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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of operations
The following table sets forth the Company’s net sales, cost of goods sold, gross profit, marketing, selling, general and administrative expenses, R&D expenses, operating income, other income, earnings before income taxes and minority interest, earnings before minority interest, and net income, expressed as a percentage of net sales, for the years ended December 31, 1998, 1997, and 1996.
|
1998
|
1997
|
1996
|
| Net Sales |
100.0
|
100.0
|
100.0
|
| Net Sales |
55.23
|
54.5
|
57.7
|
| Gross Profit |
44.8
|
45.5
|
42.3
|
| Marketing, selling, general and administrative expenses |
23.1
|
23.3
|
21.3
|
| Research and development |
2.9
|
2.6
|
2.1
|
| Aquired research and development |
.6
|
-
|
-
|
| Operating income |
18.2
|
19.6
|
18.6
|
| Other income, net |
1.0
|
.7
|
.8
|
| Earnings before income taxes and minority interest |
19.2
|
20.3
|
19.7
|
| Earnings before minority interest |
13.1
|
13.9
|
13.1
|
|
Net income
|
13.1
|
13.9
|
13.1
|
Effects of Inflation
Liquidity and Financial Resources
Acquisition of Silcon A/S
Foreign Currency Activity
Recently Issued Accounting Standard
Year 2000 Readiness Disclosure Statement
Factors That May Affect Future Results
Revenues
Net sales in fiscal year 1998 increased by 28.9% to $1,125.8 million from $873.4 million in fiscal year 1997, which reflected a 23.6% increase from $706.9 million in fiscal year 1996. The increases from 1996 to 1998 are attributable to continued strong demand for the Company's uninterruptible power supply products (“UPS”) and surge protection products, combined with $49.8 million in 1998 net sales attributable to Silcon (see “Acquisition” below). In addition, sales of new products and increased efforts by, and the addition of members to, the Company's sales staff have contributed to increased sales volumes. Net sales attributable to new products totaled approximately 11%, 8%, and 7%, of 1998, 1997 and 1996 net sales, respectively.
Foreign sales to unaffiliated customers, primarily in Europe, the Far East, Canada, and South America, were $486.6 million or 43.2% of net sales in fiscal year 1998 compared to $378.3 million or 43.3% of net sales in fiscal year 1997 and $305.1 million or 43.2% of net sales in fiscal year 1996. See also note 8 to the consolidated financial statements.
Cost of Goods Sold
Cost of goods sold was $621.1 million or 55.2% of net sales in fiscal year 1998 compared to $476.1 million or 54.5% of net sales in fiscal year 1997. Gross margins declined by approximately 70 basis points during 1998 from fiscal year 1997. Substantially all of the gross margin erosion was product mix related as the Company’s high-power UPS business now accounts for a larger percentage of revenue.
Cost of goods sold was $476.1 million or 54.5% of net sales in fiscal year 1997 compared to $407.9 million or 57.7% of net sales in fiscal year 1996. Gross margins improved by approximately 320 basis points during 1997 over fiscal year 1996, primarily attributable to several factors including, but not limited to: continued improvement in margins on lower cost Back-UPS products manufactured in the Philippines, the favorable margin impact of a higher-end product mix resulting from strong growth in Smart-UPS sales into the server segment of the power protection market, and volume production efficiencies, partially offset by certain price reductions implemented during the fourth quarter.
Total inventory reserves at December 31, 1998 were $13.3 million compared to $19.3 million at December 31, 1997. The Company’s reserve estimate methodology involves quantifying the total inventory position having potential loss exposure, reduced by an amount reasonably forecasted to be sold, and adjusting its interim reserve provisioning to cover the net loss exposure.
Operating Expenses
Marketing, selling, general, and administrative (SG&A) expenses were $260.2 million or 23.1% of net sales in 1998 compared to $203.5 million or 23.3% of net sales in 1997 and $150.4 million or 21.3% of net sales in 1996. The increases in total spending in 1998 and 1997 were due primarily to costs associated with increased staffing and operating expenses of selling, administrative, and marketing functions, as well as increased advertising and promotional costs.
The allowance for bad debts was 7.9% of accounts receivable at December 31, 1998 compared to 8.5% at December 31, 1997. The Company continues to experience strong collection performance from its accounts receivable with outstanding balances over 60 days outstanding representing 8.6% and 6.6% of total receivables at December 31, 1998 and 1997, respectively. Write-offs of uncollectible accounts represent less than 1% of net sales. A majority of international customer balances are covered by receivables insurance.
R&D expenditures for 1998, 1997 and 1996 were $32.6 million, $22.4 million, and $14.8 million, respectively. The increased R&D spending primarily reflects increased numbers of software and hardware engineers and costs associated with new product development and engineering support. In addition, during 1998, the Company recorded non-recurring charges of $7.6 million for acquired in-process R&D in connection with its acquisition of Silcon (see “Acquisition” below). The Company expects its recurring R&D expenditures to remain at substantially the same level as a percentage of sales for the foreseeable future.
Other Income, Net and Income Taxes
Other income is comprised principally of interest income, which increased substantially from 1996 to 1998 due to higher average cash balances available for investment during 1997 and 1998.
Excluding 1998 non-tax deductible charges of $7.6 million for acquired in-process R&D (see “Acquisition” below), the Company's effective income tax rates were 30.5%, 31.5%, and 33.5% in 1998, 1997 and 1996, respectively. The decrease from 1996 to 1998 is due to the expected tax savings from an increasing portion of taxable earnings being generated from the Company’s operations in Ireland, a jurisdiction which currently has a lower income tax rate for manufacturing companies than the present U.S. statutory income tax rate.
Effects of Inflation
Management believes that inflation has not had a material effect on the Company’s operations.
Liquidity and Financial Resources
Working capital at December 31, 1998 was $493.8 million compared to $426.8 million at December 31, 1997. The Company’s cash position decreased to $219.9 million at December 31, 1998 from $270.1 million at December 31, 1997, primarily due to the cash purchase of approximately 89% of the share capital of Silcon (see “Acquisition” below).
Worldwide inventories were $228.7 million at December 31, 1998 compared to $104.2 million at December 31, 1997. Inventories increased during 1998 due to increased demand and increased sourcing from the Philippines where longer transit times result in higher finished goods inventories, combined with $19 million of inventory purchased in the Silcon acquisition.
At December 31, 1998, the Company had $50 million available for future borrowings under an unsecured line of credit agreement at a floating interest rate equal to the bank’s cost of funds rate plus .625% and an additional $15 million under an unsecured line of credit agreement with a second bank at a similar interest rate. No borrowings were outstanding under these facilities at December 31, 1998. In connection with the acquisition of Silcon (see “Acquisition” below), the Company acquired $24.8 million in bank indebtedness with interest rates ranging from 4% to 8%. The Company repaid $12.3 million of this indebtedness during the second half of 1998. The Company had no significant financial commitments, other than those required in the normal course of business, at December 31, 1998.
During 1998 and 1997, the Company's capital expenditures, net of capital grants, amounted to approximately $55.7 million and $37.2 million, respectively, consisting primarily of manufacturing and office equipment, buildings and improvements, and purchased software applications. The nature and level of capital spending was made to improve manufacturing capabilities, establish additional manufacturing capabilities in China, the Philippines, and Ireland to support the increased selling, marketing, and administrative efforts necessitated by the Company's significant growth, and to improve the Company’s enterprise-wide software applications. Substantially all of the Company’s net capital expenditures were financed from available operating cash. The Company had no material capital commitments at December 31, 1998. Capital expenditures in 1999 are planned to grow in line with expected 1999 revenue growth, primarily to support planned capacity expansions.
The Company has agreements with the Industrial Development Authority of Ireland (“IDA”) under which the Company receives grant monies for costs incurred for machinery, equipment, and building improvements for its Galway and Castlebar facilities equal to 40% and 60%, respectively, of such costs up to a maximum of $13.1 million and $1.3 million, respectively. Such grant monies are subject to the Company meeting certain employment goals and maintaining operations in Ireland until termination of the respective agreements. Under separate agreements with the IDA, the Company receives direct reimbursement of training costs at its Galway and Castlebar facilities for up to $3,000 and $12,500, respectively, per new employee hired. See also note 12 to the consolidated financial statements.
During the fourth quarter of 1998, the Company began establishing a manufacturing operation in India. The Company will be leasing a 42,000 square foot facility in Bangalore and expects to begin manufacturing selected products at this facility during the second quarter of 1999.
During the first quarter of 1998, the Company established a manufacturing operation in China. The Company is leasing a 50,000 square foot facility in Suzhou and began manufacturing selected products at this facility during the third quarter of 1998. Capital expenditures for the China expansion were financed from operating cash.
The Company’s manufacturing operation in the Philippines is operating within a designated economic zone which provides certain economic incentives, primarily in the form of tax exemptions. In August 1998, the Company purchased a third manufacturing facility in the Philippines for approximately $750,000, financed from operating cash. The Philippines facilities currently manufacture certain Back-UPS and Smart-UPS products sold in the Company’s domestic and international markets.
The Company continues to evaluate international manufacturing expansion, including additional locations in the Far East and South America.
Management believes that current internal cash flows together with available cash, available credit facilities or, if needed, the proceeds from the sale of additional equity, will be sufficient to support anticipated capital spending and other working capital requirements for the foreseeable future.
Acquisition of Silcon A/S
Early in the second quarter of 1998, the Company entered into a definitive agreement with the principal management shareholders of Silcon A/S (“Silcon”) to acquire stock of Silcon, a Denmark-based manufacturer of three-phase UPSs up to 480 kilo volt-amps (“kVA”), and the Company commenced a tender offer for Silcon shares. In June 1998, the initial tender offer and purchase of stock from principal management shareholders was completed enabling the Company to operate Silcon as a majority-owned subsidiary. During the second half of 1998, the Company increased its ownership percentage to 89%. The Company’s 1998 cash outlays associated with the acquisition aggregating $64 million were financed from operating cash. In January 1999, the Company attained ownership of more than 90% of the share capital of Silcon through open market purchases financed from operating cash and commenced a mandatory redemption of the remaining Silcon shares. Through this mandatory share redemption process, the Company anticipates that it will complete its acquisition of the remaining outstanding shares of Silcon during the second half of 1999. In connection with the mandatory redemption, the Copenhagen Stock Exchange has approved the de-listing of Silcon’s shares effective March 1, 1999.
The purchase price was allocated to the net tangible and identifiable intangible assets acquired and to acquired in-process R&D (“acquired R&D”). Acquired R&D includes the value of products in the development stage that are not considered to have reached technological feasibility and that have no alternative future uses. The acquired R&D effort related to several technologies for products that Silcon was developing for which the Company intends to complete development. At the valuation date, none of these products had demonstrated their technological or commercial feasibility. Significant risk exists since the Company is unable to predict with certainty the obstacles it may encounter in the form of time and cost necessary to produce technologically feasible products. Should these proposed products fail to become viable, the in-process technology has no alternative use and it is unlikely that the Company would be able to realize any value from the sale of the technology to another party. The Company used professional consultants to assess and allocate values to the acquired R&D, which were determined by estimating the contribution of the acquired R&D technology to developing commercially viable products, estimating the resulting net cash flows from the expected sales of such products, and discounting the net cash flows to their present value using a risk-adjusted discount rate. The Company believes that the assumptions used in the forecasts were reasonable at the time of the acquisition. No assurance can be given, however, that the underlying assumptions used to estimate expected product sales, development costs, or profitability will transpire as estimated. For these reasons, actual results may vary from the projected results.
In accordance with applicable accounting rules, acquired R&D is required to be expensed. Accordingly, $7.6 million of the acquisition cost was expensed in 1998. The remaining purchase price exceeded the fair value of the tangible net assets acquired by approximately $47 million, consisting of identifiable intangible assets and goodwill, which is being amortized on a straight-line basis over 15 years. The acquisition has been accounted for as a purchase and, accordingly, Silcon’s results of operations are included in the Company’s consolidated financial statements from the date of acquisition.
Foreign Currency Activity
The Company invoices its customers in Denmark, France, Germany, Great Britain, Switzerland, and Japan in their respective local currencies. Realized and unrealized transaction gains or losses are included in the results of operations and are measured based upon the effect of changes in exchange rates on the actual or expected amount of functional currency cash flows. Transaction gains and losses were not material to the results of operations in 1998, 1997 and 1996.
At December 31, 1998, the Company’s unhedged foreign currency accounts receivable, by currency, were as follows:
| In thousands |
Foreign Currency
|
US Dollars
|
| German Marks |
21,442
|
$12,762
|
| British Pounds |
6,063
|
10,062
|
| French Fracs |
48,679
|
8,662
|
| Swiss Francs |
7,821
|
5,666
|
| Danish Kroner |
23,000
|
3,594
|
Japanese Yen
|
1,086,192
|
9,528
|
The Company also had non-trade receivables of 3.9 million Irish Pounds (approximately US$5.8 million), as well as Irish Pound denominated liabilities of 3.9 million (approximately US$5.8 million). The Company also had short term debt and liabilities denominated in various European currencies of US$42.8 million, as well as Yen denominated liabilities of approximately US$1.6 million.
The Company continually reviews its foreign exchange exposure and considers various risk management techniques, including the netting of foreign currency receipts and disbursements, rate protection agreements with customers/vendors and derivatives arrangements, including foreign exchange contracts. The Company presently does not utilize rate protection agreements or derivative arrangements.
Recently Issued Accounting Standard
The Financial Accounting Standards Board recently issued Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. This Statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The adoption of this Statement is not expected to have a material impact on the Company’s consolidated financial position or results of operations.
The AICPA Accounting Standards Executive Committee recently issued Statement of Position (“SOP”) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. This SOP requires that certain costs related to the development or purchase of internal-use software be capitalized and amortized over the estimated useful life of the software, and is effective for fiscal years beginning after December 15, 1998. The SOP also requires that costs related to the preliminary project stage and post implementation/operations stage in an internal-use computer software development project be expensed as incurred. The adoption of this SOP is not expected to have a material impact on the Company’s consolidated financial position or results of operations.
The AICPA Accounting Standards Executive Committee recently issued SOP 98-5, Reporting on the Costs of Start-Up Activities. This SOP requires that costs incurred during start-up activities, including organization costs, be expensed as incurred, and is effective for fiscal years beginning after December 15, 1998. The adoption of this SOP is expected to have no impact on the Company’s consolidated financial position or results of operations.
Year 2000 Readiness Disclosure Statement
Many computer systems were not designed to handle any dates beyond the year 1999 and, therefore, many companies will be required to modify their computer hardware and software prior to the year 2000 in order to remain fully operational. During 1998, the Company commenced a year 2000 readiness program to assess the impact of the year 2000 issue on the Company’s operations and address necessary remediation. A year 2000 program director reporting directly to senior management has been assigned to this project.
Assessment of the Company’s Products for Year 2000 Compliance
All of the Company’s hardware products and accessories are year 2000 compliant, meaning that they have been tested to verify that where date fields are processed, dates are calculated and displayed accurately, and that scheduled events such as shutdowns, self-tests, and run-time calibrations, and also the handling of unscheduled events, such as power failures, are unaffected by the millennium and century change; provided that all other third party products (e.g., software, firmware, operating systems, and hardware) properly exchange date data with the Company’s products and provided also that the Company’s products are used in accordance with the product documentation. In addition, the Company’s year 2000 compliant products recognize the year 2000 as a leap year. The Company has also tested its software products and determined that these products are substantially year 2000 compliant, and the Company intends to resolve any remaining year 2000 issues before the beginning of the fourth quarter of 1999. Periodically updated information about the Company’s software products is available at the Company’s Year 2000 Readiness Disclosure Web site (www.apcc.com). Information on this site is provided to the Company’s customers for the sole purpose of assisting in planning for transition to the year 2000. Such information is the most currently available concerning the behavior of the Company’s products in the next century and is provided “as is” without warranty of any kind. In addition, to the extent the Company’s hardware and software products are combined with the hardware and software products of other companies, there can be no assurance that users of the Company’s products will not experience year 2000 problems as a result of the combination of the Company’s hardware and software products with non-compliant products of other companies. The Company currently does not anticipate material expenditures to remedy any year 2000 issues with its products and services.
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