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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, 2003
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. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). [X] Yes [ ] No
Based on the last trade price of the Company's Common Stock on The Nasdaq Stock
Market on June 6, 2003, the aggregate market value of the voting stock held by
non-affiliates of the registrant is approximately $205,378,000.
Number of outstanding shares of Common Stock, $.01 par value, at June 6, 2003:
10,538,608
THE ANNUAL MEETING OF STOCKHOLDERS OF DREXLER TECHNOLOGY CORPORATION
WILL BE HELD ON SEPTEMBER 19, 2003.
DOCUMENTS INCORPORATED BY REFERENCE: NONE
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business
Forward-Looking Statements................................................................................. 3
General Development of Business............................................................................ 4
Financial Information about Segments....................................................................... 5
Narrative Description of Business.......................................................................... 5
LaserCard(R)Optical Memory Cards........................................................................ 5
Optical Data Storage................................................................................. 5
The Drexon(R)Laser Recording Medium.................................................................. 5
LaserCard Digital Governance Applications............................................................ 6
Reading and Writing the Cards........................................................................ 6
Data Storage Capacity................................................................................ 7
Prerecording......................................................................................... 7
Card Durability...................................................................................... 7
Card Security........................................................................................ 7
International Card Standards......................................................................... 9
Card Manufacturing and Raw Materials................................................................. 10
Product Evolution.................................................................................... 10
Marketing............................................................................................ 10
APIs and Application Software........................................................................ 11
Read/Write Drives; Manufacturing and Parts/Components................................................ 12
LaserCard Biometric ID Verification System........................................................... 12
Peripheral Equipment................................................................................. 12
Licensing............................................................................................... 13
Competition............................................................................................. 13
Other Matters........................................................................................... 15
Research and Engineering Expenses.................................................................... 15
Patents and Trademarks............................................................................... 15
Employees............................................................................................ 16
Dependence on Government Subcontracts through a Sole Contractor...................................... 16
Backlog.............................................................................................. 16
Financial Information about Geographic Areas......................................................... 17
Factors that May Affect Future Operating Results........................................................ 17
Item 2. Properties..................................................................................................... 20
Item 3. Legal Proceedings.............................................................................................. 21
Item 4. Submission of Matters to a Vote of Security Holders............................................................ 21
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters....................................... 21
Item 6. Selected Financial Data........................................................................................ 22
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................... 23
Critical Accounting Policies............................................................................... 24
Restatement of Results for Fiscal 1998-2001 and First Nine Months of Fiscal 2002........................... 25
Results of Operations-Fiscal 2003 Compared with Fiscal 2002 and Fiscal 2001................................ 26
Liquidity and Capital Resources............................................................................ 30
Item 7A. Qualitative and Quantitative Disclosures about Market Risk..................................................... 31
Item 8. Consolidated Financial Statements and Supplementary Data....................................................... 32
Reports of Independent Accountants......................................................................... 32
Consolidated Financial Statements.......................................................................... 34
Notes to Consolidated Financial Statements................................................................. 38
Quarterly Financial Information (Unaudited)................................................................ 47
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................... 48
PART III
Item 10. Directors and Executive Officers of the Registrant............................................................. 49
Item 11. Executive Compensation......................................................................................... 50
Item 12. Security Ownership of Certain Beneficial Owners and Management................................................. 52
Item 13. Certain Relationships and Related Transactions................................................................. 55
PART IV
Item 14. Controls and Procedures........................................................................................ 55
Item 15. Exhibits, Financial Statement Schedule, and Reports on Form 8-K................................................ 56
Signatures ............................................................................................................... 60
2
PART I
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ITEM 1. BUSINESS
FORWARD-LOOKING STATEMENTS. All statements contained in this report that
are not historical facts are forward-looking statements. The forward-looking
statements in this report are made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. They are not historical facts
or guarantees of future performance or events. Rather, they are based on current
expectations, estimates, beliefs, assumptions, and goals and objectives and are
subject to uncertainties that are difficult to predict. As a result, the
Company's actual results may differ materially from the statements made. Often
such statements can be identified by their use of words such as "may," "will,"
"intends," "plans," "believes," "anticipates," "visualizes," "expects," and
"estimates." Forward-looking statements made in this report include statements
as to current and potential customers, applications, orders, or market segments
for optical memory card products; statements as to anticipated orders and/or
shipment quantities and schedules under the Company's U.S. government and
Canadian government subcontracts; the Company's expectation that it will be
awarded a contract for approximately 1,000 read/write drives under the U.S.
Department of Homeland Security's Presolicitation Notice and the expectation
that there will be demand for the Company's read/write drives under the Italian
national ID card (CIE) program; the Company's belief that the U.S. government
intends to field optical card-based biometric verification systems on the
southern U.S. border and at certain U.S. airports; the objectives of the Company
in its efforts to sell read/write drives; the need for, expected success of, and
potential benefits from the Company's research and engineering efforts,
including developing new or enhanced card capabilities, software products,
production-model read-only drives, or drives with advanced security features or
lower manufacturing costs; whether introduction of new drives will increase
sales, and the effects of read/write drive prices and sales volume on gross
profits or gross margins 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 inclusive of fixed overhead costs; expectations
regarding the market for read/write drives and read/write drive prices; the
Company's belief that it has an adequate inventory of read/write drives and
components; the Company's efforts to recruit new value-added resellers (VARs) or
licensees; the adequacy of card raw material inventory on hand to meet future
demand; the Company's belief that Kodak will continue to supply sufficient
photographic film and that an alternate supplier could be established if needed;
the Company's ability to expand production capacity; anticipated release orders
and deliveries under the Company's U.S. government subcontract; expectations
regarding revenues, margins, capital resources, capital expenditures and
investments, and the Company's deferred tax asset and related valuation
allowance; anticipated reductions of federal tax cash payments due to current
Company tax benefits; statements as to expected card delivery volumes; estimates
of optical card production capacity, expected card yields therefrom, and the
Company's plans and expectations regarding the growth and associated capital
costs of such capacity; estimate that revenues will be sufficient to generate
cash from operations; the Company's expectation that it will retain any earnings
for use and reinvestment in its business; expectations regarding market growth,
product demand, and foreign business including emerging programs or prospective
applications in China, India, Italy, Macedonia, and Saudi Arabia; and
expectations as to continued, or expanded, or potential U.S. government or other
governmental card programs.
These forward-looking statements are based upon the Company's assumptions
about and assessment of the future, which may or may not prove true, and involve
a number of risks and uncertainties including, but not limited to, customer
concentration and reliance on continued U.S. government business; the
possibility that the U.S. government will not field optical card-based biometric
verification systems on the southern U.S. border and at certain U.S. airports;
lengthy sales cycles; changes in and reliance on government policy-making; the
risks associated with doing business in and with foreign countries, the impact
of litigation or governmental or regulatory proceedings; the ability of the
Company or its customers to initiate and develop new programs utilizing the
Company's card products; the Company's reliance on VARs, licensees, or other
third parties to generate sales, perform customer system integration, develop
application software, or integrate optical card systems with other technologies;
risks and difficulties associated with development, manufacture, and deployment
of optical cards, drives, and systems; potential manufacturing difficulties and
complications associated with increasing manufacturing capacity of cards and
drives and outsourcing manufacturing; ability to produce and sell read/write
drives in volume; reliance on single-source and limited-source suppliers for
certain components and raw materials; the unpredictability of customer demand
for products and customer issuance and release of corresponding orders;
government rights to withhold order releases, reduce the quantities released,
and extend shipment dates; whether the Company receives a fixed schedule,
notification, or plan for shipments out of the government-funded vault located
on the Company's premises, enabling the Company to recognize revenues on cards
delivered to the vault instead of when cards later are shipped from the vault;
the U.S. government's rights to modify or withdraw its reader/writer equipment
Presolicitation Notice or to award any resulting contract, reduce the quantities
released, and extend delivery dates; the impact of technological advances,
general economic trends, and competitive products; and the risks set forth in
the section entitled "Factors That May Affect Future Operating Results" and
elsewhere in this report. Due to these and other risks,
3
the Company's future actual results could differ materially from those discussed
above. These forward-looking statements speak only as to the date of this
report, and, except as required by law, the Company undertakes no obligation to
publicly release updates or revisions to these statements whether as a result of
new information, future events, or otherwise.
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 may also refer 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, border crossing visas, cargo
manifests, motor vehicle registration, multi-biometric identification (ID)
cards, 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 software, and markets
optical cards, read/write drives, and related systems.
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. The Company's mailing address and executive offices are located
at 1077 Independence Avenue, Mountain View, California 94043, and the telephone
number is (650) 969-7277. Throughout this report, the "Company,""we," and "us"
refer to Drexler Technology Corporation and subsidiaries, unless otherwise
indicated.
The Company's annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and all amendments to those reports can be obtained
free of charge after such material is electronically filed with or furnished to
the Securities and Exchange Commission (SEC). These documents are available as
soon as reasonably practicable on the Company's website,
"www.drexlertechnology.com" via a hypertext link to the SEC's website. They also
may be obtained directly from the SEC's website,
"www.sec.gov/edgar/searchedgar/companysearch.html" under CIK code 30140. In
addition, these documents are posted on the Company's website
"www.drexlertechnology.com" within two business days after being filed with or
furnished to the SEC.
The LaserCard optical memory card is an updatable, laser recordable,
computer readable, 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 (2.86
megabytes of user 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 systems, chip-ready hybrid
Smart/Optical(TM) cards, and related software and peripherals. Target markets
are domestic and foreign government programs, identification cards, and medical,
transportation, pay-per-use, and electronic commerce applications, among others.
The Company's products are sold mainly through value-added reseller (VAR)
companies and card-distribution licensees that develop commercial applications
for LaserCard products. Company revenues also include fees from the occasional
sale of patent licenses.
Originally a supplier of photomasks to the semiconductor industry, the
Company 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) under a subcontract
where the United States Immigration and Naturalization Service (INS) was the
ultimate customer. This initial order was followed by a series of additional
multi-million-dollar order releases under subcontracts for INS Green Cards and
U.S. Department of State "Laser Visa" Border Crossing Cards (BCCs). In June
2000, the Company was awarded a U.S. government subcontract for a minimum of 1
million cards and a maximum of 24 million Green Cards and Laser Visa BCCs over a
period of up to five years. Under this five-year subcontract, having an
authorized maximum of $81 million, successive order releases have been received
by the Company, under which 11 million cards have been sold as of March 31,
2003.
Through March 31, 2003, the Company has manufactured and sold over 20
million of its LaserCard optical memory cards for U.S. government programs. In
early 2003, the INS became part of the newly formed U.S. Department of Homeland
Security (DHS), which is now the ultimate customer under the Company's
subcontract for Green Cards and Laser Visa Border Crossing Cards.
4
The U.S. Department of Defense has employed the LaserCard since 1993 in its
Automated Manifest System, now used for both Army and Marine military cargo
shipments. In mid-2002, the Canadian government began issuing the Company's
optical memory cards as the new Canadian "Maple Leaf" Permanent Resident Card.
Applications for the LaserCard include the following:
o United States Permanent Resident Card (Green Card)
o United States Department of State Laser Visa Border Crossing Card (BCC)
o United States Department of Defense Automated Manifest System Card
o Government of Canada "Maple Leaf" Permanent Resident Card
o Anticipated Italian national ID card for citizens and permanent
resident card for non-citizens
o Trial programs involving medical record cards, permits, and vehicle
registration cards
For the fiscal year ended March 31, 2003, the Company sold approximately
7.3 million LaserCard optical memory cards. The Company's card manufacturing
facilities, located in Mountain View, California, permit expansion of card
production capacity in steps, using both roll- and sheet-manufacturing
processes. See Item 7, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," regarding current card production
capacity.
For a discussion of the risk factors related to the Company's business
operations, see the "Forward-Looking Statements" narrative at the beginning of
this report, the "Factors That May Affect Future Operating Results" at the end
of this section, and the "Management's Discussion and Analysis of Financial
Condition" contained in Item 7.
FINANCIAL INFORMATION ABOUT SEGMENTS
The Company operates in only one industry segment. See "Segment Reporting"
in footnote 2 in Item 8, "Consolidated Financial Statements and Supplementary
Data," for additional industry segment information.
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 (which can include
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.
5
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 do 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.
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 card standards for size, thickness, and
flexibility. The average wholesale price to VARs per card is under $5 when the
cards are ordered in hundreds of thousands, and even lower in cost when larger
quantities of basic cards are ordered.
LaserCard(R) Digital Governance Applications
To date, the most widespread use of LaserCard technology has been in
programs involving digital governance, defined as facilitating or expediting the
process of governing by documenting the grant of certain rights to citizens
and/or non-citizen permanent residents. The counterfeit- and tamper-resistant
cards are consumable products because they typically are replaced when the
rights conveyed by the cards expire. The following are examples of digital
governance cards:
o The current U.S. Green Card, or Permanent Resident Card, made by the
Company and issued by the Department of Homeland Security, evidences
that a foreign worker is approved to reside and be employed in the
United States.
o The current Laser Visa 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 The current Canadian "Maple Leaf" Permanent Resident Card made by the
Company, as been issued by the Government of Canada since mid-2002 to
confirm Canadian permanent resident status and as a safe proof of
status document for permanent residents re-entering Canada by
commercial carrier after international travel
(http://www.cic.gc.ca/english/pr-card/prc-about.html).
o In a planned national ID card application in Italy, the LaserCard
would identify the holder as a citizen and confer upon the holder the
rights and privileges to which a citizen is entitled. Another
potential LaserCard digital governance card program is an Italian
permanent resident card for non-citizens.
o Two 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.
o The U.S. Department of Defense uses the LaserCard as a paperless cargo
manifest in its Automated Manifest System for governing and
facilitating the shipment of military cargo to Army and Marine
deployments.
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 (SCSI) device
or via SCSI to a universal serial bus (USB) interface cable. 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.
6
Data Storage Capacity
A byte is a unit of computer storage--the amount of memory needed to store
a single number or letter. A kilobyte is 1,024 bytes. A megabyte is 1,024
kilobytes (or 1,024 x 1,024 bytes = 1,048,576 bytes). The data storage capacity
of the standard LaserCard is 4,100 kilobytes, or 4.1 megabytes, explained as
follows. The LaserCard's data storage capacity 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 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.
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 hybrid smart card, which the
Company calls a Smart/Optical(TM) card.
The amount of data 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 2.86 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, more than 35,000
transactions could be recorded. The 2.86 megabyte LaserCard has approximately
one 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.
Card Durability
Unlike most other types of digital storage media, the LaserCard can be
manufactured to withstand temperatures of 100(Degree)C (212(Degree)F) for
extended periods. Additionally, its ability to withstand flexure exceeds that of
conventional credit cards and far surpasses chip cards. Because the Drexon
material is a nonvolatile data storage medium, it is not vulnerable to data loss
or damage when exposed to X rays, 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. Very high security features are required for
government-issued ID cards, visas, immigrant work permits, 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.
7
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) text and multiple
biometrics--face photographs, signatures, fingerprints, hand scans,
iris or retina scans, and other biometrics (simultaneously).
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, which the Company does for Department of State and
Department of Homeland Security 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.
o It can contain an optically variable device for card authentication.
BIOMETRICS, DIGITIZED PHOTOS, PINS, AND DEDICATED SYSTEMS. Various
computer-readable security safeguards that can be used with the LaserCard
optical memory card include multiple 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.
With its multi-biometric data capability, the LaserCard's 2.8 megabyte
(2,800 kilobyte) storage capacity exceeds the requirements needed for the
following multi-biometric ID standards:
o U.S. National Institute of Standards and Technology's (NIST) February
11, 2003 requirements for two fingerprints (10 kilobytes each) and a
10-kilobyte facial image (total of 30 kilobytes) of data storage.
o The International Biometrics group recommends the capture of iris,
face, and fingerprint biometrics from visa applicants.
o The International Commercial Aviation Organization (ICAO) recommends
10 fingerprints, face, and iris biometrics, requiring about 250
kilobytes of data storage.
United States Green Cards and Laser Visa BCCs and Canadian "Maple Leaf"
Permanent Resident Cards contain biometrics in the form of machine-readable
fingerprints and/or digitized face photographs stored on the LaserCard's optical
stripe for biometric comparison with the card holders. Target applications such
as the proposed national ID card and permanent resident card for Italy and other
secure ID card applications are also expected to carry biometric identifiers on
the cards.
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.
Further, for applications that warrant cryptography, all data can be recorded
onto the LaserCard using data encryption algorithms. The Company's hybrid,
chip-ready 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.
8
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 image thermally printed elsewhere
on the card. These permanent, eye readable images are recorded when the card is
issued, using a specially programmed, standard optical card read/write drive.
The United States Department of Homeland Security and Department of State both
currently use this visual image technology with the Company's cards. For
checking of cards at the United States/Mexico border, the eye-readable,
laser-engraved images facilitate the immigration inspectors' job of visually
verifying cards if automated verification systems are not available.
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.
International Card 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.
9
Card Manufacturing and Raw Materials
LaserCard optical memory cards are manufactured by the Company in Mountain
View, California. The Company sold approximately 7.3 million cards in fiscal
2003, 5.6 million cards in fiscal 2002, and 5.9 million cards in fiscal 2001.
The optical memory card manufacturing facilities permit incremental expansion of
production capacity. See Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" regarding card production
capacity.
To maintain adequate raw material supplies for the manufacture of optical
memory cards, 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. If the Company is unable
to buy raw materials in sufficient quantities and on a timely basis, it would
not be able to deliver products to customers on time.
The raw materials used in the manufacture of optical memory cards are
available from one or more qualified suppliers. Such materials include plastic
films used in optical memory card production, which are available from one
supplier in the U.S. and from multiple foreign suppliers. Processing chemicals,
inks, and bonding adhesives are obtained from various U.S. and foreign
suppliers. Certain photographic films are commercially available solely from
Eastman Kodak Company, of the United States. While the Company believes that
Kodak will continue to supply such photographic films on a satisfactory basis
and in sufficient quantities, no assurances can be made. If Kodak were to
discontinue manufacturing this film, the Company would order the maximum amount
of final-run stock from Kodak for use while the Company endeavored to establish
an alternate supplier, although the purchase price could increase from a new
supplier. Considering that the United States government is a major end-user of
the Company's optical memory cards, the Company anticipates that an alternate
supplier could be established and qualified. The Company has pre-purchased a
long-term supply of the film used to produce mastering loops for prerecording
cards. With regard to the film from which the Drexon optical stripe is made, the
Company has on hand what it believes is an adequate supply to meet anticipated
demand.
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, magnetic stripes, and an optically variable device (a security
diffraction pattern) 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 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.
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 licensees of the Company in the United States and other countries. To its
VARs and licensees, the Company makes available for sale optical memory cards,
optical card read/write drives and software, and third-party peripherals.
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. Sales to the United States government and
foreign governments are made indirectly through VARs and licensees. For example,
products are sold indirectly to ultimate use customers such as the U.S.
Department of State, U.S. Department of Defense, U.S. Department of Homeland
Security, and the government of Canada, through a VAR that is a government
subcontractor.
For fiscal 2003, the Company sold LaserCard products to approximately 30
direct customers in six states and 10 foreign countries. Sales of cards destined
for U.S. government programs represented 82% of total revenues for fiscal year
10
2003 compared with 78% of total revenues for fiscal 2002 and 62% of total
revenues for fiscal 2001. Revenues by geographic region are shown in Note 4 of
the "Notes to Consolidated Financial Statements." Sales of cards and read/write
drives for the Canadian Permanent Resident Card program represented 10.5% of
total revenues for fiscal 2003 and 3% of revenues in fiscal 2002 when shipments
began. Substantially all foreign product sales have been made through VARs and
licensees. The Company believes that international markets will be an important
source of product sales and license revenue in the future.
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 and provide pre-sales technical support to assist VARs
and licensees.
MARKETING OBJECTIVES. In addition to expected continuation of its current
business involving U.S. Green Cards, U.S. Laser Visa BCCs, U.S. military
Automated Manifest System cards, and Canadian Maple Leaf Permanent Resident
Cards, the Company's marketing objectives include card applications in the
United States and abroad, such as:
o U.S. VISIT system (previously called the U.S. Entry-Exit system)
o U.S. Transportation Workers Identification Credential (TWIC)
o Registered /Trusted Traveler card (after TWIC)
o Canadian Citizens' ID card
o Italian national ID card for citizens
o Italian permanent resident card for non-citizens
o Identification cards for Macedonia and Saudi Arabia
o Motor vehicle registration card for several states in India
o Expansion of private/voluntary program in Beijing for a children's
healthcare card
o Multi-application cards, other ID card applications, and pay-per-use
cards
APIs and Application Software
The Company believes that its proprietary optical memory card Application
Programming Interface (API) and software development capabilities play a key
role in developing LaserCard applications and markets. However, API and
application software sales have not been a significant portion of revenues thus
far. 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.
APIS. As part of its read/write drive and system sales, LSC includes a
comprehensive set of APIs in order for its customers to develop optical card
applications. An API is a set of routines, protocols, and tools used by
programmers for building software applications. LaserCard-related APIs control
or facilitate the basic operations and read/write functions of optical memory
card drives so that they can interface directly with personal computers. LSC
develops LaserCard-related APIs such as device drivers, file system DLLs
(dynamic link libraries), and custom software tools to enhance read/write drive
integration.
CUSTOM APPLICATIONS. LSC also offers contract services for purchase by
customers that require custom programming in the development and integration of
their LaserCard applications. LSC also makes available for purchase by
customers, 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.
APPLICATION SOFTWARE. End-user 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. 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. LSC markets a BadgeMaker card personalization and issuing
application used for card issuance and data management, and a Biometric ID
Verification System application (discussed below).
11
Read/Write Drives; Manufacturing and Parts/Components
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. 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 the sole supplier of the drives. The Company completed the acquisition
for cash of Conlux's read/write drive manufacturing operation (manufacturing
tooling, equipment, etc.) and transferred the operation to Mountain View,
California, to produce drives locally. The Company sold approximately 175
read/write drives for fiscal 2003 compared with 450 read/write drives for fiscal
2002 and 1,280 read/write drives for fiscal 2001. The Company has recently
introduced a newer version of a read/write drive, but there is no assurance that
drive sales will increase as a result.
To maintain adequacy of parts and components for the manufacture of
read/write drives, the Company attempts to establish ongoing relationships with
principal suppliers and obtains information about alternate suppliers. If the
Company is unable to buy parts and components in sufficient quantities and on a
timely basis, it would not be able to deliver products to customers on time. The
Company purchases read/write drive parts for its anticipated read/write drive
demand, taking into consideration the order-to-delivery lead times of vendors
and the economic purchase order quantity for such parts. For read/write drives,
the optical recording head for the current drive is a Company-specific part
obtained from one supplier; Audio-Technica Corp., of Japan. No optical heads are
on order at this time because the Company believes that it has adequate
inventory of read/write drives and components. Before reordering, it is
anticipated that the existing optical head will be redesigned; therefore, the
Company is exploring new designs and alternate suppliers.
Prior to fiscal 2002, the Company 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 interface software/device drivers. In fiscal 2002,
the Company reduced the selling price for these read/write drives by 20% for
typical purchase quantities in an effort to develop a broader market and
customer base for LaserCard optical memory cards. Current and target
applications for the Company's LaserCard typically require a small number of
drives relative to the number of cards purchased.
LaserCard Biometric ID Verification System
LSC has developed a LaserCard Biometric ID Verification System that can
quickly confirm validity of optical memory card biometric ID cards, read and
display digitally stored photographs and other digital data from the cards, and
biometrically verify the cardholders' live-scanned fingerprints with the
fingerprint templates stored on the cards at time of card issuance.
The LaserCard Biometric ID Verification System has undergone successful
preliminary testing prior to the U.S. government's consideration of widespread
implementation of the system on the country's southern border. On April 22,
2003, the U.S. Department of Homeland Security issued a Presolicitation Notice
for the purchase of approximately 1,000 optical stripe read/write drives. The
Presolicitation Notice appears to indicate that the government intends to field
optical card-based biometric verification systems on the southern U.S. border
and at 12 international airports in the United States.
The Company believes that this proposed deployment would be an element of
the proposed U.S. VISIT system (previously called the U.S. Entry-Exit system) in
connection with the "U.S. Enhanced Border Security and Visa entry Reform Act"
when and if granted a contract award. The Company's card also is one of the
technologies under consideration for the U.S. Transportation Workers
Identification Credential (TWIC) program.
LSC is marketing the LaserCard Biometric ID Verification System as a
"concept" package, meaning that software which performs the same functions (but
not usable with U.S. government cards) is available in customized form to other
customers for government, industrial and commercial applications.
Peripheral Equipment
Through March 31, 2003, the sale of third-party peripheral equipment and
systems has not contributed materially to the Company's revenues. However, to
facilitate application development by its customers, LSC purchases and sells
peripherals including the following:
12
o Fingerprint sensor units to capture fingerprints for storage onto the
LaserCard as a template and as a high-resolution image.
o Digital video cameras for capturing and storing computer readable
photos in color.
LICENSING
The Company has generated a total of approximately $40 million in license
fee revenues since 1983 through nonexclusive patent license agreements related
to optical memory card manufacture, equipment for using the cards, optical data
storage, card distribution, and other aspects of the Company's technologies.
Included in the approximately $40 million of past license revenues, 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 joint venture
formed by four Japanese companies (three of the Company's read/write drive
equipment licensees and Dai Nippon Printing Co., Ltd.). On July 1, 2002, this
license was fully assumed by Dai Nippon Printing.
From time to time, the Company 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.
License revenues for fiscal 2001, 2002, and 2003 are detailed in the
"Management's Discussion and Analysis" section of this report, under the heading
"License Fees and Other Revenues."
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.
COMPETITION
The Company is unaware of other optical memory cards that currently compete
with optical memory cards made by the Company. However, there are other card
technologies that compete with optical memory cards. These alternatives may
include integrated circuit (IC) cards, 2-dimensional bar code cards and
symbology cards, magnetic-stripe cards, CD-read only cards and recordable cards,
PC cards, RF (radio frequency) 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. 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 optical memory
card a viable choice for a variety of digital card applications. As to other
optical memory cards, the Company has licensed its card patents to two Japanese
companies, Canon Inc. and Dai Nippon Printing, which the Company believes are
not manufacturing or selling such cards at this time. A decade ago other
companies had disclosed that they were developing optical memory cards, but now
appear to be inactive in that field. Therefore, the Company's primary
competition is other card products.
Competitive factors among the various card technologies include system/card
portability, interoperability, price-performance ratio of cards and associated
equipment, durability, environmental tolerance, and card security. 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. However, when the cost of drives and a large number of cards is
factored together, the Company's optical memory card technology can offer
competitive pricing compared with its closest competitor, high capacity IC
cards.
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 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.
13
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. Invented five years before the LaserCard, 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. For multi-function
applications, the Company currently offers "chip ready" optical cards to which
an IC can be added to create a hybrid smart card, called a Smart/Optical(TM)
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 roughly double the cost
of the Company's 2,800 kilobyte 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 relatively few cards per read/write
drive. Low-storage capacity IC cards are currently used mainly as telephone
cards, point-of-sale cards, and bank debit/cash card systems. These applications
are not markets for the Company's cards. Companies that manufacture IC cards of
various types and storage capacities include Gemplus, SchlumbergerSema, Sharp,
Orga Card Systems, Oberthur Card Systems, and others.
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, alternative technologies--such as magnetic stripes, IC chips,
radio (RF) circuitry, 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) may not have the security and audit trail features
required for government ID cards or 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 royalty-bearing licenses
from the Company, two Japanese companies have the right to manufacture and sell
optical memory cards in competition with the LaserCard, although apparently
neither company is currently selling such products. Licensee Optical Memory Card
Business Corporation (OMCBC)/Dai Nippon Printing Co., Ltd., did not report any
such sales for calendar year 2002, and Canon Inc. has not reported any such
sales for several years. Both Canon and Japan-based Olympus Optical Co. (an
equipment licensee of the Company) have in the past produced their own optical
card drives, although they are not believed to be doing so currently.
The Company's LaserCard utilizes the ISO/DELA card 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. Dai Nippon Printing is
believed to be capable of manufacturing both types of cards. Although both card
formats meet the ISO Standard, the Company's ISO/DELA format and the Canon
ISO/SIOC format are not functionally compatible. Olympus Optical has
manufactured and sold ISO/SIOC read/write drives and nonstandard format drives
and is capable of producing an optical card read-only drive. If the production
of ISO/SIOC cards and/or equipment were to resume by Dai Nippon Printing, Canon,
or Olympus, the Company believes that it currently offers competitive advantages
in areas such as system integration, APIs/software, customer support services,
and as the only company that manufactures both optical memory cards and
read/write drives.
14
A decade 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 computer-readable
data such as promotional materials. On June 12, 2000, Philips, Sony, and Taiyo
Yuden announced a customer-recordable version of these thick, rigid 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.
OTHER MATTERS
Research and Engineering Expenses
Research and engineering expenses were $2,818,000 for fiscal 2003,
$3,045,000 for fiscal 2002, and $2,370,000 for fiscal 2001. The Company is
continuing its efforts to develop new optical memory card features, including
the insertion of contactless chips with radio frequency (RF) capability, optical
memory card read/write drives, read-only drives (readers), and software products
in an effort to provide new products that can stimulate optical memory card
sales growth. For example, the Company has developed a prototype of a LaserCard
handheld reader. The Company anticipates that these ongoing research and
engineering efforts will result in new or enhanced card capabilities,
production-model read-only drives, or drives with advanced security features and
lower manufacturing costs; however, there is no assurance that such product
development efforts will be successful. These factors are important for the
Company's existing and future optical memory card markets. Also see Item 7,
"Management's Discussion and Analysis."
Patents and Trademarks
OPTICAL DATA STORAGE. As of March 31, 2003, the Company owned approximately
35 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), and other U.S. and foreign
patent applications have been filed. Approximately 45 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, the Company protects as
trade secrets some refinements to the Drexon medium and cards and know-how
related to card production. Since the Company's technology is now in the
commercial stage, the Company's know-how and experience in volume card
production, system development and software capabilities, brand-name recognition
within its card markets, and dominant-supplier status for optical-memory cards
are of far greater importance than the Company's patents. Therefore, at this
time, the Company believes that its patent portfolio is helpful but is no longer
essential for maintaining the LaserCard's market position.
The Company's U.S. patents have expiration dates ranging from 2003 to 2020,
with the majority expiring during the first half of this period. Counterpart
patents in foreign countries also expire during this period, usually about two
to three years after the U.S. patent expires. Under the OMCBC/Dai Nippon
Printing license agreement with the Company for manufacture of optical memory
cards, the 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 and OMCBC/Dai Nippon
Printing apparently are 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
15
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.
LaserCard(R)and Drexon(R)are federally registered trademarks of Drexler
Technology Corporation. The Company believes that its LaserCard brand name and
trade name are important assets in marketing optical memory card products.
Employees
As of March 31, 2003, the Company and its subsidiaries employed 122 persons
(including four executive officers). This workforce consisted of 110 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.
Dependence on Government Subcontracts through a Sole Contractor
For fiscal 2003, one customer represented 94% of the Company's revenues.
This Virginia-based customer is Information Spectrum, Inc., now a unit of Anteon
International Corporation (NYSE:ANT). Information Spectrum is the government
contractor for the following programs: (1) the U.S. Department of Homeland
Security (previously U.S. Immigration and Naturalization Service) Permanent
Resident Green Card, (2) the U.S. Department of State (DOS) Laser Visa Border
Crossing Card, (3) the U.S. Department of Defense/Defense Logistics Agency
(including the U.S. Army and Marines) Automated Manifest Card, and (4) the
Government of Canada Permanent Resident Card. However, since these ultimate
customers are national governments, the Company is not dependent upon the
specific contractor for continued revenues from these programs. Although not
anticipated, if Information Spectrum were to discontinue its participation as
contractor, the Company believes that other qualified contractors could be
utilized by those governments for purchasing the Company's products.
Under the U.S. government's Federal Acquisition Regulations, 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. The Company's U.S. government card
deliveries depend upon the issuance of corresponding order releases by the
government, and the Company believes that these orders will continue in
accordance with the government subcontracts. Losses would occur if either of the
Company's 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, research and engineering, and capital equipment expenditures.
Backlog
As of March 31, 2003, the backlog for LaserCard optical memory cards
totaled approximately $1.9 million in firm card orders under card supply
contracts, of which amount 54% is for U.S. government Green Cards or Laser Visas
under a U.S. government subcontract for the purchase of optical memory cards.
Since the Company had a fixed delivery schedule for card shipments out of a
secure, U.S. government-funded vault on Company premises, the Company recognized
revenues on the cards located in the vault, and therefore such cards were not
included in backlog at March 31, 2003. 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, delivered to, and located in
the government-funded vault. Of the $11.1 million amount, 85% was for U.S.
government Green Cards or Laser Visa BCCs under the Company's U.S. government
subcontract. Of the $5.3 million amount, all were Green Cards or Laser Visa BCCs
produced under this subcontract. The fluctuation in backlog for fiscal 2003
compared with fiscal 2002 is due to the receipt of fixed delivery schedules in
fiscal 2003, in addition to the fact that government release orders arrive at
irregular intervals. Purchase order releases under the Company's five-year U.S.
government subcontract are issued at irregular intervals and for varying card
quantities. At March 31, 2002, the Company had six months remaining on a January
22, 2002 release of 3.25 million cards. At March 31, 2003, the Company had one
month remaining on a September 24, 2002 release of 2.3 million cards.
On May 8, 2003, the Company announced a $1.8 million order for Canadian
"Maple Leaf" Permanent Resident Cards. This order called for deliveries
beginning in May 2003.
16
Financial Information About Geographic Areas
Financial information about geographic areas is described in Note 4 to Item
8, "Consolidated Financial Statements and Supplementary Data."
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
DEPENDENCE ON VARS AND ON A LIMITED NUMBER OF CUSTOMERS - WE DEPEND ON ONE
VAR AND TWO ULTIMATE CUSTOMERS FOR THE BULK OF OUR REVENUE. THE LOSS OF OUR
ULTIMATE CUSTOMERS OR SIGNIFICANT REDUCTIONS IN THEIR ORDERS WOULD CAUSE
REVENUES TO DECLINE, AND HAVING TO REPLACE OUR VAR COULD INTERRUPT OUR
GOVERNMENT BUSINESS. We are heavily dependent on U.S. government subcontract
release orders for DHS Green Cards and DOS Laser Visa BCCs, representing 82% of
our revenues for fiscal year 2003 compared with 78% of total revenues for fiscal
2002 and 62% of total revenues for fiscal 2001. Sales of cards and read/write
drives for the Canadian Permanent Resident Card program represented 10.5% of
total revenues for fiscal 2003 and 3% of revenues in fiscal 2002 when shipments
began. One VAR, Information Spectrum, Inc., based in Virginia, is the government
contractor for the United States Green Cards, BCCs, and Automated Manifest Card,
and the Canadian Permanent Resident Card. However, since the ultimate customers
are national governments, we are not dependent upon the specific contractor for
continued revenues from these programs. Although not anticipated, if Information
Spectrum were to discontinue its participation as contractor, other qualified
contractors could be utilized by those governments for purchasing our products,
although the process of doing so could cause program delays.
LARGEST CUSTOMER IS U.S. GOVERNMENT - OUR LARGEST ULTIMATE CUSTOMER, THE
U.S. GOVERNMENT, HAS THE RIGHT TO DELAY ITS ORDERS OR COULD CHANGE ITS
TECHNOLOGY DECISIONS, WHICH WOULD RESULT IN ORDER DELAYS OR IN LOSSES. Under the
U.S. government's Federal Acquisition Regulations, 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 to its prime
contractor and, in turn, to us, and we believe that these orders will continue
in accordance with our government subcontract. Losses would occur if either 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 the government were to change its technology decisions, or if increases in
product revenues or licenses do not keep pace with increased marketing, research
and engineering, and capital equipment expenditures. For example, the latest
release of cards under our U.S. government subcontract (2.3 million cards on
September 24, 2002) called for deliveries through April 2003. We have not
received a follow-on order as of June 23, 2003. Therefore, there is a gap in
production of at least two months. This gap will significantly affect operating
results for the quarter ending June 30, 2003.
FUTURE GROWTH DEPENDENT ON NEW FOREIGN PROGRAMS AND U.S. GOVERNMENT
PROGRAMS - OUR REVENUES WILL NOT CONTINUE TO GROW IF WE DO NOT WIN NEW BUSINESS
IN THE U.S. AND ABROAD. Revenues during fiscal 2003 included sales of 6.6
million U.S. government Green Cards and Laser Visa BCCs. We anticipate that
fiscal 2004 revenues will include sales ranging from 2 million to 3 million
cards for these government programs. In order to maintain card revenues at the
fiscal 2003 level, fiscal 2004 revenues will need to include additional orders
from new and existing programs. Optical memory card digital governance programs
that are emerging programs or prospective applications in various countries
include identification cards for Italy, Saudi Arabia, and Macedonia; motor
vehicle registration cards in India; and several new U.S. government ID card
programs due to the increasing need for enhanced U.S. border security. In the
United States, the U.S. VISIT program and TWIC program are considering the use
of optical memory cards for secure identification. From Italy, we anticipate
receiving orders for two programs--the CIE card (Carta d'Identica Elettronica)
and the PSE card (Permesso di Soggiorno Elettronico). We have been informed by
our Italian VAR that the Italian government plans to issue 1.7 million CIE cards
and 600,000 PSE cards this year through December 2003. However, we have not as
yet received any corresponding card orders. There is no assurance that the
foregoing government programs will be continued or implemented as anticipated or
that the U.S. government will select our cards for its new homeland security
programs.
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 for their use or use by their
ultimate 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.
17
government and various foreign governments and quasi-governmental organizations,
additional uncertainties and extended sales cycles can result. Factors which
increase the length of the sales cycle include government regulations, bidding
procedures, budget cycles, and other government procurement procedures, as well
as changes in governmental policy-making.
TIMING OF REVENUES DEPENDENT ON SHIPMENT SCHEDULE FROM GOVERNMENT. WE DON'T
RECOGNIZE REVENUE UNTIL CARDS ARE SHIPPED OUT OF A VAULT OR WE RECEIVE A FIXED
SHIPMENT SCHEDULE FROM THE GOVERNMENT; THEREFORE, THE TIMING OF OUR REVENUES IS
NOT UNDER OUR CONTROL AND CANNOT BE PREDICTED. We recognize revenue from product
sales when the following criteria are met: (1) persuasive evidence of an
arrangement exists; (2) delivery has occurred; (3) the fee is fixed or
determinable; and (4) collectibility is reasonably assured. Our U.S. government
subcontract requires delivery of cards to a secure, government-funded vault
built on our 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 we receive a fixed schedule, notification, or plan for
shipments out of the vault to the government, in which case revenue is
recognized upon the latter of receipt of such fixed shipment schedule or
delivery of the cards into the vault. Our revenues may fluctuate from period to
period if we do not continue to obtain fixed shipment schedules under this
contract.
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 projected card manufacturing capacity if and when customer orders reach
higher levels. 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. This could cause us to lose
new business and possibly existing business. In addition, if we overestimate
customer demand, we could incur significant costs from creating excess capacity.
The addition of fixed overhead costs results in lower profit margins unless
compensated for by increased product sales. 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. Such materials include plastic films used in
optical memory card production, which are available from one supplier in the
U.S. and from multiple foreign suppliers. Processing chemicals, inks, and
bonding adhesives are obtained from various U.S. and foreign suppliers. Certain
photographic films are commercially available solely from Eastman Kodak Company,
of the United States. While we believe that Kodak will continue to supply such
photographic films on a satisfactory basis and in sufficient quantities, no
assurances can be made. If Kodak were to discontinue manufacturing the film from
which the Drexon optical stripe is made, we would order the maximum amount of
final-run stock from Kodak for use while we endeavored to establish an alternate
supplier for such film, although the purchase price could increase from a new
supplier. Considering that the United States government is a major end-user of
our optical memory cards, we anticipate that an alternate supplier could be
established and qualified. The Company has pre-purchased a long-term supply of
the film used to produce mastering loops for prerecording cards. With regard to
the film from which the Drexon optical stripe is made, the Company has on hand
what it believes is an adequate supply to meet anticipated demand.
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. Several major components of our read/write drives are
designed specifically for our read/write drive. For example, the optical
recording head for the current drive is a part obtained from one supplier; and
at current production volumes, it is not economical to have more than one
supplier for this custom component. 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, we could encounter quality control or
other production problems at high-volume production of read/write drives. We are
also investing in research and engineering in an effort to develop new drive
products, as discussed under Item 7, "Management's Discussion and Analysis."
18
DEVELOPMENT OF READ/WRITE AND READ-ONLY DRIVES - IF WE ARE UNABLE TO
DEVELOP UPGRADED READ/WRITE DRIVES THAT COST LESS TO MANUFACTURE AND ALSO A
READ-ONLY DRIVE, WE COULD LOSE POTENTIAL NEW BUSINESS. 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 by 20% for
these read/write drives for typical purchase quantities in an effort to develop
a broader market and customer base for LaserCard optical memory cards. We
believe the price of our drives is competitive in applications requiring a large
number of cards per each drive, because the relatively low cost for our cards
offsets the high cost per drive when compared with our major competition, IC
card systems. In addition, we have recently introduced a newer version of a
read/write drive and have undertaken a product development program for a
read-only drive, both of which we believe would increase our prospects for
winning future business. However, there can be no assurance that our development
program will be successful, that production of any new design will occur in the
near term, or that significantly lower manufacturing costs or increased 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 use 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, 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 that would affect our future revenues adversely. However,
since our technology is now in the commercial stage, our know-how and experience
in volume card production, system development and software capabilities,
brand-name recognition within its card markets, and dominant-supplier status for
optical-memory cards are of far greater importance than our patents. At this
time, we believe that our existing patent portfolio is helpful but is no longer
essential for maintaining the LaserCard's market position.
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 may compete with optical memory cards that can be
manufactured and sold by two of our licensees (although neither is currently
doing so) 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 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 for certain applications, the current price of optical card
read/write drives is a competitive disadvantage in some of our targeted markets.
However, we believe the price of our drives is competitive in applications
requiring a large number of cards per each drive, because the relatively low
cost for our cards offsets the high cost per drive when compared with our major
competition, IC card systems. 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.
19
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, 2003, we had an
accumulated deficit of $5,817,000. Although we have operated profitably for the
past five years (fiscal 1999 through fiscal 2003), 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 alternative technologies emerge or if we are otherwise unable
to compete, we may not be able to achieve and sustain profitability on a
quarterly or annual basis. Annual losses would also occur if either of 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 engineering, and capital expenditures. Quarterly losses
would occur when there are gaps or delays in card orders from either of our two
largest U.S. government programs or if such 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 license revenues do
not keep pace with increased marketing and research and engineering, and capital
equipment 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, low trading
volume, and stock market conditions, as well as changes in technology and
customer demand and preferences. As a result, our stock price might be low at
the time a stockholder wants to sell the stock. Also, since we have a relatively
low number of shares outstanding (approximately 10 million shares) there will be
more volatility in our stock if one or two major holders (for example, large
institutional holders) attempt to sell a large number of shares in the open
market. There also is a large short position in our stock, which can create
volatility when borrowed shares are sold short and later if shares are purchased
to cover the short position.
NATURAL DISASTERS AND OTHER RISKS TO OUR FACILITIES - OUR FACILITIES ARE
LOCATED IN AN EARTHQUAKE ZONE AND THESE OPERATIONS COULD BE INTERRUPTED IN THE
EVENT OF AN EARTHQUAKE, FIRE, OR OTHER DISASTER. Our corporate headquarters,
card manufacturing and drive assembly operations, administrative, and product
development activities are located near major earthquake fault lines. In the
event of a major earthquake, we could experience business interruptions,
destruction of facilities and/or loss of life, all of which could materially
adversely affect us. Likewise, fires, floods, or other events could similarly
disrupt our operations and interrupt our business.
UNFORESEEN EVENTS - ACTS OF TERRORISM OR WAR MAY ADVERSELY AFFECT OUR
BUSINESS. Acts of terrorism, acts of war, and other 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, 2003, 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.
20
ITEM 3. LEGAL PROCEEDINGS
Other than as described below, there are no material pending legal
proceedings to which the Company is a party or of which its property is a
subject.
The Company learned on July 10, 2003, that its subsidiary, LaserCard
Systems Corporation, had been named as one of several defendants in a lawsuit
brought by George Rawe. Mr. Rawe alleged in the lawsuit that he was injured in
laser eye surgery performed using a Visx, Incorporated laser that incorporated a
LaserCard as a component. Mr. Rawe is suing the physicians involved for
malpractice and Visx, Incorporated., the Company, and various unnamed defendants
for product liability, alleging their products were defective. The lawsuit was
filed in California Superior Court for San Joaquin County, case number CV020962
and seeks an amount of damages which are not quantified. The Company learned on
July 10, 2003, that its subsidiary, LaserCard Systems Corporation, had been
named as one of several defendants in a lawsuit brought by George Rawe. Mr. Rawe
alleged in the lawsuit that he was injured in laser eye surgery performed using
a Visx, Incorporated laser that incorporated a LaserCard as a component. Mr.
Rawe is suing the physicians involved for malpractice and Visx, Incorporated.,
the Company, and various unnamed defendants for product liability, alleging
their products were defective. The lawsuit was filed in California Superior
Court for San Joaquin County, case number CV020962 and seeks an amount of
damages which are not quantified. The Company is just beginning to evaluate the
complaint and the Company's defenses, including the availability of insurance
coverage and any rights or obligations of indemnification involving Visx,
Incorporated.
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 2003.
PART II
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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 2002 Fiscal Year 2003
---------------- ----------------
High Trade Low Trade High Trade Low Trade
---------- --------- ---------- ---------
First Quarter................ $ 14.94 $ 10.40 $ 30.30 $ 16.61
Second Quarter............... 17.00 8.80 22.00 12.03
Third Quarter................ 24.50 14.25 21.50 12.01
Fourth Quarter............... 25.90 18.10 15.95 11.61
As of March 31, 2003, there were approximately 970 holders of record of the
Company's common stock. The total number of stockholders 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 will retain any earnings for use
and reinvestment in its business.
21
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial information as of and for
each of the five years in the period ended March 31 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, 1999 - 2003
(In thousands, except per share amounts)
(Unaudited)
OPERATIONS DATA 1999(1) 2000(1) 2001(1) 2002 2003
---- ---- ---- ---- ----
Revenues............................................. $ 12,577 $ 15,443 $ 24,906 $ 20,889 $ 26,331
Cost of product sales................................ 6,087 8,668 12,199 10,652 13,906
Selling, general, and administrative expenses........ 3,698 3,996 4,134 5,165 6,202
Research and engineering expenses.................... 456 1,299 2,370 3,045 2,818
Other income (expense), net.......................... (44) 6 -- -- --
Interest income, net................................. 312 382 612 386 397
--------- ---------- ---------- ---------- ----------
Income before income taxes........................... 2,604 1,868 6,815 2,413 3,802
Income tax provision (benefit)....................... 128 (2,919) (1,097) (2,786) 1,520
--------- ---------- ---------- ---------- ----------
Net income........................................... $ 2,476 $ 4,787 $ 7,912 $ 5,199 $ 2,282
========= ========== ========== ========== ==========
Net income per share:
Basic............................................ $ .25 $ .49 $ .80 $ .52 $ .22
========= ========== ========== ========== ==========
Diluted.......................................... $ .25 $ .48 $ .76 $ .50 $ .21
========= ========== ========== ========== ==========
Weighted average number of common and common
equivalent shares:
Basic............................................ 9,748 9,812 9,897 9,961 10,356
Diluted.......................................... 10,007 9,935 10,446 10,468 10,842
BALANCE SHEET DATA
Current assets....................................... $ 11,485 $ 14,489 $ 18,333 $ 28,118 $ 21,192
Current liabilities.................................. 5,973 8,305 7,324 7,501 3,620
Total assets......................................... 16,566 24,362 30,137 40,713 40,463
Long-term obligations................................ -- -- -- -- --
Stockholders' equity................................. 10,593 16,057 22,813 32,337 36,843
(1) As more fully described in the Company's Report on Form 8-K dated May 15,
2002, the financial statements for fiscal 1999, 2000, and 2001 were
restated due to changes in the timing of revenue recognition of LaserCard
optical memory cards that have been delivered into a secure,
government-funded vault built for the government on Company premises to
comply with security regulations under the subcontract.
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
All statements contained in this report that are not historical facts are
forward-looking statements. The forward-looking statements in this report are
made pursuant to the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995. They are not historical facts or guarantees of future
performance or events. Rather, they are based on current expectations,
estimates, beliefs, assumptions, and goals and objectives and are subject to
uncertainties that are difficult to predict. As a result, the Company's actual
results may differ materially from the statements made. Often such statements
can be identified by their use of words such as "may," "will," "intends,"
"plans," "believes," "anticipates," "visualizes," "expects," and "estimates."
Forward-looking statements made in this report include statements as to current
and potential customers, applications, orders, or market segments for optical
memory card products; statements as to anticipated orders and/or shipment
quantities and schedules under the Company's U.S. government and Canadian
government subcontracts; the Company's expectation that it will be awarded a
contract for approximately 1,000 read/write drives under the U.S. Department of
Homeland Security's Presolicitation Notice and the expectation that there will
be demand for the Company's read/write drives under the Italian national ID card
(CIE) program; the Company's belief that the U.S. government intends to field
optical card-based biometric verification systems on the southern U.S. border
and at certain U.S. airports; the objectives of the Company in its efforts to
sell read/write drives; the need for, expected success of, and potential
benefits from the Company's research and engineering efforts, including
developing new or enhanced card capabilities, software products,
production-model read-only drives, or drives with advanced security features or
lower manufacturing costs; whether introduction of new drives will increase
sales, and the effects of read/write drive prices and sales volume on gross
profits or gross margins 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 inclusive of fixed overhead costs; expectations
regarding the market for read/write drives and read/write drive prices; the
Company's belief that it has an adequate inventory of read/write drives and
components; the Company's efforts to recruit new value-added resellers (VARs) or
licensees; the adequacy of card raw material inventory on hand to meet future
demand; the Company's belief that Kodak will continue to supply sufficient
photographic film and that an alternate supplier could be established if needed;
the Company's ability to expand production capacity; anticipated release orders
and deliveries under the Company's U.S. government subcontract; expectations
regarding revenues, margins, capital resources, capital expenditures and
investments, and the Company's deferred tax asset and related valuation
allowance; anticipated reductions of federal tax cash payments due to current
Company tax benefits; statements as to expected card delivery volumes; estimates
of optical card production capacity, expected card yields therefrom, and the
Company's plans and expectations regarding the growth and associated capital
costs of such capacity; estimate that revenues will be sufficient to generate
cash from operations; the Company's expectation that it will retain any earnings
for use and reinvestment in its business; expectations regarding market growth,
product demand, and foreign business including emerging programs or prospective
applications in China, India, Italy, Macedonia, and Saudi Arabia; and
expectations as to continued, or expanded, or potential U.S. government or other
governmental card programs.
These forward-looking statements are based upon the Company's assumptions
about and assessment of the future, which may or may not prove true, and involve
a number of risks and uncertainties including, but not limited to, customer
concentration and reliance on continued U.S. government business; the
possibility that the U.S. government will not field optical card-based biometric
verification systems on the southern U.S. border and at certain U.S. airports;
lengthy sales cycles; changes in and reliance on government policy-making; the
risks associated with doing business in and with foreign countries, the impact
of litigation or governmental or regulatory proceedings; the ability of the
Company or its customers to initiate and develop new programs utilizing the
Company's card products; the Company's reliance on VARs, licensees, or other
third parties to generate sales, perform customer system integration, develop
application software, or integrate optical card systems with other technologies;
risks and difficulties associated with development, manufacture, and deployment
of optical cards, drives, and systems; potential manufacturing difficulties and
complications associated with increasing manufacturing capacity of cards and
drives and outsourcing manufacturing; ability to produce and sell read/write
drives in volume; reliance on single-source and limited-source suppliers for
certain components and raw materials; the unpredictability of customer demand
for products and customer issuance and release of corresponding orders;
government rights to withhold order releases, reduce the quantities released,
and extend shipment dates; whether the Company receives a fixed schedule,
notification, or plan for shipments out of the government-funded vault located
on the Company's premises, enabling the Company to recognize revenues on cards
delivered to the vault instead of when cards later are shipped from the vault;
the U.S. government's rights to modify or withdraw its reader/writer equipment
Presolicitation Notice or to award any resulting contract, reduce the quantities
released, and extend delivery dates; the impact of technological advances,
general economic trends, and competitive products; and the risks set forth in
the section entitled "Factors That May Affect Future Operating Results" and
elsewhere in this report. Due to these and other risks,
23
the Company's future actual results could differ materially from those discussed
above. These forward-looking statements speak only as to the date of this
report, and, except as required by law, the Company undertakes no obligation to
publicly release updates or revisions to these statements whether as a result of
new information, future events, or otherwise.
CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION. Product sales primarily consist of card sales and
sales of read/write drives. The Company recognizes revenue from product sales
when the following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred; (3) the fee is fixed or determinable; and (4)
collectibility is reasonably assured. The Company recognizes revenue on product
sales at the time of shipment when shipping terms are F.O.B. shipping point,
orders are placed pursuant to a pre-existing sales arrangement and there are no
post-shipment obligations or customer acceptance criteria. Where appropriate,
provision is made at the time of shipment for estimated warranty costs and
estimated returns.
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 is recognized upon the latter of receipt of
such fixed shipment schedule or delivery of the cards into the vault.
License revenue, which may consist of up-front license fees and long-term
royalty payments, is recognized as revenue when realized. The cost of license
revenue, unless patent litigation is involved, is not material and is included
in selling, general, and administrative expenses.
The Company applies the provisions of Statement of Position 97-2,
"Software Revenue Recognition," as amended by Statement of Position 98-9
"Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions" to all transactions involving the sale of software products.
Revenue from the license of the Company's software products is recognized when
persuasive evidence of an arrangement exists, the software product has been
delivered, the fee is fixed or determinable, and collectibility is reasonably
assured, and, if applicable, upon acceptance when acceptance criteria are
specified or upon expiration of the acceptance period. To date, software sales
have not been significant to the Company's business.
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 e