GIGA TRONICS INC - Quarter Report: 2015 December (Form 10-Q)

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(In thousands except share data)	December 26, 2015			March 28, 2015
Assets
Current assets:
Cash and cash-equivalents	$	783		$	1,170
Trade accounts receivable, net of allowance of $45, respectively		2,136			2,354
Inventories, net		4,311			3,365
Prepaid expenses and other current assets		171			373
Total current assets		7,401			7,262
Property and equipment, net		774			718
Other long term assets		68			74
Capitalized software development costs		440			—
Total assets	$	8,683		$	8,054
Liabilities and shareholders' equity
Current liabilities:
Line of credit	$	1,200		$	—
Current portion of long term debt, net of discount		575			811
Accounts payable		2,431			973
Accrued payroll and benefits		582			678
Deferred revenue		1,394			1,127
Deferred rent		144			127
Capital lease obligations		48			69
Other current liabilities		584			501
Total current liabilities		6,958			4,286
Long term loan		—			392
Warrant liability, at estimated fair value		392			252
Long term obligations - deferred rent		—			111
Long term obligations - capital lease		177			58
Total liabilities		7,527			5,099
Commitments and contingencies
Shareholders' equity:
Convertible preferred stock of no par value Authorized - 1,000,000 shares; Series A - designated 250,000 shares; no shares at December 26, 2015 and March 28, 2015 issued and outstanding		—			—
Series B, C, D- designated 19,500 shares; 18,533.51 shares at December 26, 2015 and March 28, 2015 issued and outstanding; (liquidation value of $3,540 at December 26, 2015 and March 28, 2015)		2,911			2,911
Common stock of no par value; Authorized - 40,000,000 shares; 6,752,581 shares at December 26, 2015 and 6,705,065 at March 28, 2015 issued and outstanding		20,713			19,975
Accumulated deficit		(22,468	)		(19,931	)
Total shareholders' equity		1,156			2,955
Total liabilities and shareholders' equity	$	8,683		$	8,054

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		Three Month Periods Ended								Nine Month Periods Ended
(In thousands except per share data)		December 26, 2015				December 27, 2014				December 26, 2015				December 27, 2014
Net sales		$	4,483			$	4,509			$	11,921			$	14,127
Cost of sales			2,868				2,637				7,701				8,101
Gross margin			1,615				1,872				4,220				6,026
Operating expenses:
Engineering			614				672				2,179				2,563
Selling, general and administrative			1,417				1,133				4,221				3,401
Total operating expenses			2,031				1,805				6,400				5,964
Operating income/( loss)			(416	)			67				(2,180	)			62
Gain/(loss) on adjustment of derivative liability to fair value			(98	)			107				(51	)			16
Interest expense:
Interest expense, net			(54	)			(62	)			(164	)			(199	)
Interest expense from accretion of loan discount			(34	)			(45	)			(140	)			(115	)
Total interest expense			(88	)			(107	)			(304	)			(314	)
Income / (loss) before income taxes			(602	)			67				(2,535	)			(236	)
Provision for income taxes			—				—				2				47
Net income/(loss)		$	(602	)		$	67			$	(2,537	)		$	(283	)
Earnings/ (loss) per common share - basic		$	(0.09	)		$	0.01			$	(0.40	)		$	(0.05	)
Earnings/(loss) per common share - diluted		$	(0.09	)		$	0.01			$	(0.40	)		$	(0.05	)
Weighted average shares used in per share calculation:
Basic			6,484				5,208				6,402				5,166
Diluted			6,484				5,463				6,402				5,166

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		Nine Month Periods Ended
(In thousands)		December 26, 2015				December 27, 2014
Cash flows from operating activities:
Net loss		$	(2,537	)		$	(283	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			220				237
Share based compensation			717				545
Loss on adjustment of derivative liability to fair value			51				(16	)
Accretion of discounts on loan			140				115
Change in deferred rent			(94	)			(76	)
Changes in operating assets and liabilities			708				(1,035	)
Net cash used in operating activities			(795	)			(513	)
Cash flows from investing activities:
Purchases of property and equipment			(109	)			(30	)
Net cash used in investing activities			(109	)			(30	)
Cash flows from financing activities:
Proceeds from line of credit			1,200				8,125
Repayments of debt			(680	)			(99	)
Payments on capital leases			(65	)			(123	)
Proceeds from exercise of stock options			62				145
Proceeds from issuance of debt			—				500
Repayments of line of credit			—				(7,668	)
Net cash provided by financing activities			517				880
(Decrease)/Increase in cash and cash-equivalents			(387	)			337
Beginning cash and cash-equivalents			1,170				1,059
Ending cash and cash-equivalents		$	783			$	1,396
Supplementary disclosure of cash flow information:
Cash paid for income taxes		$	2			$	2
Cash paid for interest		$	120			$	172
Supplementary disclosure of noncash financing activities:
Equipment acquired under capital lease		$	163			$	49

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(1)     Basis of Presentation

 

The condensed consolidated financial statements included herein have been prepared by Giga-tronics Incorporated (the “Company”), pursuant to the rules and regulations of the Securities and Exchange Commission. The consolidated results of operations for the interim periods shown in this report are not necessarily indicative of results to be expected for the fiscal year. In the opinion of management, the information contained herein reflects all adjustments (consisting of normal recurring entries) necessary to make the consolidated results of operations for the interim periods a fair statement of such operations. For further information, refer to the consolidated financial statements and footnotes thereto, included in the Annual Report on Form 10-K, filed with the Securities and Exchange Commission for the year ended March 28, 2015.

 

Principles of Consolidation The consolidated financial statements include the accounts of Giga-tronics and its wholly-owned subsidiary. All significant intercompany balances and transactions have been eliminated in consolidation.

 

Derivatives The Company’s derivatives are valued in accordance with US Generally Accepted Accounting Principles in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures. Changes in fair values are reported in earnings as gain or loss on adjustment of derivative liability to fair value. 

 

New Accounting Standards In July 2015, the FASB issued ASU No, 2015-11, Inventory (Topic 330): “Simplifying the Measurement of Inventory”. Topic 330, Inventory, currently requires an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The amendments do not apply to inventory that is measured using last-in, first-out (LIFO) or the retail inventory method. The amendments apply to all other inventory, which includes inventory that is measured using first-in, first-out (FIFO) or average cost. An entity should measure in scope inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. The amendments more closely align the measurement of inventory in GAAP with the measurement of inventory in International Financial Reporting Standards. For public business entities, the amendments are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. The amendments should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the impact this accounting standard update may have on its financial statements.

 

In August 2015, the FASB delayed the effective date of ASU 2015-14 – “Revenue from Contracts with Customers” (Topic 606).

The amendments in ASU 2015-14 defer the effective date of ASU 2014-09 for all entities by one year. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is currently evaluating the impact this accounting standard update may have on its financial statements.

 

Also in August 2015, the FASB amended ASU 2015-03 – “Interest—Imputation of Interest (Subtopic 835-30) - Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements”, Previously, on April 7, 2015, the FASB issued ASU 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which required entities to present debt issuance costs related to a recognized debt liability as a direct deduction from the carrying amount of that debt liability. The guidance in ASU 2015-03 (see paragraph 835-30-45-1A) does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. Given the absence of authoritative guidance within ASU 2015-03 for debt issuance costs related to line-of-credit arrangements, the SEC staff stated that they would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. For public business entities, the guidance in the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The Company does not expect a material impact on its financial statements as a result of the adoption of ASU No. 2015-03.

 

In November 2015, the FASB issued ASU 2015-17 – Income Taxes (Topic 740): “Balance Sheet Classification of Deferred Taxes”.

Topic 740 is effective for public business entities for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. For all other entities, the amendments are effective for financial statements issued for annual periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. The amendments may be applied prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. The amendments in ASU 2015-17 eliminates the current requirement for organizations to present deferred tax liabilities and assets as current and noncurrent in a classified balance sheet. Instead, organizations will be required to classify all deferred tax assets and liabilities as noncurrent. The Company is currently evaluating the impact this accounting standard update may have on its financial statements.

 

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(2)      Going Concern and Management’s Plan

 

The Company incurred net losses of $602,000 for the third quarter of fiscal 2016 and $2.5 million for the first nine months of fiscal 2016, which have contributed to an accumulated deficit of $22.5 million as of December 26, 2015.

 

The Company has experienced delays in the development of features, orders, and shipments for the new Advanced Signal Generator. These delays have significantly contributed to a decrease in working capital from $3.0 million at March 28, 2015, to $443,000 at December 26, 2015. The new Advanced Signal Generator product has now shipped to several customers, but potential delays in the development of features, longer than anticipated sales cycles, or the ability to continue shipments in volume quantities, could significantly contribute to additional future losses. The losses in the first nine months of fiscal 2016 caused working capital restraints, resulting in delayed payments to suppliers. Many suppliers have since halted the shipment of raw materials to the Company until payments for past shipments are received.

 

The Company has lost, and is seeking to regain its AS9100C Certification that is commonly required in the aircraft manufacturing industry. The Company’s Microsource division sells components used on military aircrafts to two major customers that have the expectation the Company will have a Supplier Quality Management System certified to be AS9100C compliant. The Company has worked with one of the major customers to allow continued shipping and orders during the lapse in certification by allowing the customer to do its own quality inspections prior to the shipment of the Company’s products. The Company is working with the second customer for a similar solution during the lapse in certification. The Company’s Giga-tronics division receives orders from time to time that require a Supplier Quality Management System certified to be AS9100C. If the Company was unable to regain AS9100C certification, the lack of certifications could result in a loss of revenue and have a material adverse effect on results of operations and working capital.

 

These matters raise substantial doubt as to the ability of the Company to continue as a going concern.

 

To address these matters, the Company’s management has taken several actions to provide additional liquidity and reduce costs and expenses going forward. These actions are described in the following paragraphs. 

 

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On January 29, 2016, the Company completed the sale of approximately 2.7 million shares of Common Stock yielding gross proceeds of approximately $3.5 million. Net proceeds to the Company were approximately $3.2 million. The sale included Warrants to purchase approximately 2.4 million shares of Common Stock at $1.15 per share (see Note 17, Subsequent Events). The proceeds will be used to pay suppliers past due accounts, and to fund the forecasted increases in sales and manufacturing activities associated with the Advanced Signal Generator. There is no guarantee that payments to suppliers can be made in time to allow for materials to arrive at the Company in time for anticipated fourth quarter fiscal 2016 shipments.

 

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On December 15, 2015, the Company entered into an Asset Purchase Agreement with Spanawave Corporation (“Spanawave”), whereby Spanawave agreed to purchase the Giga-tronics’ Division product lines for its Power Meters, Amplifiers and Legacy Signal Generators for $1.5 million with one-half of the payments ($750,000) expected to be received between June and July 2016 (see Note 16, Sale of Product Lines). The Company received $75,000 from Spanawave on January 4, 2016 upon the initiation of data transfer to Spanawave. Proceeds from the asset sale will be used for working capital and general corporate purposes.

 

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To assist with regaining AS9100C certification, the Company has hired a Director of Quality to lead the recertification process and retained a consulting firm to advise the Company through the recertification process.

 

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In the first quarter of fiscal 2016, the Company’s Microsource business unit also finalized a multiyear $10.0 million YIG production order (“YIG Production Order”). The Company expects to start shipping the YIG Production Order in the fall of 2016.

 

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To assist with the upfront purchases of inventory required for future product deliveries, the Company entered into advance payment arrangements with two large customers, whereby the customers reimburse the Company for raw material purchases prior to the shipment of the finished products. In the first three quarters of fiscal 2016, the Company entered into advance payment arrangements totaling $2.0 million, and during the first three quarters of fiscal 2015 the Company entered into $1.4 million of advance payment arrangements. The Company will continue to seek similar terms in future agreements with these customers and other customers.

  

Management will continue to review all aspects of the business in an effort to improve cash flow and reduce costs and expenses, while continuing to invest, to the extent possible, in new product development for future revenue streams.

 

Management will also continue to seek additional working capital through debt, equity financing or possible product line sales, however there are no assurances that such financings or sales will be available at all, or on terms acceptable to the Company.

 

 

The current year loss has had a significant negative impact on the financial condition of the Company and raises substantial doubt about the Company’s ability to continue as a going concern. The Consolidated Financial Statements have been prepared assuming the Company will continue as a going concern and do not include any adjustments that might result if the Company were unable to do so.    

 

(3)     Revenue Recognition

 

The Company records revenue when there is persuasive evidence of an arrangement, delivery has occurred, the price is fixed and determinable, and collectability is reasonably assured. This occurs when products are shipped or the customer accepts title transfer. If the arrangement involves acceptance terms, the Company defers revenue until product acceptance is received. The Company limits the amount of revenue recognition for delivered elements to the amount that is not contingent on the future delivery of products or services, future performance obligations or subject to customer-specified return or refund privileges. The Company evaluates each deliverable in an arrangement to determine whether they represent separate units of accounting. On certain large development contracts, revenue is recognized upon achievement of substantive milestones. Determining whether a milestone is substantive is a matter of judgment and that assessment is performed only at the inception of the arrangement. The consideration earned from the achievement of a milestone must meet all of the following for the milestone to be considered substantive:

 

a. It is commensurate with either of the following:

1. The Company’s performance to achieve the milestone.

2. The enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the Company's performance to achieve the milestone.

b. It relates solely to past performance.

c. It is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.

 

Milestones are agreed upon with the customer prior to the start of the contract and some milestones will be tied to product shipping while others will be tied to design review. In fiscal 2015 the Company’s Microsource business unit received a $6.5 million order from a major aerospace company for non-recurring engineering services to develop a variant of its high performance fast tuning YIG filters for an aircraft platform and to deliver a limited number of flight-qualified prototype hardware units (the “NRE Order”) which is being accounted for on a milestone basis. The Company considered factors such as estimated completion dates and product acceptance of the order prior to accounting for the NRE Order as milestone revenue. During the three and nine month periods ended December 26, 2015 and December 27, 2014, revenue recognized on a milestone basis were $6,000 and $716,000, and $1.6 million and $4.5 million, respectively.

 

On certain contracts with several of the Company’s significant customers, the Company receives payments in advance of manufacturing. Advanced payments are recorded as deferred revenue until the revenue recognition criteria described above has been met.

 

Accounts receivable are stated at their net realizable value. The Company has estimated an allowance for uncollectable accounts based on analysis of specifically identified accounts, outstanding receivables, consideration of the age of those receivables, the Company’s historical collection experience, and adjustments for other factors management believes are necessary based on perceived credit risk.

  

The Company provides for estimated costs that may be incurred for product warranties at the time of shipment. The Company’s warranty policy generally provides twelve to eighteen months depending on the customer. The estimated cost of warranty coverage is based on the Company’s actual historical experience with its current products or similar products. For new products, the required reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Adjustments are made as new information becomes available.

 

(4)            Inventories

 

Inventories consisted of the following:

 

 

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(5)            Earnings/ Loss Per Share

 

Basic earnings (loss) per share (EPS) is calculated by dividing net income or loss allocated to common shareholders by the weighted average common shares outstanding during the period. Net income allocated to common shareholders excludes earnings allocated to certain non-vested restricted stock awards that have non forfeitable dividend rights and therefore are considered participating securities. Diluted EPS reflects the net incremental shares that would be issued if unvested restricted shares became vested and dilutive outstanding stock options were exercised, using the treasury stock method. In the case of a net loss, it is assumed that no incremental shares would be issued because they would be anti-dilutive. In addition, certain options are considered antidilutive because assumed proceeds from exercise price, related tax benefits and average future compensation were greater than the weighted average number of options outstanding multiplied by the average market price during the period. The shares used in per share computations are as follows:

 

 

  

The stock options, restricted stock, convertible preferred stock and warrants not included in the computation of diluted earnings per share (EPS) for the three month period ended December 26, 2015 and nine month periods ended December 26, 2015 and December 27, 2014 are a result of the Company’s net loss and, therefore, the effect of these instruments would be anti-dilutive. The restricted stock awards and stock options not included in the computation of diluted earnings per share for the three month period ended December 27, 2014 are as a result of these instruments being anti-dilutive after application of the treasury method described above.

 

(6)     Share Based Compensation

 

The Company has established the 2005 Equity Incentive Plan, which provide for the granting of options and restricted stock for up to 2,850,000 shares of common stock at 100% of fair market value at the date of grant, with each grant requiring approval by the Board of Directors of the Company. Options granted generally vest in one or more installments in a four or five year period and must be exercised while the grantee is employed by the Company or within a certain period after termination of employment. Options granted to employees shall not have terms in excess of 10 years from the grant date. Holders of options may be granted stock appreciation rights (SARs), which entitle them to surrender outstanding awards for a cash distribution under certain changes in ownership of the Company, as defined in the stock option plan. As of December 26, 2015, no SARs have been granted under the option plan. As of December 26, 2015, the total number of shares of common stock available for issuance is 958,827. All outstanding options have either a five year or a ten year life. The Company records compensation cost associated with share-based compensation equivalent to the estimated fair value of the awards over the requisite service period. There were 25,000 options granted in the third quarter of fiscal 2016 and for the first nine months of fiscal 2016 with weighted average grant day fair value of $1.07. There were 35,000 options granted in the third quarter of fiscal 2015 and 264,500 options were granted in the first nine months of fiscal 2015 with weighted average grant date fair values of $1.23 and $1.68 per share, respectively.

  

In calculating compensation related to stock option grants, the fair value of each stock option is estimated on the date of grant using the Black-Scholes-Merton option-pricing model and the following weighted average assumptions:

 

 

 

The computation of expected volatility used in the Black-Scholes-Merton option-pricing model is based on the historical volatility of the Company’s share price. The expected term is estimated based on a review of historical employee exercise behavior with respect to option grants. The risk-free interest rate is based on the U.S. Treasury rates with maturity similar to the expected term of the option on the date of grant.

 

A summary of the changes in stock options outstanding for the nine month period ended December 26, 2015 and the fiscal year ended March 28, 2015 is as follows:

 

   

As of December 26, 2015, there was $527,000 of total unrecognized compensation cost related to non-vested options. That cost is expected to be recognized over a weighted average period of 2.7 years. There were 73,000 options and 71,750 options that vested during the quarter ended December 26, 2015 and December 27, 2014, respectively. The total grant date fair value of options vested during the quarters ended December 26, 2015 and December 27, 2014 was $98,000 and $97,000, respectively. There were 364,150 and 231,150 options that vested during the nine month period ended December 26, 2015 and December 27, 2014, respectively. The total grant date fair value of options vested during the nine month periods ended December 26, 2015 and December 27, 2014 was $383,000 and $280,000, respectively. Options of 27,300 shares were exercised in the three month period ended December 26, 2015 and no shares were exercised in the three month period ended December 27, 2014. Options of 39,300 shares were exercised in the nine month period ended December 26, 2015 and 76,500 shares were exercised in the nine month period ended December 27, 2014. Share based compensation cost recognized in operating results for the three month periods ended December 26, 2015 and December 27, 2014 totaled $93,000 and $103,000, respectively. Share based compensation cost recognized in operating results for the nine month periods ended December 26, 2015 and December 27, 2014 totaled $317,000 and $280,000, respectively.

 

Restricted Stock

 

No restricted awards were granted in the third quarter or the first nine months of fiscal 2016. The Company granted 187,000 shares of restricted stock during the first nine months of fiscal 2015 to the members of the Board of Directors in lieu of cash compensation for services to be performed in fiscal 2015. These restricted stock awards fully vested in the second quarter of fiscal 2016. The weighted average grant date fair value was $2.47. The Company granted 50,000 shares of restricted stock outside the 2005 Plan in fiscal 2013 that vested in the first quarter of fiscal 2016. The restricted stock awards are considered fixed awards as the number of shares and fair value at the grant date is amortized over the requisite service period net of estimated forfeitures.

 

As of December 26, 2015, there was $60,000 of total unrecognized compensation cost related to restricted awards. That cost is expected to be recognized over a weighted average period of 0.2 years. Compensation cost was recognized for the restricted and unrestricted stock awards for the three and nine month periods ended December 26, 2015 totaling $90,000 and $400,000, respectively. Compensation cost was recognized for the restricted and unrestricted stock awards for the three and nine month periods ended December 27, 2014 totaling $131,000 and $265,000, respectively.  

 

 

A summary of the changes in non-vested restricted stock awards outstanding at December 26, 2015 and at March 28, 2015 is as follows:

 

 

(7)      Significant Customer and Industry Segment Information

 

The Company has two reportable segments: Giga-tronics Division and Microsource.

 

Giga-tronics Division produces a broad line of test and measurement equipment used in the development, test and maintenance of wireless communications products and systems, flight navigational equipment, electronic defense systems and automatic testing systems and designs, manufactures, and markets a line of switching devices that link together many specific purpose instruments that comprise automatic test systems. These products are used primarily in the design, production, repair and maintenance of commercial telecommunications, radar, and electronic warfare equipment. Microsource develops and manufactures a broad line of YIG (Yttrium, Iron, Garnet) tuned oscillators, filters and microwave synthesizers, which are used by its customers in operational applications and in manufacturing a wide variety of microwave instruments and devices.

 

The tables below present information for the three and nine month periods ended December 26, 2015 and December 27, 2014.

 

 

  

 

 

During the third quarter of fiscal 2016, one customer accounted for 40% of the Company’s consolidated revenues and was included in the Microsource segment. A second customer accounted 21% of the Company’s consolidated revenue for the three months ended December 26, 2015 and was primarily included in the Giga-tronics Division. During the third quarter of fiscal 2015, one customer accounted for 36% of the Company’s consolidated revenue and was primarily included in the Microsource Division. A second customer accounted for 16% and was included in the Giga-tronics Division.

 

During the first nine months of fiscal 2016, one customer accounted for 34% of the Company’s consolidated revenues and was primarily included in the Microsource segment. A second customer accounted for 13% of the Company’s consolidated revenue for the nine months ended December 26, 2015 and was included in the Giga-tronics Division. One customer accounted for 32% of the Company’s consolidated revenues for the nine months ended December 27, 2014 and was primarily included in the Microsource segment. A second customer accounted for 19% of the Company’s consolidated revenues for the nine months ended December 27, 2014 and was included in the Giga-tronics Division.

 

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(8)     Income Taxes

 
The Company accounts for income taxes using the asset and liability method as codified in Topic 740. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards.

 

The Company did not incur tax expense for the three months ended December 26, 2015 and December 27, 2014. The Company’s tax expense for the nine months ended December 26, 2015 and December 27, 2014 was $2,000 and $47,000, respectively. The effective tax rate for the three months ended December 26, 2015 and December 27, 2014 was 0% primarily due to a valuation allowance recorded against the net deferred tax asset balance. The effective tax rate for the nine months ended December 26, 2015 and December 27, 2014 was 0% and 20% primarily due to a valuation allowance recorded against the net deferred tax asset balance. 

 

As of December 26, 2015 and March 28, 2015, the Company had recorded $93,000 for unrecognized tax benefits related to uncertain tax positions. The unrecognized tax benefit is netted against the non-current deferred tax asset on the Consolidated Balance Sheet. The Company does not expect the liability for unrecognized tax benefits to change materially within the next 12 months. The Company does have a California Franchise Tax Board audit that is currently in process. The Company is working with the California Franchise Tax Board to resolve all audit issues and does not believe any material taxes, penalties and fees are due. However, as a result of the ongoing examination, the Company recorded an estimated associated tax liability of $45,000 in the first quarter of fiscal 2015.

 

(9)        Warranty Obligations

 

The Company records a provision in cost of sales for estimated warranty obligations at the date products are sold. Adjustments are made as new information becomes available. The following provides a reconciliation of changes in the Company’s warranty reserve. The Company provides no other guarantees.

 

 

(10)       Fair Value

 

Fair Value Pursuant to the accounting guidance for fair value measurement and its subsequent updates, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. The accounting guidance establishes a hierarchy for inputs used in measuring fair value that minimizes the use of unobservable inputs by requiring the use of observable market data when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data. Unobservable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.  

 

The fair value hierarchy is broken down into the three input levels summarized below:

 

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Level 1 —Valuations are based on quoted prices in active markets for identical assets or liabilities and readily accessible by us at the reporting date. Examples of assets and liabilities utilizing Level 1 inputs are certain money market funds, U.S. Treasuries and trading securities with quoted prices on active markets.

 

•

Level 2 —Valuations based on inputs other than the quoted prices in active markets that are observable either directly or indirectly in active markets. Examples of assets and liabilities utilizing Level 2 inputs are U.S. government agency bonds, corporate bonds, commercial paper, certificates of deposit and over-the- counter derivatives.

 

•

Level 3 —Valuations based on unobservable inputs in which there are little or no market data, which require us to develop our own assumptions.

 

 

The carrying amounts of the Company’s cash and cash-equivalents and line of credit approximate their fair values at each balance sheet date due to the short-term maturity of these financial instruments. The fair values of term debt are based on the present value of expected future cash flows and assumptions about current interest rates and the creditworthiness of the Company (Level 3). At December 26, 2015 and March 28, 2015, the carrying amounts of the Company’s term debt totaled $575,000 and $1.1 million respectively and the estimated fair value totaled $590,000 and $1.2 million respectively. The fair value was calculated using a discounted cash flow model and utilized a 20% and 18% discount rate respectively. The rates are commensurate with market rates given the remaining term, principal repayment schedule, the Company’s creditworthiness and outstanding loan balance.

 

The Company’s derivative warrant liability is measured at fair value on a recurring basis and is categorized as Level 3 in the fair value hierarchy. The derivative warrant liability is valued using the Monte Carlo simulation model, using the following assumptions as of December 26, 2015: (i) the remaining expected life of 3.3 years, (ii) the Company’s historical volatility rate of 116.1%, (iii) risk-free interest rate of 1.38%, and (iv) a discount rate of twenty percent.

 

The Company’s assets and liabilities that are recognized and measured at fair value on a recurring basis are as follows:

 

 

 

There were no transfers between Level 1, Level 2 or Level 3 for the three and nine month periods ended December 26, 2015 and the twelve month periods ended March 28, 2015.  

 

The table below summarizes changes in gains and losses recorded in earnings for Level 3 assets and liabilities that are still held at December 26, 2015:

 

 

There were no assets measured at fair value on a recurring basis and there were no assets or liabilities measured on a non-recurring basis at December 26, 2015 and March 28, 2015.

 

The following table presents quantitative information about recurring Level 3 fair value measurements at December 26, 2015 and March 28, 2015:

 

 

 

The discount rate of twenty percent is management’s estimate of the current cost of capital given the Company’s credit worthiness. A significant increase in the discount rate would significantly decrease the fair value, but the magnitude of this decrease would be less significant in a scenario where the Company’s stock price is significantly higher than the exercise price since the holder’s option to take a cash payment at maturity represents a smaller component of the total fair value when the Company’s stock price is higher. The Monte Carlo simulation model simulated the Company’s stock price through the maturity date of March 31, 2019. At the end of the simulated period, the value of the warrant was determined based on the greater of (1) the net share settlement value, (2) the net exercise value, or (3) the fixed cash put value.

 

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(11)     Accounts Receivable Line of Credit

 

On June 1, 2015 the Company entered into a $2.5 million Revolving Accounts Receivable Line of Credit agreement with Bridge Bank. The credit facility agreement replaced the line of credit with SVB which expired April 15, 2015. The agreement provides for a maximum borrowing capacity of $2.5 million of which $2.0 million is subject to a borrowing base calculation and $500,000 is non-formula based.

 

The loan is secured by all assets of the Company including intellectual property and general intangibles and provides for a borrowing capacity equal to 80% of eligible accounts receivable. The loan matures on May 6, 2017 and bears an interest rate, equal to 1.5% over the bank’s prime rate of interest (which was 3.25% at the date of closing resulting in an interest rate of 4.75%). Interest is payable monthly with principal due upon maturity. The Company paid a commitment fee of $12,500, and an additional $12,500 is due on the first anniversary of the loan closing. The loan agreement contains financial and non-financial covenants that are customary for this type of lending and includes a covenant to maintain an asset coverage ratio of at least 135% (defined as unrestricted cash and cash equivalents maintained with Bridge Bank, plus eligible accounts receivable aged less than 90 days from the invoice date, divided by the total amount of outstanding principal of all obligations under the loan agreement). As of December 26, 2015, the Company was in compliance with all the financial covenants under the agreement. The line of credit requires a lockbox arrangement, which provides for receipts to be swept daily to reduce borrowings outstanding at the discretion of Bridge Bank. This arrangement, combined with the existence of the subjective acceleration clause in the line of credit agreement, necessitates the line of credit be classified as a current liability on the balance sheet. The acceleration clause allows for amounts due under the facility to become immediately due in the event of a material adverse change in the Company’s business condition (financial or otherwise), operations, properties or prospects, or ability to repay the credit based on the lender's judgment. As of December 26, 2015, the Company’s total outstanding borrowings and remaining borrowing capacity under the Bridge Bank line of credit were $1.2 million and $895,000, respectively.

 

(12)      Term Loan, Revolving Line of Credit and Warrants

 

On March 13, 2014 the Company entered into a three year, $2.0 million term loan agreement with PFG under which the Company received $1.0 million on March 14, 2014. Pursuant to the agreement, the Company had the ability to borrow an additional $1.0 million following the Company’s achievement of certain performance milestones which included achieving $7.5 million in net sales during the first half of fiscal 2015 and two consecutive quarters of net income greater than zero during fiscal 2015.

  

On June 16, 2014, the Company amended its loan agreement with PFG (the “Amendment”). Under the terms of the Amendment, PFG made a revolving credit line available to Giga-tronics in the amount of $500,000, and the Company borrowed the entire amount on June 17, 2014. The revolving line had a 33 month term. The Amendment also reduced the Company’s potential future borrowing availability under the PFG Loan agreement from $1.0 million to $500,000. The interest on the PFG revolving credit line was fixed, calculated on a daily basis at a rate of 12.50% per annum. The Company was allowed to prepay the loan at any time prior to its March 13, 2017 maturity date without a penalty. Beginning in October 2014, PFG had the right to convert the $500,000 revolving loan into a term loan and require principal payments to be amortized over the remaining loan term. On April 25, 2015, PFG exercised this right, and fully amortizing principal and interest payments began in May 2015.

  

On June 3, 2015, and following the Company’s new line of credit agreement with Bridge Bank (see Note 11, Accounts Receivable Line of Credit), the Company’s loan agreement with PFG was further amended (the “Second Amendment”). The Second Amendment cancelled the Company’s $500,000 of borrowing availability under the June 2014 Amendment and required the Company to pay PFG $150,000 towards its existing $500,000 outstanding balance under the revolving line of credit, in which the Company paid in July 2015. The Company also agreed to pay PFG an additional $10,000 per month towards its remaining credit line balance until repaid, followed by like payments towards its term loan balance until repaid. The Company expects to pay off the credit line by April 1, 2016. As of December 26, 2015, the Company’s total outstanding principal balance under the revolving credit line loan was $120,000.

 

Interest on the initial $1.0 million term loan is fixed at 9.75% and required monthly interest only payments during the first nine months of the agreement followed by monthly principal and interest payments over the remaining 30 months. The Company may prepay the loan at any time prior to maturity by paying all future scheduled principal and interest payments. As of December 26, 2015, the Company’s total outstanding principal balance under the PFG term loan was $500,000.  

   

The PFG loan is secured by all of the assets of the Company under a lien that is junior to the Bridge Bank debt agreement described in Note 11, and limits borrowing under the Bridge Bank credit line to $2.5 million. The Company paid a loan fee of $30,000 upon the initial draw (“First Draw”), $15,000 for the June 2014 Amendment and $5,000 for the Second Amendment. The loan fees paid are recorded as prepaid expenses and amortized to interest expense over the remaining term of the PFG amended loan agreement.  

  

The PFG loan agreement contains financial covenants associated with the Company achieving minimum quarterly net sales and maintaining a minimum monthly shareholders’ equity. In the event of default by the Company, all or any part of the Company’s obligations to PFG could become immediately due. As of the quarter ended December 26, 2015, the Company was in compliance with the financial covenant under the agreement. 

 

The loan agreement also provided for the issuance of warrants convertible into 300,000 shares of the Company’s common stock, of which 180,000 were exercisable upon receipt of the initial $1.0 million from the First Draw, and 80,000 became exercisable with the Amendment. The Second Amendment terminated the additional 40,000 warrants that would have become exercisable as part of cancelling the remaining $500,000 that was available under the Amendment. Each warrant issued under the loan agreement has a term of five years from the First Draw and an exercise price of $1.42 which was equal to the average NASDAQ closing price of the Company’s common stock for the ten trading days prior to the First Draw.

 

  

If the warrants are not exercised before expiration on March 13, 2019, the Company would be required to pay PFG $150,000 and $67,000 as settlement for warrants associated with the First Draw and the Amendment, respectively. The warrants could be settled for cash at an earlier date in the event of any acquisition or other change in control of the Company, future public issuance of Company securities or liquidation (or substantially similar event) of the Company. The Company currently has no plans for any of the aforementioned events, and as a result, the cash payment date is estimated to be the expiration date unless warrants are exercised before then. The warrants have the characteristics of both debt and equity and are accounted for as a derivative liability measured at fair value each reporting period with the change in fair value recorded in earnings. The initial fair value of the warrants associated with the First Draw and Amendment were $128,000 and $123,000, respectively.

 

As of December 26, 2015, the estimated fair values of the derivative liabilities associated with the warrants issued in connection with the First Draw and Amendment were $235,000 and $157,000, respectively, for a combined value of $392,000. The change in the fair value of the warrant liability totaled $98,000 for the three month period ended December 26, 2015 and is reported in the accompanying statement of operations as a loss on adjustment of derivative liability to fair value.

  

The initial $1.0 million in proceeds under the term loan agreement were allocated between the PFG Loan and the warrants based on their relative fair values on the date of issuance which resulted in initial carrying values of $822,000 and $178,000, respectively. The resulting discount of $178,000 on the PFG Loan is being accreted to interest expense under the effective interest method over the three-year term of the PFG Loan.

  

The proceeds from the $500,000 credit line issued in connection with the Amendment were allocated between the PFG Loan and the warrants based on their relative fair values on the date of issuance which resulted in initial carrying values of $365,000 and $135,000, respectively. The resulting discounts of $135,000 on the PFG Loan is being accreted to interest expense under the effective interest method over the remaining term of the PFG Loan.

 

For the three month periods ended December 26, 2015 and December 27, 2014, the Company recorded accretion of discount expense associated with the PFG Loan of $34,000 and $45,000 respectively. For the nine month period ended December 26, 2015 and December 27, 2014, the Company recorded accretion of discount expense associated with the PFG Loan of $140,000 and $115,000 respectively. 

 

(13)      Series B, C, D Convertible Voting Perpetual Preferred Stock and Warrants

   

On November 10, 2011, the Company received $2,199,000 in cash proceeds from Alara Capital AVI II, LLC, a Delaware limited liability company (the “Investor”), an investment vehicle sponsored by Active Value Investors, LLC, under a Securities Purchase Agreement entered into on October 31, 2011. Under the terms of the Securities Purchase Agreement, the Company issued 9,997 shares of its Series B Convertible Voting Perpetual Preferred Stock (“Series B Preferred Stock”) to the Investor at a price of $220 per share. The Company has recorded $2.0 million as Series B Preferred Stock on the consolidated balance sheet which is net of stock offering costs of approximately $202,000 and represents the value attributable to both the convertible preferred stock and warrants issued to the Investor. After considering the value of the warrants, the effective conversion price of the preferred stock was greater than the common stock price on date of issue and therefore no beneficial conversion feature was present. 

 

On February 19, 2013, the Company entered into a Securities Purchase Agreement pursuant to which it agreed to sell 3,424.65 shares of its Series C Convertible Voting Perpetual Preferred Stock (“Series C Preferred Stock”) to the Investor, for aggregate consideration of $500,000, which is approximately $146.00 per share. The Company has recorded $457,000 as Series C Preferred Stock on the consolidated balance sheet, which is net of stock offering costs of approximately $43,000.After considering the reduction in the value of the warrant, the effective conversion price of the preferred stock was greater than the common stock price on the date of issue and therefore no beneficial conversion feature was present.

 

On July 8, 2013 the Company received $817,000 in net cash proceeds from the Investor under a Securities Purchase Agreement. The Company sold to the Investor 5,111.86 shares of its Series D Convertible Voting Perpetual Preferred Stock (Series D Preferred Stock) and a warrant to purchase up to 511,186 additional shares of common stock at the price of $1.43 per share. The allocation of the $858,000 in gross proceeds from issuance of Series D Preferred Stock based on the relative fair values resulted in an allocation of $498,000 (which was recorded net of $41,000 of issuance costs) to Series D Preferred Stock and $360,000 to Common Stock. In addition, because the effective conversion rate based on the $498,000 allocated to Series D Preferred Stock was $0.97 per common share which was less than the Company’s stock price on the date of issuance, a beneficial conversion feature was present at the issuance date. The beneficial conversion feature totaled$238,000 and was recorded as an increase of common stock and an increase to accumulated deficit.

 

Each share of Series B, Series C and Series D Preferred Stock is convertible into one hundred shares of the Company’s common stock. The investor also held warrants to purchase 1,017,405 shares at an exercise price of $1.43 per share which were exercised in February and May 2015 as discussed in Note 14, Exercise of Series C and Series D Warrants.

 

 

The table below presents information as of December 26, 2015 and March 28, 2015. 

 

Preferred Stock as of December 26, 2015 and March 28, 2015    

 

 

(14) Exercise of Series C and Series D Warrants

 

On February 16, 2015, the Company entered into a Securities Purchase Agreement and Warrant Agreement with Alara Capital AVI II, LLC in which the Company received total gross cash proceeds of approximately $1.5 million. Funds were received from Alara in separate closings dated February 16, 2015 and February 23, 2015 in which Alara exercised a total of 1,002,818 of its existing Series C and Series D warrants to purchase common shares, all of which had an exercise price of $1.43 per share for total cash proceeds of $1,434,000, which was recorded net of $42,000 of stock issuance costs. As part of the consideration for this exercise, the Company sold to Alara two new warrants (“new Warrants”) to purchase an additional 898,634 and 194,437 common shares at an exercise price of $1.78 and $1.76 per share, respectively, for a total purchase price of $137,000 or $0.125 per share. The new warrants have a term of five years and may be paid in cash or through a cashless net share settlement. The Company and Alara amended the remaining 14,587 warrants as part of the February closings. On May 14, 2015, Alara exercised the remaining 14,587 warrants by acquiring 7,216 of shares of the Company’s common stock through a cashless net share settlement. The Company recorded the issuance of the new Warrants using their estimated fair value on the date of issuance. The Company estimated the fair value of the new Warrants using the Black-Scholes option valuation model with the following assumptions: expected term of 5 years, a risk-free interest rate of 1.54%, expected volatility of 90% and 0% expected dividend yield. The resulting $1.2 million from the issuance of the new Warrants was recorded as a charge to other expense in the fourth quarter of fiscal 2015.

 

(15)      Software Development Costs

 

On September 3, 2015, the Company entered into a software development agreement with a major aerospace and defense company whereby the aerospace company would develop and license its simulation software to the Company. The simulation software (also called Open Loop Simulator or OLS technology) is currently the aerospace company’s intellectual property. The OLS technology generates threat simulations and enables various hardware to generate signals for performing threat analysis on systems under test. The Company intends to license the OLS software as a bundled or integrated solution with its Advanced Signal Generator system. The Company is obligated to pay the aerospace company software development costs and fees for OLS of $919,000 in the aggregate, which is payable in monthly installments as the work is performed by the aerospace company through August 2016. The OLS technology is a perpetual license agreement that may be terminated by the Company at any time as long as the Company provides a notice to the aerospace company and pays for the development costs incurred through the notice termination date. The Company is also obligated to pay royalties to the aerospace company on net sales of its Advanced Signal Generator product sold with the OLS software equal to a percentage of net sales price of each ASG system sold and subject to certain minimums. The Company expenses research and development costs as they are incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. Capitalized software costs for the quarter ended December 26, 2015 were $440,000. The company intends to begin amortizing the costs of capitalized software to cost of sales once the product is released to its customers.

 

(16) Sale of Product Lines

 

On December 15, 2015, the Company entered into an Asset Purchase Agreement with Spanawave Corporation (“Spanawave”), whereby Spanawave agreed to purchase the Giga-tronics’ Division product lines for its Power Meters, Amplifiers and Legacy Signal Generators for $1.5 million. The product lines will transfer to Spanawave sequentially in phases beginning with certain sensor and amplifier products effective the fourth quarter of fiscal 2016, with the final product line transfer (legacy Signal Generators) estimated to be completed by August 2016. On January 4, 2016, the Company received $75,000 upon the initiation of data transfer to Spanawave. The Company expects to receive one-half of the payments ($750,000) between June and July 2016. In addition, the Company will sell to Spanawave existing inventory for these products in phases. The Company will continue to manufacture the related products until the respective product line transfer is complete. These product lines accounted for total revenues of $421,000 and $1.4 million respectively, for the three and nine month periods ended December 26, 2015. For the three and nine month periods ended December 27, 2014, revenues for the product lines were $749,000 and $1.6 million respectively. Due to the low profit margins on these product lines, the contribution to pre-tax results for the three and nine month periods ended December 26, 2015 and December 27, 2014 were immaterial to the consolidated financial statements. 

 

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(17) Subsequent Event

 

On January 19, 2016, the Company entered into a Securities Purchase Agreement for the sale of 2,787,872 Units, each consisting of one share of common stock and a warrant to purchase 0.75 shares of common stock, to approximately 20 private investors. The purchase price for each Unit was $1.24375. Gross proceeds were approximately $3.5 million. Net proceeds to the Company after fees was approximately $3.2 million. The portion of the purchase price attributable to the common shares included in each Unit was $1.15, the consolidated closing bid price for the Company’s common stock on January 15, 2016. The warrant price was $.09375 per Unit (equivalent to $0.125 per whole warrant share), with an exercise price of $1.15 per share. The term of the warrants is five years from the date of completion of the transaction. The Company expects to use the proceeds for working capital and general corporate purposes.   

 

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