This report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the factors set forth in "Business Considerations and Certain Factors that may Affect Results from Operations and/or Stock Price."
Applied Signal Technology designs, develops, manufactures and markets advanced digital signal processing equipment to collect and process a wide range of telecommunication signals for both signal reconnaissance and commercial applications. This equipment is purchased by the U.S. Government as well as allied foreign governments 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.
In recent years, accurate and comprehensive information regarding foreign affairs and developments has become increasingly important to the United States government. The reduction of United States military tactical forces overseas, coupled with political instability in certain regions such as the Middle East, Eastern Europe, Africa and South America, has heightened the United States government's need to be able to monitor overseas activities. In order to obtain information about activities within foreign countries, the United States government gathers and analyzes telecommunication signals emanating from those countries.
The Company devotes significant resources toward understanding the United States government's signal reconnaissance goals, capabilities and perceived future needs. The Company obtains information about these signal reconnaissance needs through frequent marketing contact between its employees and technical and contracting officials of the United States government. The Company believes that it has much more marketing contact with customers and potential customers than is customary among its competitors. In addition, the Company invests in Research and Development (R&D) which it anticipates will enable it to develop signal reconnaissance equipment that meets these needs. The Company believes that it invests a greater percentage of its revenues in R&D than is typical among its competitors.
Traditionally, the United States government has addressed its signal reconnaissance needs with custom signal processing solutions which tend to be both expensive and have long delivery times. These factors, combined with budgetary constraints, have caused many agencies to search for more flexible and cost-effective signal reconnaissance solutions that can be deployed promptly. The Company's signal reconnaissance products can be used, with or without further modification, to satisfy requirements of a variety of customers. The Company believes that custom equipment generally cannot be as readily deployed in as wide a variety of circumstances as the Company's products. The Company designs its products to use advanced circuitry and highly integrated components, including Company-designed application specific integrated circuits (ASICs). This enables the Company to offer products that are smaller, consume less power and cost customers less when multiple units are built than equipment of similar functionality that use fewer advanced designs and materials.
Potential commercial applications of the Company's technology and equipment include digital video processing (for example, HDTV or interactive TV), sophisticated processing of cellular radio signals (such as cellular radio fraud detection), and a variety of test equipment for the new technologies in wireless communications. In this new market area, the Company intends to license its technology to a strategic partnering company although the Company may develop and produce the commercial product from time to time.
Purchases by intelligence agencies of the United States government have historically accounted for almost all of the Company's revenues, and most of the Company's business is conducted under contracts that include United States government security requirements. While the Company believes its current customers offer significant additional sales growth opportunities and, accordingly, directs much of its marketing and research and development (R&D) resources toward these customers, in recent years the Company has attempted to broaden its customer base to include new customers in both the military and commercial markets.
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 results of operations and financial condition.
The Company believes its employees are its most valuable resource. While the Company believes that the loss of any one employee would not have a material effect on its results of operations, a significant increase in employee attrition rates could inhibit the Company's ability to execute its business plan and thus result in a shortfall of operating results.
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. The Company has experienced cost overruns in the past that have caused the Company to realize losses on contracts. 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 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 common stock to fluctuate substantially.
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.
In early fiscal 1995, the Company created two new operating divisions: Military Reconnaissance Division and Commercial Telecommunications Division. The intent 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.
The Company has had numerous discussions with companies in the commercial cable TV/video compression and telecommunications marketplaces. The Company invested 10% of its fiscal 1995 research and development funds and plans to invest approximately 20% of its fiscal 1996 research and development funds to 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 common 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/Backlog: New orders for the first quarter of fiscal 1996 were $14,129,000, up 294% from the $3,588,000 reported during the same period of fiscal 1995. Management believes the increase in order levels seen during the first quarter are the result of the Company's continued investment in R&D and marketing over the last few years.
The Company's backlog, which consists of anticipated revenues from the uncompleted portions of existing contracts (excluding unexercised options) was $27,721,000 at February 2, 1996 versus $19,782,000 at January 27, 1995. This represents a 40% increase over the prior year's backlog.
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 68.5% for the first quarter of fiscal 1996 versus 61.2% for the same period of fiscal 1995. The increase in contract costs expressed as a percentage of revenue is due in part to the reduced profit volume contribution resulting from product sales and in part to the unfavorable adjustments in the Company's estimated cost-to-complete recorded on certain production programs during the quarter.
Research and Development (R&D): Company-directed investment in R&D 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 12.1% and 13.1% for the first quarter of fiscal year 1996 and 1995, respectively. While the aggregate quarter-to-quarter investment in R&D increased, the decrease in the current quarter spending on research and development as a percent of revenue reflects the lesser allocation of resources to R&D early in the current year. The Company-funded investment in R&D for the most recent three months was 2.4% of revenue versus 3.0% for the same period during fiscal 1995.
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 $2,840,000 or 18.0% of revenues for the first quarter of fiscal 1996 compared to $1,983,000 or 14.4% for the first quarter of fiscal 1995. The increased general and administrative expenses for the most recent quarter are due, in part, to the lower profit volume recorded during the first quarter of fiscal 1996 (see "Contract Costs" above) and, in part, to the higher targeted general and administrative rate being applied to contracts for fiscal 1996 versus that applied during fiscal 1995.
Interest Income/(Expense), Net: Net interest income was $19,000 for the quarter ended February 2, 1996 compared to $134,000 of interest income for the same period of fiscal 1995. The decrease in net interest income for the 1996 period is due primarily to the Company's reduced net cash generated from operations. This required the Company to increase its average amount outstanding under the bank line of credit which caused interest expense for the first quarter of fiscal 1996 to increase to $17,000 from $5,000 for the same period of fiscal 1995. In addition, since the first quarter of fiscal 1995, the Company sold $4,100,000 of U.S. government securities as a source of working capital, which reduced interest income to $36,000 for the first quarter of fiscal 1996 from $139,000 for the same period of fiscal 1995.
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 1996--unchanged from the first quarter of fiscal 1995.
The Company has a bank credit agreement to augment cash flow needs and to provide term financing for capital investments. The Company maintains a $6,000,000 unsecured, revolving line of credit for short-term cash requirements and a $1,000,000 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 February 2, 1996). The line of credit for use in purchasing capital investments bears interest at the bank's reference rate plus one-half percent (9.25% at February 2, 1996). Outstanding amounts on the unsecured, revolving line of credit were $1,300,000 at February 2, 1996 and zero at October 31, 1995. Outstanding amounts on the line of credit for use in purchasing capital investments were zero at February 2, 1996 and October 31, 1995. Both lines expire March 1, 1997.
Operating activities: Net cash used in operating activities was $164,000 for the three-month period ending February 2, 1996, compared to $2,386,000 used in operating activities for the same period of fiscal 1995. The reduction in cash used in operating activities in the current period is primarily the result of improved accounts receivable collections and reduced investment in inventories, offset by an $870,000 reduction in net income. During the first quarter of fiscal 1996, net income decreased to $150,000 from $1,000,000 for the same period of fiscal 1995. The decrease in net income recorded during the first quarter of fiscal 1996 is due, in part, to lower profit volume contributions generated by the Company's sale of products (which have a tendency to produce higher margins) and, in part, due to unfavorable adjustments in estimated fees on certain production programs. The reduction in investment in inventories recorded during the first quarter of fiscal 1996 is attributable to management's efforts to reduce the investment in inventory ramp-up in anticipation of a high volume of new orders.
Investing activities: Net cash used in investing activities was $1,997,000 during the first quarter of fiscal 1996 compared to $277,000 provided by investing activities for the same period of fiscal 1995. Additions to property, plant and equipment were $1,997,000 for the first quarter of fiscal 1996 compared to $1,223,000 for the same period of fiscal 1995. The increase in capital investment in the first quarter of fiscal 1996 is due to an investment of approximately $1,000,000 for leasehold improvements made to the Company's newly leased building located at its corporate headquarters. The building lease was necessary to accommodate the continued planned growth of the Company's business. (See Item 2: Properties, Form 10-K filed with the Securities and Exchange Commission for fiscal year ended October 31, 1995.) In 1995 period, $1,500,000 of the Company's investments were redeemed at maturity. No such redemption occurred during the fiscal 1996 period.
Financing activities: Net cash provided by financing activities during the first quarter of fiscal 1996 was $1,792,000 compared to $917,000 provided by financing activities for the same period of fiscal 1995. The change in cash provided by financing activities during the first quarter of fiscal 1996 is attributable to the issuance of $493,000 of common stock under the employee stock purchase plan and to an increase of $300,000 in net borrowings under the Company's bank line of credit, and the absence of $615,000 of common stock repurchases authorized under the Company's buyback program during the fiscal 1995 period.
The Company believes that the funds generated from operations, current working capital, and amounts available under existing credit facilities will be sufficient to meet its cash needs for the next 12 months.
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