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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 January 31, 2005
Commission file number 0-11254
COPYTELE, INC.
- -------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 11-2622630
- ------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification no.)
900 Walt Whitman Road
Melville, NY 11747
- -------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(631) 549-5900
- -------------------------------------------------------------------------------
(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 X No
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
On March 7, 2005, the registrant had outstanding 87,069,188 shares of Common
Stock, par value $.01 per share, which is the registrant's only class of common
stock.
TABLE OF CONTENTS
-----------------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
Condensed Balance Sheets as of January 31, 2005 (Unaudited) and
October 31, 2004 3
Condensed Statements of Operations (Unaudited) for the three months
ended January 31, 2005 and 2004 4
Condensed Statements of Cash Flows (Unaudited) for the three months
ended January 31, 2005 and 2004 5
Notes to Condensed Financial Statements (Unaudited) 6 - 11
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations. 12 - 24
Item 3. Quantitative and Qualitative Disclosures About Market Risk. 24
Item 4. Controls and Procedures. 25 - 26
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. 27
Item 6. Exhibits. 27
SIGNATURES 28
2
PART I. FINANCIAL INFORMATION
-----------------------------
Item 1. Financial Statements.
---------------------
COPYTELE, INC.
CONDENSED BALANCE SHEETS
(Unaudited)
------------------
January 31, October 31,
ASSETS 2005 2004*
------ ------------------ ------------------
CURRENT ASSETS:
Cash and cash equivalents $ 1,011,954 $ 1,002,777
Accounts receivable, net of allowance for doubtful accounts of
$149,455 204,085 63,460
Other receivables, net of allowance for doubtful accounts of $108,793 84,308 84,308
Inventories 977,377 999,429
Prepaid expenses and other current assets 27,047 122,482
------------------ ------------------
Total current assets 2,304,771 2,272,456
PROPERTY AND EQUIPMENT, net 36,710 38,085
OTHER ASSETS 5,509 5,509
------------------ ------------------
$ 2,346,990 $ 2,316,050
================== ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Accounts payable $ 398,295 $ 402,640
Accrued liabilities 24,126 40,480
------------------ ------------------
Total current liabilities 422,421 443,120
SHAREHOLDERS' EQUITY:
Preferred stock, par value $100 per share; 500,000 shares authorized;
no shares issued or outstanding - -
Common stock, par value $.01 per share; 240,000,000 shares
authorized; 86,885,698 and 85,523,253 shares issued
and outstanding, respectively 868,857 855,233
Additional paid-in capital 70,518,567 69,474,058
Accumulated deficit (69,462,855) (68,456,361)
------------------ ------------------
1,924,569 1,872,930
------------------ ------------------
$ 2,346,990 $ 2,316,050
================== ==================
* Derived from audited balance sheet.
The accompanying notes are an integral part of these condensed balance sheets.
3
COPYTELE, INC.
--------------
CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)
----------------------------------------------
For the Three Months Ended
January 31,
----------------------------------------
2005 2004
------------------ ------------------
REVENUE $ 212,591 $ 39,000
COST OF REVENUE 64,573 14,599
------------------ ------------------
Gross profit 148,018 24,401
------------------ ------------------
OPERATING EXPENSES
Research and development expenses 589,953 484,543
Selling, general and administrative expenses 566,271 350,161
------------------ ------------------
Total operating expenses 1,156,224 834,704
------------------ ------------------
LOSS FROM OPERATIONS (1,008,206) (810,303)
INTEREST INCOME 1,712 949
------------------ ------------------
NET LOSS $ (1,006,494) $ (809,354)
================== ==================
PER SHARE INFORMATION:
Net loss per share:
Basic and Diluted $ (0.01) $ (0.01)
================== ==================
Shares used in computing net loss per share:
Basic and Diluted 86,163,574 80,615,351
================== ==================
The accompanying notes are an integral part of these condensed statements.
4
COPYTELE, INC.
CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED)
For the Three Months Ended
January 31,
----------------------------------------
2005 2004
------------------ ------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Payments to suppliers, employees and consultants $ (538,725) $ (332,301)
Cash received from customers 71,966 67,650
Interest received 1,712 949
------------------ ------------------
Net cash used in operating activities (465,047) (263,702)
------------------ ------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Payments for purchases of property and equipment (2,256) (2,499)
------------------ ------------------
Net cash used in investing activities (2,256) (2,499)
------------------ ------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options 476,480 110,845
------------------ ------------------
Net cash provided by financing activities 476,480 110,845
------------------ ------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 9,177 (155,356)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,002,777 1,023,531
------------------ ------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,011,954 $ 868,175
================== ==================
RECONCILIATION OF NET LOSS TO NET CASH USED IN OPERATING ACTIVITIES:
Net loss $ (1,006,494) $ (809,354)
Stock option compensation to consultants 5,009 -
Stock awards granted to employees and consultants pursuant to stock
incentive plans 461,272 457,638
Restricted stock issued for services rendered 115,372 -
Depreciation and amortization 3,631 6,158
Change in operating assets and liabilities:
Accounts receivable and other receivables (140,625) 28,650
Inventories 22,052 8,599
Prepaid expenses and other current assets 95,435 3,052
Other assets - 500
Accounts payable and accrued liabilities (20,699) 41,055
----------------- ------------------
Net cash used in operating activities $ (465,047) $ (263,702)
================= ==================
The accompanying notes are an integral part of these condensed statements.
5
COPYTELE, INC.
--------------
NOTES TO CONDENSED FINANCIAL STATEMENTS
---------------------------------------
(UNAUDITED)
-----------
1. NATURE AND DEVELOPMENT OF BUSINESS AND FUNDING
----------------------------------------------
Organization and Basis of Presentation
- --------------------------------------
CopyTele, Inc. was incorporated on November 5, 1982. Our principal
operations are the development, production and marketing of multi-functional
hardware and software based encryption products that provide information
security for domestic and international users over virtually every
communications media and the development, production and marketing of thin, high
brightness, flat panel video displays.
The condensed financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America ("US
GAAP") for interim financial reporting. Accordingly, they do not include all of
the information and footnotes required by US GAAP for complete financial
statements. The information contained herein is for the three-month periods
ended January 31, 2005 and 2004. In management's opinion, all adjustments
(consisting only of normal recurring adjustments considered necessary for a fair
presentation of the results of operations for such periods) have been included
herein.
The results of operations for interim periods may not necessarily reflect
the results of operations for a full year. Reference is made to the audited
financial statements and notes thereto included in our Annual Report on Form
10-K for the fiscal year ended October 31, 2004, for more extensive disclosures
than contained in these condensed financial statements.
Products
- --------
We currently have 17 different products in our line of hardware-based
encryption solutions. Our encryption products are multi-functional, hardware
based digital encryption systems that provide high-grade voice, fax and data
encryption using either the Citadel(TM) CCX encryption cryptographic chip (which
is manufactured by the Harris Corporation) or the Triple DES or AES algorithm
(algorithms available in the public domain which are used by many U.S.
government agencies). In addition, we have developed two software-based security
products, one of which uses either the Triple DES or the AES algorithm to
encrypt data files and e-mail attachments in both desktop and laptop computers
utilizing Microsoft Windows operating systems, and the other of which can
encrypt voice and data in cellular and satellite phones, scanners, and printers.
We sell our encryption products directly to end-users and through dealers and
distributors.
We are also continuing our research and development work on our electron
emission display ("Flat CRT") technology. We have been developing a Flat CRT
6
display based on our thin film technology ("TFT") and have produced prototype
Flat CRT displays containing TFT color matrix structures.
Funding and Management's Plans
- ------------------------------
From our inception we had met our liquidity and capital expenditure needs
primarily through the proceeds from sales of common stock in our initial public
offering, in private placements, upon exercise of warrants issued in connection
with the private placements and public offering, and upon the exercise of stock
options. Commencing in the fourth quarter of fiscal 1999, we began to generate
cash flows from sales of our encryption products.
During the three months ended January 31, 2005, our operating activities
used approximately $465,000 in cash. This resulted from payments to suppliers,
employees and consultants of approximately $539,000, which was offset by cash of
approximately $72,000 received from collections of accounts receivable related
to sales of encryption products and approximately $2,000 of interest income
received. In addition, we received approximately $476,000 in cash upon the
exercise of stock options and purchased approximately $2,000 of equipment. As a
result, our cash and cash equivalents at January 31, 2005 increased to
approximately $1,012,000 from approximately $1,003,000 at the end of fiscal
2004.
We believe that our existing cash and accounts receivable, together with
cash flows from expected sales of encryption products and flat panel displays,
and other potential sources of cash flows, will be sufficient to enable us to
continue in operation until at least the end of the first quarter of fiscal
2006. We anticipate that, thereafter, we will require additional funds to
continue our marketing, production, and research and development activities, and
we will require outside funding if cash generated from operations is
insufficient to satisfy our liquidity requirements. However, our projections of
future cash needs and cash flows may differ from actual results. If current cash
and cash that may be generated from operations are insufficient to satisfy our
liquidity requirements, we may seek to sell debt or equity securities or to
obtain a line of credit prior to the first quarter of fiscal 2006. The sale of
additional equity securities or convertible debt could result in dilution to our
stockholders. We currently have no arrangements with respect to additional
financing. There can be no assurance that we will generate sufficient revenues
in the future (through sales or otherwise) to improve our liquidity or sustain
future operations, that our production capabilities will be adequate, that other
products will not be produced by other companies that will render our products
obsolete, or that other sources of funding would be available, if needed, on
favorable terms or at all.
The auditor's report on our financial statements as of October 31, 2004
states that the net loss incurred during the year ended October 31, 2004, our
accumulated deficit as of that date, and the other factors described in Note 1
to the Financial Statements included in our Annual Report on Form 10-K for the
year ended October 31, 2004, raise substantial doubt about our ability to
continue as a going concern. The auditor's report on our financial statements
for the year ended October 31, 2003 contained a similar statement. Our financial
statements have been prepared assuming we will continue as a going concern and
do not include any adjustments that might result from the outcome of this
uncertainty.
7
2. STOCK-BASED COMPENSATION
------------------------
Financial Accounting Standards Board ("FASB") Statement of Financial
Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure" ("SFAS No. 148"), addresses financial
accounting and reporting for recording expenses for the fair value of stock
options. SFAS No. 148 requires prominent disclosures in financial statements
about the effects of stock-based compensation and provides alternative methods
of transition for a voluntary change to fair value based method of accounting
for stock-based employee compensation. SFAS No. 123 "Accounting for Stock Based
Compensation" ("SFAS No. 123") encourages but does not require companies to
record compensation cost for stock-based employee compensation plans at fair
value. We account for stock options granted to employees using the intrinsic
value method prescribed in Accounting Principles Board ("APB") Opinion No. 25
"Accounting for Stock Issued to Employees" ("APB Opinion No. 25") and comply
with the disclosure provisions of SFAS No. 123 and SFAS No. 148. Compensation
cost for stock options issued to employees and directors is measured as the
excess, if any, of the quoted market price of our stock at the date of grant
over the amount an employee or director must pay to acquire the stock. In
accordance with APB Opinion No. 25, we have not recognized any compensation
cost, as all option grants to employees and directors have been made at the fair
market value of our stock on the date of grant.
Had compensation cost for stock options granted to employees and directors
been determined at fair value, consistent with SFAS No. 123, our net loss and
net loss per share would have increased to the following adjusted amounts:
For the Three Months Ended
January 31,
----------------------------
2005 2004
------------ ------------
Net loss as reported $ (1,006,494) $ (809,354)
Add: Total stock-based employee
compensation expense, determined under
fair value based method, for all (326,616) (184,123)
awards, net of related tax effect ------------- ------------
Net loss as adjusted $ (1,333,110) $ (993,477)
============= ============
Net loss per share, basic and diluted:
As reported $ (0.01) $ (0.01)
============= ============
As adjusted $ (0.02) $ (0.01)
============= ============
The fair value of each option grant is estimated at the date of grant using
the Black-Scholes option pricing model. The following weighted-average
assumptions were used for grants during the three months ended January 31, 2005
and 2004: risk free interest rates of 2.75% and 2.02%; expected dividend yields
of 0% for both periods; expected lives of 2.50 years and 2.37 years; and
expected stock price volatility of 122% and 128%. The weighted average fair
value of options granted under SFAS No. 123 for the three months ended January
31, 2005 and 2004 was $0.50 and $0.30.
During the three-month periods ended January 31, 2005 and 2004, we granted
to employees and consultants options to purchase 640,000 shares and 610,000
shares, respectively, pursuant to the CopyTele, Inc. 2003 Share Incentive Plan
(the "2003 Share Plan"). During the three-month periods ended January 31, 2005
and 2004, stock options to purchase 637,500 shares and 219,500 shares,
respectively, were exercised, with aggregate proceeds of approximately $476,000
and $111,000, respectively.
We account for options granted to non-employee consultants using the fair
value method required by SFAS No. 123. Compensation expense for consultants,
recognized during the three-month period ended January 31, 2005, was
approximately $5,000. We recognized no such compensation expense for consultants
during the three-month period ended January 31, 2004. Such compensation expense
was recognized in accordance with Emerging Issues Task Force Issue No. 00-08,
"Accounting by a Grantee for an Equity Instrument to be Received in Conjunction
with Providing Goods or Services" and No. 96-18 "Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services," and is included in either research
and development expenses or selling, general and administrative expenses, as
applicable, in the accompanying statements of operations.
During the three-month periods ended January 31, 2005 and 2004, we issued
530,945 shares and 694,630 shares, respectively, of common stock to certain
employees for services rendered, principally in lieu of cash compensation,
pursuant to the 2003 Share Plan. We recorded compensation costs for the
three-month periods ended January 31, 2005 and 2004 of approximately $449,000
and $331,000, respectively, for the shares of common stock issued to employees.
In addition, during the three-month periods ended January 31, 2005 and 2004, we
issued 15,000 shares and 267,330 shares, respectively, of common stock to
consultants for services rendered pursuant to the 2003 Share Plan. We recorded
consulting expense for the three-month periods ended January 31, 2005 and 2004,
of approximately $13,000 and $127,000, respectively, for the shares of common
stock issued to consultants.
As of January 31, 2005, 11,420,184 shares and 25,773 shares, respectively,
were available for future grants under the 2003 Share Plan and the CopyTele,
Inc. 2000 Share Incentive Plan.
During the three-month period ended January 31, 2005, we issued 179,000
shares of restricted common stock to our outside legal counsel in satisfaction
of outstanding bills for services rendered in the amount of approximately
$115,000.
In December 2004, the FASB issued SFAS No. 123(R), "Accounting for
Stock-Based Compensation" ("SFAS No. 123(R)"). SFAS No. 123(R) establishes
standards for the accounting for transactions in which an entity exchanges its
equity instruments for goods or services. This Statement focuses primarily on
accounting for transactions in which an entity obtains employee services in
share-based payment transactions. SFAS No. 123(R) requires that the fair value
of such equity instruments be recognized as an expense in the historical
financial statements as services are performed. Prior to SFAS No. 123(R), only
certain pro forma disclosures of fair value were required. The provisions of
this Statement are effective for the first interim reporting period that begins
after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) commencing with
9
the quarter ending October 31, 2005. We are currently evaluating the impact of
SFAS No. 123(R). The adoption of SFAS No. 123(R) is expected to have a material
effect on our financial statements.
3. CONCENTRATION OF CREDIT RISK
----------------------------
Financial instruments that potentially subject us to concentrations of
credit risk consist principally of accounts receivable from sales in the
ordinary course of business. Management reviews our accounts receivable and
other receivables for potential doubtful accounts and maintains an allowance for
estimated uncollectible amounts. Generally, no collateral is received from
customers for our accounts receivable. At January 31, 2005, one customer in the
Encryption Products and Services Segment represented 98% of net accounts
receivable. At October 31, 2004, two customers in the Encryption Products and
Services Segment represented 48% and 44%, respectively, of net accounts
receivable. During the three months ended January 31, 2005, one customer in the
Encryption Products and Services Segment represented 94% of total net revenues.
During the three months ended January 31, 2004, two customers in the Encryption
Products and Services Segment represented 67% and 33%, respectively, of total
net revenues.
4. OTHER RECEIVABLES
-----------------
In May and June 2002, we received restricted common stock from a customer
in connection with an outstanding accounts receivable of approximately $323,000
and anticipated settling this accounts receivable through the ultimate sale of
the common stock. This customer has agreed with us to cure any deficiency
between the proceeds from the sale of the common stock and the balance of the
outstanding accounts receivable. In addition, the customer's principal
shareholder has personally agreed to cure any deficiency in the event that the
customer defaults on its agreement to cure such deficiency, up to $292,000. As
of January 31, 2005, we hold 240,000 shares of such common stock, subject to no
restrictions, with a fair value of approximately $60,000, and we intend to sell
the remaining portion of such stock during the next twelve months. This
receivable is stated at management's estimate of its net realizable value.
5. INVENTORIES
-----------
Inventories consist of the following as of:
January 31, October 31,
2005 2004
------------ ------------
Component parts $ 296,144 $ 304,862
Work-in-process 97,600 114,075
Finished products 583,633 580,492
------------ ------------
$ 977,377 $ 999,429
============ ============
6. NET INCOME (LOSS) PER SHARE OF COMMON STOCK
-------------------------------------------
We comply with the provisions of SFAS No. 128, "Earnings Per Share" ("SFAS
No. 128"). In accordance with SFAS No. 128, basic net income (loss) per common
10
share ("Basic EPS") is computed by dividing net income (loss) by the weighted
average number of common shares outstanding. Diluted net income (loss) per
common share ("Diluted EPS") is computed by dividing net income (loss) by the
weighted average number of common shares and dilutive common share equivalents
and convertible securities then outstanding. Diluted EPS for all periods
presented is the same as Basic EPS, as the inclusion of the effect of common
stock equivalents then outstanding would be anti-dilutive. For this reason,
excluded from the calculation of Diluted EPS for the three-month periods ended
January 31, 2005 and 2004, were options to purchase 17,819,546 shares and
15,853,546 shares, respectively.
7. SEGMENT INFORMATION
-------------------
We follow the provisions of SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS No. 131"). Reportable operating
segments are determined based on management`s approach. The management approach,
as defined by SFAS No. 131, is based on the way that the chief operating
decision-maker organizes the segments within an enterprise for making operating
decisions and assessing performance. While our results of operations are
primarily reviewed on a consolidated basis, the chief operating decision-maker
also manages the enterprise in two segments: (i) Flat-panel display and (ii)
Encryption products and services. The following represents selected financial
information for our segments for the three-month periods ended January 31, 2005
and 2004:
Encryption Products
Segment Data Flat-Panel Display and Services Total
- ------------------------------------------- --------------------- ---------------------- ---------------------
Three Months Ended January 31, 2005:
Revenue $ - $ 212,591 $ 212,591
Net loss (517,239) (489,255) (1,006,494)
Three Months Ended January 31, 2004:
Revenue $ - $ 39,000 $ 39,000
Net loss (438,068) (371,286) (809,354)
8. INVESTIGATION AND RECOVERY EFFORTS REGARDING MISAPPROPRIATED FUNDS
------------------------------------------------------------------
During fiscal 2004 and the first month of fiscal 2005, a former employee
embezzled approximately $185,000 in cash, of which approximately $10,000 relates
to the first quarter of fiscal 2005. During the first quarter of fiscal 2005, we
recovered approximately $110,000 of such loss through insurance proceeds. Of
such recovery, $10,000 was applied toward the first quarter of fiscal 2005, and
the remaining $100,000 was applied toward fiscal 2004. Accordingly, we recorded
a charge to expense in fiscal 2004 of approximately $75,000 related to this
matter, but no charge in the first quarter of fiscal 2005. During fiscal 2003
and 2002 the former employee committed additional fraudulent activities
aggregating approximately $25,000, which were expensed during such fiscal
periods. We will seek additional recoveries from other parties which, if we are
successful in recovering additional amounts, will be recorded as recoveries in
the period received.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
------------------------------------------------------------------------
of Operations.
--------------
GENERAL
- -------
Our principal operations are the development, production and marketing of
multi-functional hardware and software based encryption products that provide
information security for domestic and international users over virtually every
communications media and the development, production and marketing of thin, high
brightness, flat panel video displays ("Flat CRT").
We currently have 17 different products in our line of hardware-based
encryption solutions. Our encryption products are multi-functional, hardware
based digital encryption systems that provide high-grade voice, fax and data
encryption using either the Citadel(TM) CCX encryption cryptographic chip (which
is manufactured by the Harris Corporation) or the Triple DES or AES algorithm
(algorithms available in the public domain which are used by many U.S.
government agencies). In addition, we have developed two software-based security
products, one of which uses either the Triple DES or the AES algorithm to
encrypt data files and e-mail attachments in both desktop and laptop computers
utilizing Microsoft Windows operating systems, and the other of which can
encrypt voice and data in cellular and satellite phones, scanners, and printers.
We sell our encryption products directly to end-users and through dealers and
distributors.
We have developed modifications of our standard products for specific
applications. We have developed and are producing several products for use with
the satellite communications network of Thuraya Satellite Telecommunications
Company ("Thuraya"), a network built by Boeing Satellite Systems, Inc.
("Boeing") that provides communication in Europe, Africa, Russia, the Middle
East and Asia. Our products can encrypt voice communication, using a compact
encrypted module attached to the Thuraya handset, and automatically encrypt fax
communications over the Thuraya network. Our products thus enable the Thuraya
network to provide encrypted communications between satellite phones, from
satellite phones to desk-based phones, or between desk-based phones.
Additionally, we have developed three products to provide satellite and cellular
fax encryption between fax machines and between computers and fax machines.
In April 2004, we entered into an agreement with Boeing to provide our
encryption products for use over the Thuraya network. Under a September 2004
modification to the agreement, Boeing is the exclusive distributor of eight of
our products.
In connection with Boeing becoming the exclusive distributor of some of our
products, Boeing authorized us to use its name on our website. Accordingly,
customers desiring to purchase such products can find authorized Boeing sales
information on the "Encryption Products" page of our website. In January 2005,
Boeing introduced, demonstrated and began marketing our encryption products to
more than 100 Thuraya service providers. We assisted Boeing with such
demonstrations. The products introduced included two new encryption products
that we are selling to Boeing, the Thuraya DCS-1400 for voice encryption and the
Thuraya USS-900T for fax encryption. These products contain the brand name of
Thuraya and their operating controls are in the Arabic language.
12
We have also developed a method for encrypting Short Message Service
("SMS"), an inexpensive text message communication protocol that is used in many
cellular and satellite phones. We will utilize this encryption solution in
conjunction with the Thuraya handsets.
Our wireless encryption products are providing secure communications with
many different satellite phones, including the Thuraya 7100/7101 handheld
terminal ("HHT"), Globalstar GPS-1600 HHT, Telit SAT-550/600 HHT, Globalstar
GPS-2800/2900 fixed phone, Iridium 9500/9505 HHT, Inmarsat M4 and Mini "M" HHT
units from Thrane & Thrane and Nera. Through the use of our products, encrypted
satellite communications are available for many Thuraya docking units, including
Teknobli's Next Thuraya Docker, Thuraya Fixed Docking Adapter, APsi's FDU-2500
Fixed Docking Unit, Sattrans' SAT-OFFICE Fixed Docking Unit and SAT-VDA
Hands-Free Car Kit.
We also have developed modifications of our standard equipment for other
applications. We have provided modifications of our hardware and software
encryption solutions to several large organizations which are evaluating our
products in connection with their security requirements. We are supplying to a
major U.S. defense contractor our USS-900AF automatic fax encryption product to
secure its worldwide fax communication. We have entered into an agreement with
another major U.S. company and supplied an initial proof of concept encryption
solution utilizing another of our products that has been configured to interface
with that company's satellite global positioning system ("GPS") and data
communication fleet management network.
We have supplied another major U.S. company our USS-900AF and our DCS-1700
products. The DCS-1700 secures data links between scanners and printers in
multi-functional products. That company is in the process of evaluating the
market potential for these products for the health care industry. We are also
marketing the DCS-1700 to other major companies to meet the security
requirements of their products.
We are also continuing our research and development work on our Flat CRT
electron emission display technology. We have provided our model CTVD-101 Flat
CRT display to a potential customer for evaluation of the display's performance
in a product which must operate over a wide ambient temperature range in an
outdoor environment. After successfully testing our display, the customer
ordered a seed quantity of modules containing our display, to replace liquid
crystal display ("LCD") modules in our customer's product. We have initially
supplied the customer with model CTVD-101 displays. To be able to supply large
quantities of displays to this customer and other potential customers, however,
we are planning to produce our CTVD-201 and CTVD-202 Flat CRT displays, which
are based on our more current thin film technology ("TFT"), rather than the
CTVD-101. We are planning to replace the CTVD-101 displays previously provided
to our customer with CTVD-201 displays for our customer's evaluation.
We entered into an agreement, in June 2004, with an Asian company, which
currently mass produces TFT LCDs, to jointly produce prototypes of two modified
TFT color matrix pixel structures for our Flat CRT display based on our high
brightness technology. The two color matrix structures, which are components of
our displays, are a 7-inch (diagonal) with 1440 x 234 pixels and a 5.5 inch
13
(diagonal) with 960 x 234 pixels. As part of our TFT color matrix design, each
pixel contains memory to achieve high brightness at video rates. We have funded
the development of these prototypes, and may enter into a further agreement for
commercial production of the structures or the complete color displays. The
company has agreed to produce such structures only for us.
We have developed, with the assistance of Volga Svet Ltd. ("Volga"), a
Russian display company that we have been working with for over seven years,
prototypes of our Model CTDV-201 and Model CTDV-202, which contain the modified
TFT color matrix structures we received under our agreement with the Asian
company. The prototype Model CTDV-201 display is a 5.5 inch (diagonal)
monochrome display with 320 x 234 pixels and the prototype Model CTDV-202 is a
5.5 inch (diagonal) color display with 960 x 234 pixels. We are also completing
the assembly of a 7.0 inch (diagonal) prototype color display containing the
modified TFT color matrix structures with 1,440 x 234 pixels. The Asian company
has recently supplied additional quantities of the TFT color matrix structures
for the CTVD-201 and CTVD-202. We are utilizing these additional quantities for
a reliability evaluation of our displays. Also, we have modified the color
matrix structures to incorporate chip on glass ("COG") technology which will be
utilized for production of these displays. As part of our reliability
evaluation, we are using both the CTVD-201 and CTDV-202 color Flat CRT displays.
Upon the completion of our evaluation of the structures, we believe that Volga
will be able to supply a limited production capability. We anticipate utilizing
either the Asian company or other TFT LCD production companies to mass produce
the display for potential users. However, we have not yet entered into any
agreement for such production, and there can be no assurance that we can do so
on commercially acceptable terms or at all.
To activate the red, green and blue phosphors contained in the modified TFT
color matrix pixel structure in our displays, we are using our current electron
emission technology and are developing a new electron emission system using
nanotube technology in cooperation with a U.S. company. The new technology
consists of a unique array of low voltage controllable nanotubes for electron
emission. These nanotubes are extremely small carbon elements, approximately
2,500 times thinner than the width of a human hair, that emit electrons under
controllable conditions. In cooperation with that company, we are continuing to
produce experimental nanotube design configurations to meet our design
requirements. We have the exclusive right to use this company's nanotube
technology for display applications.
There can be no assurance that we can produce commercial quality displays,
that we can produce such displays in commercial quantities, that we can
successfully market our displays, or of the revenue we might derive from sales
of our displays.
Our operations and the achievement of our objectives in marketing,
production, and research and development are dependent upon an adequate cash
flow. Accordingly, in monitoring our financial position and results of
operations, particular attention is given to cash and accounts receivable
balances and cash flows from operations. Since our initial public offering, our
cash flows have been primarily generated through the sales of common stock in
private placements and upon exercise of stock options. We also generate cash
flows from sales of our encryption products. In an effort to generate sales, we
have marketed our encryption products directly to U.S. and international
distributors, dealers and original equipment manufacturers that market our
14
encryption products and to end-users. We have also been working with several
large organizations to provide them with both our hardware and software
encryption solutions for them to evaluate whether the solutions meet their
security requirements and have begun supplying several major U.S. companies with
our encryption products. We have also begun to market our flat panel video
display products to potential purchasers for incorporation into their products.
We anticipate that current cash on hand, cash generated from operations, and
cash generated from the exercise of employee options will be adequate to fund
our operations at least through the end of the first quarter of fiscal 2006.
CRITICAL ACCOUNTING POLICES
- ---------------------------
Our financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America. As such, we are
required to make certain estimates, judgments and assumptions that management
believes are reasonable based upon the information available. These estimates
and assumptions affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the dates of the financial
statements and the reported amounts of revenue and expenses during the reporting
periods.
We believe the following critical accounting polices affect the more
significant judgments and estimates used in the preparation of our financial
statements. For additional discussion on the application of these and other
accounting polices, refer to the financial statements and notes thereto included
in our Annual Report on Form 10-K for the year ended October 31, 2004.
Revenue Recognition
- -------------------
Sales
-----
Revenues from sales are recorded when all four of the following
criteria are met: (i) persuasive evidence of an arrangement exists;
(ii) delivery has occurred and title has transferred or services have
been rendered; (iii) our price to the buyer is fixed or determinable;
and (iv) collectibility is reasonably assured.
Sales Returns and Allowances
----------------------------
Revenues are recorded net of estimated sales returns.
Inventories
- -----------
Inventories are stated at the lower of cost, including material, labor and
overhead, determined on a first-in, first-out basis, or market, which represents
our best estimate of market value. We regularly review inventory quantities on
hand, particularly finished goods, and record a provision for excess and
obsolete inventory based primarily on forecasts of future product demand. Our
net income (loss) is directly affected by management's estimate of the
realizability of inventories. To date, sales of our products have been limited.
Accordingly, there can be no assurance that we will not be required to reduce
the selling price of our inventory below our current carrying value.
15
Stock Based Compensation
- ------------------------
We account for stock options granted to employees and directors using the
intrinsic value method prescribed in APB Opinion No. 25 "Accounting for Stock
Issued to Employees" and comply with the disclosure provision of SFAS No. 123
"Accounting for Stock Based Compensation" and SFAS No. 148 "Accounting for Stock
Based Compensation - Transition and Disclosure, an amendment of SFAS No. 123".
If we were to include the cost of employee stock option compensation in the
financial statements, our net loss for the three-month periods ended January 31,
2005 and 2004 would have increased by approximately $327,000 and $184,000,
respectively, based on the fair value of the stock options granted to employees.
See "-Impact of Recent Accounting Pronouncements."
RESULTS OF OPERATIONS
- ---------------------
Three months ended January 31, 2005 compared with three months ended January 31,
- --------------------------------------------------------------------------------
2004
- ----
Sales
Revenue. Revenue from sales increased by approximately $174,000 in the
three-month period ended January 31, 2005, to approximately $213,000, as
compared to approximately $39,000 in the comparable prior-year period. All
revenue during both periods was from encryption products and services. The
increase in sales was principally due to an increase in unit sales of our
encryption products. Our encryption sales have been limited and are sensitive to
individual large transactions. We believe that changes in sales between periods
generally represent the nature of the early stage of our product and sales
channel development.
Gross Profit. Gross profit from sales of encryption products and services
increased by approximately $124,000 in the three-month period ended January 31,
2005, to approximately $148,000, as compared to approximately $24,000 in the
comparable prior-year period. The increase in gross profit was primarily due to
the increase in revenue. Gross profit as a percent of revenue increased to
approximately 70% in the three-month period ended January 31, 2005, as compared
to approximately 63% in the comparable prior-year period. Because of the limited
number of transactions during each of the periods, gross profit percentages are
sensitive to individual transactions.
Research and Development Expenses
Research and development expenses increased by approximately $105,000 in
the three-month period ended January 31, 2005, to approximately $590,000, from
approximately $485,000 in the comparable prior-year period. The increase in
research and development expenses was principally due to an increase in employee
compensation and related costs of approximately $114,000.
16
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased by approximately
$216,000 to approximately $566,000 in the three-month period ended January 31,
2005, from approximately $350,000 in the comparable prior-year period. The
increase in selling, general and administrative expenses was principally due to
an increase in professional fees of approximately $167,000, approximately
$50,000 of which was incurred with respect to a theft by a former employee (see
"-Investigation and Recovery Efforts Regarding Misappropriated Funds"), and an
increase in employee compensation and related costs of approximately $40,000.
Interest Income
Interest income was approximately $2,000 in three-month period ended
January 31, 2005, compared to approximately $1,000 in the comparable prior-year
period.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
From our inception through June 2001, we met our liquidity and capital
expenditure needs primarily through the proceeds from sales of common stock in
our initial public offering, in private placements, upon exercise of warrants
issued in connection with the private placements and public offering, and upon
the exercise of stock options. Commencing in the fourth quarter of fiscal 1999,
we also began to generate cash from sales of our encryption products, and, from
June 2001 to January 2002, we received development payments from Futaba
Corporation of Japan.
During the three months ended January 31, 2005, our operating activities
used approximately $465,000 in cash. This resulted from payments to suppliers,
employees and consultants of approximately $539,000, which was offset by cash of
approximately $72,000 received from collections of accounts receivable related
to sales of encryption products and approximately $2,000 of interest income
received. In addition, during the three months ended January 31, 2005, we
received approximately $476,000 in cash upon the exercise of stock options and
purchased approximately $2,000 of equipment. As a result, our cash and cash
equivalents at January 31, 2005 increased to approximately $1,012,000 from
approximately $1,003,000 at the end of fiscal 2004.
Accounts receivable increased by approximately $141,000 from approximately
$63,000 at the end of fiscal 2004 to approximately $204,000 at January 31, 2005.
The increase in accounts receivable is a result of the increase in revenue and
the timing of collections. Inventories decreased approximately $22,000 from
approximately $999,000 at October 31, 2004 to approximately $977,000 at January
31, 2005, as a result of the timing of shipments and production schedules.
Prepaid expenses and other current assets decreased by approximately $95,000
from approximately $122,000 at the end of fiscal 2004 to approximately $27,000
at January 31, 2005. The decrease in prepaid expenses and other assets is
primarily due to the receipt of a receivable of approximately $100,000 from
insurance companies related to a theft by a former employee (see "-Investigation
and Recovery Efforts Regarding Misappropriated Funds"). Accounts payable and
accrued liabilities decreased by approximately $21,000 from approximately
$443,000 at the end of fiscal 2004 to approximately $422,000 at January 31,
2005, as a result of the timing of payments.
17
As a result of these changes, working capital at January 31, 2005 increased
to approximately $1,882,000 from approximately $1,829,000 at the end of fiscal
2004.
Our working capital includes inventory of approximately $977,000 at January
31, 2005. Management has recorded our inventory at the lower of cost or our
current best estimate of net realizable value. To date, sales of our products
have been limited. Accordingly, there can be no assurance that we will not be
required to reduce the selling price of our inventory below our current carrying
value.
During the three-month periods ended January 31, 2005 and 2004, we issued
shares of common stock to certain employees for services rendered, principally
in lieu of cash compensation. We recorded compensation expense for the
three-month periods ended January 31, 2005 and 2004 of approximately $449,000
and $331,000, respectively, for shares of common stock issued to employees. In
addition during three-month periods ended January 31, 2005 and 2004, we issued
shares of common stock to consultants for services rendered. We recorded
consulting expense for the three-month periods ended January 31, 2005 and 2004
of approximately $13,000 and $127,000, respectively, for shares of common stock
issued to consultants. During the three-month period ended January 31, 2005, we
also issued 179,000 shares of restricted common stock to our outside legal
counsel in satisfaction of outstanding bills for services rendered in the amount
of approximately $115,000.
The auditor's report on our financial statements as of October 31, 2004
states that the net loss incurred during the year ended October 31, 2004, our
accumulated deficit as of that date, and the other factors described in Note 1
to the Financial Statements included in our Annual Report on Form 10-K for the
year ended October 31, 2004, raise substantial doubt about our ability to
continue as a going concern. The auditor's report on our financial statements
for the year ended October 31, 2003 contained a similar statement. Our financial
statements have been prepared assuming we will continue as a going concern and
do not include any adjustments that might result from the outcome of this
uncertainty.
We believe that our existing cash and accounts receivable, together with
cash flows from expected sales of encryption products and flat panel displays,
and other potential sources of cash flows, will be sufficient to enable us to
continue in operation until at least the end of the first quarter of fiscal
2006. We anticipate that, thereafter, we will require additional funds to
continue our marketing, production, and research and development activities, and
we will require outside funding if cash generated from operations is
insufficient to satisfy our liquidity requirements. However, our projections of
future cash needs and cash flows may differ from actual results. If current cash
and cash that may be generated from operations are insufficient to satisfy our
liquidity requirements, we may seek to sell debt or equity securities or to
obtain a line of credit prior to the first quarter of fiscal 2006. The sale of
additional equity securities or convertible debt could result in dilution to our
stockholders. We currently have no arrangements with respect to additional
financing. There can be no assurance that we will generate sufficient revenues
in the future (through sales or otherwise) to improve our liquidity or sustain
future operations, that our production capabilities will be adequate, that other
18
products will not be produced by other companies that will render our products
obsolete, or that other sources of funding would be available, if needed, on
favorable terms or at all.
We are seeking to improve our liquidity through increased sales or license
of products and technology. In an effort to generate sales, we have marketed our
encryption products directly to U.S. and international distributors, dealers and
original equipment manufacturers that market our encryption products and to
end-users. We have been working with several large organizations to provide them
with both our hardware and software encryption solutions for them to evaluate
whether the solutions meet their security requirements and have begun supplying
several major U.S. companies with our encryption products. We have also begun to
market our flat panel video display products to potential purchasers for
incorporation into their products. During the three months ended January 31,
2005, we have recognized revenue from sales of encryption products of
approximately $213,000.
The following table presents our expected cash requirements for contractual
obligations outstanding as of January 31, 2005:
Payments Due by Period
----------------------
Less
Contractual than 1-3 4-5 After
Obligations 1 year years years 5 years Total
- ---------------------------- ------------- ------------- ---------- ----------- -------------
Consulting
Agreement $ 70,000 - - - $ 70,000
Noncancelable Operating
Leases $ 257,000 $ 88,000 - - $ 345,000
------------- ------------- ---------- ----------- -------------
Total Contractual
Cash Obligations $ 327,000 $ 88,000 - - $ 415,000
============= ============= ========== =========== =============
INVESTIGATION AND RECOVERY EFFORTS REGARDING MISAPPROPRIATED FUNDS
- ------------------------------------------------------------------
In December 2004, we determined that a former accounting employee embezzled
funds from us. We initially conducted an internal investigation, and
subsequently engaged an independent accounting firm to conduct an independent
investigation of this matter. Through our internal investigation, we determined
that the amount embezzled by the employee during fiscal 2004 and the first month
of fiscal 2005 was approximately $189,000. We also discovered approximately
$4,000 in deposits to our account during these periods that we believe were made
by the employee in an effort to conceal his fraudulent activity, for a net loss
to us during this period of approximately $185,000. The independent accounting
firm agreed with this conclusion. The independent accounting firm determined
that the employee had committed additional fraudulent activity during fiscal
2003, and we subsequently conducted a further internal review of activity by the
employee since his hiring in 2001 and determined that the employee had committed
19
additional fraudulent activity in fiscal 2002 and fiscal 2001, as well. The
total losses from such activity during fiscal 2003, 2002 and 2001 was
approximately $28,000. The independent accounting firm also agreed with these
conclusions.
We have recovered approximately $110,000 of the losses through insurance
proceeds. We have applied $100,000 of such recovery to fiscal 2004, and have
recorded a charge to expense of approximately $75,000 in fiscal 2004,
representing the remainder of the fiscal 2004 loss. We have applied $10,000 of
the recovery to the first quarter of fiscal 2005, representing the entire loss
identified in such period. The losses in fiscal 2001 through fiscal 2003 were
the result of false expenses for which no corresponding asset was received.
Accordingly, such amounts were previously expensed in the years such funds were
embezzled. We will seek additional recoveries from other parties which, if we
are successful in recovering additional amounts, will be recorded as recoveries
in future periods when they are received. Based on the amount and nature of the
embezzlement and the expected recoveries, we do not believe that the fraudulent
activity had a material effect on any of our previously issued financial
statements.
We incurred approximately $50,000 of accounting and other professional fees
related to this matter during the first quarter of fiscal 2005.
In connection with the audit of our financial statements for the year ended
October 31, 2004, Grant Thornton LLP, our independent registered public
accounting firm, advised us that there were material weaknesses in our internal
controls that did not allow us to prevent or detect earlier such fraudulent
activities, and that such weaknesses are "material weaknesses", as defined under
standards established by the Public Company Accounting Oversight Board. As a
result, and in response also to recommendations made by the independent
accounting firm that conducted the investigation, to help ensure against such
fraudulent activity in the future we have implemented changes to our cash
processing and control procedures. We are also in the process of implementing
changes to our operating bank account. See Item 4 "Controls and Procedures."
IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS
- ------------------------------------------
In December 2004, the FASB issued SFAS No. 123(R), "Accounting for
Stock-Based Compensation" ("SFAS No. 123(R)"). SFAS No. 123(R) establishes
standards for the accounting for transactions in which an entity exchanges its
equity instruments for goods or services. This Statement focuses primarily on
accounting for transactions in which an entity obtains employee services in
share-based payment transactions. SFAS No. 123(R) requires that the fair value
of such equity instruments be recognized as an expense in the historical
financial statements as services are performed. Prior to SFAS No. 123(R), only
certain pro forma disclosures of fair value were required. The provisions of
this Statement are effective for the first interim reporting period that begins
after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) commencing with
the quarter ending October 31, 2005. We are currently evaluating the impact of
SFAS No. 123(R). The adoption of SFAS No. 123(R) is expected to have a material
effect on our financial statements.
20
FORWARD-LOOKING STATEMENTS
- --------------------------
Information included in this Quarterly Report on Form 10-Q may contain
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements are not statements of
historical facts, but rather reflect our current expectations concerning future
events and results. We generally use the words "believes," "expects," "intends,"
"plans," "anticipates," "likely," "will" and similar expressions to identify
forward-looking statements. Such forward-looking statements, including those
concerning our expectations, involve risks, uncertainties and other factors,
some of which are beyond our control, which may cause our actual results,
performance or achievements, or industry results, to be materially different
from any future results, performance, or achievements expressed or implied by
such forward-looking statements. These risks, uncertainties and factors include,
but are not limited to, those factors set forth in "General Risks and
Uncertainties" below and Note 1 to Condensed Financial Statements. You should
read this discussion and analysis along with our Annual Report on Form 10-K for
the year ended October 31, 2004 and the condensed financial statements included
in this Report. We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. You are cautioned not to unduly rely on such
forward-looking statements when evaluating the information presented in this
Report.
GENERAL RISKS AND UNCERTAINTIES
- -------------------------------
Our business involves a high degree of risk and uncertainty, including, but
not limited to, the following risks and uncertainties:
o We have experienced significant net losses and negative cash flows from
operations and they may continue.
We have had net losses and negative cash flows from operations in each year
since our inception and in the three months ended January 31, 2005, and we may
continue to incur substantial losses and experience substantial negative cash
flows from operations. We have incurred substantial costs and expenses in
developing our encryption and flat panel display technologies and in our efforts
to produce commercially marketable products incorporating our technology. We
have had limited sales of products to support our operations from inception
through January 31, 2005. We have set forth below our net losses, research and
development expenses and net cash used in operations for the three-month periods
ended January 31, 2005 and 2004, and for the fiscal years ended October 31, 2004
and 2003:
(Unaudited)
Three Months Ended Fiscal Years Ended
January 31, October 31,
-------------------------------- ------------------------------
2005 2004 2004 2003
---- ---- ---- ----
Net loss $ 1,006,494 $ 809,354 $ 3,360,655 $ 3,114,411
Research and development expenses $ 589,953 $ 484,543 $ 2,164,427 $ 1,807,742
Net cash used in operations $ 465,047 $ 263,702 $ 1,205,122 $ 958,501
21
o We may need additional funding in the future which may not be available on
acceptable terms and, if available, may result in dilution to our
stockholders, and our auditors have issued a "going concern" audit opinion.
We anticipate that, if cash generated from operations is insufficient to
satisfy our requirements, we will require additional funding to continue our
research and development activities and market our products. The auditor's
report on our financial statements as of October 31, 2004 states that the net
loss incurred during the year ended October 31, 2004, our accumulated deficit as
of that date, and the other factors described in Note 1 to the Financial
Statements included in our Annual Report on Form 10-K for the year ended October
31, 2004, raise substantial doubt about our ability to continue as a going
concern. The auditor's report on our financial statements for the year ended
October 31, 2003 contained a similar statement. Our financial statements have
been prepared assuming we will continue as a going concern and do not include
any adjustments that might result from the outcome of this uncertainty.
We believe that our existing cash and accounts receivable, together with
cash flows from expected sales of encryption products and flat panel displays,
and other potential sources of cash flows, will be sufficient to enable us to
continue in operation until at least the end of the first quarter of fiscal
2006. We anticipate that, thereafter, we will require additional funds to
continue marketing, production, and research and development activities, and we
will require outside funding if cash generated from operations is insufficient
to satisfy our liquidity requirements. However, our projections of future cash
needs and cash flows may differ from actual results. If current cash and cash
that may be generated from operations are insufficient to satisfy our liquidity
requirements, we may seek to sell debt or equity securities or to obtain a line
of credit prior to the first quarter of fiscal 2006. The sale of additional
equity securities or convertible debt could result in dilution to our
stockholders. We can give you no assurance that we will be able to generate
adequate funds from operations, that funds will be available to us from debt or
equity financings or that, if available, we will be able to obtain such funds on
favorable terms and conditions. We currently have no arrangements with respect
to additional financing.
o We may not generate sufficient revenues to support our operations in the
future or to generate profits.
We are engaged in two principal operations: (i) the development, production
and marketing of thin high-brightness flat panel video displays and (ii) the
development, production and marketing of multi-functional encryption products
that provide information security for domestic and international users over
virtually every communications media. We have only recently started to produce
monochrome versions of our high-brightness flat panel displays and our
encryption products are only in their initial stages of commercial production.
Our investments in research and development are considerable. Our ability to
generate sufficient revenues to support our operations in the future or to
generate profits will depend upon numerous factors, many of which are beyond our
control, including:
22
o our ability to successfully market our line of thin high-brightness flat
panel video displays and encryption products;
o the capability of Volga to produce thin high-brightness monochrome video
displays and supply them to us;
o our ability to jointly develop with Volga and produce a full-color video
display;
o our ability to develop and produce displays using controllable nanotubes
and modified TFT technology;
o our production capabilities and those of our suppliers as required for the
production of our encryption products;
o long-term performance of our products;
o the capability of our dealers and distributors to adequately service our
encryption products;
o our ability to maintain an acceptable pricing level to end-users for both
our encryption and display products;
o the ability of suppliers to meet our requirements and schedule;
o our ability to successfully develop other new products under development;
o rapidly changing consumer preferences;
o the possible development of competitive products that could render our
products obsolete or unmarketable;
o our future negotiations with Volga with respect to payments and other
arrangements under our Joint Cooperation Agreement with Volga.
Because our revenue is subject to fluctuation, we may be unable to reduce
operating expenses quickly enough to offset any unexpected revenue shortfall. If
we have a shortfall in revenue in relation to expenses, our operating results
would suffer. Our operating results for any particular quarter may not be
indicative of future operating results. You should not rely on
quarter-to-quarter comparisons of results of operations as an indication of our
future performance.
o We are dependent upon a few key executives and the loss of their services
could adversely affect us.
Our future success is dependent on our ability to hire, retain and motivate
highly qualified personnel. In particular, our success depends on the continued
efforts of our Chief Executive Officer, Denis A. Krusos, and our President,
Frank J. DiSanto, who founded our company in 1982 and are engaged in the
management and operations of our business, including all aspects of the
development, production and marketing of our encryption products and flat panel
display technology. In addition, Messrs. Krusos and DiSanto, as well as our
other skilled management and technical personnel, are important to our future
business and financial arrangements. The loss of the services of any such
persons could have a material adverse effect on our business and operating
results.
o The small size of our accounting and financial staff has exposed us, and
may expose us in the future, to risks relating to our internal control, and
may limit our growth.
The small size of our accounting and financial staff has exposed us to
risks relating to our internal control over financial reporting. In particular,
as discussed in our Annual Report on Form 10-K for the year ended October 31,
23
2004 under Item 9A, Controls and Procedures, in December 2004, we discovered
that an employee in our accounting staff had defrauded us of approximately
$189,000 (of which approximately $4,000 we believe was replaced) during fiscal
2004 and the first month of fiscal 2005 and approximately $28,000 during the
period from fiscal 2001 through fiscal 2003. While we have recovered
approximately $110,000 of such loss through insurance proceeds and will seek
additional recoveries from other parties, and we have taken steps to improve our
internal controls to prevent such activity in the future, there can be no
assurance that our controls and procedures will prevent all errors or fraud, or
that any future such losses would be insured or otherwise recoverable. We may
need to recruit additional staff to improve our internal controls or to support
growth of our business, the costs of which would reduce the funds available for
research and development and marketing activities.
o The very competitive markets for our encryption products and flat panel
display technology could have a harmful effect on our business and
operating results.
The markets for our encryption products and flat panel display technology
worldwide are highly competitive and subject to rapid technological changes.
Most of our competitors are larger than us and possess financial, research,
service support, marketing, manufacturing and other resources significantly
greater than ours. Competitive pressures may have a harmful effect on our
business and operating results.
o Our common stock is subject to the SEC's penny stock rules which may make
our shares more difficult to sell.
Our stock fits the definition of a penny stock. The SEC rules regarding
penny stocks may have the effect of reducing trading activity in our common
stock and making it more difficult for investors to sell. The rules require a
broker to deliver a risk disclosure document that provides information about
penny stocks and the nature and level of risks in the penny stock market. The
broker must also give bid and offer quotations and broker and salesperson
compensation information to the customer orally or in writing prior to effecting
a transaction and in writing with the confirmation. The SEC rules also require a
broker to make a special written determination that the penny stock is a
suitable investment for the purchaser and receive the purchaser's written
agreement to the transaction before completion of the transaction. These
requirements may result in a lower trading volume of our common stock and lower
trading prices.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
-----------------------------------------------------------
We have invested a portion of our cash on hand in short term, fixed rate
and highly liquid instruments that have historically been reinvested when they
mature throughout the year. Although our existing instruments are not considered
at risk with respect to changes in interest rates or markets for these
instruments, our rate of return on these securities could be affected at the
time of reinvestment, if any.
24
Item 4. Controls and Procedures.
------------------------
We carried out an evaluation, under the supervision and with the
participation of our management including our Chairman of the Board and Chief
Executive Officer and our Vice President - Finance and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13-15(b) of the Securities Exchange Act of 1934, as
amended. Based upon that evaluation, our Chairman of the Board and Chief
Executive Officer and our Vice President - Finance and Chief Financial Officer
concluded that our disclosure controls and procedures are effective as of the
end of the period covered by this report.
As discussed more fully in Item 9A of our Annual Report on Form 10-K for
the year ended October 31, 2004, in connection with our audit of our financial
statements for the fiscal year ended October 31, 2004, we determined that a
former accounting employee embezzled funds from us. We conducted an internal
investigation, discussed the matter with our independent registered public
accounting firm, Grant Thornton LLP, and also engaged another independent
accounting firm to conduct an independent investigation of this matter.
In connection with the audit of the Company's financial statements for the
year ended October 31, 2004, Grant Thornton advised us that there was a weakness
in our internal control over financial reporting that did not allow us to
prevent or detect earlier such fraudulent activities. Specifically, Grant
Thornton found that there was a lack of procedures in place to effect an
adequate segregation of duties over cash and related cash processing. This
weakness caused the following deficiencies:
o inadequate control of processing of cash receipts,
o inadequate control over bank transfers,
o inadequate control over original bank statements and the reconciliation
process, and
o inadequate control over unused checks.
Grant Thornton advised us that these deficiencies constitute a "material
weakness" under standards established by the Public Company Accounting Oversight
Board.
As a result, and in response also to recommendations made by the
independent accounting firm that conducted the investigation, to help ensure
against such fraudulent activity in the future, we implemented changes in
certain of our internal controls over financial reporting during the fiscal
quarter ended January 31, 2005, as follows:
o an individual from management, rather than someone in the accounting
department, opens the bank statements as they are received from the bank
and reviews them for any unusual checks or other transactions before
providing the statements to the accounting department to perform
reconciliations;
o this individual compares all of the cancelled checks returned with the bank
statement with our disbursement records to ensure that the records reflect
the information on the check and reviews the checks for unusual or
unexpected endorsements; and
25
o mail is opened by personnel outside the accounting department and any
checks are immediately restrictively endorsed prior to being given to the
accounting department.
The independent accounting firm also recommended we adopt a "zero-base
balance" or a "sweep" account in our operating bank account to enable the bank
to transfer funds to the operating account only when checks are presented for
payment. We are in the process of implementing this recommendation. We are also
in the process of hiring a replacement for the former accounting employee. We
have reviewed the segregation of duties in our accounting department and will
further segregate duties once such person is hired, taking into account our
staffing size and composition. Finally, the independent accounting firm also
recommended that, as our business grows, we consider using a lockbox system for
processing cash receipts, under which customers will be requested, via notations
on invoices or monthly statements or the use of preaddressed envelopes, to send
their payments to a post office box, which will be accessible only by (and will
be collected daily by) our bank. We will continue to evaluate the effectiveness
of our disclosure controls and procedures and our internal controls over
financial reporting on an ongoing basis, and will take further action as
appropriate. However, there can be no assurance that our controls and procedures
will prevent all errors or fraud.
26
PART II. OTHER INFORMATION
--------------------------
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
------------------------------------------------------------
On November 9, 2004, the Company issued 179,000 shares of its Common Stock
to its outside legal counsel, in satisfaction of outstanding bills for services
rendered in the amount of $115,372. Such shares of Common Stock were issued
without registration in reliance on the exemption provided by Section 4(2) of
the Securities Act of 1933, as amended, for transactions not involving a public
offering. In claiming such exemption, the Company relied on representations
that, among other things, such firm was an accredited investor and was acquiring
the shares for its own account (and not for the account of others) for
investment and not with a view to distribution thereof.
Item 6. Exhibits.
---------
31.1 Certification of Chief Executive Officer, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002, dated March 10, 2005.
31.2 Certification of Chief Financial Officer, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002, dated March 10, 2005.
32.1 Statement of Chief Executive Officer, pursuant to Section 1350 of Title 18
of the United States Code, dated March 10, 2005.
32.2 Statement of Chief Financial Officer, pursuant to Section 1350 of Title 18
of the United States Code, dated March 10, 2005.
27
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
COPYTELE, INC.
By:/s/ Denis A. Krusos
-------------------
Denis A. Krusos
Chairman of the Board,
Chief Executive Officer
March 10, 2005 (Principal Executive Officer)
By:/s/Henry P. Herms
Henry P. Herms
Vice President - Finance and
Chief Financial Officer (Principal
March 10, 2005 Financial and Accounting Officer)
28