| EFJ INC ITEM 1A RISK FACTORS Summary of Business Considerations and Certain Factors That May Affect Future Results of Operations and/or Stock Price Certain matters discussed in this Annual Report may constitute forward-looking statements under Section 27A of the Securities Act and Section 21E of the Exchange Act |
| These statements may involve risks and uncertainties and relate, without limitation, to the following: • the results of our product development efforts; • future sales levels and customer confidence; • our future financial condition, liquidity and general business prospects; • perceived opportunities in the marketplace for our products; • successful launch of our products currently under development; • government regulation of policies involving our technology and / or products; • continued domestic government acceptance of Project 25 as interoperability standard; and • our other business plans for the future |
| The actual outcomes of the above referenced matters may differ significantly from the outcomes expressed or implied in these forward-looking statements |
| The following is a summary of some of the important factors that could affect our future results of operations and our stock price, and should be considered carefully |
| Reduced access by our private wireless communications segment to Motorola’s technology could harm our business and operations |
| We have obtained from Motorola a non-exclusive, worldwide license to manufacture products containing certain proprietary wireless radios and digital encryption technology |
| We believe this technology will be important to the success of certain of our existing and proposed Project 25 compliant wireless radio products |
| The license includes rights to use Motorola’s proprietary analog APCO 16 trunking technology (SmartNet^®/SmartZone^®) and Project 25 required products |
| The digital encryption technology may also be incorporated into certain other secured communications products |
| In addition, we obtained a license to utilize certain proprietary technology from Motorola relating to the development of Project 25 compliant digital wireless radios |
| This license covers infrastructure and other Project 25 technology |
| Any termination of these licensing arrangements would significantly harm our business and operations |
| We are dependent on continuing access to certain Motorola proprietary intellectual property enabling us to manufacture products containing certain wireless radio and digital encryption technology |
| We cannot assure you that Motorola will continue to supply proprietary intellectual property to us on the scale or at the price that has historically occurred |
| In addition, Motorola’s perception of us as a competitor could impact Motorola’s continued willingness to do business with us |
| A decision by Motorola to reduce or eliminate the provision of technology to us could significantly harm our business and operations |
| 12 ______________________________________________________________________ If we do not adequately manage our outsourcing arrangements, we are vulnerable to the risk that our suppliers may stop supplying services, component parts or products, which may have a material adverse effect on our sales and profitability |
| In 2005, all of the products for our private wireless communications segment, including final assembly, are being manufactured by McDonald Technologies, Inc, located in Texas, pursuant to an agreement with a term through May 14, 2009, which will be automatically extended for successive one-year periods thereafter unless sooner terminated by the parties |
| Similarly, all of the subassemblies for our secured communications segment are being manufactured by Tran Electronics, Inc, located in Minnesota, pursuant to an agreement with a term through December 2, 2009, which will be automatically extended for successive one-year periods thereafter unless sooner terminated by the parties |
| We acquire component parts, services and products from these suppliers through purchase orders at purchase prices that are updated from time to time during the term of the agreements |
| These agreements may be terminated at any time, without cause, upon, in the case of our agreement with Tran Electronics, six months prior written notice from either party and, in the case of McDonald Technologies, at least nine months prior written notice from either party, as well as, in the case of each agreement, immediately by either party in the event the other party fails timely to cure an event of default specified in the agreement |
| As a result, we effectively have limited long-term commitments regarding supply or price from these suppliers, which leaves us vulnerable to the risk that these suppliers may stop supplying services, component parts or products to us for any reason, including their financial viability |
| If the agreement with McDonald Technologies, Inc |
| Any delay in obtaining services, component parts or products from our suppliers could affect our ability to meet our customers’ needs and result in lost sales, higher costs and the need to maintain excessive inventory levels or redesign certain affected electronic sub-assemblies, which may have a material adverse effect on our sales and profitability |
| Finally, a termination of either agreement as a result of our default could expose us to liability and have a material adverse effect on our ability to compete for future contracts and orders |
| In addition, our dependence on limited and sole source suppliers of components involves additional risks of inadequate supply, late deliveries and poor quality of component parts or products |
| We depend on federal government contracts for a substantial portion of our revenues, and the loss of federal government contracts or a decline in funding of existing or future government contracts could adversely affect our revenues and cash flows |
| A substantial portion of our revenues is dependent upon continued funding of federal government agencies, as well as continued funding of the programs targeted by us |
| US government contracts are subject to termination for convenience by the government, as well as termination, reduction, or modification in the event of budgetary constraints or any change in the government’s requirements |
| Further, our contract-related costs and fees, including allocated indirect costs, may be subject to audits by the US government that may result in recalculation of contract revenues and non-reimbursement of some contract costs and fees |
| We are in the process of responding to such an audit regarding our General Service Administration, or GSA, contract, which is scheduled to expire on April 2, 2006 |
| We are unable to predict the outcome of this audit or any action the government may take as a result |
| US government contracts are conditioned upon the continuing availability of congressional appropriations |
| Congress usually appropriates funds on a fiscal year basis even though contract performance may take several years |
| Consequently, at the outset of a major program, the contract is usually incrementally funded and additional funds are normally committed to the contract by the procuring agency as Congress makes appropriations for future fiscal years |
| Any failure of such agencies to continue to fund such contracts could have a material adverse effect on our operating results |
| These or other factors could cause federal government agencies to reduce their purchases under contracts, to exercise their right to terminate contracts, or to exercise their right to not renew contracts, all of which may limit our ability to obtain or maintain contract awards |
| Any of the aforementioned actions above could adversely affect our revenues and cash flows |
| 13 ______________________________________________________________________ Unfavorable government audit results could subject us to a variety of penalties and sanctions |
| The federal government audits and reviews our performance on awards, pricing practices, cost structure, and compliance with applicable laws, regulations, and standards |
| Like most large government vendors, our awards are audited and reviewed on a continual basis by federal agencies, including the Defense Contract Management Agency and the Defense Contract Audit Agency |
| An audit of our work, including an audit of work performed by companies we have acquired or may acquire or subcontractors we have hired or may hire, could result in a substantial adjustment in the current period operating results |
| For example, any costs which were originally reimbursed could subsequently be disallowed |
| In this case, cash we have already collected may need to be refunded and our operating margins may be reduced |
| If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with US government agencies |
| In addition, we could suffer serious harm to our reputation if allegations of impropriety were made against us, even if the allegations were not true |
| If we were suspended or debarred from contracting with the US government generally, or any specific agency, if our reputation or relationship with US government agencies were impaired, or if the government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our revenue and operating results would be materially harmed |
| We may be liable for penalties under a variety of federal procurement rules and regulations, and changes in such rules and regulations could adversely impact our revenues, operating expenses and profitability |
| Parts of our business must comply with and are affected by government regulations that impact our operating costs and profit margins, as well as our internal organization and operation |
| The most significant regulations are: • the US Federal Acquisition Regulations, which comprehensively regulate the formation, administration and performance of government contracts, including our GSA contract; • the US Truth in Negotiations Act; and • the US Cost Accounting Standards |
| These regulations affect how we and our customers do business and, in some instances, impose added costs |
| Any failure to comply with applicable laws or any changes in applicable laws could result in contract termination, price reduction, customer reimbursement, contract suspension or debarment from contracting with the US government |
| Any of these results could adversely affect our financial performance |
| If we are unable to protect our intellectual property adequately or license technology from third parties, we could lose our competitive advantage |
| Our ability to compete effectively against competing technologies will depend, in part, on our ability to protect our current and future proprietary technology, product designs and manufacturing processes through a combination of patent, copyright, trademark, trade secret and unfair competition laws |
| Although we assess the advisability of patenting any technological development, we have historically relied on copyright and trade secret law, as well as employee and third-party non-disclosure agreements, to protect our proprietary intellectual property and rights |
| In addition, the laws of some countries do not protect trade secrets |
| In the event that our proprietary rights prove inadequate to protect our intellectual property, our competitors may: • independently develop substantially equivalent proprietary information, products and techniques; • otherwise gain access to our proprietary information; or 14 ______________________________________________________________________ • design around our patents or other intellectual property |
| In addition, much of our business and many of our products rely on key technologies developed by third parties, and we may not be able to obtain or renew licenses or technologies from these third parties on reasonable terms or at all |
| In addition, when we do not control the prosecution, maintenance and enforcement of certain important intellectual property, such as a technology licensed to us, the protection of the intellectual property rights may not be in our hands |
| If the entity that controls the intellectual property rights does not adequately protect those rights, our rights may be impaired which, may impact our ability to develop, market and commercialize the related products |
| If we are subject to litigation and infringement claims, they could be costly and disrupt our business |
| In recent years, there has been significant litigation involving patents and other intellectual property rights in many technology-related industries |
| There may be patents or patent applications in the United States or other countries that are pertinent to our business of which we are not aware |
| The technology that we incorporate into and use to develop and manufacture our products may be subject to claims that they infringe the patents or proprietary rights of others |
| The success of our technology efforts will also depend on our ability to develop new technologies without infringing or misappropriating the proprietary rights of others |
| We have received in the past, and may receive in the future, notices from third parties alleging patent, trademark or copyright infringement, claims regarding trade secrets or contract claims |
| Receipt of these notices could result in significant costs as a result of the diversion of the attention of management from our technology efforts |
| If a successful claim were brought against us, we may be required to license the intellectual property right from the claimant or to spend time and money to design around or avoid the intellectual property |
| Any such license may not be available at reasonable terms, or at all |
| We may, however, be involved in future lawsuits, arbitrations or other legal proceedings alleging patent infringement or other intellectual property rights violations |
| In addition, litigation, arbitration or other legal proceedings may be necessary to: • assert claims of infringement or misappropriation of or otherwise enforce our intellectual property rights; • protect our trade secrets or know-how; or • determine the enforceability, scope and validity of our intellectual property rights or those of others |
| We may be unsuccessful in defending or pursuing these lawsuits or claims |
| Regardless of the outcome, litigation can be very costly and can divert management’s efforts |
| An adverse determination may subject us to significant liabilities or require us to seek licenses to other parties’ intellectual property rights |
| We may also be restricted or prevented from developing, manufacturing, marketing or selling a product or service that we develop |
| Further, we may not be able to obtain any necessary licenses on acceptable terms, if at all |
| In addition, we may have to participate in proceedings before the United States Patent and Trademark office, or before foreign patent and trademark offices, with respect to our patents, patent applications, trademarks or trademark applications or those of others |
| These actions may result in substantial costs to us as well as a diversion of management attention |
| Furthermore, these actions could place our patents, trademarks and other intellectual property rights at risk and could result in the loss of patent, trademark or other intellectual property rights protection for the products and services on which our business strategy depends |
| Our sales to foreign customers are subject to various export regulations, and the inability to obtain, or the delay in obtaining, any required export approvals would harm revenues |
| Our sales to foreign customers are subject to export regulations |
| Sales of some of our encryption products require clearance and export licenses from the US Department of Commerce under these regulations |
| We cannot 15 ______________________________________________________________________ assure that such approvals will be available to us or our products in the future in a timely manner, or at all, or that the federal government will not revise its export policies or the list of products and countries for which export approval is required |
| In addition, the Departments of Commerce or State may prevent us from selling products to any of our distributors, customers or end-users at any time |
| Our inability to obtain, or a delay in obtaining, required export approvals would harm our international sales |
| In addition, foreign companies not subject to United States export restrictions may have a competitive advantage in the international market |
| We cannot predict the impact of these factors on the international market for our products |
| The Company’s foreign transactions are subject it to additional risks |
| Foreign Corrupt Practices Act prohibits corporations and individuals, including the Company and its employees, from engaging in certain activities to obtain or retain business or to influence a person working in an official capacity |
| Although the Company has implemented policies and procedures designed to ensure compliance with these laws, there can be no assurance that all of the Company’s employees, contractors and agents, including those based in or from countries where practices which violate such United States laws may be customary, will not take actions in violation of the Company’s policies |
| Any such violation, even if prohibited by the Company’s policies, could have a material adverse effect on the Company’s business |
| Failure to comply with financial covenants in our credit facility could result in termination of the credit facility, which would severely strain our liquidity position |
| In 2004, we amended our revolving credit facility with Bank of America, which expires on September 30, 2007 |
| The credit facility has certain financial covenants with which we were in compliance as of December 31, 2005 |
| However, there can be no assurance that we will remain in compliance with all of these financial covenants |
| Without the benefit of a revolving credit facility, a substantial decline in revenues or gross margins or a material increase in costs or expenses could severely strain our liquidity position |
| Further, without a revolving credit facility, our ability to grow, either internally or through acquisition, would be severely restricted |
| Our failure to comply with, or changes in, governmental regulation could adversely affect our business and operations |
| Our private wireless communications and secured communications products, and the spectrum within which these products are used, are subject to regulation by domestic and foreign laws and international treaties, as are our customers |
| In particular, our wireless radio products are regulated by the FCC The regulatory environment is uncertain |
| Changes in the regulatory structure, laws or regulations, or in the use or allocation of spectrum, could adversely affect us or our customers |
| Such changes could make our existing or planned products obsolete or not sellable in one or more markets, which could have a material adverse effect on us |
| Further, our failure to comply in the future with applicable regulations could result in penalties on us, such as fines, operational restrictions, or a temporary or permanent closure of our facilities |
| If we do not effectively manage the anticipated global transition from analog to digital products, our secured communications revenues would be adversely affected |
| The wireless radio markets are gradually migrating from analog to digital equipment |
| This migration is primarily due to bandwidth capacity constraints, availability of additional features, and digital transmissions being more secure than analog transmissions |
| However, if, for whatever economic or geopolitical reasons, this transition accelerates, we may not be in a position to effectively respond to the change from a market and product position |
| Accordingly, such an occurrence would adversely affect our operations as a result of the unexpected decrease in demand for our add-on security devices |
| We may be unable to meet the rapid technology requirement required by our market |
| The products as complex as those under development by us frequently are subject to delays, and we cannot assure you that we will not encounter difficulties, such as the inability to assign a sufficient number of quality 16 ______________________________________________________________________ software and hardware engineers to key projects or other unanticipated causes, that could delay or prevent the successful and timely development, introduction and marketing of new products or required product features |
| In addition, our products are implemented certain third-party hardware and software |
| We cannot assure you that we will be able to design, have manufacture, or procure from third parties, the hardware and software necessary to successfully implement our new products and applications |
| Our inability to secure satisfactory bonding arrangements would adversely affect revenues |
| In the normal course of our business activities, we are required under certain contracts with various government authorities to provide letters of credit and bonds that may be drawn upon if we fail to perform under our contracts |
| A number of factors can limit the availability of such bonds, including a company’s financial condition and operating results, a company’s record for completing similar systems contracts in the past and the extent to which a company has bonds in place for other projects |
| Bonds, which expire on various dates, totaled dlra0dtta5 million at December 31, 2005, and, as of such date, no bonds have been drawn upon |
| However, if a customer for a systems contract declares an event of default under the outstanding bond related to the system contract, the issuer of our bonds could reduce the maximum amount of bond coverage available to us, or impose additional restrictions with respect to the issuance of bonds on behalf of us |
| Our inability to secure bonding arrangements when needed would adversely affect our ability to be awarded new systems installation contracts, which would adversely affect our revenues |
| Our business has experienced periods of rapid growth that have placed, and will continue to place, significant demands on our managerial, operational and financial resources |
| In order to manage this growth, we must continue to improve and expand our management, operational and financial systems and controls, including the continued training of our employees |
| We must carefully manage research and development capabilities and production and inventory levels to meet product demand, new product introductions and product and technology transitions |
| We may not be able to timely and effectively meet that demand and maintain the quality standards required by our existing and potential customers |
| If we do not effectively manage our growth or are unsuccessful in recruiting and retaining personnel, our business and operating results will be harmed |
| The nature of our business and industry make forecasting difficult |
| Current economic and market conditions have limited our ability to forecast our sales volume and product mix, making it difficult to provide estimates of revenue and operating results |
| We continue to have limited visibility into the capital spending plans of our current and prospective customers |
| Fluctuations in our revenue can lead to even greater fluctuations in operating results |
| Our planned expense levels depend, in part, on revenue expectations |
| Our planned expenses include significant investments in research and development necessary to develop products to be sold to current and prospective customers, even though we are unsure of the volume, duration, or timing of any purchase orders |
| Accordingly, it is difficult to forecast revenue and operating results |
| If our revenue or operating results are below investor and market analyst expectations, it could cause a decline in the price of our common stock |
| We may pursue strategic acquisitions that could result in significant charges or management disruption and fail to enhance stockholder value |
| A key part of our strategy is to selectively pursue acquisitions |
| If we do identify an appropriate acquisition candidate, we may not be able to successfully negotiate the terms of the acquisition |
| In addition, in connection with an acquisition, we may incur significant amortization expenses related to intangible assets |
| We also may incur significant write-offs of goodwill associated with companies, businesses or technologies that we acquire |
| Acquisitions and strategic investments may involve a number of other risks, including: • difficulties in integrating the operations, technologies, and products of the acquired companies; 17 ______________________________________________________________________ • diversion of management’s attention from our existing business; • potential difficulties in completing the acquired company’s projects; and • the potential loss of the acquired company’s key employees |
| We cannot be assured that our future strategic investment decisions will generate adequate financial returns or that such decisions will not ultimately result in losses and a material drain on our cash resources |
| Business, political, regulatory, or economic changes in foreign countries in which we market our products or services could adversely affect our revenues |
| Although our sales have historically been denominated in US dollars, fluctuations in the value of international currencies relative to the US dollar may affect the price, competitiveness, economic attractiveness, and, ultimately, profitability of our products sold in international markets |
| Furthermore, the uncertainty of monetary exchange values has caused, and may in the future cause, some foreign customers to delay new orders or delay payment for existing orders |
| Additionally, troubled economic conditions, in regions and nations to which we presently market, could result in lower revenues for us |
| In 2005, 2004 and 2003, international sales constituted approximately 15prca, 23prca, and 13prca of revenues, respectively, most of which involve our higher margin secured communications products |
| While most of the international sales are supported by irrevocable letters of credit or cash in advance, and thereby pose little credit risk, our international business could be adversely affected by a variety of factors presenting increased risks to profitability |
| These factors include: • unexpected changes in regulatory requirements; • tariffs and other trade barriers; • political and economic instability in foreign markets; • difficulties in establishing foreign distribution channels; • longer payment cycles or uncertainty in the collection of accounts receivable; • increased costs associated with maintaining international marketing efforts; • cultural differences in the conduct of business; • natural disasters or acts or terrorism; • difficulties in protecting intellectual property; and • susceptibility to orders being cancelled as a result of foreign currency fluctuations |
| If the current Project 25 standard is supplanted by some other recommended protocol or is otherwise not supported or mandated by the federal, state and local government agencies, it would adversely affect our operations, cash flows and financial condition |
| In 1995, APCO promulgated a new recommended standard known as Project 25 |
| Our private wireless communications marketing and research and development efforts are substantially focused on Project 25 standard compliant equipment |
| We believe that sales of our Project 25 digital wireless radio products have been, and will continue in the foreseeable future to be, substantially dependent upon Motorola’s dominant position as a market leader in the Project 25 marketplace |
| Motorola is the largest manufacturer of Project 25 compliant wireless radio products and has been the principal public supporter of the Project 25 digital transmission standard for the wireless radio market |
| If Motorola does not continue to support the standard, or if the Project 25 standard is otherwise abandoned by industry and government public safety and public service users, it would adversely affect our operations, cash flows and financial condition |
| Further, if the industry materially accelerates its movement towards Phase II, the next generation of the APCO Project 25 standard, to the degree that our development efforts cannot keep pace with Phase II compliant equipment, it would have a material adverse effect on our financial results |
| 18 ______________________________________________________________________ Our sales are substantially concentrated in public sector markets that inherently possess additional risks that could harm revenues and gross margins |
| A significant portion of our revenue is derived from sales to federal, state, and local governments, both directly or through system integrators and other resellers |
| Sales to these government entities present risks in addition to those involved in sales to commercial customers, including potential disruptions due to appropriation and spending patterns, changes in government personnel, political factors and the government’s reservation of the right to cancel contracts for its convenience |
| The bidding cycle for a request for proposal, or RFP, and contract award stage can take six months to two years before a contract is awarded and the government funding process for these systems can delay the bidding cycle as well |
| We expect that sales to government entities will increasingly be subject to competitive bidding requirements |
| This intensified competition can be expected to result in lower prices, longer sales cycles and lower margins |
| Further, our sales to these domestic public safety and public service entities can be substantially attributed to Project 25 interoperability mandates and homeland security initiatives |
| Changes in governmental budget priorities could result in decreased opportunities for us to sell into this market segment |
| We face competitive pressures that could adversely affect revenues, gross margins and profitability |
| The private wireless communications and secured communications equipment industries, and the wireless radio market segment in particular, are highly competitive |
| Motorola and M/A-Com hold dominant and entrenched market positions in the domestic public safety and service market for wireless communication products |
| In addition, these competitors have financial, technical, marketing, sales, manufacturing, distribution and other resources substantially greater than our resources |
| Finally, these competitors have established trade names, trademarks, patents and other intellectual property rights and substantial technological capabilities |
| These advantages allow such competitors to: • respond more quickly to new or emerging technologies; • manage more extensive research and development programs; • undertake more far-reaching marketing campaigns; • engage in more aggressive merger and acquisition strategies; and • adopt more aggressive pricing policies |
| In addition, other wireless communication technologies, including cellular telephone, paging, SMR, satellite communications and PCS currently compete and are expected to compete in the future with certain of our stand-alone products |
| Some have already announced, or are expected to announce, the availability of Project 25 compliant products or digital land mobile radios as part of their product offering |
| Accordingly, we cannot make any assurances that we will be able to continue to compete effectively in the private wireless communications and secured communications equipment market, that competition will not intensify, or that future competition from existing or from new competitors will not have a material adverse effect on our revenues, gross margins or profitability |
| Our future success will depend upon our ability and the resources available to respond to the rapidly evolving technology and customer requirements in the markets in which we operate |
| The private wireless communications and secured communications markets in which we compete are rapidly evolving as a result of changing technology, industry standards and customer requirements |
| Our ability to compete effectively will depend upon our ability to anticipate and react to these changes in a timely manner |
| We may not have adequate capital or human resources to respond to these changes |
| Technological developments in the digital wireless radio industry include the use of digital trunking, digital simulcast and digital voting technologies |
| These technologies have led a number of manufacturers to change the architectures and methodologies used in designing, developing and implementing large wireless radio systems |
| In 19 ______________________________________________________________________ order for us to develop and integrate these new technologies into our products, we have made a substantial investment in fixed assets and human resources |
| However, there can be no assurance that such resources will be readily available to us in the future |
| Our failure to incorporate these technologies into our wireless radio products could, place our wireless radio products at a competitive disadvantage |
| This situation could possibly make our hand-held and mobile wireless radios incompatible with systems developed by other manufacturers, which would have a material adverse effect on us |
| Our operating results historically fluctuate from period to period |
| Our operating results may fluctuate from period to period due to a number of factors including: • timing of customer orders; • timing and mix of product sales; • seasonality of product sales; • timing of the introduction of new products; • general economic conditions, both in the United States and overseas; • specific economic conditions in the private wireless communications and secured communications industries; and • variable accounting treatment required for certain of our repriced stock options |
| These factors make it difficult to use our quarterly results as a predictor of future operations |
| Historically, more than half of each quarter’s revenues result from orders booked and shipped during the third month of a quarter, and disproportionately in the latter half of that month |
| These factors make revenue forecasting inherently uncertain |
| Because we plan our operating expenses, many of which are relatively fixed in the short term, on expected revenue, a relatively small revenue shortfall may cause a period’s results to be substantially below expectations |
| Such a revenue shortfall could arise from any number of factors, including lower than expected demand, supply constraints, transit interruptions, overall economic conditions, or natural disasters |