COMARCO INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended OCTOBER 31, 2002

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number 0-5449

COMARCO, INC.

(Exact name of registrant as specified in its charter)

California		95-2088894
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

2 Cromwell, Irvine, California 92618

(Address of principal executive offices and zip code)

(949) 599-7400

(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

The registrant had 7,042,065 shares of common stock outstanding as of December 12, 2002.

COMARCO, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND NINE MONTHS ENDED OCTOBER 31, 2002

TABLE OF CONTENTS

		Page

PART I — FINANCIAL INFORMATION

ITEM 1.	FINANCIAL STATEMENTS

	Condensed Consolidated Balance Sheets as of October 31, 2002 and January 31, 2002	3

	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended October 31, 2002 and 2001	4

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2002 and 2001	5

	Notes to Condensed Consolidated Financial Statements	6

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	15

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	25

ITEM 4.	CONTROLS AND PROCEDURES	25

PART II — OTHER INFORMATION

ITEM 1.	LEGAL PROCEEDINGS	26

ITEM 2.	CHANGES IN SECURITIES	27

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	27

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	27

ITEM 5.	OTHER INFORMATION	27

ITEM 6.	EXHIBITS AND REPORTS ON FORM 8-K	27

SIGNATURES		28

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

COMARCO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

	October 31, 2002		January 31, 2002
	(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents	$	24,212	$	21,288
Short-term investments		2,397		3,325
Accounts receivable, net		7,345		9,694
Inventory		4,361		6,002
Deferred tax assets, net		2,019		1,475
Other current assets		612		922

Total current assets		40,946		42,706
Property and equipment, net		3,341		3,834
Capitalized software development costs, net		5,302		10,139
Goodwill and other intangible assets, net		2,708		8,118
Other assets		1,144		1,145

	$	53,441	$	65,942

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	982	$	200
Deferred revenue		4,196		5,299
Accrued liabilities		6,086		7,186

Total current liabilities		11,264		12,685
Deferred compensation		2,397		3,325
Deferred tax liabilities, net		806		2,269
Minority interest		228		76
Stockholders’ Equity:
Preferred stock, no par value, 10,000,000 shares authorized, no shares outstanding at October 31, 2002 and January 31, 2002		—		—
Common stock, $0.10 par value, 50,625,000 shares authorized, 6,992,358 and 6,978,014 shares outstanding at October 31, 2002 and January 31, 2002, respectively		699		698
Additional paid-in capital		10,674		10,813
Retained earnings		27,373		36,076

		38,746		47,587

	$	53,441	$	65,942

The accompanying notes are an integral part of these condensed consolidated financial statements.

COMARCO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except share and per share amounts)

	Three Months Ended October 31,						Nine Months Ended October 31,
	2002			2001			2002			2001
Revenue	$	13,033		$	12,320		$	30,808		$	38,372
Cost of revenue:
Cost of goods sold		6,549			5,726			15,279			17,489
Software development amortization		288			679			2,353			1,848
Inventory impairment charge		(144	)		—			1,259			—

Total cost of revenue		6,693			6,405			18,891			19,337

Gross profit		6,340			5,915			11,917			19,035
Selling, general and administrative costs		2,369			2,873			7,099			9,733
Asset impairment charges		—			—			8,407			—
Engineering and support costs		1,703			1,630			4,423			4,287

Operating income (loss)		2,268			1,412			(8,012	)		5,015
Other income, net		94			206			297			780
Minority interest in earnings of subsidiary		(15	)		(18	)		64			(44	)

Income (loss) before income taxes		2,347			1,600			(7,651	)		5,751
Income tax expense (benefit)		861			590			(1,874	)		2,120

Net income (loss) before cumulative effect of accounting change		1,486			1,010			(5,777	)		3,631
Cumulative effect of accounting change		—			—			(2,926	)		—

Net income (loss)	$	1,486		$	1,010		$	(8,703	)	$	3,631


Net income (loss) per share—basic:
Net income (loss) before cumulative effect of accounting change	$	0.21		$	0.14		$	(0.83	)	$	0.52
Cumulative effect of accounting change	$	—		$	—		$	(0.42	)	$	—

Net income (loss) per share—basic	$	0.21		$	0.14		$	(1.25	)	$	0.52


Net income (loss) per share—diluted:
Net income (loss) before cumulative effect of accounting change	$	0.21		$	0.14		$	(0.83	)	$	0.48
Cumulative effect of accounting change	$	—		$	—		$	(0.42	)	$	—

Net income (loss) per share—diluted	$	0.21		$	0.14		$	(1.25	)	$	0.48

The accompanying notes are an integral part of these condensed consolidated financial statements.

COMARCO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

	Nine Months Ended October 31,
	2002			2001
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	(8,703	)	$	3,631
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		3,997			4,127
Tax benefit from exercise of stock options		151			615
Deferred income taxes		(2,007	)		1,331
Asset impairment charges		9,666			—
Loss (gain) on disposal of property and equipment		154			(16	)
Cumulative effect of accounting change		2,926			—
Provision for doubtful accounts receivable		(66	)		(31	)
Provision for obsolete inventory		276			321
Minority interest in earnings of subsidiary		(64	)		44
Changes in operating assets and liabilities:
Decrease in short-term investments		928			453
Decrease (increase) in accounts receivable		2,367			(2,435	)
Decrease (increase) in inventory		106			(947	)
Decrease (increase) in other assets		(414	)		911
Deferred compensation		(928	)		(627	)
Decrease in current liabilities		(813	)		(3,510	)

Net cash provided by operating activities		7,576			3,867

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales and maturities of investments		—			72
Proceeds from sales of property and equipment		131			20
Purchases of property and equipment		(1,462	)		(1,675	)
Investment in SwissQual		—			(1,073	)
Investment in Qualcomm license		(250	)		—
Cash paid for acquisition of minority interest		—			(118	)
Capitalized software development costs		(3,135	)		(4,193	)

Net cash used in investing activities		(4,716	)		(6,967	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock		226			283
Net proceeds from issuance of subsidiary common stock		78			134
Purchase of common stock		(402	)		(1,680	)

Net cash used in financing activities		(98	)		(1,263	)

Net increase (decrease) in cash and cash equivalents—continuing operations		2,762			(4,363	)
Net increase (decrease) in cash and cash equivalents—discontinued operations		162			(775	)

Net increase (decrease) in cash and cash equivalents		2,924			(5,138	)
Cash and cash equivalents, beginning of period		21,288			24,903

Cash and cash equivalents, end of period	$	24,212		$	19,765

Supplemental disclosures of cash flow information:
Cash paid for interest	$	14		$	—

Cash paid for income taxes	$	478		$	994

The accompanying notes are an integral part of these condensed consolidated financial statements.

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Organization

Comarco, Inc., through its subsidiary Comarco Wireless Technologies, Inc. (collectively, “Comarco” or the “Company”), is a leading provider of field test applications for the wireless industry. Comarco also designs and manufactures wireless emergency call box systems and mobile power products for notebook computers, cellular telephones, and handheld devices. Comarco is a California corporation that became a public company in 1971 when it was spun-off from Genge Industries, Inc. Comarco Wireless Technologies, Inc. (“CWT”) was incorporated in the state of Delaware in September 1993. During October 1999, the Company embarked on a plan to divest its non-wireless businesses, which included the defense and commercial staffing businesses. The divestiture plan was completed during November 2000. Accordingly, the Company’s continuing operations consist solely of the operations of CWT.

2. Summary of Significant Accounting Policies

Basis of Presentation:

The interim condensed consolidated financial statements of Comarco included herein have been prepared without audit in accordance with generally accepted accounting principles for interim information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The Company believes that the disclosures are adequate to make the information presented not misleading when read in conjunction with the audited consolidated financial statements included in the Company’s annual report on Form 10-K for the year ended January 31, 2002 and the Company’s quarterly report on Form 10-Q for the prior quarters of the current fiscal year. The financial information presented herein reflects all adjustments, consisting only of normal recurring accruals, which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. The results for the three and nine months ended October 31, 2002 are not necessarily indicative of the results to be expected for the year ended January 31, 2003.

Principles of Consolidation:

The condensed consolidated financial statements of the Company include the accounts of Comarco, Inc., CWT, and wholly owned subsidiaries primarily reported as discontinued operations. All material intercompany balances, transactions, and profits have been eliminated.

Use of Estimates:

The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Significant estimates made in preparing the financial statements include the allowances for doubtful accounts, inventory reserves, goodwill and purchased intangible asset valuations, deferred income tax asset valuation allowances, warranty reserves, litigation, and other contingencies. To the extent there are material differences between estimates and the actual results, future results of operations will be affected.

Reclassifications:

Certain prior period balances have been reclassified to conform to the current period presentation.

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

3. Asset Impairment Charges

Due to reduced demand for existing wireless infrastructure products in the wireless marketplace and the Company’s strategy of investing available resources in the development of XPort, a new product platform, management has analyzed the carrying value of all assets attributable to the Company’s wireless infrastructure business. Based on this analysis, the Company recorded asset impairment charges totaling $8.4 million during the second quarter of fiscal 2003. The following table sets forth the impaired assets and corresponding impairment charges (in thousands):

Property and equipment	$	205
Software development costs		5,619
Intangible assets		2,583

	$	8,407

In addition to the asset impairment charges above, an inventory impairment charge, totaling $1.3 million, was recorded as cost of revenue for the nine months ended October 31, 2002. The above asset impairment charges, as well as the inventory impairment charge are exclusively related to the Company’s legacy 2G wireless infrastructure products and do not include any assets related to the Company’s engineering services business, which ceased operations during the second quarter of fiscal 2003.

4. Goodwill and Other Intangible Assets

Effective February 1, 2002, the Company implemented Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 establishes new standards for goodwill acquired in a business combination, eliminates amortization of goodwill, and sets forth methods for periodically evaluating goodwill for impairment.

Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value as determined using a discounted cash flow methodology applied to the particular unit. This methodology differs from the Company’s previous policy, in accordance with accounting standards existing at that time, of using undiscounted cash flows on an enterprise-wide basis to determine recoverability. During the second quarter of fiscal 2003, the Company completed the required transitional impairment test under the new rules and recorded a non-cash charge of $2.9 million to write down fully the carrying value of the goodwill related to the Company’s EDX software reporting unit. This reporting unit is included in the Company’s wireless infrastructure segment for financial reporting purposes, and the related goodwill was generated through the Company’s acquisition of EDX Engineering, Inc. during December 2000. Such charge is reflected as a cumulative effect of change in accounting principle.

In calculating the impairment charge, the fair value of the impaired reporting unit underlying the wireless infrastructure segment was estimated using a discounted cash flow methodology. This charge writes off the entire carrying value of the recorded goodwill and accordingly, $2.9 million was recorded as a cumulative charge for the nine months ended October 31, 2002. An annual impairment review will be performed during the fourth quarter of each year, commencing in the fourth quarter of fiscal 2003. Future impairments of intangible assets, if any, will be recorded as operating expenses.

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Goodwill and other intangible assets consist of the following (in thousands):

	October 31, 2002			January 31, 2002
Purchased technology	$	—		$	1,790
Customer base		—			930
Goodwill		2,606			5,941
Other acquired intangible assets		1,250			1,450

	$	3,856		$	10,111
Less accumulated amortization		(1,148	)		(1,993	)

	$	2,708		$	8,118

Amortization of intangible assets for the three months ended October 31, 2002 and 2001 totaled $0 and $263,000, respectively. For the nine months ended October 31, 2002 and 2001, amortization of intangibles totaled $176,000 and $786,000, respectively.

As required by SFAS No. 142, the Company ceased amortizing goodwill and other intangible assets deemed to have indefinite lives beginning February 1, 2002. The Company recorded $0.7 million of goodwill amortization in fiscal 2002 that will not recur in future years.

The following supplemental pro forma information presents the Company’s net income (loss) and net income (loss) per share information as if the Company had been accounting for its goodwill under SFAS No. 142 for all periods presented (in thousands):

	Three Months Ended October 31,				Nine Months Ended October 31,
	2002		2001		2002			2001
Net income (loss)—as reported	$	1,486	$	1,010	$	(8,703	)	$	3,631
Adjustments:
Amortization of goodwill, net of tax		—		111		—			332

Net income (loss)—as adjusted	$	1,486	$	1,121	$	(8,703	)	$	3,963

Adjusted basic net income (loss) per share	$	0.21	$	0.16	$	(1.25	)	$	0.56

Adjusted diluted net income (loss) per share	$	0.21	$	0.15	$	(1.25	)	$	0.53

5. Recent Accounting Pronouncements

Effective February 1, 2002, the Company implemented SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which supersedes both SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” and the accounting and reporting provisions of Accounting Principles Board (“APB”) Opinion No. 30, “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” for the disposal of a segment of a business (as previously defined in that Opinion). The adoption of SFAS No. 144 did not have a material impact on the Company’s results of operations or financial position.

In April 2002, the FASB issued Statement No. 145, “Rescission of the FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS No. 145”). SFAS No. 145 eliminates the requirements to classify gains and losses from the extinguishment of indebtedness as extraordinary, requires certain lease modifications to be treated the same as a sale-leaseback transaction, and makes other non-substantive

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

technical corrections to existing pronouncements. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002, with earlier adoption encouraged. Management does not believe that the adoption of this standard will have a material impact on the Company’s results of operation or financial position.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Exit or Disposal Activities.” SFAS No. 146 addresses the recognition, measurement, and reporting of costs associated with exit and disposal activities, including restructuring activities. SFAS No. 146 also addresses recognition of certain costs related to terminating a contract that is not a capital lease, costs to consolidate facilities or relocate employees and termination of benefits provided to employees that are involuntarily terminated under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred compensation contract. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company is in the process of evaluating the adoption of SFAS No. 146 and its impact on the Company’s results of operations or financial position.

In October 2002, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” The EITF indicated that this guidance is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently assessing the impact of the adoption of these Issues on its financial position and results of operations.

6. Stockholders’ Equity

During 1992, our Board of Directors authorized a stock repurchase program of up to 3.0 million shares of our common stock. From program inception through October 31, 2002, the Company has repurchased approximately 2.5 million shares for an average price of $8.22 per share. During the three months ended October 31, 2002, the Company repurchased 8,038 shares of common stock in the open market for an average price of $6.10 per share.

7. Income (Loss) Per Share

The Company calculates net income (loss) per share in accordance with SFAS No. 128, “Earnings Per Share.” Under SFAS No. 128, basic net income (loss) per share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the reporting period. Diluted net income (loss) per share reflects the effects of potentially dilutive securities. Since the Company incurred a net loss for the nine months ended October 31, 2002, basic and diluted net loss per share were the same because the inclusion of dilutive securities would have been antidilutive. The following table presents reconciliations of the numerators and denominators of the basic and diluted income (loss) per share computations for net income (loss). In the tables below, “Income” or “Loss” represents the numerator and “Shares” represents the denominator (in thousands, except per share amounts):

	Three Months Ended October 31,				Nine Months Ended October 31,
	2002		2001		2002			2001
Basic:
Net income (loss) before cumulative effect of accounting change	$	1,486	$	1,010	$	(5,777	)	$	3,631
Weighted average shares outstanding		6,987		7,002		6,975			7,040

Basic income (loss) per share before cumulative effect of accounting change	$	0.21	$	0.14	$	(0.83	)	$	0.52

Cumulative effect of accounting change	$	—	$	—	$	(2,926	)	$	—
Weighted average shares outstanding		6,987		7,002		6,975			7,040

Basic loss per share from cumulative effect of accounting change	$	—	$	—	$	(0.42	)	$	—

Net income (loss)	$	1,486	$	1,010	$	(8,703	)	$	3,631
Weighted average shares outstanding		6,987		7,002		6,975			7,040

Basic income (loss) per share	$	0.21	$	0.14	$	(1.25	)	$	0.52

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

	Three Months Ended October 31,						Nine Months Ended October 31,
	2002			2001			2002			2001
Diluted:
Net income (loss) before cumulative effect of accounting change	$	1,486		$	1,010		$	(5,777	)	$	3,631
Effect of subsidiary options		(36	)		(44	)		—			(178	)

Net income used in calculation of diluted income (loss) per share before cumulative effect of accounting change	$	1,450		$	966		$	(5,777	)	$	3,453

Weighted average shares outstanding		6,987			7,002			6,975			7,040
Effect of dilutive securities—stock options		23			86			—			96

Weighted average shares used in calculation of diluted income (loss) per share before cumulative effect of accounting change		7,010			7,088			6,975			7,136

Diluted income (loss) per share before cumulative effect of accounting change	$	0.21		$	0.14		$	(0.83	)	$	0.48

Cumulative effect of accounting change	$	—		$	—		$	(2,926	)	$	—
Effect of subsidiary options		—			—			—			—

Net loss used in calculation of diluted loss per share from cumulative effect of accounting change	$	—		$	—		$	(2,926	)	$	—

Weighted average shares outstanding		6,987			7,002			6,975			7,040
Effect of dilutive securities—stock options		23			86			—			96

Weighted average shares used in calculation of diluted loss per share from cumulative effect of accounting change		7,010			7,088			6,975			7,136

Diluted loss per share from cumulative effect of accounting change	$	—		$	—		$	(0.42	)	$	—

Net income (loss)	$	1,486		$	1,010		$	(8,703	)	$	3,631
Effect of subsidiary options		(36	)		(44	)		—			(178	)

Net income used in calculation of diluted income (loss) per share	$	1,450		$	966		$	(8,703	)	$	3,453

Weighted average shares outstanding		6,987			7,002			6,975			7,040
Effect of dilutive securities—stock options		23			86			—			96

Weighted average shares used in calculation of diluted income (loss) per share		7,010			7,008			6,975			7,136

Diluted income (loss) per share	$	0.21		$	0.14		$	(1.25	)	$	0.48

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

8. Inventory

Inventory consists of the following (in thousands):

	October 31, 2002		January 31, 2002
Raw materials	$	3,142	$	4,657
Work in progress		170		420
Finished goods		1,049		925

	$	4,361	$	6,002

During the second quarter of fiscal 2003, the Company recorded a non-cash inventory impairment charge, totaling $1.4 million. As discussed in Note 3, the inventory impairment charge was related to the Company’s legacy 2G wireless infrastructure products. During the third quarter of fiscal 2003, the Company analyzed the inventory impairment reserve established in the prior quarter. Based on this analysis and during the third quarter of fiscal 2003, the inventory impairment reserve was reduced by approximately $144,000.

9. Capitalized Software Development Costs

Capitalized software development costs consist of the following (in thousands):

	October 31, 2002			January 31, 2002
Capitalized software development costs	$	8,729		$	18,056
Less accumulated amortization		(3,427	)		(7,917	)

	$	5,302		$	10,139

Software development costs capitalized for the three and nine months ended October 31, 2002 totaled $1.1 million and $3.1 million, respectively. Included in these balances is approximately $0.4 million paid to SwissQual, an affiliate of the Company, for software development services related to XPort, the Company’s new product platform currently under development. Software development costs capitalized for the three and nine months ended October 31, 2001 totaled $1.4 million and $4.2 million, respectively. Amortization of software development costs for the three and nine months ended October 31, 2002 totaled $0.3 million and $2.4 million, respectively. For the three and nine months ended October 31, 2001, amortization of software development costs totaled $0.7 million and $1.8 million, respectively. Amortization of software development costs has been reported in cost of revenue in the accompanying condensed consolidated financial statements.

During the second quarter ended July 31, 2002, the Company recorded a non-cash impairment charge totaling $5.6 million related to capitalized software development costs. As noted in Note 3, the asset impairment charge was attributable to the Company’s legacy 2G wireless infrastructure products.

10. Business Segment Information

The Company has two reportable operating segments: wireless infrastructure and wireless applications. Wireless infrastructure designs and manufactures hardware and software tools for use by wireless carriers, equipment vendors, and others. Radio Frequency (“RF”) engineers, professional technicians, and others use these tools to design, deploy, and optimize wireless networks, and to verify the performance of the wireless networks once deployed.

Wireless applications designs and manufactures remote voice systems and mobile power products for notebook computers, cellular telephones, and handheld devices. Remote voice systems currently include various call box products that provide emergency communication over existing wireless networks. In addition to the call box

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

products, we provide system installation and long-term maintenance services. Currently, approximately 14,000 CWT call boxes are installed, the majority of which are serviced and maintained under long-term agreements.

Performance measurement and resource allocation for the reportable segments are based on many factors. The primary financial measures used are revenue and gross profit. The revenue, gross profit, and gross margin attributable to these segments are as follows (in thousands):

	Three Months Ended October 31, 2002
	Wireless Infrastructure			Wireless Applications			Total
Revenue	$	2,909		$	10,124		$	13,033
Cost of revenue:
Cost of goods sold		991			5,558			6,549
Software development amortization		263			25			288
Inventory impairment		(144	)		—			(144	)

Total cost of revenue		1,110			5,583			6,693

Gross profit	$	1,799		$	4,541		$	6,340

Gross margin		61.8	%		44.9	%		48.7	%


	Three Months Ended October 31, 2001
	Wireless Infrastructure			Wireless Applications			Total
Revenue	$	6,931		$	5,389		$	12,320
Cost of revenue:
Cost of goods sold		2,542			3,184			5,726
Software development amortization		643			36			679
Inventory impairment		—			—			—

Total cost of revenue		3,185			3,220			6,405

Gross profit	$	3,746		$	2,169		$	5,915

Gross margin		54.0	%		40.2	%		48.0	%

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

	Nine Months Ended October 31, 2002
	Wireless Infrastructure			Wireless Applications			Total
Revenue	$	9,394		$	21,414		$	30,808
Cost of revenue
Cost of goods sold		3,217			12,062			15,279
Software development amortization		2,256			97			2,353
Inventory impairment		1,259			—			1,259

Total cost of revenue		6,732			12,159			18,891

Gross profit	$	2,662		$	9,255		$	11,917

Gross margin		28.3	%		43.2	%		38.7	%


	Nine Months Ended October 31, 2001
	Wireless Infrastructure			Wireless Applications			Total
Revenue	$	22,040		$	16,332		$	38,372
Cost of revenue
Cost of goods sold		7,747			9,742			17,489
Software development amortization		1,740			108			1,848
Inventory impairment		—			—			—

Total cost of revenue		9,487			9,850			19,337

Gross profit	$	12,553		$	6,482		$	19,035

Gross margin		57.0	%		39.7	%		49.6	%

Revenue by geographic area consists of the following (dollars in thousands):

	Three Months Ended October 31,				Nine Months Ended October 31,
	2002		2001		2002		2001
North America	$	10,595	$	11,087	$	26,010	$	35,757
Europe		1,838		—		3,155		16
Asia		540		116		908		970
Latin America		60		1,117		735		1,629

	$	13,033	$	12,320	$	30,808	$	38,372

11. Contingencies

Mobility Electronics, Inc. (“Mobility”) commenced proceedings for patent infringement against the Company and CWT with respect to CWT’s ChargeSource power supply products (the “Mobility Action”). The Company was first served with Mobility’s amended complaint on August 10, 2001. In addition to asserting that the Company and CWT have infringed a Mobility patent, the amended complaint seeks declaratory judgment that three of CWT’s power-supply related patents are either invalid or not infringed by power supplies produced or to be produced by Mobility. The Company and CWT moved for dismissal of the amended complaint in its entirety. The motion was denied, but the Court indicated that based on the results of discovery the Court may grant a renewed motion to dismiss the declaratory judgment claim. The Company and CWT believe that they have meritorious defenses with respect to Mobility’s patent and declaratory judgment causes of actions.

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

On June 21, 2002, CWT filed an action for patent infringement against the Xtend Micro Products, Inc. (“Xtend”) and its parent entity, iGo Corporation (“iGo”). CWT alleges that certain patents owned by CWT are infringed by Xtend’s PowerXtender^™ and AC Adapter power supply products as well as other power supply and power adapter products and related accessories. On July 15, 2002, Xtend and iGo answered the complaint denying the allegations in CWT’s complaint and asserting a number of affirmative defenses. Xtend and iGo have indicated in court filings that they will seek to have this case transferred to and consolidated with the Mobility Action because this case involves two of the patents involved in the Mobility Action, and Mobility and iGO have recently merged into a single corporate entity. CWT believes that its case against Xtend and iGo is meritorious and that CWT has valid grounds for opposing any motion to consolidate this case with the Mobility Action that may be filed by Xtend and/or iGo.

Los Angeles County Service Authority for Freeway Emergencies (“LASAFE”) filed an action against CWT on June 10, 2002, relating to two contracts between LASAFE and CWT concerning call box systems manufactured by CWT, upgraded by CWT to comply with the Americans with Disabilities Act (“ADA”), and maintained by CWT until its contractual obligations to provide maintenance expired. On August 2, 2002, LASAFE filed a first amended complaint. The complaint includes eight counts. In the first five counts LASAFE alleges CWT breached its contractual obligations and implied warranties by failing to properly maintain and repair the call box systems and failing to provide certain deliverables to LASAFE. In the last three counts LASAFE alleges that a patent owned by CWT should be assigned to LASAFE, and CWT should compensate LASAFE because an LASAFE employee is the true inventor of the invention claimed in the patent. The complaint seeks an unspecified amount of actual and punitive damages, ownership of the patent, an order that CWT specifically perform its obligations under the contracts, recovery of attorneys fees, and an audit to determine the number of allegedly infringing call boxes.

CWT believes that it has meritorious defenses with respect to all of LASAFE’s claims. In addition, on August 16, 2002, CWT filed an answer and a motion to dismiss the first five counts founded in state contract and warranty law on the grounds that the Federal District Court lacks jurisdiction over the state law claims.

The Company is from time to time involved in various legal proceedings incidental to the conduct of the Company’s business. Management believes that the outcome of all other such pending legal proceedings will not in the aggregate have a material adverse effect on the Company’s operating results and financial position.


ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto included elsewhere in this quarterly report on Form 10-Q. This report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms, or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. Important factors which may cause actual results to differ materially from the forward-looking statements are described in the section entitled “Risk Factors” in Part I, Item 1 of our report on Form 10-K for the year ended January 31, 2002, and other risks identified from time to time in our filings with the Securities and Exchange Commission, press releases, and other communications.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Moreover, neither any other person nor we assume responsibility for the accuracy and completeness of the forward-looking statements. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Overview

Comarco, Inc., through its subsidiary Comarco Wireless Technologies, Inc. (collectively, “Comarco,” or the “Company”), is a leading provider of field test applications for the wireless industry. Comarco also designs and manufactures wireless emergency call box systems and mobile power products for notebook computers, cellular telephones, and handheld devices. Comarco, Inc. is a California corporation that became a public company in 1971 when it was spun-off from Genge Industries, Inc. Comarco Wireless Technologies, Inc. (“CWT”) was incorporated in the State of Delaware in September 1993.

Results of Operations—Continuing Operations

We have two reportable operating segments: wireless infrastructure and wireless applications.

Wireless Infrastructure

Our wireless infrastructure business designs and manufactures hardware and software tools for use by wireless carriers, equipment vendors, and others. Radio frequency engineers, professional technicians, and others use these field test applications to design, deploy, and optimize wireless networks, and to verify the performance of the wireless networks once deployed.

Many of our customers, primarily wireless carriers, continue to be negatively impacted by a wireless industry experiencing slowing subscriber growth, intensifying price competition, reduced access to capital, and the need to manage cash flow. Coupled with a weakened economy, wireless carriers have responded to these challenges by reducing capital spending and focusing on projects that can most directly contribute to their revenue. Wireless carriers now appear focused on satisfying customer demand for enhanced data services, seamless and comprehensive coverage, improved quality of service, and faster data transmission. Many of these initiatives require capital spending for additional network capacity and next-generation technologies. With reduced availability of capital and the transition to next-generation technologies, plans, projects, and capital spending are subject to frequent change as wireless carriers reevaluate and reorder their priorities. As a result, their spending patterns continue to be volatile and difficult to predict. The downturn in the wireless industry has reduced overall demand for our wireless infrastructure products and services, and continues to make it difficult for us to forecast our wireless infrastructure operations for fiscal 2003.

In response to these challenging market conditions, significantly reduced demand for our existing 2G wireless infrastructure products, and the evolving requirements of our customers, we are in the process of transitioning our wireless infrastructure business to a newly developed product platform, the XPort. This new product platform is designed to provide wireless carriers with the flexible, scalable, and high-value tools necessary to address the complexities of transitioning existing networks from 2G to 2.5 and 3G wireless technologies. This new platform is also expected to allow us to transition our wireless infrastructure business to a significantly lower cost structure.

Additionally, the downturn in the wireless industry has caused us to reevaluate our strategy of providing engineering services. We began offering engineering services, which are complementary to our wireless infrastructure products, to wireless carriers and equipment vendors during the fourth quarter of fiscal 2000. During the subsequent two years, we were awarded several profitable multi-million dollar contracts, as well as numerous smaller engagements. However, as wireless carriers continue to reduce their spending, the competition to provide engineering services has become more intense. Reduced contract pricing and fewer opportunities have resulted in reduced revenue and profitability for all engineering services providers. Accordingly, we decided to exit the engineering services business and eliminate all related costs. During the second quarter of fiscal 2003, we completed our remaining contractual obligations, reduced head count, and sold a portion of the assets used in providing these services. We expect there to be no significant additional costs related to our exit from the engineering services business.

Wireless Applications

Our wireless applications business designs and manufactures emergency call box systems and mobile power products for notebook computers, cellular telephones, and handheld devices. Our call box products provide emergency communication over existing wireless networks. In addition to the call box products, we provide system installation and long-term maintenance services. Currently, approximately 14,000 CWT call boxes are installed, the majority of which are serviced and maintained under long-term agreements.

The wireless applications business also includes the ChargeSource family of mobile power products. The universal AC power adapter, our second-generation mobile power system, charges and powers most laptop computers, cellular telephones, handheld devices, and portable printers. During the third quarter of fiscal 2002, the ChargeSource product offering was expanded with the introduction of the ChargeSource universal DC power adapter. This universal DC power adapter allows traveling professionals to use all their existing ChargeSource SmartTips on the road or in the air. The device connects to the in-seat power outlet available on most major airlines or the cigarette lighter plug found in automobiles. Targus currently distributes these two products.

We anticipate expanding the ChargeSource product offering with a low voltage universal power adapter with both AC and DC inputs during the fourth quarter of fiscal 2003. This product is targeted at the users of cellular telephones, pocket PCs, handheld devices, and digital cameras and camcorders. In addition to the low voltage product, we expect to release several new and enhanced power products, which are currently under development, during the first half of fiscal 2004.

The following table sets forth certain items as a percentage of revenue from our condensed consolidated statements of operations for the three and nine months ended October 31, 2002 and 2001. The table and discussion that follows provides information management believes is relevant to an assessment and understanding of our condensed consolidated results of operations and financial condition. The discussion should be read in conjunction with the condensed consolidated financial statements and accompanying notes thereto included elsewhere herein.

	Percentage of Revenue
	Three Months Ended October 31,				Nine Months Ended October 31,
	2002		2001		2002		2001
Revenue	100.0	%	100.0	%	100.0	%	100.0	%
Cost of revenue:
Cost of goods sold	50.3		46.5		49.6		45.6
Software development amortization	2.2		5.5		7.6		4.8
Inventory impairment	(1.1	)	—		4.1		—

Total cost of revenue	51.4		52.0		61.3		50.4

Gross margin	48.6		48.0		38.7		49.6
Selling, general and administrative costs	18.2		23.3		23.0		25.3
Asset impairment charges	—		—		27.3		—
Engineering and support costs	13.0		13.2		14.4		11.2

Operating income (loss)	17.4		11.5		(26.0	)	13.1
Other income, net	0.7		1.7		1.0		2.0
Minority interest in earnings of subsidiary	(0.1	)	(0.2	)	0.2		(0.1	)

Income (loss) before income taxes	18.0		13.0		(24.8	)	15.0
Income tax expense (benefit)	6.6		4.8		(6.1	)	5.5

Net income (loss) before cumulative effect of accounting change	11.4	%	8.2	%	(18.7	)%	9.5	%

Comparison of the Three Months Ended October 31, 2002 to the Three Months Ended October 31, 2001

Consolidated

Revenue

Total revenue for the third quarter of fiscal 2003, which ended October 31, 2002, was $13.0 million compared to $12.3 million for the third quarter of fiscal 2002, an increase of approximately $0.7 million or 5.8 percent. As discussed below, the increase is attributable to increased sales of our wireless applications products, partially offset by decreased sales of our wireless infrastructure products.

Cost of Revenue and Gross Margin

Total cost of revenue for the third quarter of fiscal 2003 was $6.7 million compared to $6.4 million for the third quarter of fiscal 2002, an increase of approximately $0.3 million or 4.5 percent. During the third quarter of fiscal 2003, we analyzed the inventory impairment reserve recorded during the second quarter of fiscal 2003 attributable entirely to our wireless infrastructure business. Based on this analysis and during the current quarter, we reduced the inventory impairment reserve by approximately $0.1 million. Excluding the asset impairment adjustment, total cost of revenue for the third quarter of fiscal 2003 was $6.8 million. As a percentage of revenue, gross margin for the third quarter of fiscal 2003 decreased slightly to 47.5 percent compared to 48.0 percent for the

third quarter of the prior fiscal year. As discussed below, the decrease in gross margin was primarily due to the negative effect of reduced sales of our higher margin wireless infrastructure products and services substantially offset by decreased amortization of capitalized software development costs attributable to our wireless infrastructure business and improved gross margin from increased sales from our wireless applications products.

Selling, General and Administrative Costs

Selling, general and administrative costs for the third quarter of fiscal 2003 were $2.4 million compared to $2.9 million for the third quarter of fiscal 2002, a decrease of $0.5 million or 17.5 percent. This decrease was due to reduced staffing levels, selling expenses, and incentive compensation driven by significantly reduced sales of our wireless infrastructure products and services. Additionally, as of the first quarter of fiscal 2003, and in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we no longer amortize goodwill and other intangible assets deemed to have indefinite lives. For the third quarter of fiscal 2002, selling, general and administrative costs included $0.2 million of amortization of goodwill and other intangible assets deemed to have indefinite lives. As a percentage of revenue, selling, general and administrative costs were 18.2 percent and 23.3 percent for the quarters ended October 31, 2002 and 2001, respectively.

Engineering and Support Costs

Engineering and support costs, net of capitalized software development costs, for the third quarter of fiscal 2003 was $1.7 million compared to $1.6 million for the third quarter of fiscal 2002, an increase of approximately $0.1 million. Gross engineering and support costs, before reduction for capitalized software development costs, decreased $0.5 million in comparison to the third quarter of fiscal 2002. This decrease is a result of our strategy of reducing the cost structure supporting our wireless infrastructure business and developing a single flexible product platform. Offsetting this cash savings and consistent with the reduction in the number of on-going software development programs, capitalized software development costs decreased $0.6 million resulting in an increase in engineering and support costs, net of capitalized software development costs, of $0.1 million for the third quarter of fiscal 2003 in comparison to the corresponding period of the prior fiscal year.

Other Income

Other income, consisting primarily of interest income, decreased approximately $0.1 million to $0.1 million for the third quarter of fiscal 2003 compared to the corresponding period of the prior fiscal year. This decrease was primarily due to lower interest rates earned on invested cash balances.

Income Tax Expense

The effective tax rate for the three months ended October 31, 2002 and 2001 was 36.7 percent and 36.9 percent, respectively.

Wireless Infrastructure

	Three Months Ended October 31,
	2002			2001
	(Dollars in thousands)
Revenue	$	2,909		$	6,931
Cost of revenue:
Cost of goods sold		991			2,542
Software development amortization		263			643
Inventory impairment		(144	)		—

Total cost of revenue		1,110			3,185

Gross profit	$	1,799		$	3,746

Gross margin		61.8	%		54.0	%

Revenue

Wireless infrastructure revenue for the third quarter of fiscal 2003 was $2.9 million compared to $6.9 million for the third quarter of fiscal 2002, a decrease of approximately $4.0 million or 58.0 percent. This decrease reflects the reduced demand for our existing 2G wireless infrastructure products, as well as engineering services, which we ceased providing during the second quarter of fiscal 2003. Revenue from engineering services for the third quarter of fiscal 2002 totaled $2.1 million.

Cost of Revenue and Gross Margin

Wireless infrastructure cost of revenue for the third quarter of fiscal 2003 was $1.1 million compared to $3.2 million for the third quarter of fiscal 2002, a decrease of approximately $2.1 million or 65.2 percent. As discussed above, during the third quarter of fiscal 2003, we recorded an adjustment to the inventory impairment reserve established during the prior quarter and reduced cost of revenue by approximately $0.1 million. Excluding this asset impairment adjustment, wireless infrastructure cost of revenue for the third quarter of fiscal 2003 was $1.2 million. As a percentage of revenue, gross margin for the third quarter of fiscal 2003 increased to 56.9 percent compared to 54.0 percent for the third quarter of the prior fiscal year. The increase in gross margin was primarily due to decreased amortization of capitalized software development costs for the third quarter of fiscal 2003. This decrease is consistent with the asset impairment charge attributable to capitalized software development costs, totaling $5.6 million, recorded during the second quarter of fiscal 2003. We expect amortization of capitalized software development costs to increase in conjunction with the release of our new product platform.

Wireless Applications

	Three Months Ended October 31,
	2002			2001
	(Dollars in thousands)
Revenue	$	10,124		$	5,389
Cost of revenue:
Cost of goods sold		5,558			3,184
Software development amortization		25			36
Inventory impairment		—			—

Total cost of revenue		5,583			3,220

Gross profit	$	4,541		$	2,169

Gross margin		44.9	%		40.2	%

Revenue

Wireless applications revenue for the third quarter of fiscal 2003 was $10.1 million compared to $5.4 million for the third quarter of 2002, an increase of approximately $4.7 million or 87.9 percent. This increase was due primarily to increased sales of our ChargeSource mobile power products. Our combined ChargeSource sales increased approximately $4.0 million to $6.7 million for the third quarter of fiscal 2003. The third quarter of fiscal 2003 reflects increased sell-through of our existing products to both retail and corporate customers, as well as replenishment of distributor inventory levels.

Cost of Revenue and Gross Margin

Wireless applications cost of revenue for the third quarter of fiscal 2003 was $5.6 million compared to $3.2 million for the third quarter of fiscal 2002, an increase of $2.4 million or 73.4 percent. As a percentage of revenue, gross margin for the third quarter of fiscal 2003 increased to 44.9 percent from 40.2 percent for the third quarter of fiscal 2002. The increases in wireless applications cost of revenue and gross margin are primarily attributable to increased sales of our ChargeSource power products and improved absorption of fixed costs driven by higher volume unit sales.

Comparison of the Nine Months Ended October 31, 2002 to the Nine Months Ended October 31, 2001

Consolidated

Revenue

Total revenue for the nine months ended October 31, 2002 was $30.8 million compared to $38.4 million for the nine months ended October 31, 2001, a decrease of approximately $7.6 million or 19.7 percent. As discussed below, the decrease is attributable to decreased sales of our wireless infrastructure products and services partially offset by increased sales of our wireless applications products.

Cost of Revenue and Gross Margin

Total cost of revenue for the nine months ended October 31, 2002 was $18.9 million compared to $19.3 million for the nine months ended October 31, 2001, a decrease of approximately $0.4 million or 2.3 percent. Cost of revenue for the nine months ended October 31, 2002 includes a non-cash inventory impairment charge, totaling approximately $1.3 million. This inventory impairment charge is attributable to our wireless infrastructure. See the section below entitled “Asset Impairment Charges” for additional discussion. Excluding the inventory impairment charge, total cost of revenue for the nine months ended October 31, 2002 was $17.6 million. As a percentage of revenue, gross margin for the nine months ended October 31, 2002 decreased to 42.8 percent compared to 49.6 percent for the corresponding quarter of the prior fiscal year. As discussed below, the decrease in gross margin was primarily due to a change in our mix of business and the negative effect of significantly reduced sales and decreasing gross margin of our historically higher margin wireless infrastructure products and services.

Selling, General and Administrative Costs

Selling, general and administrative costs for the nine months ended October 31, 2002 were $7.1 million compared to $9.7 million for the corresponding period of the prior fiscal year, a decrease of $2.6 million or 27.1 percent. This decrease was due to reduced staffing levels, selling expenses, and incentive compensation driven by significantly reduced sales of our wireless infrastructure products and services. Additionally, as of February 1, 2002 and in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we no longer amortize goodwill and other intangible assets deemed to have indefinite lives. For the nine months ended October 31, 2001, selling, general and administrative costs included $0.5 million of amortization of goodwill and other intangible assets deemed to have indefinite lives. As a percentage of revenue, selling, general and administrative costs were 23.0 percent and 25.3 percent for the nine months ended October 31, 2002 and 2001, respectively.

Asset Impairment Charges

Due to reduced demand for existing wireless infrastructure products in the wireless marketplace and our strategy of investing available resources in the development of XPort, our new product platform, we have analyzed the carrying value of all assets attributable to our wireless infrastructure business. Based on this analysis, we recorded asset impairment charges totaling $8.4 million during the second quarter of fiscal 2003. The following table sets forth the impaired assets and corresponding impairment charges (in thousands):

Property and equipment	$	205
Capitalized software development costs		5,619
Intangible assets		2,583

	$	8,407

In addition to the asset impairment charges above, an inventory impairment charge, totaling $1.3 million, has been recorded as cost of revenue for the nine months ended October 31, 2002. The above impaired assets, as well as the inventory impairment charge are exclusively related to our legacy 2G wireless infrastructure products and do not include any assets related to our engineering services business, which ceased operations during the second quarter of fiscal 2003.

Engineering and Support Costs

Engineering and support costs, net of capitalized software development costs, for the nine months ended October 31, 2002 was $4.4 million compared to $4.3 million for corresponding period of the prior fiscal year, an increase of approximately $0.1 million. Gross engineering and support costs, before reduction for capitalized software development costs, decreased $1.4 million in comparison to the corresponding period of fiscal 2002. This decrease is a result of our strategy of reducing the cost structure supporting our wireless infrastructure business and developing a single flexible product platform. Offsetting this cash savings and consistent with the reduction in the number of on-going software development programs, capitalized software development costs decreased $1.5 million resulting in an increase in engineering and support costs, net of capitalized software development costs, of $0.1 million for the nine months ended October 31, 2002 in comparison to the corresponding period of the prior fiscal year.

Other Income

Other income, consisting primarily of interest income, decreased approximately $0.5 million to $0.3 million for the nine months ended October 31, 2002 compared to the corresponding period of the prior fiscal year. This decrease was primarily due to lower interest rates earned on invested cash balances.

Income Tax Expense

The effective tax rate for the nine months ended October 31, 2002 and 2001 was 17.7 percent and 36.9 percent, respectively. The decrease in the effective tax rate used to compute the income tax benefit for the nine months ended October 31, 2002 relates to permanent differences in our taxable loss as a result of non-deductible asset impairment charges.

Cumulative Effect of Accounting Change

As discussed in Note 4 of the accompanying financial statements, the Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets” effective February 1, 2002. During the second quarter of fiscal 2003, we completed the required transitional impairment test under the new rules and recorded a non-cash charge of $2.9 million to write down fully the carrying value of the goodwill related to our EDX software reporting unit. This reporting unit is included in our wireless infrastructure segment for financial reporting purposes, and the related goodwill was generated through our acquisition of EDX Engineering, Inc. during December 2000. Such charge is reflected as a cumulative effect of change in accounting principle. In calculating the impairment charge, the fair value of the impaired reporting unit underlying the wireless infrastructure segment was estimated using a discounted cash flow methodology. This charge writes off the entire carrying value of the recorded goodwill and accordingly, $2.9 million is recorded as a cumulative charge for the nine months ended October 31, 2002. No comparable charges were recorded during the corresponding period of the prior fiscal year.

Wireless Infrastructure

	Nine Months Ended October 31,
	2002			2001
	(Dollars in thousands)
Revenue	$	9,394		$	22,040
Cost of revenue:
Cost of goods sold		3,217			7,747
Software development amortization		2,256			1,740
Inventory impairment		1,259			—

Total cost of revenue		6,732			9,487

Gross profit	$	2,662		$	12,553

Gross margin		28.3	%		57.0	%

Revenue

Wireless infrastructure revenue for the nine months ended October 31, 2002 was $9.4 million compared to $22.0 million for the nine months ended October 31, 2001, a decrease of approximately $12.6 million or 57.4 percent. This decrease reflects the reduced demand for our existing 2G wireless infrastructure products, as well as engineering services, which we ceased providing during the second quarter of fiscal 2003. Revenue from engineering services for the nine months ended October 31, 2002 and 2001 totaled $0.9 million and $6.0 million, respectively.

Cost of Revenue and Gross Margin

Wireless infrastructure cost of revenue for the third quarter of fiscal 2003 was $6.7 million compared to $9.5 million for the corresponding quarter of the prior fiscal year, a decrease of approximately $2.8 million or 29.0 percent. As discussed above, during the nine months ended October 31, 2002, we recorded a non-cash inventory impairment charge, totaling approximately $1.3 million. Excluding this asset impairment charge, wireless infrastructure cost of revenue for the nine months ended October 31, 2002 was $5.5 million. As a percentage of revenue, gross margin for the nine months ended October 31, 2002 decreased to 41.7 percent compared to 57.0 percent for the corresponding period of the prior fiscal year. The decrease in gross margin is attributable to the ramp-down of our engineering services business, which ceased operations during the second quarter of fiscal 2002, as well as decreased absorption of fixed costs due to reduced sales of our wireless infrastructure products.

Wireless Applications

	Nine Months Ended October 31,
	2002			2001
	(Dollars in thousands)
Revenue	$	21,414		$	16,332
Cost of revenue:
Cost of goods sold		12,062			9,742
Software development amortization		97			108
Inventory impairment		—			—

Total cost of revenue		12,159			9,850

Gross profit	$	9,255		$	6,482

Gross margin		43.2	%		39.7	%

Revenue

Wireless applications revenue for the nine months ended October 31, 2002 was $21.4 million compared to $16.3 million for the corresponding quarter of the prior fiscal year, an increase of approximately $5.1 million or 31.1 percent. This increase was due primarily to increased sales of our ChargeSource mobile power products. Our combined ChargeSource sales increased approximately $5.0 million to $13.5 million for the nine months ended October 31, 2002. This increase is primarily attributable to increased sell-through of our existing products to both retail and corporate customers, as well as replenishment of distributor inventory levels.

Cost of Revenue and Gross Margin

Wireless application cost of revenue for the nine months ended October 31, 2002 was $12.2 million compared to $9.9 million for the corresponding period of the prior fiscal year, an increase of $2.3 million or 23.4 percent. As a percentage of revenue, gross margin for the nine months ended October 31, 2002 increased to 43.2 percent from 39.7 percent for the corresponding period of the prior fiscal year. The increases in wireless applications cost of revenue and gross margin are primarily attributable to increased sales of our ChargeSource power products and improved gross margins on contracts to upgrade and expand existing call box systems.

Liquidity and Capital Resources

Cash and cash equivalents were $24.2 million at October 31, 2002 compared to $21.3 million at January 31, 2002, an increase of $2.9 million. For the nine months ended October 31, 2002, operations generated approximately $7.6 million in cash and discontinued operations provided approximately $0.2 million. Comarco received approximately $0.6 million in settlement and final payment on the sale of our commercial staffing business. These proceeds were offset by payments of divestiture related accrued liabilities of $0.4 million. During the nine months ended October 31, 2002, we expended approximately $3.1 million for software development and $1.5 million for property and equipment.

Cash Flows from Operating Activities

Cash provided by operating activities is primarily derived from the sale of our products and services. Cash provided by operating activities was $7.6 million and $3.9 million for the nine months ended October 31, 2002 and 2001, respectively.

Cash provided by operating activities during the nine months ended October 31, 2002 was primarily a result of our net income from continuing operations before non-cash charges (including asset impairment charges, cumulative effect of accounting change, and depreciation and amortization), and collection of $2.4 million of accounts receivable offset by a net change in deferred income taxes of $2.0 million and a decrease in current liabilities of $0.8 million. Cash provided by operating activities during the nine months ended October 31, 2001 was primarily a result of our net income from continuing operations before non-cash charges, a tax benefit on stock options exercised of $0.6 million, and a net change in deferred income taxes of $1.3 million, offset by a $2.4 million increase in accounts receivable, and a $3.5 million decrease in current liabilities.

Cash Flows from Investing Activities

Cash used in investing activities was $4.7 million and $7.0 million for the nine months ended October 31, 2002 and 2001, respectively. Investing activities for the nine months ended October 31, 2002 and 2001 consisted primarily of cash paid for property and equipment and for the development of software to be used in products currently under development. Of the $1.5 million invested in property and equipment in the nine months ended October 31, 2002, $0.5 million relates to two new manufacturing assembly lines purchased for ChargeSource products. The current year expenditures for software development are less than the prior year due to the previously discussed transition of our wireless infrastructure product offering. Our property and equipment purchases and software development program are expected to be funded with current cash balances and cash provided by operating activities.

Cash Flows from Financing Activities

Cash used in financing activities for the nine months ended October 31, 2002 consisted of $0.4 million used to repurchase 43,943 shares of the Company’s common stock from the open market, offset by $0.2 million from the sales of common stock issued through the Company’s employee and director stock option plans, and $0.1 million from the sales of common stock issued through the Company’s subsidiary stock option plan. Cash provided by financing activities for the nine months ended October 31, 2001 consisted of $0.3 million from the sales of common stock issued through the Company’s employee and director stock option plans, and $0.1 million from the sales of common stock issued through the Company’s subsidiary stock option plan, offset by the repurchase of 124,900 shares of the Company’s common stock in the open market for approximately $1.7 million.

During 1992, the Company’s Board of Directors authorized a stock repurchase program of up to three million shares of common stock. From program inception through October 31, 2002, the Company has repurchased approximately 2,536,000 shares for an average price of $8.22 per share. For the nine months ended October 31, 2002, 43,943 shares were repurchased in the open market for an average price of $9.15 per share. Subsequent to October 31, 2002, the Company has not repurchased any additional shares.

We currently expect fiscal 2003 revenue and operating results attributable to our wireless infrastructure business to be significantly less than fiscal 2002, and, as a result we expect fiscal 2003 cash flows from operations to also decrease in comparison to fiscal 2002. We believe that our existing cash and cash equivalent balances will provide us sufficient funds to satisfy our cash requirements for at least the next twelve months.

Critical Accounting Policies

We have identified the following as critical accounting policies to our company: revenue recognition, capitalized software development costs, accounts receivable, inventory, income taxes, valuation of goodwill, and valuation of long-lived assets. These critical accounting policies have been applied during the third quarter of fiscal 2003 consistent with the prior periods and the year ended January 31, 2002, except as discussed in Note 4 with respect to goodwill amortization and impairment valuation.

For further information, refer to the discussion of critical accounting policies included in Management’s Discussion and Analysis in the Company’s annual report on Form 10-K for the year ended January 31, 2002.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Currency Risk

The Company is exposed to the risk of changes in currency exchange rates. As of October 31, 2002, we had no material accounts receivable denominated in foreign currencies. Our standard terms require customers to pay for our products and services in U.S. dollars. For those orders denominated in foreign currencies, we may limit our exposure to losses from foreign currency transactions through forward foreign exchange contracts. To date, sales denominated in foreign currencies have not been significant and we have not entered into any foreign exchange contracts.

Interest Rate Sensitivity

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline in value. To minimize this risk, we maintain a significant portion of our cash balances in money market funds. In general, money market funds are not subject to interest rate risk because the interest paid on such funds fluctuates with the prevailing interest rate.

We do not hold any derivative financial instruments.

Our cash and cash equivalents have maturities dates of three months or less and the fair value approximates the carrying value in our financial statements.

Equity Price Risk

Our short-term investments consist primarily of balances maintained in a non-qualified deferred compensation plan funded by our executives and directors. We value these investments using the closing market value for the last day of each month. These investments are subject to market price volatility. We reflect these investments on our balance sheet at their market value, with the unrealized gains and losses excluded from reported operations. We have also invested in equity instruments of SwissQual, a privately held company. We evaluate whether any decline in value of certain public and non-public equity investments is other than temporary.

Due to the inherent risk associated with some of our investments, and in light of current stock market conditions, we may incur future losses on the sales, write-downs, or write-offs of our investments. We do not currently hedge against equity price changes.

ITEM 4. CONTROLS AND PROCEDURES

Within the 90 days prior to the date of this report, an evaluation was performed, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to the Securities Exchange Act of 1934, as amended, Rule 13a-14c. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. There have been no significant changes in our internal controls or in other factors which could significantly affect internal controls subsequent to the date the evaluation was performed.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Mobility Electronics, Inc. v. Comarco, Inc. and Comarco Wireless Technologies, Inc.,

Case No. CIV-01-1489-PHX-MHM, U.S. District Court for the District of Arizona:

Comarco Wireless Technologies, Inc. v. Xtend Micro Products, Inc. and iGo Corporation,

Case No. SACV 02-640 AHS (ANx), U.S. District Court for the Central District of California, Southern Division:

Los Angeles County Service Authority for Freeway Emergencies v. Comarco Wireless Technologies, Inc.,

Case No. SACV 02-567 AHS (ANx), U.S. District Court for the Central District of California, Southern Division:

Los Angeles County Service Authority for Freeway Emergencies (“LASAFE”) filed an action against CWT on June 10, 2002, relating to two contracts between LASAFE and CWT concerning call box systems manufactured by CWT, upgraded by CWT to comply with the Americans with Disabilities Act (“ADA”), and maintained by CWT until its contractual obligations to provide maintenance expired. On August 2, 2002, LASAFE filed a first amended complaint. The complaint includes eight counts. In the first five counts LASAFE alleges CWT breached its contractual obligations and implied warranties by failing to properly maintain and repair the call box systems and failing to provide certain deliverables to LASAFE. In the last three counts LASAFE alleges that a patent owned by CWT should be assigned to LASAFE, and CWT should compensate LASAFE, because an LASAFE employee is the true inventor of the invention claimed in the patent. The complaint seeks an unspecified amount of actual and punitive damages, ownership of the patent, an order that CWT specifically perform its obligations under the contracts, recovery of attorneys fees, and an audit to determine the number of allegedly infringing call boxes.

ITEM 2. CHANGES IN SECURITIES

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

11 Schedule of Computation of Net Income (Loss) Per Share

(b) Report on Form 8-K:

None.

SIGNATURE

Pursuant to the requirements of Section 13 or 15(d) 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.


		COMARCO, INC.

Date: December 12, 2002		/s/ Thomas A. Franza Thomas A. Franza President and Chief Executive Officer

Date: December 12, 2002		/s/ Daniel R. Lutz Daniel R. Lutz Vice President and Chief Financial Officer

Certification of Chief Executive Officer

Pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002

In connection with this quarterly report on Form 10-Q of Comarco, Inc. I, Thomas A. Franza, Chief Executive Officer of Comarco, Inc., certify, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, that:

I have reviewed this quarterly report on Form 10-Q of Comarco, Inc.;

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-1 and 15d-14) for the registrant and we have:

designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize, and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: December 12, 2002		/s/ Thomas A. Franza
		Thomas A. Franza Chief Executive Officer

Certification of Chief Executive Officer

Pursuant to Section 906 of the

Sarbanes-Oxley Act of 2002

In connection with this quarterly report on Form 10-Q of Comarco, Inc. I, Thomas A. Franza, Chief Executive Officer of Comarco, Inc., certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

The report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

The information contained in this report fairly presents, in all material respects, the financial condition and results of operations of Comarco, Inc.

Date: December 12, 2002		/s/ Thomas A. Franza
		Thomas A. Franza Chief Executive Officer

Certification of Chief Financial Officer

Pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002

In connection with this quarterly report on Form 10-Q of Comarco, Inc. I, Daniel R. Lutz, Chief Financial Officer of Comarco, Inc., certify, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, that:

I have reviewed this quarterly report on Form 10-Q of Comarco, Inc.;

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations, and cash flows of Comarco, Inc. as of, and for, the periods presented in this quarterly report;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Date: December 12, 2002		/s/ Daniel R. Lutz
		Daniel R. Lutz Chief Financial Officer

Certification of Chief Financial Officer

Pursuant to Section 906 of the

Sarbanes-Oxley Act of 2002

In connection with this quarterly report on Form 10-Q of Comarco, Inc. I, Daniel R. Lutz, Chief Financial Officer of Comarco, Inc., certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

The report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

The information contained in this report fairly presents, in all material respects, the financial condition and results of operations of Comarco, Inc.

Date: December 12, 2002		/s/ Daniel R. Lutz
		Daniel R. Lutz Chief Financial Officer