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RESULTS OF OPERATIONS
The following table sets forth certain unaudited financial data for the periods indicated as a percentage of net sales.
Thirteen Weeks Ended Twenty-Six Weeks Ended
----------------------- -----------------------
June 28, July 4, June 28, July 4,
1998 1999 1998 1999
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 62.0 60.3 61.5 61.1
------- ------- ------- -------
Gross profit 38.0 39.7 38.5 38.9
Research and development costs 9.6 9.9 11.3 10.7
Selling, general and administrative costs 24.3 24.2 24.4 23.8
Amortization of intangibles 1.4 1.4 1.6 1.4
Restructuring and reorganization costs 0.0 0.3 0.0 0.1
------- ------- ------- -------
Operating income 2.7 4.0 1.2 2.9
Other income (expense), net (1.2) (0.4) (0.9) 0.2
------- ------- ------- -------
Income before taxes 1.5 3.6 0.3 3.1
Tax expense 0.5 1.5 0.1 1.2
------- ------- ------- -------
Net income 1.0% 2.1% 0.2% 1.8%
======= ======= ======= =======
Net sales. Net sales for the thirteen weeks ended July 4, 1999 increased $0.8
million (2%) and for the twenty-six weeks ended July 4, 1999 increased $10.3
million (13%) compared to the corresponding periods in 1998. Microelectronics
segment product sales increased $5.5 million (50%) for the thirteen weeks and
$11.2 million (46%) for the twenty-six weeks compared to the same periods in
1998. Electron Optics segment product sales decreased $3.4 million (15%) for the
thirteen weeks and increased $0.9 million (3%) for the twenty-six weeks ended
July 4, 1999. Product sales in the Components segment decreased $2.1 million
(47%) for the thirteen weeks and $3.5 million (43%) for the twenty-six weeks
ended July 4, 1999 compared to the same periods in 1998. Service sales increased
by $0.7 million (10%) in the thirteen weeks and $1.7 million (12%) in the
twenty-six weeks ended July 4, 1999 compared with the same periods of 1998.
Industry conditions in both the semiconductor-manufacturing sector and the data
storage sector were generally weak during 1998 but showed improvement in the
first half of 1999. These industry sectors represent the principal markets for
the Company's Components and Microelectronics segments. Electron Optics segment
sales have benefited from the Company's new product introductions in the second
half of 1998 but have been slowed by softness in the material and life sciences
market sectors. The Company believes that Components segment sales have been
weak in 1999 following record 1998 levels due to customers' utilization of on
hand inventories.
Year to date sales increased from 1998 to 1999 in each of the three major geographic regions the Company sells to, with the largest increase occurring in the Asia Pacific Region. Sales in Europe represented 31% of sales for both the twenty-six weeks ended July 4, 1999 and June 28, 1998. Sales in the Asia Pacific Region represented 21% of sales for the twenty-six weeks ended July 4, 1999 compared with 17% of sales for the same period in 1998. Sales in North America represented 45% of sales for the twenty-six weeks ended July 4, 1999 compared with 48% of sales for the same period in 1998. Sales in other geographic regions represented 3% of sales for both the twenty-six weeks ended July 4, 1999 and June 28, 1998.
The Company conducts its business in multiple currencies. In general, the US Dollar was weaker in relation to these other currencies in the first quarter of 1999 compared with the first quarter of 1998, and was stronger in the second quarter of 1999 compared to the same period in 1998. Accordingly, the translation of sales denominated in foreign currencies resulted in slightly higher reported sales in US Dollars in the first quarter of 1999 and slightly lower reported sales in US Dollars in the second quarter of 1999 as compared with 1998.
Gross profit. Gross profit for the thirteen weeks ended July 4, 1999 increased $1.1 million (6%) and for the twenty-six weeks ended July 4, 1999 increased $4.3 million (14%) compared to the same periods in 1998. Gross profit as a percentage of sales was 38.0% and 39.7% for the thirteen weeks ended June 28, 1998 and July 4, 1999 and 38.5% and 38.9% for the twenty-six weeks ended June 28, 1998 and July 4, 1999. The improvement in gross margin as a percentage of sales in the second quarter of 1999 as compared with the second quarter of 1998 is primarily due to changes in product mix.
Research and development costs. Research and development costs for the thirteen weeks ended July 4, 1999 increased $0.2 million (5%) and for the twenty-six weeks ended July 4, 1999 increased $0.6 million (7%) compared to the same periods in 1998. As a percentage of sales, research and development costs were 9.9% and 9.6% for the thirteen weeks and 10.7% and 11.3% for the twenty-six weeks ended July 4, 1999 and June 28, 1998, respectively. Research and development expenses are reported net of certain subsidies the Company receives for expenditures on selected projects. The subsidies increased by $0.3 million in the twenty-six weeks ended July 4, 1999 compared to the same period in 1998. Year over year research and development costs increased in the Microelectronics segment primarily due to increased expenditures in the development of its next generation platform technology. Research and development costs for the first half of 1999 were lower than 1998 first half levels in the Electron Optics segment, because the 1998 costs included increased costs related to development of the Company's new TEM platform. The Company is also continuing through its Microelectronics division to invest in the development of a next generation platform technology, as well as product upgrades, new software systems and products to broaden the product line offerings of its various business segments. The Company expects to increase its research and development expenditures in 1999 compared to the expenditure levels of 1998.
Selling, general and administrative costs. Selling, general and administrative costs for the thirteen weeks ended July 4, 1999 increased $0.1 million (1%) and for the twenty-six weeks ended July 4, 1999 increased $1.9 million (10%) compared to the same periods in 1998. As a percentage of sales, selling, general and administrative costs were 24.2% and 24.3% for the thirteen weeks and 23.8% and 24.4% for the twenty-six weeks ended July 4, 1999 and June 28, 1998, respectively. The first half of 1999 was affected by increased legal expenses, employee relocation costs and incentive compensation accruals. The first quarter of 1998 was not indicative of the full calendar year 1998 expense level because of the addition of new senior management and the implementation of incentive compensation plans subsequent to the first quarter of 1998.
Amortization of purchased intangibles. The Company separately reports the expense associated with amortization of intangibles arising from merger and acquisition activities on the statement of operations. The expense associated with the amortization of other intangibles is charged to cost of sales or other operating expenses. Purchase accounting for the PEO Combination as of February 21, 1997 resulted in the recognition of intangible assets in the amount of $16.5 million for existing technology that is being amortized over a 12-year period, and goodwill of $17.1 million that is being amortized over a 15-year period.
Restructuring and reorganization costs. On July 29, 1998 the Company announced a restructuring and reorganization program to consolidate operations, eliminate redundant facilities, reduce operating expenses, and provide for outsourcing of certain manufacturing activities. The program is intended to eliminate approximately 173 positions worldwide, or about 16% of the Company's work force as of July 29, 1998. A charge of $5.3 million was recognized in the year ended December 31, 1998 primarily representing the cost of providing severance, outplacement assistance, and associated benefits to affected employees. Of this charge, $2.2 million remains as a liability as of July 4, 1999. This liability will continue to be discharged during 1999 as the Company's outsourcing plan continues to be implemented. Of the 173 positions targeted for elimination, 85 positions remain to be eliminated as of July 4, 1999. The remaining positions are primarily related to the Company's manufacturing operations in Acht, The Netherlands. In July 1999 the Company reached an agreement in principle to outsource certain manufacturing operations of its facility in Acht. The charge of $0.1 million recognized in the second quarter of 1999 represents costs of consolidating the Company's UK operations. Additional charges may be recorded as they are incurred during 1999 for transitional costs of consolidating operations and outsourcing certain activities.
Other income (expense), net. Other income (expense), net was expense of $0.2 million for the thirteen weeks ended July 4, 1999 compared with expense of $0.5 million for the same period in 1998. For the twenty-six weeks ended July
4, 1999 other income (expense), net was income of $0.2 million compared with expense of $0.7 million for the corresponding period in 1998. The twenty-six weeks ended July 4, 1999 included currency transaction gains of $0.4 million compared with currency transaction losses of $0.4 million in the comparable 1998 period. These 1999 currency gains were due to non-recurring transactions.
Income tax expense. The effective income tax rate was 41% and 35% for the thirteen weeks ended July 4, 1999 and June 28, 1998, respectively, and 40% and 35% for the twenty-six weeks ended July 4, 1999 and June 28, 1998. The Company's tax rates differ from the U.S. federal statutory tax rate primarily as a result of state and foreign taxes, the amortization of intangible assets not deductible for income tax purposes and the favorable tax effect of the Company's use of a foreign sales corporation for exports from the U.S.
LIQUIDITY AND CAPITAL RESOURCES
At July 4, 1999, the Company had total cash and cash equivalents of $12.6 million compared to $15.2 million at December 31, 1998. Cash provided by operating activities for the twenty-six weeks ended July 4, 1999 was $17.1 million compared to $5.2 million for the twenty-six weeks ended June 28, 1998. Cash provided by operating activities before the effect of working capital changes was $8.0 million for the twenty-six weeks ended July 4, 1999 and $8.7 million for the twenty-six weeks ended June 28, 1998. In February 1999, the Company consummated a new credit facility with Philips whereby a substantial portion of the Company's current account payable to Philips was converted to long-term borrowings (see below).
Investing activities used cash of $4.9 million during the twenty-six weeks ended July 4, 1999 compared with $5.5 million during the same period in 1998. The 1999 decrease is primarily due to lower levels of capital expenditures for equipment, partially offset by higher expenditures for software development. The majority of equipment expenditures in both 1998 and 1999 have been for demonstration systems, application lab systems and development and manufacturing equipment. The Company expects to continue to invest in plant and equipment and technology needed for future business requirements, as well as to invest in internally developed software for its products.
Financing activities used cash of $13.3 million in the twenty-six weeks ended July 4, 1999 and $7.6 million of cash in the twenty-six weeks ended June 28, 1998. The 1999 financing activities are principally comprised of a net reduction in long-term borrowings from Philips and the repayment and termination of the prior bank line of credit agreement. The 1998 financing activities reflect net repayments under the prior bank line of credit agreement as well as repayment of a $2.7 million note payable to Philips, which arose from the PEO Combination in February 1997. In February 1999 the Company consummated a new credit agreement and obtained commitment on a three year $50 million revolving credit facility from Philips. The facility allows the Company, subject to certain financial covenants, to borrow in multiple currencies for its general corporate needs, excluding acquisitions. During the first half of 1999 the Company utilized the multiple currency capability to finance its Asian working capital needs by borrowing in Japanese yen. Borrowings under the agreement bear interest at a variable LIBOR rate from 30 to 180 days, at the Company's designation, plus a 0.75% incremental rate. See Note 6 of Notes to Condensed Consolidated Financial Statements for additional information. With this new $50 million revolving line of credit, the Company refinanced and replaced its previous $25 million revolving line of credit with a U.S. bank.
On December 3, 1998, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with Micrion Corporation ("Micrion"), a Massachusetts corporation engaged in the design, manufacture, sale and service of focused particle beam instruments. The proposed merger has been subject to regulatory approval and approval by the shareholders of both Micrion and the Company. On June 10, 1999, shareholders of both companies approved the merger. On July 29, 1999, the Company received antitrust clearance for the merger from the Federal Trade Commission. Under terms of the Merger Agreement, Micrion would become a wholly owned subsidiary of the Company. Holders of Micrion common stock are expected to receive one share of the Company's common stock and $6.00 in cash in exchange for each share of Micrion common stock. The cash portion may be reduced if Micrion's indebtedness at closing of the merger exceeds certain levels set forth in the Merger Agreement. In conjunction with the proposed merger, the Company has incurred and deferred $1,804 of acquisition costs as of July 4, 1999.
In connection with the proposed merger, Philips Business Electronics entered into a stock purchase agreement with the Company pursuant to which Philips Business Electronics has agreed to finance the cash portion of the merger consideration through the purchase from the Company of additional newly issued shares of common stock. Philips Business Electronics also has the option to purchase additional newly issued shares of common stock to maintain the same percentage ownership of the Company as it had prior to the issuance of shares to Micrion's stockholders.
The Micrion Corporation merger and the sale of additional shares to Philips Business Electronics are expected to close in the third quarter of 1999.
The Company is evaluating service and distribution businesses in approximately 20 international locations. These businesses are currently operating under a distribution agreement between the Company and a Philips affiliate. The agreement was entered into in February 1997 and had an initial term which ends on January 1, 2000, unless extended. The Company is evaluating purchasing some of these businesses or obtaining alternate distributors in some locations. Depending on a number of variables, some of which have not been quantified, the Company may make additional investment in its service and distribution network.
The Company's global sales activities and related service and support activities result in complex foreign currency exposures. The Company does not have a formal hedging program in place; however, it does enter into forward contracts to sell or purchase foreign currencies to hedge specific transactions. As of July 4, 1999, the Company had forward purchase and sale contracts of foreign currency totaling $4.0 million, which if settled at the spot exchange rate as of July 4, 1999 would have resulted in a loss of less than $0.1 million.
The introduction of the Euro also provides the Company with an opportunity to reduce its exposure to the foreign currency translation fluctuations of the various European Monetary Union ("EMU") countries in which it reports results by adopting the Euro as its reporting currency for those operations. These countries include France, Germany, Italy and The Netherlands. The Company began conducting the majority of its business transactions in Euros for these EMU countries on January 1, 1999. The Company is in the process of converting its relevant operations to use of the Euro as functional and reporting currency. The Company's automated transaction and reporting systems are capable of reporting in either local currency or Euros without extensive modification.
The Company's working capital is subject to fluctuation due to the timing of its shipments. Since the Company's products typically have a large sales value per unit, the timing of specific units in a reporting period can affect the relative levels of inventory and accounts receivable without a corresponding change in liabilities. The Company's restructuring and reorganization programs also affected working capital as discussed previously. The remaining 1998 restructuring and reorganization charges, which will be settled in 1999, total $2.2 million as of July 4, 1999.
Purchase accounting for the PEO Combination as of February 21, 1997, resulted in the recognition of an intangible asset in the amount of $38.0 million representing the estimated fair value of in-process research and development of Pre-Combination FEI. The intangible asset was written off with a charge to earnings immediately following the PEO Combination in keeping with the Company's policy to expense research and development costs as they are incurred. In connection with the purchase accounting for the PEO Combination, the Company identified four significant projects under development. The development of three of those four projects was completed in 1997 and 1998, with revenue recognized in late 1997 and during 1998 and 1999. The fourth project, the Company's next generation platform, is still under development. Based on current management estimates, the fourth project is expected to generate revenue beginning in late 1999. There remains the risk that a technological hurdle may be encountered that may delay or prevent the successful development of this product and the Company cannot predict with certainty the market demand for this product. Although the Company believes any hurdles could eventually be overcome, the Company's competitive position could be harmed if a significant market for the product develops and its competitors are successful first in developing a competing technology. While the semiconductor manufacturing sector and the data storage sector were generally weak during 1998, the Company's long-term expectations for those markets and, accordingly, for this project, have not changed significantly.
The Company believes that its cash and cash equivalents, cash flows from operating activities, existing credit facilities and proceeds from the expected sale of additional shares to Philips Business Electronics are adequate to meet the Company's cash requirements over the next 12 to 18 months.
BACKLOG
The Company's backlog consists of purchase orders it has received for products and services it expects to ship and deliver within the next 12 months. At July 4, 1999, the Company's product backlog was $57 million and its field service backlog was $11 million for a total backlog of $68 million. At December 31, 1998, the Company's product backlog was $64 million and its field service backlog was $9 million for a total backlog of $73 million. A substantial portion of the Company's backlog relates to orders for a relatively small number of products. As a result, the timing of the receipt of orders or the shipment of products could have a significant impact on the Company's backlog at any date. For this and other reasons, the amount of backlog at any date is not necessarily determinative of revenue in future periods.
YEAR 2000 DISCLOSURE
State of Readiness. In January 1998, the Company formed a Year 2000 Team composed of representatives of various aspects of the Company's operations that may be significantly affected by Year 2000 readiness issues, including hardware and software related to the Company's manufacturing control, accounting and other information technology systems, product software and hardware, supplier products and post-sales support. The Year 2000 Team developed a multi-part plan to measure and address the Company's Year 2000 readiness, consisting of: (i) product testing using test criteria developed by SEMATECH, a semiconductor industry trade association; (ii) testing information technologies hardware and software for the Company's manufacturing control, accounting and other systems and addressing deficiencies; (iii) identifying and assessing non-information technologies third-party suppliers' products raising Year 2000 compliance issues, making inquiry of such vendors concerning their state of readiness and resolving issues; (iv) communicating with the customer base concerning Year 2000readiness of the Company's products; and (v) evaluating the need for and, as appropriate, developing a contingency plan.
The Company has analyzed and partially tested its information technology systems and determined that, to the extent tested, those systems have no material Year 2000 compliance deficiencies. Testing and evaluation of the Company's internal information technology systems was largely completed by the end of the 1999 second quarter. The Company is upgrading certain internal systems as a result of this testing. Also, with regard to readiness, the Company has assumed that basic public utilities such as gas, electric and telephone services will continue to be available for operations of the Company on and after January 1, 2000 in the U.S., The Netherlands and the Czech Republic. If this assumption proves incorrect, the operations of the affected manufacturing location would be materially adversely affected for the duration of the utility interruption.
The Company has completed the testing of products under service contract and has communicated with customers concerning Year 2000 readiness of its products and certain third party products sold with the Company's systems. However, the Company is not certain that it has determined the Year 2000 status of all past products, product configurations or the status of all third-party products sold with its products. The Company has established a web page describing the state of its product readiness and continues to address inquiries from customers concerning product issues. The Company expects to continue to make direct contact with customers concerning product readiness, to respond to customer questions and to update its web-site as appropriate. The Company has also instructed certain of its post-sales field service representatives to address Year 2000 issues with customers during service calls.
The Company has solicited information concerning Year 2000 readiness from a large number of identified critical suppliers. Based on communications to date, the Company does not believe a material Year 2000 deficiency by any information technologies or non-information technologies supplier exists. However, the Company has not yet completed its assessment and planning for all identified critical suppliers and vendors and further inquiry and evaluation may identify Year 2000 deficiencies.
Costs. At this time, the Company believes costs incurred in responding to other parties' Year 2000 computer system deficiencies, together with the cost of any required modifications to the Company's systems, will not have a material impact on the Company's results of operations or financial condition. In the ordinary course the Company has improved its Year 2000 readiness through recent systems upgrades as part of its usual capital improvement efforts. The Company
has devoted management, sales and technical resources to address Year 2000 matters and expects to continue to do so. The Company has made plans to increase inventories of certain components prior to January 2000 but has not made specific allocations for this increase. Overall, the Company expects to fund any future costs through operating cash flows. Cost estimates for systems improvements are based on the Company's estimates, which make numerous assumptions about future events. There is no assurance that these estimates will be correct and actual costs could differ materially from these estimates.
Most Reasonably Likely Worst Case Scenarios for the Company. Although the Company will continue to devote resources to address its Year 2000 issues, there is no assurance that these efforts will be effective in reducing or eliminating risks associated with Year 2000 deficiencies. Moreover, there is no assurance that the Company's products do not contain undetected Year 2000 problems or that third-party products do not contain such problems. In addition, there is no assurance that the Company's assessment of third-party suppliers and vendors will be accurate or that the Company has made inquiry of the appropriate vendors. Year 2000 problems could result in system failures, data corruption, the generation of erroneous information and other significant disruptions of business activities. Beyond risks related to product and vendor non-compliance, it is possible that the Company will suffer supply chain disruptions and transport problems due to hoarding and changes in buying and shipping patterns caused by other parties' efforts to address Year 2000 problems. Furthermore, it has been widely reported that a significant amount of litigation surrounding business interruptions may arise out of Year 2000 issues. It is uncertain whether, or to what extent, the Company may be affected by any such litigation.
The Company's Contingency Plan. The Company has developed certain contingency measures but has not adopted a comprehensive contingency plan. The Company continues to evaluate the need for additional measures and expects to finish the evaluation by the end of the 1999 third quarter. The Company has secured additional transport capacity for December 1999, has identified a crisis management team, and is taking measures to increase certain of its inventory of some component parts and supplies. Additional contingency measures may be taken in the second half of 1999.
FORWARD-LOOKING STATEMENTS
From time to time the Company may issue forward-looking statements that are subject to a number of risks and uncertainties. The statements in this report concerning increased investment in plant and equipment and software development, the portions of the Company's sales consisting of international sales, expected capital requirements, Year 2000 compliance by the Company and its customers and suppliers and the expected closing of the Micrion merger constitute forward-looking statements that are subject to risks and uncertainties. Factors that could materially decrease the Company's investment in plant and equipment and software development include downturns in the semiconductor manufacturing market, lower than expected customer orders and changes in product sales mix. Factors that could materially reduce the Company's international sales include competitive factors such as increased international competition, new product offerings by competitors and price pressures, fluctuations in interest and exchange rates (including changes in foreign currency exchange rates between time of sale and payment), changes in trade policies, tariff regulations and business conditions and growth in the electronics industry and in domestic and foreign economies. Factors that could materially increase the Company's capital requirements include receipt of a significant portion of customer orders and product shipments near the end of a quarter and the other factors listed above. Factors that could materially affect the Company's results of operations and liquidity and capital resources if the Micrion merger occurs include costs involved in integrating the operations of Micrion, inability to successfully coordinate research and development and sales and marketing efforts and inability to retain key management personnel.