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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2003

OR

For the transition period from              to             

Commission file number: 001-15069

Duraswitch Industries, Inc.

(Exact name of registrant as specified in its charter)

234 S. Extension Road

Mesa, Arizona 85210

(Address of principal executive offices)

(480) 586-3300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨  No  x

As of August 4, 2003, there were 9,568,977 shares of common stock outstanding.

PART I FINANCIAL INFORMATION

Item 1. Financial Statements.

DURASWITCH INDUSTRIES, INC.

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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DURASWITCH INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See notes to consolidated financial statements.

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DURASWITCH INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See notes to consolidated financial statements.

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DURASWITCH INDUSTRIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. BASIS OF PRESENTATION

The accompanying interim financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission for interim reporting. Accounting policies utilized in the preparation of financial information herein presented are the same as set forth in our annual financial statements. Certain disclosures and information normally included in financial statements have been condensed or omitted. In the opinion of the management of Duraswitch Industries, Inc. (the “Company”), these financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the interim financial statements. Interim results of operations are not necessarily indicative of the results of operations for the full year.

2. DEFERRED LICENSING REVENUE

In April 2000, the Company entered into a license agreement with Delphi Corporation (“Delphi”), that gives Delphi the exclusive right to utilize and manufacture the Company’s patented switch technologies for the automotive industry. In connection with the license agreement, the Company also issued a warrant to Delphi to purchase 225,000 shares of common stock at $7.00 per share and a short-term option to purchase 1,651,846 shares of common stock at $7.00 per share. In exchange, Delphi paid the Company a non-refundable payment of $4 million and agreed to pay a royalty fee for each switch sold by Delphi. The term of the exclusive license agreement is seven years. The agreement also requires Delphi to make minimum royalty payments, beginning July 1, 2004, totaling $12 million during the initial seven-year term ending June 30, 2007. Delphi can maintain exclusivity for the automotive industry through June 30, 2012 by making additional minimum annual royalty payments during that period. After June 30, 2012, either party may convert the agreement to a non-exclusive agreement through 2020.

The estimated fair value of the warrant and the option was $1,134,338, as determined using the Black-Scholes valuation model. The remaining value of the non-refundable payment, totaling $2,865,662, was recorded as deferred revenue and is being amortized over the initial seven-year term of the exclusive license agreement.

The current portion of deferred licensing revenue includes the revenue to be recognized in the next twelve months related to the Delphi non-refundable payment and royalty prepayments by other licensees that have been deferred until such royalties are earned under the licensing agreements.

3. INVENTORY

The Company’s inventory is primarily comprised of licensed components. The licensed components are sold to licensees and are recognized as licensing revenue and the cost of the components is recorded as licensing cost of goods sold when the components are shipped to the licensee.

4. ASSETS HELD FOR SALE

During the second quarter of 2003, the Company began outsourcing the manufacture of research and development pieces and marketing samples and further reduced its research and development activities. As a result, equipment which had previously been utilized in these activities was offered for sale to our licensees and on our website. The net carrying value of the equipment was $72,988 and an impairment loss of $10,618 has been included in selling, general and administrative expenses.

5. PATENTS

Amortization expense for patents was $10,957 and $9,629 for the three months ended June 30, 2003 and 2002, respectively. Amortization expense for patents was $21,499 and $18,343 for the six months ended June 30, 2003 and 2002, respectively. The estimated amortization expense for existing patents is $44,240 for each of the next five years.

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The gross carrying amount and accumulated amortization of patents are as follows:

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “believe,” “expect,” “anticipate,” “intend,” “estimate” and other expressions that are predictions of or indicate future events and trends and which do not relate to historical matters identify forward-looking statements. These forward-looking statements are based largely on our expectations or forecasts of future events, can be affected by inaccurate assumptions and are subject to various business risks and known and unknown uncertainties, a number of which are beyond our control. Therefore, actual results could differ materially from the forward-looking statements contained in this document, and readers are cautioned not to place undue reliance on such forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. There can be no assurance that the forward-looking statements contained in this document will, in fact, transpire or prove to be accurate. For a more detailed description of these and other cautionary factors that may affect our future results, please refer to our Annual Report on Form 10-K for our fiscal year ended December 31, 2002 filed with the Securities and Exchange Commission.

Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported or expected financial results.

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Revenue Recognition. We enter into licensing agreements with our customers. Our licensing strategy incorporates a simplified requirement whereby the licensee purchases licensed components from us. The purchase price of the licensed components includes the royalty fee. When the components are shipped, we recognize licensing revenue and licensing cost of goods sold. In some cases, where no licensed components are supplied, we are paid a royalty per switch manufactured by the licensee.

Some of our licensees have prepaid royalties to us pursuant to their license agreements. These prepayments are recorded as deferred revenue. This deferred revenue is recognized as licensing revenue when earned under the licensing agreement. If a licensee purchases a licensed component from us, the royalty is earned when the licensed component is shipped. If the licensee is directly manufacturing our switches without purchasing licensed components from us, we consider the royalty earned when the switch is manufactured. In the case of our exclusive license agreement with Delphi, the up-front payment is nonrefundable and the portion of the $4.0 million payment allocated to deferred revenue is being amortized over the initial seven-year term of the agreement. (See Note 2 of our Notes to Unaudited Consolidated Financial Statements.)

Inventory Valuation. Our inventory is primarily comprised of licensed components that are sold to licensees. We state inventories at the lower of cost or market value, determined using the first-in, first-out method. Our policy is to write

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down our inventory for estimated obsolescence or unmarketable inventory to the extent the cost exceeds the estimated market value. We base the estimate on our assumptions about future demand and market conditions. If actual market conditions are less favorable than those assumed in our estimates, additional inventory write-downs might be required. We reflect any write-down of inventory in the period in which the facts giving rise to the inventory write-down become known to us.

Impairment or Disposal of Long-Lived Assets. We review our long-lived assets and identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Additionally, goodwill is reviewed on an annual basis. Our intangible assets are primarily our patents and the goodwill associated with the acquisition of Aztec Industries. If such assets were considered to be impaired, the impairment to be recognized would be measured by the amount by which the carrying amount of the assets exceeds the fair market value of the assets. During the second quarter of 2003, we began outsourcing the manufacture of research and development pieces and marketing samples and further reduced our research and development activities. As a result, we began selling substantially all of the equipment that had previously been used for manufacturing and modeling and some of our testing equipment. We recorded an impairment loss of $10,618 in selling, general and administrative expense for the three months ended June 30, 2003 to reduce the carrying value of these long-lived assets held for sale to their fair market value.

We evaluate the recoverability of property and equipment and intangibles (excluding goodwill) not held for sale by comparing the carrying amount of the asset or group of assets against the estimated undiscounted future net cash flows expected to result from the use of the asset or group of assets. If the undiscounted estimated cash flows are less than the carrying value of the asset or group of assets being reviewed, an impairment loss would be recorded. The loss would be measured based on the estimated fair value of the asset or group of assets compared to its carrying value. The estimated fair value would be based on the best information available under the circumstances, including prices for similar assets and the results of valuation techniques, including the present value of expected future cash flows using a discount rate commensurate with the risks involved.

We evaluate goodwill for impairment by comparing the estimated fair value of our company, which is the only reporting unit, with the carrying value, including goodwill. The estimated fair value is based on the best information available under the circumstances, including quoted market prices in stock markets, valuation techniques based on earnings, or independent valuations. If the fair value of our company exceeds the carrying amount, goodwill is not considered to be impaired. If the carrying amount of our company exceeds our fair value, the fair value of the goodwill is calculated, and the excess of the carrying value of the goodwill over its fair value is recorded as an impairment loss. To determine the fair value of goodwill, our fair value is allocated to all of our assets and liabilities, and any excess of fair value of our company over the fair value of our assets and liabilities is the estimated fair value of goodwill.

Stock-Based Compensation. At June 30, 2003, we had three stock-based employee compensation plans. SFAS No. 123, Accounting for Stock-Based Compensation encourages, but does not require, companies to record as compensation expense, over the vesting period, the fair value of all stock-based awards on the date of grant. We have chosen to account for these plans using the intrinsic value method of accounting prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. 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 market value of the underlying common stock on the date of grant. The fair value of all stock option grants is estimated on the date of grant in accordance with SFAS No. 123 using the Black-Scholes option pricing model with the following assumptions: an expected risk-free interest rate of 1.9 percent and 2.9 percent in 2003 and 2002, respectively, an expected life of three years, an expected volatility rate of 82 percent and 69 percent for options granted in 2003 and 2002, respectively, and an expected dividend rate of zero percent. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:

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Results of Operations

Net Revenue:

We recorded net revenue of $161,245 for the three months ended June 30, 2003, compared to $237,412 for the three months ended June 30, 2002, a decrease of $76,167 or 32%. Net revenue was $320,272 and $447,019 for the six months ended June 30, 2003 and 2002, respectively, a decrease of $126,747 or 28%.

Licensing revenue was $161,245 and $237,412 for the three months ended June 30, 2003 and 2002, respectively, a decrease of $76,167 or 32%. Licensing revenue was $320,272 and $422,344 for the six months ended June 30, 2003 and 2002, respectively, a decrease of $102,072 or 24%. To date, the majority of non-exclusive licensing revenue has been related to our PushGate pushbutton technology. The decrease in licensing revenue for the three and six-month periods was primarily a result of a decrease in the number of royalty bearing PushGate units sold. This decrease was due primarily to a large sale to one licensee in 2002 that was not replicated in 2003.

For each of the three months ended June 30, 2003 and 2002, recognition of revenue from the Delphi license agreement generated $102,345 of licensing revenue, representing 63% and 43% of licensing and total net revenue in 2003 and 2002, respectively. For each of the six months ended June 30, 2003 and 2002, the Delphi license agreement generated $204,690 of licensing revenue representing 64% and 48% of licensing revenue in 2003 and 2002, respectively, and 64% and 46% of total net revenue in 2003 and 2002, respectively.

We anticipate that licensing revenue will fluctuate from period to period. It will be difficult for us to predict the timing and magnitude of such revenue, as it is dependent on production orders being issued to our licensees for products utilizing our technologies. The timing of the purchase orders is dependent on economic conditions as well as market acceptance of products that incorporate our technologies. We believe that the amount of licensing revenue for any period is not necessarily indicative of results for any future period.

Product revenue was $0 for the three and six months ended June 30, 2003 compared to $0 for the three months ended June 30, 2002 and $24,675 for the six months ended June 30, 2002. As we have completed our transition from switch manufacturing to licensing our technologies, we do not expect to have any significant product revenue in the future. The 2002 product revenue was related to the collection of disputed fees for engineering services we had provided to a product customer in prior periods.

Cost of Goods Sold:

Total cost of goods sold was $13,523 for the three months ended June 30, 2003, compared to $41,222 for the three months ended June 30, 2002, a decrease of $27,699 or 67%. Total cost of goods sold was $30,576 for the six months ended June 30, 2003, compared to $57,246 for the six months ended June 30, 2002, a decrease of $26,670 or 47%. The decrease in cost of goods sold for the three and six months ended June 30, 2003 was primarily due to the decrease in unit sales of royalty bearing PushGate components. There was no product cost of goods sold.

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Selling, General and Administrative Expenses:

Selling, general and administrative expenses were $646,511 for the three months ended June 30, 2003, compared to $745,745 for the three months ended June 30, 2002, a decrease of $99,234 or 13%. Selling, general and administrative expenses were $1,221,099 for the six months ended June 30, 2003, compared to $1,564,558 for the six months ended June 30, 2002, a decrease of $343,459 or 22%. The decreases in selling, general and administrative expenses for the three and six month periods were primarily related to reductions in personnel which were announced in October 2002. During the second quarter of 2003 we made further personnel reductions. Selling, general and administrative expenses for the three and six months ended June 30, 2003 includes approximately $60,000 of expenses related to our decision to further reduce costs by outsourcing the manufacture of research and development pieces and marketing samples and reducing research and development activities and includes: a) additional reserve for inventory obsolescence, b) severance related expenses, and c) impairment loss on assets held for sale.

Research and Development:

Research and development expenses were $294,449 for the three months ended June 30, 2003, compared to $690,032 for the three months ended June 30, 2002, a decrease of $395,583 or 57%. Research and development expenses were $604,889 for the six months ended June 30, 2003, compared to $1,407,429 for the six months ended June 30, 2002, a decrease of $802,540 or 57%. These decreases were primarily related to cost-cutting initiatives that included significant reductions in research and development personnel which were announced in October 2002 and which were completed by December 31, 2002. During the second quarter of 2003 we made further reductions in research and development personnel. The efforts of our remaining research and development personnel will be directed at supporting our licensees in their efforts to commercialize our developed technologies as opposed to also focusing on the creation of new technologies.

Effective July 1, 2003, we entered into a new employment agreement with our co-founder, Anthony J. Van Zeeland. Consistent with our focus on supporting our licensees in commercializing developed technologies as opposed to focusing on the creation of new technologies, the new agreement reduces his salary and time commitment to Duraswitch by 50%.

Loss from Operations:

As a result of the factors described above, loss from operations was $793,238 for the three months ended June 30, 2003 compared to $1,239,587 for the three months ended June 30, 2002, a decrease of $446,349 or 36%. As a result of the factors described above, loss from operations was $1,536,292 for the six months ended June 30, 2003 compared to $2,582,214 for the six months ended June 30, 2002, a decrease of $1,045,922 or 41%.

Other Income (Expense)—Net:

Other income (expense)—net was expense of $27,804 for the three months ended June 30, 2003, compared to income of $43,241 for the three months ended June 30, 2002, a decrease of $71,045. Other income (expense)—net was expense of $9,577 for the six months ended June 30, 2003, compared to income of $93,055 for the six months ended June 30, 2002, a decrease of $102,632. The change in other income (expense)—net is due to the loss recorded for the disposal of fixed assets and to decreased investment income as a result of lower interest rates and lower average cash balances.

Net Loss:

The $375,304 or 31% decrease in the net loss to $821,042 for the three months ended June 30, 2003 from $1,196,346 for the three months ended June 30, 2002 and the $943,290 or 38% decrease in net loss to $1,545,869 for the six months ended June 30, 2003 from $2,849,159 for the six months ended June 30, 2002 were primarily a result of reductions in personnel.

Liquidity and Capital Resources

Cash and cash equivalents on June 30, 2003 were $5,287,792 compared to $7,036,959 on December 31, 2002. The decrease in cash and cash equivalents was primarily attributable to cash used in operations.

Net cash used in operating activities was $1,715,069 for the six months ended June 30, 2003. The net use of cash was primarily attributable to the net loss.

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Net cash used in investing activities was $25,404 for the six months ended June 30, 2003. The net cash used in investing activities related primarily to investment in patents and purchases of equipment, offset by proceeds from the sale of equipment.

Net cash used in financing activities was $8,694 for the six months ended June 30, 2003 related to principal payments on capital leases.

At December 31, 2002, we had approximately $19.9 million in net operating loss carry forwards available for federal and state income tax purposes. We have not recognized any benefit from these operating loss carry forwards which expire in 2011 through 2021.

Our license agreement with Delphi requires Delphi to pay us minimum royalty payments, beginning July 1, 2004, totaling $12 million during the initial seven-year term ending June 30, 2007. Delphi can maintain exclusivity for the automotive industry through June 30, 2012 by making additional minimum annual royalty payments during that period. After June 30, 2012, either party may convert the agreement to a nonexclusive agreement through 2020.

We have experienced significant operating losses since our inception. In October 2002, we announced cost-cutting initiatives that included significant reductions in personnel. The announced personnel reductions were completed by the end of the fourth quarter of 2002. During 2003 we continued our cost cutting initiatives through additional personnel reductions. Additionally, we have entered into a new employment agreement with our co-founder, Anthony J. Van Zeeland which reduces his salary and his time commitment to Duraswitch by 50%.

During 2002 and 2003 we reduced our personnel to 15 employees from 72 at December 31, 2001. Our existing lease commitment expires on December 31, 2003 and we anticipate that we will be able to reduce our occupancy costs at that time. We anticipate that our cash and working capital requirements will decrease in 2003 from 2002 historical levels. However, our capital expenditures and working capital requirements could increase depending on our operating results and other adjustments to our operating plan as may be needed to respond to competition or unexpected events.

We believe that our cash on hand will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least 12 months. We continually evaluate our working capital needs and we may seek to obtain additional working capital through debt or equity offerings. There can be no assurance that additional funds will be available on acceptable terms. In the event that additional funds are not available on acceptable terms, we could be required to reduce the scope of or cease operations.

The following table sets forth our contractual obligations and commitments as of June 30, 2003:

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. We do not use derivative financial instruments to manage these risks and do not hold or issue financial instruments for trading purposes.

We are currently exposed to credit risk on credit extended to our licensees. Based on the credit worthiness of our licensee base and the relative size of these financial instruments, we believe the risk associated with these instruments will not have a material adverse affect on our business, financial position, results of operations or cash flows.

Additionally, we are exposed to some market risk through interest rates related to our investments of cash and cash equivalents of approximately $5.3 million. The risk is not considered material and we manage such risk by evaluating the best investment rates available for short-term high-quality investments.

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Presently, all of our receivables and substantially all of our payments are denominated in U.S. dollars and, consequently, we believe we have minimal foreign currency exchange rate risk. However, in the future, we may enter into agreements in foreign currencies that may subject us to foreign exchange rate risk. There can be no assurance that our future efforts to reduce foreign exchange risk will be successful.

Item 4. Controls and Procedures.

We have evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of June 30, 2003. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed by us in our quarterly reports filed under the Securities Exchange Act within the time periods specified by the Securities and Exchange Commission’s rules and forms. During the quarterly period covered by this report, there have not been any changes in our internal controls over financial reporting 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 2. Changes in Securities and Use of Proceeds.

During January 2003, we issued to UTEK Corporation, a consultant to our company, 83,478 shares of common stock at a deemed value per share of $1.15 in exchange for services to be rendered over a 12-month period pursuant to a consulting agreement. We issued these shares without registration under the Securities Act in reliance on the exemption provided by Section 4(2) of the Securities Act as a transaction by an issuer not involving a public offering. During June 2003, we terminated the consulting agreement with UTEK and cancelled the 48,696 unvested shares which had been issued pursuant to the agreement.

Item 4. Submission of Matters to a Vote of Security Holders.

We held our annual meeting of stockholders at our headquarters on May 19, 2003.

William E. Peelle and John W. Hail were each elected to a three-year term expiring in 2006 or until their successors have been elected and qualified.

Our stockholders ratified the appointment of Deloitte & Touche LLP as our independent auditors for the year ending December 31, 2003 with 8,439,421 shares in favor, 9,361 against and 1,600 abstentions and broker non-votes.

Item 6. Exhibits and Reports on Form 8-K.

On May 5, 2003, we filed Form 8-K announcing our first quarter 2003 financial results.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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Exhibit Index