Summary of AWARE INC /MA/ - Yahoo! Finance

Management's Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995

Some of the information in this Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as "may," "will," "expect," "anticipate," "believe," "estimate," "continue" and similar words. You should read statements that contain these words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating results or financial condition; or (3) state other "forward-looking" information. However, we may not be able to predict future events accurately. The risk factors listed in this Form 10-Q, as well as any cautionary language in this Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this Form 10-Q could materially and adversely affect our business.

Summary. We organize ourselves as one segment with three product lines. Our product lines include i) licensing products, ii) test and diagnostics products, and ii) biometrics products. We conduct our operations in the United States, and our products are typically distributed worldwide through an OEM sales model.

Our licensing products consist of: i) DSL technology products, ii) home networking technology products, and iii) patents related to DSL, home networking and other technologies. Our technology products are licensed to semiconductor companies that sell chipsets that incorporate our technology. Our patents are sold or licensed to third parties interested in acquiring such patent rights.

Our test and diagnostics products consist of DSL hardware and software products that are used by telephone companies to improve the quality of their DSL service offerings. Our test and diagnostics products are typically sold to OEMs that incorporate our products into their products. Our OEM customers sell their equipment and software products to telephone companies.

Our biometrics products consist of software and services used in biometric systems. Biometric systems are used by governments and enterprises to verify the identification of people. Biometrics systems are used in applications such as border control, secure credentialing, and background checks. We typically sell our biometrics software and services to OEMs and system integrators that incorporate our products into their biometrics hardware and software systems. We also sell a modest amount of medical imaging software that is included in our biometrics product line revenue.

On October 14, 2009, we entered into an agreement with Lantiq to sell certain assets associated with our home networking and DSL technology for $6.75 million. Lantiq is a newly formed fabless semiconductor company that was spun out of Infineon. The planned sale includes: i) our home networking and DSL technology products; ii) certain patents and patent applications related to these technologies; and iii) a group of approximately 40 engineers and the equipment used by those engineers. The transaction is subject to closing conditions, including the closing of the acquisition of Infineon's Wireline Division by Golden Gate Capital/Lantiq. The transaction is expected to close in the fourth quarter of 2009.

Upon closing the Lantiq transaction, we will no longer derive DSL contract revenue from Infineon or Lantiq. Over the past several years, contract revenue from this source has ranged from $0.5 million to $1.0 million per quarter. We will amend and restate the existing license agreement between us and Infineon to provide Lantiq (as successor to Infineon) certain non-exclusive licenses of our patent rights, and to continue Lantiq's royalty obligations to Aware. We also expect to continue to derive contract revenue for engineering support and royalties per our existing agreements with Ikanos. We will not be pursuing new silicon intellectual property licensing customers for DSL or home networking applications. In addition, Aware will sublease certain office and lab space to Lantiq at its main facilities in Bedford, Massachusetts.

Upon closing the Lantiq transaction, we expect that quarterly licensing engineering expenses will decrease by $1.7 million to $2.0 million as a result of the transfer of approximately 40 engineers to Lantiq.

We expect the Lantiq transaction will have a minimal impact on the future financial results of our DSL test and diagnostics and our biometrics product lines. Aware and Lantiq will cooperate with one another with respect to embedded wireline diagnostics technology and products.

The planned Lantiq transaction did not affect our results of operations for the three and nine month periods ended September 2009.

Results of Operations

Product Sales. Product sales consist primarily of revenue from the sale of hardware and software products. Hardware products consist of DSL test and diagnostics hardware, including systems, modules, and modems. Software products consist of software products for biometric, medical imaging and digital imaging applications, as well as DSL test and diagnostics software.

Product sales increased 18% from $3.9 million in the third quarter of 2008 to $4.7 million in the current year quarter. As a percentage of total revenue, product sales increased from 62% in the third quarter of 2008 to 75% in the current year quarter. The dollar increase in product sales was primarily due to an increase in revenue from the sale of test and diagnostic hardware and software.

For the nine months ended September 30, 2009, product sales decreased 4% from $11.8 million in 2008 to $11.3 million in 2009. As a percentage of total revenue, product sales increased from 64% in the first nine months of 2008 to 68% in the corresponding period of 2009. The dollar decrease in product sales was primarily due to a decrease in revenue from the sale of biometric software, which was mostly offset by an increase in revenue from the sale of test and diagnostic hardware and software.

We do not expect the planned Lantiq transaction to materially affect future product sales.

Contract Revenue. Contract revenue consists of patent, license and engineering service fees that we receive under agreements relating to the sale or license of Aware's patents, DSL technology, DSL test and diagnostics technology, and biometrics technology.

Contract revenue decreased 50% from $2.0 million in the third quarter of 2008 to $1.0 million in the current year quarter. As a percentage of total revenue, contract revenue decreased from 32% in the third quarter of 2008 to 16% in the current year quarter. The dollar decrease in contract revenue was equally attributable to lower revenue from biometrics technology contracts and DSL technology contracts.

For the nine months ended September 30, 2009, contract revenue decreased 30% from $5.3 million in 2008 to $3.7 million in 2009. As a percentage of total revenue, contract revenue decreased from 29% in the first nine months of 2008 to 22% in the corresponding period of 2009. The dollar decrease in contract revenue was primarily due to decreased revenue from biometrics technology contracts. Revenue from biometrics technology contracts was lower in the current year period primarily because revenue from a large project that commenced in late 2007 was lower.

Upon closing the Lantiq transaction, we expect that contract revenue from DSL technology contracts will decline by $0.5 million to $1.0 million per quarter. Post-closing contract revenue is expected to consist of revenue from some or all of the following sources: i) Ikanos; ii) biometrics technology contracts; and
iii) sales and/or licenses of patents. We will not be pursuing new silicon IP licensing customers for DSL or home networking applications.

Royalties. Royalties consist of royalty payments that we receive under agreements with our customers. We receive royalties from customers for rights to Aware technology and/or patents, typically associated with the incorporation of Aware technology and/or patents in customer chipsets or solutions.

Royalties increased 27% from $437,000 in the third quarter of 2008 to $554,000 in the current year quarter. As a percentage of total revenue, royalties increased from 7% in the third quarter of 2008 to 9% in the current year quarter. The dollar increase in royalties was primarily due to an increase in ADSL and VDSL royalties.

For the nine months ended September 30, 2009, royalties increased 14% from $1.3 million in 2008 to $1.5 million in 2009. As a percentage of total revenue, royalties increased from 7% in the first nine months of 2008 to 9% in the corresponding period of 2009. The dollar increase in royalties was primarily due to an increase in VDSL royalties.

Our royalty revenue currently comes predominantly from ADSL chipset sales by Ikanos and ADSL and VDSL chipset sales by Infineon's wireline semiconductor group. The Lantiq transaction will not alter the royalty obligations of Ikanos or Lantiq, which we expect to continue per the existing agreements with those parties. We remain uncertain as to whether these licensees will be able to maintain their market shares and chipset prices in the face of intense competition, and whether our relationships with them will contribute meaningful royalties to us in the future.

Upon closing the Lantiq transaction, we will not be pursuing new silicon intellectual property licensing customers for DSL or home networking applications.

Cost of Product Sales. Since the cost of software product sales is minimal, cost of product sales consists primarily of the cost of hardware product sales.

Cost of product sales increased 62% from $528,000 in the third quarter of 2008 to $857,000 in the current year quarter. As a percentage of product sales, cost of product sales increased from 13% in the third quarter of 2008 to 18% in the current year quarter, which resulted in gross margins on product sales decreasing from 87% to 82%. The cost of product sales dollar increase was primarily due to higher sales of test and diagnostics hardware. The decrease in product gross margins was primarily due to a greater proportion of hardware sales in product sales in the current quarter versus the year ago quarter.

For the nine months ended September 30, 2009, cost of product sales increased 22% from $2.0 million in 2008 to $2.4 million in 2009. As a percentage of product sales, cost of product sales increased from 17% in the first nine months of 2008 to 21% in the corresponding period of 2009, which resulted in gross margins on product sales decreasing from 83% to 79%. The cost of product sales dollar increase was primarily due to: i) higher sales of hardware products; and
ii) the mix of hardware products sold in the current year period versus the prior year period. The decrease in product gross margins was primarily due to a greater proportion of hardware sales in product sales in the current nine month period versus the same period last year.

We do not expect the planned Lantiq transaction to materially affect future cost of product sales.

Cost of Contract Revenue. Cost of contract revenue consists primarily of compensation costs for engineers and expenses for consultants, technology licensing fees, recruiting, supplies, equipment, depreciation and facilities associated with customer development projects. Our total engineering costs are allocated between cost of contract revenue and research and development expense. In a given period, the allocation of engineering costs between cost of contract revenue and research and development is a function of the level of effort expended on each.

Cost of contract revenue decreased 47% from $1.4 million in the third quarter of 2008 to $0.7 million in the current year quarter. Cost of contract revenue as a percentage of contract revenue, was 68% in the third quarter of 2008 and 71% in the current quarter, which resulted in gross margins on contract revenue decreasing from 32% to 29%. The dollar decrease in cost of contract revenue was primarily due to lower revenue from biometrics technology contracts and DSL technology contracts.

For the nine months ended September 30, 2009, cost of contract revenue decreased 28% from $3.5 million in the first nine months of 2008 to $2.5 million in the corresponding period of 2009. Cost of contract revenue as a percentage of contract revenue increased from 66% in the first nine months of 2008 to 68% in the corresponding period of 2009, which resulted in gross margins on contract revenue decreasing from 34% to 32%. The dollar decrease in cost of contract revenue was primarily due to lower revenue from biometrics technology contracts.

Upon closing the Lantiq transaction, we expect that cost of contract revenue in future periods will decline by an amount equal to 80% to 90% of the decrease in DSL contract revenue that was eliminated as a result of the Lantiq transaction.

Research and Development Expense. Research and development expense consists primarily of compensation costs for engineers and expenses for consultants, recruiting, supplies, equipment, depreciation and facilities related to engineering projects to improve our broadband intellectual property offerings, as well as our software and hardware product technology.

Research and development expenses increased 8% from $2.9 million in the third quarter of 2008 to $3.2 million in the current year quarter. As a percentage of total revenue, research and development expense increased from 46% in the third quarter of 2008 to 51% in the current year quarter. The dollar increase in research and development expense was primarily due to: i) a shift of engineering resources from DSL customer contracts (i.e., cost of contract revenue) to internal development projects (i.e., research and development expense) and ii) increased engineering spending in our biometrics organization. These dollar increases were partially offset by lower spending in our DSL engineering organizations.

Research and development expenses decreased 6% from $10.0 million in the first nine months of 2008 to $9.3 million in the first nine months of 2009. As a percentage of total revenue, research and development expense increased from 54% in the first nine months of 2008 to 56% in the corresponding period of 2009. The dollar decrease in research and development expense was primarily due to headcount attrition in our DSL engineering organization and lower spending on design and other outside services.

Our research and development spending has been principally focused on developing analog and digital silicon IP solutions for broadband communications applications, developing test and diagnostics hardware and software, and developing biometrics and imaging software. If the Lantiq transaction closes, our future research and development activities will be focused on developing test and diagnostics hardware and software, and developing biometrics and imaging software.

Upon closing the Lantiq transaction, we expect that our future engineering expenses will decrease by $1.7 million to $2.0 million per quarter due to the transfer of approximately 40 engineers to Lantiq. This future period expense reduction will appear on the research and development expense and cost of contract revenue lines of our consolidated statements of operations as we allocate engineering expenses to both of these expense classifications.

Selling and Marketing Expense. Selling and marketing expense consists primarily of compensation costs for sales and marketing personnel, travel, advertising and promotion, recruiting, and facilities expense.

Sales and marketing expense increased 10% from $1.14 million in the third quarter of 2008 to $1.25 million in the current year quarter. As a percentage of total revenue, sales and marketing expense increased from 18% in the third quarter of 2008 to 20% in the current year quarter. The dollar increase was primarily due to higher stock-based compensation expenses related to an amendment to certain officer stock options.

For the nine months ended September 30, 2009, sales and marketing expenses increased 7%, from $3.3 million in 2008 to $3.5 million in 2009. As a percentage of total revenue, sales and marketing expenses increased from 18% in the first nine months of 2008 to 21% in the corresponding period of 2009. The dollar increase was mainly attributable to headcount growth in our biometrics sales organization and, to a lesser degree, to higher stock-based compensation expenses related to an amendment to certain officer stock options.

Since the Lantiq transaction does not involve any of our sales or marketing personnel, the closing of the transaction will have a minimal impact on future sales and marketing expenses.

General and Administrative Expense. General and administrative expense consists primarily of compensation costs for administrative personnel, facility costs, bad debt, audit, legal, stock exchange and insurance expenses.

General and administrative expenses increased 5% from $1.3 million in the third quarter of 2008 to $1.4 million in the current year quarter. As a percentage of total revenue, general and administrative expense increased from 21% in the third quarter of 2008 to 22% in the current year quarter. The dollar increase was primarily due to: i) higher stock-based compensation expenses related to an amendment to certain director and officer stock options; and ii) director compensation expense. Higher expenses from these items were partially offset by lower spending on legal fees.

For the nine months ended September 30, 2009, general and administrative expenses were unchanged at $3.8 million in 2008 and 2009. As a percentage of total revenue, general and administrative expenses increased from 21% in the first nine months of 2008 to 23% in the corresponding period of 2009. Level spending in the nine month periods reflects increased expenses related to stock-based compensation and director compensation, which was partially offset by lower spending on legal fees and salaries.

Since the Lantiq transaction does not involve any of our administrative personnel, the closing of the transaction will have a minimal impact on future general and administrative expenses.

Interest Income. Interest income decreased 87% from $244,000 in the third quarter of 2008 to $31,000 in the current year quarter. For the nine months ended September 30, 2009, interest income decreased 77%, from $942,000 in 2008 to $217,000 in 2009. For the three and nine month periods, the dollar decrease was primarily due to a substantial decline in money market interest rates.

Income Taxes. We made no provision for income taxes in the first nine months of 2009 and 2008 due to net losses incurred and the uncertainty of the timing of profitability in future periods, except for $5,000 and $16,000 of state excise taxes paid in the first nine months of 2009 and 2008, respectively. In 2002, we determined that due to our continuing operating losses as well as the uncertainty of the timing of profitability in future periods, we should fully reserve our deferred tax assets. As of September 30, 2009, our deferred tax assets continue to be fully reserved. We will continue to evaluate, on a quarterly basis, the positive and negative evidence affecting the realizability of our deferred tax assets.

As of December 31, 2008, we had federal net operating loss and research and experimentation credit carryforwards of approximately $46.5 million and $12.8 million respectively, which may be available to offset future federal income tax liabilities and expire at various dates from 2009 through 2029. In addition, at December 31, 2008, we had approximately $11.4 million and $6.6 million of state net operating losses and state research and development and investment tax carryforwards, respectively, which expire at various dates from 2009 through 2023.

Based on an analysis that we performed under Internal Revenue Code Section 382 on our NOLs generated for the period 1997 through 2007, we have not experienced a change in ownership as defined by Section 382, and, therefore, the NOLs are not currently under any Section 382 limitation.

Liquidity and Capital Resources

At September 30, 2009, we had cash and cash equivalents of $32.6 million, which represents a decrease of $12.9 million from December 31, 2008. The decrease in cash was primarily due to: i) cash used by operations of $3.8 million; ii) repurchases of our common stock of $9.0 million; and iii) capital spending on equipment of $0.1 million.

Cash used by operations in the first nine months of 2009 of $3.8 million was primarily the result of two factors: i) a net loss of $4.9 million, which was reduced for non-cash items related to depreciation and amortization of $0.7 million, and stock based compensation expense of $1.5 million; and ii) $1.1 million of cash used to fund working capital items.

In the second quarter of 2009, we completed a modified Dutch auction self-tender offer. We repurchased 3,500,252 shares at $2.50 per share for a total cost of $9.0 million, including expenses.

Capital spending was primarily related to the purchase of computer hardware, and laboratory equipment used principally in engineering activities.

While we can not assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents will be sufficient to fund our operations for at least the next twelve months.

Recent Accounting Pronouncements

See Note H to our Consolidated Financial Statements in Item 1.

ITEM 3: