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| AWRE > SEC Filings for AWRE > Form 10-Q on 24-Oct-2008 | All Recent SEC Filings |
24-Oct-2008
Quarterly Report
Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995
Some of the information in this Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as "may," "will," "expect," "anticipate," "believe," "estimate," "continue" and similar words. You should read statements that contain these words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating results or financial condition; or (3) state other "forward-looking" information. However, we may not be able to predict future events accurately. The risk factors listed in this Form 10-Q, as well as any cautionary language in this Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this Form 10-Q could materially and adversely affect our business.
Results of Operations
Product Sales. Product sales consist primarily of revenue from the sale of hardware and software products. Hardware products consist of DSL test and diagnostics hardware, including systems, modules, and modems. Software products consist of software products for biometric, medical imaging and digital imaging applications, as well as DSL test and diagnostics software.
Product sales decreased 23% from $5.1 million in the third quarter of 2007 to $3.9 million in the current year quarter. As a percentage of total revenue, product sales decreased from 68% in the second quarter of 2007 to 62% in the current year quarter. The dollar decrease in product sales was primarily due to a decrease in revenue from the sale of test and diagnostic hardware and software.
For the nine months ended September 30, 2008, product sales decreased 4% from $12.3 million in 2007 to $11.8 million in 2008. As a percentage of total revenue, product sales increased from 63% in the first nine months of 2007 to 64% in the corresponding period of 2008. The dollar decrease in product sales was primarily due to a decrease in revenue from the sale of test and diagnostic hardware and software, which was mostly offset by an increase in revenue from the sale of biometric software.
Contract Revenue. Contract revenue consists of patent, license and engineering service fees that we receive under agreements relating to the sale or license of Aware's patents, DSL technology, DSL test and diagnostic technology, and biometrics technology.
Contract revenue increased 9% from $1.9 million in the third quarter of 2007 to $2.0 million in the current year quarter. As a percentage of total revenue, contract revenue increased from 25% in the third quarter of 2007 to 32% in the current year quarter. The dollar increase in contract revenue was due to higher revenue from biometrics technology contracts, which was mostly offset by a decrease in revenue from DSL technology contracts. DSL contract revenue was lower because we performed less engineering services for existing customers, and we were unable to sign contracts with new customers.
For the nine months ended September 30, 2008, contract revenue increased 1% from $5.26 million in 2007 to $5.31 million in 2008. As a percentage of total revenue, contract revenue increased from 27% in the first nine months of 2007 to 29% in the corresponding period of 2008. The dollar increase in contract revenue was primarily due to increased revenue from biometrics technology contracts, which was mostly offset by lower revenue from DSL technology contracts.
While we believe that the transition to ADSL2+ and VDSL2 technology increases the value proposition of our technology, some existing and prospective DSL chipset licensees have continued to be reluctant to begin new development projects given a difficult and uncertain environment in the semiconductor and telecommunications industries, and intense ADSL chipset competition and falling chipset prices.
During the last several years, customers and potential customers cautiously evaluated new chipset projects or delayed or cancelled projects in the face of such conditions. Moreover, some of our existing customers have recently decided to exit the DSL chipset business altogether. During the first quarter of 2008, one of our unannounced DSL licensees notified us that it wished to terminate an ongoing development project with us as a result of its sale of certain DSL assets to another company. On July 15, 2008, we filed a lawsuit against this licensee seeking damages for breach of contract. In July 2008, Thomson, another one of our DSL licensees, announced that it was discontinuing its silicon solutions business. As a result of these customer actions, we do not expect to generate additional revenue from these DSL licensing contracts.
Royalties. Royalties consist of royalty payments that we receive under licensing agreements. We receive royalties from customers for the right to use our patents and technology in their chipsets or solutions.
Royalties decreased 14% from $0.5 million in the third quarter of 2007 to $0.4 million in the current year quarter. As a percentage of total revenue, royalties were 7% in the third quarter of 2007 and 2008.
For the nine months ended September 30, 2008, royalties decreased 37% from $2.1 million in 2007 to $1.3 million in 2008. As a percentage of total revenue, royalties decreased from 11% in the first nine months of 2007 to 7% in the corresponding period of 2008.
For the three and nine month periods, the dollar decrease in royalties was primarily due to a decrease in ADSL royalties, and to a lesser degree, to a decrease in VDSL and medical imaging royalties.
Our royalty revenue comes predominantly from ADSL chipset sales by Ikanos Communications, Inc. ("Ikanos"), and Infineon Technologies AG ("Infineon"). Despite steady growth of worldwide ADSL subscribers over the last several years, the availability of ADSL chipsets from a number of suppliers and intense competition among those suppliers has caused chipset prices to steadily decline. We are uncertain how the transition to ADSL2+ and VDSL2 will impact our customers in the near term, how quickly sales of our customers' chipsets will increase and whether such increases will contribute meaningful royalties to us.
Cost of Product Sales. Cost of product sales consists primarily of the cost of hardware product sales. The cost of software product sales is minimal.
Cost of product sales decreased 41% from $0.9 million in the third quarter of 2007 to $0.5 million in the current year quarter. As a percentage of product sales, cost of product sales decreased from 18% in the third quarter of 2007 to 13% in the current year quarter, which resulted in gross margins on product sales increasing from 82% to 87%.
For the nine months ended September 30, 2008, cost of product sales decreased 36% from $3.1 million in 2007 to $2.0 million in 2008. As a percentage of product sales, cost of product sales decreased from 25% in the first nine months of 2007 to 17% in the corresponding period of 2008, which resulted in gross margins on product sales increasing from 75% to 83%.
For the three and nine month periods, the dollar decrease in cost of product sales was primarily due to lower sales of test and diagnostic hardware products. The increase in gross margins on product sales was primarily due to a greater proportion of software sales in the product sales mix.
Cost of Contract Revenue. Cost of contract revenue consists primarily of compensation costs for engineers and expenses for consultants, technology licensing fees, recruiting, supplies, equipment, depreciation and facilities associated with customer development projects. Our total engineering costs are allocated between cost of contract revenue and research and development expense. In a given period, the allocation of engineering costs between cost of contract revenue and research and development is a function of the level of effort expended on each. Commencing in the fourth quarter of 2007, cost of contract revenue also includes direct expenses for third party contractors and consultants for biometrics technology contracts.
Cost of contract revenue decreased 12% from $1.6 million in the third quarter of 2007 to $1.4 million in the current year quarter. Cost of contract revenue as a percentage of contract revenue, was 84% in the third quarter of 2007 and 68% in the current quarter, which resulted in gross margins on contract revenue increasing from 16% to 32%.
For the nine months ended September 30, 2008, cost of contract revenue decreased 19% from $4.3 million in the first nine months of 2007 to $3.5 million in the corresponding period of 2008. Cost of contract revenue as a percentage of contract revenue decreased from 82% in the first nine months of 2007 to 66% in the corresponding period of 2008, which resulted in gross margins on contract revenue increasing from 18% to 34%.
For the three and nine month periods, the dollar decrease in cost of contract revenue was primarily due to lower DSL contract revenue. Lower cost of contract revenue from DSL contracts was partially offset by increased cost of contract revenue from biometrics contracts, which was due to increased revenue from such contracts.
For the three and nine month periods, the increase in gross margins on contract revenue was due to a greater proportion of higher-margin revenue from biometrics contracts in the contract revenue sales mix.
Research and Development Expense. Research and development expense consists primarily of compensation costs for engineers and expenses for consultants, recruiting, supplies, equipment, depreciation and facilities related to engineering projects to improve our broadband intellectual property offerings, as well as our software and hardware product technology. 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.
Research and development expenses increased 16% from $2.5 million in the third quarter of 2007 to $2.9 million in the current year quarter. As a percentage of total revenue, research and development expense increased from 34% in the third quarter of 2007 to 46% in the current year quarter.
For the three month period, the dollar increase in research and development expense was primarily due to a shift of engineering resources from DSL customer contracts (i.e., cost of contract revenue) to internal development projects (i.e., research and development expense). This resource shift reduced the amount of engineering expenses we allocated to cost of contract revenue, which increased research and development expense to reflect our increased focus on internal projects. The dollar increase in research and development expense due to reduced expense allocations to cost of contract revenue was partially offset by $0.1 million of lower spending on salaries and outside services, as a result of attrition.
Research and development expenses increased 29% from $7.7 million in the first nine months of 2007 to $10.0 million in the first nine months of 2008. As a percentage of total revenue, research and development expense increased from 39% in the first nine months of 2007 to 54% in the corresponding period of 2008.
For the nine month period, the dollar increase in research and development expense was primarily due to a shift of engineering resources from DSL customer contracts (i.e., cost of contract revenue) to internal development projects (i.e., research and development expense). This resource shift reduced the amount of engineering expenses we allocated to cost of contract revenue, which increased research and development expense to reflect our increased focus on internal projects. To a much lesser extent, the dollar increase in research and development expense was also due to salary increases.
Our research and development spending was principally focused on improving our VDSL2 StratiPHY3™ technology and chips, developing home networking technology in support of the International Telecommunications Union's G.hn standard, developing analog front-end solutions for broadband applications, developing test and diagnostics hardware and software, and developing biometrics and imaging software.
Selling and Marketing Expense. Selling and marketing expense consists primarily of compensation costs for sales and marketing personnel, travel, advertising and promotion, recruiting, and facilities expense.
Sales and marketing expense increased 22% from $0.9 million in the third quarter of 2007 to $1.1 million in the current year quarter. As a percentage of total revenue, sales and marketing expense increased from 13% in the third quarter of 2007 to 18% in the current year quarter.
For the nine months ended September 30, 2008, sales and marketing expenses increased 17%, from $2.8 million in 2007 to $3.3 million in 2008. As a percentage of total revenue, sales and marketing expenses increased from 14% in the first nine months of 2007 to 18% in the corresponding period of 2008.
For the three and nine month periods, the dollar increase in sales and marketing expense was mainly attributable to salary increases, headcount growth in the sales organization, increased sales commissions on higher biometrics software sales, increased travel expenses, increased tradeshow expenses and higher stock-based compensation expense.
General and Administrative Expense. General and administrative expense consists primarily of compensation costs for administrative personnel, facility costs, bad debt, audit, legal, stock exchange and insurance expenses.
General and administrative expenses increased 30% from $1.0 million in the third quarter of 2007 to $1.3 million in the current year quarter. As a percentage of total revenue, general and administrative expense increased from 14% in the third quarter of 2007 to 21% in the current year quarter.
For the nine months ended September 30, 2008, general and administrative expenses increased 16% from $3.3 million in 2007 to $3.8 million in 2008. As a percentage of total revenue, general and administrative expenses increased from 17% in the first nine months of 2007 to 21% in the corresponding period of 2008.
For the three and nine month periods, the dollar increase in general and administrative expense was mainly attributable to salary increases, higher stock-based compensation expense, and legal fees.
Interest Income. Interest income decreased 52% from $512,000 in the third quarter of 2007 to $244,000 in the current year quarter. For the nine months ended September 30, 2008, interest income decreased 38%, from $1.5 million in 2007 to $942,000 in 2008.
For the three and nine month periods, the dollar decrease in interest income was primarily due to a significant fall in money market interest rates during early 2008. The decrease was also due to a decision we made to liquidate our portfolio of auction rate securities and longer term debt instruments in the first quarter of 2008 and invest the proceeds into a lower-yielding, shorter-term, money market fund.
Income Taxes. We made no provision for income taxes in the first nine months of 2007 and 2008 due to net losses incurred and the uncertainty of the timing of profitability in future periods, except for $16,000 and $23,000 of state excise tax paid in the first nine months of 2008 and 2007, respectively. In 2002, we determined that due to our continuing operating losses as well as the uncertainty of the timing of profitability in future periods, we should fully reserve our deferred tax assets. As of September 30, 2008, 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.
As of December 31, 2007, we had federal net operating loss and research and experimentation credit carryforwards of approximately $46.1 million and $12.2 million respectively, which may be available to offset future federal income tax liabilities and expire at various dates from 2008 through 2027. In addition, at December 31, 2007, we had approximately $11.2 million and $6.2 million of state net operating losses and state research and development and investment tax carryforwards, respectively, which expire at various dates from 2008 through 2022.
Based on an analysis that we performed under Internal Revenue Code Section 382 on our NOLs generated for the period 1997 through 2007, we have not experienced a change in ownership as defined by Section 382, and, therefore, the NOLs are not currently under any Section 382 limitation.
Liquidity and Capital Resources
At September 30, 2008, we had cash, cash equivalents, short-term investments, and investments of $37.8 million, which represents a decrease of $0.7 million from December 31, 2007. The decrease in cash was primarily due to $2.3 million of stock repurchases under our stock buyback program and $0.4 million of capital spending on equipment. These uses of cash were partially offset by $1.6 million of cash provided by operations and $0.4 million of proceeds from the exercise of employee stock options.
Cash provided by operations in the first nine months of 2008 was primarily due to a net inflow of cash from working capital items of $3.0 million, which was partially offset by a net loss of $3.2 million, adjusted for non-cash items related to depreciation and amortization of $0.7 million, and stock based compensation expense of $1.1 million. Capital spending was primarily related to the purchase of computer hardware, and laboratory equipment used principally in engineering activities.
While we can not assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents will be sufficient to fund our operations for at least the next twelve months.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157 ("SFAS 157"), "Fair Value Measurements," which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. However, on February 6, 2008, the FASB issued FSP FAS 157-b which defers the effective date of SFAS 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. We adopted SFAS 157 on January 1, 2008, except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in FSP FAS 157-b. The partial adoption of SFAS 157 did not have a material impact on our consolidated financial position, results of operations or cash flows, nor do we believe that the adoption of FSP FAS 157-b will have a material impact on our consolidated financial position, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159 ("SFAS 159"), "The Fair Value Option for Financial Assets and Financial Liabilities". SFAS 159 allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value ("fair value option"). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, SFAS 159 specifies that unrealized gains and losses for that instrument be reported in earnings at each subsequent reporting date. SFAS 159 was effective on January 1, 2008. We did not apply the fair value option to any of our outstanding instruments and therefore, SFAS 159 did not have an impact on our consolidated financial statements.
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