UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------------
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2006
--------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ____________________ to ____________________
Commission file number: 0-18267
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NCT Group, Inc.
---------------
(Exact name of registrant as specified in its charter)
Delaware 59-2501025
- --------------------------------------------------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
20 Ketchum Street, Westport, Connecticut 06880
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(203) 226-4447
- --------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. /X/ Yes / / No
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the
Exchange Act). Large Accelerated Filer /_/ Accelerated Filer /_/ Non-Accelerated
Filer /X/
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). / / Yes /X/ No
The number of shares of the registrant's common stock, par value $.01 per share,
outstanding as of May 19, 2006 was 913,719,236.
Table of Contents
Page
Part I Financial Information
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets at December 31, 2005 and March 31, 2006
(Unaudited) 3
Condensed Consolidated Statements of Operations (Unaudited) and Condensed Consolidated
Statements of Comprehensive Loss (Unaudited) for the Three Months
Ended March 31, 2005 (restated) and 2006 4
Condensed Consolidated Statements of Cash Flows (Unaudited) for the Three Months
Ended March 31, 2005 (restated) and 2006 5
Notes to the Condensed Consolidated Financial Statements (Unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 22
Item 3. Quantitative and Qualitative Disclosures About Market Risk 29
Item 4. Controls and Procedures 29
Part II Other Information
Item 1. Legal Proceedings 30
Item 6. Exhibits 30
Signatures 31
2
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NCT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (Notes 1 and 6)
(in thousands, except share data)
December 31, March 31,
2005 2006
As Restated
--------------- ---------------
ASSETS (Unaudited)
Current assets:
Cash and cash equivalents $ 451 $ 261
Investment in available-for-sale marketable securities 20 20
Accounts receivable, net 640 682
Inventories, net 253 249
Other current assets (includes $98 due from former officer) 181 165
--------------- ---------------
Total current assets 1,545 1,377
Property and equipment, net 849 743
Goodwill, net 1,252 1,252
Patent rights and other intangibles, net 1,021 1,004
Other assets 53 52
--------------- ---------------
$ 4,720 $ 4,428
=============== ===============
LIABILITIES AND CAPITAL DEFICIT
Current liabilities:
Accounts payable $ 3,095 $ 3,040
Accrued expenses-related parties 3,649 3,087
Accrued expenses-other 11,811 11,722
Notes payable 576 557
Convertible notes payable to stockholder 73,111 89,308
Current maturities of convertible notes 4,884 4,981
Deferred revenue 350 350
Shares of subsidiary subject to exchange into a variable number of shares 656 661
Preferred stock subject to conversion into a variable number of shares 25,157 24,814
Derivative liabilities 7,965 5,942
Other current liabilities 7,098 7,037
--------------- ---------------
Total current liabilities 138,352 151,499
Long-term liabilities:
Convertible notes payable to stockholder 5,000 5,000
Other liabilities 27 20
--------------- ---------------
Total long-term liabilities 5,027 5,020
--------------- ---------------
Minority interest in consolidated subsidiaries 8,655 8,735
--------------- ---------------
Capital deficit:
Preferred stock, $.10 par value, 10,000,000 shares authorized:
Convertible series I preferred stock, 510 shares issued and
outstanding, (liquidation amount $510) 510 510
Common stock, $.01 par value, authorized 5,622,000,000 shares,
issued and outstanding, 838,983,565 and 889,483,510 shares, respectively 8,389 8,894
Additional paid-in capital 233,079 232,999
Accumulated deficit (389,572) (403,548)
Accumulated other comprehensive income 280 319
--------------- ---------------
Total capital deficit (147,314) (160,826)
--------------- ---------------
$ 4,720 $ 4,428
=============== ===============
The accompanying notes are an integral part of the condensed consolidated financial statements.
3
NCT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Note 1)
(Unaudited)
(in thousands, except per share amounts)
Three months ended
March 31,
---------------------------------
2005 2006
As Restated
--------------- ---------------
REVENUE:
Technology licensing fees and royalties $ 1,165 $ 457
Product sales, net 472 498
Other revenue - 2
--------------- ---------------
Total revenue 1,637 957
--------------- ---------------
COSTS AND EXPENSES:
Cost of product sales 169 231
Cost of other revenue 2 2
Selling, general and administrative 1,283 1,758
Research and development 1,019 931
--------------- ---------------
Total operating costs and expenses 2,473 2,922
Non-operating items:
Other (income) expense, net 836 2,776
Interest expense, net (including amortization of debt
discounts of $4,679 and $7,689, respectively, and beneficial
conversion features of $2,233 and $8,775, respectively) 18,110 9,235
--------------- ---------------
Total costs and expenses 21,419 14,933
--------------- ---------------
Loss from continuing operations (19,782) (13,976)
Loss from discontinued operations (46) -
--------------- ---------------
NET LOSS (19,828) (13,976)
Less: Subsidiary preferred stock dividends 83 80
--------------- ---------------
NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS $ (19,911) $ (14,056)
=============== ===============
Net loss per share attributable to
--------------- ---------------
common stockholders - basic and diluted $ (0.03) $ (0.02)
=============== ===============
Weighted average common shares outstanding -
basic and diluted 645,000 856,375
=============== ===============
NCT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
(in thousands)
Three months ended
March 31,
---------------------------------
2005 2006
As Restated
--------------- ---------------
NET LOSS $ (19,828) $ (13,976)
Other comprehensive income:
Foreign currency translation adjustment 20 39
--------------- ---------------
COMPREHENSIVE LOSS $ (19,808) $ (13,937)
=============== ===============
The accompanying notes are an integral part of the condensed consolidated financial statements.
4
NCT GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Notes 1 and 3)
(Unaudited)
(in thousands)
Three months ended March 31,
------------------------------------
2005 2006
As Restated
--------------- ---------------
Cash flows from operating activities:
Net loss $ (19,828) $ (13,976)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 76 122
Provision for inventory reserve (4) (3)
Provision for doubtful accounts and uncollectible amounts (9) (11)
(Gain) on disposition of fixed assets (12) -
Finance costs associated with non-registration of common shares 333 363
Preferred stock and subsidiary preferred stock dividends as interest 178 167
Accrued default penalties subsequently converted to principal (with a stockholder) 2,641 7,137
Accrued interest subsequently converted to principal (with a stockholder) 1,145 2,941
Amortization of discounts on notes (includes $7,661 and $4,651,
respectively, with a stockholder) 7,689 4,679
Amortization of beneficial conversion feature on convertible notes (includes
$8,707 and $2,233, respectively, with a stockholder) 8,775 2,301
Change in fair value of derivative liabilities (3,461) (4,738)
Changes in operating assets and liabilities, net of acquisitions:
Increase in accounts receivable (456) (31)
Decrease in inventories 16 7
Decrease in other assets 118 16
Increase (decrease) in accounts payable and accrued expenses 1,146 (1,068)
Decrease in other liabilities and deferred revenue (524) (59)
--------------- ---------------
Net cash used in operating activities (2,177) (2,153)
--------------- ---------------
Cash flows from investing activities:
Capital expenditures (12) -
--------------- ---------------
Net cash used in investing activities (12) -
--------------- ---------------
Cash flows from financing activities:
Proceeds from:
Issuance of convertible notes and notes payable, net 1,980 1,950
Repayment of notes (31) (26)
--------------- ---------------
Net cash provided by financing activities 1,949 1,924
Effect of exchange rate changes on cash 20 39
--------------- ---------------
Net decrease in cash and cash equivalents (220) (190)
Cash and cash equivalents at beginning of period 1,359 451
--------------- ---------------
Cash and cash equivalents at end of period $ 1,139 $ 261
=============== ===============
The accompanying notes are an integral part of the condensed consolidated financial statements.
5
NCT GROUP, INC. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Basis of Presentation:
Throughout this document, "NCT" (which may be referred to as "we," "our" or
"us") means NCT Group, Inc. or NCT Group, Inc. and its subsidiaries, as the
context requires. The accompanying condensed consolidated financial statements
are unaudited but, in the opinion of management, contain all the adjustments
(consisting of those of a normal recurring nature) considered necessary to
present fairly the condensed consolidated financial position and the results of
operations and cash flows for the periods presented in conformity with
accounting principles generally accepted in the United States of America
applicable to interim periods. The results of operations for the three months
ended March 31, 2006 and cash flows for the three months ended March 31, 2006
are not necessarily indicative of the results that may be expected for any other
interim period or the full year. These condensed consolidated financial
statements should be read in conjunction with the audited financial statements
and notes thereto for the year ended December 31, 2005 contained in our Annual
Report on Form 10-K/A.
The preparation of condensed consolidated financial statements in
conformity with accounting principles generally accepted in the United States of
America requires us to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from these estimates.
We have experienced substantial losses since our inception, which
cumulatively amounted to $403.5 million through March 31, 2006. Cash and cash
equivalents amounted to $0.3 million at March 31, 2006, decreasing from $0.5
million at December 31, 2005. A working capital deficit of $150.1 million
existed at March 31, 2006. We were in default of $0.5 million of our notes
payable and $9.1 million of our convertible notes at March 31, 2006. Our
management believes that internally generated funds are currently insufficient
to meet our short-term and long-term operating and capital requirements. These
funds include available cash and cash equivalents and revenue derived from
technology licensing fees and royalties and product sales. Our ability to
continue as a going concern is substantially dependent upon future levels of
funding from our revenue sources, which are currently uncertain. If we are
unable to generate sufficient revenue to sustain our current level of operations
and to execute our business plan, we will need to obtain additional financing to
maintain our current level of operations. We are attempting to obtain additional
working capital through debt and equity financings. However, we can give no
assurance that additional financing will be available to us on acceptable terms
or at all. The failure to obtain any necessary additional financing would have a
material adverse effect on us, including causing a substantial reduction in the
level of our operations. These reductions, in turn, could have a material
adverse effect on our relationships with our licensees, customers and suppliers.
Uncertainty exists about the adequacy of current funds to support our activities
until positive cash flow from operations can be achieved, and uncertainty exists
about the availability of external financing sources to fund any cash
deficiencies.
The accompanying condensed consolidated financial statements have been
prepared assuming that we will continue as a going concern, which contemplates
continuity of operations, realization of assets and satisfaction of liabilities
in the ordinary course of business. Our ability to continue as a going concern
is dependent upon, among other things, the achievement of future profitable
operations and the ability to generate sufficient cash from operations, equity
and/or debt financing and other funding sources to meet our obligations. The
uncertainties described in the preceding paragraph raise substantial doubt at
March 31, 2006 about our ability to continue as a going concern. The
accompanying condensed consolidated financial statements do not include any
adjustments relating to the recoverability and classification of the carrying
amount of recorded assets or the amount and classification of liabilities that
might result should we be unable to continue as a going concern.
6
Restatement of Consolidated Financial Statements to Reflect Derivative
Accounting:
The balance sheet as of March 31, 2005 and the results for the three months
ended March 31, 2005 have been restated to account for the effect of certain
restatements of our condensed consolidated statements of operations and cash
flows for the three months ended March 31, 2005. These restatements reflect the
effects of adjustments to the accounting treatment for various convertible
equity instruments in accordance with the requirements of Emerging Issues Task
Force ("EITF") Issue No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock" and the reversal
of an accrual for the non-registration penalties related to a convertible equity
instrument. As a result of these adjustments, additional paid in capital
decreased by $55.3 million, retained earnings decreased by $2.7 million, current
liabilities increased by $58.0 million, net loss increased $2.9 million and net
loss attributable to common stockholders increased by $0.3 million.
Recent Accounting Pronouncements
The Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standards No. 155, "Accounting for Certain Hybrid Financial
Instruments--an amendment of FASB Statements No. 133 and 140" ("SFAS No. 155")
in February 2006. SFAS No. 155 amends SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133") and SFAS No. 140
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities" ("SFAS No. 140"), and addresses the application of SFAS No. 133
to beneficial interests in securitized financial assets. SFAS No. 155
establishes a requirement to evaluate interests in securitized financial assets
to identify interests that are freestanding derivatives or that are hybrid
financial instruments that contain an embedded derivative requiring bifurcation.
Additionally, SFAS No. 155 permits fair value measurement for any hybrid
financial instrument that contains an embedded derivative that otherwise would
require bifurcation. SFAS No. 155 is effective for financial instruments
acquired or issued after January 1, 2007. We do not expect that the adoption of
SFAS No. 155 will have a material impact on our consolidated financial condition
or results of operations.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets--an Amendment of FASB Statement No. 140" ("SFAS No. 156"). SFAS
No. 156 provides guidance on the accounting for servicing assets and liabilities
when an entity undertakes an obligation to service a financial asset by entering
into a servicing contract. This statement is effective for all transactions in
fiscal years beginning after September 15, 2006. We do not expect that the
adoption of SFAS No. 156 will have a material impact on our consolidated
financial condition or results of operations.
2. Stock-Based Compensation:
Effective January 1, 2006, we adopted SFAS No. 123 (Revised 2004)
"Share-Based Payment" ("SFAS No. 123(R)") using the modified prospective
application transition method. The modified prospective application transition
method requires compensation cost to be recognized beginning on the effective
date (a) based on the requirements of SFAS No. 123(R) for all share-based
payments granted after the effective date and (b) based on the requirements of
SFAS No. 123 for all awards granted to employees prior to the effective date of
SFAS No. 123(R) that remain unvested on the effective date. As such, prior
periods will not reflect restated amounts to reflect the impact of SFAS No.
123(R). Prior to January 1, 2006, we accounted for our stock-based compensation
plans in accordance with Accounting Principles Board ("APB") Opinion No. 25 and
related interpretations. Under APB Opinion No. 25, no compensation costs was
recognized if the option exercise price was equal to or greater than the fair
market price of the common stock on the date of the grant. Prior to January 1,
2006, no stock-based employee compensation cost is reflected in our net loss, as
options granted under our plans had an exercise price equal to or greater than
the market value of the underlying common stock on the date of grant. There was
no stock-based employee compensation cost recognized during the three months
ended March 31, 2005 nor any compensation cost that would have been recognized
had we used the fair value method under SFAS 123.
There was no impact on our financial position, results of operations or
cash flows upon the adoption of SFAS No. 123(R). We had no outstanding unvested
options at January 1, 2006 and there were no new option grants during the three
months ended March 31, 2006.
We have stock option plans under which directors, officers, employees and
consultants may be granted options to purchase common stock or other
equity-based awards. Our stock option plans that have been approved by
7
our stockholders are as follows: the NCT Group, Inc. 1992 Stock Incentive Plan,
as amended (the "1992 Plan") and the NCT Group, Inc. 2001 Stock and Incentive
Plan, as amended (the "2001 Plan"). In addition, options outside the option
plans have been granted. Due to expiration of the plan, no future grants of
options for the purchase of shares of our common stock are available under the
1992 Plan. Stock options are valued at the date of grant using the Black-Scholes
option pricing model.
Our option plans activity is summarized as follows:
1992 Plan 2001 Plan Non Plan
------------------------ --------------------------- ---------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at December 31, 2005 38,164,531 $ 0.3917 399,359,850 $ 0.0204 423,864,000 $ 0.0402
Options granted - - -
Options exercised - - -
Options canceled, expired or forfeited - - -
----------- ------------- -----------
Outstanding at March 31, 2006 38,164,531 $ 0.3917 399,359,850 $ 0.0204 423,864,000 $ 0.0402
=========== ============= ===========
Options exercisable at March 31, 2006 38,164,531 $ 0.3917 399,359,850 $ 0.0204 423,864,000 $ 0.0402
=========== ============= ===========
Options available for grant at March 31, 2006 - 218,520,150 -
=========== ============= ===========
Weighted average remaining
Contractual life (in years) 1.93 5.98 2.76
=========== ============= ===========
Aggregate intrinsic value $ - $ - $ -
=========== ============= ===========
The aggregate intrinsic value in the table above represents the intrinsic value
(the aggregate difference between the closing stock price of our common stock on
March 31, 2006 and the exercise price for in-the-money options) that would have
been received by the option holders if all options had been exercised on March
31, 2006.
3. Other Financial Data:
Balance Sheet Items
Investment in marketable securities comprises available-for-sale securities
at fair market value. The following table sets forth the market value, carrying
value and realized and unrealized gain/(loss) of our available-for-sale
securities:
(In thousands of dollars)
Cost Market Market
Basis Unrealized Value Unrealized Value
1/1/05 Gain (Loss) 12/31/05 Gain (Loss) 3/31/06
----------- ------------- --------------------------- ------------
ITC $ 10 $ 2 $ 12 $ - $ 12
Teltran 14 (6) 8 - 8
----------- ------------- --------------------------- ------------
Totals $ 24 $ (4) $ 20 $ - $ 20
=========== ============= =========================== ============
We review declines in the value of our investment portfolio when general
market conditions change or specific information pertaining to an industry or to
an individual company becomes available. We consider all available evidence to
evaluate the realizable value of our investments and to determine whether the
decline in realizable value may be other-than-temporary. During the three months
ended March 31, 2006, we did not recognize any other than temporary decline in
realizable value of our investments.
8
Accounts receivable comprise the following:
(In thousands of dollars)
December 31, March 31,
2005 2006
-------------- --------------
Technology license fees and royalties $ 533 $ 806
Joint ventures and affiliates 34 34
Other receivables 424 182
-------------- --------------
$ 991 $ 1,022
Allowance for doubtful accounts (351) (340)
-------------- --------------
Accounts receivable, net $ 640 $ 682
============== ==============
Inventories comprise the following:
(In thousands of dollars)
December 31, March 31,
2005 2006
-------------- --------------
Finished goods $ 248 $ 244
Components 206 203
-------------- --------------
$ 454 $ 447
Reserve for obsolete and slow moving inventory (201) (198)
-------------- --------------
Inventories, net $ 253 $ 249
============== ==============
Other assets comprise the following:
(In thousands of dollars)
December 31, March 31,
2005 2006
-------------- --------------
Notes receivable $ 1,000 $ 1,000
Due from former officer 98 98
Other 181 165
-------------- --------------
$ 1,279 $ 1,263
Reserve for uncollectible amounts (a) (1,098) (1,098)
-------------- --------------
Other current assets $ 181 $ 165
============== ==============
(In thousands of dollars)
December 31, March 31,
2005 2006
-------------- --------------
Advances and deposits $ 53 $ 52
-------------- --------------
Other assets (classified as long term) $ 53 $ 52
============== ==============
Footnote:
- --------
(a) On January 9, 2001, Artera Group accepted an aggregate of $1.0 million
of non-recourse, non-interest bearing notes receivable due January 2,
2002, as partial consideration for its January 9, 2001 6% convertible
notes payable to six accredited investors (see Note 6). The notes are
fully reserved and remain unpaid at March 31, 2006. The portion of the
reserve related to the note receivable from the former officer (plus
accrued interest) is in excess of the amount owed to him.
9
Property and equipment comprise the following:
(In thousands of dollars)
December 31, March 31,
2005 2006
-------------- --------------
Machinery and equipment $ 946 (a) $ 947
Furniture and fixtures 337 316
Tooling 492 491
Leasehold improvements 388 388
Other 401 401
-------------- --------------
$ 2,564 $ 2,543
Accumulated depreciation (1,715) (1,800)
-------------- --------------
Property and equipment, net $ 849 (a) $ 743
============== ==============
Footnote:
- --------
(a) Includes the write-off of fully depreciated DMC assets of
approximately $0.8 million and the addition of approximately $0.8
million for the purchase of data center equipment for Artera Group.
Depreciation expense for each of the three months ended March 31, 2005 and
2006 was approximately $0.1 million.
Accrued expenses comprise the following:
(In thousands of dollars)
December 31, March 31,
2005 2006
-------------- --------------
Non-registration fees due to a related party $ 216 $ 262
Default penalties due to a stockholder - 405
Interest due to a stockholder 2,641 1,599
Consulting fees due to a stockholder - 70
Incentive compensation due to officers 792 751
-------------- --------------
Accrued expenses-related party $ 3,649 $ 3,087
============== ==============
Non-registration fees $ 5,721 $ 6,038
Interest 2,136 2,325
Commissions payable 124 117
Other 3,830 3,242
-------------- --------------
Accrued Expenses-other $ 11,811 $ 11,722
============== ==============
Other current liabilities comprise the following:
(In thousands of dollars)
December 31, March 31,
2005 2006
----------- -----------
License reacquisition payable $ 4,000 $ 4,000
Royalty payable 1,679 1,679
Development fee payable 650 650
Due to selling shareholders of Theater Radio Network 557 557
Due to Lernout & Hauspie 100 100
Other 139 71
----------- -----------
$ 7,125 $ 7,057
Less: other liabilities classified as long term 27 20
----------- -----------
Total other current liabilities $ 7,098 $ 7,037
=========== ===========
10
Statements of Operations Information
Other (income) expense, net consisted of the following:
(In thousands of dollars)
Three months ended March 31,
2005 2006
As Restated
------------ -------------
Finance costs associated with non-registration
of common shares $ 396 $ 363
Default penalties on debt 2,641 7,137
Change in fair value of derivative liabilities (3,461) (4,738)
Costs associated with non-conversion 1,210 -
Other 50 14
------------ -------------
Other (income) expense, net $ 836 $ 2,776
============ =============
We include losses from our majority-owned subsidiaries in our condensed
consolidated statements of operations exclusive of amounts attributable to
minority shareholders' common equity interests only up to the basis of the
minority shareholders' interests. Losses in excess of that amount are borne by
us. Such amounts from our Pro Tech Communications, Inc. subsidiary borne by us
for each of the three months ended March 31, 2005 and 2006 were less than $0.1
million. Future earnings of our majority-owned subsidiaries otherwise
attributable to minority shareholders' interests will be allocated again to
minority shareholders only upon additional investments or after future earnings
are sufficient to recover the cumulative losses previously absorbed by us
(approximately $2.7 million at March 31, 2006).
Supplemental Cash Flow Information
(In thousands of dollars)
Three months ended March 31,
-------------------------------------
2005 2006
As Restated
----------------- -----------------
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest $ 6 $ 4
================= =================
Supplemental disclosures of non-cash investing and financing activities:
Finance costs associated with non-registration of common shares $ 1,195 $ -
================= =================
Finance costs associated with non-conversion of preferred stock $ 1,210 $ -
================= =================
Issuance of series I preferred stock $ 976 $ -
================= =================
Property and equipment financed through notes payable $ 18 $ -
================= =================
Principal on stockholder convertible notes and notes payable exchanged for new notes $ 26,408 $ 66,366
================= =================
Accrued interest on stockholder convertible notes and notes payable exchanged for new notes $ 1,145 $ 2,941
================= =================
Accrued default penalties on stockholder convertible notes exchanged for new notes $ 2,641 $ 7,137
================= =================
11
4. Capital Deficit:
The changes in capital deficit during the three months ended March 31, 2006 were as follows:
Series I
Convertible Additional
Preferred Stock Common Stock Paid-in
--------------------- ---------------------
(In thousands of dollars and shares) Shares Amount Shares Amount Capital
- ------------------------------------ --------- ---------- --------- ---------- ------------
Balance at December 31, 2005 (as restated) 1 $ 510 838,984 $ 8,389 $ 233,079
Conversion of series H preferred stock - - 50,500 505 -
Dividend and amortization of discounts on beneficial
conversion feature to subsidiary preferred shareholders - - - - (80)
Net loss - - - - -
Foreign currency translation adjustment - - - - -
--------- ---------- --------- ---------- ------------
Balance at March 31, 2006 1 $ 510 889,484 $ 8,894 $ 232,999
========= ========== ========= ========== ============
Accumulated
Accumu- Other
lated Comprehensive
(In thousands of dollars and shares) Deficit Income Total
- ------------------------------------ -------------- -------------------- ---------------
Balance at December 31, 2005 (as restated) $ (389,572) $ 280 $ (147,314)
Conversion of series H preferred stock - - 505
Dividend and amortization of discounts on beneficial
conversion feature to subsidiary preferred shareholders - - (80)
Net loss (13,976) - (13,976)
Foreign currency translation adjustment - 39 39
-------------- -------------------- ---------------
Balance at March 31, 2006 $ (403,548) $ 319 $ (160,826)
============== ==================== ===============
12
5. Notes Payable:
(In thousands of dollars)
December 31, March 31,
2005 2006
------------- -------------
Note due investor (a) $ 385 $ 385
Interest at 8% per annum payable at maturity; effective interest
rate of 80.3% per annum resulting from the issuance of warrants
and finders fees; matured April 7, 2003; default interest
accrues at 18% per annum.
Note due stockholder of subsidiary 14 10
Interest at 12% per annum; monthly payments (including interest)
of $1.5 from November 2005 through September 2006,
remainder matures October 15, 2006.
Note due former employee (a) 100 100
$100 bears interest at 8.25% per annum, compounded annually;
past due.
Other financings (a) 77 62
Interest ranging from 7% to 9% per annum;
$35 due July 15, 2003; $27 due November 1, 2007.
------------- -------------
$ 576 $ 557
============= =============
Footnote:
- --------
(a) Notes payable are in default due to nonpayment.
6. Convertible Notes Payable:
(In thousands of dollars)
December 31, March 31,
Convertible notes payable to stockholder: 2005 2006
------------- -------------
Issued to Carole Salkind - (a) (see Note 10) $ 83,649 $ 96,802
Weighted average effective interest rate of 56.4% per annum; accrues
interest 8% per annum except $6,754 at 12%; collateralized by substantially all
of the assets of NCT; convertible into NCT common stock at prices ranging
from $0.0021 - $0.0166 or exchangeable for common stock of NCT
subsidiaries except for Pro Tech; maturing by quarter as follows:
2005 2006
--------------------------------
Past due $ 576 $ 4,051
Demand notes 375 3,450
March 31, 2006 69,841 -
June 30, 2006 7,857 7,857
September 30, 2006 - 76,444
December 31, 2009 5,000 5,000
Less: unamortized debt discounts (5,538) (2,494)
------------- -------------
$ 78,111 $ 94,308
Less: amounts classified as long-term (5,000) (5,000)
------------- -------------
$ 73,111 $ 89,308
============= =============
13
(In thousands of dollars)
December 31, March 31,
Convertible notes: 2005 2006
------------- -------------
8% Convertible Notes (b) $ 2,626 $ 2,626
Weighted average effective interest rate of 30.8% per annum;
generally convertible into NCT common stock at 80% of the five-day
average closing bid price preceding conversion; matures:
2005 2006
--------------------------------
March 14, 2002 $ 17 $ 17
April 12, 2002 9 9
January 10, 2004 550 550
March 11, 2004 400 400
April 22, 2005 235 235
September 4, 2005 440 440
July 23, 2006 975 975
6% Convertible Notes (in default) 2,474 2,474
Weighted average effective interest rate of 85.8% per annum;
convertible into NCT common stock at 100% of the five-day average
closing bid price preceding conversion; matures:
2005 2006
--------------------------------
January 9, 2002 $ 818 $ 818
April 4, 2002 325 325
May 25, 2002 81 81
June 29, 2002 1,250 1,250
------------- -------------
$ 5,100 $ 5,100
Less: unamortized debt discounts (216) (119)
------------- -------------
$ 4,884 $ 4,981
============= =============
Footnotes:
- --------
(a) At March 31, 2006, we were in default on repayment of $4.0 million of
principal (see Note 14 for subsequent issuances to refinance this
default). During the three months ended March 31, 2006, we issued an
aggregate of $79.5 million of convertible notes to Carole Salkind, a
stockholder and spouse of a former director of ours. These notes are
secured by substantially all of our assets. During the three months
ended March 31, 2006, we defaulted on payment of all notes that
matured during the period for an aggregate principal amount of $69.8
million. For the three months ended March 31, 2006, we refinanced an
aggregate of $66.4 million principal amount into new notes along with
default penalties ($7.1 million) and accrued interest ($2.9 million)
aggregating $75.8 million. We issued a $0.7 million note for the
quarterly interest installment due under the five-year $5.0 million
note along with a $0.5 million interest default penalty and interest.
In addition, we issued Carole Salkind notes aggregating approximately
$3.1 million in consideration of $2.0 million in cash and $1.1 million
of original issue discounts related to the convertible notes. During
the three months ended March 31, 2006, we recorded original issue
discounts of $3.8 million on the notes based upon the fair values of
the warrants granted to Ms. Salkind (see Note 10). These discounts are
amortized over the terms of the related notes. During the three months
ended March 31, 2006, there were no beneficial conversion features
recorded as a discount to the notes. For the three months ended March
31, 2006, $6.9 million of amortization related to these and prior
discounts is classified as interest expense in our condensed
consolidated statements of operations. Unamortized discounts of $5.5
million and $2.5 million have been reflected as a reduction to the
convertible notes in our condensed consolidated balance sheets as of
December 31, 2005 and March 31, 2006, respectively. The default
provisions of these notes impose a penalty of 10% of the principal
payments in default and interest calculated from the date of default
at the stated interest rate of the note plus 5%.
(b) We are in default on convertible notes aggregating $1.6 million due to
a cross-default provision and non-payment. We are also in default on
convertible notes aggregating $1.0 million dated July 23, 2004 due to
our failure to register for resale the shares of our common stock
issuable upon conversion of these notes.
14
7. Shares of Subsidiary Subject to Exchange into a Variable Number of Shares:
The monetary value of Pro Tech series B convertible preferred stock was
approximately $661,000 in our condensed consolidated balance sheet at March 31,
2006, which is comprised of $575,000 aggregate fair value of shares plus the
accrued dividends of approximately $86,000. We have the option to settle the
accrued dividends in cash or common stock. We would have to issue approximately
88.2 million shares of our common stock (calculated based upon $0.01 par value)
if settlement of the stated value along with accrued dividends had occurred as
of March 31, 2006. There is no limit on the number of shares of common stock
that we could be required to issue upon exchange of the Pro Tech series B
preferred stock.
At March 31, 2006, there were no shares of Pro Tech series A preferred
stock outstanding and 460 shares of Pro Tech series B preferred stock
outstanding. On March 31, 2005, 50 shares of the Pro Tech series A preferred
stock were converted into 1,844,007 shares of Pro Tech common stock pursuant to
a mandatory conversion requirement. For the three months ended March 31, 2006,
the 4% dividends earned by holders of the Pro Tech series B preferred stock were
approximately $5,000.
8. Commitments and Contingencies:
In July 2005, we entered into a second amended and restated private equity
credit agreement with Crammer Road LLC ("Crammer Road"), a Cayman Islands
limited liability company, that supersedes and replaces our amended and restated
private equity credit agreement dated as of September 30, 2004, which in turn
replaced a similar agreement dated as of July 25, 2002. The new credit agreement
provides that we must put to Crammer Road shares of our common stock having an
aggregate value of at least $5.0 million (the minimum commitment amount) and may
put to Crammer Road shares of our common stock having an aggregate value of up
to $50.0 million (the maximum commitment amount). The purchase price of the
shares will equal 93% of the average of the three lowest closing bid prices of
our common stock during the ten-day trading period immediately following the
date of our notice to Crammer Road of our election to put shares. The maximum
amount that we can put to Crammer Road in any single transaction is equal to, at
the time of our election, the lesser of (a) $2.0 million or (b) 500% of the
daily weighted average volume of shares of our common stock for the 15 trading
days immediately preceding the date of the put, provided that the maximum amount
is no less than $500,000. Through March 31, 2006 we have sold a total of
18,756,756, shares of our common stock to Crammer Road pursuant to our private
equity credit agreement for gross proceeds of approximately $134,000.
Delaware law restricts sales of unissued shares of common stock at a price
less than the par value of the common stock. We have put shares under the
private equity credit agreement which were issued below par value. We are
currently engaged in discussions regarding this shortfall. In the future, we do
not intend to sell shares pursuant to the private equity credit agreement when
the purchase price of such shares would be less than the par value per share. We
also will not honor conversion requests of preferred stock or convertible notes
or exercise of warrants or options if that would require us to issue shares of
our common stock when the issuance price of such shares would be less than the
par value per share.
9. Capital Stock:
Common Shares Available for Future Issuance
At March 31, 2006, we were required to reserve for issuance approximately
22.6 billion shares of our common stock based on the par value of $.01 per
share, the current par value of our common stock. Delaware law restricts sales
of unissued shares of common stock at a price less than the par value of the
common stock. The number of shares issuable upon conversion or exchange of many
of our outstanding convertible and exchangeable securities varies as a function
of the market price of our common stock. At March 31, 2006, the number of shares
we are required to reserve exceeded the number of authorized but unissued shares
of our common stock.
NCT Group, Inc. Preferred Stock
At March 31, 2006, we had two designations of issued and outstanding
preferred stock, our series H convertible preferred stock, classified as a
current liability, consisting of 2,100 designated shares, and our series I
convertible preferred stock, consisting of 1,000 designated shares. We are
obligated to register for resale shares of our common stock issuable upon the
conversion of a portion of our series H preferred stock. At March 31, 2006,
1,611.5 shares of series H preferred stock were issued and outstanding. The
series H preferred stock is senior in rank to our common stock and has a
liquidation value equal to the dividends plus the stated value ($10,000 per
15
share) in the case of our liquidation, dissolution or winding up. The holder of
our series H preferred stock (Crammer Road) has no voting rights (except as may
be required by law). Each share of series H preferred stock is convertible into
shares of our common stock at 75% of the average closing bid price of our common
stock for the five-day trading period immediately preceding conversion. The
holder of our series H preferred stock is subject to a limitation on its
percentage ownership of our outstanding common stock. The series H preferred
stock is redeemable by us in cash at any time at a redemption price that is a
function of the time between the date the series H was originally issued and the
redemption date. The redemption price ranges from 85% of stated value (within
three months of issuance) to 120% of stated value (after nine months from
issuance). On May 11, 2004, we issued 27 shares ($270,000 stated value) of our
series H preferred stock to Crammer Road for cash advanced in prior years of
$230,000 less related fees of $24,500. For the three months ended March 31,
2006, we calculated the 4% dividends earned by the holder of the outstanding
series H preferred stock at approximately $0.1 million, which is included in
interest expense. During the three months ended March 31, 2006, Crammer Road
converted 44 shares of series H preferred stock into 50,499,945 shares of our
common stock (see Note 14 for transactions subsequent to March 31, 2006).
We had received a request to convert 189 shares ($1,890,000 stated value)
of series H preferred stock plus accrued dividends into 52.5 million shares of
our common stock that we could not fulfill because of an insufficient number of
authorized but unissued shares of common stock. Under the Certificate of
Designations, Preferences and Rights governing the series H preferred stock and
incorporated into the June 21, 2002 exchange agreement pursuant to which these
shares were sold by us to Crammer Road, Crammer Road was entitled to (i)
compensation for late delivery of conversion shares of 1% of the stated value of
series H not converted ($18,900) per business day beginning March 4, 2004, the
12th business day after the conversion date; or (ii) ordinary contract breach
damages. In addition, if Crammer Road elected to purchase on the open market the
number of our common shares it should have been issued upon conversion of the
series H shares, Crammer Road was entitled to a payment equal to the excess, if
any, of the open market price over the conversion price. For the three months
ended March 31, 2005, we recorded charges of $1.2 million for non-conversion of
series H preferred stock into our common stock. On July 19, 2005, Crammer Road
irrevocably waived, rescinded and voided any and all outstanding demands with
respect to the requested conversion of the 189 shares of series H preferred
stock into shares of our common stock.
Pursuant to the terms of a registration rights agreement with Crammer Road,
we were obligated to file a registration statement covering the shares of our
common stock issuable upon conversion of the 27 shares of our series H preferred
stock issued in May 2004 no later than August 28, 2004. Because we did not have
a sufficient number of authorized shares of our common stock to issue these
shares, we were not able to file a registration statement. As a result, Crammer
Road is entitled to liquidated damages at the rate of 2% per month of the stated
value of these 27 shares of our outstanding series H preferred stock. For each
of the three months ended March 31, 2005 and 2006, we incurred a charge to other
(income) expense, net in our consolidated statement of operations of less than
$0.1 million.
At March 31, 2006, 510 shares of our series I preferred stock were issued
and outstanding and held by Steven Salkind, the son of Carole Salkind (see Note
10). Our series I preferred stock has a par value of $0.10 per share and a
stated value of $1,000 per share. No dividends are payable on the series I
preferred stock. The series I preferred stock is junior in rank to our series H
convertible preferred stock, but senior in rank to our common stock and has
preferences over the common stock with respect to distributions and payments
upon our liquidation, dissolution or winding up. The holders of our series I
preferred stock have no voting rights (except as may be required by law). Each
share of series I preferred stock is convertible into approximately 47,619
shares of our common stock, determined by dividing the $1,000 stated value by
the fixed conversion price of $0.021 per share. As a result, the 510 issued and
outstanding shares of our series I preferred stock are convertible into
24,285,714 shares of our common stock.
Artera Group, Inc. Preferred Stock
At March 31, 2006, there were 8,299 shares of Artera Group series A
preferred stock outstanding, 271 of which are held by us. Each share of series A
convertible preferred stock is convertible into shares of Artera Group common
stock at a conversion price equal to the average closing price for the five
trading days prior to the conversion date. We entered into an exchange rights
agreement in 2001 with ten accredited investors who hold $4.3 million in
aggregate stated value of Artera Group series A preferred stock. Each of the ten
holders of Artera Group series A preferred stock is entitled to exchange the
Artera Group series A preferred stock for shares of our common stock at an
exchange price per share of 100% of the average closing bid price of our common
stock for the five trading days prior to the exchange date and may not convert
into Artera Group common stock. We are obligated to register for resale shares
of our common stock issuable upon the exchange of 4,276 shares of Artera Group
series A preferred stock. For each of the three months ended March 31, 2005 and
2006, we incurred charges of
16
approximately $0.3 million for non-registration of the underlying shares of our
common stock, classified as other (income) expense, net. Pursuant to the
exchange rights agreement, we have the option at any time to redeem the shares
of Artera Group series A preferred stock subject to the agreement by paying the
holder cash equal to the aggregate stated value of the preferred stock being
redeemed (together with accrued and unpaid dividends thereon). Pursuant to an
exchange rights and release agreement dated April 10, 2003, three holders of an
aggregate of 3,154 shares of Artera Group series A preferred stock received an
additional right to exchange their shares into our preferred stock (a series to
be designated) thirty days after receipt of written notice. For each of the
three months ended March 31, 2005 and 2006, we calculated the 4% dividends
earned by holders of the Artera Group series A preferred stock at approximately
$0.1 million. The dividends are included in the calculation of loss attributable
to common stockholders. During the three months ended March 31, 2005, 271 shares
with a stated value of $271,000 along with accrued dividends of $44,000 were
exchanged for 160 shares of our series I preferred stock.
Warrants
During the three months ended March 31, 2006, in conjunction with the
issuance of convertible notes, we issued to Carole Salkind warrants to acquire
an aggregate of 1,319,000,000 shares of our common stock at exercise prices of
the greater of par value (currently $0.01) or of prices ranging from $0.0029 to
$0.0037 per share. We estimated the fair value of the warrants was $2.7 million.
Based upon the allocation of a portion of the proceeds to the fair values of the
warrants, we recorded a discount to the convertible notes issued to Carole
Salkind of $2.7 million during the three months ended March 31, 2006.
10. Related Parties:
Carole Salkind and Affiliates
During the three months ended March 31, 2006, we issued $78.8 million of 8%
convertible notes and one 12% convertible note in the amount of $0.7 million,
along with five-year warrants to acquire an aggregate of 1,319,000,000 shares of
our common stock. Of these notes, $76.4 million mature six months from the date
of issuance and $3.1 million are due upon the earlier of demand or six months
from the date of issuance. Consideration paid for these notes included
approximately $2.0 million cash and cancellation and surrender of notes
aggregating approximately $66.4 million, along with default penalties of $7.1
million and accrued interest of $2.9 million. Carole Salkind has demanded, and
we have agreed, that to the extent required in connection with her security
interests under our secured notes to her, we will pay the legal fees she incurs
as a result of certain legal matters (see Note 11).
On January 7, 2005, we entered into a three-year consulting agreement with
Morton Salkind, the spouse of Carole Salkind, to provide us ongoing financial
and consulting advisory services as we may reasonably request from time to time.
As compensation for these consulting services, we have agreed to pay to Mr.
Salkind a monthly $5,000 cash fee payable at the end of the term of the
agreement and to provide Mr. Salkind with the use of an automobile owned or
leased by us, together with auto insurance coverage, through the term of the
agreement. Our costs to provide this automobile are approximately $10,800 per
year. The consulting engagement and compensation of Mr. Salkind is not dependent
upon the ongoing funding provided by Ms. Salkind.
In March 2005, we issued 510 shares of our series I convertible preferred
stock to Steven Salkind, Carole Salkind's son, in exchange for an aggregate of
accrued consulting fees of $510,000 including amounts accrued through June 12,
2005, representing all consulting fees payable in cash to various entities
affiliated with Carole Salkind pursuant to expired or expiring consulting
agreements (but not to Morton Salkind personally pursuant to his January 2005
agreement). These consulting fees had previously been assigned to Steven Salkind
by these entities.
Incentive Compensation of Management
On March 31, 2005, three executives agreed to waive a portion of their
incentive bonus earned in 2004. The amounts waived were approximately $326,000,
$107,000 and $158,000 for our Chief Executive Officer, President and Chief
Financial Officer, respectively. Further, the payment of a portion of their
remaining bonus amounts is subject to certain limitations. In addition,
effective January 1, 2005, this bonus arrangement was revised to calculate
bonuses based on certain actual cash inflows. Bonuses based on equity or
financing cash inflows ceased effective September 30, 2005. Effective September
30, 2005, bonuses are calculated based on a percentage of product sales,
licenses, royalties and similar revenues.
17
Spyder Technologies Group, LLC
On December 16, 2005, we, Artera Group and Spyder entered into a Consulting
Agreement, pursuant to which, among other things:
o Spyder serves as a consultant to Artera Group and performs certain
computer and data processing services for which Spyder receives a cash
consulting fee of $365.00 per day;
o Spyder assigned to Artera Group any and all of Spyder's rights in
certain intellectual property developed by Spyder prior to the date of
the consulting agreement, for which Spyder will receive a fee of 2% of
the net revenues received by Artera Group from its "Rev the Web"
service; and
o Spyder assigned to Artera Group any and all of Spyder's rights in
certain intellectual property developed by Spyder from and after the
date of the consulting agreement.
Spyder earned technical consulting fees of $22,700 for the three months
ended March 31, 2006.
11. Litigation:
Founding Midcore Shareholder Litigation
In April 2004, Jerrold Metcoff and David Wilson filed a complaint against
us and Michael Parrella, our Chairman and Chief Executive Officer, in
Connecticut state court, which complaint was subsequently amended to add Carole
Salkind and her spouse, Morton Salkind, as defendants. The plaintiffs allege
that we and Mr. Parrella breached a number of representations, warranties and
obligations under or relating to the August 29, 2000 Agreement and Plan of
Merger by which Metcoff, Wilson and others sold to us 100% of the outstanding
shares of a corporation that became our subsidiary, Midcore Software, Inc. Among
those obligations was the obligation for us to issue to Metcoff and Wilson an
aggregate of 60,359,576 shares of our common stock, which we have not done. The
plaintiffs also allege that we and Mr. Parrella engaged in intentional and/or
negligent misrepresentations, fraudulent transfers of intellectual property and
other company assets, unfair trade practices and breaches of an implied covenant
of good faith and fair dealing. The complaint, as amended, seeks damages,
punitive damages, interest and attorneys' fees, and seeks a declaration that the
intellectual property acquired from the plaintiffs by the corporation that
became Midcore Software, Inc. (which intellectual property is currently used in
our Artera Turbo service offerings) is held in trust for the benefit of the
plaintiffs. The damages, punitive damages, interest and attorneys' fees sought
in the substitute complaint are all for unspecified amounts, but in other court
filings in the case, the plaintiffs have alleged that the total cash amount they
are owed exceeds $4.2 million. Mr. Parrella has told us that he intends to deny
the material allegations against him.
On January 4, 2006, the plaintiffs filed a second revised complaint. On
January 27, 2006, we filed a motion to strike six counts set forth in the
plaintiffs' second revised complaint, including certain claims of breach of
contract and breach of contractual representation and warranties against various
corporate defendants and claims of breach of fiduciary duty against Mr.
Parrella. On April 28, 2006, the court struck four of the six claims, including
two claims against Mr. Parrella on the basis that these two claims could not be
properly joined in this lawsuit. Discovery in the case is ongoing.
In November 2005, Messrs. Metcoff and Wilson filed a separate complaint
against John McCloy, Sam Oolie, Irene Lebovics, our President, and Cy Hammond,
our Chief Financial Officer (all members of our Board of Directors), in
Connecticut state court asserting claims against them for breaches of fiduciary
duty and unfair trade practices in connection with the transactions relating to
the August 29, 2000 Agreement and Plan of Merger. The damages, punitive damages,
interest and attorneys' fees sought in the complaint are for unspecified
amounts. Messrs. McCloy, Oolie and Hammond and Ms. Lebovics have indicated to us
that they intend to deny the allegations against them. On December 5, 2005,
Metcoff and Wilson filed an amended complaint. On January 12, 2006, the four
defendants in this action filed a request to revise the amended complaint, and,
on February 10, 2006, the plaintiffs filed their objections to the request to
revise. This motion is currently pending before the court.
We have agreed to indemnify Messrs. Parrella, McCloy, Oolie and Hammond and
Ms. Lebovics, to the extent permitted by our certificate of incorporation and
applicable law, for any liabilities (including legal fees) they may incur as a
result of the claims against them in these actions. We submitted the claims
against Messrs. Parrella, McCloy, Oolie and Hammond and Ms. Lebovics in the
cases to our director and officer indemnification insurance carrier, which has
denied coverage of all of the claims against Messrs. Parrella, McCloy, Oolie and
Hammond and Ms. Lebovics.
18
Carole Salkind has demanded that we indemnify her, in connection with her
security interests under our promissory notes to her, for legal fees she incurs
in the action against her. During the three months ended March 31, 2006, we did
not incur or pay such legal fees. The accrued balance of such legal fees was
$16,600 at December 31, 2005 and March 31, 2006 respectively.
Reference is made to our Annual Report on Form 10-K/A for the year ended
December 31, 2005, for further information regarding the foregoing as well as
other litigation related matters. We believe there are no other patent
infringement claims, litigation, matters or unasserted claims other than the
matters discussed above or in our most recent Form 10-K that could have a
material adverse effect on our financial position and results of operations.
12. Segment Information:
We are organized into three operating segments: communications, media and
technology. To reconcile the reportable segment data to the condensed
consolidated financial statements, we capture other information in two
categories: other-corporate and other-consolidating. Other-corporate consists of
items maintained at our corporate headquarters and not allocated to the
segments. This includes most of our debt and related cash and equivalents and
net interest expense, some litigation liabilities and non-operating fixed
assets. Also included in the components of revenue attributed to other-corporate
are license fees and royalty revenue from subsidiaries, which are offset
(eliminated) in the other-consolidating column. Other-consolidating consists of
items eliminated in consolidation, such as intercompany revenue and expense.
During the three months ended March 31, 2006, no geographic information for
revenue from external customers or for long-lived assets is disclosed, as our
primary markets and capital investments were concentrated in the United States.
Revenue from our discontinued operations (Note 13) has been reclassified and is
therefore not included in the revenue amounts presented below.
Reportable segment data for the three months ended March 31, 2005 and March
31, 2006, is as follows:
(In thousands)
------------
For the three months ended Communi- Reportable Other Consoli- Grand
March 31, 2005 (as restated) cations Media Technology Segments Corporate dating Total
- -------------------------------------- ----------- ----------- ------------ ------------ ----------- ------------- ---------------
License Fees and Royalties - External $ 630 $ 535 $ - $ 1,165 $ 6 $ (6) $ 1,165
Other Revenue - External 470 2 - 472 - - 472
Revenue - Other Operating Segments 271 - - 271 5 (276) -
Net Income (loss) (2,681) (1,023) 74 (3,630) (37,633) 21,435 (19,828)
Segment Assets 14,618 22,314 888 37,820 2,273 (34,573) 5,520
For the three months ended Communi- Reportable Other Consoli- Grand
March 31, 2006 cations Media Technology Segments Corporate dating Total
- -------------------------------------- ----------- ----------- ------------ ------------ ----------- ------------- ---------------
License Fees and Royalties - External $ 430 $ - $ 27 $ 457 $ 219 $ (219) $ 457
Other Revenue - External 499 2 - 501 - (1) 500
Revenue - Other Operating Segments 258 - - 258 4 (262) -
Net Income (loss) (3,532) (1,821) 159 (5,194) 17,826 (26,608) (13,976)
Segment Assets 12,951 20,590 690 34,231 2,667 (32,470) 4,428
19
13. Discontinued Operations:
In September 2005, we decided to modify the business model for our Hospital
Radio Network ("HRN") business. Beginning October 1, 2005, instead of continuing
to directly operate this business, under our modified business model, we are
licensing our proprietary technology used in this business to third parties. In
exchange, we will receive a percentage of the advertising revenues generated by
these third parties through existing and new installations of our Sight & Sound
systems in health care facilities. Our initial licensee is a company whose
president is a former operations manager of HRN.
This modification of the business model meets the criteria established for
recognition as discontinued operations under SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." HRN represents a component of our
media segment comprised of operations and cash flows that can be clearly
distinguished, operationally and for financial reporting purposes, from the rest
of the segment. At December 31, 2005, HRN was classified as discontinued
operations and its results of operations are separately reported for all periods
presented.
The results of operations from this business are reflected in the
statements of operations as "Loss from discontinued operations" and are
summarized as follows:
For The
Three Months
Ended
(In thousands of dollars) March 31, 2005
- ------------------------- ---------------------
Net revenue $36
Cost of sales 1
Selling, general and administrative expense 15
Research and development expense 66
---------------------
Costs and expense 82
---------------------
Loss from discontinued operations ($46)
=====================
14. Subsequent Events:
In April 2006, Crammer Road converted an aggregate of 21 shares of our
series H preferred stock along with accrued dividends of approximately $32,000,
into 24,235,726 shares of our common stock.
On April 7, 2006, we issued Carole Salkind an 8% convertible note in the
principal amount of $750,000 for which Ms. Salkind paid us $400,000 in cash.
This note is due upon demand, but in no event later than six months from the
date of issuance. Also on April 7, 2006, we issued Carole Salkind an 8%
convertible note in the principal amount of $4,633,723 to refinance our default
under three notes (dated September 26, 2005, September 26, 2005 and September
30, 2005). The principal amount of this note represents the aggregate principal
rolled over ($4,050,627), default penalty of approximately $405,000 (10% of the
principal in default) and accrued interest of approximately $178,000. This note
matures six months from the date of issuance.
The convertible notes are secured by substantially all of our assets. The
notes bear interest at the stated rate until the due date of the notes, or until
demand is made for repayment of the $750,000 note, and bear interest at a
default rate equal to the stated rate of interest plus 5% on any amount of
principal or interest that is not paid when due or upon demand. Interest is
payable upon maturity of the notes or upon demand for repayment of the $750,000
note. At the election of Ms. Salkind, the $750,000 note may be converted into
shares of our common stock at a conversion price per share equal to the greater
of (i) $0.0024 or (ii) the par value of our common stock on the date of
conversion. At the election of Ms. Salkind, the $4,633,723 note may be converted
into shares of our common stock at a conversion price per share equal to the
greater of (i) $0.0025 or (ii) the par value of our common stock on the date of
conversion. At the election of Ms. Salkind, the notes may be exchanged for
shares of common stock of any our subsidiaries (except Pro Tech Communications,
Inc.) that makes a public offering of its common stock (at the public offering
price). The notes contain events of default, any one of which (if not cured)
triggers a default penalty of 10% of the then outstanding principal. If
triggered, the default penalty, along with the outstanding principal and
20
accrued interest, becomes immediately due and payable. Events of default include
the failure to pay principal and interest when due and the failure to issue
shares of common stock upon exercise of conversion rights.
In conjunction with the issuance of the $4,633,723 note, we issued Ms.
Salkind five-year warrants to acquire an aggregate of 76,500,000 shares of our
common stock at an exercise price per share equal to the greater of (i) $0.0025
or (ii) the par value of our common stock on the date of exercise.
On April 21, 2006, we issued Carole Salkind an 8% convertible note in the
principal amount of $550,000 for which Ms. Salkind paid us $300,000 in cash.
This note is due upon demand, but in no event later than six months from the
date of issuance. Also on April 21, 2006, we issued Carole Salkind an 8%
convertible note in the principal amount of $1,447,275 to refinance our default
under notes dated October 14, 2005 and October 18, 2005. The principal amount of
this note represents the aggregate principal rolled over ($1,268,035), default
penalty of approximately $127,000 (10% of the principal in default) and accrued
interest of approximately $52,000. This note matures six months from the date of
issuance.
In addition, on April 21, 2006, we issued Carole Salkind a 12% convertible
note in the principal amount of $649,392 to refinance our default on payment of
the quarterly interest installment due under the $5,000,000 note dated December
22, 2004. The principal amount of this note represents the interest installment
due April 1, 2006 ($147,945), accrued default interest thereon of $1,447 and
interest default penalty of $500,000 (10% of the then outstanding principal).
Also on April 21, 2006, we issued Carole Salkind a 12% convertible note in the
principal amount of $1,164,838 to refinance our default on payment of the note
for interest dated October 14, 2005. The principal amount of this note
represents the principal rolled over ($1,001,330), accrued default interest
thereon of approximately $63,000 and interest default penalty of $500,000 (10%
of the then outstanding principal). These notes mature six months from the date
of issuance.
The convertible notes are secured by substantially all of our assets. The
notes bear interest at the stated rate until the due date of the notes, or until
demand is made for repayment of the $550,000 note, and bear interest at a
default rate equal to the stated rate of interest plus 5% on any amount of
principal or interest that is not paid when due or upon demand. Interest is
payable upon maturity of the notes or upon demand for repayment of the $550,000
note. At the election of Ms. Salkind, the notes may be converted into shares of
our common stock at a conversion price per share equal to the greater of (i)
$0.0022 or (ii) the par value of our common stock on the date of conversion. At
the election of Ms. Salkind, the notes may be exchanged for shares of common
stock of any our subsidiaries (except Pro Tech Communications, Inc.) that makes
a public offering of its common stock (at the public offering price). The notes
contain events of default, any one of which (if not cured) triggers a default
penalty of 10% of the then outstanding principal. If triggered, the default
penalty, along with the outstanding principal and accrued interest, becomes
immediately due and payable. Events of default include the failure to pay
principal and interest when due and the failure to issue shares of common stock
upon exercise of conversion rights.
In conjunction with the issuance of the notes, we issued Ms. Salkind
five-year warrants to acquire an aggregate of 54,000,000 shares of our common
stock at an exercise price per share equal to the greater of (i) $0.0022 or (ii)
the par value of our common stock on the date of exercise.
On May 10, 2006, we issued Carole Salkind an 8% convertible note in the
principal amount of $550,000 for which Ms. Salkind paid us $300,000 in cash.
This note is due upon demand, but in no event later than six months from the
date of issuance. Also on May 10, 2006, we issued Carole Salkind an 8%
convertible note in the principal amount of $2,230,279 to refinance our default
under two notes dated October 31, 2005. The principal amount of this note
represents the aggregate principal rolled over ($1,950,612), default penalty of
approximately $195,000 (10% of the principal in default) and accrued interest of
approximately $85,000. This note matures six months from the date of issuance.
The convertible notes are secured by substantially all of our assets. The notes
bear interest at the stated rate until the due date of the notes, or until
demand is made for repayment of the $550,000 note, and bear interest at a
default rate equal to the stated rate of interest plus 5% on any amount of
principal or interest that is not paid when due or upon demand. Interest is
payable upon maturity of the notes or upon demand for repayment of the $550,000
note. At the election of Ms. Salkind, the notes may be converted into shares of
our common stock at a conversion price per share equal to the greater of (i)
$0.0020 or (ii) the par value of our common stock on the date of conversion. At
the election of Ms. Salkind, the notes may be exchanged for shares of common
stock of any of our subsidiaries (except Pro Tech Communications, Inc.) that
makes a public offering of its common stock (at the public offering price). The
notes contain events of default, any one of which (if not cured) triggers a
default penalty of 10% of the then outstanding principal. If triggered, the
default penalty, along with the outstanding principal and accrued interest,
becomes immediately due and payable. Events of default include the failure to
pay principal and interest when due and the failure to issue shares of common
stock upon exercise of conversion rights. In conjunction with the issuance of
the $2,230,279 note, we issued Ms. Salkind five-year warrants to acquire an
aggregate of 36,750,000
21
shares of our common stock at an exercise price per share equal to the greater
of (i) $0.0020 or (ii) the par value of our common stock on the date of
exercise.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Caution Concerning Forward-Looking Statements
This report contains forward-looking statements, in accordance with Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, that reflect our current estimates,
expectations and projections about our future results, performance, prospects
and opportunities. Forward-looking statements include all statements that are
not historical facts. These statements are often identified by words such as
"anticipate," "believe," "could," "estimate," "expect," "intend," "plan," "may,"
"should," "will," "would" and similar expressions. These forward-looking
statements are based on information currently available to us and are subject to
numerous risks and uncertainties that could cause our actual results,
performance, prospects or opportunities to differ materially from those
expressed in, or implied by, the forward-looking statements we make in this
report. Important factors that could cause our actual results to differ
materially from the results referred to in the forward-looking statements we
make in this report include:
o our ability to generate sufficient revenues to sustain our current
level of operations and to execute our business plan;
o our ability to obtain additional financing when necessary;
o our substantial level of indebtedness;
o the level of demand for our products and services;
o the level and intensity of competition in our industries;
o our ability to develop new products and the market's acceptance of
these products;
o our ability to maintain and expand our strategic relationships;
o our ability to protect our intellectual property;
o difficulties or delays in manufacturing;
o our ability to effectively manage our operating costs;
o our ability to attract and retain key personnel; and
o additional factors discussed in our Annual Report on Form 10-K/A for
the year ended December 31, 2005 and our other filings with the
Securities and Exchange Commission.
You should not place undue reliance on any forward-looking statements.
Except as otherwise required by federal securities laws, we undertake no
obligation to publicly update or revise any forward-looking statements, whether
as a result of new information, future events, changed circumstances or any
other reason after the date of this report.
All references to years, unless otherwise noted, refer to our fiscal year,
which ends on December 31. All references to quarters, unless otherwise noted,
refer to the quarters of our fiscal year.
Overview
We design products and develop and license technologies based upon our
portfolio of patents and related proprietary rights and extensive technological
know-how. Our business operations are organized into three operating segments:
communications, media and technology. Our operating revenue consists primarily
of technology licensing fees and royalties and product sales. Operating revenue
for the three months ended March 31, 2006 consisted of approximately 47.8% in
technology licensing fees and royalties, 52.0% in product sales and 0.2% in
other revenue. The mix of our revenue sources during any reporting period may
have a material impact on our operating results. In particular, our execution of
technology licensing agreements and the timing of the revenue recognized from
these agreements has not been predictable.
Going Concern Risks
Since inception, we have experienced substantial recurring losses, which
amounted to $403.5 million on a cumulative basis through March 31, 2006.
Internally generated funds from our revenue sources have not been sufficient to
cover our operating costs. The ability of our revenue sources, especially
technology license fees, royalties and product sales to generate significant
cash for our operations is critical to our long-term success. We cannot predict
whether we will be successful in obtaining market acceptance of our new products
or technologies or
22
in completing our current licensing agreement negotiations. To the extent our
internally generated funds are not adequate, we believe that we will need to
obtain additional working capital through equity and/or debt financings.
However, we can give no assurance that any additional financing will be
available to us on acceptable terms or at all. In addition, in order to obtain
additional financing through the sale of shares of our common stock, we will
need to obtain the approval of our stockholders of additional amendments to our
certificate of incorporation to sufficiently increase the number of authorized
shares of our common stock and to reduce or eliminate the par value of our
common stock. However, we can give no assurance that our stockholders would
approve either or both of these amendments increases in our authorized shares of
common stock.
Our management believes that currently available funds will not be
sufficient to sustain our operations at current levels through the next six
months. These funds consist of available cash and the funding derived from our
revenue sources. At March 31, 2006, our cash and cash equivalents amounted to
$0.3 million and our working capital deficit was $150.1 million. We have been
able to continue our operations by raising additional working capital through
the sale of convertible notes. We have been primarily dependent upon funding
from Carole Salkind for the past several years. In the event that external
financing is not available or timely, we will be required to substantially
reduce our level of operations in order to conserve cash. These reductions could
have an adverse effect on our relationships with our customers and suppliers.
Reducing operating expenses and capital expenditures alone may not be adequate,
and continuation as a going concern is dependent upon the level of funding
realized from our internal and external funding sources, all of which are
currently uncertain.
Our condensed consolidated financial statements have been prepared assuming
that we will continue as a going concern, which contemplates continuity of
operations, realization of assets and satisfaction of liabilities in the
ordinary course of business. Our ability to continue as a going concern is
dependent upon, among other things, the achievement of future profitable
operations and the ability to generate sufficient cash from operations, equity
and/or debt financings and other funding sources to meet our obligations. The
uncertainties described in the preceding paragraphs raise substantial doubt at
March 31, 2006 about our ability to continue as a going concern. Our
accompanying condensed consolidated financial statements do not include any
adjustments relating to the recoverability of the carrying amount of recorded
assets or the amount of liabilities that might result from the outcome of these
uncertainties.
Critical Accounting Policies and Estimates
The following discussion of our financial condition and results of
operations is based on the condensed consolidated financial statements included
in this Form 10-Q, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenue and expenses, and the related
disclosures of contingencies. We base these estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. On an on going basis, we evaluate our estimates, including those
related to amortization and potential impairment of intangible assets and
goodwill. Actual results may differ from these estimates under different
assumptions or conditions.
An accounting policy is deemed to be critical if it requires an accounting
estimate to be made based upon assumptions about matters that are highly
uncertain at the time the estimate is made, and if different estimates that
reasonably could have been used, or changes in the accounting estimates that are
reasonably likely to occur periodically, could materially impact the financial
statements. During the three months ended March 31, 2006, there were no
significant changes to the critical accounting policies that we disclosed in
Management's Discussion and Analysis of Financial Condition and Results of
Operations in our Annual Report on Form 10-K/A for the year ended December 31,
2005. The only material change in our accounting policies was the required
adoption of SFAS 123(R), "Share-Based Payment."
The methods, estimates and judgments we use in applying our accounting
policies have a significant impact on the results we report in our financial
statements, which we discuss under the heading "Results of Operations" below.
Some of our accounting policies require us to make difficult and subjective
judgments, often as a result of the need to make estimates of matters that are
inherently uncertain. Below, we discuss the critical policies that required us
to make difficult or subjective assumptions or estimates regarding our condensed
consolidated financial statements included in this quarterly report. We also
have other policies that we consider key accounting policies, such as policies
for revenue recognition, including the deferral of revenue; however, these
policies do not require us to make estimates or judgments that are difficult or
subjective.
23
Goodwill, Patent Rights, Other Intangible Assets
The excess of the consideration paid over the fair value of net assets
acquired in business combinations is recorded as goodwill. We also record
goodwill upon the acquisition of some or all of the stock held by minority
stockholders of a subsidiary, except where such accounting is, in substance, the
purchase of licenses previously sold to such minority stockholders or their
affiliates.
Annually, or if an event occurs or circumstances change that would more
likely than not reduce the fair value of a reporting unit below its carrying
amount, we test our goodwill for impairment. We also recognize an impairment
loss on goodwill acquired upon the acquisition of stock held by minority
stockholders of subsidiaries if the subsidiary's minority interest has no
carrying value, the subsidiary has a capital deficit and the projected future
operating results of the subsidiary are not positive.
At December 31, 2005, we evaluated the goodwill allocated to our Advancel
reporting unit and our NCT Hearing reporting unit and determined no impairment
existed for Advancel or NCT Hearing. At March 31, 2006, our goodwill, net
consisting of the Advancel and NCT Hearing reporting units was $1.3 million. Our
next annual evaluation is planned for December 31, 2006.
Patent rights and other intangible assets with finite useful lives, which
includes the cost to acquire rights to patents and other rights under licenses,
are stated at cost and amortized using the straight-line method over the
remaining useful lives, ranging from one to seventeen years. Amortization
expense for each of the three months ended March 31, 2005 and 2006 was less than
$0.1 million. At March 31, 2006, our patent rights and other intangibles, net
were $1.0 million.
We evaluate the remaining useful life of intangible assets with finite
useful lives each reporting period to determine whether events and circumstances
warrant a revision to the remaining period of amortization. If the evaluation
determines that the intangible asset's remaining useful life has changed, the
remaining carrying amount of the intangible asset is amortized prospectively
over that revised remaining useful life. Our evaluations to date have not
indicated that any revisions are necessary. Our next evaluation is planned for
June 30, 2006. We evaluate our intangible assets with finite useful lives for
impairment whenever events or other changes in circumstances indicate that the
carrying amount may not be recoverable. The testing for impairment includes
evaluating the undiscounted cash flows of the asset and the remaining period of
amortization or useful life. The factors used in evaluating the undiscounted
cash flows include current operating results, projected future operating results
and cash flows and any other material factors that may effect the continuity or
the usefulness of the asset. If impairment exists, the intangible asset is
written down to its fair value based upon discounted cash flows which impacts
the results of operations whether we impair assets or accelerate their
amortization. In light of our continuing losses, a potential indicator of
impairment, we test our patent rights and other intangible assets with finite
useful lives for impairment at each reporting period.
Accounting for Derivative Instruments
We have issued and outstanding convertible debt and certain convertible
equity instruments with embedded derivative features which we analyze in
accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities," and EITF Issue No. 00-19 to determine the proper accounting
classification or if these instruments have embedded derivatives that must be
bifurcated. Under EITF No. 00-19, the estimated value of the embedded
derivative, if any, is bifurcated from its host instrument on the date of sale
or issuance of the securities or debt based on a valuation utilizing an
appropriate valuation model. The embedded derivative is classified as a
liability and is marked-to-market and adjusted to fair value at each reporting
date and the change in fair value is recorded in other income (expense). In
addition, freestanding warrants and non-employee options are accounted for as
equity instruments or liabilities in accordance with the provisions of EITF
Issue No. 00-19. As of March 31, 2006, we could not be sure we had adequate
authorized shares for the conversion or exercise of all outstanding instruments
due to certain conversion rates which vary with the fair value of our common
stock, and therefore all embedded derivatives, freestanding warrants and
non-employee options are recorded at fair value, marked-to-market at each
reporting date, and are carried on a separate line of the accompanying balance
sheet. If there is more than one embedded derivative, their value is considered
in the aggregate.
24
Stock-Based Compensation
Effective January 1, 2006, we adopted SFAS No. 123(R) "Share-Based
Payment." We elected to use the modified prospective transition method, and
accordingly, prior period results were not restated to reflect the impact of
SFAS No. 123(R). Prior to the adoption of SFAS 123(R), stock-based compensation
expense related to stock options was not recognized in the results of operations
if the exercise price was at least equal to the market value of the common stock
on the grant date, in accordance with Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees." As a result, the recognition of
employee stock-based compensation expense was generally limited to the expense
attributed to restricted stock unit awards and stock option modifications, if
any.
As of March 31, 2006, there was no unrecognized stock compensation related
to unvested awards (net of estimated forfeitures) expected to be recognized over
future periods as all awards were vested at December 31, 2005.
Results of Operations
Three months ended March 31, 2006 compared to three months ended March 31, 2005
Revenue. Total revenue for the three months ended March 31, 2006 was $1.0
million as compared to $1.6 million for same period in 2005, a decrease of $0.6
million, or 37.5%, primarily the result of having fully recognized the remaining
$0.5 million of the license fee revenue from the New Transducers Ltd. ("NXT")
license in the three months ended March 31, 2005. Total revenue for the three
months ended March 31, 2006 consisted of approximately 47.8% in technology
licensing fees and royalties, 52.0% in product sales and 0.2% in other revenue
as compared to the three months ended March 31, 2005 of approximately 71.2% in
technology licensing fees and royalties and 28.8% in product sales.
Technology licensing fees and royalties were $0.5 million for the three
months ended March 31, 2006 as compared to $1.2 million for the same period in
2005, a decrease of $0.7 million, or 58.3%. This decrease was due primarily to
having fully recognized the license fee revenue from the NXT license. In May
2005, we learned that our ClearSpeech algorithm will not be incorporated by
Sharp Corporation in its next generation product. As a result, we expect a
significant decline in our royalties from Sharp during 2006. Our revenue from
Sharp for each of the three months ended March 31, 2006 and 2005 was
approximately $0.2 million.
For each of the three months ended March 31, 2006 and 2005, product sales
were $0.5 million. Gross profit on product sales, as a percentage of product
sales, for the three months ended March 31, 2006 and 2005 was 53.6% and 49.1%,
respectively. For the three months ended March 31, 2006 and 2005, 100% and 92%,
respectively, of our product sales were attributable to our communications
segment. The mix of our product sales within the communications segment for the
three months ended March 31, 2006 included 63% of Pro Tech products and 16% of
Artera Turbo subscriptions whereas the same period in the prior year included
62% of Pro Tech products and 18% of Artera Turbo subscriptions. Our subscriber
base that generated the Artera Turbo product sales for the three months ended
March 31, 2006 consisted of residential and small business users.
Costs and expenses. Total costs and expenses for the three months ended
March 31, 2006 were $14.9 million compared to $21.4 million for the same period
in 2005, a decrease of $6.5 million, or 30.4%, due primarily to a $8.9 million
decrease in interest expense, a decrease in the adjustment of the fair value of
outstanding options, warrants and embedded derivatives of $1.3 million and a
decrease in costs associated with non-conversion of preferred stock of $1.2
million partially offset by an increase of $4.5 million in default penalties on
convertible notes.
For the three months ended March 31, 2006, selling, general and
administrative expenses totaled $1.8 million as compared to $1.3 million for the
three months ended March 31, 2005, an increase of $0.5 million, or 38.5%. This
increase was due primarily to the waiver by three executives of a portion of
their incentive bonus in the three months ended March 31, 2005. These amounts
waived in 2005 were approximately $326,000, $107,000 and $158,000 for our Chief
Executive Officer, President and Chief Financial Officer, respectively.
For the three months ended March 31, 2006, other expense, net totaled $2.8
million as compared to of $0.8 million for the three months ended March 31,
2005, an increase of $2.0 million, or 250.0%. The increase was due primarily to
an increase of $4.5 million in default penalties on convertible notes, partially
offset by a change in the adjustment of the fair value of outstanding options,
warrants and embedded derivatives of $1.3 million and a decrease in costs
associated with penalties for non-conversion of preferred stock of $1.2 million
resulting from a waiver of liquidated damages by a preferred stockholder.
25
For the three months ended March 31, 2006, interest expense, net totaled
$9.2 million as compared to $18.1 million for the three months ended March
31,2005, an decrease of $8.9 million, or 49.2%. The decrease in interest expense
was primarily attributable to the decrease in the expensing of the original
issue discount arising from the allocation of proceeds to the fair value of
warrants and the amortization of beneficial conversion features arising from
allocation of proceeds to warrants and any beneficial conversion rates on the
related debt. Interest expense for the three months ended March 31, 2006
included amortization of original issue discounts of $4.7 million, amortization
of beneficial conversion features of convertible debt of $2.3 million, and
interest on convertible debt issued by us of $2.1 million. Such amounts for the
three months ended March 31, 2005 were $7.7 million, $8.8 million and $1.5
million, respectively.
For the three months ended March 31, 2005, the consolidated net loss
included a loss from discontinued operations of less than $0.1 million. The loss
was the result of modifying the business model for operating our Hospital Radio
Network business in September 2005. Instead of continuing to directly operate
this business, under our modified business model, we are licensing our
proprietary technology used in this business to third parties. In exchange, we
will receive a percentage of the advertising revenues generated by these third
parties through existing and new installations of our Sight & Sound systems in
health care facilities.
Liquidity and Capital Resources
We have experienced substantial losses from since inception, which have
been recurring and amounted to $403.5 million on a cumulative basis through
March 31, 2006. These losses, which include the costs for development of
technologies and products for commercial use, have been funded primarily from:
o the issuance of our and our subsidiaries' convertible debt;
o the sale of our and our subsidiaries' common stock;
o the sale of our and our subsidiaries' convertible preferred stock;
o technology licensing fees;
o royalties;
o product sales;
o advertising revenue; and
o engineering and development services.
We believe that internally generated funds are currently insufficient to
meet our short-term and long-term operating and capital requirements. These
funds include available cash and cash equivalents and revenue derived from
technology licensing fees and royalties and product sales. Our ability to
continue as a going concern is substantially dependent upon future levels of
funding from our revenue sources, which are currently uncertain. Since we are
unable to generate sufficient revenue to sustain our current level of operations
and to execute our business plan, we will need to obtain additional financing to
maintain our current level of operations. We are attempting to obtain additional
working capital through debt and/or equity financings. However, we can give no
assurance that additional financing will be available to us on acceptable terms
or at all. At our 2005 annual meeting of stockholders, held on June 28, 2005,
our stockholders approved an amendment to our certificate of incorporation to
increase the number of authorized shares of our common stock to 5.622 billion
shares. This increase in the number of our authorized shares of common stock,
however, is not sufficient for us to satisfy potential requests for conversions
and exchanges of our and our subsidiaries' derivative securities. The failure to
obtain any necessary additional financing would have a material adverse effect
on us, including causing a substantial reduction in the level of our operations.
These reductions, in turn, could have a material adverse effect on our
relationships with our licensees, customers and suppliers. The uncertainty
surrounding future levels of funding from our revenue sources and the
availability of any necessary additional financing raises substantial doubt at
March 31, 2006 about our ability to continue as a going concern.
We have entered into financing transactions because internally generated
funding sources have been insufficient to maintain our operations. Our financing
transactions to fund our business pursuits during the three months ended March
31, 2006 are described in the notes to the condensed consolidated financial
statements. In 2006, we have continued to be primarily dependent upon funding
from Carole Salkind. Although we do not have a formal agreement requiring her to
do so, we believe that Ms. Salkind will continue to provide funds to us. Our
belief that funding from her will continue is based primarily upon her continued
funding of us during 2004, 2005 and to date in 2006 despite our failure to repay
her notes as they matured. However, we have no legally binding assurance that
Ms. Salkind will continue to fund us in the short-term or that the amount,
timing and duration of the funding from her will be adequate to sustain our
business operations.
26
Our monthly use of operating cash for each of the three months ended March
31, 2006 was approximately $0.7 million, down from approximately $0.8 million in
the same period of the prior year. In the absence of a significant infusion of
new capital, we anticipate that our monthly use of cash over the next 12 months
will not exceed this approximate level, assuming continued funding from Carole
Salkind or other sources to satisfy the amounts not funded by royalty
collections and product sales. Of our monthly cash expenditures, approximately
$0.6 million is used currently to fund payroll and payroll-related costs (such
as taxes and health insurance) and the balance is used for other operating
expenses (including rents, utilities and arrearage arrangements).
At March 31, 2006, our cash and cash equivalents aggregated $0.3 million
and our working capital deficit was $150.1 million, compared to a deficit of
$136.8 million at December 31, 2005, a $13.3 million increase. Our current
assets were approximately $1.4 million at March 31, 2006 compared to
approximately $1.5 million at December 31, 2005. Our current liabilities were
approximately $151.5 million at March 31, 2006 compared to approximately $138.4
million at December 31, 2005. The $13.1 million increase in current liabilities
was due primarily to the issuance and refinancing of convertible notes to Carole
Salkind of $16.2 million (net of discounts), partially offset by decreases in
derivative liabilities of $2.0 million and accrued expenses of $0.7 million. At
March 31, 2006, our current liabilities consisted of indebtedness ($94.8
million), accrued liabilities ($14.8 million), other current liabilities ($7.0
million), preferred stock subject to conversion into a variable number of shares
of common stock ($24.8 million), derivative liabilities ($5.9 million), accounts
payable ($3.0 million), deferred revenue ($0.4 million) and shares of subsidiary
subject to exchange rights ($0.7 million). Most of our indebtedness (and accrued
interest thereon) is convertible into shares of our common stock and may be
converted to the extent we have sufficient shares of authorized but unissued
common stock.
At March 31, 2006, we were in default of $0.5 million of our notes payable
and $9.1 million of our convertible notes. The following table summarizes our
indebtedness in default at March 31, 2006:
(In millions)
New Defaults
Indebtedness Defaults Cured Indebtedness
In Default during during In Default
Notes Payable: 12/31/05 the Period the Period 03/31/06
-------------- -------------- ------------- ----------------
Former Employees / Other $ 0.5 (a) $ - $ - $ 0.5 (a)
-------------- -------------- ------------- ----------------
Subtotal 0.5 - - 0.5
-------------- -------------- ------------- ----------------
Convertible Notes:
Carole Salkind Notes 0.6 69.8 (66.4) 4.0
8% Notes 2.6 (a,b) - 2.6 (a,b)
6% Notes 2.5 (a) - 2.5 (a)
-------------- -------------- ------------- ----------------
Subtotal 5.7 69.8 (66.4) 9.1
-------------- -------------- ------------- ----------------
Grand Total $ 6.2 $ 69.8 $ (66.4) $ 9.6
============== ============== ============= ================
Footnotes:
- ---------
(a) Default due to nonpayment.
(b) Default due to cross default provision (default on other debt).
Net cash used in operating activities for the three months ended March 31,
2006 was $2.2 million due primarily to funding the 2006 net loss of $14.0
million, as adjusted to reconcile to net cash.
Our deferred revenue balance at March 31, 2006 was $0.4 million. No
additional cash will be realized from our deferred revenue balance.
Net cash provided by financing activities was $1.9 million for the three
months ended March 31, 2006 and was primarily due to the issuance and sale of
convertible notes to Ms. Salkind for cash consideration of $2.0 million. The
cash proceeds from debt issued in the three months ended March 31, 2006 was
primarily used for working capital purposes.
At March 31, 2006, our short-term debt was $94.8 million (principally
comprised of $96.9 million face value of outstanding convertible notes payable,
and $0.6 million of outstanding notes payable), shown net of
27
discounts of approximately $2.6 million on our condensed consolidated balance
sheet, compared to $78.6 million of short-term debt, net at December 31, 2005,
an increase of $16.2 million due to debt issued to Carole Salkind.
During the three months ended March 31, 2006, we issued $78.8 million of 8%
convertible notes and one 12% convertible note in the amount of $0.7 million,
along with five-year warrants to acquire an aggregate of 1,319,000,000 shares of
our common stock. Of these notes, $76.4 million mature six months from the date
of issuance and $3.1 million are due upon the earlier of demand or six months
from the date of issuance. Consideration paid for these notes included
approximately $2.0 million in cash and cancellation and surrender of notes
aggregating approximately $66.4 million, along with default penalties of $7.1
million and accrued interest of $2.9 million and $1.1 million as consideration
(original issue discounts) related to the convertible notes. Carole Salkind has
demanded, and we have agreed, that to the extent required in connection with her
security interests under our secured notes to her, we will pay the legal fees
she incurs as a result of certain legal matters.
We believe that the level of financial resources available to us is
critical to our ability to continue as a going concern. We will need to raise
additional capital through equity or debt financing in order to sustain our
operations or capitalize upon business opportunities and market conditions. We
expect that from time to time our outstanding short-term debt may be replaced
with new short-term or long-term borrowings. Although we believe that we can
continue to access the capital markets in 2006 on acceptable terms and
conditions, our flexibility with regard to long-term financing activity could be
limited by the liquidity of our common stock on the open market, our current
level of short-term debt and our credit ratings.
In addition, many of the factors that affect our ability to access the
capital markets, such as the liquidity of the overall capital markets and the
current state of the economy, are outside of our control. We can give no
assurance that we will continue to have access to the capital markets on
favorable terms. In addition, our subsidiaries are at a stage where they may not
separately be able to obtain financing or other funding based upon their lack of
or limited performance history.
In July 2005, we entered into a second amended and restated private equity
credit agreement with Crammer Road that superseded and replaced our amended and
restated private equity credit agreement dated as of September 30, 2004, which
in turn, replaced a similar agreement dated as of July 25, 2002. The new credit
agreement gives us the right to sell to Crammer Road shares of our common stock
having an aggregate value of up to $50.0 million pursuant to puts made by us.
The agreement requires us to sell to Crammer Road at least an aggregate of $5.0
million of our common stock at a 7% discount from the market value of our common
stock determined at the time of a put. Through March 31, 2006, we have sold a
total of 18,756,756 shares of our common stock to Crammer Road pursuant to our
private equity credit agreement for gross proceeds of approximately $134,000, at
prices determined pursuant to the provisions of the agreement, which prices were
less than $0.01 per share, the current par value of our common stock. Delaware
law restricts sales of unissued shares of common stock at a price less than the
par value of the common stock. We do not intend to sell shares pursuant to the
private equity credit agreement when the purchase price of such shares would be
less than the par value of our common stock.
We intend to use the 2005 private equity credit agreement to raise
additional cash. However, the equity credit line may not be a reliable source of
new cash capital for us. We must maintain an active trading market able to
absorb large quantities of traded shares of our common stock. If the market for
our common stock has an insufficient volume of shares traded, large quantities
of shares of our common stock sold by Crammer Road to satisfy our puts may drive
the price of our common stock lower due to lack of demand for those shares. In
addition, the shares to be issued to Crammer Road under the private equity
credit agreement will be issued at a 7% discount to the average of the three
lowest closing bid prices for the ten trading days immediately following the
notice date of a put. Based on this discount, Crammer Road has an incentive to
sell immediately to realize the gain on the 7% discount. These discounted sales
could cause our stock price to decline. A significant downward pressure on the
price of our common stock caused by the sale of material amounts of common stock
under the private equity credit agreement could encourage short sales by third
parties. These sales could place additional downward pressure on the price of
our common stock by increasing the number of shares being sold. Furthermore, as
discussed above, we do not intend to sell shares pursuant to the private equity
credit agreement at any time the purchase price of such shares would be less
than the par value of our common stock.
We have no lines of credit with banks or other lending institutions and,
therefore, have no unused borrowing capacity.
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Capital Expenditures
In connection with our industrial safety earmuff, we have incurred 25% of
the approximate $0.1 million in tooling costs. Other than this expenditure, we
had no material commitments for capital expenditures as of March 31, 2006 and no
material commitments are anticipated in the near future.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our primary market risk exposures include fluctuations in interest rates.
We are exposed to short-term interest rate risk on some of our obligations. We
do not use derivative financial instruments to hedge cash flows for these
obligations. In the normal course of business, we employ established policies
and procedures to manage these risks.
Based upon a hypothetical 10% proportionate increase in interest rates from
the average level of interest rates during the last twelve months, and taking
into consideration commissions paid to selling agents, growth of new business
and the expected borrowing level of variable-rate debt, the expected effect on
net income related to our financial instruments would be immaterial.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness of our disclosure controls
and procedures (as defined in Rule 13a-15(e) under the Securities Act of 1934,
as amended) as of March 31, 2006. Based on that evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that our disclosure controls and
procedures as of March 31, 2006 were effective in ensuring that information
required to be disclosed by us in reports that we file or submit under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported within the time periods specified in the Securities and Exchange
Commission's rules and forms. We believe that a control system, no matter how
well designed and operated, cannot provide absolute assurance that the
objectives of the control system are met, and no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, could be detected within a company.
Changes in Internal Controls
There were no changes in our internal control over financial reporting that
occurred during the quarter ended March 31, 2006 that have materially affected,
or are reasonably likely to materially affect, our internal control over
financial reporting.
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PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
For a discussion of recent developments involving material legal
proceedings, see "Note 11 - Litigation" included in the notes to the condensed
consolidated financial statements herein.
ITEM 6. EXHIBITS
10.1(a) Form of Secured Convertible Note (demand) issued by NCT Group, Inc. to
Carole Salkind (incorporated by reference to Exhibit 10.1(a) of the
registrant's Current Report on Form 8-K dated December 22, 2005 (File
No. 0-18267)).
10.1(b) Schedule of Secured Convertible Notes (demand) issued by NCT Group,
Inc. to Carole Salkind during the three months ended March 31, 2006.
10.2(a) Form of Secured Convertible Note (refinancings after October 31, 2005)
issued by NCT Group, Inc. to Carole Salkind (incorporated by reference
to Exhibit 10.2(a) of the registrant's Current Report on Form 8-K
dated December 7, 2005 (File No. 0-18267)).
10.2(b) Schedule of Secured Convertible Notes (refinancings after October 31,
2005) issued by NCT Group, Inc. to Carole Salkind during the three
months ended March 31, 2006.
10.3(a) Form of Warrant (new financing after October 31, 2005) issued by NCT
Group, Inc. to Carole Salkind (incorporated by reference to Exhibit
10.3(a) of the registrant's Current Report on Form 8-K dated December
7, 2005 (File No. 0-18267)).
10.3(b) Schedule of Warrants (new financings after October 31, 2005) issued by
NCT Group, Inc. to Carole Salkind during the three months ended March
31, 2006.
10.4(a) Form of Warrant (refinancings after October 31, 2005) issued by NCT
Group, Inc. to Carole Salkind (incorporated by reference to Exhibit
10.4(a) of the registrant's Current Report on Form 8-K dated December
7, 2005 (File No. 0-18267)).
10.4(b) Schedule of Warrants (refinancings after October 31, 2005) issued by
NCT Group, Inc. to Carole Salkind during the three months ended March
31, 2006.
10.5(a) Form of 12% Secured Convertible Note issued by NCT Group, Inc. to
Carole Salkind (incorporated by reference to Exhibit 10.11(a) to the
registrant's Annual Report on Form 10-K for the year ended December
31, 2005 (File No. 0-18267).
10.5(b) Schedule of 12% Secured Convertible Notes issued by NCT Group, Inc. to
Carole Salkind during the three months ended March 31, 2006
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934.
31.2 Certification of Chief Financial Officer pursuant Rule 13a-14(a) under
the Securities Exchange Act of 1934.
32.1 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934
and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
NCT GROUP, INC.
By: /s/ MICHAEL J. PARRELLA
-------------------------------------
Michael J. Parrella
Chief Executive Officer and
Chairman of the Board of Directors
By: /s/ CY E. HAMMOND
-------------------------------------
Cy E. Hammond
Senior Vice President,
Chief Financial Officer and Treasurer
Dated: May 25, 2006
31