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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, 2004
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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 8,277,780 shares of voting stock held by
non-affiliates of the registrant on June 30, 2004, based on the closing price of
such stock on June 30, 2004, was $33,856,120.
The number of shares outstanding of the Registrant's Common Stock at March 17,
2005 was 18,777,790.
DOCUMENTS INCORPORATED BY REFERENCE
Sections of Nestor, Inc.'s definitive Proxy Statement for the 2005 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., through its wholly owned subsidiary, Nestor Traffic Systems, Inc.,
is a leading provider of innovative, video based traffic safety and enforcement
systems to state and local governments throughout the United States. Our
principal product, CrossingGuard(R) incorporates our patented image processing
technology into an intelligent turnkey solution that predicts and records the
occurrence of a red light violation, and manages the entire process of issuing
and processing a citation. As of December 31, 2004, we had installed
CrossingGuard at 111 approaches for 13 customers throughout the United States,
and our contracts called for us to install CrossingGuard at an additional 128
approaches. We offer an advanced mobile speed enforcement product, through an
agreement with a third party vendor which provides us with exclusive rights to
market their product throughout North America. We also offer fixed speed
enforcement solutions.
The market for intelligent transportation systems and enforcement is
experiencing significant growth, particularly in the area of traffic light
safety enforcement. There are an estimated 300,000 intersections (1.2 million
approaches) with traffic signals in the United States. Technology solutions
manage enforcement at less than 0.5% of these approaches. In 2002, as many as
207,000 crashes, 178,000 injuries and 921 fatalities in the U.S. were attributed
to red light running. Fifteen states and the District of Columbia have already
authorized or allow municipalities to elect the use of automated traffic light
systems, such as CrossingGuard; more states are currently considering such
legislation.
CrossingGuard is an automated, video-based monitoring system that predicts and
records the occurrence of a red light violation. 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 collisions
between violators 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. We provide a complete turnkey solution, offering violation review,
citation preparation and processing, billing and collection, court scheduling,
evidence, and resolution. Our advanced technology captures approximately 270
images of each violation, enabling us to have an enforcement rate in excess of
95%. Depending on the terms of each contract, we realize from $11 to $99 per
citation issued or paid or fixed monthly fees ranging from $2,000 to $12,000 per
approach for system delivery and lease, maintenance, software licensing, and
processing services. We believe that our strong suite of patents covering our
image processing technology provides us with a strategic advantage and allows us
to offer a comprehensive solution to our state and local government clients.
In April 2004, we signed a contract to provide and install our systems at up to
60 approaches in Baltimore, under a prime contract that we believe to be the
largest contract awarded by a municipality to date. In March 2004, we signed a
contract with the state of Delaware to provide and install our systems at up to
40 approaches. We believe that our contract with Delaware is the first automated
red light enforcement contract issued by a state to date.
Information about the industry segments and geographic areas in which we operate
can be found in Note 13 to the financial statements included in this report.
OUR STRENGTHS
We believe that we possess many of the attributes that will be necessary for
long-term success in our industry, including the following:
o TRAFFIC ENFORCEMENT EXPERTISE. We have provided traffic products and
services to state and local governments for seven years. Given our
expertise and track record with these customers, we believe we are
well-positioned to take advantage of the expanding market and expected
increase in spending for traffic safety activities.
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o SUBSTANTIAL INSTALLED CUSTOMER BASE AND CONTRACTS. As of December 31,
2004 we had long-term contracts with 13 customers and 111 approaches
installed and generating citations, and an additional 128 approaches
under contract, waiting for customer orders for delivery or in various
stages of delivery.
o TECHNOLOGY AND INTELLECTUAL PROPERTY LEADERSHIP. Through innovative
use of pattern recognition technology, we have produced a number of
products to identify target patterns of information. We have a strong
patent portfolio. See "--Patents." With our team of veteran
innovators, we are focused and experienced in creating and protecting
our intellectual property. We intend to continue to invest in research
and development and product engineering to enable us to continue to
offer high quality, differentiated and cost-effective products to our
customers. In addition, through development, distribution and
licensing agreements with third parties such as Vitronic, we intend to
capitalize on leading technologies currently in the market and focus
our resources on those areas that provide the most value to our
customers.
o PRODUCT CAPABILITY. We believe video-based automated traffic
enforcement solutions are more technologically advanced than competing
systems such as in-ground sensor loops and "wet film," or on digital
still camera, red light camera systems. We believe that our expertise
in video-based solutions is a competitive advantage over many of our
competitors. We have a proven track record with our video-based
traffic enforcement systems performance and scalability with our
installed customer base.
o CUSTOMER SERVICE AND SUPPORT. We believe that our high level of
customer service and support differentiates us from our competitors.
We offer our customers an array of product support services including
intersection analysis and evaluation, user training, turnkey citation
processing, full system maintenance services, toll-free telephone
numbers for customer support and violator inquiries and assistance
with public education campaigns.
OUR STRATEGY
Our goal is to be the leading provider of traffic enforcement products and
services to state and local governments. Our strategy is to deliver to our
customers complete traffic enforcement solutions, which are designed to enhance
safety and generate sufficient revenue to pay the costs of the systems. We
believe that we possess many of the attributes that will be necessary for
long-term success in our industry by applying the following strategies:
o CAPITALIZE ON EMERGING AUTOMATED TRAFFIC ENFORCEMENT MARKET AND
INCREASE MARKET SHARE. We deliver complete solutions to our customers
and are dedicated to being the industry leader in automated traffic
enforcement products. We intend to continue to grow our installed base
of approaches as our primary emphasis through 2005. Our key target
customers are mid-sized and large municipalities with significant
traffic volume. New legislation in many states has enabled automated
traffic enforcement and increased demand for our products. As a
result, we have a significant opportunity to increase the number of
state and local government clients we serve. In particular, we are
seeing more municipalities seeking automated traffic enforcement, and
we plan to initiate new relationships and expand our existing
relationships with these customers. Currently, more than fifteen
states' legislatures are considering bills to enable or expand
automated traffic enforcement. We believe that through our innovative
technology and customer service, we will have significant
opportunities to new increase our number of approaches in newly opened
geographic markets across the U.S. In addition, we believe that we
will continue to grow our market share in our existing markets as our
customers become more comfortable and familiar with our products and
services.
o SUPPORT MARKET DEVELOPMENT EFFORTS. We have sought to accelerate
market adoption of our automated traffic enforcement products by
participating in the legislative process and in industry standards
committees. We also participate in industry trade groups to broaden
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acceptance and understanding of the market. We seek to continue these
efforts to grow the overall market opportunity. We intend to
accelerate our market development efforts by hiring additional
personnel in select areas, and leveraging the relationships that
members of our management and our advisory boards have with state and
local governments.
o CONTINUE TO LEAD TECHNOLOGICAL INNOVATION. We intend to strengthen our
position by continuing to make investments in research and development
while leveraging and improving our patented technologies. We believe
that we have been able to capture additional market share due
technological leadership with new products.
o LEVERAGE CUSTOMER RELATIONSHIPS TO EXPAND PRODUCT LINE. We believe we
will have significant opportunities to leverage our existing customer
relationships into other areas of automated traffic enforcement, such
as automated speed enforcement.
o EXPAND AND DEEPEN RELATIONSHIPS WITH CUSTOMERS. We intend to
strengthen and broaden the scope of our customer relationships by
expanding our customer support services to become an integrated part
of our customers' traffic enforcement solution. To implement this
strategy, we intend to continue to collaborate with our major
customers at the design and development stage of new products and to
seek to add value to our traffic systems.
o CONTINUE TO PURSUE SELECT ALLIANCES, OPPORTUNISTIC ACQUISITIONS AND
INVESTMENTS. We will continue to evaluate and selectively pursue
strategic alliances, opportunistic acquisitions and investments that
are complementary to our business. We will continue to seek
opportunities that provide us with enhanced technological expertise,
new markets for our products, a stronger product portfolio, increased
market share, new products or a diversification of risk.
o MAINTAIN STABLE CASH FLOWS FROM OPERATIONS AND DISCIPLINED CAPITAL
SPENDING. Our automated traffic enforcement systems are sold under
long-term contracts that provide visibility on our future sales and
cash flow. We intend to maintain our financial performance through
continued productivity initiatives designed to sustain our margins,
reduce costs and improve operating efficiency throughout our
businesses. We make disciplined capital expenditure decisions,
prioritized on the basis of cost structure improvement, potential for
profit generation and maintenance of high quality service.
COMPANY HISTORY
We were incorporated in 1983. We have engaged in various businesses since our
incorporation. Today, our business is limited to providing and installing
CrossingGuard systems and Vitronic speed enforcement products, processing
citations produced by those systems and related services.
Significant events in our recent corporate history, some of which are referred
to elsewhere in this annual report, are listed here:
o CHANGE IN CONTROL. On January 15, 2003, Silver Star Partners I, LLC
purchased 49 million shares of our pre-reverse stock split common
stock for $2,376,500 and on April 16, 2003, completed a second
closing, purchasing 4,013,557 post-reverse stock split shares for
$1,946,575. William B. Danzell, our Chairman, President and CEO, is
the Managing Director of Silver Star. Upon completion of the second
closing, Silver Star owned 64% of our outstanding shares of common
stock.
o REVERSE STOCK SPLIT. We amended our certificate of incorporation on
April 11, 2003, reverse splitting our common stock one for ten. We
issued one share of our common stock after the split for every ten
shares outstanding before the split.
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o MERGER OF NESTOR TRAFFIC SYSTEMS. In January 1997, we organized two
wholly-owned subsidiaries, Nestor Traffic Systems, Inc. and Nestor
Interactive, Inc. In November 1998, we ceased further investment in
Nestor Interactive. In 1999, Nestor Traffic Systems sold a majority
common stock interest to a group of investors. In June 2000, Nestor
Traffic Systems sold additional shares of its common stock to private
investors and our ownership of Nestor Traffic Systems was diluted to
approximately 35%. On September 12, 2001, we merged Nestor Traffic
Systems, Inc. into our wholly-owned subsidiary, which was then renamed
Nestor Traffic Systems, Inc.
o APPLIED COMMUNICATIONS, INC. On February 1, 2001, we entered into a
non-exclusive license agreement with Applied Communications, Inc. We
granted Applied Communications the right to integrate and distribute
all of fraud detection products throughout its worldwide sales and
support network. Applied Communications paid us $1.1 million in four
equal installments in the first six months of 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 are required. This agreement
replaced an earlier license to Applied Communications. We sold the
royalty rights to Churchill Lane Associates from this license on July
1, 2002. We do not expect to receive future revenues from this
license.
o RETAIL DECISIONS, INC. On May 18, 2001, we entered into a license
agreement with Retail Decisions, Inc. We granted Retail Decisions a
perpetual, fully-paid, worldwide license in the field of use of fraud
and money laundering detection and risk management in certain defined
industries; and a non-exclusive, perpetual, fully-paid, worldwide
license solely for use in the field of use of customer relationship
management in certain defined industries. Retail Decisions paid us
$1,800,000 under the license agreement, and for certain marketing and
transition services, we paid Retail Decisions $968,000 in 2001. No
ongoing revenues are expected to be realized from Retail Decisions.
o NATIONAL COMPUTER SYSTEMS, INC. On June 11, 1996, we entered into a
licensing agreement and an asset purchase agreement to transfer the
development, production, and marketing rights of our character
recognition products to National Computer Systems. National Computer
Systems continues to market the products on a non-exclusive basis.
Historically, we have received approximately $25,000 in minimum
royalties per year under this license.
INDUSTRY OVERVIEW
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, in 2000, there were approximately 106,000
red light running crashes that resulted in 89,000 injuries and 1,036 deaths,
according to the Federal Highway Administration. In 2002, as many as 207,000
crashes, 178,000 injuries and 921 fatalities in the U.S. were attributed to red
light running, according to the National Campaign to Stop Red Light Running.
First-generation red-light camera systems gained early acceptance as a means of
automated traffic enforcement. Although these systems validated the market
opportunity, they generally continue to rely on in-ground vehicle sensing 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, either through state enabling
statutes or home rule statutes. To date, approximately 15 states and the
District of Columbia authorize on a full or limited basis the use of red light
cameras. States allowing red light enforcement include:
Arizona Illinois Ohio
California Iowa Oregon
Colorado Maryland South Dakota
Delaware New York Tennessee
Georgia North Carolina Washington
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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.
According to the Federal Highway Administration, a 1998 Lou Harris poll
sponsored by Advocates for Highway & Auto Safety found that 65% of Americans
favored adoption of legislation to allow use of red light cameras. However,
there remains opposition to these systems, largely based upon concerns regarding
individual privacy rights and due process rights. Many states and communities
have or are considering authorization of cameras but need to address these
minority concerns first. We believe 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. We also believe that business opportunities from the
currently authorized communities will be enough to support near term growth
objectives.
PRODUCTS AND SERVICES
Our products combine sophisticated digital and analog camera technologies with
advanced image processing to detect and interpret a wide range of
traffic-related elements and conditions. Our 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. Our products are flexible and can be configured to a
wide range of road configurations, including open roads and intersections. Our
systems offer an array of features and unique functionality that address
critical transportation management and traffic safety needs. We formerly
developed and marketed products in the fields of risk management, customer
relationship management and character recognition.
CROSSINGGUARD RED LIGHT ENFORCEMENT
Our CrossingGuard systems 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 by
combining 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, we apply algorithms to
recognize objects as vehicles and predict their motion relative to the stop
line. This advanced technology, which effectively sees and interprets objects
captured in video images, is at the core of the CrossingGuard solution.
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. We provide citation mailing and other back-office
services.
We provide a complete turnkey solution, offering violation review, citation
preparation and processing, billing and collection, court scheduling, evidence,
and resolution. In addition, we provide 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 that is used to
track approaching vehicles and record the actions of an approaching violator.
Another camera is positioned so as to see the signal lights as they change from
green to yellow to red and record the vehicle's 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
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computer runs the intelligent software and controls camera activity and is
installed in an enclosure by the wayside or fiber connection to the roadside is
used. 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 functionality as needed. We purchase
all electronic and mechanical components from third party vendors, built in
accordance with our specifications, and local contractors install the systems.
The primary attributes of CrossingGuard are:
o ACCURATE, REAL-TIME INTERPRETATION OF TRAFFIC VIDEO IMAGES. We have
applied our 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. Our image-understanding technology
is able to interpret video images accurately and respond in a
real-time environment at affordable cost.
o 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), our 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.
o COMPATIBILITY WITH INDUSTRY STANDARD PLATFORMS. Our 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.
We also provide services related to our CrossingGuard systems:
CROSSINGGUARD VIP. The CrossingGuard Video Intersection Profiling (VIP) program
is a proprietary tool that we have 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.
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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. Many
contracts compensate us 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 us to
recover the value of the system delivered, including a finance factor and
maintenance costs, over the term of the contract. Throughout 2003 and 2004,
there has been a trend by states towards fixed monthly fee as opposed to
variable per ticket fee pricing structures.
As of December 31, 2004, we had 111 approaches installed and generating
citations and an additional 128 approaches under contract, waiting for customer
orders for delivery or in various stages of delivery. No assurances can be given
that all approaches under contract will ultimately be installed. Depending upon
contract terms, we realize from $11 to $99 per citation issued or paid or fixed
monthly fees ranging from $2,000 to $12,000 per approach for system delivery and
lease, maintenance, software licensing, and processing services. State statutes
providing for automated red light enforcement may impose liability on the driver
or the registered owner of a vehicle for a violation. Driver liability statutes
require that the driver be identified, from the photographic evidence, and that
the citation be issued and sent to the driver. Registered owner statutes require
that the vehicle's owner be identified, through registration records, and that
the citation be issued and sent to the driver. As only the license plate is
required for identification under a registered owner statute, program operating
efficiencies are much higher resulting in lower per citation or monthly fees.
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.
SPEED PRODUCTS
In August 2004, we entered into an exclusive distributorship agreement with a US
subsidiary of Vitronic GmbH, a German based corporation that provides solutions
for factory and industrial automation, quality inspection, logistics and traffic
management systems. Under the terms of the agreement, we have exclusive rights
to market and sell Vitronic's PoliScan Speed Mobile throughout the United
States, Canada, and Mexico, for an initial term of five years, subject to
minimum annual sales goals.
PoliScan Speed Mobile is a system for digital speed detection and recording. In
contrast to conventional measures such as radar, light barriers, and
piezo-section, a complex installation and calibration of the system at the
measurement site is not necessary. An additional feature is the ability to
simultaneously record and measure several vehicles in parallel lanes. Thus
ambiguities and measurement errors can be reliably avoided. The system uses a
high-resolution digital camera for documentation of the speeding offense,
including pictures of the license plate, an overview picture, as well as the
image of the driver where required.
We offer a fixed site speed camera system. The system will deliver video
evidence of vehicles speeding with advanced nonintrusive, performance similar to
our CrossingGuard systems. It is designed to allow for upgrading CrossingGuard
installations to enable dual 'red-and-speed' intersection monitoring. The system
may also be installed on a standalone basis. Our fixed speed solution uses two
independent speed detection sensors to cross-reference and verify the vehicle
speed, a feature that we believe is unique to our product.
We have begun marketing our speed products to jurisdictions in the
United States that allow the automated enforcement of speed limits.
OTHER TRAFFIC PRODUCTS
We have two other traffic safety and enforcement products - Rail CrossingGuard
and TrafficVision. We are no longer marketing or developing these products and
we do not expect to receive material revenue related to them in the future. In
2002 we eliminated our marketing and sales efforts for these product lines to
focus our resources on the CrossingGuard red-light enforcement market.
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RAIL CROSSINGGUARD. We 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.
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
from the 1950's, TrafficVision is a non-intrusive sensor system for traffic
management. TrafficVision uses our 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.
SALES, MARKETING AND METHODS OF DISTRIBUTION
We market our products and services to municipalities, governmental traffic
management departments, or their integrators through our nationwide direct sales
force. Because our products require technical assistance during the sales and
installation processes, we also maintain an in-house staff of program managers
and field engineers. We obtain product inquiries from product mailings,
attendance at trade shows, trade press coverage and our Internet site. Most
CrossingGuard contracts are obtained through competitive proposal processes in
response to requests for proposals issued by municipalities. We subscribe to a
service that advises us of relevant requests for proposal issued by state and
local governments. In 2004, we submitted fifteen proposals to state and local
governments. In 2004, as a result of bids submitted in 2003 and 2004, we were
awarded three contracts and we have been selected as the provider by, but not
entered into a contract with, six municipalities. No provider has been selected
with respect to five of the requests for proposals to which we responded in
2004.
RESEARCH AND DEVELOPMENT ACTIVITIES
The focus of our research and development is to develop and improve our products
and technologies in order to maintain and improve our products' competitive
advantages, our level of customer service and satisfaction and to consider the
development of new technologies and products. We have pursued new and enhanced
technologies and products extensively in the past and may do so again in the
future, but our current emphasis is on developing and improving existing
products with a proven market.
Our research and development includes 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 our basic
technology. See "--Patents." We have two additional patent applications pending
as of December 31, 2004, both in the area of traffic management, enforcement and
safety.
Changing technologies may affect the market for our products. Our 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 we 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 us 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 our business, financial condition and results of
operations.
We spent $157,000, $121,000 and $1,604,000 in the years ended December 31, 2004,
2003 and 2002 respectively, on research and development.
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PATENTS
We have continually sought and obtained patent protection for our traffic safety
systems and for our proprietary neural networks as, 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. Our patented
neural network exhibits rapid learning and minimizes the internal connections
needed for its functioning. We believe that these capabilities make our
technology uniquely suited to applications that require field trainability or
self-modification to adapt to new or changing patterns in the data. Our patents
also cover multiple-neural-network systems, which enabled us to develop products
that combined high accuracy with high processing speeds.
During 2004, we received two additional patents relative to the CrossingGuard
product line. The first patent recognizes the transmission of video as part of
the user interface in our CitationComposer software for ticket processing and
issuance. The second patent recognizes the invention of a traffic sensor.
During 2003, we received two additional patents relative to the CrossingGuard
product line. One of those patents recognizes our method of predicting and
recording a red light violation with a video-based system including the use of
violation probability scores. The second patent 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. We own 13
United States patents and 14 foreign patents. We have one pending U.S. patent
application and three foreign patent applications pending. Six of our U.S.
patents, two of our foreign patents and all of our patent applications have
relevance to our traffic safety business. 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
We believe 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 wet film or digital still cameras that record only a
few frames of evidence regarding a violation, and in-ground sensor loops.
In-ground sensor loops require digging up the pavement and are generally
unresponsive to vehicles moving below twelve miles per hour. 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.
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 our
video evidence attractive to city councils, law enforcement officials, courts,
and the general public. Our systems have a high enforceability rate; we average
99% in registered owner liability jurisdictions and 95% in driver liability
jurisdiction. The enforceability rate is the ratio of not successfully
challenged to citations issued. We believe that our enforceability rates are
higher than those of our many of our competitors and that part of the reason for
our high rate is the perception of fairness. Because of the ability to view the
violation video sequence, violators find it difficult to challenge our citations
based on context.
We are aware of at least six competitors that purport to have video in their
systems. We have initiated patent infringement lawsuits against two of these
competitors on the basis of our February 13, 2001 patent entitled "Integrated
Traffic Light Violation Citation Generation and Court Date Scheduling System"
and, with respect to one of those competitors, on our June 22, 2004 patent
entitled "Video-file based citation generation system for traffic light
violations." See "Risk Factors --If We Fail To Protect And Preserve Our
Intellectual Property, We May Lose An Important Competitive Advantage" and "--
Legal Proceedings." There can be no assurance that we will be successful in
defending this patent and limiting the use of video by competitors in the U.S.
red light enforcement market.
11
Our 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.
Most of our competitors have significantly greater financial, marketing and
other resources than we do. 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 we may. Competitive
pressures faced by us may materially adversely affect its business, financial
condition and results of operations.
CONTRACTS WITH GOVERNMENTAL ENTITIES
Our CrossingGuard agreements are generally service contracts with states or
municipalities that in most circumstances may be cancelled by the customer for
various reasons. As these contracts are generally self-funded from ticket fees
collected from red-light violators and some contracts contain termination fee
provisions, we do not expect this to be a significant risk in the future. Our
Rail CrossingGuard and TrafficVision contracts were generally fixed-fee
deliverable contracts and termination rights were generally limited to
non-performance conditions. We retain all patent and other proprietary rights
from products developed and delivered under government-supported contracts.
EMPLOYEES
As of December 31, 2004, we had 65 full-time employees, comprising 16 in
software engineering and product development, 11 in processing and system
support, 25 in program management and field services, 7 in sales and marketing
and 6 in management, finance and office support. All of our employees are
located in the United States. None of our employees are represented by a labor
union. We have experienced no work stoppages and management believes our
employee relationships are generally good.
RISK FACTORS THAT MAY AFFECT OUR RESULTS
This Annual Report on Form 10-K and certain other communications made by us
contain forward-looking statements, including statements about our growth and
future operating results, discovery and development of products, strategic
alliances and intellectual property. For this purpose, any statement that is not
a statement of historical fact should be considered a forward-looking statement.
We often use the words "believe," "anticipate," "plan," "expect," "intend,"
"will" and similar expressions to help identify forward-looking statements.
References in this exhibit "we," "us," and "our" refer to Nestor, Inc. and its
subsidiaries.
We cannot assure investors that our assumptions and expectations will prove to
have been correct. Important factors could cause our actual results to differ
materially from those indicated or implied by forward-looking statements. Such
factors that could cause or contribute to such differences include those factors
discussed below. We undertake no intention or obligation to update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise.
RISKS RELATED TO OUR BUSINESS
WE HAVE A HISTORY OF LOSSES AND EXPECT TO INCUR LOSSES IN THE FUTURE
We have a history of net losses. For the years ended December 31, 2004, 2003,
2002, 2001 and 2000, our net losses have been approximately $4,473,000,
$4,890,000, $12,634,000, $1,565,000, $2,995,000 and $837,000, respectively. For
the three-month period ended December 31, 2004, our net loss was approximately
$1,959,000. We expect to incur continuing losses for the foreseeable future due
to significant engineering, product delivery, marketing and general and
administrative expenses, which losses could be substantial. We will need to
generate significantly higher revenue to achieve profitability, which we may be
unable to do. Even if we do achieve profitability, we may not be able to sustain
or increase our profitability in the future.
12
ALMOST ALL OF OUR CURRENT REVENUE IS FROM A SINGLE PRODUCT AND RELATED SERVICES
Currently, almost all of our revenue is from sales of our CrossingGuard systems,
services related to installing and maintaining CrossingGuard systems or
processing citations issued by CrossingGuard systems. There can be no assurance
that we will be able to develop other sources of revenue. Because our revenues
depend on a single product, any decrease in the market share held by
CrossingGuard would have a substantial adverse effect on our business and
financial results. If we fail to meet our expectations for the growth in sales
of CrossingGuard or if we are not able to develop other sources of revenue, we
will not be able to generate the significantly higher revenue that we believe we
must generate to achieve profitability.
OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS MAY BE ADVERSELY AFFECTED IF
WE ARE UNABLE TO SECURE AND MAINTAIN FUTURE CONTRACTS WITH GOVERNMENT AGENCIES
Contracts with government agencies account for substantially all of our net
revenues. The majority of these contracts may be terminated at any time on short
notice with limited penalties. Accordingly, we might fail to derive any revenue
from sales to government agencies in any given future period. If government
agencies fail to renew or if they terminate any of these contracts, it would
adversely affect our business and results of operations. In addition, many of
our contracts do not allow installations until sites have been approved by the
contracting agency; in those cases, if a government agency fails to approve
sites, we will not be able to deliver products and services.
WE FACE SUBSTANTIAL COMPETITION, WHICH MAY RESULT IN OTHERS DEVELOPING PRODUCTS
AND SERVICES MORE SUCCESSFULLY THAN WE DO
Many other companies offer products that directly compete with CrossingGuard and
our other products. Many of our current and potential competitors have
significantly greater financial, marketing, technical and other competitive
resources than we do and may be able bring new technologies to market before we
are able to do so. Some of our competitors may have a competitive advantage
because of their size, market share, legacy customer relationships, enhanced
driver imaging, additional products offered and/or citation-processing
experience. Current and potential competitors may establish cooperative
relationships with one another or with third parties to compete more effectively
against us. One of our competitors, ACS, offers state and local governments
solutions to a wide variety of data processing issues and may have a competitive
advantage because of the scope of its relationship with, and the volume of
transactions it conducts for, a particular government. It is also possible that
new competitors may emerge and acquire market share. If we are not successful in
protecting our patents, we would lose a competitive advantage. See "-- If We
Fail To Protect And Preserve Our Intellectual Property, We May Lose An Important
Competitive Advantage."
THE FAILURE OF GOVERNMENTS TO AUTHORIZE AUTOMATED TRAFFIC SAFETY ENFORCEMENT MAY
HINDER OUR GROWTH AND HARM OUR BUSINESS
Approximately fifteen states and the District of Columbia authorize some use of
automated red light enforcement or allow municipalities to elect to do so under
home rule laws. It is uncertain at this time which additional states, if any,
will authorize the use of automated red light enforcement or if there will be
other changes in the states that currently allow the practice. If additional
states do not authorize the use of automated red light enforcement, our
opportunities to generate additional revenue from the sale of CrossingGuard
systems and related services will be limited. Recently, the Virginia General
Assembly declined to extend authorization for automated red light enforcement
beyond the sunset date of June 30, 2005 in the enabling legislation.
We could be subject to differing and inconsistent laws and regulations with
respect to CrossingGuard. If that were to happen, we may find it necessary to
eliminate, modify or cancel components of our services that could result in
additional development costs and the possible loss of revenue. We cannot predict
whether future legislative changes or other changes in the eighteen states or
other states, in the administration of traffic enforcement programs, will have
an adverse effect on our business.
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The market for automated speed enforcement products in the United States is very
limited. At least five states and the District of Columbia have legislation
authorizing some use of automated speed enforcement or allow municipalities to
elect to do so under home rule laws. Some of these states authorize automated
speed enforcement only in limited circumstances such as school or work zones. If
additional states do not authorize automated speed enforcement, our
opportunities to generate additional revenue from the sale of automated speed
enforcement systems and related services will be limited.
OUR FINANCIAL RESULTS WILL DEPEND SIGNIFICANTLY ON OUR ABILITY TO CONTINUALLY
DEVELOP OUR PRODUCTS AND TECHNOLOGIES
The markets for which our products and technologies are designed are intensely
competitive and are characterized by short product lifecycles, rapidly changing
technology and evolving industry standards. As a result, our financial
performance will depend to a significant extent on our ability to successfully
develop and enhance our products. Because of the rapidly changing technologies
in the businesses in which we operate, we believe that significant expenditures
for research and development and engineering will continue to be required in the
future. To succeed in these businesses, we must anticipate the features and
functionality that customers will demand. We must then incorporate those
features and functionality into products that meet the design requirements of
our customers. The success of our product introductions will depend on several
factors, including:
o proper product definition;
o timely completion and introduction of enhanced product designs;
o the ability of subcontractors and component manufacturers to
effectively design and implement the manufacture of new or enhanced
products and technologies;
o the quality of our products and technologies;
o product and technology performance as compared to competitors'
products and technologies;
o market acceptance of our products; and
o competitive pricing of products, services and technologies.
We must successfully identify product and service opportunities and develop and
bring our products and technologies to market in a timely manner. We have in the
past experienced delays in completing the development or the introduction of new
products. Our failure to successfully develop and introduce new or enhanced
products and technologies or to achieve market acceptance for such products and
technologies may materially harm our business and financial performance.
WE MAY NEED ADDITIONAL FINANCING, WHICH MAY BE DIFFICULT TO OBTAIN AND MAY
RESTRICT OUR OPERATIONS AND DILUTE YOUR OWNERSHIP INTEREST
We may need to raise additional funds in the future to fund our operations,
deliver our products, to expand or enhance our products and services or to
respond to competitive pressures or perceived opportunities. We cannot make any
assurance that additional financing will be available on acceptable terms, or at
all. If adequate funds are not available or not available on acceptable terms,
our business and financial results may suffer.
The covenants in our outstanding 5% Senior Convertible Notes limit our ability
to raise additional debt. If we raise additional funds by issuing equity
securities, further dilution to our then existing stockholders will result and
the terms of the financing may adversely affect the holdings or the rights of
such stockholders. In addition, the terms and conditions of debt financing may
result in restrictions on our operations. We could be required to seek funds
through arrangements with collaborative partners or others that may require us
to relinquish rights to certain of our technologies, product candidates or
products which we would otherwise pursue on our own.
14
FLUCTUATIONS IN OUR RESULTS OF OPERATIONS MAKE IT DIFFICULT TO PREDICT OUR
FUTURE PERFORMANCE AND MAY RESULT IN VOLATILITY IN THE MARKET PRICE OF OUR
COMMON STOCK
Our quarterly operating results have fluctuated in the past and may fluctuate
significantly in the future. Most of our expenses are fixed in the short-term,
and we may not be able to reduce spending quickly if our revenue is lower than
expected. In addition, our ability to forecast revenue is limited. As a result,
our operating results are volatile and difficult to predict and you should not
rely on the results of one quarter as an indication of future performance.
Factors that may cause our operating results to fluctuate include the risks
discussed in this section as well as:
o costs related to customization of our products and services;
o the planned expansion of our operations, including opening new
offices, hiring new personnel, and the amount and timing of
expenditures related to this expansion;
o announcements or introductions of new products and services by our
competitors;
o the failure of additional states to adopt legislation enabling the use
of automated traffic safety enforcement systems;
o software defects and other product quality problems;
o the discretionary nature of our clients' purchasing and budgetary
cycles;
o the varying size, timing and contractual terms of orders for our
products and services; and
o the mix of revenue from our products and services.
OUR SALES CYCLES VARY SIGNIFICANTLY WHICH MAKES IT DIFFICULT TO PLAN OUR
EXPENSES AND FORECAST OUR RESULTS
Our sales cycles typically range from six to eighteen months or more. It is
therefore difficult to predict the quarter in which a particular sale will occur
and to plan our expenses accordingly. The period between our initial contact
with potential clients and the installation of our products and the use of our
services varies due to several factors, including:
o the complex nature of our products and services;
o the failure of the jurisdiction to adopt legislation enabling the use
of automated traffic safety enforcement systems or political or legal
challenges to existing legislation;
o the novelty of automated enforcement in many jurisdictions and a lack
of familiarity with automated enforcement systems on the part of
legislative, executive and judicial bodies and the public;
o our clients' budget cycles;
o the selection, award and contracting processes at municipalities and
other government entities, including protests by other bidders with
respect to competitive awards;
o our clients' internal evaluation, approval and order processes;
o the site evaluation and analysis process; and
o our clients' delays in issuing requests for proposals or in awarding
contracts because of announcements or planned introductions of new
products or services by our competitors.
15
Any delay or failure to complete sales in a particular quarter could reduce our
revenue in that quarter, as well as subsequent quarters over which revenue or
the license would likely be recognized. If our sales cycles unexpectedly
lengthen in general or for one or more large clients, it would delay our receipt
of the related revenue. If we were to experience a delay of several weeks or
longer on a large client, it could harm our ability to meet our forecasts for a
given quarter.
IF WE LOSE OUR KEY PERSONNEL OR ARE UNABLE TO ATTRACT AND RETAIN ADDITIONAL
PERSONNEL, OUR OPERATIONS WOULD BE DISRUPTED AND OUR BUSINESS WOULD BE HARMED
We believe that the hiring and retaining of qualified individuals at all levels
in our organization will be essential to our ability to sustain and manage
growth successfully. Competition for highly qualified technical personnel is
intense and we may not be successful in attracting and retaining the necessary
personnel, which may limit the rate at which we can develop products and
generate sales. We will be particularly dependent on the efforts and abilities
of our senior management personnel. The departure of any of our senior
management members or other key personnel could harm our business.
OUR PRODUCTS MIGHT NOT ACHIEVE MARKET ACCEPTANCE
The market for our products is still emerging. The rate at which state and local
government bodies have adopted CrossingGuard has varied significantly by market,
and we expect to continue to experience variations in the degree to which
CrossingGuard is accepted. To date, no state or local government bodies in our
market area have adopted our speed enforcement products. Our ability to grow
will depend on the extent to which our potential customers accept our products.
This acceptance may be limited by:
o the failure of prospective customers to conclude that our products are
valuable and should be acquired and used;
o the failure of additional states to adopt legislation enabling the use
of automated traffic safety enforcement systems;
o the novelty of automated enforcement in many jurisdictions and a lack
of familiarity with automated enforcement systems on the part of
legislative, executive and judicial bodies and the public;
o the reluctance of our prospective customers to replace their existing
solutions with our products;
o marketing efforts of our competitors; and
o the emergence of new technologies that could cause our products to be
less competitive or obsolete.
Because automated traffic enforcement in the United States is still in an early
stage of development, we cannot accurately predict how large the market will
become, and we have limited insight into trends that may emerge and affect our
business. For example, without knowing how commonplace automated enforcement
will become, we may have difficulties in predicting the competitive environment
that will develop.
OUR INTELLECTUAL PROPERTY MIGHT NOT BE PROTECTIBLE
We rely on a combination of copyright, trademark, patent, and trade-secret laws,
employee and third-party nondisclosure agreements, and other arrangements to
protect our proprietary rights. Despite these precautions, it may be possible
for unauthorized third parties to copy our products or obtain and use
information that we regard as proprietary to create products that compete
against ours. In addition, some license provisions protecting against
unauthorized use, copying, transfer, and disclosure of our licensed programs may
be unenforceable under the laws of certain jurisdictions and foreign countries.
In addition, the laws of some countries do not protect proprietary rights to the
same extent as do the laws of the United States. Were we to conduct
international activities, our exposure to unauthorized copying and use of our
products and proprietary information would increase. The scope of United States
patent protection in the software industry is not well defined and will evolve
16
as the United States Patent and Trademark Office grants additional patents.
Because some patent applications in the United States are not publicly disclosed
until the patent is issued or 18 months after the filing date, applications may
exist that would relate to our products and that are not publicly accessible.
Moreover, a patent search has not been performed in an attempt to identify
patents applicable to our business and, even if such a search were conducted,
all patents applicable to the business might not be located.
IF WE FAIL TO PROTECT AND PRESERVE OUR INTELLECTUAL PROPERTY, WE MAY LOSE AN
IMPORTANT COMPETITIVE ADVANTAGE
On November 6, 2003, we 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 our US Patent No. 6,188,329. On
November 25, 2003, we 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 that patent. We were
denied a preliminary injunction in the Transol litigation, in part because the
court determined that we had not shown a likelihood of success on our claim that
Transol's product infringes our patent. We subsequently filed additional claims
alleging that Transol and Redflex have also infringed our US Patent No.
6,754,663, but have withdrawn that claim with respect to Redflex. Transol has
filed a motion for summary judgment, on which motion a hearing is scheduled for
April 11, 2005.
We cannot give assurance that we will succeed in either action. If we are
unsuccessful in either action, it will be because either our one or both patents
are invalidated or because our competitors' products do not infringe our
patents. Were one or more of our patents invalidated, our competitors will be
able to offer the technology that those patents describe and we would lose the
competitive advantage of being the exclusive source of products using that
technology. Were our competitors' products to be found to be non-infringing, our
competitors would be able to continue to market products that are similar to
ours and we would lose some of the competitive advantages that we believe our
products enjoy.
WE ARE AT RISK OF CLAIMS THAT OUR PRODUCTS OR SERVICES INFRINGE THE PROPRIETARY
RIGHTS OF OTHERS
Given our ongoing efforts to develop and market new technologies and products,
we may from time to time be served with claims from third parties asserting that
our products or technologies infringe their intellectual property rights. If, as
a result of any claims, we were precluded from using technologies or
intellectual property rights, licenses to the disputed third-party technology or
intellectual property rights might not be available on reasonable commercial
terms, or at all. We may initiate claims or litigation against third parties for
infringement of our proprietary rights or to establish the validity of our
proprietary rights. Litigation, either as plaintiff or defendant, could result
in significant expense and divert the efforts of our technical and management
personnel from productive tasks, whether or not litigation is resolved in our
favor. An adverse ruling in any litigation might require us to pay substantial
damages, to discontinue our use and sale of infringing products and to expend
significant resources in order to develop non-infringing technology or obtain
licenses for our infringing technology. A court might also invalidate our
patents, trademarks or other proprietary rights. A successful claim against us,
coupled with our failure to develop or license a substitute technology, could
cause our business, financial condition and results of operations to be
materially adversely affected. As the number of software products increase and
the functionality of these products further overlaps, we believe that our risk
of infringement claims will increase.
IF WE ARE UNABLE TO SAFEGUARD THE INTEGRITY, SECURITY AND PRIVACY OF OUR DATA OR
OUR CLIENTS' DATA, OUR REVENUE MAY DECLINE, OUR BUSINESS COULD BE DISRUPTED AND
WE MAY BE SUED
We need to preserve and protect our data and our clients' data against loss,
corruption and misappropriation caused by system failures and unauthorized
access. We could be subject to liability claims by individuals whose data
resides in our databases for misuse of personal information, including
unauthorized marketing purposes. These claims could result in costly litigation.
Periodically, we have experienced minor systems errors and interruptions,
including Internet disruptions, which we believe may occur periodically in the
future. A party who is able to circumvent our security measures could
misappropriate or destroy proprietary information or cause interruptions in our
operations. We may be required to make significant expenditures to protect
against systems failures or security breaches or to alleviate problems caused by
any failures or breaches. Any failure that causes the loss or corruption of, or
17
unauthorized access to, this data could reduce client satisfaction, expose us to
liability and, if significant, could cause our revenue to decline.
WE MAY MAKE ACQUISITIONS, WHICH COULD DIVERT MANAGEMENT'S ATTENTION, CAUSE
OWNERSHIP DILUTION TO OUR STOCKHOLDERS AND BE DIFFICULT TO INTEGRATE
We have expanded and may seek to continue to expand our operations through the
acquisition of additional businesses that complement our core skills and have
the potential to increase our overall value. Our future growth may depend, in
part, upon the continued success of our acquisitions. Acquisitions involve many
risks, which could have a material adverse effect on our business, financial
condition and results of operations, including:
o acquired businesses may not achieve anticipated revenues, earnings or
cash flow;
o integration of acquired businesses and technologies may not be
successful and we may not realize anticipated economic, operational
and other benefits in a timely manner, particularly if we acquire a
business in a market in which we have limited or no current expertise
or with a corporate culture different from ours;
o potential dilutive effect on our stockholders from continued issuance
of common stock as consideration for acquisitions;
o adverse effect on net income of impairment charges related to goodwill
and other intangible assets and other acquisition-related charges,
costs and expenses on net income;
o competing with other companies, many of which have greater financial
and other resources to acquire attractive companies, making it more
difficult to acquire suitable companies on acceptable terms; and
o disruption of our existing business, distraction of management and
other resources and difficulty in maintaining our current business
standards, controls and procedures.
THE FAILURE OF OUR SUPPLIERS TO DELIVER COMPONENTS, EQUIPMENT AND MATERIALS IN
SUFFICIENT QUANTITIES AND IN A TIMELY MANNER COULD ADVERSELY AFFECT OUR BUSINESS
Our business employs a wide variety of components, equipment and materials from
a limited number of suppliers. To date, we have found that the components,
equipment and materials necessary for the development, testing, production and
delivery of our products and services have sometimes not been available in the
quantities or at the times we have required. Our failure to procure components,
equipment and materials in particular quantities or at a particular time may
result in delays in meeting our customer's needs, which could have a negative
effect on customer satisfaction and on our revenues and results of operations.
WE ARE SUBJECT TO POTENTIAL PRODUCT LIABILITY CLAIMS THAT COULD RESULT IN COSTLY
AND TIME-CONSUMING LITIGATION
Although our license agreements typically contain provisions designed to limit
our exposure to product liability claims, existing or future laws or unfavorable
judicial decisions could negate these limitation of liability provisions. Any
product liability claim brought against us, even if unsuccessful, would likely
be time-consuming and costly, and potential liabilities could exceed our
available insurance coverage.
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RISKS RELATED TO OUR COMMON STOCK
OUR COMMON STOCK PRICE IS VOLATILE AND MAY DECLINE IN THE FUTURE
The market price of our common stock has fluctuated significantly and may be
affected by our operating results, changes in our business, changes in the
industries in which we conduct business, and general market and economic
conditions which are beyond our control. In addition, the stock markets in
general have recently experienced extreme price and volume fluctuations. These
fluctuations have affected stock prices of many companies without regard to
their specific operating performance. These market fluctuations may make it
difficult for stockholders to sell their shares at a price equal to or above the
price at which the shares were purchased. In addition, if our results of
operations are below the expectations of market analysts and investors, the
market price of our common stock could be adversely affected.
OUR BOARD OF DIRECTORS CAN, WITHOUT STOCKHOLDER APPROVAL, CAUSE PREFERRED STOCK
TO BE ISSUED ON TERMS THAT ADVERSELY AFFECT COMMON STOCKHOLDERS
Under our certificate of incorporation, our board of directors is authorized to
issue up to 10,000,000 shares of preferred stock, of which 180,000 shares are
issued and outstanding, and to determine the price, rights, preferences,
privileges and restrictions, including voting rights, of those shares without
any further vote or action by our stockholders. If the board causes any
additional preferred stock to be issued, the rights of the holders of our common
stock would be adversely affected. The board's ability to determine the terms of
preferred stock and to cause its issuance, while providing desirable flexibility
in connection with possible acquisitions and other corporate purposes, could
have the effect of making it more difficult for a third party to acquire a
majority of our outstanding voting stock. We have no current plans to issue
additional shares of preferred stock.
OUR DIRECTORS, OFFICERS AND PRINCIPAL STOCKHOLDERS EXERCISE SIGNIFICANT CONTROL
OVER OUR BUSINESS AND AFFAIRS, INCLUDING THE APPROVAL OF CHANGE IN CONTROL
TRANSACTIONS
Our directors, officers, and principal stockholders who own more than 5% of the
outstanding common stock, and entities affiliated with them, beneficially own
approximately 52% of our common stock. These stockholders, acting together, will
be able to exert substantial influence over all matters requiring approval by
our stockholders. These matters include the election and removal of directors
and any merger, consolidation or sale of all or substantially all of our assets.
This concentration of ownership may have the effect of delaying, deferring or
preventing a change in control, or impeding a merger, consolidation, takeover or
business combination even if the transaction might be beneficial to our
stockholders.
In addition, Section 203 of the Delaware General Corporation Law restricts
business combinations with any "interested stockholder" as defined by the
statute. The statute may have the effect of delaying, deferring or preventing a
change in control of our company.
WE HAVE NOT PAID, AND DO NOT INTEND TO PAY, DIVIDENDS AND THEREFORE, UNLESS OUR
COMMON STOCK APPRECIATES IN VALUE, OUR INVESTORS MAY NOT BENEFIT FROM HOLDING
OUR COMMON STOCK
We have not paid any cash dividends since inception. We do not anticipate paying
any cash dividends in the foreseeable future. As a result, our investors will
not be able to benefit from owning our common stock unless the market price of
our common stock becomes greater than the basis that these investors have in
their shares.
THE PRICE OF OUR COMMON STOCK MAY DECLINE BECAUSE A SUBSTANTIAL AMOUNT OF OUR
COMMON STOCK IS AVAILABLE FOR TRADING IN THE PUBLIC
Availability of shares of our common stock could depress the price of our common
stock. A substantial amount of common stock is available for trading in the
public market. The stock in the market may cause the price of our common stock
19
to decline. In addition, if our stockholders sell substantial numbers of stock
of our common stock in the public markets, the market price of our common stock
could fall. These sales might also make it more difficult for us to sell equity
or equity related securities at a time and price that we would deem appropriate.
We also have issued options, warrants and convertible securities which can be
exercised for, or converted to, shares of common stock, many of which would be
freely tradable without restrictions or further registration under the
Securities Act of 1933.
There were approximately 18,777,790 shares of our common stock outstanding as of
March 17, 2005, of which 9,016,924 were freely tradable without restrictions or
further registration under the Securities Act of 1933.
As of March 17, 2005, we have issued and outstanding warrants and options to
purchase up to 2,951,066 shares of our common stock, preferred stock convertible
into 18,000 shares of our common stock and debt convertible into 927,836 shares
of our common stock. The exercise of such warrants and options and conversion of
convertible securities may dilute the interests of all stockholders. Possible
future resale of such warrants and options or conversion of such convertible
securities could adversely affect the prevailing market price of our common
stock.
OUR COMMON STOCK TRADES ON THE OTC BULLETIN BOARD AND MAY BE SUBJECT TO THE
SEC'S "PENNY STOCK" RULES
Our stockholders may find it difficult to buy, sell and obtain pricing
information about, as well as news coverage of, our common stock because it is
traded on the OTC Bulletin Board. Being traded on the OTC Bulletin Board, rather
than on a national securities exchange, may lessen investors' interest in our
securities generally and materially adversely affect the trading market and
prices for those securities and our ability to issue additional securities or to
secure additional financing. The price of our common stock could make it more
difficult for stockholders to sell their shares. Our common stock will be
subject to the penny stock rules under the Securities Exchange Act of 1934 if
its price is less than $5.00 per share. The last reported sale price on March
17, 2005 was $6.03 but our common stock traded below $5.00 per share throughout
2002, 2003 and until mid-October 2004.
The penny stock rules impose additional sales practice requirements on
broker-dealers who sell penny stock securities to people who are not established
customers or accredited investors. For example, the broker must make a special
suitability determination for the buyer and the buyer must be given written
consent before the sale. The rules also require that the broker-dealer:
o send buyers an SEC-prepared disclosure schedule before completing the
sale, disclose the broker's commissions and current quotations for the
security;
o disclose whether the broker-dealer is the sole market maker for the
penny stock and, if so, the broker's control over the market; and
o send monthly statements disclosing recent price information held in
the customer's account and information on the limited market in penny
stocks.
These additional burdens may discourage broker-dealers from effecting
transactions in our common stock. Thus, if our common stock were to fall within
the definition of a penny stock, our liquidity could be reduced, and there could
be an adverse effect on the trading market in its common stock.
20
ITEM 2. Properties.
----------
In 2000, we entered into a five-year office lease providing 9,600 square feet,
currently at $10,800 per month, located at 400 Massasoit Avenue, East
Providence, Rhode Island. In 2004, we entered into a three year lease for an
additional 4,800 feet at the same location for approximately $5,400 per month,
subject to periodic adjustments. We also maintain a local field office at 10225
Barnes Canyon Road, San Diego, California on a two-year lease dated July 2004,
and pay approximately $2,600 per month. In addition, we maintain a local field
office at 330 East Orangethorpe Ave. in Placentia, California on a two-year
lease dated February 2004, and pay approximately $1,400 per month. We believe
that these facilities are adequate to meet our current needs but will require
additional space as new installations increase processing and support hiring
needs.
ITEM 3. Legal Proceedings.
-----------------
On November 6, 2003, we 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 on our U.S. Patent No.
6,188,329 describing a system using digitized video and integrating traffic
light violation related vehicle information with court date scheduling
information. Court-ordered mediation in that lawsuit took place on October 1,
2004, but no agreement was reached through that mediation. Redflex has asserted
as a defense that our patent is invalid.
On November 25, 2003, we 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 on that same patent.
We were denied a preliminary injunction in the Transol litigation, in part
because we had not shown a likelihood of success on our claim that Transol's
products infringe on our patent. Transol has filed a counterclaim asserting the
invalidity of that patent.
On June 22, 2004, the United States Patent and Trademark Office issued Patent
Number 6,754,663 to us, describing a system using multiple cameras, including at
least one video camera, to capture multiple images of a traffic light violation
and a user interface that simultaneously displays those multiple images.
On July 13, 2004, we filed an additional lawsuit for patent infringement against
Redflex Traffic Systems, Inc., alleging that Redflex's automated red light
enforcement systems infringe our U.S. Patent Number 6,754,663, but we have since
withdrawn that additional lawsuit.
We have amended our lawsuit against Transol to include claims alleging that
Transol's automated red light enforcement systems infringe our U.S. Patent
Number 6,754,663. Transol has filed a counterclaim asserting the invalidity of
that patent as well.
Transol has moved for summary judgment against us on all of our claims of
infringement against Transol. A hearing on Transol's motion for summary judgment
is scheduled for April 11, 2005.
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, 2004.
21
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, 2004 --- ----
1st Quarter $ 2.85 $ 4.00
2nd Quarter $ 3.16 $ 4.10
3rd Quarter $ 4.05 $ 5.00
4th Quarter $ 4.75 $ 7.85
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
HOLDERS OF COMMON STOCK
At March 5, 2005, the number of holders of record of the issued and outstanding
common stock of the Company was 458, which includes brokers who hold shares for
approximately 1,994 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.
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 2004, 2003 and 2002. The Company's investment in NTS was recorded
on the equity method through September 12, 2001.
Years Ended December 31,
----------------------------------------------------------------------------------
2004 2003 2002 2001 2000
---- ---- ---- ---- ----
Revenue $ 6,034,942 $ 2,705,534 $ 2,121,574 $ 3,520,924 $ 3,652,422
Operating loss $ (4,646,604) $ (4,261,045) $(15,127,235) $ (1,297,145) $ (1,548,777)
Gain on debt extinguishment, net $ 508,124 $ --- $ --- $ --- $ ---
Contract termination reserve $ --- $ (125,000) $ --- $ --- $ ---
Gain on royalty assignment $ --- $ --- $ 2,811,590 $ --- $ ---
Other expense $ (334,116) $ (504,413) $ (318,618) $ (186,809) $ (106,675)
Net loss $ (4,472,596) $ (4,890,458) $(12,634,263) $ (1,565,054) $ (2,994,574)
Earnings per share
Weighted number of outstanding
shares - basic and diluted 18,223,609 12,964,498 5,047,611 2,881,877 1,790,160
Loss per share $ (0.25) $ (0.38) $ (2.50) $ (0.54) $ (1.67)
SELECTED BALANCE SHEET DATA:
Total assets $ 18,847,164 $ 16,299,434 $ 9,200,964 $ 22,035,420 $ 4,922,703
Working capital (deficit) $ 6,785,719 $ 3,294,231 $ (1,572,209) $ 1,775,401 $ (199,775)
Long-term
Note and lease obligations $ 6,017,263 $ 3,322,384 $ 2,849,126 $ 2,409,202 $ ---
Deferred income $ 53,472 $ --- $ --- $ 421,399 $ 2,036,896
(Note: Earnings per share information as previously reported at December 31, 2002 has been adjusted to a post-reverse split basis.)
22
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 the section of
this annual report captioned "Risk Factors That May Affect Our Results." 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 primarily operates through Nestor Traffic Systems, Inc. (NTS), a
wholly owned subsidiary. NTS's principal product is its CrossingGuard
video-based red light enforcement system and services. CrossingGuard is
marketed, maintained, and distributed through direct sales to states and
municipalities in the United States. In August 2004, NTS entered into a
distributorship agreement with Vitronic Machine Vision Ltd. for exclusive rights
to market and sell PoliScan, a speed enforcement system, throughout the United
States, Canada and Mexico, subject to minimum sales goals.
The following is a summary of key performance measurements monitored by
management:
Quarter Ended December 31, Year Ended December 31,
--------------------------------- ---------------------------------
2004 2003 2004 2003
---- ---- ---- ----
Financial:
Revenue $ 1,551,000 $ 1,122,000 $ 6,035,000 $ 2,706,000
Loss from operations 1,820,000 1,230,000 4,647,000 4,261,000
Net loss 1,959,000 1,592,000 4,473,000 4,890,000
Additional investment in
capitalized systems 310,000 822,000 1,829,000 2,341,000
Cash and marketable equity securities 6,422,000 5,410,000
Working capital 6,786,000 3,294,000
Number of CrossingGuard Approaches*: 111 88
Installed and operational
Authorized under existing contracts 128 47
------------- --------------
Total installed and planned 239 135
* At end of period. There can be no assurance that all approaches authorized under existing contracts will ultimately be installed.
23
The management team focus is to expand the Company's market share in the
emerging traffic safety market. The Company plans to expand that market share
by:
o Continuing to aggressively market CrossingGuard video-based red light
enforcement systems and services to states and municipalities for red
light enforcement and safety
o Implementing a marketing program for speed enforcement systems and
services to states and municipalities for speed enforcement and safety
o Participating in efforts to increase the public's acceptance of, and
state's authorization of, automated traffic safety systems
o Participating in industry standards setting bodies
o Enhancing and seeking patents for our traffic safety technology to
maintain or improve our position and competitive advantages in the
industry
o Vigorously defending our patented technology from competitors'
infringement
LIQUIDITY AND CAPITAL RESOURCES
CASH POSITION AND WORKING CAPITAL
The Company had cash and short-term investments of approximately $5,850,000 at
December 31, 2004 as compared with approximately $5,410,000 at December 31,
2003. At December 31, 2004, the Company had working capital of $6,786,000 as
compared with $3,294,000 at December 31, 2003. The increase in cash in 2004
primarily resulted from the sale of $6,000,000 of convertible notes and
$3,440,000 of common stock in a private placement, offset by $2,179,000 of lease
financing repayments, $2,061,000 invested in capitalized systems, property and
equipment and cash used by operations.
Working capital was favorably impacted by the net effect of these factors as the
current portion of the Laurus Note ($885,000) and lease ($639,000) payables at
December 31, 2003 were eliminated. Marketable equity securities of $572,000 and
a $590,000 increase in inventory at December 31, 2004 also contributed to
increased working capital at that date.
In November 2004, the Company completed the sale of $6 million aggregate
principal amount of its 5% Senior Convertible Notes to accredited investors in a
private placement, resulting in net proceeds to the Company of $5,555,000.
In January 2004, the Company received $3,440,000 in proceeds from the private
placement of common stock, $2,179,000 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 $2 million
convertible note issued to Laurus Master Fund, Ltd. in July 2003 by issuing
492,904 shares of Nestor common stock and repaying the note balance, accrued
interest and prepayment penalty. On the same date, the Company issued a new $1.5
million convertible note to Laurus. Although 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 second note. During 2004, the Company repaid $195,000
of principal in cash and the balance of the note was converted into common stock
by November 2004.
24
The Company had a net worth of $10,779,000 at December 31, 2004, as compared
with a net worth of $9,662,000 at December 31, 2003. The increase in net worth
is further detailed on the Consolidated Statements of Stockholders' Equity.
FUTURE COMMITMENTS
During 2004, the Company acquired additional property and leased equipment
(primarily computers and related equipment) at a cost of $232,000 and invested
$1,829,000 in capitalized systems. At December 31, 2004, Nestor recorded its
investments in computers and related equipment (net of depreciation) at $357,000
and in capitalized systems (net of depreciation to an estimated residual value)
at $3,749,000. Management expects that NTS will make future commitments for the
purchase of additional computers and related computing equipment, for furniture
and fixtures, for leasehold improvements, for delivery of capitalized systems,
for consulting and for promotional and marketing expenses.
The Company does not generally grant payment terms to customers in excess of 90
days.
The Company's future contractual obligations and other commitments are as
follows:
Contractual Obligations and Commercial Commitments:
Payment Due Date
----------------------------------------------------------
Total < 1 Year 1-3 Years 3-5 Years Thereafter
----- -------- --------- --------- ----------
Senior Convertible
Note $6,000,000 $ --- $6,000,000 $ --- $ ---
Operating leases $ 314,000 $198,000 $ 116,000 $ --- $ ---
Inflation
Management believes that the rate of inflation in recent years has not had a
material effect on the Company's operations.
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.
Unbilled Contract Revenue
Unbilled contract revenue represents revenue earned by the Company in advance of
being billable under customer contract terms. Under the terms of some current
contracts, the Company cannot bill the municipality until the court has
collected the citation fine. Management records unbilled contract revenue in
these situations at a net amount, based upon a historical pattern of collections
by the courts for the municipalities. The pattern of collections on these
citations is continually reviewed and updated by management.
Revenue Recognition
Revenue is derived mainly from the lease of products which incorporate NTS's
software and the delivery of services based upon such products. Product license
and service fees include software licenses and processing service fees tied to
citations issued to red-light violators. NTS provides equipment (either under
direct sales or lease agreements), postcontract customer processing and support
services, and engineering services. In arrangements that include multiple
25
elements, some of which include software, the total arrangement fee is allocated
among each deliverable based on the relative fair value of each of the
deliverables determined based on vendor-specific objective evidence. 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.
Long Term Asset Impairment
In assessing the recoverability of the Company's long term assets, management
must make assumptions regarding estimated future cash flows, contract renewal
options 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.
RESULTS OF OPERATIONS
In 2004, the Company focused on marketing and selling the Company's principal
product, CrossingGuard, a video-based red light enforcement system with
ancillary support services. During 2003, the Company completed the transition
from several lines of business, including financial services/PRISM, Rail and
TrafficVision, which had previously generated the majority of revenue, to
red-light enforcement services and products as the ongoing operating focus of
the Company. Future growth will depend on an increase in the number of
CrossingGuard approaches installed and operational and successful efforts to
develop and penetrate the automated speed enforcement market.
ANALYSIS OF THE THREE-MONTH PERIODS ENDED DECEMBER 31, 2004 AND 2003
In the quarter ended December 31, 2004, the Company realized a $428,000 (38%)
increase in revenues and a $1,018,000 (43%) increase in operating expenses
compared to last year's fourth quarter. The Company reported a net loss of
$1,959,000 compared to $1,592,000 in last year's fourth quarter. The increased
revenue relates primarily to $400,000 of revenue recorded under sales-type lease
accounting for Delaware approaches installed during the current year quarter.
Operating expense includes a corresponding $214,000 Delaware cost of sales, an
increase of $290,000 in amortization on capitalized systems, and costs
associated with the development of a larger sales force ($116,000 additional
internal sales expense, and $125,000 additional consultant expenses). Other
expenses--net in the fourth quarter of 2003 included the write off of the
unamortized discount on the first Laurus note and EDS interest expense.
Revenues
- --------
The Company's revenues arose from CrossingGuard lease and service fees. During
the quarter ended December 31, 2004, revenues increased $426,000 to $1,548,000
from $1,122,000 in last year's fourth quarter. This increase is due primarily to
additional revenue from Delaware installations along with increased revenue from
a larger installation base.
Operating Expenses
- ------------------
Total operating expenses amounted to $3,371,000 in the quarter ended December
31, 2004, an increase of $1,018,000 as compared to total operating costs of
$2,353,000 in last year's fourth quarter.
Cost of Goods Sold
Cost of goods sold (CGS) totaled $1,307,000 in the fourth quarter of 2004 as
compared to $614,000 in last year's fourth quarter. This year's fourth quarter
included $214,000 of costs associated with the Delaware installations, $184,000
of accelerated amortization on certain installed approaches which were not
renewed and a $106,000 overall increase in systems amortization due to a larger
installed base. Last year's fourth quarter also includes a $417,000 net
reclassification of all 2003 citation processing costs from engineering and
operations, as previously presented, to CGS.
26
Engineering and Operations
Costs related to engineering and operations totaled $999,000 in the fourth
quarter of 2004, as compared with $745,000 in 2003. These costs include the
salaries of field and office personnel as well as operating expenses related to
product design, delivery, configuration, maintenance and service. This expense
increased in 2004 as there were more customers and installations to support.
Increases in headcount and travel generated $149,000 of additional costs in the
2004 quarter and the inventory reserve, established in 2004, rose by $43,000
during the current year quarter. The 2003 comparable period includes a $417,000
net reclassification of all 2003 citation processing costs to CGS.
Research and Development
Research and development expenses totaled $32,000 in the quarter ended December
31, 2004 as compared with $29,000 in the previous year's quarter. The Company
continues its R&D activities, as deemed necessary.
Selling and Marketing
Selling and marketing costs were $377,000 in the quarter ended December 31,
2004, and $87,000 in the previous year's quarter. The increase reflects a more
aggressive marketing effort, including the cost associated with a nationwide
sales force. Outside consultants are also being used to cover strategic markets.
Attendance at trade shows escalated, as did the purchase of collateral material.
General and Administrative
General and administrative expenses totaled $654,000 in the fourth quarter of
2004, as compared with $876,000 in the previous year's quarter. The decrease is
primarily due to a $140,000 reduction in financing fees and a $62,000 reduction
in bad debt expense, offset by a $39,000 increase in patent lawsuit defense
expenses.
Other Expense
For this year's fourth quarter, net other expense was $139,000 as compared with
$362,000 in the quarter-earlier period. The decrease of $223,000 is due
primarily to the non-reoccurrence of a $169,000 write off of the unamortized
discount on the first Laurus note in 2003 and a $27,000 reduction in warrant
amortization as warrants were fully amortized in July 2004.
Net Loss
- --------
During the fourth quarter 2004, the Company experienced a loss of $1,959,000, as
compared with a loss of $1,592,000 in the previous year's quarter. For the
quarter ended December 31, 2004, loss per share available for common stock was
$0.11 per share, consistent with the corresponding period of the prior year. The
weighted average shares outstanding were 18,619,771 for the quarter ended
December 31, 2004 and 13,987,905 for the quarter ended December 31, 2003.
ANALYSIS OF THE YEARS ENDED DECEMBER 31, 2004 AND 2003
For the year ended December 31, 2004, the Company experienced a 123%
($3,329,000) increase in revenues compared to the prior calendar year. Operating
expenses increased 53% ($3,715,000) in 2004. The Company reported a net loss of
$4,473,000 in 2004 compared to a loss of $4,890,000 in the prior year. Many
significant changes occurred during these two years as more fully described
below.
27
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, 2004,
revenues increased $3,329,000 to $6,035,000 from $2,706,000 in the prior
calendar year.
Product Royalties
Product royalties totaled $37,000 in 2004, as compared with $29,000 in 2003.
Residual royalty streams from two customers account for all royalty revenues.
Product Sales, Lease and Service Fees
Product sales, lease and service fee revenues totaled $5,998,000 in 2004, as
compared with $2,677,000 in 2003. This increase is largely attributable to a
full year of revenues in 2004 on 44 approaches installed on various dates in
2003, proceeds received under the Master Lease Agreement with the State of
Delaware and revenues recognized in connection with our ACS agreement for the
city of Baltimore. The Company continues to retrofit 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 $10,682,000 in the year ended December 31,
2004, an increase of $3,715,000 over total operating costs of $6,967,000 in the
prior year. The primary changes in 2004 include increased amortization on live
approaches, an increase in CGS as a result of the Delaware installations and
Baltimore revenue, a significant increase in sales consulting expenses, and
$381,000 of additional of lawsuit defense expenses. Additionally, headcount
increased 33% in 2004 over 2003, which caused an increase in salaries and
fringes, and related travel expenses.
Costs of Goods Sold
Cost of goods sold totaled $3,932,000 in 2004 as compared to $1,791,000 in the
prior year. CGS includes amortization, maintenance and processing costs related
to revenues recorded in the respective periods. The current year increase is
primarily due to an increase of $990,000 of amortization (more installed
approaches), including $184,000 of accelerated amortization on certain installed
approaches which were not renewed, $558,000 of Delaware systems installed under
sales-type lease accounting and $232,000 of costs associated with Baltimore
revenue.
Engineering and Operations
Costs related to engineering and operations totaled $3,464,000 in 2004, as
compared with $2,578,000 in 2003. 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 additional expenses both internally and field-based, to support the
growing installed customer base. Engineering and operations staff growth in 2004
includes redeployment of five people from other departments to field support, in
addition to six new employees hired. Expenses such as travel, tools and supplies
increased, as well.
Research and Development
Research and development expenses totaled $157,000 in the year ended December
31, 2004 as compared with $121,000 in the prior year. The increase in 2004 is
directly attributable to materials purchased in support of on-going research
activities.
28
Selling and Marketing
Selling and marketing costs increased $519,000 to $874,000 in the year ended
December 31, 2004, from $355,000 in the prior year. The increase in 2004 costs
reflects the hiring of a nationwide sales force with outside consultants to
support sales activity in strategic markets.
General and Administrative
General and administrative expenses totaled $2,254,000 in 2004, as compared with
$2,121,000 in the previous year. The $133,000 increase is largely the net result
of $381,000 increased 2004 patent lawsuit defense costs, offset by a $124,000
reduction in 2004 financing fees and last year's $180,000 expense for an
employee settlement agreement.
Gain on Debt Extinguishment
- ---------------------------
Obligations to EDS and Laurus (under the July 2003 note) were fully satisfied in
January 2004, resulting in a net gain of $508,000. The early payment to EDS
resulted in a gain of $681,000, which was offset in part by a prepayment penalty
of $173,000 incurred in the Laurus settlement.
Contract Termination Reserve
- ----------------------------
A significant customer contract in the Rail line of business was 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. Payment
was satisfied in December 2004.
Other Expense
- -------------
For 2004, net other expense was $334,000; as compared with net other expense of
$504,000 in the year-earlier period. In 2004, other expense included $80,000 of
interest expense accrued as a result of a 2004 sales and use tax audit, a
decrease of $144,000 in interest expenses associated with notes payable, a
realized loss on marketable equity securities of $96,000, and a decrease of
$44,000 in warrant amortization as warrants were fully amortized in July 2004.
Non-recurring 2003 items include $164,000 of interest expense paid to EDS offset
by a $64,000 favorable vendor settlement.
Net Loss
- --------
During 2004, the Company recorded a loss of $4,473,000, as compared with a loss
of $4,890,000 in the prior year. For the year ended December 31, 2004, loss per
share was $0.25 per share, as compared with a loss per share of $0.38 in
corresponding period of the prior fiscal year. For the year ended December 31,
2004, there was outstanding a weighted average of 18,223,609 shares, as compared
to 12,964,498 shares in the year-earlier period.
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.
29
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. 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
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Total operating expenses amounted to $6,967,000 in the year ended December 31,
2003, a decr