| ESSEX CORP Item 1A RISK FACTORS Our business, results of operations and financial condition may be materially and adversely affected due to any of the following risks |
| The risks described below are not the only ones we face |
| Additional risks that we are not presently aware of or that we currently believe are immaterial may also impair our business operations |
| 14 ______________________________________________________________________ [39]Table of Contents Risks Related to Our Business We currently rely on sales to US Government entities, particularly in the intelligence and defense areas, and the loss of certain of our awards with the US Government could have an adverse impact on our operating results |
| For fiscal years ended December 31, 2005 and December 31, 2004, revenues derived from the US Government programs were dlra153dtta8 million, or 96prca, and dlra68dtta3 million, or 97prca, of our total revenues, respectively |
| Awards from the US intelligence and defense communities and other departments and agencies of the Department of Defense accounted for dlra152dtta0 million, or 95prca of our revenues, and dlra66dtta4 million, or 94prca of our revenues for fiscal years 2005 and 2004, respectively |
| For fiscal years 2005 and 2004, our top three customer programs accounted for approximately dlra83dtta1 million, or 52prca of our revenues, and dlra52dtta6 million, or 75prca of our revenues, respectively |
| For fiscal year 2005, revenues from the top three customer programs consisting of our Thunder, Woodstock and Jackhammer contracts, were all performed for the same US Government customer |
| For fiscal years 2004 and 2003, our largest award, Thunder, accounted for approximately dlra45dtta2 million, or 64prca of our revenues, and dlra1dtta5 million, or 9prca of our revenues, respectively |
| For the year ended December 31, 2005 due to significant increase in revenues from our other contracts, this contract accounted for approximately dlra53dtta3 million, or 33prca of our revenues |
| In addition, revenues generated under our Woodstock contract since February 28, 2005, the date of the Windermere acquisition, represents 15prca of our total revenues for 2005 |
| For fiscal year ended December 31, 2005, revenues from our largest customer were dlra109dtta9 million, or 69prca of the Company’s revenues |
| The loss or significant reduction in government funding of a program for which we are the prime contractor or in which we participate could reduce our revenue and cash flows and have an adverse effect on our operating results |
| We depend on US Government awards which are only partially funded and which depend upon annual budget appropriations; the US Government has no obligation to fully fund our awards |
| Budget decisions made by the US Government are outside of our control and have significant consequences for our business |
| Funding for US Government awards is subject to Congressional appropriations |
| Although multi-year awards may be planned or authorized in connection with major procurements, Congress generally appropriates funds on a fiscal year basis even though a program may be expected to continue for several years |
| Consequently, awards often initially receive only partial funding, and additional funds are committed only as Congress makes further appropriations |
| The termination of funding for any of our US Government awards would result in a loss of anticipated future revenues attributable to that program and a reduction in our cash flows and would have an adverse impact on our operating results |
| Our backlog was dlra499dtta2 million as of December 31, 2005, of which dlra90dtta5 million was funded |
| Our backlog includes orders under awards that in some cases extend for several years, with the latest expiring in 2011 |
| The US Government’s ability to select multiple winners under multiple award schedule contracts, government-wide acquisition contracts and blanket purchase agreements, as well as its right to award subsequent task orders among such multiple winners, means that there is no assurance that unfunded contract backlog will result in revenue |
| The actual receipt of revenues on awards included in backlog may never occur or may change because a program schedule could change or the program could be canceled, or a contract could be reduced, modified, or terminated early |
| Moreover, under indefinite delivery, indefinite quantity contracts, the US Government is not obligated to order more than a minimum quantity of goods or services |
| US Government awards are subject to immediate termination and are heavily regulated |
| Our US Government awards can be terminated by the US Government either at its convenience or if we default |
| If the US Government terminates any of our awards, we are entitled to payment of compensation only for work done and commitments made at the time of termination |
| If any of our US Government awards are terminated for default, we would be obligated to pay the excess costs incurred by the US Government in procuring undelivered items from another source |
| If any or all of our US Government awards are terminated under either of these circumstances, we may be unable to procure new awards to offset the lost revenues |
| 15 ______________________________________________________________________ [40]Table of Contents In addition, supplying intelligence and defense-related services and equipment to US Government agencies subjects us to the risks that the US Government may unilaterally: • suspend us from receiving new awards pending resolution in the event we are notified of alleged violations of procurement laws or regulations; • terminate our existing awards; • reduce the value of our existing awards; • audit our award-related costs and fees, including allocated indirect costs; and • control and prohibit the export of our products |
| We must comply with and are affected by laws and regulations relating to the award, administration and performance of US Government contracts |
| Government contract laws and regulations affect how we do business with our customers and, in some instances, impose added costs on our business |
| A violation of these laws and regulations could result in the imposition of fines and penalties or the termination of our contracts or debarment from bidding on contracts |
| In some instances, these laws and regulations impose terms or rights that are more favorable to the government than those typically available to commercial parties in negotiated transactions |
| Because a significant portion of our revenues are dependent on our procurement, performance and payment under our US Government awards, the loss of one or more large awards or any suspension or debarment from doing business with US Government agencies would result in a loss of anticipated future revenues from US Government awards and a reduction in cash flows and would have a material adverse effect on our operating results |
| A general decline in US intelligence and defense spending could harm our operations and adversely affect our future revenues |
| Revenues under contracts with the US Department of Defense and other intelligence and defense-related entities represented approximately 95prca of our total revenues for fiscal year 2005 and 94prca for fiscal year 2004 |
| While spending authorization for intelligence and defense-related programs have increased significantly in recent years due to greater homeland security and foreign military commitments and to a general outsourcing trend, these spending levels may not be sustainable, and future levels of expenditures and authorizations for those programs may decrease, remain constant or shift to programs in areas where we do not currently provide services |
| A general decline in United States intelligence and defense spending could reduce our revenues and cash flows and have an adverse effect on our operating results |
| If we are unable to effectively and efficiently implement measures to address weaknesses in Windermere’s internal control over financial reporting, our ability to provide the public with timely and accurate material information may be adversely affected, which could hurt our reputation and our stock price |
| In light of the recent consummation of the Windermere acquisition and management’s ongoing evaluation and corrective action with respect to the internal control over financial reporting of the Windermere subsidiary, and in reliance upon SEC staff interpretive guidance, management excluded the disclosure controls and procedures of the Windermere subsidiary from its evaluation of our own disclosure controls for the fiscal year ended December 31, 2005 |
| As disclosed in our quarterly reports on Form 10-Q for the three month periods ended March 31, 2005, June 30, 2005 and September 30, 2005, we identified certain material weaknesses in the internal control over financial reporting of our recently acquired Windermere subsidiary |
| Those weaknesses, which we believe are not unusual for a privately held company of the size of Windermere, included a lack of segregation of duties of financial personnel and inadequate financial management systems |
| In light of those weaknesses, in an effort to remediate and integrate Windermere’s internal controls, we made certain organizational and personnel changes in the period ended December 31, 2005 |
| These included altering the organizational structure of 16 ______________________________________________________________________ [41]Table of Contents Windermere, evaluating and planning training programs for financial management personnel, hiring new financial personnel, and changing reporting structures in a manner designed to provide more direct reporting from Windermere financial personnel to Essex financial personnel |
| We believe these have resulted in an overall improvement in the internal controls over financial reporting for Windermere |
| We also believe additional remediation is necessary |
| For instance, budgetary analysis and processes at Windermere require further strengthening and refinement to be better integrated with, and to be brought up to, overall industry standards to which we adhere |
| In February 2006, we implemented a new general ledger and budgetary system company-wide |
| We expect additional improvements in Windermere’s internal controls over financial reporting will be made as the financial personnel training programs progress and financial policies and procedures are adopted company-wide |
| We expect that these measures will be implemented in the first and second quarters of fiscal 2006 |
| In addition, we undertook additional review procedures to assure that the financial statements for the three and twelve month periods ended December 31, 2005 are in accordance with US GAAP Because our evaluation and remediation of weaknesses in internal control over financial reporting for our recently acquired Windermere subsidiary is ongoing, and because we have excluded Windermere from management’s assessment of the effectiveness of our disclosure controls and procedures, the effects, if any, that material weaknesses identified in Windermere’s internal controls may have on our disclosure controls and procedures are not certain at this time |
| We may find that certain material weaknesses identified in Windermere’s internal controls could have an adverse impact on the reliability of our disclosure controls |
| If we are unable to conclude that our disclosure controls are effective in any subsequent periodic report, it may harm our reputation and our stock price could be adversely affected |
| In addition, if we are unable to effectively and efficiently implement measures to remedy any adverse effects of the Windermere internal control weaknesses on our disclosure controls and procedures, it may impede our ability to timely and accurately provide material information to the public, investors may lose confidence in our reporting, and our stock price could be adversely affected |
| If we are unable to adequately address and remedy any material weaknesses which may present themselves in our internal control over financial reporting, our ability to timely and accurately report our financial results may be impeded, investors may lose confidence in our financial reports, and the market price for our common stock may be adversely affected |
| In light of the recent consummation of the Windermere acquisition and management’s ongoing evaluation and corrective action with respect to the internal control over financial reporting of the Windermere subsidiary, and in reliance upon SEC staff interpretive guidance, management excluded the internal control over financial reporting of the Windermere subsidiary from its evaluation of our own disclosure controls for the fiscal year ended December 31, 2005 |
| If we are unable to remediate any material weaknesses effectively and efficiently, it could adversely affect our ability to provide investors with timely and accurate financial information and may have a negative impact on our reputation |
| Likewise, if we are unable to assert that our internal control over financial reporting is effective in any future period (or if our auditors express an adverse opinion, or are unable to express an opinion at all, on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our stock price |
| Because our evaluation and remediation of weaknesses in internal control over financial reporting for our recently acquired Windermere subsidiary is ongoing, and because we have excluded Windermere from management’s assessment of the effectiveness of our disclosure controls and procedures, the effects, if any, that material weaknesses identified in Windermere’s internal controls may have on our internal controls are not certain at this time |
| We may find that certain material weaknesses identified in Windermere’s internal controls could have an adverse impact on the reliability of our internal controls |
| If we are unable to conclude that our internal controls are effective in any subsequent periodic report, it may harm our reputation and our stock price could be adversely affected |
| In addition, if we are unable to effectively and efficiently implement measures to remedy any adverse effects of the Windermere internal control weaknesses on our internal controls, it may 17 ______________________________________________________________________ [42]Table of Contents impede our ability to timely and accurately provide material information to the public, investors may lose confidence in our reporting, and our stock price could be adversely affected |
| Unfavorable government audit results could force us to adjust previously reported operating results and could subject us to a variety of penalties and sanctions |
| The federal government audits and reviews our performance on awards, pricing practices, cost structure, and compliance with applicable laws, regulations, and standards |
| Like most large government vendors, our awards are audited and reviewed on a continual basis by federal agencies, including the Defense Contract Management Agency and the Defense Contract Audit Agency |
| An audit of our work, including an audit of work performed by companies we have acquired or may acquire or subcontractors we have hired or may hire, could result in a substantial adjustment in our operating results for the applicable period |
| For example, any costs which were originally reimbursed could subsequently be disallowed |
| In this case, cash we have already collected may need to be refunded and our operating margins may be reduced |
| If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with US Government agencies |
| In addition, we could suffer serious harm to our reputation if allegations of impropriety were made against us, even if the allegations were not true |
| Audits for incurred contract costs for Essex are complete through fiscal year 2002 and are currently in process for fiscal year 2003; audits of incurred contract costs are complete for Windermere through fiscal year 2002; audits for incurred costs are complete through fiscal year 2001 under contracts we obtained in the acquisition of Sensys Development Laboratories, Inc |
| (“SDL”), through fiscal year 2004 for our subsidiary Computer Science Innovations, Inc |
| (“CSI”), and through fiscal 1994 under contracts we obtained in the acquisition of assets of Performance Group, Inc |
| If we were suspended or debarred from contracting with the US Government generally, or any specific agency, if our reputation or relationship with US Government agencies were impaired, or if the government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our revenues and cash flows could be reduced and our operating results could be adversely affected |
| If we are unable to manage our growth, our business could be adversely affected |
| Achieving our plans for growth will place significant demands on our management, as well as on our administrative, operational and financial resources |
| For us to successfully manage our growth, we must continue to improve our operational, financial and management information systems and expand, motivate and manage our workforce |
| If we are unable to successfully manage our growth without compromising the quality of our services and products, our business, prospects, financial condition or operating results could be adversely affected |
| A key part of our business strategy involves acquisitions; however, such acquisitions may not achieve all intended benefits |
| A key part of our strategy has been to obtain technologies, customers, and personnel through acquisitions |
| We acquired SDL in March 2003, CSI in April 2004, substantially all of the assets of PGI in June 2004, and Windermere in February 2005 |
| We intend to continue to pursue selective acquisition opportunities in the future, but we may not be able to identify and execute suitable acquisitions in the future on terms that are favorable to us, or at all |
| We may encounter other risks in our acquisition strategy, including: • diversion of management’s attention from our existing business; • increased competition for acquisitions which may increase the price of our acquisitions; • our failure to discover material liabilities in target companies; and 18 ______________________________________________________________________ [43]Table of Contents • the failure of prior owners of any acquired businesses or their employees to comply with applicable laws or regulations such as the Federal Acquisition Regulation and health, safety, employment and environmental laws, or their failure to fulfill their contractual obligations to the Federal Government or other clients |
| In connection with our future acquisitions, we may incur significant acquisition expenses as well as amortization expenses related to intangible assets |
| We also may incur significant write-offs of goodwill associated with companies, businesses or technologies that we acquire |
| Our operating results could be adversely affected by these expenses and write-offs |
| We may have difficulty integrating the operations of any companies we acquire, which may adversely affect our results of operations |
| The success of our acquisition strategy will depend upon our ability to successfully integrate any businesses we may acquire in the future |
| The integration of these businesses into our operations may result in unforeseen events or operating difficulties, absorb significant management attention and require significant financial resources that would otherwise be available for the ongoing development of our business |
| These integration difficulties could include: • the integration of personnel with disparate business backgrounds; • the transition to new information systems; • the coordination of geographically dispersed organizations; • the loss of key employees of acquired companies; • the reconciliation of different corporate cultures; and • the synchronization of disclosure and financial reporting controls of acquired companies with our controls and, where applicable, improvement of the acquired company’s controls |
| For these or other reasons, we may be unable to retain key clients or to retain or renew contracts of acquired companies |
| Moreover, any acquired business may fail to generate the revenues or net income we expected or produce the efficiencies or cost-savings that we anticipated |
| Any of these outcomes could materially adversely affect our operating results |
| We have significant contingent earn-out obligations related to our Windermere acquisition that may adversely affect our liquidity and financial condition |
| The acquisition agreement for the Windermere transaction contains earn-out provisions that may require us to make an additional purchase price payment on May 31, 2006, to be calculated based on excess earnings before interest, taxes, depreciation and amortization (“EBITDA”) of Windermere during the applicable earn-out period |
| Under the Windermere earn-out arrangement, the Company’s aggregate contingent earn-out obligation may range from a low of zero dollars to a maximum of dlra30dtta0 million in cash, and associated fees, depending upon the extent to which Windermere’s EBITDA during the period March 1, 2005 through February 28, 2006 exceeds the EBITDA target of dlra5dtta5 million for such period established and defined in the acquisition agreement |
| We are not yet able to determine the extent to which earn-out amounts may become payable under this agreement |
| We expect to enter into discussions with the Windermere sellers regarding the earn-out by the end of the first quarter of 2006 |
| Pursuant to an oral agreement between Stephen E Tate, who became an Executive Vice President of Essex upon the Windermere acquisition, and Essex, Essex paid Stephen E Tate a dlra1dtta7 million finder’s fee in connection with the Windermere acquisition |
| To the extent any earn-out is payable to the sellers in connection with the acquisition of Windermere, the Company will be obligated to pay Stephen E Tate an additional fee equal to 2dtta5prca multiplied by such earn-out amount, up to a maximum dlra750cmam000 |
| An additional 1prca finder’s fee is also due to an individual who is neither affiliated with nor employed by Essex |
| To the extent that any earn-out payment under the Windermere acquisition agreement requires cash beyond any positive cash flows and our existing cash balance at the time payment is required, we may need to obtain 19 ______________________________________________________________________ [44]Table of Contents financing to cover these contingent obligations |
| We may also use the proceeds from sales of securities under our shelf registration statement or advances under our Credit Facility |
| There can be no assurance that we will be able to obtain financing on terms favorable to us, if at all, or that we can be successful in raising the requisite amounts |
| If we are unable to make any required earn-out payment on the applicable date, we may default in our obligations under the Windermere acquisition agreement, which could result in proceedings against us and could adversely affect our liquidity and financial condition |
| We face intense competition from many competitors that have greater resources than we do, which could result in price reductions, reduced profitability and loss of market share |
| We operate in highly competitive markets and may encounter intense competition to win US Government awards |
| If we are unable to successfully compete for new business, our revenue growth may decline |
| Many of our competitors are larger and have greater financial, technical, marketing and public relations resources than we do |
| Larger competitors include Lockheed Martin Corporation and divisions of large defense contractors such as Boeing Support Services |
| These competitors may be able to compete more effectively for very large scale government awards |
| These competitors also may be able to provide customers with different or greater capabilities or benefits than we can provide in areas such as technical qualification, past performance on larger scale contracts, geographic presence, price, and the availability of key professional personnel |
| Our competitors also have established or may establish relationships among themselves or with third parties, including through mergers and acquisitions, to increase their ability to address customers’ needs |
| Accordingly, it is possible that new competitors or alliances among competitors may emerge against whom it will be difficult for us to compete |
| In addition, competition in the commercial market for network communications equipment is intense |
| This market has historically been dominated by such large companies as Alcatel, Ciena, Cisco Systems, JDS Uniphase, Lucent Technologies, NEC and Nortel Networks |
| Some of these companies, as well as emerging companies, are currently developing products that may compete in the areas that our technology is designed to address |
| We also may face competition from other large communications companies who may enter our markets |
| Many of these possible competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical and business development resources than we do and may be able to undertake more extensive marketing efforts and adopt more aggressive pricing policies than we can |
| Furthermore, additional competitors with significant market presence and financial resources may enter our markets, which are rapidly evolving, further intensifying competition |
| Our success largely depends on our ability to hire and retain key personnel |
| Our success has historically depended in large part on our ability to attract and retain highly skilled technical, managerial and operational personnel, particularly those knowledgeable about the US Government intelligence and defense agencies, those with security clearances and those skilled in optoelectronics and optical communications equipment |
| In addition, the relationships and reputation that many members of our senior management team have established and maintain with government personnel contribute to our ability to maintain good customer relationships and to identify new business opportunities |
| The loss of key personnel may impair our ability to obtain new US Government awards or adequately perform under our current US Government awards |
| We also rely on the skills and expertise of our senior technical development personnel, the loss of any of whom could prevent us from completing current development projects and restrict new development projects |
| We currently do not maintain “key man” insurance on any of our executives or key employees |
| Our quarterly operating results may vary widely |
| Our quarterly revenues and operating results have fluctuated significantly in the past, and may fluctuate in the future |
| A number of factors can cause our revenue, cash flow and operating results to vary from quarter to quarter, including: • acquisitions of other businesses; 20 ______________________________________________________________________ [45]Table of Contents • commencement, completion or termination of projects during any particular quarter; • variable purchasing patterns under government awards, blanket purchase agreements and IDIQ awards; • seasonal work patterns due to vacation, holiday, and weather incidences resulting in reduced work days on our time and materials awards; • changes in senior US Government officials that affect the timing of technology procurement; and • changes in policy or budgetary measures that adversely affect appropriations for government awards in general |
| Changes in the number of projects commenced, completed or terminated during any quarter may cause significant variations in our cash flow from operations because a relatively large amount of our expenses are fixed |
| We also may incur significant or unanticipated expenses when awards expire or are terminated |
| In addition, payments due to us from US Government agencies may be delayed due to customer payment cycles or as a result of the failure of Congress and the President to approve budgets in a timely manner |
| If we are unable to protect our intellectual property effectively, we may be unable to prevent third parties from using our technologies, which would impair our competitive advantage |
| We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights |
| We also enter into confidentiality or license agreements with our key employees and consultants and control access to and distribution of our software, documentation and other proprietary information |
| We believe that our patents and patent applications provide us with a competitive advantage and, therefore, patent protection is important to our business |
| However, our patent and other intellectual property protection may not adequately protect our rights or permit us to gain or keep any competitive advantage |
| For instance, unauthorized parties may attempt to copy, reverse engineer or otherwise obtain and use our patented products or technology without our permission, eroding or eliminating the competitive advantage we hope to gain though the exclusive rights provided by patent protection |
| Moreover, our existing patents and pending patent applications, if granted, may not protect us against competitors that independently develop proprietary technologies that are substantially equivalent or superior to our technologies, or design around our patents |
| The competitive advantage provided by patenting our technology may erode if we do not upgrade, enhance and improve our technology on an ongoing basis to meet competitive challenges |
| In addition, we conduct research and development under projects with the US Government |
| In general, our rights to technologies we develop under those projects are subject to the US Government’s non-exclusive, non-royalty bearing, world-wide license to use those technologies |
| In the case of awards under the US Government’s Small Business Innovation Research program, the US Government has limited rights to the delivered data for five years after project completion, and unlimited rights after five years |
| We retain title to the SBIR technology, but our rights to exclusively license and protect our technology may be affected by the US Government’s rights to SBIR technical data |
| Monitoring unauthorized use of our technology is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States |
| There is a risk that some of our patent applications will not be granted |
| Although we have received our first hyperfine WDM and VLI patents, we have filed several other applications for US and International patents relating to our hyperfine WDM, VLI and OPERA™ technologies, and there is a risk that some or all of the pending applications will not be granted |
| Although we believe our patent applications are valid, the failure of our pending applications to be granted would affect the competitive advantage we hope to gain by obtaining patent protection and could have a material adverse effect upon our business and operating results |
| 21 ______________________________________________________________________ [46]Table of Contents We may become involved in intellectual property disputes, which could subject us to significant liability, divert the time and attention of our management and prevent us from selling our products |
| We or our customers may be a party to litigation in the future to protect our intellectual property or to respond to allegations that we infringe on others’ intellectual property |
| We have not performed any patent infringement clearance searches and are not in a position to assess the likelihood that any claims would be asserted |
| If any parties assert that our products infringe upon their proprietary rights, we would be forced to defend ourselves and possibly our customers against the alleged infringement |
| If we are unsuccessful in any intellectual property litigation, we could be subject to significant liability for damages and loss of our proprietary rights |
| Intellectual property litigation, regardless of its success, would likely be time consuming and expensive to resolve and would divert management’s time and attention |
| In addition, we could be forced to do one or more of the following: • stop selling, incorporating or using our products that include the challenged intellectual property; • obtain from the owner of any infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, or at all; or • re-design those products that use the technology |
| If we are forced to take any of these actions, our business could be seriously harmed |
| Because we currently are developing our optoelectronic products for the commercial market, it is difficult to evaluate our future business and prospects in this market |
| We traditionally have derived our revenues from awards from the US Government |
| While we intend to enhance and expand our government business, we are continuing our work to develop new optoelectronic commercial products, including products based on our hyperfine WDM fiber optic communications technology, such as our optical encryptor |
| Because we have not begun significant commercial sales of these products, including those products under development by our recently created Commercial Communications Products Division (CCPD), our commercial revenues and profit potential is unproven and our limited history in the commercial market makes it difficult to evaluate our business and prospects |
| We cannot accurately forecast our commercial revenue and we have limited historical financial data upon which to base production budgets |
| You should consider our business and prospects in light of the heightened risks and unexpected expenses and problems we may face as a company developing new commercial products for a rapidly changing industry |
| Our ability to expand into the commercial optical networking market may be adversely affected by unfavorable and uncertain conditions in the commercial communications industry and the economy in general |
| One element of our strategy is to develop products targeted at the commercial optical networking market, including products under development by CCPD The market for communications equipment, including optical components, has suffered a severe and prolonged downturn |
| Many of our potential customers in this market have experienced significant financial distress, and some have gone out of business |
| This has resulted in a significant consolidation in the commercial communications equipment industry, combined with a substantial reduction in overall demand |
| In addition, most of the potential customers we would like to reach have become more conservative about their future purchases, which has made our commercial business slow to materialize |
| We expect the following factors to affect our ability to expand our commercial market business for an indeterminate period: • capital expenditures by many of our potential customers may be flat or reduced; • increased competition may enable commercial customers to insist on more favorable terms and conditions for sales, including extended payment terms or other financing assistance as a condition of procuring their business; and 22 ______________________________________________________________________ [47]Table of Contents • the bankruptcies or weakened financial condition of several communications companies may adversely affect the commercial market for the optical networking products we are developing |
| The result of any one or a combination of these factors could eliminate or reduce our ability to successfully enter and compete in this market |
| Our optoelectronic products are complex, operate in demanding environments and have not yet been widely deployed |
| If our products contain defects that are undiscovered until full deployment we may incur significant and unexpected expenses, losses of sales and harm to our reputation |
| Optoelectronic products are complex and are designed to be deployed across complex networks |
| Because of the nature of the products, they can only be fully tested when completely deployed in large networks with high amounts of traffic |
| Our products have not yet been deployed and tested in a commercial environment, and when they are, customers may discover errors or defects in the hardware or the software, or products we develop may not operate as expected |
| If we are unable to fix defects or other problems that may be identified in full deployment, we would likely experience: • a loss of, or delay in, revenues and loss of market share; • a loss of existing customers; • difficulties in attracting new customers or achieving market acceptance; • diversion of development resources; • increased service and warranty costs; • legal actions by our customers; and • increased insurance costs |
| Defects, integration issues or other performance problems could result in financial or other damages to our customers or could negatively affect market acceptance for the products we develop |
| Our customers could also seek damages for losses from us, which, if they were successful, could adversely affect our cash flow from operations |
| A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly and would put a strain on our management and resources |
| We have likely lost our ability to bid for and obtain new contracts under government programs aimed at small businesses |
| We currently participate in certain government programs under the regulations promulgated by the US Small Business Administration, or SBA, such as the Small Business Innovative Research, or SBIR, program and small business set-aside contracts and preferences |
| Qualification as a small business is determined under the criteria set forth in the SBA Small Business Size Standards regulation |
| These criteria include the classification of the product or service in the North American Industry Classification System, trailing three year averages of the number of employees or annual receipts, affiliates, and other applicable factors |
| The restriction of a particular project or program under small business limited competition rules is a unilateral decision that is made at the time of procurement by the responsible agency procurement authority |
| The restriction of a particular project or program to small businesses, as a small business set-aside, in one procurement cycle does not assure that it will be similarly restricted in follow-on or related procurements |
| A significant portion of our revenues historically have resulted from our participation in these small business set-aside programs |
| Our awards under our largest Set-aside for Small Business Program accounted for 40prca of our revenues for the 2005 fiscal year |
| 23 ______________________________________________________________________ [48]Table of Contents We believe that, due to the increases in the levels of our revenues and number of employees, we have lost our ability to participate in most of these programs, including receiving new awards under the programs |
| We also anticipate that some follow-on or related procurements for programs that were originally awarded to us as small business set-asides will not be issued under the small business limited competition rules of the SBA If necessary licenses of third-party technology are not available to us or are very expensive, we may not be able to sell products of the same quality, and our cost of operations could increase |
| From time to time we may be required to license technology from third parties to sell or develop our products and product enhancements |
| These third-party licenses may not be available to us on commercially reasonable terms, if at all |
| Our inability to maintain or obtain any third-party license required to sell or develop our products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost |
| If we were required to use technology with lower performance standards or quality, customers may stop buying our products and this would cause our revenues to decline |
| Similarly, if our costs rise significantly, customers may choose less expensive alternative products, which would cause our revenues to decline |
| Manmade problems such as computer viruses or terrorism may disrupt our operations and harm our operating results |
| Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems |
| Any such event could have a material adverse effect on our business, operating results, and financial condition |
| In addition, the continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to the economies of the US and other countries and create further uncertainties or otherwise materially harm our business, operating results, and financial condition |
| To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders or the manufacture or shipment of our products, our business, operating results, and financial condition could be materially and adversely affected |
| Risks Related to Our Company A limited number of shareholders are able to exert significant influence over matters requiring shareholder approval |
| As of February 28, 2006, a few private investors collectively hold approximately 3dtta2 million shares, or 15prca of our total outstanding shares of common stock |
| Accordingly, these investors could seek to exercise significant control and influence of certain actions requiring the approval of the holders of shares of our common stock |
| This concentration of ownership may also delay or prevent a change in control of us or reduce the price other investors might be willing to pay for our common stock |
| In addition, the interests of this limited number of investors may conflict with the interests of other holders of our common stock |
| The market price of our common stock is subject to significant price fluctuations |
| The trading price of our common stock has historically been volatile and will likely continue to fluctuate significantly in the future |
| We believe this volatility has often been unrelated to our operating performance |
| Volatility in the market price of our common stock may prevent investors from being able to sell their common stock at or above the price such investors paid for their shares or at any price at all |
| In addition, in the event our operating results fall below the expectations of public market analysts and investors, the market price of our common stock would likely decline |
| 24 ______________________________________________________________________ [49]Table of Contents Sales of a significant number of shares of our common stock by existing shareholders could cause the market price of our common stock to decline |
| If our shareholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options, the market price of our common stock may decline |
| These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate |
| We are unable to predict the effect that sales may have on the then prevailing market price of our common stock |
| As of February 28, 2006, there remain registered for resale under the Securities Act approximately 680cmam000 shares of our common stock on behalf of certain of our shareholders |
| There are approximately 192cmam307 shares of our common stock issued in December 2003 upon conversion of a note payable, the holder of which is entitled to “piggy-back” registration rights |
| Sales of substantial amounts of common stock under Rule 144 or pursuant to the holder’s registration rights, or the perception that such sales may occur, could depress the market price of our common stock |
| All of these shares will become eligible for public resale at various times within two years subject to volume limitations and certain restrictions on sales by affiliates |
| Changes in stock option accounting rules may adversely impact our operating results prepared in accordance with generally accepted accounting principles |
| Technology companies like ours have a history of using broad based employee stock option programs to hire, incentivize and retain our workforce in a competitive marketplace |
| Statement of Financial Accounting Standards Nodtta 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), allows companies the choice of either using a fair value method of accounting for options which would result in expense recognition for all options, or using an intrinsic value method, as prescribed by Accounting Principles Board Opinion Nodtta 25, “Accounting for Stock Issued to Employees” (“APB 25”), with a pro forma disclosure of the impact on net income (loss) of using the fair value option expense recognition method |
| We have elected to apply APB 25 and the disclosure provisions of SFAS 123 and accordingly we generally do not recognize any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant |
| In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) Nodtta 123R, “Share-Based Payment”, which is a revision of SFAS Nodtta 123, “Accounting for Stock Issued to Employees” |
| SFAS Nodtta 123R requires that all share-based payments to employees, including grants of employee stock options, be valued at fair value on the grant date and be expensed over the applicable vesting period |
| SFAS Nodtta 123R is effective for the Company on January 1, 2006 |
| The Company will transition to SFAS Nodtta 123R using the “modified prospective application” |
| Under the “modified prospective application”, compensation costs will be recognized in the financial statements for all new share-based payments granted after January 1, 2006 |
| Additionally, the Company will recognize compensation costs for the portion of previously granted awards for which the requisite service has not been rendered (“nonvested awards”) that are outstanding as of January 1, 2006 over the remaining requisite service period of the awards |
| The compensation expense to be recognized for the nonvested awards will be based on the fair value of the awards |
| Our adoption of SFAS Nodtta 123R will adversely affect our Financial Position and Results of Operations in future periods |
| At December 31, 2005, the total value of options outstanding and vesting after January 1, 2006 is expected to be approximately dlra429cmam000, with dlra369cmam000 (before the consideration of income taxes, if any) vesting in the year ending December 31, 2006 |