The Company's revenues are generated almost entirely from sales of its products and services to agencies of the United States government. The sales are either pursuant to fixed price contracts, which provide that the Company perform a contract for a fixed price and assume any cost overruns, or cost reimbursement contracts, which provide that the Company receive the direct and indirect costs of performance plus a negotiated profit.
The Company accounts for fixed price contracts using the percentage-of-completion method of accounting. Under this method, all contract costs are charged to operations as incurred; and a portion of the contract revenues, based on the estimated profits and the degree of completion of the contract as measured by a comparison of the actual and estimated costs, is recognized as revenues each quarter. The Company accounts for cost plus reimbursement contracts by charging contract costs to operations as incurred and recognizing contract revenues and profits by applying an estimated fee rate to actual costs. Management reviews contract performance, costs incurred and estimated completion costs regularly and adjusts revenues and profits on contracts in the month in which changes become determinable.
The Company has experienced significant fluctuations in operating results from quarter to quarter and expects that it will continue to experience such fluctuations in the future. These fluctuations are caused by factors inherent in government contracting and the Company's business such as the timing of cost and expense recognition for contracts and the United States government contracting and budget cycles. Fluctuations in quarterly results may cause the price of the Company's stock to fluctuate substantially.
Over the last three years, the Company has experienced a slower revenue growth rate than has been experienced in the Company's history. Management attributes this reduced growth rate to continued uncertainties within the United States defense and intelligence agencies regarding the priority set by the Clinton administration for intelligence activities. For Applied Signal Technology, this uncertainty has manifested itself in delayed new contract awards and the award of, on average, smaller development programs. Management has implemented a change in business strategy as a result of this new business climate. The Company continues to more aggressively deploy its assets in areas where long-term growth prospects reside. Effective 1 November 1994, the Company announced a reorganization which created two new operating divisions: Military Reconnaissance Division and Commercial Telecommunications Division. The intent of the reorganization was to increase the focus and accountability in these areas and mature these business segments. Although management believes that there are significant opportunities to employ the Company's technology in the areas of defense as well as the commercial marketplace there can be no assurance that the Company will be successful in pursuing these opportunities.
Almost all of the Company's contracts contain termination clauses which permit contract termination upon the Company's default or for the convenience of the other contracting party. In either case, termination could adversely affect the Company's operating results. Although the Company has not experienced any material cancellations to date, there can be no assurances that such cancellations will not occur in the future.
A significant portion of the Company's revenues are derived from fixed price contracts. Under fixed price contracts, unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in materials costs, inefficiencies or other factors, are borne by the Company. There can be no assurance that the Company will not experience cost overruns in the future or that such overruns will not have a material adverse effect on the Company's operating results.
The market for the Company's products is characterized by rapidly changing technology. The Company believes that it has been successful to date in identifying United States government signal reconnaissance needs early, investing in research and development to meet these needs and delivering products before the Company's competitors. The Company believes that its future success will depend upon continuing to develop and introduce, in a timely manner, products capable of collecting or processing new types of telecommunications signals. There can be no assurance that the Company will be able to develop and market new products successfully in the future or respond effectively to technological changes or that new products introduced by others will not render the Company's products or technologies noncompetitive or obsolete.
The signal reconnaissance equipment market is highly competitive and the Company expects that competition will increase in the future. Some of the Company's current and potential competitors have significantly greater technical, manufacturing, financial and marketing resources than the Company. Substantial competition could have a material adverse effect on the Company's future results of operations.
The Company has had numerous discussions with companies in the commercial cable TV/video compression and telecommunications marketplaces and plans to invest approximately 10% of its fiscal 1995 research and development funds exploring opportunities in these areas. The Company's primary business strategy in this area is to capitalize on its experience as a technology company and to explore areas where current or newly developed technology can be licensed into the commercial marketplace. The Company would expect to receive a royalty stream in return for its investment in research and development. There can be no assurance that this strategy will be successful.
There can be no assurance that an active trading market will be sustained for the Company's stock. Further, the market price of the Common Stock could be subject to significant fluctuations in response to quarter-to-quarter variations in operating results, United States government spending patterns and other factors. In addition, the stock market in recent years has experienced extreme price and volume fluctuations that have particularly affected the market prices of many technology companies and that have been unrelated or disproportionate to the operating performance of such companies. These fluctuations, as well as general economic and market conditions, may adversely affect the future market price of the Company's Common Stock.
Sales of shares of Common Stock in the public market by existing shareholders, warrant holders or option holders could adversely affect the market price of the Common Stock. Certain warrants and options become exercisable and eligible for sale on the market in future periods and may affect the stock price.
Due to the factors noted above, the Company's future earnings and stock price may be subject to volatility, particularly on a quarterly basis. Any shortfall in revenue or earnings from levels expected by securities analysts could have an immediate and significant adverse effect on the trading price of the Company's common stock in any given period. Additionally, the Company may not learn of such shortfalls until late in the fiscal quarter, which could result in an even more immediate and adverse effect on the trading price of the Company's common stock. Finally, the Company participates in a dynamic industry, which could result in significant volatility of the Company's common stock price.
The Company's backlog, which consists of anticipated revenues from the uncompleted portions of existing contracts (excluding unexercised options) was $19,782,000 at January 27, 1995 versus $30,473,000 at January 28, 1994. This represents a 35% decrease over the prior year's backlog. This reduction in backlog is due in part to a slowdown in new contract awards experienced during the first quarter of fiscal 1995 versus the same period for fiscal 1994 and, in part, due to the high run-rate experienced during the fourth quarter of fiscal 1994. Management has responded to this reduction in backlog with a series of steps, the most important of which is designed to minimize the effects of backlog on its future operations. Management has authorized the build-up of inventory to more aggressively support the government's "commercial-off-the-shelf" procurement strategy which is more in line with a typical commercial company's operating philosophy and which may expose the Company to greater risks of inventory obsolescence than experienced in the past. The inventory buildup, coupled with aggressive marketing and research and development, is anticipated to minimize the effects of backlog on the Company's future operations.
Contract Costs: Contract costs consist of direct costs on contracts, including materials and labor, and manufacturing overhead costs. Contract costs as a percentage of revenue were 61.2% for the first quarter of fiscal 1995 versus 64.3% for the same period of fiscal 1994. The decrease in contract costs expressed as a percentage of revenue is primarily due to the favorable changes in the Company's estimated cost-to-complete recorded on several programs during the quarter.
Research and Development (R&D): Company-directed investment in research and development consists of expenditures recoverable from customers through the Company's billing rates and expenditures funded by the Company from earnings. Research and development expenses as a percentage of revenues were 13.0% and 13.5% for the first quarter of fiscal years 1995 and 1994, respectively. The nominal decrease in the current quarter spending on research and development is primarily the result of timing related standard cost variances which are expected to be closed out by the end of the fiscal year (see Note 2--Notes to Financial Statements). The Company-funded investment in R&D for the most recent three months was 3.0% of revenue versus 3.1% for the same period during fiscal 1994.
General and Administrative: General and administrative expenses include administrative salaries, costs related to the Company's marketing and proposal activities and other administrative costs. General and administrative expenses were $1,983,000 or 14.4% of revenues for the first quarter of fiscal 1995 compared to $2,208,000 or 16.0% for the first quarter of fiscal 1994. The decreased general and administrative expenses expressed as a percentage of revenue for the quarter is due, in part, to the anticipated lower general and administrative rate expected for fiscal 1995 versus fiscal 1994, and, in part, due to the proportionally higher revenue recorded during the first quarter of fiscal 1995.
Interest Income/(Expense): Interest income was $134,000 for the quarter ended January 27, 1995 compared to $83,000 of interest income for the same period of fiscal 1994. The increase in interest income for the period is primarily due to the Company receiving a higher yield-to-maturity as a result of its longer average maturity on its United States government treasury portfolio.
Provision for Income Taxes: The provision for income taxes as a percentage of net income before income taxes was 40.0% for the first quarter of fiscal 1995 -- virtually unchanged from the first quarter of fiscal 1994.
The Company has a bank credit agreement to augment cash flow needs and to provide term financing for capital investments. The Company maintains a $4.0 million unsecured, revolving line of credit for short-term cash requirements and a $1.0 million line of credit for use in purchasing capital investments. The unsecured, revolving line of credit bears interest at the bank's reference rate (9.0% as of January 27, 1995). The line of credit for use in purchasing capital investments bears interest at the bank's reference rate plus one-half percent. Outstanding amounts on the unsecured, revolving line of credit were $999,000 at January 27, 1995 and zero at October 31, 1994. Outstanding amounts on the line of credit for use in purchasing capital investments were zero at January 27, 1995 and zero at October 31, 1994. Both lines expired March 1, 1995. The Company has renewed both lines in March, 1995.
Net cash provided by/(used in) operating activities: Net cash provided by operating activities has varied significantly from quarter to quarter. These quarter-to-quarter variances are primarily the result of changes in the rate of investment in accounts receivable and the change in inventories held by the Company. During the first quarter of fiscal 1995, $2.4 million was used in operating activities versus $0.4 million generated by operating activities during the first quarter of fiscal 1994. During the first quarter of fiscal 1995, cash used in the investment in inventories increased $3.0 million in anticipation of future contract awards for the Company's products and for the deferral of indirect rate variances. This is up from the $0.4 million used in the investment of inventory during the first quarter of fiscal 1994. During the first quarter of fiscal 1995, cash used for the reduction of accounts payable and accrued expenses was $1.9 million. This is up from the $1.2 million used for the same purposes during the first quarter of fiscal 1994. The increase in cash used to reduce accounts payable balances in the most current quarter is attributable to the high revenue recorded during the fourth quarter of fiscal 1994. Net cash provided by/(used in) investing activities: Net cash provided by investing activities was $0.3 million for the first quarter of fiscal 1995 versus $1.0 million used in investing activities during the same period of fiscal 1994. Additions to property, plant, and equipment were $1.2 million in the first quarter of fiscal 1995 compared to $1.0 million in the first quarter of fiscal 1994. The increase in capital investment in the current quarter continues to be driven by an increase in the number of contract actions awarded during the current fiscal quarter compared to the same period last year. The Company continues to experience a change in the average contract size and the volume of procurements which is necessitating increased spending primarily in the areas of computer and test equipment to support the increased contract activity. Cash provided by the maturity of investments for the first quarter of fiscal 1995 was $1.5 million as compared to zero for the same period of fiscal 1994. This cash provided by financing activities was used primarily to finance the growth in fixed assets and inventory for the period.
Net cash provided by financing activities: Cash provided in financing activities during the first quarter of fiscal 1995 was $0.9 million versus $0.4 million provided by financing activities during the first quarter of fiscal 1994. The change in cash provided by financing activities during the first quarter of fiscal 1995 is primarily attributable to the increase in the bank line of credit used to finance inventories and fixed assets. The Company also issued of $0.5 million of common stock under the employee stock purchase plan which was offset by $0.6 million of common stock repurchases authorized under the Company's buyback program. The $0.4 million increase in cash provided by financing activities during the first quarter of fiscal 1994 is primarily the result of the issuance of 87,759 shares of common stock under the Company's employee stock purchase plan. The Company believes that the funds generated from operations, existing working capital, and amounts available under existing lines of credit will be sufficient to meet its cash needs into fiscal 1996.