UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
---- -----
Commission File No. 0-21858
INTERLINK ELECTRONICS, INC.
(Exact name of registrant as specified in its charter)
Delaware 77-0056625
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
546 Flynn Road
Camarillo, California 93012
(Address of principal executive offices) (Zip Code)
(805) 484-8855
(Registrant's telephone number, including area code)
Not applicable.
(Former name, former address and former fiscal year
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports); and (2) has been subject to such
filing requirements for the past 90 days.
Yes [_] No [X]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [_] Accelerated filer [X] Non-accelerated filer [_]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [_] No [X]
Shares of Common Stock Outstanding, at June 30, 2006: 13,774,126
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERLINK ELECTRONICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(IN THOUSANDS, EXCEPT PAR VALUE)
September December
30, 2005 31,2004(1)
-------- --------
ASSETS
Current assets:
Cash and cash equivalents ....................................... $ 5,167 $ 6,067
Short-term investments, available for sale ...................... 10,000 13,000
Accounts receivable, less allowance for doubtful accounts and
product returns of $113 and $198 at 2005 and 2004, respectively 9,850 8,249
Inventories, net of reserves of $2,476 and $412 at 2005 and
2004, respectively (see Note 1) ............................... 8,350 10,256
Prepaid expenses and other current assets ....................... 243 335
-------- --------
Total current assets .......................................... 33,610 37,907
Property and equipment, net ........................................ 1,017 1,669
Patents and trademarks, less accumulated amortization
of $1,197 and $1,144 at 2005 and 2004, respectively ............. 327 265
Other assets ....................................................... 75 107
-------- --------
Total assets ....................................................... $ 35,029 $ 39,948
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt ............................ $ 244 $ 491
Accounts payable ................................................ 4,507 5,641
Accrued payroll and related expenses ............................ 1,175 1,031
Deferred revenue ................................................ 879 188
Other accrued expenses ......................................... 685 101
-------- --------
Total current liabilities ..................................... 7,490 7,452
-------- --------
Long-term debt, net of current portion ............................. 241 405
Commitments and contingencies
Stockholders' equity:
Preferred stock, $5.00 par value (100 shares authorized,
none issued and outstanding) ................................. -- --
Common stock, $0.00001 par value (50,000 shares authorized,
13,754 and 13,676 shares issued and outstanding at
2005 and 2004, respectively) ................................. 50,738 50,413
Due from stockholders .............................................. (429) (429)
Accumulated other comprehensive loss ............................... (446) (377)
Accumulated deficit ................................................ (22,565) (17,516)
-------- --------
Total stockholders' equity .................................... 27,298 32,091
-------- --------
Total liabilities and stockholders' equity ......................... $ 35,029 $ 39,948
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
----------
(1) As restated. See Note 1 to the consolidated financial statements.
2
INTERLINK ELECTRONICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTH PERIOD NINE MONTH PERIOD
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- --------------------
2005 2004(1) 2005 2004(1)
-------- -------- -------- --------
Revenues ................................. $ 10,223 $ 9,556 $ 29,756 $ 25,724
Cost of revenues ......................... 8,931 7,468 23,389 17,319
-------- -------- -------- --------
Gross profit ............................. 1,292 2,088 6,367 8,405
Operating expenses:
Product development and research ...... 1,128 1,169 3,337 3,075
Selling, general and administrative ... 2,930 2,610 8,307 7,020
-------- -------- -------- --------
Total operating expenses ............ 4,058 3,779 11,644 10,095
-------- -------- -------- --------
Operating loss ........................... (2,766) (1,691) (5,277) (1,690)
-------- -------- -------- --------
Other income (expense):
Interest income (expense), net ........ 106 (6) 296 (37)
Other income (expense) ................ (29) (9) (67) 25
-------- -------- -------- --------
Total other income (expense) ........ 77 (15) 229 (12)
-------- -------- -------- --------
Loss before provision (benefit) for
income taxes .......................... (2,689) (1,706) (5,048) (1,702)
Provision (benefit) for income tax expense -- (16) -- 1
-------- -------- -------- --------
Net loss ................................. $ (2,689) $ (1,690) $ (5,048) $ (1,703)
======== ======== ======== ========
Loss per share - basic ................... $ (0.20) $ (0.15) $ (0.37) $ (0.15)
======== ======== ======== ========
Loss per share - diluted ................. $ (0.20) $ (0.15) $ (0.37) $ (0.15)
======== ======== ======== ========
Weighted average shares - basic .......... 13,734 11,622 13,710 11,436
======== ======== ======== ========
Weighted average shares - diluted ........ 13,734 11,622 13,710 11,436
======== ======== ======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
----------
(1) As restated. See Note 1 to the consolidated financial statements.
3
INTERLINK ELECTRONICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
Nine Month Period
Ended September 30,
--------------------
2005 2004(1)
-------- --------
Cash flows from operating activities:
Net loss .......................................... $ (5,048) $ (1,703)
Adjustments to reconcile net loss to net cash
used in operating activities:
Provision for (recovery of) allowance for
doubtful accounts receivable ............... 54 (30)
Increase in reserves for excess inventories ... 2,310 345
Stock-based compensation ...................... 106 220
Depreciation and amortization ................. 858 417
Changes in operating assets and liabilities:
Accounts receivable ......................... (1,655) 215
Prepaid expenses and other current assets ... 92 42
Inventories ................................. (405) (2,207)
Other assets ................................ 32 (74)
Accounts payable ............................ (1,135) 1,381
Deferred revenue ............................ 690 49
Accrued payroll and other accrued expenses .. 728 230
-------- --------
Net cash used in operating activities .... (3,373) (1,115)
-------- --------
Cash flows from investing activities:
Sales (purchase) of marketable securities ......... 3,000 (11,001)
Purchases of property and equipment ............... (152) (405)
Costs of patents and trademarks ................... (114) (93)
-------- --------
Net cash used in investing activities .... 2,734 (11,499)
-------- --------
Cash flows from financing activities:
Net proceeds from public stock offering ........... -- 13,168
Principal payments on debt ........................ (411) (451)
Proceeds from exercise of employee/director
stock options ................................... 220 1,811
Due from shareholders ............................. -- 86
-------- --------
Net cash provided by (used in)
financing activities ................... (191) 14,614
-------- --------
Effect of exchange rate changes on cash and cash
equivalents ....................................... (70) (28)
-------- --------
Increase (decrease) in cash and cash equivalents ....... (900) 1,972
Cash and cash equivalents:
Beginning of period ............................... 6,067 4,062
-------- --------
End of period ..................................... $ 5,167 $ 6,034
======== ========
Supplemental disclosures of cash flow information:
Interest paid ..................................... $ 17 $ 64
======== ========
Income taxes paid ................................. $ 1 $ 1
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
----------
(1) As restated. See Note 1 to the consolidated financial statements.
4
INTERLINK ELECTRONICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 (UNAUDITED)
1. BASIS OF PRESENTATION OF INTERIM FINANCIAL DATA
The financial information as of September 30, 2005, and for the three
and nine month periods ended September 30, 2005 and 2004, included in this
report, is unaudited. Such information, however, reflects all adjustments
(consisting only of normal recurring adjustments) which are, in the opinion of
management, necessary for a fair presentation of results for the interim
periods.
On November 2, 2005, the Company announced that it intended to restate
its financial results for the years ended December 31, 2003 and December 31,
2004 and the first two quarters of 2005 to reflect a matter that the Company
identified in a recent reconciliation of accounts with a key vendor in China, a
second matter related to double-counting of inventory, a third matter relating
to unrecorded licensing costs and a fourth matter relating to a balance sheet
reclassification for certain cash prepayments.
The first matter relates to a net write-off of $1.1 million of certain
receivables primarily originating in the fourth quarter of 2003, with $167,000
of that amount originating in the fourth quarter of 2002, due from a key vendor
in China and the recording of $1.0 million in payables due to that same vendor
that were not properly recorded in the Company's accounting system for the third
and fourth quarters of 2004 and the first and second quarters of 2005 in the
amounts of $249,000, $224,000, $205,000 and $331,000, respectively. The second
matter relates to the understatement of cost of sales in the second quarter of
2005 of $372,000 as a result of certain inventory components being
double-counted and thus overstated in inventory as of June 30, 2005. The third
matter relates to an understatement of cost of sales in the first and second
quarters of 2005 of $51,000 and $565,000, respectively, as a result of certain
licensing charges that were not properly recorded in cost of sales and
inventory. The fourth matter relates to a balance sheet reclassification of $1.3
million in cash payments made by a customer during the second and fourth
quarters of 2004 as well as the first and second quarters of 2005 in advance of
future shipments of product. These payments were incorrectly applied against
accounts receivable rather than recorded as deferred revenue. The cash
prepayments have been properly reclassified to deferred revenue.
On March 30, 2006, the Company announced that it had discovered two
additional discrepancies in its historical financial statements. The first
matter relates to accounting for stock options of terminated employees and
resulted in an unrecorded, non-cash expense of $2.4 million in 2001, $220,000 in
2004 and $108,000 in 2005, $106,000 of which was in the first nine months of
2005. The second matter relates to overstated valuation of certain inventory in
transit between the parent company and its Hong Kong subsidiary as of December
31, 2004. This matter resulted in the understatement of cost of sales of
$837,000 in 2004, none of which was in the first nine months of 2004, and an
overstatement of cost of sales of $748,000 in 2005, $441,000 of which was in the
first nine months of 2005, for a net increase in cost of sales of $89,000.
In November 2005, the Company's audit committee began an internal
investigation into the matters disclosed in the November 2, 2005 announcement.
In connection with the restatement issues identified in November the audit
committee hired outside legal counsel to conduct an internal investigation. They
in turn retained the services of an independent accounting firm to assist with
various forensic accounting and electronic procedures performed in the course of
the investigation.
For the items discovered subsequent to the November 2005 announcement,
the Committee, seeing no evidence suggesting the involvement of any current
employees, instructed senior company management and outside legal counsel to
conduct investigations into these matters.
Based on the findings of the independent and company investigations, as
well as senior management's evaluation of the effectiveness of the design and
operation of the company's controls and procedures, the Committee determined
that inadequate internal controls contributed to the restatement issues. The
primary control deficiencies are identified on pages 27 to 29 of this Form 10-Q.
5
The information included herein reflects the restatements discussed
above and should be read in conjunction with the consolidated financial
statements and the related notes, as restated, which are included in our Annual
Report on Form 10-K for the year ended December 31, 2005, which is being filed
concurrently with this Report.
The results of operations for the interim periods presented are not
necessarily indicative of the results to be expected for the full year.
2. SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION. The Company recognizes revenue in accordance with
SEC Staff Accounting Bulletin ("SAB") No. 104, "Revenue Recognition." SAB No.
104 requires that four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred or services rendered; (3) the fee is fixed and determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4)
require management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
To satisfy the criteria, the Company: (1) inputs orders based upon receipt of a
customer purchase order; (2) records revenue upon shipment of goods and when
risk of loss and title has transferred; (3) confirms pricing through the
customer purchase order; and (4) validates creditworthiness through past payment
history, credit agency reports and other financial data. All customers have
warranty rights and some customers also have explicit or implicit rights of
return. We comply with Statement of Financial Accounting Standards No. 48 with
respect to sell-through and returns and the related recording of revenues for
potential customer returns. Should changes in conditions cause management to
determine the revenue recognition criteria are not met for certain future
transactions, such as a determination that collectibility was not reasonably
assured, revenue recognized for any reporting period could be adversely
affected.
ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS. The Company's
accounts receivable are unsecured, and are at risk to the extent such amounts
become uncollectible. The Company continually monitors individual account
receivable balances, and provides for an allowance of doubtful accounts at the
time collection may become questionable based on payment performance or age of
the receivable and other factors related to the customer's ability to pay.
RESERVE FOR ESTIMATED PRODUCT RETURNS. While not an explicit part of
the Company's terms and conditions of product sales except for some customers,
it does, on a discretionary basis, grant product exchanges for its distribution
and reseller customers in its branded business communications market for similar
products of equal value if these exchanges meet certain other criteria. The
Company estimates future product returns based on recent return history,
inventory status and product "sell-through" statistics received from its major
distributors, discussions regarding product sales activity with its major
reseller customers, and current industry product and technology trends.
Management judgment is required in evaluating the relative significance of the
aforementioned data and in the determination of the estimated value of the
returns reserve. If actual returns are greater than management's estimate then
revenues in the subsequent period will be adversely affected.
INVENTORY RESERVE. At each balance sheet date, the Company evaluates
its ending inventories for excess quantities and obsolescence. This evaluation
includes analyses of forecast sales levels by product and historical demand. The
Company writes off inventories that are considered obsolete. Remaining inventory
balances are adjusted to approximate the lower of our cost or market value and
result in a new cost basis in such inventory until sold. If future demand or
market conditions are less favorable than projections, additional inventory
write-downs may be required, and would be reflected in cost of sales in the
period the revision is made. Based on lowered expectations for future demand in
the Business Communications-OEM segment as well as limitations on the use of
certain restricted raw materials prompted by early adoption of the Restriction
of Hazardous Substances Act of 2002 by many of our customers, we increased our
reserve for excess and obsolete inventory by approximately $1.9 million in the
third quarter of 2005. The reserve is discussed in detail in the BUSINESS
SEGMENT OVERVIEW under Business Communications.
6
PROVISION FOR INCOME TAX. As part of the process of preparing the
Company's financial statements, as required by Statement of Financial Accounting
Standards ("SFAS") No. 109, the Company is required to estimate its income taxes
in each of the jurisdictions in which it operates. This process involves
estimating the Company's actual current tax exposure together with assessing
temporary differences resulting from differing treatment of items for tax and
accounting purposes. These differences result in deferred tax assets and
liabilities, which are included in the Company's balance sheet. The Company must
then assess the likelihood that its deferred tax assets will be recovered from
future taxable income and to the extent the Company believes that recovery is
not likely, it must establish a valuation reserve. To the extent the Company
establishes a reserve or increases this reserve in a period, it must include an
expense within the tax provision in the statements of operations.
Significant management judgment is required in determining the
Company's provision for income taxes, deferred tax asset and liabilities and any
valuation reserve recorded against the Company's net deferred tax assets.
Management continually evaluates its deferred tax asset as to whether it is
likely that the deferred tax asset will be realized.
Based on historical and prospective evidence, the Company has concluded
that it did not have sufficient evidence to be able to recognize any of its net
tax assets, primarily its net operating loss (NOL) carryforward benefits as
assets and thus it has recorded a 100% valuation allowance against the Company's
net deferred tax asset balance. If the Company achieves profitable operations in
the future, it will reevaluate its deferred tax asset balance and may reduce or
eliminate the valuation allowance.
As of December 31, 2004, the Company had NOL carryforwards for federal,
state and foreign income tax purposes of $36.5 million, $18.8 million and $2.4
million, respectively, which are available to offset future taxable income in
those jurisdictions through 2024.
FOREIGN EXCHANGE EXPOSURE. The Company has established relationships
with most of the major OEMs in the business communications market. Many of these
OEMs are based in Japan and approximately 21%, 28% and 23% of the Company's
revenues for the first nine months of 2005 and the years 2004 and 2003,
respectively, came from Japanese customers. Revenues from these customers are
denominated in Japanese yen and as a result the Company is subject to foreign
currency exchange rate fluctuations in the yen/dollar exchange rate. From time
to time, the Company uses foreign currency forward and average rate option
contracts to hedge this exposure. The Company uses revenue forecasts from its
Japanese subsidiary to determine the amount of forward or option contracts to
purchase and the Company attempts to enter into these contracts when it believes
the yen value is relatively strong against the U.S. dollar. To the extent that
the Company's revenue forecast may be inaccurate or the timing of forecasting
the yen's strength is wrong, the Company's actual hedge gains or losses may not
necessarily correlate with the effect of foreign currency rate fluctuations on
its revenues. The Company marks these contracts to market value and the gain or
loss from these contracts is recorded in business communications revenue. These
hedge transactions are classified as economic hedges and do not qualify for
hedge accounting under Statement of Financial Accounting Standards No. 133. In
addition, because the Company's Japanese subsidiary's functional currency is the
yen, the translation of the net assets of that subsidiary into the consolidated
results will fluctuate with the yen/dollar exchange rate.
The following table illustrates the impact of foreign currency
fluctuations on the Company's yen-denominated revenues and the effectiveness of
its foreign currency hedging activity (in thousands).
Nine Months
Ended September 30,
----------------
2005 2004
----- -----
Increase (decrease) in revenues resulting from
foreign currency fluctuations ....................... $ 118 $(116)
Hedging gains ........................................... 39 127
----- -----
Net revenue impact .............................. $ 157 $ 11
===== =====
The Company calculates the "increase (decrease) in revenues resulting
from foreign currency fluctuations" by calculating the U.S. dollar equivalent of
its yen-denominated revenues using the yen/dollar
7
exchange rate at the beginning of the period. The resulting product is compared
to the Company's yen-denominated revenues converted to U.S. dollars according to
GAAP and the difference is shown in the table above.
STOCK-BASED COMPENSATION. The Company applies Accounting Principles
Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and
related interpretations in accounting for its 1996 Stock Incentive Plan, as
amended (the "Plan"). Accordingly, no compensation cost has been recognized for
the Plan. Had compensation cost for the Plan been determined based on the fair
value at the grant dates for awards under the Plan consistent with the method of
SFAS No. 123R, "Accounting for Stock-Based Compensation," the Company would have
recorded stock-based compensation expense as follows (in thousands, except per
share information):
Nine Months
Ended September 30,
------------------
2005 2004(1)
------- -------
Net loss - as reported................................. $(5,048) $(1,703)
Stock-based compensation expense included in
reported net loss, net of related tax effects....... 106 220
Total stock-based compensation expense determined under
net of related tax fair value based method
for all awards, effects............................. (2,373) (1,914)
------- -------
Net loss - pro forma................. $(7,315) $(3,397)
======= =======
Basic and diluted loss per share - as reported....... $ (0.37) $ (0.15)
- pro forma ......................... (0.53) (0.30)
(1) As restated. See Note 1.
The weighted average fair value at the date of grant for stock options
granted during the nine months ended September 30, 2005 and 2004 was $4.21 and
$5.08 per option, respectively. The fair value of options at the date of grant
was estimated using the Black-Scholes model with the following weighted average
assumptions:
Nine Months
Ended
September 30,
-------------
2005 2004
----- -----
Expected life (years) 3 4
Interest rate ....... 3.4% 3.0%
Volatility .......... 114% 69%
Dividend yield ...... 0% 0%
3. EARNINGS PER SHARE
For all periods presented, per share information was computed pursuant
to provisions of the Statement of Financial Accounting Standards ("SFAS") No.
128, "Earnings Per Share," issued by the Financial Accounting Standards Board
("FASB"). The computation of earnings per share--basic is based upon the
weighted average number of common shares outstanding during the periods
presented. Earnings per share--diluted also include the effect of common shares
contingently issuable from options and warrants in periods in which they have a
dilutive effect.
Common stock equivalents are calculated using the treasury stock
method. Under the treasury stock method, the proceeds from the assumed
conversion of options and warrants are used to repurchase outstanding shares
using the average market price for the period.
8
The following table contains information necessary to calculate
earnings per share (in thousands):
Three Month Nine Months
Ended Ended
September 30, September 30,
--------------- ---------------
2005 2004 2005 2004
------ ------ ------ ------
Weighted average shares outstanding - basic 13,734 11,622 13,710 11,436
Effect of dilutive securities
(employee/director stock options) ........ --(1) --(1) --(1) --(1)
------ ------ ------ ------
Weighted average shares - diluted .......... 13,734 11,622 13,710 11,436
====== ====== ====== ======
(1) Due to the net loss for the three and nine month periods ended
September 30, 2005 and 2004 respectively, the diluted share calculation result
was anti-dilutive. Thus, the basic weighted average shares were used and shares
of common stock equivalents of approximately 4.1 million and 3.6 million shares
for 2005 and 2004, respectively, were excluded from the calculations.
4. LINE OF CREDIT
At September 30, 2005, the Company had a $3.0 million bank line of
credit which was secured by cash investments at the bank. The line was unused at
September 30, 2005. In May 2006, the Company terminated the line of credit.
5. COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS - On November 15, 2005, a class action alleging
violations of federal securities laws was filed against the Company and two of
its current and former officers in the United States District Court for the
Central District of California. The complaint alleges that, between April 24,
2003 and November 1, 2005, the Company and two of its current and former
officers made false and misleading statements and failed to disclose material
information regarding the Company's results of operations and financial
condition. The complaint includes claims under the Securities Act and Exchange
Act and seeks unspecified damages and legal expenses.
To date, the Court has not certified a class, and the litigation
remains in its early stages.
On January 24, 2006, a shareholder's derivative action was filed
against two of the Company's current and former officers and the members of its
Board of Directors in the Central District of California. The derivative
complaint contains the same factual allegations as the class action complaint
and sought to recover unspecified damages from the defendants, as well as
forfeiture of their equity-based compensation and contribution from them in the
event that the Company is found to have violated the federal securities laws.
Following a motion made by the defendants to dismiss, or in the alternative,
stay the derivative action, the plaintiff voluntarily dismissed the derivative
action without prejudice on June 14, 2006.
In connection with the class action and the derivative proceedings
described above, an independent investigation was undertaken at the direction of
the Audit Committee by Dorsey & Whitney, LLP. Dorsey & Whitney retained the
services of PricewaterhouseCoopers LLP with respect to various forensic
accounting and electronic procedures performed in the course of the
investigation. Related to this internal investigation, the Company has recorded
approximately $147,000 in expense for 2005 and $690,000 in expense for 2006 to
date for amounts not covered by insurance.
In connection with the class action proceeding, the Company has
recorded approximately $127,000 in expense for 2006 to date for amounts not
covered by insurance.
Other than the amounts described above, the Company cannot estimate the
possible loss or range of loss, if any, associated with the resolution of the
class action and derivative proceedings. While it intends to vigorously defend
against these allegations, the Company cannot predict the final disposition of
these matters or whether the Company will be liable for amounts not covered by
insurance. There is no
9
assurance, however, that the ultimate resolution of these matters will not
result in a material adverse effect on the Company's business, financial
condition or results of operations.
In addition to the matters identified above, from time to time, the Company is
involved in various legal actions that arise in the ordinary course of business.
6. COMPREHENSIVE INCOME (LOSS)
The following table provides the data required to calculate
comprehensive loss in thousands:
Accumulated
Other
Comprehensive Comprehensive
Loss Loss
---------- ----------
Balance at December 31, 2003 .............. $ (391)
Translation adjustment .................... (28) $ (28)
Net loss (1) .............................. (1,703)
---------- ----------
Balance at September 30, 2004 ............. $ (419) $ (1,731)
========== ==========
Balance at December 31, 2004 .............. $ (377)
Translation adjustment .................... (70) $ (70)
Net loss .................................. (5,048)
---------- ----------
Balance at September 30, 2005 ............. $ (447) $ (5,118)
========== ==========
(1) As restated. See Note 1.
7. SEGMENT INFORMATION
The Company has four business segments: (i) business communications;
(ii) home entertainment; (iii) e-transactions; and (iv) specialty components.
The accounting policies of the segments are the same as those described in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Application of Critical Accounting Policies and Estimates";
however, the Company evaluates performance based on revenue and gross profit.
The Company does not allocate any other income, expenses or assets to these
segments nor does it track revenue by product. Reportable segment information
for the nine months ended September 30, 2005 and 2004 is as follows (in
thousands):
BUSINESS HOME E- SPECIALTY
COMMUNICATIONS ENTERTAINMENT TRANSACTIONS COMPONENTS TOTAL
-------------- -------------- -------------- -------------- --------------
NINE MONTHS ENDED:
September 30, 2005
Revenue .................... $ 14,390 $ 4,630 $ 6,480 $ 4,256 $ 29,756
Gross profit ............... 1,407 821 2,180 1,959 6,367
September 30, 2004(1)
Revenue .................... $ 15,399 $ 2,650 $ 4,008 $ 3,667 $ 25,724
Gross profit ............... 4,495 (600) 2,205 2,305 8,405
(1) As restated. See Note 1
The Business Communications business segment consists of branded and
OEM products. Beginning in the fourth quarter of 2005, the Company will combine
its Business Communications OEM and Home Entertainment segments. As a result,
the Business Communications segment will consist of Branded products only.
10
GEOGRAPHIC INFORMATION--The Company attributes revenues to different
geographic areas on the basis of the location of the customer. The Company's
revenues and long-lived assets by geographic area for the nine months ended and
as of September 30, 2005 are as follows (in thousands):
NINE MONTHS ENDED AND AS OF
SEPTEMBER 30,
-----------------------------------------------
2005 2004
--------------------- ---------------------
LONG LONG
LIVED LIVED
REVENUES ASSETS REVENUES ASSETS
-------- -------- -------- --------
United States .............. $ 12,381 $ 1,158 $ 8,925 $ 869
Japan ...................... 6,302 125 7,676 584
Asia (other than Japan) .... 7,333 61 5,278 75
Europe and other ........... 3,740 -- 3,845 --
-------- -------- -------- --------
$ 29,756 $ 1,344 $ 25,724 $ 1,528
======== ======== ======== ========
MAJOR CUSTOMERS-- In the first nine months of 2005 and 2004, no single
customer exceeded 10% of total revenues. Two customers accounted for 19% and 10%
of the accounts receivable at September 30, 2005 and one customer accounted for
16% of the accounts receivable at September 30, 2004.
8. INVENTORIES
Net inventories consisted of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2005 2004(1)
---------- ----------
Raw material ........................... $ 4,332 $ 5,217
Work in process ........................ 1,695 1,908
Finished goods ......................... 4,799 3,543
Reserve for excess and
obsolete inventory ................... (2,476) (412)
---------- ----------
Total inventories ...................... $ 8,350 $ 10,256
========== ==========
(1) As restated. See Note 1.
9. STOCK OPTIONS
Under the terms of the Plan, officers and key employees may be granted
non-qualified or incentive stock options and outside directors and independent
contractors of the Company may be granted non-qualified stock options. The
aggregate number of shares which may be issued under the Plan is 7,250,000. New
options are granted at fair market value on the date of grant and generally vest
ratably over 36 months and have a ten-year term but terminate earlier if
employment is terminated. As of September 30, 2005, options for 6,827,000 shares
of stock have been granted (4,062,000 are outstanding and 2,765,000 have been
exercised, forfeited or expired) and there were 423,000 options available for
grant.
In 2006, the Company determined it had improperly accounted for stock
option exercises of certain terminated employees during 2001 through 2005. When
the Company was in an internally defined blackout period, it allowed terminated
employees to extend their stock option exercise privileges beyond the Plan's
stated 30 days. The Company evaluated all stock options that have been exercised
from 2001 through 2005 and determined who exercised stock options beyond the
30-day period as specified in the Plan. It was determined that the termination
date constituted a re-measurement date, as defined under stock option accounting
rules which require a revaluation of any stock options that were given this
benefit.
The amount of expense related to certain stock options exercised after
the 30-day period was $2,400,000 in 2001, $220,000 in 2004 and $106,000 for the
nine months ended September 30, 2005. These amounts are reflected in our
financial statements in the appropriate periods.
11
Activity under the Plan for the first nine months of 2005 is summarized
as follows (in thousands, except per share information):
Wgt. Avg.
Exercise
Options Price
-------- --------
Outstanding - beginning of period ................ 3,563 $ 6.08
Granted .......................................... 812 5.89
Exercised ........................................ (78) 2.81
Forfeited or expired ............................. (235) 8.26
--------
Outstanding - end of period ...................... 4,062 5.98
========
Exercisable - end of period ...................... 2,739 5.43
========
The following table summarizes information about stock options
outstanding under the Plan as of September 30, 2005 (in thousands, except
contractual life and exercise price per share information):
Months
Remaining
Exercise # of On
Price Per Options Contractual Options Options
Share Outstanding Life Exercisable Un-exercisable
------------- ------------- ------------- ------------- ------------------
$2.40 382 13 382 0
------------- ------------- ------------- ------------- ------------------
2.70 42 30 36 6
------------- ------------- ------------- ------------- ------------------
2.94 454 29 454 0
------------- ------------- ------------- ------------- ------------------
3.04 39 24 39 0
------------- ------------- ------------- ------------- ------------------
3.30 5 29 4 1
------------- ------------- ------------- ------------- ------------------
3.54 3 17 3 0
------------- ------------- ------------- ------------- ------------------
4.30 14 27 13 1
------------- ------------- ------------- ------------- ------------------
4.42 276 15 276 0
------------- ------------- ------------- ------------- ------------------
5.49 12 119 1 11
------------- ------------- ------------- ------------- ------------------
5.50 13 1 13 0
------------- ------------- ------------- ------------- ------------------
5.51 80 7 80 0
------------- ------------- ------------- ------------- ------------------
5.56 7 117 1 6
------------- ------------- ------------- ------------- ------------------
5.65 15 33 8 7
------------- ------------- ------------- ------------- ------------------
5.70 500 117 56 444
------------- ------------- ------------- ------------- ------------------
6.14 18 115 3 15
------------ ------------- ------------- ------------- ------------------
6.15 252 115 42 210
------------- ------------- ------------- ------------- ------------------
6.45 462 38 295 167
------------- ------------- ------------- ------------- ------------------
6.87 659 5 659 0
------------- ------------- ------------- ------------- ------------------
7.54 31 36 21 10
------------- ------------- ------------- ------------- ------------------
7.82 13 113 3 10
------------- ------------- ------------- ------------- ------------------
7.98 5 110 2 3
------------- ------------- ------------- ------------- ------------------
9.40 742 105 328 414
------------- ------------- ------------- ------------- ------------------
10.60 38 42 20 18
------------- ------------- ------------- ------------- ------------------
Total 4,062 2,739 1,323
------------- ------------- ------------- ------------- ------------------
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
We develop, manufacture, market and sell intuitive interface devices
and components for a variety of business and home applications. We generate
revenues from the sale of our hardware products, such as force sensing resistor
("FSR") sensors, FSR-based subassemblies and complete advanced input device
products. To a lesser extent, we derive revenue from the sale of software
combined with our hardware. Depending on the application, this software may be
internally developed or purchased from software partners.
We record our revenue in four different market segments: business
communications (wireless intuitive input device products addressing the
presentation market); home entertainment (wireless intuitive input device and
sensor products addressing the advanced TV viewing and home video game markets);
e-transactions (input devices for the electronic signature markets); and
specialty components (custom FSR-based sensors, subassemblies and complete
products for a variety of vertical markets). We have addressed our specialty
components market since our inception in 1985. Our other three markets have
evolved out of our specialty components market. We have addressed our business
communications market as a separate market since 1994, our e-transactions market
since 1999 and our home entertainment market since 2000. The relative revenue
and gross profit contributions of each of these segments is provided below in
BUSINESS SEGMENT OVERVIEW - THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005
COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004.
Our business communications business segment is divided into two sub
segments - the Business Communication OEM segment and the Branded segment.
Effective October 1, 2005, the Company will combine its Home Entertainment and
Business Communications OEM business segments. This new segment will be called
the OEM Remote Controls business segment. The Company will begin reporting for
this segment beginning with the results of operations for the fourth quarter of
2005 and thereafter.
QUARTERLY FINANCIAL PERFORMANCE
The following table presents certain financial information for each of
the following quarters:
QUARTER ENDED (UNAUDITED)
(in thousands, except per share data)
SEP. JUN. MAR. DEC. SEP. JUN. MAR. DEC. SEP.
30, 30, 31, 31, 30, 30, 31, 31, 30,
2005 2005(1) 2005(1) 2004(1) 2004(1) 2004(1) 2004(1) 2003(1) 2003
---------------- --------- ---------- --------- --------- --------- --------- ---------- -------- --------
Revenues $10,223 $10,263 $ 9,269 $ 9,682 $ 9,556 $ 8,232 $ 7,936 $ 8,716 $ 7,848
---------------- --------- ---------- --------- --------- --------- --------- ---------- -------- --------
Gross profit $1,292 $ 1,819 $ 3,256 $ 2,190 $ 2,088 $ 3,183 $ 3,134 $ 2,025 $ 3,285
---------------- --------- ---------- --------- --------- --------- --------- ---------- -------- --------
Net income
(loss) $(2,689) $ (1,961) $ (398) $(2,067) $(1,690) $ (78) $ 66 $ (907) $ 238
---------------- --------- ---------- --------- --------- --------- --------- ---------- -------- --------
Earnings
(loss) per $ (0.20) $ (0.14) $ (0.03) $ (0.15) $ (0.15) $ (0.01) $ 0.01 $ (0.08) $ 0.02
share - basic
---------------- --------- ---------- --------- --------- --------- --------- ---------- -------- --------
Earnings
(loss) per $ (0.20) $ (0.14) $ (0.03) $ (0.15) $ (0.15) $ (0.01) $ 0.01 $ (0.08) $0.02
share - diluted
---------------- --------- ---------- --------- --------- --------- --------- ---------- -------- --------
(1) As restated. See Note 1 to the consolidated financial statements.
13
Quarterly revenues have increased by 30% on a cumulative basis since
the third quarter of 2003. Revenues have grown relatively constantly over the
past nine quarters, with a decline in sequential revenues occurring in the first
quarter of 2004 and the first and third quarters of 2005. Earnings have
fluctuated over the previous nine quarters with losses being incurred over the
previous five quarters as a result of various factors, including fluctuating
quarterly sales levels due to market conditions and customer ordering patterns,
increases in operating costs, inventory reserve adjustments and increased
compliance and regulatory costs.
On March 9, 2005, we reported the restatement of our financial
statements for the first three quarters of 2004. The restatements were due to a
misinterpretation of the revenue recognition guidelines regarding a "bill and
hold" product sale in the first quarter of 2004. The resulting restatements
decreased revenues in the first quarter of 2004 by $498,000 and increased
revenues by $74,000 and $114,000 in the second and third quarters of 2004,
respectively. Gross profit and net income were reduced in the first quarter of
2004 by $218,000 and increased by $33,000 and $50,000 in the second and third
quarters of 2004, respectively. Also, in the third quarter of 2004, our product
costing system underestimated the initial costs and low yields of starting up
our high volume home entertainment remote control business and overstated
inventory and the amount of manufacturing overhead allocable to inventory. The
resulting restatement increased cost of sales and decreased inventory by $1.2
million in the third quarter of 2004.
On November 2, 2005, we reported our intention to make additional
restatements to our financial information for the years ended December 31, 2003
and December 31, 2004 and the first two quarters of 2005. The additional
restatements reflect adjustments to correctly account for the following four
items:
o The first item involves a key vendor in China and was
identified in a recent reconciliation of accounts with that
vendor. This matter relates to a net write-off of $1.1 million
of certain receivables primarily originating in the fourth
quarter of 2003, with $167,000 of that amount originating in
the fourth quarter of 2002, due from the vendor and the
recording of $1.0 million in payables due to that same vendor
that were not properly recorded in the Company's accounting
system for the third and fourth quarters of 2004 and the first
and second quarters of 2005.
o The second item relates to the understatement of cost of sales
in the second quarter of 2005 of $372,000 as a result of
certain inventory components being double-counted and thus
overstated in inventory as of June 30, 2005.
o The third item relates to the understatement of cost of sales
in the first and second quarters of 2005 totaling $616,000 as
a result of certain licensing charges that were not properly
recorded in cost of sales and inventory.
o The fourth item relates to a balance sheet reclassification of
$1.3 million in cash payments made by a customer during the
second and fourth quarters of 2004 as well as the first and
second quarters of 2005 in advance of future shipments of
product. These payments were incorrectly applied against
accounts receivable rather than recorded as deferred revenue.
The cash prepayments have been properly reclassified to
deferred revenue.
These additional restatements reduced stockholders' equity by an
aggregate $2.9 million and affected prior periods as follows:
o Gross profit and net income for the fourth quarter of 2003
were each reduced by $1.3 million, to a gross profit of $11.4
million and net loss of $248,000.
o For the third quarter of 2004, gross profit was reduced by
$249,000 to $2.1 million and our net loss increased by
$249,000 to $1.7 million.
o For the fourth quarter of 2004, gross profit was reduced by
$178,000 to $3.0 million and our net loss increased by
$178,000 to $1.2 million.
14
o For the first quarter of 2005, gross profit was reduced by
$238,000 to $2.5 million and our net loss increased by
$238,000 to $1.1 million.
o For the second quarter of 2005, gross profit was reduced by
$945,000 to $2.4 million and our net loss increased by
$945,000 to $1.3 million.
On March 30, 2006, we reported the discovery of two additional
discrepancies to the Company's historical financial statements. The
discrepancies affect financial information for the years ended December 31,
2001, December 31, 2004 and December 31, 2005. These additional restatements
reflect adjustments to correctly account for the following two items:
o The first item was discovered during the 2005 year-end audit
process and involves accounting for stock options exercised by
terminated employees whose termination coincided with a black
out period. The Company extended the terminated employees'
time to exercise stock options to 30 days after the black out
period as opposed to 30 days after termination as stated in
the terms of the Company's stock option plan. This treatment
results in a re-measurement date as defined under stock option
accounting rules, which require a revaluation of any stock
options that were given this benefit. The extension of time to
exercise resulted in additional non-cash expense of $2.4
million for 2001, $220,000 for 2004 and $108,000 for 2005,
$106,000 of which was in the first nine months of 2005, that
due to an error were not recorded in the Company's accounting
system.
o The second item relates to an error resulting in the
understatement of cost of sales of $837,000 in 2004, none of
which was in the first nine months of 2004, and the
overstatement of cost of sales of $748,000 in 2005, $441,000
of which was in the first nine months of 2005, as a result of
certain inventory in transit from the parent company to its
Hong Kong subsidiary being overvalued at December 31, 2004.
These additional restatements reduced stockholders' equity by an
aggregate $2.8 million and affected prior periods as follows:
o Our net loss for 2001 increased by $2.4 million, to a net loss
of $4.4 million.
o Gross profit for 2004 was reduced by $837,000 to a gross
profit of $10.6 million and our net loss for 2004 increased by
$1 million, to a net loss of $3.8 million. There was no effect
on the first nine months of 2004.
o For the first nine months of 2005, gross profit was increased
by $441,000 to a gross profit of $6.4 million and our net loss
decreased by $335,000 to a net loss of $5.0 million. Gross
profit for the year ended December 31, 2005 was increased by
$748,000 to a gross profit of $8.1 million and our net loss
decreased by $640,000 to a net loss of $8.3 million.
CURRENT OPPORTUNITIES AND CHALLENGES
A considerable portion of our effort is directed at emerging markets,
such as our e-transactions market where our success depends on our ability to
accurately forecast the nature, amount and timing of market requirements in an
environment in which historical precedent is limited or non-existent. We rely on
information generated by our internal staff and industry partners and on
independent market studies for forecasts of market demand in our focus areas,
but these studies are themselves based on limited empirical data. An inaccurate
forecast of market demand in any of our core market areas would impact our
short-term performance and could impact our competitive position and, therefore,
our long-term performance.
Our quarterly results are often affected by volatility in orders for a
particular product. For example, sales of remote controls constitute a
significant source of revenue, but are substantially dependent on advanced TV
sales that we cannot control or accurately forecast. Similarly, sales to large
institutions of
15
our e-transactions products typically come in relatively large orders that can
be one-time events or can occur at widely-dispersed intervals.
Other factors that could cause our estimates to be wrong or could
result in trends that are not apparent from our financial statements are
described under "Risk Factors" in our Annual Report on Form 10-K for the fiscal
year ended December 31, 2004 and in Part II below.
Management faces the constant challenge of balancing its investment in
new technology, product development and marketing initiatives against the
objective of steady earnings growth. A decision to make a significant investment
in a new technology, product or marketing effort may have a short-to-medium term
negative impact on earnings even if the investment proves to be justified.
Because we intend to pursue a growth strategy, it is probable that we will make
investments in new business opportunities that will increase operating costs,
decrease margins and negatively impact earnings until the investment produces
significant revenue growth.
We expect to use cash in the future to support growth through the
purchase of new technologies or businesses and through internal technology,
product and market development efforts. We expect to generate cash from existing
operations and, depending on actual cash requirements, may seek to obtain cash
from commercial borrowing and/or additional sales of securities.
16
BUSINESS SEGMENT OVERVIEW - THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005
COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004
For the three and nine months ended September 30, 2005 and 2004,
revenue and gross profit by market segment are shown in the following table:
Three Months Three Months Nine Months Nine Months
Ended Sept. 30, Ended Sept. 30, Ended Sept. 30, Ended Sept. 30,
2005 2004(1) 2005 2004 (1)
------------------------ ---------------------- --------------------- --------------------
PERCENT PERCENT PERCENT PERCENT
T OF TOTAL OF TOTAL OF TOTAL OF TOTAL
MARKET SEGMENT $000'S SALES $000'S SALES $000'S SALES $000'S SALES
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
Business Communications:
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Revenue $5,229 51% $5,679 59% $14,390 48% $15,399 60%
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit (978) 1,537 1,407 4,495
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit % of (19)% 27% 10% 29%
Segment Revenue
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
Home Entertainment:
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Revenue $728 7% $1,427 15% $4,630 16% $2,650 10%
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit 70 (821) 821 (600)
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit % of 10% (58)% 18% (23)%
Segment Revenue
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
E-Transactions:
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Revenue $3,124 31% $1,069 11% $6,480 22% $4,008 16%
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit 1,688 501 2,180 2,205
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit % of 54% 47% 34% 55%
Segment Revenue
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
Specialty Components:
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
-Revenue $1,142 11% $1,381 15% $4,256 14% $3,667 14%
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
-Gross Profit 512 871 1,959 2,305
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
-Gross Profit % of 45% 63% 46% 63%
Segment Revenue
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
All Segments:
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Revenue $10,223 100% $9,556 100% $29,756 100% $25,724 100%
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit 1,292 2,088 6,367 8,405
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
- Gross Profit % 13% 22% 21% 33%
------------------------- ---------- ------------- ---------- ----------- ---------- ---------- --------- ----------
----------
(1) As restated. See Note 1 to the consolidated financial statements.
17
BUSINESS COMMUNICATIONS
In our business communications segment, we sell wireless remote
controls on an OEM basis to the leading manufacturers of presentation
projectors. We also sell Interlink-branded wireless remote controls and
keyboards direct to computer products retailers, corporate resellers and
distributors. In the first nine months of 2005, OEM revenues comprised
approximately 63% of business communications revenues as compared to 72% in the
same period of 2004.
Overall, business communications revenues for the third quarter and
first nine months of 2005 declined 8% and 7%, respectively, as compared to the
same periods of 2004. OEM revenues fell 22% and 18%, respectively, as compared
to the third quarter and first nine months of 2004, due primarily to lower sales
to existing OEM customers. OEM average selling prices range from $2 to $25.
Revenues from branded products, which had average selling prices of
approximately $40 to $450, increased 35% and 23%, respectively, from the third
quarter and first nine months of 2004, respectively. The increase in branded
unit volume resulted from a greater number of products sold into our reseller
customer base.
Business communications gross profit margins for the third quarter and
first nine months of 2005 declined to a gross margin loss of 19% and a gross
profit margin of 10%, respectively, as compared to a gross profit margin of 27%
and 29% for the three months and nine months ended September 30, 2004 due to the
much lower profit margin percentage for OEM products sold in the 2005 periods.
The third quarter of 2005 also was affected by $2.3 million in charges related
to the following:
o Based on lowered revenue expectations for the Business
Communications-OEM segment for the next 12 months, we
increased our reserve for excess and obsolete inventory by
approximately $1.0 million.
o The Restriction of Hazardous Substances Act of 2002 (ROHS)
will, when it goes into effect, limit the use of certain
restricted raw materials in production of consumer goods. ROHS
goes into effect in the European Community in late 2006. Most
of the materials whose use is restricted under ROHS are
commonly found in electronics components in-use today,
including components that we have in inventory. In
anticipation of the implementation date of ROHS, we have been
reducing our inventories of non-compliant materials. Many of
our OEM customers are now demanding early implementation of
ROHS compliance. For this reason and due to the lowered
expectation for future demand in the Business
Communications-OEM segment, we recorded a reserve for our
expected future losses on non-ROHS compliant material totaling
approximately $900,000.
o Lowered projected Business Communications-OEM demand also
affected the depreciation rates of production tooling.
Additional tooling depreciation expense for the third quarter
of 2005 was approximately $400,000.
HOME ENTERTAINMENT
In our home entertainment segment, we primarily sell remote controls
on an OEM basis to manufacturers of advanced TV viewing devices, including
projectors sold for TV viewing. Our home entertainment revenues in the third
quarter declined 49% when compared to the third quarter of 2004 due primarily to
a reduced number of customer orders. Revenues for the first nine months of 2005
increased 75% as compared to the first nine months of 2004. This increase was
attributable to an increase in the volume of customer orders combined with the
dollar amount of certain customer orders.
Home entertainment gross profit margins for the third quarter and first
nine months of 2005 increased to 10% and 18%, respectively as compared to (58)%
and (23)% for the third quarter and first nine months of 2004 due primarily to
$1.2 million in expense attributable to an underestimation of the initial costs
and low yields in starting up the Home Entertainment business segment in 2004.
18
E-TRANSACTIONS
In our e-transactions segment, we sell electronic signature capture
devices and, depending on the customer requirement, signature-capture software.
We offer annual software maintenance agreements and hardware upgrade programs to
our existing customers; however, historically we have not recorded significant
revenues from those types of sales.
In the third quarter and first nine months of 2005, e-transaction
revenues increased 192% and 62%, respectively, over the same periods of 2004 due
primarily to an increased number of high volume customer sales in the 2005
period. Our e-transactions results from period to period are greatly affected by
individually significant sales, which are negotiated independently.
E-transaction gross profit margin for the third quarter of 2005
increased to 54% from a gross margin loss of 47% in the third quarter of 2004
due to increased sales and higher relative pricing. E-transaction gross profit
margin for the first nine months of 2005 decreased to 34% from 55% in the first
nine months of 2004 due to the varying size of customer orders and the
corresponding allocation of overhead costs and applied labor.
SPECIALTY COMPONENTS
In our specialty components segment, we sell our MicroNav(TM) products
and custom FSR's and FSR-based subassemblies to maNY customers in several
vertical markets, such as medical devices, industrial input and military input
products.
Specialty components revenues for the third quarter decreased 17% when
compared to the third quarter of 2004, but grew 16% when comparing the first
nine months of 2005 to the first nine months of 2004. The increase in sales is
primarily attributable to increased sales of our MicroNav products. The
Specialty business segment quarterly revenues will fluctuate due to the timing
of customer orders and shipments to customers.
Specialty component gross profit margin for the third quarter and first
nine months of 2005 decreased to 45% and 46%, respectively as compared to 63%
for the third quarter and first nine months of 2004. The overall margin decrease
is primarily due to a greater mix of relatively lower margin revenues related to
our new MicroNav products in the 2005 period.
OPERATING EXPENSES
Product development and research costs include internal engineering
labor, contract engineering and outside processing costs for the design and
development of our OEM and branded designs and products and the research of our
technologies. For the third quarter of 2005, our product development and
research costs declined 3% as compared to the third quarter of 2004 due to
similar levels of product development and engineering support related expenses
incurred. For the first nine months of 2005, our product development and
research costs increased 9% as compared to the same period of 2004 due to our
continued investment in future product design and development. As a percentage
of revenues, product development and research costs declined slightly to 11% in
the third quarter of 2005 compared to 12% in the third quarter of 2004. For the
first nine months of 2005, product development and research and development
represented 11% of total sales compared to 12% in the same period of 2004.
Sales, general and administrative costs ("SG&A") include sales,
marketing, legal, accounting and administrative labor, sales commissions,
advertising, general marketing, branded business communications channel
marketing and travel and entertainment costs. For the third quarter and first
nine months of 2005, SG&A grew 12% and 18%, respectively, over the same periods
of 2004 due to higher corporate governance costs, and increased sales and
marketing costs, including commissions, advertising and marketing development
costs. As a percentage of revenues, SG&A remained relatively level at 29% and
28%, respectively, in the third quarter and first nine months of 2005 compared
to 27%, respectively, in the same periods of 2004.
19
OPERATING RESULTS
In summary, our operating results in the third quarter and first nine
months of 2005 were attributable to the following factors:
o 7% growth in revenues for the third quarter of 2005 resulted
primarily from growth in our Business Communication branded
and e-transactions business segments;
o 16% growth in revenues for the first nine months of 2005
resulted primarily from growth in our Business Communication
branded, E-transactions, Home Entertainment and Specialty
Components business segments;
o Decline in gross profits margins to 13% in the third quarter
of 2005 compared to 22% in the third quarter of 2004 primarily
attributable to a $1.9 million inventory reserve adjustment
made in the third quarter of 2005, as discussed above;
o Gross profit margin for the first nine months of 2005 was 21%
compared to 33% for the first nine months of 2004. This
reduction is also attributable to the $1.9 million of
inventory reserve adjustments taken in the third quarter of
2005; and
o 7% and 15% growth in operating expenses for the third quarter
and first nine months of 2005, respectively, related to
increased corporate governance and regulatory costs and
increased sales and marketing costs to help support and grow
the revenues of the Company.
Total other income, net increased to $77,000 and $229,000,
respectively, in the third quarter and first nine months of 2005 versus net
expenses of $15,000 and $12,000 in the third quarter and the first nine months
of 2004, respectively, due to interest earned on a greater net cash balance in
the 2005 periods.
We have approximately $36.5 million in net operating loss ("NOL")
carryforwards available for U.S. federal tax purposes, of which certain amounts
expire in 2005. In determining whether or not a valuation allowance is necessary
against the deferred tax asset related to these NOL carryforwards, forecasts of
future taxable income are not considered sufficient evidence to outweigh a
history of losses. Accordingly, we have maintained the full valuation allowance
against our deferred tax assets as of September 30, 2005. This has no effect on
the Company's NOL carryforwards for tax purposes and they continue to be
available for up to 20 years.
LIQUIDITY AND CAPITAL RESOURCES
Working capital decreased to $26.1 million at September 30, 2005 from
$30.5 million at the end of 2004 due primarily to the loss from operations.
Operations used $3.4 million in cash in the first nine months of 2005
as compared to $1.1 million in the same period of 2004. The greater usage of
cash is due primarily to higher vendor payments coupled with the loss from
operations.
We spent $152,000 in the first nine months of 2005 to purchase
additional manufacturing and computer equipment compared to $405,000 in the
first nine months of 2004. We also invested $114,000 in new patent and trademark
activity in the first nine months of 2005 as compared to $93,000 in the first
nine months of 2004.
We made payments on long-term debt of $411,000 in the first nine
months of 2005 and $451,000 in the first nine months of 2004. Net proceeds from
the exercise of employee and director stock options were $220,000 and $1.8
million in the first nine months of 2005 and 2004, respectively. In the first
nine months of 2004 we also completed a public stock offering with net proceeds
of $13.2 million.
We currently have minor commitments for capital expenditures and no
material purchase obligations. We have a software license agreement that has
minimum quarterly payments through 2007.
20
Our minimum long-term debt, licensing and operating lease obligations
as of December 31, 2004, the last fiscal year-end date, were as follows (in
thousands):
Less
Than
One 1-3 4th
Total Year Years Year
------ ------ ------ ------
Long-term debt obligations ......... $ 896 $ 491 $ 405 $ --
Software licensing ................. 1,500 600 900 --
Operating lease obligations ........ 1,856 384 1,093 379
------ ------ ------ ------
Total .............................. $4,252 $1,475 $2,398 $ 379
====== ====== ====== ======
These amounts may increase as we pursue our growth strategy but the
amount of any such growth will depend on the particular requirements of any
growth commitment, the availability and attractiveness of equity capital
arrangements and our general liquidity position.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), that involve substantial risks and uncertainties and which are intended
to be covered by the safe harbors created thereby. These statements can be
identified by the fact that they do not relate strictly to historical
information and may include the words "expects", "believes", "anticipates",
"plans", "may", "will", "intends", "estimates", "continue" or other similar
expressions. These forward-looking statements are subject to various risks and
uncertainties that could cause actual results to differ materially from those
currently anticipated. These risks and uncertainties include, but are not
limited to, items discussed under the headings "Overview", "Current
Opportunities and Challenges" and "Business Segment Overview - Three and Nine
Months Ended September 30, 2005 Compared to Three and Nine Months Ended
September 30, 2004." Forward-looking statements speak only as of the date made.
We undertake no obligation to publicly release or update forward-looking
statements, whether as a result of new information, future events or otherwise.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon the consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires management to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. On an on-going basis, management evaluates
estimates, including those related to the valuation of inventory and the
allowance for uncollectible accounts receivable. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. We believe the following
critical accounting policies affect our more significant judgments and estimates
used in the preparation of our consolidated financial statements:
REVENUE RECOGNITION. We recognize revenue in accordance with SEC Staff
Accounting Bulletin ("SAB") No. 104, "Revenue Recognition." SAB No. 104 requires
that four basic criteria must be met before revenue can be recognized: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred or
services rendered; (3) the fee is fixed and determinable; and (4) collectibility
is reasonably assured. Determination of criteria (3) and (4) require
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
To satisfy the criteria, we: (1) input orders based upon receipt of a customer
purchase order; (2) record revenue upon shipment of goods and when risk of loss
and title has transferred; (3) confirm pricing through the customer purchase
order; and (4) validate creditworthiness through past payment history, credit
agency reports and other financial data. All customers have warranty rights and
some customers also have explicit or implicit rights of return. We comply with
Statement of Financial Accounting Standards No. 48 with respect to sell-through
and returns and
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the related recording of revenues for potential customer returns. Should changes
in conditions cause management to determine the revenue recognition criteria are
not met for certain future transactions, such as a determination that
collectibility was not reasonably assured, revenue recognized for any reporting
period could be adversely affected.
ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS. Our accounts
receivable are unsecured, and we are at risk to the extent such amounts become
uncollectible. We continually monitor individual account receivable balances,
and provide for an allowance of doubtful accounts at the time collection may
become questionable based on payment performance or age of the receivable and
other factors related to the customer's ability to pay.
RESERVE FOR ESTIMATED PRODUCT RETURNS. While not an explicit part of
our terms and conditions of product sales except for some customers, we do, on a
discretionary basis, grant product exchanges for our distribution and reseller
customers in our branded business communications market for similar products of
equal value if these exchanges meet certain other criteria. We estimate future
product returns based on recent return history, inventory status and product
"sell-through" statistics received from our major distributors, discussions
regarding product sales activity with our major reseller customers, and current
industry product and technology trends. Management judgment is required in
evaluating the relative significance of the aforementioned data and in the
determination of the estimated value of the returns reserve. If actual returns
are greater than management's estimate then revenues in the subsequent period
will be adversely affected.
INVENTORY RESERVE. At each balance sheet date, we evaluate our ending
inventories for excess quantities and obsolescence. This evaluation includes
analyses of forecast sales levels by product and historical demand. We write off
inventories that are considered obsolete. Remaining inventory balances are
adjusted to approximate the lower of our cost or market value and result in a
new cost basis in such inventory until sold. If future demand or market
conditions are less favorable than our projections, additional inventory
write-downs may be required, and would be reflected in cost of sales in the
period the revision is made. Based on lowered expectations for future demand in
the Business Communications-OEM segment as well as limitations on the use of
certain restricted raw materials prompted by early adoption of the Restriction
of Hazardous Substances Act of 2002 by many of our customers, we increased our
reserve for excess and obsolete inventory by approximately $1.9 million in the
third quarter of 2005. The reserve is discussed in detail in the BUSINESS
SEGMENT OVERVIEW under Business Communications.
PROVISION FOR INCOME TAX. As part of the process of preparing our
financial statements, as required by Statement of Financial Accounting Standards
("SFAS") No. 109, we are required to estimate our income taxes in each of the
jurisdictions in which we operate. This process involves estimating our actual
current tax exposure together with assessing temporary differences resulting
from differing treatment of items for tax and accounting purposes. These
differences result in deferred tax assets and liabilities, which are included in
our balance sheet. We must then assess the likelihood that our deferred tax
assets will be recovered from future taxable income and to the extent we believe
that recovery is not likely, we must establish a valuation reserve. To the
extent we establish a reserve or increase this reserve in a period, we must
include an expense within the tax provision in the statements of operations.
Significant management judgment is required in determining our
provision for income taxes, deferred tax asset and liabilities and any valuation
reserve recorded against our net deferred tax assets. Management continually
evaluates its deferred tax asset as to whether it is likely that the deferred
tax asset will be realized.
Based on historical and prospective evidence, we have concluded that we
did not have sufficient evidence to be able to recognize our NOL carryforward
benefits as assets and thus we have recorded a valuation allowance against our
deferred tax asset balance. If we achieve profitable operations in the future,
we will reevaluate our deferred tax asset balance and may reduce or eliminate
the valuation allowance.
As of December 31, 2004, we had NOL carryforwards for federal, state
and foreign income tax purposes of $36.5 million, $18.8 million and $2.4
million, respectively, which are available to offset future taxable income in
those jurisdictions through 2024.
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FOREIGN EXCHANGE EXPOSURE. We have established relationships with most
of the major OEMs in the business communications market. Many of these OEMs are
based in Japan and approximately 21%, 28% and 22% of our revenues for the first
nine months of 2005 and the years 2004 and 2003, respectively, came from
Japanese customers. Revenues from these customers are denominated in Japanese
yen and as a result we are subject to foreign currency exchange rate
fluctuations in the yen/dollar exchange rate. We use foreign currency forward
and average rate option contracts to hedge this exposure. We use revenue
forecasts from our Japanese subsidiary to determine the amount of our forward or
option contracts to purchase and we attempt to enter into these contracts when
we believe the yen value is relatively strong against the U.S. dollar. To the
extent that our revenue forecast may be inaccurate or the timing of forecasting
the yen's strength is wrong, our actual hedge gains or losses may not
necessarily correlate with the effect of foreign currency rate fluctuations on
our revenues. We mark these contracts to market value and the gain or loss from
these contracts is recorded in business communications revenue. These hedge
transactions are classified as economic hedges and do not qualify for hedge
accounting under Statement of Financial Accounting Standards No. 133. In
addition, because our Japanese subsidiary's functional currency is the yen, the
translation of the net assets of that subsidiary into the consolidated results
will fluctuate with the yen/dollar exchange rate.
The following table illustrates the impact of foreign currency
fluctuations on our yen-denominated revenues and the effectiveness of our
foreign currency hedging activity (in thousands).
NINE MONTHS
ENDED SEPTEMBER 30,
----------------
2005 2004
----- -----
Increase (decrease) in revenues resulting from
foreign currency fluctuations ....................... $ 118 $(116)
Hedging gains ........................................... 39 127
----- -----
Net revenue impact .............................. $ 157 $ 11
===== =====
We calculate the "increase (decrease) in revenues resulting from
foreign currency fluctuations" by calculating the U.S. dollar equivalent of our
yen-denominated revenues using the yen/dollar exchange rate at the beginning of
the period. The resulting product is compared to our yen-denominated revenues
converted to U.S. dollars according to GAAP and the difference is shown in the
table above.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs--an
amendment of APB Opinion No. 43, Chapter 4." SFAS No. 151 clarifies the language
used in APB Opinion No. 43 with respect to accounting for abnormal amounts of
idle facility expenses, freight, handling costs and spoilage. The guidance does
not result in substantive changes in accounting for these costs, but eliminates
inconsistencies in wording between U.S. and international accounting standards.
We adopted SFAS No. 151 as of January 1, 2006. This pronouncement is not
expected to have a material impact on our consolidated statements of operations
or financial position.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment."
This statement is a revision to SFAS No. 123, "Accounting for Stock-Based
Compensation" and APB Opinion No. 25, "Accounting for Stock Issued to
Employees." This statement establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services, primarily focusing on the accounting for transactions in which an
entity obtains employee services in share-based payment transactions. Entities
will be required to measure the cost of employee services received in exchange
for an award of equity instruments based on the grant-date fair value of the
award (with limited exceptions). That cost will be recognized over the period
during which an employee is required to provide service, the requisite service
period (usually the vesting period), in exchange for the award. The grant-date
fair value of employee share options and similar instruments will be estimated
using option-pricing models. If an equity award is modified after the grant
date, incremental compensation cost will be recognized in an amount equal to the
excess of the fair value of the modified award over the fair value of the
original award immediately before the modification. We adopted SFAS No. 123R as
of January 1, 2006. We are currently assessing the impact of this accounting
standard on our consolidated results of operations and financial position for
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2006. Based on current calculations and stock options granted through June 30,
2006, we expect that we will incur non cash expenses of approximately $4.0
million in 2006.
In December 2004, the FASB issued SFAS No. 153, "Exchanges of
Nonmonetary Assets," an amendment of APB Opinion No. 29, "Accounting for
Nonmonetary Transactions." The amendments made by SFAS No. 153 are based on the
principle that exchanges of nonmonetary assets should be measured based on the
fair value of the assets exchanged. Further, the amendments eliminate the narrow
exception for nonmonetary exchanges of similar productive assets and replace it
with a broader exception for exchanges of nonmonetary assets that do not have
commercial substance. Previously, APB Opinion No. 29 required that the
accounting for an exchange of a productive asset for a similar productive asset
or an equivalent interest in the same or similar productive asset should be
based on the recorded amount of the asset relinquished. We adopted SFAS No. 153
as of January 1, 2006. The adoption of this statement is not expected to have a
material impact on our consolidated results or operations or financial position.
In October 2004, the American Jobs Creation Act of 2004 ("Act") became
effective in the U.S. Two provisions of the Act may impact the Company's
provision (benefit) for income taxes in future periods, namely those related to
the Qualified Production Activities deduction ("QPA") and Foreign Earnings
Repatriation ("FER").
The QPA will be effective for the Company's U.S. federal tax return
year beginning after December 31, 2004. In summary, the Act provides for a
percentage deduction of earnings from qualified production activities, as
defined, commencing with an initial deduction of three percent for tax years
beginning in 2005 and increasing to nine percent for tax years beginning after
2009, with the result that the Statutory federal tax rate currently applicable
to the Company's qualified production activities of 35 percent could be reduced
initially to 33.95 percent and ultimately to 31.85 percent. However, the Act
also provides for the phased elimination of the Extraterritorial Income
Exclusion provisions of the Internal Revenue code. Due to the interaction of the
law provisions noted above as well as the particulars of the Company's tax
position, the ultimate effect of the QPA on the Company' future provision
(benefit) for income taxes has not been determined at this time. The FASB issued
FASB Staff Position FAS 109-1, Application of FASB Statement No. 109, Accounting
for Income Taxes, to the Tax Deduction on Qualified Production Activities
Provided by the American Jobs Creation Act of 2004 ("FSP 109-1"), in December
2004. FSP 109-1 required that tax benefits resulting from the QPA should be
recognized no earlier than the year in which they are reported in the entity's
tax return, and that there is to be no revaluation of recorded deferred tax
assets and liabilities as would be the case had there been a change in an
applicable statutory rate.
The FER provision of the Act provides generally for a one-time 85
percent dividends received deduction for qualifying repatriations of foreign
earnings to the U.S. Qualified repatriated funds must be reinvested in the U.S.
in certain qualifying activities and expenditures, as defined by the Act. In
December 2004, the FASB issued FASB Staff Position FAS 109-2, Accounting and
Disclosure Guidance for the Foreign Earnings Repatriation Provision with the
American Jobs Creation Act of 2004 ("FSP 109-2"). FSP 109-2 allows additional
time for entities potentially impacted by the FER provision to determine whether
any foreign earnings will be repatriated under said provisions. At this time,
the Company has not undertaken an evaluation of the application of the FER
provision and any potential benefits of effecting repatriations under said
provision. Numerous factors, including previous actual and deemed repatriations
under federal tax law provisions, are factors impacting the availability of the
FER provision to the Company and its potential benefit to the Company, if any.
We intend to examine the issue and will provide updates in subsequent periods.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and
Error Corrections." SFAS No. 154 requires retrospective application of a
voluntary change in accounting principle to prior periods' financial statements
and also requires that a change in method of depreciation, amortization, or
depletion for long-lived, non-financial assets be accounted for as a change in
accounting estimate that is affected by a change in accounting principle. We
adopted SFAS No. 154 as of January 1, 2006. We believe the adoption of SFAS No.
154 will not have a material impact on our results of operations or financial
condition.
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In March 2005, the FASB issued Financial Interpretation No. 47
"Accounting for Conditional Asset Retirements Obligations" ("FIN 47"). FIN 47
clarifies that the term "conditional asset retirement obligation" as used in
FASB Statement No. 143 "Accounting for Asset Retirement Obligations," refers to
a legal obligation to perform an asset retirement activity in which the timing
or method of settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset retirement
activity is unconditional even though uncertainty exists about the timing or
method of settlement. Thus, the timing or method of settlement may be
conditional on a future event. Accordingly, an entity is required to recognize a
liability for the fair value of a conditional asset retirement obligation if the
fair value of the liability can be reasonably estimated. FIN 47 also clarifies
when an entity would have sufficient information to reasonably estimate the fair
value of an asset retirement obligation. FIN 47 is effective no later than the
end of fiscal years ending after December 15, 2005. We do not expect the
adoption of this statement to have a material impact on our results of
operations or financial position.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
FOREIGN CURRENCY EXCHANGE RATE RISK - Our Japanese subsidiary,
Interlink Electronics K.K., generally makes sales and collects its accounts
receivable in Japanese yen. To hedge these revenues against future movements in
exchange rates, we purchase foreign exchange forward and average rate option
contracts. Gains or losses on these contracts are then offset by gains or losses
on the underlying revenue exposure and consequently a sudden or significant
change of foreign exchange rates would not have a material impact on net income
or cash flows to the extent future revenues are protected by forward currency
contracts. These contracts, however, typically have a six-month duration. Thus,
yen/dollar fluctuations lasting more than six months will have an impact on our
revenues. For the nine month periods ended September 30, 2005 and 2004, we
entered into foreign currency exchange contracts in the normal course of
business to manage our exposure against foreign currency fluctuations on
revenues denominated in foreign currencies. The principal objective of such
contracts is to minimize the risks and costs associated with financial and
global operating activities. We do not utilize financial instruments for trading
or other speculative purposes. The fair value of foreign currency exchange
contracts is estimated by obtaining quotes from bankers. During the first nine
months of 2005, we recognized $39,000 of gains on foreign currency exchange
contracts which is reflected in revenue in the accompanying consolidated
statements of operations. Our hedging policies are designed to offset the effect
of a yen devaluation on our revenues; thus, a hypothetical 10% devaluation of
the yen would reduce our yen denominated revenues by 10%; but our theoretical
hedging gains would offset that effect for a period of time, to the extent we
have such foreign currency exchange contacts outstanding.
INTEREST RATE EXPOSURE - Based on our overall interest rate exposure at
September 30, 2005, a hypothetical 10% change in interest rates applied to our
outstanding debt as of September 30, 2005, would have no material impact on
earnings or cash flows over a one-year period.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
In connection with the preparation of this Form 10-Q, the Company's
senior management, with the participation of the Company's Chief Executive
Officer and Chief Financial Officer, evaluated the effectiveness of the design
and operation of the Company's disclosure controls and procedures as of
September 30, 2005. Based upon that evaluation, the Company's Chief Executive
Officer and Chief Financial Officer concluded that the Company's disclosure
controls and procedures were ineffective, as of September 30, 2005, to provide
reasonable assurance that information required to be disclosed by the Company in
reports that it files or submits under the Exchange Act, is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms and to ensure that information required to be disclosed by the Company in
the reports that it files or submits under the Exchange Act is accumulated and
communicated to management, including the Company's principal executive and
principal financial officers, or persons performing similar functions, as
appropriate to allow timely decisions regarding required disclosures. This
conclusion is based primarily on the fact that the Company's internal control
over financial reporting was
25
ineffective as of such date. Through the date of the filing of this Form 10-Q
the Company has adopted additional remedial measures described below to address
deficiencies in its disclosure controls that existed on September 30, 2005 and
has taken additional measures to verify the information in its financial
statements. The Company believes that, as a result of these remedial and other
measures, this Form 10-Q properly reports all information required to be
included in such report.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
As of December 31, 2004, management conducted an evaluation of the
effectiveness of the system of internal control over financial reporting based
on the framework in Internal Control-Integrated Framework (the "Framework")
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Based on its evaluation, management concluded that the Company's system
of internal control over financial reporting was ineffective as of December 31,
2004. This conclusion was reached based on the identification of material
weaknesses described below:
o Certain tests undertaken in connection with the preparation of
our 2004 financial statements indicated that that our product
cost estimates had underestimated product purchase and yield
cost attributable to third quarter sales and overestimated
capitalized overhead and ending inventory cost and, therefore,
inventory value. Based on this information, we restated our
financial statements for the third quarter of 2004. Other
errors in our inventory controls misstated our inventory
reserves at December 31, 2004. At the direction of our Chief
Executive and Chief Financial Officers, we have changed the
procedures by which we estimate inventory value and,
accordingly, believe that this material weakness will be
remediated.
o In the first quarter of 2004, we initially recorded revenue
from a significant product sale when the product was completed
and stored at the customer's request in our facilities for
later shipment at the instruction of the customer. During the
course of our year-end audit, we determined that certain terms
within the contract did not meet the criteria to recognize
revenue due to certain exchange rights and a failure to meet
all of the provisions of the SEC's "bill and hold" revenue
recognition guidelines. Based on this conclusion, we restated
our financial statements for the first, second and third
quarters of 2004. A similar transaction for the same customer
was also recorded in the fourth quarter of 2004. At the
direction of our Chief Executive and Chief Financial Officers,
we have adopted new procedures by which we review and select
appropriate revenue recognition policies and, accordingly, we
believe we will remediate this material weakness.
o We identified certain weaknesses related to the closing of our
quarterly and annual financial statements and the failure to
have identified the material weaknesses described above as a
part of the closing process. At the direction of our Chief
Executive and Chief Financial Officers, we have adopted new
closing processes, and accordingly, we believe we will
remediate this material weakness.
o In tests of controls related to our Japanese subsidiary, we
identified significant deficiencies involving management's
review and approval of transactions and financial results that
could adversely affect the subsidiary's ability to initiate,
record, process, or report financial data involving the
significant processes of Sales Order To Cash, Procure To
Payment, and Treasury and Investments which, when considered
with other ineffective controls within the same financial
processes, resulted in the conclusion of a material weakness
for each significant process as a whole. At the direction of
our Chief Executive and Chief Financial Officers, we have
implemented certain revised internal control procedures and
are developing additional internal control procedures
applicable to our Japanese subsidiary and, accordingly,
believe that these material weaknesses will be remediated.
26
In addition to the material weaknesses described above, during the
third quarter of 2005 and through the filing of this report, while conducting
our ongoing evaluation of the effectiveness of the system of internal control
over financial reporting, we identified material weaknesses in our internal
controls related to our vendor account reconciliation process, our inventory
management and costing processes and the accounting for stock options of
terminated employees and determined that certain of our historical financial
statements required restatement. On November 2, 2005, we announced our intention
to restate our financial results for the years ended December 31, 2003 and
December 31, 2004 and the first two quarters of 2005. The restatement is
necessary to correct errors caused by the material weaknesses described below:
o We identified certain weaknesses in our internal controls
related to our account reconciliation process with a major
vendor. Because of our failure to timely and accurately
perform account reconciliations, a net write-off of certain
receivables totaling $1.1 million was not made in the fourth
quarter of 2003. In addition, we also failed to properly
record approximately $1.0 million of invoices received from
this same vendor from July 2004 through June 2005.
Accordingly, restatement of our third and fourth quarters of
2004 and our first and second quarters of 2005 was necessary.
At the direction of the Chief Executive and Chief Financial
Officers, we have adopted new management vendor procedures
that we believe will remedy this material weakness.
o In the course of reviewing our inventory records during the
third quarter financial close process, we identified a
material weakness in our inventory management and costing
processes. This weakness led to approximately $616,000 of
software license costs remaining in inventory that should have
been expensed in the first and second quarters of 2005 and
$372,000 of certain inventory components being double-counted
and thus overstated in inventory as of June 30, 2005. This
weakness also led to an overstated valuation of certain
inventory in transit at December 31, 2004 between the parent
company and its Hong Kong subsidiary. This matter resulted in
the understatement of cost of sales of $837,000 in 2004, none
of which was in the first nine months of 2004, and the
overstatement of cost of sales of $748,000 in 2005, $441,000
of which was in the first nine months of 2005. At the
direction of the Chief Executive and Chief Financial Officers,
we are developing revised inventory reconciliation procedures
that we believe will remedy this material weakness.
o The Company identified that it was incorrectly accounting for
stock options of terminated employees. This resulted in an
unrecorded, non-cash expense of $2.4 million in 2001, $220,000
in 2004 and $108,000 in 2005, $106,000 of which was in the
first nine months of 2005. At the direction of the Chief
Executive and Chief Financial Officers, we are implementing
new controls and procedures related to the accounting for
stock options and, accordingly, believe that this material
weakness will be remediated.
Other than as discussed above, there was no change in the Company's
internal control over financial reporting during the last fiscal quarter that
materially affected, or is likely to materially affect, the Company's internal
control over financial reporting.
LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS
Our management, including our Chief Executive Officer and Chief
Financial Officer, do not expect that our disclosure controls and procedures or
internal control over financial reporting will prevent all errors and all fraud.
A control system no matter how well designed and implemented, can provide only
reasonable, not absolute, assurance that the control system's objectives will be
met. Further, the design of a control system must reflect the fact that there
are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues within a company are detected. The inherent limitations include
the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple errors or mistakes. Controls can also be
circumvented by the individual acts of some persons, by collusion of two or more
people or by management override of the controls. Because of
27
the inherent limitations in a cost-effective control system, misstatements due
to error or fraud may occur and not be detected.
PART II - OTHER INFORMATION
ITEM 5. LEGAL PROCEEDINGS
On November 15, 2005, a class action alleging violations of federal
securities laws was filed against the Company and two of its current and former
officers in the United States District Court for the Central District of
California. The complaint alleges that, between April 24, 2003 and November 1,
2005, the Company and two of its current and former officers made false and
misleading statements and failed to disclose material information regarding the
Company's results of operations and financial condition. The complaint includes
claims under the Securities Act and Exchange Act and seeks unspecified damages
and legal expenses.
To date, the Court has not certified a class, and the litigation
remains in its early stages.
On January 24, 2006, a shareholder's derivative action was filed
against two of the Company's current and former officers and the members of its
Board of Directors in the Central District of California. The derivative
complaint contains the same factual allegations as the class action complaint
and sought to recover unspecified damages from the defendants, as well as
forfeiture of their equity-based compensation and contribution from them in the
event that the Company is found to have violated the federal securities laws.
Following a motion made by the defendants to dismiss, or in the alternative,
stay the derivative action, the plaintiff voluntarily dismissed the derivative
action without prejudice on June 14, 2006.
In connection with the class action and the derivative proceedings
described above, an independent investigation was undertaken at the direction of
the Audit Committee by Dorsey & Whitney, LLP. Dorsey & Whitney retained the
services of PricewaterhouseCoopers LLP with respect to various forensic
accounting and electronic procedures performed in the course of the
investigation.
While it intends to vigorously defend against these allegations, the
Company cannot predict the final disposition of these matters or whether the
Company will be liable for amounts not covered by insurance. There is no
assurance, however, that the ultimate resolution of these matters will not
result in a material adverse effect on the Company's business, financial
condition or results of operations.
In addition to the matters identified above, from time to time, the
Company is involved in various legal actions that arise in the ordinary course
of business.
ITEM 5(A). RISK FACTORS
WE ARE ENTERING NEW MARKETS AND IF WE FAIL TO ACCURATELY PREDICT THE GROWTH OF
THESE NEW MARKETS, WE MAY SUFFER REDUCED EARNINGS.
Historically, our sales were concentrated in the specialty components
markets, as well as remote control devices for presentation projectors. However,
we have devoted significant resources to the development of products and the
support of marketing and sales efforts in new markets, such as television
remotes and the e-transactions market. We expect to continue to identify and
develop products for new markets. These markets change rapidly and we cannot
assure you that they will grow or that we will be able to accurately forecast
market demand in time to respond appropriately. Our investment of resources in
these markets may either be insufficient to meet actual demand or result in
expenses that are excessive in light of actual sales volumes. Failure to predict
growth and demand accurately in new markets may cause us to suffer substantial
losses or reduced earnings.
28
OUR OEM REMOTE CONTROLS BUSINESS IS FOCUSED ON CONSUMER MARKETS THAT ARE
INTENSELY PRICE COMPETITIVE. IF WE CANNOT GENERATE VOLUME AND RELATED
MANUFACTURING EFFICIENCIES REQUIRED TO COMPETE IN THESE MARKETS, OUR RESULTS OF
OPERATIONS WILL BE ADVERSELY AFFECTED.
Historically, our OEM Remote Controls business was focused on selling
remote devices in the presentation projector market. As a specialty market, this
sector generated relatively low sales volumes with correspondingly high margins.
However the presentation projector market has become more consumer-oriented and
price competition has increased. We have shifted our OEM Remote Controls
business toward sales to manufacturers of advanced viewing devices which is also
very consumer oriented and price competitive but which offers the potential for
higher volumes. If we cannot increase production and sales volume, or if we
otherwise fail to achieve production efficiencies, our results of operations and
financial position will be adversely affected.
FAILURE TO MAINTAIN, DEVELOP AND EXPAND OUR OEM RELATIONSHIPS COULD CAUSE DEMAND
FOR OUR PRODUCTS TO DECREASE.
Sales to OEMs constituted 30% of our total sales for the nine months
ended September 30, 2005. If we fail to maintain, develop and expand our
relationships with significant OEMs, or if those OEMs are not successful in
their marketing and sales efforts, demand for our products may decrease. For
example, our OEM Remote Controls products are sold to OEMs and consist primarily
of remote devices that are packaged with advanced viewing devices, televisions
or presentation systems. If our OEM customers experience a significant reduction
in demand for advanced viewing devices, televisions or presentation systems it
will significantly decrease demand for our remote devices.
Our ability to generate increased revenues also depends significantly
on the extent to which our OEM customers develop, promote and sell products that
incorporate our technology and products. If our OEM customers do not
successfully develop and market products that incorporate our products, sales of
our products to our OEM customers would be adversely affected. The extent to
which our OEM customers develop, promote and sell our products is based on a
number of factors that are largely beyond our ability to control.
THE LOSS OF ANY SIGNIFICANT CUSTOMER OR ANY CANCELLATION, REDUCTION OR DELAY OF
A LARGE PURCHASE BY A SIGNIFICANT CUSTOMER COULD REDUCE OUR REVENUE AND REQUIRE
US TO WRITE-DOWN INVENTORY.
For the first nine months of 2005, approximately 46% of our total sales
were to our OEM Remote Controls customers and most of these sales were to OEM
customers. With the advent of our MICRONAV family of sensors, we expect that our
reliance on OEM sales will increase. The loss of any key OEM customers, or a
significant reduction in sales to those customers, could significantly reduce
our revenue below anticipated levels. From time to time, we expect to lose other
significant revenue streams and will be required constantly to seek new
opportunities with new and existing customers. Because our expense levels are
based on our expectations as to future revenue and are, to a large extent, fixed
in the short term, a substantial reduction or delay in sales of our products to
an OEM customer, the unexpected loss of any significant OEM or other customer,
or unexpected returns from customers, could harm our business.
FAILURE TO INCREASE MARKET AWARENESS AND ACCEPTANCE OF E-TRANSACTIONS AND OUR
E-TRANSACTION PRODUCTS MAY CAUSE OUR REVENUES IN THIS MARKET TO FALL SHORT OF
OUR EXPECTATIONS.
The prospects for our e-transactions business depend in part on the
acceptance by our target markets of electronic signatures as a replacement for
traditional pen and ink signatures. The market for e-transactions is new and
emerging and we cannot be certain that it will continue to develop or grow or
that businesses will elect to adopt our products rather than continuing to rely
on traditional pen and ink signatures. Businesses that have invested substantial
resources in traditional infrastructures may be reluctant to adopt an electronic
approach to replace their existing systems. Concerns about privacy and fraud may
cause businesses not to adopt e-transactions or our e-transaction products. We
expect that we will need to continue to pursue intensive marketing and sales
efforts to educate prospective customers about the benefits of e-transactions
and our e-transaction products. If market awareness and acceptance of
e-
29
transactions do not occur, our revenues and profitability in this market will
fall short of our expectations.
SALES OF SIMPLE SIGNATURE CAPTURE DEVICES ARE GROWING RAPIDLY AND THE
MANUFACTURERS OF THESE DEVICES COULD BROADEN THEIR PRODUCT RANGE TO INCLUDE
PRODUCTS THAT COMPETE WITH OUR EPAD.
Simple signature capture devices have recently become a common sight at
retail checkout counters and a number of companies manufacture and sell these
devices. While our EPAD product is targeted at a more demanding market,
signature capture device manufacturers could elect to upgrade their existing
products in an effort to compete in our markets. Such competition could reduce
margins or otherwise adversely affect our prospects in our e-transactions
market.
IF WE ARE UNABLE TO KEEP PACE WITH RAPID TECHNOLOGICAL CHANGE AND GAIN MARKET
ACCEPTANCE OF NEW PRODUCTS, WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY.
Technology, both in our markets and in our customers' markets, is
undergoing rapid change. In order to maintain our leadership position in our
existing markets and to emerge as a leader in new markets, we will have to
maintain a leadership position in the technologies supporting those markets.
Doing so will require, among other things, the following:
o we must accurately predict the evolving needs of our customers
and develop, in a timely manner, the technology required to
support those needs;
o we must provide products that are not only technologically
sophisticated but are also available at a price within market
tolerances and competitive with comparable products;
o we must establish and effectively defend our ownership of the
intellectual property supporting our products; and
o we must enter into relationships with other companies that
have developed complementary technology on which our products
also depend.
We cannot assure you that we will be able to achieve any of these objectives.
IF WE FAIL TO MANAGE OUR GROWTH SUCCESSFULLY, OUR OPERATIONS COULD BE ADVERSELY
IMPACTED AND OUR GROWTH COULD BE IMPAIRED.
The ability to operate our business in rapidly evolving markets
requires an effective planning and management process. We expect that growth in
our business will place a significant strain on our personnel, management
systems, infrastructure and other resources. Our ability to manage any potential
future growth effectively will require us to attract, train, motivate and manage
new employees, to integrate new employees into our overall operations and to
continue to improve our operational, financial and management controls and
procedures. If we are unable to implement adequate controls or integrate new
employees into our business in an efficient and timely manner, our operations
could be adversely affected and our growth could be impaired.
MOST OF OUR OEM AND MAJOR RETAIL CUSTOMERS ORDER FROM US ON A "JUST IN TIME"
BASIS, WHICH REQUIRES US TO ESTIMATE DEMAND FOR PARTICULAR PRODUCTS.
The agreements or understandings that we reach with most of our OEM
customers specify various terms such as product design and price, but do not
constitute firm purchase orders for a specific number of products or components.
Our OEM and major retail customers typically place firm purchase orders on a
"just in time" basis and expect products or components to be shipped to them as
soon as they can be made. Accordingly, our backlog of firm orders is typically
quite small in relation to the volume of our sales. In anticipation of customer
demand, we are often required to purchase raw materials and components based on
estimates of customer demand derived from non-binding information furnished by
the customer. If customer purchase orders differ substantially from our
estimates, we may accumulate excess inventory that
30
has to be written off. If we underestimate demand, we may be unable to meet
customer needs, which could harm our relationship with the customer.
WE RELY ON THIRD PARTIES FOR THE MATERIALS THAT WE USE TO MANUFACTURE OUR
PRODUCTS AND A SHORTAGE OF SUPPLY COULD ADVERSELY AFFECT OUR REVENUES, OPERATING
RESULTS AND CUSTOMER RELATIONSHIPS.
We rely on third-party suppliers for the raw material components of our
products. We cannot assure you that our suppliers will be able to maintain an
adequate supply of these raw materials to enable us to fulfill all of our
customers' orders on a timely basis. A failure to obtain an adequate supply of
the materials for our products could increase our costs of goods sold, cause us
to fail to meet delivery commitments and cause our customers to purchase from
our competitors, which could adversely affect our operating results and customer
relationships. In some situations, we rely on a single supplier for raw material
components of our products. Any disruption in these supplier relationships could
prevent us from maintaining an adequate supply of materials and could adversely
affect our results of operation and financial position.
DISRUPTIONS IN OUR MANUFACTURING FACILITIES OR ARRANGEMENTS COULD CAUSE OUR
REVENUES AND OPERATING RESULTS TO DECLINE.
We manufacture all of our FSR sensors at our Camarillo, California
facility. This facility is vulnerable to damage from earthquakes, floods, fires,
power loss and similar events. It could also be subject to break-ins, sabotage
and intentional acts of vandalism. Our insurance may not cover such events and,
if the event is covered, our insurance may not be sufficient to compensate us
for any losses that may occur. Despite any precautions we may take, the
occurrence of a natural disaster or other unanticipated problem at our
manufacturing facility could result in delayed shipment of products, missed
delivery deadlines and harm to our reputation, which may cause our revenues and
operating results to decline.
All of our non-FSR product manufacturing is currently done by third
parties in China identified and managed through our Hong Kong subsidiary. We
rely on our subsidiary to select and contract with contract manufacturers with
suitable manufacturing facilities and appropriately trained employees. An
interruption in our current manufacturing arrangements could adversely affect
our revenues, operating results and customer relationships.
PERFORMANCE, RELIABILITY OR QUALITY PROBLEMS WITH OUR PRODUCTS MAY CAUSE OUR
CUSTOMERS TO REDUCE OR CANCEL ORDERS WHICH WOULD HARM OUR OPERATING RESULTS.
We regularly introduce new products with new technologies or
manufacturing processes. Our products have in the past contained, and may in the
future contain, errors or defects that may be detected at any point in the life
of the product. Detection of such errors could result in delays in shipping and
sales during the period required to correct such errors. Defects may also result
in product returns, loss of sales and cancelled orders, delays in market
acceptance, injury to our reputation, injury to customer relationships and
increased warranty costs, which could have an adverse effect on our business,
operating results and financial condition.
31
INTERNATIONAL SALES AND MANUFACTURING RISKS COULD ADVERSELY AFFECT OUR OPERATING
RESULTS.
Our revenue from international sales accounted for approximately 58%,
60% and 51% of net sales for the nine months ended 2005 and for the years ended
December 31, 2004 and 2003, respectively. We believe that international sales
will represent a substantial portion of our sales for the foreseeable future.
Our non-FSR manufacturing is currently performed by third parties in China. Our
international operations involve a number of risks, including:
o import-export license requirements, tariffs, taxes and other
trade barriers;
o difficulty in staffing and managing foreign operations;
o ability to secure credit and funding;
o difficulty in maintaining an effective system of internal
controls at our foreign manufacturing facility;
o foreign collection problems;
o reduced protection of intellectual property rights;
o international unrest and terrorism;
o political and economic instability; and
o transportation risks.
Any of the above factors could adversely affect our operating results.
OUR OPERATING RESULTS COULD BE ADVERSELY AFFECTED BY FLUCTUATIONS IN THE VALUE
OF FOREIGN CURRENCIES.
International sales made through our Japanese subsidiary are generally
denominated in yen. A weak yen would materially affect total revenue and could
result in a decrease in dollar revenue even though sales remained constant or
increased. We also contract for most of our large-volume, non-technical
manufacturing in China. Although we contract in U.S. dollars, a weakening of the
dollar could cause existing contracts to be uneconomic to the vendor and
therefore require a renegotiation. Over the past two years, the valuations of
many foreign currencies have fluctuated significantly relative to the U.S.
dollar. The Japanese yen, in particular, has fluctuated in value due in part to
the economic problems experienced by Asian countries and the recent devaluation
of the U.S. dollar. Although we at times engage in currency hedging transactions
in order to protect ourselves from risks of Japanese yen currency fluctuations,
we cannot assure you that these activities will protect us from such risks.
OUR MARKETS ARE INTENSELY COMPETITIVE AND MANY OF OUR POTENTIAL COMPETITORS HAVE
RESOURCES THAT WE LACK.
Our markets are competitive and we expect competition in our newer
markets to increase. Our competitors include companies with similar products or
technologies, companies that sell complementary products to our target markets
and our OEM customers themselves, who could choose to manufacture products that
they currently buy from us. Our competitors and potential competitors may have
established business relationships that may afford them a competitive advantage
or may create technologies that are superior to ours or that set a new industry
standard that will define the successful product for that market. If any of our
competitors establish a close working relationship with our customers, they may
obtain advance knowledge of our customers' technology choices or may be afforded
an opportunity to work in partnership to develop compatible technologies and may
therefore achieve a competitive advantage. We may be unable to compete
successfully against our current and future competitors.
32
OUR PRODUCTS ARE OFTEN CUSTOMER-SPECIFIC, AND FROM TIME TO TIME WE MAY NEED TO
WRITE OFF EXCESS OR OBSOLETE INVENTORY.
A substantial percentage of our intuitive interface devices and
components are customer-specific and cannot be easily recycled for sale to other
customers. However, we must have sufficient quantities of our products available
to satisfy our customers' demands. If a particular customer fails to order as
expected or cancels or substantially delays an order, we may have excess
inventory that we may be required to hold for long periods of time or that may
eventually become obsolete. In these situations, we may be required to write off
or write down inventory, which would have a material adverse effect on our
results of operations.
EARLY IMPLEMENTATION OF THE RESTRICTION ON HAZARDOUS SUBSTANCES ACT OF 2002
("ROHS") OR THE ADOPTION OF SIMILAR RESTRICTIONS IN MARKETS OUTSIDE OF EUROPE
MAY REQUIRE US TO MAKE ADDITIONAL WRITE-DOWNS OF OUR INVENTORY.
When it goes into effect, the ROHS will limit the use of certain
restricted raw materials in production of consumer goods that are sold in
Europe. Many of these restricted materials are found in our products and in the
components we have in our inventory. Although the ROHS is not effective until
late 2006, many of our OEM customers are implementing the ROHS restrictions
early and are requiring our products to be ROHS-compliant. We previously
determined that we would not be able to adequately reduce our inventory of
non-compliant materials and as a result, we recorded an expense of $900,000 to
create a reserve for obsolescence. While we currently believe our reserve is
adequate, we may need to reassess it if other OEM customers begin demanding
ROHS-compliant products prior to the effective date of ROHS or if other markets
adopt similar restrictions.
OUR ABILITY TO OPERATE EFFECTIVELY COULD BE IMPAIRED IF WE WERE TO LOSE THE
SERVICES OF KEY PERSONNEL, OR IF WE ARE UNABLE TO RECRUIT QUALIFIED MANAGERS AND
KEY PERSONNEL IN THE FUTURE.
Our success is substantially dependent on the continued availability of
our key management and technical personnel. Several of our key management
personnel have been with us throughout most of our history and have substantial
experience with our business and technology. If one or more of our key
management personnel leaves Interlink and we are unable to find a replacement
with the combination of skills and attributes necessary to execute our business
plan, it may have an adverse impact on our business. Our success will also
depend, in part, on our ability to attract and retain additional qualified
professional, technical, production, managerial and marketing personnel, both
domestically and internationally.
IF OUR PRODUCTS DO NOT SUPPORT EVOLVING INDUSTRY STANDARDS, THEY MAY NOT ACHIEVE
OR MAINTAIN MARKET ACCEPTANCE AND OUR REVENUES MAY DECLINE.
Our wireless communication products must communicate using whatever
communication protocol is chosen by the customer. Supporting a particular
communication protocol requires specific technical expertise and we expect that
we will be required to establish and maintain such expertise with respect to
each commonly used communication protocol. New communication protocols are
constantly under development and we may fail to acquire the necessary experience
to support a popular new protocol or to respond to changes in an existing
protocol. In our e-transactions business, our customers will expect that our
products will enable them to comply with applicable requirements relating to
electronic signatures, such as the Electronic Signatures in Global Commerce Act
and procedures adopted by the National Notary Association. If our products do
not support these requirements, sales of our e-transactions products would be
adversely affected.
IF WE ARE NOT ABLE TO PROTECT OUR INTELLECTUAL PROPERTY OR IF WE INFRINGE ON THE
INTELLECTUAL PROPERTY OF OTHERS, OUR BUSINESS AND OPERATING RESULTS COULD BE
ADVERSELY AFFECTED.
We consider our intellectual property to be a key element of our
ability to compete in our chosen markets. We rely on a combination of patents,
trade secrets and proprietary software to establish and protect our intellectual
property rights. We cannot assure you that patents will be issued from any of
our pending applications or that any claims allowed from existing or pending
patents will be sufficiently broad
33
to protect our technology. We also cannot assure you that any patents issued to
us will not be challenged, invalidated or circumvented, or that the rights
granted will provide proprietary protection. Litigation may be necessary to
enforce our patents, trade secrets and other intellectual property rights, to
determine the validity and scope of the proprietary rights of others or to
defend against claims of infringement. Such litigation could result in
substantial costs and diversion of resources and could have a material adverse
effect on our business, regardless of the final outcome of the litigation.
We are not currently engaged in any patent infringement suits but we
have been threatened with one such suit in recent years. Despite our efforts to
maintain and safeguard our proprietary rights, we cannot assure you that we will
be successful in doing so or that our competitors will not independently develop
or patent technologies that are substantially equivalent or superior to our
technologies. If any of the holders of these patents assert claims that we are
infringing them, we could be forced to incur substantial litigation expenses or
to pay substantial royalties. In addition, if we were found to be infringing on
someone else's patent, we could be required to pay substantial damages, pay
royalties in the future or be enjoined from infringing in the future.
WE RELY ON OTHERS FOR ASPECTS OF OUR TECHNOLOGY DEVELOPMENT.
Our in-house research and development expertise is focused on our
sensor and communication technologies. We do not have broadly based expertise in
software development, chip design or other critical technological aspects of a
complete product. We rely on other companies with whom we may contract or enter
into joint development agreements to provide these aspects of our product
technologies. We cannot assure you that we will be able to contract or otherwise
arrange for these services in the future. We also cannot assure you that a
developer with whom we contract for technology will not use or permit others to
use similar technology in competition with us.
WE ARE A PUBLIC COMPANY AND ARE THEREFORE REQUIRED TO INCUR COSTS AND TO
DISCLOSE INFORMATION THAT PRIVATE COMPANIES ARE NOT REQUIRED TO INCUR OR
DISCLOSE.
As a public company, we are required to comply with complex and costly
accounting and disclosure requirements that do not apply to foreign companies
that are not public in the United States, private companies or to subsidiaries
or divisions of very large companies for whom the results of the subsidiary or
division are not material. The costs that we are required to incur have recently
increased dramatically, especially in connection with our reporting obligations
under Section 404 of the Sarbanes-Oxley Act of 2002, and these expenses may
continue to be incurred at historically unprecedented levels for the foreseeable
future. These costs impact our profitability and therefore constitute a
competitive disadvantage vis-a-vis much of our competition. These requirements
may also prevent our management from focusing on other areas of our business. In
addition, our public status requires us to disclose publicly information that
can afford a competitor a competitive advantage. If we are unable to maintain
costs associated with our public company status within reasonable parameters, or
if we are required to disclose information that our competitors can use to
compete with us, our ability to remain competitive in our markets could be
adversely affected.
BUSINESS ACQUISITIONS OR PARTNERING ARRANGEMENTS MAY DISRUPT OUR BUSINESS,
DILUTE SHAREHOLDER VALUE AND DISTRACT MANAGEMENT'S ATTENTION.
As part of our business strategy, we may consider acquisitions of, or
significant investments in, businesses with services, products or technologies
that we believe could complement or expand our business. Such acquisitions or
investments involve numerous risks, including:
o unanticipated costs and liabilities;
o difficulty of integrating the operations, products and
personnel of the acquired business;
o difficulties in managing the financial and strategic position
of acquired or developed products and technologies;
34
o difficulties in maintaining customer relationships;
o diversion of management's attention;
o inability to maintain uniform standards, controls, policies
and procedures;
o impairment of relationships with acquired employees and
customers occurring as a result of integration of the acquired
business; and
o accounting results that are unrelated to the performance of
either business.
Acquisitions also frequently result in recording of goodwill and other
intangible assets that are subject to potential impairments in the future.
Additionally, if we finance acquisitions by using convertible debt or stock, our
existing stockholders may be diluted which could affect the market price of our
stock. If we fail to properly evaluate and execute acquisitions or investments,
we may not achieve the anticipated additional benefit to our business, and we
may incur costs in excess of what we anticipate.
WE HAVE IDENTIFIED MATERIAL WEAKNESSES IN OUR INTERNAL CONTROL OVER FINANCIAL
REPORTING AND HAVE BEEN REQUIRED TO RESTATE OUR HISTORICAL FINANCIAL STATEMENTS.
In our Annual Report for the year ended December 31, 2004, we reported
material weaknesses in our internal control over financial reporting. Additional
material weaknesses were identified in 2005. As a result of these material
weaknesses, we were required to restate several of our historical financial
statements. We have taken significant measures to improve our financial
reporting process but, despite these measures, continued to have material
weaknesses as of September 30, 2005. These matters are more fully described
elsewhere in this Report under the captions "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Controls and
Procedures--Changes in Internal Control Over Financial Reporting."
Any continuing material weaknesses in our internal control over
financial reporting could result in errors in our financial statements. Such
errors could cause our internal planning and assessment of our business to be
based on false information and could cause our published financial statements to
fail to fairly present our financial condition and results of operations. We
cannot assure you that we will be successful in our effort to eliminate all
material control weaknesses. Any continuing material weaknesses could erode
market confidence in our company, could cause the price of our stock to be based
on false or misleading information and could result in litigation based on any
such false or misleading information.
WE ARE FACING LITIGATION BASED ON OUR RESTATEMENTS OF HISTORICAL FINANCIAL
STATEMENTS, WHICH MAY HAVE A MATERIAL ADVERSE IMPACT ON OUR CASH RESERVES AND
MAY IMPAIR OUR ABILITY TO ACHIEVE OUR BUSINESS OBJECTIVES.
Certain former Interlink stockholders have filed a class action lawsuit
claiming damages under various securities laws based on our restatement of
historical financial statements. Other stockholders have brought a derivative
action against our Chief Executive Officer, our former Chief Financial Officer
and our directors, alleging mismanagement. These actions will require a vigorous
defense and could result in a settlement or adverse award that is not covered by
insurance or that exceeds applicable insurance limits. The time and expense
required to defend these claims may also affect our ability to pursue our
strategy. There is also no assurance that the ultimate resolution of these
matters will not result in a material adverse effect on our business, financial
condition or results of operations.
35
ITEM 6. EXHIBITS
3.1 Certificate of Incorporation, as amended (incorporated by
reference to Exhibit 3.1 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 2000).
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the
Registrant's Current Report on Form 8-K filed on May 11,
2006).
31.1 Certification of Chief Executive Officer of Registrant
Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer of Registrant
Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer of Registrant
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer of Registrant
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
36
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
INTERLINK ELECTRONICS, INC.
DATE: July 24, 2006 /S/ CHARLES C. BEST
---------------------------
Charles C. Best
Chief Financial Officer
37
EXHIBIT INDEX
The following exhibits are filed with or incorporated by reference into this
Quarterly Report:
EXHIBIT
NUMBER DESCRIPTION
------- -----------
3.1 Certificate of Incorporation, as amended (incorporated by reference to
Exhibit 3.1 to the Registrant's Annual Report on Form 10-K for the year
ended December 31, 2000).
3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Registrant's
Current Report on Form 8-K filed on May 11, 2006).
31.1 Certification of Chief Executive Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer of Registrant Pursuant to SEC
Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer of Registrant Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer of Registrant Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
38