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 JUNE 30, 2006
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
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(Exact Name of Registrant as Specified in Its Charter)
MASSACHUSETTS 04-2911026
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(State or Other Jurisdiction of (I.R.S. Employer
ncorporation or Organization) Identification No.)
40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730
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(Address of Principal Executive Offices)
(Zip Code)
(781) 276-4000
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(Registrant's Telephone Number, Including Area Code)
Indicate by check whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES _X_ NO ___
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one): Large Accelerated Filer___ Accelerated Filer_X__ Non-Accelerated Filer___
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). YES___ NO_X_
Indicate the number of shares outstanding of the issuer's common stock as of
August 4, 2006:
CLASS NUMBER OF SHARES OUTSTANDING
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Common Stock, par value $0.01 per share 23,539,843 shares
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AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2006
TABLE OF CONTENTS
PAGE
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of
June 30, 2006 and December 31, 2005........................... 3
Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 2006
and June 30, 2005............................................. 4
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2006
and June 30, 2005............................................. 5
Notes to Consolidated Financial Statements.................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................... 12
Item 3. Quantitative and Qualitative Disclosures about
Market Risk................................................... 17
Item 4. Controls and Procedures....................................... 17
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................. 17
Item 1A. Risk Factors.................................................. 18
Item 4. Submission of Matters to a Vote of Security Holders........... 25
Item 6. Exhibits ..................................................... 26
Signatures.................................................... 26
2
PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
JUNE 30, DECEMBER 31,
2006 2005
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ASSETS
Current assets:
Cash and cash equivalents................................................ $18,363 $13,068
Short-term investments................................................... 19,584 23,695
Accounts receivable, net................................................. 3,994 3,749
Inventories.............................................................. 549 86
Prepaid expenses and other current assets................................ 388 764
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Total current assets............................................... 42,878 41,362
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Property and equipment, net................................................... 8,018 8,075
Other assets, net............................................................. 271 304
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Total assets....................................................... $51,167 $49,741
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LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable........................................................ $398 $607
Accrued expenses ........................................................ 195 159
Accrued compensation .................................................... 867 722
Accrued professional..................................................... 192 212
Deferred revenue......................................................... 818 538
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Total current liabilities........................................ 2,470 2,238
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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, 23,536,812 in 2006 and 23,281,575 in 2005...... 235 233
Additional paid-in capital.............................................. 80,973 79,093
Accumulated deficit.................................................... (32,511) (31,823)
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Total stockholders' equity...................................... 48,697 47,503
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Total liabilities and stockholders' equity....................... $51,167 $49,741
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The accompanying notes are an integral part of the
consolidated financial statements.
3
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ------------------------
2006 2005 2006 2005
----------- ---------- ---------- ----------
Revenue:
Product sales....................................... $1,519 $785 $3,237 $1,746
Contract revenue.................................... 2,241 978 5,934 3,141
Royalties........................................... 1,030 920 1,754 2,020
----------- ---------- ---------- ----------
Total revenue..................................... 4,790 2,683 10,925 6,907
Costs and expenses:
Cost of product sales............................... 176 62 328 122
Cost of contract revenue............................ 1,151 718 2,397 1,558
Research and development............................ 3,129 2,360 5,919 4,913
Selling and marketing............................... 920 710 1,734 1,343
General and administrative.......................... 1,083 627 2,087 1,296
----------- ---------- ---------- ----------
Total costs and expenses........................... 6,459 4,477 12,465 9,232
Loss from operations.................................... (1,669) (1,794) (1,540) (2,325)
Interest income......................................... 459 272 852 489
----------- ---------- ---------- ----------
Loss before provision for income taxes.................. (1,210) (1,522) (688) (1,836)
Provision for income taxes.............................. - - - -
----------- ---------- ---------- ----------
Net loss................................................ ($1,210) ($1,522) ($688) ($1,836)
=========== ========== ========== ==========
Net loss per share - basic and diluted................ ($0.05) ($0.07) ($0.03) ($0.08)
Weighted average shares - basic and diluted............ 23,430 23,019 23,371 22,982
The accompanying notes are an integral part of the
consolidated financial statements.
4
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
-------------------------------
2006 2005
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Cash flows from operating activities:
Net income (loss).......................................... ($688) ($1,836)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization............................. 322 295
Stock-based compensation.................................. 1,242 -
Increase (decrease) from changes in assets and liabilities:
Accounts receivable.................................. (245) 1,144
Inventories.......................................... (463) 21
Prepaid expenses..................................... 376 (99)
Accounts payable..................................... (209) 128
Accrued expenses..................................... 161 (26)
Deferred revenue..................................... 280 447
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Net cash provided by operating activities........ 776 74
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Cash flows from investing activities:
Purchases of property and equipment....................... (232) (141)
Sales of investments...................................... 11,557 16,374
Purchases of investments................................. (7,446) (11,250)
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Net cash provided by investing activities............ 3,879 4,983
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Cash flows from financing activities:
Proceeds from issuance of common stock................... 640 549
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Net cash provided by financing activities......... 640 549
Increase in cash and cash equivalents......................... 5,295 5,606
Cash and cash equivalents, beginning of period................ 13,068 7,482
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Cash and cash equivalents, end of period...................... $18,363 $13,088
============ ============
The accompanying notes are an integral part of the
consolidated financial statements.
5
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
A) BASIS OF PRESENTATION
The accompanying unaudited consolidated balance sheet, statements of
operations, and statements of cash flows reflect all adjustments
(consisting only of normal recurring items) which are, in the opinion
of management, necessary for a fair presentation of financial position
at June 30, 2006, and of operations and cash flows for the interim
periods ended June 30, 2006 and 2005.
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, 2005 in conjunction with our 2005 Annual
Report on Form 10-K.
The results of operations for the interim period ended June 30, 2006
are not necessarily indicative of the results to be expected for the
year.
B) INVENTORY
Inventory consists primarily of the following (in thousands):
JUNE 30, DECEMBER 31,
2006 2005
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Raw materials..................... $509 $86
Finished goods.................... 40 -
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$549 $86
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C) COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income or loss by
the weighted average number of common shares outstanding. Diluted
earnings per share is computed by dividing net income or loss by the
weighted average number of common shares outstanding plus additional
common shares that would have been outstanding if dilutive potential
common shares had been issued. For the purposes of this calculation,
stock options are considered common stock equivalents in periods in
which they have a dilutive effect. Stock options that are anti-dilutive
are excluded from the calculation.
6
Net income or loss per share is calculated as follows (in thousands,
except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- --------------------------
2006 2005 2006 2005
------------- ------------- ------------- ------------
Net loss.......................................... ($1,210) ($1,522) ($688) ($1,836)
Weighted average common shares outstanding........ 23,430 23,019 23,371 22,982
Additional dilutive common stock equivalents...... - - - -
------------- ------------- ------------- ------------
Diluted shares outstanding ....................... 23,430 23,019 23,371 22,982
============= ============= ============= ============
Net loss per share - basic........................ ($0.05) ($0.07) ($0.03) ($0.08)
Net loss per share - diluted...................... ($0.05) ($0.07) ($0.03) ($0.08)
For the three month period ended June 30, 2006 and 2005, potential
common stock equivalents of 1,645,384 and 1,594,581, respectively, were
not included in the per share calculation for diluted EPS, because we
had a net loss and the effect of their inclusion would be
anti-dilutive. For the six month periods ended June 30, 2006 and 2005,
potential common stock equivalents of 1,600,805 and 1,651,837,
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
June 30, 2006 and 2005, options to purchase 2,271,427 and 1,877,917
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. For the six month periods
ended June 30, 2006 and 2005, options to purchase 2,346,427 and
1,877,917 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
Effective January 1, 2006, the Company adopted the provisions of
Statement of Financial Accounting Standards 123(R), "Share-Based
Payment," ("SFAS 123(R)"), which establishes accounting for equity
instruments exchanged for employee services. Under the provisions of
SFAS 123(R), stock-based compensation cost is measured at the grant
date, based on the fair value of the award, and is recognized as an
expense over the employee's requisite service period (generally the
vesting period of the equity award). Prior to January 1, 2006, the
Company accounted for share-based compensation to employees in
accordance with Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees," ("APB 25") and related interpretations.
The Company also followed the disclosure requirements of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). The Company elected to adopt the modified
prospective transition method as provided by SFAS 123(R) and,
accordingly, financial statement amounts for the prior periods
presented in this Form 10-Q have not been restated to reflect the fair
value method of expensing stock-based compensation.
7
FIXED STOCK OPTION PLANS - We have three fixed option plans. Under the
1990 Incentive and Nonstatutory Stock Option Plan ("1990 Plan"), we may
grant incentive stock options or nonqualified stock options to our
employees and directors for up to 2,873,002 shares of common stock.
Under the 1996 Stock Option Plan ("1996 Plan"), we may grant incentive
stock options or nonqualified stock options to our employees and
directors for up to 6,100,000 shares of common stock. Under the 2001
Nonqualified Stock Plan ("2001 Plan"), we may grant nonqualified stock
options or stock awards to our employees and directors for up to
8,000,000 shares of common stock. Under all three plans, options are
granted at an exercise price as determined by the Board of Directors
and have terms ranging from four to a maximum of ten years. Our options
generally vest over three to five years, although we have granted
options that are 50% or fully vested on the date of grant. As of June
30, 2006, there were 5,150,296 shares available for grant under the
2001 Plan, and no shares available under the 1990 and 1996 Plans.
During the three (3) months ended June 30, 2006, the Company awarded
unrestricted stock to its employees under the 2001 Plan. Half of the
award was distributed in the second quarter of 2006 and the remaining
shares will be distributed in the fourth quarter of 2006 to eligible
employees. In the second quarter of 2006, a total of 31,895 shares were
distributed representing $189,000 of stock-based compensation expense.
Employee Stock Purchase Plan - In June 1996, we adopted an Employee
Stock Purchase Plan (the "ESPP Plan") under which eligible employees
could purchase common stock at a price equal to 85% of the lower of the
fair market value of the common stock at the beginning or end of each
six-month offering period. On November 29, 2005 we amended the ESPP
Plan to provide that eligible employees may purchase common stock at a
price equal to 95% of the fair market value of the common stock as of
the end of each six-month offering period. Participation in the ESPP
Plan is limited to 6% of an employee's compensation, may be terminated
at any time by the employee and automatically ends on termination of
employment. A total of 350,000 shares of common stock have been
reserved for issuance. As of June 30, 2006 there were 138,046 shares
available for future issuance under the ESPP Plan. During the three
months ended June 30, 2006, 1,761 common shares were issued under the
ESPP Plan.
The following table presents stock-based employee compensation expenses
included in the Company's unaudited condensed consolidated statements
of operations (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2006 JUNE 30, 2006
------------------------ -----------------------
Cost of product sales $5 $8
Cost of contract revenue 21 85
Research and development 396 545
Selling and marketing 110 178
General and administrative 213 426
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Stock-based compensation expense $745 $1,242
======================== =======================
As a result of adopting SFAS 123(R), the Company's net income for the
quarter ended June 30, 2006, was $745,000 lower than if it had
continued to account for stock-based compensation under APB 25. Basic
and diluted earnings per share for the quarter ended June 30, 2006 was
also lower by $0.03 due to the adoption of SFAS 123(R).
8
The Company estimates the fair value of stock options using the
Black-Scholes valuation model. This valuation model takes into account
the exercise price of the award, as well as a variety of significant
assumptions. These assumptions used to estimate the fair value of stock
options include the expected term, the expected volatility of the
Company's stock over the expected term, the risk-free interest rate
over the expected term, and the Company's expected annual dividend
yield. The Company believes that the valuation technique and the
approach utilized to develop the underlying assumptions are appropriate
in calculating the fair values of the Company's stock options granted
in the three months ended June 30, 2006. Estimates of fair value are
not intended to predict actual future events or the value ultimately
realized by persons who receive equity awards.
Assumptions used to determine the fair value of options granted during
the three months ended June 30, 2006, using the Black-Scholes valuation
model were:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2006 JUNE 30, 2006
---------------------- ------------------------
Expected term(1) 3.25 - 6.25 years 3.25 - 6.25 years
Expected volatility factor(2) 66% 66-67%
Risk-free interest rate(3) 4.99% 4.47-4.99%
Expected annual dividend yield -- --
-----------------------------------------------------------------------
(1) The expected term for each grant was determined as the midpoint
between the vesting date and the end of the contractual term, also
known as the "simplified method" for estimating the expected term
described by Staff Accounting Bulletin No. 107 ("SAB 107").
(2) The expected volatility for each grant is estimated based on an
average of historical volatility for a period equal to the expected
term of the stock option.
(3) The risk-free interest rate for each grant is based on the
U.S. Treasury yield curve in effect at the time of grant for a
period equal to the expected term of the stock option.
There is no stock-based compensation expense related to the Company's
Employee Stock Purchase Plan because it is not considered a compensatory
plan. The plan does not have a look-back feature, and has a minimal
discount of 5% of the fair market value of the common stock as of the end
of each six-month offering period.
Prior to January 1, 2006, the Company accounted for stock-based
compensation to employees in accordance with APB 25. The Company also had
previously adopted the provisions of SFAS 123, which required disclosure
only of stock-based compensation and its impact on net loss and net loss
per share. The following table illustrates the effects on net loss and net
loss per share for the three months ended June 30, 2005 as if the Company
had applied the fair value recognition provisions of SFAS 123 to
stock-based employee awards (in thousands):
9
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2005 JUNE 30, 2005
-------------------- ------------------
Net loss as reported ($1,522) $(1,836)
Add: Stock-based employee compensation expense
included in net loss
Less: Total stock-based employee compensation expense
determined under the fair value method (713) (8,449)
-------------------- ------------------
Pro forma net loss ($2,235) ($10,285)
==================== ==================
Net loss per share:
Basic and diluted -- as reported ($0.07) ($0.08)
Basic and diluted -- pro-forma ($0.10) ($0.45)
In determining the stock-based compensation expense to be disclosed under
SFAS 123, the Company was required to estimate the fair value of stock
awards granted to employees using a Black-Scholes valuation model.
However, differences between the requirements of SFAS 123(R) and SFAS 123
resulted in a different set of assumptions determined by the Company to be
used in its valuation model. Assumptions used to determine the fair value
of options granted under SFAS 123 during the three months ended June 30,
2005 were:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2005 JUNE 30, 2005
---------------------- --------------------
Expected term 5 years 5 years
Volatility 84% 84-87%
Risk-free interest rate 3.87% 3.87-3.88%
Dividend yield -- --
The Company issues common stock from previously authorized but unissued
shares to satisfy option exercises and purchases under the Company's
Employee Stock Purchase Plan.
A summary of the Company's stock option activity for the six months ended
June 30, 2006 is as follows:
WEIGHTED
AVERAGE
REMAINING
WEIGHTED CONTRACTUAL
NUMBER OF AVERAGE TERM (IN
OPTIONS EXERCISE PRICE YEARS)
-------------------- -------------- -------------
Outstanding, December 31, 2005 6,284,606 $ 4.73
Granted 181,500 5.63
Exercised (223,206) 2.99
Cancelled (140,083) 6.89
---------------- ------------
Outstanding, June 30, 2006 6,102,817 $4.77 7.46
================ ============
Exercisable at June 30, 2006 5,579,765 $4.73 7.51
All options granted during the six months ended June 30, 2006 and 2005 were
granted with exercise prices equal to the fair market value of the
Company's common stock on the grant date and had weighted average grant
date fair values of $3.03 and $4.22, respectively.
10
At June 30, 2006, the aggregate intrinsic value of options outstanding and
options exercisable was $9,176,000 and $8,815,000, respectively. The
intrinsic value of a stock option is the amount by which the market value
of the underlying stock exceeds the exercise price of the option.
The aggregate intrinsic value of options exercised during the six months
ended June 30, 2006 was $648,000.
The following table summarizes the stock options outstanding at June 30,
2006:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------------- ------------------------------
WEIGHTED WEIGHTED AVERAGE WEIGHTED
AVERAGE REMAINING AVERAGE
EXERCISE PRICE EXERCISE CONTRACTUAL EXERCISE
RANGE NUMBER PRICE TERM (IN YEARS) NUMBER PRICE
$0 to $5 3,660,715 $ 3.18 7.46 3,520,633 $ 3.18
$5 to $10 2,353,435 6.11 7.61 1,970,465 6.14
$10 to $20 2,417 12.75 0.89 2,417 12.75
$20 to $30 16,750 20.38 4.30 16,750 20.38
$30 to $40 45,000 33.56 2.96 45,000 33.56
$40 to $50 14,500 44.02 3.71 14,500 44.02
$50 to $70 10,000 58.06 3.26 10,000 58.06
---------------- ----------------
6,102,817 $ 4.77 7.46 5,579,765 $ 4.73
================ ================
At June 30, 2006, unrecognized compensation expense related to non-vested
stock options was $1,296,000, which is expected to be recognized over a
weighted average period of 1.8 years.
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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- -------------------------
2006 2005 2006 2005
----------- ----------- ----------- -----------
United States.................................... $2,098 $1,651 $6,574 $3,676
Germany.......................................... 2,236 735 3,502 1,915
Rest of World.................................... 456 297 849 1,316
----------- ----------- ----------- -----------
$4,790 $2,683 $10,925 $6,907
=========== =========== =========== ===========
F) RECENT ACCOUNTING PRONOUNCEMENTS
In July 2006, the Financial Accounting Standards Board ("FASB") issued
Financial Accounting Standards Interpretation No. 48 ("FIN 48"),
"Accounting for Uncertainty in Income Taxes." FIN 48 clarifies the
accounting for uncertainty in income tax positions taken or expected to be
taken in tax returns that effect amounts reported in a company's financial
11
statements in accordance with FASB Statement No. 109, "Accounting for
Income Taxes." FIN 48 establishes a threshold condition that a tax position
must meet for any part of the benefit of that position to be recognized in
the financial statements. FIN 48 also provides guidance concerning
derecognition, measurement, classification, interest and penalties and
disclosure of tax positions. FIN 48 is effective for fiscal years beginning
after December 15, 2006. The Company is currently analyzing the effects of
FIN 48.
In May 2005, the FASB issued FASB Statement No. 154, "Accounting Changes
and Error Corrections, a replacement of APB Opinion No. 20, Accounting
Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim
Financial Statements" ("FAS 154"). FAS 154 provides guidance on the
accounting for and reporting of accounting changes and error corrections.
It establishes, unless impracticable, retrospective application as the
required method for reporting a change in accounting principle in the
absence of explicit transition requirements specific to the newly adopted
accounting principle. FAS 154 also provides guidance for determining
whether retrospective application of a change in accounting principle is
impracticable and for reporting a change when retrospective application is
impracticable. The provisions of this Statement are effective for
accounting changes and corrections of errors made in fiscal periods
beginning after December 15, 2005. The adoption of the provisions of FAS
154 is not expected to have a material impact on the Company's financial
position or results of operations.
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 increased 94% from $0.8 million in the second quarter of 2005 to
$1.5 million in the current year quarter. As a percentage of total revenue,
product sales increased from 29% in the second quarter of 2005 to 32% in the
current year quarter. For the six months ended June 30,
12
product sales increased 85% from $1.7 million in 2005 to $3.2 million in 2006.
As a percentage of total revenue, product sales increased from 25% in the first
six months of 2005 to 30% in the corresponding period of 2006.
For the three month period, the dollar increase was due to a $0.4 million
increase in revenue from the sale of software products and a $0.3 million
increase from the sale of hardware products. For the six month period, the
dollar increase was due to a $1.2 million increase in revenue from the sale of
software products and a $0.3 million increase from the sale of hardware
products.
CONTRACT REVENUE. Contract revenue consists primarily of license and
engineering service fees that we receive under agreements with our customers to
develop DSL (including ADSL2, ADSL2plus or VDSL2) chipsets.
Contract revenue increased 129% from $1.0 million in the second quarter of 2005
to $2.2 million in the current year quarter. As a percentage of total revenue,
contract revenue increased from 36% in the second quarter of 2005 to 47% in the
current year quarter. The dollar increase was due to $0.5 million recognized
from the transfer of certain technology licenses as a result of the acquisition
of a customers' business, plus an increase of $0.7 million associated with the
delivery of licensed technology and engineering services.
For the six months ended June 30, contract revenue increased 89% from $3.1
million in 2005 to $5.9 million in the current year. As a percentage of total
revenue, contract revenue increased from 45% in the first six months of 2005 to
54% in the corresponding period of 2006. The dollar increase was due to $2.5
million recognized from the transfer of certain technology licenses as a result
of the acquisition of a customer's business, plus an increase of $0.3 million
associated with the delivery of licensed technology and engineering services.
While we believe that the transition to ADSL2plus and VDSL2 technology increases
the value proposition of our technology, some existing and prospective DSL
chipset licensees have continued 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 increased 12% from $0.9 million in the second quarter of 2005 to $1.0
million in the current year quarter. As a percentage of total revenue, royalties
decreased from 34% in the second quarter of 2005 to 21% in the current year
quarter. The dollar increase in royalty revenues was a result of increased
chipset sales by our customers. For the six months ended June 30, royalties
decreased 13% from $2.0 million in 2005 to $1.8 million in the current year. As
a percentage of total revenue, royalties decreased from 29% in the first six
months of 2005 to 16% in the corresponding period of 2006. The dollar decrease
in royalty revenues was a result of reduced chipset sales by our customers and a
decrease in royalties from Analog Devices, Inc. ("ADI") due to a one-time change
in reporting periods as a result of the technology transfer agreement with ADI
and Ikanos Communications, Inc. ("Ikanos"). The decrease in royalty as a
percentage of total revenue is due to the significant increases in both product
sales and contract revenue.
13
Our royalty revenue comes predominantly from ADSL chipset sales by Ikanos
Communications, Inc. ("Ikanos"), and Infineon Technologies AG ("Infineon"). On
February 17, 2006, Analog Devices, Inc. ("ADI") sold its ADSL business relating
to Aware technology to Ikanos and Ikanos has replaced ADI as an Aware licensee.
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 the transition to ADSL2plus and VDSL2 will impact our
customers in the near term, how quickly sales of our customers' chipsets will
increase and whether such increases will continue to 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 increased 181% from $62,000 in the second
quarter of 2005 to $176,000 in the current year quarter. As a percentage of
product sales, cost of product sales increased from 8% in the second quarter of
2005 to 12% in the current year quarter. For the six months ended June 30, cost
of product sales increased 169% from $122,000 in 2005 to $328,000 in 2006. As a
percentage of product sales, cost of product sales increased from 7% in the
first six months of 2005 to 10% in the corresponding period of 2006.
The percentage and dollar increases were primarily due to an increase in
hardware manufacturing and period costs related to new hardware products. The
resulting decrease in product margin was primarily due to a larger proportion of
hardware sales in the product sales revenue mix.
COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily
of compensation costs 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 60% from $0.7 million in the second quarter
of 2005 to $1.2 million in the current year quarter. As a percentage of contract
revenue, cost of contract revenue decreased from 73% in the second quarter of
2005 to 51% in the current year quarter. For the six months ended June 30, cost
of contract revenue increased 54% from $1.6 million in 2005 to $2.4 million in
2006. As a percentage of contract revenue, cost of contract revenue decreased
from 50% in the first six months of 2005 to 40% in the corresponding period of
2006.
The dollar increase in cost of contract revenue was primarily due to more
customer projects in the three month and six month periods of 2006 as compared
with 2005. Our cost of contract revenue is based on the level of effort we
expend on customer projects. Since the number of customer projects increased,
the cost of contract revenue increased as well. In addition, $21,000 and $85,000
of the current quarter and six month period increases, respectively, were from
stock- based compensation expense.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense
consists primarily of compensation costs 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 increased 33% from $2.4 million in the second
quarter of 2005 to $3.1 million in the current year quarter. As a percentage of
total revenue, research and
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development expense decreased from 88% in the second quarter of 2005 to 65% in
the current year quarter. For the six months ended June 30, research and
development expense increased 21% from $4.9 million in 2005 to $5.9 million in
2006. As a percentage of total revenue, research and development expense
decreased from 71% in the first six months of 2005 to 54% in the corresponding
period of 2006.
For the three month and six month periods, the dollar increase was from $396,000
and $545,000, respectively, of stock-based compensation expense and the
remainder was from increased compensation and fringe benefit cost as well as
increased spending on patent legal fees and non-capital equipment and lab
supplies. These increases were partially offset by 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 2006 than in 2005.
Our research and development spending was principally focused on improving our
ADSL, ADSL2 and ADSL2plus StratiPHY2+(TM) technology and chips, developing and
improving our VDSL2 StratiPHY3 technology and chips, developing analog front-end
technology for DSL solutions, developing test and diagnostics hardware and
software and developing imaging and biometrics software.
SELLING AND MARKETING EXPENSE. Selling and marketing expense consists
primarily of compensation costs for sales and marketing personnel, travel,
advertising and promotion, recruiting, and facilities expense. Sales and
marketing expense of $0.9 million in the second quarter of 2006 increased 30%
compared to $0.7 million in the corresponding quarter of 2005. As a percentage
of total revenue, sales and marketing expense decreased from 26% in the second
quarter of 2005 to 19% in the current year quarter due to higher revenues.
For the current six months ended June 30, selling and marketing expense of $1.7
million increased 29% from $1.3 million in 2005. As a percentage of total
revenue, selling and marketing expense decreased from 19% in the first six
months of 2005 to 16% in the corresponding period of 2006. For both the three
and six month periods, the dollar increase was mainly attributable to increased
compensation costs, and included $110,000 and $178,000 of stock-based
compensation expense, respectively.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists primarily of compensation costs for administrative personnel, facility
costs, bad debt, audit, legal, stock exchange and insurance expenses. General
and administrative expenses increased 73% from $0.6 million in the second
quarter of 2005 to $1.1 million in the current year quarter. As a percentage of
total revenue, general and administrative expense decreased slightly and was
approximately 23% in both the second quarter of 2005 and in the current year
quarter.
For the six months ended June 30, general and administrative expense increased
61% from $1.3 million in 2005 to $2.1 million in 2006. As a percentage of total
revenue, general and administrative expense increased slightly and was
approximately 19% in the first six months of 2005 and 2006. For both the three
month and six month periods, the dollar increase was mainly attributable to
increased compensation costs, and included $213,000 and $426,000 of stock-based
compensation expense, respectively.
INTEREST INCOME. Interest income increased 69% from $272,000 in the
second quarter of 2005 to $459,000 in the current year quarter. For the six
months ended June 30, interest income
15
increased 74% from $489,000 in 2005 to $852,000 in 2006. For the three and six
month periods, the dollar increase was due to higher interest rates earned on
our cash and investment balances.
INCOME TAXES. We made no provision for income taxes in the first six
months of 2005 and 2006 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 June 30, 2006, 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 June 30, 2006, we had cash, cash equivalents, and short-term investments of
$37.9 million, which represents an increase of $1.2 million from December 31,
2005. The increase was primarily due to $0.8 million of cash provided by
operations and $0.6 million of proceeds from the exercise of employee stock
options. These increases were partially offset by capital expenditures of $0.2
million.
Cash provided by operations in the first six months of 2006 was from the net
loss of $0.7 million adjusted for non-cash items related to depreciation and
amortization of $0.3 million, stock-based compensation expense of $1.2 million
and working capital requirements of $0.1 million. Capital spending was primarily
related to the purchase of computer hardware and software, and laboratory
equipment used principally in engineering activities.
Cash provided by operations in the first six months of 2005 was primarily from
changes in working capital. Capital spending was primarily related to the
purchase of computer hardware and software, and laboratory equipment used
principally in engineering activities.
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 short-term investments will be sufficient to fund our operations
for at least the next twelve months.
RECENT ACCOUNTING PRONOUNCEMENTS
In July 2006, the Financial Accounting Standards Board ("FASB") issued Financial
Accounting Standards Interpretation No. 48 ("FIN 48"), "Accounting for
Uncertainty in Income Taxes." FIN 48 clarifies the accounting for uncertainty in
income tax positions taken or expected to be taken in tax returns that effect
amounts reported in a company's financial statements in accordance with FASB
Statement No. 109, "Accounting for Income Taxes." FIN 48 establishes a threshold
condition that a tax position must meet for any part of the benefit of that
position to be recognized in the financial statements. FIN 48 also provides
guidance concerning derecognition, measurement, classification, interest and
penalties and disclosure of tax positions. FIN 48 is effective for fiscal years
beginning after December 15, 2006. The Company is currently analyzing the
effects of FIN 48.
In May 2005, the FASB issued FASB Statement No. 154, "Accounting Changes and
Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes and
FASB Statement No. 3, Reporting Accounting Changes in Interim Financial
Statements" ("FAS 154"). FAS 154 provides guidance on the accounting for and
reporting of accounting changes and error corrections. It establishes, unless
impracticable, retrospective application as the required method for reporting a
change in accounting principle in the absence of explicit transition
requirements
16
specific to the newly adopted accounting principle. FAS 154 also provides
guidance for determining whether retrospective application of a change in
accounting principle is impracticable and for reporting a change when
retrospective application is impracticable. The provisions of this Statement are
effective for accounting changes and corrections of errors made in fiscal
periods beginning after December 15, 2005. The adoption of the provisions of FAS
154 is not expected to have a material impact on the Company's financial
position or results of operations.
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:
o Cash and cash equivalents, which consist of financial instruments
with original maturities of three months or less; and
o Investments, which consist of financial instruments that meet the
high quality standards specified in our investment policy. This
policy dictates that all instruments mature in three years or
less, and limits the amount of credit exposure to any one issue,
issuer, and type of instrument.
We do not use derivative financial instruments for speculative or trading
purposes. As of June 30, 2006, we had $37.9 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.
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ITEM 1A:
RISK FACTORS
RISK FACTORS
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:
o market acceptance of broadband technologies we supply by
semiconductor or equipment companies;
o the extent and timing of new license transactions with semiconductor
companies;
o changes in our and our licensees' development schedules and levels of
expenditure on research and development;
o the loss of a strategic relationship or termination of a project by a
licensee;
o equipment companies' acceptance of integrated circuits produced by
our licensees;
o the loss by a licensee of a strategic relationship with an equipment
company customer;
o announcements or introductions of new technologies or products by us
or our competitors;
o delays or problems in the introduction or performance of enhancements
or of future generations of our technology;
o failures or problems in our hardware or software products;
o delays in the adoption of new industry standards or changes in market
perception of the value of new or existing standards;
o competitive pressures resulting in lower contract revenues or royalty
rates;
o competitive pressures resulting in lower software or hardware product
revenues;
o personnel changes, particularly those involving engineering and
technical personnel;
o costs associated with protecting our intellectual property;
18
o the potential that licensees could fail to make payments under their
current contracts;
o 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;
o VDSL market-related issues, including lower VDSL chipset unit demand
brought on by excess channel inventory and lower average selling
prices for VDSL chipsets as a result of market surpluses;
o regulatory developments; and
o 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 annual loss during 2001, 2002, 2003, 2004 and 2005 and the first
six months of 2006. We may continue to experience losses in the future if:
o the semiconductor and telecommunications markets do not improve;
o our existing customers do not increase their revenues from sales of
chipsets with our technology;
o new or existing customers do not choose to license our intellectual
property for new chipset products; or
o 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:
o 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;
o 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;
o 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
o 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
19
over our licensees' promotional and marketing efforts. They are not prohibited
from competing against us.
Our business could be seriously harmed if:
o we cannot obtain suitable licensees;
o our licensees fail to achieve significant sales of chipsets or
products incorporating our technology; or
o 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 or
VDSL chipsets, and the corresponding decreases in per unit royalties received by
us, can be sudden and dramatic. Pricing pressures may continue during the third
quarter of 2006 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 A SMALL NUMBER OF CUSTOMERS
In 2003, 2004 and 2005, we derived 27%, 28% and 20%, respectively, of our total
revenue from ADI and 20%, 28%, and 30% respectively, of our total revenue from
Infineon. ADI and Infineon have developed many generations of ADSL chipsets
based upon our technology. On February 17, 2006 ADI sold its ADSL business
relating to Aware technology to Ikanos Communications, Inc. ("Ikanos") and
Ikanos replaced ADI as an Aware licensee.
Our royalty revenue in the near term is highly dependent upon the respective
market share and pricing of Ikanos' and Infineon's ADSL chipsets. The ADSL
market has experienced significant price erosion, which has adversely affected
ADSL chipset revenues, which in turn has adversely affected our royalty revenue.
To the extent that Ikanos loses ADSL2plus market share or Infineon loses market
share, or either are unable to gain market share, unable to transition their
product to support new ADSL2, ADSL2plus and VDSL2 standards, or experience
further price erosion in their DSL chipsets, our royalty revenue could decline.
20
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 incorporate 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:
o competition from other businesses in the same industry;
o market acceptance of its products;
o its engineering, sales and marketing, and management capabilities;
o technical challenges of developing its products unrelated to our
technology; and
o 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 DSL SERVICE IN VOLUME
The success of our DSL licensing business depends upon telephone companies
installing DSL service in significant volumes. Factors that affect the volume
deployment of DSL service include:
o the desire of telephone companies to install ADSL or VDSL service,
which is dependent on the development of a viable business model for
ADSL or VDSL service, including the capability to market, sell,
install and maintain the service;
o the pricing of ADSL or VDSL services by telephone companies;
o the success of internet protocol TV ("IPTV") as a viable consumer
service offering;
o the transition by telephone companies to new ADSL technologies,
such as ADSL2, ADSL2plus and VDSL2;
o the quality of telephone companies' networks;
o deployment by phone companies of fiber-to-the home or broadband
wireless services;
o government regulations; and
o the willingness of residential telephone customers to demand DSL
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 DSL service in significant volumes, or if
telephone companies install broadband service based on other technology such as
cable or fiber-to-the-home, our business will be seriously harmed.
21
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 DSL 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 DSL
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.
22
We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our DSL 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 DSL chipsets is also intensely competitive. Our success within
the DSL industry requires that DSL equipment manufacturers buy chipsets from our
semiconductor licensees, and that telephone companies buy DSL equipment from
those equipment manufacturers. Our customers' chipsets compete with products
from other vendors of standards-based and DSL chipsets, including Broadcom,
Centillium, Conexant, ST Microelectronics and Texas Instruments.
ADSL and VDSL 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 several types of symmetric high speed DSL, including
HDSL, SDSL and G.SHDSL. 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
transmission technologies may be more successful than ADSL or VDSL and we may
not be able to participate in the markets involving these alternative
technologies.
23
Many of our current and prospective DSL 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.
BIOMETRICS BUSINESS RISKS
Our biometrics business is subject to a variety of additional risks, which could
materially adversely affect quarterly and annual operating results, including:
o market acceptance of our biometric technologies and products;
o changes in contracting practices of government or law enforcement
agencies;
o the failure of the biometrics market to experience continued growth;
o announcements or introductions of new technologies or products or our
competitors;
o delays or problems in the introduction or performance of enhancements
or of future generations of our technology;
o failures or problems in our biometric software products;
o delays in the adoption of new industry biometric standards or changes
in market perception of the value of new or existing standards;
o growth of proprietary biometric systems which do not conform to
industry standards;
o competitive pressures resulting in lower software product revenues;
o personnel changes, particularly those involving engineering,
technical and sales and marketing personnel;
o costs associated with protecting our intellectual property;
o litigation by third parties for alleged infringement of their
proprietary rights;
o the potential that licensees could fail to make payments under their
current contracts;
o regulatory developments; and
o 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 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.
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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:
o quarterly fluctuations in our operating results;
o changes in future financial guidance that we may provide to investors
and public market analysts;
o changes in our relationships with our licensees;
o announcements of technological innovations or new products by us, our
licensees or our competitors;
o changes in ADSL market growth rates as well as investor perceptions
regarding the investment opportunity that companies participating in
the ADSL industry afford them;
o changes in earnings estimates by public market analysts;
o key personnel losses;
o sales of our common stock; and
o 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 4:
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 24, 2006, we held our Annual Meeting of Stockholders (the "Annual
Meeting"). Matters voted on and the results of those votes are set forth below:
(1) Each of Michael A. Tzannes and G. David Forney, Jr. was elected to serve
as a Class I director of the Company for a term expiring at the annual
meeting of stockholders of the Company in 2009 or a special meeting in lieu
thereof. Each of John K. Kerr, Frederick D. D'Alessio, Adrian F. Kruse and
Edmund C. Reiter continued to serve as a director following the Annual
Meeting.
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The votes cast to elect the Class I directors were:
Name For Abstain
Michael A. Tzannes 22,616,803 418,173
G. David Forney, Jr. 22,350,447 684,529
ITEM 6:
EXHIBITS
(A) EXHIBITS
Exhibit 10.1 Letter agreement dated May 30, 2006 by and between
Robert J. Weiskopf and Aware, Inc. (incorporated by
reference to Exhibit 99.1 of Aware, Inc.'s current report
on form 8-K filed on May 31, 2006).
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: August 07, 2006 By: /S/ MICHAEL A. TZANNES
----------------------
Michael A. Tzannes, Chief
Executive Officer
Date: August 07, 2006 By: /S/ KEITH E. FARRIS
----------------------
Keith E. Farris, Chief Financial
Officer (Principal Financial and
Accounting Officer)
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