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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED MARCH 31, 2004
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
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(Exact Name of Registrant as Specified in Its Charter)
MASSACHUSETTS 04-2911026
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
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(Address of Principal Executive Offices)
(Zip Code)
(781) 276-4000
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(Registrant's Telephone Number, Including Area Code)
Indicate by check whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2). YES X NO
--- ---
Indicate the number of shares outstanding of the issuer's common stock as of
April 30, 2004:
CLASS NUMBER OF SHARES OUTSTANDING
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Common Stock, par value $0.01 per share 22,757,724 shares
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AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2004
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of
March 31, 2004 and December 31, 2003.......................... 3
Consolidated Statements of Operations for the
Three Months Ended March 31, 2004
and March 31, 2003............................................ 4
Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2004
and March 31, 2003............................................ 5
Notes to Consolidated Financial Statements.................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................... 10
Item 3. Quantitative and Qualitative Disclosures about
Market Risk................................................... 21
Item 4. Controls and Procedures....................................... 22
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................. 23
Item 6. Exhibits and Reports on Form 8-K.............................. 24
Signatures.................................................... 24
2
PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
MARCH 31, DECEMBER 31,
2004 2003
----------------- ----------------
ASSETS
Current assets:
Cash and cash equivalents................................................ $21,855 $19,504
Short-term investments................................................... 11,441 15,547
Accounts receivable, net................................................. 2,155 2,449
Inventories.............................................................. 91 48
Prepaid expenses and other assets........................................ 596 563
----------------- ----------------
Total current assets 36,138 38,111
----------------- ----------------
Property and equipment, net................................................... 8,686 8,921
Investments................................................................... 5,509 3,913
Other assets, net............................................................. 48 79
----------------- ----------------
Total assets....................................................... $50,381 $51,024
================= ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable........................................................ $729 $261
Accrued expenses ........................................................ 150 136
Accrued compensation .................................................... 639 439
Accrued professional..................................................... 81 77
Deferred revenue......................................................... 274 471
----------------- ----------------
Total current liabilities........................................ 1,873 1,384
----------------- ----------------
Stockholders' equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding................................................. - -
Common stock, $.01 par value; 70,000,000 shares authorized; issued
and outstanding, 22,755,006 in 2004 and 22,750,294 in 2003...... 228 228
Additional paid-in capital.............................................. 77,415 77,400
Accumulated deficit.................................................... (29,135) (27,988)
----------------- ----------------
Total stockholders' equity...................................... 48,508 49,640
----------------- ----------------
Total liabilities and stockholders' equity....................... $50,381 $51,024
================= ================
The accompanying notes are an integral part of the financial statements.
3
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
------------------------------------
2004 2003
------------------ ----------------
Revenue:
Product sales................................................. $1,223 $710
Contract revenue.............................................. 1,278 330
Royalties..................................................... 1,101 907
------------------ ----------------
Total revenue 3,602 1,947
Costs and expenses:
Cost of product sales......................................... 337 145
Cost of contract revenue...................................... 667 263
Research and development...................................... 2,671 3,448
Selling and marketing......................................... 604 575
General and administrative.................................... 593 648
------------------ ----------------
Total costs and expenses 4,872 5,079
Loss from operations.............................................. (1,270) (3,132)
Interest income................................................... 123 169
------------------ ----------------
Loss before provision for income taxes............................ (1,147) (2,963)
Provision for income taxes........................................ - -
------------------ ----------------
Net loss.......................................................... ($1,147) ($2,963)
================== ================
Net loss per share - basic and diluted ........................... ($0.05) ($0.13)
Weighted average shares - basic and diluted....................... 22,751 22,698
The accompanying notes are an integral part of the financial statements.
4
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
------------------------------------
2004 2003
---------------- ----------------
Cash flows from operating activities:
Net loss................................................... ($1,147) ($2,963)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization............................ 291 405
Increase (decrease) from changes in assets and
liabilities:
Accounts receivable.................................. 294 (411)
Inventories.......................................... (43) (53)
Prepaid expenses..................................... (33) (74)
Accounts payable..................................... 468 74
Accrued expenses..................................... 218 (270)
Deferred revenue..................................... (197) (22)
---------------- ----------------
Net cash used in operating activities............. (149) (3,314)
---------------- ----------------
Cash flows from investing activities:
Purchases of property and equipment....................... (25) (71)
Net sales (purchases) of short-term investments........... 4,106 (3,087)
Net sales (purchases) of investments...................... (1,596) 1,798
---------------- ----------------
Net cash provided by (used in) investing
activities...................................... 2,485 (1,360)
---------------- ----------------
Cash flows from financing activities:
Proceeds from issuance of common stock................... 15 -
---------------- ----------------
Net cash provided by financing activities......... 15 -
---------------- ----------------
Increase (decrease) in cash and cash equivalents.............. 2,351 (4,674)
Cash and cash equivalents, beginning of period................ 19,504 25,268
---------------- ----------------
Cash and cash equivalents, end of period...................... $21,855 $20,594
================ ================
The accompanying notes are an integral part of the financial statements.
5
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
A) BASIS OF PRESENTATION
The accompanying unaudited consolidated balance sheet, statements of
operations, and statements of cash flows reflect all adjustments
(consisting only of normal recurring items) which are, in the opinion of
management, necessary for a fair presentation of financial position at
March 31, 2004, and of operations and cash flows for the interim periods
ended March 31, 2004 and 2003.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instructions for Form 10-Q and therefore
do not include all information and footnotes necessary for a complete
presentation of our financial position, results of operations and cash
flows, in conformity with generally accepted accounting principles. We
filed audited financial statements which included all information and
footnotes necessary for such presentation for the three years ended
December 31, 2003 in conjunction with our 2003 Annual Report on Form
10-K.
The results of operations for the interim period ended March 31, 2004
are not necessarily indicative of the results to be expected for the
year.
B) INVENTORY
Inventory consists primarily of the following (in thousands):
MARCH 31, DECEMBER 31,
2004 2003
----------------- -----------------
Raw materials................. $90 $48
Finished goods................ 1 -
----------------- -----------------
Total.................. $91 $48
================= =================
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C) COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income or loss by
the weighted average number of common shares outstanding. Diluted
earnings per share is computed by dividing net income or loss by the
weighted average number of common shares outstanding plus additional
common shares that would have been outstanding if dilutive potential
common shares had been issued. For the purposes of this calculation,
stock options are considered common stock equivalents in periods in
which they have a dilutive effect. Stock options that are anti-dilutive
are excluded from the calculation.
Net income or loss per share is calculated as follows (in thousands,
except per share data):
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
-------------------------------
Net loss............................. ($1,147) ($2,963)
Weighted average common shares
outstanding........................ 22,751 22,698
Additional dilutive common stock
equivalents........................ - -
-------------------------------
Diluted shares outstanding .......... 22,751 22,698
===============================
Net loss per share - basic........... ($0.05) ($0.13)
Net loss per share - diluted......... ($0.05) ($0.13)
For the three month periods ended March 31, 2004 and 2003, potential
common stock equivalents of 434,263 and 446, respectively, were not
included in the per share calculation for diluted EPS, because we had
net losses and the effect of their inclusion would be anti-dilutive. For
the three month periods ended March 31, 2004 and 2003, options to
purchase 263,075 and 6,747,169 shares of common stock, respectively,
were outstanding, but were not included in the computation of diluted
EPS because the options' exercise prices were greater than the average
market price of the common stock and thus would be anti-dilutive.
D) STOCK-BASED COMPENSATION
We grant stock options to our employees and directors. Such grants are
for a fixed number of shares with an exercise price equal to the fair
value of the shares at the date of grant. As permitted by SFAS No. 123,
"Accounting for Stock-Based Compensation", we account for stock option
grants in accordance with Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees" and FASB
Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions
Involving Stock Compensation." Accordingly, we have adopted the
provisions of SFAS No. 123 through disclosure only.
No stock-based employee compensation cost is reflected in our net loss,
as all options granted under those plans had an exercise price equal to
the fair market value of the
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underlying common stock on the date of grant. The following table
illustrates the pro forma effect on net loss and earnings per share if
we had applied the fair value recognition provisions of SFAS No. 123 and
SFAS No. 148 to stock-based employee compensation (in thousands, except
per share data):
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
-------------------------------
Net loss - as reported................ ($1,147) ($2,963)
Deduct: Total stock-based employee
compensation expense determined
under fair value based method for
all awards.......................... 3,437 5,005
-------------------------------
Net loss - pro forma.................. ($4,584) ($7,968)
===============================
Basic loss per share - as reported.... ($0.05) ($0.13)
Basic loss per share - pro forma...... ($0.20) ($0.35)
Diluted loss per share - as reported.. ($0.05) ($0.13)
Diluted loss per share - pro forma.... ($0.20) ($0.35)
The fair value of options on their grant date was measured using the
Black-Scholes option pricing model. Key assumptions used to apply this
pricing model are as follows:
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
-------------------------------
Average risk-free interest rate........ 2.99% 2.91%
Expected life of option grants......... 5 years 5 years
Expected volatility of underlying
stock................................ 95% 98%
Expected dividend yield................ - -
E) BUSINESS SEGMENTS
The Company organizes itself as one segment and conducts its operations
in the United States.
The Company sells its products and technology to domestic and
international customers. Revenues were generated from the following
geographic regions (in thousands):
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
-------------------------------
United States......................... $2,037 $1,513
Germany............................... 1,240 374
Rest of World......................... 325 60
-------------------------------
$3,602 $1,947
===============================
8
F) 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.
9
ITEM 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
SOME OF THE INFORMATION IN THIS FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-Q, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-Q COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS.
RESULTS OF OPERATIONS
PRODUCT SALES. Product sales consist primarily of revenue from the sale
of hardware products and compression software. Hardware products primarily
include ADSL test and development systems, modules, and modems. Compression
software consists of standard off-the-shelf software products that are sold to
OEM customers that integrate our software into their equipment-based products.
Product sales increased 72% from $0.7 million in the first quarter of 2003 to
$1.2 million in the current year quarter. As a percentage of total revenue,
product sales decreased from 36% in the first quarter of 2003 to 34% in the
current year quarter. The dollar increase was primarily due to an increase in
revenue from the sale of modules and to a lesser extent an increase in revenue
from the sale of compression software. 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 sales of our JPEG 2000
products.
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 increased 287% from $0.3 million in the first quarter of 2003
to $1.3 million in the current year quarter. As a percentage of total revenue,
contract revenue increased from 17% in the first quarter of 2003 to 35% in the
current year quarter. The dollar increase was primarily due to an increase in
customer projects and engineering services we provided to our customers.
Despite the increase in contract revenue this quarter, prospective ADSL chipset
licensees continue to be 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
10
uncertain when the economic and market conditions we faced over the last several
years will materially improve.
ROYALTIES. Royalties consist of royalty payments that we receive under
licensing agreements. We receive royalties from customers for the right to use
our technology in their chipsets or solutions.
Royalties increased 21% from $0.9 million in the first quarter of 2003 to $1.1
million in the current year quarter. As a percentage of total revenue, royalties
decreased from 47% in the first quarter of 2003 to 31% in the current year
quarter. The dollar increase in royalties was primarily due to an increase in
ADSL chipset sales by Infineon Technologies AG ("Infineon") and to a lesser
extent an increase in royalties from Analog Devices, Inc. ("ADI"). Infineon has
continued to increase the number of ADSL chipsets it sells based upon our
technology. Infineon has announced design wins with several telecommunications
equipment suppliers, including Siemens AG and Alcatel Alsthom S.A., for chipsets
that are based on our ADSL technology. We are uncertain how quickly sales of
these chipsets will increase and whether they will contribute meaningful
royalties to us.
Despite the increase in ADSL chipset sales by ADI in 2003 and the first quarter
of 2004, ADI's chipset sales have declined in previous quarters primarily due to
falling ADSL chipset pricing and lower ADI sales volumes. Despite steady growth
of worldwide ADSL subscribers over the last several years, the availability of
ADSL chipsets from a number of suppliers and intense competition among those
suppliers has caused chipset prices to drop sharply. Additionally, deployments
of ADSL service in geographic areas where chipsets based upon our technology
have been sold leveled off or declined. We are uncertain whether ADSL chipset
pricing will improve, whether ADI will be able to grow its presence or whether
our other licensees will contribute meaningful royalty revenue.
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 increased 133% from
$145,000 in the first quarter of 2003 to $337,000 in the current year quarter.
As a percentage of product sales, cost of product sales increased from 20% in
the first quarter of 2003 to 28% in the current year quarter. The dollar
increase in cost of product sales was primarily due to higher sales of modules.
The overall dollar increase in product margins was primarily due to higher sales
of modules and compression software.
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 increased 153% from $0.3 million in the first quarter
of 2003 to $0.7 million in the current year quarter. As a percentage of contract
revenue, cost of contract revenue decreased from 80% in the first quarter of
2003 to 52% in the current year quarter. The dollar increase in cost of contract
revenue was primarily due to more customer projects in the first quarter of 2004
as compared with the first quarter of 2003. Since our cost of contract revenue
is based on the level of effort we expend on customer projects and the number of
customer projects increased in the first quarter of 2004, cost of contract
revenue increased as well.
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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 23% from $3.4 million in the first quarter of 2003 to $2.7
million in the current year quarter. As a percentage of total revenue, research
and development expense decreased from 177% in the first quarter of 2003 to 74%
in the current year quarter, principally as a result of increased revenues.
The dollar decrease was primarily due to lower spending on internal research and
development projects and a shift of engineers from internal research and
development projects, where spending is classified as research and development
expense, to customer projects, where spending is classified as cost of contract
revenue. This shift occurred because we had more customer projects in the first
quarter of 2004 than in the first quarter of 2003.
Our research and development spending is principally focused on projects related
to core ADSL technology, including our StratiPHY(TM) family of chips, as well as
for Dr. DSL(R), G.SHDSL, wireless local area network communications, VDSL, and
other development projects.
SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of salaries for sales and marketing personnel, travel, advertising and
promotion, recruiting, and facilities expense. Sales and marketing expense
increased 5% from $575,000 in the first quarter of 2003 to $604,000 in the
current year quarter. As a percentage of total revenue, sales and marketing
expense decreased from 30% in the first quarter of 2003 to 17% in the current
year quarter. The dollar increase was primarily due to higher sales commissions.
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 9% from $648,000 in the first quarter of 2003
to $593,000 in the current year quarter. As a percentage of total revenue,
general and administrative expense decreased from 33% in the first quarter of
2003 to 16% in the current year quarter. The dollar decrease was primarily due
to lower spending on salary and fringe benefits.
INTEREST INCOME. Interest income decreased 27% from $169,000 in the
first quarter of 2003 to $123,000 in the current year quarter. The dollar
decrease was primarily due to lower interest rates earned on our cash balances
and lower cash balances.
INCOME TAXES. We made no provision for income taxes in the first three
months of 2004 due to net losses incurred. In 2002, we determined that due to
our continuing operating losses as well as the uncertainty of the timing of
profitability in future periods, we should fully reserve our deferred tax
assets. As of March 31, 2004, our deferred tax assets continue to be fully
reserved. We will continue to evaluate, on a quarterly basis, the positive and
negative evidence affecting the realizability of our deferred tax assets.
12
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2004, we had cash, cash equivalents, short-term investments and
investments of $38.8 million, which represents a decrease of $0.2 million from
December 31, 2003. The decrease is primarily due to $0.2 million of cash used in
operations.
Cash used in operations in the first three months of 2004 was primarily the
result of operating losses and working capital requirements.
While we can not assure you that we will not require additional financing, or
that such financing will be available to us, we believe that our cash, cash
equivalents and investments will be sufficient to fund our operations for at
least the next twelve months.
RECENT ACCOUNTING PRONOUNCEMENTS
In 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.
RISK FACTORS
We believe that the occurrence of any one or some combination of the following
risk factors could seriously harm our business.
OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY
Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter to quarter. Because our revenue components
fluctuate and are difficult to predict, and our expenses are largely independent
of revenues in any particular period, it is difficult for us to accurately
forecast revenues and profitability. We generally recognize contract revenues
ratably over the period during which we expect to provide engineering services.
While this means that contract revenues from current licenses are generally
predictable, changes can be introduced by a reevaluation of the length of the
development period, or by the termination of a
13
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| failures or problems in our hardware or software products;
|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 lower ADSL chipset unit
demand brought on by excess channel inventory and lower average
selling prices for ADSL chipsets as a result of market
surpluses;
|X| regulatory developments; and
|X| general economic trends and other factors.
WE EXPERIENCED NET LOSSES
We had a net loss during 2001, 2002, 2003 and the first three months of 2004. We
expect that we will have a net loss during the second quarter of 2004. We may
continue to experience losses in the future if;
14
|X| the semiconductor and telecommunications markets do not improve;
|X| our existing customers do not increase their revenues from sales
of chipsets with our technology;
|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. In 2000, 2001 and 2002, the ADSL industry
has experienced an oversupply of ADSL chipsets and central office equipment.
Excessive inventory levels led to soft chipset demand,
15
which in turn led to declining ASPs. As a result of the soft demand and
declining ASPs for ADSL chipsets, our royalty revenue has decreased
substantially from the levels we achieved in 2000. Price decreases for ADSL
chipsets, and the corresponding decreases in per unit royalties received by us,
can be sudden and dramatic. Pricing pressures may continue during the second
quarter of 2004 and beyond. Our royalty revenue may 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, 2003 and the first three months of 2004, we derived 52%, 32%, 27%
and 21%, 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, is unable
to transition its product to support new ADSL2 and ADSL2+ standards, or
experiences further price erosion in its ADSL chipsets, our royalty revenue
could 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;
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|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;
|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.
17
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 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.
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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.
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.
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Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.
OUR STOCK PRICE MAY BE EXTREMELY VOLATILE
Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:
|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.
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ITEM 3:
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:
|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 March 31, 2004, we had $33.3 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 March 31, 2004, we had invested $5.5 million in long-term investments that
matured in one to three years. These long-term securities are invested in high
quality corporate securities and U.S. government securities. Despite the high
quality of these securities, they may be subject to interest rate risk. This
means that if interest rates increase, the principal amount of our investment
would probably decline. A large increase in interest rates may cause a material
loss to our long-term investments. The following table (dollars in thousands)
presents hypothetical changes in the fair value of our long-term investments at
March 31, 2004. 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 No change Valuation of securities
given an interest rate in interest given an interest rate
decrease of rates increase of
------------------------- -------------------------
Type of security (100BP) (50 BP) 100 BP 50 BP
- ---------------------------------------------------------------------------------------------------------------
Long-term investments with
maturities of one to three years $5,609 $5,558 $5,509 $5,410 $5,459
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ITEM 4:
CONTROLS AND PROCEDURES
Our management, including our chief executive officer and chief financial
officer, has evaluated our disclosure controls and procedures as of the end of
the quarterly period covered by this Form 10-Q and has concluded that our
disclosure controls and procedures are effective. They also concluded that there
were no changes in our internal control over financial reporting that occurred
during the quarterly period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1:
LEGAL PROCEEDINGS
From time to time we are involved in litigation incidental to the conduct of our
business. We are not party to any lawsuit or proceeding that, in our opinion, is
likely to seriously harm our business.
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ITEM 6:
EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
Exhibit 31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(B) REPORTS ON 8-K
We filed a Form 8-K dated February 5, 2004, which included as an exhibit
a press release dated February 5, 2004 announcing our financial results
for the quarter and year ended December 31, 2003.
- --------------------
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AWARE, INC.
Date: May 10, 2004 By: /s/ Michael A. Tzannes
----------------------
Michael A. Tzannes,
Chief Executive Officer
Date: May 10, 2004 By: /s/ Robert J. Weiskopf
----------------------
Robert J. Weiskopf,
Chief Financial Officer
(Principal Financial and
Accounting Officer)
24