Edgar Filing: AWARE INC /MA/

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

FORM 10-Q

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

FOR THE QUARTER ENDED MARCH 31, 2005

COMMISSION FILE NUMBER 000-21129

AWARE, INC.
(Exact Name of Registrant as Specified in Its Charter)

MASSACHUSETTS 04-2911026
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)

40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
(Address of Principal Executive Offices)
(Zip Code)

(781) 276-4000
(Registrant's Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2). YES __X__ NO _____

Indicate the number of shares outstanding of the issuer's common stock as of
April 29, 2005:

CLASS NUMBER OF SHARES OUTSTANDING
----- ----------------------------
Common Stock, par value $0.01 per share 22,992,688 shares

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AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2005

TABLE OF CONTENTS

Page
----
PART I FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Consolidated Balance Sheets as of
March 31, 2005 and December 31, 2004.......................... 3

Consolidated Statements of Operations for the
Three Months Ended March 31, 2005
and March 31, 2004............................................ 4

Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2005
and March 31, 2004............................................ 5

Notes to Consolidated Financial Statements.................... 6

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................... 10

Item 3. Quantitative and Qualitative Disclosures about
Market Risk................................................... 21

Item 4. Controls and Procedures....................................... 22

PART II OTHER INFORMATION

Item 1. Legal Proceedings............................................. 23

Item 6. Exhibits...................................................... 24

Signatures.................................................... 24

PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)

MARCH 31, DECEMBER 31,
2005 2004
----------------- -----------------

ASSETS
Current assets:
Cash and cash equivalents................................................ $9,994 $7,482
Short-term investments................................................... 28,843 27,483
Accounts receivable, net................................................. 3,314 3,070
Inventories.............................................................. 124 143
Prepaid expenses and other assets........................................ 498 417
----------------- -----------------
Total current assets 42,773 38,595
----------------- -----------------

Property and equipment, net................................................... 8,196 8,287
Investments................................................................... - 3,301
----------------- -----------------
Total assets....................................................... $50,969 $50,183
================= =================

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable........................................................ $562 $361
Accrued expenses ........................................................ 164 157
Accrued compensation .................................................... 824 625
Accrued professional..................................................... 156 169
Deferred revenue......................................................... 572 115
----------------- -----------------
Total current liabilities........................................ 2,278 1,427
----------------- -----------------

Stockholders' equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding.................................................
Common stock, $.01 par value; 70,000,000 shares authorized; issued
and outstanding, 22,987,531 in 2005 and 22,908,918 in 2004........ 230 229
Additional paid-in capital.............................................. 78,130 77,882
Accumulated deficit..................................................... (29,669) (29,355)
----------------- -----------------
Total stockholders' equity........................................ 48,691 48,756
----------------- -----------------
Total liabilities and stockholders' equity........................ $50,969 $50,183
================= =================

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

THREE MONTHS ENDED
MARCH 31,
------------------------------------
2005 2004
----------------- ----------------

Revenue:
Product sales................................................. $961 $1,223
Contract revenue.............................................. 2,163 1,278
Royalties..................................................... 1,100 1,101
----------------- ----------------
Total revenue 4,224 3,602

Costs and expenses:
Cost of product sales......................................... 60 337
Cost of contract revenue...................................... 840 667
Research and development...................................... 2,553 2,671
Selling and marketing......................................... 633 604
General and administrative.................................... 669 593
----------------- ----------------
Total costs and expenses 4,755 4,872

Loss from operations.............................................. (531) (1,270)
Interest income................................................... 217 123
----------------- ----------------

Loss before provision for income taxes............................ (314) (1,147)
Provision for income taxes........................................ - -
----------------- ----------------

Net loss.......................................................... ($314) ($1,147)
================= ================

Net loss per share - basic and diluted ........................... ($0.01) ($0.05)

Weighted average shares - basic and diluted....................... 22,943 22,751

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

THREE MONTHS ENDED
MARCH 31,
-----------------------------------
2005 2004
---------------- -----------------

Cash flows from operating activities:
Net loss................................................... ($314) ($1,147)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization............................. 150 291
Increase (decrease) from changes in assets and liabilities:
Accounts receivable.................................. (244) 294
Inventories.......................................... 19 (43)
Prepaid expenses..................................... (81) (33)
Accounts payable..................................... 201 468
Accrued expenses..................................... 193 218
Deferred revenue..................................... 457 (197)
---------------- -----------------
Net cash provided by (used in) operating
activities..................................... 381 (149)
---------------- -----------------

Cash flows from investing activities:
Purchases of property and equipment....................... (59) (25)
Sales of investments...................................... 8,309 12,214
Purchases of investments.................................. (6,368) (10,254)
---------------- -----------------
Net cash provided by investing activities......... 1,882 1,935
---------------- -----------------

Cash flows from financing activities:
Proceeds from issuance of common stock................... 249 15
---------------- -----------------
Net cash provided by financing activities......... 249 15
---------------- -----------------

Increase in cash and cash equivalents......................... 2,512 1,801
Cash and cash equivalents, beginning of period................ 7,482 2,304
---------------- -----------------

Cash and cash equivalents, end of period...................... $9,994 $4,105
================ =================

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

A) BASIS OF PRESENTATION

The accompanying unaudited consolidated balance sheet, statements of
operations, and statements of cash flows reflect all adjustments
(consisting only of normal recurring items) which are, in the opinion of
management, necessary for a fair presentation of financial position at
March 31, 2005, and of operations and cash flows for the interim periods
ended March 31, 2005 and 2004.

The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instructions for Form 10-Q and therefore
do not include all information and footnotes necessary for a complete
presentation of our financial position, results of operations and cash
flows, in conformity with generally accepted accounting principles. We
filed audited financial statements which included all information and
footnotes necessary for such presentation for the three years ended
December 31, 2004 in conjunction with our 2004 Annual Report on Form
10-K.

Auction rate securities in the amount of $17.2 million at December 31,
2003 and $17.8 million at March 31, 2004 have been reclassified from
cash and cash equivalents to short-term investments in the statement of
cash flows for the three months ended March 31, 2004 to conform to the
2005 financial statement presentation. Accordingly, the statement of
cash flows for the quarter ended March 31, 2004 reflects the gross
purchases and sales of these securities as investing activities rather
than as a component of cash and cash equivalents.

The results of operations for the interim period ended March 31, 2005
are not necessarily indicative of the results to be expected for the
year.

B) INVENTORY

Inventory consists primarily of the following (in thousands):

MARCH 31, DECEMBER 31,
2005 2004
--------------- ---------------
Raw materials............. $124 $143
=============== ===============

C) COMPUTATION OF EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income or loss by
the weighted average number of common shares outstanding. Diluted
earnings per share is computed by dividing net income or loss by the
weighted average number of common shares outstanding plus additional
common shares that would have been outstanding if dilutive potential
common shares had been issued. For the purposes of this calculation,
stock options are considered common stock equivalents in periods in
which they have a dilutive effect. Stock options that are anti-dilutive
are excluded from the calculation.

Net income or loss per share is calculated as follows (in thousands,
except per share data):

THREE MONTHS ENDED
MARCH 31,
-------------------------------
2005 2004
---------------- --------------

Net loss........................................... ($314) ($1,147)

Weighted average common shares outstanding......... 22,943 22,751
Additional dilutive common stock equivalents....... - -
---------------- --------------
Diluted shares outstanding ........................ 22,943 22,751
================ ==============

Net loss per share - basic......................... ($0.01) ($0.05)
Net loss per share - diluted....................... ($0.01) ($0.05)

For the three month periods ended March 31, 2005 and 2004, potential
common stock equivalents of 1,709,750 and 434,263, respectively, were
not included in the per share calculation for diluted EPS, because we
had net losses and the effect of their inclusion would be anti-dilutive.
For the three month periods ended March 31, 2005 and 2004, options to
purchase 1,880,917 and 263,075 shares of common stock, respectively,
were outstanding, but were not included in the computation of diluted
EPS because the options' exercise prices were greater than the average
market price of the common stock and thus would be anti-dilutive.

D) STOCK-BASED COMPENSATION

We grant stock options to our employees and directors. Such grants are
for a fixed number of shares with an exercise price equal to the fair
value of the shares at the date of grant. As permitted by SFAS No. 123,
"Accounting for Stock-Based Compensation", we account for stock option
grants in accordance with Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees" and FASB
Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions
Involving Stock Compensation." Accordingly, we have adopted the
provisions of SFAS No. 123 through disclosure only.

No stock-based employee compensation cost is reflected in our net loss,
as all options granted under those plans had an exercise price equal to
the fair market value of the

underlying common stock on the date of grant. The following table
illustrates the pro forma effect on net loss and earnings per share if
we had applied the fair value recognition provisions of SFAS No. 123 and
SFAS No. 148 to stock-based employee compensation (in thousands, except
per share data):

THREE MONTHS ENDED
MARCH 31,
-----------------------------
2005 2004
-----------------------------

Net loss - as reported................................... ($314) ($1,147)
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards.......................................... 7,736 3,437
-----------------------------
Net loss - pro forma..................................... ($8,050) ($4,584)
=============================

Basic loss per share - as reported....................... ($0.01) ($0.05)
Basic loss per share - pro forma......................... ($0.35) ($0.20)

Diluted loss per share - as reported..................... ($0.01) ($0.05)
Diluted loss per share - pro forma....................... ($0.35) ($0.20)

The fair value of options on their grant date was measured using the
Black-Scholes option pricing model. Key assumptions used to apply this
pricing model are as follows:

THREE MONTHS ENDED
MARCH 31,
-----------------------------
2005 2004
-----------------------------

Average risk-free interest rate.......................... 3.88% 2.99%
Expected life of option grants........................... 5 years 5 years
Expected volatility of underlying stock.................. 87% 95%
Expected dividend yield.................................. - -

E) BUSINESS SEGMENTS

The Company organizes itself as one segment and conducts its operations
in the United States.

The Company sells its products and technology to domestic and
international customers. Revenues were generated from the following
geographic regions (in thousands):

THREE MONTHS ENDED
MARCH 31,
-----------------------------
2005 2004
-----------------------------

United States............................................ $2,025 $2,037
Germany.................................................. 1,180 1,240
Rest of World............................................ 1,019 325
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$4,224 $3,602
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F) RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standard No. 123 (revised
2004), Share-Based Payment ("SFAS 123R"). This Statement is a revision
to SFAS 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, and supersedes APB
Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. SFAS 123R
requires the measurement of the cost of employee services received in
exchange for an award of equity instruments based on the grant-date fair
value of the award. The cost will be recognized over the period during
which an employee is required to provide service in exchange for the
award. No compensation cost is recognized for equity instruments for
which employees do not render service. The planned effective date of
SFAS 123R was to be the first interim or annual reporting period that
began after June 15, 2005. In April 2005, the effective date was
extended for calendar year companies until January 1, 2006. We expect
that the adoption of SFAS 123R will have a significant impact on our
results of operations. We do not expect the adoption of SFAS 123R to
impact our overall financial position.

ITEM 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995

SOME OF THE INFORMATION IN THIS FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-Q, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-Q COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS.

RESULTS OF OPERATIONS

PRODUCT SALES. Product sales consist primarily of revenue from the sale
of hardware and software products. Hardware products include ADSL test and
development systems, modules, and modems. Software products consist of standard
off-the-shelf software products for biometric, medical imaging and digital
imaging applications, as well as DSL test and diagnostics software.

Product sales decreased 21% from $1.2 million in the first quarter of 2004 to
$1.0 million in the current year quarter. As a percentage of total revenue,
product sales decreased from 34% in the first quarter of 2004 to 23% in the
current year quarter. The dollar decrease was due to a $0.5 million decrease in
revenue from the sale of hardware products which was partially offset by a $0.3
million increase in revenue from the sale of software products.

CONTRACT REVENUE. Contract revenue consists primarily of license and
engineering service fees that we receive under agreements with our customers to
develop ADSL (including ADSL2, ADSL2plus or VDSL2) chipsets.

Contract revenue increased 69% from $1.3 million in the first quarter of 2004 to
$2.2 million in the current year quarter. As a percentage of total revenue,
contract revenue increased from 35% in the first quarter of 2004 to 51% in the
current year quarter. The dollar increase was from new agreements with existing
and new customers.

Both existing and prospective ADSL chipset licensees continue to be reluctant to
begin new development projects given: (i) generally weak worldwide economic
conditions, (ii) a difficult and uncertain environment in the semiconductor and
telecommunications industries, and (iii) intense ADSL chipset competition and
falling chipset prices. During the last several years, customers and potential
customers cautiously evaluated new chipset projects or delayed or cancelled
projects in the face of such conditions.

ROYALTIES. Royalties consist of royalty payments that we receive under
licensing agreements. We receive royalties from customers for the right to use
our technology in their chipsets or solutions.

Royalties were $1.1 million in the first quarter of 2004 and in the current year
quarter. As a percentage of total revenue, royalties decreased from 31% in the
first quarter of 2004 to 26% in the current year quarter.

Our royalty revenue comes predominantly from ADSL chipset sales by Analog
Devices, Inc. ("ADI"), and Infineon Technologies AG ("Infineon"). Despite steady
growth of worldwide ADSL subscribers over the last several years, the
availability of ADSL chipsets from a number of suppliers and intense competition
among those suppliers has caused chipset prices to steadily decline. We are
uncertain how quickly sales of our customers' chipsets will increase and whether
such increases will contribute meaningful royalties to us.

COST OF PRODUCT SALES. Since the cost of software product sales is
minimal, cost of product sales consists primarily of the cost of hardware
product sales. Cost of product sales decreased 82% from $337,000 in the first
quarter of 2004 to $60,000 in the current year quarter. As a percentage of
product sales, cost of product sales decreased from 28% in the first quarter of
2004 to 6% in the current year quarter. The dollar decrease in cost of product
sales was due to lower sales of hardware modules. The overall dollar and
percentage increases in product margins were primarily due to a larger
proportion of software sales in the product sales revenue mix.

COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily of
salaries for engineers and expenses for consultants, technology licensing fees,
recruiting, supplies, equipment, depreciation and facilities associated with
customer development projects. Our total engineering costs are allocated between
cost of contract revenue and research and development expense. In a given
period, the allocation of engineering costs between cost of contract revenue and
research and development is a function of the level of effort expended on each.

Cost of contract revenue increased 26% from $0.7 million in the first quarter of
2004 to $0.8 million in the current year quarter. As a percentage of contract
revenue, cost of contract revenue decreased from 52% in the first quarter of
2004 to 39% in the current year quarter. The dollar increase in cost of contract
revenue was primarily due to more customer projects in the first quarter of 2005
as compared with the first quarter of 2004. Since our cost of contract revenue
is based on the level of effort we expend on customer projects and the number of
customer projects increased in the first quarter of 2005, cost of contract
revenue increased as well.

RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense
consists primarily of salaries for engineers and expenses for consultants,
recruiting, supplies, equipment, depreciation and facilities related to
engineering projects to improve our broadband intellectual property offerings,
as well as our software and hardware product technology. Research and
development expense decreased 4% from $2.7 million in the first quarter of 2004
to $2.6 million in the current year quarter. As a percentage of total revenue,
research and development expense decreased from 74% in the first quarter of 2004
to 60% in the current year quarter, principally as a result of increased
revenues.

The dollar decrease was from $0.1 million decreased spending resulting from a
shift of engineers to customer projects, where spending is classified as cost of
contract revenue. This shift occurred because we had more customer projects in
2005 than in 2004. The dollar decrease in spending was also attributable to $0.1
million lower compensation and fringe benefit costs and $0.1 million

lower depreciation expense. The dollar decreases were partially offset by a $0.2
million increase for chip design and tape out costs.

Our research and development spending was principally focused on improving our
ADSL, ADSL2 and ADSL2plus StratiPHY2+(TM) technology and chips, developing VDSL2
technology and chips, developing test and diagnostics hardware and software and
developing imaging and biometrics software.

SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of salaries for sales and marketing personnel, travel, advertising and
promotion, recruiting, and facilities expense. Sales and marketing expense
increased 5% from $604,000 in the first quarter of 2004 to $633,000 in the
current year quarter. As a percentage of total revenue, sales and marketing
expense decreased from 17% in the first quarter of 2004 to 15% in the current
year quarter. The dollar increase was primarily due to higher sales commissions
on increased revenues.

GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists primarily of salaries for administrative personnel, facility costs, bad
debt, audit, legal, stock exchange and insurance expenses. General and
administrative expense increased 13% from $593,000 in the first quarter of 2004
to $669,000 in the current year quarter. As a percentage of total revenue,
general and administrative expense was approximately 16% in the first quarter of
2004 and in the current year quarter. The dollar increase was primarily due to
higher spending on salary and fringe benefits.

INTEREST INCOME. Interest income increased 76% from $123,000 in the
first quarter of 2004 to $217,000 in the current year quarter. The dollar
increase was primarily due to higher interest rates earned on our cash balances
and higher cash balances.

INCOME TAXES. We made no provision for income taxes in the first three
months of 2005 or 2004 due to net losses incurred. In 2002, we determined that
due to our continuing operating losses as well as the uncertainty of the timing
of profitability in future periods, we should fully reserve our deferred tax
assets. As of March 31, 2005, our deferred tax assets continue to be fully
reserved. We will continue to evaluate, on a quarterly basis, the positive and
negative evidence affecting the realizability of our deferred tax assets.

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2005, we had cash, cash equivalents, short-term investments and
investments of $38.8 million, which represents an increase of $0.6 million from
December 31, 2004. The increase is primarily due to $0.4 million of cash
provided by operations and $0.2 million of proceeds from the exercise of
employee stock options.

Cash provided by operations in the first three months of 2005 was primarily the
result of net working capital increases which were partially offset by the
operating loss.

While we can not assure you that we will not require additional financing, or
that such financing will be available to us, we believe that our cash, cash
equivalents and investments will be sufficient to fund our operations for at
least the next twelve months.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based
Payment ("SFAS 123R"). This Statement is a revision to SFAS 123, ACCOUNTING FOR
STOCK-BASED Compensation, and supersedes APB Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES. SFAS 123R requires the measurement of the cost of
employee services received in exchange for an award of equity instruments based
on the grant-date fair value of the award. The cost will be recognized over the
period during which an employee is required to provide service in exchange for
the award. No compensation cost is recognized for equity instruments for which
employees do not render service. The planned effective date of SFAS 123R was to
be the first interim or annual reporting period that began after June 15, 2005.
In April 2005, the effective date was extended for calendar year companies until
January 1, 2006. We expect that the adoption of SFAS 123R will have a
significant impact on our results of operations. We do not expect the adoption
of SFAS 123R to impact our overall financial position.

RISK FACTORS

We believe that the occurrence of any one or some combination of the following
risk factors could seriously harm our business.

OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY

Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter-to-quarter. Because our revenue components
fluctuate and are difficult to predict, and our expenses are largely independent
of revenues in any particular period, it is difficult for us to accurately
forecast revenues and profitability. When appropriate, we recognize contract
revenues ratably over the period during which we expect to deliver technology
and provide engineering services. While this means that contract revenues from
certain current agreements are generally predictable, changes can be introduced
by a reevaluation of the length of the development period, or by the termination
of a contract. The initial estimate of this period is subject to revision as the
product being developed under a contract nears completion, and a revision may
result in an increase or decrease to the quarterly revenue for that contract. In
addition, accurate prediction of revenues from new contracts or licensees is
difficult because contract negotiation is a lengthy process, frequently spanning
a year or more, and the fiscal period in which a new license agreement will be
entered into, if at all, and the financial terms of such an agreement are
difficult to predict. Contract revenues also include fees for engineering
services, which are dependent upon the varying level of assistance desired by
licensees and, therefore, the revenue from these services is also difficult to
predict.

It is also difficult for us to make accurate forecasts of royalty revenues.
Royalties are recognized in the quarter in which we receive a report from a
licensee regarding the shipment of licensed integrated circuits in the prior
quarter, and are dependent upon fluctuating sales volumes and/or prices of chips
containing our technology, all of which are beyond our ability to control or
assess in advance.

Our business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:

|X| market acceptance of broadband technologies we supply by
semiconductor or equipment companies;
|X| the extent and timing of new license transactions with
semiconductor companies;
|X| changes in our and our licensees' development schedules and
levels of expenditure on research and development;
|X| the loss of a strategic relationship or termination of a project
by a licensee;
|X| equipment companies' acceptance of integrated circuits produced
by our licensees;
|X| the loss by a licensee of a strategic relationship with an
equipment company customer;
|X| announcements or introductions of new technologies or products
by us or our competitors;
|X| delays or problems in the introduction or performance of
enhancements or of future generations of our technology;
|X| failures or problems in our hardware or software products;
|X| delays in the adoption of new industry standards or changes in
market perception of the value of new or existing standards;
|X| competitive pressures resulting in lower contract revenues or
royalty rates;
|X| competitive pressures resulting in lower software or hardware
product revenues;
|X| personnel changes, particularly those involving engineering and
technical personnel;
|X| costs associated with protecting our intellectual property;
|X| the potential that licensees could fail to make payments under
their current contracts;
|X| ADSL market-related issues, including lower ADSL chipset unit
demand brought on by excess channel inventory and lower average
selling prices for ADSL chipsets as a result of market
surpluses;
|X| regulatory developments; and
|X| general economic trends and other factors.

As a result of these factors, we believe that period-to-period comparisons of
our revenue levels and operating results are not necessarily meaningful. You
should not rely on our quarterly revenue and operating results to predict our
future performance.

WE EXPERIENCED NET LOSSES

We had a net loss during 2001, 2002, 2003, 2004 and the first three months of
2005. We may continue to experience losses in the future if:

|X| the semiconductor and telecommunications markets do not improve;
|X| our existing customers do not increase their revenues from sales
of chipsets with our technology;
|X| new or existing customers do not choose to license our
intellectual property for new chipset products; or
|X| new or existing customers do not choose to use our software or
hardware products.

WE HAVE A UNIQUE BUSINESS MODEL

The success of our business model depends upon our ability to license our
technology to semiconductor and equipment companies, and our customers'
willingness and ability to sell products that incorporate our technology so that
we may receive significant royalties that are consistent with our plans and
expectations.

We face numerous risks in successfully obtaining suitable licensees on terms
consistent with our business model, including, among others:

|X| we must typically undergo a lengthy and expensive process of
building a relationship with a potential licensee before there
is any assurance of a license agreement with such party;
|X| we must persuade semiconductor and equipment manufacturers with
significant resources to rely on us for critical technology on
an ongoing basis rather than trying to develop similar
technology internally;
|X| we must persuade potential licensees to bear development costs
associated with our technology applications and to make the
necessary investment to successfully manufacture chipsets and
products using our technology; and
|X| we must successfully transfer technical know-how to licensees.

Moreover, the success of our business model also depends on the receipt of
royalties from licensees. Royalties from our licensees are often based on the
selling prices of our licensees' chipsets and products, over which we have
little or no control. We also have little or no control over our licensees'
promotional and marketing efforts. They are not prohibited from competing
against us.

Our business could be seriously harmed if:

|X| we cannot obtain suitable licensees;
|X| our licensees fail to achieve significant sales of chipsets or
products incorporating our technology; or
|X| we otherwise fail to implement our business strategy
successfully.

THERE HAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, AND THERE
IS INTENSE COMPETITION FOR ADSL CHIPSETS, WHICH HAS CAUSED OUR ROYALTY REVENUE
TO DECLINE

The royalties we receive are influenced by many of the risks faced by the ADSL
market in general, including reduced average selling prices ("ASPs") for ADSL
chipsets during periods of surplus. In 2000, 2001, and 2002, the ADSL industry
had experienced an oversupply of ADSL chipsets and central office equipment.
Excessive inventory levels led to soft chipset demand, which in turn led to
declining ASPs. ASPs have also been under pressure because of intense
competition in the ADSL chipset marketplace. As a result of the soft demand and
declining ASPs for ADSL chipsets, our royalty revenue has decreased
substantially from the levels we achieved in 2000. Price decreases for ADSL
chipsets, and the corresponding decreases in per unit royalties received by us,
can be sudden and dramatic. Pricing pressures may continue during the remainder
of 2005 and beyond. Our royalty revenue may decline over the long term.

WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES

There are a relatively limited number of semiconductor and equipment companies
to which we can license our broadband technology in a manner consistent with our
business model. If we fail to maintain relationships with our current licensees
or fail to establish a sufficient number of new licensing relationships, our
business could be seriously harmed. In addition, our prospective customers may
use their superior size and bargaining power to demand license terms that are
unfavorable to us and prospective customers may not elect to license from us.

WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM ONE CUSTOMER

In 2002, 2003, 2004 and the first three months of 2005, we derived 32%, 27%, 28%
and 24%, respectively, of our total revenue from ADI. ADI was the first customer
to license ADSL technology from us in 1993, and their chipsets are the most
mature implementations of our technology in the market. Our royalty revenues to
date have been primarily due to sales of ADI chipsets that use our ADSL
technology. Our royalty revenue in the near term is highly dependent upon ADI's
ADSL chipset market share and pricing. The ADSL market has experienced
significant price erosion, which has adversely affected ADI's ADSL revenue,
which in turn has adversely affected our royalty revenue. To the extent that ADI
has lost market share, or loses market share in the future, is unable to
transition its product to support new ADSL2 and ADSL2plus standards, or
experiences further price erosion in its ADSL chipsets, our royalty revenue
could decline.

OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES

Due to our business strategy, our success is dependent on our ability to
generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is
materially affected by the willingness of equipment companies to purchase
integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to
offer broadband communications products. We face the risk that equipment
manufacturers will choose those alternative solutions. Generally, our ability to
influence equipment companies' decisions whether to purchase integrated circuits
that incorporates our technology is limited.

We also face the risk that equipment companies that elect to use integrated
circuits that incorporate our technology into their products will not compete
successfully against other equipment companies. Many factors beyond our control
could influence the success or failure of a particular equipment company that
uses integrated circuits based on our technology, including:

|X| competition from other businesses in the same industry;
|X| market acceptance of its products;
|X| its engineering, sales and marketing, and management
capabilities;
|X| technical challenges of developing its products unrelated to our
technology; and
|X| its financial and other resources.

Even if equipment companies incorporate chipsets based on our intellectual
property into their products, their products may not achieve commercial
acceptance or result in significant royalties to us.

OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL ADSL SERVICE IN VOLUME

The success of our ADSL licensing business depends upon telephone companies
installing ADSL service in significant volumes. Factors that affect the volume
deployment of ADSL service include:

|X| the desire of telephone companies to install ADSL service, which
is dependent on the development of a viable business model for
ADSL service, including the capability to market, sell, install
and maintain the service;

|X| the pricing of ADSL services by telephone companies;
|X| the transition by telephone companies to new ADSL technologies,
such as ADSL2, ADSL2plus and VDSL2;
|X| the quality of telephone companies' networks;
|X| deployment by phone companies of fiber-to-the home or broadband
wireless services;
|X| government regulations; and
|X| the willingness of residential telephone customers to demand
ADSL service in the face of competitive service offerings, such
as cable modems, fiber-based service or broadband wireless
access.

If telephone companies do not install ADSL service in significant volumes, or if
telephone companies install broadband service based on other technology, our
business will be seriously harmed.

OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION

Because we are a technology provider, our ability to protect our intellectual
property and to operate without infringing the intellectual property rights of
others is critical to our success. We regard our technology as proprietary, and
we have a number of patents and pending patent applications. We also rely on a
combination of trade secrets, copyright and trademark law and non-disclosure
agreements to protect our unpatented intellectual property. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use our technology without authorization.

As part of our licensing arrangements, we typically work closely with our
semiconductor and equipment manufacturer licensees, many of whom are also our
potential competitors, and provide them with proprietary know-how necessary for
their development of customized chipsets based on our ADSL technology. Although
our license agreements contain non-disclosure provisions and other terms
protecting our proprietary know-how and technology rights, it is possible that,
despite these precautions, some of our licensees might obtain from us
proprietary information that they could use to compete with us in the
marketplace. Although we intend to defend our intellectual property as
necessary, the steps we have taken may be inadequate to prevent
misappropriation.

In the future, we may choose to bring legal action to enforce our intellectual
property rights. Any such litigation could be costly and time-consuming for us,
even if we were to prevail. Moreover, even if we are successful in protecting
our proprietary information, our competitors may independently develop
technologies substantially equivalent or superior to our technology. The
misappropriation of our technology or the development of competitive technology
could seriously harm our business.

Our technology, software or products may infringe the intellectual property
rights of others. A large and increasing number of participants in the
telecommunications and compression industries have applied for or obtained
patents. Some of these patent holders have demonstrated a readiness to commence
litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert patent, copyright and other intellectual
property rights to technologies that are important to our business. In the past,
we have received claims from other companies that our technology infringes their
patent rights. Intellectual property rights can be uncertain and can involve
complex legal and factual questions. We may infringe the proprietary rights of
others, which could result in significant liability for us. If we were found to
have

infringed any third party's patents, we could be subject to substantial damages
and an injunction preventing us from conducting our business.

OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE

The semiconductor and telecommunications industries, as well as the market for
high-speed network access technologies, are characterized by rapid technological
change, with new generations of products being introduced regularly and with
ongoing evolutionary improvements. We expect to depend on our ADSL technology
for a substantial portion of our revenue for the foreseeable future. Therefore,
we face risks that others could introduce competing technology that renders our
ADSL technology less desirable or obsolete. Also, the announcement of new
technologies could cause our licensees or their customers to delay or defer
entering into arrangements for the use of our existing technology. Either of
these events could seriously harm our business.

We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our ADSL technology as well as
new technologies that keep pace with changes in the telecommunications and
broadband industries and that achieve rapid market acceptance. We must
continually devote significant engineering resources to achieving technical
innovations. These innovations are complex and require long development cycles.
Moreover, we may have to make substantial investments in technological
innovations before we can determine their commercial viability. We may lack
sufficient financial resources to fund future development. Also, our licensees
may decide not to share certain research and development costs with us. Revenue
from technological innovations, even if successfully developed, may not be
sufficient to recoup the costs of development.

One element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our licensees. In the past, we
have spent significant amounts on development projects that did not produce any
marketable technologies or products, and we cannot assure you that it will not
occur again.

WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS

Our success as an intellectual property supplier depends on the willingness and
ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is
intensely competitive and has been characterized by price erosion, rapid
technological change, short product life cycles, cyclical market patterns and
increasing foreign and domestic competition.

As an intellectual property supplier to the semiconductor industry, we face
intense competition from internal development teams within potential
semiconductor customers. We must convince potential licensees to license from us
rather than develop technology internally. Furthermore, semiconductor customers,
who have licensed our intellectual property, may choose to abandon joint
development projects with us and develop chipsets themselves without using our
technology. In addition to competition from internal development teams, we
compete against other independent suppliers of intellectual property. We
anticipate intense competition from suppliers of intellectual property for ADSL.

The market for ADSL chipsets is also intensely competitive. Our success within
the ADSL industry requires that ADSL equipment manufacturers buy chipsets from
our semiconductor licensees, and that telephone companies buy ADSL equipment
from those equipment manufacturers. Our customers' chipsets compete with
products from other vendors of standards-based and ADSL chipsets, including
Broadcom, Centillium, Conexant, ST Microelectronics and Texas Instruments.

ADSL services offered over copper telephone networks also compete with
alternative broadband transmission technologies that use the telephone network
as well as other network architectures. Alternative technologies for the
telephone network include symmetric high speed DSL (also known as HDSL, SDSL and
G.SHDSL), and very high speed DSL, also known as VDSL. These DSL technologies
may be based on techniques other than those used by ADSL to transport high-speed
data over telephone lines. While we are actively developing VDSL technology to
meet new VDSL2 standards, we are not certain that we will be able to participate
in future VDSL deployments. Alternative technologies that use other network
architectures to provide high-speed data service include cable modems using
cable networks, wireless solutions using wireless networks, and optical
solutions using fiber optics technology. These alternative broadband
technologies may be more successful than ADSL and we may not be able to
participate in the markets involving these alternative technologies.

Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, ST Microelectronics and Texas Instruments have significantly greater
financial, technological, manufacturing, marketing and personnel resources than
we do. We may be unable to compete successfully, and competitive pressures could
seriously harm our business.

WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS

We prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business. The application of these principles and policies requires us to
make significant judgments and estimates. In the event that judgments and
estimates we make are incorrect, we may have to change them, which could
materially affect our financial position and results of operations.

Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.

OUR STOCK PRICE MAY BE EXTREMELY VOLATILE

Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:

|X| quarterly fluctuations in our operating results;

|X| changes in future financial guidance that we may provide to
investors and public market analysts;
|X| changes in our relationships with our licensees;
|X| announcements of technological innovations or new products by
us, our licensees or our competitors;
|X| changes in ADSL market growth rates as well as investor
perceptions regarding the investment opportunity that companies
participating in the ADSL industry afford them;
|X| changes in earnings estimates by public market analysts;
|X| key personnel losses;
|X| sales of common stock; and
|X| developments or announcements with respect to industry
standards, patents or proprietary rights.

In addition, the equity markets have experienced volatility that has
particularly affected the market prices of equity securities of many high
technology companies and that often has been unrelated or disproportionate to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock.

OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS

The extensive regulation of the telecommunications industry by federal, state
and foreign regulatory agencies, including the Federal Communications
Commission, and various state public utility and service commissions, could
affect us through the effects of such regulation on our licensees and their
customers. In addition, our business may also be affected by the imposition of
certain tariffs, duties and other import restrictions on components that our
customers obtain from non-domestic suppliers or by the imposition of export
restrictions on products sold internationally and incorporating our technology.
Changes in current or future laws or regulations, in the United States or
elsewhere, could seriously harm our business.

ITEM 3:
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:

|X| Cash and cash equivalents, which consist of financial
instruments with original maturities of three months or less;
|X| Short-term investments, which consist of financial instruments
with remaining maturities of twelve months or less, and auction
rate securities that typically have interest reset dates of
twenty-eight days; and
|X| Investments, which consist of financial instruments that mature
in three years or less.

All of our investments meet the high quality standards specified in our
investment policy. This policy dictates the maturity period and limits the
amount of credit exposure to any one issue, issuer, and type of instrument.

The interest rates on our auction rate securities are typically reset by auction
every twenty-eight days. Although our auction rate securities have been readily
marketable, if an auction were to fail, we may not be able to sell these
securities on the planned reset date thereby increasing our holding period.

We do not use derivative financial instruments for speculative or trading
purposes. As of March 31, 2005, we had invested $38.8 million in cash, cash
equivalents and short-term investments that matured in twelve months or less.
Due to the short duration of these financial instruments, we do not expect that
an increase in interest rates would result in any material loss to our
investment portfolio.

ITEM 4:
CONTROLS AND PROCEDURES

Our management, including our chief executive officer and chief financial
officer, has evaluated our disclosure controls and procedures as of the end of
the quarterly period covered by this Form 10-Q and has concluded that our
disclosure controls and procedures are effective. They also concluded that there
were no changes in our internal control over financial reporting that occurred
during the quarterly period covered by this Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.

PART II. OTHER INFORMATION

ITEM 1:
LEGAL PROCEEDINGS

From time to time we are involved in litigation incidental to the conduct of our
business. We are not party to any lawsuit or proceeding that, in our opinion, is
likely to seriously harm our business.

ITEM 6:
EXHIBITS

(A) EXHIBITS

Exhibit 31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.1 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.

--------------------

SIGNATURES

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

AWARE, INC.

Date: May 10, 2005 By: /s/ Michael A. Tzannes
----------------------
Michael A. Tzannes,
Chief Executive Officer

Date: May 10, 2005 By: /s/ Robert J. Weiskopf
----------------------
Robert J. Weiskopf,
Chief Financial Officer
(Principal Financial and
Accounting Officer)