|
|
 | | | |
- close
- close
- close
- close
COMARCO 10-K 2005 Documents found in this filing:
Table of Contents
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-K
(Mark One)
For the fiscal year ended January 31, 2005
OR
For the transition period from to
Commission File Number 0-5449
COMARCO, INC. (Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (949) 599-7400
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of July 30, 2005, the aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $51 million.
The number of shares of the Registrant’s common stock outstanding as of April 7, 2005 was 7,422,042.
Documents incorporated by reference: Part III incorporates information by reference to portions of the Registrant’s proxy statement for its fiscal 2005 annual meeting of shareholders.
Table of ContentsCOMARCO, INC.
FORM 10-K FOR THE FISCAL YEAR ENDED JANUARY 31, 2005
TABLE OF CONTENTS
Table of Contents
FORWARD-LOOKING STATEMENTS
This report on Form 10-K, including the section entitled Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 regarding our business, financial condition, results of operations, and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not deemed to represent an all-inclusive means of identifying forward-looking statements as denoted in this report. Additionally, statements concerning future matters are forward-looking statements.
Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the section below entitled “Risk Factors, Uncertainties and Other Factors that May Affect Results of Operations and Financial Condition,” as well as those discussed elsewhere in this report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report.
We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.
General
Comarco, Inc., through its subsidiary Comarco Wireless Technologies, Inc. (collectively, “we,” “Comarco,” or the “Company”), is a leading provider of wireless test solutions for the wireless industry. Comarco also designs and manufactures emergency call box systems and mobile power products for notebook computers, cellular telephones, DVDs, PDAs, and other handheld devices. Our operations consist solely of the operations of Comarco Wireless Technologies, Inc. (“CWT”).
We have three primary businesses: wireless test solutions (“WTS”), emergency call box systems (“call box” or “call box systems”), and mobile power products (“ChargeSource”). Our wireless test solutions business designs and manufactures hardware and software tools for use by wireless carriers, equipment vendors, and others. Our call box business designs and manufactures emergency call box systems and our mobile power products business designs universal power adapters for notebook computers, cellular telephones, DVDs, PDAs, and other handheld devices.
Our net revenue by business segment for fiscal 2005, 2004, and 2003 was:
1
Table of ContentsMore financial information about our business segments is contained in Note 19 “Business Segment Information” of our consolidated financial statements.
References to “fiscal” years in this report refer to our fiscal years ended January 31; for example, “fiscal 2005” refers to our fiscal year ended January 31, 2005.
We file or furnish annual, quarterly, and current reports, proxy statements, and other information with the SEC. Our SEC filings are available free of charge to the public over the Internet at the SEC’s website at http://www.sec.gov. Our SEC filings are also available on our website at http://www.comarco.com as soon as reasonably practical following the time that they are filed with or furnished to the SEC. Any document we file or furnish with the SEC can be read at the SEC’s public reference room in Washington, DC. For further information on the public reference room, call the SEC at (800) SEC-0330.
Our Businesses
Wireless Test Solutions
Our WTS business designs and manufactures hardware and software tools for use by wireless carriers, equipment vendors, and others. Radio engineers, network improvement professionals and technicians, and others use these test tools to deploy and optimize wireless networks, and to verify the performance of the wireless networks and resulting quality of service once deployed.
Products
Our WTS product offerings are based on our Seven.Five product platform. Seven.Five is a hardware and software solution that is flexible, scalable, and modular, allowing our customers to work with all 2G, 2.5G, and 3G technologies. Seven.Five can be configured in virtually any combination of test mobiles and multi-band, multi-technology scanning receivers. Test applications include optimization and benchmarking of wireless networks, in-building or in-vehicle testing, fixed or mobile testing, and voice, data, or video testing.
Our Seven.Five product platform consists of the following:
2
Table of ContentsServices
Our WTS business ceased providing engineering services during the second quarter of fiscal 2003. Prior to that time, our WTS business provided engineering services that assisted wireless carriers, equipment vendors, and others deploy, optimize, and evaluate the performance of wireless networks. When engaged, we were able to provide and support skilled radio engineers and technicians and the test tools best suited for the engagement.
We began offering engineering services, which were complementary to our WTS products, to wireless carriers and equipment vendors during the fourth quarter of fiscal 2000. During the subsequent two years, we were awarded several profitable multi-million dollar contracts, as well as numerous smaller engagements. However, wireless carriers dramatically reduced their spending near the end of fiscal 2002 and the competition to provide engineering services became more intense. Reduced contract pricing and fewer opportunities resulted in reduced revenue and profitability for all engineering services providers. Accordingly, during the first half of fiscal 2003, we ceased our efforts to obtain additional service contracts, and completed our remaining contractual obligations, reduced head count, and sold a portion of the assets previously used in providing engineering services.
Beginning in late fiscal 2004, we began leasing our WTS products. The demand for our leased equipment is primarily from customers providing engineering services similar to those we formerly provided to wireless carriers. This revenue source is expected to remain relatively flat in fiscal 2006.
Our wireless test solutions business generated $16.8 million in revenue in fiscal 2005, $11.1 million in fiscal 2004, and $10.1 million in fiscal 2003.
Emergency Call Box Systems
Products
Our emergency call box business designs and manufactures emergency call box systems for state and local government agencies primarily located in California. Our call box products provide emergency communication over existing wireless networks and are typically deployed along major highways, and at schools, universities, shopping centers, and parks.
Services
In addition to call box products, we provide system installation and long-term maintenance services. Currently, there are approximately 12,000 call boxes that we maintain under long-term agreements that expire at various dates through February 2011.
Our emergency call box systems business generated $6.6 million in revenue in fiscal 2005, $7.0 million in fiscal 2004, and $10.4 million in fiscal 2003.
Mobile Power Products (“ChargeSource”)
Products
Our ChargeSource business designs universal power adapters for notebook computers, cellular telephones, DVDs, PDAs, and other handheld devices. Our ChargeSource mobile power products, which are designed with the needs of the traveling professional in mind, provide a high level of functionality and compatibility in an industry-leading, compact design. Our current and planned product offering consists of universal AC/DC, AC, and DC power adapters designed for the right mix of power output and functionality for most retail, OEM, and enterprise customers. Our ChargeSource products are also universal, allowing those who use rechargeable electronic devices to carry just one power adapter. By simply changing the compact SmartTip connected to the end of the charging cable, our universal power adapters are capable of charging and powering multiple target devices, including most notebook computers, cellular telephones, PDAs, and other handheld devices.
3
Table of ContentsOur ChargeSource product family consists of the following released (or to be released, as indicated) universal power adapters:
We believe our patented electrical designs will continue to be the basis for even higher-power universal power adapters that are expected to meet evolving global standards, including the planned standards of the European Union (“EU”), and the increasing power requirements of the notebook computer OEMs, and allow us to offer customers cutting edge technology without significantly increasing the size or weight of our products. We also expect these higher-power universal power adapters to continue to be significantly smaller and lighter than their OEM counterpart.
Our ChargeSource business generated $5.8 million in revenue in fiscal 2005, $16.2 million in fiscal 2004, and $15.2 million in fiscal 2003.
Marketing, Sales, and Distribution
Wireless Test Solutions. We market and sell our WTS products primarily to wireless carriers through a direct sales force of technically trained personnel and through independent sales representatives, and affiliated and unaffiliated resellers. Our North America sales are made through our direct sales and marketing organizations located in California. Sales to our customers in Latin and South America are generally made through our offices located in Mexico City, Mexico, and Sao Palo, Brazil, assisted by the sales and marketing organizations based in Irvine, California. These offices also coordinate the marketing, sales, and support efforts of a network of representatives and distributors responsible for sales to customers in other geographic regions.
During fiscal 2002, we purchased an equity stake in Switzerland based SwissQual AG (“SwissQual”), a developer of Quality of Service systems and software for measuring, monitoring, and optimizing the quality of mobile, fixed, and IP-based voice and data communications. Under our alliance, SwissQual is responsible for reselling and supporting our co-branded WTS products in Europe, the Middle East, and North Africa (our “Europe” region). We have a revenue sharing agreement in place that determines how much revenue we earn from SwissQual sales and, conversely, how much revenue SwissQual earns from our sales to customers located outside the Europe region.
Emergency Call Box Systems. We market and sell our call box systems primarily to state and local government agencies located in California through a direct sales force located in Irvine, California.
4
Table of ContentsMobile Power Products (“ChargeSource”). We have primarily sold our ChargeSource products through private label resellers. Through fiscal 2004, our ChargeSource mobile power products were exclusively distributed by Targus Group International (“Targus”). During the fourth quarter of fiscal 2004 we terminated our relationship with Targus and entered into a strategic agreement with Belkin Corporation (“Belkin”). Under this agreement, Belkin was granted exclusive worldwide distribution rights to distribute ChargeSource products in several strategic end-market categories including electronic retailers, specialty retailers, OEM third-party options, and Fortune 1000 corporate customers. During fiscal 2005, the subsequent sales and marketing efforts, as well as the ramp-up of unit sales of the Belkin-branded ChargeSource products did not meet our original expectations. The Belkin supply agreement was terminated in conjunction with the execution of the mutual release during the third quarter of fiscal 2005.
During the third quarter of fiscal 2005, we entered into a supply agreement with Kensington, a tier-one distributor of consumer electronics, to distribute certain of our ChargeSource products to “Big Box” retailers and other channels.
Competition
Wireless Test Solutions. The market for our hardware and software test tools is highly competitive and is served by numerous providers. Our primary competitors with respect to our WTS products are Agilent Technologies, Ascom, Ericsson, and Andrew Corporation. Many of our competitors are larger and have greater financial resources.
The wireless industry is characterized by rapid technological changes, frequent new product and service introductions, and evolving industry standards. To compete successfully in our market, we believe we must:
Emergency Call Box Systems. The market for our emergency call box systems is also served by numerous providers, including CNE Group, Inc., Gaitronics, Talk-A-Phone, and other manufactures of wireless and wireline emergency and information telephones.
Mobile Power Products (“ChargeSource”). Numerous providers, including Mobility Electronics, Inc., Targus, Belkin and Fellowes, as well as the cellular telephone and personal computer OEMs, also serve the market for our ChargeSource mobile power products. Many of our competitors are larger and have greater financial resources. We believe that the patents that cover our ChargeSource products provide us with a competitive advantage. However, our ability to compete in these markets depends on our ability to successfully commercialize new technologies in a timely manner, and manufacture and deliver our products in sufficient volumes.
Key Customers
We derive a substantial portion of our revenue from a limited number of customers. In fiscal 2005, 2004, and 2003 Targus, the former distributor of our mobile power products, provided $4.1 million or 14 percent, $16.2 million or 47 percent, and $15.2 million or 43 percent of our revenue, respectively. SwissQual, our WTS reseller in Europe, accounted for $6.6 million or 22 percent of revenue in fiscal 2005 and TIM Cellular S.A., a WTS
5
Table of Contentscustomer located in Brazil, accounted for $4.3 million or 15 percent of revenue in fiscal 2005. The spending patterns of Kensington, our current ChargeSource distributor, or any of our other key customers can vary significantly during the year. Any significant reduction in the spending patterns of these customers could adversely affect our operating results.
International Operations
We sell our products to wireless carriers, equipment vendors, and other customers located throughout the world. In fiscal 2005, 2004, and 2003, we derived 53 percent, 84 percent, and 83 percent of our revenue, respectively, from customers in the United States and 47 percent, 16 percent, and 17 percent, respectively, from customers in foreign countries, as determined by the “ship to” address. The sharp increase in the percentage of sales to foreign countries during fiscal 2005 is due to increased sales of our WTS products through SwissQual, coupled with decreased sales of our ChargeSource products, which historically have been predominately sold in North America. In fiscal 2005, sales to Brazil accounted for $5.6 million or 19.3 percent of total revenue.
Research and Development
We sell our products in markets that are characterized by rapid technology changes, frequent new product introductions, and evolving technology standards. Accordingly, we devote significant resources to design and develop new and enhanced products that can be manufactured cost effectively and sold at competitive prices. To focus these efforts, we strive to maintain close relationships with our customers and develop products that meet their needs. We recently developed a new WTS product platform, Seven.Five, in response to the needs of wireless carriers for flexible, scalable, and high-value mobile test tools.
As of April 6, 2005, we had approximately 34 engineers and other technical personnel dedicated to our research and development efforts. Generally, our research and development and other engineering efforts are managed and focused on a product-by-product basis, and can generally be characterized as follows:
Manufacturing and Suppliers
We maintain one manufacturing facility located in Irvine, California, which is ISO-9001:2000 certified. Our manufacturing process involves the assembly of numerous individual component products by production technicians. The parts and materials used by us consist primarily of printed circuit boards, specialized subassemblies, fabricated housings and chassis, cellular telephones, and small electric circuit components, such as integrated circuits, semiconductors, resistors, and capacitors. Most of our components and sub-assemblies are made by third parties to our specifications and are generally delivered to us for final assembly and testing. During fiscal 2005, we ceased manufacturing our ChargeSource products in-house, and transitioned all manufacturing responsibility related to these products to a contract manufacturer located in China.
Patents and Intellectual Property
We hold patents that cover key technical aspects of our ChargeSource products. However, we generally rely on a combination of trade secrets, copyrights, and contractual rights to protect our intellectual property embodied in the hardware and software products of our WTS business.
6
Table of ContentsIndustry Practices Impacting Working Capital
Existing industry practices that affect working capital and operating cash flow include the level of variability of customer orders relative to the volume of production, vendor lead times, materials availability for critical parts, inventory levels held to achieve rapid customer fulfillment, and provisions of extended payment terms to certain foreign customers.
Currently, we sell our products under purchase orders that are placed with short-term delivery requirements. As a result, we maintain significant levels of inventory and associated production and technical staff in order to meet our obligations. Delays in planned customer orders could result in higher inventory levels and negatively impact our operating results.
Our standard terms require customers to pay for our products in U.S. dollars. For those orders denominated in foreign currencies, we may limit our exposure to losses from foreign currency transactions through forward foreign exchange contracts. To date, sales denominated in foreign currencies have not been significant and we have not entered into any foreign exchange contracts.
Employees
As of April 6, 2005, we employed approximately 128 employees. We believe our employee relations to be good. The majority of our employees are professional or technical personnel who possess training and experience in engineering, computer science, and management. Our future success depends in large part on our ability to retain key technical, marketing, and management personnel, and to attract and retain qualified employees, particularly those highly skilled radio, design, process, and test engineers involved in the development of new products. Competition for such personnel can be intense, and the loss of key employees, as well as the failure to recruit and train additional technical personnel in a timely manner, could have a material adverse effect on our operating results.
Our success depends to a significant extent upon the contribution of our executive officers and other key employees. We have an employee stock option plan whereby key employees can participate in our success.
Risk Factors, Uncertainties and Other Factors that May Affect Results of Operations and Financial Condition
A significant portion of our revenue is derived from the sale of our WTS products to customers in the wireless communications industry, which has experienced a significant downturn during the past several years. If the wireless communications industry does not continue to improve, our operating results and financial condition could suffer.
Revenue from the sale of our WTS products accounted for 58 percent of our revenue in fiscal 2005. Our WTS customers include national and regional wireless carriers throughout the world, equipment vendors, and others. The wireless communications industry appears to be emerging from a multi-year period during which many wireless carriers re-evaluated their network deployment plans in response to downturns in the capital markets, changing perceptions regarding industry growth, the availability and adoption of new wireless technologies, increasing price competition for subscribers, and a general economic slowdown in the United States and internationally. If the current trend in the wireless communications industry continues or if wireless carriers reduce their capital investments in wireless infrastructure and related test tools offered by our WTS business, our revenue and operating results may be adversely affected.
7
Table of ContentsA significant portion of our revenue is derived from the sale and maintenance of emergency call box systems to governmental customers that have experienced severe budgetary constraints. If current and planned projects to install or upgrade call box systems are delayed, our operating results and financial condition could suffer.
Revenue from the sale and maintenance of our emergency call box systems and upgrades accounted for 22.6 percent of our revenues in fiscal 2005. Approximately 79% of our call box revenue is derived from state and local governmental agencies in California, which prior to fiscal 2005, were experiencing severe budgetary constraints. As a result, several of our planned projects to install or upgrade call box systems were delayed in fiscal 2004 and 2003. If these adverse budgetary conditions of state and local governmental agencies in California recur we expect significant reductions in spending by our governmental customers, which would likely adversely affect our revenue and operating results.
Failure to adjust our operations due to changing market conditions or failure to accurately estimate demand for our products could adversely affect our operating results.
During the past several years, the spending patterns of many of our WTS customers have been volatile and unpredictable. In addition, consumer demand for our ChargeSource mobile power products has been subject to fluctuations as a result of our choices of distribution partners, market acceptance of our recently released products, the timing and size of customer orders and consumer demand for rechargeable mobile electronic devices. Accordingly, it has been difficult for us to forecast the demand for these products. We also are limited in our ability to quickly adapt our manufacturing and related cost structures because a significant portion of our sales and marketing, design and other engineering, and manufacturing costs are fixed. If customer demand for our WTS and Call Box products declines or if we otherwise fail to accurately forecast reduced customer demand, we will likely experience excess capacity, which could adversely affect our operating results. Conversely, if market conditions improve, our manufacturing capacity may not be adequate to fill increased customer demand. As a result, we might not be able to fulfill customer orders in a timely manner, which could adversely affect our customer relationships and operating results.
The products we make are complex and have short life cycles. If we are unable to rapidly and successfully develop and introduce new products, some of our products may become obsolete and our operating results could suffer.
The wireless communications and consumer electronics industries are characterized by rapid technological changes, frequent new product introductions and evolving industry standards. Additionally, our ChargeSource mobile power products have short life cycles, and may become obsolete over relatively short periods of time. Our future success depends on our ability to develop, introduce, and deliver on a timely basis and in sufficient quantity new products, components, and enhancements. The success of any new product offering will depend on several factors, including our ability to:
Development of new products requires high levels of innovation from both our engineers and our component suppliers. Development of a new product often requires a substantial investment before we can determine the commercial viability of the product. If we dedicate a significant amount of resources to the development of products that do not achieve broad market acceptance, our operating results may suffer. Our operating results may also be adversely affected due to the timing of product introductions by competitors, especially when a competitor introduces a new product before our own comparable product is ready to be introduced.
8
Table of ContentsThe wireless communications and consumer electronics industries are highly competitive, and our profitability will be adversely affected if we are not able to compete effectively.
The wireless communications and consumer electronics industries in which we sell our products are highly competitive in many areas, including the timing of development and introduction of new products, technology, price, quality, and customer service and support. Our competitors range from some of the respective industries’ largest corporations to many relatively small and highly specialized firms. Many of our competitors possess advantages over us, including greater financial and marketing resources, greater name recognition and larger and more established customer and supplier relationships. Our competitors also may be able to respond more quickly to new or emerging technologies and changes in customer needs. If we do not have the resources or expertise or otherwise fail to develop successful strategies to address these competitive disadvantages, we could lose customers causing our revenue to decline.
The average selling prices of our products may decrease over their sales cycles, especially upon the introduction of new products, which may negatively affect our revenue and operating results.
Our products may experience a reduction in the average selling prices over their respective sales cycles. Further, as we introduce new or next-generation products, sales prices of legacy products may decline substantially. In order to sell products that have a falling average selling price and maintain margins at the same time, we need to continually reduce product and manufacturing costs. There can be no assurances we will be successful in our efforts to reduce these costs. In order to do so, we must carefully manage the price paid for components used in our products, as well as manage our inventory costs to reduce overall product costs. If we are unable to reduce the cost of legacy products as new products are introduced, our average gross margins may decline and adversely affect our operating results.
A significant portion of our revenue is dependent in part upon our relationships with our strategic distribution partners and their performance. If we are unable to successfully manage our relationships with the distributors of our mobile power products, our revenue and operating results could suffer.
Through fiscal 2004, our ChargeSource mobile power products were distributed by Targus. During the fourth quarter of fiscal 2004, we terminated our relationship with Targus and entered into a strategic agreement with Belkin. Due to Belkin’s lack of performance, they were replaced during the third quarter of fiscal 2005 with Kensington, a tier-one distributor of consumer electronics. Due to the terms of our agreement with Kensington, our direct access to certain significant distribution channels may be limited. Accordingly, our success will depend in part upon Kensington’s ability and willingness to effectively and widely distribute our ChargeSource products. If Kensington does not purchase the volume of products that we anticipate, our revenue and results of operations will suffer.
A significant portion of our revenue is derived from a limited number of customers, and any loss of, cancellation or delay in purchases by these customers could cause a significant decrease in our revenue.
We have historically derived a significant portion of our revenue from a limited number of customers. Our three (3) key customers for the fiscal year just completed accounted for $15.3 million of our revenue, or 52 percent of our revenue for fiscal 2005. For example, Targus, the former distributor of our ChargeSource mobile power products, accounted for approximately $4.1 million, or 14 percent of our revenue in fiscal 2005 and $16.2 million, or 47 percent of our revenue in fiscal 2004. Our new distribution agreement with Kensington requires them to purchase minimum quantities from us during the term of the agreement, however, it is not assured that Kensington will be able to meet its purchase commitments, or meet or exceed our historical level of unit sales. If Kensington or any of our other key customers reduces, cancels, or delays orders from us, and we are not able to develop other customers who purchase products at comparable levels, our revenue could decrease significantly. In addition, any difficulty in collecting amounts due from one or more of our key customers would negatively impact our results of operations and financial condition. We expect that a limited number of customers will continue to represent a large percentage of our revenues.
9
Table of ContentsWe may experience quality or safety defects in our products that could cause us to institute product recalls, require us to provide replacement products and harm our reputation.
In the course of conducting our business, we experience and attempt to address various quality and safety issues with our products. Often product defects are identified during our design, development, and manufacturing processes, which we are able to correct timely. Sometimes, defects are identified after introduction and shipment of products. For example, in March 2003, we voluntarily initiated a product safety recall of our legacy 70-watt universal AC power adapters, and accrued $0.4 million in expenses related thereto in fiscal 2003 and accrued a $3.2 million credit to Targus recorded as a reduction of revenue in settlement of the recall, $1.1 million of which later was unused and recognized as revenue in fiscal 2004. If we are unable to timely fix defects or adequately address quality control issues, our relationships with our customers may be impaired, our reputation may suffer and we may lose customers. Any of the foregoing could adversely affect our business and results of operations.
Economic, political and other risks associated with our international sales and operations could adversely affect our results of operations.
We currently maintain sales and support operations in the United States, China, Europe, and Latin America. Our international operations accounted for approximately 47 percent of our revenue in fiscal 2005. Accordingly, our business is subject to worldwide economic and market conditions and risks generally associated with doing business abroad, such as fluctuating foreign currency exchange rates, weaknesses in the economic conditions in particular countries or regions, the stability of international monetary conditions, tariff and trade policies, domestic and foreign tax policies, foreign governmental regulations, political unrest and disruptions and delays in shipments. These factors, among others, could adversely affect our sales of products and services in international markets.
Additionally, we have limited experience selling our products and services in markets outside our regions in the Americas and Europe. However, it is currently our intention to expand our international operations and establish additional sales and support offices in primary international markets. If our international sales efforts are not successful, our results of operations and financial condition could suffer.
Our failure to address laws and regulations governing our government contracts, could adversely affect our business and operating results.
We depend on contracts with state and local governmental agencies for a significant portion of our revenue, and are subject to various laws and regulations that only apply to companies doing business with the government. For example, we supply call box products and provide system installation and long-term maintenance services to regional and municipal transit authorities and other governmental agencies. In fiscal 2005, we derived 21 percent of our revenue from contracts with these governmental customers. From time to time we are also subject to investigation for compliance with regulations governing our government contracts. Our failure to comply with any of these laws or regulations could result in suspension of these contracts, or subject us to administrative claims.
Disruptions in our relationships with our suppliers or in our suppliers’ operations could result in shortages of necessary components and adversely affect our operations.
We currently procure, and expect to continue to procure, certain components from single source manufacturers who provide unique component designs or who meet certain quality and performance requirements. In addition, we sometimes purchase customized components from single sources in order to take advantage of volume pricing discounts. In fiscal 2005 and 2004, no supplier accounted for more than 10 percent of our inventory purchases. In fiscal 2003, two suppliers accounted for more than 10 percent of our inventory purchases: Supercomal Advanced Cables Sdn. Bhd. (“Supercomal”), which provided $2.2 million or 19 percent of all inventory purchases, and Future Electronics, which provided $2.0 million or 17 percent of all inventory purchases. Both Future Electronics and Supercomal provided electronic components for our ChargeSource products.
10
Table of ContentsThe performance of these suppliers is largely outside our control. In the past, we have experienced, and may continue to experience, shortages of important single source components. Our suppliers may fail to timely deliver components or provide components of sufficient quality. If this occurs, we may need to adjust both product designs and production schedules, which could result in delays in the production and delivery of products to our customers. These delays or defects could harm our reputation and impair our customer relationships.
Third parties may claim that we are infringing their intellectual property, and we could suffer significant litigation, settlement or licensing costs and expenses or be prevented from selling certain products.
Third parties have claimed, and may in the future claim, that we are infringing their intellectual property rights. These intellectual property infringement claims, whether we ultimately are found to be infringing any third party’s intellectual property rights or not, are time-consuming, costly to defend, and divert resources and management attention away from our operations. Infringement claims by third parties also could subject us to significant damage awards or fines or require us to pay large amounts to settle such claims. Additionally, claims of intellectual property infringement might require us to enter into royalty or license agreements. If we cannot or do not license the infringed technology on acceptable terms or substitute similar technology from other sources, we could be prevented from or restricted in selling our products containing, or manufactured with, the infringed technology.
Third parties may infringe our intellectual property rights, and we may be required to spend significant resources enforcing these rights or otherwise suffer competitive injury.
Our success depends in large part on our proprietary technology. We generally rely upon patent, copyright, trademark, and trade secret laws in the United States and in certain other countries, and rely on confidentiality agreements with our employees, customers, and partners to establish and maintain our intellectual proprietary rights in our proprietary technology. We are required to spend significant resources to monitor and enforce our intellectual property rights; however these rights might not necessarily provide us with a sufficient competitive advantage. Our intellectual proprietary rights could be challenged, invalidated, or circumvented by competitors or others. Our employees, customers or partners could breach our confidentiality agreements, for which we may not have an adequate remedy available. We also may not be able to timely detect the infringement of our intellectual property rights, which could harm our competitive position. Finally, the rapid pace of technological change in the wireless communications and consumer electronics industries could make certain of our key proprietary technology obsolete or provide us with less of a competitive advantage.
If we suffer the loss of our manufacturing facility due to catastrophe, our operations would be adversely affected.
We have one manufacturing facility, which is located in Irvine, California. Although we carry insurance for property damage, we do not carry insurance or financial reserves for all possible catastrophes, including interruptions or potential losses arising from earthquakes or terrorism. Any significant disruption in our manufacturing operation at the facility, whether due to fire, natural disaster, or otherwise, would have a material adverse effect on our financial condition and operating results.
Additionally, as previously discussed, during fiscal 2005 we transitioned the manufacturing of our ChargeSource products to a contract manufacturer located in China. If any significant disruption occurs in the facility in China, it would have a material adverse effect on our financial condition and operating results.
We depend upon the services of key personnel, and may not be able to attract and retain additional key personnel.
Our success depends to a significant extent on the continued services and experience of our key research, engineering, sales, marketing and executive personnel. If for any reason our key personnel left our employ and we failed to replace a sufficient number of these personnel, we might not be able to maintain or expand our business.
11
Table of ContentsCompetition for such highly skilled personnel in our wireless communications and consumer electronics industries is intense, and we cannot be certain that we will be able to hire or re-hire sufficiently qualified personnel in adequate numbers to meet the demand for our products and services. If we are unable to identify, hire and integrate these skilled personnel in a timely or cost-efficient manner, our operating results could suffer.
We may not be able to successfully integrate prior or future acquisitions, which could adversely affect our business, financial condition and results of operations.
We have acquired, and are likely to acquire in the future, businesses, products, and technologies that complement or expand our current operations. Acquisitions could require significant capital investments and require us to integrate with companies that have different cultures, management teams and business infrastructure. Depending on the size and complexity of an acquisition, our successful integration of the acquisition could depend on several factors, including:
If market conditions or other factors require us to change our strategic direction, we may fail to realize the expected value from one or more of our acquisitions. Our failure to successfully integrate our acquisitions or realize the expected value from past or future acquisitions could harm our business, financial condition and results of operations.
We may need additional capital in the future to fund the growth of our businesses, which we may not be able to obtain or obtain on acceptable terms.
We currently anticipate that our available capital resources and operating income will be sufficient to meet our expected working capital and capital expenditure requirements for at least the next 12 months. However, it is not assured that such resources will be sufficient to fund the long-term growth of our business. In particular, we may experience a negative operating cash flow due to the timing of anticipated sales of our products. We may raise additional funds through public or private debt or equity financings if such financings become available on favorable terms. Or we may seek working capital financing under a revolving line of credit. We cannot assure you that any additional financing we may need will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to take advantage of unanticipated opportunities, develop new products or otherwise respond to competitive pressures. In any such case, our operating results and financial condition could be adversely affected.
Our quarterly operating results are subject to significant fluctuations and, if our operating results decline or are worse than expected, our stock price could fall.
We have experienced, and expect to continue to experience, significant quarterly fluctuations in revenue and operating results for our three businesses. Our quarterly operating results may fluctuate for many reasons, including:
12
Table of Contents
Due to these and other factors, our past results are not reliable indicators of our future performance. In addition, a significant portion of our operating expenses is relatively fixed due to sales, engineering and manufacturing overhead. If we experience a decline in revenue, we may be unable to reduce our fixed costs quickly enough to compensate for the decline, which would magnify the adverse impact of such revenue shortfall on our results of operations. If our operating results decline or are below expectations of securities analysts or investors, the market price of our stock may decline significantly.
Our stock price has been and will likely remain highly volatile.
The stock market in general, and the stock prices of technology and wireless communications companies in particular, have experienced fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. Broad market and industry stock price fluctuations may adversely affect the market price of shares of our common stock. The market price of our stock has exhibited significant price fluctuations, which makes our stock unsuitable for many investors. Our stock price may also be affected by the following factors:
Our articles of incorporation and shareholder rights plan could make a potential acquisition that is not approved by our board of directors more difficult.
Provisions of our articles of incorporation and our shareholder rights plan could make it more difficult for a third party to acquire control of us. Our articles of incorporation prohibit the consummation of a merger, reorganization or recapitalization, sale or lease of a substantial amount of assets with, or issuance of equity securities valued at $2.0 million or more to a stockholder that owns 10 percent or more of our common stock, unless certain requirements relating to board or shareholder approval are met. Our articles also prohibit shareholder action by written consent, which could make certain changes of control more difficult by requiring the holding of a special meeting of shareholders for purposes of taking shareholder action.
13
Table of ContentsIn addition, in February 2003 we adopted a shareholder rights plan whereby, for each outstanding share of common stock, we distributed a preferred stock purchase right entitling the holder to purchase one one-hundredth of a share of preferred stock at an exercise price of $75. If any person or group acquires or makes an offer to acquire 15 percent or more of our common stock, the preferred stock purchase right will become exercisable by persons other than the 15 percent or more person or group, unless our board of directors timely redeems the preferred stock purchase right or has approved the offer. As a result, the preferred stock purchase rights may cause substantial dilution to the ownership of a person or group that attempts to acquire us on terms not approved by our board of directors.
These provisions in our articles of incorporation and our shareholder rights plan could discourage takeover attempts which some shareholders might deem to be in their best interests or in which shareholders would receive a premium for their shares over the then existing market price of our common stock.
The trading volume of our common stock often has been limited and may depress the price for our common stock.
The trading volume of our common stock has been and may continue to be limited. Limited trading volume could depress the price for our common stock because fewer analysts may provide coverage for our stock and because investors might be unwilling to pay a higher market price for a stock that is less liquid. In addition, limited trading volume, along with market and industry stock price fluctuations and other factors affecting our operations, could result in greater volatility in the price of our common stock. A significant decline in our stock price, even if temporary, could result in substantial losses for individual shareholders and could subject us to costly and disruptive securities litigation.
Our headquarters and primary manufacturing facility is located in Irvine, California. This leased facility consists of approximately 42,000 square feet of office space and approximately 8,000 square feet of manufacturing/ warehouse space. The lease for this facility expires in August 2006. We also lease office space and, in some instances, warehouse space in California, New York, China, and Mexico. The leases on these facilities expire on various dates through October 2007.
Comarco Wireless Technologies, Inc. v. Targus, Inc., Case No. 050004166, Superior Court of The State of California in and for The County of Orange:
On March 16, 2005, Comarco Wireless Technologies, Inc. (“Comarco”) filed this action for breach of contract, breach of implied duty of good faith and fair dealing, open book account, goods had and received, account stated, quantum valebant, and unjust enrichment.
Targus, Inc. (“Targus”) was the exclusive distributor of our ChargeSource products through January 2004, at which time they were removed as the exclusive distributor. Throughout fiscal 2005, we continued to honor our obligations under non-cancelable and non-returnable purchase orders placed by Targus and accepted by Comarco through the first quarter of fiscal 2005 in an attempt to affect an orderly wind-down of the relationship. During December 2004, Targus ceased making payments to Comarco for product shipped under an open book account. As of January 31, 2005, Targus and its affiliates owe us approximately $1.0 million.
While we believe this action is meritorious, this matter is in the very early stages and any loss of the amounts owed to us that may result from the outcome of this matter is not determinable or estimable. No significant provision has been made for losses, if any, which may result from the final outcome of this matter.
14
Table of ContentsPulsar v. Comarco, Inc. et al, Case No. BC30638, Superior Court of California County of Los Angeles—Central District:
During fiscal 2001, we sold a business that, among other things, provided airport management services. During the fourth quarter of fiscal 2004, we were sued by a tenant at an airport where we provided management services pursuant to a contract with the County of Los Angeles (prior to the sale of this business during fiscal 2001). The claimant seeks damages of $2.0 million in addition to other unspecified damages. This matter is in the very early stages and the outcome of this matter is not determinable or estimable. No provision has been made for losses, if any, which may result from the final outcome of this matter.
In addition to the matters discussed above, we are from time to time involved in various legal proceedings incidental to the conduct of our business. We believe that the outcome of all such pending legal proceedings will not in the aggregate have a material adverse effect on our financial condition or operating results.
No matter was submitted during the fourth quarter ended January 31, 2005 to a vote of our security holders.
15
Table of ContentsPART II
Market Information
Our common stock is traded on the Nasdaq National Market® under the symbol “CMRO.” The following table sets forth for the periods indicated the quarterly high and low closing prices per share as reported by the Nasdaq National Market. These prices represent actual reported sales transactions.
Holders
As of April 12, 2005, there were 371 holders of record of our common stock.
Dividends
We have not paid any cash dividends on our common stock in the last two fiscal years. We anticipate that dividends on our common stock will not be paid for the foreseeable future and that all earnings will be retained for use in our business and for use in repurchasing our common stock pursuant to our stock repurchase program.
16
Table of Contents
17
Table of Contents
The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included in Part II, Item 8 of this report on Form 10-K. This report contains forward-looking statements including, without limitation, statements regarding trends, cyclicality, seasonality and growth in the markets we sell into, our strategic direction, expenditures in research and development, contracts, our future effective tax rate, new product introductions, changes to our manufacturing processes, our liquidity position, our ability to generate cash from continuing operations, our expected growth, the potential impact of our adopting new accounting pronouncements, our financial results, revenue generated from international sales, the impact of our enterprise resource planning systems implementation, the impact of our variable cost structure, and the existence or length of an economic recovery that involves risks and uncertainties. Our actual results could differ from the results contemplated by these forward-looking statements due to certain factors, including those discussed in Part I, Item 1 and elsewhere in this report.
Overview
Comarco, Inc., through its subsidiary Comarco Wireless Technologies, Inc. (collectively, “we,” “Comarco,” or the “Company”), is a leading provider of wireless test solutions for the wireless industry. Comarco also designs, manufactures, and maintains emergency call box systems and designs mobile power products for notebook computers, cellular telephones, PDAs, and other handheld devices. Our operations consist solely of the operations of Comarco Wireless Technologies, Inc. (“CWT”).
Our revenue and related cash flows are primarily derived from sales of our wireless test solutions (“WTS”) products, emergency call box systems and related maintenance services, and ChargeSource mobile power products. We have three reportable segments: WTS, Call Box, and ChargeSource. See “Segment Reporting” in Notes 2 and 19 of notes to our consolidated financial statements included in Part II, Item 8 of this report.
Industry and Company Trends and Uncertainties
Wireless Test Solutions
Our WTS business designs and manufactures hardware and software tools for use by wireless carriers, equipment vendors, and others. Radio engineers, network improvement professionals and technicians, and others use these test tools to deploy and optimize wireless networks, and to verify the performance of the wireless networks and resulting quality of service once deployed.
The wireless communications industry appears to be emerging from a multi-year period during which many wireless carriers re-evaluated their network deployment plans in response to downturns in the capital markets, changing perceptions regarding industry growth, the availability and adoption of new wireless technologies, increasing price competition for subscribers and a general economic slowdown in the United States and internationally. We believe there are signs of increased confidence in the industry and the markets for our WTS products. Increasing minutes of use (“MOU”), global subscribers and data-intensive applications are driving higher capacity utilization of existing networks, requiring wireless carriers around the globe to place a greater emphasis on capital expenditures devoted to their wireless networks. Wireless carriers are now allocating increasing levels of capital resources to business development and long-term strategic network planning in response to consumer demand for improved network coverage, quality of service, and enhanced data services.
Management currently considers the following additional trends, events, and uncertainties to be important to understanding our WTS business:
18
Table of Contents
The wireless industry is composed of a relatively small number of wireless carriers and equipment vendors, which can lead to volatility in our results, as our business is characterized by sales to a limited set of customers in each region where we do business. The timing and size of customer orders can vary greatly making it difficult to forecast our results from period to period. Consequently, our business may be affected in any single region by the changing priorities of a small group of customers.
During the first half of fiscal 2004, we completed the development of our Seven.Five hardware platform and various related software applications, and began shipping products to customers in Europe and Latin and South America. Seven.Five is a hardware and software solution that is flexible, scalable, and modular allowing our customers to work with all 2G, 2.5G and 3G technologies.
The European wireless marketplace is widely considered to be several years ahead of the rest of the world in deploying 3G technologies and related data-intensive applications making our European region the first to embrace our Seven.Five product platform. During fiscal 2005 many of the wireless carriers in Latin and South America, which have both financial and technology ties to the European wireless carriers, purchased our Seven.Five product platform as they continued to deploy 3G technologies consistent with the European roadmap across their wireless networks.
We believe our North America region may benefit from increased spending by certain United States wireless carriers. This increased spending can be attributed to several trends: (i) the recent availability and implementation of new technologies such as 3G wireless and broadband wireless; (ii) activity generated by efforts to consolidate networks resulting from recent merger activity; (iii) network quality enhancement programs to reduce churn; and (iv) network expansion and capacity programs geared toward enabling new and enhanced services.
Emergency Call Box Systems
Our emergency call box business designs and manufactures emergency call box systems. Our call box products provide emergency communication over existing wireless networks. In addition to call box products, we provide system installation and long-term maintenance services. Currently, there are approximately 12,000 call boxes that we maintain under long-term agreements that expire at various dates through February 2011.
Wireless carriers are reallocating spectrum away from analog, or first generation, wireless technologies to digital, or 2G and 2.5G, wireless technologies. As a result, state and local agencies are upgrading their existing call box systems to digital to maintain the functional efficiencies of their call box systems. Our upgraded call box products, based on 2.5G GSM and CDMA technologies, offer a complete solution of current technology and services at a low cost designed to meet our customers’ needs. With more than 19,000 call box units installed, we see a strong opportunity to drive our call box revenue for the next two years as only 3,200 call boxes are currently under contract for digital upgrade or have been upgraded.
19
Table of ContentsManagement currently considers the following additional trends, events, and uncertainties to be important to understanding our call box business:
Mobile Power Products (“ChargeSource”)
Designed with the needs of the traveling professional in mind, our ChargeSource mobile power products provide a high level of functionality and compatibility in an industry-leading compact design. Our current and planned product offering consists of universal AC/DC, AC, and DC power adapters designed for the right mix of power output and functionality for most retail, OEM, and enterprise customers. Our ChargeSource products are also universal allowing those who use rechargeable electronic devices to carry just one power adapter. By simply changing the compact SmartTip connected to the end of the charging cable, our universal power adapters are capable of charging and powering multiple target devices, including most notebook computers, cellular telephones, PDAs, and other handheld devices.
Prior to fiscal 2004, most notebook computers required no more than 70 watts of power to operate. However, the personal computer industry is continuing to transition to notebook computers with increasing power requirements. As power requirements increase, so does the size of the OEM power adapter sold with each notebook computer. To address this industry wide trend, we have developed a family of high-power ChargeSource products that are compatible with most legacy, current, and planned notebook computers. These new ChargeSource products are able to deliver up to 120 watts of power in a very small form factor.
Management currently considers the following additional trends, events, and uncertainties to be important to understanding our ChargeSource business:
20
Table of Contents
On March 20, 2003 and in cooperation with the U.S. Consumer Products Safety Commission (“CPSC”), we voluntarily initiated a product safety recall of our legacy ChargeSource 70-watt universal AC power adapters. This product safety recall impacts approximately 125,000 units that were sold in fiscal 2003. Comarco and Targus entered into an agreement to address the impact of the recall action. Under the terms of the agreement Comarco issued a $3.2 million credit to Targus in fiscal 2003 in consideration of a full release. Of the $3.2 million credit issued to Targus in the fourth quarter of fiscal 2003, qualifying product returns totaling $2.1 million were received from Targus through October 31, 2003. During the third quarter of fiscal 2004, the remaining $1.1 million unused credit was recorded as revenue, consistent with the expiration of the right of return and the term of the agreement. Additionally, in the fourth quarter of fiscal 2003 we accrued $183,000 in costs related to the recall action in cost of revenue. We did not incur a similar product recall in fiscal 2004 or 2005.
Critical Accounting Policies
The preparation of our consolidated financial statements requires us to apply accounting policies and make certain estimates and judgments. Our significant accounting policies are presented in note 2 to our consolidated financial statements. Of our significant accounting policies, we believe the following involve a higher degree of uncertainty, subjectivity and judgments. These policies involve estimates and judgments that are inherently uncertain. Changes in these estimates and judgments may significantly impact our annual and quarterly operating results. We have identified the following as our most significant critical accounting policies.
Revenue Recognition
We recognize product revenue upon shipment provided there are no uncertainties regarding customer acceptance, persuasive evidence of an arrangement exists, the sales price is fixed or determinable, and collectibility is probable. Generally, our products are shipped FOB named point of shipment, whether it is Irvine, our corporate headquarters, or Hong Kong, the shipping point of our ChargeSource products. Shipments to SwissQual, our WTS distributor in Europe, are shipped delivery duties unpaid (“DDU”). Under DDU, title and risk of loss for the goods shipped passes to the buyer at destination.
Our WTS products are integrated with embedded software. Accordingly, we recognize revenue using the residual method pursuant to requirements of Statement of Position No. 97-2, “Software Revenue Recognition,” and other applicable revenue recognition guidance and interpretations. Under the residual method, we allocate revenue to the undelivered element, typically maintenance, based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. We amortize the revenue allocated to the maintenance element evenly over the term of the maintenance commitment made at the time of sale. We expense as incurred the costs associated with honoring the maintenance commitment. The revenue attributable to the delivered product is the residual amount after subtracting the revenue allocated to the undelivered element from the sales price. The revenue attributable to the delivered product is recognized following the policy for product sales described above. Over time, the percentage of revenue attributable to maintenance will change if the selling price of maintenance contracts sold separately increases or decreases.
21
Table of ContentsWe recognize service revenue as the services are performed. Maintenance revenue from extended warranty sales is deferred and recognized ratably over the term of the maintenance agreement, typically 12 months.
Significant management judgments must be made and used in connection with the revenue recognized in any accounting period. For our WTS business, management must make judgments, for example, regarding uncertainties surrounding customer acceptance because some orders may include acceptance test provisions that require we defer revenue upon shipment until such time as the client has accepted the equipment. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments.
Software Development Costs
We had $3.5 million of capitalized software as of January 31, 2005, net of accumulated amortization of $5.4 million. Capitalized software amortization expense is included in cost of revenue. We capitalize software developed for sale or lease in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86 (“SFAS No. 86”), “Accounting for Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” Software costs incurred subsequent to the determination of the technological feasibility of the software product are capitalized. Technological feasibility is generally demonstrated by the completion of a working model. Our policy is to capitalize the costs associated with development of new products and expense the costs associated with new releases, which primarily consist of enhancements or increased functionality of software embedded in existing products. Significant management judgment is required in determining whether technological feasibility has been achieved for a particular software project and in estimating the economic life of the related product. Capitalization ceases and amortization of capitalized costs begins when the software product is available for general release to our customers. Each quarter we compare capitalized software development costs to our estimate of projected revenues quarterly to determine if any impairment in value has occurred that would require an adjustment in the carrying value or change in expected useful lives under the guidelines established under SFAS No. 86. We also continually evaluate the recoverability of software acquired through acquisition or by direct purchase of technology.
Accounts Receivable
We perform ongoing credit evaluations of our customers and adjust credit limits and related terms based upon payment history and the customer’s current credit worthiness. We continually monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Since our accounts receivable are concentrated in a relatively few number of customers, a significant change in the liquidity or financial position of any one of these customers could have a material adverse effect on the collectibility of our accounts receivable and our future operating results.
Specifically, our management must make estimates of the collectibility of our accounts receivable. Management analyzes specific customer accounts and establishes reserves for uncollectible receivables based upon specific identification of account balances that have indications of uncertainty of collection. Indications of uncertainty of collections may include the customer’s inability to pay, customer dissatisfaction, or other factors. Significant management judgments and estimates must be made and used in connection with establishing the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our losses for any period if management made different judgments or utilized different estimates.
Valuation of Inventory
We value inventory at the lower of the actual cost to purchase and/or manufacture the inventory (calculated on average costs, which approximates first-in, first-out basis) or market value. We regularly review inventory quantities on hand and record a write down of excess and obsolete inventory based primarily on excess quantities on hand based upon component usage in the preceding 12 months. As demonstrated during prior periods, demand
22
Table of Contentsfor our products can fluctuate significantly. A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand. In addition, our industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. In the future, if our inventory were determined to be overvalued, we would be required to recognize such costs in our cost of goods sold at the time of such determination. Therefore, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our operating results.
Income Taxes
We are required to estimate our provision for income taxes in each of the tax jurisdictions in which we conduct business. This process involves estimating our actual current tax expense in conjunction with the evaluation and measurement of temporary differences resulting from differing treatment of certain items for tax and accounting purposes. These temporary timing differences result in the establishment of deferred tax assets and liabilities, which are recorded on a net basis and included in our consolidated balance sheets. We then assess on a periodic basis the probability that our net deferred tax assets, if any, will be recovered. If after evaluating all of the positive and negative evidence, a conclusion is made that it is more likely than not that some portion or all of the net deferred tax assets will not be recovered, a valuation allowance is provided with a corresponding charge to tax expense to reserve the portion of the deferred tax assets which are estimated to be more likely than not to be realized.
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any required valuation allowance. During the second quarter of fiscal 2005, as a result of incurring cumulative losses for a three-year period, we established a valuation allowance totaling approximately $2.9 million, or the entire deferred tax asset balance existing as of the beginning of fiscal 2005, as reclassified. We reclassified $807,000 of reserves relating to research and experimentation credits included in the current taxes receivable as of January 31, 2004 to the net deferred tax asset upon the determination that it was more likely than not that the benefit of $807,000 would not be realized. In addition, a full valuation allowance has been provided on all net deferred tax asset additions during fiscal 2005, resulting in a fully reserved net tax asset. This valuation allowance was established based on management’s overall assessment of risks and uncertainties related to our future ability to realize, and hence, utilize certain deferred tax assets, primarily consisting of net operating losses, carry forward temporary differences and future tax deductions resulting from certain types of stock option exercises. Due to the losses of the third and fourth quarters, the adjusted net deferred tax assets remain fully reserved as of January 31, 2005.
During the third quarter of fiscal 2005, we recorded a tax benefit of $446,000 due to the generation of refund claims created upon completion of our fiscal 2004 corporate tax returns, which were completed in the third quarter of fiscal 2005.
Valuation of Goodwill
We account for goodwill and intangible assets in accordance with SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” Accordingly, we no longer amortize goodwill from acquisitions, but continue to amortize other acquisition-related intangibles and costs. As of January 31, 2005, we had $2.4 million of goodwill recorded in our audited consolidated balance sheet.
Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value generally determined using a discounted cash flow methodology applied to the particular unit. This methodology differs from our previous policy, in accordance with accounting standards existing at that time, of using undiscounted cash flows on an enterprise-wide basis to determine recoverability. During the second quarter of fiscal 2003, we recorded a non-cash charge of $4.1 million to write down fully the carrying value of the goodwill related to our EDX reporting unit. As the net assets of the EDX reporting unit were sold during the fourth quarter of fiscal 2004, such charge is reflected as a component of discontinued operations. Future impairments of intangible assets, if any, will be recorded as operating expenses.
23
Table of ContentsWe performed our annual goodwill impairment analysis at January 31, 2005 and identified no impairment. The impairment review is based upon a discounted cash flow approach that uses estimates of future market share and revenue and costs for the reporting units, as well as appropriate discount rates. The estimates used are consistent with the plans and estimates that we use to manage the underlying businesses. However, if we fail to deliver new products for these groups, if the products fail to gain expected market acceptance, or if market conditions in the related businesses are unfavorable, revenue and cost forecasts may not be achieved and we may incur charges for impairment of goodwill.
For intangible assets with definite useful lives, we amortize the cost over the estimated useful lives and assess any impairment by estimating the future cash flow from the associated asset in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” We also annually review the useful lives of each of our intangible assets. As of January 31, 2005, we had $1.5 million of non-goodwill intangible assets recorded in intangible assets, which includes $0.4 million for software rights and $1.1 million for intellectual property rights.
Valuation of Long-Lived Assets
We evaluate long-lived assets used in operations, including purchased intangible assets, when indicators of impairment, such as reductions in demand or significant economic slowdowns that negatively impact our customers or markets, are present. Reviews are performed to determine whether the carrying value of assets is impaired based on comparison to the undiscounted expected future cash flows. If the comparison indicates that there is impairment, the impaired asset is written down to fair value, which is typically calculated using a weighted average of the market approach and the discounted expected future cash flows using a discount rate based upon our cost of capital. Impairment is based on the excess of the carrying amount over the fair value of those assets. Significant management judgment is required in the forecast of future operating results that is used in the preparation of expected discounted cash flows. It is reasonably possible that the estimates of anticipated future net revenue, the remaining estimated economic life of the products and technologies, or both, could differ from those used to assess the recoverability of these assets. In that event, additional impairment charges or shortened useful lives of certain long-lived assets could be required.
Results of Operations—Continuing Operations
The following tables set forth certain items as a percentage of revenue from our audited consolidated statements of operations for fiscal 2005, 2004, and 2003:
Consolidated
24
Table of Contents
Revenue
Revenue in fiscal 2005 decreased by $5.0 million, or 15 percent, over fiscal 2004. This decrease was driven by the disruption of our ChargeSource business attributable to the changes in our distribution relationships and our relocation of manufacturing to China resulting in a $10.4 million decrease in ChargeSource revenue partially offset by a $5.7 million increase in sales of our WTS products driven by the release of our newly-developed Seven.Five product platform.
Revenue in fiscal 2004 decreased by $1.4 million, or 4 percent, over fiscal 2003. This decrease was driven by a significant decrease in spending by our emergency call box customers resulting in a $3.4 million decrease in revenue partially offset by modest revenue increases achieved by our WTS and ChargeSource businesses, of $1.1 million and $0.9 million, respectively.
Cost of Revenue and Gross Margin
25
Table of ContentsCost of revenue decreased 6 percent in fiscal 2005 compared to fiscal 2004. Due to significantly lower sales of our ChargeSource products during fiscal 2005, related cost of revenue decreased approximately $4.0 million, which was partially offset by a $3.3 million increase in cost of revenue attributable to sales of our WTS products. Gross margin in fiscal 2005 decreased 9 percentage points to 28 percent primarily due to lower sales of our ChargeSource products during fiscal 2005 and the inability to absorb fixed manufacturing and start-up costs attributable to transitioning the production of our ChargeSource products to a contract manufacturer located in China.
Cost of revenue decreased 28 percent in fiscal 2004 compared to fiscal 2003. As discussed below, cost of revenue for fiscal 2003 included a $5.6 million software development impairment charge and a $1.3 million inventory impairment charge. Gross margin in fiscal 2004 increased 21 percentage points to 37 percent due to the asset impairment charges of $6.9 million recorded in fiscal 2003. In addition to the asset impairment charges, our WTS business ceased providing engineering services during fiscal 2003, which also contributed to higher cost of revenue in fiscal 2003.
Asset Impairment Charges
During fiscal 2003, as a response to reduced demand for our legacy 2G WTS products in the wireless marketplace and our strategy of investing available resources in the development of the Seven.Five product platform, we analyzed the carrying value of all assets attributable to our WTS business. Based on this analysis, we recorded asset impairment charges totaling $12.5 million during the second quarter of fiscal 2003. The following table sets forth the impaired assets and corresponding impairment charges for fiscal 2003 (in thousands):
In addition to the asset impairment charges above, an inventory impairment charge totaling $1.3 million was recorded as cost of revenue during fiscal 2003. The above impaired assets, as well as the inventory impairment charge, were exclusively related to our legacy 2G WTS products and did not include any assets related to our engineering services business, which ceased operations during the second quarter of fiscal 2003. The exit costs associated with our exit from the engineering services business totaled approximately $0.2 million.
Operating Costs and Expenses
26
Table of ContentsSelling, general and administrative expenses decreased approximately $0.9 million, or 15 percent, in fiscal 2005 compared to fiscal 2004 primarily due to legal settlements and related fees incurred in fiscal 2004, totaling approximately $1.8 million, which exceeded similar type costs incurred in fiscal 2005 by approximately $1.4 million. Additionally, bad debt expense decreased $300,000 in fiscal 2005, primarily due to the reversal of previously established reserves for uncollectible ChargeSource accounts receivable which were collected. Offsetting the decrease in legal related expenses and bad debt expense and consistent with increased sales of our WTS products, selling related expenses increased by approximately $0.8 million in fiscal 2005 compared to fiscal 2004.
Selling, general and administrative expenses increased approximately $1.7 million or 38 percent to $6.3 million in fiscal 2004 compared to fiscal 2003. The increase was due to legal settlements and related fees in the amount of $1.8 million incurred during the first half of fiscal 2004, partially offset by reductions in other indirect costs and reduced legal fees in the third and fourth quarters of fiscal 2004.
Allocated corporate overhead consists of salaries and other personnel-related expenses of our accounting and finance, human resources and benefits, and other administrative personnel, as well as professional fees, directors’ fees, and other costs and expenses attributable to being a public company. These costs are typically allocated to our three segments based on each business’s percentage share of total Company costs and expenses. As a percentage of revenue, allocated corporate overhead has remained stable at 11 percent to 12 percent for fiscal 2005, 2004, and 2003. We expect allocated corporate overhead to increase in fiscal 2006 due to the following:
Gross engineering and support expenses generally consist of salaries, employer paid benefits, and other personnel related costs of our hardware and software design engineers and testing and product support personnel, as well as facility and IT costs, professional and consulting fees, lab costs, material usages, and travel and related costs incurred in the development and support of our products. Engineering and support expenses decreased approximately $1.1 million, or 12 percent, in fiscal 2005 compared to fiscal 2004. During the first half of fiscal 2004, our WTS business completed the development of our Seven.Five product platform. As a result, we were able to reduce our engineering and support costs in fiscal 2005.
Gross engineering and support expenses were stable for fiscal 2004 and fiscal 2003 and totaled approximately $8.6 million for both fiscal years.
We capitalize costs incurred for the development of software embedded in our WTS products subsequent to establishing technological feasibility. These capitalized costs are subject to an ongoing assessment of recoverability based on anticipated future revenue and changes in hardware and software technologies. Costs that are capitalized include direct labor and related overhead. We did not capitalize any software development costs in fiscal 2005 as we completed the development of the software embedded in our Seven.Five product platform during the first half of fiscal 2004. Currently, we do not expect to capitalize software development costs during fiscal 2006.
Capitalized software development costs totaled approximately $2.8 million and $3.8 million for fiscal 2004 and fiscal 2003, respectively, and are consistent with the timing of the Seven.Five product platform development program.
Other Income, net
Other income, net, consists primarily of interest income earned on invested cash balances. Other income, net, was $180,000, $237,000, and $375,000 in fiscal 2005, 2004, and 2003, respectively. The decline in other income is primarily caused by reduced interest income earned on declining cash balances.
27
Table of ContentsIncome Tax Expense (Benefit)
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any required valuation allowance. During the second quarter of fiscal 2005, we established a valuation allowance totaling approximately $2.9 million, or the entire deferred tax asset balance existing as of the beginning of fiscal 2005, as reclassified. In addition, a full valuation allowance has been provided on all net deferred tax asset additions during fiscal 2005, resulting in a fully reserved net tax asset. This valuation allowance was established based on management’s overall assessment of risks and uncertainties related to our future ability to realize, and hence, utilize certain deferred tax assets, primarily consisting of net operating losses, carry forward temporary differences and future tax deductions resulting from certain types of stock option exercises. Due to the losses of the third and fourth quarters, the adjusted net deferred tax assets remain fully reserved as of January 31, 2005.
During the third quarter of fiscal 2005, we recorded a tax benefit of $446,000 due to the generation of refund claims created upon completion of fiscal 2004 corporate tax returns, which were completed in the third quarter of fiscal 2005.
Wireless Test Solutions (“WTS”)
Revenue
Revenue in fiscal 2005 increased by 51 percent compared to fiscal 2004. During the first half of fiscal 2004, we completed development of our Seven.Five product platform and it was available for sale during all of fiscal 2005. Geographically, our customers in the Europe and Latin America/South America regions were furthest along in deploying 3G wireless technologies and, accordingly were the first regions to adopt the new 3G Seven.Five product platform. Revenue from our North America region declined 52 percent due to delays by wireless carriers based in the United States in deploying 3G technologies across their wireless networks.
28
Table of ContentsRevenue in fiscal 2004 increased by 11 percent over fiscal 2003. This increase was due to the availability for sale of our newly-developed Seven.Five product platform, which offset the declining demand for our legacy 2G WTS products. Additionally, fiscal 2003 revenue included approximately $0.9 million for engineering services, which we ceased offering during the second quarter of fiscal 2003.
Cost of Revenue and Gross Margin
Driven by increased sales, cost of product revenue in fiscal 2005 increased by 98 percent over fiscal 2004. As a percentage of revenue, cost of product revenue in fiscal 2005 increased by 12 percentage points to 50 percent. This increase was offset by a 13 percentage point decrease in amortization of software development costs. The fiscal 2005 increase in cost of product revenue as a percentage of revenue was due to the following factors:
Amortization of previously capitalized software development costs, which totaled approximately $2.0 million in fiscal 2005, is currently expected to be approximately $1.8 million, $1.4 million, and $0.3 million for fiscal 2006, 2007, and 2008, respectively.
Cost of revenue in fiscal 2004 decreased 48 percent over fiscal 2003. Fiscal 2003 cost of revenue included a $5.6 million software development impairment charge and a $1.3 million inventory impairment charge.
29
Table of ContentsOperating Costs and Expenses
Selling, general and administrative expenses generally consist of salaries, employer paid benefits, commissions and other personnel related costs of our sales, marketing and support personnel, facility and IT costs, professional fees, advertising, promotions, printed media, and travel directly attributable to our WTS business. Selling, general and administrative expenses as a percentage of revenue increased 5 percentage points in fiscal 2005 compared to fiscal 2004. Fiscal 2005 includes a $0.4 million charge recognized in settlement of a dispute with a significant customer based in Latin America, as well as a $0.5 million charge for uncollectible accounts receivable. There were no comparable charges in fiscal 2004. Selling, general and administrative expenses increased an additional $0.8 million, or 37 percent, driven by increased selling expenses consistent with our increased sales in fiscal 2005.
Selling, general and administrative expenses decreased approximately $0.7 million, or 25 percent, in fiscal 2004 compared to fiscal 2003. Approximately $0.4 million of the decrease is due to the elimination of engineering services and our revenue assurance product line. The remaining $0.3 million decrease is due primarily to a reduction of administrative personnel.
See the section above entitled “Consolidated” under the caption “Operating Costs and Expenses” for a discussion of allocated corporate overhead.
Gross engineering and support expenses generally consist of salaries, employer paid benefits, and other personnel related costs of our hardware and software design engineers and testing and product support personnel, as well as facility and IT costs, professional and consulting fees, lab costs, material usages, and travel and related costs incurred in the development and support of our WTS business. Engineering and support expenses decreased approximately $0.9 million, or 15 percent, in fiscal 2005 compared to fiscal 2004. As previously discussed, we completed the development of our Seven.Five product platform during the first-half of fiscal 2004 and have entered a maintenance mode with respect to the product platform. As a result, we were able to reduce our engineering and support costs in fiscal 2005 and during the fourth quarter of fiscal 2004.
Engineering and support expenses decreased approximately $0.9 million, or 14 percent, in fiscal 2004 compared to fiscal 2003 due to the completion of the development of our Seven.Five product platform during fiscal 2004.
30
Table of ContentsWe capitalize costs incurred for the development of software embedded in our WTS products subsequent to establishing technological feasibility. These capitalized costs are subject to an ongoing assessment of recoverability based on anticipated future revenue and changes in hardware and software technologies. Costs that are capitalized include direct labor and related overhead. We did not capitalize any software development costs in fiscal 2005 as we completed the development of the software embedded in our Seven.Five product platform during the first half of fiscal 2004. Currently, we do not expect to capitalize software development costs during fiscal 2006.
Capitalized software development costs totaled approximately $2.8 million and $3.8 million for fiscal 2004 and 2003, respectively, and are consistent with the timing of the Seven.Five product platform development program. The fiscal 2003 capitalized software development costs includes a $400,000 payment to SwissQual for software integrated into Seven.Five.
Emergency Call Box Systems
Revenue
Revenue in fiscal 2005 decreased by 5 percent over fiscal 2004 due to both reduced product sales and services revenue. In fiscal 2004, services were provided to specific call box systems that were in addition to the scope of their respective long-term maintenance contracts. These additional services typically consist of site mitigation, and the removal and relocation of specific call box units. Revenue for these services tends to fluctuate from year to year as evidenced by the fiscal 2005 decrease of 6 percent and the fiscal 2004 increase of 14 percent in services revenue compared to the corresponding prior fiscal years.
Revenue in fiscal 2004 decreased by 33 percent over fiscal 2003 due to reduced product sales. During fiscal 2003, we completed a Text Telephony (“TTY”) call box upgrade for the County of Orange, California, and a system expansion for the Metropolitan Transportation Commission (“MTC”) in California that contributed revenue of $2.5 million and $1.2 million, respectively. In fiscal 2004, we had no similar installation or upgrade projects.
31
Table of ContentsCost of Revenue and Gross Margin
Cost of revenue in fiscal 2005 decreased 2 percent over fiscal 2004. As a percentage of revenue, cost of product revenue in fiscal 2005 decreased by 19 percentage points to 54 percent. Fiscal 2004 cost of product revenue included a $0.2 million charge in settlement of a dispute with the Los Angeles SAFE. The remainder of the decrease in fiscal 2005 cost of product revenue is attributable to higher fixed manufacturing costs as a percentage of revenue incurred during fiscal 2004 as compared to fiscal 2005. Cost of service revenue in fiscal 2005 increased 10 percent over fiscal 2004. This increase is attributable to increased material usages and field personnel costs in fiscal 2005.
Cost of revenue in fiscal 2004 decreased 21 percent over fiscal 2003. This decrease is primarily attributable to lower product sales in fiscal 2004 partially offset by the Los Angeles SAFE settlement charge and higher fixed manufacturing costs as a percentage of revenue incurred in fiscal 2004. Cost of service revenue in fiscal 2004 increased 10 percent over fiscal 2003. This increase is attributable to increased service revenue in fiscal 2004.
32
Table of ContentsOperating Costs and Expenses
Selling, general and administrative expenses generally consist of salaries, employer paid benefits, commissions and other personnel related costs of our management, inside sales, and administrative personnel, facility and IT costs, professional fees, advertising, promotions, printed media, and travel directly attributable to our call box business. Selling, general and administrative expenses as a percentage of revenue decreased 5 percentage points in fiscal 2005 compared to fiscal 2004. Fiscal 2004 includes a charge for uncollectible accounts receivable and incremental legal fees attributable to the Los Angeles SAFE settlement, as compared to fiscal 2005, totaling approximately $0.2 million. The remainder of the decrease in fiscal 2005 was attributable to lower personnel costs.
Selling, general and administrative expenses as a percentage of revenue increased 3 percentage points in fiscal 2004 compared to fiscal 2003. Excluding the settlement charge and incremental legal fees attributable to the Los Angeles SAFE settlement incurred in fiscal 2004, selling, general and administrative expenses as a percentage of revenue in fiscal 2004 was comparable to fiscal 2003.
See the section above entitled “Consolidated” under the caption “Operating Costs and Expenses” for a discussion of allocated corporate overhead.
Gross engineering and support expenses generally consist of salaries, employer paid benefits, and other personnel related costs of our hardware and software design engineers and testing and product support personnel, as well as facility and IT costs, professional and consulting fees, lab costs, material usages, and travel and related costs incurred in the development and support of our call box business. Engineering and support expenses increased approximately $0.1 million, or 20 percent, in fiscal 2005 compared to fiscal 2004 driven by increased personnel and related costs.
Engineering and support expenses in fiscal 2004 were comparable to fiscal 2003.
33
Table of ContentsMobile Power Products (“ChargeSource”)
Revenue in fiscal 2005 decreased by 64 percent over fiscal 2004. This decrease is attributable to disruption in our business caused by the following initiatives:
While the above initiatives are well underway and designed to enhance our competitiveness in the marketplace, we expect to experience additional, yet decreasing, disruption and ramp-up delays during fiscal 2006.
Revenue in fiscal 2004 increased by 6 percent over fiscal 2003. In fiscal 2004 and in cooperation with the U.S. CPSC, we announced a voluntary product safety recall of approximately 125,000 detachable plugs used on our legacy ChargeSource 70-watt universal AC power adapter. In conjunction with the product safety recall,
34
Table of ContentsComarco and Targus, the exclusive distributor of the ChargeSource products at that time, entered into an agreement addressing the impact of the recall action. Accordingly, we accrued both a $3.2 million credit due to Targus reducing sales and additional recall costs of approximately $0.2 million classified in cost of revenue in the fourth quarter of fiscal 2003. During the third quarter of fiscal 2004 in conjunction with the expiration of the right of return and the term of the agreement, we recognized the unused portion of the credit in the amount of $1.1 million as revenue.
In the second quarter of fiscal 2004 we began shipping our high power ChargeSource products, the 120-watt AC/DC and DC adapters. The increase in ChargeSource product sales of $0.9 million includes the $1.1 million unused recall credit issued to our former distributor in conjunction with the product safety recall of our legacy ChargeSource 70-watt universal AC power adapter.
Cost of Revenue and Gross Margin
Driven by decreased sales of our ChargeSource products, cost of revenue in fiscal 2005 decreased 40 percent over fiscal 2004. As a percentage of revenue, cost of revenue in fiscal 2005 increased by 43 percentage points to 106 percent. Due to the strategic initiatives discussed above and related costs and production delays incurred during fiscal 2005, cost of revenue in fiscal 2005 exceeded revenue. Additionally, during the third quarter of fiscal 2005, we established an inventory reserve totaling approximately $0.5 million to fully reserve undelivered Belkin-branded ChargeSource products. We intend to destroy these legacy products. Once stabilized, we expect our gross margin to be comparable to prior fiscal years.
Cost of revenue in fiscal 2004 decreased by 6 percent. As a percentage of revenue, fiscal 2004 cost of revenue was 63 percent, an 8 percentage point decrease compared to fiscal 2003. The decrease in cost of revenue as a percentage of revenue was due to the $3.2 million recall credit recorded as a reduction in revenue during fiscal 2003 coupled with the $0.2 million in recall costs accrued as cost of revenue in fiscal 2003.
35
Table of ContentsOperating Costs and Expenses
Selling, general and administrative expenses generally consist of salaries, employer paid benefits, commissions and other personnel related costs of our management, sales, marketing and administrative personnel, facility and IT costs, professional fees, advertising, promotions, printed media, and travel directly attributable to our ChargeSource business. Selling, general and administrative expenses as a percentage of revenue decreased 4 percentage points in fiscal 2005 compared to fiscal 2004. Fiscal 2005 includes approximately $0.3 million in credits for the reversal of previously established reserves for uncollectible accounts receivables which were collected. Fiscal 2004 includes approximately $1.7 million in incremental legal, settlement, and related costs, in comparison to fiscal 2005. There were no comparable costs in fiscal 2005. The remaining decrease is attributable to reserves established for uncollectible accounts receivables in fiscal 2004.
Selling, general and administrative expenses as a percentage of revenue increased 16 percentage points in fiscal 2004 compared to fiscal 2003. The increase is primarily due to approximately $1.7 million in incremental legal, settlement, and related costs and reserves established for uncollectible accounts receivables totaling approximately $0.5 million. There were no comparable charges in fiscal 2003. The remaining increase is primarily attributable to sales and marketing salaries and personnel-related costs added during fiscal 2004.
See the section above entitled “Consolidated” under the caption “Operating Costs and Expenses” for a discussion of allocated corporate overhead.
Gross engineering and support expenses generally consist of salaries, employer paid benefits, and other personnel related costs of our electrical and mechanical design engineers and testing and product support personnel, as well as facility and IT costs, professional and consulting fees, lab costs, material usages, and travel and related costs incurred in the development and support of our ChargeSource business. Engineering and support expenses decreased approximately $0.3 million, or 14 percent, in fiscal 2005 compared to fiscal 2004. The decrease is primarily due to reduced use of temporary labor and outside design consultants.
Gross engineering and support expenses increased approximately $0.9 million, or 72 percent, in fiscal 2004 compared to fiscal 2003. The increase is primarily due to the addition of engineering design resources, including employees, temporary labor, and outside design consultants, in support of our high-power product development programs.
36
Table of ContentsDiscontinued Operations
On January 6, 2004, we sold the net assets of our reporting unit EDX. This reporting unit was formerly included in the wireless test solutions segment, and has been classified as discontinued operations.
Income from discontinued operations was $596,000 for fiscal 2004, which includes income from operations of $258,000 on revenue of $1.1 million, plus an after-tax gain of $319,000 on the sale of EDX. The loss from discontinued operations for fiscal 2003 was $5.2 million and included the asset impairment charges in the amount of $6.6 million to write-off the goodwill and intangible assets related to the EDX reporting unit.
Liquidity and Capital Resources
The following table is a summary of our Consolidated Statements of Cash Flows:
Operating Activities
Cash used in operating activities for fiscal 2005 was driven by a net loss from continuing operations of $10.4 million, offset by $4.5 million of non-cash charges for depreciation and amortization, $2.9 million non-cash charge to fully reserve our deferred tax asset, $0.3 million non-cash charge for doubtful accounts, and a net change in operating assets and liabilities that resulted in a $0.5 million increase in cash flow. Within the net change in operating assets and liabilities, decreased sales resulted in a decrease in accounts receivable and due from affiliate, increasing cash flow by $5.0 million, which was offset by a $2.3 million increase in inventory and a $1.7 million increase in deferred revenue.
Accounts receivable as of January 31, 2005 includes approximately $1.0 million due from Targus and its affiliates. The entire amount is currently past due. Of the $1.0 million due, $280,000 is reserved, which represents the most severely delinquent balances due from Targus Europe and Targus Australia, which have historically been more difficult for us to collect. Targus was the exclusive distributor of our ChargeSource products through January 2004, at which time they were removed as the exclusive distributor. Throughout fiscal 2005, we continued to honor our obligations under non-cancelable and non-returnable purchase orders placed by Targus and accepted by Comarco through the first quarter of fiscal 2005 in an attempt to affect an orderly wind-down of the relationship. During December 2004, Targus ceased making payments to Comarco for product shipped under an open book account.
In an effort to collect amounts owed us, on March 16, 2005, we filed a complaint against Targus seeking recovery of amounts due. While Comarco believes this action is meritorious, this matter is in the very early stages and any loss of the amounts owed to Comarco that may result from the outcome of this matter is not determinable or estimable. Should we not prevail in this matter, our anticipated cash flows from operations in fiscal 2006 will be reduced correspondingly.
Additionally, as of January 31, 2005, approximately $2.1 million of accounts receivable was due from TIM Cellular S.A., of which approximately $549,000 is reserved, which represents the most severely delinquent balances. Such amount represents 35 percent of gross accounts receivable on that date and a substantial portion became past due on March 1, 2005. As of April 25, 2005, $1.3 million of this balance has been collected.
37
Table of ContentsWe increased our inventory balance in fiscal 2005 by approximately $2.3 million in support of expected demand for all our products. As discussed above, we are transitioning the manufacturing of our ChargeSource products from in-house to a contract manufacturer located in China. In support of this effort, we have procured long-lead and other electrical components in accordance with our planned production plan. It is our current strategy to have our contract manufacturer build ChargeSource products under a turnkey model, whereby the contract manufacture procures all necessary components directly from our existing supply base and we simply procure the finished good from the contract manufacturer. We are currently transitioning to this model and have begun selling our inventory to the contract manufacturer to avoid component lead time delays. During the first quarter of fiscal 2006, we received the first purchase orders for our component inventory, totaling approximately $0.6 million, from our contract manufacturer.
Cash used in operating activities for fiscal 2004 was driven by a net loss from continuing operations of $1.8 million, offset by $5.2 million of non-cash charges for depreciation and amortization, $1.0 million non-cash income tax benefit that resulted in a decrease in cash flow, and a net change in operating assets and liabilities that resulted in a $9.3 million decrease in cash flow. Within the net change in operating assets and liabilities, increased sales in the second half of fiscal 2004 resulted in an increase in accounts receivable and due from affiliate, decreasing cash flow by $10.3 million. In fiscal 2004, we increased inventory levels to meet anticipated demand, resulting in a $2.2 million decrease in cash flow. These decreases in cash flow were offset by increases in operating liabilities of $2.7 million.
Cash Flows from Investing Activities
We purchased $1.3 million of property and equipment in fiscal 2005, compared to $1.7 million in fiscal 2004, and $2.1 million in fiscal 2003. The decrease in fiscal 2005 is primarily due to transitioning manufacturing of our ChargeSource products from in-house to a contract manufacturer located in China. Accordingly, we no longer have requirements to acquire, upgrade, and maintain ChargeSource production equipment.
The development of software is critical to our WTS products. During the first half of fiscal 2004, we completed the development of our Seven.Five product platform, which is compatible with all 2G, 2.5G, and 3G wireless technologies. During fiscal 2005 and subsequent to the completion of the development program, we transitioned into a maintenance mode. Accordingly, we capitalized no software development costs in fiscal 2005. In fiscal 2004 and 2003, we capitalized software development costs of $2.8 million and $3.8 million, respectively. Currently, we do not expect to capitalize any software development in fiscal 2006 due to the recent release of our Seven.Five product platform, a modular solution for all wireless carriers irrespective of the wireless technologies deployed by each carrier. In conjunction with the development and maintenance of Seven.Five, we expended $0.1 million, $0.5 million, and $0.5 million in fiscal 2005, 2004, and 2003, respectively, on rights to various wireless technologies.
On January 6, 2004, we sold the net assets of our EDX reporting unit for $0.6 million in cash and recognized a gain of $0.5 million.
Cash Flows from Financing Activities
Net cash provided by financing activities was $0.4 million in fiscal 2005, $0.5 million in fiscal 2004, and $0.2 million in fiscal 2003. In fiscal 2005 proceeds from the sales of common stock issued through employee and director stock option plans constituted all of our cash flows from financing activities. In fiscal 2004 and 2003 proceeds form the sales of common stock issued through employee and director stock option plans, offset by the repurchase of our common stock, constituted all of our cash flows from financing activities.
During 1992, our Board of Directors authorized a stock repurchase program of up to 3.0 million shares of our common stock. From program inception through January 31, 2004, we repurchased approximately 2.6 million shares for an average price of $8.22 per share. During fiscal 2004, we repurchased approximately 26,000 shares in the open market for an average price of $7.61 per share. During fiscal 2005, we had no stock repurchases.
38
Table of ContentsWe believe that our existing cash and cash equivalent balances will provide us sufficient funds to satisfy our cash requirements for at least the next twelve months. In addition to our cash and cash equivalent balances, we expect to derive a portion of our liquidity from our cash flows from operations. As discussed above, certain factors and events could negatively affect our cash flows from operations, including:
We are focused on preserving our cash balances by continuously monitoring expenses, identifying cost savings, and investing only in those development programs and products most likely to contribute to our profitability.
Contractual Obligations
In the course of our business operations, we incur certain commitments to make future payments under contracts such as operating leases and purchase orders. Payments under these contracts are summarized as follows as of January 31, 2005 (in thousands):
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment,” which revised SFAS No. 123, “Accounting for Stock-Based Compensation.” This statement supersedes APB Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees.” The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB No. 25, and requires that the compensation costs relating to such transactions be recognized in the consolidated statement of operations. The revised statement is effective as of the first fiscal year beginning after June 15, 2005. We will adopt the
39
Table of Contentsstatement on February 1, 2006 as required. We are allowed to select from two alternative transition methods, each having different reporting implications. We have not completed our evaluation of the methods of adopting SFAS No. 123R. Accordingly, the impact of adoption of SFAS No. 123R cannot be predicted at this time because it will depend on the method of adoption selected and on levels of share-based payments granted in the future.
In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets—an amendment of APB Opinion No. 29.” SFAS No. 153 amends the guidance in APB Opinion No. 29 (“APB No. 29”), “Accounting for Nonmonetary Transactions,” based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS No. 153 amends APB No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of SFAS No. 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The provisions of SFAS No. 153 are not expected to have a material effect on our consolidated financial statements.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs—an amendment of ARB No. 43, Chapter 4.” SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This statement requires that those items be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of SFAS No. 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are currently evaluating the effect that the adoption of SFAS No. 151 will have on our consolidated financial statements.
Currency Risk
We are exposed to the risk of changes in currency exchange rates. As of January 31, 2005, we had no material accounts receivable denominated in foreign currencies. Our standard terms require customers to pay for our products and services in U.S. dollars. For those orders denominated in foreign currencies, we may limit our exposure to losses from foreign currency transactions through forward foreign exchange contracts. To date, sales denominated in foreign currencies have not been significant and we have not entered into any foreign exchange contracts.
Interest Rate Sensitivity
The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline in value. To minimize this risk, we maintain a significant portion of our cash balances in money market funds. In general, money market funds are not subject to interest rate risk because the interest paid on such funds fluctuates with the prevailing interest rate.
We do not hold any derivative financial instruments.
Our cash and cash equivalents have maturities dates of three months or less and the fair value approximates the carrying value in our financial statements.
40
Table of ContentsEquity Price Risk
Our short-term investments consist of balances maintained in a non-qualified deferred compensation plan funded by our executives and directors. We value these investments using the closing market value for the last day of each month. These investments are subject to market price volatility. We reflect these investments on our balance sheet at their market value, with the unrealized gains and losses reflected as adjustments to both short-term investments and the deferred compensation liability. We have also invested in equity instruments of SwissQual, a privately held company. We evaluate whether any decline in value of certain public and non-public equity investments was other than temporary. We had no such impairments during fiscal 2005.
Due to the inherent risk associated with some of our investments, and in light of current stock market conditions, we may incur future losses on the sales, write-downs, or write-offs of our investments. We do not currently hedge against equity price changes.
41
Table of Contents
COMARCO, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
All other schedules are omitted because the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements or the notes thereto.
42
Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders Comarco, Inc.:
We have audited the accompanying consolidated balance sheet of Comarco, Inc. as of January 31, 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for the year ended January 31, 2005. We have also audited the fiscal 2005 information in the schedule listed in the accompanying index. These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audit.
We conducted our audit 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 consolidated financial statements and schedule are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit includes 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 Company’s 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 and schedule, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements and schedule. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Comarco, Inc. at January 31, 2005, and the consolidated results of its operations and its cash flows for the year ended January 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the fiscal 2005 information in the schedule presents fairly, in all material respects, the information set forth therein.
/s/ BDO Seidman, LLP
Costa Mesa, California March 24, 2005, except for certain major customer information in note 2 as to which the date is April 29, 2005
43
Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders Comarco, Inc.:
We have audited the consolidated balance sheet of Comarco, Inc. and subsidiaries as of January 31, 2004 and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the two-year period ended January 31, 2004. In connection with our audits of the consolidated financial statements, we also have audited the schedule of valuation and qualifying accounts for the years ended January 31, 2004 and 2003. These consolidated financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule based on our audits.
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. An audit 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 provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Comarco, Inc. and subsidiaries as of January 31, 2004 and the results of their operations and their cash flows for each of the years in the two-year period ended January 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
Costa Mesa, California May 9, 2004, except as to note 19, which is as of May 11, 2005
44
Table of ContentsCOMARCO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
45
Table of ContentsCOMARCO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
46
Table of ContentsCOMARCO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
47
Table of ContentsCOMARCO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||