**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549-1004**

 

**Form 10-Q**

 

**(Mark One)**

 

**ý****  Quarterly report pursuant toSection 13 or 15(d) of the Securities ExchangeAct of 1934**

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003**

 

**or**

 

**o****  Transition report pursuant toSection 13 or 15(d) of the SecuritiesExchange Act of 1934**

 

**For the transition period from                     to                     **

 

**Commission File Number 0-21681**

 

**EFJ, INC.**

(Exactname of registrant as specified in its charter)

 

| **DELAWARE**                                                                                                                |   | **47-0801192**                       |
|-----------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                                                             |   | (I.R.S. Employer Identification No.) |
|                                                                                                                        |   |                                 |
| **4800 N.W. 1st STREET  LINCOLN, NEBRASKA 68521  (402) 474-4800**                                                           |
| (Address, including zip code, and telephone number,  including area code, of registrant’s  principal executive office) |

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 
| YES  ý |   | NO o |
|------------------|--------|------|

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 
| YES  o |   | NO ý |
|-------------|--------|-----------|

 

As of October 31, 2003, 17,577,315 shares of theRegistrant’s Common Stock were outstanding.

 

 

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**PARTI.  FINANCIAL INFORMATION**

 

**ITEM1.  FINANCIAL STATEMENTS**

 

#### **EFJ,INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

September 30, 2003and December 31, 2002

(in thousands, exceptshare data)

 
|                                                                                                                                                                                                                             |   | **SEPTEMBER 30,  2003** |       | **DECEMBER 31,  2002** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|------------------------|------------|
|                                                                                                                                                                                                                             |   | **(unaudited)**         |       |                   |       |
| **ASSETS**                                                                                                                                                                                                                       |   |                    |       |                   |       |
| Current assets:                                                                                                                                                                                                                  |   |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                                                        |   | $                       | 2,308      |                   | $          | 11,333 |   |
| Accounts receivable, net of allowance for returns and doubtful accounts  of $177 and $236, respectively                                                                                                                          |   | 10,297                  |       | 6,568                  |       |
| Receivables – other                                                                                                                                                                                                         |   | 146                     |       | 252                    |       |
| Cost in excess of billings on uncompleted contracts                                                                                                                                                                              |   | 857                     |       | 1,686                  |       |
| Inventories, net                                                                                                                                                                                                                 |   | 13,449                  |       | 11,671                 |       |
| Deferred income taxes                                                                                                                                                                                                            |   | 1,000                   |       | 1,000                  |       |
| Prepaid expenses                                                                                                                                                                                                                 |   | 845                     |       | 487                    |       |
| Total current assets                                                                                                                                                                                                             |   | 28,902                  |       | 32,997                 |       |
|                                                                                                                                                                                                                             |   |                    |       |                   |       |
| Property, plant and equipment, net                                                                                                                                                                                               |   | 2,705                   |       | 2,601                  |       |
| Deferred income taxes                                                                                                                                                                                                            |   | 2,000                   |       | 2,000                  |       |
| Intangible assets, net of accumulated amortization                                                                                                                                                                               |   | 6,755                   |       | 6,760                  |       |
| Other assets                                                                                                                                                                                                                     |   | 691                     |       | 898                    |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                 |   | $                       | 41,053     |                   | $          | 45,256 |   |
|                                                                                                                                                                                                                             |   |                    | ** ** |                   | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                   |   |                    | ** ** |                   | ** ** |
| Current liabilities:                                                                                                                                                                                                             |   |                    |       |                   |       |
| Revolving line of credit                                                                                                                                                                                                         |   | $                       | —     |                   | $          | 5,000 |   |
| Current portion of long-term debt obligations                                                                                                                                                                                    |   | 129                     |       | 22                     |       |
| Accounts payable                                                                                                                                                                                                                 |   | 5,452                   |       | 4,007                  |       |
| Billings in excess of cost on uncompleted contracts                                                                                                                                                                              |   | 12                      |       | 38                     |       |
| Deferred revenue – current                                                                                                                                                                                                  |   | 439                     |       | 961                    |       |
| Accrued expenses                                                                                                                                                                                                                 |   | 2,191                   |       | 2,317                  |       |
| Total current liabilities                                                                                                                                                                                                        |   | 8,223                   |       | 12,345                 |       |
|                                                                                                                                                                                                                             |   |                    |       |                   |       |
| Long-term debt obligations, net of current portion                                                                                                                                                                               |   | 449                     |       | 264                    |       |
| Deferred revenue, net of current portion                                                                                                                                                                                         |   | 196                     |       | 160                    |       |
| **TOTAL  LIABILITIES**                                                                                                                                                                                                           |   | 8,868                   |       | 12,769                 |       |
|                                                                                                                                                                                                                             |   |                    |       |                   |       |
| Stockholders’ equity:                                                                                                                                                                                                       |   |                    |       |                   |       |
| Preferred stock ($0.01 par value; 3,000,000 shares authorized; none  issued)                                                                                                                                                     |   | —                  |       | —                 |       |
| Common stock ($0.01 par value; 25,000,000 voting shares authorized,  17,359,773 issued  and outstanding  as of September 30, 2003 and December 31, 2002; 600,000 non-voting  shares authorized, 217,542 issued and  outstanding) |   | 176                     |       | 176                    |       |
| Additional paid-in capital                                                                                                                                                                                                       |   | 99,099                  |       | 96,918                 |       |
| Accumulated deficit                                                                                                                                                                                                              |   | (67,090                 | )          | (64,607                | )          |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                                                                                             |   | 32,185                  |       | 32,487                 |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                             |   | $                       | 41,053     |                   | $          | 45,256 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

2

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**EFJ, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

Forthe three and nine months ended September 30, 2003 and 2002

(Unauditedand in thousands, except share and per share data)

 
|                                                                                                                                         |   | **THREE MONTHS ENDED  SEPTEMBER 30,** |   | **NINE MONTHS ENDED  SEPTEMBER 30,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                                         |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Revenues                                                                                                                                     |   | $                                     | 13,089 |                                 | $      | 10,136 |   | $ | 32,803 |   | $ | 29,547 |   |
| Cost of sales                                                                                                                                |   | 7,853                                 |   | 5,800                                |   | 18,974 |   | 16,646 |   |
| Gross profit                                                                                                                                 |   | 5,236                                 |   | 4,336                                |   | 13,829 |   | 12,901 |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Operating expenses:                                                                                                                          |   |                                  |   |                                 |   |   |   |   |   |
| Research and development                                                                                                                     |   | 1,939                                 |   | 1,128                                |   | 5,154 |   | 3,457 |   |
| Sales and marketing                                                                                                                          |   | 1,756                                 |   | 1,577                                |   | 4,590 |   | 4,243 |   |
| General and administrative, inclusive of non-cash  Stock option repricing adjustment of $1,890  $(199),   $2,186, and $162 (See Note 8) |   | 3,327                                 |   | 1,194                                |   | 6,523 |   | 4,642 |   |
| Total operating expenses                                                                                                                     |   | 7,022                                 |   | 3,899                                |   | 16,267 |   | 12,342 |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Income (loss) from operations                                                                                                                |   | (1,786                                | )      | 437                                  |   | (2,438 | ) | 559 |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Other income (expense)                                                                                                                       |   | 35                                    |   | 44                                   |   | 62 |   | 183 |   |
| Interest income                                                                                                                              |   | 5                                     |   | 11                                   |   | 26 |   | 60 |   |
| Interest expense                                                                                                                             |   | (41                                   | )      | (1                                   | )      | (133 | ) | (18 | ) |
| Income (loss) before income taxes                                                                                                            |   | (1,787                                | )      | 491                                  |   | (2,483 | ) | 784 |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Income tax provision                                                                                                                         |   | —                                |   | —                               |   | — |   | — |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Net income (loss)                                                                                                                            |   | $                                     | (1,787 | )                                    | $      | 491 |   | $ | (2,483 | ) | $ | 784 |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Net income (loss) per share – Basic                                                                                                     |   | $                                     | (0.10  | )                                    | $      | 0.03 |   | $ | (0.14 | ) | $ | 0.04 |   |
| Net income (loss) per share – Diluted                                                                                                   |   | $                                     | (0.10  | )                                    | $      | 0.03 |   | $ | (0.14 | ) | $ | 0.04 |   |
|                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Weighted average common shares – Basic                                                                                                  |   | 17,577,315                            |   | 17,577,315                           |   | 17,577,315 |   | 17,577,315 |   |
| Weighted average common shares – Diluted                                                                                                |   | 17,577,315                            |   | 17,837,605                           |   | 17,577,315 |   | 17,976,991 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

3

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**EFJ, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

Ninemonths ended September 30, 2003 and 2002

(Unaudited and inthousands, except share data)

** **
|                                                                                                |   | **Nine months ended September 30,** |   |
|-----------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                                |   | **2003**                            |   | **2002** |   |
| Cash flows from operating activities:                                                               |   |                                |   |   |   |
| Net income (loss)                                                                                   |   | $                                   | (2,483 | ) | $ | 784 |   |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities: |   |                                |   |   |   |
| Depreciation and amortization                                                                       |   | 827                                 |   | 851 |   |
| Non-cash compensation – intrinsic value of repriced options                                    |   | 2,186                               |   | 162 |   |
| Gain on sale of fixed assets                                                                        |   | (58                                 | )      | (75 | ) |
| Changes in assets and liabilities:                                                                  |   |                                |   |   |   |
| Accounts receivable                                                                                 |   | (3,623                              | )      | 1,097 |   |
| Cost in excess of billings on uncompleted contracts                                                 |   | 829                                 |   | 467 |   |
| Inventories                                                                                         |   | (1,778                              | )      | (1,847 | ) |
| Prepaid expenses                                                                                    |   | (318                                | )      | (713 | ) |
| Accounts payable                                                                                    |   | 1,445                               |   | (401 | ) |
| Billings in excess of cost on uncompleted contracts                                                 |   | (26                                 | )      | (147 | ) |
| Deferred revenues                                                                                   |   | (480                                | )      | (417 | ) |
| Accrued and other liabilities                                                                       |   | (126                                | )      | 47 |   |
| Total adjustments                                                                                   |   | (1,122                              | )      | (976 | ) |
| Net cash used in operating activities                                                               |   | (3,605                              | )      | (192 | ) |
|                                                                                                |   |                                |   |   |   |
| Cash flows from investing activities:                                                               |   |                                |   |   |   |
| Proceeds from sale of fixed assets                                                                  |   | 53                                  |   | 12 |   |
| Purchase of property, plant and equipment                                                           |   | (553                                | )      | (709 | ) |
| Other assets                                                                                        |   | 167                                 |   | (140 | ) |
| Net cash used in investing activities                                                               |   | (333                                | )      | (837 | ) |
|                                                                                                |   |                                |   |   |   |
| Cash flows from financing activities:                                                               |   |                                |   |   |   |
| Payments on revolving line of credit, net                                                           |   | (5,000                              | )      | (5,120 | ) |
| Principal payments on long-term debt                                                                |   | (82                                 | )      | (22 | ) |
| Other                                                                                               |   | (5                                  | )      | — |   |
| Net cash used in financing activities                                                               |   | (5,087                              | )      | (5,142 | ) |
|                                                                                                |   |                                |   |   |   |
| Net decrease in cash and cash equivalents                                                           |   | (9,025                              | )      | (6,171 | ) |
|                                                                                                |   |                                |   |   |   |
| Cash and cash equivalents, beginning of period                                                      |   | 11,333                              |   | 11,582 |   |
|                                                                                                |   |                                |   |   |   |
| Cash and cash equivalents, end of period                                                            |   | $                                   | 2,308  |   | $ | 5,411 |   |

 

**Summaryof non-cash transactions:**

 

In the nine months ending September 30, 2003 and 2002, the Companyacquired $374 and $53 of fixed assets in exchange for long-term debt.

 

See accompanying notes tothe condensed consolidated financialstatements

 

4

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**EFJ,INC. AND SUBSIDIARIES**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**Threeand nine months ended September 30, 2003 and 2002**

**(Unauditedand in thousands, except share and per share data)**

 

**1.GENERAL**

 

The condensed consolidated balance sheet of EFJ, Inc.(“EFJ” or the “Company”) at December 31, 2002 has been derived from auditedconsolidated financial statements at that date.  The condensed consolidated financial statements, as of September30, 2003 and for the three and nine months ended September 30, 2003 and 2002,are unaudited.  The condensedconsolidated financial statements reflect all normal and recurring accruals andadjustments that, in the opinion of management, are necessary for a fairpresentation of the financial position, operating results, and cash flows forthe interim periods presented in this quarterly report.  The condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and notes thereto, together with management’s discussion andanalysis of financial condition and results of operations, contained in theCompany’s Annual Report on Form 10-K for the year ended December 31, 2002.  The results of operations and cash flows forthe three and nine months ended September 30, 2003 are not necessarilyindicative of the results for any other period or the entire fiscal year endingDecember 31, 2003.  Where appropriate,items within the condensed consolidated financial statements have been reclassifiedfrom the previous period’s presentation to conform to the current presentation.

 

**2.  ORGANIZATION AND CONSOLIDATION**

 

The Company is a manufacturer of wirelesscommunications products and systems and information security products.  Through its wholly-owned subsidiary, E.F.Johnson Company (“EFJohnson”), the Company designs, develops, manufactures andmarkets: (1) mobile and portable land mobile radios (“LMR”); (2) stationary LMRtransmitters / receivers (base stations or repeaters); and (3) LMR systems.  Through its wholly-owned subsidiary,Transcrypt International, Inc. (“Transcrypt”), the Company designs andmanufactures information security products, which prevent unauthorized accessto sensitive voice and data communications. These products are based on a wide range of analog scrambling anddigital encryption technologies and are sold mainly to the LMR markets as anadd-on security device for analog radios. The Company sells its products to: (1) domestic public safety /public service and other governmental users; (2) domestic commercial users; and(3) international customers.

 

The condensed consolidated financial statementsinclude the accounts of the Company and its wholly-owned subsidiaries.  All significant intercompany accounts andtransactions have been eliminated in the consolidation.

 

**3.  NET INCOME (LOSS) PER SHARE**

 

Basic income (loss) per share (“EPS”) is calculatedbased upon the weighted average number of common shares outstanding during theperiod.  The diluted EPS calculation reflectsthe potential dilution from common stock equivalents such as stockoptions.  For the three and nine monthsended September 30, 2003, the impact of outstanding stock options on dilutedEPS was anti-dilutive as both the three and nine month periods ended September30, 2003 had a net loss; as such the basic EPS is used for both basic anddiluted EPS for the respective periods. All outstanding stock options granted as of such dates which hadexercise prices lower than the average market price of the common stock for therespective periods are considered common stock equivalents in the calculationof the diluted weighted average common shares. The Company uses the treasury stock method to calculate diluted weightedaverage common shares, as if all such options were outstanding for the periodspresented.

 

If the Company had not incurred a net loss for thethree and nine months ending September 30, 2003, the diluted weighted averagecommon shares would have been 18,779,341 and 18,580,437, respectively.  As a result of the net loss conditions, theCompany used weighted average outstanding common shares, or 17,577,315, forboth the basic and diluted weighted average common shares for the periodsending September 30, 2003.

 

5

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**4.  ACCOUNTING FOR STOCK-BASED COMPENSATION**

 

The Company applies the intrinsic value-based methodof accounting for stock options issued to employees.   When both the number of shares that an individual employee isentitled to receive and the option price are known at the grant date, totalcompensation cost for the Company’s grants of stock options is measured at thegrant date (“fixed plan awards”). However, when either or both of these factors are not known at the grantdate, the Company estimates total compensation cost each accounting period fromthe date of grant based on the estimated fair value of the Company’s commonstock at the end of each period (“variable plan awards”).  Changes, either increases or decreases, inthe estimated fair value of the shares between the date of grant and the finalexercise or expiration date of the options result in a change in the measure ofcompensation cost for variable plan awards. Compensation cost is recognized as expense over the periods in which theemployee performs the related services, which is generally presumed to be thevesting period.

 

If compensation cost for theCompany’s stock option plans had been determined based on the fair value at thegrant date for awards for the three and nine months ended September 30, 2003and 2002, the Company’s pro forma net income (loss) and pro forma net income(loss) per share would have been as follows:

 
|                                                                          |   | **Three months ended  September 30,** |   | **Nine months ended  September 30,** |   |
|-------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                          |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                          |   |                                  |   |                                 |   |   |   |   |   |
| Net income  (loss) — as reported                                         |   | $                                     | (1,787 | )                                    | $      | 491 |   | $ | (2,483 | ) | $ | 784 |   |
| General and  administrative expenses for management stock option compensation |   | (115                                  | )      | 200                                  |   | 320 |   | 492 |   |
| Pro forma net  income (loss)                                                  |   | $                                     | (1,672 | )                                    | $      | 291 |   | $ | (2,803 | ) | $ | 292 |   |
|                                                                          |   |                                  |   |                                 |   |   |   |   |   |
| Net income  (loss) per share, basic and diluted — as reported            |   | $                                     | (0.10  | )                                    | $      | 0.03 |   | $ | (0.14 | ) | $ | 0.04 |   |
| Pro forma net  income (loss) per share, basic and diluted                     |   | $                                     | (0.10  | )                                    | $      | 0.02 |   | $ | (0.16 | ) | $ | 0.02 |   |

 

The weighted average fair value peroption at date of grant during the nine months ended September 30, 2003 and2002 was $1.47 and $.51, respectively. The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model with the following weightedaverage assumptions for options granted:

 
|                        |   | **Nine months ended  September 30,** |   |
|-----------------------------|--------|--------------------------------------|--------|
|                        |   | **2003**                             |   | **2002** |   |
| Expected option  life       |   | 10  years                            |   | 10  years |   |
| Expected annual  volatility |   | 92                                   | %      | 193 | % |
| Risk-free  interest rate    |   | 3.99                                 | %      | 2.93 | % |
| Dividend yield              |   | 0                                    | %      | 0 | % |

 

6

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**5.  INVENTORIES**

 

During the nine months ended September 30, 2003, theCompany sold, disposed of, or otherwise wrote off, $1,600 of obsolete inventorythat was substantially reserved, and on which disposition the Company lostapproximately $335.

 

The following is a summary of inventory at September30, 2003 and December 31, 2002:

 
|                        |   | **September  30, 2003** |   | **December  31, 2002** |   |
|-----------------------------|--------|-------------------------|--------|------------------------|--------|
| Raw materials  and supplies |   | $                       | 6,809  |                   | $      | 7,562 |   |
| Work in progress            |   | 2,601                   |   | 1,646                  |   |
| Finished goods              |   | 5,689                   |   | 4,931                  |   |
|                        |   | 15,099                  |   | 14,139                 |   |
| Reserve for  obsolescence   |   | (1,650                  | )      | (2,468                 | )      |
| Total  inventories, net     |   | $                       | 13,449 |                   | $      | 11,671 |   |

 

**6.  INTANGIBLE ASSETS**

 

As required by Statement of Financial AccountingStandards (“SFAS”) 142, ***Goodwill and Other Intangible Assets***(“SFAS 142”)***,*** the Company doesnot amortize its goodwill, instead reviewing its goodwill for impairment, atleast annually.  The Company performedfair value-based impairment tests, in accordance with SFAS 142, at December 31,2002 and 2001, concluding that no impairment of goodwill had occurred as ofthese dates.  No events occurred duringthe three and nine months ended September 30, 2003 and 2002 that would indicatethat an impairment of such assets had taken place.  As of January 1, 2002, certain of the Company’s intangible assets(customer base, acquired workforce, and tradename) were reclassed to goodwill,as per SFAS 141, ***Business Combinations,***these assets were not deemed separable from goodwill for purposes ofrecognition.

 

Amortization expense, related to intangible assets,which are subject to amortization, was $5 and $109 for the nine months endedSeptember 30, 2003 and 2002. Amortization expense of intangible assets subject to amortization isanticipated to be $8 for 2003 and annually thereafter through 2012.  Intangible assets consist of the following:

 
|                                        |   | **September  30, 2003** |   | **December  31, 2002** |   |
|---------------------------------------------|--------|-------------------------|--------|------------------------|--------|
| Goodwill                                    |   |                    |   | $                      | 6,690  |   |   |   | $ | 6,690 |   |
| Intangible  assets subject to amortization: |   |                    |   |                   |   |   |   |   |   |
| Proprietary and  core technology            |   | 1,290                   |   |                   |   | 1,290 |   |   |   |
| Less:  accumulated amortization        |   | 1,290                   |   | —                 |   | 1,290 |   | — |   |
| Patents                                     |   | 113                     |   |                   |   | 113 |   |   |   |
| Less:  accumulated amortization        |   | 48                      |   | 65                     |   | 43 |   | 70 |   |
| Total                                       |   |                    |   | $                      | 6,755  |   |   |   | $ | 6,760 |   |

 

**7.  REVOLVING LINE OF CREDIT**

 

In November 2002, the Company enteredinto a $10.0 million secured line of credit agreement with Bank ofAmerica.  The line of credit bearsinterest at a rate of LIBOR plus 200 basis points, the effective rate atSeptember 30, 2003, which rate may be increased to LIBOR plus 275 basis pointsdependent upon certain debt ratios.  Theline of credit is collateralized by substantially all the Company’sassets.  Borrowings available under theline of credit are calculated as a percentage of eligible inventory andreceivables.  The agreement, whichexpires September 30, 2004, includes certain covenants, including financialcovenants, with which the Company was in compliance, or for which waivers hadbeen obtained, as of September 30, 2003 and December 31, 2002.  At September 30, 2003 and December 31, 2002,the Company had $0 and $5,000, respectively, outstanding on its line ofcredit.  The total available creditunder the line of credit was $9.3 million as of September 30, 2003.

 

7

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**8.  REPRICED STOCK OPTIONS**

 

In 2000 and 2001, the Companyeffectively cancelled and reissued stock options in order to lower the exerciseprice of those options to $0.656 per share, an amount approximating 150% of thethen prevailing market value of the Company’s common stock (the “repricing”).  The repricing of the stock options resultedin a new measurement date for accounting purposes and the reclassification ofthese options as variable plan awards beginning on the date of the repricing.  The Company had previously accounted forthese option grants as fixed plan awards. As of September 30, 2003 and 2002, respectively, approximately 867,000and 902,000 of these repriced options, in various stages of vesting, wereoutstanding.  At September 30, 2003 and2002, respectively, the market value of the Company’s common stock was $3.90and $0.85 per share; this compared to market values of $1.25 and $0.52 pershare at December 31, 2002 and 2001. Non-cash compensation charges, therefore, resulted to the extent thatthe market value exceeded the repriced exercise price of $0.656 per share.  In the three and nine months ended September30, 2003, the amounts of compensation expense relating to these repricedoptions were $1,890 and $2,186, respectively. In the three and nine months ended September 30, 2002, the relatedamounts of compensation expense (benefit) were $(199) and $162,respectively.  These amounts areincluded in general and administrative expenses.

 

**9.  COMMITMENTS AND CONTINGENCIES**

 

On or about February 5, 2001, ASRC Communication(“ASRC”) filed a complaint in United States District Circuit Court of Alaska,against EFJohnson.  ASRC alleges thatEFJohnson engaged in wrongful activities in association with radio productssold to ASRC.  ASRC purchased, andresold to the State of Alaska, approximately $500 of products from EFJohnsonsince 1999.  ASRC’s claims againstEFJohnson include breach of contract, breach of express warranty, breach ofimplied warranty of merchantability, breach of implied warranty of fitness fora particular purpose, breach of duty of good faith and fair dealing, equitableestoppel, misrepresentation, and violations of the Racketeer Influenced andCorrupt Organizations Act.  Thecomplaint anticipated that the State of Alaska would formally prosecute itsadministrative claim against ASRC for damages associated with EFJohnsonmanufactured radios.  At this time, theState of Alaska has not formally prosecuted its administrative claim againstASRC.  The State of Alaska has statedthat it has damages in excess of $800. In August 2003, ASRC and EFJohnson dismissed ASRC’s complaint againstthe Company. Under an agreement, EFJohnson shall defend ASRC, at EFJohnson’sexpense, against any State’s claim alleging non-performance of the EFJohnsonradios.  In addition, the parties will resolveany issue or dispute through mediation and binding arbitration.  The Company is unable to predict thelikelihood of the outcome or potential liability that may arise from thisaction.

 

The Company is involved in certainother legal proceedings incidental to the normal conduct of its business.  The Company does not believe that anyliabilities relating to such other legal proceedings are likely to be,individually or in the aggregate, material to the Company’s business, financialcondition, results of operations, or cash flows.

 

In the normal course of its businessactivities, the Company is required under a contract with various governmentalauthorities to provide letters of credit and bonds that may be drawn upon ifthe Company fails to perform under its contracts.  The letters of credit, which expire on various dates in 2003,have a total undrawn balance of $736 at September 30, 2003.  Bonds, which expire on various dates,totaled $7,840 on September 30, 2003. As of that date, no bonds have been drawn upon.

 

**10.  RELATED PARTY TRANSACTION**

 

In April 2002, the Company extended a loan to itsChief Executive Officer, Michael E. Jalbert, in the principal amount of$75.  This note is due on demand andbears interest at the annual rate of 6%. Any tax obligations associated with the loan are the sole responsibilityof Mr. Jalbert.

 

8

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**11.  SEGMENT AND RELATED INFORMATION**

 

The Company operates in the following two industrysegments:

•                  the wireless communication industry (EFJohnson), whichis comprised of the design, development, manufacture and sale of stationaryland mobile radio transmitters/receivers, mobile and portable radios andcomplete radio communication systems; and

•                  the information security industry (Transcrypt), whichis comprised of the design, manufacture and sale of devices that prevent theunauthorized interception of sensitive voice and data communication.

 

The Company evaluates segment results based on grossmargin and income from operations.  Corporate expenses are allocated to the operating segments basedupon estimated usage of corporate resources. The following table is a summary of the unaudited operating results forthe three and nine months ended September 30, 2003 and 2002.

** **
|                                  |   | **Three Months  Ended  September 30,** |       | **Nine  Months Ended  September 30,** |       |
|---------------------------------------|--------|----------------------------------------|------------|---------------------------------------|------------|
| **In thousands**                      |   | **2003**                               |       | **2002**                              |       | **2003** |   | **2002** |   |
| **Revenues:**                         |   |                                   | ** ** |                                  | ** ** |   | ** ** |   | ** ** |
| Wireless Communication                |   | $                                      | 11,992     |                                  | $          | 8,489 |   | $ | 28,139 |   | $ | 24,706 |   |
| Information Security                  |   | 1,097                                  |       | 1,647                                 |       | 4,664 |   | 4,841 |   |
|                                  |   | $                                      | 13,089     |                                  | $          | 10,136 |   | $ | 32,803 |   | $ | 29,547 |   |
| **Gross Profit:**                     |   |                                   |       |                                  |       |   |   |   |   |
| Wireless Communication                |   | $                                      | 4,448      |                                  | $          | 3,101 |   | $ | 10,428 |   | $ | 9,523 |   |
| Information Security                  |   | 788                                    |       | 1,235                                 |       | 3,401 |   | 3,378 |   |
|                                  |   | $                                      | 5,236      |                                  | $          | 4,336 |   | $ | 13,829 |   | $ | 12,901 |   |
| **Operating  Profit (Loss):**         |   |                                   |       |                                  |       |   |   |   |   |
| Wireless Communication                |   | $                                      | (1,317     | )                                     | $          | (93 | ) | $ | (2,891 | ) | $ | (327 | ) |
| Information Security                  |   | (469                                   | )          | 530                                   |       | 453 |   | 886 |   |
| **Income (Loss)  from Operations**    |   | (1,786                                 | )          | 437                                   |       | (2,438 | ) | 559 |   |
|                                  |   |                                   |       |                                  |       |   |   |   |   |
| **Other Income  (Expense), net**      |   | (1                                     | )          | 54                                    |       | (45 | ) | 225 |   |
|                                  |   |                                   |       |                                  |       |   |   |   |   |
| **Income (Loss)  before Taxes**       |   | $                                      | (1,787     | )                                     | $          | 491 |   | $ | (2,483 | ) | $ | 784 |   |
|                                  |   |                                   |       |                                  |       |   |   |   |   |
| **Depreciation  & Amortization:** |   |                                   |       |                                  |       |   |   |   |   |
| Wireless Communication                |   | $                                      | 252        |                                  | $          | 217 |   | $ | 730 |   | $ | 719 |   |
| Information Security                  |   | 34                                     |       | 39                                    |       | 97 |   | 132 |   |
|                                  |   | $                                      | 286        |                                  | $          | 256 |   | $ | 827 |   | $ | 851 |   |
|                                  |   |                                   |       |                                  |       |   |   |   |   |
| **Assets:**                           |   |                                   |       |                                  |       |   |   |   |   |
| Wireless Communication                |   | $                                      | 33,102     |                                  |       |   |   |   |   |   |
| Information Security                  |   | 5,500                                  |       |                                  |       |   |   |   |   |
| Corporate                             |   | 2,451                                  |       |                                  |       |   |   |   |   |
|                                  |   | $                                      | 41,053     |                                  |       |   |   |   |   |   |

 

9

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS****OF OPERATIONS**

 

The following table presents certain ConsolidatedStatements of Operations information as a percentage of revenues during theperiods indicated:

 
|                              |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|-----------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                              |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                              |   |                                  |   |                                 |   |   |   |   |   |
| Revenues                          |   | 100.0                                 | %      | 100.0                                | %      | 100.0 | % | 100.0 | % |
| Cost of sales                     |   | 60.0                                  | %      | 57.2                                 | %      | 57.8 | % | 56.3 | % |
| Gross profit                      |   | 40.0                                  | %      | 42.8                                 | %      | 42.2 | % | 43.7 | % |
| Operating expenses:               |   |                                  |   |                                 |   |   |   |   |   |
| Research and development          |   | 14.8                                  | %      | 11.1                                 | %      | 15.7 | % | 11.7 | % |
| Sales and marketing               |   | 13.4                                  | %      | 15.6                                 | %      | 14.0 | % | 14.4 | % |
| General and administrative        |   | 25.4                                  | %      | 11.8                                 | %      | 19.9 | % | 15.7 | % |
| Total operating expenses          |   | 53.6                                  | %      | 38.5                                 | %      | 49.6 | % | 41.8 | % |
| Income (loss) from operations     |   | (13.6                                 | )%     | 4.3                                  | %      | (7.4 | )% | 1.9 | % |
| Interest income (expense) - net   |   | (0.3                                  | )%     | 0.1                                  | %      | (0.3 | )% | 0.1 | % |
| Other income (expense)            |   | 0.3                                   | %      | 0.4                                  | %      | 0.2 | % | 0.7 | % |
| Income (loss) before income taxes |   | (13.6                                 | )%     | 4.8                                  | %      | (7.5 | )% | 2.7 | % |
| Provision for income taxes        |   | —                                |   | —                               |   | — |   | — |   |
| Net income (loss)                 |   | (13.6                                 | )%     | 4.8                                  | %      | (7.5 | )% | 2.7 | % |

 

Discussions of certain matters contained in thisQuarterly Report on Form 10-Q may constitute forward-looking statements underSection 27A of the Securities Act of 1933, as amended (the “Securities Act”),and Section 21E of the Securities Exchange Act of 1934, as amended, (the“Exchange Act”). These forward-looking statements relate to, among otherthings, the results of the Company’s product development efforts, future salesand expense levels, the Company’s future financial condition, liquidity andbusiness prospects generally, perceived opportunities in the marketplace forthe Company’s products, and the Company’s other business plans for thefuture.  These forward-lookingstatements are subject to certain risks and uncertainties that could cause theactual results, performance and outcomes to differ materially from thoseexpressed or implied in these forward-looking statements due to a number ofrisk factors including, but not limited to, the risks detailed in “ITEM 1.BUSINESS — Summary of Business Considerations and Certain Factors That MayAffect Future Results of Operations and/or Stock Price” contained in theCompany’s Annual Report on Form 10-K for the year ended December 31, 2002.

 

The following discussion is intended to provide abetter understanding of the significant changes in trends relating to theCompany’s financial condition and results of operations.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations should be read in conjunctionwith the accompanying Consolidated Financial Statements and Notes thereto.

 

Revenues

 

Revenues increased 29% to $13.1 million in the thirdquarter of 2003, as compared to $10.1 million during the same period in2002.  Of total revenues in the thirdquarter of 2003, the wireless communication segment comprised $12.0 million,which represents an increase of 41% as compared to revenues of $8.5 millionduring the same period in 2002. Information security segment revenues of $1.1 million in the thirdquarter of 2003 represent a 33% decrease as compared to revenues of $1.6million during the same period in 2002.

 

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Revenues increased by 11%, to $32.8 million during thenine months ended September 30, 2003, as compared to $29.5 million during thesame period in 2002.  Of total revenuesin the nine months ended September 30, 2003, the wireless communication segmentcomprised $28.1 million compared to $24.7 million during the same period in2002, a 14% increase.  Informationsecurity segment revenues of $4.7 million during the nine months endedSeptember 30, 2003 represent a 4% decrease as compared to revenues of $4.8million during the same period in 2002.

 

Although 2003 year-to-date revenues at EFJohnson areonly up 14% through the first three quarters, as compared to the prior year,the Company expects EFJohnson’s revenues for 2003 to be 34% to 38% higher thanits 2002 revenues.  The anticipatedfourth quarter revenues are subject to certain risks, most substantially therisk that all necessary manufacturing components will be procured in a mannerto permit timely production and the technological risk related to thesuccessful completion of certain of the Company’s research and developmentprojects.

 

EFJohnson’s revenues for the first nine months of 2003reflect the Company’s market strategy to emphasize federal, state and localgovernmental customers.  The increasedsales through the third quarter, and the anticipated increase through thefourth quarter, predominantly relates to federal sales.  As of September 30, 2003, the Company’sbacklog, comprised substantially of EFJohnson orders, was $32.1 million, ofwhich $27.4 million related to federal sales. Most of the backlog orders, approximately $30.4 million, are expected tobe delivered in the fourth quarter of 2003 and the first quarter of 2004.  Historically, only a small percentage ofbacklog is cancelled and, thereby, not delivered.  Nonetheless, if, for some unforeseen reason, a significantpercentage of the current backlog is cancelled, it would adversely affect ouranticipated fourth quarter revenues.

 

The slight decrease in revenues of the informationsecurity segment during the nine months ended September 30, 2003, as comparedto the prior year, was primarily the result of timing issues associated withfinalizing certain sales agreements. Such delayed sales are expected to be realized in the fourth quarter; assuch, the Company believes that revenues for its information security segmentfor the year ended December 31, 2003 will approximate the segment’s revenues in2002.  Accordingly, the Companyanticipates that Transcrypt’s fourth quarter revenues in 2003 will approximateits fourth quarter revenues in 2002.

 

The Company made the decision in thefourth quarter of 2000 to substantially exit the commercial LMR markets andfocus its LMR sales on the domestic public safety / public service sector.  Consequently, the Company’s sales to thedomestic public safety / public service sector have steadily increased, and theCompany’s sales to commercial users have decreased.  Although the Company would expect the trend of increasingdomestic public safety / public service sector sales to continue, the Company’ssales to commercial users would be expected to remain relatively flat through2003.  Federal sales in 2003 havecontinued to increase as a percentage of public safety / public servicerevenues, as compared to 2002; the Company expects this trend to continuethrough the remainder of 2003.

 

International sales relatesubstantially to Transcrypt, as EFJohnson’s international sales were only $1.7million and $1.0 million for the nine month periods ending September 30, 2003and 2002, respectively.  The Companyanticipates that its international sales will remain at a similar levelthroughout 2003.

 

The Company’s sales, as per itsdefined customer markets, are shown below for the three and nine months endedSeptember 30, 2003 and 2002:

 
|                                    |   | **For the three months ended  September 30,** |   | **For the nine months ended  September 30,** |   |
|-----------------------------------------|--------|-----------------------------------------------|--------|----------------------------------------------|--------|
|                                    |   | **2003**                                      |   | **2002**                                     |   | **2003** |   | **2002** |   |
| **Revenues (in thousands):**            |   | **Sales**                                     |   | **%**                                        |   | **Sales** |   | **%** |   | **Sales** |   | **%** |   | **Sales** |   | **%** |   |
| Domestic public safety / public service |   | $                                             | 11,170 |                                         | 86     | % | $ | 7,671 |   | 76 | % | $ | 26,078 |   | 80 | % | $ | 21,420 |   | 73 | % |
| Domestic commercial                     |   | 541                                           |   | 4                                            |   | 1,112 |   | 11 |   | 1,640 |   | 4 |   | 3.889 |   | 13 |   |
| International                           |   | 1,378                                         |   | 10                                           |   | 1,353 |   | 13 |   | 5,085 |   | 16 |   | 4,238 |   | 14 |   |
|                                    |   | $                                             | 13,089 |                                         |   |   | $ | 10,136 |   |   |   | $ | 32,803 |   |   |   | $ | 29,547 |   |   |   |

 

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Gross Profit

 

Cost of sales includes materials, labor, depreciation,and overhead costs associated with the production of the Company’s products, aswell as shipping, royalty and warranty product costs.

 

Consolidated gross profit was $5.2 million (40% grossmargin) for the third quarter of 2003, as compared to $4.3 million (43% grossmargin) for the same period in 2002. Gross margin for the wireless communication segment was 37% in the thirdquarter of 2003 versus 37% for the same period in 2002.  Gross margin for the information securitysegment was 72% in the third quarter of 2003 versus 75% for the same period in2002.

 

Consolidated gross profit was $13.8 million (42% grossmargin) for the nine months ended September 30, 2003, as compared to $12.9million (44% gross margin) for the same period in 2002.  Gross margin for the wireless communicationsegment was 37% for the nine months period ended September 30, 2003 versus 39%for the same period in 2002.  Grossmargin for the information security segment was 73% during the nine monthsended September 30, 2003 as compared to 70% for the same period in 2002.

 

The Company’s consolidated gross margin percentage wasdown in the third quarter of 2003 as compared to the same period in 2002; thisresulted from the lower margin wireless communication revenues being a largerpart of the consolidated mix in 2003 than in the prior year.  This trend of increasing wirelesscommunication revenues, coupled with relatively flat information securityrevenues, will continue to cause downward pressure on the Company’sconsolidated gross margin percentage. EFJohnson’s gross margin percentage for 2003 is expected to be 38% to39%, a slight increase as compared to the 37% margin realized during 2002.  Transcrypt’s gross margin percentage for2003 is expected to be 71% to 73%, a slight increase as compared to the 70%margin realized during 2002.  Grossmargins for both industry segments are likely to vary in the future, basedprimarily upon the mix of products and the amount of revenues recognized in therespective periods.  Nonetheless, due tothe aforementioned change in revenue mix among the segments, the Companyexpects its consolidated gross margin percentage to be 42% to 43% for 2003, aslight decrease from 2002.

 

Research and Development

 

Research and development expenses consist primarily ofthe costs associated with research and development personnel, third-partytechnology development, materials, and the depreciation of equipment andfacilities.

 

Research and development expenses increased to $1.9million in the third quarter of 2003 (15% of revenues) from $1.1 million in thethird quarter of 2002 (11% of revenues). Further, research and development expenses increased to $5.2 millionduring the nine months ended September 30, 2003 (16% of revenues), as comparedto $3.5 million in the same period in 2002 (12% of revenues).  The increase related primarily to Project 25LMR infrastructure development at EFJohnson. Current research and development efforts are concentrated primarily ondesign, development, enhancement, and addition to the Company’s Project 25digital LMR infrastructure products, as well as to its line of digital radios.

 

The Company’s research and development costs willcontinue to increase in the fourth quarter of 2003.  Total research and development expenses for 2003 are anticipatedto be approximately 60% higher than the research and development expensesincurred during 2002.  Further, theCompany will be establishing a Dallas-based engineering facility to augment theCompany’s current research and development efforts; however, this start-up isnot expected to have any material impact on expenses in the fourth quarter of2003.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily ofsalaries and related costs of sales personnel, including sales commissions andtravel expenses, and costs of advertising, public relations, and trade showparticipation.

 

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Sales and marketing expenses incurred year-to-date in2003 have been substantially similar to amounts incurred in 2002, in terms of apercentage of revenues.  Sales andmarketing expenses increased slightly to $1.8 million in the third quarter of2003 (13% of revenues) from $1.6 million in the third quarter of 2002 (16% ofrevenues).  Further, sales and marketingexpenses increased to $4.6 million for the nine months ended September 30, 2003(14% of revenues), as compared to $4.2 million for the same period in 2002 (14%of revenues).

 

The Company anticipates that its sales and marketingexpenses for 2003 will be incurred at a rate of approximately 13% of revenuesin the fourth quarter of 2003.  Thisdecrease from the 14% to 15% rate incurred during 2002 and the first ninemonths of 2003 results from the substantially higher revenues anticipated inthe fourth quarter of 2003, and the economy of scales achieved at these higherrevenue levels, as illustrated by the reduced percentage of 13% experienced inthe third quarter of 2003.

 

General and Administrative

 

General and administrative expenses consist primarilyof salaries and other expenses associated with the Company’s management,finance, accounting, and administration.

 

General and administrative expenses of $3.3 million inthe third quarter of 2003 (25% of revenues) were substantially higher than the$1.2 million amount incurred for the same period in 2002 (12% ofrevenues).  General and administrativeexpenses for the nine months ended September 30, 2003 were $6.5 million (20% ofrevenues); this represented a substantial increase from the $4.6 millionincurred during the same period in 2002 (16% of revenues).  The differences in both the three and ninemonths ended September 30, 2003, as compared to the same periods in 2002,relate primarily to the difference in the non-cash compensation expense(benefit) relating to the repricing of its stock options during the respectiveperiods.  As described in Note 8 of theNotes to Condensed Consolidated Financial Statements (“Notes”), the Companyincurred non-cash compensation expense (benefit) of $1,890,000 and $(199,000) forthe three months ended September 30, 2003 and 2002, respectively, and theCompany incurred non-cash compensation expense amounts of $2,186,000 and$162,000 for the nine months ended September 30, 2003 and 2002, respectively.  The compensation expense relating to theserepriced options varies according to the market value of the Company’s commonstock; presently, each increase of $0.01 per share in the Company’s stockprice, over the closing market on September 30, 2003, of $3.90 per share, willcause the Company to incur approximately $8,300 in future compensation expense.

 

Excluding the effect of the aforementioned non-cashcompensation expense, the Company’s total general and administrative expenseswere $4.3 million and $4.5 million, respectively, for the nine-month periodsended September 30, 2003 and 2002.  TheCompany anticipates future general and administrative expenses for 2003,excluding non-cash compensation relating to the repriced options, to be similarto the level experienced during the first three quarters of 2003 and 2002.

 

Other Income, net

 

Net other income / (expense) for the nine months endedSeptember 30, 2003 was minimal, $62,000. Net other income / (expense), of $183,000, for the nine months endedSeptember 30, 2002 related substantially to insurance proceeds received inrelation to a claim for stolen property. The Company would expect other income / (expense) in the future toremain at an insignificant level.

 

Interest Income / InterestExpense

 

Interest income consists of interestincome earned on cash and invested funds. Interest expense consists of interest amounts payable on the Company’sloans and bank line of credit.  Interestincome and interest expense were $26,000 and $133,000, respectively, for thenine months ended September 30, 2003, as compared to $60,000 and $18,000 in thesame period in 2002.  The Companyexpects interest income for the remainder of the fiscal year to remain similarto the level experienced in the first three quarters of 2003.  The Company’s interest expense in 2003,which includes monthly amortization of approximately $10,000 in line of creditfees, is also expected to remain

 

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similarto the level experienced in the first three quarters of 2003.  However, interest income and expense willvary according to the Company’s use of cash, interest rates, debt balances, andoperating results over the remainder of 2003.

 

Provision / Benefit for IncomeTaxes

 

The Company did not record a tax provision or benefitin any of the first three quarters of 2003 or 2002.  As of December 31, 2002, the Company had $24.8 million indeferred tax assets primarily comprised of net operating loss carryforwards;this asset was reduced by a valuation allowance of $21.8 million.  This reserve is based upon management’sexpectation as to the extent its tax assets will actually be realized, suchexpectation based upon management’s estimates of future operating results andother factors.  Accordingly, dependingupon such future estimates, all or some portion of the reserved deferred taxasset may be restored or, conversely, it may be necessary to write off all orpart of the $3.0 million deferred tax asset recorded on the balance sheet atDecember 31, 2003.

 

The factors determining the estimation of therealizability of the Company’s net operating carryforwards are subject tosubstantial variability.  However, tothe extent the Company achieves its anticipated results of operations in thefourth quarter of 2003, and assuming that the Company’s future operations areexpected to continue in a manner consistent with the results achieved in 2001through 2003, the Company’s deferred tax asset would be increased at December31, 2003.  The Company would presentlyanticipate the income tax benefit resulting from this increase to range from$3.0 million to $6.0 million for the year ended December 31, 2003.

 

Net Income (Loss)

 

The Company had a net loss of $2.5 million during thenine months ended September 30, 2003, as compared to a net income of $0.8million during the same period in 2002. Operating results for either period do not include any tax provision orbenefit.  However, in both the ninemonths ending September 30, 2003 and 2002, the Company’s operating results wereadversely affected by non-cash compensation resulting from variable accountingtreatment required for certain of the Company’s stock options repriced in thefourth quarter of 2000 and the first quarter of 2001.  The amounts of such non-cash compensation expense, included in generaland administrative expenses, were $2,186,000 and $162,000 for the nine monthsending September 30, 2003 and 2002, respectively.    Excluding the effects of this non-cash compensation expense(benefit), which the Company does not believe to be a reliable indicator of theCompany’s overall performance, the Company’s results of operations were a netloss of $(0.3) million and a net income of $0.9 million for the nine monthsended September 30, 2003 and 2002, respectively.

 

The Company expects that its net operating resultsduring the fourth quarter of 2003 will produce net income to the extent topermit net income for fiscal 2003, prior to the effect of the aforementionednon-cash compensation expense and income tax benefit, to be between $0.13 and$0.16 per share.  The Company does notattempt to predict the amount of its non-cash compensation expense during thefourth quarter as this expense amount is primarily determined by the Company’sstock price at December 31, 2003.

 

Liquidity and Capital Resources

 

Since January 1, 1997, the Company has financed itsoperations and met its capital requirements primarily through short-termborrowings, long-term debt, and stock offerings completed on January 22, 1997and October 15, 1997.  However, theCompany’s operations provided positive cash for fiscal years 2001 and2002.  As a result of expected highersales in the fourth quarter of 2003 and the first quarter of 2004, as evidencedby the Company’s current backlog, the Company anticipates that receivable andinventory balances at December 31, 2003, as compared to the prior year, willincrease to the point to where operations for the fiscal year 2003 will notprovide positive cash despite the fact that the Company’s net income isexpected to be greater in 2003 than the net incomes realized in either 2002 or2001.

 

The Company’s operating activities used cash of $3.6million and $0.2 million in the nine months ended

 

14

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September 30, 2003 and 2002, respectively.  In 2003, the net loss is relatively offset by the non-cashcompensation expense for the nine-month period; as such, the cash used inoperations substantially came from changes in working capital.  These 2003 changes in working capitalprimarily relate to a $3.6 million increase in accounts receivable, as a resultof substantial sales coming toward the end of the quarter, and increases ininventory ($1.8 million) and accounts payable ($1.4 million), resulting fromincreased inventory purchases in advance of anticipated fourth quartersales.  The Company expects minimal netcash to be provided by operations in the fourth quarter of 2003, despite theanticipated earnings, as both receivables and inventory are expected to furtherincrease.

 

Cash used by investing activities was $0.3 million forthe nine months ended September 30, 2003; this compared to cash used byinvesting activities of $0.8 million for the same period in 2002.  The difference, between 2003 and 2002,related primarily to cash flows used in the purchase of property.  However, total capital expenditures wereactually higher in 2003 as $0.4 million of such expenditures were acquiredthrough the exchange of debt and are, thus, excluded from the Statement of CashFlows.

 

Cash used by financing activities of $5.1 million inthe nine months ended September 30, 2003 primarily related to paying off theDecember 31, 2002 line of credit balance of $5.0 million.  Similarly, in the nine months endedSeptember 30, 2002, financing activities used net cash of $5.1 millionprimarily related to the pay off and termination of the Company’s previous lineof credit in February 2002.

 

In early 2000, the Company obtained a commitment froma major insurance company that provides for up to $20.0 million in new bondingarrangements at favorable rates and terms. Because of the Company’s performance in 2000, the bonding insurerindicated that any future bonding arrangements must be partially supported bycollateral, either with an irrevocable letter of credit or with cash.  As such, in 2003, the Company secured abonding arrangement with an alternative provider.  This recently negotiated agreement calls for zero-collateralbonding up to $7.0 million; however, no single bond may exceed $2.0million.  The Company believes its bondingarrangements provide it with sufficient bonding availability through 2003;however, the Company continues to seek improved bonding alternatives withincreased limits.

 

As of September 30, 2003, the Companyhad no outstanding balance on its revolving line of credit with Bank ofAmerica, described in Note 7 of the Notes herein.  At such date, the Company had unrestricted cash of $2.3 million,and the Company had $9.3 million of available credit under this line of credit,after deducting outstanding letters of credit of $0.7 million.  This current line of credit replaced theCompany’s previous line of credit with U.S. Bank, which the Company elected topay off and terminate in February 2002. Management believed that the prior facility with U.S. Bank, as structured,did not provide the operational flexibility the Company required; conversely,the Company believes its present line of credit provides such flexibility.

 

The Company’s backlog of unfilled orders at September30, 2003 was $32.1 million, compared to a backlog of $8.0 million at December31, 2002.  The Company does not believethat its backlog figures are necessarily indicative of sales of products infuture periods due to the unpredictable timing of major domestic governmentalorders and the resulting order variations from period to period.

 

The Company does not anticipate paying cash dividendsin the foreseeable future.

 

Critical Accounting Policies

 

The preparation of the Company’s consolidatedfinancial statements in conformity with “generally accepted accountingprinciples” (“GAAP”) requires management to make judgments, estimates andassumptions in certain circumstances that affect the amounts reported in theconsolidated financial statements and related footnotes.  The Company regularly evaluates theaccounting policies and estimates used to prepare its financialstatements.  Estimates are used for, butnot limited to, the accounting for allowance for doubtful accounts and salesreturns, estimates involved in applying percentage of completion accounting forlong-term contract revenues, inventory reserves, and contingencies.  These estimates are based on historicalexperience and various assumptions that the Company believes to be reasonableunder the particular applicable facts and circumstances.  Actual results could differ from thoseestimates.

 

The Company considers its critical accounting policiesto be those that (i) involve significant judgments and

 

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uncertainties, (ii) require estimates that are more difficult formanagement to determine, and (iii) have the potential to result in materiallydifferent outcomes under varying assumptions and conditions.  The application of GAAP may requiremanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying results.  Listed below are those policies the Company believes are criticaland require the use of complex judgment in their application.

 

*Revenue*

 

The Company’s revenue recognition policy is inaccordance with the criteria put forth in Staff Accounting Bulletin 101.  Revenues are recognized when the earningsprocess is complete, less an estimate for an allowance for returns, ifapplicable, if collection is reasonably assured.  The earnings process is generally complete when the product isshipped, or received by the customer, depending upon whether the title to thegoods, as well as the risks and benefits of ownership, are transferred to thecustomer at point of shipment or point of delivery.  For sales where collection is not reasonably assured, the Companyrecognizes revenue as cash is received. If collection is contingent on a future event, the Company recognizesrevenue when the contingency lapses, generally upon cash collection.

 

System sales under long-term contracts are accountedfor under the percentage-of-completion method. Under this method, revenues are recognized as work on a contractprogresses.  The recognized revenue isthat percentage of estimated total revenue that incurred costs to date bear toestimated total costs to complete the contract.  Revisions in cost and profit estimates are made when conditionsrequiring such revisions become known.  Anticipatedlosses on contracts are recognized in operations as soon as such losses aredetermined to be probable and reasonably estimable.

 

Deferred revenue includes unearned services providedunder systems maintenance contracts and unearned warranty fees on extendedproduct warranty contracts sold to customers. The Company recognizes the fees based upon a straight-line method overthe life of the contract.

 

The Company periodically reviews its revenuerecognition procedures to assure that such procedures are in accordance withthe provisions of Staff Accounting Bulletin 101.

 

*Inventory*

 

Inventory is recorded at the lower of cost or marketwith cost determined by the first-in, first-out (FIFO) method.  The Company periodically assesses itsinventory for potential obsolescence and lower-of-cost-or-market issues.  The Company makes estimates of inventoryobsolescence, providing reserves when necessary, based on, among other factors,demand for inventory based on backlog, product pricing, the ability toliquidate or sell older inventory, and the impact of introducing new products.  Charges associated with providing forinventory obsolescence, or revisions to related reserves, have historicallycorrelated with selling activity and have had a consistent impact on theCompany’s gross margins over the last three fiscal years.

 

*Goodwill*

 

In July 2002, the Financial Accounting Standards Boardissued SFAS No. 142***. ***SFAS 142 requires thatgoodwill no longer be amortized to earnings, but instead be reviewed forimpairment, on at least an annual basis, by applying a fair value-basedtest.  The Company adopted theprovisions SFAS 142 effective January 1, 2002. At least annually, the Company assesses goodwill, using a fairvalue-based test, consistent with SFAS 142. If the carrying amount exceeds the fair value, goodwill is considered tobe impaired.  In evaluating impairment,the Company estimates the sum of the expected future cash flows derived fromsuch goodwill.  Such evaluations forimpairment are significantly impacted by estimates of future revenues, costsand expenses and other factors.  The estimatesuse assumptions about the Company’s market segment share in the future andabout future expenditures by governmental entities for wireless communicationsproducts.  The Company continuallyevaluates whether events and circumstances have occurred that indicate theremaining balance of goodwill may not be recoverable.  If the Company fails to deliver new products, if the productsfail to gain expected market acceptance, or if the Company fails to achieveassumed revenue growth rates or assumed gross margin, the Company may incurcharges for impairment of goodwill in the future.

 

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# ***Income Taxes***

 

The Company accounts for income taxes using the assetand liability method.  Deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities aremeasured using current enacted tax rates. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in the results of operations in the period that includesthe enactment date.  Valuationallowances are provided to the extent that recoverability of tax assets is notconsidered likely.  In determiningwhether a tax asset is recoverable, the Company considers estimates of futurerevenues, costs and expenses and other factors.  If the Company fails to achieve revenue growth rates or grossmargins assumed in the calculation of the deferred tax asset, the Company maybe required to reduce its deferred tax assets in the future.

 

Recently Issued Accounting Standards

 

In December 2002, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard(“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting forStock-Based Compensation,” to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. In addition, SFAS No. 148 amends the disclosurerequirements of Accounting Principles Board (“APB”) Opinion No. 28,Interim Financial Reporting, to require pro-forma disclosure in interimfinancial statements by companies that elect to account for stock-basedcompensation using the intrinsic value method prescribed in APB OpinionNo. 25. The Company continues to use the intrinsic value method ofaccounting for stock-based compensation. As a result, the transition provisionswill not have an effect on the Company’s consolidated financial statements.

 

In November 2002, the FASB issued FASBInterpretation No. 45 (FIN 45), *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*. FIN 45 addresses the disclosure requirements of a guarantor in its interim andannual financial statements about its obligations under certain guarantees thatit has issued.  FIN 45 also requires a guarantor to recognize, at theinception of a guarantee, a liability for the fair value of the obligationundertaken in issuing the guarantee.  The disclosure requirements of FIN45 were effective for the Company beginning with its year ended December 31,2002.  The liability recognition requirements will be applicableprospectively to all guarantees issued or modified after December 31,2002.  This pronouncement is not anticipated to have a material effect onthe Company’s consolidated financial position or results of operations.

 

In January 2003, the FASB issued FASBInterpretation No. 46 (FIN 46), *Consolidation of Variable Interest Entities*. FIN 46 is an interpretation of Accounting Research Bulletin No. 51, *ConsolidatedFinancial Statements*, and addresses consolidation by businessenterprises of variable interest entities.  FIN 46 applies immediately tovariable interest entities created or obtained after January 31, 2003 and itapplies in the first fiscal year or interim period ending after December 15,2003, to variable interest entities in which an enterprise holds a variableinterest that is acquired before February 1, 2003.  This pronouncement iscurrently not anticipated to have a material effect on the Company’sconsolidated financial position or results of operations.

 

In May 2003, the FASB issued Statement 150,Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity. Statement 150 changes the classification in thestatement of financial position of certain common financial instruments fromeither equity or mezzanine presentation to liabilities and requires an issuerof those financial statements to recognize changes in fair value or redemptionamount, as applicable, in earnings.  SFAS 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003. The adoption of Statement 150 did not have an impact on the Company’s financialposition or results of operations.

 

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**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET RISK**

 

Although all of the Company’s sales are denominated inU.S. dollars, fluctuations in the value of international currencies relative tothe U.S. dollar may affect the price, competitiveness and profitability of theCompany’s products sold in international markets.  Furthermore, the uncertainty of monetary exchange values hascaused, and may in the future cause, some foreign customers to delay new ordersor delay payment for existing orders. Additionally, troubled economic conditions, such as that recentlyexperienced in Asia and in Latin America, could result in lower revenues forthe Company.  While much of theCompany’s international sales are supported by letters of credit, the purchaseof Company products by international customers presents increased risks, whichinclude:

•                  unexpectedchanges in regulatory requirements;

•                  tariffs andother trade barriers;

•                  political andeconomic instability in foreign markets;

•                  difficulties inestablishing foreign distribution channels;

•                  longer paymentcycles;

•                  uncertainty inthe collection of accounts receivable;

•                  increased costsassociated with maintaining international marketing efforts;

•                  difficulties inprotecting intellectual property; and

•                  susceptibilityto orders being cancelled as a result of foreign currency fluctuations (sinceall the Company quotations and invoices are denominated in U.S. dollars).

 

Some of the Company’s information security productsare subject to export controls under U.S. law, which in most cases requires theapproval of the Department of Commerce in order to ship internationally. TheCompany cannot assure that such approvals will be available to it or itsproducts in the future in a timely manner or at all or that the federalgovernment will not revise its export policies or the list of products andcountries for which export approval is required. The Company’s inability toobtain required export approvals would adversely affect the Company’sinternational sales, which would have a material adverse effect on the Company.In addition, foreign companies not subject to United States export restrictionsmay have a competitive advantage in the international information securitymarket. The Company cannot predict the impact of these factors on theinternational market for its products.

 

**ITEM 4.CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controlsand Procedures*

 

In accordance with Rule 13a-15(b) of the SecuritiesExchange Act of 1934 (“Exchange Act”), the Company evaluated the effectivenessof the design and operation of its disclosure controls and procedures asdefined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act (“DisclosureControls”) as of the quarter ended September 30, 2003.  This evaluation (the “Controls Evaluation”)was done under the supervision and with the participation of management,including our Chief Executive Officer (“CEO”) and Chief Financial Officer(“CFO”).  The effectiveness of theCompany’s Disclosure Controls, as determined by this evaluation, is disclosedin the Chief Executive Officer’s Certification of Report on Form 10-Q for theQuarterly Period Ending September 30, 2003 and the Chief Financial Officer’sCertification of Report on Form 10-Q for the Quarterly Period Ending September30, 2003 (together, “Certifications”).

 

Disclosure Controls are procedures that are designedwith the objective of ensuring that information required to be disclosed in theCompany’s reports filed under the Exchange Act, such as this Quarterly Report,is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s (“SEC”) rules and forms.  Disclosure Controls are also designed withthe objective of ensuring that such information is accumulated and communicatedto management, including the CEO and CFO, as appropriate to allow timelydecisions regarding required disclosure.

 

A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Further, the design of a control system must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs.  Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been detected. These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur

 

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because of simple error or mistake. 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 systemof controls also is based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions; over time,control may become inadequate because of changes in conditions, or the degreeof compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected, and, thus, the Company’s management cannot provide absoluteassurance that the Company’s Disclosure Controls will prevent all errors andall fraud.

 

The Company’s Disclosure Controls are also evaluatedon an ongoing basis by its Finance organization.  The overall goals of these various evaluation activities are tomonitor the Company’s Disclosure Controls and to make modifications asnecessary.  The Company’s intent in thisregard is that the Disclosure Controls will be maintained as dynamic systemsthat change (including with improvements and corrections) as conditionswarrant.

 

Based upon the Controls Evaluation, the Company’s CEOand CFO have concluded that, subject to the limitations noted above, theCompany’s Disclosure Controls are effective as of the end of the quarter endedSeptember 30, 2003 to ensure that material information relating to the Companyand its consolidated subsidiaries was made known to management, including theCEO and CFO, particularly during the period when periodic reports are beingprepared, and that the Company’s Internal Controls are effective to providereasonable assurance that its financial statements are fairly presented inconformity with GAAP.

 

*Changes in Internal Controls overFinancial Reporting*

 

During the quarter ended September 30, 2003, therehave been no significant changes in the Company’s internal control overfinancial reporting that has materially affected, or reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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**PARTII.  OTHER INFORMATION**

 

 

**ITEM 1 –5.**

 

 

**ITEM6.  EXHIBITS AND REPORTS ON FORM 8-K**

 

(a)   Exhibits– The following exhibits are filed herewith:

 
| **Exhibit No.** |   | **Description**                                                                                                                             |
|-----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                        |
| 11.1            |   | Computation of income (loss) per share                                                                                                      |
|            |   |                                                                                                                                        |
| 31.1            |   | Chief Executive Officer’s Certification of Report on  Form 10-Q for Quarterly Period Ending September 30, 2003                         |
|            |   |                                                                                                                                        |
| 31.2            |   | Chief Financial Officer’s Certification of Report on  Form 10-Q for Quarterly Period Ending September 30, 2003                         |
|            |   |                                                                                                                                        |
| 32              |   | Written Certification of Chief Executive Officer and  Chief Financial Officer, dated October 24, 2003, pursuant to 18 U.S.C.  Section 1350. |

 

(b)  Reports onForm 8-K:

 

The Company filed its earnings press release for thequarter ending June 30, 2003 as a report on Form 8-K, under Items 5, 7, and 9,on July 29, 2003.

 

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**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
|   |              | EFJ, INC. |
|--------|-------------------|-----------|
|   |              |      |
|   |              |      |
| Date:  | November 06, 2003 | By:       |  /s/ Massoud Safavi |   |
|   |              |      |   |
|   |              |      | Massoud Safavi |
|   |              |      | Senior Vice President and |
|   |              |      | Chief Financial Officer |
|   |              |      | (Principal Financial and Accounting |
|   |              |      | Officer) |

 

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