| RICHARDSON ELECTRONICS LTD/DE Item 1A Risk Factors Investors should consider carefully the following risk factors, in addition to the other information included and incorporated by reference in this Annual Report on Form 10-K While the Company believes it has identified and discussed below the key risk factors affecting its business, there may be additional risks and uncertainties that are not presently known or that are not currently believed to be significant that may adversely affect its results of operations |
| The Company has had significant operating and net losses in the past and may have future losses |
| The Company reported net losses of approximately dlra12dtta9 million in fiscal 2002, dlra26dtta7 million in fiscal 2003, dlra16dtta0 million in fiscal 2005, and dlra2dtta6 million in fiscal 2006 and cannot ensure that it will not experience operating losses and net losses in the future |
| The Company may continue to lose money if its sales do not continue to increase or its expenses are not reduced |
| The Company cannot predict the extent to which sales will continue to increase across its businesses or how quickly its customers will consume their inventories of the Company’s products |
| The Company has exposure to economic downturns and operates in cyclical markets |
| As a supplier of electronic components and services to a variety of industries, the Company can be adversely affected by general economic downturns |
| In particular, demand for the products and services of RFPD is dependent upon capital spending levels in the telecommunications industry and demand for products and services of EDG is dependent upon capital spending levels in the manufacturing industry, including steel, automotive, textiles, plastics, semiconductors, and broadcast, as well as the transportation industry |
| Accordingly, the Company’s operating results for any particular period are not necessarily indicative of the operating results for any future period |
| The markets served by its businesses have historically experienced downturns in demand that could harm its operating results |
| Future economic downturns could be triggered by a variety of causes, including outbreaks of hostilities, terrorist actions, or epidemics in the United States or abroad |
| Because the Company derives a significant portion of its revenue by distributing products designed and manufactured by third parties, it may be unable to anticipate changes in the marketplace and, as a result, could lose market share |
| The Company’s business is driven primarily by customers’ needs and demands for new products and/or enhanced performance, and by the products developed and manufactured by third parties |
| Because the Company distributes products developed and manufactured by third parties, its business would be adversely affected if its suppliers fail to anticipate which products or technologies will gain market acceptance or if it cannot sell these products at competitive prices |
| The Company cannot be certain that its suppliers will permit the Company to distribute their newly developed products, or that such products will meet the Company’s customers’ needs and demands |
| Additionally, because some of the Company’s principal competitors design and manufacture new technology, those competitors may have a competitive advantage over the Company |
| To successfully compete, the Company must maintain an efficient cost structure, an effective sales and marketing team, and offer additional services that distinguish it from its competitors |
| Failure to execute these strategies successfully could harm its results of operations |
| The Company faces intense competition in the markets it serves and, if it does not compete effectively, it could significantly harm its operating results |
| The Company faces substantial competition in its markets |
| The Company faces competition from hundreds of electronic component distributors of various sizes, locations, and market focuses as well as original equipment manufacturers, in each case for new products and replacement parts |
| Some of its competitors have significantly greater resources and broader name recognition than it |
| As a result, these competitors may be better able to withstand changing conditions within its markets and throughout the economy as a whole |
| In addition, new competitors could enter its markets |
| 13 ______________________________________________________________________ [34]Table of Contents Engineering capability, vendor representation, and product diversity create segmentation among distributors |
| The Company’s ability to compete successfully will depend on its ability to provide engineered solutions, maintain inventory availability and quality, and provide reliable delivery at competitive prices |
| To the extent the Company does not keep pace with technological advances or fails to timely respond to changes in competitive factors in its industry, it could lose market share or experience a decline in its revenue and net income |
| In addition, gross margins in the businesses in which it competes have declined in recent years due to competitive pressures and may continue to decline |
| If the Company does not continue to reduce its costs, it may not be able to compete effectively in its markets |
| The success of the Company’s business depends, in part, on its continuous reduction of costs |
| The electronic component industries have historically experienced price erosion and will likely continue to experience such price erosion |
| If the Company is not able to reduce its costs sufficiently to offset future price erosion, its operating results will be adversely affected |
| The Company has recently engaged in various cost-cutting and other initiatives intended to reduce costs and increase productivity |
| In an effort to reduce the Company’s global operating costs related to logistics, selling, general, and administrative expenses and to better align its operating and tax structure on a global basis, the Company has now begun to implement a global restructuring plan |
| This plan is intended to substantially reduce corporate and administrative expense, decrease the number of warehouses, and streamline the entire organization |
| Over the next fiscal year, the Company will be implementing a more tax-effective supply chain structure for Europe and Asia/Pacific, restructuring its Latin American operations, and reducing the total workforce which includes eliminating and restructuring layers of management |
| The total restructuring and severance costs to implement the plan are estimated to be dlra6dtta0 million, of which dlra2dtta7 million of severance costs were recorded in the fourth quarter of fiscal 2006 and the balance will be incurred in fiscal 2007 as the plan is implemented |
| The Company expects to realize the full impact of the cost savings from the restructuring plan in fiscal 2008 |
| The Company cannot ensure that it will not incur further charges for restructuring as it continues to seek cost reduction initiatives |
| Alternatively, the Company cannot ensure that it will be able to continue to reduce its costs |
| If the Company cannot fully implement its restructuring plan or cannot implement its plan within the expected time period, it may not realize the expected cost savings |
| Because the Company generally does not have long-term contracts with its vendors, it may experience shortages of products that could harm its business and customer relationships |
| The Company generally does not have long-term contracts or arrangements with any of its vendors that guarantee product availability |
| The Company cannot ensure that its vendors will meet its future requirements for timely delivery of products of sufficient quality or quantity |
| Any difficulties in the delivery of products could harm its relationships with customers and cause it to lose orders that could result in a material decrease in its revenues |
| Further, the Company competes against certain of its vendors and its relationship with those vendors could be harmed as a result of this competition |
| The Company’s EDG is dependent on a limited number of vendors to supply it with essential products |
| Electron tubes and certain other products supplied by EDG are currently produced by a relatively small number of manufacturers |
| The Company’s future success will depend, in large part, on maintaining current vendor relationships and developing new relationships |
| The Company believes that vendors supplying products to some of the product lines of EDG are consolidating their distribution relationships or exiting the business |
| The five largest suppliers to EDG by percentage of overall EDG purchases in fiscal 2006 were Communications & Power Industries, Inc, Covimag SA, New Japan Radio Co |
| These suppliers accounted for approximately 61prca of the overall EDG purchases in fiscal 2006 |
| The loss of one or more of the Company’s key vendors and the failure to find new vendors could significantly harm its business and results of operations |
| The Company has in the past and may in the future experience difficulties obtaining certain products in a timely manner |
| The inability of suppliers to provide it with the required quantity or quality of products could significantly harm its business |
| The Company maintains a significant investment in inventory and has incurred significant charges for inventory obsolescence and overstock, and may incur similar charges in the future |
| The Company maintains significant inventories in an effort to ensure that customers have a reliable source of supply |
| The market for many of its products is characterized by rapid change as a result of the development of new technologies, particularly in the semiconductor markets served by RFPD, evolving industry standards, and frequent new product introductions by some of its customers |
| The Company does not have many long-term supply contracts with its customers |
| Generally, the Company’s product sales are made on a purchase-order basis, which permits its customers to reduce or discontinue their purchases |
| If the Company fails to anticipate the changing needs of its customers and accurately forecast their requirements, its customers may not continue to place orders with the Company and the Company may accumulate significant inventories of products which it will be unable to sell or return to its vendors, or which may decline in value substantially |
| In fiscal 2002, the Company recorded a pre-tax provision for inventory obsolescence and overstock of dlra15dtta3 million, or dlra9dtta8 million net of tax, due to an industry-wide decline in sales, a prolonged recovery period, and changes in its mix of business toward higher technology products, particularly in the telecommunications market |
| In fiscal 2003, the Company recorded an additional pre-tax provision of dlra13dtta8 million, or dlra8dtta8 million net of tax, primarily for inventory obsolescence, overstock, and shrinkage, to write-down inventory to net realizable value as it sought to align its inventory and cost structure to then current sales levels amid continued economic slowdown and limited visibility |
| While the Company did not incur any material provisions for inventory in fiscal 2004 and 2006 incremental inventory write-down charges of dlra0dtta9 million were recorded during fiscal 2005 related to restructuring actions and certain product lines were discontinued |
| The Company cannot ensure that similar charges will not be incurred in the future |
| The Company may not be able to continue to make the acquisitions necessary for it to realize its growth strategy or integrate acquisitions successfully |
| One of the Company’s growth strategies is to increase its sales and expand its markets through acquisitions |
| Since 1980, the Company has acquired 37 companies or significant product lines and expects to continue making acquisitions if appropriate opportunities arise in its industry |
| The Company may not be able to identify and successfully negotiate suitable acquisitions, obtain financing for future acquisitions on satisfactory terms, or otherwise complete future acquisitions |
| Furthermore, the Company may compete for acquisition and expansion opportunities with companies that have substantially greater resources than it |
| Following acquisitions, the acquired companies may encounter unforeseen operating difficulties and may require significant financial and managerial resources that would otherwise be available for the ongoing development or expansion of its existing operations |
| If the Company is unable to successfully identify acquisition candidates, complete acquisitions, and integrate the acquired businesses with its existing businesses, its business, results of operations, and financial condition may be materially and adversely affected, and it may not be able to compete effectively within its industry |
| Economic, political, and other risks associated with international sales and operations could adversely affect the Company’s business |
| In fiscal 2006, 62dtta5prca of the Company’s sales were made outside the US and 32dtta4prca of the Company’s purchases of products were from suppliers located outside the US The Company anticipates that it will continue to expand its international operations to the extent that suitable opportunities become available |
| Accordingly, the 15 ______________________________________________________________________ [36]Table of Contents Company’s future results of operations could be harmed by a variety of factors which are not present for companies with operations and sales predominantly within the US, including: • changes in a specific country’s or region’s political or economic conditions, particularly in emerging markets, including the possibility of military action or other hostilities and confiscation of property; • increases in trade protection measures and import or export licensing requirements; • changes in tax laws and international tax treaties; • restrictions on its ability to repatriate investments and earnings from foreign operations; • difficulty in staffing and managing widespread operations; • differing labor regulations; • differing levels of protection of intellectual property; • changes in regulatory requirements; • shipping costs and delays; or • difficulties in accounts receivable collection |
| If any of these risks materialize, the Company could face substantial increases in costs, the reduction of profit, and the inability to do business |
| The Company’s success depends on its executive officers and other key personnel The Company’s future success depends to a significant degree on the skills, experience, and efforts of its executive officers and other key personnel |
| The loss of the services of any of its executive officers, particularly Edward J Richardson, its chairman of the board and chief executive officer could significantly harm its business and results of operations |
| The Company’s future success will also depend on its ability to attract and retain qualified personnel, including technical and engineering personnel |
| Competition for such personnel is intense, and the Company cannot assure that it will be successful in retaining or attracting such persons |
| The failure to attract and retain qualified personnel could significantly harm its operations |
| Changes in accounting standards regarding stock option plans, which the Company is required to adopt for its fiscal 2007, could limit the desirability of granting stock options, which could harm the Company’s ability to attract and retain employees, and could also negatively impact its results of operations |
| On December 16, 2004, the Financial Accounting Standards Board issued SFAS Nodtta 123(R), Share Based Payment, which requires all companies to treat the fair value of stock options granted to employees as an expense |
| As a result of SFAS Nodtta 123(R), beginning in the first quarter of fiscal 2007, the Company is required to record compensation expense equal to the fair value of each stock option granted |
| This change in accounting standards reduces the attractiveness of granting stock options because of the additional expense associated with these grants, which would negatively impact the Company’s results of operations |
| Nevertheless, stock options are an important employee recruitment and retention tool, and the Company may not be able to attract and retain key personnel if it reduces the scope of its employee stock option program |
| Accordingly, as a result of the requirement to expense stock option grants, the Company’s future results of operations would be negatively impacted, as would its ability to use stock options as an employee recruitment and retention tool |
| The Company has significant debt, which could limit its financial resources and ability to compete and may make it more vulnerable to adverse economic events |
| At June 3, 2006, the Company’s total debt was approximately dlra126dtta8 million, including its outstanding convertible notes |
| The Company has incurred and will likely continue to incur indebtedness to fund potential 16 ______________________________________________________________________ [37]Table of Contents future acquisitions, for strategic initiatives, to purchase inventory, and for general corporate purposes |
| Although the Company believes that the cash flow generated by its continuing operations, supplemented as necessary with funds available under credit arrangements is sufficient to meet its repayment obligations for the fiscal year ended June 2, 2007, the Company cannot ensure that this will be the case |
| The Company’s incurrence of additional indebtedness could have important consequences |
| For example, it could: • increase the Company’s vulnerability to general adverse economic and industry conditions; • require the Company to dedicate a substantial portion of its cash flow from operations to payments on its indebtedness, thereby reducing the availability of its cash flow to fund working capital, capital expenditures, acquisitions, engineering efforts, and other general corporate purposes, as well as to pay dividends; • limit the Company’s flexibility in planning for, or reacting to, changes in its business and the industry in which it operates; • place the Company at a competitive disadvantage relative to its competitors who have less debt; or • limit, along with the financial and other restrictive covenants in its indebtedness, the Company’s ability to borrow additional funds which could affect its ability to make future acquisitions, among other things |
| The Company’s ability to service its debt and meet its other obligations depends on a number of factors beyond its control |
| At June 3, 2006, the Company’s total debt was approximately dlra126dtta8 million, resulting in a debt-to-equity ratio of 129prca, and primarily consisted of: • dlra25dtta0 million aggregate principal amount of its 8prca convertible senior subordinated notes (8prca notes), which bear interest at a rate of 8prca per year payable on June 15 and December 15 and mature on June 15, 2011, subject to an additional 1prca as a result of failing to register the 8prca notes by March 21, 2006; • dlra44dtta7 million aggregate principal amount of its 7^ 3/4prca convertible senior subordinated notes (7^ 3/4prca notes), which bear interest at a rate of 7^ 3/4prca per year payable on June 15 and December 15 and mature on December 15, 2011; and • dlra57dtta1 million principal amount of indebtedness under the Company’s multi-currency revolving credit agreement (credit agreement), which expires on October 29, 2009, bears interest at London Interbank Offered Rate (LIBOR), plus a margin varying with certain financial performance criteria |
| The interest rate was 6dtta92prca at June 3, 2006 |
| The debt-to-equity ratio has been calculated based on the Company’s balance sheet dated June 3, 2006 |
| The Company’s ability to service its debt and meet its other obligations as they come due is dependent on its future financial and operating performance |
| This performance is subject to various factors, including factors beyond the Company’s control such as changes in global and regional economic conditions, changes in its industry or the end markets for its products, changes in interest or currency exchange rates, inflation in raw materials, energy and other costs |
| If the Company’s cash flow and capital resources are insufficient to enable it to service its debt and meet these obligations as they become due, the Company could be forced to: • reduce or delay capital expenditures; • sell assets or businesses; • limit or discontinue, temporarily or permanently, business plans or operations; • obtain additional debt or equity financing; or • restructure or refinance debt |
| 17 ______________________________________________________________________ [38]Table of Contents The Company cannot ensure the timing of these actions or the amount of proceeds that could be realized from them |
| Accordingly, the Company cannot ensure that it will be able to meet its debt service and other obligations as they become due or otherwise |
| The Company’s credit agreement and the indentures for its outstanding notes impose restrictions with respect to various business matters |
| The Company’s credit agreement contains numerous restrictive covenants that limit the discretion of management with respect to certain business matters |
| These covenants place restrictions on, among other things, the Company’s ability to incur additional indebtedness, to create liens or other encumbrances, to pay dividends or make other payments in respect of its shares of common stock and Class B common stock, to engage in transactions with affiliates, to make certain payments and investments, to merge or consolidate with another entity, and to repay indebtedness junior to indebtedness under the credit agreement |
| The credit agreement also contains a number of financial covenants that require the Company to meet certain financial ratios and tests relating to, among other things, tangible net worth, a borrowing base, senior funded debt to cash flow, and annual debt service coverage |
| In addition, the indentures for its outstanding notes contain covenants that limit, among other things, its ability to incur additional indebtedness |
| If the Company fails to comply with the obligations in the credit agreement and indentures, it could result in an event of default under those agreements |
| If an event of default occurs and is not cured or waived, it could result in acceleration of the indebtedness under those agreements, any of which could significantly harm its business and financial condition |
| The Company was not in compliance with certain financial covenants of the Company’s credit agreement for the quarters ended March 4, 2006, September 3, 2005, and May 28, 2005, and may not be able to comply with these financial covenants in the future |
| For the quarter ended March 4, 2006, the Company was not in compliance with credit agreement covenants with respect to the leverage ratio, fixed charge coverage ratio, and tangible net worth covenants |
| On August 4, 2006, the Company received a waiver from its lending group for the default and executed an amendment to the credit agreement |
| In addition, the amendment also (i) permitted the purchase of dlra14dtta0 million of the 8prca notes; (ii) adjusted the minimum required fixed charge coverage ratio for the first quarter of fiscal 2007; (iii) adjusted the minimum tangible net worth requirement; (iv) permitted certain sales transactions contemplated by the Company; (v) eliminated the Company’s Sweden Facility; (vi) reduced the Company’s Canada Facility by approximately dlra5dtta4 million; (vii) changed the definition of “Adjusted Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)” for covenant purposes; and (viii) provided that the Company maintain excess availability on the borrowing base of not less than dlra20dtta0 million until the Company filed its Form 10-Q for the quarter ended March 4, 2006, at which time the Company will maintain excess availability of the borrowing base of not less than dlra10dtta0 million |
| For the quarter ended September 3, 2005, the Company was not in compliance with credit agreement covenants with respect to the tangible net worth covenant due solely to the additional goodwill recorded as a result of the Kern acquisition |
| On October 12, 2005, the Company received a waiver from its lending group for the default and executed an amendment to the credit agreement |
| The amendment changed the minimum tangible net worth requirement to adjust for the goodwill associated with the Kern acquisition |
| For the quarter ended May 28, 2005, the Company was not in compliance with its credit agreement covenant with respect to the fixed charge coverage ratio |
| On August 24, 2005, the Company received a waiver from the Company’s lenders for the default and executed an amendment to the credit agreement |
| The amendment changed the maximum permitted leverage ratios and the minimum required fixed charge coverage ratios for each of the first three quarters of fiscal 2006 to provide the Company additional flexibility for these periods |
| As more fully described in Note B to the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K/A (Amendment Nodtta 2) for the fiscal year ended May 28, 2005, as a result of errors 18 ______________________________________________________________________ [39]Table of Contents discovered by the Company, the consolidated financial statements for fiscal 2005, 2004, and 2003 have been amended and restated to correct these errors |
| As a result, the Company would not have been in compliance with its tangible net worth covenant for the third quarter of fiscal 2005 and its leverage ratio and tangible net worth covenants as of the end of fiscal 2005 |
| On August 4, 2006, the Company received a waiver from its lending group for defaults arising from the restatement and executed an amendment to the credit agreement |
| In the event that the Company fails to meet a financial covenant in the future, the Company may not be able to obtain the necessary waivers or amendments to remain in compliance with the credit agreement and the Company’s lenders may declare a default and cause all of the Company’s outstanding indebtedness under the credit agreement to become immediately due and payable |
| If the Company is unable to repay any borrowings when due, the lenders under the credit agreement could proceed against their collateral, which includes most of the assets the Company owns |
| In addition, any default under the Company’s credit agreement could lead to an acceleration of debt under other debt instruments that contain cross acceleration or cross-default provisions |
| If the indebtedness under the Company’s credit agreement and the Company’s other debt instruments is accelerated, the Company may not have sufficient assets to repay amounts due under the Company’s credit agreement or indebtedness under the Company’s other debt instruments |
| The Company is exposed to foreign currency risk |
| The Company expects that international sales will continue to represent a significant percentage of its total sales, which expose it to currency exchange rate fluctuations |
| Since the revenues and expenses of the Company’s foreign operations are generally denominated in local currencies, exchange rate fluctuations between local currencies and the US dollar subject the Company to currency exchange risks with respect to the results of its foreign operations to the extent it were unable to denominate its purchases or sales in US dollars or otherwise shift to its customers or suppliers the risk of currency exchange rate fluctuations |
| The Company currently does not engage in any significant currency hedging transactions |
| Fluctuations in exchange rates may affect the results of its international operations reported in US dollars and the value of such operations’ net assets reported in US dollars |
| Additionally, its competitive position may be affected by the relative strength of the currencies in countries where its products are sold |
| The Company cannot predict whether foreign currency exchange risks inherent in doing business in foreign countries will have a material adverse effect on its operations and financial results in the future |
| If the Company does not maintain effective internal controls over financial reporting, it could be unable to provide timely and reliable financial information |
| As disclosed in the Company’s Management’s Report on Internal Control over Financial Reporting in Part II, Item 9A, “Controls and Procedures” of this Form 10-K, during fiscal 2005, the Company reported four material weaknesses in its internal control over financial reporting |
| A material weakness is a deficiency in internal control over financial reporting that results in more than a remote likelihood that a material misstatement of annual or interim financial statements will not be prevented or detected |
| The identified weaknesses were as follows: • ineffective Company level controls • inadequate controls associated with the accounting for income taxes • inadequate financial statement preparation and review procedures • inadequate policies and procedures to ensure the appropriate application of Financial Standards Board Statement Nodtta 52, Foreign Currency Translation During fiscal 2006, the Company successfully remediated three out of the four material weaknesses it identified as of May 28, 2005 |
| As of June 3, 2006, the Company continued to have a material weakness in internal controls associated with the accounting for income taxes |
| There can be no assurance that material deficiencies will not be identified in the future |
| Any failure to remediate material weaknesses in the future could have a material adverse effect on our business, results of operations, or financial condition |
| Furthermore, it is uncertain what impact an adverse opinion or a disclaimed opinion regarding internal controls would have upon the Company’s stock price or business |