Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended January 2, 2005

OR

For the transition period from                      to                     

Commission file number 1-8402

IRVINE SENSORS CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

3001 Red Hill Avenue,

Costa Mesa, California 92626

(Address of Principal Executive Offices) (Zip Code)

(714) 549-8211

(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, as amended, (the “Exchange Act”) 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 Exchange Act Rule

12b-2.)    Yes  ¨    No  x

As of January 28, 2005, there were 18,505,841 shares of common stock outstanding.

Table of Contents

IRVINE SENSORS CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE FISCAL PERIOD ENDED JANUARY 2, 2005

TABLE OF CONTENTS

2

Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

IRVINE SENSORS CORPORATION

CONSOLIDATED BALANCE SHEETS

See Accompanying Condensed Notes to Consolidated Financial Statements.

3

Table of Contents

IRVINE SENSORS CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See Accompanying Condensed Notes to Consolidated Financial Statements.

4

Table of Contents

IRVINE SENSORS CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See Accompanying Condensed Notes to Consolidated Financial Statements.

5

Table of Contents

IRVINE SENSORS CORPORATION

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1 - General

The information contained in the following Condensed Notes to Consolidated Financial Statements is condensed from that which would appear in the annual consolidated financial statements for Irvine Sensors Corporation and its subsidiaries (the “Company”). The accompanying unaudited condensed consolidated financial statements do not include certain footnotes and other financial presentations normally required under accounting principles generally accepted in the United States of America. Accordingly, the consolidated financial statements included herein should be reviewed in conjunction with the consolidated financial statements and related notes thereto contained in the Annual Report on Form 10-K of the Company for the fiscal year ended October 3, 2004 (“fiscal 2004”). It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results of operations for the interim periods presented are not necessarily indicative of the results expected for the entire year.

The consolidated financial information as of January 2, 2005 and December 28, 2003 included herein is unaudited but includes all normal recurring adjustments which, in the opinion of management of the Company, are necessary to present fairly the consolidated financial position of the Company at January 2, 2005, the results of its operations for the 13-week periods ended January 2, 2005 and December 28, 2003, and its cash flows for the 13-week periods ended January 2, 2005 and December 28, 2003.

Summary of Significant Accounting Policies

Company Operations. The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. The Company generated net losses of $4,166,900 and $1,176,100 in fiscal 2004 and the 13-week period ended January 2, 2005, respectively. However, the Company had working capital of $2,333,000 at January 2, 2005, which is an amount that management believes will be adequate to meet the liquidity requirements of the Company’s operating plan for at least the next twelve months. In the event of plan variances that impose unforeseen liquidity needs, management believes, but cannot guarantee, that the Company will be able to raise additional working capital to fund the Company’s operations. This belief is based on the Company’s historical access to equity financing. The Company has been advised of new government contract awards for the fiscal year ending October 2, 2005 (“fiscal 2005”) that management expects will contribute to cash flow in subsequent periods of fiscal 2005. At January 2, 2005, the Company had total stockholders’ equity of $7,531,600.

Consolidation. The consolidated financial statements include the accounts of Irvine Sensors Corporation (“ISC”) and its subsidiaries, Novalog, Inc., MicroSensors, Inc. (“MSI”), RedHawk Vision, Inc., iNetWorks Corporation, 3D Microelectronics, Inc. and 3D Microsystems, Inc. 3D Microelectronics and 3D Microsystems are inactive wholly-owned corporations and do not have material assets, liabilities or operations. All significant intercompany transactions and accounts have been eliminated in the consolidation.

Fiscal Periods. The Company’s fiscal year ends on the Sunday nearest September 30. Fiscal 2004 ended on October 3, 2004 and included 53 weeks, a fiscal year duration that is generally repeated once every six years. Fiscal 2005 will end on October 2, 2005 and will include 52 weeks. The Company’s

6

Table of Contents

first fiscal quarter and first 13 weeks of fiscal 2005 ended on January 2, 2005. The Company’s first fiscal quarter and first 13 weeks of fiscal 2004 ended on December 28, 2003.

Use of Estimates. The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The Company believes its estimates of inventory reserves and estimated costs to complete contracts, as further discussed below, to be the most sensitive estimates impacting financial position and results of operations in the near term.

Inventory reserves. Each quarter, the Company evaluates its inventories for excess quantities and obsolescence. Inventories that are considered obsolete are written off. Remaining inventory balances are adjusted to the lower of cost or market value. The valuation of inventories at the lower of cost or market requires the use of estimates as to the amounts of current inventories that will be sold. These estimates are dependent on management’s assessment of current and expected orders from the Company’s customers.

From time-to-time, the Company capitalizes material, labor and overhead costs expected to be recovered from a probable new contract. Due to the uncertainty associated with new or follow-on research and development contracts, the Company maintains significant reserves for this inventory to avoid overstating its value. The Company has adopted this practice because it is typically able to more fully recover such costs under the provisions of government contracts by direct billing of inventory rather than by seeking recovery of such costs through permitted indirect rates.

Estimated Costs to Complete and Accrued Loss on Contracts. The Company reviews and reports on the performance of its contracts against the respective plans. These reviews are summarized in the form of estimates of costs to complete the contracts (“ETCs”). ETCs include management’s current estimates of remaining amounts for direct labor, material, subcontract support and allowable indirect costs based on each contract’s completion status and either the current or re-planned future technical requirements under the contract. If an ETC indicates a potential overrun against budgeted program resources, it is management’s responsibility to revise the program plan in a manner consistent with customer objectives to eliminate such overrun and to secure necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, the Company attempts to negotiate the deliverable requirements of its R&D contracts to allow as much flexibility as possible in technical outcomes. When re-planning does not appear possible within program budgets, an accrual for contract overrun is recorded based on the most recent ETC of the particular program. In fiscal 2004, the Company changed its operational processes to assign an increased level of accountability for contract financial performance to the contract’s program manager.

During the 13 weeks ended January 2, 2005, the Company increased its accrued losses on contracts in progress by $35,600. This increase reflects a change in the Company’s aggregate estimate (excluding contingencies), which management believes reflects ETCs for contracts in progress based on their completion status at January 2, 2005 and current and future technical requirements under the program contracts.

Revenues. The Company’s consolidated revenues during the first 13 weeks of fiscal 2005 were primarily derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. The Company’s research and development contracts are usually cost plus fixed fee, which require the Company’s good faith performance of a statement of work within overall budgetary constraints, but with latitude as to resources

7

Table of Contents

utilized, or fixed price level of effort, which require the Company to deliver a specified number of labor hours in the performance of a statement of work. Revenues for such contracts are recognized as costs are incurred and include applicable fees or profits primarily in the proportion that costs incurred bear to estimated final costs. Costs and estimated earnings in excess of billings under government contracts are accounted for as unbilled revenues on uncompleted contracts. The Company provides for anticipated losses on contracts by a charge to income during the period in which a loss is first identified. The accrual for contract losses is adjusted quarterly based on a review of outstanding contracts. Unbilled revenues on uncompleted contracts are stated at estimated realizable value.

United States government contract costs, including indirect costs, are subject to audit and adjustment by negotiations between the Company and government representatives. Indirect contract costs have been agreed upon through fiscal 2001. Contract revenues have been recorded in amounts that are expected to be realized upon final determination of allowable direct and indirect costs for the affected contracts.

The Company’s revenues derived from product sales in the 13 weeks ended January 2, 2005 were primarily the result of shipments of memory stack products, but also included shipments of Novalog’s wireless infrared chips and modules and, for the first time, initial shipments of infrared viewers. Product orders for the Company’s products are generally priced in accordance with the Company’s established price list. Memory stack products and wireless infrared products are primarily shipped to Original Equipment Manufacturers (“OEMs”). Infrared viewers are system level products that are primarily intended to be shipped to end user customers, initially for military applications. Revenues are recorded when products are shipped. Terms are FOB shipping point. Wireless infrared products are generally shipped with a 90-day warranty, but the Company has experienced minimal returns of these products to date. RedHawk is the licensor of a shrink-wrapped software product that has also experienced minimal returns. Other products have been shipped for developmental and qualification use or have not been sold under formal warranty terms. The Company does not offer contractual price protection on any of its products. Accordingly, the Company does not presently maintain any reserves for returns under warranty or post-shipment price adjustments.

Research and Development Costs. A major portion of the Company’s operations is comprised of customer-funded research and prototype development or related activities that are recorded as cost of contract revenues. The Company also incurs costs for research and development of new concepts in proprietary products. Such unfunded research and development costs are charged to research and development expense as incurred.

Inventory. Product inventory is valued at the lower of cost or market. Cost is determined by the first-in, first-out method. Inventories are reviewed quarterly to determine salability and obsolescence. A reserve is established for slow moving and obsolete product inventory items. In addition, marketing of specific government budgets and programs is facilitated by the capitalization of material, labor and overhead costs that are recoverable under government research and development contracts. Due to the uncertainties associated with such contract awards, the Company maintains significant reserves for this inventory to avoid overstating its value. (See Note 5).

Equipment, Furniture and Fixtures. The Company capitalizes costs of additions to equipment, furniture and fixtures, together with major renewals and betterments. Some projects require several years to complete and are classified as construction in progress, including expansion of the Company’s clean room facilities and related equipment. In addition, the Company capitalizes overhead costs for all in-house capital projects. Maintenance, repairs, and minor renewals and betterments are charged to expense. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized. Depreciation of equipment, furniture and fixtures is provided over the estimated useful lives of the assets, primarily using the straight-line method.

8

Table of Contents

The useful lives are three to five years. Leasehold improvements are amortized over the terms of the leases.

Accounting for Stock-Based Compensation. Under the recently released Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) Share Based Payment (“SFAS 123(R)”), commencing with its quarterly reporting period beginning July 4, 2005 (the “implementation date”), the Company will be required to expense against the Company’s reported earnings: (1) the fair value of all option grants or stock issuances made to employees or directors on or after the implementation date, and (2) a portion of the fair value of each option grant and stock issuance made to employees or directors prior to the implementation date that is representative of the unvested portion of these share-based awards as of such date. These amounts are to be expensed after the implementation date over the respective vesting periods of each award. Additionally, if it chooses to do so, SFAS 123(R) permits the Company to adopt the new share-based award accounting by retrospectively restating results for either the earlier interim periods of fiscal 2005 or for all periods presented to facilitate period-to-period comparison. The Company has not yet made a determination as to whether it will adopt SFAS 123(R) retrospectively.

Until the adoption of SFAS 123(R), the Company will continue to account for stock-based employee compensation as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and, SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (“SFAS 148”). SFAS 148 requires pro forma disclosures of net income and net income per share as if the fair value based method of accounting for stock-based awards had been applied for employee grants. It also requires disclosure of option status on a more prominent and frequent basis. The Company accounts for stock options and warrants issued to non-employees based on the fair value method, but has not elected this treatment for grants to employees. Under the fair value based method, compensation cost is recorded based on the value of the award at the grant date and is recognized over the service period.

The exercise prices of the options granted during the 13-week period ended January 2, 2005 were equal to the closing price of the Company’s common stock as reported by the Nasdaq SmallCap Market at the date of grant.

Pursuant to SFAS 148, the Company is required to disclose the effects on the net loss and per share data as if the Company had elected to use the fair value approach to account for all of its employee stock-based compensation plans. Had the compensation cost for all of the Company’s option plans, including those of its subsidiaries, been determined using the fair value method, the compensation expense would have increased the Company’s net loss for the 13 weeks ended January 2, 2005 and December 28, 2003 as shown below. (See also Note 4 for calculation of net loss applicable to common stockholders.)

9

Table of Contents

The fair value of each option granted during the first 13 weeks of the respective fiscal year on its grant date was estimated using the Black-Scholes option-pricing model. In the 13-week period ended January 2, 2005, the Company applied assumptions of no dividend yield, risk-free interest rates ranging from 3.09% to 3.22%, which approximated the Federal Reserve Board’s rate for treasuries at the time granted, expected lives of one to two years, and volatility rates of 70.5% and 77.1%. In the 13-week period ended December 28, 2003, the Company applied assumptions of no dividend yield, risk-free interest rate of 2.38% which approximated the Federal Reserve Board’s rate for treasuries at the time granted, an expected life of one year, and a volatility rate of 69.8%. There were no option grants by subsidiaries during the 13-week periods ended January 2, 2005 and December 28, 2003. During the 13-week period ended January 2, 2005, the Company granted options to purchase 84,000 shares of the Company’s common stock, with exercise prices of $2.51 and $2.19 per share, at a weighted average fair value of $0.91 per share.

Software Development and Purchased Software. Software development and purchased software costs are capitalized when technological feasibility and marketability of the related product have been established. The Company amortizes capitalized software costs beginning when the product is available for general release to customers. Annual amortization expense is calculated using the straight-line method over the estimated useful life of the product, not to exceed five years. The Company evaluates the carrying value of unamortized capitalized software costs at each balance sheet date to determine whether any net realizable value adjustments are required.

Long-Lived Assets. The Company continually monitors events or changes in circumstances that could indicate that the carrying amount of long-lived assets to be held and used, including goodwill and intangible assets, may not be recoverable. The determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. When impairment is indicated for a long-lived asset, the amount of impairment loss is the excess of net book value over fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. At January 2, 2005, management believes no indications of impairment existed.

Intangible and Other Assets. Other assets consist principally of patents and trademarks related to the Company’s various technologies. Capitalized costs include amounts paid to third parties for legal fees, application fees and other direct costs incurred in the filing and prosecution of patent and trademark applications. These assets are amortized on a straight-line method over their estimated useful life of ten years.

Income Taxes. Deferred tax assets and liabilities are recorded for differences between the financial statement and tax basis of the assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is recorded for the amount of income tax payable or refundable for the period increased or decreased by the change in deferred tax assets and liabilities during the period.

Basic and Diluted Net Loss per Share. Basic net loss per share is based upon the weighted average number of common shares outstanding. Diluted net loss per share is based on the assumption that options, warrants and convertible preferred stock are included in the calculation of diluted earnings per share, except when their effect would be anti-dilutive. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period (See Note 4).

10

Table of Contents

Statements of Cash Flows. For purposes of the Consolidated Statements of Cash Flows, the Company considers all demand deposits and certificates of deposit with original maturities of 90 days or less to be cash equivalents.

Fair Value of Financial Instruments. The carrying amounts reported in the balance sheets for cash and cash equivalents, accounts receivable and payable and other current liabilities approximate fair value due to the short-term nature of these items.

Concentration of Credit Risk. The Company has cash deposits at U.S. banks and financial institutions, which exceed federally insured limits at January 2, 2005. The Company is exposed to credit loss for amounts in excess of insured limits in the event of non-performance by the institution; however, the Company does not anticipate non-performance.

Reclassifications. Certain reclassifications have been made to the 2004 fiscal year interim financial statements to conform to the current year presentation.

Recently Issued Accounting Pronouncements. In November 2004, the FASB issued SFAS No. 151, Inventory Costs (“SFAS 151”), which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not believe the adoption of SFAS 151 will have a material impact on its financial statements.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets (“SFAS 153”), which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not believe the adoption of SFAS 153 will have a material impact on its financial statements.

In December 2004, the FASB issued SFAS 123(R), which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and to record such amount as an expense over the related employee service period; it eliminates the alternative of accounting for such awards using the intrinsic method previously allowable under APB Opinion No. 25. SFAS 123(R) will be effective for interim or annual reporting periods beginning on or after June 15, 2005. The Company is currently evaluating the financial statement impact of the adoption of SFAS 123(R) and has not determined whether to apply SFAS 123(R) retroactively.

Note 2 – Common Stock and Common Stock Warrants

During the 13-week period ended January 2, 2005, the Company issued an aggregate of 564,900 shares of common stock in various transactions. Of this amount, 87,700 common shares were issued for cash, realizing aggregate gross proceeds of $88,700, and 477,200 shares were issued to settle operating expenses of the Company in the amount of $1,049,900. These transactions are separately discussed below.

11

Table of Contents

Cash Transactions

Of the 87,700 shares issued for cash during the 13-week period ended January 2, 2005, 84,800 shares of common stock were issued for gross proceeds of $84,800 pursuant to the exercise of a warrant. The remaining 2,900 shares of common stock issued for cash were issued as a result of the exercise of stock options during the same 13-week period, realizing gross proceeds of $3,900.

Non-Cash Transactions to Settle Operating Expenses

The 477,200 shares of common stock issued during the 13-week period ended January 2, 2005 to settle operating expenses of the Company were issued in November and December 2004 in the following transactions: (1) 363,600 shares were issued to effectuate a $800,000 non-cash contribution to the Company’s employee retirement plan, the Cash or Deferred & Stock Bonus Plan (“ESBP”), for fiscal 2005; (2) 12,200 shares were issued to effectuate a previously accrued $26,900 contribution to the ESBP for fiscal 2004; (3) 100,000 shares were issued to make a $220,000 non-cash contribution to the Company’s Non-Qualified Deferred Compensation Plan for fiscal 2005; and (4) 1,400 shares were issued to grant $3,000 in length-of-service awards to non-officer employees. Of the fiscal 2005 contributions to the Company’s ESBP and Non-Qualified Deferred Compensation Plan, $253,100 has been expensed through January 2, 2005 and the $766,900 balance is expected to be expensed during the balance of fiscal 2005. The value of these non-cash issuances of common stock was based on the closing sales price of the Company’s common stock on the date that the various transactions were authorized.

Note 3 – Stock Option Plans, Employee Retirement Plan and Deferred Compensation Plan

At the Company’s Annual Stockholders Meeting in March 2004, the Company’s stockholders approved an amendment to the Company’s 2003 Stock Incentive Plan (the “2003 Plan”) increasing the number of shares of common stock issuable pursuant to options or restricted stock grants under the 2003 Plan from an aggregate of 1,500,000 shares to an aggregate of 2,400,000 shares. Under the 2003 Plan, options and restricted stock may be granted to the Company’s employees, directors and bona fide consultants.

In December 2004, the Board of Directors authorized a contribution to the Company’s ESBP, in the amount of $800,000, which represented a contribution for fiscal 2005. This contribution represented approximately 9.8% of the Company’s expected gross salary and wages for fiscal 2005. Historically, the Company has made contributions of 10% or more of gross salary and wages in each fiscal year. It is contemplated that the Board of Directors will make an additional contribution to the ESBP later in fiscal 2005 to achieve at least this historical level once expected gross salary and wages for fiscal 2005 are known more precisely. As has been the Company’s practice, the $800,000 contribution for fiscal 2005 was made in shares of the Company’s common stock valued at the closing sales price of the Company’s common stock on the date that the contribution was authorized by the Board of Directors. Of the fiscal 2005 contribution, $198,100 was amortized in the 13-week period ended January 2, 2005. The $601,900 portion of the fiscal 2005 contribution that had not been amortized at January 2, 2005 has been recorded as a prepaid ESBP contribution in equity and will be amortized over the remaining quarters of fiscal 2005. Pursuant to the ESBP provision, vesting requirements are met as services are performed and fulfilled at each fiscal year end.

The Company maintains a deferred compensation plan, the Non-Qualified Deferred Compensation Plan, for key employees with long-term service. Annual contributions of common stock of the Company are made to a Rabbi Trust to be held for the benefit of the deferred compensation plan participants. In December 2004, the Board of Directors authorized the fiscal 2005 contribution to the deferred compensation plan in the amount of 100,000 shares of common stock valued at $220,000. Of this

12

Table of Contents

contribution, $55,000 was amortized in the 13-week period ended January 2, 2005. The $165,000 portion of the fiscal 2005 contribution that had not been amortized at January 2, 2005 has been recorded as a prepaid contribution in equity and will be amortized over the remaining quarters of fiscal 2005. Participants’ potential distributions from the Rabbi Trust represent unsecured claims against the Company. The Rabbi Trust was established by the Company and is subject to creditor claims. Shares in the plan may be distributed to each plan beneficiary when they retire from service at an age permitted under the Company’s ESBP.

Note 4 – Loss per Share

As the Company had a net loss for the 13-week periods ended January 2, 2005 and December 28, 2003, basic and diluted net loss per common share are the same.

The Company has excluded from the computation of diluted loss per common share the maximum number of shares issuable pursuant to outstanding, in-the-money stock options and warrants in the amounts of 4,455,100 shares and 4,569,500 shares of common stock as of January 2, 2005 and December 28, 2003, respectively, because the Company had a loss from continuing operations for both periods presented and to include the representative share increments would be anti-dilutive.

Note 5 – Inventories, Net

Inventories, net consisted of the following:

Title to all inventories remains with the Company. Inventoried materials and costs relate to work in process on customers’ orders and on the Company’s generic module parts and memory stacks, which the Company anticipates it will sell to customers including potential R&D contracts. Work in process includes amounts that may be sold as products or under contracts. Such inventoried costs are stated generally at the total of the direct production costs including overhead. Inventory valuations do not include general and administrative expenses. Inventories are reviewed quarterly to determine salability and obsolescence.

Costs on long-term contracts and programs in progress represent recoverable costs incurred. The Company’s marketing involves the identification and pursuit of specific government budgets and programs. The Company is frequently involved in the pursuit of a specific anticipated contract that is a follow-on or related to an existing contract. The Company often determines that it is probable that a subsequent award will be successfully received, particularly if continued progress can be demonstrated against anticipated technical goals of the projected new program while the government goes through its lengthy process required to allocate funds and award contracts. Accordingly, the Company from time-to-

13

Table of Contents

time capitalizes material, labor and overhead costs expected to be recovered from a probable new contract. Due to the uncertain timing of such contracts, the Company maintains significant reserves for this inventory to avoid overstating its value. The net book value of such capitalized pre-contract costs included in work in process at January 2, 2005 and October 3, 2004 was $901,300 and $683,300, respectively.

Note 6 – Reportable Segments and Major Customers

Beginning in fiscal 2004, pursuant to the Company’s reorganization of its operations to provide more effective access to its administrative, marketing and engineering resources across all sectors of its business and to reduce expenses, the Company began to manage its operations in two reportable segments, the contract research and development segment and the product segment. The Company’s management evaluates financial information to review the performance of the Company’s research and development contract business separately from the Company’s product business, but only to the extent of the revenues and the cost of revenues of the two segments. Because the various indirect expense operations of the Company, as well as its assets, now support all of its revenue-generating operations in a matrix manner, frequently in circumstances in which a distinction between research and development contract support and product support is difficult to identify, segregation of these indirect costs and assets is impracticable. The revenues and costs of revenues of the Company’s two reportable segments for the 13-week periods ended January 2, 2005 and December 28, 2003 is shown in the following table. The accounting policies used to develop segment information correspond to those described in the summary of significant accounting policies.

The major customers for the Company’s research and development business segment in both the 13-week period ended January 2, 2005 and the 13-week period ended December 28, 2003 were all agencies or laboratories of the U.S. government or U.S. government contractors. Such customers in the aggregate accounted for approximately 87% of the Company’s total revenues in the current period and approximately 71% of the Company’s total revenues in the 13 weeks ended December 28, 2003. Approximately 48% and 18% of total revenues were realized from contracts with SAIC, a government contractor, and the U.S. Army, respectively, in the current period. No other customer accounted for more than 10% of the Company’s total revenues during the 13-week period ended January 2, 2005. Total revenues realized from contracts with the U.S. Army and the Defense Advanced Research Projects Agency were 27% and 26%, respectively, in the 13 weeks ended December 28, 2003. The major customer for the Company’s product business segment in both the 13-week period ended January 2, 2005 and the 13-week period ended December 28, 2003 was L-3 Communications, a government contractor, which accounted for approximately 6% of the Company’s total revenues and 44% of product sales in the current period and approximately 18% of the Company’s total revenues and 64% of product sales in the 13 weeks ended December 28, 2003.

14

Table of Contents

Note 7 – Commitments and Contingencies

Government Expense Audits

The Company’s reimbursable indirect expense rates for government contracts have been audited through the fiscal year ended September 30, 2001. The Federal Government has a proposed claim for recovery of $152,400 pursuant to the fiscal 2001 indirect rate audit. Pursuant to Federal Acquisition Regulations, the Company believes that it has a basis for waiver of this claim and has submitted a formal request for such waiver. Therefore, the accompanying consolidated financial statements do not include an accrual for potential loss, if any, related to this claim. This request is currently pending. Government indirect rate audits for the fiscal years ended September 29, 2002, September 28, 2003 and October 3, 2004 have not yet been scheduled.

Litigation

In August 2004, a consultant who was engaged by the Company’s iNetWorks subsidiary to locate capital for iNetWorks filed a lawsuit in Orange County Superior Court for breach of contract against iNetWorks and against the Company as the alleged alter ego of iNetWorks. In the complaint, the consultant alleges that iNetWorks breached a Finder’s Agreement with the consultant and seeks an unspecific amount of damages. In discovery, the consultant claimed that he is owed $5.2 million; however, as the consultant did not raise any capital for iNetWorks, the Company believes this case is without merit and intends to vigorously defend this litigation. In September 2004, the Company filed an answer denying all of the allegations contained in the complaint.

Note 8 – Patents and Trademarks, Net

The Company’s intangible assets consist of patents and trademarks related to the Company’s various technologies, approximately 99% of which represents patents. Capitalized costs include amounts paid to third parties for legal fees, application fees and other direct costs incurred in the filing and prosecution of patent and trademark applications. These assets are amortized on a straight-line method over their estimated useful life of ten years. The Company reviews these intangible assets for impairment when and if impairment indicators occur in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). At January 2, 2005, management believed no indications of impairment existed.

Patents and trademarks at January 2, 2005 and October 3, 2004 are as follows:

The amortization expense for the 13-week period ended January 2, 2005 was $26,800. The amortization expense for fiscal 2004 was $96,200, of which $25,300 was incurred in the 13-week period ended December 28, 2003. The unamortized balance of patents and trademarks at January 2, 2005 is

15

Table of Contents

estimated to be amortized over the balance of this fiscal year and the next five fiscal years thereafter as follows:

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

This report contains forward-looking statements regarding Irvine Sensors which include, but are not limited to, statements concerning projected revenues, expenses, gross profit and income, market acceptance of products, the competitive nature of our business and markets, the success and timing of new product introductions and commercialization of our technologies, product qualification requirements of our customers, the need for additional capital, and the outcome of pending litigation. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “estimates,” “should,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:

We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason. Additional information on the various risks and uncertainties potentially affecting our operating results are discussed below and are contained in our publicly filed documents available through the SEC’s EDGAR database (http://www.sec.gov) or from our Investor Relations Department.

16

Table of Contents

Overview

We design, develop, manufacture and sell miniaturized electronic products for defense, security and commercial applications. We also perform customer-funded contract research and development related to these products, mostly for U.S. government customers or prime contractors. Most of our business relates to application of our proprietary technologies for stacking either packaged or unpackaged semiconductors into more compact three-dimensional forms, which we believe offer volume, power, weight and operational advantages over competing packaging approaches.

Except for fiscal years 1999 through 2001, when we realized significant commercial product sales of wireless infrared tranceivers, we have historically derived a substantial majority of our total revenues from government-funded research and development contracts rather than from product sales. We anticipate that a majority of our total revenues will continue to be derived from government-funded sources in fiscal 2005. To date, our government-funded research and development contracts have largely been early-stage in nature and relatively modest in size, and as a result, our revenues from this source have improved to a limited degree from increases in the U.S. defense budget. However, we are also placing more emphasis on deploying our marketing efforts on government programs that we believe have potential to lead to production contracts, which we believe to be both larger and more profitable than funded research and development contracts. If we are successful in securing government production contracts, an outcome that we cannot guarantee, our revenues may become more related to changes in U.S. defense budgets. We are also attempting to increase our revenues from product sales by the introduction of new products with commercial applications, in particular stacked computer memory chips. We are currently transitioning into a new generation of such products, with a view to achieving increased sales of such products, but we cannot assure you that we will be able to complete development or successfully launch any such products on a timely basis, if at all. We use contract manufacturers to produce these products, and all of our current operations occur at a single, leased facility in Costa Mesa, California.

We have a history of unprofitable operations, largely as a result of discretionary investments that we have made to commercialize our technologies and to maintain our technical staff and corporate infrastructure at levels that we believe are required for future growth. Our investments to commercialize our technologies have yet to produce sustainable profitable product sales. With respect to our investments in staff and infrastructure, the advanced technical and multi-disciplinary content of our proprietary technologies places a premium on a stable and well-trained work force. As a result, we tend to maintain our work force even when anticipated government contracts are delayed, a circumstance that occurs with some frequency and may, from time to time, result in under utilization of our labor force for revenue generation. We believe that this pattern can be overcome by the achievement of greater contract backlog and are seeking growth in our research and development contract revenue to that end. To date, however, we have not yet achieved the level of revenue required to realize profitable operations. Our ability to recover our investments through the cost-reimbursement features of our government contracts are subject to both regulatory and competitive pricing considerations.

In the past, we have had separate operating business units, including our subsidiaries, which were separately managed, with independent product development, marketing and distribution systems. However, during fiscal 2003, we consolidated all of our operations to more effectively use our administrative, marketing and engineering resources and to reduce expenses. None of our subsidiaries presently account for more than 10% of our total revenues or total assets or have separate employees or facilities. We currently report our operating results and financial condition segmented only between our research and development business and our product business. (See Note 6 to the Consolidated Financial Statements).

17

Table of Contents

Critical Accounting Estimates

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. As such, management is required to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant accounting policies that are most critical to aid in fully understanding and evaluating reported financial results include the following:

Revenue Recognition. Our consolidated total revenues during the first 13 weeks of fiscal 2005 were primarily derived from contracts to develop prototypes and provide research, development, design, testing and evaluation of complex detection and control defense systems. Our research and development contracts are usually cost plus a fixed fee (best effort) or fixed price with billing entitlements based on level of effort expended. For such research and development contracts, revenues are recognized as we incur costs and include applicable fees or profits primarily in the proportion that costs incurred bear to estimated final costs. Upon the initiation of each such contract, a detailed cost budget is established for direct labor, material, subcontract support and allowable indirect costs based on our proposal and the required scope of the contract as may have been modified by negotiation with the customer, usually a U.S. government agency or prime contractor. A program manager is assigned to secure the needed labor, material and subcontract in the program budget to achieve the stated goals of the contract and to manage the deployment of those resources against the program plan. Our accounting department collects the direct labor, material and subcontract charges for each program on a weekly basis and provides such information to the respective program managers and the senior operating management of the Company.

The program managers review and report the performance of their contracts against the respective program plans with our senior operating management, including the President and the Chief Executive Officer, on a monthly basis. These reviews are summarized in the form of estimates of costs to complete the contracts. If an ETC indicates a potential overrun against budgeted program resources, it is the responsibility of the program manager to revise the program plan in a manner consistent with customer objectives to eliminate such overrun and to secure necessary customer agreement to such revision. To mitigate the financial risk of such re-planning, we attempt to negotiate the deliverable requirements of our research and development contracts to allow as much flexibility as possible in technical outcomes. Given the inherent technical uncertainty involved in research and development contracts, in which new technology is being invented, explored or enhanced, such contractual latitude is frequently achievable. When re-planning does not appear possible within program budgets, senior management makes a judgment as to whether we plan to supplement the customer budget with company funds or whether the program statement of work will require the additional resources to be expended to meet contractual obligations. If either determination is made, an accrual for the anticipated contract overrun is recorded based on the most recent ETC of the particular program.

We provide for anticipated losses on contracts by a charge to income during the period in which a potential for loss is first identified. We adjust the accrual for contract losses quarterly based on the review of outstanding contracts. Upon closure of the contracts, any associated accrual of anticipated loss is reduced as the previously recorded obligations are satisfied. Costs and estimated earnings in excess of billings under government contracts are accounted for as unbilled revenues on uncompleted contracts. Unbilled revenues on uncompleted contracts are stated at estimated realizable value.

We consider many factors when applying accounting principles generally accepted in the United States of America related to revenue recognition. These factors generally include, but are not limited to:

18

Table of Contents

Each of the relevant factors is analyzed to determine its impact, individually and collectively with other factors, on the revenue to be recognized for any particular contract with a customer. Management is required to make judgments regarding the significance of each factor in applying the revenue recognition standards, as well as whether or not each factor complies with such standards. Any misjudgment or error by management in its evaluation of the factors and the application of the standards could have a material adverse affect on our future operating results.

Inventory. Inventories are stated at the lower of cost or market. Each quarter, we evaluate our inventories for excess quantities and obsolescence. Inventories that are considered obsolete are written off. Remaining inventory balances are adjusted to approximate the lower of cost or market value. The valuation of inventories at the lower of cost or market requires the use of estimates as to the amounts of current inventories that will be sold. These estimates are dependent on our assessment of current and expected orders from our customers.

Costs on long-term contracts and programs in progress represent recoverable costs incurred. The marketing of our research and development contracts involves the identification and pursuit of specific government budgets and programs. We are frequently involved in the pursuit of a specific anticipated contract that is a follow-on or related to an existing contract. We often determine that it is probable that a subsequent award will be successfully received, particularly if we can demonstrate continued progress against anticipated technical goals of the projected new program while the government goes through its lengthy process required to allocate funds and award contracts. Accordingly, from time-to-time, we capitalize material, labor and overhead costs expected to be recovered from a probable new contract. Due to the uncertainties associated with new or follow-on research and development contracts, we maintain significant reserves for this inventory to avoid overstating its value. We have adopted this practice because we believe that we are typically able to more fully recover such costs under the provisions of government contracts by direct billing of inventory rather than by seeking recovery of such costs through permitted indirect rates, which may be more subject to competitive market pressures.

Valuation Allowances. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance.

Results of Operations

Contract Research and Development Revenue. Contract research and development revenue consists of amounts realized or realizable from customer funded research and development contracts, largely from U.S. government agencies and government contractors. Contract research and development revenues for the first 13 weeks of fiscal 2005 increased materially over the comparable revenues of the first 13 weeks of fiscal 2004 and also continued to represent the dominant contributor to our total revenues as shown in the following table:

19

Table of Contents

The increase in contract research and development revenue for the 13 week period ended January 2, 2005 was the result of a changing emphasis toward application-oriented research and development contracts in the first 13 weeks of fiscal 2005 as opposed to the first 13 weeks of fiscal 2004. We believe that this increase is the result of the increasing maturity of our development stage technologies, which has in turn, led to the receipt of more development contracts oriented toward possible production. Typically, such contracts are larger in dollar value than early stage research and development contracts. We have been advised of the pendancy of additional government contracts of this nature that are expected to be awarded in subsequent periods of fiscal 2005 thereby further increasing our contract research and development revenue, although we cannot guarantee this outcome. Based on our current backlog and notices of pending awards, we anticipate that our contract revenue will continue to represent a majority of our total revenue for the remainder of fiscal 2005.

Cost of Contract Research and Development Revenue. Cost of contract research and development revenue consists of labor, subcontractor and vendor expenses directly incurred in support of research and development contracts, plus associated indirect expenses permitted to be charged pursuant to the relevant contracts. Our cost of contract research and development revenue for the first 13 weeks of fiscal 2005 as compared to the first 13 weeks of fiscal 2004 is shown in the following table:

The dollar increase in cost of contract research and development revenue in the 13 weeks ended January 2, 2005 reflects the fact that, to a large extent, our research and development contracts are of a cost plus fixed fee nature. Accordingly, our costs of contract research and development revenue generally increase as such revenue increases. The disproportionate increase in the 13-week period ended January 2, 2005 largely reflects that fact that the 13 weeks ended December 28, 2003 incorporated the effect of a non-recurring $316,200 reduction in our accrued loss on contracts resulting from improved program management procedures, and no comparable reduction occurred in the 13 weeks ended January 2, 2005. The period-to-period proportional difference in cost of contract research and development revenue also reflects the different mix between internal and external resources generally required to satisfy the requirements of larger contracts, such as were active during the first 13 weeks of fiscal 2005. As contract

20

Table of Contents

values increase, we are more likely to require additional support from external vendors or subcontractors to meet contractual delivery requirements. Such external support is generally more costly than use of internal resources. Since we anticipate an increasing contribution to our revenues from such larger contracts in the balance of fiscal 2005, we also anticipate that this factor may continue to have an effect on our cost of contract research and development revenue during this period.

Product Sales. Product sales are comprised of revenues derived from sales of chips, modules, thermal viewers, stacked chip products and chip stacking services. Product sales for the first 13-week periods of fiscal 2005 and fiscal 2004 are shown in the following table:

The decrease in product sales for the 13 weeks ended January 2, 2005 was largely due to timing of orders for our stacked chip products from an OEM, L-3 Communications. In the 13 week period ended December 28, 2003, a large shipment of such products was made to L-3 Communications to meet the schedule requirements of one of their programs. No comparably scheduled large delivery was required by L-3 Communications in the first 13 weeks ended January 2, 2005. As a result, during the 13-week period ended January 2, 2005, L-3 Communications was not a material customer, as contrasted to the 13-week period ended December 28, 2003 in which it accounted for approximately $601,500, or 17.5%, of our consolidated total revenues and 64% of our product sales. Based on orders received from L-3 Communications subsequent to January 2, 2005, we believe that this comparative difference between the current and prior year first fiscal quarters is simply a timing effect and not a trend. Largely due to this timing effect, stacked chip product sales accounted for $365,300, or 68%, of our product sales in the 13 weeks ended January 2, 2005 as opposed to $840,400, or 89%, of our product sales in the 13 weeks ended December 28, 2003. Approximately $66,900, or 12%, of our product sales in the 13-week period ended January 2, 2005 and $90,300, or 10%, or our product sales in the 13-week period ended December 28, 2003 were derived from sales of wireless infrared transceiver chips and module products to various customers, sold under the Novalog brand, reflecting the further erosion of sales of our infrared transceivers for use in personal digital assistants made by palmOne. We are currently qualifying a new generation of products intended to improve the economics and performance features of our wireless infrared transceivers for potential use in both personal digital assistants and cell phones, but we cannot guarantee that this new generation of products will increase our product sales in this area. We currently do not have any design wins for these new products. Product sales for the 13-week period ended January 2, 2005 included, for the first time, a contribution from sales of thermal viewer products. Sales of such products accounted for $105,000, or 20%, of product sales in this period.

Cost of Product Sales. Cost of product sales consists of labor, subcontractor and vendor expenses directly incurred in the manufacture of products sold, plus related overhead expenses. Our cost of product sales for the first 13 weeks of fiscal 2005 and fiscal 2004 is shown in the following table:

21

Table of Contents

Because of the reduction in product sales in the first 13 weeks of fiscal 2005, the cost of product sales in that period was also reduced. However, the reduction in the fiscal 2005 13-week period cost of product sales was proportionally greater than the reduction of product sales itself, resulting in some improvement in cost of sales as a percentage of product sales in the first 13 weeks of fiscal 2005, but not yet to the point of positive gross margins. This modest improvement was partially a reflection of the changed product mix between the respective fiscal year periods. The improvement also reflected the discontinuation of older wireless infrared products that were no longer economic. Such wireless infrared products negatively impacted gross margins of product sales in the first 13 weeks of fiscal 2004, but due to their discontinuation, did not impact the first 13 weeks of fiscal 2005. We expect, but cannot guarantee, that our product sales will increase in subsequent periods of fiscal 2005, which we expect will allow us to achieve economies of scale that should improve our gross margins on product sales.

General and Administrative Expense. General and administrative expense consists of labor, subcontractor and vendor expenses not directly related to the production of revenue or to internally funded research and development. This includes such internal expenses as executive, administrative, financial and marketing labor and labor-related expenses and such external expenses as legal and accounting. General and administrative expense for the first 13 weeks of fiscal 2005 increased from the first 13 weeks of fiscal 2004 as shown in the following table:

The largest element of the increase in general and administrative expense in the first 13 weeks of fiscal 2005 was a $127,400 increase in general and administrative service costs, largely consisting of accounting expenses. We anticipate this category of general and administrative expense will increase throughout fiscal 2005 as a result of implementation of the requirements associated with Section 404 of the Sarbanes-Oxley Act. The second largest element of the increase in general and administrative expense in the first 13 weeks of fiscal 2005 was a $123,700 increase in our selling, marketing, bid and proposal activities in the fiscal 2005 period to support our plans for revenue growth. We also reduced our reserve for uncollectible receivables by $40,000 in the 13-week period ended December 28, 2003 and took no comparable action in the 13-week period ended January 2, 2005. Our general and administrative labor and labor benefit costs also increased $50,300, or 9%, in the 13-week period ended January 2, 2005, as compared to the 13-week period ended December 28, 2003. This increase was largely the result of our approximate 8% increase in the number of our employees between the two fiscal year periods.

22

Table of Contents

Research and Development Expense. Research and development expense consists of labor, subcontractor and vendor expenses directly incurred in support of internally funded research and development projects, plus associated overhead expenses. Research and development expense in the first 13 weeks of fiscal 2005 decreased from research and development expense in the first 13 weeks of fiscal 2004 as shown in the following table:

The substantial decrease in research and development expense in the first 13 weeks of fiscal 2005 was primarily the result of the reduced availability of direct labor for internally funded research projects in that period. We use the same technical staff for both internal and customer funded research and development projects, and we prioritize the deployment of this labor to revenue-producing projects whenever possible. Because of the increase in contract research and development revenue in the 13 weeks ended January 2, 2005, we had less discretionary direct labor being deployed to internally funded research and development projects in the current 13-week period than in the 13-week period ended December 28, 2003. We anticipate that the utilization of our direct labor force for funded research and development contract work will increase in absolute dollars in subsequent periods of fiscal 2005. If that occurs, we expect corresponding reductions in our internally funded research and development expense during such periods.

Net Loss. Largely due to the increases in our cost of contract research and development revenue and our general and administrative expense discussed above, our net loss in the first 13 weeks of fiscal 2005 increased as shown in the following table:

These results reflect the fact that our contract research and development revenue for the 13 weeks ended January 2, 2005 was not yet at the level required to fully support our technical staff and related infrastructure. We believe that further increases in our contract research and development revenue may improve the revenue production efficiency of our technical staff and improve our operating results.

23

Table of Contents

Liquidity and Capital Resources

Our liquidity as measured by both our consolidated cash and cash equivalents and our working capital at the end of fiscal 2004 and at the end of the first 13 weeks of fiscal 2005 is shown in the following table:

The $967,600 reduction in our cash and the $814,600 reduction in our working capital in the 13-week period ended January 2, 2005 was only partly a result of our $1,176,100 net loss in that period. From a cash flow perspective, this net loss was offset by an aggregate of $696,800 of non-cash expenses consisting of $443,700 of depreciation and amortization expenses and $253,100 of common stock contributions to employee retirement plans in the current 13-week period, resulting in $479,300 of cash use derived from the net loss. Significant contributors to the use of cash and working capital during the 13-week period ended January 2, 2005 other than the net loss were various timing effects largely related to expected revenue growth. Substantial effects in this category that amplified the use of cash in the period included a $323,100 increase in inventory in anticipation of expected new contracts, an increase of $255,400 in unbilled revenues on contracts due to timing of invoices on current contracts, a $178,200 increase in accounts receivable, largely due to the same invoice timing factors and a $29,400 increase in other current assets including such expenses as prepaid insurance premiums reflecting our growth. Substantial effects in this category that mitigated the use of cash in the current period included a $325,800 increase in accounts payable resulting from increased subcontractor and vendor use on larger contracts, a $136,600 increase in deferred revenues resulting from advanced payments on new product orders, a $101,800 increase in advanced billings on uncompleted contracts and a $35,600 increase in accrued loss on contracts, a projected future effect with no immediate impact on cash. The net effect of these positive and negative timing factors was a $159,400 use of cash in the current 13-week period that was additive to the cash use derived from the net loss.

Also contributing to the net use of cash in the 13 weeks ended January 2, 2005 were the net $339,300 of cash used for the acquisition of capital facilities and equipment and the $50,000 of cash used for acquisition of patents. Of the capital facilities and equipment expenditures, $19,500 was for equipment, $6,700 was for leasehold improvements, $6,300 was for software programs, and $306,800 was for construction in progress. At January 2, 2005, approximately 42% of our construction in progress was primarily related to our current research and development contract business, approximately 29% was primarily related to our stacking products and services and approximately 29% was primarily related to our camera products. Except for lease agreements for the acquisition of capital equipment, we had no other material capital commitments as of January 2, 2005.

24

Table of Contents

At January 2, 2005, a tabular summary of our contractual obligations is as follows:

Partially mitigating the net use of cash in the 13 weeks ended January 2, 2005 was the approximate net $58,200 of cash provided by financing activities, consisting of $88,700 of gross proceeds from the exercise of warrants and options, which was offset by $30,500 of principal payments made on equipment leases.

We believe, but cannot guarantee, that our government-funded contract business will grow in the balance of fiscal 2005, and will therefore be an improved source of liquidity through both operating margins and the recovery of indirect costs as permitted under government contracts. This belief stems from our visibility into budgetary decisions of various government agencies and our present backlog. At January 2, 2005, our funded backlog was approximately $4,070,000 compared to $1,465,800 at December 28, 2003. We similarly expect that substantially all of our funded backlog at January 2, 2005 will result in revenue recognized in fiscal 2005. In addition, our government contracts typically include unfunded backlog, which is funded when the previously funded amounts have been expended. As of January 25, 2005, our total backlog was $7,945,100. Furthermore, we have been advised of additional government contract awards that we expect to receive in fiscal 2005 subsequent to January 2, 2005, although we cannot assure you that such potential contract awards will be received.

Contracts with government agencies may be suspended or terminated by the government at any time, subject to certain conditions. Similar termination provisions are typically included in agreements with prime contractors. Since our inception, we have experienced such termination of our contracts on three occasions, the latest of which was April 1999. We cannot assure you that we will not experience suspensions or terminations in the future. Any such termination, if material, could cause a disruption of our revenue stream, adversely affect our liquidity and results of operations and could result in employee layoffs.

We also believe, but cannot guarantee, that our revenues from product sales will grow in subsequent periods of fiscal 2005. Initially, we believe this growth will likely use rather than generate cash because of the time lag between incurring the expenses to manufacture the products and collecting the receivables generated by shipments of those products.

We currently believe that our working capital and liquidity at January 2, 2005 is adequate to support our existing operations in fiscal 2005, but there may be product sales growth opportunities in fiscal 2005 that could place demands on our working capital that would require external infusion of working capital through financing. We cannot guarantee that such financing would be available on a timely basis, or on acceptable terms, or at all.

25

Table of Contents

RISK FACTORS

Our future operating results are highly uncertain. Before deciding to invest in our common stock or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in our Annual Report on Form 10-K, and in our other filings with the SEC, including any subsequent reports filed on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business and results of operations. If any of these risks actually occur, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

We have historically generated substantial losses, which, if continued, could make it difficult to fund our operations or successfully execute our business plan, and could adversely affect our stock price. Since our inception, we have generated net losses in most of our fiscal periods. We experienced net losses of approximately $1.2 million for the 13 weeks ended January 2, 2005, $4.2 million for the fiscal year ended October 3, 2004, $6.3 million for the fiscal year ended September 28, 2003 and $6.0 million for the fiscal year ended September 29, 2002. In recent years, much of our losses were incurred as a result of our significant investments in our development stage operating subsidiaries or their related technologies. While we have significantly reduced our investment in our subsidiaries and their technologies and consolidated our operations with a corresponding reduction in our net losses, we cannot assure you that we will be able to achieve or sustain profitability on a quarterly or annual basis in the future. In addition, because a large portion of our expenses are fixed, we generally are unable to reduce expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. For example, we experienced contract delays in the fiscal year ended September 28, 2003 and, to a lesser degree, in the fiscal year ended October 3, 2004, that resulted in operating expenses without corresponding revenues to keep personnel on staff while the contracts were pending. Such factors could cause us to continue to experience net losses in future periods, which will make it difficult to fund our operations, manage our business and achieve our business plan, and could cause the market price of our common stock to decline.

We may need to raise additional capital in the future, and additional funds may not be available on terms that are acceptable to us, or at all. In addition to our significant net losses in recent periods, we have experienced negative cash flows from operations in the amount of approximately $636,000 for the 13-week period ended January 2, 2005, $4.2 million for the fiscal year ended October 3, 2004, approximately $3.8 million for the fiscal year ended September 28, 2003 and approximately $1.4 million for the fiscal year ended September 29, 2002. To offset the effect of these negative operational cash flows, we have historically funded our operations through multiple equity financings, and to a lesser extent through receivable financing. We engaged in various financing transactions in fiscal years 2004, 2003 and 2002, which when combined with the exercise of warrants and options, raised aggregate net proceeds of approximately $15.3 million. During fiscal years 2004, 2003 and 2002, we also issued shares of our common stock in various non-cash transactions to retire payables and expenses and to convert preferred stock. The net amount of common stock we issued in that three fiscal year period was in excess of 14.5 million shares, over 80% of the 17.8 million shares of common stock outstanding at the end of fiscal 2004, resulting in significant dilution to stockholders that did not participate in those transactions.

In addition to uncertainties about whether we will need additional funds in the future to sustain our operations, we may need to obtain additional funds to meet our future working capital needs, particularly if anticipated growth opportunities emerge. Accordingly, we anticipate that we may need to raise additional capital in the future. We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all. Future financings may require stockholder approval, which

26

Table of Contents

may not be obtainable. If we are not able to obtain additional capital as may be required, our business, financial condition and results of operations could be materially and adversely affected.

We anticipate that our capital requirements will depend on many factors, including:

If our capital requirements are materially different from those currently planned, we may need additional capital sooner than anticipated. Additional funds may be raised through borrowings, other debt or equity financings, or the divestiture of business units or select assets. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to our common stock.

Additional funds may not be available on a timely basis, on favorable terms, or at all. Even if available, financings can involve significant costs and expenses, such as legal and accounting fees, diversion of management’s time and efforts, or substantial transaction costs in certain instances. If adequate funds are not available on acceptable terms, or at all, we may be unable to finance our operations, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures, any of which could have a material adverse effect on our business, financial condition and results of operations.

If we are not able to increase our contract research and development revenue, we may not be able to fully absorb our labor and indirect expenses, making it more difficult to achieve or sustain profitability. We believe that our losses in recent years have largely resulted from a combination of insufficient contract research and development revenue to support our technical staff, amplified by the effects of discretionary investments that we have made in an attempt to commercialize our technologies. Since our technical staff is highly skilled and our technologies are generally advanced, we are not able to rapidly adjust our labor-related expenses to reflect changes in our contract research and development revenue base. As a result, we have historically retained a mix of technical staff capabilities that we believe will be necessary to support future requirements associated with our desired growth. This level of staff has typically experienced under-utilization for revenue production. If we are unable to break this chronic pattern through growth in our contract research and development revenue, we will be dependent on growth in our product sales to fully support our expenses, an outcome that we cannot guarantee.

27

Table of Contents

Our government-funded research and development business depends on a limited number of customers, and if any of these customers terminate or reduce their contracts with us, or if we cannot obtain additional government contracts in the future, our revenues will decline and our results of operations will be adversely affected. For fiscal 2004, approximately 25% of our total revenues were realized from SAIC, a government contractor, 17% of our total revenues were generated from contracts with the U.S. Army and 17% were generated from contracts with the Defense Advanced Research Projects Agency, otherwise known as DARPA. We also received approximately 6% of our total revenues in that period from L-3 Communications, a government contractor. In the 13-week period ended January 2, 2005, approximately 48% and 18% of our total revenues were realized from SAIC and the U.S. Army, respectively. Although we ultimately plan to shift our focus to include the commercialization of our technology, we expect to continue to be dependent upon research and development contracts with federal agencies and their contractors for a substantial portion of our revenues for the foreseeable future. Our dependency on a few contract sources increases the risks of disruption in this area of our business or significant fluctuations in quarterly revenue, either of which could adversely affect our consolidated revenues and results of operations.

Because we currently depend on government contracts and subcontracts, we face additional risks related to contracting with the federal government, including federal budget issues and fixed price contracts. General political and economic conditions, which cannot be accurately predicted, directly and indirectly may affect the quantity and allocation of expenditures by federal agencies. Even the timing of incremental funding commitments to existing, but partially funded, contracts can be affected by these factors. Therefore, cutbacks or re-allocations in the federal budget could have a material adverse impact on our results of operations as long as research and development contracts remain an important element of our business. Obtaining government contracts may also involve long purchase and payment cycles, competitive bidding, qualification requirements, delays or changes in funding, budgetary constraints, political agendas, extensive specification development and price negotiations and milestone requirements. Each government agency also maintains its own rules and regulations with which we must comply and which can vary significantly among agencies. Governmental agencies also often retain some portion of fees payable upon completion of a project and collection of these fees may be delayed for several months or even years, in some instances. In addition, an increasing number of our government contracts are fixed price contracts, which may prevent us from recovering costs incurred in excess of its budgeted costs. Fixed price contracts require us to estimate the total project cost based on preliminary projections of the project’s requirements. The financial viability of any given project depends in large part on our ability to estimate such costs accurately and complete the project on a timely basis. In fiscal 2004, we completed fixed-price contracts with an approximate aggregate value of $3.7 million. We experienced approximately $227,500 in losses on those contracts, representing approximately 6% of the aggregate funded amount. At January 2, 2005, we had ongoing fixed-price contracts with an approximate unrealized aggregate value of $2.9 million. While fixed-price overruns in fiscal 2004 and the first 13 weeks of fiscal 2005 were largely discretionary in nature, we may not be able to achieve or improve upon this performance in the future since each contract has its own unique technical and schedule risks. In the event our actual costs exceed the fixed contractual cost, we will not be able to recover the excess costs.

Some of our government contracts are also subject to termination or renegotiation at the convenience of the government, which could result in a large decline in revenue in any given quarter. Although government contracts have provisions providing for the reimbursement of costs associated with termination, the termination of a material contract at a time when our funded backlog does not permit redeployment of our staff could result in reductions of employees. In April 1999, we experienced the termination of one of our contracts, but this termination did not result in the non-recovery of costs or layoff of employees. We also have had to reduce our staff from time-to-time because of fluctuations in our funded government contract base. In addition, the timing of payments from government contracts is

28

Table of Contents

also subject to significant fluctuation and potential delay, depending on the government agency involved. Any such delay could result in a temporary shortage in our working capital. Since nearly 70% of our total revenues in fiscal 2002, approximately 83% of our total revenues in fiscal 2003, approximately 82% of our total revenues in fiscal 2004 and approximately 82% of our total revenues in the first 13 weeks of fiscal 2005 were derived directly or indirectly from government contracts, these risks can significantly affect our business, results of operations and financial condition.

The significant military operations in the Middle East or elsewhere may require diversions of government research and development funding, thereby causing disruptions to our contracts or otherwise adversely impact our revenues. In the near term, the funding of U.S. military operations in Iraq or elsewhere may cause disruptions in funding of government contracts. Since military operations of such magnitude are not routinely included in U.S. defense budgets, supplemental legislative funding actions are required to finance such operations. Even when such legislation is enacted, it may not be adequate for ongoing operations, causing other defense funding sources to be temporarily or permanently diverted. Such diversion could produce interruptions in funding or delays in receipt of our research and development contracts, causing disruptions and adverse effects to our operations. In addition, concerns about international conflicts, the lingering effects of September 11, 2001 and other terrorist and military activity have resulted in unsettled worldwide economic conditions. These conditions make it difficult for our customers to accurately forecast and plan future business opportunities, in turn making it difficult for us to plan our current and future allocation of resources and increasing the risks that our results of operations could be adversely affected.

If we are not able to commercialize our technology, we may not be able to increase our revenues or achieve or sustain profitability. Since commencing operations, we have developed technology, principally under government research contracts, for various defense-based applications. Contract research and development revenue accounted for approximately 69% of our total revenues for the fiscal year ended September 29, 2002, approximately 82% of our total revenues for the fiscal year ended September 28, 2003, approximately 85% of our total revenues for the fiscal year ended October 3, 2004 and approximately 86% of our total revenues for the 13 weeks ended January 2, 2005. However, since our margins on government contracts are generally limited, and our revenues from such contracts are tied to government budget cycles and influenced by numerous political and economic factors beyond our control, and are subject to our ability to win additional contracts, our long-term prospects of realizing significant returns from our technology or achieving and maintaining profitability will likely also require penetration of commercial markets. In prior years, we have made significant investments to commercialize our technologies without significant success. These efforts included the purchase and later shut down of the IBM cubing line, the formation of the Novalog, MSI, Silicon Film, RedHawk and iNetWorks subsidiaries and the development of various stacked-memory products intended for military, aerospace and commercial markets. While these changes have developed new revenue sources, they have not yet resulted in consolidated profitability to date, and a majority of our total revenues for the fiscal years ended September 29, 2002, September 28, 2003, October 3, 2004 and the 13 weeks ended January 2, 2005 were still generated from contract research and development. Only our Novalog subsidiary has experienced periods of profitability, and that subsidiary is not currently profitable primarily due to the significant decline in the sales of its products for use in personal digital assistants, the largest historical end use application of Novalog’s products.

We are currently focusing on introducing a line of stacked memory products incorporating Ball Grid Array, or BGA, attachment technology because we believe emerging commercial demand exists for such products. We are currently dedicating significant development resources and funding to pursue the commercialization of our BGA stacking technology, a process that involves technical risk. If our perceptions about market demand are incorrect or we fail to successfully complete development, introduce and achieve market penetration for these products, our total revenues may not be sufficient to

29

Table of Contents

fully absorb our present indirect expenses and achieve profitability. We cannot assure you that our BGA products or our other current or contemplated products will achieve broad market acceptance in commercial marketplaces, and if they do not, our business, results of operations and financial condition will be materially and adversely affected.

If we are not able to obtain market acceptance of our new products, our revenues and results of operations will be adversely affected. We generally focus on markets that are emerging in nature. Market reaction to new products in these circumstances can be difficult to predict. Many of our planned products, including our new stacked BGA products, incorporate our chip stacking technologies that have not yet achieved broad market acceptance. We cannot assure you that our present or future products will achieve market acceptance on a sustained basis. In addition, due to our historical focus on research and development, we have a limited history of competing in the intensely competitive commercial electronics industry. As such, we cannot assure you that we will be able to successfully develop, manufacture and market additional commercial product lines or that such product lines will be accepted in the commercial marketplace. If we are not successful in commercializing our new products, our ability to generate revenues and our business, financial condition and results of operations will be adversely affected.

Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business and stock price. We are in the process of documenting and testing our internal control processes in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments and a written report on the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing the assessments in management’s report. During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we will not be able to conclude that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective internal control environment could have a material adverse effect on our stock price and could impact our ability to use Form S-3 for financings.

Our stock price has been subject to significant volatility. You may not be able to sell your shares of common stock at or above the price you paid for them. The trading price of our common stock has been subject to wide fluctuations in the past. Since January 2000, our common stock has traded at prices as low as $0.75 per share and as high as $375.00 per share (after giving effect to the 1-for-20 reverse stock split effected in September 2001). We may not be able to increase or sustain the current market price of our common stock in the future. As such, you may not be able to resell your shares of common stock at or above the price you paid for them. The market price of the common stock could continue to fluctuate or decline in the future in response to various factors, including, but not limited to:

30

Table of Contents

The trading markets for the equity securities of high technology companies have continued to experience volatility. Such volatility has often been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. In the past, companies that have experienced volatility in the market price of their securities have been the subject of securities class action litigation. We were subject to a class action lawsuit that diverted management’s attention and resources from other matters until it was settled in June 2004. We cannot guarantee you that we will not be subject to similar class action lawsuits in the future.

If we are not able to adequately protect or enforce our patent or other intellectual property rights, our ability to compete in our target markets could be materially and adversely affected. We believe that our success will depend, in part, on the strength of our existing patent protection and the additional patent protection that we may acquire in the future. As of January 2, 2005, we held 51 U.S. patents and 16 foreign patents and had other patent applications pending before the U.S. Patent and Trademark Office as well in as various foreign jurisdictions. It is possible that any existing patents or future patents, if any, could be challenged, invalidated or circumvented, and any right granted under these patents may not provide us with meaningful protection from competition. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our products, services or technology without authorization, to develop similar technology independently or to design around our patents. In addition, we treat technical data as confidential and generally rely on internal nondisclosure safeguards, including confidentiality agreements with employees, and on laws protecting trade secrets, to protect proprietary information. We cannot assure you that these measures will adequately protect the confidentiality of our proprietary information or that others will not independently develop products or technology that are equivalent or superior to ours.

Our ability to exploit our own technologies may be constrained by the rights of third parties who could prevent us from selling our products in certain markets or could require us to obtain costly licenses. Other companies may hold or obtain patents or inventions or may otherwise claim proprietary rights to technology useful or necessary to our business. We cannot predict the extent to which we may be required to seek licenses under such proprietary rights of third parties and the cost or availability of these licenses. While it may be necessary or desirable in the future to obtain licenses relating to one or more proposed products or relating to current or future technologies, we cannot assure you that we will be able to do so on commercially reasonable terms, if at all. If our technology is found to infringe upon the rights of third parties, or if we are unable to gain sufficient rights to use key technologies, our ability to compete would be harmed and our business, financial condition and results of operations would be materially and adversely affected.

Enforcing and protecting our patents and other proprietary information can be costly. If we are not able to adequately protect or enforce our proprietary information or if we become subject to infringement claims by others, our business, results of operations and financial condition may be materially adversely affected. We may need to engage in future litigation to enforce our intellectual property rights or the rights of our customers, to protect our trade secrets or to determine the validity and scope of proprietary rights of others, including our customers. We also may need to engage in litigation in the future to enforce our patent rights. In addition, we may receive in the future communications from third parties asserting that our products infringe the proprietary rights of third parties. We cannot assure you that any such claims would not result in protracted and costly litigation. Such litigation could result in substantial costs and diversion of our resources and could materially and adversely affect our business,

31

Table of Contents

financial condition and results of operations. Furthermore, we cannot assure you that we will have the financial resources to vigorously defend or enforce our patents or other proprietary technology.

Our proprietary information and other intellectual property rights are subject to government use which, in some instances, limits our ability to capitalize on them. Whatever degree of protection, if any, is afforded to us through our patents, proprietary information and other intellectual property generally will not extend to government markets that utilize certain segments of our technology. The government has the right to royalty-free use of technologies that we have developed under government contracts, including portions of our stacked circuitry technology. While we are generally free to commercially exploit these government-funded technologies, and we may assert our intellectual property rights to seek to block other non-government users of the same, we cannot assure you that we will be successful in our attempts to do so.

We are subject to significant competition that could harm our ability to win new business or attract strategic partnerships and could increase the price pressure on our products. We face strong competition from a wide variety of competitors, including large, multinational semiconductor design firms and aerospace firms. Most of our competitors have considerably greater financial, marketing and technological resources than we or our subsidiaries do, which may make it difficult to win new contracts or to attract strategic partners. This competition has resulted and may continue to result in declining average selling prices for our products. We cannot assure you that we will be able to compete successfully with these companies. Certain of our competitors operate their own fabrication facilities and have longer operating histories and presence in key markets, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than us. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion and sale of their products. Increased competition has in the past resulted in price reductions, reduced gross margins and loss of market share. We believe that this trend may continue in the future. We cannot assure you that we will be able to continue to compete successfully or that competitive pressures will not materially and adversely affect our business, financial condition and results of operations.

We must continually adapt to unforeseen technological advances, or we may not be able to successfully compete with our competitors. We operate in industries characterized by rapid and continuing technological development and advancements. Accordingly, we anticipate that we will be required to devote substantial resources to improve already technologically complex products. Many companies in these industries devote considerably greater resources to research and development than we do. Developments by any of these companies could have a materially adverse effect on us if we are not able to keep up with the same developments. Our future success will depend on our ability to successfully adapt to any new technological advances in a timely manner, or at all.

We do not have guaranteed long-term supply relationships with any of our contract manufacturers, which could make it difficult to fulfill our backlog in any given quarter and could reduce our revenues in future periods. We extensively rely on contract manufacturers but do not maintain long-term supply agreements with any of our contract manufacturers or other suppliers. Accordingly, because our contract manufacturers allocate their manufacturing resources in periods of high demand, we face several significant risks, including a lack of adequate supply, potential product shortages and higher prices and limited control over delivery schedules, quality assurance and control, manufacturing yields and production costs. We cannot assure you that we will be able to satisfy our manufacturing needs in the future. Failure to do so will have a material adverse impact on our operations and the amount of products we can ship in any period.

32

Table of Contents

We do not have any long-term employment agreements with any of our key personnel. If we are not able to retain our key personnel, we may not be able to implement our business plan and our results of operations could be materially and adversely affected. We depend to a large extent on the abilities and continued participation of our executive officers and other key employees, particularly John Carson, our President, and John Stuart, our Chief Financial Officer. The loss of any key employee could have a material adverse effect on our business. While we have adopted employee stock option plans designed to attract and retain key employees, our stock price has declined in recent periods, and we cannot guarantee that options granted under our plans will be effective in retaining key employees. We do not presently maintain “key man” insurance on any key employees. We believe that, as our activities increase and change in character, additional, experienced personnel will be required to implement our business plan. Competition for such personnel is intense and we cannot assure you that they will be available when required, or that we will have the ability to attract and retain them.

Significant sales of our common stock in the public market will cause our stock price to fall. As of January 28, 2005, we had approximately 18.5 million shares of common stock outstanding, substantially all of which were freely tradable, other than restrictions imposed upon our affiliates. The average trading volume of our shares in December 2004, however, was only approximately 300,900 shares per day. Accordingly, the freely tradable shares are significantly greater in number than the daily average trading volume of our shares. If the holders of the freely tradable shares were to sell a significant amount of our common stock in the public market, the market price of our common stock would likely decline. If we raise additional capital in the future through the sale of shares of our common stock to private investors, we may agree to register these shares for resale on a Form S-3 registration statement as we have done in the past. Upon registration, these additional shares would become freely tradable once sold in the public market, assuming the prospectus delivery and other requirements were met by the seller, and, if significant in amount, such sales could further adversely affect the market price of our common stock.

Our stock price could decline because of the potentially dilutive effect of recent and future financings. At January 28, 2005, we had approximately 18.5 million shares of common stock outstanding as compared to approximately 12.9 million outstanding at September 28, 2003, resulting in dilution to our existing stockholders. Of the shares of common stock issued in this interval, approximately 1.9 million were the result of the exercise of “in the money” warrants and options. Additionally, in December 2003, we sold 1.0 million shares of our common stock and five-year warrants to purchase up to 250,000 shares of our common stock for an exercise price of $2.20 per share in a private placement for net proceeds of approximately $1.7 million. In June 2004, we sold an additional approximate 1.2 million shares of our common stock and five-year warrants to purchase up to 373,300 shares of our common stock for an exercise price of $2.99 per share in a private placement for net proceeds of approximately $2.5 million. Any additional equity financings or exercise of “in the money” warrants and options in the future could also result in dilution to our stockholders.

Our common stock may be delisted from the Nasdaq SmallCap Market if our stock price declines further or if we cannot maintain Nasdaq’s listing requirements. In such case, the market for your shares may be limited, and it may be difficult for you to sell your shares at an acceptable price, if at all. Our common stock is currently listed on the Nasdaq SmallCap Market. Among other requirements, to maintain this listing, our common stock must continue to trade above $1.00 per share. In July 2001, our stock had failed to meet this criterion for over 30 consecutive trading days. As a result, in accordance with Marketplace Rule 4310(c)(8)(B), we were notified by Nasdaq that we had 90 calendar days or until October 2001 to regain compliance with this Rule by reestablishing a sales price of $1.00 per share or greater for ten consecutive trading days. To regain compliance, we sought and received approval from our stockholders to effect a 1-for-20 reverse split of our common stock that became effective in September 2001, resulting in re-compliance by the Nasdaq deadline. However, subsequent to the reverse

33

Table of Contents

split, our common stock has, at various times, traded close to or below the $1.00 per share minimum standard, and we cannot assure you that the sales price of our common stock will continue to meet Nasdaq’s minimum listing standards. At January 28, 2005, the closing sales price of our common stock on the Nasdaq SmallCap Market was $2.20 per share.

In addition to the price requirement, we must also meet at least one of the three following additional standards to maintain our Nasdaq listing: (1) maintenance of stockholders’ equity at $2.5 million or greater, (2) maintenance of our market capitalization in excess of $35 million as measured by market prices for trades executed on Nasdaq, or (3) net income from continuing operations of $500,000 in the latest fiscal year or two of the last three fiscal years. In July 2001, Nasdaq notified us that we were deficient with respect to all of these additional standards based on our financial statements as of April 1, 2001. In August 2001, Nasdaq advised us that, based on updated information, we had reestablished compliance with the $35 million market capitalization standard. However, the subsequent decline in the price of our common stock resulted in another deficiency notice from Nasdaq in August 2001. At that time, we did not comply with either the market capitalization standard or the stockholders’ equity standard. However, based solely on improvements in our stockholders’ equity resulting from the net gain of approximately $0.9 million realized from the discontinuance of operations of our Silicon Film subsidiary in September 2001, we were able to meet the minimum stockholders’ equity standard and reestablish compliance in November 2001. As of January 2, 2005, we had stockholders’ equity of approximately $7.5 million and a market capitalization of approximately $48.1 million. Although we are currently in compliance with Nasdaq’s listing maintenance requirements, we cannot assure you that we will be able to maintain our compliance with these requirements in the future. If we fail to meet these or other listing requirements, our common stock could be delisted, which would eliminate the primary market for your shares of common stock. As a result, you may not be able to sell your shares at an acceptable price, if at all. In addition, such delisting may make it more difficult or expensive for us to raise additional capital in the future since we may no longer qualify to register shares for resale on a Form S-3 registration statement.

If we are delisted from the Nasdaq SmallCap Market, your ability to sell your shares of our common stock would also be limited by the penny stock restrictions, which could further limit the marketability of your shares. If our common stock is delisted, it would come within the definition of “penny stock” as defined in the Exchange Act and would be covered by Rule 15g-9 of the Exchange Act. That Rule imposes additional sales practice requirements on broker-dealers who sell securities to persons other than established customers and accredited investors. For transactions covered by Rule 15g-9, the broker-dealer must make a special suitability determination for the purchaser and receive the purchaser’s written agreement to the transaction prior to the sale. Consequently, Rule 15g-9, if it were to become applicable, would affect the ability or willingness of broker-dealers to sell our securities, and accordingly would affect the ability of stockholders to sell their securities in the public market. These additional procedures could also limit our ability to raise additional capital in the future.

We may be subject to additional risks. The risks and uncertainties described above are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also adversely affect our business operations.

34

Table of Contents

Item 3. Quantitative and Qualitative Disclosures About Market Risk

None.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in timely alerting them to the material information related to us (or our consolidated subsidiaries) required to be included in the reports we file or submit under the Securities Exchange Act of 1934.

(b) Changes in Internal Control over Financial Reporting. During the most recent completed fiscal quarter covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

In August 2004, a consultant who was engaged by the Company’s iNetWorks subsidiary to locate capital for iNetWorks filed a lawsuit in Orange County Superior Court for breach of contract against iNetWorks and against the Company as the alleged alter ego of iNetWorks. In the complaint, the consultant alleges that iNetWorks breached a Finder’s Agreement with the consultant and seeks an unspecific amount of damages. In discovery, the consultant claimed that he is owed $5.2 million; however, as the consultant did not raise any capital for iNetWorks, the Company believes this case is without merit and intends to vigorously defend this litigation. In September 2004, the Company filed an answer denying all of the allegations contained in the complaint.

The Company has been, and may from time to time, become a party to various legal proceedings arising in the ordinary course of its business. Management believes that the disposition of these matters will not have a material effect on the Company’s consolidated financial position, results of operations or liquidity.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In December 2004, the Company contributed 100,000 shares of common stock valued at $220,000 as a fiscal 2005 contribution to the Company’s Non-Qualified Deferred Compensation Plan. The shares were issued to a Rabbi Trust under such plan to be held as unsecured claims for the benefit of the plan participants.

35

Table of Contents

The issuance of the common stock described in the previous paragraph was deemed to be exempt from registration under the Securities Act of 1933, as amended (the “Act”), in reliance on Section 4(2) of the Act as transactions by an issuer not involving any public offering.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

36

Table of Contents

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.

37

Table of Contents

EXHIBIT INDEX