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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2003
Commission File Number: 000-06377
DREXLER TECHNOLOGY CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 77-0176309
- ------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1077 Independence Avenue, Mountain View, CA 94043-1601
- ------------------------------------------- -------------------
(Address of principal executive offices) (Zip Code)
(650) 969-7277
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). [X] Yes [ ] No
Number of outstanding shares of common stock, $.01 par value, at November 10,
2003: 10,567,355.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION Page Number
Item 1. Condensed Consolidated Financial Statements (Unaudited) 3
Condensed Consolidated Balance Sheets 3
Condensed Consolidated Statements of Operations 4
Condensed Consolidated Statements of Cash Flows 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
Item 3. Quantitative and Qualitative Disclosures about Market Rate Risks 20
Item 4. Controls and Procedures 20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 21
Item 6. Exhibits and Reports on Form 8-K 21
SIGNATURES 22
- -------------------------------------------------------------------------------------------
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
2
DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(In thousands, except share and per share amounts)
March 31, September 30,
2003 2003
---- ----
ASSETS
Current assets:
Cash and cash equivalents .................................................... $ 5,754 $ 10,284
Short-term investments........................................................ 4,363 3,749
Accounts receivable........................................................... 1,659 1,036
Inventories .................................................................. 5,711 5,182
Deferred tax asset, net....................................................... 2,689 4,513
Prepaid and other current assets.............................................. 1,016 588
--------- -----------
Total current assets ...................................................... 21,192 25,352
--------- -----------
Property and equipment, at cost.................................................. 23,204 23,068
Less--accumulated depreciation and amortization ............................... (15,795) (14,974)
--------- -----------
Property and equipment, net................................................ 7,409 8,094
Long-term investments............................................................ 6,898 2,144
Patents and other intangibles, net............................................... 567 485
Deferred tax asset, net.......................................................... 4,397 3,933
--------- -----------
Total assets.......................................................... $ 40,463 $ 40,008
========= ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.............................................................. $ 1,085 $ 577
Accrued liabilities .......................................................... 1,434 1,676
Advance payments from customers............................................... 1,096 2,270
Deferred revenue.............................................................. 5 467
--------- -----------
Total current liabilities.................................................. 3,620 4,990
--------- -----------
Stockholders' equity:
Preferred stock, $.01 par value:
Authorized--2,000,000 shares
Issued--none................................................................ -- --
Common stock, $.01 par value:
Authorized--30,000,000 shares
Issued--10,443,192 shares at March 31, 2003
and 10,566,622 shares at September 30, 2003........................... 104 106
Additional paid-in capital.................................................... 42,556 43,929
Accumulated deficit........................................................... (5,817) (9,017)
--------- -----------
Total stockholders' equity................................................. 36,843 35,018
--------- -----------
Total liabilities and stockholders' equity............................ $ 40,463 $ 40,008
========= ===========
The accompanying notes are an integral part of these condensed consolidated financial statements.
3
DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(In thousands, except per share amounts)
Three Months Ended Six Months Ended
September 30, September 30,
2002 2003 2002 2003
---- ---- ---- ----
Revenues
Total revenues............................................. $ 9,493 $ 2,708 $ 16,081 $ 5,154
--------- --------- --------- ---------
Cost of product sales............................................. 5,095 2,526 8,380 5,082
--------- --------- --------- ---------
Gross profit .............................................. 4,398 182 7,701 72
--------- --------- --------- ---------
Operating expenses:
Selling, general, and administrative expenses................. 1,438 1,642 3,008 3,411
Research and engineering expenses............................. 742 741 1,518 1,353
--------- --------- --------- ---------
Total operating expenses................................... 2,180 2,383 4,526 4,764
--------- --------- --------- ---------
Operating income (loss)................................. 2,218 (2,201) 3,175 (4,692)
--------- --------- --------- ---------
Other income, net................................................. 108 68 214 132
--------- --------- --------- ---------
Income (loss) before income taxes....................... 2,326 (2,133) 3,389 (4,560)
Income tax expense (benefit)...................................... 951 (389) 1,355 (1,360)
--------- --------- --------- ---------
Net income (loss)....................................... $ 1,375 $ (1,744) $ 2,034 $ (3,200)
========= ========= ========= =========
Net income (loss) per share:
Basic .................................................. $ .13 $ (.17) $ .20 $ (.30)
========= ========= ========== =========
Diluted ................................................ $ .13 $ (.17) $ .19 $ (.30)
========= ========= ========== =========
Weighted-average shares used in computing
net income (loss) per share:
Basic................................................... 10,314 10,553 10,307 10,516
Diluted................................................. 10,764 10,553 10,974 10,516
The accompanying notes are an integral part of these condensed consolidated financial statements.
4
DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
Six Months Ended
September 30,
2002 2003
---- ----
Cash flows from operating activities:
Net income (loss)....................................................................... $ 2,034 $ (3,200)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization....................................................... 884 945
Provision for doubtful accounts receivable.......................................... 11 2
Provision for product return reserve................................................ 26 --
Stock-based compensation............................................................ 43 49
Deferred tax expense (benefit)...................................................... 1,051 (1,360)
Tax benefit for stock option exercises.............................................. 97 --
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable.......................................... (216) 621
(Increase) decrease in inventories.................................................. (66) 529
Decrease in other assets............................................................ 175 428
Increase (decrease) in accounts payable and accrued liabilities..................... 582 (266)
Increase (decrease) in deferred revenue............................................. (2,860) 462
Increase (decrease) in advance payments from customers.............................. (1,952) 1,174
--------- ----------
Net cash used in operating activities.......................................... (191) (616)
--------- ----------
Cash flows from investing activities:
Purchases of property and equipment..................................................... (1,061) (1,494)
Investment in patents and other intangibles............................................. (298) (54)
Purchases of investments................................................................ (5,236) (2,713)
Proceeds from maturities of investments................................................. 3,399 8,081
--------- ----------
Net cash (used in) provided by investing activities............................ (3,196) 3,820
--------- ----------
Cash flows from financing activities:
Proceeds from sale of common stock through stock plans.................................. 916 1,326
--------- ----------
Net cash provided by financing activities...................................... 916 1,326
--------- ----------
Net (decrease) increase in cash and cash equivalents........................... (2,471) 4,530
Cash and cash equivalents:
Beginning of period..................................................................... 8,193 5,754
--------- ----------
End of period........................................................................... $ 5,722 $ 10,284
========= ==========
The accompanying notes are an integral part of these condensed consolidated financial statements.
5
DREXLER TECHNOLOGY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
BASIS OF PRESENTATION. The condensed consolidated financial statements
contained herein include the accounts of Drexler Technology Corporation and its
wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
The condensed consolidated financial statements included herein have been
prepared by the Company, without audit, pursuant to the rules and regulations of
the Securities and Exchange Commission. Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
have been condensed or omitted pursuant to such rules and regulations, although
the Company believes the disclosures which are made are adequate to make the
information presented not misleading. Further, the condensed consolidated
financial statements reflect, in the opinion of management, all adjustments
(which include only normal recurring adjustments) necessary to present fairly
the financial position and results of operations as of and for the periods
indicated.
These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and the notes thereto for
the year ended March 31, 2003, included in the Company's Annual Report on Form
10-K/A.
The results of operations for the three- and six-month periods ended
September 30, 2003 are not necessarily indicative of results to be expected for
the entire fiscal year ending March 31, 2004.
FISCAL PERIOD: For purposes of presentation, the Company labels its annual
accounting period end as March 31 and its interim quarterly periods as ending on
the last day of the corresponding month. The Company, in fact, operates and
reports based on quarterly periods ending on the Friday closest to month end.
The 13-week second quarter of fiscal 2003 ended on September 27, 2002, and the
14-week second quarter of fiscal 2004 ended on October 3, 2003.
INVENTORIES: Inventories are stated at the lower of cost or market, with
cost determined on a first-in, first-out basis and market based on the lower of
replacement cost or estimated realizable value. The components of inventories
are (in thousands):
March 31, September 30,
2003 2003
---- ----
Raw materials................... $ 3,234 $ 2,695
Work-in-process................. 220 381
Finished goods.................. 2,257 2,106
--------- ---------
$ 5,711 $ 5,182
========= =========
RECLASSIFICATIONS. Certain items have been reclassified in the prior year
to conform to the current year presentation.
NET INCOME (LOSS) PER SHARE: Basic net income (loss) per share is computed
by dividing net income (loss) by the weighted average number of shares of common
stock outstanding. Diluted net income (loss) per share is computed by dividing
net income (loss) by the weighted average number of shares of common stock and
common stock equivalents outstanding. Common stock equivalents consist of stock
options using the treasury stock method. As the effect of common stock
equivalents would be antidilutive, stock options were excluded from the
calculation of diluted net loss per share for the three and six-months ended
September 30, 2003. As the effect would be antidulutive, 414,000 and 32,000
shares, respectively, were excluded from the calculation of diluted net earnings
per share for the three months and six months ended September 30, 2002,
respectively. The reconciliation of the denominators of the basic and diluted
net income (loss) per share computation for the three and six months ended
September 30, 2002 and September 30, 2003 is shown in the following table (in
thousands, except per share data):
6
Three Months Ended Six Months Ended
September 30, September 30,
2002 2003 2002 2003
---- ---- ---- ----
Net income (loss)..................................... $ 1,375 $ (1,744) $ 2,034 $ (3,200)
========= ========= ========= =========
Basic net income (loss) per share:
Weighted average common shares outstanding........ 10,314 10,553 10,307 10,516
--------- --------- --------- ---------
Basic net income (loss) per share..................... $ .13 $ (.17) $ .20 $ (.30)
========= ========= ========= =========
Diluted net income (loss) per share:
Weighted average common shares outstanding........ 10,314 10,553 10,307 10,516
Weighted average common shares from
stock option grants............................ 450 -- 667 --
--------- --------- --------- ---------
Weighted average common shares and common
stock equivalents outstanding.................. 10,764 10,553 10,974 10,516
--------- --------- --------- ---------
Diluted net income (loss) per share................... $ .13 $ (.17) $ .19 $ (.30)
========= ========= ========= =========
REVENUE RECOGNITION. Product sales primarily consist of card sales and
sales of read/write drives. The Company recognizes revenue from product sales
when the following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the fee is fixed or determinable; and (4)
collectibility is reasonably assured. The Company recognizes revenue on product
sales at the time of shipment when shipping terms are F.O.B. shipping point,
orders are placed pursuant to a pre-existing sales arrangement, and there are no
post-shipment obligations or customer acceptance criteria. Where appropriate,
provision is made at the time of shipment for estimated warranty costs and
estimated returns.
The Company's U.S. government subcontract requires delivery into a secure,
government-funded vault located on the Company's premises. Shipments are made
from the vault on a shipment schedule provided by the prime contractor, which is
subject to revision, but not cancellation, at the option of the prime
contractor. At the time the cards are delivered into the vault, title to the
cards is transferred to the government and all risks of ownership are
transferred as well. The prime contractor is invoiced, with payment due within
thirty days, and the contract does not contain any return or cancellation
provisions. Pursuant to the provisions of SAB 101, revenue is recognized on
delivery into the vault as the Company has fulfilled its contractual obligations
and the earnings process is complete. If the Company does not receive a shipment
schedule, revenue is recognized upon shipment from the vault.
License revenue, which may consist of up-front license fees and long-term
royalty payments, is recognized as revenue when realized. The cost of license
revenue, unless patent litigation is involved, is not material and is included
in selling, general, and administrative expenses.
The Company applies the provisions of Statement of Position (SOP) 97-2,
"Software Revenue Recognition," as amended by SOP 98-9, "Modification of SOP
97-2, Software Revenue Recognition, With Respect to Certain Transactions" to all
transactions involving the sale of software products. Revenue from the license
of the Company's software products is recognized when persuasive evidence of an
arrangement exists, the software product has been delivered, the fee is fixed or
determinable, and collectibility is probable, and, if applicable, upon
acceptance when acceptance criteria are specified or upon expiration of the
acceptance period. To date, software sales have not been significant to the
Company's business.
ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
consolidated financial statements, the Company is required to estimate income
taxes in each of the jurisdictions in which it operates. This process involves
estimating the actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the consolidated balance
sheets. The Company must then assess the likelihood that the deferred tax assets
will be recovered from future taxable income and to the extent that management
believes recovery is not likely, the Company must establish a valuation
allowance. To the extent that a valuation
7
allowance is established or increased in a period, the Company must include an
expense within the tax provision in the statements of operations.
Significant management judgment is required in determining the provision
for income taxes and, in particular, any valuation allowance recorded against
the Company's deferred tax assets. The Company has recorded a valuation
allowance of $5.7 million as of September 30, 2003, due to uncertainties related
to its ability to utilize some of its deferred tax assets before they expire.
The amount of the valuation allowance has been determined based on management's
estimates of taxable income by jurisdiction in which the Company operates over
the periods in which the related deferred tax assets will be recoverable.
STOCK-BASED COMPENSATION. On December 31, 2002, the Financial Accounting
Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS)
No. 148, "Accounting for Stock Based Compensation - Transition and Disclosure,"
which amends SFAS No. 123. SFAS No. 148 requires more prominent and frequent
disclosures about the effects of stock-based compensation. The Company accounts
for its stock-based compensation plans using the intrinsic value method
prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees." Compensation cost for stock options, if any, is measured
by the excess of the quoted market price of the Company's stock at the date of
grant over the exercise price. SFAS No. 123, "Accounting for Stock-Based
Compensation," established accounting and disclosure requirements using a
fair-value based method of accounting for stock-based employee compensation
plans. Had compensation expense been determined consistent with SFAS No. 123,
the Company's net income (loss) and basic and diluted net income (loss) per
share would have decreased to the following pro forma amounts (dollars, in
thousands, except per share amounts):
Three Months Ended Six Months Ended
September 30, September 30,
2002 2003 2002 2003
---- ---- ---- ----
Net income (loss), as reported.................................... $ 1,375 $ (1,744) $ 2,034 $ (3,200)
======== ========== ======== =========
Add: Stock-based employee compensation expense
included in reported net income (loss), net of related
tax effects................................................... 9 9 26 29
Deduct: total stock-based employee compensation
determined under fair value based method for all
awards, net of related tax effects............................ (309) (328) (581) (664)
-------- ---------- -------- ---------
Pro forma net income (loss)....................................... $ 1,075 $ (2,063) $ 1,479 $ (3,835)
======== ========== ======== =========
Basic net income (loss) per common share:
As reported................................................... $ .13 $ (.17) $ .20 $ (.30)
========= ========== ========= =========
Pro forma..................................................... $ .10 $ (.20) $ .14 $ (.36)
========= ========== ========= =========
Diluted net income (loss) per common share:
As reported................................................... $ .13 $ (.17) $ .19 $ (.30)
========= ========== ========= =========
Pro forma..................................................... $ .10 $ (.20) $ .13 $ (.36)
========= ========== ========= =========
Shares used in computing basic and diluted pro forma
net income (loss) per share:
Basic ........................................................ 10,314 10,553 10,307 10,516
Diluted....................................................... 10,764 10,553 10,974 10,516
The Company computed the fair value of each option grant on the date of
grant using the Black-Scholes option valuation model with the following
assumptions:
8
Three Months Ended Six Months Ended
September 30, September 30,
2002 2003 2002 2003
---- ---- ---- ----
Risk-free interest rate.................................. 4.41% to 4.99% N/A 4.41% to 4.99% 2.74%
Average expected life of option.......................... 5 to 8 years N/A 5 to 8 years 5 years
Dividend yield........................................... 0% N/A 0% 0%
Volatility of common stock............................... 50% N/A 50% 50%
Weighted average fair value of option grants............. $10.67 N/A $10.67 $10.06
CONCENTRATION OF CREDIT RISK. One United States customer comprised 99% of
accounts receivable at March 31, 2003 and two United States customers comprised
81% and 17%, respectively, of accounts receivable at September 30, 2003.
SEGMENT REPORTING. The Company has two reportable segments: (1) optical
memory cards and (2) optical memory card drives, maintenance, and related
accessories.
The accounting policies for the segments are the same as those described in
the "Summary of Significant Accounting Policies." Resources are allocated to the
segments in a manner that optimizes optical memory card revenues as determined
by management. Segment net sales includes sales to external customers. Accounts
receivable, cash, deferred income taxes, prepaid expenses, certain fixed assets,
and other assets are not separately identifiable to segments. Therefore, the
amount of assets by segment is not meaningful. There are no inter-segment sales
or transfers.
The Company's reportable operating segments currently have different
financial characteristics. They are not strategic business units that offer
unrelated products and services. They do not utilize different technology or
require different marketing strategies. The Company's chief operating decision
maker is considered to be the Company's Co-Chief Executive Officers ("Co-CEOs").
The Co-CEOs review financial information presented on a consolidated basis that
is accompanied by disaggregated information about revenues and gross profit by
operating segment. The tables below present information for optical memory
cards, optical memory card drives, and other for the three- and six-month
periods ended September 30, 2002 and September 30, 2003:
Three Months Ended September 30, 2002 Three Months Ended September 30, 2003
------------------------------------- -------------------------------------
Gross Profit Gross Profit
Revenue Cost of Sales (Loss) Revenue Cost of Sales (Loss)
------- ------------- ------ ------- ------------- ------
Optical memory cards $ 9,236 $ 4,437 $ 4,799 $ 2,191 $ 1,851 $ 340
Optical card drives 105 535 (430) 471 652 (181)
Other 152 123 29 46 23 23
------- ------- ------- ------- ------- ------
$ 9,493 $ 5,095 $ 4,398 $ 2,708 $ 2,526 $ 182
======= ======= ======= ======= ======= ======
Six Months Ended September 30, 2002 Six Months Ended September 30, 2003
----------------------------------- -----------------------------------
Gross Profit Gross Profit
Revenue Cost of Sales (Loss) Revenue Cost of Sales (Loss)
------- ------------- ------ ------- ------------- ------
Optical memory cards $15,532 $ 7,288 $ 8,244 $ 4,480 $ 4,052 $ 428
Optical card drives 336 928 (592) 586 978 (392)
Other 213 164 49 88 52 36
------- ------- ------- ------- ------- ------
$16,081 $ 8,380 $ 7,701 $ 5,154 $ 5,082 $ 72
======= ======= ======= ======= ======= ======
LEGAL MATTERS. The Company was informed on July 10, 2003, that its
subsidiary, LaserCard Systems Corporation, had been named as one of several
defendants in a lawsuit brought by George Rawe. Mr. Rawe alleged in the lawsuit
that he was injured in laser eye surgery performed using a VISX, Incorporated
laser system that may have incorporated a LaserCard and read/write drive as
components. Mr. Rawe is suing the physicians involved for malpractice and VISX,
Incorporated, the Company, and various unnamed defendants for product liability,
alleging their products were defective. The lawsuit was filed in California
Superior Court for San Joaquin County, case number CV020962 and
9
seeks unspecified damages. The Company has tendered defense of the lawsuit to
its product liability insurance carrier, which has agreed to provide a defense.
RECENT ACCOUNTING PRONOUNCEMENTS. In November 2002, the Emerging Issues
Task Force (EITF) reached a consensus on Issue No. 00-21, "Revenue Arrangements
with Multiple Deliverables." EITF Issue No. 00-21 provides guidance on how to
account for arrangements that involve the delivery or performance of multiple
products, services and/or rights to use assets. The provisions of EITF Issue No.
00-21 will apply to revenue arrangements entered into in fiscal periods
beginning after June 15, 2003. The adoption of this standard did not have a
material impact on its consolidated financial statements.
In January 2003, the FASB issued Financial Interpretation No. 46,
"Consolidation of Variable Interest Entities" (FIN 46). FIN 46 addresses
consolidation by business enterprises of variable interest entities. Under that
interpretation, certain entities known as Variable Interest Entities (VIEs) must
be consolidated by the primary beneficiary of the entity. The primary
beneficiary is generally defined as having the majority of the risks and rewards
arising from the VIE. For VIEs in which a significant (but not majority)
variable interest is held, certain disclosures are required. It applies
immediately to variable interest entities created after January 31, 2003, and
applies in the first year or interim period beginning after June 15, 2003 to
variable interest entities in which an enterprise holds a variable interest that
it acquired before February 1, 2003. The adoption of this interpretation did not
have a material effect on the Company's consolidated financial statements.
In May 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. SFAS No. 149 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 No. 149 did not have an impact on the Company's consolidated
financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS
No. 150 establishes standards for how companies classify and measure certain
financial instruments with characteristics of both liabilities and equity. It
requires companies to classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). SFAS No. 150 is effective
beginning with the third quarter of fiscal 2004. The Company does not believe
that the adoption of SFAS No. 150 will have an impact on the Company's
consolidated financial statements.
In July 2003, the Emerging Issues Task Force ("EITF") reached a consensus
on Issue 03-5, "Applicability of AICPA Statement of Position 97-2 ("SOP 97-2")
to Non-Software Deliverables" ("EITF 03-5"). The consensus was reached that SOP
97-2 is applicable to non-software deliverables if they are included in an
arrangement that contains software that is essential to the non-software
deliverables' functionality. This consensus is to be applied to Company's
financial year beginning October 1, 2003. The Company has not yet evaluated the
impact that EITF 03-5 will have on its financial statements.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion and analysis of the Company's financial condition
and results of operations should be read in conjunction with the condensed
consolidated financial statements and related notes included elsewhere in this
Form 10-Q Report and the consolidated financial statements and notes thereto for
the year ended March 31, 2003, included in the Company's fiscal 2003 Annual
Report on Form 10-K/A.
FORWARD-LOOKING STATEMENTS
All statements contained in this report that are not historical facts are
forward-looking statements. The forward-looking statements in this report are
made pursuant to the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995. They are not historical facts or guarantees of future
performance or events. Rather, they are based on current expectations,
estimates, beliefs, assumptions, and goals and objectives and are subject to
uncertainties that are difficult to predict. As a result, the Company's actual
results may differ materially from the statements made.
10
Often such statements can be identified by their use of words such as "may,"
"will," "intends," "plans," "believes," "anticipates," "visualizes," "expects,"
and "estimates." Forward-looking statements made in this report include
statements as to current and potential market segments, customers, and
applications for and deployment of the Company's products; card quantities,
delivery rates, card backlog, and revenue recognition for U.S. or foreign
government programs; statements as to potential use of the Company's products in
the Department of Homeland Security (DHS) U.S. Visitor and Immigration Status
Indication Technology (US-VISIT) program and the Transportation Security Agency
(TSA) Transportation Workers Identification Credential (TWIC) card program; the
anticipated profit shortfall for the fiscal 2004 third quarter and the factors
related thereto; expectations as to the establishment of new sheet-lamination
production facilities and the short-term effect on gross margins; uncertainties
associated with achieving adequate production capacity for sheet-lamination
process cards to meet order requirements and delivery schedules; anticipated
continued use of the Company's cards by the governments of the United States,
Canada, and Italy, and an anticipated order for citizen ID cards for an
undisclosed country; reliance on value-added resellers and system integrators to
generate sales, perform customer system integration, develop application
software, test products, and work with governments to implement card programs;
the Company's efforts to recruit new value-added resellers (VARs); the Company's
expectations regarding current and future orders and deliveries of cards and
read/write drives under Italian government card programs; the need for, expected
success of, and potential benefits from the Company's research and engineering
efforts, including developing new or enhanced card capabilities, software
products, production-model read-only drives, or drives with advanced security
features or lower manufacturing costs; whether introduction of new drives will
increase sales, and the effects of read/write drive prices and sales volume on
gross profits or gross margins from read/write drive sales; the Company's belief
that the read/write drive inventory at September 30, 2003 is reflected at its
net realizable value; belief that there is a market for both designs of its
read/write drives to support and expand optical card sales and that the
read/write drive inventory on hand will be ordered by customers; expectations
regarding revenues, margins, capital resources, capital expenditures and
investments, and the Company's deferred tax asset and related valuation
allowance; anticipated reductions of federal tax cash payments due to current
Company tax benefits; statements as to expected card delivery volumes, estimates
of optical card production capacity, expected card yields therefrom, the
Company's ability to expand production capacity, and the Company's plans and
expectations regarding the growth and associated capital costs of such capacity;
estimates that revenues will be sufficient to generate cash from operating
activities over the next 12 months despite expected quarterly fluctuations; the
Company's expectation that it will complete the acquisition of two German card
companies in early 2004 after a due diligence period is completed; expectations
regarding market growth, product demand, and foreign business including emerging
programs or prospective applications in India, Italy, and several other
countries; and expectations as to continued, expanded, or potential U.S.
government or other governmental card programs.
These forward-looking statements are based upon the Company's assumptions
about and assessment of the future, which may or may not prove true, and involve
a number of risks and uncertainties including, but not limited to, customer
concentration and reliance on continued U.S. government business; risks
associated with doing business in and with foreign countries; lengthy sales
cycles and changes in and dependence on government policy-making; reliance on
value-added resellers and system integrators to generate sales, perform customer
system integration, develop application software, integrate optical card systems
with other technologies, test products, and work with governments to implement
card programs; risks and difficulties associated with development, manufacture,
and deployment of optical cards, drives, and systems; the possibility that
optical memory cards will not be selected for the full implementation of the
US-VISIT program, for the prototype phase of the TWIC program, or for new
government programs abroad; the impact of litigation or governmental or
regulatory proceedings; the ability of the Company or its customers to initiate
and develop new programs utilizing the Company's card products; risks and
difficulties associated with development, manufacture, and deployment of optical
cards, drives, and systems; potential manufacturing difficulties and
complications associated with increasing manufacturing capacity of cards and
drives, implementing new manufacturing processes, and outsourcing manufacturing;
the Company's ability to produce and sell read/write drives in volume; the
unpredictability of customer demand for products and customer issuance and
release of corresponding orders; government rights to withhold order releases,
reduce the quantities released, and extend shipment dates; whether the Company
receives a fixed payment schedule and/or a schedule, notification, or plan for
shipments out of the government-funded vault located on the Company's premises,
enabling the Company to recognize revenues on cards delivered to the vault
instead of when cards later are shipped from the vault; the possibility that the
proposed acquisition of two German card companies will not be completed due to
issues raised during due diligence or failure to be able to timely negotiate a
mutually acceptable agreement; the impact of technological advances, general
11
economic trends, and competitive products; and other risks detailed from time to
time in the SEC filings of Drexler Technology Corporation, including its Annual
Report on Form 10-K/A for the fiscal year ended March 31, 2003. These
forward-looking statements speak only as to the date of this report, and, except
as required by law, the Company undertakes no obligation to publicly release
updates or revisions to these statements whether as a result of new information,
future events, or otherwise.
CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION. Product sales primarily consist of card sales and
sales of read/write drives. The Company recognizes revenue from product sales
when the following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the fee is fixed or determinable; and (4)
collectibility is reasonably assured. The Company recognizes revenue on product
sales at the time of shipment when shipping terms are F.O.B. shipping point,
orders are placed pursuant to a pre-existing sales arrangement, and there are no
post-shipment obligations or customer acceptance criteria. Where appropriate,
provision is made at the time of shipment for estimated warranty costs and
estimated returns.
The Company's U.S. government subcontract requires delivery into a secure,
government-funded vault located on the Company's premises. Shipments are made
from the vault on a shipment schedule provided by the prime contractor, which is
subject to revision, but not cancellation, at the option of the prime
contractor. At the time the cards are delivered into the vault, title to the
cards is transferred to the government and all risks of ownership are
transferred as well. The prime contractor is invoiced, with payment due within
thirty days, and the contract does not contain any return or cancellation
provisions. Pursuant to the provisions of SAB 101, revenue is recognized on
delivery into the vault as the Company has fulfilled its contractual obligations
and the earnings process is complete. If the Company does not receive a shipment
schedule, revenue is recognized upon shipment from the vault.
License revenue, which may consist of up-front license fees and long-term
royalty payments, is recognized as revenue when realized. The cost of license
revenue, unless patent litigation is involved, is not material and is included
in selling, general, and administrative expenses.
The Company applies the provisions of Statement of Position (SOP) 97-2,
"Software Revenue Recognition," as amended by SOP 98-9, "Modification of SOP
97-2, Software Revenue Recognition, With Respect to Certain Transactions" to all
transactions involving the sale of software products. Revenue from the license
of the Company's software products is recognized when persuasive evidence of an
arrangement exists, the software product has been delivered, the fee is fixed or
determinable, and collectibility is probable, and, if applicable, upon
acceptance when acceptance criteria are specified or upon expiration of the
acceptance period. To date, software sales have not been significant to the
Company's business.
ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
consolidated financial statements, the Company is required to estimate income
taxes in each of the jurisdictions in which it operates. This process involves
estimating the actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the consolidated balance
sheets. The Company must then assess the likelihood that the deferred tax assets
will be recovered from future taxable income and to the extent that management
believes recovery is not likely, the Company must establish a valuation
allowance. To the extent that a valuation allowance is established or increased
in a period, the Company must include an expense within the tax provision in the
statements of operations.
Significant management judgment is required in determining the provision
for income taxes and, in particular, any valuation allowance recorded against
the Company's deferred tax assets. The Company has recorded a valuation
allowance of $5.7 million as of September 30, 2003, due to uncertainties related
to its ability to utilize some of its deferred tax assets before they expire.
The amount of the valuation allowance has been determined based on management's
estimates of taxable income by jurisdiction in which the Company operates over
the periods in which the related deferred tax assets will be recoverable.
12
The Company's net operating losses available to reduce future taxable
income expire on various dates from fiscal 2005 through fiscal 2024. The
Company's methodology for determining the realizability of its deferred tax
assets involves estimates of future taxable income; the estimated impact of
future stock option deductions; and the expiration dates and amounts of net
operating loss carryforwards. These estimates are based on near-term projections
and assumptions which management believes to be reasonable. In concluding that a
valuation allowance was required as of September 30, 2003, the Company
considered both the positive and negative evidence regarding its ability to
generate sufficient future taxable income to realize its deferred tax assets.
Positive evidence included having achieved taxable income in recent periods and
having achieved profitability for financial reporting purposes from fiscal 1999
through fiscal year 2003, which the Company concluded provided evidence
regarding its ability to generate a sustained level of future profits through
the expiration periods of the net operating loss carryforwards. Other positive
evidence included (1) the level of sales and business experienced under the
contract with the U.S. government for Permanent Resident Cards and Laser Visa
Border Crossing Cards and the Canadian government's Permanent Resident Card
program; (2) prospects in Italy and an unnamed eastern hemisphere country for
national identification card programs; (3) the heightened interest in border
security initiatives following the events of September 11, 2001, and (4)
expected future orders. Negative evidence included (1) the Company's reliance on
a limited number of customers for a substantial portion of its business; (2) the
uncertainty in timing of anticipated orders from customers; (3) the impact of
future stock option deductions on taxable income; and (4) recent experience of
net operating loss carryforwards expiring unused; and (5) the loss for the first
and second quarters of fiscal 2004. In weighing the positive and negative
evidence above, the Company considered the "more likely than not" criteria
pursuant to SFAS No. 109 as well as the risk factors related to its future
business described under the subheadings: "Dependence on VARs and on a Limited
Number of Customers," "Lengthy Sales Cycles," "Technological Change," and
"Competition" as noted in the section entitled "Factors That May Affect Future
Operating Results" in the Company's Report on Form 10-K/A for the fiscal year
ended March 31, 2003. The net deferred tax asset includes $1.9 million that
could expire during fiscal 2005 ending March 31, 2005 if the Company does not
achieve taxable profits in the interim. This would result in an additional $1.9
million in income tax expense.
In the event that actual results differ from these estimates or that these
estimates are adjusted in future periods, the Company may need to adjust the
amount of the valuation allowance based on future determinations of whether it
is more likely than not that some or all of its deferred tax assets will be
realized. An increase to the valuation allowance would require a corresponding
amount recorded as additional income tax expense, while a decrease in the
valuation allowance would be recorded as an income tax benefit or a credit to
stockholders' equity. If expected future profits and orders do not materialize
as anticipated, the Company may increase the valuation allowance, which will
result in recording income tax expense on the statement of operations.
INVENTORIES. The Company values its inventory at the lower of the actual
cost to purchase and/or manufacture the inventory or the current estimated
market value of the inventory. Management regularly reviews inventory quantities
on hand and records a provision for excess and obsolete inventory based
primarily on forecasts of product demand. Demand for read/write drives can
fluctuate significantly. LaserCard market growth could be limited and operating
results could be harmed if the Company is unable to produce and sell read/write
drives in volume. In order to obtain favorable pricing, purchases of certain
read/write drive parts are made in quantities that exceed the historical annual
sales rate of drives. The Company purchases read/write drive parts for its
anticipated read/write drive demand and takes into consideration the
order-to-delivery lead times of vendors and the economic purchase order quantity
for such parts.
Management's analysis of the carrying value of card and read/write drive
inventory is performed on a quarterly basis. With respect to inventory carrying
values, the Company follows the principles articulated in Accounting Research
Bulletin 43, Chapter 4, "Inventory Pricing," paragraphs 5 through 7 and 10 and
other authoritative guidance (Staff Accounting Bulletin 100) as it relates to
determining the appropriate cost basis of inventory and determining whether
firm, noncancelable purchase commitments should be accrued as a loss if
forecasted demand is not sufficient to utilize all such committed inventory
purchases. As part of the Company's quarterly excess/obsolete analysis,
management also determines whether lower of cost or market adjustments (i.e.,
where selling prices less certain costs are not sufficient to recover inventory
carrying values) are warranted; during the first six months of fiscal 2004, the
Company has not recorded any significant lower of cost or market adjustments. In
those instances where the Company has recorded charges for excess and obsolete
inventory, management ensures that such new cost basis is reflected in the
statement of operations if that inventory is subsequently sold.
13
RESULTS OF OPERATIONS--FISCAL 2004 SECOND QUARTER AND FIRST SIX MONTHS
COMPARED WITH FISCAL 2003 SECOND QUARTER AND FIRST SIX MONTHS
Overview
The Company's principal LaserCard market today involves high-security,
counterfeit-resistant, tamper-resistant cards for digital governance. In this
regard, the Company provides governments with high security LaserCard optical
memory cards, read/write drives, and related products to facilitate or expedite
the process of governing by documenting the grant of certain rights to citizens
and/or non-citizen permanent residents. These counterfeit- and tamper-resistant
cards are consumable products because they typically are replaced when the
rights documented by the cards expire. Within this market, the largest user of
LaserCard products is the U.S. government, which purchases the Company's
products through a value-added reseller, Information Spectrum, Inc. (ISI), a
unit of Anteon International Corporation. ISI is the government contractor for
LaserCard product sales to the U.S. Department of Homeland Security (DHS), U.S.
Department of State (DOS), U.S. Department of Defense (DOD), and the government
of Canada. Under government contracts with ISI, the DHS purchases U.S. Permanent
Resident Cards (Green Cards) and DOS "Laser Visa" Border Crossing Cards (BCCs);
the DOD purchases Automated Manifest System cards; and the Canadian government
purchases Permanent Resident Cards. Encompassing all of these programs, the
Company's product sales to ISI represented 75% of total revenues for the fiscal
2004 second quarter ended September 30, 2003, 99% of total revenues for the
fiscal 2003 second quarter ended September 30, 2002, 83% of total revenues for
the fiscal 2004 first six months, and 98% of total revenues for the fiscal 2003
first six months.
Revenues for U.S. government Green Cards and Laser Visa Border Crossing
Cards and for Canadian government Permanent Resident Cards are shown below as a
percentage of total Company revenues:
Three Months Ended Six Months Ended
September 30, September 30,
2002 2003 2002 2003
---- ---- ---- ----
United States Green Cards and Laser Visa BCCs...... 92% 47% 92% 45%
Canadian Permanent Resident Cards.................. 6% 20% 4% 31%
For the government of Italy, there are two card programs; the Company has
received orders for CIE cards (Carta d'Identica Elettronica) and anticipates
orders for the PSE cards (Permesso di Soggiorno Elettronico). The Company has
been informed by its Italian value-added reseller (VAR) that the government of
Italy plans to order significant quantities of CIE cards and PSE cards this
fiscal year, with a value estimated by the Company at approximately $5.2 million
for Phase 2 of the CIE card program (including a $2.4 million CIE card order
received in July 2003) and $2.7 million for PSE cards. After Phase 2 and if
Phase 3 is fully implemented, CIE card orders could reach 8 to 10 million cards
per year, plus several thousand optical memory card drives over time. However,
no assurance can be given that the Italian government will implement its
programs as currently visualized or that follow-on orders will result.
Potential applications for LaserCard optical memory card digital governance
programs include identification cards in several countries, motor vehicle
registration cards in India, and the expansion of current U.S. government ID
card programs due to the perceived increasing need for enhanced U.S. border
security. U.S. government ID programs include the U.S. Visitor and Immigration
Status Indication Technology (US-VISIT) program. The Company announced on
October 9, 2003 that it received an order from the US-VISIT program office for
1,000 optical memory card read/write drives and biometric verification systems
software, to be delivered by December 29, 2003. Revenue will be recognized upon
acceptance of the products by the U.S. government. These 1,000 drives and
software systems will be deployed by the DHS to air, land, and sea ports of
entry around the United States, enabling the DHS to read the encoded data on
more than 13 million Permanent Resident Cards and Border Crossing Cards
previously manufactured by the Company and issued by the U.S. government since
1998. Another potential U.S. government application for the LaserCard is the
U.S. Transportation Security Agency (TSA) Transportation Workers Identification
Credential (TWIC) card program. A small quantity of drives and cards were
purchased from the Company for the TWIC evaluation and testing phase, after
which the digital card technologies that are deemed appropriate would then be
eligible to enter into the prototype phase of the program. Since governmental
card programs typically rely on
14
government policy-making, which in turn is subject to technical requirements,
budget approvals, and political considerations, there is no assurance that these
programs will be implemented as expected or that the Company will be chosen as a
vendor for the prototype phase of the TWIC program or for the full
implementation of the US-VISIT program.
In addition to using its own marketing staff, the Company utilizes VAR
companies and card distribution licensees for the development of commercial
markets and applications for LaserCard products. Product sales to VARs and
licensees consist primarily of the Company's optical memory cards and optical
card read/write drives. The Company also offers for sale, its customized
software applications and add-on peripherals made by other companies (such as
equipment for adding a digitized photo, fingerprint, hand template, or signature
to the cards). The VARs/licensees may add application software, personal
computers, and other peripherals, and then resell these products integrated into
data systems. The Company is continuing its efforts to recruit new VARs and
eliminate nonproductive VARs.
The Company's current U.S. government subcontract for Green Cards and Laser
Visa BCCs has an authorized maximum of $81 million for up to 24 million cards
over a period of up to five years. Announced in June 2000, this subcontract was
received by the Company through a LaserCard VAR that is a U.S. government prime
contractor, under a competitively bid, government procurement contract. The
subcontract provides for an initial one-year contract period and four additional
one-year contract options. This contract was most recently extended in June 2003
for the one-year period through May 25, 2004. This subcontract has one remaining
extension, and there is no assurance that a follow-on contract will be issued by
the DHS. Under this supply subcontract for up to $81 million , $38 million has
been recorded as revenue during the period from September 2000 through September
2003. In addition, the Company has supplied optical memory cards to the U.S.
government since 1997 under previous subcontracts totaling $31 million., for a
combined total of over $69 million.
In 2002, the Company was awarded a subcontract for production of Canada's
new Permanent Resident Cards. Orders to date under this subcontract now total
1.5 million cards, including a 400,000 card order announced on September 11,
2003. The subcontract provides for a minimum purchase of 2.3 million cards over
the five-year term of the subcontract. Also in 2002, the Canadian government
purchased 220 read/write drives from the Company to read and verify Canadian
Permanent Resident Cards and to authenticate U.S. Green Cards and Laser Visa
BCCs.
On August 13, 2003, the Company announced that an undisclosed country has
selected the Company's optical memory cards for secure personal identification,
and orders for optical memory cards are anticipated. The Company sold 120 drives
for this program, most of which were shipped in the fiscal 2004 second quarter,
for installation of the infrastructure required for card issuance.
Revenues
The Company's total revenues for the fiscal 2004 second quarter ended
September 30, 2003 consisted of sales of optical memory cards, optical card
read/write drives, drive accessories, maintenance, peripherals, and other
miscellaneous items. For the fiscal 2004 second quarter, the Company's total
revenues were $2,708,000 for the fiscal 2004 second quarter and $5,154,000 for
the fiscal 2004 first six months, compared with $9,493,000 for the fiscal 2003
second quarter and $16,081,000 for the fiscal 2003 first six months. The
decrease in total revenues was due to lower sales of optical memory cards for
the U.S. government's Laser Visa BCC and Green Card programs, as described
above.
Revenue on optical memory cards totaled $2,190,000 for the fiscal 2004
second quarter compared with $9,236,000 for the fiscal 2003 second quarter.
Revenue on optical memory cards totaled $4,480,000 for the first six months of
fiscal 2004 compared with $15,532,000 for the first six months of fiscal 2003.
As reported previously by the Company, follow-on production of U.S. "Laser Visa"
Border Crossing Cards (BCCs) and Permanent Resident Cards (Green Cards) for the
U.S. Department of Homeland Security (DHS) was delayed during the fiscal 2004
first quarter while new artwork for the cards was being designed by DHS. The
artwork change for Laser Visa BCCs was completed in July 2003, and on July 14,
2003, the Company announced receipt of an optical memory card order valued at
approximately $2 million for Laser Visa BCCs, under the U.S. government
subcontract described above. The new order called for card production to start
immediately and to be completed within four months. The DHS has not yet
15
approved new artwork for Green Cards, which has resulted in no production or
revenues for these cards since April 2003.
The Company's U.S. government subcontract requires delivery into a secure,
government-funded vault located on the Company's premises. Shipments are made
from the vault on a shipment schedule provided by the prime contractor, which is
subject to revision, but not cancellation, at the option of the prime
contractor. At the time the cards are delivered into the vault, title to the
cards is transferred to the government and all risks of ownership are
transferred as well. The prime contractor is invoiced, with payment due within
thirty days, and the contract does not contain any return or cancellation
provisions. Pursuant to the provisions of SAB 101, revenue is recognized on
delivery into the vault as the Company has fulfilled its contractual obligations
and the earnings process is complete. If the Company does not receive a shipment
schedule, revenue is recognized upon shipment from the vault. For the three
months ended June 30, 2002, revenue was recognized upon shipment of U.S.
government cards from this vault because the Company did not receive a fixed
schedule for shipment of cards out of the vault to the customer. For the three
months ended September 30, 2002, for the first time, the Company did receive a
fixed schedule for shipment of the cards out of this vault to the customer;
therefore, in addition to revenue recognized upon shipment of cards from the
vault, the Company also recorded $6.9 million in revenue on U.S. Government
cards that were located in the vault on September 30, 2002 that had not yet been
shipped to the customer. For the three and six months ended September 30, 2003,
revenue of $1.3 million and $2.3 million, respectively, was recognized upon
delivery of U.S. government cards to this vault that have not yet been shipped
to the customer but for which the Company received a fixed schedule for shipment
of the cards out of the vault.
Revenue on read/write drives, drive accessories, and maintenance totaled
$472,000 for the fiscal 2004 second quarter compared with $105,000 for the
fiscal 2003 second quarter. Revenue on read/write drives, drive accessories, and
maintenance totaled $586,000 for the fiscal 2004 first six months compared with
$325,000 for the fiscal 2003 first six months. These increases were due to a
rise in unit sales volume for read/write drives. For the fiscal 2004 second
quarter, 69% of read/write drive revenues were for an unnamed eastern hemisphere
country, for the purpose of installing the infrastructure for card issuance
under a new ID card program.
Optical memory card revenues for the quarter ended September 30, 2003
mainly included sales of Laser Visa Border Crossing Cards manufactured for the
U.S. government and sales of Permanent Resident Cards made for the Canadian
government. The Company had anticipated additional sales to other customers
during the second quarter, including the Italian government for its planned
national ID card program (CIE card), for which a card order was announced on
July 28, 2003. After specifications and card structure are finalized, volume
shipments of CIE cards are expected to begin in the quarter ending December 31,
2003. In addition, as most recently reported by the Company on September 11,
2003 and October 30, 2003, the Company is still awaiting approval of the new
artwork for U.S. Department of Homeland Security (DHS) Green Cards. The Company
anticipates further orders for Green Cards this fiscal year after the design
artwork has been approved, although the amount and timing of orders and revenue
recognition cannot be predicted.
Revenues during fiscal year 2003 included about $21.2 million on sales of
Green Cards and Laser Visa BCCs. The Company anticipates that fiscal 2004
revenues for these two programs will not exceed $5 million. Revenues through the
first six months of fiscal 2004 for these two programs were approximately $2.3
million.
Backlog
As of September 30, 2003, the backlog for LaserCard optical memory cards
totaled approximately $5.75 million in firm card orders for delivery this fiscal
year. As of September 30, 2002, the backlog for LaserCard optical memory cards
totaled approximately $10.45 million. Order backlog as of September 30, 2003
includes orders for the following programs: Laser Visa BCCs for the U.S.
Department of Homeland Security, Italian government national ID cards (CIE
cards), and Canadian government Permanent Resident Cards. Backlog is subject to
fluctuation due to having few customers and the timing of orders.
Subsequent to the end of the fiscal 2004 second quarter, on October 9,
2003, the Company announced receipt of an order for 1,000 optical memory card
read/write drives and biometric verification systems software for the US-
16
VISIT program, for delivery by December 31, 2003. These 1,000 drives and
software systems will be deployed by the U.S. Department of Homeland Security
(DHS) to air, land, and sea ports of entry around the United States. They will
enable the DHS to read the encoded data on more than 13 million U.S. Permanent
Resident Cards and Border Crossing Cards previously manufactured by the Company
and issued by the U.S. government since 1998.
Gross Margin
Gross margin on product sales was 7% for the fiscal 2004 second quarter and
1% for the fiscal 2004 first six months compared with 46% for the fiscal 2003
second quarter and 48% for the fiscal 2003 first six months. The overall gross
profit declined $4,216,000, to $182,000 for the second quarter of fiscal 2004
from $4,398,000 for the second quarter of fiscal 2003. For the fiscal 2004 first
six months, overall gross profit declined $7,629,000 to $72,000 from $7,701,000
for the fiscal 2003 first six months, due principally to the decline in revenue.
OPTICAL MEMORY CARDS. Prior to fiscal 2004, optical memory card gross
margins have approximated 50%. Optical memory card gross profit and margins can
vary significantly based on average selling price, sales and production volume,
mix of card types, production efficiency and yields, and changes in fixed costs.
The gross margin on optical memory cards declined to 16% for the second quarter
of fiscal 2004 and 10% for the first six months of fiscal 2004 versus 52% for
the second quarter of fiscal 2003 and 53% for the first six months of fiscal
2003. The declines in both periods were primarily due to low revenues and
production volume and the corresponding underabsorption of fixed costs.
As reported by the Company on September 11, 2003, the gross profit margins
for production of the new national ID cards for the Italian government will be
limited in the short term due to the establishment of additional
sheet-lamination production facilities and the production ramp-up and learning
curve associated with achieving high-volume production of these new products.
This sheet-lamination process, also used to make Canadian Permanent Resident
Cards, is currently more labor intensive but allows the use of high security
offset printing and other special features, resulting in a premium card. To
date, gross margins on the Canadian cards have not exceeded approximately 40%.
The Company believes that over time it will be able to improve margins on cards
made by the sheet-lamination process through automation and yield improvements.
More significantly in the fiscal 2004 second quarter just ended, card production
orders for U.S. Green Cards and Laser Visa BCCs for the U.S. Department of
Homeland Security were much lower than last year's levels. The Company is still
awaiting approval of the new artwork for the DHS Green Cards. DHS cards are made
using the Company's normal, roll-lamination process that has been in high-volume
production since 1997, with predictable gross profit margins of approximately
50% based on production volumes of over one million cards per quarter.
READ/WRITE DRIVES. Read/write drive gross margins are currently negative,
inclusive of fixed overhead costs. Even if read/write drive sales volume
achieves positive gross profit, the Company believes that read/write drive gross
margins will remain below 10% for the foreseeable future unless the drives are
bundled with other products. For the fiscal 2004 second quarter, the Company had
a negative gross profit on read/write drive sales of approximately $180,000
compared with a negative gross profit of approximately $430,000 for the fiscal
2003 second quarter. For the fiscal 2004 first six months, gross profit on
read/write drive sales was a negative gross profit of approximately $390,000
compared with a negative gross profit of approximately $585,000 for the fiscal
2003 first six months. Last year, during the fiscal 2003 second quarter, the
Company wrote off read/write drive inventory totaling $273,000.
Income and Expenses
SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES (SG&A). SG&A expenses were
$1,642,000 for the fiscal 2004 second quarter compared with $1,438,000 for the
fiscal 2003 second quarter. The increase of $204,000 for the second quarter of
fiscal 2004 compared with the second quarter of fiscal 2003 was primarily due to
an increase of approximately $116,000 for insurance premiums and an increase of
$80,000 for accounting services. For the fiscal 2004 first six months, SG&A
expenses were $3,411,000 compared with $3,008,000 for the fiscal 2003 first six
months. The increase of $403,000 for the fiscal 2004 first six months compared
with the fiscal 2003 first six months was due mainly to an increase of $228,000
for insurance and $160,000 for accounting services. The Company believes that
SG&A expenses for fiscal 2004 will be higher than fiscal 2003 levels, mainly due
to increases in marketing and selling expenses, payroll costs, increases in
insurance premiums and accounting and audit fees, and other general increases.
17
RESEARCH AND ENGINEERING EXPENSES (R&E). The Company is continuing its
efforts to develop new optical memory card features and structures, including
various sheet-lamination card structures, the insertion of contactless chips
with radio frequency (RF) capability, Optichip OVD(TM) (optically variable
device) products and associated media development, optical memory card
read/write drives, read-only drives (readers), and software products in an
effort to provide new products that can stimulate optical memory card sales
growth. For example, the Company recently has developed a prototype of a
LaserCard handheld reader. The Company anticipates that these ongoing research
and engineering efforts will result in new or enhanced card capabilities,
production-model read-only drives, or drives with advanced security features and
lower manufacturing costs; however, there is no assurance that such product
development efforts will be successful. These features are important for the
Company's existing and future optical memory card markets. Total R&E expenses
were $741,000 for the second quarter of fiscal 2004 compared with $742,000 for
the second quarter of fiscal 2003. For the first six months of fiscal 2004, R&E
expenses were $1,353,000 compared with $1,518,000 for the first six months of
fiscal 2003. The $165,000 decrease for the fiscal 2004 first six months is
mainly due to a $51,000 reduction in purchased services, a $63,000 decrease in
prototype expenditures, and a $65,000 reduction due to the completion last year
of the amortization of design technology transfer costs.
OTHER INCOME AND EXPENSE. Total net other income for the second quarter of
fiscal 2004 was $68,000, consisting of $66,000 in interest income, compared with
$108,000 of interest income for the second quarter of fiscal 2003. Total net
other income for the first six months of fiscal 2004 was $132,000 consisting of
$128,000 of interest income compared with $214,000 of interest income for the
first six months of fiscal 2003. These decreases were due to decreases in
interest rates.
INCOME (LOSS) BEFORE INCOME TAXES. Income (loss) before income taxes for
the second quarter of fiscal 2004 decreased by $4,459,000 compared with the
second quarter of fiscal 2003, mainly due to the $4,216,000 decrease in gross
profit. For the same reason, income (loss) before income taxes for the first six
months of fiscal 2004 decreased by $7,949,000 compared with the first six months
of fiscal 2003.
INCOME TAXES. The Company recorded an income tax benefit of $389,000 for
the second quarter of fiscal 2004 compared with an income tax expense of
$951,000 for the second quarter of fiscal 2003. For the first six months of
fiscal 2004, the Company recorded an income tax benefit of $1,360,000 compared
with an income tax expense of $1,355,000 for the first six months of fiscal
2003. The amount of income tax benefit recorded for the fiscal 2004 second
quarter was based upon the Company's anticipated tax rate for the full fiscal
year, partially offset by an increase in the deferred tax asset valuation
allowance as the analysis performed by management indicated a reduction in the
anticipated realization of the deferred tax asset.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2003, the Company had cash, cash equivalents, and
short-term investments of $14,033,000, a current ratio of 5.1 to 1, and no
long-term debt. The Company also had $2,144,000 in long-term investments with
original maturities from 1 year to 2 1/2 years.
Net cash used for operating activities was $616,000 for the first six
months of fiscal 2004 compared with $191,000 for the first six months of fiscal
2003. The primary reason for the decline in operating cash flow was the net loss
recorded of $3,200,000, subtracting $364,000 in non-cash adjustments, and adding
$2,948,000 for changes in operating assets and liabilities. The primary reason
for the cash used in operating activities during the first six months of fiscal
2003 was the profit recorded of $2,034,000, adding the $2,112,000 of non-cash
adjustments, and deducting $4,337,000 for changes in operating assets and
liabilities.
The Company believes that the estimated level of revenues over the next 12
months will be sufficient to generate cash from operating activities over the
same period. However, quarterly fluctuations are expected. Operating cash flow
could be negatively impacted to a significant degree if either of the Company's
largest U.S. government programs were to be further delayed, canceled, or not
extended and not be replaced by other card orders or other sources of income, or
if increases in product revenues or licenses do not keep pace with increased
marketing and R&E expenditures.
18
The Company has not established a line of credit and has no current plans
to do so. The Company may negotiate a line of credit if and when it becomes
appropriate, although no assurance can be made that such financing would be
available on favorable terms or at all, if needed.
As a result of the $1,744,000 net loss recorded for the fiscal 2004 second
quarter, the Company's accumulated deficit increased to $9,017,000.
Stockholders' equity decreased to $35,018,000 as a result of the net loss
recorded that was partially offset by $211,000 in additions to equity due to the
sale of stock through stock plans during the fiscal 2004 second quarter.
Net cash provided by investing activities was $3,820,000 for the first six
months of fiscal 2004 compared with $3,196,000 used for investing activities in
the first six months of fiscal 2003. These amounts include changes in the
maturity of liquid investments, purchases of property and equipment of
$1,494,000 for the first six months of fiscal 2004, and $1,061,000 for the first
six months of fiscal 2003, and increases in patents and other intangibles of
$54,000 for the first six months of fiscal 2004 and $298,000 for the first six
months of fiscal 2003.
The Company considers all highly liquid investments, consisting primarily
of commercial paper, taxable notes, and U.S. government bonds, with original or
remaining maturities of three months or less at the date of purchase, to be cash
equivalents. All investments with original or remaining maturities of more than
three months but not more than one year at the date of purchase, are classified
as short-term. Investments with original or remaining maturities of more than
one year at the date of purchase are classified as long-term. The Company
determines the length of its investments after considering its cash requirements
and yields available for the type of investment considered by the Company.
Management also determines the appropriate classification of debt and equity
securities at the time of purchase and reevaluates the classification of
investments as of each balance sheet date. As of September 30, 2003, the Company
had $5,893,000 classified as short-term and long-term investments, compared with
$11,261,000 at March 31, 2003. All marketable securities were classified as
held-to-maturity. Cash, short-term investments, and long-term investments were
$16,177,000 at September 30, 2003 and $17,015,000 at March 31, 2003.
The Company made capital equipment and leasehold improvement purchases of
approximately $1.5 million during the first six months of fiscal 2004 compared
with approximately $1.1 million during the first six months of fiscal 2003.
Depending on card type, the Company's current card production capacity is
estimated at approximately 13 million cards per year. The Company plans to
purchase additional production equipment in a series of steps when deemed
appropriate by the Company. The Company is also increasing production capacity
for cards with new structures used by the Canadian and Italian programs. In
addition to investment used for expansion, the Company expects to make
additional capital expenditures for cost savings, quality improvements, and
other purposes. The Company plans to use cash on hand and cash generated from
operations to fund capital expenditures of approximately $7 million during
fiscal 2004 for equipment and leasehold improvements for card production,
read/write drive tooling and assembly, and general support items. Approximately
$5 million of this proposed expenditure is slated for new card manufacturing
equipment. The Company also may invest cash in leasehold improvements on
additional leased space and/or acquisition of companies with synergistic
products and/or manufacturing capabilities. In these regards, the Company
anticipates using cash in the amount of $3 million in the next 12 months if it
completes the planned $5.5 million acquisition of two German card companies,
which is expected to take place in early 2004, and a subsequent payment of $2.5
million spread over the following four years. The Company may raise cash through
debt and/or equity financing to fund these investments in capital equipment,
leasehold improvements, and acquisitions, including those listed above. Due to
current commercial real estate market conditions and by renegotiating an
existing lease, the Company anticipates that it will be able to lease additional
square footage at this time without increasing its lease payments.
Net cash provided by financing activities was $1,326,000 for the first six
months of fiscal 2004 compared with net cash provided by financing activities of
$916,000 for the first six months of fiscal 2003. Financing activities consisted
of proceeds on sales of common stock through the Company's stock-option and
stock-purchase plans.
There were no debt financing activities for the fiscal 2004 first six
months ended September 30, 2003.
19
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RATE RISKS
INTEREST RATE RISK. The Company invests its cash, beyond that needed for
daily operations, in high quality debt securities. In doing so, the Company
seeks primarily to preserve the value and liquidity of its capital and,
secondarily, to safely earn income from these investments. To accomplish these
goals, the Company invests only in debt securities issued by (a) the U.S.
Treasury and U.S. government agencies and corporations and (b) debt instruments
that meet the following criteria:
-- Commercial paper rated A1/P1 or debt instruments rated AAA, as rated by
the major rating services
-- Can readily be sold for cash
There were no material changes during the second quarter of fiscal 2004 to
the Company's exposure to market risk for changes in interest rates.
FOREIGN CURRENCY EXCHANGE RATE RISK. The Company sells products in various
international markets. All of these sales are denominated in U.S. Dollars. As of
September 30, 2003, the Company had no outstanding foreign currency hedge
contracts. Accordingly, the Company had no material foreign currency exchange
risk as of September 30, 2003. There were no material changes during the second
quarter of fiscal 2004 to the Company's foreign currency exchange rate risk.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. The Company's principal
executive officers and principal financial officer have evaluated the Company's
disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c)
and 15d-14(c)) as of the end of the period covered by this Form 10-Q and have
determined that they are reasonable taking into account the totality of the
circumstances.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. There were no
significant changes in the Company's internal control over financial reporting
that occurred during the period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, such control.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There have been no material developments this past quarter to the
litigation described in the Company's Annual Report on Form 10-K for the fiscal
year ended March 31, 2003, as supplemented by the Company's Quarterly Report on
Form 10-Q for the quarterly period ended June 30, 2003.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's October 10, 2003 Annual Meeting of Stockholders, the
Company's stockholders (i) re-elected the existing Board of Directors and (ii)
rejected a stockholder proposal related to engaging an investment banking firm.
Of the 10,555,923 shares of common stock outstanding as of the record date
of August 21, 2003, a total of 9,996,807 shares were voted by proxy,
representing 95% of the total votes eligible to be cast, constituting a majority
and more than a quorum of the outstanding shares entitled to vote. Votes cast in
connection with the election of directors were: Jerome Drexler (9,902,089 votes
for re-election, 94,718 votes withheld), Christopher J. Dyball (9,487,382 votes
for election, 509,425 votes withheld), Richard M. Haddock (9,908,269 votes for
election, 88,538 votes withheld), Arthur H. Hausman (9,044,016 votes for
re-election, 952,791 votes withheld), Dan Maydan (9,720,111 votes for
re-election, 276,696 votes withheld), William E. McKenna (9,038,766 votes for
re-election, 958,041 votes withheld), and Walter F. Walker (8,650,739 votes for
re-election, 1,346,068 votes withheld). On the stockholder's proposal related to
engaging an investment banking firm, 784,679 shares were voted in favor, and
there were 6,241,764 negative votes, 79,662 abstentions, and 2,890,702 broker
non-votes.
20
There were no other matters submitted to a vote of security holders during
the period for which this report is filed.
ITEM 5. OTHER INFORMATION
The Company's Audit Committee has approved certain non-audit services
provided or to be provided by KPMG LLP, the Company's independent accountants.
These services relate to consultation, advice, and other services in connection
with tax planning and compliance.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit No. Exhibit Description
----------- -------------------
3.1 Amended and Restated By-Laws as of August 21, 2003
31.1 Rule 13a-14(a) Certification of Christopher J. Dyball,
co-principal executive officer
31.2 Rule 13a-14(a) Certification of Richard M. Haddock,
co-principal executive officer
31.3 Rule 13a-14(a) Certification of Steven G. Larson,
principal financial officer
32.1 Section 1350 Certification of Christopher J. Dyball and
Richard M. Haddock, co-chief executive officers
32.2 Section 1350 Certification of Steven G. Larson, chief
financial officer
The above-listed exhibits are filed herewith. No other exhibits are
included in this report as the contents of the required exhibits are either not
applicable to Registrant, to be provided only if Registrant desires, or
contained elsewhere in this report.
(b) Reports on Form 8-K
On August 12, 2003, the Company filed a Report on Form 8-K dated August 6,
2003, which reported under Item 12 the issuance of a press release containing
financial results for the fiscal 2004 first quarter ended June 30, 2003.
On August 29, 2003, the Company filed a Report on Form 8-K dated August 28,
2003, which reported under Item 5 the issuance of a press release announcing the
appointment of Richard M. Haddock and Christopher J. Dyball as Co-Chief
Executive Officers.
On September 5, 2003, the Company filed a Report on Form 8-K dated August
29, 2003, which reported under Item 4 that PricewaterhouseCoopers LLP ("PwC")
had informed the Company that PwC would not be standing for re-appointment as
the Company's independent auditors.
21
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized:
DREXLER TECHNOLOGY CORPORATION
(Registrant)
Signature Title Date
--------- ----- ----
/s/ Christopher J. Dyball Co-Chief Executive Officer November 14, 2003
- ---------------------------------- (Co-Principal Executive Officer)
Christopher J. Dyball
/s/ Richard M. Haddock Co-Chief Executive Officer November 14, 2003
- ---------------------------------- (Co-Principal Executive Officer)
Richard M. Haddock
/s/ Steven G. Larson Vice President of Finance and Treasurer November 14, 2003
- ---------------------------------- (Principal Financial Officer and
Steven G. Larson Principal Accounting Officer)
22
INDEX TO EXHIBITS
[ITEM 14(c)]
Exhibit
Number Description
- ------ -----------
3.1 Amended and Restated By-Laws dated August 21, 2003, filed herewith
31.1 Rule 13a-14(a) Certification of Christopher J. Dyball, co-principal
executive officer
31.2 Rule 13a-14(a) Certification of Richard M. Haddock, co-principal
executive officer
31.3 Rule 13a-14(a) Certification of Steven G. Larson, principal
financial officer
32.1 Section 1350 Certification of Christopher J. Dyball and
Richard M. Haddock, co-chief executive officers
32.2 Section 1350 Certification of Steven G. Larson, chief financial
officer