RESULTS OF OPERATIONS

Net sales decreased 11% to $6,808,000 for the quarter ended September 30, 2006, as compared to the same quarter a year ago. The decrease was primarily a result of lower pool sales (down 15%) due to the slowdown in housing starts along with lower sales from Europe (down 29%) as a result of a large one-time sale in the third quarter of 2005 which was not duplicated in the third quarter of 2006. These shortfalls were partially offset by higher EFO sales of $1,346,000 in the quarter compared to $454,000 in the third quarter of 2005. Third quarter sales include $850,000 in revenue from the achievement of Navy ship install contract milestones. Net sales for the first nine months of 2006 were $19,845,000 compared to net sales of $22,102,000 for the same period in 2005, a decrease of 10%. The sales decrease in the first nine months is also due to lower traditional fiber optic sales in pool lighting products (down 13%) and Europe (down 15%) partially offset by higher EFO sales, which were $2,547,000 for nine months ending September 30, 2006 compared to $1,220,000 for the nine months ending September 30, 2005. Due to lower sales in the traditional fiber optic lines, pool lighting and traditional commercial, we expect overall sales to be down for fiscal 2006. However, the market for our products is highly dependent upon general economic conditions.

 

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On March 31, 2006, we announced that we had received funding from DARPA for $2,100,000 to develop and install our high efficiency distributed lighting systems as a “commercial” product on three US Navy ships. This project will result in revenue being recognized on a percentage of completion basis as milestones are completed over the next two years. We recognized revenue of $850,000 in the third quarter of 2006 and $1,399,000 for the nine months ending September 30, 2006 for the completion of milestones.

Gross profit was $2,036,000 in the third quarter of fiscal 2006, a 31% decrease compared to the same period in the prior year. The gross profit margin as a percentage of sales decreased from 39% for the third quarter of fiscal 2005 to 30 % for the third quarter of 2006. Gross profit margin declined primarily due to lower gross profit margins on U.S. pool lighting and commercial lighting sales. Gross profit for the first nine months of 2006 was $5,966,000, a decrease of 29% over gross profit margins for the same period in 2005. This represents gross profit margins of 30% for the first nine months of 2006 compared to 38% in 2005. The decline was due to lower margins on U.S. pool lighting and commercial lighting sales. It was partially offset by higher margins in Europe due to increased margins on several projects. We expect gross profit margins for the full 2006 year, to be lower than 2005, assuming general economic conditions remain consistent.

Research and development expenses were $630,000 in the third quarter of fiscal 2006, a decrease of $9,000 compared with the third quarter of fiscal 2005. Gross expenses for research and development decreased by 34% due to lower project costs and due to engineering costs associated with delivering the Navy ship install milestones being included in cost of sales in the third quarter of 2006, whereas there were no such reclassed expenses in 2005. Our research and development expense are reduced by credits received for achieving milestones under a development contract with the Department of Energy, “DOE” that was signed in 2005 for a total of $1,500,000. In addition, further awards were taken for a Small Business Innovative Research award with the Defense Advanced Research Projects Agency, “DARPA” totaling $199,000 signed in October, 2005. Gross research and development expenses were $2,658,000 in the first 9 months of 2006, compared to $3,149,000 for the same period in 2005. The decrease was a result of lower project costs and engineering costs included in cost of sales for the first nine months of 2006 as discussed above for the quarter. The gross research and development spending along with credits from government contracts is shown in the table:

 

			Three months ended September 30, 2006						Nine months ended September 30, 2006
			(in thousands)						(in thousands)
			2006			2005			2006			2005
Gross expenses for research and development		$	827		$	1,253		$	2,658		$	3,149
Deduct: credits from DARPA & DOE contracts			(197	)		(614	)		(1,137	)		(1,633	)
Net research and development expense		$	630		$	639		$	1,521		$	1,516

We expect research and development expense nearly flat for the full year 2006 compared to 2005 due to reduced DARPA credits offset by lower gross expenses as discussed above.

Sales and marketing expenses decreased by 13% to $2,280,000 in the third quarter of fiscal 2006 as compared to $2,611,000 for the same period in fiscal 2005. The decrease is due to a one time increase in pool sales and marketing expense in the third quarter of 2005 due to expenses associated with the settlement of a lawsuit with Pentair Water Pool and Spa, Inc. There was no such legal expense in 2006. Sales and marketing expense decreased by 3% to $7,132,000 in the first nine months of 2006 as compared to the same period in 2005, for the same reason it decreased for the quarter as described above. We expect sales and marketing expenses to increase slightly for the full year 2006 as we anticipate increasing our sales and marketing efforts for our new products.

General and administrative expenses were $1,303,000 in the third quarter of fiscal 2006, an increase of 70% compared to the third quarter of fiscal 2005. The increase was primarily due to the impact of expense recognized under FAS123R ($238,000), Sarbanes Oxley ($88,000) and increased bad debt expenses ($175,000). We will be required to comply with Section 404 of the Sarbanes-Oxley Act of 2002 by December 31, 2006. Estimates of costs required in order to comply with Section 404 for a company of our size range in the order of $600,000 or higher, independent of additional audit fees of which approximately $350,000 has been recorded through September 30^th. These additional expenses will be incurred in the remainder of fiscal year 2006. General and administrative expenses were $3,918,000 for the first nine months of 2006 compared to $2,324,000 for the same period in 2005. The increase is primarily due to option expenses and compliance costs associated with Sarbanes-Oxley. We expect general and administrative expenses to continue to increase in 2006 as compared to 2005 due to anticipated higher administration accounting costs and expenses associated with the impact of the Sarbanes- Oxley Act of 2002 and option expense under FAS123R.

 

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In June 2005, we announced our plans to close our Fremont office and consolidate most of our operations in Solon, Ohio, where we have a local sales office and a manufacturing facility. The relocation resulted in a restructuring charge of approximately $3,100,000 for severance payments, redundancy, and lease and inventory write-offs for the fiscal year 2005. During the first nine months of 2006, we charged to operations $734,000 for costs associated with this restructuring. Additional restructuring costs were necessary in 2006 beyond what was originally estimated in order to further consolidate distribution operations into our Mexican production site. Restructuring is now complete and there will be no further costs charged in 2006. We expect the total restructuring to produce cost savings of between $1,500,000 and $2,000,000 on an annual basis, and we have begun to see the impact of this savings in Q3 of 2006. These savings will be reflected largely in reduced cost of sales with a lesser amount in operating expenses. These savings are being offset by expense increases as a result of building capacity and increasing expenses for development, sales and marketing of new products, primarily EFO, and also new pool lighting products.

 

We recorded a net loss of $2,125,000 in the third quarter of fiscal 2006 as compared to a net loss of $2,074,000 in the third quarter of fiscal 2005. The net loss for the nine months ending September 30, 2006 and 2005 was $6,866,000 and $3,887,000, respectively. The net loss in 2006 was due primarily to soft sales, reduced margin from changes in product mix, and higher operating expenses.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents

At September 30, 2006, our cash and cash equivalents were $3,319,000 as compared to $5,554,000 at December 31, 2005, a net cash decrease of $2,235,000 during the first nine months of 2006. This compares to a net cash increase of $757,000 for the same period in 2005, and an ending cash balance of $4,366,000 as of September 30, 2005. We also had $14,597,000 in short-term securities at September 30, 2006 as compared to $18,024,000 in short-term securities at December 31, 2005, a decrease of $3,427,000.

Due to seasonality in the sales of our pool lighting products, our cash balances tend to decrease in the first half of the year and increase in the second half of the year. This year we expect there to be some cash utilization in the second half of the year due to increased investment in new products, however at a slower rate than in the first half. This is subject to the condition that the market for our products is highly dependent upon general economic conditions.

Cash was used in the period to purchase fixed assets and pay other accruals from December 31, 2005 relating to costs incurred in 2005 for our restructuring and resolution of legal commitments.

Cash provided by (used in) Investing Activities

Investing activities provided cash of $205,000 during the first nine months of 2006, compared to a use of cash of $532,000 for the same period of 2005. During both periods, cash was used for the acquisition of fixed assets. Fixed asset purchases from ADLT were $1,325,000 in the first nine months of 2006. The increase was due to additional fixed assets required in order to move forward with the EFO product line and future R & D efforts. The sale of short-term securities in 2006 provided cash to fund fixed asset purchases and operations.

Cash Provided by Financing Activities

Financing activities contributed $3,177,000 to cash during the first nine months of 2006. This net contribution was due primarily from long and short term borrowings of $2,875,000 and the exercise of warrants and employee stock options for $565,000. For the same period in 2005, financing activities, from the exercise of warrants and employee stock options, were $1,530,000. 

 

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The Company has a $5,000,000 Loan and Security Agreement (Accounts Receivable and Inventory) with Silicon Valley Bank. This agreement is dated August 15, 2005. It was subsequently amended and restated at December 31, 2005. It was further amended September 25, 2006 and extended through August 13, 2007. The interest rate equals prime plus 1.75% per annum computed daily. Borrowings under this Loan and Security Agreement were collateralized by its assets and intellectual property. Specific borrowings were tied to accounts receivable and inventory balances, and the Company is required to comply with certain covenants with respect to effective net worth. The Company had $1,000,000 of borrowings against this facility as of June 30, 2006 and no borrowings at December 31, 2005. The Company had total borrowings of $2,430,000 under the term-loan agreement as of September 30, 2006 and $1,092,000 as of December 31, 2005. The Company was in conformity with the bank covenants of the Silicon Valley Bank agreement as of September 30, 2006.

Through our U.K. subsidiary, we maintain a $468,000 (in UK pounds sterling based on the exchange rate at September 30, 2006) bank overdraft agreement with Lloyds Bank Plc through its UK subsidiary. There were no borrowings against this facility as of September 30, 2006 and December 31, 2005. The facility is renewed annually on January 1 and bears an interest rate of 7%.

Through our German subsidiary, we maintain a credit facility under an agreement with Sparkasse Neumarkt Bank. This credit facility is in place to finance, and is secured by, our offices owned and occupied by our German subsidiary. As of September 30, 2006 we had total borrowings of $375,000 (in Euros, based on the exchange rate at June 30, 2006) against this credit facility. As of December 31, 2005, we had $331,000 (in Euros, based on the exchange rate at December 31, 2005) borrowed against this facility. Additionally, we have a revolving line of credit of $254,000 (in Euros, based on the exchange rate at September 30, 2006) with Sparkasse Neumarkt Bank. As of September 30, 2006 there were borrowings against this facility of $222,000 (in Euros, based on the exchange rate at September 30, 2006), and there were $47,000 of borrowings against this facility as of December 31, 2005 (in Euros, based on the exchange rate at December 31, 2005). The facility is renewed annually on January 1 and bears an interest rate of 8.75%.

We believe that our existing cash balances and funds available to us through our bank lines of credit together with funds that we anticipate generating from our operations, will be sufficient to finance our currently anticipated working capital requirements and capital expenditure requirements for the next twelve months.  However, a sudden increase in product demand requiring a significant increase in manufacturing capability, or unforeseen adverse competitive, economic or other factors may impact our cash position, and thereby affect operations.  From time to time we may be required to raise additional funds through public or private financing, strategic relationships or other arrangements.  There can be no assurance that such funding, if needed, will be available on terms acceptable to us, or at all.  Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require that we relinquish rights to certain of our technologies or products.  Failure to generate sufficient revenues or to raise capital when needed could have an adverse impact on our business, operating results and financial condition, as well as our ability to achieve intended business objectives.

CRITICAL ACCOUNTING POLICIES

The preparation of our financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies and the reported amounts of revenue and expenses in the financial statements. Material differences may result in the amount and timing of revenue and expenses if different judgments or different estimates were utilized. Critical accounting policies, judgments and estimates which we believe have the most significant impact on our financial statements include allowances for doubtful accounts, returns, warranties, valuation of inventories, and stock based compensation. For the detailed discussion of the application of policies critical to our business operations, see our Annual Report Form on 10-K for the year ended December 31, 2005.

RECENTLY ADOPTED STANDARDS

In December 2004, the FASB issued SFAS No. 123 (revised 2004) as SFAS 123R, “Share-Based Payments.” SFAS 123R requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. We applied SFAS 123R on a modified prospective method beginning in 2006. Under this method, we have recorded compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at January 1, 2006.

 

In December 2004, the FASB issued SFAS No.151, “Inventory Costs,” which amends part of ARB 43, “Inventory Pricing,” concerning the treatment of certain types of inventory costs. The provisions of ARB 43 provided that certain inventory-related costs, such as double freight, re-handling, might be “so abnormal” that they should be charged against current earnings rather than be included in the cost of inventory that is capitalized to future periods. As amended by SFAS No. 151, the “so-abnormal” criterion has been eliminated. Thus, all such “abnormal” costs are required to be treated as current-period charges under all circumstances. In addition, fixed production overhead should be allocated based on the normal capacity of the production facilities, with unallocated overhead charged to expense when incurred. SFAS 151 is required to be adopted for fiscal years beginning after June 15, 2005. The impacts of adopting SFAS No.151did not have a material impact on our overall financial position.

 

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RECENT PRONOUNCEMENTS

In July, 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” providing guidance on the accounting for and reporting of corrections accounting changes and error corrections. The standard is effective for fiscal years beginning after December 15, 2006. The impact of adopting SFAS 154 is not anticipated to have a material impact on our financial position.

In July, 2006, the FASB issued FASB interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN48”), an interpretation of FASB statement No. 109, “Accounting for Income Taxes”, regarding accounting for income tax uncertainties effective for fiscal years beginning after December 15, 2006. FIN 48 will apply to all tax positions related to income taxes subject to SFAS 109 on Accounting for Income Taxes. The impact of adopting the positions of the interpretation is not anticipated to have a material impact on our overall financial position.

In September 2006, the Securities and Exchange Commission published Staff Accounting Bulletin (“SAB”) No. 108 (Topic 1N), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 requires registrants to quantify misstatements using both the balance sheet and income statement approaches, with adjustment required if either method results in a material error. The provisions of SAB No. 108 are effective for annual financial statements for the fiscal year ending after November 15, 2006. As of September 30, 2006, we are evaluating the effect, if any, SAB No. 108 may have on our financial statements, but management does not currently believe SAB No. 108 will have a material effect upon initial adoption.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this statement does not require any new fair value measurements. We will adopt this standard January 1, 2008. We do not expect it to have a material impact on our financial position or results of operations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of September 30, 2006, we had $606,000 in cash held in foreign currencies based on the exchange rates at September 30, 2006. The balances for cash held overseas in foreign currencies are subject to exchange rate risk. We have a policy of maintaining cash balances in local currencies unless an amount of cash is occasionally transferred in order to repay inter-company debts.

As of September 30, 2006 we had borrowings of $222,000 (in Euros, based on the exchange rate at September 30, 2006) against a credit facility secured by real property owned by our German subsidiary. As of December 31, 2005, we had $47,000 (in Euros, based on the exchange rate at December 31, 2005) borrowed against this credit facility.

 

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Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures.

 

We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet, and management believes they meet, reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.

 

(b) Changes in internal control over financial reporting.

 

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

On March 6, 2006, Ohms Electric, Inc. filed a complaint against Fiberstars, Inc. with the 30th Judicial Circuit Court in the State of Michigan. The complaint requests unspecified damages as a result of the Company’s product not working properly at Neighborhood Cinema in Lansing, Michigan. Management does not believe the suit will have a material affect on our financial condition.

Item 1A. Risk Factors

There are no significant changes in risk factors from our Annual Report Form 10-K for the year ended December 31, 2005.

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Item 6. Exhibits  

 

Exhibit Number			Description of Documents
10.1			Amendment No. 1 To Amended And Restated Loan And Security Agreement between Fiberstars, Inc and Silicon Valley Bank dated September 25, 2006
31.1			Rule 13a-14(a) Certification of Chief Executive Officer.
31.2			Rule 13a-14(a) Certification of Chief Financial Officer.
32.1**			Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
32.2**			Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).

 

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** In accordance with item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

			FIBERSTARS, INC.
Date: November 14, 2006		By:	/s/ John M. Davenport
			John M. Davenport
			Chief Executive Officer
		By:	/s/ Robert A. Connors
			Robert A. Connors
			Chief Financial Officer
			(Principal Financial and Accounting Officer)

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Exhibit Index

 

Exhibit Number			Description of Documents
10.1			Amendment No. 1 To Amended And Restated Loan And Security Agreement between Fiberstars, Inc and Silicon Valley Bank dated September 25, 2006
31.1			Rule 13a-14(a) Certification of Chief Executive Officer.
31.2			Rule 13a-14(a) Certification of Chief Financial Officer.
32.1**			Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).
32.2**			Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2003 (18 U.S.C. §1350).

 

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** In accordance with item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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