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U. S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended SEPTEMBER 30, 2006
or
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission File Number 1-10346
EMRISE CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 77-0226211
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
9485 HAVEN AVENUE, SUITE 100
RANCHO CUCAMONGA, CALIFORNIA 91730
(Address of Principal Executive Offices) (Zip Code)
(909) 987-9220
(Registrant's Telephone Number, Including Area Code)
NOT APPLICABLE
(Former Name, Former Address And Former Fiscal Year,
if Changed Since Last Report)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes | | No |X|
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act):Large Accelerated Filer | | Accelerated Filer | | Non-Accelerated Filed |X|
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes | | No |X|
As of January 17, 2007, there were 38,081,750 shares of the issuer's common
stock, $0.0033 par value, outstanding.
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS............................................ F-1
Condensed Consolidated Balance Sheets as of September 30, 2006
(unaudited) and December 31, 2005........................... F-1
Condensed Consolidated Statements of Operations for the Three
and Nine Months Ended September 30, 2006 and 2005 (restated)
(unaudited)................................................. F-2
Condensed Consolidated Statements of Comprehensive Income for
the Three and Nine Months Ended September 30, 2006 and 2005
(restated) (unaudited)...................................... F-3
Condensed Consolidated Statements of Stockholders' Equity for
the Nine Months Ended September 30, 2006 (unaudited)........ F-4
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 2006 and 2005 (restated)
(unaudited)................................................. F-5
Notes to Condensed Consolidated Financial Statements (restated)
(unaudited)................................................. F-6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS............................. 2
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK..................................................... 22
ITEM 4. CONTROLS AND PROCEDURES......................................... 22
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS............................................... 25
ITEM 1A. RISK FACTORS.................................................... 25
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS..... 25
ITEM 3. DEFAULTS UPON SENIOR SECURITIES................................. 25
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............. 25
ITEM 5. OTHER INFORMATION............................................... 25
ITEM 6. EXHIBITS........................................................ 26
SIGNATURES ........................................................... 27
1
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
EMRISE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
AS OF SEPTEMBER 30, 2006 AND DECEMBER 31, 2005
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
September 30, December 31,
ASSETS 2006 2005
--------------- --------------
(unaudited)
Current assets:
Cash and cash equivalents $ 2,746 $ 4,371
Accounts receivable, net 8,576 9,413
Inventories, net 11,232 10,277
Deferred income taxes 1,473 1,386
Prepaid and other current assets 809 536
--------------- --------------
Total current assets 24,836 25,983
Property, plant and equipment, net 1,998 2,073
Goodwill 12,321 12,066
Intangible assets other than goodwill, net of accumulated
amortization of $646 and $350, respectively 3,642 3,709
Other assets 501 630
--------------- --------------
$ 43,298 $ 44,461
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Borrowings under lines of credit $ 2,625 $ 3,283
Current portion of long-term debt 481 504
Notes payable to stockholders, current portion 500 500
Accounts payable 3,864 4,949
Income taxes payable 400 218
Accrued expenses 4,958 3,571
Total current liabilities 12,828 13,025
Long-term debt, less current portion 509 742
Notes payable to stockholders, less current portion 1,375 1,750
Deferred income taxes 1,108 1,108
Other liabilities 1,025 823
Total liabilities 16,845 17,448
Commitments and contingencies (Notes 8 and 14)
Stockholders' equity:
Common stock, $0.0033 par value. Authorized 150,000,000 shares;
issued and outstanding 38,082,000 and 37,550,000, respectively 126 124
Additional paid-in capital 43,371 42,877
Accumulated deficit (17,166) (15,118)
Accumulated other comprehensive income (loss) 122 (870)
Total stockholders' equity 26,453 27,013
--------------- --------------
$ 43,298 $ 44,461
=============== ==============
See accompanying notes to condensed consolidated financial statements.
F-1
EMRISE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ----------------------------
2005
2006 2005 2006 (restated)(1)
------------ ------------ ------------ -------------
Net sales $ 12,177 $ 11,177 $ 33,728 $ 28,662
Cost of sales 7,499 6,311 20,874 16,555
------------ ------------ ------------ -------------
Gross profit 4,678 4,866 12,854 12,107
Operating expenses:
Selling, general and administrative 4,180 3,292 11,645 9,583
Engineering and product development 796 600 2,410 1,736
------------ ------------ ------------ -------------
Income (loss) from operations (298) 974 (1,201) 788
Other income (expense):
Interest expense (124) (106) (341) (302)
Interest income 13 27 59 136
Other income (expense) (158) (91) (194) 21
------------ ------------ ------------ -------------
Income (loss) before income taxes (567) 804 (1,677) 643
Income tax expense (benefit) 149 (12) 371 3
------------ ------------ ------------ -------------
Net income (loss) $ (716) $ 816 $ (2,048) $ 640
============ ============ ============ =============
Basic income (loss) per share $ (0.02) $ 0.02 $ (0.05) $ 0.02
============ ============ ============ =============
Diluted income (loss) per share $ (0.02) $ 0.02 $ (0.05) $ 0.02
============ ============ ============ =============
------------------
(1) See Notes to Condensed Consolidated Financial Statements--"Note 2--Restatement of Quarterly Financial
Statements."
See accompanying notes to condensed consolidated financial statements.
F-2
EMRISE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(IN THOUSANDS)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ----------------------------
2005
2006 2005 2006 (restated)(1)
------------ ------------ ------------ -------------
Net income (loss) $ (716) $ 816 $ (2,048) $ 640
Other comprehensive loss:
Foreign currency translation adjustment 310 (6) 992 (762)
------------ ------------ ------------ -------------
Comprehensive income (loss) $ (406) $ 810 $ (1,056) $ (122)
============ ============ ============ =============
------------------
(1) See Notes to Condensed Consolidated Financial Statements--"Note 2--Restatement of Quarterly Financial
Statements."
See accompanying notes to condensed consolidated financial statements.
F-3
EMRISE CORPORATION AND SUBSIDIARIES
NINE MONTHS ENDED SEPTEMBER 30, 2006
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(UNAUDITED)
(IN THOUSANDS)
Accumulated
Common Stock Additional Other
----------------------- Paid-In Accumulated Comprehensive
Shares Amount Capital Deficit Income (Loss) Total
---------- ---------- ----------- ----------- --------------- ---------
Balance at December 31, 2005 37,550 $ 124 $ 42,877 $ (15,118) $ (870) $ 27,013
Stock option exercises 181 1 97 -- -- 98
Warrant exercises 351 1 287 -- -- 288
Stock option issuance expense -- -- 95 -- -- 95
Warrants issued for services -- -- 15 -- -- 15
Comprehensive loss -- -- -- (2,048) 992 (1,056)
----------- ----------- --------------- ---------
Balance at September 30, 2006 38,082 $ 126 $ 43,371 $ (17,166) $ 122 $ 26,453
========== ========== =========== =========== =============== =========
See accompanying notes to condensed consolidated financial statements.
F-4
EMRISE CORPORATION AND SUBSIDIARIES
NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (RESTATED)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
Nine Months
Ended September 30,
--------------------------------
2005
2006 (restated)(1)
------------ -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (2,048) $ 640
Adjustments to reconcile net income (loss) to cash used in operating
activities:
Depreciation and amortization 878 596
Provision for inventory obsolescence 1,163 1,090
Deferred taxes (87) (663)
Stock option expense 95 --
Warrants issued for services 15 22
Changes in operating assets and liabilities net of businesses acquired:
Accounts receivable 820 956
Inventories (2,313) (160)
Prepaid and other assets (144) 198
Accounts payable and accrued expenses 686 (3,831)
------------ -------------
Cash used in operating activities (935) (1,152)
------------ -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net purchases of property, plant and equipment (413) (267)
Cash paid for acquisition of Pascall, net of cash acquired -- (9,509)
Cash paid for acquisition of RO, net of cash acquired -- (4,605)
Disposal of property, plant and equipment 52 --
------------ -------------
Cash used in investing activities (361) (14,381)
------------ -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net repayments of current notes payable (658) 2,636
Repayments of long-term debt (256) (882)
Proceeds from long-term debt -- 1,052
Proceeds from issuance common stock offering -- 16,059
Payments of notes to stockholders (375) (374)
Proceeds from exercise of stock options and warrants 385 50
------------ -------------
Cash provided by (used in) financing activities (904) 18,541
------------ -------------
Effect of exchange rate changes on cash 575 (667)
------------ -------------
Net increase (decrease) in cash and cash equivalents (1,625) 2,341
Cash and cash equivalents at beginning of period 4,371 1,057
------------ -------------
Cash and cash equivalents at end of period $ 2,746 $ 3,398
============ =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest $ 314 $ 354
============ =============
Income taxes $ 77 $ 89
============ =============
------------------
(1) See Notes to Condensed Consolidated Financial Statements--"Note 2--Restatement of Quarterly Financial
Statements."
See accompanying notes to condensed consolidated financial statements.
F-5
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BUSINESS
EMRISE Corporation (the "Company"), operates through three wholly-owned
subsidiaries: EMRISE Electronics Corporation ("EMRISE Electronics"), CXR Larus
Corporation ("CXR Larus"), and CXR Anderson Jacobson ("CXR-AJ"). EMRISE
Electronics and its subsidiaries design, develop, manufacture and market
electronic components for defense, aerospace and industrial markets. CXR Larus
and CXR-AJ design, develop, manufacture and market network access and
transmission products and communications test equipment. CXR Larus also engages
in the manufacture and sale of communication timing and synchronization
products. The Company conducts its operations out of various facilities in the
United States, France, the United Kingdom and Japan and organizes itself in two
product line segments: electronic components and communications equipment.
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with the rules and regulations of the
Securities and Exchange Commission and therefore do not include all information
and footnotes necessary for a complete presentation of the financial position,
results of operations and cash flows in conformity with accounting principles
generally accepted in the United States of America.
The unaudited condensed consolidated financial statements do, however,
reflect all adjustments, consisting of only normal recurring adjustments, which
are, in the opinion of management, necessary to state fairly the financial
position as of September 30, 2006 and the results of operations and cash flows
for the related interim periods ended September 30, 2006 and 2005. However,
these results are not necessarily indicative of results for any other interim
period or for the year. It is suggested that the accompanying condensed
consolidated financial statements be read in conjunction with the Company's
audited consolidated financial statements included in its amended annual report
on Form 10-K for the year ended December 31, 2005 filed with the Securities and
Exchange Commission on December 15, 2006.
STOCK-BASED COMPENSATION
ADOPTION OF SFAS 123(R)
Prior to January 1, 2006, the Company accounted for its stock-based
compensation plans under the recognition and measurement provisions of
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and related interpretations, as permitted by Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." The Company did not recognize compensation cost related to stock
options granted to its employees and non-employee directors that had an exercise
price equal to or above the market value of the underlying common stock on the
date of grant in its condensed consolidated statement of income prior to January
1, 2006.
F-6
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
Effective January 1, 2006, the Company adopted the fair value recognition
provisions of SFAS No. 123(R), "Share-Based Payment," and related
interpretations, using the modified prospective transition method. Under that
method, compensation cost recognized in the quarterly period ended September 30,
2006 includes: (a) compensation cost for all share-based awards granted prior
to, but not yet vested as of January 1, 2006, based on the grant-date fair value
estimated in accordance with the original provisions of SFAS No. 123, and (b)
compensation cost for all share-based payments granted beginning January 1,
2006, based on the grant-date fair value estimated in accordance with the
provisions of SFAS 123(R). In accordance with the modified prospective
transition method, results for prior periods have not been restated.
The Black-Scholes option-pricing model was used to estimate the option
fair values. The option-pricing model requires a number of assumptions, of which
the most significant are, expected stock price volatility, the expected
pre-vesting forfeiture rate and the expected option term (the amount of time
from the grant date until the options are exercised or expire). Expected
volatility was calculated based upon actual historical stock price movements
over the most recent periods ending September 30, 2006 equal to the expected
option term. Expected pre-vesting forfeitures were estimated based on actual
historical pre-vesting forfeitures over the most recent periods ending September
30, 2006 for the expected option term.
Prior to the adoption of SFAS No. 123(R), the Company presented any tax
benefits from deductions resulting from the exercise of stock options within
operating cash flows in its condensed consolidated statements of cash flow. SFAS
No. 123(R) requires that the portion of benefits resulting from tax deductions
in excess of recognized compensation (the "excess tax benefits") be presented as
financing cash flows. There were no excess tax benefits for the three months
ended September 30, 2006 and would have been presented as an operating cash
inflow prior to the adoption SFAS No. 123(R) if there were any.
In November 2005, the Financial Accounting Standards Board ("FASB"),
issued FASB Staff Position FAS123(R)-3, Transition Election to Accounting for
the Tax Effects of Share-Based Payment Awards ("FSP"). This FSP requires an
entity to follow either the transition guidance for the
additional-paid-in-capital pool as prescribed in SFAS No. 123(R) or the
alternative transition method as described in the FSP. An entity that adopts
SFAS No. 123(R) using the modified prospective method may make a one-time
election to adopt the transition method described in this FSP. An entity may
take up to one year from the later of its initial adoption of SFAS No. 123(R) or
the effective date of this FSP to evaluate its available transition alternatives
and make its one-time election. This FSP became effective in November 2005. The
Company is still evaluating whether it will adopt the alternative method for
calculating its additional-paid-in-capital pool described in the FSP.
F-7
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
STOCK OPTIONS AS OF THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
The following table summarizes stock options outstanding and changes
during the quarterly period ended September 30, 2006:
WEIGHTED
NUMBER OF AVERAGE
SHARES EXERCISE PRICE
---------- --------------
Options outstanding at January 1, 2006 2,108,000 $ 1.05
Granted 50,000 $ 1.00
Exercised (181,000) $ 0.54
Canceled or forfeited --
----------
Options outstanding at September 30, 2006 1,977,000 $ 1.09
==========
Stock options outstanding and currently exercisable at September 30, 2006
are as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------- --------------------------------
WEIGHTED AVERAGE
NUMBER OF REMAINING WEIGHTED NUMBER OF WEIGHTED
OPTIONS CONTRACTUAL LIFE AVERAGE OPTIONS AVERAGE
RANGE OF EXERCISE PRICES OUTSTANDING (IN YEARS) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
------------------------ ------------- ------------------ ---------------- ------------- ----------------
$0.20 to $1.00 1,186,000 6.04 $ 0.56 1,090,000 $ 0.53
$1.01 to $2.00 780,000 9.13 $ 1.87 705,000 $ 1.92
$3.01 to $4.00 11,000 0.38 $ 3.13 11,000 $ 3.13
------------- -------------
1,977,000 7.23 $ 1.09 1,806,000 $ 1.09
============= =============
Shares available for grant under the Plan as of September 30, 2006 were
365,000.
The fair value of options granted during the three months ended September
30, 2006 was $39,000 at a weighted average per share fair value of $0.78. The
fair value was estimated as of the grant date using the Black-Scholes option
pricing model with the following assumptions: no dividend yield; expected
volatility of 87% in 2006, 88% to 92% in 2005, 92% to 107% in 2004 and 92% in
2003; risk-free interest rate of 3.0% to 4.25%; and average expected lives of
seven years.
As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company
incurred $95,000 in compensation expense during the nine months ended September
30, 2006.
Total estimated unrecognized compensation cost from unvested stock options
as of September 30, 2006 was approximately $101,000, which is expected to be
recognized over a weighted average period of approximately 15 months.
The total intrinsic value, or the difference between the exercise price
and the market price on the date of exercise, of all options exercised during
the nine month period ended September 30, 2006, was approximately $141,000. Cash
received from stock options exercised during the nine month period ended
September 30, 2006 was $98,000. No stock options were exercised during the three
months ended September 30, 2006.
F-8
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
PRO-FORMA STOCK COMPENSATION EXPENSE FOR THE QUARTERLY PERIOD ENDED SEPTEMBER
30, 2005
For the quarterly period ended September 30, 2005, the Company applied the
intrinsic value method of accounting for stock options as prescribed by APB No.
25. Since all options granted during the quarterly period ended September 30,
2005 had an exercise price equal to the closing market price of the underlying
common stock on the grant date, no compensation expense was recognized. If
compensation expense had been recognized based on the estimated fair value of
each option granted in accordance with the provisions of SFAS No. 123, as
amended, our net loss and net loss per share would have been reduced to the
following pro-forma amounts (in thousands, except per share amounts):
Nine Months
Three Months Ended September 30,
Ended September 30, 2005
2005 (restated)
------------------- -------------------
Net income as reported $ 816 $ 640
Deduct: Stock-based compensation expense,
determined under the fair value method (49) (143)
------------------- -------------------
Net income, Pro forma $ 767 $ 497
=================== ===================
Net income per share -- basic, as reported $ 0.02 $ 0.02
=================== ===================
Net income per share -- diluted, as reported $ 0.02 $ 0.02
=================== ===================
Net income per share -- basic, pro forma $ 0.02 $ 0.01
=================== ===================
Net income per share --diluted, pro forma $ 0.02 $ 0.01
=================== ===================
Pro-forma compensation expense under SFAS No. 123, among other
computational differences, does not consider potential pre-vesting forfeitures.
Because of these differences, the pro-forma stock compensation expense presented
above for the prior quarterly period ended September 30, 2005 under SFAS No. 123
and the stock compensation expense recognized during the current quarterly
period ended September 30, 2006 under SFAS 123(R) are not directly comparable.
In accordance with the modified prospective transition method of SFAS 123(R),
the prior comparative quarterly results have not been restated.
F-9
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(2) RESTATEMENT OF QUARTERLY FINANCIAL STATEMENTS
In connection with an internal investigation by the Company's Audit
Committee in response to an inquiry by the staff of the Securities and Exchange
Commission's Division of Enforcement, the Company has determined that during the
quarter ended December 31, 2004, the Company prematurely recognized certain net
sales of communications test equipment units that were not actually delivered to
the customer until the first quarter of 2005 and thus did not meet all
applicable revenue recognition criteria until the first quarter of 2005. The
Company has determined the effect of this premature recognition of revenues on
its previously issued financial statements and has restated the unaudited
quarterly financial information below, reconciling the restatement adjustments
for the first quarterly period in the year ended December 31, 2005. Other than
the restatement of the fourth quarterly period in the year ended December 31,
2004 and the first quarterly period in the year ended December 31, 2005, the
Company did not restate its quarterly financial information for any other
quarterly periods for the years ended December 31, 2004 and 2005.
As Originally Restatement
Nine Months Ended September 30, 2005 Reported Adjustments As Restated
------------------------------------ --------------- ------------- -------------
(in thousands, except per share data)
Net sales $ 28,438 $ 224 $ 28,662
Cost of sales 16,497 58 16,555
Gross profit 11,941 166 12,107
Operating expenses 11,306 13 11,319
Income from operations 635 153 788
Net income $ 487 $ 153 $ 640
Basic and diluted income per share $ 0.01 $ -- $ 0.02
F-10
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(3) EARNINGS (LOSS) PER SHARE
The following table illustrates the computation of basic and diluted
earnings per share (in thousands, except per share amounts):
Three Months Nine Months
Ended September 30, Ended September 30,
----------------------- -----------------------
2005
2006 2005 2006 (restated)
---------- ---------- ---------- ----------
NUMERATOR:
Net income (loss) $ (716) $ 816 $ (2,048) $ 640
---------- ---------- ---------- ----------
Income (loss) attributable to common stockholders $ (716) $ 816 $ (2,048) $ 640
========== ========== ========== ==========
DENOMINATOR:
Weighted average number of common shares
outstanding during the period-basic 38,082 37,456 37,947 37,163
Incremental shares from assumed conversions of
warrants and options -- 1,040 -- 1,195
---------- ---------- ---------- ----------
Adjusted weighted average number of outstanding
shares-diluted 38,082 38,496 37,947 38,358
---------- ---------- ---------- ----------
Basic earnings (loss) per share $ (0.02) $ 0.02 $ (0.05) $ 0.02
========== ========== ========== ==========
Diluted earnings (loss) per share $ (0.02) $ 0.02 $ (0.05) $ 0.02
========== ========== ========== ==========
F-11
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
The following table shows the common stock equivalents that were
outstanding as of September 30, 2006 and 2005 but were not included in the
computation of diluted earnings per share because the options' or warrants'
exercise price was greater than the average market price of the common shares
and, therefore, the effect would have been anti-dilutive:
Number of Exercise Price
Shares Per Share
----------- ----------------
Anti-dilutive common stock options:
As of September 30, 2006 1,200,000 $1.00 - $2.00
As of September 30, 2005 63,000 $1.55 - $3.44
Anti-dilutive common stock warrants:
As of September 30, 2006 4,161,000 $1.30 - $2.00
As of September 30, 2005 3,886,000 $1.73 - $2.00
(4) INVENTORIES
Inventories are summarized as follows (in thousands), net of reserves of
$5,016 and $4,160 as of September 30, 2006 and December 31, 2005, respectively:
September 30, December 31,
2006 2005
-------------- --------------
Raw materials $ 4,785 $ 4,668
Work-in-process 3,677 2,716
Finished goods 2,770 2,893
-------------- --------------
$ 11,232 $ 10,277
============== ==============
(5) REPORTABLE SEGMENTS
The Company has two reportable segments: electronic components and
communications equipment. The electronic components segment operates in the
United States, European and Asian markets and designs, manufactures and markets
digital and rotary switches, electronic power supplies , RF and microwave
components and subsystems and subsystem assemblies. The communications equipment
segment also operates in the United States, European and Asian markets and
designs, manufactures and distributes network access and transmission products,
communications test instruments and network timing and synchronization products.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. The Company evaluates
performance based upon profit or loss from operations before income taxes
exclusive of nonrecurring gains and losses. The Company accounts for
intersegment sales at prices negotiated between the individual segments.
F-12
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
The Company's reportable segments are comprised of operating entities
offering the same or similar products to similar customers. Each segment is
managed separately because each business has different customers and different
design and manufacturing and marketing strategies.
Each segment has business units or components as described in paragraph 30
of SFAS No. 142. Each component has discrete financial information and a
management structure. Following is a description of the Company's segment and
component structure as of September 30, 2006:
REPORTING UNITS WITHIN ELECTRONIC COMPONENTS SEGMENT:
o EMRISE Electronics - Rancho Cucamonga, California: Digitran
Division - manufacturer of digital and rotary switches, and
electronic subsystem assemblies for defense, aerospace and
industrial applications.
o EMRISE Electronics - Monrovia, California: XCEL Circuits
Division - manufacturer of printed circuit boards mostly for
intercompany use but with a small base of outside customers.
o RO Associates Incorporated - Sunnyvale, California -
manufacturer of standard power supplies using proprietary
technology.
o XCEL Japan Ltd. - Tokyo, Japan - reseller of Digitran switches
and other third party electronic components.
o EMRISE Electronics Ltd. - Ashford, Kent, England/Isle of
Wight, England - manufacturer of power supplies and radio
frequency products for defense and aerospace applications and
for a broad range of applications, including in-flight
entertainment systems; this reporting unit also includes XCEL
Power Systems, Ltd., Belix Wound Components Ltd., Pascall
Electronic (Holdings) Limited and Pascall Electronics Limited.
REPORTING UNITS WITHIN COMMUNICATIONS EQUIPMENT SEGMENT:
o CXR Telcom division of CXR Larus - San Jose, California -
manufacturer of telecommunications test equipment for the
field and central office applications.
o Larus division of CXR Larus - San Jose, California -
manufacturer of telecommunications synchronous timing devices
and network access equipment.
o CXR-AJ - Abondant, France - manufacturer of network access and
modem equipment.
F-13
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
There were no differences in the basis of segmentation or in the basis of
measurement of segment profit or loss from the amounts disclosed in the
Company's audited consolidated financial statements included in its amended
annual report on Form 10-K. Selected financial data for each of the Company's
operating segments is shown below (in thousands):
Three Months Nine Months
Three Months Ended Nine Months Ended
Ended September 30, Ended September 30,
September 30, 2005 September 30, 2005
2006 (restated) 2006 (restated)
-------------- -------------- -------------- --------------
SALES TO EXTERNAL CUSTOMERS:
Electronic Components $ 8,552 $ 7,262 $ 24,325 $ 17,488
Communications Equipment 3,625 3,915 9,403 11,174
-------------- -------------- -------------- --------------
Total $ 12,177 $ 11,177 $ 33,728 $ 28,662
============== ============== ============== ==============
INTEREST EXPENSE
Electronic components $ 43 $ 38 $ 142 $ 95
Communications equipment 81 68 199 207
-------------- -------------- -------------- --------------
Total $ 124 $ 106 $ 341 $ 302
============== ============== ============== ==============
DEPRECIATION AND AMORTIZATION
Electronic components $ 235 $ 161 $ 625 $ 372
Communications equipment 55 49 127 183
-------------- -------------- -------------- --------------
Total $ 290 $ 210 $ 752 $ 555
============== ============== ============== ==============
SEGMENT INCOME (LOSS) BEFORE TAX
Electronic components $ 810 $ 1,246 $ 2,366 $ 2,423
Communications equipment (82) 233 (959) 96
-------------- -------------- -------------- --------------
Total $ 728 1,479 $ 1,407 $ 2,519
============== ============== ============== ==============
September 30, December 31,
2006 2005
-------------- --------------
SEGMENT ASSETS:
Electronic components $ 25,912 $ 25,144
Communications equipment 15,415 16,358
-------------- --------------
Total $ 41,327 $ 41,502
============== ==============
F-14
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
The following is a reconciliation of the reportable segment revenues,
profit or loss and assets to the Company's consolidated totals (in thousands):
Three Months Nine Months
Three Months Ended Nine Months Ended
Ended September 30, Ended September 30,
September 30, 2005 September 30, 2005
2006 (restated) 2006 (restated)
-------------- -------------- -------------- --------------
NET SALES:
Total sales for reportable segments $ 10,817 $ 9,962 $ 21,551 $ 17,485
Elimination of intersegment sales -- -- -- --
-------------- -------------- -------------- --------------
Total consolidated net sales $ 10,817 $ 9,962 $ 21,551 $ 17,485
============== ============== ============== ==============
INCOME BEFORE INCOME TAXES
Total income for reportable segments $ 728 $ 1,479 $ 1,407 $ 2,519
Unallocated amounts: (1,295) (675) (3,084) (1,876)
-------------- -------------- -------------- --------------
Net income (loss) before income taxes $ (567) $ 804 $ (1,677) $ 643
============== ============== ============== ==============
INTEREST EXPENSE
Interest expense for reportable
segments $ 124 $ 106 $ 341 $ 302
Other interest expense -- -- -- --
-------------- -------------- -------------- --------------
Total interest expense $ 124 $ 106 $ 341 $ 302
============== ============== ============== ==============
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expense
for reportable segments $ 290 $ 210 $ 752 $ 555
Other depreciation and amortization
expense 11 15 30 41
-------------- -------------- -------------- --------------
Total depreciation and amortization $ 301 $ 225 $ 782 $ 596
============== ============== ============== ==============
September 30, December 31,
2006 2005
-------------- --------------
ASSETS
Total assets for reportable segments $ 41,327 $ 41,502
Other assets 1,971 2,959
-------------- --------------
Total consolidated assets $ 43,298 $ 44,461
============== ==============
(6) NEW ACCOUNTING PRONOUNCEMENTS
New accounting pronouncements are discussed under the heading "Impacts of
New Accounting Pronouncements" in Part I, Item 2 of this report.
F-15
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(7) INCOME TAXES
The effective tax rate for the three-month period ended September 30, 2006
was different than the 34% U.S. statutory rate primarily because of foreign
taxes on foreign source income that cannot be offset by domestic tax loss
carryforwards.
(8) CREDIT FACILITIES
On August 25, 2005, the Company, together with two subsidiaries, CXR
Laurus and EMRISE Electronics, acting as guarantors, obtained a credit facility
from Wells Fargo Bank, N.A. for the Company's U.S. operations. As guarantors,
each of CXR Telcom Corporation and EMRISE Electronics is jointly and severally
liable with the Company for up to $9,000,000. This facility is effective through
September 1, 2006. The credit facility has no prepayment penalty and is subject
to an unused commitment fee equal to 0.25% per annum, payable quarterly based on
the average daily unused amount of the line of credit described in the following
paragraph.
The credit facility provides a $9,000,000 revolving line of credit secured
by accounts receivable, other rights to payment and general intangibles,
inventories and equipment. Borrowings do not need to be supported by specific
receivables or inventory balances unless aggregate borrowings under the line of
credit exceed $3,000,000 at any time (a "conversion event"). The bank increased
this amount from $2,000,000 to $3,000,000 on March 28, 2006. If a conversion
event occurs, the line of credit will covert into a formula-based line of credit
until the borrowings are equal to or less than $3,000,000. The formula generally
provides that the outstanding borrowings under the line of credit may not exceed
an aggregate of 80% of eligible accounts receivable plus 30% of the value of
eligible finished goods inventory. Interest is payable monthly. The interest
rate is variable and is adjusted monthly based on the prime rate. The prime rate
at September 30, 2006 was 8.25%.
The credit facility is subject to various financial covenants on a
consolidated basis, which were updated on November 17, 2005 as follows. The
minimum debt service coverage ratio must be greater than 1.25:1.00 on a trailing
four-quarter basis. "Debt service coverage ratio" is defined as net profit after
taxes, plus depreciation, plus amortization, plus or minus net distributions,
divided by the sum of the current portion of long-term debt plus capitalized
lease payments. The current ratio must be not less than 1.50:1.00, determined as
of each fiscal quarter end. "Current ratio" is defined as total current assets
divided by total current liabilities. Annual net profit after taxes must be
greater than $500,000, determined as of each fiscal quarter end on a rolling
four-quarter basis; provided that the Company may not sustain net loss after tax
in any two consecutive fiscal quarters and no fiscal quarter losses to exceed
$300,000. Total liabilities divided by tangible net worth of the Company must
not at any time be greater than 1.75:1.00, determined as of each fiscal quarter
end. Tangible net worth of the Company must not at any time be less than
$12,000,000 measured at the end of each quarter. "Total liabilities" is defined
as current liabilities plus non-current liabilities, minus subordinated debt.
"Tangible net worth" is defined as stockholders' equity plus subordinated debt,
minus intangible assets.
As of September 30, 2006, the Company had no outstanding balance owing
under the revolving credit line, and the Company had $3,000,000 of availability
on the non-formula based portion of the credit line. As of September 30, 2006,
the Company was not in compliance with the covenant of the credit facility
requiring no quarterly net loss can exceed $300,000.
F-16
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
In the event of a default and continuation of a default, Wells Fargo may
accelerate the payment of the principal balance requiring the Company to pay the
entire indebtedness outstanding on that date. From and after the maturity date
of the note, or any earlier date that all principal owing under the note becomes
due and payable by acceleration or otherwise, the outstanding principal balance
will bear interest until paid in full at an increased rate per annum equal to 4%
above the rate of interest in effect from time to time under the note.
The credit facility also provides for a term loan of $150,000 secured by
equipment, amortizable over 36 months at a variable rate equal to the prime rate
plus 1.5%. The term loan portion of the facility had a balance of $38,000 at
September 30, 2006.
Wells Fargo Bank, N.A. has also provided the Company with credit for the
purchase of new capital equipment when needed of which a balance of $107,000 was
outstanding at September 30, 2006. The interest rate is equal to the 90-day
London InterBank Offered Rate ("LIBOR") (5.373% at September 30, 2006) plus
3.75% per annum. Amounts borrowed under this arrangements are amortized over 60
months from the respective dates of borrowing and are secured by the purchased
equipment.
As of September 30, 2006, the Company had approximately $122,000 of
capital leases outstanding which is included in long term debt in the
accompanying condensed consolidated financial statements.
As of September 30, 2006, the Company's foreign subsidiaries had credit
facilities, including lines of credit and term loans, with Lloyds TSB Bank PLC
("Lloyds TSB") and Lloyds TSB Commercial Finance Limited ("Lloyds") in England,
IFN Finance, a subsidiary of ABN AMRO Holdings, N.V., Banc National de Paris,
Societe Generale in France, and Sogelease and Johnan Shinkin Bank in Japan. At
September 30, 2006, the balances outstanding under the Company's United Kingdom,
France and Japan credit facilities were $1,015,000, $759,000 and $20,000,
respectively.
On July 8, 2005, XPS and Pascall obtained a credit facility with Lloyds.
At the same time, the credit facility of Venture Finance PLC, a subsidiary of
ABN AMRO Holdings, N.V., was terminated, and all debt to Venture Finance PLC was
paid off. The Lloyds facility provides a revolving loan secured by receivables,
with a maximum availability of 2,100,000 British pounds sterling (approximately
U.S. $3,932,000 based on the exchange rate in effect on September 30, 2006). The
annual interest rate on the revolving loan is 1.5% above the Lloyds TSB base
rate. The Lloyds TSB base rate was 4.5% at September 30, 2006. This credit
facility covers a period of 24 months, expiring on July 31, 2007. The financial
covenants include a 50% cap on combined export gross sales of XPS and Pascall
and days sales outstanding of less than 65 days, and the funding balance is
capped at 125% of XPS and Pascall combined gross sales. As of September 30,
2006, the revolving loan had an outstanding balance of $396,000.
F-17
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
On August 26, 2005, XPS entered into an agreement with Lloyds for an
unsecured cashflow loan of 300,000 British pounds sterling (approximately U.S.
$562,000 based on the exchange rate in effect on September 30, 2006), payable
over 12 months. The loan is structured as an overadvance on the previously
negotiated 2,100,000 British pounds sterling revolving loan with Lloyds,
bringing the maximum aggregate commitment on the revolving loan to 2,400,000
British pounds sterling (approximately U.S. $4,493,000 based on the exchange
rate in effect on September 30, 2006). As of September 30, 2006, the revolving
loan had an outstanding balance of $396,000.
The unsecured cashflow loan of 300,000 British pounds sterling is payable
at a rate of 25,000 British pounds sterling per month, the first payment falling
due one month after initial drawdown on the revolving loan. The interest rate is
variable and is adjusted monthly based on the base rate of Lloyds TSB plus 1.9%.
The Lloyds TSB base rate at September 30, 2006 was 4.5%. Lloyds TSB has sole
discretion to switch the details on this overadvance account if Lloyds
determines that we will have difficulty in meeting the specific reductions in
the overadvance account.
On August 26, 2005, EEL, a United Kingdom-based subsidiary of the Company,
entered into an agreement with Lloyds TSB for an unsecured term loan for 500,000
British pounds sterling (equivalent to U.S. $936,000 based on the exchange rate
in effect on September 30, 2006). This loan is repayable in 36 consecutive
monthly installments, representing principal and interest. The interest rate is
variable and is adjusted daily based on the Lloyds TSB base rate plus 2.5%. The
Lloyds TSB base rate at March 31, 2006 was 4.5%. The loan also includes
financial covenants. EEL must maintain consolidated profit before taxation and
interest paid and payable of no less than 500% of the consolidated interest paid
and payable. The Company failed to comply with this covenant and received a
waiver. The Company and the bank are reviewing the covenants for possible
amendment. Additionally, EEL must maintain consolidated profit before taxation,
depreciation, amortization of goodwill and other intangibles and interest paid
and payable of no less than 300% of the consolidated principal repayments and
the consolidated interest paid and payable. As of September 30, 2006, the term
loan had an outstanding balance of $169,000.
In the event of a default, Lloyds may make the loan, including any
outstanding principal and interest which has accrued, repayable on demand. If
any amount payable is not paid when due, EEL must pay an increased interest rate
per annum equal to 3% above the rate of interest in effect from time to time
under the note.
In April 2003, CXR-AJ obtained a credit facility from IFN Finance, a
subsidiary of ABN AMRO N.V. This credit facility is for a maximum of $1,522,000
based on the exchange rate in effect at September 30, 2006 for the conversion of
euros into United States dollars. CXR-AJ also had $76,000 of cash credit lines
with several other banks and $29,000 of term loans with another French bank
outstanding as of September 30, 2006. The IFN Finance facility is secured by
accounts receivable and carries an annual interest rate of 1.6% above the French
"T4M" rate. At September 30, 2006, the French T4M rate was 3.0407%, and this
facility had a balance of $655,000. This facility has no financial performance
covenants.
XCEL Japan Ltd., or XJL, obtained a term loan on November 29, 2002 from
Johnan Shinkin Bank. The loan is amortized over five years, carries an annual
fixed interest rate of 3.25% and is secured by the assets of XJL. The balances
of the loan as of September 30, 2006 were $20,000 as of September 30, 2006 for
the conversion of Japanese Yen into U.S. Dollars, using the exchange rate in
effect. There are no financial performance covenants applicable to this loan.
F-18
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(9) RELATED PARTY TRANSACTIONS
On July 13, 2004, the Company issued two promissory notes to the former
stockholders of Larus Corporation totaling $3,000,000 in addition to paying cash
and issuing shares of common stock and two zero interest short-term notes
totaling $887,500 that were repaid in 2004, in exchange for 100% of the common
stock of Larus Corporation (see Note 11). These notes are subordinated to the
Company's bank debt and are payable in 72 equal monthly payments of principal
totaling $41,667 per month plus interest at the 30-day LIBOR plus 5% with a
maximum interest rate of 7% during the first two years of the term of the notes,
8% during the third and fourth years, and 9% thereafter. At September 30, 2006,
the 30-day LIBOR was 4.84%.
Future maturities of notes payable to stockholders are as follows:
Year Ending
December 31,
------------
2006 $ 125,000
2007 500,000
2008 500,000
2009 500,000
2010 250,000
--------------
$ 1,875,000
==============
Interest paid on these notes in the nine months ended September 30, 2006
and 2005 was $113,000 and $167,000, respectively.
There are no guarantees by officers or fees paid to officers or loans to
or from officers.
(10) JANUARY 2005 PRIVATE PLACEMENT
On January 5, 2005, the Company issued to 17 accredited record holders in
a private offering an aggregate of 12,503,500 shares of common stock at a
purchase price of $1.44 per share and five-year investor warrants to purchase up
to an additional 3,125,875 shares of our common stock at an exercise price of
$1.73 per share, for total proceeds of approximately $18,005,000. The Company
paid cash placement agent fees and expenses of approximately $961,000, and
issued five-year placement warrants to purchase up to an aggregate of 650,310
shares of common stock at an exercise price of $1.73 per share in connection
with the offering. The total warrants issued, representing 3,776,185 shares of
the Company's common stock, have an estimated value of $4,400,000. Additional
costs related to the financing include legal, accounting and consulting fees
that totaled approximately $984,000 through December 31, 2005 including
liquidated damages of $480,000 charged directly to equity as a return of capital
against the gross proceeds of the financing. The Company used a portion of the
proceeds from this financing to fund the acquisition of Pascall described in
Note 11. The Company used the remaining proceeds from this financing for
additional acquisitions and for investments in new products and enhancements to
existing products.
F-19
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
(11) ACQUISITIONS
LARUS CORPORATION ACQUISITION
Pursuant to the terms of a Stock Purchase Agreement executed on July 13,
2004, the Company acquired all of the issued and outstanding common stock of
Larus Corporation. Larus Corporation was based in San Jose, California and
engaged in the manufacturing and sale of telecommunications products. Larus
Corporation had one wholly-owned subsidiary, Vista Labs, Incorporated ("Vista"),
which provided engineering services to Larus Corporation. Assets held by Larus
Corporation included intellectual property, cash, accounts receivable and
inventories owned by each of Larus Corporation and Vista.
The purchase price for the acquisition totaled $6,539,500 and consisted of
$1,000,000 in cash, the issuance of 1,213,592 shares of the Company's common
stock with a fair value of $1,000,000, $887,500 in the form of two short-term,
zero interest promissory notes that were repaid in 2004, $3,000,000 in the form
of two subordinated secured promissory notes, warrants to purchase up to an
aggregate of 150,000 shares of the Company's common stock at $1.30 per share,
and approximately $580,000 of acquisition costs. The warrants to purchase
150,000 shares of common stock were valued at $72,000 using a Black-Scholes
formula that included a volatility of 107.19%, an interest rate of 3.25%, a life
of three years and no assumed dividend.
In addition, the Company assumed $245,000 in accounts payable and accrued
expenses and entered into an above-market real property lease with the sellers.
This lease represents an obligation that exceeds the fair market value by
approximately $756,000 and is part of the acquisition accounting. The cash
portion of the acquisition purchase price was funded with proceeds from the
Company's credit facility with Wells Fargo Bank, N.A. and cash on-hand.
In conjunction with the Company's July 2004 acquisition of Larus
Corporation, the Company commissioned a valuation firm to determine what portion
of the purchase price should be allocated to identifiable intangible assets. The
study is complete and the intangible values are as follows: Larus trade name and
trademark are valued at $750,000 compared to the Company's initial estimate of
$2,800,000, and the technology and customer relationships are valued at
$1,350,000 as compared to the Company's initial estimate of $800,000. Goodwill
associated with the Larus Corporation acquisition totaled $4,043,000. The Larus
trade name and trademark were determined to have indefinite lives and therefore
are not being amortized but rather are being periodically tested for impairment.
The technology and customer relationships were both estimated to have ten-year
lives and, as a result, $162,000 of amortization expense was recorded and
charged to administrative expense in 2005.
PASCALL ACQUISITION
On March 1, 2005, the Company and EEL, a second-tier wholly-owned
subsidiary of the Company, entered into an agreement ("Purchase Agreement") for
EMRISE Electronics to acquire all of the issued and outstanding capital stock of
Pascall Electronic (Holdings) Limited ("PEHL"). The closing of the purchase
occurred on March 18, 2005. The Company loaned to EEL the funds that EEL used to
purchase PEHL. PEHL has one wholly-owned subsidiary, Pascall Electronics Limited
("Pascall"), which produces, designs, develops, manufactures and sells power
supplies and RF products for a broad range of applications, including in-flight
entertainment systems and military programs.
F-20
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
Under the Purchase Agreement, EEL purchased all of the outstanding capital
stock of PEHL, using funds loaned to EEL by the Company. The purchase price for
the acquisition initially totaled $9,669,000, subject to adjustments as
described below, and included a $5,972,000 cash payment to PEHL's former parent,
a $3,082,000 loan to PEHL and Pascall and approximately $615,000 in acquisition
costs, as described below.
The initial portion of the purchase price was 3,100,000 British pounds
sterling (approximately U.S. $5,972,000 based on the exchange rate in effect on
March 18, 2005). The initial portion of the purchase price was paid in cash at
the closing and was subject to upward or downward adjustment on a pound for
pound basis to the extent that the value of the net assets of Pascall as of the
closing date was greater or less than 2,520,000 British pounds sterling.
On May 6, 2005, the Company submitted to Intelek Properties Limited (which
is a subsidiary of Intelek PLC, a London Stock Exchange public limited company,
and is the former parent of PEHL), the Company's calculation of the value of the
net assets of Pascall as of the closing date, which the Company believed
slightly exceeded 2,520,000 British pounds sterling. Ultimately, the parties
determined that the value of the net assets of Pascall at the closing date was
2,650,000 British pounds sterling. As a result, the Company paid to Intelek
Properties Limited 130,000 British pounds sterling (approximately U.S. $236,000
based on the exchange rate in effect at September 30, 2005) on August 1, 2005 to
satisfy this obligation. The purchase price is also subject to downward
adjustments for any payments that may be made to EEL under indemnity, tax or
warranty provisions of the Purchase Agreement. EEL loaned to PEHL and Pascall at
the closing 1,600,000 British pounds sterling (approximately U.S. $3,082,000
based on the exchange rate in effect on March 18, 2005) in accordance with the
terms of a Loan Agreement entered into by those entities at the closing. The
loaned funds were used to immediately repay outstanding intercompany debt owed
by PEHL and Pascall to the seller.
In conjunction with the acquisition of Pascall, the Company commissioned a
valuation firm to determine what portion of the purchase price should be
allocated to identifiable intangible assets. The Company considered whether the
acquisition included various types of identifiable intangible assets, including
trade names, trademarks, patents, covenants not to compete, customers,
workforce, technology and software. The Company has recorded the value of the
trade name and trademark at $500,000, covenants not to compete that were
obtained from Pascall's former affiliates at $200,000, amortizable over three
years and backlog at $200,000 amortizable over two years. The Company believes
that no other identifiable intangible assets of value were acquired. No patents
were acquired. The Company has not ascribed any value to Pascall's customer base
because the Company's United Kingdom subsidiary, XPS already was selling to
Pascall's key customers. Pascall's workforce does not hold any special skills
that are not readily available from other sources. The Company did not identify
any valuable completed technology that was acquired, because Pascall utilizes
non-proprietary technology to produce custom power supplies pursuant to customer
specifications. Pascall does not develop or design software and does not own
software of any material value.
F-21
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
In accordance with the valuation study and taking into consideration
post-closing adjustments, the Company has recorded goodwill associated with the
Pascall acquisition of $4,634,000 compared to the initial goodwill recorded of
$4,571,000.
RO ASSOCIATES ACQUISITION
On September 2, 2005, the Company's wholly-owned subsidiary, EMRISE
Electronics, entered into a stock purchase agreement dated effective as of
August 31, 2005 to acquire RO Associates Incorporated, a California corporation
("RO"). Effective September 28, 2005, EMRISE Electronics entered into an
amendment to the stock purchase agreement.
Pursuant to the terms of the stock purchase agreement, as amended, EMRISE
Electronics acquired all of the issued and outstanding shares of common stock of
RO. Prior to the acquisition, all of the common stock of RO was owned by Robert
H. Okada as Trustee of the Robert H. Okada Trust Agreement dated February 11,
1992, and Sharon Vavro.
The purchase price consisted of $2,400,000 in cash paid at closing and an
additional $600,000 in cash payable in two equal installments on October 6, 2005
and March 31, 2006. The acquisition purchase price was funded with cash on-hand.
The purchase price was subject to adjustment based on the value of the
stockholders' equity, accounts receivable, accounts payable, cash on hand and
net inventory of RO, as determined by the consolidated, unaudited balance sheet
as of August 31, 2005, prepared in accordance with accounting principles
generally accepted in the United States of America. In addition, concurrently
with the closing of the acquisition of RO, EMRISE Electronics paid in full all
then existing credit facilities of RO in the aggregate amount of $1,602,000.
In determining the purchase price for RO, EMRISE Electronics considered
the historical and expected earnings and cash flow of RO, as well as the value
of companies of a size and in an industry similar to RO, comparable transactions
and the market for such companies generally. The purchase price represented a
premium of approximately $2,275,000 over the $2,340,000 recorded net worth of
the assets of RO. In determining this premium, EMRISE Electronics considered the
synergistic and strategic advantages provided by having a United States-based
power conversion manufacturer and the value of the goodwill, customer
relationships and technology of RO. Goodwill associated with the RO acquisition
totaled approximately $1,376,000. The Company commissioned a valuation firm to
determine what portion of the purchase price should be allocated to identifiable
intangible assets. The valuation study of RO's intangibles was completed in
September 2006. The Company initially estimated the intangibles to be valued as
follows: technology, $484,000, trademarks, $300,000 and customer relationships,
$200,000. The valuation study resulted in the following valuations: technology,
$500,000, trademarks, $350,000 and customer relationships, $350,000. The
intangibles were adjusted to the appraised values in the second quarter of 2006.
The technology and customer relationships are being amortized over 10 years on
their appraise values and the trademarks are not being amortized due to the
inability to determine an estimated life.
F-22
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(12) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets by segment as of September 30, 2006
are as follows (in thousands):
Technology Customer
Trademarks and Acquired -- Relationships --
Goodwill -- Trade Names -- 10-Year Life 10-Year Life
Not Amortizable Not Amortizable Amortizable Amortizable
--------------- --------------- ------------- ----------------
GROSS COST
Electronic components $ 6,974 $ 850 $ 500 $ 350
Communications equipment 6,428 750 1,150 200
--------------- --------------- ------------- ----------------
Total $ 13,402 $ 1,600 $ 1,650 $ 550
=============== =============== ============= ================
ACCUMULATED AMORTIZATION
Electronic components $ 209 $ -- $ 54 $ 38
Communications equipment 872 -- 259 45
--------------- --------------- ------------- ----------------
Total $ 1,081 $ -- $ 313 $ 83
=============== =============== ============= ================
CARRYING VALUE
Electronic components $ 6,765 $ 850 $ 446 $ 312
Communications equipment 5,556 750 891 155
--------------- --------------- ------------- ----------------
Total $ 12,321 $ 1,600 $ 1,337 $ 467
=============== =============== ============= ================
Covenant Not
to Compete -- Backlog -- Patents in
3-Year Life 2-Year Life Progress -- Not
Amortizable Amortizable Amortizable
------------- ----------- ---------------
GROSS COST
Electronic components $ 200 $ 200 $ 88
Communications equipment -- --
------------- ----------- ---------------
Total $ 200 $ 200 $ 88
============= =========== ===============
ACCUMULATED AMORTIZATION
Electronic components $ 100 $ 150 $ --
Communications equipment -- -- --
------------- ----------- ---------------
Total $ 100 $ 150 $ --
============= =========== ===============
CARRYING VALUE
Electronic components $ 100 $ 50 $ 88
Communications equipment -- -- --
------------- ----------- ---------------
Total $ 100 $ 50 $ 88
============= =========== ===============
F-23
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
Changes in goodwill by segment (in thousands):
Electronic Communications
Components Equipment Total
-------------- -------------- ---------
Balance at January 1, 2006 $ 6,510 $ 5,556 $ 12,066
Reclassed to leasehold improvements at RO (71) -- (71)
Revaluation of intangibles at RO (216) -- (216)
Foreign currency translation 542 -- 542
-------------- -------------- ---------
Balance September 30, 2006 $ 6,765 $ 5,556 $ 12,321
============== ============== =========
(13) ACCRUED EXPENSES
Accrued expenses were as follows (in thousands):
September 30, December 31,
2006 2005
-------------- --------------
Accrued salaries $ 661 $ 675
Accrued payroll taxes and benefits 969 762
Advance payments from customers 1,463 219
Other accrued expenses 1,865 1,915
-------------- --------------
Total accrued expenses $ 4,958 $ 3,571
============== ==============
(14) SUBSEQUENT EVENTS
STOCK ISSUANCE
In May 2006, the Company determined that its recent periodic filings could
not be relied upon and underwent a reaudit for the years 2003, 2004 and 2005
that had been audited previously. This matter caused the Company's S-3 filing to
become no longer effective and caused the obligation of the Company under the
Registration Rights Agreement to pay 1% liquidated damages to the remaining
shareholders from their remaining shares still owned of the private offering.
Aggregate payments in the amount of $323,135 were made from June through
December 2006. These payments were charged to administrative expenses.
EXECUTIVE MANAGEMENT
On August 18, 2006, the company's Chief Financial Officer, Randolph D.
Foote, resigned from all positions with the Company and its subsidiaries, and
entered into a Resignation and Separation Agreement with the Company, which
became effective on August 25, 2006. Under the agreement, Mr. Foote resigned all
of his positions with the Company, and the Company and Mr. Foote jointly
terminated his employment agreement dated effective as of January 1, 2006. The
agreement provides that effective as of August 21, 2006, Mr. Foote will be
assigned to temporary employment with the Company, which the parties anticipate
will terminate by approximately December 31, 2006. On December 31, 2006, the
F-24
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
Company and Mr. Foote amended the separation agreement to extend Mr. Foote's
temporary employment to March 30, 2007. During the time of his temporary
employment, Mr. Foote will assist the Company in, among other things, the
preparation of the Company's restated financial statements and its filings with
the Securities and Exchange Commission and will continue to receive his base
salary and employment benefits (other than paid vacation benefits, bonus or
incentive compensation).
CREDIT FACILITIES
On September 19, 2006, the Company entered into a Third Amendment to
Credit Agreement effective as of September 1, 2006 with Wells Fargo Bank. The
amendment provided for the waiver by Wells Fargo Bank of certain violations of
financial covenants in the Company's existing credit facility. The amendment
also provided for the reduction in the amount of the credit facility from $9.0
million to $1.5 million and limited borrowings to 80% of eligible accounts
receivable. In connection with the amendment, the Company executed a Revolving
Line of Credit Note dated September 1, 2006 in the amount of $1.5 million. On
October 9, 2006, the Company executed a letter agreement dated effective October
1, 2006 with Wells Fargo Bank extending the maturity date of the $1.5 million
note to October 20, 2006.
On November 13, 2006, Wells Fargo Bank issued a notice of default and
demand for payoff with respect to the $1.5 million note. All obligations under
the note were due and payable on November 20, 2006. On November 24, 2006, the
Company entered into a Forbearance Agreement with Wells Fargo Bank, dated
effective as of November 20, 2006, whereby Wells Fargo Bank agreed to forbear
from exercising its rights under the credit facility as described in the notice
of default and demand for payoff through December 1, 2006. On December 1, 2006,
EMRISE Corporation, EMRISE Electronics, CXR Larus, RO and Wells Fargo Bank
acting through its Wells Fargo Business Credit operating division ("WFBC")
entered into a Credit and Security Agreement providing for a revolving line of
credit and term loan. On December 5, 2006, the Company paid off the $1.5 million
Wells Fargo Bank credit facility in full.
The credit facility with WFBC provides for a $5.0 million revolving line
of credit that expires on December 1, 2009. If WFBC terminates the credit
facility during a default period, or if the Company terminates or reduces the
credit facility prior to the maturity date, or if the Company prepays the term
loan portion of the facility, the Company will be subject to penalties as
follows: if the termination or prepayment occurs during the one year period
after the initial funding date, the penalty is equal to 3% of the maximum line
amount and/or prepayment amount; if the termination or prepayment occurs during
second year after the initial funding date, the penalty is equal to 2% of the
maximum line amount and/or prepayment amount; and if the termination or
prepayment occurs at any time after the second anniversary of the initial
funding date and prior to the maturity date, the penalty is equal to 1% of the
maximum line amount and/or prepayment amount. The credit facility is subject to
an unused line fee equal to 0.25% per annum, payable monthly based on the
average daily unused amount of the line of credit described in the following
paragraph. The credit facility is also subject to a minimum monthly interest
charge of $8,500 with respect to the revolving line of credit.
F-25
EMRISE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006 AND 2005 (RESTATED)
(UNAUDITED)
The WFBC credit facility provides a $5,000,000 revolving line of credit
secured by accounts receivable, other rights to payment and general intangibles,
inventories and equipment. The line of credit is formula-based which generally
provides that the outstanding borrowings under the line of credit may not exceed
an aggregate of 80% of eligible accounts receivable plus 10% of the value of
eligible finished goods inventory. Interest is payable monthly. The interest
rate is variable and is adjusted monthly based on the prime rate plus 1%. The
prime rate at December 1, 2006 was 8.25%.
The credit facility is subject to various financial covenants on a
consolidated basis as follows. The minimum debt service coverage ratio must be
greater than 1.20:1.00 on a trailing quarterly basis. "Debt service coverage
ratio" is defined as net income after taxes, plus depreciation, plus
amortization, plus or minus changes in deferred taxes, minus capital
expenditures and minus any dividends or distributions, divided by the current
maturities of long-term debt paid or scheduled to be paid plus any payments on
subordinated debt. The credit facility also requires that the Company maintain a
minimum book net worth, determined at the end of each calendar month, in an
amount not less than $26,900,000 for the months ended December 31, 2006, January
31, 2007 and February 28, 2007 and of not less than that amount plus 80% of the
Company's net income for each calendar quarter ending on or after March 31, 2007
for each calendar month ending March 31, 2007, and each calendar month
thereafter. The Company must not incur a net loss of greater than $1,150,000 for
2006 and for each quarterly period occurring after December 31, 2006, the
Company's net income must not be less than $0. Management expects that the
Company will not be in compliance with the bank's financial covenants as of
December 31, 2006 and expects to obtain a waiver. If a waiver is not obtained
and the loan is immediately payable, management believes that the Company has
the resources to meet such a requirement.
In the event of a default and continuation of a default, Wells Fargo may
accelerate the payment of the principal balance requiring the Company to pay the
entire indebtedness outstanding on that date. From and after the maturity date
of the credit facility, or any earlier date that all principal owing under the
credit facility becomes due and payable by acceleration or otherwise, the
outstanding principal balance will bear interest until paid in full at an
increased rate per annum equal to 3% above the rate of interest in effect from
time to time under the credit facility.
The credit facility also provides for a term loan of $200,000 secured by
accounts receivable, other rights to payment and general intangibles,
inventories and equipment, amortizable over 36 months at a variable rate equal
to the prime rate plus 1%.
F-26
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion and analysis should be read in conjunction with
our condensed consolidated financial statements and notes to financial
statements included elsewhere in this document. This report and our condensed
consolidated financial statements and notes to financial statements contain
forward-looking statements, which generally include the plans and objectives of
management for future operations, including plans and objectives relating to our
future economic performance and our current beliefs regarding revenues we might
earn if we are successful in implementing our business strategies. The
forward-looking statements and associated risks may include, relate to or be
qualified by other important factors, including, without limitation:
o the projected growth or contraction in the electronic components and
communications equipment markets in which we operate;
o our business strategy for expanding, maintaining or contracting our
presence in these markets;
o our ability to efficiently and effectively integrate and operate the
businesses of our newly-acquired subsidiaries;
o our ability to identify, fund and integrate additional businesses;
o anticipated trends in our financial condition and results of operations;
and
o our ability to distinguish ourselves from our current and future
competitors.
We do not undertake to update, revise or correct any forward-looking
statements.
The information contained in this document is not a complete description
of our business or the risks associated with an investment in our common stock.
Before deciding to buy or maintain a position in our common stock, you should
carefully review and consider the various disclosures we made in this report,
and in our other materials filed with the Securities and Exchange Commission
that discuss our business in greater detail and that disclose various risks,
uncertainties and other factors that may affect our business, results of
operations or financial condition. In particular, you should review our amended
annual report on Form 10-K for the year ended December 31, 2005 filed with the
Securities and Exchange Commission on December 15, 2006, and the "Risk Factors"
we included in that report.
Any of the factors described above could cause our financial results,
including our net income or loss or growth in net income or loss to differ
materially from prior results, which in turn could, among other things, cause
the price of our common stock to fluctuate substantially.
OVERVIEW
GENERAL
We are a leading supplier of timing and synchronization systems, rotary
and digital switches, electronic power supplies and radio frequency, or RF,
devices. We sell our products to communications service providers, defense and
aerospace contractors and industrial customers. We are a multinational company
operating out of facilities located in the United States, United Kingdom, France
and Japan. As of December 31, 2006, we had approximately 300 employees.
2
We are a Delaware corporation that was formed July 14, 1989. We have three
wholly-owned operating subsidiaries, EMRISE Electronics Corporation, a New
Jersey corporation that was formed in 1983 ("EMRISE Electronics"), CXR Larus
Corporation, a Delaware corporation that was formed in 1984 ("CXR Larus"), and
CXR-Anderson Jacobson, a French company that was formed in 1973 ("CXR-AJ").
In December 2004, CXR Larus changed its name from CXR Telcom Corporation
when it succeeded by merger to the assets and liabilities of Larus Corporation,
a San Jose, California-based manufacturer and seller of telecommunications
products, and Vista Labs, Incorporated, a subsidiary of Larus Corporation that
provided engineering services to Larus Corporation. As described in more detail
elsewhere in this report, we acquired Larus Corporation and Vista Labs,
Incorporated in July 2004.
In March 2005, EMRISE Electronics Ltd. ("EEL"), a United Kingdom-based
subsidiary of EMRISE Electronics, acquired Pascall Electronic (Holdings) Limited
("PEHL") and its wholly-owned subsidiary, Pascall Electronics Limited
("Pascall"). Pascall is based in the United Kingdom and manufactures a range of
custom proprietary power systems and radio frequency ("RF") devices.
In September 2005, EMRISE Electronics acquired all of the outstanding
common stock of RO Associates Incorporated ("RO"), a manufacturer of standard
power supplies located in Sunnyvale, California.
Through our operating subsidiaries, CXR Larus, CXR-AJ and EMRISE
Electronics, and through the divisions and subsidiaries of those subsidiaries,
we design, develop, manufacture, assemble, and market products and services in
the following two material business segments:
o Electronic Components
-- digital and rotary switches
-- electronic power supplies
-- RF and microwave devices
o Communications Equipment
-- network access and transmission products
-- communication timing and synchronization products
-- communications test instruments
Sales to customers in the electronic components segment, primarily to
aerospace customers, defense contractors and industrial customers, were
approximately 72.1% and 61.0% of our total net sales during the nine months
ended September 30, 2006 and 2005, respectively. Sales of communications
equipment and related services, primarily to private customer premises and
public carrier customers, were approximately 27.9% and 39.0% of our total net
sales during the nine months ended September 30, 2006 and 2005, respectively.
Sales of our electronic components segment increased $6,838,000 (39.1%)
for the nine months ended September 30, 2006 as compared to the nine months
ended September 30, 2005. Without the increase of sales of $3,796,000 by our new
subsidiary, RO, which we acquired on September 1, 2005, our electronic
components segment sales would have increased by $3,042,000 (17.4%) for the nine
months ended 2006 as compared to the same period in 2005, primarily due to
increased sales of power supplies.
3
We experienced a $644,000 (18.2%) decrease in sales in our communications
equipment segment for the nine months ended September 30, 2006. This decrease
was primarily due to a low demand for our test equipment and timing systems by
the major United States telecommunications companies, a delay in continued
shipments on a long-term United States government infrastructure program due to
customer technical issues, and delays in French military program orders for
network access equipment.
LARUS CORPORATION ACQUISITION
In July 2004, we acquired Larus Corporation. Larus Corporation was a San
Jose, California-based manufacturer and seller of telecommunications products
that had one wholly-owned subsidiary, Vista Labs, Incorporated, or Vista, which
provided engineering services to Larus Corporation. The basic purchase terms of
the acquisition are described below. We consolidated the results of operations
of Larus Corporation beginning from the date of acquisition, July 13, 2004. CXR
Larus' United States-based sales and marketing staff, have secured relationships
with two new major United States-based distributors, Power and Tel and Graybar,
during 2005. We consolidated our CXR Larus subsidiary's operations into Larus
Corporation's facility, which resulted in annual savings in rent and facilities
expense of approximately $250,000 beginning in the third quarter of 2004.
Subsequent to March 31, 2005, we implemented further administrative, engineering
and sales cost savings through staffing reductions of approximately $700,000 on
an annual basis as compared to our costs in the three months ended March 31,
2005. These staffing reductions related to eliminating redundancies in our
electronic components segment personnel (including nine sales, marketing and
administrative positions, one engineering director and the former CXR president)
that occurred as a result of our acquisition of Larus Corporation.
We paid $6,539,500 to acquire the outstanding common stock of Larus
Corporation. As a result, we acquired assets that included intellectual
property, cash, accounts receivable and inventories owned by each of Larus
Corporation and Vista. The purchase price for the acquisition consisted of
$1,000,000 in cash, the issuance of 1,213,592 shares of our common stock with a
fair value of $1,000,000, $887,500 in the form of two short-term, zero interest
promissory notes that were repaid in 2004, $3,000,000 in the form of two
subordinated secured promissory notes, warrants to purchase up to an aggregate
of 150,000 shares of our common stock at $1.30 per share and approximately
$580,000 of acquisition costs. The number of shares of our common stock issued
as part of the purchase price was calculated based on the $0.824 per share
average closing price of our common stock for the five trading days preceding
the transaction. The warrants to purchase 150,000 shares of common stock were
valued at $72,000 using a Black-Scholes formula that included a volatility of
107.19%, an interest rate of 3.25%, a life of three years and no assumed
dividend.
In addition, we assumed $245,000 in accounts payable and accrued expenses
and entered into an above-market real property lease with the sellers. This
lease represents an obligation that exceeds the fair market value by
approximately $756,000 and is part of the acquisition accounting. The cash
portion of the acquisition purchase price was funded with proceeds from our
credit facility with Wells Fargo Bank, N.A. and cash on-hand.
In conjunction with our acquisition of Larus Corporation, we commissioned
a valuation firm to determine what portion of the purchase price should be
allocated to identifiable intangible assets. The study is complete and the
intangible values are as follows: Larus trade name and trademark are valued at
$750,000 compared to our initial estimate of $2,800,000, and the technology and
customer relationships are valued at $1,350,000 as compared to our initial
estimate of $800,000. Goodwill associated with the Larus Corporation acquisition
4
totaled $4,043,000. The Larus trade name and trademark were determined to have
indefinite lives and therefore are not being amortized but rather are being
periodically tested for impairment. The technology and customer relationships
were both estimated to have ten-year lives and, as a result, $162,000 of
amortization expense was recorded and charged to administrative expense in 2005.
PASCALL ACQUISITION
On March 18, 2005, our subsidiary, EEL, purchased all of the outstanding
capital stock of PEHL, the parent holding company of Pascall, using funds loaned
to EEL by EMRISE. The purchase price for the acquisition totaled $9,669,000,
subject to adjustments as described below, and included a $5,972,000 cash
payment to PEHL's former parent, a $3,082,000 loan to PEHL and Pascall and
approximately $615,000 in acquisition costs.
The initial portion of the purchase price was 3,100,000 British pounds
sterling (approximately U.S. $5,972,000 based on the exchange rate in effect on
March 18, 2005). The initial portion of the purchase price was paid in cash and
was subject to adjustment on a pound for pound basis to the extent that the
value of the net assets of Pascall as of the closing date was greater or less
than 2,520,000 British pounds sterling. On May 6, 2005, we submitted to Intelek
Properties Limited (which is a subsidiary of Intelek PLC, a London Stock
Exchange public limited company, and is the former parent of PEHL), our
calculation of the value of the net assets of Pascall as of the closing date,
which we believed slightly exceeded 2,520,000 British pounds sterling.
Ultimately, the parties determined that the value of the net assets of Pascall
at the closing date was 2,650,000 British pounds sterling. As a result, we paid
to Intelek Properties Limited 130,000 British pounds sterling (approximately
U.S. $236,000 based on the exchange rate then in effect) on August 1, 2005 to
satisfy this obligation. The purchase price is also subject to downward
adjustments for any payments that may be made to EEL under indemnity, tax or
warranty provisions of the purchase agreement.
EEL loaned to Pascall and PEHL at the closing 1,600,000 British pounds
sterling (approximately U.S. $3,082,000 based on the exchange rate in effect on
March 18, 2005). The loaned funds were used to immediately repay outstanding
intercompany debt owed by Pascall and PEHL to Intelek Properties Limited.
In conjunction with the acquisition of Pascall, we commissioned a
valuation firm to determine what portion of the purchase price should be
allocated to identifiable intangible assets. We considered whether the
acquisition included various types of identifiable intangible assets, including
trade names, trademarks, patents, covenants not to compete, customers,
workforce, technology and software. We have recorded the value of the trade name
and trademark at $500,000, covenants not to compete that were obtained from
Pascall's former affiliates at $200,000, amortizable over three years and
backlog at $200,000 amortizable over two years. We believe that no other
identifiable intangible assets of value were acquired. No patents were acquired.
We have not ascribed any value to Pascall's customer base because our United
Kingdom subsidiary, XPS, already was selling to Pascall's key customers.
Pascall's workforce does not hold any special skills that are not readily
available from other sources. We did not identify any valuable completed
technology that was acquired, because Pascall utilizes non-proprietary
technology to produce custom power supplies pursuant to customer specifications.
Pascall does not develop or design software and does not own software of any
material value.
In accordance with the valuation study and taking into consideration
post-closing adjustments, we have recorded goodwill associated with the Pascall
acquisition of $4,634,000 compared to the initial goodwill recorded of
$4,571,000.
5
RO ASSOCIATES ACQUISITION
On September 2, 2005, our EMRISE Electronics subsidiary acquired all of
the issued and outstanding shares of common stock of RO, a California
corporation, under the terms of a stock purchase agreement dated effective as of
August 31, 2005 and amended as of September 28, 2005. Prior to the acquisition,
all of the common stock of RO was owned by Robert H. Okada as Trustee of the
Robert H. Okada Trust Agreement dated February 11, 1992, and Sharon Vavro, an
individual.
The purchase price consisted of $2,400,000 in cash paid at closing and an
additional $600,000 in cash payable in two equal installments on October 6, 2005
and March 31, 2006. The acquisition purchase price was funded with cash on-hand.
The purchase price is subject to adjustment based on the value of the
stockholders' equity, accounts receivable, accounts payable, cash on hand and
net inventory of RO, as determined by the consolidated, unaudited balance sheet
as of August 31, 2005, prepared in accordance with accounting principles
generally accepted in the United States of America. In addition, concurrently
with the closing of the acquisition of RO, EMRISE Electronics paid in full all
then existing credit facilities of RO in the aggregate amount of $1,602,000.
In determining the purchase price for RO, EMRISE Electronics considered
the historical and expected earnings and cash flow of RO, as well as the value
of companies of a size and in an industry similar to RO, comparable transactions
and the market for such companies generally. The purchase price represented a
premium of approximately $2,275,000 over the $2,340,000 recorded net worth of
the assets of RO. In determining this premium, EMRISE Electronics considered the
synergistic and strategic advantages provided by having a United States-based
power conversion manufacturer and the value of the goodwill, customer
relationships and technology of RO. Goodwill associated with the RO acquisition
totaled approximately $1,376,000. EMRISE commissioned a valuation firm to
determine what portion of the purchase price should be allocated to identifiable
intangible assets. The valuation study of RO's intangibles was completed in
September 2006. We initially estimated the intangibles to be valued as follows:
technology, $484,000, trademarks, $300,000 and customer relationships, $200,000.
The valuation study resulted in the following valuations: technology, $500,000,
trademarks, $350,000 and customer relationships, $350,000. The intangibles were
adjusted to the appraised values in the second quarter of 2006. The technology
and customer relationships are being amortized over 10 years on their appraise
values and the trademarks are not being amortized due to the inability to
determine an estimated life.
CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of those financial statements requires us to make
estimates and judgments that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of net sales and expenses for
each period. The following represents a summary of our critical accounting
policies, defined as those policies that we believe are the most important to
the portrayal of our financial condition and results of operations and that
require management's most difficult, subjective or complex judgments, often as a
result of the need to make estimates about the effects of matters that are
inherently uncertain.
REVENUE RECOGNITION
We derive revenues from sales of electronic components and communications
equipment products and services. Our sales are based upon written agreements or
purchase orders that identify the type and quantity of the item being purchased
and the purchase price. We recognize revenues when shipment of products has
occurred or services have been rendered, no significant obligations remain on
our part, and collectibility is reasonably assured based on our credit and
collections practices and policies.
6
We recognize revenues from domestic sales of our electronic components and
communications equipment at the point of shipment of those products. Product
returns are infrequent and require prior authorization because our sales are
final and we quality test our products prior to shipment to ensure they meet the
specifications of the binding purchase orders under which they are shipped.
Normally, when a distributor requests and receives authorization to return a
product, the request is accompanied by a purchase order for a replacement
product. When an end-user requests to return a product, we either repair or
replace the product.
Revenue recognition for products and services provided by our United
Kingdom subsidiaries depends upon the type of contract involved.
Engineering/design services contracts generally entail design and production of
a prototype over a term of up to several years, with all revenue deferred until
all services under the contracts have been completed. Production contracts
provide for a specific quantity of products to be produced over a specific
period of time. Customers issue binding purchase orders for each suborder to be
produced. At the time each suborder is shipped to the customer, we recognize
revenue relating to the products included in that suborder. Returns are
infrequent and permitted only with prior authorization because these products
are custom made to order based on binding purchase orders and are quality tested
prior to shipment. Generally, these products carry a one-year limited parts and
labor warranty. We do not offer customer discounts, rebates or price protection
on these products.
We recognize revenues for products sold by our French subsidiary at the
point of shipment. Customer discounts are included in the product price list
provided to the customer. Returns are infrequent and permitted only with prior
authorization because these products are shipped based on binding purchase
orders and are quality tested prior to shipment. Generally, these products carry
a two-year limited parts and labor warranty.
Generally, our electronic components, network access and transmission
products and satellite communication timing and synchronization products carry a
one-year limited parts and labor warranty and our communications test
instruments and European network access and transmission products carry a
two-year limited parts and labor warranty. Products returned under warranty are
tested and repaired or replaced at our option. Historically, warranty repairs
have not been material. We do not offer customer discounts, rebates or price
protection on these products.
Revenues from services such as repairs and modifications are recognized
when the service has been completed and invoiced. For repairs that involve
shipment of a repaired product, we recognize repair revenues when the product is
shipped back to the customer. Service revenues represented approximately 2.6%,
5.7% and 3.1% of net sales during 2005, 2004 and 2003, respectively, and 3.4%
and 3.7% of net sales for the three and nine month periods ending September 30,
2006, respectively.
INVENTORY VALUATION
Our finished goods electronic components inventories generally are built
to order. Our communications equipment inventories generally are built to
forecast, which requires us to produce a larger amount of finished goods in our
communications equipment business so that our customers can promptly be served.
Our products consist of numerous electronic and other parts, which necessitates
that we exercise detailed inventory management. We value our inventory at the
lower of the actual cost to purchase or manufacture the inventory (first-in,
first-out) or the current estimated market value of the inventory (net
7
realizable value). We perform physical inventories at least once a year. We
regularly review inventory quantities on hand and record a provision for excess
and obsolete inventory based primarily on our estimated forecast of product
demand and production requirements for the next twelve months. Additionally, to
determine inventory write-down provisions, we review product line inventory
levels and individual items as necessary and periodically review assumptions
about forecasted demand and market conditions. Any parts or finished goods that
we determine are obsolete, either in connection with the physical count or at
other times of observation, are reserved for and subsequently discarded and
written-off.
In addition, the communications equipment industry is characterized by
rapid technological change, frequent new product development, and rapid product
obsolescence that could result in an increase in the amount of obsolete
inventory quantities on hand. Also, our estimates of future product demand may
prove to be inaccurate, in which case we may have understated or overstated the
provision required for excess and obsolete inventory. Although we make every
effort to ensure the accuracy of our forecasts of future product demand, any
significant unanticipated changes in demand or technological developments could
have a significant impact on the value of our inventory and our reported
operating results.
FOREIGN CURRENCY TRANSLATION
We have foreign subsidiaries that together accounted for approximately
62.7% of our net revenues, 52.3% of our assets and 49.6% of our total
liabilities as of and for the nine months ended September 30, 2006. In preparing
our consolidated financial statements, we are required to translate the
financial statements of our foreign subsidiaries from the currencies in which
they keep their accounting records into United States dollars. This process
results in exchange gains and losses which, under relevant accounting guidance,
are included either within our statement of operations or as a separate part of
our net equity under the caption "accumulated other comprehensive income
(loss)."
Under relevant accounting guidance, the treatment of these translation
gains or losses depends upon our management's determination of the functional
currency of each subsidiary. This determination involves consideration of
relevant economic facts and circumstances affecting the subsidiary. Generally,
the currency in which the subsidiary transacts a majority of its transactions,
including billings, financing, payroll and other expenditures, would be
considered the functional currency. However, management must also consider any
dependency of the subsidiary upon the parent and the nature of the subsidiary's
operations.
If management deems any subsidiary's functional currency to be its local
currency, then any gain or loss associated with the translation of that
subsidiary's financial statements is included as a separate component of
stockholders' equity in accumulated other comprehensive income (loss). However,
if management deems the functional currency to be United States dollars, then
any gain or loss associated with the translation of these financial statements
would be included within our statement of operations.
If we dispose of any of our subsidiaries, any cumulative translation gains
or losses would be realized into our statement of operations. If we determine
that there has been a change in the functional currency of a subsidiary to
United States dollars, then any translation gains or losses arising after the
date of the change would be included within our statement of operations.
Based on our assessment of the factors discussed above, we consider the
functional currency of each of our international subsidiaries as each
subsidiary's local currency. Accordingly, we had cumulative translation gain of
$123,000 and losses of $870,000 that were included as part of accumulated other
8
comprehensive income within our balance sheets at September 30, 2006 and
December 31, 2005, respectively. During the nine months ended September 30, 2006
and 2005, we included translation adjustments of a gain of approximately
$993,000 and a loss of $762,000, respectively, under accumulated other
comprehensive income (loss).
If we had determined that the functional currency of our subsidiaries was
United States dollars, these gains or losses would have decreased or increased
our gain or loss for the three months ended 2006 and 2005. The magnitude of
these gains or losses depends upon movements in the exchange rates of the
foreign currencies in which we transact business as compared to the value of the
United States dollar. These currencies include the euro, the British pound
sterling and the Japanese yen. Any future translation gains or losses could be
significantly higher or lower than those we recorded for these periods.
A $6,469,000 loan payable from EEL to EMRISE was outstanding as of
September 30, 2005. This loan is expected to be outstanding indefinitely.
Therefore, exchange rate losses and gains on this loan are recorded in
cumulative translation gains or losses in the equity section of the balance
sheet.
INTANGIBLES, INCLUDING GOODWILL
We periodically evaluate our intangibles, including goodwill, for
potential impairment. Our judgments regarding the existence of impairment are
based on legal factors, market conditions and operational performance of our
acquired businesses.
In assessing potential impairment of goodwill, we consider these factors
as well as forecasted financial performance of the acquired businesses. If
forecasts are not met, we may have to record additional impairment charges not
previously recognized. In assessing the recoverability of our goodwill and other
intangibles, we must make assumptions regarding estimated future cash flows and
other factors to determine the fair value of those respective assets. If these
estimates or their related assumptions change in the future, we may be required
to record impairment charges for these assets that were not previously recorded.
If that were the case, we would have to record an expense in order to reduce the
carrying value of our goodwill. On January 1, 2002, we adopted Statement of
Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible
Assets," and were required to analyze our goodwill for impairment issues by
September 30, 2002, and then at least annually after that date or more
frequently if an event occurs or circumstances change that would more likely
than not reduce the fair value of a reporting unit below its carrying amount. At
December 31, 2005, the reported goodwill totaled $12,066,000. During 2005, we
did not record any impairment losses related to goodwill and other intangible
assets.
RESULTS OF OPERATIONS
The table presented below, which compares our results of operations for
the three months ended September 30, 2006 to our results of operations for the
three months ended September 30, 2005, presents the results for each period, the
change in those results from one period to another in both dollars and
percentage change, and the results for each period as a percentage of net sales.
The columns present the following:
o The first two data columns show the absolute results for each period
presented.
o The columns entitled "Dollar Variance" and "Percentage Variance" show the
change in results, both in dollars and percentages. These two columns show
favorable changes as a positive and unfavorable changes as negative. For
example, when our net sales increase from one period to the next, that
9
change is shown as a positive number in both columns. Conversely, when
expenses increase from one period to the next, that change is shown as a
negative in both columns.
o The last two columns show the results for each period as a percentage of
net sales.
THREE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2005
RESULTS AS A PERCENTAGE
OF NET SALES FOR THE
THREE MONTHS ENDED DOLLAR PERCENTAGES THREE MONTHS ENDED
SEPTEMBER 30, VARIANCE VARIANCE SEPTEMBER 30,
------------------------ ---------------------------- -------------------------
2005 FAVORABLE FAVORABLE 2005
2006 (RESTATED) (UNFAVORABLE) (UNFAVORABLE) 2006 (RESTATED)
---------- ------------ ------------- ------------- ---------- ------------
(IN THOUSANDS)
Net sales
Electronic components $ 8,553 $ 7,261 $ 1,292 17.8% 70.2% 65.0%
Communications equipment 3,624 3,916 (292) (7.5%) 29.8% 35.0%
---------- ------------ ------------- ------------- ---------- ------------
Total net sales 12,177 11,177 1,000 8.9% 100.0% 100.0%
---------- ------------ ------------- ------------- ---------- ------------
Cost of sales
Electronic components 5,330 4,183 (1,147) (27.4%) 43.8% 37.4%
Communications equipment 2,169 2,128 (41) (1.9%) 17.8% 19.0%
---------- ------------ ------------- ------------- ---------- ------------
Total cost of sales 7,499 6,311 (1,188) (18.8%) 61.6% 56.5%
---------- ------------ ------------- ------------- ---------- ------------
Gross profit
Electronic components 3,223 3,078 145 4.7% 26.5% 27.5%
Communications equipment 1,455 1,788 (333) (18.6%) 11.9% 16.0%
---------- ------------ ------------- ------------- ---------- ------------
Total gross profit 4,678 4,866 (188) (3.9%) 38.4% 43.5%
---------- ------------ ------------- ------------- ---------- ------------
Selling, general and administrative
expenses 4,180 3,292 (888) (27.0%) 34.3% 29.5%
Engineering and product development 796 600 (196) (32.7%) 6.5% 5.4%
---------- ------------ ------------- ------------- ---------- ------------
Operating income (loss) (298) 974 (1,272) 130.6% (2.4%) 8.7%
Interest expense (124) (106) (18) (17.0%) (1.0%) (0.9%)
Interest income 13 27 (14) (51.9%) 0.1% 0.2%
Other income and expense (158) (91) (67) 73.6% (1.3%) (0.8%)
---------- ------------ ------------- ------------- ---------- ------------
Income (loss) before income tax expense (567) 804 (1,371) 170.5% (4.7%) 7.2%
Income tax expense 149 (12) (161) (1,341.7%) 1.2% (0.1%)
---------- ------------ ------------- ------------- ---------- ------------
Net income (loss) $ (716) $ 816 $ (1,532) (187.7%) (5.9%) 7.3%
========== ============ ============= ============= ========== ============
NET SALES. The $1,000,000 increase in total net sales resulted from the
combination of a $1,292,000 increase in net sales of our electronic components
and a $292,000 decrease in net sales of our communications equipment products
and services.
ELECTRONIC COMPONENTS. The increase in net sales of our electronic
components segment resulted primarily from $1,354,000 of power supply sales from
RO, which we acquired on September 1, 2005, an increase in sales of power
supplies of $328,000 at XPS due to the resumption of the Typhoon program and
$201,000 at Pascall due to increased volume of shipments. We also experienced an
increase in sales of switches produced by Emrise Electronics' Digitran Division
of $257,000 (20.1%), to $1,538,000 from $1,281,000 in the prior year period, due
to higher volume. Sales of RF components totaled $780,000 as compared to
$718,000 in the prior year period. Excluding the increased sales contributed by
RO, our net sales for this segment would have been $7,993,000, which represents
a $732,000 (10.2%) increase over net sales of $7,261,000 for, the three months
ended September 30, 2005. This increase was caused by an increase in sales of
power supplies and switches.
10
COMMUNICATIONS EQUIPMENT. The decrease in sales of our communication
equipment segment was largely due to a $514,000 (55.2%) decrease in net sales of
test equipment to $418,000 as compared to $932,000 in the prior period due to
lower sales volume. We also incurred a $630,000 (76.2%) decrease in sales of
synchronous timing systems to $197,000 from $827,000 in the prior year due to
stronger competitive products. However, sales of our U.S.-based network access
products increased $437,000 (80%) to $983,000 from $546,000 in the prior year
period. CXR-AJ experienced a $414,000 increase in net sales of network access
products due to higher volume. We anticipate that sales of our communications
test equipment will be less in 2006 than in 2005. However, we anticipate that
sales of our network access products, both in France and more importantly in the
United States, will grow as new sales channels and our stronger marketing
presence becomes effective and we work to utilize our two new United
States-based distributors we established relationships with during the first
quarter of 2006.
GROSS PROFIT. The decrease in gross profit as a percentage of total net
sales and the dollar decrease in total gross profit resulted from an increase in
gross profit in our electronic components segment that was offset by a decrease
in gross profit in our communications equipment segment.
ELECTRONIC COMPONENTS. Gross profit from our power supply operations in
the U.K. increased $292,000 (17.8%) to $1,933,000 as compared to $1,641,000 in
the prior year period due to increased sales volume. Gross profit from switches
increased slightly by $23,000 to $615,000 from $592,000 in the prior year period
due to product mix. Gross profit from our U.S. power supply operation at RO
decreased $190,000 (30.0%) to $443,000 from $633,000 in the prior year period
due to reduced licensing sales.
COMMUNICATIONS EQUIPMENT. The decrease in gross profit for our
communications equipment segment was primarily due to a $305,000 (52.7%)
decrease in gross profit from test instruments produced by CXR Larus to $274,000
from $579,000 in the prior year due to lower sales. Also, the gross margins of
CXR Larus synchronous timing devises and network access products decreased
$131,000 (24.2%) to $411,000 from $541,000 in the prior period due to lower
per-unit overhead absorption due to lower volume. However, we experienced an
increase of $104,000 (15.6%) in gross profit of CXR-AJ network access products
to $771,000 from $667,000 in the prior year period due to increased sales.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. The $888,000 increase in
selling, general and administrative expenses was primarily due to:
o $704,000 of costs related to reauditing our 2003, 2004 and 2005 financial
statements and restatement of our 2004 and 2005 financial statements.
These costs consist of $440,000 of auditing fees, $132,000 of legal fees
and $132,000 of liquidated damages paid to investors in our January 5,
2005 private equity offering as a result of our failure to maintain
effectiveness of a registration statement covering the resale of their
shares of common stock purchased in the offering; and
o an $84,000 increase in administrative expenses, primarily due to the
inclusion of a full three months of administrative costs for RO and a
$157,000 increase in administrative costs at XPS and Pascall.
11
We anticipate that selling, general and administrative expenses for the
remainder of 2006 will remain at levels higher than those we experienced during
2005 due to continued reauditing costs, the RO acquisition, increased
investments in new products, sales and marketing expenses for our new low
profile rotary and digital switches, increased activity in searching for and
analyzing potential acquisitions, expansion of our investor relations program
and increased corporate governance activities in response to the Sarbanes-Oxley
Act of 2002 and recently adopted rules and regulations of the Securities and
Exchange Commission.
ENGINEERING AND PRODUCT DEVELOPMENT EXPENSES. Engineering and product
development expenses consist primarily of research and product development
activities. The increase in these expenses resulted primarily from a $178,000
(116.3%) increase in the development of an improved satellite synchronous timing
device and the addition of $87,000 in engineering expenses at RO. The increase
was partially offset with a reduction in engineering expenses of test equipment,
switches of $41,000 and $33,000, respectively. We expect this higher level of
expense to continue throughout 2006 as we continue to develop our new satellite
synchronous timing device, our new family of rotary switches and pursue
long-term opportunities in the timing and synchronization market.
INTEREST EXPENSE, NET. Interest expense increased to $124,000 from
$106,000 due to higher interest rates.
INCOME TAX EXPENSE. We have net loss carryforwards for United States
income tax purposes. Our foreign subsidiaries combined have taxable income and a
positive foreign tax provision of $149,000 was recorded.
NET INCOME. A significant contributing factor to our net loss was the
reaudit of our 2003, 2004 and 2005 financial statements and other associated
costs associated with the restatement of our 2004 and 2005 financial statements.
In addition, we made significant investments in product development at CXR
Larus, we experienced a decline in timing system and test instrument sales, and
we experienced lower gross margins at CXR-AJ.
12
NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2005 (RESTATED)
RESULTS AS A PERCENTAGE
OF NET SALES FOR THE
NINE MONTHS ENDED DOLLAR PERCENTAGES THREE MONTHS ENDED
SEPTEMBER 30, VARIANCE VARIANCE SEPTEMBER 30,
------------------------ ---------------------------- -------------------------
2005 FAVORABLE FAVORABLE 2005
2006 (RESTATED) (UNFAVORABLE) (UNFAVORABLE) 2006 (RESTATED)
---------- ------------ ------------- ------------- ---------- ------------
(IN THOUSANDS)
Net sales
Electronic components $ 24,326 $ 17,488 $ 6,838 39.1% 72.1% 61.0%
Communications equipment 9,402 11,174 (1,772) (15.9%) 27.9% 39.0%
---------- ------------ ------------- ------------- ---------- ------------
Total net sales 33,728 28,662 5,066 17.7% 100.0% 100.0%
---------- ------------ ------------- ------------- ---------- ------------
Cost of sales
Electronic components 15,324 10,634 (4,690) (44.1%) 45.4% 37.1%
Communications equipment 5,550 5,921 371 6.3% 16.5% 20.7%
---------- ------------ ------------- ------------- ---------- ------------
Total cost of sales 20,874 16,555 (4,319) (26.1%) 61.9% 57.8%
---------- ------------ ------------- ------------- ---------- ------------
Gross profit
Electronic components 9,002 6,854 2,148 31.3% 26.7% 23.9%
Communications equipment 3,852 5,253 (1,401) (26.7%) 11.4% 18.3%
---------- ------------ ------------- ------------- ---------- ------------
Total gross profit 12,854 12,107 747 6.2% 38.1% 42.2%
---------- ------------ ------------- ------------- ---------- ------------
Selling, general and administrative
expenses 11,645 9,583 (2,062) (21.5%) 34.5% 33.4%
Engineering and product development 2,410 1,736 (674) (38.8%) 7.1% 6.1%
---------- ------------ ------------- ------------- ---------- ------------
Operating income (loss) (1,201) 788 (1,989) (252.4%) (3.6%) 2.7%
Interest expense (341) (302) (39) 12.9% (1.0%) (1.1)%
Interest income 59 136 (77) (56.5%) 0.2% 0.5%
Other income and expense (194) 21 (215) (1,023.8%) (0.6%) 0.1%
---------- ------------ ------------- ------------- ---------- ------------
Income (loss) before income tax expense (1,677) 643 (2,320) 360.8% (5.0%) 2.2%
Income tax expense 371 3 (368) (12,266.7%) 1.1% 0.0%
---------- ------------ ------------- ------------- ---------- ------------
Net income (loss) $ (2,048) $ 640 $ (2,688) 420.0% (6.1%) 2.2%
========== ============ ============= ============= ========== ============
NET SALES. The $5,066,000 increase in total net sales resulted from the
combination of a $6,838,000 increase in net sales of our electronic components
and a $1,772,000 decrease in net sales of our communications equipment products
and services.
ELECTRONIC COMPONENTS. The increase in net sales of our electronic
components segment was attributable to, among other things, an increase of
$3,156,000 in sales of Pascall power supplies and RF components and $3,252,000
in sales of RO power supplies. Because Pascall was acquired on March 18, 2005,
sales attributable to Pascall during the first quarter of 2005 were negligible.
We acquired RO on September 1, 2005 and, as a result, we did not report any RO
sales in the first or second quarter of 2005. We also experienced an increase in
sales of switches produced by Emrise Electronics' Digitran Division of $431,000,
or 9.3%, to $5,060,000 from $4,629,000 in the prior year period due to increased
volume. Excluding the increased total sales contributed by Pascall and RO, our
net sales for this segment would have been $18,268,000 which represents a
$780,000 (4.5%) increase over net sales of $17,488,000 for the nine months ended
September 30, 2005. This increase was primarily caused by a $431,000 increase in
switch sales and a $264,000 increase in power supply sales by XPS.
13
COMMUNICATIONS EQUIPMENT. The decrease in sales of our communication
equipment segment was primarily due to a $1,402,000 (62.7%) decrease in net
sales of test equipment to $834,000 as compared to $2,236,000 in the prior
period due to a delay in expected orders from a government refurbishment
project. We also experienced a decrease in sales of synchronous timing products
of $970,000 (49.8%) to $977,000 as compared to $1,947,000 in the prior year
period due to lower volume. However, we achieved a $601,000 (10.0%) increase in
sales of network access equipment to $6,632,000 from $6,031,000 in the prior
year period. This increase consisted of a $300,000 increase in net sales of
network access products by CXR Larus in the U.S. due to higher volume. CXR-AJ
experienced a $301,000 increase in net sales of network access products.
GROSS PROFIT. The decrease in gross profit as a percentage of total net
sales and the dollar increase in total gross profit resulted from an increase in
gross profit of $2,148,000 in our electronic components segment that was
partially offset by a decrease in gross profit of $1,401,000 in our
communications equipment segment.
ELECTRONIC COMPONENTS. The increase in gross profit for our electronic
components segment was primarily due to contributions from Pascall and RO, which
amounted to $1,410,000 and $463,000, respectively, of the increase. In addition,
gross profit from Digitran, which produces digital and rotary switches,
increased $257,000 (12.4%) to $2,329,000 as compared to $2,072,000 in the prior
year period due to increased sales. Gross profit from XPS's power supply
operations decreased slightly by $60,000 to $1,486,000 from $1,546,000 in the
prior year period due to product mix.
COMMUNICATIONS EQUIPMENT. The decrease in gross profit for our
communications equipment segment was primarily due to a $1,025,000 (72.2%)
decrease in gross profit from test instruments produced by CXR Larus to $394,000
from $1,419,000 in the prior year period due to lower sales. Our gross profit of
CXR Larus synchronous timing devices and network access products decreased by
$109,000 (5.8%) to $1,757,000 as compared to $1,866,000 in the prior year period
due to lower sales volume. We also experienced a reduction of $267,000 (13.6%)
in gross profit of CXR-AJ network access products to $1,701,000 from $1,968,000
in the prior year period due to product mix.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. The increase in selling,
general and administrative expenses was primarily due to:
o costs of $836,000 related to reauditing our 2003, 2004 and 2005 financial
statements and the restatement of our 2004 and 2005 financials statements.
These costs consist of $479,000 of auditing fees, $225,000 of legal fees
and $132,000 of liquidated damages paid to investors in our January 5,
2005 private offering;
o an $801,000 (22.4%) increase in administrative expenses primarily due to
the inclusion of $616,000 and $343,000 of administrative costs for Pascall
and RO, respectively. These increases were partially offset by a $285,000
reduction in administrative expenses in our communication equipment
segment due to layoffs and consolidation of our test equipment business;
and
o approximately $200,000 of expense resulted from increasing an estimated
deferred compensation liability and other miscellaneous items.
ENGINEERING AND PRODUCT DEVELOPMENT EXPENSES. Engineering and product
development expenses consist primarily of engineering and product development
activities. The increase in these expenses resulted primarily from the increase
and inclusion of $104,000 and $274,000 in expenses attributable to Pascall and
RO, respectively. Also, engineering expenses increased by $506,000 (103.1%) at
CXR Larus for the development of a new synchronous timing device. The increases
were partially offset by a reduction in engineering expenses of $87,000 to
$335,000 from $422,000 in the prior year period for rotary switch development.
14
INTEREST EXPENSE, NET. Interest expense increased due to higher interest
rates. Our interest income declined due to the use of cash for the acquisitions
of Pascall and RO.
INCOME TAX EXPENSE. Income tax expense of $371,000 consisted of $301,000
of foreign income tax on our profitable foreign operations and $70,000 state
income and franchise tax. We have net operating loss carryovers available to
apply to U.S. federal taxable income.
NET INCOME. The largest contributor to our $1,469,000 net loss was the
$836,000 in costs we incurred related to the restatement of our 2004 and 2005
financial statements. Also, lower sales of test instruments and synchronous
timing devices at CXR Larus combined with the costs associated with CXR Larus'
engineering program to develop a new and substantially improved timing device by
the end of the third quarter contributed to our loss. These negatives were
partially offset with robust business at our power supply and RF business units
in the U.K. and an improved operating profit for switches as well as power
supplies and RF components.
LIQUIDITY AND CAPITAL RESOURCES
During the nine months ended September 30, 2006, we funded our operations
primarily through revenue generated from our operations and through our existing
and previous lines of credit with Wells Fargo Bank, N.A. and various foreign
banks. During the nine months ended September 30, 2006, we continued to rely on
our foreign credit facilities. In addition, we raised approximately $16,060,000
in net proceeds through a private placement of equity securities in January 2005
as described below to support our acquisition program. As of September 30, 2006,
we had working capital of $12,315,000, as compared to $12,958,000 at December
31, 2005. At September 30, 2006 and December 31, 2005, we had accumulated
deficits of $16,587,000 and $15,118,000, respectively, and cash and cash
equivalents of $2,746,000 and $4,371,000, respectively.
Accounts receivable decreased $837,000 (8.9%) during the first nine months
of 2006 from $9,413,000 as of December 31, 2005 to $8,576,000 as of September
30, 2005 due to higher collections. Days sales outstanding, which is a measure
of our average accounts receivable collection period, decreased from 61 days for
2005 to 59 days for the first nine months of 2006. Our customers include many
Fortune 100 companies in the United States and similarly large companies in
Europe and Asia. Because of the financial strength of our customer base, we
incur few bad debts.
Inventory balances increased $955,000 (9.3%) during the first nine months
of 2006, from $10,277,000 at December 31, 2005 to $11,232,000 at September 30,
2006. Inventory represented 25.8% and 23.1% of our total assets as of September
30, 2006 and December 31, 2005, respectively. Inventory turnover, which is a
ratio that indicates how many times our inventory is sold and replaced over a
specified period, was 2.0, the same as in the same period in 2005.
We took various actions to reduce costs in 2005 and 2004. These actions
were intended to reduce the cash outlays of our communications equipment segment
to match its revenue rate, which was negatively impacted by the
telecommunications downturn of 2002 and 2003. We also have contracted with
offshore manufacturers for production of test equipment at lower prices than our
previous cost for in-house manufacturing. We have also contracted with Hitachi
to outsource the manufacture of our satellite communication timing devices
beginning approximately in the second quarter of 2006. We merged Larus
Corporation with and into CXR Telcom Corporation at the end of 2004 and
integrated their operations.
15
Cash used in our operating activities totaled $935,000 for the first nine
months of 2006 as compared to cash used in operating activities of $1,152,000
for the prior year period. This $217,000 decrease in operating cash flow usage
primarily resulted from a reduction in accrued expenses and debt.
Cash used in our investing activities totaled $361,000 for the first nine
months of 2006 as compared to $14,381,000 for the first nine months of 2005.
Included in the results for 2005 are net cash of $9,509,000 and $4,605,000 used
to acquire Pascall and RO, respectively, including acquisition costs.
Cash used in our financing activities totaled $904,000 for the first nine
months of 2006 as compared to $18,541,000 of cash provided by our financing
activities for the first nine months of 2005. The change is primarily due to the
net proceeds from the issuance of common stock in the January 2005 private
placement.
Outstanding borrowings under our revolving lines of credit were as
follows:
September 30, December 31,
2006 2005
-------------- --------------
Line of credit with a U.S. commercial lender $ -- $ --
Lines of credit with foreign banks 2,625,000 3,283,000
-------------- --------------
$ 2,625,000 $ 3,283,000
============== ==============
On August 25, 2005, we and two of our subsidiaries, CXR Laurus and EMRISE
Electronics, acting as guarantors, obtained a $9,000,000 revolving line of
credit facility from Wells Fargo Bank, N.A. for the our domestic operations. As
guarantors, each of CXR Larus and EMRISE Electronics was jointly and severally
liable with EMRISE for up to $9,000,000. This facility was initially effective
through September 1, 2006. The credit facility had no prepayment penalty and was
subject to an unused commitment fee equal to 0.25% per annum, payable quarterly
based on the average daily unused amount of the line of credit.
As of September 30, 2006, we had no outstanding balance owing under the
revolving credit line, and we had $3,000,000 of availability on the non-formula
based portion of the credit line. As of September 30, 2006, we were in
compliance with each of the covenants of the credit facility. The credit
facility also provides for a term loan of $150,000 secured by equipment,
amortizable over 36 months at a variable rate equal to the prime rate plus 1.5%.
The term loan portion of the facility had a balance of $38,000 at September 30,
2006.
As of September 30, 2006, we had approximately $123,000 of capital leases
outstanding, which amount is included in long term debt in the accompanying
condensed consolidated financial statements.
On September 19, 2006, we entered into a Third Amendment to Credit
Agreement effective as of September 1, 2006 with Wells Fargo Bank. The amendment
provided for the waiver by Wells Fargo Bank of certain violations of financial
covenants in our existing credit facility. The amendment also provided for the
reduction in the amount of the credit facility from $9.0 million to $1.5 million
and limited borrowings to 80% of eligible accounts receivable. In connection
with the amendment, we executed a Revolving Line of Credit Note dated September
1, 2006 in the amount of $1.5 million. On October 9, 2006, we executed a letter
agreement dated effective October 1, 2006 with Wells Fargo Bank extending the
maturity date of the $1.5 million note to October 20, 2006.
16
On November 13, 2006, Wells Fargo Bank issued a notice of default and
demand for payoff with respect to the $1.5 million note. All obligations under
the note were due and payable on November 20, 2006. On November 24, 2006, we
entered into a Forbearance Agreement with Wells Fargo Bank, dated effective as
of November 20, 2006, whereby Wells Fargo Bank agreed to forbear from exercising
its rights under the credit facility as described in the notice of default and
demand for payoff through December 1, 2006. On December 1, 2006, EMRISE
Corporation, EMRISE Electronics, CXR Larus, RO and Wells Fargo Bank acting
through its Wells Fargo Business Credit operating division ("WFBC") entered into
a Credit and Security Agreement providing for a revolving line of credit and
term loan. On December 5, 2006, we paid off the $1.5 million Wells Fargo Bank
credit facility in full.
The credit facility with WFBC provides for a $5.0 million revolving line
of credit that expires on December 1, 2009. If WFBC terminates the credit
facility during a default period, or if we terminate or reduce the credit
facility prior to the maturity date, or if we prepay the term loan portion of
the facility, we will be subject to penalties as follows: if the termination or
prepayment occurs during the one year period after the initial funding date, the
penalty is equal to 3% of the maximum line amount and/or prepayment amount; if
the termination or prepayment occurs during second year after the initial
funding date, the penalty is equal to 2% of the maximum line amount and/or
prepayment amount; and if the termination or prepayment occurs at any time after
the second anniversary of the initial funding date and prior to the maturity
date, the penalty is equal to 1% of the maximum line amount and/or prepayment
amount . The credit facility is subject to an unused line fee equal to 0.25% per
annum, payable monthly based on the average daily unused amount of the line of
credit described in the following paragraph. The credit facility is also subject
to a minimum monthly interest charge of $8,500 with respect to the revolving
line of credit.
The WFBC credit facility provides a $5,000,000 revolving line of credit
secured by accounts receivable, other rights to payment and general intangibles,
inventories and equipment. The line of credit is formula-based which generally
provides that the outstanding borrowings under the line of credit may not exceed
an aggregate of 80% of eligible accounts receivable plus 10% of the value of
eligible finished goods inventory. Interest is payable monthly. The interest
rate is variable and is adjusted monthly based on the prime rate plus 1%. The
prime rate at December 1, 2006 was 8.25%.
The credit facility is subject to various financial covenants on a
consolidated basis as follows. The minimum debt service coverage ratio must be
greater than 1.20:1.00 on a trailing quarterly basis. "Debt service coverage
ratio" is defined as net income after taxes, plus depreciation, plus
amortization, plus or minus changes in deferred taxes, minus capital
expenditures and minus any dividends or distributions, divided by the current
maturities of long-term debt paid or scheduled to be paid plus any payments on
subordinated debt. The credit facility also requires that we maintain a minimum
book net worth, determined at the end of each calendar month, in an amount not
less than $26,900,000 for the months ended December 31, 2006, January 31, 2007
and February 28, 2007 and of not less than that amount plus 80% of our net
income for each calendar quarter ending on or after March 31, 2007 for each
calendar month ending March 31, 2007, and each calendar month thereafter. We
must not incur a net loss of greater than $1,150,000 for 2006 and for each
quarterly period occurring after December 31, 2006, our net income must not be
less than $0. We expect we will not be in compliance with the bank's financial
covenants as of December 31, 2006 and we expect to obtain a waiver. If we do not
obtain a waiver and the loan is immediately payable, we believe that we will
have the resources to meet such a requirement.
In the event of a default and continuation of a default, Wells Fargo may
accelerate the payment of the principal balance requiring us to pay the entire
indebtedness outstanding on that date. From and after the maturity date of the
credit facility, or any earlier date that all principal owing under the credit
facility becomes due and payable by acceleration or otherwise, the outstanding
principal balance will bear interest until paid in full at an increased rate per
annum equal to 3% above the rate of interest in effect from time to time under
the credit facility.
17
The credit facility also provides for a term loan of $200,000 secured by
accounts receivable, other rights to payment and general intangibles,
inventories and equipment, amortizable over 36 months at a variable rate equal
to the prime rate plus 1%.
As of September 30, 2006, our foreign subsidiaries had credit facilities,
including lines of credit and term loans, with Lloyds TSB Bank PLC ("Lloyds
TSB") and Lloyds TSB Commercial Finance Limited ("Lloyds") in England, IFN
Finance, a subsidiary of ABN AMRO Holdings, N.V., Banc National de Paris,
Societe Generale in France, and Sogelease and Johnan Shinkin Bank in Japan. At
September 30, 2006, the balances outstanding under our United Kingdom, France
and Japan credit facilities were $1,486,000, $773,000 and $24,000, respectively.
On July 8, 2005, XPS and Pascall obtained a 24-month credit facility with
Lloyds, which facility expires July 31, 2007. At the same time, the credit
facility of Venture Finance PLC, a subsidiary of ABN AMRO Holdings, N.V., was
terminated and paid off. The Lloyds facility provides a revolving loan secured
by receivables, with a maximum availability of 2,100,000 British pounds sterling
(equivalent of U.S. $3,813,000 based on the exchange rate in effect on September
30, 2006). The annual interest rate on the revolving loan is 1.5% above the
Lloyds TSB base rate. The Lloyds TSB base rate was 4.5% at September 30, 2006.
The financial covenants include a 50% cap on combined export gross sales of XPS
and Pascall and days sales outstanding of less than 65 days, and the funding
balance is capped at 125% of XPS and Pascall combined gross sales. As of
September 30, 2006, the revolving loan had an outstanding balance of $396,000.
On August 26, 2005, XPS entered into an agreement with Lloyds for an
unsecured cashflow loan of 300,000 British pounds sterling (equivalent of U.S.
$545,000 based on the exchange rate in effect on September 30, 2006 payable over
12 months). The loan is structured as an overadvance on the previously
negotiated 2,100,000 British pounds sterling revolving loan with Lloyds,
bringing the maximum aggregate commitment on the revolving loan to 2,400,000
British pounds sterling (equivalent of U.S. $4,358,000 based on the exchange
rate in effect on September 30, 2006). As of September 30, 2006, the total
outstanding balance of the Lloyds loan was $1,015,000 and is included in
borrowings under lines of credit in the accompanying financial statements.
The unsecured cashflow loan of 300,000 British pounds sterling is payable
at a rate of 25,000 British pounds sterling per month, the first payment falling
due one month after initial drawdown on the revolving loan. The interest rate is
variable and is adjusted monthly based on the base rate of Lloyds TSB plus 1.9%.
The Lloyds TSB base rate at September 30, 2006 was 4.5%. Lloyds TSB has sole
discretion to switch the details on this overadvance account if Lloyds
determines that the Company will have difficulty in meeting the specific
reductions in the overadvance account.
On August 26, 2005, EEL entered into an agreement with Lloyds TSB for an
unsecured term loan for 500,000 British pounds sterling (equivalent to U.S.
$936,000 based on the exchange rate in effect on September 30, 2006). This loan
is repayable in 36 consecutive monthly installments of principal and interest.
The interest rate is variable and is adjusted daily based on the Lloyds TSB base
rate plus 2.5%. The Lloyds TSB base rate at September 30, 2006 was 4.5%. The
loan also includes financial covenants. EEL must maintain consolidated profit
before taxation and interest paid and payable of no less than 500% of the
consolidated interest paid and payable. Additionally, EEL must maintain
consolidated profit before taxation, depreciation, amortization of goodwill and
other intangibles and interest paid and payable of no less than 300% of the
consolidated principal repayments and the consolidated interest paid and
payable. As of June 30, 2006, the term loan had an outstanding balance of
$619,000.
18
In the event of a default, Lloyds TSB may make the loan, including any
outstanding principal and interest which has accrued, repayable on demand. If
any amount payable is not paid when due, EEL shall pay an increased interest
rate per annum equal to 3% above the rate of interest in effect from time to
time under the note.
In April 2003, CXR-AJ obtained a credit facility from IFN Finance, a
subsidiary of ABN AMRO N.V. This credit facility is for a maximum of $1,522,000
based on the exchange rate in effect at September 30, 2006 for the conversion of
euros into United States dollars. CXR-AJ also had $76,000 of cash credit lines
with several other banks and $29,000 of term loans with another French bank
outstanding as of March 31, 2006. The IFN Finance facility is secured by
accounts receivable and carries an annual interest rate of 1.6% above the French
"T4M" rate. At September 30, 2006, the French T4M rate was 3.0407%, and this
facility had a balance of $655,000. This facility has no financial performance
covenants.
XCEL Japan Ltd., or XJL, obtained a term loan on November 29, 2002 from
Johnan Shinkin Bank. The loan is amortized over five years, carries an annual
fixed interest rate of 3.25% and is secured by the assets of XJL. The balances
of the loan as of September 30, 2006 were $20,000 as of September 30, 2006 for
the conversion of Japanese Yen into U.S. Dollars, using the exchange rate in
effect. There are no financial performance covenants applicable to this loan.
Our backlog was $27,613,000 as of September 30, 2006 as compared to
$25,098,000 as of September 30, 2005. The increase in backlog of $2,515,000 was
primarily due to the increase of $1,182,000 of backlog for XPS and Pascall in
the U.K. and $430,000 for our Digitran Division. Our backlog as of September 30,
2006 was 94.1% related to our electronic components business, which business
tends to provide us with long lead-times for our manufacturing processes due to
the custom nature of the products, and 5.9% related to our communications
equipment business, which business tends to deliver standard products from stock
as orders are received. The amount of backlog orders represents revenue that we
anticipate recognizing in the future, as evidenced by purchase orders and other
purchase commitments received from customers, but on which work has not yet been
initiated or with respect to which work is currently in progress. However, there
can be no assurance that we will be successful in fulfilling such orders and
commitments in a timely manner or that we will ultimately recognize as revenue
the amounts reflected as backlog.
As described above under the heading "Overview," we acquired Larus
Corporation and Vista in July 2004. The $6,539,500 purchase price consisted of
$1,000,000 in cash, the issuance of 1,213,592 shares of our common stock with a
fair value of $1,000,000, $887,500 in the form of two short-term, zero interest
promissory notes that were repaid in 2004, $3,000,000 in the form of two
subordinated secured promissory notes, warrants to purchase up to an aggregate
of 150,000 shares of our common stock at $1.30 per share, and approximately
$580,000 of acquisition costs. In addition, we assumed $245,000 worth of
accounts payable and accrued expenses and entered into an above-market
seven-year real property lease with the sellers. This lease represents an
obligation that exceeds the fair market value by approximately $756,000 and is
part of the acquisition accounting. We funded the cash portion of the purchase
price using proceeds from our prior credit facility with Wells Fargo Bank and
our cash on-hand.
19
On January 5, 2005, we issued to 17 accredited record holders in a private
offering an aggregate of 12,503,500 shares of common stock at a purchase price
of $1.44 per share and five-year investor warrants to purchase up to an
additional 3,125,875 shares of our common stock at an exercise price of $1.73
per share, for a total purchase price of $18,005,000. We paid cash placement
agent fees and expenses of approximately $961,000, and issued five-year
placement warrants to purchase up to an aggregate of 650,310 shares of common
stock at an exercise price of $1.73 per share in connection with the offering.
Additional costs related to the financing include registration rights-related
liquidated damages of $480,000 and legal, accounting and consulting fees that
totaled approximately $984,000 through December 31, 2005.
We agreed to register for resale the shares of common stock issued to
investors and the shares of common stock issuable upon exercise of the investor
warrants and placement warrants. The registration obligations require, among
other things, that a registration statement be declared effective no later than
September 4, 2005. We were unable to meet this obligation and therefore paid to
each investor liquidated damages equal to 1% of the amount paid by the investor
to us in the offering, which damage payments totaled an aggregate of
approximately $180,000. We also paid to the investors liquidated damages
totaling $300,000 for the period from September 5, 2005 through September 30,
2005, the date the registration statement was declared effective. We also will
be required to pay to each investor liquidated damages for any future periods in
which we are unable to maintain the effectiveness of the registration in
accordance with the requirements contained in the registration rights agreement
we entered into with the investors. These liquidated damages would be, and the
liquidated damages paid for the period from September 5, 2005 through September
30, 2005 were, equal to 2% of the amount paid by each investor for the common
shares still owned by the investor on each monthly anniversary of the date of
the default that occurs prior to the cure of the default, pro rated on a daily
basis for periods of default shorter than one month. The maximum aggregate
liquidated damages payable to any investor will be equal to 10% of the aggregate
amount paid by the investor for the shares of our common stock. Accordingly, the
maximum aggregate penalty that we would be required to pay under this provision
is 10% of the $18,005,000 initial purchase price of the common stock, which
would be $1,801,000.
On May 5, 2006, our audit committee concluded that our financial
statements for the years ended December 31, 2005 and 2004 and the interim
periods during 2005 and 2004 should no longer be relied upon. The audit
committee reached this conclusion after having discussions with our former
independent registered public accountants and management as part of an
investigation conducted by the audit committee in response to an inquiry by the
staff of the Securities and Exchange Commission's Division of Enforcement. As a
result of the audit committee's conclusion regarding our financial statements,
on May 9, 2006, the registration statement was no longer effective. This event
triggered the liquidated damages provision contained in the registration rights
agreement. During the months of September through December 2006, we paid to the
remaining investors liquidated damages in the aggregate amount of $323,135.
We used a portion of the proceeds from the January 2005 private placement
to fund the acquisition of Pascall. In connection with the Pascall acquisition,
we loaned to EMRISE Electronics approximately $10,100,000 in cash that was used
to acquire Pascall and to repay Pascall's existing intercompany debt. As
described above, the Pascall purchase price is subject to upward or downward
adjustment, and accordingly we paid $237,000 to Intelek on August 1, 2005 to
compensate for an upward adjustment of Pascall's net worth. We have guaranteed
obligations of EMRISE Electronics in connection with the Pascall acquisition and
have agreed to indemnify Pascall's former parent in connection with obligations
under Pascall's facilities lease.
We used another portion of the proceeds from the January 2005 private
placement to partially fund the acquisition of RO. We used $4,002,000 of cash to
acquire RO, including paying down RO's bank debt of $1,602,000. In addition, we
agreed to make two deferred payments of $300,000 each, the first of which we
paid in October 2005, and the second of which was due on March 31, 2006.
Offsetting these amounts was $35,000 received from the former RO shareholders to
compensate for balance sheet adjustments.
20
We included in our amended annual report on Form 10-K for the year ended
December 31, 2005 a contractual obligations table that outlines payments due
from us or our subsidiaries under our lines of credit and other significant
contractual obligations through 2010, exclusive of interest. During the nine
months ended September 30, 2006, no material changes in this information
occurred outside the ordinary course of business.
We intend to grow our business through both internal growth and further
acquisitions that we identify as being potentially both synergistic and
accretive of our earnings. Any additional acquisitions would likely be funded
through the use of cash and/or a combination of cash and our stock.
We believe that current and future available capital resources, revenues
generated from operations, and other existing sources of liquidity, including
the credit facilities we have, will be adequate to meet our anticipated working
capital and capital expenditure requirements for at least the next twelve
months. If, however, our capital requirements or cash flow vary materially from
our current projections, if unforeseen circumstances occur, or if we require a
significant amount of cash to fund future acquisitions, we may require
additional financing. Our failure to raise capital, if needed, could restrict
our growth, limit our development of new products or hinder our ability to
compete.
EFFECTS OF INFLATION
The impact of inflation and changing prices has not been significant on
the financial condition or results of operations of either our company or our
operating subsidiaries.
IMPACTS OF NEW ACCOUNTING PRONOUNCEMENTS
In November 2004, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 151, "Inventory Costs, an amendment of ARB No. 43, Chapter 4," SFAS No.
151 clarifies that abnormal inventory costs such as costs of idle facilities,
excess freight and handling costs, and wasted materials (spoilage) are required
to be recognized as current period costs. The provisions of SFAS No. 151 are
effective for our fiscal 2006. We are currently evaluating the provisions of
SFAS No. 151 and do not expect that adoption will have a material effect on our
financial position, results of operations or cash flows.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections," a replacement of APB Opinion No. 20, "Accounting Changes," and
SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements." SFAS
No. 154 changes the requirements for the accounting for and reporting of a
change in accounting principle. Previously, most voluntary changes in accounting
principles required recognition of a cumulative effect adjustment within net
income of the period of the change. SFAS No. 154 requires retrospective
application to prior periods' financial statements, unless it is impracticable
to determine either the period-specific effects or the cumulative effect of the
change. SFAS No. 154 is effective for accounting changes made in fiscal years
beginning after December 15, 2005. However, SFAS No. 154 does not change the
transition provisions of any existing accounting pronouncements. We do not
believe our adoption of SFAS No. 154 will have a material effect on our
consolidated financial position, results of operations or cash flows.
21
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We have established and acquired international subsidiaries that prepare
their balance sheets in the relevant foreign currency. In order to be included
in our consolidated financial statements, these balance sheets are converted, at
the then current exchange rate, into United States dollars, and the statements
of operations are converted using weighted average exchange rates for the
applicable period. Accordingly, fluctuations of the foreign currencies relative
to the United States dollar could have an effect on our consolidated financial
statements. Our exposure to fluctuations in currency exchange rates has
increased as a result of the growth of our international subsidiaries. However,
because historically the majority of our currency exposure has related to
financial statement translation rather than to particular transactions, we do
not intend to enter into, nor have we historically entered into, forward
currency contracts or hedging arrangements in an effort to mitigate our currency
exposure.
A substantial portion of our notes payable and long-term debt have
variable interest rates based on the prime interest rate and/or the lender's
base rate, which exposes us to risk of earnings loss due to changes in such
interest rates. Our amended annual report on Form 10-K for the year ended
December 31, 2005 contains information about our debt obligations that are
sensitive to changes in interest rates under "Item 7A. Quantitative and
Qualitative Disclosures About Market Risk." There were no material changes in
those market risks during the nine months ended September 30, 2006.
ITEM 4. CONTROLS AND PROCEDURES.
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We conducted an evaluation, with the participation of our Chief Executive
Officer and Acting Chief Financial Officer, of the effectiveness of the design
and operation of our disclosure controls and procedures, as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
or the Exchange Act, as of September 30, 2006, to ensure that information
required to be disclosed by us in the reports filed or submitted by us under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Securities Exchange Commission's rules and forms,
including to ensure that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is accumulated and
communicated to management, including our principal executive and principal
financial officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. Based on that evaluation,
our Chief Executive Officer and Acting Chief Financial Officer has concluded
that as of September 30, 2006, our disclosure controls and procedures were not
effective at the reasonable assurance level due to the material weaknesses
described below.
A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board ("PCAOB") Auditing Standard No. 2) or
combination of control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected. In connection with its audit of
our consolidated financial statements for the year ended December 31, 2005,
Grant Thornton LLP ("GT"), our former independent registered public accounting
firm, advised management and our audit committee of two matters that GT
considered to be material weaknesses.
GT indicated that in the area of accounting and financial reporting, it
believed that we had insufficient accounting resources to enable us to identify
and evaluate complex accounting and reporting matters. In addition, GT
recommended that we establish procedures to ensure that our Chief Financial
Officer can more closely monitor information submitted to our corporate
headquarters by our subsidiary controllers and oversee accounting for reserves
and other areas that involving significant judgment at all company locations. GT
also recommended that we establish procedures to ensure that personnel familiar
with accounting principles generally accepted in the United States and with
Commission disclosure requirements thoroughly evaluate activities and
transactions at all company locations in order to determine that we are timely
making all required disclosures.
22
GT also indicated that we need to improve our controls over inventory
reserves. GT noted that some items that were in our inventory reserve earlier in
2005 were not present in the year-end reserve, although those items remained in
inventory at year end. Current accounting guidance would have required us to
include in our year-end reserve all items that were included in the inventory
reserve earlier in 2005, despite the fact that we no longer viewed those items
as slow moving. Our failure to continue to include those items in the inventory
reserve resulted in a material audit adjustment. In addition, GT determined that
inventory reserves in our CXR-AJ location were understated at year-end,
resulting in an additional audit adjustment.
In connection with its audit of our consolidated financial statements for
the years ended December 31, 2005, 2004 and 2003, Hein & Associates LLP
("Hein"), our independent registered pubic accounting firm, advised management
and our audit committee that they concur with GT's assessment of the material
weaknesses described above. Hein also noted that our accounting department did
not provide us with the appropriate resources, adequate technical skills and
supervision to accurately account for our revenues, as evidenced by our need to
restate our 2005 and 2004 financial statements. To initially address these
material weaknesses, management performed additional analyses and other
procedures to ensure that the financial statements included herein fairly
present, in all material respects, our financial position, results of operations
and cash flows for the periods presented.
REMEDIATION OF MATERIAL WEAKNESS
To remediate the material weakness in our disclosure controls and
procedures identified above, we have done or intend to do the following, in the
periods specified below:
To remediate the material weakness in the area of accounting and financial
reporting identified by GT and Hein, during the second and third quarters of
2006 we sought, and we intend to seek in the future, additional guidance from
our financial consultants, who are certified public accountants with the
requisite background and experience to assist us in identifying and evaluating
complex accounting and reporting matters. In addition, we intend to increase the
frequency at which our Chief Financial Officer and our Director of Financial
Controls for Europe visit and hold conference calls with accounting personnel
and managers at each of our company locations. Also, we intend to define
internal processes for identifying and disclosing non-routine and other
transactions as required by Commission disclosure requirements and for
researching and determining proper accounting treatment for those transactions.
We plan to assign individuals with appropriate knowledge and skills to perform
these processes and plan to provide those individuals with adequate technical
resources to help ensure timely disclosure of the transactions and proper
application of accounting principles generally accepted in the United States.
During the second and third quarters of 2006, we developed procedures to
document all non-routine transactions on a quarterly, including support for the
final accounting treatment, and now require the assigned individuals to review
the documentation with our Chief Financial Officer and/or Director of Financial
Controls for Europe prior to finalizing our quarterly and annual financial
statements.
In the third quarter of 2006, we developed plans to alter the current
organization of our accounting department and to hire additional personnel to
assist in our financial reporting processes. We seek to hire a Chief Financial
Officer and a Controller, each with expertise in public company financial
reporting compliance
23
We believe that a new Chief Financial Officer and a new Controller, once
hired, will contribute additional expertise to our team of finance and
accounting personnel and will assist us in our financial reporting processes. We
believe that once our accounting department is strengthened through the addition
of these additional staff members, we will have in place an adequate supervisory
structure to ensure accurate accounting for and disclosure of all transactions
in a timely manner.
Management is unsure, at the time of the filing of this report, when the
actions described above will remediate the material weakness also described
above. Although management intends to hire a new Chief Financial Officer and a
new Controller as soon as practicable, it may take an extended period of time
until suitable candidates can be located and hired. Management is, however,
optimistic that these personnel can be located and hired by the end of the first
quarter of 2007. Until we hire a new Chief Financial Officer and a new
Controller, as planned, management may hire outside consultants to assist us in
satisfying our financial reporting obligations.
Management believes that a new Chief Financial Officer will have an annual
base salary in the range of $185,000 to $200,000 and a new Controller will have
an annual base salary in the range of $130,000 to $150,000, not including
benefits and other costs of employment. Management is unable, however, to
estimate our expenditures related to fees paid or that may be paid in the future
to financial consultants in connection with their guidance in identifying and
evaluating complex accounting and reporting matters. Management is also unable
to estimate our expenditures related to the development of new internal
processes for identifying and disclosing both routine and non-routine
transactions and for researching and determining proper accounting treatment for
those transactions. Management is also unable to estimate our expenditures
related to the hiring of other outside consultants to assist us in satisfying
our financial reporting obligations. In addition, management is unable to
estimate our expenditures related to higher fees to be paid to our independent
auditors in connection with their review of this remediation.
To remediate the material weakness with regard to our controls over
inventory reserves, we have adjusted the procedures we use to compute inventory
reserves to ensure that items that are included in inventory reserves are not
removed from inventory reserves until a sale or disposal of those items occurs.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
The changes noted above, specifically, the changes relating to our (i)
efforts to locate suitable candidates for the positions of Chief Financial
Officer and Controller, (ii) engaging of financial consultants who are certified
public accountants to assist us in identifying and evaluating complex accounting
and reporting matters, (iii) new internal processes for identifying and
disclosing both routine and non-routine transactions and for researching and
determining proper accounting treatment for those transactions, and (iv)
assignment of individuals to perform these processes and provision to those
individuals of technical and other resources to help ensure the proper
application of accounting principles and the timely and appropriate disclosure
of routine and non-routine transactions, are the only changes during our most
recently completed fiscal quarter that have materially affected or are
reasonably likely to materially affect, our internal control over financial
reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.
24
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
We are not a party to any material pending legal proceedings.
ITEM 1A. RISK FACTORS.
Item 1A of Part I of our Amendment No. 1 to Form 10-K for the fiscal year
ended December 31, 2005 summarizes various material risks that investors should
carefully consider before deciding to buy or maintain an investment in our
common stock. Any of those risks, if they actually occur, would likely harm our
business, financial condition and results of operations and could cause the
trading price of our common stock to decline. There are no material changes to
the risk factors set forth in the above-referenced report.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
DIVIDENDS
We have not declared or paid any cash dividends on our capital stock in
the past, and we do not anticipate declaring or paying cash dividends on our
common stock in the foreseeable future. In addition, our credit facility with
WFBC, described in "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources," restricts the
payment of dividends without the bank's consent.
We will pay dividends on our common stock only if and when declared by our
board of directors. Our board of directors' ability to declare a dividend is
subject to restrictions imposed by Delaware law. In determining whether to
declare dividends, the board of directors will consider these restrictions as
well as our financial condition, results of operations, working capital
requirements, future prospects and other factors it considers relevant.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
ITEM 5. OTHER INFORMATION.
None.
25
ITEM 6. EXHIBITS.
NUMBER DESCRIPTION
------ -----------
10.1 Third Amendment to Credit Agreement entered into as of September 1,
2006 by and between EMRISE Corporation and Wells Fargo Bank, N.A. (1)
10.2 Revolving Line of Credit Note dated September 1, 2006 in favor of
Wells Fargo Bank (1)
10.3 Resignation and Separation Agreement dated August 18, 2006 by and
between EMRISE Corporation and Randolph D. Foote (2)
31.1 Certification of Chief Executive Officer Required by Rule 13a-14(a)
of the Securities Exchange Act of 1934, as amended, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer Required by Rule 13a-14(a)
of the Securities Exchange Act of 1934, as amended, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 Certification of Chief Executive Officer and Acting Chief Financial
Officer Pursuant to 18 U.S.C. Section 350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
-------------
(1) Filed as an exhibit to our Form 8-K for September 19, 2006 and
incorporated herein by reference.
(2) Filed as an exhibit to our Form 8-K for August 18, 2006 and incorporated
herein by reference.
26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
EMRISE CORPORATION
Dated: January 17, 2007 By: /s/ Carmine T. Oliva
--------------------------------------------
Carmine T. Oliva, Chairman of the Board,
Chief Executive Officer (principal executive
officer), President, Secretary and Acting
Chief Financial Officer (principal financial
and accounting officer)
27
EXHIBITS ATTACHED TO THIS REPORT
EXHIBIT
NUMBER DESCRIPTION
------ -----------
31.1 Certification of Chief Executive Officer Required by Rule 13a-14(a)
of the Securities Exchange Act of 1934, as amended, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer Required by Rule 13a-14(a)
of the Securities Exchange Act of 1934, as amended, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 Certification of Chief Executive Officer and Chief Financial Officer
Pursuant to 18 U.S.C. Section 350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
28