UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended September 30, 2003.
o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______________ to _______________.
Commission File Number 0-13143
Innovex, Inc.
(Exact name of registrant as specified in its charter)
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Minnesota |
41-1223933 |
|
(State or other jurisdiction of |
(IRS Employer |
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incorporation or organization) |
Identification No.) |
5540 Pioneer Creek Drive, Maple Plain, MN 55359
(Address of principal executive offices)
(763) 479-5300
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock ($.04 par value)
(Title of Class)
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 o No
Indicate by check mark if disclosure of delinquent filers pursuant to Rule 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes x No o
The aggregate market value of shares held by non-affiliates is $92, 884,724 computed by reference to the last sale price of the Company’s Common Stock, as reported in the Nasdaq National Market system, of $6.49 per share on March 31, 2003, the last business day of the Company’s most recently completed second fiscal quarter. As of November 15, 2003, the Company had outstanding 18,962,801 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held January 20, 2004, are incorporated by reference into Part III.
Index
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We maintain a website at www.innovexinc.com. Our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our periodic reports on Form 8-K (and any amendments to these reports) are available free of charge on our website as soon as reasonably practical after we file these reports with the SEC.
Our Company
We are a leading worldwide provider of flexible circuit interconnect solutions to original equipment manufacturers (“OEMs”), in the electronics industry. We offer a full range of customized flexible circuit applications and services from initial design, development and prototype to fabrication, assembly and test on a global basis. We target high volume markets where miniaturization, form and weight are driving factors and flexible circuits are an enabling technology. Applications for flexible circuits currently addressed by us include data storage devices such as hard disk drives (“HDDs”), liquid crystal displays (“LCDs”) for mobile communication devices, tape drives and arrays, flat panel displays and printers. Our customers include 3M, Dell, Hitachi, HP, Maxtor, Medtronic, Philips, Quantum, SAE Magnetics (a subsidiary of TDK), Samsung, Seagate, Staktek, StorageTek, Xerox and other leading electronic OEMs.
Our Industry and Market Trends
Flexible circuit interconnects provide electrical connection between components in electronic systems and are increasingly used as a platform to support the attachment of electronic components. Flexible circuits consist of copper conductive patterns on flexible substrate materials, such as polyimide. Flexible circuit interconnects frequently incorporate components, such as integrated circuits (“ICs”), connectors, stiffeners, resistors and capacitors mounted directly on a flexible circuit. Generally, flexible circuits offer several advantages over other technologies such as rigid printed circuit boards (“PCBs”) and ceramic hybrid circuits, particularly for small, complex electronic systems. Flexible circuits, due to their mechanical flexure and three-dimensional shape, accommodate packaging contours and motion in a manner that traditional two-dimensional, rigid PCBs cannot, particularly in applications involving smaller, more portable and complex electronic devices where space available to designers is at a premium.
We believe that the overall market for high density flexible circuits is poised for substantial growth over the next several years as a result of favorable technological and market trends that are expected to drive increased adoption. These trends include the following:
Miniaturization, Portability and Complexity of Electronic Products. Electronics OEMs continue to design and introduce more compact and portable high-performance products with greater functionality. The complexity of these new products requires smaller size, lighter weight, greater circuit and component density, better thermal dissipation properties, higher frequencies and increased reliability as compared to conventional rigid board assemblies. These requirements often necessitate the use of high density flexible circuit interconnects.
Outsourcing. OEMs are increasingly focusing on their core competencies and outsourcing their captive component and subsystem manufacturing. To meet their rapidly changing electronic interconnect requirements, many OEMs have moved to limit their vendor base to a smaller number of technically qualified, strategically located suppliers capable of providing both quick-turn prototype and pre-production quantities as well as cost-competitive volume production quantities. This allows OEMs to reduce time to market, avoid delays in new product introductions, reduce manufacturing costs and avoid logistical complexities.
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Improved HDD Industry Dynamics. The HDD industry has been an early adopter of high density flexible circuits and is a key end market for high-end, high density flexible circuits. We believe the HDD industry represented $700 million of the $2.8 billion market for high density flexible circuits in 2002. HDD applications require flexible circuits that meet highly demanding technical specifications and can be produced in high volumes in a cost-effective manner. Although the HDD industry has experienced price erosion that has negated high growth rates in unit volume, we believe the industry dynamics are improving. International Data Consulting (“IDC”) estimates that the HDD market will exhibit compound annual revenue growth of 6% from 2002 through 2007 on compound annual unit growth of 11%. Average annual selling price (“ASP”) erosion is expected to slow significantly to a compounded annual ASP decline of 5% from 2002 through 2007. In contrast, from 2001 through 2002 ASPs declined 14%.
Trends benefiting the HDD industry, and in conjunction the increased usage of flexible interconnect circuits required by HDD include:
Significant Industry Consolidation. The number of HDD manufacturers has fallen from 75 in 1984 to 22 in 1997 to seven today, with the top four HDD players (Seagate, Hitachi, Maxtor and Western Digital) representing over 85% of the market.
Less Rapid Technology Changes and Longer Product Life Cycles. Areal densities (“AD”), a measure of the number of units of storage on a specified area of a disk typically denoted by “gigabytes per square inch,” which have typically increased 100% or more per year, are now expected to grow only 50% annually. It is becoming technically more difficult to make AD advances which should extend product life cycles. Historically, the average number of heads per drive has declined quickly due to rapid AD increases, with the rate of decline decreasing in more recent periods.
Increased Usage of HDD in Consumer and Non-traditional Applications. The emerging consumer electronics segment that includes devices such as the Xbox™ gaming console, TV set top recorders and digital music players such as the iPod™, is emerging as a significant driver of growth for HDDs. According to IDC, this segment will account for 7-8% of total HDD shipments in 2003, and exhibit a compound annual unit growth of 43% from 2002 through 2007.
Beyond HDD, high density flexible circuits are increasingly being used in high unit volume consumer electronic products such as mobile communications devices, flat panel displays, digital televisions and inkjet printers. This trend is driven by the end market, which demands consumer products with additional functionality, availability in lighter weight smaller packages, better performance and lower cost than previous generations of systems. To meet this demand, OEMs will need to continually evaluate more complex interconnect solutions that allow them to continue to enhance their product offerings in a cost-effective manner.
Competitive Strengths
We believe our industry leadership is the direct result of our technological innovation and our ability to provide comprehensive solutions that address our customers’ specific interconnect needs. Our key competitive strengths include:
Technology Leadership. Although there are a large number of flexible circuit manufacturers, only a few compete with us in high-end, sub-100 micron applications. We believe that technology, design capability, quality and price are key competitive factors in this segment. Our manufacturing technology includes proprietary processes and chemical recipes which, when combined with our design expertise and experience, enable us to deliver high unit volumes of complex high density flexible circuits at cost-effective prices.
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Comprehensive Product Portfolio. Our products address a range of applications that include the following: (i) FSA, which provides the electrical interconnect from the disk drive head to the back-end electronics of the disk drive; (ii) actuator flex, which provides the back-end electrical interconnect for hard disk drives; and (iii) a variety of high-end, high density flexible circuits for markets such as LCD displays for mobile communication devices, plasma displays, printers, semiconductor packaging and medical applications.
Product Innovation. We are recognized as a technology innovator with a history of developing products that provide better performance at a lower cost than our competitors. For example, in the HDD industry our FSA technology has been selected by a leading HDD vendor as the preferred solution for its current generation, higher density platform. In addition, other HDD vendors are evaluating our proprietary FgSA technology as additional conductors are required and lower suspension stiffness is desired. The technical expertise we have developed in serving the highly demanding HDD industry has enabled us to introduce advanced products in other rapidly growing markets.
Leading Customer Relationships. We have developed strong relationships with Seagate, Maxtor, Philips, Samsung, Hitachi and other industry leaders. Our customer relationships represent significant entry barriers as we believe that once a customer has selected us to design and manufacture a flexible circuit interconnect, the customer generally relies on our design for the life of that specific application and, frequently, subsequent generations of similar applications.
Global Manufacturing and Supply Chain Efficiency. We maintain manufacturing facilities in both the U.S. and Asia. Our U.S. facilities provide a high level of automation while our Asian facilities allow us to consolidate the labor intensive aspects of production in a low-cost environment. The combination of these two manufacturing models and our continued attention to manufacturing processes allows us to continually improve our production yields, shorten our supply chain and lower the overall costs of our products.
Implementation of Six Sigma. Through the introduction of the Six Sigma quality management program, we are reducing the process variation in our manufacturing facilities, resulting in improved quality, reliability and performance of our flexible circuit products. Six Sigma is a highly disciplined quality management and process optimization methodology that relies on the rigorous use of statistical techniques to assess process variability and defects. Six Sigma has been adopted by many large industrial companies to significantly improve their business processes.
Experienced Management Team. Our management team has a demonstrated track record of successfully harnessing and capitalizing on disruptive technology. They have managed rapid technological change by successfully transforming our company from a lead wire interconnect manufacturer to a leading worldwide flexible circuit provider over a two-year period. While identifying and opening new markets for our flexible circuit products, our management team has successfully implemented manufacturing efficiency plans throughout a global manufacturing and sourcing network.
Our Strategy
To enhance our position as a leading provider of flexible interconnect solutions we intend to pursue the following business strategies:
Continue to Expand Our Market Share in Our Core Markets. We believe that we will be able to continue to capture additional market share from leading OEMs in the HDD market with our FSA, FgSA and actuator flex solutions. As the HDD industry continues to transition to higher recording densities, the advantages of our technology will provide significant benefits to our customers on both a functional and a cost basis. Certain HDD industry leaders are currently evaluating our product
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offerings for potential future applications. In addition, our FgSA product is well suited for adoption in a number of next generation HDD applications.
Continue to Penetrate New Markets. We have proven our ability to leverage our expertise in high volume, high density applications to address emerging growth opportunities. We believe the technology, research and development and manufacturing capabilities we have developed to serve our core markets have put us in a position to target additional high volume applications, such as LCD and plasma displays, semiconductor packaging applications and inkjet printer cartridges, which we believe in the aggregate represent a market opportunity for us of over $1.0 billion.
Increase Manufacturing and Supply Chain Efficiencies and Flexibility. We intend to continue our manufacturing improvement and cost reduction efforts. Through continued deployment of our Six Sigma quality management program, we intend to significantly improve our efficiency, reduce our manufacturing and operating expenses and enhance the quality of the products we manufacture by decreasing manufacturing defects and improving product reliability. We expect to realize cost efficiencies by applying more automation at all of our manufacturing facilities. In addition, by further integrating our operations with our suppliers and customers, we believe that we can continue to reduce our working capital needs and improve our responsiveness to customer requirements.
Current Product Applications
We offer our products to a broad range of markets including the hard disk drive, display, semiconductor packaging and consumer electronics markets. We believe our products are differentiated by their advanced process technology, innovative design, low cost and the functional benefits they provide to our customers.
Current markets addressed by our products include:
Flex Suspension Assembly. The disk drive market uses flexible circuits as the interconnect between the read/write head and disk drive electronics. These applications include our FSA product which provides the electrical interconnect from the disk drive head to the back-end electronics (actuator flex) of the disk drive. FSA is a flexible circuit that is bonded to a suspension for customers desiring a more complete solution. As a next generation to our FSA product we have also introduced our FgSA product. We believe FgSA represents a significant improvement over current generation suspension technology and provides improved technical performance at a lower cost than competing products by increasing the utilization of the flexible circuit mechanical characteristics, which simplifies the suspension used in the assembly.
Data Storage. Our products for the data storage market include interconnects used for tape drives, disk arrays and other interconnects used in hard disk drives. Our actuator flex product provides the back-end electronic interconnect for hard disk drives. We are a leading provider of flip chip interconnect solutions for these applications. Flip chip technology, in which an unpackaged die is mounted directly onto the flexible circuit substrate, is becoming the predominant interconnect technology for these applications. We will continue to provide flexible circuit interconnect solutions to the tape storage industry to address customers’ continuing data backup and archiving needs.
New Ventures. We continue to apply our technology and products to new markets. We produce advanced flexible circuits for high-end consumer electronics markets and other markets that could benefit from the technological advantages of our flexible interconnect solutions. Based on our assessment of industry trends and market indicators, we believe these markets will grow rapidly in the future. We are currently offering or developing new product offerings for the following applications: LCD displays for mobile communication devices, large screen plasma and LCD displays, inkjet printer cartridges, semiconductor packaging and medical applications.
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Technology
We are recognized as a technology leader in fine-line, single and double-sided flexible circuit technology and flexible circuit assembly technology, including advanced chip-on-flex, flip chip-on-flex and precision placement assembly technologies. Our process technology includes proprietary processes and chemical recipes, which coupled with our design expertise and experience, enables us to deliver high unit volumes of complex high density flexible circuits at cost-effective yields.
Design Technology. The flexible circuit interconnects we manufacture are designed specifically for each application, requiring significant joint design activities with the customer at the start of a project. We have developed design methodologies that solve difficult interconnection problems and save our customers time and money. We also design and produce, in volume, flexible circuits that range from high density, single-sided circuits to more complex double-sided and multi-layer circuits. We are continually investing in and improving our computer-based design tools to more quickly design new flexible circuit interconnects, to enhance cooperative design and communication with our customers and to more closely link designs to our manufacturing process.
Circuit Fabrication Technology. We have extensive experience producing fine-line polyimide flexible circuits and have pioneered manufacturing processes that deliver high unit volumes at cost-effective yields. At the core of the process is roll-to-roll fine-line circuit processing. The starting materials are flexible laminates composed of a thin dielectric film that is either adhesive-bonded to treated copper foil or metalized without the use of adhesives. Very accurate images (down to 0.001 inches) are produced in volume in photoresist. Circuit conductors are then formed by chemically etching the underlying copper. Coverfilm and covercoat materials are adhered to the circuitry to provide an insulative coating and to expose contact pads for surface metalization. The exposed copper surfaces are then coated with solder, gold or another surface finish for assembly or bonding applications. Laser processing is used to create various openings such as vias and to cut contoured peripheries in substrate materials.
Our key flexible circuit fabrication technologies include:
Fine Feature Wide-Width Roll-to-Roll Processing. Our process allows us to fabricate circuits with very fine line widths and spaces at higher density of parts per square foot which increases material and equipment utilization. Processing 12-inch to 24-inch wide web (as opposed to the narrower industry standard) in a continuous roll-to-roll format (as opposed to discrete panels) allows us to fabricate higher volumes at lower cost.
Process Technologies. We utilize the following process technologies in our circuit fabrication process:
Semi-additive Metallization. Allows the fabrication of flexible circuits with finer lines and spaces through the selective metalization of the conductors in the circuit fabrication process.
Laser Processing. Produces low cost, very fine openings, small vias and contoured shapes that solve density problems while avoiding more expensive traditional alternatives. Also, using a laser to cut the periphery of parts allows prototypes and low volume production parts to be built faster and without the cost of a blanking die.
Bondable Gold Plating. Prepares flexible circuit conductors and pads for various bonding processes including chip-on-flex, which saves space and improves electrical performance by wire bonding a semiconductor die directly to the flexible circuit.
Coverfilm and Covercoat Application. Adheres coverfilm and covercoat materials to the circuitry to provide an insulative coating and to expose contact pads for surface metalization. This
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process allows accurate positioning of solder plated pads to support fine pitch surface mount assembly to the finished circuits.
Assembly and Test Technology. We differentiate ourselves from our competitors by offering both assembly and test technology to provide complete flexible circuit interconnect assemblies to our customers. We assemble passive electrical and various mechanical components, including connectors, stiffeners, diodes, formed metal parts and other devices to flexible circuits in our plants in Thailand. We also perform advanced direct die attach and assembly of integrated circuit devices as well as the functional testing of these flexible circuit assemblies. Assembling these components directly onto the flexible circuit increases performance and reduces space, weight and cost.
Flex Suspension Assembly. We have exclusive license rights to a proprietary automated process to attach flexible circuits to suspensions for disk drive applications. We also have exclusive license rights to the FgSA product in the HDD industry. The FgSA product provides improved technical performance at a lower cost than competing products by increasing the utilization of the flexible circuit mechanical characteristics, which simplifies the suspension used in the assembly.
Research and Development
We continually engage in research, development and engineering activities. Our goal is to utilize these activities to improve and enhance existing products and processes and to develop new products and processes in order to expand our market share. Our research and development effort is concentrated on improving and increasing long run flexible circuit manufacturing capabilities for both adhesiveless and adhesive based flexible circuits, developing processes for manufacturing new products including flexible circuits for display, integrated circuit substrate and printer applications, developing new FSA and FgSA generations and improving the FSA attachment process.
We have a 35% investment in, and work very closely with, Applied Kinetics, Inc. (“AKI”), the company that developed the unique manufacturing process technology utilized by our FSA products and the unique product design technology utilized by our FgSA products. We have a license to use this technology in our products for disk drive applications on an exclusive basis through 2009 and on a nonexclusive basis thereafter until 2012, and we continue to work with AKI as part of our on-going development efforts.
Manufacturing
We have developed a manufacturing system that combines the use of technology with the deployment of human resources in a geographic and organizational manner that we believe allows us to be a global leader in providing low-cost, high technology flexible circuits. Quality systems are in place that are certified to standards set by demanding customers in the electronics industry. All operations have received ISO 9002 certification.
We believe our manufacturing processes, in particular our 12-inch and 24-inch wide web roll processing lines, are designed to optimize the utilization of automation, labor and capital, and deliver better yield, material utilization and throughput relative to our competitors. Most of our automated circuit fabrication processes are performed in Minnesota where there is an ample supply of qualified technical resources with the more labor intensive processes performed in Thailand to remain competitive with low cost based competitors.
Suppliers
We purchase raw circuit materials, process chemicals and various components from multiple outside sources. For components, we typically make short-term purchasing commitments to key suppliers for specific customer programs. These commitments are usually made for three to twelve month periods.
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These suppliers commit to providing cooperative engineering, as required, and in some cases maintain a local inventory to provide shorter lead times and reduced inventory levels for us. In most cases, suppliers are approved, and are often dictated by our customers. For process chemicals, we rely on a limited number of key suppliers. We currently can obtain certain types of photoresist, a liquid compound used in the photoetching process, certain copper and polyimide laminate materials and certain specialty chemicals used in our manufacturing process from only one supplier of each such material. Alternate chemical products are available from other sources, but process chemical changes would often require requalification of the processes, which could take weeks or months to complete. We mitigate these risks by identifying stable companies with leading technology and delivery positions and by attempting to qualify two suppliers for all critical raw materials and components.
Sales, Marketing and Customer Support
We sell and market our products directly to a number of industries requiring electronic interconnects through the use of an internal sales staff. In addition, we utilize sales representatives on a limited basis in several Asian countries where it is advantageous to be represented locally. Historically, we have sold a substantial portion of our flexible circuit interconnects to a limited number of customers. We have benefited from early entry as a supplier to the disk drive industry and have been able to leverage our relationships to supply next generation integrated flexible circuit interconnects. Our relationships combined with our reputation for high standards of quality and innovative manufacturing processes have established us as a predominant supplier of interconnects for the HDD industry.
We provide our customers’ product design support from our manufacturing locations in Minnesota and Thailand and from our sales and customer support offices in California, China, Singapore and the United Kingdom. In addition, we provide on-site customer design support for our customers as required.
Even though our customer mix will change from period to period in the future, we expect that sales to relatively few customers will continue to account for a high percentage of our net sales in the foreseeable future. Sales to our two largest customers, Seagate and Maxtor, constituted 65% and 10% of net sales, respectively, for fiscal 2003, 64% and 9% of net sales, respectively, for fiscal 2002 and 54% and 8% of net sales, respectively, for fiscal 2001. Sales to our five largest customers constituted 90% of net sales for fiscal 2003, 86% of net sales for fiscal 2002 and 77% of net sales for fiscal 2001. The loss of a significant customer or a substantial reduction in orders by any significant customer, including reductions due to market, economic or competitive conditions in the computer, computer peripheral, mobile communication devices and consumer markets has had and may continue to have a material adverse effect on our business, financial condition and results of operations.
Environmental Controls
Flexible circuit interconnect manufacturing requires the use of chemicals. As a result, we are subject to a variety of environmental laws relating to the storage, discharge, handling, emission, generation, manufacture, use and disposal of chemicals, solid and hazardous waste and other toxic and hazardous materials used to manufacture our products. We have discontinued operations at our Chandler, Arizona location and decommissioned the facility. Our preliminary review of the facility suggests that no material remediation costs will be required. However, given the uncertainties associated with environmental contamination, there can be no assurance that such costs will not have a material adverse impact on us. Pursuant to the agreements governing the 1993 ADFlex purchase of certain assets from Rogers Corporation (“Rogers”), Rogers has retained all environmental liabilities relating to the purchased assets prior to the closing date of the acquisition. While we believe Rogers currently has sufficient assets to fulfill its obligations under the acquisition agreements, if environmental liabilities requiring remediation are discovered and we are unable to enforce the acquisition agreement against Rogers, we could become
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subject to costs and damages relating to such environmental liabilities. Any such costs and damages imposed on us could materially adversely affect our business, financial condition and results of operations.
We believe we have been operating our facilities in substantial compliance in all material respects with existing environmental laws and regulations. However, we cannot predict the nature, scope or effect of legislation or regulatory requirements that could be imposed or how existing or future laws or regulations will be administered or interpreted with respect to products or activities to which they have not previously been applied. For this reason, we implemented procedures geared toward minimizing the negative impacts and reducing potential financial risks arising from environmental issues. Compliance with more stringent laws or regulations, or more vigorous enforcement policies of regulatory agencies could require substantial expenditures by us and could adversely affect our business, results of operations and financial condition. We do not anticipate any material amount of environmental-related capital expenditures in fiscal 2004.
Intellectual Property
We believe that, due to our customers’ demands for rapid technological advances and the resulting limited product life cycles, the success of our business generally depends more on the technical and engineering expertise, creativity and marketing and service abilities of our employees than on patents, trademarks and copyrights. Nevertheless, we own patents and have a policy of seeking patents when appropriate on inventions concerning new products and improvements as part of our ongoing research, development and manufacturing activities. We control patents related to the FSA attachment process and new generation FgSA products for disk drive applications and believe that these patents give us a competitive advantage in the disk drive industry. There can be no assurance that any patents issued to us or licensed by us will provide a competitive advantage or will not be challenged by third parties, or that the patents of others will not have an adverse effect on our ability to do business. Furthermore, there can be no assurance that others will not independently develop similar products, duplicate our products or design around the patents issued to us or licensed by us. In addition, there can be no assurance that foreign intellectual property laws or our agreements will protect our intellectual property rights in any foreign country. Any failure to protect our intellectual property rights could have a material adverse effect on our business, results of operations and financial condition.
We have a 35% investment in, and work closely with, AKI, the company that developed the unique manufacturing process technology utilized by our FSA products and the unique product design technology utilized by our FgSA products. We have a license to use this technology in our products for disk drive applications on an exclusive basis through 2009 and on a nonexclusive basis thereafter until 2012. The rights granted to us by AKI are royalty-bearing and may not be sublicensed without the consent of AKI.
Employees
As of September 30, 2003, we had a total of 4,142 employees. Of these employees, 189 were based in Maple Plain, Minnesota, 227 were based in Litchfield, Minnesota, and 3,726 were based in Thailand. Our future operating results depend in part upon our ability to attract and retain other qualified management, technical, manufacturing, sales and support personnel for our operations. Competition for such personnel is intense and there can be no assurance that we will be successful in attracting or retaining such personnel. The failure to attract or retain such persons could materially adversely affect our business, results of operations and financial condition.
Competition
The flexible circuit interconnect market is differentiated by customers, markets and geography with each niche having its own combination of complex packaging and interconnection requirements. We believe the market competes principally on the basis of design capability, price, quality, flexibility and technological advancements in underlying applications. During periods of economic slowdown in the
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electronics industry and other periods when excess capacity exists, electronic OEMs become more price sensitive. We believe that once a customer has selected a particular vendor to design and manufacture a flexible circuit interconnect, the customer generally relies upon that vendor’s design for the life of that specific application and, frequently, subsequent generations of similar applications. Accordingly, it is difficult to achieve significant sales to a particular customer with respect to any application once another vendor has been selected to design and manufacture the flexible circuit interconnect used in that application. While this market paradigm may provide a barrier to our competitors in the markets served by us, it also may present an obstacle to our entry into other markets.
The flexible circuit interconnect market is highly competitive. We experience competition world-wide from a number of leading foreign and domestic providers including 3M Company for high-end technology applications, and NOK (“Nippon Mektron”), Fujikura Ltd., Multi-Fineline Electronix, Inc. (“M-Flex”) and Sumitomo for standard flex and assembly applications. 3M, Sumitomo, NOK and Fujikura are substantially larger than we and possess greater financial and other resources. There are a number of other flexible circuit manufacturers that target other flexible circuit markets and rarely compete directly with us. In addition, competitors for disk drive market integrated suspension assembly applications include Hutchinson Technology Incorporated, KRP, Magnacomp International Limited, Nihon Hatsujo Kabusikigaisha (“NHK”) and Optimal Technology Limited. Expansion of our existing products or services could expose us to new competition. Moreover, new developments in the consumer electronics industry could render existing technology obsolete or less competitive and could potentially introduce new competition into the market. There can be no assurance that our competitors will not develop enhancements to, or future generations of, competitive products or services that will offer superior price or performance features to those offered by us or that new competitors will not enter our markets. Finally, as many of our competitors are based in foreign countries, they have cost structures and prices based on foreign currencies. Accordingly, currency fluctuations could cause our U.S. dollar-priced products to be less competitive than our competitors’ products priced in other currencies.
Backlog
The backlog for our continuing operations was $20.8 million, $23.9 million and $20.1 million at September 30, 2003, 2002 and 2001, respectively. Our backlog fluctuates based on the timing of the receipt of orders from customers. Backlog is defined by us as firm orders that are scheduled to be delivered within 12 months from the date of the order. While we believe substantially all of our current backlog will be delivered within 12 months, customers may determine not to release orders into production, may extend requested delivery dates or cancel orders. In such cases, we may not realize the revenue indicated by the backlog.
Risks Related to Our Business
An investment in our common stock involves a high degree of risk. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we may currently deem immaterial, may become important factors that harm our business, financial condition or results of operations. If any of the following risks actually occurs, our business, financial condition or results of operations could suffer. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.
Our operating results are subject to fluctuations.
Our past operating results, and our gross margins, have fluctuated from fiscal period to fiscal period. We expect our future operating results and gross margins will continue to fluctuate from fiscal period to fiscal period due to a number of factors, many of which are outside our control and any of which could cause our stock price to fluctuate.
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The primary factors that affect us include the following:
• changes in overall demand for our products;
• technological changes (such as data density improvements) that reduce the number of suspension assemblies per disk drive required by disk drive makers;
• changes in OEM customer manufacturing yields throughout their products’ life cycles;
• changes in the specific products our customers buy;
• changes in our selling prices;
• changes in utilization of our production capacity;
• changes in our infrastructure costs;
• changes in our manufacturing process, or problems related to our manufacturing process;
• changes in our manufacturing yields;
• changes in our production efficiency;
• long disruptions in operations at any of our plants for any reason; and
• changes in the cost of, or limits on, available materials and labor.
Difficulties in forecasting demand for our products make it difficult to utilize our capacity efficiently.
We continue to have limited visibility for future demand. If customer demand for our FSAs or our actuator flex, display flex, stacked memory flex or tape storage flex products weakens, or if one or more customers reduce, delay or cancel orders, our business, financial condition and results of operations could be materially adversely affected.
We typically allow customers to change or cancel orders on short notice. We plan our production and inventory based primarily on forecasts of customer demand, including forecasts of customer pulls of product out of our just-in-time inventory hubs. Our customers typically prefer a dual source supply, and therefore allocate their demand among suppliers. Both customer demand and the resulting forecasts often fluctuate substantially. These factors, among others, create an environment where scheduled production and capacity utilization can vary significantly from week to week, leading to variability in gross margins and difficulty in estimating our position in the marketplace.
The following factors complicate accurate capacity planning for market demand:
• changes in the specific products our customers buy;
• the pace of technological change;
• variability in our manufacturing yields and productivity; and
• long lead times for most of our plant and equipment expenditures, requiring major financial commitments well in advance of actual production requirements.
We have at times increased our production capacity and the overhead that supports production based on anticipated market demand which has not always developed as expected. As a result, we have periodically underutilized our capacity. Our inability to plan our capacity requirements accurately, or our failure to put in place the technologies and capacity necessary to meet market demand, could have a material adverse effect on our business, financial condition and results of operations.
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Our sales are concentrated in a small customer base and in the HDD industry.
Sales to our largest customer constituted 65% of net sales for fiscal 2003, 64% for fiscal 2002 and 54% for fiscal 2001, respectively. Sales to our five largest customers constituted 90% of net sales for fiscal 2003, 86% of net sales for fiscal 2002 and 77% of net sales for fiscal 2001. The loss of one or more of our major customers or a substantial reduction in orders by any significant customer, for any reason, including reductions due to market, economic or competitive conditions in the computer, computer peripheral, mobile communication device and high-end consumer markets, the development by a customer of the capability to produce flexible circuits in high volume for its own products, a transfer of manufacturing operations by a customer to a lower-cost country, a change in the type of interconnect or suspension assembly used by our largest customers or the failure of a customer to pay its account balance with us, could have a material adverse effect on our business, financial condition and results of operations.
Sales of our FSA and actuator flex products to the hard disk drive industry accounted for 76%, 74% and 68% of our net sales in fiscal 2003, 2002 and 2001, respectively. The disk drive industry is intensely competitive and technology changes rapidly. The industry’s demand for disk drive components also fluctuates. The disk drive industry experiences periods of increased demand and rapid growth followed by periods of oversupply and subsequent contraction. These cycles may affect suppliers to this industry because disk drive manufacturers tend to order more disk drive components than they may need during growth periods, and reduce orders for these components during periods of contraction.
Our selling prices are subject to pricing pressure from our customers and market pressure from our competitors.
We deal with a limited number of large customers who are able to exert significant pricing pressure on our products. Our selling prices are affected by changes in overall demand for our products, changes in the specific products our customers buy and our products’ life cycles. A typical life cycle for our products begins with higher pricing when a product is introduced and decreasing prices as it matures. To offset price decreases during a product’s life, we rely primarily on higher sales volume and improving our manufacturing yield and productivity to reduce a product’s cost. If we cannot reduce our manufacturing costs as prices decline during our products’ life cycles, our business, financial condition and results of operations could be materially adversely affected.
The markets in which we operate are highly competitive.
We operate in highly competitive markets and our competitors can be expected to continue to improve the design and performance of their products and to introduce new products with competitive price/performance characteristics. Competitive pressures often necessitate price reductions that adversely affect operating results. We will be required to make a continued high level of investment in product development and research, sales and marketing and ongoing customer service and support to remain competitive. There can be no assurance that existing or future competitors will not be able to duplicate our strategies or that competitive pressures faced by us will not have a material adverse effect on our business, financial condition and results of operations.
Competing technologies may reduce demand for our products.
Flexible circuit interconnects provide electrical connections between components in electrical systems and are used as a platform to support the attachment of electronic devices. While flexible circuits offer several advantages over competing printed circuit board and ceramic hybrid circuit technologies, our customers may consider changing their designs to use these alternative technologies for future applications. In particular, our largest customer is considering increased utilization of alternative interconnect technologies that compete with the electrical interconnect features of our FSA products. If our customers switch significant portions of their business to alternative technologies, our business, financial condition and results of operations could be materially adversely affected.
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Future technological innovations may reduce demand for disk drives. Data storage alternatives that compete with disk drive-based data storage currently exist. These storage alternatives include semiconductor (flash) memory, tape memory and optical (DVD and CD) drives. The current core technology for disk drive data storage has been the dominant technology in the industry for many years. This technology could be replaced by an alternate technology in the future. Our business, financial condition and results of operations could be materially adversely affected if the computer industry adopts technology that replaces disk drives as a computer data storage medium.
We have experienced annual losses from operations in the fiscal year ended September 30, 2003 and in prior years, and we may not achieve net income on a consistent basis.
While we generated a $759,000 net profit for the fourth quarter of fiscal 2003, we had a net loss of $3.0 million for fiscal 2003. We experienced net losses of $3.8 million in fiscal 2002 and $28.9 million in fiscal 2001. Whether we achieve net income on a consistent basis will depend on a number of factors, including:
• the level of revenue in any given period;
• our expense levels, particularly for manufacturing costs;
• our manufacturing efficiency, particularly with respect to new product introductions and high volume products;
• cultivating new FSA/FgSA customers; and
• the qualification of new products, including new display flex programs and printer flex products.
Data density improvements have reduced worldwide demand for suspension assemblies, and these improvements are expected to continue.
Disk drive manufacturers have been able to steadily increase data density (the amount of data that can be stored on a disk surface), and we believe that they will continue to do so for the foreseeable future. Increasing data density permits drive manufacturers to use fewer disks in each disk drive, which in turn reduces the number of components they need, including FSA products. We believe that since 1999, the rate of improvement in data density has exceeded historical rates, and that the average number of suspension assemblies required per drive has decreased from approximately 4.2 in 1999 to approximately 3.4 in 2000, approximately 3.0 in 2001 and approximately 2.5 in 2002. If improvements in data density continue to outpace growth in data storage capacity requirements, then demand for our FSA products may decline and we may not be able to maintain or grow our FSA product business.
To meet industry requirements and remain competitive, we must continue to improve our process capabilities and develop and qualify new products.
Our continued success depends on our ability to continue to develop manufacturing processes that are capable of tighter tolerances and to develop and rapidly bring to volume production new products that meet increasingly higher performance specifications. A number of risks are inherent in this process. Increasingly higher performance specifications, as well as transitions to new product platforms and materials, initially can lower our overall manufacturing yields and efficiencies. This in turn can cause us to delay or miss product shipments. We also may incur higher manufacturing costs and sales returns or we may need to change or develop new manufacturing processes. If processes change, we may need to replace, modify or design, build and install equipment. These changes may require additional capital.
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We may need to increase our research and development and engineering expenses to support technological advances and to develop and manufacture new products and product features. We expect future flexible circuits to require higher performance specifications and thinner or tighter lines and spaces and to incorporate new material sets.
If we fail to successfully introduce new products or product features on a regular and timely basis, demand for our existing products could decline, and our business, financial condition and results of operations could be materially adversely affected. If higher performance specifications and tighter lines and spaces are required and we are not able to meet those requirements, our business, financial condition and results of operations could be materially adversely affected.
We must qualify our products with our customers. The qualification process for these products can be time-consuming, complex and difficult. We cannot be sure that our products will continue to be selected for design into our customers’ products. If we are unable to obtain additional customer qualifications, or if we cannot qualify our products for high volume production quantities, or at all, our business, financial condition and results of operations could be materially adversely affected.
We may not be able to manufacture our products efficiently due to changes in demand or technology, or other unforeseen events.
We manufacture a wide variety of products with different selling prices and manufacturing costs. Our product mix varies weekly as market demand changes. Any substantial variation in product mix can lead to changes in utilization of our equipment and tooling, inventory obsolescence and overstaffing in certain areas, all of which could adversely impact our business, financial condition and results of operations.
Rapid technological change in the various electronics industries we serve has led to numerous design changes and tighter performance specifications. The resulting new product designs with tighter performance specifications initially are more difficult to manufacture, could require additional capital expenditures and may require increased development and support expenses. Manufacturing yields and efficiencies also vary from product to product. Newer products typically have lower initial manufacturing yields and efficiencies as we commence volume manufacturing and thereafter ramp to full production. We have experienced sales returns in the past and as we commence volume manufacturing, as new features for our products are introduced or as new manufacturing processes are implemented, we may experience increased sales returns in the future. We cannot be sure that we will attain our output goals and be profitable with regard to any of our new products.
We may need to transfer production of certain products from one manufacturing site to another. In the past, such transfers have lowered initial yields and/or manufacturing efficiencies. This results in higher manufacturing costs. Our manufacturing plants are located in Maple Plain and Litchfield, Minnesota and Korat and Lamphun, Thailand, all of which can experience severe weather. Severe weather has, at times, resulted in lower production and decreased our shipments.
We may not be able to adequately protect our intellectual property.
We license the technology used to produce our FgSA product and portions of our FSA products in the HDD industry on an exclusive basis from Applied Kinetics, Inc. (“AKI”). Our ability to defend our rights to this intellectual property depends on the validity and enforceability of AKI’s proprietary technology. Should we be unable to enforce our rights with respect to such intellectual property, our business, financial condition and results of operations could be materially adversely affected.
We attempt to protect our intellectual property rights through patents, copyrights, trade secrets and other measures. We may not, however, be able to protect our technology adequately. In addition, competitors may be able to develop similar technology independently. Our success depends in large part
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on trade secrets relating to our proprietary manufacturing processes. We seek to protect these trade secrets and our other proprietary technology in part by requiring each of our employees to enter into non-disclosure and non-competition agreements. In these agreements, the employee agrees to maintain the confidentiality of all of our proprietary information and, subject to certain exceptions, to assign to us all rights in any proprietary information or technology made or contributed by the employee during his or her employment. In addition, we regularly enter into non-disclosure agreements with third parties, such as consultants, suppliers and customers. These agreements may, however, be breached, and we may not have an adequate remedy for any such breach. In addition, our competitors may otherwise learn or independently develop our trade secrets.
We believe that the patents we hold, control and may obtain are valuable, but that they will not independently determine our success. Moreover, we may not receive patents for our pending patent applications, and our issued patents may not be broad enough to protect our technology adequately. We compete in industries with rapid development and technological innovation. We cannot be sure that we will be able to protect our future technology or that any patent issued to us will not be challenged, invalidated, circumvented or infringed. In addition, we have only limited patent rights outside the United States, and the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.
Defending against intellectual property claims may have a material adverse effect on our business.
We and certain users of our products, have received, and may receive, communications from third parties asserting patents against us or our customers that may relate to our manufacturing equipment or to our products or to products that include our products as a component. If any third party makes a valid infringement claim against us and we are unable to obtain a license on terms acceptable to us, our business, financial condition and results of operations could be materially adversely affected. We expect that, as the number of patents issued continues to increase, the volume of intellectual property claims made against us could increase.
We may have difficulty obtaining an adequate supply of raw materials at reasonable prices.
We currently can obtain certain types of photoresist, a liquid compound used in the photoetching process, certain copper and polyimide laminate materials and certain specialty chemicals used in our manufacturing process from only one supplier of each such material. If we could not obtain the materials referred to above in the necessary quantities, with the necessary quality and at reasonable prices, our business, financial condition and results of operations could be materially adversely affected.
The loss of key personnel could adversely affect our business.
Our success depends upon the efforts, contributions and abilities of our senior management. We cannot be sure that the services of our key personnel will continue to be available to us. The loss of services of any of these employees could have a material adverse effect on our business, financial condition and results of operations.
We may not be able to obtain the capital we need to maintain or grow our business.
Our ability to execute our long-term strategy may depend on our ability to obtain additional long-term debt and equity capital. We have no commitments for additional borrowings, other than our existing credit facilities, or for sales of equity, other than under our existing employee benefit plans. We cannot determine the precise amount and timing of our funding needs at this time. We may be unable to obtain future additional financing on terms acceptable to us, or at all. If we fail to comply with certain covenants relating to our indebtedness, we may need to refinance our indebtedness to repay it. We also may need to refinance
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our indebtedness at maturity. We may not be able to obtain additional capital on favorable terms to refinance our indebtedness.
The following factors could affect our ability to obtain additional financing on favorable terms, or at all:
• our results of operations;
• general economic conditions and conditions in the disk drive industry;
• the perception in the capital markets of our business;
• our ratio of debt to equity;
• our financial condition;
• our business prospects; and
• changes in interest rates.
In addition, certain covenants relating to our existing indebtedness impose certain limitations on additional indebtedness. If we are unable to obtain sufficient capital in the future, we may have to curtail our capital expenditures and reduce research and development expenditures. Any such actions could have a material adverse effect on our business, financial condition and results of operations.
Servicing our existing debt may constrain our future operations.
Our ability to satisfy our obligations to pay interest and to repay debt is dependent on our future performance. Our performance depends, in part, on prevailing economic conditions and financial, business and other factors, including factors beyond our control. To the extent that we use a portion of our cash flow from operations to pay the principal of, and interest on, our indebtedness, that cash flow will not be available to fund future operations and capital expenditures. We cannot be sure that our operating cash flow will be sufficient to fund our future capital expenditure and debt service requirements or to fund future operations.
Our financing agreements contain restrictive covenants with which we may not be able to comply.
We have entered into a number of financing agreements that contain restrictive financial covenants. These covenants require us, among other things, to maintain specified levels of net income, tangible net worth and interest and leverage ratios, and also impose certain limitations on additional indebtedness, leases, guarantees and the payment of dividends. Our ability to comply with restrictive financial covenants depends upon our future operating performance. Our future operating performance depends, in part, on general industry conditions and other factors beyond our control. We cannot be sure that we will be able to comply with these covenants in the future, and we may not be successful in renegotiating our financing agreements or otherwise obtaining relief from the covenants. If we default under some or all of our financing agreements, our lenders may require that we immediately repay the full outstanding amount we owe to them. In such event, we may have to pursue alternative financing arrangements. If we are not in compliance with financial covenants in our financing agreements at the end of any fiscal quarter, our business, financial condition and results of operations could be materially adversely affected.
We may not be able to successfully address problems encountered in connection with any future acquisitions.
We expect to consider opportunities to acquire or make investments in other technologies, products and businesses that could enhance our technical capabilities, complement our current products and services, or expand the breadth of our markets. Acquisitions and strategic investments, including if we elect
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to exercise our option to acquire shares of KRP in exchange for delivery of shares of our common stock, involve numerous risks, including:
• problems maintaining uniform standards, procedures, controls and policies;
• unanticipated costs associated with the acquisition, including accounting charges and transaction expenses;
•</