INTEST CORP - Quarter Report: 2001 March (Form 10-Q)

inTEST Corporation (the "Company") is a leading independent designer, manufacturer and marketer of manipulator and docking hardware products, temperature management systems and tester interface products that are used by semiconductor manufacturers in conjunction with automatic test equipment, or ATE, in the testing of integrated circuits, or ICs.

The consolidated entity is comprised of inTEST Corporation (parent) and its nine 100% owned subsidiaries: inTEST Limited (Thame, U.K.), inTEST Kabushiki Kaisha (Kichijoji, Japan), inTEST PTE, Limited (Singapore), inTEST Sunnyvale Corp. (Delaware), Temptronic Corporation (Delaware), inTEST GmbH (Germany) (operations commenced during August 2000), inTEST Investments, Inc. (a Delaware holding company), inTEST IP Corp. (a Delaware holding company) and inTEST Licensing Corp. (a Delaware holding company).

The Company manufactures its products in the U.S., U.K. and Singapore. Marketing and support activities are conducted worldwide from the Company's facilities in the U.S., U.K., Germany, Japan and Singapore.

On March 9, 2000, the Company completed a merger with Temptronic Corporation ("Temptronic") whereby Temptronic was merged into a wholly-owned subsidiary of the Company. The Company exchanged 2,046,793 shares of its common stock for all of the Temptronic common stock. Each share of Temptronic common stock was exchanged for 0.925 shares of the Company's common stock. In addition, outstanding Temptronic stock options were converted at the same exchange ratio into options to acquire 175,686 shares of the Company's common stock. The merger was accounted for under the pooling-of-interests method of accounting. At the closing of the merger, an escrow consisting of 204,654 shares was established to satisfy any indemnity claims made between closing and March 9, 2001. During the quarter ended March 31, 2001, the Company made a claim against the escrow for 3,754 shares, which were returned to the Company and subsequently cancelled. The balance of the escrow shares were distributed to the holders of record shortly thereafter. Temptronic also has a 100% owned foreign subsidiary, which is consolidated with Temptronic for reporting purposes.

Basis of Presentation

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated upon consolidation. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Risks and Uncertainties

The Company's historic results of operations as presented in these financial statements may not be indicative of future results, as these future results involve a number of risks and uncertainties. Factors that could affect the Company's future operating results and cause actual results to vary materially from historical results include, but are not limited to, the highly cyclical nature of the semiconductor industry, dependence upon capital expenditures of semiconductor manufacturers, developments and trends in the IC and ATE industries, changes in general economic, business and financial market conditions, future acquisitions and the Company's ability to successfully integrate its operations with those of the acquired entity, costs associated with future acquisitions and integration of operations, costs associated with the expansion of facilities, the ability to effectively control operating costs, competitive pricing pressures, delays in shipments of products, the mix of products sold, the mix of customers and geographic regions where products are sold, the development of new products and technologies by the Company or its competitors, the availability of materials used to manufacture the Company's products, the availability of qualified personnel, net revenues generated by foreign subsidiaries, exchange rate fluctuations and the use of forward exchange rate contracts, stock price fluctuations, the anticipated market for the Company's products, and the sufficiency of cash balances, lines of credit and net cash from operations.

Interim Financial Reporting

In the opinion of management, the accompanying unaudited consolidated financial statements include all adjustments (consisting only of normally recurring adjustments) necessary to present fairly the financial position, results of operations, and changes in cash flows for the interim periods presented.

Certain footnote information has been condensed or omitted from these financial statements. Therefore, these financial statements should be read in conjunction with the consolidated financial statements and accompanying footnotes included in the Company's Form 10K filed on March 30, 2001.

Net Earnings Per Common Share

Basic earnings per common share is computed by dividing net earnings by the weighted average number of common shares outstanding during each period. Diluted earnings per common share is computed by dividing net earnings by the weighted average number of common shares and common share equivalents outstanding during each period. Common share equivalents represent stock options and are calculated using the treasury stock method.

Weighted average common shares outstanding exclude unallocated shares of common stock held by the Company's Equity Participation Plan.

New Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS 133, as amended by SFAS 137 and 138, is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company adopted SFAS No. 133 in the first quarter of 2001, as required. The adoption of SFAS No. 133, as amended, did not have a material effect on the results of operations, financial condition or long-term liquidity of the Company.

The various products the Company designs, manufactures and markets are considered by management to form three reportable segments: manipulator and docking hardware products, temperature management systems and tester interface products. The manipulator and docking hardware segment includes the operations of the Company's Cherry Hill, New Jersey manufacturing facility as well as the operations of three of the Company's foreign subsidiaries: inTEST Limited, inTEST Kabushiki Kaisha, and inTEST PTE, Limited. Sales of this segment consist primarily of manipulator and docking hardware products which the Company designs, manufactures and markets, as well as certain other high performance test sockets and interface boards which the Company designs and markets, but which are manufactured by third parties. The temperature management segment includes the operations of Temptronic in Newton, Massachusetts as well as inTEST GmbH. Sales of this segment consist primarily of temperature management systems which the Company designs, manufactures and markets under its Temptronic product line. The tester interface segment includes the operations of inTEST Sunnyvale in Sunnyvale, California. Sales of this segment consist primarily of tester interface products which the Company designs, manufactures and markets under its TestDesign product line.

The Company operates its business worldwide and all three segments sell their products both domestically and internationally. All three segments sell to semiconductor manufacturers and ATE manufacturers.

Intercompany pricing between segments is either a multiple of cost for component parts used in manufacturing or a percentage discount from list price for finished goods sold to non-manufacturing operations.

Overview

Our business and results of operations are substantially dependent upon the demand for ATE by semiconductor manufacturers and companies that specialize in the testing of ICs. Demand for ATE is driven by semiconductor manufacturers that are opening new or expanding existing semiconductor fabrication facilities or upgrading existing equipment, which in turn is dependent upon the current and anticipated market demand for semiconductors and products incorporating semiconductors. The semiconductor industry has been highly cyclical with recurring periods of oversupply, which often have a severe impact on the semiconductor industry's demand for ATE, including the products we manufacture. This cyclicality has been clearly demonstrated during the past five years, with downward cycles in 1996 and 1998, and up cycles in 1997, 1999 and 2000. During the fourth quarter of 2000, demand for ATE entered another cyclical downturn. We cannot be sure as to the length and depth of this current downturn and when the next cyclical growth phase will occur.

In response to this downturn, we reduced our worldwide workforce by 20%, or 77 people in late March 2001. In addition, we have implemented a worldwide salary freeze, put a hold on new hires and implemented additional cost controls on other expenditures with the goal of reducing our overall operating expenditures by 10%.

We sell our products to both semiconductor manufacturers (end user sales) and to ATE manufacturers (OEM sales) who ultimately resell our equipment with theirs to semiconductor manufacturers. The mix of customers during any given period will affect our gross margin due to differing sales discounts and commissions. Historically, the majority of our manipulator, docking hardware and tester interface product sales have been directly to semiconductor manufacturers, with our end user sales typically in the range of 65% to 75% of our net revenues. In the past year, many semiconductor manufacturers have begun to show a preference for purchasing the various components of the ATE (excluding temperature management systems) they need from a single source. Typically, this source is the manufacturer of the largest and most expensive components of the ATE system, the tester manufacturer. During 2000, OEM sales as a percentage of net revenues increased from 33% to 41% for manipulator and docking hardware products and from 21% to 42% for tester interface products. This trend continued during the first quarter of 2001, with OEM sales as a percentage of net revenues increasing from 35% to 52% for manipulator and docking hardware products and from 11% to 59% for tester interface products. We anticipate that OEM sales as a percentage of net revenues may continue to increase in the future for these product segments. The impact of this increase in OEM sales as a percentage of net revenues is a reduction in our gross margin, as OEM sales have a more significant discount than end user sales. Our current net operating margins on most OEM sales for these product segments, however, are only slightly less than margins on end user sales because of the payment of third party sales commissions on most end user sales. We also expect to continue to experience demands from our OEM customers' supply line management groups to reduce our sales prices to them. This continued price pressure may have the ultimate effect of reducing our gross and operating margins if we cannot reduce our manufacturing and operating costs.

We believe that purchases of most of our products are typically made from the end users' capital expenditure budgets. Certain portions of our business, however, are less dependent upon the capital expenditure budgets of the end users. For example, purchases of certain related ATE interface products, such as sockets and interface boards, which must be replaced periodically, are typically made from the end users' operating budgets. In addition, purchases of our products for the purpose of upgrading, or to improve the utilization, performance and efficiency of, existing ATE tend to be counter cyclical to sales of new ATE. Moreover, we believe a portion of our sales of temperature management products results from the increasing need for temperature testing of circuit boards and specialized components that do not have the design or quantity to be tested in a handler. We believe that this business is less cyclical than new ATE sales.

Please refer to the section entitled "Risks That Could Affect Future Results" below for a discussion of other important factors that could cause our results to differ materially from our prior results or those expressed or implied by our forward-looking statements.

Significant Events

On March 9, 2000, we acquired Temptronic Corporation. The acquisition was in the form of a merger of Temptronic into a subsidiary of ours, and was accounted for as a pooling of interests. Temptronic designs, manufactures, sells and services high-performance temperature management systems used in the testing of ICs and other electronic products. These temperature management systems are complementary to our manipulator, docking hardware and tester interface products and expanded our line of product offerings to our customer base.

Results of Operations

All of our products are used by semiconductor manufacturers in conjunction with ATE in the testing of ICs. Consequently, the results of operations for each product segment are generally affected by the same factors. Separate discussions and analyses for each product segment would be repetitive and obscure any unique factors that affected the results of operations of our different product segments. The discussion and analysis that follows, therefore, is presented on a consolidated basis for the Company as a whole and includes discussion of factors unique to each product segment where significant to an understanding of such business.

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Three Months Ended March 31, 2001 Compared to Three Months Ended March 31, 2000:

Net Revenues. Consolidated net revenues were $20.1 million for the quarter ended March 31, 2001 compared to $20.3 million for the same period in 2000, a decrease of $149,000 or 1%. For manipulator and docking hardware products, however, net revenues decreased $2.0 million or 20% for the first quarter of 2001 as compared to 2000 while net revenues for both the temperature management and tester interface segments increased by $1.5 million or 20% and $305,000 or 11%, respectively, in 2001 as compared to 2000. We believe that the decrease in net revenues over the comparable prior period for manipulator and docking hardware products reflects the cyclical downturn in the demand for ATE in 2001 as compared to 2000. The increase in net revenues of our temperature management segment was due to continued strong demand for Thermostream(R) products. Finally, we believe the increase in net revenues of our tester interface segment was primarily the result of reduced product shipments in the first quarter of 2000 when this division relocated its primary manufacturing facility.

Gross Margin. Gross margin decreased to 40% for the quarter ended March 31, 2001 from 49% for the comparable period in 2000 primarily as a result of increases in fixed operating costs due to facility expansions and, as previously discussed, increases in the level of OEM sales. For manipulator and docking hardware products, the decline in gross margin resulted from higher levels of fixed operating costs, and, to a lesser extent, higher component material costs. The increase in fixed operating costs is primarily the result of the expansion of our Cherry Hill manufacturing facility that was completed during the fourth quarter of 2000. We believe this increased capacity adequately addressed the capacity constraints that impacted product shipments during most of 2000 and will enable us to meet the demand for these products in the foreseeable future. The increase in component material costs as a percentage of net revenues is primarily the result of an increase in OEM sales as a percentage of total sales. For tester interface products, the decline in gross margin primarily resulted from a similar shift in customer mix. For temperature management products, the decline in gross margin was the result of higher component material costs, which were partially offset by a decrease in fixed operating costs as a percentage of net revenues due to the absorption of these costs over higher net revenue levels in 2001 as compared to 2000.

Selling Expense. Selling expense was $2.9 million for the quarter ended March 31, 2001 compared to $2.3 million for the same period in 2000, an increase of $551,000 or 24%. We attribute the increase primarily to increased commission expense as well as higher levels of salary expense resulting from salary increases for existing staff as well as new sales and marketing staff hired in 2000. To a lesser extent, higher warranty costs also contributed to the increase over the prior comparable period. These increases were partially offset by decreases in advertising and travel expenditures in 2001 as compared to 2000.

Engineering and Product Development Expense. Engineering and product development expense was $1.7 million for the quarter ended March 31, 2001 compared to $1.5 million for the same period in 2000, an increase of $227,000 or 16%. We attribute the increase primarily to higher levels of salary expense resulting from salary increases for existing staff and, to a lesser extent, the addition of new engineering and technical staff, as well as fees for technical consultants associated with new product development.

General and Administrative Expense. General and administrative expense was $2.1 million for the quarter ended March 31, 2001 compared to $1.5 million for the same period in 2000, an increase of $661,000 or 45%. We attribute the increase primarily to higher administrative salary expense resulting from staffing additions in 2000 and salary increases for existing staff, as well as an increase in travel expenditures and legal fees. The increase in legal fees was primarily the result of the receipt in March 2000 of $200,000 from the settlement of patent infringement litigation which partially offset legal fees for that quarter.

Merger-related Costs. Merger-related costs totaling $2.6 million were recorded during the first quarter of 2000 as a result of our merger with Temptronic Corporation. These costs consisted of fees paid to investment bankers, professional fees, printing, escrow and other miscellaneous costs. There were no merger-related costs for the quarter ended March 31, 2001.

Other Income. Other income was $158,000 for the quarter ended March 31, 2001 as compared to $100,000 for the same period in 2000, and increase of $58,000 or 58%. The increase is primarily attributable to both foreign currency transaction gains and third party royalty income recorded during the quarter, which were partially offset by reduced levels of interest income resulting from reduced average cash balances in 2001 compared to 2000.

Income Tax Expense. Income tax expense decreased to $583,000 for the quarter ended March 31, 2001 from $1.8 million for the comparable period in 2000, a decrease of $1.2 million. Our effective tax rate for the first quarter of 2001 was 40% due to a higher portion of our income for the quarter being derived from certain foreign jurisdictions where the statutory tax rates are higher than in the U.S. In addition, a greater portion of our income for the quarter was derived from our temperature management segment, which is located in Massachusetts where the state income tax rate is higher than in other states where we operate. Our effective tax rate for the first quarter of 2000 was 79% due to the recognition of $2.3 million of non-tax deductible merger-related costs. In addition, we recognized a $237,000 taxable gain on the liquidation of life insurance policies held on certain former Temptronic officers and directors.

Liquidity and Capital Resources

Net cash provided by operations for the three months ended March 31, 2001 was $1.1 million. Accounts receivable decreased $2.3 million from December 31, 2000 to March 31, 2001 due to cash collections in excess of the net sales recorded during the first quarter of 2001. Inventories increased $714,000 as a result of purchases for future product shipments combined with delays in shipment of certain products at the end of the first quarter. Accounts payable decreased $882,000 due to timing of payments to vendors combined with the lower production levels during the first quarter of 2001. Accrued expenses decreased $1.1 million as a result of the payment of previously accrued expenses including sales commissions, incentive compensation and merger-related costs.

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Purchases of machinery and equipment were $1.1 million for the quarter ended March 31, 2001, which consisted primarily of improvements to our facilities in the U.K. and Massachusetts. We also acquired an additional coordinate measuring machine for our Cherry Hill, New Jersey facility under a capital lease. During the quarter, we relocated our U.K. manufacturing operation to a new facility and are converting the previous facility to a machine shop. We expect to spend an additional $45,000 to complete the conversion of this facility. We relocated our Singapore subsidiary during April 2001, and expect to spend $170,000 on leasehold improvements and purchases of furniture and equipment for this facility. During May 2001, we relocated our Temptronic subsidiary and expect to spend an additional $900,000 on leasehold improvements and purchases of furniture and equipment for this facility. Our lease on this facility entitles us to a reimbursement of approximately $280,000, which we expect to receive by the end of 2001.

Net cash provided by financing activities for the quarter ended March 31, 2001 was $283,000, including approximately $216,000 for equipment that was refinanced under a capital lease.

As of March 31, 2001, we had a $5.0 million committed, unsecured line of credit. This line of credit is due to expire June 30, 2001. Based upon our projected operating results for 2001, coupled with our historic results of operations, we believe that this line of credit will be renewed in 2001 by the bank which granted it. This facility has been renewed each year since the original credit agreement was signed in 1992.

International Operations

Net revenues generated by our foreign subsidiaries were 12% and 20% of consolidated net revenues for the quarters ended March 31, 2001 and 2000, respectively. We anticipate that net revenues generated by our foreign subsidiaries will continue to account for a significant portion of consolidated net revenues in the foreseeable future. The net revenues generated by our foreign subsidiaries will continue to be subject to certain risks, including political and economic instability of foreign countries, the imposition of financial and operational controls or regulatory restrictions by foreign governments, the need to comply with a variety of U. S. and foreign export and import laws, trade restrictions, changes in tariffs and taxes, longer payment cycles, fluctuations in foreign currency exchange rates, and the greater difficulty of administering business abroad. We cannot predict whether quotas, duties, taxes or other charges or restrictions will be implemented by the United States or any other country upon the importation or exportation of our products in the future. Any of these factors or the adoption of restrictive policies could have a material adverse effect on our business, financial condition or results of operations.

Net revenues denominated in foreign currencies were 11% and 15% of consolidated revenues for the quarters ended March 31, 2001 and 2000, respectively. Although we seek to operate our business such that a significant portion of our product costs are denominated in the same currency that the associated sales are made in, we may be adversely affected in the future due to our exposure to foreign operations. Moreover, net revenues denominated in currencies other than U.S. dollars expose us to currency fluctuations, which can adversely affect results of operations.

The portion of our consolidated net revenues that were derived from sales to the Asia-Pacific region were 6% and 10% for the quarters ended March 31, 2001 and 2000, respectively. Countries in the Asia-Pacific region, including Japan, have experienced economic instability resulting in weaknesses in their currency, banking and equity markets. Although the past economic instability in the Asia-Pacific region has not materially adversely affected our order backlog, balance sheet, or results of operations to date, continued economic instability could have a material adverse effect on demand for our products and our consolidated results of operations.

Risks That Could Affect Future Results

A number of the matters and subject areas discussed in this Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this report that are not historical or current facts deal with potential future circumstances and developments. These forward-looking statements typically can be identified by the use of terminology such as "believes," expects," "may," "will," "should" or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. Investors and prospective investors are cautioned that such statements are only projections and that actual events or results may differ materially from those expressed in any such forward-looking statements. In addition to other factors described elsewhere in this report, our actual consolidated quarterly or annual operating results have been affected in the past, or could be affected in the future, by factors, including, without limitation: changes in business conditions and the economy, generally; a decline in the demand for ICs; our ability to obtain patent protection, and enforce our patent rights, for existing and developing proprietary technologies; our ability to integrate successfully businesses, technologies or products which we may acquire; the effect of the loss of, or reduction in orders from, a major customer; cancellation, or delays in shipment, of orders in our backlog; competition from other manufacturers of docking hardware, manipulators, tester interfaces and related ATE interface products and temperature management products; progress of product development programs; cost overruns relating to leasehold improvements and moving costs for our Temptronic and Singapore subsidiaries, unanticipated exchange rate fluctuations; and capital requirements relating to future acquisitions. These risks and uncertainties are more fully discussed in our annual report on Form 10-K for the year ended December 31, 2000.

We are exposed to currency exchange rate risk in the normal course of our business, primarily in our Japanese operations. Our exposure results from the fact that the sales of our Japanese subsidiary are in Japanese yen and inventory purchases are in U.S. dollars. We have the same exposure in our German operations (which commenced in August 2000) as a portion of total sales are in German deutsche marks while inventory purchases are in U.S. dollars. We also have a similar exposure in our Singapore operations because our sales are in U.S. dollars but our manufacturing costs are in U.S. dollars, British pounds and Singapore dollars. We employ risk management strategies, including the use of forward exchange rate contracts, to manage our exposure to exchange rate risks involving the yen, and may, in the future, use forward exchange rate contracts to manage our exposure to exchange rate risks involving the Singapore dollar and German deutsche mark.

Our objective in managing currency exchange risk is to minimize the impact of significant currency exchange rate fluctuations. We use forward exchange rate contracts to establish a fixed conversion rate between the Japanese yen and the U.S. dollar so that the level of our gross margin from sales in Japan is not negatively affected by significant movements in the Japanese yen to U.S. dollar exchange rate. We purchase forward exchange rate contracts on a monthly basis in the amounts management deems appropriate in light of the amount of the U.S. dollar denominated obligations of our Japanese subsidiary that are due within the month. We do not purchase forward contracts with settlement dates beyond 30 days. As of March 31, 2001, there were no forward exchange rate contracts outstanding.

It is our policy to enter into forward exchange rate contracts only to the extent necessary to achieve the desired objectives of management in limiting our exposure to significant fluctuations in currency exchange rates. We do not hedge all of our currency exchange rate risk exposures in a manner that would completely eliminate the impact of changes in currency exchange rates on our net earnings. We do not expect that the results of our operations or our liquidity will be materially affected by these risk management activities.

From time to time, we may identify products manufactured and sold by others that we believe infringe our patents. If we are unable to negotiate satisfactory license arrangements with the parties engaged in such activities or otherwise prevent the manufacture and sale of such products, we may initiate legal proceedings against the parties engaged in such activities. Recently, we initiated such an action against Credence Systems Corporation. Management does not believe the prosecution of this litigation or the results of the litigation will be material to our results of operations or financial condition.

Not applicable

None

None

On April 18, 2001, the Company issued a press release regarding its earnings performance for the quarter ended March 31, 2001 and management's expectations regarding future performance. This press release is filed as an exhibit hereto and incorporated into this Report by reference.

(a)  Exhibits:

3.1*  Articles of Incorporation: Previously filed by the Company as an Exhibit
         to the Company's Registration Statement on Form S-1, File No. 333-26457,
         and incorporated herein by reference.

3.2*  By-Laws: Previously filed by the Company as an Exhibit to the Company's
         Registration Statement on Form S-1, File No. 333-26457, and incorporated
         herein by reference.

10.1  Change of Control Agreement dated April 17, 2001 between the Company and Robert E.
         Matthiessen .

10.2  Change of Control Agreement dated April 17, 2001 between the Company and Hugh T.
         Regan, Jr.

99     Press Release dated April 18, 2001

* Indicates document previously filed

(b)  Reports on Form 8-K