Back to GetFilings.com
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
-----------
(Exact Name of Registrant as Specified in Its Charter)
MASSACHUSETTS 04-2911026
------------- ----------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS 01730
---------------------------------------------------
(Address of Principal Executive Offices)
(Zip Code)
(781) 276-4000
--------------
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, PAR VALUE $.01 PER SHARE
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.YES X NO
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2). YES X NO
--- ---
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of June 30, 2003, based on the closing price of the common stock
on June 30, 2003 as reported on the Nasdaq National Market, was approximately
$51,341,703.
The number of shares outstanding of the registrant's common stock as of March 2,
2004 was 22,750,294.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive Proxy Statement to be delivered to
shareholders in connection with the registrant's Annual Meeting of Shareholders
to be held on May 27, 2004 are incorporated by reference into
Part III of this Annual Report on Form 10-K.
================================================================================
AWARE, INC.
FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2003
TABLE OF CONTENTS
PART I
Item 1. Description of the Business............................................................... 3
Item 2. Properties................................................................................ 9
Item 3. Legal Proceedings......................................................................... 9
Item 4. Submission of Matters to a Vote of Security Holders....................................... 9
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities..................................................................... 10
Item 6. Selected Financial Data.................................................................. 10
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations............................................................................. 11
Item 7A. Quantitative and Qualitative Disclosures About Market Risk................................ 24
Item 8. Consolidated Financial Statements and Supplementary Data.................................. 26
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure................................................................................ 44
Item 9A. Controls and Procedures................................................................... 44
PART III
Item 10. Directors and Executive Officers of the Registrant........................................ 44
Item 11. Executive Compensation.................................................................... 44
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters................................................................................... 44
Item 13. Certain Relationships and Related Transactions............................................ 44
Item 14. Principal Accountant Fees and Services.................................................... 44
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.......................... 45
Signatures........................................................................................... 47
2
PART I
ITEM 1. DESCRIPTION OF THE BUSINESS
COMPANY OVERVIEW
We are a worldwide leader in the development and marketing of intellectual
property for broadband communications. We license our intellectual property to
semiconductor companies that build integrated circuits based on our technology.
Our principal offering to date has been Digital Subscriber Line ("DSL")
technology for the telecommunications industry. DSL enables telephone companies
to use their existing copper telephone lines to offer broadband services.
Our principal DSL offering is a technology package for Asymmetric Digital
Subscriber Line ("ADSL"). ADSL is a broadband service that is primarily targeted
at residential telephone customers for high-speed Internet access. ADSL has been
standardized for global use by the International Telecommunications Union
("ITU"). Our ADSL technology package is compliant with applicable ITU standards.
We have complemented our core ADSL technology offering with technologies aimed
at enhancing the value of ADSL to telephone companies. We also have projects
underway to develop other forms of DSL, as well as other broadband technologies.
We play an active role in setting standards for broadband technologies so that
we can anticipate and develop technology that meets the needs of changing
markets.
During 2002 and 2003, approximately 64% and 56%, respectively, of our revenue
came from licensing ADSL intellectual property. We license our intellectual
property worldwide through our direct sales force. Our largest semiconductor
customers in 2003 were Analog Devices, Inc. and Infineon Technologies, AG. The
remainder of our revenue came from the sale of hardware and software products.
Our hardware products include board-level products that allow customers to make
products that require ADSL connectivity, such as ADSL test equipment. Our
hardware products also include system-level products that enable our customers
to develop and test their ADSL products. Our software products compress digital
images and data for law enforcement and other applications.
We are headquartered in Bedford, Massachusetts. Our telephone number is (781)
276-4000, and our website is www.aware.com. Incorporated in Massachusetts in
1986, we employed 111 people at December 31, 2003. Our stock is traded on the
Nasdaq National Market under the symbol AWRE.
Our website provides a link to a third-party website through which our annual,
quarterly and current reports, and amendments to those reports, are available
free of charge. We believe these reports are made available as soon as
reasonably practicable after we electronically file them with, or furnish them
to, the SEC. We do not maintain or provide any information directly to the
third-party website, and we do not check its accuracy.
INDUSTRY BACKGROUND
ADSL INDUSTRY BACKGROUND. ADSL technology allows telephone companies to offer
high-speed data services over their existing telephone networks by connecting
their central offices to end users' residences. Telephone companies began tests
and trials of ADSL technology in the mid 1990s. Commercial deployment of ADSL
services began in modest volumes in 1999, and during the last four years, the
rate of deployment of ADSL services accelerated dramatically, particularly
outside of the United States. According to announcements by major telephone
companies and information compiled by Point Topic Ltd., a company that provides
analysis of broadband access to the internet, approximately 5 million, 12
million, 17 million, and 28 million new ADSL subscribers were added in 2000,
2001, 2002, and 2003, respectively. As of December 31, 2003, there were
approximately 64 million global ADSL subscribers of which approximately 9
million were in the United States and approximately 55 million were in other
countries.
Some of the largest suppliers of ADSL service in North America are SBC, Verizon,
Bell South, Qwest, and Bell Canada. In Europe, some of the largest providers are
Deutsche Telekom, France Telecom, Belgacom, British
3
Telecom, Telephonica, Telecom Italia, and Telia. Large Asian providers include
Korea Telecom and Hanaro in Korea; NTT and Yahoo Broadband in Japan; Chunghwa in
Taiwan; and China Telecom in China.
In order to enable ADSL service, ADSL equipment must be installed in the central
offices of telephone companies and in end users' premises. ADSL central office
equipment and customer premises modems are available from numerous
telecommunications equipment suppliers. Some of the leading suppliers of ADSL
equipment include Alcatel Alsthom S.A. ("Alcatel"), ECI Telecom, Lucent
Technologies, Inc., NEC Corporation, Samsung Corporation, Siemens AG, Sumitomo
Corporation, UT Starcom, Westell Technologies, Inc., and Comtrend and other
Taiwanese modem manufacturers.
Telecommunications equipment suppliers are able to purchase ADSL chipsets from a
number of suppliers, including Analog Devices Inc. ("ADI"), Broadcom Corporation
("Broadcom"), Centillium Communications, Inc. ("Centillium"), Conexant Systems,
Inc. ("Conexant"), Infineon Technologies AG (`Infineon"), ST Microelectronics
N.V. ("ST"), and Texas Instruments Incorporated ("TI"). ADSL chipsets offered by
these suppliers are designed to operate in either central office equipment or
customer premises modems.
SEMICONDUCTOR INDUSTRY BACKGROUND. During the 1980s and 1990s, the semiconductor
industry moved from vertically integrated companies to horizontally specialized
companies. Vertically integrated semiconductor companies used to perform the
entire semiconductor process from design to manufacture to sales. Today the
industry consists of separate companies focused on various horizontal processes
within the semiconductor industry. Horizontal groups within the semiconductor
industry now include capital equipment companies, independent foundries, design
automation shops, fabless semiconductor companies, and semiconductor
intellectual property ("IP") companies.
The semiconductor intellectual property industry has matured and grown over the
last five years. The availability of field-proven technology from independent IP
suppliers allows semiconductor manufacturers to achieve greater financial
flexibility, reduce engineering development risks, and reduce the time it takes
to get products to market.
Semiconductor intellectual property may be classified into two principal
categories:
|X| HORIZONTAL IP consists of designs for: (i) standard chip functions,
such as timers and clocks, memory management, and hardware
controllers, (ii) configurable processors and digital signal
processors, and (iii) libraries of intellectual property that are used
during the semiconductor manufacturing process.
|X| VERTICAL IP consists of solutions for specific applications that are
usually based on standards or patents. Examples include ADSL, Code
Division Multiple Access ("CDMA"), Universal Serial Bus ("USB"),
Global System for Mobile telecommunications ("GSM"), Global
Positioning System ("GPS"), Wireless Local Area Networking ("WLAN"),
and chip-connection technology for Dynamic Random Access Memory
("DRAM").
Our intellectual property is focused on Vertical IP for applications involving
broadband communications, and in particular ADSL.
AWARE ADSL INTELLECTUAL PROPERTY
ADSL technology was first created in the late 1980s. ADSL technology expands the
usable bandwidth of copper wire so that telephone companies can offer high-speed
data services over their existing telephone networks. ADSL is a point-to-point
technology that connects the end user to a telephone company's central office.
ADSL equipment is deployed at each end of the copper wire in order to enable the
service. ADSL is targeted at the residential market and is designed to transmit
data at speeds more than 100 times faster than 56 kilobits per second ("Kbps")
voiceband modems. Actual transmission speeds depend on the length and condition
of the existing wire.
An ADSL system divides the bandwidth on a copper wire into three segments. The
first segment is used for plain old telephone service ("POTS"). The second
segment is used to transmit data upstream from the user to the central office.
The third segment is used to transmit data downstream from the central office to
the user.
4
Full-rate ADSL was first standardized in 1995 by the American National Standards
Institute as T1.413, and then by the ITU in 1999 as G.992.1. Full-rate ADSL can
transmit data at speeds up to 8 megabits per second ("Mbps") downstream and up
to 640 Kbps upstream.
In 1999, the ITU also standardized a lower speed version of ADSL, known as
G.Lite or G.992.2. G.Lite can transmit data at speeds up to 1.5 Mbps downstream
and up to 512 Kbps upstream without using special filtering equipment required
by full-rate ADSL. G.Lite was intended to make the installation of ADSL faster
and less expensive for telephone companies. Notwithstanding G.Lite's ease of
installation, most ADSL service offerings today are based on full-rate ADSL.
In 2002, the ITU consented to a new set of ADSL standards known as ADSL2 or
G.992.3 and G.992.4. These standards provide numerous improvements over previous
ADSL standards, including line diagnostics, power management, power down and
power cut-back, reduced framing and on-line configuration. In February 2003, the
ITU consented to a new standard known as ADSL2+ or G.992.5. ADSL2+ builds upon
the ADSL2 standard by increasing achievable data rates to speeds of up to 24
Mbps upstream on phone lines as long as 3,000 feet (20 Mbps out to 5,000 feet).
We license a technology package that includes a complete implementation of the
ITU standards for ADSL, ADSL2 and ADSL2+. Our intellectual property offering
includes chip designs, in the form of RTL, and software for operating the chip.
In January 2003, we announced that we had developed and manufactured a physical
chip named StratiPHY(TM) that represents our intellectual property designs. The
addition of StratiPHY to Aware's intellectual property offering provides our
customers with access to working silicon along with a complete turnkey package
of RTL and firmware. We believe the addition of a physical chip to our
intellectual property offerings has the potential of further reducing our
customers' development costs and time-to-market.
Customers can integrate our technology into their own or third party
manufacturing processes to develop monolithic chips or packaged solutions. We
also license patent rights and offer engineering services to our customers.
We have complemented our core ADSL offerings with technologies aimed at
enhancing the value proposition of ADSL for telephone companies. An important
innovation we have developed is our Dr. DSL(R) diagnostic testing technology.
Dr. DSL is designed to assist service providers with provisioning, monitoring,
and maintaining their DSL services by enabling them to collect important
information about their copper loop plant and the access network. Dr. DSL also
has the potential of providing subscribers with tools they can use to assist
with provisioning and maintenance. The primary goal of Dr. DSL is to reduce the
costs associated with service turn-on and maintenance by reducing customer
complaints and technician visits to subscriber locations. Specific Dr. DSL
features include loop length measurement, bridged tap measurement, crosstalk
disturber detection and management, subscriber self-installation, and in-home
diagnostics. We have also developed channelized voice technology, named
voice-enabled DSL (VeDSL(TM)), which allows service providers to bundle new,
profitable voice-over-DSL services to their residential subscribers, enabling
ADSL to evolve from a data-centric technology to a complete residential voice
and data solution.
AWARE BUSINESS MODEL & STRATEGY
We have adopted an intellectual property business model under which we license
our broadband technology on a nonexclusive and worldwide basis to semiconductor
companies that manufacture and sell products that incorporate our technology.
Our licensees sell integrated circuits to equipment companies that incorporate
those integrated circuits into their products.
Our business model and strategy are designed to:
|X| offer the semiconductor industry an independent source of broadband
technology;
|X| provide multiple and flexible technology solutions for numerous silicon and
equipment architectures;
|X| offer systems-level, vertical intellectual property for specific
applications that are based on worldwide standards;
5
|X| leverage our customers' distribution capabilities;
|X| contribute to industry standards by offering our expertise, which allows us
to anticipate technological changes; and
|X| generate revenue through a combination of license fees, engineering service
fees, and royalties.
AWARE ADSL HARDWARE PRODUCTS
In addition to our intellectual property licensing business, we sell
ADSL-related hardware products. Our principal hardware products include:
o ADSL MODULES - Modules are board-level products that contain all of the
components of an ADSL system. Customers, such as ADSL test equipment
companies, can integrate ADSL connectivity into their equipment-based
products using our ADSL modules;
o ADSL DEVELOPMENT SYSTEMS - Development systems are system-level products
that are designed to help our customers build ADSL chipsets by providing
them with a means to conduct performance and interoperability testing
during product development; and
o ADSL TEST SYSTEMS - Test systems are systems-level products that are
designed to help ADSL modem manufacturers test their products during
production without requiring them to purchase expensive central office
equipment.
AWARE COMPRESSION SOFTWARE PRODUCTS
We also develop and sell image and data compression products. Since 1988, we
have developed intellectual property in the field of wavelet transform-based
data compression. Our compression technology enables digital images and certain
types of data to be compressed to between 1% and 10% of their original size. Our
compression software products are sold to OEMs that integrate the software into
their equipment-based solutions. Our principal compression software products are
described below.
|X| WSQ BY AWARE compresses digital fingerprint data for use by law enforcement
agencies such as the Federal Bureau of Investigation.
|X| Our electronic ID product suite includes NISTPACK BY AWARE, SEQUENCE CHECK
BY AWARE, CJIS WEB BY AWARE, ACCUPRINT BY AWARE, AND ACCUSCAN BY AWARE.
These products are used by law enforcement agencies to format, edit,
validate, store, and print fingerprint and facial images.
|X| JPEG 2000 CODEC BY AWARE provides a solution for the compression and
decompression of still images using the high-quality, wavelet-based method
defined by the JPEG 2000 standard.
|X| We also license radiology compression software, which compresses digital
radiographs and other types of medical imagery.
RESEARCH AND DEVELOPMENT
Semiconductor intellectual property markets are characterized by rapid
technological changes and advances. Accordingly, we make substantial investments
in the design and development of new technologies, and for significant
improvement of existing technologies. Our research and development activities
are focused on the further development of our ADSL technology, including
incorporating new industry standards that we expect will be adopted. We have
also announced that we are developing technology for diagnostics and testing
(Dr. DSL), G.SHDSL (ITU standard G.991.2), and wireless local area networking.
As of December 31, 2003, we had an engineering staff of 80 employees,
representing 72% of our total employee staff. During the years ended December
31, 2003, 2002, and 2001, research and development expenses charged to
operations were $12.1 million, $14.0 million, and $10.1 million, respectively.
In addition, because our license agreements often call for us to provide
engineering development services to our customers, a portion of our total
6
engineering costs has been allocated to cost of contract revenue. We expect that
we will continue to invest substantial funds in research and development
activities.
SALES AND MARKETING
Our principal sales and marketing strategy is to license our ADSL intellectual
property to semiconductor manufacturers. We believe that decisions involving the
selection of our technology are frequently made at senior levels within a
prospective customer's organization. Consequently, we rely significantly on
presentations by our senior management to key employees at prospective
customers. As of December 31, 2003, we had twelve people in our broadband sales
and marketing organization.
Customers who have licensed our ADSL technology include ADI, Agere Systems, Inc.
("Agere"), Infineon, Intel, Legerity, Inc. (formerly Advanced Micro Devices'
Communication Products Division), NEC Corporation, ST Microelectronics ("ST"),
Metanoia Technologies (formerly a division of Sigmatel, Inc.), and 3COM/US
Robotics.
In 2003, we derived approximately 27%, 17%, and 14% of our total revenue from
ADI, Infineon, and Spirent Communications of Rockville, Inc. ("Spirent"),
respectively. In 2002, we derived approximately 32%, 15%, and 12% of our total
revenue from ADI, Infineon, and Intel, respectively. In 2001, we derived
approximately 52% and 14% of our total revenue from ADI and Intel, respectively.
All revenue in 2003, 2002, and 2001 was derived from unaffiliated customers.
We sell our software-based compression products primarily through OEMs and
systems integrators. As of December 31, 2003, there were three people in our
compression software sales organization.
COMPETITION
We compete by offering comprehensive packages of standards-based, complex,
system-level, broadband technology. 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
characterized by:
|X| rapid price erosion;
|X| rapid technological change;
|X| short product life cycles;
|X| cyclical market patterns; and
|X| increasing foreign and domestic competition.
As an intellectual property supplier to the semiconductor industry, we face
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 for DSL 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, ST and TI.
ADSL services compete with alternative DSL technologies that can also transport
high-speed data over telephone lines. These technologies include symmetric high
speed DSL (also known as HDSL, SDSL and G.SHDSL), and very high speed DSL, also
known as VDSL. We cannot give you assurances that these alternative broadband
7
technologies will not be more successful than ADSL or that we will be able to
participate in markets involving these alternative broadband technologies.
ADSL services also compete with broadband technologies that use other network
architectures to provide high-speed data service. These technologies include
cable modems using cable networks, and wireless solutions using wireless
networks. To date, ADSL services have been more successful than high-speed cable
services outside of the United States; however cable services serve a larger
number of broadband subscribers than ADSL inside the United States. We cannot
give you assurances that these alternative network architectures will not be
more successful than ADSL.
Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, ST and TI, have significantly greater financial, technological,
manufacturing, marketing and personnel resources than we do. We cannot give you
assurances that we will be able to compete successfully or that competitive
pressures will not seriously harm our business.
The markets for our wavelet image compression technology are competitive, and
are expected to become increasingly more competitive in the near future.
PATENTS AND INTELLECTUAL PROPERTY
We rely on a combination of nondisclosure agreements and other contractual
provisions, as well as patent, trademark, trade secret and copyright law to
protect our proprietary rights. We have an active program to protect our
proprietary technology through the filing of patents. As of December 31, 2003,
we had 23 issued patents and 49 pending patent applications pertaining to
telecommunications and signal processing technology. We also had 12 issued
patents and 5 pending patent applications pertaining to image compression, video
compression, audio compression, seismic data compression and optical
applications.
Although we have patented certain aspects of our technology, we rely primarily
on trade secrets to protect our intellectual property. We attempt to protect our
trade secrets and other proprietary information through agreements with our
licensees, suppliers, employees and consultants, and through security measures.
Each of our employees is required to sign a non-disclosure and non-competition
agreement. Although we intend to protect our rights vigorously, we cannot assure
you that these measures will be successful. In addition, effective intellectual
property protection may be unavailable or limited in certain foreign countries.
Third parties may assert exclusive patent, copyright and other intellectual
property rights to technologies that are important to us. In the past, we have
received letters from third parties suggesting that we may be obligated to
license such intellectual property rights. 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.
MANUFACTURING
Sales of hardware products constitute a relatively small portion of our total
revenue. Since our primary strategic focus is IP licensing, we do not intend to
produce hardware products in any material quantity for the foreseeable future.
Consequently, we rely on third party contract manufacturers to assemble and test
substantially all of our products. Our internal manufacturing capacity is
limited to final test and assembly of certain products. Other than ADSL
chipsets, which are available from ADI, we believe that other components for our
equipment-based products are available from a number of suppliers.
EMPLOYEES
At December 31, 2003, we employed 111 people, including 80 in engineering, 15 in
sales and marketing, 3 in manufacturing and 13 in finance and administration. Of
these employees, 109 were based in Massachusetts. None of our employees is
represented by a labor union. We consider our employee relations to be good.
8
We believe that our future success will depend in large part on the service of
our technical and senior management personnel and upon our ability to retain
highly qualified technical, sales and marketing and managerial personnel. We
cannot assure you that we will be able to retain our key managerial and
technical employees or that we will be able to attract and retain additional
highly qualified personnel in the future.
ITEM 2. PROPERTIES
We believe that our existing facilities are adequate for our current needs and
that additional space sufficient to meet our needs for the foreseeable future
will be available on reasonable terms. We currently occupy:
1. 72,000 square feet of office space in Bedford, Massachusetts, which serves
as our headquarters. This site is used for our research and development,
sales and marketing, and administrative activities. We own this facility.
2. 1,265 square feet of research and development space in Lafayette,
California. This facility is currently leased for a 3-year term, which
expires on August 31, 2004.
ITEM 3. 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth
quarter ended December 31, 2003.
9
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is the only class of stock we have outstanding, and it trades
on the Nasdaq National Market under the symbol AWRE. The following table sets
forth the high and the low sales prices of our common stock as reported on the
Nasdaq National Market from January 1, 2002 to December 31, 2003.
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
-----------------------------------------------------------------------
2003
High................. $2.48 $2.75 $3.29 $4.06
Low.................. 1.60 1.62 1.98 2.73
2002
High................. $9.79 $6.50 $3.94 $3.05
Low.................. 5.92 3.25 1.95 2.01
As of March 2, 2004, we had approximately 169 shareholders of record. This
number does not include shareholders from whom shares were held in a "nominee"
or "street" name. We have never paid cash dividends on our common stock and we
anticipate that we will continue to reinvest any earnings to finance future
operations.
We did not sell any equity securities that were not registered under the
Securities Act of 1933 during the three months ended December 31, 2003.
ITEM 6. SELECTED FINANCIAL DATA
In the table below, we provide you with our selected consolidated financial
data. We have prepared this information using our audited financial statements
for the years ended December 31, 2003, 2002, 2001, 2000, and 1999. When you read
this selected financial data, it is important that you read it along with
Management's Discussion and Analysis of Financial Condition and Results of
Operations, our historical consolidated financial statements, and the related
notes to the financial statements, which can be found in Item 8.
Year ended December 31, 2003 2002 2001 2000 1999
- -------------------------------------------------------------------------------------------------------
(in thousands, except per share data)
Statements of Operations Data
- -----------------------------
Revenue.................................. $10,843 $13,844 $18,547 $30,667 $20,527
Income (loss) from operations............ (8,635) (12,529) (4,823) 9,490 3,321
Cumulative effect of change in
accounting principle (1)............... - - - (1,618) -
Net income (loss)........................ (8,038) (18,728) (2,520) 13,414 4,898
Net income (loss) per share - basic...... ($0.35) ($0.83) ($0.11) $0.60 $0.23
Net income (loss) per share - diluted.... ($0.35) ($0.83) ($0.11) $0.56 $0.21
Balance Sheet Data
- ------------------
Cash and short-term investments.......... $35,051 $33,302 $57,284 $57,503 $36,265
Working capital.......................... 36,727 33,481 59,608 67,146 41,348
Total assets............................. 51,024 59,237 78,103 81,450 54,482
Total liabilities........................ 1,384 1,659 1,947 3,117 1,514
Total stockholders' equity............... 49,640 57,578 76,156 78,333 52,968
10
(1) Effective January 1, 2000, we adopted Securities and Exchange Commission
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements ("SAB 101") and recorded the impact in 2000. In 1999, the pro
forma effect of retroactive application of SAB 101 would have resulted in
net income of $3.280 million and net income per share, basic and diluted,
of $0.15 and $0.14, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
The following table sets forth, for the years indicated, certain line items from
our consolidated statements of operations stated as a percentage of total
revenue:
Year ended December 31,
--------------------------------------------
2003 2002 2001
--------------------------------------------
Revenue:
Product sales................................. 40 % 33 % 21 %
Contract revenue.............................. 26 49 44
Royalties..................................... 34 18 35
--------------------------------------------
Total revenue............................... 100 100 100
Costs and expenses:
Cost of product sales......................... 10 7 3
Cost of contract revenue...................... 14 35 37
Research and development...................... 111 101 54
Selling and marketing......................... 22 21 16
General and administrative.................... 22 26 16
--------------------------------------------
Total costs and expenses................... 179 190 126
Loss from operations............................. (79) (90) (26)
Interest income.................................. 5 6 12
--------------------------------------------
Loss before provision for income taxes........... (74) (84) (14)
Provision for income taxes....................... - (51) -
--------------------------------------------
Net loss......................................... (74) % (135) % (14) %
============================================
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 decreased 5% from $4.5 million in 2002 to $4.3 million in 2003. As
a percentage of total revenue, product sales increased from 33% in 2002 to 40%
in 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, which was partially offset by an increase in
revenue from the sales of modules. Compression software revenue decreased
primarily due to lower sales of our electronic identification products. Test and
development system revenue decreased primarily due to lower demand from our
semiconductor and equipment customers. Module sales were higher primarily due to
sales to a customer that is using them in ADSL test equipment.
11
Product sales increased 19% from $3.8 million in 2001 to $4.5 million in 2002.
As a percentage of total revenue, product sales increased from 21% in 2001 to
33% in 2002. The dollar increase was primarily due to higher unit volume sales
of modules and compression software, which was partially offset by a decrease in
revenue from the sale of test and development systems. Module sales were higher
primarily due to sales to a customer that is using them in ADSL test equipment.
Compression software revenue increased primarily due to higher demand for our
electronic identification products. Test and development system revenue
decreased primarily due to lower demand from our semiconductor and equipment
customers, which was the result of continued difficult economic conditions in
the semiconductor and telecommunications industries.
CONTRACT REVENUE
Contract revenue consists primarily of license and engineering service fees that
we receive under agreements with our customers to develop ADSL chipsets.
Contract revenue decreased 58% from $6.8 million in 2002 to $2.8 million in
2003. As a percentage of total revenue, contract revenue decreased from 49% in
2002 to 26% in 2003. Contract revenue decreased 18% from $8.3 million in 2001 to
$6.8 million in 2002. As a percentage of total revenue, contract revenue
increased from 44% in 2001 to 49% in 2002.
The dollar decreases in contract revenue in 2003 and 2002 were primarily due to
a difficult environment for licensing intellectual property for communications
integrated circuits. Both existing and prospective ADSL chipset licensees were
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
improve.
On our February 5, 2004 earnings release conference call, we referred to new
customers and new chipset development projects. One of these new customers
signed a contract in the fourth quarter of 2003. The contract requires the
customer to pay us license and service fees based upon the license of our ADSL
technology and provision of engineering services as well as royalty payments for
sales of the customer's ADSL chipsets that are based on our licensed technology.
Based on our performance under the contract, we recorded $0.2 million as revenue
in our earnings release dated February 5, 2004 announcing results for the fourth
quarter of 2003.
Subsequent to the earnings release and conference call, the customer expressed a
desire to terminate the contract because of a management change and a subsequent
decision to withdraw from the ADSL business. The customer does not have this
termination right and we are in discussions with the customer to attempt to
resolve the matter. Since this dispute created uncertainty regarding whether the
collectibility of the related receivable of $0.2 million is reasonably assured,
our financial statements reflect a reduction in revenue for the fourth quarter
of 2003 to $3.0 million and revenue for the full year to $10.8 million as
compared to amounts reported in our earnings release. There are corresponding
increases in loss from operations, loss before provision for income taxes and
net loss and an increase in our reported loss per share for the fourth quarter
of 2003 from $0.06 to $0.07.
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 47% from $2.5 million in 2002 to $3.7 million in 2003. As a
percentage of total revenue, royalties increased from 18% in 2002 to 34% in
2003. The increase in royalties was primarily due to an increase in ADSL chipset
sales by our largest customer ADI and to a lesser extent by Infineon. Despite
the increase in ADSL chipset sales by ADI over the last year, ADI's chipset
sales have declined in previous years 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
12
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.
In 2003, Infineon began increasing 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.
Royalties decreased 61% from $6.5 million in 2001 to $2.5 million in 2002. As a
percentage of total revenue, royalties decreased from 35% in 2001 to 18% in
2002. The decrease in royalties was primarily due to a decrease in ADSL chipset
sales by our largest customer, ADI. We believe that ADI's chipset sales declined
primarily due to falling ADSL chipset pricing and a potential loss of market
share. Despite strong growth of worldwide ADSL subscribers in 2002, the
availability of ADSL chipsets from a number of suppliers and intense competition
among those suppliers has caused chipset prices to drop sharply over the last
two years. Additionally, deployments of ADSL service in geographic areas where
chipsets based upon our technology have been sold leveled off or declined in
2002.
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 hardware product sales.
Cost of product sales were essentially the same at $1.0 million in 2002 and
2003. As a percentage of product sales, cost of product sales increased from 21%
in 2002 to 24% in 2003. Although cost of product sales were essentially
unchanged during 2003 and 2002, there were two offsetting factors that caused
this result. Cost of product sales increased in 2003 primarily due to an
increase in module sales. This increase was offset by a decrease in cost of
product sales that was primarily due to 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 product sales increased 52% from $0.6 million in 2001 to $1.0 million in
2002. As a percentage of product sales, cost of product sales increased from 16%
in 2001 to 21% in 2002. The increase in cost of product sales was primarily due
to a greater proportion of module sales in the sales mix. Modules have higher
cost of sales than the other products that comprise our product revenue.
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 68% from $4.9 million in 2002 to $1.6 million
in 2003. As a percentage of contract revenue, cost of contract revenue decreased
from 72% in 2002 to 55% in 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 2003 as compared to 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 2003
included a one-time contractual termination fee that had no cost of contract
revenue associated with it.
Cost of contract revenue decreased 28% from $6.8 million in 2001 to $4.9 million
in 2002. As a percentage of contract revenue, cost of contract revenue decreased
from 83% in 2001 to 72% in 2002. The dollar decrease in cost of contract revenue
in 2002 was primarily due to fewer customer contracts. Since our cost of
contract revenue is based on the level of effort we expend on customer projects
and the number of customer projects declined in 2002, cost of contract revenue
declined as well.
13
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 13% from $14.0 million in 2002 to
$12.1 million in 2003. As a percentage of total revenue, research and
development expense increased from 101% in 2002 to 111% in 2003. 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 was 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.
Research and development expense increased 38% from $10.1 million in 2001 to
$14.0 million in 2002. As a percentage of total revenue, research and
development expense increased from 54% in 2001 to 101% in 2002. The dollar
increase in research and development spending was primarily due to the following
factors:
(i) spending in 2002 includes the full year effect of a number of new
engineers hired in 2001. Spending in 2001 only reflects that portion
of the year that these employees were employed by us;
(ii) as the number of customer projects decreased over the past year, we
shifted engineers who were working on these projects to internal
research and development projects; and
(iii) we incurred additional research and development spending in 2002 to
design and manufacture an ADSL/ADSL2 chip that we have named
StratiPHY.
In October 2002, we terminated 35 employees to reduce our operating costs. Of
the 35 employees who were terminated, 32 were engineers. The cost of severance
and other employee benefits for terminated employees was approximately $700,000.
The cost was recorded in the fourth quarter of 2002, and it approximates our
historical quarterly costs for these employees as if they were active employees.
Therefore, the reduction in force had a minimal effect on research and
development spending in 2002. As of December 31, 2002, accrued severance costs
were approximately $140,000, and were paid in the first half of 2003.
In connection with the October reduction in force, we informed remaining
employees that effective January 1, 2003 their salaries would be reduced by 5%
and that senior management's salaries would be reduced by 10%. We anticipate
that the reduction in force and salary reductions will lower total 2003
engineering expenses by approximately $3.7 million annually, and will lower
total 2003 company expenses by $4.1 million annually. Total engineering expenses
include cost of contract revenue and research and development expense.
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 19% from $3.0 million
in 2002 to $2.4 million in 2003. As a percentage of total revenue, sales and
marketing expense increased from 21% in 2002 to 22% in 2003. The dollar decrease
was primarily due to lower spending on sales staff and to a lesser extent lower
sales commissions and tradeshow expenses. Lower spending on sales staff was
primarily due to the reduction in force and salary reductions we implemented in
October 2002 and January 2003, respectively. The reduction in force and salary
reductions lowered sales and marketing expenses by approximately $0.2 million in
2003.
Sales and marketing expense increased 2% from $2.9 million in 2001 to $3.0
million in 2002. As a percentage of total revenue, sales and marketing expense
increased from 16% in 2001 to 21% in 2002. The dollar increase was primarily due
to increased spending on sales staff and higher commissions for product sales,
which was partially offset by lower advertising and tradeshow expenses.
14
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 34% from $3.6
million in 2002 to $2.4 million in 2003. As a percentage of total revenue,
general and administrative expense decreased from 26% in 2002 to 22% in 2003.
The dollar decrease was primarily due to a reduction in our provisions for bad
debts and to lesser extent lower public company expenses, as well as the
reduction in force and salary reductions we implemented in October 2002 and
January 2003, respectively. The reduction in force and salary reductions lowered
general and administrative expenses by approximately $0.2 million in 2003.
General and administrative expense increased 24% from $2.9 million in 2001 to
$3.6 million in 2002. As a percentage of total revenue, general and
administrative expense increased from 16% in 2001 to 26% in 2002. The dollar
increase was primarily due to higher provisions for bad debts. In the fourth
quarter of 2002, we increased our allowance for doubtful accounts by $0.7
million for an accounts receivable balance that we considered uncollectible.
INTEREST INCOME
Interest income decreased 33% from $0.9 million in 2002 to $0.6 million in 2003.
The dollar decrease was primarily due to lower interest rates earned on our cash
balances and lower cash balances.
Interest income decreased 61% from $2.3 million in 2001 to $0.9 million in 2002.
The dollar decrease was primarily due to lower interest rates earned on our cash
balances and lower cash balances.
INCOME TAXES
We evaluate, on a quarterly basis, the positive and negative evidence affecting
the realizability of our deferred tax assets. As a result of incurring operating
losses since 2001, we determined that it is more likely than not that our
deferred tax assets may not be realized, and since the fourth quarter of 2002
have established a full valuation allowance for our net deferred tax assets.
Accordingly, we have not recorded a deferred tax benefit for the operating
losses incurred in the year ended December 31, 2003.
In 2002, we determined that due to our continuing operating losses in 2001 and
2002 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 2002 to reserve for our remaining
deferred tax assets. In 2001, we made no provision for income taxes because we
had a net loss.
As of December 31, 2003, we had federal net operating loss and research and
experimentation credit carryforwards of approximately $48.7 million and $8.8
million respectively, which may be available to offset future federal income tax
liabilities and expire at various dates through 2023. In addition, at December
31, 2003, we had approximately $41.0 million and $4.6 million of state net
operating losses and state research and development and investment tax
carryforwards, respectively, which expire at various dates through 2023.
Of the total net operating loss and research and development tax credit
carryforwards for which a valuation allowance was recorded, approximately $24.1
million is attributable to the exercise of stock options and the tax benefit
will be credited to additional paid-in capital, if realized in the future.
LIQUIDITY AND CAPITAL RESOURCES
Since our inception in March 1986, we have financed our activities primarily
through the sale of stock. In the years ended December 31, 2003, 2002 and 2001,
we received net proceeds from the issuance of stock under employee stock plans
of $0.1 million, $0.2 million and $0.3 million, respectively. Our operating
activities used net cash of $8.1 million and $9.5 million in the years ended
December 31, 2003 and 2002, respectively. Cash used in our operating activities
was primarily the result of operating losses and working capital requirements.
Operating activities provided net cash of $1.2 million in the year ended
December 31, 2001. Cash provided by operations
15
during 2001 was primarily due to the collection of accounts receivables, which
was partially offset by a decrease in deferred revenue.
In the years ended December 31, 2003, 2002, and 2001, we made capital
expenditures of $0.2 million, $0.8 million, and $1.4 million, respectively.
Capital expenditures in all three years primarily consisted of spending on
computer hardware and software, laboratory equipment, and furniture used
principally in engineering activities. We have no material commitments for
capital expenditures.
At December 31, 2003, we had cash, cash equivalents, short-term investments and
investments of $39.0 million. 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, short-term investments and investments
will be sufficient to fund our operations for at least the next twelve months.
To date, inflation has not had a material impact on our financial results. There
can be no assurance, however, that inflation will not adversely affect our
financial results in the future.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any financial partnerships with unconsolidated entities, such as
entities often referred to as structured finance, special purpose entities or
variable interest entities which are often established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Accordingly, we are not exposed to any financing, liquidity,
market or credit risk that could arise if we had such relationships.
CONTRACTUAL OBLIGATIONS
We have various contractual obligations impacting our liquidity. The following
represents our contractual obligations as of December 31, 2003 (in thousands):
Payments Due By Period
---------------------------------------------------------------------
Less than More than
Contractual Obligations Total 1 year 1-3 years 3-5 years 5 years
----------------------- ----------- ------------ ----------- ----------- ------------
Operating Leases $ 30 $ 30 $- $- $-
Purchase orders 359 359 - - -
----------- ------------ ----------- ----------- ------------
Total $389 $389 $- $- $-
=========== ============ =========== =========== ============
CRITICAL ACCOUNTING POLICIES
We consider certain accounting policies related to revenue recognition, income
taxes and the allowance for doubtful accounts to be critical policies.
REVENUE RECOGNITION. We derive our revenue from three sources (i) product
revenue, which includes revenue from the sale of ADSL equipment and compression
software products, (ii) contract revenue, which includes license and engineering
service fees that we receive under customer agreements, and (iii) royalties that
we receive under customer contracts.
As prescribed by Securities and Exchange Commission Staff Accounting Bulletin
No. 104, Revenue Recognition, we recognize revenue when there is persuasive
evidence of an arrangement, the sales price is fixed or determinable, collection
of the related receivable is reasonably assured, and delivery has occurred or
services have been rendered. We also apply the principles set forth in AICPA
Statement of Position No. 97-2, Software Revenue Recognition,
16
when recognizing compression software revenue. Our revenue recognition policies
are described more fully in Note 2, Summary of Significant Accounting Policies,
in the Notes to our Consolidated Financial Statements.
As described below, we make significant judgments and estimates during the
process of determining revenue for any particular accounting period.
In determining revenue recognition, we assess whether fees associated with
revenue transactions are fixed or determinable and whether or not collection is
reasonably assured. We make a judgment whether fees are fixed or determinable
based on the payment terms associated with that transaction. We assess
collection based on a number of factors, including past transaction history with
the customer and the credit-worthiness of the customer. If we determine that
collection of a fee is not reasonably assured, we defer the fee and recognize
revenue at the time collection becomes reasonably assured, which is generally
upon receipt of cash.
In addition to these general revenue recognition judgments, we make specific
judgments and estimates with respect to the recognition of contract revenue.
When our agreements include the transfer of technology and the provision of
engineering services, we combine the total license and engineering service fees
to be paid under the agreement. These total fees are recognized ratably over the
expected product development period, subject to the limitation that the
cumulative revenue recognized through the end of any period may not exceed
cumulative contract payments to date. We review assumptions regarding the
product development period on a regular basis and make adjustments as required.
Consistent with the principles of SAB 104, we believe that this method
represents the appropriate systematic method for revenue recognition for this
type of contract.
After customers enter into development and license agreements, they often engage
us to provide additional engineering work that is beyond the scope of their
original base agreement. When customers request additional services, both
parties agree to engineering fees that are based on the level of effort
required. We recognize revenue from these agreements either as engineering
services are performed or as milestones are achieved.
INCOME TAXES. As part of the process of preparing our consolidated financial
statements we are required to estimate our actual current tax expense. We must
also estimate temporary and permanent differences that result from differing
treatment of certain items for tax and accounting purposes. These differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. We must then assess the likelihood that our deferred
tax assets will be recovered from future taxable income and to the extent that
we believe that recovery is not likely, we must establish a valuation allowance.
To the extent we establish a valuation allowance or increase this allowance in a
period for deferred tax assets which have been recognized, we must include an
expense with the tax provision in the statement of operations.
Significant management judgment is required in determining our provision for
income taxes, our deferred tax assets, and any valuation allowance recorded
against our net deferred tax assets. Our deferred tax assets relate to net
operating losses and research and development tax credits that we are carrying
forward into future tax periods. As of December 31, 2003, we had a total of
$41.8 million of deferred tax assets for which we had recorded a full valuation
allowance.
Of the total valuation allowance, approximately $24.1 million relates to net
operating loss and research and development tax credit carryforwards that are
attributable to the exercise of stock options and the tax benefit will be
credited to additional paid-in capital, if realized in the future.
ALLOWANCE FOR DOUBTFUL ACCOUNTS. We make judgments as to our ability to collect
outstanding receivables and provide allowances for receivables when collection
becomes doubtful. Provisions are made based upon a specific review of all
significant outstanding invoices. If the judgments we make to determine the
allowance for doubtful accounts do not reflect the future ability to collect
outstanding receivables, additional provisions for doubtful accounts may be
required.
17
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2003, the SEC issued Staff Accounting Bulletin ("SAB") No. 104,
Revenue Recognition, which supersedes SAB No. 101, Revenue Recognition in
Financial Statements. SAB No. 104 rescinds accounting guidance in SAB No. 101
related to multiple-element arrangements as this guidance has been superseded as
a result of the issuance of EITF 00-21, "Accounting for Revenue Arrangements
with Multiple Deliverables" ("EITF 00-21"). The adoption of SAB No. 104 did not
have a material impact on the Company's financial position, results of
operations or cash flows.
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, the Financial Accounting Standards Board ("FASB") issued SFAS No.
149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." This statement amends SFAS 133 to provide clarification on
the financial accounting and reporting of derivative instruments and hedging
activities and requires contracts with similar characteristics to be accounted
for on a comparable basis. This statement was effective for contracts entered
into or modified after June 30, 2003 and for hedging relationships designated
after June 30, 2003. The Company adopted SFAS 149 on July 1, 2003 and the
adoption did not have a material effect on its consolidated financial position
or results of operations.
In January 2003, the FASB issued FASB Interpretation No. 46, as amended by FIN
46R, "Consolidation of Variable Interest Entities, an Interpretation of ARB 51"
("FIN 46"). The primary objectives of FIN 46 are to provide guidance on the
identification of entities for which control is achieved through means other
than through voting rights ("variable interest entities" or "VIEs") and how to
determine when and which business enterprise should consolidate the VIE. This
new model for consolidation applies to an entity which either: (a) the equity
investors (if any) do not have a controlling financial interest; or (b) the
equity investment at risk is insufficient to finance that entity's activities
without receiving additional subordinated financial support from other parties.
In addition, FIN 46 requires that both the primary beneficiary and all other
enterprises with a significant variable interest in a VIE make additional
disclosures. FIN 46 is effective for all new VIEs created or acquired after
January 31, 2003. For VIEs created or acquired prior to February 1, 2003, the
provisions of FIN 46 must be applied for the first interim or annual period
ending after March 15, 2004. The Company has not created or acquired any VIEs
after January 31, 2003. The Company does not expect the adoption of FIN 46 to
have a material impact on its financial position or results of operations.
In November 2002, the EITF reached a consensus on issue 00-21, "Accounting for
Revenue Arrangements with Multiple Deliverables." EITF 00-21 addresses revenue
recognition on arrangements encompassing multiple elements that are delivered at
different points in time, defining criteria that must be met for elements to be
considered to be a separate unit of accounting. If an element is determined to
be a separate unit of accounting, the revenue for the element is recognized at
the time of delivery. EITF 00-21 is effective for revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. The Company adopted EITF
00-21 on July 1, 2003 and the adoption did not have a material effect on its
consolidated financial position or results of operations.
FACTORS THAT MAY AFFECT FUTURE RESULTS
SOME OF THE INFORMATION IN THIS FORM 10-K 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
18
PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED IN THIS SECTION, AS
WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-K, 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-K COULD MATERIALLY AND ADVERSELY AFFECT
OUR BUSINESS. WE ASSUME NO OBLIGATION TO UPDATE ANY FORWARD-LOOKING STATEMENTS.
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.
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:
|X| market acceptance of our broadband technologies by semiconductor
companies;
|X| the extent and timing of new license transactions with semiconductor
companies;
|X| changes in our and our licensees' development schedules and levels of
expenditure on research and development;
|X| the loss of a strategic relationship or termination of a project by a
licensee;
|X| equipment companies' acceptance of integrated circuits produced by our
licensees;
|X| the loss by a licensee of a strategic relationship with an equipment
company customer;
|X| announcements or introductions of new technologies or products by us
or our competitors;
|X| delays or problems in the introduction or performance of enhancements
or of future generations of our technology;
|X| delays in the adoption of new industry standards or changes in market
perception of the value of new or existing standards;
|X| competitive pressures resulting in lower contract revenues or royalty
rates;
|X| personnel changes, particularly those involving engineering and
technical personnel;
|X| costs associated with protecting our intellectual property;
|X| the potential that licensees could fail to make payments under their
current contracts;
|X| ADSL market-related issues, including:
o lower ADSL chipset unit demand brought on by excess channel
inventory; and
o lower average selling prices for ADSL chipsets.
19
|X| regulatory developments; and
|X| general economic trends and other factors.
As a result of these factors, we believe that period-to-period comparisons of
our revenue levels and operating results are not necessarily meaningful. You
should not rely on our quarterly revenue and operating results to predict our
future performance.
WE EXPERIENCED NET LOSSES. We had a net loss during 2003, 2002 and 2001. We
expect that we will have a net loss during the first quarter of 2004. We may
continue to experience losses in the future if:
|X| the semiconductor and telecommunications markets do not recover from
the downturn that began in 2001;
|X| our existing customers do not increase their revenues from sales of
chipsets with our technology; or
|X| new and existing customers do not choose to license our intellectual
property for new chipset products, or
|X| a profitable business does not emerge from our Dr. DSL efforts.
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:
|X| 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;
|X| 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;
|X| 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
|X| 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:
|X| we cannot obtain suitable licensees;
|X| our licensees fail to achieve significant sales of chipsets or
products incorporating our technology; or
|X| 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
20
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 first
quarter of 2004 and beyond. Our royalty revenue may continue to decline over the
long term.
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. 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
2003, we derived 52%, 32% and 27%, 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' decisions 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:
|X| competition from other businesses in the same industry;
|X| market acceptance of its products;
|X| its engineering, sales and marketing, and management capabilities;
|X| technical challenges of developing its products unrelated to our
technology; and
|X| its financial and other resources.
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:
|X| 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;
21
|X| the pricing of ADSL services by telephone companies;
|X| the quality of telephone companies' networks;
|X| government regulations; and
|X| 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
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
22
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 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, 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, 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.
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.
23
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:
|X| quarterly fluctuations in our operating results;
|X| changes in future financial guidance that we may provide to investors
and public market analysts;
|X| changes in our relationships with our licensees;
|X| announcements of technological innovations or new products by us, our
licensees or our competitors;
|X| changes in ADSL market growth rates as well as investor perceptions
regarding the investment opportunity that companies participating in
the ADSL industry afford them;
|X| changes in earnings estimates by public market analysts;
|X| key personnel losses;
|X| sales of common stock; and
|X| 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.
ITEM 7A. 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:
|X| Cash and cash equivalents, which consist of financial instruments with
original maturities of three months or less; and
|X| 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 December 31, 2003, we had invested $35.1 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 December 31, 2003, we had invested $3.9 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,
24
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 December 31, 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... $3,995 $3,954 $3,913 $3,834 $3,874
25
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following consolidated financial statements of Aware, Inc. are filed as part
of this Report on Form 10-K:
CONSOLIDATED FINANCIAL STATEMENTS:
Page
----
Report of Independent Auditors................................................. 27
Consolidated Balance Sheets as of December 31, 2003 and 2002................... 28
Consolidated Statements of Operations for each of the three
years in the period ended December 31, 2003................................ 29
Consolidated Statements of Cash Flows for each of the
three years in the period ended December 31, 2003.......................... 30
Consolidated Statements of Stockholders' Equity for each of
the three years in the period ended December 31, 2003..................... 31
Notes to Consolidated Financial Statements..................................... 32
FINANCIAL STATEMENT SCHEDULE:
Page
----
Schedule II - Valuation and Qualifying Accounts................................ 43
26
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Shareholders of Aware, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of Aware,
Inc. and its subsidiary at December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2003 in conformity with accounting principles generally accepted in
the United States of America. In addition, in our opinion, the financial
statement schedule listed in the accompanying index presents fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements. These financial statements
and financial statement schedule are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements and financial statement schedule based on our audits. We conducted
our audits of these statements in accordance with auditing standards generally
accepted in the United States of America, which require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
PRICEWATERHOUSECOOPERS LLP
Boston, Massachusetts
March 10, 2004
27
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
DECEMBER 31,
-----------------------------------
2003 2002
---------------- ---------------
ASSETS
Current assets:
Cash and cash equivalents............................................. $19,504 $25,268
Short-term investments................................................ 15,547 8,034
Accounts receivable (less allowance for doubtful......................
accounts of $927 in 2003 and $1,077 in 2002) 2,449 1,258
Inventories........................................................... 48 50
Prepaid expenses and other current assets............................. 563 530
---------------- ---------------
Total current assets............................................ 38,111 35,140
---------------- ---------------
Property and equipment, net................................................ 8,921 10,038
Investments................................................................ 3,913 13,816
Other assets, net.......................................................... 79 243
---------------- ---------------
Total assets.................................................... $51,024 $59,237
================ ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable...................................................... $261 $274
Accrued expenses...................................................... 136 213
Accrued compensation.................................................. 439 965
Accrued professional.................................................. 77 65
Deferred revenue...................................................... 471 142
---------------- ---------------
Total current liabilities..................................... 1,384 1,659
---------------- ---------------
Commitments and contingent liabilities (Note 7)
Stockholders' equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding ................................................ - -
Common stock, $.01 par value; shares authorized,
70,000,000 in 2003 and 2002; issued
and outstanding, 22,750,294 in 2003 and 22,698,171 in 2002.... 228 227
Additional paid-in capital........................................... 77,400 77,301
Retained earnings (accumulated deficit).............................. (27,988) (19,950)
---------------- ---------------
Total stockholders' equity.................................... 49,640 57,578
---------------- ---------------
Total liabilities and stockholders' equity.................... $51,024 $59,237
================ ===============
The accompanying notes are an integral part of the financial statements.
28
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,
---------------------------------------------
2003 2002 2001
---------------------------------------------
Revenue:
Product sales....................................... $4,309 $4,530 $3,817
Contract revenue.................................... 2,840 6,797 8,253
Royalties........................................... 3,694 2,517 6,477
---------------------------------------------
Total revenue................................... 10,843 13,844 18,547
---------------------------------------------
Costs and expenses:
Cost of product sales............................... 1,043 955 629
Cost of contract revenue............................ 1,567 4,889 6,822
Research and development............................ 12,074 13,956 10,104
Selling and marketing............................... 2,407 2,966 2,916
General and administrative.......................... 2,387 3,607 2,899
---------------------------------------------
Total costs and expenses....................... 19,478 26,373 23,370
---------------------------------------------
Loss from operations.................................... (8,635) (12,529) (4,823)
Interest income......................................... 597 894 2,303
---------------------------------------------
Loss before provision for income taxes.................. (8,038) (11,635) (2,520)
Provision for income taxes.............................. - (7,093) -
---------------------------------------------
Net loss................................................ ($8,038) ($18,728) ($2,520)
=============================================
Net loss per share - basic and diluted.................. ($0.35) ($0.83) ($0.11)
Weighted average shares - basic and diluted............. 22,713 22,679 22,631
The accompanying notes are an integral part of the financial statements.
29
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
--------------------------------------------------
2003 2002 2001
--------------------------------------------------
Cash flows from operating activities:
Net loss.................................................. ($8,038) ($18,728) ($2,520)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization.......................... 1,471 1,844 1,720
Provision for doubtful accounts........................ (150) 707 25
Increase (decrease) from changes in assets and
liabilities:
Accounts receivable................................. (1,041) (582) 3,792
Inventories......................................... 2 232 (115)
Deferred tax assets................................. - 7,093 -
Prepaid expenses and other current assets........... (33) 265 (495)
Accounts payable.................................... (13) (79) (130)
Accrued expenses.................................... (591) (351) 429
Deferred revenue.................................... 329 142 (1,469)
--------------------------------------------------
Net cash provided by (used in) operating activities. (8,064) (9,457) 1,237
--------------------------------------------------
Cash flows from investing activities:
Purchases of property and equipment....................... (190) (807) (1,424)
Other assets.............................................. - (52) (375)
Net sales (purchases) of short-term investments........... (7,513) 13,194 (15,387)
Net sales (purchases) of investments...................... 9,903 (13,816) -
--------------------------------------------------
Net cash provided by (used in) investing activities. 2,200 (1,481) (17,186)
--------------------------------------------------
Cash flows from financing activities:
Proceeds from issuance of common stock .................. 100 150 343
--------------------------------------------------
Net cash provided by financing activities........... 100 150 343
--------------------------------------------------
Decrease in cash and cash equivalents........................ (5,764) (10,788) (15,606)
Cash and cash equivalents, beginning of year................. 25,268 36,056 51,662
--------------------------------------------------
Cash and cash equivalents, end of year ...................... $19,504 $25,268 $36,056
==================================================
The accompanying notes are an integral part of the financial statements.
30
AWARE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
Retained
Common Stock Additional Earnings Total
-------------------------- Paid-In (Accumulated Stockholders'
Shares Amount Capital Deficit) Equity
------------ ------------- ------------- -------------- -------------
Balance at December 31, 2000.............. 22,606 $226 $76,809 $1,298 $78,333
Exercise of common stock options ..... 24 - 180 180
Issuance of common stock under
employee stock purchase plan....... 28 1 162 163
Net loss.............................. (2,520) (2,520)
------------ ------------- ------------- -------------- -------------
Balance at December 31, 2001.............. 22,658 227 77,151 (1,222) 76,156
Exercise of common stock options ..... 10 - 63 63
Issuance of common stock under
employee stock purchase plan....... 30 - 87 87
Net loss.............................. (18,728) (18,728)
------------ ------------- ------------- -------------- -------------
Balance at December 31, 2002.............. 22,698 227 77,301 (19,950) 57,578
Exercise of common stock options ..... 3 - 10 10
Issuance of common stock under
employee stock purchase plan....... 49 1 89 90
Net loss.............................. (8,038) (8,038)
------------ ------------- ------------- -------------- -------------
Balance at December 31, 2003.............. 22,750 $228 $77,400 ($27,988) $49,640
============ ============= ============= ============== =============
The accompanying notes are an integral part of the financial statements.
31
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF BUSINESS
We are a leader in the development and marketing of intellectual property
for broadband communications. Our principal offering to date has been
Asymmetric Digital Subscriber Line ("ADSL") technology for the
telecommunications industry. ADSL enables telephone companies to use their
existing copper telephone lines to offer broadband services. We have
adopted an intellectual property business model in which we neither
manufacture nor sell integrated circuits incorporating our technology. We
license our broadband technology on a nonexclusive and worldwide basis to
semiconductor companies that manufacture and sell products that incorporate
our technology. Our licensees sell integrated circuits to equipment
companies who incorporate those integrated circuits into their products. We
also offer ADSL hardware products and image compression software products.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION - The consolidated financial statements include the
accounts of Aware, Inc. and its subsidiary. All significant intercompany
transactions have been eliminated.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents consist primarily of
demand deposits, money market funds, commercial paper, and discount notes
in highly liquid short-term instruments with original maturities of three
months or less from the date of purchase and are stated at cost, which
approximates market.
INVESTMENTS - At December 31, 2003 and 2002, we categorized all securities
as "available-for-sale," since we may liquidate these investments
currently. In calculating realized gains and losses, cost is determined
using specific identification. Unrealized gains and losses on
available-for-sale securities are excluded from earnings and reported in a
separate component of stockholders' equity. At December 31, 2003 and 2002,
unrealized gains and losses were not material.
The amortized cost of securities, which approximates fair value, consists
of the following at December 31, 2003 and 2002 (in thousands):
Short-term investments 2003 2002
---------------------- ------------ ------------
Corporate debt securities.......... $1,393 $3,185
U.S. agency securities............. 14,154 4,849
------------ ------------
Total............................ $15,547 $8,034
============ ============
Investments 2003 2002
----------- ------------ ------------
Corporate debt securities.......... $1,709 $1,030
U.S. agency securities............. 2,204 12,786
------------ ------------
Total............................ $3,913 $13,816
============ ============
Short-term investments mature within three to twelve months, and
investments mature within one to three years.
ALLOWANCE FOR DOUBTFUL ACCOUNTS - Accounts are charged to the allowance for
doubtful accounts as they are deemed uncollectible based on a periodic
review of the accounts.
INVENTORIES - Inventories are stated at the lower of cost or market with
cost being determined by the first-in, first-out ("FIFO") method.
32
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
PROPERTY AND EQUIPMENT - Property and equipment are stated at cost.
Depreciation and amortization of property and equipment is provided using
the straight-line method over the estimated useful lives of the assets.
Upon retirement or sale, the costs of the assets disposed of and the
related accumulated depreciation are removed from the accounts and any
resulting gain or loss is included in the determination of income or loss.
The estimated useful lives of assets used by us are:
Building and improvements........................... 30 years
Building improvements............................... 5 to 20 years
Furniture and fixtures and office equipment......... 5 years
Computer & manufacturing equipment.................. 3 years
Purchased software.................................. 3 years
IMPAIRMENT OF LONG-LIVED ASSETS - We review long-lived assets for
impairment whenever events or changes in business circumstances indicate
that the carrying amount of the assets may not be fully recoverable or that
the useful lives of these assets are no longer appropriate. Each impairment
test is based on a comparison of the undiscounted cash flows to the
recorded value of the asset. If an impairment is indicated, the asset is
written down to its estimated fair value on a discounted cash flow basis.
The cash flow estimates used to determine the impairment, if any, reflect
our best estimates using appropriate assumptions and projections at that
time. We believe that no significant impairment of our long-lived assets
has occurred as of December 31, 2003 and 2002.
REVENUE RECOGNITION. Effective January 1, 2000, we adopted Securities and
Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition
in Financial Statements ("SAB 101"), which was superseded by SAB 104
effective December 2003 and was adopted by us at that time. Accordingly,
our general revenue recognition policy is to recognize revenue when there
is persuasive evidence of an arrangement, the sales price is fixed or
determinable, collection of the related receivable is reasonably assured,
and delivery has occurred or services have been rendered.
We derive our revenue from three sources (i) product revenue, which
includes revenue from the sale of ADSL equipment products and compression
software products, (ii) contract revenue, which includes license and
engineering service fees that we receive under customer agreements, and
(iii) royalties that we receive under customer contracts. In addition to
the above general revenue recognition principles prescribed by SAB 104, our
specific revenue recognition policies for each revenue source are more
fully described below.
PRODUCT SALES. Product sales consist primarily of revenue from the sale of:
(i) hardware products, and (ii) compression software.
o Hardware products, including ADSL transceiver modules and test and
development systems are standalone products that are sold
independently of our technology licensing business. The terms of sales
generally do not contain provisions that obligate us to provide
additional products or services after shipment. Additionally, we do
not grant return rights other than normal warranty rights of return.
We recognize revenue: (i) upon shipment when products are shipped FOB
shipping point, and (ii) upon delivery at the customer's location when
products are shipped FOB destination.
o 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. The terms of sale generally do
not contain provisions that obligate us to provide additional products
or services after shipment, other than technical telephone support for
a brief period of time post sale. The cost of providing technical
support is inconsequential because of the limited scope of the
support. Additionally, we do not grant return rights other than normal
warranty rights of return, and we generally do not customize software
for customers. Occasionally, we sell maintenance contracts that
entitle customers to product updates.
33
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
We recognize compression software revenue by applying the principles
set forth in SAB 104 and American Institute of Certified Public
Accountants ("AICPA") Statement of Position No. 97-2, Software Revenue
Recognition. Accordingly, we recognize revenue for software licenses:
(i) upon shipment when products are shipped FOB shipping point, and
(ii) upon delivery at the customer's location when products are
shipped FOB destination. We recognize revenue for maintenance
contracts ratably over the related contract period.
CONTRACT REVENUE. We enter into nonexclusive development and license
agreements with semiconductor licensees that generally require us to make
technology transfers and/or provide engineering services. In return, we
receive one or more of the following forms of consideration: (i) license
fees; (ii) engineering service fees; and (iii) royalty payments.
License fees or engineering services fees are typically paid and the
revenue is recognized during the product development period as technology
transfers are made or as engineering services milestones are achieved.
Engineering milestones have historically been formulated to correlate with
the estimated level of effort and related costs. Royalties are paid once a
customer begins shipping products that incorporate our technology. We
classify license and engineering service fees as contract revenue and we
classify royalty payments as royalties.
When our agreements include both the transfer of technology and the
provision of engineering services, we combine the total license and
engineering service fees to be paid under the agreement. These total fees
are recognized ratably over the expected product development period,
subject to the limitation that the cumulative revenue recognized through
the end of any period may not exceed cumulative contract payments to date.
We review assumptions regarding the product development period on a regular
basis and make adjustments as required. We believe that this method
represents the appropriate systematic method for revenue recognition for
this type of contract.
After customers enter into development and license agreements, they often
engage us to provide additional engineering work that is beyond the scope
of their original base agreement. When customers request additional
services, both parties agree to engineering fees that are based on the
level of effort required. We recognize revenue from these agreements either
as engineering services are performed or as milestones are achieved.
ROYALTY REVENUE. Royalty revenue is generally recognized in the quarter in
which a report is received from a licensee detailing the shipments of
products incorporating our intellectual property components (i.e., in the
quarter following the sales of the licensed product by the licensee). The
terms of our licensing agreements generally require licensees to give
notification to us and to pay royalties within 45 to 60 days of the end of
the quarter during which sales of licensed products take place.
INCOME TAXES - We compute deferred income taxes based on the differences
between the financial statement and tax basis of assets and liabilities
using enacted rates in effect in the years in which the differences are
expected to reverse. We establish a valuation allowance to offset temporary
deductible differences, net operating loss carryforwards and tax credits
when it is more likely than not that the deferred tax assets will not be
realized.
CAPITALIZATION OF SOFTWARE COSTS - We capitalize certain internally
generated software development costs after technological feasibility of the
product has been established. No software costs were capitalized for the
years ended December 31, 2003, 2002 and 2001, because such costs incurred
subsequent to the establishment of technological feasibility, but prior to
commercial availability, were immaterial.
CONCENTRATION OF CREDIT RISK - At December 31, 2003 and 2002, we had cash
and investments, in excess of federally insured deposit limits of
approximately $38.9 million and $47.0 million, respectively.
Concentration of credit risk with respect to net accounts receivable
consists of $0.5 million, $0.5 million, and $0.4 million with three
customers at December 31, 2003 and $0.6 million, $0.4 million, and $0.2
million with three customers at December 31, 2002.
34
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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") 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.
At December 31, 2003, we have four stock-based employee compensation plans,
which are described more fully in Note 6. No stock-based employee
compensation cost is reflected in net income, 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, "Accounting for Stock-Based Compensation-Transition and Disclosure
- An Amendment of SFAS No. 123", to stock-based employee compensation (in
thousands, except per share data):
Year ended December 31,
--------------------------------------------------
2003 2002 2001
--------------------------------------------------
Net loss - as reported................................. ($8,038) ($18,728) ($2,520)
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards....................................... 21,107 21,207 25,253
--------------------------------------------------
Net loss - pro forma................................... ($29,145) ($39,935) ($27,773)
Basic loss per share - as reported..................... ($0.35) ($0.83) ($0.11)
Basic loss per share - pro forma....................... ($1.28) ($1.76) ($1.23)
Diluted loss per share - as reported................... ($0.35) ($0.83) ($0.11)
Diluted loss per share - pro forma..................... ($1.28) ($1.76) ($1.23)
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:
Year ended December 31,
------------------------------------------------------
2003 2002 2001
--------------- --------------- ---------------
Average risk-free interest rate............. 2.97% 3.82% 4.55%
Expected life of option grants.............. 5 years 5 years 5 years
Expected volatility of underlying stock..... 95% 99% 104%
Expected dividend yield..................... - - -
COMPUTATION OF EARNINGS PER SHARE - Basic earnings per share is computed by
dividing income available to common shareholders by the weighted average
number of common shares outstanding. Diluted earnings per share is computed
by dividing income available to common shareholders 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 antidilutive are excluded from the calculation.
USE OF ESTIMATES - The preparation of our financial statements in
conformity with generally accepted accounting principles requires us 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 amount of revenues and
expenses during the reporting period. Significant estimates include revenue
recognition, reserves for doubtful accounts, reserves for excess and
obsolete inventory, useful lives of fixed assets, valuation allowance for
deferred income tax assets, and accrued liabilities. Actual results could
differ from those estimates.
35
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FAIR VALUE OF FINANCIAL INSTRUMENTS - The carrying amounts of cash and cash
equivalents, short-term investments, accounts receivable, accounts payable
and accrued expenses approximate fair value because of their short-term
nature.
COMPREHENSIVE INCOME (LOSS) - Comprehensive income (loss) is defined as the
change in equity of a business enterprise during a period from transactions
and other events and circumstances from non-owner sources, including
foreign currency translation adjustments and unrealized gains and losses on
marketable securities. For the years ended December 31, 2003, 2002 and
2001, comprehensive income (loss) was not materially different from net
income (loss).
ADVERTISING COSTS - Advertising costs are expensed as incurred and were not
material for 2003, 2002 and 2001.
RECENT ACCOUNTING PRONOUNCEMENTS - In December 2003, the SEC issued Staff
Accounting Bulletin ("SAB") No. 104, Revenue Recognition, which supersedes
SAB No. 101, Revenue Recognition in Financial Statements. SAB No. 104
rescinds accounting guidance in SAB No. 101 related to multiple-element
arrangements as this guidance has been superseded as a result of the
issuance of EITF 00-21, "Accounting for Revenue Arrangements with Multiple
Deliverables" ("EITF 00-21"). The adoption of SAB No. 104 did not have a
material impact on the Company's financial position, results of operations
or cash flows.
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, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative
Instruments and Hedging Activities." This statement amends SFAS 133 to
provide clarification on the financial accounting and reporting of
derivative instruments and hedging activities and requires contracts with
similar characteristics to be accounted for on a comparable basis. This
statement was effective for contracts entered into or modified after June
30, 2003 and for hedging relationships designated after June 30, 2003. The
Company adopted SFAS 149 on July 1, 2003 and the adoption did not have a
material effect on its consolidated financial position or results of
operations.
In January 2003, the FASB issued FASB Interpretation No. 46, as amended by
FIN 46R, "Consolidation of Variable Interest Entities, an Interpretation of
ARB 51" ("FIN 46"). The primary objectives of FIN 46 are to provide
guidance on the identification of entities for which control is achieved
through means other than through voting rights ("variable interest
entities" or "VIEs") and how to determine when and which business
enterprise should consolidate the VIE. This new model for consolidation
applies to an entity which either: (a) the equity investors (if any) do not
have a controlling financial interest; or (b) the equity investment at risk
is insufficient to finance that entity's activities without receiving
additional subordinated financial support from other parties. In addition,
FIN 46 requires that both the primary beneficiary and all other enterprises
with a significant variable interest in a VIE make additional disclosures.
FIN 46 is effective for all new VIEs created or acquired after January 31,
2003. For VIEs created or acquired prior to February 1, 2003, the
provisions of FIN 46 must be applied for the first interim or annual period
ending after March 15, 2004. The Company has not created or acquired any
VIEs after January 31, 2003. The Company does not expect the adoption of
FIN 46 to have a material impact on its financial position or results of
operations.
In November 2002, the EITF reached a consensus on issue 00-21, "Accounting
for Revenue Arrangements with Multiple Deliverables." EITF 00-21 addresses
revenue recognition on arrangements encompassing multiple elements that are
delivered at different points in time, defining criteria that must be met
for elements to be considered to be a separate unit of accounting. If an
element is determined to be a separate unit of accounting, the revenue for
the element is recognized at the time of delivery. EITF 00-21 is effective
for
36
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
revenue arrangements entered into in fiscal periods beginning after
June 15, 2003. The Company adopted EITF 00-21 on July 1, 2003 and the
adoption did not have a material effect on its consolidated financial
position or results of operations.
SEGMENTS - We organize ourselves as one segment reporting to the chief
operating decision-maker. We have sales outside of the United States, which
are described in Note 8. All long-lived assets are maintained in the United
States.
3. INVENTORIES
Inventories consisted of the following at December 31 (in thousands):
2003 2002
------------- ------------
Raw materials........................ $48 $46
Finished goods....................... - 4
------------- ------------
Total............................ $48 $50
============= ============
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following at December 31 (in
thousands):
2003 2002
--------------- ----------------
Land..................................................... $1,080 $1,080
Building and improvements................................ 8,837 8,784
Computer equipment....................................... 5,688 5,568
Purchased software....................................... 2,827 2,818
Furniture and fixtures................................... 936 928
Office equipment......................................... 346 346
Manufacturing equipment.................................. 268 268
--------------- ----------------
Total................................................. 19,982 19,792
Less accumulated depreciation and amortization........... (11,061) (9,754)
--------------- ----------------
Property and equipment, net........................... $8,921 $10,038
=============== ================
Depreciation expense amounted to $1.3 million, $1.7 million and $1.7
million in each of the years ended December 31, 2003, 2002, and 2001,
respectively.
5. INCOME TAXES
Deferred tax assets are attributable to the following at December 31 (in
thousands):
2003 2002
-------------- --------------
Federal net operating loss carryforwards........................ $ 16,560 $ 16,370
Research and development and other tax credit carryforwards..... 11,822 10,533
State net operating loss carryforwards.......................... 2,582 3,042
Capitalized research and development costs...................... 9,872 6,932
Other .......................................................... 935 1,228
-------------- --------------
Total........................................................ 41,771 38,105
Less valuation allowance........................................ (41,771) (38,105)
-------------- --------------
Deferred tax assets, net..................................... $ - $ -
============== ==============
37
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A reconciliation of the U.S. federal statutory rate to the effective tax
rate is as follows:
Year ended December 31,
-----------------------------------------------
2003 2002 2001
------------- ------------ -------------
Federal statutory rate................................. (34%) (34%) (34%)
State rate, net of federal benefit..................... (6) (6) (6)
Tax credits............................................ (14) (14) (60)
Change in valuation allowance.......................... 50 111 100
Other 4 4 -
------------- ------------ -------------
Effective tax rate.................................. 0% 61% -%
============= ============ =============
During 2002, we recorded a valuation allowance of $38.1 million against all
of our deferred tax assets. The valuation allowance was recorded against
deferred tax assets because we determined that it was more likely than not
that all of the deferred tax assets may not be realized. In 2003, we
increased the valuation allowance by $3.7 million to $41.8 million
primarily as a result of additional operating losses and tax credits.
We have incurred operating losses in 2003, 2002 and 2001. At December 31,
2003 and 2002, these cumulative factors resulted in our decision that it is
more likely than not that all of our deferred tax assets may not be
realized. If we generate sustained future taxable income against which
these tax attributes may be applied, some portion or all of the valuation
allowance would be reversed. If the valuation allowance is reversed
approximately $24.1 million would be recorded as a credit to additional
paid in capital reflecting the benefit of deductions from the exercise of
stock options.
As of December 31, 2003, we had federal net operating loss and research and
experimentation credit carryforwards of approximately $48.7 million and
$8.8 million respectively, which may be available to offset future federal
income tax liabilities and expire at various dates through 2023. In
addition, at December 31, 2003, we had approximately $41.0 million and $4.6
million of state net operating losses and state research and development
and investment tax carryforwards, respectively, which expire at various
dates through 2023.
6. EQUITY AND STOCK COMPENSATION PLANS
At December 31, 2003, we have four stock-based compensation plans, which
are described below.
FIXED STOCK OPTION PLANS - We have three fixed option plans. Under the 1990
Incentive and Nonstatutory Stock Option Plan ("1990 Plan"), we may grant
incentive stock options or nonqualified stock options to our employees and
directors for up to 2,873,002 shares of common stock. Under the 1996 Stock
Option Plan ("1996 Plan"), we may grant incentive stock options or
nonqualified stock options to our employees and directors for up to
6,100,000 shares of common stock. Under the 2001 Nonqualified Stock Plan
("2001 Plan"), we may grant nonqualified stock options to our employees and
directors for up to 8,000,000 shares of common stock. Under all three
plans, options are granted at an exercise price as determined by the Board
of Directors; have a maximum term of ten years; and generally vest over
three to five years. As of December 31, 2003, there were 6,242,964 shares
available for grant under the 2001 Plan, 2,381,381 shares available for
grant under the 1996 Plan, and no shares available under the 1990 Plan.
38
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the transactions of our three fixed stock option plans for the
years ended December 31, 2003, 2002, and 2001 are presented below:
2003 2002 2001
-------------------------- --------------------------- -------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
-------------------------- --------------------------- -------------------------
Outstanding at beginning of year... 6,842,546 $17.47 6,268,208 $20.63 4,083,683 $29.52
Granted............................ 2,993,963 3.22 1,521,100 3.50 2,407,423 6.42
Exercised.......................... (2,937) 3.54 (9,736) 6.48 (23,731) 7.60
Forfeited or cancelled............. (6,365,643) 17.91 (937,026) 16.00 (199,167) 32.73
-------------------------- --------------------------- -------------------------
Outstanding at end of year......... 3,467,929 $4.38 6,842,546 $17.47 6,268,208 $20.63
========================== =========================== =========================
Options exercisable at year end.... 2,356,254 $4.84 4,265,956 $21.01 3,358,403 $21.28
The weighted average grant date fair values of options granted during the
years ended December 31, 2003 2002 and 2001 were $2.37, $2.65 and $5.01,
respectively.
The following table summarizes information about stock options outstanding
at December 31, 2003:
Options Outstanding Options Exercisable
----------------------------------------------------------- -------------------------------------
Number Weighted-Avg. Number
Range of Outstanding at Remaining Contractual Weighted-Avg. Exercisable Weighted-Avg.
Exercise Prices 12/31/03 Life Exercise Price At 12/31/03 Exercise Price
--------------- ----------------------------------------------------------- -------------------------------------
$0 to 5........... 3,204,854 9.7 years $3.23 2,121,583 $3.27
5 to 10.......... 110,916 7.3 $7.47 90,057 $7.55
10 to 20.......... 56,409 3.8 $10.67 54,691 $10.66
20 to 30.......... 22,250 6.8 $20.38 18,079 $20.38
30 to 40.......... 45,000 5.5 $33.56 44,688 $33.56
40 to 50.......... 18,500 6.2 $44.89 17,156 $44.67
50 to 70.......... 10,000 5.8 $58.06 10,000 $58.06
----------------------------------------------------------- -------------------------------------
3,467,929 9.4 $4.38 2,356,254 $4.84
=========================================================== =====================================
EMPLOYEE STOCK PURCHASE PLAN - In June 1996, we adopted an Employee Stock
Purchase Plan (the "ESPP Plan") under which eligible employees may purchase
common stock at a price equal to 85% of the lower of the fair market value
of the common stock at the beginning or end of each six-month offering
period. Participation in the ESPP Plan is limited to 6% of an employee's
compensation, may be terminated at any time by the employee and
automatically ends on termination of employment. A total of 350,000 shares
of common stock have been reserved for issuance. As of December 31, 2003
there were 221,117 shares available for future issuance under the ESPP
Plan. We issued 49,186, 30,694 and 27,733 common shares under the ESPP Plan
in 2003, 2002 and 2001, respectively.
STOCKHOLDER RIGHTS PLAN - In October 2001, our board of directors adopted a
stockholder rights plan and declared a dividend distribution of one share
purchase right (a "Right") for each outstanding share of our common stock
to stockholders of record at the close of business on October 15, 2001.
Each share of common stock issued after that date also will carry with it
one Right, subject to certain exceptions. Each Right, when it becomes
exercisable, will entitle the record holder to purchase from us one
ten-thousandth of a share of series A preferred stock at an exercise price
of $40.00 subject to adjustment.
The Rights become exercisable upon the earliest of the following dates: (i)
the date on which we first publicly announce that a person or group has
become an acquiring person, or (ii) the date, if any, that our board of
39
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
directors may designate following the commencement of, or first public
disclosure of an intent to commence, a tender or exchange offer which could
result in the potential buyer becoming a beneficial owner of 15% or more of
our outstanding common stock. Under these circumstances, holders of Rights
will be entitled to purchase, for the exercise price, the preferred stock
equivalent of common stock having a market value of two times the exercise
price. The Rights expire on October 2, 2011, and may be redeemed by us for
$.001 per Right.
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. 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. The replacement
options were granted more than six months and one day after the
cancellation of the old options. As a result, the new options were
considered a fixed award and did not result in any compensation expense.
7. COMMITMENTS AND CONTINGENT LIABILITIES
LEASE COMMITMENTS - We own our principal office and research facility in
Bedford, Massachusetts, which we have occupied since November 1997. We
conduct a portion of our activities in leased facilities in Lafayette,
California under a non-cancellable operating lease that expires in 2004.
The following is a schedule of future minimum rental payments (in
thousands):
YEAR ENDED DECEMBER 31,
-----------------------
2004..................................... $30
-----------
Total minimum lease payments.......... $30
===========
Rental expense was approximately $45,000, $44,000 and $36,000 in 2003, 2002
and 2001, respectively.
LITIGATION - There are no material pending legal proceedings to which we
are a party or to which any of our properties are subject which, either
individually or in the aggregate, are expected to have a material adverse
effect on our business, financial position or results of operations.
GUARANTEES AND INDEMNIFICATION OBLIGATIONS - We enter into licensing
agreements in the ordinary course of business that require us: i) to
perform under the terms of the contracts, ii) to protect the
confidentiality of our customers' intellectual property, and iii) to
indemnify customers, including indemnification against third party claims
alleging infringement of intellectual property rights. We also have
agreements with each of our directors and executive officers to indemnify
such directors or executive officers, to the extent legally permissible,
against all liabilities reasonably incurred in connection with any action
in which such individual may be involved by reason of such individual being
or having been a director or officer of Aware.
Given the nature of the above obligations and agreements, we are unable to
make a reasonable estimate of the maximum potential amount that we could be
required to pay. Historically, we have not made any significant payments on
the above guarantees and indemnifications and no amount has been accrued in
the accompanying consolidated financial statements with respect to these
guarantees and indemnifications.
8. BUSINESS SEGMENTS AND MAJOR CUSTOMERS
We manage the business as one segment and conduct our operations in the
United States.
We sell our products and technology to domestic and international
customers. Revenues were generated from the following geographic regions
(in thousands):
40
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Year ended December 31,
----------------------------------------------------
2003 2002 2001
--------------- -------------- --------------
United States................................... $8,049 $11,045 $17,092
Germany......................................... 1,990 2,271 570
Rest of world................................... 804 528 885
--------------- -------------- --------------
$10,843 $13,844 $18,547
=============== ============== ==============
The portion of total revenue that was derived from major customers was as
follows:
Year ended December 31,
----------------------------------------------------
2003 2002 2001
--------------- -------------- --------------
Customer A................................. 27% 32% 52%
Customer B................................... 17% 15% 2%
Customer C................................... 14% 7% 3%
Customer D................................ 9% 12% 14%
9. EMPLOYEE BENEFIT PLAN
In 1994, we established a qualified 401(k) Retirement Plan (the "Plan")
under which employees are allowed to contribute certain percentages of
their pay, up to the maximum allowed under Section 401(k) of the Internal
Revenue Code. Our contributions to the Plan are at the discretion of the
Board of Directors. Our contributions were $284,000, $340,000 and $313,000
in 2003, 2002 and 2001, respectively.
10. NET INCOME (LOSS) PER SHARE
Net income (loss) per share is calculated as follows (in thousands, except
per share data):
Year ended December 31,
-----------------------------------------------------
2003 2002 2001
--------------- -------------- ---------------
Net income (loss)................................. ($8,038) ($18,728) ($2,520)
Weighted average common shares outstanding........ 22,713 22,679 22,631
Additional dilutive common stock equivalents ..... - - -
--------------- -------------- ---------------
Diluted shares outstanding ....................... 22,713 22,679 22,631
=============== ============== ===============
Net income (loss) per share - basic............... ($0.35) ($0.83) ($0.11)
Net income (loss) per share - diluted............. ($0.35) ($0.83) ($0.11)
For the years ended December 31, 2003, 2002 and 2001, potential common
stock equivalents of 10,525, 226,303 and 285,427, respectively, were not
included in the per share calculation for diluted EPS, because we had a net
loss and the effect of their inclusion would be anti-dilutive. For the
years ended December 31, 2003, 2002 and 2001, options to purchase
3,352,283, 4,770,052 and 3,488,215 shares of common stock at average
weighted prices of $4.45, $23.54 and $31.95 per share, 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 shares and thus would be anti-dilutive.
41
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. QUARTERLY RESULTS OF OPERATIONS - UNAUDITED
The following table presents unaudited quarterly operating results for each
of our quarters in the two-year period ended December 31, 2003 (in
thousands, except per share data):
2003 Quarters Ended
--------------------------------------------------------------
March 31 June 30 September 30 December 31
--------------------------------------------------------------
Revenue................................. $1,947 $2,817 $3,055 $3,024
Loss from operations.................... (3,132) (2,001) (1,882) (1,620)
Net loss................................ (2,963) (1,844) (1,746) (1,485)
Net loss per share - basic.............. ($0.13) ($0.08) ($0.08) ($0.07)
Net loss per share - diluted ........... ($0.13) ($0.08) ($0.08) ($0.07)
2002 Quarters Ended
--------------------------------------------------------------
March 31 June 30 September 30 December 31
--------------------------------------------------------------
Revenue................................. $3,576 $4,012 $3,953 $2,303
Loss from operations.................... (2,815) (2,362) (2,812) (4,540)
Net loss................................ (2,576) (2,130) (9,681) (4,341)
Net loss per share - basic.............. ($0.11) ($0.09) ($0.43) ($0.19)
Net loss per share - diluted ........... ($0.11) ($0.09) ($0.43) ($0.19)
42
FINANCIAL STATEMENT SCHEDULE
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS - YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(IN THOUSANDS)
- -------------------------------------------------------------------------------------------------------------------------
COL. A COL. B COL. C (1) COL. C (2) COL. D COL. E
- -------------------------------------------------------------------------------------------------------------------------
ADDITIONS
-------------------------------------
BALANCE AT CHARGED TO CHARGED DEDUCTIONS BALANCE
BEGINNING COSTS AND TO OTHER CHARGED TO AT END
OF PERIOD EXPENSES ACCOUNTS RESERVES OF PERIOD
- -------------------------------------------------------------------------------------------------------------------------
Allowance for doubtful
accounts receivable:
2003................. $1,077 ($150) - - $927
2002................. $380 $707 - $10 $1,077
2001................. $402 $25 - $47 $380
Allowance for sales
returns and allowances:
2003................. - - - - -
2002................. - - - - -
2001................. $125 - ($125) - -
Inventory reserves:
2003................. $284 - - - $284
2002................. $284 - - - $284
2001................. $209 $75 - - $284
43
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A. 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 period covered by this Form 10-K 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 fourth quarter of 2003 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 of Form 10-K is incorporated by reference
from the information contained in the sections captioned "DIRECTORS AND
EXECUTIVE OFFICERS" and "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Proxy Statement that will be delivered to our shareholders in
connection with our May 27, 2004 Annual Meeting of Shareholders.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 of Form 10-K is incorporated by reference
from the information contained in the section captioned "COMPENSATION OF
DIRECTORS AND EXECUTIVE OFFICERS" in the Proxy Statement that will be delivered
to our shareholders in connection with our May 27, 2004 Annual Meeting of
Shareholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 of Form 10-K is incorporated by reference
from the information contained in the section captioned "SECURITY OWNERSHIP OF
CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS" in the
Proxy Statement that will be delivered to our shareholders in connection with
our May 27, 2004 Annual Meeting of Shareholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information, if any, required by Item 13 of Form 10-K is incorporated by
reference from the information contained in the section captioned "CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS" in the Proxy Statement that will be
delivered to our shareholders in connection with our May 27, 2004 Annual Meeting
of Shareholders.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 of Form 10-K is incorporated by reference
from the information contained in the section captioned "INDEPENDENT
ACCOUNTANTS" in the Proxy Statement that will be delivered to our shareholders
in connection with our May 27, 2004 Annual Meeting of Shareholders.
44
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) See Item 8 for an index to the consolidated financial statements,
supplementary financial information, and financial statement schedule.
Our chief executive officer and chief financial officer have furnished to
the SEC the certification with respect to this Report that is required by
Section 906 of the Sarbanes-Oxley Act of 2002.
(B) REPORTS ON 8-K
We filed a Form 8-K dated October 9, 2003, which included as an exhibit a
press release dated October 9, 2003 announcing our financial results for
the quarter ended September 30, 2003.
(C) INDEX TO EXHIBITS
Exhibits have been filed separately with the United States Securities and
Exchange Commission in connection with this Annual Report on Form 10-K or
have been incorporated into this Report by reference. Copies of such
exhibits may be obtained from us upon request.
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
3.1 Amended and Restated Articles of Organization (filed as Exhibit 3.2 to the Company's
Registration Statement on Form S-1, File No. 333-6807 and incorporated herein by
reference).
3.2 Articles of Amendment to the Articles of Organization (filed as Exhibit 3.3 to the
Company's Form 10-Q for the quarter ended September 30, 2002 and incorporated herein
by reference).
3.3 Amended and Restated By-Laws (filed as Exhibit 3.3 to the Company's Form 10-Q for the
quarter ended June 30, 1996 and incorporated herein by reference).
4.1 Rights Agreement dated as of October 2, 2001 between Aware, Inc. and Equiserve Trust
Company, N.A., as Rights Agent (filed as Exhibit 4(a) to the Company's Form 8-K filed
with the Securities and Exchange Commission on October 3, 2001 and incorporated herein
by reference).
4.2 Terms of Series A Participating Cumulative Preferred Stock of Aware, Inc. (attached as
Exhibit A to the Rights Agreement filed as Exhibit 4.1 hereto).
4.3 Form of Right Certificate (attached as Exhibit B to the Rights Agreement filed as
Exhibit 4.1 hereto).
10.1 1990 Incentive and Non-Statutory Stock Option Plan (filed as Exhibit 10.2 to the
Company's Registration Statement on Form S-1, File No. 333-6807 and incorporated
herein by reference).
10.2 1996 Stock Option Plan, as amended and restated (filed as Annex A to the Company's
Definitive Proxy Statement filed with the Securities and Exchange Commission on April
11, 2000 and incorporated herein by reference).
10.3 1996 Employee Stock Purchase Plan, as amended and restated (filed as Annex A to the
Company's Definitive Proxy Statement filed with the Securities and Exchange Commission
on April 15, 2003 and incorporated herein by reference).
10.4 Form of Director and Officer Indemnification Agreement (filed as Exhibit 10.4 to the
Company's Form 10-K for the year ended December 31, 2002 and incorporated herein by
reference).
10.5 2001 Nonqualified Stock Plan (filed as Exhibit 99(d)(4) to the Company's Schedule TO
filed with the Securities and Exchange Commission on March 3, 2003 and incorporated
herein by reference).
21.1* Subsidiaries of Registrant.
23.1* Consent of PricewaterhouseCoopers LLP.
45
31.1* Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.2* Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32.1* Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith
46
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.
AWARE, INC.
By: /s/ Michael A. Tzannes
---------------------------------
Michael A. Tzannes, Chief Executive
Officer
Date: March 15, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities indicated on the 15th day of March 2004.
SIGNATURE TITLE
--------- -----
/s/ Michael A. Tzannes Chief Executive Officer and Director
- --------------------------------- (Principal Executive Officer)
Michael A. Tzannes
/s/ Edmund C. Reiter President and Director
- ---------------------------------
Edmund C. Reiter
/s/ David J. Martin Interim Chief Financial Officer
- --------------------------------- (Principal Financial and Accounting
David J. Martin Officer)
/s/ John K. Kerr Chairman of the Board of Directors
- ---------------------------------
John K. Kerr
/s/ David Ehreth Director
- ---------------------------------
David Ehreth
/s/ G. David Forney, Jr. Director
- ---------------------------------
G. David Forney, Jr.
/s/ Frederick D. D'Alessio Director
- ---------------------------------
Frederick D. D'Alessio
/s/ Adrian F. Kruse Director
- ---------------------------------
Adrian F. Kruse
47