NOTES TO THE CONSOLIDATED INTERIM FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, 2007
(dollars in thousands except per share data)
NOTE 1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
of America for interim financial information and the instructions to Form 10-Q
and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. Operating
results for the three-month and nine-month periods ended September 30, 2007 are
not necessarily indicative of the results that may be expected for any other
interim period or for the year ending December 31, 2007. The balance sheet at
December 31, 2006 has been derived from the audited consolidated financial
statements at that date. For further information, refer to the consolidated
financial statements and footnotes thereto and the quarterly financial data
included in the Company's Annual Report on Form 10-K for the year ended December
31, 2006.
Certain prior period amounts have been reclassified to conform to the current
period presentation.
The results of operations for the three and nine months ended September 30, 2007
are not necessarily indicative of results that may be expected for any other
interim period or for the full fiscal year ending December 31, 2007.
NOTE 2. CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America, requires management to make
decisions regarding accounting policies and judgments regarding their
application. Materially different amounts could be reported under different
circumstances and conditions.
REVENUE
The Company generally recognizes product revenue, net of sales discounts and
allowances, when persuasive evidence of an arrangement exists, shipment or
delivery (dependent upon the terms of the sale) has occurred, all significant
contractual obligations have been satisfied, the amount is fixed or determinable
and collection is considered probable. Sales of services and system support are
deferred and recognized ratably over the contract period.
INVENTORIES
Sept. 30, December 31,
2007 2006
------ ------
Finished goods $ 644 $ 579
Raw materials 246 860
------ ------
$ 890 $1,439
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Netted in the above amounts is the Company's reserve for slow-moving and
obsolete inventories totaling $3,360 and $3,337 at September 30, 2007 and
December 31, 2006, respectively.
OTHER LIABILITIES
Sept. 30, December 31,
2007 2006
------ ------
Accrued supplemental pension plan $ 211 $ 254
Deferred compensation 110 139
Accrued pension expense 425 634
Financing fee payable 150 --
------ ------
896 1,027
Less current portion 342 363
------ ------
$ 554 $ 664
====== ======
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7
BORROWINGS
On January 16, 2007, the Company borrowed $1,500 under a term loan agreement.
The loan bears interest at the rate of 13% per annum, matures on February 10,
2010 and requires an additional $150 payment to the lender on the maturity date.
The loan is to be repaid in six interest-only monthly installments followed by
thirty monthly installments of principal and interest. The Company pledged as
collateral substantially all of its non-intellectual property business, except
pledged receivables under its accounts receivable financing agreement. In
connection with the loan agreement, the Company issued a ten-year common stock
warrant to the lender to purchase 35,000 shares of the Company's common stock at
an exercise price of $3.47 which was the closing market price on January 16,
2007. The fair value of the warrant is estimated to be $49, based on the
assumption that it will be exercised at the termination of the loan and thus
have an estimated life of three years.
On September 28, 2007, the Company entered into a accounts receivable financing
agreement. Pursuant to the financing agreement, the lender may advance the
Company from time to time up to $1.0 million, based upon the sum of 80% of the
face value of accounts receivable purchased by the lender from the Company from
time to time at the lender's sole discretion. The sale of such accounts
receivable is with full recourse against the Company. Advances under the
financing agreement bear interest at a rate of 1.65% per month, subject to
adjustment depending on changes in the commercial prime rate. The financing
agreement has a term of one year (with an evergreen annual renewal provision
unless either party provides notice of termination) and contains certain
customary non-financial covenants but does not contain any financial covenants.
Pursuant to the financing agreement, the Company pledged as collateral to the
lender substantially all its non-intellectual property business assets. In
connection with the financing agreement, the Company issued a five-year common
stock warrant to the lender to purchase 21,276 shares of the Company's common
stock at an exercise price of $1.88 per share which was the closing market price
on September 28, 2007. The fair value of the warrant is estimated to be $10,
based on the assumption that it will be exercised at the termination of the
agreement and thus have an estimated life of one year. No receivables were
financed as of September 30, 2007.
INCOME PER SHARE
In computing basic earnings per share, the dilutive effect of stock options and
warrants are excluded, whereas for diluted earnings per share they are included.
For all periods presented, options and warrants were anti-dilutive and therefore
were not included in the determination of net loss per share.
COMPREHENSIVE LOSS
SFAS No. 130, "Reporting Comprehensive Income," requires disclosure of all
components of comprehensive income (loss) on an annual and interim basis.
Comprehensive income is defined as the change in equity of a business enterprise
during a period from transactions and other events and circumstances involving
non-owner sources.
STOCK-BASED COMPENSATION
Share-based compensation cost is measured at the grant date, based on the fair
value of the award, and is recognized as an expense over the employee's
requisite service period (generally the vesting period of the equity grant).
The Company has recognized compensation expense for its restricted stock grants.
In the first quarter of 2006, upon adoption of SFAS 123(R), using the modified
prospective method, the Company recognized a benefit of $36 as a cumulative
effect of a change in accounting principle resulting from the requirement to
estimate forfeitures of the Company's restricted stock grants at the date of
grant instead of recognizing them as incurred. The estimated forfeiture rate was
applied to the previously recorded compensation expense of the Company's
unvested restricted stock in determining the cumulative effect of a change in
accounting principle.
The Company has stock-based compensation plans under which directors, officers
and other eligible employees receive stock options and other equity-based
awards. The plans provide for the grant of stock options and restricted stock
awards. Stock options are granted with an exercise price equal to the market
value of a share of common stock on the date of grant. Stock option grants
generally expire in 10 years, and generally vest over a period ranging from two
to four years. Restricted stock awards generally vest over four years.
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The following table summarizes stock option activity:
Inducement 1990 Stock Directors'
Options Option Plan Option Plan
------- ----------- -----------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------ ----- ------ ----- ------ -----
Outstanding at December 31, 2006 566,666 $2.62 973,133 $3.62 166,750 $2.84
Granted -- 349,000 $2.76 20,500 $2.17
Exercised -- (58,166) $1.97 (35,000) $1.95
Forfeited/expired (95,001) $2.55 (217,595) $4.42 (35,500) $2.27
------- --------- -------
Outstanding at September 30, 2007 471,665 $2.63 1,046,372 $3.26 116,750 $3.01
======= ========= =======
Shares available for future grant 0 459,328 197,750
======= ========= =======
Weighted average remaining term 7.0 years 5.9 years 3.9 years
Exercisable at September 30, 2007 309,992 $2.62 506,479 $3.76 95,250 $3.19
======= ========= =======
Intrinsic value:
Outstanding $ 0 $ 38 $ 3
Exercisable $ 0 $ 38 $ 3
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The intrinsic value for stock options is calculated based on the exercise price
of the underlying awards and the market price of the Company's common stock as
of the reporting date.
The following table summarizes non-vested restricted stock activity:
Stock Plan Inducement
Shares Shares
------ -------
Unvested as of December 31, 2006 22,500 275,000
Granted -- --
Vested (1,100) --
Forfeited (18,400) --
------- -------
Unvested as of September 30, 2007 3,000 275,000
======= =======
Shares available for future grant 413,600 0
======= =======
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9
The following table summarizes the components and classification of stock-based
compensation expense included in the Statement of Operations:
Three Months Ended Nine Months Ended
Sept. 30, Sept. 30,
2007 2006 2007 2006
---- ---- ---- ----
Stock options $ 103 $ 183 $ 369 $ 574
Restricted stock 35 22 100 72
----- ----- ----- -----
Total stock-based compensation expense $ 138 $ 205 $ 469 $ 646
===== ===== ===== =====
Cost of revenues $ 13 $ 15 $ 37 $ 41
Research and development (5) 156 32 390
Selling, general and administrative 130 34 400 215
----- ----- ----- -----
Total stock-based compensation expense $ 138 $ 205 $ 469 $ 646
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No tax benefits were attributed to the stock-based compensation expense because
a valuation allowance is maintained for substantially all net deferred tax
assets. The Company elected to adopt the alternative method of calculating the
historical pool of windfall tax benefits as permitted by FASB Staff Position FAS
123(R)-3, as amended "Transition Election Related to Accounting for the Tax
Effects of Share-Based Payment Awards." This is a simplified method to determine
the pool of windfall tax benefits that is used in determining the tax effects of
stock compensation in the results of operations and cash flow reporting for
awards that were outstanding as of the adoption of SFAS 123(R).
The Company estimates the fair value of stock options using the Black-Scholes
valuation model. Key input assumptions used to estimate the fair value of stock
options include the exercise price of the award, the expected option term, the
expected volatility of the Company's stock over the option's expected term, the
risk-free interest rate over the option's expected term, and the Company's
expected annual dividend yield. The Company believes that the valuation
technique and the approach utilized to develop the underlying assumptions are
appropriate in calculating the fair values of the Company's stock options
granted during the nine months ended September 30, 2007. Estimates of fair value
are not intended to predict actual future events or the value ultimately
realized by persons who receive stock option awards. The following table
summarizes the assumptions used to compute the weighted average fair value of
stock option grants of $0 and $446, respectively, for the three-month and
nine-month periods ended September 30, 2007.
Three Months Nine Months
------------ -----------
Dividend yield 0.0% 0.0%
Weighted average volatility 43.3% 41.1%
Risk-free interest rate 4.9% 4.2%
Expected holding period (in years) 4.0 4.0
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No dividend yield was assumed because the Company has never paid a cash
dividend, and has no plans at this time to pay any dividends in the future. The
weighted average volatility for the current period was developed using
historical volatility. The risk-free interest rate was developed using the U.S.
Treasury yield for periods equal to the expected life of the options on the
grant date. An increase in the risk-free interest rate will increase stock
compensation expense. The expected holding period was developed after
considering vesting schedules, life of the options, historical experience and
estimates of future exercise behavior patterns. An increase in the expected
holding period would increase stock compensation expense.
SFAS 123R requires the recognition of stock-based compensation for the number of
awards that are ultimately expected to vest. As a result, for most awards,
recognized stock compensation was reduced for estimated forfeitures prior to
vesting based on estimated annual forfeiture rates of approximately 15%.
Estimated forfeitures will be reassessed in subsequent periods and may change
based on new facts and circumstances.
As of September 30, 2007, approximately $0.9 million of unrecognized stock
compensation expense related to unvested awards (net of estimated forfeitures)
is expected to be recognized over a period of 3.7 years.
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PENSION PLAN
The Company's funding policy is to contribute amounts to the plan sufficient to
meet the minimum funding requirements set forth in the Employee Retirement
Income Security Act of 1974, plus such additional amounts as the Company may
determine to be appropriate from time to time. The Company had funding
requirements of $229 in 2007 of which $94 was funded during the quarter ended
September 30, 2007, and $229 during the nine months ended September 30, 2007.
The components of net periodic benefit cost of the plan for the three-month and
nine-month periods ended September 30 are as follows:
Three Months Ended Nine Months Ended
Sept. 30, Sept. 30,
2007 2006 2007 2006
---- ---- ---- ----
Interest cost on projected benefit
obligation $ 18 $ 19 $ 62 $ 61
Expected return on plan assets (18) (18) (59) (51)
Amortization of net loss 10 14 32 35
---- ---- ---- ----
Net periodic pension cost $ 10 $ 15 $ 35 $ 45
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INCOME TAXES
The Company adopted the provisions of FASB Interpretation No. 48, ACCOUNTING FOR
UNCERTAINTY IN INCOME TAXES - AN INTERPRETATION OF FASB STATEMENT NO. 109, or
FIN 48, on January 1, 2007. The interpretation contains a two step approach to
recognizing and measuring uncertain tax positions accounted for in accordance
with SFAS No. 109. The first step is to evaluate the tax position for
recognition by determining if the weight of available evidence indicates it is
more likely than not that the position will be sustained on audit, including
resolution of related appeals or litigation processes, if any. The second step
is to measure the tax benefit as the largest amount which is more than 50%
likely of being realized upon ultimate settlement. The adoption of this
statement by the Company did not have any material impact on its financial
statements.
The Company files income tax returns in the U.S. federal jurisdiction and
various state jurisdictions. The Company is no longer subject to U.S. federal
tax examinations for years before 2005. State jurisdictions that remain subject
to examination range from years before 2000 to 2006. The Company does not
believe there will be any material changes in its unrecognized tax positions
over the next 12 months.
The Company's policy is to recognize interest and penalties accrued on any
unrecognized tax benefits as a component of income tax expense. As of the date
of adoption of FIN 48, the Company did not have any accrued interest or
penalties associated with any unrecognized tax benefits. Additionally, no
interest expense was recognized year-to-date. The Company's effective tax rate
differs from the federal statutory rate primarily due to non-deductible expenses
and is offset somewhat by state tax credits.
As a result of the Company's continued review of its tax positions during the
period ended September 30, 2007, the Company reversed a tax liability previously
booked in relation to the defined benefit pension plan.
RELATED PARTY TRANSACTIONS
In February 2007, a former officer repaid loans and accumulated interest of
$431. Repayment consisted of 140,813 shares of the Company's common stock,
valued at the closing market price at the date of the repayment of the loans. In
May 2007, another former officer repaid loans and accumulated interest of $34.
Repayment consisted of 15,159 shares of the Company's common stock, valued at
the closing market price at the date of the repayment of the loans.
NEW ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued Statement of Financial Accounting Standard
No. 157 ("SFAS No. 157"), "Fair Value Measurements", which is effective for
financial statements issued for fiscal years beginning after November 15, 2007
and interim periods within those fiscal years, with early adoption permitted.
SFAS No. 157 clarifies the principle that fair value should be based on the
assumptions market participants would use when pricing an asset or liability and
establishes a fair value hierarchy that prioritizes the
11
information used to develop those assumptions. Under the standard, fair value
measurements would be separately disclosed by level within the fair value
hierarchy. The Company has not yet determined the effect, if any, that the
implementation of SFAS No. 157 will have on the financial position or results of
operations of the Company.
In February 2007, the FASB issued Statement of Financial Accounting Standard No.
159 (SFAS No. 159), "The Fair Value Option for Financial Assets and Financial
Liabilities - Including an amendment of FASB Statement No. 115" which is
effective for fiscal years beginning after November 15, 2007. SFAS 159 provides
entities the option to measure many financial instruments and certain other
items at fair value. The objective is to improve financial reporting by
providing entities with the opportunity to mitigate volatility in reported
earnings caused by measuring related assets and liabilities differently without
having to apply complex hedge accounting provisions. SFAS No. 159 is expected to
expand the use of fair value measurement, which is consistent with the long-term
measurement objectives for accounting for financial instruments. The Company is
currently evaluating the potential impact of this statement.