INTEVAC INC - Quarter Report: 2007 June (Form 10-Q)

 

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-Q

 

 

 

Commission file number 0-26946

 

INTEVAC, INC.

(Exact name of registrant as specified in its charter)

 

 

3560 Bassett Street

Santa Clara, California 95054

(Address of principal executive office, including Zip Code)

 

Registrant’s telephone number, including area code:

(408) 986-9888

 

 

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 þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

 

On August 3, 2007, 21,540,539 shares of the Registrant’s Common Stock, no par value, were outstanding.

 

 

INTEVAC, INC.

 

INDEX

 

 

 

INTEVAC, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

Note: Amounts as of December 31, 2006 are derived from the December 31, 2006 audited consolidated financial statements.

 

See accompanying notes.

INTEVAC, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

AND COMPREHENSIVE INCOME

 

 

See accompanying notes.

INTEVAC, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes.

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

We are the world’s leading provider of disk sputtering equipment to manufacturers of magnetic media used in hard disk drives and a developer and provider of leading technology for extreme low light imaging sensors, cameras and systems. We operate two businesses: Equipment and Imaging.

 

Our Equipment business designs, manufactures, markets and services high-productivity manufacturing systems. We are the leading supplier of capital equipment used in the sputtering, or deposition, of highly engineered thin-films of material onto magnetic disks, which are used in hard disk drives. Hard disk drives are the primary storage medium for digital data and function by storing data on magnetic disks. These disks are created in a sophisticated manufacturing process involving a variety of steps, including plating, annealing, polishing, texturing, sputtering and lubrication. We are developing products for semiconductor manufacturing. In July 2007 we announced our new “Lean Etch” semiconductor manufacturing system for the dielectric etch market.

 

Our Imaging business develops, manufactures and markets high-sensitivity imaging products and miniature Raman instruments. We provide sensors, cameras and systems for military applications such as night vision and long-range target identification and we provide cameras and Raman spectrometers to the industrial, physical science and life science markets.

 

Most of our revenue is derived from our Equipment business, and we expect that the majority of our revenues for at least the next several years will continue to be derived from our Equipment business.

 

The financial information at June 30, 2007 and for the three- and six-month periods ended June 30, 2007 and July 1, 2006 is unaudited, but includes all adjustments (consisting only of normal recurring accruals) that we consider necessary for a fair presentation of the financial information set forth herein, in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, it does not include all of the information and footnotes required by U.S. GAAP for annual financial statements. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

 

The preparation of financial statements in conformity with U.S. GAAP 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 reported amounts of revenue and expenses during the reporting period. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

 

The results for the three- and six-month periods ended June 30, 2007 are not considered indicative of the results to be expected for any future period or for the entire year.

 

“Intevac^®,” “LIVAR^®,” “D-STAR^®,” “Lean Etch^tm” and “200 Lean^®” are trademarks of Intevac, Inc.

 

 

Historically, a significant portion of our revenues in any particular period has been attributable to sales to a limited number of customers. Our largest customers tend to change from period to period.

 

We evaluate the collectibility of trade receivables on an ongoing basis and provide reserves against potential losses when appropriate.

 

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115”

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The fair value option established by SFAS 159 permits all entities to choose to measure eligible items at fair value at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting this standard.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within that fiscal year. We are currently evaluating the impact of adopting SFAS 157.

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections — a Replacement of APB Opinion No. 20 and FASB Statement No. 3” (SFAS 154), which requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principle unless it is impracticable to do so. SFAS 154 is effective for accounting changes and corrections of errors beginning in fiscal 2007. The implementation of this standard did not have a material effect on our financial position or results of operations.

 

 

Inventories are priced using average actual costs, which approximate costs under the first-in, first-out method, and are stated at the lower of cost or market. Inventories consist of the following:

 

 

Finished goods inventory consists primarily of completed systems at customer sites that are undergoing installation and acceptance testing.

 

Inventory reserves included in the above balances were $7.6 million and $9.1 million at June 30, 2007 and December 31, 2006, respectively. Each quarter, we analyze our inventory (raw materials, work-in-progress and finished goods) against the forecasted demand for the next 12 months. Raw materials with no forecasted requirements in that period are considered excess and inventory provisions are established to write those items down to zero net book value. Work-in-progress and finished goods inventories with no forecast requirements in that period are typically written down to the lower of cost or market. During this process, some inventory is identified as having no future use or value to us and is disposed of against the reserves.

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table displays the activity in the inventory provision account for the six-month periods ending June 30, 2007 and July 1, 2006:

 

 

 

At June 30, 2007, we had stock-based awards outstanding under the 2004 Equity Incentive Plan (the “2004 Plan”) and the 2003 Employee Stock Purchase Plan (the “ESPP”). Our shareholders approved both of these plans.

 

The 2004 Plan permits the grant of incentive or non-statutory stock options, restricted stock, stock appreciation rights, performance units and performance shares. During the six months ended June 30, 2007, we granted 175,000 stock options with an estimated total grant-date fair value of $2.3 million. Of this amount, we estimated that the stock-based compensation for the awards not expected to vest was $625,000.

 

The ESPP provides that eligible employees may purchase our common stock through payroll deductions at a price equal to 85% of the lower of the fair market value at the beginning of the applicable offering period or at the end of each applicable purchase period. Offering periods are generally two years in length, and consist of a series of six-month purchase intervals. Eligible employees may join the ESPP at the beginning of any six-month purchase interval. During the six months ended June 30, 2007, we granted purchase rights with an estimated total grant-date value of $158,000.

 

Compensation Expense

 

The effect of recording stock-based compensation for the three- and six-month periods ended June 30, 2007 and July 1, 2006 was as follows:

 

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Valuation Assumptions

 

The fair value of share-based payment awards is estimated at the grant date using the Black-Scholes option valuation model. The determination of fair value of share-based payment awards on the date of grant using an option- pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual employee stock option exercise behavior.

 

The weighted-average estimated value of employee stock options granted during the three months ended June 30, 2007 and July 1, 2006 was $11.49 per share and $15.93 per share, respectively. The weighted-average estimated value of employee stock options granted during the six months ended June 30, 2007 and July 1, 2006 was $13.35 per share and $12.65 per share, respectively. The weighted-average estimated fair value of employee stock purchase rights granted pursuant to the ESPP during the six months ended June 30, 2007 and July 1, 2006 was $10.54 and $5.16 per share, respectively. No purchase rights were granted under the ESPP during either the three months ended June 30, 2007 or July 1, 2006. The fair value of each option and employee stock purchase right grant is estimated on the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions:

 

 

 

The computation of the expected volatility assumptions used in the Black-Scholes calculations for new grants and purchase rights is based on the historical volatility of our stock price, measured over a period equal to the expected term of the grant or purchase right. The risk-free interest rate is based on the yield available on U.S. Treasury Strips with an equivalent remaining term. The expected life of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards and vesting schedules. The expected life of purchase is the period of time remaining in the current offering period. The dividend yield assumption is based on our history of not paying dividends and the assumption of not paying dividends in the future.

 

As the stock-based compensation expense recognized in the Condensed Consolidated Statement of Operations is based on awards ultimately expected to vest, such amount has been reduced for estimated forfeitures. Statement of Financial Accounting Standards No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on our historical experience, which we believe to be indicative of our future experience.

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Stock Plan Activity

 

2004 Equity Incentive Plan

 

A summary of activity under the above captioned plan is as follows:

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing stock price of $21.26 as of June 29, 2007, which would have been received by the option holders had all options holders exercised their options as of that date.

 

As of June 30, 2007, the unrecorded deferred stock-based compensation balance related to stock options was $8.7 million and will be recognized over an estimated weighted average recognition period of 1.6 years. The recognition period is based on the vesting period of the option.

 

2003 Employee Stock Purchase Plan

 

During the six months ended June 30, 2007, 39,069 shares were purchased at an average per share price of $17.17. At June 30, 2007, there were 348,868 shares available to be issued under the ESPP.

 

As of June 30, 2007, the unrecorded deferred stock-based compensation balance related to purchase rights was $935,000 and will be recognized over an estimated weighted average recognition period of 0.6 years. The recognition period is based on the expected term of the purchase right, which is defined as the period from grant date to expiration of the offering period.

 

 

On January 31, 2007, we completed the acquisition of the assets and certain liabilities of DeltaNu, LLC (“DeltaNu”) for a total purchase price of $6 million. The purchase price was comprised of $2 million cash due at the close of the acquisition and $2 million due on each of January 31, 2008 and January 31, 2009, which is in the form of a note. DeltaNu is a Laramie, Wyoming company specializing in small footprint and handheld Raman spectrometry instruments. We believe that the combination of DeltaNu’s miniature Raman spectrometer designs with our capabilities in near-infrared sensors will enable a new class of portable instruments with greatly enhanced chemical detection capabilities.

 

We accounted for the acquisition as a taxable purchase transaction and, accordingly, the purchase price has been allocated to tangible assets, liabilities assumed, and identifiable intangible assets acquired based on their estimated fair values on the acquisition date. The excess of the purchase price over the aggregate fair values was recorded as goodwill. The fair value assigned to identifiable intangible assets acquired is determined using the

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

income approach, which discounts expected future cash flows to present value using estimates and assumptions determined by management. Purchased intangible assets are amortized on a straight-line basis over the respective useful lives. Our allocation of the purchase price is summarized below (in thousands):

 

 

The $5.8 million allocated purchase price consists of $2.0 million paid in cash, $3.7 million in notes payable (present value at January 31, 2007) and $87,000 in acquisition-related expenses. The estimated useful economic lives of the identified intangible assets acquired are two years for the customer relationships and non-compete agreements and approximately four months for the backlog. The trademark/names asset has an indefinite life. Future amortization of the identified intangible assets will be $193,000 in 2007, $80,000 in 2008 and $7,000 in 2009.

 

The results of operations for the acquired business have been included in our condensed consolidated statements of operations for the period subsequent to our acquisition of DeltaNu. DeltaNu’s results of operations for periods prior to this acquisition were not material to our condensed consolidated statement of operations and, accordingly, pro forma financial information has not been presented.

 

 

We provide for the estimated cost of warranty when revenue is recognized. Our warranty is per contract terms and for our systems the warranty typically ranges between 12 and 24 months from customer acceptance. During this warranty period any defective non-consumable parts are replaced and installed at no charge to the customer. The warranty period on consumable parts is limited to their reasonable usable lives. We use estimated repair or replacement costs along with our historical warranty experience to determine our warranty obligation. We exercise judgment in determining the underlying estimates.

 

On the condensed consolidated balance sheet, the short-term portion of the warranty provision is included in other accrued liabilities, while the long-term portion is included in other long-term liabilities. The expense associated with product warranties issued or adjusted is included in cost of net revenues on the condensed consolidated statement of income.

 

The following table displays the activity in the warranty provision account for the three- and six-month periods ending June 30, 2007 and July 1, 2006:

 

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table displays the balance sheet classification of the warranty provision account at June 30, 2007 and at December 31, 2006:

 

 

 

We have entered into agreements with customers and suppliers that include limited intellectual property indemnification obligations that are customary in the industry. These guarantees generally require us to compensate the other party for certain damages and costs incurred as a result of third party intellectual property claims arising from these transactions. The nature of the intellectual property indemnification obligations prevents us from making a reasonable estimate of the maximum potential amount we could be required to pay our customers and suppliers. Historically, we have not made any significant indemnification payments under such agreements, and no amount has been accrued in the accompanying consolidated financial statements with respect to these indemnification obligations.

 

9.  Cash, Cash Equivalents and Investments in Debt Securities

 

Our investment portfolio consists of cash, cash equivalents and investments in debt securities and municipal bonds. We consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Investments in debt securities and municipal bonds consist principally of highly rated debt instruments with maturities generally between one and 25 months.

 

We account for our investments in debt securities and auction rate securities in accordance with Statement of Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities,” which requires certain securities to be categorized as either trading, available-for-sale or held-to-maturity. Available-for-sale securities, consisting solely of Auction Rate Securities, are carried at fair value, with unrealized gains and losses recorded within other comprehensive income (loss) as a separate component of shareholders’ equity. Auction Rate Securities have long-term underlying maturities (ranging from 20 to 40 years), however the market is highly liquid and the interest rates reset every 7 or 28 days. Our intent is not to hold these securities to maturity, but rather to use the interest rate reset feature to sell securities to provide liquidity as needed. Our practice is to invest in these securities for higher yields compared to cash equivalents. Held-to-maturity securities are carried at amortized cost. We have no trading securities. The cost of investment securities sold is determined by the specific identification method. Interest income is recorded using an effective interest rate, with the associated premium or discount amortized to interest income. Realized gains and losses and declines in value judged to be other than temporary, if any, on available-for-sale securities are included in earnings. The table below presents the amortized principal amount, major security type and maturities for our investments in debt securities and auction rate securities.

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The decline in the fair value of our investments from the principal amount is attributable to changes in interest rates and not credit quality. In accordance with EITF 03-01, we have the ability and intent to hold these investments until fair value recovers, which may be maturity, and we do not consider these investments to be other-than-temporarily impaired at June 30, 2007.

 

Cash and cash equivalents represent cash accounts and money market funds. Cash balances held in foreign bank accounts totaled $1.5 million and $1.6 million at June 30, 2007 and December 31, 2006, respectively. Included in accounts payable is $2.3 million and $2.4 million of book overdraft at June 30, 2007 and December 31, 2006, respectively.

 

 

The following table sets forth the computation of basic and diluted earnings per share:

 

 

 

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Segment Description

 

We have two reportable operating segments: Equipment and Imaging. Our reportable segments are business units that offer different products and are each managed separately, under the direction of our Chief Executive Officer. Our Equipment business designs, manufactures, markets and services high-productivity manufacturing systems used in the sputtering, or deposition, of highly engineered thin-films of material onto magnetic disks, which are used in hard disk drives and is developing products for semiconductor manufacturing. In July 2007 we announced our new “Lean Etch” semiconductor manufacturing system for the dielectric etch market. Our Imaging business develops, manufactures and markets high-sensitivity imaging products and miniature Raman instruments. We provide sensors, cameras and systems for military applications such as night vision and long-range target identification and we provide cameras and Raman spectrometers to the industrial, physical science and life science markets.

 

Included in corporate activities are general corporate expenses, less an allocation of corporate expenses to operating units equal to 3% of net revenues. Assets of corporate activities include unallocated cash and short-term investments, deferred income tax assets and other assets.

 

Segment Profit or Loss and Segment Assets

 

We evaluate performance and allocate resources based on a number of factors, including profit or loss from operations and future revenue potential. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.

 

Business Segment Net Revenues

 

 

Business Segment Profit & Loss

 

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Business Segment Assets

 

 

The portion of our long-lived assets maintained outside of the United States is immaterial.

 

Geographic Area Net Trade Revenues

 

 

International revenues include products shipped to overseas operations of U.S. companies.

 

 

For the six months ended June 30, 2007, we accrued income tax using an effective tax rate of 26.9% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. Our effective tax rate is highly dependent on the availability of tax credits and the geographic composition of our worldwide earnings. Our deferred tax asset is partially offset by a valuation allowance, resulting in a net deferred tax asset of $5.4 million at June 30, 2007.

 

For the six months ended July 1, 2006, we accrued income tax using an effective tax rate of 8.8% of pretax income. Our tax rate differed from applicable statutory rate due to the utilization of net operating loss carry-forwards and deferred credits.

 

We adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation Number 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) on January 1, 2007. As required by FIN 48, which clarifies SFAS No. 109, “Accounting for Income Taxes,” we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. At January 1, 2007, we applied FIN 48 to all tax positions for which the statute of limitations remained open and determined there are no material unrecognized tax benefits as of that date. In addition, there have been no material changes in unrecognized benefits since January 1, 2007. As a result, the adoption of FIN 48 did not have a material effect on our financial condition, or results of operation.

 

We are subject to income taxes in the U.S. federal jurisdiction, and various states and foreign jurisdictions. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. With few exceptions, we are no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for the years before 2000.

 

INTEVAC, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Company recognizes interest and penalties accrued related to unrecognized tax benefits in the provision for income taxes for all periods presented, which were not significant.

 

 

From time to time, we may have certain contingent liabilities that arise in the ordinary course of our business activities. We account for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated.

 

On July 7, 2006, we filed a patent infringement lawsuit against Unaxis USA, Inc. and its affiliates, Unaxis Balzers AG and Unaxis Balzers, Ltd., in the United States District Court for the Central District of California. Our lawsuit against Unaxis asserts infringement by Unaxis of United States Patent 6,919,001, which relates to our 200 Lean system. Our complaint seeks monetary damages and an injunction that would bar Unaxis from making, using, offering to sell or selling in the United States, or importing into the United States, Unaxis’ allegedly infringing product. We believe we have meritorious claims, and we intend to pursue them vigorously.

 

On September 12, 2006, Unaxis filed a response to our lawsuit in which it asserted non-infringement, invalidity of our patent, inequitable conduct by Intevac, patent misuse by Intevac, and lack of jurisdiction by the Court as defenses. Additionally, Unaxis requested a declaratory judgment of patent non-infringement, invalidity and unenforceability; asserted that Intevac violated the California Business and Professional Code; requested that we be enjoined from engaging in any unfair competition; and requested that we be required to pay Unaxis’ attorney fees. We believe such claims lack merit, and we intend to defend ourselves vigorously.

 

We replied to Unaxis’ response on October 3, 2006, denying the assertions of non-infringement, invalidity and unenforceability of the Intevac patent, and denying any unfair competition. With the approval of the Court, we amended our complaint on February 6, 2007 to assert an additional ground for our infringement claim and to add a request for a declaratory judgment of infringement. Unaxis filed a response on February 21, 2007, in which it repeated the assertions of its September 12, 2006 response.

 

On May 21, 2007, the Court granted Unaxis’ request to stay the litigation pending reexamination of United States Patent 6,919,001, after the U.S. Patent Office granted Unaxis’ February 27, 2007 reexamination request and issued an initial office action rejecting the claims of the patent. The Court also ordered the parties to file a joint report every 120 days to keep it informed of the reexamination status. Intevac had no input to the initial determination by the U.S. Patent Office.

 

On June 20, 2007, we filed a reply to the initial office action in reexamination. Our reply addresses the rejections of the original claims and proposes amended claims that we believe are supported by the original patent’s specification. Unaxis has the opportunity to respond, after which the U.S. Patent Office will consider both parties’ submissions. During the reexamination process, the patent remains valid.

 

 

During the six-month period ending June 30, 2007, we sold stock to our employees under Intevac’s Equity Incentive and Employee Stock Purchase Plans. A total of 223,000 shares were issued under these plans, for which Intevac received $1.9 million.

 

 

Certain prior year amounts in the Condensed Consolidated Financial Statements have been reclassified to conform to 2007 presentation. The reclassifications had no material effect on total assets, liabilities, equity, revenue, net income or comprehensive income as previously reported.

 

This Quarterly Report on Form 10-Q contains forward-looking statements, which involve risks and uncertainties. Words such as “believes,” “expects,” “anticipates” and the like indicate forward-looking statements. These forward looking statements include comments related to our shipments, projected revenue recognition, product costs, gross margin, operating expenses, interest income, income taxes, cash balances and financial results in 2007; projected customer requirements for our new and existing products,, and when, and if, our customers will place orders for these products; Imaging’s ability to proliferate its technology into major military weapons programs and to develop and introduce commercial imaging products; and the timing of delivery and/or acceptance of the systems and products that comprise our backlog for revenue; legal proceedings; and internal controls. Our actual results may differ materially from the results discussed in the forward-looking statements for a variety of reasons, including those set forth under “Risk Factors” and in other documents we file from time to time with the Securities and Exchange Commission, including Intevac’s Annual Report on Form 10-K filed in March 2007, Form 10-Q’s and Form 8-K’s.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“US GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported. Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of our Annual Report on Form 10-K. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below.

 

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial conditions and results of operations. Specifically, critical accounting estimates have the following attributes: 1) We are required to make assumptions about matters that are highly uncertain at the time of the estimate; and 2) different estimates we could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on our financial condition or results of operations.

 

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they become known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. Many of these uncertainties are discussed in the section below entitled “Risk Factors.” Based on a critical assessment of our accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that our consolidated financial statements are fairly stated in accordance with US GAAP, and provide a meaningful presentation of our financial condition and results of operation.

 

We believe the following critical accounting policies affect the more significant judgments and estimates we make in preparing our consolidated financial statements. We also have other key accounting policies and accounting estimates related to the collectibility of trade receivables and prototype product costs. We believe that these other accounting policies and other accounting estimates either do not generally require us to make estimates and judgments that are as difficult or subjective, or are less likely to have a material impact on our reported results of operation for a given period.

 

Revenue Recognition

 

Certain of our system sales with customer acceptance provisions are accounted for as multiple-element arrangements. If we have previously met defined customer acceptance levels with the specific type of system, then we recognize revenue for the fair market value of the system upon shipment and transfer of title, and recognize revenue for the fair market value of installation and acceptance services when those services are completed. We estimate the fair market value of the installation and acceptance services based on our actual historical experience. For systems that have generally not been demonstrated to meet a particular customer’s product specifications prior

to shipment, revenue recognition is typically deferred until customer acceptance. For example, while initial shipments of our 200 Lean system were recognized for revenue upon customer acceptance during 2004, revenue was recognized upon shipment for the majority of 200 Leans shipped in 2005, 2006 and 2007 to date. Most of the systems in backlog at June 30, 2007 are for customers where we have met defined customer acceptance levels, and we expect to recognize revenue upon shipment for those systems.

 

In some instances, hardware that is not essential to the functioning of the system may be delivered after acceptance of the system. In these cases, we estimate the fair market value of the non-essential hardware as if it had been sold on a stand-alone basis, and defer recognizing revenue on that value until the hardware is delivered.

 

In certain cases, we sell limited rights to our intellectual property. Revenue from the sale of any intellectual property license will generally be recognized at the inception of the license term.

 

We perform best efforts research and development work under various government-sponsored research contracts. These contracts are a mixture of cost-plus-fixed-fee (“CPFF”) and firm fixed-price (“FFP”). Revenue on CPFF contracts is recognized in accordance with contract terms, typically as costs are incurred. Revenue on FFP contracts is generally recognized on the percentage-of-completion method based on costs incurred in relation to total estimated costs. Provisions for estimated losses on government-sponsored research contracts are recorded in the period in which such losses are determined.

 

Inventories

 

Inventories are priced using average actual costs, which approximate first-in, first-out, and are stated at the lower of cost or market. The carrying value of inventory is reduced for estimated excess and obsolescence by the difference between its cost and the estimated market value based on assumptions about future demand. We evaluate the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional inventory adjustments would be required, which could have a material adverse effect on our business, financial condition and results of operation. A cost-to-market reserve is established for work-in-progress and finished goods inventories when the value of the inventory plus the estimated cost to complete exceeds the net realizable value of the inventory.

 

Warranty

 

We provide for the estimated cost of warranty when revenue is recognized. Our warranty is per contract terms and for our systems the warranty typically ranges between 12 and 24 months from customer acceptance. We use estimated repair or replacement costs along with our actual warranty experience to determine our warranty obligation. We exercise judgment in determining the underlying estimates. Should actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on our business, financial condition and results of operations.

 

Income Taxes

 

We account for income taxes in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes,” (“SFAS 109”), which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Based on our history of losses through 2004, our deferred tax asset was fully offset by a valuation allowance as of December 31, 2005. During 2006, the deferred tax asset and the related valuation allowance were both reduced due to the usage of our remaining NOL and credit carry-forwards. As of December 31, 2006, $4.6 million of the deferred tax asset was valued on the balance sheet, net of a valuation allowance of $2.8 million. This represents the amount of the deferred tax asset from which we expect to realize a benefit. We cannot predict with certainty when, or if, we will realize the benefit of the portion of the deferred tax asset currently offset with a valuation allowance.

On a quarterly basis, we provide for income taxes based upon an annual effective income tax rate. The effective tax rate is highly dependent upon the level of our projected earnings, the geographic composition of worldwide earnings, tax regulations governing each region, net operating loss carry-forwards, availability of tax credits and the effectiveness of our tax planning strategies. We carefully monitor the changes in many factors and adjust our effective income tax rate on a timely basis. If actual results differ from the estimates, this could have a material effect on our business, financial condition and results of operations. For example, as our projected level of earnings increased throughout 2006, we increased the annual effective tax rate from 3.0% at the end of the first quarter, to 8.8% at the end of the second quarter, to 10.0% at the end of the third quarter and to 12% at the end of the fourth quarter. Similarly, as we reduced our projected level of earnings for 2007, we decreased our effective tax rate at the end of the second quarter of 2007 to 26.9% from 31.6% at the end of the first quarter of 2007.

 

The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material effect on our business, financial condition and results of operations.

 

Results of Operations

 

Three Months Ended June 30, 2007 and July 1, 2006.

 

Net revenues

 

 

Net revenues consist primarily of sales of equipment used to manufacture thin-film disks, related equipment and system components, flat panel equipment technology license fees, contract research and development related to the development of electro-optical sensors, cameras and systems and low light imaging products.

 

Equipment revenues for the three months ended June 30, 2007 included revenue recognition for twelve 200 Lean systems, and a significant quarter over quarter increase in revenue from disk equipment technology upgrades and spare parts. Revenue for the three months ended July 1, 2006 included revenue recognition of eleven 200 Lean systems and seven disk lubrication systems. We expect Equipment revenues in the second half of 2007 will be significantly lower than the comparable period of 2006, due to a slowdown in orders for new 200 Lean systems.

 

Imaging revenue for the three months ending June 30, 2007 consisted of $2.5 million of research and development contract revenue and $1.1 million of product sales. Revenue for the three months ended July 1, 2006 consisted of $2.7 million of contract research and development revenue and $378,000 of product sales. Product revenue included contributions from our new DeltaNu subsidiary, which was acquired on January 31, 2007. Substantial growth in future Imaging revenues is dependent on proliferation of our technology into major military weapons programs, the ability to obtain export licenses for foreign customers, obtaining production subcontracts for these programs, and development and sale of commercial products.

 

Our backlog of orders at June 30, 2007 was $57.5 million, as compared to $125.0 million at December 31, 2006, $92.8 million at March 31, 2007 and $96.2 million at July 1, 2006. The decrease in backlog during the quarter was primarily the result of the recognition for revenue of twelve disk sputtering systems while orders for only two systems were received. Our outlook for orders for new systems over the remainder of 2007 has been negatively impacted by Western Digital’s announced acquisition of Komag and the use of legacy systems for the production of first generation perpendicular media. We include in backlog the value of purchase orders for our products that have scheduled delivery dates. We do not recognize revenue on this backlog until we have met the criteria contained in our revenue recognition policy, including customer acceptance of newly developed systems.

International sales increased by 23% to $63.2 million for the three months ended June 30, 2007 from $51.5 million for the three months ended July 1, 2006. International revenues include products shipped to overseas operations of U.S. companies. The increase in international sales was primarily due to an increase in net revenues from disk sputtering systems, disk equipment technology upgrades and spare parts. Substantially all of our international sales are to customers in Asia. International sales constituted 88% of net revenues for the three months ended June 30, 2007 and 86% of net revenues for the three months ended July 1, 2006.

 

Gross margin

 

 

Cost of net revenues consists primarily of purchased materials and costs attributable to contract research and development, and also includes fabrication, assembly, test and installation labor and overhead, customer-specific engineering costs, warranty costs, royalties, provisions for inventory reserves and scrap. Cost of net revenues for the three months ended June 30, 2007 and July 1, 2006 included $120,000 and $93,000, respectively, of equity-based compensation expense.

 

Equipment gross margin improved 43.0% in the three months ended June 30, 2007 from 36.4% in the three months ended July 1, 2006. The increase in gross margin was due primarily to cost reduction programs and product mix. We expect the gross margin for the Equipment business in 2007 to be better than 2006, primarily as a result of continued cost reduction efforts undertaken on the 200 Lean system. Gross margins in the Equipment business will vary depending on a number of factors, including product mix, product cost, system configuration and pricing, factory utilization, and provisions for excess and obsolete inventory.

 

Imaging gross margin improved to 38.9% in the three months ended June 30, 2007 from 25.4% in the three months ended June 30, 2006. The increase in gross margin resulted primarily from higher margins on development contracts and favorable adjustments related to contract closeouts. We expect Imaging gross margin in 2007 to improve over 2006, due primarily to an increase in both product revenue and revenue from fully funded research and development contracts.

 

Research and development

 

 

Research and development expense consists primarily of prototype materials, salaries and related costs of employees engaged in ongoing research, design and development activities for disk sputtering equipment, semiconductor equipment and Imaging products. Research and development expense for the three months ended June 30, 2007 and July 1, 2006 included $448,000 and $328,000, respectively, of equity-based compensation expense.

Research and development spending increased in Equipment during the three months ended June 30, 2007 as compared to the three months ended July 1, 2006, while spending in Imaging was flat quarter over quarter. The increase in Equipment was due primarily to spending on the development of our Lean Etch^tm product line to serve the semiconductor market and, to a lesser extent, spending for continuing development of our disk sputtering products. Engineering headcount increased from 107 at July 1, 2006 to 133 at June 30, 2007. We expect that research and development spending will increase from 2006 to 2007 due primarily to expenditures related to our new semiconductor equipment product line and the addition of key engineering personnel.

 

Research and development expenses do not include costs of $1.4 million and $1.9 million for the three-month periods ended June 30, 2007 and July 1, 2006, respectively, which are related to contract research and development and included in cost of net revenues.

 

Selling, general and administrative.

 

 

Selling, general and administrative expense consists primarily of selling, marketing, customer support, financial and management costs and also includes production of customer samples, travel, liability insurance, legal and professional services and bad debt expense. All domestic sales and international sales of disk sputtering products in Asia, with the exception of Japan, are typically made by Intevac’s direct sales force, whereas sales in Japan of disk sputtering products and other products are typically made by our Japanese distributor, Matsubo, who provides services such as sales, installation, warranty and customer support. We also have offices in China, Japan, Korea, Malaysia, and Singapore to support our equipment customers in Asia. Selling, general and administrative expense for the three months ended June 30, 2007 and July 1, 2006 included $748,000 and $274,000, respectively, of equity-based compensation expense.

 

The increase in selling, general and administrative spending in the three months ended June 30, 2007 as compared to the three months ended July 1, 2006 was primarily the result of increases in costs related to business development, customer service and support in the Equipment business and legal expenses associated with the Unaxis litigation. Our selling, general and administrative headcount increased from 66 at July 1, 2006 to 95 at June 30, 2007. We expect that selling, general and administrative expenses will increase in 2007 over the amount spent in 2006 due primarily to a projected increase in costs related to customer service and support for the Equipment business, the addition of key business development and administrative personnel and increasing legal expenses.

 

Interest income and other, net

 

 

Interest income and other, net consists primarily of interest and dividend income on investments and foreign currency gains and losses. The increase in the three months ended June 30, 2007 was driven by higher interest rates on our investments and a higher average invested balance. We expect interest income and other, net to increase in from 2006 to 2007 due to a higher average level of investments.

Provision for income taxes.

 

 

For the three months ended June 30, 2007, we accrued income tax using an effective tax rate of 22.4% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. Our effective tax rate is highly dependent on our projected level of earnings, the availability of tax credits and the geographic composition of our worldwide earnings. Our deferred tax asset is partially offset by a valuation allowance, resulting in a net deferred tax asset of $5.4 million at June 30, 2007.

 

For the three months ended July 1, 2006, we accrued income tax using an effective tax rate of 12.8% of pretax income. Our tax rate differs from the applicable statutory rates due to the utilization of net operating loss carry-forwards and deferred credits.

 

Six Months Ended June 30, 2007 and June 1, 2006.

 

Net revenues

 

 

The increase in Equipment revenue was the result of higher sales of disk sputtering systems, disk equipment technology upgrades and spare parts. We recognized revenue on twenty-five 200 Leans systems in the six months ended June 30, 2007. The increase in Imaging revenues was the result of both increased contract research and development work and a 153% increase in product sales.

 

International sales increased by 43% to $132.5 million for the six months ended June 30, 2007 from $92.5 million for the six months ended July 1, 2006. The increase in international sales was due to higher shipments of disk sputtering systems, disk equipment technology upgrades and spare parts to customers in Asia. International sales constituted 89% of net revenues for the six months ended June 30, 2007 and 85% of net revenues for the six months ended July 1, 2006. International revenues include products shipped to overseas operations of US companies.

 

Gross margin

 

Gross margin in Equipment for the six months ended June 30, 2007 increased relative to the comparable 2006 period primarily due to cost reduction programs, increased volume and product mix. The increase in Imaging was primarily a result of higher margins on development contracts and favorable adjustments related to contract closeouts. Cost of net revenues for the six months ended June 30, 2007 and July 1, 2006 included $293,000 and $139,000, respectively, of equity-based compensation expense.

 

Research and development

 

 

Research and development spending increased in both Equipment and in Imaging during the six months ended June 30, 2007 as compared to the six months ended July 1, 2006. The increase in Equipment was due primarily to spending on the development of our Lean Etch^tm product line to serve the semiconductor market and, to a lesser extent, spending for continuing development of our disk sputtering products. The increase in Imaging was due primarily to spending on the development of our commercial Imaging products. Research and development spending for the six months ended June 30, 2007 and July 1, 2006 included $950,000 and $532,000, respectively of equity-based compensation expense.

 

Research and development expenses do not include costs of $2.9 million in both of the six-month periods ended June 30, 2007 and July 1, 2006 related to Imaging contract research and development. These expenses are included in cost of net revenues.

 

Selling, general and administrative

 

 

The increase in selling, general and administrative expense for the six months ending June 30, 2007 was primarily the result of increases in costs related to business development, customer service and support in the Equipment business, legal expenses associated with the Unaxis litigation and provisions for employee profit sharing and bonus plans. Included in selling, general and administrative spending for the six months ended June 30, 2007 and July 1, 2006 was $1,427,000 and $452,000, respectively, of equity-based compensation expense.

 

Interest income and other, net

 

 

Interest income and other, net in both 2007 and 2006 consisted primarily of interest and dividend income on investments. The increase in the six months ended June 30, 2007 was the driven by higher interest rates on our investments and a higher average invested balance.

Provision for income taxes.

 

 

For the six months ended June 30, 2007, we accrued income tax using an effective tax rate of 26.9% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”.

 

For the six months ended July 1, 2006, we accrued income tax using an effective tax rate of 8.8% of pretax income.

 

Stock-Based Compensation

 

During the three and six months ended June 30, 2007, we recorded stock-based compensation expense related to stock options of $1.2 million and $2.3 million respectively. As of June 30, 2007, the unrecorded deferred stock-based compensation balance related to stock options was $8.7 million and will be recognized over an estimated weighted average amortization period of 1.6 years.

 

The compensation cost associated with the employee stock purchase plan for the three and six months ended June 30, 2007 was $214,000 and $427,000 respectively. There were 39,069 shares purchased under the employee stock purchase plan during the six months ended June 30, 2007.

 

Approximately $72,000 and $69,000 of stock-based compensation was capitalized as inventory at June 30, 2007 and December 31, 2006, respectively.

 

Liquidity and Capital Resources

 

During the first six months of 2007, cash and cash equivalents decreased by $9.0 million, from $39.4 million at December 31, 2006 to $30.4 million as of June 30, 2007.

 

Operating activities provided cash of $17.2 million during the six months ended June 30, 2007. The cash provided from operating activities was due primarily to net income, adjusted to exclude the effect of non-cash charges including depreciation and equity-based compensation, and to a decrease in inventories. This was partially offset by decreases in customer advances and accrued payroll. Accounts receivable totaled $39.0 million at June 30, 2007, compared to $39.9 million at December 31, 2006, a decrease of $0.9 million. Net inventories decreased by $10.0 million during the six months ended June 30, 2007 due to a reduction in material receipts and production levels in anticipation of a slower second half of 2007. Accounts payable decreased $6.2 million to $9.8 million at June 30, 2007. The decrease was a result of the lower level of material receipts in the quarter. Accrued payroll and related liabilities decreased by $3.2 million during the six months ended June 30, 2007 due primarily to bonuses and profit sharing payments. Other accrued liabilities totaled $7.5 million at June 30, 2007 compared to $6.6 million at December 31, 2006. The increase of $0.9 million is due primarily to income tax accruals. Customer advances decreased by $10.9 million during the six months ended June 30, 2007, due to the number of systems shipped and accepted during the first six months of the year.

 

Investing activities in the first six months of 2007 used cash of $32.7 million. Purchases of investments, net of proceeds from sales and maturities, totaled $23.5 million and our acquisition of DeltaNu, LLC used cash of $5.8 million during the first half of 2007. Capital expenditures for the six months ended June 30, 2007 were $3.4 million.

 

Financing activities provided cash of $6.4 million during the six months ended June 30, 2007 due primarily to the issuance of $3.8 million in notes payable related to the acquisition of DeltaNu, LLC. We also sold $1.9 million of Intevac common stock to our employees through our employee benefit plans and recognized $767,000 in tax benefits from equity-based compensation.

We have generated operating income for the last two years, after incurring annual operating losses from 1998 through 2004. We expect our Equipment business to be profitable again in 2007. We also expect to continue to invest in Imaging during 2007, but with lower losses than in 2006.

 

We believe that our existing cash, cash equivalents and short-term investments, combined with the cash we anticipate generating from operating activities will be sufficient to meet our cash requirements for the foreseeable future. We intend to undertake approximately $7.0 million in capital expenditures during the remainder of 2007.

 

Contractual Obligations

 

In the normal course of business, we enter into various contractual obligations that will be settled in cash. These obligations consist primarily of operating lease and purchase obligations. The expected future cash flows required to meet these obligations as of June 30, 2007 are shown in the table below.

 

 

Interest rate risk.  Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We place our investments with high quality credit issuers and, by policy, limit the amount of credit exposure to any one issuer. Short-term investments typically consist of investments in commercial paper, auction rate securities and debt instruments issued by the US government and its agencies.

 

The table below presents principal amounts and related weighted-average interest rates by year of maturity for our investment portfolio at June 30, 2007.