BSQUARE CORP /WA - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003


[ ]		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: 000-27687

BSQUARE CORPORATION

(Exact name of registrant as specified in its charter)


Washington		91-1650880
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

3150 139th Avenue SE, Suite 500, Bellevue WA		98005
(Address of principal executive offices)		(Zip Code)

(425) 519-5900
(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. Yes [X] No [ ].

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]

As of October 31, 2003, there were 37,457,164 shares of the registrant’s common stock outstanding.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
INDEX TO EXHIBITS
EXHIBIT 10.18
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

BSQUARE CORPORATION

FORM 10-Q

For the Quarterly Period Ended September 30, 2003

TABLE OF CONTENTS


		Page

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
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 and Reports on Form 8-K	31

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

BSQUARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)


			September 30,			December 31,
			2003			2002

ASSETS
Current assets:
	Cash and cash equivalents		$	8,962		$	11,041
	Restricted cash			2,000			2,582
	Short-term investments			7,730			18,444
	Accounts receivable, net			6,512			6,494
	Income taxes receivable			155			2,934
	Prepaid expenses and other current assets			1,075			1,966
	Deferred income taxes			28			28

		Total current assets		26,462			43,489
Furniture, equipment and leasehold improvements, net				2,064			3,124
Restricted cash				4,192			3,358
Investments				—			210
Intangible assets, net				412			850
Deposits and other assets				730			2,566

		Total assets	$	33,860		$	53,597

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	1,976		$	1,942
	Accrued compensation			1,107			3,079
	Restructuring costs, current portion			2,126			5,659
	Other accrued expenses			2,962			3,204
	Deferred income taxes			28			28
	Deferred revenue			1,960			1,620

		Total current liabilities		10,159			15,532
Restructuring costs, net of current portion				556			5,431

		Total liabilities		10,715			20,963

Commitments and contingencies
Shareholders’ equity:
	Preferred stock, no par value: authorized 10,000,000 shares; no shares issued and outstanding			—			—
	Common stock, no par value: authorized 150,000,000 shares, issued and outstanding, 37,451,988 shares as of September 30, 2003 and 36,968,128 shares as of December 31, 2002			117,844			117,149
	Deferred stock-based compensation			—			(15	)
	Accumulated other comprehensive loss			(213	)		(325	)
	Accumulated deficit			(94,486	)		(84,175	)

		Total shareholders’ equity		23,145			32,634

		Total liabilities and shareholders’ equity	$	33,860		$	53,597

See notes to condensed consolidated financial statements.

BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)


				Three Months						Nine Months
				Ended September 30,						Ended September 30,

				2003			2002			2003			2002

Revenue:
	Product			$	7,101		$	5,594		$	19,570		$	12,662
	Service				2,307			4,412			7,287			15,560

		Total revenue			9,408			10,006			26,857			28,222

Cost of revenue:
	Product				5,002			4,482			14,566			8,702
	Service				2,441			4,556			7,317			13,491

		Total cost of revenue			7,443			9,038			21,883			22,193

			Gross profit		1,965			968			4,974			6,029
Operating expenses:
	Research and development				2,156			3,636			7,387			12,790
	Selling, general and administrative				2,967			5,043			10,326			14,969
	Acquired in-process research and development				—			—			—			1,698
	Amortization of intangible assets				146			133			438			1,242
	Impairment of goodwill and other intangible assets				—			6,472			435			6,472
	Restructuring and other related charges (credit)				360			9,885			(2,416	)		12,090

			Total operating expenses		5,629			25,169			16,170			49,261

			Loss from operations		(3,664	)		(24,201	)		(11,196	)		(43,232	)
Other income (expense), net:
	Investment income, net				144			298			450			1,233
	Other income (expense), net				591			(1,644	)		504			(3,403	)

Loss before income taxes and cumulative effect of change in accounting principle					(2,929	)		(25,547	)		(10,242	)		(45,402	)
Provision for income taxes					(40	)		—			(69	)		(2,124	)

Loss before cumulative effect of change in accounting principle					(2,969	)		(25,547	)		(10,311	)		(47,526	)
Cumulative effect of change in accounting principle					—			—			—			(14,932	)

		Net loss		$	(2,969	)	$	(25,547	)	$	(10,311	)	$	(62,458	)

	Basic and diluted loss per share:
		Loss before cumulative effect of change in accounting principle		$	(0.08	)	$	(0.69	)	$	(0.28	)	$	(1.31	)
		Cumulative effect of change in accounting principle			—			—			—			(0.41	)

			Basic and diluted loss per share	$	(0.08	)	$	(0.69	)	$	(0.28	)	$	(1.72	)

	Shares used in calculation of loss per share:
		Basic and diluted			37,323			36,783			37,179			36,245

See notes to condensed consolidated financial statements.

BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)


					Nine Months Ended
					September 30,

					2003			2002

Cash flows from operating activities:
	Net loss				$	(10,311	)	$	(62,458	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization				1,511			3,085
		Deferred income taxes				—			5,792
		Write down of investments				78			3,446
		Gain on sale of investments				(627	)		—
		Acquired in-process research and development				—			1,698
		Cumulative effect of change in accounting principle				—			14,932
		Restructuring and other related charges (credit)				(2,416	)		12,090
		Impairment of goodwill				435			6,472
		Issuance of common stock warrants				332			—
		Other				114			33
		Changes in operating assets and liabilities, net of effects of acquisition:
			Restricted cash			(552	)		(5,940	)
			Income taxes receivable			2,779			—
			Accounts receivable, net			(18	)		2,284
			Prepaid expenses and other current assets			891			(1,498	)
			Deposits and other assets			1,836			(291	)
			Accounts payable, restructuring costs, accrued compensation and other accrued expenses			(8,172	)		(5,580	)
			Deferred revenue			340			(1,255	)

				Net cash used in operating activities		(13,780	)		(27,190	)

Cash flows from investing activities:
	Purchases of furniture, equipment and leasehold improvements					(116	)		(1,856	)
	Maturity of short-term investments					10,714			9,873
	Proceeds from the sale of investments					759			—
	Purchase of Infogation Corporation, net of cash acquired					—			(3,893	)
	Purchase of customer list					—			(75	)

				Net cash provided by investing activities		11,357			4,049

Cash flows from financing activities:
	Proceeds from exercise of stock options					232			1,095

				Net cash provided by financing activities		232			1,095

Effect of exchange rate changes on cash						112			78

				Net decrease in cash and cash equivalents		(2,079	)		(21,968	)
Cash and cash equivalents, beginning of period						11,041			30,303

Cash and cash equivalents, end of period					$	8,962		$	8,335

See notes to condensed consolidated financial statements.

BSQUARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
(unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by BSQUARE Corporation (the “Company” or “BSQUARE”) pursuant to the rules and regulations of the Securities and Exchange Commission for interim financial reporting and include the accounts of the Company and its subsidiaries. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company, the unaudited financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation, in conformity with U.S. generally accepted accounting principles, of the Company’s financial position at September 30, 2003 and its operating results and cash flows for the three and nine months ended September 30, 2003 and 2002. The accompanying consolidated balance sheet as of December 31, 2002 has been derived from the audited financial statements included in the Company’s annual report on Form 10-K for the year then ended. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Examples include provision for bad debts, valuation of long-lived assets and deferred revenue. Actual results may differ from these estimates. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with the Company’s financial statements and notes thereto contained in the Company’s annual report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission. Certain reclassifications have been made for consistent presentation.

Stock-Based Compensation

The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for employee stock options rather than the alternative fair value accounting allowed by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense related to the Company’s employee stock options is measured based on the intrinsic value of the stock option. SFAS No. 123, amended by SFAS No. 148 “Accounting for Stock-Based-Compensation - Transition and Disclosure,” requires companies that continue to follow APB No. 25 to provide pro forma disclosure of the impact of applying the fair value method of SFAS No. 123. The Company recognizes compensation expense for options granted to non-employees in accordance with the provisions of SFAS No. 123 and the Emerging Issues Task Force consensus Issue 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” which require using the Black-Scholes option pricing model and re-measuring such stock options to the current fair market value as the underlying options vest.

Deferred stock-based compensation consists of amounts recorded when the exercise price of an option is lower than the subsequently determined fair value of the underlying common stock on the date of grant. Deferred stock-based compensation is amortized in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 28, on an accelerated basis, over the vesting period of the underlying option.

Pro forma information regarding net loss is required by SFAS No. 123 and SFAS No. 148 as if the Company had accounted for its employee stock options under the fair value method. The fair value of the Company’s options was estimated on the date of grant using the Black-Scholes method, with the following assumptions:


	Three Months Ended
	September 30,

	2003			2002

Dividend yield		0	%		0	%
Expected life	4 years			5 years
Expected volatility		170	%		180	%
Risk-free interest rate		2.7	%		2.8	%

Because the determination of the fair value of the Company’s options is based on assumptions described above, and because additional option grants are expected to be made in future periods, this pro forma information is not likely to be representative of the pro forma effects on reported net income or loss for future periods.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. The following table illustrates what net loss would have been had the Company accounted for its stock options under the provisions of SFAS 123 (in thousands, except per share data):


		Three Months						Nine months
		Ended September 30,						Ended September 30,

		2003			2002			2003			2002

		(unaudited)
Net loss, as reported		$	(2,969	)	$	(25,547	)	$	(10,311	)	$	(62,458	)
Compensation expense recognized under APB 25			7			38			15			98
Incremental pro forma compensation expense under SFAS 123			(397	)		(316	)		(112	)		(2,008	)

Pro forma net loss		$	(3,359	)	$	(25,825	)	$	(10,408	)	$	(64,368	)

Pro forma basic and diluted loss per share		$	(0.09	)	$	(0.70	)	$	(0.28	)	$	(1.78	)

Shares used in calculation of pro forma loss per share:
	Basic and diluted		37,323			36,783			37,179			36,245

Earnings Per Share

Basic earnings per share is computed using the weighted average number of common shares outstanding during the period, net of shares subject to repurchase, and excludes any dilutive effects of common stock equivalent shares, such as options and warrants (using the treasury stock method) and convertible securities (using the if-converted method). Diluted earnings per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the period; common stock equivalent shares are excluded from the computation if their effect is antidilutive.

As of September 30, 2003 and 2002, there were stock options and warrants outstanding to acquire 4,888,806 and 6,931,505 common shares, respectively, that were excluded from the computation of diluted loss per share, as their effect was antidilutive. If the Company had reported net income, the calculation of per share amounts would have included the dilutive effect of these common stock equivalents using the treasury stock method.

Change in Accounting for Goodwill and Certain Other Intangible Assets

Effective January 1, 2002, the Company adopted SFAS No. 142, which requires companies to discontinue amortizing goodwill and certain intangible assets with an indefinite useful life. SFAS No. 142 requires that goodwill and indefinite life intangible assets be reviewed for impairment upon adoption of the accounting standard and annually thereafter, or more frequently if impairment indicators arise. During the third quarter of 2002 the Company completed its evaluation of goodwill and other intangible assets acquired in prior years, as required. As a result, the Company recorded a retroactive impairment loss of $14.9 million as of January 1, 2002. In calculating these impairment losses, the Company evaluated the fair value of its reporting units by estimating the expected present value of their future cash flows. The Company’s policy provides that goodwill and indefinite life intangible assets will be reviewed for impairment on October 1st of each year. See Note 3 for further discussion.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), which had an original effective date of July 1, 2003. In October 2003, the FASB deferred the effective date of FIN 46 until the first interim or annual period ending after December 15, 2003. As such, FIN 46 will be effective for the Company for the quarter ending December 31, 2003. The Company, in consultation with its advisors, is reviewing FIN 46 to determine its impact, if any, upon the Company’s consolidated financial statements. Based upon its initial analysis, the Company does not believe that FIN 46 will have a material adverse effect upon its consolidated financial statements.

In May 2003, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes standards for how a company classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the

first interim period beginning after September 15, 2003. The Company has determined that SFAS 150 does not affect the classification or measurement of any of its financial instruments.

2. Consolidation of Excess Facilities and Restructuring Charge

During the third quarter of 2003, to further reduce expenses, the Company announced a company-wide reduction in workforce of 14 employees, approximately 8% of its remaining workforce. In connection with this headcount reduction, the Company paid approximately $175,000 in severance and other benefits in the third quarter of 2003. Also during the third quarter, the Company finalized negotiations for the termination of its San Diego, California facility lease, resulting in accelerated cash payments of approximately $300,000 made in July 2003. In addition, the Company agreed to enter into a new lease with the landlord, at a reduced rate, for approximately 2,600 square feet through January 2005.

During the second quarter of 2003, the Company announced a reduction in workforce of 16 employees, approximately 8% of its then remaining workforce. These reductions resulted from the curtailment of certain product offerings. In connection with this headcount reduction, the Company paid approximately $200,000 in severance and other benefits in the second quarter of 2003.

During the second quarter of 2003, the Company also negotiated a termination of its Sunnyvale, California facility lease. This lease termination resulted in accelerated cash payments of approximately $698,000 made during the second quarter of 2003 and the issuance of a warrant to purchase up to 400,000 shares of the Company’s common stock at a price of $1.14 per share. The warrant value was estimated at $332,000 using the Black-Scholes model with an expected dividend yield of 0.0%, a risk-free interest rate of 1.5%, volatility of 180% (estimated based on the two-year average volatility of its common stock price) and an expected life of five years.

During the first, third and fourth quarters of 2002, the Company initiated restructuring activities to reduce headcount and infrastructure, and to eliminate excess leased facilities. During 2002, the Company recorded $16.2 million in restructuring and other related charges.

The roll-forward of the restructuring liability follows (in thousands):


		Employee						Other
		Separation			Excess			Related
		Costs			Facilities			Charges			Total

Balance, December 31, 2002		$	1,254		$	9,836		$	—		$	11,090
	Restructuring charge recognized in the second quarter of 2003		200			286			274			760
	Restructuring charge recognized in the third quarter of 2003		175			—			184			359
	Change in estimates due to the effect of lease termination arrangements		—			(3,536	)		—			(3,536	)
	Warrant issued pursuant to lease termination agreement		—			(332	)		—			(332	)
	Cash payments pursuant to lease termination agreements		—			(998	)		—			(998	)
	Cash payments		(1,629	)		(2,574	)		(458	)		(4,661	)

Balance, September 30, 2003		$	—		$	2,682		$	—		$	2,682

Current portion											$	2,126
Long-term portion											$	556

3. Goodwill and Other Intangible Assets

The Company’s intangible assets and related accumulated amortization consisted of the following (in thousands):


		September 30, 2003							December 31, 2002

				Accumulated							Accumulated
		Gross		Amortization			Net		Gross		Amortization			Net

Developed technology		$	1,600	$	(1,200	)	$	400	$	1,600	$	(800	)	$	800
Customer list			75		(63	)		12		75		(25	)		50

	Total	$	1,675	$	(1,263	)	$	412	$	1,675	$	(825	)	$	850

Amortization expense associated with intangible assets was $146,000 and $133,000 for the three months the ended September 30, 2003 and 2002, respectively. For the nine months ended September 30, 2003 and 2002, amortization expense was $438,000 and $1.2 million, respectively. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for the remaining three months of 2003 and the year ending December 31, 2004 is $145,000 and $267,000, respectively, and zero thereafter.

4. Comprehensive Loss

Comprehensive loss is defined as the change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net loss and comprehensive loss for the Company results from foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities.

Components of comprehensive loss consist of the following (in thousands):


	Three Months						Nine months
	Ended September 30,						Ended September 30,

	2003			2002			2003			2002

Net loss	$	(2,969	)	$	(25,547	)	$	(10,311	)	$	(62,458	)
Foreign currency translation gain (loss)		189			(74	)		112			78
Reclassification adjustment for gains included in net loss		(203	)		—			—			—

Comprehensive loss	$	(2,983	)	$	(25,621	)	$	(10,199	)	$	(62,380	)

5. Commitments and Contingencies

Contractual Commitments

The Company leases its offices under non-cancelable operating leases that expire at various dates through 2005. Rental expense under operating lease agreements for the three and nine months ended September 30, 2003 was $667,000 and $1.9 million, respectively, and for the three and nine months ended September 30, 2002 was $1.3 million and $3.9 million, respectively.

During the second quarter of 2003, the Company entered into a purchase commitment for inventory of approximately $2.0 million, to be delivered in late 2003, from a contract manufacturer in China. To secure this purchase commitment, the Company issued a letter of credit in the amount of $2.0 million to the contract manufacturer. The Company pledged $2.0 million, included in restricted cash, as collateral for this letter of credit. The Company expects this inventory to be delivered in the fourth quarter of 2003 and that this purchase commitment will be paid.

The Company has pledged $4.2 million as collateral for bank letters of credit issued to landlords for deposits against lease commitments. The pledged cash is recorded as restricted cash and may be reduced annually after lease commitment payments are made.

The Company’s contractual commitments at September 30, 2003 are as follows (in thousands):


		Remainder of
		2003		2004		2005		Total

Restructuring-related commitments:
	Operating leases	$	248	$	1,000	$	8	$	1,256
	Early lease termination fees		285		1,141		—		1,426

Restructuring-related commitments			533		2,141		8		2,682
Other commitments:
	Inventory purchases		2,000		—		—		2,000
	Operating leases		429		1,668		—		2,097

Total commitments		$	2,962	$	3,809	$	8	$	6,779

Legal Proceedings

In summer and early fall 2001, four purported shareholder class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its current and former officers and directors (the “Individual Defendants”), and the underwriters of its initial public offering. The suits purport to be class actions filed on behalf of purchasers of the Company’s common stock during the period from October 19, 1999 to December 6, 2000. The complaints against the Company have been consolidated into a single action and a Consolidated Amended Complaint, which was filed on April 19, 2002 and is now the operative complaint.

Plaintiffs allege that the underwriter defendants agreed to allocate stock in our initial public offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the prospectus for the Company’s initial public offering was false and misleading in violation of the securities laws because it did not disclose these arrangements. The action seeks damages in an unspecified amount.

The action is being coordinated with approximately 300 other nearly identical actions filed against other companies. On July 15, 2002, the Company moved to dismiss all claims against it and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based upon Stipulations of Dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against the Company. The Company has approved a Memorandum of Understanding (“MOU”) and related agreements which set forth the terms of a settlement between the Company and the plaintiff class. It is anticipated that any potential financial obligation of the Company to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, the Company does not expect that the settlement will involve any payment by the Company. The MOU and related agreements are subject to a number of contingencies, including the approval of the MOU by a sufficient number of the other approximately 300 companies who are part of the consolidated case against the Company, the negotiation of a settlement agreement, and approval by the Court. We cannot offer an opinion as to whether or when a settlement will occur or be finalized and are unable at this time to determine whether the outcome of the litigation will have a material impact on our results of operations or financial condition in any future period.

6. Segment Information

The Company follows the requirements of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. As defined in SFAS No. 131, the Company operates in two reportable segments: service and products. The service segment includes revenue earned for design and development of integration tools for semiconductor vendors, original equipment manufacturers, original design manufacturers, and network administrators. The product segment includes revenue earned from licensing of software products to original equipment manufacturers, distributing products through resellers, and distribution of third-party products. The Company has not tracked assets or operating expenses by operating segments. Consequently, it is not practicable to show assets or operating expenses by operating segments.

7. Related Party Transactions

During the second quarter of 2003, the Company hired Bibeault & Associates as turnaround consultants. Under this consulting arrangement, the Company incurred approximately $355,000 of consulting fees. In July 2003, the Company named Donald Bibeault, the President of Bibeault & Associates, as Chairman of the Board of Directors and entered into a new six-month consulting agreement. Under the new agreement, Mr. Bibeault provides the Company 10 days per month of onsite consulting services. For the three months ended September 30, 2003, the Company incurred expenses of approximately $46,000 under the new agreement.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

From time to time, information provided by us, statements made by our employees or information included in our filings with the Securities and Exchange Commission may contain statements that are “forward-looking statements” involving risks and uncertainties. In particular, statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” relating to our revenue, profitability, and sufficiency of capital to meet working capital and capital expenditure requirements may be forward-looking statements. The words “expect,” “anticipate,” “plan,” “believe,” “seek,” “estimate” and similar expressions are intended to identify such forward-looking statements. Such statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that could cause our future results to differ materially from those expressed in any forward-looking statements made by or on behalf of us. Many such factors are beyond our ability to control or predict. Readers are accordingly cautioned not to place undue reliance on forward-looking statements. We disclaim any intent or obligation to update any forward-looking statements, whether in response to new information or future events or otherwise. Important factors that may cause our actual results to differ from such forward-looking statements include, but are not limited to, the factors discussed elsewhere in this report in the section entitled “Factors That May Affect Future Results.”

Critical Accounting Judgments

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as those that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments and assumptions that are relevant to understanding our results. For additional information see Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business and Accounting Policies” contained in our annual report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission. Although we believe that our estimates, assumptions and judgments are reasonable, they are necessarily based upon presently available information. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

Revenue Recognition

We generally recognize revenue from product sales or services rendered when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured.

We recognize product revenue upon shipment provided that collection is determined to be probable and no significant obligations remain on our part. We also enter into multiple element arrangements in which a customer purchases a combination of software licenses, post-contract customer support (“PCS”), and/or professional services. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including how the price should be allocated among the deliverable elements if there are multiple deliverables, whether undelivered elements are essential to the functionality of delivered elements, and when to recognize revenue. PCS, or maintenance, includes rights to upgrades, when and if available, telephone support, updates, and enhancements. Professional services relate to consulting and development services and training. When vendor specific objective evidence (“VSOE”) of fair value exists for all elements in a multiple element arrangement, revenue is allocated to each element based on the relative fair value of each of the elements. VSOE of fair value is established by the price charged when the same element is sold separately. Generally, we determine VSOE of fair value of PCS based on the price charged when the same element is sold separately. In a multiple element arrangement whereby VSOE of fair value of all undelivered elements exists but VSOE of fair value does not exist for one or more delivered elements, revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue, assuming delivery has occurred and collectibility is probable. Revenue allocated to PCS is recognized ratably over the contract term, typically one to two years. Changes in the allocation of the sales price between deliverables might impact the timing of revenue recognition, but would not change the total revenue recognized on the contract.

Service revenue from fixed-priced consulting contracts is recognized using the percentage of completion method. Percentage of completion is measured monthly based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. Losses on fixed-priced contracts are recognized in the period when they become known.

We record OEM licensing revenue, primarily royalties, when OEM partners ship products incorporating our software, if collection of such revenue is deemed probable.

Deferred revenue includes deposits received from customers for service contracts and unamortized service contract revenue, customer advances under OEM licensing agreements and maintenance revenue. In cases where we will provide a specified free upgrade to an existing product, we defer revenue until the future obligation is fulfilled.

Estimated costs of future warranty claims and claims under indemnification provisions in certain licensing agreements are accrued based on historical experience.

We perform ongoing credit evaluations of our customers’ financial condition and generally do not require collateral. We maintain allowances for estimated credit losses.

Long-Lived Assets

We assess the impairment of our long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider, which could trigger an impairment review, include significant underperformance relative to expected historical or projected future operating results and a significant change in the manner of use of the assets or the strategy for our overall business. When we determine that the carrying value of certain long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we then measure any impairment based on a projected discounted cash flow method using a discount rate determined by us to be commensurate with the risk inherent in our current business model. This approach uses our estimates of future market growth, forecasted revenue and costs, expected periods the assets will be utilized and appropriate discount rates.

Accounting for Goodwill and Certain Other Intangibles

Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, which requires companies to discontinue amortizing goodwill and certain intangible assets with an indefinite useful life. SFAS No. 142 requires that goodwill and indefinite life intangible assets be reviewed for impairment annually, or more frequently if impairment indicators arise. Our policy provides that goodwill and indefinite life intangible assets will be reviewed for impairment on October 1st of each year. In calculating our impairment losses, we evaluated the fair value of the relevant reporting units by estimating the expected present value of their future cash flows.

Restructuring Estimates

Restructuring-related liabilities include estimates for, among other things, anticipated disposition costs of lease obligations. Key variables in determining such estimates include anticipated commencement timing of sublease rentals, estimates of sublease rental payment amounts and tenant improvement costs and estimates for brokerage and other related costs. We periodically evaluate and, if necessary, adjust our estimates based on currently available information.

Taxes

As part of the process of preparing our condensed consolidated financial statements, we are required to estimate income taxes in each of the countries in which we operate. This process involves estimating our current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have provided a full valuation allowance on deferred tax assets because of our uncertainty regarding their realizability based on our estimates.

We cannot predict what future laws and regulations might be adopted that could have a material effect on our results of operations. We assess the impact of significant changes in laws and regulations on a regular basis and update the assumptions and estimates used to prepare our financial statements when deemed necessary.

Results of Operations

The following table presents certain financial data as a percentage of total revenue for the three- and nine-month periods ended September 30, 2003 and 2002. Our historical operating results are not necessarily indicative of the results for any future periods.


					Three Months						Nine months
					Ended September 30,						Ended September 30,

					2003			2002			2003			2002

Revenue:
	Product					75	%		56	%		73	%		45	%
	Service					25			44			27			55

			Total revenue			100			100			100			100

Cost of revenue:
	Product					53			45			54			31
	Service					26			45			27			48

			Total cost of revenue			79			90			81			79

				Gross profit		21			10			19			21

Operating expenses:
		Research and development				22			36			28			45
		Selling, general and administrative				32			50			38			53
		Acquired in-process research and development (1)				—			—			—			6
		Amortization of intangible assets				2			1			2			4
		Impairment of goodwill and other intangible assets				—			65			2			23
		Restructuring and other related charges (credit)				4			99			(9	)		43

				Total operating expenses		60			251			61			174

				Loss from operations		(39	)		(241	)		(42	)		(153	)

Other income (expense), net:
		Investment income, net				1			3			2			4
		Other income (expense), net				6			(16	)		2			(12	)

	Loss before income taxes and cumulative effect of change in accounting principle					(32	)		(254	)		(38	)		(161	)
	Provision for income taxes					—			—			—			(8	)

	Loss before cumulative effect of change in accounting principle					(32	)		(254	)		(38	)		(169	)
	Cumulative effect of change in accounting principle					—			—			—			(53	)

				Net loss		(32	)%		(254	)%		(38	)%		(222	)%

(1) The consolidated statements of operations include a charge of $1.7 million (6% of total revenue) for the nine months ended September 30, 2002 for acquired in-process research and development costs associated with our purchase of Infogation Corporation in March 2002.

Revenue

Total revenue consists of product and service revenue. Product revenue consists primarily of third-party product distribution, and, to a lesser extent, software licensing fees and royalties from our software development tool products, debugging tools and applications, and smart device reference designs. Service revenue is derived from hardware and software development consulting, porting contracts, maintenance and support contracts, and customer training.

Total revenue was $9.4 million and $10.0 million in the three months ended September 30, 2003 and 2002, respectively, representing a decrease of 6%. Total revenue was $26.9 million and $28.2 million in the nine months ended September 30, 2003 and 2002, respectively, representing a decrease of 5%. These decreases were due primarily to reductions in the volume of services provided to Microsoft Corporation. Microsoft service revenue accounted for 2% and 16% of total revenue in the three months ended September 30, 2003 and 2002, respectively, and 2% and 20% of total revenue in the nine months ended September 30, 2003 and 2002, respectively. We do not expect that future service revenue from Microsoft will be a significant percentage of our total revenue because workplans under our Microsoft Master Agreement, which defines our service volume and fees, have significantly decreased. This decrease was partially offset by an increase in revenue from the sales of third-party software products.

Revenue from outside the United States was $1.6 million and $2.2 million in the three months ended September 30, 2003 and 2002, respectively, representing a 27% decrease. In the nine months ended September 30, 2003 and 2002, revenue from

outside the United States was $4.2 million and $6.2 million, respectively, representing a 32% decrease. This decrease in international revenue was due to a decrease in the number and size of software service projects with international porting partners, particularly in Japan. We expect international revenues will continue to represent a significant portion of revenue, although as a percentage of total revenue it may fluctuate from period to period.

Product revenue

Product revenue was $7.1 million and $5.6 million in the three months ended September 30, 2003 and 2002, respectively, representing an increase of 27%. In the nine months ended September 30, 2003 and 2002, product revenue was $19.6 million and $12.7 million, respectively, representing a 55% increase. As a percentage of total revenue, product revenue was 75% and 56% in the three months ended September 30, 2003 and 2002, respectively, and 73% and 45% in the nine months ended September 30, 2003 and 2002, respectively. These increases were primarily due to increased sales of third-party software products, and increased sales for our own SDIO Now! Product and, to a lesser extent, the recognition of previously deferred revenue upon the establishment of VSOE. As a percentage of product revenue, third-party product revenue was 84% and 85% for the three months ended September 30, 2003 and 2002, respectively, and was 89% and 78% for the nine months ended September 30, 2003 and 2002, respectively. We expect third-party software product sales to continue to be a significant percentage of our total product revenue.

Service revenue

Service revenue was $2.3 million and $4.4 million in the three months ended September 30, 2003 and 2002, respectively, representing a decrease of 48%. In the nine months ended September 30, 2003 and 2002, service revenue was $7.3 million and $15.6 million, respectively, representing a 53% decrease. The decrease was due primarily to reductions in Microsoft service projects.

Gross profit

Gross profit is revenue less the cost of revenue, which consists of cost of products and cost of services.

• Cost of products consists primarily of license fees and royalties for third-party software and the costs of product media, product duplication and manuals.

• Cost of services consists primarily of salaries and benefits for our software engineers, plus related facilities and depreciation costs.

Gross profit was $2.0 million, or 21% and $968,000, or 10%, in the three months ended September 30, 2003 and 2002, respectively, which was an increase of 103%. Gross profit was 21% and 10% of revenue in the three months ended September 30, 2003 and 2002, respectively. The gross profit improvement for the three months ended September 30, 2003 was due primarily to professional engineering services headcount reductions, reduced wages per employee and reduced excess services capacity as compared to the same period in 2002. Since September 30, 2002, net headcount has reduced 53% in our professional services group. In the nine months ended September 30, 2003 and 2002, gross profit was $5.0 million and $6.0 million, respectively, representing a decrease of 17%. Gross profit was 19% and 21% in the nine months ended September 30, 2003 and 2002, respectively. In addition to the professional services headcount reductions, the overall decrease in 2003 was also the result of a significant increase in third-party product revenue as a percentage of our total sales. The majority of this revenue was generated by the distribution of Microsoft product licenses, which generate lower gross profit percentages.

Operating Expenses

Research and development

Research and development expenses consist primarily of salaries and benefits for software developers, quality assurance personnel, program managers and related facilities and depreciation costs.

Research and development expenses were $2.2 million and $3.6 million in the three months ended September 30, 2003 and 2002, respectively, representing a decrease of 41%. As a percentage of total revenue, research and development expenses represented 22% and 36% in the three months ended September 30, 2003 and 2002, respectively. In the nine months ended September 30, 2003 and 2002, research and development expenses were $7.4 million and $12.8 million, respectively, representing a decrease of 42%. As a percentage of total revenue, research and development expenses represented 28% and 45% in the nine months ended September 30, 2003 and 2002, respectively. These decreases were primarily due to reductions

in our developer workforce and our more focused development initiatives. In addition, the development stage of our initial Power Handheld design is nearing completion.

Selling, general and administrative

Selling, general and administrative expenses consist primarily of salaries and benefits for our sales, marketing and administrative personnel and related facilities and depreciation costs.

Selling, general and administrative expenses were $3.0 million and $5.0 million in the three months ended September 30, 2003 and 2002, respectively, representing a decrease of 41%. Selling, general and administrative expenses represented 32% and 50% of total revenue in the three months ended September 30, 2003 and 2002, respectively. In the nine months ended September 30, 2003 and 2002, selling, general and administrative expenses were $10.3 million and $15.0 million, representing 38% and 53% of total revenue, respectively. These decreases were due primarily to restructuring steps that reduced our personnel and facilities during 2003 and 2002.

Impairment of goodwill

On March 13, 2002, we acquired Infogation Corporation (“Infogation”) in a purchase transaction valued at approximately $8.7 million. The purchase price was allocated to the fair value of the acquired assets and assumed liabilities based on their fair market values at the date of the acquisition. Due to weaker-than-expected demand for telematics products and services, we subsequently eliminated all our telematics personnel and no longer expect to actively pursue telematics work. As a result, we evaluated the carrying value of the goodwill and other intangible assets associated with the purchase of Infogation and recognized an impairment loss of $6.5 million in the third quarter of 2002.

In March 2003, $300,000 and 129,729 shares of common stock (together, the “Escrow Consideration”) previously held in an escrow account related to our purchase of Infogation were released to the former owners of Infogation (the “Sellers”). The escrow account was designated for a variety of uncertainties and potential claims related to representations and warranties of the Sellers. The Escrow Consideration related to the original purchase price of Infogation and upon its release date, was valued at $435,000 and considered a purchase price adjustment. Because of the 2002 decision to significantly reduce telematics personnel and no longer pursue such work, we evaluated this amount and recorded an impairment charge for the entire value.

Restructuring charges (credit)

During the third quarter of 2003, to further reduce expenses, we announced a company-wide reduction in workforce of 14 employees, approximately 8% of our remaining workforce. In connection with this headcount reduction, we paid approximately $175,000 in severance and other benefits in the third quarter of 2003. Also during the third quarter, we finalized negotiations for the termination of our San Diego, California facility lease, resulting in accelerated cash payments of approximately $300,000 made in July 2003. In addition, we agreed to enter into a new lease with the landlord, at a reduced rate, for approximately 2,600 square feet through January 2005.

During the second quarter of 2003, we announced a reduction in workforce of 16 employees, approximately 8% of our then remaining workforce. These reductions resulted from the curtailment of certain product offerings. In connection with this headcount reduction, we paid approximately $200,000 in severance and other benefits in the second quarter of 2003.

During the second quarter of 2003, we also negotiated the termination of our Sunnyvale, California facility lease. This lease termination resulted in accelerated cash payments of approximately $698,000 made during the second quarter of 2003 and the issuance of a warrant to purchase up to 400,000 shares of our common stock at a price of $1.14 per share. The warrant value was estimated at $332,000 using the Black-Scholes model with an expected dividend yield of 0.0%, a risk-free interest rate of 1.5%, volatility of 180% (estimated based on the two-year average volatility of our common stock price) and an expected life of five years.

During the first, third and fourth quarters of 2002, we initiated restructuring activities to reduce headcount and infrastructure, and to eliminate excess leased facilities. During 2002, the Company recorded $16.2 million in restructuring and other related charges.

The roll-forward of the restructuring liability follows (in thousands):


		Employee						Other
		Separation			Excess			Related
		Costs			Facilities			Charges			Total

Balance, December 31, 2002		$	1,254		$	9,836		$	—		$	11,090
	Restructuring charge recognized in the second quarter of 2003		200			286			274			760
	Restructuring charge recognized in the third quarter of 2003		175			—			184			359
	Change in estimates due to the effect of lease termination arrangements		—			(3,536	)		—			(3,536	)
	Warrant issued pursuant to lease termination agreement		—			(332	)		—			(332	)
	Cash payments pursuant to lease termination agreements		—			(998	)		—			(998	)
	Cash payments		(1,629	)		(2,574	)		(458	)		(4,661	)

Balance, September 30, 2003		$	—		$	2,682		$	—		$	2,682

Current portion											$	2,126
Long-term portion											$	556

Other Income (Expense), Net

Other income (expense), net, consists primarily of earnings on our cash, cash equivalents and short-term investments offset by adjustments made to the carrying value of cost-based investments. Other income (expense), net was $735,000 and $(1.3) million in the three months ended September 30, 2003 and 2002. In the nine months ended September 30, 2003 and 2002, other income (expense), net was $954,000 and $(2.2) million. In September 2003, we sold cost-based investments for a gain of $627,000. In the three- and nine-months ended September 30, 2002, we reduced the carrying value of cost-based investments by $1.6 million and $3.4 million, respectively, which were offset by lower interest income as a result of lower average cash, cash equivalent and short-term investment balances due to our use of cash for operations, acquisitions and restructuring.

Income Taxes

During the second quarter of 2003, we collected $2.8 million related to the refund of prior years’ income taxes paid resulting from our carry back of net operating losses applied to prior year tax returns. At September 30, 2003, we maintained a tax receivable of $155,000 for the remaining expected refund. In the nine months ended September 30, 2002, we recorded a tax provision of $2.1 million, primarily as a result of the increase in the valuation allowance against deferred tax assets due to the uncertainties of their recovery.

Cumulative effect of change in accounting principle

Effective January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires companies to discontinue amortizing goodwill and certain intangible assets with an indefinite useful life. SFAS No. 142 requires that goodwill and indefinite life intangible assets be reviewed for impairment upon adoption of the accounting standard and annually thereafter, or more frequently if impairment indicators arise. During the second quarter of 2002, we performed the first of the required impairment tests of goodwill and indefinite lived intangible assets and found instances of impairment in our recorded goodwill. Accordingly, during the third quarter of 2002, we completed our evaluation of goodwill and other intangible assets acquired in prior years. As a result, we retroactively recorded an impairment loss of $14.9 million as of January 1, 2002 as a cumulative effect of a change in accounting principle. Amounts presented for the nine months ended September 30, 2002 reflect the cumulative effect of change in accounting principle attributable to the adoption of SFAS 142, not previously reported in our Form 10-Q for that period.

Liquidity and Capital Resources

As of September 30, 2003, we had $22.9 million of cash, cash equivalents, restricted cash, and short-term investments, compared to $35.4 million at December 31, 2002. Specifically, we had $16.7 million of unrestricted cash and $6.2 million of restricted cash. Our working capital at September 30, 2003 was $16.3 million compared to $28.0 million at December 31, 2002.

During the nine months ended September 30, 2003, net cash used in operating activities was $13.8 million primarily due to our net loss of $10.3 million and the payment of obligations resulting from our restructuring activities, offset by receipts in the second quarter of $2.8 million from the refund of prior years’ income taxes and $1.5 million from the settlement of a legal dispute. During the nine months ended September 30, 2002, net cash used in operating activities was $27.2 million, primarily due to our net loss of $62.5 million, offset by the adjustment for the cumulative effect of change in accounting principle, depreciation and amortization and restructuring and other related charges.

Investing activities provided cash of $11.4 million and $4.0 million in the nine months ended September 30, 2003 and 2002, respectively. Investing activities in 2003 included $10.7 million provided by maturities of short-term investments and proceeds of $759,000 from the sale of an investment, and $116,000 used for capital equipment purchases. Investing activities in 2002 included $9.9 million provided by maturities of short-term investments, $1.9 million used for capital equipment purchases, and $3.9 million of net cash used in the acquisition of Infogation Corporation.

Financing activities generated $232,000 and $1.1 million in the nine months ended September 30, 2003 and 2002, respectively, as a result of employees’ exercises of stock options.

During the three and nine months ended September 30, 2003, we used approximately $2.1 million and $5.8 million of our cash on development efforts related to the Power Handheld.

We recently received our first customer commitments to purchase Power Handheld devices, and our belief is that orders for the device will increase in the fourth quarter and beyond. Manufacturing and distributing these devices is a new business for us, and the complete impact on our internal resources if this business expands is not yet clear. Although we outsource all of our manufacturing, we have to date, nevertheless, been required to use cash to finance such manufacturing through a variety of mechanisms, including letters of credit, and upfront payments. For example, during the second quarter of 2003, we entered into an inventory purchase commitment for our Power Handheld product of approximately $2.0 million, from a contract manufacturer in China. To secure this purchase commitment, we issued a letter of credit in the amount of $2.0 million to the contract manufacturer. We pledged $2.0 million, included in restricted cash, as collateral for this letter of credit. We expect this inventory to be delivered in the fourth quarter of 2003, and that this purchase commitment will be paid. To date, we have been able to finance our relatively small-scale manufacturing, inventory and distribution expenses with our cash, and we will continue to do so in the short term. However, depending on the market acceptance of the Power Handheld, the cash needed to fund these requirements could increase significantly. To the extent our internal cash reserves are not adequate to fund these increased expenses, we will consider alternative debt or equity financing sources to meet our working capital needs.

In the nine months ended September 30, 2003 we paid a total of $5.7 million for restructuring related costs. As of September, 30 2003, we had an accrued balance of $2.7 million in estimated remaining restructuring-related costs, consisting of $1.3 million for excess facilities primarily related to non-cancelable leases and $1.4 million for early lease termination commitments.

In addition to our $2 million purchase commitment for the Power Handheld, our other principal commitments consist of obligations outstanding under operating leases, which expire through 2005. In 2002 we agreed to certain early lease termination fees related to our corporate headquarters in Bellevue, Washington, of which $1.4 million, payable in quarterly installments through 2004, remains outstanding at September 30, 2003. We also have lease commitments for office space in Eden Prairie, Minnesota; San Diego, California; Tokyo, Japan; and Taipei, Taiwan. The current obligation under these leases total approximately $3.8 million, through the end of the lease terms.

As of September 30, 2003, we had $4.2 million pledged as collateral for bank letters of credit issued to landlords as deposits against our lease commitments. The pledged cash is recorded as restricted cash.

Contractual commitments at September 30, 2003 are as follows (in thousands):


		Remainder of
		2003		2004		2005		Total

Restructuring-related commitments:
	Operating leases	$	248	$	1,000	$	8	$	1,256
	Early lease termination fees		285		1,141		—		1,426

Restructuring-related commitments			533		2,141		8		2,682
Other commitments:
	Inventory purchases		2,000		—		—		2,000
	Operating leases		429		1,668		—		2,097

Total commitments		$	2,962	$	3,809	$	8	$	6,779

Our revenue decreased 7% in the nine months ended September 30, 2003 as compared to the previous nine months and 39% in 2002 as compared to 2001. If our revenue declines at historic rates or faster than we reduce our costs, we will continue to experience losses and will be required to use our existing cash faster than planned to fund our operations. If we experience increased orders for the Power Handheld, the Company’s working capital requirements would increase in the short term and we have initiated steps to seek additional debt or equity financing sources to meet such needs, should that occur. If we do not experience increased orders or are unable to raise such additional debt or equity financing, we will be required to either curtail or significantly reduce any continuing product development efforts or seek other alternatives. We believe that if we are successful in our efforts to address the Power Handheld’s increased working capital needs, our existing cash, cash equivalents and short-term investments will be sufficient to meet our remaining needs for working capital and capital expenditures for the next 12 months. See “Factors That May Affect Future Results.” There can be no assurance that additional debt or equity financing will be available on acceptable terms, if at all.

FACTORS THAT MAY AFFECT FUTURE RESULTS

The following risk factors and other information included in this Quarterly Report should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected.

Our revenue may continue to decline or we may not be able to return to profitability in accordance with our plans.

Our revenue decreased 7% during the nine months ended September 30, 2003 compared to the last nine months of 2002, 39% from 2001 to 2002, and 3% from 2000 to 2001. The decline in our revenue may continue in the future. In addition, the continuing slowness in the U.S. economy has added economic and consumer uncertainty that has adversely affected our revenue and could continue to do so. We expect that our expenses will continue to be substantial in the foreseeable future as we continue to develop our technology and refocus our product and service offerings. These efforts may prove more expensive than we currently expect, and we may not succeed in increasing our revenue sufficiently to offset our expenses.

If we fail to develop, manufacture and sell products successfully and in a timely manner, including those based on our Power Handheld reference design, we will not be able to compete effectively and our ability to generate revenue will suffer.

The market for Windows-based embedded products and services is competitive, new and evolving. As a result, the life cycles of our products are difficult to estimate. To be successful, we must continue to enhance our current product line and develop new products that are appealing to our customers with acceptable features, prices and terms. We have experienced delays in enhancements and new product release dates in the past and may be unable to introduce enhancements or new products successfully or in a timely manner in the future. Our business may be harmed if we must delay releases of our products and product enhancements or if we fail to accurately anticipate our customers’ needs or technical trends and are unable to introduce new products into the market successfully. In addition, our customers may defer or forego purchases of our products if we, Microsoft, our competitors or major hardware, systems or software vendors introduce or announce new products or product enhancements. Such deferrals or failures to purchase would decrease our revenue and our ability to generate product revenue will suffer.

We are devoting a substantial portion of our resources on devices based on our Power Handheld reference design. The device market is new to us and is subject to many uncertainties. If this initiative is not successful, our revenue and earnings will suffer.

In connection with the cost reduction efforts described elsewhere in this report, we were forced to make certain product development decisions based on limited information regarding the future demand for those products. There can be no assurance that we decided to pursue the right product offerings to take advantage of future market opportunities. Specifically, we have made the strategic decision to devote a substantial portion of both our research and development resources and our working capital towards the development, manufacture and marketing of devices based on our Power Handheld reference design. We have limited experience in producing, marketing or distributing such devices, and there can be no assurance that these devices, or the underlying technology, will achieve market acceptance or that they will ultimately prove to be profitable in light of the many uncertainties inherent in introducing a new product or technology to market. These uncertainties include the intense competition found in the market generally for handheld computing devices, the various manufacturing and distribution risks involved in producing and marketing a new electronic product, the length of the sales cycle and the variation in customer ordering patterns. In the event that these product development initiatives do not meet our expectations, our revenue and earnings are likely to suffer and we would continue to be dependent on our other sources of revenue, including the relatively low margin revenue generated from our distribution agreements with Microsoft.

Manufacturing and distributing Power Handheld devices will require substantial working capital. If our internal resources are inadequate, we may be forced to seek other funding sources.

continue to do so in the short term. Depending on the market acceptance of the Power Handheld, the resources required to fund these requirements could increase significantly. We expect that as we begin manufacturing and distributing the Power Handheld, that will create additional new working capital requirements as we must pay in advance for the manufacturing and inventory costs while waiting, in accordance with contractual terms, for payments from our customers. To the extent our internal cash reserves are not adequate to fund these increased expenses, we will likely need to consider alternative debt or equity financing sources and we have initiated steps to seek additional debt or equity financing sources. We cannot assure you that financing for our working capital requirements, if needed, will be available to us on favorable terms or at all. If other financing sources are not available on acceptable terms, our ability to continue to manufacture and distribute our Power Handheld devices would be negatively impacted, with a corresponding effect on our revenues and results of operations. In addition, any future equity financings would be dilutive to the existing holders of our common stock. Future debt financings could involve restrictive covenants, which could impair our ability to engage in certain business transactions. It is also possible that we may be required to make organizational changes to facilitate any such debt or equity financing.

If we do not maintain a good relationship with Microsoft, our revenue could decrease and our business would be adversely affected.

For the three months ended September 30, 2003 and 2002, approximately 2% and 16% of our revenue, respectively, was generated under our Master Agreement with Microsoft. We expect that service revenue from Microsoft will continue to not be as significant as our historical experience because work plans under our Master Agreement have significantly decreased. Separately, we also have entered into distribution agreements with Microsoft, which enable us to distribute certain Microsoft licenses to our customers and generate product revenue. For the three months ended September 30, 2003 and 2002, approximately 63% and 47% of total revenue, respectively, was generated under those distribution agreements. If our distribution agreements with Microsoft are terminated, our product revenues would decrease significantly. Moreover, if our distribution agreements with Microsoft are renewed on less favorable terms, our revenue could decrease, and our gross margins from these transactions, which are already low, would further decline. Microsoft is a publicly traded company that files financial reports and information with the Securities and Exchange Commission. These reports are publicly available under Microsoft’s Exchange Act filing number 000-14278.

Our products and services, including those based on our Power Handheld reference design, could infringe the intellectual property rights of third parties, which could expose us to additional costs and litigation and could adversely affect our ability to sell our products or cause shipment delays or stoppages.

It is difficult to determine whether our products and services infringe third-party intellectual property rights, particularly in a rapidly evolving technological environment in which technologies often overlap and where there may be numerous patent applications pending, many of which are confidential when filed, with regard to similar technologies. If we were to discover that a device based on one of our reference designs, or one of our other products, violated a third party’s proprietary rights, we may not be able to obtain a license on commercially reasonable terms, or at all, to continue offering that product. Similarly, third parties may claim that our current or future products and services, infringe their proprietary rights, regardless of merit. Any such claims could increase our costs and harm our business. In certain cases, we have been unable to obtain indemnification against potential claims that the technology we license from third parties infringes the proprietary rights of others. Moreover, any indemnification we do obtain may be limited in scope or amount. Even if we receive broad third-party indemnification, these indemnitors may not have the financial capability to indemnify us in the event of infringement. In addition, in some circumstances we could be required to indemnify our customers for claims made against them that are based on our solutions.

There can be no assurance that infringement or invalidity claims related to the products and services we provide or arising from the incorporation by us of third-party technology, and claims for indemnification from our customers resulting from such claims, will not be asserted or prosecuted against us. Some of our competitors with respect to the products we develop have, or are affiliated with, companies having substantially greater resources than ours and these competitors may be able to sustain the costs of complex intellectual property litigation to a greater degree and for longer periods of time than we could. In addition, we expect that software product developers will be increasingly subject to infringement claims, as the number of products and competitors in the software industry grows and the functionality of products in different industry segments overlaps. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays. Furthermore, if we were unsuccessful in resolving a patent or other intellectual property infringement action claim against us, we may be prohibited from developing or commercializing certain of our technologies and products unless we obtain a license from the holder of the patent or other intellectual property rights. There can be no assurance that we would be able to obtain any such license on commercially favorable terms, or at all. If such license is not obtained, we would be required to cease these related business operations, which could have a material adverse effect on our business, financial conditions and results of operations.

Unexpected fluctuations in our operating results could cause our stock price to decline significantly.

Our operating results have fluctuated in the past, and we expect that they will continue to do so. We believe that period-to-period comparisons of our operating results are not meaningful, and you should not rely on such comparisons to predict our future performance. If our operating results fall below the expectations of stock analysts and investors, the price of our common stock may fall. Factors that have in the past and may continue in the future to cause our operating results to fluctuate include:

l Managing operations and risks, including:

• the failure of the smart device market to develop;

• our inability to develop, have manufactured, market and sell new and enhanced products and services on a timely basis;

• excess inventory or insufficient inventory to meet demand;

• changes in the mix of our services and product revenue, which have different gross margins;

• changes in demand for our products and services, including the early termination of customer contracts;

• increased competition and changes in our pricing as a result of increased competitive pressure;

• underestimates by us of the costs to be incurred in fixed-fee service projects;

• varying customer buying patterns, which are often influenced by year-end budgetary pressures;

• our ability to increase our revenue to a level that exceeds our costs and expenses; and

• our ability to control our expenses, a large portion of which are relatively fixed and which are budgeted based on anticipated revenue trends;

l Uncertainties associated with retaining business with Microsoft and other key third-party partners, including:

• adverse changes in our relationship with Microsoft, from which a substantial portion of our revenue was generated and on which we rely to continue to develop and promote Windows Embedded operating systems and Windows Mobile targeted platforms such as Windows Mobile for Smartphone and Windows Mobile for PocketPC;

• the failure or perceived failure of Windows Embedded operating systems and Windows Mobile targeted platforms upon which demand for the majority of our current products and services is dependent, to achieve or maintain widespread market acceptance; and

• unanticipated delays, or announcement of delays, by Microsoft of Windows product releases, which could cause us to delay our product introductions or delay commencement of service contracts and adversely affect our customer relationships.

In addition, our stock price may fluctuate due to conditions unrelated to our operating performance, including general economic conditions in the software industry and the market for technology stocks.

If we do not maintain our favorable relationship with Microsoft, we will have difficulty marketing our software products and services and may not receive developer releases of Windows Embedded operating systems and Windows Mobile targeted platforms and our revenue and operating margins will suffer.

We maintain a strategic marketing relationship with Microsoft. In the event that our relationship with Microsoft were to deteriorate, our efforts to market and sell our software products and services to original equipment manufacturers and network operators could be adversely affected and our business would be harmed. Microsoft has great influence over the development plans and buying decisions of original equipment manufacturers utilizing Windows Embedded operating systems and Windows Mobile targeted platforms for smart devices. Microsoft provides referrals of some of our original equipment manufacturer customers to us. Moreover, Microsoft controls the marketing campaigns related to its operating systems, including Windows CE

and XPe. Microsoft’s marketing activities, including trade shows, direct mail campaigns and print advertising, are important to the continued promotion and market acceptance of Windows Embedded operating systems and Windows Mobile targeted platforms, and consequently, of our Windows-based software products and services. We must maintain a successful relationship with Microsoft so that we may continue to participate in joint marketing activities with Microsoft, including participating in “partner pavilions” at trade shows and listing our services on Microsoft’s website, and to receive referrals from Microsoft. In the event that we are unable to continue our joint marketing efforts with Microsoft or fail to receive referrals from Microsoft, we would be required to devote significant additional resources and incur additional expenses to market our software products and services directly to potential customers. In addition, we depend on receiving from Microsoft developer releases of new versions of and upgrades to Windows CE and related Microsoft software in order to timely develop and ship our products and provide services. If we are unable to receive these developer releases, our revenue and profit margins would suffer.

If we are unable to license key software from third parties our business could be harmed.

We often integrate third-party software with our internally developed software or hardware to provide products and services for our customers. If our relationships with our third-party vendors were to deteriorate, we might be unable to obtain licenses on commercially reasonable terms, if at all, for newer versions of their software required to maintain compatibility. In the event that we are unable to obtain additional licenses, we would be required to develop this technology internally, which could delay or limit our ability to introduce enhancements or new products or to continue to sell existing products.

Our software or hardware products or the third-party hardware or software integrated with our products and services may suffer from defects or errors that could impair our ability to sell our products and services.

Software and hardware components as complex as those needed for smart devices frequently contain errors or defects, especially when first introduced or when new versions are released. We have had to delay commercial release of certain versions of our products until problems were corrected, and in some cases have provided product enhancements to correct errors in released products. Some of our contracts require us to repair or replace products that fail to work. To the extent that we repair or replace products our expenses may increase, resulting in a decline in our gross margins. In addition, it is possible that by the time defects are fixed the market opportunity may have been missed which may result in lost revenue. Moreover, to the extent that we provide increasingly comprehensive products and rely on third-party manufacturers to manufacture our and our customers’ products, including those related to our Power Handheld based devices that we distribute, we will be dependent on the ability of third-party manufacturers to correct, identify and prevent manufacturing errors. Errors that are discovered after commercial release could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation or increased service and warranty costs, all of which could harm our business.

We rely on third parties to manufacture our products, including our Power Handheld based devices, and our reputation and revenues could be adversely affected if these third parties fail to meet their performance obligations.

We outsource all of our manufacturing requirements (primarily our Power Handheld devices) to third party manufacturers. We depend on them to produce a sufficient volume of our products in a timely fashion and at satisfactory quality levels. If our third party manufacturers fail to produce quality products on time and in sufficient quantities, our reputation and results of operations could suffer. In addition, we rely on our third party manufacturers to place orders with suppliers for the components they need to manufacture our products. If they fail to place timely and sufficient orders with suppliers, our revenues could suffer.

Our Power Handheld devices are currently manufactured by our third party manufacturers at their international facilities, which are primarily located in China. The cost, quality and availability of third party manufacturing operations are essential to the successful production and sale of our handheld devices. Our reliance on third party manufacturers exposes us to risks, which are not in our control and our revenues or cost of revenues could be negatively impacted. For example, another outbreak of Severe Acute Respiratory Syndrome (SARS) in China could result in quarantines or closures of our third party manufacturers or their suppliers. In the event of such a quarantine or closure, our ability to deliver product on a timely basis could be impaired and, as a result, our revenues, expenses and results of operations could be negatively impacted.

We do not have manufacturing agreements with all of the third party manufacturers upon which we rely to manufacture our device products. The absence of a manufacturing agreement means that, with little or no notice, these manufacturers could refuse to continue to manufacture all or some of the units of our devices that we require or change the terms under which they manufacture our device products. If these manufacturers were to stop manufacturing our devices, we may be unable to replace the lost manufacturing capacity on a timely basis and our results of operations could be harmed. In addition, if these manufacturers were to change the terms under which they manufacture for us, our manufacturing costs could increase and our cost of revenues could increase.

If Microsoft adds features to its Windows operating system or develops products that directly compete with products and services we provide, our revenue could be reduced and our profit margins could suffer.

As the developer of Windows, Windows XP Embedded, Windows CE, Windows Mobile for Smartphone and Windows Mobile for PocketPC, Microsoft could add features to its operating systems or could develop products that directly compete with the products and services we provide to our customers. Such features could include, for example, driver development tools, faxing, hardware-support packages and quality-assurance tools. The ability of our customers or potential customers to obtain products and services directly from Microsoft that compete with our products and services could harm our business. Even if the standard features of future Microsoft operating system software were more limited than our offerings, a significant number of our customers and potential customers might elect to accept more limited functionality in lieu of purchasing additional software. Moreover, the resulting competitive pressures could lead to price reductions for our products and reduce our profit margins.

If the market for Windows Embedded operating systems and Windows Mobile targeted platforms fails to develop further, develops more slowly than we expect, or declines, our business and operating results will be materially harmed.

Because a significant portion of our revenue to date has been generated by software products and services dependent on the Windows Embedded operating systems and Windows Mobile targeted platforms, if the market fails to develop further or develops more slowly than we expect, or declines, our business and operating results will be significantly harmed. Market acceptance of Windows Embedded and Windows Mobile will depend on many factors, including:

• Microsoft’s development and support of the Windows Embedded and Windows Mobile market. As the developer and primary promoter of Windows CE, XP Embedded, Windows Mobile for Smartphone and Windows Mobile for PocketPC, if Microsoft were to decide to discontinue or lessen its support of these operating systems and platforms, potential customers could select competing operating systems, which would reduce the demand for our Windows Embedded and Windows Mobile software products and services;

• the ability of the Windows Embedded operating systems to compete against existing and emerging operating systems for the smart device market including: VxWorks and pSOS from WindRiver Systems Inc., VRTX from Mentor Graphics Corporation, JavaOS from Sun Microsystems, Inc., Linux, Symbian and proprietary operating systems. In particular, in the market for palm-size devices, Windows Embedded operating systems and Windows Mobile targeted platforms face intense competition from Palm Incorporated, Research In Motion and Linux based devices. In the market for cellular phones, Windows Embedded operating systems and Windows Mobile for Smartphone face competition from the EPOC operating system from Symbian, a joint venture among several of the largest manufacturers of cellular phones. Windows Embedded operating systems and Windows Mobile for Smartphone may be unsuccessful in capturing a significant share of these two segments of the smart device market, or in maintaining its market share in those other segments of the smart device market on which our business currently focuses, including the markets for Internet-enabled television set-top boxes, handheld industrial devices, consumer Internet appliances such as kiosk terminals and vehicle navigational devices, and Windows-based terminals;

• the acceptance by original equipment manufacturers and consumers of the mix of features and functions offered by Windows embedded operating systems and Windows Mobile targeted platforms; and

• the willingness of software developers to continue to develop and expand the applications that run on Windows Embedded operating systems and Windows Mobile targeted platforms. To the extent that software developers write applications for competing operating systems that are more attractive to smart device end users than those available on Windows Embedded operating systems and Windows Mobile targeted platforms, potential purchasers could select competing operating systems over Windows Embedded operating systems and Windows Mobile targeted platforms.

Unexpected delays, or announcement of delays, by Microsoft of Windows Embedded operating systems and Windows Mobile targeted platforms product releases could adversely affect our sales.

Unexpected delays, or announcement of delays, in Microsoft’s delivery schedule for new versions of its Windows Embedded operating systems could cause us to delay our product introductions and impede our ability to complete customer projects on a timely basis. These delays or announcements by Microsoft of delays could also cause our customers to delay or cancel their project development activities or product introductions. Any resulting delays in, or cancellations of, our planned product introductions or in our ability to commence or complete customer projects may adversely affect our revenue and operating results.

Our senior management has experienced significant turnover and change of job function, which could disrupt our business and operations.

Since June 2003, there have been numerous changes in our senior management team. On June 17, 2003, we announced the departures of James R. Ladd, Senior Vice President of Finance & Operations and Chief Financial Officer, and Kent A. Hellebust, Senior Vice President of Marketing & Product Management. On that same date, we announced that Nogi Asp was promoted from Director of Finance to Vice President of Finance and Chief Financial Officer. On July 24, 2003, we announced that one of our founders, William T. Baxter, was stepping down as Chairman of the Board and Chief Executive Officer. Mr. Baxter remains on our Board of Directors and is currently our Chief Technology Officer. Also on July 24, 2003 we also announced that Brian T. Crowley, our then Vice President of Product Development, was appointed by our Board of Directors to succeed Mr. Baxter as Chief Executive Officer and to serve on our Board, that Donald D. Bibeault was elected to the position of Chairman of the Board, and that Jeffrey T. Chambers had resigned from our Board of Directors.

Because of these recent management departures, additions and changes in roles, our current management team has not worked together in their current positions for a significant length of time and may not be able to work together effectively in these new positions to successfully develop and implement business strategies. In addition, as a result of these management changes, management may need to devote significant attention and resources to preserve and strengthen relationships with employees and customers. Mr. Crowley and Mr. Asp, in particular, will need to successfully meet the increased internal and external challenges and responsibilities of their new positions. All members of our management team will need to overcome the challenges created by any vacancies in our senior management positions that remain unfilled. If our new management team is unable to develop successful business strategies, achieve our business objectives or maintain effective relationships with employees and customers, our ability to grow our business and successfully meet operational challenges could be impaired.

Erosion of the financial condition of our customers could adversely affect our business.

Our business could be adversely affected in the event that the financial condition of our customers erodes because such erosion could cause these customers to reduce their demand for our products and services or even terminate their relationship with us, and also could result in these customers being greater credit risks. As the global information technology market weakens, the likelihood of the erosion of the financial condition of our customers increases, which could adversely affect the demand for our products and services. Moreover, our distribution of Microsoft licenses is a relatively low-margin business, and we could face increased credit risk with the accounts receivable from certain customers. While we believe that our allowance for doubtful accounts is adequate, those allowances may not cover actual losses, which could adversely affect our business.

Our efforts to reduce expenses, including reductions in work force, may not achieve the results we intend and may harm our business.

During 2002 and 2003, we initiated a number of measures to streamline operations and reduce expenses, including cuts in discretionary spending, reductions in capital expenditures, reductions in our work force and consolidation of certain office locations, as well as other steps to reduce expenses. In connection with our cost reduction efforts, we were required to make certain product and product development decisions with limited information regarding the future demand for those products. There can be no assurance that we decided to pursue the correct product offerings to take advantage of future market opportunities. Furthermore, the implementation of such measures has placed, and may continue to place, a significant strain on our managerial, operational, financial, employee and other resources. Additionally, the restructuring may negatively affect our recruiting and retention of important employees. It is possible that these reductions could impair our marketing, sales and customer support efforts or alter our product development plans. If we experience difficulties in carrying out such measures, our expenses could decrease more slowly than we expect. If we find that our planned reductions do not achieve our objectives, it may be necessary to make additional reductions in our expenses and our work force, or to undertake additional measures.

If the market for smart devices fails to develop further or develops more slowly than we expect, or declines, our revenue will not develop as anticipated, if at all.

The market for smart devices is emerging and the potential size of this market and the timing of its development are not known. As a result, our profit potential is uncertain and our revenue may not develop as anticipated, if at all. We are dependent upon the broad acceptance by businesses and consumers of a wide variety of Windows-based smart devices, which will depend on many factors, including:

• the development of content and applications for smart devices;

• the willingness of large numbers of businesses and consumers to use devices such as smartphones, personal digital assistants and handheld industrial data collectors to perform functions currently carried out manually or by traditional PCs, including inputting and sharing data, communicating among users and connecting to the Internet; and

• the evolution of industry standards or the necessary infrastructure that facilitate the distribution of content over the Internet to these devices via wired and wireless telecommunications systems, satellite or cable.

Our market is extremely competitive, which may result in price reductions, lower gross margins and loss of market share.

The market for Windows-based software products and services is extremely competitive, as is the market for our Power Handheld based devices. In addition, competition is intense for the business of the limited number of original equipment manufacturer customers that are capable of building and shipping large quantities of smart devices. Moreover, in certain cases, foreign competitors are able to offer professional engineering services to our customers at prices that are below our costs. Increased competition may result in price reductions, lower gross margins and loss of market share, which would harm our business. We face competition from:

• our current and potential customers’ internal research and development departments that may seek to develop their own proprietary solutions;

• professional engineering services firms, domestic and foreign;

• established smart device hardware, software and tools manufacturers and vendors; and

• software and component distributors.

As we develop new products, particularly products focused on specific industries, we may begin competing with companies with which we have not previously competed. It is also possible that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft, that may enable them to rapidly increase their market share. Microsoft has not agreed to any exclusive arrangement with us nor has it agreed not to compete with us. In fact, we believe that Microsoft has decided to bring more of the core development services and expertise that we provide in-house to Microsoft resulting in reduced opportunities for service revenue for us. The barrier to entering the market as a provider or distributor of Windows-based smart device software and services is low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows Embedded. These systems integrators are given substantially the same access by Microsoft to the Windows technology as we are. New competitors may have lower overhead than us and may therefore be able to offer advantageous pricing. We expect that competition will increase as other established and emerging companies enter the Windows-based smart device market and as new products and technologies are introduced.

If we fail to adequately protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position, reduce our revenue and increase our costs.

If we fail to adequately protect our intellectual property, our competitive position could be weakened and our revenue adversely affected. We rely primarily on a combination of patent, copyright, trade secret and trademark laws, confidentiality procedures and contractual provisions to protect our intellectual property. These laws and procedures provide only limited protection. We have applied for a number of patents relating to our engineering work. These patents, if issued, may not provide sufficiently broad protection or they may not prove to be enforceable against alleged infringers. There can be no assurance that any of our pending patents will be granted. Even if granted, these patents may be circumvented or challenged and, if challenged, may be invalidated. Any patents obtained may provide limited or no competitive advantage to us. It is also possible that another party could obtain patents that block our use of some, or all, of our products and services. If that occurred, we would need to obtain a license from the patent holder or design around their patent. The patent holder may or may not choose to make a license available to us at all or on acceptable terms. Similarly, it may not be possible to design around such a blocking patent.

In general, there can be no assurance that our efforts to protect our intellectual property rights through patent, copyright, trade secret and trademark laws will be effective to prevent misappropriation of our technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by us. We frequently license the source code of our products and the source code results of our services to customers. There can be no assurance that customers with access to our source code will comply with the license terms or that we will discover any violations of the license terms or, in the event of discovery of violations that we will be able to successfully enforce the license terms and/or recover the economic value lost from such violations. To license many of our software products, we rely in part on “shrinkwrap” and

“clickwrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. As with other software products, our products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult.

A significant portion of our marks include the word “BSQUARE” or the preface “b.” Other companies use forms of “BSQUARE” or the preface “b” in their marks alone or in combination with other words, and we cannot prevent all such third-party uses. We license certain trademark rights to third parties. Such licensees may not abide by our compliance and quality control guidelines with respect to such trademark rights and may take actions that would harm our business.

The computer software market is characterized by frequent and substantial intellectual property litigation, which is often complex and expensive, and involves a significant diversion of resources and uncertainty of outcome. Litigation may be necessary in the future to enforce our intellectual property or to defend against a claim of infringement or invalidity. Litigation could result in substantial costs and the diversion of resources and could harm our business and operating results.

Our international operations expose us to greater intellectual property, management, collections, regulatory and other risks.

Foreign customers generated approximately 17% and 22% of our total revenue in the three months ended September 30, 2003 and 2002, respectively, and 16% and 22% for the nine months ended September 30, 2003, respectively. Our international operations expose us to a number of risks, including the following:

• greater difficulty in protecting intellectual property due to less stringent foreign intellectual property laws and enforcement policies;

• greater difficulty in managing foreign operations due to the lack of proximity between our home office and our foreign operations;

• longer collection cycles than we typically experience in the U.S.;

• unfavorable changes in regulatory practices and tariffs;

• adverse changes in tax laws;

• greater difficulty in managing foreign third-party manufacturing;

• the impact of fluctuating exchange rates between the U.S. dollar and foreign currencies; and

• general economic and political conditions in Asian and European markets, as a result of such events as the spread of the SARS illness and otherwise, which may differ from those in the U.S.

These risks could have a material adverse effect on the financial and managerial resources required to operate our foreign offices, as well as on our future international revenue, which could harm our business.

As we increase the amount of product and service development we are doing in non-US locations, potential delays and quality issues may impact our ability to deliver our products and services on time, potentially impacting our revenue.

During 2003, we initiated a program to move certain development activities to non-US locations, primarily India, in order to take advantage of the high-quality, low-cost software development resources found in some developing countries. To date we have limited experience in managing software development done in non-US locations. Moving portions of our development contracts to these locations inherently increases the complexity of managing these programs, and may result in delays in introducing new products to market, or delays in completing service projects for our customers, which in turn may impact the amount of revenue we are able to recognize for those products and services.

Past acquisitions have proven difficult to integrate, and future acquisitions, if any, could disrupt our business, dilute shareholder value and adversely affect our operating results.

We have acquired the technologies and/or operations of other companies in the past and may acquire or make investments in complementary companies, services and technologies in the future. If we fail to properly evaluate, integrate and execute acquisitions and investments, including these recent acquisitions, our business and prospects may be seriously harmed. In

some cases, we have been required to implement reductions in force and office closures in connections with an acquired business, which has resulted in significant costs to us. To successfully complete an acquisition, we must properly evaluate the technology, accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses, integrate and retain personnel, combine potentially different corporate cultures and effectively integrate products and research and development, sales, marketing and support operations. If we fail to do any of these, we may suffer losses and impair relationships with our employees, customers and strategic partners, and our management may be distracted from our day-to-day operations. We also may be unable to maintain uniform standards, controls, procedures and policies, and significant demands may be placed on our management and our operations, information services and financial, legal and marketing resources. Finally, acquired businesses sometimes result in unexpected liabilities and contingencies, which could be significant. In addition, acquisitions using debt or equity securities dilute the ownership of existing shareholders, which could affect the market price of our stock.

We may be subject to product liability claims that could result in significant costs.

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. It is possible, however, that these provisions may be ineffective under the laws of certain jurisdictions. Although we have not experienced any product liability claims to date, the sale and support of our products and services entail the risk of such claims and we may be subject to such claims in the future. In addition, to the extent we develop and sell increasingly comprehensive, customized turnkey solutions for our customers, including those based on our Power Handheld reference designs, we may be increasingly subject to risks of product liability claims. There is a risk that any such claims or liabilities may exceed or fall outside the scope of our insurance coverage, and we may be unable to retain adequate liability insurance in the future. A product liability claim brought against us, whether successful or not, could harm our business and operating results.

The lengthy sales cycle of our products and services makes our revenue susceptible to fluctuations.

Our sales cycle is typically three to nine months because the expense and complexity of our products and services generally require a lengthy customer approval process, and may be subject to a number of significant risks over which we have little or no control, including:

• customers’ budgetary constraints and internal acceptance review procedures;

• the timing of budget cycles; and

• the timing of customers’ competitive evaluation processes.

In addition, to successfully sell our products and services, we frequently must educate our potential customers about the full benefits of our products and services, which can require significant time. If our sales cycle lengthens unexpectedly, it could adversely affect the timing of our revenue, which could cause our quarterly results to fluctuate.

The volatility of the stock markets could adversely affect our stock price.

Stock markets are subject to significant price and volume fluctuations which may be unrelated to the operating performance of particular companies, and the market price of our common stock may therefore frequently change. The market price of our common stock could also fluctuate substantially due to a variety of other factors, including quarterly fluctuations in our results of operations, our ability to meet analysts’ expectations, adverse circumstances affecting the introduction and market acceptance of new products and services offered by us, announcements of new products and services by competitors, changes in the information technology environment, changes in earnings estimates by analysts, changes in accounting principles, sales of our common stock by existing holders and the loss of key personnel. In the past, following periods of volatility in the market price of a company’s stock, class action securities litigation has often been instituted against such companies. Such litigation, if instituted, could result in substantial costs and diversion of management’s attention and resources which would materially adversely affect our business, financial condition and operating results.

A small number of our existing shareholders can exert control over us.

Our executive officers, directors and principal shareholders holding more than 5% of our common stock together control a majority of our outstanding common stock. As a result, these shareholders, if they act together, could control our management and affairs of the company and all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control of us and might affect the market price of our common stock.

It might be difficult for a third party to acquire us even if doing so would be beneficial to our shareholders.

Certain provisions of our articles of incorporation, bylaws and Washington law may discourage, delay or prevent a change in the control of us or a change in our management even if doing so would be beneficial to our shareholders. Our board of directors has the authority under our amended and restated articles of incorporation to issue preferred stock with rights superior to the rights of the holders of common stock. As a result, preferred stock could be issued quickly and easily with terms calculated to delay or prevent a change in control of our company or make removal of our management more difficult. In addition, our board of directors is divided into three classes. The directors in each class serve for three-year terms, one class being elected each year by our shareholders. This system of electing and removing directors may tend to discourage a third party from making a tender offer or otherwise attempting to obtain control of our company because it generally makes it more difficult for shareholders to replace a majority of our directors.

In addition, Chapter 19 of the Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with a defined “acquiring person” for a period of five years after the acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s board of directors prior to the time of acquisition. This provision may have the effect of delaying, deterring or preventing a change in control of our company. The existence of these anti-takeover provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Risk. We do not hold derivative financial instruments or equity securities in our short-term investment portfolio. Our cash equivalents consist of high-quality securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one issue to a maximum of 15% and any one issuer to a maximum of 10% of the total portfolio with the exception of treasury securities, commercial paper and money market funds, which are exempt from size limitation. The policy limits all short-term investments to mature in two years or less, with the average maturity being one year or less. These securities are subject to interest rate risk and will decrease in value if interest rates increase.

Foreign Currency Exchange Rate Risk. Currently, the majority of our revenue and expenses is denominated in U.S. dollars, and, as a result, we have not experienced significant foreign exchange gains or losses to date. While we have conducted some transactions in foreign currencies and expect to continue to do so, we do not expect that foreign exchange gains or losses will be significant. We have not engaged in foreign currency hedging to date, although we may do so in the future.

Our international businesses are subject to risks typical of international activity, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our future results could be materially adversely impacted by changes in these or other factors.

Our exposure to foreign exchange rate fluctuations can vary as the financial results of our foreign subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and adversely impact overall expected results of operations. The effect of foreign exchange rate fluctuations for the three and nine months ended September 30, 2003 was not material.

Investment Risk. We review our long-lived assets, for impairment annually and whenever events or changes in circumstances otherwise indicate that the carrying amount of an asset may not be recoverable.

Item 4. 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) of the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report were effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in 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, within a company have been detected.

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

In summer and early fall 2001, four purported shareholder class action lawsuits were filed in the United States District Court for the Southern District of New York against us, certain of our current and former officers and directors (the “Individual Defendants”), and the underwriters of our initial public offering. The suits purport to be class actions filed on behalf of purchasers of our common stock during the period from October 19, 1999 to December 6, 2000. The complaints against us have been consolidated into a single action and a Consolidated Amended Complaint, which was filed on April 19, 2002 and is now the operative complaint.

Plaintiffs allege that the underwriter defendants agreed to allocate stock in our initial public offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the prospectus for our initial public offering was false and misleading in violation of the securities laws because it did not disclose these arrangements. The action seeks damages in an unspecified amount.

The action is being coordinated with approximately 300 other nearly identical actions filed against other companies. On July 15, 2002, we moved to dismiss all claims against us and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based upon Stipulations of Dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against us. We have approved a Memorandum of Understanding (“MOU”) and related agreements which set forth the terms of a settlement between us and the plaintiff class. It is anticipated that any potential financial obligation of us to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, we do not expect that the settlement will involve any payment by us. The MOU and related agreements are subject to a number of contingencies, including the approval of the MOU by a sufficient number of the other approximately 300 companies who are part of the consolidated case against us, the negotiation of a settlement agreement, and approval by the Court. We cannot offer an opinion as to whether or when a settlement will occur or be finalized and are unable at this time to determine whether the outcome of the litigation will have a material impact on our results of operations or financial condition in any future period.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits


Exhibit No.		Exhibit Description

	3.1	Amended and Restated Articles of Incorporation (incorporated by reference to our registration statement on Form S-1 (File No. 333-85351) filed with the Securities and Exchange Commission on October 19, 1999)

	3.1(a)	Articles of Amendment to Amended and Restated Articles of Incorporation (incorporated by reference to our quarterly report on Form 10-Q filed with the Securities and Exchange Commission on August 7, 2000)

	3.2	Bylaws and all amendments thereto (incorporated by reference to our annual report on Form 10-K filed with the Securities and Exchange Commission on March 19, 2003)

	10.18**	OEM Distribution Agreement for Software Products for Embedded Systems between BSQUARE Corporation and Microsoft Licensing, GP dated September 16, 2003.

	31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

	32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K

On July 24, 2003, we filed a Form 8-K announcing our second quarter results.

On July 24, 2003, we filed a Form 8-K announcing the resignation of William T. Baxter as Chairman and Chief Executive Officer and the appointment of Brian T. Crowley as Chief Executive Officer, the appointment of Donald B. Bibeault as Chairman of the Board of Directors and the resignation of Jeffrey T. Chambers from the Board of Directors.

On September 23, 2003, we filed a Form 8-K announcing that we received notification from The Nasdaq Stock Market that we regained compliance with the Nasdaq National Market’s listing maintenance standards regarding minimum bid price.

** Confidential Treatment Requested

SIGNATURE

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.


		BSQUARE CORPORATION (Registrant)

Date: November 14, 2003		/S/ Brian T. Crowley

		Brian T. Crowley
		Chief Executive Officer
		(Principal executive officer)

Date: November 14, 2003		/S/ Nogi A. Asp

		Nogi A. Asp
		Chief Financial Officer
		(Principal financial officer)

BSQUARE CORPORATION

INDEX TO EXHIBITS


Exhibit
Number
(Referenced to
Item 601 of		Exhibit
Regulation S-K)		Description

	3.1	Amended and Restated Articles of Incorporation (incorporated by reference to the registrant’s registration statement on Form S-1 (File No. 333-85351) filed with the Securities and Exchange Commission on October 19, 1999)

	3.1(a)	Articles of Amendment to Amended and Restated Articles of Incorporation (incorporated by reference to the registrant’s quarterly report on Form 10-Q filed with the Securities and Exchange Commission on August 7, 2000)

	3.2	Bylaws and all amendments thereto (incorporated by reference to the registrant’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 19, 2003)

	10.18**	OEM Distribution Agreement for Software Products for Embedded Systems between BSQUARE Corporation and Microsoft Licensing, GP dated September 16, 2003.

	31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

	32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

** Confidential Treatment Requested

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•		Cost of products consists primarily of license fees and royalties for third-party software and the costs of product media, product duplication and manuals.

•		Cost of services consists primarily of salaries and benefits for our software engineers, plus related facilities and depreciation costs.

	•		the failure of the smart device market to develop;

	•		our inability to develop, have manufactured, market and sell new and enhanced products and services on a timely basis;

	•		excess inventory or insufficient inventory to meet demand;

	•		changes in the mix of our services and product revenue, which have different gross margins;

	•		changes in demand for our products and services, including the early termination of customer contracts;

	•		increased competition and changes in our pricing as a result of increased competitive pressure;

	•		underestimates by us of the costs to be incurred in fixed-fee service projects;

	•		varying customer buying patterns, which are often influenced by year-end budgetary pressures;

	•		our ability to increase our revenue to a level that exceeds our costs and expenses; and

	•		our ability to control our expenses, a large portion of which are relatively fixed and which are budgeted based on anticipated revenue trends;

	•		adverse changes in our relationship with Microsoft, from which a substantial portion of our revenue was generated and on which we rely to continue to develop and promote Windows Embedded operating systems and Windows Mobile targeted platforms such as Windows Mobile for Smartphone and Windows Mobile for PocketPC;

	•		the failure or perceived failure of Windows Embedded operating systems and Windows Mobile targeted platforms upon which demand for the majority of our current products and services is dependent, to achieve or maintain widespread market acceptance; and

	•		unanticipated delays, or announcement of delays, by Microsoft of Windows product releases, which could cause us to delay our product introductions or delay commencement of service contracts and adversely affect our customer relationships.

	•		Microsoft’s development and support of the Windows Embedded and Windows Mobile market. As the developer and primary promoter of Windows CE, XP Embedded, Windows Mobile for Smartphone and Windows Mobile for PocketPC, if Microsoft were to decide to discontinue or lessen its support of these operating systems and platforms, potential customers could select competing operating systems, which would reduce the demand for our Windows Embedded and Windows Mobile software products and services;

	•		the ability of the Windows Embedded operating systems to compete against existing and emerging operating systems for the smart device market including: VxWorks and pSOS from WindRiver Systems Inc., VRTX from Mentor Graphics Corporation, JavaOS from Sun Microsystems, Inc., Linux, Symbian and proprietary operating systems. In particular, in the market for palm-size devices, Windows Embedded operating systems and Windows Mobile targeted platforms face intense competition from Palm Incorporated, Research In Motion and Linux based devices. In the market for cellular phones, Windows Embedded operating systems and Windows Mobile for Smartphone face competition from the EPOC operating system from Symbian, a joint venture among several of the largest manufacturers of cellular phones. Windows Embedded operating systems and Windows Mobile for Smartphone may be unsuccessful in capturing a significant share of these two segments of the smart device market, or in maintaining its market share in those other segments of the smart device market on which our business currently focuses, including the markets for Internet-enabled television set-top boxes, handheld industrial devices, consumer Internet appliances such as kiosk terminals and vehicle navigational devices, and Windows-based terminals;

	•		the acceptance by original equipment manufacturers and consumers of the mix of features and functions offered by Windows embedded operating systems and Windows Mobile targeted platforms; and

	•		the willingness of software developers to continue to develop and expand the applications that run on Windows Embedded operating systems and Windows Mobile targeted platforms. To the extent that software developers write applications for competing operating systems that are more attractive to smart device end users than those available on Windows Embedded operating systems and Windows Mobile targeted platforms, potential purchasers could select competing operating systems over Windows Embedded operating systems and Windows Mobile targeted platforms.

	•		the willingness of large numbers of businesses and consumers to use devices such as smartphones, personal digital assistants and handheld industrial data collectors to perform functions currently carried out manually or by traditional PCs, including inputting and sharing data, communicating among users and connecting to the Internet; and

	•		the evolution of industry standards or the necessary infrastructure that facilitate the distribution of content over the Internet to these devices via wired and wireless telecommunications systems, satellite or cable.

	•		our current and potential customers’ internal research and development departments that may seek to develop their own proprietary solutions;

	•		professional engineering services firms, domestic and foreign;

	•		established smart device hardware, software and tools manufacturers and vendors; and

	•		software and component distributors.

	•		greater difficulty in protecting intellectual property due to less stringent foreign intellectual property laws and enforcement policies;

	•		greater difficulty in managing foreign operations due to the lack of proximity between our home office and our foreign operations;

	•		longer collection cycles than we typically experience in the U.S.;

	•		unfavorable changes in regulatory practices and tariffs;

	•		adverse changes in tax laws;

	•		greater difficulty in managing foreign third-party manufacturing;

	•		the impact of fluctuating exchange rates between the U.S. dollar and foreign currencies; and

	•		general economic and political conditions in Asian and European markets, as a result of such events as the spread of the SARS illness and otherwise, which may differ from those in the U.S.

	•		customers’ budgetary constraints and internal acceptance review procedures;

	•		the timing of budget cycles; and

	•		the timing of customers’ competitive evaluation processes.

(b)		Reports on Form 8-K

		On July 24, 2003, we filed a Form 8-K announcing our second quarter results.

		On July 24, 2003, we filed a Form 8-K announcing the resignation of William T. Baxter as Chairman and Chief Executive Officer and the appointment of Brian T. Crowley as Chief Executive Officer, the appointment of Donald B. Bibeault as Chairman of the Board of Directors and the resignation of Jeffrey T. Chambers from the Board of Directors.

		On September 23, 2003, we filed a Form 8-K announcing that we received notification from The Nasdaq Stock Market that we regained compliance with the Nasdaq National Market’s listing maintenance standards regarding minimum bid price.