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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[Mark One] FORM 10-K
[ x ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended March 31, 2002
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: 000-6377
DREXLER TECHNOLOGY CORPORATION
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(Exact name of registrant as specified in its charter)
Delaware 77-0176309
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1077 Independence Avenue, Mountain View, CA 94043-1601
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(Address of principal executive offices) (Zip Code)
(650) 969-7277
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None None
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(Title of each class (Name of each exchange
so registered) on which registered)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 Par Value
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(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 that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. [x] Yes [ ] No
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. [x]
Based on the last trade price of the Company's Common Stock on The Nasdaq Stock
Market on June 14, 2002, the aggregate market value of the voting stock held by
non-affiliates of the registrant is approximately $206,271,000.
Number of outstanding shares of Common Stock, $.01 par value,
at June 14, 2002: 10,311,929
DOCUMENTS INCORPORATED BY REFERENCE: NONE
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business
Forward-Looking Statements................................................................................. 3
General Development of Business............................................................................ 3
Narrative Description of Business.......................................................................... 5
LaserCard(R) Optical Memory Cards........................................................................ 5
Optical Data Storage................................................................................. 5
The Drexon(R) Laser Recording Medium.................................................................. 5
LaserCard Applications............................................................................... 5
Reading and Writing the Cards........................................................................ 6
Data Storage Capacity................................................................................ 6
Prerecording......................................................................................... 7
Card Durability...................................................................................... 7
Card Security........................................................................................ 7
International Standards.............................................................................. 9
LaserCard(R) Products................................................................................... 9
Card Manufacturing................................................................................... 9
Product Evolution.................................................................................... 9
Marketing............................................................................................ 10
Software Products.................................................................................... 10
Optical Card Read/Write Drives and Peripherals....................................................... 12
Competition............................................................................................. 12
IC Cards............................................................................................. 13
Other Card Products.................................................................................. 13
Other Optical Memory Cards and Equipment............................................................. 13
Licensing............................................................................................... 14
Other Matters........................................................................................... 15
Research and Engineering Expenses.................................................................... 15
Patents.............................................................................................. 15
Trademarks........................................................................................... 16
Employees............................................................................................ 16
Backlog.............................................................................................. 16
Financial Information About Geographic Areas......................................................... 16
Factors that May Affect Future Operating Results........................................................ 17
Item 2. Properties..................................................................................................... 19
Item 3. Legal Proceedings.............................................................................................. 19
Item 4. Submission of Matters to a Vote of Security Holders............................................................ 19
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters....................................... 20
Item 6. Selected Financial Data........................................................................................ 21
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................... 22
Item 7A. Qualitative and Quantitative Disclosures about Market Risk..................................................... 29
Item 8. Consolidated Financial Statements and Supplementary Data....................................................... 30
Reports of Independent Accountants......................................................................... 30
Consolidated Financial Statements.......................................................................... 32
Notes to Consolidated Financial Statements................................................................. 36
Quarterly Financial Information (Unaudited)................................................................ 44
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................... 45
PART III
Item 10. Directors and Executive Officers of the Registrant............................................................. 46
Item 11. Executive Compensation......................................................................................... 47
Item 12. Security Ownership of Certain Beneficial Owners and Management................................................. 49
Item 13. Certain Relationships and Related Transactions................................................................. 51
PART IV
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K................................................ 52
Signatures ............................................................................................................... 56
2
PART I
ITEM 1. BUSINESS
FORWARD-LOOKING STATEMENTS. When used in this report, the words "expects,"
"anticipates," "believes," "estimates," "plans," and similar expressions are
intended to identify forward-looking statements. These statements, including
expectations as to deferred revenue and gross profit as a result of the
restatement of financial information discussed in Item 7; statements as to
expected benefits of the Company's direct control of the read/write drive
assembly and design and the Company's research and engineering efforts,
including the expected development of lower cost drives, customer-optimized
drive systems, and drive systems with advanced security features; the need for
and efforts to develop read-only drives and new read/write drives and software
products; the Company's efforts to recruit new value-added resellers (VARs) or
licensees and eliminate nonproductive VARs; the adequacy of inventory;
anticipated orders from the Company's U.S. government subcontract; expected
delivery volumes for the 2003 and 2004 fiscal years; expectations regarding
revenues, margins, expenses, capital resources, capital expenditures and
investments, and the Company's deferred tax asset and valuation allowance;
potential reductions of federal tax cash payments due to current Company tax
benefits; the effects of read/write drive prices on gross profits from
read/write drive sales; the Company's estimates for the level of sales of drives
that would be necessary to achieve a gross profit at current prices;
expectations regarding the market for read/write drives, read/write drive
prices, and inventory of drives and parts; statements as to card delivery
volumes; current and potential customers, applications, or market segments for
optical memory card products; the Company's plans and expectations regarding the
growth of its manufacturing capacity and expected card yields therefrom; and
expectations regarding market growth and product demand, including the expected
emergence of opportunities for the Company's products in Canada, China, India,
Italy, Macedonia, Mexico, and Saudi Arabia and further opportunities in
expansion of current U.S. government ID card programs are subject to risks and
uncertainties that could cause actual results to differ materially from those
projected.
These risks and uncertainties include, but are not limited to those risks
discussed below, as well as the impact of litigation or governmental or
regulatory proceedings; Arthur Andersen LLP's ability to timely consent to
including the restated financial information in the Company's SEC filings; the
Company's ability to initiate and grow new programs utilizing the Company's card
products; the Company's reliance on VARs and licensees to generate sales,
perform customer system integration, and develop application software; risks
associated with doing business in and with foreign countries; potential
manufacturing difficulties and complications associated with increasing
manufacturing capacity of cards and drives; uncertainties associated with the
design, development, manufacture, and deployment of optical card drives and
systems; reliance on single-source and limited-source suppliers for certain
components and raw materials; customer concentration and reliance on continued
U.S. government business; lengthy sales cycles; manufacturing difficulties;
general economic trends; the unpredictability of customer demand for products
and customer issuance and release of corresponding orders; the U.S. government's
right to withhold order releases, reduce the quantities released, and extend
delivery dates; the impact of technological advances and competitive products
and the ability of the Company or its customers to develop software and
integrate optical card systems with other technologies; and the risks set forth
below in the section entitled "Factors That May Affect Future Operating
Results."
These forward-looking statements speak only as of the date hereof. The
Company expressly disclaims any obligation or undertaking to release publicly
any updates or revisions to any forward-looking statements contained herein to
reflect any change in the Company's expectations with regard thereto or any
change in events, conditions or circumstances on which any statement is based.
TRADEMARKS. LaserCard(R)and Drexon(R)are the Company's registered
trademarks. Smart/Optical(TM)card, LaserCard(R) ConciergeCard(TM), and
LaserBadge(TM)are the Company's trademarks. The Company also refers to
trademarks of other corporations and organizations in this document.
GENERAL DEVELOPMENT OF BUSINESS
Headquartered in Mountain View, California, Drexler Technology Corporation
develops, manufactures, and markets optical data storage products and systems
featuring LaserCard(R) optical memory cards and chip-ready Smart/Optical(TM)
cards. Drexler-made LaserCard(R) optical memory cards are used for "digital
governance" applications such as immigration, visas,
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cargo manifests, motor vehicles, pay-per-use systems, and ID/access; and other
digital read/write card applications. LaserCard Systems Corporation (LSC), a
wholly owned subsidiary of Drexler Technology, makes optical card read/write
drives, develops optical card system software, and markets optical cards,
related data systems, and peripherals. Drexler Technology was incorporated under
the laws of the State of California on July 23, 1968, and was reincorporated as
a Delaware corporation on June 24, 1987. Throughout this report, the "Company"
refers to Drexler Technology Corporation and subsidiaries.
The LaserCard optical memory card is an updatable, laser recordable,
computer readable, nonvolatile, credit-card sized, data storage card--invented,
patented, developed, and manufactured by the Company. It contains a reflective
stripe of laser-recording material called Drexon(R), a Company invention. Along
with its ability to record, update, and store up to 4 megabytes of digital data,
this unique card offers multiple data-security features, can be carried in a
wallet, and is highly resistant to counterfeiting and data tampering. This makes
the LaserCard ideal for portable, recordable, secure, cumulative data storage.
The Company's LaserCard product line currently consists of optical memory
cards, optical card read/write drives, optical card data systems, chip-ready
hybrid Smart/Optical(TM) cards, and related system software and peripherals. The
Company's products are sold mainly through value-added reseller (VAR) companies
and card-distribution licensees that develop commercial applications for
LaserCard products. Target markets are domestic and foreign government programs,
identification cards, and medical, transportation, pay-per-use, and electronic
commerce applications, among others. Company revenues also include fees from the
occasional sale of patent licenses.
Originally a supplier of photomasks to the semiconductor industry, the
Company gradually transitioned its business into optical memory cards over a
number of years of research, product development, production engineering,
marketing, and licensing. After several years of moderate-sized orders, the
breakthrough order for LaserCard optical memory cards came in February 1997 in
the form of a $7.1 million order for Permanent Resident Cards (Green Cards) to
be issued by the United States Immigration and Naturalization Service (INS).
This initial order was followed by a series of card orders for INS Green Cards
and U.S. Department of State "Laser Visa" border crossing cards: a $6.4 million
order in December 1997, a $3 million order in November 1998, a $7.5 million
order in May 1999, a $6.8 million order in December 1999, and a U.S. government
subcontract awarded in June 2000, with an authorized maximum of $81 million for
up to 24 million cards over a period of up to five years. Under this latest
subcontract, 4.4 million cards have been shipped as of March 31, 2002. In fiscal
2002, this subcontract resulted in card purchase orders of $3.8 million in July
2001, $4.8 million in September 2001, and $10.4 million in January 2002, which
is the Company's largest card order to date. Including this subcontract and the
earlier card orders, approximately 12 million U.S. and Mexican residents have
received the Company's optical memory cards since 1997, in the form of either
Green Cards or Laser Visas. It is estimated that the population of North
American LaserCard holders is growing at an average rate of about 300,000
individuals per month.
Government, commercial, and trial applications for the LaserCard include
the following:
o United States INS Green Cards
o United States Department of State Laser Visa border crossing cards
o Electronic commerce debit cards/pay-per use cards
o PC-like hybrid "smart cards" (chip/optical) for multi-function
applications
o Tamper-resistant ID cards
o Licenses, permits, vehicle registration cards
o Medical record cards
For the fiscal year ended March 31, 2002, the Company sold approximately
5.6 million LaserCard optical memory cards. The Company's multi-million card
manufacturing plant, located in Mountain View, California, is designed to permit
expansion of production capacity in steps, up to an estimated capacity of
approximately 25 million optical memory cards per year, depending upon card type
and color-printing specifications. Please see Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations," regarding
current card production capacity.
Item 8, "Consolidated Financial Statements and Supplementary Data,"
contains industry segment information.
4
NARRATIVE DESCRIPTION OF BUSINESS
LASERCARD(R) OPTICAL MEMORY CARDS
OPTICAL DATA STORAGE
Optical data storage systems use a beam of laser light to write and read
information. This information is stored digitally in a binary code of "1" or "0"
bits that are represented by either the presence or absence of a physical "spot"
on the recording surface. The difference in reflectivity between the background
surface and the individual spot is measured by a light-sensing device and
converted into an electrical signal. These signals are then translated by a
microprocessor into text, graphics, sound, and pictures (including facial images
and other biometric identifiers). Using optical data storage, a large amount of
data can be stored on a relatively small surface area since the digital data
spots are microscopic in size.
THE DREXON(R) LASER RECORDING MEDIUM
The Drexon(R) laser recording medium was invented and patented by the
Company for optical data storage. It consists of a thin, organic film or
colloidal matrix that contains a thin layer of microscopic silver particles.
Using proprietary and patented processes, the Drexon material is produced by
chemical conversion of photographic emulsions, creating a reflective recording
surface. As described under "Prerecording," Drexon allows data to be laser
recorded, prerecorded using photolithography, or both.
The Drexon medium is DRAW (direct-read-after-write). DRAW media permit data
to be read immediately after laser recording--for instantaneous checking of
information. Data can be laser written onto the Drexon material at any time
(over a period of weeks, months, or years) but data can be written in a specific
location on the medium only once (write once). After an area is recorded,
software prevents that same location from being overwritten with new data.
Obsolete data can be ignored by the system but remains permanently stored on the
Drexon optical card as an audit trail of all changes. New or revised information
is recorded in a new location. Through these procedures, the card is easily
updatable.
Thus, although the Drexon material is not physically erasable like magnetic
storage media, Drexon can be corrected and updated at any time and has the
important audit trail feature that magnetic media does not have. Data can be
read at any time (read many times), allowing access to newly recorded data and
to the audit trail. The permanent audit trail inhibits data tampering and is of
fundamental importance for high security identification card applications.
Because the Drexon material is a nonvolatile data storage medium, it is not
vulnerable to data loss or damage when exposed to X rays, electronic signals, or
magnetic fields. Additionally, because the surface of the Drexon material is
reflective, it can hold eye readable, laser engraved, low reflectivity images
(such as photographs, text, and graphics) that can be viewed and verified
without special equipment, or readers. Also see "Card Security."
To form LaserCard optical memory cards, the Drexon laser recording material
is encapsulated within layers of polycarbonate plastic (laminated using
electron-beam equipment) and then die cut into card shape. The resulting
LaserCard conforms to international standards for size, thickness, and
flexibility. The typical wholesale price to VARs per basic card is under $4 when
the cards are ordered in hundreds of thousands, and even lower in cost when
larger quantities of basic cards are ordered.
LASERCARD(R) APPLICATIONS
To date, the most successful LaserCard programs involve "digital
governance," meaning counterfeit- and tamper-resistant licenses or permits
employing the LaserCard as proof that the cardholder has a formal permission,
privilege, or right from a government, agency, or company. The card-issuing
government, agency, or company would use the LaserCard optical memory card to
limit and control access to these very valuable rights because the LaserCard
inhibits counterfeiting and data tampering.
A government-issued, card-based authorization or "license" is a formal
permission, privilege, or right from a federal, state, city, or foreign
government or agency, such as in the following current and nascent optical card
programs:
5
o The current U.S. Green Card, or Permanent Resident Card, made by the
Company and issued by the INS, permits approved foreign workers to
reside and be employed in the United States.
o The current LaserVisa border-crossing card, made by the Company and
issued by the United States Department of State, permits Mexican
citizens to visit and shop in the United States (within 25 miles of the
U.S. border) for up to 72 hours.
o In a planned national ID card application in Italy, the card would
identify the holder as a citizen and confer upon the holder all the
rights and privileges to which a citizen is entitled (welfare, medical
benefits, etc.).
o Three of India's 26 states have issued requests for proposals related
to smart optical cards for motor vehicle registration for the purpose
of inhibiting motor vehicle theft and preventing operators of trucks
and buses from making counterfeit licenses. These programs call for
vendor financing, which will determine if and when they will be
implemented.
o In a trial program, building construction LaserCard licenses have been
issued in certain cities in China to prevent counterfeit licenses from
being used.
A company-issued, card-based authorization or "license" is a formal
permission or right related to a commercial application, for example:
o In an existing application, some of the VISX, Incorporated laser
eye-surgery equipment uses LaserCard optical memory cards as
pay-per-use cards to initiate vision correction surgical procedures.
o For a potential application, the Company is developing a LaserCard
program under which frequent travelers would receive privileges.
READING AND WRITING THE CARDS
The optical card read/write drive contains a low-power, semiconductor diode
laser for writing (10.0 milliwatts) and reading (0.5 milliwatts) of data. The
laser is about the size of a thumbtack. The read/write drive is connected to a
personal computer as an external small computer system interface, or SCSI,
device. Information is recorded when the read/write drive focuses the laser beam
through the upper clear layer of the card, forming microscopically small spots
in linear tracks on the Drexon material. The recorded spots represent digital
data, the language of computers. Since the read/write drive is connected to a
PC, data can be entered onto the LaserCard via computer keyboard, from the
computer's memory, from the Internet, and from intranet computer networks.
DATA STORAGE CAPACITY
A byte is a unit of computer storage--the amount of memory needed to store
a single number or letter. A megabyte is 1,000,000 bytes; a kilobyte is 1,000
bytes. The digital data storage capacity of the LaserCard is determined by the
spot size, track pitch, and width of the Drexon optical stripe used in the card.
The standard spot size is 2.5 microns and the standard track pitch is 12
microns. A micron is 1/1,000 of a millimeter, or about 1/75 the width of a human
hair. The smallest size spot the human eye can see is about 20 microns. Two card
products conforming to international standards are manufactured by the Company:
a 16-millimeter stripe LaserCard (1.5 megabyte capacity) and a 35-millimeter
stripe LaserCard (4.1 megabyte capacity). The LaserCard itself is the size of a
conventional credit card.
A significant portion of the LaserCard's total data capacity is used for an
error detection and correction, or EDAC, algorithm. EDAC is routinely used in
various data storage and transfer methods to compensate for data errors
resulting from transmission errors, surface scratches above the recording
material, or contamination such as dust or fingerprints. EDAC is automatically
added to data written onto the LaserCard, to achieve written data error rates of
less than one in a trillion.
6
The resulting data storage capacities are 2.86 megabytes of "user" capacity
for the standard 4.1 megabyte LaserCard and 1.1 megabytes of "user" capacity for
the 1.5 megabyte LaserCard. The 16-millimeter stripe LaserCard with 1.1
megabytes of user capacity can be employed in conjunction with a
microcontroller/microprocessor chip to create a PC-like, hybrid smart card,
which the Company calls a Smart/Optical(TM) card.
The amount of information that can be stored on the LaserCard varies
depending upon the type of digital file, file compression algorithm, formatting
parameters, and data encoding sector size. Typically, a 4.1 megabyte LaserCard
can store more than 1,200 digital text pages or 200 scanned text pages. If the
LaserCard is used in a transaction-based application (payment cards, access
cards), more than 35,000 transactions could be recorded.
The 4.1 megabyte LaserCard has a hundred times the storage capacity of a 32
kilobyte integrated circuit (IC) smart card and over 10,000 times the capacity
of a magnetic-stripe card.
PRERECORDING
Another feature of the LaserCard is its recordability both during and after
the card manufacturing process. Since photographic film is the base material
from which Drexon is made, photolithography is used during the manufacturing
process to prerecord optical digital data, graphics, and formatting such as
tracks and other indicia, while the film is still photosensitive. Later, after
the film is chemically processed to become Drexon media and is made into cards,
data can be laser recorded or updated at any time--even over a period of years
(such as a health history card).
CARD DURABILITY
Unlike most other types of digital storage media, the LaserCard can be
manufactured to withstand temperatures of 100o C (212o F) for extended periods.
Additionally, its ability to withstand flexure exceeds that of conventional
credit cards. And, since the LaserCard is a nonvolatile data storage medium, it
is unaffected by static electricity, application of voltage, or other
electromagnetic interference.
Testing has indicated that, when protected by an appropriate envelope, the
LaserCard is not normally damaged by the usual dust particles, grime, and
scratches common to other types of cards carried in a wallet environment. The
ISO/DELA Standard (discussed below) uses a pit center data detection scheme for
the highest reliability in reading and writing, coupled with a powerful EDAC
code to maximize the life of the LaserCard.
The longest running LaserCard programs have been the U.S. Department of
Defense "Automated Manifest" card (since 1993) and the VISX, Incorporated eye
surgery system VisionKey(R) card (since 1992).
CARD SECURITY
The level of data security used with the LaserCard would depend upon the
type of application. Storing automobile maintenance records requires little or
no data security. However, very high security features are required for
government-issued ID cards, visas, immigrant work permits, company-issued
licenses or permits, and for the protection of confidential information such as
medical records and other personal data. The LaserCard's relatively high storage
capacity accommodates the use of multiple, nonerasable, security safeguards in
addition to holding all of the user data and an audit trail. These security
measures include eye readable and computer readable security features to enhance
data security, confidentiality, and resistance to counterfeiting and data
tampering.
The LaserCard is a multiple-security-feature, digital identity card
solution that offers customers the capability of utilizing all or any
combination of the following security features on the same card:
o It can be upgraded time and again to deter data tampering and
high-tech counterfeiters.
o It can store PC-readable (digitized) face photographs, signatures,
biometric data, and text.
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o It can permanently contain an "audit trail" of all digital data
recorded on the card--even data that is thought to be "erased" by the
user.
o It can utilize a patented process of uniquely laser-engraving an
"eye-readable" image of the cardholder's face, biographic data,
signature, document number, and card expiration date.
o It can have a unique, laser-engraved, sequential identification
number.
o It can store precise, high-resolution microimages during the card
manufacturing process--for example, images of all U.S. presidents and
all state flags, as in the Department of State (Dos) and INS cards.
o It can store digital certificates, digital signatures, and public and
private cryptographic keys based upon public key infrastructure for
use with the Internet, intranets, or extranets for verifying identity.
BIOMETRICS, DIGITIZED PHOTOS, PINs, AND DEDICATED SYSTEMS. Various
computer-readable security safeguards that can be used with the LaserCard
optical memory card include many biometric identifiers on the same card--such as
digitized iris or retina scans, signatures, fingerprints, and hand geometries;
digitized color photographs; biographic data; and one or more personal
identification numbers (PINs). Combinations of these and other security features
can be recorded onto the card when it is initialized by the card issuer, for
later authentication of the card when it is in actual use. Also, the Company can
factory-prerecord dedicated interface codes onto the cards' embedded optical
memory stripe so that cards without these codes will not function in dedicated
equipment, or vice versa.
DATA SEGMENTATION, SECURITY SOFTWARE, AND ENCRYPTION. If desired, data
storage on the LaserCard can be segmented by type of information stored (for
example, patient records separated from insurance information or pharmacy
records) so that access to each type of data can be controlled separately. In
addition, software products are available that can be used with the LaserCard to
protect computer-based data against unauthorized access. Further, for
applications that warrant cryptography, all data can be recorded onto the
LaserCard using data encryption algorithms. The Company's hybrid, PC-like Smart/
Optical(TM) card--with a microprocessor and over 1 megabyte of updatable optical
memory--could be used to store digital signatures, digital certificates, and
cryptographic keys such as public key infrastructure for Internet e-commerce, as
well as multi-application programs and software upgrades.
AUDIT TRAIL. Because the LaserCard contains an updatable, nonvolatile WORM
memory (write-once, read-many times) that is recorded permanently, the card can
hold a complete audit trail of data, changes, updates, and deletions. This can
be achieved using software--to allow access to previously recorded files and, if
desired, to record all attempts to access data from the LaserCard.
MATCHING, EYE READABLE IMAGES. The LaserCard uniquely offers this key
security feature for maximum counterfeit-resistance. Cardholder-specific
information (typically, the cardholder's face photograph, name, signature,
number, or other identifying information) is laser-engraved onto the card's
reflective stripe (through the card's protective transparent polycarbonate
layer). These laser-engraved visual images provide an ultra-secure, matching
reference to the identical cardholder-specific images thermally printed
elsewhere on the card. These permanent, eye readable, laser-engraved images are
recorded when the card is issued, using a specially programmed, standard optical
card read/write drive. The United States INS and Department of State both
currently use this visual image technology. For high-speed checking of cards at
the United States/Mexico border, the eye-readable, laser-engraved images
facilitate the immigration inspectors' job of quickly verifying cards.
MICROPRINTING, THERMAL PRINTING, AND OTHER SECURITY ADD-ONS. Using
photolithography, microimages (readable with magnifiers) can be factory
prerecorded onto the LaserCard's optical stripe as further deterrents against
counterfeiting. Examples include complex optical watermarks, emblems, seals, and
logos. Later, using digital identification technology and commercially available
thermal printers, visual data and images can be thermally printed directly onto
the back of the LaserCard at the time the card is initialized (i.e., during card
issuance). Visual data could include the cardholder's name and address, a face
photograph (in full color or black and white), signature, or other information.
Various other security options that can be added to the LaserCard include
conventional holograms, OCR-B (optical character recognition), bar codes, serial
numbers, etc.
8
INTERNATIONAL STANDARDS
Standardization of optical memory cards allows interchange of the digital
information encoded on the cards and facilitates compatibility among optical
memory card systems. The Company participates in optical card standards
activities in the United States and internationally. The standard format under
which the Company's optical memory cards operate is called the DELA Standard (so
named by the Drexler European Licensees Association). Shown below is the current
status of optical memory card standards under ISO/IEC (the International
Organization for Standardization/International Electrotechnical Committee) and
ANSI (the American National Standards Institute). The LaserCard optical memory
card system, featuring the DELA Standard format, complies with all of the
documents listed.
o ISO/IEC 11693 (2000) describes the general characteristics of optical
memory cards. This approved international standard was first published
in 1994.
o ISO/IEC 11694-1 (2000) describes the physical characteristics of the
card, such as height, width, thickness, etc. This approved
international standard was first published in 1994.
o ISO/IEC 11694-2 (2000) describes the dimensions and location of the
accessible area--the area on the card where data writing/reading
occurs. This approved international standard was first published in
1995.
o ISO/IEC 11694-3 (2001) describes the optical properties and
characteristics of the card and provides the technical specifications
which allow interchange. This approved international standard was
published in 1995.
o ISO/IEC 11694-4 (2001) describes the logical data structure on the
card and defines the method of writing and reading card data. This
approved international standard was published in 1996.
o In the United States, ANSI has adopted all of the above ISO Standards
as ANSI/ISO Standards.
LASERCARD(R) PRODUCTS
CARD MANUFACTURING
LaserCard optical memory cards are manufactured by the Company in Mountain
View, California. The optical memory card manufacturing plant is designed to
permit step-by-step expansion of production capacity, depending upon type of
card, color-printing specifications, and numerical serialization requirements.
See Item 7, "Management's Discussion and Analysis of Financial Condition and
Results of Operations" regarding card production capacity. The Company produced
and sold approximately 5.6 million cards in fiscal 2002, 5.9 million cards in
fiscal 2001, and 4 million cards in fiscal 2000. The Company also produces
additional quantities of cards for distribution at trade shows as marketing
samples.
To maintain adequacy of raw material supplies, the Company attempts to
establish ongoing relationships with principal suppliers and obtains information
about alternate suppliers. The Company maintains raw materials inventory levels
that take into account current expected demand, order-to-delivery lead times,
supplier production cycles, and minimum order quantities. To enable the Company
to plan raw material inventory levels, quotes to potential customers generally
provide for certain advance payments upon placing purchase orders with the
Company.
PRODUCT EVOLUTION
The Company continues to add features to its optical memory card products,
making them much more than simple, digital data storage devices. The Company has
enhanced its optical memory card manufacturing capabilities to meet evolving
international standards and, for some applications, to add security printing,
sequential serial numbers, bar coded data, laser-engraved eye-readable images,
signature panels, and magnetic stripes onto the cards, if specified. In
addition, "chip ready" optical memory cards can be purchased from the Company,
for insertion of IC chips to create PC-like, hybrid Smart/Optical(TM) cards. The
Company intends to continue its research and development efforts to evolve its
products and services to meet changing market needs or to create new markets for
optical cards.
9
MARKETING
CHANNEL MARKETING, CUSTOMER BASE, AND TECHNICAL SUPPORT. LaserCard Systems
Corporation (LSC), a wholly owned subsidiary of Drexler Technology Corporation,
markets the Company's products, primarily through value-added resellers (VARs)
and licensed card distributors in the United States and other countries. VARs
and licensees purchase optical cards, card read/write drives and other
peripherals, and system software from the Company. VARs/licensees may add value
in the form of services, application-specific software, personal computers, or
other peripherals, and then resell these products as integrated systems.
During fiscal 2002, the Company sold LaserCard products or provided
services to approximately 32 customers located in seven states and 15 foreign
countries. Due to the Company's large U.S. government and commercial orders
during the past three fiscal years, sales of the Company's LaserCard products in
the U.S.A. were 95% of net sales for fiscal 2002, 85% of net sales for fiscal
2001, and 97% of net sales for fiscal 2000. However, the Company believes that
international markets will be an important source of product sales and license
revenue in the future. Substantially all foreign product sales have been made
through VARs and licensed distributors.
LaserCard marketing operations are conducted through the Company's offices
in California, New York, and France, and through the LaserCard Systems Web site
at www.lasercard.com, which supports worldwide marketing activities. The
Company's marketing staff, general management, and technical personnel work
closely with customers. LSC also provides customer technical support related to
optical card system integration, software, sales, and maintenance. This
technical support is provided by a staff of software, engineering, and
administrative professionals.
MARKETING FOCUS. In addition to its focus on U.S. homeland security
programs such as the INS Green Card and U.S. Department of State Laser Visa
card, the Company plans to continue pursuing card markets and applications such
as:
o Foreign government visa, passport, identification, motor vehicle
registration, and building construction permit programs; medical
record card applications; multi-function card programs involving
financial transactions; and high security, high value, electronic
commerce over networks, including the Internet.
o Multi-application cards for frequent airline travelers to obtain
services at airports.
o Pay-per-use LaserCard "tickets" for scheduling, queuing, setting time
limits, and maintaining a time-and-date log of utilization of an
item--such as equipment, machinery, facilities, or system, where the
users pay the lessor or licensor only when the item is actually
utilized (minutes, hours, days, weeks).
SOFTWARE PRODUCTS
The Company believes that its proprietary optical memory card software
provides a strong competitive advantage in developing digital governance
markets. The Company's system software consists of optical memory card interface
software/device drivers, file systems, software development tools, demonstration
software, and an application software program. To date, the Company's software
development has been completed concurrent with the establishment of
technological feasibility and, accordingly, all software development costs have
been charged to research and engineering expense in the accompanying statements
of income.
LSC develops LaserCard-related system software such as device drivers, file
system DLLs (dynamic link libraries), and custom software tools to enhance
read/write drive integration. LSC also offers contract service support to VARs
that require custom programming in the development and integration of their
LaserCard applications. LSC provides software for demonstrating data storage,
medical, and security concepts involving the LaserCard, software-development
tools for related peripherals, and a card issuance application software package.
The Company continues to upgrade its software capabilities.
SYSTEM SOFTWARE
System software controls or facilitates the basic operations and read/write
functions of optical memory card drives so that they can interface directly with
personal computers.
WINDOWS 3.x/DOS DEVICE DRIVER SOFTWARE. A device driver is system software
that translates operating system commands so that the optical card read/write
drive emulates an erasable drive. LaserCard device drivers save VARs and
10
customers considerable custom-software development time because existing
application software can be modified for LaserCard applications.
WINDOWS NT DEVICE DRIVER SOFTWARE. This device driver, developed by LSC's
engineering staff, allows the LaserCard to be used with computers operating
under Windows NT, a widely used network operating system. The NT device driver:
o Provides compatibility between device drivers--files written to the
LaserCard using the DOS/Windows 3.x driver are compatible with the
Windows NT driver, and vice versa.
o Enables use of LaserCard with network software sold by Microsoft,
Novell, and others.
o Supports multitasking applications and background read/write drive
operation.
o Facilitates the first-ever connectivity of optical card read/write
drives to multiple hardware platforms (such as Intel x86, DEC Alpha,
IBM Power PC).
o Functions with application software compatible with Windows NT.
LASERCARD FILE SYSTEM (LCFS) DLL SOFTWARE. The LCFS DLL is a complete
software development package that supports Windows(R) 3.x, Windows(R) 95,
Windows(R) 98, Windows(R) NT, and the Linux operating system. The LaserCard File
System itself is independent of any operating system; therefore, it can be
ported to an operating system along with the application, while retaining
compatibility with previously written optical memory cards and the application.
LCFS can optimize the LaserCard's WORM recording medium without the constraints
of a DOS or Windows or Linux file structure. Since LCFS is not part of an
operating system (as device drivers are), access to the card is available only
from the software application that created the data on the optical card or from
a related application.
The LCFS DLL is used to develop LaserCard applications with enhanced
security features that can prevent direct access to files on the optical memory
card. Before granting access to any particular file, the application prompts the
user for the password relating to that file and will deny access if the proper
password is not entered. Features of the LaserCard File System DLL include:
o Enables use of the LaserCard with database management systems of
Microsoft, Oracle, Sybase, and others.
o Permits writing of LaserCard application programs under software
languages such as Visual Basic, C++, and others.
o Generates up to 16 partitions for highly secure, password protected,
multiple application cards.
o Enables LaserCard file format to be operating-system independent.
o Supports multiple sector size recording to optimize data capacity.
Note: Windows, Windows 95, Windows 98, and Windows NT are trademarks
of Microsoft Corporation.
APPLICATION SOFTWARE
Application software is an important factor in developing commercial
markets for optical memory cards because it directs computers to do specific
tasks related to the customer's end-user application for the LaserCard (such as
storing a health record). Typically, the Company's VARs and/or their customers
develop software for specific end-user applications. In this role, VARs may
integrate optical card products into existing software products, write new
application software for specific optical memory card programs, or license
software from other VARs. Several VARs have written optical card software
programs for applications.
LASERBADGE(TM) APPLICATION SOFTWARE. In addition to developing
system-related software, LSC has developed a complete LaserCard issuing
application, in coordination with an existing commercial software company.
Called LaserBadge(TM), the application is a card personalization and data
management software package that uses an existing ODBC (open database
connectivity)-compliant database to print and optically encode personal data
onto the LaserCard. This
11
software package is offered for sale to all VARs, allowing them to integrate the
LaserBadge into their end-user application for printing and encoding of the
LaserCard.
OPTICAL CARD READ/WRITE DRIVES
Optical memory cards are used in conjunction with a card read/write device
(drive) that connects to a personal computer. The price, performance, and
availability of read/write drives are factors in the commercialization of
optical cards. The Company sells read/write drives to VARs and other customers
for less than three thousand dollars per unit, and these units generally include
the Company's interface software/device drivers. In fiscal 2002, the prices were
reduced by 20% for typical purchase quantities.
During fiscal 2000, the Company established in-house capabilities in
read/write drive assembly and design. Previously, the Company purchased
assembled drives from a licensee in Japan, Nippon Conlux Co., Ltd. ("Conlux"),
which was a sole supplier of the drives. The Company completed the acquisition
for cash of Conlux's read/write drive manufacturing facility (manufacturing
tooling, equipment, etc.), transferred the facility to Mountain View,
California, and is producing drives locally. Initially, the Company purchased
sets of parts from Conlux for assembly in the United States. Currently, the
Company purchases read/write drive parts from vendors it has qualified.
With LaserCard read/write drive assembly and design now under the Company's
direct control in Silicon Valley, lower cost drives, customer-optimized drive
systems, and drive systems with advanced security features are expected to
emerge. Also, the Company now can more quickly provide quotations for larger
quantities of read/write drives or customized drives. However, the Company can
give no assurance that increased read/write drive production or enhanced drive
capabilities will occur in the near term or that high volume sales and lower
prices will result.
PERIPHERALS
LSC purchases and resells the following application-specific peripherals:
o Dye-diffusion color card printers for printing of eye readable photos,
graphics, and text in black and white or color onto cards.
o Digital biometric identity verification systems (hand geometry,
fingerprint, and signature verification systems) for comparing a
unique biometric identifier stored on the LaserCard with that of the
card user.
o X-ray scanners.
o Electronic digital video cameras for storing computer readable photos
in color.
COMPETITION
The Company's optical memory cards compete with optical memory cards made
by a licensee (Optical Memory Card Business Corporation) and with other types of
portable data storage cards and technologies used for the storage and transfer
of digital information. These alternatives may include integrated circuit (IC)
cards, 2-dimensional bar code cards and symbology cards, magnetic-stripe cards,
CD-read only cards or recordable cards, PC cards, and small, digital devices
such as data-storage keys, tokens, finger rings, and small cards and tags. The
financial and marketing resources of some of the competing companies are greater
than the Company's resources.
Competitive product factors include system/card portability,
interoperability, price-performance ratio of cards and associated equipment,
durability, environmental tolerance, and card security. Although the Company
believes its cards offer key technological and security advantages, the current
price of optical card read/write drives is a competitive disadvantage to the
Company in some markets because alternative technologies typically have lower
priced drives. In addition, in countries where the telecommunications
infrastructure is extensive and low cost, centralized databases and wide-area
networks may limit the penetration of optical memory cards. These trends toward
Internet, intranet, and remote
12
wireless networks will preclude some potential applications for the Company's
cards but, on the other hand, may create market opportunities in other areas
such as information security and card personalization via the Internet.
The Company believes that the LaserCard's storage capacity, read/write
capability, price-performance ratio, rugged card construction and flexibility,
optional technology add-ons, ability to store audit trails, and resistance to
counterfeiting and tampering make the LaserCard a viable choice for a variety of
digital card applications. These include high security ID-based card systems for
federal, state, and foreign governments, pay-per-use licenses/permits, and
medical data uses.
IC CARDS. The LaserCard competes in some applications, such as the
identification card market, with cards that contain an integrated circuit (IC)
microprocessor and memory. These are known as "smart cards," "IC cards," or
"chip cards." The IC card is more vulnerable to tampering and can be more easily
damaged in everyday use, whereas the Company's card construction and the use of
polycarbonate plastic make the LaserCard more rugged. Also, a 32-kilobyte IC
card can store less than 2% of the amount of data storable on a LaserCard
optical memory card.
IC card prices and performance vary widely. The IC card uses a much lower
cost read/write drive than is used with an optical card, whereas a typical smart
card containing a 32-kilobyte IC and a microprocessor is higher priced than the
Company's 4.1 megabyte optical memory card. Because of their low-priced
read/write drive, IC cards containing a 32-kilobyte IC and a microprocessor are
particularly competitive in systems using one-card per read/write drive and in
the markets for financial-transaction and telephone systems. The IC card was
invented five years before the LaserCard and has a greater installed base
outside of North America. Low-storage capacity IC cards are currently used as
telephone cards and point-of-sale cards, particularly in Europe. Low-storage
capacity cards for telephones and for bank debit/cash card systems are not
markets for the Company's cards. However, for multi-function applications, the
Company currently offers "chip ready" optical cards to which an IC can be added,
creating a PC-like, hybrid smart card, called a Smart/Optical(TM) card.
OTHER CARD PRODUCTS. Read/write magnetic-stripe cards and read-only memory
cards such as 2-dimensional bar code cards and symbology cards are lower priced
and compete with the Company's read/write optical memory cards for certain
markets, such as identification cards. However, the Company's cards have
significantly higher storage capacity and offer unique security features to
deter counterfeiting and data tampering. Commercial magnetic-stripe cards are
relatively easy to duplicate and, because they are erasable and rerecordable,
are highly susceptible to unauthorized erasure and alteration. Two-dimensional
bar codes on cards and other symbology cards store relatively small amounts of
data compared to the LaserCard and are not recordable/updatable after they are
issued. Moreover, some of these alternative technologies--such as magnetic
stripes, IC chips, and bar codes/symbology--can be incorporated into the
Company's optical memory cards, thereby adding additional performance features
to the LaserCard. In 2000, a small company announced it was developing a 5
megabyte magnetic card. However, the Company believes that magnetic-based cards
(which are easily erasable) probably would not have the high security
features/audit trail required for government ID cards or the security and audit
trail features required for medical record cards. Experimental card technologies
probably are under development at other companies.
There also are high capacity, high cost storage cartridges called PCMCIA
(Personal Computer Memory Card Industry Association) cards, or PC cards, that
are used in personal computer applications, for example, data-storage devices
for portable computers. Because they are structurally rigid, thick, and
significantly higher in cost, PC cards are not considered competitive with the
LaserCard for low cost, wallet-card applications. Other small, digital
devices--such as data-storage keys, tokens, finger rings, and small cards and
tags--are viable alternatives for some card-based applications. Competitive
factors include system/card portability, interoperability, price-performance
ratio, and environmental tolerance.
OTHER OPTICAL MEMORY CARDS AND EQUIPMENT. Under a royalty-bearing license
from the Company, Optical Memory Card Business Corporation (OMCBC), a Japanese
company, makes and sells optical memory cards in competition with the LaserCard.
Another Japanese company, Canon Inc., also purchased a license from the Company
to make optical memory cards and equipment; however, Canon apparently is no
longer actively selling these products. Japan-based Olympus Optical Co., also a
licensee of the Company, has produced its own optical card equipment, although
it is not believed to be doing so currently, and has purchased cards from OMCBC,
which Olympus partially owns.
13
The Company's LaserCard utilizes the ISO/DELA format developed by the
Company in conjunction with a group of its licensees. Canon's optical memory
card used the ISO/SIOC format developed by Canon. Although both card formats
meet the ISO Standard, the Company's ISO/DELA format and the Canon ISO/SIOC
format are not functionally compatible. The Company believes that its ISO/DELA
format offers some performance advantages over Canon's ISO/SIOC format. Olympus
Optical has manufactured and sold ISO/SIOC read/write drives and nonstandard
drives and is capable of producing an optical card read-only drive.
The Company produces ISO/DELA format cards and read/write drives. Dai
Nippon Printing Co., Ltd. (the principal owner of OMCBC) produces optical memory
cards using the ISO/SIOC format, in addition to cards using the ISO/DELA format,
and is capable of producing the nonstandard Olympus format. At least several
times as many ISO/DELA cards have been manufactured and sold than ISO/SIOC
format cards. Nevertheless, ISO/SIOC format cards and read/write drives have
been sold in competition with Company products, and the marketing resources of
Dai Nippon Printing, Canon, and Olympus Optical are substantially greater than
those of the Company. The Company also believes that it currently offers
competitive advantages in areas such as system integration, system software,
customer support services, and as the only company that manufactures both
optical memory cards and read/write drives.
More than five years ago, a number of firms disclosed the development of
alternative optical cards, including Asahi Chemical, Polaroid, Sony, and Toppan
Printing. However, the Company is not aware of any current optical memory
card-related commercial activities by those firms. During the past several
years, prerecorded read-only optical cards functioning with CD players have been
used as high-data capacity, 1.2-millimeter thick, "business cards" containing
promotional materials. On June 12, 2000, Philips, Sony, and Taiyo Yuden
announced a customer-recordable version of these thick, rigid, promotional-data
cards based upon the widely used CD-recordable format; however, they do not meet
the ISO Standards for either credit cards or identification cards. Also in 2000,
it became known that a small company is developing a high-data capacity,
ultraviolet-laser recordable, read-only, optical memory disk and optical memory
card that would be read with a second laser operating in the visible or
near-infrared wavelength. That company's news releases imply a primary focus on
disks.
LICENSING
The Company has developed a portfolio of U.S. and foreign patents which
have generated a total of over $40 million in license fee revenues through
license agreements related to optical memory cards, equipment for using the
cards, optical data storage, and other aspects of the Company's patents. The
Company presently offers nonexclusive, royalty bearing licenses for optical card
read/write drive manufacture, for assembly of read/write drives from kits, for
optical card finishing using Company-supplied materials, and for card
manufacturing. In the past, the Company also offered card distribution licenses
to create distributors, in selected regions of the world, that can buy cards
wholesale from the Company at prices lower than those charged to VARs.
In the past, the Company sold two $10 million, nonexclusive, royalty
bearing, patent licenses for optical memory card manufacture--one in fiscal 1989
to Canon Inc., and one in fiscal 1991 to Optical Memory Card Business
Corporation (OMCBC), a Japanese company formed by four companies--Dai Nippon
Printing Co., Ltd. along with three of the Company's read/write drive equipment
licensees. OMCBC is a competitive manufacturer of optical memory cards and an
alternate, second-source supplier to the Company's customers for optical cards
that are compatible with the Company's cards.
Fiscal 2000 license revenue included $119,000 realized from the sale of a
license in Italy to assemble optical card reader/writers using parts kits
supplied by the Company. Fiscal 2001 license revenue included $712,000 from the
Italian read/write drive assembly license and $1,465,000 realized from the sale
of a digital sound patent license. (See Note 6 to the Consolidated Financial
Statements.) Fiscal 2002 license revenue included $1,206,000 recognized on
digital sound patent licenses and $119,000 realized from the Italian read/write
drive assembly license.
The Company conducts its licensing efforts on a selective basis. The
timing, number, type, and magnitude of future license sales, if any, cannot be
predicted or inferred from past events. There is no assurance that any of the
Company's patent licensing efforts will be successful.
14
OTHER MATTERS
RESEARCH AND ENGINEERING EXPENSES
Research and engineering expenses were $3,045,000 for fiscal 2002,
$2,370,000 for fiscal 2001, and $1,299,000 for fiscal 2000. See Item 7,
"Management's Discussion and Analysis."
PATENTS
OPTICAL DATA STORAGE. As of March 31, 2002, the Company owned over 40 U.S.
patents relating to optical data storage (including optical storage media,
optical cards, formats, equipment, systems, software, the utilization of optical
storage media, and e-commerce technology). Other U.S. patent applications have
been filed, including five related to the field of e-commerce technology.
Approximately 60 counterpart patents of certain U.S. patents are issued in
various foreign countries. However, the Company owns certain U.S. patents as to
which foreign counterparts have either not been filed or the examination process
has been terminated without issuance of the foreign patents. From time to time,
the Company elects to allow some of its U.S. or foreign patents to expire when
maintenance fees become due, if the patents are deemed no longer relevant. In
addition to its patents, the Company protects as trade secrets some refinements
to the Drexon medium and cards and knowhow related to card production.
The Company's U.S. patents have expiration dates ranging from 2002 to 2020,
with the majority expiring during the first half of this period. Counterpart
patents in foreign countries also expire during this period. Two of the three
U.S. patents that expire in 2002 have counterpart patents that expire in 2005 in
the following countries: Belgium, Canada, France, Germany, Israel, Japan, United
Kingdom, Korea, and Spain. Under its license agreement with the Company for
manufacture of optical memory cards, OMCBC's obligation to pay royalties to the
Company for use of the licensed patents ceases on December 31, 2003. Canon's
royalty obligations in connection with its licenses to manufacture optical
memory cards and reading and writing equipment expire on December 31, 2008.
however, Canon apparently is no longer actively selling these products. Other
royalty-bearing licenses sold by the Company, related to equipment for reading
and writing optical memory cards, provide for royalty payments to cease on the
last expiration date of the licensed patents. Royalty payments to the Company
from its licensees have not been significant to date. The Company cannot predict
whether the expiration or invalidation of its patents would result in the
introduction of competitive products which would affect its future revenues
adversely.
The Company presently intends to pursue any infringement of its patents
either by litigation, arbitration, or negotiation. However, there can be no
assurance that any of the Company's patents will be sufficiently broad in scope
to afford protection from products with comparable characteristics that may be
sold by competitors in the future. There also can be no assurance that the
validity of any patents actually granted will not be challenged. In 1992, the
claims of three of the Company's issued U.S. patents successfully passed
reexamination proceedings in the U.S. Patent and Trademark Office (USPTO) after
a two-year review by the USPTO's Board of Patent Appeals and Interferences.
"PACKET WRITING" AND DRIVE-LETTER ACCESS METHOD FOR CD-R AND DVD-R DRIVES.
In 1991, the Company was issued U.S. Patent 5,029,125 entitled, "Method of
Reading and Writing Files on Nonerasable Storage Media." Counterpart patents
were granted in Japan, Germany, France, the U.K., Italy, and Canada. The patent
relates to methods of reading and writing data files on a nonerasable (and the
equivalent) laser recordable optical disk and methods of transferring,
inputting, and outputting data files within a computer system that utilizes both
a computer memory and an optical disk, such as a CD-R or DVD-R disk. The
system/software architecture used in the patented method facilitates the use of
"packet writing" and drive-letter access and is applicable to various PC
operating systems. The invention permits a number of separate laser recordings
on a single track of an optical disk with minimum waste of data storage space
for "overhead" functions. On June 5, 1997, the Optical Storage Technology
Association (OSTA) announced the release of Universal Disk Format (UDF 1.5)
which defines support for CD-R with Windows 95 and Windows NT. OSTA stated,
"CD-R users who record disks in multiple sessions need to employ packet writing
to avoid substantial loss of storage capacity." Avoiding such a loss of storage
capacity was a significant objective of U.S. Patent 5,029,125 when filed March
7, 1989. The Company takes steps to protect its patents. During fiscal 1998 and
fiscal 2001, more than two dozen companies were put on notice by the Company
with regard to possible infringement of this patent.
15
TRADEMARKS
LaserCard(R) and Drexon(R) are federally registered trademarks of Drexler
Technology Corporation.
EMPLOYEES
As of March 31, 2002, the Company and its subsidiaries employed 117 persons
(including four executive officers). This workforce consisted of 105 persons in
administration, marketing/sales, manufacturing, and research and engineering,
plus 12 temporary personnel mainly for quality assurance inspection of cards.
None of the Company's employees is represented by a labor union.
BACKLOG
As of March 31, 2002, the backlog for LaserCard optical memory cards
totaled approximately $16.4 million, consisting of approximately $11.1 million
in firm card orders under card supply contracts, and approximately $5.3 million
in cards produced and delivered to a secure, government-funded vault. Of the
$11.1 million amount, 85% is for U.S. government Green Cards or Laser Visas
under a U.S. government subcontract for the purchase of optical memory cards. Of
the $5.3 million amount, all are Green Cards or Laser Visas produced under this
subcontract. As of March 31, 2001, the backlog for LaserCard optical memory
cards totaled approximately $12 million, consisting of approximately $6.2
million in firm card orders under card supply contracts, and approximately $5.8
million in cards produced and delivered to a secure, government-funded vault.
Announced in June 2000, the Company's U.S. government subcontract has an
authorized maximum of $81 million for up to 24 million cards, at an average
selling price of about $3.23 per card, over a period of up to five years. The
subcontract was received by the Company through a LaserCard VAR that is a U.S.
government prime contractor, under a competitively bid, government procurement
contract. The subcontract states that the U.S. government anticipates placing
orders in units of at least one million optical memory cards per order. The
subcontract provides for an initial one-year contract period and four additional
one-year contract options. Deliveries commenced in September 2000, and 6 million
cards have been delivered to the vault as of March 31, 2002, under this
subcontract.
The Company's U.S. government subcontract requires delivery to a secure,
government-funded vault built on Company premises. Deliveries are made into the
vault on a fixed schedule specified by the prime contractor. At the time the
cards are delivered to the vault, title to the cards transfers to the
government, the prime contractor is invoiced, and payment is due according to
normal trade payment terms. However, revenue is recognized when the cards are
shipped from the vault to the government unless the Company receives a fixed
schedule, notification, or plan for shipments out of the vault to the
government, in which case revenue would be recognized upon the latter of receipt
of such fixed shipment schedule or delivery of the cards into the vault.
As of March 31, 2002, the vault contained 1.7 million cards with a sales
value of $5.3 million. The $5.3 million in sales value will be recorded as
revenue and the associated costs will be recorded in cost of sales when the
cards are shipped unless the Company receives a fixed schedule, notification, or
plan for shipments out of the vault to the government, in which case revenue
would be recognized upon receipt of such fixed delivery schedule. The 1.7
million cards are owned by the U.S. government and are not included in inventory
on the Company's consolidated balance sheets. The net of the revenue value of
$5.34 million and the $2.48 million cost is recorded as deferred gross profit in
the amount of $2.86 million on the consolidated balance sheets.
FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS
Financial information about geographic areas is described in Note 4 to Item
8, "Consolidated Financial Statements and Supplementary Data."
16
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS - WE DEPEND ON A LIMITED NUMBER
OF CUSTOMERS, AND THE LOSS OF THESE CUSTOMERS OR SIGNIFICANT REDUCTIONS IN THEIR
ORDERS WOULD CAUSE REVENUES TO DECLINE. We are heavily dependent on U.S.
government orders for INS Green Cards and Department of State Laser Visa cards,
representing 75% of our fiscal 2002 revenues. These two programs provide the
largest component of our currently anticipated card production. As is the case
in all U.S. government procurement, the government reserves certain rights, such
as the right to withhold releases, to reduce the quantities released, extend
delivery dates, reduce the rate at which cards are issued, and cancel all or
part of its orders. Our U.S. government card deliveries depend upon the issuance
of corresponding order releases by the government, and we believe that these
orders will continue in accordance with our government subcontract. Losses would
occur if both of our largest U.S. government programs were to be delayed,
canceled, or not extended and not be replaced by other card orders or other
sources of income, or if increases in product revenues or licenses do not keep
pace with increased marketing and R&D expenditures. VISX, Incorporated, a
non-government customer of ours since 1992, represented 7% of our fiscal 2002
revenues. Although some of its LaserCard-equipped surgery systems continued to
use our optical memory cards in fiscal 2002, VISX does not employ LaserCard
drives for system activation of its currently produced laser eye-surgery
equipment. This had an adverse effect on our revenue levels in fiscal 2001 and
2002.
LENGTHY SALES CYCLES - SINCE THE SALES CYCLE FOR OUR PRODUCTS IS TYPICALLY
LONG AND UNPREDICTABLE, WE HAVE DIFFICULTY PREDICTING FUTURE REVENUE GROWTH.
Initial product sales to value-added resellers and other customers are generally
in small quantities, for evaluation purposes and trial programs. Obtaining
substantial, follow-on orders from these customers usually involves a lengthy
sales cycle, requiring marketing and technical time and expense with no
guarantee that substantial orders will result. This long sales cycle results in
uncertainties in predicting operating results, particularly on a quarterly
basis. In addition, since our major marketing programs involve the U.S.
government and various foreign governments and quasi-governmental organizations,
additional uncertainties and extended sales cycles can result. Contributing
factors include government regulations, bidding procedures, budget cycles, and
other factors that influence governmental policy-making and procurement.
EXPANSION OF CARD MANUFACTURING CAPACITY - WE COULD EXPERIENCE EQUIPMENT,
RAW MATERIAL, QUALITY CONTROL, OR OTHER PRODUCTION PROBLEMS UNDER VERY
HIGH-VOLUME PRODUCTION. There can be no assurance that we will be able to meet
our maximum projected card manufacturing capacity of up to 25 million optical
memory cards per year, if and when customer orders reach that level. We have
made and intend to continue to make significant capital expenditures to expand
our card manufacturing capacity. However, since customer demand is difficult to
predict, we may be unable to ramp up our production quickly enough to timely
fill new customer orders. In addition, if we overestimate customer demand, we
could incur significant costs relating to excess capacity. When purchasing raw
materials for our anticipated optical card demand, we take into consideration
the order-to-delivery lead times of vendors and the economic purchase order
quantity for such raw materials. If we over-estimate customer demand, excess raw
material inventory can result.
OPTICAL CARD RAW MATERIALS--SOURCES OF SUPPLY - IF WE ARE UNABLE TO BUY RAW
MATERIALS IN SUFFICIENT QUANTITIES AND ON A TIMELY BASIS, WE WILL NOT BE ABLE TO
DELIVER PRODUCTS TO CUSTOMERS ON TIME. As a result, we could lose customers, and
revenues could decline. We depend on sole source and limited source suppliers
for optical card raw materials. The ability to produce optical memory cards in
high volume in our card manufacturing plant is dependent upon maintaining
sources of supply of certain materials. Such materials include special
photographic films which are commercially available solely from Eastman Kodak
Company, of the United States; we believe that Kodak will continue to supply
such photographic films to us on a satisfactory basis and in sufficient
quantities. Plastic films used in optical memory card production are available
from one supplier in the U.S. and from multiple foreign suppliers. Processing
chemicals, inks, bonding adhesives, and packaging materials are obtained from
various U.S. and foreign suppliers.
PRODUCTION OF READ/WRITE DRIVES; PARTS/COMPONENTS; INVENTORY LEVELS - AN
INTERRUPTION IN THE SUPPLY OF READ/WRITE DRIVE PARTS OR DIFFICULTIES ENCOUNTERED
IN READ/WRITE DRIVE ASSEMBLY COULD CAUSE A DELAY IN DELIVERIES OF DRIVES AND
OPTICAL MEMORY CARDS AND A POSSIBLE LOSS OF SALES, WHICH WOULD ADVERSELY AFFECT
OUR OPERATING RESULTS. We maintain an inventory of read/write drives and sets of
drive parts that we believe are adequate to meet customer demand. However,
several major components are custom designed specifically for the read/write
drive. For example, the optical recording head for the current drive is a custom
part obtained from one supplier; and at current production volumes, it is not
economical to have more than one supplier for this custom component. We have not
yet needed to establish drive manufacturing capability for high-volume output
levels. The ability to produce read/write drives in high-volume production, if
required, will be dependent upon maintaining or developing sources of supply of
components that meet our requirements for high volume, quality, and cost. In
addition, the we could encounter quality control or other production
17
problems at high-volume production of read/write drives. Purchases of read/write
drive parts are made in quantities that exceed the historical annual sales rate.
Therefore, based upon the fiscal 2002 sales quantity, we have more than
one-year's supply of read/write drive parts on hand. We purchase read/write
drive parts for our anticipated read/write drive demand and take into
consideration the order-to-delivery lead times of vendors and the economic
purchase order quantity for such parts. At March 31, 2002, read/write drive
parts and finished goods inventory totaled $3.4 million compared with $2.2
million at March 31, 2001. During fiscal 2003, we expect to purchase an
additional $500,000 in read/write drive parts necessary to complete the
currently planned production of drives. Including about 585 drives in finished
goods inventory, approximately 800 read/write drives of the current design can
be assembled from this parts inventory. We believe there is a market for the
read/write drives. However, since potentially lower cost read/write drive
designs may become available from us before the parts are utilized, a portion of
this inventory could be written down if we determine that the market price of
drives would need to be reduced for the read/write drive design containing those
parts.
PRICE OF READ/WRITE DRIVES - IF WE ARE UNABLE TO PRODUCE AND SELL
READ/WRITE DRIVES IN VOLUME AND AT PRICES COMPETITIVE WITH ALTERNATE
TECHNOLOGIES, OUR OPERATING RESULTS COULD BE HARMED. The price of read/write
drives is an important factor in the commercialization of optical cards. Prior
to fiscal 2002, we had been selling read/write drives for less than three
thousand dollars per unit in quantities of six or more, and these units
generally include our interface software/device drivers. In fiscal 2002, we
reduced the selling price for these read/write drives by about 20% for typical
purchase quantities in an effort to develop a broader market and customer base
for LaserCard optical memory cards. Also, we have undertaken product development
programs for a new, upgraded, potentially less expensive read/write drive and a
read-only drive. However, there can be no assurance that these development
programs will be successful, that production of any new design will occur in the
near term, or that significantly lower prices and higher volume sales will
result.
TECHNOLOGICAL CHANGE - IF WE ARE UNABLE TO ADAPT TO TECHNOLOGICAL CHANGES
IN THE DATA CARD INDUSTRY AND IN THE INFORMATION TECHNOLOGY INDUSTRY GENERALLY,
WE MAY NOT BE ABLE TO EFFECTIVELY COMPETE FOR FUTURE BUSINESS. The information
technology industry is characterized by rapidly changing technology and
continuing product evolution. The future success and growth of our business will
require the ability to maintain and enhance the technological capabilities of
the LaserCard product line. There can be no assurance that the products
currently sold or under development will remain competitive or provide sustained
revenue growth.
PATENT PROTECTION - IF WE FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS,
COMPETITORS MAY BE ABLE TO USE OUR TECHNOLOGIES, WHICH COULD WEAKEN OUR
COMPETITIVE POSITION, REDUCE REVENUES, OR INCREASE COSTS. We rely on a
combination of patent, trademark, and trade secret laws, confidentiality
procedures and licensing arrangements to establish and protect our proprietary
rights. Our existing and future patents may not be sufficiently broad to protect
our proprietary technologies. Despite our efforts to protect proprietary rights,
policing the unauthorized use of our products is difficult, and we cannot be
certain that the steps we have taken will prevent the misappropriation or
unauthorized use of our technologies, particularly in foreign countries where
the laws may not protect proprietary rights as fully as U.S. law. Any patents we
may obtain may not be adequate to protect our proprietary rights. Our
competitors may independently develop similar technology, duplicate our
products, or design around any of our issued patents or other intellectual
property rights. Litigation may be necessary to enforce our intellectual
property rights or to determine the validity or scope of the proprietary rights
of others. This litigation could result in substantial costs and diversion of
resources and may not ultimately be successful. We cannot predict whether the
expiration or invalidation of our patents would result in the introduction of
competitive products which would affect our future revenues adversely.
COMPETITION - THE MARKETS FOR OUR PRODUCTS ARE COMPETITIVE, AND IF WE ARE
UNABLE TO COMPETE SUCCESSFULLY, REVENUES COULD DECLINE OR FAIL TO GROW. Our
optical memory cards compete with optical memory cards made by a licensee of
ours and with other types of portable data storage cards and technologies used
for the storage and transfer of digital information. These may include
integrated circuit/chip cards; 2-dimensional bar code cards and symbology cards;
magnetic-stripe cards; thick, rigid CD-read only cards or recordable cards; PC
cards; and small, digital devices such as data-storage keys, tokens, finger
rings, and small cards and tags. The financial and marketing resources of some
of the competing companies are greater than our resources. Competitive product
factors would include system/card portability, interoperability,
price-performance ratio of cards and associated equipment, durability,
environmental tolerance, and card security. Although we believe our cards offer
key technological and security advantages, the current price of optical card
read/write drives is a competitive disadvantage in some of our targeted markets.
In addition, in countries where the telecommunications infrastructure is
extensive and low cost, centralized databases and wide-area networks may limit
the penetration of optical memory cards. These trends toward Internet, intranet,
and remote wireless networks will in some cases preclude potential applications
for our cards. Also see the Competition section appearing earlier in this
report.
18
HISTORICAL LOSSES - WE HAVE INCURRED NET LOSSES IN THE PAST, MAY INCUR
LOSSES IN THE FUTURE, AND MAY NOT BE ABLE TO GENERATE SUFFICIENT NET REVENUE IN
THE FUTURE TO ACHIEVE AND SUSTAIN PROFITABILITY. As of March 31, 2002, we had an
accumulated deficit of $8,099,000. Although we have operated profitably from
fiscal 1999 through fiscal 2002, we have incurred significant losses in the
past, including in fiscal 1997 and 1998. We are relying upon our optical memory
card technology to generate future product revenues, earnings, and cash flow. If
an alternative technology emerges or if we are otherwise unable to compete, we
may not be able to achieve and sustain profitability on a quarterly or annual
basis. Losses would occur if our two largest U.S. government programs were to be
delayed, canceled, or not extended and not replaced by other card orders or
other sources of income, or if increases in product revenues or licenses do not
keep pace with increased marketing, research and development, and capital
expenditures.
STOCK PRICE VOLATILITY - THE PRICE OF OUR COMMON STOCK IS SUBJECT TO
SIGNIFICANT VOLATILITY. This volatility may be due to fluctuations in revenues,
earnings, liquidity, press coverage, financial market interest, and stock market
conditions, as well as changes in technology and customer demand and
preferences.
UNFORESEEN EVENTS - ACTS OF TERRORISM OR WAR MAY ADVERSELY AFFECT OUR
BUSINESS. Acts of terrorism, acts of war, and other unforeseen events may cause
damage or disruption to our properties, business, employees, suppliers,
distributors, resellers, and customers, which could have an adverse effect on
our business, financial condition, and operating results. Such events may also
result in an economic slowdown in the United States or elsewhere, which could
adversely affect our business, financial condition, and operating results.
ITEM 2. PROPERTIES
As of March 31, 2002, approximately 45,000 square feet of floor space are
leased by the Company for card manufacturing, read/write drive production,
administration, sales, and research and engineering, in three buildings located
in Mountain View, California. These facilities have a current total annualized
rental of approximately $1,170,000 on leases that expire on various dates from
2004 to 2006. The Company also leases a small marketing office in France.
Management believes these leased buildings to be satisfactory for its present
operations. Upon expiration of the leases, management believes that these or
other suitable buildings will be able to be leased on a reasonable basis.
ITEM 3. LEGAL PROCEEDINGS
There are no material pending legal proceedings to which the Company is a
party or of which its property is a subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of fiscal 2002.
19
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK
AND RELATED STOCKHOLDER MATTERS
The Company's only class of common stock, $.01 par value, is traded on The
Nasdaq Stock Market(R) under the symbol DRXR and is quoted in THE WALL STREET
JOURNAL and other newspapers. The table below sets forth the high and low trade
prices for the Company's common stock (rounded to two decimal points) as
reported by Nasdaq during the fiscal periods indicated.
Quarterly Stock Prices (Unaudited)
----------------------------------
Fiscal Year 2001 Fiscal Year 2002
---------------- ----------------
High Trade Low Trade High Trade Low Trade
---------- --------- ---------- ---------
First Quarter........ $ 15.37 $ 9.62 $ 14.94 $ 10.40
Second Quarter....... 21.62 11.50 17.00 8.80
Third Quarter........ 25.00 10.81 24.50 14.25
Fourth Quarter....... 17.69 11.25 25.90 18.10
As of March 31, 2002, there were approximately 790 holders of record of the
Company's common stock. The total number of shareholders is believed by the
Company to be several thousand higher since many holders' shares are listed
under their brokerage firms' names.
The Company has never paid cash dividends on its common stock. The Company
anticipates that for the foreseeable future, it would retain any earnings for
use and reinvestment in its business and for the repurchase of common stock.
20
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial information for, and as of
the end of, each of the years in the five-year period ended March 31, 2002, is
derived from the consolidated financial statements of the Company. This
financial data should be read in conjunction with the consolidated financial
statements and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" appearing in Item 7 of this report.
DREXLER TECHNOLOGY CORPORATION
FIVE-YEAR SUMMARY OF FINANCIAL INFORMATION
Fiscal Years Ended March 31, 1998 - 2002
(In thousands, except per share amounts)
OPERATIONS DATA 1998 1999 2000 2001 2002
---- ---- ---- ---- ----
Revenues............................................. $ 6,161 $ 12,577 $ 15,443 $ 24,906 $ 20,740
Cost of sales........................................ 3,713 6,087 8,668 12,199 10,503
Selling, general, and administrative expenses........ 2,978 3,698 3,996 4,134 5,165
Research and engineering expenses.................... 435 456 1,299 2,370 3,045
Other income (expense), net.......................... 16 (44) 6 -- --
Interest income, net................................. 138 312 382 612 386
--------- --------- --------- --------- ---------
Income (loss) before income taxes.................... (811) 2,604 1,868 6,815 2,413
Income tax provision (benefit)....................... 68 128 (2,919) (1,097) (2,786)
--------- --------- --------- --------- ---------
Net income (loss).................................... $ (879) $ 2,476 $ 4,787 $ 7,912 $ 5,199
========= ========= ========= ========= =========
Net income (loss) per share:
Basic............................................ $ (.09) $ .25 $ .49 $ .80 $ .52
========= ========= ========= ========= =========
Diluted.......................................... $ (.09) $ .25 $ .48 $ .76 $ .50
========== ========= ========= ========= =========
Weighted average number of common
and common equivalent shares:
Basic............................................ 9,391 9,748 9,812 9,897 9,961
Diluted.......................................... 9,391 10,007 9,935 10,446 10,468
BALANCE SHEET DATA
Current assets....................................... $ 7,561 $ 11,485 $ 14,489 $ 18,333 $ 28,118
Current liabilities.................................. 4,249 5,973 8,305 7,324 7,501
Total assets......................................... 11,248 16,566 24,362 30,137 40,713
Long-term obligations................................ -- -- -- -- --
Stockholders' equity................................. 6,999 10,593 16,057 22,813 32,337
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
When used in this discussion, the words "expects," "anticipates,"
"believes," "estimates" and similar expressions are intended to identify
forward-looking statements. These statements, including expectations as to
deferred revenue and gross profit as a result of the restatement of financial
information discussed below; statements as to expected benefits of the Company's
direct control of the read/write drive assembly and design and the Company's
research and engineering efforts, including the expected development of lower
cost drives, customer-optimized drive systems, and drive systems with advanced
security features; the need for and efforts to develop read-only drives and new
read/write drives and software products; the Company's efforts to recruit new
VARs or licensees and eliminate nonproductive value-added resellers (VARs) or
licensees and eliminate nonproductive VARs; the adequacy of inventory;
anticipated orders from the Company's U.S. government subcontract; expected
delivery volumes for the 2003 and 2004 fiscal years; expectations regarding
revenues, margins, expenses, capital resources, capital expenditures and
investments, and the Company's deferred tax asset and valuation allowance;
potential reductions of federal tax cash payments due to current Company tax
benefits; the effects of read/write drive prices on gross profits from
read/write drive sales; the Company's estimates for the level of sales of drives
that would be necessary to achieve a gross profit at current prices;
expectations regarding the market for read/write drives, read/write drive
prices, and inventory of drives and parts; statements as to card delivery
volumes; current and potential customers, applications, or market segments for
optical memory card products; the Company's plans and expectations regarding the
growth of its manufacturing capacity and expected card yields therefrom; and
expectations regarding market growth and product demand, including the expected
emergence of opportunities for the Company's products in Canada, China, India,
Italy, Macedonia, Mexico, and Saudi Arabia and further opportunities in
expansion of current U.S. government ID card programs are subject to risks and
uncertainties that could cause actual results to differ materially from those
projected.
These risks and uncertainties include, but are not limited to those risks
discussed below, as well as the impact of litigation or governmental or
regulatory proceedings; Arthur Andersen LLP's ability to timely consent to
including the restated financial information in the Company's SEC filings; the
Company's ability to initiate and grow new programs utilizing the Company's card
products; the Company's reliance on VARs and licensees to generate sales,
perform customer system integration, and develop application software; risks
associated with doing business in and with foreign countries; potential
manufacturing difficulties and complications associated with increasing
manufacturing capacity of cards and drives; uncertainties associated with the
design, development, manufacture, and deployment of optical card drives and
systems; reliance on single-source and limited-source suppliers for certain
components and raw materials; customer concentration and reliance on continued
U.S. government business; lengthy sales cycles; manufacturing difficulties;
general economic trends; the unpredictability of customer demand for products
and customer issuance and release of corresponding orders; the U.S. government's
right to withhold order releases, reduce the quantities released, and extend
delivery dates; the impact of technological advances and competitive products
and the ability of the Company or its customers to develop software and
integrate optical card systems with other technologies; and the matters
discussed in the section entitled "Factors That May Affect Future Operating
Results" in Item 1 of this Report.
These forward-looking statements speak only as of the date hereof. The
Company expressly disclaims any obligation or undertaking to release publicly
any updates or revisions to any forward-looking statements contained herein to
reflect any change in the Company's expectations with regard thereto or any
change in events, conditions or circumstances on which any statement is
CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION. The Company recognizes revenue when the following
criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery
has occurred or services rendered; (3) the fee is fixed and determinable; and
(4) collectibility is reasonably assured. Where appropriate, provision is made
at that time for estimated warranty costs and estimated returns relating to
product sales.
22
The Company's U.S. government subcontract requires delivery to a secure,
government-funded vault built on Company premises. Deliveries are made into the
vault on a fixed schedule specified by the prime contractor. At the time the
cards are delivered to the vault, title to the cards transfers to the
government, the prime contractor is invoiced, and payment is due according to
normal trade payment terms. However, revenue is recognized when the cards are
shipped from the vault to the government unless the Company receives a fixed
schedule, notification, or plan for shipments out of the vault to the
government, in which case revenue would be recognized upon the latter of receipt
of such fixed shipment schedule or delivery of the cards into the vault.
ACCOUNTING FOR INCOME TAXES. As part of the process of preparing its
consolidated financial statements, the Company is required to estimate income
taxes in each of the jurisdictions in which it operates. This process involves
estimating the actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the consolidated balance
sheets. The Company must then assess the likelihood that the deferred tax assets
will be recovered from future taxable income and to the extent that management
believes recovery is not likely, the Company must establish a valuation
allowance. To the extent that a valuation allowance is established or increased
in a period, the Company must include an expense within the tax provision in the
statements of income.
Significant management judgment is required in determining the provision
for income taxes, deferred tax assets and liabilities, and any valuation
allowance recorded against the net deferred tax assets. The Company has recorded
a valuation allowance of $5.3 million as of March 31, 2002, due to uncertainties
related to the Company's ability to utilize some of the deferred tax assets,
primarily consisting of certain net operating losses carried forward, before
they expire. The valuation allowance is based on management's estimates of
taxable income by jurisdiction in which the Company operates and the period over
which the deferred tax assets will be recoverable. In the event that actual
results differ from these estimates or that these estimates are adjusted in
future periods, the Company may need to establish an additional valuation
allowance which could materially impact the Company's results of operations.
INVENTORIES. The Company values its inventory at the lower of the actual
cost to purchase and/or manufacture the inventory or the current estimated
market value of the inventory. Management regularly reviews inventory quantities
on hand and records a provision for excess and obsolete inventory based
primarily on the estimated forecast of product demand. As demonstrated during
fiscal 2002, demand for read/write drive products can fluctuate significantly.
If the Company is unable to produce and sell read/write drives in volume and at
prices competitive with alternate technologies, its operating results could be
harmed. In order to obtain favorable pricing, purchases of read/write drive
parts are made in quantities that exceed the historical annual sales rate.
Therefore, based upon last year's sales quantity, the Company has more than
one-year's supply of read/write drive parts on hand. The Company purchases
read/write drive parts for its anticipated read/write drive demand and takes
into consideration the order-to-delivery lead times of vendors and the economic
purchase order quantity for such parts. At March 31, 2002, read/write drive
parts and finished goods inventory totaled $3.4 million compared with $2.2
million at March 31, 2001. During fiscal 2003, the Company expects to purchase
an additional $500,000 in read/write drive parts necessary to complete the
currently planned production of drives. Including approximately 585 drives in
finished goods inventory, approximately 800 read/write drives of the current
design can be assembled from this parts inventory. In addition, approximately
1,300 read/write drives of a new design could be assembled with the additional
purchase discussed above. The Company believes there is a market for basic and
upgraded read/write drives to support and expand optical card sales and, based
on current proposals in process, that the read/write drive inventory on hand at
March 31, 2002, including parts to be received, will be ordered by customers. If
these anticipated orders do not materialize, the Company may need to write-down
the value of its inventory for any potential excess quantities. During fiscal
2002, the Company sold approximately 450 read/write drives. The Company believes
that sales of approximately 475 read/write drives per quarter would be necessary
to achieve a gross profit on read/write drive sales at current selling prices
and costs. The Company believes that the read/write drive inventory as of March
31, 2002 is reflected at its net realizable value. In addition, since lower cost
read/write drive designs may become available from the Company before the
existing parts are utilized, a portion of this inventory may be deemed obsolete
and would require an inventory write-down. However, it is anticipated that the
introduction of any new read/write drive would be timed to minimize this risk.
In addition, the Company is investing in research and engineering in an effort
to develop new read/write drive products, as discussed under "Research and
Engineering Expenses."
23
RESTATEMENT OF RESULTS FOR FISCAL 1998-2001 AND FIRST NINE MONTHS OF FISCAL 2002
In connection with the Company's audit for the fiscal year ended March 31,
2002, the Company and its newly appointed independent accountants conducted an
internal review of revenue recognition practices that were being followed as
they related to a government subcontract. This review, as more fully described
in the Company's Report on Form 8-K dated May 15, 2002, resulted in accounting
adjustments arising from changes in the timing of revenue recognition of
LaserCard optical memory card shipments into and out of a secure,
government-funded vault built for the government on Company premises to comply
with security regulations under the subcontract. In the past, the Company
recognized revenue upon deliveries to the vault since the customer takes title
to the cards, assumes all risks of ownership, is obligated to remit payment for
the cards at that time, and has no rights of return except for product defects.
However, Drexler's newly appointed independent accountants advised the Company
that under the terms and conditions of the Company's U.S. government supply
subcontract, the transfer of title and the imminent cash payment pursuant to the
contract payment terms upon delivery of the cards to the vault are necessary but
not necessarily sufficient to recognize revenue upon delivery of cards to the
vault, under the SEC's Staff Accounting Bulletin 101, Revenue Recognition, and
under the prior criteria set forth in the SEC's Accounting and Auditing
Enforcement Release No. 108. In the restated financial statements, revenue is
recognized upon shipment of cards from the vault to the customer since the
Company had not been provided with a fixed schedule, notification, or plan for
shipments out of the vault to the government. The Company has restated
previously issued results for fiscal years 1998 through 2001 and the first nine
months of fiscal 2002 to reflect these adjustments in the timing of revenue
recognition. As a result of the restatement, revenue for fiscal 1998, fiscal
1999, and fiscal 2000 declined, while revenue for fiscal 2001 and the first nine
months of fiscal 2002 increased.
RESULTS OF OPERATIONS--FISCAL 2002 COMPARED WITH FISCAL 2001 AND FISCAL 2000
REVENUES
For the 2002 fiscal year ended March 31, 2002, the Company's total revenues
were $20,740,000 compared with $24,906,000 for fiscal 2001 and $15,443,000 for
fiscal 2000.
PRODUCT REVENUES. Sales of LaserCard(R) optical memory cards and related
products totaled $19,413,000 for fiscal 2002 compared with $22,690,000 for
fiscal 2001 and $15,299,000 for fiscal 2000. The changes in product revenues
over these periods were due primarily to the sale of optical memory cards for
two U.S. government card programs, as described below. For fiscal 2002, the
Company sold LaserCard products or provided services to approximately 32
customers in seven states and 15 foreign countries. The Company's card
deliveries to all customers totaled 5.6 million optical memory cards and 450
read/write drives for fiscal 2002 compared with 5.9 million optical cards and
1,280 read/write drives for fiscal 2001 and 4 million cards and 860 read/write
drives for fiscal 2000. Read/write drive revenues decreased by $2.6 million for
fiscal 2002 compared with fiscal 2001 and increased by approximately $1.3
million in fiscal 2001 as compared with fiscal 2000. Of the 1,280 read/write
drives sold during fiscal 2001, approximately 600 drives were delivered mainly
for the U.S. Department of Defense "Automated Manifest System" as compared with
approximately 60 read/write drives for fiscal 2002 and approximately 270 drives
for fiscal 2000. Orders for this program have historically been sporadic. The
remaining decrease in read/write drive deliveries was due to a reduction in
sales to VISX, Incorporated, discussed below.
The Company's principal LaserCard market today involves high-security,
counterfeit-resistant, tamper-resistant cards for "digital governance," defined
as the utilization of digital information technology by a nation, state, region,
municipality, agency, or institution. Within this market, the Company's largest
customer for LaserCard products is the United States government, representing
78% of total revenues for fiscal year 2002 compared with 62% of total revenues
for fiscal 2001 and 57% of total revenues for fiscal 2000. These revenues are
predominantly the result of two card programs--U.S. Immigration and
Naturalization Service (INS) Permanent Resident Cards ("Green Cards") and U.S.
Department of State (DOS) border crossing cards ("Laser Visas"). VISX,
Incorporated, a non-government customer since 1992, represented 7% of the
Company's fiscal 2002 revenues. Although some of VISX's LaserCard-equipped
surgery systems continued to use the Company's optical memory cards in fiscal
2002, VISX does not employ LaserCard drives for system activation of its
currently produced laser eye-surgery equipment. This had an adverse effect on
the Company's revenue levels in fiscal 2001 and 2002. Optical memory card
digital governance programs that appear to be emerging in other countries
include an electronic national identification card/social services card in
Italy, building construction permit cards and children's healthcare cards in
China, and state government motor-vehicle registration cards in India. The
24
Company believes that market opportunities for optical memory cards also appear
to include identification cards for Saudi Arabia and Macedonia, a document card
program in Mexico, and resident immigrant cards for Canada, as well as an
expansion of current U.S. government ID card programs. In addition, the Company
is continuing its efforts to develop new optical card read/write drives and
read-only drives and software products.
In addition to using its own marketing staff, the Company utilizes
value-added reseller (VAR) companies and card distribution licensees for the
development of commercial markets and applications for LaserCard products.
Product sales to VARs and licensees include the Company's optical memory cards,
the Company's system software, optical card read/write drives, and add-on
peripherals made by other companies (such as equipment for adding a digitized
photo, fingerprint, hand template, or signature to the cards). The
VARs/licensees may add application software, personal computers (PCs), and other
peripherals, and then resell these products integrated into data systems. The
Company is continuing its efforts to recruit new VARs and card distribution
licensees and eliminate nonproductive VARs. The Company provides customer
technical support and system software to assist VARs and licensees.
LICENSE FEE REVENUES. Fiscal 2000 license revenue included $119,000
realized from the sale of a license in Italy to assemble optical card
reader/writers using parts kits supplied by the Company. Fiscal 2001 license
revenue included $712,000 from the Italian read/write drive assembly license and
$1,465,000 realized from the sale of a digital sound patent license. (See Note 6
to the Consolidated Financial Statements.) Fiscal 2002 license revenue included
$1,206,000 recognized on digital sound patent licenses and $119,000 realized
from the Italian read/write drive assembly license.
BACKLOG
As of March 31, 2002, the backlog for LaserCard optical memory cards
totaled approximately $16.4 million, consisting of approximately $11.1 million
in firm card orders under card supply contracts, and approximately $5.3 million
in cards produced and delivered to a secure, government-funded vault. Of the
$11.1 million amount, 85% is for U.S. government Green Cards or Laser Visas
under a U.S. government subcontract for the purchase of optical memory cards. Of
the $5.3 million amount, all are Green Cards or Laser Visas produced under this
subcontract. As of March 31, 2001, the backlog for LaserCard optical memory
cards totaled approximately $12 million, consisting of approximately $6.2
million in firm card orders under card supply contracts, and approximately $5.8
million in cards produced and delivered to a secure, government-funded vault.
Announced in June 2000, the Company's U.S. government subcontract has an
authorized maximum of $81 million for up to 24 million cards, at an average
selling price of about $3.23 per card, over a period of up to five years. The
subcontract was received by the Company through a LaserCard VAR that is a U.S.
government prime contractor, under a competitively bid, government procurement
contract. The subcontract states that the U.S. government anticipates placing
orders in units of at least one million optical memory cards per order. The
subcontract provides for an initial one-year contract period and four additional
one-year contract options. Deliveries commenced in September 2000, and 6 million
cards have been delivered to the vault as of March 31, 2002, under this
subcontract.
The Company's U.S. government subcontract requires delivery to a secure,
government-funded vault built on Company premises. Deliveries are made into the
vault on a fixed schedule specified by the prime contractor. At the time the
cards are delivered to the vault, title to the cards transfers to the
government, the prime contractor is invoiced, and payment is due according to
normal trade payment terms. However, revenue is recognized when the cards are
shipped from the vault to the government unless the Company receives a fixed
schedule, notification, or plan for shipments out of the vault to the
government, in which case revenue would be recognized upon the latter of receipt
of such fixed shipment schedule or delivery of the cards into the vault.
As of March 31, 2002, the vault contained 1.7 million cards with a sales
value of $5.3 million. The $5.3 million in sales value will be recorded as
revenue and the associated costs will be recorded in cost of sales when the
cards are shipped unless the Company receives a fixed schedule, notification, or
plan for shipments out of the vault to the government, in which case revenue
would be recognized upon receipt of such fixed delivery schedule. The 1.7
million cards are owned by the U.S. government and are not included in inventory
on the Company's consolidated balance sheets. The net of the revenue value of
$5.34 million and the $2.48 million cost is recorded as deferred gross profit in
the amount of $2.86 million on the consolidated balance sheets.
25
GROSS PROFIT
The gross margin on product sales was 46% for fiscal 2002 and fiscal 2001,
and 43% for fiscal 2000.
OPTICAL MEMORY CARDS. The Company continues to depend on gross profit
generated from optical memory card sales. Gross profit on optical memory card
sales was about $9.5 million for fiscal 2002, $9.9 million for fiscal 2001, and
$6.4 million for fiscal 2000. The decrease in gross profit for fiscal 2002 was
mainly due to lower sales volume. Optical memory card gross profit and margins
can vary based on average selling price, sales and production volume, mix of
card types, production efficiency and yields, and changes in fixed costs.
READ/WRITE DRIVES. For fiscal 2002, gross profit on read/write drive sales
decreased by about $1 million, to a negative gross profit of about $640,000
compared with a gross profit of about $430,000 for fiscal 2001 and $120,000 for
fiscal 2000. The decrease for fiscal 2002 was due to lower selling prices for
drives and lower sales volume to a level that does not fully absorb fixed
manufacturing expenditures. In fiscal 2002, the Company reduced the selling
prices of its basic read/write drives by 20% for typical sales quantities, in an
effort to increase certain markets for optical memory cards. This reduced gross
profit on read/write drive sales in fiscal 2002, and increased the level of
sales required to achieve gross profits on read/write drive sales. Currently,
the Company's priority is to increase the number of read/write drives in the
marketplace rather than maximizing per-unit gross profit on read/write drives.
The Company has no plans to further lower read/write drive prices for the
current model.
The Company believes that potential markets for read/write drives include
the U.S. Immigration and Naturalization Service, U.S. Department of State, the
U.S. armed forces, Canada, Italy, and several other countries. The Company
maintains an inventory of read/write drive parts and finished drives that it
believes is adequate to meet customer demand. However, an interruption in the
supply of read/write drive parts or difficulties encountered in read/write drive
assembly could cause a delay in deliveries of drives and optical memory cards
and a possible loss of sales, which would adversely affect the Company's
operating results.
INCOME AND EXPENSES
SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES (SG&A). SG&A expenses were
$5,165,000 for fiscal 2002, $4,134,000 for fiscal 2001, and $3,996,000 for
fiscal 2000. The increase for fiscal 2002 compared with fiscal 2001 included
approximately $575,000 for increased marketing and selling expenditures, an
increase of $365,000 in general and administrative expenditures, and an increase
of $80,000 in Company 401(k) matching and Company contribution to the Employee
Stock Purchase Plan. The $138,000 increase in fiscal 2001 compared with fiscal
2000 was due to an increase in general corporate compensation expense of
$238,000, a $68,000 expense for Company 401(k) matching, a $97,000 increase in
general expenses including insurance, partially offset by a $59,000 decrease in
bad debt expense, a $106,000 decrease in patent amortization expense, and a
$100,000 expenditure in fiscal 2000 for a third-party market study. The Company
believes that SG&A expenses for fiscal 2003 will remain above fiscal 2002
levels, mainly due to increases in marketing expenses and other general
increases.
RESEARCH AND ENGINEERING EXPENSES (R&E). The Company is continuing its
efforts to develop new optical memory card read/write drives and read-only
drives and software products in order to provide new products that can stimulate
sales growth. The Company anticipates that these R&E efforts will result in
lower cost drives, customer-optimized drive systems, and drive systems with
advanced security features. R&E expenses were $3,045,000 for fiscal 2002,
$2,370,000 for fiscal 2001, and $1,299,000 for fiscal 2000