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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 September 26, 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 incorporation or (I.R.S. Employer
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 October 30, 1998
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Page 1 of 19
Exhibit Index on Page 19
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SMARTFLEX SYSTEMS, INC.
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets (Unaudited) as of September 30,
1998 and December 31, 1997 3
Condensed Consolidated Statements of Operations (Unaudited) for the
three and nine months ended September 30, 1998 and September 30, 1997 4
Consolidated Statements of Cash Flows for the nine months ended
September 30, 1998 and September 30, 1997 5
Notes to Unaudited Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 8-16
PART II. OTHER INFORMATION
Item 5. Other Information 17
Item 6. Exhibits and Reports on Form 8-K 17
SIGNATURES 18
INDEX TO EXHIBITS 19
</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
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SMARTFLEX SYSTEMS, INC.
Condensed Consolidated Balance Sheets (Unaudited)
(Dollars in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
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<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 3,553 $ 2,069
Short-term investments 25,302 26,051
Accounts receivable, net of allowance for doubtful accounts
of $935 at September 30, 1998 and $1,384 at
December 31, 1997 14,194 19,252
Inventories:
Raw materials 1,868 6,943
Work-in-process 1,924 2,725
Finished goods 908 2,432
-------- --------
Total inventories 4,700 12,100
Deferred income taxes 3,541 3,541
Prepaid expenses and other current assets 1,614 1,755
-------- --------
Total current assets 52,904 64,768
Property and equipment, at cost:
Machinery and equipment 24,093 20,930
Office furniture and equipment 4,164 3,148
Leasehold improvements 4,920 4,460
-------- --------
33,177 28,538
Less accumulated depreciation and amortization (15,816) (12,260)
-------- --------
Total property and equipment 17,361 16,278
Deferred income taxes 350 350
Other assets 669 510
-------- --------
$ 71,284 $ 81,906
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable to related parties $ 177 $ 533
Accounts payable 6,905 18,990
Accrued compensation and related costs 1,768 1,569
Accrued restructuring liabilities 1,363 3,923
Other accrued liabilities 8,654 5,050
Current portion of notes payable 596 1,063
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Total current liabilities 19,463 31,128
Long-term portion of notes payable 1,100 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
September 30, 1998 and 6,362,477 at
December 31, 1997, respectively 16 16
Additional paid-in capital 36,401 36,118
Retained earnings 14,304 12,955
-------- --------
Total stockholders' equity 50,721 49,089
-------- --------
$ 71,284 $ 81,906
======== ========
</TABLE>
See accompanying notes. -3-
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SMARTFLEX SYSTEMS, INC.
Condensed Consolidated Statements of Operations
(In thousands except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30 September 30
----------------------- -----------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net revenues $ 20,504 $ 28,010 $ 84,546 $ 95,285
Cost of revenues 18,086 26,670 75,000 88,401
-------- -------- -------- --------
Gross margin 2,418 1,340 9,546 6,884
Costs and expenses:
Marketing and sales expense 898 812 2,714 2,632
General and administrative
expense 1,646 1,932 5,613 5,038
Restructuring expense -- 6,500 -- 6,500
-------- -------- -------- --------
Operating (loss) income (126) (7,904) 1,219 (7,286)
Interest income 334 233 818 760
Interest expense (59) (129) (146) (389)
Other income (expense) 53 (67) 151 (159)
-------- -------- -------- --------
Income (loss) before income taxes 202 (7,867) 2,042 (7,074)
Income tax provision (benefit) 68 (2,431) 694 (2,430)
-------- -------- -------- --------
Net income $ 134 $ (5,436) $ 1,348 $ (4,664)
======== ======== ======== ========
Net income per share:
Basic $ 0.02 $ (0.86) $ 0.21 $ (0.73)
======== ======== ======== ========
Diluted $ 0.02 $ (0.85) $ 0.21 $ (0.72)
======== ======== ======== ========
Shares used in computing net
income per share:
Basic 6,431 6,338 6,408 6,334
======== ======== ======== ========
Diluted 6,464 6,424 6,462 6,436
======== ======== ======== ========
</TABLE>
See accompanying notes. -4-
<PAGE> 5
SMARTFLEX SYSTEMS, INC.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
-----------------------
1998 1997
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<S> <C> <C>
Cash flow from operating activities:
Net income (loss) $ 1,348 $ (4,644)
Adjustments to reconcile net income (loss) to
cash provided by (used in) operating activities:
Depreciation and amortization 3,672 3,104
Loss on sale of property and equipment -- 150
Provision for doubtful accounts 165 (189)
Provision for inventory obsolescence 2,252 564
Deferred income taxes -- (68)
Other changes in operating assets and liabilities:
Receivables 4,893 3,971
Inventories 5,148 (2,385)
Prepaid expenses and other assets (18) 161
Accounts payable to related parties (356) (1,698)
Accrued restructuring cost (2,560) --
Accounts payable and accrued expenses (8,279) 1,412
-------- --------
Net cash provided by (used in)
operating activities 6,265 378
Cash flow from investing activities:
Capital expenditures (4,757) (9,309)
Purchase of short-term investments (614) (12,036)
Proceeds from the sale of short-term investments 1,363 15,180
-------- --------
Net cash used in investing activities (4,008) (6,165)
Cash flow from financing activities:
Net proceeds from issuance of common stock 283 231
Net borrowings on revolving line of credit -- 4,939
(Repayments) borrowings on term loan (1,056) 1,723
-------- --------
Net cash (used in) provided by
financing activities (773) 6,893
-------- --------
Net (decrease) increase in cash 1,484 1,106
Cash at beginning of period 2,069 1,164
-------- --------
Cash at end of period $ 3,553 $ 2,270
======== ========
Supplemental disclosures of cash flow information:
Interest paid $ 146 $ 310
Taxes paid 1,315 101
</TABLE>
See accompanying notes. -5-
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SMARTFLEX SYSTEMS, INC.
Notes to Unaudited Condensed Consolidated Financial Statements
September 30, 1998
Note (A) -- Basis of Presentation
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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 September 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
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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
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On October 1, 1998, 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, 2000. At September 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 September 30,
1998, the outstanding balance of the term loan was approximately $1.7 million.
The facility additionally provides for a second unsecured term loan totaling
$3.0 million for land and building commitments in relation to the Company's
Monterrey Mexico facility. The loan bears interest at LIBOR plus 1.5%. Principal
and interest are payable monthly and the loan matures five years after funding.
At September 30, 1998, there was no borrowing against this term loan.
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Note (E) -- Impact of newly issued pronouncement by the Financial Accounting
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Standards Board
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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 nine months ended September 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
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of Operations
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The following information includes forward-looking statements, such as
all plans, intentions, projections, and beliefs, the realization of which may be
impacted materially by certain important factors discussed in "Risk Factors,"
below, and the other information in this Form 10-Q. Therefore, investors are
cautioned not to place undue reliance thereon or on historic information as an
indication of future performance.
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 nine months ended September 30, 1998, HDD revenues comprised
48.8% of total revenues, compared to 61.1% for the same period last year.
During the first nine months 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 third quarter of 1998 decreased 26.8% from the same
period in the prior year and they decreased 24.2% from the previous quarter of
the current year. During the second quarter ended September 30, 1998, total unit
shipments were approximately 2,101,000 units, or 35.68%, less than the second
quarter of 1998 and approximately 430,000 units, or 10.2%, less than the same
period in 1997. Average selling prices ("ASP") increased during this period from
the previous quarter of the current year, as the product mix percentage of
non-HDD to the total was higher. On average non-HDD products have historically
had higher ASP's than the average of HDD products.
RESULTS OF OPERATIONS
Net Revenues
Net revenues in the third quarter of 1998 decreased approximately $7.5
million or 26.8% from the comparable quarter in the prior year. Net revenues in
the third quarter of 1998 decreased approximately $6.5 million or 24.2% from the
previous quarter in the current year. The decrease in the third quarter of 1998
is believed attributable to the uncertainty in the technology markets and
continuing softness in demand in the data storage industry. Net revenues for the
first nine months of 1998 decreased approximately $10.7 million or 11.3% from
the comparable nine months of 1997.
During the first nine months of fiscal 1998, net revenues from non-HDD
programs increased to 51.2% of total revenues from 38.9% during the same period
in the prior year primarily due to increases in the removable and tape storage
programs and a reduction in HDD programs.
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<PAGE> 9
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 export sales were
73.1% in the third quarter of 1998, compared to 77.5% in the third quarter in
1997. The decrease was due to reduced shipments primarily in the 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 September 1998, the Company had used approximately $3.1 million for
the write-down of non-current assets and other expenses and has paid
approximately $993,000 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 11.8% and 4.8% for
the third quarters of fiscal 1998 and 1997, respectively. Gross margins for the
nine month periods ended September 30, 1998 and 1997 were 11.3% and 7.2%,
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
and third quarters of the current year, as compared to the same two periods in
the prior year.
Marketing and Sales Expense
Marketing and sales expenses consist primarily of salaries, facility and
travel costs for marketing, sales, customer service, and new business
development personnel, and sales commissions paid to direct sales personnel and
sales representative organizations. These expenses increased slightly during the
third quarter and for the first nine months of fiscal 1998 as compared to the
same respective period in the prior year. Decreases in commissions, as a result
of lower revenue, were offset somewhat by increased staffing within the sales
and new business development organizations, and increased travel and advertising
expense. As a percentage of net revenues, marketing and sales expenses increased
to 3.2% for the first nine months of fiscal 1998, compared to 2.8% 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 nine months ended
September 30, 1998 compared to the same period in 1997. In absolute dollars G &
A expenses were approximately $5.6 million in the first nine months of fiscal
1998, an increase of approximately $575,000 from the G & A expenses in the first
nine months of fiscal 1997. As a percentage of net revenues, G & A expenses were
6.6% for the current year's first nine months, compared to 5.3% for the nine
months ended September 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. This was
offset by decreases in
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<PAGE> 10
profit sharing expense and other spending controls in the third quarter of 1998,
which resulted in a decrease of $286,000 compared to the third quarter of 1997.
Interest Income
Short-term investments, on average, were at a slightly higher level
during the first nine months of fiscal 1998 compared to the first half of fiscal
1997, resulting in a $58,000 increase in interest income compared to the same
period a year ago.
Income Taxes
The Company's provision for income taxes was approximately $694,000 in
the nine months ended September 30, 1998, as compared to an income tax benefit
of $2.4 million for the nine months ended September 30, 1997. The Company's
restructuring in the third quarter of the prior year coupled with an operational
loss in the same period allowed the Company to book the benefit.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1998, the Company's principal sources of liquidity
included $28.9 million in cash and short-term investments, and $28.0 million in
available borrowings under its bank credit facility ("facility"). On October 1,
1998, 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, 2000. At September 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 September 30, 1998, the outstanding balance of the term loan was
approximately $1.7 million. The facility additionally provides for a second
unsecured term loan totaling $3.0 million for land and building commitments in
relation to the Company's Monterrey Mexico facility. The loan bears interest at
LIBOR plus 1.5%. Principal and interest are payable monthly and the loan matures
five years after funding. At September 30, 1998, there was no borrowing against
this term loan.
Short-term investments at September 30, 1998 totaled $25.3 million, and
consisted primarily of holdings in municipal bonds, money market instruments,
and 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 $749,000 as of September 30, 1998 as compared to
December 31, 1997. For all short-term investments at September 30, 1998, cost
approximated fair market value. Cash and cash equivalents increased $1.5 million
over the nine-month period ended September 30, 1998.
Over the nine months ended September 30, 1998, net inventory levels
decreased $7.4 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 nine months ended September 30, 1998, the Company acquired
$4.8 million in capital equipment and leasehold improvements, primarily for the
expansion of its offshore manufacturing facilities.
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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 data storage industry, dependence upon export sales, the
impact of conducting international operations, international currency
fluctuations, the transition of volume manufacturing operations from Singapore
to the Philippines, efficient utilization of manufacturing facilities and
financial resources, qualification of manufacturing processes, potential
interruption of the flow of components from a limited number of suppliers,
subsequent changes in business strategy or plan, the ability to retain and
attract qualified personnel, timely completion of the business systems
implementation, and structural and strategic changes affecting certain of the
Company's existing customers, suppliers and competitors, the future financial,
economic, competitive and market conditions and their potential direct or
indirect effect, including cancellations of orders included in backlog, the
integration and management of newly acquired entities or businesses, the ability
to effectively identify, investigate, conclude, integrate and manage
acquisitions and large scale projects, 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,
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<PAGE> 12
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 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
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<PAGE> 13
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 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 its Monterrey, 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.
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<PAGE> 14
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 nine months 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.
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
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<PAGE> 15
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.
Year 2000 Readiness Disclosure
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. So called "embedded systems" that may control manufacturing equipment
and other fixtures and equipment, have been identified, and though minimal, have
been determined to be 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. The project consists of five main steps or phases: the first phase
being an assessment of viable alternatives from commercially available
applications; the second phase being the decision process of which application
to secure; the third phase consists of configuring the system to run the
Company's business; phase four will include training, testing and piloting all
applications; and the final phase consisting of company wide implementation. The
team identified, and the Company has committed to implement an enterprise
application that is Y2K compliant. Maintenance or modification costs will be
expenses as incurred, while the costs of new software will be capitalized and
amortized over the software's useful life. The Company has completed phases one,
two and three and is currently in the training process. All user functions have
or will be going through training, and all requirements are being developed for
immediate use upon implementation. The total project is estimated to be
completed by the middle of fiscal 1999 at a cost of approximately $1,000,000,
which will be spent throughout the duration of the project implementation. Cost
to date has been approximately $440,000. 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.
The Company is in the process of contacting its major external
suppliers, customers and other business partners to estimate their 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.
The Company feels that it will successfully implement the Y2K compliant
software, described above. However, a contingency plan is being developed if
timely implementation is not achieved. The contingency plan will be completed by
January 1, 1999.
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
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<PAGE> 16
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.
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<PAGE> 17
PART II. OTHER INFORMATION
Item 5. Other information
The Company announced on October 8, 1998 that it purchased all the outstanding
stock of Logical Services Inc., of Santa Clara, California for $2.3 million in
cash. Logical is a privately held electronic engineering, design and development
company whose inception dates to 1973.
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
September 30, 1998.
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<PAGE> 18
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)
<TABLE>
<S> <C>
November 6, 1998 By: /s/ John W. Hohener
- --------------------------------- --------------------------------------------------
Date John W. Hohener
Vice President, Chief Financial Officer, and
Duly Authorized Officer
(Principal financial and accounting officer)
</TABLE>
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<PAGE> 19
INDEX TO EXHIBITS
Exhibit
Number Description
- ---------- ----------------------------------------------------------------
27 Financial Data Schedule (filed electronically).
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 3,553
<SECURITIES> 25,302
<RECEIVABLES> 15,129
<ALLOWANCES> 935
<INVENTORY> 4,700
<CURRENT-ASSETS> 52,904
<PP&E> 33,177
<DEPRECIATION> 15,816
<TOTAL-ASSETS> 71,284
<CURRENT-LIABILITIES> 19,463
<BONDS> 0
0
0
<COMMON> 16
<OTHER-SE> 50,705
<TOTAL-LIABILITY-AND-EQUITY> 71,284
<SALES> 84,546
<TOTAL-REVENUES> 84,546
<CGS> 75,000
<TOTAL-COSTS> 75,000
<OTHER-EXPENSES> 8,327
<LOSS-PROVISION> 165
<INTEREST-EXPENSE> 146
<INCOME-PRETAX> 2,042
<INCOME-TAX> 694
<INCOME-CONTINUING> 1,348
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,348
<EPS-PRIMARY> 0.21
<EPS-DILUTED> 0.21
</TABLE>
