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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 SEPTEMBER 30, 2006
COMMISSION FILE NUMBER 000-21129
AWARE, INC.
-----------
(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 Identification No.)
Incorporation or Organization)
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
November 6, 2006:
CLASS NUMBER OF SHARES OUTSTANDING
----- ----------------------------
Common Stock, par value $0.01 per share 23,569,937
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AWARE, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2006
TABLE OF CONTENTS
PAGE
----
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of
September 30, 2006 and December 31, 2005.......................... 3
Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2006
and September 30, 2005............................................ 4
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2006
and September 30, 2005............................................ 5
Notes to Consolidated Financial Statements........................ 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................... 13
Item 3. Quantitative and Qualitative Disclosures about
Market Risk....................................................... 18
Item 4. Controls and Procedures........................................... 19
PART II OTHER INFORMATION
Item 1. Legal Proceedings................................................. 19
Item 1A. Risk Factors...................................................... 19
Item 6. Exhibits ......................................................... 28
Signatures........................................................ 28
2
PART I. FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2006 2005
-------- --------
ASSETS
Current assets:
Cash and cash equivalents ......................................... $ 12,679 $ 13,068
Short-term investments ............................................ 22,497 23,695
Accounts receivable, net .......................................... 5,855 3,749
Inventories ....................................................... 752 86
Prepaid expenses and other current assets ......................... 748 764
-------- --------
Total current assets ........................................ 42,531 41,362
-------- --------
Property and equipment, net ............................................ 7,934 8,075
Investments ............................................................ 2,484 -
Other assets, net ...................................................... 254 304
-------- --------
Total assets ................................................ $ 53,203 $ 49,741
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable .................................................. $ 456 $ 607
Accrued expenses .................................................. 302 159
Accrued compensation .............................................. 1,150 722
Accrued professional .............................................. 209 212
Deferred revenue .................................................. 758 538
-------- --------
Total current liabilities ................................. 2,875 2,238
-------- --------
Long-term deferred revenue ............................................. 330 -
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, 23,569,937 in 2006 and 23,281,575 in 2005 236 233
Additional paid-in capital ....................................... 81,434 79,093
Accumulated deficit .............................................. (31,672) (31,823)
-------- --------
Total stockholders' equity ................................ 49,998 47,503
-------- --------
Total liabilities and stockholders' equity ................ $ 53,203 $ 49,741
======== ========
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ----------------------
2006 2005 2006 2005
-------- -------- -------- --------
Revenue:
Product sales ............................. $ 1,736 $ 2,417 $ 4,973 $ 4,163
Contract revenue .......................... 3,990 1,920 9,924 5,061
Royalties ................................. 956 750 2,710 2,770
-------- -------- -------- --------
Total revenue ............................ 6,682 5,087 17,607 11,994
Costs and expenses:
Cost of product sales ..................... 286 157 615 279
Cost of contract revenue .................. 1,363 826 3,759 2,384
Research and development .................. 2,726 2,487 8,646 7,400
Selling and marketing ..................... 784 721 2,518 2,064
General and administrative ................ 843 644 2,930 1,940
-------- -------- -------- --------
Total costs and expenses ................. 6,002 4,835 18,468 14,067
Income/(loss) from operations ................. 680 252 (861) (2,073)
Interest income ............................... 490 309 1,342 798
-------- -------- -------- --------
Income/(loss) before provision for income taxes 1,170 561 481 (1,275)
Provision for income taxes .................... 330 - 330 -
-------- -------- -------- --------
Net income/(loss) ............................. $ 840 $ 561 $ 151 ($ 1,275)
======== ======== ======== ========
Net income/(loss) per share - basic ........... $ 0.04 $ 0.02 $ 0.01 ($ 0.06)
Net income/(loss) per share - diluted ......... $ 0.03 $ 0.02 $ 0.01 ($ 0.06)
Weighted average shares - basic ............... 23,552 23,116 23,433 23,027
Weighted average shares - diluted ............. 24,987 25,168 24,976 23,027
The accompanying notes are an integral part of the consolidated financial statements.
4
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
2006 2005
-------- --------
Cash flows from operating activities:
Net income (loss) ............................................ $ 151 ($ 1,275)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization ............................... 491 460
Stock-based compensation .................................... 1,694 -
Increase (decrease) from changes in assets and liabilities:
Accounts receivable .................................... (2,106) (536)
Inventories ............................................ (666) 89
Prepaid expenses ....................................... 17 (239)
Accounts payable ....................................... (151) 90
Accrued expenses ....................................... 567 389
Deferred revenue ....................................... 551 (10)
-------- --------
Net cash provided by (used in) operating activities . 548 (1,032)
-------- --------
Cash flows from investing activities:
Purchases of property and equipment ......................... (301) (219)
Other assets ................................................ - (339)
Sales of investments ........................................ 14,031 20,028
Purchases of investments .................................... (15,316) (13,388)
-------- --------
Net cash provided by (used in) investing activities . (1,586) 6,082
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ..................... 649 842
-------- --------
Net cash provided by financing activities ........... 649 842
-------- --------
Increase (decrease) in cash and cash equivalents ................ (389) 5,892
Cash and cash equivalents, beginning of period .................. 13,068 7,482
-------- --------
Cash and cash equivalents, end of period ........................ $ 12,679 $ 13,374
======== ========
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
September 30, 2006, and of operations and cash flows for the interim
periods ended September 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 September 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):
SEPTEMBER 30, DECEMBER 31,
2006 2005
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Raw materials............................. $752 $86
=========== ==========
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2006 2005 2006 2005
-------- -------- -------- --------
Net income (loss) .......................... $ 840 $ 561 $ 151 ($ 1,275)
Weighted average common shares outstanding . 23,552 23,116 23,433 23,027
Additional dilutive common stock equivalents 1,435 2,052 1,543 -
-------- -------- -------- --------
Diluted shares outstanding ................. 24,987 25,168 24,976 23,027
======== ======== ======== ========
Net income (loss) per share - basic ........ $ 0.04 $ 0.02 $ 0.01 ($ 0.06)
Net income (loss) per share - diluted ...... $ 0.03 $ 0.02 $ 0.01 ($ 0.06)
For the nine month period ended September 30, 2005, potential common
stock equivalents of 1,789,280 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 September 30, 2006 and 2005, options to purchase 2,441,742 and
202,167 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 nine month periods ended
September 30, 2006 and 2005, options to purchase 2,415,492 and 1,876,167
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.
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"),
7
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 September 30, 2006, there were 5,107,363 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 September 30, 2006 there were 138,046 shares
available for future issuance under the ESPP Plan. During the three
months ended September 30, 2006, no 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 NINE MONTHS ENDED
SEPTEMBER 30, 2006 SEPTEMBER 30, 2006
------------------ ------------------
Cost of product sales .......... $ 4 $ 12
Cost of contract revenue ....... 13 98
Research and development ....... 241 786
Selling and marketing .......... 88 266
General and administrative ..... 106 532
------------------ ------------------
Stock-based compensation expense $ 452 $1,694
================== ==================
As a result of adopting SFAS 123(R), the Company's net income for the
three and nine months ended September 30, 2006 was lower by $452,000 and
$1,694,000, respectively, than if it had continued to account for
stock-based compensation under APB 25. Basic and diluted earnings per
share for the three and nine months ended September 30, 2006 was also
lower by $0.02 and $0.07, respectively, due to the adoption of SFAS
123(R).
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
8
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 September 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 and nine months ended September 30, 2006, using the
Black-Scholes valuation model were:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2006 SEPTEMBER 30, 2006
---------------------- ----------------------
Expected term(1) 4.75 years 3.25 - 6.25 years
Expected volatility factor(2) 64% 64-67%
Risk-free interest rate(3) 4.84% 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 income
(loss) and net income (loss) per share. The following table illustrates
the effects on net income (loss) and net income (loss) per share for the
three and nine months ended September 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 NINE MONTHS ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
------------------ ------------------
Net income (loss) as reported $ 561 $ (1,275)
Add: Stock-based employee compensation expense included in net
income (loss)
Less: Total stock-based employee compensation expense
determined under the fair value method (593) (9,042)
------------------ ------------------
Pro forma net loss ($ 32) ($10,317)
================== ==================
Net income (loss) per share:
Basic and diluted -- as reported $ 0.02 ($ 0.06)
Basic and diluted -- pro-forma $ 0.00 ($ 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 the 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 and
nine months ended September 30, 2005 were:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
------------------ ------------------
Expected term 5 years 5 years
Volatility 82% 82-87%
Risk-free interest rate 4.04% 3.87-4.04%
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 nine months
ended September 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 236,500 5.55
Exercised (254,706) 3.01
Cancelled (159,087) 6.77
------------------- --------------
Outstanding, September 30, 2006 6,107,313 $4.78 7.22
=================== ==============
Exercisable at September 30, 2006 5,670,567 $4.71 7.28
All options granted during the nine months ended September 30, 2006 and
2005 were granted with exercise prices equal to the fair market value of
the Company's common stock
10
on the grant date and had weighted average grant date fair values of
$3.02 and $4.22, respectively.
At September 30, 2006, the aggregate intrinsic value of options
outstanding and options exercisable was $29,200,000 and $26,695,000,
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 nine
months ended September 30, 2006 was $710,000.
The following table summarizes the stock options outstanding at
September 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 3,628,146 $ 3.18 7.21 3,595,300 $ 3.17
$5 to $10 2,390,500 6.10 7.39 1,986,600 6.13
$10 to $20 2,417 12.75 0.64 2,417 12.75
$20 to $30 16,750 20.38 4.05 16,750 20.38
$30 to $40 45,000 33.56 2.71 45,000 33.56
$40 to $50 14,500 44.02 3.46 14,500 44.02
$50 to $70 10,000 58.06 3.01 10,000 58.06
--------- ---------
6,107,313 $ 4.78 7.22 5,670,567 $ 4.71
========= =========
At September 30, 2006, unrecognized compensation expense related to
non-vested stock options was $1,117,000, which is expected to be
recognized over a weighted average period of 2 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2006 2005 2006 2005
------------- ------------- ------------- --------------
North America.................................... $3,396 $3,470 $10,604 $8,092
Europe........................................... 1,223 1,598 4,892 3,621
Rest of World.................................... 2,063 19 2,111 281
------------- ------------- ------------- --------------
$6,682 $5,087 $17,607 $11,994
============= ============= ============= ==============
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
11
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 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.
In September 2006 the FASB issued Statement No. 157, FAIR VALUE
MEASUREMENTS. The Statement provides guidance for using fair value to
measure assets and liabilities. This Statement references fair value as
the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants in the
market in which the reporting entity transacts. The Statement applies
whenever other standards require (or permit) assets or liabilities to be
measured at fair value. The Statement does not expand the use of fair
value in any new circumstances. It is effective for financial statements
issued for fiscal years beginning after November 15, 2007, and interim
periods within those fiscal years. The adoption of SFAS No. 157 is not
expected to have a material impact on our financial position, results of
operations or cash flows.
In September 2006, the Securities and Exchange Commission, or SEC, Staff
issued Staff Accounting Bulletin No. 108 (SAB 108) addressing how the
effects of prior-year uncorrected financial statement misstatements
should be considered in current-year financial statements. SAB 108
requires registrants to quantify misstatements using both balance-sheet
and income-statement approaches and to evaluate whether either approach
results in quantifying an error that is material in light of relative
quantitative and qualitative factors. SAB 108 does not change the SEC
staff's previous guidance in Staff Accounting Bulletin No. 99 on
evaluating the materiality of misstatements.
SAB 108 addresses the mechanics of correcting misstatements that include
the effects from prior years. Additionally, SAB 108 requires registrants
to apply the new guidance for the first time that it identifies material
errors in existence at the beginning of the first fiscal year ending
after November 15, 2006 by correcting those errors through a one-time
cumulative effect adjustment to beginning-of-year retained earnings. We
do not anticipate the adoption of SAB 108 to have a material effect on
our financial position, results of operations or cash flows.
12
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 FORM 10-Q, 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 28% from $2.4 million in the third quarter of 2005 to
$1.7 million in the current year quarter. As a percentage of total revenue,
product sales decreased from 48% in the third quarter of 2005 to 26% in the
current year quarter. For the nine months ended September 30, product sales
increased 19% from $4.2 million in 2005 to $5.0 million in 2006. As a percentage
of total revenue, product sales decreased from 35% in the first nine months of
2005 to 28% in the corresponding period of 2006.
For the three month period, the dollar decrease was due to a $0.9 million
decrease in revenue from the sale of software products, offset by a $0.2 million
increase from the sale of hardware products. For the nine month period, the
dollar increase was due to a $0.3 million increase in revenue from the sale of
software products and a $0.5 million increase from the sale of hardware
products.
CONTRACT REVENUE. Contract revenue consists of patent, license and
engineering service fees that we receive under customer agreements relating to
Aware's patents, Aware's DSL technology and Aware's DSL test and diagnostics
technology.
Contract revenue increased 108% from $1.9 million in the third quarter of 2005
to $4.0 million in the current year quarter. As a percentage of total revenue,
contract revenue increased from 38% in the third quarter of 2005 to 60% in the
current year quarter. The increase of $2.1 million was primarily due to patent
and license fees that we received under agreements with our customers including
a patent license agreement with a new customer.
13
For the nine months ended September 30, contract revenue increased 96% from $5.1
million in 2005 to $9.9 million in the current year. As a percentage of total
revenue, contract revenue increased from 42% in the first nine months of 2005 to
56% 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 $2.3 million
due to patent and license fees that we received under agreements with our
customers, including a patent licensing agreement with a new customer.
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 a difficult and uncertain environment in the semiconductor and
telecommunications industries, and 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 patents and technology in their chipsets or solutions.
Royalties increased 27% from $0.8 million in the third quarter of 2005 to $1.0
million in the current year quarter. As a percentage of total revenue, royalties
decreased from 15% in the third quarter of 2005 to 14% in the current year
quarter. The dollar increase in royalty revenues was a result of increased
chipset sales by our customers. For the nine months ended September 30,
royalties decreased 2% from $2.8 million in 2005 to $2.7 million in the current
year. As a percentage of total revenue, royalties decreased from 23% in the
first nine months of 2005 to 15% in the corresponding period of 2006. The dollar
decrease in royalty revenues was due to lower royalties from DSL chipset
customers. The decrease in royalty as a percentage of total revenue is due to
the increase in both product sales and contract revenue.
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 82% from $157,000 in the third
quarter of 2005 to $286,000 in the current year quarter. As a percentage of
product sales, cost of product sales increased from 7% in the third quarter of
2005 to 16% in the current year quarter. For the nine months ended September 30,
cost of product sales increased 120% from $279,000 in 2005 to $615,000 in 2006.
As a percentage of product sales, cost of product sales increased from 7% in the
first nine months of 2005 to 12% 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. In
addition, $4,000 and $12,000 of the
14
current quarter and nine month period increases, respectively, were from
stock-based compensation expense. The resulting decrease in product margin was
primarily due to a larger proportion of new 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 65% from $0.8 million in the third quarter of
2005 to $1.4 million in the current year quarter. As a percentage of contract
revenue, cost of contract revenue decreased from 43% in the third quarter of
2005 to 34% in the current year quarter. For the nine months ended September 30,
cost of contract revenue increased 58% from $2.4 million in 2005 to $3.8 million
in 2006. As a percentage of contract revenue, cost of contract revenue decreased
from 47% in the first nine months of 2005 to 38% 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 nine 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, $13,000 and $98,000
of the current quarter and nine 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 10% from $2.5 million in the third
quarter of 2005 to $2.7 million in the current year quarter. As a percentage of
total revenue, research and development expense decreased from 49% in the third
quarter of 2005 to 41% in the current year quarter. For the nine months ended
September 30, research and development expense increased 17% from $7.4 million
in 2005 to $8.6 million in 2006. As a percentage of total revenue, research and
development expense decreased from 62% in the first nine months of 2005 to 48%
in the corresponding period of 2006.
For the three month and nine month periods, the dollar increase was $241,000 and
$786,000, respectively, of stock-based compensation expense, increased
compensation and fringe benefit cost, and increased patent legal fees. 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,
15
recruiting, and facilities expense. Sales and marketing expense of $0.8 million
in the third quarter of 2006 increased 9% compared to $0.7 million in the
corresponding quarter of 2005. As a percentage of total revenue, sales and
marketing expense decreased from 14% in the third quarter of 2005 to 12% in the
current year quarter due to higher revenues. For the three month period, the
dollar increase was mainly attributable to stock-based compensation expense of
$88,000.
For the nine months ended September 30, selling and marketing expense of $2.5
million increased 22% from $2.1 million in 2005. As a percentage of total
revenue, selling and marketing expense decreased from 17% in the first nine
months of 2005 to 14% in the corresponding period of 2006. For the nine month
period, the dollar increase was mainly attributable to stock-based compensation
expense of $266,000 and other compensation expenses of $130,000.
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 31% from $0.6 million in the third quarter
of 2005 to $0.8 million in the current year quarter. As a percentage of total
revenue, general and administrative expense decreased slightly and was
approximately 13% in both the third quarter of 2005 and in the current year
quarter. For the three month period, the dollar increase was mainly attributable
to stock-based compensation expense of $106,000 and other compensation expenses
of $54,000.
For the nine months ended September 30, general and administrative expense
increased 51% from $1.9 million in 2005 to $2.9 million in 2006. As a percentage
of total revenue, general and administrative expense remained relatively flat at
approximately 16% in the first nine months of 2005 and 2006. For the nine month
period, the dollar increase was mainly attributable to stock-based compensation
expense of $532,000, other compensation expenses of $266,000 and professional
fees of $53,000.
INTEREST INCOME. Interest income increased 59% from $309,000 in the
third quarter of 2005 to $490,000 in the current year quarter. For the nine
months ended September 30, interest income increased 68% from $798,000 in 2005
to $1,342,000 in 2006. For the three and nine 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 nine
months of 2005 and 2006 due to net losses incurred and the uncertainty of the
timing of profitability in future periods, except for taxes paid in non-U.S.
jurisdictions that assess a source withholding tax. 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 September 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 September 30, 2006, we had cash, cash equivalents, and short and long-term
investments of $37.7 million, which represents an increase of $0.9 million from
December 31, 2005. The increase was primarily due to $0.6 million of cash
provided by operations and $0.6 million of
16
proceeds from the exercise of employee stock options. These increases were
partially offset by capital expenditures of $0.3 million.
Cash provided by operations in the first nine months of 2006 was from the net
income of $0.2 million adjusted for non-cash items related to depreciation and
amortization of $0.5 million, stock-based compensation expense of $1.7 million
and working capital requirements of $1.8 million. Capital spending was primarily
related to the purchase of computer hardware and software, and laboratory
equipment used principally in engineering activities.
Cash used in operations in the first nine months of 2005 was primarily from
operating losses. Capital spending was primarily related to the purchase of
computer hardware and software, and laboratory equipment used principally in
engineering activities, as well as expenditures related to the purchase of
certain technology assets.
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 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.
In September 2006 the FASB issued Statement No. 157, FAIR VALUE MEASUREMENTS.
The Statement provides guidance for using fair value to measure assets and
liabilities. This Statement references fair value as the price that would be
received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants in the market in which the reporting
entity transacts. The Statement applies whenever other standards require (or
permit) assets or liabilities to be measured at fair value. The Statement does
not expand the use of fair value in any new circumstances. It is effective for
financial statements issued for fiscal years
17
beginning after November 15, 2007, and interim periods within those fiscal
years. The adoption of SFAS No. 157 is not expected to have a material impact on
our financial position, results of operations or cash flows.
In September 2006, the Securities and Exchange Commission, or SEC, Staff issued
Staff Accounting Bulletin No. 108 (SAB 108) addressing how the effects of
prior-year uncorrected financial statement misstatements should be considered in
current-year financial statements. SAB 108 requires registrants to quantify
misstatements using both balance-sheet and income-statement approaches and to
evaluate whether either approach results in quantifying an error that is
material in light of relative quantitative and qualitative factors. SAB 108 does
not change the SEC staff's previous guidance in Staff Accounting Bulletin No. 99
on evaluating the materiality of misstatements.
SAB 108 addresses the mechanics of correcting misstatements that include the
effects from prior years. Additionally, SAB 108 requires registrants to apply
the new guidance for the first time that it identifies material errors in
existence at the beginning of the first fiscal year ending after November 15,
2006 by correcting those errors through a one-time cumulative effect adjustment
to beginning-of-year retained earnings. We do not anticipate the adoption of SAB
108 to have a material effect on our financial position, results of operations
or cash flows.
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 September 30, 2006, we had $35.2 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.
As of September 30, 2006, we had invested $2.5 million in long-term investments
that matured in one to three years. These long-term securities are invested in
high quality U.S. government securities. Despite the high quality of these
securities, they may be subject to interest rate risk. This means that if
interest rates increase, the principal amount of our investment would probably
decline. A large increase in interest rates may cause a material loss to our
long-term investments. The following table (dollars in thousands) presents
hypothetical changes in the fair value of our long-term investments at September
30, 2006. The modeling technique measures the change in fair value arising from
selected potential changes in interest rates. Movements in interest rates of
plus or minus 50 basis points (BP) and 100 BP reflect immediate hypothetical
shifts in the fair value of these investments.
18
VALUATION OF SECURITIES VALUATION OF SECURITIES
GIVEN AN INTEREST RATE GIVER AN INTEREST RATE
DECREASE OF NO CHANGE INCREASE OF
------------------------- IN INTEREST -------------------------
Type of security (100BP) (50 BP) RATES 100 BP 50 BP
---------------------------------------------------------------------------------------------------------------
Long-term investments with
maturities of one to three years... $2,519 $2,501 $2,484 $2,448 $2,466
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 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
19
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;
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.
20
WE EXPERIENCED NET LOSSES
We had a net annual loss during 2001, 2002, 2003, 2004 and 2005, but have net
income for the first nine months of 2006. We may 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 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
21
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 fourth 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 or Infineon lose market share or are unable to gain
market share, or experience further price erosion in their DSL 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 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;
22
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") and video over DSL
as viable consumer service offerings;
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.
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
23
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.
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.
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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
and VDSL.
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, Ikanos, 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.
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;
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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.
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:
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.
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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.
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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: November 8, 2006 By: /s/ Michael A. Tzannes
----------------------
Michael A. Tzannes, Chief
Executive Officer
Date: November 8, 2006 By: /s/ Keith E. Farris
-------------------
Keith E. Farris, Chief Financial
Officer (Principal Financial and
Accounting Officer)
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