GEOSPACE TECHNOLOGIES CORP - Quarter Report: 2004 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

for the Quarterly Period Ended June 30, 2004

OR

Commission file number 001-13601

OYO GEOSPACE CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

7007 Pinemont Drive

Houston, Texas 77040-6601

(Address of Principal Executive Offices)

(713) 986-4444

(Registrant’s telephone number, including area code)

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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

There were 5,588,310 shares of the Registrant’s Common Stock outstanding as of the close of business on August 9, 2004.

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

OYO GEOSPACE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands)

The accompanying notes are an integral part of the consolidated financial statements.

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

1. Significant Accounting Policies

Basis of Presentation

The consolidated balance sheet of OYO Geospace Corporation and its subsidiaries (the “Company”) at September 30, 2003 was derived from the Company’s audited consolidated financial statements at that date. The consolidated balance sheet at June 30, 2004 and the consolidated statements of operations for the three and nine months ended June 30, 2004 and 2003, and the consolidated statements of cash flows for the nine months ended June 30, 2004 and 2003, were prepared by the Company, without audit. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary to present fairly the consolidated financial position, results of operations and cash flows were made. The results of operations for the three and nine months ended June 30, 2004 and 2003 are not necessarily indicative of the operating results for a full year or of future operations.

Certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States of America were omitted. The accompanying consolidated financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended September 30, 2003.

Inventories

The Company records a write-down of its inventory when the cost basis of any manufactured product (including any estimated future costs to complete the manufacturing process) exceeds its net realizable value. Inventories are stated at the lower of cost (as determined by the first-in, first-out method) or market value.

Revenue Recognition

Revenue is primarily derived from the sale, and short-term rental under operating leases, of seismic instruments and equipment and commercial graphics products. Sales revenues are generally recognized when the Company’s products are shipped and title and risk of loss have passed to the customer. Rental revenues are recognized as earned over the rental period. Rentals of the Company’s equipment are generally on a short-term basis and generally range from daily rentals to rental periods of up to six months. Except for certain of the Company’s reservoir characterization products, products are generally sold without any customer acceptance provisions and do not allow customers to return products for credit. In circumstances where acceptance provisions are significant, the revenue and related profit are deferred until such time as acceptance occurs. Most of the Company’s products do not require installation assistance from the Company or sophisticated instruction.

Research and Development Costs

The Company expenses research and development costs as incurred. Research and development costs include salaries, employee benefit costs, department supplies, project expenses, and other related costs.

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

Product Warranties

The Company offers a standard product warranty obligating it to repair or replace equipment with manufacturing defects. The Company maintains a reserve for future warranty costs based on historical experience or, in the absence of historical product experience, management’s estimates. Changes in the warranty reserve are contained in the following table (in thousands):

In December 2003, the product warranty provision contained in a contract for the sale of a deepwater seismic reservoir characterization system expired resulting in the reversal of the associated potential warranty costs of approximately $0.5 million in the first quarter. During the quarter ended June 30, 2004, the Company extended its warranty provisions for certain elements of the system and recorded a charge of $0.3 million.

Stock-Based Compensation

Employee stock plans are accounted for under the intrinsic value method of recognition and measurement principles as discussed in the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. The Company utilizes the Black-Scholes option valuation model to value stock options for pro forma presentation of income and per share data as if the fair value based method in Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”, had been used to account for stock-based compensation. The following presents pro forma effect on net income and earnings per share data as if a fair value based method had been used to account for stock-based compensation:

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

The FASB has indicated that it expects to issue a final standard during 2004 that will require the use of a fair value method of accounting for stock-based compensation. The Company will evaluate the provisions of that standard when issued and will expect to include a charge to its results of operations in each future reporting period after the new standard is required to be implemented.

New Accounting Pronouncements

In December 2003, the SEC issued Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”), which supercedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind accounting guidance contained within SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. SAB 104 did not have a material effect on the financial position or results of operations of the Company.

2. Earnings Per Common Share

The following table summarizes the calculation of net earnings and weighted average common shares and common equivalent shares outstanding for purposes of the computation of earnings per share (in thousands, except per share data):

Options totaling 8,649 and 141,703 equivalent shares for the three months ended June 30, 2004 and 2003, and 21,452 and 194,051 for the nine months ended June 30, 2004 and 2003, respectively, were not included in the computation of weighted average shares because the effect of these options was antidilutive.

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

3. Comprehensive Income

Comprehensive income includes all changes in a company’s equity, except those resulting from investments by and distributions to stockholders. The following table summarizes the components of comprehensive income (in thousands):

4. Trade Accounts and Notes Receivable

Current trade accounts and notes receivable consisted of the following (in thousands):

At June 30, 2004, trade notes receivable in the above table do not include $0.5 million of notes receivable classified as long-term. At September 30, 2003, trade notes receivable in the above table do not include $1.3 million of notes receivable classified as long-term.

5. Inventories

Inventories consisted of the following (in thousands):

The Company’s reserve for slow moving and obsolete inventories is analyzed and adjusted periodically to reflect the Company’s best estimate of the net realizable value of such inventories.

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

6. Segment and Geographic Information

The Company evaluates financial performance based on two business segments: Seismic and Commercial Graphics. The Company’s seismic products currently consist of geophones and hydrophones, including multi-component geophones and hydrophones, seismic leader wire, geophone string connectors, seismic telemetry cable, high definition reservoir characterization products and services, marine seismic cable retrieval devices and small data acquisition systems targeted at niche markets. Commercial graphics products include thermal imaging equipment and dry thermal film.

Summary financial data by business segment is presented below. Certain prior year amounts were reclassified to conform to the current year presentation.

Included in the nine months ended June 30, 2004 results for the seismic business segment is a bonus award of approximately $3.6 million resulting from successful performance of our permanent seabed seismic reservoir characterization and monitoring system.

7. Line of Credit

The Company has entered into a credit agreement pursuant to which it can borrow up to $10.0 million secured by its accounts receivable and inventories (the “Credit Agreement”). The Credit Agreement, as amended, expires on February 27, 2005. Borrowings under the Credit Agreement are subject to borrowing base restrictions based on (i) consolidated net income plus consolidated interest expense, income taxes, depreciation and amortization (“EBITDA”) and (ii) levels of eligible accounts receivable and inventories. The Credit Agreement limits the incurrence of additional indebtedness, requires the maintenance of certain financial amounts and contains other

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

covenants customary in agreements of this type. As of August 9, 2004, there were no borrowings outstanding under the Credit Agreement, and additional borrowings available under the Credit Agreement of $9.8 million. The Company’s borrowing interest rate is, at the Company’s option, the bank’s prime rate or a LIBOR based rate. The interest rate for Company’s borrowings at June 30, 2004 was 4.0%. The Company has mortgage notes payable in the amount of $6.3 million in relation to a newly purchased facility and two surplus properties located in the Houston area.

8. Film Supplier Developments

In April 2002, the Company purchased certain intellectual property rights from its then primary supplier of dry thermal film (the “Former Primary Film Supplier”) for $2.3 million. Such purchase gave the Company exclusive ownership of all technology used by the Former Primary Film Supplier to manufacture dry thermal film. Such purchase included technology then existing and any dry thermal film technology thereafter developed by the Former Primary Film Supplier for use in the Company’s equipment. The Company also entered into an amended supply agreement pursuant to which the Former Primary Film Supplier agreed to provide the Company with the dry thermal film. In connection with the purchase, the Company agreed to license the technology to the Former Primary Film Supplier on a perpetual basis so long as it could meet predefined quality and delivery requirements. If the Former Primary Film Supplier could not meet such requirements, the Company has the right to use the technology itself or to license the technology to any third party to manufacture dry thermal film.

On July 3, 2002, the Former Primary Film Supplier filed a Chapter 11 reorganization petition in Federal Bankruptcy Court for the Western District of New York. At the date of such bankruptcy filing, the Company had $3.4 million of long-term assets carried on its balance sheet as a result of the Company’s prior transactions with the Former Primary Film Supplier (including the $2.3 million investment in intellectual property acquired from the Former Primary Film Supplier described above).

Shortly thereafter, the Former Primary Film Supplier ceased providing the Company with dry thermal film. As a result, the Company is currently purchasing a large quantity of dry thermal film from its alternate supplier of dry thermal film (the “Other Film Supplier”) and the Company is using the technology it purchased from the Former Primary Film Supplier to manufacture dry thermal film internally.

As a result of the bankruptcy filing by the Former Primary Film Supplier, the Company recorded a $1.2 million charge in its third quarter of fiscal year 2002 due to the ultimate uncertainty of realization of value on certain assets, particularly certain prepaid purchase benefits and similar benefits under the amended supply agreement with the Former Primary Film Supplier. The Company does not believe there has been any impairment in the value of the intellectual property it acquired from the Former Primary Film Supplier because of its ability to utilize the intellectual property to have dry thermal film manufactured internally or possibly elsewhere.

On December 10, 2002, the Company received a notice of claim, in connection with the Former Primary Film Supplier’s bankruptcy, for alleged preferential payments made by the Former Primary Film Supplier to the Company in the period before filing of the bankruptcy proceeding in the approximate amount of $259,000. On July 7, 2004, an amended claim was filed against the Company and the amount of the alleged preferential payments made by the Former Primary Film Supplier to the Company was increased to approximately $895,000. The Company intends to vigorously defend against such claim under the overall circumstances of its relationship with

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OYO GEOSPACE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

the Former Primary Film Supplier. At present, the Company does not know whether it will make any claims against the Former Primary Film Supplier and it is unable to predict whether any additional claims will be made against the Company in connection with the Former Primary Film Supplier’s bankruptcy proceeding as to any aspect of its relationship with the Former Primary Film Supplier. The Company is unable at this time to predict the outcome and effects of this situation. The Company had, nevertheless, made a provision for the initial claim made by the Former Primary Film Supplier and it believes such provision is adequate at this time, although it is unable to make such predictions with any certainty.

9. Income Taxes

The United States statutory tax rate for the periods reported was 34.0%; however, the Company’s effective tax rate for the three months and nine months ended June 30, 2004 was a benefit of 57.0% and an expense of 2.5%, respectively, compared to an effective rate of a benefit of 34.8% and a benefit of 33.2%, respectively, for the three and nine months ended June 30, 2003. During the three months ended June 30, 2004, the Company recorded tax benefits of $0.5 million reflecting a change in estimate for previously unrecognized tax deductions and tax credits related to its fiscal year 2003 U.S. tax return. During the nine months ended June 30, 2004, in addition to the tax deductions and credits previously referred to, the Company reversed a deferred tax valuation allowance of $0.8 million during its first quarter of fiscal year 2004. The reversal of the deferred tax allowance resulted from the significant amount of U.S. taxable income recorded by the Company in its first quarter. In addition, as a result of improving market conditions and cost reductions, the Company expects to record additional U.S. taxable income in future periods, including taxable income from foreign sources, which are expected to result in the further utilization of its deferred tax assets.

10. Relocation and Consolidation of Facilities

The Company has recently relocated the operations of five separate Houston-area facilities to a single newly purchased facility in northwest Houston and incurred relocation expenditures of $0.5 million. As a result of this facility consolidation, the Company expects to realize significant cost savings. The relocation and consolidation was completed during the quarter ended March 31, 2004.

During the first quarter, the Company sold a vacant parcel of land and a surplus building and associated land. Proceeds from the sale of the surplus properties totaled $1.1 million. The sale or lease of the Company’s surplus properties is an integral part its plan to consolidate facilities and reduce operating costs. The Company has entered into a contract to sell a surplus office facility located in Stafford, Texas. The Company expects the sale of the Stafford office facility to close in the fourth quarter of fiscal year 2004.

The Company is actively marketing for lease its 77,000 square foot manufacturing building in northwest Houston. This facility has a net book value of $4.9 million and is reflected in the accompanying balance sheet under property, plant and equipment, net. The Company is actively marketing the lease of the building and believes the expected cash flows under an operating lease based on current real estate market conditions will allow it to recover the value of the asset. However, should current market real estate conditions change and the Company can not complete its plan to lease the facility, it may decide to sell this facility and there is no assurance that the Company will not recognize an impairment on the asset based on current market real estate conditions at that time.

11. Subsequent Events

On July 14, 2004, the Company announced the signing of an agreement to purchase the thermal printhead production business of Graphtec Corporation located in Yokohama, Japan, for a purchase price of 200 million yen (approximately $1.9 million). The acquisition is expected to close on September 30, 2004, and the Company expects to fund the acquisition from its operating cash flows or from borrowings under the Company’s Credit Agreement.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is management’s discussion and analysis of the major elements of our consolidated financial statements. You should read this discussion and analysis together with our consolidated financial statements and accompanying notes and other detailed information appearing elsewhere in this Form 10-Q. The discussion of our financial condition and results of operations includes various forward-looking statements about our markets, the demand for our products and services and our future plans and results. These statements are based on assumptions that we consider to be reasonable, but that could prove to be incorrect. For more information regarding our assumptions, you should refer to the section entitled “Forward-Looking Statements and Risks” contained elsewhere in this Form 10-Q.

Industry Overview

We design and manufacture instruments and equipment used in the acquisition and processing of seismic data. We have been in the seismic instrument and equipment business since 1980, marketing our products primarily to the oil and gas industry worldwide. We also design and manufacture thermal imaging equipment and distribute dry thermal film products to the commercial graphics industry. We have been serving the commercial graphics industry since 1995.

Seismic Industry

Geoscientists use seismic data to map potential or existing oil and gas bearing formations and the geologic structures that surround them. Seismic data is used primarily in connection with the exploration, development and production of oil and gas.

Seismic data acquisition is conducted on land by combining a seismic energy source and a data recording system. The energy source imparts seismic waves into the earth, reflections of which are received and measured by geophones and hydrophones. Electrical signals generated by the geophones and hydrophones are simultaneously transmitted through leader wire, geophone and hydrophone string connectors and telemetric cable to data collection units, which store information for processing and analysis. Seismic thermal imaging output devices are used in the field or office to create a graphic representation of the seismic data after it has been acquired.

Marine seismic data acquisition is conducted primarily by large ocean-going vessels that tow long seismic cables known as “streamers”. Usually, the energy source used in marine seismic data acquisition is an airgun, and the reflected seismic waves are received and measured by hydrophones, which are an integral part of the streamers. The streamers simultaneously transmit the electrical impulses back to the vessel via telemetric cable included within the streamers, and the seismic data is recorded and processed in much the same manner as it is on land.

An estimated one to two-thirds of the reserves found with every oil and gas discovery will be left behind in the reservoir, not recoverable either economically or at times even identified. Reservoir characterization and management programs, in which the reservoir is carefully imaged and monitored throughout its economic life by seismic instruments and equipment, are now seen as vital tools for improving production recovery rates. Seismic surveys repeated over selected time intervals show dynamic changes within the reservoir and can be used to monitor the effects of production.

We expect to incur significant future research and development expenditures aimed at the development of additional seismic acquisition products used for high definition reservoir characterization in both land and marine environments.

While orders for our products can vary substantially from quarter to quarter, reservoir characterization projects, especially deepwater projects, require the use of more equipment over a longer period of time than is required by conventional surface seismic systems. Revenue recognition in accordance with generally accepted accounting principles for these large-scale projects has the potential to result in substantial fluctuations in our quarterly performance. These variations may impact our operating results and cash flow, manufacturing capability and expense levels in any given quarter. Furthermore, because of the scale and nature of reservoir characterization projects, there may be delays in their implementation and uncertainties about their final course.

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During our fiscal year ended September 30, 2002, we delivered a reservoir characterization and monitoring system to a major oil company, for installation in one of its fields in the North Sea. In accordance with the terms of the contract, we recognized $15.8 million of revenues in our fiscal year ended September 30, 2002 and $2.5 million of revenues in our fiscal year ended September 30, 2003. Due to the system’s sucessful performance through December 31, 2004, we earned a $3.6 million performance bonus, of which $3.1 million and $0.5 million were recognized as revenue in the first and third quarters, respectively, of fiscal year 2004. We have agreed to extend our standard product warranty for certain components of the system until 2006. All other warranty obligations contained in the contract for the sale of this system have expired resulting in the net reversal of the associated potential warranty costs of approximately $0.1 million during fiscal year 2004.

We believe that our reservoir characterization systems, including the system referenced above, are important new technologies in our industry and our ability to develop and market them will be a key determinant of our success in the future.

Commercial Graphics Industry

Our entry into the commercial graphics business occurred in 1995 as we leveraged our thermal imaging product technology, originally designed for seismic data processing applications, into new markets. With minor product modifications, we were successful in adapting these products for use in the commercial graphics industry.

Our commercial graphics business segment designs, manufactures and sells thermal imaging equipment and distributes dry thermal film primarily to the screen print, point of sale, signage and textile market sectors. Our thermal imaging equipment is capable of producing data images ranging in size from 12 to 54 inches wide, with resolution ranging from 400 to 1,200 dpi (dots per inch). This business segment has some sales to customers in the seismic industry.

In April 2002, we purchased certain intellectual property rights from our then primary supplier of dry thermal film (the “Former Primary Film Supplier”) for $2.3 million. Such purchase gave us exclusive ownership of all technology used by the Former Primary Film Supplier to manufacture dry thermal film. Such purchase included technology then existing and any dry thermal film technology thereafter developed by the Former Primary Film Supplier for use in our equipment. We also entered into an amended supply agreement pursuant to which the Former Primary Film Supplier agreed to provide us with dry thermal film. In connection with the purchase, we agreed to license the technology to the Former Primary Film Supplier on a perpetual basis so long as it could meet predefined quality and delivery requirements. If the Former Primary Film Supplier could not meet such requirements, the agreement provides us with the right to use the technology ourselves or to license the technology to any third party to manufacture dry thermal film.

On July 3, 2002, the Former Primary Film Supplier filed a Chapter 11 reorganization petition in Federal Bankruptcy Court for the Western District of New York. At the date of such bankruptcy filing, we had $3.4 million of long-term assets carried on our balance sheet as a result of the prior transactions with the Former Primary Film Supplier (including the $2.3 million investment in intellectual property acquired from the Former Primary Film Supplier described above).

Shortly thereafter, the Former Primary Film Supplier ceased providing us with dry thermal film. As a result, we are currently purchasing a large quantity of dry thermal film from our alternate film supplier (the “Other Film Supplier”) and we are using the technology we purchased from the Former Primary Film Supplier to manufacture dry thermal film internally.

As a result of the bankruptcy filing by the Former Primary Film Supplier, we recorded a $1.2 million charge in our third quarter of fiscal year 2002 due to the ultimate uncertainty of realization of value on certain assets, particularly certain prepaid purchase benefits and similar benefits under the amended supply agreement with the Former Primary Film Supplier. We do not believe there has been any impairment in the value of the intellectual property we acquired from the Former Primary Film Supplier because of our ability to utilize the intellectual property to have dry thermal film manufactured internally or possibly elsewhere.

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On December 10, 2002, we received a notice of claim, in connection with the Former Primary Film Supplier’s bankruptcy, for alleged preferential payments made by the Former Primary Film Supplier to us in the period before filing of the bankruptcy proceeding in the approximate amount of $259,000. On July 7, 2004, an amended claim was filed against us and the amount of the alleged preferential payments made by the Former Primary Film Supplier to us was increased to approximately $895,000. We intend to vigorously defend against such claim under the overall circumstances of our relationship with the Former Primary Film Supplier. At present we do not know whether we will make any claims against the Former Primary Film Supplier and we are unable to predict whether any additional claims will be made against us in connection with the Former Primary Film Supplier’s bankruptcy proceeding as to any aspect of our relationship with such Former Primary Film Supplier. We are unable at this time to predict the outcome and effects of this situation. We had, nevertheless, made a provision for the initial claim made by the Former Primary Film Supplier, and we believe such provision is adequate at this time, although we are unable to make such predictions with any certainty.

Results of Operations

We report and evaluate financial information for two segments: Seismic and Commercial Graphics. Summary financial data by business segment is presented below. Certain prior year amounts were reclassified to conform to the current year presentation.

Overview

Three and nine months ended June 30, 2004 compared to three and nine months ended June 30, 2003

Consolidated sales for the three months ended June 30, 2004 increased by $1.1 million, or 8.5%, from the corresponding period of the prior fiscal year. Such increase for the quarter generally reflects higher revenues from our traditional seismic and reservoir products offset by lower sales of our commercial graphics products. Sales for the nine months ended June 30, 2004 increased by $8.2 million, or 20.8%, from the corresponding period of the prior fiscal year. Substantially all of the increase in sales for the year-to-date period is due to higher sales of our seismic products, including a bonus award of $3.6 million (recorded in the first and third quarters) resulting from the successful installation and performance of a permanent seismic reservoir characterization system delivered to a major oil company.

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Consolidated gross profits for the three months ended June 30, 2004 increased by $1.8 million, or 68.2%, from the corresponding period of the prior year. Such increase is primarily due to increased sales and gross profits from our traditional seismic and reservoir characterization products, along with higher gross profits from our commercial graphics products in spite of lower sales. Consolidated gross profits for the nine months ended June 30, 2004 increased by $8.7 million, or 90.3% from the corresponding period of the prior year. Such increase in gross profits resulted from the bonus award, increased sales from Russian and Canadian operations and gross profits realized from sales of our reservoir characterization products. Also impacting improved gross profits for the periods ended June 30, 2004 are personnel and facility cost reductions associated with our relocation into a new northwest Houston facility.

Consolidated operating expenses for the three months ended June 30, 2004 decreased $0.4 million, or 8.7%, from the corresponding periods of the prior fiscal year. Such decrease is the result of cost cutting measures associated with our facilities consolidation, partially offset by $0.2 million of increased incentive compensation expense and facility relocation expenses. Consolidated operating expenses for the nine months ended June 30, 2003 decreased $0.1 million, or 1.0%, from the corresponding period of the prior fiscal year. Such decrease in operating expenses primarily resulted from the facilities consolidation referred to above. However, these cost decreases were mostly offset by expenditures of $0.5 million to consolidate our five Houston-area facilities and a charge of $0.8 million for incentive compensation expense.

The United States statutory tax rate for the periods reported was 34.0%; however, our effective tax rate for the three months and nine months ended June 30, 2004 was a benefit of 57.0% and expense of 2.5%, respectively, compared to an effective rate of a benefit of 34.8% and a benefit of 33.2%, respectively, for the three and nine months ended June 30, 2003. During the three months ended June 30, 2004, we recorded tax benefits of $0.5 million reflecting a change in estimate for previously unrecognized tax deductions and tax credits related to our fiscal year 2003 U.S. tax return. During the nine months ended June 30, 2004, in addition to the tax deductions and credits previously referred to, we reversed a deferred tax valuation allowance of $0.8 million during our first quarter of fiscal year 2004. The reversal of the deferred tax allowance resulted from the significant amount of U.S. taxable income recorded by us in our first quarter. In addition, as a result of improving market conditions and cost reductions, we expect to record additional U.S. taxable income in future periods, including taxable income from foreign sources, which are expected to result in the further utilization of our deferred tax assets.

Seismic

Our seismic product lines currently consist of high definition reservoir characterization products and services, geophones and hydrophones, including multi-component geophones and hydrophones, seismic leader wire, geophone string connectors, seismic telemetry cable, marine seismic cable retrieval devices and small data acquisition systems targeted at niche markets.

Net Sales

Sales of our seismic products for the three months ended June 30, 2004 increased by $1.3 million, or 14.5%, from the corresponding period of the prior fiscal year. The increase in sales is primarily attributable to higher revenues from reservoir characterization products, including borehole and retrievable ocean bottom products. In addition, demand for our traditional seismic and industrial sensor products has improved. Sales for the nine months ended June 30, 2004 increased by $8.2 million, or 27.4%, from the corresponding period of the prior fiscal year. The increase in sales includes a bonus award of $3.6 million resulting from the successful installation and performance of a permanent seismic reservoir characterization system delivered to a major oil company. Also during this period, we delivered $7.2 million of reservoir characterization systems, including retrievable seismic reservoir and borehole seismic acquisition systems. Furthermore, our Russian and Canadian operations recorded strong sales increases as a result of increased demand due to the cold winter season.

Operating Income

Operating income for the three months ended June 30, 2004 increased $1.7 million from the corresponding period of the previous fiscal year primarily due to increased sales, and particularly sales of reservoir characterization

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products which have higher gross margins. Operating income for the nine months ended June 30, 2004 increased $8.0 million from the corresponding period of the prior fiscal year. Such increase reflects (i) higher gross profits from the bonus award, (ii) increased sales of the retrievable seismic reservoir and borehole seismic acquisition systems, and (iii) cost reductions resulting from our facilities consolidation.

Commercial Graphics

Our commercial graphics business segment manufactures and sells thermal imaging equipment and dry thermal film primarily to the screen print, point of sale, signage and textile market sectors. This business segment also has some sales to customers in the seismic industry.

Net Sales

Sales of our commercial graphics products for the three months ended June 30, 2004 decreased $0.2 million, or 5.5%, from the corresponding period of the prior year. The decrease in sales is primarily due to a decline of thermal equipment sales. Sales for the nine months ended June 30, 2004 were relatively unchanged from the corresponding period of the prior year.

Operating Income

Our operating income for the three months and nine months ended June 30, 2004 increased $0.4 million, and $0.8 million, respectively, from the corresponding period of the prior fiscal year. Such increases are the result of increased gross profits due to improved manufacturing processes for our dry thermal film. In addition, we have realized cost reductions from our facilities consolidation and reorganization.

Liquidity and Capital Resources

At June 30, 2004, we had $2.4 million in cash and cash equivalents. For the nine months ended June 30, 2004, we generated approximately $8.0 million of cash from operating activities. The cash provided by operating activities resulted from a combination of our net income of $5.4 million and non-cash charges of $3.6 million for depreciation and amortization. In addition, we increased accrued expenses by $1.5 million, primarily reflecting accrued incentive compensation expenses. Income taxes payable increased by $0.7 million, primarily reflecting taxes owed on the profits of our foreign subsidiaries. These operating cash flows were partially offset by a non-cash income tax benefit of $0.9 million and increased inventories of $2.9 million in response to an increase in sales orders from customers.

For the nine months ended June 30, 2004, we used approximately $0.9 million of cash in investing activities. We received $1.2 million of cash proceeds from the sale of a surplus building and from the sale of a vacant parcel of land. The sale of these surplus properties is an integral part of our plan to consolidate facilities and reduce operating costs. We used $2.2 million of cash for capital expenditures of which approximately $1.3 million represented improvements to our new facility. We estimate that our capital expenditures in fiscal year 2004 will be approximately $3.0 million. We expect to fund such capital expenditures through operating cash flows and borrowings under our credit facility.

For the nine months ended June 30, 2004, we used approximately $5.2 million of cash in financing activities primarily for the repayment of borrowings under our credit facility and repayment of a loan to a Russian bank. Proceeds from the exercise of stock options generated approximately $0.3 million.

We recently renewed our credit agreement with a bank pursuant to which we can borrow up to $10.0 million secured by our accounts receivable and inventory (the “Credit Agreement”). The Credit Agreement, as amended, expires on February 27, 2005. Borrowings under the Credit Agreement are subject to borrowing base restrictions based on (i) consolidated net income plus consolidated interest expense, income taxes, depreciation and amortization and (ii) levels of eligible accounts receivable and inventories. The Credit Agreement limits the incurrence of additional indebtedness, requires the maintenance of certain financial amounts and contains other covenants customary in agreements of this type. As of August 9, 2004, there were no borrowings outstanding under the Credit Agreement, and additional borrowings available under the Credit Agreement of $9.8 million. Our borrowing interest rate is, at our option, the bank’s prime rate or a LIBOR based rate.

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We anticipate that the existing cash balance as of June 30, 2004, cash flows from operations and borrowing availability under the Credit Facility will provide adequate cash resources and liquidity for fiscal year 2004. We expect that the liquidity from such amounts and cash flows from operations in fiscal year 2004 will satisfy our capital expenditures, scheduled debt payments, and on-going operations for the remainder of the fiscal year.

We have mortgage notes payable in the amount of $6.3 million in relation to our newly purchased facility and our surplus properties located in the Houston area.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. We consider many factors in selecting appropriate operational and financial accounting policies and controls and in developing the estimates and assumptions that are used in the preparation of these financial statements. We continually evaluate our estimates, including those related to bad debts reserves, inventory obsolescence reserves, self-insurance reserves, product warranty reserves, intangible assets and deferred income tax assets. We base our estimates on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different conditions or assumptions.

Revenue is primarily derived from the sale, and short-term rental under operating leases, of seismic instruments and equipment and commercial graphics products. Sales revenues are generally recognized when our products are shipped and title and risk of loss have passed to the customer. Rental revenues are recognized as earned over the rental period. Rentals of our equipment are generally on a short-term basis and generally range from daily rentals to rental periods of up to nine months. Except for certain of our reservoir characterization products, our products are generally sold without any customer acceptance provisions and do not require installation assistance or sophisticated instruction. Our standard terms of sale do not allow customers to return products for credit. We offer a standard product warranty obligating us to repair or replace equipment with manufacturing defects. We maintain a reserve for future warranty costs based on historical experience. We record a write-down of inventory when the cost basis of any item (including any estimated future costs to complete the manufacturing process) exceeds its net realizable value.

New Accounting Pronouncements

In December 2003, the SEC issued Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”), which supercedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind accounting guidance contained within SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. SAB 104 did not have a material effect on our financial position or our results of operations.

Forward Looking Statements and Risks

Certain of the statements we make in this document and in documents incorporated by reference herein, including those made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are, or may be, forward-looking statements for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934. Such statements include projections of our expectations regarding our future capital expenditures, research and development expenses, expansion of product lines, growth of product markets and other statements that relate to future events or circumstances. These statements are subject to known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to differ materially from the future results, performance or achievements expressed or implied by such forward-looking statements, including the risks and factors described below. You are cautioned to consider the following factors and risks in connection with evaluating any such forward-looking statements or otherwise evaluating an investment in our company.

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Management’s Current Outlook

Our estimates as to future results and industry trends, to the extent described in this document, are generally based on assumptions regarding the future level of seismic exploration activity and seismic reservoir monitoring projects and, in turn, their effect on the demand and pricing of our products and services. Our analysis of the market and its impact on us is based upon the following outlook for fiscal year 2004:

Our outlook is based on various macro-economic factors and our internal assessments, and actual market conditions could vary materially from those assumed.

Risk Factors

Our New Products May Not Achieve Market Acceptance

In recent years we have incurred significant expenditures to fund our research and development efforts and we intend to continue those expenditures in the future. However, research and development is by its nature speculative, and we cannot assure you that these expenditures will result in the development of new products or services or that any new products and services we have developed recently or may develop in the future will be commercially marketable or profitable to us.

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In particular, we have incurred substantial expenditures to develop seismic products for borehole and reservoir characterization applications. For a discussion of particular factors and risks relating to projects in the reservoir characterization area, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Industry Overview” in this Report on Form 10-Q. We cannot assure you that we will realize our expectations regarding market acceptance and revenues from these products and services.

A Decline in Industry Conditions Could Affect our Projected Results

Any unexpected material changes in oil and gas prices or other market trends that would impact seismic exploration activity would likely affect the forward-looking information contained in this document. In addition, the oil and gas industry is extremely volatile and subject to change based on political and economic factors outside our control. In fact, our results for fiscal year 2003 and results from our land based seismic activity in particular, were adversely affected by the downturn in the industry, particularly as the industry has continued to limit exploration activities and to be cautious in spending notwithstanding some recent improvements in, or some relative stabilization of, oil and gas commodity prices.

We May Experience Fluctuations in Quarterly Results of Operations

Historically, the rate of new orders for our products has varied substantially from quarter to quarter. Moreover, we typically operate, and expect to continue to operate, on the basis of orders in hand for our products before we commence substantial manufacturing “runs”. Thus completion of orders, particularly large orders for deepwater reservoir characterization projects, can significantly impact the operating results and cash flow for any quarter, and results of operations for any one quarter may not be indicative of results of operations for future quarters.

Our Credit Risks Could Increase as our Customers Continue to Face Difficult Economic Circumstances

We believe, and have assumed that our allowance for bad debts at June 30, 2004 is adequate in light of known circumstances. However, we cannot assure you that additional amounts attributable to uncollectible receivables and bad debt write-offs will not have a material adverse effect on our future results of operations. Many of our customers, particularly seismic contractors, have suffered from lower revenues and experienced liquidity challenges resulting from the economic difficulties throughout our industry. We have in the past incurred significant write-offs in our accounts receivable due to customer credit problems. We have found it necessary from time to time to extend trade credit and promissory notes to long-term customers and others where some risks of non-payment or late payment exist. Given recent industry conditions, some of our customers have experienced liquidity difficulties, which increases those credit risks.

Demand for Our Products is Volatile

Demand for our products depends primarily on the level of worldwide oil and gas exploration activity. That activity, in turn, depends primarily on prevailing oil and gas prices and availability of seismic data. Historically, the markets for oil and gas have been volatile, and those markets are likely to continue to be volatile. Oil and gas prices are subject to wide fluctuation in response to relatively minor changes in the supply of and demand for oil and gas, market uncertainty and a variety of additional factors that are beyond our control. These factors include the level of consumer demand, weather conditions, domestic and foreign governmental regulations, price and availability of alternative fuels, political conditions and hostilities in the Middle East and other significant oil-producing regions, foreign supply of oil and gas, prices of foreign imports and overall economic conditions. Continued low demand for our products could materially and adversely affect our results of operations and liquidity. For a further discussion on this, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Industry Overview”.

We Have a Relatively Small Public Float, and Our Stock Price May be Volatile

We have approximately 2.4 million shares outstanding held by non-affiliates. This small float results in a relatively illiquid market for our common stock. Our daily trading volume during fiscal year 2004 has averaged approximately 6,000 shares. Our small float and daily trading volumes has in the past caused, and may in the future result in, greater volatility of our stock price.

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Our Industry is Characterized by Rapid Technological Development and Product Obsolescence

Our instruments and equipment are constantly undergoing rapid technological improvement. Our future success depends on our ability to continue to:

Current competitors or new market entrants may develop new technologies, products or standards that could render our products obsolete. We cannot assure you that we will be successful in developing and marketing, on a timely and cost effective basis, product enhancements or new products that respond to technological developments, that are accepted in the marketplace or that comply with industry standards.

We Operate in Highly Competitive Markets

The markets for our products are highly competitive. Many of our existing and potential competitors have substantially greater marketing, financial and technical resources than we do. Additionally, two competitors in our seismic business segment currently offer a broader range of instruments and equipment for sale and market this equipment as “packaged” data acquisition systems. We do not now offer for sale such a complete “packaged” data acquisition system. Further, certain of our competitors offer financing arrangements to customers on terms that we may not be able to match. In addition, new competitors may enter the market and competition could intensify.

We cannot assure you that sales of our products will continue at current volumes or prices if current competitors or new market entrants introduce new products with better features, performance, price or other characteristics than our products. Competitive pressures or other factors also may result in significant price competition that could have a material adverse effect on our results of operations.

We Have a Limited Market

In our seismic business segment, we market our products to contractors and large, independent and government-owned oil and gas companies. We estimate that, based on published industry sources, fewer than 30 seismic contracting companies are currently operating worldwide (excluding those operating in Russia and the former Soviet Union, India, the People’s Republic of China and certain Eastern European countries, where seismic data acquisition activity is difficult to verify). We estimate that fewer than ten seismic contractors are engaged in marine seismic exploration. Due to these market factors, a relatively small number of customers, some of whom are experiencing financial difficulties, have accounted for most of our sales. From time to time these seismic contractors have sought to vertically integrate and acquire our competitors, which has influenced their supplier decisions before and after such transactions. The loss of a small number of these customers for whatever reason could materially and adversely impact our sales.

We Cannot Be Certain of Patent Protection of Our Products

We have applied for and hold certain patents relating to our seismic data acquisition and other products. We also acquired several patents which relate to the development of dry thermal film from our Former Primary Film Supplier. We cannot assure you that our patents will prove enforceable, that any patents will be issued for which we have applied or that competitors will not develop functionally similar technology outside the protection of any patents we have or may obtain.

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Our Foreign Subsidiaries and Foreign Marketing Efforts Face Additional Risks and Difficulties

Net sales outside the United States accounted for approximately 60% of our net sales during fiscal year 2003 and are again expected to represent a substantial portion of our net sales for fiscal year 2004 and subsequent years. Substantially all of our sales from the United States are made in U.S. dollars, but from time to time we may make sales in foreign currencies and may, therefore, be subject to foreign currency fluctuations on our sales. In addition, net assets reflected on the balance sheets of our Russian, Canadian and U.K. subsidiaries are subject to currency fluctuations. Significant foreign currency fluctuations could adversely impact our results of operations.

Foreign sales are subject to special risks inherent in doing business outside of the United States, including the risk of war, terrorist activities, civil disturbances, embargo and government activities and foreign attitudes about conducting business activities with United States or, with reference to our Japanese parent OYO Corporation, Japanese trading partners, all of which may disrupt markets. Foreign sales are also generally subject to the risk of compliance with additional laws, including tariff regulations and import and export restrictions. Sales in certain foreign countries require prior United States government approval in the form of an export license. We cannot assure you that we will not experience difficulties in connection with future foreign sales. Also, should we experience substantial growth in certain markets, for example Russia, we may not be able to transfer cash balances to the United States to assist with debt servicing obligations.

Our subsidiary in Russia currently does not maintain property and casualty insurance coverage for certain plant, equipment and personal property. We are evaluating the cost of obtaining minimum levels of insurance coverage for such assets.

We Rely on Key Suppliers for Significant Product Components

A Japanese manufacturer unaffiliated with us is currently the only supplier (the “Japanese Supplier”) of wide format thermal printheads that we use to manufacture our wide format thermal imager equipment. Over the years we have experienced some quality control issues with such printheads and have returned significant quantities of these products to the Japanese Supplier for repair, testing and quality assurance review. We have recently announced the signing of an agreement to purchase the Japanese Supplier’s production of thermal printhead business effective September 30, 2004. Until the acquisition is consummated, unforeseen problems with the Japanese Supplier, if they develop, could have a significant effect on our ability to meet future production and sales commitments and our ability to compete in the thermal imaging marketplace could be severely damaged, adversely affecting our financial performance. We are not able to evaluate the implications, if any, of that situation at present. We believe we maintain an adequate inventory of certain printheads to continue production for two to nine months should our source of supply be disrupted.

The Integration of the Business Purchased From the Japanese Supplier May be Difficult and May Result in a Failure to Realize Some of the Anticipated Potential Benefits of the Acquisition.

We may not be able to integrate or manage the business purchased from the Japanese Supplier to produce the returns that we have anticipated. Any difficulty in successfully integrating or managing the operations of the businesses could lead to a failure to realize the anticipated synergies. Our management also will be required to dedicate substantial time and effort to the integration of business. These efforts could divert management’s focus and resources from other strategic opportunities and operational matters.

We Are Subject to Control by a Principal Stockholder

OYO Corporation, a Japanese corporation, owns indirectly in the aggregate approximately 51.0% of our common stock. Accordingly, OYO Corporation, through its wholly owned subsidiary OYO Corporation U.S.A., is able to elect all of our directors and to control our management, operations and affairs. We currently have, and may continue to have, a variety of contractual relationships with OYO Corporation and its affiliates.

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Our Success Depends Upon A Limited Number of Key Personnel

Our success depends on attracting and retaining highly skilled professionals. A number of our employees are highly skilled engineers and other professionals. If we fail to continue to attract and retain such professionals, our ability to compete in the industry could be adversely effected. In addition, our success depends to a significant extent upon the abilities and efforts of the members of our senior management.

A General Downturn in the U.S. Economy in Future Periods May Adversely Affect our Business

A general downturn in the U.S. economy in future periods could adversely affect our business in ways that we cannot yet identify. Any further economic downturn, may adversely affect the demand for oil and gas generally or cause volatility in oil and gas prices and, therefore, adversely affect the demand for our services to the oil and gas industry and related service industry. It could also adversely affect the demand for consumer products, which could in turn adversely affect our commercial graphics business. To the extent these factors adversely affect other seismic companies in the industry, we could see an oversupply of products and services and continued downward pressure on pricing for seismic products and services that would also adversely affect us.

Sarbanes-Oxley Act of 2002

In response to several high profile cases of accounting irregularities, the Sarbanes-Oxley Act of 2002 (“the Act”) was enacted into law on July 30, 2002. We are required to begin to comply with the annual requirements of Section 404 of the Act effective with our fiscal year beginning October 1, 2004. The Act, and rules promulgated thereunder, as well as new NASDAQ listing standards addressing corporate governance issues, endeavor to provide greater accountability and promote investor confidence by imposing specific corporate governance requirements, by requiring more stringent controls and certifications by corporate management and by utimately imposing new auditor attestations. The Act and new NASDAQ rules affect how audit committees, corporate management and auditors of publicly traded companies carry out their respective responsibilities and interact with each other and mandate composition of audit committees by independent directors. The Act will likely result in higher expenses for publicly traded companies as a result of higher audit and review fees, higher legal fees, higher director fees and higher internal costs to document and test internal controls. The Act, together with the financial scandals and difficult economic enviroment of recent years have also led to substantially increased premiums for director and officer liability insurance. These likely increased expenses will affect smaller public companies, like us, disproportionately from their effects on companies with larger revenue and operating income bases with which to absorb such increased costs.

We May Not Enjoy the Expected Benefits of Our Move to a Newly Purchased Facility and Other Internal Restructurings

While we have recently purchased a large facility to house all our existing U.S. operations and activities and have taken other measures, all with the expectation of improving our efficiency and margins, we cannot assure you that our efforts will be successful or that we will enjoy the full benefit of capital and operating expenditures incurred in connection with such measures.

We are actively marketing for lease our 77,000 square foot manufacturing building in northwest Houston. This facility has a net book value of $4.9 million and is reflected in the accompanying balance sheet under property, plant and equipment, net. We are actively marketing the lease of the building and believe the expected cash flows under an operating lease based on current real estate market conditions will allow us to recover the value of the asset. However, should current market real estate conditions change and we can not complete our plan to lease the facility, we may decide to sell this facility and there is no assurance that we will not recognize an impairment on the asset based on current market real estate conditions at that time.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

The following discussion of our exposure to various market risks contains “forward looking statements” that involve risks and uncertainties. These projected results have been prepared utilizing certain assumptions considered reasonable in light of information currently available to us. Nevertheless, because of the inherent unpredictability of foreign currency rates, as well as other factors, actual results could differ materially from those projected in this forward looking information. For a description of our significant accounting policies associated with these activities, see Note 1 to the consolidated financial statements.

We do not have any market risk as to market risk sensitive instruments entered into for trading purposes and have only very limited risk as to arrangements entered into other than for trading purposes. Further, we do not engage in commodity or commodity derivative instrument purchasing or selling transactions.

Foreign Currency Exchange Rate Risk

We purchase printheads from OYO Corporation, which purchases them from the Japanese Supplier, pursuant to terms under which such purchases are denominated in Japanese yen. We routinely attempt to hedge our currency exposure on these purchases by entering into foreign currency forward contracts with a bank. The purpose of entering into these forward hedge contracts is to eliminate variability of cash flows associated with foreign currency exposure risk on amounts payable in Japanese yen. Our forward contracts with the bank are considered derivatives. Accounting principles generally accepted in the United States require that we record these foreign currency forward contracts on the balance sheet and mark them to fair value at each reporting date. Our aggregate dollar exposure to forward yen contracts usually does not exceeded $0.5 million and such contracts ordinarily are settled within 10 months. Resulting gains and losses are reflected in income and were not material for our fiscal quarter ended June 30, 2004. At June 30, 2004, we had $0.3 million of yen denominated foreign currency forward contracts, and we had $0.3 million of yen denominated accounts payable.

Foreign Currency and Operations Risk

We have a subsidiary located in Russia. Therefore, our financial results may be affected by factors such as changes in foreign currency exchange risks, weak economic conditions or changes in Russia’s political climate. Our consolidated balance sheet at June 30, 2004 reflected approximately $1.9 million of net working capital related to our Russian subsidiary. This subsidiary generally receives its income and pays its expenses primarily in Russian rubles. To the extent that transactions of this subsidiary are settled in rubles, a devaluation of the ruble versus the U.S. dollar could reduce any contribution from our Russian subsidiary to our consolidated results of operations as reported in U.S. dollars. We do not hedge the market risk with respect to our operations in Russia; therefore, such risk is a general and unpredictable risk of future disruptions in the valuation of Russian rubles versus U.S. dollars to the extent such disruptions result in any reduced valuation of the Russian subsidiary’s net working capital or future contributions to our consolidated results of operations.

Foreign Currency Intercompany Accounts and Notes Receivable

From time-to-time, we provide access to capital to our foreign subsidiaries through U.S. dollar denominated interest bearing promissory notes. Such funds are generally used by our foreign subsidiaries to purchase capital assets and for general working capital needs. In addition, we sell products to our foreign subsidiaries in U.S. dollars on trade credit terms. Because these U.S. dollar denominated intercompany debts are accounted for in the local functional currency of the foreign subsidiary, any appreciation or devaluation of such foreign currencies against the U.S. dollar will result in a gain or loss, respectively, to our consolidated statement of operations. At June 30, 2004, we had outstanding accounts and notes receivable of $1.4 million and $7,000 from our subsidiaries in Russia and Canada, respectively. There were no accounts or notes receivable due from our subsidiary in the U.K.

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Floating Interest Rate Risk

We have a revolving credit agreement and a real estate mortgage agreement with banks, each with floating interest rates. These floating interest rates subject us to the risk of increased interest costs associated with any upward movements in bank market interest rates. Under the revolving credit agreement, our borrowing interest rate is the bank’s prime rate or a LIBOR rate plus 250 basis points, whichever we select. Under the real estate mortgage agreement, our borrowing rate is a LIBOR rate plus 250 basis points with a minimum rate of 4.0%. As of June 30, 2004, we had no borrowings under our revolving credit agreement. We had $3.0 million borrowed under the real estate mortgage agreement at a minimum borrowing rate of 4.0%. Due to the amount of borrowings outstanding under these facilities, including potential borrowings available under the revolving credit agreement, any increased interest costs associated with movements in market interest rates could be material to our financial condition, results of operation or cash flow. Based on current borrowings, a 1.0% increase in interest rates would increase interest expense annually by approximately $30,000.

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of June 30, 2004, our Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

Changes in Internal Control

There were no significant changes in our internal controls over financial reporting or in other factors that could materially affect our internal controls during the quarter or subsequent to the date of the evaluation of our disclosure controls and procedures referred to in the preceding paragraph. As we begin to evaluate our internal controls in greater detail under Section 404, there may be certain future improvements not currently considered significant.

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PART II - OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

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SIGNATURES

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.

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