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AWRE > SEC Filings for AWRE > Form 10-Q on 31-Oct-2012All Recent SEC Filings

Show all filings for AWARE INC /MA/

Form 10-Q for AWARE INC /MA/


31-Oct-2012

Quarterly Report

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 our Annual Report on Form 10-K for the year ended December 31, 2011, 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 of Operations. We have been a supplier of signal processing and digital communications technology for imaging and telecommunications applications since the early 1990s. Presently, our business operations are focused along three product lines: i) biometrics and imaging; ii) DSL service assurance; and iii) patent management, which is included in our Corporate segment.

Biometrics & Imaging. Our biometrics products consist of software and services used in biometric systems, and our imaging products consist of software used primarily in medical imaging applications. Biometrics systems are used in applications such as law enforcement, border control, national defense, secure credentialing, access control and background checks. We typically sell our biometrics software and services to: i) systems integrators that incorporate our software products into biometrics systems that they are developing on behalf of their customers; ii) OEMs that incorporate our products into their biometrics hardware and software solutions; and iii) directly to government agencies that are deploying biometrics systems. Our imaging software is primarily sold to OEMs and systems integrators that incorporate our software into their medical and imaging products.

DSL Service Assurance. Our DSL service assurance products consist of DSL software products that are used by telephone companies to improve the quality of their DSL service offerings. We sell our DSL service assurance software products through OEMs and directly to telephone companies.

Patent Management. As previously disclosed, we have been executing a strategy to monetize a significant portion of our patent portfolio unrelated to our biometrics and DSL service assurance product lines. Those activities have produced two significant patent sales in the second and third quarters of 2012, which are described below:

On April 26, 2012, we entered into an agreement to sell a portion of our patent portfolio pertaining to wireless technology for $75.0 million. The proceeds from the sale were reduced by $3.8 million of transaction costs, which consisted primarily of fees from the law firm that assisted us in the sale. The transaction closed on June 21, 2012 and a gain of $71.2 million was included in our financial results for the three months ended June 30, 2012.

On August 22, 2012, we entered into an agreement to sell a portion of our patent portfolio pertaining to digital subscriber line ("DSL") technology for $16.0 million. The proceeds from the sale were reduced by $0.8 million of transaction costs, which also consisted primarily of fees from the law firm that assisted us in the sale. The transaction closed on September 21, 2012 and a gain of 15.2 million was included in our financial results for the three months ended September 30, 2012.


The majority of the remaining patents in our patent portfolio relate to our biometrics and imaging and DSL service assurance software product lines. At the current time, we do not intend to pursue patent monetization alternatives for these patents, although that decision is subject to change.

We believe that the wireless and DSL patent sales will have no material impact on our biometrics and imaging and DSL service assurance software product lines.

Prior to November 2009, we were also a supplier of DSL silicon intellectual property to the semiconductor industry. We continue to receive royalties from two customers that use our DSL silicon IP in their DSL chipsets.

Discontinued Operations. In January 2012, our Board of Directors approved the shutdown of our DSL service assurance hardware product line which was a component of our DSL Service Assurance Segment. We continued to build and ship DSL service assurance hardware products to satisfy final customer orders during the three and nine month periods ended September 30, 2012. During the third quarter of 2012, we substantially completed the shutdown and we will no longer have any significant continuing involvement or cash flows from this product line. Accordingly, we began reporting the results of our DSL service assurance hardware product line as discontinued operations in the third quarter of 2012.

Income (loss) from discontinued operations attributable to the DSL service assurance hardware product line was (in thousands):

                                                 Three Months Ended              Nine Months Ended
                                                   September 30,                   September 30,
                                                 2012            2011           2012           2011

Revenue                                      $      724       $   1,002     $    2,809      $   4,355
Expenses                                            364           1,319          2,206          4,879
Income (loss) before income taxes                   360            (317 )          603           (524 )
Income taxes                                        143               -            243              -
Income (loss) from discontinued operations   $      217      ($     317 )   $      360     ($     524 )

There were $286,000 of assets and $20,000 of liabilities remaining on the balance sheet as of September 30, 2012 related to the DSL service assurance hardware product line.

Included in income from discontinued operations for the nine months ended September 30, 2012 was approximately $282,000 of one-time shutdown costs, the majority of which were severance and employee-related costs.

Summary of Financial Results

Net income from continuing operations for the three months ended September 30, 2012 was $10.1 million, or $0.45 per diluted share, which compares to net income from continuing operations of $1.6 million, or $0.08 per diluted share, for the three months ended September 30, 2011.

Net income from continuing operations for the nine months ended September 30, 2012 was $66.0 million, or $3.01 per diluted share, which compares to net income from continuing operations of $2.1 million, or $0.10 per diluted share, for the nine months ended September 30, 2011.

Higher net income from continuing operations in three and nine month periods ended September 30, 2012 versus the corresponding periods in 2011 was primarily a result of gains on the sale of patent assets. Operating income before gain on the sale of patent assets in the three and nine month periods ended September 30, 2011 and 2012 was comparable in both years.


Results of Operations

Product Sales. Product sales consist primarily of revenue from the sale of software products. Software products consist of software licenses and maintenance contracts for biometrics, medical imaging, and DSL service assurance applications.

Product sales increased 4% from $3.9 million in the three months ended September 30, 2011 to $4.0 million in the same three month period in 2012. As a percentage of total revenue, product sales increased from 72% in the third quarter of 2011 to 77% in the current year quarter. The dollar increase in product sales was primarily due to a $0.2 million increase in revenue from the sale of biometrics and imaging software which was partially offset by a $0.1 million decrease in revenue from the sale of DSL service assurance software.

Product sales increased 10% from $9.6 million in the nine months ended September 30, 2011 to $10.5 million in the same nine month period in 2012. As a percentage of total revenue, product sales increased from 67% in the first nine months of 2011 to 74% in the corresponding period of 2012. The dollar increase in product sales was primarily due to a $1.6 million increase in revenue from the sale of biometrics and imaging software which was partially offset by a $0.7 million decrease in revenue from the sale of DSL service assurance software.

Increases in revenue from the sale of biometrics and imaging software in the three and nine month periods ended September 30, 2012 versus the corresponding periods in 2011 were primarily due to larger-sized license transactions as a result of our channel partners purchasing licenses for their end user customers projects. In addition, in the third quarter of 2012 we had a large direct license sale to a U.S. government customer.

Decreases in revenue from the sale of DSL service assurance software in the three and nine month periods ended September 30, 2012 were primarily due to a lack of any significant sales of our LDP product during the three and nine month periods of 2012.

Services. Services primarily consist of engineering service fees related to: i) our biometrics and imaging product line; ii) our DSL service assurance software product line; and iii) a legacy DSL silicon contract.

Services decreased 25% from $1.0 million in the three months ended September 30, 2011 to $0.7 million in the same three month period in 2012. As a percentage of total revenue, services decreased from 18% in the third quarter of 2011 to 14% in the current year quarter. The dollar decrease in services sales was primarily due to a $0.2 million decrease in revenue from the sale of biometrics engineering services; a $46,000 decrease in revenue from the sale of DSL service assurance engineering services; and a $47,000 decrease in revenue from the sale of legacy DSL silicon services.

Services decreased 34% from $3.2 million in the first nine months of 2011 to $2.1 million in the same nine month period in 2012. As a percentage of total revenue, services decreased from 22% in the first nine months of 2011 to 15% in the corresponding period of 2012. The dollar decrease in services sales was primarily due to a $0.8 million decrease in revenue from the sale of biometrics engineering services; a $0.2 million decrease in revenue from the sale of DSL service assurance engineering services; and a $47,000 decrease in revenue from the sale of legacy DSL silicon services.

Decreases in revenue from biometrics engineering services in the three and nine month periods ended September 30, 2012 were primarily due to two factors: i) we had two large projects with U.S. government customers in 2011, one of which ended in late 2011, and the other has been winding down in 2012; and ii) we had fewer larger projects with other customers in 2012. While we are attempting to grow our biometrics services business, we are unable to predict whether services revenue will trend upward or downward in future periods as we continue to develop this business.

Decreases in revenue from DSL service assurance engineering services in the three and nine month periods ended September 30, 2012 were primarily due to no significant LDP product sales during these periods.


Royalties. Royalties consist of royalty payments we receive under legacy DSL silicon contracts. We receive royalties from DSL silicon customers for the right to incorporate our silicon IP in their DSL chipsets.

Royalties decreased 12% from $549,000 in the three months ended September 30, 2011 to $484,000 in the same three month period in 2012. As a percentage of total revenue, royalties decreased from 10% in the third quarter of 2011 to 9% in the current year quarter. The dollar decrease in royalties was primarily due to lower DSL royalties reported to us by both of our licensees.

Royalties increased 4% from $1.54 million in the first nine months of 2011 to $1.60 million in the same nine month period in 2012. As a percentage of total revenue, royalties were unchanged at 11% in the first nine months of 2011 and 2012. The dollar increase in royalties was primarily due to higher DSL royalties reported to us by one of our licensees, which was partially offset by lower royalties from our other licensee.

Our royalty revenue currently comes predominantly from DSL chipset sales by Ikanos Communications, Inc. ("Ikanos") and Lantiq Deutschland GmbH ("Lantiq"). The sale of our DSL silicon IP assets in November 2009 did 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. Accordingly, we are unable to predict whether royalties reported by our licensees will trend upward or downward in future periods.

Cost of Services. Cost of services consists of engineering costs to complete customer engineering projects. Such costs primarily include: i) engineering salaries, stock-based compensation, fringe benefits, and facilities; and ii) engineering consultants and contractors.

Cost of services increased 2% from $414,000 in the three months ended September 30, 2011 to $421,000 in the same three month period in 2012. Cost of services as a percentage of services increased from 43% in the third quarter of 2011 to 58% in the current quarter, which means that gross margins on services decreased from 57% to 42%.

For the three month period, the dollar increase in cost of services was primarily due to higher costs associated with delivering biometrics engineering services despite declining services revenue. Higher biometrics services costs were partially offset by lower DSL service assurance and legacy DSL silicon cost of services. Higher biometrics engineering services costs and the corresponding decrease in gross margins on services was primarily due to the mix of engineering service projects. The profitability of service revenue is affected by the size and profitability of individual customer projects.

Cost of services decreased 7% from $1.2 million in the nine months ended September 30, 2011 to $1.1 million in the same nine month period of 2012. Cost of services as a percentage of services increased from 38% in the first nine months of 2011 to 54% in the corresponding period of 2012, which means that gross margins on services decreased from 62% to 46%.

For the nine month period, the dollar decrease in cost of services was primarily due to a decrease in revenue from biometrics engineering, DSL service assurance, and legacy DSL silicon services as described in the Services section above. The decrease in gross margins on services was primarily due to the mix of engineering service projects. The profitability of service revenue is affected by the size and profitability of individual customer projects that comprise service revenue in any particular quarter.

Research and Development Expense. Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies, equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop technology, products and patents related to our various product lines are classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide engineering services for customer projects are classified as cost of services, and are not included in research and development expense.


The classification of total engineering costs to research and development expense and cost of services was (in thousands):

                                      Three Months Ended         Nine Months Ended
                                        September 30,              September 30,
                                       2012         2011         2012         2011

Research and development expense   $   1,466      $ 1,357     $   4,431     $ 4,063
Cost of services                         421          414         1,138       1,221
Total engineering costs            $   1,887      $ 1,771     $   5,569     $ 5,284

Research and development expense increased 8% from $1.4 million in the three months ended September 30, 2011 to $1.5 million in the same three month period in 2012. As a percentage of total revenue, research and development expense increased from 25% in the third quarter of 2011 to 28% in the corresponding period of 2012.

The dollar increase in research and development expense was primarily due to higher spending in our biometrics engineering organization. Higher biometrics engineering spending was the result of headcount additions and third party contractor expenses.

Research and development expense increased 9% from $4.1 million in the nine months ended September 30, 2011 to $4.4 million in the same nine month period in 2012. As a percentage of total revenue, research and development expense increased from 28% in the first nine months of 2011 to 31% in the corresponding period of 2012.

The dollar increase in research and development expense was primarily due to higher spending in our biometrics engineering organization; and ii) less engineering costs classified as cost of services as presented in the table above. Higher biometrics engineering spending was the result of headcount additions and third party contractor expenses. Less engineering costs were classified to cost of services because of a decrease in biometrics engineering services revenue.

Our research and development activities are focused primarily on developing biometrics and imaging software, and DSL service assurance software.

Selling and Marketing Expense. Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions, stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses.

Sales and marketing expense increased 9% from $1.0 million for the three months ended September 30, 2011 to $1.1 million for the same three month period in 2012. As a percentage of total revenue, sales and marketing expense increased from 18% in the third quarter of 2011 to 20% in the corresponding period of 2012.

The dollar increase in sales and marketing expense was primarily due to higher spending in our biometrics sales organization. Higher biometrics and imaging sales spending was the result of headcount additions, higher commissions, and third party agents.

Sales and marketing expense increased 8% from $2.9 million for the nine months ended September 30, 2011 to $3.1 million for the same nine month period in 2012. As a percentage of total revenue, sales and marketing expense increased from 20% in the first nine months of 2011 to 22% in the corresponding period of 2012.

The dollar increase in sales and marketing expense was primarily due to: i) higher spending in our biometrics sales organization due to headcount additions, higher commissions and third party agents; and ii) higher employee and travel costs related to the sale of patents. Higher sales spending related to these two factors was partially offset by lower expenses in our DSL service assurance sales and marketing organization, which was primarily due to headcount attrition.


General and Administrative Expense. General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel, including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs and bad debt provisions.

General and administrative expense decreased 21% from $1.1 million in the three months ended September 30, 2011 to $0.9 million in the same three month period in 2012. As a percentage of total revenue, general and administrative expense decreased from 20% in the third quarter of 2011 to 16% in the current year quarter.

For the three month period, the dollar decrease in general and administrative expense was primarily due to lower expenses related to: i) consulting expenses for our former CEO; and ii) salary and other expenses for our former Chairman. We entered into a consulting contract with our former CEO upon his exit from the Company in April 2011 that ended on September 30, 2011. There were costs associated with that consulting contract in 2011, but not in 2012. In the fourth quarter of 2011, our former Chairman's title and role were changed to focus his activities on selling our patents. As a result of that change, we began classifying his salary, stock-based compensation and other expenses to sales and marketing expense instead of general and administrative expense, which resulted in the exclusion of such costs in general and administrative expenses in 2012.

General and administrative expense decreased 28% from $4.1 million in the nine months ended September 30, 2011 to $2.9 million in the same nine month period in 2012. As a percentage of total revenue, general and administrative expense decreased from 28% in the first nine months of 2011 to 21% in the corresponding period of 2012.

For the nine month period, the dollar decrease in general and administrative expense was primarily due to: i) lower expenses related to our former CEO; ii) lower expenses related to our former Chairman; and iii) lower stock-based compensation expenses for other members of senior management and our administrative staff. Lower general and administrative expenses related to these three factors were partially offset by higher third party tax accounting fees to assist us with the tax accounting on gains on patent asset sales. The nine months ended September 30, 2011 included: i) $0.8 million of salary, severance, stock-based compensation, and consulting expenses for our former CEO; and ii) $0.5 million of salary, stock-based compensation, and other expenses for our former Chairman whose expenses were classified as sales and marketing expense commencing in the fourth quarter of 2011 when his title and role changed as described above.

Gain on Sale of Patent Assets. In the three months ended September 30, 2012, we recorded a $15.2 million gain from the sale of patents pertaining to DSL technology. Gross sale proceeds of $16.0 million were reduced by $0.8 million of transaction costs which consisted primarily of fees from the law firm that assisted us with the sale.

During the nine months ended September 30, 2012, we recorded $86.4 million of gains on the sale of patents. The total gain represented two separate patent sales, including the DSL patent sale described in the previous paragraph and a $71.2 million gain from the sale of patents pertaining to wireless technology that we recorded in the second quarter of 2012. Gross sale proceeds from the wireless patent sale were $75.0 million, which was reduced by $3.8 million of transaction costs which consisted primarily of fees from the law firm that assisted us with the sale.

Other Income. We recorded $85,000 of other income in the nine month period ended September 30, 2012. This amount represented realized gains on the sale of high yield bond investments.


Interest Income. Interest income increased 271% from $12,000 in three months ended September 30, 2011 to $45,000 in the same three month period in 2012. The dollar increase was primarily due to higher cash balances as a result of proceeds from patent sales in the second and third quarters of 2012.

Interest income increased 190% from $47,000 in the nine months ended September 30, 2011 to $137,000 in the same nine month period in 2012. The dollar increase was primarily due to: i) higher cash balances as a result of proceeds from patent sales in the second and third quarters of 2012; and ii) interest income from high yield bonds.

Income Taxes. The gains on sale of patent assets were primarily responsible for producing $89.2 million of income from continuing operations before taxes in the nine month period ended September 30, 2012. We used a significant portion our available deferred tax assets to reduce income taxes on year-to-date pre-tax earnings. Income taxes due on pre-tax earnings for the nine months ended of September 30, 2012 were $7.7 million. The $5.3 million income tax liability on our balance sheet at September 30, 2012 consisted of $3.8 million of federal income taxes and $1.5 million of state income taxes, after being reduced by $2.4 million of estimated taxes that we paid during the third quarter of 2012.

A substantial portion of the deferred tax assets we utilized comprised cumulative deductions for stock options in excess of book expense. Under income tax accounting rules, that portion of tax benefits attributable to such deductions must be recorded as an adjustment to equity versus a reduction of income tax expense. In the three and nine months ended September 30, 2012, the tax benefits from such stock-based awards were $3.1 million and $15.8 million, which we recorded as an equity adjustment to additional paid-in capital.

Total income tax expense for the three months ended September 30, 2012 was $6.7 million, including $6.6 million that was recorded in continuing operations and $0.1 million that was recorded in discontinued operations. Total income tax expense for the nine months ended September 30, 2012 was $23.5 million, including $23.2 million that was recorded in continuing operations and $0.3 million that was recorded in discontinued operations. The Company's actual tax liability for the first nine months of 2012 was $7.7 million as taxes that are currently payable were reduced by the $15.8 million equity adjustment mentioned above.

We continue to record a full valuation allowance against our remaining deferred tax assets because based on all the available evidence, we continue to believe that it is more likely than not that our deferred tax assets are not currently realizable. In reaching this determination, we evaluated our three-year cumulative results as well as the impact that current economic conditions may have on our future results.

Included in total deferred tax assets at September 30, 2012 is approximately $11.8 million of federal and state research credit carryforwards. As mentioned above, the Company has provided a full valuation allowance against these carryforwards, based on the uncertainty surrounding the realization of these assets. In addition, in connection with a detailed review of the prior year credits, the Company has determined that up to $7.7 million of these credit carryforwards represent an uncertain tax position.

We will continue to assess the level of valuation allowance required in future periods. Should more positive than negative evidence regarding the realizability . . .

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