NOVANTA INC - Quarter Report: 2007 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended September 28, 2007

Or

Commission File No. 000-25705

GSI Group Inc.

(Exact name of registrant as specified in its charter)

(978) 439-5511

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the registrant is 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  ¨    Accelerated filer  x    Non-accelerated filer  ¨

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

As of October 19, 2007 there were approximately 42,716,203 of the Registrant’s common shares, no par value, issued and outstanding.

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GSI GROUP INC.

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PART I — FINANCIAL INFORMATION

GSI GROUP INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

The accompanying notes are an integral part of these financial statements.

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GSI GROUP INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(U.S. GAAP and in thousands of U.S. dollars, except share and per share amounts)

The accompanying notes are an integral part of these financial statements.

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GSI GROUP INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(U.S. GAAP and in thousands of U.S. dollars)

The accompanying notes are an integral part of these financial statements.

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GSI GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

As of September 28, 2007

(U.S. GAAP and tabular amounts in thousands of U.S. dollars, except share amounts)

1. Basis of Presentation

These unaudited interim consolidated financial statements have been prepared by GSI Group Inc. in United States (U.S.) dollars and in accordance with generally accepted accounting principles in the U.S. for interim financial statements and the rules and regulations promulgated by the U.S. Securities and Exchange Commission, including the instructions to Form 10-Q and the provisions of Regulation S-X pertaining to interim financial statements. Accordingly, these interim consolidated financial statements do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. The consolidated financial statements reflect all adjustments and accruals, consisting only of adjustments and accruals of a normal recurring nature, which management considers necessary for a fair presentation of financial position and results of operations for the periods presented. The consolidated financial statements include the accounts of GSI Group Inc. and its wholly-owned subsidiaries (the “Company”). Intercompany transactions and balances have been eliminated. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. The results for interim periods are not necessarily indicative of results to be expected for the year or for any future periods. The amounts are stated in thousands of U.S. dollars, unless otherwise indicated.

Comparative Amounts

Classification of Deferred Revenue

Beginning in the second quarter of 2007, as a result of increased shipments to customers with acceptance provisions, the Company changed how it presents deferred revenue on the balance sheet. Deferred revenue attributable to these transactions, as well as other revenue deferrals, has been reported separately in current liabilities. In prior periods, these amounts were incorrectly shown as an offset to accounts receivable until payment was received. The Company believes the amounts for the prior periods, approximately $4.0 million at December 31, 2006, are not material and thus, have not restated the related balance sheet amounts. There was no effect on income or shareholders equity for this change.

2. Supplementary Balance Sheet Information

The following tables provide details of selected balance sheet accounts.

Inventories

Other Assets

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Intangible Assets

Goodwill

The Company accounts for goodwill pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires that goodwill not be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. During the second quarter of 2007, the Company completed its annual testing of goodwill. There were no indications of impairment; therefore, no write-down of goodwill was necessary.

Other Accrued Expenses

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Accrued Warranty

3. New Accounting Pronouncements

Fair Value Measurements

In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosure requirements about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for the Company beginning January 1, 2008. The Company is currently assessing the potential impact that the adoption of SFAS No. 157 will have on our financial statements.

Fair Value Option for Financial Assets and Financial Liabilities

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - including an Amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to measure eligible financial assets, financial liabilities and certain other assets and liabilities at fair value on an instrument-by-instrument basis. The fair value measurement election is irrevocable once made and subsequent changes in fair value must be recorded in earnings. The effect of adoption will be reported as a cumulative-effect adjustment to beginning retained earnings. This statement is effective for the Company beginning January 1, 2008. The Company will to adopt SFAS No. 159 in 2008 and is currently evaluating if it will elect the fair value option for any of its eligible financial instruments and other items.

4. Stockholders’ Equity

Capital Stock

The authorized capital of the Company consists of an unlimited number of common shares without nominal or par value. During the nine months ended September 28, 2007 and September 29, 2006, 995,376 and 568,571 common shares, respectively, were issued pursuant to the exercise of stock options and warrants and the vesting of restricted stock for proceeds of approximately $7.3 and $4.3 million.

In the nine months ended September 28, 2007, the Company repurchased and cancelled 250,000 shares of its common stock on the open market in accordance with its stock repurchase plan. These shares were purchased at an aggregate cost of approximately $2.4 million. As of September 28, 2007, approximately $8.8 million remains in the Company’s program to purchase shares on the open market.

Accumulated Other Comprehensive Loss

FAS 158 Pension Adjustments

In September 2006, the FASB issued Statement of Accounting Standards No. 158 (“FAS No. 158”) Employers Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88,106 and 132(R). This statement improves financial reporting by requiring employers to recognize the over-funded or under-funded status of a defined benefit postretirement plan as an asset or liability and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Company adopted this standard in 2006. In the Company’s Form 10-K for the year ended December 31, 2006, a FAS No. 158 transition adjustment in the amount of $344 thousand, net of tax, was recognized as a component of the ending balance of Accumulated Other Comprehensive

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Income (Loss). This adjustment was misapplied as a component of Comprehensive Income rather than as a component to the ending Accumulated Other Comprehensive Income (Loss). The table below reflects the misapplication of this adjustment at December 31, 2006.

The Company will correct the Other Comprehensive Loss and Comprehensive Income presentation in the Form 10-K for the year ending December 31, 2007. This change in presentation will not affect the Consolidated Balance Sheets or Consolidated Statements of Operations.

The following table provides the details of accumulated other comprehensive loss at:

The components of comprehensive income (loss) are as follows:

Net income per common share

Basic net income per common share was computed by dividing net income by the weighted-average number of common shares outstanding during the period. For diluted net income per common share, the denominator also includes dilutive outstanding stock options, restricted stock and warrants determined using the treasury stock method.

Common and common share equivalent disclosures are:

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5. Stock Based Compensation

The Company has several stock-based compensation plans, the 2006 Equity Incentive Plan, under which stock-based grants may be issued and several other plans under which no new grants will be made. The 2006 Equity Incentive Plan provides for grants of various stock based awards including, but not limited to, stock options, stock appreciation rights and restricted stock. Since 2006, the Company has issued only restricted stock in the form of time and performance-based grants to senior executives, key employees and directors.

Restricted Stock

The Company recorded compensation expense, primarily included in selling, general and administrative expenses, related to its restricted stock awards totaling $0.8 million and $1.8 million during the three and nine months ended September 28, 2007, respectively. For the three and nine months ended September 29, 2006 the company recorded $0.4 and $0.5 million. These expenses have been recorded as an increase in additional paid-in capital on the Company’s balance sheet.

It is the Company’s policy to issue new shares for equity awards. The Company recognizes compensation expense on fixed awards on a straight-line basis over the requisite service period. The Company estimates the performance-shares expected to be earned based on the probability of meeting the performance criteria. The Company estimates the forfeiture rate periodically and adjusts for actual experience as necessary.

On March 26, 2007 the Compensation Committee granted 693,450 restricted stock awards to senior executives and key employees of the Company. Of these restricted awards, 251,250 are time-based, and the remaining 442,200 are performance-based. Consistent with the Company’s 2006 grants, performance based shares are earned based on achievement of 2007 profitability targets. All grants vest annually over 3 years on March 26, 2008, March 26, 2009 and March 26, 2010.

In July 2007 the Compensation and Governance Committees granted 36,742 restricted stock awards to employees and directors of the Company. Of these awards, 31,742 are time-based, and 5,000 are performance-based. These grants vest annually over 3 years.

Restricted Stock activity for the nine months ended September 28, 2007 is presented below.

As of September 28, 2007, there was $11.1 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the 2006 Equity Incentive Plan. That cost is expected to be recognized over a weighted-average remaining period of 2.31 years. As of September 28, 2007, there remain 933,058 common shares available to issue pursuant to this plan.

Stock Option Plans

The Company has several stock option plans and a warrant plan with outstanding grants issued prior to 2006. In 2005, the vesting of all options was accelerated making all options and warrants in these plans fully vested. No new options or warrants will be granted under these old plans, as all future equity grants will proceed under the 2006 Equity Incentive Plan.

Stock option and warrant activity for the nine months ended September 28, 2007 is presented below.

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The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying options and warrants and the quoted price of our common shares for the 316,136 options and warrants that were in the money at September 28, 2007. The intrinsic value of exercised options and warrants for the three months ended September 28, 2007 was $0.3 million. For the three months ended September 29, 2006, no options or warrants were exercised, therefore there was no intrinsic value. The intrinsic value of exercised options and warrants for the nine months ended September 28, 2007 and September 29, 2006 was $0.5 million and $3.0 million, respectively.

6. Related Party Transactions

Richard B. Black, the Chairman of the Board of Directors of the Company, is also the President and Chief Executive Officer of ECRM, Inc. ECRM, Inc. purchases Precision Technology products at prices and terms approximately equivalent to third-party transactions. For the three and nine months ended September 28, 2007 ECRM, Inc. purchased $0.1 and $0.7 million from the Company. For the three and nine months ended September 29, 2006 ECRM, Inc. purchased $0.2 and $0.3 million from the Company. Receivables from ECRM, Inc. of $0.2 and $0.3 million at September 28, 2007 and December 31, 2006, respectively, are included in accounts receivable.

The Company recorded sales revenue from Sumitomo Heavy Industries Ltd., a significant shareholder of the Company, of $0.9 million in the three months ended September 28, 2007 and $1.6 million in the three months ended September 29, 2006 at prices and terms approximately equivalent to third-party transactions. In the nine months ended September 28, 2007 and September 29, 2006, these revenues were $2.6 million and $4.1 million, respectively. Receivables from Sumitomo Heavy Industries Ltd. of $0.2 million and $0.7 million as at September 28, 2007 and December 31, 2006, respectively, are included in accounts receivable on the balance sheet. The Company purchases raw materials from Sumitomo at amounts and terms approximately equivalent to third-party transactions. The Company purchased $0.1 million and $0.1 million from Sumitomo in the three month period ended September 28, 2007 and September 29, 2006, respectively. In the nine months ended September 28, 2007 and September 29, 2006, those purchases were $0.1 and $0.2 million, respectively. There was no payable due to Sumitomo Heavy Industries Ltd. at September 28, 2007 and a payable of $6 thousand at December 31, 2006 which is included in accounts payable on the balance sheet.

Through July 2006, the Company had an agreement with V2Air LLC relating to the use of V2Air LLC’s aircraft for Company purposes. At that time the Company’s former President and Chief Executive Officer, Charles D. Winston owned V2Air LLC. Pursuant to the terms of the agreement, the Company was required to reimburse V2Air LLC for certain expenses associated with the use of the aircraft for Company business travel. This agreement was terminated in July 2006. During the three and nine months ended September 29, 2006 the Company reimbursed V2Air LLC a total of $41 thousand and $0.2 million respectively under the terms of the agreement.

7. Financial Instruments

Long-term Investments

Long term investments at September 28, 2007 and December 31, 2006 consists of a 25.1% equity investment in a private United Kingdom company, valued at approximately $0.8 million at September 28, 2007 and $0.7 million at December 31, 2006. Beginning in the forth quarter of 2006, the Company uses the equity method to record the results of this entity. For the nine months ended September 28, 2007, the Company recognized as other income approximately $0.1 million in earnings related to this investment.

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Derivative Financial Instruments

The Company uses currency derivatives to manage exposure to changes in foreign currency exchange rates associated with forecasted sales transactions, primarily in Japanese Yen. The Company records, at fair value, all outstanding derivatives as of quarter end as assets or liabilities in the consolidated balance sheet, with classification as current or long-term depending on the duration of the instrument. The changes in fair value are recorded in the consolidated statement of operations.

The Company enters into foreign currency contracts which are generally less than nine months in duration to hedge a portion of its foreign currency risk on sales transactions. As of September 28, 2007, the Company held the following derivative contracts:

At September 28, 2007 the unrealized loss was $18 thousand.

The Company had the following foreign exchange contracts at September 29, 2006.

8. Restructuring and Other

Restructuring Charges

In February 2007, the Company announced a plan to expand the Company’s manufacturing operations in China and restructure its manufacturing operations in the United Kingdom. This move is part of the Company’s overall plan to expand its presence in Asia and increase profitability. The Precision Technology Group will be moving additional laser and high speed air bearing spindle manufacturing from two UK facilities to the Company’s Suzhou, China facility. The Company expects to complete the manufacturing transfer and related restructuring by the end of 2007. The Company expects to record restructuring charges during 2007 of between $6.5 million and $7.0 million. The restructuring charges were projected to include approximately:

For the nine months ended September 28, 2007 the Company has incurred $6.0 million in restructuring costs of which: $2.6 million related to termination benefits, $3.0 million was for inventory write offs and $0.4 million was for manufacturing transition costs.

As a result of restructuring programs undertaken prior to 2006, the Company has $1.3 million of reserves for excess space in Munich, Germany. In May of 2007, the Company fully sub-let this building, at a current market rate. Each quarter the Company reviews its Munich facility excess space restructuring accrual, which covers the anticipated future contractual lease payments (through January 2013) less the proceeds from the sub-lease. For the three and nine months ended September 28, 2007, the Company has received $0.1 and $0.2 million in rental income from the sub-lease of the Munich facility. The following table summarizes changes in the restructuring reserve included in other accrued expenses on the balance sheet.

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Acquisition of the UK Beryllium Business

On June 1, 2007, the Company acquired the beryllium mirror and structures business of UK-based Thales Optronics (Taunton) Ltd, for approximately $2.5 million, plus approximately $0.5 million in acquisition related expenses. The acquisition will help strengthen our market position in optical scanning. The acquisition was accounted for under FAS No. 141 “Business Combinations”. The Company allocated its’ costs of acquisition to the assets acquired and liabilities assumed based on their estimated fair values at the acquisition date. In accordance with FAS No. 141 the excess of the fair value of the acquired net assets over the purchase cost was allocated on a pro rata basis to the acquired long term assets, which consisted of property, plant and equipment and intangible assets. The results of operations are included in the Precision Technology Segment of the Company’s financial statements as of the acquisition date. The purchase price allocation as of September 28, 2007 is preliminary.

Other

On June 30, 2006, the Company sold a small parcel of land in Nepean, Ontario, Canada for Cdn $380 thousand (approximately US$338 thousand) and recorded a gain of $0.2 million on the transaction.

At September 28, 2007, the net book value of two buildings located in Poole, U.K., were classified as “held for sale” and included in other assets. These buildings were vacated as part of the Company’s 2007 U.K. restructuring program.

9. Commitments and Contingencies

Operating leases

The Company leases certain equipment and facilities under operating lease agreements. Most of these lease agreements expire between 2007 and 2013. In the United Kingdom, where longer leases are more common, the Company has land leases that extend through 2078. The facility leases require the Company to pay real estate taxes and other operating costs. The rent on certain leases is subject to escalation clauses in future years.

Legal Proceedings and Disputes

In March 2007, the Company and Lumenis settled the previously reported Spectron legal claims for a cash payment from Lumenis to the Company. A portion of the payment has been applied in full satisfaction of a receivable from Lumenis, and the remainder ($2.0 million) has been recorded as an offset to selling, general and administrative expenses as it represents a recovery of previous amounts expensed.

The Company is also subject to various legal proceedings and claims that arise in the ordinary course of business. The Company does not believe that the outcome of these claims will have a material adverse effect upon the Company’s financial conditions or results of operations but there can be no assurance that any such claims, or any similar claims, would not have a material adverse effect upon the Company’s financial condition or results of operations.

Guarantees

In the normal course of our operations, we execute agreements that provide for indemnification and/or guarantees to counterparties in transactions such as business dispositions, the sale of assets, sale of products and operating leases. Additionally, the by-laws of the Company require it to indemnify certain current or former directors, officers, and employees

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of the Company against expenses incurred by them in connection with each proceeding in which he or she is involved as a result of serving or having served in certain capacities. Indemnification is not available with respect to a proceeding as to which it has been adjudicated that the person did not act in good faith in the reasonable belief that the action was in the best interests of the Company. These indemnities and guarantees are routine and customary in the industry.

Historically, we have not made any significant payments under such indemnifications. At September 28, 2007 and December 31, 2006, nothing has been accrued in the consolidated financial statements with respect to these indemnification undertakings.

10. Income Taxes

At the end of each interim reporting period, the Company determines its estimated annual effective tax rate, which is revised, as required, at the end of each successive interim period based on facts known at that time. The estimated annual effective tax rate is applied to the year-to-date pre-tax income at the end of each interim period. The tax effect of significant unusual items is reflected in the period in which they occur. The Company’s reported effective tax rate of 31.7% for the nine months ended September 28, 2007, differed from the expected Canadian federal statutory rate of 32.0%, primarily due to the mix of jurisdictions in which the Company earns income, changes to the valuation allowance for deferred tax assets in Canada, the United States, and the United Kingdom, the recognition of prior year extraterritorial income exclusion in the U.S., and return to provision adjustments in the United States and Korea.

As part of the process of preparing the consolidated financial statements, the Company is required to estimate its income tax provision (benefit) in each of the jurisdictions in which it operates. This process involves estimating the current income tax provision (benefit) together with assessing the future effects of temporary differences resulting from differing treatment of items for tax and accounting purposes. The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement carrying amount and the tax bases of assets and liabilities.

The Company records a valuation allowance if it is more likely than not that a portion of its deferred tax assets will not be realized. The Company has considered historical losses, future taxable income, and expected reversals of existing temporary differences in assessing the need for a valuation allowance. The Company has not recorded a provision for withholding tax on undistributed earnings of foreign subsidiaries, as the Company currently has no plans to repatriate those earnings. Determination of the amount of unrecognized deferred tax liabilities is not practicable because of the complexities associated with its hypothetical calculation.

The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (FIN No. 48) on January 1, 2007. As a result of the implementation of FIN No. 48, the Company recognized a $0.1 million increase in the liability for unrecognized tax benefits. On the date of adoption of FASB Interpretation No. 48, the Company had total unrecognized tax benefits of approximately $2.4 million (including interest and penalties of $0.5 million) that, if recognized, would impact the Company’s effective tax rate. Also, as a result of this adoption the Company has re-classified $1.4 million of tax liabilities to long-term. At September 28, 2007, the Company had total unrecognized tax benefits of $3.0 million (including interest and penalties of $0.6 million). The Company recognizes interest and penalties accrued related to unrecognized tax benefits as income tax expense.

The Company expects to have a decrease of approximately $1.1 million of unrecognized tax benefits within the next twelve months related to the completion of its audit with the Internal Revenue Service. The Company is in the final stages of the appeals process and has reached a tentative settlement. The Company expects to have an ultimate settlement of this audit within the next twelve months.

The Company operates and files income tax returns in numerous taxing jurisdictions. The Company’s income tax returns could still be reviewed in the following countries and for the following periods under the appropriate statute of limitations; United States (1999-2006), Canada (2002-2006), United Kingdom (2004-2006), Germany (2004-2006), and Japan (2004-2006).

11. Defined Benefit Pension Plan

The Company’s subsidiary in the United Kingdom maintains a pension plan, known as the GSI Lumonics Ltd. United Kingdom Pension Scheme Retirement Savings Plan. The plan has two components: the Final Salary Plan, which is a defined benefit plan, and the Retirement Savings Plan, which is a defined contribution plan. Membership to the defined benefit Final Salary Plan has been closed to new members for more than ten years, and, in 2003 participant benefits stopped accruing.

The Company continues to follow its policy to fund pensions and other benefits based on widely used actuarial methods as permitted by regulatory authorities. The funded amounts reflect actuarial assumptions regarding compensation, interest and other projections. The assets of this plan consist primarily of equities, real estate and fixed income securities of U.K. and foreign issuers.

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Pension and other benefit costs reflected in the consolidated statements of operations are based on the projected benefit method of valuation. Within the consolidated balance sheet, pension plan benefit liabilities are included in accrued compensation and benefits.

The table below sets forth the estimated net periodic pension cost of the Final Salary Plan of GSI Lumonics Ltd. United Kingdom Pension Scheme Retirement Savings Plan.

The Company’s Japanese subsidiary maintains a tax qualified pension plan. The plan, a quasi-defined benefit pension plan, covers substantially all regular employees, under which the company deposits funds under various fiduciary-type arrangements and/or purchases annuities under group contracts. Benefits are based on years of service and the employee’s compensation at retirement. For employees with less than twenty years of service to the Company, the benefit is paid out in a lump sum based on years of service and the employee’s compensation at retirement. For employees with twenty or more years of service to the Company, the benefit is guaranteed for a certain number of years and is based on years of service and the employee’s compensation at retirement. Participants may under certain circumstances, receive a benefit upon termination of employment.

The assumptions used to value the costs and obligations of the plan reflect the Japanese economic environment. The Company continues to fund the plan sufficiently to meet current benefits as well as to fund a certain portion of future benefits as permitted in accordance with regulatory authorities.

The table below sets forth the estimated net periodic cost of the Japanese tax qualified pension plan.

12. Segment Information

The Company reports in two segments; Precision Technology Group and Semiconductor Systems Group.

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Segments

Information on reportable segments is as follows:

The Company’s chief operating decision maker does not review asset information or operating income on a segmented basis, therefore a breakdown of assets and operating income by segments is not included.

Geographic Segment Information

The Company attributes revenues to geographic areas on the basis of the bill-to customer location. Not infrequently, equipment is sold to large international companies, which may be headquartered in Asia-Pacific for example, but the sales of our systems are billed and shipped to locations in the United States. In this example, these sales are reflected in North America totals in the table below. Long-lived assets, which include property, plant and equipment, intangibles and goodwill, but exclude other assets, long-term investments and deferred tax assets, are attributed to geographic areas in which the Company assets reside.