1. OPERATIONS
The Company is incorporated under the laws of Delaware and is engaged through
its wholly-owned subsidiary in developing, manufacturing and marketing advanced
electronic products.
2. BASIS OF PRESENTATION
The accompanying interim consolidated financial statements include the accounts
of the Company and its wholly-owned subsidiary of the same name, based in San
Diego, California.
The interim consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the discharge of
liabilities in the normal course of business for the foreseeable future. The
Company has incurred significant losses and negative cash flow from operations
in each of the last three fiscal years and for the nine month period ended
December 31, 1999 and has an accumulated deficit of $40,983,774 at December 31,
1999. The Company's operational plan involves focusing on licensing and product
development on a contract basis and for the Company's own account. The Company's
ability to continue as a going concern is in doubt and is dependent upon
achieving a profitable level of operations, and if necessary, obtaining
additional financing.
These interim consolidated financial statements do not give effect to any
adjustments which would be necessary should the Company be unable to continue as
a going concern and therefore be required to realize its assets and discharge
its liabilities in other than the normal course of business and at amounts
different from those reflected in the accompanying interim consolidated
financial statements.
These interim consolidated financial statements have been prepared in accordance
with accounting principles generally accepted for interim financial information
and the instructions to Form 10-QSB. They do not include all information and
footnotes required by generally accepted accounting principles for complete
financial statements. The interim consolidated financial statements and notes
thereto should be read in conjunction with the Company's audited consolidated
financial statements and notes thereto for the fiscal year ended March 31, 1999.
In the opinion of management, the interim consolidated financial statements
reflect all adjustments of a normal recurring nature necessary for a fair
statement of the results for interim periods. Operating results for the nine
month period ended December 31, 1999 are not necessarily indicative of the
results that may be expected for the fiscal year ending March 31, 2000.
3. RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Investments
and Hedging Activities" ("SFAS No. 133") which establishes accounting and
reporting standards requiring that every derivative instrument be recorded in
the balance sheet as either an asset or liability measured at its fair value.
The statement also requires that changes in the derivative's fair value be
recognized currently in earnings unless specific hedge accounting criteria are
met. SFAS No. 133 is effective for fiscal years beginning after June 15, 2000.
The Company does not expect the adoption of SFAS No. 133 to have a material
effect on the Company's consolidated financial statements.
4. LOSS PER SHARE
The Company's losses for the periods presented cause the inclusion of potential
common stock ("Common Stock") instruments outstanding to be antidilutive and,
therefore, in accordance with Statement of Financial Accounting Standards
("SFAS") No. 128, "Earnings Per Share," the Company is not required to present a
diluted earnings (loss) per share. Stock options, warrants, convertible notes
payable, and convertible preferred stock exercisable into 9,835,833 shares of
Common Stock were outstanding as at December 31, 1999. These securities were not
included in the computation of diluted earnings (loss) per share because of the
losses, but could potentially dilute earnings (loss) per share in future
periods.
The loss available to common stockholders was increased during the nine months
ended December 31, 1999 by an imputed deemed dividend of $390,000 based on the
value of warrants issued in connection with 7% Series B Convertible Preferred
Stock ("Series B stock") (see note 7). The loss available to common stockholders
was also increased by a $150,000 deemed
6
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E.DIGITAL CORPORATIONS AND SUBSIDIARY
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
December 31, 1999
dividend computed from the discount provision included in the Series B stock.
The deemed dividends are not contractual obligations on the part of the Company
to pay such deemed dividends. The Series A Preferred stock ("Series A stock")
provides for a dividend of 8% per annum and the Series B stock provides for a
dividend of 7% per annum. The dividends for the period ended December 31, 1999
were $93,205, which also increases the loss available to common stockholders.
The loss available to common stockholders' is computed as follows:
Nine months ended December 31,
1999 1998
---- ----
Loss and comprehensive loss $(1,760,126) $(1,370,904)
Imputed deemed dividend on warrants
issued with Series B stock (390,000) -
Dividends on Series A and B stock (93,205) (52,996)
Series B stock dividends computed based on
imputed discount at issuance (150,000) -
----------- -----------
Loss available to common stockholders $(2,393.331) $(1,423,900)
=========== ===========
5. INVENTORY
Inventory of raw material and finished goods is recorded at the lower of cost
and net realizable value. Cost is determined on a first-in, first-out basis.
Inventories consist of the following:
December 31, 1999 March 31, 1999
----------------- --------------
Raw material $ 83,886 $46,907
Finished goods 26,390 -
-------- -------
$110,276 $46,907
======== =======
6. PROMISSORY NOTES
The Company retired the balance of its 15% unsecured, subordinated, promissory
during the quarter ended December 31, 1999.
7. PREFERRED STOCK
Series A
- --------
The 7,500 shares of Series A stock outstanding at December 31, 1999 are
convertible into shares of Common Stock computed for each preferred share by
dividing $10.00 plus accrued and unpaid dividends at 8% per annum by $0.0875,
subject to certain future adjustments. At December 31, 1999, the Series A stock
was convertible into approximately one million shares of Common Stock. The
Company is required to redeem the Series A stock at $10.00 per share plus
accrued and unpaid dividends on September 1, 2000 and upon the occurrence of
certain other events. Subsequent to December 31, 1999, 4,200 shares of Series A
stock were converted into 568,594 common shares.
Series B
- --------
On June 25, 1999 the Company issued 300 shares of convertible Series B stock for
cash of $10,000 per share and gross proceeds of $3,000,000. During the quarter
ended December 31, 1999, the 300 shares of Series B stock and accrued dividends
of 7% was converted, in accordance with its terms, into 2,053,049 shares of
Common Stock
In connection with the issuance of the Series B stock, the Company also issued
to the purchaser warrants to purchase 195,000 shares of Common Stock at $2.40
per share until June 24, 2004. Subsequent to December 31, 1999 the warrants to
purchase 195,000 shares of Common Stock were exercised (see Note 9).
In connection with the Series B stock financing, the Company incurred placement
agent fees and legal and related costs of approximately $250,000 and issued a
warrant to purchase 137,615 shares of Common Stock at $3.27 per share until June
24, 2004 as a placement agent fee. The value assigned to the 137,615 warrants
issued as a placement fee was $275,000. Subsequent to December 31, 1999 the
warrants to purchase 137,615 shares of Common Stock were exercised (see Note 9).
7
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E.DIGITAL CORPORATIONS AND SUBSIDIARY
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
December 31, 1999
8. COMMON STOCKHOLDERS' EQUITY (DEFICIENCY)
The following table summarizes common stockholders' equity transactions during
the nine month period ended December 31, 1999:
<TABLE>
<CAPTION>
Additional
paid-in Prepaid Contributed Accumulated
Shares Amount capital Warrants Surplus Deficit Total
------ ------ ------- -------- ------- ------- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, March 31, 1999 97,321,297 $ 97,321 $35,126,914 $ 261,047 $1,592,316 $(38,833,648) $(1,756,050)
Stock issued on exercise of
prepaid warrants 4,493,335 4,493 256,554 (261,047) - - -
Stock issued on exercise of
stock options 2,043,944 2,044 178,004 - - - 180,048
Stock issued for services 98,867 99 132,730 - - - 132,829
Stock issued on exercise of
warrants 10,610,712 10,611 1,795,087 - - - 1,805,698
Stock issued for exercise of
cashless warrants 828,476 828 (828) - - - -
Stock issued on conversion
of 5,000 shares of Series A stock 3,246,458 3,247 275,952 - - - 279,199
Stock issued on conversion
of 300 shares of Series B stock 2,053,049 2,053 2,562,519 - - - 2,564,572
Deemed dividend on 195,000
warrants issued with Series B stock - - 390,000 - - (390,000) -
Value assigned to 137,615
warrants granted in connection
with issuance of Series B stock - - 275,000 - - - 275,000
Dividends on Series A stock - - (13,633) - - - (13,633)
Dividends on Series B stock - - (79,572) - - - ( 79,572)
Net loss for the period - - - - - (1,760,126) (1,760,126)
- ----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 120,696,138 $ 120,696 $40,898,727 - $1,592,316 $(40,983,774) $(1,627,965)
==================================================================================================================================
</TABLE>
9. WARRANTS AND OPTIONS
At December 31, 1999 warrants were outstanding/exercisable into the following
listed shares.
Number of Exercise Price
Description Shares $ Expiration Date
- --------------------------------------------------------------------------------
Warrants 20,570 0.25 February 2000
Warrants 25,000 0.25 March 2000
Warrants 27,500 0.25 March 2001
Warrants 125,000 0.0875 October 2001
Warrants 1,157,143 0.15 March 2002
Warrants 1,900,000 0.10 June 2003
Warrants 450,000 0.10 January 2004
Warrants 195,000 2.40 June 2004
Warrants 137,615 3.27 June 2004
- --------------------------------------------------------------------------------
Total 4,037,828
================================================================================
Subsequent to December 31, 1999 warrants to purchase 2,002,972 shares of Common
Stock were exercised for cash proceeds of $1,128,492.
8
<PAGE>
E.DIGITAL CORPORATIONS AND SUBSIDIARY
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
December 31, 1999
The following table summarizes stock option activity for the period:
Number of Weighted Average
Shares Exercise Price
Outstanding at March 31, 1999 6,334,000 $0.1362
Granted 555,000 $1.4334
Exercised (2,043,944) $0.0881
Expired (60,000) $ 3.65
Canceled - -
----------
Outstanding at December 31, 1999 4,785,056 $0.1853
==========
Exercisable at December 31, 1999 3,497,556 $ 0.164
==========
Options outstanding are exercisable at prices ranging from $0.0875 to $3.375 and
expire over the period from 2000 to 2004 with an average life of 3.82 years.
Subsequent to December 31, 1999 stock options to purchase 787,740 shares of
Common Stock were exercised for cash proceeds of $270,665.
10. INCOME TAXES
The Company has not provided a tax provision for the current period, due to
current losses. As of March 31, 1999, the Company has U.S. net operating loss
carryforwards of approximately $29,945,000 and $14,787,000 for federal and state
taxes purposes, respectively, subject to certain limitations.
9
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO THE
COMPANY'S FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY
FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A
VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW AND UNDER THE SUB-HEADING,
"BUSINESS RISKS." SEE ALSO THE COMPANY'S ANNUAL REPORT ON FORM 10-KSB FOR THE
YEAR ENDED MARCH 31, 1999.
General
We provide innovative product designs and technologies for the rapidly growing
market for electronic devices using portable storage media. We employ our
patented MicroOS(TM) file management system as the intelligence targeted for
portable digital voice, music, audio, image, video and data recording devices
that interface with computers and the Internet. We anticipate that the majority
of our future revenues will be from licenses, royalty fees, and private label
agreements for products employing our MicroOS(TM) technology and from contract
development services for, and sales to, OEMs of custom digital products.
The Company supports various emerging Digital Rights Management Systems ("DRMS")
that support the Secure Digital Music Initiative ("SDMI"). The SDMI is a
collection of companies within various industries congregating to develop and
establish baseline rules to allow access to download digital audio files from
the Internet. We have signed a non-exclusive license agreement to support Liquid
Audio Inc.'s SP3 DRMS and a non-exclusive agreement to integrate RioPort's
secure digital audio platform with the Company's Internet music player design
and intend to support other emerging DRMS developers. We are also in discussions
with other popular DRMS suppliers. We also support various memory devices
including CompactFlash and others.
In January 2000, we announced our plans to be compatible with the new, Secure
Digital (SD) Memory Card technology and IBM's new tiny removable Microdrive
technology. We are also extending a wide range of activities with key
participants in the Internet music industry. We can not guarantee that we will
support additional DRMS or that additional OEM's will use our technology or our
Internet music player reference designs.
During the third quarter we supplied third-generation digital music player
prototypes to Lucent Technologies and other OEM's interested in using our
Internet music player reference designs. During the third quarter, we also
completed the work to port Lucent's Enhanced Perceptual Audio Coder ("EPAC")
compression technology to a new Texas Instrument Digital Signal Processor
("DSP"). We are actively seeking to develop additional licensing, private label,
and OEM opportunities, to penetrate the digital recording and playback market.
We commenced initial shipments in late June 1999 against production orders from
our first major OEM customer, Lanier Worldwide, Inc. Since the commencement of
these initial shipments through the quarter ended December 31, 1999 we were in
production startup with our contract manufacturer. We had anticipated a
significant increase in production by the end of the third fiscal quarter
(ending December 31, 1999). However due to technical startup issues by our
contract manufacturer and a worldwide short term shortage of flash memory, the
timing of increased shipments has been delayed. Although there can be no
assurance, we expect that our contact manufacturer can accelerate production and
that this delay will not materially impact total shipments for the fiscal year.
Anticipated shipments are subject to change due to a variety of factors, many
outside our control. Our customers may modify or cancel orders and delay or
change schedules. Shipments may also be delayed due to production delays,
component shortages and other production related issues.
We are also working on other OEM development projects. We recognize revenues
from these projects as the related services are performed.
We have incurred operating losses in each of the last three fiscal years and
these losses have been material. We incurred an operating loss of $2.6 million
in fiscal 1998 (including an inventory write-off of $1.3 million) and $1.8
million in fiscal 1999. Our current level of monthly cash operating costs is
approximately $185,000 per month compared to $120,000 per month for December
1998, with the growth attributed to increased expenditures in the development of
our digital music technology and the addition of research and development
personnel. Moreover, we may increase expenditure levels in future periods to
support our digital music business and to support OEM customers. Accordingly,
our losses are expected to continue until such time as we are able to realize
supply, licensing, royalty and development revenues sufficient to cover our
10
<PAGE>
fixed costs of operations. We continue to be subject to the risks normally
associated with any new business activity, including unforeseeable expenses,
delays and complications. There is no assurance that we can or will report
operating profits in the future.
We are focused on OEM licensing with respect to our MicroOS(TM) file management
system and contract development of private label and custom-designed products
for digital music applications, dictation systems, and computer peripherals and
telecommunication equipment. Revenue from licensing, royalties and development
services, and product supply arrangements are expected to be subject to
significant month to month variability resulting from the limited market
penetration and license activity to date, the timing and delays associated with
OEM new product introductions and the seasonal nature of demand for consumer
electronic products. Development and OEM contracts and product orders may be
delayed or terminated by customers and are subject to a number of factors beyond
the Company's control. The termination of the OEM agreements or the lack of
market success of the OEM products could have a material adverse effect on our
operations. The markets for consumer electronic products are subject to rapidly
changing customer tastes and a high level of competition. Demand for our OEM
products is expected to be influenced by OEM market success, technological
developments and general economic conditions. Because these factors can change
rapidly, customer demand for our technology can also shift quickly. We may not
be able to respond to technical developments by competitors because of the time
required and risks involved in the development or introduction of new or
improved technology and due to limited financial resources. Our business depends
on emerging markets and new technology and products for which the prospects are
uncertain.
Results of Operations
For the first nine months of fiscal 2000, we reported revenues of $306,584, a
25% decrease from revenues of $412,674 for the first nine months of fiscal 1999.
Product sales increased in the current period due to OEM shipments while service
revenues decreased primarily due to a decline in OEM development services
revenues. Three customers accounted for 95% of fiscal 1999's first nine months
of revenues and three customers accounted for total revenue in the first nine
months of fiscal 2000. The loss of a customer could have a material adverse
impact on our results of operations.
Revenue for the first nine months of fiscal 2000 included product revenue of
$171,973 compared to $154,218 for the prior year's first nine months. The
increase is due from our OEM product shipments to Lanier. Product revenue
generated a gross profit for the nine months ended December 31, 1999 of $62,041
compared to a gross profit of $27,086 for the first nine months of fiscal 1999.
Product sales for the three months ended December 31, 1999 decreased to $31,696
as compared to $80,323 for the comparable period of the prior year.
Service revenues for the first nine months of fiscal 2000 were $134,611 compared
to $258,456 for the comparable period of the prior year. Prior years service
revenue of $258,456 was generated by the Company as a result of being in the
final stage of the Lanier agreement which accounted for substantially all
development revenues in the prior period. For the nine months ended December 31,
1999 service revenues included $41,905 and $50,000 recognized under our Intel
and Lucent development agreements, respectively. The timing and amount of
service revenues is dependent upon limited number of projects. We are increasing
our focus on internally developed technology to be offered to OEM customers in
order to speed adoption and enhance our revenues.
For the nine months ended December 31, 1999, we reported a gross profit of
$78,218 compared to a gross loss of $148,332 for the first nine months of fiscal
1999. Cost of sales for the nine months ended December 31, 1999 consisted of
$109,932 of product costs and $118,434 of contract services consisting mostly of
research and development labor being funded in part by OEM development
agreements. Cost of sales for the three months ended December 31, 1999 and 1998
were $44,005 and $223,601, respectively. Although we do not anticipate any
significant future contract losses, we can not guarantee that we can attain
positive gross margins in the future or with future customers. At the present
time warranty reserves are not material and we do not anticipate significant
warranty costs in future periods. Our contract supply agreement provides a
twelve month manufacturing warranty.
Total operating expenses (consisting of research and related expenditures and
selling and administrative expenses) for the nine months ended December 31,
1999, were $1,773,989, as compared to $994,810 for the nine months ended
December 31, 1998. Selling and administrative costs aggregated $876,744 in the
first nine months of fiscal 2000 compared to $561,242 in the prior period. The
$315,502 increase in selling and administrative costs resulted primarily from an
increase in legal expenses and related costs of $68,503; an increase in annual
meeting related costs of $86,040 due to a significant increase in the number of
shareholders; and an increase in personnel expenditures and associated costs of
$218,997 offset
11
<PAGE>
by the inclusion of a $55,000 non-recurring equity transaction fee in the prior
year's first quarter. Selling and administrative costs for the three months
ended December 31, 1999 were $413,302 compared to $196,710 for the third quarter
of the prior year. We anticipate selling and administrative expenses to continue
at higher levels than prior periods due to increased personnel costs. We hired a
business development executive in October 1999 to support an increase in
prospective customers.
Research and related expenditures for the nine months ended December 31, 1999
were $897,245, as compared to $433,568, for the nine months ended December 31,
1998. The $463,677 increase in research and development costs resulted primarily
from an increase in consulting and engineering services of $35,806; an increase
in preproduction and other related costs of $95,638; and an increase in
engineering personnel and related costs of $283,821 resulting from a greater
percentage of in-house development compared to contract services. Research and
development for the three months ended December 31, 1999 and 1998 were $350,869
and $141,079, respectively. Research and development costs are subject to
significant quarterly variations depending on the use of outside services, the
assignment of engineers to development projects and the availability of
financial resources.
We reported an operating loss of $1,695,771 for the nine months ended December
31, 1999, as compared to operating loss of $1,143,142 for the nine months ended
December 31, 1998. The operating loss for the third quarter of fiscal 2000 was
$689,480 compared to $404,157 in the third quarter of the prior year. The
increase resulted primarily due to increased operating costs. We believe, but we
can not guarantee, that our strategy of investing in OEM developments with
supply or royalty provisions will provide positive margins in future periods.
The timing and amount of product sales and the recognition of contract service
revenues impact our operating losses. Accordingly, there is substantial
uncertainty about future operating results and the results for the first nine
months are not necessarily indicative of operating results for future periods or
the fiscal year.
Our cash interest expense for the nine months ended December 31, 1999 was
$49,714 comparable to $53,330 for the prior period.
We reported a loss for the first nine months of the current fiscal year of
$1,760,126 compared to a loss of $1,370,904 for the prior year's first nine
months.
The loss available to common stockholders for the nine months ended December 31,
1999 of $2,393,331, includes $390,000 of imputed dividends on the issuance of
warrants with the Series B stock, $79,572 of dividends and $150,000 related to
an imputed discount at issuance of the Series B stock.
Liquidity and Capital Resources
At December 31, 1999, we had working capital of $1,583,443 compared to a working
capital deficit of $1,378,155 at March 31, 1999. We had $110,276 of working
capital invested in inventories at December 31, 1999. In June 1999, we completed
the sale of $3,000,000 of Series B stock. The proceeds are being applied for
continued operating capital.
For the nine months ended December 31, 1999, net cash increased by $2,104,693.
Cash used in operating activities was $1,926,131. Major components using cash
were a loss of $1,760,126 reduced by $30,051 of aggregate depreciation and
amortization, $132,829 for services paid by issuance of Common Stock and $82,499
of non-cash interest, or a use of cash of $1,514,747. The major change in assets
and liabilities providing cash from operating activities was a reduction in
amount receivable on research and development contracts of $60,000. The major
changes in assets and liabilities using operating cash was an increase in
accounts receivable of $140,612, a reduction in accounts payable, trade of
$149,600 |
