ITEM 1 BUSINESS
General - -------
Southwall Technologies Inc. ("Southwall" or the "Company") designs, develops, manufactures and markets sputtered thin-film coatings on wide-web, flexible substrates for energy conservation and electronics applications. The Company has developed and currently offers a variety of thin-film products for the residential and commercial architectural glazing, automotive glazing and electronic display markets. These products include transparent insulation and solar-control films, anti-reflective film for computer monitor CRTs, transparent conductive films for use in touch screen displays, and various other types of commercial film.
During 1996 and years prior, the Company also manufactured products for various applications in the aerospace industry, including thin-film materials for shielding and other applications, adhesiveless conductive films for use in flexible electronic circuits and films that reduce detectability of objects in selected portions of the electromagnetic spectrum. However, the Company began a phase out of these products during 1996 and is no longer pursuing these markets.
In September, 1994, the Company entered into an agreement to lease all the assets formerly of Safety Glass, Inc., dba Armour Worldwide Glass, a glass laminator in Southern California. The Company created a subsidiary, Southwall Worldwide Glass Inc., which operated the facility to manufacture the Company's proprietary California Series(TM) solar control laminated glass, as well as bullet resistant, security, custom and standard laminated glass products. That subsidiary operation was closed in March 1996 and certain custom and laminated glass products were discontinued. The Company continues to manufacture the proprietary California Series(TM) solar control product line.
Effective October 31, 1994, the Company acquired Sunflex L.P. which assembles and markets aftermarket film, mesh and glass anti-reflective filters primarily for personal computer monitors under such trademark names as Krystal Clear(TM), OPTIVIEW(TM) and Protector(TM).
Markets and Products - --------------------
Southwall is currently supplying products for use in two broad markets: energy conservation and electronic displays. The Company's current commercial products include: (1) its family of transparent Heat Mirror(TM) films for high performance architectural glazing applications, (2) transparent coatings for use in conjunction with architectural and automotive glazing laminates and applied film to provide solar control to windows, (3) anti-reflective films, both OEM and after market, (4) its Altair(TM) family of transparent conductors, (5) laminated glass products, and (6) other commercial thin-film products.
Energy Conservation Products - ----------------------------
Heat Mirror - Transparent Window Insulation -------------------------------------------
The Company offers a family of Heat Mirror films with various shading and insulating properties. Windows are primary areas of heat loss in winter and a major source of heat gain in summer. Windows containing Heat Mirror, while generally more expensive, have approximately double the insulating capacity of conventional double-pane windows, and transmit high levels of visible light with desired degrees of shading. Heat Mirror films, which are sold in rolls to window manufacturers, are suspended in the airspace between sealed double-pane residential and commercial windows. The Company has developed and patented this film-mounting technology, which it licenses to window fabricators. The Company currently offers a variety of different Heat Mirror films for residential and commercial architectural applications, including Heat Mirror with XUV(R) fading protection.
The Company believes that the Heat Mirror and Heat Mirror related Superglass(R) system is the most comprehensive window glass product available today, providing R-8 to R-10 insulation, transparent solar shading and protection from damaging ultraviolet radiation, while also reducing noise and condensation build-up.
Sales of the Company's Heat Mirror products have been subject to seasonal buying patterns in the past. See Management's Discussion and Analysis of Financial Condition and Results of Operations.
Solar-Control Films for Laminated Glazing Applications ------------------------------------------------------
The Company's Heat Mirror XIR(R) Coating is a transparent, sputter-coated, polyester film used in laminated safety glass for architectural and automotive applications. The film has a patented, transparent solar-control coating on one side and a proprietary adhesion-promotion layer on the other side.
The Company's California Series laminated glazing product is comprised of Heat Mirror XIR, PVB and glass, for architectural and specialty transportation applications such as agricultural and construction vehicles.
Applied Solar-Control Films ---------------------------
Another glazing product utilizing the Heat Mirror XIR coating is Solis(R) solar-control films for the retro-fit market for both architectural and automotive glass. The product has a protective hard coat over the patented, transparent solar-control coating on one side and an adhesion layer on the other side and is applied to existing windows.
Silver Reflector Films ----------------------
Southwall markets these mirrored films to fluorescent reflector manufacturers for energy efficient lighting, primarily for the retrofit market in North America, and to other manufacturers for various applications including large screen televisions.
Electronic Products - -------------------
Anti-Reflective Film and Filters --------------------------------
Southwall's anti-reflective film for computer monitor CRTs minimize reflection of ambient light, electromagnetic interference ("EMI") radiation and static. This film is currently sold primarily to Sony Corporation under a supply agreement for use in Sony's manufacture of CRTs. The Company, through its Southwall-Sunflex, Inc. subsidiary, markets aftermarket mesh, glass and film anti-reflective filters primarily for personal computer monitors under such trademark names as Krystal Clear(R), OPTIVIEW lite(R), and Protector(R).
Transparent Conductors ----------------------
Southwall currently markets several transparent conductive thin-films under the brand names ALTAIR-O(TM) and ALTAIR-M(TM). Transparent conductive thin films combine high visible light transmission with electrical conductivity and environmental stability. They are typically used where the circuit or conductive material must not obscure visual information behind the coating. ALTAIR-M films are sold in roll and sheet form for incorporation into such electronic devices as touch panels, liquid crystal displays and electroluminescent lighting and displays. ALTAIR films are also used in EMI shielding, infrared rejection and electrostatic discharge packaging applications.
Other Products --------------
Southwall manufactures a variety of other commercial thin-films, including highly reflective coatings for use in optical storage media.
Manufacturing - -------------
Three large-scale sputtering production machines currently provide most of the Company's sputtered thin-film coatings manufacturing capacity. The Company also uses two small-scale sputtering machines for smaller production runs, and research and development projects.
The Company has committed to a lease and is currently in the process of equipping a new facility for the manufacturing of anti-reflective film. The Company estimates that it will cost approximately $14 million to equip this facility, of which approximately $2.4 million was expended in 1996, approximately $9 million will be spent in 1997 and an additional $3 million in 1998. The Company secured $5 million of financing for the project from a lending institution during December 1996 and is in negotiations with lending institutions to finance the balance of the costs of this expansion.
The Company anticipates that the new manufacturing facility will begin operations according to schedule and that adequate financing for the facility will be obtained. To the extent that completion of the new facility is delayed or the Company is not able to obtain necessary financing for the facility on commercially reasonable terms, if at all, the Company's business and results of operations could be materially adversely affected.
Sources of Supply - -----------------
The Company has more than one supplier for much of its raw materials and maintains inventories and close working relationships with its suppliers to ensure timely and reliable delivery. The substrates used in the manufacture of Heat Mirror and anti-reflective film are currently available only from a single source. In each case, an alternative source of supply is being pursued, however, there can be no assurance that alternative sources of supply will be successfully developed. Although Southwall has not experienced major interruptions in production due to a shortage of raw materials, prolonged supply shortages would materially and adversely affect the Company's manufacturing operations, business and financial performance.
Research and Development - ------------------------
Southwall's research and development activities are focused upon the development of new proprietary products, thin-film materials science, and deposition process optimization and automation. Company-funded research and development expenditures totaled $2,310,000, $2,069,000 and $2,487,000, 11%, 6% and 6% of total net revenues during, 1994, 1995 and 1996, respectively.
Marketing and Customers - -----------------------
The Company markets its products to OEMs in the United States, Canada, Europe, the middle East and Asia principally through its own direct sales force and sales representatives. Mitsui and Marubeni Corporation, are the Company's distributors for Heat Mirror and certain electronics products in Japan. Mitsui also has exclusive manufacturing rights for certain of the Company's electronics products in Japan using the Company's proprietary sputtering technology. Approximately 80%, 63% and 46% of the Company's net product sales (see below) resulted from sales to customers located in the United States in 1994, 1995 and 1996, respectively.
In 1992, the Company established and staffed a European office to provide marketing, sales and field service support in Europe primarily for the Company's Heat Mirror product line.
In 1995, the Company established and staffed a sales office in Hong Kong to provide marketing and sales support in Australia and Asia, primarily for the Company's window products. That office was moved to Singapore during 1996.
In 1995, Southwall started selling its proprietary anti-reflective film under a Supply Agreement to Sony Corporation, Japan for computer monitor CRTs. During the first quarter of 1996, the Company and Sony Corporation signed an Addendum #1 to Supply Agreement. Under the terms of the amended agreement, among other things, Sony has agreed to increase its minimum order of anti- reflective film beginning July 1, 1997 and extending through December 31, 2000, and Southwall has agreed to install any necessary additional manufacturing capacity by July 1, 1997.
Southwall supplies Heat Mirror products to approximately 60 insulating glass and window fabricators and distributors worldwide. The Company's proprietary mounting technology is licensed to its customers, who must acquire or build specialized mounting equipment for the manufacture of Heat Mirror- equipped windows. The Company's Field Services organization trains customers in the manufacture of
Heat Mirror-equipped windows.
In North America, the Company also promotes its Heat Mirror product line, including its California Series laminated glazing product to the design community, through approximately 30 regionally based architectural sales representatives.
The Company sells its anti-reflective filters primarily through independent direct sales organizations.
Southwall's products are sold with a limited warranty. The Company has not experienced significant product returns and the costs of its warranty programs have not been substantial.
A small number of customers have accounted for a substantial portion of the Company's revenues. The Company's ten largest customers accounted for 47% and 53% of net product sales in 1995 and 1996, respectively. The loss of any of these customers could have a materially adverse effect on the Company's operating results. The Company anticipates that customer concentration will continue for the foreseeable future.
Orders for the Company's products are typically short-term and Southwall usually ships its products from inventory or produces special customer runs within 90 days of receiving orders. As a result, the Company generally experiences no significant order backlog.
Competition - -----------
The thin-film coatings industry and the markets in which Southwall's customers compete experience rapid technological change. Southwall's revenues and operating results could be materially adversely affected by new equipment or process technologies that improve or change the methods of depositing films on substrates. Technological change in customers' markets may also result in obsolescence of the Company's products. Southwall's future success will depend, in large part, on its ability to anticipate technological change and to introduce new products.
Southwall has a number of present and potential competitors, many of which have greater financial resources and greater selling, marketing and technical resources than the Company. Other U.S. companies serving some of the same markets as the Company include Material Sciences Corporation and Optical Coating Laboratories, Inc. One of the largest U.K. polymer film companies, Courtaulds PLC, entered the market in the mid-1980's by acquiring certain U.S. thin-film manufacturers. The Company also competes in certain markets with a number of Japanese companies. Southwall believes that competition for its commercial products comes primarily from other types of films, various chemical coatings and solar control coatings deposited directly on glass, and heat absorbing glass, and that the principal competition to its electronic display products is currently from non-thin-film alternatives as well as thin-film alternatives.
The Company competes primarily on the basis of the characteristics and quality of its products, its ability to meet individual customer specifications and the quality and level of technical assistance furnished to customers.
Patents and Licenses - --------------------
The Company relies primarily upon trade secrets and know-how to develop and maintain its competitive position. There can be no assurance that others will not develop and patent similar technology or that the confidentiality agreements upon which the Company relies will be honored.
The Company has twenty-six (26) patents and seven (7) patent applications pending in the United States that cover materials, processes, products and production equipment. The Company also has patents and patent applications pending in various foreign countries covering the same technology. Expiration dates for the various patents range from 1997 to 2014. Southwall considers its proprietary technology, as well as its patent protection, to be a significant factor in its business. There can be no assurance that any patent will be issued on pending applications or that any patent issued will provide adequate protection for the technology or product covered by it. In addition, other companies and universities have obtained patents covering film configurations and processes. The Company has obtained licenses under some of these patents and may from time to time require licenses under additional patents. There can be no assurance that Southwall will be able to obtain such licenses, if required, upon commercially reasonable terms or at all.
Litigation has been and may in the future be necessary from time-to-time to enforce patents issued to the Company to protect trade secrets and know-how owned by the Company or to determine the enforceability, scope or validity of the proprietary rights of others. Any such litigation could result in substantial costs to the Company and division of effort by the Company's management and technical personnel.
Employees - ---------
As of December 31, 1996, Southwall had 215 regular full-time employees, of whom 31 were engaged in engineering, 128 in manufacturing, and 56 in selling, general management, finance and administration. The Company is highly dependent upon the existence and continuing services of certain key scientists, engineers and management personnel. The loss of services of these employees could have a materially adverse impact on the business and prospects of the Company. Many of the Company's employees are highly skilled, and the Company faces strong competition in recruiting and retaining such personnel.
None of the Company's employees are covered by a collective bargaining agreement, and the Company has not experienced any work stoppages. The Company believes that its employee relations are good.
Environmental Matters - ---------------------
The Company uses certain hazardous materials in its research and manufacturing operations and has air and water emissions that require controls. As a result, Southwall is subject to stringent federal, state and local regulations governing the storage, use and disposal of wastes. The Company has implemented a program to monitor its past and present compliance with environmental laws and regulations. Although the Company believes that it is currently in material compliance with such laws and regulations, current or future laws and regulations may require the Company to make expenditures for compliance with chemical exposure, waste treatment or disposal regulations.
There can be no assurance that the operations, business or assets of the Company will not be materially adversely affected by the interpretation and enforcement of current or future environmental laws and regulations.
ITEM 2.
ITEM 2. PROPERTIES
Southwall's administrative, marketing, engineering and manufacturing facilities are located in five buildings totaling approximately 119,000 square feet in Palo Alto, California, and 15,000 square feet in Sligo, Ireland where most of the Company's anti-reflective filters are assembled. The buildings are occupied under leases that expire from May 1997 to December 1999, with options to extend some of these leases for terms expiring through 2009. In November 1996, the Company committed to lease of a manufacturing facility currently under construction in Tempe, Arizona, for ten years, plus two five year options, to begin May 1, 1997. The Company believes that these facilities are suitable for it's manufacturing requirements at least through 1997. However, should demand for the Company's products increase significantly, additional facilities could be necessary. The Company believes that such additional facilities could be available at reasonable costs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company has been named a defendant in a lawsuit filed on April 5, 1996 by one of its customers in the United States District Court for the Eastern District of New York. The Lawsuit in federal court alleges certain unfair competition, tort and contractual violations by the Company and seeks relief in an aggregate amount in excess of $35 million. The Company believes that this lawsuit is without merit and intends to defend against it vigorously.
In addition, the Company is involved in certain other legal actions arising in the ordinary course of business. The Company believes, however, that none of these actions, either individually or in the aggregate, will have a material adverse effect on the Company's business or its consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter ended December 31, 1996.
PART II =======
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock has been traded on the NASDAQ National Market System under the symbol "SWTX" since the completion of the Company's initial public offering in June 1987. Prices in the following table represent the high and low closing sales prices for the Company's Common Stock as reported by NASDAQ.
Common Stock Prices: - -------------------
The Company has not paid cash dividends and has no present plans to do so. There were approximately 2,600 stockholders at December 31, 1996, which includes stockholders of record and an estimate of the number of stockholders holding Common Stock in broker name.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) Includes $3.5 million in 1992 and $1.1 million in 1993 of revenues from sale of a production machine constructed for a Southwall customer in Japan in connection with a license agreement.
(2) Includes $1 million of charges during the fourth quarter of 1994 to eliminate three minor product lines ($.5 million) and to consolidated facilities ($.5 million).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (in thousands)
This Form 10-K Report may contain, in this section and elsewhere in the report, forward looking statements as that term is defined in the Private Securities Reform Act of 1995, including, without limitation, statements regarding the Company's expectations, beliefs intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements.
General -------
The Company has experienced significant fluctuations in quarterly results of operations. Revenues have varied from quarter to quarter due to the seasonal buying patterns for the Company's Heat Mirror products, which typically have been strongest in the second and third quarters and the timing of short-term sales contracts. Sales of the Company's energy conservation products are significantly influenced by the residential and commercial construction industries, and reduction in construction has generally resulted in a reduction in the sales of the Company's Heat Mirror products. In addition, revenues and operating results have historically varied from quarter to quarter as a function of the utilization of the Company's production machines. Manufacturing inefficiencies have resulted from underutilization of capacity, primarily in 1994, the development and introduction of new products and the changing mix of products manufactured. Primarily as a result of these factors and in view of the Company's strategy of developing additional applications for its thin-film technology, and its ongoing practice of upgrading its manufacturing processes, the Company may continue to experience quarterly fluctuations in its results of operations.
Although the Company has not experienced any significant amount of inventory obsolescence and believes that its inventory is recoverable, obsolescence of the Company's products could be affected by technological change, competition, loss of customers and reduction in demand, among other factors.
Effective September 1, 1994, the Company commenced leasing all the assets formerly owned by Safety Glass, Inc., dba Armour Worldwide Glass, located in Southern California, under a five year operating lease for $40 per month. A
wholly-owned subsidiary, Southwall Worldwide Glass Inc. ("SWGI"), was created to operate the facility and to manufacture the Company's proprietary California Series solar control laminated glass, as well as bullet resistant, security, custom and standard laminated glass products. The Company closed that subsidiary operation in March, 1996 and certain custom and laminated glass products were discontinued. The Company continues to manufacture the proprietary California Series solar control product line.
Effective October 31, 1994, the Company acquired Sunflex L.P. ("Sunflex") for $500, which will only be paid from Sunflex's operating income, if any, over the four calendar years ending December 31, 1998. Sunflex assembles and markets aftermarket mesh, glass and film anti-reflective filters primarily for personal computer monitors. Sunflex did not have operating income in 1995 or 1996, and, as a result, no payments have been made to previous owners.
The Company believes that it must continue to increase revenues to achieve sustained profitability. Although the Company is seeking to expand existing applications, to develop new applications and to expand international marketing and sales efforts, there can be no assurance that the Company will be able to remain profitable.
The following table sets forth for the periods indicated (I) the percentage relationship to revenues of expense and income items and (ii) the percentage change of such items as compared to the prior period. The table and the subsequent discussion should be read in conjunction with the financial statements and the notes thereto included elsewhere in this Form 10-K.
Results of Operations (in thousands) -----------------------------------
1996 Compared to 1995 ---------------------
The Company's net sales were $41.7 million for 1996 compared to $33.5 million in 1995, a 25% increase. Net sales of electronic products, including sales of the Company's new anti-reflective film for computer monitors, increased by approximately $7.8 million. In addition, net sales of energy conservation products increased by approximately $1.7 million, offsetting a decrease of approximately $1.3 million in discontinued product sales.
Cost of sales for 1996 was 67% of sales compared to 69% for 1995. The percentage decrease was primarily due to increased sales volume and the related improvement in manufacturing efficiencies.
Research and development expenses, as a percent of sales, were 6% for 1996, compared to 6% for 1995. The absolute dollar increase in 1996 is due to an increased amount of new product development.
Selling, general and administrative expenses, as a percent of net sales, decreased to 21% in 1996, from 22% in 1995 due to increased sales volume. The increase from $7.4 million in 1995 to $8.7 million in 1996, is attributable to the new operations discussed above, and increased sales and marketing expenses associated with the introduction of new products and continued expansion in the Pacific Rim.
As a result of the factors discussed above, the Company reported a pre-tax income of $2.5 million for 1996, compared to a pre-tax income of $.6 million for 1995.
1995 Compared to 1994 ---------------------
The Company's net sales were $33.5 million for 1995 compared to $21.7 million in 1994, a 54% increase. Of this increase, which was primarily volume related, approximately $2.5 million was from the new operations discussed above. In addition, net sales of energy conservation products increased by approximately $6.5 million, and net sales of electronic products, including sales of the Company's new anti-reflective film product for computer monitors, increased by approximately $3.5 million, offsetting a decrease of approximately $.5 million in aerospace and other product sales.
Cost of sales for 1995 was 69% of sales compared to 79% for 1994. The percentage decrease was primarily due to increased sales volume and the related improvement in manufacturing efficiencies.
Research and development expenses, as a percent of sales, were 6% for 1995, compared to 11% for 1994. The decrease is primarily attributable to an increased volume of sales. The absolute dollar decrease in 1995 is due to a decreased amount of new product development.
Selling, general and administrative expenses, as a percent of net sales, decreased to 22% in 1995, from 28% in 1994 due to increased sales volume. The increase from $6.1 million in 1994 to $7.4 million in 1995, is attributable to the new operations discussed above, and increased sales and marketing expenses
associated with the introduction of new products and expansion in the Pacific Rim.
As a result of the factors discussed above, the Company reported a pre-tax income of $.6 million for 1995, compared to a pre-tax loss of $3.9 million for 1994.
Liquidity and Capital Resources -------------------------------
At December 31, 1996, the Company's net working capital was $15.8 million compared to $9.7 million at December 31, 1995. For the past four years the Company has financed its operations primarily from existing cash and cash flow from operations.
In the first quarter 1996, the Company entered into an addendum to a previous supply agreement with a major customer which provides for certain "best efforts" sales and purchase commitments of the Company's anti-reflective film from the date of the addendum through June 30, 1997. Beginning July 1, 1997, the Company is firmly committed to supply and the customer is committed to purchase fixed volumes for the period July 1, 1997 through December 31, 1997, and annually thereafter until December 31, 2000. Should either the Company fail to supply or the customer fail to purchase the specified quantities, a penalty, which is based on the sales price to the customer from the prior period, must be paid to the other. In order to meet the supply commitment, additional capacity is planned to be on line during the second half of 1997. The Company estimates that it will cost approximately $14 million to equip this facility, approximately $2.4 million of which was expended during 1996, approximately $9 million which will be expended during 1997 and approximately $3 million during 1998. During December, 1996, the Company obtained partial financing for this project in the amount of $5.0 million under a four year term loan secured by an existing production machine.
From December 31, 1995 to December 31, 1996, cash and short-term investments increased by $3.9 million, primarily from cash generated by operations and debt financing; partially offset by expenditures for property and equipment. Accounts receivable increased by $1.8 million and inventories increased by $1.8 million. The increase in accounts receivable is primarily attributable to the increase in net revenues from $9.1 million in the fourth quarter of 1995 to $10.1 million in the fourth quarter of 1996, and to the timing of sales, most of which occurred during the later portion of the quarter. The increase in inventories is primarily due to strong production during the fourth quarter and preparing for anticipated continued growth in orders in the first quarter of 1997.
The Company anticipates total capital expenditures of approximately $2.5 million during 1997, in addition to the amounts relating to the new facility described above. If demand for the Company's products increase significantly, additional capital expenditures could be necessary.
At December 31, 1996, the Company had $7.4 million of cash and short- term investments, a $6 million line of credit and a $5 million term loan, which are subject to certain financial covenants. As of December 31, 1996, there were no borrowings under the line of credit. Additional debt financing of $6 million is currently being negotiated, and the Company has received proposals for a bridge loan from it's line bank and for an additional term loan from a financing institution. Under the proposal from the Company's line bank, the line of credit could be reduced to as low as $3 million should the Company accept the $6 million
bridge loan as proposed by the bank, but would increase back to $6 million when the bridge loan is converted to a term loan, which is anticipated to occur during the third or fourth quarter of 1997.
Existing working capital and cash generated from operations are expected to be adequate to satisfy the Company's capital and operating requirements, excluding the expansion project, at least through 1997. The Company believes that long term debt funding received during December, 1996 and the above described additional financing currently under negotiation will satisfy the Company's requirements for financing of the manufacturing facility expansion project currently under way. Failure to generate sufficient cash flow from operations or external sources would have a material adverse effect on the Company.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
REPORT OF INDEPENDENT ACCOUNTANTS ---------------------------------
To the Board of Directors and Stockholders of Southwall Technologies Inc.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, cash flows and stockholders' equity present fairly, in all material respects, the financial position of Southwall Technologies Inc. and its subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP San Jose, California January 24, 1997
SOUTHWALL TECHNOLOGIES INC. CONSOLIDATED BALANCE SHEETS -------------------------------- (in thousands) ASSETS ------
LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------
See accompanying notes to financial statements.
SOUTHWALL TECHNOLOGIES INC.
CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- (in thousands, except per share data)
See accompanying notes to financial statements.
SOUTHWALL TECHNOLOGIES INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ----------------------------------------------- (in thousands)
*Indicates amount less than $500.
See accompanying notes to financial statements.
SOUTHWALL TECHNOLOGIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- (in thousands)
See accompanying notes to financial statements.
SOUTHWALL TECHNOLOGIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ (in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: - ---------------------------------------------------
Operations - ----------
Southwall Technologies Inc. (the "Company") operates in a single industry segment and is engaged in the design, development and production of thin film coatings on flexible substrates. These coatings selectively absorb, reflect or transmit certain types of electromagnetic radiation for use in energy conservation and electronics applications. The Company has developed and currently markets a variety of thin-film products for the residential and commercial architectural glazing, automotive glazing and electronic display markets. These products include transparent insulation and solar-control films, anti-reflective film for computer monitor CRTs, transparent conductive films for use in touch screen displays, and various other commercial film.
Principles of consolidation - ---------------------------
The consolidated financial statements include the accounts of Southwall Technologies Inc. and its wholly-owned subsidiaries. The Company's foreign operations, which are not significant, are translated using appropriate rates of exchange, with the U.S. dollar as the functional currency. Foreign currency transaction gains and losses have not been significant. All significant intercompany balances and transactions have been eliminated.
Management estimates - --------------------
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash equivalents and short-term investments - -------------------------------------------
Cash equivalents and short-term investments consist of domestic and Eurodollar certificates of deposit, treasury bills, commercial paper, bankers' acceptances, corporate notes and mutual funds. Investments with maturities of three months or less from the date of purchase are included in cash equivalents.
The Company has classified its short-term investments as "available-for- sale securities." At December 31, 1996, the difference between cost and fair market value was insignificant and the gains/losses on sales of securities during the year were insignificant.
Concentration of credit risk - ----------------------------
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of investments and trade accounts receivable.
The Company invests, as stated above, in a variety of financial instruments. The Company, by policy, limits the amount of credit exposure to any one financial institution or commercial issuer.
The Company sells its products throughout the world. The Company performs ongoing credit evaluations of its customers' financial condition and, generally, requires no collateral from its customers. The Company maintains an allowance for uncollectible accounts receivable based upon expected collectibility of all accounts receivable. The write-off of uncollectible amounts has been insignificant.
Revenue recognition - -------------------
Revenues from sales of manufactured products are recorded at the time shipments are made. Revenues from long-term contracts, which are not significant, are generally recorded using the percentage-of-completion method.
The Company has agreements under which it receives fees for certain rights to technology and products. License revenues associated with these agreements are recognized when earned, generally upon receipt of payment or shipment of product.
Accounts receivable - -------------------
Accounts receivable are stated net of allowance for doubtful accounts of $534 and $682 at December 31, 1995 and 1996, respectively.
Inventories - -----------
Inventories are stated at the lower of cost (determined by the first-in, first-out method) or market. Cost includes materials, labor and manufacturing overhead.
Property and equipment - ----------------------
Property and equipment are stated at cost. The Company uses the units-of- production method for calculating depreciation on certain of its production machines and the straight-line method for all other property and equipment. Estimated useful lives of the assets range from five to ten years. On its large scale production machine, for which the units-of-production depreciation method is used, the Company records minimum annual depreciation of at least one-half of the depreciation that would have been recorded utilizing the straight-line depreciation method over a ten-year life. Leasehold improvements are amortized using the term of the related lease or the economic life of the improvements, if shorter.
Additions, major renewals and betterments are included in the asset accounts at cost. Ordinary maintenance and repairs are charged to expense as incurred. Gains or losses from disposal are included in earnings.
Intangible assets - -----------------
Patents, licenses and trademarks relating to the Company's commercial products are stated at cost less accumulated amortization. Amortization is computed on the straight-line basis over terms of up to 17 years. At December 31, 1995 and 1996 patents, licenses and trademarks are included in other assets at a cost of $906 and $882, net of accumulated amortization of $703 and $817,
respectively. Amortization expense for 1994, 1995 and 1996 was $103, $136 and $121, respectively.
Stock options - -------------
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation".
Income taxes - ------------
Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts.
Net income (loss) per share - ----------------------------
Net income (loss) per share is computed based upon the weighted average number of common and dilutive common equivalent shares outstanding. Common equivalent shares include the effect of stock options utilizing the modified treasury stock method. Under the modified treasury stock method, all stock options are assumed exercised whether dilutive or not, and the proceeds from the assumed exercise are applied in steps. First, stock is assumed to be repurchased up to a maximum of 20% of the actual outstanding shares. Any remaining proceeds are assumed to be used to reduce debt, and then to acquire outstanding government securities. For purposes of this calculation, net income is adjusted by the after tax interest effect related to such assumed transactions. The result of the two step approach is aggregated and, if dilutive, enters into the earnings per share calculation. The modified treasury stock method can result in different earnings per share than those calculated using the treasury stock method. In the periods presented, the assumed repurchase of stock was less than 20% of the actual outstanding shares, therefore there was no pro forma earnings adjustment. Convertible debentures are not included since they are anti-dilutive.
NOTE 2 - BALANCE SHEET DETAIL: - -----------------------------------
Depreciation and amortization expense for the years ended December 31, 1994, 1995 and 1996 was $1,956, $2,021 and $2,192 respectively.
NOTE 3 - LONG-TERM DEBT: - -----------------------
The Company's long term debt includes a $2.65 million convertible debenture, due May 31, 1999, bearing interest, payable semi-annually with the Company's common stock, at 2% below prime, but not less than 7% nor higher than 11%, and convertible into the Company's common stock at a price of $9.95 per share (subject to certain adjustments).
Also included is a $5 million Promissory Note dated December 16, 1996, secured by an existing production machine, at an interest rate of 9.7037%, and the Company is subject to certain financial covenants. The note is payable in monthly installments plus interest for a term of 48 months. Principal reductions of the note are scheduled as follows:
NOTE 4 - INCOME TAXES: - ---------------------
The income tax provision in 1996 results primarily from minimum tax liabilities related to federal taxes and foreign withholding taxes on royalty payments. The effective income tax rate differs from the federal statutory rate primarily as a result of the utilization of net operating loss carryforwards. The deferred tax assets valuation allowance at December 31, 1994, 1995 and 1996 is attributable to federal and state deferred tax assets. Management believes that sufficient uncertainty exists with regards to the realizability of these tax assets such that a full valuation allowance is necessary. During 1994, 1995 and 1996, the Company realized $0, $.4 and $.6 million respectively of deferred tax assets previously reserved.
Deferred tax (liabilities) assets are comprised of the following:
At December 31, 1996 the Company had net federal operating loss carryforwards of approximately $19 million which expire at various dates from 1997 through 2009. The net operating loss carryforwards include approximately $2.4 million resulting from employee exercises of non-incentive stock options or disqualifying dispositions, the tax benefit of which, when realized, will be accounted for as an addition to capital in excess of par value, rather than as a reduction of the provision for income taxes. Research and development, investment tax and foreign tax credit carryovers of approximately $1 million are also available to reduce future federal income taxes and expire at various dates through 2005. If certain substantial changes in the Company's ownership occur, there would be an annual limitation on the amount of the carryforwards which can be utilized.
NOTE 5 -STOCKHOLDER'S EQUITY - ----------------------------
Stock Option Plans: - ------------------
The Company has granted stock options under certain option agreements in 1981 and 1983, its 1983 Qualified and Non-Qualified Stock Option Plan, and its restated 1987 Stock Option Plan. The plans and agreements are administered by the Board of Directors. Under the terms of the 1983 Plan and the 1981 and 1983 Agreements, options to the Company's employees, directors and consultants were granted at prices not less than the fair market value of the Company's stock on the date of grant. The exercise price of options granted under the restated 1987 Stock Option Plan must be at least 85% of the fair market value of the stock at the date of grant.
Options under the plans generally vest at a rate of 25% per year, are non-transferable and generally expire over terms not exceeding ten years from the date of grant or three months after termination of the optionee's relationship with the Company.
In October 1994, the Company allowed all holders of outstanding options to exchange higher priced options for new non-qualified options at $2.50 per share, the fair market value at the time of the Board's action. The repricing terms provided that for each 100 shares of options exchanged, 75 shares of new options would be granted; those options vested at the time of the exchange would revest in one year; and those options unvested at the time of the exchange would vest on the original option schedule. Options for 1,493 shares were exchanged for new options for 1,120 shares.
During 1996, certain employees, officers and directors exercised stock options under the plan by issuing full recourse notes to the Company with an interest rate of 8.75%. The principal and accrued interest on the Notes are due one year from the date of the Note. These notes aggregate $596 at December 31, 1996.
As of December 31, 1996, there were 62 shares of Common Stock available for grant under all plans. In addition, at December 31, 1996, 652 options were vested and exercisable at prices ranging from $2.50 to $6.75.
Employee Stock Purchase Plan - ----------------------------
In April 1988, the Company adopted the Employee Stock Purchase Plan ("the Purchase Plan") and reserved 150 shares of Common Stock for issuance thereunder. Employees of the Company, subject to certain limitations, may purchase shares at 85% of the lower of the fair market value of the Common Stock at the beginning of the six month offering period, or the last day of the purchase period. During 1994, 1995 and 1996, 12, 20 and 20 shares, respectively, were sold under the Purchase Plan.
Accounting for Stock Based Compensation - ---------------------------------------
The Company has two stock option plans which reserve shares of Common Stock for issuance to employees, officers and directors. The Company applies APB Opinion 25 and related Interpretations in accounting for it's plans. Accordingly, no compensation cost has been recognized for the stock option plans, except for $123 related to certain transactions in 1996. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation". Had compensation cost for the Company's two stock option plans been determined based on the fair value at the grant date for awards granted in 1995 and 1996 under those plans consistent with the provisions of FAS No. 123, the Company's net income and income per share would have been reduced to the pro forma amounts indicated below:
The pro forma amounts reflect compensation expense related to 1995 and 1996 stock option grants and purchase rights only. In future years, the annual compensation expense will increase relative to the fair value of stock options granted in those future years.
For the Stock Option Plan, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model for the multiple option approach with the following weighted-average assumptions used for grants in 1995 and 1996, respectively; expected volatility of 60% in both years; risk-free interest rate of 6.0% and 6.2%; and expected lives from vesting date of .68 and .72 years. The Company has not paid dividends and assumed no dividend yield. The weighted-average fair value of those stock options granted in 1995 and 1996 was $1.69 and $2.99 per share, respectively.
For the Employee Stock Purchase Plan, the fair value of each purchase right is estimated on the beginning of the offering period using the Black- Scholes option-pricing model with the following weighted-average assumptions used in 1995 and 1996, respectively; expected volatility of 63% and 57%; risk- free interest rate of 6.1% and 5.4%; and expected lives of .5 years in both 1995 and 1996. The Company has not paid dividends and assumed no dividend yield. The weighted-average fair value of those purchase rights granted in 1995 and 1996 was $0.90 and $1.82 per right, respectively.
The activity under the option plans, combined, was as follows:
The following table summarizes information about stock options outstanding at December 31, 1996:
NOTE 6 - COMMITMENTS: - --------------------
The Company leases certain property and equipment as well as its facilities under noncancellable operating leases and $224 of computer equipment under a capital lease. These leases expire at various periods through 2007.
As of December 31, 1996, the future minimum payments under these leases are as follows:
Rent expense under operating leases was approximately $1,337, $1,720 and $1,398, in 1994, 1995, and 1996, respectively.
During the first quarter 1996, the Company entered into an addendum to a previous supply agreement with a major customer which provides for certain "best efforts" sales and purchase commitments of the Company's anti-reflective film from the date of the addendum through June 30, 1997. Beginning July 1, 1997, the Company is firmly committed to supply and the customer is committed to purchase fixed volumes for the period July 1, 1997 through December 31, 1997, and annually thereafter until December 31, 2000. Should either the Company fail to supply or the customer fail to purchase the specified quantities, a penalty, which is based on the sales price to the customer from the prior period, must be paid to the other. In order to meet the supply commitment, additional capacity is planned to be on line during the second half of 1997. The Company estimates that it will cost approximately $14 million to equip this facility, approximately $2.4 million of which was expended during 1996, approximately $9 million which will be expended during 1997 and approximately $3 million during 1998.
NOTE 7 - LINE OF CREDIT AGREEMENT: - ---------------------------------
The Company has secured a $6 million revolving line of credit which expires in June 1997, but may be extended for additional one year terms with the bank's approval. The amount of borrowings is based upon a percentage of accounts receivable, which at December 31, 1996, limited available borrowing to $3.7 million. The line is secured by certain assets of the Company and bears interest at an annual rate of prime plus .5%. Under the terms of the agreement, the Company is required to maintain certain financial ratios. As of December 31, 1996, there were no borrowings under this line of credit.
NOTE 8 - MAJOR CUSTOMERS: - ------------------------
One customer accounted for 13% of net sales in 1994. In 1995, no one customer accounted for 10% of net sales and the five largest customers accounted for 32% of net sales. In 1996, one customer accounted for 26% of net sales. Export sales accounted for 20%, 37% and 54%, (24% and 38% in the Pacific Rim in 1995 and 1996) in 1994, 1995 and 1996, respectively.
NOTE 9 - ACQUISITIONS: - ---------------------
Effective September 1, 1994, the Company commenced leasing all the assets formerly owned by Safety Glass, Inc., dba Armour Worldwide Glass, located in Southern California, under a five year operating lease for $40 per month. A wholly-owned subsidiary, Southwall Worldwide Glass Inc. ("SWGI") was created to operate the facility and to manufacture the Company's proprietary California Series solar control laminated glass, as well as bullet resistant, security, custom and standard laminated glass products. The Company closed that subsidiary operation in March, 1996 and certain custom and laminated glass products were discontinued. The Company continues to manufacture the proprietary California Series solar control product line.
The consolidated financial statements for 1994 include four months of SWGI operations. For the four month period ended December 31, 1994, SWGI's sales were $809 and SWGI's loss before income taxes was $323. SWGI's assets at December 31, 1994 include accounts receivable of $290 and inventories of $147. SWGI sales were $5 million for 1995, of which approximately $2.1 million were from product discontinued in 1996. Sales in 1996 from products discontinued in March, 1996 were $.6 million and $.1 million were still in accounts receivable at the end of 1996 and fully reserved. There were no other assets remaining on the books for SWGI at the end of 1996.
Effective October 31, 1994, the Company acquired Sunflex L.P. ("Sunflex") for $500 to be paid from Sunflex's operating income, if any, over the next four years. Sunflex assembles and markets aftermarket mesh, glass and film anti-reflective filters primarily for personal computer monitors.
This acquisition was accounted for as a purchase. Since the purchase price is contingent upon future operating income, no payments were made at the time of acquisition. Sunflex did not have operating income in 1995 or 1996 and, as a result, no payments were made in any of those years. At the date of acquisition, assets exceeded liabilities by $105, resulting in negative goodwill. This negative goodwill will be amortized over 36 months.
The consolidated financial statements for 1994 include two months of Sunflex operations. For the two month period ended December 31, 1994, Sunflex's sales were $260 and Sunflex's loss before income taxes was $65.
NOTE 10 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED):
Summarized quarterly financial data for 1995 and 1996 is as follows:
Per share amounts, based on average shares outstanding each quarter, may not add to the total for the year.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III ========
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
The information required by this Item concerning the Company's directors and the Company's executive officers is incorporated by reference to the sections entitled "Nominees" and "Management", respectively, appearing in the Company's Proxy Statement for its 1997 Annual Meeting of Stockholders (the "Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the sections entitled "Executive Compensation", "Severance Agreement" and "Report of the Board of Directors Concerning Executive Compensation" appearing in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to the section entitled "Security Ownership of Officers, Directors and Principal Stockholders" appearing in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to the section entitled "Certain Relationships and Other Transactions" appearing in the Proxy Statement.
PART IV =======
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The following documents are filed as part of this Form 10-K:
(a)(1) Index to Financial Statements. The following Financial Statements of Southwall Technologies Inc. are filed as part of this Form 10-K:
(a)(2) Index to Financial Statement Schedules. Schedules have been omitted because they are not applicable or required, or the information required to be set forth therein is included in the Financial Statements or notes thereto.
(a)(3) Exhibits. Reference is made to the Exhibit Index on -------- pages 37 through 42 of this Form 10-K.
(b) Reports on Form 8-K. -------------------
None
For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 12, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows:
Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has
been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the 1933 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered on the Form S-8 identified below, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the 1933 Act and will be governed by the final adjudication of such issue.
The preceding undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 33-28599 (filed on May 9, 1989), 33-37247 (filed October 11, 1990), 33-42753 (filed on September 16, 1991), 33-51758 (filed on September 8, 1992) and 33-82138 (filed on July 28, 1994).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, as of the 14th day of March, 1997.
SOUTHWALL TECHNOLOGIES INC.
By /s/Martin M. Schwartz --------------------- Martin M. Schwartz President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities indicated, as of March 14, 1997.
Signature Title --------- -----
/s/J. Larry Smart Chairman of the Board of Directors - ----------------- J. Larry Smart)
/s/Martin M. Schwartz President, Chief Executive Officer - --------------------- and Director (Principal Executive (Martin M. Schwartz) Officer)
/s/L. Ray Christie Vice President, Chief Financial - --------------------- Officer and Secretary (Principal Financial (L. Ray Christie) and Accounting Officer)
/s/Bruce J. Alexander Director - --------------------- (Bruce J. Alexander)
/s/ Joseph B. Reagan Director - --------------------- (Joseph B. Reagan)
/s/ Walter C. Sedgwick Director - ---------------------- (Walter C. Sedgwick)
INDEX TO EXHIBITS FILED WITH FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1996
_________________
(1) Filed as an exhibit to the Registration Statement on Form S-1 filed with the Commission on April 27, 1987 (Registration No. 33- 13779) (the "Registration Statement") and incorporated herein by reference.
(2) Filed as an exhibit to the Form 10-Q Quarterly Report for Quarter Ended June 30, 1988, filed with the Commission on August 15, 1988 and incorporated herein by reference.
(3) Filed as an exhibit to the Form 10-Q Quarterly Report for Quarter Ended July 2, 1989, filed with the Commission on August 16, 1989 and incorporated herein by reference.
(4) Filed as an exhibit to the Form 10-K Annual Report 1989, filed with the Commission on March 30, 1990 and incorporated herein by reference.
(5) Filed as an exhibit to the Form 10-K Annual Report 1990, filed with the Commission on March 25, 1991 and incorporated herein by reference.
(6) Filed as an exhibit to the Form 10-K Annual Report 1992, filed with the Commission on March 15, 1993 and incorporated herein by reference.
(7) Filed as an exhibit to the Form 10-Q Quarterly Report for Quarter Ended July 3, 1994, filed with the Commission on August 15, 1994 and incorporated herein by reference.
(8) Filed as an exhibit to the Form 10-Q Quarterly report for Quarter Ended
October 2, 1994, filed with the Commission on November 9, 1994 and incorporated herein by reference.
(9) Filed as Exhibit No. 28.1 to Post-Effective Amendment No. 1 to the Registration Statement, filed with the Commission on June 9, 1987 and incorporated herein by reference.
(10) Filed as an exhibit to the Form 10-K Annual Report 1994, filed with the Commission on March 2, 1995 and incorporated herein by reference.
(11) Filed as an exhibit to the Form 10-K Annual Report 1995, filed with the Commission on March 19, 1996 and incorporated herein by reference.