10-Q 1 v98774e10vq.htm FORM 10-Q Spatializer Audio Laboratories, Inc. - 3/31/2004
Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q


(Mark One)

    [X]     Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the period ended: March 31, 2004

OR

    [  ]     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 000-26460

SPATIALIZER AUDIO LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

     
Delaware
(State or other jurisdiction of
incorporation or organization)
  95-4484725
(IRS Employer
Identification No.)

920 Hampshire Road, Suite A-34
Westlake Village, California 91361

(Address of principal executive offices)

1754 Technology Drive, Suite 125
San Jose, California 95110

(Address of principal corporate offices)

Telephone Number: (408) 453-4180

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

     
Yes [X]
  No [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

     
Yes [   ]
  No [X]

As of May 7, 2004, there were 47,015,865 shares of the Registrant’s Common Stock outstanding.



 


TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF OPERATIONS
CONSOLIDATED STATEMENT OF CASH FLOWS
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 2. CHANGES IN SECURITIES
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8K
SIGNATURES
EXHIBIT 31.1
EXHIBIT 32.1


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PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

                 
    March 31,   December 31,
    2004
  2003
    (unaudited)        
ASSETS
               
Current Assets:
               
Cash and Cash Equivalents
  $ 647,148     $ 589,797  
Accounts Receivable, net
    182,519       345,411  
Prepaid Expenses and Deposits
    7,844       35,430  
 
   
 
     
 
 
Total Current Assets
    837,511       970,638  
Property and Equipment, net
    38,221       42,022  
Intangible Assets, net
    188,897       192,485  
 
   
 
     
 
 
Total Assets
  $ 1,064,629     $ 1,205,145  
 
   
 
     
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current Liabilities:
               
Notes Payable to Related Party, Short Term
    37,500       37,500  
Accounts Payable
    40,246       21,466  
Accrued Wages and Benefits
    44,491       36,973  
Accrued Professional Fees
    5,000       20,000  
Accrued Commissions
    17,813       33,856  
Accrued Expenses
    29,197       28,197  
 
   
 
     
 
 
Total Current Liabilities
    174,247       177,992  
Notes Payable to Related Party, Long Term
    57,771       70,746  
Commitments and Contingencies
               
Series B-1, Redeemable Convertible Preferred shares, $.01 par value, 1,000,000 shares authorized, 102,762 shares issued and outstanding at March 31, 2004 and December 31, 2003.
    1,028       1,028  
Shareholders’ Equity:
               
Common shares, $.01 par value, 65,000,000 shares authorized, 47,015,865 shares issued and outstanding at March 31, 2004 and December 31, 2003.
    470,159       470,159  
Additional Paid-In Capital
    46,428,615       46,428,615  
Accumulated Deficit
    (46,067,191 )     (45,943,395 )
 
   
 
     
 
 
Total Shareholders’ Equity
    831,583       955,379  
 
   
 
     
 
 
Total Liabilities and Shareholders’ Equity
    1,064,629       1,205,145  

 


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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

                 
    For the Three Month Period Ended
    March 31,   March 31,
    2004
  2003
Revenues:
               
License Revenues
  $     $  
Royalty Revenues
    170,679       332,378  
Product Revenues
           
 
   
 
     
 
 
 
    170,679       332,378  
Cost of Revenues
    17,004       35,942  
 
   
 
     
 
 
Gross Profit
    153,675       296,436  
Operating Expenses:
               
General and Administrative
    166,630       156,402  
Research and Development
    95,482       109,003  
Sales and Marketing
    13,701       102,139  
 
   
 
     
 
 
 
    275,813       367,544  
 
   
 
     
 
 
Operating (Loss)
    (122,138 )     (71,108 )
Interest and Other Income
    941       2,492  
Interest and Other Expense
    (2,599 )     (2,813 )
 
   
 
     
 
 
 
    (1,658 )     (321 )
 
   
 
     
 
 
(Loss) Before Income Taxes
    (123,796 )     (71,429 )
Income Taxes
          (3,020 )
 
   
 
     
 
 
Net (Loss)
  $ (123,796 )   $ (74,449 )
 
   
 
     
 
 
Basic (Loss) Per Share
  $ (0.00 )   $ (0.00 )
 
   
 
     
 
 
Weighted Average Shares Outstanding
    47,015,865       47,406,939  
 
   
 
     
 
 

 


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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
                 
    Three Months Ended
    March 31,
    2004
  2003
Cash Flows from Operating Activities:
               
Net (Loss)
  $ (123,796 )   $ (74,449 )
Adjustments to reconcile net (loss) to net cash provided by (used in) operating activities:
               
Depreciation and Amortization
    17,097       25,806  
Net Change in Assets and Liabilities:
               
Accounts Receivable and Employee Advances
    162,892       153,523  
Prepaid Expenses and Deposits
    27,586       (7,238 )
Accounts Payable
    18,780       (7,034 )
Accrued Wages and Benefits
    7,518          
Accrued Professional Fees
    (15,000 )        
Accrued Commissions
    (16,043 )        
Accrued Expenses
    1,000       (53,985 )
 
   
 
     
 
 
Net Cash Provided By (Used In) Operating Activities
    80,034       36,623  
 
   
 
     
 
 
Cash Flows from Investing Activities:
               
Purchase/Disp of Property and Equipment
          (1,770 )
Increase in Capitalized Patent and Technology Costs
    (9,708 )      
 
           
 
 
Net Cash Provided By (Used in) Investing Activities
    (9,708 )     (1,770 )
 
   
 
     
 
 
Cash flows from Financing Activities:
               
Issuance of Preferred Shares, Net
           
Issuance of Common Shares, Net
           
Exercise of Options
           
Exercise of Warrants
           
Issuance of Notes Payable
           
Issuance of Related Party Payable
           
Repayment of Notes Payable
    (12,975 )      
 
   
 
     
 
 
Net Cash Provided by Financing Activities
    (12,975 )      
 
   
 
     
 
 
Increase (Decrease) in Cash and Cash Equivalents
    57,351       34,853  
Cash and Cash Equivalents, Beginning of Period
    589,797       858,724  
 
   
 
     
 
 
Cash and Cash Equivalents, End of Period
  $ 647,148     $ 893,577  
 
   
 
     
 
 
Supplemental Disclosure of Cash Flow Information:
               
Cash paid during the period for:
               
Interest
  $ 2,599     $ 2,811  
Income Taxes
          3,020  
 
   
 
     
 
 

 


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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(unaudited)

                                         
    Common Shares
                   
                                    Total
    Number of           Additional   Accumulated   Shareholders’
    shares
  Par value
  paid-in-capital
  Deficit
  Equity
Balance, December 31, 2003
    47,015,865     $ 470,159     $ 46,428,615     $ (45,943,395 )   $ 955,379  
Issuance of Preferred Shares, Net
                             
Options Exercised
                             
Warrants Exercised
                             
Options Issued for Services
                             
Conversion of Preferred Shares, Net
                             
Net (Loss)
                      (123,796 )     (123,796 )
 
   
 
     
 
     
 
     
 
     
 
 
Balance, March 31, 2004
    47,015,865     $ 470,159     $ 46,428,615     $ (46,067,191 )   $ 831,583  
 
   
 
     
 
     
 
     
 
     
 
 

 


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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(1) Nature of Business

     Spatializer Audio Laboratories, Inc. and subsidiaries (the “Company”) is in the business of developing and licensing technology. The Company sales, research and subsidiary administration are conducted out of facilities in Santa Clara, California.

     The Company’s wholly-owned subsidiary, Desper Products, Inc. (“DPI”), is in the business of developing proprietary advanced audio signal processing technologies and products for consumer electronics, entertainment, and multimedia computing. All Company revenues are generated from this subsidiary.

The foregoing interim financial information is unaudited and has been prepared from the books and records of the Company. The financial information reflects all adjustments necessary for a fair presentation of the financial condition, results of operations and cash flows of the Company in conformity with generally accepted accounting principles. All such adjustments were of a normal recurring nature for interim financial reporting. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Accordingly, your attention is directed to footnote disclosures found in the December 31, 2003 Annual Report and particularly to Note 1, which includes a summary of significant accounting policies.

(2) Significant Accounting Policies

     Basis of Consolidation — The consolidated financial statements include the accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, Desper Products, Inc. All significant intercompany balances and transactions have been eliminated in consolidation. Corporate administration is not allocated to subsidiaries.

     Revenue Recognition — The Company recognizes revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

     Concentration of Credit Risk — Financial instruments, which potentially subject the company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at CitiBank FSB. At March 31, 2004 substantially all cash and cash equivalents were on deposit at two financial institutions.

     At March 31, 2004, four major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: Matsushita, Samsung, Sharp and Orion Corporation, each of whom accounted for greater than 10% of our total 2004 accounts receivable. One OEM accounted for 44.0%, another accounted for 15%, another accounted for 12.0% and one accounted for 12% of our total accounts receivable at March 31, 2004.

 


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     The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable. Due to the contractual nature of sales agreements and historical trends, no allowance for doubtful accounts has been provided.

     The Company does not apply interest charges to past due accounts receivable.

     Cash and Cash Equivalents — Cash equivalents consist of highly liquid investments with original maturities of three months or less.

     Customers Outside of the U.S. — Sales to foreign customers were 100% and 77% of total sales in the year to date periods ended March 31, 2004 and 2003, respectively. Approximately 88% of sales were generated in Japan.

     Major Customers — During the quarter ended March 31, 2004, four customers accounted for 44%, 15%, 12% and 12%, respectively, of the Company’s net sales.

     Research and Development Costs — The Company expenses research and development costs as incurred, which is presented as a separate line on the statement of operations.

     Property and Equipment — Property and equipment are stated at cost. Major renewals and improvements are charged to the asset accounts while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to income. Property and equipment are depreciated over the useful lives of the asset ranging from 3 years to 5 years under the straight line method.

     Intangible Assets — Intangible assets consist of patent costs and trademarks which are amortized on a straight-line basis over the estimated useful lives of the patents which range from five to twenty years. The weighted average useful life of patents was approximately 12 years.

     Earnings Per Share — Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The following table presents contingently issuable shares, options and warrants to purchase shares of common stock that were outstanding during the three month periods ended March 31, 2004 and 2003 which were not included in the computation of diluted loss per share because the impact would have been antidilutive or less than $0.01 per share:

                 
    2004
  2003
Options
    3,035,000       2,571,500  
Warrants
    0       0  
 
   
 
     
 
 
 
    3,035,000       2,571,500  
 
   
 
     
 
 

 


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During the three months ended March 31, 2004, no options were granted to officers and board members and no options had expired.

     Impairment of Long-Lived Assets and Assets to be Disposed of - The Company adopted the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, on January 1, 1996. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amounts of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

     Segment Reporting - The Financial Accounting Standards Board issued Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in June 1997. SFAS No. 131 establishes standards for the way public business enterprises are to report information about operating segments in annual financial statements and requires enterprises to report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. It replaces the “industry segment” concept of SFAS No. 14, Financial Reporting for Segments of a Business Enterprise, with a “management approach” concept as to basis for identifying reportable segments. SFAS 131 is effective for financial statements for fiscal years beginning after December 15, 1997. The Company adopted SFAS 131 in December 1997. MDT is considered a discontinued operation as of September 1998. As of March 31, 2004, the Company has only one operating segment, DPI, the Company’s Audio Signal Processing business.

     Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     Recent Accounting Pronouncements - The FASB recently issued the following statements: FASB 146 - Accounting for Costs Associated with Exit or Disposal Activities, FASB 147 - Acquisitions of Certain Financial Institutions, FASB 148 - Accounting for Stock-Based Compensation. These FASB statements did not, or are not expected to, have a material impact on the Company’s financial position and results of operations, FASB 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity and FASB Interpretation 46 “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.”

     Use of Estimates - Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

 


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     Fair Value of Financial Instruments - The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2003 and March 31, 2004 approximated fair value due to their short maturity or nature.

     The fair values of notes payable to a related party at December 31, 2003 and March 31, 2004 are materially consistent with the related carrying values based on current rates offered to the Company for instruments with similar maturities.

(3) Property and Equipment

     Property and equipment, as of December 31, 2003 and March 31, 2004, consists of the following, net of a reserve for impairment loss in 1998 in accordance with application of SFAS 121:

                 
    March 31, 2004
  December 31, 2003
Office Computers, Software, Equipment and Furniture
  $ 309,744     $ 309,744  
Test Equipment
    73,300       73,300  
Tooling Equipment
    45,539       45,539  
Trade Show Booth and Demonstration Equipment
    171,301       171,301  
Automobiles
    7,000       7,000  
Leasehold Improvements
    0       0  
Total Property and Equipment
    606,884       606,884  
 
   
 
     
 
 
Less Accumulated Depreciation and Amortization
    568,663       564,862  
 
   
 
     
 
 
Property and Equipment, Net
  $ 38,221     $ 42,022  
 
   
 
     
 
 

(4) Intangible Assets

     Intangible assets, as of December 31, 2003 and March 31, 2004 consist of the following:

                 
    March 31, 2004
  December 31, 2003
Capitalized Patent, Trademarks and Technology Costs
  $ 515,196     $ 505,487  
Less Accumulated Amortization
    326,299       313,002  
 
   
 
     
 
 
Intangible Assets, Net
  $ 188,897     $ 192,485  
 
   
 
     
 
 

     Estimated amortization is as follows:

         
2004
  $ 43,794  
2005
  $ 25,733  
2006
  $ 16,702  
2007
  $ 16,702  
Thereafter
  $ 85,966  
 
   
 
 
 
    188,897  

 


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(5) Notes Payable to Related Parties

     The Company was indebted to the Desper Family Trust, a related party, in the amount of $95,271 at March 31, 2004. In the fourth quarter of 2003, in response to the calling of the Note by the holder, we negotiated and completed the conversion of the original $112,500 related party 10% demand note to a three-year 10% term note. This amount bears interest at a fixed rate of 10% annually, is paid in monthly installments of $5,191 that commenced on December 1, 2003 and continues for twenty-four months until the entire balance of principal and interest is paid in full.

(6) Shareholders’ Equity

     During the quarter ended March 31, 2004, no shares were issued or converted.

     During the year ended December 31, 2003, shares were issued or converted as follows:

An employee exercised options to purchase 166,666 shares of common stock in 2003, increasing shareholders’ equity by $10,000.

Capitalization

Series A Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Company’s Series A Preferred Stock are outstanding and that no shares of the Series A Preferred Stock will be issued.

Series B Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Company’s Series B Preferred Stock are outstanding and that no shares of the Series B Preferred Stock will be issued.

Series B-1 Redeemable Convertible Preferred Stock: On November 6, 2002 the Board of Directors Designated a Series B-1 Preferred Stock. The series has a par value of $0.01 and a stated value of $10.00 per share which is designated as a liquidation preference. The stock ranks prior to the Company’s common stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion rights exist on or after January 1, 2003 to convert the Series B-1 Preferred Stock to common at a certain formula. At December 29, 2005 certain mandatory conversion requirements exist subject to a certain formula. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading exist based on date sensitive events. In December 2002, 87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B Preferred Stock.

 


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(7) Escrowed Performance Shares

In December 1996, the Company accepted the terms outlined by the British Columbia Securities Commission (“BCSC”) for the release of the Company’s 5,776,700 escrowed “Performance Shares” from Canadian Escrow into a new escrow arrangement with the Company. The overall modification was approved by the Company’s stockholders in August 1996. Under the revised arrangement, the performance shares were released automatically as follows: 20% prior to June 22, 2000, 20% on June 22, 2000; 30% on June 22, 2001; and 30% on June 22, 2002. Under the revised escrow arrangement, the performance shares vested, provided the individual had not voluntarily terminated his/her relationship with the Company prior to applicable vesting dates.

Based on the revised escrow arrangement, which primarily converted the escrow shares release from performance criteria to a time-based criteria, the Company recorded as compensation expense the excess of the fair market value of the 5,776,700 performance shares on the date the Company accepted the terms of the new escrow arrangement over the purchase price of such escrow shares.

All of the performance shares are included in the issued and outstanding shares for the years ended December 31, 2003, 2002 and 2001. However, the shares were not reflected in the calculation of loss per common share until earned by and released to the holders on December 30, 1996, the date on which the Company and the BCSC accepted and entered into the terms of the current escrowed agreement as discussed above. As of December 31, 2002, all performance shares under the escrow arrangement have been released. In December 2003, the remaining 557,740 shares of former employees or participants, who lost entitlement to such shares under the terms of the BCSC, were cancelled.

(8) Stock Options

     In 1995, the Company adopted a stock option plan (the “Plan”) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The Plan which was approved by the stockholders authorizes grants of options to purchase authorized but unissued common stock up to 10% of total common shares outstanding at each calendar quarter, 4,701,587 as of December 31, 2004. Stock options are granted with an exercise price equal to the stock’s fair market value at the date of grant. Stock options have five-year terms and vest and become fully exercisable up to three years from the date of grant.

     At March 31, 2004, there were 1,666,587 additional shares available for grant under the Plan.

     There were no options granted in the quarter ended March 31, 2004.

 


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     The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for the fair value of its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net income (loss) would have been increased to the pro forma amounts indicated below:

         
    2004
NET INCOME (LOSS):
       
As Reported
  $ (124,000 )
Pro Forma
  $ (125,000 )
BASIC AND DILUTED LOSS:
       
As Reported
  $ (0.00 )
Pro Forma
  $ (0.00 )

     At March 30, 2004, the number of options exercisable was 3,035,000 and the weighted-average exercise price of those options was $0.10.

     There were no warrants outstanding at December 31, 2003 and March 31, 2004.

(9) Commitments and Contingencies

     We also anticipate that, from time to time, we may be named as a party to other legal proceedings that may arise in the ordinary course of our business.

Operating Lease Commitments

     The Company is obligated under several non-cancelable operating leases. Future minimum rental payments at March 30, 2004 for all operating leases were approximately $17,000 through November 2004. Rent expense amounted to approximately $5,400 and $21,000 for the quarters ended March 30, 2004 and 2003, respectively.

(10) Profit Sharing Plan

     The Company has a 401(k) profit sharing plan covering substantially all employees, subject to certain participation and vesting requirements. The Company may elect to make discretionary contributions to the Plan, but has never done so over the life of the Plan..

 


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

Approach to MD&A

     The purpose of MD&A is to provide our shareholders and other interested parties with information necessary to gain an understanding of our financial condition, changes in financial condition and results of operations. As such, we seek to satisfy three principal objectives:

  to provide a narrative explanation of a company’s financial statements that enables investors to see the Company through the eyes of management;
 
  to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
 
  to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.

     We believe the best way to achieve this is to give the reader:

  An understanding of our operating environment
 
  An outline of critical accounting policies
 
  A review of the key components of the financial statements and our cash position and capital resources
 
  Disclosure on our internal controls and procedures

Operating Environment

     We operate in a very competitive business environment. This environment impacts us in the following ways, further discussed in greater detail under Risk Factors:

    Our Operating Results Fluctuate and If We Are Unable to Achieve or Sustain Profitability in the Future or Obtain Future Financing Our Business Operations May Fail

    Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.

    We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third parties Have Their Own Priorities and Alliances that May Delay or Thwart our Sales Efforts to Potential Customers.

    If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive Products May Reach The Market Before Our Products.

    Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those Of Our Competitors

    If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully Operate Our Business.

 


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The PC and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in features. While we present a value proposition that stresses the cost reducing capabilities of our audio solutions through improved performance from lower cost components as well as product differentiation that Spatializer technology can deliver, all such features are closely scrutinized by potential customers’ product marketing and engineering. This makes it more challenging to secure new design wins, particularly in product categories that have become commoditized, such as the case with DVD players. It also may result in the elimination of features, including ours, if cost is of paramount importance. When this occurs, we receive very short notice and revenues from such an account will typically begin a steep decline in the subsequent quarter, resulting in period-to-period fluctuation. Our response has been to strengthen our value proposition, more aggressively price and feature enrich our products and enter new segments, such as cell phones, with different competitive pressure.

Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to actual cash flow. These schedules are also prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce new deals until the target product is being introduced.

Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company.

Therefore, when reviewing the operating results or drawing conclusions with regard to future performance, these competitive forces and uncertainties must be taken into consideration. Without absolute long-term visibility, it is difficult to draw such conclusions in absolute terms. Further, the dynamic nature of the business environment creates the potential for both positive and negative fluctuations in near and long term operating performance. While management strives to mitigate these risks, as outlined in Risk Factors, it is not possible to be fully immune from such dynamics.

 


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Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are critical to an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.

     The first critical accounting policy relates to revenue recognition. We recognize revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

     The second critical accounting policy relates to research and development expenses. We expense all research and development expenses as incurred. Costs incurred to establish the technological feasibility of our algorithms (which is the primary component of our licensing) is expensed as incurred and included in Research and Development expenses. Such algorithms are refined based on customer requirements and licensed for inclusion in the customer’s specific product. There are no production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86.

     The third critical accounting policy relates to intangible assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the patent (which range from 3 to 20 years) using the straight-line method. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, only intangible assets with definite lives are amortized. Non-amortized intangible assets are instead subject to annual impairment testing.

     Audit Committee

     This committee is directed to review the scope, cost and results of the independent audit of our books and records, the results of the annual audit with management and the internal auditors and the adequacy of our accounting, financial, and operating controls; to recommend annually to the Board of Directors the selection of the independent auditors; to approve proposals made by our independent auditors for consulting work; and to report to the Board of Directors, when so requested, on any accounting of financial matters.

     Additionally, following the completion of the audit, the committee meets with the independent accountants to review with the independent accountants any problems or difficulties the accountants may have encountered in connection with the audit, the adequacy of the internal accounting controls, the financial and accounting personnel and any management letter provided by the independent accountants and the Company’s response to that letter. The committee also discusses with the independent accountants any matters that are required to be discussed under applicable rules, including without limitation those matters required to be discussed by Statement on Auditing Standards No. 61 relating to the conduct of the audit.

     Compensation and Stock Committee

     Our Compensation and Stock Option Committee (the “Compensation Committee”) currently consists of Messrs. Pace and Segel, each of whom is a non-employee director of the Company and a “disinterested person” with respect to the plans administered by such

 


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committee, as such term is defined in Rule 16b-3 adopted under the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (collectively, the “Exchange Act”). The Compensation Committee reviews and approves annual salaries, bonuses and other forms and items of compensation for our senior officers and employees. Except for plans that are, in accordance with their terms or as required by law, administered by the Board of Directors or another particularly designated group, the Compensation Committee also administers and implements all of our stock option and other stock-based and equity-based benefit plans (including performance-based plans), recommends changes or additions to those plans or awards under the plans.

Special Committee

In November of 2002, the Board of Directors created a Special Committee to review certain strategic opportunities as they arise and to obtain additional information regarding such opportunities for consideration and evaluation by the Board of Directors.

Results of Operations

This form 10-Q contains forward-looking statements, within the meaning of the Private Securities Reform Act of 1995, which are subject to a variety of risks and uncertainties. Our actual results, performance, or achievements may differ significantly from the results, performance, or achievements expressed or implied in such forward-looking statements.

Revenues

Revenues for the three months ended March 31, 2004 were $171,000, compared to revenues of $332,000 in the comparable period last year, a decrease of 48%. The decline in revenue resulted from the expiration of a licensing agreement with a major computer account in January 2003 ($75,000 reduction) and the effects of cost reductions by DVD player accounts resulting in outsourcing to manufacturers in China who generally decline to pay for such software or where features must be eliminated to achieve manufacturing cost targets. This resulted in an additional reduction of revenue of approximately $90,000. This was partially offset by an increase in revenues from cell phone accounts that started shipping commercial quantities with our technologies in the first quarter.

Gross Profit

Gross profit for the three months ended March 31, 2004 was $154,000 (90% of revenue) compared to gross profit of $296,000 (89% of revenue) in the comparable period last year, a decrease of 48%. Gross profit decreased due to the decrease in revenue.

Operating Expenses

Operating expenses in the three months ended March 31, 2004 were $276,000 (161% of revenue) compared to operating expenses of $368,000 (111% of revenue) in the comparable period last year, decrease of 25%. The decrease in operating expenses for the three months ended March 31, 2004 resulted primarily from decreased sales and marketing expenses.

General and Administrative

General and administrative expenses in the three months ended March 31, 2004 were $167,000 (98% of revenue) compared to general and administrative expenses of $156,000 (47% of revenue) in the comparable period last year, an increase of 7%. The increase in general and administrative expense resulted primarily from higher legal and accounting expenses arising from new regulatory public company requirements and higher executive overseas travel by the chief executive to secure additional contracts with manufacturers and maintain existing relationships with our customers.

 


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Research and Development

Research and development expenses in the three months ended March 31, 2004 were $95,000 (56% of revenue) compared to research and development expenses of $109,000 (33% of revenue) in the comparable period last year, a decrease of 13%. The decrease in such expenses resulted primarily from lower cost Silicon Valley facilities, partially offset by greater use of outside specialist engineering consulting compared with the prior period.

Sales and Marketing

Sales and marketing expenses in the three months ended March 31, 2004 were $14,000 (8% of revenue) compared to sales and marketing expenses of $102,000 (31% of revenue) in the comparable period last year, a decrease of 86%. The decrease in sales and marketing expense resulted primarily from the elimination of a senior sales executive position ($50,000), transition of Japan sales to a commission only structure ($20,000), lower cost Silicon Valley facilities ($15,000) and lower marketing support staff expense ($3,000) as compared with the comparable period last year.

Net (Loss)

     Net loss in the three months ended March 31, 2004 was $124,000, ($0.00) basic per share, compared with net loss of $74,000 ($0.00) basic per share in the comparable period last year. The net loss resulted from decreased revenues, partially offset by slightly lower operating expenses.

Liquidity and Capital Resources

     At March 31, 2004, we had $647,000 in cash and cash equivalents as compared to $589,000 at December 31, 2003. The increase in cash and cash equivalents is attributed to the decreases in accounts receivable. We had working capital of $663,000 at March 31, 2004 as compared with working capital of $792,000 at December 31, 2003. Our future cash flow will come primarily from the audio signal processing licensing, Original Equipment Manufacturers’ (“OEM”) royalties and from possible common stock issuances including warrants and options. We are actively engaged in negotiations for additional audio signal processing licensing arrangements which should generate additional cash flow without imposing any substantial costs on the Company. We anticipated that there will be a wind down of our licensing program in 2003 with a large computer account and reductions in licensing to DVD accounts that are under extreme pressure to reduce costs. We announced two new licensing arrangements in the cellular phone market and expect this category to expand in 2004. We are also targeting other markets where the cost pressure is not as acute and which might be more receptive to licensing our products.

     In November 2002, the Board of Directors and the holders of our previously outstanding Series B Preferred Stock agreed to exchange the Series B Preferred Stock for a new Series B-1 Preferred Stock, which are convertible commencing in December 2005 into restricted Common Stock at a 10% discount, based on the 10 day average closing bid price prior to the conversion, but subject to a minimum conversion of $.56 per share and a maximum of $1.12 per share. The exchange was completed in December 2002. In connection with the exchange the Series B-1 Preferred Stock, we withdrew the Series A and Series B Preferred Stock and,

 


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therefore, currently the Series B-1 Preferred Stock is our only authorized or outstanding class of preferred stock.

     In the fourth quarter of 2003, we negotiated and completed the conversion of a $112,500 related party 10% demand note to a three-year 10% term note. Principal and interest of $5,191 is paid monthly, which we pay on a current basis. Installments due in more than twelve months are classified as Notes Payable to Related Parties-long-term.

     We continue to maintain an accrual for unasserted claims or settlement costs of approximately $28,000. We do not expect any final liability to be in excess of this balance.

     Future payments due under operating lease obligations as of March 31, 2004 are described below:

                                         
            Payments due by period
   
            Less than                   More than
Contractual obligations
  Total
  1 year
  1-3 years
  3-5 years
  5 years
[Long-Term Debt Obligations]
  $ 95,271     $ 37,500     $ 57,771                  
[Capital Lease Obligations]
                                       
[Operating Lease Obligations]
  $ 16,600     $ 16,600                          
[Purchase Obligations]
                                       
[Other Long-Term Liabilities Reflected on the Registrant’s Balance Sheet under GAAP]
                                       
Total
  $ 111,871     $ 54,100     $ 57,771                  

     Our future cash flow will come primarily from the audio signal processing licensing, OEM royalties and from possible common stock issuances including warrants and options. We are actively engaged in negotiations for additional audio signal processing licensing arrangements which we believe should generate additional cash flow without imposing any substantial costs on us. We anticipate that there may continue to be dislocations of individual licensing programs due to continuing pressure to reduce costs, particularly in the DVD player segment. We currently believe that growth from other licensing arrangements, which include new markets such as cellular phones, and other arrangements that are pending but not announced or in negotiation, will substantially offset any revenue shortfalls from market dynamics or transitioning platforms. Further, we anticipate that our cost reduction initiative implemented in the fourth quarter of 2003 will lower the revenues needed to reach the break-even point.

     The fluid, competitive and dynamic nature of the market continues a degree of uncertainty to our operations. The operations of our business, and those of our competitors, may also be impacted by the continued trend in the semiconductor industry to offer free, but minimal audio solutions to certain product classes to maintain and attract market share. This challenges our ability to convert business opportunities to licensing agreements in those segments that allow us to maintain or rapidly increase revenue. As a result, we must develop

 


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and license its products and software solutions in a market that treats some audio products, including those of our competitors, on a commodity basis in those cases where the OEM product is considered a commodity product. While our software applications deliver what we and most manufacturers who listen to it believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. We have responded by offering additional products targeted to each price/quality segment of the market and continue to aggressively pursue new opportunities in emerging product categories such as cellular phones and notebook computers that complements our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for us, and our rational commercial competitors, to enhance their operating results.

     To the extent we maintain or exceed our projected revenues and are not required to fund significant contingencies, we expect to continue to retain our current cash reserves and therefore, maintain our liquidity position at a consistent level both on a short-term and long-term basis. To the extent that we do not achieve current operating levels or are required to fund contingencies, we will be required to use some of our cash reserves and this could impact our longer term liquidity. In addition, we wish to achieve accelerated growth and to take advantage of the dynamic market forces in which we operate, rather than to be affected by them. We believe our current cash reserves and cash generated from our existing operations and customer base are sufficient for us to meet our operating obligations and the anticipated additional research and development for our audio technology business for at least the next 12 months. We will also continue to consider and evaluate capital investment or business arrangements with financial or strategic participants or investors as such opportunities become available to us on terms that enhance shareholder value and support our business strategy.

Net Operating Loss Carry forwards

     At December 31, 2003, we had net operating loss carry forwards for Federal income tax purposes of approximately $27,000,000 which are available to offset future Federal taxable income, if any, through 2023. Approximately $17,000,000 of these net operating loss carry forwards are subject to an annual limitation of approximately $1,000,000.

Inflation

     We believe that the moderate inflation rate of the last several years has not impacted our operations.

Recently Issued Accounting Pronouncements

     In July 2001, the FASB issued SFAS No. 141, “Business Combinations,” which establishes financial accounting and reporting for business combinations and supersedes APB Opinion No. 16, “Business Combinations,” and FASB statement No. 38, “Accounting for Preacquisition Contingencies of Purchased Enterprises.” SFAS No. 141 requires that all business combinations be accounted for using one method, the purchase method. The

 


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provisions apply to all business combinations initiated after June 30, 2001.

     In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets,” which establishes financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, “Intangible Assets.” SFAS No. 142 addresses how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition, and after they have been initially recognized in the financial statements. The provisions of SFAS no. 142 were effective for fiscal years beginning after December 15, 2001. We adopted SFAS No. 142 during the first quarter of fiscal 2002, and the adoption of SFAS No. 142 had no material impact on our financial reporting and related disclosures.

     In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which is effective for us beginning fiscal 2003. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made, with the associated asset retirement costs capitalized as part of the carrying amount of the long-lived assets. We do not expect the adoption of SFAS No. 143 to have a material impact on our financial position and results of operations.

     In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001 and interim periods within those fiscal periods. SFAS No. 144 supersedes FASB Statement No. 121 and parts of APB Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions Relating to Extraordinary Items.” However, SFAS No. 144 retains the requirement of APB Opinion No. 30 to report discontinued operations separately from continuing operations and extends that reporting to a component of an entity that either has been disposed of (by sale, by abandonment or in a distribution to owners) or is classified as held for sale. SFAS No. 144 addresses financial accounting and reporting for the impairment of certain long-lived assets and for long-lived assets to be disposed of. We do not expect the adoption of SFAS No. 144 to have a material impact on our financial position and results of operations.

     In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities”, which nullifies EITF Issue 94-3. SFAS 146 is effective for exit and disposal activities that are initiated after December 31, 2002 and requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred in contrast to the date of an entity’s commitment to an exit plan, as required by EITF Issue 94-3. We do not expect the adoption of SFAS No. 146 to have a material impact on our financial position and results of operations.

     In December 2002, the FASB issued SFAS 148 “Accounting for Stock-Based Compensation” an amendment to SFAS 123. SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for fiscal years

 


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ending after December 15, 2002 for transition guidance and annual disclosure provisions; for financial reports containing financial statements for interim periods beginning after December 15, 2002 for interim disclosure provisions. The adoption of SFAS No. 148 did not have a material impact on our financial position and results of operations.

In January 2003 the FASB issued Interpretation 46 “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”. This Interpretation requires a Company to consolidate the financial statements of a “Variable Interest Entity” (“VIE”), sometimes also known as a “special purpose entity”, even if the entity does not hold a majority equity interest in the VIE. The Interpretation requires that if a business enterprise has a “controlling financial interest” in a VIE, the assets, liabilities, and results of the activities of the VIE should be included in consolidated financial statements with those of the business enterprise, even if it holds a minority equity position. This Interpretation was effective immediately for all VIE’s created after January 31, 2003; for the first fiscal year or interim period beginning after June 15, 2003 for VIE’s in which a Company holds a variable interest that it acquired before February 1, 2003.

In May 2003 the FASB issued SFAS 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. This Statement establishes standards for how an issuer of debt or equity 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 (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this pronouncement is not expected to have a material effect on the Company’s financial position, results from operations or cash flows.

In December 2003, the FASB issued SFAS 132R “Employers’ Disclosures about Pensions and Other Postretirement Benefits — an amendment of FASB Statements No. 87, 88, and 106". This Statement revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers’Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The Company will adopt the provisions of SFAS 132R on January 1, 2004. The adoption of this pronouncement is not expected to have a material effect on the Company’s financial position, results from operations or cash flows.

Risk Factors

     Certain information in this report includes forward-looking statements. Forward-looking statements include statements regarding our expectations, beliefs, intentions, plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements that are other than statements of historical fact. When used in this report the

 


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words “shall,” “should,” “forecast,” “all of,” “projected,” “believes,” “anticipates,” “expects,” and similar expressions are intended to identify these forward-looking statements. In addition, we may from time to time make oral forward-looking statements. We wish to caution readers that a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed above in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” elsewhere in this report or from time to time described in our other filings with the Securities and Exchange Commission.

Our Operating Results Fluctuate and If We Are Unable to Achieve or Sustain Profitability in the Future or Obtain Future Financing Our Business Operations May Fail

     We experienced a loss from operations in 2003 and 2001 but were profitable in 2002. We experienced small losses in the last quarter of 2002, the first quarter of 2003, a larger loss in the second quarter of 2003 and a reduced loss in subsequent quarters. While our objective and full effort is on managing a profitable business, due to the market conditions and factors outlined above and below and their impact on fluctuations in operating expenses and revenues , we cannot provide assurance that we will be able to generate a positive profit position in any given future period. We cannot guarantee that we will increase sales of our products and technologies, or that we will successfully develop and market any additional products, or achieve or sustain future profitability, and we may have to rely on the sale of shares or on debt financings in the future, which may have a dilutive effect on our existing shareholders. Further, we cannot assure you that debt or equity financing will be available as required and if not available, we would have to further scale down operations or even cease operations.

Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.

     We are seeking commercial acceptance of our products in highly competitive markets. Certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. We have responded by offering additional products targeted to each price and quality segment of the market and continue to aggressively pursue new opportunities in emerging product categories and complements to our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for us, and its rational commercial competitors, to enhance their operating results. There is no assurance that our present or contemplated future products will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors who had access to significantly greater resources or which are willing to “give away” their products.

We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third parties Have Their Own Priorities and Alliances that May Delay or Thwart our Sales Efforts to Potential Customers.

Spatializer does not develop or market semiconductors. That is why we carry no inventory or

 


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have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company.

If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive Products May Reach The Market Before Our Products.

     Since our inception, we have experienced delays in bringing new products to market and commercial application as a result of delays inherent in technology development, financial resource limits and industry responses and maturity. These delays have resulted in delays in the timing of revenues and product introduction. In the future, delays in new product development or technology introduction on behalf of us, our original equipment manufacturers of consumer electronics and multimedia computer products (OEMs), integrated circuit (IC) foundries or our software producers and marketers could result in further delays in revenues and could allow competitors to reach the market with products before us. In view of the emerging nature of the technology involved, and the rapidly changing character of the entire media, internet and computer markets, our expansion into other technology areas such as cellular telephones and the uncertainties concerning the ability of our current products and new products to achieve meaningful commercial acceptance in these new technology areas, there can be no assurance of when or if we will achieve or sustain profitability.

     Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to cash flow. These schedules are also prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce new deals until the target product is being introduced.

     We expect that we will continue to be dependent upon a limited number of OEMs for a significant portion of our net sales in future periods, although no OEM is presently obligated either to purchase a specified amount of products or to provide us with binding forecasts of product purchases for any period. Our four largest customers as of March 30, 2004 accounted for 44%, 15%, 12% and 12% of our net sales. The loss of any one of our major customers or licensees would significantly reduce our revenues and harm our ability to achieve or sustain acceptable levels of operating results. The loss, or signing of a similarly sized account or accounts would have a material short term impact on our operations and there is no assurance that we will not lose all or some of the revenues from one or more of these accounts. While we are working to broaden the sources of our royalty streams, there can be no assurance that we will be successful in retaining or attracting such key accounts and broadening such revenue stream sources.

 


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     Our products are typically one of many related products used by consumer electronic users. Demand for our products is therefore subject to many risks beyond our control, including, among others:

  competition faced by our OEM customers in their particular end markets;
 
  the technical, sales and marketing and management capabilities of our OEM customers;
 
  the pressure faced by our OEM customers to reduce cost

     There can be no assurance that we will not lose sales in the future as a result of the pressure to reduce costs faced by our customers. The reduction of orders from our significant OEM customers, or the discontinuance of our products by our end users may subject us to potential adverse revenue fluctuations.

Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those Of Our Competitors.

     We operate in a technology environment which is competitive and rapidly changing. While our software applications deliver what we, and most manufacturers who listen to it, believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. Our future success is dependent on establishing and maintaining the technological superiority of our products over those of competitors, our ability to successfully identify and bring other compatible technologies and products to market and a recognition by the market of product value. We compete with a number of entities that produce various stereo audio enhancement processes, technologies and products in both traditional two-speaker environments such as consumer electronics and multimedia computing, and in multi-channel, multi-speaker applications such as Home Theater. In the field of 3-D or “virtual audio”, our principal competitors are SRS Labs, Inc., QSound Labs, Inc. and Dolby Laboratories or technologies and products developed by other companies, including entities that have business relationships with us. There can be no assurance that we will be able to favorably compete in this market in the future.

If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully Operate Our Business.

     Our future success primarily depends on the abilities and efforts of a small number of individuals, with particular management obligations and technical expertise. Loss of the services of any of these persons could adversely affect our business prospects. There is no assurance that we will be able to retain this group or successfully recruit other personnel, as needed. We compete with other enterprises with stronger financial resources and larger staffs that may offer employment opportunities to our staff which are more desirable than those which we are able to offer. Failure to maintain skilled personnel with the software and engineering skills critical to our business could have an adverse impact upon our business, the results of our operations and our prospects. Currently, we have an employment agreement with Henry R. Mandell with a term expiring in November 2005.

 


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Item 3. Quantitative and Qualitative Disclosures About Market Risk

We have not been exposed to material future earnings or cash flow fluctuations from changes in interest rates on our short-term investments at March 31, 2004. A hypothetical decrease of 100 basis points in interest rate (ten percent of our overall earnings rate) would not result in a material fluctuation in future earnings or cash flow. We have not entered into any derivative financial instruments to manage interest rate risk or for speculative purposes and we are not currently evaluating the future use of such financial instruments.

Item 4. Controls and Procedures

The Company carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer had concluded that the Company’s disclosure controls and procedures as of March 31, 2004 were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms. There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 


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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     From time to time we may be involved in various disputes and litigation matters arising in the normal course of business. As of May 13, 2004, we are not involved in any legal proceedings that are expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our results of operations of the period in which the ruling occurs. Our estimate of the potential impact on our financial position or overall results of operations for new legal proceedings could change in the future.

ITEM 2. CHANGES IN SECURITIES

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8K

(a)  Exhibits

     
31.1   Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1   Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
*   Certification will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934.

(b) Reports on Form 8-K:

On March 18, 2004, we filed a Current Report on Form 8-K regarding a press release issued with earnings information for the year ended December 31, 2003. The information furnished in the report shall not be deemed to be filed for purposes of Section 18 of the Securities Exchange Act of 1934.

 


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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.

Dated: May 13, 2004

     
    SPATIALIZER AUDIO LABORATORIES, INC.
(Registrant)
 
 
    /s/ Henry R. Mandell
   
    Henry R. Mandell
Chairman of the Board, Chief Executive Officer
Chief Financial Officer and Secretary