Kliegman LLP to also act as its independent auditors for the fiscal year ended July 31, 2005. The interim consolidated financial statements contained in this report have now been reviewed by Marcum & Kliegman LLP. The Company understands that completion of the review of its interim financial statements and the filing of this amendment will make this report current, although it will not be deemed timely for purposes of the rules governing eligibility to use registration statements on Forms S-2 and S-3. Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 Certain statements contained in this report are "forward-looking statements" that involve various important assumptions, risks, uncertainties and other factors which could cause the Company's actual results to differ materially from those expressed in such forward-looking statements. Forward-looking statements can be identified by terminology such as "may", "will", "should" , "expects", "intends", "anticipates", "believes", "estimates", "predicts", "continue", or the negative of these terms or other comparable terminology. These important factors include, without limitation, a large percentage of sales are under government contracts, cost overruns under fixed price contracts, doing business in foreign markets, customer concentration, competitive factors and pricing pressures, effective integration of acquired businesses, management of future growth, recruiting and retaining qualified technical personnel, general economic conditions, as well as other risks previously disclosed in the Company's securities filings and press releases. Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, performance or achievements. Further, the Company is under no duty to update any of the forward-looking statements after the date of this quarterly report to conform such statements to actual results. Business Overview We are a leading supplier of microwave products and systems to defense and aerospace entities worldwide. Our primary customers include large defense prime contractors (including Raytheon, Northrop Grumman, General Dynamics, Lockheed Martin and Boeing), the U.S. Government (including the Department of Defense, NASA and other U.S. Government agencies) and international customers (including the German, Japanese, Turkish, British, Norwegian and South Korean militaries, 18 and suppliers to international militaries). We are a leading provider of microwave technologies for use in command and control systems, flight instrumentation, weapons sensors, high power amplifiers, electronic warfare systems, wireless data communications products and services, and radar threat and electronic countermeasure simulation systems. We have served the defense industry since 1965 by designing and manufacturing microwave devices and systems for use in high technology defense electronics applications. Our products and systems are currently deployed on a wide range of high profile military platforms, including the F-16 Falcon, the F/A-18E/F Super Hornet, the EA-6B Prowler, the EA-18 Growler, the AH-64D Apache Longbow, AEGIS class destroyers, the AMRAAM missile, unmanned aerial vehicles (UAVs), as well as high priority national security programs such as National Missile Defense and the Trident II D-5 missile. Results of Operations Thirty-nine weeks ended April 30, 2006 and May 1, 2005 ------------------------------------------------------ Net sales for the thirty-nine weeks ended April 30, 2006 were approximately $133,466,000 compared to $108,610,000 in the first nine months of fiscal 2005, an increase of $24.9 million (22.9%). Net sales through the acquisitions of MSI and ICI completed in the third quarter of fiscal 2005 accounted for an increase of approximately $22.4 million, or 90% of the increase in net sales for the thirty-nine weeks ended April 30, 2006. We also experienced an approximate $2.5 million net increase in sales at our other operations as follows: * An increase in sales at our Lancaster operation of $1.0 million, which includes $2.2 million in revenue in connection with a claim due to customer delays and changes in specifications and designs under a major program offset by decreases in overall sales volume; and * A net increase in sales at our GMC facility of approximately $1.7 million, including $2.5 million in power amplifier sales to the Government of Israel for multiplatform communications; Offset by * A decline of $1.2 million at EWST as they near completion of certain major contracts. The gross profit margin in the thirty-nine weeks ended April 30, 2006 was 28.9% compared to 30.9% in the three quarters of fiscal 2005, a decrease of 2.0%. Contributing to the reduction in gross profit for the nine months are the following items: * Engineering development costs overruns on certain contracts in excess of billings to customers; * startup production costs on certain programs; and * the cumulative effects of changes in contract costs estimates on certain programs accounted for under the percentage completion method of accounting. Selling and administrative expenses for the thirty-nine weeks ended April 30, 2006 increased approximately $4.2 million over fiscal 2005 and were 19.3% of net sales as compared to 19.8% in fiscal 2005. Significant changes during the period included: * An increase of approximately $4.2 million attributable to selling and administrative expenses related to the two acquisitions completed in the third quarter of fiscal 2005 (MSI and ICI); * Legal expenses in fiscal 2006 were $1,450,000 primarily attributable to legal costs associated with a continuing investigation by the U.S. Attorneys' office in Pennsylvania which, inter alia, involves pricing under two contracts with the U.S. Department of Defense relating to voltage control oscillators and a contract relating to powerheads. Legal costs incurred in fiscal 2005 were $1,965,000, of which $1,236,000 relates to the current investigation by the U.S. Attorneys' office, and the balance relates primarily to the litigation involving Robinson Laboratories, Inc. and Ben Robinson which was settled in fiscal 2005; * Stock compensation costs in connection with the adoption of SFAS 123R as of August 1, 2005 of $0.3 million. Operating income for the nine months was $12,781,000 or 9.6% of net sales, as compared to $12,035,000 or 11.1% of net sales in 2005. The decrease in operating income as a percentage of net sales is primarily attributable to the reduction in gross margins discussed above. Our foreign operations contributed approximately $2,018,000 in operating income for the nine months as compared to $1,653,000 in fiscal 2005. Investment income decreased by $191,000 in the nine months of fiscal 2006 because of a decline on average of approximately $38 million in funds invested, offset by an increase of approximately 76% in the rate of interest earned on the investment of excess cash reserves during the period as compared to interest rates in the prior year. The reduction in the average balance of funds invested 19 in the first three quarters of fiscal 2006 versus the prior year was caused by the investments in capital expenditures and recent acquisitions financed out of our investment funds. The Company recognized a net foreign exchange gain of $273,000 through the third quarter of fiscal 2006, versus a gain of $264,000 in fiscal 2005. The foreign exchange gains are attributable to our UK subsidiary primarily in connection with temporary advances we have made to them. Provision for income taxes for the first nine months of fiscal 2006 was $3,749,000 representing an effective tax rate of approximately 28%, comparable to the effective tax rate of 28% in the first nine months of fiscal 2005. The favorable effective rate in fiscal 2006 is due to various favorable tax benefits, including a lower effective tax rate on foreign source income, the tax benefit attributable to extra territorial income, research and development tax credits, the Section 199 manufacturing deduction, and tax exempt interest income. Thirteen weeks ended April 30, 2006 and May 1, 2005 --------------------------------------------------- Net sales for the thirteen weeks ended April 30, 2006 were approximately $45,689,000, as compared to $41,266,000 in the thirteen weeks ended May 1, 2005, an increase of $4.4 million (10.7%). Net sales through the acquisition of ICI completed in the third quarter of fiscal 2005 accounted for an increase of approximately $3.7 million, or 83% of the increase in net sales for the quarter ended April 30, 2006. We experienced an approximate $1.1 million increase in net sales related primarily to microwave components, which sales were depressed in the prior year''s third quarter. Offsetting these increases was a decline of $0.8 million at EWST as they near completion of certain major contracts. The gross profit margin in the thirteen weeks ended April 30, 2006 was 24.0% compared to 32.5% in the third quarter of fiscal 2005, a decrease of 8.5%. Contributing to the reduction in gross profit for the quarter are the following items: * Engineering development costs overruns on certain contracts in excess of billings to customers; * startup production costs on certain programs; * the cumulative effects of changes in contract costs estimates on certain programs accounted for under the percentage completion method of accounting; and * engineering development costs in connection with the Xytrans development agreement. Selling and administrative expenses for the thirteen weeks ended April 30, 2006 increased approximately $95,000 over the third quarter of fiscal 2005 and were 19.6% of net sales as compared to 21.5% in fiscal 2005. Significant changes during the period included: * An increase of approximately $822,000 attributable to selling and administrative expenses related to the acquisition of ICI completed in the third quarter of fiscal 2005, and * Stock compensation costs in connection with the adoption of SFAS 123R as of August 1, 2005 of $120,000, Offset by * A decrease in legal costs from $1,285,000 in the third quarter of fiscal 2005 to $425,000 in the third quarter of fiscal 2006. Legal costs in fiscal 2006 are primarily attributable to the continuing investigation by the U.S. Attorneys' office in Pennsylvania which, inter alia, involves pricing under two contracts with the U.S. Department of Defense relating to voltage control oscillators and a contract relating to powerheads. Operating income for the third quarter of fiscal 2006 was $1,993,000 or 4.4% of net sales, as compared to $4,556,000 or 11.0% of net sales in the prior year. The decrease in operating income as a percentage of net sales is primarily attributable to the reduction in gross margins discussed above. Our foreign operations contributed $881,000 in operating income for the quarter as compared to $561,000 in the third quarter of fiscal 2005. Investment income increased by $16,000 in the third quarter of fiscal 2006 due to an increase of approximately 56% in the rate of interest earned on the investment of excess cash reserves as compared to the prior year, despite the decline on average of approximately $17 million in funds invested. The reduction in the average balance of funds invested versus the prior year is due to the funding of the acquisitions of MSI and ICI during the third quarter of fiscal 2005. In the thirteen weeks ended April 30, 2006, the Company recognized a foreign exchange gain of $170,000 versus a gain of $79,000 in the third quarter of fiscal 2005. The foreign exchange gains are attributable to our UK subsidiary primarily in connection with temporary advances we have made to them. 20 Provision for income taxes for the third quarter of fiscal 2006 was $662,000 representing an effective tax rate of approximately 28%, as compared to an effective tax rate of 25% in the prior year's third quarter. The lower effective tax rate in the third quarter of fiscal year 2005 is due to the cumulative recognition of research and development credits that were realized in the prior year third quarter. The overall effective rate for the quarter ended April 30, 2006 is due to various favorable tax benefits, including a lower effective tax rate on foreign source income, the tax benefit attributable to extra territorial income, research and development tax credits, the Section 199 manufacturing deduction, and tax exempt interest income. Liquidity and Capital Resources ------------------------------- As of April 30, 2006 and July 31, 2005, working capital was $99,650,000 and $88,343,000, respectively, and the ratio of current assets to current liabilities was 3.8 to 1 and 3.6 to 1, respectively. As is customary in the defense industry, inventory is partially financed by customer deposits and progress payments. The un-liquidated balance of these deposits and payments was approximately $5,109,000 at April 30, 2006, and $3,966,000 at July 31, 2005. Net cash provided by operations during the thirty-nine weeks ended April 30, 2006 was approximately $10,010,000 as compared to $12,273,000 during the comparable period in the prior year, a decrease of approximately $2,263,000. Income from operations (adjusted for depreciation, amortization, and foreign exchange (gain) loss) was $14,852,000 in the first nine months of the current fiscal year versus $13,113,000 in the similar period in the prior year, an increase of approximately $1,739,000. Significant items contributing to the overall decrease in cash provided by operations of $2,263,000 include the following: 1. A decrease of approximately $7.9 million in cash generated from collection of accounts receivable during the first nine months of fiscal 2006 versus fiscal 2005. The largest impact was from a major contract at our Lancaster facility in connection with an upgrade for US Navy aircraft. This job was largely shipped during fiscal 2004 and early in fiscal 2005, which resulted in increased collections of accounts receivable in the first quarter of fiscal 2005. Additionally, an increase in shipments of approximately 11% during the third quarter of fiscal 2006 versus the third quarter of fiscal 2005 resulted in higher accounts receivable at the close of the quarter; 2. a decrease of approximately $2.5 million generated through amounts due to vendors and accrued expenses; and 3. a reduction in income taxes payable of approximately $3.6 million. Offset primarily by 1. a reversal in the growth of inventory since the beginning of the current fiscal year resulting in an improvement in cash flow of approximately $3.4 million; 2. an increase of approximately $1.1 million in cash generated from billings in excess of costs incurred and income recognized on uncompleted contracts during the course of the nine-month period; 3. a reduction of approximately $1.1 million in the amount of cash invested in costs incurred and income recognized in excess of billings on uncompleted contracts, after including $2.2 million of estimated costs incurred in connection with a claim due to customer delays and changes in specification and designs under a major program; and 4. an increase of approximately $2.6 million in advanced payments from customers on contracts in progress. Net cash used in investing activities includes capital expenditures of $4,525,000 including $584,000 at the Company's CTI facility for the purchase of equipment used for the production of millimeter wave products relating to the Xytrans license agreement during the first nine months of the current fiscal year. In June 2002, the Company entered into a new $50,000,000 Revolving Credit Loan Agreement with two banks on an unsecured basis which may be used for general corporate purposes, including business acquisitions. The revolving credit facility requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on March 31, 2008 (as amended). The Company may elect to borrow up to a maximum of $5,000,000 with interest based on the Federal Funds Target Rate plus a margin of 1.50% to 1.80%, or up to a maximum of $45,000,000 with interest based on LIBOR plus a margin of 1.35% to 1.65%. The applicable incremental margin is based on the ratio of total liabilities to tangible net worth, as those terms are defined in the agreement. The Federal 21 Funds Target Rate and the LIBOR rate was 4.75% and 5.04%, respectively, at April 30, 2006. There is a fee of 15 basis points per annum on the unused portion of the $45,000,000 LIBOR based portion of the credit facility payable quarterly. There are no borrowings under the credit line at April 30, 2006 and July 31, 2005. Stand-by letters of credit were outstanding in the amount of approximately $11,479,000 under the credit facility at April 30, 2006, and $10,703,000 at July 31, 2005. The agreement contains various financial covenants, including, among other matters, minimum tangible net worth, total liabilities to tangible net worth, debt services coverage, and restrictions on other borrowings. The company is in compliance with all covenants at April 30, 2006. The Company believes that presently anticipated future cash requirements will be provided by internally generated funds, its existing unsecured credit facility, and existing cash reserves. A significant portion of our revenue for fiscal 2006 will be generated from our existing backlog of sales orders. The backlog of orders at April 30, 2006 was approximately $143 million of which $136 million are orders covered by funded signed contracts or purchase orders. The remaining $7 million of backlog is "unfunded" and consists of the portion of a contract expected to be recognized as our customer increases the funding allotment for completion of the aggregate firm contract award. Contracts involving government programs may be terminated at the discretion of the government. In the event of the cancellation of a significant amount of government contracts included in the Company's backlog, the Company will be required to rely more heavily on cash reserves and its existing credit facility to fund its operations. The Company is not aware of any events which are reasonably likely to result in any cancellation of its government contracts. As of April 30, 2006, the Company has approximately $38,521,000 available under its bank credit facility, net of outstanding stand-by letters of credit of approximately $11,479,000, and cash reserves of approximately $27,364,000. Disclosure Regarding Contractual Obligations and Commitments ------------------------------------------------------------ Accounting standards require disclosure concerning the Company's obligations and commitments to make future payments under contracts, including interest, such as debt and lease agreements, and other contingent commitments, such as stand-by letters of credit. The following table summarizes the Company's contractual obligations and other contingent commitments, including interest, at July 31, 2005 (in thousands):
Within 2-3 4-5 After 5 Obligations Total 1 Year Years Years Years ----------- ----- ------ ----- ----- ----- Mortgage Note $ 2,571 $ 124 $ 270 $ 308 $ 1,869 Industrial Revenue Bonds 3,811 220 442 442 2,707 EWST Note 606 606 - - - Operating Lease Obligations 17,095 2,876 5,629 3,655 4,935 Purchase Obligations 22,038 17,739 3,106 1,063 130 ---------- ---------- ---------- -------- -------- 46,121 21,565 9,447 5,468 9,641 Standby Letters of Credit 10,703 2,327 7,989 325 62 ---------- ---------- ---------- -------- -------- Total Contractual Obligations $ 56,824 $ 23,892 $ 17,436 $ 5,793 $ 9,703 ========== ========== ========== ======== ========
Other than the ordinary course fulfillment of open purchase orders and placement of new purchase orders, there have been no other significant changes to the Company's contractual obligations table since July 31, 2005. New Accounting Pronouncements ----------------------------- See Note 13 of Notes to Consolidated Financial Statements - (Unaudited) for the discussion on recent accounting pronouncements. Item 3: Quantitative and Qualitative Disclosures About Market Risk The Company's exposures to market risk have not changed significantly since July 31, 2005. Item 4: Controls and Procedures (a) Evaluation of disclosure controls and procedures. The term "disclosure controls and procedures" is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 as amended (the "Exchange Act"). These rules refer to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported within the required time periods. The Company's management, with participation of the Company's Chief Executive Officer and 22 Chief Financial Officer, has evaluated the design, operation and effectiveness of the Company's disclosure controls and procedures and have concluded, based on such evaluation, that such controls and procedures were effective at providing reasonable assurance that required information will be disclosed in the Company's reports filed under the Exchange Act as of April 30, 2006. (b) Changes in internal controls. There were no changes in the Company's internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended April 30, 2006 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II - OTHER INFORMATION Item 1 - Legal Proceedings: As previously reported, there has been a continuing investigation by the U.S. Attorneys' Office in Pennsylvania which, inter alia, involves pricing under contracts with the U.S. Department of Defense relating to voltage control oscillators and powerheads. The contracts aggregate approximately $3.9 million in total revenue. On June 6, 2006, an indictment was returned against the Company and Lee Blatt, its former Chairman. No other officer or director of the Company was named in the indictment. The indictment alleges 29 counts of violations of the wire fraud statute (18 U.S.C. Section 1343); 2 counts of violations of the obstruction of a federal audit statute (18 U.S.C. Section 1516); 1 count of violating the major fraud against the United States statute (18 U.S.C. Section 1031); 3 counts of violating the false statements to the government statute (18 U.S.C. Section 1001) and a notice of forfeiture. The Company believes that no criminal conduct has occurred and will vigorously contest the charges. In June and July 2006, the Company was served with several class-action complaints against the Company and certain of its officers in the United States District Court for the Eastern District of Pennsylvania. The claims are made under Section 10(b) and 20(a) of the Securities Exchange act of 1934 and Rule 10b-5 thereunder. In July 2006, the Company and its directors were also served with a derivative complaint for breach of fiduciary duty brought pursuant to Rule 23.1 of the Federal Rules of Civil Procedure. The complaints relate to the Company's indictment in the matter discussed above. In addition, in June 2006 the Company was notified by representatives of the United States Attorney's Office for the Eastern District of Pennsylvania, Civil Division, that they intended to file a civil lawsuit against the Company pursuant to inter alia, the False Claims Act, 31 U.S.C. Sec. 3729 et. seq. The Company entered into a Tolling Agreement on June 21, 2006, and does not anticipate any further activity related to this potential claim until after the trial of the criminal matter mentioned above. The Company is involved in various other legal proceedings and claims which arise in the ordinary course of its business. While any litigation contains an element of uncertainty, management believes that the outcome of such other litigation will not have a material adverse effect on the Company's financial position or results of operations. Item 2 - Changes In Securities: None Item 3 - Defaults Upon Senior Securities: None Item 4 - Submission Of Matters To A Vote Of Security Holders: None Item 5 - Other Information: None Item 6 - Exhibits 15. Independent Registered Public Accounting Firm's Acknowledgement Letter 31. Certifications pursuant to Rules 13a-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32. Certifications pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 23 FORM 10-Q/A (Amendment No. 1) SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HERLEY INDUSTRIES, INC. Registrant BY: /S/ Myron Levy ----------------------------------- Myron Levy, Chief Executive Officer BY: /S/ Kevin J. Purcell ----------------------------------- Kevin J. Purcell, Chief Financial Officer DATE: September 14, 2006 24