**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10- Q**

 

**(Mark One)**

 
| **ý**                           | ** ** | **Quarterly Report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                               |
|--------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                 |       |                                                                                                                                                                                       |
|                                 |       | **For the quarterly period ended:          SEPTEMBER  24, 2004**                                                                              |
|                                 |       |                                                                                                                                                                                       |
| **o**                                | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                              |
|                                 |       |                                                                                                                                                                                       |
|                                 |       | **For the transition period from            to             ** |
|                                 |       |                                                                                                                                                                                       |
| **Commission  File Number: 1-08101** |

 

**SMTEKINTERNATIONAL, INC.**

Exact Name of Registrantas Specified in Its Charter

 

| **DELAWARE**                                                    | **33-0213512**                      |
|-----------------------------------------------------------------|-------------------------------------|
| State or Other  Jurisdiction of  Incorporation or Organization: | I.R.S. Employer  Identification No. |

 

**200 Science Drive, Moorpark,CA  93021**

**(805) 532-2800**

(Address, including zipcode, and telephone number, including

area code, of registrant’sprincipal. Executive offices)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.                Yes ý   No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Securities Exchange Act of 1934).  Yes o   No ý

 

The registrant had 2,700,745 shares of Common Stock outstanding as of October22, 2004.

 

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**SMTEK INTERNATIONAL, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCESHEETS (UNAUDITED)**

**(In thousands except shareamounts)**

 
| ** **                                                                                                                                                         | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------|------------|
|                                                                                                                                                               |       |                    |       |               |       |
| **ASSETS**                                                                                                                                                         |       |                    |       |               |       |
| Current assets:                                                                                                                                                    |       |                    |       |               |       |
| Cash and cash  equivalents                                                                                                                                         |       | $                       | 522        |               | $          | 406 |   |
| Marketable  securities                                                                                                                                             |       | 253                     |       | 210                |       |
| Accounts  receivable, less allowance for doubtful accounts of $407 and $406, as of  September 30, 2004 and June 30, 2004, respectively                             |       | 18,148                  |       | 13,734             |       |
| Inventories                                                                                                                                                        |       | 14,496                  |       | 12,971             |       |
| Prepaid expenses                                                                                                                                                   |       | 734                     |       | 608                |       |
| Total current  assets                                                                                                                                              |       | 34,153                  |       | 27,929             |       |
|                                                                                                                                                               |       |                    |       |               |       |
| Property,  equipment and improvements, net of accumulated depreciation and amortization                                                                            |       | 6,014                   |       | 6,103              |       |
| Other assets,  net                                                                                                                                                 |       | 442                     |       | 471                |       |
|                                                                                                                                                               |       | $                       | 40,609     |               | $          | 34,503 |   |
|                                                                                                                                                               |       |                    |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                      |       |                    |       |               |       |
| Current  liabilities:                                                                                                                                              |       |                    |       |               |       |
| Current portion  of long-term debt                                                                                                                                 |       | $                       | 1,486      |               | $          | 1,371 |   |
| Accounts payable                                                                                                                                                   |       | 16,113                  |       | 13,536             |       |
| Other accrued  liabilities                                                                                                                                         |       | 2,869                   |       | 2,943              |       |
| Total current  liabilities                                                                                                                                         |       | 20,468                  |       | 17,850             |       |
|                                                                                                                                                               |       |                    |       |               |       |
| Long-term  liabilities:                                                                                                                                            |       |                    |       |               |       |
| Long-term bank  line of credit payable                                                                                                                             |       | 10,569                  |       | 8,648              |       |
| Long-term debt  and other                                                                                                                                          |       | 3,288                   |       | 3,264              |       |
| Total  liabilities                                                                                                                                                 |       | 34,325                  |       | 29,762             |       |
|                                                                                                                                                               |       |                    |       |               |       |
| Commitments and  contingencies                                                                                                                                     |       |                    |       |               |       |
|                                                                                                                                                               |       |                    |       |               |       |
| Stockholders’  equity:                                                                                                                                        |       |                    |       |               |       |
| Preferred stock,  $1 par value; 1,000,000 shares authorized; 250,000 shares issued and  outstanding at June 30, 2004                                               |       | —                  |       | 475                |       |
| Common stock,  $.01 par value; 20,000,000 shares authorized; 2,695,995 and 2,386,016 issued  and outstanding at September 30, 2004 and June 30, 2004, respectively |       | 27                      |       | 24                 |       |
| Additional  paid-in capital                                                                                                                                        |       | 38,164                  |       | 37,465             |       |
| Accumulated  deficit                                                                                                                                               |       | (31,942                 | )          | (33,279            | )          |
| Accumulated  other comprehensive loss                                                                                                                              |       | 35                      |       | 56                 |       |
| Total  stockholders’ equity                                                                                                                                   |       | 6,284                   |       | 4,741              |       |
|                                                                                                                                                               |       | $                       | 40,609     |               | $          | 34,503 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**SMTEK INTERNATIONAL, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**AND OTHER COMPREHENSIVE INCOME(LOSS) (Unaudited)**

**(In thousands except per shareamounts)**

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Revenues                                                        |       | $                                     | 29,855     |   | $ | 20,692 |   |
| Cost of goods  sold                                             |       | 26,192                                |       | 18,007 |   |
| Gross profit                                                    |       | 3,663                                 |       | 2,685 |   |
|                                                            |       |                                  |       |   |   |
| Operating  expenses:                                            |       |                                  |       |   |   |
| Administrative  and selling                                     |       | 2,009                                 |       | 2,027 |   |
| Total operating  expenses                                       |       | 2,009                                 |       | 2,027 |   |
| Operating income                                                |       | 1,654                                 |       | 658 |   |
| Non-operating  income (expense):                                |       |                                  |       |   |   |
| Interest  expense, net                                          |       | (213                                  | )          | (215 | ) |
| Other income,  net                                              |       | 25                                    |       | 908 |   |
| Total  non-operating (expense) income, net                      |       | (188                                  | )          | 693 |   |
|                                                            |       |                                  |       |   |   |
| Income before  income taxes                                     |       | 1,466                                 |       | 1,351 |   |
| Income tax  provision                                           |       | 129                                   |       | 37 |   |
| Net income                                                      |       | $                                     | 1,337      |   | $ | 1,314 |   |
|                                                            |       |                                  |       |   |   |
| Net income per  share - basic                                   |       | $                                     | 0.50       |   | $ | 0.58 |   |
|                                                            |       |                                  |       |   |   |
| Net income per  share - diluted                                 |       | $                                     | 0.45       |   | $ | 0.56 |   |
|                                                            |       |                                  |       |   |   |
| Shares used in  computing basic and diluted earnings per share: |       |                                  |       |   |   |
| Basic                                                           |       | 2,671                                 |       | 2,284 |   |
| Diluted                                                         |       | 3,001                                 |       | 2,362 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**SMTEKINTERNATIONAL, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS (Unaudited)**

**(In thousands)**

 
| ** **                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                             | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Cash flows from  operating activities:                                                                 |       |                                  |       |   |   |
| Income from  continuing operations                                                                     |       | $                                     | 1,337      |   | $ | 1,314 |   |
| Adjustments to  reconcile income from continuing operations to net cash used in operating  activities: |       |                                  |       |   |   |
| Depreciation and  amortization                                                                         |       | 480                                   |       | 454 |   |
| Unrealized gain  on marketable securities                                                              |       | (43                                   | )          | — |   |
| Expense of  warrants issued for professional services                                                  |       | 48                                    |       | — |   |
| Gain on  retirement of debt                                                                            |       | —                                |       | (817 | ) |
| Changes in  operating assets and liabilities                                                           |       |                                  |       |   |   |
| Accounts  receivable                                                                                   |       | (4,414                                | )          | (1,307 | ) |
| Inventories                                                                                            |       | (1,524                                | )          | (813 | ) |
| Accounts payable                                                                                       |       | 2,577                                 |       | 1,350 |   |
| Accrued  liabilities                                                                                   |       | (38                                   | )          | (16 | ) |
| Prepaid expense                                                                                        |       | (89                                   | )          | (424 | ) |
| Net cash used in  operating activities                                                                 |       | (1,666                                | )          | (259 | ) |
|                                                                                                   |       |                                  |       |   |   |
| Cash flows from  investing activities:                                                                 |       |                                  |       |   |   |
| Capital  expenditures                                                                                  |       | (391                                  | )          | (118 | ) |
| Net cash used in  investing activities                                                                 |       | (391                                  | )          | (118 | ) |
|                                                                                                   |       |                                  |       |   |   |
| Cash flows from  financing activities:                                                                 |       |                                  |       |   |   |
| Proceeds from bank  lines of credit                                                                    |       | 1,921                                 |       | 1,229 |   |
| Proceeds from  equipment line of credit                                                                |       | 407                                   |       | — |   |
| Repayments of  short-term debt                                                                         |       | —                                |       | (398 | ) |
| Repayments of  long-term debt                                                                          |       | (268                                  | )          | (607 | ) |
| Proceeds from  the exercise of stock options                                                           |       | 135                                   |       | — |   |
| Proceeds from  the issuance of preferred stock                                                         |       | —                                |       | 500 |   |
| Costs related to  new credit facility                                                                  |       | —                                |       | (134 | ) |
| Net cash  provided by financing activities                                                             |       | 2,195                                 |       | 590 |   |
|                                                                                                   |       |                                  |       |   |   |
| Effect of  exchange rate changes on cash                                                               |       | (22                                   | )          | 50 |   |
| Increase in cash  and cash equivalents                                                                 |       | 116                                   |       | 263 |   |
|                                                                                                   |       |                                  |       |   |   |
| Cash and cash  equivalents at beginning of period                                                      |       | 406                                   |       | 583 |   |
| Cash and cash  equivalents at end of period                                                            |       | $                                     | 522        |   | $ | 846 |   |
|                                                                                                   |       |                                  |       |   |   |
| Supplemental  cash flow information:                                                                   |       |                                  |       |   |   |
| Interest paid                                                                                          |       | $                                     | 202        |   | $ | 136 |   |

 

250,000 shares of Series A Preferred Stock and accrued dividends of$36,000 were converted into an aggregate of 268,369 shares of common stock.

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

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**SMTEKINTERNATIONAL, INC. AND SUBSIDIARIES**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**Three Months Ended September 30,2004 and 2003**

 

**NOTE 1 - DESCRIPTION OF BUSINESS AND BASIS OFPRESENTATION**

 

SMTEK International, Inc. (the “Company,” “we,” “us”or “our”) is an electronics manufacturing services (“EMS”) provider servingoriginal equipment manufacturers (“OEMs”) in the medical, industrialinstrumentation, telecommunications, security, financial services automationand aerospace and defense industries.  Weprovide integrated solutions to OEMs across the entire product life cycle, fromdesign to manufacturing to end-of-life services, for the worldwide highcriticality, high reliability, high complexity segment of the EMS industry.

 

We have four wholly-owned subsidiaries:  SMTEK, Inc. (dba SMTEK Moorpark), located inMoorpark, California; SMTEK New England, located in Marlborough, Massachusetts;SMTEK Santa Clara, located in Santa Clara, California; and SMTEK InternationalThailand Limited, located in Ayutthya, Thailand.

 

On January 9, 2004, we sold our subsidiary JoltTechnology, Inc. (aka SMTEK Fort Lauderdale), located in Fort Lauderdale,Florida, for approximately $940,000 in cash to the president of Jolt and anaffiliated investor of the Company.  Theloss on the sale of Jolt was approximately $85,000 and was recognized in thesecond quarter of the fiscal year ended June 30, 2004 as a non-operatingexpense.  The results of operations ofJolt are included in the accompanying Condensed Consolidated Statement ofOperations in the first quarter of fiscal 2004 ended September 30, 2003.  For further discussion, see Note 2.

 

The unaudited consolidated financial informationfurnished herein has been prepared in accordance with generally acceptedaccounting principles and reflects all adjustments, consisting only of normalrecurring adjustments, which in the opinion of management, are necessary tofairly state the Company’s financial position, the results of its operationsand its cash flows for the periods presented.

 

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and the accompanying notes. Actual results could differ from those estimates and such differencesmay be material to the financial statements. The results of operations for the three months ended September 30, 2004are not necessarily indicative of results for the entire fiscal year endingJune 30, 2005.

 

As permitted under applicable rules and regulations ofthe Securities and Exchange Commission, certain notes and other information arecondensed or omitted from the interim financial statements presented in thisQuarterly Report on Form 10-Q. Therefore, these condensed financial statements should be read inconjunction with our 2004 Annual Report on Form 10—K as filed with theSecurities and Exchange Commission on September 2, 2004 and the amendmentthereto on form 10-K/A as filed on October 22,2004.

 

**Marketable Securities**

 

Our marketable securities consist of an investment incommon stock of a public company which, for accounting purposes, is classifiedas trading securities.  Accordingly, theinvestment is marked to market quarterly with the change in value beingrecorded in the statement of operations. For the three months ended September 30, 2004, we recognized anunrealized gain on

 

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marketable securities of approximately $43,000 that was recorded asnon-operating income in the accompanying unaudited Condensed ConsolidatedStatements of Operations.  Management’sintention is to sell off the shares of such public company as the marketallows.  At September 24, 2004, the lastbusiness day of our first quarter of fiscal 2005, we held 168,500 shares with afair market value of $1.50 per share.

 

**Restructuring Costs**

 

In connection with the closure and transition of theCompany’s San Diego facility in the second quarter of 2003, we incurred approximately$1.6 million in expenses consisting of severance costs of $287,000, write-offof leasehold improvements of $370,000 and accrual of remaining lease obligationof $4,011,000 less sublease income of $3,038,000.  All severance costs were paid out and, of the$973,000 lease-related commitments, $473,000 has been paid out, resulting in areserve at September 30, 2004 of $500,000 of which $150,000 is recorded inaccrued liabilities and $350,000 is recorded in long-term debt.

 

**Revenue Recognition**

 

All of our subsidiaries recognize revenues once all ofthe following conditions have been met: a) an authorized purchase order hasbeen received in writing, b) the customer’s credit worthiness has beenestablished, c) shipment of the product has occurred, d) title and risk ofownership has transferred, e) if stipulated by the contract, customeracceptance has occurred and f) all significant vendor obligations, if any, havebeen satisfied.  We ship products FOBshipping point and, accordingly, title and risk of ownership pass to thecustomer upon shipment.

 

**Principles of Consolidation**

 

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of SMTEK International, Inc. and itswholly owned subsidiaries.  Allsignificant intercompany transactions and accounts have been eliminated inconsolidation.

 

**Stock Based Compensation**

 

SFAS No. 123, “Accounting for Stock-Based Compensation”allows entities to continue to apply the provisions of Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” andprovide pro forma net income and pro forma earnings per share disclosures forstock-based awards as if the fair-value-based method defined in SFAS No. 123had been applied.  In accordance with APBOpinion No. 25 and related interpretations, compensation expense wouldgenerally be recorded for fixed option grants only if, on the date of grant,the current market price of the underlying stock exceeded the exerciseprice.  We have elected to continue toapply the provisions of APB Opinion No. 25 and provide the pro forma disclosureprovisions of SFAS No. 123.  Accordingly,no compensation expense has been recognized for our employee stock option plansand award of options to non-employee directors. Had compensation expense for stock-based awards been determinedconsistent with SFAS No.123, our results of operation would have been reducedto the pro forma amounts indicated below (in thousands except per shareamounts):

 

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| ** **                                                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                                                              |       |                                  |       |   |   |
| Net income as  reported                                                                                           |       | $                                     | 1,337      |   | $ | 1,314 |   |
| Deduct total  stock-based employee compensation expense under fair value-based method for  all awards, net of tax |       | (46                                   | )          | (65 | ) |
| Pro forma net income                                                                                              |       | $                                     | 1,291      |   | $ | 1,249 |   |
|                                                                                                              |       |                                  |       |   |   |
| Pro forma  earnings per share - basic                                                                             |       | $                                     | 0.48       |   | $ | 0.55 |   |
| Pro forma  earnings per share - diluted                                                                           |       | $                                     | 0.43       |   | $ | 0.53 |   |

 

**Accounting Period**

 

We utilize a 52-53 week fiscal year ending on theFriday closest to June 30, which for fiscal year 2004 fell on June 25,2004.  In the accompanying unauditedcondensed consolidated financial statements, the 2004 fiscal year end is shownas June 30 and the interim period end for both years is shown as September 30for clarity of presentation.  The actualinterim periods ended on September 24, 2004 and September 26, 2003.

 

**NOTE 2 - SALE OF SUBSIDIARY**

 

On January 9, 2004, we sold our subsidiary JoltTechnology, Inc. (aka SMTEK Fort Lauderdale), located in Fort Lauderdale,Florida, for approximately $940,000 in cash to the president of Jolt and anaffiliated investor of the Company.  Theloss on the sale of Jolt was approximately $85,000 and was recognized in thesecond quarter of fiscal 2004 ended December 31, 2003.  Jolt’s revenues, cost of goods sold andoperating income of $839,000, $619,000 and $62,000, respectively, and theresults of operations of Jolt for the three months ended September 30, 2003were included in the accompanying unaudited Condensed Consolidated Statementsof Operations and Other Comprehensive Income (Loss).

 

Net assets of Jolt as of the sale date of January 9,2004 consisted of the following (in thousands):

 
| Current assets                        |   | $   | 1,026  |   |
|---------------------------------------|--------|-----|--------|--------|
| Property,  equipment and improvements |   | 58  |   |
| Other assets                          |   | 20  |   |
| Current  liabilities                  |   | (79 | )      |
| Net assets                            |   | $   | 1,025  |   |

 

There were no results ofoperations for Jolt in the current quarter ended September 30, 2004.

 

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**NOTE 3 - EARNINGS PER SHARE**

 

Basic earnings per share is computed by dividing netincome available to common stockholders by the weighted average number ofcommon shares outstanding during the period. Diluted earnings per share reflects the potential dilution that couldoccur if convertible securities or other contracts to issue common stock wereexercised or converted into common stock or resulted in the issuance of commonstock that then shared in our earnings.

 

Common stock equivalents used in the determination ofdiluted earnings per share include the effect, when such effect is dilutive, ofour outstanding employee stock options, the 8-1/2% Convertible SubordinatedDebentures (which are convertible into 4,988 shares of common stock at $212.50per share of common stock), warrants to purchase 15,000 shares of common stockat $7.95 per share (see Note 8 to the unaudited Condensed ConsolidatedFinancial Statements) and, for September 30, 2003 only, the Series A PreferredStock (which is convertible into 250,000 shares of common stock at $2.00 pershare of common stock, see Note 7 to the unaudited Condensed ConsolidatedFinancial Statements).  The following isa summary of the calculation of basic and diluted earnings per share (dollarsin thousands, except per share data):

 
| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                         |       |                                  |       |   |   |
| Net income                                                   |       | $                                     | 1,337      |   | $ | 1,314 |   |
|                                                         |       |                                  |       |   |   |
| Weighted average  shares:                                    |       |                                  |       |   |   |
| Basic weighted  average number of common shares outstanding  |       | 2,671,037                             |       | 2,284,343 |   |
| Dilutive effect  of outstanding common stock equivalents     |       | 329,999                               |       | 77,254 |   |
|                                                         |       |                                  |       |   |   |
| Diluted weighed  average number of common shares outstanding |       | 3,001,036                             |       | 2,361,597 |   |
|                                                         |       |                                  |       |   |   |
| Earnings per  share - basic                                  |       | $                                     | 0.50       |   | $ | 0.58 |   |
|                                                         |       |                                  |       |   |   |
| Earnings per  share - diluted                                |       | $                                     | 0.45       |   | $ | 0.56 |   |

 

Options to purchaseapproximately 13,092 shares of common stock at prices ranging from $9.75 to$10.00 which were outstanding at September 30, 2004, are not included in thecomputation of diluted earnings per share for the three months ended September30, 2004, because the exercise price of these options was greater than theaverage market price of our common stock and the effect would beantidilutive.  Options to purchaseapproximately 325,992 shares of common stock at prices ranging from $1.50 to$10.00 which were outstanding at September 30, 2003, are not included in thecomputation of diluted earnings per share for the three months ended September30, 2003, because the exercise price of these options was greater than theaverage market price of our common stock and the effect would be antidilutive.

 

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Convertible subordinated debentures aggregating$1,060,000, due in 2008 and convertible at a price of $212.50 per share at anytime prior to maturity were outstanding during the three months ended September30, 2004 and September 30, 2003 but were not included in the computation ofdiluted earnings per share due to their antidilutive effect.

 

**NOTE 4 - INVENTORIES**

 

Inventories consist of the following (in thousands):

 
| ** **         | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|--------------------|------------|-------------------------|------------|--------------------|------------|
| Raw materials      |       | $                       | 8,235      |               | $          | 7,209 |   |
| Work in process    |       | 5,832                   |       | 5,285              |       |
| Finished goods     |       | 429                     |       | 477                |       |
| Total  inventories |       | $                       | 14,496     |               | $          | 12,971 |   |

 

**Note 5 - PROPERTY, EQUIPMENT AND IMPROVEMENTS**

 

Property, equipment and improvements consist of thefollowing (in thousands):

 
| ** **                                      | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|--------------------|------------|
| Land                                            |       | $                       | 491        |               | $          | 498 |   |
| Buildings and  improvements                     |       | 1,965                   |       | 1,835              |       |
| Plant equipment                                 |       | 13,480                  |       | 13,265             |       |
| Office and other  equipment                     |       | 1,757                   |       | 1,704              |       |
| Less accumulated  depreciation and amortization |       | (11,679                 | )          | (11,199            | )          |
| Total property,  equipment and improvements     |       | $                       | 6,014      |               | $          | 6,103 |   |

 

**NOTE 6 - FINANCING ARRANGEMENTS**

 

At September 30, 2004, as one component of our creditfacility, we have a $15 million working capital line collateralized by accountsreceivable, inventory and equipment for our domestic operating units thatmatures September 30, 2007.  Borrowingsunder the working capital line bear interest, at our option, at either the bank’sprime rate (4.75% at September 30, 2004) plus 0.75% or a Libor-base rate (1.84%at September 30, 2004) plus 3.50%.  AtSeptember 30, 2004, borrowings under our working capital line amounted to $10.6million, the effective interest rate was 5.5% and our borrowing capacity wasapproximately $4.4 million.  Borrowingsunder our working capital line at September 30, 2004 have been classified aslong-term.  In addition, in September2003 we borrowed $1 million on our term credit facility, the second componentof our credit facility.  This advance hasa maturity date of September 19, 2006 and bears interest, at our option, ateither the bank’s prime rate (4.75% at September 30, 2004) plus 0.75% or aLibor-base rate (1.84% at September 30, 2004) plus 3.50%.  At September 30, 2004, the balanceoutstanding was $667,000 and the effective interest rate was 5.5%.  The third component of our credit facility,the capital expenditure credit facility of $2.5 million, is being used tofinance our capital expenditures.  Eachadvance under the capital expenditure credit facility will have a three yearterm at either the Bank’s prime rate plus 0.75% or, at our option, at a fixedrate

 

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equal to the Libor-base rate plus 3.50%.  Borrowings under the capital expenditurecredit facility were $547,000 as of September 30, 2004 and the effectiveinterest rate was 4.75%.  Our bankcovenants include requirements related to net income, stockholders’ equity anddebt service ratio.  We were incompliance with all covenants on the above credit facilities at September 30,2004.

 

On May 6, 2004, we finalized a Credit FacilityAgreement between SMTEK International Thailand Limited (our Thailandsubsidiary) and BankThai Public Company Limited and an unconditional guaranteeby SMTEK International, Inc. for the purpose of funding the growth andexpansion of our Thailand facility.  Thecredit facility includes a $678,000 mortgage loan for the purchase of thebuilding and land at our Thailand facility. The mortgage has a seven year term with an initial interest rate of5.75%, based on Thailand Prime Rate (5.75% at September 30, 2004) and a monthlypayment of approximately $9,000.  TheCredit Facility Agreement also includes a $440,000 construction loan for theexpansion of the Thailand facility.  Theconstruction loan has a 78 month term with interest at Thailand Prime Rate andwill have a monthly payment of approximately $5,000 starting after thecompletion of construction which is presently scheduled for November 2004.  The Credit Facility Agreement also includes aworking capital line of approximately $500,000 with interest at Thailand PrimeRate, a one year term and it is secured by all the assets of the Thailandfacility.  All liabilities andobligations under the Credit Facility are denominated in Baht, the currency ofThailand.  As of September 30, 2004, wehave a mortgage note of $678,000 for the purchase of the land and building andhave accrued $185,000 for construction in progress on the new building.

 

**NOTE 7 - PREFERRED STOCK**

 

In September 2003, we sold in a private placement250,000 shares of convertible Series A Preferred Stock at $2.00 per share forgross offering proceeds of $500,000.  Theshares were convertible into common stock initially on a one-to-one basis andare redeemable, solely at the Company’s option, at 1.5 times the purchase priceafter 180 days from the date of issuance. Holders of Series A Preferred Stock have voting rights equal to holdersof common stock on an as converted basis and enjoy a liquidation preference toany junior stock whereby preferred holders receive 1.5 times their initialinvestment plus any accrued dividends before any distributions to juniorstockholders.  Preferred holders areentitled to receive, on January 1 of each year, out of any assets legallyavailable therefor, payable when, as and if declared by the Board, prior and inpreference to any declaration or payment of any dividend on Junior Securities,dividends at the rate of 9% of the Purchase Price per annum plus any accruedand unpaid dividends.  Such dividendsaccrue annually in arrears whether or not declared by the Board of Directorsand shall be cumulative.  If the Companydeclares and pays dividends or distributions on common stock then the holdersof shares of Series A Preferred Stock are entitled to share in such dividendsor distributions on a pro rata basis as if their shares had been converted intoshares of common stock.  Dividendsaccrued on the preferred stock amounted to $36,000 at June 30, 2004.

 

In July 2004, the 250,000 shares of Series A PreferredStock and accrued dividends of approximately $36,000 were converted into anaggregate of 268,369 shares of common stock.

 

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**NOTE 8 - WARRANTS**

 

During fiscal 2004, we issued warrants to purchase15,000 shares of common stock at $7.95 per share in exchange for professionalservices to be rendered over a 14-month period. The fair value of the warrants, which amounted to $147,000 at September30, 2004, is recorded as prepaid expense and amortized to expense over the14-month service period.  In the threemonth period ended September 30, 2004, $48,000 was charged to administrativeand selling expense.

 

**NOTE 9 - GEOGRAPHIC INFORMATION**

 

We operate in a single business segment - the EMSindustry.  Our revenues and long-livedassets, net of accumulated depreciation, by geographic area are as follows (inthousands):

 
| ** **     | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------|------------|---------------------------------------|------------|
| ** **     | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Revenues:      |       |                                  |       |   |   |
| United States  |       | $                                     | 26,325     |   | $ | 18,742 |   |
| Thailand       |       | 3,530                                 |       | 1,950 |   |
| Total revenues |       | $                                     | 29,855     |   | $ | 20,692 |   |

 
| ** **               | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|--------------------------|------------|-------------------------|------------|--------------------|------------|
| Long-lived  assets:      |       |                    |       |               |       |
| United States            |       | $                       | 4,281      |               | $          | 4,448 |   |
| Thailand                 |       | 1,733                   |       | 1,655              |       |
| Total long-lived  assets |       | $                       | 6,014      |               | $          | 6,103 |   |
|                          |            |                         |            |                    |            |  |  |  |

 

**ITEM 2.****          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

References in this report to “the Company”, “SMTEK”, “we”,“our”, or “us” mean SMTEK International, Inc. together with its subsidiaries,except where the context otherwise requires. This Quarterly Report on Form 10-Qcontains certain statements that are, or may be deemed to be, forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934, and are made in relianceupon the protections provided by such acts for forward-looking statements.These forward-looking statements (such as when we describe what “will,” “may”or “should” occur, what we “plan,” “intend,” “estimate,” “believe,” “expect” or“anticipate” will occur, and other similar statements) include, but are not limitedto, statements regarding future sales and operating results, future prospects,anticipated benefits of proposed (or future) acquisitions and new facilities,growth, the capabilities and capacities of business operations, any financialor other guidance and all statements that are not based on historical fact, butrather reflect our current expectations concerning future results and events.We make certain assumptions when making forward-looking statements, any ofwhich could prove inaccurate, including, but not limited

 

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to, statements about our future operating results and business plans.The**ultimate correctness of theseforward-looking statements is dependent upon a number of known and unknown risksand events, and is subject to various uncertainties and other factors that maycause our actual results, performance or achievements to be different from anyfuture results, performance or achievements expressed or implied by thesestatements.

 

The following important factors, among others, couldaffect future results and events, causing those results and events to differmaterially from those expressed or implied in our forward-looking statements:business conditions and growth in our customers’ industries, the electronicmanufacturing services industry and the general economy, variability ofoperating results, our dependence on a limited number of major customers, thepotential consolidation of our customer base, availability of components,dependence on certain industries, seasonality, variability of customerrequirements, our ability to successfully negotiate definitive agreements andconsummate acquisitions, and to integrate operations following consummation ofacquisitions, our ability to take advantage of our restructuring to improveutilization and realize savings, other economic, business and competitivefactors affecting our customers, our industry and business generally and otherfactors that we may not have currently identified or quantified. For a furtherlist and description of various risks, relevant factors and uncertainties thatcould cause future results or events to differ materially from those expressedor implied in our forward-looking statements, see “Factors that May Affect ourResults” below, as well as in our Annual Report on Form 10-K for the fiscalyear ended June 30, 2004, as amended, any subsequent Reports on Form 10-Q andForm 8-K and other filings with the Securities and Exchange Commission.

 

All forward-looking statements included in thisQuarterly Report on Form 10-Q are made only as of the date of this QuarterlyReport on Form 10-Q, and we do not intend to publicly update or correct anyforward-looking statements to reflect events or circumstances that subsequentlyoccur or of which we hereafter become aware. You should read this document andthe documents, if any, that we incorporate by reference into this QuarterlyReport on Form 10-Q completely and with the understanding that our actualfuture results may be materially different from what we expect. We may notupdate these forward-looking statements, even if our situation changes in thefuture. All forward-looking statements attributable to us are expresslyqualified by these cautionary statements.

 

The following discussionand analysis should be read in conjunction with the condensed consolidatedfinancial statements and related notes included elsewhere in this report.

 

**RISK FACTORS THAT MAY AFFECT OUR BUSINESS ANDRESULTS OF OPERATIONS**

 

The following factorsupdate certain risk factors identified in our 2004 Annual Report on Form 10-Kwhich was filed with the SEC on September 2, 2004.  We direct readers to the documents we filewith the SEC, including our most recent Reports on Forms 10-K, 10-Q and 8-K,each as it may be amended from time to time, for a more complete description ofimportant risk factors affecting our Company.

 

**Our Industry is Characterized byLow Profit Margins.**

 

Competition in the EMS industry is primarily driven byprice often resulting in lower profit margins for EMS providers. In thisregard, customers have sought and continue to seek price reductions.  In addition, designing and manufacturingproducts for new customers can result in higher costs and lower profit marginsthan we typically experience with our established customers since initialproduction runs do not reflect full production efficiencies.  Unless we successfully achieve furthermaterial cost reductions, efficiencies

 

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and productivity gains, we may experience a material adverse effect onour operating results and our financial condition.  There can be no assurance, however, thatreductions in material costs will be effective or adequate to compensate for suchprice reductions or that we will be successful in furthering efficiencies andproductivity gains.

 

**The Loss of Any One of Our LargerCustomers May Adversely Affect Our Results and Financial Condition.**

 

Sales to four customers were greater than 10% of totalsales and accounted for 14.1%, 13.8% 11.6% and 11.1% of revenues in the threemonths ended September 30, 2004.  Theloss of one or more of our larger customers, or a significant reduction insales to any of our major customers, could have an adverse effect on ourbusiness, results of operations and financial condition.

 

**OurLiquidity is Currently Limited and Our Debt Profile May Change and May AffectOur Operations and Financial Condition.**

 

Our liquidity is currentlylimited, and, at September 30, 2004, our debt-to-equity ratio, excluding bankline of credit classified as long-term, was 0.76 to 1.00.  Although our debt load recently decreased andwe have reduced costs, several factors, including but not limited to, acontinued prolonged economic downturn, capital investment to increase production,acquisitions of other EMS companies or our inability to remain profitable, maysignificantly change our debt profile, resulting in an increase in debt to apoint that over-extends our cash-flow capacity. Also, under such circumstances, we may have future capital requirementsand our ability to obtain additional financing will be subject to a number offactors, including market conditions, our operating performance and investorsentiment.  These factors may make thetiming, amount, terms and conditions of additional financing unavailable orunattractive to us.  Any of these eventsor conditions could have a material adverse effect on our business, financialcondition and results of operations.

 

**Our Domestic Line of CreditAgreement and our Thailand Credit Facility Contain Certain Financial CovenantsThat Must Be Met And Failure To Do So Could Negatively Affect our FinancialCondition.**

 

Our domestic credit facility, which matures September30, 2007, includes certain covenants that we are required to comply with. Ourbank covenants include requirements related to our net income, stockholders’equity and debt service ratio.  On May 6,2004, we entered into a new Thailand credit facility (See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources - Thailand Credit Facility”). In the event ofdefault under these credit agreements, any and all outstanding borrowings couldbecome immediately due and payable which would likely create significant operatingand financial restrictions on us, further causing an adverse effect upon ourbusiness, operating results and financial condition.

 

**Adverse Changes in theAvailability and Expense of Components and Materials May Materially AdverselyAffect Our Operations.**

 

For our surface mount assemblies and turnkeyoperations, we purchase components and material from approved suppliers.  Any failure on the part of these suppliers todeliver required components to us or any failure of such components to meetperformance requirements could impair our ability to meet scheduled shipmentdates.  This in turn could delaycompleting our sales and receipt of payment, which may adversely affect ourbusiness, financial condition and results of operations.  From time to time, we have experienced, andmay in the future experience, shortages of certain types of electroniccomponents.  These shortages may increaseour costs and may also cause us to experience delays in deliveries to our customers.

 

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In addition, our customers may specify that wepurchase parts or materials from particular manufacturers of components for usein the assembly process.  Certaincomponents used in a number of our customer programs are obtained from solesource suppliers.  To the extent thesecomponents are not available on a timely basis or are in short supply becauseof allocations imposed by the component manufacturer, and the customer isunwilling to accept a substitute component, delays may occur.  Such delays are experienced in the EMSbusiness from time to time and have caused sales and inventory fluctuations inour business.

 

To the extent our customers do not absorb the costsassociated with parts or materials shortages or price increases, whether byagreement or to maintain a business relationship with a customer, we couldsuffer a material adverse effect on our business, financial condition andresults of operations.

 

**The****Reserve Established for the Closure and Transition of Our San Diego Facility(Poway) Was Based on Estimates and, Therefore, May Not Fully Represent AllFuture Costs For That Facility.**

 

In the second quarter of fiscal 2003, we established areserve for future costs related to the closure and transition to Moorpark ofour San Diego (Poway) facility.  Inestimating these future costs, we considered the cost of our lease obligationnet of estimated future proceeds from subleasing the facility.  The facility is currently vacant and if thefacility were to remain vacant for an extended period of time during theremaining term of the lease, we may be required to increase the reserve andthis could negatively impact our operating results and financial condition.

 

**DESCRIPTION OF THE BUSINESS**

 

SMTEK International, Inc. (the “Company,” “we,” “us”or “our”) is an electronics manufacturing services (“EMS”) provider servingoriginal equipment manufacturers (“OEMs”) in the medical, industrialinstrumentation, telecommunications, security, financial services automationand aerospace and defense industries.  Weprovide integrated solutions to OEMs across the entire product life cycle, fromdesign to manufacturing to end-of-life services, for the worldwide highcriticality, high reliability, high complexity segment of the EMS industry.

 

We have four wholly-owned subsidiaries:  SMTEK, Inc. (dba SMTEK Moorpark), located inMoorpark, California; SMTEK New England, located in Marlborough, Massachusetts;SMTEK Santa Clara, located in Santa Clara, California; and SMTEK InternationalThailand Limited, located in Ayutthya, Thailand.

 

**CRITICAL ACCOUNTING POLICIES AND ESTIMATES**

 

The following information describes our accountingpolicies in regards to risks, estimates and subjective assessments whoseapplication may have an impact on our reported results of operations andfinancial condition.

 

REVENUE RECOGNITION—All of our subsidiaries recognizerevenues once all of the following conditions have been met: a) an authorizedpurchase order has been received in writing, b) the customer’s creditworthiness has been established, c) shipment of the product has occurred, d)title and risk of ownership has transferred, e) if stipulated by the contract,customer acceptance has occurred and f) all significant vendor obligations, ifany, have been satisfied.  The majorityof our products ship FOB shipping point and, accordingly, in these cases titleand risk of ownership pass to the customer upon shipment.

 

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ACCOUNTS RECEIVABLE—We perform ongoing creditevaluations of our customers and adjust credit limits based upon each customer’spayment history and current credit worthiness, as determined by creditinformation available at that time.  Wecontinuously monitor collections and payments from our customers and wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments.  If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.

 

INVENTORIES—Inventoriesare stated at the lower of cost or net realizable value, with cost determinedby use of the first-in, first-out method. We write down inventory for slow-moving and obsolete inventory based onassessments of future demands, market conditions and customers which may beexperiencing financial difficulties.  Ifthese factors are less favorable than those projected, additional inventorywrite downs may be required.

 

LONG-LIVED ASSETS—Property, equipment and improvementsare stated at cost.  Depreciation andamortization are computed on the straight-line method.  The principal estimated useful lives are:buildings - 20 years; improvements — 5 to 10 years; and plant, office and otherequipment - 3 to 7 years.  Therecoverability of long-lived assets is evaluated whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. If future undiscounted cash flows expected to result from the useof such assets are believed insufficient to recover the carrying value of theasset, the carrying value is written down to fair value in the period theimpairment is identified.  Factors weconsider important which could trigger an impairment review include, but arenot limited to, the following:

 

•             the asset’s abilityto continue to generate income;

 

•             loss of legalownership or title to the asset;

 

•             significant changesin our strategic business objectives and utilization of the asset;

 

•             the impact ofsignificant negative industry or economic trends; or

 

•             a significantdecrease in the market value of the asset

 

ACCOUNTING FOR STOCKOPTIONS— SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended bySFAS No. 148, allows entities to continue to apply the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and provide pro forma net income and pro forma earnings per sharedisclosures for stock-based awards as if the fair-value-based method defined inSFAS No. 123 had been applied.  Inaccordance with APB Opinion No. 25 and related interpretations, compensationexpense would generally be recorded for fixed option grants only if, on thedate of grant, the current market price of the underlying stock exceeded theexercise price.  We have elected tocontinue to apply the provisions of APB Opinion No. 25 and provide the proforma disclosure provisions of SFAS No. 123. Accordingly, no compensation expense has been recognized for ouremployee stock option plans and award of options to non-employeedirectors.  See Note 1 to the unauditedCondensed Consolidated Financial Statements for detail regarding pro formaresults, had compensation expense for stock-based awards been determinedconsistent with SFAS No.123.

 

VALUATION ALLOWANCEAGAINST DEFERRED TAX ASSETS— In assessing the realizability of net deferred taxassets, management considers whether it is more likely than not that someportion or all of the net deferred tax assets will be realized.  The ultimate realization of net deferred taxassets is

 

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dependent upon the generation of future income.  Based on the level of historical losses,management believes that it does not have the basis to conclude that it is morelikely than not that the deferred tax assets will be realized, and therefore,has recorded a 100% valuation allowance to offset the net deferred tax assets.

 

**RESULTS OF OPERATIONS**

 

We utilize a 52-53 week fiscal year ending on theFriday closest to June 30, which for fiscal year 2004 fell on June 25,2004.  In the accompanying unauditedcondensed consolidated financial statements, the 2004 fiscal year end is shownas June 30 and the interim period end for both years is shown as September 30for clarity of presentation. The actual interim periods ended on September 24,2004 and September 26, 2003.

 

**Revenues**

(dollars in thousands)

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Revenues             | ** ** | **$**                                 | **29,855** |   | $ | 20,692 |   |
| Percentage  Increase | ** ** | **44.3%**                             |       |
|                      |            |                                       |            |  |  |  |  |

 

More than 48% of the increase in revenues wasattributable to new customers.  Theremainder of the increase was attributable to already established customersincreasing demand for existing products.

 

**Gross profit**

(dollars in thousands)

 
| ** **   | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------|------------|---------------------------------------|------------|
| ** **   | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Gross Profit | ** ** | **$**                                 | **3,663**  |   | $ | 2,685 |   |
| Gross Margin | ** ** | **12.3**                              | **%**      | 13.0 | % |
|              |            |                                       |            |  |  |  |  |

 

The decrease in gross margin was primarily related toincreased material cost related to product mix. Indirect costs decreased as apercentage of sales.  We now operate in fourfacilities, a decrease from seven throughout much of fiscal 2003 and fivethrough the first two quarters of fiscal 2004. The reduction in excess capacity and the more efficient utilization inthe remaining facilities has allowed us to spread fixed costs and applyvariable costs over a larger production volume. This factor did not offset theincreases in material costs that we have experienced.  We cannot be sure that our capacityutilization will remain at its current level and any decrease in revenues withthe resultant under-utilization of capacity could negatively impact our grossprofit margin.

 

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**Administrative and selling expenses**

(dollars in thousands)

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Administrative  and selling expenses | ** ** | **$**                                 | **2,009**  |   | $ | 2,027 |   |
| Percent of sales                     | ** ** | **6.7**                               | **%**      | 9.8 | % |
|                                      |            |                                       |            |  |  |  |  |

 

Administrative andselling expenses have decreased as a percentage of sales as we continue toclosely control our expenditures despite sales volume increases, such controlincludes limiting increases in staffing.

 

**Interest expense, net**

(dollars in thousands)

 
| ** **             | ** ** | **Three Months Ended  September 30,** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Interest  expense, net | ** ** | **$**                                 | **213**    |   | $ | 215 |   |
|                        |            |                                       |            |  |  |  |  |

 

Interest expense iscomparable in the comparable periods.  Eventhough we have increased the use of our bank lines of credit to fund productiongrowth and capital expenditures, we have also reduced other debt including theaccelerated payoff in the second quarter of fiscal 2004 of several equipmentnotes aggregating approximately $190,000 and the payment in June 2004 ofapproximately $2.0 million to fully retire our obligation with the IRS.

 

**Other income, net**

(dollars in thousands)

 
| ** **         | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------|------------|---------------------------------------|------------|
| ** **         | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Other income,  net | ** ** | **$**                                 | **25**     |   | $ | 908 |   |
|                    |            |                                       |            |  |  |  |  |

 

Other income, net of$25,000 for the three months ended September 30, 2004 consists primarily of anunrealized gain on marketable securities classified as trading securities of$43,000 offset by currency transaction losses in our Thailand facility.  Other income for the three months endedSeptember 30, 2003 included $817,000 gain on extinguishment of debt andcurrency translation gain of $70,000.

 

**Income tax provision**

(dollars in thousands)

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Income tax provision | ** ** | **$**                                 | **129**    |   | $ | 37 |   |
|                      |            |                                       |            |  |  |  |  |

 

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The income tax provisionis primarily related to state franchise taxes. The State of California does not allow us to carry forward our netoperating losses.

 

**Net income**

(dollars in thousands)

 
| ** ** | ** ** | **Three Months Ended  September 30** | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net income | ** ** | **$**                                | **1,337**  |   | $ | 1,314 |   |
|            |            |                                      |            |  |  |  |  |

 

The increase in netincome is primarily attributable to higher revenues and control of ourexpenses.  As discussed above under theheading “Other income, net”, there were also certain non-recurring itemscontributing to net income for the three months ended September 30, 2003, mostsignificantly, a non-recurring $817,000 gain on extinguishment of debt. Wecannot assure that we will maintain our current revenue and gross profit marginlevels.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Our primary sources ofliquidity are our cash and cash equivalents, which amounted to $522,000 atSeptember 30, 2004, and amounts available under our bank lines of credit, whichprovided approximately $4.4 million of availability in excess of currentborrowings at September 30, 2004.

 

**Current assets, current liabilities and long-termdebt**

The following table sets forth certain debt and liquidity measurements(dollars in thousands):

 
| ** **                                       | ** ** | **At September 30, 2004** | ** ** | **At June 30, 2004** | ** ** |
|--------------------------------------------------|------------|---------------------------|------------|----------------------|------------|
|                                             |       |                      |       |                 |       |
| Working capital                                  |       | $                         | 13,685     |                 | $          | 10,079 |   |
| Long-term  borrowings, including current portion |       | $                         | 4,774      |                 | $          | 4,635 |   |
| Borrowings under  bank line of credit            |       | $                         | 10,569     |                 | $          | 8,648 |   |
| Ratio of current  assets to current liabilities  |       | 1.67                      |       | 1.56                 |       |

 

The increase in theworking capital is related primarily to our improved earnings.  The outstanding balance of our bank line ofcredit, classified as long-term, has increased by $1.9 million to $10.6 millionin the first quarter of fiscal 2005 as we have funded our increased productionlevels.  Our availability in excess ofborrowings on the working capital line of credit increased by $2.1 million to$4.4 million.

 

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**Cash flows provided by (used in)**

The following table sets forth, for the periods indicated, selectedconsolidated cash flow information (dollars in thousands):

 
| ** **                                 | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|
| ** **                                 | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Operating  Activities                      |       | $                                     | (1,666     | ) | $ | (259 | ) |
| Investing Activities                       |       | (391                                  | )          | (118 | ) |
| Financing  Activities                      |       | 2,195                                 |       | 590 |   |
| Effect of  exchange rate changes on cash   |       | (22                                   | )          | 50 |   |
|                                       |       |                                  |       |   |   |
| Net increase in  cash and cash equivalents |       | $                                     | 116        |   | $ | 263 |   |

 

The increase in sales, particularly in the last halfof the quarter ended September 30, 2004, has resulted in an increase inaccounts receivables, as compared to the same quarter in fiscal 2003.  In addition, inventory increased inpreparation for a second quarter production plan more weighted toward the firsthalf of the second quarter.  An increasein accounts payable did not entirely compensate for these uses of operatingfunds.  Although inventory levels arehigher compared to the first quarter of fiscal 2003, inventory turns haveimproved.

 

Net cash used in investing activities for the threemonths ended September 30, 2004 consists of capital expenditures of$391,000.  In addition to ongoingupgrades to manufacturing and computer equipment, approximately $66,000 ofconstruction in progress was recorded relating to the Thailand facilityexpansion.

 

The most significantsource of cash from financing activities was use of our bank line of credit tofund the increasing production.  Otherproceeds from financing activities included borrowing against our bank capitalexpenditure line of credit and proceeds from the exercise of stockoptions.  Cash was used to make recurringpayments on debt.

 

**Thailand credit facility**

 

In May 2004, we finalized a Credit Facility Agreementbetween our subsidiary SMTEK International Thailand Limited (“SMTEK Thailand”)and BankThai Public Company Limited and we unconditionally guaranteed SMTEKThailand’s liabilities and obligations under the Credit Facility Agreement forthe purpose of funding the growth and expansion of our Thailand facility.  The credit facility includes a $678,000mortgage loan for the purchase of the building and land at our Thailandfacility.  The mortgage has a seven yearterm with an initial interest rate of 5.75%, based on Thailand Prime Rate, anda monthly payment of approximately $9,000. The Credit Facility Agreement also includes a $440,000 construction loanfor the expansion of the Thailand facility. The construction loan has a 78 month term with interest at ThailandPrime Rate and a monthly payment of approximately $5,000.  The Credit Facility Agreement also includes aworking capital line of approximately $500,000 with interest at Thailand PrimeRate, a one year term and it is collateralized by all the assets of theThailand facility.  All liabilities andobligations under the Credit Facility are denominated in Baht, the currency ofThailand, and therefore the above estimates fluctuate with changes in the Bahtto U.S. dollar exchange rate.

 

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**Wells Fargo credit facility and other liquidityand capital resources issues**

 

In September 2003, we entered into a new long-termcredit facility with Wells Fargo Business Credit to replace a credit facilitywith Comerica Bank that had been in effect at June 30, 2003.  In June 2004 the Wells Fargo credit facilitywas amended to the form under which we are operating as of September 30,2004.  This new credit facility consistsof a $15 million working capital line, a term credit facility in the amount ofup to $1.0 million and a capital expenditure facility of $2.5 million.  The $15 million working capital line iscollateralized by accounts receivable, inventory and equipment.  Borrowings under the credit agreement bearinterest at either the bank’s prime rate (4.75% at September 30, 2004) plus 0.75%or a Libor rate (1.84% at September 30, 2004) plus 3.50%.  The working capital credit facility containsvarious financial covenants and matures September 30, 2007.  The financial covenants include requirementsrelated to net income, stockholders’ equity and debt service ratio.  We believe we were in compliance with allcovenants at September 30, 2004.  Theterm credit facility has a three year term and was used to repay the outstandingbalance on our equipment line of credit. The capital expenditure credit facility of $2.5 million will be used tofinance our capital expenditures.  Eachadvance under the capital expenditure credit facility will have a three yearterm at either the Bank’s prime rate plus 0.75% or, at our option, at a fixedrate equal to the Libor-base rate plus 3.50%.

 

We anticipate thatadditional capital expenditures of as much as $2.3 million may be incurredduring fiscal 2005, primarily to improve production efficiency at all oursubsidiaries.  A substantial portion ofthese capital expenditures are expected to be financed by our new line ofcredit or other notes/leases payable.

 

Management believes that our cash resources, cash fromoperations and available borrowing capacity on our working capital lines ofcredit are sufficient to fund operations for at least the next 12 months.  Long term, however, despite our costreduction measures and efficiency improvements, if we are unable to continue toincrease sales and maintain profitability, we may have to obtain additionaldebt or equity financing.  There can beno assurance that we will be able to obtain additional debt or equityfinancing, if and when needed, on terms acceptable to us.

 

**ENVIRONMENTAL MATTERS**

 

Since the early 1990s, wecontinue to be involved in certain remediation and investigative studiesregarding soil and groundwater contamination at the site of a former printedcircuit board manufacturing plant in Anaheim, California.  One of our former subsidiaries,Aeroscientific Corp., leased the Anaheim facility.  Under the terms of a cost sharing agreemententered into several years ago, the remaining remediation costs are currentlybeing shared on a 50-50 basis with the landlord.  There is no environmental insurance coveragefor this remediation.  At September 30,2004, we had a reserve of $419,000 for future remediation costs.  Management, based in part on consultationswith outside environmental engineers and scientists, believes that this reserveis adequate to cover its share of future remediation costs at this site.  However, the future actual remediation costscould differ significantly from the estimates. Further, our portion could potentially exceed the amount of ourreserve.  Our liability for remediationin excess of our reserve could have a material adverse impact on our business,financial condition, results of operations and cash flows.

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Our financial instruments include cash and cashequivalents, accounts receivable and short-term and long-term debt.  At September 30, 2004, the carrying amount oflong-term debt (including current portion thereof but excluding bank line ofcredit) was $4.8 million and the fair value was $4.3 million.  The carrying values of our other financialinstruments approximated their fair values. The fair value of our financial instruments is estimated based on quotedmarket prices for the same or similar issues. A change in interest rates of one percent would result in an annualimpact on interest expense of approximately $130,000.

 

It is our policy not to enter into derivativefinancial instruments for speculative purposes. We may, from time to time, enter into foreign currency forward exchangecontracts in an effort to protect us from adverse currency rate fluctuations onforeign currency commitments entered into in the ordinary course ofbusiness.  These commitments aregenerally for terms of less than one year. The foreign currency forward exchange contracts are executed with banksbelieved to be creditworthy and are denominated in currencies of majorindustrial countries.  In accordance withSFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,”all derivative financial instruments are measured at fair value and arerecognized as either assets or liabilities in the balance sheet.  The accounting treatment of changes in fairvalue is dependent upon whether or not a derivative financial instrument isdesignated as a hedge and, if so, the type of hedge.  Changes in fair value are recognized incurrent results of operations for fair value hedges and in other comprehensiveincome for cash flow hedges.  Derivativefinancial instruments not qualifying for hedge accounting treatment under SFASNo. 133, as amended by FAS 149, are recognized as assets or liabilities withgains or losses recognized in current results of operations.  At September 30, 2004, we had no forwardforeign currency contracts.

 

Our operations include investments in a foreignoperating unit.  Our foreign subsidiaryrepresents approximately 12% of our revenues and 9% of our total assets.  As a result, our financial results have beenand may continue to be affected by changes in foreign currency exchange rates.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

**Evaluationof disclosure controls and procedures**.

 

Basedon management’s evaluation (with the participation of our principal executiveand financial officer), as of the end of the period covered by this report, ourprincipal executive officer and financial officer has concluded that ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”))are effective to ensure that information required to be disclosed by us inreports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in SEC rules andregulations.

 

**Changesin internal control over financial reporting**.

 

Therewas no change in our internal control over financial reporting during our firstfiscal quarter of 2005 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**Limitation on the Effectiveness of Controls**

 

Our management, including our President and ChiefFinancial Officer, does not expect that our disclosure controls and internalcontrols will prevent all error and all fraud. A control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. Further, thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control.

 

The design of any system of controls also is based inpart upon certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions.

 

**PART II. OTHER INFORMATION**

 

**Revised Deadline for Receipt of StockholderProposals for the 2004 Annual Meeting**

 

We will hold our 2004 Annual Meeting of stockholderson January 26, 2005.  Stockholderproposals that are intended to be presented at the 2004 Annual Meeting andincluded in the Company’s proxy materials relating to the 2004 Annual Meetingmust be received by the company no later than November 16, 2004.  All stockholder proposals must be incompliance with applicable laws and regulations in order to be considered forpossible inclusion in the proxy statement and form of proxy for the 2004 AnnualMeeting.

 

If a stockholder wishes to present a proposal at theCompany’s 2004 Annual Meeting and the proposal is not intended to be includedin the Company’s proxy statement relating to the 2004 Annual Meeting, thestockholder must give advance notice to the Company prior to the deadline forthe annual meeting determined in accordance with the Company’s bylaws (the “BylawDeadline”). Stockholder proposals intended for presentation at the 2004 AnnualMeeting must be received by the Company’s Secretary no later than the 90th dayprior to the annual meeting and not later than the close of business on thelater of the 60th day prior to such annual meeting or the 10th day followingthe date on which public announcement of the date of such meeting is firstmade.  If a stockholder gives notice ofsuch proposal after the Bylaw Deadline, the stockholder will not be permittedto present the proposal to the stockholders for a vote at the meeting.  All stockholder proposals must be in the formrequired by the Company’s bylaws.

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

In the ordinary course of business, we experiencevarious types of claims which sometimes result in litigation or other legalproceedings.  We do not anticipate thatany of these claims or proceedings that are currently pending will have amaterial adverse effect on us.

 

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**ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS**

 

**Conversion of Series A Preferred Stock**

 

In July 2004, 250,000 shares of preferred stock andaccrued dividends of approximately $36,000 were converted by the holder into268,369 shares of common stock (see Note 7 to the unaudited CondensedConsolidated Financial Statements).

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

NONE

 

**ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K**

 
| a.    Exhibits: |   |                                                                    |
|-------------------------------------|--------|-------------------------------------------------------------------------|
|                                |   |                                                                    |
| 31.1+                               |   | Rule 13a-14(a)/15d-14(a) Certification of Principal  Executive Officer. |
|                                |   |                                                                    |
| 31.2+                               |   | Rule 13a-14(a)/15d-14(a) Certification of Principal  Financial Officer. |
|                                |   |                                                                    |
| 32.1+                               |   | Section 1350 Certification of Principal Executive  Officer.             |
|                                |   |                                                                    |
| 32.2+                               |   | Section 1350 Certification of Principal Financial  Officer.             |

 

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+  Filed herewith

 

**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
| November 8, 2004 |   | /s/  Kirk A. Waldron       |   |
|------------------|--------|----------------------------|--------|
| Date             |   | Kirk  A. Waldron           |
|             |   | Interim  President,        |
|             |   | Senior  Vice President and |
|             |   | Chief  Financial Officer   |

 

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