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ARTX > SEC Filings for ARTX > Form 10-Q on 14-Aug-2014All Recent SEC Filings

Show all filings for AROTECH CORP

Form 10-Q for AROTECH CORP


14-Aug-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements involve inherent risks and uncertainties. When used in this discussion, the words "believes," "anticipated," "expects," "estimates" and similar expressions are intended to identify such forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those set forth elsewhere in this report. Please see "Risk Factors" in our Annual Report on Form 10-K and in our other filings with the Securities and Exchange Commission.

Arotech™ is a trademark and Electric Fuel® is a registered trademark of Arotech Corporation. All company and product names mentioned may be trademarks or registered trademarks of their respective holders. Unless the context requires otherwise, all references to us refer collectively to Arotech Corporation and its subsidiaries.

We make available through our internet website free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to such reports and other filings made by us with the SEC, as soon as practicable after we electronically file such reports and filings with the SEC. Our website address is www.arotech.com. The information contained in this website is not incorporated by reference in this report.

The following discussion and analysis should be read in conjunction with the interim financial statements and notes thereto appearing elsewhere in this Quarterly Report. We have rounded amounts reported here to the nearest thousand, unless such amounts are more than 1.0 million, in which event we have rounded such amounts to the nearest hundred thousand.

Executive Summary

We are a defense and security products and services company, engaged in two business areas: interactive simulation for military, law enforcement and commercial markets; and batteries and charging systems for the military. We operate in two business units:

††† we develop, manufacture and market advanced high-tech multimedia and interactive digital solutions for use-of-force training and driving training of military, law enforcement, security and other personnel (our Training and Simulation Division); and

††† we provide advanced battery solutions, innovative energy management and power distribution technologies and world-class product design and manufacturing services for the aerospace, defense, law enforcement and homeland security markets, and we manufacture and sell lithium and Zinc-Air batteries, for defense and security products, including our Soldier Wearable Integrated Power Equipment System (SWIPES)™ power hubs, and other military applications (our Battery and Power Systems Division).

Between 2002 and December 2011, we were also engaged in the production of armored vehicles and aviation armor, through our Armor Division. In December 2011, our Board of Directors approved management's plan to sell our Armor Division in order to focus on the more profitable and growth-oriented aspects of our business. We completed the sale of our Armor Division in June 2012.

Our results for the first three months of 2014 do not include the results of UEC Electronics, LLC, a South Carolina limited liability company that we purchased on April 1, 2014. See "Recent Developments - Acquisition of UEC Electronics, LLC," below.


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Overview of Results of Operations

Acquisitions

In the acquisition of subsidiaries, part of the purchase price is allocated to intangible assets and goodwill. Amortization of definite-lived intangible assets related to acquisition of subsidiaries is recorded based on the estimated expected life of the assets. Accordingly, for a period of time following an acquisition, we incur a non-cash charge related to amortization of definite-lived intangible assets in the amount of a fraction (based on the useful life of the definite-lived intangible assets) of the amount recorded as intangible assets. Such amortization charges continued during the first six months of 2014. We are required to review long-lived intangible assets and goodwill for impairment at least annually or whenever events or changes in circumstances indicate that carrying amount of the assets may not be recoverable. If we determine, through the impairment review process, that the carrying amount of these assets has been impaired, we must record the impairment charge in our statement of comprehensive income.

We incurred non-cash charges for amortization of intangible assets in the first six months of 2014 and 2013 in the amount of $961,183 and $550,112, respectively.

Restricted Shares, Restricted Stock Units and Options

In accordance with FASB ASC 505-50, we incurred, for the six months ended June 30, 2014 and 2013, compensation expense related to restricted stock units and restricted shares of approximately $258,000 and $167,000, respectively. Our directors received their annual restricted stock grants on April 1, 2014 in accordance with the terms of the directors' stock compensation plan.

Overview of Operating Performance and Backlog

Overall, our income from continuing operations before income tax expense for the six months ended June 30, 2014 was $3.2 million on revenues of $50.2 million, compared to $2.4 million on revenues of $44.4 million during the six months ended June 30, 2013. As of June 30, 2014, our overall backlog totaled $74.1 million compared to $65.7 million in the second quarter of 2013.

In our Training and Simulation Division, revenues decreased from approximately $30.5 million in the first six months of 2013 to $28.9 million in the first six months of 2014. As of June 30, 2014, our backlog for our Training and Simulation Division totaled $52.4 million compared to $51.1 million in the second quarter of 2013.

In our Battery and Power Systems Division, revenues increased from approximately $14.0 million in the first six months of 2013 to approximately $21.3 million in the first six months of 2014. As of June 30, 2014, our backlog for our Battery and Power Systems Division totaled $21.7 million, including backlog related to our UEC acquisition, compared to $14.6 million in the second quarter of 2013, which does not include any acquisition-related backlog.

The table below details the percentage of total recognized revenue by type of arrangement for the six months ended June 30, 2014 and 2013:

                                                      Six months ended June 30,
                  Type of Revenue                      2014               2013
    Sale of products                                       94.5 %             93.8 %
    Maintenance and support agreements                      3.3 %              3.0 %
    Long term research and development contracts            2.2 %              3.2 %
    Total                                                 100.0 %            100.0 %

Recent Developments

Common Stock Offering

In July 2014, we sold 2,860,000 shares of our common stock in a public offering for an aggregate of $10.0 million (before underwriting discounts, commission and expenses of the offering). The following day, we sold an additional 429,000 shares in this public offering for an aggregate of $1.5 million (before underwriting discounts, commission and expenses of the offering).


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Acquisition of UEC Electronics, LLC

On April 1, 2014, we entered into and consummated a Membership Interest Purchase Agreement (the "Agreement") to purchase all of the membership interests of UEC Electronics, LLC, a South Carolina limited liability company ("UEC"), from the seller of UEC (the "Seller"), a company principally owned by UEC's two top managers (together with the Seller, the "Sellers"). UEC management will stay with UEC and will continue to manage UEC as a wholly-owned subsidiary of ours. We considered the purchase of UEC to be an accretive addition to our Battery and Power Systems Division.

UEC develops and manufactures electronic components and subsystems primarily for military, aerospace and industrial customers. UEC specializes in core, proprietary engineering capabilities in highly-demanded solution areas, including: (i) hybrid power generation systems, (ii) smart power subsystems for military vehicles and dismounted applications, and (iii) aircraft and missile systems support for cutting-edge weapons and communications technologies.

The initial acquisition price of UEC was $28 million plus 775,000 shares of our common stock, as well as a potential earn-out of up to $5.5 million over the next two calendar years, which earn-out is payable in cash or shares of our common stock at our option. The liability for the earn out was recorded in other accounts payable and accrued expenses ($2.2 million) and other long-term liabilities ($2.3 million). On April 1, 2014, the closing price of our common stock on the Nasdaq Global Market was $5.44 per share, causing the common stock issued in the acquisition to be valued for accounting purposes at $4.2 million, subject to potential reduction to reflect the fact that the stock being issued in the acquisition is unregistered and not freely tradable. The source of the cash used was $22.5 provided by the financing transaction described below and $5.5 million of our working capital. The amount of consideration was determined based upon arm's-length negotiations between ourselves and the Sellers.

Our condensed consolidated statements of comprehensive income include $11.6 million of revenue and $2.4 million of net income that was contributed by UEC in the first quarter of combined operation.

Bank Financing

Our FAAC subsidiary has a $15.0 million line of credit (the "Line of Credit") with Fifth Third Bank (the "Bank") at a rate of LIBOR plus 3.5%, secured by the assets and receivables of FAAC and by the assets and receivables of us and of our subsidiary EFB. Additionally, we and EFB are guarantors of the Line of Credit.

On April 1, 2014, pursuant to an Amended and Restated Credit Agreement (the "Amend­ed Credit Agreement"), the parties to the original credit agreement (the "Original Credit Agreement") agreed to amend the Line of Credit to add two term loans to it: an $18.0 million 61-month senior term loan at a 2014 interest rate of 3.75% over LIBOR, and a $4.5 million 61-month B term loan at a 2014 interest rate of 5.5% over LIBOR. Pursuant to a joinder agreement that took effect upon our acquisition of UEC (the "Joinder Agreement"), UEC became a party to the Amended Credit Agreement as a co-borrower with FAAC, and provided a guaranty and security substantially identical to that granted by us and EFB. We, FAAC, and EFB also entered into a patent and trademark security agreement with the Bank; upon effectiveness of the Joinder Agreement, UEC executed a substantially identical agreement.

Certain covenants contained in the Original Credit Agreement have been modified in the Amended Credit Agreement. Commencing with the fiscal quarter ending September 30, 2014, our "Fixed Charge Coverage Ratio," determined on a combined basis with UEC and otherwise computed in the same manner as under the Original Credit Agreement, has been raised to 1.25 to 1 from 1.10 to 1. "Net Advances to Affiliates" as defined in the Original Credit Agreement are now defined with reference to FAAC or UEC, as the case may be, and may not increase by more than $5,500,000 on a combined basis for both borrowers in any calendar year over a "Base Amount" to be determined by mutual agreement of FAAC and the bank.

In addition, two new covenants have been added in the Amended Credit Agreement. First, UEC's earnings before interest, taxes, depreciation and amortization with certain add-backs ("EBITDA"), computed on a stand-alone basis, may not be less than $4,500,000 for any trailing twelve-month period ending at the end of a fiscal quarter (a "Test Period") beginning with the Test Period ending September 30, 2014 and each succeeding fiscal quarter thereafter. Second, the ratio of "Combined Funded Indebtedness" (defined as all indebtedness (a) in respect of money borrowed, (b) evidenced by a note, debenture or other like written obligation to pay money, (c) in respect of rent or hire of property under leases or lease arrangements which under GAAP are required to be capitalized or (d) in respect of obligations under conditional sales or other title retention agreements, all as determined on a combined basis for FAAC and UEC) to "Combined Adjusted EBITDA" (defined as EBITDA of FAAC and UEC computed on a combined basis) may not exceed (a) 2.25 to 1.0 for the Test Period ending September 30, 2014 or any Test Period ending as of the end of any fiscal quarter thereafter prior to the fiscal quarter ending March 31, 2015 or (b) 2.00 to 1.0 for the Test Period ending March 31, 2015 or any Test Period ending as of the end of any fiscal quarter thereafter.


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Pursuant to the requirements of the Amended Credit Agreement, we were required to deliver an Interest Rate Swap agreement fixing the interest rate of 1.37% on approximately $9.0 million of the outstanding term loans associated with the acquisition of UEC. Accordingly, in April 2014, we entered into an interest rate swap for a notional amount of $9.0 million. The expiration date of this interest rate swap is April 1, 2019. The unrealized $85,000 expense to date associated with this derivative has been charged to Financial Expenses and will be adjusted through Financial Expense as the swap matures.

Functional Currency

We consider the United States dollar to be the currency of the primary economic environment in which we and EFL operate and, therefore, both we and EFL have adopted and are using the United States dollar as our functional currency. Transactions and balances originally denominated in U.S. dollars are presented at the original amounts. Gains and losses arising from non-dollar transactions and balances are included in net income.

The majority of financial transactions of Epsilor is in New Israeli Shekels ("NIS") and a substantial portion of Epsilor's costs is incurred in NIS. Management believes that the NIS is the functional currency of Epsilor. Accordingly, the financial statements of Epsilor have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of comprehensive income amounts have been translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive income/loss in stockholders' equity.

Results of Operations

Preliminary Note

Results for the three and six months ended June 30, 2014 include the results of UEC for such period as a result of our acquisition of this company on April 1, 2014. The results of UEC were not included in our operating results for the three and six months ended June 30, 2013. Accordingly, the following period-to-period comparisons should not necessarily be relied upon as indications of future performance.

Three months ended June 30, 2014 compared to the three months ended June 30, 2013.

Revenues. Revenues for the three months ended June 30, 2014 totaled $27.8 million, compared to $22.4 million in the comparable period in 2013, an increase of $5.4 million, or 24.3%. In the second quarter of 2014, revenues were $13.2 million for the Training and Simulation Division (compared to $14.8 million in the second quarter of 2013, a decrease of $1.6 million, or 10.8%, due primarily to the wind down of the first phase of our VCTS program (revenues generated by the second phase of our VCTS program are anticipated to commence in the third quarter of 2014)); and $14.6 million for the Battery and Power Systems Division (compared to $7.6 million in the second quarter of 2013, an increase of $7.0 million, or 92.5%, due primarily to revenue generated by our new UEC subsidiary, offset by reduced revenue in our other U.S. subsidiary).

Cost of revenues. Cost of revenues totaled $17.9 million during the second quarter of 2014, compared to $16.1 million in the second quarter of 2013, an increase of $1.8 million, or 11.0%, due primarily to the product mix of the reporting units, which included products sold at a higher margin. Cost of revenues was $7.5 million for the Training and Simulation Division (compared to $10.0 million in the second quarter of 2013, a decrease of $2.5 million, or 24.9%, also due primarily to the product mix); and $10.4 million for the Battery and Power Systems Division (compared to $6.1 million in the second quarter of 2013, an increase of $4.3 million, or 70.1%, due primarily to the increased revenue associated with our new UEC subsidiary, offset by the reduced product sales in our other U.S. subsidiary).

Research and development expenses. Research and development expenses for the second quarter of 2014 were $936,000, compared to $595,000 during the second quarter of 2013, an increase of $342,000, or 57.4%, due primarily to continuing research on training systems and battery technologies for new products.


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Selling and marketing expenses. Selling and marketing expenses for the second quarter of 2014 were $1.5 million, compared to $1.4 million in the second quarter of 2013, an increase of $163,000, or 11.8%, due primarily to increased trade show representation and the sales efforts of both divisions, including additional expenses related to our addition of a new subsidiary.

General and administrative expenses. General and administrative expenses for the second quarter of 2014 were $4.3 million, compared to $2.5 million in the second quarter of 2013, an increase of $1.8 million, or 73.0%, due primarily to $600,000 in one-time, acquisition-related expenses, along with the additional, normally occurring expenses related to our addition of a new subsidiary.

Amortization of intangible assets. Amortization of intangible assets totaled $887,000 in the second quarter of 2014, compared to $274,000 in the second quarter of 2013, an increase of $613,000, or 224.2%, due primarily to the additional $811,000 in amortization expenses relating to our acquisition of UEC, offset by fully amortized acquisition related intangibles recorded in 2013 relating to other subsidiaries in our Battery and Power Systems Division.

Other income. Other income totaled $197,000 in the second quarter of 2014, compared to other income of $269,000 in the second quarter of 2013, a decrease of $70,000, due primarily to the reduction in insurance proceeds (related to a fire in our offices in 2012) received in our Battery and Power Systems Division in 2013.

Financial expense, net. Financial expense totaled $564,000 in the second quarter of 2014, compared to financial expense of $114,000 in the second quarter of 2013, an increase of $450,000, due primarily to increased long term debt interest relating to our acquisition of UEC.

Income taxes. We recorded $180,000 in tax expense in the second quarter of 2014, compared to $254,000 in tax expense in the second quarter of 2013, a decrease of $74,000, or 29.1%. This expense mainly concerns "naked" credits ("naked" credits occur when deferred tax liabilities that are created by indefinite-lived assets such as goodwill cannot be used as a source of taxable income to support the realization of deferred tax assets). This amount includes the required adjustment of taxes due to the deduction of goodwill "naked" credits for U.S. federal taxes, which totaled $150,000 and $150,000 in non-cash expenses in the second quarter of 2014 and 2013, respectively.

Net income. Due to the factors cited above, we went from a net income of $1.5 million in the second quarter of 2013 to a net income of $1.8 million in the second quarter of 2014, an improvement of $292,000.

Six months ended June 30, 2014 compared to the six months ended June 30, 2013.

Revenues. Revenues for the six months ended June 30, 2014 totaled $50.2 million, compared to $44.4 million in the comparable period in 2013, an increase of $5.8 million, or 13.0%. In the first six months of 2014, revenues were $28.9 million for the Training and Simulation Division (compared to $30.5 million in the first six months of 2013, a decrease of $1.6 million, or 5.2%, due primarily to the wind down of the first phase of our VCTS program (revenues generated by the second phase of our VCTS program are anticipated to commence in the third quarter of 2014); and $21.3 million for the Battery and Power Systems Division (compared to $14.0 million in the first six months of 2013, an increase of $7.3 million, or 52.7%, due primarily to revenue generated by our new UEC subsidiary, offset by reduced revenue in our other U.S. subsidiary).

Cost of revenues. Cost of revenues totaled $32.9 million during the first six months of 2014, compared to $32.9 million in the first six months of 2013, an increase of $41,000, or 0.1%, due primarily to the product mix of the reporting units, which included products sold at a higher margin. Cost of revenues were $17.7 million for the Training and Simulation Division (compared to $21.4 million in the first six months of 2013, a decrease of $3.7 million, or 17.6%, due primarily to the product mix) and $15.3 million for the Battery and Power Systems Division (compared to $11.4 million in the first six months of 2013, an increase of $3.8 million, or 33.3%, due primarily to revenue generated by our new UEC subsidiary, offset by reduced revenue in our other U.S. subsidiary).

Research and development expenses. Research and development expenses for the first six months of 2014 were $1.9 million, compared to $1.1 million during the first six months of 2013, an increase of $804,000, or 71.2%, due primarily to continuing research on training systems and battery technologies for new products.


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Selling and marketing expenses. Selling and marketing expenses for the first six months of 2014 were $3.0 million, compared to $2.6 million in the first six months of 2013, an increase of $357,000, or 13.6%, due primarily to due primarily to increased trade show representation and the sales efforts of both divisions, including additional expenses related to our addition of a new subsidiary.

General and administrative expenses. General and administrative expenses for the first six months of 2014 were $7.8 million, compared to $4.9 million in the first six months of 2013, an increase of $3.0 million, or 60.8%, due primarily to due primarily to $1.1 million in one-time, acquisition related expenses, along with increased corporate salary and benefits expenses and the additional, normally occurring expenses related to our addition of a new subsidiary.

Amortization of intangible assets. Amortization of intangible assets totaled $961,000 in the first six months of 2014, compared to $550,000 in the first six months of 2013, an increase of $411,000, or 74.7%, due primarily to the additional $811,000 in amortization expenses relating to our acquisition of UEC, offset by fully amortized acquisition related intangibles recorded in 2013 relating to other subsidiaries in our Simulation and Battery and Power Systems Divisions.

Other income. Other income totaled $229,000 in the first six months of 2014, compared to other income of $269,000 in the first six months of 2013, a decrease of $39,000, due primarily to a reduction in insurance proceeds (related to a fire in our offices in 2012) received in our Battery and Power Systems Division in 2013.

Financial expense, net. Financial expense totaled $683,000 in the first six months of 2014, compared to financial expense of $303,000 in the first six months of 2013, an increase of $380,000, due primarily to increased long term interest and bank financing fees relating to our acquisition of UEC, offset by a decrease in corporate interest and bank charges in the first quarter of 2014.

Income taxes. We recorded $379,000 in tax expense in the first six months of 2014, compared to $429,000 in tax expense in the first six months of 2013, a decrease of $50,000, or 11.7%, mainly concerning "naked" credits ("naked" credits occur when deferred tax liabilities that are created by indefinite-lived assets such as goodwill cannot be used as a source of taxable income to support the realization of deferred tax assets). This amount includes the required adjustment of taxes due to the deduction of goodwill "naked" credits for U.S. federal taxes, which totaled $299,000 and $299,000, respectively, in non-cash expenses in the first six months of 2014 and 2013.

Net income. Due to the factors cited above, we went from a net income of $2.0 million in the first six months of 2013 to a net income of $2.8 million in the first six months of 2014, an improvement of $828,000.

Liquidity and Capital Resources

As of June 30, 2014, we had $972,000 in cash and $249,000 in restricted collateral deposits, as compared to December 31, 2013, when we had $5.8 million in cash and $498,000 in restricted collateral deposits. We also had $7.6 million in available, unused bank lines of credit with our main bank as of June 30, 2014, under a $15.0 million credit facility under our FAAC subsidiary, described below.

We and FAAC maintain a $15.0 million credit facility with FAAC's primary bank that is secured by Arotech's assets and the assets of our other domestic subsidiaries and guaranteed by Arotech and our other domestic subsidiaries, at a rate of 3.5% over LIBOR. As discussed under "Recent Developments," above, we renegotiated the credit facility with our primary bank. These changes were effective April 1, 2014. The updated credit facility expires May 31, 2016. Additionally, on April 1, 2014 we added two term loans to the credit facility:
an $18.0 million 61-month senior term loan at a 2014 interest rate of 3.75% over LIBOR, and a $4.5 million 61-month B term loan at a 2014 interest rate of 5.5% over LIBOR.

The credit agreement with FAAC's primary bank contains certain financial covenants. Commencing with the fiscal quarter ending September 30, 2014, our "Fixed Charge Coverage Ratio," determined on a combined basis with UEC and otherwise computed in the same manner as under the Original Credit Agreement, has been raised to 1.25 to 1 from 1.10 to 1. "Net Advances to Affiliates" as defined in the Original Credit Agreement are now defined with reference to FAAC or UEC, as the case may be, and may not increase by more than $5,500,000 on a combined basis for both borrowers in any calendar year over a "Base Amount" to be determined by mutual agreement of FAAC and the bank.


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