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| IRSN > SEC Filings for IRSN > Form 10-Q on 17-Feb-2009 | All Recent SEC Filings |
17-Feb-2009
Quarterly Report
In this report, the terms "Irvine Sensors," "Company," "we," "us" and "our"
refer to Irvine Sensors Corporation ("ISC") and its subsidiaries.
This report contains forward-looking statements regarding Irvine Sensors which
include, but are not limited to, statements concerning our projected revenues,
expenses, gross profit and income, mix of revenue, demand for our products, the
benefits and potential applications for our products and technologies, the
proposed 2008 Patent Sale and License, the effect of the sale of the assets of
Optex Systems, Inc., the need for additional capital, our ability to obtain and
successfully perform additional new contract awards and the related funding and
profitability of such awards, market acceptance of our products and
technologies, the competitive nature of our business and markets, the success
and timing of new product introductions and commercialization of our
technologies, product qualification requirements of our customers, our
significant accounting policies and estimates, and the outcome of expense
audits. These forward-looking statements are based on our current expectations,
estimates and projections about our industry, management's beliefs, and certain
assumptions made by us. Words such as "anticipates," "expects," "intends,"
"plans," "predicts," "potential," "believes," "seeks," "hopes," "estimates,"
"should," "may," "will," "with a view to" and variations of these words or
similar expressions are intended to identify forward-looking statements. These
statements are not guarantees of future performance and are subject to risks,
uncertainties and assumptions that are difficult to predict. Therefore, our
actual results could differ materially and adversely from those expressed in any
forward-looking statements as a result of various factors. Such factors include,
but are not limited to the following:
• our ability to obtain additional financing for working capital on
acceptable terms in a timely manner;
• our ability to maintain compliance with Nasdaq's listing requirements;
• our ability to satisfy the closing conditions and consummate the 2008 Patent Sale and License on favorable terms, on a timely basis, or at all;
• our ability to continue as a going concern;
• our ability to obtain critical and timely product and service deliveries from key vendors due to our working capital limitations, competitive pressures or other factors;
• our ability to satisfy our debt instruments;
• our ability to successfully execute our business plan and control costs and expenses;
• our ability to obtain expected and timely bookings and orders resulting from existing contracts;
• our ability to secure and successfully perform additional research and development contracts;
• governmental agendas, budget issues and constraints and funding delays;
• our ability to maintain adequate internal controls and disclosure procedures, and achieve compliance with Section 404 of the Sarbanes-Oxley Act;
• our ability to introduce new products, gain broad market acceptance for such products and ramp up manufacturing in a timely manner;
• new products or technologies introduced by our competitors, many of whom are bigger and better financed than us;
• the pace at which new markets develop;
• our ability to establish strategic partnerships to develop our business;
• our limited market capitalization;
• general economic and political instability; and
• those additional factors which are listed under the section "Risk Factors" in Part II, 1A of this report.
We do not undertake any obligation to revise or update publicly any
forward-looking statements for any reason, except as required by law. Additional
information on the various risks and uncertainties potentially affecting our
operating results are discussed below and are contained in our publicly filed
documents available through the SEC's website (www.sec.gov) or upon written
request to our Investor Relations Department at 3001 Red Hill Avenue, Costa
Mesa, California 92626.
Overview
We are a vision systems company enabled by proprietary technology for
three-dimensional packaging of electronics and manufacturing of electro-optical
products. We design, develop, manufacture and sell vision systems and
miniaturized electronic products for defense, security and commercial
applications. We also perform customer-funded contract research and development
related to these products, mostly for U.S. government customers or prime
contractors. Most of our historical business relates to application of our
proprietary technologies for stacking either packaged or unpackaged
semiconductors into more compact three-dimensional forms, which we believe offer
volume, power, weight and operational advantages over competing packaging
approaches, and which we believe allows us to offer proprietary higher level
products with unique operational features.
In December 2005, we completed the Initial Acquisition of Optex, a privately
held manufacturer of telescopes, periscopes, lenses and other optical systems
and instruments whose customers are primarily agencies of and prime contractors
to the U.S. Government. In consideration for the Initial Acquisition, we made an
initial cash payment to the sole shareholder of Optex, Timothy Looney, in the
amount of $14.0 million and made an additional cash payment of $64,200 to
Mr. Looney in July 2006 upon completion of the audit of Optex's financial
statements for the year ended December 31, 2005. As additional consideration, we
were initially required to pay to Mr. Looney cash earnout payments in the
aggregate amount up to $4.0 million based upon the net cash generated from the
Optex business, after debt service, for fiscal 2006 and the next two subsequent
fiscal years. Mr. Looney was not entitled to any earnout payments for fiscal
2006, for fiscal 2007 or for fiscal 2008. In January 2007, we negotiated an
amendment to our earnout agreement with Mr. Looney that extended his earnout
period to December 2009 and reduced the aggregate maximum earnout by $100,000 to
$3.9 million in consideration for a secured subordinated term loan providing for
advances from an entity owned by Mr. Looney to Optex of up to $2 million. This
term loan bears interest at 10% per annum and matures on the earlier of
February 2009 or 60 days after repayment of our senior debt. As of December 28,
2008, this term loan was fully advanced to Optex. Mr. Looney has brought a
lawsuit against the Company alleging that the Company is obligated to pay him
the full earnout as a result of the Optex Asset Sale. (See Part II, Item I,
Legal Proceedings).
In connection with the Initial Acquisition, we entered into the Buyer Option
with Mr. Looney, pursuant to which we agreed to purchase the remaining 30% of
the capital stock of Optex held by Mr. Looney. On December 29, 2006, we amended
certain of our agreements with Mr. Looney regarding the Buyer Option. In
consideration for such amendments, we issued a one-year unsecured subordinated
promissory note to Mr. Looney in the principal amount of $400,000, bearing
interest at a rate of 11% per annum. We exercised the Buyer Option on
December 29, 2006 and issued Mr. Looney approximately 269,231 shares of our
common stock, after giving effect to our 2008 Reverse Stock Split, as
consideration for our purchase of the remaining 30% of the outstanding common
stock of Optex held by him. As a result of the Initial Acquisition and exercise
of the Buyer Option, Optex became our wholly-owned subsidiary.
We financed the Initial Acquisition of Optex by a combination of $4.9 million of
senior secured debt from Square 1 Bank under a term loan and $10.0 million of
senior subordinated secured convertible notes from two private equity funds,
which are sometimes referred to in this report collectively as "Pequot." In
December 2006, both of these obligations were refinanced with two new senior
Lenders, Longview and Alpha. These transactions resulted in approximately
$4.4 million of non-recurring debt extinguishment expenses, which were largely
non-cash, and approximately $12.4 million of future additional interest expense
resulting from debt discounts and issuance costs. In November 2007, we
restructured these obligations, as well as a short-term $2.1 million debt
obligation to Longview, to extend the maturity date of all of such obligations,
including the related interest, to December 30, 2009 in consideration for a
restructuring fee of approximately $1.1 million, which fee is also payable
December 30, 2009.
In September 2008, we entered into a binding Memorandum of Understanding for
Settlement and Debt Conversion Agreement (the "MOU") with the Lenders with the
intent to effect a global settlement and restructuring of our aggregate
outstanding indebtedness payable to the Lenders, which was then approximately
$18.4 million. In October 2008, pursuant to the MOU, an entity controlled by the
Lenders delivered a notice to us and to Optex of the occurrence of an event of
default and acceleration of the obligations due to the Lenders and their
assignee and conducted the Optex Asset Sale, which was a public UCC foreclosure
sale of the assets of Optex. The entity controlled by the Lenders credit bid
$15 million in the Optex Asset Sale, which was the winning bid. As a result,
$15 million of our aggregate indebtedness to the Lenders was extinguished. All
financial statements and schedules of the Company give effect to this event and
report Optex as a discontinued operation for both the current and prior fiscal
periods. We recorded a loss on disposal of the Optex discontinued operations of
approximately $7.6 million during the fiscal year ended September 28, 2008.
Subject to satisfying certain conditions, including our consummation of
specified debt and equity financings, the Lenders have agreed to exchange
certain indebtedness payable to them after the Optex Asset Sale (the "Residual
Obligations") for a new class of non-voting convertible preferred stock of the
Company. In particular, the Lenders have agreed to exchange $1.0 million of the
Residual Obligations for shares of the new preferred stock upon the completion
of a $1.0 million bridge debt financing. We completed such a financing in
February 2009. The Lenders have also agreed to exchange the balance of the
Residual Obligations for shares of the new preferred stock in the event we also
consummate either of the following: (i) securing a new debt facility with net
proceeds of at least $2.0 million; or (ii) completing an equity offering with
net proceeds of at least $2.0 million. Pursuant to the MOU, the Lenders have
provided their consent to the foregoing debt or equity offerings. The new
preferred stock will not be issued until the closing of offerings described
above, or if no such closing occurs, then at a mutually agreed upon time. The
issuance of the new preferred stock is also subject to stockholder approval,
which has not yet been obtained and cannot be assured. The conversion of the new
preferred stock into shares of our common stock is expected to be subject to the
same conversion blocker as contained in our existing Series A-1 Preferred Stock.
In December 2008, we entered into an agreement to sell most of our patent
portfolio to a patent acquisition company for up to a $9.5 million cash payment
and it is anticipated that we will be granted a perpetual, worldwide,
royalty-free, non-exclusive license to use the sold patents in our business (the
"2008 Patent Sale and License"). The exact list of patents to be sold has not
yet been finalized. At the date of this report, this transaction was pending,
and we cannot guarantee that it will close. See Note 9 to the Condensed
Consolidated Financial Statements included with this report.
Since 2002, and prior to our acquisition of Optex, we historically derived a
substantial majority of our total revenues from government-funded research and
development rather than from product sales. Optex also historically derived most
of its revenues from product sales to government agencies or prime contractors.
We anticipate that a substantial majority of our total revenues will continue to
be derived from government-funded sources in the immediately foreseeable future.
Prior to fiscal 2005, with a few exceptions, our government-funded research and
development contracts were largely early-stage in nature and relatively modest
in size. As a result, our revenues from this source during that period were not
significantly affected by changes in the U.S. defense budget. In fiscal 2008,
our contract research and development revenues were adversely affected by
procurement delays, as well as diversion of management and financial resources
to address supply chain and margin issues at Optex. Our current marketing
efforts are focused on government programs that we believe have the potential to
transition to government production contracts. If we are successful in this
transition, our future revenues may become more dependent upon U.S. defense
budgets, funding approvals and political agendas. We are also attempting to
increase our revenues from product sales by introducing new products with
commercial applications, in particular, miniaturized cameras and stacked
computer memory chips. We cannot assure you that we will be able to complete
development, successfully launch or profitably manufacture and sell any such
products on a timely basis, if at all. We generally use contract manufacturers
to produce these products, and all of our other current operations occur at a
single, leased facility in Costa Mesa, California. Prior to the Optex Asset
Sale, Optex manufactured its products at its leased facility in Richardson,
Texas.
We have a history of unprofitable operations due in part to our investment in
Optex and due to discretionary investments that we have made to commercialize
our technologies and to maintain our technical staff and corporate
infrastructure at levels that we believed were required for future growth. These
investments have yet to produce profitable operating results. With respect to
our investments in staff and infrastructure, the advanced technical and
multi-disciplinary content of our proprietary technologies places a premium on a
stable and well-trained work force. As a result, we generally maintain the size
of our work force even when anticipated government contracts are delayed, a
circumstance that has occurred with some frequency in the past and that has
resulted in under-utilization of our labor force for revenue generation from
time to time. Delays in receipt of research and development contracts are
unpredictable, but we believe such delays represent a recurring characteristic
of our research and development contract business. We anticipate that the impact
on our business of future delays can be mitigated by the achievement of greater
contract backlog and are seeking growth in our research and development contract
revenue to that end. We are also seeking to expand the contribution to our total
revenues from product sales, which have not historically experienced the same
types of delays that can occur in research and development contracts. We have
not yet demonstrated the level of sustained research and development contract
revenue or product sales that we believe is required to achieve profitable
operations. Our ability to recover our investments through the
cost-reimbursement features of our government contracts is constrained due to
both regulatory and competitive pricing considerations.
To offset the adverse working capital effect of our net losses, we have
historically financed our operations through issuance of various equity
instruments. To finance the acquisition of Optex, we also incurred material
long-term debt, and we have exchanged a significant portion of that debt into
preferred stock that is convertible into our common stock. Since the beginning
of fiscal 2006, we have issued approximately 3.8 million shares of our common
stock, an increase of approximately 202% over the approximately 1.9 million
shares of our common stock outstanding at the beginning of that period, and a
substantial dilution of stockholder interests. At December 28, 2008, our fully
diluted common stock position was approximately 17.6 million shares. At December
28, 2008, we had approximately $4.6 million of debt, exclusive of debt discounts
and exclusive of the $2.0 million of debt owed by Optex.
None of our subsidiaries accounted for more than 10% of our total assets at
December 28, 2008 or have separate employees or facilities. We currently report
our operating results and financial condition in two operating segments, our
research and development business and our product business.
Critical Accounting Estimates
Our consolidated financial statements have been prepared in conformity with
GAAP. As such, management is required to make judgments, estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. The significant accounting
policies that are most critical to aid in fully understanding and evaluating
reported financial results include the following:
Revenue Recognition. Our consolidated total revenues during the 13 weeks ended
December 28, 2008 were primarily derived from contracts to develop prototypes
and provide research, development, design, testing and evaluation of complex
detection and control defense systems. Our research and development contracts
are usually cost reimbursement plus a fixed fee, fixed price with billing
entitlements based on the level of effort we expended or occasionally firm fixed
price. Our cost reimbursement plus fixed fee research and development contracts
require our good faith performance of a statement of work within overall
budgetary constraints, but with latitude as to resources utilized. Our fixed
price level of effort research and development contracts require us to deliver a
specified number of labor hours in the performance of a statement of work. Our
firm fixed price research and development contracts require us to deliver
specified items of work independent of resources utilized to achieve the
required deliverables. For all types of research and development contracts, we
recognize revenues as we incur costs and include applicable fees or profits
primarily in the proportion that costs incurred bear to estimated final costs.
Costs and estimated earnings in excess of billings under government research and
development contracts are accounted for as unbilled revenues on uncompleted
contracts, stated at estimated realizable value and are expected to be realized
in cash within one year.
Upon the initiation of each research and development contract, a detailed cost
budget is established for direct labor, material, subcontract support and
allowable indirect costs based on our proposal and the required scope of the
contract as may have been modified by negotiation with the customer, usually a
U.S. government agency or prime contractor. A program manager is assigned to
secure the needed labor, material and subcontract in the program budget to
achieve the stated goals of the contract and to manage the deployment of those
resources against the program plan. Our accounting department collects the
direct labor, material and subcontract charges for each contract on a weekly
basis and provides such information to the respective program managers and
senior management.
The program managers review and report the performance of their contracts
against the respective program plans with our senior management on a monthly
basis. These reviews are summarized in the form of estimates of costs to
complete the contracts ("ETCs"). If an ETC indicates a potential overrun against
budgeted program resources, it is the responsibility of the program manager to
revise the program plan in a manner consistent with the customer's objectives to
eliminate such overrun and achieve planned contract profitability, and to seek
necessary customer agreement to such revision. To mitigate the financial risk of
such re-planning, we attempt to negotiate the deliverable requirements of our
research and development contracts to allow as much flexibility as possible in
technical outcomes. Given the inherent technical uncertainty involved in
research and development contracts, in which new technology is being invented,
explored or enhanced, such flexibility in terms is frequently achievable. When
re-planning does not appear possible within program budgets, senior management
makes a judgment as to whether the program statement of work will require
additional resources to be expended to meet contractual obligations or whether
it is in our interest to supplement the customer's budget with our own funds. If
either determination is made, we record an accrual for the anticipated contract
overrun based on the most recent ETC of the particular contract.
We provide for anticipated losses on contracts by recording a charge to earnings
during the period in which a potential for loss is first identified. We adjust
the accrual for contract losses quarterly based on the review of outstanding
contracts. Upon completion of a contract, we reduce any associated accrual of
anticipated loss on such contract as the previously recorded obligations are
satisfied. Costs and estimated earnings in excess of billings under government
contracts are accounted for as unbilled revenues on uncompleted contracts and
are stated at estimated realizable value.
We consider many factors when applying GAAP related to revenue recognition.
These factors generally include, but are not limited to:
• The actual contractual terms, such as payment terms, delivery dates, and
pricing terms of the various product and service elements of a contract;
• Time period over which services are to be performed;
• Costs incurred to date;
• Total estimated costs of the project;
• Anticipated losses on contracts; and
• Collectibility of the revenues.
We analyze each of the relevant factors to determine its impact, individually
and collectively with other factors, on the revenue to be recognized for any
particular contract with a customer. Our management is required to make
judgments regarding the significance of each factor in applying the revenue
recognition standards, as well as whether or not each factor complies with such
standards. Any misjudgment or error by our management in evaluation of the
factors and the application of the standards could have a material adverse
affect on our future operating results.
We recognize revenue from product sales upon shipment, provided that the
following conditions are met:
• There are no unfulfilled contingencies associated with the sale;
• We have a sales contract or purchase order with the customer; and
• We are reasonably assured that the sales price can be collected.
The absence of any of these conditions, including the lack of shipment, would cause revenue recognition to be deferred. Our terms are FOB shipping point. Historically, our products have not been sold under formal warranty terms. We do not offer contractual price protection on any of our products. Accordingly, we do not presently maintain any reserves for returns under warranty or post-shipment price adjustments although we do record product support expenses incurred and accrue such expenses expected to be incurred in relation to shipped products.
We do not utilize distributors for the sale of our products nor do we enter into
revenue transactions in which the customer has the right to return product,
other than pursuant to warranty. Accordingly, we do not make any provisions for
sales returns, contractual price protection or adjustments in the recognition of
revenue.
Inventory. Inventories are stated at the lower of cost or market value. Each
quarter, we evaluate our inventories for excess quantities and obsolescence. We
write off inventories that are considered obsolete and adjust remaining
inventory balances to approximate the lower of cost or market value. The
valuation of inventories at the lower of cost or market requires us to estimate
the amounts of current inventories that will be sold. These estimates are
dependent on our assessment of current and expected orders from our customers.
Costs on long-term contracts and programs in progress generally represent
recoverable costs incurred. The marketing of our research and development
contracts involves the identification and pursuit of contracts under specific
government budgets and programs. We are frequently involved in the pursuit of a
specific anticipated contract that is a follow-on or related to an existing
contract. We often determine that it is probable that a subsequent award will be
successfully received, particularly if continued progress can be demonstrated
against anticipated technical goals of the projected new program while the
government goes through its lengthy approval process required to allocate funds
and award contracts. When such a determination occurs, we capitalize material,
labor and overhead costs that we expect to recover from a follow-on or new
contract. Due to the uncertainties associated with new or follow-on research and
development contracts, we maintain significant reserves for this inventory to
avoid overstating its value. We have adopted this practice because we believe
that we are typically able to more fully recover such costs under the provisions
of government contracts by direct billing of inventory rather than by seeking
recovery of such costs through permitted indirect rates, which may be more
vulnerable to competitive market pressures.
Cost of our product inventory includes direct material and labor costs, as well
as manufacturing overhead costs allocated based on direct labor dollars.
Inventory cost is determined using the average cost method. Pursuant to contract
provisions, agencies of the U.S. Government and certain other customers may have
title to, or a security interest in, inventories related to certain contracts as
a result of advances and progress payments. In such instances, we reflect those
advances and payments as an offset against the related inventory balances.
Inventories are reviewed quarterly to determine salability and obsolescence. A
reserve is established for slow moving and obsolete product inventory items.
Valuation Allowances. We maintain allowances for doubtful accounts for estimated
losses resulting from a deterioration of a customer's ability to make required
payments to the point where we believe it is likely there has been an impairment
of its ability to make payments. Such allowances are established, maintained or
modified at each reporting date based on the most current available information.
We record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. We have considered future taxable
income and ongoing prudent and feasible tax planning strategies in assessing the
need for the valuation allowance.
Goodwill and Other Intangible Assets. Goodwill represents the cost of acquired
businesses in excess of fair value of the related net assets at acquisition.
(See also Note 1 to the Condensed Consolidated Financial Statements). Valuation
of intangible assets such as goodwill requires us to make significant estimates
and assumptions including, but not limited to, estimating future cash flows from
. . .
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