UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

 

Commission File Number: 000-51828

 

EAGLE TEST SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

(847) 367-8282

(Registrant’s telephone number, including area code)

 

Securities to be registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act  Yes o      No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act  Yes o     No þ

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ      No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2.)

 

Large Accelerated Filer o          Accelerated Filer o          Non-Accelerated Filer þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)  Yes o     No þ

 

The aggregate market value of the common stock held by non-affiliates of the registrant as of March 31, 2006, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $100.2 million (based on the closing price for the registrant’s common stock on the Nasdaq Global Market of $15.40 per share).

 

At November 30, 2006, 22,858,824 shares of the registrant’s common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The registrant intends to file a proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended September 30, 2006. Portions of such proxy statement are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

TABLE OF CONTENTS

 

 

Certain statements in this Annual Report on Form 10-K are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements involve a number of risks, uncertainties and other factors that could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Factors which could materially affect such forward-looking statements can be found in the section entitled “Risk Factors” in Part 1, Item 1A. in this Annual Report on Form 10-K. Investors are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements made herein are only made as of the date hereof and we will undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

 

References in this Annual Report on Form 10-K to “Eagle Test,” the “Company,” “we,” “us” or “our” are to Eagle Test Systems, Inc., a Delaware corporation, and its subsidiaries.

 

Overview

 

We design, manufacture, sell and service high-performance automated test equipment, or ATE, for the semiconductor industry. Our test equipment is designed to address our customers’ volume production needs and to enable them to achieve low cost-of-test per device. Our customers, including semiconductor manufacturers and assembly and test subcontractors, use our products to test analog, a combination of digital and analog, known as mixed-signal, and radio frequency, or RF, semiconductors. Our proprietary SmartPin^tm technology enables multiple semiconductor devices to be tested simultaneously, or in parallel, on an individual test system, permitting greater test throughput. We believe that our technology and ATE architecture offer significant test speed and precision, leading to high production yields and repeatable results. Our modular and scalable test systems are designed to provide our customers with cost-efficient, customized solutions. Semiconductors tested by our systems are incorporated into a wide range of products in high-growth markets, including digital cameras, MP3 players, cellular telephones, video/multimedia products, automotive electronics, computer peripherals, and notebook and desktop computers.

 

Semiconductor manufacturers continuously strive for manufacturing and process improvements in order to satisfy the demand for smaller, better performing and lower cost semiconductors. Semiconductor manufacturers are aggressively pursuing strategies to reduce their overall cost-of-test by increasing the throughput of their test systems. Cost-of-test includes the initial ATE and ancillary equipment purchase price, as well as set-up and operating costs, and is often the most significant manufacturing cost, particularly for high-volume, low-cost devices. For these types of devices, ATE throughput, or the number of devices that can be tested in a given unit of time on a single test system, is a key determinant of cost-of-test per device and of a manufacturer’s ability to compete profitably.

 

We were founded and began providing test solutions in 1976. Since October 1, 2003, we have delivered over 600 test systems to more than 60 customers worldwide including Allegro MicroSystems, Inc., Fairchild Semiconductor International, Inc., Guidant Corporation, Intersil Corporation, National Semiconductor Corporation, ON Semiconductor Corporation and Texas Instruments Incorporated. Our global headquarters is located at our new manufacturing facility in Buffalo Grove, Illinois. We operate sales, services and engineering support facilities in the United States through regional offices and globally through our offices in Korea, Singapore, Taiwan, Italy, Germany, China, Malaysia and the Philippines. We completed our initial public offering on March 14, 2006.

 

Industry Background

 

Semiconductor devices are the foundation of the modern electronic world. Semiconductors are typically divided into two broad categories, digital and analog. Digital semiconductors, such as microprocessors, digital

signal processors, or DSPs, and memory devices, are used to process and store data in a binary format using electrical signals to represent the binary digits, “1” and “0.” In contrast, analog semiconductors, such as amplifiers, RF devices, voltage regulators and other power management devices, are used to measure, control and transform physical properties, such as light, sound and movement, into a digital format by producing electrical signals that have a continuous range of values. Mixed-signal semiconductors contain both analog and digital elements on a single device but are generally classified as analog semiconductors.

 

Semiconductor prices typically decline as new devices are introduced and as devices advance through their product life cycles. This price compression takes place against a backdrop of increasing device complexity. Consequently, semiconductor device manufacturers, especially those serving high-volume markets, must continually seek cost reductions in all aspects of their manufacturing process.

 

The Importance of Testing in Semiconductor Production; The ATE Market

 

The process of designing and manufacturing semiconductors is complex and capital intensive. The wafer fabrication process, or “front-end” process, involves numerous and repetitive processing steps during which hundreds or even thousands of copies of a device are formed simultaneously on a single wafer. The subsequent testing and assembly of devices into packaged products ready for sale is commonly referred to as the “back-end” process.

 

Device testing is a critical part of the semiconductor production process and is a significant component of the cost of manufacturing semiconductors. Test equipment is typically used in the back-end process where each device is often tested several times to validate functional and electrical performance prior to shipment. ATE is generally used in two steps in the back-end semiconductor production process:

 

 

In addition to identifying devices that do not function properly in the back-end process, ATE also generates information that semiconductor manufacturers use to improve the yield of their overall production process and to assist in the semiconductor design and development phase. Demand for ATE is driven by increases in semiconductor unit production, increases in the complexity of semiconductor devices and the need to improve the overall cost-effectiveness of the semiconductor manufacturing process.

 

Current Test Challenges

 

Device manufacturers have continually focused on manufacturing and process improvements to satisfy the demand for smaller, better performing and lower cost semiconductors. Technological advances, such as smaller device geometries, higher transistor density and the introduction of larger, 300 mm wafers, have led to significant economies of scale in the front-end process and a general decline in overall manufacturing cost per device. However, as front-end costs have been decreasing, back-end costs, of which testing costs can be the most significant component, have not enjoyed the same rate of improvement. As a result, test cost has become a growing percentage of overall manufacturing cost and can be the most significant cost associated with manufacturing a semiconductor, especially in the case of high-volume devices. Consequently, semiconductor manufacturers are aggressively pursuing strategies to reduce their overall cost-of-test.

 

In analyzing total cost-of-test, semiconductor manufacturers focus on the initial ATE purchase price, equipment throughput, the range of products that can be effectively tested, costs associated with test application development, ability to upgrade, on-going maintenance and training requirements, and the need for

ancillary equipment and floor space. Reducing the total cost-of -test is an important consideration for all device manufacturers, but is of particular significance to vendors of high-volume, low-cost devices for whom overall manufacturing cost is a critical factor in the ability to compete profitably. Significant challenges for device manufacturers in achieving lower overall cost-of-test include:

 

 

Our Solution

 

Our products are designed to enable our customers to achieve low overall cost-of-test per device. We believe our test systems deliver increased test throughput for high-volume, price-sensitive semiconductors in the analog, mixed-signal and RF markets. We offer test systems that enable our customers to achieve a high level of test accuracy and repeatability, and our flexible system architecture can be easily reconfigured and adapted to meet our customers’ current and evolving testing needs. By focusing on low cost-of-test per device and based on informal feedback from customers, we believe that our test systems offer customers a competitive overall test solution that enables them to lower their semiconductor production costs and improve their profit opportunity. The aspects of our solution that facilitate low cost-of-test include:

 

Increased Throughput.  Our test systems are designed to enable our customers to improve throughput, which lowers total cost-of-test. We improve throughput in the following manner:

 

 

Improved Yield with Precision and Repeatability.  Our proprietary technology and product architecture are designed to achieve test precision and repeatable results in order to deliver higher yields. We believe our solution improves yield in the following ways:

 

 

Scalable and Flexible Architecture.  Our test system architecture is designed to enable our customers to quickly and cost-effectively upgrade or reconfigure their test systems as their testing needs evolve. Our architecture offers the following benefits:

 

 

Lower Switching Costs.  We have developed a proprietary, adaptable interface that enables our test systems to operate using other vendors’ DUT boards, as well as earlier generations of our DUT boards, which is a significant advantage to us as our customers’ testing needs change. This proprietary architecture, which we call Chameleon^tm technology enables customers to easily migrate from some competing test platforms or earlier generations of our own product line, to a newer and more cost-effective Eagle Test solution. Our test systems are designed to offer customers a low-cost and time-saving option for migrating test platforms.

 

During the sales process, prospective and existing customers generally engage in an evaluation process in which they compare the costs and test results, such as yield and repeatability, of their current test solution against our proposed test solution. The customer’s current test solution may consist of a test system provided by one of our competitors, such as Credence Systems Corporation, LTX Corporation or Teradyne, Inc., a test system internally developed by the customer, or one of our previous generation test systems. An important consideration in the comparative evaluation process is the overall cost-of-test, which includes factors such as the number of devices to be tested, the total test system acquisition cost, the amount of required floor space, test time and the number of test systems required, and also considers system flexibility, upgradeability and maintenance costs. Customers often share with us their conclusions from their comparative evaluation of the cost-of-test of their current test solution versus our proposed test solution. This feedback, together with our experience with customers selecting our test solution after employing this evaluation process, supports our belief that our test systems often provide a low cost-of-test, as compared to the customer’s current test solution. We believe that in most cases in which a customer decides to switch to our proposed test solution, the customer has concluded that the cost of switching to a new test platform is outweighed by the reduction in the overall cost-of-test. In addition, customers also consider other relevant factors, such as service and technical support capabilities, brand awareness, financial viability and production capacity.

 

Our test systems are currently not designed to address the test requirements of semiconductors with large digital content, such as memory devices or microprocessors, which are typically tested by more costly test systems with different capabilities.

 

Products

 

Test Systems

 

We design, manufacture, sell and service a family of high-performance test systems that test analog, mixed-signal and RF semiconductors. Our current products are designed to provide our customers with the optimal level of test performance and functionality for their particular testing needs. The following table sets forth our current product offerings, their features and the devices tested by each product.

 

 

ETS-600 and ETS-364.  Introduced in 2001, the ETS-600 and ETS-364 offer our highest performance analog, mixed-signal and RF test platforms across a broad range of semiconductors. The systems were designed to maximize throughput capability by enabling SimulTest^tm multi-site testing for up to 64 sites, through our SmartPin^tm technology, our highest digital capabilities, and our custom designed RF6000 architecture. The RF6000 is a resource board and accessory to the ETS-600 or ETS-364 that enables the tester to simultaneously source and measure RF signals across multiple RF devices in a fully calibrated environment through the use of a proprietary RF Source Distribution Module. This functionality allows users to distribute RF source signals simultaneously to multiple device ports and calibrate each port to ensure that each port receives the precise desired RF signal to each device. The RF6000’s unique measurement capabilities are achieved through the use of RF signal “down converters” per port, which allow users to simultaneously

measure the RF signal output of each RF device under test. These key features minimize RF device test times in multi-site applications by avoiding unnecessary switching between RF signal source and measurement functions while maintaining the signal integrity needed in an RF test environment.

 

The ETS-600 delivers our highest level of performance and functionality with up to 256 digital pins, over 480 analog channels, and up to 32 RF ports. The ETS-364 delivers up to 128 digital pins, over 240 analog channels, and up to 16 RF ports. The ETS-364 was designed to be fully compatible with the ETS-600 test system. Utilizing a common DUT interface and software command structure, the ETS-600 and ETS-364 offer customers a natural migration path between medium and large-scale, multi-site testing.

 

ETS-300 and ETS-200.  We introduced the ETS-300 and ETS-200 in 1998 as low-cost, high-performance analog and mixed-signal test systems. The ETS-300 delivers up to 32 digital pins and over 240 analog channels. This system offers SimulTest^tm multi-site testing with up to 32 site capability. The ETS-300 is an attractive solution for analog applications and applications requiring less significant digital capabilities for testing devices such as switching regulators, power factor controllers, and various automotive devices.

 

The ETS-200 serves a similar market, but delivers up to 16 digital pins and up to 120 analog channels of throughput. The ETS-200 offers SimulTest^tm multi-site testing with up to 16 site capability. The ETS-200 is intended for targeted applications such as operational amplifiers, low dropout regulators, and other analog applications, and/or applications requiring limited digital capabilities. The ETS-200 was designed to be fully compatible with the ETS-300 test system. Utilizing a common DUT interface and software command structure, the ETS-300 and ETS-200 offer customers a scalable migration path for multi-site, analog applications.

 

ETS-200T.  We introduced the ETS-200T in 2003 to test specific types of semiconductors known as a Field Effect Transistors, or FETs. The ETS-200T delivers high throughput with up to 16 site testing capability and a custom designed software environment to make FET program development easy and effective. Since its introduction, the 200T has received positive early customer acceptance for its unique ability to test these devices in highly parallel applications.

 

Software Products

 

ATE operating software is required to design and run test routines, and to record and analyze the results of such test routines. Our Eagle Vision software is a feature-rich, user-friendly software platform, designed to help our customers rapidly develop test programs on our platforms. For example, our plotting tools facilitate quick and easy graphing of response data. Our automatic code generation tools help programmers avoid incorrect entries and our point-and-click status screens allow easy monitoring and adjustment of test system settings. The production environment offers numerous data aggregation options and supports multiple data output formats. Our software includes user-friendly tools for generation and analysis of test data that are enabled by simple point-and-click operations.

 

We have developed our Eagle Vision software as the uniform operating environment for all of our various test platforms. This approach reduces our customers’ overall cost of ATE ownership by reducing the employee training and platform set-up time usually associated with bringing new test platforms on line. Eagle Vision, when combined with our Chameleon^tm device interface hardware, provides our customers with a compatible test system upgrade path, allowing our customers to migrate devices to our new platforms without abandoning their investment in their existing Eagle Test systems and associated software and device interface hardware.

 

Technology

 

SmartPin^tm.  Our patented SmartPin^tm technology enables our products to generate and measure both current and voltage signals at each device pin. Furthermore, our SmartPin^tm technology enables digital signal processing to be performed locally at each pin, which eliminates the need to move test data through a common signal bus for processing, thereby decreasing processing time, reducing interference and improving accuracy and yield. In addition to these features, SmartPin^tm technology provides the capability to generate multiple signals of various ranges, which allows our customers to execute a full set of test routines with a single starting signal, eliminating the time required for additional software programming commands. In this way,

SmartPin^tm technology optimizes simultaneous, or parallel, testing across multiple sites on the same test system. We refer to this capability as SimulTest^tm.

 

Chameleon^tm.  Our Chameleon^tm technology provides interoperability among different test platforms by allowing test application hardware from one test system to be used on another test system. Chameleon^tm provides hardware compatibility among our various test platforms, as well as with test hardware from some of our competitors’ test platforms.

 

Pattern-Based Testing^tm.  Our Pattern-Based Testing^tm is enabled by our SmartPin^tm technology in conjunction with our Eagle Vision software. In Pattern-Based Testing^tm, predetermined digital and analog waveforms are presented to a DUT in a time synchronized sequence. Pattern-Based Testing^tm technology provides the capability to simultaneously capture and analyze both analog and digital waveforms that are emitted from the DUT, thus reducing device test times and permitting increased throughput and lower cost-of-test.

 

Floating Resources.  Our test platform architecture provides electrical separation between disparate test sites on the same piece of test equipment by eliminating the need for our test instrumentation resources to access power or move signals across a common electrical pathway. Because our floating resources have independent ground connections, interference normally associated with a common ground pathway is minimized, allowing each device’s results to remain isolated from the results of other adjacent sites. This leads to better test accuracies and fewer devices failing due to device-to-device errors.

 

Sales and Marketing

 

With the exception of the United Kingdom and Japan, we market and sell our products exclusively through our direct sales organization, which consists of sales professionals, application engineers (technical sales support), technical marketing and sales personnel. In the United Kingdom, we utilize a combination of direct sales representatives and distributors while in Japan we use direct distributors. Our account managers oversee and manage our worldwide sales activity. As of September 30, 2006, we had 81 people in sales, marketing and applications, including 17 direct sales representatives, who provide account management, sales administration and technical sales support. Because we focus on the development of long-term relationships with major customers, the large majority of our sales and technical sales support personnel is located in close proximity to key customer sites. For foreign customers, this support is typically provided through one of our foreign subsidiaries. As of September 30, 2006 we had 54 foreign personnel providing sales, service and applications support to our foreign customers.

 

Our customers generally undertake an extensive evaluation of new test technology prior to adopting such technology. We work with potential customers with the goal of offering them a superior solution for their test requirements. In typical situations, our applications engineers are required to develop a custom test program designed to demonstrate our equipment’s performance and capability to address the customer’s specific needs. In cases involving existing customers, we typically work closely with their respective product development and production groups to help maximize the utility of our test systems throughout their organization and to align our product development efforts with their anticipated test requirements.

 

We employ a sales model that emphasizes reducing the customer’s total cost-of-test per device rather than the acquisition cost of the individual test system. We demonstrate how a customer’s test costs can be reduced by utilizing our products in lieu of competitors’ test systems.

 

We believe that strong service and support are critical to providing an overall lower cost-of-test solution. In addition to our applications engineering support staff, we maintain a global network of service personnel who seek to maximize test system up-time. We also offer services to enable our customers to maintain and effectively use our test systems, and to enhance our customer relationships. Our standard product warranty includes coverage of hardware products for one year from the date of purchase and warrants against defects in design, materials and workmanship. In order to minimize system down-time in the event of a service requirement, we typically ship a replacement product for any non-functional standard equipment within

24 hours of the service request. We also offer our customers additional support after the warranty period in the form of maintenance contracts or extended warranties.

 

Customers

 

We target analog, mixed-signal and RF semiconductor manufacturers and related companies that serve a broad range of market segments. Since October 1, 2003, we have delivered over 600 test systems to more than 60 customers. Our customers include many of the world’s leading semiconductor manufacturers, IDMs, fabless design companies, and assembly and test subcontractors. Companies that use our systems include:

 

 

Our customers have historically been semiconductor device manufacturers, but our customer base has expanded to include assembly and test subcontractors, such as STATS ChipPAC Ltd. and ASE Electronics (M) Sdn. Bhd. Semiconductor manufacturers and fabless semiconductor companies utilize these subcontractors to provide incremental capacity and to lower their fixed production costs.

 

For the fiscal year ended September 30, 2006, sales to Texas Instruments Incorporated accounted for 52.9% of our net revenue. For the fiscal year ended September 30, 2005, Texas Instruments Incorporated accounted for 44.3% of our net revenue. For the fiscal year ended September 30, 2004, two customers, National Semiconductor Corporation and Texas Instruments Incorporated, accounted for 36.1% and 31.9%, respectively, of our net revenue. These customers are the only customers who have accounted for 10% or more of our net revenue during these periods. We expect that a small number of customers will continue to represent a significant portion of our net revenue for the foreseeable future. Sales to customers in the United States accounted for approximately 30.6%, 46.2% and 21.6% of net revenue for the years ended September 30, 2006, 2005 and 2004, respectively. Sales to customers in Malaysia accounted for approximately 38.8%, 21.4% and 51.0% of net revenue for the fiscal years ended September 30, 2006, 2005 and 2004, respectively. Sales to customers in other locations accounted for approximately 30.6%, 32.4% and 27.4% of net revenue for the fiscal years ended September 30, 2006, 2005 and 2004, respectively.

 

Manufacturing and Assembly

 

Our test platforms consist of standard products that we custom configure based on each customer’s specific needs. A large portion of our subassembly manufacturing is outsourced to contract manufacturers for printed circuit board fabrication, automated assembly and the supply of machine parts. Our major contract manufacturers include Millennium Electronics, Inc. and Universal Electronics, Inc., both of which manufacture our printed circuit board assemblies, including surface mount and through-hole technologies, and Sentral Assemblies & Components, which manufactures our cable assemblies and power supplies. We contract with these manufacturers on an individual purchase order basis and do not have long term contracts with them. We believe this selected outsourcing strategy provides us with the flexibility to respond more rapidly to changes in industry conditions or demand for our test systems. We perform mechanical assembly, subassembly testing operations and final systems integration at our Illinois manufacturing facility in order to ensure quality. We focus on quality assurance by monitoring the various stages of the manufacturing process to identify areas for improvement and manage potential manufacturing issues.

Although our products consist mainly of standard components and prefabricated parts manufactured to our specifications, some components and subassemblies are purchased from a limited number of suppliers or sole source suppliers. Our major suppliers include Arrow Electronics, Inc. and Future Electronics, both of which provide us with electronic components and integrated circuits, as well as Pickering Electronics Limited, which provides us with relays, switches and integrated circuits, and Marcel Electronics International, which provides us with printed circuit boards. We work closely with our suppliers to plan our inventory procurement in quantities that will minimize our inventory risks; however, we cannot be certain that shortages will not develop in the future. We purchase components and subassemblies through separate purchase orders and do not currently have long-term purchase contracts with our suppliers. We believe our ability to procure components and subassemblies is a key determinant of our ability to provide our customers with quality products on a timely basis and we continue to evaluate alternative sources for the supply of our inventory.

 

Research and Development

 

Our continued commitment to research and development and the timely introduction of new products, features and upgrades are integral to maintaining our competitive position. Our research and development efforts seek to address new opportunities and demands within our customer base. Our efforts are focused on the design of test systems that lower the overall cost-of-test for semiconductor companies. We concentrate on advancements in electrical performance, software tools, parallel test efficiency and test system resource density. We also focus on the design of modular hardware for rapid implementation of new features and a uniform software platform for operating compatibility across our entire line of test systems. This strategy reduces our overall product development cycles and development costs and maximizes our research and development resources. Our research and development activities are directed by individuals with significant expertise and industry experience. As of September 30, 2006, we had 55 employees dedicated to research and development.

 

Our research and development organization is segmented into specific product development groups, including mixed-signal, high performance data converters and automotive products, discrete components and RF products, which provides highly dedicated focus for the investigation of new technical opportunities in our target markets, and the development of solutions specifically targeted at those opportunities.

 

We leverage our engineering efforts by utilizing standard components whenever possible. We generally avoid the use of customized components, such as Application-Specific Integrated Circuits, or ASICs, when implementing functionality because it is easier to adapt standard semiconductor designs to changing requirements. This also eliminates high engineering risks and costs associated with ASIC design. We use standard PCs with Microsoft Windows as the main control computer of our test systems. The strategy of using industry standard products has proven successful, allowing us to leverage the significant investments made by the largest companies in the technology field, with minimal cost to us.

 

Our historical research and development expenditures for the fiscal years ended September 30, 2006, 2005 and 2004 were $8.9 million, $7.9 million and $6.1 million, respectively, representing 7.2%, 12.4% and 5.4% of net revenue in each of the respective fiscal years.

 

Competition

 

We face substantial competition in the ATE market throughout the world. Our principal competitors include Credence Systems Corporation, LTX Corporation and Teradyne, Inc., all of which are major manufacturers of ATE for the analog, mixed-signal and RF markets, in addition to other markets in which we do not compete. Some of our competitors’ products that test analog, mixed-signal and RF semiconductors have higher digital pin counts than our products, and accordingly may be considered to have a greater functional testing range and the ability to test types of devices that our products do not test. Accordingly, a customer that manufactures high-end digital semiconductors, for example, as well as analog, mixed-signal or RF devices, may be more inclined to purchase a test system from one of our competitors. We believe, based on the published report of an independent industry research organization, that our competitors named above each have a larger share of our addressable market than we do. Additionally, some of our competitors, including

those named above, have greater brand recognition and greater financial, engineering, manufacturing and marketing resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or market developments by devoting greater resources to the development, promotion and sale of products. Some of our competitors also have broader product offerings, larger installed customer bases and more extensive customer support capabilities than we do. We expect our competitors to continue to improve the performance of and support for their current products and to introduce new products, technologies or services that could adversely affect sales of our current and future products. In addition, other test companies that do not currently focus on our target markets could choose to do so.

 

We believe the primary competitive factors in the analog, mixed-signal, discrete and RF ATE markets are the overall cost-of-test, test accuracy, throughput, yield and support infrastructure. We believe we compete favorably with respect to each of these factors in the markets that we address. Based on our experience in marketing our products in competition against those of our competitors, we believe we are a very strong competitor within the analog, mixed-signal markets and discrete, and also an effective competitor in the RF market. However, in contrast to a number of our competitors, we do not compete for opportunities to test primarily digital semiconductors, such as memory devices or microprocessors, where more costly test systems with different capabilities are required to compete effectively.

 

Intellectual Property

 

Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, service marks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights. We own two U.S. patents. These patents will expire in approximately 16 years. While these patents are important and relate to some of our distinct technology, we have relied primarily on our trade secrets and copyright protection as well as confidentiality provisions to protect our intellectual property.

 

There are always risks that third parties may claim that we are infringing upon their intellectual property rights and we could be prevented from selling our products or services, or suffer significant litigation or licensing expenses as a result of these claims. In addition, third parties may infringe or design around our intellectual property rights, and we may expend significant resources enforcing our rights or suffer competitive injury with adverse effects on our results of operations. Our efforts to protect our intellectual property rights may be less effective in some foreign countries where intellectual property rights are not as well protected as in the U.S. For additional, important information, review the information set forth in “Risk Factors — Risks Related to Intellectual Property.”

 

Employees

 

As of September 30, 2006, we had 302 full time employees. Of our total employees, 55 were dedicated to research and development and 81 were dedicated to sales, marketing and applications. None of our employees located in the United States is represented by a union. Our employees in Europe are represented by workers’ councils. We believe our relationships with our employees are good.

 

Backlog

 

Our backlog, calculated on the basis of unfilled purchase orders with a firm delivery date for all products and services, was $13.2 million at September 30, 2006, compared with $4.7 million at September 30, 2005. Since customers may cancel or delay their orders with little regard for potential penalties, and since new order volume may decrease very rapidly, our backlog at any particular date is not necessarily indicative of our future backlog or actual sales that may be generated for any succeeding period. In the past, our test systems have generally shipped within six to eight weeks from the time we receive a customer’s purchase order, and we expect at least 85% of our backlog as of September 30, 2006 to ship prior to the end of December 2006. Any change in our manufacturing capacity and the time it takes to ship our products will affect our level of backlog. Historically, our backlog levels have also fluctuated based on our customers’ ordering patterns and their inability to predict order trends in the semiconductor industry with any certainty.

 

Set forth below are certain risk factors that could harm our business, results of operations and financial condition. You should carefully read the following risk factors, together with the financial statements, related notes and other information contained in this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements that contain risks and uncertainties. Please refer to the discussion of “Forward-Looking Statements” on page one of this Annual Report on Form 10-K in connection with your consideration of the risk factors and other important factors that may affect future results described below.

 

Risks Related to Our Business and Industry

 

The highly cyclical nature of the semiconductor industry could adversely affect our operating results.

 

Our business and operating results depend to a significant extent on capital expenditures by companies in the semiconductor industry that purchase our ATE. Historically, the semiconductor industry has been highly cyclical with recurring periods of over-supply. These cycles typically have a disproportionately negative impact on capital equipment manufacturers, including providers of test systems like Eagle Test. In most cases, the decrease in capital expenditures for test systems by our customers is more pronounced than the downturn in the overall semiconductor industry.

 

We believe that semiconductor industry downturns will likely recur, and because they often occur very rapidly, we cannot adequately foresee their timing and extent, or their effect on customer orders and revenues. If we do not accurately predict the timing or extent of a downturn, we may not adequately reduce our operating expenses in light of decreased revenue, which will adversely affect our financial performance, and potentially our stock price. During downturns we experienced, and in the future we may experience:

 

 

As a result of these and other factors, industry downturns are expected to negatively impact our business and financial performance. Moreover, such downturns, or the speculation about such downturns by investors or industry analysts, may have a material adverse effect on our stock price.

 

Our quarterly operating results may fluctuate significantly from period to period and this may cause our stock price to decline.

 

In the past we have experienced, and in the future we expect to experience, fluctuations in revenues and results of operations from quarter to quarter. These fluctuations can be caused by a variety of factors including:

 

 

 

A significant portion of our revenue is derived from the sale of a relatively small number of test systems. Accordingly, a decline in the number, or change in the timing or terms, of the test systems we sell from quarter-to-quarter may also cause significant changes in our results of operations. This, in turn, would likely cause a decline in the market price of our common stock.

 

We believe that quarter-to-quarter comparisons of our revenue and operating results are not necessarily meaningful or an accurate indicator of our future performance. Because of this difficulty in predicting future performance, our results of operations may fall below the expectations of securities analysts or investors in future quarters. Our failure to meet these expectations would likely cause a decline in the market price of our common stock.

 

We depend on a small number of customers for a significant portion of our sales, and the loss of any of these customers will adversely affect our revenue.

 

A small number of customers has accounted for a significant portion of our revenue in any particular period. We expect that we will continue to depend on a small number of customers to account for a significant percentage of our revenue for the foreseeable future. Our customers, including our most significant customers, are not obligated by long-term contracts to purchase our test systems, and may cancel orders with little regard for potential penalties. If any of our large customers reduces or cancels its purchases from us for any reason, it could have an adverse effect on our revenue and results of operations. For additional information, see the section entitled “Business — Customers” in Part I, Item 1. in this Annual Report on Form 10-K.

 

We face difficulty in obtaining new customers because of the high cost of switching test equipment vendors in our markets.

 

Semiconductor companies typically select one vendor’s systems for testing an entire product family of semiconductors, and make substantial investments to obtain test systems and ancillary equipment, and to develop related test program software. Once a semiconductor company has implemented a test system for a product family of semiconductors, it is often difficult and costly to switch to another vendor’s test system because the test system is often part of the product specifications for a newly developed device. Accordingly, unless our test systems offer substantial performance or cost advantages that materially outweigh a customer’s expense of switching to our test systems, it will be difficult for us to achieve significant sales to that customer once it has selected another vendor’s test system for an application.

Our sales cycle is long, requires significant investment, and may not result in additional sales.

 

Our customers generally take considerable time to evaluate our test systems, and many people are involved in the evaluation and decision-making process. Our product sales cycle typically ranges from six to nine months. Sometimes our sales cycle can be much longer, particularly when the sales process involves developing new test programs for our customers or the introduction of new products. During the sales process, we commit substantial time and financial resources to our sales efforts prior to receiving any revenue. Despite these efforts, we may never receive any revenue from such potential customers. The length of time it takes for us to complete a sale and the extent of our investment depends on many factors, including:

 

 

In addition, if we do make a sale to a new customer, the customer may purchase only one of our test systems, or may evaluate a test system’s performance for a lengthy period of time before considering whether to purchase any additional test systems from us. Variations in the length of the period between purchases by new customers can cause our revenue and results of operations to vary widely from period to period.

 

We face substantial competition that, among other things, may adversely affect our sales and may lead to price pressure.

 

We face substantial competition in the ATE market throughout the world. Our principal competitors include Credence Systems Corporation, LTX Corporation and Teradyne, Inc. Some of these competitors have greater financial, engineering, manufacturing and marketing resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or market developments by devoting greater resources to the development, promotion and sale of products, which could impair our revenue. Some of these competitors also have broader product offerings, larger installed customer bases and more extensive customer support capabilities than we do. We expect our competitors to continue to improve the performance of and support for their current products and to introduce new products, technologies or services that could adversely affect sales of our current and future products. In addition, other test equipment companies that do not currently focus on our target markets could choose to do so. We may not be able to compete effectively with any new or current competitors, which would have an adverse effect on our revenue and results of operations.

 

Our competitors may also elect to reduce the prices of their products in order to increase their market share or obtain new customers, leading to a reduction in test system ASPs throughout our industry. We may be required to react to these and other competitive dynamics. Any decrease in the prices of our test systems or any increase in the discounts granted to our customers could adversely impact our growth, revenue and results of operations.

 

We rely on a few key employees and our success depends on our ability to hire and retain key personnel.

 

Our future success depends in large part on the continued service of our key executive officers, including Leonard Foxman, our founder and Chief Executive Officer, Theodore Foxman, our Chief Operating Officer, and Stephen J. Hawrysz, our Chief Financial Officer. Leonard Foxman has managed us since our inception and would be extremely difficult to replace. We are also dependent on the continued service of our key research, engineering, manufacturing, marketing and sales personnel, each of whom possesses unique skills and experience. Although we have employment and non-competition agreements with each of our executive officers, these individuals or other key employees may nevertheless leave us. Because these employees would be difficult to replace, the loss of any of our key employees could have an adverse effect on our business,

financial condition and results of operations. Also, to support our current operations and future growth, we will need to attract and retain additional qualified employees. Competition for qualified personnel in the technology area is intense, and we operate in several geographic locations where labor markets are particularly competitive.

 

Our future success depends to a significant extent on the ability of our executive officers and other members of our management team to operate effectively, both individually and as a group. Our business may be harmed if we do not successfully allocate responsibilities among our management team or if some members of our management team do not succeed in their roles.

 

If we fail to maintain adequate internal control over financial reporting, if we are unable to timely complete our assessment of the effectiveness of our internal control over financial reporting, or if our independent registered public accounting firm cannot attest to our assessment of our internal control over financial reporting, we may be subject to regulatory sanctions and a loss of public confidence and the trading price of our stock could be negatively impacted.

 

Effective internal controls are necessary for us to provide reliable financial reports and effectively detect and prevent fraud. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, under currently published SEC rules, we will be required beginning with our fiscal year ending September 30, 2007 to include in our annual report our assessment of the effectiveness of our internal control over financial reporting. Furthermore, our registered independent public accounting firm will be required to report on our assessment of the effectiveness of our internal control over financial reporting and separately report on the effectiveness of our internal control over financial reporting. Under rules recently proposed by the SEC, we may not be required to complete this assessment until our fiscal year ending September 30, 2008. We have begun but have not yet completed our assessment of the effectiveness of our internal control over financial reporting. If we fail to timely complete this assessment, or if our independent registered public accounting firm cannot attest to our assessment when required, we may be subject to regulatory sanctions and a loss of public confidence. Also, the lack of effective internal control over financial reporting may adversely impact our ability to prepare timely and accurate financial statements.

 

We have grown rapidly and if we fail to manage our growth, our business will suffer.

 

Although we commenced operations in 1976, over the past five years we have experienced, and continue to experience, rapid growth in our operations. This growth has included hiring key personnel, relocating our manufacturing facility, entering foreign markets and developing new customer relationships. We anticipate that further expansion of our operations will be required to address potential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a substantial strain on our management, operational and financial resources. In order to manage future growth, we will be required to improve existing, and implement new, operating and management systems, procedures and controls. We also need to hire, train and manage additional qualified personnel. A significant factor in our growth has been a substantial increase in customer demand for our products. If we do not effectively manage our growth, including the addition and training of new personnel, we will not adequately satisfy such demand. In addition, the quality of our test systems or our ability to manufacture and ship our test systems on a timely basis could suffer. This could negatively impact our reputation, revenue and results of operations and lead to order cancellations or a decrease in order volume.

 

If we are not successful in developing new and enhanced products, we will lose market share to our competitors and our operating results will suffer.

 

We operate in an industry that is characterized by evolving industry standards and rapid technological advancements. To remain competitive, we must design, develop and introduce in a timely manner new test systems or improve our existing test systems in order to meet the performance and price demands of our

customers and prospective customers. Our success in this regard will depend on many factors, including our ability to:

 

 

We must devote resources to research and development to remain innovative and competitive with rapidly evolving industry technologies and emerging trends. In light of the long product development cycles inherent in our industry, development of new products generally requires a substantial investment well before commercial viability or the prospect of deriving any revenue from new products. The future success of our new technologies, products and services also depends on broad acceptance among our customers. In addition, new methods of testing semiconductors may be developed. These developments may render our products uncompetitive or obsolete. If we fail to adequately predict our customers’ needs and technological advances, we may invest heavily in the research and development of products and services that do not lead to significant revenue, or we may fail to invest in research and development necessary to satisfy evolving customer demands.

 

Products that do not meet customer specifications or that contain defects could cause us to lose customers and revenue.

 

We must develop and deliver reliable customized hardware and software to meet our customers’ specific ATE requirements. The complexity and ongoing development of our products could lead to design or manufacturing problems. If any of our products fails to meet specifications, the customer may delay or reject acceptance of the test system and the recognition of revenue from these sales will be delayed or forfeited. Moreover, if any of our products has reliability or quality problems, we may be required to replace the test system or issue the customer an equipment credit in accordance with the customer’s warranty terms. If these quality problems occur, our reputation could be damaged significantly and customers might be reluctant to buy our products, which could result in a decline in revenue, an increase in product returns, the loss of existing customers and/or the failure to attract new customers.

 

You should not rely on our level of backlog as an indication of our future revenues.

 

Since customers typically cancel or delay their orders with little regard for potential penalties, and since new order volume may decrease very rapidly, our backlog, if any, at any particular date is not necessarily indicative of our future backlog or actual sales that may be generated for any succeeding period. Any change in our manufacturing capacity and the time it takes to ship our products will affect our level of backlog. Historically, our backlog levels have also fluctuated based on our customers’ ordering patterns and our inability to predict order trends in the semiconductor industry with any certainty. During an industry downturn, our backlog could be substantially reduced or eliminated. Accordingly, you should not rely on our level of backlog as an indication of our future revenues. For additional information, see the section entitled “Business — Backlog” in Part I, Item 1. in this Annual Report on Form 10-K.

 

We obtain some of the components and subassemblies included in our test systems from a limited number of suppliers and subcontractors, which may result in production delays, loss of revenue or increased costs.

 

We obtain some of the components and subassemblies included in our test systems from a limited number of, or in some cases sole source, suppliers and subcontractors with whom we do not have long-term contracts. These suppliers and subcontractors are under no obligation to supply our requirements. This reliance gives us less control over the manufacturing process and exposes us to significant risks. Identifying and qualifying new

or alternative sources of these materials can be a lengthy and difficult process. From time to time, we may be unable to obtain an adequate supply of components or subassemblies. In addition, the lead time required for shipments of some of our components or subassemblies can be lengthy and such lead time may increase in periods of heightened demand. We may also experience increases in the prices of these components or subassemblies, delays in delivery and poor component or subassembly quality. If we are unable to accurately predict our component and subassembly needs, if our supply is disrupted or delayed, if any of the components or subassemblies on which we rely are discontinued due to obsolescence or otherwise, or if we otherwise experience any other adverse change in our relationships with these suppliers or subcontractors, we would experience a delay in shipments of our test systems, damage to our customer relationships, an increase in our production costs and/or a reduction in our sales, any of which could have an adverse effect on our revenue and results of operations.

 

If we cannot accurately plan the production of products to meet our customers’ demands, we could incur excess inventory or miss sales opportunities.

 

Due to the volatile nature of our industry, we cannot predict with certainty future levels of purchase orders. In anticipation of future orders, we typically order components and subassemblies and build some inventory in advance of the receipt of actual purchase orders. If we do not obtain orders as we anticipate, or if orders are cancelled, we could have excess inventory for a specific product that we would not be able to return to our suppliers, potentially resulting in inventory write-offs, which could have an adverse effect on our results of operations. Alternatively, if we underestimate our component and subassembly needs, we may not be able to meet the demand for our test systems on a timely basis and we may miss opportunities for additional sales of our test systems, which could have an adverse effect on our results of operations and customer relationships.

 

Our manufacturing activities are conducted at a single facility, and any prolonged disruption in the operations of that facility could have a material adverse effect on our revenue.

 

Once we receive subassemblies and other components from our subcontractors and suppliers, we complete the production of all of our test systems in our manufacturing facility located in Buffalo Grove, Illinois. Any prolonged disruption in the operations of our manufacturing facility, whether due to technical or labor difficulties, destruction or damage as a result of a fire or extreme weather conditions or any other reason, could seriously harm our ability to satisfy our customers’ order deadlines. If we cannot deliver our test systems in a timely manner, our reputation, revenue and results of operations could be adversely affected.

 

We have no experience with acquiring other companies and our future efforts to do so may subject us to significant costs without the realization of the anticipated benefits of those acquisitions.

 

As a public company, we believe we have greater opportunities to make acquisitions of, or significant investments in, complementary companies, products or technologies, although no acquisitions or investments are currently pending or planned. This is due to the fact that we have additional available capital for these purposes, as well as a market-determined value for our common stock. To date, our management has had very little experience completing acquisitions or managing the integration of acquisitions. Accordingly, we cannot guarantee that we will be able to successfully complete or integrate any business, products, technologies or personnel that we might acquire or seek to acquire in the future, and our failure to do so could harm our business. Furthermore, any future acquisitions, if completed, would subject us to many risks, including:

 

 

Economic, political and other risks associated with international sales and operations, particularly in Asia, could adversely affect our revenue.

 

Because our products and services are sold worldwide, we are subject to the risks associated with conducting business internationally. We anticipate that international sales will continue to account for a significant portion of our revenue for the foreseeable future. Our international operations subject us to many risks, including:

 

 

In particular, the economies of Asia have been highly volatile in the past, resulting in significant fluctuations in local currencies and other instabilities. In recent years, many countries in Asia have experienced weakness in their currency, banking and equity markets as a result of certain events, including the occurrence of severe acute respiratory syndrome, or SARS. These instabilities continue and may recur. Our exposure to the business risks presented by the economies of Asia will increase to the extent that we and our customers continue to expand operations in that region. Any instability in Malaysia or elsewhere in the Asia Pacific region, including those resulting from any additional outbreak of SARS or a potential outbreak of avian influenza, could delay customer acceptance of our products or prevent us from installing or servicing our products sold in the affected region.

 

We could experience a decline in international sales due to currency fluctuations.

 

All of our international sales are denominated in U.S. dollars. As a result, if the U.S. dollar rises in relation to foreign currencies, our test systems will become more expensive to customers outside the U.S. and less competitive with systems produced by local competitors. These conditions could adversely impact our international sales volume or force us to lower our prices internationally. In the past, there have been, and in the future there may be, significant fluctuations in the exchange rates between the U.S. dollar and the currencies of countries in which we do business. In addition, competitive conditions in the future may require us to enter into purchase orders denominated in foreign currencies. While we have not entered into foreign currency hedging arrangements in the past, we may do so in the future. We cannot assure you that any hedging transactions we may enter into will be effective or will not result in foreign exchange hedging losses.

 

Accounting for employee stock options using the fair value method could significantly reduce our net income.

 

We have adopted Statement of Financial Accounting Standards (SFAS) No. 123R — “Share-Based Payment” effective October 1, 2005, which requires us to expense stock options in the income statement based on option grant date fair value. We are using the Black-Scholes Option Pricing Model to determine the fair value of stock options granted and will amortize this amount to compensation expense as options vest and have adopted the prospective method of transition as of the date of adoption. See Notes 2 and 12 of Notes to

Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a more detailed presentation of accounting for stock-based compensation plans. If we issue a significant option grant, or series of option grants, the stock-based compensation expense related to these grants may have a materially adverse effect on our results of operations.

 

Risks Related to Intellectual Property

 

Third parties may claim we are infringing their intellectual property rights, and we could be prevented from selling our products or services, or suffer significant litigation or licensing expenses, even if these claims have no merit.

 

Our competitive position is driven in large part by our proprietary products, processes and services, such as SmartPin^tm and our floating resource architecture. Third parties, however, may claim that we or our products, systems or operations are infringing their intellectual property rights, and we may be unaware of intellectual property rights of others that may cover some of our assets, technology, products and services. Any litigation regarding patents, trademarks, copyrights or other intellectual property rights, even those without merit, could be costly and time consuming, and divert our management and key personnel from operating our business. The complexity of the technology involved and inherent uncertainty and cost of intellectual property litigation increases our risks. If any third party has a meritorious or successful claim that we are infringing its intellectual property rights, we may be forced to change our products, services or manufacturing processes, which may be costly or impractical. If we are unable to make such changes to avoid infringing third party intellectual property rights, we may be forced to enter into royalty or license agreements. However, we may not be able to obtain royalty or license agreements on terms acceptable to us, or at all, and we may therefore be required to cease the infringing aspect of our operations. This may require us to stop selling our products as currently engineered, which could harm our competitive position. We also may be subject to significant damages or injunctions that prevent the further development of certain of our products or services.

 

Third parties may infringe or design around our intellectual property rights, and we may expend significant resources enforcing our rights or suffer competitive injury.

 

Our success and competitive position depend in large part on our ability to obtain and maintain intellectual property rights protecting our products and services. We rely on a combination of patents, copyrights, trademarks, service marks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our intellectual property and proprietary rights. We may be required to spend significant resources to establish, monitor and protect our intellectual property rights. We may not be able to detect infringement and we may lose our competitive position in the market before we do so. If we fail to successfully protect our intellectual property rights, or competitors design around our technology or develop competing technologies, our competitive position could suffer, which could harm our results of operations.

 

We own two patents. These patents or any new patents may not be sufficient in scope or strength to provide us with a significant competitive advantage, and the validity or scope of the patents may be challenged by third parties. We may not be able to develop additional proprietary technology that is patentable. If we do file patent applications on additional technology, the applications may not be allowed. Moreover, the scope of our patents is limited, which could allow competitors to design around the scope of our patents.

 

In addition to patent protection, we rely on trade secret protection for our confidential and proprietary information and technology. We routinely enter into confidentiality agreements with our employees and other third parties. However, in the event these agreements may be breached, we may not have adequate available remedies. Our confidential and proprietary information and technology might also be independently developed by or otherwise become known by third parties, which may damage our competitive position.

 

We have filed federal trademark applications to help protect certain trademarks that we use in conjunction with our business, including EAGLE TEST SYSTEMS, EAGLE TEST SYSTEMS (& design), SMARTPIN, SIMULTEST, CHAMELEON, EAGLE VISION, PATTERN-BASED TESTING and our Eagle logo. Our pending applications may not be registered by the U.S. Patent and Trademark Office, and third parties may challenge the validity or scope of the trademark applications or registrations.

 

Despite our proprietary rights, there can be no assurance that others will not develop similar products, duplicate our products or design around our products.

 

Our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States.

 

We have not sought patent protection or registered our trademarks outside the U.S., which may impair our ability to use or protect our technology and brand in foreign jurisdictions.

 

Furthermore, the laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the U.S. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against copying or infringement in such countries, some of which are countries in which we have sold and continue to sell our systems. There is a risk that our means of protecting our proprietary rights may not be adequate in these countries. Our competitors in these countries may independently develop similar technology or duplicate our test systems, even if unauthorized, thus likely reducing our sales in these countries.

 

Risks Related to our Common Stock and our Capital Structure

 

There is a limited history of a trading market for our common stock, and the market price of our common stock may be highly volatile or may decline regardless of our operating performance.

 

There has only been a public market for our common stock since the completion of our initial public offering in March 2006. The trading market in our common stock may be volatile. The market prices of the securities of newly public companies have been volatile, and have been known to decline rapidly. Broad market and industry conditions and trends may cause fluctuations in the market price of our common stock, regardless of our actual operating performance.

 

Future sales of our shares could adversely affect the market price of our common stock.

 

We have only been a public company since March 2006. For the quarterly period ended September 30, 2006, the average daily trading volume of our common stock on the Nasdaq Global Market has been less than 194,000 shares. On October 3, 2006, we completed a public offering of 5,500,000 shares of common stock, 2,000,000 of which were sold by us and 3,500,000 of which were sold by certain of our stockholders. In connection with this public offering, all directors, executive officers, and certain significant stockholders other than the Employee Stock Ownership Plan, entered into lock-up agreements with the underwriters of that offering. As a result of these lock-up agreements, 9,824,308 shares of our common stock are subject to contractual restrictions on resale, through December 26, 2006.

 

The Employee Stock Ownership Plan is able to sell or distribute its shares of our common stock under certain circumstances. We currently anticipate that the Employee Stock Ownership Plan will distribute 834,565 shares of our common stock to employees, to be held in individual self-directed accounts. Other than this anticipated distribution, we have agreed not to cause the disposition of any shares of our common stock currently held by the Employee Stock Ownership Plan prior to December 26, 2006, without the prior written consent of the underwriters of our recent public offering. In addition, we have agreed not to cause the Employee Stock Ownership Plan to transfer investment control over 834,565 shares of our common stock to employees, or otherwise take any action that would result in a transfer of investment control to employees, until after December 1, 2006, thus preventing the sale of these shares prior to such date. After the date of such transfer of investment control to employees, and after the effective date of a registration statement on Form S-8 under the Securities Act which we expect to file prior to such date to register these shares, such shares will be generally available for resale in the public market, except for 73,009 shares of common stock held by executive officers that will be subject to the lock-up agreements described above.

After the expiration of the “lock-up” period described above, we will not be contractually prohibited from issuing and selling additional shares of our common stock. Any future sale by us or our current stockholders of our common stock in the public market, or the perception that sales could occur, could adversely affect the prevailing market price for our common stock.

 

Our directors and certain significant stockholders exercise significant control over Eagle Test.

 

Our directors, and significant stockholders and their affiliates, including TA Associates, collectively control approximately 47.0% of our outstanding common stock. Investment funds affiliated with TA Associates hold an aggregate of 29.2% of our outstanding common stock. As a result, these stockholders, if they act together, are able to influence our management and affairs and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control of Eagle Test and might affect the market price of our common stock.

 

Provisions in our certificate of incorporation and by-laws may deter third parties from acquiring us.

 

Our certificate of incorporation and by-laws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following:

 

 

These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actions that you desire.

 

Section 203 of the Delaware General Corporation Law may delay, defer or prevent a change in control that our stockholders might consider to be in their best interests.

 

We are subject to Section 203 of the Delaware General Corporation Law which, subject to certain exceptions, prohibits “business combinations” between a Delaware corporation and an “interested stockholder,” which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation’s voting stock, for a three-year period following the date that such stockholder became an interested stockholder absent prior approval of our board of directors. Section 203 could have the effect of delaying, deferring or preventing a change in control that our stockholders might consider to be in their best interests.

 

Our Website

 

Our web site is www.eagletest.com. We make available, free of charge through our website, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, including exhibits, and any amendments to those reports filed or furnished with the Securities and Exchange Commission pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. We make these reports available through our web site as soon as reasonably practicable after our electronic filing of such materials with, or the furnishing of them to, the Securities and Exchange Commission. The information contained or incorporated on our web site is not a part of this Annual Report on Form 10-K.

 

Not applicable.

 

Our corporate headquarters are currently located in Buffalo Grove, Illinois, which we relocated to in January 2005, and where we lease approximately 96,000 square feet of commercial space under a lease that expires in 2015. We use this space for our principal sales, engineering, customer service and administrative purposes. The facility was designed by us specifically to maximize our engineering, system design and manufacturing capabilities and to accommodate future growth. The facility provides substantially increased production capability from our previous headquarters facility, and has dedicated laboratory environments for research and development.

 

We also lease additional offices in Santa Clara, California; Tempe and Tucson, Arizona; Bedford, New Hampshire; Dallas, Texas; Singapore; Gyeonggi-Do, Korea; Hsinchu City, Taiwan; Munich, Germany; Basiano, Italy; Melaka, Malaysia; Alabang, The Philippines; and Suzhou, China. We perform various activities, including sales, customer service, training, research and development and applications engineering in some or all of these offices. We do not anticipate significant difficulty in obtaining lease renewals or alternate space as needed, although obtaining renewals or alternate space on acceptable terms cannot be assured. We also, in addition, own a residence in Vernon Hills, Illinois principally used for travel purposes by out-of-town employees.

 

From time to time, we may be a party to various claims, suits and complaints. Currently, there are no such claims, suits or complaints that, in our opinion, would have a material adverse effect on our business, results of operations and financial condition.

 

No matters were submitted to a vote of our security holders through a solicitation of proxies or otherwise during the quarterly period ended September 30, 2006.

PART II

 

Market Information

 

Our common stock is listed and has been traded on the Nasdaq Global Market under the symbol “EGLT” since our initial public offering on March 8, 2006. Prior to that time there was no public market for our common stock. The following table sets forth the high and low closing prices of our common stock, as reported by the Nasdaq Global Market, for each of the periods listed.

 

 

Holders

 

As of November 30, 2006, there were 12 holders of record of our common stock.

 

Dividends

 

We currently anticipate that we will retain future earnings for the development, operation and expansion of our business. Accordingly, we do not anticipate declaring or paying any cash dividends for the foreseeable future. Our board of directors will have discretion in determining whether to pay dividends, which will depend upon our financial condition, results of operations, capital requirements and such other factors as the board of directors deems relevant.

 

Securities Authorized For Issuance Under Equity Compensation Plans

 

The following table sets forth information regarding securities authorized for issuance under our equity compensation plans as of September 30, 2006.

 

 

 

Recent Sales of Unregistered Securities

 

We did not sell any unregistered securities during the fiscal year ended September 30, 2006.

 

Use of Proceeds from Registered Securities

 

On March 8, 2006, our registration statement on Form S-1 (Registration No. 333-130521) was declared effective for our initial public offering, pursuant to which we offered and sold 6,130,000 shares of common stock and received net proceeds of approximately $88.7 million. We used these proceeds to repurchase all of our senior subordinated notes and to redeem all outstanding shares of our redeemable preferred stock, and to pay offering related expenses. As of September 30, 2006, we retained approximately $23.6 million of these net proceeds, none of which were used during the three month period ended September 30, 2006. We intend to use the remaining $23.6 million of the net proceeds from our initial public offering for general corporate purposes, including working capital and possible acquisitions and investments. We currently have no agreements or commitments with respect to any acquisitions or investments and we do not currently have any acquisitions or investments planned. Pending specific application of our net proceeds, we plan to invest our net proceeds in government securities and other short-term, investment-grade, marketable securities.

 

Issuer Purchases of Equity Securities

 

None.

 

The following selected consolidated financial data should be read in conjunction with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7. of this Annual Report on Form 10-K and the section entitled “Financial Statements and Supplementary Data” in Part II, Item 8. of this Annual Report on Form 10-K. The data for and as of the end of each of the five fiscal years in the period ended September 30, 2006 is derived from our audited consolidated financial statements.

 

 

 

 

 

You should read the following discussion in conjunction with our consolidated financial statements and related notes thereto. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences include those described in “Risk Factors” in Part 1, Item 1A. in this Annual Report on Form 10-K.

 

Overview

 

We design, manufacture, sell and service high-performance ATE for the semiconductor industry. Our test equipment addresses our customers’ volume production needs and is designed to enable our customers to achieve low overall cost-of-test per device. Our innovative products test analog, mixed-signal and RF semiconductors. Semiconductors tested by our systems are incorporated into a wide range of products in high-growth markets, including digital cameras, MP3 players, cellular telephones, video/multimedia products, automotive electronics, computer peripherals, and notebook and desktop computers.

We were founded and began providing test solutions in 1976. Our customers include semiconductor manufacturers, integrated device manufacturers, or IDMs, fabless design companies, and assembly and test subcontractors, including Allegro MicroSystems, Inc., Fairchild Semiconductor International, Inc., Guidant Corporation, Intersil Corporation, National Semiconductor Corporation, ON Semiconductor Corporation and Texas Instruments Incorporated. Since October 1, 2003, we have delivered over 600 test systems to more than 60 customers worldwide. We completed our initial public offering in March 2006.

 

Our business and operating results depend significantly on the level of capital expenditures by companies in the semiconductor industry. Historically, the semiconductor industry has been highly cyclical with recurring periods of over-supply and under-supply, which has resulted in wide fluctuations in demand for our products and services. These demand fluctuations have resulted in significant variations in our revenue, expenses and results of operations in the periods presented. Fluctuations are likely to continue in future periods.

 

Our business experienced significant growth in fiscal 2006 as our net revenue increased to $124.7 million from $63.5 million in fiscal 2005, an increase of $61.3 million, or 96.5%, and our net income increased to $22.6 million from $7.4 million in fiscal 2005, an increase of $15.2 million, or 204.3%. In fiscal 2005, our business experienced a slowdown during the downturn in the semiconductor industry. Our net revenue decreased significantly during fiscal 2005, to $63.5 million from $111.2 million during fiscal 2004, a decrease of $47.7 million, or 42.9%, and our net income in this period decreased to $7.4 million from $22.1 million, a decrease of $14.6 million, or 66.4%. Revenues in the fourth quarter of fiscal 2005 increased sharply, and amounted to 44.9% of the total revenue for the year, as the industry and our business experienced a rebound.

 

Changes in industry conditions often occur very rapidly and can be very difficult to predict. Thus, we cannot foresee the timing and extent of such changes or their effect on our customer orders and revenue with significant accuracy. In addition, these cycles typically have a disproportionately negative impact on capital equipment manufacturers, including providers of test systems. As part of our strategy to address this volatility and lack of visibility, we outsource a substantial portion of our manufacturing functions to third party subcontractors. The purpose of this strategic outsourcing model is to reduce our fixed costs and working capital requirements, making our expense structure more flexible during downturns. Outsourcing also allows us to increase production rapidly to capitalize on market opportunities during upturns. We believe our outsourcing strategy provides us with the flexibility to respond more rapidly to changes in industry conditions and demand for our test systems.

 

Historically, a significant portion of our revenue in each quarter and year has been derived from sales to relatively few customers. While we seek to expand and diversify our customer base, we expect our revenue to continue to be derived from a small number of customers. In fiscal 2006, sales to Texas Instruments Incorporated accounted for 52.9% of our net revenue, and sales to our five largest customers accounted for an aggregate of 76.7% of our net revenue. In fiscal 2005, sales to Texas Instruments Incorporated accounted for 44.3% of our net revenue, and sales to our five largest customers accounted for an aggregate of 66.9% of our net revenue. In fiscal 2004, sales to National Semiconductor Corporation and Texas Instruments Incorporated accounted for 36.1% and 31.9% of our net revenue, respectively, and sales to our five largest customers accounted for an aggregate of 79.2% of our net revenue.

 

With the exception of the United Kingdom and Japan, we market and sell our products exclusively through our direct sales organization, which consists of sales professionals, application engineers (technical sales support), technical marketing and sales personnel. In the United Kingdom, we utilize a combination of direct sales representatives and independent distributors while in Japan we use independent distributors. Our direct sales force earns commissions based on the sales they generate. Our distributors earn commissions based on sales of equipment shipped into their regions or in some cases, we offer our distributors discounts on our products for resale. A significant majority of our sales is generated by our direct sales organization and we expect to continue to expand our sales organization in the future.

 

We do not have purchase contracts that require any of our customers or distributors to continue to purchase our products, and our customers or distributors could cease purchasing products from us at any time. A delay in product orders or acceptances or a cancellation by any of our large customers could cause quarterly revenue to vary significantly. Our backlog of orders is subject to order cancellations, accelerations, changes and delays, and is not necessarily indicative of future customer purchases or revenue streams.

During a given quarter, a significant portion of our revenue may be derived from the sale of a relatively small number of test systems. Our test systems range widely in average selling price, depending upon many factors such as model, configuration and level of testing resources sold with the system. Consequently, a small change in the number or product mix of systems sold may cause significant changes in our operating results. Thus, we do not believe that period-to-period comparisons of our financial results are necessarily meaningful, and they should not be relied upon as an indication of our future performance.

 

In connection with recently becoming a public company, we expect that we will incur significant additional expenses such as audit fees, professional fees, increased directors and officers insurance, board compensation, and expenses related to hiring additional personnel and expanding our administrative functions. Some of these expenses were not incurred by us as a private company and are not included in our results of operations through fiscal 2005. We began to incur certain of these expenses during fiscal 2005 and 2004, and we expect that these expenses will continue to increase.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, under currently published SEC rules, we will be required beginning with our fiscal year ending September 30, 2007 to include in our annual report our assessment of the effectiveness of our internal control over financial reporting. Furthermore, our registered independent public accounting firm will be required to report on our assessment of the effectiveness of our internal control over financial reporting and separately report on the effectiveness of our internal control over financial reporting. Under rules recently proposed by the SEC, we may not be required to complete this assessment until our fiscal year ending September 30, 2008. We have begun but have not yet completed our assessment of the effectiveness of our internal control over financial reporting. If we fail to timely complete this assessment, which we do not anticipate at this time, or if our independent registered public accounting firm cannot attest to our assessment when required, we may be subject to regulatory sanctions and a loss of public confidence.

 

Net Revenue.  Net revenue consists of sales of test systems and individual test instrumentation boards, otherwise known as resource boards, net of returns and allowances. Substantially all of our net revenue is derived from sales of our test systems. Net revenue from sales of individual resource boards has historically not been significant. We expect that this mix of net revenue will continue for the foreseeable future. Net revenue is subject to both quarterly and annual fluctuations as a result of the cyclical nature of the semiconductor industry, as well as product mix and system configuration.

 

Cost of Goods Sold.  Cost of goods sold consists primarily of manufacturing materials, outsourced manufacturing costs, salaries and manufacturing-related overhead, which includes provisions for excess and obsolete inventory reserves. We rely on a limited number of subcontractors and suppliers to provide key components of our products, some of which are sole-sourced. We build products based on forecasts and customer backlog, and purchase materials and supplies to support that demand. We are subject to variations in the cost of raw materials, components and subsystems. Because we do not have long-term fixed-price contracts with our suppliers, our costs could fluctuate from period-to-period.

 

Gross Profit.  Our gross profit has varied from period-to-period. Factors that have affected and will continue to affect gross profit in the future include product configuration, product sales mix, manufacturing volume, manufacturing efficiencies, excess and obsolete inventory reserves, pricing by competitors, subcontractors and suppliers, and new product introductions.

 

Selling, General and Administrative.  Selling, general and administrative, or SG&A, expenses relate to compensation and associated expenses for sales, marketing and applications engineering personnel, sales commissions paid to sales representatives and distributors, outside contractor expenses and other sales and marketing program expenses. In addition, SG&A expenses include travel and professional service expenses, as well as salaries and related expenses for administrative, finance, human resources and executive personnel. SG&A expenses will increase as a result of becoming a public company. We believe the incremental costs of items such as directors and officers insurance, investor relations services, professional fees and other legal and accounting compliance costs could exceed $1.5 million annually, and we will also incur additional SG&A expenses associated with improvements to our internal controls. SG&A expenses may also increase in absolute dollars as we continue to develop our sales and marketing efforts and expand our administrative functions, and as a result of increased option expenses related to adoption of changes in generally accepted accounting

principles. In addition, commission and variable compensation expenses included in SG&A can fluctuate with changes in sales volume and profitability.

 

Research and Development.  Research and development, or R&D, expenses consist primarily of compensation and related expenses for personnel engaged in product development, as well as expenses related to materials, outside contractors, depreciation of equipment used in R&D, and other engineering overhead expenses. R&D costs are expensed as incurred. We believe our R&D expenses will generally increase in absolute dollars as we continue to develop and improve our hardware and software technologies.

 

Interest Expense.  Interest expense consists of interest on our debt and loans. The increase in interest expense beginning in fiscal 2004 resulted from the issuance on September 30, 2003 to TA Associates of $30.0 million in principal amount of 12% senior subordinated convertible notes due September 30, 2009. The senior subordinated convertible notes held by TA Associates converted into 12% senior subordinated notes due September 30, 2009 and warrants to purchase 525,040 shares of our common stock just prior to our initial public offering. These senior subordinated notes were repurchased with proceeds from our initial public offering which was completed on March 14, 2006 for an aggregate amount equal to approximately $30.6 million.

 

Increase (Decrease) in Value of Warrants.  Increase (decrease) in value of warrants is a non-cash charge (benefit) related to recording the increase (decrease) in the fair market value of the common stock warrants issuable upon conversion of the 12% senior subordinated convertible notes due September 30, 2009. The warrants enabled the holders to put the warrants to us at any time after September 30, 2008 at fair value, and thus the warrants were considered liability instruments that were required to be accounted for at fair value. This determination historically has been based upon independent valuations. The holders of the warrants exercised the warrants for common stock in connection with our initial public offering which was completed on March 14, 2006, thus the warrants no longer exist.

 

Other (Income) and Expense.  Other (income) and expense consists of income from cash, cash equivalents and marketable securities, realized investment gains, losses and impairments, and miscellaneous other income and expense.

 

Provision for Income Taxes.  We account for income taxes under the asset and liability method whereby the expected future tax consequences of temporary differences between the book value and the tax basis of assets and liabilities are recognized as deferred tax assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to be recognized. A valuation allowance is provided if it is more likely than not that some or all of the entire deferred tax asset will not be realized.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates, assumptions and judgments that affect the amounts reported in our financial statements and the accompanying notes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable. Although these estimates are based on our present best knowledge of the future impact on us of current events and actions, actual results may differ from these estimates, assumptions and judgments.

 

We consider “critical” those accounting policies that require our most subjective or complex judgments, which often result from a need to make estimates about the effect of matters that are inherently uncertain, and that are among the most important of our accounting policies in the portrayal of our financial condition and results of operations. These critical accounting policies are: revenue recognition, valuation of excess and obsolete inventory, accounting for warranty reserves, determination of our allowance for sales returns and uncollectibles, and stock-based compensation.

 

Revenue Recognition.  We derive revenue primarily from sales of test systems and individual resource boards. Substantially all of our revenue to date has been denominated in United States dollars. Revenue related to test system sales is recognized when:

 

 

 

Installation services are generally part of the test system sale. Revenue from test system sales is deferred until the test system is delivered, installed and accepted at the customer location.

 

When sales to a customer involve multiple elements, revenue is recognized on the delivered element, provided that the undelivered element is a standard product with evidence of fair value, there is a history of acceptance of the product with the customer, and the undelivered element is not essential to the customer’s application. When a sale of a test system includes post contract customer support, or PCS, revenue for the PCS is recognized ratably over the PCS period. Revenue related to individual resource boards is recognized upon shipment.

 

In a few instances we have entered into short-term rental agreements with customers for the use of our test systems. We recognize rental revenue ratably over the applicable rental period. Rental revenue is included as a component of test system sales and has been immaterial to date.

 

Inventory Reserves.  We state our inventories at the lower of cost or estimated market value, determined on a first-in, first-out method. We establish inventory reserves when conditions exist that suggest inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for test systems or market conditions. We evaluate the ability to realize the value of our inventory based on a combination of factors, including forecasted sales or usage, estimated product end-of-life dates, estimated current and future market value and new product introductions. Purchasing and alternative usage options are also explored to mitigate obsolete inventory exposure. If actual demand for test systems deteriorates or market conditions are less favorable than those we project, additional inventory reserves may be required.

 

We determine the valuation of excess and obsolete inventory by making our best estimate considering the current quantities of inventory on hand and our forecast of the need for this inventory to support future sales of our test systems. We often have limited information on which to base our forecasts. If future sales differ from these forecasts, the valuation of excess and obsolete inventory may change.

 

Warranty Reserves.  Our test systems are sold with warranty provisions that require us to remedy deficiencies in quality or performance of our test systems. We are also subject to laws and regulations in the various countries in which we sell regarding vendor obligations to ensure product performance. At the time we recognize revenue from a test system’s sale, we determine the reserve for the future cost of meeting our obligations under the standard warranties and product performance laws and regulations by considering our historical experience with the costs of meeting these obligations. If the future costs of meeting these obligations differ from our historical experience, additional reserves for warranty obligations may be required.

 

Allowance for Sales Returns and Uncollectibles.  We determine our allowance for sales returns and uncollectibles by making our best estimate considering our historical accounts receivable collection experience, current economic trends, changes in customer payment terms and recent information that we have about the current status of our accounts receivable balances. If future conditions cause our collections experience to change or if we later obtain different information about the status of any or all of our accounts receivable, additional allowances for sales returns and uncollectibles may be required.

 

Stock-Based Compensation.  Effective October 1, 2005, we have adopted Statement of Financial Accounting Standard No. 123R “Share Based Payment” (SFAS 123R) which amends SFAS 123 “Accounting for Stock Based Compensation,” (SFAS 123), which requires us to expense stock options based upon the fair market value on the date of grant. We are amortizing the fair market value of options granted over the vesting period of the options and we are using the prospective method of adoption as defined under SFAS 123R. Expense associated with stock options issued to nonemployees/nondirectors is recorded in accordance with SFAS 123.

 

For options issued prior to October 1, 2005, we accounted for these options using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” APB No. 25. We had adopted the disclosure only provision of SFAS 123 for options issued to employees and directors.

For all options issued after October 1, 2005, we are recording compensation expense under the provisions of SFAS 123R using the fair value of the options granted amortized over the vesting service period. Expense recognized for the fiscal year ended September 30, 2006 was $354,000.

 

Results of Operations

 

The following sets forth certain operating data as a percentage of net revenue for the periods presented:

 

 

The following sets forth our net revenue breakdown by geographic region, in thousands and as a percentage of net revenue, during the periods presented. Substantially all of our revenue to date has been denominated in United States dollars in thousands.

 

 

In fiscal 2004 and fiscal 2006, our product sales had a significantly greater concentration of customers in Malaysia than in other periods. This is primarily due to the fact that our major customers had increased their production in Malaysia, and as a result require additional and/or replacement ATE in their Malaysian manufacturing facilities. We believe that this concentration in Malaysia may continue as our customers continue to focus operations and facilities in the Asia Pacific Rim area, particularly Malaysia. However, this will vary from year to year and from period to period based upon our global customers’ needs at various locations.

 

The following customers accounted for 10% or more of our net revenue in one or more of the periods presented:

 

 

 

Year Ended September 30, 2006 Compared to Year Ended September 30, 2005

 

Net Revenue.  Net revenue was $124.7 million in fiscal 2006 and $63.5 million in fiscal 2005, an increase of $61.3 million or 96.5%. This increase was primarily due to a $37.8 million increase in test system sales to Texas Instruments Incorporated and a general increase in tester shipments to semiconductor manufacturers who use our automated test equipment.

 

Gross Profit.  Gross profit was $82.4 million, or 66.1% of net revenue, in fiscal 2006 and $36.9 million, or 58.1% of net revenue, in fiscal 2005. Gross profit increased as a percentage of net revenue due to increased sales and better utilization of overhead costs and manufacturing personnel due to higher volume production as compared to fiscal 2005. Additionally, gross profit percentage of net revenue for fiscal 2005 was adversely impacted by additional inventory reserves of $2.3 million. The additional reserves established in fiscal 2005 were a result of lower visibility of demand for our products going into fiscal 2006.

 

Selling, General and Administrative.  SG&A expenses were $29.0 million, or 23.2% of net revenue, in fiscal 2006 and $21.1 million, or 33.2% of net revenue, in fiscal 2005. This increase of $7.9 million, or 37.5%, was primarily due to $4.4 million of additional commission, incentive compensation and warranty accruals as a result of increased system sales and better operating performance, $2.0 million in increased personnel costs related to sales and service offices opened in Asia and Europe in fiscal 2006, and $0.9 million of additional expenses in connection with becoming a public company.

 

Research and Development.  R&D expenses were $8.9 million, or 7.2% of net revenue, in fiscal 2006 and $7.9 million, or 12.4% of net revenue, in fiscal 2005, an increase of $1.1 million or 13.4%. This increase was primarily due to $1.7 million in additional personnel and related facility costs for headcount, and additional depreciation expense on increased equipment used in the development process, offset in part by a $0.7 million decrease in materials used in the product development process, resulting primarily from the timing of prototype expenditures.

 

Interest Expense.  Interest expense was $3.5 million and $3.9 million for fiscal 2006 and 2005, respectively. The decrease is due to a reduction in interest expense of $2.0 million due to repayment of the senior subordinated convertible notes on March 14, 2006, offset by a $1.0 million writeoff of unamortized debt discount and a $0.6 million redemption premium recorded on the senior subordinated convertible notes which were repaid with the proceeds of our initial public offering.

 

Increase (Decrease) in Value of Warrants.  The increase in value of warrants was $5.5 million in fiscal 2006, compared to a decrease in value of warrants of $0.6 million in fiscal 2005. The warrant valuation adjustment was due to the change in the fair market value of the common stock warrants because under certain circumstances we could be required to purchase these after September 30, 2008 at fair market value. These warrants were exercised and redeemed at the time of completion of our initial public offering in the March 2006 quarter. Since the warrants are no longer outstanding at September 30, 2006, there will be no further charges for changes in the value of this instrument in future periods.

 

Other (Income) and Expense, Net.  Other (income) expense, net was income of $1.9 million and $2.3 million in fiscal 2006 and 2005, respectively. The decrease of $0.4 million is due to an increase of $1.5 million in interest income from increased cash equivalents and marketable securities balances from cash generated by operations and cash of $23.6 million retained from our initial public offering completed March 14, 2006, offset by gains in fiscal 2005 of $1.6 million realized upon the liquidation of the marketable securities portfolio, in accordance with our new investment policy, and $0.4 million realized in the March 2005 quarter upon the sale of our former corporate headquarters facility.

 

Provision (Benefit) for Income Taxes.  Income tax expense was $14.8 million, a 39.7% effective tax rate, in fiscal 2006 and an income tax benefit of $0.5 million, a (7.6)% effective tax rate, in fiscal 2005. The increase in tax provision of $15.4 million was due to an increase in pretax income of $30.5 million and an increase in value of warrants of $6.1 million, which is not includable as a deduction in computing taxable income. In addition, in fiscal 2005, the Company filed its prior year tax returns and adjusted the current year tax provision for actual deductions taken in those returns. The tax effect of the deductions amounted to a $1.6 million tax benefit and primarily related to additional extraterritorial income exclusion and state income

taxes different from the amounts originally estimated. Furthermore, in fiscal 2005 we filed for tax method changes with the Internal Revenue Service relating to inventory valuation. Accrued taxes were adjusted to reflect the actual tax liability based upon these tax method change filings and to reverse the liability for tax positions of closed tax years. The net reduction in the current year tax provision for accrued taxes in fiscal 2005 was an additional benefit of 13.8%, or $1.0 million. We believe our effective tax rate will be closer to 36% in future periods since the warrants are no longer outstanding.

 

Year Ended September 30, 2005 Compared to Year Ended September 30, 2004

 

Net Revenue.  Net revenue was $63.5 million in fiscal 2005 and $111.2 million in fiscal 2004, a decrease of $47.7 million, or 42.9%. The significant decrease in net revenue was due to reduced demand by our customers for our test systems. In fiscal 2005, as compared to fiscal 2004, we experienced $35.0 million and $7.3 million decreases in net revenue from two of our largest customers, National Semiconductor Corporation and Texas Instruments Incorporated, respectively.

 

Cost of Goods Sold.  Cost of goods sold was $26.6 million in fiscal 2005 and $37.3 million in fiscal 2004, a decrease of $10.7 million. The decrease was primarily the result of decreased sales of our test systems.

 

Gross Profit.  Gross profit was $36.9 million, or 58.1% of net revenue, in fiscal 2005 and $73.9 million, or 66.4% of net revenue, in fiscal 2004. The decrease in gross profit as a percentage of net revenue was primarily due to decreased sales and lower utilization of overhead costs and manufacturing personnel due to lower volume production as compared to fiscal 2004. Additionally, increased reserves of $2.3 million, or 3.8% of net revenue, were recorded to account for excess inventory on hand above our projected usage based upon our forecasts.

 

Selling, General and Administrative.  SG&A expenses were $21.1 million, or 33.2% of net revenue, in fiscal 2005 and $23.9 million, or 21.5% of net revenue, in fiscal 2004. SG&A expenses decreased $2.9 million, or 12.0%, primarily due to $2.7 million in decreased sales commissions as a result of decreased sales, and lower warranty reserves also as a result of lower sales. These decreases were offset in part by increased personnel cost of sales and service offices opened in Suzhou, China; Basiano, Italy and Munich, Germany.

 

Research and Development.  R&D expenses were $7.9 million, or 12.4% of net revenue, in fiscal 2005 and $6.1 million, or 5.4% of net revenue, in fiscal 2004. R&D expenses increased $1.8 million, or 30.3%, primarily due to a $1.1 million increase in product development materials. The remaining increase was due to additional personnel and related facility costs for headcount added in fiscal 2005, and additional depreciation expense on equipment used in the development process.

 

Write-off of Offering Expenses.  During fiscal 2004, significant expenses were incurred related to preparing documents and filings in preparation for a planned initial public offering of common stock. These offering costs were being deferred and were going to be offset against the proceeds of the offering when completed. Due primarily to market conditions, our initial public offering was delayed, resulting in $1.9 million of expense of these deferred costs.

 

Interest Expense.  Interest expense was $3.9 million in fiscal 2005 and 2004 due to interest on the senior subordinated convertible notes issued on September 30, 2003.

 

Increase (Decrease) in Value of Warrants.  Decrease in value of warrants was $0.6 million in fiscal 2005. Increase in value of warrants was $1.5 million in fiscal 2004. These amounts were due to recording the (decrease) increase in fair market value of the common stock warrants that, under certain circumstances, require us to purchase these warrants after September 30, 2008. Because of this put feature, we are required to account for the change in warrant value as a liability.

 

Other (Income) and Expense, Net.  Other (income) and expense, net increased to income of $2.3 million for fiscal 2005 from $0.4 million in fiscal 2004, primarily due to gains realized upon the liquidation of the marketable securities portfolio, in accordance with our new investment policy. Our new investment policy required us to liquidate our equity securities and position our investment portfolio in investment grade

securities focused on preservation of principal. In addition, in fiscal 2005, we realized a gain of $0.4 million upon the sale of our former corporate headquarters facility.

 

Provision (Benefit) for Income Taxes.  Our income tax provision was a benefit of $0.5 million, or a (7.6)% effective tax rate, in fiscal 2005 and tax expense of $15.0 million, or a 40.4% effective tax rate, in fiscal 2004. The decrease in tax provision of $15.5 million was primarily a result of a decrease in pretax income of $30.1 million. In addition, during fiscal 2005 we filed our prior year tax returns and adjusted the current year tax provision for actual deductions taken in those returns. The net impact on the effective tax rate for 2005 was an additional benefit of 23.0%, or $1.6 million, and primarily related to additional extraterritorial income exclusion deduction and state income taxes above the amounts originally estimated. Furthermore, in fiscal 2005 we filed for tax method changes with the Internal Revenue Service relating to inventory valuation. Accrued taxes were adjusted to reflect the actual tax liability based upon these tax method change filings and to reverse the liability for tax positions of closed tax years. The net reduction in the current year tax provision for accrued taxes in fiscal 2005 was an additional benefit of 13.8%, or $1.0 million.

 

Liquidity and Capital Resources

 

Since our inception we have financed our operations primarily through cash generated from operations and our existing cash balances. On March 14, 2006, we completed our initial public offering, generating net proceeds to us of $86.7 million, of which $63.1 million was used to redeem our senior subordinated notes and redeemable preferred stock. As of September 30, 2006, we had $75.9 million in cash, cash equivalents and marketable securities.

 

Subsequent to September 30, 2006, on October 3, 2006, we completed a public offering to sell an additional 2,000,000 shares of common stock, generating net proceeds of $30.7 million. Since the shares were sold on September 27, 2006, the transaction was included in stockholders’ equity and recorded as a receivable from sale of common stock as of September 30, 2006. On October 11, 2006, the underwriters exercised their option to purchase an additional 200,000 shares, generating net proceeds of $3.1 million.

 

Our balance in cash, cash equivalents and marketable securities increased from $22.7 million as of September 30, 2005 to $75.9 million as of September 30, 2006. Operating activities during fiscal 2006 provided cash of $32.7 million, due to income of $22.6 million resulting primarily from sales of test systems, an increase in value of warrants of $5.5 million that did not require cash, and an increase in accounts payable and accrued expenses of $9.8 million due to a standard lag in payment on purchases used to support increased sales activity. These increases in working capital were offset in part by increased accounts receivables (net of deferred revenue) of $2.1 million due to increased sales activity, and an increase in inventory of $4.7 million due to additional component purchases, work-in-process, and finished goods to support anticipated increasing sales activity. Investing activities used cash to purchase capital equipment of $2.8 million, which primarily represented test and computer equipment, as well as new research and development equipment for use in product and application development. Financing activities generated cash of $86.7 million from our initial public offering completed March 14, 2006, of which $63.1 million was used to redeem $30.6 million of senior subordinated notes and $32.5 million of redeemable preferred stock.

 

Our balance in cash, cash equivalents and marketable securities decreased slightly from $23.7 million as of September 30, 2004, to $22.7 million as of September 30, 2005. Operating activities during the twelve months ended September 30, 2005 provided cash of $5.0 million, due to income of $7.4 million resulting primarily from sales of test systems, depreciation expense of $2.2 million that did not require cash, and $10.0 million of inventory reductions due to purchasing less material than that used in product shipments. These increases in working capital were offset in part by working capital used for increased accounts receivables (net of deferred revenue) of $1.1 million and a decrease in accounts payable, accrued expenses and accrued compensation of $10.9 million due to payments made to vendors and for accrued expenses which were not as significant at September 30, 2005 due to lower operating levels than existed a year ago. Investing activities used cash to purchase capital equipment of $7.1 million, which primarily represented test and computer equipment, office furniture and leasehold improvements purchased for new headquarter facilities to

which we relocated in January 2005, as well as new research and development equipment for use in product and application development.

 

Our balance in cash, cash equivalents and marketable securities increased from $22.0 million as of September 30, 2003 to $23.7 million as of September 30, 2004. Operating activities during fiscal 2004 provided cash of $8.4 million primarily from net income of $22.1 million and from an increase of $6.2 million in accounts payable and accrued expenses due to a standard lag in payment on purchases used to support increased sales activity. During this period there was also an increase of $2.2 million in accrued compensation due to increases in employee incentive plan accruals as a result of improved operating performance that were not paid out until December 2004. These items were offset by an increase in inventory of $16.1 million due to additional component purchases made to support anticipated increased sales activity experienced in the fourth quarter of fiscal 2004 and an increase in accounts receivable (net of deferred revenue) of $4.3 million due to increased test system sales. Investing activities used cash to purchase capital equipment of $4.6 million, which primarily represented test and computer equipment, and software purchased during the period for human resources, CRM and customer service applications. Financing activities used cash of $2.3 million primarily as a result of a dividend of $2.0 million paid to our common stockholders that was accrued at September 30, 2003.

 

Contractual Obligations

 

The following table describes our cash commitments, in thousands, to settle contractual obligations as of September 30, 2006.

 

 

 

 

We believe our existing cash balance and marketable securities will be sufficient to meet our anticipated cash needs for at least the next twelve months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancements to existing products, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products. To the extent that our existing cash, cash equivalents and short-term investments balances and any cash from operations, are insufficient to fund our future activities, we may need to raise additional funds through bank lines of credit or public or private equity or debt financing. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, products or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us, or at all.

 

Recently Issued Accounting Pronouncements

 

In November 2004, FASB issued SFAS No. 151, “Inventory Costs,” an amendment of ARB No. 43, Chapter 4. SFAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period costs. The provisions of SFAS 151 are effective for fiscal year 2006. Adoption of SFAS 151 did not have a material impact on our financial position, results of operations or cash flows.

In December 2004, FASB issued FASB Staff Position No. SFAS 109-a, “Application of FAS 109 for the Tax Deduction Provided to U.S. Based Manufacturers by the American Job Creation Act of 2004,” and FASB Staff Position No. SFAS 109-b, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” The American Jobs Creation Act of 2004 (“Act”) repeals export tax benefits, transitions in a new tax deduction for qualifying U.S. manufacturing activities and provides for the repatriation of earnings from foreign subsidiaries at reduced federal income tax rates. These two staff positions provide accounting and disclosure guidance related to the American Job Creation Act of 2004. The adoption of FASB Staff Position No. SFAS 109-a and 109-b did not have a material impact on the Company’s financial position and results of operations.

 

In May 2005, FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” which requires the direct effects of voluntary accounting principle changes to be retrospectively applied to prior periods’ financial statements. SFAS 154 does not change the transition provisions of any existing accounting pronouncements, but would apply in the unusual instance that a pronouncement does not include specific transition provisions. SFAS 154 maintains existing guidance with respect to accounting estimate changes and corrections of errors, and is effective for us beginning with fiscal year 2007. Adoption is not expected to have a material impact on our financial position, results of operation or cash flows.

 

In December 2004, FASB finalized SFAS No. 123R, “Share Based Payment,” amending SFAS No. 123. SFAS 123R requires us to expense stock options based on grant date fair value in the income statement. Further, SFAS 123R requires additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. We adopted SFAS 123R effective October 1, 2005. Under SFAS 123R, we are using the Black-Scholes Option Pricing Model to determine the fair value of stock options granted. This model uses such factors as the price of the underlying shares at date of issuance, exercise price of the option, the expected term of the option utilizing the simplified method as set forth in SAB No. 107, a risk-free interest rate and an expected volatility rate based upon a peer group of companies given no historical data for our own stock. The resulting fair value will be amortized to expense as vesting occurs. Since we used the minimum value method of measuring equity share options for pro forma disclosure purposes under SFAS 123, implementation of SFAS 123R will apply prospectively to new awards after October 1, 2005. Expense recognized as a result of adoption in fiscal 2006 was $354,000.

 

In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation will become effective for the Company during the first fiscal quarter of 2008. The Company is still evaluating the impact of this Interpretation but does not expect it to have a material impact on its financial condition or results of operations.

 

In fiscal 2005 we adopted an investment strategy that has eliminated investments in equity securities that we have held in the past and limits our investments to government securities and other short-term, investment-grade, marketable securities. This revised investment policy is substantially more conservative than prior practices and focuses on preservation of principal. As of September 30, 2006, most of our investments represent investment-grade securities focused on preservation of principal, with interest rates that are reset every 7 to 28 days, and have a put option to convert to cash within 2 to 5 days.

 

Our revenues and expenses are denominated in U.S. dollars. In addition, our sales contracts are also denominated in U.S. dollars. As a result, we have little exposure to currency exchange risks. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we feel our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.

 

INDEX TO FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULE

 

 

To the Board of Directors and Stockholders of

Eagle Test Systems, Inc.

 

We have audited the accompanying consolidated balance sheets of Eagle Test Systems, Inc. and subsidiaries as of September 30, 2006 and 2005, and the related consolidated statements of net income and comprehensive income, stockholders’ equity (deficit), and cash flows for each of the three years in the period ended September 30, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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 our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Eagle Test Systems, Inc. and subsidiaries at September 30, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended September 30, 2006 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As described in Note 2, the Company adopted Statement of Financial Accounting Standard No. 123(R), “Share Based Payment” effective October 1, 2005 using the prospective transition method.

 

 

Chicago, Illinois

November 14, 2006

EAGLE TEST SYSTEMS, INC.

 

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

EAGLE TEST SYSTEMS, INC.

 

CONSOLIDATED STATEMENTS OF NET INCOME AND COMPREHENSIVE INCOME

(In thousands, except share and per share data)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

EAGLE TEST SYSTEMS, INC.

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

(In thousands, except share and per share data)

 

 

The accompanying notes are an integral part of these financial statements.

EAGLE TEST SYSTEMS, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)