-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Dy9ARpyVIEp1MrJtsZ6ppL2IhOtmIK5lSLYkp+dqIWoOVSm/tSMaPHdPcl8y3rEj KbY9L67XzKfPc7OxdrCLIQ== 0000741696-99-000015.txt : 19990419 0000741696-99-000015.hdr.sgml : 19990419 ACCESSION NUMBER: 0000741696-99-000015 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19981031 FILED AS OF DATE: 19990416 FILER: COMPANY DATA: COMPANY CONFORMED NAME: APPLIED SIGNAL TECHNOLOGY INC CENTRAL INDEX KEY: 0000741696 STANDARD INDUSTRIAL CLASSIFICATION: RADIO & TV BROADCASTING & COMMUNICATIONS EQUIPMENT [3663] IRS NUMBER: 770015491 STATE OF INCORPORATION: CA FISCAL YEAR END: 1031 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 000-21236 FILM NUMBER: 99595752 BUSINESS ADDRESS: STREET 1: 400 WEST CALIFORNIA AVENUE CITY: SUNNYVALE STATE: CA ZIP: 94086 BUSINESS PHONE: 4087491888 MAIL ADDRESS: STREET 1: 400 W CALIFORNIA CITY: SUNNYVALE STATE: CA ZIP: 94086 10-K/A 1 FORM 10-K/A UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K/A AMENDEMENT NO. 1 TO (Mark One) [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE FISCAL YEAR ENDED OCTOBER 31, 1998 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Transition Period from ____________________to ____________________. Commission file number 0-21236 APPLIED SIGNAL TECHNOLOGY, INC. ------------------------------ (Exact name of registrant as specified in its charter) CALIFORNIA 77-0015491 ---------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 400 WEST CALIFORNIA AVE., SUNNYVALE, CA 94086 --------------------------------------------- (Address of principal executive offices) (408) 749-1888 -------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Exchange Act: Not Applicable. Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock, without par value. Indicate by a check 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 periods 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 a check mark if disclosure by delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K. [ ] Aggregate market value of the voting stock held by non-affiliates of the registrant: Common Stock, without par value -- $59,466,319 as of March 18, 1999. Number of shares of registrant's common stock outstanding: Common Stock, without par value -- 8,346,150 shares as of March 18, 1999. DOCUMENTS INCORPORATED BY REFERENCE None. This Amendment No. 1 to Annual Report on Form 10-K consists of 58 pages, includint eshibits; the exhibit index is on page 56. The undersigned registrant hereby amends the following items, financial state- ments and exhibits or other portions of its Annual Report on Form 10-K filed January 28, 1999 as set forth in the pages attached hereto. INDEX APPLIED SIGNAL TECHNOLOGY, INC. PART I. Item 1. Business Item 2. Properties Item 3. Legal Proceedings Executive Officers of Registrant PART II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosure about Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure PART III. Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions PART IV. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Signatures PART I ITEM 1: BUSINESS Forward-looking statements in this Report are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. In this report, the words "anticipates," "believes," "expects," "future," "intends," and similar expressions identify forward-looking statements. Shareholders are cautioned that all forward-looking statements pertaining to the Company involve risks and uncertainties, including, without limitation, those contained under the caption, "Business Considerations and Certain Factors that May Affect Future Results of Operations and/or Stock Price" and other risks detailed from time to time in the Company's periodic reports and other information filed with the Securities and Exchange Commission. Actual events and results may differ materially from the Company's current expectations and beliefs. GENERAL Applied Signal Technology, Inc. (Applied Signal Technology or the Company) designs, develops, and manufactures signal processing equipment to collect and process a wide range of telecommunication signals. This equipment is used for reconnaissance of foreign telecommunications predominantly by the United States Government and allied foreign governments, for certain industrial applications and for defense communications systems. Signal reconnaissance systems are composed of collection equipment and processing equipment. Collection equipment consists of sophisticated receivers that scan the radio frequency (RF) spectrum (cellular telephone, microwave, ship-to-shore, and military transmissions) to collect certain signals from, potentially, thousands of signals within the RF spectrum. Signal processing equipment, using sophisticated software and hardware, evaluates the characteristics of the collected signals and selects signals that are likely to contain relevant information. Industrial applications include commercial communication system quality monitoring and data network intrusion detection. Defense communication equipment provide reliable, high-speed data transfer for military applications. Since inception, the Company has focused its efforts primarily on processing equipment, but also provides specialized collection equipment, as well as complete systems. Signal Reconnaissance In recent years, accurate and comprehensive information regarding foreign affairs and developments has become increasingly important to the United States Government. The reduction of United States military tactical forces overseas, coupled with political instability in certain regions such as the Middle East, Eastern Europe, Africa and South America, has heightened the United States Government's need to be able to monitor overseas activities. In order to obtain information about activities within foreign countries, the United States Government gathers and analyzes telecommunication signals emanating from those countries. The Company devotes significant resources toward understanding the United States Government's signal reconnaissance goals, capabilities and perceived future needs. The Company obtains information about these signal reconnaissance needs through frequent marketing contact between its employees and technical and contracting officials of the United States Government. The Company believes that it has much more marketing contact with customers and potential customers than is customary among its competitors. In addition, the Company invests in research and development (R&D) which it anticipates will enable it to develop signal reconnaissance equipment that meets these needs. The Company believes that it invests a greater percentage of its revenues in R&D than is typical among its competitors. (See "Research and Development.") Budgetary constraints and critical time-to-deployment requirements have caused many United States Government agencies to search for more flexible and cost-effective signal reconnaissance solutions that can be deployed promptly. The Company's signal reconnaissance products can be used, with or without further modification, to satisfy requirements of a variety of customers. The Company believes its products can be readily deployed in a wide variety of circumstances to meet current United States Government signal reconnaissance requirements. The Company designs its products to use advanced circuitry and highly integrated components, including Company-designed application-specific integrated circuits (ASICs). This enables the Company to offer products that are smaller, consume less power, and cost customers less when multiple units are built than equipment of similar functionality that use fewer advanced designs and materials. Industrial Applications The volume of data transferred and made available to individuals is growing exponentially worldwide. This trend dictates maximum efficiency of spectrum usage by the commercial telecommunications companies. The spectrum usage is especially critical in the band limited radio frequency (RF) environment that personal communication systems (e.g., cellular systems) and communication satellite systems (e.g., PanAmSat, Intelsat, InMarSat) utilize. As these systems attempt to maximize this usage, there is an increasingly higher probability that data transfer will be impaired. This creates demand for sophisticated data quality monitoring. The Company believes that its signal processing prowess in non- intrusive signal reconnaissance developed over the years, lends itself nicely to this quality monitoring requirement. In addition, as the Company continues to stay abreast of the United States Government's future signal reconnaissance needs, it naturally stays abreast of trends in telecommunication technology. The Company believes this knowledge places it in the favorable position of understanding the data transfer techniques that will require quality monitoring in the future. As the world becomes more reliant upon data transfer and data access for its day-to-day activities (i.e., E-Commerce), it also becomes more vulnerable to unauthorized data access or manipulation. This creates a requirement for data system intrusion detection. This intrusion detection must obviously be performed without impact upon the data transfer. The Company believes that the technological expertise it has developed for signal reconnaissance positions the Company to develop and commercialize intrusion detection technology. In particular, the Company's signal processing prowess provides the fundamentals for the development of intrusion detection equipment. Defense Communications Just as the civilian world is becoming increasingly dependent upon data transfer and access, so is the military. The military branches utilize data transfer for guidance, computer-to-computer battlefield planning, high quality communications, and so forth. Many times this data transfer must occur under non-ideal transport modes. The transport invariably is in the radio frequency spectrum and must occur under sub-optimum conditions such as minimal frequency planning for interference mitigation; inaccurate antenna pointing; and moving platforms. These defense communication systems must be able to mitigate these data transfer anomalies in an automated or semi- automated manner in order to provide reliable, rapidly deployed communications. The Company believes that the technological expertise it has developed for signal reconnaissance systems to adequately process data collected in non-ideal situations lends itself to these defense communication system requirements. In particular, our vast experience in adaptive equalization/demodulation of sophisticated data telecommunication signals provide the capability to develop equipment that overcomes these data transport anomalies. DESCRIPTION OF THE BUSINESS Applied Signal Technology designs, develops, and manufactures equipment to collect and process telecommunication signals for signal reconnaissance, industrial applications, and defense communication systems. The signal reconnaissance equipment is purchased by military and intelligence organizations of the United States Government and foreign countries to be used for foreign signal reconnaissance. The industrial signal processing equipment can be purchased by private industry as well as government organizations (United States and foreign) for telecommunication quality monitoring and data network intrusion detection applications. The defense communication equipment is purchased by the Unites States Military to provide high-speed data transfer capabilities. Signal Reconnaissance In recent years, accurate and comprehensive information regarding foreign affairs and developments has become increasingly important to the United States Government. The reduction in United States military tactical forces overseas has heightened the United States Government's need to quickly assess military risks, particularly in areas of instability as they develop around the world. The breakup of the Soviet Union and civil unrest in certain nations in Eastern Europe, Africa, and South America indicate an increase in geographic areas that might require monitoring. In addition, the United States Government requires information regarding overseas activities to conduct drug interdiction operations. As part of its efforts to obtain information, the United States Government gathers and analyzes telecommunication signals emanating from foreign countries. In recent years, the use of established telecommunication technologies has increased throughout the world and new telecommunication technologies, supplementing rather than replacing prior technologies, have been developed and commercialized. These trends have led to a significant increase in the overall volume of information communicated and an increase in the density of signals transmitted throughout the radio frequency spectrum. This increase can be seen in the proliferation of facsimile, cellular, and digital signal telecommunications equipment and the global information network (World Wide Web) in the last decade, resulting in a significant increase in the amount of information being communicated. These trends have required the development of signal reconnaissance equipment capable of collecting and processing an increased volume of signals as well as new types of signals. Traditionally, organizations within the United States Government have satisfied their signal reconnaissance needs by first identifying their specific requirements and then contracting with government contractors to provide equipment. Contractors typically designed and built custom signal processing systems optimized to satisfy the particular needs of various agencies. Development of custom systems usually required many years of effort and involved great expense. The time required to develop these systems often meant that when a system was delivered, it did not address new telecommunications technologies that had evolved during the development process. These factors, combined with growing budgetary constraints, have caused many agencies to search for more flexible and cost-effective signal reconnaissance solutions that can be deployed promptly. Industrial Applications The current technological trend worldwide is exponential growth in the volume of data transferred and made available to the individual. This trend dictates maximum efficiency of frequency spectrum usage by the commercial telecommunication companies. The spectrum usage is especially critical in the band limited radio frequency (RF) environment that personal communication systems (e.g., cellular systems) and communication satellite systems (e.g., PanAmSat, Intelsat, InMarSat) utilize. As these systems attempt to maximize this usage, there is an increasingly higher probability that data transfer will be impaired. This creates demand for sophisticated data quality monitoring. Traditionally, telecommunication techniques have been sufficiently low technology that fairly unsophisticated techniques could be used for quality monitoring. The rapid advancement of telecommunication technology and desire to maximize data transfer in the recent years has created a major technological challenge for the quality monitoring. the commercial telecommunication companies are just now realizing the need for sophisticated signal processing equipment to perform quality monitoring. As the world become more reliant upon data transfer and data access for its day-to-day activities (i.e., E-Commerce), it also becomes more vulnerable to unauthorized data access or manipulation. This creates a requirement for data system intrusion detection. This intrusion detection must obviously be performed without impact upon the data transfer. The information providers and database ownerso of data networks are increasingly assessing their vulnerabilities and protection needs. Data network protection is becoming a concern of organizations worldwide. Defense Communications Just as the civilian world is becoming increasingly dependent upon data transfer and access, so is the military. The military branches utilize data transfer for guidance, computer-to-computer battlefield planning, high quality communications, and so forth. This data transfer many times must occur under non-ideal transport modes. The transport invariably is in the radio frequency spectrum and must occur under sub-optimum conditions such as minimal frequency planning for interference mitigation; inaccurate antenna pointing; and moving platforms. These defense communication systems must be able to mitigate data transfer anomalies in an automated or semi- automated manner in order to provide reliable, rapidly deployed communications. The military branches are adapting to advancing state-of-the- art data transfer technologies. As they are adopting these capabilities and understanding the new technologies they are faced with added complexities compared to commercial applications. The United States Government started investing in research and development to overcome these complexities. The goal is to provide a reliable all- digital battlefield by 2010. STRATEGY Applied Signal Technology's objective is to anticipate the needs of the telecommunication processing marketplace and to invest in research and development in an effort to provide solutions before the Company's competitors. In some cases, this involves the development of equipment to address new telecommunications technologies. In other cases, it involves the development of equipment that offers smaller size, lower power consumption, and lower cost than potentially competitive products. The Company's strategy to accomplish its objective includes the following elements: - Anticipate Marketplace Needs. The Company devotes significant resources in order to understand perceived future telecommunication processing needs. The Company monitors technological and commercial advances in telecommunications to identify advances it believes will create new opportunities. The Company obtains information about marketplace needs through frequent contact with customer employees and technical and contracting officials. In contrast, the Company believes that competitors often wait until potential customers request competitive proposals for equipment to satisfy specific requirements and then respond to these requests. Many times, sole source contracts are granted by the United States Governments when a single contractor is deemed to have an expertise or technology that is superior to that of competing contractors. Since the Company's inception, the majority of its revenues have been from sole source contracts. The Company believes that the large number of sole source contracts it obtains demonstrates that it often anticipates marketplace needs correctly. There can be no assurance, however, that the Company will anticipate correctly the marketplace needs in the future. - Invest in Research and Development. The Company invests in research and development it believes will enable it to develop equipment that will satisfy the telecommunication processing needs of the future. The Company believes that it invests a greater percentage of its revenues in R&D than is typical among its competitors. The Company believes its R&D investments often enable it to offer superior products before its competitors. - Develop Flexible Products. The Company develops products that can be used, with or without further modification, to satisfy the needs of a variety of customers. The Company uses its prior product development efforts to offer customers cost- effective solutions and to offer these solutions promptly. The Company believes that custom equipment developed by many of the Company's competitors generally cannot be as readily deployed in as wide a variety of circumstances as the Company's products. - Develop Highly Integrated Products. The Company designs its products to use advanced circuitry and highly integrated components. This enables the Company to offer products that are smaller, consume less power, and cost customers less when multiple units are built than equipment of similar functionality that use fewer advanced designs and materials. The lower cost of many of the Company's products appeals to customers with budget constraints, and the smaller size and low power consumption of many of the Company's products appeal to customers with physical installation constraints. - Focus on Signal Processing. Since inception, the Company has focused much of its attention on developing signal processing equipment. The Company believes that there have been and will continue to be more opportunities to develop specialized signal processing equipment to satisfy emerging technological requirements. - Increase Penetration and Broaden Customer Base. The Company believes that its traditional customers offer significant opportunities for sales growth, both in terms of additional units of developed products and the development of new products and, accordingly, directs much of its marketing efforts toward these customers in order to increase the Company's penetration of these markets. In addition, more recently, the Company has been attempting to broaden its customer base through the aggressive pursuit of new markets relating to quality monitoring of commercial satellite communications, data network intrusion protection, and defense communications. PRODUCTS The Company's products consist of signal collection and processing equipment that use software and hardware developed over many years by the Company in the course of performing development contracts to provide signal reconnaissance equipment to the United States Government. This software and hardware enable the Company's processing equipment to evaluate large numbers of radio frequency signals and to select the relatively small proportion which contain information likely to be useful in the signal reconnaissance programs of the United States Government. More recently, the Company has leveraged its product and technology base into some products outside the traditional signal reconnaissance market. The Company offers a variety of signal reconnaissance products, which can be categorized as follows: - Voice Grade Channel Processors. These processors are designed to process voice grade channels (VGCs) which carry audio and other signals. The standard telecommunication systems used throughout the world put a large number of VGCs on a single carrier channel to increase the number of signals that can be transmitted at a particular frequency. VGC processors can scan thousands of signals in less than one second and use sophisticated processing technology to detect and record relevant data, which is then analyzed by United States Government personnel. These processors evaluate the characteristics of collected signals and select those signals that are likely to contain relevant information. The Company's VGC processors currently range in price from approximately $40,000 to approximately $200,000. - Wideband Processors. These processors "clean" telecommunication signals for further processing by VGC processors by adjusting for signal distortions that commonly occur during transmission. The two primary types of distortion these processors correct are multipath interference (caused by the reception of a signal and its reflections) and cochannel interference (caused by the reception of multiple interfering signals). Commercial telecommunications companies overcome these distortions with careful alignment and tuning which requires interruption of the telecommunication signals. The Company's wideband processors perform this alignment independently and automatically by adjusting processing parameters using proprietary adaptive algorithms that let the processors "learn" how to process the incoming signals. One of the Company's wideband processors processes signals that carry thousands of VGCs in a digital format which is rapidly being proliferated through the world and is particularly susceptible to distortions. The Company's wideband processors currently range in price from approximately $80,000 to approximately $150,000. - Processing Systems. Although the Company has emphasized subsystem or "product" development since its inception, it has also developed and delivered signal processing systems in situations where the capabilities of its products have enabled it to obtain a system development contract on a sole source basis from the United States Government. The Company's two largest system installations, for which the Company developed custom systems software, integrated a number of the Company's standard VGC processors and were developed to exacting United States Government software and documentation standards. Pricing for processing systems can vary widely depending on the system requirements. Prices may range from $100,000 to millions of dollars. - Collection Products. The Company offers a limited number of signal collection products designed to complement certain of the Company's processing products. The Company's collection products include a low-cost, small-size receiver that collects very complex signaling formats and a receiver that overcomes cochannel interference and certain forms of multipath interference by optimizing multiple antenna inputs. The Company's collection products currently range in price from approximately $20,000 to approximately $60,000. The Company is now developing industrial telecommunication processing equipment and defense communications equipment marketplaces with the following product categories: - Communication Satellite Quality Monitors. These products collect a variety of radio frequency signals as they are emitted from the satellites and perform precise signal parameter measurements using advanced digital signal processing techniques to provide signal quality monitoring. The equipment interfaces with system control networks to provide total system quality monitoring. These products are priced in a range of approximately $50,000 to $100,000. - Telephone Intrusion Detection Equipment. This equipment is a variant of the voice grade channel processor using the multi- channel processing capability to detect unusual channel activity within a telephone network. This activity could be indicative of attempts at unauthorized data network entry. These products currently range in price from approximately $40,000 to $150,000. - Defense Communication Products. This equipment is based on the wideband processor technology. The communication products not only "clean" the signals for subsequent processing, but also include the signal generation capability to provide the complete function of an adaptive equalization wideband modem. These products currently range in price from approximately $20,000 to $40,000. CUSTOMERS, CONTRACTS, AND MARKETING CUSTOMERS To date, purchases by the United States Government have accounted for almost all of the Company's revenues. Most of the Company's revenues have come from contracts directly with the United States Government. The Company also has subcontracts under which it supplies products or services to prime contractors that have contracts with the United States Government. Subcontract revenues accounted for approximately 34%, 29%, and 27% of the Company's total revenues for its fiscal years 1998, 1997, and 1996, respectively. In addition, the Company occasionally sells small quantities of equipment to foreign governments. Foreign revenues have accounted for approximately 9%, 2%, and 3% of the Company's total revenues for fiscal years 1998, 1997, and 1996, respectively. The Company's United States Government customers consist of approximately six military and intelligence agencies with signal reconnaissance needs. Within these six major customers, the Company has contracts with approximately 20 different offices, each with separate budgets and contracting authority. Concentration of revenue sources is significant for the United States Government. The Company's largest contract accounted for 18% of the Company's revenues in fiscal year 1998, 22% in fiscal year 1997, and 15% in fiscal year 1996. Two intelligence agencies accounted for approximately 39% and 28%, respectively, of revenues in fiscal year 1998; approximately 57% and 28%, respectively, of revenues in fiscal year 1997; and approximately 52% and 26%, respectively, of revenues in fiscal year 1996. In recent years, the United States defense budget has been reduced, causing customers and potential customers of the Company's products to re-evaluate their needs. The Company believes that budget reductions have caused agencies increasingly to favor standard products similar to the Company's products rather than custom products that generally are more expensive, take longer to deliver, and provide solutions to a narrower range of signal reconnaissance problems. Future reductions in United States Government spending on signal reconnaissance equipment or future changes in the kinds of signal reconnaissance products or services required by United States Government agencies, however, could limit demand for the Company's products, which would have a material adverse effect on the Company's operating results. CONTRACTS Most of the Company's business is conducted under contracts that include United States Government security requirements. The Company's contracts with United States Government agencies can be categorized in several ways. Sole source contracts are let by the United States Government when a single contractor is deemed to have an expertise or technology that is superior to that of competing contractors. Potential suppliers compete informally for sole source contracts through R&D investment and marketing efforts. This competition requires a contractor to identify the United States Government's requirements early and invest in developing potential solutions so that the contractor can demonstrate a distinguishing expertise or technology promptly after the United States Government has identified a signal reconnaissance requirement. Competitive bid contracts are awarded after a formal bid and proposal competition among suppliers, and sole source contracts are awarded without a formal competition. During fiscal years 1998, 1997, and 1996, approximately 62%, 69%, and 75%, respectively, of the Company's revenues were from sole source contracts, and approximately 38%, 31%, and 25%, respectively, were from competitively bid contracts. During fiscal years 1998, 1997 and 1996, the Company experienced an increase in the percentage of revenues from contracts awarded on a competitive basis. This increase is primarily due to an increase in the number of subcontracts awarded to the Company; subcontracts are generally awarded on a competitive basis. Management does not believe the shift in the percentage of revenues from subcontracts via competitive bidding will have a material impact on future operating results or financial condition of the Company. Competitive bid contracts are awarded based on objective proposal evaluation criteria established by the procuring agency. Interested contractors prepare a bid and proposal that responds to the agency's request for proposal. A bid and proposal is usually prepared in a short period of time (for example, 45 days) in response to a deadline and requires the extensive involvement of numerous technical and administrative personnel. Competitive bid or sole source contracts can be either fixed-price contracts, pursuant to which the Company agrees to deliver equipment for a fixed price and assumes the risk of cost overruns, or cost-plus contracts, pursuant to which the Company is reimbursed for its direct and indirect costs and paid a negotiated profit. During fiscal year 1998, approximately 46% of the Company's revenues were from fixed- price contracts and approximately 54% were from cost-plus contracts. During fiscal year 1997, approximately 50% of the Company's revenues were from fixed-price contracts and approximately 50% were from cost-plus contracts. During fiscal year 1996, approximately 52% of the Company's revenues were from fixed-price contracts and approximately 48% were from cost-plus contracts. Most of the Company's fixed-price contracts are for the manufacture of multiple units of its products, rather than the development of new products. The Company believes that the risk of cost overruns is much less in the case of fixed-price manufacturing contracts, where the product already has been developed and at least a prototype made, than in the case of fixed-price development contracts. The Company is subject to price redetermination on certain fixed- price U. S. Government contracts if it is determined that the Company did not price its products and services consistent with the requirements of the Federal Acquisition Regulations. As of October 31, 1998, the Company has not had a material claim sustained against it for noncompliance. See Item 3: "Legal Proceedings." Almost all of the Company's contracts contain termination clauses that permit contract termination upon the Company's default or for the convenience of the other contracting party. In either case, termination could adversely affect the Company's operating results. Although the Company has not experienced any material cancellations in the past, there can be no assurance such cancellations will not occur in the future. MARKETING The Company's primary marketing efforts consist of personal contact between technical representatives of customers and potential customers and technical personnel of the Company. The Company involves all technically qualified staff members in its marketing program. The Company believes it is extremely important to have technically knowledgeable staff make marketeing contacts since an initial system concept is often developed during the first such contact. The Company believes that it has much more marketing contact with government customers and potential government customers than is customary among its competitors generally, and that this contact enables the Company to anticipate telecommunication signal processing needs, thereby giving the Company a potential advantage over its competitors. In addition to its primary technical marketing, the Company also conducts marketing activities designed to increase its visibility with existing and potential customers. Each year the Company conducts two equipment shows in the Washington, D.C. area demonstrating the operation of many of its signal reconnaissance products. The Company uses direct mail and magazine advertising from time to time to inform potential customers of available products. The Company also produces a signal reconnaissance product summary catalog that is updated every six months, and a quarterly newletter for direct mailing. The Company's mailing list includes contacts at private sector companies that may purchase the Company's products for their own use or for inclusion in systems they are developing, as well as contacts at United States Government agencies that buy products but do not contract for development efforts. BACKLOG The Company's backlog, which consists of anticipated revenues from the uncompleted portions of existing contracts, was $49.4 million, $83.3 million, and $82.9 million at October 31, 1998, 1997, and 1996, respectively. Anticipated revenues included in backlog may be realized over a multi-year period. The Company includes a contract in backlog when the contract is signed by both the Company and the customer. The Company believes that the backlog figures are firm, subject only to the cancellation and modification provisions contained in its contracts. (See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations: "Backlog.") RESEARCH AND DEVELOPMENT Research and Development The Company conducts R&D pursuant to United States Government R&D contracts and as part of its own R&D program. United States Government R&D contracts generated approximately $60.9 million of revenues in fiscal year 1998, approximately $48.0 million in fiscal year 1997, and approximately $23.0 million in fiscal year 1996. The Company's R&D program is funded by the billing rates charged to its customers. The Company's R&D expenditures as a percentage of revenues in fiscal years 1998, 1997, and 1996 were 11.1%, 10.5%, and 12.1%, respectively. Research and development conducted by the Company was approximately $12.2 million for fiscal year 1998, $10.1 million for fiscal year 1997, and $9.4 million for fiscal year 1996. The Company believes that its investment in R&D provides it with a significant competitive advantage. The Company seeks to develop technology capable of addressing new telecommunication signal processing requirements before its competitors. In addition, the Company focuses its R&D on developing products that can be used, with or without further modification, to satisfy various needs of a variety of customers, thereby permitting the Company to offer a solution promptly. The Company attempts to allocate its R&D funds among projects intended to yield revenues within one to two years, projects intended to yield revenues in two to five years, and projects intended to yield revenues in more than five years. Most of the Company's R&D expenditures are for projects intended to yield revenues within one to two years. An important aspect of the Company's R&D efforts is understanding telecommunication trends to anticipate the future signal processing needs of its customers. Not only does this allow the Company to direct its R&D engineering efforts to produce solutions promptly once a customer expresses a need, but it often allows the Company to educate the customer about its potential needs and simultaneously present a conceptual solution to those needs. COMPANY DIVISIONS The Company is organized into three technical divisions and a finance division. Two of the three technical divisions-Communication Systems and Strategic Systems-are engineering divisions which perform all of the Company's development. The engineering divisions are primarily responsible for conducting R&D and the initial development of products, while the Operations Division is primarily responsible for manufacturing multiple units of products. All divisions work together to ensure that production-related issues, such as manufacturability, reliability, and maintainability, are addressed from initial product definition through final product shipment. The Company's technical staff includes personnel with systems development expertise, which the Company applies not only to system development but also to its product development in order to ensure the compatibility of its products with a variety of system requirements. As of January 5, 1999, there were 339 employees in the engineering divisions and 180 employees in the operations division. (See "-Employees.") Engineering. The engineering divisions are responsible for the Company's R&D. The Company's R&D activities include both United States Government R&D contracts and the Company's R&D projects. The engineering division activities are directed toward developing products that will ultimately be produced by the Operations Division. The engineering divisions work in conjunction with the Operations Division to assure that the development efforts will culminate in a product able to be manufactured efficiently in quantity. In addition to corporate headquarters in Sunnyvale, California, the Company has offices in Herndon, Virginia and Annapolis Junction, Maryland. As of January 5, 1999, there were 15 employees in the Virginia office and 31 employees in the Maryland office. Most of the personnel staffing these offices are technical personnel and, in addition to marketing activities, are involved in research and development and customer support (for example, installation, training, and troubleshooting). Recently, the Company relocated an employee to Salt Lake City, Utah to open an office in March 1999. Operations. The Operations Division is responsible for completing final product development and manufacturing multiple units of products. By combining engineering and production expertise within the Operations Division, the Company believes it is able to maximize manufacturing efficiency and, therefore, reduce overall production costs. Operations manufactures products using batch production methods. The division achieves labor efficiency by extensive cross- training of its personnel, which permits these personnel to participate in the production of all of the Company's products. The division is also responsible for managing the Company's purchases of goods and services, including third party manufacturing and assembly services. (See "-Suppliers.") SUPPLIERS The Company uses suppliers in order to obtain quality goods and services without incurring the costs of providing those goods and services in-house. The Company purchases from suppliers nearly all circuit boards, integrated circuits, and other components used in its products. In addition, the Company contracts with suppliers to assemble some of its products. The Company's reliance on suppliers involves several risks, including the possibility of a shortage of certain key components and assemblies and reduced control over delivery schedules, manufacturing yields, quality, and costs. If the Company experiences significant availability or quality control problems in the future, its operating results could be adversely affected. Although the Company procures most of its parts and components from multiple sources or believes that these components are readily available from numerous other sources, certain components are available only from sole sources or from a limited number of sources. A number of the Company's products contain critical components like single board computers available solely from Motorola, Inc. and Force Computers, Inc. and digital signal processing integrated circuits available solely from Texas Instruments, Inc. While the Company believes that substitute components or assemblies could be obtained, use of substitutes would require development of new suppliers or would require the Company to re-engineer its products, or both, which could delay the Company's shipment of its products and could have a material adverse effect on the Company's operating results. COMPETITION The telecommunication signal processing equipment market is highly competitive and the Company expects that competition will increase in the future. Some of the Company's current and potential competitors have significantly greater technical, manufacturing, financial, and marketing resources than the Company. The Company's current competitors include L-3 Communications Corporation; Boeing-North America; E-Systems, Inc. (a subsidiary of Raytheon Corporation); GTE Government Systems Corporation; Harris Corporation; Lockheed Martin Corporation; Motorola Government Electronics Group (a subsidiary of Motorola, Inc.); SAT Corporation; Stanford Telecommunications, Inc.; Comsat Corporation; and TRW, Inc. Substantial competition could have a material adverse effect on the Company's results of operations. The competition for competitively bid contracts differs from the competition for sole source contracts. Companies competing for competitive bid contracts prepare bids and proposals in response to either a commercial or government request and typically compete on price. Potential suppliers compete informally for sole source contracts through R&D investment and marketing efforts. Companies competing for sole source contracts attempt to identify the customer's requirements early and invest in solutions so that they can demonstrate a distinguishing expertise or technology promptly after the customer has identified a signal processing requirement. The principal factors of competition for sole source contracts include investments in R&D; the ability to respond to government needs promptly; product price relative to performance, quality, and customer support. The Company believes that it competes favorably on each of these factors. PROPRIETARY RIGHTS The United States Government has rights to most of the technology developed by the Company under government contracts, including rights to permit other companies, including the Company's competitors, to use this technology to develop products for the United States Government. The Company is not aware that the United States Government has exercised these rights. The Company has filed patent applications for certain of its technology. As of October 31, 1998, three patents have been granted to the Company. The Company believes that given the rapidly changing nature of signal collection and processing technology, its future success will depend primarily upon the technical competence and creative skills of its personnel. The Company attempts to protect its trade secrets and other proprietary information through agreements with customers, employees, and consultants and other security measures. There can be no assurance that the measures adopted by the Company for the protection of its intellectual property will be adequate. Although the Company does not believe and has not received notice that it is infringing upon the intellectual property rights of others, there can be no assurance that such a claim will not be asserted against the Company. In the event any third party made a valid claim against the Company and a license was not made available to the Company on commercially reasonable terms, this could have a material adverse effect on the Company's results of operations. GOVERNMENT REGULATIONS Many of the Company's operations are subject to compliance with regulatory requirements of federal, state and municipal authorities, including regulations concerning employment obligations and affirmative action, workplace safety and protection of the environment. While compliance with applicable regulations has not adversely affected the Company's operations in the past, there can be no assurance that the Company will continue to be in compliance in the future or that these regulations will not change. In particular, the Company must comply with detailed government procurement and contracting regulations and with United States Government security regulations, certain of which carry substantial penalty provisions for nonperformance or misrepresentation in the course of negotiations. Failure of the Company to comply with its government procurement or contracting obligations or security obligations could result in penalties or suspension of the Company from government contracting, which would have a material adverse effect on the Company's results of operations. (See Item 1 "-Customers, Contracts, and Marketing," and Item 3 "-Legal Proceedings.") EMPLOYEES As of January 5, 1999, the Company had approximately 648 full-time employees, 170 of whom hold advanced technical degrees (master and/or doctoral degrees), including 21 with doctoral degrees. The Company's business requires that a large number of its technical employees obtain security clearances from the United States Government, which limits the available pool of eligible candidates for such positions to those who can satisfy the prerequisites to obtaining these clearances. In particular, the personnel involved in signal reconnaissance marketing require the appropriate clearances to meet with government technical representatives and discuss the government's needs. The Company has a United States Government-sanctioned security program that allows staff members to obtain appropriate clearances. Approximately 62% of the Company's staff have security clearances. The success of the Company is dependent on attracting, retaining, and motivating qualified key management and technical personnel, the loss of whom, could adversely affect the Company's business. Such personnel are in great demand and limited supply. The Company believes its employees are its most valuable resource and that its workforce possesses a strong feeling of dedication to and pride in the Company. This dedication is reinforced through incentive compensation arrangements based on Company performance. The Company's employees are not represented by any collective bargaining agreements, and the Company has never experienced a work stoppage. SUMMARY OF BUSINESS CONSIDERATIONS AND CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS AND/OR STOCK PRICE The Company's future operating results and stock price may be subject to volatility, particularly on a quarterly basis, due to the following: Customer Concentration: Historically, defense and intelligence agencies of the United States Government have accounted for almost all of the Company's revenues. Future reductions in United States Government spending on signal reconnaissance and communications equipment or future changes in the kind of signal reconnaissance and communications products or services required by the United States Government agencies could limit demand for the Company's products which would have a material adverse effect on the Company's operating results and financial condition. In addition, as a supplier of these agencies, the Company must comply with numerous regulations, including regulations governing security and contracting practices. Failure to comply with these regulations could disqualify the Company as a supplier of these agencies, which would have a material adverse effect on the Company's future results of operation and financial condition. Revenue Concentration: Due to the award of certain larger contracts, the Company has experienced a significant concentration of revenues from a single contract in recent periods. Revenue related to a single contract comprised 18% of revenue for fiscal 1998. This compares to 22% and 15% attributable to the same contract in fiscal years 1997 and 1996, respectively. This contract may be terminated at the sole discretion of the United States Government. If this contract or other larger contracts of the Company were terminated, this could have a material adverse effect on the Company's future results of operation and financial condition. Competition: The telecommunication signal processing market is highly competitive and the Company expects that competition will increase in the future. Some of the Company's current and potential competitors have significantly greater technical, manufacturing, financial and marketing resources than the Company. Substantial competition could have a material adverse effect on the Company's future results of operations and financial condition. Dependence Upon Personnel: The Company's ability to execute its business plan is contingent upon successfully attracting and retaining qualified employess. During the last two years, the Company experienced difficulty in attracting new talent due to an increasingly competitive market for qualified personnel. Management believes this effect is, in part, attributable to the expanding U.S. economy and, in particular, the local California economy where the Company must compete for new talent in the rapidly expanding telecommunications sector and, in part, due to the difficulty in recruiting new staff capable of obtaining the necessary security clearance. (See "Employees.") While the company believes progress in attracting and retaining sufficient personnel has been made over the last year, there can be no assurance that the Company will continue to be successful at attracting and retaining sufficient personnel. Failure to do so could have a material adverse effect on the Company's future results of operations and financial condition. Risk of Fixed Price and Contract Terminations: A significant portion of the Company's revenues are derived from fixed-price contracts. Under fixed-price contracts, unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in materials costs, inefficiencies or other factors, are borne by the Company. The Company has experienced cost overruns in the past that have resulted in losses on certain contracts. There can be no assurance that the Company will not experience cost overruns in the future or that such overruns will not have a material adverse effect on the Company's future results of operations and financial condition. In addition, almost all of the Company's contracts contain termination clauses which permit contract termination upon the Company's default or for the convenience of the other contracting party. In either case, termination could adversely affect the Company's operating results. Although the Company has not experienced any material contract terminations to date, there can be no assurance that such terminations will not occur in the future. Potential Fluctuations in Quarterly Results and Market Volatility: The Company has experienced significant fluctuations in operating results from quarter to quarter and expects that it will continue to experience such fluctuations in the future. These fluctuations are caused by, among other factors, conditions inherent in government contracting and the Company's business, such as the timing of cost and expense recognition for contracts and the United States Government contracting and budget cycles. Fluctuations in quarterly results, shortfalls in revenues or earnings from levels forecast by securities analysts, changes in estimates by analysts, competition, or announcements of extraordinary events such as acquisitions or litigation may cause the price of the Company's common stock to fluctuate substantially. In addition, there can be no assurance that an active trading market will be sustained for the Company's common stock. The stock market in recent years has experienced extreme price and volume fluctuations that have particularly affected the market prices of many technology companies and that have been unrelated or disproportionately related to the operating performance of such companies. These fluctuations, as well as general economic and market conditions, may adversely affect the future market price of the Company's common stock. Rapid Technological Change: The market for the Company's products is characterized by rapidly changing technology. The Company believes that it has been successful to date in identifying United States Government signal reconnaissance needs early, investing in research and development to meet these needs and delivering products before the Company's competitors. The Company believes that its future success will depend upon continuing to develop and introduce, in a timely manner, products capable of collecting or processing new types of telecommunications signals. There can be no assurance that the Company will be able to develop and market new products successfully in the future or respond effectively to technological changes, such as data encryption technology and others, or that new products introduced by others will not render the Company's products or technologies noncompetitive or obsolete. Dependence Upon Certain Suppliers: Although the Company procures most of its parts and components from multiple sources or believes that these components are readily available from numerous other sources, certain components are available only from sole sources or from a limited number of sources. A number of the Company's products contain critical components like single board computers available solely from Motorola and Force Computers and digital signal processing integrated circuits available solely from Texas Instruments. While the Company believes that substitute components or assemblies could be obtained, use of substitutes would require development of new suppliers or would require the Company to re-engineer its products, or both, which could delay the Company's shipment of its products and could have a material adverse effect on the Company's future results of operations and financial condition. Year 2000 (Y2K) Risks: The Company has been implementing a program over the last 18 months to define and minimize risks related to transitioning into the Year 2000 and beyond. The program and associated risk assessment is segregated into the following three main areas: 1)Product Readiness Program, 2)Internal Infrastructure Readiness Program and 3)Business Partners Readiness Program. For each readiness area, the Company is systematically performing risk assessment and conducting tests and remediation as well as developing contingency plans to mitigate risk. Further, the Company is communicating with its employees, suppliers and customers regarding the Year 2000 issue in an effort to raise awareness and further mitigate risk by requesting compliance letters from its key business partners. Specific status of each area is as follows: Product Readiness Program Prior to January 1, 1997 (the "Certification Date"), the Company had no contractual obligation to provide Y2K compliant products/systems. As is the nature with most government contractors, the Company either developed or delivered a product to customer-defined acceptance criteria. As the government became more concerned regarding the impact of Y2K on their systems, they began requiring contractors, as part of the contractual terms and conditions, to certify all deliveries are Y2K compliant. The risk assessment for products and systems delivered prior to and after the Certification Date is as follows: Products and Systems Delivered Prior to the Certifications Date: The Company will bring all products delivered under contracts entered into prior to the certification date into compliance upon the customer's request. The Company has performed a risk assessment for the government so they have an understanding of what previously delivered products have Y2K exposure. Since the Company's products and systems met the original contract acceptance criteria, it is generally expected that the customers would pay for the necessary upgrades. Products and Systems Delivered After to the Certifications Date: Company personnel have worked with customers to develop a comprehensive test plan and are now certifying that our products meet a mutually agreed upon set of criteria for testing Y2K. Internal Infrastructure Readiness Program The Company has embarked on a comprehensive inventory, evaluation, remediation and/or replacement of all internal applications and hardware used to run its business. The Company expects a fully compliant internal infrastructure by September 1999. The compliance matrix the Company is using includes all network switches, hubs, routers, servers, critical business systems software and hardware, engineering support applications and tools, desktop systems, and telephone/voicemail systems. Business Partners Readiness Program The Company is working with its suppliers and service providers to minimize risk and provide uninterrupted service including unimpeded flow of materials to its programs. Specific status is as follows: Suppliers (Hardware and Software for Programs): The Company has investigated all purchased items which may have an impact on its products resulting from the suppliers' hardware/software not being Y2K compliant. The risk in this area has been reduced to two areas: 1) key software providers and 2) providers of the single board computers. 1) Key software providers include Sun Microsystems and Wind River Systems. Wind River has provided a certification of their Y2K compliance. Sun Microsystems is implementing a Y2K compliance program. 2) The manufacturers of the Company's single board computers used in certain products include Force, Ariel, Actel and Motorola. All of these manufacturers have provided certification of Y2K compliance. Suppliers (Operational Controls): The Company's goal is to insure the unimpeded flow of materials to its programs. A review of all other components than those described above indicates that there are multiple sources available from which the Company could procure the items in the event one of the Company's suppliers has an internal control problem related to Y2K. Other Business Partners The Company has been in contact with its other critical business partners (such as its 401K plan carrier and insurance provider) to insure there will be uninterrupted availability of services. All critical business partners have provided compliance letters to the Company. Summary The Company expects to implement successfully the systems and programming changes necessary to insure continued operations as a normal part of the Company's activities (upgrades, maintenance, normal communications, etc.). Additionally, since the programs described in this section are ongoing, all potential Year 2000 issues may have not been identified. Therefore, the potential impact of these issues on the Company's financial condition are not determinable at this time. Costs related to the Year 2000 compliance program are either borne by certain contracts which are paid directly by the customer or administrative costs which are reimbursed indirectly through the Company's billing rates. While the Year 2000 administrative costs incurred to date have not been material, the Company anticipates incurring additional costs as the phases are completed. The Company has set aside $140,000 for investigating and remedying issues directly related to Year 2000 compliance. The Company has not included Year 2000 costs for activities which are accomplished as part of normal system upgrades and/or improvements since other factors are driving these requirements. However, the Company does not believe that the cost of such actions will have a material effect on the Company's results of operations or financial condition. There can be no assurance, however, that there will not be a delay in, or increased costs associated with, the implementation of such changes, and the Company's inability to implement such changes could have an adverse effect on future results of operations. The Company has not developed extensive formal contingency plans as backup to that discussed above. The Company expects the plans discussed above to be successful and not limit the ability of the Company to develop and sell its products and services. ITEM 2: PROPERTIES The Company currently leases six buildings (76,379, 58,000, 58,000, 52,364, 51,851, and 34,862 square feet, respectively) in Sunnyvale, California pursuant to leases which expire in March 2012. These buildings are used as the Company's headquarters and include development, engineering, production, marketing, and administrative offices. In July 1998, under the terms of its lease, the Company exercised an option to construct a building with occupancy targeted for September 1999. Additionally, under the terms of its lease, the Company has options to construct two buildings over a 5 year period commencing September 1999. The Company leases a 15,250 square foot building in Herndon, Virginia pursuant to a lease which expires in February 1999. This building houses a small development facility and marketing and administrative offices. The Company leases 29,121 square feet of a 90,000 square foot building in Annapolis Junction, Maryland pursuant to a lease which expires in April 2004. This building also houses a small development facility and marketing and administrative offices. In addition, the Company also leases a 5,900 square foot warehouse in Sunnyvale, California which expires in October 2000. The warehouse is used as a storage facility. The Company recently signed a lease for approximately 9,500 square feet of a 28,000 square foot building in Salt Lake City, Utah. The five year lease is expected to commence in March 1999. This building will house a small development facility with marketing and administrative offices. The Company's business requires that it maintain at each of its offices a facility clearance sponsored and approved by the United States Government. This approval could be suspended or revoked if the Company is found not to have complied with security regulations applicable to such facilities. Any revocation of such approval, and any suspension of such approval that materially delayed the Company's delivery of its products to customers would materially adversely affect the Company's results of operations. Although the Company has adopted policies directed at assuring its compliance with relevant regulations, there can be no assurance that the approved status of the Company's facilities will continue without interruption. ITEM 3: LEGAL PROCEEDINGS In April 1994, the Company was served with a subpoena by the Department of Defense Office of Inspector General (OIG) in connection with approximately six contracts, several of which had been audited by the Defense Contract Audit Agency (DCAA) the previous year. As is routine in such matters involving government contracts, the OIG referred the matter to another government agency which also had contracts with the Company. Shortly thereafter, this second agency issued a request for information related to nine additional contracts. To date, the Company has not received any allegations of wrong-doing from the OIG or the other agency. At the request of its Board of Directors, the Company initiated its own review of the contracts in conjunction with its legal counsel. Further review of the contracts in question and related contracts through April 1995 indicated the Company was not compliant with Public Law 87-653, Truth in Negotiations Act, which requires disclosure of all actual costs available on the date of cost certification on certain contracts performed during the 1989 and 1990 timeframe. These findings have resulted in a voluntary disclosure to the government which is expected to result in a downward price adjustment on certain contracts. In June 1995, the Company announced it was taking a charge against the third quarter operating results in anticipation of a settlement with the government on the subject contracts. The charge resulted in a reduction of the fiscal 1995 third quarter's operating income by $1.2 million. In April 1996, the Company was served with a second subpoena by the OIG in connection with all contracts entered into between 1990 and the date of the subpoena related to three products: the Model 102P Voice Channel Demodulator, the Model 120 Multichannel Processor, and the Model 150 FAX Scanner. The Company is presently in discussions with the OIG to etermine the scope of the subpoena and intends to fully comply with the request. In February 1998, the Company was contacted by one of its primary customers to negotiate an administrative settlement regarding voluntary disclosure discussed above. The Company has provided the necessary information to the Government. While management believes the fiscal year 1995 third quarter charge is adequate to cover all potential liabilities associated with this investigation by the United States Government, the United States Government has not concluded its investigation or agreed to a settlement with the Company. There can be no assurances the Company will not be required to take additional charges in connection with this matter in future periods. EXECUTIVE OFFICERS OF THE REGISTRANT As of January 5, 1999, set forth below is certain information with respect to age and background for each of the executive officers of the Company:
NAME AGE POSITION ---- --- ------- Gary L. Yancey 53 President, CEO and Chairman of the Board Brian M. Offi 45 Vice President-- Finance and Chief Financial Officer Mary Rogge 52 Secretary Bani M. Scribner, Jr. 54 Vice President-- Strategic Systems Division Ken Snow 58 Vice President-- Operations Division Kenway Wong 49 Vice President-- Communication System Division
Gary L. Yancey, a co-founder of the Company, has served the Company as President, CEO and Chairman of the Board since the Company's incorporation in January 1984. Prior to co-founding the Company, he was employed for 10 years by ARGOSystems, a manufacturer of electronic reconnaissance systems. Brian M. Offi joined the Company in October 1990 as Chief Financial Officer and was elected Vice President-Finance in May 1991. From May 1987 to October 1990, he served as Chief Financial Officer of S-Tron, Inc., a manufacturer of life-support equipment worn by military personnel. Mary Rogge joined the Company in 1986 as an executive secretary reporting to the President and was elected Secretary of the Company in March 1988. Bani M. Scribner, Jr. joined the Company in 1992 as senior staff reporting to the President. In November 1996 he was elected Vice President of the Strategic Systems Division. Ken Snow joined the Company in January 1990 as a senior staff engineer. He was promoted to the position of Deputy Director of Engineering in 1991. In October of 1994 he became the Director of the Operations Division and in March 1995 he was elected Vice President of Operations. Kenway Wong joined the Company in 1988 as a senior engineer. He was promoted to Department Manager in 1989, and Engineering Director in 1994. In November 1997, he was elected Vice President of the Communication Systems Division. PART II ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Selected Common Stock Data: Applied Signal Technology, Inc. Common Stock was first offered to the public on March 26, 1993. Since the initial public offering, the stock has been traded on The Nasdaq National Market under the symbol "APSG". As of January 5, 1999, the Company had approximately 570 shareholders of record. The following table sets forth the range of high, low and closing sale prices for the Company's Common Stock over the last eight (8) quarters ending October 31, 1998. The "last" price per share in the table represents the closing price on the last trading day of the quarter. The quotations represent inter-dealer quotations, without retail markups, markdowns, or commissions and may not necessarily represent actual transactions.
Share Volume High Low Last (in 000'S) -------- -------- -------- ---------- Fiscal year ended October 31, 1997 First quarter $5.63 $4.13 $4.38 1,431.0 Second quarter $5.13 $4.00 $4.38 833.9 Third quarter $10.13 $4.25 $8.00 8,682.0 Fourth quarter $13.88 $7.50 $12.07 9,853.4 Fiscal year ended October 31, 1998 First quarter $13.63 $13.38 $13.50 5,647.1 Second quarter $11.75 $11.06 $11.50 10,255.8 Third quarter $12.88 $11.63 $11.63 3,765.6 Fourth quarter $11.88 $11.25 $11.31 2,080.0
The Company has not paid any dividends on its stock since its inception and anticipates that for the foreseeable future, it will retain its earnings for use in operations. Nasdaq Market Makers: As of December 31, 1998, the following firms were registered market makers of the Company's Common Stock on the Nasdaq National Market: Cowen & Co.; Fahnestock & Co. Inc.; Mayer & Schweitzer Inc.; Sherwood Securities Corp.; Troster Singer Corp.; Tucker Anthony Incorporated; G.V.R. Company; Herzog, Heine, Geduld, Inc.; Barber & Bromin, Inc.; Knight Securities L.P. Item 6. SELECTED FINANCIAL DATA All data is in thousands except per share data.
Summary of Operations Fiscal Year Ended: October 31, 1998 1997 1996 1995 1994 --------- --------- --------- --------- --------- Revenues from contracts $110,087 $96,259 $77,410 $67,664 $64,341 Operating expenses: Contract costs 67,840 60,404 53,333 45,418 40,830 Research and development 12,208 10,137 9,380 9,873 8,551 General and administrative 14,262 13,642 11,954 11,221 10,219 --------- --------- --------- --------- --------- Total operating expenses 94,310 84,183 74,667 66,512 59,600 --------- --------- --------- --------- --------- Operating income 15,777 12,076 2,743 1,152 4,741 Interest income/(expense), net 584 190 49 187 409 --------- --------- --------- --------- --------- Income before provision for income taxes 16,361 12,266 2,792 1,339 5,150 Provision for income taxes 6,217 4,600 977 435 2,010 --------- --------- --------- --------- --------- Net income $10,144 $7,666 $1,815 $904 $3,140 ========= ========= ========= ========= ========= Earnings per Share: Basic $1.20 $0.94 $0.23 $0.12 $0.42 Diluted $1.15 $0.91 $0.23 $0.12 $0.40 Average Shares: Basic 8,468 8,128 7,754 7,454 7,442 Diluted 8,859 8,435 7,919 7,635 7,769 Financial Position at End of Fiscal Year: 1998 1997 1996 1995 1994 --------- --------- --------- --------- --------- Working capital $39,716 $34,936 $26,477 $24,269 $21,888 Total assets 72,463 64,161 52,103 49,030 47,316 Retained earnings 37,711 27,569 19,866 18,052 17,153 Shareholders' equity 56,866 49,766 39,965 36,947 35,809 Book value per common share $6.77 $5.96 $5.08 $4.90 $4.84
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Applied signal Technology, Inc. designs, develops, and manufactures signal processing equipment to collect and process a wide range of telecommunication signals for reconnaissance and industrial application. Signal reconnaissance equipment is used for the monitoring of foreign telecommunications, predominantly by the United States Government and allied foreign governments. Industrial applications include spectrum monitoring equipment for commercial communication satellite systems, and data intrusion detection equipment for data network protection. Signal reconnaissance systems are composed of collection equipment and processing equipment. Signal collection equipment consist of sophisticated receivers that can scan the radio frequency (RF) spectrum (cellular telephone, microwave, ship-to-shore, military transmissions, etc.) to collect certain signals from potentially thousands of signals within the RF spectrum. Process equipment, using sophisticated software and hardware, evaluates the characteristics of collected signals and selects those signals likely to contain relevant information. Spectrum monitoring equipment evaluate a communication satellite's frequency spectrum usage to detect any misuse that could cause substandard service. Data intrusion detection equipment monitor commercial data networks to detect unauthorized system entry for the purpose of altering or pirating data. Since inception, the Company has focused its efforts primarily on processing equipment, but also provides specialized collection equipment, as well as complete signal processing systems. The Company's business involves risks and uncertainties, including, without limitation, those contained in this report in "Business Considerations and Certain Factors That May Affect Future Results of Operations and/or Stock Prices." The Company's revenues are primarily generated from sales of its products and services to two agencies of the United States Government. The two agencies accounted for 39% and 34%, respectively, of revenues for fiscal 1998. For fiscal 1997, the two agencies accounted for 57% and 29%, respectively, of revenues and for fiscal 1996, the percentages of revenues derived from these two agencies were 52% and 27%, respectively. The Company's revenues are derived from either fixed price contracts, which provide that the Company perform a contract for a fixed price and assume the risk of any cost overruns or cost plus reimbursement contracts, which provide that the Company receive the direct and indirect costs of performance plus a negotiated profit. In fiscal 1998, approximately 46% of the Company's revenues were derived from fixed price contracts, and approximately 54% of the Company's revenues were derived from cost plus reimbursement contracts. In fiscal 1997, approximately 50% of the Company's revenues were derived from fixed price contracts, and approximately 50% of the Company's revenues were derived from cost plus reimbursement contracts. In fiscal 1996, approximately 52% of the Company's revenues were derived from fixed price contracts, and approximately 48% of the Company's revenues were derived from cost plus reimbursement contracts. Under fixed price contracts, unexpected increases in the cost-to- develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies or other factors, are borne by the Company, and could have a material adverse effect on the Company's results of operations. In accounting for cost plus reimbursement type contracts, all costs are charged to operations as incurred (including allowable administrative expenses), and revenues are recognized based on costs incurred plus estimated fee rates at the date of evaluation. In accounting for fixed price type contracts, revenue is recognized using the percent completion method which is substantially the same as that used for cost type contracts described above. All costs are charged to operations (including allowable administrative expenses) as incurred, and revenues are recognized based on estimated costs and profits at completion on a contract by contract basis. Losses on any individual contracts are provided for at the time they become known. (See Note 1 to Financial Statements.) Operating Results-Fiscal Years Comparison The following table sets forth, for the periods indicated, statements of operations data as a percentage of revenues from contracts and, at the end of each period indicated, the Company's backlog:
Year Ended October 31, -------------------------------------- 1998 1997 1996 ------------ ------------ ------------ Revenues from contracts 100.0% 100.0% 100.0% Operating expenses: Contract costs 61.6% 62.8% 68.9% Research and development 11.1% 10.5% 12.1% General and administrative 13.0% 14.2% 15.5% ------------ ------------ ------------ Total operating expenses 85.7% 87.5% 96.5% ------------ ------------ ------------ Operating income 14.3% 12.5% 3.5% Interest income/(expense), net 0.6% 0.2% 0.1% ------------ ------------ ------------ Income before provision for income 14.9% 12.7% 3.6% Provision for income taxes 5.7% 4.7% 1.3% ------------ ------------ ------------ Net income 9.2% 8.0% 2.3% ============ ============ ============ Backlog (thousands of dollars) $49,380 $83,268 $82,886
Revenues Revenues from contracts increased by 14% from approximately $96,259,000 in fiscal 1997 to approximately $110,087,000 in fiscal 1998. Revenues increased by 24% from approximately $77,410,000 in fiscal 1996 to approximately $96,259,000 in fiscal 1997. The revenue increase in fiscal 1998 is due in part to increased contract activity experienced in the military marketplace and, in part, due to an increasing demand from the intelligence agencies for development contracts. The revenue increase in fiscal 1997 over the revenue reported in fiscal 1996 was due, in part, to the introduction of new products and services, as well as an increase in average fees recorded for production contracts. The following table identifies the source of the Company's revenues for fiscal years 1998, 1997 and 1996 by major market:
FY98 FY97 FY96 ----- ----- ----- Intelligence Agencies 81% 91% 81% Military 9% 7% 12% Foreign 9% 2% 3% Commercial 1% -- 4%
Backlog The Company's backlog, which consists of anticipated revenues from the uncompleted portions of existing contracts (excluding unexercised options), was approximately $49,380,000 at the end of fiscal 1998. This represents an approximate decrease of 40.7% from the prior year's ending backlog of approximately $83,268,000. The backlog for fiscal year 1997 was nominally greater than the backlog of approximately $82,886,000 for fiscal year 1996. Regarding the decrease in backlog experienced during fiscal 1998, management believes the decrease in backlog between fiscal 1997 and fiscal 1998 is due in part to a delay in specific contract awards from the United States Government and, in part, due to a reduced number of awards for the Company's off-the-shelf products. Although it is impossible to determine the precise cause of the order slowdown, management believes it is caused in part by a diversion of the Government's focus to the Year 2000 problem and in part, caused by a preponderance of product sales to a certain intelligence office during fiscal year 1997 who, consequently, purchased less in fiscal year 1998. While management believes that the demand for global intelligence and tactical communications systems should continue, there can be no assurances that the reduced order flow experienced during fiscal 1998 will not have an impact on future revenues. Contract Costs Contract costs consist of direct costs on contracts, such as labor, materials and manufacturing overhead costs. Contract costs, as a percentage of revenues, decreased to 61.6% in fiscal year 1998 from 62.8% in fiscal year 1997. As a percentage of revenues, contract costs for fiscal year 1997 were lower than contract costs of 68.9% of revenues for fiscal year 1996. The continued decrease in contract costs as a percentage of revenue for fiscal year 1998 compared to fiscal year 1997 is in part attributable to higher contract fees and, in part due to the lower manufacturing overhead applied to contracts during fiscal 1998 compared to fiscal 1997. The decrease in contract costs as a percentage of revenue for fiscal year 1997, compared to fiscal year 1996, is attributable to economies of scale related to a higher percentage of production contracts in fiscal 1997, and fewer products being transitioned from development stage to production stage in fiscal 1997. Research and Development Expenses Company directed investment in research and development consists of expenditures recoverable from customers through the Company's billing rates and expenditures funded by the Company from earnings. Research and development expenses as a percentage of revenues were 11.1%, 10.5% and 12.1% for fiscal years 1998, 1997, and 1996, respectively. Research and development spending grew by approximately $2,070,000 in fiscal 1998 from $10,137,000 in fiscal 1997, and, correspondingly, grew as a percentage of revenues in fiscal 1998 when compared to the percentage of revenue in fiscal 1997. This increase in research and development spending during fiscal 1998 is due to management's decision to increase research and development activities for the benefit of future business. Although R&D spending grew approximately $757,000 to approximately $10,137,000 in fiscal 1997 from approximately $9,380,000 in fiscal 1996, research and development expenses as a percentage of revenues decreased in fiscal 1997 when compared to fiscal 1996. The decrease in research and development spending as a percentage of revenues in fiscal 1997 was attributable to the demands of contract work which resulted in limited availability of staff to work on research and development contracts. General and Administrative Expenses General and administrative expenses include administrative salaries, costs related to the Company's marketing and proposal activities, and other administrative costs. General and administrative expenses were approximately $14,262,000 or 13.0% of revenues in fiscal 1998 compared to approximately $13,642,000 or 14.2% of revenues in fiscal 1997 and approximately $11,954,000 or 15.5% of reveunes in fiscal 1996. The decrease in general and administrative expenses as a percentage of revenues in fiscal 1998 is primarily attributable to the higher profit recognized on contracts during fiscal 1998 compared to fiscal 1997. The higher general and administrative expenses in fiscal years 1997 and 1996 reflect an increase in bid and proposal activity experienced during the fiscal years, as well as, an increase in marketing costs. In recent years, management has continued to emphasize the marketing component of G&A in an effort to generate revenues in future periods. Interest Income/Expense (Net) Net interest income/expense for fiscal 1998 increased approximately $394,000 from approximately $190,000 net interest income in fiscal 1997 to approximately $584,000 in fiscal 1998. Net interest income in fiscal 1997 increased approximately $141,000 over net interest income in fiscal 1996 of approximately $49,000. The increase in interest income during fiscal 1998 is due primarily to investing higher cash balances generated from operations as well as from additional efforts expended to collect outstanding receivable balances. The higher interest income received in fiscal 1997 was primarily due to funds received on short-term investments because of cash generated from higher profit margins and due to the interest expense incurred during fiscal 1996 for the Company's higher average outstanding line of credit balances throughout fiscal 1996. Provision for Income Taxes Income taxes as a percentage of income before provision for income taxes have been provided for at a combined federal and state rate of 38% for fiscal 1998 versus 37.5% for fiscal 1997 and 35% for fiscal 1996. The 1998 effective tax rate is lower than the combined federal and state statutory income tax rates primarily due to the benefit derived from federal and state income tax credits. The increases in the effective tax rate from fiscal 1997 to fiscal 1998 and from fiscal 1996 to fiscal 1997 are primarily a result of the increases in federal and state tax liabilities as a result of the lower impact of federal and state tax credits on increased profitability. Quarterly Results The following table sets forth certain unaudited quarterly financial data for the eight quarters ending October 31, 1998. In the opinion of the Company's management, the unaudited information set forth below has been prepared on the same basis as the audited information and includes all adjustments necessary to present fairly the information set forth herein. The operating results for any quarter are not indicative of results for any future period. All data is in thousands except per common share data.
FISCAL YEAR 1998 FISCAL YEAR 1997 ---------------------------------------------- ------------------------------------------ Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 ---------- ---------- ---------- ---------- --------- --------- --------- --------- Revenues from contracts $24,361 $27,732 $27,373 $30,621 $20,084 $23,987 $22,600 $29,588 Operating expenses Contract costs 15,095 17,327 16,695 18,723 13,136 15,742 13,793 17,733 Research and development 1,593 1,823 1,742 7,050 2,470 2,394 2,269 3,004 General and administrative 4,205 4,524 4,604 929 3,182 3,171 3,062 4,227 ---------- ---------- ---------- ---------- --------- --------- --------- --------- Total operating expenses 20,893 23,674 23,041 26,702 18,788 21,307 19,124 24,964 ---------- ---------- ---------- ---------- --------- --------- --------- --------- Operating income 3,468 4,058 4,332 3,919 1,296 2,680 3,476 4,624 Interest income/(expense), net 147 145 140 152 60 37 18 75 ---------- ---------- ---------- ---------- --------- --------- --------- --------- Income before provision for income taxes 3,615 4,203 4,472 4,071 1,356 2,717 3,494 4,699 Provision for income taxes 1,410 1,639 1,621 1,547 495 992 1,351 1,762 ---------- ---------- ---------- ---------- --------- --------- --------- --------- Net income $2,205 $2,564 $2,851 $2,524 $861 $1,725 $2,143 $2,937 ========== ========== ========== ========== ========= ========= ========= ========= Net income per common share Basic $0.26 $0.30 $0.34 $0.30 $0.11 $0.21 $0.26 $0.35 Diluted $0.25 $0.28 $0.32 $0.29 $0.11 $0.21 $0.25 $0.34 Average shares outstanding Basic 8,480 8,580 8,429 8,388 7,978 8,032 8,188 8,317 Diluted 8,954 9,000 8,776 8,708 8,113 8,156 8,517 8,749
The Company has at times experienced fluctuations in its quarterly results due to both seasonal and nonseasonal factors inherent in its business. These have included costs associated with uneven flows of incoming material, the level of research and development spending during any given quarter, fee recognition on development contracts in the early phases of contract performance where the financial risk is not entirely known until the contract is further along in the development cycle, the United States Government and the timing of contract awards. Management expects these fluctuations to continue into the future. Analysis of Liquidity and Capital Resources The Company's primary source of liquidity has been the cash flow generated from operations, as well as the issuance of common stock through its employee stock plans. The Company has a $3,000,000 unsecured, revolving line of credit for short-term cash requirements bearing interest at the bank's reference rate (8% as of October 31, 1998). Outstanding amounts on the line of credit were zero at October 31, 1998 and 1997. The line expires on March 15, 1999; the Company intends to renew the line at that time. Net cash from operating activities: Net cash provided by operating activities has varied significantly from year to year. For fiscal years 1998, 1997 and 1996, cash provided by operating activities was approximately $16,035,000, $9,806,000 and $5,378,000 million, respectively. The year-to-year variances are primarily the result of changes in net income, changes in accounts receivable, changes in the level of accrued liabilities and the change in inventories held by the Company. During fiscal 1998 net income increases to approximately $10,144,000. During fiscal 1997, net income increased to approximately $7,666,000 from approximately $1,815,000 in fiscal 1996. The improvement in net income for fiscal 1998 is primarily due to an increase in the average gross margin profitability recorded on contracts during the year, and in part to a reduction in general and administrative expenses recorded as a percentage of revenue for the fiscal year. During fiscal 1998, accounts receivable decreased by approximately $2,068,000 when compared to an increase of approximately $2,630,000 for fiscal 1997. The cash generated by accounts receivable in fiscal 1998 is due, in part to greater collection efforts and, in part, due to collections received from a one-time billing modification authorized by the U.S. Government in the fourth quarter of fiscal 1997. The increased level of accounts receivable during fiscal 1997 was primarily due to greater contract activity, and in part to certain limitations and terms stipulated in certain engineering and production contracts. Cash generated by the increased levels of liabilities for fiscal 1998 approximated $1,203,000 and was primarily due to increased tax liabilities associated with higher profit margins. Cash generated by the increased levels of accrued liabilities for fiscal 1997 was approximately $2,132,000 and was primarily due to the year-end accrual for payroll and employee benefits. Cash used by the increased levels of inventories, prepaid expenses and other current assets of approximately $1,589,000 in fiscal 1998 is primarily due to the increase in work-in-progress for engineering and production contracts and, in part, due to the increase in prepaid income taxes related to higher profits. Cash used by the increased levels of inventories, prepaid expenses and other current assets in fiscal 1997 was primarily due to the purchase of parts required for future production, as well as for purchases for anticipated future contract awards. Net cash from investing activities: Net cash used in investing activities was approximately $5,925,000 for fiscal 1998 compared to approximately $5,822,000 during fiscal 1997 and approximately $5,322,000 in fiscal 1996. The use of cash for investing activities for the last three fiscal years was primarily for additions to property and equipment. The Company's capital investment continues to be driven by an increase in the number of new employees and by the level of development-type contracts that have required test and computing equipment. Cash provided by investing activities throughout fiscal 1998 for the purchase and maturity of short- term investments, primarily in U.S. Government treasuries, was approximately $300,000. Other cash provided by investing activities during fiscal 1997 included the maturity of approximately $800,000 of the Company's short-term investments in U.S. Government treasuries. Net cash from financing activities: Net cash used in financing activities was approximately $3,429,000 during fiscal 1998 compared to approximately $1,860,000 provided by investing activities during fiscal 1997 and approximately $1,134,000 provided by investing activities during fiscal 1996. During fiscal 1998, the $3,429,000 used in financing activities is attributable to the issuance of approximately $2,778,000 of common stock under the Employee Stock Purchase Plan and stock option plan offset by approximately $6,207,000 of common stock repurchases initiated and completed under the Company's buyback program. The $1,860,000 and $1,134,000 provided by financing activities during fiscal 1997 and fiscal 1996, respectively, were predominately due to the issuance of common stock under the Company's employee stock purchase plan and stock option plans. The Company believes that the funds generated from operations, existing working capital, and amounts available under existing lines of credit will be sufficient to meet its cash needs for at least the next 12 months. Year 2000 Risks A complete discussion of the impact of Year 2000 issues on the Company's Year 2000 readiness programs is set forth in Item 1: "Summary of Business Consideration and Certain Factors that May Affect Future Results of Operations Operations and/or Stock Price." ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS Board of Directors and Shareholders Applied Signal Technology, Inc. We have audited the accompanying balance sheets of Applied Signal Technology, Inc. as of October 31, 1998 and 1997, and the related statements of income, shareholders' equity and cash flows for each of the three years in the period ended October 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Applied Signal Technology, Inc. at October 31, 1998 and 1997 and the results of its operations and its cash flows for each of the three years in the period ended October 31, 1998 in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG LLP Palo Alto, California December 10, 1998 STATEMENTS OF INCOME
Year Ended October 31, -------------------------------------- 1998 1997 1996 ------------ ------------ ------------ Revenues from contracts $110,087,178 $96,258,831 $77,410,481 Operating expenses: Contract costs 67,840,318 60,403,961 53,333,328 Research and development 12,207,696 10,137,304 9,380,007 General and administrative 14,261,997 13,641,613 11,953,861 ------------ ------------ ------------ Total operating expenses 94,310,012 84,182,878 74,667,196 ------------ ------------ ------------ Operating income 15,777,166 12,075,953 2,743,285 Interest income/(expense), net 583,863 189,953 48,843 ------------ ------------ ------------ Income before provision for income taxes 16,361,029 12,265,906 2,792,128 Provision for income taxes 6,217,191 4,599,715 977,245 ------------ ------------ ------------ Net income $10,143,838 $7,666,191 $1,814,883 ============ ============ ============ Net income per common share Basic $1.20 $0.94 $0.23 Diluted $1.15 $0.91 $0.23 Number of shares used in calculating net income per common share Basic 8,468,463 8,128,062 7,753,886 Diluted 8,858,662 8,435,191 7,918,603
See accompanying notes. BALANCE SHEETS
October 31, ------------------------- 1998 1997 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $14,084,727 $7,403,128 Short term investments 1,029,223 1,330,656 Accounts receivable: Billed 14,298,029 20,495,931 Unbilled 16,282,067 12,152,475 ------------ ------------ Total accounts receivable 30,580,096 32,648,406 Inventory 5,551,312 4,821,541 Prepaid expenses and other current assets 3,034,544 2,175,087 ------------ ------------ Total current assets 54,279,902 48,378,818 Property and equipment, at cost: Machinery and equipment 31,653,925 27,311,561 Furniture and fixtures 4,010,924 3,650,412 Leasehold improvements 5,812,967 5,310,361 Construction in process 1,438,036 418,689 ------------ ------------ 42,915,852 36,691,023 Accumulated depreciation and amortization (24,775,359) (20,979,847) ------------ ------------ Net property and equipment 18,140,493 15,711,176 Other assets 42,221 70,573 ------------ ------------ Total Assets $72,462,616 $64,160,567 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $3,841,929 $3,704,581 Accrued payroll and related benefits 6,330,405 6,294,724 Other accrued liabilities 2,091,566 1,877,054 Income taxes payable 2,300,098 1,566,676 ------------ ------------ Total current liabilities 14,563,998 13,443,035 Deferred income taxes 1,032,910 951,372 Commitments Shareholders' equity: Preferred stock, no par value: 2,000,000 shares authorized; none issued and outstanding Common stock, no par value: 20,000,000 shares authorized; issued and outstanding shares - 8,393,526 at October 31, 1998 and 8,351,629 at October 31, 1997 19,154,309 22,197,167 Retained earnings 37,711,399 27,568,993 ------------ ------------ Total shareholders' equity 56,865,708 49,766,160 ------------ ------------ Total Liabilities and Shareholders' Equity $72,462,616 $64,160,567 ============ ============
See accompanying notes. STATEMENTS OF CASH FLOWS
Years Ended October 31, ----------------------------------- 1998 1997 1996 ----------- ----------- ----------- Operating activities: Net income $10,143,838 $7,666,191 $1,814,883 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,795,512 3,781,431 3,706,093 Tax benefit related to stock plans 385,895 238,114 69,448 Changes in: Accounts receivable 2,068,310 (2,630,098) (453,670) Inventory, prepaid expenses and other current assets (1,589,228) (1,553,618) 127,382 Other assets 28,352 47,560 58,143 Accounts payable, taxes payable and accrued expenses 1,120,964 2,132,001 75,718 Deferred income taxes 81,538 123,944 (19,914) ----------- ----------- ----------- Net cash provided by operating activities 16,035,181 9,805,525 5,378,083 Investing activities: Purchases of available-for-sale securities (6,000,000) -- -- Maturity of available-for-sale securities 6,300,000 800,000 -- Additions to property and equipment (6,224,829) (6,621,535) (5,322,077) ----------- ----------- ----------- Net cash used in investing activities (5,924,829) (5,821,535) (5,322,077) Financing activities: Issuances of common stock 2,777,870 1,866,925 1,135,129 Repurchases of common stock (6,206,623) (6,999) (760) ----------- ----------- ----------- Net cash provided by (used in) financing activities (3,428,753) 1,859,926 1,134,369 ----------- ----------- ----------- Net increase in cash and cash equivalents 6,681,599 5,843,916 1,190,375 Cash and cash equivalents at beginning of year 7,403,128 1,559,212 368,837 ----------- ----------- ----------- Cash and cash equivalents at end of year $14,084,727 $7,403,128 $1,559,212 =========== =========== =========== Supplemental disclosures of cash flow information: Interest paid $33,509 $49,089 $82,983 Taxes paid $5,574,000 $4,374,800 $1,128,686 =========== =========== ===========
See accompanying notes. STATEMENTS OF SHAREHOLDERS' EQUITY
Total Common Retained Shareholders' Stock Earnings Equity ------------ ------------ ------------ Balance at October 31, 1995 $18,895,310 $18,051,858 $36,947,168 Issuance of 340,949 common shares to employees under stock purchase agreements and stock option plan 1,135,129 -- 1,135,129 Repurchase of 245 common shares (760) -- (760) Tax benefit related to stock plans 69,448 -- 69,448 Net unrealized loss on securities available for sale -- (1,116) (1,116) Net income -- 1,814,883 1,814,883 ------------ ------------ ------------ Balance at October 31, 1996 20,099,127 19,865,625 39,964,752 Issuance of 483,259 common shares to employees under stock purchase agreements and stock option plan 1,866,925 -- 1,866,925 Repurchase of 4,977 common shares (6,999) -- (6,999) Tax benefit related to stock plans 238,114 -- 238,114 Net unrealized gain on securities available for sale -- 37,177 37,177 Net income -- 7,666,191 7,666,191 ------------ ------------ ------------ Balance at October 31, 1997 22,197,167 27,568,993 49,766,160 Issuance of 529,397 common shares to employees under stock purchase agreements and stock option plan 2,777,870 -- 2,777,870 Repurchase of 487,500 common shares (6,206,623) -- (6,206,623) Tax benefit related to stock plans 385,895 -- 385,895 Net unrealized loss on securities available for sale -- (1,432) (1,432) Net income -- 10,143,838 10,143,838 ------------ ------------ ------------ Balance at October 31, 1998 $19,154,309 $37,711,399 $56,865,708 ============ ============ ============
See accompanying notes. NOTES TO FINANCIAL STATEMENTS OCTOBER 31, 1998 NOTE 1: ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization Applied Signal Technology, Inc. (the Company) was incorporated in California on January 12, 1984. The Company designs, develops, manufactures signal processing equipment to collect and process a wide range of telecommunication signals. This equipment is used for reconnaissance of foreign telecommunications predominantly by the United States Government and allied foreign governments, for certain industrial applications and for defense communications systems. For the three years ended October 31, 1998, substantially all of the Company's revenues were from contracts with the U.S. Government, its agencies, or prime contractors for the U.S. Government. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Contracts and Contract Accounting Approximately 54% of contract revenues in fiscal 1998 (50% in fiscal 1997 and 48% in fiscal 1996) is represented by cost reimbursement type contracts. In accounting for these contracts, all costs are charged to operations as incurred (including allowable administrative expenses) and revenues are recognized based on costs incurred plus estimated effective fee rates. Estimated fee rates are determined on a contract- by-contract basis according to the type of fee (e.g., fixed, incentive, or award) and the most recent estimated cost of completion of the individual contract. Approximately 46% of contract revenues in fiscal 1998 (50% in fiscal 1997 and 52% in fiscal 1996) is represented by fixed price type contracts. In accounting for these contracts, the Company uses the percentage-of-completion method which is substantially the same method as that used for cost reimbursement type contracts as described above. All contract costs (including administrative expenses) are charged to operations as incurred and revenues are recognized based on estimates of costs and profits at completion on a contract-by-contract basis. Losses on any individual contract are provided for at the time they become known. A significant portion of the Company's revenues are derived from fixed price contracts. Under fixed price contracts, unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies or other factors, are borne by the Company, and could have a material adverse effect on the Company's results of operations. Accounts receivable are segregated between billed and unbilled accounts. The Company bills incurred costs and ratable portions of fees regularly under its cost reimbursement type contracts. Under fixed price contracts, the Company either regularly progress bills 90% of incurred costs or bills contract costs on a milestone or unit of delivery basis. Unbilled amounts result from recognition of contract revenue in advance of contractual billing or progress billing terms. The Company regards the credit risk of its business to be minimal. Price Redetermination As a government contractor, the Company is subject to price redetermination on certain fixed price contracts if it is determined that the Company did not price its products and services consistent with the requirements of the Federal Acquisition Regulations. Cash Equivalents and Short-Term Investments The Company considers all highly liquid debt investments purchased with a maturity of three months or less to be cash equivalents. Short-term investments are comprised of U.S. Government treasury bills and notes, with contract maturities staggered through November 1998. Management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. The Company's debt securities, which consist of U.S. Treasury securities, are classified as available-for- sale and are carried at fair market value in short-term investments and long-term investments. Unrealized gains and losses, net of tax, are reported in shareholders equity as part of retained earnings and were immaterial as of October 31, 1998. Realized gains and losses on available-for-sale securities have not been material. The cost of securities sold is based on the specific identification method. Property and Equipment Machinery and equipment as well as furniture and fixtures are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to five years. Leasehold improvements are amortized using the straight-line method over the lesser of the useful life of the assets or the lease term. Per Share Data In fiscal 1998, the Company adopted Statement of Financial Accounting Standards No. 128, Earnings Per Share ("SFAS 128"). Basic earnings per share is based on the weighted effect of all common shares issued and outstanding during the period. Diluted earnings per share is calculated by dividing net income available to common stockholders, adjusted for the effect, if any, from assumed conversion of all potentially dilutive common shares outstanding, by the weighted average number of common shares used in the basic earnings per share calculation plus the number of common shares that would be issued assuming conversion of all potentially dilutive common shares outstanding. All historical earnings per share amounts have been restated to conform to the provision of this statement.
(in thousands, except per share amounts) Years Ended October 31, -------------------------------------- 1998 1997 1996 ------------- ----------- ----------- Net Income $10,144 $7,666 $1,815 Share used to compute net income per common share - basic 8,468 8,128 7,754 Effect of dilutive options 391 307 165 ------------- ----------- ----------- Share used to compute net income per common share - diluted 8,859 8,435 7,919 ------------- ----------- ----------- Net income per common share - basic $1.20 $0.94 $0.23 ------------- ----------- ----------- Net income per common share - diluted $1.15 $0.91 $0.23 ------------- ----------- -----------
Impact of Recently Issued Accounting Standards In 1997, the Financial Accounting Standards Board ("FASB") issued the Statement of Financial Accounting Standards No. 130 ("SFAS 130") "Reporting Comprehensive Income," and the Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure About Segments of an Enterprise and Related Information." The Company is required to adopt the provisions of SFAS 130 and SFAS 131 in fiscal year 1999 and expects the adoption will not impact results of operations or financial position, but may require additional financial statement disclosure. NOTE 2: INVENTORY The Company manufactures product subassemblies in inventory to be able to quickly meet the requirements of future contracts. Inventories are stated at the lower of average cost or market and consisted of the following:
October 31, -------------------------- 1998 1997 ----------- ----------- Raw materials $ 1,101,992 $ 1,121,625 Work-in-process 4,113,729 3,130,648 Finished goods 244,869 278,832 ----------- ----------- 5,460,590 4,531,105 Precontract costs 90,722 290,436 ----------- ----------- $ 5,551,312 $ 4,821,541 =========== ===========
Precontract costs represent costs incurred in connection with ongoing level-of-effort type contracts for which contract modifications have not been definitized ($87,424 at October 31, 1998 and $216,726 at October 31, 1997) and production costs incurred in anticipation of specific expected future contract awards. The production items in the latter group generally would be usable if the expected contract awards did not occur. Allocable administrative expenses included in precontract costs have not been material. NOTE 3: LINES OF CREDIT As of October 31, 1998, the Company has a $3,000,000 revolving line of credit available with a bank. Borrowings under the line of credit bear interest at the bank's reference rate (8% at October 31, 1998), payable monthly, and expires on March 15, 1999; the Company intends to renew this line of credit. At both October 31, 1998 and 1997 this facility was unused. Under this credit facility, the Company is subject to certain commitment and utilization fees on the unused portion of the committed amount. Fees incurred were not material during the last three fiscal years. The line of credit agreement requires compliance with certain financial covenants and restricts dividend payments, stock repurchases and any loans or advances made to any third parties without the prior written consent of the lender. At both October 31, 1998 and 1997, the Company was in compliance with the Bank's required covenants and restrictions. NOTE 4: COMMITMENTS Facility Commitment The Company leases its facilities under noncancelable lease agreements which expire at various dates between fiscal years 1999 and 2012. Certain of the leases contain escalation clauses and requirements for the payment of property taxes, insurance and maintenance expenses. The aggregate minimum annual lease commitments at October 31, 1998 under long-term operating leases are as follows: Fiscal Year: ----------- 1999 $ 3,921,597 2000 3,899,987 2001 4,023,162 2002 4,056,097 2003 4,073,208 Thereafter 32,172,179 ----------- $51,146,230 ===========
Rent expense under operating leases was $4,013,335 in fiscal 1998 ($3,296,185 in fiscal 1997; $3,078,843 in fiscal 1996). The Company had outstanding letters of credit at October 31, 1998 of $1,000,000 of which $218,250 and $11,755 are used as security deposits for its leased operating facilities. The Company had no noncancelable purchase commitments for materials as of October 31, 1998 and as of October 31, 1997. NOTE 5: SHAREHOLDERS' EQUITY Employee Stock Purchase Plan Under the Company's 1993 Employee Stock Purchase Plan ("1993 Plan"), a total of 1,600,000 shares of common stock have been reserved for issuance. The 1993 Plan permits eligible employees to purchase common stock through payroll deductions (which cannot exceed 10% of any employee's compensation) at 85% of the lower of its fair market value at the beginning or end of the purchase period. As of October 31, 1998, 594,948 shares remain eligible for purchase under the 1993 Plan. Stock Option Plan The Company's 1991 Stock Option Plan ("1991 Plan") provides for the granting of incentive stock options and non-qualified stock options to employees, directors, and consultants of the Company at prices ranging from 85% to 110% (depending on the type of grant) of the fair market value of the common stock on the date of grant. Some options are only exercisable at the end of a two- year vesting period and some options are exercisable at the rate of 1/5 per year over five years. A summary of the option activity under the 1991 Plan is as follows:
Options Outstanding --------------------------------------------------- Options Available Weighted for Number of Aggregate Average Grant Shares Price Exercise Price ------------- ----------- ----------- ------------- Balance at October 31, 1995 377,143 989,414 $4,256,185 $4.30 Granted (263,080) 263,080 1,203,860 $4.58 Exercised -- (82,321) (220,420) $2.68 Canceled 83,434 (83,434) (436,568) $5.23 ------------- ----------- ----------- Balance at October 31, 1996 197,497 1,086,739 4,803,057 $4.42 Additional Authorization 500,000 Granted (20,000) 20,000 90,000 $4.50 Exercised -- (179,173) (800,821) $4.47 Canceled 203,183 (203,183) (997,799) $4.91 ------------- ----------- ----------- Balance at October 31, 1997 880,680 724,383 3,094,437 $4.27 Granted (295,900) 295,900 4,593,950 $15.53 Exercised -- (229,985) (1,119,663) $4.87 Canceled 10,168 (10,168) (135,860) $13.36 ------------- ----------- ----------- Balance at October 31, 1998 594,948 780,130 $6,432,864 $8.25
Accounting for Stock-Based Compensation The following table summarizes information about options outstanding at October 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ------------------------- Weighted Number of Shares Average Weighted Number of shares Weighted Range of Outstanding as Remaining Average Exercisable Average Exercise Prices of 10/31/98 Contract Life Ex. Price @10/31/98 Exercise Price - ------------- ----------- ------------- ----------- ----------- -------------- $2.50 143,655 2.46 $2.50 143,655 $2.50 $4.50 190,825 2.59 $4.50 170,825 $4.50 $4.63 138,000 1.97 $4.63 138,000 $4.63 $5.50 20,000 2.35 $5.50 20,000 $5.50 $15.50 281,650 7.05 $15.50 -- $16.75 6,000 7.35 $16.75 -- -------- ------------- ----------- ----------- ------------- $2.50 - $16.75 780,130 4.10 $8.25 472,480 $3.98
The Company applies Accounting Principles Board Opinion No. 25, and related interpretations in accounting for its stock option plans. The Company has opted under Statement of Financial Accounting Standards No. 123, "Accounting for StockBased Compensation" (SFAS 123") to disclose its stock-based compensation with no financial effect. The pro forma effects of applying SFAS 123 in this initial phase-in period are not necessarily representative of the effects on reported net income or loss for future years. Had compensation expense for the Company's stock options plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS 123, the Company's pro forma net income and net income per share would have been as follows:
1998 1997 1996 ------- ------- ------- Net income As reported $10,143,838 $7,666,191 $1,814,883 Pro forma 8,416,194 5,984,637 396,689 Net income per share Basic - As reported $1.20 $0.94 $0.23 - Pro forma 0.99 0.74 0.05 Diluted - As reported $1.15 $0.91 $0.23 - Pro forma 0.95 0.71 0.05
The weighted average fair value at date of grant for options granted during fiscal years 1998, 1997 and 1996 were $8.78, $3.17 and $2.29 per option, respectively. The weighted average fair value at date of grant for shares purchased through the employee stock purchase plans during fiscal years 1998, 1997 and 1996 were $4.01, $2.51 and $2.56 per share, respectively. The fair value of options at the date of grant was estimated using Black Scholes model with the following weighted average assumptions:
Employee Employee Stock Option Plans Purchase ---------------------------- --------------------------- 1998 1997 1996 1998 1997 1996 -------- -------- -------- -------- -------- ------- Risk-free interest rate 4.9% 6.0% 5.9% 4.0% 6.0% 6.0% Expected lives (in years) 4.7 2.5 2.5 .5 .5 .5 Expected volatility .63 .84 .84 .63 .84 .84 Dividend yeild 0% 0% 0% 0% 0% 0%
NOTE 6: INCOME TAXES The provision for income taxes for the years ended October 31, 1998, 1997 and 1996 consists of the following:
1998 1997 1996 ------------- ----------- ----------- Federal: Current $5,759,182 $3,921,838 $1,164,539 Deferred (prepaid) (515,097) 44,731 348,533 ------------- ----------- ----------- 5,244,085 3,966,569 1,513,072 State: Current 933,639 218,788 136,388 Deferred (prepaid) 39,467 414,358 (672,215) ------------- ----------- ----------- 973,106 633,146 (535,827) ------------- ----------- ----------- $6,217,191 $4,599,715 $977,245 ============= =========== ===========
The tax benefits associated with disqualifying dispositions of stock options or employee stock purchase plan shares reduce taxes currently payable as shown by $385,895, $238,114, and $69,448 for fiscal 1998, 1997, and 1996, respectively. Such benefits are credited to additional paid-in-capital when realized. The provision for income taxes differs from the amount computed by applying the federal income tax rate of 35% for fiscal years 1998 and 1997, and 34% for fiscal year 1996 to income before provision for income taxes as follows:
Years Ended October 31, ------------------------------------- 1998 1997 1996 ------------- ----------- ----------- Computed expected tax provision $5,726,360 $4,293,067 $949,324 State income tax, net of federal benefit 632,519 411,545 (17,817) Other individually immaterial items (141,688) (104,897) 45,738 ------------- ----------- ----------- $6,217,191 $4,599,715 $977,245 ------------- ----------- ----------- Effective Tax Rate 38.0% 37.5% 35.0% ============= =========== ===========
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities are as follows:
October 31, ----------------------- 1998 1997 ----------- ----------- Deferred tax assets: Accrued expenses and reserves $1,694,481 $1,377,004 Deferred revenue 32,906 (64,998) State taxes and other 222,817 81,030 ----------- ----------- $1,950,204 $1,393,036 =========== =========== Deferred tax liabilities: Tax over financial statement depreciation ( 1,032,910) (951,372) ----------- ----------- $917,294 $441,664 =========== ===========
The Company made total cash payments, net of refunds, of approximately approximately $5,574,000 during fiscal 1998, $4,347,000 during fiscal 1997, and $1,279,000 during fiscal 1996 for income tax purposes. NOTE 7: RETIREMENT PLAN All employees who perform at least 1,000 hours of service per year are covered under the Company's retirement plan (the Retirement Plan). Contributions to the Retirement Plan by the Company are discretionary and currently are at the rate of 4% of qualified compensation up to $150,000. The Company accrues for the accumulated contributions which are payable bi-weekly to the Retirement Plan's administrator. The Company has expensed approximately $1,655,000 in fiscal 1998 ($1,524,000 in fiscal 1997 and $1,275,000 in fiscal 1996), which is included in general and administrative expenses. NOTE 8: CONTINGENCY In April 1994, the Company was served with a subpoena by the Department of Defense Office of Inspector General (OIG) in connection with approximately six contracts, several of which had been audited by the Defense Contract Audit Agency (DCAA) the previous year. As is routine in such matters involving government contracts, the OIG referred the matter to another government agency which also had contracts with the Company. Shortly thereafter, this second agency issued a request for information related to nine additional contracts. To date, the Company has not received any allegations of wrong-doing from the OIG or the other agency. At the request of its Board of Directors, the Company initiated its own review of the contracts in conjunction with its legal counsel. Further review of the contracts in question and related contracts through April 1995 indicates the Company was not compliant with Public Law 87-653, Truth in Negotiations Act, which requires disclosure of all actual costs available on the date of cost certification on certain contracts performed during the 1989 and 1990 timeframe. These findings have resulted in a voluntary disclosure to the government which is expected to result in a downward price adjustment on certain contracts. In June 1995, the Company announced it was taking a charge against the third quarter operating results in anticipation of a settlement with the government on the subject contracts. The charge resulted in a reduction of $1.2 million of the fiscal 1995 third quarter's operating income. In April 1996, the Company was served with a second subpoena by the OIG in connection with all contracts entered into between 1990 and the date of the subpoena related to three products: the Model 102P Voice Channel Demodulator, the Model 120 Multichannel Processor, and the Model 150 FAX Scanner. The Company is presently in discussions with the OIG to determine the scope of the subpoena and intends to fully comply with the request. While management believes the fiscal 1995 provision is adequate to cover all potential liabilities associated with this investigation by the United States Government, the United States Government has not concluded its investigation or agreed to a settlement with the Company. There can be no assurances the Company will not be required to take additional charges in connection with this matter in future periods. PART III ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to executive officers of the Company is contained in Part I of this report. Set forth below is certain information with repect to age and background for each of the Company's directors.
DIRECTOR NAME POSITIONS WITH THE COMPANY AGE SINCE - -------------------------- -------------------------------------- ----- -------- Class I directors, whose terms will expire at the 1999 Annual Meeting of Shareh John P. Devine Director 61 1995 David D. Elliman Director 48 1991 Gary L. Yancey President and Chairman of the Board 53 1984 Class II directors, who are nominees for election at this annual meeting: James F. Collins Laboratory Manager and Director 56 1984 John R. Treichler Senior Scientist and Director 51 1984 Stuart G. Whittelsey, Jr. Director 69 1990
John P. Devine has been a director of the Company since May, 1995. Mr. Devine served as Deputy Director, National Security Agency (NSA), for Technology and Systems from 1992 to 1995 and as Deputy Director, NSA for Research and Engineering from 1990 to 1992. From 1989 to 1990 he served as NSA Chief of Staff. Mr. Devine has been a consultant to the defense industry since his retirement from the NSA. David D. Elliman has been a director of the Company since 1991. He founded in 1981 and continues to serve as a principal of Elmrock, Inc., an investment advising firm. He is a trustee of numerous trusts, the director of closely held companies and general partner of several limited partnerships engaged in investment activities. Mr. Elliman serves as President of several special purpose finance affiliates of Citicorp Bank, Chase Manhattan Bank, Sovran Financial Bank, Society Bancorp, Hyatt International and State Street Bank and Trust. Gary L. Yancey, a co-founder of the Company, has served the Company as President and Chairman of the Board since the Company's incorporation in January 1984. Prior to co-founding the Company, he was employed for ten years by ARGOSystems Inc., a manufacturer of electronic reconnaissance systems, most recently serving as Director of the Strategic Systems Division, and for seven years as an engineer with GTE Sylvania Inc., a defense electronics company. James F. Collins, a co-founder of the Company, has been a director of and employed by the Company since its incorporation in 1984. He has served in the position of Laboratory Manager with the Company since 1984. Prior to co-founding the Company, Mr. Collins worked at ARGOSystems Inc., a manufacturer of electronic reconnaissance systems, for fourteen years, most recently serving in the Strategic Systems Division. Prior to working at ARGOSystems, Inc., Mr. Collins served for three years as an officer in the United States Navy. John R. Treichler, a co-founder of the Company, has been a director of and employed by the Company since its incorporation in 1984. He has served in the position with of Senior Scientist with the Company since 1984. Prior to co-founding the Company, he worked at ARGOSystems Inc. for seven years, most recently serving as a senior scientist in the Strategic Systems Division, and at Stanford University for three years in the Information Systems Laboratory. Stuart G. Whittelsey, Jr. has been a director of the Company since 1990. Since April 1994 he has been a principal of his own consulting firm, Whittelsey Associates, which is engaged in corporate financial management. From July 1993 through April 1994, he was Chief Executive Officer of Lytton Garden Inc., a residence for HUD qualified seniors combined with a skilled nursing facility in Palo Alto, California. From January 1990 through June 1993, he was employed by Acurex Environmental Corporation, an environmental engineering firm, and its affiliated companies, where he most recently served as Vice President, Finance and Administration and Chief Financial Officer. ITEM 11: EXECUTIVE COMPENSATION The following table sets forth information for each of the Company's last three fiscal years concerning the compensation of the chief executive officer of the Company and the other executive officers of the Company whose total salary and bonus for service in all capacities to the Company for the fiscal year ended October 31, 1998 exceeded $100,000 during such fiscal year: SUMMARY COMPENSATION TABLE
Long Term Annual Compensation Compensation ----------------------------- ------------ Securities Other Underlying Fiscal Salary Bonus Annual Options Name and Principal Position Year ($) ($) Compensation(*) (#) - ----------------------------- --------- --------- --------- -------------------------- Gary L. Yancey 1998 $371,534 $25,442 $17,395 5,600 President and Chief Executive 1997 334,720 12,051 15,592 0 Officer 1996 308,516 998 15,249 0 Kenneth Snow 1998 223,395 15,097 9,523 5,600 Vice President-Operations 1997 205,572 5,141 8,071 0 1996 182,710 2,215 7,166 1,000 Brian M. Offi 1998 227,347 15,100 9,523 5,600 Vice President Finance and 1997 205,578 5,192 8,122 0 Chief Financial Officer 1996 185,159 2,324 7,834 6,000 Bani M. Scribner, Jr. 1998 233,645 14,970 9,523 5,600 Vice President-Strategic 1997 204,382 4,020 7,229 20,000 Systems Division 1996 120,549 1,658 4,771 20,000 Kenway Wong 1998 209,730 13,613 7,902 5,600 Vice President-Communication 1997 179,015 4,591 6,903 0 Systems Division * Company funded Applied Signal Technology 401K Retirement Plan contribution.
OPTION GRANTS IN LAST FISCAL YEAR - 1998 Options were granted in fiscal 1998 to the persons named in the Option Grants Table.
Potential Realizable Value at Assumed Annual Rates of Stock Price Apperciation for Individual Grants Option Term (1) - ---------------------------------------------------------------------------- ------------------ Number of Securities Percent of Total Underlying Options Granted Exercise or Options to Employees Base Price Name Granted (#) in Fiscal Year ($/Sh) (2) Expiration date 5% ($) 10% ($) - ---------------- ------------ --------------- ----------- -------------- ------ ------- Brian Offi 5,600 1.9% $15.50 11/20/05 (3) $128,243 $186,064 Ben Scribner 5,600 1.9% $15.50 11/20/05 (3) $128,243 $186,064 Ken Snow 5,600 1.9% $15.50 11/20/05 (3) $128,243 $186,064 Ken Wong 5,600 1.9% $15.50 11/20/05 (3) $128,243 $186,064 Gary Yancey 5,600 1.9% $15.50 11/20/05 (3) $128,243 $186,064
(1) These gains are based on assumed rates of stock appreciation of five percent and ten percent, compounded annually from the date the options were granted to the date of their expieration. The gains shown are net of the option price, but do not include deductions for taxes and other expenses that may be associated with the exercise. Actual gains, if any, on stock option exercises will depend on future performance of the common stock, the option holder's continued employemnt through the option period, and the date which the options are exercised. (2) All options were granted at market value on date of grant. (3) Option grant pursuant to the Company's 1991 Stock Option Plan. Options vest on a basis of one-fifth per year date over a period of 5 years while optionee remains an employee of the Company/ OPTION EXERCISES AND FISCAL 1998 YEAR-END VALUES OPTION EXERCISES AND FISCAL 1998 YEAR-END VALUES
Option Exercises in Fiscal 1998 and FY-End Option Value ------------------------------------------------- Number of Securities Value of Unexercised Underlying Options at In-the-Money Options at October 31, 1998 October 31, 1998 (1) ------------------------------- ------------------------------- Shares Value Exercisable Unexercisable Exercisable Unexercisable Acquired on Realized ($) (2) (#) (#) ($) ($) Name Exercise (#) - ------------------------------------ --------------- --------------- --------------- --------------- --------------- Brian M. Offi 8,270 $54,830 5,600 0 0 Ken Snow 360 2,362 5,000 5,600 46,550 0 Ken Wong 360 2,362 11,200 5,600 84,827 0 Gary L. Yancey 360 2,362 0 5,600 0 0 Ben Scribner 0 0 20,000 25,600 116,200 136,200
---------- (1) The closing sale price for the common stock as reported by the the Nasdaq National Market on October 31, 1998 was $11.31. October 31, 1998 was $11.31. Value is calculated on the basis of the difference between the option exercise price and $11.31 multiplied by the number of shares of common stock underlying the option. (2) The values in this column are based on the last reported sale price of the common stock on the respective dates of exercise as reported by the Nasdaq National Market, less the respective option exercise prices. REPORT OF THE COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION The Compensation Committee of the Board of Directors set compensation for the Company's executive officers for fiscal 1997. The Committee is comprised of the three non-employee directors of the Company, Messrs. Elliman, Devine and Whittelsey. The Compensation Committee is responsible for setting and administering the total compensation program for the executive officers of the Company. Recommendations for annual salary for the executive officers are made to the Compensation Committee by the Chief Executive Officer ("CEO") and the Company's Human Resources Manager. Salaries are generally set for the executive officers by evaluating their performance, evaluating their goals, evaluating the importance of each position to the achievement of the Company's strategic goals, and comparing compensation for the same positions at similarly sized electronics companies. The compensation of the Company's executive officers consists of salaries which are set toward the upper end of the appropriate salary ranges observed at similarly sized electronics companies and relatively modest bonuses received under plans in which all employees of the Company participate (under which bonuses are determined using a common objective formula based upon the entire Company's profit performance), thereby leading to total cash compensation (salary and bonus) of the Company's executive officers within the range of the total cash compensation of similarly situated counterparts at other electronics companies. For fiscal 1998 the Committee again considered whether to change the historical compensation structure for the executive officers to provide for discretionary cash bonuses or equity awards such as stock options based on personal performance goals. The Committee has decided to increase the use of stock options for executive compensation. It believes this will more closely align the compensation of Company executives with Company performance, as well as with the compensation packages offered executives at other similarly sized electronic companies. Details of option grants to officers and directors is disclosed in the table of "Option Grants in Last Fiscal Year - 1998". With the background of this philosophy, the Compensation Committee used the following criteria to establish compensation for fiscal 1998 for its executive officers. First, the Committee considered the current importance of each position held by an executive officer to the ability of the Company to achieve its strategic objectives, including not only the importance of the function of the group managed by the executive officer, but also the group's management needs, considering its organization and operation. Second, the Committee received and considered compensation survey data covering the total cash compensation (salary and bonus) paid by companies in the electronics industry with similar annual revenues to the Company. Finally, the Committee reviewed the self-evaluations of each executive officer and the CEO's annual review of all other executive officers. With respect to the Company's CEO Gary Yancey , the Committee evaluated his performance during fiscal year 1998 with respect to the Company's revenues, Company's profit margin, the size and progress of the Company's research anddevelopment efforts, and the quality of the CEO's management of his line managers. The Committee unanimously concluded that the CEO had a successful fiscal year, and approved a percentage increase in the CEO's salary which was in line with the Company's average salary increase for the fiscal year and placed the CEO in approximately the 75-80th percentile in terms of total cash compensation as compared to his peers at similarly sized electronics companies. The Company's policy with respect to compensation paid to its executive officers is to deduct such compensation which qualifies under Section 162(m) of the Internal Revenue Code, as amended, as an expense. THE COMPENSATION COMMITTEE David D. Elliman John P. Devine Stuart G. Whittelsey, Jr. COMPARISON OF SHAREHOLDER RETURN Set forth below is a line graph comparing the annual percentage change in the cumulative total return on the Company's Common Stock with the cumulative total return of the Standard & Poor's 400 Mid-Cap Index ("S&P 400") and the Standard & Poor's Aerospace and Defense Index ("S&P Aerospace and Defense") for the period commencing on October 29, 1993, and ending on October 31, 1998. COMPARISON OF CUMULATIVE TOTAL RETURN FROM OCTOBER 29, 1993 THROUGH OCTOBER 31, 1998(1) APPLIED SIGNAL TECHNOLOGY, INC., S&P 400, S&P AEROSPACE AND DEFENSE [CHART 1] PLOT POINTS
Applied S&P Signal S&P 400 Aerospace Date Technology Mid-Cap and Defense - ---------------- ------------- ------------ ------------ 29 Oct. 1993 $100.00 $100.00 $100.00 31 Oct. 1994 $110.12 $100.34 $69.57 31 Oct. 1995 $159.28 $119.32 $82.61 31 Oct. 1996 $213.53 $137.76 $82.61 31 Oct. 1997 $225.48 $180.14 $209.78 31 Oct. 1998 $228.98 $189.90 $196.70
- - ------------ (1) Assumes that $100.00 was invested on October 29, 1993, in the Company's Common Stock and each index and that all dividends were reinvested. No dividends have been declared on the Company's Common Stock. Shareholder returns over the indicated period should not be considered indicative of future shareholder returns. ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information regarding beneficial ownership of the Company's Common Stock as of January 4, 1999 by (i) each person who is known by the Company to own beneficially more than 5 percent of the outstanding Common Stock of the Company, (ii) each of the Company's directors and director-nominees, (iii) the Chief Executive Officer and the other executive officers of the Company whose total salary and bonus for the year ended October 31, 1998 exceeded $100,000, and (iv) all directors and executive officers of the Company as a group.
SHARES PERCENT OF NAME OF BENEFICIAL OWNER OF GROUP BENEFICIALLY COMMON STOCK AND NATURE OF BENEFICIAL OWNERSHIP(1) OWNED OUTSTANDING - -------- ---------------- ------------ Capital Technology 513,900 6.1 McMullen Creek Office Center P.O. Box 472428 Charlotte, NC 28247-2428 David D. Elliman 496,256 (2) 5.9 18 East 74th Street New York, NY 10021 John R. Treichler 504,481 (4) 6.0 Globeflex Capital LP 456,100 5.4 ** 4365 Executive Dr. Ste. 720 San Diego, CA 92121 Gary L. Yancey 441,121 (5) 5.3 Dimensional Fund ADV 426,000 5.0 ** 1299 ocean Ave. 11th Floor Santa Monica, CA 90411 James F. Collins 414,431 (3) 4.9 Bani M. Scribner, Jr. 36,727 (6) * Kenneth Snow 32,009 (7) * Kenway Wong 56,173 (8) * Brian M. Offi 30,174 (9) * Stuart G. Whittelsey, Jr. 5,001 * John P. Devine 1,000 * All directors and executive officers 2,037,594 (10) 24.3 as a group (11 persons)
- ----------- * Less than 1% ** Form 13F Reporting (1) Except as indicated in the footnotes to this table, the persons named in the table possess sole voting and investment power with respect to all shares of Common Stock shown as beneficially owned by them, subject to joint tenancy, tenancy-in-common or community property laws, where applicable. Unless otherwise indicated, the business address of each of the beneficial owners is 400 W. California Avenue, Sunnyvale, CA 94086. (2) Includes 161,378 shares held by Underhill charitable Lead Trust of which the reporting person is a trustee and a beneficiary and the reporting person disclaims beneficial ownership of his shares in excess of his beneficiary's interest in the trust; 118,544 shares held by Trust u/w Isabel S. Rockefeller of which the reporting person is a trustee and a membr of ther reporting person's immediae family is beneficiary and the reporting person disclaims beneficial ownership of shares in excess of the reporting person's interest in the trust; 100,000 share held by Rama Investment Partnership of which the reporting person is a general partner and ther reporting person disclaims beneficial ownership of shares in excess of his partnership interest; 41,666 shares held by Trust u/d Avery Rockefeller of which the reporting person is a trustee and member of the repoting person's immediate family is a beneficiary, and the reporting person disclaims beneficial ownership of shares in excess of the reporting person's interest in the trust; 16,111 shares held directly as a result of transfers to the reporting person of securities previously reported as indirectly owned by Rockefeller Charitable Lead Trust and the A.M. Rockefeller Trust; 14,147 shares held by Rockefeller Charitable Lead Trust of which the reporting person is a trustee and beneficial ownreship of shares of the reporting person's interest in the trust; 14,013 shares held by A.M. Rockefeller Trust of which the reporting person is a trustee and a beneficiary and the reporting person disclaims beneficial ownership of sares in excess of the reporting person's interest in the trust (the change reflects a transfer to the reporting person); 7,275 shares held by Overhills Partnership, Inc. of which the reporting person is a partner and the reporting person disclaims beneficial ownership of shares in excess of his partnership interest; 5,335 shares held by Estate of Anna M. Rockefeller of which the reporting person is an executor and beneficiary and the reporting person disclaims beneficial ownership of shares in excess of his interest in the estate; 3,201 shares held by Estate of Gladys Underhill of which the reporting person is an executor and a beneficiary, and the reporting person disclaims bendficial ownership of shares in excess of his interest in the estate; 2,425 shares held by Underhill Foundation of which the reporting person is a trustee, and the reporting person disclaims beneficial ownership of such shares; 2,425 shares held by Wild Wings Foundation of which the reporting person is a trustee and the reporting person disclaims beneficial ownership of such shares; 2,245 shares held by Trust u/w Avery Rockefeller of which the reporting person is a trustee and beneficiary, and the reporting person disclaims beneficial ownership in excess of the reporting person's interest in the trust; and 36 shares held by PARock Limited Partnership of which the reporting person is a general partner. (3) Includes 1,120 shares subject to an option that is exercisable within 60 days of January 5, 1999. (4) Includes 1,120 shares subject to an option that is exercisable within 60 days of January 5, 1999. (5) Includes 1,120 shares subject to an option that is exercisable within 60 days of January 5, 1999. (6) Includes 21,120 shares subject to an option that is exercisable within 60 days of January 5, 1999. (7) Includes 6,120 shares subject to an option that is exercisable within 60 days of January 5, 1999. (8) Includes 12,320 shares subject to an option that is exercisable within 60 days of January 5, 1999. (9) Includes 1,120 shares subject to an option that is exercisable within 60 days of January 5, 1999. (10) Includes 44,200 shares subject to an option that is exercisable within 60 days of January 5, 1999. ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) AND (2) -- The following documents of Applied Signal Technology, Inc. are filed as part of this report under Item 8. Balance Sheets -- October 31, 1998 and 1997 Statements of Income -- Years ended October 31, 1998, 1997, and 1996 Statements of Shareholders' Equity -- Years ended October 31, 1998, 1997, and 1996 Statements of Cash Flows -- Years ended October 31, 1998, 1997, and 1996 Notes to Financial Statements -- October 31, 1998 Report of Ernst & Young LLP, Independent Auditors. All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (3) -- Listing of Exhibits -- See Exhibit Index on page XX of this Report on Form 10-K. (b) Reports on Form 8-K filed in the Company's fiscal year ended October 31, 1998: None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused Amendment No. 1 to this report to be signed on its behalf by the undersigned, therewith duly authorized. APPLIED SIGNAL TECHNOLOGY, INC. (Registrant) Dated March 23, 1999 /s/ Gary L. Yancey ------------------------------ Gary L. Yancey, President, Chief Executive Officer and Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this Amendment No. 1 to this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE DATE TITLE --------- ---- ----- /s/ Gary L. Yancey ____________ President, Chief Executive Officer and - ----------------------------- Chairman of the Board (Principal Executive Officer) /s/ Brian M. Offi ____________ Vice President of Finance and Chief - ----------------------------- Financial Officer (Principal Financial and Accounting Officer) /s/ James F. Collins ____________ Director - ---------------------------- /s/ John P. Devine ____________ Director - ---------------------------- /s/ David D. Elliman ____________ Director - ---------------------------- /s/ John R. Treichler ____________ Director - ---------------------------- /s/ Stuart G. Whittelsey, Jr. ____________ Director - ----------------------------
APPLIED SIGNAL TECHNOLOGY INDEX TO EXHIBITS
EXHIBIT DESCRIPTION OF DOCUMENT NUMBER ---------------------- - - ------ 3.1(1) Second Amended and Restated Articles of Incorporation 3.2(1) Amended and Restated Bylaws 4.1(1) Specimen Common Stock Certificate 4.2(1) Rights Agreement dated January 25, 1991 10.1(1) Form of Indemnification Agreement for directors and officers 10.2(1) 1984 Stock Purchase Plan and form of agreement thereunder 10.3(1) 1991 Stock Option Plan and forms of agreements thereunder 10.4(1) 1993 Employee Stock Purchase Plan 10.5(1) Profit Sharing Policy 10.6(1) Summary Plan Description of 401(k) Retirement Plan 10.7(1) Warrant to Purchase Common Stock dated June 27, 1990 issued to Owenoake Partners, L.P. ("Owenoake"), Letter Agreement with Owenoake dated September 20, 1990, and Amendment Number One to Warrants to Purchase Common Stock with Owenoake and certain warrant holders dated February 8, 1993 10.8(1) Warrants to Purchase Common Stock dated September 25, 1990 issued to certain warrant holders 10.9(2) Line of Credit Agreement dated June 10, 1993 with Sanwa Bank California and related Equipment Purchase Line of Credit Agreement dated June 10, 1993 10.10(1) Lease Agreement dated August 21, 1985 with Lincoln Mathilda Associates, Ltd. and Patrician Associates, Inc., and amendments thereto 10.11(3) Lease agreements dated November 23, 1994 with Lincoln Property Company Management Services, Inc. for Buildings H and I 10.12(4) Amendment to Commercial Credit Agreement dated March 7, 1995 with Sanwa Bank California and related Equipment Purchase Line Agreement dated March 10, 1995 10.13(5) Amendments to Commercial Credit Agreements dated March 1, 1996 with Sanwa Bank California 10.14(6) Lease agreement dated May 31, 1996 with Constellation Real Estate, Inc., for 135 National Business Parkway 10.15(6) Amendments to lease agreements dated November 23, 1994 with Lincoln Property Company Management Services, Inc. 10.16 Commercial Credit Agreement dated March 3, 1997 with Sanwa Bank California 10.17 Lease agreement dated May 29, 1996 with Constellation Real Estate, Inc. 23.1 Consent of Independent Auditors 27.1 Financial Data Schedule
(1) Incorporated by reference to corresponding Exhibit filed as an Exhibit to Registrant's Registration Statement on Form S-1 filed January 29, 1993 (File No. 33-58168). (2) Incorporated by reference to corresponding Exhibit filed with the Registrant's Form 10-K for fiscal year 1993 dated January 22, 1994. (3) Incorporated by reference to corresponding Exhibit filed with the Registrant's Form 10-K for fiscal year 1994 dated January 27, 1995. (4) Incorporated by reference to corresponding Exhibit filed with the Registrant's Form 10-K for fiscal year 1995 dated January 26, 1996. (5) Incorporated by reference to corresponding Exhibit filed with the Registrant's Form 10-Q for fiscal year 1996 dated August 2, 1996. (6) Incorporated by reference to corresponding Exhibit filed with the Registrant's Form 10-K for fiscal year 1996 dated January 26, 1997. EX-23.1 2 CONSENT OF ERNST & YOUNG LLP APPLIED SIGNAL TECHNOLOGY, INC. EXHIBIT 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-21236) pertaining to the Applied Signal Technology, Inc. Non-Incentive Stock Option Plan of our report dated December 10, 1998, with respect to the financial statements of Applied Signal Technology, Inc. included in this Annual Report (Form 10-K/A) for the year ended October 31, 1998. /s/ Ernst & Young LLP Palo Alto, California April 14, 1999 EX-27 3 ARTICLE 5 FIN. DATA SCHEDULE FOR 10-K
5 This schedule contains summary financial information extracted from the Consolidated Balance Sheet and Consolidated Statement Income included in the Company's Form 10-K for the period ende October 31, 1998 and is qualified in its entirety by reference such Financial Statements. 1,000 U.S. DOLLARS 1 Oct-31-1998 Nov-01-1997 Oct-31-1998 12-MOS 14,085 1,029 30,580 0 5,551 54,280 42,916 24,775 72,463 14,564 0 0 0 19,154 37,711 72,463 110,087 110,087 67,840 94,310 26,470 0 (49) 16,361 6,217 10,144 0 0 0 10,144 $1.20 $1.15
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