| MERRIMAC INDUSTRIES INC ITEM 1A RISK FACTORS You should carefully consider the matters described below before making an investment decision |
| The risks and uncertainties described below are not the only ones facing our company |
| Our business operations may be impaired by additional risks and uncertainties of which we are unaware or that we currently consider immaterial |
| 13 _________________________________________________________________ Our business, results of operations or cash flows may be adversely affected if any of the following risks actually occur |
| In such case, the trading price of our common stock could decline, and you may lose part or all of your investment |
| The market for our products, in particular our Multi-Mix^® products, is new and rapidly evolving |
| If we are not able to develop or enhance our products, or to respond to customer needs, our net sales will suffer |
| Our future success depends in large part on our ability to develop and market our new line of Multi-Mix^® modules, filters, couplers and delay lines products, particularly to the wireless basestation and defense sectors |
| We will also need to continually enhance our existing core products (passive RF and microwave component assemblies, power dividers and other micro circuitry products), lower product cost and develop new products that maintain technological competitiveness |
| Our core products must meet changing customer, regulatory and particular technological requirements and standards, and our Multi-Mix^® products especially must respond to the changing needs of our customers, particularly our OEM customers |
| These customer requirements might or might not be compatible with our current or future product offerings |
| We might not be successful in modifying our products and services to address these requirements and standards and our business could suffer |
| We have made capital investments of approximately dlra14dtta2 million in our proprietary line of Multi-Mix^® Microtechnology products |
| While we have generated revenues and developed a customer base for our Multi-Mix^® products, if a competitive product or decreased consumer demand for our Multi-Mix^® products resulted in significant decrease in those revenues, our ability to recover our investment in our Multi-Mix^® Microtechnology product assets could be negatively impacted and result in a write off of the carrying value of these assets and an impairment charge to our earnings |
| In addition, we have invested significant engineering, research and development, personnel and other resources in developing our Multi-Mix Zapper^® product line, introduced in June 2004 |
| While revenues to date have not been material, we intend to incur significant additional expenses, including sales and marketing costs, in implementing our strategic plan to commercialize various applications of our Multi-Mix^® technologies |
| These products are direct drop-in replacements for competing technologies used in virtually all wireless basestations |
| There are competing technologies already in the marketplace, and in order to obtain market share we will have to convince customers to convert to our products from those that are already in use |
| We may seek to enter into joint ventures, research and development, distribution and other arrangements with third party OEM’s, defense contractors, universities and research institutions and others in order to successfully market our Multi-Mix^® products |
| In fact, we may find it necessary to enter into such arrangements if our own resources are inadequate to develop recurring revenues and a sustained commercial market for these products |
| There can be no assurance we will be able to enter into such arrangements, or do so on commercially attractive terms, if necessary |
| Our business plan anticipates significant future revenues from our Multi-Mix^® products |
| Due to economic and market conditions in the wireless industry over the past several years, telecommunications system service providers substantially reduced their capital equipment purchases from our customers |
| While these circumstances have resulted in the delay or cancellation of Multi-Mix^® Microtechnology product purchases that had been anticipated from certain specific customers or programs, in connection with the improved conditions in the industry, the Company has implemented a strategic plan utilizing product knowledge and customer focus to expand specific sales opportunities |
| Continued extended delay or reduction from planned levels in new orders expected from customers for these products could require the Company to pursue alternatives related to the utilization or realization of these assets and commitments |
| If we are unable to generate significant future revenues from these Multi-Mix^® products or identify alternative uses, sufficient to recover our investment, we could have to write down the carrying value of these assets, thereby incurring an impairment charge to earnings, which would significantly harm our operations and financial condition |
| 14 _________________________________________________________________ Our products are intended for use in various sectors of the satellite, defense and telecommunications industries, which produces technologically advanced products with short life cycles |
| Factors affecting the satellite, defense and telecommunications industries, in particular the short life cycle of certain products, could seriously harm our customers and reduce the volume of products they purchase from us |
| These factors include: [spacer |
| gif] • the inability of our customers to adapt to rapidly changing technology and evolving industry standards that result in short product life cycles; [spacer |
| gif] • the inability of our customers to develop and market their products, some of which are new and untested; and [spacer |
| gif] • the potential that our customers’ products may become obsolete or the failure of our customers’ products to gain widespread commercial acceptance |
| The expenses relating to our products might increase, which could reduce our gross margins |
| In the past, developing engineering solutions, meeting research and development challenges and overcoming production and manufacturing issues have resulted in additional expenses |
| These expenses create pressure on our average selling prices and may result in decreased margins of our products |
| We expect that this will continue |
| In the future, competition could increase, and we anticipate this may result in additional pressure on our pricing |
| We also may not be able to increase the price of our products in the event that the cost of components or overhead increase |
| Changes in exchange rates between the United States and Canadian dollars, and other currencies, might result in further disparity between our costs and selling price and hurt our ability to maintain gross margins |
| We carry inventory and there is a risk we may be unable to dispose of certain items |
| We procure inventory based on specific customer orders and forecasts |
| Customers have certain rights of modification with respect to these orders and forecasts |
| As a result, customer modifications to orders and forecasts affecting inventory previously procured by us and our purchases of inventory beyond customer needs may result in excess and obsolete inventory for the related customers |
| Although we may be able to use some of these excess components and raw materials in other products we manufacture, a portion of the cost of this excess inventory may not be recoverable from customers, nor may any excess quantities be returned to the vendors |
| We also may not be able to recover the cost of obsolete inventory from vendors or customers |
| Write offs or write downs of inventory generally arise from: [spacer |
| gif] • declines in the market value of inventory; [spacer |
| gif] • changes in customer demand for inventory, such as cancellation of orders; and [spacer |
| gif] • our purchases of inventory beyond customer needs that result in excess quantities on hand and that we are not able to return to the vendor or charge back to the customer |
| Our products and therefore our inventories are subject to technological risk |
| At any time either new products may enter the market or prices of competitive products may be introduced with more attractive features or at lower prices than ours |
| There is a risk we may be unable to sell our inventory in a timely manner and avoid it becoming obsolete |
| As of December 31, 2005, our inventories including raw materials, work-in-process and finished goods, were valued at dlra3dtta7 million reflecting reductions due to valuation allowances for obsolescence of approximately dlra1dtta1 million against these inventories |
| In the event we are required to substantially discount our inventory or are unable to sell our inventory in a timely manner, we would be required to increase our valuation allowances and our operating results could be substantially adversely affected |
| We generally do not obtain long-term volume purchase commitments from customers, and, therefore, cancellations, reductions in production quantities and delays in production by our customers could adversely affect our operating results |
| 15 _________________________________________________________________ We generally do not obtain firm, long-term purchase commitments from our customers |
| Customers may cancel their orders, choose not to exercise options for further product purchases, reduce production quantities or delay production for a number of reasons |
| In the event our customers experience significant decreases in demand for their products and services, our customers may cancel orders, delay the delivery of some of the products that we manufactured or place purchase orders for fewer products than we previously anticipated |
| Even when our customers are contractually obligated to purchase products from us, we may be unable or, for other business reasons, choose not to enforce our contractual rights |
| Cancellations, reductions or delays of orders by customers would: [spacer |
| gif] • adversely affect our operating results by reducing the volumes of products that we manufacture for our customers; [spacer |
| gif] • delay or eliminate recoupment of our expenditures for inventory purchased in preparation for customer orders; and [spacer |
| gif] • lower our asset utilization, which would result in lower gross margins |
| Products we manufacture may contain design or manufacturing defects that could result in reduced demand for our services and liability claims against us |
| We manufacture products to our customers’ specifications that are highly complex and may at times contain design or manufacturing defects |
| Defects have been discovered in products we manufactured in the past and despite our quality control and quality assurance efforts, defects may occur in the future |
| Defects in the products we manufacture, whether caused by design, manufacturing or component defects, may result in delayed shipments to customers or reduced or cancelled customer orders |
| Should these defects occur in large quantities or frequently, our business reputation may also be tarnished |
| In addition, these defects may result in liability claims against us |
| Even if customers are responsible for the defects, we may assume responsibility for any costs or payments |
| We are subject to risks of currency fluctuations |
| Our Canadian operations were adversely impacted in fiscal 2005 and 2004 as a result of changes in the Canadian and US Dollar exchange rates |
| We cannot predict the impact of future exchange rate fluctuations |
| In addition, certain of our subsidiaries that have non-US dollar functional currencies transact business in US dollars |
| We rely on a small number of customers for a substantial portion of our net sales, and declines in sales to these customers could adversely affect our operating results |
| Sales to our five largest customers accounted for 47dtta3prca of our net sales in the fiscal year ended December 31, 2005 and our three largest customers, Israel Aircraft Industries Ltd, Lockheed Martin Corporation and Raytheon Company, accounted for 11dtta2prca, 10dtta9prca and 10dtta5prca, respectively, of our 2005 sales |
| We depend on the continued growth, viability and financial stability of our customers, substantially all of which operate in an environment characterized by rapid technological change, short product life cycle, consolidation, and pricing and margin pressures |
| We expect to continue to depend upon a relatively small number of customers for a significant percentage of our revenue |
| Consolidation among our customers may further concentrate our business in a limited number of customers and expose us to increased risks relating to dependence on a small number of customers |
| In addition, a significant reduction in sales to any of our large customers or significant pricing and margin pressures exerted by a key customer would adversely affect our operating results |
| In the past, some of our large customers have significantly reduced or delayed the volume of products ordered from us as a result of changes in their business, consolidation or divestitures or for other reasons |
| We cannot be certain that present or future large customers will not terminate their arrangements with us or significantly change, reduce or delay the amount of products ordered from us, any of which would adversely affect our operating results |
| 16 _________________________________________________________________ A substantial portion of our revenues are related to the defense and military communications sectors |
| However, in times of armed conflict or war, military spending is concentrated on armaments build up, maintenance and troop support, and not on the research and development and specialty applications that are the Company’s core strengths and revenue generators |
| Accordingly, our defense and military product revenues may decrease, and should not be expected to increase, at times of armed conflicts or war |
| Variations in our quarterly operating results could occur due to factors including changes in demand for our products, the timing of shipments and changes in our mix of net revenues |
| Our quarterly net revenues, expenses and operating results have varied in the past and might vary significantly from quarter to quarter in the future |
| Quarter-to-quarter comparisons of our operating results are not a good indication of our future performance, and should not be relied on to predict our future performance |
| Our short-term expense levels and manufacturing and production facilities infrastructure overhead are relatively fixed and are based on our expectations of future net revenues |
| If we were to experience a reduction in net revenues in a quarter, we could have difficulty adjusting our short-term expenditures and absorbing our excess capacity expenses |
| If this were to occur, our operating results for that quarter would be negatively impacted |
| Other factors that might cause our operating results to fluctuate on a quarterly basis include |
| gif] • customer decisions to defer, accelerate or cancel orders; [spacer |
| gif] • changes in the mix of net revenues attributable to higher-margin and lower-margin products; [spacer |
| gif] • changes in product mix which could cause unexpected engineering or research and development costs; [spacer |
| gif] • announcements or introductions of new products by our competitors; [spacer |
| gif] • engineering or production delays due to product defects or quality problems and production yield issues; and [spacer |
| gif] • dynamic defense budgets which could cause military program delays or cancellations |
| Recent changes in accounting for equity-related compensation could impact our financial statements |
| On December 16, 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards Nodtta 123 (Revised 2004), ‘‘Share-Based Payment’’ (‘‘SFAS 123R’’) |
| SFAS 123R is a revision of Financial Accounting Standards Nodtta 123, as amended, ‘‘Accounting for Stock-Based Compensation’’ (‘‘SFAS 123’’) and supercedes Accounting Principles Board Opinion Nodtta 25, ‘‘Accounting for Stock Issued to Employees’’ |
| SFAS 123R eliminates the alternative to use the intrinsic value method of accounting that was provided in SFAS 123, which generally resulted in no compensation expense being recorded in the financial statements related to the issuance of equity awards to employees |
| SFAS 123R requires the Company to measure all employee stock-based compensation awards using a fair value method and to record such expense in the consolidated financial statements, as opposed to the pro forma note presentation previously used |
| The Company adopted SFAS 123R at the beginning of its first quarter in fiscal 2006, and will apply the provisions of the statement prospectively for any newly issued, modified or settled award after the date of initial adoption, as well as for any awards that were granted prior to the adoption date for which the requisite service period has not been provided as of the adoption date |
| We intend to continue to use the Black-Scholes option pricing model to calculate total stock compensation expense |
| The Company expects the adoption of this statement will have a non-cash material effect on its financial statements, but the Company cannot reasonably estimate the impact of the adoption with respect to future grants because certain assumptions used in the calculation of the value of share-based payments may change |
| As of December 31, 2005 the total future compensation cost related to vested and non-vested stock options and the employee stock purchase plan not yet recognized in the statement of operations was dlra185cmam000 |
| The microwave component and subsystems industry continues to be highly competitive |
| The Company competes against many companies, both foreign and domestic, many of which are larger and have greater financial and other resources |
| Direct competitors for Merrimac in the commercial market are Anaren, Sirenza, Vari-L, Radiall and Sochen |
| Major competitors for Merrimac in the military market are Anaren, M/A Com, L-3 Communications (Narda), Sage, TRM and KW Microwave |
| Major competitors for Filtran in the microwave micro-circuitry market are Labtech, MPC and Precision Instruments |
| As a direct supplier to OEMs, the Company also faces significant competition from the in-house capabilities of its customers |
| Thus, the Company believes that internal customer competition exists predominantly in its defense and satellite businesses |
| In the wireless market, increased price pressure from the Company’s customers is a continuing challenge |
| It is anticipated that this pricing pressure will continue indefinitely |
| The principal competitive factors are technical performance, reliability, ability to produce in volume, on-time delivery and price |
| Based on these factors, the Company believes that it competes favorably in its markets |
| The Company believes that it is particularly strong in the areas of technical performance and on-time delivery in the wireless marketplace |
| The Company believes that it competes favorably on price as well |
| The RF Microwave components industry is highly competitive and has become more so as defense spending has changed program spending profiles |
| Furthermore, current Department of Defense efforts are shifting funds to support troops engaged in existing hostilities around the world |
| We compete against numerous US and foreign providers with global operations, as well as those who operate on a local or regional basis |
| In addition, current and prospective customers continually evaluate the merits of manufacturing products internally |
| Changes in the industries and sectors we service could significantly harm our ability to compete, and consolidation trends could result in larger competitors that may have significantly greater resources with which to compete against us |
| We may be operating at a cost disadvantage compared to manufacturers who have greater direct buying power from component suppliers, distributors and raw material suppliers or who have lower cost structures |
| Our manufacturing processes are generally not subject to significant proprietary protection, and companies with greater resources or a greater market presence may enter our market or increase their competition with us |
| Increased competition could result in price reductions, reduced sales and margins or loss of market share |
| Intellectual property |
| Substantial litigation regarding intellectual property rights exists in our industry |
| We do not believe our intellectual properties infringe those of others, and are not aware that any third party is infringing our intellectual property rights |
| A risk always exists that third parties, including current and potential competitors, could claim that our products, or our customers’ products, infringe on their intellectual property rights or that we have misappropriated their intellectual property |
| We may discover that a third party is infringing upon our intellectual property rights, or has been issued an infringing patent |
| Infringement suits are time consuming, complex, and expensive to litigate |
| Such litigation could cause a delay in the introduction of new products, require us to develop non-infringing technology, require us to enter into royalty or license agreements, if available, or require us to pay substantial damages |
| We have agreed to indemnify certain customers for infringement of third-party intellectual property rights |
| We could incur substantial expenses and costs in case of a successful indemnification claim |
| A significant negative impact would result if a successful claim of infringement were made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis |
| The Company’s success depends to a significant degree upon the preservation and protection of its product and manufacturing process designs and other proprietary technology |
| To protect its 18 _________________________________________________________________ proprietary technology, the Company generally limits access to its technology, treats portions of such technology as trade secrets, and obtains confidentiality or non-disclosure agreements from persons with access to the technology |
| The Company’s agreements with its employees prohibits employees from disclosing any confidential information, technology developments and business practices, and from disclosing any confidential information entrusted to the Company by other parties |
| Consultants engaged by the Company who have access to confidential information generally sign an agreement requiring them to keep confidential and not disclose any non-public confidential information |
| The Company currently has 16 active patents and has received a Notice of Allowance from the US Patent and Trademark Office for a new patent that is expected to be issued shortly |
| The Company plans to pursue intellectual property protection in foreign countries, primarily in the form of international patents, in instances where the technology covered is considered important enough to justify the added expense |
| By agreement, Company employees who initiate or contribute to a patentable design or process are obligated to assign their interest in any potential patent to the Company |
| Our executive officers, engineers, research and development and technical personnel are critical to our business, and without them we might not be able to execute our business strategy |
| Our financial performance depends substantially on the performance of our executive officers and key employees |
| We are dependent in particular on Mason N Carter, who serves as our Chief Executive Officer, Reynold Green, our Chief Operating Officer, Robert Condon, who serves as our Chief Financial Officer and James Logothetis, our Chief Technology Officer |
| We are also dependent upon our other highly skilled engineering, research and development and technical personnel, due to the specialized technical nature of our business |
| If we lose the services of any of our key personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel might decide to leave, and we might incur increased operating expenses associated with finding and compensating replacements |
| Government regulation |
| The Company’s products are incorporated into telecom and wireless communications systems that are subject to regulation domestically by various government agencies, including the Federal Communications Commission and internationally by other government agencies |
| In addition, because of its participation in the satellite and defense industry, the Company is subject to audit from time to time for compliance with government regulations by various governmental agencies |
| The Company is also subject to a variety of local, state and federal government regulations relating to environmental laws, as they relate to toxic or other hazardous substances used to manufacture the Company’s products |
| The Company believes that it operates its business in material compliance with applicable laws and regulations |
| However, any failure to comply with existing or future laws or regulations could have a material adverse affect on the Company’s business, financial condition and results of operations |
| The Companyapstas products are subject to the Export Administration Regulations (‘‘EAR’’) administered by the US Department of Commerce and may, in certain instances, be subject to the International Traffic in Arms Regulations (‘‘ITAR’’) administered by the US Department of State |
| EAR restricts the export of dual-use products and technical data to certain countries, while ITAR restricts the export of defense products, technical data and defense services |
| The Company believes that it has implemented internal export procedures and controls in order to achieve compliance with the applicable US export control regulations |
| However, the US government agencies responsible for administering EAR and ITAR have significant discretion in the interpretation and enforcement of these regulations, and it is possible that these regulations could adversely affect the Companyapstas ability to sell its products to non-US customers |
| Risks of international operations |
| A significant percentage of the Company’s revenues is derived from the operations of its wholly-owned subsidiaries in Costa Rica and Canada |
| These revenues are subject to the risks normally 19 _________________________________________________________________ associated with international operations which include, without limitation, fluctuating currency exchange rates, changing political and economic conditions, difficulties in staffing and managing foreign operations, greater difficulty and expense in administering business abroad, complications in complying with foreign laws and changes in regulatory requirements, and cultural differences in the conduct of business |
| While the Company believes that current political and economic conditions in Canada and Costa Rica are relatively stable, such conditions may adversely change so as to effect underlying business assumptions about the current opportunities which exist for doing business in those countries |
| In particular, the government in Costa Rica could change, the currency exchange rate between the US and Canadian dollars may change adversely (as occurred in 2005 and 2004), or the cost of labor and/or goods and services necessary to the operations of the Company may increase |
| Recently enacted changes in the Securities Laws and Regulations are likely to increase costs |
| The Sarbanes-Oxley Act of 2002 (the ‘‘Sarbanes-Oxley Act’’) has required changes in some of our corporate governance, securities disclosure and compliance practice |
| In response to the requirements of the Sarbanes-Oxley Act, the SEC and the American Stock Exchange have promulgated new rules in a variety of subjects |
| Compliance with these new rules has increased our legal and accounting costs, and we expect these increased costs to continue indefinitely |
| These developments may also make it more difficult for us to attract and retain qualified members of our board of directors or qualified executive officers |
| If we receive other than an unqualified opinion on the adequacy of our internal control over financial reporting as of December 29, 2007 and future year-ends as required by Section 404 of the Sarbanes-Oxley Act, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock |
| As required by Section 404 of the Sarbanes-Oxley Act, the SEC adopted rules requiring public companies to include a report of management on the companyapstas internal control over financial reporting in their annual reports on Form 10-K or 10-KSB that contains an assessment by management of the effectiveness of the Companyapstas internal control over financial reporting |
| In addition, the public accounting firm auditing a companyapstas financial statements must attest to and report on both managementapstas assessment as to whether the company maintained effective internal control over financial reporting and on the effectiveness of the companyapstas internal control over financial reporting |
| We are currently undergoing a comprehensive effort to comply with Section 404 of the Sarbanes-Oxley Act |
| If we are unable to complete our assessment in a timely manner or if our independent auditors issue other than an unqualified opinion on the design, operating effectiveness or management’s assessment of internal control over financial reporting, this could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our shares to decline |