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TII NETWORK TECHNOLOGIES, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with the foregoing unaudited Condensed Consolidated Financial Statements and related notes thereto appearing elsewhere in this Report. Overview Business Tii Network Technologies, Inc. and subsidiaries (together, "Tii," the "company," "we," "us" or "our") designs, manufactures and sells products to the service providers in the communications industry for use in their networks. We sell our products through a network of sales channels, principally to telephone operating companies ("Telcos"), multi-system operators ("MSOs") of communications services, including cable and satellite service providers, and original equipment manufacturers ("OEMs"). Our products are typically found in Telcos central offices, outdoors in the service providers' distribution network, at the interface where the service providers' network connects to the users' network, and inside the users' home or apartment, and are critical to the successful delivery of voice and broadband communication services. Sales to the Company's customers are generally through "as ordered" general supply agreements. General supply agreements do not require customers to purchase specific quantities of product and can be terminated for various reasons at any time. The Company forecasts inventory requirements through historical trends and discussions with our customers. Most of the sales to a large international customer are currently being made under an agreement that the customer has put out to bid. The Company is participating in the bidding process and believes that the customer will renew with us on terms that are relatively consistent with the prior contract, however, there can be no assurance that the Company will prevail in its bid. In the event that the Company does not prevail, the Company may have excess inventory in an amount that exceeds the related reserves. Recent Acquisitions On March 11, 2011, we acquired 100% of the capital stock of Frederick Fiber Optics ("F2O") for an initial cash payment of $750,000 from available cash on hand, and two contingent cash payments of $125,000 to be made based on the achievement of certain performance objectives over the subsequent two years. The fair value of the contingent consideration has been included in the overall purchase price of F2O based on the assessment that the achievement of these targets is highly probable. F2O, headquartered in Frederick, Maryland, manufactures a wide variety of high performance fiber optic cable assemblies, wall and rack mounted fiber distribution panels, and miscellaneous fiber accessories and services. This acquisition was made in order to expand our fiber optics product offerings. On May 19, 2010, we acquired all of the assets, exclusive of cash, and assumed certain operating liabilities, primarily accounts payable and accrued expenses, of the Copper Products Division of Porta Systems Corp. (the "Porta Copper Products Division") for cash of $8,150,000, subject to purchase price adjustments. The Porta Copper Products Division was comprised of two wholly owned subsidiaries, one in England and the other in Mexico, as well as domestic assets and liabilities exclusively related to copper telecommunications products. Concurrent with this acquisition, we sold the acquired Mexican subsidiary, exclusive of customer contracts and certain machinery and equipment which we retained, to our principal contract manufacturer, which is now operating this manufacturing facility. In consideration for this sale, we received $1,000,000 from the contract manufacturer, subject to purchase price adjustments, as well as an option to reacquire up to approximately 9% of a newly formed entity that now owns the Mexican subsidiary, for a total exercise price of $100,000. We believe that the value of this option, which expired on May 18, 2011, was not material and we did not allocate a portion of the net Porta Copper Products Division purchase price to this option. 15 --------------------------------------------------------------------------------We paid the net purchase price of $7,249,000 predominately from the proceeds of the redemption of our $7,000,000 certificate of deposit. Additionally, we sold to the contract manufacturer certain raw material and component inventories, which were acquired as part of the Porta Copper Products Division transaction, for approximately $1,175,000. Our financial statements include, and the following discussion and analysis reflects, the activity of the Porta Copper Products Division for the three and six months ended June 30, 2011, but only for the period from May 19, 2010 through June 30, 2010 in the reported 2010 periods, and the activity of F2O only since its March 11, 2011 date of acquisition. Results of Operations The following tables sets forth certain income statement information in thousands of dollars and as a percentage of net sales for the periods indicated, except "Income tax provision" (which is stated as a percentage of "income before income taxes"), as well as the dollar increase or decrease between the periods and the percentage of the dollar increase or decrease: Three months ended June 30, (dollars in thousands) 2011 2010 % of % of net sales net sales (except as (except as Dollar noted noted increase Percent Amount above) Amount above) (decrease) change Net sales $ 13,576 100.0 % $ 10,345 100.0 % $ 3,231 31.2 % Cost of sales 8,780 64.7 % 6,682 64.6 % 2,098 31.4 % Gross profit 4,796 35.3 % 3,663 35.4 % 1,133 30.9 % Operating expenses: Selling, general and administrative 2,803 20.6 % 2,853 27.6 % (50 ) -1.8 % Research and development 627 4.6 % 487 4.7 % 140 28.7 % Total operating expenses 3,430 25.3 % 3,340 32.3 % 90 2.7 % Operating income 1,366 10.1 % 323 3.1 % 1,043 322.7 % Foreign currency transaction loss (33 ) -0.2 % - 0.0 % (33 ) 100.0 % Interest expense (14 ) -0.1 % - 0.0 % (14 ) 100.0 % Interest income - 0.0 % 3 0.0 % (3 ) 100.0 % Income before income taxes 1,319 9.7 % 326 3.2 % 993 304.5 % Income tax provision 491 37.2 % 134 41.1 % 357 266.4 % Net income $ 828 6.1 % $ 192 1.9 % $ 636 331.1 % 16-------------------------------------------------------------------------------- Six months ended June 30, (dollars in thousands) 2011 2010 % of % of Net sales Net sales (except as (except as Dollar noted noted increase Percent Amount above) Amount above) (decrease) change Net sales $ 28,552 100.0 % $ 18,088 100.0 % $ 10,464 57.9 % Cost of sales 19,173 67.2 % 11,234 62.1 % 7,939 70.7 % Gross profit 9,379 32.8 % 6,854 37.9 % 2,525 36.8 % Operating expenses: Selling, general and administrative 5,452 19.1 % 4,902 27.1 % 550 11.2 % Research and development 1,290 4.5 % 872 4.8 % 418 47.9 % Total operating expenses 6,742 23.6 % 5,774 31.9 % 968 16.8 % Operating income 2,637 9.2 % 1,080 6.0 % 1,557 144.2 % Foreign currency transaction loss (91 ) -0.3 % - 0.0 % (91 ) 100.0 % Interest expense (14 ) 0.0 % - 0.0 % (14 ) 100.0 % Interest income - 0.0 % 9 0.0 % (9 ) 100.0 % Income before income taxes 2,532 8.9 % 1,089 6.0 % 1,443 132.5 % Income tax provision 914 36.1 % 434 39.9 % 480 110.6 % Net income $ 1,618 5.7 % $ 655 3.6 % $ 963 147.0 % Net sales for the three months ended June 30, 2011 were $13,576,000 compared to $10,345,000 for the comparable prior year period, an increase of $3,231,000 or 31.2%. Net sales for the six months ended June 30, 2011 were $28,552,000 compared to $18,088,000 for the comparable prior year period, an increase of $10,464,000 or 57.8%. The sales growth was primarily due to the sales from our Porta Copper Products Division acquired on May 19, 2010, sales from our F2O acquisition on March 11, 2011, and increased sales to existing customers. Sales from the acquired Porta Copper Products Division and F2O aggregated $4,485,000 and $10, 807,000 during the three and six months ended June 30, 2011, respectively, accounting for 81% and 85% of the total sales increase for the three and six month period, respectively. Gross profit for the three months ended June 30, 2011 was $4,796,000 compared to $3,663,000 for the comparable prior year period, an increase of $1,133,000 or 30.9%. Gross profit margin remained relatively consistent at 35.3% in the current year three month period compared to 35.4% in the 2010 three month period. Gross profit for the six months ended June 30, 2011 was $9,379,000 compared to $6,854,000 in the prior year period, an increase of $2,525,000 or 36.8%. Gross profit margin decreased to 32.8% from 37.9%. The gross profit margin decrease was primarily attributable to sales from our acquired Porta Copper Products Division product line which has historically sold at lower margins than our existing products. Selling, general and administrative expenses for the three months ended June 30, 2011 were $2,803,000 compared to $2,853,000 for the comparable prior year period, a decrease of $50,000 or 1.8%. The 2011 three month decrease was primarily attributable to the absence of transaction and integration costs of approximately $607,000 incurred during the three months ended June 30, 2010 in connection with the Porta Copper Products Division acquisition offset, in large part, by increases in salaries and related benefits resulting from the acquisition and an increase in commissions resulting from the increase in sales. Selling, general and administrative expenses for the six months ended June 30, 2011 were $5,452,000 compared to $4,902,000 for the comparable prior year period, an increase of $550,000 or 11.2%. The increase in expenses for the 2011 six month period was due to increases in salaries and related benefits resulting from the Porta Copper Products Division acquisition and an increase in commissions resulting from the increase in sales offset, in part, by the absence of transaction and integration costs of approximately $744,000 incurred during the six months ended June 30, 2010, which were incurred in connection with the Porta Copper Products Division acquisition. 17 -------------------------------------------------------------------------------- Research and development expenses for the three months ended June 30, 2011 were $627,000 compared to $487,000 for the comparable prior year period, an increase of $140,000 or 28.7%. Research and development expenses for the six months ended June 30, 2011 were $1,290,000 compared to $872,000 for the comparable prior year period, an increase of $418,000 or 48.0%. This increase was primarily attributable to product development expenses resulting from redesigning and qualifying certain of the Porta Copper Products Division products and additional salaries and related benefits resulting from this acquisition. The foreign currency transaction losses of $33,000 and $91,000 for the three months and six months ended June 30, 2011, respectively, was primarily related to our United Kingdom subsidiary acquired as part of the Porta Copper Products Division acquisition. We had interest expense of $14,000 in the three months ended June 30, 2011 and none in the prior year. Interest expense was the result of borrowing $3,000,000 on our credit facility during the current quarter to support our higher levels of accounts receivable and inventories related to our acquired businesses. We had no interest income in the three and six months ended June 30, 2011. Interest income was $3,000 and $9,000 in the three and six months ended June 30, 2010, respectively. The reduction was due to the redemption of our $7,000,000 certificate of deposit in May 2010 for use in funding our acquisition of the Porta Copper Products Division. During the three months ended June 30, 2011 and 2010, we recorded a provision for income taxes of $491,000 and $134,000, respectively. During the six months ended June 30, 2011 and 2010, we recorded a provision for income taxes of $914,000 and $434,000, respectively. Our income tax provision for each period consisted of amounts necessary to align our year-to-date tax provision with the effective tax rate we expect to achieve for the full year. That rate differs from the U.S. statutory rate primarily as a result of the non-deductibility of certain share-based compensation expense for income tax purposes that has been recognized for financial statement purposes, a foreign tax rate differential and state taxes. Impact of Inflation We do not believe our business is affected by inflation to a greater extent than the general economy. Our products contain a significant amount of plastic that is petroleum based. Additionally, we import most of our products from our principal contract manufacturer, located in China and Mexico, and fuel costs are, therefore, a significant component of transportation costs to obtain delivery of products. Accordingly, the recent increases in petroleum prices are expected to increase the cost of our products. Our products also contain a significant amount of certain precious and semi-precious metals, in particular copper, gold and steel. The continuing increases in the cost of these metals are expected to increase the cost of our products. Increased labor costs in China and Mexico, the countries in which our contract manufacturer produces products for us, could also increase the cost of our products. We monitor the impact of inflation and attempt to adjust prices where market conditions permit, except that we may not increase prices under certain of our general supply agreements with our principal customers. Inflation has not had a significant effect on our operations during any of the reported periods. 18 --------------------------------------------------------------------------------Liquidity and Capital Resources As of June 30, 2011, we had $20,511,000 of working capital, which included $1,294,000 of cash and cash equivalents, and our current ratio was 2.7 to 1. As of December 31, 2010, we had $18,204,000 of working capital, which included $1,635,000 of cash and cash equivalents, and our current ratio was 2.8 to 1. During the six months ended June 30, 2011, our cash flows from operations used $1,852,000, primarily for a $2,993,000 increase in inventory to support our higher sales levels and the need to maintain additional inventory to accommodate anticipated customer orders and supplier lead-time requirements, a $1,763,000 decrease to accounts payable and accrued liabilities related to timing of vendor payments, a $949,000 increase to accounts receivable due to increased sales in the current period resulting from both organic sales growth and sales resulting from both the Copper Products Division and F2O and a $417,000 increase to other assets. This was partially offset by cash profitability before non-cash expenses for depreciation and amortization, deferred taxes and share-based compensation of $3,874,000. During the six months ended June 30, 2010, our cash flows from operations used cash of $1,241,000, primarily to support a $3,889,000 increase in inventory to fulfill anticipated sales and an $2,070,000 increase in accounts receivable due to increased sales, offset, in part, by cash profitability before non-cash expenses for depreciation and amortization, deferred taxes and share-based compensation of $2,062,000 and an increase in accounts payable and accrued liabilities of $2,384,000. Investing activities in the 2011 six month period used cash of $1,460,000, primarily for the acquisition of F2O for $717,000 net of cash acquired and for capital expenditures of $743,000 for tools, molds, dies and equipment used to manufacture new products. In the comparable 2010 period $600,000 was used for capital expenditures and a net $150,000 (after redeeming a $7,000,000 certificate of deposit) paid out for the acquisition of the Copper Products Division. Financing activities in the 2011 six month period provided cash of $2,996,000 primarily from $3,000,000 of short term borrowings under our bank credit facility and from $34,000 of proceeds from stock option exercises. There was no cash provided by or used in financing activities in the first six months of 2010. In December 2010, we entered into an amendment to our bank credit agreement (the "credit agreement") which replaced a $5,000,000 facility that was expiring. Under the credit agreement, we are entitled to borrow from the bank up to $5,000,000 in the aggregate at any one time outstanding, but limited to a borrowing base which, in general, equal to 80% of eligible accounts receivable (as defined), plus the lesser of 30% of eligible inventory (as defined, generally to include, with certain exceptions, inventories at the Company's continental United States warehouse), after certain reserves, or $1,500,000. This amendment extended the agreement through December 31, 2013. As of June 30, 2011, our borrowing base was in excess of the amount available to borrow of $5,000,000. Loans under the credit agreement mature on December 31, 2013. On April 12, 2011, we borrowed $3,000,000 under the credit agreement. Outstanding loans under the credit agreement bear interest, at our option, either at (a) the bank's prime rate, provided that the prime rate shall not be less than an adjusted one-month London Interbank Offered Rate ("LIBOR") (as defined in the credit agreement), or (b) under a formula based on LIBOR plus 1.85% per annum. At June 30, 2011 the interest rate applicable to the outstanding borrowing under the credit agreement was 2.07% per annum. We also pay a commitment fee equal to 0.25% per annum on the average daily unused portion of the credit facility. Our obligations under the credit agreement are collateralized, pursuant to a Continuing Security Agreement, by all of our accounts receivable and inventory, and are also guaranteed by one of our subsidiaries. 19 -------------------------------------------------------------------------------- The credit agreement contains various covenants, including financial covenants and covenants that prohibit or limit a variety of actions without the bank's consent. These include, among other things, covenants that prohibit our payment of dividends and limit our ability to repurchase stock, incur or guarantee indebtedness, create liens, purchase all or a substantial part of the assets or stock of another entity, other than certain permitted acquisitions, create or acquire any subsidiary, or substantially change our business. The amended agreement requires us to maintain, as of the end of each fiscal quarter, tangible net worth and subordinated debt of at least $28,500,000, a ratio of net income before interest expense and taxes for the 12-month period ending with such fiscal quarter to interest expense for the same period of at least 2.25 to 1.00, and a ratio of total liabilities, excluding accounts payable in the ordinary course of business, accrued expenses or losses and deferred revenues or gains, to net income before interest expense, income taxes, depreciation and amortization for the 12-month period ending with the fiscal quarter for which compliance is being determined of not greater than 2.5 to 1.0. As of June 30, 2011, we were in compliance with all financial covenants in the amended agreement. We believe that existing cash, together with internally generated funds and the remaining availability under our line of credit will be sufficient for our working capital requirements and capital expenditure needs for at least the next twelve months and meet our long-term liquidity needs. Seasonality Our operations are subject to seasonal variations primarily due to the fact that our principal products, NIDs, are typically installed on the side of homes. During the hurricane season, sales may increase depending upon the severity and location of hurricanes and the number of NIDs that are damaged and need replacement. Conversely, during winter months when severe weather hinders or delays the Telco's installation and maintenance of their outside plant network, NID sales have been adversely affected until replacements can be installed, at which time sales may increase. Off Balance Sheet Financing We have no off-balance sheet contractual arrangements, as that term is defined in Item 303(a)(4) of Regulation S-K. Critical Accounting Policies, Estimates and Judgments Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments. A summary of our most critical accounting policies can be found in the Management's Discussion and Analysis of Financial Condition and Results of Operation section of our Annual Report on Form 10-K for year ended December 31, 2010, as filed with the Securities Exchange Commission on March 31, 2011. We regularly evaluate items which may impact our critical accounting estimates and judgments. During the three months ended June 30, 2011, we did not change our critical accounting policies. Forward-Looking Statements Certain statements in this Report are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. When used in this Report, words such as "may," "should," "seek," "believe," "expect," "anticipate," "estimate," "project," "intend," "strategy" and similar expressions are intended to identify forward-looking statements regarding events, conditions and financial trends that may affect our future plans, operations, business strategies, operating results and financial position. Forward-looking statements are subject to a number of known and unknown risks and uncertainties that could cause our actual results, performance or achievements to differ materially from those described or implied in the forward-looking statements as a result of several factors, including, but not limited to, those factors discussed below, in our Annual Report on Form 10-K for the year ended December 31, 2010, and in other filings made from time to time with the Securities and Exchange Commission. Among those factors are: 20 --------------------------------------------------------------------------------Relating to our overall business: · exposure to increases in the cost of our products, including increases in the cost of our petroleum-based plastic products and precious and semi-precious metals; · general economic and business conditions, especially as they pertain to the telecommunications industry; · potential changes in customers' spending and purchasing policies and practices, which are effected by customers' internal budgetary allotments that have been, and may continue to be, impacted by the current economic climate; · pressures from customers to reduce pricing without achieving a commensurate reduction in costs; · our ability to market and sell products to new markets beyond our principal copper-based telephone operating company ("Telco") market which has been declining over the last several years, due principally to the impact of alternate technologies; · our ability to timely develop products and adapt our products to address technological changes, including changes in our principal market; · the ability of our contract manufacturer to obtain raw materials and components used in manufacturing our products; · competition in our principal market and new markets into which we have been seeking to expand; · our dependence on, and ability to retain, our "as-ordered" general supply agreements with certain of our principal customers and our ability to win new contracts; · our dependence on third parties for certain product development; · our dependence on products and product components from our China and Mexico contract manufacturer, including on-time delivery that could be interrupted as a result of third party labor disputes, political factors or shipping disruptions, quality control and exposure to changes in costs, including wages, and changes in the valuation of the Chinese Yuan and Mexican Peso; · weather and similar conditions, including the effect of typhoons or hurricanes on our contract manufacturer's facilities in China and Mexico, which can disrupt production; · the effect of hurricanes in the United States which can affect the demand for our products and the effect of harsh winter conditions in the United States which can temporarily disrupt the installation of certain of our products by Telcos; · our ability to attract and retain technologically qualified; and · the availability of financing on satisfactory terms. Relating to our Recent Acquisitions: • our ability to successfully complete the integration of our recently acquired businesses, including their products, sales forces and employees into our business; • our ability to retain the general supply agreements of the acquired Copper Products Division with two significant customers; • our ability to penetrate the markets and customers of the acquired products with our products, and to penetrate our existing markets with the recently acquired products; • our ability to execute our plans with our contract manufacturer to improve gross margins of the products of the acquired Copper Products Division; • the stability of the Pound Sterling and Mexican Peso relative to the U.S. dollar exchange rate. We undertake no obligation to update any forward-looking statement to reflect events after the date of this Report. 21-------------------------------------------------------------------------------- |