ZIGO Zygo Corp. (MM)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

( Amounts in thousands, except share and per share amounts )

Note 1: Accounting Policies

Basis of Presentation and Principles of Consolidation

Zygo Corporation is a worldwide supplier of optical metrology instruments, precision optics, and electro-optical design and manufacturing services, serving customers in the semiconductor capital equipment, research, defense, life sciences and industrial markets. The accompanying condensed consolidated financial statements include the accounts of Zygo Corporation and its subsidiaries (“Zygo,” “we,” “us,” “our” or “the Company”). The Company follows accounting principles generally accepted in the United States of America (“US GAAP”). Zygo’s reporting currency is the U.S. dollar. The functional currencies of our foreign subsidiaries are their local currencies; and amounts included in the condensed consolidated statements of operations are translated at the weighted-average exchange rates for the period. Assets and liabilities are translated at period-end exchange rates, and resulting foreign exchange translation adjustments are recorded in the condensed consolidated balance sheets as a component of accumulated other comprehensive income. All transactions and accounts with the subsidiaries are eliminated from the condensed consolidated financial statements. The results of operations for the three and nine month periods ended March 31, 2014 are not necessarily indicative of the results to be expected for the full fiscal year.

In management’s opinion, the accompanying condensed consolidated balance sheets and condensed consolidated interim statements of income, comprehensive income, and cash flows include all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the results of the interim periods. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in our Annual Report on Form 10-K for the year ended June 30, 2013, including items incorporated therein by reference.

Adoption of new Accounting Pronouncements

In July 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-10, Derivatives and Hedging: Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (a consensus of the FASB Emerging Issues Task Force) . FASB Accounting Standards Codification (“ASC”) 815 provides guidance on the risks that are permitted to be hedged in a fair value or cash flow hedge. Among those risks for financial assets and financial liabilities is the risk of changes in a hedged item’s fair value or a hedged transaction’s cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk). In the United States, currently only the interest rates on direct Treasury obligations of the U.S. government (“UST”) and, for practical reasons, the London Interbank Offered Rate (“LIBOR”) swap rate are considered benchmark interest rates. The ASU permits the Overnight Index Swap Rate (“OIS”) to be used as a U.S. benchmark interest rate for hedge accounting purposes under FASB ASC 815, in addition to UST and LIBOR and also removes the restriction on using different benchmark rates for similar hedges. The update is effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. The adoption of this guidance in the first quarter of fiscal 2014 did not have a material impact on our condensed consolidated financial statements and is not expected to have a material impact on future financial statements.

Recent Accounting Guidance Not Yet Adopted

In July 2013, FASB issued ASU No. 2013-11, Income Taxes: Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (a consensus of the FASB Emerging Issues Task Force) . FASB ASC 740, Income Taxes , does not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. There is diversity in practice in the presentation of unrecognized tax benefits in those instances. Some entities present unrecognized tax benefits as a liability unless the unrecognized tax benefit is directly associated with a tax position taken in a tax year that results in, or that resulted in, the recognition of a net operating loss or tax credit carryforward for that year, and the net operating loss or tax credit carryforward has not been utilized. Other entities present unrecognized tax benefits as a reduction of a deferred tax asset for a net operating loss or tax credit carryforward in certain circumstances. The objective of ASU 2013-11 is to eliminate that diversity in practice.

Under ASU 2013-11, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position, or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist at the reporting date and should be made presuming disallowance of the tax position at the reporting date. The update should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The update is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The effective date for Zygo is the first quarter of fiscal year 2015, unless earlier adopted. We are currently evaluating this guidance but do not expect its adoption to have a material effect on our condensed consolidated financial statements.

Reclassifications

Certain amounts included in the condensed consolidated balance sheets for the prior year have been reclassified to conform with the current year presentation of “Deferred income taxes” long term liability. In fiscal 2013, “Deferred income taxes” current liability of $123 was reported as a component of other accrued expenses in the condensed consolidated balance sheet. In fiscal 2014, deferred income taxes is presented separately for March 31, 2013 and June 30, 2013.

Note 2: Weighted Average Shares Outstanding

For the three and nine months ended March 31, 2014, outstanding stock options and restricted stock awards for an aggregate of 352,347 shares and 407,420 shares, respectively, (for the three and nine months ended March 31, 2013, outstanding stock options and restricted stock awards for an aggregate of 361,938 shares and 230,791 shares, respectively) of the Company’s common stock were excluded from the calculation of diluted earnings per share because they were antidilutive.

The following table sets forth the reconciliation of basic weighted average shares outstanding and diluted weighted average shares outstanding for the periods presented:

Note 4: Marketable Securities

Marketable securities as of March 31, 2014 consisted of a mutual fund investment comprised primarily of corporate securities classified as a trading security corresponding to elections made in our deferred compensation program. Dividend and interest income are recognized when earned. Straight-line amortization related to discounts and premiums on the purchase of marketable securities is recorded in interest income. Realized gains and losses are included in net income and are derived using the specific identification method for determining the cost of securities sold.

We make quarterly distributions in accordance with the deferred compensation program agreement. The following table sets forth the beginning balance at July 1, 2013 and 2012, of gross unrealized gains and losses, contributions, redemptions and fair value of trading securities at March 31, 2014 and 2013:

Note 5.  Fair Value Measurements   

Fair value measurement disclosures utilize a valuation hierarchy for determining the grouping of the inputs used. This hierarchy prioritizes the inputs into three broad levels. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on management’s assumptions used to measure assets and liabilities at fair value. A financial asset or liability classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. 

The Company uses quoted market prices to determine the fair value of its assets and liabilities included in Level 1. When quoted market prices are unobservable, the Company uses quotes from independent pricing vendors based on recent trading activity and other relevant information for similar products. The carrying value of other financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities, approximates fair value due to their short maturities.

The following tables provide the assets and liabilities carried at fair value measured on a recurring basis as of March 31, 2014 and June 30, 2013:

Note 6: Share-Based Payments

We recorded share-based compensation expense for the three months ended March 31, 2014 and 2013 of $1,136 and $1,479, respectively, with related tax benefits of $ 426 and $529, respectively. For the nine months ended March 31, 2014 and 2013, we recorded share-based compensation expense of $3,958 and $4,235, respectively, with related tax benefits of $1,486 and $1,524, respectively.

Stock Options

We use the Black-Scholes option-pricing model to calculate the fair value of stock option awards. The key assumptions for this valuation method include the expected term of the option, stock price volatility, risk-free interest rate, dividend yield and exercise price. Many of these assumptions are judgmental and highly sensitive in the determination of compensation expense.

Under the assumptions indicated below, the weighted-average fair value of stock option grants for the three months ended March 31, 2013 was $9.45. The weighted-average fair value of stock option grants for the nine months ended March 31, 2014 and 2013 was $8.55 and $12.64, respectively. There were no stock options granted for the three months ended March 31, 2014. During the three months ended March 31, 2013, we granted stock options aggregating 50,000 shares of common stock. During the nine months ended March 31, 2014 and 2013, we granted stock options aggregating 169,738 and 172,934 shares of common stock, respectively.

The table below indicates the key assumptions used in the option valuation calculations for options granted in the periods presented:

Restricted Stock

Our share-based compensation expense also includes the effects of the issuance of restricted stock units. The compensation expense related to restricted stock awards is determined based on the market price of our stock at the date of grant applied to the total number of shares anticipated to fully vest, which is then amortized over the expected term. There were no shares of restricted stock issued during the three months ended March 31, 2014 and 2013. During the nine months ended March 31, 2014 and 2013, an aggregate of 213,915 and 162,901 shares, respectively, of restricted stock units were issued at a weighted average stock price at date of grant of $14.42 and $18.49, respectively. Generally, the restrictions on the restricted stock units granted to employees prior to January 1, 2011 lapse at a rate of 50% on the three-year anniversary and the remaining 50% on the fourth year anniversary. Restrictions on restricted stock units granted to employees after January 1, 2011 lapse at a rate of 25% each year.

Note 9: Property, Plant and Equipment

Property, plant and equipment are stated at cost less depreciation and impairments. Maintenance and repairs are charged to expense as incurred. Management evaluates, on an ongoing basis, the carrying value of property, plant and equipment and makes adjustments when impairments are identified. Depreciation is based on the estimated useful lives of the various classes of assets and is computed using the straight-line method. The following table sets forth the components of property, plant and equipment at March 31, 2014 and June 30, 2013:

Depreciation expense was $1,335 and $1,193 for the three months ended March 31, 2014 and 2013, respectively, and $3,864 and $3,537, respectively, for the nine months ended March 31, 2014 and 2013.

Note 10: Warranty

A limited warranty is provided on our products for periods ranging from 3 to 12 months, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires management to make estimates of product return rates and expected costs to repair or replace products under warranty. If actual return rates or repair and replacement costs, or both, differ significantly from management estimates, adjustments to the expense will be required.

The following table is a reconciliation of the beginning and ending balances of the accrued warranty liability, which is included in “Other accrued expenses” in the condensed consolidated balance sheets:

Note 11: Intangible Assets

Intangible assets includes patents, customer relationships and technology. The cost of patents and customer relationships and technology is amortized on a straight-line basis over estimated useful lives ranging from 3-17 years.

The following table sets forth the components of intangible assets, as of March 31, 2014 and June 30, 2013:

Amortization expense related to intangibles of $199 and $211 for the three months ended March 31, 2014 and 2013, respectively, and $598 and $650 for the nine months ended March 31, 2014 and 2013, respectively is included in “Cost of goods sold” and “Selling, general and administrative expenses” in the condensed consolidated statements of operations.

Based on the carrying amount of the intangible assets as of March 31, 2014, the estimated future amortization expense is as follows:

Note 12: Segment and Major Customer Information

Our business is organized into two operating divisions and reporting segments – Metrology Solutions and Optical Systems. The Metrology Solutions segment includes 3-Dimensional surface metrology products, precision positioning systems and custom-engineered solutions used in the semiconductor capital equipment, research, defense and industrial markets. The Optical Systems segment designs, develops and manufactures high precision optical components and electro-optical systems used in the semiconductor capital equipment, defense, life sciences and research markets. The chief operating decision-maker uses this information to allocate resources.

The following table sets forth segment net revenue, gross profit and gross margin for the three and nine months ended March 31, 2014 and 2013:

Separate financial information by segment for total assets, capital expenditures and depreciation and amortization is not evaluated by our chief operating decision-maker. Substantially all of our operating expenses, assets and depreciation and amortization are U.S.-based.

The following table sets forth revenue by geographic area:

Revenue from one customer in the Metrology Solutions Segment accounted for 12% of net revenue for the three months ended March 31, 2014. Revenue from two customers in the Metrology Solutions Segment accounted for 16% and 10% of net revenue for the nine months ended March 31, 2014. These revenues related primarily to the shipments of precision positioning systems. Revenue from one customer in the Metrology Solutions segment amounted to 11% of net revenue for the three months ended March 31, 2013. No customer accounted for over 10% of our revenue for the nine months ended March 31, 2013.

Note 13: Transactions with Shareholder

Revenue from Canon Inc., a shareholder, and Canon Sales Co. Inc., a distributor of certain of our products in Japan and a subsidiary of Canon Inc. (collectively referred to as “Canon”), amounted to $4,781 and $3,694 (12% and 11% of net revenue, respectively) for the three months ended March 31, 2014 and 2013, respectively. For the nine months ended March 31, 2014 and 2013, revenues from Canon amounted to $12,789 and $9,362 (10% and 9% of net revenue, respectively). Selling prices of products sold to Canon are based, generally, on the terms customarily given to distributors. At March 31, 2014 and June 30, 2013, there were, in the aggregate, $1,658 and $1,771, respectively, of trade accounts receivable from Canon.

Note 14: Derivatives and Hedging Activities

We enter into foreign currency forward contracts to reduce the impact of adverse fluctuations on earnings associated with foreign currency exchange rate changes. We do not enter into any derivative transactions for speculative purposes.

Most derivative contracts are used as hedging instruments but do not qualify for hedge accounting treatment under authoritative guidance on accounting for derivative instruments and hedging activities. These non-qualifying derivative contracts are entered into for periods consistent with the currency transaction exposures from the point of shipment to the point of collection, generally three to six months, and are marked-to-market with changes in fair value recorded in the condensed consolidated statements of operations in Other miscellaneous income (expense), net. Any gains and losses on the fair value of these derivative contracts would largely offset corresponding foreign currency losses and gains on the underlying transactions.

In the case of derivative contracts used as hedges for significant orders with shipping dates that may extend more than six months in the future, we may designate those derivative contracts as cash flow hedges that qualify as hedging instruments under authoritative guidance on accounting for derivative instruments and hedging activities. These qualifying derivative contracts are entered into for periods consistent with the currency transaction exposures from the order date through shipment and collection. For these cash flow hedges, any gains or losses on the fair value of these contracts would be charged to the account accumulated other comprehensive income (“AOCI”) and subsequently relieved to net revenue upon shipment to the customer. In addition, at the point of shipment to the customer, the cash flow hedge will be de-designated, with any future gains or losses from that point forward charged to Other miscellaneous income (expense), net. Those gains and losses would be expected to largely offset corresponding losses and gains on the underlying receivable transactions. In the case where a designated cash flow hedge is accounted for under the spot method, a portion of the adjustment that would otherwise be accounted for in AOCI would be charged to Other miscellaneous income (expense), net and would not be offset by any corresponding gains or losses on an underlying transaction up to the point of shipment or revenue recognition.

Derivatives not designated as hedging instruments.

As of March 31, 2014, we had four foreign currency forward contracts outstanding involving our German operations with notional amounts aggregating $1,205. These foreign currency hedges are not designated as hedging instruments. Net unrealized gains recognized from foreign currency forward contracts for the three months ended March 31, 2014 and 2013 were $19 and $47, respectively. For the nine months ended March 31, 2014 and 2013, net unrealized gains (losses) recognized from foreign currency forward contracts were ($115) and $263, respectively. These gains and losses are substantially offset by foreign exchange losses and gains on intercompany balances recorded by our subsidiaries and were included in Other miscellaneous income (expense), net in the condensed consolidated statements of operations.

The following table summarizes the fair value of derivative instruments as of March 31, 2014 and June 30, 2013.

Derivative designated as a hedging instrument

As of March 31, 2014, we had one foreign currency forward contract outstanding involving our Japanese operations with a notional amount of $6,504 to protect against foreign currency fluctuations for current transactions and longer term orders denominated in Japanese Yen.

This foreign currency hedge is designated as a hedging instrument qualifying as a cash flow hedge utilizing a window forward approach used in situations where multiple shipments occur over a period of time. The cash flow hedge is in effect for the period of April 2013 through June 2014. The cash flow hedge is evaluated quarterly to ensure that hedge accounting treatment still applies.

The window forward approach provides for the use of the spot method to determine the amount to be included in AOCI. This method requires current period expensing of the impact in changes to the forward rates while allowing the changes in the spot rate to be recorded in AOCI. At the time the various shipments occur, AOCI is relieved for a pro-rata amount of the basis which is reclassified to net revenue in the condensed consolidated statements of operations. Concurrently, that portion of the hedge related to current shipments is de-designated as a cash flow hedge for accounting purposes and any future changes in fair value related to that portion of the hedge is included in Other miscellaneous income (expense), net in the condensed consolidated statements of operations. These gains and losses from the de-designated portion of the hedge are substantially offset by foreign exchange losses and gains on balances recorded by our subsidiary.

Net unrealized gains (losses) recognized from the ineffective portion of the cash flow hedge for the three and nine months ended March 31, 2014 was $1 and $65, respectively, and the de-designated portions of the hedge for the same periods were ($222) and $309, respectively, included in Other miscellaneous income (expense), net in the condensed consolidated statements of operations. Amounts reclassified from AOCI to revenue based on shipments to customers resulted in increases in net revenue of $125 and $363 for the three and nine months ended March 31, 2014, respectively. Any remaining amounts that were in AOCI during the current quarter have been reclassified into net revenue.

The following table summarizes the foreign exchange cash flow hedge value as of March 31, 2014 and June 30, 2013:

Income tax expense for the nine months ended March 31, 2014 resulted in an annual effective tax rate of 37%, similar to the annualized effective tax rate for the prior year, after giving effect to the prior year adjustments described below. The current year income tax calculation includes estimated United States federal research and development credits for the first six months of the year. The federal research and development credit expired on December 31, 2013, and no research and development credits are included in the tax calculation for the three months ended March 31, 2014. The prior year tax calculation for the three and nine months ended March 31, 2013 included estimated research and development credits for the nine month period. The research and development credit had expired at December 31, 2012 and was renewed on January 1, 2013 for a one year period.

The Company is subject to U.S. federal income tax, as well as income tax in multiple state and foreign jurisdictions. The Company is subject to U.S. federal income tax audit or tax adjustments for years ended June 30, 2000 and later because there are net operating losses (“NOL”) and credit carryforwards attributable to those years. Those years are subject to audit at the time the NOLs or credits available from those years are utilized. The Company is no longer subject to state and foreign income tax audit or tax adjustments for years prior to June 30, 2006.

In the normal course of business, we analyze for uncertain tax positions and adjust unrecognized tax benefits or liabilities accordingly. For the three and nine months ended March 31, 2014, we recognized additional liabilities for uncertain tax positions of $39 and $231, respectively. We are not aware of any tax positions that would create a material adjustment to unrecognized tax benefits during the next twelve months.

As previously reported, the Company has been undergoing a review of its tax accounts using third party advisors. As a result of that review, the Company reported that subsequent to the issuance of the financial information for the third fiscal quarter ended March 31, 2013, the Company’s management identified the following errors within the Company’s accounting for income taxes, which the Company determined to be immaterial to the financial information previously reported:

The Company’s management has evaluated the impact of these errors on the previously reported financial information on the basis of quantitative and qualitative considerations and does not believe the errors are material to the previously-issued financial information.  However, because correction of these amounts in the current period would be significant to the current statement of operations, they have been corrected by immaterial restatement of the previously-reported amounts. The table below provides a reconciliation of the restated balances to the amounts previously reported:

(Amounts in thousands, except per share amounts)

Note 16: Commitments and Contingencies

On November 12, 2010, we completed a transaction with ASML US, Inc. (“ASML”) to purchase substantially all the assets of their Richmond, California operations. These assets were acquired for $12,475, of which $7,142 was in cash, and the balance was future consideration, with a then-net-present value of $5,333 using a discount factor of 14%, based on the level of shipments to ASML over the subsequent three years beginning January 1, 2011. On the acquisition date, the future consideration was recorded as a liability, with $1,127 recorded as a current liability and $4,206 recorded as a long-term liability. The future consideration represented a supply agreement that was entered into with ASML that provided for a volume discount on future purchases. The volume discount portion of the agreement expired on December 31, 2013.

From time to time we are subject to certain legal proceedings and claims that arise in the ordinary course of business.

We are aware of certain levels of environmental contamination that are below reportable levels on one of our properties. In addition, we are aware of certain contamination on an adjacent property that we formerly owned. The future effect of environmental matters, including potential liabilities, is often difficult to estimate. At this time, we are unable to determine or reasonably estimate the amount of costs, if any, that we might incur or for which we may potentially be responsible. Subsequent to March 31, 2014, Zygo executed an Indemnity and Release Agreement with the owner of the adjacent property, pursuant to which the Company has agreed to share equally in the cost of remediation, if any, up to an aggregate of $1,000 ($500 as the Company’s portion). We will record a reserve for the exposure related to the environmental contamination when it is both probable that a liability has been incurred, and the amount of any liability can be reasonably estimated, whether or not a claim has been asserted.