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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED SEPTEMBER 30, 2002MARCH 31, 2003
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
-----------
(Exact Name of Registrant as Specified in Its Charter)
MASSACHUSETTS 04-2911026
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(State or Other Jurisdiction of (I.R.S. Employer
Identification No.) Incorporation or Organization) Identification No.)
40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
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(Address of Principal Executive Offices)
(Zip Code)
(781) 276-4000
--------------
(Registrant's Telephone Number, Including Area Code)
Indicate by check 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 X NO
----- -------- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2).
YES X NO
--- ---
Indicate the number of shares outstanding of the issuer's common stock as of
November 1, 2002:April 30, 2003:
CLASS NUMBER OF SHARES OUTSTANDING
----- ----------------------------
Common Stock, par value $0.01 per share 22,686,03022,698,171 shares
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AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002MARCH 31, 2003
TABLE OF CONTENTS
PAGEPage
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PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of
September 30, 2002March 31, 2003 and December 31, 2001....................2002......................... 3
Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2002March 31, 2003
and September 30, 2001......................................March 31, 2002........................................... 4
Consolidated Statements of Cash Flows for the
NineThree Months Ended September 30, 2002March 31, 2003
and September 30, 2001......................................March 31, 2002........................................... 5
Notes to Consolidated Financial Statements..................Statements................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations......................... 10Operations.......................... 11
Item 3. Quantitative and Qualitative Disclosures about
Market Risk.................................................Risk.................................................. 23
Item 4. Controls and Procedures..................................... 23Procedures...................................... 24
PART II OTHER INFORMATION
Item 1. Legal Proceedings........................................... 24Proceedings............................................ 25
Item 5. Other Information........................................... 24Information............................................ 25
Item 6. Exhibits and Reports on Form 8-K............................ 25
Signatures.................................................. 25
Certifications..............................................8-K............................. 26
Signatures................................................... 26
Certifications............................................... 27
2
PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30,MARCH 31, DECEMBER 31,
2003 2002
2001
----------------- ---------------- ASSETS----------------
ASSETS
Current assets:
Cash and cash equivalents................................................ $48,678 $36,056$20,594 $25,268
Short-term investments................................................... 1,208 21,22811,121 8,034
Accounts receivable, net................................................. 2,513 1,3831,669 1,258
Inventories.............................................................. 103 50 282
Deferred tax assets...................................................... - 1,811
Prepaid expenses and other assets........................................ 710 795
-----------------604 530
---------------- ----------------
Total current assets............................................... 53,159 61,555
-----------------assets 34,091 35,140
---------------- ----------------
Property and equipment, net................................................... 10,212 10,937
Deferred tax assets........................................................... - 5,2829,748 10,038
Investments................................................................... 12,018 13,816
Other assets, net............................................................. 235 329
-----------------199 243
---------------- ----------------
Total assets....................................................... $63,606 $78,103
=================$56,056 $59,237
================ ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable........................................................ $647 $353$348 $274
Accrued expenses ........................................................ 183 521193 213
Accrued compensation .................................................... 642 948593 965
Accrued professional..................................................... 202 125187 65
Deferred revenue......................................................... 43 -
-----------------120 142
---------------- ----------------
Total current liabilities........................................ 1,717 1,947
-----------------1,441 1,659
---------------- ----------------
Stockholders' equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding................................................. - -
Common stock, $.01 par value; 70,000,000 shares authorized; issued
and outstanding, 22,686,03022,698,171 in 20022003 and 22,657,741 in 2001......2002.................... 227 227
Additional paid-in capital.............................................. 77,272 77,15177,301 77,301
Accumulated deficit.................................................... (15,610) (1,222)
-----------------(22,913) (19,950)
---------------- ----------------
Total stockholders' equity...................................... 61,889 76,156
-----------------54,615 57,578
---------------- ----------------
Total liabilities and stockholders' equity....................... $63,606 $78,103
=================$56,056 $59,237
================ ================
The accompanying notes are an integral part of the financial statements.
3
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED
NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- ------------------------------MARCH 31,
------------------------------------
2003 2002
2001 2002 2001
--------------- --------------- --------------- -------------------------------- ----------------
Revenue:
Product sales....................................... $1,298 $819 $3,399 $2,959sales................................................. $710 $1,007
Contract revenue.................................... 1,926 1,538 6,177 6,412
Royalties........................................... 729 751 1,965 5,972
--------------- --------------- --------------- --------------revenue.............................................. 330 2,093
Royalties..................................................... 907 476
------------------ ----------------
Total revenue..................................... 3,953 3,108 11,541 15,343revenue 1,947 3,576
Costs and expenses:
Cost of product sales............................... 489 173 831 447sales......................................... 145 166
Cost of contract revenue............................ 1,352 1,376 4,344 5,516revenue...................................... 263 1,465
Research and development............................ 3,378 3,007 9,915 6,917development...................................... 3,448 3,365
Selling and marketing............................... 774 704 2,275 2,186marketing......................................... 575 683
General and administrative.......................... 772 722 2,165 2,172
--------------- --------------- --------------- --------------administrative.................................... 648 712
------------------ ----------------
Total costs and expenses........................... 6,765 5,982 19,530 17,238expenses 5,079 6,391
Loss from operations.................................... (2,812) (2,874) (7,989) (1,895)operations.............................................. (3,132) (2,815)
Interest income......................................... 224 522 695 1,953
--------------- --------------- --------------- --------------
Income (loss)income................................................... 169 239
------------------ ----------------
Loss before benefit from (provision for)provision for income taxes......................................... (2,588) (2,352) (7,294) 58
Benefit from (provision for)taxes............................ (2,963) (2,576)
Provision for income taxes............... (7,093) 313 (7,093)taxes........................................ - --------------- --------------- --------------- ---------------
------------------ ----------------
Net income (loss).......................................loss.......................................................... ($9,681)2,963) ($2,039) ($14,387) $58
=============== =============== =============== ==============2,576)
================== ================
Net income (loss)loss per share - basic.....................basic and diluted ........................... ($0.43)0.13) ($0.09) ($0.63) $0.00
Net income (loss) per share - diluted................... ($0.43) ($0.09) ($0.63) $0.000.11)
Weighted average shares - basic......................... 22,686 22,639 22,675 22,621
Weighted average shares -basic and diluted....................... 22,686 22,639 22,675 22,87622,698 22,664
The accompanying notes are an integral part of the financial statements.
4
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINETHREE MONTHS ENDED
SEPTEMBER 30,MARCH 31,
------------------------------------
2003 2002 2001
---------------- ----------------
Cash flows from operating activities:
Net income (loss)..........................................loss................................................... ($14,387) $582,963) ($2,576)
Adjustments to reconcile net income (loss)loss to net cash
provided by (used in)used in operating activities:
Depreciation and amortization............................. 1,405 1,249
Provision for doubtful accounts......................... - 25amortization............................ 405 479
Increase (decrease) from changes in assets and
liabilities:
Accounts receivable.................................. (1,130) 2,190(411) (860)
Inventories.......................................... 232 (200)
Deferred tax assets.................................. 7,093 -(53) 45
Prepaid expenses and other assets ................... 85 (202)expenses..................................... (74) 128
Accounts payable..................................... 294 6774 (13)
Accrued expenses..................................... (567) (127)(270) (622)
Deferred revenue..................................... 43 (1,451)(22) -
---------------- ----------------
Net cash provided by (used in)used in operating activities..................................... (6,932) 1,609activities............. (3,314) (3,419)
---------------- ----------------
Cash flows from investing activities:
Purchases of property and equipment....................... (587) (1,030)
Other assets.............................................. - (175)equipment........................ (71) (403)
Net sales (purchases) of short-term investments...................... 20,020 2,821investments............ (3,087) 20,028
Net purchases of investments............................... 1,798 -
---------------- ----------------
Net cash provided by (used in) investing
activities........ 19,433 1,616activities...................................... (1,360) 19,625
---------------- ----------------
Cash flows from financing activities:
Proceeds from issuance of common stock................... 121 262stock..................... - 61
---------------- ----------------
Net cash provided by financing activities......... 121 262- 61
---------------- ----------------
Increase (decrease) in cash and cash equivalents......................... 12,622 3,487equivalents.............. (4,674) 16,267
Cash and cash equivalents, beginning of period................ 25,268 36,056 51,662
---------------- ----------------
Cash and cash equivalents, end of period...................... $48,678 $55,149$20,594 $52,323
================ ================
The accompanying notes are an integral part of the financial statements.
5
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
A) BASIS OF PRESENTATION
The accompanying unaudited consolidated balance sheets, statements of
operations, and statements of cash flows reflect all adjustments
(consisting only of normal recurring items) which are, in the opinion
of management, necessary for a fair presentation of financial position
at September 30, 2002,March 31, 2003, and of the results of operations and cash flows for the interim
periods ended September 30, 2002March 31, 2003 and 2001.2002.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instructions for Form 10-Q and
therefore do not include all information and footnotes necessary for a
complete presentation of our financial position, results of operations
and cash flows, in conformity with generally accepted accounting
principles. We filed audited financial statements which included all
information and footnotes necessary for such presentation for the three
years ended December 31, 20012002 in conjunction with our 20012002 Annual
Report on Form 10-K.
The results of operations for the interim period ended September 30,
2002March 31, 2003
are not necessarily indicative of the results to be expected for the
year.
B) INVENTORY
Inventory consists primarily of the following (in thousands):
SEPTEMBER 30,MARCH 31, DECEMBER 31,
2003 2002
2001
----------------- --------------------------------- ---------------
Raw materials............. $15 $146$100 $46
Finished goods............ 35 136
----------------- -----------------3 4
---------------- ---------------
Total.............. $103 $50
$282
================= ================================= ===============
6
C) COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income or loss by
the weighted average number of common shares outstanding. Diluted
earnings per share is computed by dividing net income or loss by the
weighted average number of common shares outstanding plus additional
common shares that would have been outstanding if dilutive potential
common shares had been issued. For the purposes of this calculation,
stock options are considered common stock equivalents in periods in
which they have a dilutive effect. Stock options that are anti-dilutive
are excluded from the calculation.
Net income or loss per share is calculated as follows (in thousands,
except per share data):
THREE MONTHS ENDED
NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------MARCH 31,
-------------------------------
2003 2002
2001 2002 2001
------------- ------------- ------------- ---------------------------- ---------------
Net income (loss).................................loss........................................... ($9,681)2,963) ($2,039) ($14,387) $582,576)
Weighted average common shares outstanding........ 22,686 22,639 22,675 22,621outstanding......... 22,698 22,664
Additional dilutive common stock equivalents......equivalents....... - -
- 255
------------- ------------- ------------- ---------------------------- ---------------
Diluted shares outstanding ....................... 22,686 22,639 22,675 22,876
============= ============= ============= =============........................ 22,698 22,664
=============== ===============
Net income (loss)loss per share - basic...............basic......................... ($0.43)0.13) ($0.09) ($0.63) $0.000.11)
Net income (loss)loss per share - diluted.............diluted....................... ($0.43)0.13) ($0.09) ($0.63) $0.000.11)
For the three month periods ended September 30,March 31, 2003 and 2002, and 2001, potential
common stock equivalents of 459446 and 65,329,447,572, respectively, were not
included in the per share calculation for diluted EPS, because we had
a net loss and the effect of their inclusion would be
anti-dilutive. For the nine month period ended September 30, 2002,
potential common stock equivalents of 309,647 were not included in the
per share calculation for diluted EPS, because we had a net losslosses and the effect of their inclusion would be anti-dilutive.
For the three month periods ended September 30,March 31, 2003 and 2002, and 2001, additional options to
purchase 7,594,3046,747,169 and 5,259,2235,213,516 shares of common stock, respectively,
were outstanding, but were not included in the computation of diluted
EPS because the options' exercise prices were greater than the average
market price of the common stock and thus would be anti-dilutive.
ForD) STOCK-BASED COMPENSATION
We grant stock options to our employees and directors. Such grants are
for a fixed number of shares with an exercise price equal to the nine month periods ended September 30, 2002fair
value of the shares at the date of grant. As permitted by SFAS No. 123,
"Accounting for Stock-Based Compensation", we account for stock option
grants in accordance with Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees" and 2001, additionalFASB
Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions
Involving Stock Compensation." Accordingly, we have adopted the
provisions of SFAS No. 123 through disclosure only.
No stock-based employee compensation cost is reflected in net loss, as
all options granted under those plans had an exercise price equal to
the fair market value of the
7
underlying common stock on the date of grant. The following table
illustrates the pro forma effect on net loss and earnings per share if
we had applied the fair value recognition provisions of SFAS No. 123
and SFAS No. 148 to stock-based employee compensation (in thousands,
except per share data):
THREE MONTHS ENDED
MARCH 31,
-----------------------------
2003 2002
-----------------------------
Net loss - as reported................................... ($2,963) ($2,576)
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards......................................... 5,005 5,283
-----------------------------
Net loss - pro forma..................................... ($7,968) ($7,859)
=============================
Basic loss per share - as reported....................... ($0.13) ($0.11)
Basic loss per share - pro forma......................... ($0.35) ($0.35)
Diluted loss per share - as reported..................... ($0.13) ($0.11)
Diluted loss per share - pro forma....................... ($0.35) ($0.35)
The fair value of options on their grant date was measured using the
Black-Scholes option pricing model. Key assumptions used to apply this
pricing model are as follows:
THREE MONTHS ENDED
MARCH 31,
-----------------------------
2003 2002
-----------------------------
Average risk-free interest rate.......................... 2.91% 3.82%
Expected life of option grants........................... 5 years 5 years
Expected volatility of underlying stock.................. 98% 99%
Expected dividend yield.................................. - -
E) EMPLOYEE STOCK OPTION EXCHANGE PROGRAM
On March 3, 2003, we commenced an offer to exchange outstanding stock
options with eligible employees. Under the terms of the program,
eligible employees had the right to tender for cancellation all stock
options that they held with an exercise price above $3.00 per share by
April 1, 2003. We accepted for exchange options to purchase 5,364,298 and 3,496,090an
aggregate of 6,162,952 shares of our common stock. Subject to the terms
and conditions of the offer, we will issue new options to purchase an
aggregate of up to 3,081,563 shares of our common stock respectively, were outstanding, but were not included inbetween October
2, 2003 and November 13, 2003. Such replacement options will be priced
at the computationcurrent market value of diluted EPS becauseour stock on the options' exercise prices were
greater than the average market price of the common stock and thus
would be anti-dilutive.
7replacement grant date.
8
D)F) BUSINESS SEGMENTS
We organize the companyThe Company organizes itself as one segment and conduct ourconducts its operations
in the United States.
We sell ourThe Company sells its products and technology to domestic and
international customers. Revenues were generated from the following
geographic regions (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2002 2001 2002 2001
------------- ------------- ------------- --------------
United States.................................... $3,153 $2,849 $9,294 $14,507
Asia/Pacific..................................... 434 59 1,523 97THREE MONTHS ENDED
MARCH 31,
------------------------------
2003 2002
------------------------------
United States..................... $1,513 $3,018
Germany........................... 374 440
Rest of World.................................... 366 200 724 739
------------- ------------- ------------- --------------
$3,953 $3,108 $11,541 $15,343
============= ============= ============= ==============
E) INCOME TAXES
We have evaluated, on a quarterly basis, the positive and negative
evidence affecting the realizability of our deferred tax assets. In the
third quarter of 2002, we determined that due to our continuing
operating losses over the last six quarters as well as the uncertainty
of the timing of profitability in future periods, we should fully
reserve our deferred tax assets as of September 30, 2002. As a result,
we recorded a tax provision of $7.1 million in the quarter ended
September 30, 2002.
At December 31, 2001, we had federal net operating loss carryforwards
of approximately $50.9 million, which begin to expire in 2005, and
federal research and development credit carryforwards of approximately
$6.7 million, which begin to expire in 2003. At December 31, 2001, we
also had available state net operating loss carryforwards of
approximately $50.9 million, which began to expire in 2002, and state
research and development and investment tax credit carryforwards of
approximately $3.5 million, which begin to expire in 2003.
F) SUBSEQUENT EVENT
In October 2002, we terminated 35 employees to reduce our operating
costs. Of the 35 employees who were terminated, 32 were in engineering,
2 were in selling and marketing, and 1 was in administration. We
estimate that the cost of severance and other employee benefits for
terminated employees will be approximately $700,000. The full cost of
the headcount reduction will be recorded in the fourth quarter of 2002.
8
World..................... 60 118
------------------------------
$1,947 $3,576
==============================
G) RECENTLY ADOPTEDRECENT ACCOUNTING PRONOUNCEMENTS
In August 2001, the FASB issued Statement of Financial Accounting
Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or
Disposal of Long-Lived Assets." SFAS 144 supercedes FASB Statement No.
121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of." SFAS 144 applies to all
long-lived assets (including discontinued operations) and consequently
amends Accounting Principles Board Opinion No. 30, "Reporting Results
of Operations - Reporting the Effects of Disposal of a Segment of a
Business." SFAS 144 is effective for financial statements issued for
fiscal years beginning after December 15, 2001. We adopted SFAS 144 in
the first quarter of 2002. The implementation of SFAS 144 did not have
an effect on our financial statements.
In June 2002, the FASB issued SFAS No. 146,148, "Accounting for Costs
Associated with Exit or Disposal Activities" ("Stock-Based
Compensation-Transition and Disclosure - An Amendment of SFAS 146"). This
statement addressesNo. 123."
SFAS 148 amends SFAS 123, "Accounting for Stock-Based Compensation" to
provide alternative methods of transition for those companies who
voluntarily change to the fair value based method of accounting for
stock-based employee compensation. In addition, this Statement amends
the disclosure requirements of SFAS 123 to require prominent
disclosures in both the annual and interim financial statements about
the method of accounting for stock-based employee compensation and reporting for costs
associated with exit or disposal activitiesthe
effect of the method used on reported results. The transition and
supercedes EITF Issue
No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs
Incurred in a Restructuring)" ("EITF 94-3"). SFAS 146 requires that a
liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. EITF 94-3 allowed for an
exit cost liability to be recognized at the date of an entity's
commitment to an exit plan. SFAS 146 also requires that liabilities
recorded in connection with exit plans be initially measured at fair
value. Theannual disclosure provisions of SFAS 146148 are effective for exit or disposal
activities that are initiatedfiscal years
ending after December 15, 2002. We have not adopted the fair value
method of accounting for stock-based compensation, and will continue to
apply APB 25 for our stock-based compensation plans. We have adopted
the disclosure requirements of SFAS 148 in this Form 10-Q, which is
included in the "Stock-Based Compensation" footnote of our consolidated
financial statements.
In January 2003, FASB issued FASB Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities," which addresses
consolidation by a business of variable interest entities in which it
is the primary beneficiary. The Interpretation is effective immediately
for certain disclosure requirements and variable interest entities
created after January 31, 2002, with early
adoption encouraged.2003, and periods beginning after June 15,
2003 for variable interest entities created before February 1, 2003. We
do not expect that the adoption of SFAS 146FIN 46 will have a material impact
on our financial position orand results of operations.
In November 2002, the EITF issued No. 00-21, "Accounting for Revenue
Arrangements with Multiple Deliverables." EITF Issue No. 00-21
addresses certain aspects of the accounting by a vendor for
arrangements under which it will perform multiple revenue-generating
activities. EITF Issue No. 00-21 establishes three principles: revenue
should be recognized separately for separate units of accounting,
revenue for a separate unit of accounting should be recognized only
when the arrangement consideration is reliably
9
measurable and the earnings process is substantially complete, and
consideration should be allocated among the separate units of
accounting in an arrangement based on their relative fair values. EITF
Issue No. 00-21 is effective for all revenue arrangements entered into
in fiscal periods beginning after June 15, 2003, with early adoption
permitted. We are currently determining the impact, if any, EITF Issue
No. 00-21 will have on our financial position and results of
operations.
10
ITEM 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
SOME OF THE INFORMATION IN THIS FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-Q, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-Q COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS.
RESULTS OF OPERATIONS
PRODUCT SALES. Product sales consist primarily of revenue from the sale
of asymmetric digital subscriber line ("ADSL") equipmenthardware products and compression software products. Thesoftware. Hardware products that compriseprimarily
include ADSL equipment sales are primarily test and development systems, modules, and modems. Compression
software consists of standard off-the-shelf software products that are sold to
OEM customers that integrate our software into their equipment-based products.
Product sales increased 58%decreased 29% from $0.8$1.0 million in the thirdfirst quarter of 20012002 to
$1.3$0.7 million in the current year quarter. As a percentage of total revenue,
product sales increased from 26%28% in the thirdfirst quarter of 20012002 to 33%36% in the
current year quarter. The dollar increasedecrease was primarily due to an increase in
revenue from the sale of modules and compression software. Module sales were
higher primarily due to sales to a customer that is using them in ADSL test
equipment. Compression software revenue increased primarily due to higher demand
for our electronic identification products.
For the nine months ended September 30, product sales increased 15% from $3.0
million in 2001 to $3.4 million in 2002. As a percentage of total revenue,
product sales increased from 19% in the first nine months of 2001 to 29% in the
corresponding period of 2002. The dollar increase was primarily due to an
increase in revenue from the sale of modules, which was partially offset by a decrease in
revenue from the sale of test and development systems. Module sales
were highercompression software. Compression software revenue
decreased primarily due to lower sales to a customer that is using them in ADSL test
equipment.of our electronic identification
products.
CONTRACT REVENUE. Contract revenue consists primarily of license and
engineering service fees that we receive under agreements with our customers to
develop ADSL chipsets.
Contract revenue increased 25%decreased 84% from $1.5$2.1 million in the thirdfirst quarter of 20012002 to
$1.9$0.3 million in the current year quarter. As a percentage of total revenue,
contract revenue was 49% fordecreased from 59% in the thirdfirst quarter of 2001 and the current year
quarter. The dollar increase was primarily due2002 to the completion of a project
with one of our existing customers.
10
For the nine months ended September 30, contract revenue decreased 4% from $6.4
million in 2001 to $6.2 million in 2002. As a percentage of total revenue,
contract revenue increased from 42% in the third quarter of 2001 to 54%17% in the
current year quarter. The dollar decrease was primarily due to a difficult
semiconductor industry environment.environment for licensing intellectual property for communications integrated
circuits. Both existing and prospective ADSL chipset licensees have beenwere reluctant or slow to
begin new development projects with us.
We believe this isgiven: (i) generally weak worldwide economic
conditions, (ii) a result of the uncertaintydifficult and uncertain environment in the semiconductor and
telecommunications industries.industries, and (iii) intense ADSL chipset competition and
falling chipset prices. During the last several years, customers and potential
customers cautiously evaluated new chipset projects or delayed or cancelled
projects in the face of such conditions. We are uncertain when the economic and
market conditions we faced over the last six quartersseveral years will improve.
11
ROYALTIES. Royalties consist of royalty payments that we receive under
licensing agreements. We receive royalties from customers for the right to use
our technology in their chipsets or solutions.
Royalties decreased 3%increased 90% from $0.8$0.5 million in the thirdfirst quarter of 20012002 to $0.7$0.9
million in the current year quarter. As a percentage of total revenue, royalties
decreasedincreased from 24%13% in the thirdfirst quarter of 20012002 to 18%47% in the current year
quarter. For the nine months ended September 30,The increase in royalties decreased 67% from
$6.0 million in 2001 to $2.0 million in 2002. As a percentage of total revenue,
royalties decreased from 39% in the first nine months of 2001 to 17% in the
corresponding period of 2002.
For the three and nine months periods, the decrease in royaltiesthis quarter was primarily due to a decreasean increase
in ADSL chipset sales by our largest customer, Analog Devices, Inc. ("ADI").
We believe that sluggishDespite the increase in ADSL chipset demand and lower chipset prices
were the primary reasons behind the decline insales by ADI this quarter, ADI's chipset
sales. Whilesales have declined in previous quarters primarily due to falling ADSL chipset
pricing and a potential loss of market share. Despite strong growth of worldwide
demand for ADSL service remains strong, demand for ADSL chipsets has
been weaker because of excess equipment capacity at telephone companies' central
offices. Also,subscribers over the last several years, the availability of ADSL chipsets
from a number of suppliers and intense competition among those suppliers has
caused chipset prices to drop sharply over the last six quarters.sharply. Additionally, deployments of ADSL service
in geographic areas where chipsets based upon our technology have been sold,
leveled off or declined recently. We are uncertain when these market
conditionsADSL chipset pricing
will improve.improve, whether ADI will be able to continue to grow its presence or
whether our other licensees will contribute meaningful royalty revenue.
COST OF PRODUCT SALES. Since the cost of compression software license
sales is minimal, cost of product sales consists primarily of ADSL equipment
sales. Cost of product sales increased 183%decreased 13% from $173,000$166,000 in the thirdfirst quarter of
20012002 to $489,000$145,000 in the current year quarter. As a percentage of product sales,
cost of product sales increased from 21%16% in the thirdfirst quarter of 20012002 to 38%20% in
the current year quarter. ForIn terms of dollars, the nine months ended September 30, cost of
product sales increased 86% from $447,000 in 2001 to $831,000 in 2002. As a
percentage of product sales, cost of product sales increased from 15% in the
first nine months of 2001 to 24% in the corresponding period of 2002.
For the three and nine month periods, the increasedecrease in cost of product
sales was primarily due to lower sales of modules during the current quarter.
The decline in product margins was primarily due to a greatersmaller proportion of
modulecompression software sales in the product sales revenue mix. Modules
have higher cost of sales than the other products that comprise our product
revenue.
COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily
of salaries for engineers and expenses for consultants, recruiting, supplies,
equipment, depreciation and facilities associated with customer development
projects. Our total engineering costs are allocated between cost of contract
revenue and research and development expense. In a given period, the allocation
of engineering costs between cost of contract revenue and research and
development is a function of the level of effort expended on each.
As a
particular technology matures from the development stage to integration into
customer chips, engineering costs typically shift from research and development
to cost of contract revenue.
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For the three months ended September 30, costCost of contract revenue was
essentially the same at $1.4decreased 82% from $1.5 million in 2001 andthe first quarter of
2002 to $0.3 million in 2002.the current year quarter. As a percentage of contract
revenue, cost of contract revenue decreasedincreased from 89%70% in the thirdfirst quarter of
20012002 to 70%80% in the current year quarter. Cost of contract revenue as
a percentage of contract revenue fell in 2002 because the mix of license fees
and engineering services fees in contract revenue in 2002 produced more
profitable business than in 2001.
For the nine months ended September 30, cost of contract revenue decreased 21%
from $5.5 million in 2001 to $4.3 million in 2002. As a percentage of contract
revenue, cost of contract revenue decreased from 86% in the first nine months of
2001 to 70% in the corresponding period of 2002. The dollar decrease in cost of contract
revenue was primarily due to two factors: (i) contract revenue was
lowerfewer customer contracts in 2002the first quarter of
2003 as compared to 2001, thereforewith the first quarter of 2002. Since our cost of contract
revenue was lower
as well,is based on the level of effort we expend on customer projects and (ii) the
mixnumber of license fees and engineering service fees incustomer projects declined from the first quarter of 2002 to the first
quarter of 2003, cost of contract revenue in 2002 produced more profitable business than in 2001.declined as well.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense
consists primarily of salaries for engineers and expenses for consultants,
recruiting, supplies, equipment, depreciation and facilities related to
engineering projects to enhance and extend our broadband intellectual property
offerings, and our compression software technology. Research and development
expense increased by 12% from $3.0 million inwas essentially the third quarter of 2001 tosame at $3.4 million in the current year quarter. As a percentage of total revenue, research
and development expense decreased from 97% in the thirdfirst quarter of 2001 to 85%
in the current year quarter. For the nine months ended September 30, research2002
and development expense increased by 43% from $6.9 million in 2001 to $9.9
million in 2002.2003. As a percentage of total revenue, research and development expense
increased from 45%94% in the first nine monthsquarter of 20012002 to 86%177% in the corresponding periodcurrent year
quarter. Although research and
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development expenses were essentially unchanged during the first quarter of 2002.
For the three2003
and nine month periods, the dollar increase in research2002, there were two offsetting factors that caused this result. Research
and development spending was primarily due to two factors: (i) we hiredincreased in the first quarter of 2003 because of a
numbershift of new engineers during 2001, therefore our 2002 spending reflects the full period
effect of those new hires, whereas 2001 spending reflects that portion of the
period that these employees were with us; and (ii) as our customer contract
revenue projects decreased over the past year, we have shifted engineers who
were working on thesefrom customer projects to internal research and development
projects.projects, as we had fewer customer projects in the first quarter of 2003 than in
the first quarter of 2002. This increase was offset by a decrease of
approximately $1.0 million in salaries and related expenses due to the reduction
in force we implemented in October 2002 and salary reductions we imposed on
January 1, 2003.
Our research and development spending is principally focused on projects related
to core ADSL technology, VeDSL,including our StratiPHY chip, as well as for Dr. DSL,
G.SHDSL, wireless local area network communications, as well asand other development
projects.
In October 2002, we terminated 35 employees to reduce our operating costs. Of
the 35 employees who were terminated, 32 were engineers. We estimate that the
cost of severance and other employee benefits for terminated employees will be
approximately $700,000. This cost will be recorded in the fourth quarter of
2002, and it approximates our historical quarterly costs for these employees as
if they were active employees. Consequently, we expect fourth quarter research
and development expenses will be consistent with prior quarters in 2002 assuming
consistent levels of contract revenue. If contract revenue in the fourth quarter
declines relative to the prior quarters of 2002, more engineering resources will
shift from cost of contract revenue into research and development, and as a
result research and development expense may increase despite the reduction in
force.
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In connection with the October reduction in force, we informed remaining
employees that effective January 1, 2003 their salaries would be reduced by 5%
and that senior management's salaries would be reduced by 10%. We anticipate
that the reduction in force and salary reductions will lower total 2003
engineering expenses by approximately $3.7 million annually, and will lower
total 2003 company expenses by $4.1 million annually. Total engineering expenses
include cost of contract revenue and research and development expense.
SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of salaries for sales and marketing personnel, travel, advertising and
promotion, recruiting, and facilities expense. SellingSales and marketing expense
increased 10%decreased 16% from $704,000$683,000 in the thirdfirst quarter of 20012002 to $774,000$575,000 in the
current year quarter. As a percentage of total revenue, sellingsales and marketing
expense decreasedincreased from 23%19% in the thirdfirst quarter of 20012002 to 20%30% in the current
year quarter. The dollar increasedecrease was primarily due to increased spending onlower sales staff, higher sales commissions and higher legal expenses associated with
negotiating development and licensing agreements.
For the nine months ended September 30, selling and marketing expense increased
by 4% from $2.2 million in 2001 to $2.3 million in 2002. As a percentage of
total revenue, selling and marketing expense increased from 14% in the first
nine months of 2001 to 20% in the corresponding period of 2002. The dollar
increase was primarily due to increased spending on sales staff and higher commissions
for product sales which was partially offset by lower advertisingas well as the reduction in force we implemented in October
2002 and tradeshow expenses.salary reductions we imposed on January 1, 2003.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists primarily of salaries for administrative personnel, facilities costs,
and public company, bad debt, legal, and audit expenses. General and
administrative expense increased 7%decreased 9% from $722,000$712,000 in the thirdfirst quarter of 20012002
to $772,000$648,000 in the current year quarter. As a percentage of total revenue,
general and administrative expense decreasedincreased from 23%20% in the thirdfirst quarter of
20012002 to 20%33% in the current year quarter. The dollar increase isdecrease was primarily due
to higher expenses associated with being a public company.
For the nine months ended September 30, generalreduction in force we implemented in October 2002 and administrative expenses were
$2.2 million in 2001 and in 2002. As a percentage of total revenue, general and
administrative expense increased from 14% in the first nine months of 2001 to
19% in the corresponding period of 2002.salary reductions
we imposed on January 1, 2003.
INTEREST INCOME. Interest income decreased 57%29% from $522,000$239,000 in the
thirdfirst quarter of 20012002 to $224,000$169,000 in the current year quarter. For the nine
months ended September 30, interest income decreased 64% from $1,953,000 in 2001
to $695,000 in 2002. For the three and nine month periods, theThe dollar
decrease iswas primarily due to lower interest rates earned on our cash balances
and to a
lesser extent lower cash balances.
INCOME TAXES. We have evaluated, on a quarterly basis,made no provision for income taxes in the positivefirst
quarter of 2003 and negative evidence affecting the realizability of our deferred tax assets.2002 due to net losses incurred. In the
third quarter of 2002, we determined that
due to our continuing operating losses over the last six quartersin 2001 and 2002 as well as the
uncertainty of the timing of profitability in future periods, we should fully
reserve our deferred tax assets. As of March 31, 2003, our deferred tax assets
ascontinue to be fully reserved. We will continue to evaluate, on a quarterly
basis, the positive and negative evidence affecting the realizability of September 30, 2002. As a result, we recorded aour
deferred tax provision of $7.1
million in the quarter ended September 30, 2002.assets.
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In the first quarter of 2001, we recorded a $1.4 million provision for income
taxes based on our profitability in that quarter and our projected taxable
income for 2001. As 2001 progressed, it became apparent that deteriorating ADSL
market conditions would adversely affect our full year revenue and profit
expectations. Consequently, we revised our 2001 effective tax rate and reversed
$1.1 million and $0.3 million of the first quarter income tax provision in the
second and third quarters of 2001, respectively.
At December 31, 2001, we had federal net operating loss carryforwards of
approximately $50.9 million, which begin to expire in 2005, and federal research
and development credit carryforwards of approximately $6.7 million, which begin
to expire in 2003. At December 31, 2001, we also had available state net
operating loss carryforwards of approximately $50.9 million, which began to
expire in 2002, and state research and development and investment tax credit
carryforwards of approximately $3.5 million, which begin to expire in 2003.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2002,March 31, 2003, we had cash, cash equivalents, and short-term investments and
investments of $49.9$43.7 million, which represents a decrease of $7.4$3.4 million from
December 31, 2001.2002. The decrease is primarily due to $6.9$3.3 million of cash used in
operations, and $587,000$71,000 of cash invested in capital equipment, which was partially offset
by $121,000 of proceeds from the issuance of common stock.equipment.
Cash used in operations in the first ninethree months of 20022003 was primarily the
result of operating losses and working capital requirements. Capital spending
was primarily related to the purchase of computer hardware and software, and
laboratory equipment used principally in engineering activities.
While we can not assure you that we will not require additional financing, or
that such financing will be available to us, we believe that our cash, cash
equivalents and short-term investments will be sufficient to fund our operations
for at least the next twelve months.
RECENTLY ADOPTEDRECENT ACCOUNTING PRONOUNCEMENTS
In August 2001, the FASB issued Statement of Financial Accounting Standards No.
144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived
Assets." SFAS 144 supercedes FASB Statement No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
SFAS 144 applies to all long-lived assets (including discontinued operations)
and consequently amends Accounting Principles Board Opinion No. 30, "Reporting
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business." SFAS 144 is effective for financial statements issued for fiscal
years beginning after December 15, 2001. We adopted SFAS 144 in the first
quarter of 2002. The implementation of SFAS 144 did not have an effect on our
financial statements.
In June 2002, the FASB issued SFAS No. 146,148, "Accounting for Costs Associated
with Exit or Disposal Activities" ("Stock-Based
Compensation-Transition and Disclosure - An Amendment of SFAS 146"). This statement addressesNo. 123." SFAS 148
amends SFAS 123, "Accounting for Stock-Based Compensation" to provide
alternative methods of transition for those companies who voluntarily change to
the fair value based method of accounting for stock-based employee compensation.
In addition, this Statement amends the disclosure requirements of SFAS 123 to
require prominent disclosures in both the annual and interim financial
statements about the method of accounting for stock-based employee compensation
and reporting for costs associated with exit or disposal
activitiesthe effect of the method used on reported results. The transition and supercedes EITF Issue No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
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Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3").
SFAS 146 requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred. EITF 94-3
allowed for an exit cost liability to be recognized at the date of an entity's
commitment to an exit plan. SFAS 146 also requires that liabilities recorded in
connection with exit plans be initially measured at fair value. Theannual
disclosure provisions of SFAS 146148 are effective for exit or disposal activities that are initiatedfiscal years ending after
December 15, 2002. We have not adopted the fair value method of accounting for
stock-based compensation, and will continue to apply APB 25 for our stock-based
compensation plans. We have adopted the disclosure requirements of SFAS 148 in
this Form 10-Q, which is included in the "Stock-Based Compensation" footnote of
our consolidated financial statements.
In January 2003, FASB issued FASB Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities," which addresses consolidation by
a business of variable interest entities in which it is the primary beneficiary.
The Interpretation is effective immediately for certain disclosure requirements
and variable interest entities created after January 31, 2002, with early adoption encouraged.2003, and periods
beginning after June 15, 2003 for variable interest entities created before
February 1, 2003. We do not expect that the adoption of SFAS 146FIN 46 will have a
material impact on our financial position orand results of operations.
In November 2002, the EITF issued No. 00-21, "Accounting for Revenue
Arrangements with Multiple Deliverables." EITF Issue No. 00-21 addresses certain
aspects of the accounting by a vendor for arrangements under which it will
perform multiple revenue-generating activities. EITF Issue No. 00-21 establishes
three principles: revenue should be recognized separately for separate units of
accounting, revenue for a separate unit of accounting should be recognized only
when the arrangement consideration is reliably measurable and the earnings
process is
14
substantially complete, and consideration should be allocated among the separate
units of accounting in an arrangement based on their relative fair values. EITF
Issue No. 00-21 is effective for all revenue arrangements entered into in fiscal
periods beginning after June 15, 2003, with early adoption permitted. We are
currently determining the impact, if any, EITF Issue No. 00-21 will have on our
financial position and results of operations.
RISK FACTORS
We believe that the occurrence of any one or some combination of the following
risk factors could seriously harm our business.
OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY
Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter to quarter. Because our revenue components
fluctuate and are difficult to predict, and our expenses are largely independent
of revenues in any particular period, it is difficult for us to accurately
forecast revenues and profitability. We generally recognize contract revenues
ratably over the period during which we expect to provide engineering services.
While this means that contract revenues from current licenses are generally
predictable, changes can be introduced by a reevaluation of the length of the
development period.period, or by the termination of a contract. The initial estimate of
this period is subject to revision as the product being developed under a
contract nears completion, and a revision may result in an increase or decrease
to the quarterly revenue for that contract. In addition, accurate prediction of
revenues from new licensees is difficult because the development of a business
relationship with a potential licensee is a lengthy process, frequently spanning
a year or more, and the fiscal period in which a new license agreement will be
entered into, if at all, and the financial terms of such an agreement are
difficult to predict. Contract revenues also include fees for engineering
services, which are dependent upon the varying level of assistance desired by
licensees and, therefore, the revenue from these services is also difficult to
predict.
It is also difficult for us to make accurate forecasts of royalty revenues.
Royalties are generally recognized in the quarter in which we receive a report from a
licensee regarding the shipment of licensed integrated circuits in the prior
quarter, and are dependent upon fluctuating sales volumes and/or prices of chips
containing our technology, all of which are beyond our ability to control or
assess in advance.
Our business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:
|X| market acceptance of our broadband technologies by
semiconductor companies;
|X| the extent and timing of new license transactions with
semiconductor companies;
|X| changes in our and our licensees' development schedules and
levels of expenditure on research and development;
|X| the loss of a strategic relationship with a licensee;
|X| equipment companies' acceptance of integrated circuits
produced by our licensees;
|X| the loss by a licensee of a strategic relationship with an
equipment company customer;
15
|X| announcements or introductions of new technologies or products
by us or our competitors;
15
|X| delays or problems in the introduction or performance of
enhancements or of future generations of our technology;
|X| delays in the adoption of new industry standards or changes in
market perception of the value of new or existing standards;
|X| competitive pressures resulting in lower contract revenues or
royalty rates;
|X| personnel changes, particularly those involving engineering
and technical personnel;
|X| costs associated with protecting our intellectual property;
|X| the potential that licensees could fail to make payments under
their current contracts;
|X| ADSL market-related issues, including lower ADSL chipset unit
demand brought on by excess channel inventory and lower
average selling prices for ADSL chipsets as a result of market
surpluses;
|X| regulatory developments; and
|X| general economic trends and other factors.
WE HAVE EXPERIENCED NET LOSSES
We had a net lossesloss during 2001, 2002 and the first nine monthsquarter of 2002.2003. We expect
that we will have a net loss during the fourthsecond quarter of 2002.2003. We may continue
to experience losses beyondin the fourth quarter of 2002 if:future if;
|X| the semiconductor and telecommunications markets do not
recover from the downturn that began in 2001;2001.
|X| our existing customers do not increase their revenues from
sales of chipsets with our technology; or
|X| new and existing customers do not choose to license our
intellectual property for new chipset products.
WE HAVE A UNIQUE BUSINESS MODEL
The success of our business model depends upon our ability to license our
technology to semiconductor and equipment companies, and our customers'
willingness and ability to sell products that incorporate our technology so that
we may receive significant royalties that are consistent with our plans and
expectations.
We face numerous risks in successfully obtaining suitable licensees on terms
consistent with our business model, including, among others:
|X| we must typically undergo a lengthy and expensive process of
building a relationship with a potential licensee before there
is any assurance of a license agreement with such party;
|X| we must persuade semiconductor and equipment manufacturers
with significant resources to rely on us for critical
technology on an ongoing basis rather than trying to develop
similar technology internally;
|X| we must persuade potential licensees to bear development costs
associated with our technology applications and to make the
necessary investment to successfully produce chipsets and
products using our technology; and
16
|X| we must successfully transfer technical know-how to licensees.
16
Moreover, the success of our business model also depends on the receipt of
royalties from licensees. Royalties from our licensees are often based on the
selling prices of our licensees' chipsets and products, over which we have
little or no control. We also have little or no control over our licensees'
promotional and marketing efforts. Our licensees are not required to pay us
royalties unless they use our technology. They are not prohibited from competing
against us.
Our business could be seriously harmed if:
|X| we cannot obtain suitable licensees;
|X| our licensees fail to achieve significant sales of chipsets or
products incorporating our technology; or
|X| we otherwise fail to implement our business strategy
successfully.
THERE ISHAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, WHICH HAS
CAUSED OUR ROYALTY REVENUE TO DECLINE
The royalties we receive are influenced by many of the risks faced by the ADSL
market in general; including reduced average selling prices ("ASPs") for ADSL
chipsets during periods of surplus. Since late 2000, the ADSL industry has
experienced an oversupply of ADSL chipsets and central office equipment.
Excessive inventory levels led to soft chipset demand, which in turn led to
declining ASPs. As a result of the soft demand and declining ASPs for ADSL
chipsets, our royalty revenue has decreased substantially from the levels we
achieved in 2000. Price decreases for ADSL chipsets, and the corresponding
decreases in per unit royalties received by us, can be sudden and dramatic.
Pricing pressures may continue during the fourthsecond quarter of 20022003 and beyond. Our
royalty revenue may continue to decline.decline over the long term.
WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES
There is a relatively limited number of semiconductor and equipment companies to
which we can license our broadband technology in a manner consistent with our
business model. If we fail to maintain relationships with our current licensees
or fail to establish a sufficient number of new licensee relationships, our
business could be seriously harmed. OurWe are less certain than we have been in the
past that one of our large customers, Intel, will offer ADSL products based upon
licensed technology from Aware. Over the last year, our confidence that Intel
will be a large, long term source of revenue for us has diminished. In addition,
our prospective customers may use their superior size and bargaining power to
demand license terms that are unfavorable to us and prospective customers may
not elect to license from us.
WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM ONE CUSTOMER
In 2001, 2002 and the first nine monthsquarter of 2002,2003, we derived a significant amount52%, 32% and 40%,
respectively of our total revenue from ADI. ADI was the first customer to
license ADSL technology from us in 1993, and their chipsets are the most mature
implementations of our technology in the market. Our royalty revenues to date
have been primarily due to sales of ADI chipsets that use our ADSL technology.
Our royalty revenue in the near term is highly dependent upon ADI's ability to
maintain its market share and pricing. The ADSL market has experienced
significant price erosion, which has adversely affected ADI's ADSL revenue,
which in turn has adversely affected
17
our royalty revenue. To the
17
extent that ADI has lost market share, or loses
market share in the future, or experiences further price erosion in its ADSL
chipsets, our royalty revenue maycould continue to decline.
OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES
Due to our business strategy, our success is dependent on our ability to
generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is
materially affected by the willingness of equipment companies to purchase
integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to
offer broadband communications products. We face the risk that equipment
manufacturers will choose those alternative solutions. Generally, our ability to
influence equipment companies' decisionsdecision whether to purchase integrated circuits
that incorporateincorporates our technology is limited.
We also face the risk that equipment companies that elect to use integrated
circuits that incorporate our technology into their products will not compete
successfully against other equipment companies. Many factors beyond our control
could influence the success or failure of a particular equipment company that
uses integrated circuits based on our technology, including:
|X| competition from other businesses in the same industry;
|X| market acceptance of its products;
|X| its engineering, sales and marketing, and management
capabilities;
|X| technical challenges of developing its products unrelated to
our technology; and
|X| its financial and other resources.
Even if equipment companies incorporate our chipsets based on our intellectual
property into their products, their products may not achieve commercial
acceptance or result in significant royalties to us.
OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL ADSL SERVICE IN VOLUME
The success of our ADSL licensing business depends upon telephone companies
installing ADSL service in significant volumes. Factors that affect the volume
deployment of ADSL service include:
|X| the desire of telephone companies to install ADSL service,
which is dependent on the development of a viable business
model for ADSL service, including the capability to market,
sell, install and maintain the service;
|X| the pricing of ADSL services by telephone companies;
|X| the quality of telephone companies' networks;
|X| government regulations; and
|X| the willingness of residential telephone customers to demand
ADSL service in the face of competitive service offerings,
such as cable modems.
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If telephone companies do not install ADSL service in significant volumes, or if
telephone companies install ADSL service based on other technology, our business
will be seriously harmed.
18
OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION
Because we are a technology provider, our ability to protect our intellectual
property and to operate without infringing the intellectual property rights of
others is critical to our success. We regard our technology as proprietary, and
we have a number of patents and pending patent applications. We also rely on a
combination of trade secrets, copyright and trademark law and non-disclosure
agreements to protect our unpatented intellectual property. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use our technology without authorization.
As part of our licensing arrangements, we typically work closely with our
semiconductor and equipment manufacturer licensees, many of whom are also our
potential competitors, and provide them with proprietary know-how necessary for
their development of customized chipsets based on our ADSL technology. Although
our license agreements contain non-disclosure provisions and other terms
protecting our proprietary know-how and technology rights, it is possible that,
despite these precautions, some of our licensees might obtain from us
proprietary information that they could use to compete with us in the
marketplace. Although we intend to defend our intellectual property as
necessary, the steps we have taken may be inadequate to prevent
misappropriation.
In the future, we may choose to bring legal action to enforce our intellectual
property rights. Any such litigation could be costly and time-consuming for us,
even if we were to prevail. Moreover, even if we are successful in protecting
our proprietary information, our competitors may independently develop
technologies substantially equivalent or superior to our technology. The
misappropriation of our technology or the development of competitive technology
could seriously harm our business.
Our technology may infringe the intellectual property rights of others. A large
and increasing number of participants in the telecommunications industry have
applied for or obtained patents. Some of these patent holders have demonstrated
a readiness to commence litigation based on allegations of patent and other
intellectual property infringement. Third parties may assert patent, copyright
and other intellectual property rights to technologies that are important to our
business. From time to time,In the past, we have received claims from other companies that our
technology infringes their patent rights. While we believe our technology
offerings do not infringe the intellectual property of others, we cannot be
sure. Intellectual property rights can be
uncertain and can involve complex legal and factual questions. We may be unknowingly infringinginfringe
the proprietary rights of others, which could result in significant liability
for us. If we were found to have infringed any third party's patents, we could
be subject to substantial damages and an injunction preventing us from
conducting our business.
OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE
The semiconductor and telecommunications industries, as well as the market for
high-speed network access technologies, are characterized by rapid technological
change, with new generations of products being introduced regularly and with
ongoing evolutionary improvements.
19
We expect to depend on our ADSL technology for a substantial portion of our
revenue for the foreseeable future. Therefore, we face risks that others could
introduce competing technology that renders our ADSL technology less desirable
or obsolete. Also, the announcement of new technologies could cause our
licensees or their customers to delay or defer entering into
19
arrangements for
the use of our existing technology. Either of these events could seriously harm
our business.
We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our ADSL technology as well as
new technologies that keep pace with changes in the telecommunications and
broadband industries and that achieve rapid market acceptance. We must
continually devote significant engineering resources to achieving technical
innovations. These innovations are complex and require long development cycles.
Moreover, we may have to make substantial investments in technological
innovations before we can determine their commercial viability. We may lack
sufficient financial resources to fund future development. Also, our licensees
may decide not to share certain research and development costs with us. Revenue
from technological innovations, even if successfully developed, may not be
sufficient to recoup the costs of development.
One element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our licensees. In the past, we
have spent significant amounts on development projects that did not produce any
marketable technologies or products, and we cannot assure you that it will not
occur again.
WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS
Our success as an intellectual property supplier depends on the willingness and
ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is
intensely competitive and has been characterized by price erosion, rapid
technological change, short product life cycles, cyclical market patterns and
increasing foreign and domestic competition.
As an intellectual property supplier to the semiconductor industry, we face
intense competition from internal development teams within potential
semiconductor customers. We must convince potential licensees to license from us
rather than develop technology internally. Furthermore, semiconductor customers,
who have licensed our intellectual property, may choose to abandon joint
development projects with us and develop chipsets themselves without using our
technology. In addition to competition from internal development teams, we
compete against other independent suppliers of intellectual property. We
anticipate intense competition from suppliers of intellectual property for ADSL,
and wireless local area networking.
The market for ADSL chipsets is also intensely competitive. Our success within
the ADSL industry requires that ADSL equipment manufacturers buy chipsets from
our semiconductor licensees, and that telephone companies buy ADSL equipment
from those equipment manufacturers. Our customers' chipsets compete with
products from other vendors of standards-based and ADSL chipsets, including
Alcatel, Broadcom, Centillium, Conexant, GlobespanVirata, ST Microelectronics and Texas
Instruments.
ADSL services offered over copper telephone networks also compete with
alternative broadband transmission technologies that use the telephone network
as well as other network architectures.
20
Alternative technologies for the telephone network include symmetric high speed
DSL (also known as HDSL, SDSL and G.SHDSL), and very high speed DSL, also known
as VDSL. These DSL technologies are based on techniques other than those used by
ADSL to transport high-speed data over telephone lines. Alternative technologies
that use other network architectures to 20
provide high-speed data service include
cable modems using cable networks, and wireless solutions using wireless
networks. These alternative broadband technologies may be more successful than
ADSL.ADSL and we may not be able to participate in the markets involving these
alternative technologies.
Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Alcatel,
Broadcom,
Conexant, GlobespanVirata, ST Microelectronics and Texas Instruments have
significantly greater financial, technological, manufacturing, marketing and
personnel resources than we do. We may be unable to compete successfully, and
competitive pressures could seriously harm our business.
OUR RECENT REDUCTION IN WORKFORCE MAY ADVERSELY AFFECT THE MORALE AND
PERFORMANCE OF OUR PERSONNEL, OUR ABILITY TO HIRE NEW PERSONNEL AND OUR
OPERATIONS.OPERATIONS
In October 2002, as part of an effort to reduce operating expenses, we
terminated 35 employees, which constituted approximately 22 percent of our
workforce. As a result of that workforce reduction, we have incurred costs
related to severance and other employee-related costs. Our workforce reduction
may also subject us to litigation risks and expenses. In addition, our restructuring plan may yield unanticipated consequences, such as
attrition beyond our planned reduction in workforce. As a result of these
reductions, our ability to respond to unexpected challenges may be impaired, and
we may be unable to take advantage of new opportunities. Further, the reduction
in force may reduce employee morale and may create concern among existing
employees about job security, which may lead to increased attrition or turnover.
As a result of these factors, our remaining personnel may decide to seek
employment with more established companies, and we may have difficulty
attracting new personnel that we might wish to hire in the future.
WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS
We prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business. The application of these principles and policies requires us to
make significant judgments and estimates. In the event that judgments and
estimates we make are incorrect, we may have to change them, which could
materially affect our financial position and results of operations.
Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.
21
OUR STOCK PRICE MAY BE EXTREMELY VOLATILE
Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:
|X| quarterly fluctuations in our operating results;
|X| changes in future financial guidance that we may provide to
investors and public market analysts;
|X| changes in our relationships with our licensees;
|X| announcements of technological innovations or new products by
us, our licensees or our competitors;
|X| changes in ADSL market growth rates as well as investor
perceptions regarding the investment opportunity that
companies participating in the ADSL industry afford them;
|X| changes in earnings estimates by public market analysts;
|X| key personnel losses;
|X| sales of common stock; and
|X| developments or announcements with respect to industry
standards, patents or proprietary rights.
21
In addition, the equity markets have experienced volatility that has
particularly affected the market prices of equity securities of many high
technology companies and that often has been unrelated or disproportionate to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock.
OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS
The extensive regulation of the telecommunications industry by federal, state
and foreign regulatory agencies, including the Federal Communications
Commission, and various state public utility and service commissions, could
affect us through the effects of such regulation on our licensees and their
customers. In addition, our business may also be affected by the imposition of
certain tariffs, duties and other import restrictions on components that our
customers obtain from non-domestic suppliers or by the imposition of export
restrictions on products sold internationally and incorporating our technology.
Changes in current or future laws or regulations, in the United States or
elsewhere, could seriously harm affect our business.
22
ITEM 3:
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:
|X| Cash and cash equivalents, which consist of financial
instruments with original maturities of three months or less;
and
|X| Investments, which consist of financial instruments that meet
the high quality standards specified in our investment policy.
This policy dictates that all instruments mature in three
years or less, and limits the amount of credit exposure to any
one issue, issuer, and type of instrument.
We do not use derivative financial instruments for speculative or trading
purposes. As of September 30, 2002, all of ourMarch 31, 2003, we had $31.7 million in cash, cash equivalents
and short-term investments that matured in twelve months or less. Due to the
short duration of thethese financial instruments, we invest
in, we do not expect that an increase
in interest rates would result in any material loss to our investment portfolio.
As of March 31, 2003, we had invested $12.0 million in long-term investments
that matured in one to three years. These long-term securities are invested in
high quality corporate securities and U.S. government securities. Despite the
high quality of these securities, they may be subject to interest rate risk.
This means that if interest rates increase, the principal amount of our
investment would probably decline. A large increase in interest rates may cause
a material loss to our long-term investments. The following table (dollars in
thousands) presents hypothetical changes in the fair value of our long-term
investments at March 31, 2003. The modeling technique measures the change in
fair value arising from selected potential changes in interest rates. Movements
in interest rates of plus or minus 50 basis points (BP) and 100 BP reflect
immediate hypothetical shifts in the fair value of these investments.
VALUATION OF SECURITIES VALUATION OF SECURITIES
GIVEN AN INTEREST RATE GIVEN AN INTEREST RATE
DECREASE OF NO CHANGE INCREASE OF
------------------------- IN INTEREST -------------------------
Type of security (100BP) (50 BP) RATES 100 BP 50 BP
- ---------------------------------------------------------------------------------------------------------------
Long-term investments with
maturities of one to three years $12,210 $12,113 $12,018 $11,830 $11,923
23
ITEM 4:
CONTROLS AND PROCEDURES
(a) DISCLOSURE CONTROLS AND PROCEDURES. Within 90 days before filing this
report, we evaluated the effectiveness of the design and operation of our
disclosure controls and procedures. Our disclosure controls and procedures are
the controls and other procedures that we designed to ensure that we record,
process, summarize and report in a timely manner the information we must
disclose in reports that we file with or submit to the SEC. Our disclosure
controls and procedures include a significant portion of our internal controls.
Michael A. Tzannes, our Chief Executive Officer, and Richard P. Moberg, our Vice
President and Chief Financial Officer, supervised and participated in this
evaluation. Based on this evaluation, Mr. Tzannes and Mr. Moberg concluded that,
as of the date of their evaluation, our disclosure controls and procedures were
effective.
(b) INTERNAL CONTROLS. Since the date of the evaluation described above, there
have not been any significant changes in our internal controls or in other
factors that could significantly affect those controls.
2324
PART II. OTHER INFORMATION
ITEM 1:
LEGAL PROCEEDINGS
From time to time we are involved in litigation incidental to the conduct of our
business. We are not party to any lawsuit or proceeding that, in our opinion, is
likely to seriously harm our business.
ITEM 5:
OTHER INFORMATION
CERTIFICATION UNDER SARBANES-OXLEY ACT
Our chief executive officer and chief financial officer have furnished to the
SEC the certification with respect to this Report that is required by Section
906 of the Sarbanes-Oxley Act of 2002.
2425
ITEM 6:
EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
EXHIBIT NO. DESCRIPTION
3.3* Articles of Amendment to the Articles of OrganizationNone
(B) REPORTS ON 8-K
None.
- --------------------
* filed herewith
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.
AWARE, INC.
Date: NovemberMay 12, 20022003 By: /s/ Michael A. Tzannes
----------------------
Michael A. Tzannes,
Chief Executive Officer
Date: NovemberMay 12, 20022003 By: /s/ Richard P. Moberg
---------------------
Richard P. Moberg, Vice President
and Chief Financial Officer
(Principal Financial and
Accounting Officer)
2526
CERTIFICATIONS
I, Michael A. Tzannes, Chief Executive Officer of Aware, Inc., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of Aware,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this quarterly
report;
4. The registrant's other certifying officersofficer and I are responsible
for establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about
the effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officersofficer and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves
management or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officersofficer and I have indicated in
this quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
26
Date: NovemberMay 12, 20022003 /s/ Michael A. Tzannes
----------------------------- -------------------------------------------------------------- ----------------------------------
Michael A. Tzannes
Chief Executive Officer
27
I, Richard P. Moberg, Vice President and Chief Financial Officer of
Aware, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Aware,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this quarterly
report;
4. The registrant's other certifying officersofficer and I are responsible
for establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about
the effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officersofficer and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
27
b) any fraud, whether or not material, that involves
management or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officersofficer and I have indicated in
this quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: NovemberMay 12, 20022003 /s/ Richard P. Moberg
----------------------------- --------------------------------------------------------------- ----------------------------------
Richard P. Moberg
Vice President and
Chief Financial Officer
28