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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the period ended December 31, 2003
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
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Commission file Number 0-12965
NESTOR, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 13-3163744
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(State of incorporation) (I.R.S. Employer
Identification No.)
400 Massasoit Avenue; Suite 200, East Providence, Rhode Island 02914
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(Address of principal executive offices) (Zip Code)
(401) 434-5522
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(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 Par Value
(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period than the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
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Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
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The aggregate market value of the 4,897,156 shares of voting stock held by
non-affiliates of the registrant on June 30, 2003, based on the closing price of
such stock on June 30, 2003, was $9,794,312.
The number of shares outstanding of the Registrant's Common Stock at March 16,
2004 was 18,009,526.
DOCUMENTS INCORPORATED BY REFERENCE
Sections of Nestor, Inc.'s definitive Proxy Statement for the 2004 Annual
Meeting of Stockholders are incorporated by reference into Parts II and III of
this report.
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PART I
ITEM 1. Business
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GENERAL
Nestor, Inc., and its wholly owned subsidiary Nestor Traffic Systems, Inc.
(together the "Company"), provides traffic safety solutions and services to
states and municipalities. The Company's products combine sophisticated digital
and analog video technologies with advanced image-processing to detect and
interpret a wide range of traffic-related elements and conditions. Using the
captured video images, Nestor applies proprietary neural network predictive
models and other algorithms to convert existing data into meaningful
recommendations and actions. This advanced technology, which effectively sees
and interprets objects captured in video images, is at the core of each product
solution. These products are a combination of Nestor-developed software and
modular hardware components that provide monitoring for traffic-data collection,
control of traffic flows, enforcement and emergency response. These products are
flexible and can be configured to a wide range of road configurations, including
open roads and intersections. The Company's systems offer an array of features
and unique functionality that address critical transportation management and
traffic safety needs. The Company formerly developed and marketed products in
the fields of risk management, customer relationship management and character
recognition.
The Company is currently devoting its resources to its core product,
CrossingGuard(R), and expects that all material revenue will come from
CrossingGuard or associated products and services. Offered as part of a turnkey
system for automated red light enforcement, CrossingGuard(R) is tailored to meet
clients specific needs, including intersection analysis, hardware and software
installation, user training and support, and backroom processing. The
CrossingGuard system provides a unique combination of aboveground vehicle
detection, multiple time-synchronized videos, and a collision avoidance safety
feature.
Exclusive rights in the field of traffic-management solutions were granted
Nestor Traffic Systems, Inc. (NTS) on January 1, 1997; co-exclusive rights in
the field of Risk Management and non-exclusive rights in the field of Customer
Relationship Management Systems (CRM) are held by Applied Communications, Inc.
(ACI) and Retail Decisions, Inc. (ReD); and non-exclusive rights in the field of
Intelligent Character Recognition Systems (ICR) are held by National Computer
Systems, Inc. (NCS). IBM has non-exclusive rights to incorporate Nestor's
technology into hardware products known as the ZISC family of computer chips.
NTS is an emerging leader in providing innovative, video-based monitoring
systems and services for traffic management and safety. NTS incorporates
patented pattern-recognition technologies into intelligent, real-time solutions
that promote traffic efficiency, intersection safety, and railway grade crossing
monitoring and safety. In the past, NTS has developed and marketed
CrossingGuard(R), Rail CrossingGuard(R), and TrafficVision(R). These products
are a combination of Nestor-developed software and modular hardware components
that provide monitoring for traffic-data collection, control of traffic flows,
enforcement and emergency response. These products are flexible and can be
configured to a wide range of road configurations, including open roads and
intersections.
In June 2002, the Company underwent a significant restructuring involving
management changes and cost control to lower personnel and facilities expenses
as the Company refocused its efforts solely on its red-light video enforcement
contracts for CrossingGuard(R) installations. The Company terminated 19
full-time employees, affecting all departments, and offices were consolidated
into smaller facilities.
Information about the industry segments and geographic areas in which the
Company operates can be found in Note 11 to the financial statements included in
this report.
PRODUCTS
The Company's traffic enforcement products use high speed image processing and
target-tracking technology applied to real-time video scenes. The products use
software and video cameras to detect red light violators at signalized
intersections.
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CrossingGuard(R). CrossingGuard is an automated, video-based monitoring system
that predicts and records the occurrence of a red light violation. The software,
through a video camera, tracks vehicles approaching an intersection. Based on
the vehicle's speed, acceleration, and distance from the intersection, the
system predicts whether a red light violation will occur. If a violation is
expected to occur, the system can send a signal to the traffic controller to
request a brief extension of the red phase for cross traffic. This helps prevent
a collision between the violator and vehicles in the cross traffic accelerating
on a green signal. The system simultaneously records the violation sequence,
including a close-up of the vehicle and license plate, and transmits video
evidence electronically to the police department, which reviews the violation
and issues a citation. Citation mailing and other back-office services are
provided by the Company.
The Company provides a complete turnkey solution, offering violation review,
citation preparation and processing, billing and collection, court scheduling,
evidence, and resolution. In addition, the Company provides direct, remote, and
online equipment monitoring and maintenance primarily through its field and
office personnel and through local contractors as necessary.
The CrossingGuard system consists of a video camera installed on top of a
traffic signal pole or a roadside pole installed by the Company used to track
approaching vehicles and record the actions of an approaching violator. Another
camera is positioned so as to see the signal heads as they change from green to
yellow to red and record the vehicles actions as the lights change and it enters
the intersection. The views from these two cameras can also be presented in a
side-by-side synchronized mode to demonstrate the complete view of the
violation, including extenuating circumstances, aggressive behavior, or other
factors. Finally, an enforcement camera is positioned to obtain a close-up image
of the vehicle license plate, and where needed the driver image, based upon
vehicle location instructions provided by the tracking camera. A personal
computer is installed in an enclosure by the wayside, or remotely if a fiber
connection to the roadside is used, that runs the intelligent software and
controls camera activity. High-speed communications transmit video and data from
the intersection to a designated facility for processing. The facility is
equipped with a CrossingGuard Server PC that receives and stores violation data
and supports authorized viewing of violation video sequences.
CrossingGuard is built upon standard PC hardware and software components. This
design provides the reliability and performance benefits of improving PC
hardware and the ability to upgrade and add functionalities as needed. The
Company purchases components from third party vendors, built in accordance with
Nestor's specifications, and the systems are installed by local contractors.
CrossingGuard VIP. The CrossingGuard Video Intersection Profiling (VIP) program
is a proprietary tool that the Company has developed to help municipalities
pre-qualify intersections. Since intersection violation rates can range from an
average of a few per day to over fifty per hour, the system helps the
municipality develop an estimate of safety issues at a given intersection and
the long-term ticket volume by counting and profiling violations for all
directions at a particular intersection.
CrossingGuard Services. CrossingGuard Services is the complete package of
services and support that can be customized to a client's needs. It consists of
site planning and equipment installation, equipment maintenance, user training
and support, violation review, citation preparation and processing, fine
collection and processing, account management, toll free hotline support, public
education, and expert testimony.
The economics of the CrossingGuard product are tied to the number of violations
processed by the systems and the number of operating systems in the field. Most
contracts compensate NTS on a per ticket paid or issued basis in return for both
equipment lease, maintenance and back office services. Generally, but not in all
cases, the contracts require a monthly minimum fee designed to allow NTS to
recover the value of the system delivered, including a finance factor and
maintenance costs, over the term of the contract. During 2003, there has been a
trend by states towards fixed monthly fee as opposed to variable per ticket fee
pricing structures.
As of December 31, 2003, NTS had 90 approaches installed and generating
citations, including two pilot program approaches, and an additional 47
approaches under contract and in various stages of delivery. In March 2004, NTS
executed a new contract for up to an additional 40 approaches (20
intersections). No assurances can be given that all approaches under contract
will ultimately be installed. The Company realizes from $25 to $97 per citation
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issued or paid or fixed monthly fees ranging from $4,000 to $12,000 per approach
for system delivery and lease, maintenance, software licensing, and processing
services, depending upon state statutes regarding driver versus registered owner
liability for a violation. Driver liability statutes require the driver be
identified in the photographic evidence and the citation be sent to the
identified driver. Registered owner statutes identify the vehicles owner,
through DMV records, as the responsible party for a violation. As only the
license plate is required for identification, program operating efficiencies are
much higher resulting in lower per citation or monthly fees to cities. Current
trends in the industry are towards compensating red-light program vendors on a
fixed fee basis instead of a variable fee basis tied to ticket volumes. Actual
results from deployment of CrossingGuard systems are expected to fluctuate
substantially depending upon intersection selection and configuration, driver
response to installed systems, and many other factors. Minimum monthly fee and
fixed monthly fees would reduce the risk of fluctuations in citation capture and
issuance rates.
During 2003, NTS realized $2,677,000 in CrossingGuard related revenues, a 217%
increase over the $844,000 earned in 2002 due to the increase in installed
approaches during the respective periods.
Status of the CrossingGuard market. Ineffective red-light safety enforcement is
a costly and growing problem that until recently has been largely unaddressed by
technology solutions. There are an estimated 300,000 intersections with traffic
signals in the United States where approximately 218,000 collisions and as many
as 181,000 injuries and 880 deaths occurred as a result of red-light running as
per Federal Highway Administration 2001 statistics. First-generation Red-Light
Camera Systems gained early acceptance as a means of automated traffic
enforcement. While these systems have validated the market opportunity, they
generally continue to rely on in-ground vehicle sensors ("loops") and still
photography and have become inferior solutions because of their (i) significant
roadbed installation issues, (ii) high maintenance requirements, and (iii)
general lack of functionality.
The use of cameras to enforce red light running violations requires specific
authority at the state or local government level (state statutes or home rule
statutes). To date, approximately 15 states, including the District of Columbia,
have authorized on a full or limited basis the use of red light cameras. Recent
studies have shown these systems to be effective in reducing red light running
at enforced intersections, and a positive halo effect at surrounding unenforced
intersections. The Federal Highway Administration and other organizations have
recently acknowledged these systems as positive tools in the reduction of red
light running and correspondingly the number of accidents. However, there
remains opposition to these systems, largely based upon concerns regarding
individual privacy rights and due process rights. Many additional states and
communities have or are considering authorization of cameras but need to address
these minority concerns first. The Company believes that the overall trend is
towards expanded state authorization of camera based red light enforcement
systems, and eventually speed enforcement systems, but it is difficult to
estimate when these changes may occur. The Company also believes that business
opportunities from the currently authorized communities will be enough to
support near term growth objectives.
Rail CrossingGuard. NTS developed Rail CrossingGuard, a system to monitor
grade-crossing vehicle and train traffic, as well as signalization activity, to
provide grade-crossing-integrity measurement, real-time crossing alert
capabilities and crossing violation enforcement. This product has the potential
to enhance rail-crossing safety by improving signal and crossing gate
monitoring, alerting personnel to dangerous crossing situations, and enforcing
train and vehicle safety regulations. Rail CrossingGuard may also be integrated
with train communications systems to provide a method of alerting trains to
dangerous rail crossing conditions.
On April 1, 2001, NTS completed its first Rail CrossingGuard installation in
DuPage County, Illinois and had completed design work necessary to commence
construction on the delivery of five Rail CrossingGuard units in Florida. In
addition, NTS had received a contract from the Federal Railroad Administration
(FRA) to develop a portable Rail CrossingGuard unit for non-permanent data
gathering capabilities. Also, NTS, working with GeoFocus, Inc., a Florida
company, won a contract to expand two of the Rail CrossingGuard units in Florida
to incorporate remote communication capabilities between Rail CrossingGuard
units and train operators. During 2003, NTS realized $10,000 in Rail
CrossingGuard related revenues as compared to $426,000 in 2002. During 2002, the
Company reduced its marketing and sales efforts in this product line to focus
its resources on the CrossingGuard red-light enforcement market. The Company
does not expect to receive material revenue related to Rail CrossingGuard in the
future.
TrafficVision. TrafficVision is a product that uses video cameras to monitor
traffic flow and to send traffic data to a central Traffic Operations Center.
Replacing short-life, high-maintenance, road-embedded copper-loop technologies
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from the 1950's, TrafficVision is a non-intrusive sensor system for traffic
management. TrafficVision uses Nestor's proprietary high-speed image-processing
technology to analyze video content to sense and monitor traffic on highways,
roadways and intersections in real-time. TrafficVision recognizes and classifies
multiple vehicles continuously so that surveillance and traffic management are
based upon detailed, real-time information. TrafficVision is installed at 26
locations in Rhode Island and in the state's centralized Traffic Operations
Center in Providence. During 2002, NTS realized $187,000 in TrafficVision
related revenues and no such revenues in 2003. During 2002, the Company reduced
its marketing and sales efforts in this product line to focus its resources on
the CrossingGuard red-light enforcement market. The Company does not expect to
receive material revenue related to TrafficVision in the future.
The following are the primary attributes of NTS products and services:
Accurate, real-time interpretation of traffic video images. NTS has applied
Nestor's high-speed pattern-recognition technologies in real-time processing and
video-image interpretation for traffic management, enforcement and safety. Prior
industry attempts to provide video-based detection of traffic have not proven
effective due to the difficulty of designing robust detection algorithms under a
variety of illumination, visibility and traffic conditions, as well as the need
to implement such algorithms on cost-effective computing platforms that provide
real-time operation. Nestor's image-understanding technology is able to
interpret video images accurately and respond in a real-time environment at
affordable cost.
Vehicle trajectory analysis for real-time forecasting. As each frame in a video
sequence is interpreted, the individual objects in the scene are identified and
located. This information, passed from frame to frame, enables accurate tracing
of vehicles' trajectories. Unlike competitive vision systems, which note
changing images in a fixed and static area of the image (so-called virtual
loops), NTS's proprietary vehicle-centric technology can use the trajectories to
predict vehicle positions. In the CrossingGuard application, when a vehicle is
about to run a red light, a signal can then be sent to the traffic controller to
extend the all-red phase of the traffic signal so that cross traffic vehicles
can be briefly delayed before they proceed into the intersection. Thus,
intersections equipped with CrossingGuard have the potential to become smarter
and safer.
Compatibility with industry standard platforms. NTS traffic monitoring solutions
are built upon dominant industry-standard platforms: namely, Microsoft Windows
operating systems, tools and communication components and general "WinTel"
hardware specifications. This facilitates integration into a customer's existing
computing environment, leverages PC economics to offer a compelling
price/performance advantage and lowers product engineering development costs.
Additionally, the traffic monitoring systems are designed to support the
emerging NTCIP communications standards being mandated in the traffic industry.
Further, roadside detector stations will be compatible with existing and new
traffic controller hardware, such as the CALTRANS 2070 controller standard.
Description of other products and services:
In 2001, Nestor ceased direct product development, sales and support in the
fields of fraud detection, financial risk management, and CRM. The Company does
not expect to receive material revenue related to fraud detection, financial
risk management, or CRM in the future. Through license agreements entered into
with ACI on February 1, 2001, and with ReD on May 18, 2001, co-exclusive
development, sales and support rights were granted to these resellers in fraud
and risk management; and non-exclusive rights in the field of CRM were granted
to ReD. In addition, all expenses associated with development, support and
selling these products were transferred to these parties.
Nestor's PRISM(R) fraud detection solutions help financial institutions detect
and prevent fraudulent payments, manage merchant risks and identify illicit
account usage (money laundering). The fraud detection products are used by many
of the world's largest financial institutions and represented approximately 31%
and 87% of Nestor's 2002 and 2001 revenues, respectively. Effective July 1,
2002, the Company assigned its ACI royalty rights (Note 13) and no longer
receives product royalties.
Nestor's ICR applications increase productivity in document image-processing
applications. Royalties from the ICR business represented less than 1% of
Nestor's 2003 and 2002 revenues.
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Nestor's technology is licensed to IBM on a non-exclusive basis for
incorporation into hardware products known as the ZISC family of computer chips.
Royalties from the IBM business represented less than 1% of Nestor's 2003 and
2002 revenues.
Sales, Marketing and Methods of Distribution
The Company distributes and markets its intelligent traffic-management solution
(ITS) software and services in North America through a direct sales
organization. The Company distributed its other software solutions in North
America and throughout the world through third- party licensing and distribution
agreements.
Currently, the Company markets its products and services to municipalities,
governmental traffic management departments, or their integrators through its
Providence and San Diego based two-person direct sales force. Since the traffic
products require technical assistance during the sales and installation
processes, the Company also maintains an in-house staff of four program managers
and eight engineers. The Company obtains product inquiries from product
mailings, attendance at trade shows, trade press coverage and its Internet site.
Most CrossingGuard contracts are obtained through competitive proposal processes
in response to RFP's issued by municipalities.
The Company's Intelligent Character Recognition products are marketed by NCS.
The Company's PRISM and eCLIPSE products are licensed through two distributors,
Applied Communications, Inc. (ACI) and Retail Decisions, Inc., primarily to
financial institutions. Effective with the sale of the future royalty revenues
due from the ACI license to Churchill Lane Associates, LLC (CLA) on September
30, 2002, no future revenues related to the PRISM business are expected to be
realized by the Company.
During 2002, ACI accounted for 31% of the Company's revenues. During 2002, Other
Income of $2,812,000 was recorded as a result of the sale of the ACI royalty
rights to CLA. No such revenues were recorded in 2003
Pattern-Recognition Technology
The Company's technology deals with the problem of pattern recognition within
complex data. When presented with complex high-volume data, it can be valuable
to identify target patterns of information often hidden in that data, whether
patterns of fraudulent credit card use, customer buying behavior, handwritten
characters, objects in a video stream, vehicles in a traffic flow, or others.
Several methods currently exist to address the problem of processing information
in order to recognize a pattern in the information. Included among these are
"expert systems" of rules, statistical analysis, and neural networks. The
Company's products may combine all of these methods to optimize pattern
recognition capabilities.
Neural-networks simulate a virtual network of interconnected units, processing
data in parallel, and communicating with each other at high speeds. A trained
neural-network receives input and then outputs a response - either
"unrecognized", "recognized", or "not sure". Exceeding the capability of
if-then-else conditional rules, the power of the neural-networks is in their
ability to accurately recognize patterns in multi-dimensional non-linear input,
such as attempting to recognize characters from a scanned handwritten sample,
which is ill-defined, affected by "noise", or blatantly unusual (i.e. overly
large or small, or containing skewed characters). The Company, as the result of
extensive research, has created a proprietary neural-network technology referred
to as the Restricted Coulomb Energy Model(TM) (RCE), which has been granted five
patents.
The Company has also been granted a sixth patent for a multi-unit system
referred to as the Nestor Learning System(TM) (NLS), which is ideally suited for
many real-world pattern recognition applications. The NLS has a patented
hierarchical, multi-network system for better control and accuracy. The Company
believes that the rapid model development and operational flexibility afforded
by its technology provides a competitive advantage in the development of
intelligent-decision software solutions.
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RESEARCH AND DEVELOPMENT ACTIVITIES OF THE COMPANY
The Company continues to develop and improve its technologies and products and
to develop new technologies and products. The Company intends to pursue new and
enhanced technologies and products. The Company attempts to locate external
resources to assist in funding the costs of developing new technologies or
products, but may bear all of such costs internally.
The Company's research is almost entirely applied research intended to develop
solutions to specific pattern-recognition problems. This research has resulted
in various patents and patents pending relating to improvements to the Company's
basic technology (see "Patents"). The Company has additional patent applications
pending as of December 31, 2003, primarily in the area of traffic management,
enforcement and safety.
The market for the Company's products may be impacted by changing technologies.
The Company's success will depend upon its ability to maintain and enhance its
current products and develop new products in a timely and cost-effective manner
that meets changing market conditions. There can be no assurance that the
Company will be able to develop and market on a timely basis, if at all, product
enhancements or new products that respond to changing market conditions or that
will be accepted by customers. Any failure by the Company to anticipate or to
respond adequately to changing market conditions, or any significant delays in
product development or introduction could have a material adverse effect on the
Company's business, financial condition and results of operations.
The Company expended $121,000, $1,604,000 and $1,641,000 in the years ended
December 31, 2003, 2002 and 2001 respectively, in support of the various aspects
of Company-sponsored research and development.
PATENTS
The Company has continually sought and obtained patent protection for its
proprietary neural networks and other systems, which have as a principal feature
rapid learning from a relatively small number of examples or the application of
video techniques in traffic management applications. The Company's RCE neural
network exhibits rapid learning and minimizes the internal connections needed
for it's functioning. The Company believes that these capabilities make the
Company's technology uniquely suited to applications that require field
trainability or self-modification to adapt to new or changing patterns in the
data. The Company's patents also cover multiple-neural-network systems, which
enable the company to develop products that combine high accuracy with high
processing speeds.
During 2003, the Company received two additional patents relative to the
CrossingGuard product line. The first issued in June 2003 recognizes the
Company's method of predicting and recording a red light violation with a
video-based system including the use of violation probability scores. The second
patent issued in November 2003 defines a system and method of detecting and
filtering non-violations in a traffic light enforcement system employing a video
camera to improve the effectiveness of the system.
During 2002, the Company received two additional patents relative to the
CrossingGuard product line. The first patent recognizes the Company's invention
of providing for a collision avoidance feature in a video-based red light
enforcement system. The second patent recognizes the invention of a video-based
red light enforcement system integrating a client management system integrated
with a court scheduling system for ticket processing and issuance.
The Company owns 10 United States patents and 5 foreign patents issued in four
countries, Australia and Europe. The foreign patents correspond to one or more
of the United States patents. The United States patents expire at various times
from 2006 to 2021.
COMPETITION
The Company believes that CrossingGuard is more technologically advanced than
most competing systems for traffic safety enforcement. Its competition generally
consists of "wet film" or digital still image red light camera systems. These
systems generally rely on in-ground sensor loops and wet film, or on digital
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still cameras that record only a few frames of evidence regarding a violation.
For wet film systems, there is the added burden of retrieving, replacing,
developing, and scanning the film. By the end of 2003, most competitors have
developed digital still systems and do not promote wet film applications. The
Company is aware of two competitors that have included video cameras in their
systems. The Company has initiated patent infringement lawsuits against these
competitors on the basis of its February 13, 2001 patent entitled "Integrated
Traffic light Violation Citation Generation and Court Date Scheduling System".
See "Item 3 -- Legal Proceedings." There can be no assurance that the Company
will be successful in defending this patent and limiting the use of video by
competitors in the U.S. red light enforcement market.
CrossingGuard vehicle detection cameras, on the other hand, are installed above
the ground, on roadside poles or if needed, mast arms. (This helps avoid some of
the logistical problems associated with installing in-ground sensors at an
intersection.) In case of a dispute, unlike non-video systems, the violation
video sequence has the ability to provide an instant replay of the event. Its
digital video evidence consists of both front and rear vehicle images and is
viewed by the police who then issue (or give authorization to issue) a citation.
This ensures fairness so that violations may not be issued out of context (e.g.,
if the violation occurred to make way for an emergency vehicle, as part of a
funeral procession, or to avoid a crash). This perception of fairness makes the
Company's video evidence attractive to city councils, law enforcement officials,
courts, and the general public.
NTS's largest competitors in the intersection market are Affiliated Computer
Services, Inc. (ACS), which has the greatest number of red-light camera systems
installed, and Redflex Traffic Systems, Inc. (Redflex). Among others are Laser
Craft, Mulvihill ICS, Peek Traffic, Poltech, Traffipax, Transol, and Transcore.
Although these companies use buried loops, still or digital cameras and/or wet
film systems, some may pose a competitive threat due to their size, market
share, legacy customer relationships, enhanced driver image, additional products
offered, and/or citation-processing experience.
NTS's TrafficVision and Rail products face competition primarily from
traffic-management-systems companies such as ISS, Econolite, Traficon, Iteris,
Peek Traffic, Odetics, Computer Recognition Systems, Siemens, Sumitomo, and
Rockwell International. Management believes that the platforms on which these
products operate do not provide the image processing capabilities possessed by
TrafficVision and Rail CrossingGuard. However, the Company is not currently
investing substantial finances in the development, marketing or sales of these
product lines.
Most of the Company's competitors in the ITS market have significantly greater
financial, marketing and other resources than the Company. As a result, they may
be able to respond more quickly to new or emerging technologies or to devote
greater resources to the development, promotion and sale of their products than
the Company. Competitive pressures faced by the Company may materially adversely
affect its business, financial condition and results of operations.
CONTRACTS WITH GOVERNMENTAL ENTITIES
NTS's CrossingGuard agreements are generally service contracts with states or
municipalities that in most circumstances may be cancelled by the customer for
various reasons including non-appropriation of annual program funding. As these
contracts are generally self-funded from ticket fees collected from red-light
violators and some contracts contain termination fee provisions, NTS does not
expect this to be a significant risk in the future. NTS's Rail CrossingGuard and
TrafficVision contracts were generally fixed-fee deliverable contracts and
termination rights were generally limited to non-performance conditions. NTS
retains all patent and other proprietary rights from products developed and
delivered under government-supported contracts.
EMPLOYEES
As of December 31, 2003, the Company had 49 full-time employees, including 11 in
software engineering and product development, 11 in processing and system
support, 17 in program management and field services, 3 in sales and marketing
and seven in management, finance and office support. All of these employees are
located in the United States. None of the Company's employees are represented by
a labor union. The Company has experienced no work stoppages and believes its
employee relationships are generally good.
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The Company's success depends to a significant degree upon the continued
employment of the Company's key personnel. Accordingly, the loss of any key
personnel could have a materially adverse effect on the Company's business,
financial condition and results of operations. The Company believes its future
success will depend upon its ability to attract and retain industry-skilled
managerial, engineering, software development and sales personnel, for whom the
competition has been intense. In the past, the Company has experienced
difficulty in recruiting a sufficient number of qualified engineering and sales
people. In addition, competitors may attempt to recruit the Company's key
employees. There can be no assurance that the Company will be successful in
attracting, assimilating and retaining such qualified personnel, and the failure
to attract, assimilate and retain key personnel could have a materially adverse
effect on the Company's business, financial condition and results of operations.
LICENSING, JOINT VENTURE AND DEVELOPMENT AGREEMENTS
The Company entered into license agreements and research and development
contracts in order to obtain greater market penetration and additional funding
of the development of its technology in specific fields of use.
Applied Communications, Inc. (ACI) On February 1, 2001, the Company entered into
a new non-exclusive license agreement with Applied Communications, Inc., a
subsidiary of Transaction Systems Architects, Inc. Pursuant to the license
agreement, ACI has been granted the right to integrate and distribute all of the
Company's PRISM and fraud detection products throughout ACI's worldwide sales
and support network. ACI paid $1.1 million to the Company in four equal
installments over the four months following February 1, 2001, and was required
to make guaranteed minimum royalty payments during the first year in an amount
of approximately $500,000. The license requires the payment of a 15% royalty
starting on February 1, 2002, but no further guaranteed minimum royalty payments
will be required. This agreement replaces the license agreement signed with ACI
on April 18, 1997. Additionally, ACI hired twelve of the Company's engineering,
modeling, and customer support employees and assumes responsibility for product
enhancements, installation, modeling, and support for ACI licensees. The Company
sold the royalty rights to CLA on July 1, 2002. The Company does not expect to
receive future revenues from this license.
Retail Decisions, Inc. (ReD) On May 18, 2001, Nestor entered into a license
agreement with Retail Decisions, Inc. in which Nestor granted to ReD: (i) an
exclusive (other than ACI), perpetual, fully-paid, worldwide license in the
field of use of fraud and money laundering detection and risk management in
certain defined industries; and (ii) a non-exclusive, perpetual, fully-paid,
worldwide license solely for use in the field of use of customer relationship
management in certain defined industries. Additionally, Nestor transferred to
ReD certain assets that were supportive of the technology licensed thereunder.
The assets transferred to ReD by Nestor include all of the right, title and
interest of Nestor in certain equipment, license agreements (excluding ACI) and
trademark rights. To support its newly acquired license, ReD hired 13 of
Nestor's employees. ReD paid $1,800,000 to Nestor under the license agreement,
and Nestor agreed, for certain marketing and transition services, to pay to ReD:
(i) $500,000 which was paid on July 2, 2001; (ii) $250,000 which was paid on
October 1, 2001; and (iii) $218,000 which was paid on December 31, 2001. The
Company recorded $832,000 as net license revenue in the second quarter in
connection with this agreement. No ongoing revenues are expected to be realized
from ReD.
National Computer Systems, Inc. (NCS) On June 11, 1996, the Company entered into
an exclusive Licensing Agreement and an Asset Purchase Agreement with NCS
transferring the development, production, and marketing rights of the Company's
Intelligent Character Recognition (ICR) products to NCS. In June 1998, NCS did
not meet its minimum royalty for the license year and forfeited exclusive
rights. NCS continues to market the ICR products on a non-exclusive basis.
Nestor receives approximately $25,000 in minimum royalties per year under this
license.
ITEM 2. Properties.
----------
In 2000, NTS entered into a five-year lease for offices providing 9,600 square
feet for approximately $10,800 per month located at 400 Massasoit Avenue, East
Providence, Rhode Island 02914. NTS also maintains a local field office at 737
Pearl Street, La Jolla, CA 92037 on a month-to-month lease dated August 2002,
and pays approximately $1,500 per month. NTS also maintains a local field office
at 330 East Orangethorpe Ave. in Placentia, CA on a twenty-four month lease
dated March 2004, and pays approximately $1,400 per month. The Company believes
10
these facilities are adequate to meet its current needs and will require
additional space as new installations increase processing and support hiring
needs.
In April 2001, NTS entered into a forty-six month sublease for its California
operations at 10145 Pacific Heights Blvd., San Diego, CA 92121 providing for
approximately 5,700 square feet for $12,050 per month. As a result of the
Company's reorganization in early 2002, NTS could no longer use the amount of
space leased. Due to past due lease payments, the landlord terminated the lease
and notified NTS to leave the premises, which NTS did in early August 2002. The
Company is carrying a reorganization reserve related to projected costs of
settling this lease obligation, and reached a settlement with the landlord under
terms within the reserve established.
ITEM 3. Legal Proceedings.
-----------------
On November 6, 2003, the Company filed a complaint in the United States District
Court for Rhode Island against Redflex Traffic Systems, Inc., alleging that
Redflex's automated red light enforcement systems infringe the Company's patent.
Redflex denies this allegation. On November 25, 2003, the Company filed a
complaint in the United States District Court for the District of Central
California against Transol USA, Inc., alleging that Transol's automated red
light enforcement systems infringe the Company's patent. Transol has
counterclaimed that Nestor's patent is invalid and that Transol does not
infringe on it. Nestor was denied a preliminary injunction in the Transol
litigation. The Company cannot give assurance that we will be successful in
either action.
During April 2003, the former president of NTS resigned as a member of the board
of directors of the Company. The president's employment with the Company and NTS
terminated. The president filed a complaint against the Company and NTS in the
Providence Superior Court seeking severance benefits, including twelve months
salary of $180,000, upon termination. See Form 8-K dated April 9, 2003 for
further information. The parties reached a mutually agreeable settlement on
December 31, 2003, the terms of which are confidential. All claims have been
dismissed.
ITEM 4. Submission of Matters to a Vote of Security Holders.
----------------------------------------------------
No matters were submitted to a vote of security holders during the fourth
quarter of the year ended December 31, 2003.
11
PART II
ITEM 5. Market for Registrant's Common Stock and Related Stockholder Matters.
--------------------------------------------------------------------
The Company's common stock was first offered to the public in December 1983 and
is traded on the Nasdaq OTC Bulletin Board under the symbol "NESO." The prices
below have been adjusted to reflect the 1 for 10 reverse stock split during the
second quarter of 2003. Before the stock split, the Company's common stock
traded under the symbol "NEST."
Low High
--- ----
Year Ended December 31, 2003
- ----------------------------
1st Quarter $ .30 $ 1.90
2nd Quarter $ .80 $ 2.60
3rd Quarter $ 1.30 $ 2.05
4th Quarter $ 1.60 $ 4.90
Year Ended December 31, 2002
- ----------------------------
1st Quarter $ 4.50 $10.30
2nd Quarter $ 1.80 $ 5.80
3rd Quarter $ .80 $ 2.80
4th Quarter $ .20 $ 1.00
Holders of Common Stock
At March 18, 2004, the number of holders of record of the issued and outstanding
common stock of the Company was 483, which includes brokers who hold shares for
approximately 1,555 beneficial holders.
Dividend Policy
The Company has not paid any cash dividends with respect to its common stock
since formation and does not expect to pay cash dividends in the foreseeable
future.
Securities Authorized for Issuance Under Equity Compensation Plans
Incorporated by reference from the Company's definitive proxy or information
statement to be filed with the Securities and Exchange Commission not later than
120 days following the end of the Company's fiscal year.
Recent Sales of Unregistered Securities
On December 31, 2003, the Company exercised its option to satisfy its
obligations to Silver Star Partners I, LLC under a $2,000,000 principal amount
convertible note by issuing 676,384 shares of the Company's common stock at a
conversion price of $3.00 per share.
The Company issued 2,843,000 shares of its common stock in January 2004 in a
series of private placements made to accredited investors, at an aggregate price
of $8,529,000. In connection with those private placements, the Company paid an
aggregate sales commission of $682,320. The shares of common stock were issued
without registration under the Securities Act in reliance on the exemption
provided by Section 4(2) of the Securities Act.
On January 14, 2004, the Company issued to Laurus Master Fund Ltd. ("Laurus") a
Convertible Note (the "Note") in the principal amount of $1,500,000 that bears
interest at the prime rate plus 1.25% (subject to a floor of 5.25% per year) and
12
matures on January 14, 2006. The Note may be repaid at the Company's option, in
cash or, subject to certain limitations, through the issuance of shares of
common stock. The Company will have an option to pay the monthly amortized
amount in shares at the fixed conversion price of $3.50 per share if the shares
are registered with the Securities and Exchange Commission ("SEC") for public
resale and the then current market price is 120% above the fixed conversion
price. The Note includes a right of conversion in favor of Laurus. If Laurus
exercises its conversion right at any time or from time to time at or prior to
maturity, the Note will be convertible into shares of the Company's common stock
at a fixed conversion price, subject to adjustments for stock splits,
combinations and dividends and for shares of common stock issued for less than
the fixed conversion price (unless exempted pursuant to the Company's agreement
with Laurus). In conjunction with this transaction, Sage Investments, Inc. will
be paid a fee of $60,000. The Company has agreed to file a registration
statement with the SEC to register the public resale by Laurus of the common
stock to be issued upon conversion of the Note. The Note was issued without
registration under the Securities Act in reliance on the exemption provided by
Section 4(2) of the Securities Act.
ITEM 6. Selected Financial Data.
-----------------------
The following data includes the accounts of Nestor, Inc. for all periods
presented and NTS for the period September 13, 2001 through December 31, 2001
and the years 2003 and 2002. (From January 1, 1999 through September 12, 2001,
the Company's investment in NTS was recorded on the equity method.)
Years Ended December 31,
----------------------------------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Revenue $ 2,705,534 $ 2,121,574 $ 3,520,924 $ 3,652,422 $ 5,114,779
Operating income (loss) $ (4,261,045) $ (15,127,235) $ (1,297,145) $ (1,548,777) $ 742,451
Contract termination reserve $ (125,000) $ --- $ --- $ --- $ ---
Gain on royalty assignment $ --- $ 2,811,590 $ --- $ --- $ ---
Other expense $ (504,413) $ (318,618) $ (186,809) $ (106,675) $ (97,386)
Net loss $ (4,890,458) $ (12,634,263) $ (1,565,054) $ (2,994,574) $ (836,824)
Earnings per share
Weighted number of
outstanding shares -
basic and diluted 12,964,498 5,047,611 2,881,877 1,790,160 1,784,433
Loss per share $ (0.38) $ (2.50) $ (0.54) $ (1.67) $ (0.49)
SELECTED BALANCE SHEET DATA:
Total assets $ 16,299,434 $ 9,200,964 $ 22,035,420 $ 4,922,703 $ 6,773,905
Working capital (deficit) $ 3,294,231 $ (1,572,209) $ 1,775,401 $ (199,775) $ 1,211,257
Long-term
Note and lease obligations $ 3,322,384 $ 2,849,126 $ 2,409,202 $ --- $ ---
Deferred income $ --- $ --- $ 421,399 $ 2,036,896 $ 1,965,532
(Note: Earnings per share information as previously reported at December 31, 2002 has been adjusted to a post-reverse split basis.)
13
ITEM 7. Management's Discussion and Analysis
------------------------------------
PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
The following discussion includes "forward-looking statements" within the
meaning of Section 21E of the Securities and Exchange Act of 1934, and is
subject to the safe harbor created by that section. Forward-looking statements
give our current expectations or forecasts of future events. All statements,
other than statements of historical facts, included or incorporated in this
report regarding our strategy, future operations, financial position, future
revenues, projected costs, prospects, plans and objectives of management are
forward-looking statements. The words "anticipates," "believes," "estimates,"
"expects," "intends," "may," "plans," "projects," "will," "would" and similar
expressions are intended to identify forward-looking statements, although not
all forward-looking statements contain these identifying words. Factors that
could cause results to differ materially from those projected in the
forward-looking statements are set forth in this section and in Exhibit 99.1.
The following discussion should also be read in conjunction with the
Consolidated Financial Statements and accompanying Notes thereto.
Readers are cautioned not to place undue reliance on these prospective
statements, which speak only as of the date of this report. The Company
undertakes no obligation to revise any forward-looking statements in order to
reflect events or circumstances that may subsequently arise. Readers are urged
to carefully review and consider the various disclosures made by the Company in
this report and in the Company's other reports filed with the Securities and
Exchange Commission.
EXECUTIVE SUMMARY
The Company considers following areas to be of highest importance in 2003 and
2004:
o During 2003 through January 2004, the Company raised $15.7 million in
financing. This was critical to the continuance of operations in early
2003 and the Company's ability to support construction on its 2003
customer contract backlog. Expensive debt obligations were eliminated
in January 2004 and the Company has both cash and available financing
to support anticipated 2004 business expansion.
o The Company has completed the transition from several lines of
business including financial services/PRISM, Rail and TrafficVision
which generated the majority of revenue in 2001 and 2002, to
intelligent traffic management products and services, primarily
red-light enforcement services and products, as the on-going operating
focus of the Company. The Company's leading product is its
CrossingGuard video-based red light enforcement system.
o Revenues are not yet sufficient to support operating expenses. The
Company needs to install additional CrossingGuard approaches and is
currently retrofitting some operating approaches to improve
performance. Over the past year, the Company more than doubled the
number of operating red-light enforcement approaches to 88 at December
31, 2003. Additional approaches to contribute to 2004 revenue are
expected to come from existing customer contracts which have not been
fully built out, the recently announced Delaware Department of
Transportation statewide contract and new customers to be signed.
o Over the past years, the Company has devoted substantial resources to
the development of its patented technology and it will vigorously
contest infringement thereon. In November 2003, the Company filed
complaints in United States District Courts against two of its
competitors, alleging that their automated red light enforcement
systems infringe upon the Company's patent. Further details are
discussed in the Liquidity and Capital Resources and Results of
Operations sections below.
LIQUIDITY AND CAPITAL RESOURCES
Cash Position and Working Capital
The Company had cash and short-term investments of approximately $5,410,000 at
December 31, 2003 as compared with approximately $309,000 at December 31, 2002.
At December 31, 2003, the Company had working capital of $3,294,000, as compared
with a working capital deficit of $1,572,000 at December 31, 2002. The increase
in cash and working capital in 2003 substantially relates to private placement
common stock sold at year-end.
14
In January 2004, the Company received $3.4 million in additional proceeds on the
remaining private placement offering, $2.2 million of which was used to settle
the remaining lease obligation to Electronic Data Systems Corporation (EDS). The
EDS settlement resulted in a gain on early extinguishment of debt of $681,000
and eliminated the 12% interest obligation.
Also in January 2004, the Company satisfied its obligations on a July 2003 $2
million Laurus Master Fund, Ltd. (Laurus) convertible note by issuing 492,904
shares of Nestor common stock and repaying the note balance, accrued interest
and prepayment penalty. On the same date, Laurus entered into a new $1.5 million
note ("second Laurus note"). While Nestor received $98,000 as a net result of
these transactions, the more beneficial change was increasing the fixed
conversion price, as defined in the notes, from $1.55 per share in the first
note to $3.50 in the new note.
The Company had a net worth of $9,662,000 at December 31, 2003, as compared with
a net worth of $3,865,000 at December 31, 2002. The increase in net worth
resulted primarily from the equity financing activities vigorously pursued
during the year, resulting in over $10 million being raised, offset by the
consolidated net loss. Silver Star Partners I, LLC (SSP) invested $4.2 million
through April 2003 and, on December 31, 2003, the Company converted an October
2003 $2 million note payable to SSP into common stock. Also in December 2003,
the Company raised $4.4 million from a private placement offering. See Note 9
for additional information.
Future Commitments
During 2003, the Company acquired additional property and leased equipment
(primarily computers and related equipment) at a cost of $86,000, and invested
$2,341,000 in capitalized systems. At December 31, 2003, Nestor recorded its
investments in computers and related equipment (net of depreciation) at
$385,000, and in capitalized systems (net of depreciation) at $3,515,000.
Management expects that NTS will make future commitments for the purchase of
additional computers and related computing equipment, for furniture and
fixtures, for delivery of capitalized systems, for consulting and for
promotional and marketing expenses.
As discussed above, the Laurus note payable and the EDS lease payable presented
on the December 31, 2003 balance sheet were satisfied in January 2004. The
second Laurus note calls for principal repayments to commence May 2004 with
$375,000 due in 2004, $1,012,500 due in 2005 and $112,500 due in January 2006
before maturity.
The Company does not generally grant payment terms to customers in excess of 90
days.
After satisfying the initial Laurus note payable and the EDS lease payable in
January 2004, the Company's future contractual obligations (assuming Laurus does
not exercise its conversion rights) and other commitments are as follows:
Contractual Obligations and Commercial Commitments:
Payment Due Date
----------------------------------------------------
Total < 1 Year 1-3 Years 3-5 Years Thereafter
----- -------- --------- --------- ----------
Second Laurus note $1,500,000 $375,000 $1,125,000 $ --- $ ---
payable
Operating leases $ 221,000 $137,000 $ 84,000 $ --- $ ---
Inflation
Management believes that the rate of inflation in recent years has not had a
material effect on the Company's operations.
15
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Nestor's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States, which require the
Company to make estimates and assumptions (see Note 2 to the Consolidated
Financial Statements). The Company believes that of its significant accounting
policies (see Note 2 to the Consolidated Financial Statements), the following
may involve a higher degree of judgment and complexity.
Revenue Recognition
The Company's CrossingGuard product generates lease and service fee revenue
generally tied to the number of citations issued to red-light violators. Under
the terms of several current contracts, the Company cannot bill the municipality
until the court has collected the citation fine. On these contracts, management
estimates the percentage of citations that are expected to be collectible and
recognizes revenue accordingly. To the extent these estimates are not accurate,
the Company's operating results may be significantly and negatively affected.
This will have less impact on the Company going forward as new contracts do not
have this provision and are trending towards fixed fee terms.
In arrangements, some of which include software, or where software services are
deemed essential, revenue is recognized using contract accounting. This
methodology involves a percentage-of-completion approach, based on
progress-to-completion measures on estimated total costs. If the Company does
not accurately estimate these total costs, or the projects are not properly
managed to planned periods and expectations, then future margins may be
significantly and negatively affected or losses on existing contracts may need
to be recognized.
Long Term Asset Impairment
In assessing the recoverability of the Company's long term assets, management
must make assumptions regarding estimated future cash flows and other factors to
determine the fair value. If these estimates change in the future, the Company
may be required to record impairment charges that were not previously recorded
pursuant to Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets" and SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets".
RESULTS OF OPERATIONS
During 2003, the Company completed the transition from several lines of business
including financial services/PRISM, Rail and TrafficVision which generated the
majority of revenue in 2001 and 2002, to red-light enforcement services and
products as the on-going operating focus of the Company. The Company's leading
product is its CrossingGuard video-based red light enforcement system and
services, and future growth will be tied to the increase in the number of
CrossingGuard approaches installed and operational. In 2002 and 2001, the
Company reorganized by (i) eliminating direct investment in its financial
services/Risk Management products, transferring all contracts through license
and/or assignment to other parties and (ii) through a further operations
reduction, restructured the Company to focus primarily on its CrossingGuard
product.
ANALYSIS OF THE THREE-MONTH PERIODS ENDED DECEMBER 31, 2003 AND 2002
In the quarter ended December 31, 2003, the Company realized a 236% ($788,000)
increase in revenues and 142% ($1,379,000) increase in operating expenses
compared to the prior year, same quarter. After consideration of $340,000 of
increased other expenses in 2003, the Company reported a net loss of $1,592,000
compared to $662,000 in the prior year fourth quarter. The revenue and expense
increases relate primarily to having more than double the number of installed
operational approaches in the current year fourth quarter compared to the prior
year fourth quarter. Additionally, operating expenses include $225,000 relating
to financing activities and $130,000 of patent lawsuit expenses in the current
year quarter. Other expense in the fourth quarter of 2003 included the write off
of the unamortized discount on the first Laurus note and EDS interest expense,
both of which did not occur in the prior year fourth quarter.
16
Revenues
- --------
The Company's revenues arose from CrossingGuard lease and service fees. During
the quarter ended December 31, 2003, revenues increased $788,000 to $1,122,000
from $334,000 in the prior year fourth quarter. The Company had 48 additional
installed approaches in the current year fourth quarter compared to the prior
year fourth quarter. At December 31, 2003, the Company had 88 installed
operational approaches.
Operating Expenses
- ------------------
Total operating expenses amounted to $2,353,000 in the quarter ended December
31, 2003, an increase of $1,379,000 as compared to total operating costs of
$974,000 in the prior year same quarter.
Cost of Goods Sold
Cost of goods sold (CGS) totaled $940,000 in the fourth quarter of 2003 as
compared to $97,000 in 2002. The 2003 CGS relates to amortization, maintenance
and processing costs to support 88 approaches compared to only 40 in the fourth
quarter of 2002. The 2003 quarter also includes a $417,000 net reclassification
of all 2003 citation processing costs from engineering and operations as
previously presented to CGS. Citation processing costs were not material in the
2002 quarter and were not reclassified to conform to the 2003 presentation.
Additionally, the fourth quarter of 2002 included a $102,000 reversal of EDS
processing costs which was not repeated in 2003.
Engineering and Operations
Costs related to engineering and operations totaled $419,000 in the fourth
quarter of 2003, as compared with $596,000 in 2002. These costs include the
salaries of field and office personnel as well as operating expenses related to
product design, delivery, configuration, maintenance and service. Increases in
headcount, travel and supplies generated $206,000 of additional costs in the
2003 quarter but were offset by a $417,000 net reclassification of all 2003
citation processing costs to CGS in fourth quarter 2003. Citation processing
costs were not material to 2002 engineering and operations and were not
reclassified to conform to the 2003 presentation.
Research and Development
Research and development expenses totaled $29,000 in the quarter ended December
31, 2003 as compared with $31,000 in the previous year's quarter. The Company
continues its R&D activities, as deemed necessary.
Selling and Marketing
Selling and marketing costs were $87,000 in the quarter ended December 31, 2003,
and $89,000 in the previous year's quarter. Sales and marketing efforts had been
limited recently due to cash constraints but are expected to increase in 2004.
General and Administrative
General and administrative expenses totaled $876,000 in the fourth quarter of
2003, as compared with $160,000 in the previous year's quarter. These costs were
unusually high in the current year quarter due to (i) $225,000 of Laurus and
Silver Star deferred financing fees being expensed in connection with note
redemptions/conversions, (ii) $130,000 of patent lawsuit defense expenses and
(iii) $84,000 of bad debt expense. Additionally, the fourth quarter of 2002
included a reversal of $113,000 of Wand Partners, Inc. fees in connection with a
Termination and Release Agreement.
Other Expense
For the fourth quarter 2003, net other expense was $362,000 as compared with net
other expense of $22,000 in the quarter-earlier period. In 2003, other expense
was primarily interest of (i) $169,000 relative to the write off of the
17
unamortized discount on the first Laurus note and $59,000 of other Laurus
interest, (ii) $89,000 to EDS. Both periods included warrant amortization
expense of $26,000.
Net Loss
- --------
During the fourth quarter 2003, the Company experienced a loss of $1,592,000, as
compared with a loss of $662,000 in the previous year's quarter. For the quarter
ended December 31, 2003, loss per share available for common stock was $0.11 per
share, as compared with a loss per share of $0.13 in the corresponding period of
the prior year. The weighted average shares outstanding were 13,987,905 for the
quarter ended December 31, 2003 and 5,047,611 for the quarter ended December 31,
2002.
ANALYSIS OF THE YEARS ENDED DECEMBER 31, 2003 AND 2002
For the year ended December 31, 2003, the Company experienced a 28% ($584,000)
increase in revenues compared to the prior calendar year. Operating expenses
decreased 60% ($10,282,000) in 2003. After consideration of the $2,812,000 gain
on royalty assignment in 2002 and $311,000 of increased other expenses in 2003,
the Company reported a net loss of $4,890,000 in 2003 compared to a loss of
$12,634,000 in the prior year. Many significant changes occurred during these
two years as more fully described below.
Revenues
- --------
The Company's revenues arose from royalties and product sales, lease and service
fees as discussed separately below. During the year ended December 31, 2003,
revenues increased $584,000 to $2,706,000 from $2,122,000 in the prior calendar
year. CrossingGuard accounted for 40% of 2002 revenues and substantially all
2003 revenues.
Ongoing revenues from the risk management product line continued under the ACI
distributor agreement until July 2002 when it was assigned to CLA.
Product Royalties
Product royalties totaled $29,000 in 2003, as compared with $664,000 in 2002.
The Company continued to receive royalties from ACI until July 1, 2002 when
these royalty rights were assigned to Churchill Lane Associates, LLC. Residual
royalty streams from two customers account for 2003 royalty revenues.
Product Sales, Lease and Service Fees
Product sales, lease and service fee revenues from the traffic business totaled
$2,677,000 in 2003, as compared with $1,457,000 in 2002, due primarily to the
installed base of approaches more than doubling from December 31, 2002 to
December 31, 2003. Revenue in 2002 was comprised of $844,000 in CrossingGuard
video-based traffic enforcement, $387,000 in Rail business and $187,000 in
TrafficVision business, whereas 2003 revenue was substantially all
CrossingGuard.
CrossingGuard construction started slowly in Q1 '03 but by the end of Q2, there
were 20 additional approaches installed, followed by 12 and 16 more in Q3 and
Q4, respectively, to total 88 live approaches by the end of 2003. Construction
is not expected to continue at this pace in 2004 unless new contracts are
signed. During March 2004, the Company installed three new approaches under its
contract with the Delaware Department of Transportation. The Company is
currently retrofitting some operating approaches to improve performance and is
working with its customers to complete build outs of remaining approaches
committed under existing contracts.
Operating Expenses
- ------------------
Total operating expenses amounted to $6,967,000 in the year ended December 31,
2003, a decrease of $10,282,000 over total operating costs of $17,249,000 in the
prior year. The 2002 expenses include $743,000 in restructuring costs and
$9,294,000 of impairment charges. Excluding restructuring and impairment
18
charges, operating expenses in 2002 were $7,212,000. The most significant
changes in 2003 were $414,000 of increased amortization on live approaches,
$240,000 of increased financing fees and $130,000 of patent lawsuit defense
expenses; offset by $538,000 of CGS expense pertaining to discontinued product
lines (Rail, TrafficVision) and pilot programs.
Costs of Goods Sold
Cost of goods sold totaled $1,791,000 in 2003 as compared to $1,476,000 in the
prior year. CGS includes amortization, maintenance and processing costs related
to revenues recorded in the respective periods. Fiscal year 2002 includes
$289,000 (Rail), $138,000 (TrafficVision) and $111,000 (pilot program) CGS which
did not recur in 2003 but were offset by a $414,000 current year increase in
system amortization due to the increased number of installed approaches and a
$417,000 net reclassification of 2003 citation processing costs from engineering
and operations as previously presented to CGS. Additionally, 2002 included a
$102,000 reversal of EDS processing costs which was not repeated in 2003.
Engineering and Operations
Costs related to engineering and operations totaled $2,578,000 in 2003, as
compared with $2,070,000 in 2002. These costs include the salaries of field and
office personnel as well as operating expenses related to product design,
delivery, configuration, maintenance and service. The increase in these costs
reflects the addition of NTS expenses both internally and field-based, to
support the growing installed customer base. Staff realignments from R & D were
necessary to assist in engineering efforts. Also, $417,000 of net citation
processing costs were reclassified to CGS in fourth quarter 2003. Citation
processing costs were not material to 2002 engineering and operations and were
not reclassified to conform to the 2003 presentation.
Research and Development
Research and development expenses totaled $121,000 in the year ended December
31, 2003 as compared with $1,604,000 in the prior year. R & D efforts had been
significant to roll out the Rail and CrossingGuard products, which occurred in
2002. In March 2002, management took steps to reduce the heavy use of third
party contractors to support development projects (consulting costs decreased by
$183,000 in 2003) and also made staff realignments to assist engineering with
the increased customer base. Although the June 2002 restructuring further
contributed to a $361,000 reduction in salaries, talent and capacity remain for
research and development, as management deems appropriate.
Selling and Marketing
Selling and marketing costs decreased $253,000 to $355,000 in the year ended
December 31, 2003, from $608,000 in the prior year. The decrease in selling
costs in the year reflects, primarily, the re-focus of strategy to one product
line, which lowered salaries and collateral costs. Sales and marketing efforts
had been limited recently due to cash constraints but are expected to increase
in 2004.
General and Administrative
General and administrative expenses totaled $2,121,000 in 2003, as compared with
$1,453,000 in the previous year. The increase is the net result of (i) $240,000
of financing fees in conjunction with the July 2003 Laurus and the October 2003
Silver Star notes, (ii) $130,000 of legal expenses on patent lawsuit defense,
(iii) $102,000 in general legal expenses, (iv) $84,000 of bad debt expense and
(v) the 2002 reversal of $113,000 of Wand Partners, Inc. fees in conjunction
with a Termination and Release Agreement.
Restructuring Costs
In June 2002, the Company underwent a significant restructuring involving
management changes and cost control to lower personnel and facilities expenses
as the Company refocused its efforts solely on its red-light video enforcement
contracts for CrossingGuard installations. The Company terminated 19 full-time
employees, affecting all departments, and offices were consolidated into smaller
facilities. During the quarter ended June 30, 2002, the Company recorded
19
restructuring costs of $743,000 primarily comprised of $332,000 in employee
severance agreements and estimated lease obligations associated with closing its
Providence, RI and San Diego, CA offices. A settlement was reached in 2002 in
connection with the Providence office lease and in 2003 in connection with the
San Diego office lease.
Capitalized Systems Costs Impairment
During the quarter ended June 30, 2002, the Company determined that potential
citation revenues from certain CrossingGuard installations in two cities would
not exceed the cost of the underlying carrying value of the capitalized systems.
These contracts were signed in the early stages of CrossingGuard development and
the site selection procedures and contract terms have since been improved. In
accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", the Company wrote off capitalized systems costs of $794,000
and recorded a corresponding impairment charge in operating expenses. Ongoing
revenues from these installations are expected to offset future costs of system
operations.
Goodwill Impairment Loss
On January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other
Intangible Assets." Under SFAS No. 142, the Company will test goodwill for
impairment on an annual basis, or whenever indicators of impairment are
identified. The Company completed the transitional impairment test of goodwill
during the quarter ended June 30, 2002 and concluded that no impairment existed
on January 1, 2002, when the standard was adopted. Management considers the
Company's quoted stock price to be the best indicator of fair value for purposes
of performing these analyses.
Based on the decline of the Company's stock price during the second and third
quarters of 2002, however, the fair value was recomputed using the quoted
quarter-end stock prices. Such computations resulted in goodwill impairment
charges of $3,000,000 and $5,500,000 recorded as operating expenses during the
respective 2002 quarters. The Company continues to monitor goodwill for
potential impairment.
Gain on Royalty Assignment
On July 15, 2002, the Company entered into a Memorandum of Understanding ("MOU")
with Churchill Lane Associates, LLC ("CLA"), assigning CLA certain of the
Company's rights to royalty income under the license agreement between the
Company and ACI ("ACI License"). CLA is owned and controlled by Alan M. Wiener,
Alvin J. Siteman and Robert M. Carroll, former directors and shareholders of the
Company. The MOU also provided a schedule for advances by CLA to provide interim
financing to the Company during the period prior to the closing. Upon closing on
September 30, 2002, CLA paid the Company $3.1 million in cash (less advances)
for the irrevocable assignment of its royalty rights under the ACI License from
July 1, 2002 and in perpetuity. No obligations or other rights of the Company
were transferred or assigned to CLA.
After offsetting $860,000 of ACI unbilled contract revenue, $632,000 of ACI
deferred income and $60,000 in related professional fees, the Company recorded a
$2,812,000 gain on this royalty assignment on September 30, 2002. The
elimination of ACI unbilled contract revenue and deferred income were recorded
as non-cash reductions.
Contract Termination Reserve
A significant customer contract in the Rail line of business may be terminated
by mutual agreement prior to its completion as a result of the Company's
decision to focus its resources on CrossingGuard systems and services. The
Company accrued $125,000 of estimated contract termination fees in June 2003.
20
Other Expense
- -------------
For 2003, net other expense was $504,000; as compared with net other expense of
$319,000 in the year-earlier period. In 2003, other expense included interest
expense of $470,000 as compared to $217,000 in 2002, 2003 also included a
$64,000 favorable settlement with a vendor and both years included $106,000 of
amortization expense related to the assigned value of warrants outstanding and
being amortized over their remaining life. Interest expense was high in 2003 due
to the $169,000 write off of the unamortized discount on the first Laurus note
and $59,000 of other Laurus interest.
Net Loss
- --------
During 2003, the Company experienced a loss of $4,890,000, as compared with a
loss of $12,634,000 in the prior year. For the year ended December 31, 2003,
loss per share was $0.38 per share, as compared with a loss per share of $2.50
in the corresponding period of the prior fiscal year. For the year ended
December 31, 2003, there was outstanding a weighted average of 12,964,498
shares, as compared to 5,047,611 shares in the year-earlier period.
ANALYSIS OF THE YEARS ENDED DECEMBER 31, 2002 AND 2001
In the year ended December 31, 2002, the Company experienced a 40% decrease in
revenues compared to the prior calendar year. Operating expenses increased 258%
in 2002 resulting in a loss of $12,634,000 as compared to a loss of $1,565,000
in the prior year.
Revenues
- --------
The Company's revenues arose from royalties and product sales, lease and service
fees as discussed separately below. During the year ended December 31, 2002,
revenues decreased $1,399,000 to $2,122,000 from $3,521,000 in the prior
calendar year. The Company granted source-code distribution rights to two
companies in 2001 for up-front source-code license fees and, from ACI, ongoing
royalties of equal to 15% of future revenues realized from the licensed
software. Beginning in the fourth quarter of 2001, the Company's revenues were
generated primarily from sales, support, and services provided regarding its
intelligent traffic management product line. Ongoing revenues from the risk
management product line continued under the ACI agreement until July 2002 when
it was assigned to CLA.
Product Royalties
Product royalty revenues totaled $664,000 in 2002, as compared with $2,997,000
in 2001. The Company realized net ReD license revenues of $832,000 in the second
quarter of 2001, and $1,104,000 from the ACI license in the first quarter of
2001. The Company continued to receive royalties from ACI until July 1, 2002
when these royalty rights were assigned to CLA
Product Sales, Lease and Service Fees
Product sales, lease and service fee revenues from the traffic business totaled
$1,457,000 in 2002, as compared with $524,000 in 2001, which included only
post-merger revenues.
Operating Expenses
- ------------------
Total operating expenses amounted to $17,249,000 in the year ended December 31,
2002, an increase of $12,431,000 over total operating costs of $4,818,000 in the
prior year. The 2001 operating expenses reflect risk management operations that
were transferred to ACI and ReD in 2001 whereas the 2002 expenses reflect
current traffic management operations, which include $743,000 in restructuring
costs and $9,294,000 of impairment charges. Excluding restructuring and
impairment charges, operating expenses in 2002 were $7,212,000.
21
Costs of Goods Sold
Cost of goods sold totaled $1,476,000 in 2002 as compared to $692,000 in the
prior year, which included only post September 12, 2001 expenses. CGS includes
third party goods and services related to revenues recorded in the respective
periods and is high in proportion to revenues realized due to (i) rail projects
completed in the first quarter of 2002 that carried higher equipment and
construction costs than prior experience as NTS acted as prime contractor on
these construction related projects, and (ii) our back-office processing
agreement with EDS required a monthly minimum fee that was proportionately high
in relation to actual ticket volumes generated. In July 2002 a letter agreement
was reached and finalized in January 2003 to eliminate the monthly minimum fee,
reducing the per-ticket processing fees charged retroactive to January 1, 2002.
In December 2002, NTS recorded a $102,000 reduction in CGS in connection with
the modified terms. NTS performs these services internally as of March 31, 2003.
Additionally, in the quarter ended September 30, 2002, NTS reclassified
customer-related telecommunications expenses from various operating expenses to
CGS, effective October 1, 2001.
Engineering Services
Costs related to engineering services totaled $2,070,000 in 2002, as compared
with $509,000 in 2001. The increase reflects the addition of NTS engineering
expenses effective with the merger completed September 12, 2001.
Research and Development
Research and development expenses totaled $1,604,000 in the year ended December
31, 2002 as compared with $1,623,000 in the prior year. The increase in such
costs reflects the net increased investment in the NTS products included in the
consolidated expenses after the merger completed on September 12, 2001, offset
by the transfer of PRISM research and development activity to ACI and ReD during
early 2001.
Selling and Marketing
Selling and marketing costs decreased $171,000 to $608,000 in the year ended
December 31, 2002, from $779,000 in the prior year. The decrease in selling
costs in the year reflects, primarily, the transfer of sales and marketing
activity for the PRISM product to ACI and ReD during early 2001.
General and Administrative
General and administrative expenses totaled $1,453,000 in 2002, as compared with
$1,214,000 in the previous year. The increase is the net result of a full year
of combined Nestor and NTS expense in 2002, offset in part by the 2002 reversal
of $113,000 of Wand Partners, Inc. fees in connection with a Termination and
Release Agreement and reduced payroll expenses after the June 2002
restructuring.
Restructuring Costs
In June 2002, the Company underwent a significant restructuring involving
management changes and cost control to lower personnel and facilities expenses
as the Company refocused its efforts solely on its red-light video enforcement
contracts for CrossingGuard installations. The Company terminated 19 full-time
employees, affecting all departments, and offices were consolidated into smaller
facilities. During the quarter ended June 30, 2002, the Company recorded
restructuring costs of $743,000 primarily comprised of $332,000 in employee
severance agreements and estimated lease obligations associated with closing its
Providence, RI and San Diego, CA offices. A settlement was reached in 2002 in
connection with the Providence office lease and in 2003 in connection with the
San Diego office.
Capitalized Systems Costs Impairment
During the quarter ended June 30, 2002, the Company determined that potential
citation revenues from certain CrossingGuard installations in two cities would
not exceed the cost of the underlying carrying value of the capitalized systems.
These contracts were signed in the early stages of CrossingGuard development and
22
the site selection procedures and contract terms have since been improved. In
accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", the Company wrote off capitalized systems cost of $794,000
and recorded a corresponding impairment charge in operating expenses. Ongoing
revenues from these installations are expected to offset future costs of system
operations.
Goodwill Impairment Loss
On January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other
Intangible Assets." Under SFAS No. 142, the Company will test goodwill for
impairment on an annual basis, or whenever indicators of impairment are
identified. The Company completed the transitional impairment test of goodwill
during the quarter ended June 30, 2002 and concluded that no impairment existed
on January 1, 2002, when the standard was adopted. Management considers the
Company's quoted stock price to be the best indicator of fair value for purposes
of performing these analyses.
Based on the decline of the Company's stock price during the second and third
quarters of 2002, however, the fair value was recomputed using the quoted
quarter-end stock prices. Such computations resulted in goodwill impairment
charges of $3,000,000 and $5,500,000 recorded as operating expenses during the
respective 2002 quarters. The Company continues to monitor goodwill for
potential impairment.
Gain on Royalty Assignment
On July 15, 2002, the Company entered into a Memorandum of Understanding ("MOU")
with Churchill Lane Associates, LLC ("CLA"), assigning CLA certain of the
Company's rights to royalty income under the license agreement between the
Company and ACI ("ACI License"). CLA is owned and controlled by Alan M. Wiener,
Alvin J. Siteman and Robert M. Carroll, former directors and shareholders of the
Company. The MOU also provided a schedule for advances by CLA to provide interim
financing to the Company during the period prior to the closing. Upon closing on
September 30, 2002, CLA paid the Company $3.1 million in cash (less advances)
for the irrevocable assignment of its royalty rights under the ACI License from
July 1, 2002 and in perpetuity. No obligations or other rights of the Company
were transferred or assigned to CLA.
After offsetting $860,000 of ACI unbilled contract revenue, $632,000 of ACI
deferred income and $60,000 in related professional fees, the Company recorded a
$2,812,000 gain on this royalty assignment on September 30, 2002. The
elimination of ACI unbilled contract revenue and deferred income were recorded
as non-cash reductions.
Other Expense
- -------------
For 2002, net other expense was $319,000 as compared with net other expense of
$187,000 in the year-earlier period. In 2002, other expense included interest
expense of $217,000 as compared to $65,000 in 2001, and both years included
$106,000 of amortization expense related to the assigned value of warrants
outstanding and being amortized over their remaining life. Interest expense was
higher in 2002 in comparison to 2001 as 2001 only included three and one-half
months of NTS interest expense.
Loss from Investment in Affiliate
- ---------------------------------
The pre-merger loss from investment in affiliate recorded in 2001 of $81,100
reflected Nestor's portion of NTS losses realized under the equity method of
accounting prior to the merger, and limited by Nestor's net investment in the
subsidiary as of December 31, 2000. Effective as of the merger, NTS operating
results are included in the consolidated financial statements.
Net Loss
- --------
During 2002, the Company experienced a loss of $12,634,000, as compared with a
loss of $1,565,000 in the prior year. For the year ended December 31, 2002, loss
per share was $2.50 per share, as compared with a loss per share of $0.54 in the
corresponding period of the prior fiscal year. For the year ended December 31,
23
2002, there was outstanding a weighted average of 5,047,611 shares (post reverse
split), as compared to 2,881,877 shares in the year-earlier period.
ITEM 7A. Quantitative and Qualitative Disclosure about Market Risk.
---------------------------------------------------------
The Company has long term obligations, however the interest rate is fixed. The
Company also has a convertible note payable at prime plus 1.25% through its
January 2006 maturity. The Company does not hedge against this exposure.
Management assesses their exposure to these risks as immaterial.
ITEM 8. Financial Statements and Supplementary Data.
-------------------------------------------
See annexed financial statements.
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure
------------------------------------------------------------------
On January 6, 2003, the Company filed with the Securities and Exchange
Commission a current report on Form 8-K dated January 2, 2003 to disclose the
change in Certifying Accountants. Ernst & Young LLP audited the Company's
financial statements for the year ended December 31, 2001. Their opinion on the
2001 financial statements did not contain an adverse opinion or disclaimer of
opinion nor was it qualified or modified as to uncertainty, audit scope or
accounting principles except that it included a paragraph indicating that there
was substantial doubt about the Company's ability to continue as a going
concern. There have been no disagreements with Ernst & Young LLP relating to any
matters of accounting principles or practices, financial statements, disclosures
or auditing scope or procedures for the year ended December 31, 2001, which
disagreements, if not resolved to the satisfaction of Ernst & Young LLP, would
have caused it to make a reference to the subject matter of the disagreement(s),
in connection with its report. During the year ended December 31, 2001 and the
subsequent period preceding Ernst & Young's resignation, no event occurred that
is required to be disclosed pursuant to paragraph (a)(1)(v) of Item 304 of
Regulation S-K.
On January 2, 2003, the Company's Audit Committee of the Board of Directors
engaged the independent accounting firm, Carlin, Charron & Rosen LLP, 50
Exchange Terrace, Providence, Rhode Island 02903, a member of the Securities and
Exchange Commission practice section of the AICPA, to audit the fiscal year
ended December 31, 2002. During the fiscal year ended December 31, 2002 or any
subsequent interim period prior to engaging Carlin, Charron & Rosen LLP, the
Company did not consult Carlin, Charron & Rosen LLP regarding the application of
accounting principles to a specific transaction or with respect to the type of
audit opinion that might be rendered on the Company's financial statements or
any matter to be disclosed pursuant to paragraph (a)(2) of Item 304 of
Regulations S-K.
ITEM 9A. Controls and Procedures.
-----------------------
Nestor, Inc. management, including the Chief Executive Officer and Chief
Financial Officer, conducted an evaluation of the effectiveness of the design
and operation of the Company's disclosure controls and procedures as defined in
Exchange Act Rule 13a-15(e) and 15d-15(e) as of December 31, 2003. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company's disclosure controls and procedures were effective as of
December 31, 2003. There have been no significant changes in internal controls,
or in factors that could significantly affect internal controls, subsequent to
the date the Chief Executive Officer and Chief Financial Officer completed their
evaluation.
24
PART II
ITEM 8.
CONSOLIDATED FINANCIAL STATEMENTS
---------------------------------
FORM 10-K
---------
December 31, 2003
-----------------
25
NESTOR, INC.
------------
CONTENTS
--------
Page No.
--------
Independent Auditors' Reports 27
Consolidated Balance Sheets -
December 31, 2003 and 2002 29
Consolidated Statements of Operations -
For the Years Ended December 31, 2003, 2002 and 2001 30
Consolidated Statements of Stockholders' Equity -
For the Years Ended December 31, 2003, 2002 and 2001 31
Consolidated Statements of Cash Flows -
For the Years Ended December 31, 2003, 2002 and 2001 32
Notes to Consolidated Financial Statements 33
26
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
of Nestor, Inc.
East Providence, Rhode Island
We have audited the accompanying consolidated balance sheets of Nestor, Inc. as
of December 31, 2003 and 2002, and the related consolidated statements of
operations, stockholders' equity and cash flows for the years then ended. Our
audit also included the financial statement schedule for the years ended
December 31, 2003 and 2002 listed in the index at Item 15(a)(2). These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audit.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the 2003 and 2002 financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Nestor,
Inc. at December 31, 2003 and 2002 and the consolidated results of its
operations and its cash flows for the years then ended in conformity with
accounting principles generally accepted in the United States of America. Also,
in our opinion, the related financial statement schedule when considered in
relation to the basic financial statements taken as a whole, presents fairly in
all material respects the information set forth therein.
/s/Carlin, Charron & Rosen, LLP
Providence, Rhode Island
March 16, 2004
27
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
of Nestor, Inc.
We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows for the year ended December 31, 2001. Our
audit also included the financial statement schedule listed for the year ended
December 31, 2001 in the index at Item 15(a)(2). These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated results of Nestor, Inc.'s operations and
its cash flows for the year ended December 31, 2001 in conformity with
accounting principles generally accepted in the United States. Also, in our
opinion, the related financial statement schedule when considered in relation to
the basic financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
The accompanying financial statements have been prepared assuming that Nestor,
Inc. will continue as a going concern. As discussed in Note 1, the Company is
currently expending cash in excess of cash generated from operations, as
revenues are not yet sufficient to support operations and the Company has
incurred significant losses. These conditions raise substantial doubt about the
Company's ability to continue as a going concern. Management's plans in regard
to these matters are discussed in Note 1. The financial statements do not
include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification of
liabilities that may result from the outcome of this uncertainty.
/s/Ernst & Young LLP
Providence, Rhode Island
February 26, 2002
28
NESTOR, INC.
Consolidated Balance Sheets
---------------------------
DECEMBER 31,
ASSETS 2003 2002
---- ----
CURRENT ASSETS:
Cash and cash equivalents $ 5,410,123 $ 308,894
Accounts receivable, net of allowance for doubtful accounts 521,872 141,263
Unbilled contract revenue 158,952 122,684
Inventory 442,298 281,108
Other current assets 75,791 60,963
------------- -------------
Total current assets 6,609,036 914,912
NONCURRENT ASSETS:
Capitalized system costs, net of accumulated depreciation 3,514,908 1,936,783
Property and equipment, net of accumulated depreciation 385,165 486,740
Goodwill 5,580,684 5,580,684
Patent development costs, net of accumulated amortization 175,216 153,275
Other long term assets 34,425 128,570
------------- -------------
TOTAL ASSETS $ 16,299,434 $ 9,200,964
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Note payable $ 884,750 $ ---
Accounts payable 468,289 616,878
Accrued employee compensation 386,652 354,269
Accrued liabilities 765,676 795,749
Leases payable 662,541 354,286
Restructuring reserve 146,897 365,939
------------- -------------
Total current liabilities 3,314,805 2,487,121
NONCURRENT LIABILITIES:
Long term note payable 1,030,000 ---
Long term leases payable 2,292,384 2,849,126
------------- -------------
Total liabilities 6,637,189 5,336,247
------------- -------------
Commitments and contingencies --- ---
STOCKHOLDERS' EQUITY:
Preferred stock, $1.00 par value, authorized 10,000,000 shares;
issued and outstanding: Series B - 190,000 shares at
December 31, 2003 and 235,000 shares at December 31, 2002 190,000 235,000
Common stock, $.01 par value, authorized 20,000,000 shares;
issued and outstanding: 13,997,238 shares at December 31, 2003
and 5,024,111 shares at December 31, 2002 139,972 50,241
Warrants 1,377,251 1,072,825
Additional paid-in capital 49,230,803 45,227,851
Stock pending issuance 6,335,877 ---
Accumulated deficit (47,611,658) (42,721,200)
------------- -------------
Total stockholders' equity 9,662,245 3,864,717
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 16,299,434 $ 9,200,964
============= =============
See Independent Auditors' Reports and Notes to the Financial Statements.
29
NESTOR, INC.
Consolidated Statements of Operations
-------------------------------------
YEARS ENDED DECEMBER 31,
2003 2002 2001
-------------------------------------------------------
Revenue:
Product royalties $ 28,555 $ 664,401 $ 2,996,550
Product sales, lease and service fees 2,676,979 1,457,173 524,374
------------- ------------- -------------
Total revenue 2,705,534 2,121,574 3,520,924
------------- ------------- -------------
Operating expenses:
Cost of goods sold 1,791,203 1,475,945 692,418
Engineering and operations 2,578,056 2,070,476 508,955
Research and development 121,350 1,604,159 1,623,182
Selling and marketing 354,847 607,901 779,389
General and administrative 2,121,123 1,453,342 1,214,125
Restructuring costs --- 742,705 ---
Capitalized system costs impairment --- 794,281 ---
Goodwill impairment loss --- 8,500,000 ---
------------- ------------- -------------
Total operating expenses 6,966,579 17,248,809 4,818,069
------------- ------------- -------------
Loss from operations (4,261,045) (15,127,235) (1,297,145)
Contract termination reserve (125,000) --- ---
Gain on royalty assignment --- 2,811,590 ---
Other expense - net (504,413) (318,618) (186,809)
------------- ------------- -------------
Loss before investment loss (4,890,458) (12,634,263) (1,483,954)
Loss from investment in affiliate --- --- (81,100)
------------- ------------- --------------
Net loss $ (4,890,458) $ (12,634,263) $ (1,565,054)
============= ============= =============
Loss Per Share:
Loss per share, basic and diluted $ (0.38) $ (2.50) $ (0.54)
============= ============= =============
Shares used in computing loss per share:
Basic and diluted 12,964,498 5,047,611 2,881,877
============= ============= =============
See Independent Auditors' Reports and Notes to the Financial Statements.
30
Nestor, Inc.
Consolidated Statements of Stockholders' Equity
For the Years Ended December 31, 2003, 2002 and 2001
Preferred Stock Common Stock Additional Stock
------------------ -------------------- Paid in Pending Accumulated
Shares Amount Shares Amount Warrants Capital Issuance Deficit Total
------ ------ ------ ------ -------- ------- --------- --------- -----
Balance at
Dec. 31, 2000 235,000 $235,000 1,768,845 $ 17,688 $ 843,434 $27,593,325 $ --- $(28,521,883) $ 167,564
Issuance of
Common Stock --- --- 3,233,856 32,339 --- 17,490,520 --- --- 17,522,859
Accretion value
of warrants --- --- --- --- 106,484 --- --- --- 106,484
Variable
warrants --- --- --- --- 1,662,450 (1,662,450) --- --- ---
Options
exercised --- --- 21,410 214 --- 160,430 --- --- 160,644
Loss for the
year ended
Dec. 31, 2001 --- --- --- --- --- --- --- (1,565,054) (1,565,054)
-------- -------- ---------- --------- ---------- ----------- ---------- ------------ -----------
Balance at
Dec. 31, 2001 235,000 $235,000 5,024,111 $ 50,241 $2,612,368 $43,581,825 --- $(30,086,937) $16,392,497
Accretion value
of warrants --- --- --- --- 106,483 --- --- --- 106,483
Variable
warrants --- --- --- --- (1,646,026) 1,646,026 --- --- ---
Loss for the
year ended
Dec. 31, 2002 --- --- --- --- --- --- --- (12,634,263) (12,634,263)
-------- -------- ---------- --------- ---------- ----------- ---------- ------------ -----------
Balance at
Dec. 31, 2002 235,000 $235,000 5,024,111 $ 50,241 $1,072,825 $45,227,851 --- $(42,721,200) $ 3,864,717
Issuance of
Common Stock --- --- 8,968,627 89,686 --- 3,997,561 --- --- 4,087,247
Conversion
of Preferred
Stock to
Common Stock (45,000) (45,000) 4,500 45 --- 44,955 --- --- ---
Stock issuance
outstanding --- --- --- --- --- --- 6,335,877 --- 6,335,877
Issuance of
warrants --- --- --- --- --- 158,378 --- --- 158,378
Accretion value
of warrants --- --- --- --- 106,484 --- --- --- 106,484
Variable
warrants --- --- --- --- 197,942 (197,942) --- --- ---
Loss for the
year ended
Dec. 31, 2003 --- --- --- --- --- --- --- (4,890,458) (4,890,458)
-------- -------- ---------- --------- ---------- ----------- ---------- ------------ -----------
Balance at
Dec. 31, 2003 190,000 $190,000 13,997,238 $139,972 $1,377,251 $49,230,803 $6,335,877 $(47,611,658) $ 9,662,245
======== ======== ========== ======== ========== =========== ========== ============ ===========
See Independent Auditors' Reports and Notes to the Financial Statements.
31
NESTOR, INC.
Consolidated Statements of Cash Flows
-------------------------------------
YEARS ENDED DECEMBER 31,
2003 2002 2001
-----------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (4,890,458) $ (12,634,263) $ (1,565,054)
Adjustments to reconcile net loss
to net cash used by operating activities:
Depreciation and amortization 1,012,123 601,938 239,178
Loss on disposal of fixed assets 5,291 17,402 66,666
Loss from investment in affiliate --- --- 81,100
Goodwill impairment loss --- 8,500,000 ---
Capitalized system costs impairment --- 794,281 ---
Gain on royalty assignment --- (2,811,