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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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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 June 27, 1998
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from to
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Commission File Number: 0-26472
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SMARTFLEX SYSTEMS, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 33-0581151
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
14312 Franklin Avenue, Tustin, California 92781-2085
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(Address of principal executive offices) (Zip Code)
(714) 838-8737
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(Registrant's telephone number, including area code)
NOT APPLICABLE
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(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 the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days [X] Yes [ ] No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Common Stock, $.0025 par value - 6,431,470 shares as of July 29, 1998
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Page 1 of 17
Exhibit Index on Page 17
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SMARTFLEX SYSTEMS, INC.
INDEX
<TABLE>
<CAPTION>
Page
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<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets (Unaudited) as of June 30, 1998 3
and December 31, 1997
Condensed Consolidated Statements of Operations (Unaudited) for the three and 4
six months ended June 30, 1998 and June 30, 1997
Consolidated Statements of Cash Flows for the six months ended
June 30, 1998 and June 30, 1997 5
Notes to Unaudited Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and 7-14
Results of Operations
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 6. Exhibits and Reports on Form 8-K 15
SIGNATURES 16
INDEX TO EXHIBITS 17
</TABLE>
The Company's fiscal year is 52 or 53 weeks, ending on the Saturday nearest
December 31 each year, and follows a four-four-five week quarterly cycle. For
clarity of presentation, the Company has presented its fiscal years as ending
December 31, and its fiscal quarters as ending on March 31, June 30, September
30 and December 31.
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PART I --- FINANCIAL INFORMATION
Item 1. Financial Statements
SMARTFLEX SYSTEMS, INC.
Condensed Consolidated Balance Sheets (Unaudited)
(Dollars in thousands)
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997
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<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 1,697 $ 2,069
Short-term investments 28,641 26,051
Accounts receivable, net of allowance for doubtful accounts
of $935 at June 30, 1998 and $1,384 at December 31, 1997 13,779 19,252
Inventories:
Raw materials 3,105 6,943
Work-in-process 1,841 2,725
Finished goods 795 2,432
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Total inventories 5,741 12,100
Deferred income taxes 3,541 3,541
Prepaid expenses and other current assets 1,366 1,755
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Total current assets 54,765 64,768
Property and equipment, at cost:
Machinery and equipment 23,170 20,930
Office furniture and equipment 3,807 3,148
Leasehold improvements 4,919 4,460
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31,896 28,538
Less accumulated depreciation and amortization (14,225) (12,260)
-------- --------
Total property and equipment 17,671 16,278
Deferred income taxes 350 350
Other assets 801 510
======== ========
$ 73,587 $ 81,906
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable to related parties $ 137 $ 533
Accounts payable 8,761 18,990
Accrued compensation and related costs 1,772 1,569
Accrued restructuring liabilities 2,517 3,923
Other accrued liabilities 7,949 5,050
Current portion of notes payable 626 1,063
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Total current liabilities 21,762 31,128
Long-term portion of notes payable 1,238 1,689
Stockholders' equity:
Preferred stock, $.001 par value:
Authorized shares -- 5,000,000
Issued and outstanding -- none -- --
Common stock, $.0025 par value:
Authorized shares -- 25,000,000
Issued and outstanding shares -- 6,431,470 at June 30, 1998 and
6,362,477 at December 31, 1997, respectively 16 16
Additional paid-in capital 36,401 36,118
Retained earnings 14,170 12,955
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Total stockholders' equity 50,587 49,089
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$ 73,587 $ 81,906
======== ========
</TABLE>
See accompanying notes.
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SMARTFLEX SYSTEMS, INC.
Condensed Consolidated Statements of Operations
(In thousands except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended June 30 Six Months Ended June 30
-------------------------- -------------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net revenues $ 27,037 $ 37,003 $ 64,042 $ 67,275
Cost of revenues 24,054 33,412 56,914 61,731
-------- -------- -------- --------
Gross margin 2,983 3,591 7,128 5,544
Costs and expenses:
Marketing and sales expense 886 963 1,816 1,820
General and administrative expense 1,886 1,807 3,967 3,106
-------- -------- -------- --------
Operating income 211 821 1,345 618
Interest income 221 251 484 527
Interest expense (25) (196) (87) (260)
Other income (expense) 171 (113) 98 (92)
-------- -------- -------- --------
Income before income taxes 578 763 1,840 793
Income tax provision 191 205 625 1
-------- -------- -------- --------
Net income $ 387 $ 558 $ 1,215 $ 792
======== ======== ======== ========
Net income per share:
Basic $ 0.06 $ 0.09 $ 0.19 $ 0.13
======== ======== ======== ========
Diluted $ 0.06 $ 0.09 $ 0.19 $ 0.12
======== ======== ======== ========
Shares used in computing net income per share:
Basic 6,422 6,334 6,397 6,333
======== ======== ======== ========
Diluted 6,476 6,428 6,469 6,444
======== ======== ======== ========
</TABLE>
See accompanying notes.
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SMARTFLEX SYSTEMS, INC.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended June 30,
-------------------------
1998 1997
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<S> <C> <C>
Cash flow from operating activities:
Net income $ 1,215 $ 792
Adjustments to reconcile net income to cash provided by (used in)
operating activities:
Depreciation and amortization 1,965 2,054
Loss on sale of property and equipment -- 150
Provision for doubtful accounts 165 (189)
Provision for inventory obsolescence 1,941 34
Other changes in operating assets and liabilities:
Receivables 5,308 (1,992)
Inventories 4,418 (3,669)
Prepaid expenses and other assets 97 96
Accounts payable to related parties (396) (1,315)
Accrued restructuring cost (1,406) --
Accounts payable and accrued expenses (7,125) 3,615
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Net cash provided by (used in) operating activities 6,182 (492)
Cash flow from investing activities:
Capital expenditures (3,358) (7,593)
Purchase of short-term investments (2,590) (7,978)
Proceeds from the sale of short-term investments -- 11,352
-------- --------
Net cash used in investing activities (5,948) (4,219)
Cash flow from financing activities:
Net proceeds from issuance of common stock 282 228
Net borrowings on revolving line of credit -- 2,874
(Repayments) borrowings on term loan (888) 1,906
-------- --------
Net cash (used in) provided by financing activities (606) 5,008
-------- --------
Net (decrease) increase in cash (372) 297
Cash at beginning of period 2,069 1,164
-------- --------
Cash at end of period $ 1,697 $ 1,461
======== ========
Supplemental disclosures of cash flow information:
Interest paid $ 87 $ 161
Taxes paid 960 101
</TABLE>
See accompanying notes.
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SMARTFLEX SYSTEMS, INC.
Notes to Unaudited Condensed Consolidated Financial Statements
June 30, 1998
Note (A) -- Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
include the accounts of Smartflex Systems, Inc. and its wholly owned
subsidiaries ("Smartflex" or "the Company"), and have been prepared in
accordance with generally accepted accounting principles for interim financial
information, and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three-month period ended June 30, 1998 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 1998. These financial statements should be read in
conjunction with the consolidated financial statements and footnotes thereto
included in the Company's Annual Report to Stockholders for the year ended
December 31, 1997.
Note (B) -- Fiscal Year
The Company's fiscal year is 52 or 53 weeks, ending on the Saturday
nearest December 31 each year, and follows a four-four-five week quarterly
cycle. For clarity of presentation, the Company has presented its fiscal years
as ending December 31, and its fiscal quarters as ending on March 31, June 30,
September 30 and December 31.
Note (C) -- Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.
Note (D) -- Credit Facility
On September 26, 1997, the Company amended its bank credit facility
("facility") to provide for aggregate borrowings of $25.0 million under a
revolving line of credit ("credit line"). Borrowings under the credit line
include a sublimit for the issuance of up to $2.0 million in commercial or
standby letters of credit for the purchase of inventory. Outstanding balances on
the credit line bear interest at the bank's reference rate or, at the Company's
option, LIBOR plus 1.5%, and unused portions of the credit line bear interest at
.125% per annum. Interest is payable monthly and principal is payable at
maturity on September 30, 1999. At June 30, 1998, there were no borrowings on
the credit line and no letters of credit outstanding as of that date. The
facility additionally provides for an unsecured term loan totaling $2.2 million
for the purchase of equipment. The loan bears interest at the bank's reference
rate plus .5% or, at the Company's option, LIBOR plus 2%. Principal and interest
are payable monthly and the loan matures on March 30, 2001. At June 30, 1998,
the outstanding balance of the term loan was approximately $1.9 million.
Note (E) -- Impact of newly issued pronouncement by the Financial Accounting
Standards Board
Effective January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income," ("SFAS 130"), which
establishes standards for reporting and displaying comprehensive income and its
components in the financial statements. For the six months ended June 30, 1998
and 1997, the Company did not have any components of comprehensive income as
defined in SFAS 130.
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SMARTFLEX SYSTEMS, INC.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following information includes forward-looking statements, the
realization of which may be impacted by certain important factors discussed in
"Risk Factors," below, and the other information in this Form 10-Q.
OVERVIEW
Smartflex is a technology leader in electronics manufacturing
services. The Company specializes in developing and automating the precision
assembly of comprehensive interconnect solutions, utilizing precision surface
mount and direct chip attach technologies on multiple circuit substrates. The
Company's customer base includes hard disk drive ("HDD") and non-HDD
manufacturers. Examples of flex assemblies used in non-HDD applications include
read/write head assemblies in tape drives and removable personal storage
products, and flex assemblies in miniaturized packaging for gene chips and fluid
analyzers. Revenues from the HDD customers have represented the Company's
predominant market. For the six months ended June 30, 1998, HDD revenues
comprised 52.0% of total revenues, compared to 67.1% for the same period last
year.
During the first half of 1998, due to the changing business dynamics of
the data storage industry, many Original Equipment Manufacturers ("OEM") had
higher inventories, reduced demand, and competitive pricing pressures. As a
result, some of the OEMs began to change their methodology of inventory
management. They began the move to a "build-to-order" or "pull" system of
inventory management from the traditional "build-to-forecast" system of
inventory management. Such a change in business dynamics results in reducing the
Company's visibility for orders, which in turn reduces order backlog.
Net revenues in the second quarter of 1998 decreased 26.9% from the
same period in the prior year and from the previous quarter of the current year.
During the second quarter ended June 30, 1998, total unit shipments were
approximately 566,000 units or 8.8% less than the first quarter of 1998 and
approximately 1.8 million units or 43.2% more than the same period in 1997.
Average selling prices ("ASP") decreased during this period from the comparable
period in the prior year primarily due to component cost decreases passed
through to customers in the form of lower prices and price decreases as a result
of competitive pressures.
RESULTS OF OPERATIONS
Net Revenues
Net revenues in the second quarter of 1998 decreased approximately $10
million or 26.9% both from the prior quarter of the current year and from the
comparable period in the prior year. The decrease in the second quarter of 1998
is attributable to the uncertainty in the technology markets and continuing
softness in demand in the data storage industry. This decrease in the second
quarter more than offset an increase in net revenues of 22.2% in the first
quarter of 1998 as compared to the first quarter of 1997, resulting in a
decrease of 4.8% during first half of 1998 from the levels in the first half of
the prior year. The increase in the first quarter of 1998 was attributable to
the absence of component availability issues and customer shipment
postponements, which had impacted net revenues in the first quarter of the prior
year. Decreases in component costs, which were passed through to customers in
the form of lower prices, and price decreases as a result of competitive
pressures, also negatively impacted the revenues.
During the first half of fiscal 1998, net revenues from non-HDD
programs increased to 48.0% of total revenues from 32.9% during the same period
in the prior year primarily due to increases in the removable storage programs.
Export sales arise primarily from the shipment of assembled products to
the international operations of U.S.-based customers as well as shipments to
intermediary companies that also service these accounts. Total
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export sales decreased to 72.2% from 93.4% in the first quarter of 1998 and
88.0% in the second quarter in 1997. The decrease was due to reduced shipments
in both the HDD and non-HDD applications.
Restructuring
The Company restructured its worldwide operations in the third quarter
of 1997, moving volume manufacturing from Singapore to the Company's lower-cost
facility in Cebu. The Singapore operations have become the focal point of
Smartflex business development and customer support in Asia as the Company's Far
East Regional Services and Technology Center. The restructuring also included a
reduction of manufacturing and other personnel from the Company's Tustin,
California operations. As part of this restructuring, the Company provided for
the following in the third quarter of 1997: $1.4 million for the write-off of
inventories included in the cost of revenues, $3.5 million for the write-down of
non-current assets and other expenses, $1.1 million for severance and other
employee-related costs associated with the reduction in force, and approximately
$500,000 towards a potential Singapore tax liability. During fiscal 1997 and to
the end of June 1998, the Company had used approximately $2.3 million for the
write-down of non-current assets and other expenses and has paid approximately
$810,000 in severance and other employee-related costs. The Company expects to
utilize the remaining portion of the restructuring expense provision in 1998.
See "Risk Factors."
Gross Margins
Gross margins as a percentage of net revenues were 11.0% and 9.7% for
the second quarters of fiscal 1998 and 1997, respectively. Gross margins for the
six month periods ended June 30, 1998 and 1997 were 11.1% and 8.2%,
respectively. The increases were primarily due to a reduced cost structure
resulting from the realignment of operations in the prior year and due to cost
control measures put in place during the current year. In addition, the Company
also benefited from favorable foreign currency exchange rates during the second
quarter of the current year, as compared to the same period in the prior year.
Marketing and Sales Expense
Marketing and sales expenses consist primarily of salaries, facility
and travel costs for marketing, sales and customer service personnel, and sales
commissions paid to direct sales personnel and sales representative
organizations. These expenses remained flat at $1.8 million during the first six
months of fiscal 1998 as compared to the same period in the prior year.
Decreases in commissions, as a result of lower revenue, were offset somewhat by
increased staffing within the sales organization and increased travel. As a
percentage of net revenues, marketing and sales expenses increased to 2.8% for
the first half of fiscal 1998, compared to 2.7% for the same period in fiscal
1997.
General and Administrative Expenses
General and administrative ("G & A") expenses increased both as a
percentage of net revenues, and in absolute dollars, for the first half ended
June 30, 1998 compared to the same period in 1997. In absolute dollars G & A
expenses were approximately $4.0 million in the first six months of fiscal 1998,
an increase of approximately $861,000 from the G & A expenses in the first six
months of fiscal 1997. As a percentage of net revenues, G & A expenses were 6.2%
for the current year's first half, compared to 4.6% for the six months ended
June 30, 1997. This increase was primarily due to provision for bad debts in the
first half of fiscal 1998 compared to a reversal of bad debt expense during the
same period in the prior year. The increase in G & A was also due to increased
profit sharing expense accrual in the first half of 1998, compared to the first
half of 1997, as well as due to the increase in information systems expense, a
portion of which is allocated to G & A.
Interest Income
Short-term investments, on average, were at a slightly reduced level
during the first half of fiscal 1998 compared to the first half of fiscal 1997,
resulting in a $43,000 decrease in interest income compared to the same period a
year ago.
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Income Taxes
The Company's provision for income taxes was approximately $625,000 in
the six months ended June 30, 1998, as compared to an income tax provision of
$1,000 for the six months ended June 30, 1997. The Company's tax liability in
the first half of the prior year was reduced due to domestic tax benefits
resulting from a successful conclusion of the Internal Revenue Service
examination and profits in foreign operations offset by domestic losses in the
prior year.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 1998, the Company's principal sources of liquidity included
$30.3 million in cash and short-term investments, and $25.0 million in available
borrowings under its bank credit facility ("facility"), net of borrowings under
the term loan. On September 26, 1997, the facility was amended to provide for
aggregate borrowings of $25.0 million under a revolving line of credit ("credit
line"). Borrowings under the credit line include a sublimit for the issuance of
up to $2.0 million in commercial or standby letters of credit for the purchase
of inventory. Outstanding balances on the credit line bear interest at the
bank's reference rate or, at the Company's option, LIBOR plus 1.5%, and unused
portions of the credit line bear interest at .125% per annum. Interest is
payable monthly and principal is payable at maturity on September 30, 1999. At
June 30, 1998, there were no borrowings on the credit line and no letters of
credit outstanding as of that date. The facility additionally provides for an
unsecured term loan totaling $2.2 million for the purchase of equipment. The
loan bears interest at the bank's reference rate plus .5% or, at the Company's
option, LIBOR plus 2%. Principal and interest are payable monthly and the loan
matures on March 30, 2001. At June 30, 1998, the outstanding balance of the term
loan was approximately $1.9 million.
Short-term investments at June 30, 1998 totaled $28.6 million, and
consisted primarily of holdings in municipal bonds, money market instruments,
commercial paper and bankers' acceptances in accordance with the Company's
investment policy, which is designed to maintain a highly liquid portfolio with
minimal risk. The Company's short-term investments, which are classified as
available-for-sale, increased $2.2 million for the six months ended June 30,
1998 as compared to the comparable period in the prior year, primarily due to
increased collection of receivable balances during the first half of 1998 as
compared to the first half of 1997. For all short-term investments at June 30,
1998, cost approximated fair market value.
Over the six months ended June 30, 1998, inventory levels decreased
$6.4 million. Inventory levels fluctuate directly with the volume of the
Company's manufacturing; changes or significant fluctuations in market demands
can cause fluctuations in inventory levels, which may result in changes in
levels of inventory turns and liquidity. See "Risk Factors."
During the six months ended June 30, 1998, the Company acquired $3.4
million in capital equipment and leasehold improvements, primarily for the
expansion of its offshore manufacturing facilities.
The Company believes that existing cash and investments balances, funds
generated from operations and funds available under its current bank credit
facility will be sufficient to meet the Company's cash requirements during the
next twelve months. See "Risk Factors."
RISK FACTORS
Important Factors Related to Forward-Looking Statements and Associated Risks
This Quarterly Report on Form 10-Q contains forward-looking statements
that are based on current expectations and involve a number of risks and
uncertainties. All information herein, which is not historic, and any inference
from historic information concerning future periods, is a forward-looking
statement. Factors that may materially affect revenues, expenses and operating
results include, without limitation, the impact of competitive products and
pricing, dependence upon a small number of customers and upon customers
predominantly in the
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data storage industry, dependence upon export sales, the impact of conducting
international operations, the transition of volume manufacturing operations from
Singapore to the Philippines, efficient utilization of manufacturing facilities,
potential interruption of the flow of components from a limited number of
suppliers, subsequent changes in business strategy or plan, timely completion of
the business systems implementation, and structural and strategic changes
affecting certain of the Company's existing customers, suppliers and
competitors, and all of the other material factors discussed above, under the
heading "Management Discussion and Analysis of Financial Condition and Results
of Operations."
The forward-looking statements included herein are based on current
assumptions of management that the Company will continue to develop, market,
manufacture and ship new products on a timely basis, that competitive conditions
within the Company's market will not change materially or adversely, that demand
for the Company's products and services will meet the Company's forecasts, that
the market will accept the Company's new products and services, that the Company
will retain existing key management personnel, that inventory risks due to
shifts in market demand will be minimized, that the Company's forecasts will
accurately anticipate market demand, and that there will be no material adverse
change in the Company's operations or business. Assumptions relating to the
foregoing involve judgments that are difficult to predict accurately and are
subject to many factors that can materially affect results. Budgeting and other
management decisions are subjective in many respects and thus susceptible to
interpretations and periodic revisions based on actual experience and business
developments, the impact of which may cause the Company to alter its marketing,
capital expenditure, or other budgets, which may in turn affect the Company's
results. In light of the factors that can materially affect the forward-looking
information included herein, the inclusion of such information should not be
regarded as a representation by the Company or any other person that the
objectives or plans of the Company will be achieved.
Because of these and other factors affecting the Company's operating
results, past financial performance should not be overly relied upon as an
indicator of future performance, and investors should not overly rely upon
historical trends to anticipate results or trends in future periods. The
following factors also may materially affect results and therefore should be
considered.
The Company has experienced substantial fluctuations in its annual and
quarterly operating results, and such fluctuations are expected to continue in
future periods, and are unpredictable as to timing and magnitude. The Company's
operating results are affected by a number of factors, many of which are beyond
the Company's control. All products manufactured by the Company are custom
designed and assembled for a specific customer's requirement in anticipation of
the receipt of volume production orders from that customer, which may not always
materialize. The Company typically incurs significant start-up costs in the
production of a particular product, which costs are expensed as incurred.
Accordingly, the Company's level of experience in manufacturing a particular
product and its efficiency in minimizing start-up costs will affect the
Company's operating results during the periods in which production begins and
ramp-up occurs. The efficiencies of the Company in managing inventories and
fixed assets, shortages of components or labor, the degree of automation used in
the assembly process, fluctuations in material costs and the mix of materials,
labor, manufacturing and overhead costs are also significant factors affecting
annual and quarterly operating results. Other factors contributing to
fluctuations in the Company's operating results include price competition, the
inability to pass on cost overruns, the timing of expenditures in anticipation
of increased sales, customer product delivery requirements and the range of
services provided. In addition, the amount and timing of orders placed by a
customer may vary due to a number of factors, including inventory balancing,
changes in manufacturing strategy and variation in product demand attributable
to, among other things, product life cycles, competitive factors and general
economic conditions. Any one of these factors, or a combination thereof, could
materially adversely affect the Company's annual and quarterly results of
operations.
The Company's customers generally require short delivery cycles, and a
substantial portion of the Company's backlog is typically scheduled for delivery
within 90 days. Quarterly sales and operating results therefore depend in large
part on the volume and timing of bookings received during the quarter, which are
difficult to forecast. The short lead time for the Company's backlog also
affects its ability to accurately plan production and inventory levels. In
addition, a significant portion of the Company's operating expenses is
relatively fixed in nature and planned expenditures are based in part on
anticipated orders. Any inability to adjust
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spending by a sufficient amount or quickly enough to compensate for any revenue
shortfall may magnify the adverse impact of such revenue shortfall on the
Company's results of operations.
Dependence on the Data Storage Market
The Company's principal market is the data storage industry, which is
characterized by intense competition, relatively short product life cycles,
rapid technological change, significant fluctuations in product demand and
significant pressure on vendors to reduce or minimize costs. The storage
industry is also highly cyclical and has experienced periods of increased demand
and rapid growth followed by periods of oversupply and contraction. The impact
of cyclical trends on suppliers to this industry has been exacerbated by the
tendency of manufacturers of data storage products to order components in excess
of their needs during growth periods, followed by a sharp reduction in demand
for components during periods of contraction. The Company's operating results
have been adversely affected from time to time during storage industry slowdowns
and could be materially adversely affected in the event of further slowdowns in
this industry now or in the future. Although the Company is attempting to reduce
its dependence on the storage industry, revenues attributable to this market
represent a large majority of its revenues, and the Company's dependence on the
data storage industry is expected to continue or increase in the foreseeable
future.
Customer Concentration
The Company's customer base is highly concentrated. During fiscal 1997
and 1996, the Company's five largest customers (which include, in some cases,
multiple divisions) accounted for approximately 80% and 90% of net revenue,
respectively. The Company expects that sales to a relatively small number of
OEMs will continue to account for a substantial portion of net revenues for the
foreseeable future, and the loss of, or a decline in orders from, even one of
the Company's key customers would have a material adverse effect on the
Company's financial and operating results.
Component Supply and Sources
Substantially all of the Company's manufacturing services are provided
on a turnkey basis in which the Company, in addition to providing design,
assembly and testing services, is responsible for the procurement of the
components which are assembled by the Company for the customer. In certain
circumstances, the Company is required to bear the risk of component price
fluctuations, which could adversely affect the Company's gross margins. In
addition, in order to assure an adequate supply of certain key components which
have long procurement lead times, such as integrated circuits, the Company often
must order such components prior to receiving customer purchase orders for the
assemblies which require such components. Failure to accurately anticipate the
volume or timing of customer orders can result in component shortages or excess
component inventory, which in either case could adversely affect the Company's
financial and operating results.
Some of the assemblies manufactured by the Company require one or more
components that are ordered from, or which may be available from, only one
source or a limited number of sources. In particular, the Company relies on the
timely supply of components from ADFlex Solutions, Inc. ("ADFlex"), IBM, Mektec
Corporation ("Mektec"), Texas Instruments, Inc. ("TI"), Silicon Systems, Inc. (a
wholly owned subsidiary of TI), Toshiba America, Inc., and VTC, Inc. ADFlex is
also one the Company's competitors. During fiscal 1997, 1996 and 1995, the
Company purchased a majority of its flex components from either ADFlex or
Mektec, and a majority of its integrated circuits from IBM, TI and VTC, Inc.
Delivery problems relating to components purchased from any one of these or the
Company's other key suppliers could have a material adverse impact on the
financial performance of the Company. From time to time, the Company's suppliers
allocate components among their customers in response to supply shortages. In
some cases, supply shortages will substantially curtail production of all
assemblies using a particular component. In addition, at various times there
have been industry-wide shortages of electronic components, such as servo or
read/write circuits. The Company has experienced shortages of components in the
recent past. For example, in the first quarter of 1997, the Company experienced
a shortage of ceramic substrates for its COC program. During the second quarter
of 1997 this issue was resolved since all three
-11-
<PAGE> 12
of the Company's ceramic substrate suppliers were able to reach their planned
production goals. However, there can be no assurance that such shortages will
not recur in the future. Any such shortages could have a material adverse effect
on the Company's operating results.
International Operations
The Company maintains international operations in Singapore, Mexico,
and the Philippines. In September 1997, the Company announced a restructuring
plan to streamline worldwide operations. As part of this restructuring, the
Company moved its volume manufacturing from Singapore to its lower-cost
manufacturing facility in Cebu. The Singapore operations have become the focal
point of Smartflex customer support in Asia as the Company's Far East Regional
Services and Technology Center. In light of the continued relocating to offshore
facilities on the part of certain of the Company's customers, Smartflex
anticipates that it will be required to increase its presence overseas.
Manufacturing and sales operations outside the United States are accompanied by
a number of risks inherent in international operations, including but not
limited to imposition of governmental controls, compliance with a wide variety
of foreign and United States export laws, currency fluctuations, unexpected
changes in trade restrictions, tariffs and barriers, political and economic
instability, longer payment cycles typically associated with foreign sales,
difficulties in administering business overseas, labor union issues and
potentially adverse tax consequences. The Company historically has denominated
all export sales in United States dollars, and accordingly, whenever the
relative value of the U.S. dollar in comparison to the currency of the Company's
foreign customers or competitors increases, the resulting effective price
increase of the Company's products to such foreign customers has resulted and
would be expected to continue to result in decreased sales. The Company's
production employees at the Mexico facility are represented by a labor union and
covered by a collective bargaining agreement that is subject to revision
annually under Mexican law. The current agreement is subject to revision in
February 1999. While the Company believes that it has established good
relationships with its labor force in Mexico, there can be no assurance that
such relationships will continue in the future.
Variability of Customer Requirements and Customer Financing
The level and timing of orders placed by customers vary due to the
customers' attempts to balance their inventory, changes in customers'
manufacturing strategies and variations in demand for the customers' products.
Due in part to these factors, most of the Company's customers do not commit to
firm production schedules for more than three months in advance of requirements.
The Company's inability to forecast the level of customer orders with certainty
makes it difficult to schedule production and optimize utilization of
manufacturing capacity. In the past, the Company has been required to increase
staffing and incur other expenses in order to meet the anticipated demand of its
customers. From time to time, anticipated orders from some of the Company's
customers have failed to materialize and delivery schedules have been deferred
as a result of changes in a customer's business needs, both of which have
adversely affected the Company's operating results. On other occasions,
customers have required rapid increases in production, which have placed an
excessive burden on the Company's resources. Such customers' order fluctuations
and deferrals have had an adverse effect on the Company's operating results in
the past, and there can be no assurance that the Company will not experience
such effects in the future. In addition, the Company incurs significant accounts
receivable in connection with providing manufacturing services to its customers.
If one or more of the Company's principal customers were to become insolvent, or
otherwise were to fail to pay for the services and materials provided by the
Company, the Company's operating results and financial condition would be
adversely affected.
During the first half of 1998, due to the changing business dynamics of
the data storage industry, many Original Equipment Manufacturers ("OEM") had
higher inventories, reduced demand, and competitive pricing pressures. As a
result, some of the OEMs began to change their methodology of inventory
management. They began the move to a "build-to-order" or "pull" system of
inventory management from the traditional "build-to-forecast" system of
inventory management. Such a change in business dynamics results in reducing the
Company's visibility for orders, which in turn reduces order backlog.
-12-
<PAGE> 13
Rapid Technological Change
The Company and the Company's customer base each competes in markets
that are characterized by rapid technological change and short product life
cycles. In particular, the data storage, computer and communications markets are
prone to rapid product obsolescence by new technologies. The flexible
interconnect industry could experience future competition from new or emerging
technologies that render existing technology less competitive or obsolete. The
inability of the Company to develop technologies to meet the evolving market
requirements of its customer base could have a material adverse effect on the
Company's business, financial condition and results of operations, including the
Company's ability to maintain its revenue base.
Management of Growth
The Company has experienced certain periods of rapid growth which has
placed, and is expected to recurrently place, a significant strain on the
Company's management, operational and financial resources. The Company expects
that growth would require the addition of new management personnel and the
development of additional expertise by existing management personnel. The
Company's ability to manage growth effectively, particularly given the
increasingly international scope of its operations, will require it to continue
to implement and improve its operational, financial and management information
systems as well as to develop the management skills of its managers and
supervisors and to train, motivate and manage its employees. The Company's
failure to effectively manage growth could have a material adverse effect on the
Company's results of operations.
Dependence on Key Employees
The Company is highly dependent on its Chief Executive Officer, William
L. Healey, and each of the other principal members of its management team, the
loss of whose services could have a material adverse effect upon the business
and financial condition of the Company, as well as the ability of the Company to
achieve its objectives. None of such persons has a formal employment contract
with the Company. Principal members of management are entitled to severance
benefits in certain circumstances in accordance with a Company severance plan.
The Company is also dependent on other key personnel, and on its ability to
continue to attract, retain and motivate highly skilled personnel. The
competition for such employees is intense, and there can be no assurance that
the Company will be successful in attracting, retaining or motivating key
personnel or that personnel cost increases will not have an adverse effect on
the Company's net income or results of operations.
The Year 2000 issue
The "Year 2000 issue" variously known as "Y2K issue" or the "Millennium
Bug" arises out of the fact that many existing computer programs use only two
digits to identify a year in the date field, and if uncorrected, would fail or
create erroneous results by or at the Year 2000.
Early in 1997, the Company evaluated the Y2K issue and its impact on
the Company's operations. Currently, the Company uses IBM AS400 applications,
which are not Y2K compliant, and various desktop applications, which are Y2K
compliant.
A project to implement the latest versions of the IBM AS400
applications was launched in late 1997. This project also addresses the Y2K
issue. The project team consists of both dedicated resources and key functional
participants. Maintenance or modification costs will be expensed as incurred,
while the costs of new software will be capitalized and amortized over the
software's useful life. The project is estimated to be completed by the middle
of fiscal 1999 at a cost of approximately $750,000, most of which will be spent
in the current fiscal year. Failure to execute successfully and complete this
project and each step thereof as scheduled could cause material disruption of
the Company's operations and have material adverse impacts on its competitive
posture, financial position and results of operations. Many of the Company's
customers, suppliers and lenders have required the Company to provide assurances
concerning the Company's Y2K issue, and any failure by the Company also could
result in material demands or assertions of liability by such third parties or
others.
-13-
<PAGE> 14
The Company is in the process of contacting its major external
suppliers and customers to estimate compliance with the Y2K issue and is
presently evaluating inputs received from these external relationships. Failure
of any of the Company's major external suppliers and customers to appropriately
and timely address the Y2K issue could cause material disruption of the
Company's business and have material adverse impacts on the Company's results of
operations.
Environmental Compliance
The Company is subject to a variety of environmental regulations
relating to the use, storage, discharge and disposal of hazardous chemicals and
substances used in its manufacturing process. While the Company believes that it
is in material compliance with all existing applicable environmental statutes
and regulations, any failure by the Company to comply with statutes and
regulations presently existing or enacted in the future could subject it to
liabilities or the suspension of production. In addition, compliance with such
statutes and regulations could restrict the Company's ability to expand its
facilities or require the Company to acquire costly equipment or to incur other
significant expenses. Also see "Environmental Concerns."
Factors Inhibiting Change of Control
The Company's Certificate of Incorporation includes a provision that
allows the Board of Directors to issue up to 5,000,000 shares of Preferred Stock
and to determine the rights, preferences, privileges and restrictions of those
shares without stockholder approval. Preferred Stock could be issued with
voting, liquidation and dividend rights superior to those of holders of Common
Stock. An issuance of Preferred Stock also could have the effect of delaying or
preventing a change of control of the Company.
In addition, Section 203 of the Delaware General Corporation Law
restricts certain business combinations with any "interested stockholder" as
defined by such statute.
The Company's Shareholder Rights Plan provides for holders of Common
Stock (other than certain acquirers) to have the right to purchase stock of the
Company or an acquiring person at 50% of its fair market value following certain
events. The Shareholder Rights Plan could have the effect of delaying or
preventing a change of control of the Company.
Such provisions may reduce the price that certain investors may be
willing to pay in the future for shares of the Company's Common Stock, and may
reduce the possibility of any acquisition of the Company at a premium price,
unless such acquisition meets with approval by the Company's Board of Directors.
-14-
<PAGE> 15
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders.
The Company held its Annual Meeting of Stockholders on May 20, 1998.
The following is a brief description of each matter voted upon at the meeting
and a statement of the number of votes cast for, the number withheld or against,
as the case may be, and the number of abstentions with respect to each matter.
Both proposals were approved by the stockholders.
(a) The stockholders approved the election of the Company's board of directors.
<TABLE>
<CAPTION>
DIRECTOR FOR WITHHELD ABSTAINED
-------- --- -------- ---------
<S> <C> <C> <C>
William L. Healey 5,278,055 61,010 ---
William E. Bendush 5,275,640 63,425 ---
Alan V. King 5,277,355 61,710 ---
William A. Klein 5,291,240 47,825 ---
Gary E. Liebl 5,292,355 46,710 ---
</TABLE>
(b) The stockholders approved the appointment of Ernst & Young LLP as the
auditors of the Company for the fiscal year ending December 31, 1998.
<TABLE>
<CAPTION>
FOR AGAINST ABSTAINED
--- ------- ---------
<S> <C> <C>
5,313,288 21,274 4,503
</TABLE>
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits --- See Exhibit Index.
(b) No reports on Form 8-K were filed during the three months ended June 30,
1998.
-15-
<PAGE> 16
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.
SMARTFLEX SYSTEMS, INC.
(Registrant)
August 10, 1998 By: /s/ John W. Hohener
- ------------------------- --------------------------------------------
Date John W. Hohener
Vice President, Chief Financial Officer, and
Duly Authorized Officer
(Principal financial and accounting officer)
-16-
<PAGE> 17
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------------ -------------------------------------------------------------
<S> <C>
27 Financial Data Schedule (filed electronically).
</TABLE>
-17-
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 1,697
<SECURITIES> 28,641
<RECEIVABLES> 14,714
<ALLOWANCES> 935
<INVENTORY> 5,741
<CURRENT-ASSETS> 54,765
<PP&E> 31,896
<DEPRECIATION> 14,225
<TOTAL-ASSETS> 73,587
<CURRENT-LIABILITIES> 21,762
<BONDS> 0
0
0
<COMMON> 16
<OTHER-SE> 50,571
<TOTAL-LIABILITY-AND-EQUITY> 73,587
<SALES> 64,042
<TOTAL-REVENUES> 64,042
<CGS> 56,914
<TOTAL-COSTS> 56,914
<OTHER-EXPENSES> 5,783
<LOSS-PROVISION> 165
<INTEREST-EXPENSE> 87
<INCOME-PRETAX> 1,840
<INCOME-TAX> 625
<INCOME-CONTINUING> 1,215
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,215
<EPS-PRIMARY> 0.19
<EPS-DILUTED> 0.19
</TABLE>
