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. In addition, effective November 1, 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. 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 or option holders could adversely affect the market price of the Common Stock. Certain 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.
New orders for the first six months of fiscal 1995 were $16,145,000. This compares favorably to the $15,859,000 for new orders experienced during the same period of fiscal 1994.
The Company's backlog, which consists of anticipated revenues from the uncompleted portions of existing contracts (excluding unexercised options) was $19,815,000 at April 28, 1995 versus $25,039,000 at April 29, 1994. This represents a 20.9% decrease over the prior year's backlog. The decrease in backlog is primarily due to the reduced ratio of contract awards to revenues recognized during fiscal 1994, resulting in a lower beginning backlog entering fiscal 1995.
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 68.8% for the second quarter of fiscal 1995 versus 67.9% for the same period of fiscal 1994. Contract costs for the six months ending April 28, 1995 were 64.9% of revenue, versus 66.2% for the first six months of fiscal 1994. Contract costs expressed as a percentage of revenue for the quarter is up primarily due to a targeted higher overhead rate being applied to contracts for fiscal year 1995 as compared to fiscal 1994. For the first six months, this increase in overhead applied to contracts is entirely offset by favorable adjustments to program estimated costs to complete. In addition, the first six months contract costs as a percentage of revenue compares favorably to fiscal 1994 due to the unfavorable adjustments in program estimated costs at complete recorded during the first and second quarters of fiscal 1994.
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. It is the Company's accounting practice to record R&D expenses based on annual targeted indirect rates. (See Notes to Financial Statements; Note 2--Inventory.) Research and development expenses as a percentage of revenues were 12.7% and 13.3% for the second quarter of fiscal years 1995 and 1994, respectively. R&D expenses for the first six months of fiscal years 1995 and 1994 were 12.9% and 13.4% of revenues, respectively. The fiscal 1995 quarter and year-to-date spending on research and development is nominally unchanged when compared to the same periods of fiscal 1994. The Company funded investment in R&D for the most recent six months was 3.5% of revenue versus 3.6% for the same period during fiscal 1994. The Company intends to continue to make substantial investments in research and development in an effort to meet the needs of customers before its competitors, however, there can be no assurances that the Company will be able to develop and market new products successfully in the future.
General and Administrative: General and administrative expenses include administrative salaries, costs related to the Company's marketing and proposal activities and other administrative costs. It is the Company's accounting practice to record general and administrative expenses based on annual targeted indirect rates. (See Notes to Financial Statements; Note 2--Inventory.) General and administrative expenses were $2,015,000 or 15.5% of revenues for the second quarter of 1995 compared to $2,308,000 or 15.4% for the second quarter of 1994. General and administrative expenses were $3,998,000 or 14.9% and $4,516,000 or 15.7% of revenues for the six months ended April 28, 1995 and April 29, 1994, respectively. Consistent with government contracting methodology, the Company considers both general and administrative expenses and research and development expenses part of its general and administrative indirect expense pool. Combined, R&D and general and administrative expenses were 27.8% for the first six months of fiscal 1995 versus 29.1% for the same period of fiscal 1994. General and administrative expenses as a percentage of revenue are down for the first six months of fiscal 1995 when compared to the same period of fiscal 1994 due to higher average fees being recognized during the current period.
Interest Income/(Expense): Net interest income was $59,000 for the quarter ended April 28, 1995, down from $100,000 for the same period of fiscal 1994. Net interest income for the first six months of fiscal 1995 was $193,000 compared to interest income of $184,000 for the same period of fiscal 1994. The drop in interest income received during the quarter is primarily due to the reduction of cash balances resulting from the investment in inventory. (See Notes to Financial Statements; Note 2--Inventory.)
Provision for Income Taxes: The provision for income taxes as a percentage of net income before income taxes was 40.0% for the second quarter of fiscal 1995 as compared to 37.6% for the second quarter of fiscal 1994. The effective tax rate for the six months ended April 28, 1995 and April 29, 1994 was 40.0% and 39.0%, respectively. The increase in the quarter and year-to-date tax rate is primarily the result of the reduction of benefits obtained from research and development tax credits earned in prior years.
The Company has a bank credit agreement to augment cash flow needs and to provide term financing for capital investments. The Company maintains a $6.0 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 bankÕs reference rate plus one-half percent. Outstanding amounts on the unsecured, revolving line of credit and the capital investment line of credit facility were zero at April 28, 1995 and zero at October 31, 1994. Both lines expire March 1, 1996.
Net cash provided from operating activities: Net cash from 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 six months of fiscal 1995, $0.2 million was provided by operating activities versus $4.7 million generated by operating activities during the comparable period of fiscal 1994. During the first six months of fiscal 1995, cash used in the investment in inventories increased $6.0 million in part due to the anticipation of future contract awards for the Company's products and in part, due to timing related targeted indirect rate variances. (See Notes to Financial Statements; Note 2--Inventory.) This is up from the $1.0 million used in the investment of inventory during the first six months of fiscal 1994. During the first six months of fiscal 1995, cash used for the reduction of accounts payable and accrued expenses was $1.4 million. This is up from the $0.2 million used for the same purposes during the comparable period of fiscal 1994. The increase in cash used to reduce accounts payable balances in the current period is attributable to the high revenue recorded during the fourth quarter of fiscal 1994 thereby necessitating payment of accounts payable under normal terms.
Net cash provided from investing activities: Net cash used in investing activities was $0.5 million for the first six months of fiscal 1995 versus $2.3 million used in investing activities during the same period of fiscal 1994. Additions to property, plant and equipment were $2.5 million in the first six months of fiscal 1995 compared to $2.3 million in the first six months of fiscal 1994. Consistent with fiscal 1994, 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 six months of fiscal 1995 was $2.0 million as compared to $1.6 million for the same period of fiscal 1994. For the first six months of fiscal 1994, the $1.6 million of cash provided by investing activities was used to repurchase U.S. Government Treasuries. During the first six months of fiscal 1995, the cash provided by the maturity of investments was used primarily to finance the growth in fixed assets, inventory and to repurchase common stock for the period.
Net cash provided by financing activities: Cash used in financing activities during the first six months of fiscal 1995 was $0.4 million versus $0.1 million provided by financing activities during the first six months of fiscal 1994. The change in cash used in financing activities during the first six months of fiscal 1995 is primarily attributable to the repurchase of the Company's common stock offset by the cash received due to new issuances of common stock. The Company repurchased 223,000 shares of common stock during the first six months of fiscal 1995, versus 60,000 shares repurchased during the same period of fiscal 1994.
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.
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