| DIGITAL RECORDERS INC Item 1A Risk Factors Many of the risks discussed below have affected our business in the past, and many are likely to continue to do so |
| These risks may materially adversely affect our business, financial condition, operating results or cash flows, or the market price of our Common Stock |
| Risks Related to Indebtedness, Financial Condition and Results of Operations Our substantial debt could adversely affect our financial position, operations and ability to grow |
| As of December 31, 2005, our total debt of approximately dlra6dtta2 million consisted of long-term debt in the amount of dlra1dtta2 million, most of which is classified as current, and short-term debt of dlra5 million |
| Included in the long-term debt is dlra418 thousand outstanding under a term loan to a Swedish bank, dlra250 thousand outstanding under an 8dtta0 percent convertible debenture held by a shareholder and director, and dlra503 thousand outstanding under a note payable to an investor |
| The short-term debt consisted of the outstanding balances under our domestic and European revolving credit facilities |
| Our substantial indebtedness could have adverse consequences in the future |
| For example, it could: • require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, which would reduce amounts available for working capital, capital expenditures, research and development and other general corporate purposes; • limit our flexibility in planning for, or reacting to, changes in our business and the industries in which we operate; • increase our vulnerability to general adverse economic and industry conditions; • place us at a disadvantage compared to our competitors that may have less debt than we do; • make it more difficult for us to obtain additional financing that may be necessary in connection with our business; • make it more difficult for us to implement our business and growth strategies; and • cause us to have to pay higher interest rates on future borrowings |
| If interest rates increase, or if we incur additional debt, the potential adverse consequences, including those described above, may be intensified |
| If our cash flow and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay planned expansion and capital expenditures, sell assets, obtain additional equity financing or restructure our debt |
| Some of our existing credit facilities contain covenants that, among other things, limit our ability to incur additional debt |
| Future cash requirements or restrictions on cash could adversely affect our financial position, and an event of default under our outstanding debt instruments could impair our ability to conduct business operations |
| Our cash balance declined in the current year and we could incur negative overall cash flow in future periods |
| If cash flow significantly deteriorates in the future, our liquidity and ability to operate our business could be adversely impacted |
| Additionally, our ability to raise financial capital may be hindered due to our net losses and the possibility of future negative cash flow, thus reducing our operating flexibility |
| The following items, among others, could require unexpected future cash payments, limit our ability to generate cash or restrict our use of cash: • triggering of certain payment obligations, or acceleration of payment obligations, under our revolving credit facilities or our outstanding convertible debentures; • triggering of redemption obligations under our outstanding convertible debentures; • costs associated with unanticipated litigation relating to our intellectual property or other matters; 15 _________________________________________________________________ [69]Table of Contents • taxes due upon the transfer of cash held in foreign locations; and • taxes assessed by local authorities where we conduct business |
| On March 16, 2006, the Company entered into a two-year asset-based lending agreement with Laurus Master Fund (“Laurus Credit Agreement”) to replace the current agreement with LaSalle Business Credit (“LaSalle Credit Agreement”) |
| The Laurus Credit Agreement provides up to dlra6dtta0 million in borrowings under a revolving credit facility to be used to retire all outstanding debt under the LaSalle Credit Agreement and for general corporate purposes and is secured by all tangible and intangible assets of the Company in the US and Canada |
| Borrowing availability under the Laurus Credit Agreement is based upon an advance rate equal to 90prca of eligible accounts receivable and up to dlra2dtta0 million based upon 40prca of eligible inventory |
| The interest rate on borrowings under the Laurus Credit Agreement is the Wall Street Journal prime rate plus 1dtta75prca, subject to a floor of 8prca |
| The Laurus Credit Agreement contains no financial covenants |
| We also have a revolving credit facility with a Swedish bank that we use in connection with our European operations and which is secured by substantially all the assets of our Mobitec AB subsidiary |
| Our maximum borrowing capacity under that facility is 18 million Swedish Krona, equivalent to approximately dlra2dtta3 million US dollars |
| That facility also contains affirmative, negative, and financial covenants |
| We additionally have a revolving credit facility with a German bank that we use in connection with our German operations which is secured by accounts receivable and inventory of our German subsidiary, Mobitec GmbH (formerly known as Transit Media-Mobitec GmbH) |
| Our maximum borrowing capacity under that facility is 512 thousand Euros, equivalent to approximately dlra606 thousand US dollars |
| As of December 31, 2005, our outstanding balances were dlra3dtta3 million under the domestic facilities and dlra1dtta7 million under the European facilities |
| A convertible subordinated debenture in the amount of dlra250 thousand dated August 26, 2002, is payable to Mr |
| John Higgins, a shareholder and member of the Board of Directors, and is due in full August 26, 2009, if not sooner redeemed or converted, with annual interest at 8dtta0 percent paid monthly |
| The loan agreement under which the convertible debenture was issued subjected the Company to certain financial covenants |
| All covenants were waived by the debt holder for calendar year 2004 |
| On March 31, 2005, the financial covenants were amended to require the same tangible net worth and escalating fixed charges coverage ratios as those set forth in the LaSalle Credit Agreement |
| We were not in compliance with the fixed charge covenant ratio under the convertible debenture as of December 31, 2005, but secured a waiver for that period from the lender |
| While we plan to adhere to the covenants in our credit facilities to the best of our ability, in the event it appears we are unable to avoid an event of default, it may be necessary or advisable to retire and terminate one or more of the facilities and pay all remaining balances borrowed |
| Any such payment would further limit our available cash and cash equivalents |
| Furthermore, we may not be able to retire the credit facilities if we do not have adequate resources available when necessary to avoid an event of default or if we do not have adequate time to retire the credit facilities |
| The consequences of an event of default under one or more of our credit facilities or other debt instruments may prevent us from conducting normal business operations |
| The above cash requirements or restrictions could lead to an inadequate level of cash for operations or for capital requirements, which could have a material negative impact on our financial position and significantly harm our ability to operate the business |
| We have a history of net losses and cannot assure you that we will become profitable |
| We have incurred losses in almost every fiscal year since we have been a public company |
| Our net loss applicable to common shareholders was dlra6dtta5 million in 2005, dlra3dtta5 million in 2004, dlra2dtta2 million in 2003, and dlra367 thousand in 2002 |
| We cannot assure you that we will become profitable or, if we do, that we will be able to sustain or increase profitability in the future |
| We had an accumulated deficit of dlra18dtta5 million as of December 31, 2005 |
| If we cannot achieve or sustain profitability, our financial condition will be materially adversely affected and it will be much more difficult, if possible at all, to obtain additional financing and to continue to grow our business |
| Our efforts to reduce costs may not be effective |
| If we fail to reduce costs effectively, we may not achieve profitability or positive cash flow |
| We believe cost containment and expense reductions are essential to 16 _________________________________________________________________ [70]Table of Contents achieving profitability and positive cash flow from operations in future periods |
| We cannot assure you that we will be able to achieve sufficient cost reductions to allow us to become or remain profitable |
| If we are not able to grow our sales while reducing our costs, as a percentage of sales, we will not be able to achieve profitability and our business and financial condition could be materially and adversely affected |
| Moreover, sales lost due to the cancellation of, or our inability to fill, an order in one period may not be necessarily made up by sales in any future period |
| Our operating results will continue to fluctuate |
| Our operating results may fluctuate from period to period and period over period depending upon numerous factors, including: (1) customer demand and market acceptance of our products and solutions; (2) new product introductions; (3) variations in product mix; (4) delivery due date changes; and (5) other factors |
| We operate in a market characterized by long sales cycles |
| The time from first contact to order delivery may be a period of two years or longer in certain instances |
| Delivery schedules, as first established with the customer in this long cycle may change with little or no advance notice as the original delivery schedule draws near |
| Our business is sensitive to the spending patterns and funding of our customers, which, in turn, are subject to prevailing economic conditions and other factors beyond our control |
| Moreover, we derive sales primarily from significant orders from a limited number of customers |
| For that reason, a delay in delivery of our products in connection with a single order may significantly affect the timing of our recognition of sales between periods |
| Moreover, sales lost due to the cancellation of, or our inability to fill, an order in one period may not be necessarily made up by sales in any future period |
| Risks Related to Internal Controls Required reporting on internal control over financial reporting |
| In accordance with Section 404 of the Sarbanes-Oxley Act, we will be required to deliver our initial report on the effectiveness of our internal controls over financial reporting in connection with our annual report for the fiscal year ending December 31, 2007 |
| We are in the process of implementing our plan for complying with Section 404 of the Sarbanes-Oxley Act of 2002 |
| However, these efforts could fail to be successful, which, in turn could cause investors to lose confidence in our internal control environment |
| Risks Related to Our Operations and Product Development A significant portion of our sales is derived from sales to a small number of customers |
| If we are not able to obtain new customers or repeat business from existing customers, our business could be seriously harmed |
| We sell our products to a limited and largely fixed set of customers and potential customers |
| In our transportation communications segment, we sell primarily to original equipment manufacturers and to end users such as municipalities, regional transportation districts, transit agencies, federal, state and local departments of transportation, and rental car agencies |
| The identity of the customers who generate the most significant portions of our sales may vary from year to year |
| In 2005, three major customers accounted for 22dtta8 percent of our net sales, compared to two major customers accounting for 22dtta9 percent in 2004 and one major customer accounting for 16dtta2 percent in 2003 |
| If any of our major customers stopped purchasing products from us, and we were not able to obtain new customers to replace the lost business, our business and financial condition would be materially adversely affected |
| Many factors affect whether customers reduce or delay their investments in products such as those we offer, including decisions regarding technology spending levels and general economic conditions in the countries and specific markets where the customers are located |
| We depend on third parties to supply components we need to produce our products |
| Our products and solutions are dependent upon the availability of quality components that are procured from third-party suppliers |
| Reliance upon suppliers, as well as industry supply conditions, generally involves several risks, including the possibility of defective parts (which can adversely affect the reliability and reputation of our products), a shortage of components and reduced control over delivery schedules (which can adversely affect our manufacturing efficiencies) and increases in component costs (which can adversely affect our profitability) |
| 17 _________________________________________________________________ [71]Table of Contents We have some single-sourced supplier relationships, because either alternative sources are not readily or economically available or the relationship is advantageous due to performance, quality, support, delivery, and capacity or price considerations |
| If these sources are unable to provide timely and reliable supply, we could experience manufacturing interruptions, delays, or inefficiencies, adversely affecting our results of operations |
| Even where alternative sources of supply are available, qualification of the alternative suppliers and establishment of reliable supplies could result in delays and a possible loss of sales, which could adversely affect operating results |
| Many of our customers rely on government funding, and that subjects us to risks associated with governmental budgeting and authorization processes |
| A majority of our sales address end customers having some degree of national, federal, regional, state, or local governmental-entity funding |
| These governmental-entity funding mechanisms are beyond our control and often are difficult to predict |
| Further, general budgetary authorizations and allocations for state, local, and federal agencies can change for a variety of reasons, including general economic conditions, and have a material adverse effect on us |
| For example, the TEA-21 legislation under which the funding for our transportation products business segment domestic sales are derived was subject to reauthorization in 2003, but was not replaced with new legislation, The Safe, Accountable, Flexible, Efficient Transportation Equity Act — A Legacy for Users (“SAFETEA-LU”), until August, 2005 |
| In the interim period, federal funding was available through short-term extensions of TEA-21; however, we believe the underlying longer term funding uncertainties had been a source of significant market disruption |
| In addition to federal funding to the public transit side of our domestic market, a majority of our customers rely on state and local funding |
| These tend to be affected by general economic conditions |
| For example, some transit operating authorities reduced service in 2004 and 2005, in response to the slow economy and uncertainties on the reauthorization of SAFETEA-LU; this can have a depressing effect on sales of our products |
| It is not possible to precisely quantify this impact |
| Any unfavorable change in any of these factors and considerations could have a material adverse effect upon us |
| We must continually improve our technology to remain competitive |
| Our industry is characterized by, and our business strategy is substantially based upon, continuing improvement in technology |
| This results in frequent introduction of new products, short product life cycles, and continual change in product price/performance characteristics |
| We must develop new technologies in our products and solutions in order to remain competitive |
| We cannot assure you that we will be able to continue to achieve or sustain the technological leadership that is necessary for success in our industry |
| In addition, our competitors may develop new technologies that give them a competitive advantage, and we may not be able to obtain the right to use those technologies at a reasonable cost, if at all, or to develop alternative solutions that enable us to compete effectively |
| A failure on our part to manage effectively the transitions of our product lines to new technologies on a timely basis could have a material adverse effect upon us |
| In addition, our business depends upon technology trends in our customers’ businesses |
| To the extent that we do not anticipate or address these technological changes, our business may be adversely impacted |
| We cannot assure you that any new products we develop will be accepted by customers |
| Even if we are able to continue to enhance our technology and offer improved products and solutions, we cannot assure you we will be able to deliver commercial quantities of new products in a timely manner or that our products will achieve market acceptance |
| Further, it is necessary for our products to adhere to generally accepted and frequently changing industry standards, which are subject to change in ways that are beyond our control |
| Risks Related to Our International Operations There are numerous risks associated with international operations, which represent a significant part of our business |
| Our international operations generated about 40 percent of our sales in 2004 and approximately 47 percent of our sales in 2005 |
| Our sales outside the United States were primarily in Europe (particularly the Nordic countries), South America, the Middle East, and Australia |
| The success and profitability of international operations are subject to numerous risks and uncertainties, such as economic and labor conditions, political instability, tax laws (including US taxes upon foreign subsidiaries), and changes in the 18 _________________________________________________________________ [72]Table of Contents value of the US dollar versus the local currency in which products are sold |
| Any unfavorable change in one or more of these factors could have a material adverse effect upon us |
| We maintain cash deposits in foreign locations, portions of which may be subject to significant tax or tax withholding upon transfer or withdrawal |
| Many countries impose taxes or fees upon removal from the country of cash earned in that country |
| Moreover, complying with foreign tax laws can be complicated, and we may incur unexpected tax obligations in some jurisdictions |
| While we believe our tax positions in the foreign jurisdictions in which we operate are proper and fully defensible, tax authorities in those jurisdictions may nevertheless assess taxes and render judgments against us if we are unable to adequately defend our position |
| In such an event, we could be required to make unexpected cash payments in satisfaction of such assessments or judgments or incur additional expenses to defend our position |
| Risks Related to Intellectual Property We may not be able to defend successfully against claims of infringement against the intellectual property rights of others, and such defense could be costly |
| Third parties, including our competitors, individual inventors or others, may have patents or other proprietary rights that may cover technologies that are relevant to our business |
| Several claims of infringement have been asserted against us in the past |
| Even if we believe a claim asserted against us is not valid, defending against the claim may be costly |
| Intellectual property litigation can be complex, protracted, and highly disruptive to business operations by diverting the attention and energies of management and key technical personnel |
| Further, plaintiffs in intellectual property cases often seek injunctive relief and the measures of damages in intellectual property litigation are complex and often subjective or uncertain |
| In some cases, we may decide that it is not economically feasible to pursue a vigorous and protracted defense and decide, instead, to negotiate licenses or cross-licenses authorizing us to use a third party’s technology in our products |
| If we are unable to defend successfully against litigation of this type, or to obtain and maintain licenses on favorable terms, we could be prevented from manufacturing or selling our products, which would cause severe disruptions to our operations |
| For these reasons, intellectual property litigation could have a material adverse effect on our business or financial condition |
| Risks Related to Our Equity Securities and Convertible Debentures The public market for our Common Stock may be volatile, especially since market prices for technology stocks often have been unrelated to operating performance |
| We cannot assure you that an active trading market will be sustained or that the market price of our Common Stock will not decline |
| Recently, the stock market in general, and the shares of technology companies in particular, have experienced significant price fluctuations |
| The market price of our Common Stock is likely to continue to be highly volatile and could be subject to wide fluctuations in response to factors such as: • Actual or anticipated variations in our quarterly operating results; • Historical and anticipated operating results; • Announcements of new product or service offerings; • Technological innovations; • Competitive developments in the public transit industry; • Changes in financial estimates by securities analysts; • Conditions and trends in the public transit industry; • Funding initiatives and other legislative developments affecting the transit industry; • Adoption of new accounting standards affecting the technology industry or the public transit industry; and • General market and economic conditions and other factors |
| 19 _________________________________________________________________ [73]Table of Contents Further, the stock markets, and particularly the NASDAQ Capital Market, have experienced extreme price and volume fluctuations that have particularly affected the market prices of equity securities of many technology companies and have often been unrelated or disproportionate to the operating performance of such companies |
| These broad market factors have and may continue to adversely affect the market price of our Common Stock |
| In addition, general economic, political and market conditions, such as recessions, interest rate variations, international currency fluctuations, terrorist acts, military actions or war, may adversely affect the market price of our Common Stock |
| Our preferred stock and convertible debentures have preferential rights over our Common Stock |
| We currently have outstanding shares of Series AAA Redeemable Nonvoting Preferred Stock, Series E Redeemable Nonvoting Convertible Preferred Stock, Series G Redeemable Preferred Stock, and Series H Redeemable Convertible Preferred Stock, as well as certain eight percent (8dtta0 percent) convertible debentures, all of which have rights in preference to holders of our Common Stock in connection with any liquidation of the Company |
| The aggregate liquidation preference is dlra890 thousand for the Series AAA stock, dlra1dtta0 million for the Series E stock, dlra1dtta7 million for the Series G stock, and dlra250 thousand for the Series H stock, in each case plus accrued but unpaid dividends, and the aggregate principal amount of the outstanding eight percent (8dtta0prca) convertible debentures is dlra250 thousand |
| Holders of the Series AAA, Series E, Series G, and Series H stock are entitled to receive cumulative quarterly dividends at the rate of five percent (5dtta0prca) per annum, seven percent (7dtta0prca) per annum, eight percent (8dtta0prca) per annum, and eight percent (8dtta0prca) per annum, respectively, on the liquidation value of those shares |
| Dividends on the Series H stock are payable in kind in additional shares of Series H stock |
| The purchase agreements, pursuant to which we issued our outstanding eight percent (8dtta0prca) convertible debentures, as well as our domestic senior credit facility, prohibit the payment of dividends to holders of our Common Stock |
| The holders of the debentures have the right to require us to redeem the debentures upon the occurrence of certain events, including certain changes in control of the Company or our failure to continue to have our stock listed on the NASDAQ Stock Market or another stock exchange |
| In such an event, the holders would have the right to require us to redeem the debentures for an amount equal to the principal amount plus an 18 percent annual yield on the principal amount through the date of redemption, and we might not have the ability to make the required redemption payments |
| The preferential rights of the holders of our convertible debentures and preferred stock could substantially limit the amount, if any, that the holders of our Common Stock would receive upon any liquidation of the Company |
| Risks Related to Anti-Takeover Provisions Our articles of incorporation, bylaws and North Carolina law contain provisions that may make takeovers more difficult or limit the price third parties are willing to pay for our stock |
| Our articles of incorporation authorize the issuance of shares of “blank check” preferred stock, which would have the designations, rights and preferences as may be determined from time to time by the board of directors |
| Accordingly, the board of directors is empowered, without shareholder approval (but subject to applicable regulatory restrictions), to issue additional preferred stock with dividend, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of the common stock |
| Our board of directors could also use the issuance of preferred stock, under certain circumstances, as a method of discouraging, delaying or preventing a change in control of our company |
| In addition, our bylaws require that certain shareholder proposals, including proposals for the nomination of directors, be submitted within specified periods of time in advance of our annual shareholders’ meetings |
| These provisions could make it more difficult for shareholders to effect corporate actions such as a merger, asset sale or other change of control of our company |
| These provisions could limit the price that certain investors might be willing to pay in the future for shares of our Common Stock, and they may have the effect of delaying or preventing a change in control |
| We are also subject to two North Carolina statutes that may have anti-takeover effects |
| The North Carolina Shareholder Protection Act generally requires, unless certain “fair price” and procedural requirements are satisfied, the affirmative vote of 95 percent of our voting shares to approve certain business combination transactions with an entity that is the beneficial owner, directly or indirectly, of more than 20 _________________________________________________________________ [74]Table of Contents 20 percent of our voting shares, or with one of our affiliates if that affiliate has previously been a beneficial owner of more than 20 percent of our voting shares |
| The North Carolina Control Share Acquisition Act, which applies to public companies that have substantial operations and significant shareholders in the state of North Carolina, eliminates the voting rights of shares acquired in transactions (referred to as “control share acquisitions”) that cause the acquiring person to own a number of our voting securities that exceeds certain threshold amounts, specifically, one-fifth, one-third and one-half of our total outstanding voting securities |
| There are certain exceptions |
| For example, this statute does not apply to shares that an acquiring person acquires directly from us |
| The holders of a majority of our outstanding voting stock (other than such acquiring person, our officers and our employee directors) may elect to restore voting rights that would be eliminated by this statute |
| If voting rights are restored to a shareholder that has made a control share acquisition and holds a majority of all voting power in the election of our directors, then our other shareholders may require us to redeem their shares at fair value |
| These statutes could discourage a third party from making a partial tender offer or otherwise attempting to obtain a substantial position in our equity securities or seeking to obtain control of us |
| They also might limit the price that certain investors might be willing to pay in the future for shares of our Common Stock, and they may have the effect of delaying or preventing a change of control |
| Risks Associated with Potential Growth We may not be able to obtain the financing we will need to continue to grow |
| Our business and operating strategy embraces growth |
| The strategy includes internal growth through the expansion of our present operations to current and new customers, as well as acquisition-oriented growth scenarios |
| This strategy requires that we maintain a high degree of emphasis on finding and securing both debt and equity financing sources |
| Success in these financing requirements can be adversely impacted by economic conditions and other factors beyond our control |
| We cannot assure you that our revolving credit facilities and cash flow from operations will be sufficient to fund our current business operations for the next 12 months, nor can we assure you that we will not require additional sources of financing to fund our operations |
| Any significant acquisition or other growth initiative would also require additional financing |
| Additional financing may not be available to us on terms we consider acceptable, if it is available at all |
| If we cannot raise funds on acceptable terms, we may not be able to develop next-generation products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which could have a material adverse effect on our ability to grow our business |
| Further, if we issue equity securities, holders of our Common Stock may experience dilution of their ownership percentage, and the new equity securities could have rights, preferences or privileges senior to those of our Common Stock |
| There are many risks associated with potential acquisitions |
| We intend to continue to evaluate potential acquisitions that we believe will enhance our existing business or enable us to grow |
| If we acquire other companies or product lines in the future, it may dilute the value of existing shareholders’ ownership |
| The impact of dilution may restrict our ability to consummate further acquisitions |
| Issuance of equity securities in connection with an acquisition may further restrict utilization of net operating loss carryforwards because of an annual limitation due to ownership changes under the Internal Revenue Code |
| We may also incur debt and losses related to the impairment of goodwill and other intangible assets if we acquire another company, and this could negatively impact our results of operations |
| We currently do not have any definitive agreements to acquire any company or business, and we may not be able to identify or complete any acquisition in the future |
| Additional risks associated with acquisitions include the following: • It may be difficult to assimilate the operations and personnel of an acquired business into our own business; • Management information and accounting systems of an acquired business must be integrated into our current systems; • Our management must devote its attention to assimilating the acquired business, which diverts attention from other business concerns; • We may enter markets in which we have limited prior experience; and • We may lose key employees of an acquired business |