UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006 or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
---- -----
Commission File No. 0-21858
INTERLINK ELECTRONICS, INC.
(Exact name of registrant as specified in its charter)
Delaware 77-0056625
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
546 Flynn Road 93012
Camarillo, California (Zip Code)
(Address of principal executive offices)
(805) 484-8855
(Registrant's telephone number, including area code)
Not applicable.
Former name, former address and former fiscal year
if changed since last report)
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 [_] No [X]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [_] Accelerated filer [X] Non-accelerated filer [_]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [_] No [X]
Shares of Common Stock Outstanding, at November 2, 2006: 13,755,561
INTERLINK ELECTRONICS, INC.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets--
March 31, 2006 and December 31, 2005 .................. 3
Condensed Consolidated Statements of Operations--
Three Months Ended March 31, 2006 and March 31, 2005 .. 4
Condensed Consolidated Statements of Cash Flows--
Three Months Ended March 31, 2006 and March 31, 2005 .. 5
Notes to Condensed Consolidated Financial
Statements--March 31, 2006 ............................ 6
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations ......... 16
ITEM 3. Quantitative and Qualitative Disclosures
about Market Risk ..................................... 27
ITEM 4. Controls and Procedures ................................. 28
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings ....................................... 30
ITEM 1A. Risk Factors ............................................ 31
ITEM 6. Exhibits ................................................ 39
SIGNATURES ................................................................ 40
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
INTERLINK ELECTRONICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(IN THOUSANDS, EXCEPT PAR VALUE)
March 31, December
2006 31, 2005
-------- --------
ASSETS
Current assets:
Cash and cash equivalents .................................... $ 3,741 $ 3,938
Short-term investments, available for sale ................... 8,500 10,000
Accounts receivable, less allowance for doubtful accounts and
product returns of $390 and $423 at March 31, 2006 and
December 31, 2005, respectively ............................ 6,927 9,184
Inventories, net of reserves of $1,927 and $1,739 at March 31,
2006 and December 31, 2005, respectively ................... 9,447 8,119
Prepaid expenses and other current assets .................... 616 456
-------- --------
Total current assets ....................................... 29,231 31,697
Property and equipment, net ..................................... 1,056 1,099
Patents and trademarks, less accumulated amortization of $1,223
and $1,201 at March 31, 2006 and December 31, 2005,
respectively ................................................. 294 308
Other assets .................................................... 87 67
-------- --------
Total assets .................................................... $ 30,668 $ 33,171
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt ......................... $ 154 $ 154
Accounts payable ............................................. 5,048 5,731
Accrued payroll and related expenses ......................... 1,688 1,931
Deferred revenue ............................................. 755 863
Other accrued expenses ....................................... 96 66
-------- --------
Total current liabilities .................................. 7,741 8,745
-------- --------
Long-term debt, net of current portion .......................... 154 154
Commitments and contingencies
Stockholders' equity:
Preferred stock, $5.00 par value (100 shares authorized, none -- --
issued and outstanding)
Common stock, $0.00001 par value (50,000 shares authorized,
13,754 shares issued and outstanding at March 31, 2006 and
December 31, 2005) ......................................... 51,813 50,740
Due from stockholders ........................................ (156) (157)
Accumulated other comprehensive loss ......................... (470) (490)
Accumulated deficit .......................................... (28,414) (25,821)
-------- --------
Total stockholders' equity ................................. 22,773 24,272
-------- --------
Total liabilities and stockholders' equity ...................... $ 30,668 $ 33,171
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
3
INTERLINK ELECTRONICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Month Period
Ended March 31,
------------------------
2006 2005 (1)
-------- --------
Revenues ....................................... $ 8,531 $ 9,269
Cost of revenues ............................... 4,849 6,013
-------- --------
Gross profit ................................... 3,682 3,256
Operating expenses:
Product development and research ............ 1,415 1,028
Selling, general and administrative ......... 4,900 2,690
-------- --------
Total operating expenses .................. 6,315 3,718
-------- --------
Operating loss ................................. (2,633) (462)
-------- --------
Other income (expense):
Interest income, net ........................ 127 82
Other expense ............................... (16) (18)
-------- --------
Total other income ........................ 111 64
-------- --------
Loss before income tax benefit ................. (2,522) (398)
Provision (benefit) for income tax ............. 71 --
-------- --------
Net loss ....................................... $ (2,593) $ (398)
======== ========
Loss per share - basic ......................... $ (0.19) $ (0.03)
======== ========
Loss per share - diluted ....................... $ (0.19) $ (0.03)
======== ========
Weighted average shares - basic ................ 13,754 13,692
======== ========
Weighted average shares - diluted .............. 13,754 13,692
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
----------
(1) As restated. See Note 1 to the consolidated financial statements
4
INTERLINK ELECTRONICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
Three Month Period
Ended March 31,
------------------
2006 2005(1)
------- -------
Cash flows from operating activities:
Net loss ...................................................... $(2,593) $ (398)
Adjustments to reconcile net loss to net cash used in operating
activities:
Provision for allowance for doubtful accounts receivable
and product returns ..................................... (33) 2
Increase in reserves for excess inventories ................. 188 6
Stock-based compensation .................................... 1,070 22
Depreciation and amortization ............................... 126 125
Changes in operating assets and liabilities:
Accounts receivable ....................................... 2,290 (974)
Prepaid expenses and other current assets ................. (160) 31
Inventories ............................................... (1,516) (835)
Other assets .............................................. (20) (44)
Accounts payable .......................................... (683) (1,212)
Deferred revenue .......................................... (108) 197
Accrued payroll and other accrued expenses ................ (210) (155)
------- -------
Net cash used in operating activities ................... (1,649) (3,235)
------- -------
Cash flows from investing activities:
Sales of marketable securities ................................ 1,500 3,000
Purchases of property and equipment ........................... (61) --
Costs of patents and trademarks ............................... (7) (25)
------- -------
Net cash provided by investing activities ............... 1,432 2,975
------- -------
Cash flows from financing activities:
Principal payments on debt .................................... -- (135)
Proceeds from exercise of employee/director stock options ..... -- 56
------- -------
Net cash used in financing activities ................... -- (79)
------- -------
Effect of exchange rate changes on cash and cash equivalents ..... 20 (21)
------- -------
Decrease in cash and cash equivalents ............................ (197) (360)
Cash and cash equivalents:
Beginning of period ....................................... 3,938 6,067
------- -------
End of period ............................................. $ 3,741 $ 5,707
======= =======
Supplemental disclosures of cash flow information:
Interest paid ............................................. $ 4 $ 6
======= =======
Income taxes paid ......................................... $ 71 $ 1
======= =======
The accompanying notes are an integral part of these consolidated financial
statements.
----------
(1) As restated. See Note 1 to the consolidated financial statements
5
INTERLINK ELECTRONICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THREE MONTHS ENDED MARCH 31, 2006 AND 2005 AND
MARCH 31, 2006 AND DECEMBER 31, 2005 (UNAUDITED)
1. BASIS OF PRESENTATION OF INTERIM FINANCIAL DATA
The financial information as of March 31, 2006, and for the three month
periods ended March 31, 2006 and 2005, included in this report, is unaudited.
Such information, however, reflects all adjustments (consisting only of normal
recurring adjustments) which are, in the opinion of management, necessary for a
fair presentation of results for the interim periods.
On November 2, 2005, the Company announced that it intended to restate
its financial results for the years ended December 31, 2003 and December 31,
2004 and the first two quarters of 2005 to reflect a matter that the Company
identified in a reconciliation of accounts with a key vendor in China, a second
matter related to double-counting of inventory, a third matter relating to
unrecorded licensing costs and a fourth matter relating to a balance sheet
reclassification for certain cash prepayments. The first matter relates to a net
write-off of $1.1 million of certain receivables primarily originating in the
fourth quarter of 2003, with $167,000 of that amount originating in the fourth
quarter of 2002, due from a key vendor in China and the recording of $1.0
million in payables due to that same vendor that were not properly recorded in
the Company's accounting system for the third and fourth quarters of 2004 and
the first and second quarters of 2005 in the amounts of $249,000, $224,000,
$205,000 and $331,000, respectively. The second matter relates to the
understatement of cost of sales in the second quarter of 2005 of $372,000 as a
result of certain inventory components being double-counted and thus overstated
in inventory as of June 30, 2005. The third matter relates to an understatement
of cost of sales in the first and second quarters of 2005 of $51,000 and
$565,000, respectively, as a result of certain licensing charges that were not
properly recorded in cost of sales and inventory. The fourth matter relates to a
balance sheet reclassification of $1.3 million in cash payments made by a
customer during the second and fourth quarters of 2004 as well as the first and
second quarters of 2005 in advance of future shipments of product. These
payments were incorrectly applied against accounts receivable rather than
recorded as deferred revenue. The cash prepayments have been properly
reclassified to deferred revenue.
On March 30, 2006, the Company announced that it had discovered two
additional discrepancies in its historical financial statements. The first
matter relates to accounting for stock options of terminated employees and
resulted in an unrecorded, non-cash expense of $2.4 million in 2001, $220,000 in
2004 and $108,000 in 2005, $22,000 of which was in the first three months of
2005. The second matter relates to overstated valuation of certain inventory in
transit between the parent company and its Hong Kong subsidiary as of December
31, 2004. This matter resulted in the understatement of cost of sales of
$837,000 in the fourth quarter of 2004 and an overstatement of cost of sales of
$748,000 in 2005, $687,000 of which was in the first three months of 2005, for a
net increase in cost of sales of $89,000.
In November 2005, the Company's audit committee began an internal
investigation into the matters disclosed in the November 2, 2005 announcement.
In connection with the restatement issues identified in November the audit
committee hired outside legal counsel to conduct an internal investigation. They
in turn retained the services of an independent accounting firm to assist with
various forensic accounting and electronic procedures performed in the course of
the investigation.
For the items discovered subsequent to the November 2005 announcement,
the Committee, seeing no evidence suggesting the involvement of any current
employees, instructed senior company management and outside legal counsel to
conduct investigations into these matters.
Based on the findings of the independent and company investigations, as
well as senior management's evaluation of the effectiveness of the design and
operation of the company's controls and procedures, the Committee determined
that inadequate internal controls contributed to the restatement issues. The
primary control deficiencies are identified on pages 25 to 26 of this Form 10-Q.
6
The information included herein reflects the restatements discussed
above and should be read in conjunction with the consolidated financial
statements and the related notes, as restated, which are included in our Annual
Report on Form 10-K for the year ended December 31, 2005.
The results of operations for the interim periods presented are not
necessarily indicative of the results to be expected for the full year.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and the satisfaction of liabilities in the normal
course of business. As of March 31, 2006, the Company had cash, cash equivalents
and short term investments of $12.2 million. Based on the Company's business
plan and related estimates of cash requirements, that amount may be insufficient
to fund the Company's operations for the next 12 months. The Company expects to
require additional cash in the fourth quarter of 2006 to pursue its planned
operations. If the Company were to be unable to raise additional capital in the
form of commercial or securitized debt, sales of equity securities or other
alternatives, it would be required to curtail its operations. As of March 31,
2006, the Company's total consolidated indebtedness for money borrowed was
$308,000. The Company is in discussions with respect to various financing
alternatives. However, there is no assurance that the Company will be successful
in obtaining the required capital. Any financing arrangements that the Company
may enter into may increase future costs or be dilutive to existing
stockholders. The Company's independent registered public accounting firm has
informed the Company that it may include in its report on the Company's
financial statements for the year ending December 31, 2006 an explanatory
paragraph expressing substantial doubt about the Company's ability to continue
as a going concern if the Company fails to successfully fund its current
operations.
2. SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION. The Company recognizes revenue in accordance with
SEC Staff Accounting Bulletin ("SAB") No. 104, "Revenue Recognition." SAB No.
104 requires that four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred or services rendered; (3) the fee is fixed and determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4)
require management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
To satisfy the criteria, the Company: (1) enters orders based upon receipt of a
customer purchase order; (2) records revenue upon shipment of goods and when
risk of loss and title has transferred; (3) confirms pricing through the
customer purchase order; and (4) validates creditworthiness through past payment
history, credit agency reports and other financial data. All customers have
warranty rights and some customers also have explicit or implicit rights of
return. We comply with Statement of Financial Accounting Standards No. 48 with
respect to sell-through and returns and the related recording of reserves for
potential customer returns. Should changes in conditions cause management to
determine the revenue recognition criteria are not met for certain future
transactions, such as a determination that collectibility was not reasonably
assured, revenue recognized for any reporting period could be adversely
affected.
ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS. The Company's
accounts receivable are unsecured, and are at risk to the extent such amounts
become uncollectible. The Company continually monitors individual account
receivable balances, and provides for an allowance of doubtful accounts at the
time collection may become questionable based on payment performance or age of
the receivable and other factors related to the customer's ability to pay.
RESERVE FOR ESTIMATED PRODUCT RETURNS. While not an explicit part of
the Company's terms and conditions of product sales except for some customers,
it does, on a discretionary basis, grant product exchanges for its distribution
and reseller customers in its Business Communications - branded products market
for similar products of equal value if these exchanges meet certain other
criteria. The Company estimates future product returns based on recent return
history, inventory status and product "sell-through" statistics received from
its major distributors, discussions regarding product sales activity with its
major reseller customers, and current industry product and technology trends.
Management judgment is required in evaluating the relative significance of the
aforementioned data and in the determination of the estimated value of the
returns reserve. If actual returns are greater than management's estimate then
revenues in the subsequent period will be adversely affected.
7
INVENTORY RESERVE. At each balance sheet date, the Company evaluates
its ending inventories for excess quantities and obsolescence. This evaluation
includes analyses of forecast sales levels by product and historical demand. The
Company writes off inventories that are considered obsolete. Remaining inventory
balances are adjusted to approximate the lower of our cost or market value and
result in a new cost basis in such inventory until sold. If future demand or
market conditions are less favorable than projections, additional inventory
write-downs may be required, and would be reflected in cost of sales in the
period the revision is made. Based on lowered expectations for future demand in
the OEM Remote business segment as well as limitations on the use of certain
restricted raw materials prompted by early adoption of the Restriction of
Hazardous Substances Act of 2002 by many of our customers, we increased our
reserve for excess and obsolete inventory by approximately $1.9 million in the
third quarter of 2005. The reserve is discussed in detail in the BUSINESS
SEGMENT OVERVIEW under OEM Remotes in our Annual Report on Form 10-K for the
year ended December 31, 2005.
PROVISION FOR INCOME TAX. As part of the process of preparing the
Company's financial statements, as required by Statement of Financial Accounting
Standards ("SFAS") No. 109, the Company is required to estimate its income taxes
in each of the jurisdictions in which it operates. This process involves
estimating the Company's actual current tax exposure together with assessing
temporary differences resulting from differing treatment of items for tax and
accounting purposes. These differences result in deferred tax assets and
liabilities, which are included in the Company's balance sheet. The Company must
then assess the likelihood that its deferred tax assets will be recovered from
future taxable income and to the extent the Company believes that recovery is
not likely, it must establish a valuation reserve. To the extent the Company
establishes a reserve or increases this reserve in a period, it must include an
expense within the tax provision in the statements of operations.
Significant management judgment is required in determining the
Company's provision for income taxes, deferred tax asset and liabilities and any
valuation reserve recorded against the Company's net deferred tax assets.
Management continually evaluates its deferred tax asset as to whether it is
likely that the deferred tax asset will be realized.
Based on historical and prospective evidence, the Company has concluded
that it did not have sufficient evidence to be able to recognize any of its net
tax assets, primarily its net operating loss (NOL) carryforward benefits as
assets and thus it has recorded a 100% valuation allowance against the Company's
net deferred tax asset balance. If the Company achieves profitable operations in
the future, it will reevaluate its deferred tax asset balance and may reduce or
eliminate the valuation allowance.
As of December 31, 2005, the Company had NOL carryforwards for federal,
state and foreign income tax purposes of $39.7 million, $23.9 million and $5.9
million, respectively, which are available to offset future taxable income in
those jurisdictions through 2025.
FOREIGN EXCHANGE EXPOSURE. The Company has established relationships
with most of the major OEMs in the OEM Remote market. Many of these OEMs are
based in Japan and approximately 14%, 20% and 28% of the Company's revenues for
the first three months of 2006 and the years 2005 and 2004, respectively, came
from Japanese customers. Revenues from these customers are denominated in
Japanese yen and as a result the Company is subject to foreign currency exchange
rate fluctuations in the yen/dollar exchange rate. From time to time, the
Company uses foreign currency forward and average rate option contracts to hedge
this exposure. The Company uses revenue forecasts from its Japanese subsidiary
to determine the amount of forward or option contracts to purchase and the
Company attempts to enter into these contracts when it believes the yen value is
relatively strong against the U.S. dollar. To the extent that the Company's
revenue forecast may be inaccurate or the timing of forecasting the yen's
strength is wrong, the Company's actual hedge gains or losses may not
necessarily correlate with the effect of foreign currency rate fluctuations on
its revenues. The Company marks these contracts to market value and the gain or
loss from these contracts is recorded in OEM Remote revenue. These hedge
transactions are classified as economic hedges and do not qualify for hedge
accounting under Statement of Financial Accounting Standards No. 133. In
addition, because the Company's Japanese subsidiary's functional currency is the
yen, the translation of the net assets of that subsidiary into the consolidated
results will fluctuate with the yen/dollar exchange rate.
8
The following table illustrates the impact of foreign currency
fluctuations on the Company's yen-denominated revenues and the effectiveness of
its foreign currency hedging activity (in thousands).
THREE MONTHS
ENDED MARCH 31,
----------------------
2006 2005
--------- ---------
Increase (decrease) in revenues resulting
from foreign currency fluctuations ................. $ -- $ 54
Hedging loss .......................................... (1) 38
--------- ---------
Net revenue impact ............................... $ (1) $ 92
========= =========
The Company calculates the "increase (decrease) in revenues resulting
from foreign currency fluctuations" by calculating the U.S. dollar equivalent of
its yen-denominated revenues using the yen/dollar exchange rate at the beginning
of the period. The resulting product is compared to the Company's
yen-denominated revenues converted to U.S. dollars according to GAAP and the
difference is shown in the table above. As of March 31, 2006, the Company did
not have any contracts outstanding to hedge its foreign exchange exposure.
STOCK-BASED COMPENSATION. On January 1, 2006, the Company adopted
Statement of Accounting Standards No. 123R, "Share-Based Payment" ("SFAS 123R"),
which requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123R supersedes the Company's previous accounting under
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005, the
Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
("SAB 107") relating to SFAS 123R. The Company has applied the provisions of SAB
107 in its adoption of SFAS 123R.
The Company adopted SFAS 123R using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006. The Company's financial statements as of and for the three months ended
March 31, 2006 reflect the impact of SFAS 123R. In accordance with the modified
prospective transition method, the Company's financial statements for prior
periods have not been restated to reflect, and do not include, the impact of
SFAS 123R. Stock-based compensation expense recognized under SFAS 123R for
employees and directors for the three months ended March 31, 2006 was
$1,070,000. The effect on basic and diluted earnings per share for the three
months ended March 31, 2006 was $(0.08) per share. As of March 31, 2006, the
Company has $5,789,000 of unrecognized stock based compensation cost related to
non-vested stock options. This cost is expected to be recognized over a weighted
average period of 3 years.
During the three months ended March 31, 2006, the Company granted
options to acquire 1,085,050 shares of its common stock at an average exercise
price of $3.15 per share. The estimated fair value of all awards granted during
the quarter was $2,307,000, of which $288,000 was recorded as of March 31, 2006.
There were no stock options exercised during the quarter ended March 31, 2006.
The following table illustrates the effect on net loss and loss per
share if the Company had applied the fair value recognition of SFAS 123R to
stock-based awards granted under the Company's stock option plan for the three
months ended March 31, 2005. For the purposes of this pro forma disclosure, the
fair value of the options is estimated using the Black-Scholes option pricing
formula ("Black-Scholes model") and amortized to expense generally over the
options' requisite service periods (vesting periods) (in thousands, except per
share information):
9
THREE MONTHS
ENDED
MARCH 31,
2005(1)
------------
Net loss - as reported ...................................... $ (398)
Stock-based compensation expense included
in reported net loss, net of related
tax effects .............................................. 22
Total stock-based compensation expense
determined under fair value based method for
all awards, net of related tax effects ................... (830)(2)
------------
Net loss - pro forma ............................... $ (1,206)
============
Basic and diluted loss per share - as reported ....... $ (0.03)
- pro forma ......... (0.09)
(1) As restated. See Note 1.
(2) As restated. As part of the Company's implementation of SFAS 123R, we
discovered that amounts previously stated in footnote disclosure under the
requirements of SFAS 123 for stock based compensation expense were calculated in
error. For the three months ended March 31, 2005, the Company previously
recorded a stock based compensation amount of $452,000. This amount is now
calculated to be $830,000. The effect on the pro forma basic and diluted
earnings per share was $(.03), changing from $(.06) to $(.09).
SFAS 123R requires companies to estimate the fair value of share-based
payment awards to employees and directors on the date of grant using an
option-pricing model. The value of the portion of the award that is ultimately
expected to vest is recognized as expense over the requisite service periods in
the Company's Statement of Operations. Stock-based compensation expense
recognized in the Statement of Operations for the three months ended March 31,
2006 included compensation expense for share-based payment awards granted prior
to, but not yet vested as of January 1, 2006 based on the grant date fair value
estimated in accordance with the pro forma provisions of SFAS 123 and included
compensation expense for the share-based payment awards granted subsequent to
January 1, 2006 based on the grant date fair value estimated in accordance with
the provisions of SFAS 123R. For stock-based awards issued to employees and
directors, stock-based compensation is attributed to expense using the
straight-line single option method, which is consistent with how the prior
period pro formas were provided. As stock-based compensation expense recognized
in the Statement of Operations for March 31, 2006 is based on awards expected to
vest, SFAS 123R requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. For the three months ended March 31, 2006, forfeitures are
estimated at 9% and totaled $30,000. In the pro forma information provided under
SFAS 123 for the periods prior to fiscal 2006, the Company accounted for
forfeitures as they occurred.
Prior to the adoption of SFAS 123R, the Company accounted for
stock-based awards to employees and directors using the intrinsic value method
in accordance with APB 25, and complied with the disclosure provisions of SFAS
123. Under the intrinsic value method, the Company recognized share-based
compensation equal to the award's intrinsic value at the time of the grant over
the requisite service periods using the straight-line method. Forfeitures were
recognized as incurred. During the three months ended March 31, 2005, there was
$22,000 of stock-based compensation expense recognized in the Statement of
Operations for awards issued to certain employees and directors.
The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of complex and subjective variables. These variables include, but are
not limited to, the expected stock price volatility over the expected term of
the awards, and actual and projected employee stock option exercise behaviors.
The Company estimates expected volatility using historical data. The expected
term is estimated using the "safe harbor" provisions under SAB 107.
10
The weighted average fair value at the date of grant for stock options
granted during the three months ended March 31, 2006 and 2005 was $2.35 and
$5.25 (as restated) per option, respectively. The fair value of options at the
date of grant was estimated using the Black-Scholes model with the following
weighted average assumptions:
THREE MONTHS
ENDED MARCH 31,
---------- ----------
2006 2005(1)
---------- ----------
Expected life (years) ............................ 5.5 5.7
Interest rate .................................... 4.6% 4.6%
Volatility ....................................... 90% 74%
Dividend yield ................................... 0% 0%
(1) As Restated
A summary of the Company's nonvested shares as of December 31, 2005 and
changes during the quarter ended March 31, 2006, is presented below:
Wgt. Avg.
Exercise
Options Price
-------- --------
Nonvested December 31, 2005 ......................... 1,301 $ 7.24
Granted ............................................. 1,085 3.15
Vested .............................................. (190) 7.39
Forfeited or expired ................................ 0 0.00
-------- --------
Nonvested - March 31, 2006 .......................... 2,196 $ 5.21
======== ========
The Company is evaluating and has not yet determined which method
provided in SFAS 123R to use for calculating the beginning balance of the
additional paid in capital pool ("APIC pool") related to the tax effects of
employee stock-based compensation, and to determine the subsequent impact on the
APIC pool and Statement of Cash Flows of the tax effects of employee stock-based
compensation awards that are outstanding upon adoption of SFAS 123R. The Company
has until December 31, 2006 to make this decision.
3. EARNINGS PER SHARE
For all periods presented, per share information was computed pursuant
to provisions of the Statement of Financial Accounting Standards ("SFAS") No.
128, "Earnings Per Share," issued by the Financial Accounting Standards Board
("FASB"). The computation of earnings per share--basic is based upon the
weighted average number of common shares outstanding during the periods
presented. Earnings per share--diluted also include the effect of common shares
contingently issuable from options and warrants in periods in which they have a
dilutive effect.
Common stock equivalents are calculated using the treasury stock
method. Under the treasury stock method, the proceeds from the assumed
conversion of options and warrants are used to repurchase outstanding shares
using the average market price for the period.
11
The following table contains information necessary to calculate
earnings per share (in thousands):
THREE MONTHS
ENDED MARCH 31,
----------------
2006 2005
------ ------
Weighted average shares outstanding - basic ............. 13,754 13,692
Effect of dilutive securities (employee/director stock
options) ............................................. -- (1) -- (1)
------ ------
Weighted average shares - diluted ....................... 13,754 13,692
====== ======
(1) Due to the net loss for the three month periods ended March 31, 2006 and
2005, respectively, the diluted share calculation result was anti-dilutive.
Thus, the basic weighted average shares were used and shares of common stock
equivalents of approximately 4.5 million and 3.6 million shares for 2006 and
2005, respectively, were excluded from the calculations.
4. LINE OF CREDIT
At March 31, 2006, the Company had a $3.0 million bank line of credit
which was secured by cash investments at the bank. The line was unused at March
31, 2006. In May 2006, the Company terminated the line of credit.
5. COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS - On November 15, 2005, a class action alleging
violations of federal securities laws was filed against the Company and two of
its current and former officers in the United States District Court for the
Central District of California. The complaint alleges that, between April 24,
2003 and November 1, 2005, the Company and two of its current and former
officers made false and misleading statements and failed to disclose material
information regarding the Company's results of operations and financial
condition. The complaint includes claims under the Securities Act and Exchange
Act and seeks unspecified damages and legal expenses.
To date, the Court has not certified a class, and the litigation
remains in its early stages.
On January 24, 2006, a shareholder's derivative action was filed
against two of the Company's current and former officers and the members of its
Board of Directors in the Central District of California. The derivative
complaint contains the same factual allegations as the class action complaint
and sought to recover unspecified damages from the defendants, as well as
forfeiture of their equity-based compensation and contribution from them in the
event that the Company is found to have violated the federal securities laws.
Following a motion made by the defendants to dismiss, or in the alternative,
stay the derivative action, the plaintiff voluntarily dismissed the derivative
action without prejudice on June 14, 2006.
On August 17, 2006, the plaintiff refiled the derivative action in
California state court. The refiled complaint alleges securities-related
violations of the California Corporations Code, as well as various common law
and Delaware corporate law claims. The members of the Company's board of
directors are no longer named as defendants. Plaintiffs seek treble damages
based on the difference between the prices at which the named defendants sold
their shares and the market value that those shares would have had at the time
of such sales but for the allegedly false and misleading financial statements,
as well as contribution from the defendants in the event that the Company is
found to have violated the federal securities laws and other unspecified
damages.
In connection with the class action and the derivative proceedings
described above, an independent investigation was undertaken at the direction of
the Audit Committee by Dorsey & Whitney, LLP. Dorsey & Whitney retained the
services of PricewaterhouseCoopers LLP with respect to various forensic
accounting and electronic procedures performed in the course of the
investigation. Related to this internal investigation, the Company has recorded
approximately $147,000 in expense for 2005 and $615,000 in expense for 2006 to
date for
12
amounts not covered by insurance. Additionally, in connection with the class
action proceeding, the Company has recorded approximately $266,000 in expense
for 2006 to date for amounts not covered by insurance.
Other than the amounts described above, the Company cannot estimate the
possible loss or range of loss, if any, associated with the resolution of the
class action and derivative proceedings. While it intends to vigorously defend
against these allegations, the Company cannot predict the final disposition of
these matters or whether the Company will be liable for amounts not covered by
insurance. There is no assurance, however, that the ultimate resolution of these
matters will not result in a material adverse effect on the Company's business,
financial condition or results of operations.
In addition to the matters identified above, from time to time, the
Company is involved in various legal actions that arise in the ordinary course
of business.
6. COMPREHENSIVE INCOME (LOSS)
The following table provides the data required to calculate
comprehensive loss in thousands:
Accumulated
Other
Comprehensive Comprehensive
Loss Loss
------------- -------------
Balance at December 31, 2004 ................. $ (377) --
Translation adjustment ....................... (20) $ (21)
Net loss (1) ................................. (398)
------------- -------------
Balance at March 31, 2005 .................... $ (397) $ (419)
============= =============
Balance at December 31, 2005 ................. $ (490) --
Translation adjustment ....................... 20 $ 20
Net loss ..................................... (2,593)
------------- -------------
Balance at March 31, 2006 .................... $ (470) $ (2,573)
============= =============
(1) As restated. See Note 1.
13
7. SEGMENT INFORMATION
The Company has four business segments: (i) Business Communications -
branded products; (ii) OEM Remotes; (iii) E-transactions; and (iv) Specialty
Components. The accounting policies of the segments are the same as those
described in "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Application of Critical Accounting Policies and
Estimates"; however, the Company evaluates performance based on revenue and
gross profit. The Company does not allocate any other income, expenses or assets
to these segments nor does it track revenue by product. Reportable segment
information for the three month periods ended March 31, 2006 and 2005 is as
follows (in thousands):
BUSINESS
COMMUNICATIONS OEM SPECIALTY
THREE MONTHS ENDED: - BRANDED REMOTES E-TRANSACTIONS COMPONENTS TOTAL
----------------------------------- --------------- --------------- --------------- --------------- ---------------
March 31, 2006
Revenue ........................ $ 1,786 $ 4,002 $ 1,611 $ 1,132 $ 8,531
Gross profit ................... 1,021 1,016 1,020 625 3,682
March 31, 2005(1)
Revenue ........................ $ 1,655 $ 4,916 $ 1,357 $ 1,341 $ 9,269
Gross profit ................... 992 938 623 703 3,256
(1) As restated. See Note 1
The Business Communications - branded products business segment
consists specifically of company branded products. The OEM Remotes business
segment consists of OEM products.
GEOGRAPHIC INFORMATION--The Company attributes revenues to different
geographic areas on the basis of the location of the customer. The Company's
revenues and long-lived assets by geographic area for the three month periods
ended and as of March 31, 2006 and 2005 are as follows (in thousands):
THREE MONTHS ENDED AND AS OF
MARCH 31,
-------------------------------------------------
2006 2005
----------------------- -----------------------
LONG LIVED LONG LIVED
REVENUES ASSETS REVENUES ASSETS
---------- ---------- ---------- ----------
United States .............. $ 4,667 $ 1,166 $ 3,520 $ 1,203
Japan ...................... 1,163 129 2,075 535
Asia (other than Japan) .... 1,908 55 1,197 96
Europe and other ........... 793 -- 2,477 --
---------- ---------- ---------- ----------
$ 8,531 $ 1,350 $ 9,269 $ 1,834
========== ========== ========== ==========
MAJOR CUSTOMERS-- In the first quarters of 2006 and 2005, no single
customer exceeded 10% of total revenues. One customer accounted for 18% and 14%
of the accounts receivable at March 31, 2005 and 2006, respectively.
14
8. INVENTORIES
Net inventories consisted of the following (in thousands):
MARCH 31, DECEMBER 31,
2006 2005
----------- -----------
Raw material ..................................... $ 6,625 $ 4,475
Work in process .................................. 1,964 1,230
Finished goods ................................... 2,785 4,153
Reserve for excess and obsolete inventory ........ (1,927) (1,739)
----------- -----------
Total inventories ................................ $ 9,447 $ 8,119
=========== ===========
9. STOCK OPTIONS
Under the terms of the Plan, officers and key employees may be granted
non-qualified or incentive stock options and outside directors and independent
contractors of the Company may be granted non-qualified stock options. The
aggregate number of shares which may be issued under the Plan is 7,250,000. New
options are granted at fair market value on the date of grant and generally vest
ratably over 36 months and have a ten-year term but terminate earlier if
employment is terminated. As of March 31, 2006, options for 7,224,000 shares of
stock have been granted (4,459,000 are outstanding and 2,765,000 have been
exercised, forfeited or expired) and there were 26,000 options available for
grant.
In 2006, the Company determined it had improperly accounted for stock
option exercises of certain terminated employees during 2001 through 2005. When
the Company was in an internally defined blackout period, it allowed terminated
employees to extend their stock option exercise privileges beyond the Plan's
stated 30 days. The Company evaluated all stock options that have been exercised
from 2001 through 2005 and determined who exercised stock options beyond the
30-day period as specified in the Plan. It was determined that the termination
date constituted a re-measurement date, as defined under stock option accounting
rules which require a revaluation of any stock options that were given this
benefit.
The amount of expense related to certain stock options exercised after
the 30-day period was $2,400,000 in 2001, $220,000 in 2004 and $108,000 in 2005.
These amounts are reflected in our financial statements in the appropriate
periods.
Activity under the Plan for the first three months of 2006 is
summarized as follows (in thousands, except per share information):
Wgt. Avg.
Options Exercise Price
--------------- ---------------
Outstanding - beginning of period ........ 4,053 $ 5.98
Granted .................................. 1,085 3.15
Exercised ................................ 0 0.00
Forfeited or expired ..................... (679) 6.81
--------------- ---------------
Outstanding - end of period .............. 4,459 $ 5.16
=============== ================
Exercisable - end of period .............. 2,358 $ 5.26
=============== ================
The intrinsic value of vested and exercisable stock options outstanding
as of March 31, 2006 is $320,000 and the weighted average remaining contractual
life of exercisable options outstanding is 56 months.
15
The following table summarizes information about stock options
outstanding under the Plan as of March 31, 2006 (in thousands, except
contractual life and exercise price per share information):
--------------- --------------- --------------- --------------- ---------------
Months
Remaining
Exercise Price # of Options On Contractual Options Options
Per Share Outstanding Life Exercisable Un-exercisable
--------------- --------------- --------------- --------------- ---------------
$ 2.40 378 7 378 0
--------------- --------------- --------------- --------------- ---------------
2.70 42 24 42 0
--------------- --------------- --------------- --------------- ---------------
2.94 454 23 454 0
--------------- --------------- --------------- --------------- ---------------
3.04 38 18 38 0
--------------- --------------- --------------- --------------- ---------------
3.15 1,085 120 0 1,085
--------------- --------------- --------------- --------------- ---------------
3.30 5 23 5 0
--------------- --------------- --------------- --------------- ---------------
3.54 3 11 3 0
--------------- --------------- --------------- --------------- ---------------
4.30 14 21 14 0
--------------- --------------- --------------- --------------- ---------------
4.42 269 9 269 0
--------------- --------------- --------------- --------------- ---------------
5.49 12 111 3 9
--------------- --------------- --------------- --------------- ---------------
5.50 6 0 6 0
--------------- --------------- --------------- --------------- ---------------
5.51 80 1 80 0
--------------- --------------- --------------- --------------- ---------------
5.56 7 110 2 5
--------------- --------------- --------------- --------------- ---------------
5.65 15 27 14 1
--------------- --------------- --------------- --------------- ---------------
5.70 500 111 125 375
--------------- --------------- --------------- --------------- ---------------
6.14 18 108 5 13
--------------- --------------- --------------- --------------- ---------------
6.15 248 108 75 173
--------------- --------------- --------------- --------------- ---------------
6.45 462 32 359 103
--------------- --------------- --------------- --------------- ---------------
7.54 31 30 26 5
--------------- --------------- --------------- --------------- ---------------
7.82 13 107 5 8
--------------- --------------- --------------- --------------- ---------------
7.98 4 104 2 2
--------------- --------------- --------------- --------------- ---------------
9.40 737 99 429 308
--------------- --------------- --------------- --------------- ---------------
10.60 38 36 24 14
--------------- --------------- --------------- --------------- ---------------
Total 4,459 2,358 2,101
--------------- --------------- --------------- --------------- ---------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
We develop, manufacture, market and sell intuitive interface devices
and components for a variety of business and home applications. We generate
revenues from the sale of our hardware products, such as force sensing resistor
("FSR") sensors, FSR-based subassemblies and complete advanced input device
products. To a lesser extent, we derive revenue from the sale of software
combined with our hardware. Depending on the application, this software may be
internally developed or purchased from software partners.
We record our revenue in four different market segments: Business
Communications -branded products (wireless intuitive input device products
addressing the presentation market); OEM Remotes (wireless intuitive input
device and sensor products addressing primarily the advanced TV viewing, video
projector and home entertainment media center markets); E-transactions (input
devices for the electronic signature markets); and Specialty Components (custom
FSR-based sensors, subassemblies and complete products for a variety of vertical
markets). Effective October 1, 2005, the Company combined its Home Entertainment
and Business Communications OEM business segments into the current business
segment entitled OEM Remotes. The current Business Communications - branded
products business segment is now referring specifically to our branded products.
All references in this document to business segments is using our re-aligned
business segments that became effective October 1, 2005.
We have addressed our Specialty Components market since our inception
in 1985. Our other three markets have evolved out of our Specialty Components
market. We have addressed our Business Communications - branded
16
products market as a separate market since 1994, our E-transactions market since
1999 and our OEM Remotes market since 1994. The relative revenue and gross
profit contributions of each of these segments is provided below in BUSINESS
SEGMENT OVERVIEW - THREE MONTHS ENDED MARCH 31, 2006 COMPARED TO THREE MONTHS
ENDED MARCH 31, 2005.
QUARTERLY FINANCIAL PERFORMANCE
The following table presents certain financial information for each of
the following quarters:
QUARTER ENDED (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
MAR. 31, DEC. 31, SEP. 30, JUN. 30, MAR. 31, DEC. 31, SEP. 30, JUN. 30, MAR. 31,
2006 2005 2005 2005(1) 2005(1) 2004(1) 2004(1) 2004(1) 2004(1)
-------- -------- -------- -------- -------- -------- -------- -------- --------
Revenues ................ $ 8,531 $ 8,484 $ 10,223 $ 10,263 $ 9,269 $ 9,682 $ 9,556 $ 8,232 $ 7,936
Gross profit ............ $ 3,682 $ 1,691 $ 1,292 $ 1,819 $ 3,256 $ 2,190 $ 2,088 $ 3,183 $ 3,134
Net income (loss) ....... $ (2,593) $ (3,256) $ (2,689) $ (1,961) $ (398) $ (2,067) $ (1,690) $ (78) $ 66
Earnings (loss) per
share - basic ......... $ (0.19) $ (0.24) $ (0.20) $ (0.14) $ (0.03) $ (0.15) $ (0.15) $ (0.01) $ 0.01
Earnings (loss) per
share - diluted ....... $ (0.19) $ (0.24) $ (0.20) $ (0.14) $ (0.03) $ (0.15) $ (0.15) $ (0.01) $ 0.01
(1) As restated. See Note 1 to the consolidated financial statements
Quarterly revenues increased from the first to fourth quarters of 2004.
Though there was a slight decline in the first quarter of 2005 compared to the
fourth quarter of 2004, the second and third quarters of 2005 saw increased
growth from the fourth quarter of 2004. Revenues decreased in the fourth quarter
of 2005 due primarily to declines in our OEM Remote and our E-transactions
business segments. Revenues for the first quarter of 2006 were slightly higher
than the revenues for the fourth quarter of 2005 due primarily to higher
Business Communications - branded products revenues. Earnings have fluctuated in
each of the previous nine quarters with losses being incurred over the previous
eight quarters as a result of various factors, including fluctuating quarterly
sales levels due to market conditions and customer ordering patterns,
fluctuations in gross margins, increases in operating costs, inventory reserve
adjustments and increased compliance and regulatory costs.
On March 9, 2005, we reported the restatement of our financial
statements for the first three quarters of 2004. The restatements were due to a
misinterpretation of the revenue recognition guidelines regarding a "bill and
hold" product sale in the first quarter of 2004. The resulting restatements
decreased revenues in the first quarter of 2004 by $498,000 and increased
revenues by $74,000 and $114,000 in the second and third quarters of 2004,
respectively. Gross profit and net income were reduced in the first quarter of
2004 by $218,000 and increased by $33,000 and $50,000 in the second and third
quarters of 2004, respectively. Also, in the third quarter of 2004, our product
costing system underestimated the initial costs and low yields of starting up
our high volume Home Entertainment remote control business and overstated
inventory and the amount of manufacturing overhead allocable to inventory. The
resulting restatement increased cost of sales and decreased inventory by $1.2
million in the third quarter of 2004.
On November 2, 2005, we reported our intention to make additional
restatements to our financial information for the years ended December 31, 2003
and December 31, 2004 and the first two quarters of 2005. The additional
restatements reflect adjustments to correctly account for the following four
items:
o The first item involved a key vendor in China and was
identified in a reconciliation of accounts with that vendor.
This matter relates to a net write-off of $1.1 million of
certain receivables primarily
17
originating in the fourth quarter of 2003, with $167,000 of
that amount originating in the fourth quarter of 2002, due
from the vendor and the recording of $1.0 million in payables
due to that same vendor that were not properly recorded in the
Company's accounting system for the third and fourth quarters
of 2004 and the first and second quarters of 2005 in the
amounts of $249,000, $224,000, $205,000 and $331,000,
respectively.
o The second item related to the understatement of cost of sales
in the second quarter of 2005 of $372,000 as a result of
certain inventory components being double-counted and thus
overstated in inventory as of June 30, 2005.
o The third item related to the understatement of cost of sales
in the first and second quarters of 2005 totaling $616,000 as
a result of certain licensing charges that were not properly
recorded in cost of sales and inventory.
o The fourth item related to a balance sheet reclassification of
$1.3 million in cash payments made by a customer during the
second and fourth quarters of 2004 as well as the first and
second quarters of 2005 in advance of future shipments of
product. These payments were incorrectly applied against
accounts receivable rather than recorded as deferred revenue.
The cash prepayments have been properly reclassified to
deferred revenue.
These additional restatements reduced stockholders' equity by an
aggregate $2.9 million and affected prior periods as follows:
o Gross profit and net income for the fourth quarter of 2003
were each reduced by $1.3 million, to a gross profit of $11.4
million and net loss of $248,000.
o For the third quarter of 2004, gross profit was reduced by
$249,000 to $2.1 million and our net loss increased by
$249,000 to $1.7 million.
o For the fourth quarter of 2004, gross profit was reduced by
$178,000 to $3.0 million and our net loss increased by
$178,000 to $1.2 million.
o For the first quarter of 2005, gross profit was reduced by
$238,000 to $2.5 million and our net loss increased by
$238,000 to $1.1 million.
o For the second quarter of 2005, gross profit was reduced by
$945,000 to $2.4 million and our net loss increased by
$945,000 to $1.3 million.
On March 30, 2006, we reported the discovery of two additional
discrepancies to the Company's historical financial statements. The
discrepancies affect financial information for the years ended December 31,
2001, December 31, 2004 and December 31, 2005. These additional restatements
reflect adjustments to correctly account for the following two items:
o The first item was discovered during the 2005 year-end audit
process and involves accounting for stock options exercised by
terminated employees whose termination coincided with a black
out period. The Company extended the terminated employees'
time to exercise stock options to 30 days after the black out
period as opposed to 30 days after termination as stated in
the terms of the Company's stock option plan. This treatment
results in a re-measurement date as defined under stock option
accounting rules, which require a revaluation of any stock
options that were given this benefit. The extension of time to
exercise resulted in additional non-cash expense of $2.4
million for 2001, $220,000 for 2004 and $108,000 for 2005,
$22,000 of which was in the first three months of 2005, which
due to an error were not recorded in the Company's accounting
system.
18
o The second item related to an error resulting in the
understatement of cost of sales of $837,000 in the fourth
quarter of 2004 and the overstatement of cost of sales of
$748,000 in 2005, $687,000 of which was in the first three
months of 2005, as a result of certain inventory in transit
from the parent company to its Hong Kong subsidiary being
overvalued at December 31, 2004.
These additional restatements reduced stockholders' equity by an
aggregate $2.8 million and affected prior periods as follows:
o Our net loss for 2001 increased by $2.4 million, to a net loss
of $4.4 million.
o Gross profit for 2004 was reduced by $837,000 to a gross
profit of $10.6 million and our net loss for 2004 increased by
$1 million, to a net loss of $3.8 million.
o For the first three months of 2005, gross profit was increased
by $534,000 to a gross profit of $3.3 million and our net loss
decreased by $511,000 to a net loss of $398,000. Gross profit
for the year ended December 31, 2005 was increased by $748,000
to a gross profit of $8.1 million and our net loss decreased
by $640,000 to a net loss of $8.3 million.
CURRENT OPPORTUNITIES AND CHALLENGES
A considerable portion of our effort is directed at emerging markets,
such as our E-transactions market where our success depends on our ability to
accurately forecast the nature, amount and timing of market requirements in an
environment in which historical precedent is limited or non-existent. We rely on
information generated by our internal staff and industry partners and on
independent market studies for forecasts of market demand in our focus areas,
but these studies are themselves based on limited empirical data. An inaccurate
forecast of market demand in any of our core market areas would impact our
short-term performance and could impact our competitive position and, therefore,
our long-term performance.
Our quarterly results are often affected by volatility in orders for a
particular product. For example, sales of remote controls constitute a
significant source of revenue, but are substantially dependent on advanced TV
sales that we cannot control or accurately forecast. Similarly, sales to large
institutions of our E-transactions products typically come in relatively large
orders that can be one-time events or can occur at widely-dispersed intervals.
Other factors that could cause our estimates to be wrong or could
result in trends that are not apparent from our financial statements are
described under "Risk Factors" in our Annual Report on Form 10-K for the fiscal
year ended December 31, 2005 and in Part II below.
Management faces the constant challenge of balancing its investment in
new technology, product development and marketing initiatives against the
objective of steady earnings growth. A decision to make a significant investment
in a new technology, product or marketing effort may have a short-to-medium term
negative impact on earnings even if the investment proves to be justified.
Because we intend to pursue a growth strategy, it is probable that we will make
investments in new business opportunities that will increase operating costs,
decrease margins and negatively impact earnings until the investment produces
significant revenue growth.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and the satisfaction of liabilities in the normal
course of business. As of March 31, 2006, the Company had cash, cash equivalents
and short term investments of $12.2 million. Based on the Company's business
plan and related estimates of cash requirements, that amount may be insufficient
to fund the Company's operations for the next 12 months. The Company expects to
require additional cash in the fourth quarter of 2006 to pursue its planned
operations. If the Company were to be unable to raise additional capital in the
form of commercial or securitized debt, sales of equity securities or other
alternatives, it would be required to curtail its operations. As of March 31,
2006, the Company's total consolidated indebtedness for money borrowed was
$308,000. The Company is in discussions with respect to various financing
alternatives. However, there is no assurance that the Company will be successful
in obtaining the required capital. Any financing
19
arrangements that the Company may enter into may increase future costs or be
dilutive to existing stockholders. The Company's independent registered public
accounting firm has informed the Company that it may include in its report on
the Company's financial statements for the year ending December 31, 2006 an
explanatory paragraph expressing substantial doubt about the Company's ability
to continue as a going concern if the Company fails to successfully fund its
current operations.
BUSINESS SEGMENT OVERVIEW - THREE MONTHS ENDED MARCH 31, 2006 COMPARED TO THREE
MONTHS ENDED MARCH 31, 2005
For the three months ended March 31, 2006 and 2005, revenue and gross
profit by market segment are shown in the following table:
THREE MONTHS ENDED THREE MONTHS ENDED
MARCH 31, 2006 MARCH 31, 2005 (1)
-------------------------- -------------------------
PERCENT OF PERCENT OF
MARKET SEGMENT $000'S TOTAL SALES $000'S TOTAL SALES
----------------------------- ----------- ----------- ----------- -----------
Business
Communications -
branded products:
- Revenue ................... $ 1,786 21% $ 1,655 18%
- Gross Profit .............. 1,021 992
- Gross Profit % of ......... 57% 60%
Segment Revenue
OEM Remotes:
- Revenue ................... $ 4,002 47% $ 4,916 53%
- Gross Profit .............. 1,016 938
- Gross Profit % of ......... 25% 19%
Segment Revenue
E-Transactions:
- Revenue ................... $ 1,611 19% $ 1,357 15%
- Gross Profit .............. 1,020 623
- Gross Profit % of ......... 63% 46%
Segment Revenue
Specialty Components:
-Revenue .................... $ 1,132 13% $ 1,341 14%
-Gross Profit ............... 625 703
-Gross Profit % of .......... 55% 52%
Segment Revenue
All Segments:
- Revenue ................... $ 8,531 100% $ 9,269 100%
- Gross Profit .............. 3,682 3,256
- Gross Profit % ............ 43% 35%
(1) As restated. See Note 1 to the consolidated financial statements.
BUSINESS COMMUNICATIONS - BRANDED PRODUCTS
In our Business Communications - branded products segment, we sell
Interlink-branded wireless remote controls and keyboards direct to computer
products retailers, corporate resellers and distributors.
20
Overall, Business Communications -branded products revenues for the
three months ended March 31, 2006 increased 8% as compared to the three months
ended March 31, 2005. Revenues from branded products for the first quarter of
2006 had average selling prices ranging from approximately $40 to $450.
Increases in revenues are the result of a change in the mix of products being
sold and the corresponding average selling prices.
Business Communications - branded products gross profit margins for the
three months ended March 31, 2006 remained relatively stable at 57% as compared
to a gross profit margin of 60% for the three months ended March 31, 2005.
OEM REMOTES
In our OEM Remotes segment, we sell wireless remote controls on an OEM
basis to manufacturers of advanced viewing devices, including projectors sold
for TV viewing and for use with certain computer software presentation
applications. Our OEM Remotes revenues in the three months ended March 31
declined 19% compared to the three months ended March 31, 2005 due primarily to
reduced volume in customer orders and the lack of higher quantity per customer
sales.
OEM Remotes gross profit margins for the three months ended March 31,
2006 increased to 25% as compared to 19% for the three months ended March 31,
2005 due primarily to the Company's success in bringing in higher margin sales.
This has been the Company's intent since its recognition of the general downward
trend in average selling process in this business segment. In addition, this
increase in margin is reflected in a shift of more unabsorbed costs being
allocated to other business segments for the three months ended March 31, 2006
as compared to the three months ended March 31, 2005.
E-TRANSACTIONS
In our E-transactions segment, we sell electronic signature capture
devices and, depending on the customer requirement, signature-capture software.
We offer annual software maintenance agreements and hardware upgrade programs to
our existing customers; however, historically we have not recorded significant
revenues from those types of sales.
For the three months ended March 31, 2006, E-transaction revenues
increased 19% compared to the three months ended March 31, 2005 due primarily to
increases in specific customer sales in the 2006 period, which includes certain
high volume transactions. Our E-transactions results from period to period are
greatly affected by individually significant sales, which are negotiated
independently.
E-transaction gross profit margin for the three months ended March 31,
2006 increased to 63% from a gross margin profit of 46% in the three months
ended March 31, 2005 due primarily to increased sales and increased average
selling prices. In addition, incrementally more unabsorbed overhead costs were
applied to the E-transactions for the three months ended March 31, 2005 than
during the three months ended March 31, 2006 due to new product introductions
and larger custom orders in the quarter ended March 31, 2005 than in the quarter
ended march 31, 2006.
SPECIALTY COMPONENTS
In our Specialty Components segment, we sell our MICRONAV(TM) products
and custom FSR's and FSR-based subassemblies to many customers in several
vertical markets, such as medical devices, industrial input and military input
products.
Specialty Components revenues for the three months ended March 31, 2006
decreased 16% when compared to the three months ended March 31, 2005. The
decrease is primarily attributable to a lower number of MicroNav sales. The
Specialty business segment quarterly revenues will fluctuate due to the timing
of customer orders and shipments to customers.
21
Specialty Component gross profit margin for the three months ended
March 31, 2006 remained relatively constant at 55% as compared to 52% for the
three months ended March 31, 2005. The slight margin increase is primarily due
to a greater mix of relatively lower margin revenues related to our new MICRONAV
products in the 2005 period.
OPERATING EXPENSES
Our operating expenses for the three months ended March 31, 2006 were
affected by a total of $869,000 as a result of the implementation of Statement
of Financial Accounting Standard 123R (SFAS 123R). R & D expenses were affected
by $225,000 and SG&A were affected by $644,000.
Product development and research costs include internal engineering
labor, contract engineering and outside processing costs for the design and
development of our OEM and branded designs and products and the research of our
technologies. Our product development and research costs increased 38% or
$387,000 from $1,028,000 for the three months ended March 31, 2005 to $1,415,000
for the three months ended March 31, 2006. This increase was primarily due to
$225,000 of a non-cash expense attributable to the implementation of SFAS 123R
and $183,000 of increased product development costs. As a percentage of
revenues, product development and research costs increased to 17% in the first
quarter of 2006 compared to 11% in the first quarter of 2005.
Sales, general and administrative costs ("SG&A") include sales,
marketing, legal, accounting and administrative labor, sales commissions,
advertising, general marketing, branded OEM Remote and business communication -
branded products channel marketing and travel and entertainment costs. For the
first quarter of 2006, SG&A costs increased 81%, from $2,690,000 to $4,900,000
over the same period of 2005. This $2,210,000 increase is comprised of $644,000
of a non-cash expense attributable to the implementation of SFAS 123R $239,000
of increased payroll and related costs, $150,000 of SOX costs, $589,000 of costs
related to an internal investigation undertaken by the Company, increased
professional and increased consulting fees of $303,000,due to increased demands
on the administrative staff, and increased sales and marketing costs, including
commissions, advertising and marketing development costs. As a percentage of
revenues, SG&A increased to 57% in the first quarter of 2006 compared to 29%, in
the same period of 2005.
OPERATING RESULTS
In summary, our operating results in the three months ended March 31,
2006 were attributable to the following factors:
o A $1,070,000 non-cash charge for stock-based compensation
related to the implementation of SFAS 123R. This amount is
reflected throughout each line item within the financial
statements including cost of sales ($201,000), R & D
($225,000) and SG&A ($644,000);
o 8% decline in revenues for the three months ended March 31,
2006 compared to the three months ended March 31, 2005 due
primarily to lower OEM Remote revenues and a 1% increase in
revenues from the three months ended December 31, 2005 due
primarily to increases in our Branded revenues. The fourth
quarter Branded revenues were effected by a smoothing of
purchases by our distribution base;
o Increases in gross profits margins to 43% in the three months
ended March 31, 2006 compared to 20% in the three months ended
December 31, 2005 primarily attributable to increased revenues
in the E-transactions business segment, which have higher
gross margins than other business segments and to increased
margins in our OEM remote business segment due primarily to
higher gross margins in our Japanese subsidiary due to the
ability sell certain previously reserved inventory and to
overall higher product margins sales. In addition, gross
margins were affected downward in the fourth quarter of 2005
by adjustments to inventory as a result of a 2005 year end
physical inventory; and
22
o Increased operating expenses compared to the three months
ended December 31, 2005 due to SFAS 123R mentioned above, plus
increased audit, consulting, Sarbanes-Oxley (SOX) and
professional fees, and costs associated with continued
infrastructure building within the finance department
primarily through increased personnel.
Total other income, net increased to $111,000 in the three months ended
March 31, 2006 versus other income, net of $64,000 in the three months ended
march 31, 2005 due to interest earned on a greater net cash balance in the 2006
period.
We have approximately $39.7 million in net operating loss ("NOL")
carryforwards available for U.S. federal tax purposes, of which $666,000 expire
in 2006. In determining whether or not a valuation allowance is necessary
against the deferred tax asset related to these NOL carryforwards, forecasts of
future taxable income are not considered sufficient evidence to outweigh a
history of losses. Accordingly, we have maintained the full valuation allowance
against our deferred tax assets as of March 31, 2006. This has no effect on the
Company's NOL carryforwards for tax purposes and they continue to be available
for up to 20 years.
LIQUIDITY AND CAPITAL RESOURCES
Working capital decreased to $21.5 million at March 31, 2006 from $23.0
million at the end of 2005 due primarily to the loss from operations.
Operations used $1.6 million in cash in the first three months of 2006
as compared to $3.2 million in the same period of 2005. The decrease in cash is
due primarily to the loss from operations.
We spent $61,000 in the first three months of 2006 to purchase
additional manufacturing and computer equipment while there were no purchases in
the first three months of 2005. We also invested $7,000 in new patent and
trademark activity in the first three months of 2006 as compared to $25,000 in
the first three months of 2005.
We made no payments on long-term debt in the first three months of 2006
and $135,000 in the first three months of 2005. Net proceeds from the exercise
of employee and director stock options were $56,000 in the first three months of
2005, while there were no exercises in the first three months of 2006.
We currently have minor commitments for capital expenditures and no
material purchase obligations. We have a software license agreement that has
minimum quarterly payments through 2007.
Our minimum long-term debt, licensing and operating lease obligations
as of December 31, 2005, the last fiscal year-end date, were as follows (in
thousands):
Less than 1-3
Total One Year Years 4th Year
--------- --------- --------- ---------
Long-term debt obligations ..... $ 308 $ 154 $ 154 $ --
Software licensing ............. 900 600 300 --
Operating lease obligations .... 1,713 469 836 408
--------- --------- --------- ---------
Total .......................... $ 2,921 $ 1,223 $ 1,290 $ 408
========= ========= ========= =========
These amounts may increase as we pursue our growth strategy but the
amount of any such growth will depend on the particular requirements of any
growth commitment, the availability and attractiveness of equity capital
arrangements and our general liquidity position.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and the satisfaction of liabilities in the
23
normal course of business. As of March 31, 2006, the Company had cash, cash
equivalents and short term investments of $12.2 million. Based on the Company's
business plan and related estimates of cash requirements, that amount may be
insufficient to fund the Company's operations for the next 12 months. The
Company expects to require additional cash in the fourth quarter of 2006 to
pursue its planned operations. If the Company were to be unable to raise
additional capital in the form of commercial or securitized debt, sales of
equity securities or other alternatives, it would be required to curtail its
operations. As of March 31, 2006, the Company's total consolidated indebtedness
for money borrowed was $308,000. The Company is in discussions with respect to
various financing alternatives. However, there is no assurance that the Company
will be successful in obtaining the required capital. Any financing arrangements
that the Company may enter into may increase future costs or be dilutive to
existing stockholders. The Company's independent registered public accounting
firm has informed the Company that it may include in its report on the Company's
financial statements for the year ending December 31, 2006 an explanatory
paragraph expressing substantial doubt about the Company's ability to continue
as a going concern if the Company fails to successfully fund its current
operations.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), that involve substantial risks and uncertainties and which are intended
to be covered by the safe harbors created thereby. These statements can be
identified by the fact that they do not relate strictly to historical
information and may include the words "expects", "believes", "anticipates",
"plans", "may", "will", "intends", "estimates", "continue" or other similar
expressions. These forward-looking statements are subject to various risks and
uncertainties that could cause actual results to differ materially from those
currently anticipated. These risks and uncertainties include, but are not
limited to, items discussed under the headings "Overview", "Current
Opportunities and Challenges" and "Business Segment Overview - Three Months
Ended March 31, 2006 Compared to Three Months Ended March 31, 2005."
Forward-looking statements speak only as of the date made. We undertake no
obligation to publicly release or update forward-looking statements, whether as
a result of new information, future events or otherwise.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon the consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires management to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. On an on-going basis, management evaluates
estimates, including those related to the valuation of inventory and the
allowance for uncollectible accounts receivable. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. We believe the following
critical accounting policies affect our more significant judgments and estimates
used in the preparation of our consolidated financial statements:
REVENUE RECOGNITION. We recognize revenue in accordance with SEC Staff
Accounting Bulletin ("SAB") No. 104, "Revenue Recognition." SAB No. 104 requires
that four basic criteria must be met before revenue can be recognized: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred or
services rendered; (3) the fee is fixed and determinable; and (4) collectibility
is reasonably assured. Determination of criteria (3) and (4) require
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
To satisfy the criteria, we: (1) enter orders based upon receipt of a customer
purchase order; (2) record revenue upon shipment of goods and when risk of loss
and title has transferred; (3) confirm pricing through the customer purchase
order; and (4) validate creditworthiness through past payment history, credit
agency reports and other financial data. All customers have warranty rights and
some customers also have explicit or implicit rights of return. We comply with
Statement of Financial Accounting Standards No. 48 with respect to sell-through
and returns and the related recording of reserves for potential customer
returns. Should changes in conditions cause management to determine the revenue
recognition criteria are not met for certain future transactions, such as a
determination that collectibility was not reasonably assured, revenue recognized
for any reporting period could be adversely affected.
24
STOCK BASED COMPENSATION. On January 1, 2006, we adopted the provision
of SFAS 123R, which requires that compensation expense be measured and
recognized at an amount equal to the fair value of share-based payments granted
under compensation arrangements. We calculate the fair value of stock options by
using the Black-Scholes option-pricing model. The determination of the fair
value of share-based awards at the grant date requires judgment in developing
assumptions, which involve a number of variables. These variables include, but
are not limited to, the expected stock-price volatility over the term of the
awards, the expected dividend yield and the expected stock option exercise
behavior. Additionally, judgment is also required in estimating the number of
share-based awards that are expected to be forfeited. Our computation of
expected volatility is based on a combination of historical and market-based
implied volatility. The expected term of options granted was derived by
averaging the vesting term with the contractual term.
We recorded stock-based compensation expense net of estimated
forfeitures. In determining the estimated forfeiture rates, we consider many
factors including the type of award, the employee class and historical
experience. The estimation of stock awards that will ultimately be forfeited
requires significant judgment and to the extent that actual results or updated
estimates differ from our current estimates, such amounts will be recorded as a
cumulative adjustment in the period such estimates are revised.
If any of the assumptions used in the Black-Scholes model change
significantly, stock-based compensation expense may differ materially in the
future from that recorded in the current period. We believe the accounting for
stock-based compensation is a critical accounting policy because it requires the
use of complex judgment in its application.
ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS. Our accounts
receivable are unsecured, and we are at risk to the extent such amounts become
uncollectible. We continually monitor individual account receivable balances,
and provide for an allowance of doubtful accounts at the time collection may
become questionable based on payment performance or age of the receivable and
other factors related to the customer's ability to pay.
RESERVE FOR ESTIMATED PRODUCT RETURNS. While not an explicit part of
our terms and conditions of product sales except for some customers, we do, on a
discretionary basis, grant product exchanges for our distribution and reseller
customers in our Business Communications - branded products market for similar
products of equal value if these exchanges meet certain other criteria. We
estimate future product returns based on recent return history, inventory status
and product "sell-through" statistics received from our major distributors,
discussions regarding product sales activity with our major reseller customers,
and current industry product and technology trends. Management judgment is
required in evaluating the relative significance of the aforementioned data and
in the determination of the estimated value of the returns reserve. If actual
returns are greater than management's estimate then revenues in the subsequent
period will be adversely affected.
INVENTORY RESERVE. At each balance sheet date, we evaluate our ending
inventories for excess quantities and obsolescence. This evaluation includes
analyses of forecast sales levels by product and historical demand. We write off
inventories that are considered obsolete. Remaining inventory balances are
adjusted to approximate the lower of our cost or market value and result in a
new cost basis in such inventory until sold. If future demand or market
conditions are less favorable than our projections, additional inventory
write-downs may be required, and would be reflected in cost of sales in the
period the revision is made. Based on lowered expectations for future demand in
the OEM Remote segment as well as limitations on the use of certain restricted
raw materials prompted by early adoption of the Restriction of Hazardous
Substances Act of 2002 by many of our customers, we increased our reserve for
excess and obsolete inventory by approximately $1.9 million in the third quarter
of 2005. The reserve is discussed in detail in the BUSINESS SEGMENT OVERVIEW
under OEM Remotes in our Annual Report on Form 10-K for the year ended December
31, 2005.
PROVISION FOR INCOME TAX. As part of the process of preparing our
financial statements, as required by Statement of Financial Accounting Standards
("SFAS") No. 109, we are required to estimate our income taxes in each of the
jurisdictions in which we operate. This process involves estimating our actual
current tax exposure together with
25
assessing temporary differences resulting from differing treatment of items for
tax and accounting purposes. These differences result in deferred tax assets and
liabilities, which are included in our balance sheet. We must then assess the
likelihood that our deferred tax assets will be recovered from future taxable
income and to the extent we believe that recovery is not likely, we must
establish a valuation reserve. To the extent we establish a reserve or increase
this reserve in a period, we must include an expense within the tax provision in
the statements of operations.
Significant management judgment is required in determining our
provision for income taxes, deferred tax asset and liabilities and any valuation
reserve recorded against our net deferred tax assets. Management continually
evaluates its deferred tax asset as to whether it is likely that the deferred
tax asset will be realized.
Based on historical and prospective evidence, we have concluded that we
did not have sufficient evidence to be able to recognize our NOL carryforward
benefits as assets and thus we have recorded a valuation allowance against our
deferred tax asset balance. If we achieve profitable operations in the future,
we will reevaluate our deferred tax asset balance and may reduce or eliminate
the valuation allowance.
As of December 31, 2005, we had NOL carryforwards for federal, state
and foreign income tax purposes of $39.7 million, $23.9 million and $5.9
million, respectively, which are available to offset future taxable income in
those jurisdictions through 2025.
FOREIGN EXCHANGE EXPOSURE. We have established relationships with most
of the major OEMs in the OEM Remotes market. Many of these OEMs are based in
Japan and approximately 14%, 20% and 28% of our revenues for the first three
months of 2006 and the years 2005 and 2004, respectively, came from Japanese
customers. Revenues from these customers are denominated in Japanese yen and as
a result we are subject to foreign currency exchange rate fluctuations in the
yen/dollar exchange rate. We use foreign currency forward and average rate
option contracts to hedge this exposure. We use revenue forecasts from our
Japanese subsidiary to determine the amount of our forward or option contracts
to purchase and we attempt to enter into these contracts when we believe the yen
value is relatively strong against the U.S. dollar. To the extent that our
revenue forecast may be inaccurate or the timing of forecasting the yen's
strength is wrong, our actual hedge gains or losses may not necessarily
correlate with the effect of foreign currency rate fluctuations on our revenues.
We mark these contracts to market value and the gain or loss from these
contracts is recorded in OEM Remote revenue. These hedge transactions are
classified as economic hedges and do not qualify for hedge accounting under
Statement of Financial Accounting Standards No. 133. In addition, because our
Japanese subsidiary's functional currency is the yen, the translation of the net
assets of that subsidiary into the consolidated results will fluctuate with the
yen/dollar exchange rate.
The following table illustrates the impact of foreign currency
fluctuations on our yen-denominated revenues and the effectiveness of our
foreign currency hedging activity (in thousands).
Three Months
Ended MARCH 31,
----------------
2006 2005
------ ------
Increase (decrease) in revenues resulting from
foreign currency fluctuations .......................... $ -- $ 54
Hedging loss ................................................ (1) 38
------ ------
Net revenue impact ..................................... $ (1) $ 92
====== ======
We calculate the "increase (decrease) in revenues resulting from
foreign currency fluctuations" by calculating the U.S. dollar equivalent of our
yen-denominated revenues using the yen/dollar exchange rate at the beginning of
the period. The resulting product is compared to our yen-denominated revenues
converted to U.S. dollars according to GAAP and the difference is shown in the
table above. As of March 31, 2006, we did not have any contracts outstanding to
hedge our foreign exchange exposure.
26
RECENT ACCOUNTING PRONOUNCEMENTS
In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140").
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is a derivative instrument. This
statement is effective for instruments that are acquired on or issued after the
beginning of an entity's first fiscal year that begins after September 15, 2006.
We are currently evaluating the impact of this new Standard, but believe that it
will not have a material impact on the Company's financial position, or results
of operations.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. We are currently
evaluating the impact of this Statement.
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes -- An Interpretation of FASB Statement No. 109",
(FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB
Statement No. 109, "Accounting for Income Taxes". FIN 48 also prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return that results in a tax benefit. Additionally, FIN 48 provides guidance
on de-recognition, income statement classification of interest and penalties,
accounting in interim periods, disclosure, and transition. This interpretation
is effective for fiscal years beginning after December 15, 2006. The Company is
currently evaluating the effect that the application of FIN 48 will have on its
results of operations and financial condition.
In September 2006, the Securities and Exchange Commission (SEC) issued
Staff Accounting Bulletin ("SAB") No. 108 "Quantifying Financial Statement
Misstatements", (SAB 108). Due to diversity in practice among registrants, SAB
108 expresses SEC staff views regarding the process by which misstatements in
financial statements are evaluated for purposes of determining whether financial
statement restatement is necessary. SAB 108 is effective for fiscal years ending
after November 15, 2006, and early application is encouraged. The Company does
not believe SAB 108 will have a material impact on its financial condition, its
results of operations or liquidity
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
FOREIGN CURRENCY EXCHANGE RATE RISK - Our Japanese subsidiary,
Interlink Electronics K.K., generally makes sales and collects its accounts
receivable in Japanese yen. To hedge these revenues against future movements in
27
exchange rates, we purchase foreign exchange forward and average rate option
contracts. Gains or losses on these contracts are then offset by gains or losses
on the underlying revenue exposure and consequently a sudden or significant
change of foreign exchange rates would not have a material impact on net income
or cash flows to the extent future revenues are protected by forward currency
contracts. These contracts, however, typically have a six-month duration. Thus,
yen/dollar fluctuations lasting more than six months will have an impact on our
revenues. For the three month periods ended March 31, 2006 and 2005, we entered
into foreign currency exchange contracts in the normal course of business to
manage our exposure against foreign currency fluctuations on revenues
denominated in foreign currencies. The principal objective of such contracts is
to minimize the risks and costs associated with financial and global operating
activities. We do not utilize financial instruments for trading or other
speculative purposes. The fair value of foreign currency exchange contracts is
estimated by obtaining quotes from bankers. During the first three months of
2006, we recognized $1,000 of loss on foreign currency exchange contracts which
is reflected in revenue in the accompanying consolidated statements of
operations. Our hedging policies are designed to offset the effect of a yen
devaluation on our revenues; thus, a hypothetical 10% devaluation of the yen
would reduce our yen denominated revenues by 10%; but our theoretical hedging
gains would offset that effect for a period of time, to the extent we have such
foreign currency exchange contacts outstanding. As of March 31, 2006, we do not
have any contracts outstanding to hedge our foreign exchange exposure.
INTEREST RATE EXPOSURE - Based on our overall interest rate exposure at
March 31, 2006, a hypothetical 10% change in interest rates applied to our
outstanding debt as of March 31, 2006, would have no material impact on earnings
or cash flows over a one-year period.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
In connection with the preparation of this Form 10-Q, the Company's
senior management, with the participation of the Company's Chief Executive
Officer and Chief Financial Officer, evaluated the effectiveness of the design
and operation of the Company's disclosure controls and procedures as of March
31, 2006. Based upon that evaluation, the Company's Chief Executive Officer and
Chief Financial Officer concluded that the Company's disclosure controls and
procedures were ineffective, as of March 31, 2006, to provide reasonable
assurance that information required to be disclosed by the Company in reports
that it files or submits under the Exchange Act, is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms and to ensure that information required to be disclosed by the Company in
the reports that it files or submits under the Exchange Act is accumulated and
communicated to management, including the Company's principal executive and
principal financial officers, or persons performing similar functions, as
appropriate to allow timely decisions regarding required disclosures. This
conclusion is based primarily on the fact that the Company's internal control
over financial reporting was ineffective as of such date. Through the date of
the filing of this Form 10-Q the Company has adopted additional remedial
measures described below to address deficiencies in its disclosure controls that
existed on March 31, 2006 and has taken additional measures to verify the
information in its financial statements. The Company believes that, as a result
of these remedial and other measures, this Form 10-Q properly reports all
information required to be included in such report.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
As of December 31, 2005, management conducted an evaluation of the
effectiveness of the system of internal control over financial reporting based
on the framework in Internal Control-Integrated Framework (the "Framework")
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Based on its evaluation, management concluded that the Company's system
of internal control over financial reporting was ineffective as of December 31,
2005. This conclusion was reached based on the identification of material
weaknesses described below:
o Certain weaknesses were identified related to the closing and
financial reporting of our quarterly and annual financial
statements. These weaknesses resulted in adjustments in
accounts receivable and allowance for doubtful accounts, sales
return reserves, prepaid expenses and other assets, accounts
payable, stockholders' equity and due from stockholders. The
failure to have identified certain material adjustments to the
financial statements also resulted in the following
restatement issues:
- failure to identify $1.0 million in payables due to a
vendor, for the third and fourth quarters of 2004 and
the first and second quarters of 2005, that were not
properly recorded and a write-down of $1.1 million of
certain net receivables from the same vendor, for the
fourth quarters of 2002 and 2003, as a result of not
reconciling accounts with the vendor in a timely
manner; and
28
- failure to record stock option expense, in accordance
with generally accepted accounting principles, of
$2,400,000, $221,000 and $108,000 for 2001, 2004 and
2005, respectively, by allowing terminated employees
to extend the period in which to exercise their
options to 30 days after a black out period as
opposed to 30 days after termination as explicitly
stated in our stock option plan. This practice
results in a re-measurement date as defined under
stock option accounting rules, which require a
revaluation of any stock options given this benefit.
While these adjustments were correctly identified and made as
a result of a review of the financial statements, this
material weakness prevented us from filing our Quarterly
Report on Form 10-Q for the three months ended September 30,
2005, our Annual Report on Form 10-K for the year ended
December 31, 2005 and our Quarterly Report on Form 10-Q for
the three months ended March 31, 2006 in a timely manner. At
the direction of our Chief Executive and Chief Financial
Officers, we are adopting new closing processes and procedures
that we believe will remediate this material weakness.
o We identified a material weakness related to certain
weaknesses in our inventory management, reserves for excess
and obsolete inventory and costing process, in the course of
reviewing our inventory records. These adjustments resulted in
the following restatement issues:
- failure to recognize approximately $616,000 of
software license costs remaining in inventory that
should have been expensed in the first and second
quarters of 2005;
- failure to identify an additional $372,000 of certain
inventory components that were double-counted
resulting in an overstatement of inventory as of June
30, 2005; and
- Failure to properly recognize $837,000 of overstated
inventory in transit from our US and Japan operations
to our Hong Kong subsidiary as of December 31, 2004
and $748,000 of overstated cost of sales in 2005, for
a net increase to cost of sales of $89,000.
- At the direction of the Chief Executive and Chief
Financial Officers, we have developed and are
implementing revised internal control procedures
related to our inventory management and costing
process that we believe will remediate this material
weakness.
o Due to the number of deficiencies and significant deficiencies
found within the Sales Order to Cash, Procure to Payment and
Stockholders' Equity processes, in addition to the items
discussed above, we have assessed the financial control
environment as a whole as a material weakness. We are adopting
new processes and procedures that we believe will remediate
this material weakness
Other than as discussed above, there was no change in the Company's
internal control over financial reporting during the last fiscal quarter that
materially affected, or is likely to materially affect, the Company's internal
control over financial reporting.
LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS
Our management, including our Chief Executive Officer and Chief
Financial Officer, do not expect that our disclosure controls and procedures or
internal control over financial reporting will prevent all errors and all fraud.
A control system no matter how well designed and implemented, can provide only
reasonable, not absolute, assurance
29
that the control system's objectives will be met. Further, the design of a
control system must reflect the fact that there are resource constraints, and
the benefits of controls must be considered relative to their costs. Because of
the inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues within a company are
detected. The inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple
errors or mistakes. Controls can also be circumvented by the individual acts of
some persons, by collusion of two or more people or by management override of
the controls. Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be detected.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On November 15, 2005, a class action alleging violations of federal
securities laws was filed against the Company and two of its current and former
officers in the United States District Court for the Central District of
California. The complaint alleges that, between April 24, 2003 and November 1,
2005, the Company and two of its current and former officers made false and
misleading statements and failed to disclose material information regarding the
Company's results of operations and financial condition. The complaint includes
claims under the Securities Act and Exchange Act and seeks unspecified damages
and legal expenses.
To date, the Court has not certified a class, and the litigation
remains in its early stages.
On January 24, 2006, a shareholder's derivative action was filed
against two of the Company's current and former officers and the members of its
Board of Directors in the Central District of California. The derivative
complaint contains the same factual allegations as the class action complaint
and sought to recover unspecified damages from the defendants, as well as
forfeiture of their equity-based compensation and contribution from them in the
event that the Company is found to have violated the federal securities laws.
Following a motion made by the defendants to dismiss, or in the alternative,
stay the derivative action, the plaintiff voluntarily dismissed the derivative
action without prejudice on June 14, 2006.
On August 17, 2006, the plaintiff refiled the derivative action in
California state court. The refiled complaint alleges securities-related
violations of the California Corporations Code, as well as various common law
and Delaware corporate law claims. The members of the Company's board of
directors are no longer named as defendants. Plaintiffs seek treble damages
based on the difference between the prices at which the named defendants sold
their shares and the market value that those shares would have had at the time
of such sales but for the allegedly false and misleading financial statements,
as well as contribution from the defendants in the event that the Company is
found to have violated the federal securities laws and other unspecified
damages.
In connection with the class action and the derivative proceedings
described above, an independent investigation was undertaken at the direction of
the Audit Committee by Dorsey & Whitney, LLP. Dorsey & Whitney retained the
services of PricewaterhouseCoopers LLP with respect to various forensic
accounting and electronic procedures performed in the course of the
investigation.
While it intends to vigorously defend against these allegations, the
Company cannot predict the final disposition of these matters or whether the
Company will be liable for amounts not covered by insurance. There is no
assurance, however, that the ultimate resolution of these matters will not
result in a material adverse effect on the Company's business, financial
condition or results of operations.
In addition to the matters identified above, from time to time, the
Company is involved in various legal actions that arise in the ordinary course
of business.
30
ITEM 1(A) RISK FACTORS
WE HAVE INCURRED NET LOSSES FOR THE PAST EIGHT FISCAL QUARTERS AND EXPECT FUTURE
LOSSES. AS A RESULT, WE WILL NEED ADDITIONAL CAPITAL IN THE NEAR FUTURE.
We have incurred losses in each of the previous eight quarters as a result of
various factors, including fluctuating quarterly sales levels due to market
conditions and customer ordering patterns, fluctuations in gross profit margins,
increases in operating costs, inventory reserve adjustments, increased
compliance and regulatory costs, and internal investigation costs. We expect to
continue to incur net losses as we complete the implementation of enhanced
internal controls over financial reporting and continue to invest in new
technology and emerging markets. As a result of these losses, our capital
requirements have increased and we expect to require additional financing in the
fourth quarter of 2006 to fund our operations. We currently have no financing
facility in place. Although we are in discussions with respect to various
financing alternatives, we cannot assure you that we will be successful in
obtaining the required capital. Any financing arrangements that we may enter
into may increase future costs, involve restrictions on our financing and
operating activities or be dilutive to existing stockholders. If we are unable
to obtain additional financing as needed, we may be required to reduce the scope
of, or curtail, our operations. Our independent registered public accounting
firm has informed us that it may include in its report on the Company's
financial statements for the year ending December 31, 2006 an explanatory
paragraph expressing substantial doubt about the Company's ability to continue
as a going concern if the Company fails to successfully fund its current
operations.
WE ARE FACING LITIGATION BASED ON OUR RESTATEMENTS OF HISTORICAL FINANCIAL
STATEMENTS, WHICH MAY HAVE A MATERIAL ADVERSE IMPACT ON OUR CASH RESERVES AND
MAY IMPAIR OUR ABILITY TO ACHIEVE OUR BUSINESS OBJECTIVES.
Certain former Interlink stockholders have filed a class action lawsuit
claiming damages under various federal securities laws based on our restatement
of historical financial statements. Other stockholders have brought a derivative
action against our Chief Executive Officer and our former Chief Financial
Officer that alleges, among other things, securities-related violations of the
California Corporations Code. These actions will require a vigorous defense and
could result in a settlement or adverse award that is not covered by insurance
or that exceeds applicable insurance limits. The time and expense required to
defend these claims may also affect our ability to pursue our strategy. There is
also no assurance that additional lawsuits will not be filed or that the
ultimate resolution of these matters will not result in a material adverse
effect on our business, financial condition or results of operations.
WE HAVE IDENTIFIED MATERIAL WEAKNESSES IN OUR INTERNAL CONTROL OVER FINANCIAL
REPORTING AND HAVE BEEN REQUIRED TO RESTATE OUR HISTORICAL FINANCIAL STATEMENTS.
In our Annual Report for the year ended December 31, 2005, we reported
material weaknesses in our internal control over financial reporting. As a
result of these material weaknesses, we were required to restate several of our
historical financial statements. We have taken significant measures to improve
our financial reporting process but, despite these measures, continued to have
material weaknesses as of March 31, 2006. These matters are more fully described
elsewhere in this Report under the captions "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Controls and
Procedures--Changes in Internal Control Over Financial Reporting."
Any continuing material weaknesses in our internal control over
financial reporting could result in errors in our financial statements. Such
errors could cause our internal planning and assessment of our business to be
based on false information and could cause our published financial statements to
fail to fairly present our financial condition and results of operations. We
cannot assure you that we will be successful in our effort to eliminate all
material control weaknesses. Any continuing material weaknesses could erode
market confidence in our company, could cause the price of our stock to be based
on false or misleading information and could result in litigation based on any
such false or misleading information.
31
WE ARE ENTERING NEW MARKETS AND IF WE FAIL TO ACCURATELY PREDICT THE GROWTH OF
THESE NEW MARKETS, WE MAY SUFFER REDUCED EARNINGS.
Historically, our sales were concentrated in the Specialty Components
markets, as well as remote control devices for presentation projectors. However,
we have devoted significant resources to the development of products and the
support of marketing and sales efforts in new markets, such as television
remotes and the E-transactions market. We expect to continue to identify and
develop products for new markets. These markets change rapidly and we cannot
assure you that they will grow or that we will be able to accurately forecast
market demand in time to respond appropriately. Our investment of resources in
these markets may either be insufficient to meet actual demand or result in
expenses that are excessive in light of actual sales volumes. Failure to predict
growth and demand accurately in new markets may cause us to suffer substantial
losses or reduced earnings.
Our OEM Remote Controls business is focused on consumer markets that
are intensely price competitive. If we cannot generate volume and related
manufacturing efficiencies required to compete in these markets, our results of
operations will be adversely affected.
Historically, our OEM Remote Controls business was focused on selling
remote devices in the presentation projector market. As a specialty market, this
sector generated relatively low sales volumes with correspondingly high margins.
However the presentation projector market has become more consumer-oriented and
price competition has increased. We have shifted our OEM Remote Controls
business toward sales to manufacturers of advanced viewing devices which is also
very consumer oriented and price competitive but which offers the potential for
higher volumes. If we cannot increase production and sales volume, or if we
otherwise fail to achieve production efficiencies, our results of operations and
financial position will be adversely affected.
FAILURE TO MAINTAIN, DEVELOP AND EXPAND OUR OEM RELATIONSHIPS COULD CAUSE DEMAND
FOR OUR PRODUCTS TO DECREASE.
Sales to OEMs constituted 47% of our total sales for the three months
ended March 31, 2006. If we fail to maintain, develop and expand our
relationships with significant OEMs, or if those OEMs are not successful in
their marketing and sales efforts, demand for our products may decrease. For
example, our OEM Remote Controls products are sold to OEMs and consist primarily
of remote devices that are packaged with advanced viewing devices, televisions
or presentation systems. If our OEM customers experience a significant reduction
in demand for advanced viewing devices, televisions or presentation systems it
will significantly decrease demand for our remote devices.
Our ability to generate increased revenues also depends significantly
on the extent to which our OEM customers develop, promote and sell products that
incorporate our technology and products. If our OEM customers do not
successfully develop and market products that incorporate our products, sales of
our products to our OEM customers would be adversely affected. The extent to
which our OEM customers develop, promote and sell our products is based on a
number of factors that are largely beyond our ability to control.
THE LOSS OF ANY SIGNIFICANT CUSTOMER OR ANY CANCELLATION, REDUCTION OR DELAY OF
A LARGE PURCHASE BY A SIGNIFICANT CUSTOMER COULD REDUCE OUR REVENUE AND REQUIRE
US TO WRITE-DOWN INVENTORY.
For the first three months of 2006, approximately 47% of our total
sales were to our OEM Remote Controls customers and most of these sales were to
OEM customers. With the advent of our MICRONAV family of sensors, we expect that
our reliance on OEM sales will increase. The loss of any key OEM customers, or a
significant reduction in sales to those customers, could significantly reduce
our revenue below anticipated levels. From time to time, we expect to lose other
significant revenue streams and will be required constantly to seek new
opportunities with new and existing customers. Because our expense levels are
based on our expectations as to future revenue and are, to a large extent, fixed
in the short term, a substantial reduction or delay in sales of our products to
an OEM customer, the unexpected loss of any significant OEM or other customer,
or unexpected returns from customers, could harm our business.
32
FAILURE TO INCREASE MARKET AWARENESS AND ACCEPTANCE OF E-TRANSACTIONS AND OUR
E-TRANSACTION PRODUCTS MAY CAUSE OUR REVENUES IN THIS MARKET TO FALL SHORT OF
OUR EXPECTATIONS.
The prospects for our E-transactions business depend in part on the
acceptance by our target markets of electronic signatures as a replacement for
traditional pen and ink signatures. The market for E-transactions is new and
emerging and we cannot be certain that it will continue to develop or grow or
that businesses will elect to adopt our products rather than continuing to rely
on traditional pen and ink signatures. Businesses that have invested substantial
resources in traditional infrastructures may be reluctant to adopt an electronic
approach to replace their existing systems. Concerns about privacy and fraud may
cause businesses not to adopt E-transactions or our E-transaction products. We
expect that we will need to continue to pursue intensive marketing and sales
efforts to educate prospective customers about the benefits of E-transactions
and our E-transaction products. If market awareness and acceptance of
E-transactions do not occur, our revenues and profitability in this market will
fall short of our expectations.
SALES OF SIMPLE SIGNATURE CAPTURE DEVICES ARE GROWING RAPIDLY AND THE
MANUFACTURERS OF THESE DEVICES COULD BROADEN THEIR PRODUCT RANGE TO INCLUDE
PRODUCTS THAT COMPETE WITH OUR EPAD.
Simple signature capture devices have recently become a common sight at
retail checkout counters and a number of companies manufacture and sell these
devices. While our EPAD product is targeted at a more demanding market,
signature capture device manufacturers could elect to upgrade their existing
products in an effort to compete in our markets. Such competition could reduce
margins or otherwise adversely affect our prospects in our E-transactions
market.
IF WE ARE UNABLE TO KEEP PACE WITH RAPID TECHNOLOGICAL CHANGE AND GAIN MARKET
ACCEPTANCE OF NEW PRODUCTS, WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY.
Technology, both in our markets and in our customers' markets, is
undergoing rapid change. In order to maintain our leadership position in our
existing markets and to emerge as a leader in new markets, we will have to
maintain a leadership position in the technologies supporting those markets.
Doing so will require, among other things, the following:
o we must accurately predict the evolving needs of our customers
and develop, in a timely manner, the technology required to
support those needs;
o we must provide products that are not only technologically
sophisticated but are also available at a price within market
tolerances and competitive with comparable products;
o we must establish and effectively defend our ownership of the
intellectual property supporting our products; and
o we must enter into relationships with other companies that
have developed complementary technology on which our products
also depend.
We cannot assure you that we will be able to achieve any of these objectives.
IF WE FAIL TO MANAGE OUR GROWTH SUCCESSFULLY, OUR OPERATIONS COULD BE ADVERSELY
IMPACTED AND OUR GROWTH COULD BE IMPAIRED.
The ability to operate our business in rapidly evolving markets
requires an effective planning and management process. We expect that growth in
our business will place a significant strain on our personnel, management
systems, infrastructure and other resources. Our ability to manage any potential
future growth effectively will require us to attract, train, motivate and manage
new employees, to integrate new employees into our overall operations and to
continue to improve our operational, financial and management controls and
procedures. If
33
we are unable to implement adequate controls or integrate new employees into our
business in an efficient and timely manner, our operations could be adversely
affected and our growth could be impaired.
MOST OF OUR OEM AND MAJOR RETAIL CUSTOMERS ORDER FROM US ON A "JUST IN TIME"
BASIS, WHICH REQUIRES US TO ESTIMATE DEMAND FOR PARTICULAR PRODUCTS.
The agreements or understandings that we reach with most of our OEM
customers specify various terms such as product design and price, but do not
constitute firm purchase orders for a specific number of products or components.
Our OEM and major retail customers typically place firm purchase orders on a
"just in time" basis and expect products or components to be shipped to them as
soon as they can be made. Accordingly, our backlog of firm orders is typically
quite small in relation to the volume of our sales. In anticipation of customer
demand, we are often required to purchase raw materials and components based on
estimates of customer demand derived from non-binding information furnished by
the customer. If customer purchase orders differ substantially from our
estimates, we may accumulate excess inventory that has to be written off. If we
underestimate demand, we may be unable to meet customer needs, which could harm
our relationship with the customer.
WE RELY ON THIRD PARTIES FOR THE MATERIALS THAT WE USE TO MANUFACTURE OUR
PRODUCTS AND A SHORTAGE OF SUPPLY COULD ADVERSELY AFFECT OUR REVENUES, OPERATING
RESULTS AND CUSTOMER RELATIONSHIPS.
We rely on third-party suppliers for the raw material components of our
products. We cannot assure you that our suppliers will be able to maintain an
adequate supply of these raw materials to enable us to fulfill all of our
customers' orders on a timely basis. A failure to obtain an adequate supply of
the materials for our products could increase our costs of goods sold, cause us
to fail to meet delivery commitments and cause our customers to purchase from
our competitors, which could adversely affect our operating results and customer
relationships. In some situations, we rely on a single supplier for raw material
components of our products. Any disruption in these supplier relationships could
prevent us from maintaining an adequate supply of materials and could adversely
affect our results of operation and financial position.
DISRUPTIONS IN OUR MANUFACTURING FACILITIES OR ARRANGEMENTS COULD CAUSE OUR
REVENUES AND OPERATING RESULTS TO DECLINE.
We manufacture all of our FSR sensors at our Camarillo, California
facility. This facility is vulnerable to damage from earthquakes, floods, fires,
power loss and similar events. It could also be subject to break-ins, sabotage
and intentional acts of vandalism. Our insurance may not cover such events and,
if the event is covered, our insurance may not be sufficient to compensate us
for any losses that may occur. Despite any precautions we may take, the
occurrence of a natural disaster or other unanticipated problem at our
manufacturing facility could result in delayed shipment of products, missed
delivery deadlines and harm to our reputation, which may cause our revenues and
operating results to decline.
All of our non-FSR product manufacturing is currently done by third
parties in China identified and managed through our Hong Kong subsidiary. We
rely on our subsidiary to select and contract with contract manufacturers with
suitable manufacturing facilities and appropriately trained employees. An
interruption in our current manufacturing arrangements could adversely affect
our revenues, operating results and customer relationships.
PERFORMANCE, RELIABILITY OR QUALITY PROBLEMS WITH OUR PRODUCTS MAY CAUSE OUR
CUSTOMERS TO REDUCE OR CANCEL ORDERS WHICH WOULD HARM OUR OPERATING RESULTS.
We regularly introduce new products with new technologies or
manufacturing processes. Our products have in the past contained, and may in the
future contain, errors or defects that may be detected at any point in the life
of the product. Detection of such errors could result in delays in shipping and
sales during the period required to correct such errors. Defects may also result
in product returns, loss of sales and cancelled orders, delays in market
acceptance, injury to our reputation, injury to customer relationships and
increased warranty costs, which could have an adverse effect on our business,
operating results and financial condition.
34
INTERNATIONAL SALES AND MANUFACTURING RISKS COULD ADVERSELY AFFECT OUR OPERATING
RESULTS.
Our revenue from international sales accounted for approximately 45%,
55% and 60% of net sales for the three months ended 2006 and for the years ended
December 31, 2005 and 2004, respectively. We believe that international sales
will represent a substantial portion of our sales for the foreseeable future.
Our non-FSR manufacturing is currently performed by third parties in China. Our
international operations involve a number of risks, including:
o import-export license requirements, tariffs, taxes and other
trade barriers;
o difficulty in staffing and managing foreign operations;
o ability to secure credit and funding;
o difficulty in maintaining an effective system of internal
controls at our foreign manufacturing facility;
o foreign collection problems;
o reduced protection of intellectual property rights;
o international unrest and terrorism;
o political and economic instability; and
o transportation risks.
Any of the above factors could adversely affect our operating results.
OUR OPERATING RESULTS COULD BE ADVERSELY AFFECTED BY FLUCTUATIONS IN THE VALUE
OF FOREIGN CURRENCIES.
International sales made through our Japanese subsidiary are generally
denominated in yen. A weak yen would materially affect total revenue and could
result in a decrease in dollar revenue even though sales remained constant or
increased. We also contract for most of our large-volume, non-technical
manufacturing in China. Although we contract in U.S. dollars, a weakening of the
dollar could cause existing contracts to be uneconomic to the vendor and
therefore require a renegotiation. Over the past two years, the valuations of
many foreign currencies have fluctuated significantly relative to the U.S.
dollar. The Japanese yen, in particular, has fluctuated in value due in part to
the economic problems experienced by Asian countries and the recent devaluation
of the U.S. dollar. Although we at times engage in currency hedging transactions
in order to protect ourselves from risks of Japanese yen currency fluctuations,
we cannot assure you that these activities will protect us from such risks.
OUR MARKETS ARE INTENSELY COMPETITIVE AND MANY OF OUR POTENTIAL COMPETITORS HAVE
RESOURCES THAT WE LACK.
Our markets are competitive and we expect competition in our newer
markets to increase. Our competitors include companies with similar products or
technologies, companies that sell complementary products to our target markets
and our OEM customers themselves, who could choose to manufacture products that
they currently buy from us. Our competitors and potential competitors may have
established business relationships that may afford them a competitive advantage
or may create technologies that are superior to ours or that set a new industry
standard that will define the successful product for that market. If any of our
competitors establish a close working relationship with our customers, they may
obtain advance knowledge of our customers' technology choices or may be afforded
an opportunity to work in partnership to develop compatible technologies and may
therefore achieve a competitive advantage. We may be unable to compete
successfully against our current and future competitors.
35
OUR PRODUCTS ARE OFTEN CUSTOMER-SPECIFIC, AND FROM TIME TO TIME WE MAY NEED TO
WRITE OFF EXCESS OR OBSOLETE INVENTORY.
A substantial percentage of our intuitive interface devices and
components are customer-specific and cannot be easily recycled for sale to other
customers. However, we must have sufficient quantities of our products available
to satisfy our customers' demands. If a particular customer fails to order as
expected or cancels or substantially delays an order, we may have excess
inventory that we may be required to hold for long periods of time or that may
eventually become obsolete. In these situations, we may be required to write off
or write down inventory, which would have a material adverse effect on our
results of operations.
ADOPTION OF THE RESTRICTION ON HAZARDOUS SUBSTANCES ACT OF 2002 ("ROHS") OR THE
ADOPTION OF SIMILAR RESTRICTIONS IN MARKETS OUTSIDE OF EUROPE MAY REQUIRE US TO
MAKE ADDITIONAL WRITE-DOWNS OF OUR INVENTORY.
ROHS went into effect on July 1, 2006. ROHS limits the use of six
hazardous raw materials in the production of electronic and electrical goods
that are sold in Europe. Many of these restricted materials are found in our
products and in the components we have in our inventory. Many of our OEM
customers have implemented ROHS restrictions and are requiring our products to
be ROHS-compliant. In 2005, we determined that we would not be able to
adequately reduce our inventory of non-compliant materials and, as a result, we
recorded an expense of $900,000 to create a reserve for obsolescence. While we
currently believe our inventory reserve is adequate, we may have additional
inventory write downs due to ROHS or other similar restrictions implemented by
other markets.
OUR ABILITY TO OPERATE EFFECTIVELY COULD BE IMPAIRED IF WE WERE TO LOSE THE
SERVICES OF KEY PERSONNEL, OR IF WE ARE UNABLE TO RECRUIT QUALIFIED MANAGERS AND
KEY PERSONNEL IN THE FUTURE.
Our success is substantially dependent on the continued availability of
our key management and technical personnel. Several of our key management
personnel have been with us throughout most of our history and have substantial
experience with our business and technology. If one or more of our key
management personnel leaves Interlink and we are unable to find a replacement
with the combination of skills and attributes necessary to execute our business
plan, it may have an adverse impact on our business. Our success will also
depend, in part, on our ability to attract and retain additional qualified
professional, technical, production, managerial and marketing personnel, both
domestically and internationally.
IF OUR PRODUCTS DO NOT SUPPORT EVOLVING INDUSTRY STANDARDS, THEY MAY NOT ACHIEVE
OR MAINTAIN MARKET ACCEPTANCE AND OUR REVENUES MAY DECLINE.
Our wireless communication products must communicate using whatever
communication protocol is chosen by the customer. Supporting a particular
communication protocol requires specific technical expertise and we expect that
we will be required to establish and maintain such expertise with respect to
each commonly used communication protocol. New communication protocols are
constantly under development and we may fail to acquire the necessary experience
to support a popular new protocol or to respond to changes in an existing
protocol. In our E-transactions business, our customers will expect that our
products will enable them to comply with applicable requirements relating to
electronic signatures, such as the Electronic Signatures in Global Commerce Act
and procedures adopted by the National Notary Association. If our products do
not support these requirements, sales of our E-transactions products would be
adversely affected.
IF WE ARE NOT ABLE TO PROTECT OUR INTELLECTUAL PROPERTY OR IF WE INFRINGE ON THE
INTELLECTUAL PROPERTY OF OTHERS, OUR BUSINESS AND OPERATING RESULTS COULD BE
ADVERSELY AFFECTED.
We consider our intellectual property to be a key element of our
ability to compete in our chosen markets. We rely on a combination of patents,
trade secrets and proprietary software to establish and protect our intellectual
property rights. We cannot assure you that patents will be issued from any of
our pending applications or that any claims allowed from existing or pending
patents will be sufficiently broad to protect our technology. We also cannot
assure you that any patents issued to us will not be challenged, invalidated or
circumvented, or that the rights granted will provide proprietary protection.
Litigation may be necessary to enforce our patents, trade secrets and other
intellectual property rights, to determine the validity and scope of the
proprietary rights of others or to defend against
36
claims of infringement. Such litigation could result in substantial costs and
diversion of resources and could have a material adverse effect on our business,
regardless of the final outcome of the litigation.
We are not currently engaged in any patent infringement suits but we
have been threatened with one such suit in recent years. Despite our efforts to
maintain and safeguard our proprietary rights, we cannot assure you that we will
be successful in doing so or that our competitors will not independently develop
or patent technologies that are substantially equivalent or superior to our
technologies. If any of the holders of these patents assert claims that we are
infringing them, we could be forced to incur substantial litigation expenses or
to pay substantial royalties. In addition, if we were found to be infringing on
someone else's patent, we could be required to pay substantial damages, pay
royalties in the future or be enjoined from infringing in the future.
WE RELY ON OTHERS FOR ASPECTS OF OUR TECHNOLOGY DEVELOPMENT.
Our in-house research and development expertise is focused on our
sensor and communication technologies. We do not have broadly based expertise in
software development, chip design or other critical technological aspects of a
complete product. We rely on other companies with whom we may contract or enter
into joint development agreements to provide these aspects of our product
technologies. We cannot assure you that we will be able to contract or otherwise
arrange for these services in the future. We also cannot assure you that a
developer with whom we contract for technology will not use or permit others to
use similar technology in competition with us.
WE ARE A PUBLIC COMPANY AND ARE THEREFORE REQUIRED TO INCUR COSTS AND TO
DISCLOSE INFORMATION THAT PRIVATE COMPANIES ARE NOT REQUIRED TO INCUR OR
DISCLOSE.
As a public company, we are required to comply with complex and costly
accounting and disclosure requirements that do not apply to foreign companies
that are not public in the United States, private companies or to subsidiaries
or divisions of very large companies for whom the results of the subsidiary or
division are not material. The costs that we are required to incur have recently
increased dramatically, especially in connection with our reporting obligations
under Section 404 of the Sarbanes-Oxley Act of 2002, and these expenses may
continue to be incurred at historically unprecedented levels for the foreseeable
future. These costs impact our profitability and therefore constitute a
competitive disadvantage vis-a-vis much of our competition. These requirements
may also prevent our management from focusing on other areas of our business. In
addition, our public status requires us to disclose publicly information that
can afford a competitor a competitive advantage. If we are unable to maintain
costs associated with our public company status within reasonable parameters, or
if we are required to disclose information that our competitors can use to
compete with us, our ability to remain competitive in our markets could be
adversely affected.
BUSINESS ACQUISITIONS OR PARTNERING ARRANGEMENTS MAY DISRUPT OUR BUSINESS,
DILUTE SHAREHOLDER VALUE AND DISTRACT MANAGEMENT'S ATTENTION.
As part of our business strategy, we may consider acquisitions of, or
significant investments in, businesses with services, products or technologies
that we believe could complement or expand our business. Such acquisitions or
investments involve numerous risks, including:
o unanticipated costs and liabilities;
o difficulty of integrating the operations, products and
personnel of the acquired business;
o difficulties in managing the financial and strategic position
of acquired or developed products and technologies;
o difficulties in maintaining customer relationships;
o diversion of management's attention;
37
o inability to maintain uniform standards, controls, policies
and procedures;
o impairment of relationships with acquired employees and
customers occurring as a result of integration of the acquired
business; and
o accounting results that are unrelated to the performance of
either business.
Acquisitions also frequently result in recording of goodwill and other
intangible assets that are subject to potential impairments in the future.
Additionally, if we finance acquisitions by using convertible debt or stock, our
existing stockholders may be diluted which could affect the market price of our
stock. If we fail to properly evaluate and execute acquisitions or investments,
we may not achieve the anticipated additional benefit to our business, and we
may incur costs in excess of what we anticipate.
38
ITEM 6. EXHIBITS
3.1 Certificate of Incorporation, as amended (incorporated by
reference to Exhibit 3.1 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 2000).
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the
Registrant's Current Report on Form 8-K filed on October 10,
2006).
31.1 Certification of Chief Executive Officer of Registrant
Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer of Registrant
Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer of Registrant
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer of Registrant
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
39
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.
INTERLINK ELECTRONICS, INC.
DATE: November 16, 2006 /S/ CHARLES C. BEST
---------------------------
Charles C. Best
Chief Financial Officer
40
EXHIBIT INDEX
The following exhibits are filed with or incorporated by reference into this
Quarterly Report:
EXHIBIT
NUMBER DESCRIPTION
------- -----------------------------------------------------------------------
3.1 Certificate of Incorporation, as amended (incorporated by reference to
Exhibit 3.1 to the Registrant's Annual Report on Form 10-K for the year
ended December 31, 2000).
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Registrant's
Current Report on Form 8-K filed on October 10, 2006).
31.1 Certification of Chief Executive Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer of Registrant Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer of Registrant Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
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