Applied Signal Technology designs, develops, manufactures and markets advanced digital signal processing equipment to collect and process telecommunication signals for signal reconnaissance and commercial applications. The signal reconnaissance equipment is purchased by military as well as intelligence organizations and is used for foreign signal reconnaissance. The commercial telecommunication processing equipment is used in digital video transmission, cellular radio communication systems, and as equipment for a variety of wireless communication technologies.
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 it believes 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 or products can be manufactured and sold 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.
New orders for the first nine months of fiscal 1995 were $31,072,000, up 23% from the $25,226,000 reported 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 $20,194,000 at July 28, 1995 versus $21,207,000 at July 29, 1994, a 5% decrease over the prior year's backlog. The decrease in backlog is primarily due to the high revenues recorded versus new orders received 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 78.7% for the third quarter of fiscal 1995 versus 62.6% for the same period of fiscal 1994. Contract costs for the nine months ended July 28, 1995 were 69.7% of revenues, versus 65.1% for the first nine months of fiscal 1994. Contract costs expressed as a percentage of revenues for the quarter and nine months ended July 18, 1995 is up in part, due to the previously announced charge to contract costs taken by the Company in the third quarter in connection with the government's investigation regarding the Company's compliance with all statutory contracting requirements and, in part, due to the higher targeted overhead rate being applied to contracts during fiscal 1995. (See Part II, Item 1 Ñ "Legal Proceedings").
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 16.7% and 14.3% for the third quarter of fiscal years 1995 and 1994, respectively. R&D expenses for the first nine months of fiscal years 1995 and 1994 were 14.3% and 13.6% of revenues, respectively. The quarter and year-to-date spending on research and development in fiscal 1995 is up when compared to the same periods of fiscal 1994 primarily due to the higher applied overhead rate experienced during fiscal 1995 and due to a lower average fee as a percentage of revenue being recognized on contracts for the first nine months of fiscal 1995 as compared to the same period of fiscal 1994. The Company-funded investment in R&D for the most recent nine months was 6.1% of revenue versus 4.4% 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 $2,651,000 or 18.5% of revenues for the third quarter of fiscal 1995 compared to $2,204,000 or 16.7% for the third quarter of fiscal 1994. General and administrative expenses were $6,649,000 or 16.2% and $6,720,000 or 16.0% of revenues for the nine months ended July 28, 1995 and July 29, 1994, respectively. General and administrative expenses as a percentage of revenues increased in the third quarter of fiscal 1995 as compared with the comparable period in fiscal 1994, primarily due to the higher targeted general and administrative rate being applied for fiscal 1995 compared to fiscal 1994. General and administrative expenses are nominally unchanged for the first nine months of fiscal 1995 when compared to the same period of fiscal 1994. 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 30.4% for the first nine months of fiscal 1995 versus 29.6% for the same period of fiscal 1994.
Interest Income/(Expense): Net interest expense was $9,000 for the quarter ended July 28, 1995, down from $97,000 of interest income for the same period of fiscal 1994. Interest income for the first nine months of fiscal 1995 was $184,000 compared to interest income of $281,000 for the same period of fiscal 1994. The drop in interest income during the 1995 quarter and year-to-date periods is primarily due to the reduction of cash balances resulting from the investment in inventory. (See"Notes to Financial Statements; Note 2--Inventory")
Income Taxes: The benefit for income taxes as a percentage of net loss before income taxes was 40.0% for the third quarter of fiscal 1995 as compared to a 39.0% provision for the third quarter of fiscal 1994. The effective provisional tax rate for the nine months ended July 28, 1995 and July 29, 1994 was 40.0% and 39.0%, respectively.
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 requirement 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 (8.75% as of July 28, 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 $3,640,000 at July 28, 1995 and zero at October 31, 1994. Outstanding amounts on the line of credit for use in purchasing capital investments were zero at July 28, 1995 and 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 nine months of fiscal 1995, $3.0 million was used by operating activities versus $6.0 million provided by operating activities during the comparable period of fiscal 1994. During the first nine months of fiscal 1995, cash used in the investment in inventories increased $7.1 million in part due to the anticipation of future contract awards for the Company's products and in part due to targeted indirect rate variances. (See "Notes to Financial Statements; Note 2--Inventory") This is up from the $2.8 million used in the investment of inventory during the first nine months of fiscal 1994. During the first nine month of fiscal 1995, cash provided by accounts receivable was $3.8 million. This is down from the $6.9 million provided by accounts receivable during the comparable period of fiscal 1994. The decrease in cash provided by accounts receivable is primarily due to heavy billing activity occurring during the month of July resulting in reduced cash collections through the third quarter of fiscal 1995.
Net cash provided from investing activities: Net cash used in investing activities was $2.0 million for the first nine months of fiscal 1995 versus $4.2 million used in investing activities during the same period of fiscal 1994. Additions to property, plant and equipment were $4.0 million in the first nine months of fiscal 1995 compared to $3.2 million in the first nine months of fiscal 1994. The level of spending in capital investment in the current year continues to be driven by an increase in the number of contracts awarded during the current year compared to the same period last year, and due to the increased investment in research and development. 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. No cash was used for the purchase of investments for the first nine months of fiscal 1995 compared to $3.1 million used for purchasing investments for the same period of fiscal 1994. During the first nine months of fiscal 1995, the $2.0 million of cash provided by the maturity of investments was used primarily to finance the growth in fixed assets, inventory and to repurchase common stock.
Net cash provided by financing activities: Cash provided by financing activities during the first nine months of fiscal 1995 was $3.8 million versus $0.2 million used in financing activities during the first nine months of fiscal 1994. The change in cash from financing activities during the first nine months of fiscal 1995 is primarily attributable to the increase in the bank line of credit borrowings. The cash provided by the bank line of credit was used primarily to finance the growth in fixed assets, inventory and to repurchase common stock.
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 through fiscal 1996.
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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