Gross Profit

Gross profit declined for both the second quarter and the first six months of 2008.

Gross profit for the second quarter of 2008 decreased by 1% to $13.3 million and, for the six months, decreased by 9% to $26.7 million. Gross profit margin decreased by 70 basis points to 36.3% for the second quarter of 2008 from 37.0% in the 2007 period and decreased to 39.1% for the first six months of 2008 from 40.0% in the first six months of 2007.

The decline in gross profit margin in each 2008 period was primarily due to the changes in revenue mix and lower volume of Large-Frame systems’ sales, which resulted in the company’s inability to fully absorb its overhead, and the high incidence of used-equipment sales that resulted in reduced gross profit.

These higher sales of used equipment, combined with the items mentioned below, negatively affected the company’s gross profit margin in the second quarter of 2008 by approximately 5 percentage points after reflecting the offsetting favorable effect of foreign currency translation on revenue with the unfavorable effect of foreign currency translation on cost of goods sold for that quarter.

These other items included:

• amounts associated with our initial planned build up of V-Flash^® finished goods inventory in anticipation of commercial shipments of that new system once the company is fully satisfied with it;
• higher warranty costs;
• duplicate supply-chain costs related to the company’s efforts to discontinue the outsourcing of its domestic logistics activities and to relocate them to its Rock Hill facility, which the company has targeted to complete this month; and
• the unfavorable effect of foreign currency translation on cost of goods sold, which on a net basis reduced the company’s gross profit margin by 60 basis points for the second quarter and 40 basis points for the first six months of 2008.

Cost of sales increased by $0.4 million in the second quarter of 2008 and decreased by $2.3 million in the first six months of 2008, in each case in relation to the respective 2007 periods. These changes were generally in line with the company’s changes in revenue in each period.

“We have been subject to these foreign currency exchange effects on gross profit as part or our normal business operations for a number of years. However, as a result of persisting foreign currency pressures, we have begun taking steps to mitigate the effect of this exposure on our profit margins,” continued Reichental. “These steps include transferring production of certain of these materials that are sold in U.S. dollars to the United States and more closely managing the hedging of our currency exposure to items that we acquire or produce in other currencies.

“We are disappointed that the items discussed above largely negated our gross profit improvement initiatives during the second quarter. While we expect to benefit from our previously disclosed gross profit improvement initiatives starting in the fourth quarter of this year, we also expect that as we continue our planned build-up of V-Flash^® inventory and subsequent shipments, this activity will suppress our gross profit margins by $0.5 million to $1.0 million per quarter for the near term,” concluded Reichental.

Operating Expenses

Operating expenses continued their downward trend in the second quarter of 2008, declining by 12% to $16.1 million from $18.4 million in the second quarter of 2007. This decrease primarily reflected lower selling, general and administrative expenses as research and development expenses were essentially flat compared to the second quarter of 2007, notwithstanding the company’s expanded new product development activities.

For the first six months of 2008, operating expenses declined by 10% compared to the 2007 period.

The decline in SG&A expenses for the second quarter and first six months of 2008 arose primarily from lower contract labor and consultant costs, lower severance and stock-based compensation expense and lower audit expenses. These decreases were partially offset by unfavorable foreign currency exchange effects and higher marketing costs. The 2008 six-month period also included $0.6 million of expenses that the company incurred in connection with the previously disclosed Audit Committee investigation in the first quarter of 2008. Legal expenses for the six-month period, while below their level for the first six months of 2007, are expected to be higher than the company’s targeted legal expenses for the full year 2008 primarily as a result of expenses associated with its previously disclosed pending litigation.

“ I am not at all satisfied with our slower than expected progress on carrying out SG&A cost reductions, and as a result of the continued uncertain economic environment, we have decided to undertake additional cost reduction programs, including curtailment of certain planned discretionary expenses for the balance of 2008 which are intended to speed-up our progress. While I believe that our quarterly SG&A expenses have begun to resume a more normalized run rate, we are not yet achieving our stated targets, ” commented Reichental. “ Reflecting on our actual mid-year SG&A performance and factoring in our planned marketing activities for the remainder of this year and the uncertainty of our legal expenses arising from litigation for the second half of this year, I expect SG&A expenses for the second half of 2008 to fall in the range of $24 million to $26 million. ”