10-Q 1 t10q-2563a.txt 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED MARCH 31, 2004 COMMISSION FILE NUMBER 000-21129 AWARE, INC. ----------- (Exact Name of Registrant as Specified in Its Charter) MASSACHUSETTS 04-2911026 ------------- ---------- (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS, 01730 ---------------------------------------------------- (Address of Principal Executive Offices) (Zip Code) (781) 276-4000 -------------- (Registrant's Telephone Number, Including Area Code) Indicate by check whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2). YES X NO --- --- Indicate the number of shares outstanding of the issuer's common stock as of April 30, 2004: CLASS NUMBER OF SHARES OUTSTANDING ----- ---------------------------- Common Stock, par value $0.01 per share 22,757,724 shares ================================================================================ AWARE, INC. FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2004 TABLE OF CONTENTS Page ---- PART I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003.......................... 3 Consolidated Statements of Operations for the Three Months Ended March 31, 2004 and March 31, 2003............................................ 4 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2004 and March 31, 2003............................................ 5 Notes to Consolidated Financial Statements.................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................... 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk................................................... 21 Item 4. Controls and Procedures....................................... 22 PART II OTHER INFORMATION Item 1. Legal Proceedings............................................. 23 Item 6. Exhibits and Reports on Form 8-K.............................. 24 Signatures.................................................... 24 2
PART I. FINANCIAL INFORMATION ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS AWARE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (UNAUDITED) MARCH 31, DECEMBER 31, 2004 2003 ----------------- ---------------- ASSETS Current assets: Cash and cash equivalents................................................ $21,855 $19,504 Short-term investments................................................... 11,441 15,547 Accounts receivable, net................................................. 2,155 2,449 Inventories.............................................................. 91 48 Prepaid expenses and other assets........................................ 596 563 ----------------- ---------------- Total current assets 36,138 38,111 ----------------- ---------------- Property and equipment, net................................................... 8,686 8,921 Investments................................................................... 5,509 3,913 Other assets, net............................................................. 48 79 ----------------- ---------------- Total assets....................................................... $50,381 $51,024 ================= ================ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable........................................................ $729 $261 Accrued expenses ........................................................ 150 136 Accrued compensation .................................................... 639 439 Accrued professional..................................................... 81 77 Deferred revenue......................................................... 274 471 ----------------- ---------------- Total current liabilities........................................ 1,873 1,384 ----------------- ---------------- Stockholders' equity: Preferred stock, $1.00 par value; 1,000,000 shares authorized, none outstanding................................................. - - Common stock, $.01 par value; 70,000,000 shares authorized; issued and outstanding, 22,755,006 in 2004 and 22,750,294 in 2003...... 228 228 Additional paid-in capital.............................................. 77,415 77,400 Accumulated deficit.................................................... (29,135) (27,988) ----------------- ---------------- Total stockholders' equity...................................... 48,508 49,640 ----------------- ---------------- Total liabilities and stockholders' equity....................... $50,381 $51,024 ================= ================ The accompanying notes are an integral part of the financial statements.
3
AWARE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED MARCH 31, ------------------------------------ 2004 2003 ------------------ ---------------- Revenue: Product sales................................................. $1,223 $710 Contract revenue.............................................. 1,278 330 Royalties..................................................... 1,101 907 ------------------ ---------------- Total revenue 3,602 1,947 Costs and expenses: Cost of product sales......................................... 337 145 Cost of contract revenue...................................... 667 263 Research and development...................................... 2,671 3,448 Selling and marketing......................................... 604 575 General and administrative.................................... 593 648 ------------------ ---------------- Total costs and expenses 4,872 5,079 Loss from operations.............................................. (1,270) (3,132) Interest income................................................... 123 169 ------------------ ---------------- Loss before provision for income taxes............................ (1,147) (2,963) Provision for income taxes........................................ - - ------------------ ---------------- Net loss.......................................................... ($1,147) ($2,963) ================== ================ Net loss per share - basic and diluted ........................... ($0.05) ($0.13) Weighted average shares - basic and diluted....................... 22,751 22,698 The accompanying notes are an integral part of the financial statements.
4
AWARE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) THREE MONTHS ENDED MARCH 31, ------------------------------------ 2004 2003 ---------------- ---------------- Cash flows from operating activities: Net loss................................................... ($1,147) ($2,963) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization............................ 291 405 Increase (decrease) from changes in assets and liabilities: Accounts receivable.................................. 294 (411) Inventories.......................................... (43) (53) Prepaid expenses..................................... (33) (74) Accounts payable..................................... 468 74 Accrued expenses..................................... 218 (270) Deferred revenue..................................... (197) (22) ---------------- ---------------- Net cash used in operating activities............. (149) (3,314) ---------------- ---------------- Cash flows from investing activities: Purchases of property and equipment....................... (25) (71) Net sales (purchases) of short-term investments........... 4,106 (3,087) Net sales (purchases) of investments...................... (1,596) 1,798 ---------------- ---------------- Net cash provided by (used in) investing activities...................................... 2,485 (1,360) ---------------- ---------------- Cash flows from financing activities: Proceeds from issuance of common stock................... 15 - ---------------- ---------------- Net cash provided by financing activities......... 15 - ---------------- ---------------- Increase (decrease) in cash and cash equivalents.............. 2,351 (4,674) Cash and cash equivalents, beginning of period................ 19,504 25,268 ---------------- ---------------- Cash and cash equivalents, end of period...................... $21,855 $20,594 ================ ================ The accompanying notes are an integral part of the 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 March 31, 2004, and of operations and cash flows for the interim periods ended March 31, 2004 and 2003. 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, 2003 in conjunction with our 2003 Annual Report on Form 10-K. The results of operations for the interim period ended March 31, 2004 are not necessarily indicative of the results to be expected for the year. B) INVENTORY Inventory consists primarily of the following (in thousands): MARCH 31, DECEMBER 31, 2004 2003 ----------------- ----------------- Raw materials................. $90 $48 Finished goods................ 1 - ----------------- ----------------- Total.................. $91 $48 ================= ================= 6 C) COMPUTATION OF EARNINGS PER SHARE Basic earnings per share is computed by dividing net income or loss by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income or loss by the weighted average number of common shares outstanding plus additional common shares that would have been outstanding if dilutive potential common shares had been issued. For the purposes of this calculation, stock options are considered common stock equivalents in periods in which they have a dilutive effect. Stock options that are anti-dilutive are excluded from the calculation. Net income or loss per share is calculated as follows (in thousands, except per share data): THREE MONTHS ENDED MARCH 31, ------------------------------- 2004 2003 ------------------------------- Net loss............................. ($1,147) ($2,963) Weighted average common shares outstanding........................ 22,751 22,698 Additional dilutive common stock equivalents........................ - - ------------------------------- Diluted shares outstanding .......... 22,751 22,698 =============================== Net loss per share - basic........... ($0.05) ($0.13) Net loss per share - diluted......... ($0.05) ($0.13) For the three month periods ended March 31, 2004 and 2003, potential common stock equivalents of 434,263 and 446, respectively, were not included in the per share calculation for diluted EPS, because we had net losses and the effect of their inclusion would be anti-dilutive. For the three month periods ended March 31, 2004 and 2003, options to purchase 263,075 and 6,747,169 shares of common stock, respectively, were outstanding, but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the common stock and thus would be anti-dilutive. D) STOCK-BASED COMPENSATION We grant stock options to our employees and directors. Such grants are for a fixed number of shares with an exercise price equal to the fair value of the shares at the date of grant. As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation", we account for stock option grants in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and FASB Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions Involving Stock Compensation." Accordingly, we have adopted the provisions of SFAS No. 123 through disclosure only. No stock-based employee compensation cost is reflected in our net loss, as all options granted under those plans had an exercise price equal to the fair market value of the 7 underlying common stock on the date of grant. The following table illustrates the pro forma effect on net loss and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 and SFAS No. 148 to stock-based employee compensation (in thousands, except per share data): THREE MONTHS ENDED MARCH 31, ------------------------------- 2004 2003 ------------------------------- Net loss - as reported................ ($1,147) ($2,963) Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards.......................... 3,437 5,005 ------------------------------- Net loss - pro forma.................. ($4,584) ($7,968) =============================== Basic loss per share - as reported.... ($0.05) ($0.13) Basic loss per share - pro forma...... ($0.20) ($0.35) Diluted loss per share - as reported.. ($0.05) ($0.13) Diluted loss per share - pro forma.... ($0.20) ($0.35) The fair value of options on their grant date was measured using the Black-Scholes option pricing model. Key assumptions used to apply this pricing model are as follows: THREE MONTHS ENDED MARCH 31, ------------------------------- 2004 2003 ------------------------------- Average risk-free interest rate........ 2.99% 2.91% Expected life of option grants......... 5 years 5 years Expected volatility of underlying stock................................ 95% 98% Expected dividend yield................ - - E) BUSINESS SEGMENTS The Company organizes itself as one segment and conducts its operations in the United States. The Company sells its products and technology to domestic and international customers. Revenues were generated from the following geographic regions (in thousands): THREE MONTHS ENDED MARCH 31, ------------------------------- 2004 2003 ------------------------------- United States......................... $2,037 $1,513 Germany............................... 1,240 374 Rest of World......................... 325 60 ------------------------------- $3,602 $1,947 =============================== 8 F) RECENT ACCOUNTING PRONOUNCEMENTS In December 2003, the SEC issued Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, which supersedes SAB No. 101, Revenue Recognition in Financial Statements. SAB No. 104 rescinds accounting guidance in SAB No. 101 related to multiple-element arrangements as this guidance has been superseded as a result of the issuance of EITF 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). The adoption of SAB No. 104 did not have a material impact on the Company's financial position, results of operations or cash flows. In May 2003, FASB issued Statement of Financial Accounting Standards 150 ("SFAS 150"), "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability. For all financial instruments entered into or modified after May 31, 2003, SFAS 150 is effective immediately. For all other instruments, SFAS 150 goes into effect at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our financial position or results of operations. 9 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 products and compression software. Hardware products primarily include ADSL test and development systems, modules, and modems. Compression software consists of standard off-the-shelf software products that are sold to OEM customers that integrate our software into their equipment-based products. Product sales increased 72% from $0.7 million in the first quarter of 2003 to $1.2 million in the current year quarter. As a percentage of total revenue, product sales decreased from 36% in the first quarter of 2003 to 34% in the current year quarter. The dollar increase was primarily due to an increase in revenue from the sale of modules and to a lesser extent an increase in revenue from the sale of compression software. Module sales were higher primarily due to sales to a customer that is using them in ADSL test equipment. Compression software revenue increased primarily due to higher sales of our JPEG 2000 products. CONTRACT REVENUE. Contract revenue consists primarily of license and engineering service fees that we receive under agreements with our customers to develop ADSL chipsets. Contract revenue increased 287% from $0.3 million in the first quarter of 2003 to $1.3 million in the current year quarter. As a percentage of total revenue, contract revenue increased from 17% in the first quarter of 2003 to 35% in the current year quarter. The dollar increase was primarily due to an increase in customer projects and engineering services we provided to our customers. Despite the increase in contract revenue this quarter, prospective ADSL chipset licensees continue to be reluctant to begin new development projects given: (i) generally weak worldwide economic conditions, (ii) a difficult and uncertain environment in the semiconductor and telecommunications industries, and (iii) intense ADSL chipset competition and falling chipset prices. During the last several years, customers and potential customers cautiously evaluated new chipset projects or delayed or cancelled projects in the face of such conditions. We are 10 uncertain when the economic and market conditions we faced over the last several years will materially improve. 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 21% from $0.9 million in the first quarter of 2003 to $1.1 million in the current year quarter. As a percentage of total revenue, royalties decreased from 47% in the first quarter of 2003 to 31% in the current year quarter. The dollar increase in royalties was primarily due to an increase in ADSL chipset sales by Infineon Technologies AG ("Infineon") and to a lesser extent an increase in royalties from Analog Devices, Inc. ("ADI"). Infineon has continued to increase the number of ADSL chipsets it sells based upon our technology. Infineon has announced design wins with several telecommunications equipment suppliers, including Siemens AG and Alcatel Alsthom S.A., for chipsets that are based on our ADSL technology. We are uncertain how quickly sales of these chipsets will increase and whether they will contribute meaningful royalties to us. Despite the increase in ADSL chipset sales by ADI in 2003 and the first quarter of 2004, ADI's chipset sales have declined in previous quarters primarily due to falling ADSL chipset pricing and lower ADI sales volumes. 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 drop sharply. Additionally, deployments of ADSL service in geographic areas where chipsets based upon our technology have been sold leveled off or declined. We are uncertain whether ADSL chipset pricing will improve, whether ADI will be able to grow its presence or whether our other licensees will contribute meaningful royalty revenue. COST OF PRODUCT SALES. Since the cost of compression software license sales is minimal, cost of product sales consists primarily of costs associated with ADSL hardware product sales. Cost of product sales increased 133% from $145,000 in the first quarter of 2003 to $337,000 in the current year quarter. As a percentage of product sales, cost of product sales increased from 20% in the first quarter of 2003 to 28% in the current year quarter. The dollar increase in cost of product sales was primarily due to higher sales of modules. The overall dollar increase in product margins was primarily due to higher sales of modules and compression software. COST OF CONTRACT REVENUE. Cost of contract revenue consists primarily of salaries for engineers and expenses for consultants, technology licensing fees, recruiting, supplies, equipment, depreciation and facilities associated with customer development projects. Our total engineering costs are allocated between cost of contract revenue and research and development expense. In a given period, the allocation of engineering costs between cost of contract revenue and research and development is a function of the level of effort expended on each. Cost of contract revenue increased 153% from $0.3 million in the first quarter of 2003 to $0.7 million in the current year quarter. As a percentage of contract revenue, cost of contract revenue decreased from 80% in the first quarter of 2003 to 52% in the current year quarter. The dollar increase in cost of contract revenue was primarily due to more customer projects in the first quarter of 2004 as compared with the first quarter of 2003. Since our cost of contract revenue is based on the level of effort we expend on customer projects and the number of customer projects increased in the first quarter of 2004, cost of contract revenue increased as well. 11 RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense consists primarily of salaries for engineers and expenses for consultants, recruiting, supplies, equipment, depreciation and facilities related to engineering projects to enhance and extend our broadband intellectual property offerings, and our compression software technology. Research and development expense decreased 23% from $3.4 million in the first quarter of 2003 to $2.7 million in the current year quarter. As a percentage of total revenue, research and development expense decreased from 177% in the first quarter of 2003 to 74% in the current year quarter, principally as a result of increased revenues. The dollar decrease was primarily due to lower spending on internal research and development projects and a shift of engineers from internal research and development projects, where spending is classified as research and development expense, to customer projects, where spending is classified as cost of contract revenue. This shift occurred because we had more customer projects in the first quarter of 2004 than in the first quarter of 2003. Our research and development spending is principally focused on projects related to core ADSL technology, including our StratiPHY(TM) family of chips, as well as for Dr. DSL(R), G.SHDSL, wireless local area network communications, VDSL, and other development projects. SELLING AND MARKETING EXPENSE. Selling and marketing expense consists primarily of salaries for sales and marketing personnel, travel, advertising and promotion, recruiting, and facilities expense. Sales and marketing expense increased 5% from $575,000 in the first quarter of 2003 to $604,000 in the current year quarter. As a percentage of total revenue, sales and marketing expense decreased from 30% in the first quarter of 2003 to 17% in the current year quarter. The dollar increase was primarily due to higher sales commissions. GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense consists primarily of salaries for administrative personnel, facilities costs, and public company, bad debt, legal, and audit expenses. General and administrative expense decreased 9% from $648,000 in the first quarter of 2003 to $593,000 in the current year quarter. As a percentage of total revenue, general and administrative expense decreased from 33% in the first quarter of 2003 to 16% in the current year quarter. The dollar decrease was primarily due to lower spending on salary and fringe benefits. INTEREST INCOME. Interest income decreased 27% from $169,000 in the first quarter of 2003 to $123,000 in the current year quarter. The dollar decrease was primarily due to lower interest rates earned on our cash balances and lower cash balances. INCOME TAXES. We made no provision for income taxes in the first three months of 2004 due to net losses incurred. In 2002, we determined that due to our continuing operating losses as well as the uncertainty of the timing of profitability in future periods, we should fully reserve our deferred tax assets. As of March 31, 2004, 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. 12 LIQUIDITY AND CAPITAL RESOURCES At March 31, 2004, we had cash, cash equivalents, short-term investments and investments of $38.8 million, which represents a decrease of $0.2 million from December 31, 2003. The decrease is primarily due to $0.2 million of cash used in operations. Cash used in operations in the first three months of 2004 was primarily the result of operating losses and working capital requirements. While we can not assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash, cash equivalents and investments will be sufficient to fund our operations for at least the next twelve months. RECENT ACCOUNTING PRONOUNCEMENTS In December 2003, the SEC issued Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, which supersedes SAB No. 101, Revenue Recognition in Financial Statements. SAB No. 104 rescinds accounting guidance in SAB No. 101 related to multiple-element arrangements as this guidance has been superseded as a result of the issuance of EITF 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). The adoption of SAB No. 104 did not have a material impact on the Company's financial position, results of operations or cash flows. In May 2003, FASB issued Statement of Financial Accounting Standards 150 ("SFAS 150"), "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability. For all financial instruments entered into or modified after May 31, 2003, SFAS 150 is effective immediately. For all other instruments, SFAS 150 goes into effect at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our financial position or results of operations. RISK FACTORS We believe that the occurrence of any one or some combination of the following risk factors could seriously harm our business. OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY Our quarterly revenue and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. Because our revenue components fluctuate and are difficult to predict, and our expenses are largely independent of revenues in any particular period, it is difficult for us to accurately forecast revenues and profitability. We generally recognize contract revenues ratably over the period during which we expect to provide engineering services. While this means that contract revenues from current licenses are generally predictable, changes can be introduced by a reevaluation of the length of the development period, or by the termination of a 13 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 licensees is difficult because the development of a business relationship with a potential licensee is a lengthy process, frequently spanning a year or more, and the fiscal period in which a new license agreement will be entered into, if at all, and the financial terms of such an agreement are difficult to predict. Contract revenues also include fees for engineering services, which are dependent upon the varying level of assistance desired by licensees and, therefore, the revenue from these services is also difficult to predict. It is also difficult for us to make accurate forecasts of royalty revenues. Royalties are recognized in the quarter in which we receive a report from a licensee regarding the shipment of licensed integrated circuits in the prior quarter, and are dependent upon fluctuating sales volumes and/or prices of chips containing our technology, all of which are beyond our ability to control or assess in advance. Our business is subject to a variety of additional risks, which could materially adversely affect quarterly and annual operating results, including: |X| market acceptance of our broadband technologies by semiconductor companies; |X| the extent and timing of new license transactions with semiconductor companies; |X| changes in our and our licensees' development schedules and levels of expenditure on research and development; |X| the loss of a strategic relationship or termination of a project by a licensee; |X| equipment companies' acceptance of integrated circuits produced by our licensees; |X| the loss by a licensee of a strategic relationship with an equipment company customer; |X| announcements or introductions of new technologies or products by us or our competitors; |X| delays or problems in the introduction or performance of enhancements or of future generations of our technology; |X| failures or problems in our hardware or software products; |X| delays in the adoption of new industry standards or changes in market perception of the value of new or existing standards; |X| competitive pressures resulting in lower contract revenues or royalty rates; |X| personnel changes, particularly those involving engineering and technical personnel; |X| costs associated with protecting our intellectual property; |X| the potential that licensees could fail to make payments under their current contracts; |X| ADSL market-related issues, including lower ADSL chipset unit demand brought on by excess channel inventory and lower average selling prices for ADSL chipsets as a result of market surpluses; |X| regulatory developments; and |X| general economic trends and other factors. WE EXPERIENCED NET LOSSES We had a net loss during 2001, 2002, 2003 and the first three months of 2004. We expect that we will have a net loss during the second quarter of 2004. We may continue to experience losses in the future if; 14 |X| the semiconductor and telecommunications markets do not improve; |X| our existing customers do not increase their revenues from sales of chipsets with our technology; |X| new and existing customers do not choose to license our intellectual property for new chipset products; or |X| a profitable business does not emerge from our Dr. DSL efforts. WE HAVE A UNIQUE BUSINESS MODEL The success of our business model depends upon our ability to license our technology to semiconductor and equipment companies, and our customers' willingness and ability to sell products that incorporate our technology so that we may receive significant royalties that are consistent with our plans and expectations. We face numerous risks in successfully obtaining suitable licensees on terms consistent with our business model, including, among others: |X| we must typically undergo a lengthy and expensive process of building a relationship with a potential licensee before there is any assurance of a license agreement with such party; |X| we must persuade semiconductor and equipment manufacturers with significant resources to rely on us for critical technology on an ongoing basis rather than trying to develop similar technology internally; |X| we must persuade potential licensees to bear development costs associated with our technology applications and to make the necessary investment to successfully produce chipsets and products using our technology; and |X| we must successfully transfer technical know-how to licensees. Moreover, the success of our business model also depends on the receipt of royalties from licensees. Royalties from our licensees are often based on the selling prices of our licensees' chipsets and products, over which we have little or no control. We also have little or no control over our licensees' promotional and marketing efforts. Our licensees are not required to pay us royalties unless they use our technology. They are not prohibited from competing against us. Our business could be seriously harmed if: |X| we cannot obtain suitable licensees; |X| our licensees fail to achieve significant sales of chipsets or products incorporating our technology; or |X| we otherwise fail to implement our business strategy successfully. THERE HAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, 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 has experienced an oversupply of ADSL chipsets and central office equipment. Excessive inventory levels led to soft chipset demand, 15 which in turn led to declining ASPs. As a result of the soft demand and declining ASPs for ADSL chipsets, our royalty revenue has decreased substantially from the levels we achieved in 2000. Price decreases for ADSL chipsets, and the corresponding decreases in per unit royalties received by us, can be sudden and dramatic. Pricing pressures may continue during the second quarter of 2004 and beyond. Our royalty revenue may decline over the long term. WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES There is 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 licensee relationships, our business could be seriously harmed. In addition, our prospective customers may use their superior size and bargaining power to demand license terms that are unfavorable to us and prospective customers may not elect to license from us. WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM ONE CUSTOMER In 2001, 2002, 2003 and the first three months of 2004, we derived 52%, 32%, 27% and 21%, respectively of our total revenue from ADI. ADI was the first customer to license ADSL technology from us in 1993, and their chipsets are the most mature implementations of our technology in the market. Our royalty revenues to date have been primarily due to sales of ADI chipsets that use our ADSL technology. Our royalty revenue in the near term is highly dependent upon ADI's ability to maintain its market share and pricing. The ADSL market has experienced significant price erosion, which has adversely affected ADI's ADSL revenue, which in turn has adversely affected our royalty revenue. To the extent that ADI has lost market share, or loses market share in the future, is unable to transition its product to support new ADSL2 and ADSL2+ standards, or experiences further price erosion in its ADSL chipsets, our royalty revenue could decline. OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES Due to our business strategy, our success is dependent on our ability to generate significant royalties from our licensing arrangements with semiconductor manufacturers. Our ability to generate significant royalties is materially affected by the willingness of equipment companies to purchase integrated circuits that incorporate our technology from our licensees. There are other competitive solutions available for equipment companies seeking to offer broadband communications products. We face the risk that equipment manufacturers will choose those alternative solutions. Generally, our ability to influence equipment companies' decisions whether to purchase integrated circuits that incorporates our technology is limited. We also face the risk that equipment companies that elect to use integrated circuits that incorporate our technology into their products will not compete successfully against other equipment companies. Many factors beyond our control could influence the success or failure of a particular equipment company that uses integrated circuits based on our technology, including: |X| competition from other businesses in the same industry; |X| market acceptance of its products; 16 |X| its engineering, sales and marketing, and management capabilities; |X| technical challenges of developing its products unrelated to our technology; and |X| its financial and other resources. Even if equipment companies incorporate our chipsets based on our intellectual property into their products, their products may not achieve commercial acceptance or result in significant royalties to us. OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL ADSL SERVICE IN VOLUME The success of our ADSL licensing business depends upon telephone companies installing ADSL service in significant volumes. Factors that affect the volume deployment of ADSL service include: |X| the desire of telephone companies to install ADSL service, which is dependent on the development of a viable business model for ADSL service, including the capability to market, sell, install and maintain the service; |X| the pricing of ADSL services by telephone companies; |X| the quality of telephone companies' networks; |X| government regulations; and |X| the willingness of residential telephone customers to demand ADSL service in the face of competitive service offerings, such as cable modems. If telephone companies do not install ADSL service in significant volumes, or if telephone companies install ADSL service based on other technology, our business will be seriously harmed. OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION Because we are a technology provider, our ability to protect our intellectual property and to operate without infringing the intellectual property rights of others is critical to our success. We regard our technology as proprietary, and we have a number of patents and pending patent applications. We also rely on a combination of trade secrets, copyright and trademark law and non-disclosure agreements to protect our unpatented intellectual property. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization. As part of our licensing arrangements, we typically work closely with our semiconductor and equipment manufacturer licensees, many of whom are also our potential competitors, and provide them with proprietary know-how necessary for their development of customized chipsets based on our ADSL technology. Although our license agreements contain non-disclosure provisions and other terms protecting our proprietary know-how and technology rights, it is possible that, despite these precautions, some of our licensees might obtain from us proprietary information that they could use to compete with us in the marketplace. Although we intend to defend our intellectual property as necessary, the steps we have taken may be inadequate to prevent misappropriation. 17 In the future, we may choose to bring legal action to enforce our intellectual property rights. Any such litigation could be costly and time-consuming for us, even if we were to prevail. Moreover, even if we are successful in protecting our proprietary information, our competitors may independently develop technologies substantially equivalent or superior to our technology. The misappropriation of our technology or the development of competitive technology could seriously harm our business. Our technology, software or products may infringe the intellectual property rights of others. A large and increasing number of participants in the telecommunications and compression industries have applied for or obtained patents. Some of these patent holders have demonstrated a readiness to commence litigation based on allegations of patent and other intellectual property infringement. Third parties may assert patent, copyright and other intellectual property rights to technologies that are important to our business. In the past, we have received claims from other companies that our technology infringes their patent rights. Intellectual property rights can be uncertain and can involve complex legal and factual questions. We may infringe the proprietary rights of others, which could result in significant liability for us. If we were found to have infringed any third party's patents, we could be subject to substantial damages and an injunction preventing us from conducting our business. OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE The semiconductor and telecommunications industries, as well as the market for high-speed network access technologies, are characterized by rapid technological change, with new generations of products being introduced regularly and with ongoing evolutionary improvements. We expect to depend on our ADSL technology for a substantial portion of our revenue for the foreseeable future. Therefore, we face risks that others could introduce competing technology that renders our ADSL technology less desirable or obsolete. Also, the announcement of new technologies could cause our licensees or their customers to delay or defer entering into arrangements for the use of our existing technology. Either of these events could seriously harm our business. We expect that our business will depend to a significant extent on our ability to introduce enhancements and new generations of our ADSL technology as well as new technologies that keep pace with changes in the telecommunications and broadband industries and that achieve rapid market acceptance. We must continually devote significant engineering resources to achieving technical innovations. These innovations are complex and require long development cycles. Moreover, we may have to make substantial investments in technological innovations before we can determine their commercial viability. We may lack sufficient financial resources to fund future development. Also, our licensees may decide not to share certain research and development costs with us. Revenue from technological innovations, even if successfully developed, may not be sufficient to recoup the costs of development. One element of our business strategy is to assume the risks of technology development failure while reducing such risks for our licensees. In the past, we have spent significant amounts on development projects that did not produce any marketable technologies or products, and we cannot assure you that it will not occur again. 18 WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS Our success as an intellectual property supplier depends on the willingness and ability of semiconductor manufacturers to design, build and sell integrated circuits based on our intellectual property. The semiconductor industry is intensely competitive and has been characterized by price erosion, rapid technological change, short product life cycles, cyclical market patterns and increasing foreign and domestic competition. As an intellectual property supplier to the semiconductor industry, we face intense competition from internal development teams within potential semiconductor customers. We must convince potential licensees to license from us rather than develop technology internally. Furthermore, semiconductor customers, who have licensed our intellectual property, may choose to abandon joint development projects with us and develop chipsets themselves without using our technology. In addition to competition from internal development teams, we compete against other independent suppliers of intellectual property. We anticipate intense competition from suppliers of intellectual property for ADSL. The market for ADSL chipsets is also intensely competitive. Our success within the ADSL industry requires that ADSL equipment manufacturers buy chipsets from our semiconductor licensees, and that telephone companies buy ADSL equipment from those equipment manufacturers. Our customers' chipsets compete with products from other vendors of standards-based and ADSL chipsets, including Broadcom, Centillium, Conexant, ST Microelectronics and Texas Instruments. ADSL services offered over copper telephone networks also compete with alternative broadband transmission technologies that use the telephone network as well as other network architectures. Alternative technologies for the telephone network include symmetric high speed DSL (also known as HDSL, SDSL and G.SHDSL), and very high speed DSL, also known as VDSL. These DSL technologies are based on techniques other than those used by ADSL to transport high-speed data over telephone lines. Alternative technologies that use other network architectures to provide high-speed data service include cable modems using cable networks, and wireless solutions using wireless networks. These alternative broadband technologies may be more successful than ADSL and we may not be able to participate in the markets involving these alternative technologies. Many of our current and prospective ADSL licensees, as well as chipset competitors that compete with our semiconductor licensees, including Broadcom, Conexant, ST Microelectronics and Texas Instruments have significantly greater financial, technological, manufacturing, marketing and personnel resources than we do. We may be unable to compete successfully, and competitive pressures could seriously harm our business. WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS We prepare our financial statements in accordance with generally accepted accounting principles and certain critical accounting polices that are relevant to our business. The application of these principles and policies requires us to make significant judgments and estimates. In the event that judgments and estimates we make are incorrect, we may have to change them, which could materially affect our financial position and results of operations. 19 Moreover, accounting standards have been subject to rapid change and evolving interpretations by accounting standards setting organizations over the past few years. The implementation of new standards requires us to interpret and apply them appropriately. If our current interpretations or applications are later found to be incorrect, our financial position and results of operations could be materially affected. OUR STOCK PRICE MAY BE EXTREMELY VOLATILE Volatility in our stock price may negatively affect the price you may receive for your shares of common stock and increases the risk that we could be the subject of costly securities litigation. The market price of our common stock has fluctuated substantially and could continue to fluctuate based on a variety of factors, including: |X| quarterly fluctuations in our operating results; |X| changes in future financial guidance that we may provide to investors and public market analysts; |X| changes in our relationships with our licensees; |X| announcements of technological innovations or new products by us, our licensees or our competitors; |X| changes in ADSL market growth rates as well as investor perceptions regarding the investment opportunity that companies participating in the ADSL industry afford them; |X| changes in earnings estimates by public market analysts; |X| key personnel losses; |X| sales of common stock; and |X| developments or announcements with respect to industry standards, patents or proprietary rights. In addition, the equity markets have experienced volatility that has particularly affected the market prices of equity securities of many high technology companies and that often has been unrelated or disproportionate to the operating performance of such companies. These broad market fluctuations may adversely affect the market price of our common stock. OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS The extensive regulation of the telecommunications industry by federal, state and foreign regulatory agencies, including the Federal Communications Commission, and various state public utility and service commissions, could affect us through the effects of such regulation on our licensees and their customers. In addition, our business may also be affected by the imposition of certain tariffs, duties and other import restrictions on components that our customers obtain from non-domestic suppliers or by the imposition of export restrictions on products sold internationally and incorporating our technology. Changes in current or future laws or regulations, in the United States or elsewhere, could seriously harm our business. 20 ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market risk relates primarily to our investment portfolio, and the effect that changes in interest rates would have on that portfolio. Our investment portfolio has included: |X| Cash and cash equivalents, which consist of financial instruments with original maturities of three months or less; and |X| 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 March 31, 2004, we had $33.3 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 March 31, 2004, we had invested $5.5 million in long-term investments that matured in one to three years. These long-term securities are invested in high quality corporate securities and 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 March 31, 2004. 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.
Valuation of securities No change Valuation of securities given an interest rate in interest given an interest rate decrease of rates increase of ------------------------- ------------------------- Type of security (100BP) (50 BP) 100 BP 50 BP --------------------------------------------------------------------------------------------------------------- Long-term investments with maturities of one to three years $5,609 $5,558 $5,509 $5,410 $5,459
21 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. 22 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. 23 ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K (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. (B) REPORTS ON 8-K We filed a Form 8-K dated February 5, 2004, which included as an exhibit a press release dated February 5, 2004 announcing our financial results for the quarter and year ended December 31, 2003. -------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AWARE, INC. Date: May 10, 2004 By: /s/ Michael A. Tzannes ---------------------- Michael A. Tzannes, Chief Executive Officer Date: May 10, 2004 By: /s/ Robert J. Weiskopf ---------------------- Robert J. Weiskopf, Chief Financial Officer (Principal Financial and Accounting Officer) 24