| AWARE INC /MA/ Item 1A Risk Factors |
| 11 ITEM 1A RISK FACTORS SOME OF THE INFORMATION IN THIS FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES YOU CAN IDENTIFY THESE STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "e MAY, "e "e WILL, "e "e EXPECT, "e "e ANTICIPATE, "e "e BELIEVE, "e "e ESTIMATE, "e "e CONTINUE "e AND SIMILAR WORDS YOU SHOULD READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR FINANCIAL CONDITION; OR (3) STATE OTHER "e FORWARD-LOOKING "e INFORMATION HOWEVER, WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY THE RISK FACTORS LISTED IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-K, PROVIDE EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING STATEMENTS YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-K COULD MATERIALLY AND ADVERSELY AFFECT OUR BUSINESS WE ASSUME NO OBLIGATION TO UPDATE ANY FORWARD-LOOKING STATEMENTS OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY Our quarterly revenue and operating results are difficult to predict and may fluctuate significantly from quarter-to-quarter |
| Because our revenue components fluctuate and are difficult to predict, and our expenses are largely independent of revenues in any particular period, it is difficult for us to accurately forecast revenues and profitability |
| When appropriate, we recognize contract revenues ratably over the period during which we expect to deliver technology and provide engineering services |
| While this means that contract revenues from certain current agreements are generally predictable, changes can be introduced by a reevaluation of the length of the development period, or by the termination of a contract |
| The initial estimate of this period is subject to revision as the product being developed under a contract nears completion, and a revision may result in an increase or decrease to the quarterly revenue for that contract |
| In addition, accurate prediction of revenues from new contracts or licensees is difficult because contract negotiation is a lengthy process, frequently spanning a year or more, and the fiscal period in which a new license agreement will be entered into, if at all, and the financial terms of such an agreement are difficult to predict |
| Contract revenues also include fees for engineering services, which are dependent upon the varying level of assistance desired by licensees and, therefore, the revenue from these services is also difficult to predict |
| It is also difficult for us to make accurate forecasts of royalty revenues |
| Royalties are recognized in the quarter in which we receive a report from a licensee regarding the shipment of licensed integrated circuits in the prior quarter, and are dependent upon fluctuating sales volumes and/or prices of chips containing our technology, all of which are beyond our ability to control or assess in advance |
| Our business is subject to a variety of additional risks, which could materially adversely affect quarterly and annual operating results, including: o market acceptance of broadband technologies we supply by semiconductor or equipment companies; o the extent and timing of new license transactions with semiconductor companies; o changes in our and our licensees &apos development schedules and levels of expenditure on research and development; o the loss of a strategic relationship or termination of a project by a licensee; o equipment companies &apos acceptance of integrated circuits produced by our licensees; o the loss by a licensee of a strategic relationship with an equipment company customer; o announcements or introductions of new technologies or products by us or our competitors; o delays or problems in the introduction or performance of enhancements or of future generations of our technology; o failures or problems in our hardware or software products; o delays in the adoption of new industry standards or changes in market perception of the value of new or existing standards; o competitive pressures resulting in lower contract revenues or royalty rates; o competitive pressures resulting in lower software or hardware product revenues; o personnel changes, particularly those involving engineering and technical personnel; o costs associated with protecting our intellectual property; o the potential that licensees could fail to make payments under their current contracts; o ADSL market-related issues, including lower ADSL chipset unit demand brought on by excess channel inventory and lower average selling prices for ADSL chipsets as a result of market surpluses; 11 o VDSL market-related issues, including lower VDSL chipset unit demand brought on by excess channel inventory and lower average selling prices for VDSL chipsets as a result of market surpluses; o regulatory developments; and o general economic trends and other factors |
| As a result of these factors, we believe that period-to-period comparisons of our revenue levels and operating results are not necessarily meaningful |
| You should not rely on our quarterly revenue and operating results to predict our future performance |
| We may continue to experience losses in the future if: o the semiconductor and telecommunications markets do not improve; o our existing customers do not increase their revenues from sales of chipsets with our technology; o new or existing customers do not choose to license our intellectual property for new chipset products; or o new or existing customers do not choose to use our software or hardware products |
| WE HAVE A UNIQUE BUSINESS MODEL The success of our business model depends upon our ability to license our technology to semiconductor and equipment companies, and our customers &apos willingness and ability to sell products that incorporate our technology so that we may receive significant royalties that are consistent with our plans and expectations |
| We face numerous risks in successfully obtaining suitable licensees on terms consistent with our business model, including, among others: o we must typically undergo a lengthy and expensive process of building a relationship with a potential licensee before there is any assurance of a license agreement with such party; o we must persuade semiconductor and equipment manufacturers with significant resources to rely on us for critical technology on an ongoing basis rather than trying to develop similar technology internally; o we must persuade potential licensees to bear development costs associated with our technology applications and to make the necessary investment to successfully manufacture chipsets and products using our technology; and o we must successfully transfer technical know-how to licensees |
| Royalties from our licensees are often based on the selling prices of our licensees &apos chipsets and products, over which we have little or no control |
| We also have little or no control over our licensees &apos promotional and marketing efforts |
| They are not prohibited from competing against us |
| Our business could be seriously harmed if: o we cannot obtain suitable licensees; o our licensees fail to achieve significant sales of chipsets or products incorporating our technology; or o we otherwise fail to implement our business strategy successfully |
| THERE HAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, AND THERE IS INTENSE COMPETITION FOR ADSL CHIPSETS, WHICH HAS CAUSED OUR ROYALTY REVENUE TO DECLINE The royalties we receive are influenced by many of the risks faced by the ADSL market in general, including reduced average selling prices ( "e ASPs "e ) for ADSL chipsets during periods of surplus |
| In 2000, 2001, and 2002, the ADSL industry had experienced an oversupply of ADSL chipsets and central office equipment |
| Excessive inventory levels led to soft chipset demand, which in turn led to declining ASPs |
| ASPs have also been under pressure because 12 of intense competition in the ADSL chipset marketplace |
| As a result of the soft demand and declining ASPs for ADSL chipsets, our royalty revenue has decreased substantially from the levels we achieved in 2000 |
| Price decreases for ADSL or VDSL chipsets, and the corresponding decreases in per unit royalties received by us, can be sudden and dramatic |
| Pricing pressures may continue during the first quarter of 2006 and beyond |
| Our royalty revenue may decline over the long term |
| WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES There are a relatively limited number of semiconductor and equipment companies to which we can license our broadband technology in a manner consistent with our business model |
| If we fail to maintain relationships with our current licensees or fail to establish a sufficient number of new licensing relationships, our business could be seriously harmed |
| In addition, our prospective customers may use their superior size and bargaining power to demand license terms that are unfavorable to us and prospective customers may not elect to license from us |
| WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM A SMALL NUMBER OF CUSTOMERS In 2003, 2004 and 2005, we derived 27prca, 28prca and 20prca, respectively, of our total revenue from ADI and 20prca, 28prca, and 30prca respectively, of our total revenue from Infineon |
| ADI and Infineon have developed many generations of ADSL chipsets based upon our technology |
| On February 17, 2006 ADI sold its ADSL business relating to Aware technology to Ikanos Communications, Inc |
| Our royalty revenue in the near term is highly dependent upon the respective market share and pricing of Ikanos &apos and Infineonapstas ADSL chipsets |
| The ADSL market has experienced significant price erosion, which has adversely affected ADSL chipset revenues, which in turn has adversely affected our royalty revenue |
| To the extent that Ikanos loses ADSL2plus market share or Infineon loses market share, is unable to gain market share, is unable to transition its product to support new ADSL2, ADSL2plus and VDSL2 standards, or experiences further price erosion in its DSL chipsets, our royalty revenue could decline |
| OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES Due to our business strategy, our success is dependent on our ability to generate significant royalties from our licensing arrangements with semiconductor manufacturers |
| Our ability to generate significant royalties is materially affected by the willingness of equipment companies to purchase integrated circuits that incorporate our technology from our licensees |
| There are other competitive solutions available for equipment companies seeking to offer broadband communications products |
| We face the risk that equipment manufacturers will choose those alternative solutions |
| Generally, our ability to influence equipment companies &apos decisions whether to purchase integrated circuits that incorporate our technology is limited |
| We also face the risk that equipment companies that elect to use integrated circuits that incorporate our technology into their products will not compete successfully against other equipment companies |
| Many factors beyond our control could influence the success or failure of a particular equipment company that uses integrated circuits based on our technology, including: o competition from other businesses in the same industry; o market acceptance of its products; o its engineering, sales and marketing, and management capabilities; o technical challenges of developing its products unrelated to our technology; and o its financial and other resources |
| Even if equipment companies incorporate chipsets based on our intellectual property into their products, their products may not achieve commercial acceptance or result in significant royalties to us |
| OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL DSL SERVICE IN VOLUME The success of our DSL licensing business depends upon telephone companies installing DSL service in significant volumes |
| Factors that affect the volume deployment of DSL service include: 13 o the desire of telephone companies to install ADSL or VDSL service, which is dependent on the development of a viable business model for ADSL or VDSL service, including the capability to market, sell, install and maintain the service; o the pricing of ADSL or VDSL services by telephone companies; o the success of internet protocol TV ( "e IPTV "e ) as a viable consumer service offering; o the transition by telephone companies to new ADSL technologies, such as ADSL2, ADSL2plus and VDSL2; o the quality of telephone companies &apos networks; o deployment by phone companies of fiber-to-the home or broadband wireless services; o government regulations; and o the willingness of residential telephone customers to demand DSL service in the face of competitive service offerings, such as cable modems, fiber-based service or broadband wireless access |
| If telephone companies do not install DSL service in significant volumes, or if telephone companies install broadband service based on other technology such as cable or fiber-to-the-home, our business will be seriously harmed |
| OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION Because we are a technology provider, our ability to protect our intellectual property and to operate without infringing the intellectual property rights of others is critical to our success |
| We regard our technology as proprietary, and we have a number of patents and pending patent applications |
| We also rely on a combination of trade secrets, copyright and trademark law and non-disclosure agreements to protect our unpatented intellectual property |
| Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization |
| As part of our licensing arrangements, we typically work closely with our semiconductor and equipment manufacturer licensees, many of whom are also our potential competitors, and provide them with proprietary know-how necessary for their development of customized chipsets based on our ADSL technology |
| Although our license agreements contain non-disclosure provisions and other terms protecting our proprietary know-how and technology rights, it is possible that, despite these precautions, some of our licensees might obtain from us proprietary information that they could use to compete with us in the marketplace |
| Although we intend to defend our intellectual property as necessary, the steps we have taken may be inadequate to prevent misappropriation |
| In the future, we may choose to bring legal action to enforce our intellectual property rights |
| Any such litigation could be costly and time-consuming for us, even if we were to prevail |
| Moreover, even if we are successful in protecting our proprietary information, our competitors may independently develop technologies substantially equivalent or superior to our technology |
| The misappropriation of our technology or the development of competitive technology could seriously harm our business |
| Our technology, software or products may infringe the intellectual property rights of others |
| A large and increasing number of participants in the telecommunications and compression industries have applied for or obtained patents |
| Some of these patent holders have demonstrated a readiness to commence litigation based on allegations of patent and other intellectual property infringement |
| Third parties may assert patent, copyright and other intellectual property rights to technologies that are important to our business |
| In the past, we have received claims from other companies that our technology infringes their patent rights |
| Intellectual property rights can be uncertain and can involve complex legal and factual questions |
| We may infringe the proprietary rights of others, which could result in significant liability for us |
| If we were found to have infringed any third partyapstas patents, we could be subject to substantial damages and an injunction preventing us from conducting our business |
| OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE The semiconductor and telecommunications industries, as well as the market for high-speed network access technologies, are characterized by rapid technological change, with new generations of products being introduced regularly and with ongoing evolutionary improvements |
| We expect to depend on our DSL technology for a substantial portion of our revenue for the foreseeable future |
| Therefore, we face risks that others could introduce competing technology that renders our DSL technology less desirable or obsolete |
| Also, the announcement of new 14 technologies could cause our licensees or their customers to delay or defer entering into arrangements for the use of our existing technology |
| We expect that our business will depend to a significant extent on our ability to introduce enhancements and new generations of our DSL technology as well as new technologies that keep pace with changes in the telecommunications and broadband industries and that achieve rapid market acceptance |
| We must continually devote significant engineering resources to achieving technical innovations |
| These innovations are complex and require long development cycles |
| Moreover, we may have to make substantial investments in technological innovations before we can determine their commercial viability |
| We may lack sufficient financial resources to fund future development |
| Also, our licensees may decide not to share certain research and development costs with us |
| Revenue from technological innovations, even if successfully developed, may not be sufficient to recoup the costs of development |
| One element of our business strategy is to assume the risks of technology development failure while reducing such risks for our licensees |
| In the past, we have spent significant amounts on development projects that did not produce any marketable technologies or products, and we cannot assure you that it will not occur again |
| WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS Our success as an intellectual property supplier depends on the willingness and ability of semiconductor manufacturers to design, build and sell integrated circuits based on our intellectual property |
| The semiconductor industry is intensely competitive and has been characterized by price erosion, rapid technological change, short product life cycles, cyclical market patterns and increasing foreign and domestic competition |
| As an intellectual property supplier to the semiconductor industry, we face intense competition from internal development teams within potential semiconductor customers |
| We must convince potential licensees to license from us rather than develop technology internally |
| Furthermore, semiconductor customers, who have licensed our intellectual property, may choose to abandon joint development projects with us and develop chipsets themselves without using our technology |
| In addition to competition from internal development teams, we compete against other independent suppliers of intellectual property |
| We anticipate intense competition from suppliers of intellectual property for ADSL The market for DSL chipsets is also intensely competitive |
| Our success within the DSL industry requires that DSL equipment manufacturers buy chipsets from our semiconductor licensees, and that telephone companies buy DSL equipment from those equipment manufacturers |
| Our customers &apos chipsets compete with products from other vendors of standards-based and DSL chipsets, including Broadcom, Centillium, Conexant, ST Microelectronics and Texas Instruments |
| ADSL and VDSL services offered over copper telephone networks also compete with alternative broadband transmission technologies that use the telephone network as well as other network architectures |
| Alternative technologies for the telephone network include several types of symmetric high speed DSL, including HDSL, SDSL and GSHDSL Alternative technologies that use other network architectures to provide high-speed data service include cable modems using cable networks, wireless solutions using wireless networks, and optical solutions using fiber optics technology |
| These alternative broadband transmission technologies may be more successful than ADSL or VDSL and we may not be able to participate in the markets involving these alternative technologies |
| Many of our current and prospective DSL licensees, as well as chipset competitors that compete with our semiconductor licensees, including Broadcom, Conexant, ST Microelectronics and Texas Instruments, have significantly greater financial, technological, manufacturing, marketing and personnel resources than we do |
| We may be unable to compete successfully, and competitive pressures could seriously harm our business |
| WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS We prepare our financial statements in accordance with generally accepted accounting principles and certain critical accounting polices that are relevant to our business |
| The application of these principles and policies requires us to make significant judgments and estimates |
| In the event that judgments and estimates we make are incorrect, we may have to change them, which could materially affect our financial position and results of operations |
| 15 Moreover, accounting standards have been subject to rapid change and evolving interpretations by accounting standards setting organizations over the past few years |
| The implementation of new standards requires us to interpret and apply them appropriately |
| If our current interpretations or applications are later found to be incorrect, our financial position and results of operations could be materially affected |
| OUR STOCK PRICE MAY BE EXTREMELY VOLATILE Volatility in our stock price may negatively affect the price you may receive for your shares of common stock and increases the risk that we could be the subject of costly securities litigation |
| The market price of our common stock has fluctuated substantially and could continue to fluctuate based on a variety of factors, including: o quarterly fluctuations in our operating results; o changes in future financial guidance that we may provide to investors and public market analysts; o changes in our relationships with our licensees; o announcements of technological innovations or new products by us, our licensees or our competitors; o changes in ADSL market growth rates as well as investor perceptions regarding the investment opportunity that companies participating in the ADSL industry afford them; o changes in earnings estimates by public market analysts; o key personnel losses; o sales of our common stock; and o developments or announcements with respect to industry standards, patents or proprietary rights |
| In addition, the equity markets have experienced volatility that has particularly affected the market prices of equity securities of many high technology companies and that often has been unrelated or disproportionate to the operating performance of such companies |
| These broad market fluctuations may adversely affect the market price of our common stock |
| OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS The extensive regulation of the telecommunications industry by federal, state and foreign regulatory agencies, including the Federal Communications Commission, and various state public utility and service commissions, could affect us through the effects of such regulation on our licensees and their customers |
| In addition, our business may also be affected by the imposition of certain tariffs, duties and other import restrictions on components that our customers obtain from non-domestic suppliers or by the imposition of export restrictions on products sold internationally and incorporating our technology |
| Changes in current or future laws or regulations, in the United States or elsewhere, could seriously harm our business |