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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2010

Commission File Number 0-20734
 
 
e.Digital Corporation
(Exact name of registrant as specified in its charter)

Delaware
33-0591385
(State or other jurisdiction of
(I.R.S. Empl. Ident. No.)
incorporation or organization)
 
   
16770 West Bernardo Drive, San Diego, California
92127
(Address of principal executive offices)
(Zip Code)

(858) 304-3016
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   ¨Yes   ¨ No  (not required)

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer ¨
Accelerated filer ¨
Non-accelerated filer    ¨ (Do not check if a smaller reporting company)
Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x

As of February 1, 2011 a total of 293,003,158 shares of the Registrant’s Common Stock, par value $0.001, were issued and outstanding.
 

 

 

e.DIGITAL CORPORATION

INDEX

       
Page
PART I. FINANCIAL INFORMATION
   
         
 
Item 1.
Financial Statements (unaudited):
 
         
   
Condensed Consolidated Balance Sheets as of December 31, 2010 and March 31, 2010
 
3
         
   
Condensed Consolidated Statements of Operations for the three and nine months ended December 31, 2010 and 2009
 
4
         
   
Condensed Consolidated Statements of Cash Flows for the nine months ended December 31, 2010 and 2009
 
5
         
   
Notes to Interim Consolidated Financial Statements
 
6
         
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
14
         
 
Item 4.
Controls and Procedures
 
20
         
PART II. OTHER INFORMATION
   
         
 
Item 1.
Legal Proceedings
 
21
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
22
 
Item 3.
Defaults Upon Senior Securities
 
22
 
Item 4.
(Removed and Reserved)
 
22
 
Item 5.
Other Information
 
22
 
Item 6.
Exhibits
 
22
     
SIGNATURES
 
22

 
2

 

Item 1. Financial Statements:
e.Digital Corporation and subsidiary

CONDENSED CONSOLIDATED BALANCE SHEETS

   
December 31,
       
   
2010
   
March 31,
 
   
(Unaudited)
   
2010
 
   
$
   
$
 
ASSETS
           
Current
           
Cash and cash equivalents
    1,931,824       2,818,727  
Accounts receivable
    93,202       108,749  
Inventory, net
    289,969       347,078  
Deposits and prepaid expenses
    47,763       59,072  
Total current assets
    2,362,758       3,333,626  
Property, equipment and intangibles, net of accumulated depreciation and amortization of $191,864 and $184,382, respectively
    6,384       11,090  
Total assets
    2,369,142       3,344,716  
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current
               
Accounts payable, trade
    99,108       51,997  
Accrued and other liabilities
    124,332       315,948  
Total current liabilities
    223,440       367,945  
Total liabilities
    223,440       367,945  
                 
Commitments and Contingencies
               
                 
Stockholders' equity
               
Preferred stock, $0.001 par value; 5,000,000 shares authorized Series AA Convertible Preferred stock, $0.001 par value, 100,000 shares designated: -0- and 55,000 issued and outstanding, respectively Liquidation preference of $-0- and $598,370, respectively
    -       573,830  
Common stock, $0.001 par value, authorized 350,000,000, 293,003,158 and 286,950,900 shares issued and outstanding, respectively
    293,003       286,951  
Additional paid-in capital
    82,745,550       82,073,012  
Accumulated deficit
    (80,892,851 )     (79,957,022 )
Total stockholders' equity
    2,145,702       2,976,771  
                 
Total liabilities and stockholders' equity
    2,369,142       3,344,716  

See notes to interim consolidated financial statements

 
3

 


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

   
For the three months ended
   
For the nine months ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
 
 
$
   
$
   
$
   
$
 
Revenues:
                               
   Products
    8,253       106,570       361,080       164,085  
   Services
    126,639       177,600       499,041       605,382  
   Patent license
    5,778       -       31,042       1,250,000  
      140,670       284,170       891,163       2,019,467  
                                 
Cost of revenues:
                               
   Products
    14,764       96,630       291,445       173,423  
   Services
    74,820       83,188       259,752       259,996  
   Patent license
    5,778       -       31,042       443,000  
      95,362       179,818       582,239       876,419  
Gross profit
    45,308       104,352       308,924       1,143,048  
                                 
Operating expenses:
                               
   Selling and administrative
    280,582       558,600       920,495       1,386,013  
   Research and related expenditures
    81,653       130,163       327,737       336,493  
          Total operating expenses
    362,235       688,763       1,248,232       1,722,506  
                                 
Operating loss
    (316,927 )     (584,411 )     (939,308 )     (579,458 )
                                 
Other income (expense):
                               
   Interest expense
    -       (1,265 )     -       (17,099 )
   Other income (expense) - net
    -       32,891       -       29,332  
          Other income (expense)
    -       31,626       -       12,233  
                                 
Loss before provision for income taxes
    (316,927 )     (552,785 )     (939,308 )     (567,225 )
Income tax benefit
    3,479       237,500       3,479       31,250  
Loss for the period
    (313,448 )     (315,285 )     (935,829 )     (535,975 )
Accrued and deemed dividends on preferred stock
    -       (45,387 )     (31,396 )     (144,088 )
Loss attributable to common stockholders
    (313,448 )     (360,672 )     (967,225 )     (680,063 )
Loss per common share - basic and diluted
    (0.00 )     (0.00 )     (0.00 )     (0.00 )
                                 
Weighted average common shares outstanding
                               
  Basic and diluted
    293,003,158       286,625,653       291,000,411       284,520,917  

See notes to interim consolidated financial statements

 
4

 


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

   
For the nine months ended
 
   
December 31,
 
   
2010
   
2009
 
 
 
$
   
$
 
OPERATING ACTIVITIES 
           
Loss for the period
    (935,829 )     (535,975 )
Adjustments to reconcile loss to net cash used in operating activities:
               
Depreciation and amortization
    7,482       13,781  
Accretion related to promissory notes
    -       6,141  
Interest paid with common stock
    -       10,631  
Warranty provision
    13,731       9,502  
Stock-based compensation
    104,760       147,663  
Changes in assets and liabilities:
               
Accounts receivable
    15,547       (118,885 )
Inventory
    57,109       90,065  
Deposits and prepaid expenses
    11,309       6,656  
Accounts payable, trade
    47,111       (101,943 )
Accrued and other liabilities
    (205,347 )     (453,583 )
Cash used in operating activities
    (884,127 )     (925,947 )
                 
INVESTING ACTIVITIES
               
Purchase of equipment
    (2,776 )     (1,211 )
Cash used in investing activities
    (2,776 )     (1,211 )
FINANCING ACTIVITIES
               
Payment on convertible term note
    -       (47,865 )
Cash used in financing activities
    -       (47,865 )
Net decrease in cash and cash equivalents
    (886,903 )     (975,023 )
Cash and cash equivalents, beginning of period
    2,818,727       3,813,990  
Cash and cash equivalents, end of period
    1,931,824       2,838,967  
                 
Supplemental disclosures of cash flow information:
               
Cash paid for interest
    -       327  
Cash paid for taxes
    -       368,750  
Supplemental schedule of noncash investing and financing activities:
               
Common stock issued on conversion of preferred stock
    605,226       212,083  
Accrued and deemed dividends on preferred stock
    31,396       144,088  
Term note payments paid in common stock
    -       350,000  

See notes to interim consolidated financial statements

 
5

 

1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION
e.Digital Corporation is a holding company incorporated under the laws of Delaware that operates through a wholly-owned California subsidiary of the same name. The Company markets the eVU™ mobile entertainment system for the travel and recreational industries and licenses and enforces its Flash-R™ portfolio of patents related to the use of flash memory in portable devices.

Unaudited Interim Financial Statements
These unaudited consolidated financial statements have been prepared by management in accordance with accounting principles generally accepted in the United States and with the instructions to Form 10-Q and Article 10 of Regulation S-X on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. These interim consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited consolidated financial statements reflect all adjustments considered necessary for a fair statement of the Company's financial position at December 31, 2010, and the results of its operations and cash flows for the periods presented, consisting only of normal and recurring adjustments. All significant intercompany transactions have been eliminated in consolidation. Operating results for the nine months ended December 31, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2011. For further information, refer to the Company's consolidated financial statements and footnotes thereto for the year ended March 31, 2010 filed on Form 10-K.

Going Concern
The Company has incurred significant losses and negative cash flow from operations and has an accumulated deficit of $80,892,851 at December 31, 2010. The Company has incurred losses in the current fiscal year to date and could continue to incur losses in the future until product, service and/or licensing revenues are sufficient to sustain continued profitability. Until the Company can demonstrate sustained profitability its ability to continue as a going concern is in doubt and may be dependent upon obtaining additional financing in the future. These consolidated financial statements do not give effect to any adjustments that would be necessary should the Company be unable to continue as a going concern and therefore be required to realize its assets and discharge its liabilities in other than the normal course of business and at amounts different from those reflected in the accompanying consolidated financial statements.

Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

2. RECENT ACCOUNTING PRONOUNCEMENTS
With the exception of those discussed below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the nine months ended December 31, 2010, as compared to the recent accounting pronouncements described in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2010, that are of significance, or potential significance to the Company.

In February 2010, the FASB issued ASU 2010-09, Subsequent Events (Topic 855). This update provides amendments to Subtopic 855-10-50-4 and related guidance within U.S. GAAP to clarify that an SEC registrant is not required to disclose the date through which subsequent events have been evaluated. This change alleviates potential conflicts between Subtopic 855-10 and the SEC’s requirements. The Company adopted this update effective June 15, 2010 and it had no effect on its financial position.

In September 2009, the FASB issued Accounting Standards Update (ASU) No. 2009-13, Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force (ASU 2009-13). It updates the existing multiple-element revenue arrangements guidance currently included under ASC 605-25, which originated primarily from the guidance in EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21). The revised guidance primarily provides two significant changes: 1) eliminates the need for objective and reliable evidence of the fair value for the undelivered element in order for a delivered item to be treated as a separate unit of accounting, and 2) eliminates the residual method to allocate the arrangement consideration. In addition, the guidance also expands the disclosure requirements for revenue recognition. ASU 2009-13 will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. The Company believes this pronouncement is consistent with and will not change its revenue recognition for patent licenses and will have no impact on its consolidated financial statements.

 
6

 

In April 2010, the FASB issued ASU No. 2010-17—Revenue Recognition—Milestone Method (Topic 605), which provides guidance on the criteria that should be met for determining whether the milestone method of revenue recognition is appropriate. A vendor can recognize consideration that is contingent upon achievement of a milestone in its entirety as revenue in the period in which the milestone is achieved only if the milestone meets all criteria to be considered substantive. The amendments in this Update are effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. The Company expects that the adoption of the amendments in this update will not have any significant impact on its financial position and results of operations.
 
In January 2010, the FASB issued ASU No. 2010-06—Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.  This update amends Subtopic 820-10 that requires new disclosures about transfers in and out of Levels 1 and 2 and activity in Level 3 fair value measurements. This update also amends Subtopic 820-10 to clarify certain existing disclosures. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010. The adoption of this update had no effect on the Company’s financial position.

There have been no other recent accounting pronouncements or changes in accounting pronouncements during the period ended December 31, 2010, or subsequently thereto, that the Company believes are of potential significance to its financial statements.

3. LOSS PER SHARE
Basic loss per common share is computed by dividing loss attributable to common shareholders by the weighted-average number of shares of common stock outstanding during the period. The loss to common stockholders was increased by accrued and deemed dividends on preferred stock during the three and nine months ended December 31, 2010 of $-0- and $31,396 respectively (three and nine months ended December 31, 2009 by $45,387 and $144,088, respectively). Diluted earnings per common share is computed by dividing loss attributable to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities included outstanding stock options, and warrants. These securities were not included in the computation of diluted loss per share for the periods because they are antidilutive, but they could potentially dilute earnings per share in future periods.
 
4. INVENTORIES
 
Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out cost basis, or market.
Inventories consisted of the following:

   
December 31,
   
March 31,
 
   
2010
   
2010
 
   
$
   
$
 
Raw materials
    79,962       111,399  
Work in process
    19,027       19,033  
Finished goods
    190,980       216,646  
      289,969       347,078  

 
7

 

5. STOCK-BASED COMPENSATION COSTS
 
The Company accounts for stock-based compensation under the provisions of ASC 718, Share-Based Payment and ASC 505-50, Equity-Based Payments to Non-Employees. ASC 718 requires measurement of all employee stock-based awards using a fair-value method and recording of related compensation expense in the consolidated financial statements over the requisite service period. Further, as required under ASC 718, the Company estimates forfeitures for stock-based awards that are not expected to vest. The Company recorded stock-based compensation in its consolidated statements of operations for the relevant periods as follows:
 
   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
   
$
   
$
   
$
   
$
 
Research and development
    4,330       19,446       26,694       20,483  
Selling and administrative
    266       109,891       78,066       127,180  
Total stock-based compensation expense
    4,596       129,337       104,760       147,663  

As of December 31, 2010 total estimated compensation cost of stock options granted but not yet vested was $18,439 and is expected to be recognized over the weighted average period of 1.23 years.

The following table sets forth the weighted-average key assumptions and fair value results for stock options granted during the nine-month periods ended December 31, 2010 and 2009 (annualized percentages).

   
Nine Months Ended
 
   
December 31,
 
   
2010
   
2009
 
Volatility
    76 %     77 %
Risk-free interest rate
    0.47 %     0.95 %
Forfeiture rate
    0.0 %     0.0%-0.5 %
Dividend yield
    0.0 %     0.0 %
Expected life in years
    2.1       2.2  
Weighted-average fair value of options granted
  $ 0.04     $ 0.06  

The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of the common stock over the period commensurate with the expected life of the options. The Company has a small number or option grants and limited exercise history and accordingly has for all new option grants applied the simplified method prescribed by SEC Staff Accounting Bulletin 110, Share-Based Payment: Certain Assumptions Used in Valuation Methods - Expected Term, to estimate expected life (computed as vesting term plus contractual term divided by two). The expected forfeiture rate is estimated based on historical and expected experience for determined option groups and is zero for options vesting on grant. Additional expense is recorded when the actual forfeiture rates are lower than estimated and a recovery of prior expense will be recorded if the actual forfeitures are higher than estimated.

See Note 7 for further information on outstanding stock options.

 
8

 

6. WARRANTY RESERVE

Details of the estimated warranty liability included in other accounts payable and accrued liabilities are as follows:

   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
   
$
   
$
   
$
   
$
 
Beginning balance
    10,123       5,359       5,262       14,155  
Warranty provision
    2,404       1,036       13,731       9,502  
Warranty deductions
    (7,187 )     (1,036 )     (13,653 )     (18,298 )
Ending balance
    5,340       5,359       5,340       5,359  

7. STOCKHOLDERS’ EQUITY
The following table summarizes stockholders’ equity transactions during the nine-month period ended December 31, 2010:

   
Preferred stock
   
Common stock
   
Additional
   
Accumulated
   
Total stockholders'
 
   
Amount
   
Shares
   
Amount
   
paid-in capital
   
deficit
   
equity
 
   
$
         
$
   
$
   
$
   
$
 
Balance, April 1, 2010
    573,830       286,950,900       286,951       82,073,012       (79,957,022 )     2,976,771  
Dividends on Series AA preferred stock
    6,856       -       -       (6,856 )     -       -  
Accretion of discount on Series AA preferred stock
    24,540       -       -       (24,540 )     -       -  
Conversion of Series AA preferred stock
    (605,226 )     6,052,258       6,052       599,174       -       -  
Stock-based compensation
    -       -       -       104,760       -       104,760  
Loss and comprehensive loss
    -       -       -       -       (935,829 )     (935,829 )
Balance, December 31, 2010
    -       293,003,158       293,003       82,745,550       (80,892,851 )     2,145,702  

Options
The following table summarizes stock option activity for the period:

         
Weighted average
   
Aggregate
 
   
Shares
   
exercise price
   
Intrinsic Value
 
   
#
   
$
   
$
 
Outstanding April 1, 2010
    4,965,500       0.15        
Granted
    2,490,000       0.09        
Exercised
    -                
Canceled/expired
    (1,280,000 )     0.16        
Outstanding December 31, 2010
    6,175,500       0.12     $ 23,200  
Exercisable at December 31, 2010
    5,488,830       0.12     $ 23,200  

 
(1)
Options outstanding are exercisable at prices ranging from $0.09 to $0.23 and expire over the period from 2011 to 2014.
 
(2)
Aggregate intrinsic value is based on the closing price of our common stock on December 31, 2010 of $0.10 and excludes the impact of options that were not in-the-money.

 
9

 

Share warrants
The Company has outstanding share warrants as of December 31, 2010, as follows:

   
Number of
   
Exercise Price
   
Description
 
Common Shares
   
Per Share $
 
  Expiration Date
               
Warrants
    7,500,000       0.10  
June 30, 2011

No warrants were granted, exercised or cancelled/expired during the nine months ended December 31, 2010.

8. PREFERRED STOCK
On June 27, 2008 the Company issued 75,000 shares of 5% Series AA Convertible Preferred Stock (the “Series AA Stock”) with a stated value of $10 per share. Dividends of 5% per annum were payable in shares of common stock or at the Company’s election additional shares of Series AA Stock or under certain circumstances in cash. The stated value plus accrued dividends on Series AA Stock was convertible into common stock at $0.10 per common share with automatic conversion on June 30, 2010. On June 30, 2010 the Company issued 6,052,258 shares of common stock upon the conversion of 55,000 shares of Series AA Stock and as a result no shares of Series AA Stock remained outstanding thereafter.

9. FAIR VALUE MEASUREMENTS
Cash and cash equivalents are measured at fair value in the Company’s financial statements. Accounts receivable are financial assets with carrying values that approximate fair value due to the short-term nature of these assets. Accounts payable, deferred revenue and accrued and other liabilities are financial liabilities with carrying values that approximate fair value due to the short-term nature of these liabilities. Effective April 1, 2008 the Company adopted and follows ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) which established a fair value hierarchy that requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instruments categorization within the hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The Company’s cash and cash equivalents are valued using unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 inputs under ASC 820).

10. SEGMENT INFORMATION
ASC 280 Segment Reporting provides annual and interim reporting standards for an enterprise’s business segments and related disclosures about its products, services, geographical areas and major customers. The Company has two operating segments: (1) products and services and (2) patent licensing. Products and services consist of sales of the Company’s electronic eVU mobile entertainment device and related content services and patent licensing consists of intellectual property revenues from the Flash-R patent portfolio.

Accounting policies for each of the operating segments are the same as on a consolidated basis.

 
10

 

Our reportable segment information for the three and nine months ended December 31, 2010 and 2009 is as follows:

   
For the three months ended
   
For the nine months ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
   
$
   
$
   
$
   
$
 
REVENUES:
                       
Products and services
    134,892       284,170       860,121       769,467  
Patent licensing
    5,778       -       31,042       1,250,000  
Total revenue
    140,670       284,170       891,163       2,019,467  
                                 
GROSS PROFIT:
                               
Products and services
    45,308       104,352       308,924       336,048  
Patent licensing
    -       -       -       807,000  
Total gross profit
    45,308       104,352       308,924       1,143,048  
                                 
RECONCILIATION:
                               
Total segment gross profit
    45,308       104,352       308,924       1,143,048  
Operating expenses
    (362,235 )     (688,763 )     (1,248,232 )     (1,722,506 )
Other income (expense)
    -       31,626       -       12,233  
Loss before income taxes
    (316,927 )     (552,785 )     (939,308 )     (567,225 )

The Company does not have significant assets employed in the patent license segment and does not track capital expenditures or assets by reportable segment. Consequently it is not practical to show this information.

Revenue by geographic region is determined based on the location of the Company’s direct customers or distributors for product sales and services. Patent license revenue is considered United States revenue as payments are for licenses for United States operations irrespective of the location of the licensee’s home domicile.

   
For the three months ended
 
For the nine months ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
   
$
 
$
 
$
 
$
 
United States
    5,778       77,600       31,042       1,327,600  
International
    134,892       206,570       860,121       691,867  
Total revenue
    140,670       284,170       891,163       2,019,467  

Revenues from three customers comprised 27%, 16% and 12% of revenue for the nine months ended December 31, 2010, with no other customer accounting for more than 10% of revenues. Revenues from two customers comprised 61% and 13% of revenue for the nine months ended December 31, 2009. Accounts receivable from three customers comprised 40%, 25% and 10% of net accounts receivable at December 31, 2010.

11. COMMITMENTS AND CONTINGENCIES

Legal Matters

Intellectual Property Litigation
In September 2007 and March 2008, the Company filed complaints against eight electronic product manufacturers in the U.S. District Court for the Eastern District of Texas asserting that products made by the companies infringe four of the Company's U.S. patents covering the use of flash memory technology. These patents are part of the Company’s Flash-R patent portfolio. By September 30, 2009 the Company had licensed and settled the litigation with seven of the manufacturers and suspended the complaint against one defendant in bankruptcy.

 
11

 
 
In November 2009 the Company filed an additional patent infringement complaint in the United States District Court for the District of Colorado against nineteen companies that manufacture devices using flash memory. By March 31, 2010 the Company had licensed and settled the litigation with three of the defendants.

Although most fees, costs and expenses of intellectual property litigation are covered under the Company’s arrangement with Duane Morris LLP as described below, the Company may incur support and related expenses for this litigation that may become material.

Commitment Related to Intellectual Property Legal Services
On March 23, 2007, the Company entered into an agreement for legal services and a contingent fee arrangement with Duane Morris LLP. The agreement provides that Duane Morris is the Company’s legal counsel in connection with the assertion of the Company’s flash memory related patents against infringers (“Patent Enforcement Matters’).

Duane Morris has agreed to handle the Company’s Patent Enforcement Matters and certain related appeals on a contingent fee basis. Duane Morris also has agreed to advance certain costs and expenses including travel expenses, court costs and expert fees. The Company has agreed to pay Duane Morris a fee equal to 40% of any license or litigation recovery related to Patent Enforcement Matters, after recovery of expenses, and 50% of recovery if appeal is necessary.

In the event the Company is acquired or sold or elects to sell the covered patents or upon certain other corporate events or in the event the Company terminates the agreement for any reason, then Duane Morris shall be entitled to collect accrued costs and a fee equal to three times overall time and expenses accrued in connection with the agreement and a fee of 15% of a good faith estimate of the overall value of the covered patents. Any such corporate event or termination fee will only be recorded if and when such applicable event becomes probable. The Company has provided Duane Morris a lien and a security interest in the covered patents to secure its obligations under the agreement.

Contract Manufacturers and Suppliers
At December 31, 2010, the Company had outstanding unfilled purchase orders and was committed to a contract manufacturer and component suppliers for approximately $14,181 of future deliveries.

Facility Lease
In March 2006, the Company entered into a sixty-two month lease, commencing June 1, 2006, for approximately 4,800 square feet with a current aggregate payment of $6,535 per month excluding utilities and costs. Future lease commitments aggregated $45,740 at December 31, 2010.

Concentration of Credit Risk and Sources of Supply
Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash and cash equivalents and trade receivables. The Company at December 31, 2010 had substantially all of its cash and cash equivalents at one financial institution in a non-interest bearing account. FDIC deposit insurance has changed to provide full deposit insurance coverage for non-interest bearing deposit transaction accounts through December 31, 2010.  The Company does not believe that it is subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships. The Company performs periodic evaluations of the relative credit standing of these financial institutions. The Company has not experienced any significant losses on its cash equivalents.

Concentrations of credit risk with respect to trade accounts receivable are limited due to the number and nature of customers comprising the Company’s customer base and their geographic dispersion. The Company has not incurred any significant credit related losses.

The Company relies on one third-party contract manufacturer to produce its eVU mobile entertainment product and generally relies on single suppliers for batteries, charging stations and other components. The Company also relies on one legal firm to represent it in patent licensing and enforcement matters.

Guarantees and Indemnifications
The Company enters into standard indemnification agreements in the ordinary course of business. Some of the Company’s product sales and services agreements include a limited indemnification provision for claims from third parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with ASC 450, Contingencies. The indemnification is generally limited to the amount paid by the customer. To date, there have been no claims under such indemnification provisions.

 
12

 

The Company provides a one-year limited warranty for most of its products.

12. INCOME TAXES
During the nine months ended December 31, 2010 the Company recorded a tax benefit of $3,479 reflecting refunds of prior taxes paid.  There was no other income tax provision or benefit for the three or nine months ended December 31, 2010 due to net operating losses.

At December 31, 2010, the Company had deferred tax assets associated with federal net operating losses (“NOLs”), related state NOLs, foreign tax credits and certain Federal and California research and development tax credits, but recorded a corresponding full valuation allowance as it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 
13

 

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

THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO THE COMPANY'S FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW. SEE ALSO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED MARCH 31, 2010.

Cautionary Note on Forward Looking Statements
In addition to the other information in this report, the factors listed below should be considered in evaluating our business and prospects.  This report contains a number of forward-looking statements that reflect our current views with respect to future events and financial performance.  These forward-looking statements are subject to certain risks and uncertainties, including those discussed below and elsewhere herein, that could cause actual results to differ materially from historical results or those anticipated.  In this report, the words “anticipates,” “believes,” “expects,” “intends,” “future” and similar expressions identify forward-looking statements.  Readers are cautioned to consider the specific factors described below and not to place undue reliance on the forward-looking statements contained herein, which speak only as of the date hereof.  We undertake no obligation to publicly revise these forward-looking statements, to reflect events or circumstances that may arise after the date hereof.

General
We are a holding company incorporated under the laws of Delaware that operates through a wholly-owned California subsidiary of the same name. We market our eVU mobile entertainment system for the travel and recreational industries and license and enforce our Flash-R portfolio of flash memory patents for use in portable devices produced by electronic product manufacturers.

With the inception of patent license revenue in September 2008, we determined that we have two operating segments: (1) products and services and (2) patent licensing and enforcement. Our products and services revenue is derived from the sale of eVU products and accessories to customers, warranty and technical support services and content integration fees and related services. Our patent licensing and enforcement revenue consists of intellectual property revenues from our Flash-R patent portfolio.

Our strategy is to market our eVU products and services to U.S. and international companies for use in the airline and other travel and leisure industries. We employ direct sales and sales through value added resellers (VARs) that provide marketing, logistic and/or content services to corporate customers.

We are commercializing our Flash-R patent portfolio through licensing and we are aggressively pursuing enforcement by litigating against targeted parties that we believe are infringing our patents. The international law firm of Duane Morris LLP is handling our patent enforcement matters on a contingent fee basis. During the period commencing September 2007 through March 2008, we filed complaints against eight electronic product manufacturers and subsequently licensed and settled the litigation with seven of the manufacturers and suspended the complaint against one defendant that filed for bankruptcy. In November 2009, we filed an additional patent infringement complaint against nineteen companies and we have subsequently licensed and settled with three companies. While we expect to file future complaints against additional companies and license additional companies there can be no assurance of the timing or amounts of any related license revenue.

Our business is high risk in nature. There can be no assurance we can achieve sufficient eVU or patent license revenues to sustain profitability. We continue to be subject to the risks normally associated with any new business activity, including unforeseeable expenses, delays and complications. Accordingly, there is no guarantee that we can or will report operating profits in future periods.

Overall Performance and Trends
We focused significant efforts on developing, licensing and enforcing our patent portfolio during the first nine months and during the fiscal years ended March 31, 2010 and 2009. We successfully completed our first round of enforcement litigation in September 2009 when we licensed the last of the remaining original defendants. In November 2009 we filed additional enforcement actions against nineteen defendants, licensed our first customer from the second round in December 2009 and by December 31, 2010 had licensed a total of three licensees from the second round. There is a reluctance of patent infringers to negotiate and ultimately take a patent license without at least the threat of legal action. However, the majority of patent infringement contentions settle out of court, based on the strength of the patent claims, validity, and persuasive evidence and clarity that the patent is being infringed. We believe we are building a track record of demonstrating the strength, validity and clarity of our patent claims that could result in significant future revenues from our patent portfolio.

 
14

 

We are proceeding toward trial on the remaining sixteen defendants. A Markman hearing (patent claims construction hearing) for our second round enforcement action was held January 28, 2011. In related enforcement developments the United States Patent and Trademark Office (“USPTO”) granted a Request for Ex Parte Reexamination of our U.S. Patent No. 5,491,774 (the “‘774 patent”) related to a handheld record and playback device with flash memory. During the reexamination process, the USPTO will review the patent and could determine that the patent claims, as written, were properly allowed. This determination would assist us in defending challenges to the validity of the ‘774 patent. Alternatively, the USPTO could narrow or reject certain or all of the claims of the ‘774 patent. Depending upon the specifics of what narrowing amendments are required and the claims rejected, these determinations of the USPTO could have a material adverse impact on our results of operations. The timing of the USPTO’s completion of the reexamination is uncertain. We believe that the USPTO should reconfirm the validity of the ‘774 patent. However, there can be no guarantee as to the outcome.

We recently reorganized personnel and consultants and we are developing several new technologies in the areas of communication networks and digital data distribution. These efforts are in the early stage of development and our intent is to seek strategic relationships for these technologies. There can be no assurance we can exploit these new innovations in future periods.

Our eVU in-flight entertainment (“IFE”) business has remained slow due to airline economics. While we are seeing continued interest from existing and new customers, we are unable to predict future sales levels in this market as orders have been are expected to remain sporadic in the future. As a leading producer of dedicated portable IFE products we continue to respond to inquiries and pursue new business in the airline and other markets for our eVU product line.

Management faces challenges for the remainder of fiscal 2011 to execute its plan to grow product and service revenues and increase Flash-R patent portfolio license fees. We are in the early stages of licensing our patents and only recently filed additional infringement claims as described above and in Part II, Item 1 “Legal Proceedings” below. While we expect additional patent licenses in future periods there can be no assurance of the timing or amounts of any such license revenue. The failure to obtain additional patent license revenues or eVU orders or delays of orders or production delays could have a material adverse impact on our operations. Our patent licensing business is subject to significant uncertainties as to the timing and amount of future license revenues, if any. We may also face unanticipated technical or manufacturing obstacles as well as warranty and other risks in our business.

For the nine months ended December 31, 2010 we recognized a net loss before income taxes of $939,308 compared to a net loss before income taxes of $567,225 for the comparable period of the prior fiscal year. Our revenues were $891,163 for the first nine months of fiscal 2011 with $31,042 of patent license revenue. This compares to $2,019,467 for the prior year’s first nine months with $1,250,000 of patent license revenue reported. We reported reduced operating expenses totaling $1,248,232 in the nine months ended December 31, 2010 compared to $1,722,506 in the comparable period prior primarily due to reduced legal fees for litigation concluded in the prior year.

Our monthly cash operating costs average approximately $125,000 per month. However, we may increase expenditure levels in future periods to support and expand our revenue opportunities and continue advanced product and technology research and development. Our quarterly results are highly dependent on the timing and amount of licensing fees and accordingly quarterly results can vary dramatically from period to period. As a result of this and other factors, past results and expenditure levels may not be indicative of future quarters. We have incurred losses and negative cash flow from operations during fiscal 2010 and the first half of fiscal 2011. We expect to incur losses in the future until product, service and/or licensing revenues are sufficient to sustain continued profitability. Our ability to continue as a going concern is in doubt and is dependent upon achieving a profitable level of operations and if necessary obtaining additional financing.

 
15

 

Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements located in Item 1 of Part I, “Financial Statements,” and in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report of Form 10-K for the year ended March 31, 2010. The preparation of these financial statements prepared in accordance with accounting principles generally accepted in the United States requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates, including but not limited to those related to revenue recognition, bad debts, inventory valuation, intangible assets, financing operations, warranty obligations, stock-based compensation, fair values, derivatives, income taxes, contingencies and litigation.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

We believe that, of the significant accounting policies discussed in our consolidated financial statements, the following accounting policies require our most difficult, subjective or complex judgments:

 
·
revenue recognition;
 
·
estimates and allowances (primarily doubtful accounts and inventory obsolescence);
 
·
stock-based compensation expense; and
 
·
income taxes.

Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results. There were no significant changes or modification of our critical accounting policies and estimates involving management valuation adjustments affecting our results for the nine months ended December 31, 2010. For further information on our critical accounting policies, refer to Note 2 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended March 31, 2010.

Results of Operations

Three months ended December 31, 2010 compared to the three months ended December 31, 2009

   
Three Months Ended December 31,
             
   
2010
         
2009
                   
         
% of
         
% of
   
Change
 
   
Dollars
   
Revenue
   
Dollars
   
Revenue
   
Dollars
   
%
 
Revenues:
                                   
Products
    8,253       6 %     106,570       38 %     (98,317 )     (92 )%
Services
    126,639       90 %     177,600       62 %     (50,961 )     (29 )%
Patent license
    5,778       4 %     -       0 %     5,778          
      140,670       100 %     284,170       100 %     (143,500 )     (50 )%
Gross Profit:
                                               
Product gross profit (loss)
    (6,511 )     (5 )%     9,940       3 %     (16,451 )     (166 )%
Service gross profit
    51,819       37 %     94,412       33 %     (42,593 )     (45 )%
Patent license
    -       0 %     -       0 %     -          
      45,308       32 %     104,352       37 %     (59,044 )     (57 )%
Operating Expenses:
                                               
Selling and administrative
    280,582       199 %     558,600       197 %     (278,018 )     (50 )%
Research and related
    81,653       58 %     130,163       46 %     (48,510 )     (37 )%
      362,235       258 %     688,763       242 %     (326,528 )     (47 )%
Other expense
    -       0 %     31,626       11 %     (31,626 )     (100 )%
Loss before income taxes
    (316,927 )     (225 )%     (552,785 )     (195 )%     235,858       (43 )%

Loss Before Income Taxes
The loss before income taxes resulted primarily from limited product and service sales and margins insufficient to cover reduced operating expenses compared to the comparable quarter of the prior year.

 
16

 

Revenues
Revenues decreased during third fiscal quarter of 2011 compared to the same quarter of the prior fiscal year due to reduced product and service revenues due to no significant new customers on service revenue which varies significantly from customer to customer and quarter to quarter. eVU product sales activity has been slow and sporadic due to airline industry economics, with airlines curtailing expansion and new projects. Our product sales in the second quarter are not necessarily indicative of future orders and we had no significant product backlog at December 31, 2010. Our service arrangements and terms vary with each customer and there is no assurance in the current airline environment that our service revenues will continue at comparable levels for the balance of the fiscal year or in future periods.

We have an outstanding complaint against sixteen additional electronics manufacturers, and while we expect additional patent licenses from these and other companies in future periods, there can be no assurance of the timing or amounts of future patent license revenue. We are pursuing new eVU and other technology business but our results will continue to be dependent on the timing and quantity of eVU orders and the timing and amount of any patent licensing arrangements.

Gross Profit
Gross profit for the third quarter of fiscal 2011 was $45,308 or 32% of revenues. The gross profit for the prior year’s third quarter was $104,352 or 37% of revenues due to fixed costs being absorbed by lower revenues. Our margin on service declined from 53% to 41% due to repair and content mix. Gross profit margins are highly dependent on revenue mix, prices charged, volume of orders, and for periods with patent licensing revenues the amounts of contingency legal fees and costs.

Operating Expenses
Selling and administrative costs for the three months ended December 31, 2010 declined by $278,018 compared to the same period in the year prior. The current period included a $266 expense for noncash stock-based compensation expense compared to $109,891 for the prior year’s third quarter as a result of granting immediately vested stock options. Reduced current period selling and administrative expenses included $91,000 of reduced professional fees resulting primarily from reduced tax related consulting costs incurred in the prior year’s third quarter. In the prior year’s third quarter we also incurred $57,500 of annual meeting costs with no comparable costs incurred in the most recent quarter.

Research and related expenses in the most recent quarter included $4,330 of noncash stock-based compensation costs compared to $19,446 in the prior year third quarter. Research and related expenses decreased $48,510 due to reduced staffing costs and more allocation of dual use personnel to service revenue work. Research and related expenses can vary significantly from quarter to quarter based on the allocation of time spent by personnel who work on both revenue producing service and repair projects and on internal research projects. Such expenses also vary based on decisions made regarding outside engineering and consulting.

Other Income (Expense)
We had no other income or expenses in the current period compared to $31,626 of net other income for the prior year’s third quarter including a foreign exchange gain of $10,391 and $20,000 of other income from a favorable litigation settlement.

Income Taxes
We had a $3,479 tax benefit for the current period from state refunds and the prior year’s third quarter included a foreign tax benefit of $237,500 resulted from foreign taxes refunded.

Loss Attributable to Common Stockholders
The loss attributable to common stockholders equaled the net loss after taxes of $313,448. The net loss after tax for the prior comparable third quarter was $315,285 decreased by accrued and deemed dividends of $45,387 for net loss attributable to common stockholders of $360,672. Since all shares of Series AA Stock were converted into common at June 30, 2010 we had no Series AA dividends or accretion in the third quarter and will have no further dividends or accretion in future quarters.

 
17

 

Nine months ended December 31, 2010 compared to the nine months ended December 31, 2009

   
Nine Months Ended December 31,
             
   
2010
         
2009
                   
         
% of
         
% of
   
Change
 
   
Dollars
   
Revenue
   
Dollars
   
Revenue
   
Dollars
   
%
 
Revenues:
                                   
Product revenues
    361,080       41 %     164,085       8 %     196,995       120 %
Service revenues
    499,041       56 %     605,382       30 %     (106,341 )     (18 )%
Patent license
    31,042       3 %     1,250,000       62 %     (1,218,958 )     (98 )%
      891,163       100 %     2,019,467       100 %     (1,128,304 )     (56 )%
Gross Profit:
                                               
Product gross profit
    69,635       8 %     (9,338 )     0 %     78,973       (846 )%
Service gross profit
    239,289       27 %     345,386       17 %     (106,097 )     (31 )%
Patent license gross profit
    -       0 %     807,000       40 %     (807,000 )     (100 )%
      308,924       35 %     1,143,048       57 %     (834,124 )     (73 )%
Operating Expenses:
                                               
Selling and administrative
    920,495       103 %     1,386,013       69 %     (465,518 )     (34 )%
Research and related
    327,737       37 %     336,493       17 %     (8,756 )     (3 )%
      1,248,232       140 %     1,722,506       85 %     (474,274 )     (28 )%
Other expense
    -       0 %     12,233       1 %     (12,233 )     (100 )%
Loss before income taxes
    (939,308 )     (105 )%     (567,225 )     (28 )%     (372,083 )     66 %

Loss Before Income Taxes
The loss before income taxes of $939,308 resulted primarily from limited patent license revenue in the most recent quarter and product sales and margins insufficient to cover reduced operating expenses compared to the comparable nine months of the prior year which included $1,250,000 of patent license revenue.

Revenues
Revenues decreased during the most recent nine months compared to the comparable period of the prior year due to the decrease in patent license revenue from $1,250,000 to $31,042. We currently have two licensees reporting periodic royalties with all other royalties including the $1,250,000 in the prior year being one time fully paid up royalties. We cannot predict future license revenue from existing license agreements providing for periodic future payments tied to licensee activity. Product revenues increased $196,995 due to increased first quarter product sales. Service revenues declined $106,341 and vary depending on repair and content services provided to a changing customer mix. eVU product sales activity has been slow and sporadic due to airline industry economics with airlines curtailing expansion and new projects. Our product sales for the first nine months are not necessarily indicative of future orders and we had no significant product backlog at December 31, 2010. Our service arrangements and terms vary with each customer and there is no assurance in the current airline environment that our service revenues will continue at comparable levels for the balance of the fiscal year or in future periods.

We have an outstanding complaint against sixteen additional electronics manufacturers, and while we expect additional patent licenses from these and other companies in future periods, there can be no assurance of the timing or amounts of future patent license revenue. We are pursuing new eVU and other technology business but our results will continue to be dependent on the timing and quantity of eVU orders and the timing and amount of any patent licensing arrangements.

Gross Profit
Gross profit for the nine months ended December 31, 2010 was $308,924 or 35% of revenues.  The gross profit for the prior year’s first nine months was $1,143,048 or 57% of revenues including $807,000 of margin from patent licensing. While our margin on service declined from 57% to 48% due to repair and content mix, our product gross margin was positive compared to the prior year. Gross profit margins are highly dependent on revenue mix, prices charged, volume of orders, and for periods with patent licensing revenues the amounts of contingency legal fees and costs.

 
18

 

Operating Expenses
Selling and administrative costs for the nine months ended December 31, 2010 declined by $465,518 compared to the same period in the year prior. The current period included a $78,066 expense for noncash stock-based compensation expense compared to $127,180 for the prior year’s first nine months. Reduced current period selling and administrative expenses included $300,000 of reduced professional fees primarily due to reduced business litigation costs as a result of the favorable outcome of the digEcor litigation reported last year and a reduction in tax consulting costs from those incurred in the prior year related to foreign taxes. Shareholder costs reduced by $69,000 primarily as an annual meeting was held last fiscal year with no comparable expenses incurred so far this fiscal year.

Research and related expenses in the most recent nine month period ended December 31, 2010 included $26,694 of noncash stock-based compensation costs compared to $20,483 in the prior year. Research and related expenses included $6,000 of increased consulting costs primarily associated with new projects offset by $14,000 of reduced travel costs. Research and related expenses can vary significantly from quarter to quarter based on the allocation of time spent by personnel who work on both revenue producing service and repair projects and on internal research projects. Such expenses also vary based on decisions made regarding outside engineering and consulting.

Other Income (Expense)
We had no other income or expenses in the current nine month period ended December 31, 2010 compared to net other income of $12,233 for the nine months ended December 31, 2009 included a foreign exchange gain of $9,332 and $20,000 of other income from a favorable litigation settlement reduced by interest expense of $17,099 (including $16,772 of noncash interest expense).

Income Taxes
We had a $3,479 tax benefit for the current period from state refunds and in the prior year period we had the income tax benefit of $31,250 included a refund of foreign taxes paid in the prior year offset by foreign taxes paid on current year patent license revenue.

Loss Attributable to Common Stockholders
The loss attributable to common stockholders was $967,225 equal to the net loss after taxes of $935,829 increased by accrued and deemed dividends of $31,396. The net loss attributable to common stockholders for the prior comparable nine month period was $680,063 including accrued and deemed dividends of $144,088. Since all shares of Series AA Stock were converted into common stock at June 30, 2010 we will not have further Series AA dividends or accretion in future quarters.

Liquidity and Capital Resources
At December 31, 2010, we had working capital of $2,139,318 compared to a working capital of $2,965,681 at March 31, 2010. At December 31, 2010 we had cash on hand of $1,931,824.

Operating Activities
Cash used in operating activities was $884,127 for the nine months ended December 31, 2010. Cash used in operating activities included the net loss of $935,829 reduced by net non-cash expenses of $125,973. Major components also providing operating cash was a decrease of $57,109 in inventory and an increase of $47,111 in accounts payable. Major components using operating cash included a $205,347 reduction in accrued and other liabilities including a reduction of $153,743 reduction in deferred revenue and customer deposits at March 31, 2010 that converted into revenue during the nine months ended September 30, 2010.

Cash used in operating activities during the nine months ended December 31, 2009 was $925,947 with the usage including a $118,885 increase in accounts receivable. Our terms to customers vary but we often require payment prior to shipment of product and any such payments are recorded as deposits. Patent license payments are normally due at signing of the license or within 30-45 days of settlement or end of royalty reporting period.

Individual working capital components can change dramatically from period to period due to timing of sales and shipments and corresponding receivable, inventory and payable balances. Accordingly operating cash requirements vary significantly from period to period.

 
19

 

Investing Activities
The Company’s efforts are primarily on operations and currently we have no significant investing capital needs. We have no commitments requiring investment capital.

Financing Activities
There were no cash financing activities during the nine months ended December 31, 2010. For the nine months ended December 31, 2009 we paid $47,865 as the final payment on our term debt. On June 30, 2010 a total of $605,226 of preferred stock automatically converted to common stock with no cash impact.

Debt and Other Commitments
We currently have no debt outstanding other than trade payables and accruals. At December 31, 2010 we were committed to $14,181 as purchase commitments for product and components. These orders are generally subject to modification as to timing, quantities and scheduling and in certain instances may be cancelable without penalty.

We are also committed for our office lease as more fully described in our interim consolidated financial statements.

Our legal firm Duane Morris is handling patent enforcement matters and certain related appeals on our Flash-R patent portfolio on a contingent fee basis. Duane Morris also has agreed to advance certain costs and expenses including travel expenses, court costs and expert fees. We have agreed to pay Duane Morris a fee equal to 40% of any license or litigation recovery related to patent enforcement matters, after recovery of expenses, and 50% of recovery if appeal is necessary.

In the event we are acquired or sold or elect to sell the covered patents or upon certain other corporate events or in the event we terminate the agreement for any reason, then Duane Morris shall be entitled to collect accrued costs and a fee equal to three times overall time and expenses accrued in connection with the agreement and a fee of 15% of a good faith estimate of the overall value of the covered patents. Duane Morris has a lien and a security interest in the covered patents to secure its obligations under the agreement.

Cash Requirements
Other than cash on hand and accounts receivable, we have no material unused sources of liquidity at this time.  Based on our cash position at December 31, 2010 and current planned expenditures and level of operation, we believe we have sufficient capital resources for the next twelve months. Actual results could differ significantly from management plans. We believe we may be able to obtain additional funds from future patent licensing and eVU product sales and services but the timing of licenses and shipments and the amount and quantities of shipments, orders and reorders are subject to many factors and risks, many outside our control. We may incur significant legal fees related to the reexamination of patent ‘774 but management has not yet determined an estimate of such costs.

Since we have not demonstrated sustainable profitability, our company’s ability to continue as a going concern is in doubt and is dependent upon achieving sustained profitability and if necessary obtaining additional financing. We currently have no plans, arrangements or understandings regarding any acquisitions.

Item 4. Controls and Procedures
Based on an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) as of December 31, 2010, our Chief Executive Officer and Principal Accounting Officer have concluded that our disclosure controls and procedures were effective at the reasonable assurance level in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission's rules and forms.

In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the relationship between the benefit of desired controls and procedures and the cost of implementing new controls and procedures.

 
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CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
In connection with the preparation of our annual financial statements, our management performed an assessment of the effectiveness of internal control over financial reporting as of March 31, 2010. Management's assessment included an evaluation of the design of our internal control over financial reporting and testing of the operational effectiveness of those controls. Based on this evaluation, management determined that, as of March 31, 2010, there was a material weakness in our internal control over financial reporting: the lack of independent oversight by an audit committee of independent members of the Board of Directors. In light of this material weakness, management concluded that, as of March 31, 2010, we did not maintain effective internal control over financial reporting.

During our fiscal quarter ended December 31, 2010 we remediated the control deficiency by changing members of our audit committee such that it is now comprised of two members of the Board of Directors (Renee Warden and Allen Cocumelli) that we believe to be independent as defined under the NASDAQ Stock Market rules and Rule 10A-3 of the Securities Exchange Act of 1934. Allen Cocumelli as Chairman of our Board of Directors, is technically considered as an executive officer under our bylaws. However, we do not believe that he meets the definition of an “executive officer” under Rule 16a-1(f) of the Securities Exchange Act of 1934 in that he does not perform any policy-making functions for our Company, nor is he compensated for this position. Ms. Warden has been designated as the “Audit Committee Financial Expert,” as defined by Regulation S-K.

Our process for evaluating controls and procedures is continuous and encompasses constant improvement of the design and effectiveness of established controls and procedures and the remediation of any deficiencies which may be identified during this process.

PART II.
OTHER INFORMATION

Item 1. Legal Proceedings

Intellectual Property Litigation
During the period commencing September 2007 through and including March 2008, we filed complaints against eight electronic product manufacturers in the U.S. District Court for the Eastern District of Texas asserting that products made by the companies infringe four of our U.S. patents covering the use of flash memory technology. These patents are part of our Flash-R patent portfolio. By September 30, 2009 we had licensed and settled the litigation with seven of the manufacturers and suspended the complaint against one defendant currently in bankruptcy.

In November 2009, we filed an additional patent infringement complaint in the United States District Court for the District of Colorado against nineteen companies that manufacture devices using flash memory. Subsequently we have licensed and settled with three of the defendants.

We are proceeding toward trial on the remaining sixteen defendants. A Markman hearing (patent claims construction hearing) for our second round enforcement action was held January 28, 2011. In related enforcement developments the United States Patent and Trademark Office (“USPTO”) granted a Request for Ex Parte Reexamination of our U.S. Patent No. 5,491,774 (the “‘774 patent”) related to a handheld record and playback device with flash memory. During the reexamination process, the USPTO will review the patent and could determine that the patent claims, as written, were properly allowed. This determination would assist us in defending challenges to the validity of the ‘774 patent. Alternatively, the USPTO could narrow or reject certain or all of the claims of the ‘774 patent. Depending upon the specifics of what narrowing amendments are required and the claims rejected, these determinations of the USPTO could have a material adverse impact on our results of operations. The timing of the USPTO’s completion of the reexamination is uncertain. We believe that the USPTO should reconfirm the validity of the ‘774 patent. However, there can be no guarantee as to the outcome.

Although most fees, costs and expenses of the litigation are covered under our arrangement with Duane Morris LLP, we may incur support and related expenses for this litigation that may become material. This includes fees we may incur related to the reexamination of the ‘774 patent described above.

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

 
(a)
NONE
 
(b)
NONE
 
(c)
NONE

Item 3. Defaults Upon Senior Securities

NONE

Item 4. (Removed and Reserved)

Item 5. Other Information

(a) NONE
(b) NONE

Item 6. Exhibits

Exhibit 31.1 – Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by Alfred H. Falk, President and CEO (Principal Executive Officer).

Exhibit 31.2 – Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, signed by MarDee Haring-Layton (Principal Accounting Officer).

Exhibit 32.1 – Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Alfred H. Falk, President and CEO (Principal Executive Officer) and MarDee Haring-Layton (Principal Accounting Officer).

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.

 
e.DIGITAL CORPORATION
     
 
By:  
/s/ ALFRED H. FALK
   
Alfred H. Falk, President and Chief Executive Officer
     
 
By:
/s/ MARDEE HARING-LAYTON
   
MarDee Haring-Layton, Principal Accounting Officer

Date:
February 3, 2011
 
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