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INTEVAC INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 29, 2014

This Quarterly Report on Form 10-Q contains forward-looking statements, which involve risks and uncertainties. Words such as "believes," "expects," "anticipates" and the like indicate forward-looking statements. These forward-looking statements include comments related to Intevac's shipments, projected revenue recognition, product costs, gross margin, operating expenses, interest income, income taxes, cash balances and financial results in 2014 and beyond; projected customer requirements for Intevac's new and existing products, and when, and if, Intevac's customers will place orders for these products; Intevac's ability to proliferate its Photonics technology into major military programs; the timing of delivery and/or acceptance of the systems and products that comprise Intevac's backlog for revenue and the Company's ability to achieve cost savings. Intevac's actual results may differ materially from the results discussed in the forward-looking statements for a variety of reasons, including those set forth under "Risk Factors" and in other documents we file from time to time with the Securities and Exchange Commission, including our Annual Report on Form 10-K filed on February 20, 2014, and our periodic Form 10-Q's and Form 8-K's.



Overview

Intevac provides process manufacturing equipment solutions to the hard disk drive industry and offers high-productivity, thin film processing systems to the photovoltaic ("PV") industry and to adjacent markets for thin film deposition applications. Intevac also provides sensors, cameras and systems for government applications such as night vision and long-range target identification. Intevac's customers include manufacturers of hard disk drives and PV cells as well as the U.S. government and its agencies and contractors. Intevac reports two segments: Equipment and Photonics.



Product development and manufacturing activities occur in North America and Asia. Intevac has field offices in Asia to support its equipment customers. Intevac's equipment and service products are highly technical and are sold primarily through Intevac's direct sales force. Intevac also sells its products through distributors in Japan and China.

Intevac's results are driven by worldwide demand for hard disk drives, which in turn depends on the growth in digital data creation and storage, the rate of areal density improvements, the end-user demand for personal computers, enterprise data storage, including on-line, cloud storage and near-line applications, personal audio and video players and video game platforms that include such drives. Demand for Intevac's equipment is impacted by Intevac's customers' relative market share positions and production capacity needs. Intevac continues to execute its strategy of equipment diversification into new markets by introducing new products for PV solar cell manufacturing and most recently a thin film physical vapor deposition ("PVD") application for protective coating for touch screen cover glass manufacturing. Intevac believes that expansion into these markets, which Intevac believes are significantly larger than the hard disk drive deposition equipment market, will result in incremental equipment revenues for Intevac and decrease Intevac's dependence on the hard disk drive industry. Intevac's equipment business is subject to cyclical industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for hard disk drives, PV cells, and cell phones as well as other factors such as global economic conditions and technological advances in fabrication processes. 22



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The following table presents certain significant measurements for the three and six months ended June 28, 2014 and June 29, 2013:

Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In



thousands, except percentages and

per share amounts) Net revenues $ 14,715$ 16,983$ (2,268 )$ 31,730$ 29,965 $ 1,765 Gross profit $ 5,211$ 3,829$ 1,382$ 10,021$ 7,343 $ 2,678 Gross margin percent 35.4 % 22.5 % 12.9 points 31.6 % 24.5 % 7.2 points Loss from operations $ (5,246 )$ (6,990 )$ 1,744$ (9,970 )$ (16,014 ) $ 6,044 Net loss $ (5,007 )$ (6,412 )$ 1,405$ (9,528 )$ (14,676 ) $ 5,148 Loss per diluted share $ (0.21 )$ (0.27 ) $ 0.06 $ (0.40 )$ (0.62 ) $ 0.22 Net revenues decreased for the second quarter of fiscal 2014 compared to the same period in the prior year primarily due to lower equipment sales to disk manufacturers and lower Photonics' contract research and development ("R&D"), offset in part by higher Photonics' product sales. In the second quarter of 2013, Intevac recognized revenue on its first production system for its solar implant ENERGi™ product. The net loss for the second quarter fiscal 2014 decreased compared to the same period in the prior year due to higher gross margins and by lower operating expenses as a result of cost reduction efforts, offset in part by lower revenues and increased costs associated with a contested Board of Directors election. Net revenues increased for the first six months for fiscal 2014 compared to the same period in the prior year primarily due to higher Photonics' product sales offset in part by lower equipment sales to disk manufacturers and lower Photonics' contract R&D. Intevac recognized revenue on one 200 Lean system in the first half of fiscal 2014 and did not recognize revenue on any 200 Lean systems in the first half of fiscal 2013. The net loss for the first six months of fiscal 2014 decreased compared to the same period in the prior year due to higher revenues, higher gross margins and lower operating expenses as a result of cost reduction efforts offset in part by increased costs associated with a contested Board of Directors election. In fiscal 2014, Intevac expects that demand for and growth in hard disk media may increase, but this demand will not exceed the existing capacity during the year. The Company therefore expects that shipments of Intevac equipment to hard disk drive manufacturers will be approximately at the same levels as 2013. In 2014, Intevac expects higher sales of new thin-film equipment products. For fiscal 2014, Intevac expects that Photonics business levels will increase from 2013 as Photonics delivers production shipments of the pilot night vision system for the Apache helicopter.



Intevac's trademarks, include the following: "200 Lean®," "AccuLuber™," "EBAPS®," "ENERGi™," "I-Port™," "LithoPrime™," "LIVAR®," "INTEVAC MATRIX™," "MicroVista®," "NightVista®," and "Night Port™".

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Table of Contents Results of Operations Net revenues Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In thousands) Equipment $ 3,762$ 9,164$ (5,402 )$ 12,809$ 14,532$ (1,723 ) Photonics: Products 8,276 4,070 4,206 12,549 7,588 4,961 Contract R&D 2,677 3,749 (1,072 ) 6,372 7,845 (1,473 ) 10,953 7,819 3,134 18,921 15,433 3,488 Total net revenues $ 14,715$ 16,983$ (2,268 )$ 31,730$ 29,965$ 1,765 Equipment revenue for the three and six months ended June 28, 2014 decreased over the same periods in the prior year as a result of lower sales of technology upgrades, service and spare parts. During the second quarter of 2014 Intevac recognized revenue on disk equipment technology upgrades, spare parts and service. During the second quarter of 2013 Intevac recognized revenue on one solar implant ENERGi system, disk equipment technology upgrades, spare parts and service. Equipment revenue for the six months ended June 28, 2014 included revenue recognition for one 200 Lean system, upgrades and spare parts. Equipment revenue for the six months ended June 29, 2013 included revenue recognition for one solar implant ENERGi system, two AccuLuber systems, upgrades and spare parts. Photonics revenue for the three and six month periods ended June 28, 2014 increased over the same periods in the prior year as a result of increased product sales offset in part by lower contract R&D work. The decrease in contract R&D revenue was the result of completion of the program to design the Apache pilot night viewing system during mid-2013. The increase in product sales resulted from the transition to production deliveries for the Apache pilot night viewing camera at the end of 2013. On March 29, 2013, Intevac sold certain assets comprising its Raman spectroscopy instruments product line, also known as DeltaNu, and no longer offers Raman spectroscopy products. Backlog June 28, December 31, June 29, 2014 2013 2013 (In thousands) Equipment $ 8,613$ 13,565$ 29,295 Photonics 37,772 46,319 48,295 Total backlog $ 46,385$ 59,884$ 77,590 Equipment backlog at June 28, 2014 included one PV deposition system and one PVD touch screen cover glass coating system. Equipment backlog at December 31, 2013 included one 200 Lean system and one PV deposition system. Equipment backlog at June 29, 2013 included three 200 Lean systems. Photonics backlog at June 28, 2014 includes $28.8 million in revenue that will be earned in one year and $9.0 million in revenue that will be earned beyond one year. 24



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Table of Contents Revenue by geographic region Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In thousands) United States $ 10,843$ 9,714$ 1,129$ 25,351$ 17,047$ 8,304 Asia 2,937 5,881 (2,944 ) 4,417 10,366 (5,949 ) Europe 935 1,388 (453 ) 1,962 2,552 (590 ) Total net revenues $ 14,715$ 16,983$ (2,268 )$ 31,730$ 29,965$ 1,765 International sales include products shipped to overseas operations of U.S. companies. The increase in U.S. sales in 2014 versus 2013 was primarily due to delivery of a 200 Lean system to a U.S. customer, higher camera sales and the initial production shipments of the pilot night vision camera for the Apache helicopter. The decrease in sales to the Asia region in 2014 versus 2013 was primarily due to lower net revenues from solar implant systems, disk lubrication systems and technology upgrades. The decrease in sales to the Europe region in 2014 versus 2013 was primarily due to lower sales of Photonics' digital night-vision cameras to a NATO customer. Gross profit Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In



thousands, except percentages)

Equipment gross profit $ 312$ 1,352$ (1,040 )$ 2,317$ 2,554$ (237 ) % of Equipment net revenues 8.3 % 14.8 % 18.1 % 17.6 % Photonics gross profit $ 4,899$ 2,477$ 2,422$ 7,704$ 4,789$ 2,915 % of Photonics net revenues 44.7 % 31.7 % 40.7 % 31.0 % Total gross profit $ 5,211$ 3,829$ 1,382$ 10,021$ 7,343$ 2,678 % of net revenues 35.4 % 22.5 % 31.6 % 24.5 %



Cost of net revenues consists primarily of purchased materials and costs attributable to contract research and development, and also includes fabrication, assembly, test and installation labor and overhead, customer-specific engineering costs, warranty costs, royalties, provisions for inventory reserves and scrap.

Equipment gross margin was 8.3% in the three months ended June 28, 2014 compared to 14.8% in the three months ended June 29, 2013 and was 18.1% in the six months ended June 28, 2014 compared to 17.6% in the six months ended June 29, 2013. The lower gross margin for the three months ended June 28, 2014 was due primarily to lower systems and spares shipments, offset in part by lower inventory provisions and the lower system margin on the first solar implant ENERGi system for which revenue was recognized in second quarter of 2013. The higher gross margin for the six months ended June 28, 2014 was due primarily to lower factory costs as a result of cost containment efforts, lower inventory provisions and the lower system margin on the first solar implant ENERGi system for which revenue was recognized in second quarter of 2013. Gross margins in the Equipment business will vary depending on a number of factors, including product mix, product cost, system configuration and pricing, factory utilization, and provisions for excess and obsolete inventory. Photonics gross margin increased to 44.7% in the three months ended June 28, 2014 compared to 31.7% in the three months ended June 29, 2013 and increased to 40.7% in the six months ended June 28, 2014 compared to 31.0% in the six months ended June 29, 2013. The higher gross margin for the three months ended June 28, 2014 was due to higher margins on both products and contract R&D and lower inventory provisions. The higher gross margin for the six months ended June 28, 2014 was due to higher margins on contract R&D, lower warranty costs and lower inventory provisions. Gross margins in the Photonics business will vary depending on a number of factors, including sensor yield, product mix, product cost, pricing, factory utilization, provisions for warranty and inventory reserves. 25



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Table of Contents Research and development Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In thousands)



Research and development expense $ 4,558$ 5,584$ (1,026 )$ 8,831$ 11,943$ (3,112 )

Research and development spending decreased in Equipment and in Photonics during the three and six month periods ended June 28, 2014 as compared to the same periods in the prior year. The decrease in Equipment spending was due primarily to decreased PV development and from cost reduction initiatives. Photonics research and development spending during the first half of fiscal 2013 included costs from DeltaNu which did not re-occur in the first half of fiscal 2014 as DeltaNu was sold on March 29, 2013. Research and development expenses do not include costs of $2.0 million and $4.4 million for the three and six months ended June 28, 2014 respectively, or $3.0 million and $6.1 million for the three and six months ended June 29, 2013, respectively, which are related to customer-funded contract R&D programs at Photonics and therefore included in cost of net revenues.



Selling, general and administrative

Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In thousands) Selling, general and administrative expense $ 5,899$ 5,235 $



664 $ 11,160$ 11,206 $ (46 )

Selling, general and administrative expense consists primarily of selling, marketing, customer support, financial and management costs. The increase in selling, general and administrative spending in the three months ended June 28, 2014 was primarily the result of increased professional service costs associated with a contested Board of Directors election, higher charges associated with the change in the fair value of the contingent consideration obligations related to the SIT acquisition, offset in-part by lower variable compensation program expense and savings from cost reduction initiatives.



Cost reduction plans

During the first quarter of fiscal 2014, Intevac substantially completed implementation of the 2014 cost reduction plan (the "Plan"), which was intended to reduce expenses and reduce its workforce by 6 percent. The total cost of implementing the Plan was $288,000 of which $43,000 was reported under cost of net revenues and $245,000 was reported under operating expenses. Substantially all cash outlays in connection with the Plan occurred in the first half of fiscal 2014. Implementation of the Plan is expected to reduce salary, wages and other employee-related expenses by approximately $2.1 million on an annual basis. During the first quarter of fiscal 2013, Intevac announced the 2013 cost reduction plan (the "2013 Plan") to reduce expenses including a reduction in its workforce. Implementation of the Plan was substantially completed in the first half of fiscal 2013 and the workforce was reduced by 18 percent. During the first half of 2013, Intevac recognized employee-related costs of $742,000 of which $315,000 was reported under cost of net revenues and $427,000 was reported under operating expenses in connection with the 2013 Plan. All cash outlays in connection with the 2013 Plan occurred in the first half of fiscal 2013. As of June 28, 2014, activities related to the 2013 Plan were complete. 26



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Loss on divestiture

On March 29, 2013, the Company sold certain assets, including existing tangible and intangible assets, which comprised its Raman spectroscopy instruments product line, also known as DeltaNu, for consideration not to exceed $1.5 million, of which $500,000 was received in cash upon closing, and recorded a loss of $208,000. The first earnout payment in the amount of $75,000 was received in the second quarter of fiscal 2014 and was reported in interest and other income, net on the condensed consolidated statement of operations. See Note 7 "Divestiture" in the notes to the condensed consolidated financial statements for additional information related to the loss on divestiture.



Interest income and other, net

Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In thousands)



Interest income and other, net $ 120$ 92 $

28 $ 192$ 172 $ 20

Interest income and other, net is comprised of interest income and realized gains and losses on sales of investments, foreign currency gains and losses, and other income and expense such as gains and losses on sales of fixed assets and earnout income from divestitures. Income tax benefit Three months ended Six months ended June 28, June 29, Change over June 28, June 29, Change over 2014 2013 prior period 2014 2013 prior period (In thousands) Income tax benefit $ 119$ 486 $ (367 ) $ 250$ 1,166 $ (916 ) Intevac recorded income tax benefits of $119,000 and $250,000 for the three and six months ended June 28, 2014, respectively. Intevac recorded income tax benefits of $486,000 and $1.2 million for the three and six months ended June 29, 2013, respectively. The income tax provisions for the three and six month periods are based upon estimates of annual income (loss), annual permanent differences and statutory tax rates in the various jurisdictions in which Intevac operates. Intevac did not recognize a benefit on the U.S. net operating loss for the three and six months ended June 28, 2014 and June 29, 2013 due to having full valuation allowances on the U.S. deferred tax assets. Intevac's tax rate differs from the applicable statutory rates due primarily to establishment of a valuation allowance, the utilization of deferred and current credits and the effect of permanent differences and adjustments of prior permanent differences. Intevac's future effective income tax rate depends on various factors including, the level of Intevac's projected earnings, the geographic composition of worldwide earnings, tax regulations governing each region, net operating loss carryforwards, availability of tax credits and the effectiveness of Intevac's tax planning strategies. Management carefully monitors these factors and timely adjusts the effective income tax rate.



Liquidity and Capital Resources

At June 28, 2014, Intevac had $75.3 million in cash, cash equivalents, and investments compared to $81.4 million at December 31, 2013. During the first six months of 2014, cash, cash equivalents and investments decreased by $6.1 million due primarily to cash used by operating activities, purchases of fixed assets, repurchases of common stock and increases in restricted cash partially offset by cash received from the sale of Intevac common stock to Intevac's employees through Intevac's employee benefit plans. 27



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Cash, cash equivalents and investments consist of the following:

June 28, December 31, 2014 2013 (In thousands) Cash and cash equivalents $ 25,059 $

20,121 Short-term investments 33,173 48,975 Long-term investments 17,064 12,318



Total cash, cash equivalents and investments $ 75,296$ 81,414

Operating activities used cash of $2.6 million during the first six months of 2014 and used cash of $4.2 million during the first six months of 2013. The decrease in cash used by operating activities was due primarily to a smaller net loss and to reductions in working capital during the first six months of 2014, offset in part by the payment of annual bonuses. Accounts receivable totaled $9.3 million at June 28, 2014, compared to $15.0 million at December 31, 2013. The decrease of $5.8 million in the receivable balance was due primarily to decreased revenue levels and improved collections. Total net inventories decreased slightly to $22.6 million at June 28, 2014, compared to $22.8 million at December 31, 2013. Accounts payable increased slightly to $4.3 million at June 28, 2014 compared to $4.0 million at December 31, 2013 in line with business levels. Accrued payroll and related liabilities decreased to $4.2 million at June 28, 2014 compared to $5.0 million at December 31, 2013 primarily related to the payment for prior year bonuses. Customer deposits decreased to $2.1 million at June 28, 2014 compared to $3.7 million at December 31, 2013. Investing activities generated cash of $8.0 million during the first six months of 2014. Proceeds from sales of investments net of purchases totaled $11.2 million. Intevac is required to maintain a standby letter of credit for $1.0 million for the Santa Clara, California campus lease. This standby letter of credit is secured with $1.0 million of restricted cash. Capital expenditures for the six months ended June 28, 2014 were $2.2 million. Financing activities in the first six months of 2014 used cash of $381,000. The sale of Intevac common stock to Intevac's employees through Intevac's employee benefit plans generated cash $1.2 million. Cash used to repurchase shares of common stock under the Company's stock repurchase program totaled $1.6 million for the six months ended June 28, 2014. Intevac's investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, certificates of deposit, commercial paper, municipal bonds and corporate bonds. Intevac regularly monitors the credit risk in its investment portfolio and takes measures, which may include the sale of certain securities, to manage such risks in accordance with its investment policies. As of June 28, 2014, approximately $10.2 million of cash and cash equivalents were domiciled in foreign tax jurisdictions. Intevac expects a significant portion of these funds to remain off shore in the short term. If the Company chose to repatriate these funds to the United States, it would be required to accrue and pay additional taxes on any portion of the repatriation where no United States income tax had been previously provided. Intevac believes that its existing cash, cash equivalents and investments will be sufficient to meet its cash requirements for the foreseeable future. Intevac intends to undertake approximately $3.5 million to $4.0 million in capital expenditures during the remainder of 2014. 28



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Contractual Obligations

The following table summarizes Intevac's contractual obligations as of June 28, 2014: Payments due by period Total < 1 Year 1-3 Years 3-5 Years > 5 Years (in thousands) Operating lease obligations $ 27,744$ 1,023$ 6,296$ 5,276$ 15,149 Purchase obligations and commitments 1 6,044 6,044 - - - Other long-term liabilities 2, 4 409 409 - - - Total 3, 4 $ 34,197$ 7,476$ 6,296$ 5,276$ 15,149



1 Purchase obligations include agreements to purchase goods or services that are

enforceable and legally binding on Intevac and that specify all significant

terms, including fixed or minimum quantities to be purchased; fixed, minimum or

variable price provisions; and the approximate timing of the transaction.

Purchase obligations exclude agreements that are cancelable without penalty.

These purchase obligations are related principally to inventory and other

items.

2 Intevac is unable to reliably estimate the timing of future payments related

to uncertain tax positions; therefore, $425,000 of unrecognized tax benefits

has been excluded from the table above.

3 Total excludes contractual obligations already recorded on the condensed

consolidated balance sheet as current liabilities (except other long-term

liabilities) and certain purchase obligations.

4 Total excludes contingent consideration that may be paid pursuant to asset

purchases or business combinations.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America ("US GAAP") requires management to make judgments, assumptions and estimates that affect the amounts reported. Intevac's significant accounting policies are described in Note 1 to the consolidated financial statements included in Item 8 of Intevac's Annual Report on Form 10-K filed on February 20, 2014. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below. A critical accounting policy is defined as one that is both material to the presentation of Intevac's financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on Intevac's financial conditions and results of operations. Specifically, critical accounting estimates have the following attributes: 1) Intevac is required to make assumptions about matters that are highly uncertain at the time of the estimate; and 2) different estimates Intevac could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Intevac's financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Intevac bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Intevac's operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they become known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. Many of these uncertainties are discussed in the section below entitled "Risk Factors." Based on a critical assessment of Intevac's accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Intevac's consolidated financial statements are fairly stated in accordance with US GAAP, and provide a meaningful presentation of Intevac's financial condition and results of operation. 29



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For further information about Intevac's other critical accounting policies, see the discussion of critical accounting policies in Intevac's 2013 Form 10-K. Management believes that there has been no significant change during the six months ended June 28, 2014 to the items identified as critical accounting policies in Intevac's 2013 Form 10-K.


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