| MERCURY COMPUTER SYSTEMS INC ITEM 1A RISK FACTORS We depend heavily on defense electronics programs that incorporate our products, which may be only partially funded and are subject to potential termination and reductions and delays in government spending |
| Sales of our computer systems, primarily as an indirect subcontractor or team member with prime contractors and in some cases directly, to the US Government and its agencies, as well as foreign governments and agencies, accounted for approximately 55prca, 59prca and 68prca of our total revenues in fiscal 2006, 2005 and 2004, respectively |
| Our computer systems are included in many different domestic and international programs |
| Over the lifetime of a program, the award of many different individual contracts and subcontracts may impact our products’ requirements |
| The funding of US Government programs is subject to Congressional appropriations |
| Although multiple-year contracts may be planned in connection with major procurements, Congress generally appropriates funds on a fiscal year basis even though a program may continue for several years |
| Consequently, programs are often only partially funded initially, and additional funds are committed only as Congress makes further appropriations and prime contracts receive such funding |
| The reduction or delay in funding or termination of a government program in which we are involved would result in a loss of or delay in receiving anticipated future revenues attributable to that program and contracts or orders received |
| The US Government could reduce or terminate a prime contract under which we are a subcontractor or team member irrespective of the quality of our products or services |
| The termination of a program or the reduction in or failure to commit additional funds to a program in which we are involved could negatively impact our revenues and have a material adverse effect on our financial condition and results of operations |
| In addition, delays in funding of a program, or of the defense appropriation generally, could negatively impact our revenues and have a material adverse effect on our financial condition and results of operations for the period in which such revenues were originally anticipated |
| We face other risks and uncertainties associated with defense-related contracts, which may have a material adverse effect on our business |
| Whether our contracts are directly with the US Government, a foreign government or one of its respective agencies, or indirectly as a subcontractor or team member, our contracts and subcontracts are subject to special risks, including: • Changes in government administration and national and international priorities, including developments in the geo-political environment such as the current “War on Terrorism,” “Operation Enduring Freedom,” “Operation Iraqi Freedom,” and the threat of nuclear proliferation in North Korea and Iran, could have a significant impact on national or international defense spending priorities and the efficient handling of routine contractual matters |
| These changes could have a negative impact on our business in the future |
| 14 ______________________________________________________________________ [55]Table of Contents • Our contracts with the US and foreign governments and their prime contractors and subcontractors are subject to termination either upon default by us or at the convenience of the government or contractor if, among other reasons, the program itself has been terminated |
| Termination for convenience provisions generally entitle us to recover costs incurred, settlement expenses and profit on work completed prior to termination, but there can be no assurance in this regard |
| • Because we contract to supply goods and services to the US and foreign governments and their prime and subcontractors, we compete for contracts in a competitive bidding process and, in the event we are awarded a contract, we are subject to protests by disappointed bidders of contract awards that can result in the reopening of the bidding process and changes in governmental policies or regulations and other political factors |
| • Consolidation among defense industry contractors has resulted in a few large contractors with increased bargaining power relative to us |
| The increased bargaining power of these contractors may adversely affect our ability to compete for contracts and, as a result, may adversely affect our business or results of operations in the future |
| • Our customers include US Government contractors who must comply with and are affected by laws and regulations relating to the formation, administration and performance of US Government contracts |
| A violation of these laws and regulations could result in the imposition of fines and penalties to our customer or the termination of its contract with the US Government |
| As a result, there could be a delay in our receipt of orders from our customer or a termination of such orders |
| • We sell products to US and international defense contractors and also directly to the US Government as a commercial supplier such that cost data is not supplied |
| To the extent that there are interpretations or changes in the Federal Acquisition Regulations (FARs) regarding the qualifications necessary to be a commercial supplier, there could be a material adverse effect on our business and operating results |
| • Defense Federal Acquisition Regulations require that certain “specialty metals” (as defined in the regulations) incorporated in articles delivered under Department of Defense contracts must be melted in the United States or a “qualifying country,” subject to certain exceptions |
| While these regulations generally do not apply to subcontractors such as the Company, they do apply to subcontractors in connection with certain types of military programs |
| Certain of the products we have historically sold to US Government defense contractors may contain third-party components which incorporate specialty metals that are non-compliant with these regulations |
| Our customers may not accept certain of our products for the affected programs, which could have a material adverse effect on our business and operating results, if (a) our third-party vendors are not able to supply us with components that comply with these requirements, or (b) we are not able to procure compliant substitutes for these components, or (c) our products do not otherwise qualify for an exception to, or fall outside the scope of, these requirements |
| The loss of one or more of our largest customers could adversely affect our results of operations |
| We are dependent on a small number of customers for a large portion of our revenues |
| A significant decrease in the sales to or loss of any of our major customers would have a material adverse effect on our business and results of operations |
| For fiscal 2006 four customers, Argon ST, Inc, Northrop Grumman Corporation, KLA-Tencor Corporation and GE Healthcare (formerly GE Medical Systems) accounted for 15prca, 12prca, 11prca and 10prca, respectively, of our total revenues |
| In fiscal 2005, KLA-Tencor Corporation, Argon ST, Inc, Northrop Grumman Corporation and GE Medical Systems accounted for 14prca, 14prca, 11prca and 11prca of our total revenues, respectively |
| Customers in the Defense market generally purchase our products in connection with government programs that have a limited duration, leading to fluctuating sales to any particular customer in this market from year to year |
| In addition, our revenues are largely dependent upon the ability of customers to develop and sell products that incorporate our products |
| No assurance can be given that our customers will not experience financial, technical or other difficulties that could adversely affect their operations and, in turn, our results of operations |
| 15 ______________________________________________________________________ [56]Table of Contents Our CIV, Advanced Solutions and MPS revenues currently come from a small number of customers and modalities, and any significant decrease in revenue from one of these customers or modalities could adversely impact our operating results |
| If a major CIV, Advanced Solutions or MPS customer significantly reduces the amount of business it does with us, there would likely be an adverse impact on our operating results |
| GE Healthcare and Philips Medical Systems accounted for substantially all of our CIV revenues for the fiscal years ended June 30, 2006, 2005 and 2004 |
| In particular, GE Healthcare accounted for 44prca, 56prca and 60prca of our aggregate CIV sales in fiscal 2006, fiscal 2005 and fiscal 2004, respectively |
| Additionally, in fiscal 2006, due to the acquisition of SoHard AG, Siemens AG became a significant customer of CIV In fiscal 2006, Siemens AG accounted for 13prca of our aggregate CIV sales |
| Further, we are currently expecting that our 2D business with GE Healthcare, Motorola GmbH and Philips Medical Systems will significantly decrease over the next 12-months as these customers transition to new platforms and new component manufactures |
| We expect that this forecasted decline in our 2D business will be offset, either partially or fully, by an increase in our 3D business |
| KLA-Tencor Corporation accounted for 63prca, 72prca and 66prca of our total sales in the Advanced Solutions market in fiscal 2006, fiscal 2005 and fiscal 2004 |
| Additionally, for the MPS segment, which was consolidated into our company starting in the second quarter of 2005, Motorola Computer Group, SS8 Networks Inc, Continuous Computing Corporation and Lockheed Martin Corporation accounted for 27prca, 15prca, 10prca and 10prca, respectively, of the aggregate MPS sales for the year ended June 30, 2006 |
| Although we are seeking to broaden our commercial customer base, we expect to continue to depend on sales to a relatively small number of major customers in both the Advanced Solutions and MPS markets |
| Because it often takes significant time and added cost to replace lost business, it is likely that our operating results would be adversely affected if one or more of our major customers were to cancel, delay or reduce significant orders in the future |
| Our customer agreements typically permit the customer to discontinue future purchases without cause after timely notice |
| Our sales to the CIV market could be adversely affected by changes in technology, strength of the economy, and health care reforms |
| The economic and technological conditions affecting our industry in general or any major CIV OEM customer in particular, may adversely affect our operating results |
| CIV OEM customers provide products to markets that are subject to both economic and technological cycles |
| Any change in the demand for medical imaging devices that renders any of our products unnecessary or obsolete, or any change in the technology in these devices, could result in a decrease in our revenues |
| In addition to our CIV OEM customers, the end users of their products and the health care industry generally are subject to extensive federal, state and local regulation in the United States, as well as in other countries |
| Changes in applicable health care laws and regulations or new interpretations of existing laws and regulations could cause these customers or end users to demand fewer CIV products |
| There can be no assurance that future health care regulation or budgetary legislation or other changes in the administration or interpretation of governmental health care programs both in the United States and abroad will not have a material adverse effect on our business |
| Competition from existing or new companies in the CIV business could cause us to experience downward pressure on prices, fewer customer orders, reduced margins, the inability to take advantage of new business opportunities and the loss of market share |
| CIV competes in highly competitive industries, and our CIV OEM customers generally extend the competitive pressures they face throughout their respective supply chains |
| We are subject to competition based upon product design, performance, pricing, quality and services |
| Our product performance, embedded systems engineering expertise, and product quality have been important factors in our growth |
| While we try to maintain competitive pricing on those products that are directly comparable to products manufactured by others, in many instances our products will conform to more exacting specifications and carry a higher price than analogous products |
| Many of our CIV OEM customers and potential CIV OEM customers have the capacity to design and internally manufacture products that are similar to our products |
| We face competition from research and product development groups and the manufacturing operations of current and potential customers, who continually 16 ______________________________________________________________________ [57]Table of Contents evaluate the benefits of internal research and product development and manufacturing versus outsourcing |
| This competition could result in fewer customer orders and a loss of market share |
| Our sales in the defense market could be adversely affected by the emergence of commodity-type products as acceptable substitutes for certain of the Company’s products and by uncertainty created by emerging changes in standards that may cause customers to delay purchases or seek alternative solutions |
| Our computing products for the defense market are designed for operating under physical constraints such as limited volume, weight, and electrical power |
| Furthermore, these products are often designed to be “rugged,” that is, to withstand enhanced environmental stress such as extended temperature range, shock, vibration, and exposure to sand or salt spray |
| Historically these requirements have often precluded the use of less expensive, readily available commodity-type systems typically found in more benign non-military settings |
| Factors that may increase the acceptability of commodity-type products in some defense platforms that we serve include improvements in the physical properties and durability of such alternative products, combined with the relaxation of physical and ruggedness requirements by the military due to either a reevaluation of those requirements or the installation of computing products in a more highly environmentally isolated setting |
| In addition, recent proposed changes in the VMEbus computer infrastructure standard, to which a majority of our defense products adhere, may cause program managers with the US Government and prime contractors to delay decisions on new program implementations in order to determine which emerging standards and configurations will be the dominant design in the market, and may result in program managers selecting new standards or configurations that we have not chosen to invest in |
| These developments could negatively impact our revenues and have a material adverse effect on our business and operating results |
| If we are unable to respond adequately to our competition, we may lose existing customers and fail to win future business opportunities |
| The markets for our products are highly competitive and are characterized by rapidly changing technology, frequent product performance improvements and evolving industry standards |
| Competitors may be able to offer more attractive pricing or develop products that could offer performance features that are superior to our products, resulting in reduced demand for our products |
| Due to the rapidly changing nature of technology, we may not become aware in advance of the emergence of new competitors into our markets |
| The emergence of new competitors into markets historically targeted by us could result in the loss of existing customers and may have a negative impact on our ability to win future business opportunities |
| With continued microprocessor evolution, low-end systems could become adequate to meet the requirements of an increased number of the lesser-demanding applications within our target markets |
| Workstation manufacturers and other low-end single-board computer or merchant board computer companies, or new competitors, may attempt to penetrate the high-performance market for defense electronics systems, which could have a material adverse effect on our business |
| We cannot predict the consequences of future terrorist activities, but they may adversely affect the markets in which we operate, our ability to insure against risks, and our operations or profitability |
| The terrorist attacks in the United States on September 11, 2001, as well as the US-led response, including ongoing military operations in Iraq and Afghanistan, the potential for future terrorist activities, and the development of a Homeland Security organization have created economic and political uncertainties that could have a material adverse effect on business and the price of our common stock |
| These matters have caused uncertainty in the world’s financial and insurance markets and may increase significantly the political, economic and social instability in the geographic areas in which we operate |
| These developments may adversely affect our business and profitability and the prices of our securities in ways that cannot be predicted at this time |
| Our growth strategy includes developing new products and entering new markets, as well as identifying and integrating acquisitions |
| Our ability to compete in new markets will depend upon a number of factors including, among others: • our ability to create demand for products in new markets; • our ability to manage growth effectively; • our ability to successfully integrate any acquisitions that we make; • our ability to respond to changes in our customers’ businesses by updating existing products and introducing, in a timely fashion, new products which meet the needs of our customers; • the quality of our new products; and • our ability to respond rapidly to technological change |
| The failure to do any of the foregoing could have a material adverse effect on our business, financial condition and results of operations |
| In addition, we may face competition in these new markets from various companies that may have substantially greater research and development resources, marketing and financial resources, manufacturing capability and customer support organizations |
| We may be unable to successfully integrate acquisitions |
| We completed the acquisitions of SoHard and Echotek in fiscal year 2006, MCI in fiscal year 2005 and TGS Group and ARC in fiscal year 2004 |
| We may in the future acquire or make investments in complementary companies, products or technologies |
| Acquisitions may pose risks to our operations, including: • problems and increased costs in connection with the integration of the personnel, operations, technologies or products of the acquired companies; • unanticipated costs; • diversion of management’s attention from our core business; • adverse effects on business relationships with suppliers and customers and those of the acquired company; • acquired assets becoming impaired as a result of technical advancements or worse-than-expected performance by the acquired company; • entering markets in which we have no, or limited, prior experience; and • potential loss of key employees, particularly those of the acquired organization |
| In addition, in connection with any acquisitions or investments we could: • issue stock that would dilute our existing shareholders’ percentage ownership; • incur debt and assume liabilities; • obtain financing on unfavorable terms; • incur amortization expenses related to acquired intangible assets or incur large and immediate write-offs; • incur large expenditures related to office closures of the acquired companies, including costs relating to termination of employees and facility and leasehold improvement charges relating to vacating the acquired companies’ premises; and • reduce the cash that would otherwise be available to fund operations or to use for other purposes |
| 18 ______________________________________________________________________ [59]Table of Contents The failure to successfully integrate any acquisition or for acquisitions to yield expected results may negatively impact our financial condition and operating results |
| We may be unable to obtain critical components from suppliers, which could disrupt or delay our ability to deliver products to our customers |
| Several components used in our products are currently obtained from sole-source suppliers |
| We are dependent on key vendors like LSI Logic, Xilinx and Toshiba for custom-designed ASICs and FPGAs; Freescale and IBM for PowerPC microprocessors; IBM for a specific SRAM; and Arrow, Hybricon, and Motorola for chassis and chassis components |
| Generally, suppliers may terminate their contracts with us without cause upon 30 days’ notice and may cease offering their products upon 180 days’ notice |
| If any of our sole-source suppliers limits or reduces the sale of these components, we may be unable to fulfill customer orders in a timely manner or at all |
| In addition, if these or other component suppliers, some of which are small companies, experienced financial difficulties or other problems that prevented them from supplying us with the necessary components, we could experience a loss of revenues due to our inability to fulfill orders |
| These sole-source and other suppliers are each subject to quality and performance issues, materials shortages, excess demand, reduction in capacity and other factors that may disrupt the flow of goods to us or to our customers, which would adversely affect our business and customer relationships |
| We have no guaranteed supply arrangements with our suppliers and there can be no assurance that these suppliers will continue to meet our requirements |
| If supply arrangements are interrupted, we may not be able to find another supplier on a timely or satisfactory basis |
| We may incur significant set-up costs and delays in manufacturing should it become necessary to replace any key vendors due to work stoppages, shipping delays, financial difficulties or other factors |
| We may not be able to effectively manage our relationships with contract manufacturers |
| We may not be able to effectively manage our relationship with contract manufacturers, and the contract manufacturers may not meet future requirements for timely delivery |
| We rely on contract manufacturers to build hardware sub-assemblies for our products in accordance with our specifications |
| During the normal course of business, we may provide demand forecasts to contract manufacturers up to five months prior to scheduled delivery of our products to customers |
| If we overestimate requirements, the contract manufacturers may assess cancellation penalties or we may be left with excess inventory, which may negatively impact our earnings |
| If we underestimate requirements, the contract manufacturers may have inadequate inventory, which could interrupt manufacturing of our products and result in delays in shipment to customers and revenue recognition |
| Contract manufacturers also build products for other companies, and they may not have sufficient quantities of inventory available or sufficient internal resources to fill our orders on a timely basis or at all |
| In addition, there have been a number of major acquisitions within the contract manufacturing industry in recent periods |
| While there has been no significant impact on our contract manufacturers to date, future acquisitions could potentially have an adverse effect on our working relationships with contract manufacturers |
| Moreover, we currently rely primarily on two contract manufacturers |
| The failure of these contract manufacturers to fill our orders on a timely basis or in accordance with our customers’ specifications could result in a loss of revenues and damage to our reputation |
| We may not be able to replace these contract manufacturers in a timely manner or without significantly increasing our costs if such contract manufacturers were to experience financial difficulties or other problems that prevented them from fulfilling our order requirements |
| Our performance and stock price may decline if we are unable to retain and attract key personnel |
| We are largely dependent upon the skills and efforts of senior management including James R Bertelli, our president and chief executive officer, as well as our senior managerial, sales and technical employees |
| None of our senior management or other key employees is subject to employment contracts |
| The loss of services of any executive or other key personnel could have a material adverse effect on our business, financial condition and results of operations and stock price |
| In addition, our future success will depend to a significant extent on the 19 ______________________________________________________________________ [60]Table of Contents ability to attract, train, motivate and retain highly skilled technical professionals, particularly project managers, engineers and other senior technical personnel |
| There can be no assurance that we will be successful in retaining current or future employees |
| We are exposed to risks associated with international operations and markets |
| We market and sell products in international markets, and have established offices and subsidiaries in the United Kingdom, Japan, France and Germany |
| Revenues from international operations accounted for 7prca, 9prca and 9prca of total revenues for fiscal years 2006, 2005 and 2004, respectively |
| From our US operations, we also ship directly to international customers, which shipments accounted for 5prca, 12prca and 10prca of total revenues for fiscal years 2006, 2005 and 2004, respectively |
| There are inherent risks in transacting business internationally, including: • changes in applicable laws and regulatory requirements; • export and import restrictions; • export controls relating to technology; • tariffs and other trade barriers; • less favorable intellectual property laws; • difficulties in staffing and managing foreign operations; • longer payment cycles; • problems in collecting accounts receivable; • political instability; • fluctuations in currency exchange rates; • expatriation controls; and • potential adverse tax consequences |
| There can be no assurance that one or more of these factors will not have a material adverse effect on our future international activities and, consequently, on our business and results of operations |
| We may be exposed to unfavorable currency exchange rate fluctuations, which may lead to lower operating margins, or may cause us to raise prices which could result in reduced sales |
| Currency exchange rate fluctuations could have an adverse effect on our net sales and results of operations |
| Unfavorable currency fluctuations could require us to increase prices to foreign customers, which could result in lower net sales by us to such customers |
| Alternatively, if we do not adjust the prices for our products in response to unfavorable currency fluctuations, our results of operations could be adversely affected |
| In addition, most sales made by our foreign subsidiaries are denominated in the currency of the country in which these products are sold, and the currency they receive in payment for such sales could be less valuable at the time of receipt as a result of exchange rate fluctuations |
| We do not currently hedge our foreign currency exchange rate exposure |
| If we are unable to respond to technological developments and changing customer needs on a timely and cost-effective basis, our results of operations may be adversely affected |
| Our future success will depend in part on our ability to enhance current products and to develop new products on a timely and cost-effective basis in order to respond to technological developments and changing customer needs |
| Military planners have historically funded significantly more design projects than 20 ______________________________________________________________________ [61]Table of Contents actual deployments of new equipment, and those systems that are deployed tend to contain the components of the subcontractors selected to participate in the design process |
| In order to participate in the design of new defense electronics systems, we must demonstrate the ability to deliver superior technological performance on a timely and cost-effective basis |
| There can be no assurance that we will secure an adequate number of defense design wins in the future, that the equipment in which our products are intended to function will eventually be deployed in the field, or that our products will be included in such equipment if it eventually is deployed |
| Customers in our CIV and Advanced Solutions markets, including the semiconductor imaging market, also seek technological improvements through product enhancements and new generations of products |
| OEMs historically have selected certain suppliers whose products have been included in the OEMs’ machines for a significant portion of the products’ life cycles |
| We may not be selected to participate in the future design of any medical or semiconductor imaging equipment, or if selected, we may not generate any revenues for such design work |
| The design-in process is typically lengthy and expensive, and there can be no assurance that we will be able to continue to meet the product specifications of OEM customers in a timely and adequate manner |
| In addition, any failure to anticipate or respond adequately to changes in technology and customer preferences, or any significant delay in product developments or introductions, could negatively impact our financial condition and results of operations, including the risk of inventory obsolescence |
| Because of the complexity of our products, we have experienced delays from time to time in completing products on a timely basis |
| If we are unable to design, develop or introduce competitive new products on a timely basis, our future operating results may be adversely affected |
| Our products are complex, and undetected defects may increase our costs, harm our reputation with customers or lead to costly litigation |
| Our products are extremely complex and must operate successfully with complex products of other vendors |
| Our products may contain undetected errors when first introduced or as we introduce product upgrades |
| The pressures we face to be the first to market new products or functionality increases the possibility that we will offer products in which we or our customers later discover problems |
| We have experienced new product and product upgrade errors in the past and expect similar problems in the future |
| These problems may cause us to incur significant costs to support our service contracts and other costs and divert the attention of personnel from our product development efforts |
| If we are unable to repair these problems in a timely manner, we may experience a loss of or delay in revenue and significant damage to our reputation and business prospects |
| Many of our customers rely upon our products for business-critical applications |
| Because of this reliance, errors, defects or other performance problems in our products could result in significant financial and other damage to our customers |
| Our customers could attempt to recover those losses by pursuing products liability claims against us which, even if unsuccessful, would likely be time-consuming and costly to defend and could adversely affect our reputation |
| We may be unsuccessful in protecting our intellectual property rights |
| Our ability to compete effectively against other companies in our industry depends, in part, on our ability to protect our current and future proprietary technology under patent, copyright, trademark, trade secret and unfair competition laws |
| We cannot assure that our means of protecting our proprietary rights in the United States or abroad will be adequate, or that others will not develop technologies similar or superior to our technology or design around the proprietary rights we own |
| In addition, we may incur substantial costs in attempting to protect our proprietary rights |
| Also, despite the steps taken by us to protect our proprietary rights, it may be possible for unauthorized third parties to copy or reverse-engineer aspects of our products, develop similar technology independently or otherwise obtain and use information that we regard as proprietary and we may be unable to successfully identify 21 ______________________________________________________________________ [62]Table of Contents or prosecute unauthorized uses of our technology |
| Furthermore, with respect to our issued patents and patent applications, we cannot assure you that any patents from any pending patent applications (or from any future patent applications) will be issued, that the scope of any patent protection will exclude competitors or provide competitive advantages to us, that any of our patents will be held valid if subsequently challenged or that others will not claim rights in or ownership of the patents (and patent applications) and other proprietary rights held by us |
| If we become subject to intellectual property infringement claims, we could incur significant expenses and could be prevented from selling specific products |
| We may become subject to claims that we infringe the intellectual property rights of others in the future |
| We cannot assure that, if made, these claims will not be successful |
| Any claim of infringement could cause us to incur substantial costs defending against the claim even if the claim is invalid, and could distract management from other business |
| Any judgment against us could require substantial payment in damages and could also include an injunction or other court order that could prevent us from offering certain products |
| For a description of certain pending litigation in which we are |