Aladdin Knowledge Systems 20-F 2007
Documents found in this filing:
(Jurisdiction of incorporation or organization)
35 Efal Street, Kiryat Arye, Petach Tikva 49511, Israel
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act:
Ordinary Shares, nominal value 0.01 New Israeli Shekel per share
(Class of Securities)
registered or to be registered pursuant to Section 12(g) of the Act:
for which there is a reporting obligation pursuant to Section 15(d) of the Act:
number of outstanding shares of each of the issuers classes of capital or
common stock as of
14,683,488 Ordinary Shares
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
o Yes x No
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.
x Yes o No
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
o Yes x No
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.
o Large Accelerated Filer x Accelerated Filer o Non-Accelerated Filer
Indicate by check mark which financial statements the registrant has elected to follow.
Item 17 o Item 18 x
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o Yes x No
CAUTIONARY NOTE FOR FORWARD-LOOKING STATEMENTS
Except for the historical information contained herein, the statements contained in this annual report are forward-looking statements, within the meaning of the Private Securities Litigation Report Act of 1995 with respect to our business, financial condition and results of operations. Actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including, but not limited to, all the risks discussed or identified in this annual report and our other public filings, such as general economic and market conditions, changes in regulations and taxes and changes in competition and pricing environments.
We desire to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and we are including this cautionary statement in connection with this safe harbor legislation. This document and any other written or oral statements made by us or on our behalf may include forward-looking statements, which reflect our current views with respect to future events and financial performance. We urge you to consider that statements which use the terms believe, do not believe, expect, plan, intend, estimate, anticipate, and similar expressions are intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and are subject to risks and uncertainties. Except as required by applicable law, including the securities laws of the United States, we do not intend to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
We have based these forward-looking statements on our current expectations and projections about future events. These statements include but are not limited to:
As used in this annual report, the terms we, us, our, the Company and Aladdin mean Aladdin Knowledge Systems Ltd. and its subsidiaries, unless otherwise indicated.
We have prepared our consolidated financial statements in United States dollars. All references herein to dollars or $ are to United States dollars, and all references to Shekels or NIS are to New Israeli Shekels.
TABLE OF CONTENTS
A. Selected Financial Data
We derived the selected consolidated statement of operations data set forth below for the years ended December 31, 2004, 2005 and 2006, and the selected consolidated balance sheet data as of December 31, 2005 and 2006, from our audited consolidated financial statements, included elsewhere in this annual report. We derived the consolidated statement of operations data for the years ended December 31, 2002 and 2003 and the selected consolidated balance sheet data as of December 31, 2002, 2003 and 2004 from audited consolidated financial statements that are not included in this annual report. See Note 2 to our consolidated financial statements for a discussion of our significant accounting policies. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, referred to as GAAP.
The following selected financial data should be read in conjunction with the section of this annual report entitled Operating and Financial Review and Prospects and our consolidated financial statements and notes thereto included elsewhere in this annual report. Historical results are not necessarily indicative of any results to be expected in any future period. See Notes 2 and 16 to our consolidated financial statements for an explanation regarding the computation of basic and diluted net earnings (loss) per ordinary share.
B. Capitalization and Indebtedness
C. Reasons for the Offer and Use of Proceeds
D. Risk Factors
Risks Related to Our Business
We face intense competition in each of the segments in which we operate and our results of operations will be adversely affected if we fail to compete successfully.
We face intense competition in each of the segments in which we operate. In the hardware-based software licensing authentication token, or SLAT, market, our software digital rights management, or DRM, solutions compete with products sold by SafeNet Inc. Our competitors in the authentication market are RSA Security Inc., which holds a dominant position in the one-time passwords, or OTP market, and SafeNet, which manufactures a USB-based authentication product. We also compete with smart card manufacturers. Our primary competitor in the content security market for gateway solutions is Trend Micro Inc., which holds a dominant market position. In addition, the overall content security market is characterized by a number of large companies, such as Symantec Corporation, McAfee, Inc. and Trend Micro, which in 2006 together accounted for over 60% of global revenues in this market as well as a large number of smaller companies. While a substantial part of the products marketed by these companies provide primarily desktop or network solutions and not the gateway solution offered by eSafe, we face competition from some gateway solutions provided by these companies. In addition, some vendors of firewalls offering gateway security products, compete with our eSafe product. Many of our current and potential competitors have significantly greater name recognition, larger customer bases and greater financial, technical, manufacturing, marketing and other resources than we do. Our results of operations will be adversely affected if our competitors succeed in marketing products with superior performance or at lower prices than our products.
We derive a substantial portion of our revenues and all of our profits from our software DRM segment. Our results of operations would be materially adversely affected if sales of our software DRM products were to decline.
We currently derive a substantial portion of our revenues and all of our profits from our software DRM segment, consisting entirely of sales of our HASP line of products. We expect to continue to derive a substantial portion of our revenues and profits from this segment for the foreseeable future. Since our software DRM products target the software industry, sales reflect trends in the software business cycle. Demand for our software DRM products is driven, to some extent, by end-user demand for software applications. If software vendors experience deteriorating sales due to an economic downturn, demand for our software DRM products could decline. This would have a material adverse effect on our results of operations.
Sales of our products at low gross margins may adversely affect our results of operations.
In order to penetrate emerging markets, from time to time we conclude transactions at low gross margins. In 2006, gross margin from enterprise security decreased to 62.4%, compared to 71.8% in 2005. The decrease in gross margin from enterprise security was mainly attributable to several transactions made in the Asia-Pacific region that were conducted at low gross margins in order to increase our market share in the region. If we continue to enter into transactions at low gross margins, our results of operations could be adversely affected.
We rely on sole source suppliers for a number of key components of our products and if we need to seek alternate suppliers our results of operations could be adversely affected.
We purchase certain key components for each of our hardware-based products from sole source suppliers. In particular, we obtain from sole source suppliers the application specific integrated circuits and microcontrollers included in our HASP products, and the microcontroller and the smart card, including its operating system, for our eToken products. In addition, we license the anti-spam and web filtering functions incorporated in eSafe and receive services related to these functions from a third party pursuant to a license agreement that expires on December 31, 2007 but automatically renews for unlimited successive one-year periods subject to either partys request to terminate at the end of each year. We would need to seek an alternative licensor and service provider for these functions if this third party ceases to provide these services or decides not to extend the license. If any of our suppliers become unable to or refuses to manufacture these components or if we experience delays in delivery of, or shortages in, these components, which has happened from time to time, it could interrupt and delay the manufacture of our products. In the event of a disruption in supply, we cannot assure you that our inventory would be sufficient to enable us to continue manufacturing during the time that it would take to modify the design and integrate substitute components. Any such disruption could adversely affect our results of operations.
Changing preferences and new industry initiatives may render our products obsolete.
We cannot assure you that software publishers will continue to prefer to protect their software through hardware-based solutions over software-based solutions. A change in preference towards software-based solutions could materially adversely affect the sales of our HASP HL token-based products, which currently represent approximately 68% of our total revenues.
An emerging trend in the software industry is providing Software as a Service (SaaS). This concept is based on hosting the software application in a server and providing its functionality as a centralized service, combined with a strong underlying business model and connectivity to the customers back-office. SaaS does not sell software the traditional way, by burning software onto CDs for sale. Consequently, SaaS does not require piracy protection and licensing the way traditional software products do. It requires instead strong protection of the server against intruders, and higher level of authentication of the user. These protections are not provided by our existing software DRM solutions. We cannot guarantee that we will be able to modify HASP HL to meet the needs of SaaS. If SaaS becomes a significant trend in the software industry it may adversely affect our results of operations.
Furthermore, a number of participants in the computer industry have commenced an initiative to implement trusted computing functions which may replicate some of the features of our software DRM products. In particular, Microsoft Corporation has announced the development of its Next-Generation Secure Computing Base architecture which, among other things, is intended to contain software DRM functionality. In addition, a consortium of companies in the computer industry, including Advanced Micro Devices, Inc., Hewlett-Packard Company, IBM Corporation, Intel Corporation, Microsoft, Sony Corporation and Sun Microsystems, Inc. have formed the Trusted Computing Group to implement trusted computing. The Trusted Computing Groups principal goal is the development of an additional chip that enhances security of computers.
Software developers have started to add security features to new versions of their software that are designed to limit intrusions by unauthorized users or viruses and spyware via the Internet. Microsoft has announced an anti-virus service geared towards consumers as well as a new strategy for anti-virus protection for businesses. In addition the new version of Windows (Vista) has many security features that are designed to minimize penetration of malicious code. Stronger security in future Microsoft platforms may significantly minimize the vulnerabilities
through which virus and vandal penetration is possible. This, in turn, might lower the need to implement anti-virus and content security solutions such as eSafe. As the incorporation of such features in future versions of operating systems and software make these systems less susceptible to outside penetration, our eSafe product may be rendered obsolete or unmarketable.
We may not be successful in keeping pace with the rapid technological changes that characterize our industry.
The markets for our products are characterized by rapid technological change, evolving industry standards and changes in end-user requirements. Hackers constantly improve their methods of stealing end-user technology, software and identities, and new viruses and unwanted content are constantly emerging. In addition, new software operating systems, network systems or industry standards could emerge. Emerging trends in these systems and standards currently include applications distributed over the Internet and the use of a web browser to access client-server systems. Our existing products might be incompatible with some or all of such standards. Therefore, our future success depends upon our ability to enhance our existing products and to develop and introduce products that address these new requirements. We cannot assure you that we will be able to develop new or enhanced products in a timely manner. Our failure to keep pace with these changes could adversely affect our results of operations.
A key element of our growth strategy is increasing sales of our eToken product line.
A key element of our growth strategy is increasing sales of our eToken product line worldwide, which currently represents a small portion of our revenues. Much of this growth will depend on widespread market acceptance of USB-based authentication devices over competing authentication technologies, such as OTP and smart cards. We cannot assure you that the market will continue to accept our eToken products as superior to these existing technologies. If this market does not grow as projected, or if our marketing and selling efforts do not succeed, and eToken adoption rates are lower than we project, we may not achieve our growth targets, and our results of operations may be adversely affected.
We may not be able to prevent others from successfully claiming that we infringed their proprietary rights.
The software protection and Internet security industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. Many of our competitors have extensive patent portfolios with broad claims. In addition, individuals and organizations that may not compete with us directly may also have patents with broad claims. As the number of competitors in the market grows and the functionality of our products increases, the possibility of an intellectual property claim against us increases. In addition, because patent applications can take many years to be published, there may be a patent application now pending of which we are unaware, which will cause us to be infringing when issued in the future. To address any patent infringement or other intellectual property claims, we may have to redesign our products to avoid infringement or enter into royalty or licensing agreements on disadvantageous commercial terms. We may also be unable to successfully redesign our products or obtain a necessary license. These outcomes could result in us having to stop the sale, or result in increased costs, of some of our products, and could harm our reputation.
In the past, we have been subject to claims that resulted in us paying amounts in settlements or obtaining licenses to use intellectual property rights as a result of third-party claims against us. In 2004, we were named as defendant in a U.S. patent infringement complaint alleging that certain of our products infringed a now-expired patent. In 2005, we reached a settlement with respect to this claim. In addition, from time to time, we have received notices from third parties offering to license to us certain aspects of their technology. Any infringement or other intellectual property claims, with or without merit, which are brought against us could be time consuming and expensive to litigate or settle and could divert managements attention from our business.
We may not be able to protect our intellectual property rights.
Our success and ability to compete greatly depends on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secrets, know-how and confidentiality clauses in our
agreements to protect our intellectual property. We cannot assure you that we will successfully protect our technology because:
We also have a number of patents and certain patent applications pending. We cannot be certain that patents will be issued with respect to any of our pending or future patent applications or, that if patents are issued, the patents will be issued in a form that is advantageous to us. In the event that these or any other patent applications are published but not issued, they will become publicly available and proprietary information will become available to others. In addition, we do not know whether any issued patents will be upheld as valid, proven enforceable against alleged infringers or that they will prevent the development of competitive products.
Sales of products that contain encryption technologies are subject to export and other restrictions, and our failure to comply with applicable government regulations could subject us to sanctions and adversely affect our ability to sell our products.
Our eToken and HASP product lines contain encryption technologies which require a permit from the Israeli government for their development and export. We have obtained a general permit for our HASP HL product which does not require renewals, and we have a special permit to export eToken which requires annual renewal. Any failure to renew this permit on a timely basis or at all would prevent us from exporting eToken for sale outside of Israel. The sale of eToken in some countries may require special approval by the Israeli government, per sale, and there can be no guarantee that the Israeli government will provide such approval. In addition, we may need to apply for additional permits in the future to export products currently under development that include encryption technologies. There can be no guarantee that the Israeli government will grant such permits. Furthermore, the laws or regulations governing the export of encryption technologies may change and we may be required to comply with more stringent requirements. We also conduct some of our research and development activities in Germany and may be subject to regulations regarding export of technologies.
In addition, the import and sale of products containing encryption technologies are subject to various regulations in the countries in which we sell our products. Our independent distributors are contractually responsible for compliance with any governmental regulations in countries in which they sell our products, and we rely upon them to fully comply with these regulations. We are responsible for compliance with governmental regulations in countries or regions in which we make direct sales of our products. We have not conducted a survey of applicable governmental regulations in the jurisdictions in which we make direct sales, and we have not conducted an audit of our independent distributors to determine their compliance with applicable governmental regulations. Therefore, our subsidiaries and independent distributors may be noncompliant with the laws and regulations of these jurisdictions and could face fines, penalties or other sanctions, including limitations on their ability to sell our products.
We rely on independent distributors for a portion of our revenues, and we intend to enter into additional distribution arrangements in the future, which may increase this reliance.
We market and sell our software DRM products through independent distributors in all of the countries in which we do not have subsidiaries, and we market and sell our eSafe and eToken product lines generally through indirect sales channels, which include independent distributors. In 2006, 40% of our revenues were generated from
sales to independent distributors. Under our agreements with independent distributors, each distributor is granted a non-exclusive right in each particular country or region to market our products for an initial term of one year, subject to meeting minimum sales targets. Our success in generating sales in countries or regions where we have engaged independent distributors depends in part on their efforts. We cannot assure you that our distributors will devote sufficient resources to market and support our products effectively or that they will meet minimum sales targets. In the future, we intend to sign additional distribution agreements, which may make us more dependent on our distributors. In addition, if we decide to terminate a relationship with an independent distributor, this could disrupt our relationships with customers served by the terminated distributor.
Our strategy of establishing original equipment manufacturer, or OEM, relationships for sales of our enterprise security product lines may not succeed and may result in difficulties in distinguishing our brand.
A key element of our growth strategy in our enterprise security segment is to establish OEM relationships with large technology vendors with the aim of encouraging them to incorporate our eToken and eSafe product lines into their products. To date, we have entered into two such relationships with respect to eToken. We believe that the success of our enterprise security segment is dependent, in part, on the establishment of additional OEM relationships in the future. The establishment of OEM relationships is a time-consuming, expensive and unpredictable process, and often involves complex issues relating to the adaptation of our products. Furthermore, OEM relationships may not contain any minimum purchase requirements and there can be no guarantee that any relationship that we establish will result in significant sales. In addition, because OEMs purchase products to be incorporated into their own products, we may lose the ability to brand our products effectively and interact directly with end-users of our products. This may make it easier for OEMs to replace our products with those of our competitors or with products that the OEM partner has developed on its own. Should this occur, we could experience pressure to reduce our prices, or risk losing these relationships. Either of these would adversely affect our results of operations.
Fluctuations in currency exchange rates may have a significant impact on our reported results of operations.
Although our reporting currency is the U.S. dollar and the majority of our revenues are generated in U.S. dollar, a significant portion of our revenues and expenses in certain locations are denominated in currencies other than the U.S. dollar including, in particular, the euro. In periods when the U.S. dollar strengthens against these other currencies, our reported results of operations may be adversely affected. In addition, fluctuations in currencies may result in valuation adjustments in our assets and liabilities which could affect our reported results of operations.
Maintenance and upgrades of our products may disrupt our customers operations and may provide them with an opportunity to switch to competing products.
We need to upgrade and improve our products periodically. When we upgrade or deploy new versions of our products, we require the cooperation of our existing customers. If our periodic upgrades cause complications or disruptions, we may lose revenues and we may also be the subject of negative publicity that may harm our reputation. In addition, the upgrade process creates a decision point for our customers to consider and possibly switch to alternative products.
Our products may contain undetected errors which could disrupt our customers critical business functions.
Some of our products could contain errors or defects. Our eSafe product resides on the customers gateway, a critical juncture that allows access to the Internet. A failure of our eSafe product can temporarily cause the disruption of critical business functions, including the ability to access the Internet or communicate by electronic mail during an outage. Such a failure of eSafe or our other products could cause significant financial losses and disruption to our customers. Our end-user license agreements, distribution agreements and reseller agreements contain limitation of liabilities clauses which may not be enforceable for indirect or incidental damages arising from the use of our products. This could expose us to greater financial risk and adversely affect our results of operations. Any defects in our existing or new products could result in a loss of revenues and claims against us, a diversion of our resources, damage to our reputation or increased service and other costs.
Some of our products may cause conflicts and failures in our customers systems.
Some models of our HASP products operate through the parallel port of a users computer. We believe that over half of our installed base of HASP keys use this technology. The design of the parallel port-based HASP keys employs technologies that may not function properly when used in conjunction with certain printers or other devices that share the parallel port. Also, future changes in design by printer and device manufacturers could result in HASP keys that were installed and worked properly in the past no longer operating effectively. While we do not warrant the full compatibility of the parallel port-based HASP keys with all parallel port devices, our reputation could be harmed by widespread failures of these products.
Our software DRM products may leave customers vulnerable to piracy, which could seriously harm our business.
Our software DRM products do not provide absolute protection against piracy. We, together with our customers, continuously face challenges from computer hackers, who attempt to neutralize the protection our products provide in order to enable unlicensed copying of our customers software. In recent years, we have faced increasing attacks by hackers who have developed methods to circumvent the protection provided by our software DRM products. Such methods are often publicized over the Internet, making them readily available to those who wish to make unlicensed copies of our customers software. We cannot guarantee that hackers will not continue to develop methods to contravene the protection provided by our products. Failure to provide effective software protection solutions could seriously harm our business.
Our content security products may fail to protect our customers networks from virus attacks and vandalism, which could seriously harm our business.
Our content security products do not provide absolute protection against viruses and vandalism. We, together with our customers, continuously face challenges from hackers, who attempt to neutralize the protection that our products provide in order to penetrate and harm our customers networks. Failure to provide effective content security solutions could seriously harm our business.
Acquisitions could result in dilution, operating difficulties and other adverse consequences.
During the last decade, we have completed a number of acquisitions of businesses and product lines. The process of integrating any acquired business into our own business and operations is challenging and may create unforeseen operating difficulties and expenditures. The areas in which we may face difficulties include:
Future acquisitions could also result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities or impairment related to goodwill and other intangible assets, any of which could harm our business. In addition, future acquisitions could require us to obtain additional equity or debt financing, which may not be available on favorable terms or at all and may be dilutive.
We must comply with new European governmental regulations setting environmental standards.
Our activities in Europe require that we comply with European Union Directives with respect to product quality assurance standards and environmental standards. Directive 2002/95/ec of the European Parliament on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, known as the RoHS Directive, became effective on July 1, 2006 and requires that certain of our products be modified to meet this regulation. If we fail to achieve compliance, we may be restricted from selling our products in the European Union and this could adversely affect our results of operations. European Directive 2002/96/EC on waste, electrical and electronic equipment, known as the WEEE Directive, makes manufacturers of electrical and electronic equipment
financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The WEEE Directive became effective on August 13, 2005. We may incur financial responsibility for the collection, recycling, treatment or disposal of products covered under the WEEE Directive. Because the EU member states have not fully implemented the WEEE Directive, the nature and extent of the costs to comply and fees or penalties associated with noncompliance are unknown at this time. Costs to comply with the WEEE Directive and similar future legislation, if applicable, may also include legal and regulatory costs and insurance costs. We may also be required to take additional reserves for costs associated with compliance with these regulations.
Risks Related to Our Ordinary Shares
The market prices of our ordinary shares have been and may continue to be volatile.
Our ordinary shares have been subject to and will continue to be subject to a great deal of volatility. For example, during 2006, the price of our ordinary shares on The Nasdaq Global Market fluctuated between $13.72 and $23.57 per share. We cannot predict the fluctuations in the market price of our ordinary shares. The broader market for technology stocks and, in particular, those of companies based in Israel has also been subject to significant price fluctuations. These broad market fluctuations may adversely affect the market price of our ordinary shares, regardless of our actual operating performance. Such volatility in relation to our ordinary shares may also affect our ability to raise additional equity financing in the future.
Our chairman and chief executive officer, Jacob (Yanki) Margalit, and our director, Dany Margalit, have significant influence over matters requiring shareholder and board approval.
Our chairman and chief executive officer, Jacob (Yanki) Margalit, and our director, Dany Margalit, collectively own or control 18.34% of our outstanding ordinary shares. Messrs. Margalit are brothers, and both sit on our board of directors which comprises a total of five members. Accordingly, they have significant influence over the outcome of corporate actions requiring director or shareholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets and any other significant corporate transaction. These shareholders may also delay or prevent a change of control of us, even if such a change of control would benefit our other shareholders.
Our ordinary shares are traded on more than one market and this may result in price variations and volatility.
Our ordinary shares are traded on The Nasdaq Global Market and the Tel Aviv Stock Exchange. Trading in our ordinary shares on these markets is made in different currencies (dollars on The Nasdaq Global Market and New Israeli Shekels on the Tel Aviv Stock Exchange) and at different times (due to different time zones, trading days and public holidays in the United States and Israel). The trading prices of our ordinary shares on these two markets may differ due to these and other factors. In addition, due to the smaller size of the local capital markets, we may receive more media coverage in Israel and Israeli investors may react to this coverage more quickly than investors elsewhere. Any decrease in the trading price of our ordinary shares on one of these markets could cause a decrease in the trading price of our ordinary shares on the other market.
Our results of operations are inherently difficult to project and we may fail to meet our guidance or analysts projections, which may adversely affect our share price.
We deliver our products promptly following the receipt of customer orders and, therefore, we do not have a significant backlog. In addition, a large proportion of our sales are concentrated at the end of each quarter. These factors make it difficult to project our quarterly and annual results of operations. At the beginning of 2007, we released financial guidance to the public with respect to the forthcoming year. We intend to continue to release to the public at the beginning of each year an annual financial guidance. Should our actual results of operations fall short of our guidance or analysts estimates, the price of our ordinary shares may decline.
Risks Related to Our Operations in Israel
Security, political and economic instability in Israel may harm our business.
Our corporate headquarters, manufacturing facilities and principal research and development facilities are located in Israel. Accordingly, security, political and economic conditions in Israel may directly affect our business. Over the past several decades, a number of armed conflicts have occurred between Israel and its Arab neighbors. Any hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could affect our operations. Since September 2000, there has been a marked increase in violence, civil unrest and hostility, including armed clashes between the State of Israel and the Palestinian Authority and other groups in the West Bank and Gaza Strip, and acts of terror have been committed inside Israel and against Israeli targets in the West Bank and Gaza. During July and August 2006, major hostilities have broken out between Israel and both Palestinian factions in Gaza and Hezbollah in Lebanon, leading to an escalation of the conflict in the area. Major towns and settlements in northern Israel, including Haifa, Naharia, Safed and Karmiel were under attacks from Hezbollah missiles. Such conflicts, as well as the internal military conflicts between the Hamas and Fatah in the Gaza Strip and some parts of the West Bank, may affect Israels security, foreign relations and the stability of the region. Increased hostilities, future armed conflicts, political developments in other states in the region, or continued or increased terrorism could make it more difficult for us to conduct our operations in Israel, which could increase our costs and adversely affect our financial results. For example, as many of our male employees in Israel are obligated to perform annual military reserve duty typically until 45 years of age and in some cases up to 54 years of age, any major escalation in hostilities in the region could result in a portion of our employees being required to perform military duty for an extended period of time.
In 2005, Israel experienced unionized general strikes in connection with economic reforms being passed into legislation. In addition, during July and August 2006, Haifa Port was closed as a result of the escalation of the military conflict in northern Israel. Due to the fact that our products are manufactured in Israel and, for the most part, sold to customers outside of Israel, a prolonged general strike or a disruption of any of the Israeli ports for an extended period of time, would affect our ability to deliver our products to our non-Israeli customers. We cannot guarantee that a prolonged general strike in Israel or a disruption of any of the Israeli ports as a result of a military conflict, would not have a material adverse effect on our business, results of operations and financial condition.
We receive tax benefits that may be reduced or eliminated in the future.
Several of our expansion programs in Israel have been granted approved and privileged enterprise status. We are therefore eligible for tax benefits under the Israeli Law for Encouragement of Capital Investments, 1959. The availability of these tax benefits is subject to certain requirements, including making specified investments in property and equipment, and financing a percentage of investments with share capital. If we do not meet these requirements in the future, the tax benefits may be cancelled and we could be required to refund any tax benefits that we have already received, plus interest and penalties thereon. We cannot assure you that the tax benefits that our current approved and privileged enterprise programs receive will be continued in the future at their current levels or at all. If these tax benefits were reduced or eliminated, the amount of taxes that we pay would likely increase.
It may be difficult and costly to enforce a U.S. judgment against us, our officers and directors in Israel or the United States, or to assert U.S. securities laws claims in Israel or serve process on our officers and directors and these experts.
We are incorporated in Israel. The majority of our executive officers and directors are not residents of the United States, and the majority of our assets and the assets of these persons are located outside the United States. Therefore, it may be difficult to:
The rights and responsibilities of our shareholders are governed by Israeli law and differ in some respects from the rights and responsibilities of shareholders under U.S. law.
We are incorporated under Israeli law. The rights and responsibilities of holders of our ordinary shares are governed by our articles of association and by Israeli law. These rights and responsibilities differ in some respects from the rights and responsibilities of shareholders in typical U.S. corporations. In particular, a shareholder of an Israeli company has a duty to act in good faith toward the company and other shareholders and to refrain from abusing his power in the company, including, among other things, in voting at the general meeting of shareholders on certain matters. Israeli law provides that these duties are applicable in shareholder votes on, among other things, amendments to a companys articles of association, increases in a companys authorized share capital, mergers and interested party transactions requiring shareholder approval. In addition, a shareholder who knows that it possesses the power to determine the outcome of a shareholder vote or to appoint or prevent the appointment of a director or executive officer in the company has a duty of fairness toward the company. However, Israeli law does not define the substance of this duty of fairness. Because Israeli corporate law has undergone extensive revision in recent years, there is little case law available to assist in understanding the implications of these provisions that govern shareholder behavior.
Provisions of Israeli law may delay, prevent or make difficult a merger with or an acquisition of us, which could prevent a change of control and therefore depress the price of our shares.
Provisions of Israeli corporate and tax law may have the effect of delaying, preventing or making more difficult a merger with, or other acquisition of, us. This could cause our ordinary shares to trade at prices below the price for which third parties might be willing to pay to gain control of us. Third parties who are otherwise willing to pay a premium over prevailing market prices to gain control of us may be unable or unwilling to do so because of these provisions of Israeli law. For additional information about some anti-takeover effects of Israeli law, see Item 10.B. Articles of AssociationAnti-Takeover Provisions; Mergers and Acquisitions under Israeli Law.
We will be exposed to risks relating to evaluations of controls required by Section 404 of the Sarbanes-Oxley Act of 2002.
Under the current rules of the Securities and Exchange Commission, or the SEC, we are required to comply with the management assessment of internal controls over financial reporting requirement of Section 404 of the Sarbanes-Oxley Act of 2002 for our fiscal year ending December 31, 2006 and with the auditor attestation requirement of Section 404 for our fiscal year ending December 31, 2007. We are in the process of evaluating our internal controls systems to allow management to report on, and our independent auditors to audit, our internal controls over financial reporting. We will be performing the system and process evaluation and testing (and any necessary remediation) required to comply with the management assessment and auditor attestation requirements of Section 404. However, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations. Furthermore, upon completion of this process, we may identify control deficiencies of varying degrees of severity under applicable SEC and Public Company Accounting Oversight Board rules and regulations that remain unremediated. We will be required to report, among other things, control deficiencies that constitute a material weakness or changes in internal controls that, or are reasonably likely to, materially affect internal controls over financial reporting. A material weakness is a control deficiency, or combination of control deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. If we fail to implement the requirements of Section 404 in a timely manner, we might be subject to sanctions or investigation by regulatory authorities such as the SEC or by Nasdaq. Additionally, failure to comply with Section 404 or the report by us of a material weakness may cause investors to lose confidence in our financial statements and our share price may be adversely affected. If we fail to remedy any material weakness, our financial statements may be inaccurate, we may not have access to the capital markets, and our share price may be adversely affected.
A. History and Development of the Company
Our legal and commercial name is Aladdin Knowledge Systems Ltd. We were incorporated in Israel in 1985. Our principal executive offices are located at 35 Efal Street, Kiryat Arye, Petach Tikva, Israel 49511, and our telephone number is 972-3-978-1222. Our agent in the United States is Aladdin Knowledge Systems Inc., 601 Campus Dr. Ste C-1, Arlington Heights, Illinois 60004, its telephone number is 1-847-818-3800. Our Internet address is: http://www.Aladdin.com. Information on our web site is not incorporated by reference in this annual report.
During the past three years, our capital expenditures amounted to approximately $2.7 million. Our capital expenditure program primarily included investment in IT systems, equipment for research and development and testing purposes as well as general computer software and hardware. We continue to make capital investments of a similar nature in our Israeli facilities and also in connection with our production activities.
B. Business Overview
We are a global provider of security solutions that reduce software theft, strongly authenticate network users and protect against unwanted Internet and e-mail-borne content, including spam and viruses. We have experienced significant growth since our founding in 1985. Our products are organized into two segments: software digital rights management, or DRM, and enterprise security. Our software DRM solutions allow software publishers to limit revenue loss from software theft and piracy. Our enterprise security solutions enable organizations to secure their information technology assets by controlling who has access to their networks and applications (authentication) and what content their users can utilize (content security).
Our software DRM product line, HASP, offers a comprehensive solution for the protection, licensing and distribution needs of software publishers. Our enterprise security products consist of eToken and eSafe. eToken is a solution based on smart card devices, which ensures that only legitimate users gain access to networks and PCs. eSafe is a gateway-based solution that proactively protects networks against viruses, worms, spam and other unwanted Internet- and e-mail-borne content.
We sell our products globally to a large number of customers. We market and sell our software DRM products directly, as well as through a network of independent distributors. We market and sell our enterprise security solutions through indirect channels, which include distributors, value-added resellers and system integrators, and more recently, through OEM relationships. Organizations that have adopted our enterprise security solutions include Fortune 500 companies and cover a broad range of industries such as financial services, telecommunications, airline, manufacturing and technology.
Within the software DRM market, we provide solutions primarily to the hardware-based software licensing authentication token, or SLAT, market, which is the largest segment of the software DRM market. We launched our new generation of HASP, HASP SRM, in March 2007. HASP SRM combines software-based software DRM solution together with hardware-based solution in a single platform. We anticipate that HASP SRM will increase our global presence in the software-based software DRM field. We have grown our customer base through a history of innovation in the security market and have a broad portfolio of intellectual property, including a number of patents and patent applications pending.
With global software piracy, malicious code attacks and unauthorized network access presenting ever-greater threats, the need for reliable digital security solutions has never been greater. To combat increasing software piracy, software publishers are seeking DRM solutions to protect their intellectual property. Software DRM solutions reduce software piracy by using either hardware or software-based software protection solutions. To avoid
malicious code attacks and unauthorized network access, and to enhance enterprise security, organizations are seeking authentication and content security solutions. Authentication solutions positively identify users (internally as well as from outside the enterprise) before granting access to critical applications and resources. Content security solutions protect networks against viruses, worms, spam and other Internet and e-mail-borne unwanted content.
Software DRM Overview
The advancement of digital technologies makes it possible to produce an essentially perfect copy of any digital asset with minimal effort. Piracy affects all forms of digital content, such as music, movies, text and software. With the advent of the personal computer, software piracy first became an issue in the 1980s. Development of the Internet in the 1990s virtually eliminated the need for a physical medium to perform illegal transfers of digital assets. According to a May 2006 study by the Business Software Alliance and IDC, software developers lost $34 billion of potential revenue in 2004 due to software piracy, and in some countries approximately 90% of all software in use is pirated. Software piracy impacts software publishers by preventing them from realizing all of the licensing revenue from the use of their software products. Software piracy can occur in many forms, including end-users making unauthorized copies and distributing them to friends or co-workers, retailers selling illegal copies, computer dealers loading illegal copies onto their customers hardware, commercial counterfeiters offering illegal copies for sale and enterprises exceeding the number of users or scope of use authorized by license agreements.
Software DRM can be implemented either through a hardware device or a software solution. The hardware device is a hardware key that connects either to the USB or parallel port of a computer and unlocks software residing on that computer. IDC refers to this market as the software licensing authentication token, or SLAT, market and projects that this market will grow from $140 million in 2005 to $166 million in 2009. Software-based solutions allow software publishers to control end-use without distributing a hardware device. Software DRM solutions also include licensing and distribution capabilities.
Software DRM market trends
We believe that the following are key growth drivers of the software DRM market:
Enterprise security overview
Enterprise security has become a critical element of enterprise networks due to the growing need for organizations to increase connectivity to their networks, enhance their online services, and open new opportunities for electronic business. To combat network security breaches, corruption of software environments, and legal exposure, organizations are primarily focused on securing their networks by controlling who accesses their networks (authentication) and what content users can utilize (content security).
Organizations are rapidly increasing the exchange of electronic information both internally, among their employees and departments, and externally, with their customers, vendors, business partners, suppliers and others. Extending information access both inside and outside an organization has become critical to operating organizations effectively. Increased access to critical information, however, can lead to a greater risk of exposing this information to unauthorized users. Hackers, cyber-terrorists, identity thieves, disgruntled employees and even competitors can intercept information. A number of security technologies have emerged to help organizations positively identify users before granting access to enterprise networks.
Authentication solutions range from simple single-factor systems that rely only on something the user knows, like a password, to strong or two-factor systems that rely on multiple factors such as something the user has, like a token, as well as something the user knows (like a password). Strong authentication systems include, among others, OTP tokens, smart cards and USB tokens. OTP tokens allow users to authenticate themselves to backend servers by manually entering a randomly generated, one-time password. Smart cards are authentication cards that connect to a personal computer through special readers. USB tokens are devices that connect to any computer USB port and have embedded software to automatically perform user authentication functions. According to IDC, USB tokens represent a high level of security and user acceptance.
Authentication market trends
According to IDC, the traditional OTP token market is projected to grow from $214 million in 2005 to $245 million in 2009, representing a compound annual growth rate of 3.4%. The USB hardware authentication market is projected to grow from $58 million to $212 million during this same period, representing a compound annual growth rate of 38.3%. We believe that the following are key growth drivers of the authentication market:
Content security overview
Existing enterprise network infrastructure is susceptible to security attacks, which compromise and threaten the utility of Internet usage and electronic messaging. Enterprises are constantly exposed to viruses and spam spawned by access to unauthorized Internet content and content contained in electronic messages.
In addition, unmanaged, non-business use of company computing and network resources, including Internet access, can result in increased risk and costs to the employer, including lost employee productivity, increased network bandwidth consumption, increased network security breaches and potential legal liability.
The evolution of computing, organizational growth, content type and electronic communication has resulted in increasing challenges for todays content security solutions. Enterprises often have some form of information technology, or IT, security; however, most installed solutions cannot adapt to the creativity and volume of continuing threats and increasing regulatory requirements. Organizations demand solutions that can operate within heterogeneous environments, are able to scale to meet increasing content volume demands that lower management costs and enable safe electronic communication.
Content security solutions enable policy-based management of Internet traffic and electronic messaging and include virus protection, e-mail protection, web filtering and other malicious content blocking (e.g., spyware, adware). There are two principal approaches to intercepting malicious content: reactive and proactive. The reactive approach involves the identification of malicious content that has already invaded a network, and the subsequent updating of a database consisting of a signature in order to block identical content in the future. The shortcoming of this approach is that malicious content must first have attacked and damaged a network before it can be identified and blocked in the future. A proactive approach involves training the system to identify behaviors that characterize malicious content, and eliminating content that meets these criteria even before any network is damaged.
Organizations implement content security in three different layers: on the individual desktops, on the network servers and on the perimeter Internet gateways. Gateway solutions are complementary to the desktop and network server solutions. Many enterprises look for different solution providers for different layers to improve security. However, the advantage of a gateway solution over other approaches is the ability to enforce a single comprehensive security solution managed from a central location and enforce company-wide policies. Managing network security from one central location is much more efficient than trying to manage it from the desktop or network servers.
Content security market trends
The content security market is projected to grow from $4.5 billion in 2004 to $10.5 billion in 2009, according to IDC. Sub-segments of content security include:
Our software DRM solutions allow publishers to manage how their software is utilized while limiting software piracy and unauthorized use. We believe that our software DRM solutions have the following benefits:
We believe that no competing product offers the combination of such features and the associated level of security.
We provide organizations with tools that allow only authorized personnel to access their networks, as well as provide protection to their networks from malicious code. We believe that our enterprise security solutions have the following benefits:
Our objective is to be the leading provider of security solutions to protect digital assets and enable secured e-business. To achieve this objective, we are pursuing the following strategies:
Extend our technology and introduce new products
We intend to leverage our technology, product strengths and expertise to further expand our core product functionality and continue to develop complementary solutions. We will continue to invest in research and development and expect to announce several new product and technology offerings during 2007. Current initiatives include the following:
Provide customer focus to leverage our existing customer base
We believe our dedication to customer service has fostered significant loyalty within our customer base and that a significant portion of our revenues in 2006 were from repeat customers. In the software DRM field, repeat customers accounted for more than 95% of our sales. In addition, we believe that our established enterprise security customer base represents a significant opportunity to cross-sell our other enterprise solutions.
Establish new strategic OEM relationships and other distribution channels
We market our enterprise security products, eToken and eSafe, through indirect channels, including distributors, value-added resellers and system integrators, and in the last two years, through OEM relationships. We believe that this strategy allows us to provide our security solutions to the largest number of end-users. We intend to increase our channel sales to accelerate the growth of our enterprise security segment particularly by establishing OEM relationships with large technology vendors. For example, in the first quarter of 2006, we announced an OEM relationship with RSA Security Inc. for our eToken products which represented a second phase to the patent licensing agreement we entered into with RSA Security Inc. in January 2005.
Pursue strategic acquisitions
Over the last decade, we have completed and integrated several acquisitions that have expanded our product lines and customer base. While we believe our current platform will enable us to achieve our strategic goals, we will continue to seek acquisitions of businesses, products or technologies that we believe will expand our product lines and both expand and further penetrate our customer base.
Our products are organized into two segments: software DRM and enterprise security.
Our HASP product line is a comprehensive software DRM solution for software publishers software protection, secure software licensing and secure software distribution needs. Software publishers can choose from hardware-based (HASP HL) and software-based (HASP SL) options. Hardware-based options are available in a variety of form factors including USB, parallel port and PC-card.
Our enterprise security products address both safe network access (eToken) and exclusion of bad traffic (eSafe).
eToken. eToken is a fully portable solution for strong user authentication and password management. Our eToken USB-based smart card authentication devices are intended to ensure that only legitimate users gain access to network or PC resources by requiring that the users token be inserted into the computers USB port combined with a password to ensure strong two-factor authentication. The eToken family includes the following products:
eSafe. eSafe is a gateway-based, integrated content security solution that proactively protects networks against viruses, worms, spyware, spam and non-productive Internet-borne content. eSafe includes antivirus, anti-spam, anti-spyware, web filtering and protection against unauthorized peer-to-peer (P2P) traffic. eSafes ability to block known and unknown viruses and other threats is designed to protect critical information and reduce network and user downtime. Our solutions are targeted at the enterprise and the service providers market.
eSafe incorporates our NitroInspection technology. NitroInspection allows fast response times and has built-in fail-over and load-balancing capabilities to enable a high volume of traffic as well as redundancy and high availability of services in case of failures.
Sales and Marketing
We sell our software DRM products primarily to software developers and distributors. None of our customers accounted for more than 10% of our total revenues in 2004, 2005 or 2006.
We market and sell our software DRM solutions directly through our head office in Israel and through our international subsidiaries, including in the United States, the United Kingdom, Germany, France, The Netherlands, Spain, Italy, China and Japan. In addition, we have about 30 distributors covering additional countries not covered by our subsidiaries. In 2006, we recorded revenues of approximately $36.0 million, representing 40%of our total revenues from sales by distributors. Under the terms of our distribution agreements, we generally grant to one distributor in each particular country or region a non-exclusive right to market our software DRM solutions for an initial term of one year. During this period, the distributor is required to meet minimum sales targets set out in the distribution agreement. Following the expiration of the initial period, the distribution agreement with each distributor is automatically renewed, unless we or the distributor give prior written notice. Each distributor is responsible for preparing and submitting to us for approval a marketing plan for sales in that distributors sales
territory and for obtaining and maintaining any local regulatory approvals required to sell our software DRM solutions in that territory.
We market and sell our enterprise security solutions, eSafe and eToken, through indirect channels, which include distributors, value-added resellers and system integrators. In addition to selling our enterprise security solutions through channel distributors, we are pursuing a strategy to establish OEM relationships with large technology vendors. In February 2006, we announced an agreement with RSA Security Inc., according to which RSA Security Inc. releases a new RSA SecurID® authenticator that incorporates the Aladdin eToken USB technology. In addition, our solutions for the service providers market are sold through OEM and direct sales.
In April 2007, The Consortium for Indian Information Technology Education, referred to as CIITE, selected our eToken authentication solution to secure its vast network of e-Learning resources throughout India. Over the next three years, our eToken will be provided to CIITEs students wishing to access the CIITE Educational Portal. eToken will secure access to online academic services, including online libraries, video-based learning, and IT-related texts. CIITEs initiative emphasizes the use of technology among the countrys current and upcoming generations of young professionals.
In addition to eToken, we have provided CIITE with eSafe content security solution and an authentication course - a comprehensive, academic-level DVD training course detailing authentication and security. This course will be used by students in CIITE-supported institutes and high-level educational organizations. Over the last year, the course was adopted to meet special CIITE requirements.
We conduct a number of marketing activities to support the sale and distribution of our products. These activities are designed to inform existing and potential customers about the capabilities and benefits of our products. These marketing activities include:
Our software DRM solutions compete with hardware-based systems and software-based systems. In the hardware-based software licensing authentication token, or SLAT, market, we compete principally with SafeNet (which about three years ago acquired Rainbow Technologies). We also compete in the SLAT market with a number of smaller vendors including WIBU Systems AG. In the software-based software protection market, we face competition from a larger number of vendors, primarily Macrovision Corporation and SafeNet, which provide software solutions for distribution and licensing.
Authentication. In the strong, or two-factor, authentication market, our eToken product line competes principally with smart cards and traditional strong authentication tokens, including OTP tokens, which are currently the dominant method of strong authentication. In addition, our eToken product line competes with other USB-based authentication systems. One of our competitors in the authentication market is EMC Corporation (formerly RSA Security Inc.) which holds a dominant position in the traditional authentication token market, in addition to VASCO Data Security International, Inc. and ActivIdentity Corp. We have entered into licensing and OEM agreements with RSA Security Inc. Our principal competitor in the USB-based strong authentication market is SafeNet, in addition to Gemplus Incorporated S.A. and Eutron SpA. According to a report of Lazard Capital Markets in November 2006, we accounted for 34% of the global USB hardware authentication market in 2005, while SafeNet accounted for 25% of the market.
Content security. Our primary competitors in the content security market for gateway solutions are BlueCoat, Fortinet and Trend Micro Inc. Each of them holds a dominant position in this market. The overall content security market is characterized by a small number of large companies, such as Symantec Corporation, McAfee Inc. and Trend Micro, which together in 2005 accounted for over 75% of global revenues in this market, as well as a large number of smaller companies.
While a substantial part of the products marketed by these companies are primarily desktop or network server solutions and not the gateway solution that eSafe provides, we may face competition from these companies to the extent that a portion of their product portfolios includes gateway solutions. Vendors of firewalls might decide to extend their offerings to gateway security, and these could compete with our eSafe product. In the field of Internet service providers solutions, we currently face a slight competition, but it may intensify in the future.
We have devoted over 20 years to the development of proprietary information security technologies. We have also made certain strategic acquisitions that have enabled us to add significant technologies to our intellectual property portfolio.
Our intellectual property rights are important to our business. We rely on a combination of patents, copyrights, trademarks, trade secrets and confidentiality clauses and other protective clauses in our agreements to protect our intellectual property. We require employees and independent contractors to enter into confidentiality agreements and assignments of intellectual property rights upon the commencement of their employment and commercial relationships with us.
The software industry is characterized by constant product changes resulting from new technological developments, performance improvements and lower hardware costs. We believe that our future growth depends to a large extent on our ability to be an innovator in the development and application of hardware and software technology. We have adopted a policy of registering patents to protect our core technologies.
We cannot be certain that any patents, or patents that are advantageous to us, will be issued. On January 31, 2005, we announced that RSA Security Inc. has licensed two of our patents relating to our eToken technology. We believe that this license to a market leader in strong, two factor authentication technology supports the strength of our intellectual property portfolio in this segment of our business. We have 26 registered patents and 54 pending applications in the United States. We also had 12 registered patents and 58 pending applications outside of the United States.
Regulation of Encryption Technologies
Our eToken and HASP product lines contain encryption technologies which require a permit from the Israeli government for their development and export. We have obtained a general permit for our HASP HL product, which does not require renewal, and we have a special permit to export eToken, which requires annual renewal. The
sale of eToken in some countries may require special approval by the Israeli government, per sale, and there can be no guarantee that the Israeli government will provide such approval. In addition, we may need to apply for additional permits in the future to export products currently under development that include encryption technologies. There can be no guarantee that the Israeli government will grant such permits. Furthermore, the laws or regulations governing the export of encryption technologies may change and we may be required to comply with more stringent requirements. We also conduct some of our research and development activities in Germany and may be subject to regulations regarding export of technologies.
In addition, the import and sale of products containing encryption technologies are subject to various regulations in the countries in which we sell our products. Our independent distributors are contractually responsible for compliance with any governmental regulations in countries in which they sell our products, and we rely upon them to fully comply with these regulations. We are responsible for compliance with governmental regulations in countries or regions in which we make direct sales of our products through our subsidiaries. We have not conducted a survey of applicable governmental regulations in the jurisdictions in which we make direct sales and we have not conducted an audit of our independent distributors to determine their compliance with applicable governmental regulations. Therefore, we or our subsidiaries may be noncompliant with the laws and regulations of these jurisdictions, and could face fines, penalties or other sanctions, including limitations on the ability to sell our products.
Our European activities require us to comply with European Union Directives with respect to product quality assurance standards and environmental standards. Directive 2002/95/ec of the European Parliament on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (the RoHS Directive) became effective on July 1, 2006. This directive provides that producers of electrical and electronic equipment may not place new equipment containing lead, mercury and certain other materials deemed to be hazardous, in amounts exceeding the set maximum concentration values, on the market in the European Union. Certain of our products must be modified to meet this regulation. Complying with this directive imposes some additional costs and administrative burden on us. European Directive 2002/96/EC on waste, electrical and electronic equipment, known as the WEEE Directive, makes manufacturers of electrical and electronic equipment financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The WEEE Directive became effective on August 13, 2005. We may incur financial responsibility for the collection, recycling, treatment or disposal of products covered under the WEEE Directive. Because the EU member states have not fully implemented the WEEE Directive, the nature and extent of the costs to comply and fees or penalties associated with noncompliance are unknown at this time. Costs to comply with the WEEE Directive and similar future legislation, if applicable, may also include legal and regulatory costs and insurance costs. We may also be required to take reserves for costs associated with compliance with these regulations.
The manufacturing process of our hardware-based products, which consists of tokens for our HASP and eToken products, involves the assembly of purchased components and sub-assemblies. We have one production facility in Kiryat Gat, Israel. After assembly, each hardware-based product is tested and packaged. In the future, we may enter into arrangements with subcontractors with respect to the assembly of our products. We believe that our current manufacturing facility, together with any future arrangements with subcontractors, will be sufficient to meet the projected demand for our products.
We purchase both custom and off-the-shelf components from a number of suppliers. Except as described below, the components we purchase can be obtained from more than one supplier, although in some cases lead-time may be required in order to change suppliers. We rely on a number of single source suppliers for the following key components of our hardware-based products:
We do not have any long term supply arrangements with any of our suppliers with respect to these key components. We estimate that it would take between six months and one year to find alternate suppliers for these key components and modify our products to incorporate them. We believe that our inventory of each of the key components referred to above is sufficient to enable us to continue manufacturing our products in the event that we need to change one of our single source suppliers. Nevertheless, we may encounter delays or difficulties in redesigning our products and may not be able to locate alternate suppliers on a timely basis. If an adequate supply of any of these components is not obtained in a timely manner or at all, we may have difficulty meeting our production needs.
We license the anti-spam and web filtering functions incorporated in our eSafe product pursuant to a license agreement which is automatically renewed for successive one-year terms, unless a notice of termination is given by either of the parties prior to the renewal. We pay our licensor royalties consisting of a percentage of our revenues from eSafe. In the event that our licensor cancels this license arrangement with us, we will be required to seek an alternate licensor for these functions.
C. Organizational Structure
We are organized under the laws of the State of Israel. We wholly own the subsidiaries listed below directly or through other subsidiaries, unless otherwise specified in the footnotes below. These subsidiaries are involved in distribution, support for and management of our products:
We also have a representative office in China.
D. Property, Plants and Equipment
In August 2006, we moved our corporate headquarters and principal research and development facilities to our new location at Kiryat Arye industrial area in Petach Tikva, Israel. Our new facilities consist of 49,514 square feet which are leased for 5 years, with an option to extend for an additional 5 years. Our manufacturing facility is located in a 10,521 square foot facility in Kiryat Gat, Israel. We lease this facility pursuant to a lease agreement that
expired in December 2006 and negotiations for the extension of the lease are currently ongoing. We also lease an 11,883 square foot facility in Tirat Hacarmel, Israel used for our content security research and development activities, for a term expiring in December 2007.
Our subsidiaries also lease facilities in France, Germany, Japan, The Netherlands, the United Kingdom, Spain, Italy, China, India and the United States. These facilities are primarily used for sales and marketing functions. We also conduct research and development activities at our facilities near Munich, Germany.
Our aggregate annual lease expenses in 2006 for our facilities were $2.2 million. We believe that our current facilities together with our new corporate headquarters and principal research and development facility are adequate for our current and foreseeable needs. We believe we will be able to find alternate facilities if we require them or if we are unable to renew our existing leases on reasonable terms or at all.
You should read the following discussion together with our consolidated financial statements, related notes and other financial information included elsewhere in this annual report. This discussion may contain predictions, estimates and other forward-looking statements that involve risks and uncertainties, including those discussed under Risk Factors and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below.
We are a global provider of security solutions that reduce software theft, authenticate network users and protect against unwanted Internet and email-borne content, including spam and viruses. Our products are divided into two segments: software digital rights management, or DRM, and enterprise security. Our software DRM products allow software publishers to limit revenue loss from software theft and piracy. Our enterprise security solutions enable organizations to secure their information technology assets by controlling the access to their networks (authentication) and what content their users can utilize (content security).
We were established in 1985 with our principal focus on software protection through our HASP product line. In the last decade, we completed five acquisitions of businesses and product lines which broadened our product offering and enhanced our research and development, direct marketing and selling capabilities. We acquired our eSafe product line at the end of 1998. In 1999, we penetrated the enterprise security market by complementing eSafe with our eToken product line. As a result of the additional expenses incurred in this transition, as well as generally adverse economic conditions, we incurred net losses in 2001 and 2002. In 2003 and subsequent interim periods, we returned to profitability. At the beginning of 2004, we constituted our enterprise security segment as a separate reportable segment. In 2006, we generated 68% of our revenues from our software DRM segment and the rest from our enterprise security segment. All of our profits in 2006 were derived from our software DRM products.
We have two reportable segments: software security (DRM) and enterprise security. These segments are strategic business units that offer different products to different types of customers and are managed separately because each segment requires different marketing strategies. Increased adoption of our eToken and eSafe products has driven growth of our enterprise security segment although we currently derive all of our profit from the software DRM segment. The following table sets forth information for the periods indicated regarding the percentage of our revenues derived from each of our business segments:
We generate revenues from two main sources: sales of hardware products and software licenses. To date, we have derived the most of our revenues from sales of hardware products, although our software licenses have increased as a percentage of sales over the past four years.
In 2005 and 2006, part of our revenues was denominated in euros, Japanese Yen and British pounds. When translating these revenues into U.S. dollars for the purposes of preparing our consolidated financial statements, our reported revenues are affected. In our period to period discussion below, we have indicated the effects of currency fluctuations on our revenues in our reported segments. We also refer you to Item 11. Quantitative and Qualitative Disclosures About Market Risk below for disclosure of the effect of changes in exchange rates on our overall revenues, gross profit and operating income for the years ended December 31, 2004, 2005 and 2006.
Product revenues. Revenues from product sales are recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collectibility is probable and we do not have any obligation to customers after the date on which products are delivered.
Software licenses. We enter into perpetual licenses and, in some cases, time-based licenses, with purchasers of eSafe. Time-based licenses are mostly for one or two-year periods with respect to additional functionalities of eSafe, such as anti-spam, web and application filtering. License fees are recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, no significant obligations with regard to implementation remain, the fee is fixed or determinable and collectibility is probable.
We provide maintenance and support services to purchasers of perpetual licenses. When the agreement includes multiple elements, we determine the fair value of the maintenance and support component, which includes the right to periodic updates on when and if available basis, based on the price charged by us for such maintenance and support when provided separately. Maintenance and support revenue is deferred and recognized on a straight-line basis over the term of the maintenance and support agreement, which is typically one year.
Time-based licenses include maintenance and support, which include the right to periodic updates when and if available. License fees from time-based licenses, and the maintenance and support component, are recognized on a straight-line basis over the term of the license arrangement.
Deferred revenues include unearned amounts received from maintenance and support contracts.
Our deferred revenues as of December 31, 2005 and 2006 were $5.6 million and $6.2 million; respectively. The increase was primarily due to an increase in time-based license revenues.
Revenue trends and drivers
Customer concentration. We sell our products to a large number of customers. In the past three years, no customer accounted for more than 10% of our revenues.
Geographic breakdown. The following table sets forth the geographic breakdown of our revenues for the periods indicated:
Repeat customers. We consider the proportion of our revenues from repeat customers to be an important tool in analyzing our business in our software DRM segment. We believe that a significant portion of our revenues in 2006 was from repeat customers.
Cost of revenues and gross profit
Software DRM. Cost of revenues for our software DRM products consists primarily of the cost of components, manufacturing costs (including costs of subcontractors), salaries and related personnel expenses for employees engaged in the manufacture and support of our products, and an allocation of overhead and facilities costs.
Enterprise security. Cost of revenues for our eToken products consists primarily of the cost of components, manufacturing costs (including costs of subcontractors), salaries and related personnel expenses for employees engaged in the manufacture and support of our products, and an allocation of overhead and facilities costs. Cost of revenues for eSafe consists primarily of costs associated with the provision of technical support, appliances and royalties payable to third-party licensees.
Our gross margin is impacted principally by the mix of hardware and software-based solutions that we sell due to the higher cost of revenues associated with hardware-based solutions.
Research and development. Research and development expenses consist primarily of salaries and related expenses. Other such expenses include subcontractor costs related to the design, development and testing of new products and technologies, product enhancements and an allocation of overhead and facilities costs. All research and development costs are expensed as incurred.
Selling and marketing. Selling and marketing expenses consist primarily of salaries and related expenses, commissions, marketing efforts, as well as travel and an allocation of overhead and facilities costs.
General and administrative. General and administrative expenses consist primarily of salaries and related expenses for executive, accounting, finance, legal and litigation, human resources, administrative, network and information systems personnel. Other such expenses include facilities maintenance, professional fees, allowance for bad debt, goodwill amortization and other general corporate expenses.
Financial income, net. Financial income, net, consists primarily of interest earned on bank deposits net of bank charges, interest and impairment on our investments in marketable securities, and foreign currency gains or losses.
Taxes on income. Although Israeli companies were generally subject to income tax at the corporate rate of 31% in 2006, we benefit from Israeli government tax exemption programs that reduce our effective tax rate as described under the caption Corporate Tax.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, based upon information available at the time, historical experience and various other factors that are believed to be reasonable under the circumstances. These estimates are evaluated by us on an on-going basis. Actual results may differ from these estimates under different conditions. We believe that the application of the following critical accounting policies entails the most significant judgments and estimates used in the preparation of our consolidated financial statements:
Allowance for doubtful accounts
We are required to perform ongoing credit evaluations of our trade receivables and maintain an allowance for doubtful accounts, based upon our judgment as to our ability to collect outstanding receivables. Provisions are made based upon a specific review of all the outstanding invoices. In determining the provisions, we analyze our historical collection experience, current economic trends and the financial position of our customers. If the financial condition of our customers deteriorates, our revenues might be limited and additional allowances might be required. As of December 31, 2006, our allowance for doubtful accounts was $274,000 and our trade receivables were $16.4 million.
Inventories are stated at the lower of cost or market value. Cost is determined by the moving average cost method. We periodically evaluate our quantities on hand relative to current and historical selling prices and historical and projected sales volume. Based on these evaluations, inventory write-offs and write-down provisions are provided to cover risks arising from slow moving items. If the future 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 provision is made.
On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, referred to as SFAS 123(R), which requires the measurement and recognition of compensation expense based on estimated fair values for all share-based payment awards made to employees and directors. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, under which we previously accounted for our share based awards granted to employees and directors. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107, or SAB 107, relating to SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).
SFAS 123(R) requires companies to estimate the fair value of equity-based payment awards 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 an expense over the requisite service periods in our consolidated income statement. Prior to the adoption of SFAS 123(R), we accounted for equity-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, or SFAS 123. Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to our expected stock price volatility over the terms of the awards, and actual and projected employee stock option exercise behaviors. Although the fair value of employee stock options is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard starting from January 1, 2006, the first day of our fiscal year 2006. Under that transition
method, compensation cost recognized in 2006, includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123; and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). Results for prior periods have not been restated.
We recognize compensation expenses for the value of our awards, which have graded vesting, based on the accelerated attribution method over the vesting period, net of estimated forfeitures. Estimated forfeitures are based on actual historical pre-vesting forfeitures.
As a result of adopting SFAS 123(R) on January 1, 2006, our income before taxes in 2006, was $2.3 million lower than we had continued to account for stock-based compensation under APB 25. Basic and diluted net earnings per share for 2006, were both $0.15 lower than if we had continued to account for share-based compensation under APB 25.
Taxes on income and deferred tax
We account for income taxes using the asset and liability method. Deferred tax assets net of valuation allowances, totaled $3.1 million as of December 31, 2006. Deferred tax assets, related valuation allowances and deferred tax liabilities are determined separately by each tax jurisdiction. We believe that sufficient uncertainty exists regarding our ability to realize our deferred tax assets in certain foreign jurisdictions and, accordingly, a valuation allowance has been established against the deferred tax assets in those jurisdictions. We believe that it is more likely than not that the results of future operations will generate sufficient taxable income to utilize the remaining deferred tax assets, net of valuation allowances. While we have considered future taxable income and ongoing tax planning strategies in assessing the need for any valuation allowance, in the event we were to determine that we will be able to realize our deferred tax assets in the future in excess of the net recorded amount, an adjustment to the valuation allowance would increase income in the period such a determination is made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the valuation allowance would be charged to income in the period such a determination is made. Our effective tax rate is directly affected by the relative proportions of revenue and income before taxes generated in different tax jurisdictions, as well as the estimated level of annual pre-tax income. We are also subject to changing tax laws in the multiple jurisdictions in which we operate.
Tax returns are subject to audit by various taxing authorities. Although we believe that adequate accruals have been made for unsettled issues, additional gains or losses could occur in future years from resolution of outstanding matters. We continue to assess our potential tax liability included in accrued taxes in our financial statements, and revise our estimates accordingly. Such revisions in our estimates could materially impact our results of operations and financial position.
Under Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, or SFAS 142, goodwill acquired in a business combination is deemed to have indefinite life and will not be amortized. SFAS 142 requires goodwill to be tested for impairment on adoption and at least annually thereafter or between annual tests in certain circumstances, and written down when impaired. Goodwill is tested for impairment by comparing the fair value of each reporting units with its carrying value. Our reporting units for purposes of the impairment test are our two operating segments, the software security DRM, and enterprise security. Fair value is determined for each reporting unit by estimating the present value of the reporting units future cash flows. If the fair value exceeds the carrying value, no impairment loss is recognized. Significant estimates used in the methodologies included estimates of future cash flows and estimates of discount rates. As of December 31, 2006, we had total goodwill of $7.7 million on our balance sheet. We perform the annual impairment tests during the fourth quarter every year and no impairment losses were identified. In assessing the recoverability of our goodwill, we must make assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.
Intangible assets acquired are amortized over their useful life using a method of amortization that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up, in accordance with SFAS 142. Indefinite-lived intangible assets are not amortized, but rather are subject to an annual impairment test. Other intangible assets are amortized using the straight-line method over the estimated useful life, as described below.
Impairment of long-lived assets
Under Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds the fair value of the asset group. Assets to be disposed of would be separately presented on the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. In 2004, 2005 and 2006, we have not recorded impairment charges for long-lived assets.
Investment in other companies
We have investments in two related investment funds managed by Tamir Fishman Ventures Management II LLC. In addition, we have invested in IDesia Ltd. (formerly known as C-Signature Ltd.), an Israeli company engaged in biometric identity recognition technology. The investments are stated at cost since we do not have the ability to exercise significant influence over operating and financial policies of the investees. Our management reviews our investment for impairment whenever events or changes in circumstances indicate that the carrying amount of an investment may not be recoverable.
During 2006, we invested in Athena Smartcard Solution Ltd. (Athena), a Japanese company and an expert in developing smart card systems. The investment in this company, in which we hold 23.5% as of December 31, 2006, is being accounted using the equity method.
Impact of recently issued accounting standards
In July 2006, the FASB issued FASB Interpretation 48, Accounting for Income Tax Uncertainties, referred to as FIN 48. FIN 48 defines the threshold for recognizing the benefits of tax return positions in the financial statements as more-likely-than-not to be sustained with the taxing authority. The recently issued literature also provides guidance on derecognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of disclosures associated with any recorded income tax uncertainties. FIN 48 is effective for fiscal years beginning after December 15, 2006. The differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. The adoption of FIN 48 has insignificant impact on our consolidated financial statements in the total amount of $ 182,000.
In September 2006, FASB issued SFAS No. 157, Fair Value Measurements, referred to as SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years whether we will choose to apply SFAS No. 159 The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS 159, than the influence of SFAS 157 may be material.
In February 2007, the FASB issued SFAS 159. SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. SFAS 159 requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, although earlier adoption is permitted. We are currently evaluating the impact that SFAS 159 will have on our consolidated financial statements.
Management sets aside liabilities related to litigation brought against us when it is probable that a loss risk be incurred and the amount of the potential loss can be estimated. Because of the uncertainties related to an unfavorable outcome of litigation, and the amount and range of loss on pending litigation, our management is often unable to make an accurate estimate of the liability that could result from an unfavorable outcome. As litigation progresses, we continue to assess our potential liability and revise our estimates accordingly. Such revisions in our estimates could materially impact our results of operations and financial position. Estimates of litigation liability affect our accrued liability line item in our consolidated balance sheet and our general and administrative expense line item in our statement of operations.
Results of Operations
The following table sets forth certain statement of operations data as a percentage of revenues for the periods indicated:
Year ended December 31, 2006 compared to year ended December 31, 2005
Total revenues increased by 8.9% to $89.0 million in 2006 from $81.8 million in 2005.
Software DRM. Revenues from software DRM increased by 7.0% to $60.6 million in 2006 from $56.6 million in 2005. This increase was attributable to increased HASP sales in our international markets, mainly in Europe and APAC.
Enterprise security. Revenues from enterprise security increased by 13.0% to $28.5 million in 2006 from $25.2 million in 2005. This increase was attributable to a 16.3% increase in eToken sales mainly in Europe, APAC and the Middle east and a 9.0% increase in eSafe sales, mainly in Europe, the Middle East and South America.
Cost of revenues
Total cost of revenues increased by 17.9% to $20.0 million in 2006 from $17.0 million in 2005.
Software DRM. Cost of revenues for software DRM decreased by 5.9% to $9.3 million in 2006 from $9.9 million in 2005. This decrease was primarily attributable to a decrease in subcontracting and overhead costs, due to our increased manufacturing efficiency resulting from our accumulated experience with our products. Gross margin from software DRM products increased to 84.7% in 2006 compared to 82.5% in 2005.
Enterprise security. Cost of revenues for enterprise security increased by 51.0% to $10.7 million in 2006 from $7.1 million in 2005. This increase was attributable to the increase in sales of our enterprise security products. Gross margin from enterprise security decreased to 62.4% in 2006 compared to 71.8% in 2005. This decrease was mainly attributable to several deals we had in the Asia-Pacific region that were conducted at a low gross margin in order to penetrate this market. In addition, in 2005, we received a certain payment for licensing fees from one of our customers with respect of which we had no cost of revenues. We have not received any similar payment in 2006.
Gross profit increased by 6.5% to $69.0 million in 2006 from $64.8 million in 2005. Our gross margin decreased to 77.5% in 2006 from 79.2% in 2005.
Research and development
Research and development expenses increased by 18.2% to $14.3 million in 2006 compared to $12.1 million in 2005, representing 16.1% of revenues in 2006 compared to 14.8% in 2005. This increase was primarily attributable to a significant increase in the eToken research and development activity and to an increase of $666,000 of stock based compensation expenses as a result of adopting SFAS 123(R).
Selling and marketing
Selling and marketing expenses increased by 6.5% to $28.7 million in 2006 from $27.0 million in 2005. This increase was mainly attributable to the increase of $717,000 of stock based compensation expenses as a result of adopting SFAS 123(R). As a percentage of revenues, selling and marketing expenses were stable at 32.2% in 2006 compared to 33.0% in 2005.
General and administrative
General and administrative expenses increased by 14.4% to $12.8 million in 2006 from $11.2 million in 2005. This increase was primarily attributable to an increase in compensation expenses mainly $845,000 of stock based compensation expenses as a result of adopting SFAS 123(R). As a percentage of revenues, general and administrative expenses increased to 14.4% in 2006 from 13.7% in 2005.
Operating expenses in 2005 included a $2.0 million one-time charge to settle a patent lawsuit representing 2.4% of revenues.
Financial income, net
Financial income, net, in 2006 was $3.2 million compared to financial income, net, of $1.0 million in 2005. This increase was primarily attributable to interest income earned on the proceeds from our secondary offering consummated in 2005, net of losses resulting from currency fluctuations.
Taxes on income
Taxes on income were $2.7 million in 2006 compared to $1.2 million in 2005. In 2006, taxes on income in the amount of $2.8 million were partially offset by an increase in the deferred tax asset of $124,000 related to certain foreign net operating losses carried forward and other timing differences.
Year ended December 31, 2005 compared to year ended December 31, 2004
Total revenues increased by 18.4% to $81.8 million in 2005 from $69.1 million in 2004.
Software DRM. Revenues from software DRM increased by 11.7% to $56.6 million in 2005 from $50.6 million in 2004. This increase was attributable to increased sales of our HASP products in all geographic markets.
Enterprise security. Revenues from enterprise security increased by 36.4% to $25.2 million in 2005 from $18.5 million in 2004. This increase was mainly attributable to an 85.6%, or $6.5 million, increase in eToken sales. This increase is also attributable to income from the patent license agreement with RSA Security.
Cost of revenues
Total cost of revenues increased by 23.1% to $17.0 million in 2005 from $13.8 million in 2004.
Software DRM. Cost of revenues for software DRM increased by 3.4% to $9.9 million in 2005 from $9.5 million in 2004. This slight increase was primarily attributable to an increase in subcontracting and overhead costs, due to the increase in sales. Gross margin from software DRM products remained relatively stable at 82.5% in 2005 compared with 81.2% in 2004.
Enterprise security. Cost of revenues for enterprise security increased by 67.5% to $7.1 million in 2005 from $4.2 million in 2004. This increase was primarily attributable to an increase in manufacturing costs of $1.8 million and subcontracting costs of $582,000, due to the increase in sales. Gross margin from enterprise security decreased to 71.8% in 2005 compared to 77.0% in 2004.
Gross profit increased by 17.1% to $64.8 million in 2005 from $55.3 million in 2004. Our gross margin decreased to 79.2% in 2005 from 80.1% in 2004.
Research and development
Research and development expenses remained stable at $12.1 million in 2005 compared to $12.0 million in 2004. As a percentage of revenues, research and development expenses decreased to 14.8% in 2005 from 17.4% in 2004.
Selling and marketing
Selling and marketing expenses increased by 9.2% to $26.9 million in 2005 from $24.7 million in 2004. This increase was primarily attributable to an increase of $1.2 million in compensation expenses and an increase of $950,000 in general marketing expenses. As a percentage of revenues, selling and marketing expenses decreased to 33.0% in 2005 from 35.7% in 2004.
General and administrative
General and administrative expenses increased by 26.8% to $11.2 million in 2005 from $8.8 million in 2004. This increase was primarily attributable to an increase of $1.1 million in compensation expenses and an increase of $600,000 in professional and legal fees. As a percentage of revenues, general and administrative expenses increased to 13.7% in 2005 from 12.7% in 2004.
Operating expenses in 2005 also included a $2.0 million one-time charge to settle a patent lawsuit consisting 2.4% of revenues.
Financial income, net
Financial income, net, in 2005 was $1.0 million compared to financial income, net, of $53,000 in 2004. This increase was primarily attributable to interest income earned on the proceeds from our secondary offering, net of losses resulting from currency fluctuations.
Taxes on income
Taxes on income were $1.2 million in 2005 compared to $957,000 in 2004. In 2005, taxes on income in the amount of $2.1 million were partially offset by an increase in the deferred tax asset of $832,000 related to certain foreign net operating losses carried forward and other timing differences.
Liquidity and Capital Resources
Our primary sources of liquidity are our cash, cash equivalents and marketable securities and our cash flow from operations. In 2005, we also had proceeds from our secondary offering completed on March 30, 2005. This underwritten public offering of 2,000,000 ordinary shares resulted in net proceeds to us of $38.8 million after deducting the underwriting discount and offering expenses. As of December 31, 2006, we had cash, cash equivalents and marketable securities aggregating $90.9 million.
On April 1, 2007, our board of directors authorized the use of our available cash for the repurchase of Aladdins ordinary shares. According to the terms of the buy-back program approved by the board, we are authorized to repurchase Aladdins ordinary shares utilizing up to $10 million or to repurchase such number of ordinary shares not to exceed 500,000 shares. On June 11, 2007, our board of directors increased the extent of the buy-back program by an additional $10 million. The combined total authorization now stands at $20 million. As of June 20, 2007, we repurchased 464,973 shares utilizing approximately $10 million.
Under the buy-back program, we are authorized to repurchase Aladdins shares, from time to time, in the open market, based on market conditions, share price and other factors. Purchases are made in compliance with the applicable provisions of Section 302 of the Israeli Companies Law, 1999, the applicable provisions of Rule 10b-18 of the Securities Exchange Act of 1934, as amended, referred to as the Exchange Act, and Regulation M promulgated under the Exchange Act. In accordance with the Israeli law, shares purchased by us under the buy-back program do not confer upon us any voting rights (although they entitle Aladdin to participation rights upon distribution).
Our operating activities provided cash in the amount of $18.9 million in 2006 and $14.6 million in 2005. The major contributing factors were higher net income excluding stock based compensation expenses, offset by an increase in accounts receivable, mainly attributed to the increase in revenues. Our operating activities provided cash in the amount of $14.6 million in 2005 compared to $8.8 million in 2004. In 2005, our cash generated from operating activities was impacted by higher net income, an increase in other current liabilities, trade payables and deferred revenues, which was partially offset by an increase in trade receivables and inventory. The increase in other current liabilities was mainly attributable to an increase in our current tax liability. The increase in deferred revenues, trade receivables and inventory was primarily due to the increase in our revenues in 2005 compared to 2004.
Our investing activities used cash in the amount of $8.5 million in 2006, mainly consisting of investments in available-for-sale marketable securities less proceeds in the amount of $2.1 million, investment in other assets in the amount of $2.5 million and the purchase of property and equipment in the amount of $4.6 million, offset by proceeds from return on investment of other companies, net of investment in other companies, in the amount of $0.6 million. Our investing activities used cash in the amount of $42.7 million in 2005 mainly consisting of an investment in available-for-sale marketable securities in the amount of $40.5 million and the purchase of property and equipment in the amount of $2.3 million. Our investing activities used cash in the amount of $13.6 million in 2004, mainly due to the acquisition of our former distributor, Aladdin Knowledge España S.L., in the amount of $1.8 million (net of cash on hand), an investment in Tamir Fishman Ventures II LLC in the amount of $1.3 million, an investment in IDesia Ltd. in the amount of $1.1 million, an investment in
available-for-sale marketable securities in the amount of $7.0 million, the purchase of property and equipment in the amount of $1.2 million and the purchase of intangible assets in the amount of $1.2 million.
Our financing activities provided cash in the amount of $0.8 million in 2006 resulting from proceeds from exercises of stock options by employees. In 2005 and 2004, our financing activities provided cash in the amount of $39.3 million and $3.6 million, respectively, resulting mainly from proceeds from issuance of shares in 2005 and proceeds from the exercise of stock options by employees in 2004.
We had working capital of $100.0 million as of December 31, 2006, $85.0 million as of December 31, 2005 and $34.1 million as of December 31, 2004.
The following table summarizes our contractual obligations and commercial commitments as of December 31, 2006:
The table does not include our obligation accrued severance pay under Israels Severance Pay Law, 1963, which as of December 31, 2006 was $3.4 million, of which $2.7 million was funded through deposits into severance pay funds, leaving a net obligation of $700,000.
We believe that our accumulated cash, in conjunction with cash generated from operations and available funds, will be sufficient to meet our cash requirements for working capital and capital expenditures for at least the next twelve months.
In April 2004, we entered into a convertible loan agreement with IDesia Ltd., an Israeli company engaged in the development of biometric identity recognition technology. Pursuant to the agreement, we invested an aggregate amount of $1.1 million in IDesia Ltd. In addition, we incurred expenses in the amount of $50,000 in connection with this investment. This investment consisted of a $550,000 convertible loan, which was automatically converted into series A preferred shares of IDesia Ltd. upon the achievement of certain agreed upon milestones. Concurrently with the conversion of the loan, we invested the remaining $500,000 by purchasing additional series A preferred shares of IDesia Ltd.
In October 2005, we signed an agreement titled License and OEM Agreement with IDesia Ltd. Under this agreement, IDesia Ltd. will develop, manufacture, provide and license to us certain chip-sets for the
implementation of biometric technology as specified in the agreement. According to the agreement, we made to IDesia Ltd. an advance payment in the amount of $200,000 in consideration for the committed chip-sets.
As of December 31, 2006, we invested an aggregate amount of $8.1 million in two investment funds managed by Tamir Fishman Ventures Management II Ltd. We have no control over the operating and financial policies of these funds. In 2002, we recorded an impairment charge of $1.0 million related to these investments.
In 2005 and 2006, as a result of exit transactions of portfolio companies of Tamir Fishman, we received cash distributions of $910,000 and $1.7 million, respectively. The proceeds received from these cash distributions were recorded as a return of investment.
In November 2006, we entered into an agreement with K.K. Athena Smartcard Solutions Ltd., a Japanese company, referred to as Athena, whereby we were granted an option allowing us to invest up to $745,000 in Athena at any time until June 30, 2007, in consideration for the issuance of shares of Athena. The option was exercised in three installments of $248,000 each, in November 2006, January 2007 and April 2007.
We had invested in Athena previously but Athena has incurred losses over the years and we reduced our investments and loans in Athena to zero in 2004. Following a reconsideration of our management, we decided to reinvest in Athena as described above.
Israeli companies are generally subject to income tax at the declining corporate rate of 31% in 2006, 29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter. We benefit from Israeli government tax exemption programs that reduce our effective tax rate. We currently have several effective expansion programs that have been granted approved enterprise status. Therefore, we are eligible for tax benefits under the Israeli Law for the Encouragement of Capital Investments, 1959. Subject to compliance with applicable requirements, the portion of our undistributed income derived from our approved enterprise programs was exempt from income tax during the first two years in which these investment programs produced taxable income and are currently subject to a reduced tax rate of zero and 10% to 25% (depending on the specific program) for the remaining eight years of the programs. In order to enjoy these benefits, we have determined not to declare dividends or otherwise distribute earnings out of tax exempt income. The availability of these tax benefits is subject to certain requirements, including making specified investments in property and equipment, and financing a percentage of investments with share capital. If we do not meet these requirements in the future, the tax benefits may be cancelled and we could be required to refund any tax benefits that we have already received, plus interest and penalties accrued thereon. Since our taxable income is derived from more than one approved enterprise program and since part of our taxable income is not derived from an approved enterprise (including taxable income of our subsidiaries), our effective tax rate is a weighted average rate based on the various applicable rate and tax exemptions.
On April 1, 2005, the Israeli Parliament passed an amendment to the Investment Law, in which it revised the criteria for investments qualified to receive tax benefits. An eligible investment program under the amendment will qualify for benefits as a privileged enterprise (rather than the previous terminology of approved enterprise). Among other things, the amendment provides tax benefits to both local and foreign investors and simplifies the approval process. If our investment programs comply with the requirements of the law, we will be entitled to certain tax benefits. We cannot assure you that any additional investment program adopted by us in the future will comply with the requirements of the law or that the tax benefits for investment programs continue at current levels.
As of December 31, 2006, the net operating loss carry-forwards of our subsidiaries for tax purposes amounted to $26.9 million, the majority of which related to our United States and German subsidiaries. A subsidiarys net operating loss carry-forwards for tax purposes relating to a jurisdiction are generally available to offset future taxable income of such subsidiary in that jurisdiction, subject to applicable expiration dates.
A. Directors and Senior Management
Our executive officers and directors, their ages and positions, as of the date of this report are as follows:
Jacob (Yanki) Margalit founded our company in 1985 and has served as our chairman of the board and chief executive officer since 1987. Mr. Margalit served as our chief financial officer from 1987 to 1993 and has served as a director since 1985. Jacob Margalit is the brother of Dany Margalit.
Aviram Shemer was appointed as our chief financial officer in January 2007. Prior to that, during 2006, Mr. Shemer served as the chief financial officer of PowerDsine Ltd., a developer of power over ethernet (PoE) solutions recently acquired by Microsemi Corporation. In 2006, Mr. Shemer also served as vice president, finance of Alvarion Ltd., a provider of wireless broadband solutions and specialized mobile networks. From 1999 until 2005, Mr. Shemer served at Aladdin in various positions, including serving as vice president, finance in 2005. Mr. Shemer holds a B.A. in accounting and economics and an MBA with a specialization in finance and accounting from the Tel Aviv University.
Elinor Nissensohn has served as our global vice president of sales and marketing since July 2006. Ms. Nissensohn began working in our company in January 2003 as our business development manager. In July 2004, she was appointed as our customer relations manager and in March 2005, Ms. Nissensohn became vice president of customer relations. Ms. Nissensohn had previously worked for IBM Corp., Bezeq - Israel Telecommunications Company, the leading Israeli phone service provider, and Motorola Semiconductor. Ms. Nissensohn holds an LLB from Tel Aviv University and an MBA from Columbia Business School. Ms. Nissensohn is also admitted to the Israeli Bar.
David Assia has served as a director since 1993. Mr. Assia is a co-founder of Magic Software Enterprises Ltd., a provider of development and integration technology, and Formula Vision Technologies (F.V.T.) Ltd. (formerly known as Mashov Computers Ltd.), a software holding company. Mr. Assia currently serves as the executive chairman of Magic. From 1983 to 1996, Mr. Assia was the chief executive officer and chairman of Magic. Mr. Assia is also a member of the boards of directors of Radview Software Ltd., a developer of verification software, RRSat Global Communications Network Ltd. a provider of end to end transmission services to the television and radio industries, and the Weizmann Institute of Science. Mr. Assia holds a B.A. in economics and statistics and an M.B.A. from Tel Aviv University.
Dr. Menahem Gutterman has served as one of our outside directors since 2000. Since January 2005, Dr. Gutterman has been the deputy president for research, development and relations with industry of AFEKA Tel-Aviv Academic College of Engineering. From 2001 until January 2005, Dr. Gutterman was a senior managing partner of Atid Capital Partners, an American/Israeli venture capital fund. Dr. Gutterman has served as executive vice president and head of the operations information systems division of Israel Discount Bank Ltd. from 1992 until 2001. Until 2000, Dr. Gutterman served as a senior lecturer at Tel Aviv University, Faculty Management, and School of Business Administration. Dr. Gutterman holds a D.Sc. in mathematics from The Technion-Israel Institute of Technology.
Dr. Orna Berry has served as one of our outside directors since 2001. Dr. Berry is a partner in Gemini Israel Funds Ltd. and since 2000 has served as chairperson of Lambda Crosing Ltd. and Riverhead Networks, Inc., which was sold to Cisco in March 2004. Since January 2005, she has served as chairperson of Adamind Ltd. Dr. Berry served as the Chief Scientist of the Ministry of Industry and Trade of the Government of Israel from 1997 to 2000. From 1993 until 1997, Dr. Berry was a co-president of Ornet Data Communications Technologies Ltd., a provider of high-speed switches, which was acquired by Siemens AG. During 1992 and 1993, Dr. Berry served as a consultant to Intel Communications Division and Elbit Systems Ltd. Dr. Berry holds a B.A. in statistics and mathematics from Haifa University, an M.A. in statistics and mathematics from Tel Aviv University and a Ph.D. in computer science from the University of Southern California.
Dany Margalit joined our company in 1987 as research and development manager and has served as a director since 1994. In 1989, Mr. Margalit was appointed executive vice president, research and development and served in this position until 1998. From 1998 until April 2006, Mr. Margalit served as our executive vice president, technologies. As of April 2006, Mr. Margalit serves as an advisor to the Company. Mr. Margalit holds a B.Sc. in mathematics and computer science from Tel Aviv University. Dany Margalit is the brother of Jacob Margalit.
There are no arrangements or understandings with major shareholders, customers, suppliers or others, pursuant to which any person referred to above was selected as a director or member of senior management.
For the year ended December 31, 2006, we paid in the aggregate approximately $1.8 million as direct remuneration to our directors and executive officers. This amount includes directors fees and expenses, but does not include amounts expended by us for automobiles made available to our officers, expenses reimbursed to officers (including business travel, professional and business association dues and expenses) and other fringe benefits commonly reimbursed or paid by companies in Israel.
The compensation paid to our directors, including to our directors who also serve as executive officers, is subject to our audit committee, board of directors and shareholder approval.
Outside Directors. We reimburse our outside directors at the maximum amount permitted under the Companies Regulations (Rules for the Payment of Remuneration and Expenses of Outside Directors) 2002, which currently include the following amounts:
The abovementioned amounts are linked to the Israeli consumer price index in accordance with the regulations.
In addition, we granted to each of our outside directors options to purchase 12,000 ordinary shares under the Companys Worldwide 2003 Share Option Plan, for each three-year term of service. The exercise price per share equals to the closing price of our ordinary shares on The Nasdaq Global Market on the last day of trading prior to the approval of the grant by the shareholders meeting. The options vest in three installments at the end of each of the three years of service, subject to the outside directors continued service as an outside director at each of these dates.
Non-employee directors. We reimburse our non-employee directors, which currently include Mr. David Assia and Mr. Dany Margalit, in the same amounts approved for our outside directors. Mr. Margalit is entitled to such compensation as of October 1, 2006.
Jacob (Yanki) Margalit. Effective October 2002, the annual base salary of Jacob (Yanki) Margalit, our chairman and chief executive officer, is $150,000. In addition, since the first quarter of 2002, Mr. Margalit has received an annual performance-based bonus equivalent to 1.5% of year-to-year increases in our annual revenues. Since the first quarter of 2002, Mr. Margalit also has received a quarterly performance-based bonus equivalent to
3.0% of our quarterly net profits. Under this arrangement, in 2006, Mr. Margalit was entitled to a cash bonus in the amount of $ 530,000. In April 2003, we granted to Mr. Margalit options to purchase 100,000 of our ordinary shares at an exercise price per share of $1.20, representing a discount of $1.47 to the last reported sale price of our ordinary shares on The Nasdaq Global Market on the date of grant. One-third of the options become exercisable on each of the first three anniversaries of the date of grant. Mr. Margalit also uses a company car and is entitled to 25 days of paid vacation per year, as well as other benefits commonly paid by companies in Israel.
Dany Margalit. Dany Margalit served as our executive vice president, technologies, until April 2006. According to the agreed terms of engagement with Mr. Margalit, Mr. Margalit continued to receive his monthly salary and retain the company car used by him until the termination of his employment relationship with our company (i.e. until September 30, 2006). Mr. Margalits base salary in 2006 was $115,000. In December 2003, we granted to Mr. Margalit options to purchase 65,000 of our ordinary shares at an exercise price per share of $8.52 representing the last reported sale price of our ordinary shares on The Nasdaq Global Market on the date of grant. One quarter of the options become exercisable on each of the first four anniversaries of the date of grant. As of April 2006, Mr. Margalit began providing our company with advisory services. In consideration for these services, we pay him a monthly compensation of $6,000 as of October 1, 2006. In addition, we reimburse Mr. Margalit, currently a non-employee director of our company, in the same amounts payable to our outside directors.
C. Board Practices
Board of directors and executive officers
Our articles of association provide that we may have up to eight directors, each of whom, except for our outside directors, elected at an annual general meeting of our shareholders by a vote of the holders of a majority of the voting power present and voting at that meeting. Our board of directors currently consists of five directors. Each director listed above will hold office until the next annual general meeting of our shareholders, except for our outside directors whose terms will expire pursuant to the Israeli Companies Law, 1999, hereinafter referred to as the Companies Law, as described under Outside Directors. Other than Jacob (Yanki) Margalit, our chairman and chief executive officer, and Dany Margalit, a director, none of our directors are our employees or are party to a service contract with us.
At a general meeting, a simple majority of our shareholders may remove any of our directors from office (other than our outside directors), elect directors in their stead and fill any vacancy, however created, in our board of directors. In addition, vacancies on our board of directors, other than a vacancy created by an outside director, may be filled by a vote of a majority of the directors then in office (notwithstanding failure to meet the quorum requirement). A director so chosen or appointed will hold office until the next general meeting of our shareholders. Our board of directors may also appoint additional directors up to the maximum number permitted under our articles of association. A director so chosen or appointed will hold office until the next general meeting of our shareholders.
Outside and independent directors
Under the Companies Law, companies incorporated under Israeli Law, whose shares have been offered to the public in or outside of Israel, are required to appoint at least two outside directors. The Companies Law provides that a person may not be appointed as an outside director if such person or persons relative, partner, employer or any entity under such persons control, has, as of the date of such persons appointment as an outside director, or had, during the two years preceding that date, any affiliation with the company or any entity controlling, controlled by or under common control with the company. The term affiliation includes:
No person may serve as an outside director if such persons position or other business activities create, or may create a conflict of interest with the persons responsibilities as an outside director or may otherwise interfere with such persons ability to serve as an outside director or if such person is an employee of the Israel Securities Authority or of an Israeli stock exchange. If, at the time of election of an outside director, all other directors are of the same gender, the outside director to be elected must be of the other gender. Outside directors are elected by a majority vote at a shareholders meeting, provided that either:
Pursuant to the Companies Law, an outside director must have financial and accounting expertise or professional qualifications, provided that at least one outside director will have financial and accounting expertise. The terms financial and accounting expertise and professional qualifications have been defined in regulations promulgated under the Companies Law.
The initial term of an outside director is three years and may be extended for an additional three year term. Under a recent amendment to the Israeli Companies Regulations (Alleviation for Public Companies Whose Shares are Listed on a Stock Exchange Outside of Israel) 2000, dual listed companies, like us, may appoint an outside director for additional three-year terms, above the maximum six-year term permitted under the Companies Law, if the audit committee and the board of directors confirm that due to the expertise and special contribution of the outside director to the work of the board and its committees, his re-appointment is in the best interests of the company. Dr. Orna Berry was appointed as an outside director on December 31, 2001 for an initial three-year term and was reappointed for a second three-year term, ending December 31, 2007. Dr. Menahem Gutterman was appointed as an outside director in 2000 for an initial three-year term and was reappointed in December 2003 for a second three-year term. At the general meeting held in December 2006, following a determination by the audit committee and the Board that he should be reappointed for a third term due to his experience and special contributions, Dr. Gutterman was appointed for an additional three-year term, ending on December 31, 2009.
Each committee exercising the powers of the board of directors is required to include at least one outside director. However, the audit committee must include all the outside directors.
An outside director is entitled to compensation as provided in regulations promulgated under the Companies Law and is otherwise prohibited from receiving any compensation, directly or indirectly, in connection with services provided as an outside director.
In addition to the requirements of the Israeli law, we comply with The Nasdaq Global Market listing requirements, pursuant to which our board of directors must have at least three independent directors (including all members of our audit committee) as defined in those rules. We believe that each member of our audit committee currently satisfies this requirement.
Qualifications of other directors
Under the Companies Law, the board of directors of a publicly traded company is required to make a determination as to the minimum number of directors who must have financial and accounting expertise according to a criterion defined in regulations promulgated under the Companies Law, which became effective in January 2006. According to the Companies Law, the determination of the board will be based, among other things, on the type of the company, its size, the volume and complexity of its activities and the number of directors. Based on the foregoing considerations, our board determined that the number of directors with financial and accounting expertise in our company shall not be less than two. Dr. Orna Berry and Mr. David Assia qualify as having the required financial and accounting expertise under the Companies Law.
The board of directors of an Israeli public company must appoint an audit committee comprised of at least three directors, which must include all of the companys outside directors. The chairman of the board, any controlling shareholder, any relative of a controlling shareholder or any director which is employed or provides services to the company on a regular basis (other than as a board member) may not serve on the audit committee. Under The Nasdaq Global Market listing requirements, we are required to have an audit committee consisting of independent directors who are financially literate and one of whom has accounting or related financial management expertise.
Currently, the members of our audit committee are Mr. Assia, Dr. Gutterman and Dr. Berry. The rules of the Securities and Exchange Commission require us to disclose whether one or more members of our audit committee is a financial expert. We believe that Mr. Assia qualifies as a financial expert under the SEC rules.
Our audit committee assists the board of directors in fulfilling its oversight responsibilities relating to our financial accounting, reporting and controls. Pursuant to its charter, the audit committee is responsible for monitoring the integrity of our financial statements and auditing, accounting and financial reporting processes, pre-approving all auditing services and permitted non-audit services (including the fees and other terms), evaluating the qualifications and independence of the external auditor and detecting defects in the management of our business through consultation with the internal auditor. The responsibilities of the audit committee under Israeli law include identifying irregularities in the management of the companys business, nominating an internal auditor and approving certain related party transactions.
The board of directors of an Israeli public company must appoint an internal auditor nominated by the audit committee. An internal auditor may not be an office holder, or an interested party (i.e., a holder of 5% or more of the voting rights in the company or of its issued share capital, the chief executive officer of the company or any of its directors, or a person who has the authority to appoint the companys chief executive officer or any of its directors), or a relative of an office holder or of an interested party. In addition, the companys external auditor or its representative may not serve as the companys internal auditor.
The role of the internal auditor is to examine, among other things, the compliance of the companys conduct with applicable law and orderly business procedures. Mr. Doron Ruppin serves as our internal auditor.
Compensation and nominating committees
Our compensation and nominating committees each consist of our independent directors, Mr. Assia, Dr. Gutterman and Dr. Berry. In accordance with the corporate governance rules of The Nasdaq Global Market, our compensation and nominating committees adopted charters, which set forth each committees responsibilities. Pursuant to the charters, the compensation and nominating committees are authorized to make decisions regarding executive compensation and terms and conditions of employment, as well as to recommend that the board of directors issue options under our share option plans. The compensation and nominating committees are also responsible for recommending to the board of directors nominees for board membership. The charters require that the composition of the committees must satisfy The Nasdaq Global Markets independent director requirements.
As of December 31, 2006, we and our subsidiaries had 440 employees of whom 268 were based in Israel, 104 in Europe, 55 in the United States, 11 in Japan and Asia, one in Brazil and one in India.
The following table sets forth for the last three fiscal years the breakdown of our employees by activity:
Certain provisions of the collective bargaining agreements between the Histadrut (General Federation of Labor in Israel) and the Coordination Bureau of Economic Organizations (including the Industrialists Associations) might be applicable to our employees in Israel by order of the Israeli Ministry of Labor. These provisions concern principally the length of the workday, minimum daily wages for professional workers, insurance for work-related accidents, procedures for dismissing employees, determination of severance pay, and other conditions of employment. We generally provide our employees with benefits and working conditions beyond the legal minimums. In addition to salary and other benefits, certain of our sales personnel are paid commissions based on our performance in certain territories worldwide. In certain European countries, restrictive labor laws can inhibit our ability to terminate the employment of certain of our subsidiaries employees.
E. Share Ownership
All of the persons listed above, under the caption Directors and Senior Management who are employed by us, own shares and/or options to purchase ordinary shares. Except as set forth below, none of the named directors or employees owns shares and/or options amounting to 1% or more of our outstanding ordinary shares. As of June 20, 2007, Jacob (Yanki) Margalit beneficially owned 1,758,549 ordinary shares, representing 12.32% of our outstanding share capital, and Dany Margalit owned 859,195 ordinary shares, representing 6.02% of our outstanding share capital. Information regarding our share option plans presented in Note 14(e) to our consolidated financial statements is incorporated herein by reference.
In January 2007, our board of directors approved an amendment to our Worldwide 2003 Share Option Plan pursuant to which we are authorized to grant to employees restricted share units (in addition to options to purchase shares initially authorized under the plan) in accordance with the terms of the plan. As of June 20, 2007 we have not yet granted to our employees restricted share units under the plan.
A. Major Shareholders
The following table sets forth information regarding beneficial ownership of our ordinary shares as of the date of this report by:
We have determined beneficial ownership in accordance with the rules of the Securities and Exchange Commission. Unless indicated otherwise, to our knowledge, the persons and entities named in the table below have sole voting and sole dispositive power with respect to all shares beneficially owned, subject to community property laws where applicable. Ordinary shares and options that are currently exercisable or exercisable within 60 days after the date of this report are deemed outstanding and beneficially owned by the person holding the options for the purpose of computing the percentage ownership of that person, but are not treated as outstanding for the purpose of computing the percentage ownership of any other person. Unless indicated below, the address for each listed shareholder is c/o Aladdin Knowledge Systems Ltd., 35 Efal Street, Kiryat Arye, Petach Tikva 49511, Israel.
The percentage of shares beneficially owned is based on 14,272,252 ordinary shares outstanding as of June 20, 2007, and excludes 464,973 shares which were purchased under our buy back program and are held by Aladdin. Pursuant to Israeli law, the shares held by Aladdin do not confer upon Aladdin any voting rights (although such
shares entitle their holder to participation rights upon distribution). For more information about our buy back program, see below.
(1) Based on a Schedule 13D filed on September 29, 2000. The address of Juniper Trading Services, Inc. is Compass Point Building, 9 Bermudiana Road, Bermuda.
(2) Consists of 1,758,549 ordinary shares and options to purchase 100,000 ordinary shares.
(3) Based on a Schedule 13G/A filed on February 15, 2006. The beneficial ownership indicated above represents the aggregate beneficial ownership of Galleon Advisors, LLC, Galleon Management, LLC, Galleon Management, LP, Galleon Captains Partners, LP, Galleon Captains Offshore, LTD., Galleon Technology Partners II, LP, Galleon Technology Offshore, LTD., Galleon Explorers Partners, LP, Galleon Explorers Offshore Ltd. and Galleon Buccaneers Offshore, Ltd. Galleon Management, L.P. is located at 135 East 57th Street, 16th Floor, New York, New York, 10022 and is controlled by Raj Rajaratnam.
(4) Based on a Schedule 13G filed on February 14, 2007. The beneficial ownership indicated above represents the aggregate beneficial ownership of the following subsidiaries of BlackRock, Inc.: BlackRock Advisors LLC, BlackRock Investment Management UK Ltd., BlackRock Capital Management, Inc., BlackRock Investment Management LLC, BlackRock (Channel Islands) Ltd., BlackRock Japan Co. Ltd. and State Street Research & Management Co. BlackRock, Inc. is located at 40 East 52nd Street, New York, NY 10022.
(5) Based on a Schedule 13G filed on February 14, 2007. The beneficial ownership above represents the aggregate beneficial ownership of FMR Corp. and Fidelity International Limited, parent companies of various investment advisors that manage institutional accounts and open-end investment companies. FMR Corp. is located at 82 Devonshire Street, Boston, Massachusetts, and Fidelity International is located at P.O. Box 670, Hamilton, HMCX, Bermuda.
(6) Based on a Schedule 13G filed on February 6, 2007. The beneficial ownership indicated above represents the aggregate beneficial ownership of Tracer Capital Management L.P., Tracer Capital Partners, L.P., Tracer Capital Partners QP, L.P. and Tracer Capital Offshore Fund Ltd. c/o Goldman Sachs (Cayman) Trust Limited. Tracer Capital Management L.P. is located at 540 Madison Avenue, 33rd Floor, New York, New York 10022, and is controlled by Riley McCormack and Matt Hastings.
(7) Based on a Schedule 13G/A filed on February 14, 2006. The beneficial ownership indicated above represents the aggregate beneficial ownership of Diker Management LLC and Diker GP, LLC. Diker Management, LLC is located at 745 Fifth Avenue, Suite 1409, New York, New York 10151, and is controlled by Charles M. Diker and Mark N. Diker.
(8) Consists of 859,195 ordinary shares and options to purchase 65,000 ordinary shares.
(9) Consists of 2,617,744 ordinary shares and options to purchase 308,350 ordinary shares.
To our knowledge, the only significant change in the percentage of ownership held by any major beneficial shareholders during the past three years has been the change in the ownership by FMR Corp. In the past several months, FMR Corp has decreased its percentage of ownership from 14.7% to its current percentage ownership of 8.7%.
The voting rights of our major shareholders do not differ from the voting rights of other holders of our ordinary shares, except for the voting rights of Aladdin with respect to the shares held by it as described below.
As of May 31, 2007, there were a total of 53 holders of record of our outstanding ordinary shares, of which 32 were registered with addresses in the United States. Such United States holders were, as of such date, the holders of record of approximately 82% of our issued and outstanding ordinary shares
B. Related Party Transactions
We pay directors fees in respect of service by our non-employee directors (including outside directors). For more information, see Item 6.B. Directors, Senior Management and Employees Compensation.
Agreements with Directors and Officers
We maintain written employment agreements with all of our officers. In addition, we entered into a written agreement with Dany Margalit, a director and advisor of our company. For more information regarding the compensation of our officers, see Item 6.B. Directors, Senior Management and Employees Compensation.
Indemnification and insurance
We have entered into agreements with each of our officers and directors undertaking to exculpate and indemnify them to the fullest extent permitted by our articles of association. This indemnification is limited to events and amounts determined as foreseeable by the board of directors. In the opinion of the Securities and Exchange Commission, such indemnification of directors and officers for liabilities arising under the Securities Act is against public policy as expressed in the Securities Act and is therefore unenforceable.
Our directors and officers are currently covered by a directors and officers liability insurance policy. To date, no claims for liability have been submitted under this policy.
For more information about indemnification and insurance of our directors and officers, see Item 10.B. Memorandum and Articles of Association - Exculpation, insurance and indemnification of directors and officers.
C. Interests of Experts and Counsel
A. Consolidated Statements and Other Financial Information
The financial statements required by this item are found at the end of this annual report, beginning on page F-1.
We are not involved in any proceedings in which any of our directors, members of our senior management or any of our affiliates is either a party adverse to us or to our subsidiaries or has a material interest adverse to us or to our subsidiaries. We are also not involved in any material legal proceedings, except as described below.
We submitted claims in the U.S. District Court for the District of Delaware against a Chinese entity, Feitian Technologies Co. Ltd., and a number of other entities, who, we allege, act as U.S. distributors for Feitian and who, with or through Feitian, import, distribute, sell and offer for sale certain products that we believe infringe two of our U.S. patents. One of the defendants entered into a settlement agreement with us in which it acknowledged the validity and enforceability of the patents, acknowledging that certain products manufactured or distributed by
Feitian infringe those patents, and agreed to cease to import, distribute, sell, or offer to sell in or into the United States any products that infringe these patents. Feitian and several other defendants moved to dismiss the case on the basis that the court did not have jurisdiction over them. The court granted the motion as to certain defendants and dismissed the case against them without prejudice. The court denied the motion as to Feitian and another defendant, RS-Computer. The court allowed us to proceed with the discovery to support our claim that the court has jurisdiction over Feitian and RS-Computer. Upon the completion of the discovery, we filed a supplemental brief with the court concerning the jurisdictional issues. We intend to vigorously pursue our claims whether we remain in the federal court in Delaware or file a lawsuit in another court in the United States. At this stage, we cannot predict the outcome of the proceedings.
We currently intend to retain all earnings to support our operations and to finance the growth and development of our business, and have no current intentions to declare or pay any cash dividends on our ordinary shares. We are not subject to any contractual restrictions on paying dividends. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects and other factors as the board of directors may deem relevant. Israeli law limits the distribution of cash dividends to the greater of retained earnings or earnings generated over the two most recent years, in either case provided that we reasonably believe that the dividend will not render us unable to meet our current or foreseeable obligations when due.
B. Significant Changes
Except as otherwise disclosed in this annual report, there has been no material change in our financial position since December 31, 2006.
A. Offer and Listing Details
On June 20, 2007, the last reported sale price of our ordinary shares on The Nasdaq Global Market was $20.58 per share. The table below sets forth the high and low closing sales prices of our ordinary shares, as reported by The Nasdaq Global Market during the periods indicated:
The following table sets forth, for the periods indicated, the high and low closing sales prices of our ordinary shares on the Tel Aviv Stock Exchange:
As of June 20, 2007, the exchange rate of the NIS to the U.S. dollar was $1=NIS 4.187
B. Plan of Distribution
The primary trading market for our ordinary shares is The Nasdaq Global Market, where our shares are listed under the symbol ALDN. Since July 28, 2004, our ordinary shares have also been listed on the Tel Aviv Stock Exchange under the symbol ALDN.
Pursuant to NASDAQ Marketplace Rule 4350(a)(1), we received an exemption from Marketplace Rule 4350(i)(1), which requires a company to seek shareholder approval prior to the issuance of securities. We follow Israeli law and practice. For issuances of securities, we obtain the approval of our board of directors and in certain circumstances, we also obtain the approval of our audit committee or share option compensation committee. Our practices comply with the Israeli law.
D. Selling Shareholders
F. Expenses of the Issue
A. Share Capital
B. Memorandum and Articles of Association
We are registered with the Israeli Companies Register under the number 52-004003-1. Our objects are specified in our articles of association and include engaging in any lawful act or activity for which companies may be organized under the Companies Law.
Approval of certain transactions under the Companies Law
The Companies Law codifies the fiduciary duties that office holders, including directors and executive officers, owe to a company. An office holders fiduciary duties consist of a duty of care and a duty of loyalty. The duty of loyalty includes (i) avoiding any conflict of interest between the office holders position in the company and his personal affairs; (ii) avoiding any competition with the company; (iii) avoiding exploiting any business opportunity of the company in order to receive personal advantage for himself or others; and (iv) revealing to the company any information or documents relating to the companys affairs which the office holder has received due to his position as an office holder. Each person listed in the table in Item 6A under Directors and Senior Management is an office holder. Under the Companies Law, arrangements regarding the compensation of directors (whether in their capacity as directors or in any other position in the company) require the approval of the audit committee, the board of directors and shareholders. Arrangements regarding compensation of officers who do not serve as directors, require the approval of the audit committee and the board of directors.
The Companies Law requires that an office holder of a company promptly disclose any personal interest that he or she may have and all related material information known to him or her, in connection with any existing or proposed transaction or act by the company. In addition, if the transaction is an extraordinary transaction as defined under the Companies Law, the office holder must also disclose any personal interest of the office holders spouse, siblings, parents, grandparents, descendants, spouses descendants and the spouses of any of the foregoing. In addition, the office holder must also disclose any interest of any corporation in which the office holder owns 5% or more of the share capital, is a director or general manager or in which he or she has the right to appoint at least one director or the general manager. An extraordinary transaction is defined as a transaction conducted not in the ordinary course of business, not on market terms or that is likely to have a material impact on the companys profitability, assets or liabilities.
Under the Companies Law, after the office holder complies with the disclosure requirements described above, only board approval is required for any transaction which is not an extraordinary transaction, unless the articles of association of the company provide otherwise, and provided the transaction is not adverse to the companys interest. If the transaction is an extraordinary transaction, the company must receive any approval stipulated by its articles of association, the approval of the audit committee and the approval of the board of directors, as well as shareholder approval. An office holder who has a personal interest in a matter that is considered at a meeting of the board of directors or the audit committee may not be present at this meeting or vote on this matter. However, if the majority of the board members or members of the audit committee, as applicable, have a personal interest in such matter, they may all participate in the discussion and vote thereon but the matter shall also be subject to shareholder approval.
The Companies Law applies the same disclosure requirements to a controlling shareholder of a public company. The term controlling shareholder also includes a shareholder that holds 25% or more of the voting rights in the company if no other shareholder owns more than 50% of the voting rights in the company. Extraordinary transactions with a controlling shareholder or in which a controlling shareholder has a personal interest, and the terms of compensation of a controlling shareholder or its relative who is an office holder or an employee of the company, require the approval of the audit committee, the board of directors and the shareholders of the company. The shareholder approval must include at least one-third of the shareholders who have no personal interest in the transaction and are voting on the subject matter or, alternatively, the total shareholdings of those who have no personal interest in the transaction who vote against the transaction must not represent more than one percent of the voting rights in the company. In certain cases provided in regulations promulgated under the Companies Law, shareholder approval is not required.
The approvals of the board of directors and shareholders are required for a private placement of securities (or a series of related private placements during a 12-month period or that are part of one continuous transaction or transactions conditioned upon each other) in which:
Under the Companies Law, a shareholder has a duty to act in good faith towards the company and other shareholders and to refrain from abusing his power in the company including, among other things, voting in a general meeting of shareholders on the following matters:
In addition, any controlling shareholder, any shareholder who knowingly possesses power to determine the outcome of a shareholder vote and any shareholder who, pursuant to the provisions of a companys articles of association, has the power to appoint or prevent the appointment of an office holder in the company, is under a duty to act with fairness towards the company. The Companies Law does not describe the substance of this duty.
For information concerning personal interests of certain of our office holders and our principal shareholders in certain transactions with us, see Item 7.B. Related Party Transactions.
Our Articles of Association
We currently have only one class of securities outstanding, our ordinary shares, par value NIS 0.01 per share. No preferred shares are currently authorized.
Holders of ordinary shares have one vote per share, and are entitled to participate equally in the payment of dividends and share distributions and, in the event of our liquidation, in the distribution of assets after satisfaction of liabilities to creditors. Our articles of association may be amended by a resolution carried at a general meeting by an ordinary majority (50%) of those who voted on the matter. The shareholders rights may not be modified in any other way unless otherwise expressly provided in the terms of issuance of the shares.
Our articles of association require that we hold our annual general meeting of shareholders once every calendar year and in accordance with the timing requirements set forth under Israeli law, at a time and place determined by the board of directors. A 21-day prior written notice shall be given to our shareholders with respect to every shareholders meeting. In some instances specified in regulations promulgated under the Companies Law, a 35-
day prior notice should be given of a shareholders meeting. No business may be commenced until a quorum of two or more shareholders who hold or represent between or among them at least 33 1/3% of the Companys issued share capital are present in person or by proxy. If within a half hour from the time appointed for the meeting a quorum is not present, the meeting, shall be dissolved, but in any other case it shall stand adjourned for one week, at the same day, time and place as specified in the notice or to such later day and at such time and place as the chairman may determine with the consent of a simple majority. No further notice of the adjourned meeting is required to be given. If a quorum is not present at the adjourned meeting within half an hour of the time fixed for the commencement thereof, subject to the provisions of applicable law, the persons present shall constitute a quorum. Shareholders may vote in person or by proxy, and will be required to prove title to their shares as required by the Companies Law pursuant to procedures established by the board of directors. Resolutions regarding the following matters must be passed at a general meeting of shareholders:
A special meeting of our shareholders shall be convened by the board, at the request of any two directors or one quarter of the officiating directors, or by request of one or more shareholders holding at least 5% of our issued share capital and 1% of our voting rights, or by request of one or more shareholders holding at least 5% of our voting rights. Shareholders requesting a special meeting must submit their proposed resolution with their request. Within 21 days of receipt of the request, the board must convene a special meeting and send out notices setting forth the date, time and place of the meeting. Such notice must be given at least 21 days, but not more than 35 days, prior to the special meeting.
Our articles of association provide that our board of directors may from time to time, at its discretion, borrow or secure the payment of any sum of money for the objectives of the company. Our directors may raise or secure the repayment of such sum in a manner, time and terms as they see fit.
Our board of directors is authorized to declare dividends, subject to the provisions of the Companies Law. Dividends on our ordinary shares may be paid only out of profits and other surplus, as defined in the Companies Law, as of the end date of the most recent financial statements or as accrued over a period of two years, whichever is higher. Alternatively, if we do not have sufficient profits or other surplus, then permission to effect a distribution can be granted by order of an Israeli court. In any event, our board of directors is authorized to declare dividends, provided there is no reasonable concern that the dividend will prevent us from satisfying our existing and foreseeable obligations as they become due. Dividends may be paid in cash or in kind.
Exculpation, insurance and indemnification of directors and officers
Under the Companies Law, an Israeli company may not exempt an office holder from liability with respect to a breach of his duty of loyalty, but may exempt in advance an office holder from his liability to the company, in whole or in part, with respect to a breach of his duty of care, provided, however, that such a breach is not related to a distribution of a dividend or any other distribution by the company.
Office holders insurance
Our articles of association provide that the Company may insure an office holder for any liability imposed on such office holder in connection with an act performed in the office holders capacity as an office holder of the company, subject to the provisions of the Companies Law, with respect to each of the following: (i) violation of the
duty of care of the office holder towards the Company or towards another person; (ii) breach of fiduciary duty towards the company provided that the office holder acted in good faith and with reasonable grounds to assume that the action in question was in the best interests of the company; (iii) a financial obligation imposed on the office holder for the benefit of another person; and (iv) any other obligation or expense for which it is or shall be permitted to insure and office holder.
The foregoing shall not apply under any of the following circumstances: (i) a breach of an office holders fiduciary duty, in which the office holder did not act in good faith and with reasonable grounds to assume that the action in question was in the best interest of the Company; (ii) a grossly negligent or intentional violation of an office holders duty of care; (iii) an intentional action by an office holder in which such office holder intended to reap a personal gain illegally; and (iv) a fine or ransom levied on an office holder.
Indemnification of office holders
Our articles of association provide that the company may indemnify, either retroactively or in advance, any office holder to the fullest extent permitted by the Companies Law.
The Company may resolve retroactively to indemnify an office holder with respect to the following liabilities and expenses, provided that such liabilities or expenses were incurred by such office holder in such office holders capacity as an office holder of the company: (i) a monetary liability imposed on an office holder pursuant to a judgment in favor of another person, including a judgment imposed on such office holder in a compromise or in an arbitration decision that was approved by a competent court; (ii) reasonable legal expenses, including attorneys fees, which the office holder incurred or with which the office holder was charged by a court of law, in a proceeding brought against the office holder, by the Company or by another on behalf of the Company, or in a criminal prosecution in which the office holder was acquitted, or in a criminal prosecution in which the office holder was convicted of an offense that does not require proof of criminal intent; and (iii) any other obligation or expense for which it is or shall be permitted to indemnify an office holder.
The company may resolve in advance to indemnify the office holders for those same liabilities and expenses it may resolve retroactively to indemnify an office holder, provided that (i) in the opinion of the board of directors such liabilities and expenses can be foreseen at the time the undertaking to indemnify is provided, and (ii) the board of directors shall set a reasonable limit to the amounts for such indemnification under the circumstances.
The foregoing shall not apply under certain circumstances defined in the Companies Law as described below.
Limitations on exemption, insurance and indemnification
The Companies Law provides that a company may not indemnify an office holder, neither enter into an insurance contract that would provide coverage for any monetary liability, nor exempt an office holder from liability, with respect to any of the following:
These limitations are included in our articles of association.
In addition, under the Companies Law, indemnification of, and procurement of insurance coverage for, our office holders must be approved by our audit committee and our board of directors and, in specified circumstances, by our shareholders.
Anti-takeover provisions; mergers and acquisitions under Israeli law
The Companies Law includes provisions that allow a merger transaction and requires that each company that is party to a merger approve the transaction by its board of directors and a vote of the majority of its shares voting on the proposed merger at a shareholders meeting called on at least 21 days prior notice. In determining whether a majority has approved the merger, shares held by the other party to the merger or any person holding at least 25% of the other party to the merger are excluded from the vote. The Companies Law does not require court approval of a merger other than in specified situations. Upon the request of a creditor of either party to the proposed merger, the court may delay or prevent the merger if it concludes that there exists a reasonable concern that as a result of the merger, the surviving company will be unable to satisfy the obligations of any of the parties to the merger. In addition, a merger may not be completed unless at least 30 days have passed since the approval of the merger by the shareholders of each of the merging companies and 50 days have passed from the time that a proposal for approval of the merger has been filed with the Israeli registrar of companies.
The Companies Law also provides that an acquisition of shares of a public company on the open market must be made by means of a tender offer if as a result of the acquisition the purchaser would become a 25% shareholder of the company. The rule does not apply if there is already another 25% shareholder of the company. Similarly, the Companies Law provides that an acquisition of shares in a public company must be made by means of a tender offer if, as a result of the acquisition, the purchaser would become a 45% shareholder, unless there is a 50% shareholder of the company. These rules do not apply if the acquisition is made by way of a merger as opposed to a tender offer. Regulations adopted under the Companies Law provide that these tender offer requirements do not apply to companies whose shares are listed for trading outside of Israel if, according to the law in the country in which the shares are traded, including the rules and regulations of the stock exchange on which the shares are traded, there is either a limitation on acquisition of any level of control of the company, or the acquisition of any level of control requires the purchaser to do so by means of a tender offer to the public. The Companies Law also provides that if following any acquisition of shares, the acquirer holds 90% or more of the companys shares or of a class of shares, the acquisition must be made by means of a tender offer for all the target companys shares or all the shares of the class, as applicable. An acquirer who wishes to eliminate all minority shareholders must do so by way of a tender offer and acquire 95% of all shares not held by or for the benefit of the acquirer before the acquisition. If, however, the tender offer to acquire 95% is not successful, the acquirer may not acquire shares tendered if by doing so the acquirer would own more than 90% of the shares of the target company.
C. Material Contracts
D. Exchange Controls
Under Israeli law and permits issued pursuant to the law, non-residents of Israel who purchase ordinary shares with certain non-Israeli currencies (including dollars) may freely repatriate in such non-Israeli currencies all amounts received in Israeli currency in respect of the ordinary shares, whether as a dividend, as a liquidating distribution, or as proceeds from any sale in Israel of the ordinary shares, provided in each case that any applicable Israeli income tax is paid or withheld on such amounts. The conversion into the non-Israeli currency must be made at the rate of exchange prevailing at the time of conversion.
Under Israeli law, both residents and non-residents of Israel may freely hold, vote and trade our ordinary shares.
The following is a description of material tax consequences regarding the ownership and disposition of our ordinary shares under Israeli tax laws to which our shareholders may be subject. The information below does not apply to specific persons or cover specific situations. Therefore, you are advised to consult your own tax advisor as to particular tax consequences unique to you related to an investment in our ordinary shares including the effects of applicable Israeli or foreign or other tax laws and possible changes in the tax laws.
To the extent that the discussion is based on legislation yet to be judicially or administratively interpreted, we cannot assure you that the views we express herein will accord with any such interpretation in the future.
Tax Consequences Regarding Disposition of Our Ordinary Shares
In general, Israel imposes capital gains tax on the sale of capital assets, including shares of Israeli companies by both Israeli residents and non-Israeli resident shareholders, unless a specific exemption is available or unless a tax treaty between Israel and the shareholders country of residence provide otherwise. Shareholders that are not Israeli residents are generally exempt from Israeli capital gains tax on any gain derived from the sale of our ordinary shares, provided that (i) such shareholders did not acquire the shares prior to our initial public offering; (ii) such gains did not derive from a permanent establishment of such shareholders in Israel; and (iii) such gains were not subject to the provisions of the Inflationary Adjustments Law. However, non-Israeli corporations will not be entitled to the foregoing exemption if an Israeli resident (a) has a controlling interest of 25% or more in such non-Israeli corporation; or (b) is the beneficiary of or is entitled to 25% or more of the revenues or profits of such non-Israeli corporation, whether directly or indirectly.
In certain instances where our non-Israeli shareholders may be liable to Israeli tax on the sale of our ordinary shares, the payment of the consideration may be subject to Israeli withholding tax.
In addition, the sale, exchange or disposition of our ordinary shares by shareholders who are U.S. residents (within the meaning of the U.S.-Israel Tax Treaty) holding the ordinary shares as a capital asset will be also exempt from Israeli capital gains tax under the U.S.-Israel Tax Treaty, unless, either (i) the shareholders hold, directly or indirectly, shares representing 10% or more of our voting shares during any part of the 12-month period preceding such sale, exchange or disposition; or (ii) the capital gains arising from such sale, exchange or disposition are attributable to a permanent establishment of the shareholders located in Israel. In such case, the shareholders would be subject to Israeli capital gain tax, to the extent applicable, as mentioned above. However, under the U.S.-Israel Tax Treaty, the U.S. resident would be permitted to claim a credit for such taxes against the U.S. federal income tax imposed on the sale, exchange or disposition, subject to the limitation in the U.S. law applicable to foreign tax credits. The U.S.-Israel Tax Treaty does not relate to U.S. state or local taxes.
Israeli individual shareholders selling our ordinary shares are subject to 20% tax rate on any real capital gain accrued after January 1, 2003, or 25% tax rate if such individual shareholder holds more than 10% interest in the company. Israeli corporate shareholders (which were subject to the provisions of the Inflationary Adjustments Law, prior to the publishing of amendment no. 147 to the Income Tax Ordinance, in 2005), selling our ordinary shares are subject to a 25% tax rate on any real capital gain. Israeli corporate shareholders which were subject in 2005 to the provisions of the Inflationary Adjustments Law, selling our ordinary shares are subject to the regular corporate tax rates on any capital gain.
Taxes Applicable to Dividends
Non-residents of Israel are generally subject to Israeli income tax on the receipt of dividends paid on our ordinary shares at the rate of 20% or 15% for dividends or income generated by an approved enterprise, which tax will be withheld at source, unless a different rate is provided in a treaty between Israel and the shareholders country of residence.
However, the tax rate on dividends paid to a substantial shareholder (which is someone who alone, or together with another person, holds, directly or indirectly, at least 10% in one or all of any of the means of control in the corporation) is 25%.
Under the U.S.-Israel Tax Treaty, the maximum rate of tax withheld in Israel on dividends paid to a holder of our ordinary shares who is a U.S. resident (within the meaning of the U.S.-Israel Tax Treaty) is 25%. However, dividends paid from income derived from our Approved Enterprise are subject to withholding at the rate of 15%, although we cannot assure you that we will designate the profits that are being distributed in a way that will reduce shareholders tax liability according to the U.S.-Israel Tax Treaty. Furthermore, the maximum rate of withholding tax on dividends, not generated by our Approved Enterprise, that are paid to a U.S. corporation holding 10% or more of our outstanding voting capital during the part of the tax year that precedes the date of the payment of the dividend and during the whole of its prior tax year, is 12.5%. This reduced rate will not apply if more than 25% of our gross income consists of interest or dividends, other than dividends or interest received from a subsidiary corporation 50% or more of the outstanding shares of the voting shares of which are owned by the company.
A non-resident of Israel who receives dividends with respect of which tax was fully paid, is generally exempt from the duty to file returns in Israel in respect of such income, provided such income was not derived from a business conducted in Israel by the taxpayer, and the taxpayer has no other taxable sources of income in Israel.
Subject to the limitations described herein, the following is a discussion of the material U.S. federal income tax consequences of the purchase, ownership and disposition of our ordinary shares to a U.S. holder. A U.S. holder is a beneficial owner of our ordinary shares who is:
A non-U.S. holder is a beneficial owner of our ordinary shares that is not a U.S. holder. Unless otherwise specifically indicated, this discussion does not consider the U.S. federal income tax consequences to a person that is a non-U.S. holder and considers only U.S. holders that will own the ordinary shares as capital assets.
If a partnership (or any other entity treated as a partnership for U.S. federal income tax purposes) holds our ordinary shares, the tax treatment of the partnership and a partner in such partnership will generally depend on the status of the partner and the activities of the partnership. Such a partner or partnership should consult its tax advisor as to its tax consequences.
This discussion is based on current provisions of the Internal Revenue Code of 1986, as amended (the Code), current and proposed Treasury Regulations promulgated under the Code and administrative and judicial interpretations of the Code, all as currently in effect and all of which are subject to change, possibly with retroactive effect. This discussion does not address all aspects of U.S. federal income taxation that may be relevant to any particular U.S. holder based on the U.S. holders particular circumstances. In particular, this discussion does not address the U.S. federal income tax consequences to U.S. holders who are broker-dealers or who own, directly, indirectly or constructively, 10% or more of our outstanding shares (by vote), real estate investment trusts, regulated investment companies, grantor trusts, U.S. holders holding the ordinary shares as part of a hedging, straddle or conversion transaction, U.S. holders whose functional currency is not the U.S. dollar, insurance companies, tax-exempt organizations, financial institutions, persons that receive ordinary shares as compensation for the performance of services, certain former citizens or long-term residents of the United States and persons subject to the alternative minimum tax, who may be subject to special rules not discussed below. Additionally, this discussion
does not address the possible application of U.S. federal estate or gift taxes or any aspect of state, local or non-U.S. tax laws.
Each holder of our ordinary shares is advised to consult his or her tax advisor with respect to the specific U.S. federal, state, local and foreign income tax consequences to him or her of purchasing, holding or disposing of our ordinary shares.
U.S. Holders of Ordinary Shares
Taxation of distributions on ordinary shares
Subject to the discussion below under Tax Consequences if we are a passive foreign investment company, a distribution paid by us with respect to our ordinary shares, including the amount of any non-US taxes withheld, to a U.S. holder will be treated as dividend income to the extent that the distribution does not exceed our current and accumulated earnings and profits, as determined for U.S. federal income tax purposes. Dividends that are received with respect to ordinary shares by U.S. holders that are individuals, estates or trusts generally will be taxed at the rate applicable to long-term capital gains (currently a maximum rate of 15% for the taxable years beginning on or before December 31, 2010), provided that such dividends meet the requirements of qualified dividend income. Dividends that fail to meet such requirements, and dividends received by corporate U.S. holders, are taxed at ordinary income rates. No dividend received by a U.S. holder will be a qualified dividend (1) if the U.S. holder held the ordinary share with respect to which the dividend was paid for less than 61 days during the 121-day period beginning on the date that is 60 days before the ex-dividend date with respect to such dividend, excluding for this purpose, under the rules of Code section 246(c), any period during which the U.S. holder has an option to sell, is under a contractual obligation to sell, has made and not closed a short sale of, is the grantor of a deep-in-the-money or otherwise nonqualified option to buy, or has otherwise diminished its risk of loss by holding other positions with respect to, such ordinary share (or substantially identical securities); or (2) to the extent that the U.S. holder is under an obligation (pursuant to a short sale or otherwise) to make related payments with respect to positions in property substantially similar or related to the ordinary share with respect to which the dividend is paid. If we were to be a passive foreign investment company (as such term is defined in the Code) for any year, dividends paid on our ordinary shares in such year or in the following year would not be qualified dividends. In addition, a non-corporate U.S. holder will be able to take a qualified dividend into account in determining its deductible investment interest (which is generally limited to its net investment income) only if it elects to do so; in such case the dividend will be taxed at ordinary income rates.
The amount of any distribution which exceeds the amount treated as a dividend will be treated first as a non-taxable return of capital, reducing the U.S. holders tax basis in its ordinary shares to the extent thereof, and then as capital gain from the deemed disposition of the ordinary shares. Corporate holders will not be allowed a deduction for dividends received in respect of the ordinary shares.
Dividends paid by us in NIS will be included in the gross income of U.S. holders at the dollar amount of the dividend (including any Israeli taxes withheld therefrom), based upon the spot rate of exchange in effect on the date the distribution is included in income. U.S. holders will have a tax basis in the NIS for U.S. federal income tax purposes equal to that dollar value. Any subsequent gain or loss in respect of the NIS arising from exchange rate fluctuations will generally be taxable as U.S. source ordinary income or loss.
Subject to the limitations set forth in the Code and the Treasury Regulations thereunder, U.S. holders may elect to claim as a foreign tax credit against their U.S. federal income tax liability the non-U.S. income tax withheld from dividends received in respect of the ordinary shares. The limitations on claiming a foreign tax credit include, among others, computation rules under which foreign tax credits allowable with respect to specific classes of income cannot exceed the U.S. federal income taxes otherwise payable with respect to each such class of income. In this regard, dividends paid by us will be foreign source passive income for U.S. foreign tax credit purposes or, in the case of certain U.S. holders, financial services income (for tax years beginning after December 31, 2006, as general category income). U.S. holders that do not elect to claim a foreign tax credit may instead claim a deduction for the non-U.S. income tax withheld if they itemize deductions. The rules relating to foreign tax credits are complex, and you should consult your tax advisor to determine whether and to what extent you would be entitled to this credit. A U.S. holder will be denied a foreign tax credit for non-U.S. income taxes withheld from a dividend
received on the ordinary shares (i) if the U.S. holder has not held the ordinary shares for at least 16 days of the 31-day period beginning on the date which is 15 days before the ex-dividend date with respect to such dividend or (ii) to the extent the U.S. holder is under an obligation to make related payments with respect to positions in substantially similar or related property. Any days during which a U.S. holder has substantially diminished its risk of loss on the ordinary shares are not counted toward meeting the required 16-day holding period. Distributions of current or accumulated earnings and profits will be foreign source passive income for U.S. foreign tax credit purposes.
Taxation of the disposition of ordinary shares
Subject to the discussion below under Tax Consequences if we are a passive foreign investment company, upon the sale, exchange or other disposition of our ordinary shares, a U.S. holder will recognize capital gain or loss in an amount equal to the difference between the amount realized on the disposition and the U.S. holders tax basis in the ordinary shares. The gain or loss recognized on the disposition of the ordinary shares will be long-term capital gain or loss if the U.S. holder held the ordinary shares for more than one year at the time of the disposition (long-term capital gains are currently taxable at a maximum rate of 15% for taxable years beginning on or before December 31, 2010). Capital gain from the sale, exchange or other disposition of ordinary shares held for one year or less is short-term capital gain. Gain or loss recognized by a U.S. holder on a sale, exchange or other disposition of ordinary shares will be generally treated as U.S. source income or loss for U.S. foreign tax credit purposes.
A U.S. holder that uses the cash method of accounting calculates the dollar value of the proceeds received on the sale as of the date that the sale settles. However, a U.S. holder that uses the accrual method of accounting is required to calculate the value of the proceeds of the sale as of the trade date and may therefore realize foreign currency gain or loss. A U.S. holder may avoid realizing foreign currency gain or loss by electing to use the settlement date to determine the proceeds of sale for purposes of calculating the foreign currency gain or loss. In addition, a U.S. holder that receives foreign currency upon disposition of ordinary shares and converts the foreign currency into dollars after the settlement date or trade date (whichever date the U.S. holder is required to use to calculate the value of the proceeds of sale) will have foreign exchange gain or loss based on any appreciation or depreciation in the value of the foreign currency against the dollar, which will generally be U.S. source ordinary income of loss.
Tax consequences if we are a passive foreign investment company
We will be a passive foreign investment company, or PFIC, for a taxable year if either (1) 75% or more of our gross income in a taxable year is passive income or (2) 50% or more of the value, determined on the basis of a quarterly average, of our assets in the taxable year produce, or are held for the production of, passive income. If we own (directly or indirectly) at least 25% by value of the stock of another corporation, we will be treated for purposes of the foregoing tests as owning our proportionate share of the other corporations assets and as directly earning our proportionate share of the other corporations income. Passive income for this purpose generally includes dividends, interest, royalties, rents and gains from commodities and securities transactions.
We believe that we were not a PFIC for our 2006 taxable year. Our status in the current and future taxable years will depend on our assets and income in those years. We have no reason to believe that our assets or income will change in a manner that would cause us to be classified as a PFIC. However, since the determination of whether we are a PFIC is based upon such factual matters as the valuation of our assets (which may depend upon our market capitalization, which is subject to fluctuation) and, in certain cases, the assets of companies held by us, there can be no assurance that we will not become a PFIC. If we were a PFIC, and you are a U.S. holder, you generally would be subject to imputed interest charges and other disadvantageous tax treatment with respect to any gain from the sale or exchange of, and certain distributions with respect to, your ordinary shares (including the denial of the taxation of such distributions and gains at the lower rates applicable to long-term capital gains as discussed above under Taxation of distributions on ordinary shares and Taxation of the disposition of ordinary shares).
If we were a PFIC, you could make certain elections that may alleviate certain tax consequences referred to above, and one of these elections may be made retroactively if certain conditions are satisfied. It is expected that the
conditions necessary for making certain of such elections will apply in the case of our ordinary shares. We will notify U.S. holders in the event we conclude that we will be treated as a PFIC for any taxable year.
U.S. holders are urged to consult their tax advisors regarding the application of the PFIC rules, including eligibility for and the manner and advisability of making certain elections with respect to our PFIC status.
Information reporting and backup withholding
A U.S. holder generally is subject to information reporting and may be subject to backup withholding at a rate of 28% with respect to dividend payments made within the United States or by a U.S. payor or U.S. middleman and receipt of the proceeds from the disposition of the ordinary shares. Backup withholding will not apply with respect to payments made within the United States or by a U.S. payor or U.S. middleman to exempt recipients, including corporations, or if a U.S. holder provides a correct taxpayer identification number, certifies that such holder is not subject to backup withholding or otherwise establishes an exemption. Backup withholding is not an additional tax. It may be claimed as a credit against the U.S. federal income tax liability of a U.S. holder or the U.S. holder may be eligible for a refund of any excess amounts withheld under the backup withholding rules provided, in either case, that the required information is furnished to the Internal Revenue Service.
Non-U.S. Holders of Ordinary Shares
Except as provided below, a non-U.S. holder of ordinary shares will not be subject to U.S. federal income or withholding tax on the receipt of dividends on, and the proceeds from the disposition of, an ordinary share, unless that item is effectively connected with the conduct by the non-U.S. holder of a trade or business in the United States and, in the case of a resident of a country which has an income tax treaty with the United States, that item is attributable to a permanent establishment in the United States or, in the case of an individual, a fixed place of business in the United States. In addition, gain recognized by an individual non-U.S. holder will be subject to tax in the United States if such non-U.S. holder is present in the United States for 183 days or more in the taxable year of the sale and other conditions are met.
Non-U.S. holders are generally not subject to information reporting or backup withholding with respect to the payment of dividends on, or proceeds from the disposition of, ordinary shares, provided that the non-U.S. holder provides its taxpayer identification number, certifies to its foreign status or otherwise establishes an exemption.
F. Dividends and Paying Agents
G. Statements by Experts
H. Documents on Display
We are required to file reports and other information with the SEC under the Securities Exchange Act of 1934 and the regulations thereunder applicable to foreign private issuers. Reports and other information filed by us with the SEC may be inspected and copied at the SECs public reference facilities described below. Although as a foreign private issuer we are not required to file periodic information as frequently or as promptly as United States companies, we generally do publicly announce our quarterly and year-end results promptly and file periodic information with the SEC under cover of Form 6-K. As a foreign private issuer, we are also exempt from the rules under the Exchange Act prescribing the furnishing and content of proxy statements and our officers, directors and principal shareholders are exempt from the reporting and other provisions of Section 16 of the Exchange Act.
You may review a copy of our filings with the SEC, including any exhibits and schedules, at the SECs public reference facilities in 100 F Street, N.E., Washington, D.C. 20549 and at the regional offices of the SEC located at the Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661. You may also obtain copies of such materials from the Public Reference Section of the SEC, 100 F Street, N.E., Washington,
D.C. 20549, at prescribed rates. You may call the SEC at 1-800-SEC-0330 for further information on the public reference rooms. In addition, such information concerning our company can be inspected and copied at the offices of the National Association of Securities Dealers, Inc., 9513 Key West Avenue, Rockville, Maryland 20850 and at the offices of the Israel Securities Authority at 22 Kanfei Nesharim St., Jerusalem, Israel. As a foreign private issuer, all documents which were filed after November 4, 2002 on the SECs EDGAR system will be available for retrieval on the SECs website at www.sec.gov. You may read and copy any reports, statements or other information that we file with the SEC at the SEC facilities listed above. These SEC filings are also available to the public from commercial document retrieval services. We also generally make available on our own web site all our quarterly and year-end financial statements as well as other information.
Any statement in this annual report about any of our contracts or other documents is not necessarily complete. If the contract or document is filed as an exhibit to the registration statement, the contract or document is deemed to modify the description contained in this annual report. We urge you to review the exhibits themselves for a complete description of the contract or document.
I. Subsidiary Information
Market risk is the risk of losses related to changes in market prices and foreign exchange rates that may adversely impact our consolidated financial position, results of operations or cash flows.
Foreign exchange risk
Although we report our consolidated financial statements in U.S. dollars, in 2006 a portion of our revenues and expenses was denominated, in other currencies. We derived approximately 50% of revenues in U.S. dollars, 33% in euros, 10% in Japanese Yen and 7% in British pounds. In 2006, 75% of our expenses was denominated in U.S. dollars, 18% in euros, 4% in Japanese Yen and 3% in British pounds.
Exchange differences upon translation from the functional currency of our German subsidiary, which is the euro, to U.S. dollars are accumulated as a separate component of accumulated other comprehensive loss under shareholders equity. As of December 31, 2006, accumulated other comprehensive loss decreased by$441,000 compared to December 31, 2005. As of December 31, 2005, accumulated other comprehensive loss increased by $492,000 compared to December 31, 2004. Exchange differences upon translation from the functional currency from our other selling and marketing subsidiaries (other than our U.S. subsidiary) to U.S. dollars are reflected in our income statement under financial income net.
We have entered into foreign currency forward contracts and forward exchange options generally of less than one year duration to hedge a portion of our foreign currency risk on sales transactions and on non-U.S. dollar monetary items. The objective of these transactions is to hedge cash flow in U.S. dollars and non-U.S. dollar monetary items against fluctuations in the exchange rates of the euro, British pound and the Japanese Yen. As of December 31, 2006, we held one euro forward contract with a nominal amount of 530,000 euros, one British pound forward contract with a nominal amount of 430,000 British pounds, one Japanese Yen forward contract with nominal amount of 160 million Japanese Yen and one New Israeli Shekel forward contract with a nominal amount of NIS 6 million.
We held equity investments in two companies whose securities are traded on the Tel Aviv Stock Exchange, Tamir Fishman Venture Capital II Ltd. and Comsec Information Security Ltd. In 2006, we sold these investments for an aggregate consideration of $1.4 million.
As of December 31, 2006, we had invested approximately $8.1 million in two related private investment funds managed by Tamir Fishman Ventures Management II Ltd. Each of these funds invests primarily in securities of privately-held technology companies in Israel.
In 2002, we recognized an impairment charge of $1.0 million related to these investments and we may recognize additional impairment charges in the future. We have a commitment to invest an additional $400,000 in these entities. In April 2006 and in April 2005, as a result of exit transactions for portfolio companies managed by Tamir Fishman Ventures Management II Ltd., we received cash proceeds of $1.7 million and $910,000, respectively. The proceeds from these distributions received in 2005 and 2006 were recorded as a return of investment.
Interest rate risk
Our investments consist primarily of cash and cash equivalents, consisting of short-term bank deposits with maturities of up to three months. In November 2004 and July 2005, we invested in U.S. government bonds with maturities of up to three and two years, respectively. The bonds mature in 2007.
Due to the short -term maturities of these investments, their carrying value approximates the fair value.
(a) Disclosure Controls and Procedures. Our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended) as of December 31, 2006, have concluded that, as of such date, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the periods specified by the SECs rules and forms.
(b) Management Annual Report on Internal Control over Financial Reporting. Our board of directors and audit committee are responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation and fair presentation of our consolidated financial statements.
Our chief executive officer and chief financial officer assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, they used the criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, our chief executive officer and chief financial officer have concluded that, as of December 31, 2006, our internal control over financial reporting is effective based on those criteria.
Notwithstanding the foregoing, all internal control systems no matter how well designed have inherent limitations. Therefore, even those systems determined to be effective may not prevent or detect misstatements and can provide only reasonable assurance with respect to financial statement preparation and presentation. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
(c) Firm Report of the Registered Public Accounting Firm. This annual report does not include an attestation report of our registered public accounting firm assessing our internal control over financial reporting. Our managements report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the SEC that permit us to provide only the managements report in this annual report.
(d) Changes in Internal Control over Financial Reporting. Since the date of the evaluation described above, there have been no significant changes in our internal controls over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Our board of directors has determined that Mr. David Assia, an independent director, qualifies as an audit committee financial expert under SEC rules.
We have adopted a code of ethics that imposes certain policies relating to ethical conduct on all of our employees, officers and directors, including our chief executive officer, chief financial officer, principal accounting officer, and persons performing similar functions.
The following table presents fees for professional audit services rendered by Kost, Forer, Gabbay & Kaisierer, a member of Ernst & Young Global, for the audit of our consolidated annual financial statements for the years ended December 31, 2006 and 2005, and fees billed for other services rendered by Ernst & Young LLP.
Our audit committee has adopted a policy for pre-approval of audit and non-audit services. Under the policy, independent auditor proposed services either may be pre-approved without consideration of specific case-by-case services by the audit committee, referred to as a general pre-approval, or they may require the specific pre-approval of the audit committee, referred to as a specific pre-approval. The audit committee employs
a combination of these two approaches. Unless a type of service has received general pre-approval, it will require specific pre-approval by the audit committee if it is to be provided by the independent auditor. The term of any general pre-approval is 12 months from the date of pre-approval, unless the audit committee considers a different period and states otherwise. The audit committee reviews annually and pre-approves the services that may be provided by the independent auditor without obtaining specific pre-approval from the audit committee. The audit committee adds to or subtracts from the list of general pre-approved services from time to time, based on subsequent determinations.
Pre-approval fee levels or budgeted amounts for all services to be provided by the independent auditor are to be established annually by the audit committee. Any proposed services exceeding these levels or amounts require specific pre-approval by the audit committee.
See our consolidated financial statements, following the signature page and certifications below.
The exhibits filed with or incorporated into this annual report are listed on the index of exhibits below.
Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant certifies that it meets all the requirements for filing on Form 20-F and has duly caused and authorized the undersigned to sign this Annual Report on its behalf in the City of Petach Tikva, State of Israel, on this 2 day of July 2007.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
ALADDIN KNOWLEDGE SYSTEMS LTD. AND ITS SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
AS OF DECEMBER 31, 2006
IN U.S. DOLLARS
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To the Board of Directors and Shareholders of
ALADDIN KNOWLEDGE SYSTEMS LTD.
We have audited the accompanying consolidated balance sheets of Aladdin Knowledge Systems Ltd. (the Company) and its subsidiaries as of December 31, 2005 and 2006, and the related consolidated statements of income, changes in shareholders equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements, based on our audits. We did not audit the financial statements of Aladdin Western Europe Ltd., a wholly-owned U.K. subsidiary, which statements reflect total assets constituting 2% in 2005 and 2006, and total revenues constituting 16% in 2004, 13% in 2005 and 7% in 2006 of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the data included for Aladdin Western Europe Ltd., is based solely on the report of the other auditors.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Companys internal control over financial reporting. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company and its subsidiaries as of December 31, 2005 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, in 2006, the Company adopted Statement Financial Accounting Standards No. 123(revised 2004), Share Based Payment.
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The accompanying notes are an integral part of the consolidated financial statements.
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The accompanying notes are an integral part of the consolidated financial statements.
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The accompanying notes are an integral part of the consolidated financial statements.
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The accompanying notes are an integral part of the consolidated financial statements.
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The accompanying notes are an integral part of the consolidated financial statements.
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The accompanying notes are an integral part of the consolidated financial statements.
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