UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-K
Commission File Number 0-26536
SMITH MICRO SOFTWARE, INC.
Registrant’s telephone number, including area code: (949) 362-5800
Securities registered pursuant to Section 12(b) of the Act: NoneSecurities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 par value
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ ].
Indicate by check mark if whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES [ ] NO [X]
The Registrant does not have different classes of Common Stock. As of June 28, 2002, the last business day of the Registrant’s most recently completed second quarter, the aggregate market value of the Common Stock of the Registrant held by non-affiliates was $7,432,158, based upon the closing sale price of such stock on that date. For purposes of such calculation, only executive officers, board members, and beneficial owners of more than 10% of the Company’s outstanding Common Stock are deemed to be affiliates.
As of March 5, 2003, there were 16,227,416 shares of Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s Proxy Statement for the Annual Meeting of Stockholders currently expected to be held on May 20, 2003, as filed with the Securities Exchange Act of 1934, are incorporated by reference in Part III of this Report.
TABLE OF CONTENTS
2002 FORM 10-K ANNUAL REPORT
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The Private Securities Litigation Reform Act Of 1995 Provides A “Safe Harbor” For Forward-Looking Statements. The Statements Contained In This Annual Report On Form 10-K That Are Not Statements Of Historical Fact May Be Forward Looking Statements. Words Such As “Anticipates,” “Believes,” “Expects,” “Intends,” “Plans” Or Similar Expressions Are Intended To Identify Such Forward-Looking Statements. Such Statements Are Not Guarantees Of Future Performance And Are Subject To A Number Of Risks And Uncertainties That Could Cause The Actual Results Of The Company To Materially Differ From Those Anticipated. Readers Are Cautioned Not To Place Undue Reliance On These Forward-Looking Statements That Speak Only As The Date Hereof. The Company Disclaims Any Obligation To Publicly Release The Results Of Any Revisions To These Forward Looking Statements That May Be Made To Reflect Events Or Circumstances Occurring Subsequent To The Filing Of This Form 10-K With The Securities And Exchange Commission Or Otherwise To Revise Or Update Any Oral Or Written Forward Looking Statement That May Be Made From Time To Time By Or On Behalf Of The Company. Readers Are Also Urged To Carefully Review And Consider The Various Disclosures Made By The Company That Describe Certain Factors Which Affect The Company’s Business, Including The “Risk Factors” Commencing On Page 21 Of This Annual Report, In “Management’s Discussion And Analysis Of Financial Condition And Results Of Operations” And Similar Discussions In Our Other Securities And Exchange Commission Filings. You Should Carefully Consider Those Factors, In Addition To The Other Information In This Annual Report, Before Deciding To Invest In Our Company Or To Maintain Or Increase Your Investment.
In This Document, The Terms “Smith Micro,” “Company,” “We,” “Us,” And “Our” Refer To Smith Micro Software, Inc. And Its Subsidiaries.
PART I
Item 1. BUSINESS
General
Smith Micro Software, Inc., a Delaware corporation, (the “Company”) is a developer and marketer of wireless, communications, diagnostic, utility and eBusiness software products as well as a provider of Internet consulting, hosting and fulfillment services. We design integrated, cross platform, easy-to-use software for personal computing and business solutions. Our software includes products developed for the wireless and Internet technologies, products that enable wireless communications, eBusiness, Internet communications, video conferencing, general system utility and diagnostic products and network fax along with traditional computer telephony. We continue to develop new products that leverage off our core technologies. We also leverage our experience and position with original equipment manufacturers, commonly known as OEM’s, to deploy these new product releases.
We manufacture, market and sell value-added wireless telephony products primarily targeted at the OEM market, particularly mobile phone manufacturers and wireless service providers. We offer software products for Windows XP, Windows 2000, Windows NT, Windows 98, Windows 95, Windows ME, Windows CE, Pocket PC, Palm, Macintosh, Unix and Linux operating systems. The underlying design concept is the long-standing Smith Micro concept of “enhancing the out-of-box experience” for the ultimate consumer, thereby keeping the consumer satisfaction high and the OEM device sold. In addition, our custom engineering services bring more than 20 years of hardware and software experience to OEM’s seeking to better market their products by adding additional product features, customizing existing features and translating an application into additional languages. We currently maintain OEM relationships with many wireless service providers and manufacturers that produce wireless handsets that take advantage of the high bandwidth Internet connectivity including: Audiovox, Cingular Wireless, Hughes Network Systems, Kyocera, LGIC, Samsung and Verizon Wireless.
The Company’s diagnostic & utility products include well-known brands such as HotFax, HotFax MessageCenter, FAXstf, FAXstfPro and CheckIt. These products are sold in both the OEM and retail channels. In
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the OEM market, we are a supplier of communication and diagnostic utility software, having shipped over 40 million copies of products. We currently maintain OEM relationships with many companies including Apple Computer and Philips Consumer Electronics. Additionally, these products are available through our web store, retail stores, direct sales, online locations, and value-added resellers (VAR’s) for the consumer and business markets.
The Internet marketplace is the focus of the Company’s WebDNA™ eBusiness software product, targeted at a broad spectrum of Internet users including developers, entrepreneurs, small businesses and large corporations. WebDNA™ provides the tools necessary to develop a Web site or an eBusiness site supporting Windows, Mac, Unix and Linux. Wireless WebDNA™ is an additional function that can be added to a web site built using WebDNA™ that enables WAP (Wireless Application Protocol) capability. WebDNA™ is available directly from the Company in five editions to cover a broad range of users. Consulting services offered include: website design and installation, website hosting, fulfillment services for customer web stores and WebDNA™ consulting. ISS customers include: CB Richard Ellis, Diedrich’s Coffee, Kyocera Wireless, Harmon Multimedia, Rubio’s Restaurants and Verizon Wireless, among others.
Industry Backgrounds
Wireless Industry — The evolving types of wireless infrastructures being implemented, such as 1xRTT, GPRS and ultimately 3G, offer wider bandwidth data services. Wireless platforms include the basic cellular phone, personal computing devices (PC’s) and personal communications devices including PDA’s and handheld’s. The adoption of these new mobile and wireless communications services provides opportunities for new communications software products.
Diagnostic/Utility Software Industry — Diagnostic and utility software products assist home or corporate users, and hardware manufacturers or service companies to identify and repair computer system related errors and problems.
Internet Industry— Businesses and consumers are using the Internet to communicate, transact business, share information, and access vast information resources. This is driving the adoption of new technology, products and services that enhance the Internet experience. Our cross-platform (Windows, Unix, Linux and Macintosh) WebDNA™ product is targeted at this market.
Computer Consulting Industry — A corporation’s information technology department generally evaluates whether to design, build or support computer applications internally or to contract some or all of this work to outside specialists with technical expertise. Many corporations choose to use outside consulting contractors for this work in order to focus their resources on their core competencies and avoid the time and expense required to train their own employees. Our efforts are focused on these outsourced services.
Smith Micro Strategy and Products
The Company operates in two business segments: Software Products and Services. Within the software products segment, the Company concentrates on wireless products, Macintosh products, eBusiness products for the OEM and retail markets. The Services segment provides eBusiness consulting services, web site hosting and order fulfillment services. The Company does not separately allocate operating expenses to these segments, nor does it allocate specific assets to these segments. See Note 7 of Notes to Consolidated Financial Statements for financial information related to our operating segments.
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Products and Services
The following is a list of the software products and services we offer, as well as a brief description of their principal features and functions:
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Acquisitions
In September 2000, we acquired the eBusiness consulting practice of QuickStart Technologies, Inc. As a result of this acquisition, we now have a comprehensive suite of services to assist middle market clients in planning, implementing and supporting eBusiness initiatives. These services include methodologies to help clients focus, define and prioritize Internet investments; develop eBusiness sites and custom eBusiness applications; implement tools to increase revenue per online transaction and transactions per customer; warehouse, mine and integrate data for enhanced accessibility and effective decision support; and select the right technology infrastructure to support eBusiness.
In July 2000, we acquired the CheckIt® line of software products from Touchstone Software Corporation and eSupport.Com, Inc., a wholly owned subsidiary of TouchStone Software Corporation. We market these products under the Smith Micro CheckIt® brand including: CheckIt® NetOptimizer™, CheckIt® Utilities; CheckIt® FastMove™; and CheckIt® Suite. CheckIt® NetOptimizer™ analyzes and optimizes wireless, broadband and dialup Internet connections for maximum performance. CheckIt® Utilities enables users to uncover potential problems, check PC performance and assess system reliability. CheckIt® FastMove™ is a file synchronization and transfer program for users who work on multiple PC’s and also includes file management utilities. These products are also included as components in the CheckIt® Suite product as well as available in special versions for OEM customers along with CheckIt® Factory Edition, targeted at PC manufacturers for factory testing and burn-in.
Sales and Marketing
Our products are available worldwide to customers through channels that include distributors, retail, mail order, corporate resellers, Internet based online resellers, value added resellers, and original equipment manufacturers. We also sell products and product upgrades over the Internet through our own web store at www.smithmicro.com.
We maintain distribution relationships with major independent distributors. These distributors stock our products for redistribution to independent dealers, retailers, consultants and other resellers. Our sales force works closely with our major distributor and reseller accounts to manage the flow of orders and inventory levels.
Our agreements with distributors are generally nonexclusive and may be terminated by either party without cause. These distributors are not within our control; are not obligated to purchase products from us; and they also represent other vendors’ product lines. As a percentage of our net revenues, retail sales represented 9.5% of our revenues in 2002, 13.8% of our revenues in 2001 and 24.4% of our revenues in 2000. For further discussion, see Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements in this Form 10-K.
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Our OEM market continues to evolve as we continue to offer new communications products and OEM’s adopt new technologies and software bundling techniques. Our OEM customers include: wireless phone manufacturers; wireless service providers; camera manufacturers; and other PC related equipment manufacturers. These manufacturers bundle our software products with their own products. We have translated selected products into as many as eighteen languages to allow our OEM customers the flexibility of offering multi-language products that meet the needs of their worldwide markets.
The cycle from the placement of an OEM order to shipping is very short. OEM customers generally operate under a just-in-time system and we generally ship our products as we receive orders. Additionally, an increasing percentage of our OEM revenue is derived from royalties accrued by customers that are authorized to replicate or to preload our software products.
The three largest OEM customers, and their respective affiliates, in each year, have accounted for 39.4% of our net revenues in 2002, 23.4% of our net revenues in 2001, and 21.0% of our net revenues in 2000. Our major customers could reduce their orders of our products in favor of a competitor’s product or for any other reason. The loss of any of our major OEM customers, decisions by a significant OEM customer to substantially decrease purchases or our inability to collect receivables from these customers could have an adverse effect on our business.
We have relatively little backlog for our OEM products at any given time and we do not consider backlog to be a significant indicator of future performance. Moreover, we generally do not produce software in advance of anticipated orders and therefore have insignificant amounts of inventory. As a result of the foregoing, our revenues in any quarter are substantially dependent on orders booked in that quarter.
Our consulting service group assists customers in deploying and using computer operating systems, applications, and communications products. This group works out of our Internet Software & Solutions unit and helps create enterprise-wide computing solutions for large corporate accounts.
Customer Service and Technical Support
We provide technical support and customer service through our web site, email, telephone and fax. OEM customers generally provide their own primary customer support functions and rely on us for back-up support for their own technical support personnel. We provide technical support to end users of OEM customers through the technical support section of our web site.
Product Development
The software industry, particularly the Internet and wireless markets, is characterized by rapid and frequent changes in technology and user needs. We work closely with industry groups and customers, both current and potential, to help us anticipate changes in technology and determine future customer needs. Software functionality depends upon the capabilities of the hardware. Accordingly, we maintain engineering relationships with various hardware and silicon chip manufacturers and we develop our software in tandem with their development. Our engineering relationships with manufacturers, as well as with our major customers, are central to our product development efforts. In addition, we participate in software product developer programs sponsored by key industry companies such as Microsoft and Apple. We remain focused on the development and expansion of our technology, particularly our wireless, diagnostic, utility and Internet software technologies. Research and development expenditures amounted to $2.2 million, $3.0 million and $4.0 million for the years ended December 2002, 2001 and 2000, respectively.
Manufacturing
Our software is sold in several forms. We offer a package that includes: a CD-ROM; a manual; and certain other documentation or marketing material. We also permit selected OEM customers to duplicate their own CD-ROM’s
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and pay a royalty based on usage. This method of sale does not require us to provide a CD or manual. Finally, we grant licenses to certain OEM customers that enable those customers to preload a copy of our software onto a personal computer’s hard drive. With the corporate sales program, we offer site licenses under which a corporate user is allowed to distribute copies of the software to users within the corporate sites.
Our product development groups produce a product master for each product that is then duplicated and packaged into products by the manufacturing organization. All product components are purchased by our personnel in our Aliso Viejo, California facility. The manufacturing steps that are subcontracted to outside vendors include the replication of CD-ROM’s and the printing of documentation materials. Assembly of the final package is completed in our Aliso Viejo, California manufacturing facility.
Competition
The markets in which we operate are highly competitive and subject to rapid changes in technology. The strategic directions of major personal computer and wireless communication hardware manufacturers and operating system developers are also subject to change. We compete with other software vendors for access to distribution channels, retail shelf space and the attention of customers. We also compete with other software companies in our efforts to acquire software technology developed by third parties and in attracting qualified personnel.
We believe that the principal competitive factors affecting the communication and diagnostic utility software market include product features and ease of use, willingness of the vendor to customize the product to fit customer-specific needs, product reputation, product quality, product performance, price, customer service and support and the effectiveness of sales and marketing efforts. Although we believe that our products currently compete favorably with respect to these factors, there can be no assurance that we can maintain our competitive position against current and potential competitors, especially those with significantly greater financial, marketing, service, support, technical and other resources.
Because there are relatively low barriers to entry in the communication and diagnostic utility software market and because rapidly changing technology is constantly creating new opportunities in this market, we expect new competitors to enter the market. We also believe that competition from established and emerging software companies will continue to intensify as the emerging mobile, wireless and Internet markets evolve. The markets in which we compete have been characterized by the consolidation of established communication software suppliers and we believe that this trend may continue, which may lead to the creation of additional large and better-financed competitors. Increased competition could result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business.
We face competition from Microsoft, which dominates the personal computer software industry. Due to its market dominance and the fact that it is the publisher of the most prevalent personal computer operating systems, Windows, Microsoft represents a significant competitive threat to all personal computer software vendors, including us. We also compete with Symantec and Network Associates, among others, for communication, diagnostic and utility software products. Some of our competitors have a retail emphasis and offer OEM products with a reduced set of features. The opportunity for retail upgrade sales may induce these and other competitors to make OEM products available at their own cost or even at a loss. Such a pricing strategy could have an adverse effect on our business.
Many of our current and prospective competitors have significantly greater financial, marketing, service, support, technical and other resources than we do. Moreover, these companies may introduce additional products that are competitive with ours, and our products may not compete effectively with such products. We believe that our ability to compete depends on elements both within and outside of our control, including the success and timing of new product development and introduction, product performance, price, distribution and customer support. We may not be able to compete successfully with respect to these and other factors. We believe that the market for our software products has been and will continue to be characterized by significant price competition. A material reduction in the price of our products could negatively affect our profitability.
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Many of our existing and potential OEM customers have substantial technological capabilities. These customers may currently be developing, or may in the future develop, products that compete directly with our products. In such event, these customers may discontinue purchases of our products. Our future performance is substantially dependent upon the extent to which existing OEM customers elect to purchase communication software from us rather than design and develop their own software. In light of the fact that our customers are not contractually obligated to purchase any of our products, they may cease to rely, or fail to expand their reliance, on us as an external source for communication software in the future.
Proprietary Rights and Licenses
Our success and ability to compete is dependent upon our software code base, our programming methodologies and other intellectual properties. To protect our proprietary technology, we rely on a combination of trade secrets, nondisclosure and patent, copyright and trademark law that may afford only limited protection. We apply for various patents and trademarks to protect intellectual property. We seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us and by restricting access to our source code. The steps that we have taken to protect our proprietary technology may not be adequate to deter misappropriation of our proprietary information or prevent the successful assertion of an adverse claim to software utilized by us. In addition, we may not be able to detect unauthorized use of our intellectual property rights or take effective steps to enforce those rights.
In selling our products, we primarily rely on “shrink wrap” licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Accordingly, the means we use currently to protect our proprietary rights may not be adequate. Moreover, our competitors may independently develop technology similar to ours. We also license technology on a non-exclusive basis from several companies for inclusion in our products and anticipate that we will continue to do so in the future. If we are unable to continue to license these technologies or to license other necessary technologies for inclusion in our products, or if we experience substantial increases in royalty payments under these third party licenses, our business could be materially and adversely affected.
Although we believe that our products do not infringe on the intellectual property rights of others, such a claim may be asserted against us in the future. From time to time, we have received and may receive in the future, communications from third parties asserting that trademarks used by us or features or content of certain of our products infringe upon intellectual property rights held by such third parties. As the number of trademarks, patents, copyrights and other intellectual property rights in our industry increases, and as the coverage of these patents and rights and the functionality of products in the market further overlap, we believe that our products, with their existing technology, may increasingly become the subject of infringement claims. Moreover, any of these proceedings could also result in an adverse decision as to the priority of our inventions. Such results would materially and adversely affect us, and may also require us to obtain one or more licenses from third parties. We may not be able to obtain any such required licenses upon reasonable terms, if at all, and the failure by us to obtain such licenses could prohibit us from selling some of our products or require us to modify some of our existing products.
Employees
As of December 31, 2002, we had a total of fifty-six employees: twenty-five engaged in engineering; ten in sales and marketing; nine in management and administration; seven in customer support; and five in manufacturing. We utilize temporary labor to assist during peak periods of manufacturing volume. We believe that our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support, research and development personnel and consulting staff. Like other software companies, we face intense competition for such personnel, and we have at times experienced and continue to experience difficulty in
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recruiting qualified personnel. There can be no assurance that we will be successful in attracting, assimilating and retaining other qualified personnel in the future. We are not subject to any collective bargaining agreement and we believe that our relationships with our employees are good.
Item 2. PROPERTIES
Our corporate headquarters, including our principal administrative, sales and marketing, customer support and research and development facility is located in approximately 28,500 square feet of space in Aliso Viejo, California. We have leased this facility through March 31, 2003. The company is currently evaluating alternative solutions for the Aliso Viejo facility and will enter into a month-to-month arrangement for the current facility if required. We operate both our products and services reporting segments within this facility.
Our other locations include a facility of approximately 7,000 square feet in San Diego, California pursuant to a lease that expires July 31, 2005. This space is currently sublet to a third party through December 31, 2003. Additionally, we have approximately 3,100 square feet in Beaverton, Oregon pursuant to a lease that extends through February 28, 2005. As part of the restructuring plan implemented in 2001, this facility has been vacated and we are in the process of securing a sub-tenant or negotiating a settlement with the leaseholder. We also have a facility of approximately 3,000 square feet in Lee’s Summit, Missouri pursuant to a lease that expires August 31, 2004. We believe that suitable additional or alternative space will be available in the future on commercially reasonable terms as needed.
Item 3. LEGAL PROCEEDINGS
There are no pending material legal issues at this time although we may become subject to various legal proceedings and claims that arise in the ordinary course of business.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of stockholders during the quarter ended December 31, 2002.
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PART II
Item 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Our common stock is traded on the Nasdaq SmallCap Market under the symbol “SMSI.” The high and low sale prices for our common stock as reported by Nasdaq are set forth below for the periods indicated.
On March 5, 2003, the closing sale price for our common stock as reported by Nasdaq was $0.54.
Holders
As of March 5, 2003, there were 148 holders of record of our common stock.
Dividends
We have never paid any cash dividends on our common stock and we have no current plans to do so.
Recent Sales of Unregistered Securities
None.
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Item 6. SELECTED FINANCIAL DATA
The table above sets forth our selected consolidated financial data. We derived this information from the consolidated financial statements of Smith Micro for each of the five years ended December 31, 2002.
You should read this selected consolidated financial data along with the consolidated financial statements and related Notes contained in this Report and in our other reports filed with the SEC, as well as the section of this Report and our other reports titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain Statements In This Report, Including Statements Regarding The Company’s Strategy, Financial Performance And Revenue Sources, Are Forward-Looking Statements Within The Meaning Of The Private Securities Litigation Reform Act Of 1995, Section 21e Of The Securities Exchange Act Of 1934, As Amended, And Section 27a Of The Securities Act Of 1933, As Amended, And Are Subject To The Safe Harbors Created By That Act And Those Sections. These Forward-Looking Statements Are Based On Current Expectations And Entail Numerous Risks And Uncertainties That Could Cause The Company’s Actual Results To Differ Materially From Those Expressed In Such Forward-Looking Statements. The Company’s Actual Results Could Differ Materially From The Results Anticipated In These Forward-Looking Statements As A Result Of Those Factors Set Forth Under “Risk Factors” And Elsewhere In This Report. Readers Are Urged To Carefully Review And Consider The Various Disclosures Made By The Company In This Report And In The Company’s Other Reports Filed With The SEC That Attempt To Advise Interested Parties Of Certain Risks Factors That May Affect The Company’s Business. Readers Are Cautioned Not To Place Undue Reliance On Any Forward-Looking Statements Contained In This Report. You Should Read The Following Discussion And Analysis In Conjunction With The Company’s Consolidated Financial Statements And Notes Thereto Contained Elsewhere In This Report.
Critical Accounting Policies
The Company’s discussion and analysis of its results of operations, financial condition and liquidity are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may materially differ from these estimates under different assumptions or conditions. On an on-going basis, the Company reviews its estimates to ensure that the estimates appropriately reflect changes in its business or as new information becomes available.
Management believes the following critical accounting policies affect its more significant estimates and assumptions used in the preparation of its consolidated financial statements:
Revenue Recognition — Software revenue is recognized in accordance with the Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended.SOP 97-2 provides guidance on when revenue should be recognized for licensing, selling, leasing or otherwise marketing computer software. We generally recognize revenues from sales of our software as completed products are shipped and title passes and from royalties generated as authorized customers duplicate our software, assuming collectibility is reasonably assured. Returns from OEM customers are generally limited to defective goods or goods shipped in error. We may permit retail customers to return or exchange product and may provide price protection on products unsold by a customer. In accordance with Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition when Right of Return Exists, revenue is recorded net of an allowance for estimated returns and other concessions to the extent that such returns are estimable and certain other conditions are met. Such reserves are based upon management’s evaluation of historical experience, current industry trends and estimated costs. While returns and other concessions have historically been within management’s estimates, the amount of estimated reserves could change as new information becomes available. In July of 2002, we signed a new distribution agreement with our primary distributor. As a result of the negotiation of sales return and collection terms in a new distribution agreement, revenue from distributors is now recognized upon sell-through to the end customer, rather than upon shipment to the distributor. The related impact during the third quarter of 2002 was to defer recognition of sales to distributors and increase reserves for inventory
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currently in the channel, totaling approximately $200,000. We also provide technical support to our customers. Such costs have historically been insignificant.
We recognize consulting services and hosting revenues as services are provided or as milestones are delivered and accepted by our customers.
Sales Incentives— In 2001 the Emerging Issues Task Force issued EITF 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Product). Effective January 1, 2002, we adopted EITF 01-09. Pursuant to EITF 01-09, the cost of sales incentives we offer without charge to customers that can be used in, or that are exercisable by a customer as a result of, a single exchange transaction, is required to be accounted for as a reduction of revenue. Our consolidated financial statements for prior periods have been reclassified to comply with the revised income statement display requirements for comparative purposes. The result of this adoption was a reduction in revenue with a corresponding reduction in selling and marketing expense of $223,000, $1.3 million and $259,000 in the three years ended December 31, 2002, 2001 and 2000, respectively.
Accounts Receivable — We sell our products worldwide. We perform ongoing credit evaluations of our customers and generally do not require collateral. We maintain reserves for estimated credit losses, and those losses have historically been within our expectations. We cannot, however, guarantee that we will continue to experience the same credit loss rates that we have in the past. If not, this could have an adverse effect on our consolidated financial statements. Allowances for product returns are included in other adjustments to accounts receivable on the accompanying consolidated balance sheet.
Long Lived Assets— We account for the impairment and disposition of long-lived assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. This statement addresses financial accounting and reporting for the impairment of long-lived assets and for the disposal of long-lived assets. SFAS No. 144 superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and is effective for fiscal years beginning after December 15, 2001. We adopted SFAS No. 144 on January 1, 2002. In accordance with SFAS No. 144, long-lived assets to be held are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of long-lived assets to determine whether or not an impairment to such value has occurred. We have determined that there was no impairment at December 31, 2002.
Goodwill— SFAS No. 142, which was adopted on January 1, 2002, requires that goodwill and other intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually and written down when impaired. SFAS No. 142 also requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite. In accordance with this Standard, we no longer amortize goodwill and indefinite life intangible assets but evaluates their carrying value at least on an annual basis or when events or circumstances indicate that their carrying value may be impaired. We ceased amortizing goodwill as of the beginning of fiscal 2002. In accordance with SFAS No. 142, we were required to perform a two-step transitional impairment review. The first step of this review was completed by June 30, 2002 with the determination of the fair value of our reporting units in order to identify whether the fair value of each reporting unit is less than its carrying amount. In the event that the fair value of the reporting unit is less than the carrying amount, the second step of the test would be required to determine if the carrying value of goodwill exceeds the implied value. We determined that we did not have any impairment of goodwill at transition on January 1, 2002 or at December 31, 2002. We had no indefinite life intangibles as of January 1, 2002. If estimates change, a materially different impairment conclusion could result. In accordance with this pronouncement, effective January 1, 2002, we no longer amortize goodwill. For comparison, goodwill amortization expense was $522,000 and $431,000 in the years ended December 31, 2001 and 2000, respectively. At December 31, 2002, the amount of goodwill allocated to the products reporting segment is $1,380,000. The amount of goodwill allocated to the services reporting segment is $335,000.
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Results of Operations
The following table sets forth certain consolidated statement of operating data as a percentage of total revenues for the periods indicated:
Year Ended December 31, 2002 compared to year ended December 31, 2001
Revenues
Total net revenues were $7.1 million and $9.5 million for 2002 and 2001, respectively, representing a decrease of $2.4 million, or 24.9%, from 2001 to 2002.
Products. Net revenues from sales of products were $6.0 million and $6.9 million for 2002 and 2001, respectively, representing a decrease of $916,000 or 13.2% from 2001 to 2002. Product revenues accounted for 84.6% of total revenues in 2002 and 73.2% of total revenues in 2001.
The decrease in net product revenues from 2001 to 2002 was primarily the result of the reduction of sales through the retail distribution channel. As a result of this continued erosion of retail distribution economics, during 2002 we have significantly reduced distribution channel inventory through a combination of sell-through and lowering of restocking levels. Additionally, we began recording retail revenue only upon distribution channel sell-through, rather than upon shipment pursuant to the negotiation of a new distributor agreement, which resulted in a decrease in revenue of approximately $200,000 compared to 2001.
We operate with little backlog because we generally ship our software products as we receive orders and because our royalty revenue is based upon our customers’ actual usage in a given period. As a result, our sales in any quarter are dependent on orders that we book and ship in that quarter. This makes it difficult for us to predict future revenues and trends.
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Services. Consulting services revenues were $1.1 million in 2002 and $2.5 million in 2001, respectively, representing a decrease of $1.4 million or 56.7% from 2001 to 2002. The decrease in service revenue is due to the cessation of significant “Microsoft products” consulting announced in the first quarter of 2002, due to the decrease in demand for such services. Services revenue accounted for 15.4% of total revenues in 2002 and 26.8% of total revenues in 2001.
Cost of Revenues
Cost of Product Revenues. Cost of product revenues was $1.4 million and $1.9 million in 2002 and 2001, respectively, representing a decrease of $460,000 or 24.5% from 2001 to 2002. The decrease in the cost of software revenue is directly related to the decrease in software revenue during the period. The cost of software revenue as a percentage of software revenue was 23.6% in 2002 and 27.1 % in 2001.
Cost of Service Revenues. Cost of service revenues was $782,000 and $2.0 million in 2002 and 2001, respectively, representing a decrease of $1.3 million, or 61.8% from 2001 to 2002. Cost of service revenues includes the cost of our consulting personnel and the cost of any outside consultants contracted to support our staff. The decrease in the cost of service revenues was due to headcount reductions related to the cessation of significant “Microsoft products” consulting announced in the first quarter of 2002. Cost of service revenues as a percentage of service revenues was 71.0% in 2002 and 80.5% in 2001.
Operating Expenses
Selling and Marketing. Selling and marketing expenses were $2.2 million and $4.6 million 2002 and 2001, respectively, representing a decrease of $2.4 million or 52.4%, from 2001 to 2002. Our selling and marketing expenses consist primarily of personnel costs, advertising costs, sales commissions and trade show expenses. These expenses vary significantly from quarter to quarter based on the timing of trade shows and product introductions. The decrease in these costs is attributable to cost reduction measures in all the above expense areas as implemented by management and a reduced emphasis on retail channel marketing activities. As a percentage of net revenues, selling and marketing expenses have decreased to 30.5% in 2002 from 48.2% in 2001.
Research and Development. Research and development expenses were $2.2 million and $3.0 million in 2002 and 2001, respectively, representing a decrease of $835,000, or 27.9%, from 2001 to 2002. Our research and development expenses consist primarily of personnel and equipment costs required to conduct our software development efforts. We remain focused on the development and expansion of our technology, particularly our wireless, diagnostic, utility and Internet software technologies. The decrease in our research and development expenses is primarily due to the cost reduction efforts implemented by management, primarily headcount related, and realigns our research and development cost base consistent with current revenues. As a percentage of net revenues, research and development expenses have decreased to 30.3% in 2002 from 31.6% in 2001.
General and Administrative. General and administrative expenses were $2.3 million and $3.7 million in 2002 and 2001, respectively, representing a decrease of $1.4 million, or 38.0%, from 2001 to 2002. The decrease in our general and administrative expenses is due primarily to decreased bad debt expense of approximately $600,000 and the cessation of goodwill amortization of $522,000. The decrease was also due to cost reduction efforts implemented by management that consisted of reductions in compensation and professional services. This reduction further aligns our general and administrative cost base consistent with current revenues. As a percentage of net revenues, general and administrative expenses have decreased to 32.5% in 2002 from 39.4% in 2001.
Restructuring Costs. In the second quarter of 2001 we began implementing a restructuring plan to consolidate facilities and reduce personnel costs. The plan was fully implemented by December 31, 2001. Total expense related to the restructuring amounted to $380,000, consisting of facility closure costs of $230,000 and employee severance costs of $150,000. These reductions were made to correlate with revised revenue forecasts. As of December 31, 2002, $241,000 had been paid and $139,000 was included in accrued liabilities. This amount will be paid over the remaining term of the lease, unless a sublessor is found or a settlement is reached with the landlord.
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Interest Income. Interest income was $45,000 and $199,000 in 2002 and 2001, respectively, representing a decrease of $154,000 or 77.4%, from 2001 to 2002. Decreases in our interest income, in each of years being reported, are directly related to the reductions in our cash balance and declining interest rates. We have not changed our investment strategy during the periods being reported on, with our excess cash consistently being invested in short term marketable securities. (See “Liquidity and Capital Resources” for further discussion elsewhere in this annual report.)
Interest and Other Expense. Interest and other expenses were $71,000 and $113,000 in 2002 and 2001, respectively, representing a decrease of $42,000, or 37.2%, from 2001 to 2002. Interest and other expense primarily consist of bank fees and credit card processing charges and may vary considerably from year to year.
Provision for Income Taxes. In the year ended December 31, 2002, we reported an income tax benefit in the amount of $1.1 million. This benefit is the result of a net operating loss carryback, which pursuant to a change in the federal tax law, allowed the Company to file for a refund of income taxes paid in 1996. Prior to the tax law change such amount was included in the net operating loss carryforward, which had carried a full valuation allowance. Provision for income taxes was $90,000 in 2001. The provision for income taxes in 2001 is primarily due to taxes on foreign income, which may vary significantly from year to year. We completed a tax audit during the first quarter of 2001, which resulted in a payment of $127,000. The payment was offset by foreign tax credits in the amount of $69,000.
Year Ended December 31, 2001 compared to year ended December 31, 2000
Total net revenues were $9.5 million and $13.5 million for 2001 and 2000, respectively, representing a decrease of $4.0 million or 29.6%.
Products. Net revenues from sales of products were $6.9 million, and $10.9 million for 2001 and 2000, respectively, representing decrease of $3.9 million, or 36.2%, from 2000 to 2001. Product revenues accounted for 73.2% of total revenues in 2001 and 80.8% of total revenues in 2000.
The decrease in net product revenues from 2000 to 2001 was primarily the result of declining legacy OEM fax product revenues and a substantial and unexpected change in order taking and stocking policies by our largest distributor in the second quarter of 2001. During that quarter, the distributor announced that its future inventories would run at approximately 20% of previous levels. As a result of this policy shift, new purchases from the distributor were unusually low during the second quarter of 2001. Additionally, in June 2001, we agreed to accept a significantly higher level of product returns than we had anticipated, totaling approximately $1.1 million, in an effort to work with the distributor to reduce their inventory. This one-time return resulted in a corresponding decrease in retail software sales during the second quarter of 2001.
Services. Consulting services revenues were $2.5 million in 2001 and $2.6 million in 2000. Services revenue accounted for 26.8% of total revenues in 2001 and 19.2% of total revenues in 2000.
Cost of Product Revenues. Cost of product revenues was $1.9 million and $2.5 million in 2001 and 2000, respectively, representing a decrease of $619,000 or 24.8% from 2000 to 2001. The decrease in the cost of software revenue is directly related to the decrease in product revenue during the period. The cost of product revenue as a percentage of product revenue was 27.1 % and 23.0% for 2001 and 2000, respectively.
Cost of Service Revenues. Cost of service revenues was $2.0 million and $1.2 million in 2001 and 2000, respectively, representing an increase of $898,000, or 78.1% from 2000 to 2001. Cost of service revenues includes
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the cost of our consulting personnel and the cost of any outside consultants contracted to support our staff. The increase in the cost of consulting service revenues was due to the impact of a full year of QuickStart operations in 2001. Cost of consulting services revenues as a percentage of consulting services revenues was 80.5% in 2001 and 44.3% in 2000. The increase in cost of consulting service revenues as a percentage of revenues was due to higher personnel costs and lower utilization of such personnel due to lower than expected revenues.
Selling and Marketing. Selling and marketing expenses were $4.6 million and $5.3 million in 2001 and 2000, respectively, representing a decrease of $748,000, or 14.1% from 2000 to 2001. Our selling and marketing expenses consist primarily of personnel costs, advertising costs, sales commissions and trade show expenses. These expenses vary significantly from quarter to quarter based on the timing of trade shows and product introductions. The decrease in these costs is attributable to cost reduction measures implemented by management and a decreased emphasis on retail channel marketing activities. As a percentage of net revenues, selling and marketing expenses have increased to 48.2% in 2002 from 39.5% in 2001, primarily as a result of the reduction in revenues.
Research and Development. Research and development expenses were $3.0 million and $4.0 million in 2001 and 2000, respectively, representing a decrease of $1.0 million or 25.8% from 2000 to 2001. Our research and development expenses consist primarily of personnel and equipment costs required to conduct our software development efforts. We remain focused on the development and expansion of our technology, particularly our wireless, diagnostic, utility and Internet software technologies. The decrease in our research and development expenses is primarily due to the cost reduction efforts implemented by management. This reduction realigns our research and development cost base consistent with current revenues. As a percentage of net revenues, research and development expenses have increased to 31.6% in 2002 from 30.0% in 2001, primarily as a result of the decrease in revenues.
General and Administrative. General and administrative expenses were $3.7 million and $4.0 million in 2001 and 2000, respectively, representing a decrease of $251,000, or 6.3% from 2000 to 2001. The decrease in our general and administrative expenses is due primarily to cost reduction efforts implemented by management that consisted of reductions in headcount, compensation and professional services. This reduction further aligns our general and administrative cost base consistent with current revenues. These decrease were partially offset by higher bad debt expense in 2001. As a percentage of net revenues, general and administrative expenses have increased to 39.4% in 2002 from 29.6% in 2001, primarily as a result of the decrease in revenues.
Restructuring Costs. In the second quarter of 2001 we began implementing a restructuring plan to consolidate facilities and reduce personnel costs. The plan was fully implemented by December 31, 2001. Total expense related to the restructuring amounted to $380,000 consisting of facility closure costs of $230,000 and employee severance costs of $150,000. These reductions were made to correlate with revised revenue forecasts.
Interest Income. Interest income was $199,000 and $482,000 in 2001 and 2000, respectively, representing a decrease of $283,000, or 58.7% from 2000 to 2001. Decreases in our interest income are directly related to the reductions in our cash balance and declining interest rates. We have not changed our investment strategy during the periods being reported on, with our excess cash consistently being invested in short term marketable securities. (See “Liquidity and Capital Resources” for further discussion elsewhere in this annual report.)
Interest and Other Expense. Interest and other expenses were $113,000 and $68,000 in 2001 and 2000, respectively, representing an increase of $45,000, or 66.2%, from 2000 to 2001. Interest and other expense primarily consist of bank fees and credit card processing charges and may vary considerably from year to year.
Provision for Income Taxes. Provision for income taxes was $90,000 and $54,000 in 2001 and 2000, respectively. The provision for income taxes is primarily due to taxes on foreign income, which may vary significantly from year to year. We completed a tax audit during the first quarter of 2001, which resulted in a payment of $127,000. The payment was offset by foreign tax credits in the amount of $69,000.
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Liquidity and Capital Resources
Since inception, we have financed our operations primarily through cash generated from operations and from net proceeds of $18.1 million generated by our initial public offering in 1995. Our principal source of liquidity as of December 31, 2002 consisted of cash and cash equivalents of $3.6 million.
Net cash provided by operations was $426,000 in 2002 compared with net cash used in operations of $2.9 million in 2001. The significant improvement in operating cash flows is primarily due to the reduction in the net loss. Additionally, accounts receivable decreased dramatically in 2002 as a result of improved collections and a decrease in shipments to retail distributors. This was partially offset by a decrease in accounts payable and accrued liabilities as a result of cost cutting measures implemented by management.
Cash flows used in investing activities were $23,000 in 2002 and $101,000 in 2001, related to investments in property and equipment, including computers and production equipment.
Cash flows from financing activities were insignificant in 2002 and 2001.
At December 31, 2002, we had $3.6 million in cash and cash equivalents and $3.4 million of working capital. We have no significant capital commitments, and currently anticipate that capital expenditures will not vary significantly from recent periods. We believe that our existing cash, cash equivalent investment balances and cash flow from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next twelve months. We may require additional funds to support our working capital requirements or for other purposes and may seek to raise additional funds through public or private equity or debt financing or from other sources. If additional financing is needed, we cannot assure you that such financing will be available to us at commercially reasonable terms or at all.
We are currently in the process of renegotiating a long-term facility lease to replace the lease on our corporate headquarters, which expires at the end of March, 2003. We have non-cancelable operating leases for our building facilities that expire on various dates through July 31, 2005 and no debt. Future minimum rental commitments for these leases consist of the following (in thousands):
Year ending December 31:
Recent Accounting Pronouncements
In June 2001, the FASB issued two new pronouncements: SFAS No. 141,Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 prohibits the use of the pooling-of-interest method for business combinations initiated after June 30, 2001 and also applies to all business combinations accounted for by the purchase method that are completed after June 30, 2001. The adoption of SFAS No. 141 did not have a material impact on our consolidated financial statements. SFAS No. 142, which was adopted on January 1, 2002, requires that goodwill and other intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually and written down when impaired. SFAS No. 142 also requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite. In accordance with this Standard, we no longer amortize goodwill and indefinite life intangible assets but evaluates their carrying value at least on an annual basis or when events or circumstances indicate that their carrying value may be impaired. We ceased amortizing goodwill as of the beginning of fiscal 2002. In accordance with SFAS No. 142, we were required to
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perform a two-step transitional impairment review. The first step of this review was completed by June 30, 2002 with the determination of the fair value of our reporting units in order to identify whether the fair value of each reporting unit is less than its carrying amount. In the event that the fair value of the reporting unit is less than the carrying amount, the second step of the test would be required to determine if the carrying value of goodwill exceeds the implied value. We determined that we did not have any impairment of goodwill at transition on January 1, 2002 or at December 31, 2002. We had no indefinite life intangibles as of January 1, 2002. If estimates change, a materially different impairment conclusion could result. In accordance with this pronouncement, effective January 1, 2002, we no longer amortize goodwill. For comparison, goodwill amortization expense was $522,000 and $431,000 in the years ended December 31, 2001 and December 31, 2000, respectively.
In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. We will adopt the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002.
In January 2003, the FASB issued Interpretation (FIN) No. 46,Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN No. 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. We believe that the adoption of FIN No. 46 will not have a material impact on our financial position or results of operations because we have no variable interest entities.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We are required to follow the prescribed disclosure format and have provided the additional disclosures required by SFAS No. 148 for the year ended December 31, 2002 (see Notes 1 and 9) and must also provide the disclosures in our quarterly reports containing condensed financial statements for interim periods beginning with the quarterly period ending March 31, 2003.
In November 2002, the FASB issued FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107, and rescission of FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others. FIN No. 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002; while, the provisions of the disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN No. 45 is not expected to have a material impact on our results of operations or financial position.
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RISK FACTORS
Before Deciding To Invest In Our Company Or To Maintain Or Increase Your Investment, You Should Carefully Consider The Risks Described Below, In Addition To The Other Information Contained In This Report And In Our Other Filings With The SEC, Including Our Subsequent Reports On Forms 10-Q And 8-K. The Risks And Uncertainties Described Below Are Not The Only Ones Facing Our Company. Additional Risks And Uncertainties Not Presently Known To Us Or That We Currently Deem Immaterial May Also Affect Our Business Operations. If Any Of These Risks Actually Occur, That Could Seriously Harm Our Business, Financial Condition Or Results Of Operations. In That Event, The Market Price For Our Common Stock Could Decline And You May Lose All Or Part Of Your Investment.
Our quarterly operating results may fluctuate and cause the price of our common stock to fall.
Our quarterly revenues and operating results have fluctuated significantly in the past and may continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. If our operating results do not meet the expectations of securities analysts or investors, our stock price may decline. Fluctuations in our operating results may be due to a number of factors, including the following:
A large portion of our operating expenses, including rent, depreciation, amortization, and capital lease expenditures, is fixed and difficult to reduce or change. Accordingly, if our total revenue does not meet our expectations, we probably would not be able to adjust our expenses quickly enough to compensate for the shortfall in revenue. In that event, our business, financial condition and results of operations would be materially and adversely affected.
Due to all of the foregoing factors, and the other risks discussed in this report, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of future performance.
If we are unable to comply with NASDAQ’s continued listing requirements, our common stock could be delisted from the NASDAQ.
In June 2002, our common stock failed to meet the minimum bid price of $1.00 per share for 30 consecutive days, which caused our stock price to fail to meet one of the minimum standards required by Nasdaq for continued listing as a Nasdaq National Market security. On July 25, 2002, we announced that we had voluntarily submitted an application to Nasdaq to transfer from the Nasdaq National Market to the Nasdaq SmallCap Market. Our application has been approved and we became a SmallCap Market company effective August 5, 2002. This change increased the grace
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period available for SmallCap companies that comply with the core initial listing standards of the SmallCap Market — that is, either net income of $750,000, stockholders’ equity of $5 million or market capitalization of $50 million. If our stock cannot maintain trading at prices over $1.00 or we cannot meet any subsequent grace period requirements, we may become subject to the delisting process.
There can be no assurance that we will satisfy all requirements for continued listing of our common stock on the Nasdaq SmallCap Market. If we are unable to meet the continued listing requirements in the future, our common stock will be subject to delisting, which may have a material adverse effect on the price of our common stock and the levels of liquidity currently available to our stockholders.
In order to meet NASDAQ’s continued minimum $1.00 trading price requirement and remain listed, we may have to request shareholder approval to execute a reverse split for our common stock.
The effect of a reverse split upon the market price of our common stock cannot be predicted with any certainty and it is possible that the per share price of our common stock after the reverse split will not rise in proportion to the reduction in the number of shares of our common stock outstanding resulting from the reverse stock split. There can be no assurance that the market price per post-reverse split share will either exceed or remain in excess of the $1.00 minimum bid price for any sustained period of time. The market price of our common stock may be based also on other factors that may be unrelated to the number of shares outstanding, including our future performance. In addition, there can be no assurance that we will not be delisted due to a failure to meet other continued listing requirements even if the market price per post-reverse split share of our common stock remains in excess of $1.00.
Technology and customer needs change rapidly in our market, which could render our products obsolete and negatively affect our revenues.
Our future success will depend on our ability to anticipate and adapt to changes in technology and industry standards. We will also need to continue to develop and introduce new and enhanced products to meet our customers’ changing demands, keep up with evolving industry standards, including changes in the Microsoft operating systems with which our products are designed to be compatible, and to promote those products successfully. The communications and utilities software markets in which we operate are characterized by rapid technological change, changing customer needs, frequent new product introductions, evolving industry standards and short product life cycles. Any of these factors could render our existing products obsolete and unmarketable. In addition, new products and product enhancements can require long development and testing periods as a result of the complexities inherent in today’s computing environments and the performance demanded by customers. If our software markets do not develop as we anticipate or our products do not gain widespread acceptance in these markets, or if we are unable to develop new versions of our software products that can operate on future operating systems, our business, financial condition and results of operations could be materially and adversely affected.
Competition within our product markets is intense and includes numerous established competitors, which could negatively affect our revenues.
We operate in markets that are extremely competitive and subject to rapid changes in technology. Microsoft Corporation poses a significant competitive threat to us because Microsoft operating systems, Windows XP, Windows ME, Windows 2000, Windows 98, Windows 95 and Windows NT, may include some capabilities now provided by certain of our OEM and retail software products. If users are satisfied relying on the capabilities of Windows XP, Windows ME, Windows 2000, Windows 98, Windows 95, Windows NT or other operating systems, sales of our products are likely to decline. In addition, our principal fax related retail products, HotFax MessageCenter and HotFax, currently compete directly with Symantec’s WinFax Pro. In addition, because there are low barriers to entry into the software market, we expect significant competition from other established and emerging software companies in the future. Furthermore, many of our existing and potential OEM customers may acquire or develop products that compete directly with our products.
Microsoft and many of our other current and prospective competitors have significantly greater financial,
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marketing, service, support, technical and other resources than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the promotion and sale of their products. There is also a substantial risk that announcements of competing products by large competitors such as Microsoft and Symantec could result in the cancellation of orders by retailers, distributors or other customers in anticipation of the introduction of such new products. In addition, some of our competitors, such as Symantec, currently make complementary products that are sold separately. Such competitors could decide to enhance their competitive position by bundling their products to attract customers seeking integrated, cost-effective software applications. Some competitors have a retail emphasis and offer OEM products with a reduced set of features. The opportunity for retail upgrade sales may induce these and other competitors to make OEM products available at their own cost or even at a loss. We also expect competition to increase as a result of software industry consolidations, which may lead to the creation of additional large and well-financed competitors. Increased competition is likely to result in price reductions, fewer customer orders, reduced margins and loss of market share.
We maintain relationships with multiple distributors and retailers to sell our retail software products. Loss of a distributor, retailer or unanticipated retail product returns could have a negative impact on our revenues.
In addition to our direct sales efforts including our web store, we depend on distributors and retailers to sell our retail software products. Our relationships with these distributors and retailers depend upon a number of factors, including sales volume. Our agreements with distributors and retailers are not exclusive and may be terminated by either party without cause. Distributors or retailers may purchase fewer products from us or return product to us in any given quarter with little or no advanced notice to us for reasons beyond our control such as a change in their inventory strategies. Although we do not recognize revenue until our product is sold through the channel, if any of these events were to occur, our future retail sales would be adversely affected.
Acquisitions of companies or technologies may disrupt our business and divert management attention and cause our current operations to suffer.
We have in the past made and we expect to continue to consider acquisitions of complementary companies, products or technologies. If we make any additional acquisitions, we will be required to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may cause disruptions in our operations and divert management’s attention from our company’s day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. Acquisitions may also subject us to liabilities and risks that are not known or identifiable at the time of the acquisition.
We may also have to incur debt or issue equity securities in order to finance future acquisitions. The issuance of equity securities for any acquisition could be substantially dilutive to our existing stockholders. In addition, we expect our profitability could be adversely affected because of acquisition-related accounting costs and write offs. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have had limited or no prior experience. If we are unable to fully integrate acquired businesses, products or technologies within existing operations, we may not receive the intended benefits of acquisitions.
Our stock price is highly volatile. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid for them.
The market price of our common stock has fluctuated substantially in the past and is likely to continue to be highly volatile and subject to wide fluctuations. These fluctuations have occurred and may continue to occur in response to various factors, many of which we cannot control, including:
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In addition, the market prices of securities of high technology companies have been especially volatile. This volatility has significantly affected the market prices of securities of many technology companies. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid. In the past, companies that have experienced volatility in the market price of their securities have been the subjects of securities class action litigation. If we were the object of a securities class action litigation, it could result in substantial losses and divert management’s attention and resources from other matters.
Our products may contain undetected software errors, which could negatively affect our revenues.
Our software products are complex and may contain undetected errors. In the past, we have discovered software errors in certain of our products and have experienced delayed or lost revenues during the period it took to correct these errors. Although we and our OEM customers test our products, it is possible that errors may be found in our new or existing products after we have commenced commercial shipment of those products. These undetected errors could result in adverse publicity, loss of revenues, delay in market acceptance of our products or claims against us by customers.
We may need to raise additional capital in the future through the issuance of additional equity or convertible debt securities or by borrowing money, in order to meet our capital needs. Additional funds may not be available on terms acceptable to us to allow us to meet our capital needs.
We believe that the cash, cash equivalents and investments on hand and the cash we expect to generate from operations will be sufficient to meet our capital needs for at least the next twelve months. However, it is possible that we may need or choose to obtain additional financing to fund our activities. We could raise these funds by selling more stock to the public or to selected investors, or by borrowing money. We may not be able to obtain additional funds on favorable terms, or at all. If adequate funds are not available, we may be required to curtail our operations or other business activities significantly or to obtain funds through arrangements with strategic partners or others that may require us to relinquish right to certain technologies or potential markets. If we raise additional funds by issuing additional equity or convertible debt securities, the ownership percentages of existing stockholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock. We currently have no established line of credit or other business borrowing facility in place.
It is possible that our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors, including:
In addition, we may require additional capital to accommodate planned growth, hiring, infrastructure and facility needs or to consummate acquisitions of other businesses, products or technologies.
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Marketing efforts for our retail software products require substantial investments that may adversely affect our operating margins.
Maintaining product distribution channels for our retail software products requires significant investments in marketing and sales related to these products. We expect to continue to minimize these costs in the future. Accordingly, our retail sales may not provide us with the revenue levels that we have historically achieved.
Inability or delays in deliveries from our component suppliers could damage our reputation and could cause our net revenues to decline and harm our results of operations.
We rely on third party suppliers to provide us with the components for our product kits. These components include CDs and printed manuals. We also rely on third parties for CD-ROM replication. We do not have long-term supply arrangements with any vendor to obtain these necessary components for our products. If we are unable to purchase components from these suppliers or if the CD-ROM replication facilities that we use do not deliver our requirements on schedule, we may not be able to deliver products in a CD-ROM format to our customers on a timely basis or enter into new orders because of a shortage in components. Any delays that we experience in delivering our products to customers could impair our customer relationships and adversely impact our reputation and our business. In addition, if our third party suppliers raise their prices for components or CD-ROM replication services, our gross margins would be reduced.
Because we currently operate with little or no backlog, our ability to predict our revenues and operating results is extremely limited.
We operate with little backlog because we generally ship our software products as we receive orders and because our royalty revenue is based upon our customers’ actual usage in a given period. Accordingly, we recognize revenue shortly after orders are received or royalty reports are generated. As a result, our sales in any quarter are dependent on orders that we book and ship in that quarter. This makes it difficult for us to predict what our revenues and operating results will be in any quarter.
We may be unable to adequately protect our intellectual property and other proprietary rights, which could negatively impact our revenues.
Our success is dependent upon our software code base, our programming methodologies and other intellectual properties and proprietary rights. In order to protect our proprietary technology, we rely on a combination of trade secret, nondisclosure and copyright and trademark law. However, these measures afford us only limited protection. We currently own United States trademark registrations for certain of our trademarks, but we have not yet obtained registrations for all of our trademarks in the United States or other countries. In addition, prior to becoming a publicly held entity, we did not require our employees to sign proprietary information and inventions agreements stipulating to our software ownership rights. We only recently started the patent application process for a number of technologies relating to our existing products and products under development. Furthermore, we rely primarily on “shrink wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. Accordingly, despite the precautions we have taken to protect our intellectual property and proprietary rights, it is possible that third parties may copy or otherwise obtain our rights without our authorization. It is also possible that third parties may independently develop technologies similar to ours. It may be difficult for us to detect unauthorized use of our intellectual property and proprietary rights.
We may be subject to claims of intellectual property infringement as the number of trademarks, patents, copyrights and other intellectual property rights asserted by companies in our industry grows and the coverage of these patents and other rights and the functionality of software products increasingly overlap. From time to time, we have received communications from third parties asserting that our trade name or features, content, or trademarks of certain of our products infringe upon intellectual property rights held by such third parties. We have also received correspondence from third parties separately asserting that our fax products may infringe on certain patents held by each of the parties. Although we are not aware that any of our products infringe on the proprietary rights of others, third parties may claim
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infringement by us with respect to our current or future products. Infringement claims, whether with or without merit, could result in time-consuming and costly litigation, divert the attention of our management, cause product shipment delays or require us to enter into royalty or licensing agreements with third parties. If we are required to enter into royalty or licensing agreements, they may not be on terms that are acceptable to us. Unfavorable royalty or licensing agreements could seriously impair our ability to market our products.
If we are unable to retain key personnel, the loss of their services could materially and adversely affect our business, financial condition and results of operations.
Our future performance depends in significant part upon the continued service of our senior management and other key technical and consulting personnel. We do not have employment agreements with our key employees that govern the length of their service. The loss of the services of our key employees would likely materially and adversely affect our business, financial condition and results of operations. Our future success also depends on our ability to continue to attract, retain and motivate qualified personnel, particularly highly skilled engineers involved in the ongoing research and development required to develop and enhance our communication software products as well those in our highly specialized consulting business. Competition for these employees remains high and employee retention is a common problem in our industry. Our inability to attract and retain the highly trained technical personnel that are essential to our product development, consulting services, marketing, service and support teams may limit the rate at which we can generate revenue, develop new products or product enhancements and generally have an adverse effect on our business, financial condition and results of operations. Additionally, retaining key employees during restructuring efforts is critical to company success.
If commerce conducted over the Internet grows more slowly than in the past, our future sales and future profits may decline.
If eBusiness does not continue to grow or grows more slowly than in the past, demand for certain of our products and services will be reduced. Certain of our products, including WebDNA™, enhance companies’ abilities to transact business and conduct Web-based operations. As a result, future sales and any future profits from those products are substantially dependent upon the widespread acceptance and use of the Internet as an effective medium of commerce by consumers and businesses.
Our business, financial condition and operating results could be adversely affected as a result of legal, business and economic risks specific to international operations.
Approximately 15.1%, 10.1% and 19.3% of our revenues in the years ended December 31, 2002, , 2001 and 2000, respectively, were derived from sales to customers outside the United States. We also frequently ship products to our domestic customers’ international manufacturing divisions and subcontractors. In the future, we may expand these international business activities. International operations are subject to many inherent risks, including:
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Our officers and directors could control matters submitted to our stockholders and affect the outcome of any vote.
As of March 5, 2003, William W. Smith Jr., the President, Chief Executive Officer and Chairman of the Board of our company, and Rhonda L. Smith, the Secretary, Treasurer and Vice-Chairman of the Board of our company, beneficially owned approximately 60.2% of our outstanding shares of common stock. William W. Smith Jr. and Rhonda L. Smith are married to one another and, acting together, will have the ability to elect our directors and determine the outcome of any corporate action requiring stockholder approval, including a sale of the company, irrespective of how other stockholders may vote. This concentration of ownership may discourage a potential acquirer from making an offer to buy our company, which, in turn, could adversely affect the market price of our common stock.
Future sales of our common stock could cause the price of our shares to decline.
As of March 5, 2003, we had 16,227,319 shares of common stock outstanding. Of this amount, the 9,770,670 shares held by William W. Smith, Jr. and Rhonda L. Smith are available for sale in the public market (subject to the volume and other applicable restrictions of Rule 144). Overall, our trading volume fluctuates widely and at times is relatively limited. Sales of a substantial number of shares of our common stock by William W. Smith, Jr., Rhonda L. Smith or any other person, including through any directed selling plan, either individually or when aggregated with sales by other persons, could adversely affect the market price of our common stock.
Provisions of our charter and bylaws and Delaware law could make a takeover of our Company difficult.
Our certificate of incorporation and bylaws contain provisions that may discourage or prevent a third party from acquiring us, even if doing so would be beneficial to our stockholders. For instance, our certificate of incorporation authorizes the board of directors to fix the rights and preferences of shares of any series of preferred stock, without action by our stockholders. As a result, the board can authorize and issue shares of preferred stock, which could delay or prevent a change of control because the rights given to the holders of such preferred stock may prohibit a merger, reorganization, sale or other extraordinary corporate transaction. In addition, we are organized under the laws of the State of Delaware and certain provisions of Delaware law may have the effect of delaying or preventing a change in our control.
Item 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Our financial instruments include cash and cash equivalents. At December 31, 2002, the carrying values of our financial instruments approximated fair values based on current market prices and rates. Because of their short duration, changes in market interest rates would not have a material effect on fair value.
It is our policy not to enter into derivative financial instruments. We do not currently have any significant foreign currency exposure as we do not transact business in foreign currencies. As such, we do not have significant currency exposure at December 31, 2002.
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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and schedule appear in a separate section of this Annual Report on Form 10-K beginning on page F-1 and S-1, respectively.
SUPPLEMENTARY FINANCIAL DATA
SELECTED QUARTERLY FINANCIAL DATASTATEMENT OF OPERATIONS DATA(UNAUDITED)
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Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS
The sections titled “Executive Officers of the Company,” “Directors and Nominees” and “Compliance with Section 16(a) of the Exchange Act” appearing in our Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
Item 11. EXECUTIVE COMPENSATION
The section titled “Executive Compensation and Related Information” appearing in our Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The section titled “Ownership of Securities” appearing in our Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
Securities Authorized for Issuance Under Equity Compensation Plan
The following table provides information as of December 31, 2002 with respect to the shares of common stock that may be issued under our existing equity compensation plan.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
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Item 14. CONTROLS AND PROCEDURES
The principal executive officer and principal financial officer of the Company have evaluated the effectiveness of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934 as of a date within 90 days prior to the filing date of this report. Based on that evaluation, such officers have concluded that the Company’s disclosure controls and procedures are effective to ensure that material information relating to the Company and its subsidiaries is made known to such officers in a timely manner for inclusion in the Company’s periodic filings with the SEC.
There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation by the Company’s principal executive officer and principal financial officer.
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PART IV
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
Smith Micro’s financial statements appear in a separate section of this Annual Report on Form 10-K beginning on the pages referenced below:
Smith Micro’s financial statement schedule appears in a separate section of this Annual Report on Form 10-K on the pages referenced below. All other schedules have been omitted as they are not applicable, not required or the information is included in the consolidated financial statements or the notes thereto.
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A Current Report on Form 8-K was filed with the Securities and Exchange Commission on October 24, 2002 to report the adoption of a stock repurchase program. The Board of Directors approved the repurchase of up to 1,000,000 shares of our common stock in the open market at prevailing market prices.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
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CERTIFICATIONS
I, William W. Smith, Jr., certify that:
Date: March 26, 2003
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I, Robert W. Scheussler, certify that:
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Each of the undersigned hereby certifies, in accordance with 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, in his capacity as an officer of Smith Micro Software, Inc., that, to his knowledge, the Annual Report of Smith Micro Software, Inc. on Form 10-K for the period ended December 31, 2002, fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 and that the information contained in such report fairly presents, in all material respects, the financial condition and results of operation of the company.
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SMITH MICRO SOFTWARE, INC. AND SUBSIDIARIES
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors and Stockholders of Smith Micro Software, Inc.:
We have audited the accompanying consolidated balance sheets of Smith Micro Software, Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Smith Micro Software, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets as a result of adopting Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets, effective January 1, 2002.
DELOITTE & TOUCHE LLPCosta Mesa, CaliforniaFebruary 13, 2003
F-1
CONSOLIDATED BALANCE SHEETSAS OF DECEMBER 31, 2002 AND 2001(In thousands, except share and per share data)
See notes to consolidated financial statements
F-2
CONSOLIDATED STATEMENTS OF OPERATIONSFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002(In thousands, except per share data)
F-3
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002(In thousands)
F-4
CONSOLIDATED STATEMENTS OF CASH FLOWSFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002(In thousands)
F-5
CONSOLIDATED STATEMENTS OF CASH FLOWSFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002 (Continued)(In thousands)
DISCLOSURE OF NON-CASH FINANCING AND INVESTING ACTIVITIES:
F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002
F-7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002 (Continued)
F-8
F-9
F-10
F-11
F-12
F-13
F-14
F-15
F-16
F-17
F-18
F-19
F-20
F-21
F-22
INDEPENDENT AUDITORS’ REPORT ON SCHEDULE
S-1
SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTSFOR EACH OF THE THREE YEARSIN THE PERIOD ENDED DECEMBER 31, 2002 (Continued)(In thousands)
EXHIBIT INDEX