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TMCNet:  ANAREN INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[January 25, 2013]

ANAREN INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the condensed consolidated financial statements and the notes thereto appearing elsewhere in this Form 10-Q. The following condensed discussion, other than historical facts, contains forward-looking statements that involve a number of risks and uncertainties. The Company's results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including factors described elsewhere in this Quarterly Report on Form 10-Q and factors described in the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 2012.



Overview The condensed consolidated financial statements present the financial condition of the Company as of December 31, 2012 and June 30, 2012, and the consolidated results of operations and cash flows of the Company for the three and six months ended December 31, 2012 and 2011.

The Company designs, develops and markets microwave components and assemblies for the wireless communications, satellite communications and defense electronics markets. The Company's distinctive manufacturing and packaging techniques enable it to cost-effectively produce compact, lightweight microwave products for use in base stations and subscriber equipment for wireless communications as well as, in satellites and in defense electronics systems. The Company sells its products to leading wireless communications equipment manufacturers such as Ericsson, Nokia Siemens Networks, and Huawei, and to satellite communications and defense electronics companies such as Boeing Satellite, ITT, Lockheed Martin, Northrop Grumman and Raytheon.

Net sales generally are recognized when units are shipped. Net sales under certain long-term contracts of the Space & Defense Group, many of which provide for periodic payments, are recognized under the percentage-of-completion method based on units of delivery. Estimated manufacturing cost-at-completion for these contracts are reviewed on a routine periodic basis, and adjustments are made periodically to the estimated cost-at-completion based on actual costs incurred, progress made, and estimates of the costs required to complete the contractual requirements. When the estimated manufacturing cost-at-completion exceeds the contract value, the contract is written down to its net realizable value, and the loss resulting from cost overruns is immediately recognized. To properly match net sales with costs, certain contracts may have revenue recognized in excess of billings (unbilled revenues), and other contracts may have billings in excess of net sales recognized (billings in excess of contract costs). Under long-term contracts, the prerequisites for billing the customer for periodic payments generally involve the Company's achievement of contractually specific, objective milestones (e.g., completion of design, testing, or other engineering phase, delivery of test data or other documentation, or delivery of an engineering model or flight hardware).

The Company operates in the wireless communications, satellite communications and defense electronics markets all of which have been affected by the current economic climate and recession. The United States defense budget has a direct impact on the level of funding available for programs that the Company currently participates in or has targeted for future participation. We continue to assess the effect of the 2012/ 2013 defense budget on these programs and, to date have seen only minimal negative impact on our anticipated Space & Defense Group order rate. The economic downturn has negatively impacted the worldwide Wireless infrastructure market as the market has delayed or downsized system expansions and upgrades. Wireless Group sales have declined in the first six months of fiscal 2013, compared to the first six months of fiscal 2012 due to the softening of demand for standard components beginning in the fourth quarter of calendar 2011. Demand for consumer and infrastructure standard components has rebounded from the lowest levels of fiscal 2012 and the Company is cautiously optimistic about fiscal 2013 component shipment levels.

15 -------------------------------------------------------------------------------- Third Quarter of Fiscal 2013 Outlook For the third quarter of fiscal 2013, we anticipate comparable sales for the Wireless Group and an increase in sales for the Space & Defense Group compared to the second quarter levels. As a result, we expect net sales to be in the range of $37 to $41 million. We expect GAAP net earnings, inclusive of a tax benefit of approximately $0.09 per share related to of the impact of the reinstatement of the Federal Research and Experimentation credit retroactive to January 1, 2012, to be in the range of $0.29 - $0.37 per diluted share for the third quarter.

Results of Operations Net sales for the three months ended December 31, 2012 were $38.0 million, up 6.3% from sales of $35.7 million for the second quarter of fiscal 2012. Net income for the second quarter of fiscal 2013 was $3.5 million, or 9.2% of net sales, up $2.3 million from net income of $1.2 million in the second quarter of fiscal 2012.

The following table sets forth the percentage relationships of certain items from the Company's condensed consolidated statements of income as a percentage of net sales.

Three Months Ended Six Months Ended Dec. 31, 2012 Dec. 31, 2011 Dec. 31, 2012 Dec. 31, 2011 Net Sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of Sales 60.5 % 68.3 % 61.8 % 65.3 % Gross profit 39.5 % 31.7 % 38.2 % 34.7 % Operating Expenses: Marketing 6.3 % 6.8 % 6.4 % 6.8 % Research and development 8.5 % 8.7 % 8.5 % 9.4 % General and administrative 11.3 % 12.3 % 11.5 % 11.8 % Total operating expenses 26.1 % 27.8 % 26.4 % 28.0 % Operating income 13.4 % 3.9 % 11.8 % 6.7 % Other income (expense): Interest expense (0.2 )% (0.1 )% (0.1 )% (0.2 )% Other, primarily interest income 0.4 % 0.4 % 0.5 % 0.4 % Total other income 0.2 % 0.3 % 0.4 % 0.2 % Income before income tax expense 13.6 % 4.2 % 12.2 % 6.9 % Income tax expense 4.4 % 0.9 % 3.9 % 1.9 % Net income 9.2 % 3.3 % 8.3 % 5.0 % The following table summarizes the Company's net sales by operating segments for the periods indicated. Amounts are in thousands.

Three Months Ended Six months Ended Dec. 31, 2012 Dec. 31, 2011 Dec. 31, 2012 Dec. 31, 2011 Wireless $ 12,849 $ 10,793 $ 26,051 $ 29,007 Space and Defense 25,153 24,944 51,013 45,450 Total $ 38,002 $ 35,737 $ 77,064 $ 74,457 16-------------------------------------------------------------------------------- Three Months Ended December 31, 2012 Compared to Three Months Ended December 31, 2011 Net sales. Net sales were $38.0 million for the second quarter of fiscal 2013, up 6.3% compared to $35.7 million for the second quarter of fiscal 2012. Sales of Wireless Group products increased $2.1 million, or 19.0%, while sales of Space & Defense Group products rose $0.2 million, or 0.8%, in the current second quarter compared to the second quarter of fiscal 2012.

The increase in sales of Wireless Group products, which consist of standard components for use in building wireless base station and consumer equipment, was the result of the current rebound in worldwide demand for Wireless infrastructure components from the depressed levels experienced in the second and third quarter of fiscals 2012 due to declining orders from both European original equipment manufacturers (OEMs) and Asian contract manufacturers. Sales of Wireless Group products have rebounded approximately 20% in the current second quarter of fiscal 2013 compared to the Wireless Group sales of $10.8 million in the second quarter last year. Wireless Group quarterly sales are expected to remain relatively flat throughout fiscal 2013 based on current customer demand.

Space & Defense Group products consist of custom components and assemblies for commercial and military satellites, as well as radar, receiver, and countermeasure subsystems for the military. Sales of Space & Defense Group products rose $0.2 million, or 0.8% in the second quarter of fiscal 2013 compared to the second quarter of the previous fiscal year. Second quarter 2013 Space & Defense Group sales were comparable to sales in this group for the preceding last three quarters of fiscal 2012 and the first quarter of 2013. The current sales levels, compared to fiscal 2012 second quarter sales, reflects both the Space & Defense backlog levels of approximately $95 - $105 million during the past twelve months and the resolution of production and customer specification issues which has allowed for consistent quarterly Space & Defense Group product shipments over the trailing twelve month period. Quarterly Space & Defense Group sales are expected to exceed second quarter levels for the remainder of fiscal 2013.

Gross Profit. Cost of sales consists primarily of engineering design costs, materials, material fabrication costs, assembly costs, direct and indirect overhead, and test costs. Gross profit for the second quarter of fiscal 2013 was $15.0 million, (39.5% of net sales), up $3.7 million from $11.3 million (31.7% of net sales) for the same quarter of the prior year. Gross profit as a percent of sales increased significantly in the second quarter of fiscal 2013 from the second quarter of fiscal 2012 due to a more favorable product mix in both the Wireless and Space & Defense Groups, which resulted in a decline in material content in the current quarter compared to the second quarter last year.

Additionally, gross profit in the current second quarter was enhanced by lower payroll due to personnel reductions in the second quarter of fiscal 2012 and health care costs due to a significant improvement in large healthcare claim expenses in the Company's self-insured program in the current second quarter compared to last year.

Marketing. Marketing expenses consist mainly of employee related expenses, commissions paid to sales representatives, trade show expenses, advertising expenses and related travel expenses. Marketing expenses were $2.4 million (6.3% of net sales) for the second quarter of fiscal 2013, unchanged from $2.4 million (6.8% of net sales) for the second quarter of fiscal 2012. Marketing expenses in the current second quarter remained flat as reductions in consulting, advertising, and support costs in the current quarter were offset by higher commissions and personnel costs compared to the second quarter of fiscal 2012.

Research and Development. Research and development expenses consist of material, salaries and related overhead costs of employees engaged in ongoing research, design and development activities associated with new products and technology development. Research and development expenses were $3.2 million (8.5% of net sales) in the second quarter of fiscal 2013, up 3.8% from $3.1 million (8.7% of net sales) for the second quarter of fiscal 2012. The increase resulted from the completion of a number of customer funded Space & Defense Group development projects over the past six months, allowing personnel to be assigned to internal development work for that Group in the current quarter. Research and development expenditures are supporting further development of Wireless Group infrastructure and consumer component opportunities, as well as new technology development in the Space & Defense Group. The Company expects to maintain its current research and development efforts and spending levels for the remainder of fiscal 2013.

17 -------------------------------------------------------------------------------- General and Administrative. General and administrative expenses consist of employee related expenses, incentive compensation, professional services, intangible amortization, travel related expenses and other corporate costs. General and administrative expenses decreased 1.3% to $4.3 million (11.3% of net sales) for the second quarter of fiscal 2013, from $4.4 million (12.3% of net sales) for the second quarter of fiscal 2012. The decrease in general and administrative expense in the current quarter was due to a reduction in consulting and professional service expenses, year over year, in the current second quarter. Quarterly general and administrative costs are expected to remain at current levels for the remainder of fiscal 2013.

Operating Income. Operating income increased $3.7 million in the second quarter of fiscal 2013 to $5.1 million, (13.4% of net sales), compared to $1.4 million (3.9% of net sales) for the second quarter of fiscal 2012. This increase in operating income was a result of the $2.3 million rise in sales coupled with no increase in operating expenses. Additionally, a more favorable product mix, which included a five percentage point reduction in material content, drove a 7.8 percentage point increase in gross margins during the current second quarter compared to the same quarter last year.

On an operating segment basis, Wireless Group operating income was $2.0 million (15.8% of Group sales) for the second quarter of fiscal 2013, up $2.9 million from the Group's operating loss of $(0.9) million (7.9% of Group sales) in the second quarter of fiscal 2012. The rise in Wireless Group operating income in the second quarter of fiscal 2013, compared to the second quarter of fiscal 2012, was due to the $2.1 million, or 19.0%, increase in Wireless Group sales coupled with a $0.3 million reduction in operating expenses and a more favorable product mix resulting in lower material content. Additionally, lower production costs in the current quarter resulting from the personnel and expense reductions in the first half of fiscal 2012 had a large impact on margins in the current second quarter compared to the same quarter last year.

Space & Defense Group operating income was $3.1 million, (12.1% of Group sales) in the second quarter of fiscal 2013, compared to operating income of $2.4 million, (9.5% of Group sales) for the second quarter of fiscal 2012. Operating margins for this Group increased in the current first quarter due mainly to the $1.1 million increase in gross margin compared to the second quarter last year.

Gross margin improvement resulted from a more favorable product mix with more mature production, lower material content products and lower production costs resulting from the personnel and expense reductions in the first half of fiscal 2012.

Other Income. Other income primarily consists of interest income received on invested cash balances and rental income. Other income was $0.1 million in the second quarter of fiscal 2013 compared to $0.1 million for the second quarter of last year. Higher short-term interest rates and cash balances in China, year-over-year, have had a positive impact on interest income. Other income will fluctuate based on short term market interest rates and the level of investable cash balances.

Interest Expense. Interest expense consists mainly of interest on Company borrowings and deferred items. Interest expense in the second quarter of fiscal 2013 was flat, compared to the second quarter of fiscal 2012 and was less than $0.1 million. Interest expense has remained relatively low and has declined due to the continuing low level of the 30 day London Inter-Bank Offer Rate (LIBOR) interest rate. During the first quarter of fiscal 2013, the Company borrowed a total of $8 million, which is currently outstanding under the Line. These borrowings bear interest at the 30 day LIBOR rate, plus 100 to 200 basis points, based upon the Company's rolling twelve month earnings before interest and taxes and depreciation and amortization (EBITDA) performance. The rate is reset monthly and for the third quarter of fiscal 2013 is expected to be approximately 1.3%.

Income Taxes. Income taxes for the second quarter of fiscal 2013 were $1.7 million (4.4% of net sales), representing an effective tax rate of 32.0%. This compares to income tax expense of $0.3 million (0.9% of net sales) for the second quarter of fiscal 2012, representing an effective tax rate of 21.4%. The increase in the effective rate for the second quarter of fiscal 2013 is a result of the increase in taxable income, the expiration of the research and experimentation credit and the mix of foreign and domestic taxable income year over year. The projected effective tax rate for fiscal 2013, absent one-time events and adjusted for the reinstatement of the Federal Research and Experimentation credit in January 2013 is expected to be approximately 27 - 28%%.

18 -------------------------------------------------------------------------------- Six Months Ended December 31, 2012 Compared to Six Months Ended December 31, 2011 Net sales. Net sales were $77.1 million for the first half of fiscal 2013, up 3.5% compared to $74.5 million for the first half of fiscal 2012. Sales of Wireless Group products fell $3.0 million, or 10.2%, and sales of Space & Defense Group products increased $5.6 million, or 12.2%, in the current first six months compared to the first half of fiscal 2012.

The decline in sales of Wireless Group products in the first half of fiscal 2013 compared to the first half of fiscal 2012 was the result of a substantial decrease in demand for Wireless infrastructure products beginning in the latter half of the fiscal 2012 first quarter, which dropped the quarterly Wireless Group sales rate from over $18.0 million in the first quarter last year to the current $12.0 - $13.0 million run rate. Sales of these products dropped $3.0 million in the first six months of fiscal 2013 compared to the first six months of fiscal 2012 due to declining orders from both European OEMs and Asian contract manufacturers.Wireless Group sales have stabilized and are expected to remain relatively flat throughout fiscal 2013 based on current customer demand.

Sales of Space & Defense Group products increased $5.6 million, or 12.2% in the first half of fiscal 2013 compared to the first half of the previous fiscal year. First and second quarter fiscal 2013 Space & Defense Group sales were comparable to sales in this Group for the preceding last three quarters of fiscal 2012. The improvement over fiscal 2012 first six months sales reflects both the Space & Defense Group backlog level of approximately $95 - $105 million during the past twelve months and the resolution of production and customer specification issues which has allowed for consistent quarterly Space & Defense Group product shipments over the trailing twelve month period. Quarterly Space & Defense Group sales are expected to exceed first and second quarter levels for the remainder of fiscal 2013.

Gross Profit. Gross profit for the first half of fiscal 2013 was $29.4 million, (38.2% of net sales), up from $25.9 million (34.7% of net sales) for the same period of the prior year. Gross profit as a percent of sales increased significantly in the first half of fiscal 2013 from the first half of fiscal 2012 due to efficiencies from the higher sales levels and a more favorable product mix in both the Wireless and Space & Defense Groups, which resulted in a decline in material content in the current first six months compared to the first six months of last year. Additionally, gross profit in the first half of fiscal 2013 was enhanced by lower payroll and health care costs due to personnel reductions in the first half of fiscal 2012 and a substantial reduction in healthcare costs in the Company's self-insured program, for the current first six months compared to the same period in fiscal 2012.

Marketing. Marketing expenses were $4.9 million (6.4% of net sales) for the first half of fiscal 2013 down $0.1 million from $5.0 million (6.8% of net sales) for the first half of fiscal 2012. Marketing expenses in the current first half declined slightly due to lower advertising, marketing support and travel expenses, which off-set higher commission expenses in the current first six months compared to the first half of fiscal 2012.

Research and Development. Research and development expenses were $6.6 million (8.5% of net sales) in the first half of fiscal 2013, down 6.7% from $7.0 million (9.4% of net sales) for the first half of fiscal 2012. The decline in fiscal 2013 research and development expenditures resulted from a reduction in engineering personnel at the beginning of the second quarter of fiscal 2012 due to a reduction in design work and the reassignment of some engineering personnel to funded engineering development work in the Space & Defense Group. Research and development expenditures are supporting further development of Wireless Group infrastructure and consumer product opportunities, as well as new technology development in the Space & Defense Group. The Company expects to maintain its current research and development efforts and spending levels in the second half of fiscal 2013, and is presently working on a number of new standard and custom Wireless Group and Space & Defense Group opportunities.

General and Administrative. General and administrative expenses were $8.9 million (11.5% of net sales) for the first half of fiscal 2013, relatively unchanged from $8.8 million (11.8% of net sales) for the first half of fiscal 2012. The small increase in general and administrative expense in the current first half was due to increased compensation costs related to deferred compensation accruals and additional consultant expense. General and administrative costs are expected to remain at current levels for the remainder of fiscal 2013.

19-------------------------------------------------------------------------------- Operating Income. Operating income increased $4.1 million in the first half of fiscal 2013 to $9.1 million, (11.8% of net sales), compared to $5.0 million (6.7% of net sales) for the first half of fiscal 2012. This increase in operating income was a result of the $2.6 million rise in sales coupled with a $0.5 million decrease in operating expenses. Additionally, a more favorable product mix and a reduction in material content, as a percent of sales, drove a 3.5 percentage point increase in gross margins during the current first six months compared to the same six months last year.

On an operating segment basis, Wireless Group operating income was $3.9 million (14.9% of Group sales) for the first six months of fiscal 2013, up $1.1 million from the Group's operating income of $2.8 million (9.7% of Group sales) in the first six months of fiscal 2012. The rise in Wireless Group operating income in the first half of fiscal 2013, compared to the first half of fiscal 2012, was due to a $1.3 million reduction in operating expenses consisting of a $0.9 million decline in group research and development spending and a $0.5 million decrease in general and administrative expense. Additionally, a more favorable product mix which resulted in lower material content and lower production costs resulting from the personnel and expense reductions instituted in the first half of fiscal 2012 had a large impact on improved Group gross margins in the current first six months compared to the same period last year.

Space & Defense Group operating income was $5.2 million, (10.2% of Group sales) in the first six months of fiscal 2013, compared to operating income was $2.3 million, (5.0% of Group sales) for the first six months of fiscal 2012. Operating margins for this Group increased in the current first six months due mainly to the $3.8 million increase in gross margin compared to the same period last year. Gross margin improvement resulted from the $5.6 million increase in sales, a more favorable product mix with more mature production, lower material content products and lower production costs resulting from the personnel and expense reductions in the first half of fiscal 2012.

Other Income. Other income was $0.4 million in the first half of fiscal 2013 up $0.1 million from the first half of last year. Other income will fluctuate based on short term market interest rates and the level of investable cash balances.

Interest Expense. Interest expense consists mainly of interest on Company borrowings and deferred items. Interest expense in the first half of fiscal 2013 and fiscal 2012 was $0.1 million. Interest expense has remained relatively low and has declined due to the continuing low level of the 30 day London Inter-Bank Offer Rate (LIBOR) interest rate. During the first quarter of fiscal 2013, the Company borrowed a total of $8 million, which is currently outstanding under the Line. These borrowings bear interest at the 30 day LIBOR rate, plus 100 to 200 basis points, based upon the Company's rolling twelve month earnings before interest and taxes and depreciation and amortization (EBITDA) performance. The rate is reset monthly and for the third quarter of fiscal 2013 is expected to be approximately 1.3%.

Income Taxes. Income tax expense for the first half of fiscal 2013 was $3.0 million (3.9% of net sales), representing an effective tax rate of 32.0%. This compares to income tax expense of $1.4 million (1.9% of net sales) for the first half of fiscal 2012, representing an effective tax rate of 28.0%. The increase in the effective rate for the first six months is a result of the increase in taxable income, the expiration of the research and experimentation credit and the mix of foreign and domestic taxable income year over year. The projected effective tax rate for fiscal 2013, absent one-time events and adjusted for the reinstatement of the Federal Research and Experimentation credit in January 2013 is expected to be approximately 28%.

Critical Accounting Policies There have been no changes to the Company's critical accounting policies, estimates, or judgments from those discussed in the Company's 2012 Annual Report on Form 10-K.

Liquidity and Capital Resources Net cash provided by operations for the first six months of fiscal 2013 was $6.9 million and resulted primarily from net income before depreciation, amortization and non-cash equity based compensation expense. The positive cash flow from operations for the first six months was reduced by a $2.8 million increase in accounts receivable due to lengthening of customer terms, a $1.7 million increase in inventory due to the current higher sales levels, and a $2.0 million decrease in accounts payable.

20-------------------------------------------------------------------------------- Net cash provided by operations for the first six months of fiscal 2012 was $7.9 million and resulted primarily from net income before depreciation, amortization and non-cash equity based compensation expense. The positive cash flow from operations for the first six months was further enhanced by a $3.4 million decrease in accounts receivable due to improved collections, which was off-set by a $3.3 million increase in inventory due to the lower Wireless sales levels, and a $3.8 million decrease in accounts payable and accrued expenses.

Net cash provided by investing activities in the first six months of fiscal 2013 was $12.1 million and consisted of $9.1 million provided by maturities of marketable debt securities plus $5.2 million provided by proceeds from the sale and leaseback of the Company's Salem, NH manufacturing facility, less $2.2 million used for capital additions.

Net cash used in investing activities in the first half of fiscal 2012 was $4.3 million and consisted of $4.4 million used to pay for capital additions which, was partially off-set by $0.1 million provided by the net maturities of held to maturity debt securities.

Net cash used in financing activities was $10.1 million in the first six months of fiscal 2013 and consisted of $8.0 million provided by borrowings under the Company's credit facility, $2.0 million of cash and tax benefits provided by the exercise of stock options, less $20.1 million used to purchase approximately 1.1 million treasury shares. Net cash used in financing activities in the first six months of fiscal 2012 was $31.7 million and consisted of $30.0 million used to pay down long-term debt and $6.6 million used to purchase approximately 374,000 treasury shares during the period, which were partially offset by $4.9 million generated by cash receipts and tax benefits from the exercise of stock options.

During the remainder of fiscal 2013, the Company anticipates that its primary cash requirement will be for capital expenditures and possible repurchase of the Company's common stock. Capital expenditures for the remainder of fiscal 2013 are expected to be in the range of $3.0 - $4.0 million, (4-5% of anticipated sales), and will be funded from existing cash and investments, and expected cash flow generated by operations.

The Company has a $50.0 million revolving credit facility with its principal bank and currently has $8.0 million outstanding under the Line. These borrowings bear interest at the 30 day LIBOR rate, plus 100 to 200 basis points, based upon the Company's rolling twelve month earnings before interest and taxes and depreciation and amortization (EBITDA) performance. The rate is reset monthly and for the third quarter of fiscal 2013 is expected to be approximately 1.3%.

The Company may continue to repurchase shares of its common stock in the open market and/or through privately negotiated transactions under the current Board authorization, depending on market conditions. At December 31, 2012, there were approximately 1.3 million shares remaining under the current Board repurchase authorization.

At December 31, 2012, the Company had approximately $43.6 million in cash, cash equivalents, and marketable securities. Included in the Company's cash and cash equivalents balance is $16.4 million that is deposited in banks in China. The Company has had positive operating cash flow for over twelve years, and believes that its cash requirements for the foreseeable future will be satisfied by currently invested cash balances and expected cash flows from operations.

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