Definitive Proxy Statement
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

SCHEDULE 14A

 

Proxy Statement Pursuant to Section 14(a) of the

Securities Exchange Act of 1934

 

 

Filed by the Registrant    þ                            Filed by a Party other than the Registrant    ¨

 

Check the appropriate box:

 

¨ Preliminary proxy statement

 

¨ Confidential, For Use of the Commission Only (as permitted by Rule 14a-6(e)(2))

 

þ Definitive Proxy Statement

 

¨ Definitive Additional Materials

 

¨ Soliciting Material Pursuant to Rule 14a-12

 

 

 

PECO II, INC.

(Name of Registrant as Specified in its Charter)

 

 

 


(Name of Person(s) Filing Proxy Statement, if other than the Registrant)

 

 

Payment of Filing Fee (Check the appropriate box):

 

þ No fee required.

 

¨ Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and 0-11

 

  (1) Title of each class of securities to which transaction applies:

 

 
  (2) Aggregate number of securities to which transaction applies:

 

 
  (3) Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (set forth the amount on which the filing fee is calculated and state how it was determined):

 

 
  (4) Proposed maximum aggregate value of transaction:

 

$            

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$            

 

¨ Fee paid previously with preliminary materials:

 

¨ Check box if any part of the fee is offset as provided by Exchange Act Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the Form or Schedule and the date of its filing.

 

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PECO II, INC.

1376 State Route 598

Galion, Ohio 44833

 

Dear Shareholder:

 

On October 13, 2005, we entered into a definitive asset purchase agreement (the “Asset Purchase Agreement”) with Delta Products Corporation (“Delta”) to acquire the assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply agreements with wireline and wireless communications providers and related inventory and to assume the liabilities associated therewith of Delta’s U.S. and Canadian service provider business. In exchange, we will issue 4,740,375 shares of our common stock without par value (the “Primary Shares”) to Delta and a warrant (the “Warrant”) to purchase up to approximately 12.9 million shares of our common stock, or such other number of shares that, when aggregated with the Primary Shares, will represent 45% of our issued and outstanding shares of capital stock measured as of five business days before the exercise of the Warrant (the “Warrant Shares”), at an exercise price of $2.00 per share, exercisable immediately upon issuance and for a period of 30 months thereafter.

 

We will hold a Special Meeting of Shareholders of PECO II, Inc. (“PECO II”) at St. Joseph’s Activity Center, 135 North Liberty Street, Galion, Ohio on Tuesday, March 21, 2006 at 9:00 a.m. local time. At the special meeting, we will ask you to approve the issuance of both the Primary Shares, and the issuance of the Warrant and the Warrant Shares to be issued in connection with the exercise of the Warrant. In addition, we will ask you to vote on an amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act and a proposal to allow us to adjourn the special meeting, if necessary, to solicit additional proxies to gain approval of all the proposals.

 

You are not being asked to approve the Asset Purchase Agreement. Our Board of Directors has approved the Asset Purchase Agreement and the transactions contemplated thereby. You are only being asked to approve: (i) an amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, (ii) the issuance of the Primary Shares, (iii) the issuance of the Warrant and the underlying Warrant Shares, and (iv) a proposal allowing us to adjourn the special meeting, if necessary, to solicit additional proxies to gain approval of all the proposals.

 

Completion of the transactions contemplated by the Asset Purchase Agreement is subject to a number of conditions, including approval at the special meeting by our shareholders of: (i) the amendment to our Amended and Restated Code of Regulations, (ii) the issuance of the Primary Shares, and (iii) the issuance of the Warrant and the underlying Warrant Shares. Approval of the amendment to our Amended and Restated Code of Regulations requires the affirmative vote of a majority of the outstanding shares of our common stock. Approval of the other proposals requires the affirmative vote of a majority of the shares of our common stock voting in person or by proxy at the special meeting.

 

Your vote is important. We cannot complete the transactions contemplated by the Asset Purchase Agreement unless these proposals are approved. Whether or not you plan to attend the special meeting in person, please submit your proxy without delay. We encourage you to read the accompanying proxy statement carefully because it explains the proposed purchase of assets and assumption of liabilities, the documents related to the Asset Purchase Agreement and the proposals which require your favorable vote.

 

Our Board of Directors has carefully reviewed and considered the terms of the Asset Purchase Agreement and has determined that the Asset Purchase Agreement and the transactions contemplated thereby are in the best interests of PECO II and our shareholders. Accordingly, the Board has unanimously approved the Asset Purchase Agreement and the various transactions contemplated in such agreement and unanimously recommends that you vote “FOR” the amendment to the Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, “FOR” the issuance of the Primary Shares, “FOR” the issuance of the Warrant and the underlying Warrant Shares, and “FOR” the proposal allowing us to adjourn the special meeting, if necessary, to solicit additional proxies.

 

This proxy statement is dated February 13, 2006 and is first being mailed to shareholders on or about February 14, 2006.

 

Sincerely,

 
James L. Green

Chairman of the Board


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PECO II, INC.

1376 STATE ROUTE 598

GALION, OHIO 44833

 

NOTICE OF SPECIAL MEETING OF SHAREHOLDERS

To Be Held On March 21, 2006

 

NOTICE IS HEREBY GIVEN THAT a Special Meeting of Shareholders of PECO II, Inc. (“PECO II”) will be held at St. Joseph’s Activity Center, 135 North Liberty Center, Galion, Ohio on Tuesday, March 21, 2006 at 9:00 a.m. local time, for the following purposes:

 

  1. To consider and vote on a proposal to approve and adopt an amendment to the PECO II Amended and Restated Code of Regulations providing that the Ohio Control Share Acquisition Act shall not apply to acquisitions of PECO II’s equity securities.

 

  2. To consider and vote on a proposal to approve the issuance of 4,740,375 shares of PECO II common stock without par value (the “Primary Shares”) to Delta Products Corporation (“Delta”), pursuant to an asset purchase agreement between PECO II and Delta, dated October 13, 2005 (the “Asset Purchase Agreement”), whereby PECO II will acquire the assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply agreements with wireline and wireless communications providers and related inventory and will assume the liabilities associated therewith of Delta’s U.S. and Canadian service provider business.

 

  3. To consider and vote on a proposal to issue a warrant (the “Warrant”) to permit Delta to purchase approximately 12.9 million shares of PECO II common stock without par value or such other number of shares that, when aggregated with the Primary Shares, will represent 45% of the issued and outstanding shares of PECO II capital stock, measured as of the date five business days prior to the exercise of the Warrant at an exercise price of $2.00 per share, exercisable immediately upon issuance and until the date that is 30 months following the closing date of the transactions contemplated by the Asset Purchase Agreement.

 

  4. To consider and vote on a proposal to allow the Board of Directors to adjourn the special meeting, if necessary, to solicit additional proxies in the event that there are not sufficient votes at the time of the special meeting to approve and adopt the proposals.

 

  5. To transact any other business that may properly come before the special meeting or any adjournment or postponement thereof.

 

Only shareholders who held shares of record as of the close of business on February 7, 2006 are entitled to receive notice of and to vote at the special meeting or any adjournment or postponement of the meeting.

 

By order of the Board of Directors

 
James L. Green
Chairman of the Board


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TABLE OF CONTENTS

 

     Page

Questions and Answers About the Special Meeting

   1

Additional Information

   3

Summary

   4

The Companies

   11

Forward-Looking Statements

   12

Selected Consolidated Financial Data

   13

PECO II Selected Consolidated Financial Data (Historical)

   13

Delta’s Selected Financial Data (Historical) for Delta Business Assets to be Acquired

   14

Pro Forma Selected Consolidated Financial Data of PECO II and Delta Business Assets

   14

Pro Forma Comparative Unaudited Per Share Data

   15

Pro Forma Condensed Consolidated Financial Information

   15

Service Provider Portion of Delta Products Corporation’s Telecom Power Division

   23

Delta Management’s Discussion and Analysis—Financial Results of Delta Business Assets

   23

Delta Business Assets Financial Statements

   24

The Special Meeting

   34

The Proposals

   34

Record Date and Voting

   34

Required Vote

   35

Proxies; Revocation

   35

Interests of Certain Persons in Matters to be Acted Upon

   36

The Asset Purchase

   38

Background of the Transactions Contemplated by the Asset Purchase Agreement

   38

Our Reasons for the Transaction Contemplated by the Asset Purchase Agreement; Recommendation of Our Board of Directors

   41

Opinions of Our Financial Advisor

   43

Update of Fairness Opinion of Our Financial Adviser

   48

Governmental and Third Party Approvals

   53

The Asset Purchase Agreement

   54

The Transaction

   54

Consideration

   54

The Closing

   54

Representations and Warranties

   54

Conduct of Business Pending the Closing

   56

Our Restrictions

   56

Delta Restrictions

   57

No Solicitation

   57

Conditions to Closing

   59

Termination

   60

Expenses and Termination Fee

   60

Dilution to Our Shareholders; Ownership of PECO II after the Acquisition

   61

Amendment

   61

The Voting Agreement

   61

The Supply Agreement

   63

The Support Agreement and Irrevocable Proxy

   63


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     Page

The Registration Rights Agreement

   63

Interests of Certain Persons In Matters To Be Voted On

   64

Proposal 1: Amendment to the Amended and Restated Code of Regulations of PECO II, Inc. to Opt Out of the Ohio Control Share Acquisition Act

  

65

Overview

   65

Reasons for the Proposed Amendment

   65

Summary of the Ohio Control Share Acquisition Act

   66

Potential Benefits of the Ohio Control Share Acquisition Act

   67

Vote Required

   67

Proposal 2: The Issuance of the Primary Shares

   67

Description of the Asset Purchase

   67

Description of the Primary Shares to be Issued

   68

Vote Required

   68

Proposal 3: The Issuance of the Warrant and the Underlying Warrant Shares

   68

Description of the Asset Purchase

   68

Description of the Warrant and Warrant Shares to be Issued

   68

Vote Required

   69

Proposal 4: Permission of Board of Directors to Adjourn the Special Meeting

   69

Proposal to Permit Adjournment of the Special Meeting

   69

Vote Required

   69

Share Ownership of Principal Holders and Management

   70

Independent Accountants

   72

Shareholder Proposals

   72

Other Business

   72

Where You Can Find More Information

   72

Appendix A—Proposed Second Amended and Restated Code of Regulations of PECO II, Inc.  

   A-1

Appendix B—Ohio Control Share Acquisition Act

   B-1

Appendix C—Asset Purchase Agreement, dated October 13, 2005, between the Company and Delta Products Corporation

  

C-1

Appendix D —Voting Agreement, dated October 13, 2005, between the Company, Delta Products Corporation and certain Significant Holders of the Company

  

D-1

Appendix E —Support Agreement and Irrevocable Proxy, dated October 13, 2005 between the Company, Delta Products Corporation and certain Significant Holders of the Company

  

E-1

Appendix F—Opinion of GBQ Consulting, LLC, dated October 13, 2005

   F-1

Appendix G—Opinion of GBQ Consulting, LLC, dated January 17, 2006

   G-1

Appendix H—Annual Report on Form 10-K for the year ended December 31, 2004

   H-1

Appendix I—Quarterly Report on Form 10-Q for the quarter ended March 31, 2005

   I-1

Appendix J—Quarterly Report on Form 10-Q for the quarter ended June 30, 2005

   J-1

Appendix K —Quarterly Report on Form 10-Q for the quarter ended September 30, 2005

   K-1


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Questions and Answers About the Special Meeting

 

Q. What am I being asked to vote on?

 

A. You are being asked to vote on four proposals:

 

  1. To approve and adopt an amendment to our Amended and Restated Code of Regulations providing that the Ohio Control Share Acquisition Act will not apply to acquisitions of our equity securities.

 

  2. To approve the issuance of 4,740,375 shares of our common stock without par value (the “Primary Shares”) to Delta Products Corporation (“Delta”), pursuant to an asset purchase agreement between PECO II, Inc. (“PECO II”) and Delta, dated October 13, 2005 (the “Asset Purchase Agreement”), pursuant to which PECO II will acquire the assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply agreements with wireline and wireless communications providers and related inventory and will assume the liabilities associated therewith of Delta’s U.S. and Canadian service provider business.

 

  3. To approve the issuance of a warrant (the “Warrant”) to permit Delta to purchase approximately 12.9 million shares of our common stock without par value or such other number of shares that, when aggregated with the Primary Shares, will represent 45% of our outstanding capital stock measured of the date that is five business days from the date of exercise of the Warrant (the “Warrant Shares”), at an exercise price of $2.00 per share, exercisable immediately upon issuance and until the date that is 30 months following the closing date of the transactions contemplated by the Asset Purchase Agreement.

 

  4. To approve a proposal allowing the Board of Directors to adjourn the special meeting, if necessary, to solicit additional proxies in the event that there are not sufficient votes at the time of the special meeting to approve and adopt the proposals.

 

Q. Why has PECO II entered into the Asset Purchase Agreement?

 

A. We have entered into the Asset Purchase Agreement because we believe that the transactions contemplated thereby will provide us with access to Delta’s manufacturing capabilities and supply agreements, which are expected to reduce our cost of goods sold. Also, we will gain access to new customers and new markets with existing customers. We will be able to improve our future product development capabilities. We will obtain standardized components for manufacturing. Finally, we will be able to streamline manufacturing toward standardized products, which is also expected to lower our cost of goods sold.

 

Q. Do the transactions contemplated by the Asset Purchase Agreement constitute a change of control of PECO II?

 

A. No. The issuance of the Primary Shares will result in Delta owning approximately 18% of our outstanding capital stock as of the closing. If Delta exercises all of its rights to acquire the Warrant Shares from the date of issuance for a period of 30 months thereafter, Delta will own 45% of our outstanding capital stock. Although such ownership will permit Delta to exercise significant influence over PECO II, our Board of Directors has determined that the ownership by Delta does not constitute a change of control of PECO II.

 

Q. What shareholder approvals are needed?

 

A. The affirmative vote of the holders of a majority of our outstanding shares of common stock is required to approve the amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act. Approval of the other proposals requires the affirmative vote of the holders of a majority of the shares of our common stock voting in person or by proxy at the special meeting.

 

Q. What is the recommendation of the PECO II Board of Directors as to the four proposals described in this proxy statement?

 

A.

At its meetings held on September 30, 2005 and October 13, 2005, our Board of Directors considered all of the facts and circumstances important to recommending whether to vote in favor of or against the four proposals. At its meeting held on December 13, 2005, our Board of Directors considered whether the approval of the four proposals remained in the best interests of PECO II and its shareholders after taking into account the recent

 

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increase in the price at which our common stock had been trading and other new facts and circumstances about the assets being acquired from Delta. After discussion with our legal counsel concerning its fiduciary duties under Ohio law and consideration of such recent developments, our Board of Directors established a special committee to coordinate with our financial adviser, GBQ Consulting, LLC (“GBQ”), to consider the impact of these recent developments to the value of the ranges set forth in GBQ’s fairness opinion dated October 13, 2005. On January 17, 2006, the special committee reviewed the updated fairness opinion and recommended that our Board of Directors also review it. On January 17, 2006, our Board of Directors reviewed the updated fairness opinion, which stated that the consideration to be received as a result of the consummation of the transactions contemplated by the Asset Purchase Agreement was fair, from a financial point of view, to our shareholders. After carefully considering this information and the advice of its counsel, and after extensive discussion, our Board of Directors concluded that it would unanimously recommend that the PECO II shareholders vote in favor of the proposals set forth in this proxy statement.

 

Q. What do I need to do now?

 

A. After carefully reading and considering the information contained in this proxy statement, please respond by completing, signing and dating your proxy card and returning it in the enclosed postage paid envelope.

 

Q. What if I do not vote?

 

A. If you fail to respond, your shares will not count toward a quorum necessary to conduct the vote at the special meeting, and will not be counted as either a vote for or against any of the four proposals. Because the proposal to amend our Amended and Restated Code of Regulations requires that affirmative vote of the holders of a majority of the outstanding shares of our common stock, your failure to vote will have the effect of voting against this proposal.

 

If you respond and do not indicate how you want to vote, your proxy will be counted as a vote in favor of each of the four proposals.

 

Q. Can I change my vote after I have delivered my proxy?

 

A. Yes. You can change your vote at any time before your proxy is voted at the special meeting. You can do this by revoking your proxy or submitting a new proxy. If you choose either of these two methods and you are a shareholder of record, you must submit your notice of revocation or your new proxy to the Secretary of PECO II before the special meeting. If your shares are held in an account at a brokerage firm or bank, you should contact your brokerage firm or bank to change your vote.

 

If you are a shareholder of record, you can also attend the special meeting and vote in person, which will automatically revoke any previously submitted proxy.

 

Q. When do you expect the transactions contemplated by the Asset Purchase Agreement to close and the Primary Shares and Warrant to be issued?

 

A. We are working to close the transactions contemplated by the Asset Purchase Agreement, including the issuance to Delta of the Primary Shares and the Warrant, as soon as possible after our special meeting. We expect to close the transactions by March 31, 2006.

 

Q. Who can help answer my questions?

 

A. If you have any questions about the transactions contemplated by the Asset Purchase Agreement or any of the proposals, or how to submit your proxy, or if you need additional copies of the proxy statement or the enclosed proxy card or voting instructions, you should contact:

 

PECO II, Inc.

Attn: Investor Relations

1376 State Route 598

Galion, Ohio 44833

(419) 468-7600

 

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Additional Information

 

This document incorporates important business and financial information about PECO II from documents that are not included in or delivered with this document. You can obtain documents incorporated by reference in this document by requesting them in writing or by telephone from PECO II, Inc., Attn: Lisa Green, 1376 State Route 598, Galion, Ohio 44833, telephone: (419) 468-7600.

 

You will not be charged for any of these documents that you request. If you wish to request documents, you should do so by March 14, 2006 in order to receive them before the Special Meeting. See “Where You Can Find More Information” on page 72.

 

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Summary

 

This summary highlights selected information from this proxy statement about the proposals and may not contain all of the information that is important to you as a PECO II shareholder. Accordingly, we encourage you to read carefully this entire document, including the appendices, and the other documents to which we refer you.

 

Ohio Control Share Acquisition Act Opt Out (page 65)

 

    Our Board of Directors has unanimously approved a resolution to amend our Amended and Restated Code of Regulations, which, if adopted, would make an Ohio anti-takeover statute, referred to herein as the “Ohio Control Share Acquisition Act,” inapplicable to the acquisition of our equity securities. The full text of the proposed amendment is contained in Article X of PECO II’s proposed Second Amended and Restated Code of Regulations, attached hereto as Appendix A. The various sections of the Ohio Revised Code comprising the Ohio Control Share Acquisition Act are attached hereto as Appendix B.

 

    Simultaneous with the execution of the Asset Purchase Agreement, Messrs. Matthew P. Smith and James L. Green, and their respective affiliates, executed a support agreement and irrevocable proxy (the “Support Agreement”), under which each such person agreed, severally and not jointly, to vote all of the shares of our common stock beneficially owned by such persons at any PECO II shareholders meeting or by any consensual action:

 

    in favor of the proposal to opt out of the Ohio Control Share Acquisition Act,

 

    in favor of the issuance of the Primary Shares (as defined below) and the Warrant (as defined below),

 

    in favor of the other transactions contemplated by the Asset Purchase Agreement and in favor of any other matter that could reasonably be expected to facilitate consummation of the transactions contemplated by the Asset Purchase Agreement,

 

    against any change in a majority of the members of our Board of Directors, and

 

    against any other action that would impede, interfere with, delay, postpone or materially adversely affect the closing of the transactions contemplated by the Asset Purchase Agreement.

 

In addition, Messrs. Smith and Green, and their respective affiliates, granted an irrevocable proxy to two of Delta’s designees to vote all of the shares of our common stock beneficially owned by such persons in accordance with the five bullet points above.

 

    Currently, the Ohio Control Share Acquisition Act is applicable to the acquisition of our equity securities, and, therefore, the shares beneficially owned by Mr. Green (because he is an officer of PECO II) are deemed to be “interested shares” under the Ohio Control Share Acquisition Act and ineligible for purposes of voting in favor of the proposals at the special meeting. The proposed amendment to our Amended and Restated Code of Regulations will permit the voting of the shares of our common stock beneficially owned by Mr. Green, and his affiliates, in favor of approving the proposals to be included in the vote to be held at the special meeting.

 

    Although shareholder rights advocates often express the view that state takeover statutes, such as the Ohio Control Share Acquisition Act, are contrary to shareholder interests, there may be reasons why shareholders may not want to opt out the Ohio Control Share Acquisition Act, including the fact such act requires shareholder approval prior to certain large acquisitions of our securities. See the discussion under the heading “Proposal 1—Amendment to the Amended and Restated Code of Regulations of PECO II, Inc. to Opt-Out of the Ohio Control Share Acquisition Act—Potential Benefits of the Ohio Control Share Acquisition Act” on page 67 for more information.

 

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Our Board of Directors Unanimously Recommends that Shareholders Vote “FOR” the Amendment to the Amended and Restated Code of Regulations (page 67)

 

    Our Board of Directors has determined, by unanimous vote, that the proposed amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act is in the best interest of PECO II and its shareholders. Our Board of Directors unanimously recommends that you vote “FOR” the proposed amendment to our Amended and Restated Code of Regulations.

 

Issuance of the Primary Shares (page 67)

 

    Subject to the terms and conditions of the Asset Purchase Agreement, we will acquire the assets that relate to Delta’s Telecom Power Division from Delta. At the closing, we will issue to Delta 4,740,375 shares of our common stock without par value (the “Primary Shares”). As a result, Delta will own approximately 18% of the issued and outstanding shares of our common stock following the issuance of the Primary Shares. On October 13, 2005, the date we entered into the Asset Purchase Agreement, the value of the Primary Shares to be issued to Delta at the closing was approximately $5,498,835, based on a closing stock price of our common stock of $1.16 per share. On January 11, 2006, the value of the Primary Shares to be issued to Delta at the closing was approximately $8,674,886, based on a closing stock price of $1.83 per share.

 

Our Board of Directors Unanimously Recommends that Shareholders Vote “FOR” the Issuance of the Primary Shares (page 68)

 

    Our Board of Directors has determined, by a unanimous vote, that the issuance of the Primary Shares as contemplated by the Asset Purchase Agreement is in the best interest of PECO II and its shareholders. Our Board of Directors unanimously recommends that you vote “FOR” the issuance of the Primary Shares to Delta at the special meeting.

 

Issuance of the Warrant and the Underlying Warrant Shares (page 68)

 

    Subject to the terms and conditions of the Asset Purchase Agreement and a warrant to be issued to Delta at the closing of the transactions contemplated by the Asset Purchase Agreement (the “Warrant”), Delta will have the right to purchase up to approximately 12.9 million shares of our common stock, or such other number of shares that, when aggregated with the Primary Shares, will represent 45% of the issued and outstanding shares of our capital stock measured as of five business days prior to the date of exercise of the Warrant (the “Warrant Shares”), at an exercise price of $2.00 per share, exercisable immediately upon issuance and for a period of 30 months following the closing of the transactions contemplated by the Asset Purchase Agreement. On October 13, 2005, the date we entered into the Asset Purchase Agreement, the value of the Warrant to be issued to Delta at the closing was $4,783,470 using a Black-Scholes valuation model. On January 11, 2006, the value of the Warrant was to be issued to Delta at the closing was approximately $8,144,827 using the Black-Scholes valuation model.

 

    By way of example, if on the date that is five business days prior to the exercise date, we had 26,335,418 shares of our capital stock issued and outstanding, the number of Warrant Shares would be calculated as follows: (i) the quotient of (A) the issued and outstanding shares (i.e., 26,335,418) minus the shares of common stock issued at closing (i.e., 4,740,375), divided by (B) 0.55, minus (ii) the outstanding shares of Common Stock (i.e., 26,335,418) and (iii) rounded to the nearest whole number of shares. In this example, the number of Warrant Shares would be 12,928,297 representing, when aggregated with the Primary Shares, 45% of our issued and outstanding capital stock.

 

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Our Board of Directors Unanimously Recommends that Shareholders Vote “FOR” the Issuance of the Warrant and the Underlying Warrant Shares (page 69)

 

    Our Board of Directors has determined, by unanimous vote, that the issuance of the Warrant and the issuance of the underlying Warrant Shares are in the best interest of PECO II and its shareholders. Our Board of Directors unanimously recommends that you vote “FOR” the issuance to Delta of the Warrant and the underlying Warrant Shares.

 

Value of the Primary Shares and Warrant

 

    On October 13, 2005, the date we entered into the Asset Purchase Agreement, the aggregate value of the Primary Shares and the Warrant constituting the consideration to be paid to Delta for the business assets was $10,282,305. On January 11, 2006, the value of the Primary Shares and Warrant was approximately $16,819,713.

 

Permission to Adjourn the Special Meeting (page 69)

 

    In order to consummate the transactions contemplated by the Asset Purchase Agreement, the proposals to adopt an amendment to the Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, approve the issuance of the Primary Shares, and approve the issuance of the Warrant and the underlying Warrant Shares, must first be approved by our shareholders. If there are insufficient votes at the time of the special meeting to approve each of the proposals, our Board of Directors believes it is appropriate and in the best interest of PECO II and its shareholders to adjourn the meeting and solicit additional proxies.

 

Our Board of Directors Unanimously Recommends that Shareholders Vote “FOR” the Proposal to Adjourn the Special Meeting (page 69)

 

    Our Board of Directors unanimously recommends that you vote “FOR” the proposal to allow the Board of Directors to adjourn the special meeting, if necessary, to solicit additional proxies in the event that there are not sufficient votes at the time of the special meeting to approve the proposals.

 

Description of the Assets To Be Purchased (page 67)

 

    The assets we will acquire from Delta under the Asset Purchase Agreement relate to Delta’s Telecom Power Division, consisting of rights to and under business supply agreements with wireline and wireless communications providers, inventory related to such business supply agreements comprised of raw materials, work in process, and finished products relating to Delta’s U.S. and Canadian service provider business, rights to and under related business records, all rights, claims and causes of action against third parties exclusively relating to the purchased assets, and all rights of indemnity, warranty rights, rights of contribution, rights to refunds and other rights of recovery exclusively relating to the purchased assets. In addition, we will assume and agree to pay, perform or discharge all liabilities and obligations under the business supply agreements arising on or after the closing date, and other obligations and liabilities set forth in the Asset Purchase Agreement.

 

Financial Advisor Opinion (page 43)

 

    GBQ Consulting, LLC (“GBQ”), our financial adviser, has told our Board of Directors that the consideration to be received as a result of the consummation of the transactions contemplated by the Asset Purchase Agreement is fair, from a financial standpoint, to our shareholders.

 

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Conditions to the Transactions Contemplated by the Asset Purchase Agreement and Expected Timing (page 59)

 

    The completion of the transactions contemplated by the Asset Purchase Agreement depends on a number of conditions being satisfied or waived, including approval by our shareholders of the amendment of our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, the issuance of the Primary Shares to Delta, the issuance of the Warrant and the underlying Warrant Shares, the appointment of Delta’s designee as a Class II member of our Board of Directors, as well as the receipt of third party consents to the assignment and assumption of the business supply agreements.

 

    We expect to consummate the transactions contemplated by the Asset Purchase Agreement by March 31, 2006, but we cannot be certain when or if the conditions to closing will be satisfied or waived. We may adjourn the special meeting, if necessary, to solicit additional proxies in the event there are not sufficient votes at the time of the special meeting to approve and adopt the proposals, or we may recirculate a new proxy statement and resolicit the vote if material conditions to the consummation of the transactions contemplated by the Asset Purchase Agreement are waived.

 

    Our shareholders must approve EACH of Proposals 1, 2 and 3 for the transactions contemplated by the Asset Purchase Agreement to close.

 

The Asset Purchase Agreement may be Terminated under Certain Circumstances (page 60)

 

The Asset Purchase Agreement provides that we or Delta may terminate the agreement before the closing of the transactions contemplated thereby in a number of circumstances.

 

Either Delta or we may terminate the Asset Purchase Agreement if:

 

    the two parties mutually agree in writing to terminate;

 

    the closing has not occurred by March 31, 2006;

 

    a governmental entity issues an order, decree, or ruling, or takes any other action (including failure to take a necessary action), that permanently restrains, enjoins, or otherwise prohibits the transactions contemplated by the Asset Purchase Agreement; or

 

    we fail to receive shareholder approval of the proposals described in this proxy statement.

 

In addition, we may terminate the Asset Purchase Agreement if:

 

    Delta materially breaches any representation, warranty, or covenant contained in the Asset Purchase Agreement and such breach is not cured;

 

    we receive a superior offer and, after we give notice to Delta, Delta has a reasonable opportunity to make a revised offer and has not done so; or

 

    Delta’s financial statements to be delivered prior to the closing reflect information that was not previously made available to us and would cause a Material Adverse Effect on the Business (as defined below).

 

Finally, Delta may terminate the Asset Purchase Agreement if:

 

    we materially breach any representation, warranty, or covenant contained in the Asset Purchase Agreement and such breach is not cured; or

 

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    any time before our shareholders’ approval of the proposal to issue the Primary Shares, the Warrant and the underlying Warrant Shares, a “Triggering Event” with respect to us occurs. Such a “Triggering Event” shall be deemed to have occurred if:

 

    our Board of Directors or any committee thereof shall for any reason have withdrawn or shall have amended or modified in a manner adverse to Delta, its unanimous recommendation to the shareholders to vote in favor of the proposals set forth in this proxy statement (the “Recommendation”),

 

    we shall have failed to include the Recommendation in this proxy statement,

 

    our Board of Directors or any committee thereof shall have approved or recommended any Acquisition Proposal (as defined below), or

 

    a tender or exchange offer relating to our securities shall have been commenced by a person unaffiliated with us and we shall not have timely sent to our shareholders a statement disclosing that our Board of Directors recommends rejection of such tender or exchange offer.

 

We May be Obligated to Reimburse Delta for its Expenses Relating to the Asset Purchase Agreement and to Pay a Termination Fee Under Certain Circumstances (page 60)

 

    In the event that we terminate the Asset Purchase Agreement because we received a superior offer or Delta terminates the Asset Purchase Agreement because our Board withdraws, amends or modifies its Recommendation, we must pay Delta a fee of $500,000 simultaneously with delivery of the notice to terminate.

 

    In the event the transactions contemplated by the Asset Purchase Agreement are consummated, we must pay up to $100,000 of the fees and expenses incurred by Delta (including attorneys’ fees and accountant fees) in connection with the negotiation, execution and delivery of the Asset Purchase Agreement, plus one-half of the fees and expenses incurred by Delta (including fees incurred by Delta’s auditor) in connection with the preparation and delivery of Delta’s financial statements prior to closing. These fees must be paid within 10 business days following Delta’s delivery to us of a certificate setting forth the amount of such fees and expenses incurred.

 

Dilution to Our Shareholders; Ownership of PECO II after the Acquisition (page 61)

 

    If the transactions contemplated by the Asset Purchase Agreement are consummated, you will incur immediate and substantial dilution. Currently, 21,954,741 shares of our common stock are issued and outstanding. We will issue the Primary Shares to Delta, representing 4,740,375 shares of common stock without par value, at the closing pursuant to the Asset Purchase Agreement. Pursuant to the Warrant to be issued to Delta at the closing, Delta will have the right to purchase Warrant Shares, at an exercise price of $2.00 per share and exercisable immediately upon issuance and for a period of 30 months after the closing, that will allow Delta to purchase that number of additional shares of our common stock without par value that, when aggregated with the Primary Shares, will represent 45% of our issued and outstanding capital stock measured as of five business days prior to the exercise date of the Warrant. By way of example, assuming we had 26,335,418 shares of common stock issued and outstanding after the issuance of the Primary Shares, the number of Warrant Shares eligible for purchase by Delta would be 12,928,297. As a result, we would have 39,263,715 issued and outstanding shares of common stock, resulting in Delta owning 45% of our issued and outstanding capital stock.

 

Amendment (page 61)

 

   

Subject to applicable law, the Asset Purchase Agreement may be amended by Delta and us at any time before or after approval of the various proposals by our shareholders at the special meeting; provided,

 

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after any such approval by our shareholders, no amendment shall be made which by law or in accordance with the rules of any relevant stock exchange requires further approval by our shareholders, without such further shareholder approval.

 

Supply Agreement (page 63)

 

    As a condition to the consummation of the transactions contemplated by the Asset Purchase Agreement, at the closing, we will enter into a supply agreement (the “Supply Agreement”) with Delta Electronics, Inc. (“DEI”), an affiliate of Delta, pursuant to which DEI will grant to us the right to purchase and incorporate DEI modules into our systems and to market, promote, sell and distribute DEI modules, PECO II systems and/or DEI systems to our customers in the U.S. and Canadian markets. The rights described above shall be exclusive to us for a period of 24 months from the effective date of the Supply Agreement. The term of the Supply Agreement is 30 months.

 

Voting Agreement; Change in Board Composition (page 61)

 

    Concurrent with the execution of the Asset Purchase Agreement, we, together with certain of our Board members and executive officers who are significant holders of our capital stock, and Delta entered into a voting agreement (the “Voting Agreement”), which is attached hereto as Appendix D, pursuant to which, effective at the closing, our Board of Directors will appoint a designee of Delta to our Board of Directors to fill our existing Class II director vacancy. As long as Delta or an affiliate holds or has the right to acquire at least 5% of our capital stock, Delta has the right to choose a designee for election to our Board of Directors as part of our management slate of nominees for inclusion in our proxy materials relating to the election of directors. In addition, each significant holder agrees to vote his or her shares of our capital stock to elect Delta’s designee as a member of our Board of Directors and Delta agrees to vote all of its shares of our capital stock to elect our designees as members of our Board of Directors. Pursuant to the terms of the Voting Agreement, Delta has the right to designate a board observer to attend all of our Board of Directors meetings in a non-voting capacity. The Voting Agreement terminates on the earlier of:

 

    the written agreement of Delta and us;

 

    the date Delta, or any of its affiliates (other than PECO II), no longer holds or has the right to acquire at least 5% of our outstanding voting stock;

 

    the date Delta, alone or together with any of its affiliates (other than PECO II), holds 45% or more of our issued and outstanding voting capital stock;

 

    the consummation of a business transaction the result of which is that our shareholders (other than Delta and its affiliates) immediately preceding such transaction hold less than 50% of the equity interests of the surviving or resulting entity of such transaction; or

 

    the sale of all or substantially all of our assets.

 

Support Agreement and Irrevocable Proxy (page 63)

 

    Simultaneous with the execution of the Asset Purchase Agreement, Messrs. Matthew P. Smith and James L. Green, and their respective affiliates, executed a support agreement and irrevocable proxy (the “Support Agreement”), under which each such person agreed, severally and not jointly, to vote all of the shares of our common stock beneficially owned by such persons at any PECO II shareholders meeting or by any consensual action:

 

    in favor of the proposal to opt out of the Ohio Control Share Acquisition Act;

 

    in favor of the issuance of the Primary Shares and the Warrant;

 

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    in favor of the other transactions contemplated by the Asset Purchase Agreement and in favor of any other matter that could reasonably be expected to facilitate consummation of the transactions contemplated by the Assert Purchase Agreement;

 

    against any change in a majority of the members of our Board of Directors; and

 

    against any other action that would impede, interfere with, delay, postpone or materially adversely affect the closing of the transactions contemplated by the Asset Purchase Agreement.

 

    Messrs. Smith and Green, and their respective affiliates, also granted an irrevocable proxy to two of Delta’s designees to vote all of the shares of our common stock beneficially owned by such persons in accordance with the five bullet points above.

 

Interests of Certain Persons in Matters to be Voted On (page 36)

 

    Our directors, except for Mr. John G. Heindel, our President and Chief Executive Officer, and certain of our executive officers may have interests different from our shareholders resulting from them being parties to certain transactional documents in connection with the asset purchase. Our directors may benefit from the execution of the Voting Agreement with Delta by virtue of Delta’s agreement to vote in favor of our Board of Directors’ designees to the management slate of nominees for election to our Board of Directors and to not bring any proposal that would result in the removal from our Board of our Board designees without cause. Our directors have agreed to appoint a Delta designee to fill our existing Class II director vacancy as of the closing. Our directors and executive officers who are parties to the Voting Agreement have also agreed to vote their shares of our capital stock in favor of Delta’s designee to our Board of Directors, and we will include such designee on our management slate of nominees for election to our Board of Directors.

 

    We have entered into a Support Agreement with Delta, Messrs. Smith and Green, and certain affiliates of Messrs. Smith and Green, pursuant to which Messrs. Smith and Green and their affiliates have granted to two of Delta’s designees an irrevocable proxy to vote for the amendment to our Amended and Restated Code of Regulation, to vote in favor of the issuance of the Primary Shares to Delta, to vote in favor of the Warrant and the issuance of the Warrant Shares pursuant to Delta’s purchase rights thereunder, and to vote in favor of any other matter that could be reasonably expected to facilitate the consummation of the transactions contemplated by the Asset Purchase Agreement.

 

    In the absence of the approval by our shareholders of the proposed amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, the shares of our capital stock beneficially owned by James L. Green would be deemed “interested shares” under such act and would not be counted in the vote to approve the various proposals with respect to the asset purchase set forth in this proxy statement. In such an event, it may be more difficult to obtain the necessary vote to approve the various proposals and meet all of the various conditions to closing of the transactions contemplated by the Asset Purchase Agreement.

 

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The Companies

 

PECO II, Inc.

1376 State Route 598

Galion, Ohio 44833

(419) 468-7600

 

We are an Ohio corporation that engages in the design, manufacture, and marketing of communications power systems and equipment for the communication industry in the United States. Our products include power systems, power distribution and measurement equipment, rectifiers, converter plants, inverters, and ringing systems. We also provide engineering and installation, onsite repair, technical training to customer technicians, preventative maintenance programs, refurbishes and upgrades, and transport installation. Additional information about us is included in documents incorporated by reference in this proxy statement. See “Where You Can Find More Information” on page 72.

 

Delta Products Corporation

4405 Cushing Parkway

Fremont, California 94538

(510) 668-5100

 

Delta is a California corporation and is part of the Delta Group, one of the world’s largest providers of switching power supplies and a major source of power management solutions, components, visual displays, industrial automation, and networking products. Delta Group has sales offices worldwide and manufacturing plants in Taiwan, Thailand, China, Mexico and Europe.

 

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Table of Contents

Forward-Looking Statements

 

This proxy statement contains or incorporates by reference a number of “forward-looking statements” within the “safe harbor” provisions of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 with respect to our financial condition, results of operations and business, and the expected impact of the Delta asset purchase on our financial performance. Forward-looking statements often, although not always, include words or phrases like “will likely result,” “expect,” “will continue,” “anticipate,” “estimate,” “intend,” “plan,” “project,” “outlook,” or similar expressions. These forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those statements and are not guarantees of future performance. Many of the important factors that will determine these results and values are beyond our ability to control or predict. Our shareholders are cautioned not to put undue reliance on any forward-looking statements. Except as otherwise required by law, we do not assume any obligation to update any forward-looking statements.

 

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Selected Consolidated Financial Data

 

PECO II Selected Consolidated Financial Data (Historical)

 

Our selected consolidated financial data is derived from our consolidated financial statements and notes to consolidated financial statements. The following information is only a summary. The selected consolidated financial data as of and for the 12-month periods ended December 31, 2004, 2003, 2002, 2001 and 2000 is derived from audited financial statements. Our selected consolidated financial data as of and for the nine-month period ended September 30, 2005 is derived from unaudited financial statements. You should read our selected consolidated financial data together with the historical financial statements and related notes contained in the annual reports and other reports that we have filed with the Securities and Exchange Commission. See “Where You Can Find More Information” beginning on page 72.

 

PECO II, Inc.

 

    Year ended
2000


  Year ended
2001


    Year ended
2002


    Year ended
2003


    Year ended
2004


    Nine-month
Period ended
September 30,
2005


 
    in thousands, except share data  

Operating revenues

  $ 156,548   $ 106,743     $ 62,060     $ 38,607     $ 31,564     $ 30,125  

Income (Loss) from operations

  $ 20,414   $ (11,676 )   $ (47,092 )   $ (36,404 )   $ (12,798 )   $ (1,930 )

Income (Loss) from operations per common basic share

  $ 1.21   $ (0.54 )   $ (2.19 )   $ (1.72 )   $ (0.60 )   $ (0.09 )

Total assets

  $ 154,146   $ 160,168     $ 108,856     $ 65,524     $ 53,981     $ 50,380  

Long term obligations

  $ 4,941   $ 10,433     $ 691     $ 535     $ 448     $ 378  

Cash dividends declared per common share

    N/A     N/A       N/A       N/A       N/A       N/A  

Basic earnings (loss) per share, as reported

  $ 0.72   $ (0.31 )   $ (1.94 )   $ (1.72 )   $ (0.57 )   $ (0.08 )

Basic weighted average shares outstanding

    16,908     21,579       21,506       21,220       21,488       21,579  

 

PECO II, Inc. Financial Notes.

 

For the readers’ information, the following events were determined to have significant impact on the Income (Loss) of PECO II, Inc. (“PECO II” or the “Company”) for each specific year:

 

2001

 

    Operating results were adversely affected by the downturn in the communications industry.

 

    In August 2001, the Company entered into an adjustable industrial revenue bond for $6.5 million for the purchase of a facility located in Denver.

 

2002

 

    The Company reviewed its physical facilities and listed its New Hampshire, Colorado, and Worthington, Ohio facilities for sale.

 

    An asset impairment of $2.0 million was recognized for the physical facilities held for sale.

 

    The industrial revenue bond for the Company’s Colorado facility that was held for sale was moved to current debt.

 

    The Company provided for a write-off and disposed of approximately $8.0 million in inventory.

 

2003

 

    The Company added its new Galion, Ohio manufacturing and headquarters buildings to our list of facilities for sale.

 

    Upon review of the listing of the Galion, Ohio facilities for sale, the Company also recognized a $1.1 million asset impairment.

 

    The Company sold its Worthington, Ohio engineering facility in May and New Hampshire facility in August of 2003.

 

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    The Company wrote off $8.6 million of inventory.

 

    The Company recognized a $3.3 million machinery and equipment impairment.

 

    The Company recognized a $5.7 million goodwill impairment.

 

2004

 

    The annual assessment of goodwill resulted in a $6.0 million impairment.

 

Delta’s Selected Financial Data (Historical) for Delta Business Assets to be Acquired

 

The selected financial data for the business supply agreements and related assets being acquired by the Company from Delta (the “Delta Business Assets”) as of and for the 12-month period ended December 31, 2004 is derived from audited financial statements and the selected financial data for the Delta Business Assets as of and for the nine-month periods ended September 30, 2005 and the 12-month periods ended December 31, 2000, 2001, 2002 and 2003 are derived from unaudited financial statements, which we believe reflect all adjustments necessary for a fair presentation of the results for the respective periods.

 

Delta Business Assets

 

    Year ended
2000


  Year ended
2001


  Year ended
2002


  Year ended
2003


  Year ended
2004


  Nine-month
Period ended
September 30,
2005


 
    in thousands, except share data  

Operating revenues

  $ 11,536   $ 9,565   $ 20,309   $ 21,970   $ 10,355   $ 8,352  

Income (Loss) from operations

  $ 1,927   $ 2,059   $ 3,444   $ 3,014   $ 117   $ (116 )

Income (Loss) from operations per common basic share

    N/A     N/A     N/A     N/A     N/A     N/A  

Total assets

  $ 4,523   $ 3,337   $ 3,769   $ 6,592   $ 5,968   $ 6,759  

Long term obligations

  $ —     $ —     $ —     $ —     $ —     $ —    

Cash dividends declared per common share

    N/A     N/A     N/A     N/A     N/A     N/A  

 

Pro Forma Selected Consolidated Financial Data of PECO II and Delta Business Assets

 

The following tables summarize the unaudited pro forma consolidated financial data, giving effect to the purchase of the Delta Business Assets, as if they had occurred on the date indicated (which we refer to as “pro forma” information). In presenting the comparative pro forma information for certain time periods, we assumed that we had made the asset purchase throughout those periods and made certain other assumptions.

 

The pro forma information, while helpful in illustrating the financial characteristics of PECO II after the asset purchase under one set of assumptions, does not attempt to predict or suggest future results. The pro forma information also does not necessarily reflect what the historical results of PECO II would have been had the asset purchase occurred prior to these periods. For additional information, you should refer to the section of this document entitled “Pro Forma Condensed Consolidated Financial Information” below.

 

PECO II/Delta Business Assets

 

     Year ended
2004


   

Nine-month

Period ended
September 30,
2005


 
     in thousands, except share data  

Operating revenues

   $ 41,919     $ 38,477  

Income (Loss) from operations

   $ (12,602 )   $ (1,387 )

Income (Loss) from operations per common basic share

   $ (0.48 )   $ (0.05 )

Total assets

   $ 65,216     $ 61,615  

Long term obligations

   $ 448     $ 378  

Cash dividends declared per common share

     N/A       N/A  

Basic earnings (loss) per share

   $ (0.46 )   $ (0.05 )

Basic weighted average shares outstanding

     26,228       26,319  

 

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Pro Forma Comparative Unaudited Per Share Data

 

The following table shows information about our income (loss) per common share, dividends per share and book value per share, and similar information as if the asset purchase had occurred on the date indicated. In presenting the comparative pro forma information for certain time periods, we assumed that we had acquired the Delta Business Assets prior to those periods and made certain other assumptions.

 

The pro forma information, while helpful in illustrating the financial characteristics of PECO II after the asset purchase under one set of assumptions does not attempt to predict or suggest future results. The pro forma information also does not necessarily reflect what the historical results of PECO II would have been after the purchase of the Delta Business Assets if such asset purchase had occurred prior to these periods.

 

    PECO II Historical

    Delta Business Assets
Historical


  Pro Forma PECO II
Consolidated


    Pro Forma Delta Business
Assets Consolidated


   

Nine-month
Period ended

September 30,
2005


   

Year

ended

December 31,
2004


   

Nine-month
Period ended

September 30,
2005


 

Year

ended

December 31,
2004


 

Nine-month
Period ended

September 30,
2005


   

Year

ended

December 31,
2004


    Nine-month
Period ended
September 30,
2005


 

Year

ended

December 31,
2004


Book value per share

  $ 1.65     $ 1.74     N/A   N/A   $ 1.78     $ 1.85     N/A   N/A

Cash dividends declared per share

    —         —       N/A   N/A     —         —       N/A   N/A

Basic earnings from continuing operations per share

  $ (0.09 )   $ (0.60 )   N/A   N/A   $ (0.05 )   $ (0.46 )   N/A   N/A

Diluted earnings from continuing operations per share

  $ (0.09 )   $ (0.60 )   N/A   N/A   $ (0.05 )   $ (0.46 )   N/A   N/A

 

Pro Forma Condensed Consolidated Financial Information

 

The following unaudited pro forma condensed consolidated financial information for PECO II gives effect to the purchase of the Delta Business Assets using the purchase method of accounting, based on preliminary allocations of the total estimated purchase price. The final purchase price will be determined per EITF 99-12. The historical financial information has been derived from the respective historical financial statements of PECO II and the Delta Business Assets, and should be read in conjunction with the financial statements and related notes included elsewhere in this proxy statement or incorporated by reference.

 

The unaudited pro forma condensed consolidated balance sheets have been prepared assuming the asset purchase took place as of December 31, 2004 and September 30, 2005, respectively. Allocation of the total estimated purchase price to the fair value of assets and liabilities of the Delta Business Assets at these dates is based on preliminary valuations.

 

The unaudited pro forma condensed consolidated statements of operations consolidate PECO II’s and Delta’s historical statements of operations of the Delta Business Assets and give effect to the asset purchase as if they occurred on January 1, 2004, the beginning of the earliest period presented.

 

The total estimated and actual purchase prices of the Delta Business Assets have been allocated on a preliminary basis to assets and liabilities based on management’s estimates of their fair values. These allocations are subject to change pending a final determination and analysis of the total purchase prices and fair values of the assets acquired and liabilities assumed. The impact of these changes could be material.

 

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The unaudited pro forma condensed consolidated financial information is presented for illustrative purposes only and is not necessarily indicative of operating results or financial condition that would have actually occurred if the asset purchase had been completed as of the dates indicated, nor is it necessarily indicative of the future operating results or financial position of PECO II after the asset purchase. The pro forma adjustments are based on the information available as of the date of this proxy statement.

 

PECO II, Inc.

Unaudited Pro Forma Consolidated Balance Sheet with Delta Business Assets

as of September 30, 2005

 

    PECO II

    Delta Business
Assets


  Pro forma
Adjustment


    Note 3
Ref.


 

Pro forma
Results

Nine-month
Period ended
September 30,
2005


 
    Nine-month
Period ended
September 30,
2005


    Nine-month
Period ended
September 30,
2005


     
    (In thousands)  

Current assets

                                 

Cash & equivalents

  $ 4,668                       $ 4,668  

Due from owner

          $ 3,167   $ (3,167 )   A        

Accounts receivable

    7,200       693     (693 )   B     7,200  

Inventories, net

    11,474       1,964     36     C     13,474  

Restricted cash

    9,441                         9,441  

Other current assets

    9,611       935     (935 )   D     9,661  
   


 

 


     


Total current assets

    42,394       6,759     (4,759 )         44,394  
   


 

 


     


Property & equipment, at cost

                                 

Building, land and improvements

    4,854                         4,854  

Machinery and equipment

    9,159                         9,159  

Furniture and fixtures

    6,096                         6,096  
   


                   


      20,109                         20,109  

Less: accumulated depreciation

    (13,907 )                       (13,907 )

Property and equipment, net

    6,202                         6,202  

Other assets

    1,784             9,235     E     11,019  
   


 

 


     


Total assets

  $ 50,380     $ 6,759   $ 4,476         $ 61,615  
   


 

 


     


Current liabilities

                                 

Industrial revenue bonds

  $ 5,630                       $ 5,630  

Accounts payable and other accrued expense

    8,657     $ 1,671   $ (1,571 )   F     8,757  
   


 

 


     


Total current liabilities

    14,287       1,671     (1,571 )         14,387  
   


 

 


     


Long term liabilities

    378                         378  
   


                   


Shareholders’ equity

                                 

Common shares

    2,816             601     G     3,417  

Additional paid-in capital

    110,215             10,534     H     120,749  

Retained (deficit) earnings

    (76,338 )     5,088     (5,088 )   I     (76,338 )

Treasury shares

    (978 )                       (978 )
   


 

 


     


Total shareholders equity

    35,715       5,088     6,047           46,850  
   


 

 


     


Total liabilities and shareholders’ equity

  $ 50,380     $ 6,759   $ 4,476         $ 61,615  
   


 

 


     


 

See Notes to Unaudited Pro Forma Condensed Consolidated Financial Information.

 

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Table of Contents

PECO II, Inc.

Unaudited Pro Forma Condensed Consolidated Statement of Operations with Delta Business Assets

For the Year Ended December 31, 2004

 

    PECO II, Inc

   

Delta

Business Assets


    Pro forma
Adjustment


    Note 3
Ref.


 

Pro forma
Results

Year ended
December 31,
2004


 
    Year ended
December 31,
2004


    Year ended
December 31,
2004


       
    (In thousands, except for per share amounts)  

Net sales

                                   

Product

  $ 21,049     $ 10,355                 $ 31,404  

Services

    10,515                           10,515  
   


 


 


     


      31,564       10,355                   41,919  

Cost of goods sold

                                   

Product

    17,660       8,103     $ 471     J     26,234  

Services

    9,801                           9,801  
   


 


 


     


      27,461       8,103       471           36,035  

Gross margin

                                   

Product

    3,389       2,252       (471 )         5,170  

Services

    714                           714  
   


 


 


     


      4,103       2,252       (471 )         5,884  

Operating expenses

                                   

Research, development and engineering

    2,956                           2,956  

Selling, general and administrative

    7,958       2,135       (550 )   K     9,543  

Impairment charges

    5,987                           5,987  
   


 


 


     


      16,901       2,135       (550 )         18,486  
   


 


 


     


Income (Loss) from continuing operations

    (12,798 )     117       (79 )         (12,602 )

Other (income) and expense

    (65 )     280       (280 )   L     (65 )
   


 


 


     


Income (loss) before tax

    (12,733 )     (163 )     359           (12,537 )

Benefit (provision) for income tax

    463       68       (68 )   M     463  
   


 


 


     


Net income (loss)

  $ (12,270 )   $ (95 )   $ 291         $ (12,074 )
   


 


 


     


Basic earnings from continuing operations per share

  $ (0.60 )                       $ (0.48 )

Diluted earnings from continuing operations per share

  $ (0.60 )                       $ (0.48 )

Net loss per common share

                                   

Basic

  $ (0.57 )                       $ (0.46 )

Diluted

  $ (0.57 )                       $ (0.46 )

Weighted average common shares outstanding

                                   

Basic

    21,488                     N     26,228  

Diluted

    21,488                           26,228  

 

See Notes to Unaudited Pro Forma Condensed Consolidated Financial Information.

 

17


Table of Contents

PECO II, Inc.

Unaudited Pro Forma Condensed Consolidated Statement of Operations with Delta Business Assets

For the Nine Months Ended September 30, 2005

 

    PECO II, Inc.

    Delta Business
Assets


    Pro forma
Adjustment


    Note 3
Ref.


 

Pro forma
Results

Period

ended
September 30,
2005


 
   

Period

ended
September 30,

2005


   

Period

ended

September 30,

2005


       
    (In thousands, except for per share amounts)  

Net sales

                                 

Product

  $ 21,523     $ 8,352               $ 29,875  

Services

    8,602                         8,602  
   


 


 

     


      30,125       8,352                 38,477  

Cost of goods sold

                                 

Product

    15,817       6,267     354     J     22,438  

Services

    7,735                         7,735  
   


 


 

     


      23,552       6,267     354           30,173  

Gross margin

                                 

Product

    5,706       2,085     (354 )         7,437  

Services

    867                         867  
   


 


 

     


      6,573       2,085     (354 )         8,304  

Operating expenses

                                 

Research, development and engineering

    2,189                         2,189  

Selling, general and administrative

    5,884       2,202     (1,013 )   K     7,073  

Impairment charges

    430                         430  
   


 


 

     


      8,503       2,202     (1,013 )         9,692  
   


 


 

     


Income (Loss) from continuing operations

    (1,930 )     (117 )   659           (1,388 )

Other (income) and expense

    135       (133 )   133     L     135  
   


 


 

     


Income (loss) before tax

    (1,795 )     (250 )   792           (1,253 )

Benefit (provision) for income tax

    54       103     (103 )   M     54  
   


 


 

     


Net income (loss)

    (1,741 )     (147 )   689           (1,199 )
   


 


 

     


Basic earnings from continuing operations per share

  $ (0.09 )                     $ (0.05 )

Diluted earnings from continuing operations per share

  $ (0.09 )                     $ (0.05 )

Net loss per common share

                                 

Basic

  $ (0.08 )                     $ (0.05 )

Diluted

  $ (0.08 )                     $ (0.05 )

Weighted average common shares outstanding

                                 

Basic

    21,579                   N     26,319  

Diluted

    21,579                         26,319  

 

See Notes to Unaudited Pro Forma Condensed Consolidated Financial Information

 

18


Table of Contents

PECO II, Inc.

Note to Unaudited Pro Forma Condensed Consolidated Financial Information

With Delta Business Assets

 

1. Description of Transaction and Basis of Presentation

 

On October 13, 2005, the Company entered into an Asset Purchase Agreement with Delta to acquire the assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply agreements with wireline and wireless communications providers, the related inventory, comprised of raw materials, work in process and finished products (the “Inventory”), and the business records of Delta’s U.S. and Canadian service provider business (the “Delta Business Assets”). The Company will also assume the associated liabilities of the Delta Business Assets after the closing. In consideration of the purchase of the Delta Business Assets, at closing the Company will issue 4,740,375 shares of common stock (the “Primary shares”) to Delta. Also at closing, the Company will issue to Delta a warrant to purchase up to approximately 12.9 million shares of its common stock (the “Warrant Shares”) at an exercise price of $2.00 per share (the “Warrant”). The Warrant is immediately exercisable upon issuance and for a period of 30 months thereafter. As a result of the issuance of the Primary Shares and the exercise of the purchase rights under the Warrant for the Warrant Shares, Delta will have the right to acquire, when aggregated with the Primary Shares, up to 45% of the issued and outstanding capital stock of the Company measured as of the date that is five business days prior to the date of exercise.

 

2. Purchase Price

 

The reader should be advised that the pro forma information is preliminary and unaudited. The transaction cost is determined by PECO II’s market value per share based on EITF-99-12 guidance and the final price will be determined upon shareholder approval of the issuance of the Primary Shares and Warrant. Due to market uncertainty, the transactions reflected in the pro forma balance sheet and statement of operations will change based on changes in market value.

 

A preliminary estimate of the purchase price is as follows (table in thousands):

 

Estimated market value of Primary Shares issued

   $ 6,352

Estimated fair value of Warrant issued

     4,783
    

Subtotal

     11,135

Estimated transaction costs incurred per agreement

     100
    

Estimated purchase price

   $ 11,235
    

 

For pro forma purposes, the fair value of the shares used in determining the purchase price was $1.34 which was based on the average closing price of PECO II common stock for the five business days prior to, the date of, and the five days after the public announcement of the execution of the Asset Purchase Agreement. The fair value of the Warrant was also determined using the Black-Scholes option pricing model with the following assumption: stock price of $1.34; volatility of 60%; risk-free interest rate of 3.96%; and an expected life of 2.5 years.

 

For pro forma purposes, the estimated purchase price has been allocated per the Asset Purchase Agreement (table in thousands):

 

Current assets

      

Inventory

   $ 2,000

Other assets

      

Customer relationships

Supply agreement

    
 
2,820
2,820

Goodwill

     3,595
    

Total other assets

   $ 9,235
    

Total assets

   $ 11,235
    

 

19


Table of Contents

The allocation of the purchase price is a preliminary estimate. The final purchase price allocation will not be completed until after our receipt of shareholder approval at the special meeting of the proposals set forth in this proxy statement. Our decision to obtain the final purchase price allocation after the special meeting is based on our reliance on FAS141, B183, which states that the allocation period should not exceed one year from the consummation date. As a result, we believe it appropriate to delay the final purchase price allocation until after the special meeting, at which meeting we anticipate obtaining the approval of our shareholders to consummate the transactions contemplated by the Asset Purchase Agreement.

 

Management believes that its preliminary allocation among the specific intangibles of the consideration in the amount of $11.235 million to be paid in exchange for the Delta Business Assets is reasonable. The specific intangibles identified in our preliminary allocation are customer relationships, the Supply Agreement and Goodwill, estimated to comprise 31%, 31% and 38%, respectively, of the total consideration of $11.235 million to be paid for the Delta Business Assets, less $2.0 million of tangible inventory.

 

We expect very little attrition with the customer relationships that comprise a portion of the intangible assets and we anticipate that the Supply Agreement will be renewed. As an estimate of useful life of the customer relationships and the Supply Agreement prior to the completion of the final purchase price allocation, we anticipate their useful life to be 6 years and 9 years, respectively. The useful lives were used to calculate our pro forma amortization. When the purchase price allocation is completed, we anticipate using the midpoint of future cash flows or possibly other means to determine the useful life of each of the customer relationships and the Supply Agreement, based on further contract or cash flow review.

 

We have concluded that the proposed acquisition of the Delta Business Assets represents the acquisition of a business based on guidance in Rule 11-01(d) of Regulation S-X and EITF 98-3. As a result, there will be intangible assets and possible goodwill depending on the purchase price allocation. The allocation will be performed upon the approval and completion of the purchase transaction.

 

3. Pro Forma Adjustments (in thousands)

 

Balance Sheet

 

     Nine-month
Period ended
September 30,
2005


   

Year

ended
December 31,

2004


    

A.

   $ (3,167 )        To eliminate Delta’s due from owner account.

B.

   $ (693 )        To eliminate Delta’s accounts receivable accounts.

C.

   $ (1,964 )        To eliminate Delta’s inventory accounts.
       2,000          Acquisition of inventory per the Asset Purchase Agreement.
    


        
       36          Total pro forma adjustment.

D.

   $ (935 )        To eliminate Delta’s other current assets.

E.

   $ 9,235          To record the estimated fair value of the intangible assets acquired in the asset purchase, see note 2.

F.

   $ (1,671 )        To eliminate Delta’s accounts payable and other accrued accounts.
       100          To record the agreed upon legal/accounting expenses in the Asset Purchase Agreement.
    


        
       (1,571 )        Total pro forma accrued expense adjustment.

G.

   $ 601          To record the issuance of 4,740,375 Primary Shares at a stated value of $.126857 per share.

H.

   $ 5,751          To record the additional paid-in capital at market price less stated value times issuance of 4,740,375 Primary Shares.
       4,783          To record the cost of the Warrant, see note 2.
    


        
       10,534          Total pro forma additional paid-in capital adjustment.

I.

   $ (5,088 )        To eliminate Delta’s retained earnings accounts.

 

20


Table of Contents

Statement of Operations

 

     Nine-month
Period ended
September 30,
2005


   

Year

ended
December 31,

2004


             

J.

   $ (354 )   $ 471     To record the amortization of the Supply Agreement over the estimated remaining useful life.

K.

   $ (359 )   $ (373 )   To eliminate Delta’s corporate administration as it is an internal allocation from its corporate headquarters group. The Delta administration expense allocation for both December 31, 2004 of $373,000 and September 30, 2005 of $359,000 were based on various administrative department expenses. The administrative departments included human resources, information system services, accounting/finance, corporate management/facilities, sales administration, and local office expenses that would cover the Raleigh, North Carolina facility and the associated administrative expenses from that facility. None of these expenses will be transferred to PECO II as it is already covered under our existing administrative structure today.
                     The allocation of Delta’s corporate administration is based on headcount of the particular division or segment, divided by the entire headcount except the administrative departments’ headcount, times the total various administrative departmental expenses. For 2004, the total headcount was 228, which includes administrative headcount of 39. For 2005, the total headcount was 230, which includes administrative headcount of 40.
       (1,843 )     (1,762 )   To eliminate Delta’s selling expenses as the existing selling staff of PECO II will be used along with a few Delta sales personnel who will be transferred (see next line item below) as they have established relationships with customers. A breakdown of the selling expense follows:
                     Year ended
December 31, 2004


 

Nine month

Period ended
September 30, 2005


                    

Payroll & benefits

  $ 1,263,984   $ 1,367,789
                    

Travel & entertainment

    127,669     156,770
                    

Depreciation

    84,489     71,437
                    

Promotion

    52,127     23,503
                    

HUB(3rd party whse) expenses

    45,475     30,816
                    

Telephone & postage

    32,862     23,272
                    

Bad debt

    31,683     26,558
                    

Others

    123,657     142,382
                        

 

                    

Total selling expenses

  $ 1,761,946   $ 1,842,527
                        

 

       600       800     To record the estimated selling expenses to be incurred by PECO II of transferred Delta sales personnel referred to above.
       589       785     To record the amortization of the remaining intangible assets over their estimated remaining useful life.
    


 


   
       (1,013 )     (550 )   Total pro forma operating expense adjustments.

 

21


Table of Contents
     Nine-month
Period ended
September 30,
2005


   

Year

ended
December 31,

2004


             

L.

   $ (133 )   $ (280 )   To remove non-operating income and expense accounts.

M.

   $ (103 )   $ (68 )   To remove tax provision.

N.

                   To record the following adjustment:

 

     Year ended
December 31, 2004


   Nine months ended
September 30, 2005


Weighted average basic common shares, pre acquisition

   21,488    21,579

Primary Shares issued per Asset Purchase Agreement

   4,740    4,740
    
  

Weighted average basic common shares, post acquisition

   26,228    26,319
    
  

 

22


Table of Contents

Delta Business Assets

 

Delta Management’s Discussion and Analysis—Financial Results of Delta Business Assets

 

The Delta Business Assets to be acquired by PECO II from Delta relate to Delta’s Telecom Power Division, which is one segment of Delta’s business. Delta is a sales and distribution channel for operations in the Americas of its parent, Delta Group. Sales orders are taken by Delta through customer requests and existing supply arrangements with various parties, and such orders are communicated to various manufacturing plants of Delta Group that are located worldwide. The Telecom Power Division of Delta coordinates customer orders and supply contracts and manages the inventory relating to such orders with respect to telecommunications power products for Delta. The Telecom Power Division of Delta does not maintain a separate bank account or operate as a financially distinct entity from Delta as a whole. Accordingly, specific discussions on liquidity and capital resources are not applicable to this business unit, or to the Delta Business Assets being acquired. However, to the extent relevant, the following is a discussion of trends that affected the overall results of operations of the Telecom Power Division of Delta and certain events and economic changes in the market during recent years that affected the market pertaining to the Delta Business Assets being acquired.

 

Generally, participants in the telecommunications power supply industry, including the Telecom Power Division, experience increased activity and realize higher revenues during spring through late fall of each year due to the ability of their customers to access and install telecommunications power sites during these periods, particularly with respect to mountainous regions and other areas subject to extreme winter conditions. This period is referred to in the industry as the “build season.” Consistent with the rest of the industry, the Delta Business Assets being acquired are subject to the build season trend of higher revenues during the second and third quarters of each year, and a corresponding decrease in revenues during the first and fourth quarters of each year. The fiscal year 2003 Delta Business Assets quarterly results are indicative of this seasonality.

 

In fiscal 2004, two factors led to a reduction in the overall revenues associated with the Delta Business Assets. The first was an erosion of the Telecom Power Division’s market share resulting from inroads made by new market entrants like Valere Power, Inc., and the other was a change in the purchasing activities of certain of Delta’s key customers. These trends had a negative affect on the financial performance of the Delta Business Assets.

 

In addition, one of Delta’s large customers purchased significantly less inventory than the amount anticipated by Delta, resulting in decreased revenues and management’s decision to increase the amount of inventory reserve from $1.1 million to $2.02 million beginning the second quarter of 2004. The decrease in revenues led to a loss in income for the Delta Business Assets during the last quarter of 2004 and increased inventory in 2005.

 

The following condensed financial information for the service provider portion of Delta Products Corporation’s Telecom Power Division (which service provider portion is referred to in this proxy statement as the Delta Business Assets) for the 12-month period ended December 31, 2004 is derived from audited financial statements and the condensed financial information for the Delta Business Assets as of and for the nine-month period ended September 30, 2005, as well as for the 12-month periods ended December 31, 2002 and 2003 is derived from unaudited financial statements, all of which we believe reflect all adjustments necessary for a fair presentation of the results for the respective periods.

 

23


Table of Contents

Service Provider Portion of Delta Products Corporation’s Telecom Power Division Financial Statements

 

LOGO

 

INDEPENDENT AUDITORS’ REPORT

 

Board of Directors

Delta Products Corporation

Fremont, California

 

We have audited the accompanying balance sheet of the service provider portion of Delta Product Corporation’s Telecom Power Division (“the Division”) as of December 31, 2004, and the related statements of operations, owner’s equity in division, and cash flows for the year then ended. These financial statements are the responsibility of the management of Delta Products Corporation. Our responsibility is to express an opinion on these financial statements based on our audit.

 

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the service provider portion of Delta Product Corporation’s Telecom Power Division at December 31, 2004, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 1 to the financial statements, the Division is owned and operated by Delta Products Corporation. The Division has extensive transactions with Delta Electronics Inc., a minority shareholder of Delta America Ltd., the parent of Delta Products Corporation.

 

LOGO

November 11, 2005

 

2000 West Dorothy Lane  n  Dayton, Ohio 45439  n  TEL 937-298-0201  n  FAX 937-298-5758  n  www.battellecpas.com

 

An Independently Owned Member of the RSM McGladrey Network

 

24


Table of Contents

Service Provider Portion of Delta Products Corporation’s Telecom Power Division

Quarterly Balance Sheets

 

    Quarters Ended

 
    Mar. 31,
2003


    June 30,
2003


    Sept. 30,
2003


    Dec. 31,
2003


    Mar. 31,
2004


    June 30,
2004


    Sept. 30,
2004


    Dec. 31,
2004


    Mar. 31,
2005


    June 30,
2005


   

Sept. 30,

2005


 
    (In thousands)  

Current Assets

                                                                 

Due from Owner

  2,267     2,630     1,913     2,326     1,982     2,383     4,530     3,331     3,643     4,716     3,167  

Accounts Receivable

  1,375     1,683     753     609     429     500     355     460     611     589     693  

Inventory

                                                                 

Inventory

  2,389     3,949     6,009     5,252     5,537     4,637     3,174     3,353     3,599     3,479     4,057  

Inventory Reserve

  (1,050 )   (1,100 )   (1,100 )   (1,925 )   (1,925 )   (2,020 )   (2,020 )   (2,093 )   (2,093 )   (2,093 )   (2,093 )
   

 

 

 

 

 

 

 

 

 

 

Inventory, Net

  1,339     2,849     4,909     3,327     3,612     2,617     1,154     1,260     1,506     1,459     1,964  

Deferred Income Tax asset

  —       —       —       330     —       —       —       917     —       —       935  
   

 

 

 

 

 

 

 

 

 

 

Total Assets

  4,980     7,162     7,576     6,592     6,023     5,500     6,040     5,968     5,760     6,691     6,759  
   

 

 

 

 

 

 

 

 

 

 

Current Liabilities

                                                                 

Accounts payable

  1,141     2,785     2,359     1,119     527     (31 )   369     586     429     1,270     1,523  

Other accrued expense

  58     90     111     142     60     94     115     148     77     120     149  
   

 

 

 

 

 

 

 

 

 

 

Total Current Liabilities

  1,199     2,875     2,470     1,261     587     63     484     734     506     1,390     1,672  

Long term liabilities

  —       —       —       —       —       —       —       —       —       —       —    

Owner’s Equity

                                                                 

Owner’s equity in division

  3,781     4,287     5,106     5,331     5,436     5,437     5,556     5,234     5,254     5,301     5,087  
   

 

 

 

 

 

 

 

 

 

 

Total owner’s equity

  3,781     4,287     5,106     5,331     5,436     5,437     5,556     5,234     5,254     5,301     5,087  
   

 

 

 

 

 

 

 

 

 

 

Total liabilities and owners’ equity

  4,980     7,162     7,576     6,592     6,023     5,500     6,040     5,968     5,760     6,691     6,759  
   

 

 

 

 

 

 

 

 

 

 

 

 

See Notes to Financial Statements of the Service Provider Portion of Delta Products Corporation’s Telecom Power Division

 

25


Table of Contents

Service Provider Portion of Delta Products Corporation’s Telecom Power Division

Quarterly Statements of Operations

 

    Quarters Ended

 
    Mar. 31,
2003


  June 30,
2003


  Sept. 30,
2003


  Dec. 31,
2003


  Mar. 31,
2004


  June 30,
2004


  Sept. 30,
2004


  Dec. 31,
2004


    Mar. 31,
2005


  June 30,
2005


  Sept. 30,
2005


 
    (In thousands)  

Net Sales

     

Product

  3,920   6,119   7,585   4,347   2,815   2,693   2,677   2,169     2,523   2,902   2,928  

Services

  —     —     —     —     —     —     —     —       —     —     —    
   
 
 
 
 
 
 
 

 
 
 

    3,920   6,119   7,585   4,347   2,815   2,693   2,677   2,169     2,523   2,902   2,928  

Cost of Goods Sold

                                               

Product

  3,135   4,630   5,513   3,294   2,088   2,145   1,933   1,937     1,822   2,169   2,276  

Services

  —     —     —     —     —     —     —     —       —     —     —    
   
 
 
 
 
 
 
 

 
 
 

    3,135   4,630   5,513   3,294   2,088   2,145   1,933   1,937     1,822   2,169   2,276  

Gross Margin

                                               

Product

  785   1,489   2,072   1,053   727   548   744   232     701   733   652  

Services

  —     —     —     —     —     —     —     —       —     —     —    
   
 
 
 
 
 
 
 

 
 
 

    785   1,489   2,072   1,053   727   548   744   232     701   733   652  

Operating Expenses

                                               

Research, development and engineering

  —     —     —     —     —     —     —     —       —     —     —    

Selling, general and administrative

  596   597   595   596   468   468   486   713     618   618   966  

Impairment charges

  —     —     —     —     —     —     —     —       —     —     —    
   
 
 
 
 
 
 
 

 
 
 

    596   597   595   596   468   468   486   713     618   618   966  

Income (loss) from continuing operations

  189   892   1,477   457   259   80   258   (481 )   83   114   (314 )

Other (income) and expense

  56   48   112   82   83   77   61   59     49   38   46  
   
 
 
 
 
 
 
 

 
 
 

Income (loss) before tax

  133   844   1,365   375   176   3   197   (540 )   34   76   (360 )

Benefit (provision) for income tax

  53   338   546   150   70   2   79   (218 )   14   31   (148 )
   
 
 
 
 
 
 
 

 
 
 

Net Income (loss)

  80   506   819   225   106   1   118   (322 )   20   46   (212 )
   
 
 
 
 
 
 
 

 
 
 

 

 

See Notes to Financial Statements of the Service Provider Portion of Delta Products Corporation’s Telecom Power Division

 

26


Table of Contents

Service Provider Portion of Delta Products Corporation’s Telecom Power Division

Annual Statements of Operations

 

     Years ended December 31,

   

Period ended
September 30,
2005


 
     2002

    2003

    2004

   
     (In thousands)  

Net Sales

                        

Product

   20,309     21,970     10,355     8,353  

Services

   —       —       —       —    
    

 

 

 

     20,309     21,970     10,355     8,353  

Cost of Goods Sold

                        

Product

   15,021     16,572     8,103     6,267  

Services

   —       —       —       —    
    

 

 

 

     15,021     16,572     8,103     6,267  

Gross Margin

                        

Product

   5,288     5,398     2,252     2,086  

Services

   —       —       —       —    
    

 

 

 

     5,288     5,398     2,252     2,086  

Operating Expenses

                        

Research, development and engineering

   —       —       —       —    

Selling, general and administrative

   1,844     2,383     2,135     2,202  

Impairment charges

   —       —       —       —    
    

 

 

 

     1,844     2,383     2,135     2,202  

Income (loss) from continuing operations

   3,444     3,015     117     (116 )

Other (income) and expense

   574     299     280     133  
    

 

 

 

Income (loss) before tax

   2,870     2,716     (163 )   (249 )

Benefit (Provision) for income tax

   (1,148 )   (1,086 )   67     103  
    

 

 

 

Net Income (loss)

   1,722     1,630     (96 )   (146 )
    

 

 

 

 

 

See Notes to Financial Statements of the Service Provider Portion of Delta Products Corporation’s Telecom Power Division

 

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Service Provider Portion of Delta Products Corporation’s Telecom Power Division

Annual Statements of Cash Flows

 

     Years ended December 31,

    Period ended
September 30,
2005


 
     2002

    2003

    2004

   
     (In thousands)  

Cash flow from operating activities:

                        

Net income (loss)

   1,722     1,630     (96 )   (147 )

Change in assets & liabilities

                        

Accounts receivable

   (919 )   1,070     149     (233 )

Inventory

   707     (1,457 )   2,067     (704 )

Accounts payable

   (243 )   1,188     (533 )   937  

Accrued expenses

   5     5     5     1  

Deferred income tax benefit

         (330 )   (587 )   (18 )

Due from owner

   (1,272 )   (2,106 )   (1,005 )   164  
    

 

 

 

Net cash provided by operating activities

   —       —       —       —    

Cash & cash equivalents at beginning of year

   —       —       —       —    
    

 

 

 

Cash & cash equivalents at end of year

   —       —       —       —    
    

 

 

 

 

 

See Notes to Financial Statements of the Service Provider Portion of Delta Products Corporation’s Telecom Power Division

 

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SERVICE PROVIDER PORTION OF DELTA PRODUCTS CORPORATION’S TELECOM POWER DIVISION

 

NOTES TO FINANCIAL STATEMENTS

 

For periods ending September 30, 2005, December 31, 2004, December 31, 2003 and December 31, 2002

 

The condensed financial information for the 12-month period ended December 31, 2004 is derived from audited financial statements. For the nine-month period ended September 30, 2005, the 12-month period ended December 31, 2003 and December 31, 2002, management believes the notes reflect a fair presentation of the results for the respective periods.

 

NOTE 1—THE DIVISION

 

The Telecom Power Division is owned and operated by Delta Products Corporation (“DPC”). DPC markets and distributes electronic parts and components to providers of wireless communication service throughout the United States of America. These “carve-out” financial statements include only the service provider portion of DPC’s Telecom Power Division (“the Division”). The Division was started by DPC in 1996.

 

The Division distributes power units for cell phone towers and provides service related to these units. The Division has inventory in DPC-owned warehouses in Raleigh, North Carolina and Fremont, California, and in third party owned warehouse in Durham, North Carolina.

 

The Division has extensive transactions with Delta Electronics Inc. (“DEI”), a Taiwanese company and minority shareholder of Delta America Ltd, the parent of DPC (see Note 3).

 

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Use of estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Inventories

 

Inventory, which consists solely of finished goods, is stated at the lower of cost (determined by the first in, first out method) or market value. The Division maintains a finished goods valuation allowance, which is based upon the age of inventory held. It is reasonably possible that the estimated finished goods reserve will change by a material amount within one year due to events in the industry, including consolidation of customers and new technology.

 

Revenue Recognition and Accounts Receivable

 

Revenues from product sales are recognized upon shipment to customer, provided that the Division has received an executed purchased order, the sales price is fixed, title has transferred, collection of the resulting receivable is probable and there is no customer acceptance requirement. The Division records an estimated allowance for returns at the time revenue is recognized based on historical experience. The Division maintains an allowance for doubtful accounts based upon the expected collection of its outstanding receivable balance. Trade accounts receivable are considered past due when they are outstanding in excess of 30 days. Accounts are charged off through the allowance when they are deemed to be uncollectible.

 

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Advertising

 

Advertising costs are charged to operations as incurred. Advertising costs related to the Division amounted to:

 

Unaudited


  

Audited


  

Unaudited


  

Unaudited


September 30, 2005

$23,787

  

December 31, 2004

$55,811

  

December 31, 2003

$71,308

  

December 31, 2002

$97,553

 

Expense Allocations

 

DPC allocates certain corporate expenses to the Division. These are the administrative expense portion of selling and administrative expense reported in the Statement of Income. Administrative expenses are the allocation of DPC’s administrative expense, which includes the salaries and benefits, travel expenses, professional fees and other expenses incurred by DPC’s administration on behalf of the Division.

 

Selling expenses include direct expenses of the service provider portion of the Division, including salaries and benefits, occupancy charges to DPC, which owns the property and equipment of the Division, fuel and delivery expenses, travel and entertainment, sales and promotion expenses, and other direct costs not included in cost of revenue.

 

The Statement of Income also includes an allocated interest charge for the use of DPC’s bank line of credit. Because of the complexity of the line of credit use, no debt can be reasonably allocated to the Division by DPC. Management believes that all of the expense allocation methods are reasonable.

 

It is reasonably possible that the results of operations would have been different if the Division had operated on a stand alone basis; however, it is not practicable to estimate what expenses would have been had the Division operated on a stand alone basis.

 

Income Tax

 

The Division recognizes deferred tax assets and liabilities for expected future tax consequences of temporary differences between financial and tax reporting (see Note 5). The Division is part of DPC, which is consolidated with Delta America Ltd. for federal income tax reporting purposes. However, any income tax accrual, representing the Division’s estimated portion of the consolidated federal income tax recovery or liability, is included in the Balance Sheet as part of the amount due from DPC (since DPC is ultimately responsible for its portion of the consolidated income tax liability).

 

NOTE 3—TRANSACTIONS WITH RELATED PARTIES

 

The following summarizes transactions and balances with related parties:

 

    

Unaudited

9/30/2005


  

Audited

12/31/2004


  

Unaudited

12/31/2003


  

Unaudited

12/31/2002


 

Receivable from DPC

   $ 3,166,725    $ 3,331,404    $ 2,326,343    $ 220,041  
    

  

  

  


Payable to DEI

   $ 1,522,342    $ 584,740    $ 1,106,643    $ (72,586 )
    

  

  

  


 

The Division does not have its own checking account. All of the Division’s expenditures are made by DPC; therefore, the Receivable from DPC row above represents the Division’s allocation of cash held by DPC.

 

In excess of 95% of the Division’s cost of revenues is related to purchases from DEI.

 

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NOTE 4—BALANCE SHEET COMPONENTS

 

The composition of various balance sheet line items are as follows:

 

     Unaudited
9/30/2005


    Audited
12/31/2004


    Unaudited
12/31/2003


    Unaudited
12/31/2002


 

Accounts receivable - trade, net

                                

Trade accounts receivable

   $ 751,050     $ 491,568     $ 674,561     $ 1,720,247  

Allowances for doubtful accounts and sales returns

     (58,058 )     (31,500 )     (66,188 )     (41,345 )
    


 


 


 


     $ 692,992     $ 460,068     $ 608,373     $ 1,678,902  
    


 


 


 


Inventory, net:

                                

Finished goods

   $ 4,057,271     $ 3,352,544     $ 5,251,870     $ 2,819,895  

Finished goods valuation allowance

     (2,093,000 )     (2,093,000 )     (1,925,000 )     (950,000 )
    


 


 


 


     $ 1,964,271     $ 1,259,544     $ 3,326,870     $ 1,869,895  
    


 


 


 


Other current liabilities:

                                

Payroll and related costs

   $ 111,550     $ 122,010     $ 117,317     $ 112,805  

Other

     36,536       25,539       25,000       24,038  
    


 


 


 


     $ 148,086     $ 147,549     $ 142,317     $ 136,843  
    


 


 


 


 

NOTE 5—INCOME TAX

 

The provision for (benefit from) income taxes consists of the following:

 

     Unaudited
9/30/2005


    Audited
12/31/2004


    Unaudited
12/31/2003


    Unaudited
12/31/2002


 

Current:

                                

Federal

   $ (67,500 )   $ 23,500     $ 1,235,000     $ 979,000  

State

     (17,500 )     6,000       321,000       255,000  
    


 


 


 


       (85,000 )     29,500       1,556,000       1,234,000  
    


 


 


 


Deferred:

                                

Federal

     (14,000 )     (77,000 )     (309,000 )     (1,500 )

State

     (4,000 )     (20,000 )     (80,000 )     (500 )
    


 


 


 


       (18,000 )     (97,000 )     (389,000 )     (2,000 )
    


 


 


 


Reported as a component of:

                                

Provision for (benefit from) income taxes

   $ (103,000 )   $ (67,500 )   $ 1,167,000     $ 1,232,000  
    


 


 


 


Deferred tax assets consist of the following:                                 

Finished goods reserve

   $ 896,000     $ 897,000     $ 785,000     $ 407,000  

Allowance for doubtful accounts and sales returns

     25,000       13,000       28,000       18,000  

Other

     14,000       7,000       7,000       6,000  
    


 


 


 


     $ 935,000     $ 917,000     $ 820,000     $ 431,000  
    


 


 


 


 

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A reconciliation of the difference between current income tax (benefit) expense and amounts computed by applying the expected federal and state income tax rates to net loss before income tax expense (benefit) is presented as follows:

 

Anticipated income tax expense (benefit)

   $ (107,000 )   $ (70,000 )   $ 1,162,000    $ 1,229,000

Increase (reduction) related to:

                             

Temporary differences

     18,000       97,000       389,000      2,000

Other non-deductible expenses

     4,000       2,500       5,000      3,000
    


 


 

  

Current income tax (benefit) expense

   $ (85,000 )   $ 29,500     $ 1,556,000    $ 1,234,000
    


 


 

  

 

Deferred income tax expense is based on the following items:

 

Finished goods reserve

   $ (11,000 )   $ (111,000 )   $ (378,000 )   $ —    

Allowance for doubtful accounts and sales returns

             15,000       (11,000 )     (2,000 )

Other

     (7,000 )     (1,000 )                
    


 


 


 


Total

   $ (18,000 )   $ (97,000 )   $ (389,000 )   $ (2,000 )
    


 


 


 


 

NOTE 6—CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMERS

 

Financial instruments that potentially subject the Division to significant concentrations of credit risk consist primarily of trade accounts receivable. With respect to trade accounts receivable, the Division performs ongoing credit evaluations and maintains reserves for potential credit losses; historically, such losses have been immaterial.

 

September 30, 2005 Unaudited

 

Two Customers accounted for approximately 53% of total accounts receivable at September 30, 2005. Two Customers accounted for approximately 59% of total sales for the nine months ended September 30, 2005.

 

December 31, 2004 Audited

 

Two customers accounted for approximately 45% of total accounts receivable at December 31, 2004. Two customers accounted for approximately 64% of total sales for 2004.

 

December 31, 2003 Unaudited

 

Two customers accounted for approximately 61% of total accounts receivable at December 31, 2003. Two customers accounted for approximately 62% of total sales for 2003.

 

December 31, 2002 Unaudited

 

Two customers accounted for approximately 55% of total accounts receivable at December 31, 2002. Two customers accounted for approximately 40% of total sales for 2002.

 

NOTE 7—EMPLOYEE BENEFIT PLANS

 

Delta America Ltd. sponsors a 401(K) defined contribution plan covering substantially all employees of the Division. Employer contributions under this plan related to the Division amounted to:

 

For the nine-months period ended 9/30/2005

   $48,214 (unaudited)

For the year ended 12/31/2004

   $50,496 (audited)

For the year ended 12/31/2003

   $38,660 (unaudited)

For the year ended 12/31/2002

   $31,447 (unaudited)

 

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NOTE 8—SUBSEQUENT EVENTS

 

On October 13, 2005, DPC entered into an Asset Purchase Agreement with PECO II, an Ohio Corporation, whereby PECO II agreed to purchase certain business assets of DPC’s Telecom Power Division in exchange for shares of stock in PECO II.

 

When this transaction closes, DPC will transfer to PECO II its business assets ((a) inventory, rights to and under business contracts, (b) rights to and under business records, (c) all rights, claims and causes of action against third parties exclusively relating to the business assets and (d) all rights of indemnity, warranty rights, rights of contribution, rights to refunds and other rights of recovery exclusively related to the business assets) in exchange for (1) 4,740,375 shares of PECO II common stock, (2) a warrant to purchase a certain number of PECO II common stock and (3) the assumption of certain DPC liabilities related to the assets transferred. The agreement provides for an inventory adjustment if its value at the closing date is other than $2,000,000.

 

Concurrent with the execution of this agreement, DPC, PECO II and PECO II’s significant shareholders executed a Voting Agreement, which states that there will be no restrictions on the voting rights associated with the shares received by DPC. Immediately following the execution of this agreement, they were to enter into a Support Agreement. In connection with the closing, DPC and PECO II will enter into various other agreements, including a Transition Services Agreement and Registration Rights Agreement, and in addition, an affiliate of DPC will enter into a Supply Agreement with PECO II.

 

If the transactions set forth in the Asset Purchase Agreement are consummated, PECO II will reimburse DPC for up to $100,000 of fees and expenses incurred related to the agreement plus one-half of the fees and expenses incurred relating to the preparation and delivery of DPC’s financial statements as required by the Agreement. In the event that the Agreement is terminated prior to closing by DPC due to a Triggering Event (as defined in the Agreement), or by PECO II if it receives a superior offer (under the terms of the Agreement), PECO II will pay DPC a $500,000 termination fee.

 

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Table of Contents

The Special Meeting

 

The Proposals

 

This proxy statement is being furnished to our shareholders in connection with the solicitation of proxies by our Board of Directors for use at a Special Meeting of Shareholders to be held at St. Joseph’s Activity Center, 135 North Liberty Street, Galion, Ohio, on Tuesday, March 21, 2006 at 9:00 a.m. local time. The purpose of the special meeting is for you to consider and vote upon the following proposals:

 

  1. To consider and vote on a proposal to approve and adopt an amendment to our Amended and Restated Code of Regulations providing that the Ohio Control Share Acquisition Act shall not apply to acquisitions of PECO II’s equity securities.

 

  2. To consider and vote on a proposal to approve the issuance of 4,740,375 shares of PECO II common stock without par value (the “Primary Shares”) to Delta Products Corporation (“Delta”), pursuant to an asset purchase agreement between PECO II and Delta, dated October 13, 2005 (the “Asset Purchase Agreement”), whereby PECO II will acquire the assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply agreements with wireline and wireless communications providers and related inventory and will assume the liabilities associated therewith of Delta’s U.S. and Canadian service provider business.

 

  3. To consider and vote on a proposal to issue a warrant (the “Warrant”) to permit Delta to purchase approximately 12.9 million shares of PECO II common stock without par value or such other number of shares that, when aggregated with the Primary Shares, will represent 45% of the issued and outstanding shares of PECO II capital stock measured as of the date five business days prior to the exercise date of the Warrant (the “Warrant Shares”), at an exercise price of $2.00 per share, exercisable immediately upon issuance and until a date that is 30 months following the closing date of the transactions contemplated by the Asset Purchase Agreement.

 

  4. To consider and vote on a proposal to allow the Board of Directors to adjourn the special meeting, if necessary, to solicit additional proxies in the event that there are not sufficient votes at the time of the special meeting to approve and adopt the proposals.

 

  5. To transact any other business that may properly come before the special meeting or any adjournment or postponement thereof.

 

A copy of the Asset Purchase Agreement is attached as Appendix C to this proxy statement. This proxy statement and the enclosed form of proxy are first being mailed to our shareholders on or about February 14, 2006.

 

Record Date and Voting

 

The holders of record of our common stock as of the close of business on the record date, which was February 7, 2006 are entitled to receive notice of, and to vote at, the special meeting. On the record date, there were 21,954,741 shares of our common stock outstanding.

 

The holders of a majority of our shares of common stock that were outstanding on the record date, represented in person or by proxy, will constitute a quorum for purposes of the special meeting. A quorum is necessary to hold the special meeting. Any shares of our common stock held in treasury by us are not considered to be outstanding for purposes of determining a quorum. In accordance with Ohio law, abstentions and properly executed broker non-votes will be counted as shares present and entitled to vote for the purposes of determining a quorum. “Broker non-votes” result when the beneficial owners of shares of common stock do not provide specific voting instructions to their brokers. Under applicable rules, brokers are precluded from exercising their voting discretion with respect to the approval of non-routine matters such as the proposals described in this proxy statement, and, thus, absent specific instructions from the beneficial owner of those shares, brokers are not empowered to vote the shares with respect to the approval of these proposals.

 

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Table of Contents

Required Vote

 

Each share of our common stock that was outstanding on the record date entitles the holder to one vote at the special meeting. Completion of the transactions contemplated by the Asset Purchase Agreement, such as the issuance of the Primary Shares, the issuance of the Warrant and the underlying Warrant Shares, and the proposal to permit the Board of Directors to adjourn the special meeting requires the affirmative vote of the holders of a majority of our shares of common stock voting in person or by proxy at the special meeting. The affirmative vote of a majority of the shares of our common stock is required to approve the amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act. Because the vote for the proposal to amend our Amended and Restated Code of Regulations is based on the number of shares of our common stock outstanding rather than on the number of votes cast, failure to vote your shares (including as a result of broker non-votes), and votes to abstain, are effectively votes against this proposal. Record holders may vote their shares of our common stock:

 

    by completing and returning the enclosed proxy card by mail; or

 

    by appearing and voting in person by ballot at the special meeting.

 

Regardless of whether you plan to attend the special meeting, you should vote your shares by proxy as described above as promptly as possible.

 

If you hold your shares through a bank, brokerage firm or nominee, you must vote in accordance with the instructions on the voting instruction card that your bank, brokerage firm or nominee provides to you. You should instruct your bank, brokerage firm or nominee as to how to vote your shares, following the directions contained in such voting instruction card.

 

As of the record date, our executive officers and directors owned an aggregate of approximately 6,050,112 shares of our common stock, entitling them to exercise approximately 27.6% of the voting power of our common stock entitled to vote at the special meeting. These executive officers and directors have indicated that they intend to vote in favor of the proposals.

 

In addition, simultaneous with the execution of the Asset Purchase Agreement, Messrs. Matthew P. Smith and James L. Green, and their respective affiliates, executed a support agreement and irrevocable proxy (the “Support Agreement”), under which each such person agreed, severally and not jointly, to vote all of the shares of our common stock beneficially owned by such persons at any PECO II shareholders meeting or by any consensual action:

 

    in favor of the proposal to opt out of the Ohio Control Share Acquisition Act;

 

    in favor of the issuance of the Primary Shares and the Warrant;

 

    in favor of the other transactions contemplated by the Asset Purchase Agreement and in favor of any other matter that could reasonably be expected to facilitate consummation of the transactions contemplated by the Asset Purchase Agreement;

 

    against any change in a majority of the members of our Board of Directors; and

 

    against any other action that would impede, interfere with, delay, postpone or materially adversely affect the closing of the transactions contemplated by the Asset Purchase Agreement.

 

In addition, Messrs. Smith and Green, and their respective affiliates, granted an irrevocable proxy to two of Delta’s designees to vote all of the shares of our common stock beneficially owned by such persons in accordance with the five bullet points above.

 

Proxies; Revocation

 

If you vote your shares of our common stock by signing a proxy, your shares will be voted at the special meeting as you indicate on your proxy card. If no instructions are indicated on your signed proxy card, your

 

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Table of Contents

shares of our common stock will be voted “FOR” the approval and adoption of the amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, “FOR” the approval of the issuance of the Primary Shares, “FOR” the issuance of the Warrant and the underlying Warrant Shares and “FOR” the proposal to allow the Board of Directors to adjourn the special meeting, if necessary, to solicit additional proxies in the event that there are not sufficient votes at the time of the special meeting to approve the proposals before the special meeting.

 

You may revoke your proxy at any time before the proxy is voted at the special meeting. A proxy may be revoked prior to the vote at the special meeting in any of three ways:

 

    by delivering a written revocation, dated after the date of the proxy that is being revoked, to the Secretary of PECO II at 1376 State Route 598, Galion, OH 44833;

 

    by delivering a later-dated proxy relating to the same shares to the Secretary of PECO II; or

 

    by attending the special meeting and voting in person by ballot.

 

Attendance at the special meeting will not, in itself, constitute revocation of a previously granted proxy. If you do not hold your shares of our common stock in your own name, you may revoke or change a previously given proxy by following the instructions provided by the bank, brokerage firm, nominee or other party that is the registered owner of the shares.

 

We will pay the costs of soliciting proxies for the special meeting. Our officers, directors and employees may solicit proxies by telephone, mail, the Internet or in person; however, they will not be paid any additional amounts for soliciting proxies. We will also request that individuals and entities holding shares in their names, or in the names of their nominees, that are beneficially owned by others, send proxy materials to and obtain proxies from those beneficial owners, and will reimburse those holders for their reasonable expenses in performing those services. We have retained Georgeson Shareholder Communications, Inc. to assist us in the solicitation of proxies, and will pay fees of up to $15,000, plus reimbursement of out-of-pocket expenses.

 

Interests of Certain Persons in Matters to be Acted Upon

 

Our directors and certain of our executive officers may have interests different from our shareholders resulting from them being parties to certain transactional documents.

 

The Voting Agreement

 

Each director (except for Mr. Heindel), Ms. Frankhouse and Mr. McIntosh are parties to the Voting Agreement. Our directors may benefit from the execution of the Voting Agreement with Delta, which states that Delta agrees to vote in favor of our Board of Directors’ designees to the management slate of nominees for election to our Board of Directors. In addition, under the terms of the Voting Agreement, Delta has agreed not to bring any proposal that would result in the removal from our Board of our Board’s designees without cause. Our directors and executive officers who are parties to the Voting Agreement have agreed to appoint a Delta designee to fill our existing Class II director vacancy as of the closing and to vote their shares of our capital stock in favor of Delta’s designee to our Board of Directors, and we will include such designee on our management slate of nominees for election to our Board of Directors. Therefore, it would be unlikely that our shareholders could elect any nominee for director outside of those designated by our Board of Directors to the management slate of nominees pursuant to the Voting Agreement because the parties to the Voting Agreement will also vote in favor of such nominees. Our directors (except for Mr. Heindel), Ms. Frankhouse and Mr. McIntosh, who are parties to the Voting Agreement, beneficially owned in the aggregate 6,750,358 shares, or 30.2% of our capital stock as of September 30, 2005.

 

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Table of Contents

The Support Agreement and Irrevocable Proxy

 

Two of our directors may have interests different from our shareholders and which may constitute a conflict of interest. Messrs. Smith and Green are parties to the Support Agreement, pursuant to which they have agreed with us and Delta, at our special meeting of shareholders, to vote the shares of our capital stock beneficially owned by them in favor of the proposal to amend our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, to vote in favor of the issuance of the Primary Shares to Delta, to vote in favor of the Warrant and the issuance of the Warrant Shares pursuant to Delta’s purchase rights thereunder, and to vote in favor of any other matter that could be reasonably expected to facilitate the consummation of the transactions contemplated by the Asset Purchase Agreement. Messrs. Smith and Green irrevocably appointed Delta, through its designees, as its proxy and sole attorney-in-fact to vote at the special shareholders meeting in favor of the above proposals. Mr. Smith beneficially owned 3,000,857 shares or 13.8% of our capital stock and Mr. Green beneficially owned 2,504,344 shares or 11.5% of our capital stock as of September 30, 2005.

 

Ohio Control Share Acquisition Act

 

In the absence of the approval by our shareholders of the proposed amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, the shares of our capital stock beneficially owned by James L. Green, our Chairman, would be deemed to be “interested shares” and would be ineligible for purposes of voting in favor of the proposals at the special meeting. In such an event, it may be more difficult for us to obtain the necessary vote to approve the proposals set forth in this proxy statement and meet all of the conditions to close the various transactions contemplated by the Asset Purchase Agreement.

 

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The Asset Purchase

 

Background of the Transactions Contemplated by the Asset Purchase Agreement

 

During late March 2005, Mr. Trygve Ivesdal, one of our Board members, and James L. Green, our current Chairman of the Board, were contacted by Mr. Lanford Liu, Director of Corporate Development, of Delta Electronics, Inc. (“DEI”), an affiliate of Delta, who expressed interest in a possible transaction with us. In April 2005, Mr. Green and other representatives of PECO II engaged in further discussions with Mr. Liu, Mr. Bruce Chen, Chairman, Mr. Albert Chang, General Manager of Telcom Power Systems, Mr. Austin Tseng, Telecom Product Sales Manager of DEI, and other representatives of DEI, concerning DEI’s interest in a possible transaction with us. On May 3, 2005, PECO II and DEI entered into a Mutual Non-Disclosure Agreement pursuant to which the parties agreed to keep discussions confidential.

 

On May 20, 2005, Mr. Liu and other representatives of DEI, including its legal advisor, met with Mr. Green, Ms. Sandra Frankhouse, our Chief Financial Officer, Mr. John G. Heindel, who at that time was serving as a consultant to PECO II, and our legal advisor in Columbus, Ohio. Elements of DEI’s proposal were discussed, including the proposal for PECO II to purchase the assets associated with Delta’s U.S. and Canadian service provider business in exchange for the issuance of common stock and the issuance of a warrant. PECO II requested additional information from Delta concerning the financial condition of the Delta Business Assets proposed to be sold to PECO II as well an evaluation by PECO II of the proposed consideration to be paid in exchange for the Delta Business Assets.

 

On July 8, 2005, DEI sent to us a draft preliminary term sheet, which provided the terms for the proposed transaction, along with a draft amendment to the Mutual Non-Disclosure Agreement. The terms of the proposed transaction included the execution of an asset purchase agreement, and various other transactional documents, including a voting agreement dealing with certain corporate governance matters, a support agreement pursuant to which certain significant shareholders would agree to vote in favor of the proposals, a supply agreement between DEI and us pursuant to which we would acquire certain exclusive rights to distribute DEI products in the United States and Canada, and a registration rights agreement to cover any resales by Delta of the Primary Shares and the Warrant Shares. The amendment to the Mutual Non-Disclosure Agreement, dealing with the non-disclosure of the proposed transaction, was executed by PECO II and Delta on July 11, 2005.

 

During the week of August 1, 2005, Mr. Heindel and our legal advisor met with Mr. Liu, other DEI representatives and DEI’s legal advisor in Palo Alto, California to discuss the proposed transaction and proposed transaction documents. During the remainder of August and continuing through September 2005, the parties negotiated the material terms and conditions of the Asset Purchase Agreement and the ancillary agreements thereto, including a voting agreement (the “Voting Agreement”), a support agreement and irrevocable proxy (the “Support Agreement”) and a supply agreement (the “Supply Agreement”).

 

The negotiations relating to the Voting Agreement and the Supply Agreement dealt primarily with Delta’s concern that we contractually evidence our support of the transaction to our shareholders. By virtue of entering into the Voting Agreement, Delta would acquire the right, as of the closing, to have its designee appointed by our Board of Directors to fill our current Class II director vacancy and to have its designee appointed by our Board of Directors as a board observer at our Board of Directors meetings in a non-voting capacity. In addition, the Voting Agreement provided that we would not remove Delta’s designee to our Board of Directors without cause. The Support Agreement is intended to provide Delta a greater assurance that the transactions contemplated by the Asset Purchase Agreement would be supported by our directors, except for Mr. Heindel, and two of our executive officers who are significant shareholders, and that they would agree to vote the shares of our capital stock beneficially owned by them in favor of the proposals to issue the Primary Shares, to issue the Warrant and the purchase rights thereunder to acquire the Warrant Shares and to adopt the amendment to our Code of Regulations to opt out of the Ohio Control Share Acquisition Act.

 

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The negotiations between Delta and us concerning the Supply Agreement were primarily designed to provide that, after the closing, we obtained the exclusive rights to purchase and incorporate DEI’s modules into our systems and to market, promote and sell the modules, our systems and/or DEI’s systems in the United States and Canada during the term of the Supply Agreement, including on an exclusive basis during the first 24 months of the agreement (the “Exclusivity Period”). In addition, we negotiated to obtain during the Exclusivity Period additional preferential rights, such as the right to obtain more favorable prices for a product if such prices were offered by DEI to another person in the United States or Canada, and to engage in joint exploration and discussions with respect to system-level design and component-design.

 

On September 30, 2005, our Board of Directors held a meeting to analyze and review, with the advice and assistance of our legal and financial advisors, among other things, certain strategic, financial and legal considerations concerning a possible transaction with Delta, the terms of the most recent drafts of the Asset Purchase Agreement and ancillary agreements, and the potential impact to our shareholders. At this meeting, GBQ Consulting, LLC (“GBQ”), our financial advisor, discussed the methods, factors, and analyses used in preparing its fairness opinion with respect to the fairness of the consideration to be received by our shareholders in connection with the proposed transaction. While no decision was reached at this meeting by our Board of Directors with respect to DEI’s proposal, it was the consensus of our Board of Directors that Mr. Heindel, other representatives of our management, and our legal advisor should continue to negotiate the material terms and conditions of the Asset Purchase Agreement and the ancillary agreements.

 

Messrs. Green and Heindel, other representatives of PECO II management, and our legal advisor continued to finalize the proposed Asset Purchase Agreement and related ancillary agreements from September 30, 2005 through October 13, 2005. At a special meeting of our Board of Directors on October 13, 2005, Mr. Heindel and our legal advisor reported that the parties had satisfactorily resolved all open issues with respect to the material terms and conditions of the Asset Purchase Agreement and ancillary agreements. GBQ then rendered its oral opinion (which was subsequently confirmed in writing) to the effect that, as of October 13, 2005, the consideration to be received by our shareholders pursuant to the Asset Purchase Agreement was fair to our shareholders from a financial point of view. Our Board of Directors unanimously approved the Asset Purchase Agreement and the ancillary agreements, authorized the execution and delivery of the Asset Purchase Agreement and the Voting Agreement, unanimously determined that the issuance of the Primary Shares, the issuance of the Warrant and the underlying Warrant Shares and the proposed amendment to the Amended and Restated Code of Regulations were fair to and in the best interest of PECO II and its shareholders, and unanimously resolved to recommend that our shareholders approve the issuance of the Primary Shares, the issuance of the Warrant and the underlying Warrant Shares and the proposed amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act.

 

Concurrently with the execution of the Asset Purchase Agreement, we also entered into the Voting Agreement with Delta and certain of our significant shareholders (who are the only shareholders whose consent we solicited), consisting of: each member of our Board of Directors (except for Mr. Heindel); certain affiliates of our Chairman of the Board, Mr. Green; certain affiliates of our Board member Mr. Smith; Ms. Frankhouse, our Chief Financial Officer, Treasurer and Secretary; and Mr. McIntosh, our Vice President of Power Systems, to be effective as of closing, whereby Delta and each such shareholder (collectively, the “Voting Agreement Shareholders”) have agreed to vote all of the shares of our common stock beneficially owned by such Voting Agreement Shareholder at any PECO II shareholder meeting or by any consensual action:

 

    in favor of electing, in the case of Delta, the individual designated by Delta to stand for election to serve on our Board of Directors; and

 

    in favor of electing, in the case of PECO II, the individuals nominated by our Board of Directors to stand for election to serve on our Board of Directors.

 

As of September 30, 2005, the Voting Agreement Shareholders beneficially owned 6,750,358 shares, or 30.2%, of our common stock.

 

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On October 13, 2005, we issued a press release announcing the execution of the Asset Purchase Agreement. On October 19, 2005, we filed with the Securities and Exchange Commission Form 8-K describing the material terms of the transactions contemplated by the Asset Purchase Agreement.

 

Recent Developments

 

During the week of November 21, 2005, Mr. Heindel met with Delta representatives to discuss various business and transitional matters associated with the Delta Business Assets. As a result of those meetings, we determined that several of the forecasting assumptions utilized by PECO II management in evaluating the value of the Delta Business Assets and relied upon by GBQ in connection with its determination of the fair range of consideration to be paid by PECO II in exchange for the value of the Delta Business Assets as set forth in its fairness opinion needed to be modified. Specifically, we determined that Delta’s updated 2006 business plan was adjusted to reflect projected revenue of $14 million, due in part to Delta’s delay in the implementation of a new product line and an anticipated decrease in the revenues to be generated under the Supply Agreement. In addition, since the announcement of the transaction, PECO II’s common stock price had substantially increased, impacting the value of the consideration to be paid to Delta for the Delta Business Assets through the issuance of the Primary Shares and the Warrant.

 

Additionally, in late November and December 2005, Mr. Heindel and PECO II management conferred with its legal counsel to discuss whether the transactions contemplated by the Asset Purchase Agreement remained in the best interest of PECO II and its shareholders considering the changes in the forecasting assumptions for the valuation of the Delta Business Assets and the recent increase in the trading range of PECO II’s common stock, which increases the value of the consideration being paid to Delta for the Delta Business Assets.

 

On October 13, 2005, when GBQ rendered its fairness opinion, the closing price of PECO II’s common stock on Nasdaq was $1.16 per share. Subsequent to October 13, 2005, PECO II’s stock price increased significantly. From October 14, 2005 through December 12, 2005, PECO II’s stock generally traded on Nasdaq at prices between $1.38 and $1.92 per share, on significantly higher volume.

 

In view of these recent developments, at a meeting on December 13, 2005, our Board of Directors conferred with our management and our independent legal counsel to determine whether the transactions contemplated by the Asset Purchase Agreement remained in the best interest of PECO II and its shareholders.

 

At its December 13, 2005 meeting, management confirmed the percentage of capital stock of PECO II to be owned by Delta through the issuance of Primary Shares (i.e., 4,740,375 shares of our common stock) and the Warrant to purchase such number of shares that, when aggregated with the Primary Shares, will represent 45% of our issued and outstanding shares of capital stock measured as of five business days before the exercise of the Warrant. Thus, as our stock price increases, the value of the Primary Shares and the Warrant also increases. As a result, the Board discussed whether the value of the Primary Shares and the Warrant currently exceeded the valuation range of the Delta Business Assets set by GBQ and whether the Board may still rely on such valuation range in light of the recent developments with respect to forecasting the value of the Delta Business Assets. In view of these developments and after consultation with its legal counsel regarding its fiduciary duties under Ohio law, our Board of Directors established a special committee to consult with GBQ to determine whether the valuation range in its fairness opinion had changed materially since GBQ had rendered its fairness opinion in October 2005 and, if so, whether the consideration to be received by our shareholders would be fair, from a financial point of view, at the time of our Board’s recommendation to our shareholders.

 

On January 17, 2006, GBQ advised the special committee that it had updated its fairness opinion to take into account the recent developments impacting the consideration to be received by our shareholders. GBQ expressed to the special committee its opinion that, even as a result of a modification to the valuation range set forth in its original opinion due to the impact of these recent developments, the consideration to be received by PECO II’s shareholders was fair to them, from a financial point of view. As a result, the special committee recommended

 

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that our Board review the updated fairness opinion and determine whether its recommendation to our shareholders should be affirmed, modified or withdrawn.

 

At its January 17, 2006 meeting, our Board reviewed GBQ’s updated fairness opinion. After carefully considering the information included in the fairness opinion, including the new valuation range resulting from the recent developments, and the advice of its independent legal counsel, and after extensive discussion, our Board of Directors concluded to unanimously recommend that our shareholders vote in favor of the proposals set forth in this proxy statement. See “Update of Fairness Opinion of our Financial Advisor” on page 48.

 

Our Reasons for the Transactions Contemplated by the Asset Purchase Agreement; Recommendation of Our Board of Directors

 

Our Board of Directors reviewed and discussed the various proposals with our management and its financial and legal advisor in determining that the transactions contemplated by the Asset Purchase Agreement are fair to, and in the best interests of, our Company and our shareholders. In reaching its conclusion to approve and adopt the Asset Purchase Agreement and to seek the approval of the shareholders of the proposals described in this proxy statement, our Board of Directors considered a number of factors, including the following positive factors that supported the Board’s decision to approve and adopt the Asset Purchase Agreement:

 

    that the transactions contemplated by the Asset Purchase Agreement will provide us with access to Delta’s low-cost manufacturing capabilities and business supply agreements, which is expected to reduce our cost of goods sold while expanding our customer base and allowing us to be more successful in the marketplace;

 

    that we will acquire access to new customers in addition to new markets with existing customers, enabling us to better compete in the marketplace;

 

    that the transactions contemplated by the Asset Purchase Agreement will enable us to streamline manufacturing toward standardized products, which is expected to lower our cost of goods sold and thereby increase our operating profit margin, making us more competitive in the marketplace;

 

    that the transactions contemplated by the Asset Purchase Agreement will improve our future product development capabilities;

 

    that we will partner with Delta, an affiliate of a large, publicly-traded company (on the Taiwan Stock Exchange), with more funding and access to public markets, which may add value to our Company because Delta will have the ability to fund new opportunities for our Company that may arise from time to time through the exercise of its Warrant;

 

    our Board of Directors’ belief that, based on its understanding of, and the presentations of our management regarding our business, operations, management, financial condition, earnings and prospects, by entering into the transactions contemplated by the Asset Purchase Agreement, we would improve our ability to compete in the telecommunications industry through increased operating margins, access to a larger customer base, and diversification of our product offering;

 

    our Board of Directors’ belief that, based on its knowledge of the current and prospective environment in which we operate, including national and local economic conditions, the competitive environment, and the likely effect of these factors on our potential growth, development, productivity, profitability and strategic options, our Company, on a stand-alone basis, may be viewed at a competitive disadvantage in the marketplace because many of our competitors have acquired and/or partnered with other complementary entities to diversify their product offerings and customer base and to increase their operating margins, and our Company would be better positioned as a result of the transactions contemplated by the Asset Purchase Agreement than as a stand-alone company;

 

   

our Board of Directors’ belief that that our Company would be able to diversify our product offering, increase our customer base and have low-cost manufacturing capabilities by entering into the Asset

 

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Purchase Agreement that otherwise would be more difficult to achieve on an organic basis in the current global telecommunications market;

 

    the review by our Board of Directors with its legal advisor of the structure of the acquisition and the financial and other terms of the Asset Purchase Agreement and ancillary agreements, which allows our Company to acquire the Delta Business Assets using our capital stock and not cash;

 

    the current and historical market prices of our common stock, and the current and historical market prices of our common stock relative to those of other industry participants and general market indices;

 

    the likelihood that the transactions contemplated by the Asset Purchase Agreement will be completed, including the likelihood that the shareholder approvals needed to complete the transactions will be obtained;

 

    management’s view that the transactions contemplated by the Asset Purchase Agreement and the relationships to be obtained by virtue of entering into the ancillary agreements will allow for enhanced products and opportunities for our clients and customers; and

 

    the presentation made to the special committee of our Board of Directors by GBQ, including the updated written opinion of GBQ that, as of January 17, 2006, based upon and subject to the matters stated in such opinion, the value of the consideration to be received by our shareholders in connection with the Asset Purchase Agreement was fair from a financial point of view. GBQ’s presentation involved various valuation analyses performed by GBQ that are described under “Opinions of Our Financial Advisor—Update of Opinion of Our Financial Advisor” and the full text of its updated written opinion, which sets forth the revised assumptions made and the new matters considered and limitations on the review undertaken in connection with the opinion, is attached as Appendix G.

 

Our Board of Directors also considered potential risks relating to the transactions contemplated by the Asset Purchase Agreement or the failure by us to consummate such transactions, including the following:

 

    the fact that the transactions contemplated by the Asset Purchase Agreement would dilute our current shareholders’ ownership of our common stock as a result of the issuance of the Primary Shares and any Warrant Shares exercised pursuant to the Warrant;

 

    our management’s belief that our business plan must change in order to combat sustained operating losses, and the failure to modify our manufacturing capabilities by not entering into the transactions contemplated by the Asset Purchase Agreement to meet changing customer demands and pricing may result in sustaining such operating losses;

 

    our opportunities to achieve success in the future without partnering with Delta may be limited as most of our competitors have already aligned themselves with complementary businesses to better position themselves to accelerate the development of their business initiatives and opportunities;

 

    the Supply Agreement restricts our use of Delta products to North America;

 

    the Supply Agreement restricts our ability to do business with certain potential customers without the consent of DEI;

 

    the possibility that the failure to consummate the transactions contemplated by the Asset Purchase Agreement will result in a missed opportunity for our stock price to increase;

 

    absent the consummation of the transactions contemplated by the Asset Purchase Agreement, a significant reduction in size or even liquidation is possible given historical losses and our current book value of $1.60 per share; and

 

    if we do not consummate the transactions contemplated by the Asset Purchase Agreement, our Company may not be able to partner in the future with a larger, diversified industry participant such as Delta, and also retain some autonomy while eliminating costs and adding volume.

 

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The discussion of the information and factors considered by our Board of Directors is not exhaustive, but includes all material factors considered by our Board. In view of the wide variety of factors considered by our Board in connection with its evaluation of the transactions contemplated by the Asset Purchase Agreement and the complexity of these matters, our Board of Directors did not consider it practical to, nor did it attempt to, quantify, rank or otherwise assign relative weights to the specific factors that it considered in reaching its decision. Our Board evaluated the factors described above, including asking questions of our management and our legal advisor, and reached the unanimous decision that the transactions contemplated by the Asset Purchase Agreement were in the best interests of our Company and our shareholders. In considering the factors described above, individual members of our Board of Directors may have given different weights to different factors. Our Board of Directors considered these factors as a whole, and overall considered them to be favorable to, and to support, its determination. It should be noted that this explanation of our Board’s reasoning and all other information presented in this section is forward-looking in nature and, therefore, should be read in light of the factors discussed under the heading “Forward Looking Statements.”

 

Our Board of Directors determined that the proposed amendment to the Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, the issuance of the Primary Shares, the issuance of the Warrant and the Warrant Shares, and the proposal to allow our Board of Directors to adjourn the special meeting to solicit additional proxies if there are not sufficient votes at the time of the special meeting to approve the proposals, are advisable, fair to and in the best interests of PECO II and its shareholders. Accordingly, our Board of Directors unanimously approved and adopted the Asset Purchase Agreement and unanimously recommends that you vote “FOR” the approval and adoption of amendment to the Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, the issuance of the Primary Shares, the issuance of the Warrant and the issuance of Warrant Shares, and the proposal to allow our Board of Directors to adjourn the special meeting to solicit additional proxies if there are not sufficient votes at the special meeting to approve the proposals.

 

Opinions of Our Financial Advisor

 

We engaged GBQ to render its opinion with respect to the fairness or inadequacy, from a financial point of view, to our shareholders, of the transactions contemplated by the Asset Purchase Agreement. On September 30, 2005, GBQ rendered its oral opinion to our board of directors that as of that date, and based upon and subject to certain matters stated in that opinion, from a financial point of view, the transactions contemplated by the Asset Purchase Agreement were fair to our shareholders. GBQ subsequently orally confirmed its opinion on October 13, 2005 and by subsequent oral confirmation on and delivery of its written opinion dated October 13, 2005 (the “October Opinion”). GBQ has consented to our use of its October Opinion in this proxy statement.

 

The full text of GBQ’s October Opinion is attached as Appendix F to this proxy statement. The October Opinion outlines the procedures followed, assumptions made, matters considered and qualifications and limitations on the review undertaken by GBQ in rendering its October Opinion. The description of the October Opinion set forth below is qualified in its entirety by reference to the October Opinion. We urge you to read the entire October Opinion carefully in connection with their consideration of the four proposals, as qualified by the update to the October Opinion as described in “Recent Development” beginning on page 40 and “Updated Opinion of Our Financial Advisor” beginning on page 48.

 

The October Opinion was provided for the information and assistance of our Board of Directors in connection with its consideration of the fairness of the transactions contemplated by the Asset Purchase Agreement. The October Opinion does not address any other aspect of the transaction and is not intended to be and does not constitute a recommendation to any shareholder of our Company as to how that shareholder should vote with respect to the proposed amendment to the Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, the issuance of the Primary Shares, the issuance of the Warrant or the Warrant Shares or the proposal to allow our Board of Directors to adjourn the special meeting to solicit additional proxies if there are not sufficient votes at the special meeting to approve the proposals. GBQ was not

 

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requested to opine as to, and the October Opinion does not address, our underlying business decision to proceed with or effect the transactions contemplated by the Asset Purchase Agreement, nor does the October Opinion address the relative merits of the transactions contemplated by the Asset Purchase Agreement compared to any other business strategies or alternatives that might be available to us.

 

In arriving at its opinion, GBQ reviewed and analyzed the following primary sources of information publicly available information concerning PECO II that GBQ believed to be relevant to its analysis, including:

 

    our Annual Reports on Form 10-K for the fiscal years ended December 31, 2000 through 2004 and our Quarterly Report on Form 10-Q for the quarter ended June 30, 2005;

 

    drafts of the Asset Purchase Agreement, the Warrant and the Supply Agreement;

 

    financial and operating information with respect to the business, operations and prospects of PECO II furnished to GBQ by us;

 

    a review of the historical market prices and trading volume of our publicly traded common stock, an analysis of our shareholder profile and the number of our shareholders, and a review of publicly available news articles and press releases relating to Delta and our Company;

 

    a comparison of the historical financial results and present financial condition of our Company with those of other companies that GBQ deemed relevant to PECO II and Delta; and

 

    various PECO II management-prepared documents, lists and schedules, such as customer lists, competitor lists, sales forecasts and margin estimates.

 

In addition, GBQ had discussions with our management concerning our business, operations, assets, liabilities, financial condition and prospects.

 

In arriving at its opinion, GBQ assumed and relied upon the accuracy and completeness of the financial and other information used by GBQ without assuming any responsibility for independent verification of that information. GBQ further relied upon the assurances of our management that they were not aware of any facts or circumstances that would make that information inaccurate or misleading. In arriving at its opinion, GBQ did not conduct a physical inspection of our properties and facilities and did not make or obtain any evaluations or appraisals of our assets or liabilities. The October Opinion necessarily was based upon market, economic and other conditions as they existed on, and could be evaluated as of, the date of the October Opinion.

 

In arriving at its opinion, GBQ also considered the issuance of the Primary Shares and Warrant Shares and the dilutive effect such shares would have on our shareholders. According to GBQ, our existing shareholders would hold a smaller percentage of the total issued and outstanding shares of our capital stock as a result of the issuance of the Primary Shares and Warrant Shares; however, the addition of the Delta Business Assets to be acquired under the Asset Purchase Agreement would increase our value as of the closing by an amount commensurate with the value of the consideration paid by us pursuant to the Asset Purchase Agreement, approximately $8.9 million, assuming all of the Primary Shares and Warrant Shares are issued. As GBQ indicated that the value of the consideration to be paid by PECO for the Delta Business Assets pursuant to the Asset Purchase Agreement was in the lower range of its concluded range of value for the Delta Business Assets, GBQ did not believe there would necessarily be a dilutive effect to the share price of our capital stock and, consequently, to our shareholders, solely as a result of the issuance of the Primary Shares and Warrant Shares.

 

At the September 30, 2005 meeting of our Board of Directors, GBQ made a presentation of certain financial analyses of the transactions contemplated by the Asset Purchase Agreement.

 

The following is a summary of the material valuation, financial and comparative analyses in the presentation that was delivered to our Board of Directors by GBQ on September 30, 2005.

 

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Valuation of the Delta Business Assets

 

In valuing the Delta Business Assets, GBQ used two valuation methods: the Discounted Cash Flow Method and the Guideline Public Company Method.

 

Discounted Cash Flow Method

 

The discounted cash flow method is based on the theory that the total value of a business is the present value of its projected future cash flows, plus the present value of the terminal value. GBQ analyzed Delta’s sales and operating profits under two operating scenarios for the Delta Business Assets to be acquired by us pursuant to the Asset Purchase Agreement:

 

    a “High” scenario assuming high growth in revenue, steady gross margins and operating expenses growing at the same rate as revenues; and

 

    a “Low” scenario assuming moderate growth in revenue, relatively constant operating margins, and operating expenses growing at the same rate as revenues.

 

Management provided GBQ with annual projections for the Delta Business Assets under both scenarios for the years ended December 31, 2006 through 2009. Both scenarios reflected Delta’s projected cash flows from PECO II’s standpoint assuming certain cost savings from the acquisition of the business. As a result, the indicated values from the Discounted Cash Flow Method were on a strategic basis.

 

Under the High scenario, revenue and operating income for the business was projected to total $26.9 million (a compound annual growth rate of 20.5% over 2004 revenue) and $4.3 million, respectively, by 2009. Gross margins were projected to remain constant at 23.3%. Operating expenses were projected to total $800,000 in 2005 and $1.2 million in 2006. Beyond 2006, operating expenses were forecasted to grow at the same rate as revenue.

 

Under the Low scenario, revenue and operating income for the business was projected to total $16.1 million (a compound annual growth rate of 9.2% over 2004 revenue) and $2.6 million, respectively, by 2009. Gross margins were projected to remain constant at 23.3%. Operating expenses were projected to total $800,000 in 2005 and grow at the same rate as revenue for every year thereafter.

 

The cash flows, as well as the terminal value, were discounted to the net present value utilizing a weighted average cost of capital and a terminal value capitalization rate. The weighted average cost of capital or required rate of return was derived by determining the appropriate required returns on equity and debt under an appropriate capital structure. Utilizing the capital asset pricing model (“CAPM”), the cost of equity was calculated to be 23.00%. Utilizing a long-term interest rate of 7.59% and a tax rate of 40%, the post-tax cost of debt was calculated to be 4.55%. GBQ used an industry based capital structure of 80% equity and 20% debt to determine the appropriate weighting between the cost of equity and the cost of debt. As a result, the weighted average cost of capital was calculated to be 19.0%. The terminal value was calculated by GBQ dividing the terminal cash flow by the discount rate less the Company’s long-term projected growth rate of 5%, providing a terminal capitalization rate of 14%.

 

Utilizing the financial projections of both scenarios and the required rate of return GBQ suggested to our Board of Directors that a fair value of the Delta Business Assets to be acquired by us pursuant to the Asset Purchase Agreement was $8.0 to $13.6 million.

 

Guideline Public Company Method

 

The Guideline Public Company method relies on the principle of substitution, whereby a prudent buyer would pay no more for a property that it would cost to acquire a substitute property with the same utility. In other words, this method estimates value through analysis of similar public companies. GBQ completed an extensive review of publicly available information and held discussions with our management to identify comparable public companies (i.e., companies with an underlying similarity of relevant investment characteristics, such as markets, products, growth, or other pertinent factors).

 

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Although no single public company was found to be directly comparable to the Delta Business Assets to be acquired from Delta in terms of size, products, and markets served, GBQ identified six publicly-traded companies operating primarily in the telecommunications electronic component industry for use in its analysis: Vicor Corporation, Wireless Facilities, Inc., Applied Innovation Inc., Artesyn Technologies, Inc., Power-One, Inc., and Ault, Inc. In applying the Guideline Public Company Method, GBQ reviewed and considered various pricing relationships among the guideline companies based on their historical (2004 and five-year weighted average) and projected (2005 and 2006) revenue and their total invested capital (market value of equity plus debt minus cash and equivalents, or “TIC”) as of September 21, 2005. An overview of these valuation multiples is provided in the table below:

 

     Low

    Median

    Mean

    High

 

% TIC / 5-Year Wtd. Avg. Revenue

   31.1 %   101.1 %   125.3 %   295.3 %

% TIC / 2004 Revenue

   34.7 %   105.9 %   126.4 %   294.9 %

% TIC / 2005 Revenue

   81.4 %   101.0 %   141.2 %   281.6 %

% TIC / 2006 Revenue

   71.1 %   89.2 %   123.4 %   244.0 %

 

To determine the appropriate multiples to apply to the Delta Business Assets to be acquired by us, GBQ considered any discernable risk and return characteristics relative to the guideline companies, including size, growth, cost structures, profitability, return on investment, liquidity and leverage. The specific multiple ranges selected by GBQ included:

 

    

Selected Multiple

Range


 

% TIC / 5-Year Wtd. Avg. Revenue

   60.0 %   to   90.0 %

% TIC / 2004 Revenue

   60.0 %   to   90.0 %

% TIC / 2005 Revenue

   50.0 %   to   80.0 %

% TIC / 2006 Revenue

   40.0 %   to   70.0 %

 

The multiples selected by GBQ in the table above were then multiplied by the TIC for each measurement period to provide a range of total invested capital. GBQ then averaged these numbers to arrive at a business enterprise value of the Delta Business Assets of $6,600,000 to $10,600,000.

 

In addition, the range of values from the Guideline Public Company Method did not incorporate the strategic synergies expected to be obtained by us as a result of consummating the transactions contemplated by the Asset Purchase Agreement. Accordingly, GBQ informed our Board of Directors that it was appropriate to consider applying an acquisition premium to the indicated range of values. GBQ reviewed Mergerstat Review which tracks publicly announced formal transfers of ownership of at least 10% of a company’s equity. According to these studies, the medium premium paid for controlling interests relative to non-controlling interests in publicly-traded companies ranged from 23.4% to 43.5% over the past 24 years, with a median premium of 31.8%. These studies indicated that smaller transactions generally featured larger acquisition premiums, although transactions under $25.0 million had a medium premium of 21.4% in 2004. GBQ applied an acquisition premium of 20% to the indicated values from the Guideline Public Company Method. Accordingly, applying the selected ranges and acquisition premium, GBQ suggested a fair value of $7.9 to $12.7 million for the Delta Business Assets to be acquired by us pursuant to the Asset Purchase Agreement.

 

GBQ Conclusion of Delta Business Valuation

 

According to GBQ, the results of the Discounted Cash Flow Method and the Guideline Public Company Method suggested a fair value of $7.9 million to $13.6 million for the Delta Business Assets to be acquired by us pursuant to the Asset Purchase Agreement.

 

Valuation of PECO II

 

Shares of our common stock are not covered by Wall Street analysts and therefore have little public following. As of September 21, 2005 (the date GBQ valued our shares for this presentation), our trading price of

 

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$1.27 per share corresponded with a market capitalization of $28.5 million. To assess the reasonableness of our current market capitalization, GBQ performed an independent valuation analysis of our common stock using valuation techniques including the Discounted Cash Flow Method, the Guideline Public Company Method, and the Net Asset Value Method.

 

In connection with the Discounted Cash Flow Method, GBQ noted that we had not achieved a profit from operations since 2000 and our cash flows had been erratic and unpredictable. In addition, our operating performance was closely tied to the capital expenditure forecasts of the telecommunications industry. Projections provided by our management included:

 

    consolidated pro forma monthly projections for fiscal 2006—Income Statement, Balance Sheet, and Cash Flow Statement;

 

    pro forma monthly projections for fiscal 2006 by reporting unit (product and service units)—Income Statement, Balance Sheet, and Cash Flow Statement;

 

    consolidated pro forma quarterly projections for fiscal 2006 and 2007—Income Statement, Balance Sheet, and Cash Flow Statement; and

 

    consolidated pro forma annual projections for fiscal 2008, 2009, 2010, and 2011—Income Statement, Balance Sheet, and Cash Flow Statement.

 

Management projected revenue increasing to $66.2 million by 2009, or a compound annual growth rate of 16.0% from 2004 revenue. Gross margins were projected to fluctuate between 23.1% and 26.0%. Operating expenses were projected to total $11.3 million in 2005 and grow at a modest rate for every year thereafter. Depreciation was forecasted to outpace capital additions in the near future.

 

Utilizing our management’s financial projections and a required rate of return of 19.0% (derived in the same fashion as in GBQ’s valuation of the Delta Business Assets), GBQ suggested a fair value of $0.98 per share for PECO II common stock.

 

In connection with the Guideline Public Company Method, GBQ completed an exhaustive review of publicly available information and held discussions with our management to identify comparable public companies. The six publicly-traded companies identified and the pricing multiples analyzed in valuing the Delta Business Assets in connection with the Guideline Public Company Method for the Delta Business Assets were used in GBQ’s analysis of us. The following table outlines the multiple ranges selected by GBQ in their valuation of PECO II:

 

     Selected Multiple
Range


 

% TIC / 2004 Revenue

   45.0 %   to    75.0 %

% TIC / 2005 Revenue

   45.0 %   to    75.0 %

% TIC / 2006 Revenue

   30.0 %   to    60.0 %

 

In applying the selected multiple ranges under the Guideline Public Company Method, GBQ suggested a fair value of $0.97 to $1.52 per share for our common stock.

 

In connection with the Net Asset Value Method, all of our business assets and liabilities were identified and restated to fair value either collectively or discretely. GBQ used the reported book value of our common stock as a proxy for net asset value and suggested a fair value of $1.60 per share for our common stock.

 

Based on the Discounted Cash Flow, Guideline Public Company and Net Asset Value Methods, GBQ determined that the current trading price of $1.27 per share for our common stock was in the range of fair value of $0.97 to $1.60 per share for our common stock.

 

Value of Consideration to be Paid by PECO II

 

Based on the number of Primary Shares to be issued to Delta and a current market value of $1.27 per share as of September 21, 2005 (the date GBQ valued our shares for this presentation), GBQ indicated that we would be issuing approximately $6.02 million of our common stock to Delta.

 

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In valuing the Warrant, GBQ utilized the Black-Scholes Option Pricing Model (“BSOPM”). The BSOPM is an arbitrage pricing model that was developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage. The BSOPM calculates the price of a traditional call option by analyzing the volatility and opportunity cost of investing in the underlying asset.

 

The following is a listing of the six variables used in the BSOPM and GBQ’s input for each variable:

 

    underlying asset price—$1.27 per share per current market price;

 

    strike price—$2.00;

 

    remaining time to maturity—2.5 years (30 months);

 

    risk-free rate of return—GBQ utilized a 3.96% risk free rate of return based on the yields of 2- and 3-year (consistent with the investment time horizon) Treasury bonds;

 

    dividend yield—0.0%; and

 

    annual stock volatility—GBQ analyzed the historical 1-, 2-, and 3-year annualized stock volatility of PECO II and the aforementioned six guideline public companies in arriving at an estimated volatility of 60.0%.

 

Following an adjustment for dilution that would occur when the Warrant is exercised and Warrant Shares are issued, the GBQ assumptions suggested a market value of $0.22 per share for each Warrant Share. Based on the initial consideration of Primary Shares and fully diluted shares outstanding of 39.26 million (post-exercise of the Warrant), we would be issuing the Warrant on approximately 12.93 million shares. As a result, GBQ suggested the total value of the Warrant issued to Delta to be estimated at $2.83 million.

 

Accordingly, GBQ suggested that the market value of the total consideration to be paid to Delta by us for the purchase of the Delta Business Assets pursuant to the Asset Purchase Agreement was estimated to be $8.9 million. This market value was in the lower range of the estimated value GBQ believed may be added to PECO II as a result of our purchase of the Delta Business Assets, being valued in a range of $7.9 million to $13.6 million. This wide range of estimated value of the Delta Business Assets was derived from the High scenario or aggressive forecast of future performance and Low scenario or conservative forecast of future performance provided to GBQ by our management.

 

The consideration to be offered to our shareholders by virtue of our Company entering into the Asset Purchase Agreement and consummating the transactions contemplated thereby were determined through arms’-length negotiations between Delta and us and were approved by our Board of Directors. GBQ did not recommend any specific price per share or other form of consideration to our Company or that any specific price per share or other form of consideration constituted the only appropriate consideration for the acquisition. The October Opinion was one of many factors taken into consideration by our Board of Directors in making its determination to approve the Asset Purchase Agreement. The analysis of GBQ summarized above should not be viewed as determinative of the opinion of our Board of Directors with respect to the value of our Company or whether our Board of Directors would have been willing to agree to a different price per share or other forms of consideration.

 

Our Board of Directors selected GBQ as its financial advisor because of GBQ’s reputation as a recognized financial advisory firm with substantial experience in transactions similar to the transactions contemplated by the Asset Purchase Agreement. As part of its financial advisory business, GBQ is continually engaged in the valuation of businesses and their securities in connection with acquisitions and valuations for corporate and other purposes.

 

Pursuant to an engagement letter between PECO II and GBQ, we agreed to pay a fee which was payable upon delivery of the October Fairness Opinion. We agreed to pay GBQ a fee of $50,000 plus reimbursement of its reasonable out of pocket expenses incurred in connection with the engagement. In addition, we agreed to indemnify GBQ and its related parties from and against certain liabilities, including liabilities under the federal securities laws.

 

Update of Fairness Opinion of Our Financial Adviser

 

In late November 2005, we determined that certain of the forecasting assumptions utilized by our management in evaluating the value of the Delta Business Assets and relied upon by GBQ in connection with its

 

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determination of the fair range of consideration to be paid by us in exchange for the value of the Delta Business Assets as set forth in GBQ’s October Opinion needed to be updated. Delta’s updated 2006 business plan was adjusted to reflect projected revenue of $14 million, due in part to Delta’s delay in the implementation of a new product line and an anticipated decrease in the revenues to be generated under the Supply Agreement. In addition, since the announcement of the transaction, PECO II’s common stock price had substantially increased, impacting the value of the consideration to be paid to Delta for the Delta Business Assets through the issuance of the Primary Shares and the Warrant. In late November and December 2005, our management conferred with our legal counsel to discuss whether the transactions contemplated by the Asset Purchase Agreement remained in the best interests of our Company and its shareholders considering the changes in the forecasting assumptions from the valuation of the Delta Business Assets and the recent increase in the trading range of PECO II’s common stock.

 

On October 13, 2005, when GBQ rendered its October Fairness Opinion, the closing price of PECO II’s common stock on Nasdaq was $1.16 per share. Subsequent to October 13, 2005, PECO II’s stock price increased significantly. From October 14, 2005 through December 12, 2005, PECO II’s stock generally traded on Nasdaq at prices between $1.38 and $1.83 per share, on significantly higher volume.

 

In view of these recent developments, at a meeting on December 13, 2005, our Board of Directors conferred with our management and our independent legal counsel to determine whether the transactions contemplated by the Asset Purchase Agreement remained in the best interests of PECO II and its shareholders. The Board discussed whether the value of the Primary Shares and the Warrant currently exceeded the valuation range of the Delta Business Assets set by GBQ in its October Opinion and whether the Board may still rely on such valuation range in light of the recent developments with respect to forecasting the value of the Delta Business Assets and the increase in PECO II’s common stock price. Our Board of Directors established a special committee to consult with GBQ to determine whether the valuation range in its October Opinion had changed materially since GBQ had rendered its fairness opinion in October 2005 and, if so, whether the consideration to be received by our shareholders would be fair, from a financial point of view, at the time of our Board’s recommendation to our shareholders.

 

On January 17, 2006, GBQ orally confirmed its oral opinion to our special committee and by delivery of an updated written fairness opinion (the “January Opinion”). On January 17, 2006, our Board subsequently reviewed the January Opinion. GBQ has consented to our use of its January Opinion in this proxy statement.

 

The full text of GBQ’s January Opinion is attached as Appendix G to this proxy statement. The updated opinion outlines the procedures followed, revised assumptions, if any, made, matters considered and qualifications and limitations on the review undertaken by GBQ in rendering its updated opinion. The description of the January Opinion set forth below is qualified in its entirety by reference to the January Opinion. We urge you to read the entire opinion carefully in connection with your consideration of the four proposals.

 

The January Opinion was provided for the information and assistance of our Board of Directors in connection with its consideration of the impact of developments between the date of the Asset Purchase Agreement and its recommendations set forth in this proxy statement to determine whether the transactions contemplated by the Asset Purchase Agreement are fair as of the date of this proxy statement. The January Opinion is an update of the October Opinion, taking into account revised assumptions that were not known as of the date of the October Opinion, developments subsequent to the October Opinion that could have a material affect on the valuation range set forth therein, and certain synergies specific to PECO II arising from the transaction that will benefit PECO II but were not quantified in the October Opinion. The January Opinion quantified these synergies because GBQ, in considering the impact of the developments since the October Opinion, believed it appropriate to value the synergies that PECO II is bringing to the transaction.

 

As with the October Opinion, the January Opinion does not address any other aspect of the transaction and is not intended to be and does not constitute a recommendation to any shareholder of our Company as to how that

shareholder should vote with respect to the proposed amendment to the Amended and Restated Code of

 

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Regulations to opt out of the Ohio Control Share Acquisition Act, the issuance of the Primary Shares, the issuance of the Warrant or the Warrant Shares or the proposal to allow our Board of Directors to adjourn the special meeting to solicit additional proxies if there are not sufficient votes at the special meeting to approve the proposals. GBQ was not requested to opine as to, and the January Opinion does not address, our underlying business decision to proceed with or effect the transactions contemplated by the Asset Purchase Agreement, nor does the January Opinion address the relative merits of the transactions contemplated by the Asset Purchase Agreement compared to any other business strategies or alternatives that might be available to us.

 

In updating the October Opinion, GBQ reviewed and analyzed the following primary sources of information concerning PECO II that GBQ believed to be relevant to its analysis, including:

 

    the elimination of the High operating scenario and Low operating scenario for the Delta Business Assets due to reliance on our updated forecast scenario of Delta’s projected revenues for the Delta Business Assets;

 

    improved gross margins on our manufactured products anticipated to be derived from Delta’s competitively superior customer supply agreements;

 

    our adjustment to the residual value of PECO II by virtue of our ability to utilize net operating loss carryforwards on a more accelerated time table if the transaction were to close; and

 

    our increase in cash, reduction of debt, reduction in non-operating assets and increase in interest income as the result of our sale of two real estate properties.

 

In addition, GBQ had discussions with our management concerning developments since the date of the October Opinion that have had an impact on our business, and the operations, assets, liabilities, financial condition and prospects of the Delta Business Assets to be acquired by us.

 

In arriving at the January Opinion, GBQ assumed and relied upon the accuracy and completeness of the financial and other information used by GBQ without assuming any responsibility for independent verification of that information. GBQ further relied upon the assurances of our management that they were not aware of any facts or circumstances that would make that information inaccurate or misleading. In arriving at its opinion, GBQ did not conduct a physical inspection of our properties and facilities and did not make or obtain any evaluations or appraisals of our assets or liabilities. GBQ’s opinion necessarily was based upon market, economic and other conditions as they existed on, and could be evaluated as of, the date of the January Opinion.

 

At the January 17, 2005 meeting of our special committee, and at the January 17, 2005 meeting of our Board of Directors, GBQ made a presentation of its updated financial analyses of the transactions contemplated by the Asset Purchase Agreement.

 

The following is a summary of the updated material valuation, financial and comparative analyses in the presentation that was delivered by GBQ to our special committee and considered by our Board of Directors in connection with the January Opinion.

 

Discounted Cash Flow Method

 

GBQ considered the projections of our management’s best estimate of the Delta Business Assets’ business prospects for the fiscal years ending December 2006 through December 2009, which were extended out one year based on an extrapolation of operating trends. GBQ analyzed the resulting indicated values from the Discounted Cash Flow Method in the January Opinion on a strategic basis, taking into account certain synergies specific to PECO II, including anticipated improvement in cash flows from savings related to Delta’s overhead costs, improved gross margins on PECO II manufactured products from competitively superior customer supply agreements, and more immediate use of PECO II’s net operating loss carryforward. Based on the forecasted profitability of PECO II, GBQ determined that the acquisition of the Delta Business Assets would allow PECO II to realize tax savings from the net operating loss carryforward on a more accelerated timetable.

 

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Management projected revenue and operating income for the business increasing to $19.6 million (a compound annual growth rate of 12.2% over 2005 estimated revenue) and $4.5 million, respectively, by 2009. Gross margins were projected to improve to 30.4% in 2006, 32.8% in 2007, 32.3% in 2008, 31.8% in 2009, and 32.0% in 2010, including a 15% reduction in material purchasing costs for PECO II. Operating expenses were projected to total $800,000 in 2005 and $1.2 million in 2006. Beyond 2006, operating expenses were forecasted to grow at a rate of 8.9% of revenue by 2010.

 

The cash flows, as well as the terminal value, were discounted to the net present value utilizing a weighted average cost of capital and a terminal value capitalization rate. The weighted average cost of capital or required rate of return was derived by determining the appropriate required returns on equity and debt under an appropriate capital structure. Utilizing the CAPM, the cost of equity was calculated to be 23.02%. Utilizing a long-term interest rate of 7.61% and a tax rate of 40%, the post-tax cost of debt was calculated to be 4.57%. GBQ used an industry based capital structure of 90% equity and 10% debt to determine the appropriate weighting between the cost of equity and the cost of debt. The applied capital structure shifted between the October Opinion and the January Opinion in favor of a higher equity weighting based on movement of the capital structures of the guideline public companies. As a result, the weighted average cost of capital was calculated to be 21.0%. The terminal value was calculated by GBQ dividing the terminal cash flow by the discount rate less the Company’s long-term project growth rate of 5%, providing a terminal capitalization rate of 16%.

 

In addition, based on the forecasted profitability of PECO II, the addition of the Delta Business Assets would allow PECO II to realize tax savings from its net operating loss carryforward at an accelerated pace. Utilizing the weighted average cost of capital of 21.0%, GBQ calculated the present value of the Delta Business Assets to PECO II’s net operating loss carryforward usage to be approximately $7.0 million.

 

Utilizing the revised financial projections, the required rate of return, and the present value of PECO II’s net operating loss carryforward, GBQ suggested to our Board of Directors that a revised fair value of the Delta Business Assets to be acquired by us pursuant to the Asset Purchase Agreement is $19.3 to $23.9 million.

 

Guideline Public Company Method

 

The Guideline Public Company Method was updated to January 11, 2006 for the January Opinion. GBQ reviewed and considered various pricing relationships among the guideline companies based on their historical (2004 and five-year weighted average) and projected (2005 and 2006) revenue and their total invested capital (market value of equity plus debt minus cash and equivalents or “TIC”) as of January 11, 2006. An overview of these valuation multiples is provided in the table below:

 

     Low

    Median

    Mean

    High

 

% TIC / 5-Year Wtd. Avg. Revenue

   28.2 %   131.0 %   146.4 %   355.6 %

% TIC / 2004 Revenue

   30.5 %   115.9 %   146.3 %   355.2 %

% TIC / 2005 Revenue

   91.2 %   145.4 %   180.0 %   338.2 %

% TIC / 2006 Revenue

   82.4 %   129.2 %   158.1 %   291.5 %

 

The specific multiple ranges selected by GBQ included:

 

    

Selected Multiple

Range


 

% TIC / 5-Year Wtd. Avg. Revenue

   60.0 %   to   90.0 %

% TIC / 2004 Revenue

   70.0 %   to   100.0 %

% TIC / 2005 Revenue

   65.0 %   to   95.0 %

% TIC / 2006 Revenue

   60.0 %   to   90.0 %

 

The multiples selected by GBQ in the table above were then multiplied by the TIC for each measurement period to provide a range of total invested capital. GBQ then averaged these numbers to arrive at a business enterprise value of the Delta Business Assets of $7,800,000 to $11,500,000.

 

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GBQ applied an acquisition premium of 20% to the indicated values of the Guideline Public Company Method to reflect anticipated synergies, including the approximately $7.0 million present value of the PECO II net operating loss carryforward. Based on this new analysis, GBQ’s application of the Guideline Public Company Method suggested a strategic equity value of $16.4 to $20.8 million for the Delta Business Assets.

 

GBQ Conclusion of Delta Business Valuation

 

According to GBQ, the results of the updated Discounted Cash Flow Method and the Guideline Public Company Method suggests a fair value of $16.4 million to $23.9 million for the Delta Business Assets to be acquired by us pursuant to the Asset Purchase Agreement.

 

Valuation of PECO II

 

In connection with the updated Discounted Cash Flow Method for the January Opinion, GBQ noted that PECO II’s operations have improved since our largest historical net loss in fiscal year 2002. GBQ also considered projections of management’s best estimate of our business prospects for the fiscal years ending December 2006 through December 2011. The specific set of projections provided by our management to GBQ included:

 

    consolidated pro forma monthly projections for fiscal 2006—Income Statement, Balance Sheet, and Cash Flow Statement;

 

    pro forma monthly projections for fiscal 2006 by reporting unit (product and service units)—Income Statement, Balance Sheet, and Cash Flow Statement;

 

    consolidated proforma quarterly projections for fiscal 2006 and 2007—Income Statement, Balance Sheet, and Cash Flow Statement; and

 

    consolidated pro forma annual projections for fiscal 2008, 2009, 2010, and 2011—Income Statement, Balance Sheet, and Cash Flow Statement.

 

Management projected revenue increasing to $62.4 million by 2009, or a compound annual growth rate of 12.0% from 2004 revenue. Gross margins were projected to improve to 25.2% by 2007. Operating expenses were projected to total $12.3 million in 2006 and grow at a modest rate for every year thereafter. Depreciation was forecasted to outpace capital additions in the near future.

 

The projections relied on by GBQ reflect PECO II’s prospects as well as GBQ’s analysis of the present value of PECO II’s net operating loss carryforward assuming the transactions contemplated by the Asset Purchase Agreement do not close. Utilizing these projections, a required rate of return of 21% (derived in the same fashion as in GBQ’s valuation of the Delta Business Assets), and adjusting for nonoperating assets, GBQ’s application of the Discounted Cash Flow Method suggests a fair value of $0.94 per share for PECO II’s common stock.

 

In connection with the Guideline Public Company Method, the following table outlines the multiple ranges selected by GBQ:

 

    

Selected Multiple

Range


 

% TIC / 2004 Revenue

   60 %   to    90 %

% TIC / 2005 Revenue

   50 %   to    80 %

% TIC / 2006 Revenue

   40 %   to    70 %

 

GBQ’s updated application of the Guideline Public Company Method suggested a fair value of $1.45 to $1.97 per share for PECO II’s common stock.

 

GBQ assumed certain upward and downward adjustments to reflect the fair values of PECO II’s assets and liabilities in connection with the updated Net Asset Value Method, suggesting a fair value of $1.49 per share for PECO II’s common stock.

 

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GBQ noted that our common stock price has increased approximately 58% since October 13, 2005, the date we announced the transaction. GBQ’s analysis suggests that a majority of the advancement of our market value relates to investors’ reactions to the transactions contemplated by the Asset Purchase Agreement as well as general increases in market values. GBQ noted that deducting the anticipated synergies from the transaction from our actively traded per share price of $1.83 is representative of the theoretical stock price of PECO II common stock and is within the central area of GBQ’s concluded value range for our per share value.

 

Value of Consideration to be Paid by PECO II

 

Based on the number of Primary Shares to be issued to Delta and a current market value of $1.83 per share as of January 11, 2006 (the date GBQ valued our shares for its January presentation), GBQ indicated that we would be issuing approximately $8.67 million of our common stock to Delta.

 

In valuing the Warrant, GBQ updated its Black-Sholes Option Pricing Model (“BSOPM”) to utilize a $1.83 per share per current market price for our common stock, a 4.39% risk free rate of return based on the yields of 2- and 3-year (consistent with the investment time horizon) Treasury bonds, and annual stock volatility of 55%.

 

As a result, GBQ suggested the total value of the Warrant issued to Delta to be estimated at $5.45 million.

 

Accordingly, GBQ suggested that the market value of the total consideration to be paid to Delta by us for the purchase of the Delta Business Assets pursuant to the Asset Purchase Agreement is estimated to be $14.1 million. This market value is lower than the range of the fair value of consideration PECO II will receive, being valued in a range of $16.4 million to $23.9 million.

 

Pursuant to a modification to our original engagement letter between PECO II and GBQ, we agreed to pay an additional fee of $40,000 plus reimbursement of its reasonable out of pocket expenses incurred in connection with the update to the October Fairness Opinion.

 

Governmental and Third Party Approvals

 

Delta has agreed to use its reasonable commercial efforts to obtain the necessary third party consents to the assignment of the business supply agreements to and the assumption by us of such contracts to complete the transactions contemplated by the Asset Purchase Agreement. The approval or consent of any governmental authority is not required to consummate the transactions contemplated by the Asset Purchase Agreement.

 

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The Asset Purchase Agreement

 

The following is a summary description of the material terms of the Asset Purchase Agreement, not summarized elsewhere herein. Certain capitalized terms used and not defined herein have the meanings ascribed to them in the Asset Purchase Agreement and the other referenced documents which constitute exhibits to the Asset Purchase Agreement. This summary does not purport to be complete and is qualified in its entirety by reference to the Asset Purchase Agreement, a copy of which is attached to this proxy statement as Appendix C and is incorporated herein by reference. Shareholders are advised to read such document in its entirety prior to voting in person or by proxy on the proposals.

 

The Transaction

 

Under the terms of the Asset Purchase Agreement and subject to the satisfaction of the conditions set forth therein, on the closing date, we will purchase from Delta the assets used in Delta’s U.S. and Canadian service provider business. The Delta Business Assets consist of the rights to and under the Business Contracts, the Inventory owned by Delta as of the closing date related to the Business Contracts, rights to and under the Business Records and all rights, claims, and causes of action against third parties exclusively relating to the Delta Business Assets. In addition, we will assume on the closing date the Assumed Liabilities relating to the Delta Business Assets.

 

Consideration

 

Under the terms of the Asset Purchase Agreement and subject to the satisfaction of the conditions set forth therein, on the closing date, in exchange for the Delta Business Assets we will issue to Delta the Primary Shares. In addition, we will issue to Delta a Warrant to purchase that number of Warrant Shares that, after taking into account the Primary Shares, will represent 45% of our issued and outstanding capital stock measured as of the date that is five business days of the exercise date of the Warrant. The exercise price of the Warrant is $2.00 per share, and the Warrant is exercisable immediately as of the closing date and for a period of 30 months following thereafter.

 

The Closing

 

Subject to the satisfaction or waiver of all conditions to closing set forth in the Asset Purchase Agreement, the closing will occur on a Friday as soon as reasonably practicable following the satisfaction or waiver of all such conditions.

 

Representations and Warranties

 

In the Asset Purchase Agreement, both Delta and we have made representations and warranties, customary for a transaction such as this asset purchase by our Company, with respect to, among other things:

 

    organization and qualification;

 

    authority to execute and deliver the Asset Purchase Agreement;

 

    enforceability and binding effect of the Asset Purchase Agreement;

 

    absence of any breach or conflict with material agreements, governmental authorizations or charter documents;

 

    required consents, approvals and filings;

 

    absence of undisclosed liabilities; and

 

    compliance with applicable laws.

 

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In the Asset Purchase Agreement, we have also made representations and warranties, customary for a transaction such as this asset purchase where the consideration consists of the issuance of the buyer’s securities, with respect to, among other things:

 

    our capitalization;

 

    our financial statements;

 

    environmental matters;

 

    employees and employee benefit plans;

 

    intellectual property;

 

    absence of certain changes or events, including any changes or events having a Material Adverse Effect on Buyer (as defined below); and

 

    receipt of a fairness opinion.

 

As used in the Asset Purchase Agreement, “Material Adverse Effect on Buyer” means any change, effect or circumstance (such item, an “Effect”) that, when taken individually or together with all other Effects, is, or would reasonably be expected to be, materially adverse to the condition (financial or otherwise), properties, assets, liabilities, business or operations of PECO II and its subsidiaries, taken as a whole; provided, however, that in no event shall any of the following be taken into account in determining whether there has been or will be a Material Adverse Effect on Buyer:

 

    any Effect that is the result of general market or political factors or economic factors affecting the economy as a whole;

 

    any Effect that is the result of factors generally affecting the industry or specific markets in which PECO II competes;

 

    any Effect that is the result of an outbreak or escalation of hostilities involving the U.S., the declaration by the U.S. of a national emergency or war, or the occurrence of any acts of terrorism;

 

    any Effect arising out of or resulting from the actions expressly contemplated by the Parties in connection with the Asset Purchase Agreement; or

 

    any Effect resulting from the loss, diminution or disruption of our existing or prospective customer, distributor or supplier relationships that we successfully bear the burden of proving directly results from or is directly attributable to the public announcement of the transactions contemplated by the Asset Purchase Agreement.

 

In the Asset Purchase Agreement, Delta has also made representations and warranties, customary for a transaction such as this asset purchase where the consideration consists of the issuance of the buyer’s securities, with respect to, among other things:

 

    the quantity and quality of the Inventory;

 

    title to the Delta Business Assets;

 

    no infringement of intellectual property of a third party;

 

    employee matters;

 

    absence of certain changes or events, including any changes or events having a Material Adverse Effect on the Business (as defined below);

 

    validity and effect of the Business Contracts; and

 

    investment matters.

 

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As used in the Asset Purchase Agreement, “Material Adverse Effect on the Business” means any Effect that, when taken individually or together with all other Effects, is, or would reasonably be expected to be, materially adverse to the Delta Business Assets, taken as a whole; provided, however, that in no event shall any of the following be taken into account in determining whether there has been or will be a Material Adverse Effect on the Business:

 

    any Effect that is the result of general market or political factors or economic factors affecting the economy as a whole;

 

    any Effect that is the result of factors generally affecting the industry or specific markets in which the Business competes;

 

    any Effect that is the result of an outbreak or escalation of hostilities involving the United States, the declaration by the United States of a national emergency or war, or the occurrence of any acts of terrorism;

 

    any Effect arising out of or resulting from the actions expressly contemplated by the Parties in connection with the Asset Purchase Agreement; or

 

    any Effect resulting from the loss, diminution or disruption of Delta’s existing or prospective customer, distributor or supplier relationships relating to the Business that Delta successfully bears the burden of proving directly results from or is directly attributable to the public announcement of the transactions contemplated by the Asset Purchase Agreement.

 

Conduct of Business Pending the Closing

 

In the Asset Purchase Agreement, we have covenanted and agreed that, at all times up to and including the closing date, unless Delta otherwise consents in writing, which consent shall not be unreasonably withheld, delayed or conditioned, or as otherwise required or contemplated by the Asset Purchase Agreement, we shall, and shall cause each of our subsidiaries to:

 

    conduct our business only in the ordinary course of business, consistent with past practice;

 

    use commercially reasonable efforts to preserve intact our business, organization and relationship with third parties; and

 

    comply with various restrictions on the ability of us and our subsidiaries to take various actions prior to the closing.

 

In the Asset Purchase Agreement, Delta has covenanted and agreed that, at all times up to and including the closing date, unless we otherwise consent in writing, which consent shall not be unreasonably withheld, delayed or conditioned, or as otherwise required or contemplated by the Asset Purchase Agreement, Delta shall:

 

    use commercially reasonable efforts to preserve the Delta Business Assets and its relationships with third parties with respect thereto; and

 

    comply with various restrictions on the ability of Delta to take various actions prior to the closing.

 

Our Restrictions

 

The restrictions we agreed to with respect to our and our subsidiaries’ ability to take various actions (without the prior written consent of Delta, which consent is not to be unreasonably withheld, delayed or conditioned) prior to the closing include, among other things:

 

    except with respect to amending the Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, amend our charter documents in a manner that would reasonably be likely to adversely affect our capital stock;

 

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    pay an extraordinary dividend or distribution;

 

    purchase, redeem, or otherwise acquire any shares of our capital stock;

 

    knowingly take any action that would result in a failure to maintain trading of our common stock on Nasdaq;

 

    fail to make in a timely manner any filings with the Securities and Exchange Commission required under applicable law; or

 

    consummate any significant acquisition.

 

In addition, we agreed to first consult with Delta with respect to:

 

    entering into an agreement relating to a material joint venture, strategic partnership or alliance;

 

    entering, modifying or amending in a manner adverse in any material respect to us any material contract;

 

    grant any exclusive rights with respect to any of our material intellectual property; or

 

    incur any material indebtedness for borrowed money or guarantee the indebtedness of another person.

 

Delta Restrictions

 

The restrictions Delta agreed to with respect to its ability to take various actions (without the prior written consent of PECO II, which consent is not to be unreasonably withheld, delayed or conditioned) prior to the closing include, among other things:

 

    sell, lease, license, encumber or dispose of the Delta Business Assets except in the ordinary course of business;

 

    incur or assume any material liabilities or obligations with respect to the Delta Business Assets other than in the ordinary course of business;

 

    terminate (except pursuant to its terms), or materially modify or amend any Business Contract; or

 

    revalue any of the Delta Business Assets.

 

No Solicitation

 

The Asset Purchase Agreement provides that we will not, and will not permit or cause any of our subsidiaries or any of our officers or directors or those of our subsidiaries to, and shall direct our and our subsidiaries’ representatives not to, directly or indirectly:

 

    solicit, initiate, encourage or knowingly facilitate the making, submission or announcement of, any Acquisition Proposal (as defined below) with respect to our Company;

 

    participate or engage in any discussions or negotiations regarding, or furnish to any person any nonpublic information with respect to, or take any other action intended to facilitate any inquiries or the making of any proposal that constitutes or may reasonably be expected to lead to, any Acquisition Proposal with respect to our Company;

 

    approve, endorse or recommend any Acquisition Proposal with respect to our Company (except to the extent specifically permitted under the Asset Purchase Agreement); or

 

    enter into any letter of intent or similar document or any contract or commitment contemplating or otherwise relating to any Acquisition Proposal with respect to our Company;

 

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provided, however, that in the event that, prior to the approval of the proposals listed in this proxy statement, we received an unsolicited, bona fide Acquisition Proposal that our Board of Directors has in good faith concluded is reasonably likely to result in a Superior Offer (as defined below) and we have otherwise complied with our non-solicitation obligations discussed above, nothing contained in the Asset Purchase Agreement prevents us from:

 

    providing information in response to a request therefor by a person who has made such an unsolicited bona fide written Acquisition Proposal, provided that such person is a party to a confidentiality agreement with us, and we give Delta notice of such event and furnish Delta with the same information;

 

    engaging in any negotiations or discussions with any person who has made such an unsolicited bona fide written Acquisition Proposal, provided we give Delta notice of our intention to enter into such negotiations; or

 

    approving or recommending such an unsolicited bona fide Acquisition Proposal to our shareholders, if and only to the extent that we terminate the Asset Purchase Agreement in a manner whereby we:

 

    notify Delta three business days prior to terminating the Asset Purchase Agreement that we have received a Superior Offer, attaching the then current version of the Superior Offer,

 

    afford Delta a reasonable opportunity to make a revised offer, and

 

    pay Delta a termination fee of $500,000.

 

For purposes of the Asset Purchase Agreement, “Acquisition Proposal” means any offer or proposal or public announcement of a proposal or plan, relating to any transaction or series of related transactions involving:

 

    any purchase from our Company or acquisition by any person or “group” (as defined under Section 13(d) of the Exchange Act and the rules and regulations thereunder) of more than a 15% interest in our total outstanding voting securities or any of our subsidiaries, directly or indirectly, or any tender offer or exchange offer that if consummated would result in any person or group beneficially owning 15% or more of our total outstanding voting securities or any of our subsidiaries, directly or indirectly, or any merger, consolidation, business combination or similar transaction involving us or any of our subsidiaries; or

 

    any sale, lease (other than in the ordinary course of business), exchange, transfer, license (other than in the ordinary course of business), acquisition or disposition of more than 15% of our assets (including our subsidiaries taken as a whole).

 

For purposes of the Asset Purchase Agreement, “Superior Offer” means an unsolicited, bona fide written offer made by a third party to acquire, directly or indirectly, pursuant to a tender offer, exchange offer, merger, consolidation or other business combination, all or substantially all of our assets or a majority of the total outstanding voting securities of our Company and as a result of which our shareholders immediately preceding such transaction would hold less than 50% of the equity interests in the surviving or resulting entity of such transaction or any direct or indirect parent or subsidiary thereof, on terms that our Board of Directors has in good faith concluded:

 

    to be more favorable to our shareholders (in their capacities as shareholders) than the terms provided pursuant to the Asset Purchase Agreement;

 

    the conditions to the consummation of which are reasonably capable of being satisfied; and

 

    financing for which, to the extent such offer is conditioned thereon, is then committed or in the good faith judgment of our Board of Directors reasonably available.

 

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Conditions to the Closing

 

The Asset Purchase Agreement provides that the respective obligations of Delta and our Company to effect the transactions contemplated by the Asset Purchase Agreement are subject to the satisfaction or waiver on or prior to the closing date of each of the following conditions:

 

    the approval of the amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act by the affirmative vote of a majority of the outstanding shares of our common stock;

 

    approval of the issuance to Delta of the Primary Shares at the closing by the affirmative vote of a majority of the votes cast by our shareholders voting, in person or by proxy, at the special meeting;

 

    approval of the issuance of the Warrant and the issuance of the Warrant Shares thereunder by the affirmative vote of a majority of the votes cast by our shareholders voting, in person or by proxy, at the special meeting;

 

    the Primary Shares and Warrant Shares shall have been authorized for listing on Nasdaq, subject to official notice of issuance;

 

    all applicable waiting periods (and any extensions thereof) under any applicable antitrust laws shall have expired or otherwise been terminated and all approvals required under applicable antitrust laws shall have been obtained; and

 

    no governmental entity shall have enacted, issued, promulgated, enforced or entered any law, rule, regulation, judgment, decree, executive order or award which is then in effect and has the effect of making the transactions contemplated by the Asset Purchase Agreement illegal or otherwise prohibiting consummation of the transactions contemplated by the Asset Purchase Agreement.

 

Our obligations to effect the transactions contemplated by the Asset Purchase Agreement are subject to the satisfaction or waiver on or prior to the closing date of the following additional conditions:

 

    the representations and warranties of Delta contained in the Asset Purchase Agreement being true and correct at and as of the closing date as if made at and as of such date, except where the failure to be true and correct would not have a Material Adverse Effect on the Business; and

 

    the performance by Delta, in all material respects, of its obligations contained in the Asset Purchase Agreement.

 

The obligations of Delta to effect the transactions contemplated by the Asset Purchase Agreement are subject to the satisfaction or waiver on or prior to the closing date of the following additional conditions:

 

    the representations and warranties of our Company contained in the Asset Purchase Agreement being true and correct at and as of the closing date as if made at and as of such date, except where the failure to be true and correct would not have a Material Adverse Effect on Buyer;

 

    the representations and warranties of our Company with respect to our capitalization shall be true and correct in all material respects;

 

    the performance by us, in all material respects, of our obligations contained in the Asset Purchase Agreement;

 

    no Material Adverse Effect on Buyer shall have occurred since the date of the Asset Purchase Agreement and be continuing as of the closing date; and

 

    Delta’s designee to our Board of Directors shall have been appointed by us to serve as a Class II director on our Board of Directors, and the Voting Agreement relating to such appointment shall be in full force and effect on the closing date.

 

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Termination

 

The Asset Purchase Agreement provides that it may be terminated and the transactions contemplated thereby abandoned at any time prior to the closing:

 

    by mutual consent;

 

    by either Delta or us, if the other party materially breaches any representation, warranty or covenant contained in the Asset Purchase Agreement, which breach would cause a material adverse effect, subject to a right to cure;

 

    by either Delta or us, if the closing shall not have occurred on or before March 31, 2006;

 

    by either Delta or us, if a governmental entity has issued an order, decree or ruling or taken any other action (including the failure to have taken an action), in any case having the effect of permanently restraining, enjoining or otherwise prohibiting the transactions contemplated by the Asset Purchase Agreement, which order, decree, ruling or other action is final and nonappealable;

 

    by Delta, if (at any time prior to approval of the various matters subject to the required vote of our shareholders at the special meeting) a Triggering Event (as defined below) with respect to our Company shall have occurred;

 

    by us if we receive a Superior Offer and we afford Delta a reasonable opportunity to make a revised offer, along with payment of a $500,000 termination fee;

 

    by either Delta or us, if the

 

    amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act,

 

    the issuance of the Primary Shares, and

 

    the issuance of the Warrant and the underlying Warrant Shares thereunder to Delta are not approved by our shareholders by reason of the failure to obtain the required vote at the special meeting; and

 

    by us if Delta’s financial statements required to be delivered prior to the closing reflect information that was not previously made available to us and would cause a Material Adverse Effect on the Business.

 

For the purposes of the Asset Purchase Agreement, a “Triggering Event” means if:

 

    our Board of Directors or any committee thereof shall for any reason have withdrawn or shall have amended or modified in a manner adverse to Delta, its unanimous recommendation to our shareholders to vote in favor of the proposals set forth herein;

 

    we failed to include such unanimous recommendation in this proxy statement;

 

    our Board of Directors or any committee thereof shall have approved or recommended any Acquisition Proposal; or

 

    a tender or exchange offer relating to our securities shall have been commenced by a person unaffiliated with us and our Board of Directors did not timely send to our shareholders a statement disclosing that our Board of Directors recommends rejection of such tender or exchange offer.

 

Expenses and Termination Fee

 

If the transactions contemplated hereby are not consummated, except as set forth below, all fees and expenses incurred in connection with this Agreement and the transactions contemplated hereby shall be paid by the party incurring such expenses.

 

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If the transactions contemplated by the Asset Purchase Agreement are consummated, we will pay:

 

    up to $100,000 of the fees and expenses incurred by Delta (including attorneys’ fees and accountant fees) in connection with its negotiation, execution and delivery of the Asset Purchase Agreement, plus

 

    one-half of the fees and expenses incurred by Delta (including fees incurred by Delta’s auditor) in connection with the preparation and delivery of financial statements to be delivered to us prior to the closing.

 

In the event that the Asset Purchase Agreement is terminated by us, due to our receiving a Superior Offer, or by Delta, if a Triggering Event occurs, we will pay Delta a termination fee equal to $500,000.

 

Dilution to Our Shareholders; Ownership of PECO II after the Acquisition

 

If the transactions contemplated by the Asset Purchase Agreement are consummated, you will incur immediate and substantial dilution. Currently, 21,954,741 shares of our common stock are issued and outstanding. We will issue the Primary Shares to Delta, representing 4,740,375 shares of common stock without par value, at the closing pursuant to the Asset Purchase Agreement. Pursuant to the Warrant to be issued to Delta at the closing, Delta will have the right to purchase Warrant Shares, at an exercise price of $2.00 per share and exercisable immediately upon issuance and for a period of 30 months after the closing, that will allow Delta to purchase that number of additional shares of our common stock without par value that, when aggregated with the Primary Shares, will represent 45% of our issued and outstanding capital stock measured as of five business days prior to the exercise date of the Warrant. By way of example, assuming we had 26,335,418 shares of common stock issued and outstanding after the issuance of the Primary Shares, the number of Warrant Shares eligible for purchase by Delta would be 12,928,297. As a result, we would have 39,263,715 issued and outstanding shares of common stock, resulting in Delta owning 45% of our issued and outstanding capital stock.

 

Amendment

 

Subject to applicable law, the Asset Purchase Agreement may be amended by Delta and us at any time before or after approval of the various proposals by our shareholders at the special meeting; provided, after any such approval by our shareholders, no amendment shall be made which by law or in accordance with the rules of any relevant stock exchange requires further approval by our shareholders, without such further shareholder approval.

 

The Voting Agreement

 

Concurrently with the execution of the Asset Purchase Agreement, we also entered into the Voting Agreement with Delta and certain of our significant shareholders to be effective as of closing, whereby Delta and each such shareholder (collectively, the “Voting Agreement Shareholders”) have agreed to vote all of the shares of our common stock beneficially owned by such Voting Agreement Shareholder at any PECO II shareholder meeting or by any consensual action:

 

    in favor of electing, in the case of Delta, the individual designated by Delta to stand for election to serve on our Board of Directors; and

 

    in favor of electing, in the case of PECO II, the individuals nominated by our Board of Directors to stand for election to serve on our Board of Directors.

 

In addition, the Voting Agreement provides that during the term of the agreement, Delta shall have the right to designate a representative to serve as a board observer and attend all meetings of our Board of Directors, subject to the right of our Board of Directors to exclude the board observer from any meeting under certain circumstances.

 

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The Voting Agreement terminates upon the earlier of:

 

    the written agreement of Delta and us;

 

    the date Delta, or any of its affiliates (other than PECO II), no longer holds shares of our common stock or rights to purchase such shares, representing at least 5% of our outstanding voting stock;

 

    the date Delta (alone, or together with any of its affiliates (other than PECO II)) holds 45% or greater of our then issued and outstanding voting capital stock; and

 

    the consummation of:

 

    any tender offer, exchange offer, merger, consolidation or other business combination of PECO II the result of which is that PECO II shareholders (other than Delta and its affiliates in the case of a tender offer) immediately preceding such transaction hold less than 50% of the equity interests in the surviving or resulting entity of such transaction (or any direct or indirect parent or subsidiary thereof), or

 

    the sale of all or substantially all of our assets.

 

There is no shared voting power pursuant to the terms of the Voting Agreement.

 

Because Delta will not receive any shares of our capital stock until the closing of the transactions and currently has no pecuniary interest in any of our shares, the term of the Voting Agreement begins on the closing date when the Primary Shares will be issued to Delta pursuant to the Asset Purchase Agreement. The significant shareholders who are Voting Agreement Shareholders are:

 

    directors Matthew P. Smith, James L. Green, E. Richard Hottenroth, Trygve A. Ivesdal, Eugene V. Smith, George J. Dallas, Mark R. McBride, R. Louis Schneeberger, and Thomas R. Thomsen;

 

    certain affiliates of Messrs. Smith (Linda H. Smith, Ashwood I, LLC, and Ashwood II, LLC) and Green (Green Family Trust 03/16/1995, Green Family Trust 03/16/1995, Jim Green & Mary Green TR UA 05/09/01 Green Charitable Trust, and Jim Green & Mary Green TR UA 05/09/01 Green Charitable Trust); and

 

    Ms. Sandra Frankhouse, our Chief Financial Officer, Treasurer and Secretary, and Mr. Miles McIntosh, our Vice President of Power Systems.

 

Collectively, the Voting Agreement Shareholders beneficially own 6,750,358 shares, or 30.2%, of our capital stock as of September 30, 2005.

 

A copy of the Voting Agreement is attached hereto as Appendix D and is incorporated herein by reference.

 

Certain conflicts of interest between our shareholders and our directors, executive officers and Delta may exist as a result of the Voting Agreement. Delta receives the right, as a result of the issuance of the Primary Shares and the purchase rights under the Warrant, to have its designee appointed by our Board of Directors on the closing date to fill our existing Class II director vacancy and to have its designee named for election to our Board of Directors as part of our management slate and to be included in all of our proxy materials relating to the election of our directors during the term of the Voting Agreement. As a result of the Voting Agreement Shareholders agreeing to vote all of the shares of our capital stock beneficially owned by them as necessary to elect and maintain in office Delta’s designee to our Board of Directors, it is unlikely that the Delta designee will fail to serve as a member of our Board of Directors during the term of the Voting Agreement. Similarly, because Delta has agreed to vote all of the shares of our capital stock beneficially owned by it, which may, as a result of the issuance of the Primary Shares at the closing and the exercise thereafter of its purchase rights under the Warrant to acquire the Warrant Shares, result in Delta beneficially owning up to 45% of our issued and outstanding shares of capital stock, it is unlikely that the designees to our Board chosen by our Board of Directors and named for election as part of our management slate will fail to serve as members of our Board of Directors during the term of the Voting Agreement.

 

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The Supply Agreement

 

As a condition to the consummation of the transactions contemplated by the Asset Purchase Agreement, at the closing, we will enter into a supply agreement (the “Supply Agreement”) with DEI (an affiliate of Delta), pursuant to which DEI will grant to us the right to purchase and incorporate DEI modules into our systems and to market, promote, sell and distribute DEI modules, PECO systems and/or DEI systems to our customers in the U.S. and Canadian markets. The rights described above shall be exclusive to us for a period of 24 months from the closing of the transactions contemplated by the Asset Purchase Agreement. The term of the Supply Agreement is 30 months. The Supply Agreement also provides that DEI and our Company expect to engage in joint exploration and discussions with respect to system-level design and component-level design.

 

In connection with approving the transactions contemplated by the Asset Purchase Agreement, our Board of Directors considered the benefits of entering into the Supply Agreement. Our Board of Directors considered that the Supply Agreement will provide us with access to DEI’s manufacturing capabilities, which is expected to reduce our costs of goods sold, and we will gain access to new customers in addition to new markets with existing customers.

 

A copy of the form of Supply Agreement may be found as Exhibit A to the Asset Purchase Agreement, which is attached hereto as Appendix B.

 

The Support Agreement and Irrevocable Proxy

 

Simultaneous with the execution of the Asset Purchase Agreement, Messrs. Matthew P. Smith and James L. Green, and their respective affiliates (Linda H. Smith, Ashwood I, LLC, and Ashwood II, LLC, in the case of Mr. Smith, and Green Family Trust 03/16/1995, Green Family Trust 03/16/1995, Jim Green & Mary Green TR UA 05/09/01 Green Charitable Trust, and Jim Green & Mary Green TR UA 05/09/01 Green Charitable Trust, in the case of Mr. Green) executed a support agreement and irrevocable proxy (the “Support Agreement”), under which each such person agreed, severally and not jointly, to vote all of the shares of our common stock beneficially owned by such persons at any PECO II shareholders meeting or by any consensual action:

 

    in favor of the proposal to opt out of the Ohio Control Share Acquisition Act;

 

    in favor of the issuance of the Primary Shares and the Warrant;

 

    in favor of the other transactions contemplated by the Asset Purchase Agreement and in favor of any other matter that could reasonably be expected to facilitate consummation of the transactions contemplated by the Assert Purchase Agreement;

 

    against any change in a majority of the members of our Board of Directors; and

 

    against any other action that would impede, interfere with, delay, postpone or materially adversely affect the closing of the transactions contemplated by the Asset Purchase Agreement.

 

Messrs. Smith and Green, and their respective affiliates, also granted an irrevocable proxy to two of Delta’s designees to vote all of the shares of our common stock beneficially owned by such persons in accordance with the five bullet points above.

 

A copy of the Support Agreement and Irrevocable Proxy is attached hereto as Appendix E and is incorporated herein by reference.

 

The Registration Rights Agreement

 

As a condition to the consummation of the transactions contemplated by the Asset Purchase Agreement, at the closing, we will enter into a registration rights agreement (the “Registration Rights Agreement”) with Delta

 

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under which we will be obligated to file a shelf registration statement to cover the potential resale by Delta of the Primary Shares and the Warrant Shares. We will be obligated to keep the shelf registration statement continuously effective until either all the Primary Shares and Warrant Shares have been sold pursuant to Rule 144 or pursuant to an effective registration statement, or may be sold without volume restrictions pursuant to Rule 144.

 

Interests of Certain Persons In Matters To Be Voted On

 

Our directors and certain of our officers may have interests different from our shareholders which may constitute a conflict of interest. Each director, except for Mr. Heindel, and Ms. Frankhouse and Mr. McIntosh, are parties to the Voting Agreement, which will be effective as of the closing, pursuant to which they have agreed to vote their shares of our capital stock to elect (and to maintain in office) Delta’s designee to our Board of Directors during the term of the Voting Agreement. Pursuant to the terms of the Voting Agreement, Delta has agreed to vote its shares of our capital stock to elect (and to maintain in office) our designees to our Board of Directors as we may designate from time to time as part of our management slate and included in our proxy materials. Therefore, our shareholders will have limited opportunities to take action that would result in the replacement of one of our directors if either of our directors and officers or Delta determine to vote otherwise. Delta has also agreed not to bring any proposal before our shareholders the intent of which would be to remove from our Board of Directors without cause any of our designees to the Board. PECO II has similarly agreed not to bring any proposal before our shareholders the intent of which would be to remove from our Board of Directors without cause Delta’s designee to the Board. Our current Board of Directors benefits from the Voting Agreement in that the terms of the Voting Agreement make it more difficult for our shareholders to bring a proposal to change the composition of our Board of Directors.

 

As of September 30, 2005, our directors and officers who are Voting Agreement Shareholders beneficially own in the aggregate 6,750,358 shares of our capital stock, constituting in the aggregate 30.2% of the voting power of our capital stock. Assuming Delta exercises all of its rights to acquire the Warrant Shares during the term of the Warrant, Delta will beneficially own approximately 17,668,672 shares of our capital stock, constituting 45% of the voting power of our capital stock.

 

Two of our directors may have interests different from our shareholders and which may constitute a conflict of interest. Messrs. Matthew P. Smith and James L. Green are parties to the Support Agreement, pursuant to which they have agreed with us and Delta, at our special meeting of shareholders, to vote the shares of our capital stock beneficially owned by them in favor of the proposal to amend our Second Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act, to vote in favor of the issuance of the Primary Shares to Delta, to vote in favor of the issuance of the Warrant and the issuance of the Warrant Shares pursuant to Delta’s purchase rights thereunder, and to vote in favor of any other matter that could reasonably be expected to facilitate the consummation of the transactions contemplated by the Asset Purchase Agreement. Messrs. Smith and Green irrevocably appointed Delta, through its designees, as its proxy and sole attorney-in-fact to vote such shares of our capital stock at the special shareholders meeting in favor of the above proposals.

 

As of September 30, 2005, Mr. Smith beneficially owns 3,000,857 shares and Mr. Green beneficially owns 2,504,344 shares of our capital stock, representing 13.8% and 11.5%, respectively, of the voting power of our capital stock. As a result, as of the date hereof, 25.3% of the aggregate voting power of PECO II will vote in favor of each of the proposals set forth in this proxy statement.

 

Mr. Green’s shares of our capital stock are deemed to be “interested shares” under the Ohio Control Share Acquisition Act and are ineligible for purposes of voting in favor of the proposals set forth in this proxy statement unless our shareholders agree to the proposed amendment to our Amended and Restated Code of Regulations to opt out of the Ohio Control Share Acquisition Act. Thus, our officers and directors benefit from the Support Agreement by virtue of the fact that the voting power evidenced by the Support Agreement is material to obtaining at the special meeting the necessary percentage of votes required to approve the various proposals set forth in this proxy statement.

 

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Proposal 1

 

Amendment to the Amended and Restated Code of Regulations of PECO II, Inc. to Opt Out of the Ohio

Control Share Acquisition Act

 

Proposal 1 is to approve and adopt an amendment to the Amended and Restated Code of Regulations of PECO II, Inc., providing that the Ohio Control Share Acquisition Act shall not apply to acquisitions of its equity securities.

 

Overview

 

Our Board of Directors has approved a resolution to amend our Amended and Restated Code of Regulations, which, if adopted, would make an Ohio anti-takeover statute, referred to herein as the “Ohio Control Share Acquisition Act,” inapplicable to the acquisition of our Company’s equity securities. The full text of the proposed amendment is contained in Article X of our proposed Second Amended and Restated Code of Regulations, attached hereto as Appendix A. Article X is the only proposed amendment to our Amended and Restated Code of Regulations. Our Board of Directors unanimously recommends a vote for the proposed amendment.

 

Reasons for the Proposed Amendment

 

The adoption of the proposed amendment will facilitate the consummation of the transactions contemplated by the Asset Purchase Agreement. Without the amendment, the granting of the irrevocable proxy under the Support Agreement to the Delta designees to vote the 2,504,344 shares of our common stock beneficially owned by James L. Green, our Chairman, representing approximately 11.5% of our issued and outstanding capital stock as of September 30, 2005, in favor of the proposals to be voted on by the shareholders at the special meeting will deem such shares to be “interested shares” under the Ohio Control Share Acquisition Act and, accordingly, such shares may not be counted for purposes of voting at the special shareholders meeting. The Support Agreement was negotiated by Delta and us as part of the overall negotiations of the transactional documents and the execution of the Support Agreement by us, and Messrs. Smith and Green was an inducement for Delta to enter into the Asset Purchase Agreement. While we have called this special meeting, at which our shareholders will consider, among other things, the issuance of the Primary Shares and the issuance of the Warrant and underlying Warrant Shares, special meetings of shareholders required by the Ohio Control Share Acquisition Act are subject to certain procedures, including proxy counting requirements, that are complex, time consuming and, in this instance, not beneficial to the interests of our Company or our shareholders, including our unaffiliated shareholders, because we cannot complete the asset purchase if the Ohio Control Share Acquisition Act is applicable. If our shareholders do not approve Proposal 1, a condition to the closing of the transactions contemplated by the Asset Purchase Agreement will not be met and Delta may terminate the Asset Purchase Agreement.

 

In addition, with respect to the proposed transactions contemplated by the Asset Purchase Agreement and the absence of an opt out of the Ohio Control Share Acquisition Act, we will be required to follow certain complex statutory procedures that will ultimately serve to delay and increase the cost of the acquisition. Among these procedures is the requirement for an additional special meeting of shareholders at which the shareholders would be asked to approve the issuance of the Warrant Shares at such time or times that Delta may exercise its purchase rights. During our negotiations, Delta indicated it would not enter into the Asset Purchase Agreement if we were required to obtain shareholder approval each time Delta exercised its purchase rights under the Warrant to acquire Warrant Shares in amounts that exceeded the applicable threshold under the Ohio Control Share Acquisition Act.

 

Even if we were to obtain shareholder approval in connection with the Ohio Control Share Acquisition Act each time Delta exercised its purchase rights under the Warrant if an applicable threshold was exceeded, all of

 

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the approved transactions must be consummated within 12 months of shareholder approval; thus, we would be unable to issue a warrant to Delta with a term longer than 12 months without obtaining subsequent shareholder approval. Thus, we need the amendment to allow us to issue the Warrant without subsequent shareholder approval.

 

Summary of the Ohio Control Share Acquisition Act

 

In November 1982, the Ohio General Corporation Law was amended to include the “Control Share Acquisition Act,” which requires that “control share acquisitions” be approved by shareholders of an issuing public corporation.

 

The Ohio Control Share Acquisition Act gives shareholders who are not holders of “interested shares” a veto power over certain acquisitions of shares of an “issuing public corporation.” If the proposed amendment to our Amended and Restated Code of Regulations is adopted, you are waiving this veto power for future transactions involving PECO II. An “issuing public corporation” is a corporation with 50 or more shareholders that has in Ohio:

 

    its principal place of business;

 

    its principal executive offices;

 

    assets having substantial value; or

 

    a substantial percentage of its assets.

 

It also must not have a valid close corporation agreement in place.

 

Under the Ohio Control Share Acquisition Act, a “control share acquisition” is a direct or indirect acquisition by any person or entity of such number of voting shares of a corporation which, when added to those shares which the person or entity already owns or with respect to which the person or entity may exercise or direct the exercise of the voting power, would give the person or entity voting power within any of the following ranges:

 

    one-fifth or more but less than one-third of such voting power;

 

    one-third or more but less than a majority of such voting power; or

 

    a majority or more of such voting power.

 

A person or entity who proposes to make a control share acquisition must provide notice of the proposal to the corporation in accordance with specific requirements. The board of directors must then call a special meeting of the shareholders within 50 days for the purpose of voting on the proposed control share acquisition. A quorum for this meeting is achieved only if there is present at the meeting, in person or by proxy, a majority of the voting power of the corporation in the election of directors, and a majority of the portion of such voting power excluding the voting power of “interested shares.”

 

“Interested shares” are those shares of the corporation in respect of which any of the following persons may exercise or direct the exercise of the voting power of the corporation in the election of directors:

 

    the acquiring person;

 

    any officer of the corporation elected or appointed by the directors of the corporation; or

 

    any employee of the corporation who is also a director of the corporation.

 

“Interested shares” include any shares of the corporation acquired, directly or indirectly, by any person from the holder or holders thereof for a valuable consideration during the period beginning with the date of the first

 

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public disclosure of a proposed control share acquisition of the corporation or any proposed merger, consolidation, or other transaction that would result in a change in control of the corporation or in the sale of all or substantially all of its assets, and ending on the date of any special meeting of the corporation’s shareholders held thereafter for the purpose of voting on a control share acquisition proposed by an acquiring person if either of the following applies: the aggregate consideration paid or given by the person who acquired the shares, and any other persons acting in concert with him, for all such shares exceeds $250,000, or the number of shares acquired by the person who acquired the shares, and any other persons acting in concert with him, exceeds one-half of one percent of the outstanding shares entitled to vote in the election of directors.

 

A proposed control share acquisition may be consummated only if, at a special meeting of the shareholders at which at least a majority of the voting power is represented in person or by proxy, the acquisition is approved by both holders of a majority of the voting power of the corporation in the election of directors represented at the meeting by person or by proxy, and holders of a majority of the portion of such voting power excluding the voting power of interested shares. A proposed control share acquisition which receives approval in the manner described must be consummated, in accordance with the terms so authorized, no later than 360 days following shareholder authorization of the control share acquisition. The Ohio Control Share Acquisition Act does not apply to a corporation whose articles of incorporation or code of regulations provides that it does not apply.

 

Potential Benefits of the Ohio Control Share Acquisition Act

 

Even though shareholder rights advocates often express the view that state takeover statutes, such as the Ohio Control Share Acquisition Act, are contrary to shareholder interests, the Ohio Control Share Acquisition Act was adopted by the Ohio General Assembly to address serious issues. The primary purpose was to require any person seeking to obtain ownership or voting rights with respect to a substantial block of shares to provide the corporation with detailed information regarding the potential share acquisition and to present the acquisition to shareholders for approval at a special meeting. With respect to transactions which are in the best interests of a public company, the Ohio Control Share Acquisition Act, together with federal proxy rules, assures that shareholders will be given adequate notice and opportunity to review the transaction and consent to the resulting effects of the acquisition. This process was intended to prevent the unfettered ability of a single holder to obtain a substantial block of shares, which could result in significant changes in corporate circumstances, and to avoid the coercive environment which the legislature found was often present in tender offers. The Ohio General Assembly further limited the coercive nature of the shareholder vote by not permitting the proposed acquirer to vote on the transaction. Since the potential acquirer can solicit proxies at the mandatory special shareholders meeting to approve the proposed transaction, there is a check on the power of a company’s board or management to entrench itself by using the Ohio Control Share Acquisition Act as a defensive tool. If you vote in favor of Proposal 1 and permit the Company to “opt out” of the statute, the potential benefits of the Ohio Control Share Acquisition Act will not be available to the Company or its shareholders.

 

Vote Required

 

The affirmative vote of the holders of a majority of the outstanding shares of our common stock is required to approve this proposal.

 

Our Board of Directors Unanimously Recommends a Vote “FOR” Proposal 1.

 

Proposal 2

 

The Issuance of the Primary Shares

 

Description of the Asset Purchase

 

On October 13, 2005, we entered into an Asset Purchase Agreement with Delta pursuant to which we will acquire assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply

 

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agreements with wireline and wireless communications providers and related inventory, and will assume the liabilities associated therewith of Delta’s U.S. and Canadian service provider business, in exchange for the issuance to Delta of the Primary Shares and the issuance of the Warrant and the underlying Warrant Shares.

 

Description of the Primary Shares to be Issued

 

Pursuant to the terms of the Asset Purchase Agreement, at the closing we will issue to Delta 4,740,375 shares of common stock without par value, free and clear of any encumbrance by us and with no restriction on the voting rights or transfer thereof except as provided for by applicable law, the Voting Agreement and Registration Rights Agreement set forth as exhibits to the Asset Purchase Agreement. There are no preemptive rights with respect to the Primary Shares. We currently have issued and outstanding 21,954,741 shares of our 50,000,000 authorized shares of common stock. The issuance of the Primary Shares and the Warrant Shares will have the effect of diluting your ownership in our Company by virtue of holding a smaller percentage of the total issued and outstanding shares of our capital stock. The addition of the Delta Business Assets to be acquired under the Asset Purchase Agreement, however, will increase the value of our Company. Therefore, we believe any dilutive effect to our existing shareholders will be offset by the increased value of PECO II.

 

Vote Required

 

The affirmative vote of the holders of a majority of the shares of our common stock voting in person or by proxy at the special meeting is required to approve this proposal.

 

Our Board of Directors Unanimously Recommends a Vote “FOR” the Issuance of the Primary Shares.

 

Proposal 3

 

The Issuance of the Warrant and the Underlying Warrant Shares

 

Description of the Asset Purchase

 

On October 13, 2005, we entered into an Asset Purchase Agreement with Delta pursuant to which we will acquire assets that relate to Delta’s Telecom Power Division, consisting of the exclusive rights to business supply agreements with wireline and wireless communications providers and related inventory, and will assume the liabilities associated therewith of Delta’s U.S. and Canadian service provider business, in exchange for the issuance to Delta of the Primary Shares and the issuance of the Warrant and the underlying Warrant Shares.

 

Description of the Warrant and Warrant Shares to be Issued

 

Pursuant to the terms of the Asset Purchase Agreement and the Warrant, at the closing we will issue to Delta a Warrant to purchase that number of Warrant Shares which, when aggregated with the Primary Shares, will permit Delta to acquire up to 45% of our issued and outstanding capital stock measured as of five business days prior to the date of exercise of the Warrant.

 

The formula for determining the number of Warrant Shares is: (i) the quotient of (A) the Outstanding Shares (as defined below) minus the Primary Shares issued at closing, divided by (B) 0.55, minus (ii) the Outstanding Shares (rounded to the nearest whole share). Currently, we anticipate the maximum number of Warrant Shares to be issued under the Warrant is approximately 12,928,297; however, if we issue additional shares of our common stock, this number will increase. The exercise price under the Warrant is $2.00 per share, and the Warrant is exercisable immediately upon issuance for a term of 30 months from the issuance date of the Warrant. The Warrant is subject to customary adjustments for subdivisions, combinations and certain issuances, reclassifications, reorganizations and consolidations. The issuance of any Warrant Shares will have the effect of

 

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diluting your ownership in our Company. We currently have issued and outstanding 21,954,741 shares of our 50,000,000 authorized shares of common stock. The issuance of the Primary Shares and the Warrant Shares will have the effect of diluting your ownership in our Company by virtue of holding a smaller percentage of the total issued and outstanding shares of our capital stock. The addition of the Delta Business Assets to be acquired under the Asset Purchase Agreement, however, will increase the value of our Company. Therefore, we believe any dilutive effect to our existing shareholders will be offset by the increased value of PECO II.

 

For purposes of the Warrant, the term “Outstanding Shares” means all issued and outstanding shares of our capital stock measured as of the date that is five days before the date of exercise of the Warrant.

 

Vote Required

 

The affirmative vote of the holders of a majority of our shares common stock voting in person or by proxy at the special meeting is required to approve this proposal.

 

Our Board of Directors Unanimously Recommends a Vote “FOR” the Issuance of the Warrant and the Warrant Shares.

 

Proposal 4

 

Permission of Board of Directors to Adjourn Special Meeting

 

Proposal to Permit Adjournment of Special Meeting

 

The proposals set forth in this proxy statement are conditions precedent to the closing of the transactions contemplated by the Asset Purchase Agreement. Our Board of Directors believes each of the proposals are in the best interest of our Company and our shareholders. Accordingly, our Board of Directors is seeking shareholder approval to adjourn the special meeting, if necessary, to solicit additional proxies because there are not sufficient votes available at the special meeting to approve the proposals set forth in the proxy statement.

 

Vote Required

 

The affirmative vote of the holders of a majority of the shares of PECO II common stock voting in person or by proxy at the special meeting is required to approve this proposal.

 

Our Board of Directors Unanimously Recommends a Vote “FOR” the Proposal to Allow the Board to Adjourn the Special Meeting.

 

*  *  *

 

Please note that our shareholders must approve each of Proposals 1, 2 and 3 for the transactions contemplated by the Asset Purchase Agreement to close.

 

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Share Ownership of Principal Holders and Management

 

The following table shows information regarding beneficial ownership of our common shares as of September 30, 2005, unless otherwise indicated, by each person or group which is known by us to own beneficially more than 5% of our common shares, each director, each named executive officer, and all directors and executive officers as a group. Unless otherwise indicated, each person named below has sole voting power and investment power or shares this power with his or her spouse with respect to the number of shares set forth opposite his or her respective name.

 

The number of shares beneficially owned by each shareholder is determined under rules issued by the Securities and Exchange Commission. This information is not necessarily indicative of beneficial ownership for any other purpose. Under these rules, beneficial ownership includes any shares as to which the individual or entity has sole or shared voting power or investment power and any shares as to which the individual or entity has the right to acquire beneficial ownership within 60 days after September 30, 2005 through the exercise of any stock option or other right.

 

Name and Address of Beneficial Owner(1)


   Common Shares
Beneficially Owned


   Percent
Owned


 

Austin W. Marxe and David M. Greenhouse(2)

   1,547,462    7.2 %

Matthew P. Smith(3)

&