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| KVHI > SEC Filings for KVHI > Form 10-K on 13-Mar-2009 | All Recent SEC Filings |
13-Mar-2009
Annual Report
The following discussion and analysis should be read in conjunction with the other financial information and consolidated financial statements and related notes appearing elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of a variety of factors, including those discussed under the heading "Item 1A. Risk Factors" and elsewhere in this annual report.
Overview
We are a leading manufacturer of solutions that provide global high-speed internet, television, and voice services via satellite to mobile users at sea, on land, and in the air. We are also a premier manufacturer of high-performance navigational sensors and integrated inertial systems for defense and commercial guidance and stabilization applications.
Our mobile satellite business includes receive-only TracVision satellite TV systems, 2-way TracPhone satellite communications systems, and the mini-VSAT Broadband airtime service. Our TracVision mobile satellite TV systems enable mobile reception in vehicles or vessels of most leading satellite TV services, such as DIRECTV, DISH Network, and ExpressVu in North America, and Astra and Eutelsat in Europe. In February 2008, we entered the aviation market with a development and production contract for a satellite TV antenna that will be sold on an OEM basis by LiveTV. Our TracPhone satellite communications systems enable reception of Inmarsat L-Band MSS services or our own mini-VSAT Broadband Ku-band FSS service, and are sold primarily to mariners. We sell our mobile satellite products and airtime services through our direct sales force and an extensive international network of independent sales representatives, distributors and retailers to leisure, commercial, and government customers.
Our guidance and stabilization products use our precision FOG and digital compass technologies to help stabilize platforms such as antennas, gun turrets, optical systems, material handling equipment, and radar units and to provide guidance for torpedoes and other munitions. These products are either integrated within our own navigation and antenna systems or sold as modules to other manufacturers. We also use our FOG and digital compass technology to produce some variants of our TACNAV line of navigation systems for military vehicles. We sell our guidance and stabilization products to commercial and military customers either directly to U.S. and allied governments and government contractors or through an international network of authorized independent sales representatives.
Year Ended December 31,
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2008 2007 2006
-------- -------- --------
(in thousands)
Mobile communications $ 59,690 $ 60,651 $ 56,205
Guidance and stabilization 22,714 20,264 22,768
- ------ - ------ - ------
Net sales $ 82,404 $ 80,915 $ 78,973
- ------ - ------ - ------
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In addition to revenue from product sales, our mobile satellite revenue includes revenue earned from product repairs, revenue from satellite phone and Internet usage services, and certain DIRECTV account referral fees earned in conjunction with the sale of our products. We provide, for a fee, third-party satellite phone and Internet airtime to our TracPhone and Internet customers who choose to activate their subscriptions with us. We also earn revenue from service sold with our mini-VSAT products. Under current DIRECTV programs, we are eligible to receive a one-time, new mobile account activation fee from DIRECTV for each customer who activates their DIRECTV service directly through us. Our guidance and stabilization revenue primarily includes product sales to both military and commercial markets and, to a lesser extent, revenue from product repairs and engineering services provided under development contracts.
Our guidance and stabilization business is characterized by a small number of customers who place a small number of relatively large dollar value orders. In the years ended December 31, 2008, 2007 and 2006, our top four guidance and stabilization customers, including the U.S. military as a single customer, accounted for 47%, 44% and 51%, respectively, of our net sales attributable to guidance and stabilization products and services, and
13%, 11% and 15%, respectively, of our total net sales for all products and services. Direct sales to the U.S. military accounted for 1%, 0% and 4% of our total net sales for the years ended December 31, 2008, 2007 and 2006, respectively. Orders for our guidance and stabilization products typically vary in size and are sometimes in the range of several hundred thousand dollars to over one million dollars. Accordingly, our quarterly net sales of guidance and stabilization products usually consist of a relatively small number of orders. Each order can have a significant impact on our net sales, and because our guidance and stabilization products generally have higher gross margins than our mobile satellite communications products, each order can have an impact on our net income that is disproportionately large relative to the revenue generated by the order. Moreover, customers of our guidance and stabilization products are predominantly governments and government contractors that typically must adhere to lengthy procurement processes, which make the timing of individual orders difficult to predict and often result in long sales cycles. Government customers and their contractors can generally cancel orders for our products for convenience.
We have historically derived a substantial portion of our revenue from sales to customers located outside the United States and Canada. The following table provides, for the periods indicated, sales to specified geographic regions:
Year Ended December 31,
------------------------------
2008 2007 2006
-------- -------- --------
(in thousands)
Originating from North American locations
United States $ 49,761 $ 59,264 $ 58,385
Canada 3,107 1,408 2,114
Europe 6,558 2,699 2,856
Other 3,201 1,525 2,991
- ------ - ------ - ------
Total North America 62,627 64,896 66,346
Originating from European location
Europe 14,885 12,302 10,096
Other 4,892 3,717 2,531
- ------ - ------ - ------
Total Europe 19,777 16,019 12,627
- ------ - ------ - ------
Net sales $ 82,404 $ 80,915 $ 78,973
- ------ - ------ - ------
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See note 11 to our consolidated financial statements for more information on our geographic segments.
In addition to our internally funded research and development efforts, we also conduct research and development activities that are funded by our customers. These activities relate primarily to engineering activities including engineering studies, surveys, prototype development, program management and standard product customization. In accordance with accounting principles generally accepted in the United States of America, we account for customer-funded research as revenue, and we account for the associated research costs as cost of goods sold. As a result, customer-funded research and development are not included in the research and development expense that we present in our statement of operations. The following table presents our total annual research effort, representing the sum of research cost of goods sold and the operating expense of research and development as described in our statement of operations. Our management believes this information is useful because it provides a better understanding of our total expenditures on research and development activities.
Year ended December 31,
---------------------------------
2008 2007 2006
--------- ------- -------
(in thousands)
Research and development expense presented on statement
of operations $ 7,655 $ 9,265 $ 7,720
Cost of customer-funded research and development
included in cost of service sales 1,011 638 2,060
-- ------ - ----- - -----
Total expenditures on research and development
activities $ 8,666 $ 9,903 $ 9,780
-- ------ - ----- - -----
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In addition to the expenses listed above, we have incurred a total of $3.2 million in development costs related to a long-term antenna development and production agreement that was entered into on February 18, 2008. These development costs are reflected in other non-current assets, as we have a contractual right to recover these costs. See note 13 to our consolidated financial statements for further discussion.
As of December 31, 2008, we had approximately $42.7 million in cash, cash equivalents and marketable securities and an accumulated deficit of approximately $5.3 million.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure at the date of our financial statements. Our significant accounting policies are summarized in note 1 to our consolidated financial statements. The significant accounting policies that we believe are the most critical in understanding and evaluating our reported financial results include the following:
Revenue Recognition
Product sales. Product sales are recognized when persuasive evidence of an arrangement exists, goods are shipped, title has passed and collectability is reasonably assured. Our standard sales terms require that:
• All sales are final;
• Terms are generally either Net 30 or Net 45;
• Shipments are tendered and shipped FOB (or as may be applicable, FCA, or EXW) our plant or warehouse; and
• Title and risk of loss or damage passes to the dealer or distributor at the point of shipment when delivery is made to the possession of the carrier.
For certain guidance and stabilization product sales, customer acceptance or inspection may be required before title and risk of loss transfers to the customer. For those sales revenue is recognized after transfer of title and risk of loss and after notification of customer acceptance.
Under certain limited conditions, we, at our sole discretion, provide for the return of goods. No product is accepted for return and no credit is allowed on any returned product unless we have granted and confirmed prior written permission by means of appropriate authorization. We establish reserves for potential sales returns, credit and allowances, and evaluate, on a monthly basis, the adequacy of those reserves based upon historical experience and our expectations for the future.
Satellite connectivity sales. Directly sold and re-sold satellite connectivity service for voice, data and Internet is recognized monthly based upon minutes or megabytes of traffic processed or contracted fixed fee schedules. All subscribers enter into a contracted one-year minimum service agreement. We record all satellite connectivity service sales to subscribers as gross sales, as we are the primary obligor in the contracted service arrangement. All associated regulatory service fees and costs are recorded net in our consolidated financial statements. The accounting estimates related to the recognition of satellite connectivity service sales in our results of operations require us to make assumptions about future billing adjustments for disputes with subscribers as well as unauthorized usage.
See note 10 to our consolidated financial statements for disclosures associated with our significant customers.
Accounts Receivable Allowance
Our estimate of allowance for doubtful accounts related to trade receivables is primarily based on specific, historical criteria. We evaluate specific accounts where we have information that the customer may have an inability to meet its financial obligations. We make judgments, based on facts and circumstances, regarding the need to record a specific reserve for that customer against amounts owed to reduce the receivable to the amount that we expect to collect. We also provide for a reserve based on an aging analysis of our accounts receivable. We evaluate these reserves on a monthly basis and adjust them as we receive additional information that impacts the amount reserved. If circumstances change, we could change our estimates of the recoverability of amounts owed to us by a material amount. For example, included in the reserve balance as of December 31, 2005 was a $492,000 specific reserve resulting from a voluntary liquidation under local law of a European distributor during 2004. As the liquidation was finalized in 2007, the Company wrote-off the entire remaining account and reserve of $492,000 related to this distributor in 2007. Also, included in the beginning reserve balance as of December 31, 2007 was a $129,000 specific reserve related to a distributor that ultimately went bankrupt in 2008. As the bankruptcy was finalized in 2008, the Company wrote-off the entire remaining account and reserve of $129,000 related to this distributor in 2008.
Inventories
Inventory is valued at the lower of cost or market. We generally must order components for our products and build inventory in advance of product shipments. We regularly review current quantities on hand, actual and projected sales volumes and anticipated selling prices on products and write down, as appropriate, slow-moving and/or obsolete inventory to its net realizable value. Generally, our inventory does not become obsolete because the materials we use are typically interchangeable among various product offerings. However, if we overestimate projected sales or anticipated selling prices, our inventory might be overstocked, and we would have to reduce our inventory valuation accordingly.
For example, as of December 31, 2008 we had approximately $0.7 million of inventory on hand related to military products whose utilization will be dependent upon the receipt of additional sales orders in the future. If such sales orders do not occur, and we are unable to redeploy the components of such inventory for other product sales, we may be required to record additional write-downs to inventory which would negatively impact both gross margins and net income in the period when such write-downs are recorded.
Our inventory level at December 31, 2008 increased 66% compared to the prior year. The increase was largely the result of two factors. First, commencing during the second quarter of 2008 we began to build up inventory levels of fiber optic gyro materials in anticipation of large orders for remote weapon station and MK54 torpedo programs. Second, the dramatic weakening of the RV market commencing in the first half of the year, particularly during the second quarter, and the crisis of consumer confidence in the general economy during the second half of the year, caused precipitous declines in demand for our RV products and substantial reductions in demand for our marine consumer products. While shipments of fiber optic gyros for remote weapon stations are now underway, we anticipate that it will take several quarters to reduce other product inventories to more normal levels if the current weak level of demand continues. We currently anticipate to receive a large order for the MK54 torpedo program in June 2009, but there can be no assurance that the order will not be delayed or cancelled. As of December 31, 2008 we had approximately $0.7 million of inventory, primarily made up of raw materials, for military products whose utilization will be dependent upon the receipt of additional sales orders in the future. If we do not receive such sales orders, and we are unable to redeploy the components of such inventory for other product sales, we may be required to record additional write-downs to inventory which would negatively impact both gross margins and net income in the period when such write-downs are recorded. If our inventory reduction and rebalancing efforts are unsuccessful or take a very extended period of time, we may have to consider sizeable inventory reserves or write-downs to address potential excess and obsolete inventory, or our gross margins may fall below historical levels, which would adversely affect our financial results.
Income Taxes and Deferred Income Tax Assets and Liabilities
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss carry-forwards. On a quarterly basis, we assess the recoverability of our deferred tax assets by considering whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.
For 2008 and 2007, we generated net income of $3.1 million and $2.5 million, respectively. In assessing the realizability of our deferred tax assets, we considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends upon the generation of future taxable income during the periods in which those temporary differences become deductible. As of December 31, 2008 and 2007, we have recorded a valuation allowance against a portion of our deferred tax assets because we believe that, after considering all of the available objective evidence, including available tax planning strategies, historical and prospective results of operations, with greater weight given to historical evidence, it is more likely than not that a portion of the assets will not be realized. The amount of valuation allowance was approximately $4.1 million as of December 31, 2008. Should we generate net income in 2009 and project net income for 2010 and beyond, we may determine, after considering all available objective evidence, that it is more likely than not that all of our net deferred tax assets would be realized. Should that determination be made, we would reverse all or a portion of our deferred tax asset valuation allowance at such time and recognize a reduction of income tax expense (as of December 31, 2008 the amount of any reduction which would impact income tax expense was approximately $2.0 million). In addition, as a portion of our deferred tax assets was generated from excess tax deductions from share-based payment awards, pursuant to SFAS No. 123(R), a portion of such valuation allowance reversal would be recorded to additional paid-in capital when the deduction reduces taxes payable (as of December 31, 2008 such amount would have been $1.9 million).
Our tax planning strategy provides a basis for the realization of a portion of our total domestic deferred tax assets as of December 31, 2008 and 2007. Specifically, as of December 31, 2008 and 2007, we had approximately $3.3 million of U.S. net deferred tax assets, which consist of federal net operating loss carry-forwards available to offset future taxable income. Our strategy to utilize these assets is based upon our ability to sell our property located in Middletown, Rhode Island for the express purpose of generating taxable income to utilize these loss carry-forwards before they expire. This tax strategy is not an action that we ordinarily would take, but would take, if necessary, to realize tax benefits prior to expiration. The U.S. net deferred tax assets as of December 31, 2008 of approximately $3.3 million are derived from our estimate that the property sale would generate net taxable gains, should we decide to execute on our strategy to utilize the benefit of our net deferred tax assets. Because the realizable value of our net deferred tax assets is derived from the fair market valuation of the Middletown property, future tax expense and/or benefit are highly correlated to changes in property values in Rhode Island.
Warranty Provision
We typically offer a one to two year warranty for all of our base products. We provide for the estimated cost of product warranties at the time product revenue is recognized. Factors that affect our warranty reserves include the number of units sold, historical and anticipated rates of warranty repairs and the cost per repair. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our estimated warranty obligation is affected by ongoing product failure rates, specific product class failures outside our baseline experience, material usage and service delivery costs incurred in correcting a product failure. For example, our warranty costs incurred in 2008 increased approximately $0.2 million from 2007. The primary reason for the increase was driven by demand for our TracPhone V7 product that we launched in the fourth quarter of 2007. The TracPhone V7 has the highest manufacturing cost and selling price of any of our mobile communication products. We anticipate that the warranty costs incurred as a percentage of TracPhone V7 product sales will decrease as a result of recent quality
programs related to this product. If actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Assumptions and historical warranty experience are evaluated to determine the appropriateness of such assumptions. We assess the adequacy of the warranty provision and we may adjust this provision if necessary.
Results of Operations
The following table provides, for the periods indicated, certain financial data expressed as a percentage of net sales:
Year Ended December 31,
-----------------------------
2008 2007 2006
------- ----- -----
Sales:
Product 84.9 % 90.9 % 89.6 %
Service 15.1 9.1 10.4
------- -- ----- - ----- -
Net sales 100.0 100.0 100.0
------- -- ----- - ----- -
Costs and expenses:
Cost of product sales 51.6 55.5 53.8
Cost of service sales 7.5 4.4 5.9
Research and development 9.3 11.5 9.8
Sales, marketing and support 19.6 19.0 18.2
General and administrative 8.5 9.3 9.9
------- -- ----- - ----- -
Total costs and expenses 96.5 99.7 97.6
------- -- ----- - ----- -
Income from operations 3.5 0.3 2.4
Interest income 1.5 3.4 3.0
Interest expense 0.2 0.2 0.2
Other expense 0.3 0.1 0.1
------- -- ----- - ----- -
Income before income taxes 4.5 3.4 5.1
Income tax expense 0.8 0.3 0.4
------- -- ----- - ----- -
Net Income 3.7 % 3.1 % 4.7 %
------- -- ----- - ----- -
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Years ended December 31, 2008 and 2007
Net Sales
Product sales decreased in 2008 by $3.6 million, or 5%, to $69.9 million from $73.5 million in 2007. The primary reason for the decrease was a decrease in sales of our land mobile products of $8.2 million, or 46%, driven by decreased recreational vehicle sales, resulting from increased fuel prices and challenging consumer credit markets. Partially offsetting the decrease was an increase in sales of our marine products of $4.0 million, or 11%, driven primarily by demand for our TracPhone V7 product that we launched in the fourth quarter of 2007 and to a lesser extent sales of Inmarsat-compatible TracPhone products. Mobile communications product sales originating from our Danish subsidiary increased $2.6 million, or 17%, from 2007 to 2008. Contributing to the sales increase were favorable currency rate fluctuations between the Euro and the U.S. dollar. Mobile communications product sales originating from North America decreased $6.8 million, or 17%, from 2007 to 2008.
Sales of our guidance and stabilization products increased in 2008 by $0.6 million, or 4%, to $18.6 million from $18.0 million in 2007. Specifically, sales related to our TACNAV defense and legacy navigation products increased by $1.7 million, driven primarily by a $1.4 million TACNAV sale to a Turkish contractor . . .
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