Item 1. Business
Overview
Spatializer Audio Laboratories, Inc. (“Spatializer” or “Company”) has been a developer, licensor and marketer of next generation technologies for the consumer electronics, personal computing, entertainment and cellular telephone markets. Our technology is incorporated into products offered by our licensees and customers on various economic and business terms. Our position as a developer of next generation technologies is based on our business relationships with brand leaders, such as Toshiba, Samsung, Sanyo and Matsushita. We conduct our audio business through our parent company and our wholly owned subsidiary, Desper Products, Inc. (“DPI”). DPI has developed a full complement of patented and proprietary 3-D or virtual audio signal processing technologies directed to the consumer electronics and multimedia PC markets. Our product offerings are targeted to take advantage of the growing digital audio marketplace specifically for consumer products like Digital Versatile Disc (“DVD”) players, portable mp3 players, digital televisions and digital home, portable and cellular handset devices. As of December 31, 2005, more than 49 million licensed units had been shipped covering all of these applications. DPI’s virtual audio signal processing technologies are currently incorporated in products offered by global brand leaders in consumer electronics, PCs and cell phones including Toshiba, Matsushita, Samsung, Intervideo, Sanyo, and Sharp.
On January 10, 2006, the Company announced that it would hold an open auction for the sale of substantially all of its assets. The Board of Directors of the Company decided that it is in the best interests of the stockholders to hold an open auction for the acquisition of the assets of the Company or the granting of an unlimited amount of non-exclusive perpetual licenses for a one-time fee and a subsequent auction of the residual assets. The consummation of any of such transactions will be subject to approval by the stockholders of the Company. The Company received non-conforming bids for such assets on the February 15, 2006 deadline. The Board of Directors of the company, in consultation with their financial and legal advisors, extended the auction period to March 10, 2006, to provide bidders and other interested parties additional time to clarify their offers and perform due diligence, as well as to solicit additional offers. Negotiations continue with auction participants who submitted bids by March 10, 2006. The Company will announce its decision upon completion of its evaluation of such bids.
We were incorporated in the State of Delaware in February, 1994 and are the successor company in a Plan of Arrangement pursuant to which the outstanding shares of Spatializer Audio Laboratories, Inc., a publicly held Yukon, Canada corporation, were exchanged for an equal number of shares of our common stock. Our corporate office and research center is located at 2025 Gateway Place, Suite 365, San Jose, California 95110, Telephone (408) 453-4180. We also maintain executive offices at 2625 Townsgate Road, Suite 330, Westlake Village, California 91361. We have a Website at www.spatializer.com. Copies of this Annual Report, including our financial statements and our quarterly reports on Form 10-Q as well as other corporate information, including press releases, of interest to our stockholders are available on our website promptly after filing or distribution. As used herein, Spatializer, the “Company,” “we” or “our” means Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiaries
Our financial statements beginning on page 42 hereof contain information relating to our revenues, loss and total assets for the fiscal year ended December 31, 2005.
Desper Products, Inc. - Virtual Audio Signal Processing Technologies
DPI has developed a suite of proprietary advanced audio signal processing technologies for the entire spectrum of applications falling under the general category of virtual audio. The objective in each product category is to create or simulate the effect of a multi-speaker sonic environment using two ordinary speakers (or headphones) for playback. The market for virtual audio is segmented into six broad categories of technology as identified in the listing below. Each of these technologies utilizes different underlying scientific principles in accomplishing its design objectives and is targeted to a specific class of consumer electronics or multimedia computer depending on the intended product use and functional capability of the product.
Technology
Product Categories
Audio Enhancement
Spatializer® 3-D Stereo
Stereo TV’s, Stereo Components and Systems, Car Audio, Laptop and Desktop Multimedia Computers, Set-top Boxes
Surround sound enhancement from an ordinary stereo (two-channel) signal
Spatializer ((environ))TM
Cell Phones and Mobile Multimedia Players
Widens sound stage and improves stereo separation from two-channel ring tones, compressed audio, FM and TV broadcast and games.
Spatializer N-2-2 Ultra TM
DVDP, DVDR, PVR, AV Receivers, Multimedia PCs, DTV,STB
Creation of spatially accurate home theater surround sound from two channel sources
Spatializer enCompass AV TM
Products incorporating multi-channel audio sources like Dolby ProLogic II®: AV Receivers
Creation of spatially accurate multi-speaker cinematic audio experience from two-channel audio information
Spatializer Audio Alchemy TM
Computers and Recordable DVD utilizing DVD/MPEG and decoding, Cell phone handsets.
Static noise reduction combined with stabilization of dynamic audio range
Spatializer Vi.B.E. TM
Mobile Multimedia Players, Cell Phones, DVD Players/Recorders, DTV, Stereo Components and Systems, Car Audio, Laptop and Desktop Multimedia PCs and Headphones.
Simulation of low frequency response from speakers with poor low frequency capability
Spatializer DRC TM
Laptop and Desktop Multimedia Computers, Cell Phones and Portable Multimedia Players
Prevents over-driving speakers, headphones or ear buds while maximizing the dynamic audio output
Spatializer Natural Headphone TM
Headphones, Mobile Phones, Mobile Multimedia Players
Creation of spatially accurate multi- speaker cinematic audio experience from headphones utilizing discrete multi-channel audio information
Spatializer PCE TM
DTV, Mobile Phones, Mobile Multimedia Players, Multimedia PCs, Headphones
Creation of more recognizable and “cleaner” music or dialog from all media sources
Licensed Products
Our current technology product applications are directed to (1) speaker enhancement, (2) stereo surround sound enhancement, (3) mobile entertainment enhancement and (4) noise reduction.
1.
Spatializer 3D Stereo. Based upon proprietary methods of stereo signal processing, our Spatializer 3-D Stereo technology is designed to create a vivid and expansive three- dimensional surround sound listening experience from any stereo source input using only two ordinary speakers. Along with professional audio quality and coherent stable sonic imaging, the technology includes our unique DDP™ (Double Detect and Protect™) algorithm. DDP continuously monitors the underlying stereo signal and dynamically optimizes spatial processing, avoiding deleterious sonic artifacts common in other systems and provides “set and forget” ease of use for consumers. First introduced in July 1994 by DPI, in the form of a 20 pin analog integrated circuit (IC) from Matsushita Electronics Corporation (“MEC”), the technology is now incorporated into low-cost, standard process ICs by three chip foundries (Matsushita, ESS Technologies, Inc. and OnChip Systems) for easy and inexpensive implementation in any consumer electronics or computer products utilizing stereo audio. The technology is currently available in both analog and digital formats. Matsushita introduced a new Spatializer IC design in 1999, offering the Spatializer 3-D Stereo effect in a simplified, lower cost package. In early 2002, we introduced a new algorithm-based technology which provides a virtual surround sound effect from a two channel input for DSP-based environments. In 2003, we introduced Spatializer ((environ)), especially designed for cellular phones with two, closely spaced speakers to enhance both ring tones and music.
2.
Spatializer N-2-2 Ultra Digital Virtual Surround. In September 1996, DPI introduced Spatializer N-2-2, which we consider a “core”, and “enabling” technology for Dolby Digital-based home theater products and personal computers. In mid-2001, DPI introduced Spatializer N-2-2 Ultra as the latest generation of this core audio technology. The audio standards for multi-channel digital audio(based upon geographic region) are multi-channel audio formats (Dolby Digital® (AC-3) and MPEG-2) which carry up to eight (or more) discrete (independent) channels of audio - the front left and right channels, a center channel (for vocal tracks), two rear surround channels and a Low Frequency Effects (LFE or “sub-woofer”) channel for sound effects. The Spatializer N-2-2Ultra software- based algorithms permit spatially accurate reproduction of this multi-channel audio over any ordinary stereo system using two rather than the five or six speakers normally required in traditional home theater setups. Spatializer N-2-2Ultra runs in real-time on general purpose Digital Signal Processing (“DSP”) hardware platforms like those offered by LSI, Acer Labs, Inc., NEC, Motorola, MediaTek and Zoran; may be integrated with host based software-only MPEG-2 or DVD decoders (like WinDVD and PowerDVD, offered by InterVideo and Cyberlink, respectively, for the Intel® Pentium® series of microprocessors); and can be ported to any of the principal audio codecs or media processor/accelerator platforms performing Dolby Digital (AC-3) or MPEG-2 audio decoding. Spatializer N-2-2Ultra has been approved by Dolby Laboratories and qualifies Spatializer licensees to use the newly created Dolby Digital VIRTUAL™ trademark on products incorporating the technology. We believe our Spatializer N-2-2 Ultra process has helped to widen and accelerate the market for DVD acceptance, because it delivers the full cinematic audio experience to ordinary consumers without the additional expense and complication of multi-speaker home theater playback systems. The Company holds a patent on this technology.
3.
Spatializer Vi.B.E. In early 1999, DPI introduced Spatializer Vi.B.E., a virtual bass enhancement technology. Spatializer Vi.B.E. produces a dynamic bass response from even the lowest-end speakers or headphones. This is particularly important in enhancing the audio of all forms of portable digital audio devices. Spatializer Vi.B.E. uses proprietary technology to generate the perception of realistic bass frequencies that are unaffected by actual speaker system frequency response capability.
4.
Spatializer VSP-11 First introduced by DPI in early 2002, Spatializer VSP-11 (Virtual Sound Processor 11) is a stand-alone application program for Microsoft Windows 95, 98, ME, 2000 and XP platforms that utilizes Spatializer proprietary psychoacoustic techniques to allow consumers to enjoy the benefits of the renowned Spatializer audio enhancement technologies on leading media players, soft DVD players and file sharing programs. This means that Spatializer VSP-11 is a universal audio enhancement software package that will enhance output from the Microsoft® Media Player, Real Player®, Real Jukebox®, WinAmp®, WinDVD®, PowerDVD®, among others, without any special modification. It will run in conjunction with any sound card, as well as with USB audio.
5.
Spatializer Natural Headphone Spatializer Natural Headphone, introduced by DPI in March 2001, renders spatially accurate multiple speaker positions simulating the typical home theater or stereo arrangement through a headphone. The headphone algorithm delivers a high performance simulated surround sound experience, using a reasonable amount of processing power at a reasonable cost. Thus, this solution is equally practical and effective for both low-power portable devices and home theater applications. Unlike typical virtual surround sound headphone solutions, which rely heavily on reverberation which can sound unnatural, Spatializer Natural Headphone utilizes a combination of techniques to provide an expanded, yet natural sound field.
6.
Spatializer PCE, introduced in October 2001, makes high frequencies clearer, crisper and more brilliant while low frequencies are more dramatic, tighter and have more impact. Spatializer® PCE gives the manufacturer an inexpensive way to dramatically improve the sound of low-end loudspeakers, such as the kind found in televisions, boom boxes and computers. Spatializer PCE is also ideal for improving the quality of Internet audio, which can sound rather lackluster and dull due to compression or low bit rates. It can be applied prior to encoding audio streams, and can just as easily enhance the playback of the decompressed audio. It can improve the clarity, intelligibility and impact of both dialog and music. Spatializer PCE works by both modifying and smoothing non-linear phase response and by creating psycho-acoustic cues. Typical equalization techniques cause phase distortion (non-zero group delay) due to non-linear phase response. Spatializer PCE has a nearly-linear phase response, which results in a near-zero group delay. This improves the “naturalness”, or transparency of the dialog or music by not adding to phase distortion already present in many playback systems. This technology is patent pending. Spatializer PCE can be custom tailored for two or an array of speaker configurations. The technology, without a surround sound effect, can enhance single speaker applications as well.
7.
Spatializer enCompass AV Spatializer enCompass AV, launched in late 2002, is designed to offer high quality, multi-channel audio, even from mono or stereo sources. This technology allows owners of home theater systems with five or more speakers to hear a surround sound effect, utilizing all of their speakers to deliver full system utility from CDs, cassettes or VHS tape or records.
8.
Spatializer VirtuaLFE processes the sub-woofer channel with proprietary psycho-acoustic techniques to virtualize, reinforce and enhance the effect for accurate reproduction through two speaker home audio or on-board television speakers. The result is an emotive low frequency effect that brings DVDs alive as if an actual sub-woofer speaker were employed. The efficient algorithm architecture makes implementation feasible on a wide array of home entertainment products.
9.
Spatializer Audio Alchemy dynamically removes noise from up to six input channel simultaneously. Utilizing state of the art noise removal and reduction techniques, Spatializer Audio Alchemy dynamically adjusts to changing noise levels and environments. Tailored for the human voice, Spatializer Audio Alchemy removes background noise such as fans, motor hum, and tape hiss. Spatializer Audio Alchemy features an advanced equalization processor to compensate for frequency response limitations in the audio recording hardware and transducers. In addition, Spatializer Audio Alchemy also performs spatial reconstruction to simulate the original acoustic environment, and normalizes the dynamic range of the digital audio source to a level compatible with home theater environments. This technology is patent pending.
In addition, we offer three whole product solutions with multiple Spatializer technologies that comprehensively address the unique audio delivery challenges inherent in each targeted platform. The Spatializer HD Class is comprised of three new products specifically targeted at home audio, cellular telephones and other mobile applications and personal computers. The Spatializer technologies in each package operate in a complementary fashion, such that the concurrent technologies deliver a more powerful and effective audio experience than that possible from a single solution. Further, each technology has been optimized and customized for the targeted application and is designed to overcome the audio challenges presented by small form factor, transducer limitations and even cost constraints.
Spatializer UltraMobile HD™ delivers higher definition digital audio to mobile audio systems through the multiple and complementary use of Spatializer Natural Headphone, Spatializer Vi.B.E. and Spatializer PCE. UltraMobile HD improves the performance of low cost headphones or ear buds, as well as from compressed audio by opening up the sound field while improving bass performance. In cellular telephone applications, Spatializer ((environ)) delivers maximum performance from micro-speakers that are mounted closely together and helps compensate for the more limited dynamic range as compared with standard size speakers. When applied to stereophonic ring tones, Spatializer ((environ)) creates a startling and expressive sound field when such speakers are utilized in cellular handsets.
Spatializer UltraTV HD™ delivers higher definition digital audio performance to digital televisions, DVD players and DVD Recorders. HDTV signals can realistically be retrieved only in limited ways, leading to customer disappointment. The Spatializer UltraTV HD processor is designed to compensate for these shortcomings in digital home entertainment for the millions of households without home theater systems. Realistic surround sound, near-sub-woofer effects and crisp dialog is made possible through two speakers, rather than through expensive arrays of external speakers. Another unique aspect of this product is that it is designed specifically for playback through television speakers and can be custom tailored to the frequency aspects of a manufacturer’s speaker set.
Spatializer UltraPC HD™ helps ease the transition of the personal computer from business tool to a comprehensive component of the digital home entertainment experience. Spatializer UltraPC HD includes Spatializer N-2-2 Ultra that delivers surround sound through only two speakers, Spatializer Natural Headphone for personal surround sound, Spatializer VirtuaLFE™ that processes the sub-woofer channel for a low frequency effect through ordinary speakers and Spatializer PCE for dialog clarity. Each of these technologies has been optimized for small speaker or headphone playback and can be custom tuned to a manufacturer’s specific speaker set.
Licensing Activities
Until 2000, we licensed our technologies primarily through semiconductor manufacturing and distribution licenses (“Foundry Licenses”) with semiconductor foundries. In turn, the foundries manufacture and distribute integrated circuits ICs (integrated circuits) or DSPs (digital signal processors) incorporating Spatializer technology to consumer electronics and multimedia computer OEMs (original equipment manufacturers).
In 2000, we began offering foundries the option of entering into a non-royalty bearing distribution agreement with us. Under this business model, the foundry offers Spatializer technology as an optional feature, promotes our technology in their sales materials and cooperates with the Spatializer sales force in closing license agreements for Spatializer technology with the OEM customer. This business model provides the foundry with an additional selling feature at no additional cost to the foundry. The OEM can obtain use of the technology directly from Spatializer without any additional mark-up from the foundry.
The terms of all of our licenses are negotiated on an individual basis requiring the payment of a per unit running royalty according to sliding scales based upon cumulative volume. Some of our licenses call for the payment of an up-front license issuance fee either in lieu of, or in addition to the running royalty. Other agreements require the OEM customer, rather than the foundry, to pay the royalty. Per unit royalties are generally reportable and payable 45 days after the end of the quarter following shipment from the foundry to the OEM or, in the case of a distribution agreement, by the OEM to its accounts.
OEMs who desire to incorporate these DSPs or ICs into their products are required to enter into a license (“OEM Licenses”) with us before they may purchase the ICs in quantity. Foundry Licenses generally have limited the sale of DSPs or ICs with Spatializer technology to OEMs who have entered into an OEM License with us. OEM licenses generally provide for the payment of a further per unit royalty by the OEM for OEM products incorporating a Spatializer IC (“Licensed Products”) payable in the quarter following shipment by the OEM of its Licensed Products.
We are currently offering these assets for sale or for perpetual license, as outlined in the second paragraph of the Overview section above.
IC/DSP Foundry Licenses
The Company, through its wholly-owned subsidiary, Desper Products, Inc., entered into a major multi-technology licensing agreement with Samsung Electronics, Co. Ltd. on August 22, 2004.
As of December 31, 2005, we have entered into non-exclusive Foundry Licenses for our Virtual Audio Signal Processing technologies with Matsushita Electronics Corporation (“MEC”), Samsung Electronics, Sigmatel, ESS Technology, Inc. (“ESS”), OnChip Systems, Inc. (“OnChip”), LSI Logic, Inc. (“LSI”), Acer Labs, Inc. (“Ali”), MIPS Technologies, NJRC, Tvia, Inc., Texas Instruments, Cirrus Logic, NEC and MediaTek. Foundry Licenses generally require the payment of per unit running royalties based upon a sliding scale computed on the number of Spatializer ICs or DSPs sold.
As of December 31, 2005, more than 49 million ICs, programmable processors and DSPs incorporating Spatializer audio signal
processing technology had been manufactured and sold.
OEM Licensees and Customers
As of December 31, 2005, our technology has been incorporated in products offered by more than 105 separate OEM Licensees and customers on various economic and business terms. Some of these OEM Licenses required a license issuance fee and/or a separate per unit royalty, while others were licensed under the Logo Usage Agreement (“LUA”) or were authorized customers under bundled royalty licenses with the IC foundries. The OEM Licensees and customers offer a wide range of products, which include DVD players and recorders, cellular phones, portable digital audio players, programmable processors, multimedia desktop personal computers, notebook computers and digital televisions.
In 2005 three major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Matsushita, Sharp and Samsung, each of whom accounted for greater than 10% of our total 2005 revenues. One OEM accounted for 33%, one accounted for 28% each and one accounted for 16% of our royalty revenues during 2005. One other account comprised more than 5%, but less than 10% of revenues. All other OEM’s accounted for less than 5% of royalty revenues individually. The following table is a partial list of the OEM Licensees and authorized customers as of December 31, 2005:
• Acer Labs
• MediaTek
• Sanyo Corp.
• Apple Computer
• Micronas
• Sharp Corp.
• Cirrus Logic
• Mitsubishi Image and Information Works
• Sigmatel
• InterVideo
• Motorola
• Texas Instruments
• JVC
• NEC
• Theta Digital
• LG Electronics
• Panasonic Car Audio
• Toshiba DVD
• Logitech
• Panasonic TV
• Toshiba TV
• LSI
• Samsung
• Zoran
We have extensive relationships with OEM licensees and customers outside the United States. Japanese and Korean based entities accounted for 62% and 34% of our total revenues, respectively, in 2005, 70% and 25% of our total revenues, respectively, in 2004, and 71% and 20% of our total revenues, respectively, in 2003. The products incorporating our technology are, in turn, sold throughout the world, in market segments and amounts that are consistent with the overall general world markets for consumer electronics and software.
Customers, Revenues and Expenses
We generate revenues in our audio business from royalties pursuant to our Foundry, OEM, and other licenses, and from non-recurring engineering fees to port our technologies to specific licensees’ applications. Our revenues, which totaled $1,192,000 in 2005, were derived almost entirely from Foundry and OEM license fees and royalties.
We have sought to maximize return on our intellectual property base by concentrating our efforts in higher margin licensing and software products and eliminating our hardware product operations. Licensing operations have been managed internally by our personnel and through use of an international sales representative force. In 2005 three major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Matsushita, Sharp and Samsung, each of whom accounted for greater than 10% of our total revenues. One OEM accounted for 33%, one accounted for 28% each and one accounted for 16% of our royalty revenues during 2005. One other account comprised more than 5%, but less than 10% of revenues. All other OEM’s accounted for less than 5% of royalty revenues individually.
In 2005, revenues were stagnant as compared with the prior year. Revenues from Toshiba and Mitsubishi wound down as the devices with our technology reached end of life and new models did not include our technology. This revenue was replaced by higher revenue from Samsung and Matsushita. However, in late 2005, based on future third party product plans and discussions with these customers, it became apparent that revenues from these two accounts were not sustainable at current levels in the future with a degree of certainty. As a result, and due to the resignations of two directors and the CEO, our board of directors determined in late December 2005 to offer the Company’s assets for sale or to sell perpetual non-exclusive licenses of our intellectual property (with a subsequent sale of the residual assets) and to position the Company to exit the audio licensing business and to wind up and dissolve.
Competition
We competed with a number of entities that produce various audio enhancement processes, technologies and products, some utilizing traditional two-speaker playback, others utilizing multiple speakers, and others restricted to headphone listening. These include the consumer versions of multiple speakers, matrix and discrete digital technologies developed for theatrical motion picture exhibition (like Dolby Digital®, Dolby ProLogic®, and DTS®), as well as other technologies designed to create an enhanced stereo image from two or more speakers.
Our principal competitors in the field of virtual audio are SRS Labs, Inc., Dolby Laboratories, Inc., Sonaptic and Qsound Labs, Inc. In addition, some DSP foundries and OEMs have proprietary virtual audio technologies that they regularly offer to OEMs at no cost. These companies have, or may have, substantially greater resources than us to devote to further technologies and new product developments.
Pressure on OEMs to reduce their costs, particularly in the DVD market, is intense. The marketplace is also susceptible to undisciplined competitors who, from time to time, may offer below market prices to generate short term revenue and larger market penetrations even if it does not provide for viable margins. In the future, our products and technologies also may compete with audio technologies and product applications developed by other companies including entities that have business relationships with us. Factors that affect our ability to compete include product quality, performance and features, conformance to existing and new standards, price, customer support and marketing and distribution strategies.
We were unable to compete in this market, even though we offered a single source, complete suite of patented and proprietary 3D Stereo, interactive positional, virtual surround sound, headphone and speaker virtualization technologies. We lacked sufficient financial resources to compete, were closely dependent on third party licensee marketing plans which generally presented a longer or uncertain revenue stream than our cash resources could support and found the market less receptive to our value proposition than we had expected.
Research and Development
Our research and development expenditures in 2005, 2004 and 2003 were approximately 30%, 34% and 28% of total operating expenses, respectively. These expenses consist of salaries and related costs of employees and consultants engaged in ongoing research, design and development activities and costs for engineering materials and supplies.
As of December 31, 2005, we had one employee in our R&D group representing 33% of our total human resources. In addition and not included above, we had the availability of three dedicated engineers at an outside consulting company in India for applications engineering. Our software, hardware and application engineers had focused on developing intellectual property, technology solutions and consumer products. In 2004, we established a relationship with an engineering services firm in Bangalore, India for the substantial transfer to such firm of our applications engineering work. In addition to substantially lowering costs for consulting services as compared to costs associated with using domestic contractors, project completion dates were reliable and throughput expanded due to such firm’s relatively large engineering staff. Thus, multiple projects were completed simultaneously and within lower cost and time parameters. Despite the foregoing, based on our board of directors’ decision to offer our assets for sale, we discontinued our technology development efforts in December 2005.
Intellectual Property and Proprietary Information
We rely on a variety of intellectual property protections for our products and services, including patent, copyright, trademark and trade secret laws, and contractual obligations. Our core signal processing technology is covered by U.S. patent 6,307,941. On March 20, 1998, we filed a patent application on our enCompass V 2.0 technology with the United States Patent & Trademark Office (“USPTO”) covering our enCompass 2.0 positional audio gaming technology. In June 2000, we filed an additional patent application for our reduced cost/higher performance 3-D Stereo circuit design. In late 2002, we filed a patent application covering our Spatializer PCE technology. In 2003, we filed a patent application for Spatializer Audio Alchemy. Much of our intellectual property consists of trade secrets. In 2002, patent 6,307,941 was issued by the USPTO covering our Spatializer N-2-2 technology. We possess copyright protection for its principal software applications and has U.S. and foreign trademark protection for its key product names and logo marks.
There can be no assurance that these measures will be successful, or that competitors will not be able to produce a non-infringing competitive product or service. In addition, the laws of certain countries in which our products are or may be developed, manufactured
or sold, including various countries in Asia, may not protect our products and intellectual property rights to the same extent as the laws of the United States, or at all. There can be no assurance that third parties will not assert infringement claims against us, or that if required to obtain any third party licenses as a result of an infringement dispute, we will be able to obtain such licenses.
Seasonality
Due to our dependence on the consumer electronics market, we have experienced seasonal fluctuations in sales and earnings. In particular, we believe that there has been seasonality relating to the Christmas season in the third and fourth quarters, which generally are our strongest quarters, as well as the first quarter, which is generally our weakest quarter. We attempted to diversify our key market segments in the consumer electronics industry in an effort to even out our seasonal fluctuation. Overall, seasonality does not have a material effect on our business.
Employees
We began 2005 with three full-time and five part-time employees and sales representatives and decreased our staff to two full time and five part-time employees, consultants and sales representatives by December 31, 2005. At year-end, there was one full-time employee engaged in research and development. In addition, we utilized an engineering firm with three dedicated engineers to our projects on an as-needed basis. We have employed the services of outside professional consultants, particularly in the audio engineering area, due to the costly and tight labor market for such professionals in Silicon Valley as well as the need for specialized expertise in the course of our business. None of our employees are represented by a labor union or are subject to a collective bargaining agreement. We consider our relations with our employees and consultants to be satisfactory.
Item 1A.
Item 1A. Risk Factors
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, reflecting management’s current expectations. Examples of such forward-looking statements include our expectations with respect to our strategy. Although we believe that our expectations are based upon reasonable assumptions, there can be no assurances that our financial goals or any transactions described herein will be realized. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Numerous factors may affect our actual results and may cause results to differ materially from those expressed in forward-looking statements made by or on behalf of our company. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. The important factors discussed under the caption “Factors That May Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, herein, among others, would cause actual results to differ materially from those indicated by forward-looking statements made herein and represent management’s current expectations and are inherently uncertain. Investors are warned that actual results may differ from management’s expectations. We assume no obligation to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information.
Our Board of Directors has Determined it is in the Company’s and its Stockholders Best Interests to Attempt to Sell the Company’s Assets.
We have experienced a loss from operations in four of the last five fiscal years. In December 2005 our revenues were stagnant, with those from certain of our major customers winding down. Revenues from certain of our other customers appear not to be sustainable in the future. In December 2005, two of our three independent directors resigned and the Chairman of the Board, Chief Executive Officer, Chief Financial Officer and Secretary resigned from all positions held with the Company other than as a director, Chairman and Secretary. For these and other reasons, and after exploring other exit strategies and opportunities, our Board of Directors concluded in December 2005 to attempt to sell the Company either through a sale of assets or a sale of multiple, non-exclusive perpetual licenses with a subsequent sale of the residual assets and engaged Strategic Equity Group to assist us in this endeavor. Following such transaction, it is anticipated that the Company would be wound up and dissolved. The consummation of any such transaction and the determination to wind up and dissolve is subject to stockholder approval. There is no assurance that the Company will be able to negotiate an agreement for the sale of assets. There is no assurance that, if such an agreement is successfully negotiated, that such transaction will be approved by stockholders or consummated. Further, even if such transaction is consummated, there is no assurance that there will be any funds available for distribution to stockholders. If such sale and subsequent wind up and
dissolution is not approved, the Board of Directors will be required to explore other alternatives for the Company and its business.
Our Operating Results Fluctuate, We Are Unable to Achieve or Sustain Profitability in the Future or Obtain Future Financing and Our Business Operations Will Fail
We have experienced a loss from operations in four of the last five years. We experienced losses in the last two years. While our objective and full effort has been on managing a profitable business, due to the market conditions and factors outlined in this Annual Report on Form 10-K and their impact on fluctuations in operating expenses and revenues, we no longer believe that we will be able to generate a positive profit position in any given future period, nor do we believe that is feasible. We cannot guarantee that we will increase sales of our products and technologies, or that we will successfully develop and market any additional products, or achieve or sustain future profitability. We cannot, because of market and business conditions, rely on the sale of shares or on debt financings in the future. Further, we do not believe that debt or equity financing will be available as required and as such, have decided to try to sell the assets of the Company.
Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.
The PC and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in or substitution of features. Therefore, we have been seeking commercial acceptance of our products in highly competitive markets. We responded by offering additional products targeted to each price and quality segment of the market, more aggressively priced and feature enriched our products and entered new segments, such as cell phones, with different competitive pressure. Our value proposition that stressed the cost reducing capabilities of our audio solutions through improved performance from lower cost components as well as product differentiation that Spatializer technology can deliver, failed to resonate with our targeted customers in this highly competitive environment. The result was the elimination of features, including ours, to reduce cost. There is no assurance that our present or contemplated future products or a repositioned value proposition will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors or customers who had access to significantly greater resources or which are willing to “give away” their products.
Because Our Relative Size and Power Is Small Compared To That of Our Customers, Our Business Leverage With Some Customers Is Generally Weak and Communication Not Always Transparent
We deal with some of the largest global consumer electronics makers in the world, the vast majority of which are in Asia. Spatializer is a small company and there are other options for manufacturers, including those from our competitors, their chip suppliers, or eliminating the use of audio enhancement technology altogether. As such, our leverage with our customers is generally weak. This imbalance made it very difficult for the Company to be viewed as a worthy or reliable partner and made negotiations in general imbalanced against us. In addition, the culture in our local markets may not dictate clear, direct and transparent communication of business plans or technology usage as is the culture in our home country. When this occurs, we have received very short notice of discontinued use of our technology and revenues from such an account would typically begin a steep decline in the subsequent quarter, resulting in period-to-period fluctuation. This also results in limited visibility with regard to future revenues and its impact on our operating results. Our response has been to strengthen our business relationships with more onsite visits, increase our understanding of cultural differences and focus more intently on service. We also emphasize to our overseas sales representatives the need for close customer support, with the objective that both new opportunities and possible difficulties are brought to light as soon as possible.
We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third Parties Have Their Own Priorities and Alliances That May Delay or Thwart our Sales Efforts to Potential Customers.
Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor
manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company. In addition, standards may be adopted by cell phone system operators or manufacturers that may impede or prevent the penetration of non-standard technology onto their platforms. Lastly, customer implementation delays have put off expected cash flow into the future, beyond the time frame of operations based on our available cash resources.
If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive Products May Reach The Market Before Our Products.
Since our inception, we have experienced delays in bringing new products to market and commercial application as a result of delays inherent in technology development, financial resource limits and industry responses and maturity. These delays have resulted in delays in the timing of revenues and product introduction. In the future, delays in new product development or technology introduction on behalf of us, our original equipment manufacturers of consumer electronics and multimedia computer products (OEMs), integrated circuit (IC) foundries or our software producers and marketers could result in further delays in revenues and could allow competitors to reach the market with products before us. In view of the emerging nature of the technology involved, and the rapidly changing character of the entire media, internet and computer markets, our expansion into other technology areas and the uncertainties concerning the ability of our current products and new products to achieve meaningful commercial acceptance, there is no likelihood of achieving or sustaining profitability.
Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to cash flow. These schedules are also prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce new deals until the target product is being introduced. The delays experienced on one of these deals made it impossible for the Company to sustain operations until the new cash flow, which was not assured, might be realized.
We Expect That We Will Continue to be Dependent upon a Limited Number of OEMs for a Significant Portion of Our Net Sales in Future Periods
Although no OEM is presently obligated either to purchase a specified amount of products or to provide us with binding forecasts of product purchases for any period, we anticipate being dependent upon a limited number of OEMs for a large port of our net sales. Our three largest customers as of December 31, 2005 accounted for 33%, 28% and 16% of our net sales. The loss of any one of our major customers or licensees would significantly reduce our revenues and harm our ability to achieve or sustain acceptable levels of operating results. The loss, or signing of a similarly sized account or accounts would have a material short term impact on our operations and there is no assurance that we will not lose all or some of the revenues from one or more of these accounts. In late December 2005, management and the Board of Directors concluded that revenues from two of the three largest accounts would be significantly reduced in 2006, putting the liquidity of the Company in jeopardy as it operated through 2006.
Demand for Our Products is Subject to Risks Beyond Our Control.
Our products are typically one of many related products used by consumer electronic users. As a result, demand for our products is therefore subject to many risks beyond our control, including, among others:
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competition faced by our OEM customers in their particular end markets;
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the technical, sales and marketing and management capabilities of our OEM customers;
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the pressure faced by our OEM customers to reduce cost
There can be no assurance that we will not lose sales in the future as a result of the pressure to reduce costs faced by our customers. In late December 2005, management and the Board of Directors concluded that revenues from two of the three largest accounts would be significantly reduced in 2006, putting the liquidity of the Company in jeopardy by subjecting us to adverse revenue fluctuations.
Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be Successful In Establishing And
Maintaining The Technological Superiority Of Our Products Over Those Of Our Competitors.
We operate in a technology environment which is competitive and rapidly changing. While our software applications deliver what we, and most manufacturers who listen to it, believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. Our future success was dependent on establishing and maintaining the technological superiority of our products over those of competitors, our ability to successfully identify and bring other compatible technologies and products to market and a recognition by the market of product value. We compete with a number of entities that produce various stereo audio enhancement processes, technologies and products in both traditional two-speaker environments such as consumer electronics and multimedia computing, and in multi-channel, multi-speaker applications such as Home Theater. In the field of 3-D or “virtual audio”, our principal competitors are SRS Labs, Inc., QSound Labs, Inc. and Dolby Laboratories or technologies and products developed by other companies, including entities that have business relationships with us. There can be no assurance that we would be able to favorably compete in this market in the future, even if we had adequate liquidity.
If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully Operate Our Business.
Our future success primarily depends on the abilities and efforts of a small number of individuals, with particular management obligations and technical expertise. Loss of the services of any of these persons could adversely affect our business prospects. There is no assurance that we will be able to retain this group or successfully recruit other personnel, as needed. Our CEO resigned in January 2006, as did our two outside directors, in December 2005. We compete with other enterprises with stronger financial resources and larger staffs that may offer employment opportunities to our staff which are more desirable than those which we are able to offer. Failure to maintain skilled personnel with the software and engineering skills critical to our business had an adverse impact upon our business, the results of our operations and our prospects.
The Market For Our Stock May Be Not Remain Liquid And The Stock Price May Be Subject To Volatility
Our stock is quoted on the OTC Bulletin Board, where low trading volume and high volatility is often experienced. While a few firms make a market in our stock, the historically low trading volume and relatively few market makers of our stock makes it more likely that a severe fluctuation in volume, either up or down, will significantly impact the stock price. There can be no assurance that these market makers will continue to quote our stock and a reduction in such market makers would negatively impact trading liquidity. Further, with our constrained resources and increased cost and time associated with implementation of Sarbanes-Oxley, it may not be possible for us to remain listed on the OTC Bulletin Board in the future as a fully reporting company. This and the existing limited market and volume in the trading of our stock, may result in our shareholders having difficulty selling our common stock. The trading price of our Common Stock has been, and will likely continue to be, subject to wide fluctuations in response to quarterly variations in our operating results, announcements of new products or technological innovations by the Company or our competitors, strategic alliances between us and third parties, general market fluctuations and other events and factors, some of which may be beyond our control.
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2.
Item 2. Properties
Our corporate office and research center in San Jose, California, is the primary location for our audio technology division, Desper Products, Inc. (“DPI”). We occupy approximately 1,300 square feet with an annual rent on a full service basis of approximately $25,500 in calendar 2005 and $26,275 in calendar 2006. The lease expires on December 30, 2006 and is renewable at market rates thereafter. We lease our space at rental rates and on terms which management believes are consistent with those available for similar space in the applicable local area. Such property is well maintained and we believe is adequate to support our current requirements. Based on the decision to try to sell the Company’s assets, it is unlikely the lease will be renewed.
Our executive office was located in Westlake Village, California, where we occupied approximately 100 square feet with an annual rent of approximately $5,300. The lease term on this space expired on June 30, 2005 and was renewable on a month to month basis thereafter. This space in the Los Angeles area was used to facilitate business and contacts with the entertainment community as well as with our accountants, lawyers and directors. This space was vacated and the month to month lease terminated in February
2006.
We leased an apartment in San Jose, California for use by the chief executive officer when away from the executive office. The annual rent on this apartment was approximately $16,800. The lease was on a month-to-month basis and was terminated in January 2006.
Item 3.
Item 3. Legal Proceedings
From time to time we may be involved in various disputes and litigation matters arising in the normal course of business. As of the date of this Annual Report on Form 10-K, we are not involved in any legal proceedings that are expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our results of operations of the period in which the ruling occurs. Our estimate of the potential impact on our financial position or overall results of operations for the above legal proceedings could change in the future. At present, there are no active legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of our security holders either through solicitation of proxies or otherwise in the fourth quarter of the fiscal year ended December 31, 2005.
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
Our Common Stock was listed and commenced trading on the NASDAQ SmallCap market on August 21, 1995 under the symbol “SPAZ”. In January 1999, the Common Stock was delisted by the NASDAQ SmallCap Market due to our inability to maintain listing requirements. Our Common Stock immediately commenced trading on the OTC Bulletin Board under the same symbol. The following table sets forth the high and low bid price of our Common Stock as reported on the OTC Bulletin Board for fiscal years 2004 and 2005. The quotations listed below reflect interim dealer prices without retail mark-up, mark-down or commission and may not represent actual transactions.
On March 1, 2006, the closing price reported by the OTC Bulletin Board was U.S. $0.021. Stockholders are urged to obtain current market prices for our Common Stock. Computershare Investor Services, LLC is our transfer agent and registrar.
There were no sales of unregistered securities by the Company during the year ended December 31, 2004. In December 2005, we issued shares of our Common Stock in connection with the mandatory conversion of our Series B-1 Redeemable Convertible Preferred Stock, par value $.01 per share, which transaction was previously described and included in our Form 8-K filed with the SEC on December 30, 2005 (with date of earliest event reported of December 29, 2005).
To our knowledge, there were approximately 200 holders of record of the stock of the Company as of March 1, 2006. Our transfer agent has indicated that beneficial ownership is in excess of 4,000 stockholders.
We have not paid any cash dividends on our Common Stock and have no present intention of paying any dividends. Our current
policy is to retain earnings, if any, for use in operations and in the development of our business. Our future dividend policy will be determined from time to time by the Board of Directors.
The Company did not repurchase any of its equity securities during the fourth quarter of the fiscal year ended December 31, 2005.
Item 6.
Item 6. Selected Financial Data
The following selected consolidated financial data should be read in conjunction with our Consolidated Financial Statements and related Notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included in Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Executive Overview
Revenues increased to $1,192,000 for the year ended December 31, 2005 compared to $1,106,000 for the year ended December 31, 2004, an increase of 8%. Revenues are almost entirely comprised of royalties pertaining to the licensing of Spatializer® audio signal processing algorithms. A key issue discussed is the difficulty in obtaining revenue traction when traditional revenue sources are eroding, while being replaced by new revenue sources at a lower rate.
Net loss was $82,000 for the year ended December 31, 2005; ($0.00) basic per share, compared to net loss of $157,000, ($0.00) per share basic and diluted, for the year ended December 31, 2004. Net loss for the current period is primarily the result of lower revenue, partially offset by lower overhead. A key issue discussed is management’s efforts to reduce overhead in view of declining revenue, while maintaining competitiveness.
Net cash used by operating activities was $256,568 for the year ended December 31, 2005, as compared to net cash provided by operating activities was $343,939 for the year ended December 31, 2004 and net cash used in operating activities of $253,965 for the year ended December 31, 2003. The decrease in cash flows from operations for the year ended December 31, 2005 was primarily a
result of the decrease in deferred income, the net loss, a decrease in accounts payable and a decrease in notes payable, partially offset by a decrease in accounts receivable. Deferred income decreased due to full revenue realization of a prior year licensing prepayment and accounts receivable decreased due to reduced year over year revenue. A key issue is the Company’s ability to generate continued positive cash flow to continue operations.
The business environment in which we operate is highly competitive and is offers substantial risk. These risks should be studied and understood, as outlined in Risk Factors under Item 1A above.
Approach to MD&A
An important demonstration of our commitment to our stockholders is a clear explanation of the Company’s operating results, risks and opportunities. The purpose of MD&A is to provide our shareholders and other interested parties with information necessary to gain an understanding of our financial condition, changes in financial condition and results of operations. As such, we seek to satisfy three principal objectives:
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to provide a narrative explanation of a company’s financial statements “in plain English” that enables the average investor to see the company through the eyes of management;
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to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
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to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood and relationship of past performance being indicative of future performance.
We believe the best way to achieve this is to give the reader:
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An understanding of our operating environment and its risks
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An outline of critical accounting policies
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A review of our corporate governance structure
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A review of the key components of the financial statements and our cash position and capital resources
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A review of the important trends in the financial statements and our cash flow
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Disclosure on our internal controls and procedures
Operating Environment
We operate in a very competitive business environment. This environment impacts us in the following ways, further discussed in greater detail under Item 1A above.
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Our Board of Directors has Determined it is in the Company’s and it’s Stockholders’ Interests to Attempt to Sell the Company’s Assets
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We Face Significant Pricing Pressure and Competition that has Resulted in Our Technology Being Designed Out Within a Short Time Frame, and Impeded Efforts to Secure New Design Wins
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New Customer Product Development Has been Delayed. This Resulted in Delays In Revenues. Further, Where our Products are Delayed, Competitive Products May Reach The Market Before, or Replace Our Products.
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We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third parties Have Their Own Priorities and Alliances that Delayed or Could Thwart our Sales Efforts to Potential Customers.
We have experienced a loss from operations in four of the last five fiscal years. In December 2005 our revenues were stagnant, with those from certain of our major customers to decrease significantly in 2006. Revenues from certain of our other customers appear not to be sustainable in the future. In December 2005, two of our three independent directors resigned and the Chairman of the Board, Chief Executive Officer, Chief Financial Officer and Secretary resigned from all positions held with the Company other than as a director, Chairman and Secretary. For these and other reasons, and after exploring other exit strategies and opportunities, our Board of Directors concluded in December 2005 to attempt to sell the Company either through a sale of assets or a sale of multiple, non-exclusive perpetual licenses with a subsequent sale of the residual assets and engaged Strategic Equity Group to assist us in this endeavor. Following such transaction, it is anticipated that the Company would be wound up and dissolved. The consummation of any such transaction and the determination to wind up and dissolve is subject to stockholder approval. There is no assurance that the Company will be able to negotiate an agreement for the sale of assets. There is no assurance that, if such an agreement is successfully negotiated, that such transaction will be approved by stockholders or consummated. Further, even if such transaction is consummated, there is no assurance that there will be any funds available for distribution to stockholders. If such sale and subsequent wind up and dissolution is not approved, the Board of Directors will be required to explore other alternatives for the Company and its business.
We have experienced a loss from operations in four of the last five years. We experienced losses in the last two years. While our objective and full effort has been on managing a profitable business, due to the market conditions and factors outlined in this Annual Report on Form 10-K and their impact on fluctuations in operating expenses and revenues, we no longer believe that we will be able to generate a positive profit position in any given future period, nor do we believe that is feasible. We cannot guarantee that we will increase sales of our products and technologies, or that we will successfully develop and market any additional products, or achieve or sustain future profitability. We cannot, because of market and business conditions, rely on the sale of shares or on debt financings in the future. Further, we do not believe that debt or equity financing will be available as required and as such, have decided to try to sell the assets of the Company.
The PC and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in or substitution of features. Therefore, we have been seeking commercial acceptance of our products in highly competitive markets. We responded by offering additional products targeted to each price and quality segment of the market, more aggressively priced and feature enriched our products and entered new segments, such as cell phones, with different competitive pressure. Our value proposition that stressed the cost reducing capabilities of our audio solutions through improved performance from lower cost components as well as product differentiation that Spatializer technology can deliver, failed to resonate with our targeted customers in this highly competitive environment. The result was the elimination of features, including ours, to reduce cost. There is no assurance that our present or contemplated future products or a repositioned value proposition will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors or customers who had access to significantly greater resources or which are willing to “give away” their products.
Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company. In addition, standards may be adopted by cell phone system operators or manufacturers that may impede or prevent the penetration of non-standard technology onto their platforms. Lastly, customer implementation delays have put off expected cash flow into the future, beyond the time frame of operations based on our available cash resources.
Therefore, when reviewing the operating results or drawing conclusions with regard to future performance, these competitive forces and uncertainties must be taken into consideration. Though there is no absolute long-term visibility, it is likely that our operations would fail if we attempted to continue long-term in this environment. Hence, the Company’s Board of Directors has decided to attempt to sell the assets of the Company and liquidate the business, subject to stockholders’ approval.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which
have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are critical to an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.
The first critical accounting policy relates to revenue recognition. We recognize revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries. These revenues are reported to us by our Licensees in formal, written royalty reports, which serve as the basis for our quarterly revenue accruals. Infrequently, certain written reports are received after our required reporting deadlines, sometimes due to contractual requirements. In such cases, management tries to obtain verbal reports or informal reports from the Licensee. In the absence of such information, management may utilize conservative estimates based on information received or historical trends. In such isolated cases, management strives to under-estimate such revenues to err on the side of caution. In the event such estimates are used, the revenue for the following quarter is adjusted based on receipt of the written report. In addition, any error in Licensee reporting, which is very infrequent, is adjusted in the subsequent quarter when agreed by both parties as correct.
The second critical accounting policy relates to research and development expenses. We expense all research and development expenses as incurred. Costs incurred to establish the technological feasibility of our algorithms (which is the primary component of our licensing) is expensed as incurred and included in Research and Development expenses. Such algorithms are refined based on customer requirements and licensed for inclusion in the customer’s specific product. There are no production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86.
The third critical accounting policy relates to intangible assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents and trademarks, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the asset (which range from 3 to 20 years) using the straight-line method. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, only intangible assets with definite lives are amortized. Non-amortized intangible assets are instead subject to annual impairment testing.
Corporate Governance
Audit Committee
This committee is directed to review the scope, cost and results of the independent audit of our books and records, the results of the annual audit with management and the internal auditors and the adequacy of our accounting, financial, and operating controls; to recommend annually to the Board of Directors the selection of the independent auditors; to approve proposals made by our independent auditors for consulting work; and to report to the Board of Directors, when so requested, on any accounting of financial matters. Gilbert Segel was the only independent director on this committee. Mr. Segel resigned from our Board of Directors in December 2005. Mr. Mandell, Chairman of the Board and Secretary of the Company, served as ex-officio member of the Audit Committee during fiscal year 2005. Mr. Mandell resigned his employment with Company effective January 6, 2006. There were no members of the committee upon the resignation of Mr. Segel.
Compensation and Stock Committee
Our Compensation and Stock Option Committee (the “Compensation Committee”) consisted of Messrs. Pace and Segel, each of whom was a non-employee director of the Company and a “disinterested person” with respect to the plans administered by such committee, as such term is defined in Rule 16b-3 adopted under the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (collectively, the “Exchange Act”). The Compensation Committee reviews and approves annual salaries, bonuses and other forms and items of compensation for our senior officers and employees. Except for plans that are, in accordance with their terms or as required by law, administered by the Board of Directors or another particularly designated group, the Compensation Committee also administers and implements all of our stock option and other stock-based and equity-based benefit plans (including performance-based plans), recommends changes or additions to those plans or awards under the plans. Messrs. Pace and Segel resigned as directors in December 2005.
Our Audit Committee and Compensation and Stock Committee charters are available in print to any stockholder upon request in
writing to our principal corporate office at 2025 Gateway place, Suite 365, San Jose, California 95110.
Key Components of the Financial Statements and Important Trends
The financial statements, including the Consolidated Balance Sheets, the Consolidated Statements of Cash Flows and the Consolidated Statements of Stockholders’ Equity, should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report. MD&A explains the key components of each of these financial statements, key trends and reasons for reporting period-to-period fluctuations.
The Consolidated Balance Sheet provides a snapshot view of our financial condition at the end of our fiscal year. A balance sheet helps management and our stockholders understand the financial strength and capabilities of our business. Balance sheets can help identify and analyze trends, particularly in the area of receivables and payables. A review of cash compared to the comparable year and in relation to ongoing profit or loss can show the ability of the Company to withstand business variations. The relationship between Current Assets and Current Liabilities Working capital (current assets less current liabilities) measures how much in liquid assets a company has available to build its business. The presence of Deferred Revenue indicates cash received on revenue to be earned over the next twelve months. Receivables that are substantially higher than revenue for the quarter may indicate a slowdown of collections, with an impact on future cash position. This is addressed further in MD&A under Liquidity and Capital Resources.
The Consolidated Statement of Operations tells the reader whether the Company had a profit or loss. It shows key sources of revenue and major expense categories. It is important to note period-to-period comparisons of each line item of this statement, reasons for any fluctuation and how costs are managed in relation to the overall revenue trend of the business. These statements are prepared using accrual accounting under generally accepted accounting standards in the United States. This is addressed further in MD&A under Revenues and Expenses.
The Consolidated Statement of Cash Flows explains the actual sources and uses of cash. Some expenses of the Company, such as depreciation and amortization do not result in a cash outflow in the current period, since the underlying patent expenditure or asset purchase was made years earlier. New capital expenditures, on the other hand, result in a disbursement of cash, but will be expensed in the Consolidated Statement of Operations over its useful life. Fluctuations in receivables and payables also explain why the net change in cash is not equal to the loss reported on the Statement of Operations. Therefore, it is possible that the impact of a net loss on cash is less or more than the actual amount of the loss. This is discussed further in MD&A under Liquidity and Capital Resources.
The Consolidated Statement of Changes in Stockholders’ Equity shows the impact of the operating results on the Company’s equity. In addition, this statement shows new equity brought into the Company through stock sales or stock option exercise. This is discussed further in MD&A under Liquidity and Capital Resources.
Results of Operations
The following discussion and analysis relates to our financial condition and results of operations for the year ended December 31, 2005 compared to the year ended December 31, 2004, and the year ended December 31, 2004 compared to the year ended December 31, 2003. The following discussion of the financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report.
For the Year Ended December 31, 2005, Compared to the Year Ended December 31, 2004
Revenues
Revenues increased to $1,192,000 for the year ended December 31, 2005 compared to $1,106,000 for the year ended December 31, 2004, an increase of 8%. Revenues are almost entirely comprised of royalties pertaining to the licensing of Spatializer® audio signal processing algorithms.
The increase in revenue resulted from a greater recognition of deferred revenue in the current year, as compared to the prior year, in which a royalty advance was received. In addition, revenues increased from royalties on a third party semiconductor used in cellular phones, as compared to the prior year. This was partially offset by declining revenues from two accounts whose products using our technology reached end of life. Their new models do not utilize our technology.
Gross Profit
Gross profit increased to $1,086,000 for the year ended December 31, 2005 compared to $995,000 in the comparable period last year, an increase of 9%. Gross margin was 91% of revenue in the year ended December 31, 2005 compared with 90% of revenue for the comparable period last year. The increase in gross profit resulted from higher revenues in fiscal 2005. We maintain a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs other than commissions paid to our independent representatives that solicit and oversee the particular accounts. All development costs are expensed as engineering and development expenses in the period they are incurred.
Operating Expenses
Operating expenses for the year ended December 31, 2005 increased to $1,177,000 (99% of sales) from $1,146,000 (105% of sales) for the year ended December 31, 2004, an increase of 3%. The increase in operating expenses resulted primarily from increases in general and administrative expense and sales and marketing expense. General and Administrative expenses increased due to higher legal and audit expenses. Sales and marketing expenses increased due to higher travel expenses resulting from more overseas licensing trips.
General and Administrative
General and administrative expense increased to $670,000 for the year ended December 31, 2005 from $615,000 for the year ended December 31, 2004, an increase of 9%. The increase is primarily due to increased legal and accounting expenses related to public filings, in part in response to the additional requirements imposed on public companies by the Sarbanes-Oxley Act, and to increased travel costs by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.
Research and Development
Research and Development costs decreased to $354,000 for the year ended December 31, 2005, compared to $393,000 for the year ended December 31, 2003, a decrease of 10%. The decrease in research and development expense was due to the commencement of the use of lower cost applications engineering consultants in India in the second half of 2004 and the elimination of an in-house applications engineering position in early 2005. The number of projects completed by the Indian engineering firm were higher in 2005 as compared to 2004, partially offsetting the savings from the eliminated in-house engineering staff position.
We continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of Spatializer ((environ)) 3G and applications engineering to port our technology to leading processor platforms.
Sales and Marketing
Sales and Marketing costs increased to $152,000 for the year ended December 31, 2005, compared to $138,000 for the year ended December 31, 2004, an increase of 10%. The increase in such expenses resulted from higher international travel in search of new licensing arrangements.
Net Income (Loss)
Net loss was $81,000 for the year ended December 31, 2005; ($0.00) basic per share, compared to net loss of $157,000, ($0.00) per share basic and diluted, for the year ended December 31, 2004. The reduction in net loss for the current period is primarily the result of higher revenue, partially offset by higher overhead.
For the Year Ended December 31, 2004, Compared to the Year Ended December 31, 2003
Revenues
Revenues decreased to $1,106,000 for the year ended December 31, 2004 compared to $1,269,000 for the year ended December 31, 2003, a decrease of 13%. Revenues are almost entirely comprised of royalties pertaining to the licensing of Spatializer® audio
signal processing algorithms.
While the overall decrease was relatively modest, the revenue mix by licensee platform was significantly different year over year. The decrease in revenues is attributed primarily to the loss or reduction at three key DVD player accounts and one PC account which in aggregate, generated approximately 56% of total fiscal 2003 revenue. In each case, these licensees decided to use no licensed virtual surround solution or opted for a free solution from their chip supplier, driven primarily by cost reduction pressure. These losses were partially offset by three new revenue sources in cellular phones, mobile audio semiconductors and PCs, and the expansion of an existing license relating to recordable DVD.
Gross Profit
Gross profit decreased to $995,000 for the year ended December 31, 2004 compared to $1,147,000 in the comparable period last year, a decrease of 13%. Gross margin held steady at 90% of revenue in the year ended December 31, 2004 compared with 90% of revenue for the comparable period last year. The decrease in gross profit results from lower revenues in the current year We maintain a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs other than commissions paid to our independent representatives that solicit and oversee the particular accounts. All development costs are expensed as engineering and development expenses in the period they are incurred.
Operating Expenses
Operating expenses for the year ended December 31, 2004 decreased to $1,146,000 (105% of sales) from $1,631,000 (128% of sales) for the year ended December 31, 2003, a decrease of 30%. The decrease in operating expenses results primarily from reductions in general and administrative expense and sales and marketing expense. General and Administrative expenses declined due to the relocation to smaller and less expensive offices in December 2003 and lower occupancy-related expenses. Sales and marketing expenses declined due to the elimination of a marketing and business development executive position and related travel in the fourth quarter of 2003 and the restructuring of our Japan sales operation. These responsibilities were transferred to another executive and to a new commissioned representative firm in Japan.
General and Administrative
General and administrative expense decreased to $615,000 for the year ended December 31, 2004 from $811,000 for the year ended December 31, 2003, a decrease of 24%. The decrease is primarily due to the relocation of our offices to smaller and lower cost facilities in December 2003, upon expiration of an existing lease, lower occupancy related expenses, partially offset by increased legal and accounting expenses related to public filings, in part in response to the additional requirements imposed on public companies by the Sarbanes-Oxley Act and increased travel by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.
Research and Development
Research and Development costs decreased to $393,000 for the year ended December 31, 2004, compared to $459,000 for the year ended December 31, 2003, a decrease of 14%. The decrease in research and development expense was due to the commencement of the use of lower cost specialist consultants in India in the second half of 2004.
We continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of Spatializer Audio Alchemy, refinement of Spatializer Natural Headphone, development of new cell phone solutions and applications engineering to port our technology to leading processor platforms.
Sales and Marketing
Sales and Marketing costs decreased to $138,000 for the year ended December 31, 2004, compared to $361,000 for the year ended December 31, 2003, a decrease of 62%. The reduction in such expenses resulted from the elimination of a sales consultant position, the elimination of a sales executive position in the third quarter of 2003 and fewer trade show participations.
Net Income (Loss)
Net loss was $157,000 for the year ended December 31, 2004; ($0.00) basic per share, compared to net loss of $495,000, ($0.01) per share basic and diluted, for the year ended December 31, 2003. Net loss for the current period is primarily the result of lower revenue, partially offset by lower overhead.
Liquidity and Capital Resources
At December 31, 2005, we had $551,000 in cash and cash equivalents as compared to $871,000 at December 31, 2004. The decrease in cash resulted from full recognition of deferred income, the net loss, a decrease in accounts payable and a decrease in notes payable, partially offset by a decrease in accounts receivable. Deferred income decreased due to full revenue realization of a prior year licensing prepayment and accounts receivable decreased due to reduced year over year revenue. We had working capital of $560,000 at December 31, 2005 as compared with working capital of $586,000 at December 31, 2004.
Net cash used by operating activities was $256,568 for the year ended December 31, 2005, as compared to net cash provided by operating activities of $343,939 for the year ended December 31, 2004 and net cash used by operating activities of $253,965 for the year ended December 31, 2003. The decrease in cash flows from operations for the year ended December 31, 2005 was primarily a result of the decrease in deferred income, the net loss, a decrease in accounts payable and notes payable, partially offset by a decrease in accounts receivable.
We use cash in investing activities primarily to secure patent and trademark protection for our proprietary technology and brand name, and to purchase short-term investments such as bank certificates of deposit. Cash used in investing activities totaled $8,145, $20,587 and $20,709, respectively, in the years ended December 31, 2005, 2004, and 2003. All expenditures for on-going research and development are expenses and therefore included in the Net Loss.
Net cash flows used in financing activities totaled $55,809 and $41,994 for the year ended December 31, 2005 and 2004, respectively. Cash provided by financing activities totaled $5,746 for the years ended December 31, 2003.
In December 2005, the Company, as stipulated by the related Subscription Agreement, forced the conversion of all outstanding Series B-1 Preferred Stock, into Restricted Common Stock at the minimum conversion price of $.56 per share. This resulted in the issuance of 1,788,018 Common Stock shares, worth approximately $100,000 at market value at issuance. This issuance diluted existing common stockholders by approximately 4%, but eliminated $1.1 million in liquidation preference shares.
In the fourth quarter of 2003, we negotiated and completed the conversion of a $112,500 related party 10% demand note to a three-year 10% term note. Principal and interest of $5,191 is paid monthly, which we pay on a current basis. Since the director who was an indirect beneficiary of the demand note retired from the Board of Directors in June 2003, the demand note is classified as a note payable at December 31, 2004. There are no installments due in more than twelve months as of December 31, 2004.
Future payments due under operating lease obligations as of December 31, 2005 are described below:
In the event the Company is to be would up and dissolved the Company would attempt to settle these amounts, negotiate early termination, or pay the remaining obligation if cash resources permitted.
Our future cash flow will come primarily from the audio signal processing licensing and OEM royalties until or if our efforts to sell the assets of the company, with stockholders approval, is consummated and in that case from any net proceeds from the sale of
assets or perpetual licenses. The Board of Directors will, with the approval of the stockholders, decide on the dispensation of such proceeds.
The fluid, competitive and dynamic nature of the market continues a high degree of uncertainty to our operations. The operations of our business, and those of our competitors, are also impacted by the continued trend in the semiconductor industry to offer free, but minimal audio solutions to certain product classes to maintain and attract market share. In addition, the commoditization of many consumer electronics segments, our lack of resources and the departure of key employee and directors has made it unfeasible to continue to compete.
Based on current and projected operating levels, we no longer believe that we can maintain our liquidity position at a consistent level both on a short-term and long-term basis. As such, we do not believe our current cash reserves and cash generated from our existing operations and customer base are sufficient for us to meet our operating obligations and the anticipated additional research and development for our audio technology business for at least the next 12 months.
On January 10, 2006, the Company announced that it would hold an open auction for the sale of substantially all of its assets. The Board of Directors of the Company decided that it is in the best interests of the stockholders to hold an open auction for the acquisition of the assets of the Company or the granting of an unlimited amount of non-exclusive perpetual licenses for a one-time fee and a subsequent auction of the residual assets. The consummation of any of such transactions will be subject to approval by the stockholders of the Company. The Company received non-conforming bids for such assets on the February 15, 2006 deadline. The Board of Directors of the company, in consultation with their financial and legal advisors, extended the auction period to March 10, 2006, to provide bidders and other interested parties additional time to clarify their offers and perform due diligence, as well as to solicit additional offers. Negotiations continue with auction participants who submitted bids by March 10, 2006 and will announce its decision upon completion of its evaluation of such bids.
Net Operating Loss Carry forwards
At December 31, 2005, we had net operating loss carry forwards for Federal income tax purposes of approximately $26,500,000 which are available to offset future Federal taxable income, if any, through 2014. Approximately $21,700,000 of these net operating loss carry forwards is subject to an annual limitation of approximately $1,000,000.
Recently Issued Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share Based Payment”. This Statement is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. This Statement supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans”. The Securities and Exchange Commission has delayed the adoption requirement of SFAS No. 123R until the first annual reporting period beginning after December 15, 2005. We adopted SFAS No. 123R as of January 1, 2006 as required.
In May 2005 the FASB issued SFAS 154 “Accounting Changes and Error Corrections”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle and also corrections of error in previously issued financial statements. This Statement harmonizes US accounting standards with existing international accounting standards by requiring companies to report voluntary changes in accounting principles via a retrospective application, unless impracticable. Also, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We have not been exposed to material future earnings or cash flow fluctuations from changes in interest rates on our short-term investments at December 31, 2005. A hypothetical decrease of 100 basis points in interest rate (ten percent of our overall earnings rate) would not result in a material fluctuation in future earnings or cash flow. We have not entered into any derivative financial instruments to manage interest rate risk or for speculative purposes and we are not currently evaluating the future use of such financial instruments.
Item 8.
Item 8. Financial Statements and Supplementary Data
REPORT of REGISTERED PUBIC ACCOUNTING FIRM
To the Board of Directors of Spatializer Audio Laboratories, Inc.:
We have audited the accompanying consolidated balance sheets of Spatializer Audio Laboratories, Inc. and subsidiaries (The “Company”) as of December 31, 2005 and 2004 and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended December 31, 2005, 2004 and 2003. These consolidated 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Spatializer Audio Laboratories, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of its operations and its cash flows for the years ended December 31, 2005, 2004 and 2003 in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company’s significant operating losses raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ FARBER HASS HURLEY & MCEWEN LLP
Camarillo, California
February 24, 2006
SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements
SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements
SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements
SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
See accompanying notes to consolidated financial statements
SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Nature of Business
Spatializer Audio Laboratories, Inc. and subsidiaries (the “Company”) is in the business of developing and licensing technology. The Company sales, research and subsidiary administration are conducted out of facilities in San Jose, California.
The Company’s wholly-owned subsidiary, Desper Products, Inc. (“DPI”), is in the business of developing proprietary advanced audio signal processing technologies and products for consumer electronics, entertainment, and multimedia computing. All Company revenues are generated from this subsidiary.
(2) Significant Accounting Policies
Basis of Consolidation - The consolidated financial statements include the accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, Desper Products, Inc. All significant intercompany balances and transactions have been eliminated in consolidation. Corporate administration expenses are not allocated to subsidiaries.
Reclassification - Certain 2003 amounts have been reclassified to conform with the 2004 and 2005 presentation. In that regard, the Company has reflected the issuance of 15,384 shares of Class B-1 Convertible Preferred Stock that was originally recorded in Additional Paid in Capital. This resulted in a reclassification of $154 to Convertible Preferred Stock from APIC.
Going Concern - The Company has incurred substantial operating losses in four of the last five years. Also, license contracts with two of the Company’s largest customers will expire on terms in 2006. Those customers have informed the Company that the contracts will not be renewed nor replaced with other licenses.
Revenue Recognition - The Company recognizes revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries. The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin 104.
Concentration of Credit Risk - Financial instruments, which potentially subject the company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at Citibank FSB. At December 31, 2005 and 2004, substantially all cash and cash equivalents were on deposit at one financial institution.
At December 31, 2005, three major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: Matsushita, Sharp and Funai Corporation, each of whom accounted for greater than 10% of our total 2005 accounts receivable. One customer accounted for 52.0%, another accounted for 22% and one accounted for 14% of our total accounts receivable at December 31, 2005. At December 31, 2004, three major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: Matsushita, Sharp and Toshiba Corporation, each of whom accounted for greater than 10% of our total 2004 accounts receivable. One customer accounted for 31.0%, another accounted for 27% and one accounted for 18% of our total accounts receivable at December 31, 2004.
The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable. Due to the contractual nature of sales agreements and historical trends, no allowance for doubtful accounts has been provided.
The Company does not apply interest charges to past due accounts receivable.
Cash and Cash Equivalents - Cash equivalents consist of highly liquid investments with original maturities of three months or less.
Customers Outside of the U.S.- Sales to foreign customers were 95%, 95% and 91% of total sales in the years ended December 31, 2005 and 2004 and 2003, respectively.
Major Customers - During the year ended December 31, 2005, three customers accounted for 42%, 23% and 12%, respectively, of the Company’s net sales. During the year ended December 31, 2004, four customers accounted for 29%, 25%, 21% and 13%, respectively, of the Company’s net sales.
Research and Development Costs - The Company expenses research and development costs as incurred, which is presented as a separate line on the statement of operations.
Advertising Costs - Costs incurred for producing and communicating advertising are expensed when incurred and included in selling, general and administrative expenses. Consolidated advertising expense amounted to $18,931, $4,289 and $2,960 in 2005, 2004 and 2003, respectively.
Property and Equipment - Property and equipment are stated at cost. Major renewals and improvements are charged to the asset accounts while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to income. Property and equipment are depreciated over the useful lives of the asset ranging from 3 years to 5 years under the straight line method.
Intangible Assets - Intangible assets consist of patent costs and trademarks which are amortized on a straight-line basis over the estimated useful lives of the patents which range from five to twenty years.
Earnings Per Share - The Company determines earnings per share in accordance with Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”). Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
Since the Company generated a net loss in 2005, 2004 and 2003, outstanding stock options and warrants would have been anti-dilutive and are not applicable to this calculation.
Stock Option Plan -The Company determines the effect of stock based compensation in accordance with SFAS No. 123, Accounting for Stock-Based Compensation ,as amended which permits entities to recognize as expense using the “fair-value” method over the vesting period of all employee stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to utilize the “intrinsic value” method for equity instruments granted to employees and provide pro forma net income (loss) and pro forma earnings (loss) per share disclosures for employee stock option grants after 1994 as if the fair-value-based method defined in SFAS No. 123 has been applied. The Company has elected to continue to utilize the “intrinsic value” method for employee stock option grants and provide the pro forma disclosure provisions of SFAS No. 123 (Note 8).
Impairment of Long-Lived Assets and Assets to be Disposed of - The Company adopted the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, on January 1, 1996. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amounts of the assets exceed the fair value of the assets (see Notes 4). Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
Segment Reporting - The Company adopted SFAS 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in December 1997. MDT has been considered a discontinued operation since September 1998. As of December 31, 2002, the Company has only one operating segment, DPI, the Company’s Audio Signal Processing business.
Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Recent Accounting Pronouncements - In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share Based Payment”. This Statement is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. This Statement supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans”. The Securities and Exchange Commission has delayed the adoption requirement of SFAS No. 123R until the first annual period beginning after December 15, 2005. We adopted SFAS No. 123R as of January 1, 2006 as required.
In May 2005 the FASB issued SFAS 154 “Accounting Changes and Error Corrections”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle and also corrections of error in previously issued financial statements. This Statement harmonizes US accounting standards with existing international accounting standards by requiring companies to report voluntary changes in accounting principles via a retrospective application, unless impracticable. Also, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
The Company believes that the adoption of these pronouncements may not have a material effect on the Company’s financial position, results from operations or cash flows. This impact cannot be determined at this time, as future option grants are indeterminable.
Use of Estimates - Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.
Fair Value of Financial Instruments - The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2004 and 2003 approximated fair value due to their short maturity or nature.
The fair value of notes payable at December 31, 2005 is materially consistent with the related carrying values based on current rates offered to the Company for instruments with similar maturities.
(3) Property and Equipment
Property and equipment, as of December 31, 2005 and 2004, consists of the following, net of a reserve for impairment loss in 1998 in accordance with application of SFAS 121:
(4) Intangible Assets
Intangible assets, as of December 31, 2005 and 2004 consist of the following:
Estimated amortization is as follows:
Management estimates that the recorded net book value of intangible assets would be realized through a sale of assets.
(5) Notes Payable to Related Parties
The Company was indebted to the Premium Finance, Inc., an unrelated insurance premium finance company, in the amount of $10,443 at December 31, 2005. This note finances the Company’s annual Directors’ and Officers’ Liability Insurance. This amount bears interest at a fixed rate of 10% annually, is paid in monthly installments of $5,221 that commenced on June 1, 2005 and continues for nine months until the entire balance of principal and interest is paid in full.
The Company was indebted to the Desper Family Trust, through November 30, 2005, when the note was paid in full. The Desper Family Trust’s principal beneficiary is the mother of a former director of the Company. This director’s term expired in June 2003 and as such, is not a related party. This note bore interest at a fixed rate of 10% annually, was paid in monthly installments of $5,191 that commenced on December 1, 2003 and continued for twenty-four months until the entire balance of principal and interest was paid in full.
(6) Shareholders’ Equity
During the year ended December 31, 2005, shares were issued or converted as follows:
In December 2005, the Company, as stipulated by the related Subscription Agreement, forced the conversion of all outstanding Series B-1 Preferred Stock, into Restricted Common Stock at the minimum conversion price of $.56 per share. This resulted in the issuance of 1,788,018 Common Stock shares.
Options to purchase 75,000 and 100,000 shares of common stock previously granted to an employee, at exercise prices of $0.27 and $0.05, respectively, were cancelled upon his resignation from the Company.
Options to purchase a total of 500,000 shares of common stock were granted to the CEO related to the extension of his employment agreement. These options vested half on issuance and half in November, 2005, if the executive is in the employ of the Company. These options may be exercised at a price of $0.10 per share through February, 2010. These options had no value at December 31, 2005.
During the year ended December 31, 2004, shares were issued or converted as follows:
Unissued Performance Shares held in escrow were cancelled.
Options to purchase common shares in exchange for services were issued with a value of $1,000.
Capitalization
Series B-1 Redeemable Convertible Preferred Stock: On November 6, 2002 the Board of Directors Designated a Series B-1 Preferred Stock. The series had a par value of $0.01 and a stated value of $10.00 per share US and was designated as a liquidation preference. The stock ranked prior to the Company’s common stock. No dividends were to be paid on the Series B-1 Preferred Stock. Conversion rights vested on January 1, 2003 to convert the Series B-1 Preferred Stock to common at a certain formula based on an average closing share price, subject to a floor of $0.56 and a ceiling of $1.12. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading existed based on date sensitive events based on the Company’s Insider Trading Policy. In December 2002, 87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B Preferred Stock. In 2004, the Company reflected the issuance of 15,384 shares of Series B-1 Convertible Preferred Stock that was originally recorded in Additional Paid in Capital. This resulted in a reclassification of $154 to Convertible Preferred Stock from APIC. In December 2005, the Company, as stipulated by the related Subscription Agreement, forced the conversion of all outstanding Series B-1 Preferred Stock, into Restricted Common Stock at the minimum conversion price of $.56 per share. This resulted in the issuance of 1,788,018 Common Stock shares.
(7) Stock Options
In 1995, the Company adopted a stock option plan (the “Plan”) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The Plan which was approved by the stockholders authorizes grants of options to purchase authorized but unissued common stock up to 10% of total common shares outstanding at each calendar quarter, 4,697,537 as of September 30, 2005. Stock options were granted under the Plan with an exercise price equal to the stock’s fair market value at the date of grant. Outstanding stock options under the Plan have five-year terms and vest and become fully exercisable up to three years from the date of grant. The Plan expired in February 2005. To date, the Company has not adopted a new stock option plan.
There were 500,000 options granted in the quarter ended March 31, 2005 to the CEO in connection with the extension of his employment agreement. These options vested half on issuance and half in November, 2005. These options may be exercised at a price of $0.10 per share through February, 2010. The Company cancelled 175,000 options previously granted to an employee, upon his resignation in January 2005. Options to purchase 150,000 shares of common stock expired in the quarter ended December 31, 2005.
At December 31, 2004, there were 2,066,339 additional shares available for grant under the Plan. The per share weighted-average fair value of stock options granted during 2005, 2004 and 2003 was $0.02, $0.09 and $0.05, respectively, on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2005- expected dividend yield 0%, risk-free interest rate of 4.5%, expected volatility of 150% and an expected life of 5 years 2004- expected dividend yield 0%, risk-free interest rate of 4.1%, expected volatility of 150% and an expected life of 5 years; 2003- expected dividend yield 0%, risk-free interest rate of 2.25%, expected volatility of 137% and an expected life of 5 years;
The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for the fair value of its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net income (loss) would have been increased to the pro forma amounts indicated below:
Stock option activity during the periods indicated is as follows:
At December 31, 2005, the number of options exercisable was 2,726,666 and the weighted-average exercise price of those options was $0.10.
(8) Warrants
Warrant activity for the periods indicated below is as follows:
There were no warrants issued and outstanding during the last three years.
(9) Income Taxes
The Company files a consolidated return for U.S. income tax purposes. Income tax expense for the years ended December 31, 2005, 2004 and 2003 consisted of the following:
Certain revenues received from customers in foreign countries are subject to withholding taxes that are deducted from outgoing funds at the time of payment. These taxes range from approximately 10% to 16.5% and are recorded as net royalty revenue.
Income tax expense for the years ended December 31, 2005, 2004 and 2003 differed from the amounts computed by applying the U.S. federal income tax rate of 34 percent to loss before income taxes primarily due to the generation of additional net operating loss carry forwards for which no tax benefit has been provided.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets at December 31, 2005 is composed primarily of the net loss carry forwards. The net change in the total valuation allowance for the year ended December 31, 2005 was insignificant. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable losses, management believes it is more likely than not the Company will not realize the benefits of these deductible differences and has established a valuation allowance to fully reserve the deferred tax assets at December 31, 2005. Additionally, the ultimate realizability of net operating losses may be limited by change of control provisions under Section 382 of the Internal Revenue Code.
At December 31, 2005, the Company had net operating loss carry forwards for Federal income tax purposes of approximately $26,500,000 which are available to offset future Federal taxable income, if any, through 2014. Approximately $21,700,000 of these net operating loss carry forwards are subject to an annual limitation of approximately $1,000,000.
(10) Commitments and Contingencies
We also anticipate that, from time to time, we may be named as a party to other legal proceedings that may arise in the ordinary course of our business.
Operating Lease Commitments
The Company is obligated under several non-cancelable operating leases. Future minimum rental payments for all operating leases of approximately $27,000 through December, 2006. Rent expense amounted to approximately $25,000, $23,000 and $ 83,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
(11) Profit Sharing Plan
The Company has a 401(k) profit sharing plan covering substantially all employees, subject to certain participation and vesting requirements. The Company may elect to make discretionary contributions to the Plan, but has never done so over the life of the Plan. The amount charged to administrative expense for the Plan in 2005, 2004 and 2003 was approximately $2,000 per annum.
(12) Quarterly Financial Data (unaudited)
The following is a summary of the quarterly results of operations for the years ended December 31, 2005 and 2004:
(13) Subsequent Events and Management Plans (unaudited)
On January 10, 2006, the Company announced that it would hold an open auction for the sale of substantially all of its assets. The Board of Directors of the Company decided that it is in the best interests of the stockholders to hold an open auction for the acquisition of the assets of the Company or the granting of an unlimited amount of non-exclusive perpetual licenses for a one-time fee and a subsequent auction of the residual assets. The consummation of any of such transactions will be subject to approval by the stockholders of the Company. The Company received non-conforming bids for such assets on the February 15, 2006 auction close deadline. The Board of Directors of the company, in consultation with their financial and legal advisors, extended the auction period to March 10, 2006, to provide bidders and other interested parties additional time to clarify their offers and perform due diligence, as well as to solicit additional offers. Negotiations continue with auction participants who submitted bids by March 10, 2006. The Company will announce its decision and recommendation to the stockholders upon finalization of bids and completion of its evaluation of such bids.
Item 9.
Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
We carried out an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer had concluded that our disclosure controls and procedures as of the end of the period covered by this report were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms. There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information required for this item incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Stockholders.
Code of Ethics
We adopted a Code of Ethics that applies to all of our directors, officers and employees, including our Chief Executive Officer, our Chief Financial Officer and other senior financial officers. The Company will provide a copy of our code of ethics to any person, free of charge, upon written request sent to our principal corporate office at 2025 Gateway Place, Suite 365, San Jose, California 95110.
Item 11.
Item 11. Executive Compensation
Information required for this item incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Stockholders.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Equity Compensation Plan Information
The remaining information is required for this item is incorporated by reference to our Proxy Statement for the 2005 Annual Meeting of Stockholders.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information required for this item incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Stockholders.
Item 14.
Item 14. Principal Accountant Fees and Services
Information required for this item incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Stockholders.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Financial Statements
See Item 8.
(b) Exhibits
The following Exhibits are filed as part of, or incorporated by reference into, this Report:
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.
Dated: March 27, 2006
SPATIALIZER AUDIO LABORATORIES, INC.
(Registrant)
/s/ Henry R. Mandell
Henry R. Mandell
Chairman & Secretary
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.