Southwall Technologies 10-Q 9-30-2006
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
__________________
FORM
10-Q
(MARK
ONE)
|
x
|
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
|
For
the quarterly period ended September 30, 2006
or
|
o
|
TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
|
For
the transition period from to
Commission
File Number: 0-15930
___________________
SOUTHWALL
TECHNOLOGIES INC.
(Exact
name of registrant as specified in its charter)
|
Delaware
|
|
94-2551470
|
|
|
(State
or other jurisdiction of incorporation or organization)
|
|
(I.R.S.
Employer Identification Number)
|
|
|
|
|
|
|
|
3788
Fabian Way, Palo Alto, California
(Address
of principal executive offices)
|
|
94303
(Zip
Code)
|
|
Registrant's
telephone number, including area code:
(650) 798-1200
___________________
Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes x No o
Indicate
by check mark whether the registrant is an accelerated filer (as defined in
Rule
12b-2 of the Exchange Act). Yes o No x
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
Yes
o No x
As
of
November 1, 2006, there were 26,957,001 shares of the Registrant's Common Stock
outstanding.
SOUTHWALL
TECHNOLOGIES INC.
INDEX
|
|
Page
|
|
PART
I - FINANCIAL INFORMATION
|
|
|
|
|
Item
1
|
|
|
|
|
3
|
|
|
4
|
|
|
5
|
|
|
6
|
Item
2
|
|
14
|
Item
3
|
|
24
|
Item
4
|
|
25
|
|
|
|
|
PART
II - OTHER INFORMATION
|
|
|
|
|
Item
1
|
|
26
|
Item
1A
|
|
27
|
Item
2
|
|
29
|
Item
3
|
|
29
|
Item
4
|
|
29
|
Item
5
|
|
29
|
Item
6
|
|
29
|
|
|
30
|
PART
I.
FINANCIAL INFORMATION
Item
1--Financial Statements:
SOUTHWALL
TECHNOLOGIES INC.
|
|
UNAUDITED
CONDENSED CONSOLIDATED BALANCE SHEETS
|
|
(in
thousands, except per share data)
|
|
|
|
|
|
|
|
|
|
September
30,
2006
|
|
December
31,
2005
|
|
|
|
|
|
|
|
ASSETS
|
Current
assets:
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
5,032
|
|
$
|
6,600
|
|
Restricted
cash
|
|
|
206
|
|
|
402
|
|
Accounts
receivable, net of allowance for doubtful accounts of $170 at
September 30, 2006 and $208 at December 31, 2005
|
|
|
4,804
|
|
|
6,780
|
|
Inventories,
net
|
|
|
5,241
|
|
|
5,879
|
|
Other
current assets
|
|
|
1,492
|
|
|
982
|
|
Total
current assets
|
|
|
16,775
|
|
|
20,643
|
|
|
|
|
|
|
|
|
|
Property,
plant and equipment, net
|
|
|
16,689
|
|
|
16,857
|
|
Restricted
cash loans
|
|
|
1,063
|
|
|
995
|
|
Other
assets
|
|
|
1,161
|
|
|
1,146
|
|
Total
assets
|
|
$
|
35,688
|
|
$
|
39,641
|
|
|
|
|
|
|
|
|
|
LIABILITIES,
PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
Current
portion of long term debt
|
|
$
|
1,030
|
|
$
|
1,317
|
|
Line
of credit
|
|
|
2,996
|
|
|
2,996
|
|
Accounts
payable
|
|
|
1,543
|
|
|
1,402
|
|
Accrued
compensation
|
|
|
1,109
|
|
|
1,161
|
|
Other
accrued liabilities
|
|
|
6,300
|
|
|
5,076
|
|
Total
current liabilities
|
|
|
12,978
|
|
|
11,952
|
|
|
|
|
|
|
|
|
|
Term
debt
|
|
|
8,544
|
|
|
8,790
|
|
Government
grants advanced
|
|
|
206
|
|
|
396
|
|
Other
long term liabilities
|
|
|
2,531
|
|
|
2,564
|
|
Total
liabilities
|
|
|
24,259
|
|
|
23,702
|
|
|
|
|
|
|
|
|
|
Commitments
and contingencies (Note 5)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Series
A 10% cumulative convertible preferred stock, $0.001 par value; $1.00
stated value; 5,000 shares authorized, 4,893 shares outstanding at
September 30, 2006 and December 31, 2005, respectively (Liquidation
preference: $5,749 and $5,383 at September 30, 2006 and December
31, 2005,
respectively)
|
|
|
4,810
|
|
|
4,810
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity:
|
|
|
|
|
|
|
|
Common
stock, $0.001 par value per share; 50,000 shares authorized, 26,957
shares
and 26,793 shares outstanding at September 30, 2006 and December
31, 2005,
respectively
|
|
|
27
|
|
|
27
|
|
Capital
in excess of par value
|
|
|
78,050
|
|
|
77,828
|
|
Accumulated
other comprehensive income:
|
|
|
|
|
|
|
|
Accumulated
translation adjustment
|
|
|
3,236
|
|
|
2,532
|
|
Accumulated
deficit
|
|
|
(74,694
|
)
|
|
(69,258
|
)
|
Total
stockholders’ equity
|
|
|
6,619
|
|
|
11,129
|
|
|
|
|
|
|
|
|
|
Total
liabilities, preferred stock and stockholders’ equity
|
|
$
|
35,688
|
|
$
|
39,641
|
|
See
accompanying notes to unaudited condensed consolidated financial
statements.
SOUTHWALL
TECHNOLOGIES INC.
|
|
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
|
|
(in
thousands, except per share data)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
months ended
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
September
30,
2006
|
|
October
2,
2005
|
|
|
|
|
|
|
|
|
|
|
|
Net
revenues
|
|
$
|
9,597
|
|
$
|
12,025
|
|
$
|
30,968
|
|
$
|
42,844
|
|
Cost
of revenues
|
|
|
5,667
|
|
|
7,921
|
|
|
19,301
|
|
|
28,979
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
profit
|
|
|
3,930
|
|
|
4,104
|
|
|
11,667
|
|
|
13,865
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Research
and development
|
|
|
1,659
|
|
|
1,334
|
|
|
5,376
|
|
|
3,047
|
|
Selling,
general and administrative
|
|
|
4,674
|
|
|
2,104
|
|
|
9,761
|
|
|
6,461
|
|
Impairment
recoveries for long-lived assets, net
|
|
|
(325
|
)
|
|
-
|
|
|
|
)
|
|
(170
|
) |
Restructuring
charges
|
|
|
263
|
|
|
-
|
|
|
974
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
operating expenses
|
|
|
6,271
|
|
|
3,438
|
|
|
15,994
|
|
|
9,338
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
(loss) from operations
|
|
|
(2,341
|
)
|
|
666
|
|
|
(4,327
|
)
|
|
4,527
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
expense, net
|
|
|
(169
|
)
|
|
(210
|
)
|
|
(550
|
)
|
|
(778
|
)
|
Other
income (expenses), net
|
|
|
(18
|
)
|
|
9
|
|
|
161
|
|
|
142
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
(loss) before provision for income tax
|
|
|
(2,528
|
)
|
|
465
|
|
|
(4,716
|
)
|
|
3,891
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision
for income taxes
|
|
|
193
|
|
|
450
|
|
|
719
|
|
|
782
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income (loss)
|
|
|
(2,721
|
)
|
|
15
|
|
|
(5,435
|
)
|
|
3,109
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deemed
dividend on preferred stock
|
|
|
123
|
|
|
120
|
|
|
367
|
|
|
363
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income (loss) attributable to common stockholders
|
|
$
|
(2,844
|
)
|
$
|
(105
|
)
|
$
|
(5,802
|
)
|
$
|
2,746
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income (loss) per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(0.11
|
)
|
$
|
0.00
|
|
$
|
(0.22
|
)
|
$
|
0.10
|
|
Diluted
|
|
$
|
(0.11
|
)
|
$
|
0.00
|
|
$
|
(0.22
|
)
|
$
|
0.09
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares
used in computing net income (loss) per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
26,957
|
|
|
26,788
|
|
|
26,907
|
|
|
26,727
|
|
Diluted
|
|
|
26,957
|
|
|
32,720
|
|
|
26,907
|
|
|
32,999
|
|
See
accompanying notes to unaudited condensed consolidated financial
statements.
SOUTHWALL
TECHNOLOGIES INC.
|
|
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
|
|
(in
thousands)
|
|
|
|
|
|
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
|
|
|
|
|
|
Cash
flows from operating activities:
|
|
|
|
|
|
Net
income (loss)
|
|
$
|
(5,435
|
)
|
$
|
3,109
|
|
Adjustments
to reconcile net income (loss) to net cash (used in) provided by
operating activities:
|
|
|
|
|
|
|
|
Deferred
income tax
|
|
|
54
|
|
|
-
|
|
Impairment
recoveries from long-lived assets, net
|
|
|
(117
|
)
|
|
(170
|
)
|
Depreciation
and amortization
|
|
|
1,836
|
|
|
1,677
|
|
Stock
compensation
|
|
|
487
|
|
|
45
|
|
Change
in assets and liabilities:
|
|
|
|
|
|
|
|
Deferred
revenues
|
|
|
(26
|
)
|
|
(26
|
)
|
Accounts
receivable, net
|
|
|
1,982
|
|
|
1,456
|
|
Inventories,
net
|
|
|
638
|
|
|
1,112
|
|
Accrued
restructuring
|
|
|
124
|
|
|
-
|
|
Other
current and non current assets
|
|
|
(524
|
)
|
|
723
|
|
Accrued
liabilities - deferred rent
|
|
|
(1,192
|
)
|
|
-
|
|
Accounts
payable and accrued liabilities
|
|
|
2,025
|
|
|
(2,627
|
)
|
|
|
|
|
|
|
|
|
Net
cash (used in) provided by operating activities
|
|
|
(148
|
)
|
|
5,299
|
|
|
|
|
|
|
|
|
|
Cash
flows from investing activities:
|
|
|
|
|
|
|
|
Restricted
cash
|
|
|
181
|
|
|
244
|
|
Proceeds
from sale of property, plant and equipment
|
|
|
422
|
|
|
170
|
|
Expenditures
for property, plant and equipment
|
|
|
(781
|
)
|
|
(535
|
)
|
|
|
|
|
|
|
|
|
Net
cash used in investing activities
|
|
|
(178
|
)
|
|
(121
|
)
|
|
|
|
|
|
|
|
|
Cash
flows from financing activities:
|
|
|
|
|
|
|
|
Repayments
under capital lease
|
|
|
-
|
|
|
(5
|
)
|
Proceeds
from exercise of stock options
|
|
|
32
|
|
|
20
|
|
Principal
payments on borrowings
|
|
|
(1,133
|
)
|
|
(
1,354
|
)
|
Payments
on line of credit
|
|
|
-
|
|
|
(2,975
|
)
|
Borrowings
on line of credit
|
|
|
-
|
|
|
2,996
|
|
Investment
credit in Germany
|
|
|
(219
|
)
|
|
(30
|
)
|
|
|
|
|
|
|
|
|
Net
cash used in financing activities
|
|
|
(1,320
|
)
|
|
(1,348
|
)
|
|
|
|
|
|
|
|
|
Effect
of foreign exchange rate changes on cash
|
|
|
78
|
|
|
(311
|
)
|
|
|
|
|
|
|
|
|
Net
(decrease) increase in cash and cash equivalents
|
|
|
(1,568
|
)
|
|
3,519
|
|
Cash
and cash equivalents, beginning of period
|
|
|
6,600
|
|
|
4,547
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, end of period
|
|
$
|
5,032
|
|
$
|
8,066
|
|
See
accompanying notes to unaudited condensed consolidated financial
statements.
SOUTHWALL
TECHNOLOGIES INC.
NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1--Interim
Period Reporting:
The
accompanying interim condensed consolidated financial statements of Southwall
Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain
information and footnote disclosure normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been condensed or omitted. In the opinion of
management, the unaudited condensed consolidated financial statements reflect
all adjustments, consisting only of normal recurring adjustments, considered
necessary to present fairly the financial position, results of operations and
cash flows of Southwall and its subsidiaries for all periods presented. The
year-end condensed balance sheet data was derived from audited financial
statements, but does not include all disclosures required by accounting
principles generally accepted in the United States of America. The Company
suggests that these condensed consolidated financial statements be read in
conjunction with the consolidated financial statements and notes thereto
contained in the Company's Form 10-K for the year ended December 31, 2005
filed with the Securities and Exchange Commission on March 29, 2006. The results
of operations for the interim periods presented are not necessarily indicative
of the operating results of the full year.
In
2005,
the Company used a 52-week fiscal year ending on December 31. In 2006, the
Company changed to a fiscal calendar year ending on December 31 with fiscal
quarters ending on March 31, June 30, and September 30. The third fiscal
quarters of 2006 and 2005 ended on September 30, 2006 and October 2, 2005,
respectively. The October 2, 2005 quarter included 13 weeks.
Note 2—Inventories,
Net:
In
January 2006, the Company changed its inventory valuation method from the
first-in, first-out method to the average cost method. With the closing of
the
Company’s Palo Alto, California manufacturing facility and all production now
being performed in our German subsidiary’s facility, the use of the average cost
method was deemed preferable as it both accommodates our German subsidiary’s
statutory reporting requirements and fairly approximates actual costs. In
addition, the impact of the change was $0.3 million which the Company considers
immaterial.
Inventories
are stated at the lower of cost (determined by the average method) or market.
Cost includes materials, labor and manufacturing overhead. The Company
establishes provisions for excess and obsolete inventories to reduce such
inventories to their estimated net realizable value. Such provisions are charged
to cost of revenues. At September 30, 2006 and December 31, 2005, inventories
consisted of the following (in thousands):
|
|
September
30,
2006
|
|
December
31,
2005
|
|
Raw
materials
|
|
$
|
3,165
|
|
$
|
3,482
|
|
Work-in-process
|
|
|
791
|
|
|
1,409
|
|
Finished
goods
|
|
|
1,285
|
|
|
988
|
|
|
|
$
|
5,241
|
|
$
|
5,879
|
|
Note 3--Net
Income (Loss) Per Share:
Basic
net
income (loss) per share is computed by dividing net income (loss) attributable
to common stockholders (numerator) by the weighted average number of common
shares outstanding (denominator) for the period. Diluted net income (loss)
per
share gives effect to all dilutive common shares potentially outstanding during
the period, including stock options, warrants to purchase common stock and
redeemable convertible preferred stock. Preferred stock dividends are added
back
to net income attributable to common stockholders since they would not have
been
accrued if the preferred stock had been converted to common stock at the
beginning of the period.
The
Company excludes options from the computation of diluted weighted average shares
outstanding if the exercise price of the options is greater than the average
market price of the shares because the inclusion of these options would be
anti-dilutive to earnings per share. Accordingly, stock options to
purchase 5,985,000 and 5,806,963 shares were excluded from the computation
of
diluted weighted average shares outstanding for the three and nine-month periods
ended September 30, 2006, respectively. Stock options to purchase 2,415,005
and
1,737,505 shares at a weighted average price of $2.74 and $3.35 per share,
respectively, were excluded from the computation of diluted weighted average
shares outstanding for the three and nine-month periods ended October 2, 2005
respectively.
In
net
loss periods, the basic and diluted weighted average shares of common stock
and
common stock equivalents are the same because inclusion of common stock
equivalents would be anti-dilutive. Accordingly, for the three and nine-month
periods ended September 30, 2006, there was no difference between the
denominators used for the calculation of basic and diluted net income (loss)
per
share. Tables
summarizing net income/(loss) attributable to common stockholders, for diluted
net income (loss) per share, and shares outstanding are shown below (in
thousands):
|
|
Three
months ended
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
September
30,
2006
|
|
October
2,
2005
|
|
Net
income (loss) attributable to common stockholders-basic
|
|
$
|
(2,844
|
)
|
$
|
(105
|
)
|
$
|
(5,802
|
)
|
$
|
2,746
|
|
Add:
Deemed dividend on preferred stock
|
|
|
123
|
|
|
120
|
|
|
367
|
|
|
363
|
|
Net
income (loss) attributable to common stockholders-diluted
|
|
$
|
(2,721
|
)
|
$
|
15
|
|
$
|
(5,435
|
)
|
$
|
3,109
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average common shares outstanding-basic
|
|
|
26,957
|
|
|
26,788
|
|
|
26,907
|
|
|
26,727
|
|
Dilutive
effect of warrants
|
|
|
-
|
|
|
356
|
|
|
-
|
|
|
357
|
|
Dilutive
effect of performance shares
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
50
|
|
Dilutive
effect of Series A preferred shares
|
|
|
-
|
|
|
4,893
|
|
|
-
|
|
|
4,893
|
|
Dilutive
effect of stock options
|
|
|
-
|
|
|
683
|
|
|
-
|
|
|
972
|
|
Weighted
average common shares outstanding - diluted
|
|
|
26,957
|
|
|
32,720
|
|
|
26,907
|
|
|
32,999
|
|
Note 4
- Segment Reporting:
Southwall
reports segment information using the management approach to determine segment
information. The management approach designates the internal organization that
is used by management for making operating decisions and assessing performance
as the source of its reportable segments. The Company is organized on the basis
of products and services. The total net revenues for the automotive glass,
electronic display, window film and architectural product lines for the three
and nine-month periods ended September 30, 2006 and October 2, 2005 were as
follows (in thousands):
|
|
Three
months ended
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
September
30,
2006
|
|
October
2,
2005
|
|
Automotive
glass
|
|
$
|
3,019
|
|
$
|
3,857
|
|
$
|
9,726
|
|
$
|
15,179
|
|
Electronic
display
|
|
|
2,564
|
|
|
3,049
|
|
|
8,325
|
|
|
10,425
|
|
Window
film
|
|
|
2,424
|
|
|
3,907
|
|
|
8,880
|
|
|
13,034
|
|
Architectural
|
|
|
1,590
|
|
|
1,212
|
|
|
4,037
|
|
|
4,206
|
|
Total
net revenues
|
|
$
|
9,597
|
|
$
|
12,025
|
|
$
|
30,968
|
|
$
|
42,844
|
|
The
following is a summary of net revenues by geographic area (based on the location
of the Company's customers) for the three and nine-month periods ended September
30, 2006 and October 2, 2005, respectively (in thousands):
|
|
Three
months ended
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
September
30,
2006
|
|
October
2,
2005
|
|
United
States
|
|
$
|
3,231
|
|
$
|
3,290
|
|
$
|
10,408
|
|
$
|
11,001
|
|
Japan
|
|
|
2,639
|
|
|
2,822
|
|
|
7,948
|
|
|
9,252
|
|
France
|
|
|
855
|
|
|
1,955
|
|
|
2,283
|
|
|
8,448
|
|
Pacific
Rim
|
|
|
1,916
|
|
|
2,713
|
|
|
6,617
|
|
|
8,798
|
|
Germany
|
|
|
667
|
|
|
693
|
|
|
2,612
|
|
|
3,406
|
|
Rest
of the world
|
|
|
289
|
|
|
552
|
|
|
1,100
|
|
|
1,939
|
|
Total
net revenues
|
|
$
|
9,597
|
|
$
|
12,025
|
|
$
|
30,968
|
|
$
|
42,844
|
|
Note 5--Commitments
and Contingencies:
Commitments
On
January 19, 2006, the Company announced its plans to close its Palo Alto
manufacturing facility consisting of two buildings. As a result of this
decision, the Company is in negotiation with its landlords to decommission
and
surrender these premises. During the quarter ended September 30, 2006, the
Company has accrued $1.7 million for the estimated costs for decommissioning
and
surrender of these buildings, which may require an adjustment in the fourth
quarter. This amount is included in accrued liabilities in the accompanying
balance sheet. The Company believes that it can resolve all issues with its
landlords and will complete any potential obligations in the fourth quarter
of
2006.
On
February 19, 2004, the Company entered into the second amendment to the lease
for one of the buildings. The amendment reflected a payment schedule for a
rent
deferral. In January of 2006, the Company paid off approximately $1.2 million
in
deferred rent. As of September 30, 2006, there was no deferred rent
outstanding.
Contingencies
The
Company was named as a defendant, along with Bostik, Inc., in an action
captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
Inc.,
Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court for
the
Northern District of California on June 18, 2002. The Company was served with
the Complaint in this matter on July 1, 2002. The plaintiff filed the matter
as
a class action on behalf of all entities and individuals in the United States
who manufactured and/or sold and warranted the service life of insulated glass
units manufactured between 1989 and 1999, which contained Southwall Heat Mirror
film and were sealed with a specific type of sealant manufactured by Bostik,
Inc. The plaintiff alleged that the sealant provided by Bostik, Inc. was
defective, resulting in elevated warranty replacement claims and costs. The
plaintiff asserted claims against the Company for breach of an implied warranty
of fitness, misrepresentation, fraudulent concealment, negligence, and negligent
interference with prospective economic advantage, breach of contract, unfair
business practices and false or misleading business practices. The plaintiff
sought recovery on behalf of the class of $100 million for damages allegedly
resulting from elevated warranty replacement claims, restitution, injunctive
relief, and non-specific compensation for lost profits. By Order entered
December 22, 2003, the Court dismissed all claims against the Company. The
plaintiff appealed to the Ninth Circuit Court of Appeals. On January 13, 2006,
the Court of Appeals affirmed the lower court decision. On January 26, 2006,
the
plaintiff filed a petition for rehearing with the Ninth Circuit Court of
Appeals. In March of 2006, the Ninth Circuit Court of Appeals denied the
plaintiff's petition. On May 26, 2006 the plaintiff filed a petition for writ
of
certiorari to the United States Supreme Court. On
October 2, 2006, the Supreme Court denied Wasco’s petition for writ of
certiorari.
The
insurance carriers in some of the litigation related to alleged product failures
and defects in window products manufactured by others in which the Company
was a
defendant in the past paid the defense and settlement costs related to such
litigation. Certain of those insurance carriers reserved their rights to recover
a portion or all of such payments from the Company. As a result, those insurance
carriers could seek from us up to an aggregate of $2 million plus defense
costs, although any such recovery would be restricted to claims that were not
covered by the Company's insurance policies. The Company intends to vigorously
defend any attempts by these insurance carriers to seek reimbursement. The
Company is not able to estimate the likelihood that these insurance carriers
will seek to recover any such payments, the amount, if any, they might seek,
or
the outcome of such attempts.
On
June
13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
Company in the Superior Court of California in and for the County of Santa
Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
Plaintiff's Complaint alleged claims for race discrimination, national origin
discrimination, retaliation, medical condition discrimination, breach of
contract, breach of fiduciary duty, fraud, negligence, intentional infliction
of
emotional distress, and punitive damages. In October of 2006 the Company settled
this suit with the Plaintiff for an amount not considered material to the
financial statements of the Company. The Company has accrued for this settlement
in its accompanying financial statements as of September 30, 2006.
In
addition, the Company is involved in certain other legal actions arising in
the
ordinary course of business. The Company believes, however, that none of these
actions, either individually or in the aggregate, will have a material adverse
effect on its business, consolidated financial position, results of operations
or cash flows.
Note 6--Stock-Based
Compensation:
The
Company has a stock-based compensation program that provides its Board of
Directors broad discretion in creating employee equity incentives. The Company
has granted stock options under various option plans and agreements in the
past
and currently grants stock options under the 1997 Stock Incentive Plan and
the
1998 Stock Option Plan for employees, board members and consultants. The Board
of Directors adopted the 1997 and 1998 Stock Option Plans on May 12, 1997 and
August 6, 1998, respectively. The Compensation Committee of the Board of
Directors administers the plans and agreements. The exercise price of options
granted under the 1997 and 1998 plans must be at least 85% of the fair market
value of the stock at the date of grant. Options granted under the 1998 plan
prior to October 2004 generally vest at a rate of 25% per year, are
non-transferable and expire over terms not exceeding ten years from the date
of
grant or three months after the optionee terminates his relationship with the
Company. Options granted under the 1997 plan prior to October 2004 generally
vest at a rate of 25% per year, are non-transferable and expire over terms
not
exceeding ten years from the date of grant or eighteen months after the optionee
terminates his relationship with the Company. Grants from and after October
2004
until April 2006 under both plans vest at a rate of 25% after six months and
then evenly monthly thereafter for the remaining 42 months. From and after
April
2006 grants under both plans vest at a rate of 25% per year on each anniversary
of the grant date.
The
Company also has an Employee Stock Purchase Plan (ESPP) that allows employees,
subject to certain limitations, to purchase shares at 85% of the lower of the
fair market value of the Common Stock at the beginning of the six-month offering
period, or the last day of the purchase period.
As
of
September 30, 2006, the Company had approximately 2,158,000 shares of common
stock reserved for future issuance under its stock option plans and
ESPP.
On
January 1, 2006, the Company adopted the provisions of SFAS 123R, “Shared-Based
Payment” (SFAS 123R), requiring it to recognize expense related to the fair
value of its stock-based compensation awards. The Company elected to use the
modified prospective transition method as permitted by SFAS 123R and therefore
has not restated its financial results for prior periods. Under this transition
method, stock-based compensation expense for the three and nine-month periods
ended September 30, 2006 includes compensation expense for all stock-based
compensation awards granted prior to, but not yet vested as of January 1, 2006,
based on the grant date fair value estimated in accordance with the original
provisions of SFAS 123, “Accounting for Stock-Based Compensation” (SFAS 123).
Stock-based compensation expense for all stock-based compensation awards granted
subsequent to January 1, 2006 was based on the grant-date fair value estimated
in accordance with the provisions of SFAS 123R. The Company is recognizing
compensation expense for stock option awards on a graded vesting basis over
the
requisite service period of the award.
The
following table sets forth the total stock-based compensation expense resulting
from stock options included in the condensed consolidated statements of
operations (in thousands):
|
|
Three
months ended
September
30,
2006
|
|
Nine
months ended
September
30,
2006
|
|
Cost
of sales
|
|
$
|
-
|
|
$
|
11
|
|
Research
and development
|
|
|
21
|
|
|
109
|
|
Selling,
general and administrative
|
|
|
56
|
|
|
296
|
|
Stock-based
compensation expense before income taxes
|
|
|
77
|
|
|
416
|
|
Income
tax benefit
|
|
|
-
|
|
|
-
|
|
Total
stock-based compensation expense after income taxes
|
|
$
|
77
|
|
$
|
416
|
|
There
were no cash proceeds from the exercise of stock options for the three months
ended September 30, 2006 and October 2, 2005, respectively, and the amounts
were
immaterial for the nine months ended September 30, 2006 and October 2, 2005,
respectively. No income tax benefit was realized from stock option exercises
during the three and nine-month periods ended September 30, 2006, and October
2,
2005. In accordance with SFAS 123R, the Company presents excess tax benefits
from the exercise of stock options, if any, as financing cash flows rather
than
operating cash flows.
Prior
to
the adoption of SFAS 123R, the Company applied SFAS 123, amended by SFAS No.
148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (SFAS
148), which allowed companies to apply the existing accounting rules under
APB
25, “Accounting for Stock Issued to Employees” (APB 25), and related
Interpretations. In general, as the exercise price of options granted under
these plans was equal to the market price of the underlying common stock on
the
grant date, no stock-based employee compensation cost was recognized in the
Company's net income (loss). As required by SFAS 148 prior to the adoption
of
SFAS 123R, the Company provided pro forma net income (loss) and pro forma net
income (loss) per common share disclosures for stock-based awards, as if the
fair-value-based method defined in SFAS 123 had been applied.
The
following table illustrates the effect on net income after tax and net income
per common share as if the Company had applied the fair value recognition
provisions of SFAS 123 to stock-based compensation during the three and
nine-month periods ended October 2, 2005 (in thousands, except per share
amounts):
|
|
Three months
ended
October
2,
2005
|
|
Nine
months ended
October
2,
2005
|
|
Net
income attributable to common stockholders:
|
|
|
|
|
|
As
reported
|
|
$
|
(105
|
)
|
$
|
2,746
|
|
Add:
Stock-based employee compensation expense included in reported net
income,
net of related tax effects
|
|
|
-
|
|
|
45
|
|
Deduct:
Total stock-based employee compensation determined under fair value
based
method for all awards, net of related tax effects
|
|
|
(200
|
)
|
|
(502
|
)
|
Pro
forma net income attributable to common stockholders
|
|
$
|
(305
|
)
|
$
|
2,289
|
|
|
|
|
|
|
|
|
|
Net
income attributable to common stockholders per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As
reported - basic
|
|
$
|
0.00
|
|
$
|
0.10
|
|
Pro
forma - basic
|
|
$
|
(0.01
|
)
|
$
|
0.09
|
|
|
|
|
|
|
|
|
|
As
reported - diluted
|
|
$
|
0.00
|
|
$
|
0.09
|
|
Pro
forma - diluted
|
|
$
|
(0.01
|
)
|
$
|
0.08
|
|
The
fair
value of stock-based awards was estimated using the Black-Scholes model with
the
following weighted-average assumptions for the three and nine-month periods
ended September 30, 2006, and October 2, 2005, respectively:
|
|
Three
months ended
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
September
30,
2006
|
|
October,
2,
2005
|
|
Expected
life (in years)
|
|
|
2.59
|
|
|
2.24
|
|
|
2.44
|
|
|
1.94
|
|
Risk-free
interest rate
|
|
|
4.84
|
%
|
|
4.01
|
%
|
|
4.87
|
%
|
|
3.82
|
%
|
Volatility
|
|
|
109
|
%
|
|
116
|
%
|
|
109
|
%
|
|
116
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
fair value at grant date
|
|
$
|
0.38
|
|
$
|
0.70
|
|
$
|
0.41
|
|
$
|
0.65
|
|
The
Company's computation of expected volatility for the quarter ended September
30,
2006 is based on historical volatility. The Company's computation of expected
life is based on historical exercise patterns. The interest rate for periods
within the expected life of the award is based on the U.S. Treasury yield in
effect at the time of grant.
Stock
option activity for the nine months ended September 30, 2006 was as follows
(in
thousands, except per share amounts):
|
|
Shares
|
|
Weighted-Average
Exercise Price
|
|
Weighted-Average
Remaining Contractual Term (in years)
|
|
Aggregate
Intrinsic Value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding
at December 31, 2005
|
|
|
5,572
|
|
$
|
1.53
|
|
|
|
|
|
|
|
Grants
|
|
|
905
|
|
|
0.68
|
|
|
|
|
|
|
|
Exercises
|
|
|
(57
|
)
|
|
0.50
|
|
|
|
|
|
|
|
Forfeitures
or expirations
|
|
|
(435
|
)
|
|
2.59
|
|
|
|
|
|
|
|
Outstanding
at September 30, 2006
|
|
|
5,985
|
|
$
|
1.33
|
|
|
7.55
|
|
$
|
-
|
|
Vested
and expected to vest at September 30, 2006
|
|
|
5,109
|
|
$
|
1.41
|
|
|
7.29
|
|
$
|
-
|
|
Exercisable
at September 30, 2006
|
|
|
3,449
|
|
$
|
1.66
|
|
|
6.58
|
|
$
|
-
|
|
The
aggregate intrinsic value in the table above represents the total pretax
intrinsic value (i.e., the difference between Southwall's closing stock price
on
the last trading day of its third quarter of fiscal 2006 and the exercise price,
times the number of shares) that would have been received by the option holders
had all option holders exercised their options on September 30, 2006. This
amount changes based on the fair market value of Southwall's stock. Total
intrinsic value of options exercised was immaterial for the three and nine-month
periods ended September 30, 2006. Total fair value of options vested is $0.1
million and $0.4 million for the three and nine-month periods ended September
30, 2006, respectively.
As
of
September 30, 2006, $0.4 million of total unrecognized compensation cost related
to stock options, net of forfeitures, was expected to be recognized over a
weighted-average period of approximately 1.63 years.
On
May
11, 2006, the Company granted 515,000 Performance Stock Units (“PSUs”) to
certain employees under the 2006 Long Term Incentive Program. In accordance
with
SFAS 123R, the PSUs have been valued on the date of grant based on their fair
value determined under the Black-Scholes valuation model. Under the Plan, the
PSUs will vest when certain milestones are met and the participants will then
have immediate ownership of the PSUs, which convert to common stock of the
Company on a 1:1 basis. The PSUs have no purchase price/cost to the participants
and the participants must be employed with the Company on the date the milestone
is achieved in order to vest. As of September 30, 2006, the milestones have
not
been achieved and thus no PSUs had vested. For the quarter ended September
30,
2006, an immaterial amount of compensation was recognized. The PSUs are expected
to vest over a 23 month period and had a weighted average grant date fair value
of $0.71 and an aggregate intrinsic value of $0.2 million as of September 30,
2006. As of September 30, 2006, $0.3 million of unrecognized compensation cost
related to the PSUs is expected to be recognized over the remaining expected
service period of 18 months.
Note
7 - Restructuring:
In
December 2002, we implemented a reduction in force at our Palo Alto
location and elected to vacate certain buildings in Palo Alto. As a result
of these actions, we incurred a restructuring charge of $2.6 million in 2002
relating to employee severance packages and the remaining rents due on excess
facilities in Palo Alto that we no longer occupy. In 2003, we recorded a
credit to operating expenses of $0.1 million as a result of modifications to
the
severance packages of certain employees. On January 19, 2006, we commenced
restructuring actions to improve our cost structure. These actions include
the
closure of our Palo Alto, California manufacturing facility and a reduction
in
force at our Palo Alto site in the first half of 2006. As a result of these
actions, we incurred a restructuring charge of $1.0 million during the first
nine months of 2006 relating to employee severance packages and related facility
closure charges.
The
following tables set forth the beginning and ending liability balances relating
to the above described restructuring activities as well as activity during
the
nine month periods ended September 30, 2006 and October 2, 2005 (in
thousands):
|
|
Restructuring
Plan
2006
|
|
Restructuring
Plan
2002
|
|
|
|
Severance
and
Benefits
|
|
Facilities
Related
and
Other
|
|
Facilities
Related
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Balance
at January 1, 2005
|
|
$
|
-
|
|
$
|
-
|
|
$
|
274
|
|
$
|
274
|
|
Provisions
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Adjustment
to reserve
|
|
|
-
|
|
|
-
|
|
|
-
|
|
|
-
|
|
Cash
payments
|
|
|
-
|
|
|
-
|
|
|
(21
|
)
|
|
(21
|
)
|
Balance
at October 2, 2005
|
|
$
|
-
|
|
$
|
-
|
|
$
|
253
|
|
$
|
253
|
|
|
|
Severance
and Benefits
|
|
Facilities
Related
and
Other
|
|
Facilities
Related
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Balance
at January 1, 2006
|
|
$
|
-
|
|
$
|
-
|
|
$
|
199
|
|
$
|
199
|
|
Provisions
|
|
|
375
|
|
|
753
|
|
|
-
|
|
|
1,128
|
|
Adjustment
to reserve
|
|
|
(5
|
)
|
|
(149
|
)
|
|
-
|
|
|
(154
|
)
|
Cash
payments
|
|
|
(349
|
)
|
|
(449
|
)
|
|
(53
|
)
|
|
(851
|
)
|
Balance
at September 30, 2006
|
|
$
|
21
|
|
$
|
155
|
|
$
|
146
|
|
$
|
322
|
|
At
September 30, 2006, $0.3 million was included in other accrued liabilities,
and
a minimal amount was included in other long-term liabilities in the condensed
consolidated balance sheet.
Note
8 - Guarantees:
The
Company establishes a reserve for sales returns and warranties for specifically
identified, as well as anticipated sales returns and warranties based on
experience. The activity in the reserve for sales returns and warranties account
during the nine-month periods ended September 30, 2006 and October 2, 2005
were
as follows (in thousands):
|
|
Balance
at December 31, 2005
|
|
Provision
|
|
Utilized
|
|
Balance
at September30,
2006
|
|
Accrued
sales returns and warranty
|
|
$
|
1,556
|
|
$
|
571
|
|
$
|
(570
|
)
|
$
|
1,557
|
|
|
|
Balance
at December 31, 2004
|
|
Provision
|
|
Utilized
|
|
Balance
at October 2, 2005
|
|
Accrued
sales returns and warranty
|
|
$
|
2,701
|
|
$
|
21
|
|
$
|
(1,137
|
)
|
$
|
1,585
|
|
These
amounts are included in other accrued liabilities in the condensed consolidated
balance sheets.
Note
9 - Comprehensive Income (Loss):
The
Company has adopted the provisions of SFAS No. 130 "Reporting Comprehensive
Income". SFAS 130 establishes standards for reporting and display in the
financial statements of total net income (loss) and the components of all other
non-owner changes in equity, referred to as comprehensive income (loss).
Accordingly, the Company has reported the translation gain (loss) from the
consolidation of its foreign subsidiary in comprehensive income
(loss).
The
components of comprehensive income (loss) for the three and nine-month periods
ended September 30, 2006 and October 2, 2005 were as follows (in
thousands):
|
|
Three
months ended
|
|
Nine
months ended
|
|
|
|
September
30,
2006
|
|
October
2,
2005
|
|
September
30,
2006
|
|
October
2,
2005
|
|
Foreign
Currency Translation Adjustment
|
|
$
|
(141
|
)
|
$
|
(28
|
)
|
$
|
704
|
|
$
|
(1,568
|
)
|
Net
Income (Loss)
|
|
|
(2,721
|
)
|
|
15
|
|
|
(5,435
|
)
|
|
3,109
|
|
Other
Comprehensive Income (Loss)
|
|
$
|
(2,862
|
)
|
$
|
(13
|
)
|
$
|
(4,731
|
)
|
$
|
1,541
|
|
The
components of accumulated other comprehensive income were as follows at
September 30, 2006 (in thousands):
Accumulated
Other Comprehensive Income at December 31, 2005
|
|
$
|
2,532
|
|
Foreign
Currency Translation Adjustment
|
|
|
704
|
|
Accumulated
Other Comprehensive Income at September 30, 2006
|
|
$
|
3,236
|
|
Note
10 - Recent Accounting Pronouncements
In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 157, “Fair Value Measurements”
(“SFAS 157”). This statement defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles and expands
disclosures about fair value measurements. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years. We are currently evaluating the
effect that the adoption of SFAS 157 will have on our financial position and
results of operations.
On
September 13, 2006, the Securities and Exchange Commission (“SEC”) issued Staff
Accounting Bulletin No. 108 (“SAB 108”). The interpretations in SAB 108 were
issued to address diversity in practice in quantifying financial statement
misstatement and the potential under current practice for the build up of
improper amounts on the balance sheet. We are currently evaluating the effect
that the adoption of SAB 108 will have on our financial position and results
of
operations.
Item
2--Management's Discussion and Analysis of Financial Condition
and Results of Operations:
The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our unaudited condensed
consolidated financial statements and notes thereto appearing elsewhere in
this
report. This discussion and analysis contains forward-looking statements that
involve risks and uncertainties, including those discussed below under
"Forward-Looking Statements" and "Risk Factors" and in our Annual Report on
Form 10-K for the year ended December 31, 2005. You should not place undue
reliance on these forward-looking statements. Actual results may differ
materially from those anticipated in the forward-looking statements. These
forward-looking statements represent our judgment as of the date of the filing
of this Form 10-Q.
Overview
We
are a
global developer, manufacturer and marketer of thin film coatings on flexible
substrates for the automotive glass, electronic display, architectural glass
and
window film markets. We have developed a variety of products that control
sunlight in automotive glass, reduce light reflection, reduce electromagnetic
radiation and improve image quality in electronic display products and conserve
energy in architectural products. Our products consist of transparent
solar-control films for automotive glass; anti-reflective films for computer
screens, including flat panel displays and plasma displays; transparent
conductive films for use in touch screen and liquid crystal displays; energy
control films for architectural glass; and various other coatings.
Restructuring
and financing activities.
As a
consequence of the decline in our revenues and negative cash flows in 2003,
we
implemented several cost cutting and business restructuring activities during
2003 and 2004. These activities, which included employee layoffs and the closure
of several facilities (including the closure of our Tempe manufacturing facility
in the fourth quarter of 2003), were designed to improve our cash flow from
operations to allow us to continue as a going concern. During the fourth quarter
of 2003 and the first quarter of 2004, we agreed to new payment terms with
all
of our major creditors and vendors, which extended or reduced our payment
obligations. We also issued $4.5 million of convertible promissory notes and
warrants to investors. The convertible promissory notes were converted to Series
A 10% Cumulative Preferred Stock and the warrants were exercised for shares
of
common stock in the fourth quarter of 2004. On January 19, 2006, we commenced
restructuring actions to improve our cost structure. These actions included
the
closure of our Palo Alto, California manufacturing facility and a reduction
in
force at our Palo Alto site in the first half of 2006. We are targeting a
reduction in our total operating expenses of approximately $4 million on an
annual basis from these restructuring activities. As a result of these actions,
we incurred a restructuring charge of $1.0 million during the first nine months
of 2006 relating to employee severance packages and facility related charges
(see Note 7 of Notes to Unaudited Condensed Consolidated Financial
Statements--Restructuring).
Demand
for our customers' products.
We
derive significant benefits from our relationships with a few large customers
and suppliers. Our revenues and gross profit can increase or decrease rapidly
reflecting underlying demand for the products of one or a small number of our
customers. We may also be unable to replace a customer when a relationship
ends
or demand for our product declines as a result of evolution of our customers'
products.
Our
three
largest customers in the automotive glass and window film markets include
Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings Pte. Ltd., or
Globamatrix, which collectively accounted for approximately 45%, 54% and 45%
of
our total revenues during the first nine months of 2006, and during fiscal
year
2005 and fiscal year 2004, respectively.
Under
our
agreement with Globamatrix, as amended, Globamatrix agreed to an annual minimum
purchase commitment which was $9.0 million of product in 2004.
For each
year after 2004 through and including 2011, Globamatrix is required to purchase
an amount of product equal to 110% of the amount of product it was required
to
purchase in the prior year. Globamatrix is obligated to purchase $10.9 million
of product in 2006. During the first nine months of 2006, Globamatrix purchased
approximately $8.8 million of product.
During
the first nine months of 2006, our revenues in the automotive market decreased
due to a reduction in demand from Saint Gobain. The reduction in demand was
due
to the ongoing “de-contenting” (a change by auto manufacturers to make the parts
in which our products are found optional features rather than standard features
to control their costs) trend in the automotive industry.
Sales
returns and allowances. Our
gross margins and profitability have been adversely affected from time to time
by product quality claims. From 2003 to 2005, our sales returns provision has
averaged approximately 2.5% to 4.5% of gross revenues. During the first nine
months of 2006, our sales returns provision has averaged approximately 4.2%
of
our gross revenues due to quality claims received during the
period.
Critical
Accounting Policies and Estimates
The
accompanying discussion and analysis of our financial condition and results
of
operations are based upon our condensed consolidated financial statements,
which
have been prepared in accordance with generally accepted accounting principles
in the United States (U.S. GAAP). The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts
of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. These estimates form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. We base our estimates and judgments on historical
experience and on various other assumptions that we believe are reasonable
under
the circumstances. However, future events cannot be forecasted with certainty
and the best estimates and judgments routinely require adjustment. We are
required to make estimates and judgments in many areas, including those related
to revenue recognition, allowance for doubtful accounts and sales returns,
valuation of inventories, assessment of probability of the outcome of current
litigation, restructuring costs, stock-based compensation expense, impairment
charge for long-lived assets and accounting for income taxes. We believe the
policies disclosed are the most critical to our financial statements because
their application places the most significant demands on management's judgment.
Senior management has discussed the development, selection and disclosure of
these estimates with the Audit Committee of our Board of Directors.
We
believe there have been no significant changes during the first nine months
of
fiscal 2006 to the items that we disclosed as our critical accounting policies
and estimates in our discussion and analysis of financial condition and results
of operations in our 2005 Form 10-K, except as noted below.
Valuation
of Inventories
In
January 2006, we changed our inventory valuation method from the first-in,
first-out method to the average cost method. With the closing of our Palo Alto,
California manufacturing facility and all production now being performed in
our
German subsidiary's facility, the use of the average cost method was deemed
preferable as it both accommodates our German subsidiary's statutory reporting
requirements and fairly approximates actual costs. In addition, the impact
of
the change was $0.3 million which we consider immaterial.
Stock
Based Compensation Expense
We
account for stock-based compensation in accordance with the provisions of SFAS
123R. Under the fair value recognition provisions of SFAS 123R, stock based
compensation cost is estimated at the grant date based on the fair value of
the
award and is recognized as expense ratably over the requisite service period
of
the award. Determining the appropriate fair value model and calculating the
fair
value of stock-based awards requires judgment, including estimating stock price
volatility, forfeiture rates and expected lives.
Three
Months Ended September 30, 2006 compared with Three Months Ended October 2,
2005
Results
of Operations
Net
revenues. Our
net
revenues for the three months ended September 30, 2006 and October 2, 2005
were
$9.6 million and $12.0 million, respectively. The decline in revenues affected
all of our product lines, except for our architectural products.
Our
net
revenues in our window film product line decreased by $1.5 million, or 38%,
from
$3.9 million in the third quarter of 2005 to $2.4 million in the same period
in
2006. In the second half of 2005, we ceased converting (processing the sputtered
film into finished applied window film) for one of our window film product
models and agreed with our customer that they would take over responsibility
for
this process. This resulted in a decline in average sales prices for our TX
product line and a majority of the decrease in window film market net revenues.
In addition, the returns and allowances provision for window film was $0.6
million higher in the third quarter of 2006 as compared to the same period
of
2005. The higher allowance was a result of supplier quality problems. Shipments
of the product have been stopped until the exact cause of the defect is
identified. Resolution of this defect is expected to occur during the fourth
quarter.
Our
net
revenues in the automotive market decreased by $0.8 million, or 22%, from $3.9
million in the third quarter of 2005 to $3.0 million in the same period of
2006.
The decrease was primarily due to a reduction in demand in 2006 by Saint Gobain
as a result of the ongoing “de-contenting” (a change by auto manufacturers to
make the parts in which our products are found optional features rather than
standard features to control their costs) trend in the automotive industry,
partially offset by increases in demand from some of our Automotive Replacement
Glass customers.
Our
net
revenues in the electronic display market decreased by $0.5 million, or 16%,
from $3.0 million in the third quarter of 2005 to $2.6 million for the same
period of 2006. The decrease was due to lower shipments to our major customer
in
the electronic display market which was the result of using our limited machine
capabilities for research and development of a potential new product for this
customer. In addition, we encountered yield issues with one electronic display
product as we transferred the manufacture of this product from our Palo Alto
facility to our German facility. We are focused on improving the yield for
this
product at our German plant..
Our
net
revenues in the architectural market increased by approximately $0.4 million,
or
31%, from $1.2 million in the third quarter of 2005 to $1.6 million in the
same
period of 2006. The increase was due primarily to an increase in sales in the
U.S. region due to higher demand for energy efficient products.
Cost
of revenues.
Cost of
revenues consists of materials, subcontractor services, labor and manufacturing
overhead. Cost of revenues was $5.7 million in the third quarter of 2006
compared to $7.9 million in the same period of 2005. The decrease in cost
of revenues was primarily due to lower revenues, transfer of production to
our
lower cost German manufacturing facility, and savings related to the shutdown
of
our manufacturing facility in Palo Alto.
Gross
profit.
Our
gross profit decreased $0.2 million from $4.1 million in the third quarter
of
2005 to $3.9 million in the same period of 2006. As a percentage of sales,
gross
profit increased from 34% in the third quarter of 2005 to 41% in the same period
in 2006. As a result of shutting down our Palo Alto operation most of our
manufacturing is now performed in Germany resulting in full overhead absorption
at that location. The combination of eliminating cost at Palo Alto and full
utilization in Germany accounted for the entire gross profit percentage
improvement from 34% during the third quarter 2005 to 41% during the third
quarter of 2006.
Operating
expenses
Research
and development.
Research and development expenses increased $0.3 million from $1.3 million
in
the third quarter of 2005 to $1.7 million in the same period of 2006. The
increase from year to year was due the cost associated with the development
of a
potential new display product for our largest electronic display customer and
to
an increase in employees involved in research and development year over
year.
Selling,
general and administrative.
Selling, general and administrative expenses consist primarily of corporate
and
administrative overhead, selling commissions and occupancy costs. Selling,
general and administrative expenses increased $2.6 million from $2.1 million
in
the third quarter of 2005 to $4.7 million in the same period of 2006. The
increase in general and administrative expenses in the third quarter of 2006
was
primarily due to the accrual of leasehold retirement obligations and other
expenses of approximately $1.7 million related to the closure of our Palo Alto
manufacturing facility, a severance cost of approximately $0.3 million,
approximately $0.2 million for legal fees and settlement cost on an employee
lawsuit and higher legal, consulting and accounting fees of approximately $0.4
million.
Impairment
charge (recoveries) for long-lived assets.
In the
third
quarter
of 2006, we sold certain machinery for $0.3 million from our recently closed
Palo Alto manufacturing location. No such sales occurred in the third quarter
of
2005.
Restructuring.
On
January 10,
2006,
we commenced restructuring actions to improve our cost structure. These actions
include the closure of our Palo Alto, California manufacturing plant and a
reduction in force at our Palo Alto site in the first half of 2006. As a result
of these actions, we incurred an additional $0.3 million during the third
quarter of 2006 primarily relating to outside services to decommission our
manufacturing equipment and scrapped production materials. There was no such
restructuring charge in the third quarter of 2005.
Income
(loss) from operations.
Loss
from operations was $2.3 million in the third quarter of 2006 as compared to
income of approximately $0.7 million in same period of 2005. The decrease was
primarily due to a decrease in revenue, an increase in research and development
costs, recognition of stock based employee compensation expenses, and
restructuring charges and impairment charges in the third quarter of 2006 as
detailed above.
Interest
expense, net.
Interest
expense, net remained unchanged at $0.2 million in the third quarter of 2006,
which is the same amount as during the third quarter of 2005.
Other
income (expense), net.
Other
income (expense), net, mainly reflects foreign exchange transaction gains and
losses. Some
of
our transactions with foreign customers and suppliers are denominated in foreign
currencies, principally the Euro. As exchange rates fluctuate relative to the
U.S. dollar, exchange gains and losses occur. We incurred $34,000 of exchange
loss during the third quarter of 2006 compared to an exchange gain of $9,000
during the third quarter of 2005.
Income
(loss) before provision for income taxes.
We
recorded a pre-tax loss of $2.5 million in the third quarter of 2006 compared
to
pre-tax income of $0.5 million in the third quarter of 2005. The 2006 loss
of
$2.5 million was primarily due to an increase in selling, general and
administrative expenses, lower revenue, and increase in research and development
costs as discussed above.
Provision
for income taxes.
The
decrease of approximately $0.3 million from $0.5 million to $0.2 million in
the provision for income taxes in the third quarter of 2006 compared to the
same
period in 2005 is related to lower taxable income in 2006 in our foreign
subsidiary, Southwall Europe GmBH, or SEG. There are no United States income
taxes included in the provision as the Company has a net operating loss carry
forward for U.S. tax purposes.
Net
income (loss).
In the
third quarters of 2006 and 2005, we recorded a net loss of $2.7 million and
net
income of $15,000, respectively. The decrease of $2.7 million was primarily
due
to a decrease in revenue, an increase in research and development costs, an
increase in selling, general and administrative costs, leasehold retirement
obligation costs, recognition of a stock based employee compensation
expense and restructuring charges.
Deemed
dividend on preferred stock.
We
accrued $0.1 million of deemed dividend on preferred stock in each of the third
quarters of 2006 and 2005. The holders of our secured convertible promissory
notes converted those notes to shares of Series A preferred stock in December
2004. The Series A preferred stock accrues cumulative dividends at the rate
of
10% per annum.
Nine
Months Ended September 30, 2006 compared with Nine Months Ended October 2,
2005
Results
of Operations
Net
revenues.
Our net
revenues for the nine months ended September 30, 2006 and October 2, 2005 were
$31.0 million and $42.8 million, respectively.
Our
net
revenues in the automotive market decreased by $5.5 million, or 36%, from $15.2
million in the first nine months of 2005 to $9.7 million in the same period
of
2006. The decrease was primarily due to a reduction in demand throughout the
first nine months of 2006 by a major customer as a result of their large
inventory build-up at 2005 year end and the ongoing “de-contenting” (a change by
auto manufacturers to make the parts in which our products are found optional
features rather than standard features to control their costs) trend in the
automotive industry.
Our
net
revenues in the window film market decreased by $4.2 million, or 32%, from
$13.0
million in the first nine months of 2005 to $8.9 million in the same period
in
2006. In the second half of 2005, we ceased converting (processing the sputtered
film into finished applied window film) for one of our window film product
models and agreed with our customer that they would take over responsibility
for
this process. This resulted in a decline in average sales prices for one TX
product line. In addition, revenues for our other window film product lines
were
higher in the first half of 2005 due to the fact that the last shipment from
the
fourth quarter of 2004 was rescheduled into the beginning of the first quarter
of 2005 at the customer's request, resulting in unusually high sales for this
product line in the first nine months of 2005. In addition, the returns and
allowances provision for window film was $0.6 million higher in the first nine
months of 2006 as compared to the same period of 2005. The higher allowance
was
a result of supplier quality problems. Shipments of the product have been
stopped until the exact cause of the defect is identified. Resolution of this
defect is expected to occur during the fourth quarter.
Our
net
revenues in the electronic display market decreased by $2.1 million, or 20%,
from $10.4 million in the first nine months of 2005 to $8.3 million in the
same
period of 2006. The decrease was due to the termination of the AR product line,
a decline in demand for Silver reflector film for the LCD back-light market
and
reduced average sales prices on film sold to Mitsui for Plasma Display Panel,
or
PDP, filters. An overall decrease in the average selling prices for PDP products
resulted in price pressures on all suppliers in the market. In addition, we
encountered yield issues with one electronic display product as we transferred
the manufacture of this product from our Palo Alto facility to our German
facility. We are focused on improving the yield for this product at our German
plant.
Our
net
revenues in the architectural market were essentially flat year over year with
$4.0 million in revenue for the first nine months of 2006 as compared to $4.2
million for the first nine months of 2005.
Cost
of revenues.
Cost of
revenues was $19.3 million in the first nine months of 2006 compared to $29.0
million in the same period of 2005. The decrease in cost of revenues was
primarily due to lower revenues, transfer of production to our lower cost German
manufacturing facility, manufacturing savings as a result of closing our Palo
Alto manufacturing location, partially offset by inventory reserves for our
window film products.
Gross
profit and gross margin.
Our
gross profit decreased $2.2 million from $13.9 million in the first nine months
of 2005 to $11.7 million in the same period of 2006. As a percentage of sales,
gross profit increased from 32% in the first nine months of 2005 to 38% in
the
same period in 2006. As a result of shutting down our Palo Alto operation,
most
of our manufacturing is now performed in Germany resulting in full overhead
absorption at that location. The combination of eliminating unabsorbed cost
at
Palo Alto and full utilization in Germany accounted for the entire gross profit
percentage improvement from 32% during the first nine months of 2005 to 38%
during the first nine months of 2006. This benefit was partially reduced by
lower margins in our electronic display products and inventory reserves for
the
window film products.
Operating
expenses
Research
and development.
Research and development expenses increased $2.3 million from $3.0 million
in
the first nine months of 2005 to $5.4 million in the same period of 2006. The
increase from year to year was due primarily to an increase in labor and
employee benefits costs as a result of expanding our engineering organization.
In June 2005, we hired a new Chief Technology Officer and Senior Vice President,
and a new Director of Engineering for the automotive market. In September 2005,
we hired a new Director of Engineering for the electronic display market. In
addition, we spent more on research and development materials in the first
nine
months of 2006 than in the same period in 2005. We expect expenditures relating
to research and development for the remainder of 2006 to be lower than their
average for the first nine months of 2006.
Selling,
general and administrative.
Selling, general and administrative expenses increased $3.3 million from $6.5
million in the first nine months of 2005 to $9.8 million in the same period
of
2006. The increase in general and administrative expenses in the first nine
months of 2006 as compared to the same period 2005 was primarily due to a
severance package and leasehold retirement obligations on the closure of two
Palo Alto facilities of approximately $2.0 million. Additional increases to
selling, general and administrative expenses were due to stock based
compensation expense, and higher legal, accounting and consulting costs in
2006.
Impairment
charge (recoveries) for long-lived assets.
As a
result of our decision to cease manufacturing in Palo Alto, we recorded a $0.3
million impairment charge related to a production machine which was
decommissioned in the second quarter of 2006. There was no such charge in the
first
nine months
of 2005.
In addition, in the first
nine months
of 2006,
we recorded the recovery of $0.2 million of previously recorded impairment
charges related to long-lived assets which were impaired in prior and current
years. In the first
nine months
of 2005,
we recorded the recovery of $0.2 million of previously recorded impairment
charges related to the final payment from the sale of a production machine
which
was impaired in the third quarter of 2003. Also, in the third quarter 2006,
we
sold two machines for $0.3 million that were previously written
down.
Restructuring.
On
January 19, 2006, we commenced restructuring actions to improve our cost
structure. These actions include the closure of our Palo Alto, California
manufacturing facility and a reduction in force at our Palo Alto site in the
first half of 2006. As
a
result of these actions, we incurred a restructuring charge of $1.0 million
during the first nine months of 2006 relating to employee severance packages,
outside services relating to decommissioning our production machine and
scrapping some of our production materials. There
was
no such restructuring charge in the first
nine months
of 2005.
Income
(loss) from operations.
The
loss from operations for the first nine months of 2006 was $4.3 million as
compared to an operating income of $4.5 million in the first nine months of
2005. The loss was primarily due to a decrease in revenue, an increase in
selling, general and administrative expenses, an increase in research and
development costs, recognition of a stock based employee compensation expense,
and restructuring charges in the first nine months of 2006 as detailed above.
Interest
expense, net. Interest
expense, net, decreased $0.2 million from $0.8 million in the first nine months
of 2005 to $0.6 million in the same period of 2006. The decrease in interest
expense was primarily attributable to less outstanding debt during the first
nine months of 2006 compared to the same period in 2005.
Other
income, net.
In
the
first
nine months
of 2006,
the net exchange gain due to Euro fluctuation was $0.1 million compared to
a net
exchange loss of $0.3 million in the same period in 2005. In addition to the
exchange gain recognized in the first nine months of 2006, our German
subsidiary, Southwall Europe GmBH, or SEG, received a $0.1 million energy and
waste rebate refund from the German government. The exchange loss incurred
in
the first nine months of 2005 was offset by an energy and waste rebate refund
of
$0.4 million received by SEG from the German government.
Income
(loss) before provision for income taxes.
We
recorded a pre-tax loss of $4.7 million in the first
nine months
of 2006
and pre-tax income of $3.9 million in the first
nine months
of 2005.
The decrease of $8.6 million was primarily due to a decrease in revenue, an
increase in selling, general and administrative expenses, increase in research
and development costs, recognition of stock based employee compensation expense,
and restructuring charges in the first nine months of 2006.
Provision
for income taxes.
The
provision for income taxes of $0.7 million and $0.8 million for the first nine
months of 2006 and 2005 respectively, primarily relate to SEG our German
subsidiary. There are no United States income taxes included in the provision
as
we have a net operating loss carry-forward for U.S. tax purposes.
Net
income (loss).
In the
first
nine months
of 2006
and 2005, we recorded a net loss of $5.4 million and net income of $3.1 million,
respectively. The decrease was primarily due to a decrease in revenue, an
increase in selling, general and administrative expenses, an increase in
research and development costs, recognition of stock based employee compensation
expense, and restructuring charges.
Deemed
dividend on preferred stock.
We
accrued $0.4 million of deemed dividend on the Series A preferred stock in
the
first
nine months
of 2006
and 2005. The Series A preferred stock accrues cumulative dividends at the
rate
of 10% per annum.
Liquidity
and capital resources.
Liquidity
Our
principal liquidity requirements are for working capital, consisting primarily
of accounts receivable and inventories. We believe that because of the
relatively long production cycle of certain of our products, our inventories
will continue to represent a significant portion of our working
capital.
Our
cash
and cash equivalents decreased $1.6 million from $6.6 million at December 31,
2005 to $5.0 million at September 30, 2006. Cash used in operating activities
of
$0.1 million for the first nine months of 2006 was primarily the result of
a net
loss of $5.4 million and a deferred rent payment of $1.2 million, partially
offset by non-cash depreciation of $1.8 million, decreases in accounts
receivable of $2.0 million, a decrease in inventories of $0.6 million, an
increase in accounts payable and accrued liabilities of $2.0 million and a
non-cash stock compensation expense of $0.5 million. Cash provided from
operations for the first nine months of 2005 of $5.3 million was primarily
the
result of net income of $3.1 million, non-cash depreciation of $1.7 million,
and
decreases in accounts receivable of $1.5 million, in inventories of $1.1 million
and in other current and non-current assets of $0.7 million, partially offset
by
impairment recoveries from long-lived assets of $0.2 million and a decrease
in
accounts payable and accrued liabilities of $2.6 million.
Cash
used
in investing activities for the first nine months of 2006 was $0.2 million
and
was primarily the result of capital expenditures of $0.8 million reduced by
the
proceeds of $0.4 million from the sale of assets and a decrease in restricted
cash of $0.2 million. Cash used in investing activities for the first nine
months of 2005 was $0.1 million, primarily the result of a decrease in
restricted cash of $0.2 million and proceeds from the sale of fixed assets
of
$0.2 million, offset by capital expenditures of $0.5 million.
Cash
used
in financing activities for the first nine months of 2006 was $1.3 million
and
was primarily the result of payments of $1.1 million on our borrowings. Cash
used in financing activities for the first nine months of 2005 of $1.3 million
was primarily the result of principal payments on borrowings.
We
entered into an agreement with the Saxony government in May 1999 under
which we receive investment grants. As of September 30, 2006, we had
received 5.0 million Euros or $5.0 million at historical exchange rate of
the grants and accounted for these grants by applying the proceeds received
to
reduce the cost of our fixed assets in our Dresden manufacturing facility.
Additionally, as of September 30, 2006, we had a balance remaining from the
government grants that we are entitled to receive of $0.2 million, which has
been recorded as an advance and held as restricted cash until we receive
approval from the Saxony government to apply the funds to reduce our capital
expenditures. The total annual amount of investment grants and investment
allowances that we are entitled to seek varies from year to year based upon
the
amount of our capital expenditures that meet certain requirements of the Saxony
government. Generally, we are not eligible to seek investment grants and
allowances in the aggregate for any year in excess of 33% of our eligible
capital expenditures in Germany for that year. The measurement date of these
requirements was June 30, 2006, at which time we did not meet some of these
requirements. If we fail to meet certain requirements in connection with these
grants, the Saxony government has the right to demand repayment of the grants.
In June 2006, we re-filed to amend our agreement with the Saxony government.
In
this amendment, we sought to modify the amount of capital spending required
to
have been spent through June 30, 2006, to reflect the actual amount spent and
to
count workstations instead of employees. We expect a Saxony government audit
at
SEG in the latter part of 2006. We expect to negotiate with the State of Saxony
to reach an agreement on our requested amendment by the end of 2006 or early
2007. No assurance can be given, however, that such negotiations will be
successful or what the outcome will be.
Borrowing
arrangements
On
April
28, 2005, we entered into a credit agreement (the “Credit Agreement”) with Wells
Fargo HSBC Trade Bank, N.A. (the “Bank”). The Credit Agreement provided for two
facilities. All amounts borrowed under both facilities under the Credit
Agreement had to be repaid on or before May 31, 2006. We renewed the first
credit facility for another year in May 2006. We did not renew the second
facility of the Credit Agreement.
The
credit facility includes a revolving line of credit under which we may from
time
to time borrow up to $3 million, subject to satisfaction of certain conditions.
Amounts borrowed under the credit facility bear interest at the prime rate
minus
1.75% per annum or LIBOR plus 1% per annum, at our option. We borrowed
approximately $3.0 million from this facility on April 28, 2005 which amount
remained outstanding as of September 30, 2006.
All
borrowings under the Credit Agreement are collateralized by a letter of credit
posted by Needham & Company, one of our stockholders. There are no financial
covenants to this Credit Agreement.
The
terms
of the Credit Agreement, limit our ability to (i) merge into or consolidate
with
any other entity, (ii) make any substantial change in the nature of our business
as conducted as of the date hereof, (iii) acquire all or substantially all
of
the assets of any other entity for an amount greater than $3 million, (iv)
sell,
lease, transfer or otherwise dispose of all or a substantial or material portion
of our assets except in the ordinary course of business.
The
foregoing description does not purport to be a complete statement of the
parties' rights and obligations under the Credit Agreement and the transactions
contemplated thereby or a complete explanation of the material terms
thereof.
Capital
expenditures
We
expect
to spend approximately $1.5 million in 2006 on upgrades and refurbishment of
our
production machines and research and development tools.
We spent
approximately $0.8 million in capital expenditures during the first nine months
of 2006.
Future
payment obligations
Our
future payment obligations on our borrowings pursuant to our term debt, line
of
credit, non-cancelable operating leases and other non-cancelable contractual
commitments are as follows at September 30, 2006 (in thousands):
|
|
|
|
Less
|
|
|
|
|
|
Greater
|
|
|
|
|
|
Than
|
|
|
|
|
|
Than
|
|
|
|
Total
|
|
1
Year
|
|
1-3
Years
|
|
3-5
Years
|
|
5
Years
|
|
Contractual
Obligations:
|
|
|
|
|
|
|
|
|
|
|
|
Term
debt (1)
|
|
$
|
9,574
|
|
$
|
1,030
|
|
$
|
2,061
|
|
$
|
3,793
|
|
$
|
2,690
|
|
Line
of credit
|
|
|
2,996
|
|
|
2,996
|
|
|
--
|
|
|
--
|
|
|
--
|
|
Operating
leases (2)
|
|
|
2,136
|
|
|
482
|
|
|
835
|
|
|
819
|
|
|
--
|
|
Total
contractual cash obligations
|
|
$
|
14,706
|
|
$
|
4,508
|
|
$
|
2,896
|
|
$
|
4,612
|
|
$
|
2,690
|
|
|
(1)
|
Represents
loan agreements with Portfolio Financing Servicing Company, Wells
Fargo
Bank and several German banks.
|
|
(2)
|
Represents
the remaining rents owed on buildings we rent in Palo Alto,
California.
|
On
June
13, 2006, we signed a sublease agreement with Maxspeed to sublease 3782-3788
Fabian Way, Palo Alto, California 94303. The term of this sublease commenced
on
June 16, 2006 and will continue until December 31, 2008, with monthly rent
payments of $17,920 through May 31, 2007, $18,368 through May 31, 2008, and
$19,040 through December 31, 2008.
On
June
21, 2006, we amended our lease with Richard Christina to extend our original
lease through June 30, 2011 for the facilities at 3780 Fabian Way, Palo Alto,
California 94303. Also, on June 21, 2006, we entered into a lease agreement
with
Richard Christina to lease 3782-3788 Fabian Way, Palo Alto, California. The
term
of this lease extends the rental term for all premises (3780 and 3782-3788
Fabian Way, Palo Alto, California) to June 30, 2011 at a Base Rent of $37,717.50
per month. On January 1, 2010 and 2011, the Base Rent shall increase by
3%.
Item
3--Quantitative and Qualitative Disclosures about Market
Risk
We
are
exposed to the impact of interest rate changes, foreign currency fluctuations,
and changes in the market values of our investments.
Financing
risk:
Our
exposure to market rate risk for changes in interest rates relates primarily
to
our line of credit which bears an interest rate equal to 1.0% above the bank
LIBOR rate (which was 5.25% at September 30, 2006) and is calculated based
on
amounts borrowed under the facility. In addition, the interest rate on one
of
our German loans has been reset to the prevailing market rate of 5.75% and
another of our German loans will have its interest rate reset to the prevailing
market rate in 2009. Fluctuations or changes in interest rates may adversely
affect our expected interest expense. The effect of a 10% fluctuation in the
interest rate on our line of credit and term debt would have had an immaterial
effect on our interest expense for the third quarter of 2006.
Investment
risk:
We
invest our excess cash in money market accounts and, by practice, limit the
amount of exposure to any one institution. Investments in both fixed rate and
floating rate interest earning instruments carry a degree of interest rate
risk.
Fixed rate securities may have their fair market value adversely affected due
to
a rise in interest rates, while floating rate securities may produce less income
than expected if interest rates fall. The effect of a 10% fluctuation in the
interest rate on our excess cash investments would not have had a material
effect on our interest expense in the third quarter of 2006.
Foreign
currency risk:
International revenues (defined as sales to customers located outside of the
United States) accounted for approximately 66% of our total sales in the third
quarter of 2006. Approximately 43% of our international revenues were
denominated in Euros relating to sales from our Dresden operation in the third
quarter of 2006. The other 64% of our international sales were denominated
in US
dollars. In addition, certain transactions with foreign suppliers are
denominated in foreign currencies (principally Japanese Yen). The effect of
a
10% fluctuation in the Euro exchange rate would have had an effect of
approximately $0.2 million on net revenues for the third quarter of 2006 and
the
effect on expenses of a 10% fluctuation in the Yen exchange rate would have
been
immaterial.
FORWARD-LOOKING
STATEMENTS
This
Quarterly Report contains forward-looking statements, which are subject to
a
number of risks and uncertainties. All statements other than statements of
historical facts are forward-looking statements. These statements are identified
by terminology such as "may," "will," "could," "should," "expects," "plans,"
"intends," "seeks," "anticipates," "believes," "estimates," "potential," or
"continue," or the negative of such terms or other comparable terminology,
although not all forward-looking statements contain these identifying words.
Forward-looking statements are only predictions and include statements relating
to:
|
·
|
our
ability to remain as a going
concern;
|
|
·
|
our
strategy, future operations and financial plans, including, without
limitation, our plans to install and commercially produce products
on new
machines;
|
|
·
|
the
success of our restructuring activities and our expectations as to
expense
reductions;
|
|
·
|
the
continued trading of our common stock on the Over-the-Counter Bulletin
Board;
|
|
·
|
our
projected need for, and ability to obtain, additional borrowings
and our
future liquidity;
|
|
·
|
future
applications of thin-film technologies and our development of new
products;
|
|
·
|
statements
about the future size of markets;
|
|
·
|
our
expectations with respect to future grants, investment allowances
and bank
guarantees from the Saxony
government;
|
|
·
|
our
expected results of operations and cash
flows;
|
|
·
|
pending
and threatened litigation and its outcome;
and
|
|
·
|
our
projected capital expenditures.
|
You
should not place undue reliance on our forward-looking statements. Actual events
or results may differ materially. In evaluating these statements, you should
specifically consider various factors, including the risks outlined below under
"Risk Factors" and under “Risk Factors” in our 2005 Form 10-K and in our Form
10-Qs for the first and second quarters of 2006. These factors may cause our
actual results to differ materially from any forward-looking statement. Although
we believe the expectations reflected in our forward-looking statements are
reasonable as of the date they are being made, we cannot guarantee our future
results, levels of activity, performance, or achievements. Moreover, neither
we,
nor any other person, assume responsibility for the future accuracy and
completeness of these forward-looking statements.
Item
4--Controls and Procedures
|
(a)
|
Evaluation
and Disclosure Controls and Procedures.
Under the supervision and with the participation of our management,
including our chief executive office and vice president of finance,
we
conducted an evaluation of the effectiveness of the design and operation
of our disclosure controls and procedures, as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
as of
September 30, 2006. Based on this evaluation, our chief executive
officer
and vice president of finance concluded as of the Evaluation Date
that our
disclosure controls and procedures were effective such that the
information relating to our Company, including our consolidated
subsidiary, required to be disclosed in our Securities and Exchange
Commission (“SEC”) reports (i) is recorded, processed, summarized and
reported with the time period specified in the SEC rules and forms,
and
(ii) is accumulated and communicated to our management, including
our
chief executive officer and vice president of finance, as appropriate
to
allow timely decisions regarding required
disclosure.
|
|
(b)
|
Report
on Internal Control Over Financial Reporting.
We will be required by the Sarbanes-Oxley Act to include an assessment
of
our internal control over financial reporting and an attestation
from
management in our annual report on Form 10-K beginning with the filing
for
our fiscal year ending December 31, 2007. In addition, we will need
an
attestation of our internal control from an independent registered
public
accounting firm in our Annual Report on Form 10-K beginning with
the
filing for our fiscal year ending December 31,
2008.
|
|
(c) |
Changes
in Internal Controls.
There were no changes during the first nine months of 2006 in our
internal
controls over financial reporting that have materially affected,
or are
reasonably likely to materially affect, the internal controls over
financial reporting.
|
PART
II--OTHER INFORMATION
Item
1--Legal Proceedings
The
Company was named as a defendant, along with Bostik, Inc., in an action
captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
Inc.,
Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court for
the
Northern District of California on June 18, 2002. The Company was served with
the Complaint in this matter on July 1, 2002. The plaintiff filed the matter
as
a class action on behalf of all entities and individuals in the United States
who manufactured and/or sold and warranted the service life of insulated glass
units manufactured between 1989 and 1999, which contained Southwall Heat Mirror
film and were sealed with a specific type of sealant manufactured by Bostik,
Inc. The plaintiff alleged that the sealant provided by Bostik, Inc. was
defective, resulting in elevated warranty replacement claims and costs. The
plaintiff asserted claims against the Company for breach of an implied warranty
of fitness, misrepresentation, fraudulent concealment, negligence, and negligent
interference with prospective economic advantage, breach of contract, unfair
business practices and false or misleading business practices. The plaintiff
sought recovery on behalf of the class of $100 million for damages allegedly
resulting from elevated warranty replacement claims, restitution, injunctive
relief, and non-specific compensation for lost profits. By Order entered
December 22, 2003, the Court dismissed all claims against the Company. The
plaintiff appealed to the Ninth Circuit Court of Appeals. On January 13, 2006,
the Court of Appeals affirmed the lower court decision. On January 26, 2006,
the
plaintiff filed a petition for rehearing with the Ninth Circuit Court of
Appeals. In March of 2006, the Ninth Circuit Court of Appeals denied the
plaintiff's petition. On May 26, 2006 the plaintiff filed a petition for writ
of
certiorari to the United Sates Supreme Court. On October 2, 2006, the Supreme
Court denied Wasco’s petition for writ certiorari.
The
insurance carriers in some of the litigation related to alleged product failures
and defects in window products manufactured by others in which the Company
was a
defendant in the past paid the defense and settlement costs related to such
litigation. Certain of those insurance carriers reserved their rights to recover
a portion or all of such payments from the Company. As a result, those insurance
carriers could seek from us up to an aggregate of $2 million plus defense
costs, although any such recovery would be restricted to claims that were not
covered by the Company's insurance policies. The Company intends to vigorously
defend any attempts by these insurance carriers to seek reimbursement. The
Company is not able to estimate the likelihood that these insurance carriers
will seek to recover any such payments, the amount, if any, they might seek,
or
the outcome of such attempts.
On
June
13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
Company in the Superior Court of California in and for the County of Santa
Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
Plaintiff's Complaint alleged claims for race discrimination, national origin
discrimination, retaliation, medical condition discrimination, breach of
contract, breach of fiduciary duty, fraud, negligence, intentional infliction
of
emotional distress, and punitive damages. The Company settled this suit in
October 2006 for an amount not considered to be material to the financial
statements of the Company.
In
addition, the Company is involved in certain other legal actions arising in
the
ordinary course of business. The Company believes, however, that none of these
actions, either individually or in the aggregate, will have a material adverse
effect on Southwall's business, Southwall's consolidated financial position,
and
results of operations or cash flows.
The
following information updates, and should be read in conjunction with, the
information disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form
10K for the year ended December 31, 2005 and filed with the SEC on March 29,
2006 and in Part II Item 1A of our Quarterly Reports on Form 10-Q for the
quarters ended March 31, 2006 and June 30, 2006.
Financial
Risks
Our
working capital position, financial commitments and historical performance
may
raise doubt about our ability to have positive earnings in the
future.
We
incurred net losses in the first nine months of 2006, and in 2005 and 2004
and
negative cash flows from operations in the first nine months of 2006 and in
2003. These factors together with our working capital position and our
significant debt service and other contractual obligations at September 30,
2006, may raise doubt about our ability to restore profitable operations,
generate cash flow from operating activities and obtain additional financing.
These and other factors related to our business during recent years, our past
failure to comply with covenants in our financing agreements and our voluntary
delisting from NASDAQ in March 2004 may make it difficult for us to secure
the
required additional borrowings on favorable terms or at all. We intend to seek
additional borrowings or alternative sources of financing; however, difficulties
in borrowing money or raising financing could have a material adverse effect
on
our operations, planned capital expenditures and ability to comply with the
terms of government grants.
Restrictions
or defaults under our credit and other loan agreements may prevent us from
borrowing or force us to curtail our operations.
As
of
September 30, 2006, we had total outstanding obligations under our credit and
other loan agreements of $12.6 million. Our inability to make timely payments
of
interest or principal under these facilities could materially adversely affect
our ability to borrow money under existing credit facilities, to secure
additional borrowings or to function as a going concern. Many of these loans
contain provisions that permit the lender to declare the loans immediately
due
if there is a material adverse change in our business. These credit facilities
also contain events of default that could require us to pay off indebtedness
before its maturity. The restrictions imposed by these credit facilities or
the
failure of lenders to advance funds under these facilities could force us to
curtail our operations or have a material adverse effect on our
liquidity.
We
expect to be subject to increased foreign currency risk in our international
operations.
In
2003,
2004, 2005 and during the first nine months of 2006, approximately 34%, 31%,
32%
and 43 % of our revenues, respectively, were denominated in Euros, primarily
related to sales from our Dresden operation, including sales to one of our
largest customers, a European automotive glass manufacturer. In addition, other
customers may request to make payments in foreign currencies. Also, certain
transactions with foreign suppliers are denominated in foreign currencies,
primarily Japanese Yen.
A
strengthening in the dollar relative to the currencies of those countries in
which we do business would increase the prices of our products as stated in
those currencies and could hurt our sales in those countries. Significant
fluctuations in the exchange rates between the U.S. dollar and foreign
currencies could cause us to lower our prices and thus reduce our profitability
and cash flows. These fluctuations could also cause prospective customers to
cancel or delay orders because of the increased relative cost of our
products.
Failure
to meet requirements under our investment grant agreements with the Saxony
government may require us to repay grants or force us to curtail our
operations.
We
entered into an agreement with the Saxony government in May 1999 under
which we receive investment grants. As of September 30, 2006, we had
received 5.0 million Euros or $5.0 million at historical exchange rate of
the grants and accounted for these grants by applying the proceeds received
to
reduce the cost of our fixed assets in our Dresden manufacturing facility.
If we
fail to meet certain requirements in connection with these grants, the Saxony
government has the right to demand repayment of the grants. The measurement
date
of these requirements was June 30, 2006, at which time we did not meet some
of
these requirements. We are currently seeking an amendment to our agreement
with
the Saxony Government which would bring us into compliance with the
requirements. If such negotiations are unsuccessful, we could be required to
repay the grants which would adversely effect our operations.
Operational
Risks
We
depend on a small number of customers for nearly all of our revenues, and the
loss of a large customer could materially adversely affect our revenues or
operating results.
Our
nine
largest customers accounted for approximately 79%, 82%, 79% and 84% of net
revenues during the first nine months of 2006 and in 2005, 2004 and 2003,
respectively. We expect to continue to derive a significant portion of our
net
sales from this relatively small number of customers. Accordingly, the loss
of a
large customer could materially hurt our business, and the deferral or loss
of
anticipated orders from a large customer or a small number of customers could
materially reduce our revenue and operating results in any period. Some of
our
largest automotive glass customers have used a technology--direct-to-glass
sputtering--as an alternative to our window films, which in 2003 resulted in
a
decrease in orders from these customers. The continued or expanded use of this
technology by our automotive glass customers would have a material adverse
effect on our results of operations and financial position.
Fluctuations
or slowdowns in the overall electronic display industry have and may continue
to
adversely affect our revenues.
Our
business depends in part on sales by manufacturers of products that include
electronic displays. The markets for electronic display products are highly
cyclical and have experienced periods of oversupply resulting in significantly
reduced demand for our products. For example, during the first nine months
of
2006, we experienced a decrease of 20% from the first nine months of 2005 in
our
net revenues in the electronic display market primarily due to lower demand
for
our sputtered thin film filter products for Plasma Display Panel products due
to
increased competition, and we expect this trend to continue. Mitsubishi Electric
was the only CRT manufacturer that buys our anti-reflective, or AR, film and
it
decided to consolidate all of the manufacturing of this product to Japan. In
connection with that consolidation, Mitsubishi ceased production of the 17"
AR
product in its Mexico plant during the third quarter of 2003. In 2005, we
stopped converting (cutting the film to the customer's specifications) one
of
our window film product models and agreed with our customers that they would
complete this process. This resulted in a decline in average sales prices for
the TX product line and the decrease in window film market net
revenues.
Our
business is susceptible to numerous risks associated with international
operations.
Revenues
from international sales amounted to approximately 66%, 74%, 79% and 89% of
our
net revenues during the first nine months of 2006 and in 2005, 2004 and 2003,
respectively. The distance between our two manufacturing sites creates
logistical and communications challenges. In addition, to achieve acceptance
in
international markets, our products must be modified to handle a variety of
factors specific to each international market as well as local regulations.
We
may also be subject to a number of other risks associated with international
business activities. These risks include:
|
·
|
unexpected
changes in and the burdens and costs of compliance with a variety
of
foreign laws and regulatory
requirements;
|
|
·
|
potentially
adverse tax consequences; and
|
|
·
|
global
economic turbulence and political
instability.
|
Item
2-- Unregistered Sales of Equity Securities and Use of
Proceeds
None.
Item
3--Defaults upon Senior Securities
Not
applicable.
Item
4--Submission of Matters to a Vote of
Stockholders
None
Item
5--Other Information
None.
Exhibit
Number
|
Item
|
|
|
|
Certification
of Principal Executive Officer pursuant to Exchange Act Rules 13a-14
and
15d-14
|
|
|
|
Certification
of Principal Financial Officer pursuant to Exchange Act Rules 13a-14
and
15d-14
|
|
|
|
Certification
of Principal Executive Officer pursuant to 18 U.S.C Section
1350
|
|
|
|
Certification
of Principal Financial Officer pursuant to 18 U.S.C Section
1350
|
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant
has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
Dated:
November 13, 2006
|
|
|
|
|
Southwall
Technologies Inc.
|
|
|
|
|
By:
|
/s/
Dr. Eugene Goodson
|
|
|
Dr.
Eugene Goodson
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President
and Chief Executive Officer
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By:
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/s/
Sylvia Kamenski
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Sylvia
Kamenski
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Vice
President of Finance
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