AI
Wednesday, March 16, 2005 4:50:01 PM
Form 10-K for WAVE SYSTEMS CORP
16-Mar-2005
Annual Report
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Overview
In 2003 Wave's management made a shift in its business focus by devoting less attention and resource to its proprietary EMBASSY Trust System and more attention to developing and marketing TCG-compliant software products known as it's EMBASSY Trust Suite and EMBASSY Trust Server Applications. These are products designed and built around the TCG specifications, known as Trusted Platforms, that are being adopted into the Information Security Services marketplace. Wave devoted a substantial amount of its activities and resources during the year ended December 31, 2003 to organizing its business to capitalize on the opportunities presented by the emergence of the TCG specifications.
In 2004, Wave continued to pursue a strategy of educating the marketplace on the benefits that trusted computing has to offer, while continuing to develop the basic software applications designed to enable this emerging technology. The market trends and opportunities that management focused the company's activities during the year ended December 31, 2004 included the following:
† The market for information security services is growing rapidly-according to industry analyst, IDC, the U.S. market for information security services is expected to grow from approximately $4 billion in 2001 to $10.7 billion in 2006 representing a compound annual growth rate of 21.7%. The global market for information security is expected to reach $23 billion by 2006. (1)
† The persistence of security threats indicates that hardware is needed to provide more robust security than traditional software solutions.
† Emergence of TPM-enabled PCs being sold into the marketplace-this emergence is complementary to Wave's business model, which largely relies upon providing services for Trusted Platforms rather than selling the hardware itself.
† Business and security strategies are becoming more closely aligned due to the increasing rate of significant high profile and costly security breaches and the associated risks presented by this phenomenon.
† In-house security expertise remains in short supply-Wave seeks to capitalize on its expertise as awareness of TPM-enabled solutions increases.
† Microsoft has required TPM version 1.2 in its draft Longhorn operating system hardware requirements specification for logo compliance. Wave believes that a significant percentage of the approximately 150 million unit PC market will include TPMs by May 2006, which is Microsoft's stated launch date for Longhorn.
In pursuing these opportunities, we recognize many significant challenges that must be overcome, including:
† Tight enterprise IT budgets-industry data appear to show that, while enterprise security will be a priority, it will be challenged by tight budgets
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(1) IDC, The Shifting Landscape: U.S. Information Security Services, Jan. 2003, document # 28640.
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† Long sales cycle due to continued lack of support for enterprise spending on security solutions - information security continues to be viewed as an IT issue versus a business issue
† Need to educate the marketplace of the advantages of utilizing hardware-based trusted platforms as a security solution
† Limited availability of capital resources-Wave continues to rely on financing the development of its business by issuing new equity (See Liquidity and capital resources section for a detailed discussion of financing activities during 2004).
As more PC and chip OEMs have begun introducing their Trusted Platform offerings, management has focused on entering into licensing contracts in which the OEM licenses our applications and bundles them with their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such bundling agreements with three separate OEM partners. For the year ended December 31, 2004, Wave received approximately $308,000 in royalties from these OEM partners pursuant to its license agreements with them. Revenue recognized on these contracts through December 31, 2004 totaled approximately $60,000, while the remaining $248,000 is deferred revenue. We continue to pursue OEM business under the royalty model described herein. In addition, we seek to enter into arrangements with resellers that sell to PC OEMs to distribute our applications as a product offering that users may choose when purchasing a TPM-equipped computer from the PC OEM. For instance, in February, 2005, Dell Computers Inc began offering Wave's ETS Software as an option for purchase on select models through their website at Dell.com. Wave hopes to capitalize on this association with Dell products and the wider distribution of TPM-equipped personal computers that a Dell TPM offering represents. In addition, we have sought to develop our products such that they operate on all of the major PC OEM Trusted Platforms that are currently shipping product in the marketplace and our applications have been approved to work with the Trusted Platforms of IBM, HP, Atmel, Infineon and others.
Management is also focused on developing the client and server-side applications and tools that will enable enterprises to manage an IT infrastructure that relies on products built using TCG specifications. Wave is devoting a significant portion of its research and development budget to address this opportunity, as this will be a key ingredient for enterprises in successfully implementing a Trusted Platform solution. Wave released these tools and applications in 2004, and has signed a license agreement in the first quarter of 2005 with an embedded systems manufacturer to license the Wave TCG-enabled toolkit and KTM ES AD.
With respect to sales and marketing, management is focused on broadening our distribution strategies to include the direct engagement of our channel partners using their resellers and systems integrators and has hired regional representation in Japan. We have also expanded our targeted presence selling directly to OEMs. We have specifically focused our resources towards solution selling in these channels. We have reorganized and shifted the focus of our sales force during the year in order to achieve these objectives.
Management is also focused on opportunities for its eTMS product suite to provide digital signing and document management solutions to the financial services and other vertical markets in which there is a clear and identifiable value proposition in implementing these solutions. Although we have met significant implementation challenges and long sales cycles with this effort, we have also experienced significant interest in these products and we continue to pursue this opportunity.
Wavexpress is focused on building a sustainable revenue stream based on establishing partnerships with branded content providers to provide paid and advertising supported video entertainment services. These services are designed into existing web sites and presented as extensions to Microsoft Media Center Edition PC's. The company is extending the technology so that its subscriber management system can leverage the added security of a TPM and is preparing back-office systems for standalone deployment into
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enterprise installations. Wavexpress currently has three active contracts that are generating revenue going into 2005. It is expected that these contracts will generate revenue that is in line with the revenue that Wavexpress has generated in the last two fiscal quarters. Management plans to devote increasing development resources towards building its feature set to meet market demand.
While management is primarily focused on the emerging TCG Trusted Platform opportunities, it remains committed to pursuing business opportunities that involve its proprietary EMBASSY Trust System products and services, primarily in the government sector.
Operating Expense Trends
In addition to the trend of decreasing research and development expenses shown in Item I-Business; selling, general and administrative expenses ("S,G&A") have likewise been trending downward over the three years ended December 31, 2004. For the years ended December 31, 2004, 2003 and 2002 we have incurred approximately $12.3 million, $12.7 million and $19.2 million, in S,G&A expenses, respectively. The activities supported by these expenditures include business development, sales, marketing (including product management), corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions. The downward trend in S,G&A expenses and expenses in general, is indicative of Wave's strict cost-cutting measures, which began during the second half of 2001 and continued through the end of 2003, and have since flattened into 2004. Much of these cost reductions were the result of Wave's abandonment of several lines of business that it had previously been pursuing, including Internet services and consumer e-commerce. In addition, Wave de-emphasized the marketing of its proprietary EMBASSY Trust System platform in 2003 other than to the government security sector. While Wave adjusted its emphasis to focus on the emerging TCG services market segment toward the end of 2002 and into 2003, it drastically reduced several areas within the selling, general and administrative category including product management, sales and marketing, business development and support areas including accounting, human resources, information systems and other corporate overhead, that had supported the higher level of business activity that has now been reduced. The expense reductions being referred to herein came mostly in the form of headcount and outside services expenditure reductions. Now that Wave has begun selling an introductory suite of software applications into the market and has identified and begun developing the next generation of these products that will include key management and infrastructure services, we've begun rebuilding our sales force, expanding our distribution channels and implementing a global sales and marketing strategy.
Although we've reduced our expenditures significantly, given the early stage nature of the markets for products that use our technology, we will continue to expend considerable resources in the sales, marketing, business development and support activities referred to above that will be necessary for us to be successful in developing salable products and markets for our technology. The outlook over the short-term is for sales and marketing expenditures to remain relatively flat, compared with 2004, with research and development remaining at approximately the same level as 2004 as well. (See Liquidity and capital resources)
The following discussion related to the consolidated financial statements of Wave should be read in conjunction with the financial statements appearing in Item 8.
Critical Accounting Policies
Wave's discussion and analysis of its financial condition and results of operations are based on the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of
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assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, accounts receivable reserves, marketable securities, valuation of long-lived and intangible assets, accounting for joint ventures and software development. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The following accounting policies are deemed critical to the understanding of the consolidated financial statements included under Item 8-Financial Statements and Supplementary Data.
Method of Accounting for Joint Ventures-Wave accounts for its investments in joint ventures using the equity method of accounting when its ownership interest in the joint venture is less than fifty percent and it is determined that Wave has the ability to exercise significant influence over the joint venture's operating and financial policies. The financial statements of joint ventures in which Wave owns greater than a fifty-percent interest are consolidated with Wave's financial statements pursuant to Accounting Principles Board ("APB") Opinion No. 18.
Marketable Securities-Investments, which consist solely of equity securities, are accounted for under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities" issued by the Financial Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115, investments are classified as "trading", "available-for sale" or "held to maturity". "Trading" securities are bought and held principally for the purpose of selling them in the near term and are recorded at fair value. Fair value is based upon quoted market prices. Unrealized gains and losses on trading securities are included in the determination of net earnings. "Available-for-sale" securities are being held for an unspecified period of time and may be used for liquidity or other corporate purposes and are recorded at fair value. Unrealized gains and losses on available-for-sale securities are reported as a separate component of comprehensive income (loss) in stockholders' equity. Unrealized losses that are determined to be other than temporary are recognized as charges against earnings. Factors considered when determining if an other than temporary decline has occurred include: whether a decline in market value is related to specific concerns of the issuer of the securities as opposed to general market conditions, the length of time of the decline in market price, the financial condition and near-term prospects of the issuer and other factors that may indicate that the value of the securities will not recover. "Held to maturity" securities are debt securities that are intended to be held to maturity and are recorded at amortized cost. As of December 31, 2004, all of Wave's marketable equity securities are classified as available-for-sale.
Research and Development and Software Development Costs-Research and development costs are expensed as incurred. Software development costs are accounted for pursuant to Statement of Financial Accounting Standards No. 86 "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed" ("SFAS No. 86"). SFAS No. 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development costs until technological feasibility has been established for the product. Once technological feasibility is established and the product has achieved commercial marketability, all development costs should be capitalized until the product is available for general release to customers. We consider technological feasibility to be established upon completion of a detail program design, or in the absence of a detail program design, upon completion of a working model of the software as defined in SFAS No. 86. Judgment is required in determining when the technological feasibility of a product is established, if the product has achieved commercial marketability and in estimating the life of the product for which the capitalized costs will be amortized.
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Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of-Wave reviews the valuation of long-lived assets, including property and equipment and capitalized software, under the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" and SFAS No. 86. Wave is required to assess the recoverability of long-lived assets and capitalized software costs whenever events and circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:
† significant underperformance relative to expected historical or projected future operating results;
† significant changes in the manner of our use of the acquired assets or the strategy of our overall business;
† significant negative industry or economic trends; and
† significant decline in our stock price for a sustained period.
In accordance with SFAS No. 144, when we determine that the carrying value of applicable long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we evaluate whether the carrying amount of the asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of that asset. If such a circumstance exists, we would measure an impairment loss to the extent the carrying amount of the particular long-lived asset or group exceeds its fair value. We would determine the fair value based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. In accordance with SFAS No. 86, when we determine that the carrying value of certain other types of long-lived assets may not be recoverable, we evaluate whether the unamortized cost exceeds the expected future net realizable value of the products. If the unamortized costs exceed the expected future net realizable value of the products, the excess amount is written off. Changes in judgments on any of these factors could impact the value of the asset being evaluated.
Revenue Recognition-Wave's business model targets revenues from various sources including: licensing of EMBASSY Trust Suite, Wavexpress' broadband media distribution and eTMS software products, sales of hardware and development contracts. Many of our sales arrangements include multiple-elements, and/or required significant modification or customization of our software.
Wave follows the provisions of statement of position "SOP" 97-2, Software Revenue Recognition as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Generally, Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Wave reduces revenue for estimated customer returns, rotations and sales rebates when such amounts can be estimated. When these amounts cannot be estimated Wave defers revenue until the product is sold to the end-user. Revenue from software license agreements that have significant customizations and modification of the software product is deferred and recognized in a manner that approximates the percentage of completion method. In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.
PRODUCTS-SOFTWARE AND HARDWARE
Revenue from delivered elements of one-time charge licensed software is recognized at the inception of the license term, provided Wave has vendor-specific objective evidence of the fair value of each undelivered element, for arrangements that contain multiple elements. Revenue is deferred for undelivered elements for these arrangements. Revenue is also deferred for the entire arrangement, if vendor-specific objective evidence does not exist for each undelivered contract element. Examples of undelivered elements in which the timing of delivery is uncertain include contractual elements that give
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customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The revenue that is deferred for any contract element is recognized when all of the revenue recognition criteria have been met for that element.
Prepaid royalty fees received pursuant to distribution software licenses with OEMs in which Wave earns a royalty, based upon units shipped by the OEM to end customers, are deferred when received, and recognized as revenue as units are shipped by the OEM.
Revenue from the sale of hardware components is recognized when persuasive evidence of an arrangement exists, the product has been shipped to the customer, the sales price is fixed or determinable, and collectivity is reasonably assured. All of the product is shipped with ownership passing to the buyer upon leaving our premises and payment terms are generally net 30.
SERVICES
Revenue from time and material service contracts is recognized as the services are provided. Revenue from fixed price, long-term service or development contracts is recognized over the contract term based on the percentage of services that are provided during the period compared with the total estimated services to be provided over the entire contract. Losses on fixed price contracts are recognized during the period in which the loss first becomes apparent. Payment terms vary by contract.
Comparison of the years ended December 31, 2004 and 2003
Results of Operations
For the twelve months ended December 31, 2004 and December 31, 2003, revenues were $209,311 and $189,363, respectively. The increase in revenue is attributable to increases in product, and licensing revenue offset by a decrease in service revenues, as set forth in the following table:
2004 2003 Increase/(Decrease) % Change
Product $ 7,160 $ 3,350 $ 3,810 113.7 %
Services 18,833 65,343 (46,510 ) (71.2 %)
Licensing and Other 183,318 120,670 62,648 51.9 %
Total Net Revenues $ 209,311 $ 189,363 $ 19,948 10.5 %
Cost of sales for the year ended December 31, 2004, was $151,704 compared with $55,179 for the same period in 2003. Gross profit was $57,607 representing a gross profit margin of 28% for the year ended December 31, 2004 while $134,184 represented a gross profit margin of 71% for the year ended December 31, 2003. The decrease in gross profit margin was the result of the higher margins on service contracts in 2003 versus 2004, and higher costs of license revenues in 2004 versus 2003 resulting from the amortization expense of capitalized software costs.
Research and development expenses for the twelve months ended December 31, 2004 were $6,852,754 as compared to $7,384,708 for the comparable period of 2003. This 7% decrease in research and development expenses was primarily attributable to headcount reductions of employees and consultants, which decreased expenses by a total of $640,928 including salary and consultant compensation. Wavexpress' research and development expenses were $1,657,376 for the year ended December 31, 2004 versus $1,873,463, for a reduction of 12%. The amounts set forth for Wavexpress are included in the consolidated amounts referred to above. Also, the reasons for the reduction in expenditures set forth above pertain to both Wave as a whole and Wavexpress.
S,G&A expenses for the twelve months ended December 31, 2004 were $12,255,427 as compared to $12,698,682 for the comparable period of 2003. The 3% decrease in selling, general and administrative expenses was attributable primarily to headcount reductions at both Wave and Wavexpress. Wavexpress
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incurred S,G&A expenses of $1,789,997 in 2004, compared to $2,014,828 for 2003, for a decrease of 11%. The reasons set forth above encompass Wavexpress, as well as Wave as a whole.
For the year ended December 31, 2004, Wave took a charge of approximately $301,000 to write-off developed software that had been capitalized. The software that was written off was developed for a distribution agreement that was entered into with NSC, whereby NSC was to distribute it with their trusted platform module chip. The write-off was the result of the termination of the agreement and because the version of the software that was written off has been discontinued and superseded by a new version. Consequently, the value of the software became impaired because it had no alternative uses. No such impairment charges were incurred in the year ended December 31, 2003. Wave continues to maintain a license agreement with NSC, whereby Wave is paid royalties based on Wave technology that is included in NSC's chip design.
For the year ended December 31, 2003, Wave recorded a write down of approximately $1,114,000, representing the value of its EMBASSY 2100 chips held in inventory. This charge was taken because of the amount of time that continued to elapse without any substantial sales of this inventory coupled with the emergence within the trusted computing market towards TCG-compliant chips that have less functionality than the EMBASSY 2100 chips, but for which the marketplace is more readily accepting at this stage in the development of the trusted computing market.
Other Income and Expenses
Interest income for the year ended December 31, 2004 was $24,931 versus December 31, 2003 of $74,822 for a decrease of 67%. The decrease in interest income is primarily attributable to interest income having been recognized on the officer loan recovery referred to below for the year ended Deceember 31, 2003, and from a decrease in interest-bearing assets during 2004.
Wave sold 2,507,300 shares of its holdings of SSP Solutions, Inc., common stock and 966,300 shares of Saflink Corporation common stock during the year ended December 31, 2004, for total proceeds of $6,759,748, recording a realized gain of $4,330,248 on the sales. In August, 2004, SSP Solutions, Inc. merged with and became a wholly-owned subsidiary of Saflink Corporation. For the year ended December 31, 2003, Wave sold 332,500 shares of SSP for proceeds of $430,934, realizing an aggregate gain from the sales of $234,759.
During the fourth quarter of 2003, Wave incurred $155,716 in liquidated damages in connection with the issuance of 3,725,263 shares of its Class A Common Stock at a price of $1.90 per share and warrants to purchase 931,309 shares of Class A Common Stock at an exercise price of $2.62 per share in a private placement to a group of accredited investors for proceeds of approximately $6,562,000, net of issuance costs of approximately $516,000. The shares were issued pursuant to a securities purchase agreement dated November 18, 2003 between Wave and certain purchasers. Pursuant to a related registration rights agreement, if Wave did not file a registration statement for the shares within 30 days from the date of the closing of the securities purchase agreement, Wave would be required to pay liquidated damages to each purchaser equal to 2% of each purchaser's subscription amount, for each month elapsed beyond the 30 day deadline. Because Wave was not able to file the registration statement until one month and three days after the 30 day deadline, Wave incurred an aggregate of $155,716 in . . .
16-Mar-2005
Annual Report
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Overview
In 2003 Wave's management made a shift in its business focus by devoting less attention and resource to its proprietary EMBASSY Trust System and more attention to developing and marketing TCG-compliant software products known as it's EMBASSY Trust Suite and EMBASSY Trust Server Applications. These are products designed and built around the TCG specifications, known as Trusted Platforms, that are being adopted into the Information Security Services marketplace. Wave devoted a substantial amount of its activities and resources during the year ended December 31, 2003 to organizing its business to capitalize on the opportunities presented by the emergence of the TCG specifications.
In 2004, Wave continued to pursue a strategy of educating the marketplace on the benefits that trusted computing has to offer, while continuing to develop the basic software applications designed to enable this emerging technology. The market trends and opportunities that management focused the company's activities during the year ended December 31, 2004 included the following:
† The market for information security services is growing rapidly-according to industry analyst, IDC, the U.S. market for information security services is expected to grow from approximately $4 billion in 2001 to $10.7 billion in 2006 representing a compound annual growth rate of 21.7%. The global market for information security is expected to reach $23 billion by 2006. (1)
† The persistence of security threats indicates that hardware is needed to provide more robust security than traditional software solutions.
† Emergence of TPM-enabled PCs being sold into the marketplace-this emergence is complementary to Wave's business model, which largely relies upon providing services for Trusted Platforms rather than selling the hardware itself.
† Business and security strategies are becoming more closely aligned due to the increasing rate of significant high profile and costly security breaches and the associated risks presented by this phenomenon.
† In-house security expertise remains in short supply-Wave seeks to capitalize on its expertise as awareness of TPM-enabled solutions increases.
† Microsoft has required TPM version 1.2 in its draft Longhorn operating system hardware requirements specification for logo compliance. Wave believes that a significant percentage of the approximately 150 million unit PC market will include TPMs by May 2006, which is Microsoft's stated launch date for Longhorn.
In pursuing these opportunities, we recognize many significant challenges that must be overcome, including:
† Tight enterprise IT budgets-industry data appear to show that, while enterprise security will be a priority, it will be challenged by tight budgets
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(1) IDC, The Shifting Landscape: U.S. Information Security Services, Jan. 2003, document # 28640.
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† Long sales cycle due to continued lack of support for enterprise spending on security solutions - information security continues to be viewed as an IT issue versus a business issue
† Need to educate the marketplace of the advantages of utilizing hardware-based trusted platforms as a security solution
† Limited availability of capital resources-Wave continues to rely on financing the development of its business by issuing new equity (See Liquidity and capital resources section for a detailed discussion of financing activities during 2004).
As more PC and chip OEMs have begun introducing their Trusted Platform offerings, management has focused on entering into licensing contracts in which the OEM licenses our applications and bundles them with their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such bundling agreements with three separate OEM partners. For the year ended December 31, 2004, Wave received approximately $308,000 in royalties from these OEM partners pursuant to its license agreements with them. Revenue recognized on these contracts through December 31, 2004 totaled approximately $60,000, while the remaining $248,000 is deferred revenue. We continue to pursue OEM business under the royalty model described herein. In addition, we seek to enter into arrangements with resellers that sell to PC OEMs to distribute our applications as a product offering that users may choose when purchasing a TPM-equipped computer from the PC OEM. For instance, in February, 2005, Dell Computers Inc began offering Wave's ETS Software as an option for purchase on select models through their website at Dell.com. Wave hopes to capitalize on this association with Dell products and the wider distribution of TPM-equipped personal computers that a Dell TPM offering represents. In addition, we have sought to develop our products such that they operate on all of the major PC OEM Trusted Platforms that are currently shipping product in the marketplace and our applications have been approved to work with the Trusted Platforms of IBM, HP, Atmel, Infineon and others.
Management is also focused on developing the client and server-side applications and tools that will enable enterprises to manage an IT infrastructure that relies on products built using TCG specifications. Wave is devoting a significant portion of its research and development budget to address this opportunity, as this will be a key ingredient for enterprises in successfully implementing a Trusted Platform solution. Wave released these tools and applications in 2004, and has signed a license agreement in the first quarter of 2005 with an embedded systems manufacturer to license the Wave TCG-enabled toolkit and KTM ES AD.
With respect to sales and marketing, management is focused on broadening our distribution strategies to include the direct engagement of our channel partners using their resellers and systems integrators and has hired regional representation in Japan. We have also expanded our targeted presence selling directly to OEMs. We have specifically focused our resources towards solution selling in these channels. We have reorganized and shifted the focus of our sales force during the year in order to achieve these objectives.
Management is also focused on opportunities for its eTMS product suite to provide digital signing and document management solutions to the financial services and other vertical markets in which there is a clear and identifiable value proposition in implementing these solutions. Although we have met significant implementation challenges and long sales cycles with this effort, we have also experienced significant interest in these products and we continue to pursue this opportunity.
Wavexpress is focused on building a sustainable revenue stream based on establishing partnerships with branded content providers to provide paid and advertising supported video entertainment services. These services are designed into existing web sites and presented as extensions to Microsoft Media Center Edition PC's. The company is extending the technology so that its subscriber management system can leverage the added security of a TPM and is preparing back-office systems for standalone deployment into
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enterprise installations. Wavexpress currently has three active contracts that are generating revenue going into 2005. It is expected that these contracts will generate revenue that is in line with the revenue that Wavexpress has generated in the last two fiscal quarters. Management plans to devote increasing development resources towards building its feature set to meet market demand.
While management is primarily focused on the emerging TCG Trusted Platform opportunities, it remains committed to pursuing business opportunities that involve its proprietary EMBASSY Trust System products and services, primarily in the government sector.
Operating Expense Trends
In addition to the trend of decreasing research and development expenses shown in Item I-Business; selling, general and administrative expenses ("S,G&A") have likewise been trending downward over the three years ended December 31, 2004. For the years ended December 31, 2004, 2003 and 2002 we have incurred approximately $12.3 million, $12.7 million and $19.2 million, in S,G&A expenses, respectively. The activities supported by these expenditures include business development, sales, marketing (including product management), corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions. The downward trend in S,G&A expenses and expenses in general, is indicative of Wave's strict cost-cutting measures, which began during the second half of 2001 and continued through the end of 2003, and have since flattened into 2004. Much of these cost reductions were the result of Wave's abandonment of several lines of business that it had previously been pursuing, including Internet services and consumer e-commerce. In addition, Wave de-emphasized the marketing of its proprietary EMBASSY Trust System platform in 2003 other than to the government security sector. While Wave adjusted its emphasis to focus on the emerging TCG services market segment toward the end of 2002 and into 2003, it drastically reduced several areas within the selling, general and administrative category including product management, sales and marketing, business development and support areas including accounting, human resources, information systems and other corporate overhead, that had supported the higher level of business activity that has now been reduced. The expense reductions being referred to herein came mostly in the form of headcount and outside services expenditure reductions. Now that Wave has begun selling an introductory suite of software applications into the market and has identified and begun developing the next generation of these products that will include key management and infrastructure services, we've begun rebuilding our sales force, expanding our distribution channels and implementing a global sales and marketing strategy.
Although we've reduced our expenditures significantly, given the early stage nature of the markets for products that use our technology, we will continue to expend considerable resources in the sales, marketing, business development and support activities referred to above that will be necessary for us to be successful in developing salable products and markets for our technology. The outlook over the short-term is for sales and marketing expenditures to remain relatively flat, compared with 2004, with research and development remaining at approximately the same level as 2004 as well. (See Liquidity and capital resources)
The following discussion related to the consolidated financial statements of Wave should be read in conjunction with the financial statements appearing in Item 8.
Critical Accounting Policies
Wave's discussion and analysis of its financial condition and results of operations are based on the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of
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assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, accounts receivable reserves, marketable securities, valuation of long-lived and intangible assets, accounting for joint ventures and software development. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The following accounting policies are deemed critical to the understanding of the consolidated financial statements included under Item 8-Financial Statements and Supplementary Data.
Method of Accounting for Joint Ventures-Wave accounts for its investments in joint ventures using the equity method of accounting when its ownership interest in the joint venture is less than fifty percent and it is determined that Wave has the ability to exercise significant influence over the joint venture's operating and financial policies. The financial statements of joint ventures in which Wave owns greater than a fifty-percent interest are consolidated with Wave's financial statements pursuant to Accounting Principles Board ("APB") Opinion No. 18.
Marketable Securities-Investments, which consist solely of equity securities, are accounted for under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities" issued by the Financial Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115, investments are classified as "trading", "available-for sale" or "held to maturity". "Trading" securities are bought and held principally for the purpose of selling them in the near term and are recorded at fair value. Fair value is based upon quoted market prices. Unrealized gains and losses on trading securities are included in the determination of net earnings. "Available-for-sale" securities are being held for an unspecified period of time and may be used for liquidity or other corporate purposes and are recorded at fair value. Unrealized gains and losses on available-for-sale securities are reported as a separate component of comprehensive income (loss) in stockholders' equity. Unrealized losses that are determined to be other than temporary are recognized as charges against earnings. Factors considered when determining if an other than temporary decline has occurred include: whether a decline in market value is related to specific concerns of the issuer of the securities as opposed to general market conditions, the length of time of the decline in market price, the financial condition and near-term prospects of the issuer and other factors that may indicate that the value of the securities will not recover. "Held to maturity" securities are debt securities that are intended to be held to maturity and are recorded at amortized cost. As of December 31, 2004, all of Wave's marketable equity securities are classified as available-for-sale.
Research and Development and Software Development Costs-Research and development costs are expensed as incurred. Software development costs are accounted for pursuant to Statement of Financial Accounting Standards No. 86 "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed" ("SFAS No. 86"). SFAS No. 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development costs until technological feasibility has been established for the product. Once technological feasibility is established and the product has achieved commercial marketability, all development costs should be capitalized until the product is available for general release to customers. We consider technological feasibility to be established upon completion of a detail program design, or in the absence of a detail program design, upon completion of a working model of the software as defined in SFAS No. 86. Judgment is required in determining when the technological feasibility of a product is established, if the product has achieved commercial marketability and in estimating the life of the product for which the capitalized costs will be amortized.
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Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of-Wave reviews the valuation of long-lived assets, including property and equipment and capitalized software, under the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" and SFAS No. 86. Wave is required to assess the recoverability of long-lived assets and capitalized software costs whenever events and circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:
† significant underperformance relative to expected historical or projected future operating results;
† significant changes in the manner of our use of the acquired assets or the strategy of our overall business;
† significant negative industry or economic trends; and
† significant decline in our stock price for a sustained period.
In accordance with SFAS No. 144, when we determine that the carrying value of applicable long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we evaluate whether the carrying amount of the asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of that asset. If such a circumstance exists, we would measure an impairment loss to the extent the carrying amount of the particular long-lived asset or group exceeds its fair value. We would determine the fair value based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. In accordance with SFAS No. 86, when we determine that the carrying value of certain other types of long-lived assets may not be recoverable, we evaluate whether the unamortized cost exceeds the expected future net realizable value of the products. If the unamortized costs exceed the expected future net realizable value of the products, the excess amount is written off. Changes in judgments on any of these factors could impact the value of the asset being evaluated.
Revenue Recognition-Wave's business model targets revenues from various sources including: licensing of EMBASSY Trust Suite, Wavexpress' broadband media distribution and eTMS software products, sales of hardware and development contracts. Many of our sales arrangements include multiple-elements, and/or required significant modification or customization of our software.
Wave follows the provisions of statement of position "SOP" 97-2, Software Revenue Recognition as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Generally, Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Wave reduces revenue for estimated customer returns, rotations and sales rebates when such amounts can be estimated. When these amounts cannot be estimated Wave defers revenue until the product is sold to the end-user. Revenue from software license agreements that have significant customizations and modification of the software product is deferred and recognized in a manner that approximates the percentage of completion method. In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.
PRODUCTS-SOFTWARE AND HARDWARE
Revenue from delivered elements of one-time charge licensed software is recognized at the inception of the license term, provided Wave has vendor-specific objective evidence of the fair value of each undelivered element, for arrangements that contain multiple elements. Revenue is deferred for undelivered elements for these arrangements. Revenue is also deferred for the entire arrangement, if vendor-specific objective evidence does not exist for each undelivered contract element. Examples of undelivered elements in which the timing of delivery is uncertain include contractual elements that give
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customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The revenue that is deferred for any contract element is recognized when all of the revenue recognition criteria have been met for that element.
Prepaid royalty fees received pursuant to distribution software licenses with OEMs in which Wave earns a royalty, based upon units shipped by the OEM to end customers, are deferred when received, and recognized as revenue as units are shipped by the OEM.
Revenue from the sale of hardware components is recognized when persuasive evidence of an arrangement exists, the product has been shipped to the customer, the sales price is fixed or determinable, and collectivity is reasonably assured. All of the product is shipped with ownership passing to the buyer upon leaving our premises and payment terms are generally net 30.
SERVICES
Revenue from time and material service contracts is recognized as the services are provided. Revenue from fixed price, long-term service or development contracts is recognized over the contract term based on the percentage of services that are provided during the period compared with the total estimated services to be provided over the entire contract. Losses on fixed price contracts are recognized during the period in which the loss first becomes apparent. Payment terms vary by contract.
Comparison of the years ended December 31, 2004 and 2003
Results of Operations
For the twelve months ended December 31, 2004 and December 31, 2003, revenues were $209,311 and $189,363, respectively. The increase in revenue is attributable to increases in product, and licensing revenue offset by a decrease in service revenues, as set forth in the following table:
2004 2003 Increase/(Decrease) % Change
Product $ 7,160 $ 3,350 $ 3,810 113.7 %
Services 18,833 65,343 (46,510 ) (71.2 %)
Licensing and Other 183,318 120,670 62,648 51.9 %
Total Net Revenues $ 209,311 $ 189,363 $ 19,948 10.5 %
Cost of sales for the year ended December 31, 2004, was $151,704 compared with $55,179 for the same period in 2003. Gross profit was $57,607 representing a gross profit margin of 28% for the year ended December 31, 2004 while $134,184 represented a gross profit margin of 71% for the year ended December 31, 2003. The decrease in gross profit margin was the result of the higher margins on service contracts in 2003 versus 2004, and higher costs of license revenues in 2004 versus 2003 resulting from the amortization expense of capitalized software costs.
Research and development expenses for the twelve months ended December 31, 2004 were $6,852,754 as compared to $7,384,708 for the comparable period of 2003. This 7% decrease in research and development expenses was primarily attributable to headcount reductions of employees and consultants, which decreased expenses by a total of $640,928 including salary and consultant compensation. Wavexpress' research and development expenses were $1,657,376 for the year ended December 31, 2004 versus $1,873,463, for a reduction of 12%. The amounts set forth for Wavexpress are included in the consolidated amounts referred to above. Also, the reasons for the reduction in expenditures set forth above pertain to both Wave as a whole and Wavexpress.
S,G&A expenses for the twelve months ended December 31, 2004 were $12,255,427 as compared to $12,698,682 for the comparable period of 2003. The 3% decrease in selling, general and administrative expenses was attributable primarily to headcount reductions at both Wave and Wavexpress. Wavexpress
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incurred S,G&A expenses of $1,789,997 in 2004, compared to $2,014,828 for 2003, for a decrease of 11%. The reasons set forth above encompass Wavexpress, as well as Wave as a whole.
For the year ended December 31, 2004, Wave took a charge of approximately $301,000 to write-off developed software that had been capitalized. The software that was written off was developed for a distribution agreement that was entered into with NSC, whereby NSC was to distribute it with their trusted platform module chip. The write-off was the result of the termination of the agreement and because the version of the software that was written off has been discontinued and superseded by a new version. Consequently, the value of the software became impaired because it had no alternative uses. No such impairment charges were incurred in the year ended December 31, 2003. Wave continues to maintain a license agreement with NSC, whereby Wave is paid royalties based on Wave technology that is included in NSC's chip design.
For the year ended December 31, 2003, Wave recorded a write down of approximately $1,114,000, representing the value of its EMBASSY 2100 chips held in inventory. This charge was taken because of the amount of time that continued to elapse without any substantial sales of this inventory coupled with the emergence within the trusted computing market towards TCG-compliant chips that have less functionality than the EMBASSY 2100 chips, but for which the marketplace is more readily accepting at this stage in the development of the trusted computing market.
Other Income and Expenses
Interest income for the year ended December 31, 2004 was $24,931 versus December 31, 2003 of $74,822 for a decrease of 67%. The decrease in interest income is primarily attributable to interest income having been recognized on the officer loan recovery referred to below for the year ended Deceember 31, 2003, and from a decrease in interest-bearing assets during 2004.
Wave sold 2,507,300 shares of its holdings of SSP Solutions, Inc., common stock and 966,300 shares of Saflink Corporation common stock during the year ended December 31, 2004, for total proceeds of $6,759,748, recording a realized gain of $4,330,248 on the sales. In August, 2004, SSP Solutions, Inc. merged with and became a wholly-owned subsidiary of Saflink Corporation. For the year ended December 31, 2003, Wave sold 332,500 shares of SSP for proceeds of $430,934, realizing an aggregate gain from the sales of $234,759.
During the fourth quarter of 2003, Wave incurred $155,716 in liquidated damages in connection with the issuance of 3,725,263 shares of its Class A Common Stock at a price of $1.90 per share and warrants to purchase 931,309 shares of Class A Common Stock at an exercise price of $2.62 per share in a private placement to a group of accredited investors for proceeds of approximately $6,562,000, net of issuance costs of approximately $516,000. The shares were issued pursuant to a securities purchase agreement dated November 18, 2003 between Wave and certain purchasers. Pursuant to a related registration rights agreement, if Wave did not file a registration statement for the shares within 30 days from the date of the closing of the securities purchase agreement, Wave would be required to pay liquidated damages to each purchaser equal to 2% of each purchaser's subscription amount, for each month elapsed beyond the 30 day deadline. Because Wave was not able to file the registration statement until one month and three days after the 30 day deadline, Wave incurred an aggregate of $155,716 in . . .
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