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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
-----------
(Exact Name of Registrant as Specified in Its Charter)
MASSACHUSETTS 04-2911026
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
----------------------------------------------------
(Address of Principal Executive Offices)
(Zip Code)
(781) 276-4000
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(Registrant's Telephone Number, Including Area Code)
Indicate by check whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2). YES X NO
--- ---
Indicate the number of shares outstanding of the issuer's common stock as of
October 31, 2003:
CLASS NUMBER OF SHARES OUTSTANDING
----- ----------------------------
Common Stock, par value $0.01 per share 22,720,721 shares
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AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of
September 30, 2003 and December 31, 2002........................ 3
Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2003
and September 30, 2002.......................................... 4
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2003
and September 30, 2002.......................................... 5
Notes to Consolidated Financial Statements...................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................. 11
Item 3. Quantitative and Qualitative Disclosures about
Market Risk..................................................... 25
Item 4. Controls and Procedures......................................... 26
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................... 27
Item 6. Exhibits and Reports on Form 8-K................................ 28
Signatures...................................................... 28
2
PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
---------------- ----------------
ASSETS
Current assets:
Cash and cash equivalents............................................. $19,215 $25,268
Short-term investments................................................ 15,762 8,034
Accounts receivable, net.............................................. 1,239 1,258
Inventories........................................................... 305 50
Prepaid expenses and other assets..................................... 597 530
---------------- ----------------
Total current assets 37,118 35,140
---------------- ----------------
Property and equipment, net............................................. 9,192 10,038
Investments............................................................. 5,936 13,816
Other assets, net....................................................... 111 243
---------------- ----------------
Total assets....................................................... $52,357 $59,237
================ ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable...................................................... $303 $274
Accrued expenses ..................................................... 127 213
Accrued compensation ................................................. 645 965
Accrued professional.................................................. 131 65
Deferred revenue...................................................... 88 142
---------------- ----------------
Total current liabilities.......................................... 1,294 1,659
---------------- ----------------
Stockholders' equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding................................................... - -
Common stock, $.01 par value; 70,000,000 shares authorized; issued
and outstanding, 22,717,784 in 2003 and 22,698,171 in 2002......... 227 227
Additional paid-in capital............................................ 77,338 77,301
Accumulated deficit................................................... (26,502) (19,950)
----------------- ----------------
Total stockholders' equity......................................... 51,063 57,578
----------------- ----------------
Total liabilities and stockholders' equity......................... $52,357 $59,237
================= ================
The accompanying notes are an integral part of the financial statements.
3
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- -------------------------------
2003 2002 2003 2002
--------------- --------------- --------------- ---------------
Revenue:
Product sales....................................... $1,431 $1,298 $2,727 $3,399
Contract revenue.................................... 691 1,926 2,213 6,177
Royalties........................................... 933 729 2,879 1,965
--------------- --------------- --------------- ---------------
Total revenue...................................... 3,055 3,953 7,819 11,541
Costs and expenses:
Cost of product sales............................... 293 489 629 831
Cost of contract revenue............................ 447 1,352 998 4,344
Research and development............................ 2,962 3,378 9,513 9,915
Selling and marketing............................... 637 774 1,837 2,275
General and administrative.......................... 598 772 1,857 2,165
--------------- --------------- --------------- ---------------
Total costs and expenses........................... 4,937 6,765 14,834 19,530
Loss from operations.................................. (1,882) (2,812) (7,015) (7,989)
Interest income....................................... 136 224 463 695
--------------- --------------- --------------- ---------------
Loss before provision for income taxes................ (1,746) (2,588) (6,552) (7,294)
Provision for income taxes............................ - (7,093) - (7,093)
--------------- --------------- --------------- ---------------
Net loss.............................................. ($1,746) ($9,681) ($6,552) ($14,387)
=============== =============== =============== ===============
Net loss per share - basic and diluted................ ($0.08) ($0.43) ($0.29) ($0.63)
Weighted average shares - basic and diluted........... 22,718 22,686 22,707 22,675
The accompanying notes are an integral part of the financial statements.
4
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------------
2003 2002
-------------- --------------
Cash flows from operating activities:
Net loss........................................................ ($6,552) ($14,387)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization.................................. 1,147 1,405
Provision for doubtful accounts.............................. (75) -
Increase (decrease) from changes in assets and liabilities:
Accounts receivable....................................... 94 (1,130)
Inventories............................................... (255) 232
Deferred taxes............................................ - 7,093
Prepaid expenses.......................................... (67) 85
Accounts payable.......................................... 29 294
Accrued expenses.......................................... (340) (567)
Deferred revenue.......................................... (54) 43
-------------- --------------
Net cash used in operating activities.................. (6,073) (6,932)
-------------- --------------
Cash flows from investing activities:
Purchases of property and equipment............................ (169) (587)
Net sales (purchases) of short-term investments................ (7,728) 20,020
Net purchases of investments................................... 7,880 -
-------------- --------------
Net cash provided by (used in) investing activities.... (17) 19,433
-------------- --------------
Cash flows from financing activities:
Proceeds from issuance of common stock........................ 37 121
-------------- --------------
Net cash provided by financing activities.............. 37 121
-------------- --------------
Increase (decrease) in cash and cash equivalents................... (6,053) 12,622
Cash and cash equivalents, beginning of period..................... 25,268 36,056
-------------- --------------
Cash and cash equivalents, end of period........................... $19,215 $48,678
============== ==============
The accompanying notes are an integral part of the financial statements.
5
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
A) BASIS OF PRESENTATION
The accompanying unaudited consolidated balance sheet, statements of
operations, and statements of cash flows reflect all adjustments
(consisting only of normal recurring items) which are, in the opinion of
management, necessary for a fair presentation of financial position at
September 30, 2003, and of operations and cash flows for the interim
periods ended September 30, 2003 and 2002.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instructions for Form 10-Q and therefore do
not include all information and footnotes necessary for a complete
presentation of our financial position, results of operations and cash
flows, in conformity with generally accepted accounting principles. We
filed audited financial statements which included all information and
footnotes necessary for such presentation for the three years ended
December 31, 2002 in conjunction with our 2002 Annual Report on Form 10-K.
The results of operations for the interim period ended September 30, 2003
are not necessarily indicative of the results to be expected for the year.
B) INVENTORY
Inventory consists primarily of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
----------------- -----------------
Raw materials............................... $260 $46
Finished goods.............................. 45 4
----------------- -----------------
Total................................ $305 $50
================= =================
6
C) COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income or loss by the
weighted average number of common shares outstanding. Diluted earnings per
share is computed by dividing net income or loss by the weighted average
number of common shares outstanding plus additional common shares that
would have been outstanding if dilutive potential common shares had been
issued. For the purposes of this calculation, stock options are considered
common stock equivalents in periods in which they have a dilutive effect.
Stock options that are anti-dilutive are excluded from the calculation.
Net income or loss per share is calculated as follows (in thousands, except
per share data):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- --------------------------
2003 2002 2003 2002
------------- ------------- ------------- ------------
Net loss.......................................... ($1,746) ($9,681) ($6,552) ($14,387)
Weighted average common shares outstanding........ 22,718 22,686 22,707 22,675
Additional dilutive common stock equivalents...... - - - -
------------- ------------- ------------- ------------
Diluted shares outstanding ....................... 22,718 22,686 22,707 22,675
============= ============= ============= ============
Net loss per share - basic........................ ($0.08) ($0.43) ($0.29) ($0.63)
Net loss per share - diluted...................... ($0.08) ($0.43) ($0.29) ($0.63)
For the three month periods ended September 30, 2003 and 2002, potential
common stock equivalents of 22,537 and 459, respectively, were not included
in the per share calculation for diluted EPS, because we had net losses and
the effect of their inclusion would be anti-dilutive. For the nine month
periods ended September 30, 2003 and 2002, potential common stock
equivalents of 3,267 and 309,647, respectively, were not included in the
per share calculation for diluted EPS, because we had net losses and the
effect of their inclusion would be anti-dilutive. For the three month
periods ended September 30, 2003 and 2002, options to purchase 489,785 and
7,594,304 shares of common stock, respectively, were outstanding, but were
not included in the computation of diluted EPS because the options'
exercise prices were greater than the average market price of the common
stock and thus would be anti-dilutive. For the nine month periods ended
September 30, 2003 and 2002, options to purchase 514,785 and 5,364,298
shares of common stock, respectively, were outstanding, but were not
included in the computation of diluted EPS because the options' exercise
prices were greater than the average market price of the common stock and
thus would be anti-dilutive.
D) STOCK-BASED COMPENSATION
We grant stock options to our employees and directors. Such grants are for
a fixed number of shares with an exercise price equal to the fair value of
the shares at the date of grant. As permitted by SFAS No. 123, "Accounting
for Stock-Based Compensation", we account for stock option grants in
accordance with Accounting Principles Board ("APB")
7
Opinion No. 25, "Accounting for Stock Issued to Employees" and FASB
Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions
Involving Stock Compensation." Accordingly, we have adopted the provisions
of SFAS No. 123 through disclosure only.
No stock-based employee compensation cost is reflected in our net loss, as
all options granted under those plans had an exercise price equal to the
fair market value of the underlying common stock on the date of grant. The
following table illustrates the pro forma effect on net loss and earnings
per share if we had applied the fair value recognition provisions of SFAS
No. 123 and SFAS No. 148 to stock-based employee compensation (in
thousands, except per share data):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------- ------------- ------------- -------------
Net loss - as reported............................ ($1,746) ($9,681) ($6,552) ($14,387)
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards........................... 3,146 5,321 13,159 15,887
------------- ------------- ------------- -------------
Net loss - pro forma ............................. ($4,892) ($15,002) ($19,711) ($30,274)
============= ============= ============= =============
Basic loss per share - as reported................ ($0.08) ($0.43) ($0.29) ($0.63)
Basic loss per share - pro forma.................. ($0.22) ($0.66) ($0.87) ($1.34)
Diluted loss per share - as reported.............. ($0.08) ($0.43) ($0.29) ($0.63)
Diluted loss per share - pro forma................ ($0.22) ($0.66) ($0.87) ($1.34)
The fair value of options on their grant date was measured using the
Black-Scholes option pricing model. Key assumptions used to apply this
pricing model are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------- ------------- ------------- -------------
Average risk-free interest rate................... 3.14% 3.82% 2.87% 3.82%
Expected life of option grants.................... 5 years 5 years 5 years 5 years
Expected volatility of underlying stock........... 96% 99% 96% 99%
Expected dividend yield........................... - - - -
E) EMPLOYEE STOCK OPTION EXCHANGE PROGRAM
On March 3, 2003, we commenced an offer to exchange outstanding stock
options with eligible employees. Under the terms of the program, eligible
employees had the right to tender for cancellation all stock options that
they held with an exercise price above $3.00 per share by April 1, 2003. We
accepted for exchange options to purchase an aggregate of 6,162,952 shares
of our common stock. Subject to the terms and conditions of the offer, we
were obligated to issue new options to purchase an aggregate of up to
3,081,563 shares of our common stock between October 2, 2003 and November
8
13, 2003. On October 14, 2003, we granted options to purchase an aggregate
of 2,854,213 shares of our common stock at the then current market value of
$3.27 per share in connection with the offer to exchange. In accordance
with FIN 44, since the replacement options were granted more than six
months and one day after cancellation of the old options, the new options
were considered a fixed award and will not result in any compensation
expense.
F) BUSINESS SEGMENTS
The Company organizes itself as one segment and conducts its operations in
the United States.
The Company sells its products and technology to domestic and international
customers. Revenues were generated from the following geographic regions
(in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2003 2002 2003 2002
------------- ------------- ------------- --------------
United States.................................... $1,995 $3,153 $5,794 $9,295
Germany.......................................... 729 787 1,279 1,835
Rest of World.................................... 331 13 746 411
------------- ------------- ------------- --------------
$3,055 $3,953 $7,819 $11,541
============= ============= ============= ==============
G) RECENT ACCOUNTING PRONOUNCEMENTS
In May 2003, FASB issued Statement of Financial Accounting Standards 150
("SFAS 150"), "Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity." SFAS 150 establishes
standards for how an issuer classifies and measures certain financial
instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its
scope as a liability. For all financial instruments entered into or
modified after May 31, 2003, SFAS 150 is effective immediately. For all
other instruments, SFAS 150 goes into effect at the beginning of the first
interim period beginning after June 15, 2003. The adoption of SFAS 150 did
not have a material impact on our financial position or results of
operations.
In April 2003, FASB issued Statement of Financial Accounting Standards 149
("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." SFAS 149 amends and clarifies accounting and reporting
of derivative instruments, including certain derivative instruments
embedded in other contracts, and hedging activities under SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities." This
statement is effective for contracts entered into or modified after June
30, 2003 and for hedging relationships designated after June 30, 2003. The
adoption of SFAS 149 did not have a material impact on our financial
position and results of operations.
9
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure - An Amendment of SFAS No. 123."
SFAS 148 amends SFAS 123, "Accounting for Stock-Based Compensation" to
provide alternative methods of transition for those companies who
voluntarily change to the fair value based method of accounting for
stock-based employee compensation. In addition, this Statement amends the
disclosure requirements of SFAS 123 to require prominent disclosures in
both the annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the
method used on reported results. The transition and annual disclosure
provisions of SFAS 148 are effective for fiscal years ending after December
15, 2002. We have not adopted the fair value method of accounting for
stock-based compensation, and will continue to apply APB 25 for our
stock-based compensation plans. We have adopted the disclosure requirements
of SFAS 148 in this Form 10-Q, which is included in the "Stock-Based
Compensation" footnote of our consolidated financial statements.
In January 2003, FASB issued FASB Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities," which addresses
consolidation by a business of variable interest entities in which it is
the primary beneficiary. The Interpretation is effective immediately for
certain disclosure requirements and variable interest entities created
after January 31, 2003, and periods beginning after June 15, 2003 for
variable interest entities created before February 1, 2003. The adoption of
FIN 46 did not have a material impact on our financial position and results
of operations.
The EITF issued No. 00-21, "Accounting for Revenue Arrangements with
Multiple Deliverables." EITF Issue No. 00-21 addresses certain aspects of
the accounting by a vendor for arrangements under which it will perform
multiple revenue-generating activities. EITF Issue No. 00-21 establishes
three principles: revenue should be recognized separately for separate
units of accounting, revenue for a separate unit of accounting should be
recognized only when the arrangement consideration is reliably measurable
and the earnings process is substantially complete, and consideration
should be allocated among the separate units of accounting in an
arrangement based on their relative fair values. EITF Issue No. 00-21 is
effective for all revenue arrangements entered into in fiscal periods
beginning after June 15, 2003, with early adoption permitted. The adoption
of EITF Issue No. 00-21 did not have a material impact on our financial
position and results of operations.
10
ITEM 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
SOME OF THE INFORMATION IN THIS FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-Q, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-Q COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS.
RESULTS OF OPERATIONS
PRODUCT SALES. Product sales consist primarily of revenue from the sale of
hardware products and compression software. Hardware products primarily include
ADSL test and development systems, modules, and modems. Compression software
consists of standard off-the-shelf software products that are sold to OEM
customers that integrate our software into their equipment-based products.
Product sales increased 10% from $1.3 million in the third quarter of 2002 to
$1.4 million in the current year quarter. As a percentage of total revenue,
product sales increased from 33% in the third quarter of 2002 to 47% in the
current year quarter. The dollar increase was primarily due to an increase in
revenue from the sale of compression software, which was partially offset by
lower revenue from the sale of test and development systems. Compression
software revenue increased primarily due to higher sales of our electronic
identification products. Test and development system revenue decreased primarily
due to lower demand from our semiconductor and equipment customers.
For the nine months ended September 30, product sales decreased 20% from $3.4
million in 2002 to $2.7 million in 2003. As a percentage of total revenue,
product sales increased from 29% in the first nine months of 2002 to 35% in the
corresponding period of 2003. The dollar decrease was primarily due to a
decrease in revenue from the sale of compression software and to a lesser extent
lower revenue from the sale of test and development systems. Compression
software revenue decreased primarily due to lower sales of our electronic
identification products. Lower sales of electronic identification products in
the first nine months of 2003 were due to the timing of orders from our OEM
customers. Test and development system revenue decreased primarily due to lower
demand from our semiconductor and equipment customers.
CONTRACT REVENUE. Contract revenue consists primarily of license and
engineering service fees that we receive under agreements with our customers to
develop ADSL chipsets.
11
Contract revenue decreased 64% from $1.9 million in the third quarter of 2002 to
$0.7 million in the current year quarter. As a percentage of total revenue,
contract revenue decreased from 49% in the third quarter of 2002 to 23% in the
current year quarter. For the nine months ended September 30, contract revenue
decreased 64% from $6.2 million in 2002 to $2.2 million in 2003. As a percentage
of total revenue, contract revenue decreased from 54% in the first nine months
of 2002 to 28% in the corresponding period of 2003. Contract revenue in the
first nine months of 2003 includes a significant one-time contractual
termination fee from a large customer.
For the three and nine month periods, the dollar decrease was primarily due to a
difficult environment for licensing intellectual property for communications
integrated circuits. Both existing and prospective ADSL chipset licensees have
been reluctant to begin new development projects given: (i) generally weak
worldwide economic conditions, (ii) a difficult and uncertain environment in the
semiconductor and telecommunications industries, and (iii) intense ADSL chipset
competition and falling chipset prices. During the last several years, customers
and potential customers cautiously evaluated new chipset projects or delayed or
cancelled projects in the face of such conditions. We are uncertain when the
economic and market conditions we faced over the last several years will
materially improve.
ROYALTIES. Royalties consist of royalty payments that we receive under
licensing agreements. We receive royalties from customers for the right to use
our technology in their chipsets or solutions.
Royalties increased 28% from $0.7 million in the third quarter of 2002 to $0.9
million in the current year quarter. As a percentage of total revenue, royalties
increased from 18% in the third quarter of 2002 to 31% in the current year
quarter. For the nine months ended September 30, royalties increased 47% from
$2.0 million in 2002 to $2.9 million in 2003. As a percentage of total revenue,
royalties increased from 17% in the first nine months of 2002 to 37% in the
corresponding period of 2003.
For the three and nine month periods, the increase in royalties was primarily
due to an increase in ADSL chipset sales by our largest customer, Analog
Devices, Inc. ("ADI") and to a lesser extent by Infineon Technologies AG
("Infineon"). Despite the increase in ADSL chipset sales by ADI over the last
three quarters, ADI's chipset sales have declined in previous quarters primarily
due to falling ADSL chipset pricing and lower ADI sales volumes. Despite steady
growth of worldwide ADSL subscribers over the last several years, the
availability of ADSL chipsets from a number of suppliers and intense competition
among those suppliers has caused chipset prices to drop sharply. Additionally,
deployments of ADSL service in geographic areas where chipsets based upon our
technology have been sold leveled off or declined. We are uncertain when ADSL
chipset pricing will improve, whether ADI will be able to continue to grow its
presence or whether our other licensees will contribute meaningful royalty
revenue.
Infineon has continued to increase the number of ADSL chipsets it sells based
upon our technology. Infineon has announced design wins with several
telecommunications equipment suppliers, including Siemens AG and Alcatel Alsthom
S.A., for chipsets that are based on our ADSL technology. We are uncertain how
quickly sales of these chipsets will increase and whether they will contribute
meaningful royalties to us.
COST OF PRODUCT SALES. Since the cost of compression software license sales
is minimal, cost of product sales consists primarily of costs associated with
ADSL equipment sales. Cost of
12
product sales decreased 40% from $489,000 in the third quarter of 2002 to
$293,000 in the current year quarter. As a percentage of product sales, cost of
product sales decreased from 38% in the third quarter of 2002 to 20% in the
current year quarter. In terms of dollars, the decrease in cost of product sales
was primarily due to higher margins on module sales during the current quarter.
The increase in overall product margins was primarily due to a higher proportion
of compression software sales in the product sales revenue mix.
For the nine months ended September 30, cost of product sales decreased 24% from
$831,000 in 2002 to $629,000 in 2003. As a percentage of product sales, cost of
product sales decreased from 24% in the first nine months of 2002 to 23% in the
corresponding period of 2003. In terms of dollars, the decrease in cost of
product sales was primarily due to higher margins on module sales and lower
sales of test and development systems. The decline in overall product margins
was primarily due to a smaller proportion of compression software sales in the
product sales revenue mix.
COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily of
salaries for engineers and expenses for consultants, technology licensing fees,
recruiting, supplies, equipment, depreciation and facilities associated with
customer development projects. Our total engineering costs are allocated between
cost of contract revenue and research and development expense. In a given
period, the allocation of engineering costs between cost of contract revenue and
research and development is a function of the level of effort expended on each.
Cost of contract revenue decreased 67% from $1.4 million in the third quarter of
2002 to $0.4 million in the current year quarter. As a percentage of contract
revenue, cost of contract revenue decreased from 70% in the third quarter of
2002 to 65% in the current year quarter. The dollar and percentage decrease in
cost of contract revenue was primarily due to fewer customer contracts in the
third quarter of 2003 as compared with the third quarter of 2002, so our cost of
contract revenue declined as well, and we are licensing a more technically
mature intellectual property package that requires us to provide less
engineering services to our customers.
For the nine months ended September 30, cost of contract revenue decreased 77%
from $4.3 million in 2002 to $1.0 million in 2003. As a percentage of contract
revenue, cost of contract revenue decreased from 70% in the first nine months of
2002 to 45% in the corresponding period of 2003. The dollar and percentage
decrease in cost of contract revenue was primarily due to the following factors:
i) there were fewer customer contracts in contract revenue in the first nine
months of 2003 as compared to the corresponding period in 2002, so our cost of
contract revenue declined as well; ii) in 2003, we began licensing a more
technically mature intellectual property package that requires us to provide
less engineering services to our customers; and iii) contract revenue in the
first nine months of 2003 included a one-time contractual termination fee that
had no cost of contract revenue associated with it.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense consists
primarily of salaries for engineers and expenses for consultants, recruiting,
supplies, equipment, depreciation and facilities related to engineering projects
to enhance and extend our broadband intellectual property offerings, and our
compression software technology. Research and development expense decreased 12%
from $3.4 million in the third quarter of 2002 to $3.0 million in 2003. As a
percentage of total revenue, research and development expense increased from 85%
in the third quarter of 2002 to 97% in the current year quarter. For the nine
months ended September 30, research and development expense decreased by 4% from
$9.9 million in 2002 to $9.5 million in 2003. As a percentage of total revenue,
research and development
13
expense increased from 86% in the first nine months of 2002 to 122% in the
corresponding period of 2003.
For the three and nine month periods, the dollar decrease was primarily due to a
decrease of approximately $1.0 million per quarter in salaries and related
expenses due to the reduction in force we implemented in October 2002 and salary
reductions we imposed on January 1, 2003. This was partially offset by increased
spending resulting from a shift of engineers from customer projects, where
spending is classified as cost of contract revenue, to internal research and
development projects, where spending is classified as research and development
expense. This shift occurred because we had fewer customer projects in 2003 than
in 2002, and we changed our technology offering such that it requires less
engineering support by us.
Our research and development spending is principally focused on projects related
to core ADSL technology, including our StratiPHY(TM) chip, as well as for Dr.
DSL(R), G.SHDSL, wireless local area network communications, VDSL, and other
development projects.
SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of salaries for sales and marketing personnel, travel, advertising and
promotion, recruiting, and facilities expense. Sales and marketing expense
decreased 18% from $774,000 in the third quarter of 2002 to $637,000 in the
current year quarter. As a percentage of total revenue, sales and marketing
expense increased from 20% in the third quarter of 2002 to 21% in the current
year quarter. The dollar decrease was primarily due to lower tradeshow expenses
and lower legal expenses associated with negotiating development and licensing
agreements; as well as the reduction in force and salary reductions we
implemented in October 2002 and January 2003, respectively.
For the nine months ended September 30, selling and marketing expense decreased
19% from $2.3 million in 2002 to $1.8 million in 2003. As a percentage of total
revenue, selling and marketing expense increased from 20% in the first nine
months of 2002 to 23% in the corresponding period of 2003. The dollar decrease
was primarily due to lower tradeshow expenses and sales commissions, and lower
legal expenses associated with negotiating development and licensing agreements;
as well as the reduction in force and salary reductions we implemented in
October 2002 and January 2003, respectively.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists primarily of salaries for administrative personnel, facilities costs,
and public company, bad debt, legal, and audit expenses. General and
administrative expense decreased 22% from $772,000 in the third quarter of 2002
to $598,000 in the current year quarter. As a percentage of total revenue,
general and administrative expense was 20% for the third quarter of 2002 and the
current year quarter. For the nine months ended September 30, general and
administrative expense decreased 14% from $2.2 million in 2002 to $1.9 million
in 2003. As a percentage of total revenue, general and administrative expense
increased from 19% in the first nine months of 2002 to 24% in the corresponding
period of 2003.
For the three and nine month periods, the dollar decrease was primarily due to
lower provisions for bad debts and lower public company expenses; as well as the
reduction in force and salary reductions we implemented in October 2002 and
January 2003, respectively.
INTEREST INCOME. Interest income decreased 39% from $224,000 in the third
quarter of 2003 to $136,000 in the current year quarter. For the nine months
ended September 30, interest
14
income decreased 33% from $695,000 in 2002 to $463,000 in 2003. For the three
and nine month periods, the dollar decrease was primarily due to lower interest
rates earned on our cash balances and lower cash balances.
INCOME TAXES. We made no provision for income taxes in the first nine
months of 2003 due to net losses incurred. In the third quarter of 2002, we
determined that due to our continuing operating losses as well as the
uncertainty of the timing of profitability in future periods, we should fully
reserve our deferred tax assets. As a result, we recorded a tax provision of
$7.1 million in the third quarter of 2002 to reserve for our remaining deferred
tax assets. As of September 30, 2003, our deferred tax assets continue to be
fully reserved. We will continue to evaluate, on a quarterly basis, the positive
and negative evidence affecting the realizability of our deferred tax assets.
15
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2003, we had cash, cash equivalents, short-term investments and
investments of $40.9 million, which represents a decrease of $6.2 million from
December 31, 2002. The decrease is primarily due to $6.1 million of cash used in
operations and $0.2 million of cash invested in capital equipment.
Cash used in operations in the first nine months of 2003 was primarily the
result of operating losses and working capital requirements. Capital spending
was primarily related to the purchase of computer hardware and software, and
laboratory equipment used principally in engineering activities.
While we can not assure you that we will not require additional financing, or
that such financing will be available to us, we believe that our cash, cash
equivalents and investments will be sufficient to fund our operations for at
least the next twelve months.
RECENT ACCOUNTING PRONOUNCEMENTS
In May 2003, FASB issued Statement of Financial Accounting Standards 150 ("SFAS
150"), "Accounting for Certain Financial Instruments with Characteristics of
Both Liabilities and Equity." SFAS 150 establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability. For all financial
instruments entered into or modified after May 31, 2003, SFAS 150 is effective
immediately. For all other instruments, SFAS 150 goes into effect at the
beginning of the first interim period beginning after June 15, 2003. The
adoption of SFAS 150 did not have a material impact on our financial position or
results of operations.
In April 2003, FASB issued Statement of Financial Accounting Standards 149
("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities." SFAS 149 amends and clarifies accounting and reporting of
derivative instruments, including certain derivative instruments embedded in
other contracts, and hedging activities under SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities." This statement is effective for
contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. The adoption of SFAS 149 did not
have a material impact on our financial position and results of operations.
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure - An Amendment of SFAS No. 123." SFAS 148
amends SFAS 123, "Accounting for Stock-Based Compensation" to provide
alternative methods of transition for those companies who voluntarily change to
the fair value based method of accounting for stock-based employee compensation.
In addition, this Statement amends the disclosure requirements of SFAS 123 to
require prominent disclosures in both the annual and interim financial
statements about the method of accounting for stock-based employee compensation
and the effect of the method used on reported results. The transition and annual
disclosure provisions of SFAS 148 are effective for fiscal years ending after
December 15, 2002. We have not adopted the fair value method of accounting for
stock-based compensation, and will continue to apply APB 25 for our stock-based
compensation plans. We have adopted the disclosure requirements of SFAS
16
148 in this Form 10-Q, which is included in the "Stock-Based Compensation"
footnote of our consolidated financial statements.
In January 2003, FASB issued FASB Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities," which addresses consolidation by
a business of variable interest entities in which it is the primary beneficiary.
The Interpretation is effective immediately for certain disclosure requirements
and variable interest entities created after January 31, 2003, and periods
beginning after June 15, 2003 for variable interest entities created before
February 1, 2003. The adoption of FIN 46 did not have a material impact on our
financial position and results of operations.
The EITF issued No. 00-21, "Accounting for Revenue Arrangements with Multiple
Deliverables." EITF Issue No. 00-21 addresses certain aspects of the accounting
by a vendor for arrangements under which it will perform multiple
revenue-generating activities. EITF Issue No. 00-21 establishes three
principles: revenue should be recognized separately for separate units of
accounting, revenue for a separate unit of accounting should be recognized only
when the arrangement consideration is reliably measurable and the earnings
process is substantially complete, and consideration should be allocated among
the separate units of accounting in an arrangement based on their relative fair
values. EITF Issue No. 00-21 is effective for all revenue arrangements entered
into in fiscal periods beginning after June 15, 2003, with early adoption
permitted. The adoption of EITF Issue No. 00-21 did not have a material impact
on our financial position and results of operations.
RISK FACTORS
We believe that the occurrence of any one or some combination of the following
risk factors could seriously harm our business.
OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY
Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter to quarter. Because our revenue components
fluctuate and are difficult to predict, and our expenses are largely independent
of revenues in any particular period, it is difficult for us to accurately
forecast revenues and profitability. We generally recognize contract revenues
ratably over the period during which we expect to provide engineering services.
While this means that contract revenues from current licenses are generally
predictable, changes can be introduced by a reevaluation of the length of the
development period, or by the termination of a contract. The initial estimate of
this period is subject to revision as the product being developed under a
contract nears completion, and a revision may result in an increase or decrease
to the quarterly revenue for that contract. In addition, accurate prediction of
revenues from new licensees is difficult because the development of a business
relationship with a potential licensee is a lengthy process, frequently spanning
a year or more, and the fiscal period in which a new license agreement will be
entered into, if at all, and the financial terms of such an agreement are
difficult to predict. Contract revenues also include fees for engineering
services, which are dependent upon the varying level of assistance desired by
licensees and, therefore, the revenue from these services is also difficult to
predict.
17
It is also difficult for us to make accurate forecasts of royalty revenues.
Royalties are recognized in the quarter in which we receive a report from a
licensee regarding the shipment of licensed integrated circuits in the prior
quarter, and are dependent upon fluctuating sales volumes and/or prices of chips
containing our technology, all of which are beyond our ability to control or
assess in advance.
Our business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:
o market acceptance of our broadband technologies by semiconductor
companies;
o the extent and timing of new license transactions with semiconductor
companies;
o changes in our and our licensees' development schedules and levels of
expenditure on research and development;
o the loss of a strategic relationship or termination of a project by a
licensee;
o equipment companies' acceptance of integrated circuits produced by our
licensees;
o the loss by a licensee of a strategic relationship with an equipment
company customer;
o announcements or introductions of new technologies or products by us
or our competitors;
o delays or problems in the introduction or performance of enhancements
or of future generations of our technology;
o delays in the adoption of new industry standards or changes in market
perception of the value of new or existing standards;
o competitive pressures resulting in lower contract revenues or royalty
rates;
o personnel changes, particularly those involving engineering and
technical personnel;
o costs associated with protecting our intellectual property;
o the potential that licensees could fail to make payments under their
current contracts;
o ADSL market-related issues, including lower ADSL chipset unit demand
brought on by excess channel inventory and lower average selling
prices for ADSL chipsets as a result of market surpluses;
o regulatory developments; and
o general economic trends and other factors.
WE EXPERIENCED NET LOSSES
We had a net loss during 2001, 2002 and the first nine months of 2003. We expect
that we will have a net loss during the fourth quarter of 2003. We may continue
to experience losses in the future if;
o the semiconductor and telecommunications markets do not recover
from the downturn that began in 2001;
o our existing customers do not increase their revenues from sales
of chipsets with our technology;
o new and existing customers do not choose to license our
intellectual property for new chipset products; or
o a profitable business does not emerge from our Dr. DSL efforts.
18
WE HAVE A UNIQUE BUSINESS MODEL
The success of our business model depends upon our ability to license our
technology to semiconductor and equipment companies, and our customers'
willingness and ability to sell products that incorporate our technology so that
we may receive significant royalties that are consistent with our plans and
expectations.
We face numerous risks in successfully obtaining suitable licensees on terms
consistent with our business model, including, among others:
o we must typically undergo a lengthy and expensive process of building
a relationship with a potential licensee before there is any assurance
of a license agreement with such party;
o we must persuade semiconductor and equipment manufacturers with
significant resources to rely on us for critical technology on an
ongoing basis rather than trying to develop similar technology
internally;
o we must persuade potential licensees to bear development costs
associated with our technology applications and to make the necessary
investment to successfully produce chipsets and products using our
technology; and
o we must successfully transfer technical know-how to licensees.
Moreover, the success of our business model also depends on the receipt of
royalties from licensees. Royalties from our licensees are often based on the
selling prices of our licensees' chipsets and products, over which we have
little or no control. We also have little or no control over our licensees'
promotional and marketing efforts. Our licensees are not required to pay us
royalties unless they use our technology. They are not prohibited from competing
against us.
Our business could be seriously harmed if:
o we cannot obtain suitable licensees;
o our licensees fail to achieve significant sales of chipsets or
products incorporating our technology; or
o we otherwise fail to implement our business strategy successfully.
THERE HAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, WHICH HAS
CAUSED OUR ROYALTY REVENUE TO DECLINE
The royalties we receive are influenced by many of the risks faced by the ADSL
market in general, including reduced average selling prices ("ASPs") for ADSL
chipsets during periods of surplus. Since late 2000, the ADSL industry has
experienced an oversupply of ADSL chipsets and central office equipment.
Excessive inventory levels led to soft chipset demand, which in turn led to
declining ASPs. As a result of the soft demand and declining ASPs for ADSL
chipsets, our royalty revenue has decreased substantially from the levels we
achieved in 2000. Price decreases for ADSL chipsets, and the corresponding
decreases in per unit royalties received by us, can be sudden and dramatic.
Pricing pressures may continue during the fourth quarter of 2003 and beyond. Our
royalty revenue may continue to decline over the long term.
19
WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES
There is a relatively limited number of semiconductor and equipment companies to
which we can license our broadband technology in a manner consistent with our
business model. If we fail to maintain relationships with our current licensees
or fail to establish a sufficient number of new licensee relationships, our
business could be seriously harmed. We also continue to have a low level of
confidence that Intel, to whom we have licensed our technology, will offer ADSL
products based upon licensed technology from Aware. In addition, our prospective
customers may use their superior size and bargaining power to demand license
terms that are unfavorable to us and prospective customers may not elect to
license from us.
WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM ONE CUSTOMER
In 2001, 2002 and the first nine months of 2003, we derived 52%, 32% and 30%,
respectively of our total revenue from ADI. ADI was the first customer to
license ADSL technology from us in 1993, and their chipsets are the most mature
implementations of our technology in the market. Our royalty revenues to date
have been primarily due to sales of ADI chipsets that use our ADSL technology.
Our royalty revenue in the near term is highly dependent upon ADI's ability to
maintain its market share and pricing. The ADSL market has experienced
significant price erosion, which has adversely affected ADI's ADSL revenue,
which in turn has adversely affected our royalty revenue. To the extent that ADI
has lost market share, or loses market share in the future, or experiences
further price erosion in its ADSL chipsets, our royalty revenue could continue
to decline.
OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES
Due to our business strategy, our success is dependent on our ability to
generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is
materially affected by the willingness of equipment companies to purchase
integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to
offer broadband communications products. We face the risk that equipment
manufacturers will choose those alternative solutions. Generally, our ability to
influence equipment companies' decision whether to purchase integrated circuits
that incorporates our technology is limited.
We also face the risk that equipment companies that elect to use integrated
circuits that incorporate our technology into their products will not compete
successfully against other equipment companies. Many factors beyond our control
could influence the success or failure of a particular equipment company that
uses integrated circuits based on our technology, including:
o competition from other businesses in the same industry;
o market acceptance of its products;
o its engineering, sales and marketing, and management capabilities;
o technical challenges of developing its products unrelated to our
technology; and
o its financial and other resources.
20
Even if equipment companies incorporate our chipsets based on our intellectual
property into their products, their products may not achieve commercial
acceptance or result in significant royalties to us.
OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL ADSL SERVICE IN VOLUME
The success of our ADSL licensing business depends upon telephone companies
installing ADSL service in significant volumes. Factors that affect the volume
deployment of ADSL service include:
o the desire of telephone companies to install ADSL service, which is
dependent on the development of a viable business model for ADSL
service, including the capability to market, sell, install and
maintain the service;
o the pricing of ADSL services by telephone companies;
o the quality of telephone companies' networks;
o government regulations; and
o the willingness of residential telephone customers to demand ADSL
service in the face of competitive service offerings, such as cable
modems.
If telephone companies do not install ADSL service in significant volumes, or if
telephone companies install ADSL service based on other technology, our business
will be seriously harmed.
OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION
Because we are a technology provider, our ability to protect our intellectual
property and to operate without infringing the intellectual property rights of
others is critical to our success. We regard our technology as proprietary, and
we have a number of patents and pending patent applications. We also rely on a
combination of trade secrets, copyright and trademark law and non-disclosure
agreements to protect our unpatented intellectual property. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use our technology without authorization.
As part of our licensing arrangements, we typically work closely with our
semiconductor and equipment manufacturer licensees, many of whom are also our
potential competitors, and provide them with proprietary know-how necessary for
their development of customized chipsets based on our ADSL technology. Although
our license agreements contain non-disclosure provisions and other terms
protecting our proprietary know-how and technology rights, it is possible that,
despite these precautions, some of our licensees might obtain from us
proprietary information that they could use to compete with us in the
marketplace. Although we intend to defend our intellectual property as
necessary, the steps we have taken may be inadequate to prevent
misappropriation.
In the future, we may choose to bring legal action to enforce our intellectual
property rights. Any such litigation could be costly and time-consuming for us,
even if we were to prevail. Moreover, even if we are successful in protecting
our proprietary information, our competitors may independently develop
technologies substantially equivalent or superior to our technology. The
21
misappropriation of our technology or the development of competitive technology
could seriously harm our business.
Our technology, software or products may infringe the intellectual property
rights of others. A large and increasing number of participants in the
telecommunications and compression industries have applied for or obtained
patents. Some of these patent holders have demonstrated a readiness to commence
litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert patent, copyright and other intellectual
property rights to technologies that are important to our business. In the past,
we have received claims from other companies that our technology infringes their
patent rights. Intellectual property rights can be uncertain and can involve
complex legal and factual questions. We may infringe the proprietary rights of
others, which could result in significant liability for us. If we were found to
have infringed any third party's patents, we could be subject to substantial
damages and an injunction preventing us from conducting our business.
OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE
The semiconductor and telecommunications industries, as well as the market for
high-speed network access technologies, are characterized by rapid technological
change, with new generations of products being introduced regularly and with
ongoing evolutionary improvements. We expect to depend on our ADSL technology
for a substantial portion of our revenue for the foreseeable future. Therefore,
we face risks that others could introduce competing technology that renders our
ADSL technology less desirable or obsolete. Also, the announcement of new
technologies could cause our licensees or their customers to delay or defer
entering into arrangements for the use of our existing technology. Either of
these events could seriously harm our business.
We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our ADSL technology as well as
new technologies that keep pace with changes in the telecommunications and
broadband industries and that achieve rapid market acceptance. We must
continually devote significant engineering resources to achieving technical
innovations. These innovations are complex and require long development cycles.
Moreover, we may have to make substantial investments in technological
innovations before we can determine their commercial viability. We may lack
sufficient financial resources to fund future development. Also, our licensees
may decide not to share certain research and development costs with us. Revenue
from technological innovations, even if successfully developed, may not be
sufficient to recoup the costs of development.
One element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our licensees. In the past, we
have spent significant amounts on development projects that did not produce any
marketable technologies or products, and we cannot assure you that it will not
occur again.
WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS
Our success as an intellectual property supplier depends on the willingness and
ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is
intensely competitive and has been
22
characterized by price erosion, rapid technological change, short product life
cycles, cyclical market patterns and increasing foreign and domestic
competition.
As an intellectual property supplier to the semiconductor industry, we face
intense competition from internal development teams within potential
semiconductor customers. We must convince potential licensees to license from us
rather than develop technology internally. Furthermore, semiconductor customers,
who have licensed our intellectual property, may choose to abandon joint
development projects with us and develop chipsets themselves without using our
technology. In addition to competition from internal development teams, we
compete against other independent suppliers of intellectual property. We
anticipate intense competition from suppliers of intellectual property for ADSL,
and wireless local area networking.
The market for ADSL chipsets is also intensely competitive. Our success within
the ADSL industry requires that ADSL equipment manufacturers buy chipsets from
our semiconductor licensees, and that telephone companies buy ADSL equipment
from those equipment manufacturers. Our customers' chipsets compete with
products from other vendors of standards-based and ADSL chipsets, including
Broadcom, Centillium, Conexant, GlobespanVirata, ST Microelectronics and Texas
Instruments.
ADSL services offered over copper telephone networks also compete with
alternative broadband transmission technologies that use the telephone network
as well as other network architectures. Alternative technologies for the
telephone network include symmetric high speed DSL (also known as HDSL, SDSL and
G.SHDSL), and very high speed DSL, also known as VDSL. These DSL technologies
are based on techniques other than those used by ADSL to transport high- speed
data over telephone lines. Alternative technologies that use other network
architectures to provide high-speed data service include cable modems using
cable networks, and wireless solutions using wireless networks. These
alternative broadband technologies may be more successful than ADSL and we may
not be able to participate in the markets involving these alternative
technologies.
Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, GlobespanVirata, ST Microelectronics and Texas Instruments have
significantly greater financial, technological, manufacturing, marketing and
personnel resources than we do. We may be unable to compete successfully, and
competitive pressures could seriously harm our business.
OUR RECENT REDUCTION IN WORKFORCE MAY ADVERSELY AFFECT THE MORALE AND
PERFORMANCE OF OUR PERSONNEL, OUR ABILITY TO HIRE NEW PERSONNEL AND OUR
OPERATIONS
In October 2002, as part of an effort to reduce operating expenses, we
terminated 35 employees, which constituted approximately 22 percent of our
workforce. Our restructuring plan may yield unanticipated consequences, such as
attrition beyond our planned reduction in workforce. As a result of these
reductions, our ability to respond to unexpected challenges may be impaired, and
we may be unable to take advantage of new opportunities. Further, the reduction
in force may reduce employee morale and may create concern among existing
employees about job security, which may lead to increased attrition or turnover.
As a result of these factors, our remaining personnel may decide to seek
employment with more established companies, and we may have difficulty
attracting new personnel that we might wish to hire in the future.
23
WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS
We prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business. The application of these principles and policies requires us to
make significant judgments and estimates. In the event that judgments and
estimates we make are incorrect, we may have to change them, which could
materially affect our financial position and results of operations.
Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.
OUR STOCK PRICE MAY BE EXTREMELY VOLATILE
Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:
o quarterly fluctuations in our operating results;
o changes in future financial guidance that we may provide to investors
and public market analysts;
o changes in our relationships with our licensees;
o announcements of technological innovations or new products by us, our
licensees or our competitors;
o changes in ADSL market growth rates as well as investor perceptions
regarding the investment opportunity that companies participating in
the ADSL industry afford them;
o changes in earnings estimates by public market analysts;
o key personnel losses;
o sales of common stock; and
o developments or announcements with respect to industry standards,
patents or proprietary rights.
In addition, the equity markets have experienced volatility that has
particularly affected the market prices of equity securities of many high
technology companies and that often has been unrelated or disproportionate to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock.
OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS
The extensive regulation of the telecommunications industry by federal, state
and foreign regulatory agencies, including the Federal Communications
Commission, and various state public utility and service commissions, could
affect us through the effects of such regulation on our licensees and their
customers. In addition, our business may also be affected by the imposition of
certain tariffs, duties and other import restrictions on components that our
customers obtain from non-domestic suppliers or by the imposition of export
restrictions on products sold internationally and incorporating our technology.
Changes in current or future laws or regulations, in the United States or
elsewhere, could seriously harm our business.
24
ITEM 3:
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:
o Cash and cash equivalents, which consist of financial instruments with
original maturities of three months or less; and
o Investments, which consist of financial instruments that meet the high
quality standards specified in our investment policy. This policy
dictates that all instruments mature in three years or less, and
limits the amount of credit exposure to any one issue, issuer, and
type of instrument.
We do not use derivative financial instruments for speculative or trading
purposes. As of September 30, 2003, we had $35.0 million in cash, cash
equivalents and short-term investments that matured in twelve months or less.
Due to the short duration of these financial instruments, we do not expect that
an increase in interest rates would result in any material loss to our
investment portfolio.
As of September 30, 2003, we had invested $5.9 million in long-term investments
that matured in one to three years. These long-term securities are invested in
high quality corporate securities and U.S. government securities. Despite the
high quality of these securities, they may be subject to interest rate risk.
This means that if interest rates increase, the principal amount of our
investment would probably decline. A large increase in interest rates may cause
a material loss to our long-term investments. The following table (dollars in
thousands) presents hypothetical changes in the fair value of our long-term
investments at September 30, 2003. The modeling technique measures the change in
fair value arising from selected potential changes in interest rates. Movements
in interest rates of plus or minus 50 basis points (BP) and 100 BP reflect
immediate hypothetical shifts in the fair value of these investments.
VALUATION OF SECURITIES VALUATION OF SECURITIES
GIVEN AN INTEREST RATE GIVEN AN INTEREST RATE
DECREASE OF NO CHANGE INCREASE OF
------------------------- IN INTEREST --------------------------
TYPE OF SECURITY (100BP) (50 BP) RATES 100 BP 50 BP
- ---------------------------------------------------------------------------------------------------------------
Long-term investments with
maturities of one to three years $6,049 $5,992 $5,936 $5,826 $5,881
25
ITEM 4:
CONTROLS AND PROCEDURES
Our management, including our chief executive officer and chief financial
officer, has evaluated our disclosure controls and procedures as of the end of
the quarterly period covered by this Form 10-Q and has concluded that our
disclosure controls and procedures are effective. They also concluded that there
were no changes in our internal control over financial reporting that occurred
during the quarterly period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
26
PART II. OTHER INFORMATION
ITEM 1:
LEGAL PROCEEDINGS
From time to time we are involved in litigation incidental to the conduct of our
business. We are not party to any lawsuit or proceeding that, in our opinion, is
likely to seriously harm our business.
27
ITEM 6:
EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit 31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) REPORTS ON 8-K
We filed a Form 8-K dated July 31, 2003, which included as an exhibit a
press release dated July 31, 2003 announcing our financial results for
the quarter ended June 30, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AWARE, INC.
Date: November 12, 2003 By: /s/ Michael A. Tzannes
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Michael A. Tzannes, Chief
Executive Officer
Date: November 12, 2003 By: /s/ David J. Martin
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David J. Martin, Interim Chief
Financial Officer (Principal
Financial and Accounting Officer)
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