Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
The following information should be read in conjunction with the Consolidated Financial
Statements, including the notes thereto, included elsewhere in this Form 10-Q and Managements Discussion and Analysis of Financial Condition and Results of Operations included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2012.
FARO Technologies, Inc. (FARO, the Company, us,
we, or our) has made forward-looking statements in this report (within the meaning of the Private Securities Litigation Reform Act of 1995). Statements that are not historical facts or that describe our plans,
beliefs, goals, intentions, objectives, projections, expectations, assumptions, strategies, or future events are forward-looking statements. In addition, words such as may, will, believe, plan,
should, could, seek, expect, anticipate, intend, estimate, project and similar words, or discussions of our strategy or other intentions, identify
forward-looking statements. Specifically, this Quarterly Report on Form 10-Q contains, among others, forward-looking statements regarding:
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the Companys ability to achieve and maintain profitability;
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the impact of fluctuations in exchange rates;
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market conditions in the regions where the Company operates;
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the effect of estimates and assumptions with respect to critical accounting policies and the impact of the adoption of recently issued accounting
pronouncements;
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the impact of changes in technologies on the competitiveness of the Companys products or their components;
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the magnitude of increased warranty costs from new product introductions and enhancements to existing products;
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the sufficiency of the Companys plants to meet its manufacturing requirements;
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the outcome of litigation and its effect on the Companys business, financial condition or results of operations;
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the continuation of the Companys share repurchase program;
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the sufficiency of the Companys working capital, cash flow from operations, and credit facility to fund its long-term liquidity requirements;
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the impact of geographic changes in the manufacturing or sales of the Companys products on its tax rate; and
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the ability of the Company to comply with the requirements for favorable tax rates in foreign jurisdictions.
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Forward-looking statements are not guarantees of future performance and are subject to a number of known and unknown risks,
uncertainties, and other factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Consequently, undue reliance should not be placed on these forward-looking statements. The
Company does not intend to update any forward-looking statements, whether as a result of new information, future events, or otherwise, unless otherwise required by law. Important factors that could cause actual results to differ materially from
those contemplated in such forward-looking statements include, among others, the following:
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economic downturn in the manufacturing industry or the domestic and international economies in the regions of the world where the Company operates;
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the Companys inability to further penetrate its customer base and target markets;
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development by others of new or improved products, processes or technologies that make the Companys products obsolete or less competitive;
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the Companys inability to maintain its technological advantage by developing new products and enhancing its existing products;
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the Companys inability to successfully identify and acquire target companies or achieve expected benefits from acquisitions that are consummated;
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the cyclical nature of the industries of the Companys customers and material adverse changes in its customers access to liquidity and
capital;
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the market potential for the computer-aided measurement (CAM2) market and the potential adoption rate for the Companys products are
difficult to quantify and predict;
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the inability to protect the Companys patents and other proprietary rights in the United States and foreign countries;
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fluctuations in the Companys annual and quarterly operating results and the inability to achieve its financial operating targets as a result of a
number of factors, including, without limitation (i) litigation and regulatory action brought against the Company, (ii) quality issues with its products, (iii) excess or obsolete inventory, (iv) raw material price fluctuations,
(v) expansion of the Companys manufacturing capability and other inflationary pressures, (vi) the size and timing of customer orders, (vii) the amount of time that it takes to fulfill orders and ship the Companys products,
(viii) the length of the Companys sales cycle to new customers and the time and expense incurred in further penetrating its existing customer base, (ix) increases in operating expenses required for product development and new product
marketing, (x) costs associated with new product introductions, such as product development, marketing, assembly line start-up costs and low introductory period production volumes, (xi) the timing and market acceptance of new products and
product enhancements, (xii) customer order deferrals in anticipation of new products and product enhancements, (xiii) the Companys success in expanding its sales and marketing programs, (xiv) start-up costs associated with
opening new sales offices outside of the United States, (xv) fluctuations in revenue without proportionate adjustments in fixed costs, (xvi) the efficiencies achieved in managing inventories and fixed assets, (xvii) investments in
potential acquisitions or strategic sales, product or other initiatives, (xviii) shrinkage or other inventory losses due to product obsolescence, scrap or material price changes, (xix) adverse changes in the manufacturing industry and
general economic conditions, (xx) compliance with government regulations including health, safety, and environmental matters, and (xxi) other factors noted herein;
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changes in gross margins due to changing mix of products sold and the different gross margins on different products and sales channels;
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the Company may incur additional material costs related to increases in sales of extended product warranties without a corresponding increase in
revenue if actual product failure rates, parts and equipment costs, or service labor costs exceed the Companys estimates;
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the Companys inability to successfully maintain the requirements of Restriction of use of Hazardous Substances (RoHS) and Waste
Electrical and Electronic Equipment (WEEE) compliance in its products;
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the inability of the Companys products to displace traditional measurement devices and attain broad market acceptance;
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the impact of competitive products and pricing in the CAM2 market and the broader market for measurement and inspection devices;
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the effects of increased competition as a result of recent consolidation in the CAM2 market;
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risks associated with expanding international operations, such as fluctuations in currency exchange rates, difficulties in staffing and managing
foreign operations, political and economic instability, compliance with import and export regulations, and the burdens and potential exposure of complying with a wide variety of U.S. and foreign laws and labor practices;
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the loss of the Companys Chief Executive Officer or other key personnel;
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difficulties in recruiting research and development engineers and application engineers;
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the failure to effectively manage the effects of the Companys growth;
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the impact of reductions or projected reductions in government spending, particularly in the defense sector;
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variations in the effective income tax rate and the difficulty in predicting the tax rate on a quarterly and annual basis;
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the loss of key suppliers and the inability to find sufficient alternative suppliers in a reasonable period or on commercially reasonable terms; and
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other risks and uncertainties discussed in Part I, Item 1A. Risk Factors in the Companys Annual
Report on Form 10-K for the year ended December 31, 2012.
Overview
The Company designs, develops, manufactures, markets and supports portable, software driven, 3-D measurement and
imaging systems that are used in a broad range of manufacturing, industrial, building construction and forensic applications. The Companys FaroArm®, FARO Laser ScanArm® and FARO Gage articulated measuring devices, the FARO Laser
Tracker Vantage, the FARO Focus
3D
, the FARO 3D
Imager AMP and their companion CAM2® software, provide for Computer-Aided Design, or CAD-based inspection and/or factory-level statistical process control, and high-density surveying. Together, these products integrate the measurement, quality
inspection, and reverse engineering functions with CAD software to improve productivity, enhance product quality and decrease rework and scrap in the manufacturing process. The Company uses the acronym CAM2 for this process, which stands
for computer-aided measurement.
As of June 29, 2013, the Companys products have been purchased by approximately
15,000 customers worldwide, ranging from small machine shops to such large manufacturing and industrial companies as Audi, Bell Helicopter, Bombadier, Boeing, British Aerospace, Caterpillar, Daimler AG, Ford, General Electric, General Motors, Honda,
Johnson Controls, Komatsu America International, Lockheed Martin, NASA, Nissan, Northrup Grumman, Siemens and Volkswagen, among many others.
The Company derives revenues primarily from the sale of its FaroArm, FARO Laser ScanArm, FARO Gage, FARO Laser Tracker and FARO Focus
3D
measurement equipment, and their related multi-faceted software. Revenue related to these products is generally
recognized upon shipment. In addition, the Company sells one- and three-year extended warranties and training and technology consulting services relating to its products. The Company recognizes the revenue from extended warranties on a straight-line
basis. The Company also receives royalties from licensing agreements for its historical medical technology and recognizes the revenue from these royalties as licensees use the technology.
The Company manufactures its FaroArm, FARO Gage, FARO 3D Imager AMP, and FARO Laser Tracker ION products in the
Companys manufacturing facilities located in Florida and Pennsylvania for customer orders from the Americas, in its manufacturing facility located in Switzerland for customer orders from the Europe/Africa region, and in its manufacturing
facility located in Singapore for customer orders from the Asia/Pacific region. The Company manufactures its FARO
Focus
3D
product in its facility located in Stuttgart,
Germany. The Company expects all its existing plants to have the production capacity necessary to support its volume requirements through 2013.
The Company operates in international markets throughout the world. It maintains sales offices in the United States, Brazil, Mexico, France, Germany, Great Britain, Italy, Netherlands, Poland, Spain,
China, India, Japan, Malaysia, Singapore, Thailand, and Vietnam. The Company manages and reports its global sales in three regions: the Americas, Europe/Africa and Asia/Pacific.
In the six months ended June 29, 2013, 40.7% of the Companys sales were in the Americas compared to 38.5% in the first of six
months of 2012, 33.7% were in the Europe/Africa region compared to 35.0% in the first six months of 2012, and 25.6% were in the Asia/Pacific region compared to 26.5% in the same prior year
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period. In the second quarter of 2013, new order bookings decreased $4.3 million, or 6.1%, to $66.7 million from $71.0 million in the prior year period. New orders in the second quarter of 2013
increased $0.1 million, or 0.4%, in the Americas to $27.5 million from $27.4 million in the prior year period. New orders in the second quarter of 2013 decreased $4.1 million, or 15.9%, to $21.7 million in Europe/Africa from $25.8 million in the
second quarter of 2012. In Asia/Pacific, new orders in the second quarter of 2013 decreased $0.3 million, or 1.7%, to $17.5 million from $17.8 million in the second quarter of 2012.
The Company accounts for wholly owned foreign subsidiaries in the currency of the respective foreign jurisdiction; therefore,
fluctuations in exchange rates may have an impact on inter-company accounts reflected in the Companys consolidated financial statements. The Company is aware of the availability of off-balance sheet financial instruments to hedge exposure to
foreign currency exchange rates, including cross-currency swaps, forward contracts and foreign currency options (see Foreign Exchange Exposure below). However, it does not regularly use such instruments, and none were utilized in 2012 or the six
months ended June 29, 2013.
The Company was profitable in each quarter in the years ended
December 31, 2012, 2011, and 2010. The Company incurred a net loss in the year ended December 31, 2009, primarily as a result of a decrease in product sales. The Company attributes the decrease in product sales principally to the decline
of the global economy. Prior to 2009, the Company had a history of sales and earnings growth and 26 consecutive profitable quarters through December 31, 2008. Its historical sales and earnings growth were the result of a number of factors,
including: continuing market demand for and acceptance of the Companys products, increased sales activity in part through additional sales staff worldwide, new products and product enhancements such as the FARO Edge Arm and FARO Focus
3D
, and the effect of acquisitions. However, the Companys
historical financial performance is not indicative of its future financial performance.
Results of Operations
Three Months Ended June 29, 2013 Compared to the Three Months Ended June 30, 2012
Sales increased by $1.5 million, or 2.3%, to $68.3 million in the three months ended June 29, 2013 from $66.8 million for the three
months ended June 30, 2012. The Companys sales growth continues to be impacted by economic softness in Europe and Asia while there are signs of improvement in the Americas region. Product sales decreased by $0.3 million, or 0.5%, to $55.2
million for the three months ended June 29, 2013 from $55.5 million for the second quarter of 2012. Service revenue increased by $1.8 million, or 16.1%, to $13.1 million for the three months ended June 29, 2013 from $11.3 million in the
same period during the prior year primarily due to an increase in warranty revenue.
Sales in the Americas region increased by
$2.7 million, or 10.5%, to $28.4 million for the three months ended June 29, 2013 from $25.7 million in the three months ended June 30, 2012. Product sales in the Americas region increased by $1.6 million, or 7.7%, to $22.5 million for the
three months ended June 29, 2013 from $20.9 million in the second quarter of the prior year. Service revenue in the Americas region increased by $1.1 million, or 21.7%, to $5.9 million for the three months ended June 29, 2013 from $4.8
million in the same period during the prior year primarily due to an increase in warranty revenue.
Sales in the Europe/Africa
region were $23.2 million for the three months ended June 29, 2013 and the three months ended June 30, 2012. Product sales in the Europe/Africa region decreased by $0.9 million, or 4.3%, to $18.2 million for the three months ended
June 29, 2013 from $19.1 million in the second quarter of the prior year. Service revenue in the Europe/Africa region increased by $0.9 million, or 19.9%, to $5.0 million for the three months ended June 29, 2013 from $4.1 million in the
same period during the prior year primarily due to an increase in warranty revenue.
Sales in the Asia/Pacific region
decreased by $1.2 million, or 6.7%, to $16.7 million for the three months ended June 29, 2013 from $17.9 million in the three months ended June 30, 2012. Product sales in the Asia/Pacific region decreased by $1.1 million, or 6.8%, to
$14.5 million for the three months ended June 29, 2013 from $15.6 million in the second quarter of the prior year. Service revenue in the Asia/Pacific region remained at $2.3 million for the three months ended June 29, 2013 and the three
months ended June 30, 2012.
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Gross profit decreased by $0.2 million, or 0.4%, to $36.9 million for the three months ended
June 29, 2013 from $37.1 million for the three months ended June 30, 2012. Gross margin decreased to 54.0% for the three months ended June 29, 2013 from 55.5% for the three months ended June 30, 2012. The decrease in gross margin
is primarily due to a decrease in gross margin from product sales to 58.5% in the three months ended June 29, 2013 from 59.7% for the three months ended June 30, 2012, primarily as a result of lower average selling prices. Gross margin
from service revenues increased to 35.5% in the three months ended June 29, 2013 from 34.8% for the three months ended June 30, 2012, primarily due to an increase in warranty revenue.
Selling expenses increased by $0.9 million, or 5.5%, to $16.7 million for the three months ended June 29, 2013 from $15.8 million
for three months ended June 30, 2012. This increase was primarily due to an increase in compensation expense of $0.6 million and an increase in travel costs of $0.3 million.
Worldwide sales and marketing headcount increased by 56, or 15.7%, to 413 at June 29, 2013 from 357 at June 30, 2012.
Regionally, the Companys sales and marketing headcount increased by 25, or 24.3%, to 128 from 103 for the Americas; increased by 13, or 10.8%, in Europe/Africa to 133 from 120; and increased by 18, or 13.4%, in Asia/Pacific to 152 from 134.
As a percentage of sales, selling expenses increased to 24.5% of sales in the three months ended June 29, 2013 from
23.7% in the three months ended June 30, 2012. Regionally, selling expenses were 20.8% of sales in the Americas for the quarter, compared to 20.3% of sales in the second quarter of 2012; 30.7% of sales for Europe/Africa for the quarter compared
to 28.8% of sales from the same period in the prior year; and 22.1% of sales for Asia/Pacific for the quarter compared to 22.0% of sales from the same period in the prior year.
General and administrative expenses decreased by $0.3 million, or 3.8%, to $7.8 million for the three months ended June 29, 2013
from $8.1 million for the three months ended June 30, 2012, primarily due to a decrease in legal fees of $1.2 million related to the FCPA matter, offset by an increase in compensation of $0.3 million, an increase in other professional fees of
$0.3 million, and bad debt expenses of $0.2 million.
Depreciation and amortization expense remained at $1.7 million for the
three months ended June 29, 2013 and June 30, 2012.
Research and development expenses increased to $5.2 million for
the three months ended June 29, 2013 from $4.5 million for the three months ended June 30, 2012, primarily as a result of an increase in compensation expense of $0.4 million and subcontractors expense of $0.2 million. Research and
development expenses as a percentage of sales increased to 7.6% for the three months ended June 29, 2013 from 6.8% for the three months ended June 30, 2012.
Other expense (income), net increased by $0.1 million to $0.5 million of expense for the three months ended June 29, 2013, from $0.4 million of expense for the three months ended June 30, 2012,
primarily as a result of an increase in foreign currency transaction losses resulting from changes in foreign exchange rates on the value of current intercompany account balances of the Companys subsidiaries denominated in different
currencies.
Income tax expense decreased by $0.3 million to $1.4 million for the three months ended June 29, 2013 from
$1.7 million for the three months ended June 30, 2012. This decrease was primarily due to a decrease in pretax income. The Companys effective tax rate increased to 27.4% for the three months ended June 29, 2013 from 27.0% in the
prior year period. The Companys tax rate continues to be lower than the statutory tax rate in the United States primarily as a result of favorable tax rates in foreign jurisdictions. However, the Companys tax rate could be impacted
positively or negatively by geographic changes in the manufacturing or sales of its products and the resulting effect on taxable income in each jurisdiction.
Net income decreased by $1.1 million to $3.6 million for the three months ended June 29, 2013 from $4.7 million for the three months ended June 30, 2012 as a result of the factors described
above.
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Six Months Ended June 29, 2013 Compared to the Six Months Ended June 30 2012
Total sales increased by $1.7 million, or 1.3%, to $133.7 million in the six months ended June 29, 2013 from $132.0 million for the
six months ended June 30, 2012. The Companys sales growth continues to be impacted by economic softness in Europe and Asia with improving conditions in the Americas region. Product sales decreased by $2.2 million, or 2.0%, to $107.7
million for the six months ended June 29, 2013 from $109.9 million for the six months ended June 30, 2012. Service revenue increased by $3.9 million, or 17.7%, to $26.0 million for the six months ended June 29, 2013 from $22.1 million
in the same period during the prior year due primarily to an increase in warranty revenue.
Sales in the Americas region
increased by $3.7 million, or 7.3%, to $54.5 million for the six months ended June 29, 2013 from $50.8 million in the six months ended June 30, 2012. Product sales in the Americas region increased by $1.4 million, or 3.4%, to $42.8 million
for the six months ended June 29, 2013 from $41.4 million in the prior year period. Service revenue in the Americas region increased by $2.3 million, or 24.7%, to $11.7 million for the six months ended June 29, 2013 from $9.4 million in
the same period during the prior year, due primarily to an increase in warranty revenue.
Sales in the Europe/Africa region
decreased by $1.1 million, or 2.4%, to $45.1 million for the six months ended June 29, 2013 from $46.2 million in the six months ended June 30, 2012. Product sales in the Europe/Africa region decreased by $2.6 million, or 6.9%, to $35.3
million for the six months ended June 29, 2013 from $37.9 million in the prior year period. Service revenue in the Europe/Africa region increased by $1.5 million, or 17.8%, to $9.8 million for the six months ended June 29, 2013 from $8.3
million in the same period during the prior year due primarily to an increase in warranty revenue.
Sales in the Asia/Pacific
region decreased by $0.9 million, or 2.6%, to $34.1 million for the six months ended June 29, 2013 from $35.0 million in the six months ended June 30, 2012. Product sales in the Asia/Pacific region decreased by $1.0 million, or 3.2%, to
$29.5 million for the six months ended June 29, 2013 from $30.5 million in the prior year period. Service revenue in the Asia/Pacific region increased by $0.1 million, or 2.6%, to $4.6 million for the six months ended June 29, 2013 from
$4.5 million in the same period during the prior year, due primarily to an increase in warranty revenue.
Gross profit
decreased by $0.6 million, or 0.7%, to $73.8 million for the six months ended June 29, 2013 from $74.2 million for the six months ended June 30, 2012. Gross margin decreased to 55.2% for the six months ended June 29, 2013 from 56.3%
for the six months ended June 30, 2012. The decrease in gross margin is primarily due to a decrease in gross margin from product sales to 58.9% in the six months ended June 29, 2013 from 61.0% for the six months ended June 30, 2012
primarily as a result of lower average selling prices and an increase in the sales mix of Laser Scanner product sold to distributors. Gross margin from service revenues increased to 39.8% in the six months ended June 29, 2013 from 32.6% for the
six months ended June 30, 2012.
Selling expenses increased by $1.5 million, or 4.7%, to $33.4 million for the six months
ended June 29, 2013 from $31.9 million for the six months ended June 30, 2012, primarily due to an increase in compensation expense of $0.9 million and an increase in travel related expenses of $0.9 million, offset by a decrease in
marketing and advertising expenses of $0.2 million.
As a percentage of sales, selling expenses increased to 25.0% of sales in
the six months ended June 29, 2013 from 24.2% in the six months ended June 30, 2012. Regionally, selling expenses were 21.2% of sales in the Americas for the six months ended June 29, 2013 compared to 21.3% of sales in the prior year
period; 30.6% of sales for Europe/Africa for the six months ended June 29, 2013 compared to 28.3% of sales from the same period in the prior year; and 23.6% of sales for the six months ended June 29, 2013 compared to 22.8% of sales for
Asia/Pacific from the same period in the prior year.
General and administrative expenses increased by $0.6 million, or 3.9%,
to $15.3 million for the six months ended June 29, 2013 from $14.7 million for the six months ended June 30, 2012, primarily due to an increase in compensation of $1.0 million, bad debt expenses of $0.4 million, and recruiting costs of
$0.3 million, offset by a decrease in professional fees related to the FCPA matter of $1.4 million.
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Depreciation and amortization expenses increased by $0.3 million, or 6.0%, to $3.6 million
for the six months ended July 29, 2013 from $3.3 million for the six months ended June 30, 2012.
Research and
development expenses increased to $10.3 million for the six months ended June 29, 2013 from $8.9 million for the six months ended June 30, 2012, primarily as a result of an increase in compensation expenses of $1.1 million and
subcontractors expense of $0.3 million. Research and development expenses as a percentage of sales increased to 7.7% for the six months ended June 29, 2013 from 6.8% for the six months ended June 30, 2012.
Other expense (income), net increased by $0.4 million to $0.6 million for the six months ended June 29, 2013 from $0.2 million of
expense for the six months ended June 30, 2012, primarily as a result of an increase in foreign exchange transaction losses resulting from changes in foreign exchange rates on the value of current intercompany account balances of the
Companys subsidiaries denominated in different currencies.
Income tax expense decreased by $1.3 million to $2.4
million for the six months ended June 29, 2013 from $3.7 million for the six months ended June 30, 2012. This change was primarily due to a decrease in pretax income. The Companys effective tax rate decreased to 22.6% for the six
months ended June 29, 2013 from 24.2% in the prior year period, primarily as a result of a decrease in taxable income in jurisdictions with higher tax rates and a reduction in the income tax rates of 0.1% and 2.8%, respectively, related to the
tax benefit of the exercise of employee stock options. The effective tax rate for the six months ended June 29, 2013 also included the discrete tax benefit of 4.0% related to the retroactive legislative reinstatement on January 2, 2013 of
the Research and Development tax credit for the year ended December 31, 2012, which is required to be included in the period the reinstatement was enacted into law. The Companys tax rate continues to be lower than the statutory tax rate
in the United States primarily as a result of favorable tax rates in foreign jurisdictions. However, the Companys tax rate could be impacted positively or negatively by geographic changes in the manufacturing or sales of its products and the
resulting effect on taxable income in each jurisdiction.
Net income decreased by $3.3 million to $8.2 million for the six
months ended June 29, 2013 from $11.5 million for the six months ended June 30, 2012 as a result of the factors described above.
Liquidity and Capital Resources
Cash and cash equivalents increased by
$18.1 million to $111.3 million at June 29, 2013, from $93.2 million at December 31, 2012. The increase was primarily attributable to net income and non-cash expenses of $15.5 million, proceeds from stock option exercises of $3.1 million,
and a decrease in working capital of $3.6 million, partially offset by $1.7 million in purchases of equipment and intangible assets for the six months ended June 29, 2013.
On July 11, 2006, the Company entered into a loan agreement providing for an available line of credit of $30.0 million, which was
most recently amended effective March 15, 2012. Loans under the Amended and Restated Loan Agreement, as amended, bear interest at the rate of LIBOR plus a fixed percentage between 1.50% and 2.00% and require the Company to maintain a minimum
cash balance and tangible net worth measured at the end of the Companys fiscal quarters. As of June 29, 2013, the Company was in compliance with all of the covenants under the Amended and Restated Loan Agreement, as amended. The term of
the Amended and Restated Loan Agreement, as amended, extends to March 31, 2015. The Company has not drawn on this line of credit.
The Company believes that its working capital, anticipated cash flow from operations, and credit facility will be sufficient to fund its long-term liquidity requirements for the foreseeable future.
The Company has no off balance sheet arrangements.
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Critical Accounting Policies
The preparation of the Companys consolidated financial statements requires the Companys management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, as well as disclosure of contingent assets and liabilities. The Company bases its estimates on historical experience, along with various other factors
believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Some of these judgments can be
subjective and complex and, consequently, actual results may differ from these estimates under different assumptions or conditions. While for any given estimate or assumption made by the Companys management there may be other estimates or
assumptions that are reasonable, the Company believes that, given the current facts and circumstances, it is unlikely that applying any such other reasonable estimate or assumption would materially impact the financial statements.
In response to the SECs financial reporting release, FR-60, Cautionary Advice Regarding Disclosure About Critical Accounting
Policies, the Company has selected its critical accounting policies for purposes of explaining the methodology used in its calculation, in addition to any inherent uncertainties pertaining to the possible effects on its financial condition.
The critical policies discussed below are the Companys processes of recognizing revenue, the reserve for excess and obsolete inventory, income taxes, the reserve for warranties and goodwill impairment. These policies affect current assets and
operating results and are therefore critical in assessing the Companys financial and operating status. These policies involve certain assumptions that, if incorrect, could have an adverse impact on the Companys operations and financial
position.
Revenue Recognition
Revenue related to the Companys measurement equipment and related software is generally recognized upon shipment, as the Company considers the earnings process complete as of the shipping date.
Revenue from sales of software only is recognized when no further significant production, modification or customization of the software is required and where persuasive evidence of a sales agreement exists, delivery has occurred, and the sales price
is fixed or determinable and deemed collectible. Revenues resulting from sales of comprehensive support, training and technology consulting services are recognized as such services are performed. Extended maintenance plan revenues are recognized on
a straight-line basis over the life of the plan. The Company warrants its products against defects in design, materials and workmanship for one year. A provision for estimated future costs relating to warranty expense is recorded when products are
shipped. Costs relating to extended maintenance plans are recognized as incurred. Revenue from the licensing agreements for the use of the Companys historical technology for medical applications is recognized when the technology is used by the
licensees.
Reserve for Excess and Obsolete Inventory
Since the value of inventory that will ultimately be realized cannot be known with exact certainty, the Company relies upon both past
sales history and future sales forecasts to provide a basis for the determination of the reserve. Inventory is considered obsolete if the Company has withdrawn those products from the market or had no sales of the product for the past 12 months and
has no sales forecasted for the next 12 months. Inventory is considered excess if the quantity on hand exceeds 12 months of expected remaining usage. The resulting obsolete and excess parts are then reviewed to determine if a substitute usage or a
future need exists. Items without an identified current or future usage are reserved in an amount equal to 100% of the FIFO cost of such inventory. The Companys products are subject to changes in technologies that may make certain of its
products or their components obsolete or less competitive, which may increase its historical provisions to the reserve.
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Income Taxes
The Company reviews its deferred tax assets on a regular basis to evaluate their recoverability based upon expected future reversals of deferred tax liabilities, projections of future taxable income over
a two-year period, and tax planning strategies that it might employ to utilize such assets, including net operating loss carryforwards. Based on the positive and negative evidence of recoverability, the Company establishes a valuation allowance
against the net deferred assets of a taxing jurisdiction in which it operates, unless it is more likely than not that it will recover such assets through the above means. In the future, the Companys evaluation of the need for the
valuation allowance will be significantly influenced by its ability to achieve profitability and its ability to predict and achieve future projections of taxable income.
Significant judgment is required in determining the Companys worldwide provision for income taxes. In the ordinary course of operating a global business, there are many transactions for which the
ultimate tax outcome is uncertain. The Company establishes provisions for income taxes when, despite the belief that tax positions are fully supportable, there remain certain positions that do not meet the minimum probability threshold as described
by ASC 740, which is a tax position that is more likely than not to be sustained upon examination by the applicable taxing authority. In the ordinary course of business, the Company and its subsidiaries are examined by various federal, state, and
foreign tax authorities. The Company regularly assesses the potential outcomes of these examinations and any future examinations for the current or prior years in determining the adequacy of its provision for income taxes. The Company assesses the
likelihood and amount of potential adjustments and adjusts the income tax provision, the current tax liability and deferred taxes in the period in which the facts that gave rise to a revision become known.
Reserve for Warranties
The Company establishes at the time of sale a liability for the one year warranty included with the initial purchase price of equipment,
based upon an estimate of the repair expenses likely to be incurred for the warranty period. The warranty period is measured in installation-months for each major product group. The warranty reserve is reflected in accrued liabilities in the
accompanying consolidated balance sheets. The warranty expense is estimated by applying the actual total repair expenses for each product group in the prior period and determining a rate of repair expense per installation-month. This repair rate is
multiplied by the number of installation-months of warranty for each product group to determine the provision for warranty expenses for the period. The Company evaluates its exposure to warranty costs at the end of each period using the estimated
expense per installation-month for each major product group, the number of units remaining under warranty and the remaining number of months each unit will be under warranty. The Company has a history of new product introductions and enhancements to
existing products, which may result in unforeseen issues that increase its warranty costs. While such expenses have historically been within expectations, the Company cannot guarantee this will continue in the future.
Goodwill Impairment
Goodwill represents the excess cost of a business acquisition over the fair value of the net assets acquired. Indefinite-life
identifiable intangible assets and goodwill are not amortized but are tested for impairment. The Company performs an annual review in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine if
the carrying value of the recorded goodwill is impaired. If an asset is impaired, the difference between the value of the asset reflected on the financial statements and its current fair value is recognized as an expense in the period in which the
impairment occurs.
The Company first performs a qualitative assessment to determine whether it is necessary to perform the
two-step goodwill impairment test. If the Company believes, as a result of its qualitative assessment, that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the first and second steps of
the goodwill impairment test are unnecessary.
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If necessary, as a result of the qualitative assessment, the goodwill impairment test is
applied using a two-step approach. In performing the first step, the Company calculates the fair values of the reporting units using discounted cash flows (DCF) of each reporting unit. If the carrying amount of the reporting unit exceeds
the fair value, the second step is performed to measure the amount of the impairment loss, if any. In the second step, the implied fair value of the goodwill is estimated as the fair value of the reporting unit as calculated in the first step, less
the fair values of the net tangible and intangible assets of the reporting unit other than goodwill. If the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized in an amount equal to that excess, not to exceed
the carrying amount of the goodwill. Management has concluded there was no goodwill impairment in the six months ended June 29, 2013 or the year ended December 31, 2012.