Description
Filed with the SEC from May 31 to June 6:
LeCroy (LCRY)
Gamco Investors (GBL) has 1,304,310 shares (7.8%) after buying 1,005,200 from May 29 through May 31 at $14.17 to $14.26 per share. On May 29, LeCroy said that it will be acquired by Teledyne Technologies (TDY) for $14.30 a share, a 57% premium to its prior close.
BUSINESS OVERVIEW
Our Company
LeCroy Corporation (the “Company,” “LeCroy,” “us,” “we” or “our”) was founded in 1964 and is incorporated in the State of Delaware. Our principal executive offices and manufacturing facilities are located at 700 Chestnut Ridge Road, Chestnut Ridge, New York 10977 and our telephone number is (845) 425-2000. Our website is located at www.lecroy.com . We sell our products and provide service worldwide through direct sales, including our wholly-owned subsidiaries, manufacturers’ representatives, telesales, distributors, and electronic commerce.
We develop, manufacture, sell and license high-performance oscilloscopes and communication protocol analyzers. Our oscilloscopes are tools used by designers and engineers to measure and analyze complex electronic signals in order to develop high-performance systems, validate electronic designs and improve time to market. We offer seven families of real-time oscilloscopes, which address different solutions: LabMaster 9 Zi-A, our newly introduced highest performance oscilloscope system; WaveMaster, our industry leading high-performance oscilloscope family; WavePro, which is targeted at the mid-to high-performance sector; WaveRunner, designed for the mid-performance sector; WaveSurfer designed for users in the low bandwidth sector of the market; WaveJet, designed for value-oriented users in the low bandwidth sector of the market; and WaveAce, our entry-level oscilloscope products. In addition to our real-time oscilloscopes, we have the WaveExpert family of sampling oscilloscopes and modules. Our protocol analyzers are used by designers and engineers to reliably and accurately monitor communications traffic and diagnose operational problems in a variety of communications devices to ensure that they comply with industry standards.
We generate revenue in a single segment within the Test and Measurement industry, primarily from the sale of our oscilloscopes, protocol analyzers, related test and measurement equipment, probes, accessories, and applications solutions. To a lesser extent, we also generate revenue from the sales of our extended warranty contracts, maintenance contracts and repairs and calibrations on our instruments after their warranties expire. We sell our products into a broad range of industry sectors, including Computer/Semiconductor/Co nsumer Electronics, Data Storage, Automotive/Industrial, Military/Aerospace and Telecommunication. We believe designers in all of these industry sectors are developing products which rely on increasingly complex electronic signals to provide the features and performance their customers require.
Test and Measurement Industry
Test and measurement equipment is used in the design, development, manufacture, deployment and operation of electronic products and systems. This equipment is required to verify functionality and performance of new product designs and to ensure compliance to industry standards and overall product quality. These instruments are used across all electronic equipment industries, including computer, semiconductor, consumer, automotive, defense, and telecommunication. In addition, test and measurement instruments are utilized to install, maintain and monitor wireless and wire-line communications and broadcast networks. This test and measurement equipment aids in the research and development of new products, testing of products in production, and maintenance and service of products in the field.
According to Prime Data, Inc., an independent market research firm tracking the Test and Measurement industry, the market for this equipment was approximately $7.0 billion in 2010. Certain segments of the Test and Measurement industry have historically experienced greater volatility than the overall industry because of their exposure to certain end markets, such as communications, that experienced rapid growth in the late 1990s, followed by rapid declines.
Growth in the Test and Measurement industry is driven by improvements in electronic systems performance, growth in the electronics sector and emerging technologies and standards. Designers in a wide variety of industries are being constantly driven to increase the performance of their products and to add new features and capabilities.
These improvements rely on advanced semiconductor technology and require the design of faster, more powerful and complex electronic systems. As a result, the underlying technological advances in communications and electronic signals are increasing exponentially in complexity and speed. This is driving the demand for analysis tools that allow designers and manufacturers of these devices to improve new-product-development cycle time. With each advance in technology, engineers designing next generation technologies and products must contend with both a reduced margin for error and a progressively more difficult task of fully characterizing new product design.
While the overall Test and Measurement industry is made up of hundreds of different types of instruments and measurement tools, one of the largest single product categories is oscilloscopes. We estimate that oscilloscopes represented approximately $1.0 billion of the overall $7.0 billion industry in 2010 and protocol analyzers, inclusive of versions for telecommunication protocols, represented approximately $700 million. Protocol analyzers address specific communications standards in the wide area network (WAN), local area network (LAN), storage area network (SAN), computer peripheral interconnect market spaces and wireless networks and systems. LeCroy presently focuses on the storage area network memory systems and computer peripheral interconnect space. We believe the potential total available market for the Company’s protocol analyzers lies in the $100 million range of the total protocol analyzer product category.
Oscilloscope Product Category
Oscilloscopes are among several instrument types used by engineers for testing and analyzing electronic signals. Engineers also use logic analyzers, spectrum analyzers, digitizers, bit error rate testers (“BERTs”), and vector network analyzers, among other instruments, to test and analyze these signals. An oscilloscope utilizes a graphical display device that allows an engineer to view an electronic signal. The most basic display of an oscilloscope plots a signal’s voltage versus time (typically in billionths and trillionths of a second), providing a user insight into the performance of an electronic circuit.
Protocol Analyzer Product Category
The demand for digital information has accelerated the need for communication among multiple electronic devices in various markets, including computers, telecommunications, networking, storage, consumer electronics, aerospace, automotive, industrial automation and medical instrumentation. This growing demand centers on the widespread need to transmit digital information. Communication among digital devices, or connectivity, occurs over a variety of physical media, such as copper wire and fiber optic cable, as well as using wireless technology.
Computer technology initially provided connectivity only among internal devices, such as the processor, memory and storage, and with external peripheral devices, such as the keyboard, mouse and printer. Today, computer technology also enables connectivity among multiple computing devices and across networks, such as LAN, WAN, SAN, MAN, home area networks, personal area networks and the Internet. Consumer electronics technology is progressively enabling connectivity among devices, such as Internet appliances, digital cameras, mobile telephones, gaming systems, audio systems and televisions.
Digital devices communicate by sending electronic signals through a transmission channel according to a specified protocol. A protocol is a set of detailed rules that govern and regulate the manner in which the signals are sent, received, and interpreted. The channel and the protocol are both typically specified in a formal communications standard. For communication to be successful, each device must implement and conform to the same standard.
Early communications standards were relatively simple, typically involving low-speed communications between two simple devices connected directly by copper wire. Current standards are increasingly complex, typically involving high-speed communications among multiple sophisticated devices indirectly linked to other devices and across various physical media, including copper wire and fiber optic cables, or wireless technologies with rapidly fluctuating frequencies. As a result, standards that were specified initially in only a few pages of text may now extend to over one thousand pages. The specifications for these standards are broadly available, which facilitates interoperability of hardware and software products from different manufacturers.
A standard is implemented over a lifecycle that includes three overlapping phases: development, production and market deployment. During the development phase, key component manufacturers develop and produce important building blocks such as semiconductors, embedded software, protocol stacks and device drivers which will be used by others in the industry to create products. During the production phase, system and device manufacturers apply these building blocks to construct their unique products and applications. The market deployment phase includes the introduction and sale of products and applications to end users in the market. Similarly, products associated with a particular standard follow their own unique lifecycle from development through production and deployment.
Protocol analyzers are “standard specific” tools; they enable a design engineer to analyze the “conversation” between two devices which employ the specific standard. Many distinct communications standards are emerging to meet the growing demand for digital connectivity in the Computer/Semiconductor/Co nsumer Electronics, Data Storage, Automotive/Industrial, and Military/Aerospace industries. The characteristics of each standard, including its principal uses, physical medium, transmission speed and distance covered, vary greatly. Examples of existing and emerging standards supported by our products in the computer peripheral interconnect and storage space include the following:
• Fibre Channel. Fibre Channel enables reliable, cost-effective information storage and delivery at very high-speeds. Fibre Channel development started in 1988 and the American National Standards Institute (ANSI) standards body approved the first revision in 1994. Fibre Channel is designed to operate at speeds of 1, 2, 4, and 8 Gbps and gives users the option to develop storage networks with configuration choices at different price points, levels of scalability and availability.
• PCI Express. PCI Express was introduced in 2002 and is intended to enhance the Peripheral Connect Interface (PCI) architecture. It is a high-performance, general purpose I/O interconnect bus that is backwards compatible to PCI. It spans the following computer market segments: clients (desktop and mobile), servers (standard and enterprise), embedded computers and communication devices. PCI Express provides system original equipment manufacturers, or OEMs, and peripheral developers the ability to realize product versatility and market differentiation without the burden of maintaining obsolete interfaces or losing compatibility. The PCI Express bus connects each endpoint device directly to a CPU or root complex through a high-speed link. Link sizes can be x1, x2, x4, x8 or x16 lanes. PCI Express 1.0 runs at 2.5 Gbps per lane in each direction, providing a total bandwidth of 8GB/s in a 16-lane configuration. PCI Express 2.0, Generation 2 or Gen 2, runs at 5.0 GB/s per lane in each direction, providing a total bandwidth of 16 GB/s for a 16-lane configuration. The latest generation of PCI Express 3.0, Generation 3 or Gen 3, runs at 8.0 Gbps per lane in each direction providing a total bandwidth of 32 GB/s in a 16-lane configuration. Recent extensions such as virtualization and address translation services keep the protocol current to the evolving needs of the enterprise market.
• Serial ATA. The Serial ATA standard (Serial Advanced Technology Attachment, or SATA) enables high-speed, low-cost internal storage connections for desktops and mobile computers. Serial ATA was introduced in 2000 and has replaced Parallel ATA, the standard used to connect storage devices such as hard drives, DVD and CD drives to the motherboard. Serial ATA operates over copper wire at speeds up to 6 Gbps over distances of up to one meter. Broad based adoption of Serial ATA in the storage market has led to the use of SATA in new applications including server, networked storage and consumer electronics devices.
• Serial Attached SCSI. Initiated in December 2001 by the Small Computer System Interface (SCSI) Trade Association, Serial Attached SCSI (SAS) was designed to be the logical evolution of SCSI to satisfy the data center requirements of scalability, performance, reliability and manageability, while leveraging a common low-cost electrical and physical connection interface from Serial ATA. SAS provides universal interconnect with Serial ATA, while offering logical SCSI compatibility along with the reliability, performance and manageability of parallel SCSI. SAS is positioned primarily for enterprise class storage applications. SAS allows each host to address up to 4,096 devices via expanders. SAS’s flexibility allows single or multiple lane communications with devices, with a 3 Gbps four lane wide connection providing 12 Gbps total throughput. The SAS-2 specification runs at 6.0 Gbps per lane in each direction, providing a total bandwidth of 24 Gbps.
• Universal Serial Bus. The Universal Serial Bus standard (USB) enables low, medium and high-speed connectivity between computers and peripheral devices, including keyboards, mice, printers, scanners, joysticks and cameras, using plug and play technology. In addition, it is becoming widely used as the replacement technology for proprietary cabling on medical and industrial control equipment. USB was introduced in 1995 and replaces the serial, parallel, mouse and keyboard ports. The specifications for the second version of USB, or USB 2.0, were released in April 2000. USB 2.0 enabled connectivity through copper wires at speeds of up to 480 Mbps over distances of up to five meters. USB 3.0 was ratified in November 2008 and introduced a new connectivity speed of 5.0 Gbps over distances of up to five meters.
• DDR SDRAM. Also known as double data rate synchronous dynamic random access memory, DDR SDRAM is the primary memory technology found in computer systems and embedded devices where high bandwidth volatile storage is required. DDR3 was launched in 2007 and its primary advantage is its ability to transfer data at twice the rate of DDR2. DDR3 memory also provides a reduction in power consumption of 30% compared to DDR2 modules due to DDR3’s 1.5 V supply voltage, compared to DDR2’s 1.8 V or the original DDR’s 2.5 V. Lower voltages in DDR3 has increased its appeal in low power systems as well as within today’s modern semiconductor process technologies.
LeCroy is a provider of protocol analyzers for existing and emerging digital communications standards. Our products are used by semiconductor, device, system and software companies at each phase of their products’ lifecycles from development through production and market deployment.
Our Competitive Strengths
We are a leading, worldwide provider of oscilloscopes and protocol analyzers as well as a provider of related test and measurement equipment used by electronic designers and engineers to measure and analyze complex electronic signals and communication protocols. Our key competitive strengths include:
Technology leadership. We are a recognized technology leader in the Test and Measurement industry and continue to leverage our core strengths to develop new and innovative products for the changing requirements of the industry sectors we serve. Most recently, we have focused on incorporating our internally developed operating system and our advanced methodology for enabling high-speed signal acquisition into our entire oscilloscope product line. We are a major participant in the various standards groups found in our portfolio of supported protocols. Our expertise has helped make it possible for protocol technologies to increase in scope of utility and stability. We believe this has allowed us to transform general purpose oscilloscopes into application-specific analysis tools, providing a competitive advantage to our products. These, and our other core technologies, are currently protected by 123 U.S. patents. We also have a significant number of pending U.S. patent applications, as well as foreign patents and applications where we believe seeking such protection will provide us a competitive advantage.
Broad product portfolio. We offer a broad range of oscilloscope and protocol analyzer products which are designed to capture and analyze a wide range of electronic signals and data packets. We have also identified emergent test and measurement needs which were not adequately addressed in the market and developed new instrument classes based on our oscilloscope and protocol analyzer technologies. We believe our breadth of product offerings, coupled with our ability to create application-specific analysis tools, address the specific needs of design engineers and systems integration teams in many industries.
Leading customer relationships. Our major customers are leaders in a range of industries, including Computer/Semiconductor/Co nsumer Electronics, Data Storage, Automotive/Industrial, and Military/Aerospace. Our ability to work with innovative, industry-leading customers allows us to continuously refine our products to better address the needs of the latest technologies.
Global sales and distribution. We have a global sales force and distribution structure covering the Americas, Europe/Middle East and Asia/Pacific. Each of these regions is a major contributor to our revenue. We currently have direct sales personnel in 12 countries and operate in over 50 smaller geographies through regional managers, distributors and manufacturers’ sales representatives. We believe that our sales engineers are recognized by our customers for their technical expertise. Our sales force often works in tandem with design engineers to create solutions to complex applications.
Experienced management team. Our management team has a long and successful track record in the Test and Measurement industry with an average of over 20 years of experience in the industry. Our management team has overseen the introduction of many new products over the recent years and has restructured our operations, enhancing our focus on our core sectors while developing our ongoing business strategy, which encourages product innovation.
Our Strategy
In order to enhance our position as a leading provider of oscilloscopes and protocol analyzers, our objective is to grow our Company and our share in the overall Test and Measurement industry. In addition, we may pursue strategic alliances that have strong adjacent market positions or complement our current product lines.
Our key strategy is to broaden our solutions aimed at high speed data communication and serial data test applications. The sector for testing important serial data standards, including DDR, PCI Express, Fibre Channel, Serial ATA, SAS, and USB, is rapidly growing. The primary tools associated with testing serial data links are oscilloscopes, high speed signal generators, BERTs, logic analyzers, network analyzers and protocol analyzers, among others. Our oscilloscope and protocol analyzer development efforts are aimed primarily at satisfying the needs of customers in these important applications area.
CEO BACKGROUND
Norman R. Robertson
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Mr. Robertson joined our Board as an independent director in May 2004 and is the designated Audit Committee financial expert. Mr. Robertson was the Senior Vice President, Finance and Administration, and Chief Financial Officer of Progress Software Corporation from May 1996—March 2011. The Massachusetts-based company supplies technologies for the development, deployment, integration and management of business applications. He holds a Bachelor of Business Administration from the University of Massachusetts and a Master of Business Administration from Boston University. In March 2011, Mr. Robertson retired from Progress Software. Mr. Robertson currently serves on the Board of Directors of Open Exchange Inc., an early stage provider of meeting software for financial service applications, where he is Chairman of the Audit Committee and a member of the Compensation and Governance Committees.
We believe Mr. Robertson’s qualifications to serve on our Board of Directors stem from his leadership experience at a publicly traded global software company. His experience with strategic acquisitions, capital markets and treasury functions are a valuable resource to the Board in reviewing financial and operating plans. Mr. Robertson also contributes to the oversight of the financial reporting function through his knowledge of current accounting and reporting requirements.
William G. Scheerer
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Mr. Scheerer joined our Board as an independent director in July 1995. After receiving his Masters of Science in Electrical Engineering from Caltech, he contributed to education and technology innovation in the intelligence community during a two year commitment with the United States Army. The majority of his career was with Bell Labs, including leadership of a development organization responsible for over $1 billion of annual product sales and the establishment of a global organization providing innovative technology and business consulting with Bell Labs, AT&T and some external customers. He was President of Performance QUEST LLC, a private consulting company, from January 1997 until December 31, 2003. Mr. Scheerer was Vice President of Kalman Saffran Associates, Inc., a high-technology research and development contract company, from March 1997 to January 2001. He has been a management consultant since January 2004. He has served on various public and private boards and has completed several director education programs at the Sloan School of MIT and the Harvard Business School. Mr. Scheerer has earned the National Association of Corporate Directors’ (“NACD”) Certificate of Director Education and is a 2011 NACD Governance Fellow.
We believe Mr. Scheerer’s qualifications to serve on our Board of Directors include a significant understanding of engineering, technology and manufacturing matters, as well as world-wide business. These attributes continue to facilitate technology development programs.
Allyn C. Woodward, Jr.
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Mr. Woodward joined our Board as an independent director in June 1998 and was elected Chairman of the Board in November 2008. He has worked as an independent consultant since January 2006. He was Vice Chairman of Adams Harkness Financial Group (formerly Adams, Harkness & Hill, Inc.), an institutional research, brokerage and investment-banking firm, from April 2001 to January 2006. Mr. Woodward previously served as President of Adams, Harkness & Hill, Inc. from 1995 to 2001. Mr. Woodward worked for Silicon Valley Bank from April 1990 to April 1995, initially as Executive Vice President and co-founder of the Wellesley, MA office and subsequently as Senior Executive Vice President and Chief Operating Officer of the parent bank in California. Silicon Valley bank is a commercial bank, headquartered in Santa Clara, CA whose principal lending focus is directed toward the technology, healthcare and venture capital industries. Prior to joining Silicon Valley Bank, Mr. Woodward was Senior Vice President and Group Manager of the Technology group at Bank of New England, Boston, MA where he was employed from 1963 to 1990.
Mr. Woodward serves as a Lead Independent Director, Chairman of the Compensation Committee and Chairman of the Nominating and Governance Committee of Hercules Technology Growth Capital, Inc. He also serves as a member of their Audit Committee and Valuation Committee. He is a former Director of Viewlogic and Cayenne Software, Inc. Mr. Woodward serves on the board of directors for three private companies and is on the board of advisors of five venture capital funds. He is an Overseer for Life and Member of the Finance Committee of the Newton-Wellesley Hospital. Additionally, Mr. Woodward is on the Board of Overseers, a member of the Investment Committee, Private Equity Committee and Finance Committees of Babson College in Wellesley, MA, where he earned a degree in finance and accounting. He also graduated from the Stonier Graduate School of Banking at Rutgers University.
Mr. Woodward holds a Masters Professional Director Certification from the American College of Corporate Directors, a public company director education and credentialing organization and is a member of the National Association of Corporate Directors. He is also a member of the Board Leaders, a group comprised of directors of public companies.
We believe Mr. Woodward’s qualifications to serve as Chairman of our Board include his leadership and management skills, experience in the commercial and investment banking industry, predominantly in the technology sector, as well as his understanding of finance and capital markets. As Chairman, Mr. Woodward’s focus has been improving the quality of decision making at the Board level and strengthening the tone of good corporate governance.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
We were founded in 1964 to develop, manufacture and sell high performance signal analysis tools to scientists engaged in high-energy physics research. In 1985 we introduced our first oscilloscope using our core competency of designing signal acquisition and digitizing technology.
We are a leading, worldwide provider of oscilloscopes and protocol analyzers as well as a provider of related test and measurement equipment and currently operate as one business segment in the Test and Measurement industry. Our oscilloscopes are tools used by designers and engineers to measure and analyze complex electronic signals in order to develop high-performance systems, to validate electronic designs and to improve time to market. We currently offer seven families of real-time oscilloscopes, which address different solutions: LabMaster 9 Zi-A, our newly introduced highest performance oscilloscopes family system; WaveMaster, our industry leading high-performance product family; WavePro, which is targeted at the mid- to high-performance sector; WaveRunner, designed for the mid-performance sector; WaveSurfer, designed for users in the low bandwidth sector of the market; WaveJet, designed for value-oriented users in the low bandwidth sector of the market; and WaveAce, our entry-level oscilloscope products. In addition to our real-time oscilloscopes, we have the WaveExpert family of sampling oscilloscopes and modules. Our protocol analyzers are tools used by designers and engineers to generate and monitor traffic over high speed serial data interfaces, including Fibre Channel, PCI Express, Serial ATA, Serial Attached SCSI (SAS), USB, DDR, SDRAM and others.
LeCroy’s product development teams have moved dramatically beyond many critical hardware and software limitations that challenge today’s design engineers by leveraging the advanced silicon-based technologies deployed in our high-end WaveMaster oscilloscopes. In 2011, LeCroy introduced an array of innovative new products, demonstrating continued leadership in the speed, performance and analysis capabilities of oscilloscopes and signal integrity test solutions. The new product lineup includes LabMaster 9 Zi-A, the world’s highest bandwidth, 45 GHz and highest channel count, 20 channels at 20 GHz oscilloscope; WaveMaster 845 Zi-A, the award-winning 45GHz, 120 GS/s oscilloscope; the new WaveRunner 6 Zi oscilloscope platform featuring an exceptional price point for 4 GHz of bandwidth, a pivoting display and the industry’s first 12-bit oscilloscope; SPARQ-4012E, a 12-port, 40GHz signal integrity network analyzer; and Kibra, the industry’s first stand-alone DDR3 protocol analyzer. With the addition of LeCroy’s PeRT, a protocol-aware receiver transmitter tolerance tester, LeCroy is able to deliver comprehensive end-to-end test instrument suites for PCI Express ® 3.0, USB 3.0 and other leading edge serial data standards. We believe that our diversified product mix and continued technology innovation strategically position us to expand our presence in oscilloscopes. For design engineers requiring 45 GHz bandwidth, or multiple channels at the highest bandwidths or 12-bit display resolution, LeCroy currently has the only solutions available. There are also emerging opportunities for protocol analyzers to be deployed for next-generation standards.
We sell our products into a broad range of industry sectors, including Computer/Semiconductor/Co nsumer Electronics, Data Storage, Automotive/Industrial, and Military/Aerospace. We believe that our products offer a strong value proposition in these sectors by providing advanced analysis capabilities coupled with innovative and proprietary technology features. We believe designers in all of these sectors are developing products which rely on increasingly complex electronic signals to provide the features and performance their customers require.
We employ a direct sales model utilizing a highly skilled global sales force primarily focused on the higher end of our business. We have partnered with distributors whose primary focus is on the lower end of our business. Where it is not economically beneficial for us to have a direct presence, we supplement our direct sales force with a combination of manufacturers’ representatives and distributors. We divide the world into three areas — the Americas, Europe/Middle East and Asia/Pacific. In the Americas, we primarily sell our products in the United States. In Europe/Middle East, we directly sell our products in Switzerland, Germany, Italy, France, the United Kingdom and Sweden. In Asia/Pacific, we directly sell our products in South Korea, Singapore, Japan and China.
We generate revenue in a single segment within the Test and Measurement industry, primarily from the sale of our oscilloscopes, protocol analyzers, probes, accessories, and applications solutions. To a lesser extent, we also generate revenue from the sales of our extended warranty, maintenance contracts and repairs and calibrations on our instruments after their warranties expire.
Generally, we transact revenues and pay our operating expenses in the local currencies of the countries in which we have a direct distribution presence or other operations, with limited exceptions, most notably in China where our sales are principally denominated in U.S. dollars. In Europe/Middle East, we transact business in Euros, Swiss francs, British pounds, Swedish krona and U.S. dollars. In Japan, we transact business in Japanese yen. In South Korea, we transact business in Korean won and in Singapore, we transact business in both U.S. dollars and Singapore dollars.
Historically, we have, at times, experienced lower levels of demand during our first fiscal quarter than in other fiscal quarters which, we believe, have been principally due to the lower level of general market activity during the summer months, particularly in Europe.
Cost of revenues represents manufacturing and service costs, which primarily comprise materials, labor and factory overhead. Gross profit represents revenues less cost of revenues. Gross profit earned on our products is impacted primarily by product mix and the effects of foreign currencies, as approximately two-thirds of our revenues are derived overseas, most of which is denominated in local currencies while product manufacturing costs are primarily U.S. dollar denominated.
Selling, general and administrative (“SG&A”) expenses consist primarily of salaries, share-based compensation, and related overhead costs for sales, marketing and administrative personnel as well as legal, accounting and other professional services.
Research and development (“R&D”) expenses consist primarily of salaries, share-based compensation, and related overhead costs associated with employees engaged in research, design and development activities, as well as the cost of masks, wafers and other materials and related test services and equipment used in the development process.
Our Business Risks
Our results of operations and financial position are affected by a variety of factors. We believe the most significant recurring factors are the economic strength of the technology industry sectors into which we sell our products, volatility of currencies in which we transact, our ability to identify market demands and develop competitive products to meet those demands, the announcements and actions of our competitors and our ability to enter into new industry sectors and broaden our presence in existing sectors. Our sales are largely dependent on the health and growth of technology companies whose operations tend to be cyclical. Consequently, demand for our products tends to coincide with the increase or decrease in capital spending in the Computer/Semiconductor/Co nsumer Electronics, Data Storage, Automotive/Industrial, and Military/Aerospace industries.
We face significant competition in our target industry sectors. We believe that in order to continue to compete successfully, we need to anticipate, recognize and respond to changing market demands by providing products that serve our customers’ needs as they arise at acceptable prices. We believe that we compete favorably with our competition in each of these areas. Consequently, we are constantly reviewing our product development strategy and invest time, resources and capital in development projects we deem most likely to succeed.
In response to fluctuations in the technology sectors we target, we continually assess and adopt programs aimed at positioning us for long-term success. These programs may include streamlining operations, discontinuing older and less profitable product lines, changing our future product strategy, and reducing operating expenses when necessary.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial position and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. Generally Accepted Accounting Principles. Our significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the Consolidated Financial Statements and accompanying notes. These estimates and assumptions are based on management’s judgment and available information and, consequently, actual results could differ from these estimates.
The accounting policies that we believe are the most critical in understanding and evaluating our reported financial results include: revenue recognition; reserves on accounts receivable; allowance for excess and obsolete inventory; uncertain tax positions; valuation of deferred tax assets; the effective income tax rate and geographical distribution of taxable income; valuation of long-lived assets and goodwill; estimation of warranty liabilities; share-based compensation expense and separation of Convertible notes between debt and equity.
Revenue Recognition . We enter into agreements to sell products, services, and other arrangements that include combinations of products and services. Revenues from products are included in revenues from Test and measurement products in the Consolidated Statements of Operations, net of any applicable sales or value added taxes. Revenue from product sales, net of allowances for anticipated returns, is recognized provided that persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collection is reasonably assured. Delivery is considered to have occurred when title and risk of loss have transferred to the customer, or when services have been provided. The price is considered fixed or determinable when it is not subject to refund or adjustments.
In fiscal 2010 and 2009, the Company recognized revenue on the sales of its protocol analyzer products, in accordance with specific software revenue recognition guidance, upon shipment, provided there was persuasive evidence of an arrangement, the product had been delivered, the price was fixed or determinable and collection was probable. Software maintenance support revenue was deferred based on its vendor specific objective evidence of fair value (“VSOE”) and recognized ratably over the maintenance support periods. In limited circumstances where VSOE did not exist for software maintenance support, the Company recognized revenue and accrued costs, if applicable, as determined by the facts and circumstances of each transaction.
Under new accounting guidance, which we adopted prospectively on July 4, 2010, our protocol analyzer products are considered hardware, as the tangible products contain software components and non- software components that function together to deliver the products’ essential functionality. These products are excluded from the scope of software revenue recognition guidance and are subject to other relevant revenue recognition guidance, including the recognition criteria described above. Post-contract support (“PCS”) is provided on certain protocol analyzers. When vendor specific objective evidence (“VSOE”) or third party evidence (“TPE”) for deliverables in an arrangement cannot be determined, a best estimate of the selling price (“ESP”) is required to separate the deliverables and allocate arrangement consideration using the relative selling price method. Beginning in fiscal 2011, revenue recognition related to protocol analyzer sales for certain products includes an allocation for PCS, based on management’s estimate of relative selling price, as VSOE is no longer established by the sale of maintenance agreements. Any deferred revenue for PCS prior to adopting the new accounting guidance is recognized based on its initial deferral period. The adoption did not have a material impact on the Company’s consolidated financial position, results of operations or related disclosures.
Revenue from services is deferred and recognized on a straight-line basis over the contractual period or as services are rendered and accepted by the customer. When arrangements include multiple elements, we use the relative selling price method to allocate revenue to the elements and recognize revenue when the criteria for revenue recognition have been met for each element. The amount of revenue recognized is affected by our judgments as to whether an arrangement includes multiple elements and if so, whether objective and reliable evidence of fair value exists for those elements. Changes to the elements in an arrangement and the ability to establish objective and reliable evidence of fair value for those elements could affect the timing of the revenue recognition.
In an effort to provide end-user customers an alternative to purchasing the Company’s higher end products under its standard terms and conditions, the Company offers customers an opportunity to enter into sales-type or direct financing leases for these products. Revenue from sales type leases is recognized at the inception of the lease. Revenues from equipment rentals under operating leases are recognized as earned over the lease term on a straight-line basis. Lease and rental revenues are reported within Test and measurement product revenue.
Reserves on Accounts Receivable . We maintain an allowance for anticipated returns and doubtful accounts relating to the portion of the accounts receivable which we estimate is non-collectible. We analyze historical bad debts, customer concentrations, customer creditworthiness, current economic trends, changes in customer payment patterns, known customer return exposures and the age of outstanding receivables when evaluating the adequacy of the allowance for doubtful accounts. Changes in the overall economic environment or in the financial condition of our customers may require adjustments to the allowance for doubtful accounts which could have a material adverse effect on our consolidated financial position, results of operations and cash flows.
Allowance for Excess and Obsolete Inventory . We assess the valuation of our inventory and provide an allowance for the value of estimated excess and obsolete inventory. Our marketing department plays a key role in our inventory review process by providing updated sales forecasts, managing product rollovers and working with our manufacturing department to maximize recovery of excess inventory. Based upon management’s forecast, inventory items no longer expected to be used in the future are considered obsolete and the difference between an inventory’s quantity and its forecasted usage are classified as excess. If actual market conditions are less favorable than those projected by management, additional inventory allowances for excess or obsolete inventory may be required.
Uncertain Tax Positions . The recognition and measurement of uncertain tax positions that we have taken or expect to take is inherently difficult and requires subjective estimations. We reevaluate the uncertain tax positions each quarter based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues, and new audit activity. Such a change in recognition or measurement could result in the recognition of a tax benefit or an additional charge to the tax provision in the period. Although we believe the measurement of our liabilities for uncertain tax positions is reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals. If additional taxes are assessed as a result of an audit or litigation, it could have a material effect on our income tax provision and net income in the period or periods for which that determination is made.
Valuation of Deferred Tax Assets . We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, benefits and deductions, and in the calculation of certain tax assets and liabilities, including liabilities and assets which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes, as well as interest and penalties related to uncertain tax positions. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period.
The Company is required to recognize a valuation allowance for all or a portion of its deferred tax assets if it believes that it is not more likely than not, given the weight of all available evidence, that all or a portion of its deferred tax assets will be realized. In the assessment for a valuation allowance, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, excess of appreciated asset value over the basis of net assets, the duration of statutory carryforward periods, the Company’s experience with operating loss and tax credit carryforwards not expiring unused, and tax planning alternatives. The Company’s analysis of the need for a valuation allowance recognizes that the Company has incurred a cumulative loss for its domestic operations over the recent years, which was principally due to a non-recurring goodwill impairment charge in fiscal 2009, acquisition and business realignment charges and non-cash amortization of the Convertible notes. The Company believes it will be able to realize all of its domestic deferred tax assets, net of the $1.8 million valuation allowance. Consideration has also been given to the period over which these net deferred tax assets can be realized, and the Company’s history of not having federal tax loss carryforwards expire unused. In addition, the Company has considered tax planning strategies that are both prudent and feasible that will be implemented in a timely manner, if necessary, which will allow the Company to recognize the future tax attributes by increasing taxable income in the United States.
A valuation allowance of approximately $2.6 million and $2.0 million existed as of July 2, 2011 and July 3, 2010, respectively, for certain tax credit carryforwards, and foreign deferred tax assets due to the uncertainty surrounding the utilization of these deferred tax assets. During the years ended July 2, 2011 and July 3, 2010, the valuation allowance increased by approximately $0.6 million and less than $0.1 million, respectively. The increases were mainly due to increases in foreign net operating loss carryforwards and uncertainty surrounding the utilization of such carryforwards. Management believes that it is more likely than not that the Company will realize the benefits of the Company’s net deductible temporary differences, net of the valuation allowance. The factors that management considered in assessing the likelihood of realization of the deferred tax assets included, the forecast of future taxable income, reversal of taxable temporary differences and available tax planning strategies that could be implemented to realize the deferred tax assets. Management will continue to assess the realizability of the deferred tax assets at each interim and annual balance sheet date based on actual and forecasted operating results. Adjustments to the valuation allowance may be made in the future if it is determined that the realizable amount of net operating losses and other deferred tax assets is greater or less than the amount recorded. Such adjustments may be material to the Company’s financial position, and results of operations.
At July 2, 2011, the Company’s net U.S. domestic deferred tax assets amounted to approximately $11.4 million. Management has considered the realizability of the deferred tax assets and has concluded that a domestic valuation allowance of approximately $1.8 million should be recorded, mainly related to certain tax credit carryforwards that are not anticipated to be realized. Although management determined that a valuation allowance was not required with respect to the remaining net U.S. domestic deferred tax assets, realization of these assets is primarily dependent on achieving the forecast of future taxable income, as well as prudent and feasible tax planning strategies. At July 2, 2011, the Company requires approximately $33.6 million in cumulative domestic future operating income to be generated at various times in the future to realize the domestic net deferred tax assets. Based upon projections, the domestic net operating loss carryforwards and federal tax credit carryforwards would be fully utilized before their expiration. (See Note 11 to the Consolidated Financial Statements — Income Taxes for additional information).
Income Tax Rate and Geographical distribution of taxable income. We calculate income tax expense or benefit based upon an annual estimated effective tax rate that includes estimates and assumptions that may change. The differences between the annual estimated effective tax rate and the U.S. federal statutory rate principally result from the Company’s geographical distribution of taxable income and differences between the book and tax treatment of certain items. (See Note 11 to the Consolidated Financial Statements — Income Taxes for additional information).
Valuation of Long-Lived Asset and Goodwill . We assess the recoverability of our long-lived assets whenever events or changes in circumstances indicate that the carrying values may not be recoverable. When such events or changes in circumstances occur, we assess the recoverability of long-lived assets by determining whether the carrying values of such assets will be recovered through undiscounted expected future cash flows. If the undiscounted cash flows are less than the carrying amounts, an impairment loss is recorded to the extent that the carrying amounts exceed the fair value. Factors which could trigger an impairment review include, but are not limited to the following: significant underperformance by us relative to historical or projected operating results; significant changes in the manner of our use of the assets or the strategy for the overall business; and significant negative industry or economic trends.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Our Critical Accounting Policies and Estimates
The preparation of our Consolidated Financial Statements in conformity with U.S. Generally Accepted Accounting Principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the Consolidated Financial Statements and accompanying notes. These estimates and assumptions are based on management’s judgment and available information and, consequently, actual results could differ from these estimates.
The accounting policies that we believe are the most critical to understanding and evaluating our reported financial results include: revenue recognition; reserves on accounts receivable; allowance for excess and obsolete inventory; uncertain tax positions; valuation of deferred tax assets; the effective income tax rate and geographical distribution of taxable income; valuation of long-lived assets; share-based compensation expense; estimation of warranty liabilities and the separation of convertible notes between debt and equity.
Business Realignment Initiative
As a result of changes in the organization, the Company developed a cost-reduction program that consisted of reductions in work force. In the third quarter of fiscal 2012, we recorded severance of approximately $0.4 million, of which approximately $0.2 million was expensed to Cost of revenue, $0.1 million was expensed to Selling, general and administrative and $0.1 million was expensed to Research and development. This resulted from headcount reductions of 8 employees or approximately 1.6% of the workforce compared to July 2, 2011. As of March 31, 2012, approximately $0.2 million has been paid in cash and approximately $0.2 million remains in Accrued expenses and other current liabilities on the Consolidated Balance Sheet. Severance is estimated to be paid by the end of the first quarter of fiscal 2013.
Fiscal Year
Our fiscal years end on the Saturday closest to June 30.
Recent Accounting Pronouncements
In September 2011, the Financial Accounting Standards Board, (the “FASB”), issued amended guidance that simplifies goodwill impairment tests. The guidance states that a qualitative assessment may be performed to determine whether further impairment testing is necessary. The guidance is effective for interim and annual periods beginning after December 15, 2011. The Company believes its adoption will not have a material impact on the Company’s consolidated financial position and results of operations, but may require enhanced disclosures.
In June 2011, the FASB issued guidance to amend the presentation of comprehensive income. It allows an entity the option to present the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This guidance eliminates the option to present the components of other comprehensive income as part of the Statement of Stockholders’ Equity. The amendments in this guidance do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The guidance is effective for fiscal years and interim periods within those years, beginning after December 15, 2011 and should be applied retrospectively. Early adoption is permitted. The Company believes its adoption will not have a material impact on the Company’s consolidated financial position, results of operations or cash flows, as this guidance impacts disclosure requirements only.
For the quarter ended March 31, 2012, world-wide revenues, in dollars, increased due to improved customer demand in the Americas. Sales in Europe and China were soft and unfavorable foreign currency fluctuations negatively impacted revenue by approximately $0.5 million.
Gross profit for the quarter ended March 31, 2012 was approximately $28.7 million, or 58.7% gross margin, compared to approximately $28.4 million, or 61.2% gross margin, for the comparable prior year period. The gross margin percentage for the quarter ended March 31, 2012 was negatively impacted by product mix and the weakness in the value of the Euro. Additionally, there was an approximate $0.2 million charge in the current quarter related to severance. Share-based compensation expense for both of the quarters ended March 31, 2012 and April 2, 2011 was approximately $0.2 million.
Selling, general and administrative (“SG&A”) expense was approximately $16.5 million for the quarter ended March 31, 2012 as compared to approximately $17.5 million for the quarter ended April 2, 2011, representing a decrease of approximately 5.9% or $1.0 million. The decrease was primarily attributable to a decrease of approximately $1.1 million in share-based compensation expense which was approximately $3.7 million in the current period as compared to $4.7 million in the third quarter of fiscal 2011, driven by the decrease in the fair value of the SARs. In addition, the current period includes an expense of approximately $0.1 million for severance charges and approximately $0.1 million of amortization expense for intangibles acquired through the Company’s acquisition of Bogatin Enterprises, L.L.C.
Research and development (“R&D”) expense was approximately $10.3 million for the quarter ended March 31, 2012, compared to approximately $9.4 million for the comparable prior year period, an increase of approximately 9.4% or $0.9 million. The increase in R&D was attributable to incremental charges associated with our new products and expenditures for ongoing initiatives and approximately $0.1 million of severance charges due to organizational changes. Share-based compensation expense was approximately $0.8 million for both quarters ended March 31, 2012 and April 2, 2011.
Other expense, net, which consists primarily of: interest income and expense, foreign exchange gains and losses and amortization of debt discount on convertible notes was approximately $0.2 million for the quarter ended March 31, 2012 compared to approximately $0.9 million for the quarter ended April 2, 2011, a decrease of approximately $0.7 million or 77.5%. The decrease is primarily due to the elimination of the amortization of debt discount on the convertible notes, redeemed on October 17, 2011, which was approximately $0.4 million for the quarter ended April 2, 2011. Interest expense decreased by approximately $0.3 million from approximately $0.5 million for the quarter ended April 2, 2011, to approximately $0.2 million for the comparable current year period due to a decreased borrowing base and lower interest rates.
Comparison of the Three Quarters Ended March 31, 2012 and April 2, 2011
Total revenues were approximately $149.0 million for the three quarters ended March 31, 2012, compared to $130.6 million for the comparable prior year period, representing an increase of approximately $18.4 million, or 14.1%, primarily due to stronger customer demand for all ranges of our oscilloscopes.
Service and other revenues consist primarily of service revenue and maintenance fees. Service and other revenues were approximately $10.3 million for the three quarters ended March 31, 2012, representing an increase of approximately 20.9 % or $1.8 million, compared to $8.5 million for the comparable prior year period. The increase was primarily the result of increased demand for ancillary services and the addition of approximately $0.5 million in training and seminar revenue in the current period.
For the three quarters ended March 31, 2012, revenues were higher in terms of dollars in all geographic regions due to increased customer demand. Additionally, for the three quarters ended March 31, 2012, favorable foreign currency fluctuations positively impacted revenue by approximately $1.6 million.
Gross profit for the three quarters ended March 31, 2012 was approximately $89.0 million, or 59.8% gross margin, compared to $79.5 million, or 60.9% gross margin, for the comparable prior year period. The gross margin percentage for the three quarters ended March 31, 2012 was negatively impacted by product mix, and positively impacted by foreign currency fluctuations. In terms of dollars, gross margin increased due to higher volumes and a decrease in share-based compensation of approximately $0.4 million, slightly offset by approximately $0.2 million of severance charges in the current period.
SG&A expense was approximately $41.7 million for the three quarters ended March 31, 2012 compared to approximately $48.6 million for the three quarters ended April 2, 2011, representing a decrease of approximately $6.8 million or 14.1%. The decrease was mainly attributable to a decrease in stock-based compensation expense of approximately $11.6 million driven by the lower fair value of SARs and the reimbursement of certain legal expenses. The decrease was partially offset by higher selling and marketing expenses incurred as a direct result of the 14.1% increase in sales for the period ended March 31, 2012 compared to the period ended April 2, 2011. In addition, the three quarters ended March 31, 2012 includes approximately $0.8 million of severance charges due to organizational changes and approximately $0.2 million of amortization of intangible assets acquired through the Bogatin acquisition.
R&D expense was approximately $29.2 million for the three quarters ended March 31, 2012, compared to $27.5 million for the comparable prior year period, an increase of approximately 6.4% or $1.8 million. The increase primarily resulted from costs associated with our new products and approximately $0.4 million of severance charges due to organizational changes and was partially off-set by a decrease in share-based compensation expense of approximately $1.5 million for the three quarters ended March 31, 2012 versus April 2, 2011, as a result of the lower fair value of the SARs.
Other expense, net, which consists primarily of: a loss on the extinguishment of our convertible notes, net of issue cost write-off, interest income and expense, foreign exchange gains and losses and amortization of debt discount on convertible notes was approximately $2.0 million for the three quarters ended March 31, 2012 compared to approximately $4.6 million for the three quarters ended April 2, 2011, a decrease of approximately $2.6 million or 56.9%. The decrease is primarily due to a decrease of amortization of debt discount on the convertible notes redeemed on October 17, 2011, which decreased by approximately $1.0 million from approximately $1.5 million for the three quarters ended April 2, 2011 compared to approximately $0.6 million for the comparable current period ended March 31, 2012. Additionally, the decrease is attributable to a decrease of approximately $0.9 million in interest expense from approximately $1.9 million for the three quarters ended April 2, 2011, compared to approximately $1.0 million for the comparable current year period. Other, net decreased by approximately $0.3 million, from approximately $0.6 million for the three quarters ended April 2, 2011 to approximately $0.3 million in the comparable current period predominantly due to decreased foreign currency losses. The three quarters ended March 31, 2012 include a charge of approximately $0.2 million for the write-off of bank deferred financing fees related to our prior credit agreement. The prior period included a loss on the extinguishment of convertible notes, net of issue cost write-off, of approximately $0.5 million.
Income Taxes
We calculate income tax expense based upon an annual effective tax rate forecast, including estimates and assumptions that could change during the year. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, state and local taxes, graduated federal tax rate reductions, research tax credits, domestic production activities deductions and non-deductible expenses. We recognize the tax effects of significant unusual or infrequently occurring items as discrete items in the interim period in which the events occur. We file income tax returns in the U.S., various states and in foreign jurisdictions. These taxing authorities routinely examine our tax returns.
Our effective income tax rates for the quarter and three quarters ended March 31, 2012 were 21.6% and 29.2%, respectively, as compared to effective income tax rates of 15.7% and 57.8%, respectively, for the quarter and three quarters ended April 2, 2011. Our effective income tax rate for the three quarters ended March 31, 2012 includes a tax benefit of approximately $0.1 million related to tax credits and tax benefit of approximately $0.1 million related to the recognition of prior unrecognized tax benefits. Our effective income tax rate for the three quarters ended April 2, 2011 includes the write-off of deferred tax assets related to equity-based compensation of less than $0.1 million, a tax benefit of approximately $0.3 million related to tax credits, and the recognition of prior unrecognized tax benefits of approximately $0.1 million.
Liquidity and Capital Resources
Cash and cash equivalents at March 31, 2012 were approximately $6.1 million compared to approximately $5.5 million at July 2, 2011. As of March 31, 2012, we had $17.3 million in borrowings outstanding under our existing credit facility. We borrowed against our credit line to fund the approximately $29.7 million repurchase of the Notes on October 17, 2011. We have repaid approximately $12.4 million of this amount as of March 31, 2012 through cash from our operating activities.
We believe that our cash and cash equivalents on hand, cash flow expected to be generated by our operations and availability under our revolving credit line will be sufficient to fund our operations, working capital and capital expenditure requirements for the foreseeable future.
Operating Activities
Net cash provided by operating activities was approximately $18.1 million for the three quarters ended March 31, 2012 compared to net cash provided by operating activities of approximately $7.1 million in the same period last year. The fiscal 2012 net cash provided by operating activities was attributable to net income, depreciation and amortization, deferred income taxes, share-based compensation, debt related amortization and write-off of debt issuance costs of approximately $11.4 million, $5.5 million, $2.6 million, $1.4 million, $0.8 million and $0.2 million respectively, and were partially offset by working capital consumption of approximately $3.5 million and $0.2 million gross profit on non-cash sale transaction.
The fiscal 2011 net cash provided by operating activities was attributable to net loss, working capital consumption and deferred income taxes of approximately $0.5 million, $13.0 million and $0.8 million, respectively, more than offset by share-based compensation expense of approximately $14.8 million, depreciation and amortization of approximately $4.1 million, debt related amortization of approximately $1.9 million and loss on extinguishment of convertible notes, net of issue cost write-off, of approximately $0.5 million.
Investing Activities
Net cash used in investing activities was attributable to the purchase of property, plant and equipment of approximately $4.5 million and business acquisition of approximately $0.7 million for the three quarters ended March 31, 2012 compared to approximately $4.1 million used to purchase, property, plant and equipment in the comparable prior year period.
Financing Activities
Net cash used in financing activities was approximately $12.0 million for the three quarters ended March 31, 2012, compared to net cash used in financing activities of approximately $3.4 million in the same period in fiscal 2011. Net cash used in financing activities was primarily due to the redemption of the convertible notes of approximately $29.7 million, repayment of borrowings under the revolving credit facility of approximately $20.0 million, payment of debt issuance costs of approximately $0.4 million and payments on capital leases of approximately $0.2 million. Net cash used in financing activities was partially offset by borrowing under the credit line of approximately $37.3 million and proceeds from employee stock purchase and option plans of approximately $0.9 million.
For the comparable period in fiscal 2011, net cash used in financing activities was primarily due to the repayment of borrowings under our revolving credit line of approximately $20.5 million, repurchase of convertible notes of approximately $10.2 million and payment of debt issuance costs of approximately $0.7 million in connection with the prior credit agreement and subsequent modifications. Net cash used in financing activities was partially offset by proceeds from our stock issuance, net of underwriters’ discount of approximately $22.7 million, borrowings under our credit line of approximately $3.5 million and proceeds from employee stock purchase and option plans of approximately $2.0 million.
Share Repurchase Program
On January 9, 2012, our Board of Directors authorized a share repurchase program of up to five million shares of the Company’s common stock. We are authorized to make repurchases from time-to-time in the open market and in privately negotiated transactions. The program may be discontinued at any time at our discretion. We cancelled our prior general stock repurchase program authorized on May 25, 2006. We have not repurchased any shares in connection with this program.
CONF CALL
David Calusdian
Good morning, everyone, and welcome. In connection with this conference call LeCroy wishes to take advantage of the safe harbour provisions of the Private Securities Litigation Reform Act of 1995 with respect of statements that may be deemed to be forward-looking under the act. All such forward-looking statements are only estimates of future results and there can be no assurance that actual results will not differ materially from these expectations.
Information on all of the potential factors that could affect LeCroy Corporation’s business are described in the company’s reports on file with the Securities Exchange Commission as well as in this morning’s press release. Any forward-looking statements only represent the company’s views as of today, January 28, 2009. While LeCroy may choose to update these forward-looking statements at a later date, the company specifically disclaims any duty to do so.
On the call with me this morning are LeCroy’s president and chief executive officer, Tom Reslewic, and vice president and chief financial officer, Sean O’Connor. I’ll now turn the call over to Tom.
Thomas H. Reslewic
Thank you, David. Good morning, everyone. We’re glad you could join us today.
I’ll start things off with our second quarter highlights and then Sean will take you through the financials. After that I’ll return with some colour on the order trends, the product road map, the new business pipeline, as well as our guidance and outlook. At that point we’ll turn it over for questions.
As you saw in our news release this morning, we wrote off $105.8 million in goodwill this quarter. As with other companies that have made acquisitions in the past few years, external market conditions triggered the impairment of our goodwill on our balance sheet associated with our two protocol acquisitions, CATC and Catalyst. Having to take a charge like this is enormously disappointing to us, as is the downturn in the public equity markets that lead to the write-off in the first place. As a non-cash charge, however, it has no impact on our liquidity and our ability to generate cash going forward. Nor does it affect our banking relationships, how we’re running the business, or our ability to capitalize on growth opportunities and execute on our product road map.
LeCroy actually performed quite well in the second quarter despite seeing signs of softening in the demand environment starting in mid to late November. Now we all know what’s happened to the economy since then. Everything you’ve been reading in the newspapers is consistent with what we’re now seeing in our orders and the implications for Q3 and Q4 fiscal 2009 are not encouraging. Before going back to the outlook let me briefly take you through the second quarter business highlights.
Our oscilloscope business turned in a solid quarter with orders for scope units the highest in the company’s history. In fact, on a local currency basis, second quarter oscilloscope revenues increased 6% compared to a year ago. Late in the first quarter we entered a completely new market segment when we launched our WaveAce series of low cost oscilloscopes. WaveAce is our first scope in the sub-100-MHz space at price points as low as $1,000.
WaveAce did especially well in Europe in the December quarter. We continued to increase our penetration in Europe. We have a strong overall presence in the market and that helps us get new products like the WaveAce out of the gate that much faster.
Although overall European demand was relatively strong in the second quarter orders softened in the US and Asian markets where more customers postponed their spending as the economic outlook deteriorated. Our protocol solutions group rebounded from a soft first quarter in our December quarter as revenues increased greater than 20% from the summer quarter. We’re clearly benefiting from our strong position for PCI Express Gen II and USB 3.0, and in our storage protocols SAS and SATA. In fact, our storage protocol orders were up 35% from the sequential first quarter.
Our order linearity, or the percentage of total orders that we receive in the first nine weeks of a quarter, was 65% in the second quarter compared with our target of 61%. When we have strong linearity like this that can sometimes indicate late quarter softening, which was certainly the case in the December quarter. Linearity figure for the quarter and the early order trends in the subsequent quarter generally paint a pretty accurate picture of overall demand. Orders in early January were off about 20% compared to a year ago, which is consistent with our expectations for the early part of this quarter.
Total sales for the December quarter were $39.1 million compared with $40.6 million in Q2 last year and $40.7 million in the sequential first quarter. Our overall non-GAAP gross margin increased to 59% for the second quarter, mainly due to lower production costs associated with our latest high-end scope products and a higher percentage of protocol business in the quarter.
Our ability to improve gross margins this quarter was particularly encouraging considering the significant unfavourable impact of foreign currency in the quarter of almost $2 million compared to last year. This figure highlights the relatively strong Q2 performance of the sales and the product margins in local currencies.
In mid-November we started to see some lengthening of the sales cycles and saw order delays that foreshadowed the weakening demand environment that we saw in December and are continuing to see today. We responded with aggressive actions to reduce our cost structure and focus our business on key growth opportunities, including a 10% workforce reduction, termination of several projects that we believed would yield limited return on investment, and as a result we exited our optical scope product line in one of our programs and protocol incurring a non-cash inventory charge of $2.7 million. We also cut salaries across the board by 10%, reduced variable compensation, and suspended the company’s 401K match plan. We expect these initiatives, in addition to those implemented at the beginning of the current quarter, to generate cost savings of approximately $8 million annually. In our current quarter we’ll get a significant benefit from these actions, but it will be in the fourth quarter that we’ll see the full benefit.
Our non-GAAP net income for the second quarter was $1.7 million compared with $2.4 million for the second quarter of 2008. This translates into non-GAAP EPS of $0.14 a diluted share for the quarter compared with $0.20 in the same quarter a year ago. With that I’ll turn it over to Sean to review the financials in more detail.
Sean B. O’Connor
Thank you, Tom, and good morning, everyone. In my discussion I’ll occasionally be referring to non-GAAP operating results. We use non-GAAP results as a supplement to our results based on GAAP because we believe this provides additional insight into our underlying results and can enhance the understanding of the company’s ongoing business. The press release we issued this morning contains a reconciliation of the non-GAAP results to their most closely related GAAP results. The non-GAAP adjustments in the second quarter include the following special charges.
First, a non-cash goodwill impairment charge of approximately $105.771 million, which was primarily generated from the CATC and Catalyst protocol analyzer acquisitions. I’d just like to spend a few minutes providing additional background on this item.
It was the volatility in decline in the public equity markets that unfortunately had an adverse effect on our stock price during the most recent quarter. Since our market capitalization value was below our net book value, including goodwill, we were required to reassess our goodwill impairment analysis. So following FAS 142, we performed with the assistance of an outside valuation expert a fair value analysis which included valuing the company’s tangible and then significant intangible assets. However, the company is not allowed to record these much higher values on the books. The result of this analysis established that the estimated fair value was fully applied to identifiable assets, which results in a goodwill impairment charge.
While this large non-cash charge has an impact on our GAAP earnings for the second quarter it is important to note that it does not affect the company’s operations, liquidity, or ability to generate future cash flows. The second special charge we incurred was the recording of a severance restructuring charge of $1.471 million. Third, a non-cash inventory business realignment charge of $2.736 million, plus $16,000 for the purchase accounting fair value adjustment of Catalyst inventory that was sold. And last, a non-cash share-based compensation expense of approximately $158,000.
Turning to the second quarter results, as Tom mentioned, primarily due to currency headwinds revenue for the second quarter decreased 3.6% to $39.1 million from $40.6 million for the year-earlier quarter. Revenues were down approximately 4% from the sequential first quarter.
Our cost of sales in the second quarter was $18.8 million. This includes first the $2.7 million non-cash inventory write down and the $16,000 charge for the incremental purchase accounting adjustment for Catalyst inventory that was sold. Second, $55,000 for restructuring severance charges. And last, $14,000 of share-based compensation expense.
Excluding the non-cash inventory write down and the other charges our non-GAAP gross margin for the second quarter was 59%. This compares with 58.7% non-GAAP gross margin for the same period last year and 56.7% for the sequential first quarter.
Gross margins are up 230 basis points from the first quarter, primarily due to the higher mix of protocol products relative to scope products, as well as the improved cost of goods associated with new scope product introductions.
Total operating expense for the second quarter was approximately $127.4 million. This included $105 million non-cash goodwill impairment charge, $1.4 million in severance restructuring charges of which $849,000 was charged to SG&A and $567,000 was charged to R&D, $144,000 in share-based compensation expense of which approximately $71,000 was charged to SG&A and $73,000 was charged to R&D. Excluding these items non-GAAP R&D expense was $8.2 million or 20.9% of revenues. Due to certain NREs associated with the new WaveMaster 8 series we launched in January, this is slightly higher from an R&D expense of $7.8 million or 19.2% of revenues for Q2 last year.
Excluding the special non-cash cost I just mentioned, non-GAAP SG&A expense in the second quarter was $11.9 million or 30.5% of revenues, which is in line compared with $11.9 million or 29.4% of revenues in the same period last year.
Turning to operating income on a GAAP basis, including the non-cash charges, we generated a second quarter loss of $107.2 million compared to a $2.3 million profit for Q2 last year. excluding the non-cash goodwill impairment and other charges our Q2 2009 non-GAAP operating income was $3 million or 7.7% non-GAAP operating margin. This compares with $4.1 million or 10.1% non-GAAP operating margin in the second quarter of last year.
Other expense was $883,000 for the second quarter. This consisted primarily of net interest expense of $916,000 offset by a $33,000 foreign currency gain. In the corresponding quarter of fiscal 2008 we reported other expense of $1.2 million, primarily net interest expense and foreign currency loss.
Our effective tax rate on a GAAP basis for the second quarter was approximately 1.1% compared with 10.3% for the same period last year. excluding the impact of the primarily non-deductable goodwill impairment and share-based compensation expense and other special charges, the full year normalized tax rate was approximately 30% compared to 31.5% in the year-ago period. In addition, the company benefitted this quarter from [inaudible] associated with the filing of our tax return, as well as the impact of the retroactive reinstatement of the R&D credit.
For the second quarter of 2009 we recorded a GAAP net loss of $106.8 million or $8.93 per share. This includes the after-tax effects of the goodwill and other non-cash 123R charges previously noted. Excluding those charges our non-GAAP net income was $1.7 million or $0.14 per diluted share. This compares with non-GAAP net income of $2.4 million or $0.20 per share in the same period last year.
The number of shares outstanding used to compute the second quarter GAAP EPS was 11.962 million shares. This compares with 12.1 million diluted shares outstanding in the same period last year, which is approximately the same amount of shares we used for our current non-GAAP earnings per share.
Now turning to the balance sheet. Our cash position was approximately $9.2 million at the end of the quarter. During the quarter we repurchased approximately 65,000 shares of company stock paying approximately $393,000 or an average price of $6.04.
Our Q2 net accounts receivable balance decreased to $32 million compared with a prior year-end balance of $33.3 million.
Inventory decreased by approximately $400,000 during the quarter to $35 million. This is primarily due to the write down of inventory previously described offset by the demo inventory built for the new WaveMaster 8 product launch.
In Q2 we used cash from operations of approximately $770,000 due primarily to the increased inventory requirements associated with the WaveMaster introduction.
Capital expenditures for the second quarter was approximately $870,000 and depreciation and amortization was $1.6 million.
Today the company currently employees 419 employees, down from 462 employees last quarter. About 65% are in the United States, 21% in Europe, and 14% in Asia-Pacific. Our annualized revenue per employee was $345,000 in the second quarter of fiscal 2009, down slightly from $353,000 last quarter.
So to wrap up, as Tom mentioned, although we’re generally pleased with our second quarter operating results we believe there will be challenges in 2009. However, our reduced cost structure positions us well to manage this economic cycle. We have a strong team, clear vision, and confidence that the company’s recently launched product portfolio, as well as upcoming exciting new product introductions, will enable us to come out of this economic down cycle in even stronger company and better position for future growth.
I’ll now turn the call back to Tom.
Thomas H. Reslewic
Okay. Thank you, Sean. I’ll pick up here with a little bit more colour on the business starting with the oscilloscope products. We’re certainly in the midst of a recession and some complicated balance sheet moves, but it’s also true that we’re in the midst of the most ambitious product roll-out campaign in LeCroy’s history. Q2 was a very strong quarter for scopes. Despite the slowdown in the economy in November and December, oscilloscope unit sales were up more than 20% compared to last year. It was a record quarter for oscilloscope units at LeCroy.
As I mentioned, orders for the new WaveAce in Europe drove a lot of this growth in units. We entered the low-cost space with some uncertainty about future developments in this market, but we are very pleased with our results to date.
We’re developing a strong third-party distribution channel primarily to sell our low-end product lines starting with the WaveSurfer and the WaveJet. Adding the WaveAce has given our distributors a sub-$1000 product to sell for the first time and this has greatly improved their effectiveness in the market.
In addition, by opening up a presence for LeCroy in the low-cost market, WaveAce enables us to put a great new product in the hands of engineers, students, and others involved at levels of the design process where brand familiarity and loyalty are typically created, not just in Europe but in the rest of the markets around the world.
So if you look at the scope market overall, the segment that’s been affected the most by the economic slowdown is the mid range of the market, our WaveRunners and WavePros. Our WavePro 7 series launched in Q1 with great customer feedback, very strong initial sales pipeline, a lot of orders and so forth. While the sales funnel remains very high, orders are coming out of the pipeline rather slowly. Contributing to this effect is a sharp slowdown in orders from data storage customers.
The very high-end products, on the other hand, seem to be somewhat less affected. If you’re running an R&D project that absolutely depends on the performance of a high-end tool you have a better chance of getting your purchases approved for budget and for spending. We launched our latest high-end scope, the WaveMaster 8 Zi in the beginning of the current third quarter. We’re having a very enthusiastic response from customers. The sales funnel is developing nicely. We’re actually seeing more early orders than we might have expected due to the high ticket price. At the other end of the spectrum, products like the WaveAce and WaveSurfer seem to sit below certain sign-off thresholds, so those orders are also moving through the sales pipeline. It really seems to be the mid-range product line where the slowness has impacted us the most.
As I mentioned earlier, this mid-range is also hurting due to segment issues. The erosion in the disc drive market in particular. When the disc drive industry sneezes our mid-range scopes, like the Runner and the Probe, get sick. What looked like mid-range sniffles in the second quarter is developing into a full-blown cold here in the third quarter.
In terms of our market segments, data storage isn’t the only one facing major headwinds. The computer, semi-conductor, and consumer electronics segment remain the largest component of our business at 32% of total in the second quarter, but many companies in this space have made the front page recently announcing conservative outlooks and spending cutbacks.
Our next largest segment is the automotive electronics industry which, despite being part of a generally weak industry, increased to 23% of our total business in the second quarter.
Data storage, which is in deep recession, represented only about 11% of our total business in Q2, which is the lowest level in many, many quarters for a disc drive at LeCroy.
Looking at the business geographically, the strong performance of our European scope business was born out in the numbers again this quarter as sales in Europe were up more than 9% year over year. We believe that LeCroy is continuing to gain share in that region. North America was down substantially in the second quarter as sales declined about 15% from the second quarter last year. In the Asia-Pacific region overall business was roughly flat year on year with Japan actually posting about 15% growth while the rest of Asia declined by about the same amount.
Turning to our protocol business, as I mentioned before, the top line of PSG was up about 20% from the sequential first quarter. But sales were still down by about 10% compared to a year ago. In fact, the sequential quarter comparison was fairly easy because Q1 was unusually slow. A number of customers delayed orders waiting for the new storage and USB 3.0 solutions, and in addition demand for PCI Express in the summer quarter was relatively soft.
As we expected, orders for our Voyager USB 3.0 solution were a significant uptick in Q2. Voyager’s been very well received because it allows customers to buy USB 2.0 capability today with a migration path to 3.0, which offers significantly higher speeds.
The PSG unit remains very profitable and we feel good about where we’ve positioned the business. We’re number one in market share in every segment we serve. Our growth trajectory in protocol will depend on three factors. First, the underlying evolution of the standards and their adoption rates in areas like PCI Express, storage, and super speed USB 3.0. The second driver, of course, is the economy, in particular its impact on the computer and storage markets. We don’t have any special insight into where the economy’s going, but what we can do and are doing is preparing ourselves with new solutions that can drive growth when demand recovers. The final growth factor for the protocol business is our ability to deploy our protocol technology into new product areas. We’ve started a number of organic developments in this area and we expect to launch a series of new products in the next several months. The good thing about protocol is that the product development cycles are much shorter than in the scope business and our road map is very well aligned with where we believe the industry will be in terms of standards, adoption, and deployment when the market’s ready.
Now let’s turn to our outlook and financial guidance. As I mentioned before, we believe that LeCroy is well positioned to weather this recession and its impact on the test-to-measurement market. We have significantly trimmed our fixed costs and expect to maintain positive operating margins in the low single digits during the down turn.
We also expect to reliably generate cash as we reduce our inventory in the next few quarters. Inventory has increased due to the significant roll out of new products and our initial plans for much higher production rates during the current quarter.
The products we’ve recently launched are generating strong interest and will gain market share for LeCroy. We’ve enhanced and focused our R&D capabilities, and on the heels of our latest WaveMaster 8 Zi series of scopes we expect to continue launching new products based on this Apollo chip set throughout calendar 2009. The market reaction thus far to our new WaveMaster 8 Zi has been excellent and our initial order indications are also excellent. Our sales force will continue to aggressively call in our customers and we’ll be prepared with high performance products when the economy improves and our customers are ready to increase their investments and test equipment.
Now, due to the unusually volatile markets and uncertain economy, we do not have strong visibility beyond the current third fiscal quarter. As a result, we’re rescinding our full-year 2009 guidance and until further notice we will provide guidance solely on a quarter basis.
While we did not experience a dramatic slowdown in the December quarter, we are concerned about the strength of the demand environment for the first half of the calendar 2009. We’ve modelled our business to anticipate year over year revenue declines in the range of 10% to 20% from our $40 million quarter baseline. I should point out that modelling means just that; we’ve prepared ourselves for this range of outcomes and we know that we can manage under a wide variety of circumstances like these ones I’ve described. We’re still not comfortable predicting where the demand market will settle out.
These cost reductions we’ve taken would enable us to be profitable even in the event of a decrease in revenue of more than 20% from our baseline of $40 million should market conditions deteriorate to those levels. That said, we currently expect to report revenues for the third quarter of fiscal 2009 in the range of $32 million to $36 million with non-GAAP operating margins in the range of 3% to 5%.
With that we’ll stop and take your questions.
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