UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

 

 

 

Commission file number 01-34443

 

 

 

 

FLOW INTERNATIONAL CORPORATION

 

 

 

 

 

23500 — 64th Avenue South
Kent, Washington 98032
(253) 850-3500

 

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $.01 Par Value

Common Share Purchase Rights

 

Name of each exchange on which registered:

The NASDAQ Global Market

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o.

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o.

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):  Yes o     No þ

 

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $109,406,057 as of October 31, 2009, the last business day of the registrant’s most recently completed second fiscal quarter, based on a closing price of $2.41 per share as quoted by the NASDAQ Stock Market as of such date. The determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

The registrant had 46,991,027 shares of Common Stock, $0.01 par value per share, outstanding as of June 22, 2010.

 

 

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The registrant intends to file a definitive proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended April 30, 2010 (the “2010 Proxy Statement”). Portions of such proxy statement are incorporated by reference into Part II and III of this Form 10-K. With the exception of such portions of the 2010 Proxy Statement expressly incorporated by into this Annual Report on Form 10-K by reference, such document shall not be deemed filed as part of this Annual Report on Form 10-K.

 

 

Table of Contents:

 

Forward-Looking Statements

 

Forward-looking statements in this report, including without limitation, statements relating to the Company’s plans, strategies, objectives, expectations, intentions, and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “may,” “expect,” “believe,” “anticipate,” “estimate,” “plan” and similar expressions are intended to identify forward-looking statements. These statements are no guarantee of future performance and involve certain risks, assumptions, and uncertainties that are difficult to predict. Therefore, actual outcome and results may differ materially from what is expressed or forecasted in such forward-looking statements.

 

We make forward-looking statements of our expectations which include but are not limited to:

 

 

There may be other factors not mentioned above or included in our SEC filings that may cause our actual results to differ materially from those in any forward-looking statement. You should not place undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements as a result of new information, future events or developments, except as required by federal securities laws.

 

 

Business Overview

 

Flow International Corporation and its subsidiaries (hereinafter collectively referred to as “the Company”, “we”, or “our” unless the context requires otherwise) is a technology-based global company providing customer-driven waterjet cutting, surface preparation and cleaning solutions. Our ultrahigh-pressure water pumps generate pressures from 40,000 to over 94,000 pounds per square inch (psi) and power waterjet systems that are used to cut and clean materials. Waterjet cutting is a fast-growing alternative to traditional methods, which utilize lasers, saws, knives, shears, plasma, routers, drills, soda blasting and abrasive blasting techniques, and has uses in many applications from food and paper products to steel and carbon fiber composites.

 

This portion of our Form 10-K provides detailed information about who we are and what we do. Unless otherwise specified, current information reported in this Form 10-K is as of, or for the year ended April 30, 2010.

 

Our History

 

Flow International Corporation was incorporated in Delaware in 1983 as Flow Systems, Inc. and was reincorporated in Washington in October 1998. Our innovations and accomplishments through the years include:

 

Prior to the 1990s, we:

 

 

In the 1990s, we;

 

 

In the 2000s, we:

 

 

Our Business Strategy

 

We are a technology-based global company whose objective is to deliver profitable dynamic growth by providing technologically advanced waterjet cutting, surface preparation and cleaning solutions to our customers. Our machines require significant capital outlay across all market segments.

 

The deterioration in global economic conditions, that started in fiscal 2009, and the instability in the stock market and tightening of credit markets caused a reduction in capital spending which negatively impacted our business. In fiscal year 2010, our primary focus was on managing our cash flow and maintaining sufficient liquidity as result of the economic conditions. In fiscal 2011, we intend to continue focusing on generating positive cash flow, performing better than the market in each of our business segments, and, as our revenues grow, taking advantage of our market position and ability to scale. In the longer term, our strategy is to continue to introduce the highest quality products with the most innovative technology at a rate faster than our competitors; to distribute products through a model that benefits our shareholders — leveraging our direct sales force and continuing to pursue additional channels and partners for distribution; to provide world-class service to our customers; to develop and maintain low-cost manufacturing processes and continually improve productivity and efficiency; and to attract and retain skilled and knowledgeable people. These factors will promote our ability to grow from expansion of our existing businesses.

 

Our ability to fully implement our strategies and achieve our objective may be influenced by a variety of factors, many of which are beyond our control. Refer to discussion of some of these factors under Item 1A: Risk Factors.

 

Products and Services

 

Our mission is to provide the highest value customer-driven waterjet cutting, surface preparation and cleaning solutions. We strive to improve our customers’ profitability through the development of innovative products and services that expand our customers’ markets and increase their productivity. We launched a new Mach Series of waterjet cutting equipment which feature the next generation of waterjet technology in fiscal year 2010. Our new Mach Series consists of three distinct product lines: the Mach 4, Mach 3, and Mach 2, all of which offer complete systems solutions to address a full array of customer needs while delivering the widest range of capabilities, technologies and price in the industry.

 

The primary components of our product line include versatile waterjet cutting, surface preparation and industrial cleaning systems which provide total system solutions for various industries including aerospace, metalworking, stone and tile, job shop, automotive, industrial surface preparation and cleaning.

 

Our ultrahigh-pressure technology has two broad applications: cutting and surface preparation and cleaning.

 

Waterjet Cutting.  The primary application of our ultrahigh-pressure water pumps is cutting. In cutting applications, an ultrahigh-pressure pump pressurizes water from 40,000 to 94,000 rated psi, and forces it through a small orifice, generating a stream of water traveling at supersonic speeds. In order to cut metallic and other hard materials, an abrasive substance, usually garnet, is added to the waterjet stream creating an abrasive jet. Our cutting systems typically include a robotic manipulator that moves the cutting head, either 2-dimensionally or 3-dimensionally. Our systems may also combine waterjet with other applications such as material handling, conventional machining, routing inspection, assembly, and other automated processes. Our waterjet cutting systems cut virtually any shape in a single step with edge quality that usually requires no secondary finishing and are the most productive solutions for cutting a wide range of materials from 1/16 inch to over 24 inches thick. We offer two different pump technologies: ultrahigh-pressure intensifier and direct drive pumps, ensuring our customers get the pump that is right for them and their unique application. Our intensifier pumps can deliver water continuously at up to 94,000 psi, and our direct drive pumps up to 55,000 psi.

 

Waterjet cutting is recognized as a more flexible, cost effective and accurate alternative to traditional cutting methods such as lasers, wire electronic data machines, saws or plasma. It offers greater versatility in the types of products it can cut, and, because it cuts without creating appreciable heat or mechanical stress and

often reduces or eliminates the need for secondary processing operations and special fixturing. Waterjet cutting has applications in many industries, including aerospace, defense, automotive, semiconductors, disposable products, food, glass, job shop, sign, metal cutting, marble, tile and other stone cutting, and paper slitting and trimming.

 

Surface Preparation and Industrial Cleaning Products.  Our ultrahigh-pressure surface preparation and industrial cleaning systems are used in waterjet cleaning for fast coating removal. These systems use direct drive pumps to create pressures in the range of 40,000 to 55,000 psi. Because only pure water is used to remove coatings, waterjetting costs less than grit blasting by eliminating the need for collection, containment, and disposal of abrasive. Removing coatings with water instead of grit allows other work to be done at the same time as the waterjet operation and reduces containment and cleanup issues. Steel, mechanical and electrical work, or painting, can be performed concurrently with waterjet industrial cleaning, which means projects are completed in less time and there are fewer environmental concerns than with traditional methods such as sandblasting.

 

Parts and Services.  We also offer consumable parts and services. Consumables represent parts used by the pump and cutting head during operation, such as seals and orifices. Many of the consumable parts are proprietary in nature and are patent protected. We also sell various tools and accessories which incorporate ultrahigh-pressure technology.

 

Marketing and Customers

 

Our marketing emphasizes a consultative application-oriented sales approach and is centered on increased awareness of the capabilities of our technology as we believe that waterjet technology is still in the early adoption phase of its product life cycle. These efforts include presence at tradeshows, advertising in print media and other product placements and demonstration/educational events as well as an increase in domestic and international sales representation, including distributors. To enhance sales efforts, our marketing staff and sales force gather detailed information on applications and requirements in targeted market segments. We also utilize telemarketing and the Internet to generate sales leads in addition to lead generation through tradeshows and print media. This information is used to develop standardized and customized solutions using ultrahigh-pressure and robotics technologies.

 

We offer our consumable parts through the Internet at our www.flowparts.com website in the U.S. and www.floweuropeparts.com in Europe. We strive to ensure that we are able to ship a large number of parts within 24 hours to our customers.

 

We have established strong relationships with a diverse set of customers. Our largest customer in the Advanced segment (refer to our discussion on our Business Segments below) — Airbus - accounted for approximately 11% of consolidated sales in fiscal year 2010. No single customer or group of customers under common control accounted for 10% or more of our total consolidated sales for the respective years ending April 30, 2009 and 2008.

 

We believe that the productivity-enhancing nature of our ultrahigh-pressure technology will enable us to grow our market share in the machine cutting tool market as we exit the recession. Further, we believe that the diversity of our markets, along with the relatively early adoption phase of our technology, and the displacement of more traditional methods for machining, fabricating and surface preparation, will enable us to continue weathering the economic downturn better than conventional machine tool manufacturers.

 

Competition in Our Markets

 

Our major markets — both domestic and foreign — are highly competitive, with our products competing against other waterjet competitors as well as technologies such as lasers, saws, plasma, shears, routers, drills, and abrasive blasting techniques. Most of our waterjet competitors provide only portions of a waterjet system such as pumps or control systems. Other competitors integrate components from a variety of suppliers to provide a complete solution. With the launch of our latest Mach Series technology releases, we now have waterjet systems that match our diverse customers’ applications and budgets. Under the Flow brand, we

compete in the high-end and mid-tier segments of the waterjet cutting market through product quality and superior service reliability, value, service and technology. Through our Mach 2 series, we compete in the lower priced segments of the market. Approximately 80 firms, other than Flow, have developed tools for cleaning and cutting based on waterjet technology. We believe we are the leader in the global waterjet cutting systems market.

 

Waterjet cutting systems offer manufacturers many advantages over traditional cutting machines including an ability to cut or machine virtually any material, in any direction, with improved manufacturing times, and with minimal impact on the material being cut. These factors, in addition to the elimination of secondary processing in many circumstances, enhance the manufacturing productivity of our systems.

 

We estimate that the waterjet cutting solutions market opportunity exceeds $1 billion in annual revenue potential or more than twice the current level. The total market potential continues to grow as new applications are developed. The rapidly increasing global market for waterjet solutions, while providing high growth opportunities, is also attracting new market entrants which will increase competition.

 

In addition to pumps and systems, we sell consumable parts and services. We believe our on-time delivery and technical service combine for the best all-around value for our customers but, we face competition from numerous other companies who sell non-proprietary replacement parts for our machines. While they generally offer a lower price, we believe the quality of our parts, coupled with our service, makes us the value leader in consumable parts.

 

Business Segments

 

We report our operating results to our Chief Executive Officer, who is the chief operating decision maker, based on market segments which is consistent with management’s long-term growth strategy. Our reportable segments are Standard and Advanced. The Standard segment includes sales and cost of sales related to our cutting, surface preparation and cleaning systems using ultrahigh-pressure water pumps as well as parts and services to sustain these installed systems. Systems included in this segment do not require significant custom configuration. The Advanced segment includes sales and cost of sales related to our complex Advanced segment systems which require specific custom configuration and advanced features, including robotics, to match unique customer applications as well as parts and services to sustain these installed systems.

 

Financial information about our segments is included in Note 17 — Business Segments and Geographic Information of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data.

 

Sales Outside the United States

 

In fiscal year 2010, 59% — or $102.7 million — of our total consolidated sales were to customers outside the United States, this included:

 

 

Raw Materials

 

We depend on the availability of raw materials, parts and subassemblies from our suppliers and subcontractors. Principal materials used to make waterjet products are metals, and plastics, typically in sheets, bar stock, castings, forgings and tubing. We also purchase many electrical and electronic components, fabricated metal parts, high-pressure fluid hoses, ball screws, seals and other items integral to our products. Suppliers are competitively selected based on quality, delivery and cost. Our suppliers’ ability to provide timely and quality raw materials, components, kits and subassemblies affects our production schedules and contract profitability. We maintain an extensive qualification and performance surveillance system to control

risks associated with this reliance on the supply chain. Some of our business units purchase these items from sole or limited source suppliers

 

Our strategic sourcing and new product development initiatives seek to find ways of mitigating the inflationary pressures of the marketplace including renegotiating with our suppliers and customers to avoid a significant impact to our margins and product enhancements and to leverage quality and cost benefit. Macro-economic pressures may increase our operating costs with consequential risk to our cash flow and profitability. We currently do not employ forward contracts or other financial instruments to hedge commodity price risk, although we continuously explore supply chain risk mitigation strategies.

 

Intellectual Property

 

We have a number of patents related to our processes and products both domestically and internationally. While in the aggregate our patents are of material importance to our business, we believe that no single patent or group of patents is of material importance to our business as a whole. We also rely on non-patented proprietary trade secrets and knowledge, confidentiality agreements, creative product development and continuing technological advancement to maintain a technological lead on our competitors.

 

Product Development

 

We strive to improve our competitive position in all of our segments by continuously investing in research and development to drive innovation in our products and manufacturing technologies. Our research and development investments support the introduction of new products and enhancements to existing products. During the year ended April 30, 2010, we expensed $8.1 million related to product research and development as compared to $8.6 million in fiscal year 2009 and $8.3 million in fiscal year 2008. Research and development expenses as a percentage of revenue were between 3% and 5% during each of the respective years ended April 30, 2010, 2009, and 2008. In light of the economic downturn, we have undertaken significant efforts to reduce our fixed and variable expenses to adjust our total cost structure to current market conditions. However, reductions in research and development expenses in fiscal year 2010 were minimal, reflecting our ongoing commitment to being the worldwide leader in waterjet technology.

 

Backlog

 

Our backlog increased 3.5% from $45.7 million at April 30, 2009 to $47.3 million at April 30, 2010. The backlog at April 30, 2010 and 2009 represented 27% and 22% of our trailing twelve months sales as of April 30, 2010 and 2009, respectively.

 

Backlog includes firm orders for which written authorizations have been accepted and revenue has not yet been recognized. Generally, our products, exclusive of our Advanced segment systems, can be shipped within a four to 16 week period. Advanced segment systems typically have lead times of six to 18 months. The unit sales price for most of our products and services is relatively high (typically ranging from tens of thousands to millions of dollars) and individual orders can involve the delivery of several hundred thousand dollars of products or services at one time. Due to possible customer changes in delivery schedules and cancellation of orders, our backlog at any particular date is not indicative of actual sales for any succeeding period. Delays in delivery schedules and/or a reduction of backlog during any particular period could have a material adverse effect on our business and results of operations.

 

Working Capital Practices

 

There are no special or unusual practices relating to our working capital items. We generally require advance payments as deposits on customized equipment and standard systems and require progress payments for customized equipment during the manufacturing of these products or prior to product shipment.

Employees

 

We had 594 full time employees as of April 30, 2010 compared to 649 and 759 for the respective years ended April 30, 2009 and 2008, with 65% located in the United States and 36% located in other foreign locations. Our success depends in part on our ability to attract and retain employees.

 

Available Information

 

We are subject to the reporting requirements of the Exchange Act and its rules and regulations. The Exchange Act requires us to file reports, proxy statements and other information with the U.S. Securities and Exchange Commission (“SEC”). Copies of these reports, proxy statements and other information can be read and copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549 and can also be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a Web site that contains reports, proxy statements and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC’s Web site at www.sec.gov.

 

We make available, free of charge on our Web site, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file these documents with, or furnish them to, the SEC. These documents are posted on our Web site at www.flowcorp.com — select the “Investor Relations” link and then the “Reports” link.

 

 

Our business is subject to certain risks and events that, if they occur, could adversely affect our financial condition and results of operations, and the trading price of our common stock.

 

You should consider the following risk factors, in addition to the other information presented in this report and the matters described in our “Forward-Looking Statements” section, as well as other reports and registration statements we file from time to time with the SEC, in evaluating us, our business, and an investment in our securities.

 

Risks Related to our Business

 

Our results of operations and financial condition could be materially affected by changes in product mix or pricing.

 

Our overall profitability may not meet expectations if our products, customers or geographic mix are substantially different than anticipated. Our profit margins vary among products, customers and geographic markets. Consequently, if our mix of any of these is substantially different from what is anticipated in any particular period, our profitability may be lower than anticipated.

 

Failure to effectively manage our indirect sales channel could adversely affect our results of operations and financial condition.

 

In order to expand sales and capture a leading market share globally, we have recently focused on establishing an indirect sales channel, through distributors and sales agents, to augment our existing direct sales force. Our success in integrating this indirect sales channel into our business will be impacted by our ability to train and manage new and existing relationships with distributors and sales agents. If we are not able to effectively train and manage our indirect sales channel, we may not be able to achieve our operating results and this could have a negative effect on our operating results and financial condition.

 

Foreign currency exchange rates and commodity prices may adversely affect our results of operations and financial condition.

 

We have substantial assets, liabilities, revenues and expenses denominated in currencies other than the U.S. dollar, and to prepare our consolidated financial statements, we must translate these items into U.S. dollars

at the applicable exchange rates. We are therefore exposed to movements in foreign exchange rates against the U.S. Dollar. Of these, the most significant is currently the Euro. A portion of our sales to our customers and operating costs in Europe are denominated in Euro creating an exposure to foreign currency exchange rates. Additionally, certain of our foreign subsidiaries make sales denominated in U.S. Dollars which expose them to foreign currency transaction gains and losses.

 

In addition, we are a large buyer of steel, as well as other commodities required for the manufacture of products. As a result, changes in currency exchange rates and commodity prices may have an adverse effect on our results of operations and financial condition.

 

If we fail to obtain sufficient quantities of materials, components and equipment required for our manufacturing activities at competitive prices and quality and on a timely basis or fail to effectively adapt out cost structure to changing market conditions our business and financial results will suffer.

 

We purchase materials, components and equipment from third parties for use in our manufacturing operations. Some of our business units purchase these items from sole or limited source suppliers. If we cannot obtain sufficient quantities of materials, components and equipment at competitive prices and quality and on a timely basis, we may not be able to produce sufficient quantities of product to satisfy market demand, product shipments may be delayed or our material or manufacturing costs may increase. In addition, because we cannot always immediately adapt our cost structures to changing market conditions, our manufacturing capacity may at times exceed our production requirements or fall short of our production requirements. Any or all of these problems could result in the loss of customers, provide an opportunity for competing products to gain market acceptance and otherwise adversely affect our business and financial results.

 

Our operations may be impaired as a result of disasters, business interruptions or similar events.

 

Disasters and business interruptions such as earthquakes, flooding, fire, and electrical failure affecting our operating activities and major facilities could materially and adversely affect our operations, our operating results and financial condition. In particular, our facility in Kent, Washington, which is our headquarters and the primary manufacturing facility for our ultra-high pressure pumps, is in close proximity to the Green River which currently has an increased risk of flooding over the next 3 to 5 years because of the structural integrity of a dam on the river. If such flooding occurs, it could be extremely disruptive to our business and could materially and adversely affect our operations, operating results and financial condition. We have developed a disaster recovery plan to mitigate the negative results of such an occurrence, however, the implementation and execution of such plans may not be adequate.

 

The recent economic recession and its impact on the credit markets could adversely affect our results of operations and access to capital.

 

The economic recession and the impact that it has had on the financial and credit markets has resulted in a period of turmoil that has included the failure or sale of various financial institutions and an unprecedented level of intervention from the United States government. While it is difficult to predict the lingering effects of these events, they may impair our customers’ ability to borrow money or raise capital for their operations.

 

Volatile market conditions could:

 

 

We may not be able to comply with the financial tests or ratios required to comply with our covenant requirements under our Line of Credit which may impact our ability to draw funds and may result in the acceleration of the maturity of, and/or the termination of the Line of Credit.

 

Our Line of Credit agreement requires us to comply with or maintain certain financial tests and ratios and restrict our ability to:

 

 

Our ability to comply with these covenants is subject to various risks and uncertainties. In addition, events beyond our control could affect our ability to comply with and maintain the financial tests and ratios required by this indebtedness. Any failure by us to comply with and maintain all applicable financial tests and ratios and to comply with all applicable covenants could result in an event of default with respect to a substantial portion of our debt which would result in the acceleration of the maturity and/or the termination of our credit facility. Even if we are able to comply with all applicable covenants, the restrictions on our ability to operate our business in our sole discretion could harm our business.

 

We may need to raise additional funds to finance our future capital and/or operating needs.

 

In September 2009, we completed an underwritten public offering of 8,998,750 common shares at an offering price of $2.10 per share, generating net proceeds of approximately $17.2 million after deducting underwriting commissions and estimated offering expenses. We may need to raise additional funds through public or private debt or sale of equity to achieve our current business strategy in future periods. The financing we need may not be available when needed. Even if this financing is available, it may be on terms that we deem unfavorable or are materially adverse to our shareholders’ interests, and may involve substantial dilution to our shareholders. Our inability to obtain financing will inhibit our ability to implement our development strategy, and as a result, could require us to diminish or suspend our development strategy and possibly cease certain of our operations. If we require additional funds and are unable to obtain additional financing on reasonable terms, we could be forced to delay, scale back or eliminate certain product development programs and/or our capital projects. In addition, such inability to obtain additional financing on reasonable terms could have a negative effect on our business, operating results, or financial condition to such extent that we are forced to restructure, sell assets or cease operations, any of which could put our shareholders’ investment dollars at significant risk.

 

If we fail to technologically advance our products through continued research and development, our financial results may be adversely affected.

 

In order to maintain our position in the market, we need to continue investment in research and development to improve our products and technologies and to introduce new products and technologies. If we are unable to make such investment, if our research and development efforts do not lead to new and/or improved products or technologies, or if we experience delays in the development or acceptance of new and/or improved products, our financial condition and results of operations could be adversely affected.

 

We might fail to adequately protect our intellectual property rights or third parties might assert that our technologies infringe on their intellectual property.

 

We rely on a combination of patents, trade secrets, trademarks and copyrights to protect our intellectual property, but this protection might be inadequate. For example, our pending or future patent applications might not be approved or, if allowed, they might not be of sufficient strength or scope. Conversely, third parties, certain of whom have filed lawsuits against us in the past, might assert that our technologies infringe their

proprietary rights. Any future related litigation to defend our intellectual property and/or defend ourselves from assertions of infringement could result in substantial costs and diversion of our efforts and could adversely affect our business, whether or not we are ultimately successful.

 

Changes in our income tax rates or exposure to additional income tax liabilities could affect our profitability. In addition, audits by tax authorities could result in additional tax payments for prior periods.

 

We are subject to income taxes in the U.S. and in various foreign jurisdictions. Domestic and international tax liabilities are subject to the allocation of income among various tax jurisdictions. Our effective tax rate can be affected by changes in the mix of earnings in countries with differing statutory tax rates, accruals related to unrecognized tax benefits, the results of audits and examinations of previously filed tax returns and changes in tax laws. Any of these factors may adversely affect our tax rate and decrease our profitability. The amount of income taxes we pay is subject to ongoing audits by U.S. federal, state and local tax authorities and by non-U.S. tax authorities. If these audits result in assessments different from our unrecognized tax benefits, our future results may include unfavorable adjustments to our tax liabilities.

 

Unexpected losses in future reporting periods may require the Company to adjust the valuation allowance against its deferred tax assets.

 

We evaluate our deferred tax assets for realizability based on all available evidence. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between the future projected operating performance and our actual results. We are required to establish a valuation allowance for deferred tax assets if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In determining the more-likely-than-not criterion, we evaluate all positive and negative available evidence as of the end of each reporting period. Future adjustments, either increases or decreases, to the deferred tax asset valuation allowance will be determined based upon changes in the expected realization of the net deferred tax assets. The realization of the deferred tax assets ultimately depends on the existence of sufficient taxable income in either the carry back or carry forward periods under the tax law. Due to significant estimates utilized in establishing the valuation allowance and the potential for changes in facts and circumstances, it is reasonably possible that we may be required to record adjustments to the valuation allowance in future reporting periods. Such a charge could have a material adverse effect on our results of operations and financial condition. As of April 30, 2010, we had approximately $24 million of net deferred tax assets.

 

International economic, political, legal and business factors could negatively affect our results of operations, cash flows and financial condition.

 

In fiscal year 2010, approximately 59% of our sales were derived outside the U.S. Since our growth strategy depends in part on our ability to further penetrate markets outside the U.S., we expect to continue to increase our sales outside the U.S., particularly in emerging markets. In addition, some of our sales distribution offices and many of our suppliers are located outside the U.S. Our international business is subject to risks that are customarily encountered in non-U.S. operations, including:

 

 

 

Any of these risks could negatively affect our results of operations, cash flows, financial condition and overall growth.

 

If we are unable to complete the upgrades to our information technology systems that are currently in process, or our upgrades are unsuccessfully implemented, our future success may be negatively impacted.

 

In order to maintain our leadership position in the market and efficiently process increased business volume, we are making a significant multi-year upgrade to our computer hardware, software and our Enterprise Resource Planning (“ERP”) system. Should we be unable to continue to fund the completion of this upgrade in all our locations, or should the ERP system upgrade be unsuccessful or take longer to implement than anticipated, our ability to grow the business and our financial results could be adversely impacted.

 

We may incur net losses in the future, and we may not be able to regain or sustain profitability on a quarterly or annual basis.

 

We incurred net losses during fiscal year 2010. We may continue to incur net losses in the future including losses from our operations, the impairment of long-lived assets and restructuring charges. There can be no assurance that we will be able to conduct our business profitably in the future.

 

Our stock price has been and is likely to continue to be highly volatile.

 

The trading price of our common stock has been highly volatile. On June 22, 2010, the closing price of our common stock was $2.48. Our stock price could decline or be subject to wide fluctuations in response to factors such as the risks discussed in this section and the following:

 

 

In addition, there has been significant volatility in the market price and trading volume of our securities that is sometimes unrelated to our operating performance. Some companies that have had volatile market prices for their securities have been the target of a hostile takeover or subject to involvement by activist shareholders. If litigation of this type is brought against us it, it could result in substantial costs and would divert management’s attention and resources.

 

If we are unable to hire, retain and motivate highly qualified employees, including our key employees, we may not be able to successfully manage our business.

 

Our success depends on our ability to identify, attract, hire, retain and motivate highly skilled technical, managerial, sales and marketing, and corporate personnel. If we fail to successfully hire and retain a sufficient number of highly qualified employees, we may have difficulties in supporting our customers or expanding our

business. Realignments of resources, reductions in workforce, temporary reductions of wages and suspension of certain benefits in response to the economic downturn, and/or other operational decisions have created and could continue to create an unstable work environment that may have a negative effect on our ability to hire, retain and motivate employees.

 

Our business and operations are substantially dependent on the performance of our key employees, all of whom, except our chief executive officer, are employed on an at-will basis. While none of our key personnel is irreplaceable, the loss of the services of any of these individuals may be disruptive to our business. There can be no assurance that any retention program we initiate will be successful at retaining employees, including key employees.

 

We have unresolved claims with the purchaser of Avure.

 

During fiscal year 2009, we were notified by the purchaser of our Avure Business (“Purchaser”), which we reported as a discontinued operation for the year ended April 30, 2006, that the Swedish tax authority was conducting an audit which includes periods during the time that we owned the subsidiary. Pursuant to our agreement with the Purchaser, we had made commitments to indemnify various liabilities and claims, including any tax matters when we owned the business. The Swedish tax authority concluded its audit and issued a final report in November 2009 asserting that Avure owes 19.5 million Swedish Krona in additional taxes, penalties and fines. In April 2010, we filed an appeal to contest the findings by the Swedish Tax Authority. While we intend to continue contesting the findings, the ultimate outcome of this matter is uncertain and an unfavorable outcome ranging from $0 to the assessed $1.2 million is reasonably possible. An equivalent of $1.2 million was accrued during the current fiscal year related to the periods during which we owned Avure.

 

Risks Related to the Industries in Which We Operate

 

Intense competition in our markets could prevent us from increasing distribution of our products in those markets or cause us to lose market share.

 

We face competition in a number of our served markets as a result of the entry of new competitors and alternative technologies such as lasers, saws, plasma, shears, routers, drills and abrasive blasting techniques. Some of our competitors or potential competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, more developed infrastructures or more established relationships in the industry than we have. Our competitors may be able to adopt more aggressive pricing policies, develop and expand their product offerings more rapidly, take advantage of acquisitions and other opportunities more readily, achieve greater economies of scale, and devote greater resources to the marketing and sale of their products than they do. Our failure to compete effectively may reduce our revenues, profitability and cash flow, and pricing pressures may adversely impact our profitability.

 

Cyclical economic conditions may adversely affect our financial condition and results of operations or our growth rate could decline if the markets into which we sell our products decline or do not grow as anticipated.

 

Our products are sold in industries and end-user applications that have historically experienced periodic downturns, such as automotive, aerospace, paper, job shops and stone and tile. Cyclical weaknesses in the industries that we serve have led and could continue to lead to a reduced demand for our products and adversely affect our financial condition and results of operations. Any competitive pricing pressures, slowdown in capital investments or other downturn in these industries could adversely affect our financial condition and results of operations in any given period. Additionally, visibility into our markets is limited. Our quarterly sales and operating results depend substantially on the volume and timing of orders received during the quarter, which are difficult to forecast. Any decline in our customers’ markets would likely result in diminished demand for our products and services and would adversely affect our growth rate and profitability.

 

There are no unresolved comments that were received from the SEC staff relating to our periodic or current reports under the Securities Exchange Act of 1934 as of April 30, 2010.

 

 

We occupied approximately 362 thousand square feet of floor space on April 30, 2010 for manufacturing, warehousing, engineering, sales offices, and administration, of which approximately 58% was located in the United States.

 

The following table provides a summary of the floor space by segment:

 

 

We have operations at the following locations:

 

 

We believe that our principal properties are adequate for our present needs and, supplemented by planned improvements, expect them to remain adequate for the foreseeable future.

 

 

Refer to Note 13 — Commitments and Contingencies of the Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data for a summary of legal proceedings.

 

 

 

Market Information

 

Our stock is traded on the NASDAQ Stock Market under the symbol “FLOW”. The range of high and low sales prices for our common stock for the last two fiscal years is set forth in the following table.

 

Holders of the Company’s Common Stock

 

As of June 22, 2010, there were approximately 1,004 holders of record of our common stock.

 

Dividends

 

We have not paid dividends to common shareholders in the past. Our Board of Directors intends to retain future earnings, if any, to finance development and expansion of our business and reduce debt and does not expect to declare dividends to common shareholders in the near future. Our ability to pay cash dividends is restricted under our senior Credit Facility Agreement. Refer to Note 11 — Long-Term Obligations and Notes Payable to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, for further discussion on this credit facility.

 

Issuer Purchases of Equity Securities

 

None.

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

Information about the Company’s equity compensation plans as of April 30, 2010 is as follows:

 

 

For more detailed information regarding the Company’s equity compensation plans, refer to Note 15 — Stock-based Compensation to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data.

Comparison of Five-Year Cumulative Total Shareholder Return*

 

The graph below compares the cumulative 5-year total return of holders of our common stock with the cumulative total returns of the S&P Smallcap 600 index, the NASDAQ Composite index, and the Dow Jones US Industrial Machinery index.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Flow International Corporation, The S&P Smallcap 600 Index.
The NASDAQ Composite Index And The Dow Jones US Industrial Machinery Index

 

 

 

 

Performance Graph Assumptions

 

 

Recent Sales of Unregistered Securities

 

None.

 

The following selected consolidated financial data should be read in conjunction with our audited consolidated financial statements, the related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations, which are included in this Annual Report on Form 10-K.

 

 

 

 

 

In this discussion and analysis, we discuss and explain our financial condition and results of operations, including:

 

 

As you read this discussion and analysis, refer to our Consolidated Statements of Operations included in Item 8 — Financial Statements and Supplementary Data, which presents the results of our operations for the respective years ended April 30, 2010, 2009 and 2008. We analyze and explain the differences between the periods in the specific line items of our Consolidated Statements of Operations. This discussion and analysis has been organized as follows:

 

 

Certain other statements in Management’s Discussion and Analysis are forward-looking as defined in the Private Securities Litigation Reform Act of 1995. Our ability to fully implement our strategies and achieve our objective may be influenced by a variety of factors, many of which are beyond our control. These risks and uncertainties pertaining to our business are set forth in Part  I, Item 1A — Risk Factors.

 

Executive Summary

 

Overview and Outlook

 

We are a technology-based global company whose objective is to deliver profitable dynamic growth by providing technologically advanced waterjet cutting, surface preparation and cleaning systems to our customers. To achieve this objective, we offer versatile waterjet cutting and industrial cleaning systems and we strive to expand market share in our current markets; continue to identify and penetrate new markets; capitalize on our customer relationships and business competencies; develop and market innovative products and applications; continue to improve operating margins by focusing on operational improvements; and pursue additional channels and partners for distribution.

 

In fiscal year 2010, we continued certain activities in order to operate effectively in a challenging economy while maintaining our strategic objective to solidify our leadership position in our industry and positioning ourselves to take advantage of market opportunities when we exit the recession by:

 

 

 

Actions in support of our strategic objective in fiscal year 2010 included the following:

 

Repositioning our Products, Investing in New Products, and Enhancing Global Customer Access through Indirect Sales Channel

 

 

Cost Reduction Initiatives and Manufacturing Realignment

 

 

Appropriate Capital Structure and Use of Funds to Invest in the Business

 

 

We will continue to focus strongly on working capital management and cash flow generation. In addition, while we will continue to invest in our business, it will be limited to a few specific strategic initiatives. These efforts may result in additional resources to provide flexibility in the event of a prolonged economic downturn. We anticipate that the initiatives taken above, in addition to the continued implementation of our long-term strategy, will enable us to emerge as a stronger and more viable company when we exit the recession.

 

Matters Affecting Comparability

 

The following events occurred in the respective years ended April 30, 2010, 2009 and 2008, which we believe impact the comparability of our results of operations:

 

Restructuring and Other Operating Charges

 

We implemented certain initiatives to improve our cost structure, better utilize overall capacity and improve general operating efficiencies. During the respective years ended April 30, 2010 and 2009, we recorded charges of $1.0 million and $3.1 million related to these restructuring activities.

 

Further in fiscal year 2009, under ASC 805, “Business Combinations”, we expensed $3.8 million of previously deferred direct transaction costs which had been capitalized as part of the contemplated acquisition cost of OMAX as it was deemed probable that the contemplated merger with OMAX would not close prior to the adoption of ASC 805 on May 1, 2009.

 

Provision for Patent Litigation and Termination of OMAX Merger Agreement.

 

In March 2009, we simultaneously entered into the following two agreements with OMAX:

 

(1) A Settlement and Cross License Agreement (the “Agreement”) where both parties agreed to dismiss the litigation pending between them and release all claims made up to the date of the execution of the Agreement. We agreed to pay $29 million to OMAX in relation to this agreement which was funded as follows:

 

 

(2) An amendment to the existing Merger Agreement which provided for the following:

 

 

We recorded a $29 million provision related to the settlement of this patent litigation, pursuant to the terms of the Settlement and Cross Licensing Agreement, in fiscal year 2009.

 

In fiscal year 2010, we terminated our option to acquire OMAX following a thorough investigation of financing alternatives to complete the merger and unsuccessful attempts to negotiate a lower purchase price

with OMAX. Pursuant to the terms of the amended Merger Agreement and the Settlement and Cross Licensing Agreement, the $15 million held in escrow was released to OMAX. We recorded a $6 million charge pursuant to the provisions of the amended Merger Agreement in the first quarter of fiscal year 2010, net of a $2.8 million discount as the two subordinated notes issued to OMAX were at a stated interest rate of 2%, which is below our incremental borrowing rate. This discount is being amortized as interest expense through the maturity of the subordinated notes in August 2013.

 

Goodwill Impairment Charges

 

Our results in fiscal year 2009 included a non-cash goodwill impairment charge of $2.8 million, which represented the carrying value of all of our goodwill at the time of impairment. This charge was recognized due to a combination of factors, including the current economic environment which had resulted in a significant decline in the results of our operations and the sustained period of decline in our market capitalization.

 

Discontinued Operations

 

In fiscal year 2009, we were notified by the purchaser of our Avure Business (“Purchaser”), which was reported as a discontinued operation for the year ended April 30, 2006, that the Swedish Tax Authority was conducting an audit which included periods during the time that we owned the subsidiary. Pursuant to an agreement with the Purchaser, we had made commitments to indemnify various liabilities and claims, including any tax matters when it owned the business. The Swedish tax authority concluded its audit and issued a final report in November 2009 asserting that Avure owes 19.5 million Swedish Krona in additional taxes, penalties and fines. In April 2010, we filed an appeal to contest the findings by the Swedish Tax Authority. While we intend to continue contesting the findings, an equivalent of $1.2 million was accrued in fiscal year 2010 related to the periods during which we owned Avure. This amount was accounted for as an adjustment to the loss on the disposal of the Avure Business and is reported as a charge to discontinued operations in our Consolidated Statement of Operations.

 

In fiscal year 2009, we shut down our CIS division, which provided technical services to improve the productivity of automated assembly lines and would have been reported as part of our Advanced segment. Accordingly, we recast all periods presented to reflect this division’s results as discontinued operations.

Results of Operations

 

Consolidated

 

 

 

bpts = basis points

 

NM = not meaningful

 

 

 

NM = not meaningful

 

Fiscal year 2010 compared to fiscal year 2009

 

The sales decrease of $36.4 million or 17% was primarily due to reduced global demand for our products and services across most geographies compared with fiscal year 2009, most notably in North America and Europe. The continued uncertainty in the global economy and increased credit constraints severely limited our customers’ purchasing power causing delayed capital spending and expansion plans. In particular, we experienced significant sales volume declines in our Standard systems and consumable parts which had a combined revenue decline of $49 million or 45% in the first half of the year with North America and Europe representing $39.4 million of this decline. These declines were partially offset by improved sales of $11.2 million in our Advanced segment during the same period. During the second half of the year, we experienced a modest rebound in Standard system and consumable parts sales. Excluding the impact of foreign currency changes, consolidated sales decreased by $38 million or 18% compared to the prior year.

Our gross margin percentage decreased by 300 basis points in fiscal year 2010 to 39% compared to 42% in fiscal year 2009. The decrease was primarily attributable to lower fixed-cost absorption and inefficiencies due to reduced production rates particularly during the first half of fiscal year 2010. Further, Advanced segment sales, which are generally at lower gross profit margins, constituted a higher percentage of total sales. The decrease in gross margin percentage was partially offset by our cost reduction efforts and streamlining of our manufacturing processes.

 

Selling, general and administrative expenses decreased by $8.8 million or 11% to $70.5 million in fiscal year 2010. The decrease was primarily related to successful cost reduction initiatives implemented in fiscal year 2010 and lower commissions driven by the lower full-year sales volume, partially offset by higher depreciation expense related to our Enterprise Resource Planning (“ERP”) system.

 

During fiscal year 2010, we continued our restructuring activities, which included reducing our global workforce and the consolidation of our manufacturing operations. As a result, we recorded $1.6 million in restructuring charges which were partially offset by a $600,000 gain from the sale of our building in Hsinchu, Taiwan. Comparative prior year charges of $3.1 million included severance and termination charges, inventory impairment charges and contract termination charges associated with the shutdown of our Canadian, Korean and Taiwan operations.

 

As noted in the “Matters Affecting Comparability” section above, we recorded a net charge of $3.2 million in fiscal year 2010 to record the termination of our option to acquire OMAX following a thorough investigation of financing alternatives to complete the merger and unsuccessful attempts to negotiate a lower purchase price with OMAX.

 

Fiscal year 2009 compared to fiscal year 2008

 

Despite the weak macroeconomic conditions in North America as we entered into fiscal year 2009, our consolidated systems sales remained consistent with the prior year during the first half of the year. However, during the second half of the fiscal year, we experienced a significant decline in system sales as a result of global recession, primarily in North America and Europe with sales down by $30.2 million or 32% in these two geographies. Consolidated consumable parts sales increased by $2.2 million or 7% in the first half of the fiscal year primarily as a result of the continued increase in our installed base of systems but declined by $6.0 million or 17% in the latter half of the fiscal year due to lower capacity utilization in our customers’ operations. These declines were slightly offset by improved sales of a combined $2.5 million in the rest of our geographies. Excluding the impact of foreign currency changes, consolidated sales decreased by $33.8 million or 14% versus fiscal year 2008.

 

Our gross margin percentage in fiscal year 2009 was consistent with fiscal year 2008.

 

Selling, general and administrative expenses decreased by $5.6 million or 7% to $79.3 million in fiscal year 2009. The decrease was mainly as a result of successful cost reduction initiatives undertaken in fiscal year 2009 as well as lower performance awards expense in fiscal year 2009.

 

During fiscal year 2009, we adjusted our manufacturing footprint from four factories to two, exited two unprofitable business, and reduced our global headcount by 20%. We expensed $3.1 million related to severance and termination charges, inventory impairment charges and contract termination charges associated with these actions.

 

As noted in the “Matters Affecting Comparability” section above, we settled outstanding patent litigation with OMAX in fiscal year 2009, removing a potential long-term risk. We recorded a charge of $29 million related to record this settlement. Further, in fiscal year 2009, under ASC 805, “Business Combinations”, we expensed $3.8 million of previously deferred direct transaction costs which had been capitalized as part of the contemplated acquisition cost of OMAX as it was deemed probable that the contemplated merger with OMAX would not close prior to the adoption of the new guidance on May 1, 2009.

Segment Results of Operations

 

We report our operating results to the chief operating decision maker based on market segments which is consistent with management’s long-term growth strategy. Our reportable segments are Standard and Advanced. The Standard segment includes sales and cost of sales related to our cutting surface preparation and cleaning systems using ultrahigh-pressure water pumps as well as parts and services to sustain these installed systems. Systems included in this segment do not require significant custom configuration. The Advanced segment includes sales and cost of sales related to our complex aerospace and automation systems which require specific custom configuration and advanced features to match unique customer applications as well as parts and services to sustain these installed systems. Segment results in fiscal year 2010 were measured based on revenue growth and gross margin. Previously, segment operating results were measured based on revenue growth, gross margin and operating income (loss). We have revised prior period comparable segment presentation to reflect this change in measurement of segment results by our chief operating decision maker.

 

This section provides a comparison of net sales and gross margin for each of our reportable segments for the last three fiscal years. For further discussion on our reportable segments, refer to Note 17 — Business Segments and Geographic Information of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data.

 

Standard Segment

 

 

 

bpts = basis points

 

Fiscal year 2010 compared to fiscal year 2009

 

Sales in our Standard segment decreased $43.6 million or 24% over the prior year. This decline was primarily due to significant standard system sales volume decline in North America and Europe, which were the markets affected the most by the global recession. These two regions had a combined decline in system sales of $29.0 million or 32% in fiscal year 2010 when compared to the prior year. Consumable parts revenue for this segment also declined by $6.2 million or 13% in fiscal year 2010 due to lower system utilization by our customers. Excluding the impact of foreign currency changes, sales in the Standard segment declined $45.3 million or 25% in fiscal year 2010 compared to the prior year.

 

Gross margin in fiscal year 2010 was $56.1 million or 41% compared to $79.9 million or 44% in the prior year. Generally, comparison of gross margin rates in this segment will vary period over period based on changes in our product sales mix and prices, and levels of production volume. The 300 basis point decline in our margins in fiscal year 2010 was primarily attributable to a greater mix of lower margin systems versus the prior year as well as lower fixed-cost absorption and inefficiencies due to lower production rates particularly during the first half of the current fiscal year.

 

Fiscal year 2009 compared to fiscal year 2008

 

Sales in our Standard segment decreased $34.9 million or 16% over the prior year. This decline is primarily due to significant standard system sales volume declines in North America and Europe which are the markets affected the most by the recession. These two regions had a combined decline in system sales of $35.5 million or 28% for year ended April 30, 2009 over the prior year. This decline was offset by a $4.1 million or 19% increase in combined sales in South America and Asia Pacific regions in fiscal year 2009, due to continued strong demand for our standard shapecutting systems in those markets. Consumable parts

revenue for this segment also declined by $2.0 million in fiscal 2009. Excluding the impact of foreign currency changes, sales in the Standard segment declined $32.8 million or 15% in fiscal year 2009 compared to fiscal 2008.

 

Gross margin in fiscal year 2009 was $79.9 million or 44% compared to $96.8 million or 45% in the prior year. Generally, comparison of gross margin rates will vary period over period based on changes in our product sales mix and prices, and levels of production volume. The 100 basis point decline in our margins in fiscal year 2009 was primarily attributable to a greater mix of lower margin systems versus fiscal 2008.

 

Advanced Segment

 

In fiscal year 2009, we shut down our CIS Technical Solutions division (“CIS division”) which provided technical services to improve the productivity of automated assembly lines. Technical services provided included robot programming, process improvement, systems integration and production support which sales and related expenses would have been presented as part of our Advanced segment. The results of this segment have been presented as discontinued operations for the respective years ended April 30, 2009 and 2008.

 

 

 

bpts = basis points

 

Fiscal year 2010 compared to fiscal year 2009

 

Sales in the Advanced segment will vary period over period for various reasons, such as the timing of contract awards, timing of project design and manufacturing schedule, and the timing of shipments to customers.

 

In fiscal year 2010, sales in our Advanced segment increased by $7.3 million or 25%. This increase was primarily due to the timing of revenue recognition for some significant aerospace contracts which were in the project design phase during the first half of fiscal 2009. As of April 30, 2010, our Advanced segment backlog was $21.9 million. We anticipate the continued realization of this backlog in fiscal year 2011 and beyond. However, based on the timing of contract awards and project design, we expect a sequential decline in Advanced segment revenue in fiscal year 2011 as we work through some significant aerospace contracts. Backlog includes firm orders for which written authorizations have been accepted and revenue has not yet been recognized.

 

Gross margin in fiscal year 2010, amounted to $11.7 million or 32% compared to $8.5 million or 29% of sales in the prior year. The improvement in gross margin as a percentage of sales when compared to the prior year was attributable to improved contract pricing as well as continued labor and material efficiencies from consolidating the manufacturing for all our advanced systems in our Jeffersonville, Indiana facility.

 

Fiscal year 2009 compared to fiscal year 2008

 

In fiscal year 2009, sales in our Advanced segment increased by $775,000 or 3%. This increase was primarily due to the timing of revenue recognition for some of our aerospace contracts as well as comparatively higher projects in fiscal year 2009.

 

Gross margin in fiscal year 2009, amounted to $8.5 million or 29% compared to $4.9 million or 18% of sales in the prior year. The improvement in gross margin as a percentage of sales when compared to the prior

year was attributable to improved contract pricing and labor efficiencies from consolidating the manufacturing for all our advanced systems in our Jeffersonville, Indiana facility.

 

Selling, General and Administrative Expenses

 

 

Fiscal year 2010 compared to fiscal year 2009

 

Our consolidated operating expenses decreased by $8.8 million or 11% when compared to fiscal year 2009. This decrease was primarily as a result of the following:

 

 

These reductions were offset by an increase in costs related to depreciation expense for our new ERP system which was placed into service in October 2009.

 

Looking forward into fiscal 2011, we anticipate that our selling general and administrative expenses will increase as we record a full year of depreciation expense related to our ERP system. Further, we have restored some of the temporary wage reductions and suspended benefits, which will also negatively impact gross margin and increase selling, general, and administrative expenses as compared to fiscal year 2010.

 

Fiscal year 2009 compared to fiscal year 2008

 

Our consolidated selling, general and administrative expenses decreased by $5.6 million or 7% when compared to fiscal year 2008. This decrease was primarily as a result of the following:

 

 

Other (Income) Expense

 

Interest Income and Interest Expense

 

 

 

NM = not meaningful

 

Our interest income was $252,000, $494,000, and $780,000 for the respective years ended April 30, 2010, 2009 and 2008. The sequential declines in fiscal years 2010 and 2009 were mainly the result of lower average cash balances and interest rates on highly liquid cash and cash equivalents. Additionally, we wrote off $114,000 of accrued interest due from the Purchaser of Avure following an agreement with the Purchaser in fiscal year 2009 that only the principal amount on the note outstanding from the sale of the Avure Business would be paid to us.

 

The major components of our interest expense are amortization of deferred financing charges, interest charged on our outstanding standby letters of credit and our revolving lines of credit, and the amortization of imputed interest on our Subordinated Notes to OMAX. The increase in interest expense over fiscal 2009 is primarily due to imputed interest of $735,000 related to the two Subordinated Notes issued to OMAX. Interest charged on outstanding balances on our Senior Credit Facility as well on outstanding standby letters of credit was comparable to fiscal year 2009.

 

The increase in interest expense in fiscal year 2009 when compared to fiscal year 2008 was attributable to the following:

 

 

Other Income (Expense), Net

 

Our Other Income (Expense), net in the Consolidated Statement of Operations is comprised of the following:

 

 

 

NM = Not Meaningful

During the year ended April 30, 2010, we recorded Other Expense, net of $1.1 million, compared to Other Expense, net of $614,000 and $1.8 million for the respective years ended April 30, 2009 and 2008. During fiscal year 2010, we recorded a $1.3 million foreign currency translation adjustment related to the liquidation of two dormant subsidiaries as a realized foreign exchange loss. This non-cash charge was previously recorded as an unrealized foreign exchange loss in our currency translation account as a component of other comprehensive income. In the fourth quarter of fiscal year 2009, management determined that payment of certain intercompany balances by its foreign subsidiaries would not be required in the foreseeable future. Accordingly, we began to recognize gains and losses related to these intercompany balances whose settlement was not planned or anticipated in the foreseeable future as a component of other comprehensive income which accounts for the majority of the comparative change in its unrealized net foreign exchange losses from fiscal year 2010 to fiscal year 2009. The remainder of the changes in other income and expense primarily resulted from fluctuations in realized and unrealized foreign exchange gains and losses on revaluation of third party and intercompany settled and unsettled balances whose payment is anticipated in the foreseeable future.

 

Miscellaneous income in fiscal year 2009 included royalty income of $418,000, net of settlement costs of $500,000, from the license of certain patents and $318,000 from a stockholder in settlement of a claim under Section 16(b) of the Exchange Act.

 

In fiscal year 2008, we repurchased 403,300 warrants from certain funds managed or advised by Third Point LLC for an aggregate purchase price of $3 million. The cash paid in excess of the fair market value of those warrants on the repurchase date of $629,000 was recorded as Other Expense.

 

Income Taxes

 

Our (benefit)/provision for income taxes for our continuing operations over the last three years consisted of:

 

 

We recognize a net deferred tax asset for items that will generate a reduction in future taxable income to the extent that it is “more likely than not” that these deferred assets will be realized. A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. The ultimate realization of deferred tax assets depends on the generation of future taxable income during the period in which the tax benefit will be realized. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which the tax benefit will be realized. In determining the realizability of these assets, we considered numerous factors, including historical profitability, estimated future taxable income and the industry in which we operate. In fiscal year 2008, we reversed approximately $17.2 million and $1 million of valuation allowance against deferred tax assets related to U.S. and Germany net operating loss (NOL) carryforwards and other net deferred tax assets, respectively, after concluding that it was more likely than not that these benefits would be realized based on cumulative positive results of operations and anticipated future profit levels. For the fiscal year ended April 30, 2010 we concluded that, after evaluation of all available evidence, we anticipate generating sufficient future taxable income to realize the benefits of our U.S. and German deferred tax assets. As part of this evaluation we considered the impact of the global economic downturn on our business. While our business declined as a result of this downturn, we saw an upward trend in our business during the second half of the current fiscal year. Currently, the positive evidence we evaluated exceeds the negative evidence and supports our conclusion that it is more likely than not that these deferred assets will be realized. If, in the future, the negative evidence were in excess of the positive evidence our conclusion regarding the realizability of the benefit of our deferred tax assets would change. At April 30, 2010, the recorded amount of our deferred tax assets was $23.9 million, net of valuation allowance on certain foreign NOLs.

Our foreign tax provision consists of current and deferred tax expense. The United States tax provision consists of current and deferred tax expense (benefit), state taxes and foreign withholding taxes. With the exception of certain of our subsidiaries, it is our general practice and intention to reinvest the earnings of our non-U.S. subsidiaries in those operations. As of April 30, 2010, we had not made a provision for U.S. or additional foreign withholding taxes of the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries with the exception of our subsidiaries in Taiwan, Japan, and Switzerland for which we provide deferred taxes. During fiscal year 2010, we repatriated a total of $192,000, net of tax of $38,000 from one foreign subsidiary, and we plan to continue repatriating additional funds from this subsidiary in the future.

 

In fiscal year 2009, the foreign tax provision consisted of current and deferred tax expense. The United States tax provision consisted primarily of federal alternative minimum tax, state taxes, and accrued foreign withholding taxes. We recorded a $304,000 liability for withholding taxes payable on future repatriation of foreign earnings in fiscal year 2009. In fiscal year 2009, we repatriated $1.6 million, net of tax of $329,000 from two foreign subsidiaries.

 

In fiscal year 2008, the foreign tax provision consisted of current and deferred tax expense. The United States tax provision consisted primarily of federal alternative minimum tax, state taxes, and accrued foreign withholding taxes. We recorded a $304,000 liability for withholding taxes payable on future repatriation of foreign earnings in fiscal year 2009. In fiscal year 2009, we repatriated $9.8 million, net of tax of $885,000 from two foreign subsidiaries.

 

Liquidity and Capital Resources

 

Sources of Cash

 

Historically, our most significant sources of financing have been funds generated by operating activities, available cash and cash equivalents and available lines of credit. From time to time, we have borrowed funds from our available revolving credit facility and have raised funds through the sale of common stock.

 

Cash Generated by Operating Activities

 

Cash generated by operating activities was $3.8 million for year ended April 30, 2010, compared to a use of cash of $6.5 million in the year ended April 30, 2009. Cash generated by or used in operating activities is primarily related to changes in our working capital accounts. Changes in our working capital resulted in a net $2.8 million use of cash for the year ended April 30, 2010 compared to $23.3 million use of cash for the year ended April 30, 2009. The change in working capital was attributable to changes in accounts payable due to the timing of purchases and payments to vendors, deferred revenue and customer deposits due to the timing of contract awards and shipments to customers, as well as the timing of inventory purchases and collection of accounts receivable. Further, fiscal year 2009 use of cash included a cash payment of $8 million to OMAX to fund a portion of the patent litigation settlement.

 

Available Cash and Cash Equivalents

 

At April 30, 2010 we had total cash and cash equivalents of $6.4 million. To the extent that our cash needs in the U.S. exceed our cash reserves and availability under our Senior Credit Facility, we may repatriate cash from certain of our foreign subsidiaries, however, this could be limited by our ability to repatriate such cash in a tax efficient manner. We believe that our existing cash and cash equivalents as of April 30, 2010, anticipated revenue and funds generated from our operations, and financing available under our existing credit facilities will be sufficient to fund our operations for at least the next twelve months. However, in the event that there are changes in our expectations or circumstances, we may need to raise additional funds through public or private debt or sale of equity to fund our operations.

 

In the first quarter of fiscal year 2010, we filed a registration statement on Form S-3 filed with the SEC covering the offer and sale, at our discretion, of up to $35 million in common and preferred stock, warrants, and units. This registration statement was declared effective by the SEC in July 2009. In September 2009, we

completed a public offering of 8,998,750 common shares at an offering price of $2.10 per share, generating net proceeds of approximately $17.2 million after deducting underwriting commissions and estimated offering expenses. The proceeds from this offering were used to reduce a significant portion of our outstanding debt, including outstanding amounts under our Senior Credit Facility.

 

Refer to Part I, Item 1A — Risk Factors for a discussion of the risks and uncertainties pertaining to our business and industry.

 

Credit Facilities and Debt

 

On June 10, 2009, we amended our $40 million Senior Credit Facility Agreement which modified the maturity date of the line to June 10, 2011 as well as certain covenants that we are required to maintain.

 

In connection with our sale of common stock (refer to Note 14 — Shareholders’ Equity of the Notes to the Condensed Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data), we further amended our Senior Credit Facility Agreement in August 2009, which adjusted the financial covenants that we are required to maintain. The amendment eliminated the requirement to maintain a minimum Consolidated Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) based on trailing four quarters of $8 million. Under the amended covenants, we were required to maintain the following ratios in each of the fiscal year 2010 quarters:

 

 

In fiscal year 2011, we will be required to maintain the following ratios:

 

 

 

 

The revised covenants also require us to meet a liquidity test such that our consolidated indebtedness shall not exceed the total of 65% of the book value of our accounts receivable and 40% of the book value of our inventory.

 

A violation of any of the covenants above would result in event of default and accelerate the repayment of all unpaid principal and interest and the termination of any letters of credit.

 

Our leverage ratio and fixed charge coverage ratio were 0.86 and 3.3 for the quarter ended April 30, 2010. Our consolidated indebtedness did not exceed the total of 65% of the book value of our accounts receivable and 40% of the book value of our inventory. Our calculations of these financial ratios are reported in Exhibit No. 99.1 of this Annual Report on Form 10-K. We were in compliance with all our financial covenants as of April 30, 2010, as amended. As of April 30, 2010, the balance outstanding under the Senior Credit Facility Agreement amounted to $350,000 which is reflected under Notes Payable in the Consolidated Financial Statements.

 

We expect to be in compliance with our covenants pursuant to the Senior Credit Facility Agreement for at least the next twelve months. However, in the event that there is a possibility of default, we may institute

additional cost reductions; raise additional funds through public or private debt or sale of equity; possibly seek further amendments to our Senior Credit Facility Agreement or a combination of these items. Refer to Part I, Item 1A — Risk Factors for discussion of the risks and uncertainties pertaining to our business and industry.

 

All of our domestic assets, including certain interests of some foreign subsidiaries, are pledged as collateral under our Senior Credit Facility Agreement. Interest on the Line of Credit is based on the bank’s prime rate or LIBOR rate plus a percentage spread between 3.25% and 4.5% depending on whether we use the bank’s prime rate or LIBOR rate and based on our current leverage ratio. We also pay an annual letter of credit fee equal to 3.5% of the amount available to be drawn under each outstanding stand-by letter of credit. The annual letter of credit fee is payable quarterly in arrears and varies depending on our leverage ratio.

 

As of April 30, 2010, we had $35.0 million available under our Line of Credit, net of $350,000 drawn against the Line of Credit, bearing interest at 5.25% per annum, and $4.6 million in outstanding letters of credit which reduce amounts available under the Senior Credit Facility Agreement. As of April 30, 2010, based on our maximum allowable leverage ratio, the incremental amount we could have borrowed under our Lines of Credit would have been approximately $14.5 million.

 

There were no outstanding balances under our unsecured Taiwan credit facilities as of April 30, 2010. The total unsecured commitment for the Taiwan credit facilities totaled $2.8 million at April 30, 2010, bearing interest at 2.5% per annum.

 

As of April 30, 2009, we had an outstanding seven-year long-term variable rate loan of $1.9 million, expiring in 2011, bearing interest at an annual rate of 3.67%. The loan was collateralized by our building in Taiwan. The outstanding balance on this loan was fully paid off in fiscal year 2010 with no prepayment penalty charges.

 

Other Sources of Cash

 

In addition to cash and cash equivalents, cash from operations and cash available under our credit facilities, we may also generate cash from the exercise of stock options. There were no option exercises in each of the respective years ended April 30, 2010, 2009 and 2008.

 

In September 2009, we consummated the sale of our building in Hsinchu, Taiwan for $4.7 million and simultaneously entered into an asset lease agreement for an insignificant portion of the building which was treated as an operating lease. This sale concluded our efforts to consolidate our manufacturing activities. We generated net cash proceeds of approximately $600,000 from the sale of the building, after paying off closing costs, the outstanding balances on the two unsecured credit facilities in Taiwan, and the outstanding mortgage, which aggregated to $4.1 million as of April 30, 2009.

 

Uses of Cash

 

Capital Expenditures

 

Our capital spending plans currently provide for outlays ranging from approximately $4 million to $6 million over the next twelve months, primarily related to the completion of Enterprise Resource Planning system and other information technology related projects as well as patent and trademark maintenance. It is expected that funds necessary for these expenditures will be generated internally or from available financing. To the extent that funds cannot be generated through operations or we are unable to obtain financing on reasonable terms, we will reduce our capital expenditures accordingly. Our capital spending for the each of the respective years ended April 30, 2010, 2009 and 2008 amounted to $10.0 million, $8.9 million and $6.3 million. Capital expenditures primarily consist of investments in our Enterprise Resource Planning system, and information technology infrastructure and enhancements to our manufacturing facilities to improve efficiency.

 

Other Strategic Investments

 

In fiscal year 2009, we entered into an equity purchase agreement in which we acquired a minority interest in Dardi International (“Dardi”), a waterjet manufacturer based in China, for $2 million in cash.

Additionally, we incurred $1.7 million in direct costs attributed to the acquisition. We accounted for the $3.7 million investment in Dardi using the cost method. This investment has been classified as an Other Long-Term Asset on the Consolidated Balance Sheet.

 

As discussed above, we made the decision to terminate our option to acquire OMAX in fiscal year 2010 following a thorough investigation of financing alternatives to complete the merger and unsuccessful attempts to negotiate a lower purchase price. Refer to Note 18 — Provision for Patent Litigation and Termination of OMAX Merger Agreement of the Notes to the Condensed Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data for further details on the contemplated merger with OMAX including the execution of a Settlement and Cross Licensing Agreement with OMAX for $29 million payable to OMAX, of which $23 million had been funded as of April 30, 2009.

 

Repayment of Debt and Notes Payable

 

Our total repayment of debt and notes payable were $37.7 million, $3.3 million and $7.5 million for the respective years ended April 30, 2010, 2009 and 2008.

 

Repurchase of Warrants

 

In fiscal year 2008, in a privately negotiated transaction, we purchased from certain funds managed or advised by Third Point LLC (collectively, “Third Point”) outstanding warrants that gave Third Point the right until March of 2010 to purchase 403,300 of our common stock at an exercise price of $4.07 per share (the “Warrants”). Third Point purchased the Warrants, together with shares of common stock, in our March 2005 Private Investment Public Equity transaction (the “PIPE Transaction”). The Warrants were repurchased from Third Point in connection with a previously announced program to repurchase up to $45 million of the Company’s securities. The Warrants were repurchased at a price of $7.43 per Warrant for an aggregate purchase price of $3 million.

 

Disclosures about Contractual Obligations and Commercial Commitments

 

The following table summarizes our known future payments pursuant to certain contracts as of April 30, 2010 and the estimated timing thereof. More detail about our contractual obligations and commercial commitments are in Note 11 — Long-term Obligations and Notes Payable and Note 13 — Commitments and Contingencies of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data.

 

 

 

Off-Balance Sheet Arrangements

 

As of April 30, 2010, the Company had no off-balance sheet arrangements.

 

Critical Accounting Estimates

 

Our discussion and analysis of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make certain assumptions and estimates about future events, and apply judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements. We base our assumptions, estimates, and judgment on historical experience, current trends and other factors which management believes to be relevant and appropriate at the time our consolidated financial statements are prepared. On a regular basis, management reviews its assumptions, estimates, and judgments to ensure that our consolidated financial statements are presented fairly. However, because future events cannot be determined with certainty, actual results may differ from our assumptions and estimates, and such differences could be material.

Our significant accounting policies are summarized in — Note 1 — The Company and Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data. Management identifies its most critical accounting policies as those that are the most pervasive and important to the portrayal of the Company’s financial position and results of operations, and that require the most difficult, subjective and/or complex judgments by management regarding estimates that are inherently uncertain.

 

 

Impairment of Long Lived Assets

 

We routinely consider whether indicators of impairment of our property and equipment assets, particularly our manufacturing equipment, are present. Factors we consider include, but are not limited to, significant underperformance relative to historical or projected operating results; significant changes in the manner of use of long-lived assets or the strategy for the overall business; and significant negative industry or economic trends. If such indicators are present, we determine whether the sum of the estimated undiscounted cash flows attributable to the asset group in question is less than their carrying value. For purposes of impairment testing, long-lived assets are grouped at the component level, which for us is by regional locations, as this is the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If the sum of the undiscounted cash flows attributable to the asset group is less than the carrying value of the asset group, an impairment loss is recognized based on the excess of the carrying value of the asset group over its respective fair value. Fair value is determined by discounting estimated future cash flows, appraisals or other methods deemed appropriate. If the asset group determined to be impaired is to be held and used, we recognize an impairment charge to the extent the present value of anticipated net cash flows attributable to the asset group is less than the assets’ carrying value. The fair value of the assets then becomes the assets’ new carrying value, which is depreciated over the remaining estimated useful life of the assets.

We concluded that there were no long-lived assets impairment indicators in each of the fiscal years ended April 30, 2010 and 2008. We will continue to monitor circumstances and events in future periods to determine whether asset impairment testing is warranted based on the existence of one or more of the above impairment indicators.

 

Based on a combination of factors, including the economic environment which resulted in a significant decline in the results of our operations and a sustained period of decline in our market capitalization, we recorded a goodwill impairment charge of $2.8 million in fiscal year 2009. In connection with these triggering events for goodwill, we reviewed our long-lived assets during fiscal year 2009 and determined that none of our long-lived asset groups were impaired. The determination was based on reviewing estimated undiscounted cash flows for our asset groups.

 

When an undiscounted cash flow assessment is performed, as was the case in fiscal year 2009, the evaluation of the recoverability of long-lived assets requires us to make significant estimates and assumptions. The principal assumptions utilized in our fiscal year 2009 estimated undiscounted cash flows for long-lived assets include (a) revenue growth rates ranging from -10% to 10% and (b) operating profit ranging from -5% to 15%. For this analysis, negative revenue and operating profit growth rates were considered in the near term for certain asset groups based on current economic conditions present at the time the impairment assessment was performed. Revenue growth rate and operating profit assumptions are consistent with those utilized in our operating plan and long-term financial planning process. Methodologies used for valuing our long lived assets have not changed from prior periods.

 

A 10% change in the estimates and assumptions used to calculate the estimated undiscounted cash flows, which is a reasonable change in our assumptions, did not result in a shortfall of the sum of the estimated undiscounted cash flows against carrying value for any of our asset groups tested for impairment.

 

Valuation of Deferred Tax Assets and Uncertain Tax Positions

 

We account for uncertain tax positions in accordance with ASC 740 which utilizes a two-step approach for evaluating tax positions. Recognition (Step 1) occurs when an enterprise concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination. Measurement (Step 2) is only addressed if Step 1 has been satisfied. Under Step 2, the tax benefit is measured at the largest amount of benefit, determined on a cumulative probability basis that is more likely than not to be realized upon settlement. As used in ASC 740, the term “more likely than not” means that the likelihood of an occurrence is greater than 50%. To the extent that we prevail in matters for which unrecognized tax benefits have been established, or are required to pay amounts in excess of our unrecognized tax benefits, our effective tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would require the use of our cash and would result in an increase to our effective income tax rate in the period of resolution. A favorable tax settlement would be recognized as a reduction in our effective income tax rate in the period of resolution.

 

Our annual effective tax rate is based on income, statutory tax rates and tax planning strategies available in various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating tax positions. Tax positions are reviewed quarterly and balances are adjusted as new information becomes available. Deferred income tax assets and liabilities are recognized for the estimated future tax consequences attributable to temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. These assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to reverse. Future tax benefits of tax losses and credit carryforwards are recognized to the extent that realization of these benefits is considered more likely than not. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence including our past operating results, the existence of cumulative net operating losses in the most recent years and our forecast of future taxable income. In estimating future taxable income, we develop assumptions including the amount of future federal, state and foreign pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant

judgment about the forecasts of future taxable income and are consistent with the plans and estimates we use to manage our business.

 

As of April 30, 2010, we had approximately $57.4 million of domestic net operating loss and $38.8 million of state net operating loss carryforwards to offset certain earnings for federal and state income tax purposes. These net operating loss carryforwards expire between fiscal year 2023 and fiscal year 2030. Net operating loss carryforwards in foreign jurisdictions amount to $44.8 million. A valuation allowance of $24.7 million has been provided against these net operating loss carryforwards in certain of our foreign jurisdictions as realization of the tax benefit in those jurisdictions is uncertain. Most of the foreign net operating losses can be carried forward indefinitely, with certain amounts expiring between fiscal years 2014 and 2017. The federal, state and foreign net operating loss carryforwards per the income tax returns filed include uncertain tax positions taken in prior years. Due to the application of ASC 740, the net operating loss carryforwards per the income tax returns are larger than the net operating loss carryforwards considered more likely than not to be realized in recognizing deferred tax assets for consolidated financial statement purposes. We also have a capital loss carryover of $5.5 million, for which we provide a full valuation allowance, that expires between 2011 and 2015. Utilization of net operating losses may be subject to limitation due to ownership changes and other limitations provided by the Internal Revenue code and similar state provisions. If such a limitation applies, the net operating loss may expire before full utilization.

 

Our income tax returns are periodically audited by domestic and foreign tax authorities. These audits include questions regarding our filing tax positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. At any one time, multiple tax years are subject to audit by the various tax authorities.

 

Legal Contingencies

 

At any time, we may be involved in certain legal proceedings. Our policy is to routinely assess the likelihood of any adverse judgments or outcomes related to legal matters, as well as ranges of probable losses. A determination of the amount of the reserves required, if any, for these contingencies is made after thoughtful analysis of each known issue and an analysis of historical experience. We record reserves related to certain legal matters for which it is probable that a loss has been incurred and the range of such loss can be estimated. Gain contingencies are not recorded until management determines it is certain that the future event will become or does become a reality. Such determinations are subject to interpretations of certain facts and circumstances, forecasts of future events, and estimates of financial impacts of such events. Management discloses the facts regarding material matters assessed as reasonably possible and potential exposure, if determinable. Costs incurred with defending claims are expensed as incurred. As of April 30, 2010, we have accrued our estimate of the probable liabilities for the settlement of these claims. Refer to Note 13 — Commitments and Contingencies of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data.

 

Because of inherent uncertainties related to these legal matters, we base our loss accruals on the best information available at the time. As additional information becomes available, we reassess our potential liability and may revise our estimates. Such revisions could have a material impact on future quarterly or annual results of operations.

 

Revenue Recognition

 

We sell ultrahigh-pressure waterjet systems. Sales of waterjet systems within in the Standard segment are primarily related to our cutting and cleaning systems using ultrahigh-pressure water pumps and do not require significant custom configuration or modifications. Installation of these waterjet systems by us is not essential to the functionality of the waterjet systems but we do provide installation as a separate service. Sales of waterjet systems within the Advanced segment are generally complex aerospace and automation systems, which require specific custom configuration and advanced features to match unique customer applications as well as parts and services to sustain these installed systems. Installation by us is essential to the functionality of waterjet systems sold within the Advanced segment.

We recognize revenue for sales of ultrahigh-pressure waterjet pumps, consumables, and services, and billing for freight charges, in accordance with ASC 605, Revenue Recognition, (“ASC 605”). Additionally, because FlowMaster^tm software, our PC-based waterjet control, is essential to the functionality of the Company’s waterjet systems, the Company recognizes revenue on sales of waterjet systems in accordance with ASC 985, Software. Specifically, for our waterjet systems that do not require significant modification or customization, the Company recognizes revenue when persuasive evidence of an arrangement exists, title and risk of loss have passed to the customer, the price is fixed or determinable, and collectibility is reasonably assured, or probable in the case of sale of waterjet systems.

 

Unearned revenue is recorded for products or services that have not been provided but have been invoiced under contractual agreements or paid for by a customer, or when products or services have been provided but all the criteria for revenue recognition have not been met.

 

We recognize revenue for delivered elements only when the delivered elements have standalone value, fair values of undelivered elements are known, uncertainties regarding customer acceptance are resolved, and there are no customer-negotiated refund or return rights affecting the revenue recognized for delivered elements. For contract arrangements that combine deliverables such as systems with embedded software, and installation, each deliverable is generally considered a separate unit of accounting or element. The consideration received is allocated among the separate units of accounting based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. In cases where there is objective and reliable evidence of the fair value of the undelivered item in an arrangement but no such evidence for the delivered item, the residual method is used to allocate the arrangement consideration.

 

In general, sales of our waterjet systems within our Standard segment are FOB shipping point or FOB destination, depending on geographical location, and the title passes to the customer based on the specific terms in each contract.

 

For complex aerospace and automation systems designed and manufactured to buyers’ specification, the Company recognizes revenue using the percentage of completion method. Typical lead times can range from two to 18 months for these systems. Sales and profits on such contracts are recorded based on the ratio of total actual incurred costs to date to the total estimated costs for each contract (the “cost-to-cost” method). Management reviews these estimates as work progresses and the effect of any change in cost estimates is reflected in the calculation of the expected margin and the percent complete. Accounting for the profit on a contract requires (1) the total contract value, (2) the estimated total cost to complete which is equal to the sum of the actual incurred costs to date on the contract and the estimated costs to complete the scope of work, and (3) the measurement of progress towards completion. The estimated profit or loss on a contract is equal to the difference between the contract value and the estimated total cost to completion. If the contract is projected to create a loss, the entire estimated loss is recognized in the period such loss first becomes known. Adjustments to original estimates may be required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract may not change, or if contract modifications occur. For contract modifications supported by a change in contract price, profit on such contract modifications are only recognized upon receipt of a signed contract amendment and only in the proportion of such contract’s progress towards completion. For modifications not supported by a change in contract price, those additional costs are treated as contract costs and charged to expense in the proportion of such contract’s progress towards completion. A number of internal and external factors affect our cost of sales estimates, including material costs, labor rates and efficiency variances and installation and testing requirements. While we believe that our historical experience provides a sound basis for our estimates, actual results may differ from management’s estimates. The complexity of the estimation process and issues related to the assumptions, risks and uncertainties inherent with the application of the percentage of completion method affect the amounts reported in our financial statements.

 

Shipping revenues and expenses are recorded in revenue and cost of goods sold, respectively.

 

Valuation of Obsolete/Excess Inventory

 

We currently write-down obsolete or excess parts and equipment inventory that is no longer used due to design changes to our products or lack of customer demand. We regularly monitor our inventory levels and, if

we identify an excess condition based on our usage, we record a corresponding inventory reserve which establishes a new cost basis for our inventory. Subsequent changes in facts or circumstances do not result in the reversal of previously recorded markdowns or an increase in that newly established cost basis. The amount of inventory write-down requires the use of management judgment regarding technological obsolescence and forecasted customer demand. If estimates regarding consumer demand are inaccurate or changes in technology affect demand for certain products in an unforeseen manner, we may be exposed to losses that could be material.

 

Valuation of Cost Method Investments

 

We evaluate our cost method investments for impairment on a quarterly basis in accordance with ASC 325, Cost Method Investments (“ASC 325”), which specifically addresses accounting for cost method investments subsequent to initial measurement. An impairment charge is recorded whenever a decline in value of an investment below its carrying amount is determined to be other-than-temporary. In determining if a decline is other-than-temporary, factors such as the length of time and extent to which the fair value of the investment has been less than the carrying amount of the investment, the near-term and longer-term operating and financial prospects of the affiliate and the intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery are considered.

 

Recently Issued Accounting Pronouncements

 

Refer to Note 2 — Recently Issued Accounting Pronouncements of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, for a discussion of recently issued accounting developments.

 

 

The types of market risk we are exposed to in our normal business activities are interest rate risk and currency exchange risk.

 

Interest Rate Risk

 

We are exposed to fluctuations in interest rates through our issuance of fixed rate and variable rate debt. At April 30, 2010, we had $350,000 in interest bearing debt, all of which was related to borrowings under our Lines of Credit. Interest on the Line of Credit is based on the bank’s prime rate or LIBOR rate plus a percentage spread between 3.25% and 4.5% depending on whether we use the bank’s prime rate of LIBOR rate and based on our current leverage ratio. Refer to Note 11 — Long-term Obligations and Notes Payable of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, for additional contractual information on our long-term obligations and notes payable. As of April 30, 2010, a 10% change in variable interest rates would not result in a material change in interest expense on a rolling twelve-month basis. At April 30, 2010, we had no derivative instruments to offset the risk of interest rate changes. We may choose to use derivative instruments, such as interest rate swaps, caps, collars and put or call options, to manage the risk associated with interest rate changes in future periods.

 

Foreign Currency Exchange Rate Risk

 

We transact business in a number of countries around the world and as a result are exposed to changes in foreign currency exchange rates. Costs in some countries are incurred, in part, in currencies other than the applicable functional currency. Our non-U.S. operations account for approximately 59% of consolidated revenue. Based on our results for the year ended April 30, 2010 for our foreign subsidiaries, a hypothetical 10% favorable and unfavorable change in foreign currency exchange rates would have affected our annualized foreign-currency-denominated operating results by approximately $3.0 million. Our consolidated financial position and cash flows could be similarly impacted. We may from time to time selectively utilize forward exchange rate contracts which we may or may not designate as cash flow hedges to protect against the adverse effect exchange rate fluctuations may have on foreign currency denominated accounts receivable and accounts payable (both trade and inter-company).

 

The following consolidated financial statements are filed as a part of this report:

 

 

To the Board of Directors and Stockholders of

Flow International Corporation

Kent, Washington

 

We have audited the accompanying consolidated balance sheets of Flow International Corporation and subsidiaries (the “Company”) as of April 30, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended April 30, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15. We also have audited the Company’s internal control over financial reporting as of April 30, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedule and an opinion on the Company’s internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Flow International Corporation and subsidiaries as of April 30, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended April 30, 2010, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of April 30, 2010, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

 

Seattle, Washington

July 1, 2010

FLOW INTERNATIONAL CORPORATION

 

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these consolidated financial statements.

FLOW INTERNATIONAL CORPORATION

 

CONSOLIDATED STATEMENTS OF OPERATIONS