-----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, MggbnaApnuwBz2BAZ6SF/JHVIU7zvtOuS4OFXVJkGZTpYbnlUTegyd/VaMnUCvmX q92qCHoI75Fn3zJqXtVO5A== 0001201800-08-000030.txt : 20080312 0001201800-08-000030.hdr.sgml : 20080312 20080312165631 ACCESSION NUMBER: 0001201800-08-000030 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20080203 FILED AS OF DATE: 20080312 DATE AS OF CHANGE: 20080312 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HERLEY INDUSTRIES INC /NEW CENTRAL INDEX KEY: 0000047035 STANDARD INDUSTRIAL CLASSIFICATION: SEARCH, DETECTION, NAVIGATION, GUIDANCE, AERONAUTICAL SYS [3812] IRS NUMBER: 232413500 STATE OF INCORPORATION: DE FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-05411 FILM NUMBER: 08684070 BUSINESS ADDRESS: STREET 1: 101 NORTH POINTE BOULEVARD CITY: LANCASTER STATE: PA ZIP: 17601-4133 BUSINESS PHONE: 7177358117 MAIL ADDRESS: STREET 1: 101 NORTH POINTE BOULEVARD CITY: LANCASTER STATE: PA ZIP: 17601-4133 FORMER COMPANY: FORMER CONFORMED NAME: HERLEY MICROWAVE SYSTEMS INC DATE OF NAME CHANGE: 19900510 FORMER COMPANY: FORMER CONFORMED NAME: HERLEY INDUSTRIES INC DATE OF NAME CHANGE: 19831103 10-Q 1 hrly10q-feb2008.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: February 3, 2008 ---------------- 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 of (I.R.S. Employer Identification Number) 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 March 7, 2008 - 13,502,677 shares of Common Stock are outstanding. HERLEY INDUSTRIES, INC. AND SUBSIDIARIES INDEX TO FORM 10-Q
PAGE ---- PART I - FINANCIAL INFORMATION Item 1 - Financial Statements: Condensed Consolidated Balance Sheets - February 3, 2008 (Unaudited) and July 29, 2007 2 Condensed Consolidated Statements of Operations (Unaudited) - For the fourteen and twenty-seven weeks ended February 3, 2008 and for the thirteen and twenty-six weeks ended January 28, 2007 3 Condensed Consolidated Statement of Shareholders' Equity (Unaudited) - For the twenty-seven weeks ended February 3, 2008 4 Condensed Consolidated Statements of Cash Flows (Unaudited) - For the twenty-seven weeks ended February 3, 2008 and for the twenty-six weeks ended January 28, 2007 5 Notes to Condensed Consolidated Financial Statements (Unaudited) 6 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 21 Item 4 - Controls and Procedures 21 PART II - OTHER INFORMATION Item 1 - Legal Proceedings 21 Item 1A- Risk Factors 23 Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 23 Item 3 - Defaults Upon Senior Securities 23 Item 4 - Submission of Matters to a Vote of Security Holders 23 Item 5 - Other Information 24 Item 6 - Exhibits 24 Signatures 25
Part I - Financial Information Item 1 - Financial Statements HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data)
February 3, 2008 July 29, (Unaudited) 2007 ------------ ------------ ASSETS Current Assets: Cash and cash equivalents $ 24,808 $ 35,181 Trade accounts receivable, net 19,326 28,058 Income Taxes Receivable 819 819 Costs incurred and income recognized in excess of billings on uncompleted contracts and claims 18,779 14,448 Other receivables 2,911 2,816 Inventories, net 54,787 51,815 Deferred income taxes 7,176 4,254 Other current assets 1,878 1,069 ------------ ------------ Total Current Assets 130,484 138,460 Property, Plant and Equipment, net 31,223 29,996 Goodwill 73,885 74,044 Intangibles, net of accumulated amortization of $6,381 at February 3, 2008 and $5,256 at July 29, 2007 17,276 18,431 Other Assets 586 1,662 ------------ ------------ Total Assets $ 253,454 $ 262,593 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Current portion of long-term debt $ 1,372 $ 1,346 Current portion of employment settlement agreement - (net of imputed interest of $163 at February 3, 2008 and $245 at July 29, 2007) 1,194 1,113 Current portion of litigation settlement (net of imputed interest of $18) 1,482 - Accounts payable and accrued expenses 20,091 19,049 Billings in excess of costs incurred and income recognized on uncompleted contracts 864 99 Income taxes payable 340 3,518 Accrual for contract losses 1,190 1,564 Accrual for warranty costs 1,017 1,106 Advance payments on contracts 6,954 7,163 ------------ ------------ Total Current Liabilities 34,504 34,958 Long-term Debt 5,267 5,951 Long-term Portion of Employment Settlement Agreement - (net of imputed interest of $505 at February 3, 2008 and $580 at July 29, 2007) 3,488 4,117 Long-term portion of litigation settlement (net of imputed interest of $214) 1,786 - Other Long-term Liabilities 1,438 1,311 Deferred Income Taxes 7,123 6,615 Accrued Income Taxes Payable 3,244 - ------------ ------------ Total Liabilities 56,850 52,952 ------------ ------------ Commitments and Contingencies Shareholders' Equity: Common stock, $.10 par value; authorized 20,000,000 shares; issued and outstanding 13,502,677 at February 3, 2008, and 13,977,115 at July 29, 2007 1,350 1,398 Additional paid-in capital 100,734 107,094 Retained earnings 92,973 99,404 Accumulated other comprehensive income 1,547 1,745 ------------ ------------ Total Shareholders' Equity 196,604 209,641 ------------ ------------ Total Liabilities and Shareholders' Equity $ 253,454 $ 262,593 ============ ============ See notes to condensed consolidated financial statements.
2 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands except per share data) (Unaudited)
Twenty- Fourteen Thirteen seven Twenty-six weeks weeks weeks weeks ended ended ended ended February 3, January 28, February 3, January 28, 2008 2007 2008 2007 ----------- ---------- ---------- ----------- Net sales $ 34,661 $ 37,997 $ 69,794 $ 78,113 ----------- ----------- ----------- ----------- Cost and expenses: Cost of products sold 29,668 28,010 54,808 57,841 Selling and administrative expenses 9,098 7,398 17,918 16,420 Litigation settlement (Notes 2 and 6) - - 6,042 - Employment contract settlement costs (Note 2) - - - 8,914 ----------- ----------- ----------- ----------- 38,766 35,408 78,768 83,175 ----------- ----------- ----------- ----------- (Loss) income from operations (4,105) 2,589 (8,974) (5,062) ----------- ----------- ----------- ----------- Other income (expense): Investment income 379 263 808 479 Interest expense (238) (222) (263) (365) Foreign exchange transactions (loss) gain (194) 266 (48) 283 ----------- ----------- ----------- ----------- (53) 307 497 397 ----------- ----------- ----------- ----------- (Loss) income before income taxes (4,158) 2,896 (8,477) (4,665) (Benefit) provision for income taxes (318) 1,223 (2,046) (327) ----------- ----------- ----------- ----------- Net (loss) income $ (3,840) $ 1,673 $ (6,431) $ (4,338) =========== =========== =========== =========== (Loss) earnings per common share - Basic $ (.28) $ .12 $ (.47) $ (.31) =========== =========== =========== =========== Basic weighted average shares 13,617 13,902 13,791 13,882 =========== =========== =========== =========== (Loss) earnings per common share - Diluted $ (.28) $ .12 $ (.47) $ (.31) =========== =========== =========== =========== Diluted weighted average shares 13,617 14,405 13,791 13,882 =========== =========== =========== =========== See notes to condensed consolidated financial statements.
3 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED) Twenty-seven weeks ended February 3, 2008 (In thousands, except share data)
Accumulated Additional Other Common Stock Paid-in Retained Treasury Comprehensive Shares Amount Capital Earnings Stock Income (Loss) Total ------------- -------- ----------- --------- --------- --------------- --------- Balance at July 29, 2007 13,977,115 $ 1,398 $ 107,094 $ 99,404 $ - $ 1,745 $209,641 Exercise of stock options 19,500 - 170 170 Purchases of 493,938 shares of treasury stock (7,138) (7,138) Tax benefit upon exercise of stock options 47 47 Stock-based compensation costs 513 513 Retirement of treasury stock (493,938) (48) (7,090) 7,138 - ------------- -------- ----------- --------- --------- --------------- --------- Subtotal 13,502,677 1,350 100,734 99,404 - 1,745 203,233 --------- Net loss (6,431) (6,431) Other comprehensive (loss) income: Unrealized loss on interest rate swap (52) (52) Foreign currency translation loss (146) (146) --------- Comprehensive loss (6,629) ------------- -------- ----------- --------- --------- --------------- --------- Balance at February 3, 2008 13,502,677 $ 1,350 $ 100,734 $ 92,973 $ - $ 1,547 $196,604 ============= ======== =========== ========= ========= =============== ========= See notes to condensed consolidated financial statements.
4 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (In thousands)
Twenty-seven Twenty-six weeks weeks ended ended February 3, January 28, 2008 2007 ----------- ---------- Cash flows from operating activities: Net Loss $ (6,431) $ (4,338) ---------- ---------- Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 3,718 3,507 Stock-based compensation costs 513 225 Excess tax benefit from exercises of stock options (47) (212) Employment contract settlement costs (includes $196 of stock option modification costs) - 5,914 Litigation settlement costs 5,942 - Imputed interest 226 111 Deferred tax benefit (2,391) (2,307) Loss (gain) on sale of fixed assets 8 (107) Foreign exchange transaction losses (gains) 48 (68) Inventory valuation reserve charges 859 424 Reduction in accrual for contract losses (826) (664) Warranty reserve charges 566 634 Changes in operating assets and liabilities: Trade accounts receivable 8,638 2,162 Costs incurred and income recognized in excess of billings on uncompleted contracts and claims (4,331) 920 Other receivables (95) (888) Inventories (3,914) (1,499) Other current assets (809) (315) Accounts payable and accrued expenses 1,042 (5,266) Billings in excess of costs incurred and income recognized on uncompleted contracts 765 146 Income taxes payable 113 1,774 Accrual for contract losses 452 (321) Employment settlement payments (705) (130) Litigation settlement payments (2,500) - Advance payments on contracts (209) 1,517 Other, net (462) 201 ---------- ---------- Total adjustments 6,601 5,758 ---------- ---------- Net cash provided by operating activities 170 1,420 ---------- ---------- Cash flows from investing activities: Acquisition of technology license - (179) Proceeds from sale of fixed assets - 202 Capital expenditures (2,886) (2,235) ---------- ---------- Net cash used in investing activities (2,886) (2,212) ---------- ---------- Cash flows from financing activities: Borrowings under bank line of credit 9,400 8,500 Borrowings - other - 1,746 Proceeds from exercise of stock options 170 1,087 Excess tax benefit from exercises of stock options 47 212 Payments of long-term debt (733) (440) Payments under bank line of credit (9,400) (8,500) Purchase of treasury stock (7,138) - ---------- ---------- Net cash (used in) provided by financing activities (7,654) 2,605 ---------- ---------- Effect of exchange rate changes on cash (3) 8 ---------- ---------- Net (decrease) increase in cash and cash equivalent (10,373) 1,821 Cash and cash equivalents at beginning of period 35,181 22,303 ---------- ---------- Cash and cash equivalents at end of period $ 24,808 $ 24,124 ========== ========== See notes to condensed consolidated financial statements.
5 HERLEY INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) 1. Principles of Consolidation and Basis of Presentation The unaudited condensed 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. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X and do not include all of the information and note disclosures normally included in annual financial statements as 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, as well as the recording of the litigation settlement costs and employment contract settlement costs discussed in Note 2) considered necessary for a fair presentation have been included in the accompanying condensed consolidated financial statements. Operating results for this quarter are not necessarily indicative of the results of operations that may be expected for any other interim period or for the 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 2007 Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July 29, 2007, as filed with the Securities and Exchange Commission ("SEC"). The accounting policies used in preparing these unaudited condensed interim financial statements are consistent with those described in the July 29, 2007 audited financial statements except for the adoption of Financial Accounting Standards Board ("FASB") Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"), which is discussed in Note 4. The consolidated balance sheet at July 29, 2007 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires that management of the Company make certain estimates and assumptions that affect the reported amounts of assets, liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting periods. These judgments can be subjective and complex, and consequently actual results could differ from those estimates and assumptions. The most significant estimates include: valuation and recoverability of long-lived assets; income taxes; recognition of revenue and costs on production contracts; estimated claims and unpriced change orders under contracts; the valuation of inventory; and stock-based compensation costs valued in accordance with FAS 123(R). Each of these areas requires the Company to make use of reasoned estimates including estimating the cost to complete a contract, the recoverability of contractual claims, the net realizable value of its inventory and the market value of its products. Changes in estimates can have a material impact on the Company's financial position and results of operations. The remaining accrual for contract losses associated with the ICI acquisition (more fully described in Note A-3 and Note B of Form 10-K/A Amendment No. 1 for the fiscal year ended July 29, 2007), in the amount of $826,000 was eliminated in the twenty-seven weeks ended February 3, 2008 (which is included as a reduction of costs of products sold) as a result of the customer not exercising the remaining two contract options under the contract. Shipments under the contract were completed during the first quarter of fiscal 2008 and the remaining options under the contract expired. The Company recognized a loss of approximately $966,000 in the fourteen weeks ended February 3, 2008 on a development contract due to cost overruns and a change in management's estimate of the recoverability of the costs on future contracts. Certain prior period balances have been reclassified to conform to the current period's financial statement presentation. 2. Significant Events In connection with a lawsuit filed on April 10, 2007, by EADS Deutschland GmbH ("EADS"), a German corporation, against the Company (see Note 6), the parties have entered into an agreement effective December 5, 2007 providing for a mutual release and dismissal, with prejudice and without costs or attorney's fees to either party, of all claims and counterclaims filed. To avoid further dilution of management's time and energies, as well as legal costs on a long and protracted legal dispute, the Company agreed to pay to EADS the sum of $6,000,000. A payment of $2,500,000 was made on December 5, 2007; $1,500,000 is due by March 31, 2008; and a payment of $1,000,000 is due on March 31, 2009 and March 31, 2010, respectively. The agreement further provides for the transfer to EADS of all drawings in the Company's possession, custody or control for the equipment supplied in conjunction with a contract between the parties; providing EADS with the use of such drawings for the exclusive purpose of fulfilling its obligations towards its own customers under the contract. As security for the payments due in March of 2008, 2009 and 2010, the Company issued an irrevocable stand-by letter of credit in the amount of $3,500,000 under its existing credit facility. The Company recorded a charge to operations in the twenty-seven weeks ended February 3, 2008 of approximately $6,042,000 consisting of payments due under the agreement of approximately $5,699,000, net of imputed interest of approximately $301,000 discounted at an imputed interest rate of 7.25%, plus costs and other direct settlement expenses of approximately $343,000. On June 27, 2007, the Company was notified by the Office of the General Counsel, Acquisition Integrity Office, Department of Navy (the "Navy"), that certain of its operations had been suspended from receiving new contract awards from the 6 U.S. Government as discussed in Note A-1 in the Company's 2007 Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July 29, 2007. The affected operations included facilities in Lancaster, Pennsylvania; Woburn, Massachusetts and Chicago, Illinois. The Chicago, Illinois location is a two-person marketing office. On August 15, 2007 the suspension was lifted following an amendment to the Administrative Agreement (originally signed on October 12, 2006) with the Navy as discussed below. While the suspension was in place, these facilities could not be solicited for or awarded new contracts or contract extensions without special exceptions. The suspended facilities were permitted to receive contract awards or subcontracts from the Federal Government if the head of the agency stated in writing the compelling reason to do so. A significant portion of our business is received under contracts where we are the only qualified supplier on critical defense programs. On June 13, 2006, in connection with the legal matter discussed in Note 6 "Litigation," the Company was notified that certain of its operations had been suspended from receiving new contract awards from the U. S. Government. The affected operations included facilities in Lancaster, Pennsylvania; Woburn, Massachusetts; Chicago, Illinois and the Company's subsidiary in Farmingdale, New York. The Chicago, Illinois location is a two-person marketing office. The result of this suspension was that these facilities were not solicited for or awarded new contracts or contract extensions without special exceptions, pending the outcome of the legal proceedings. The suspended facilities were permitted to receive contract awards or subcontracts from the Federal Government if the contracting agency stated in writing the compelling reason to do so. A significant portion of the Company's business is received under contracts where the Company is the only qualified supplier on critical defense programs. The Company's facilities which were not included in the action and who were free at all times to contract with the U.S. Government are the facilities in Whippany, New Jersey (Herley-CTI); Jerusalem (Herley-Israel); McLean, Virginia (Innovative Concepts, Inc.); Fort Walton Beach, Florida (Micro Systems, Inc. and Herley-RSS) and Farnborough, U.K. (EW Simulation Technology, Limited). Effective October 12, 2006, the Company entered into an Administrative Agreement with the Department of the Navy, on behalf of the Department of Defense that requires the Company, among other things, to implement a comprehensive program of compliance reviews, audits and reports for a period of four years (as amended August 15, 2007) or until settlement or adjudication of the legal matter referenced above, whichever is later, unless shortened or extended by written agreement of the parties. In addition, the Company was required to sever its relationship with its former Chairman of the Board of Directors, as an employee or consultant to the Company. In return, the Navy, on behalf of the Department of Defense terminated the suspension of the Company from receiving new contract awards from the U.S. Government. Effective October 12, 2006 and as a condition to entering into the Administrative Agreement with the Department of the Navy noted above, the Company entered into an agreement (the "Agreement") with its former Chairman to terminate the Employment Agreement between him and the Company dated as of July 29, 2002 and modified on December 9, 2003. Aggregate costs of approximately $8,914,000 under the Agreement, including a cash payment of $3,000,000, payments due under a Promissory Note of approximately $5,354,000, medical and life insurance benefits of approximately $364,000 (both discounted at an imputed interest rate of 6.75%) and the fair value of the modification of stock options of approximately $196,000 (using the Black-Scholes option valuation model), have been recorded in the Company's condensed consolidated financial statements in the twenty-six weeks ended January 28, 2007. 3. Inventories The major components of inventories are as follows (in thousands):
February 3, July 29, 2008 2007 ---------- ---------- Purchased parts and raw materials $ 28,865 $ 28,526 Work in process 31,098 27,797 Finished products 2,295 2,576 ----------- ----------- $ 62,258 $ 58,899 Less: Allowance for obsolete and slow moving inventory 5,961 5,163 Unliquidated progress payments 1,510 1,921 ----------- ----------- $ 54,787 $ 51,815 =========== ===========
4. Income Taxes In June 2006, the 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 7 statements in accordance with SFAS 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, including requiring certain expanded disclosures. FIN 48 states that a tax benefit from an uncertain tax position may be recognized only if it is "more likely than not" that the position is sustainable, based on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with a taxing authority having full knowledge of all relevant information. A tax benefit from an uncertain tax position was previously recognized if it was "probable" of being sustained. Under FIN 48, the liability for unrecognized tax benefits is classified as noncurrent unless the liability is expected to be settled in cash within 12 months of the reporting date. 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 and was adopted by the Company on July 30, 2007. The adoption of FIN 48 did not have a material impact on the Company's consolidated financial position, results of operations or cash flows. On July 30, 2007, the Company adopted FIN 48. The cumulative effect of applying the provisions of FIN 48 resulted in a reclassification of $3,139,000 of tax liabilities (including interest and penalties of $ 734,000) from current to non-current and did not require an adjustment to retained earnings. The total amount of unrecognized tax benefits could increase or decrease within the next twelve months for a number of reasons including the expiration of statutes of limitations, audit settlements, tax examination activities and the recognition and measurement considerations under FIN 48. As of February 3, 2008, the Company's unrecognized tax benefits, that if recognized would affect the Company's effective tax rate, were $3,244,000 in the aggregate of which $2,733,000 may no longer be required during the Company's fiscal year ending August 3, 2008. This unrecognized tax benefit relates to a deduction taken for a previously impaired investment on a prior year's tax return for which the statute of limitations will expire in April 2008, unless extended. The ultimate timing of the tax consequences of the other tax benefits is uncertain. The Company has elected to retain its existing accounting policy with respect to the treatment of interest and penalties attributable to income taxes in accordance with FIN 48, and continues to reflect interest and penalties attributable to income taxes, to the extent they arise, as a component of its income tax provision or benefit as well as its outstanding income tax assets and liabilities. At February 3, 2008 the Company had $839,000 of accrued interest and penalties which is included in unrecognized tax benefits discussed above and included as "Accrued Income Taxes Payable" under long-term liabilities in the accompanying balance sheet. The Company has identified its federal tax return and its state tax return in Pennsylvania as major tax jurisdictions. The Company is also subject to multiple other state and foreign jurisdictions. The Company's evaluation of FIN 48 tax matters was performed for tax years ended 2002 through 2007, the only periods subject to examination. The Company believes that its income tax positions and deductions would be sustained on audit and does not anticipate any adjustments, other than those identified above that would result in a material change to its financial position. The income tax benefit recognized in the first half of fiscal 2008 was $2,046,000 (an effective income tax benefit rate of 24.1%) as compared to a benefit of $327,000 (an effective income tax benefit rate of 7.0%) in the first half of the prior fiscal year. The estimated effective income tax rate for fiscal 2008 is 20.0% which is lower than the statutory rate of 35.0% primarily due to lower domestic earnings as a result of the EADS litigation settlement, as well as lower projected operating income for domestic operations in fiscal 2008, resulting in foreign earnings being a greater percentage of total earnings. The Company's foreign earnings are attributable primarily to our Israeli subsidiary which is taxed at an estimated rate of 10% for fiscal 2008, thereby reducing the effective income tax rate by approximately 18%. Other non-recurring items contributing to the tax benefit in the first half of fiscal 2008 include a research and development credit carryover and a lower than expected tax rate in Israel for fiscal 2007 which increased the income tax benefit for the first six months of fiscal 2008 by approximately 4.1% resulting in an overall effective rate for the first half of fiscal 2008 of approximately 24.1%. 5. 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 fourteen and twenty-seven weeks ended February 3, 2008 and the thirteen and twenty-six weeks ended January 28, 2007 (in thousands):
Twenty- Twenty- Fourteen Thirteen seven six weeks weeks weeks weeks ended ended ended ended February 3, January 28, February 3, January 28, 2008 2007 2008 2007 ----------- ----------- ----------- ----------- Balance at beginning of period $ 1,081 $ 1,068 $ 1,106 $ 986 Provision for warranty obligations 218 368 566 634 Warranty costs charged to the reserve (282) (286) (655) (470) ----------- ----------- ----------- ----------- Balance at end of period $ 1,017 $ 1,150 $ 1,017 $ 1,150 ----------- ----------- ----------- -----------
6. 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 8 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 as superseded on January 30, 2007 alleges 27 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); aiding and abetting (18 U.S.C. Section 2); and a notice of forfeiture. The Company moved to dismiss the indictment and that motion was denied on November 5, 2007. A trial is currently scheduled for May 5, 2008. 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. All defendants in the class-action complaints filed motions to dismiss on April 6, 2007. On July 17, 2007, the Court issued an order denying the Company's and Mr. Blatt's motion to dismiss and granted, in part, the other defendants' motion to dismiss. Specifically, the Court dismissed the Section 10(b) claim against the other defendants and denied the motion to dismiss the Section 20(a) claim against them. On July 18, 2007, the Court granted defendant's motion to stay these actions until after the trial of the criminal matter referenced above. On February 8, 2008, the Court issued an Order allowing for certain document discovery to commence. In July and August 2006, the Company and certain of its current and former officers and directors were also served with two separate derivative complaints 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 and were consolidated into one action on March 9, 2006. All defendants in the derivative complaints filed motions to dismiss on February 26, 2007. On July 20, 2007, the Court issued an order denying defendants' motions in part and granting them in part. Specifically, the Court dismissed the claim that the named officers and directors failed to oversee Mr. Blatt and denied the motions with respect to the other alleged claims. The Court also granted defendants' motion to stay the action until after the trial of the criminal matter. On February 8, 2008, the Court issued an Order allowing for certain document discovery to commence. 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. Section 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 which is currently scheduled for May 5, 2008. The Company believes it has substantial defenses to the charges alleged in the indictment and intends to vigorously defend against these allegations. The Company believes it is entitled to recovery of certain legal fees associated with the above matters under its D&O insurance policy. Accordingly, as of February 3, 2008, the Company recorded claims of approximately $3,565,000 (net of a deductible of $500,000) in anticipation of recoveries. As of February 3, 2008, partial payments of approximately $1,557,000 have been received leaving a receivable balance of $2,008,000. The amount is included in other receivables in the accompanying condensed consolidated balance sheet at February 3, 2008. Subsequent to February 3, 2008, the Company received an additional payment of approximately $440,000. The insurance carrier may contest the claim in whole or in part. In addition, the Company has entered into an agreement dated January 11, 2007 with the insurance carrier whereby if it is determined by final decision of an arbitration panel, or by final judgment of a court, or other final decision of a tribunal having jurisdiction thereof, that any amount paid by the insurance carrier was not a loss, as that term is defined in the policy, the Company shall repay to the insurance carrier any such uncovered sums previously advanced to the Company. The term "Loss" is defined in the policy as follows: "Loss means the amount that any Insured becomes legally obligated to pay on account of any covered Claim, including but not limited to damages (including punitive or exemplary damages, or the multiple portion of any multiplied damage award, if and to the extent such damages are insurable under the law of the jurisdiction most favorable to the insurability of such damages provided such jurisdiction has a substantial relationship to the relevant Insureds, to the Company, or to the Claim giving rise to the damages), judgments, settlements, pre-judgment and post-judgment interest, Defense Costs and, solely with respect to Insuring Clause 2, Settlement fees." Further, the policy defines "Defense Costs" as follows: "Defense Costs means that part of Loss consisting of reasonable costs, charges, fees (including but not limited to attorneys' fees and experts' fees) and 9 expenses (other than regular or overtime wages, salaries, fees or benefits of the directors, officers or employees of the Organization) incurred in defending any Claim and the premium for appeal, attachment or similar bonds." In establishing the receivable for legal recoveries, the Company identified and segregated defense costs related to the defense of the class action lawsuits and the defense of the former Chairman and officer of the Company in the criminal case. The Company believes such costs represent a "loss" under its D&O policy and are recoverable. The Company excluded all defense costs related to the defense of the Company pertaining to the criminal case as such costs may not be recoverable under the D&O policy. On June 27, 2007, the Company was notified by the Office of the General Counsel, Acquisition Integrity Office, Department of Navy (the "Navy"), that certain of its operations had been suspended from receiving new contract awards from the U.S. Government. The affected operations included facilities in Lancaster, Pennsylvania; Woburn, Massachusetts and Chicago, Illinois. The Chicago, Illinois location is a two-person marketing office. On August 15, 2007 the suspension was lifted following an amendment to the Administrative Agreement with the Navy (originally signed on October 12, 2006) extending the term of the agreement for one additional year. While the suspension was in place, these facilities could not be solicited for or awarded new contracts or contract extensions without special exceptions. The suspended facilities were permitted to receive contract awards or subcontracts from the Federal Government if the head of the agency stated in writing the compelling reason to do so. A significant portion of our business is received under contracts where we are the only qualified supplier on critical defense programs. On April 10, 2007, EADS Deutschland GmbH ("EADS"), a German corporation, filed a lawsuit against Herley Industries, Inc., General Microwave Corporation and General Microwave Export Corporation d/b/a Herley Power Amplifier Systems (collectively the "Company") in the United States District Court for the Eastern District of New York. EADS claims that the Company breached a Transfer of Technology Agreement entered into on May 30, 2001 under which the Company was granted the right to use certain technology owned by EADS in performing under an exclusive sales and marketing agreement entered into on May 30, 2001. EADS asserted claims for breach of contract and conversion, claiming that the Company was wrongfully in possession of the intellectual property that was transferred to the Company. EADS also sought a preliminary injunction. The Company denied any wrongdoing and filed counterclaims against EADS. On August 2, 2007, the Company and EADS entered into a settlement of this motion, which was reduced to a written consent decree entered by the Court on August 29, 2007. EADS's claims for breach of contract and for conversion remained pending, as did the Company's counterclaims. Pursuant to the consent decree, the parties agreed to a mediation/settlement conference of all their respective claims with the Court, and further agreed to stay all proceedings pending the outcome of that mediation/settlement conference on October 17, 2007. In November 2007, the Company reached a comprehensive settlement agreement with EADS effective December 5, 2007, as discussed in Note 2. 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. 7. Comprehensive (Loss) Income Comprehensive (loss) income for the periods presented is as follows (in thousands):
Twenty- Twenty- Fourteen Thirteen seven six weeks weeks weeks weeks ended ended ended ended February 3, January 28, February 3, January 28, 2008 2007 2008 2007 ---- ---- ---- ---- Net (loss) income $ (3,840) $ 1,673 $ (6,431) $ (4,338) Unrealized (loss) income on interest rate swap (42) 12 (52) (9) Foreign currency translation (loss) gain (188) 436 (146) 415 ------------ ----------- ------------ ----------- Comprehensive (loss) income $ (4,070) $ 2,121 $ (6,629) (3,932) ============ =========== ============ ===========
The foreign currency translation (loss) gain relates to the Company's investment in its U.K. subsidiary and fluctuations in exchange rates between its local currency and the U.S. dollar. The components of accumulated other comprehensive income are as follows (in thousands):
February 3, July 29, 2008 2007 ---- ---- Unrealized loss on interest rate swap $ (81) $ (29) Foreign currency translation gain 1,628 1,774 ---------- ---------- Accumulated other comprehensive income $ 1,547 $ 1,745 ========== ==========
10 8. Share-Based Compensation The Company has various fixed stock option plans which are described in Note N of the Company's July 29, 2007 Annual Report on Form 10-K/A Amendment No. 1 that provide for the grant of stock options to eligible employees and directors. The Company recorded total share-based costs related to stock options, included as compensation costs in operating expenses, of approximately $266,000 and $513,000 for the fourteen and twenty-seven weeks ended February 3, 2008 and approximately $109,000 and $224,000 for the thirteen and twenty-six weeks ended January 28, 2007, respectively. As of February 3, 2008, there were 3,544,450 stock options outstanding. Options for 4,000 shares of common stock were issued at an average price of $13.87 during the twenty-seven weeks ended February 3, 2008. The aggregate fair value of the options issued, as determined using a Black-Scholes option valuation model, is approximately $23,000. No stock options were granted during the twenty-six weeks ended January 28, 2007. The aggregate value of unvested options as of February 3, 2008, as determined using a Black-Scholes option valuation model, was approximately $1,384,000 (net of estimated forfeitures) which is expected to be recognized over a weighted-average period of 1.8 years. Options for 19,500 shares of common stock were exercised during the twenty-seven weeks ended February 3, 2008 at exercise prices of $7.63 and $9.13 per share and options for 80,500 shares of common stock expired or were forfeited during the period. The total intrinsic value of options exercised during the twenty-seven weeks ended February 3, 2008, based on the difference between the Company's stock price at the time of exercise and the related exercise price, was approximately $123,000. A summary of stock option activity under all plans for the twenty-seven weeks ended February 3, 2008 is as follows:
Non-Qualified Stock Options - ---------------------------- Weighted Aggregate Average Intrinsic Number Price Range Exercise Value of shares per share Price (in thousands) --------- ----------- ---------- -------------- Outstanding July 29, 2007 3,640,450 $ 7.25 - 21.18 $ 14.84 Granted 4,000 $ 12.58 - 15.16 $ 13.87 Exercised (19,500) $ 7.63 - 9.13 $ 8.78 Cancelled (80,500) $ 17.98 - 20.09 $ 19.28 -------------- ---------------- -------------- Outstanding February 3, 2008 3,544,450 $ 7.25 - 21.18 $ 14.77 $ 3,809 ============== -------------- ------- Exercisable February 3, 2008 (1) 3,111,950 $ 14.46 $ 3,809 -------------- -------------- ------- Vested and expected to vest February 3, 2008 3,470,553 $ 14.72 $ 3,809 -------------- -------------- ------- (1) There are 1,074,450 vested options with exercise prices greater than the closing stock price of $12.97 as of February 3, 2008.
9. (Loss) earnings per Common Share ("EPS") The following table shows the components used in the calculation of basic loss per common share and loss per common share assuming dilution (in thousands):
Twenty- Twenty- Fourteen Thirteen seven six weeks weeks weeks weeks ended ended ended ended February 3, January 28, February 3, January 28, 2008 2007 2008 2007 ---- ---- ---- ---- Numerator: Net (loss) income $ (3,840) $ 1,673 $ (6,431) $ (4,338) ========= ======= ========= ========= Denominator: Basic weighted-average shares 13,617 13,902 13,791 13,882 Effect of dilutive securities: Employee stock options - 503 - - ---------------------------------------------------------------------- Diluted weighted-average shares 13,617 14,405 13,791 13,882 ====================================================================== Stock options not included in computation 3,544 1,730 3,544 3,387 ====================================================================== Exercise price range per share $7.25 - $21.18 $15.78 - $21.18 $7.25 - $21.18 $4.31 - $21.18
11 No employee stock options were considered in the computation of diluted net loss per share for the fourteen and twenty-seven weeks ended February 3, 2008 and for the twenty-six weeks ended January 28, 2007 as their effect is anti-dilutive. The options which were outstanding as of February 3, 2008 and excluded from the computation in the table above expire at various dates through June 8, 2017. 10. Stock Buyback Program On October 12, 2007, the Company announced that its Board of Directors had approved an expansion of its existing stock buyback program to make additional purchases of up to 1,000,000 shares of its common stock in the open market or private transactions, in accordance with applicable SEC rules. During the twenty-seven weeks ended February 3, 2008 the Company repurchased and retired 493,938 shares of its common stock, pursuant to this program at an aggregate cost of approximately $7,138,000 including transaction costs. Funds to acquire the shares came from excess cash reserves. Common stock at par value and additional paid-in capital were reduced by approximately $48,000 and $7,090,000, respectively. The timing, actual number and value of any additional shares that may be repurchased under this program will depend on a number of factors, including the Company's future financial performance, the Company's available cash resources and competing uses for the cash, prevailing market prices of the Company's common stock and the number of shares that become available for sale at prices that the Company believes are attractive. As of February 3, 2008, approximately 614,000 shares are available under the Company's buyback program. 11. Geographic Information and Major Customers The Company's chief operating decision makers are considered to be the Chairman/Chief Executive Officer and the Chief Operating Officer. These individuals evaluate both consolidated and disaggregated financial information, primarily gross revenues, in deciding how to allocate resources and assess performance. They also use certain disaggregated financial information for the Company's product groups. The Company does not determine a measure of operating income or loss by product group. The Company's product groups have similar long-term economic characteristics, such as application, and are similar in regards to (a) nature of products and production processes, (b) type of customers and (c) method used to distribute products. Accordingly, the Company operates as a single integrated business and as such has one operating segment as a provider of complex microwave technology solutions for the defense, aerospace and medical industries worldwide. All of the Company's revenues result from sales of its products. Net sales for defense electronics and commercial technologies were as follows:
Twenty- Twenty- Fourteen Thirteen seven six weeks weeks weeks weeks ended ended ended ended February 3, January 28, February 3, January 28, 2008 2007 2008 2007 ---- ---- ---- ---- Defense electronics $ 32,398 $ 34,270 $ 64,595 $ 69,243 Commercial technologies 2,263 3,727 5,199 8,870 ----------- ----------- ----------- ---------- Net sales $ 34,661 $ 37,997 $ 69,794 $ 78,113 =========== =========== =========== ==========
Net sales directly to the U.S. Government in the twenty-seven and twenty-six weeks ended February 3, 2008 and January 28, 2007 accounted for approximately 14% and 21% of net sales, respectively, and in the fourteen and thirteen weeks ended February 3, 2008 and January 28, 2007 net sales directly to the U.S. Government accounted for approximately 14% and 20% of net sales. Northrop Grumman and Lockheed Martin each accounted for approximately 12% of net sales in the twenty-seven weeks ended February 3, 2008. No other customer accounted for 10% or more of consolidated net sales in the periods presented. Foreign sales amounted to approximately $22,986,000 (33%) and $23,646,000 (30%) in the twenty-seven and twenty-six weeks ended February 3, 2008 and January 28, 2007, respectively; and in the fourteen and thirteen weeks ended February 3, 2008 and January 28, 2007 foreign sales amounted to approximately $11,116,000 (32%) and $11,483,000 (30%), respectively. 12 Geographic net sales based on place of contract performance, were as follows (in thousands):
Twenty- Twenty- Fourteen Thirteen seven six weeks weeks weeks weeks ended ended ended ended February 3, January 28, February 3, January 28, 2008 2007 2008 2007 ---- ---- ---- ---- United States $ 28,284 $ 31,653 $ 58,716 $ 65,238 Israel 5,518 5,125 9,940 9,500 England 859 1,219 1,138 3,375 ----------- ----------- ----------- ----------- Net sales $ 34,661 $ 37,997 $ 69,794 $ 78,113 =========== =========== =========== ===========
Net property, plant and equipment by geographic area were as follows (in thousands):
February 3, July 29, 2008 2007 ---- ---- United States $ 26,519 $ 24,904 Israel 4,547 4,844 England 157 248 --------- --------- $ 31,223 $ 29,996 ========= =========
12. Supplemental Cash Flow information is as follows (in thousands):
Twenty-seven Twenty-six weeks ended weeks ended February 3, 2008 January 28, 2007 ---------------- ---------------- Net cash paid during the period for: Interest $ 206 $ 247 Income taxes $ 232 $ - Non-cash financing transactions: Retirement of 493,938 shares of treasury stock $ 7,138 $ -
13. New Accounting Pronouncements In December 2007, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 141 (revised 2007), "Business Combinations" (SFAS 141(R)). The objective of this Statement is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination. Specifically, it establishes principles and requirements over how the acquirer (1) recognizes and measures the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (2) recognizes and measures goodwill acquired in the business combination or a gain from a bargain purchase, and; (3) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141(R) also requires acquisition-related transaction expenses and restructuring costs be expensed as incurred rather than capitalized as a component of the business combination. This Statement is effective for fiscal years beginning after December 15, 2008 (the Company's 2010 fiscal year). The Company does not believe this Statement will have a material impact on the financial statements. SFAS 141(R) would have an impact on accounting for any businesses acquired after the effective date of this pronouncement. In December 2007, the FASB issued Statement of Financial Accounting Standard No. 160, "Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB No. 51" (SFAS 160). The objective of this Statement is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards for the noncontrolling interest in a subsidiary (minority interests) and for the deconsolidation of a subsidiary. SFAS 160 also requires that a retained noncontrolling interest upon the deconsolidation of a subsidiary be initially measured at its fair value. Upon adoption of SFAS 160, the Company would be required to report any noncontrolling interests as a separate component of stockholders' equity. The Company would also be required to present any net income allocable to noncontrolling interests and net income attributable to the stockholders of the Company separately in its consolidated statements of income. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008 (the Company's 2010 fiscal year). SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests, and would have an impact on the presentation and disclosure of the noncontrolling interest of any non wholly-owned businesses acquired in the future. 13 14. Related Party Transactions The Company leases one of its buildings in Fort Walton Beach, Florida from MSI Investments, a Florida General Partnership which is owned by four individuals, two of whom are currently employees of MSI and one who serves as a consultant. Rent expense in the fourteen and twenty-seven weeks ended February 3, 2008 was approximately $73,000 and $142,000, respectively, and for the thirteen and twenty-six weeks ended January 28, 2007 was approximately $68,000 and $135,000, respectively. The Company leases its facilities in Farmingdale, New York from a partnership partially owned by the children of an officer of the Company. Rent expense in the fourteen and twenty-seven weeks ended February 3, 2008 was approximately $187,000 and $298,000, respectively, and for the thirteen and twenty-six weeks ended January 28, 2007 was approximately $175,000 and $342,000, respectively. 15. Stand-by Letters of Credit The Company maintains a letter of credit facility in connection with its revolving credit agreement with two banks that provides for the issuance of stand-by letters of credit and requires the payment of a fee of 1.0% per annum of the amounts outstanding under the facility. The facility expires March 31, 2009. At February 3, 2008, stand-by letters of credit aggregating approximately $14,765,000 were outstanding under this facility. On March 4, 2008 the Company issued a stand-by letter of credit on behalf of our customer as a repayment guarantee for an advance of approximately $4.0 million in connection with an order from their customer. Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations 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. Explanatory Note We begin Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") of Herley Industries, Inc. with a business overview. This is followed by a discussion of the critical accounting estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results, which we discuss under "Results of Operations." We then provide an analysis of cash flows under "Liquidity and Capital Resources." This MD&A should be read in conjunction with our unaudited condensed consolidated financial statements, the notes thereto, the other unaudited financial data included elsewhere in this 10-Q and our 2007 Form 10-K/A Amendment No. 1. 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 Northrop Grumman Corporation, Lockheed Martin Corporation, Raytheon Company, The Boeing Company, BAE Systems and Harris Corporation), the U.S. Government (including the Department of Defense, NASA and other U.S. Government agencies) and international customers (including the Egyptian, German, Japanese and South Korean militaries and suppliers to international militaries). We are a leading provider of microwave technologies for use in command and control systems, flight instrumentation, weapons sensors and electronic warfare systems. We have served the defense industry since 1965 by designing and manufacturing microwave devices 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 E-2C/D Hawkeye, EA-18G Growler, the AEGIS class surface combatants, the EA-6B Prowler, the AMRAAM air to air missile, CALCM (Conventional Air Launch Cruise Missile), Multi-mission Maritime Aircraft and unmanned aerial vehicles, or UAVs, as well as high priority national security programs such as National Missile Defense and the Trident II D-5. Critical Accounting Policies and Estimates Our significant accounting policies are described in Note A of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July 29, 2007. A discussion of our critical accounting policies and estimates are included in Management's Discussion and Analysis of Results of Operations and Financial Condition in our Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July 29, 2007. Management has discussed the development and selection of these policies with the Audit Committee of the Company's Board of Directors, and the Audit Committee of the Board of Directors has reviewed the Company's disclosures of these policies. We adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48) effective July 30, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS 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 14 periods, disclosure and transition. We had no cumulative effect adjustment related to the adoption. However, certain amounts have been reclassified in the consolidated balance sheet in order to comply with the requirements of the statement. Other than the adoption of FIN 48, there have been no material changes to the critical accounting policies or estimates reported in Management's Discussion and Analysis section of the audited financial statements for the fiscal year ended July 29, 2007 as filed with the Securities and Exchange Commission. Results of Operations Our Company's senior management regularly reviews the performance of our operations including reviews of key performance metrics as well as the status of operating initiatives. We review information on the financial performance of the operations, new business opportunities, customer relationships and initiatives, IR&D activities, human resources, manufacturing effectiveness, cost reduction activities, as well as other subjects. We compare performance against budget, against prior comparable periods, and against our most recent internal forecasts. The following table presents a financial summary comparison (in thousands) of the key performance metrics.
Second Quarter Six Months Year to Date ------------------------------------ ------------------------------------ 2008 2007 % Change 2008 2007 % Change ------------------------------------ ------------------------------------ Key performance metrics Net sales $34,661 $37,997 (9)% $69,794 $78,113 (11)% Gross profit $4,993 $9,987 (50)% $14,986 $20,272 (26)% Gross profit percentage 14.4% 26.3% 21.5% 26.0% Operating (loss) income ($4,105) $2,589 (259)% ($8,974) ($5,062) (77)% Bookings $41,695 $43,316 (4)% $81,973 $88,196 (7)% Backlog $148,002 $136,303 9 % $148,002 $136,303 9 %
As you will see in the following management discussion of the results of operations, the results for the Company in our second quarter were poor and we find the performance to be unacceptable. There were a number of specific performance issues across several of our operations that impacted the results negatively and significantly. In our discussion below, we will explain the key performance metrics and provide a thorough and complete analysis of the performance of the Company in the second quarter. While the results of the second quarter are highly disappointing, we do not believe they are indicative of a trend and we expect to return to profitability this year. However, there can be no assurance that we will achieve our expectations. Our backlog remains strong and at high levels while our proposal activity continues to be very active and promising. The current poor financial performance is driven largely by engineering and manufacturing difficulties on a number of significant and important contracts, including contracts that are primarily developmental in nature. We believe we understand the various technical problems we are facing and we have action plans well underway to resolve them. In addition, we have been impacted by delayed receipt of key follow-on contract awards. We are now in final negotiations with our customers on these contracts and expect to book these orders during our third quarter. Although there can be no assurance that we will succeed, we are confident that we will successfully work through these challenges. During recent months, a number of operational improvement initiatives have been undertaken at our operating facilities which we expect will provide operational performance improvement, some of which should have immediate effects. We have established four improvement objectives across all locations. They are: improve cycle time, reduce defects, improve customer satisfaction, and increase Herley pride. We have motivated our employees to actively engage in this program. Across our eight locations we now have 125 active teams addressing company specific improvement objectives aligned with these four corporate objectives. Each of these teams has a quantifiable improvement objective targeted for completion on or before the end of our fiscal year. We are also emphasizing a culture of honoring our commitments in everything we do. We are seeing this process improvement culture beginning to take root in our operations. Although we believe that our expectations for the success of these initiatives are reasonable, there are no guarantees that future results, performance or achievements may be realized. Similarly, we formed five Councils which are: Technology, Operations, Business Development, Finance, and Contracts. Each Council has a representative from each of our locations and is chartered with the objective of implementing process improvements in their respective discipline that crosses all locations as well as sharing of best practices across Herley. Each Council has identified specific, measurable objectives that will be achieved on or before the end of this fiscal year. Thirty different issues are being addressed by the Councils, each of which we believe will improve the performance of the Company. In addition, we are identifying and implementing specific and substantive actions immediately to control costs and focus the resources of the Company directly on the operational performance issues which are designed to bring about measurable improvement in a short period of time. Accordingly, we believe we are taking appropriate and aggressive actions to meet the challenges facing our Company and we remain optimistic that the Company's performance issues will be short-lived. 15 Fourteen weeks ended February 3, 2008 and thirteen weeks ended January 28, 2007 - ------------------------------------------------------------------------------- Net sales for the fourteen weeks ended February 3, 2008 were approximately $34.7 million, as compared to $38.0 million in the thirteen weeks ended January 28, 2007, a decrease of $3.3 million (8.8%). This decrease is attributable to: o a decrease of $2.5 million due to delays in booking and reduction in scope for certain cost plus fixed fee contracts for software development at Innovative Concepts, Inc. ("ICI"); o a decrease of $1.1 million due to the completion of a contract for radio communications equipment at ICI; o a decrease of $1.2 million as the result of delays in certain microwave development programs at Herley Farmingdale; o a decrease at Herley Medical Products of approximately $0.8 million in medical equipment sales to two key commercial customers due to timing of their capital purchasing requirements; o and a decrease of $0.4 million versus the prior year quarter as certain commercial programs ended and the transition towards military business progressed at Herley CTI. Offsetting these decreases was: o an increase of $1.3 million of simulation systems through Micro Systems, Inc.; o an increase of $1.0 million in volume of certain key second generation production programs at Herley New England; o and an increase of $0.4 million of microwave systems and products through our Israeli subsidiary. Domestic and foreign sales from all locations were 68% and 32% respectively of total net sales in the quarter, versus 70% and 30% respectively in the prior year quarter. Bookings in the second quarter were approximately $41.7 million, and were 80% domestic and 20% foreign. This compares to bookings of approximately $43.3 million in the prior year second quarter which were 58% domestic and 42% foreign. Gross profit in the fourteen weeks ended February 3, 2008 was $5.0 million (14.4% of net sales) compared to $10.0 million (26.3% of net sales) in the second quarter of fiscal 2007, a decrease of approximately $5.0 million. Contributing to the decrease in gross profit for the quarter are the following items: o Estimated gross profit of approximately $2.0 million due to delays in booking of certain software development programs at ICI. We believe that our engineering personnel at ICI have unique experience that provides us the ability to receive this follow-on work on a sole source basis. These contracts are now in final negotiations and currently scheduled for award during our third fiscal quarter. Mitigating the effects of the $2.0 million gross profit shortfall resulting from the delayed software development programs was the redeployment of certain engineering personnel to independent research and development projects which amounted to approximately $0.7 million. o Gross profit at our Herley Lancaster operation was significantly lower than the prior year second quarter. Contributing to the decrease in gross profit was approximately $0.4 million due to manufacturing issues on various production contracts that reduced production throughput, as well as higher than normal scrap costs. The most significant issues resulted from supplier quality issues related to printed circuit boards and plating. In both instances defects were identified during the manufacturing process resulting in delayed shipments as well as excessive scrap rates. We have changed suppliers and have instituted additional incoming inspection procedures designed to prevent this problem from recurring. In addition, Herley Lancaster was also unfavorably impacted by approximately $0.5 million due to additional indirect costs including costs associated with the manufacturing issues already described, as well as indirect costs associated with the implementation of Dynamics AX. A decrease in third party sales volume reduced gross profit by approximately $0.3 million. Increased costs of independent research and development programs focusing on certain strategic opportunities at Herley Lancaster approximated $0.4 over the comparable period in 2007. o In addition to the independent research and development costs at ICI and Herley Lancaster, we incurred higher independent research and development costs of approximately $0.4 million on investments in certain strategic opportunities at other Herley operations. o A loss of approximately $1.0 million on a development contract at Herley Farmingdale due to cost overruns and a change in management's estimate of the recoverability of the costs on future contracts. o Higher costs at our Israeli subsidiary of approximately $0.4 million due to the unfavorable exchange rate of the U.S. Dollar versus the Israeli Shekel. o ICI was awarded a firm fixed-price contract with the U.S. Army in 2004 which included four options to extend the contract. Since the U.S. Army was not obligated to exercise any of the four options, ICI did not invest fully in product costs at inception of the contract, but rather waited for government acceptance of each future option. This fact exposed ICI to cost increases and to an estimated loss on the contract. Therefore, a contract loss provision was established. During the 2007 fiscal year, ICI commenced delivery of units under the first two options under the contract. As these units were successfully manufactured in 2007, we measured the actual costs of producing those units and incorporated that knowledge into our estimates for future production costs under the contract. We monitored production performance and evaluated the contract loss provision for this contract on a quarterly basis. Therefore, based on a change in management's estimate of costs under the contract directly attributable to the actual cost realized in the production of the units under the first two options approximately $0.7 million of estimated contract losses were reversed during the thirteen weeks ended January 28, 2007. This contributed to the lower gross profit earned in the fourteen weeks ended February 3, 2008 as compared to the prior year. 16 Offset by o Gross profit improvement within various businesses due to product mix or performance improvement. Selling and administrative expenses for the fourteen weeks ended February 3, 2008 increased approximately $1.7 million over the second quarter of fiscal 2007 and was 26% of net sales as compared to 19% in fiscal 2007. Significant expenses during the period included: o An increase in legal fees, net of accrued insurance recoveries, over the prior year second quarter of approximately $214,000. During the fourteen weeks ended February 3, 2008, gross legal costs were approximately $1,542,000, while legal costs net of accrued insurance recoveries were approximately $694,000 as compared to $480,000 in thirteen weeks ended January 28, 2007. Legal costs in both periods are primarily attributable to the current indictment. o An increase in sales commissions of approximately $400,000 over the prior year second quarter. o An increase in stock compensation costs recorded per SFAS 123(R) of approximately $156,000. o An increase in amortization of intangibles of approximately $110,000. o An increase in compensation costs and general corporate expenses of approximately $550,000. We believe we are entitled to recovery of certain legal fees associated with the recent indictment and class-action complaints under our D&O insurance policy. Accordingly, as of February 3, 2008, we have recorded a claim of approximately $3,565,000 (net of a deductible of $500,000) and have received partial payments of approximately $1,557,000 leaving a receivable balance of $2,008,000. The amount is included in other receivables in the accompanying condensed consolidated balance sheet at February 3, 2008. Subsequent to the balance sheet date of February 3, 2008, we received an additional payment of approximately $440,000. The insurance carrier may contest the claim in whole or in part. In addition, we have entered into an agreement dated January 11, 2007 with the insurance carrier whereby if it is determined by final decision of an arbitration panel, or by final judgment of a court, or other final decision of a tribunal having jurisdiction thereof, that any amount paid by the insurance carrier was not a loss, as that term is defined in the policy, we shall repay to the insurance carrier any such uncovered sums previously advanced to us. The term "Loss" is defined in the policy as follows: "Loss means the amount that any Insured becomes legally obligated to pay on account of any covered Claim, including but not limited to damages (including punitive or exemplary damages, or the multiple portion of any multiplied damage award, if and to the extent such damages are insurable under the law of the jurisdiction most favorable to the insurability of such damages provided such jurisdiction has a substantial relationship to the relevant Insureds, to the Company, or to the Claim giving rise to the damages), judgments, settlements, pre-judgment and post-judgment interest, Defense Costs and, solely with respect to Insuring Clause 2, Settlement fees." Further, the policy defines "Defense Costs" as follows: "Defense Costs means that part of Loss consisting of reasonable costs, charges, fees (including but not limited to attorneys' fees and experts' fees) and expenses (other than regular or overtime wages, salaries, fees or benefits of the directors, officers or employees of the Organization) incurred in defending any Claim and the premium for appeal, attachment or similar bonds." In establishing the receivable for legal recoveries, the Company identified and segregated defense costs related to the defense of the class action lawsuits and the defense of the former Chairman and officer of the Company in the criminal case. The Company believes such costs represent a "loss" under its D&O policy and are recoverable. The Company excluded all defense costs related to the defense of the Company pertaining to the criminal case as such costs may not be recoverable under the D&O policy. Loss from operations for the second quarter of fiscal 2008 was $4.1 million or 11.8% of net sales, as compared to income from operations of $2.6 million or 6.8% of net sales in the prior year. The loss from operations for the second quarter of fiscal 2008 was largely impacted by the shortfall in gross margin as well as the increased general and administrative costs as described above. Other income (expense) decreased in the second quarter of fiscal 2008 over the prior year by approximately $360,000 primarily due to foreign currency exchange fluctuations. The foreign exchange gains and losses are attributable to fluctuations in exchange rates between the U.S. dollar and the local currency of our U.K. subsidiary primarily in connection with temporary advances we have made to them in U.S. dollars. The income tax benefit recognized in the second quarter of fiscal 2008 was $318,000 as compared to a provision of $1,223,000 in the prior year's second quarter. The estimated effective income tax rate for fiscal 2008 of 20.0% is lower than the statutory rate of 35% primarily due to lower projected domestic operating income resulting in foreign earnings being a greater percentage of total earnings. The Company's foreign earnings are attributable primarily to our Israeli subsidiary which is taxed at an estimated rate of 10% for fiscal 2008, thereby reducing the effective income tax rate by approximately 18% for the 2008 fiscal year. 17 Twenty-seven weeks ended February 3, 2008 and twenty-six weeks ended January 28, 2007 - ---- Net sales for the twenty-seven weeks ended February 3, 2008 were approximately $69.8 million compared to $78.1 million in the first six months of fiscal 2007, a decrease of $8.3 million (11%). The decrease in net sales is primarily related to: o a decrease of approximately $4.6 million due to delays in booking and reduction in scope for certain cost plus fixed fee contracts for software development at ICI; o a decrease of approximately $1.1 million in deliveries due to the completion of a contract for radio communications equipment at ICI; o delays in key microwave development and production programs at Herley Farmingdale of approximately $2.3 million; o a decrease at Herley Medical Products of approximately $1.4 million in equipment sales to two key commercial customers due to timing of their capital purchasing requirements; o disruptions across several production programs due to supplier quality issues; and o a decrease in revenues of approximately $2.0 million versus the first six months of the prior year as certain commercial programs ended and the transition towards military business progressed at Herley CTI. Offsetting these decreases was: o an increase of $4.0 million of simulation systems and other product sales through Micro Systems, Inc.; o an increase of approximately $0.7 million at Herley New England due to volume of certain key second generation production programs; o and a $0.4 million increase of microwave systems and products through our Israeli subsidiary. Domestic and foreign sales were 67% and 33% respectively of net sales in the twenty-seven weeks ended February 3, 2008, versus 70% and 30% respectively in the prior year comparable period. Bookings were approximately $82.0 million, and were 76% domestic and 24% foreign. This compares to bookings of approximately $88.2 million in the prior year period which were 64% domestic and 36% foreign. Gross profit in the twenty-seven weeks ended February 3, 2008 was $15.0 million (21.5% of net sales) compared to $20.3 million (26.0% of net sales) in the first half of fiscal 2007, a decrease of $5.3 million. The decrease was approximately $0.3 million during the first quarter and approximately $5.0 during the second quarter. Contributing to the reduction in gross profit during the first six months of fiscal 2008 are the following items: o Estimated gross profit of approximately $4.0 million due to delays in booking of certain software development programs at ICI. We believe that our engineering personnel at ICI have unique experience that provides us the ability to receive this follow-on work on a sole source basis. These contracts are now in final negotiations and currently scheduled for award during our third fiscal quarter. Mitigating the effects of the $4.0 million gross profit shortfall resulting from the delayed software development programs was the redeployment of certain engineering personnel to independent research and development projects which amounted to approximately $0.9 million. o Gross profit performance at our Herley Lancaster operation during the first quarter was measurably better than the prior year first quarter due in part to product mix and performance. However, during the second quarter the gross profit performance was significantly lower than the prior year quarter. Contributing to the decrease in gross profit during the second quarter was approximately $0.4 million due to manufacturing issues on various production contracts that reduced production throughput, as well as higher than normal scrap costs. The most significant issues resulted from supplier quality issues related to printed circuit boards and plating. In both instances defects were identified during the manufacturing process resulting in delayed shipments as well as excessive scrap rates. We have changed suppliers and have instituted additional incoming inspection procedures designed to prevent this problem from recurring. In addition, Herley Lancaster was also unfavorably impacted by approximately $0.5 million due to additional indirect costs including costs associated with the manufacturing issues already described, as well as indirect costs associated with the implementation of Dynamics AX. A decrease in third party sales volume during the second quarter reduced gross profit by approximately $0.3 million. Increased costs of independent research and development programs focusing on certain strategic opportunities at Herley Lancaster approximated $0.7 million over the comparable six-month period in 2007. o In addition to the independent research and development costs at ICI and Herley Lancaster, we incurred higher independent research and development costs of approximately $0.6 million on investments in certain strategic opportunities at other Herley operations. o A loss of approximately $1.0 million on a development contract at Herley Farmingdale due to cost overruns and a change in management's estimate of the recoverability of the costs on future contracts. o Higher costs at our Israeli subsidiary due to the unfavorable exchange rate of the U.S. Dollar versus the Israeli Shekel. Offset by o A reversal in the accrual for contract losses in the first half of fiscal 2008 at ICI of approximately $0.8 million due to the completion of a contract with the U. S. Army and the expiration of the remaining options under the contract compared to the reversal of $0.7 million in the first half of fiscal 2007 due to revisions in cost estimates to complete the contract. o Non-recurrence startup production costs on certain programs primarily at Herley New England. 18 Selling and administrative expenses for the twenty-seven weeks ended February 3, 2008 were 26% of net sales as compared to 21% in the first six months of fiscal 2007. The $1.5 million increase in selling and administrative expenses is attributable to an increase in commissions related primarily to our international business; an increase in stock compensation costs recorded per SFAS 123(R); an increase in amortization expense; and an increase in compensation and general corporate expenses. We had an operating loss for the first six months of fiscal 2008 of $9.0 million compared to an operating loss of $5.0 million in the comparable period of fiscal 2007. Excluding both the litigation settlement costs in the first quarter of fiscal 2008 and the employment contract settlement costs recorded in the first quarter of fiscal 2007, operating loss for the first six months of fiscal 2008 was $2.9 million or 4.2% of net sales, as compared to operating income of $3.9 million or 4.9% of net sales in the first six months of fiscal 2007. The decrease in operating income is primarily attributable to the reduced sales volume, the 4.5% decrease in gross margin percentage as discussed above, and the increase in selling and administrative expenses. Investment income was $808,000, an increase of $329,000 in the first six months of fiscal 2008 because of higher interest rates earned on higher average cash balances. Interest expense was $263,000, a decrease in the first half of $102,000 versus the prior year first half period primarily due to the capitalization of certain interest costs associated with the development of software for internal use in accordance with FAS 34, capitalization of interest cost. We recognized a net foreign exchange loss of $48,000 through the second quarter of fiscal 2008, versus a gain of $283,000 in the prior year period. The foreign exchange losses and gains are attributable to fluctuations in exchange rates between the U.S. dollar and the local currency of our U.K. subsidiary primarily in connection with temporary advances we have made to them in U.S. Dollars. The income tax benefit recognized in the first half of fiscal 2008 was $2,046,000 (an effective income tax benefit rate of 24.1%) as compared to a benefit of $327,000 (an effective income tax benefit rate of 7.0%) in the first half of the prior fiscal year. The estimated effective income tax rate for fiscal 2008 is 20.0% which is lower than the statutory rate of 35.0% primarily due to lower domestic earnings as a result of the EADS litigation settlement, as well as lower projected operating income for domestic operations in fiscal 2008, resulting in foreign earnings being a greater percentage of total earnings. The Company's foreign earnings are attributable primarily to our Israeli subsidiary which is taxed at an estimated rate of 10% for fiscal 2008, thereby reducing the effective income tax rate by approximately 18%. Other non-recurring items contributing to the tax benefit in the first half of fiscal 2008 include a research and development credit carryover and a lower than expected tax rate in Israel for fiscal 2007 which increased the income tax benefit for the first six months of fiscal 2008 by approximately 4.1% resulting in an overall effective rate for the first half of fiscal 2008 of approximately 24.1%. Liquidity and Capital Resources As of February 3, 2008 and July 29, 2007, working capital was $95,980,00 and $103,502,000, respectively, and the ratio of current assets to current liabilities was 3.8 to 1 and 4.0 to 1, respectively. As is customary in the defense industry, inventory is partially financed by progress payments. In addition, it is customary for us to receive advanced payments from customers on major contracts at the time a contract is entered into. The un-liquidated balance of progress payments was approximately $1,510,000 at February 3, 2008 and $1,921,000 at July 29, 2007. The balance of advanced payments was approximately $6,954,000 at February 3, 2008 and $7,163,000 at July 29, 2007. Net cash provided by operations during the twenty-seven weeks ended February 3, 2008 was approximately $170,000 as compared to $1.4 million during the first half of the prior year, a net decrease of approximately $1.3 million. We had a net loss in the first half of the current fiscal year of $6.4 million versus a loss of $4.3 million in the prior year first half, an increase in the loss of approximately $2.1 million. The first half of fiscal 2008 was impacted by the settlement of litigation and related costs of approximately $6.0 million and the first half of fiscal 2007 included employment settlement costs of approximately $8.9 million, including a cash payment of $3.0 million (as discussed in Note 2). Significant increases in cash provided by operating activities during the twenty-seven weeks ended February 3, 2008 include the following: 1. A decrease in trade accounts receivable of $8.6 million, and 2. an increase of approximately $1.0 million generated through amounts due to vendors and accrued expenses. Offset primarily by the following decreases in cash provided by operating activities: 1. An increase of approximately $4.3 million in the amount of cash invested in costs incurred and income recognized in excess of billings on uncompleted contracts and claims, 2. an increase in inventory of approximately $3.9 million, and 19 3. payments of $2.5 million in connection with the EADS litigation settlement. Net cash used in investing activities relates to capital expenditures of approximately $2.9 million. Net cash used in financing activities includes: 1. The purchase and retirement of 493,938 shares of our common stock at an aggregate cost of approximately $7.1 million, including transaction costs, pursuant to an expansion of a stock buyback program to make additional purchases of up to 1,000,000 shares of our common stock in the open market or private transactions. As of February 3, 2008, approximately 614,000 shares are available for purchase under the buyback program, and 2. payments of $0.7 million related to our long-term debt. During the twenty-seven weeks ended February 3, 2008 we borrowed and repaid $9.4 million under our revolving credit facility for short-term working capital needs. On April 30, 2007, we replaced our existing credit facility with a new $40 million Revolving Credit Loan Agreement with two banks on an unsecured basis which may be used for general corporate purposes, including business acquisitions and stand-by letters of credit. The revolving credit facility requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on March 31, 2009. We may elect to borrow with interest based on the bank's prime rate of interest minus 0.50% or 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. There is a fee of 20 basis points per annum on the unused portion of the credit facility payable quarterly. If at any time our backlog of orders falls below $50 million, the bank may obtain a security interest in eligible accounts receivable, as defined, and if the outstanding advances are greater than 100% of eligible receivables, a lien on all inventory. Our backlog as of February 3, 2008 was approximately $148 million. During the quarter ended February 3, 2008, we utilized the credit facility for short-term working capital needs to the extent of $9.4 million. There are no borrowings under the credit line at February 3, 2008 and July 29, 2007. Stand-by letters of credit were outstanding in the amount of approximately $14.8 million under the credit facility at February 3, 2008, and $11.5 million at July 29, 2007. A stand-by letter of credit in the amount of $4.0 million was issued on March 4, 2008 as discussed below. 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. We are in compliance with all covenants at February 3, 2008. We believe that presently anticipated future cash requirements will be provided by internally generated funds, our existing unsecured credit facility, and existing cash reserves. A significant portion of our revenue for fiscal 2008 will be generated from our existing backlog of sales orders. Our backlog at February 3, 2008 was approximately $148 million. In the event of the cancellation of a significant amount of government contracts included in our backlog, we will be required to rely more heavily on cash reserves and our existing credit facility to fund operations. We are not aware of any events which are reasonably likely to result in any cancellation of our government contracts. As of February 3, 2008, we have approximately $25.2 million available under our bank credit facility, net of outstanding stand-by letters of credit of approximately $14.8 million and cash reserves of approximately $24.8 million. Contractual Financial Obligations, Commitments and Off-Balance Sheet Arrangements Our financial obligations and commitments to make future payments under contracts include purchase orders, debt and lease agreements, and contingent commitments such as stand-by letters of credit. These financial obligations are recorded in accordance with accounting rules applicable to the underlying transaction, with the result that some are recorded as liabilities on the Condensed Consolidated Balance Sheet, while others are required to be disclosed in the Notes to Consolidated Financial Statements and Management's Discussion and Analysis. The Company's contractual financial obligations and other contingent commitments are disclosed in our Annual Report on Form 10-K/A Amendment No. 1 for the fiscal year ended July 29, 2007 under Management's Discussion and Analysis. In addition to the financial obligations contained therein, the following payments (including imputed interest), and a stand-by letter of credit, are required under the terms of the litigation settlement discussed in Note 2; and on March 4, 2008 the Company issued a stand-by letter of credit on behalf of our customer as a repayment guarantee for an advance of approximately $4.0 in connection with an order from their customer (in thousands):
Stand-by Letters of Credit -------------------------- Payments Litigation Other -------- ---------- ----- Within one year $1,500 $1,500 $3,960 2-3 years 2,000 2,000 - ------ ------ ------ Total $3,500 $3,500 $3,960 ====== ====== ======
Upon the adoption of FIN 48, the Company reclassified to long term its liabilities for unrecognized tax benefits in the amount of approximately $3.1 20 million, as discussed in Note 4 to the Condensed Consolidated Financial Statements. The Company is unable to make reasonable estimates as to the period(s) in which cash will be paid for these liabilities. New Accounting Pronouncements For a discussion of new accounting standards, see Note 13 to our Condensed Consolidated Financial Statements - (Unaudited) in Item 1. Item 3: Quantitative and Qualitative Disclosures About Market Risk The Company's exposures to market risk have not changed significantly since July 29, 2007. 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 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 February 3, 2008. (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 February 3, 2008 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: 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 as superseded on January 30, 2007 alleges 27 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); aiding and abetting (18 U.S.C. Section 2); and a notice of forfeiture. The Company moved to dismiss the indictment and that motion was denied on November 5, 2007. A trial is currently scheduled for May 5, 2008. 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. All defendants in the class-action complaints filed motions to dismiss on April 6, 2007. On July 17, 2007, the Court issued an order denying the Company's and Mr. Blatt's motion to dismiss and granted, in part, the other defendants' motion to dismiss. Specifically, the Court dismissed the Section 10(b) claim against the other defendants and denied the motion to dismiss the Section 20(a) claim against them. On July 18, 2007, the Court granted defendant's motion to stay these actions until after the trial of the criminal matter referenced above. On February 8, 2008, the Court issued an Order allowing for certain document discovery to commence. In July and August 2006, the Company and certain of its current and former officers and directors were also served with two separate derivative complaints 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 and were consolidated into one action on March 9, 2006. All defendants in the derivative complaints filed motions to dismiss on February 26, 2007. On July 20, 2007, the Court issued an order denying defendants' motions in part and granting them in part. Specifically, the Court dismissed the claim that the named officers and directors failed to oversee Mr. Blatt and denied the motions with respect to the other alleged claims. The Court also granted defendants' motion to stay the action until after the trial of the criminal matter. On February 8, 2008, the Court issued an Order allowing for certain document discovery to commence. 21 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. Section 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 which is currently scheduled for May 5, 2008. The Company believes it has substantial defenses to the charges alleged in the indictment and intends to vigorously defend against these allegations. The Company believes it is entitled to recovery of certain legal fees associated with the above matters under its D&O insurance policy. Accordingly, as of February 3, 2008, the Company recorded a receivable of $3,565,000 (net of a deductible of $500,000) in anticipation of recoveries. As of February 3, 2008, partial payments of approximately $1,557,000 have been received leaving a receivable balance of $2,008,000. The amount is included in other receivables in the accompanying consolidated balance sheet at February 3, 2008. Subsequent to February 3, 2008, the Company received an additional payment of approximately $440,000. The insurance carrier may contest the claim in whole or in part. In addition, the Company has entered into an agreement dated January 11, 2007 with the insurance carrier whereby if it is determined by final decision of an arbitration panel, or by final judgment of a court, or other final decision of a tribunal having jurisdiction thereof, that any amount paid by the insurance carrier was not a loss, as that term is defined in the policy, the Company shall repay to the insurance carrier any such uncovered sums previously advanced to the Company. The term "Loss" is defined in the policy as follows: "Loss means the amount that any Insured becomes legally obligated to pay on account of any covered Claim, including but not limited to damages (including punitive or exemplary damages, or the multiple portion of any multiplied damage award, if and to the extent such damages are insurable under the law of the jurisdiction most favorable to the insurability of such damages provided such jurisdiction has a substantial relationship to the relevant Insureds, to the Company, or to the Claim giving rise to the damages), judgments, settlements, pre-judgment and post-judgment interest, Defense Costs and, solely with respect to Insuring Clause 2, Settlement fees." Further, the policy defines "Defense Costs" as follows: "Defense Costs means that part of Loss consisting of reasonable costs, charges, fees (including but not limited to attorneys' fees and experts' fees) and expenses (other than regular or overtime wages, salaries, fees or benefits of the directors, officers or employees of the Organization) incurred in defending any Claim and the premium for appeal, attachment or similar bonds." In establishing the receivable for legal recoveries, the Company identified and segregated defense costs related to the defense of the class action lawsuits and the defense of the former Chairman and officer of the Company in the criminal case. The Company believes such costs represent a "loss" under its D&O policy and are recoverable. The Company excluded all defense costs related to the defense of the Company pertaining to the criminal case as such costs may not be recoverable under the D&O policy. On June 27, 2007, the Company was notified by the Office of the General Counsel, Acquisition Integrity Office, Department of Navy (the "Navy"), that certain of its operations had been suspended from receiving new contract awards from the U.S. Government. The affected operations included facilities in Lancaster, Pennsylvania; Woburn, Massachusetts and Chicago, Illinois. The Chicago, Illinois location is a two-person marketing office. On August 15, 2007 the suspension was lifted following an amendment to the Administrative Agreement with the Navy (originally signed on October 12, 2006) extending the term of the agreement for one additional year. While the suspension was in place, these facilities could not be solicited for or awarded new contracts or contract extensions without special exceptions. The suspended facilities were permitted to receive contract awards or subcontracts from the Federal Government if the head of the agency stated in writing the compelling reason to do so. A significant portion of our business is received under contracts where we are the only qualified supplier on critical defense programs. On April 10, 2007, EADS Deutschland GmbH ("EADS"), a German corporation, filed a lawsuit against Herley Industries, Inc., General Microwave Corporation and General Microwave Export Corporation d/b/a Herley Power Amplifier Systems (collectively the "Company") in the United States District Court for the Eastern District of New York. EADS claims that the Company breached a Transfer of Technology Agreement entered into on May 30, 2001 under which the Company was granted the right to use certain technology owned by EADS in performing under an exclusive sales and marketing agreement entered into on May 30, 2001. EADS asserted claims for breach of contract and conversion, claiming that the Company was wrongfully in possession of the intellectual property that was transferred to the Company. EADS also sought a preliminary injunction. The Company denied any wrongdoing and filed counterclaims against EADS. On August 2, 2007, the Company and EADS entered into a settlement of this motion, which was reduced to a written consent decree entered by the Court on August 29, 2007. EADS's claims for breach of contract and for conversion remained pending, as did the Company's counterclaims. Pursuant to the consent decree, the parties agreed to a mediation/settlement conference of all their respective claims with the Court, and further agreed to stay all proceedings pending the outcome of that mediation/settlement conference on October 17, 2007. In November 2007, the Company reached a comprehensive settlement agreement with EADS effective 22 December 5, 2007, as discussed in Note 2 of Notes to Condensed Consolidated Financial Statements. 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 1A - Risk Factors In addition to the other information set forth in this report, you should carefully consider the risk factors disclosed under Part 1 -"Item 1A. Risk Factors" in our Annual Report on Form 10-K/A Amendment No. 1 for the year ended July 29, 2007, which could materially adversely affect our business, financial condition, operating results and cash flows. The risks and uncertainties described in our Form 10-K/A Amendment No. 1 for the year ended July 29, 2007 are not the only ones we face. Risks and uncertainties not currently known to us or that we currently deem immaterial also may materially adversely affect our business, financial condition, operating results or cash flows. Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds: On October 12, 2007, the Company announced that its Board of Directors had approved an expansion of its existing stock buyback program by an additional 1,000,000 shares of its common stock bringing the total up to 2,000,000 shares for purchase in the open market or private transactions, in accordance with applicable SEC rules. During the fourteen weeks ended February 3, 2008 the Company repurchased and retired 408,994 shares of its common stock, pursuant to this program at an aggregate cost of approximately $5,851,588 including transaction costs. As of February 3, 2008, approximately 614,000 shares are available under the Company's buyback program. Purchases of equity securities during the fourteen weeks ended February 3, 2008 were as follows:
Issuer Purchases of Equity Securities -------------------------------------------------------------------------------- (c) Total Number of (d) Maximum Number (a) Total Number (b) Average Shares Purchased of shares that May Yet of Shares Price Paid as Part of Publicly Be Purchased Under Period Purchased per Share Announced Plans the Plans or Program ------ --------- ---------- ------------------- --------------------- October 29, 2007 - December 2, 2007 205,462 $15.04 205,462 817,263 December 3, 2007 - December 30, 2007 119,760 $13.58 119,760 697,503 December 31, 2007 - February 3, 2008 83,772 $13.56 83,772 613,731 -------------------------------------------------------------------------------- Total 408,994 $14.31 408,994 613,731 ================================================================================
Item 3 - Defaults Upon Senior Securities: None Item 4 - Submission of Matters to a Vote of Security Holders: (1) The Registrant held its Annual Meeting of Stockholders on February 26, 2008. (2) Two directors were elected at the Annual Meeting of Stockholders as follows: Class II - To hold office until the 2010 Annual Meeting of Stockholders.
Name Votes For Votes Withheld ---- --------- -------------- Myron Levy 9,132,012 3,700,733 Dr. Edward A. Bogucz 9,197,999 3,634,746
23 (3) An amendment to the by-laws to provide for the submission of a letter of resignation by any director nominee who receives more "withheld" than "for" votes in an uncontested election was approved as follows:
Votes For Votes Against Abstained ---------- ------------- --------- 12,646,546 181,491 4,708
(4) The appointment of Marcum &Kliegmann, LLP as our independent registered public accountants for the year ending August 3, 2008 was approved as follows:
Votes For Votes Against Abstained ---------- ------------- --------- 12,767,423 64,638 683
Item 5 - Other Information: None Item 6 - Exhibits 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. 24 FORM 10-Q 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: March 12, 2008 EX-31 2 hrly10qfeb08-ex31.txt CERTIFICATION EXHIBIT 31 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO RULE 13a-14(a) I, Myron Levy, Chairman of the Board and Chief Executive Officer, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Herley Industries, Inc. ("the registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining "disclosure controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's fiscal quarter ended February 3, 2008 that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 12, 2008 By: /S/ Myron Levy -------------------------- Name: Myron Levy Title: Chairman of the Board and Chief Executive Officer CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO RULE 13a-14(a) I, Kevin J. Purcell, Chief Financial Officer, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Herley Industries, Inc. ("the registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining "disclosure controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's fiscal quarter ended February 3, 2008 that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 12, 2008 By: /S/ Kevin J. Purcell ------------------------ Name: Kevin J. Purcell Title: Chief Financial Officer EX-32 3 hrly10qfeb08-ex32.txt CERTIFICATION EXHIBIT 32 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Herley Industries, Inc. (the "Company") on Form 10-Q for the quarter ended February 3, 2008, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Myron Levy, Chairman of the Board and Chief Executive Officer of the Company, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge: (1) Such Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in such Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 12, 2008 By: /S/ Myron Levy ---------------------------------- Name: Myron Levy Title: Chairman of the Board and Chief Executive Officer CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Herley Industries, Inc. (the "Company") on Form 10-Q for the quarter ended February 3, 2008, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Kevin J. Purcell, Chief Financial Officer of the Company, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge: (1) Such Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in such Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 12, 2008 By: /S/ Kevin J. Purcell ------------------------------- Name: Kevin J. Purcell Title: Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----