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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[Mark One]
[ x ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended March 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from to _____
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.)
1875 North Shoreline Boulevard, 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
- -------------------- ----------------------
(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
----------------------------
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. [x] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [x]
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 10, 2004, the aggregate market value of the voting stock held by
non-affiliates of the registrant is approximately $141,000,000.
Number of outstanding shares of Common Stock, $.01 par value, at June 10, 2004:
11,410,064
DOCUMENTS INCORPORATED BY REFERENCE: NONE
PART I
Page
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Item 1. Business....................................................................................................... 3
Forward-Looking Statements..................................................................................... 3
General Development of Business............................................................................ 4
Financial Information about Segments....................................................................... 6
Narrative Description of Business.......................................................................... 6
LaserCard(R)Optical Memory Cards......................................................................... 6
Optical Data Storage................................................................................. 6
The Drexon(R)Laser Recording Medium................................................................... 6
LaserCard Digital Governance Applications............................................................ 6
Reading and Writing Optical Memory Cards............................................................. 8
Data Storage Capacity................................................................................ 8
LaserCard Prerecording............................................................................... 8
LaserCard Durability................................................................................. 8
LaserCard Security Features and Capabilities......................................................... 9
International Standards for Optical Memory Cards..................................................... 11
LaserCard Manufacturing.............................................................................. 11
Raw Materials........................................................................................ 11
Subsidiaries and Marketing Organization ............................................................. 12
Card Product Evolution............................................................................... 13
APIs and Application Software........................................................................ 13
LaserCard Read/Write Drives; Manufacturing and Parts/Components...................................... 14
LaserCard Biometric ID Verification System........................................................... 14
Other Advanced-Technology Cards...................................................................... 15
Peripheral Equipment................................................................................. 15
Licensing............................................................................................... 15
Competition............................................................................................. 16
Other Matters........................................................................................... 17
Research and Engineering Expenses.................................................................... 17
Patents and Trademarks............................................................................... 18
Employees............................................................................................ 18
Dependence on Government Subcontracts through a Sole Contractor...................................... 19
Backlog.............................................................................................. 19
Financial Information about Geographic Areas......................................................... 19
Factors that May Affect Future Operating Results........................................................ 20
Item 2. Properties..................................................................................................... 26
Item 3. Legal Proceedings.............................................................................................. 26
Item 4. Submission of Matters to a Vote of Security Holders............................................................ 26
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters....................................... 27
Item 6. Selected Financial Data........................................................................................ 28
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................... 29
Critical Accounting Policies............................................................................... 30
Results of Operations--Fiscal 2004 Compared with Fiscal 2003 and Fiscal 2002................................ 31
Liquidity and Capital Resources............................................................................ 37
Item 7A. Quantitative and Qualitative Disclosures about Market Risk..................................................... 41
Item 8. Consolidated Financial Statements and Supplementary Data....................................................... 42
Reports of Independent Registered Public Accounting Firms.................................................. 42
Consolidated Financial Statements.......................................................................... 44
Notes to Consolidated Financial Statements................................................................. 48
Quarterly Financial Information (Unaudited)................................................................ 66
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................... 67
Item 9A. Controls and Procedures........................................................................................ 67
PART III
Item 10. Directors and Executive Officers of the Registrant............................................................. 68
Item 11. Executive Compensation......................................................................................... 69
Item 12. Security Ownership of Certain Beneficial Owners and Management................................................. 71
Item 13. Certain Relationships and Related Transactions................................................................. 73
PART IV
Item 14. Principal Accountant Fees and Services......................................................................... 74
Item 15. Exhibits, Financial Statement Schedule, and Reports on Form 8-K................................................ 75
Signatures................................................................................................................ 88
2
PART I
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 market segments, customers, and applications for and
deployment of the products of the Company; statements as to the business
benefits to the Company as a result of the March 2004 acquisition of two German
companies--including increased revenue potential, card production capacity and
product flexibility; statements as to the advantages of, potential income from,
and duties to be performed under the sale of a second-source card manufacturing
license; statements as to the Global Investments Group (GIG) license for
second-source card production in Slovenia, including future scheduled payments
and royalties, targeted startup date and production capacity, and that the
Company will sell equipment to GIG, provide GIG with installation support, and
have on-site personnel; production quantities, delivery rates and expected
delivery schedule, backlog, and revenue recognition for Company products for
U.S. or foreign government programs; statements as to potential deployment and
use of the Company's products in the Department of Homeland Security (DHS) U.S.
Visitor and Immigration Status Indication Technology (US-VISIT) program;
expectations as to the new sheet-lamination production facilities and the
short-term effect on gross margins; uncertainties associated with achieving
adequate production capacity for sheet-lamination process cards to meet order
requirements and delivery schedules; anticipated continued use of the Company's
products by the governments of the United States, Canada, and Italy; reliance on
value-added resellers and system integrators to generate sales, perform customer
system integration, develop application software, test products, and work with
governments to implement card programs; the Company's efforts to recruit new
value-added resellers (VARs); 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 belief that
the read/write drive inventory is reflected at its net realizable value; belief
that there is a market for both designs of its read/write drives to support and
expand optical card sales and that the read/write drive inventory on hand will
be ordered by customers; expectations regarding revenues, margins, capital
resources, and 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, the Company's ability to expand production capacity, and
the Company's plans and expectations regarding the growth and associated capital
costs of such capacity; estimates that revenues will be sufficient to generate
cash from operating activities over the next 12 months despite expected
quarterly fluctuations; expectations regarding market growth, product demand,
and the continuation of current programs; potential expansion or implementation
of government programs utilizing optical memory cards, including without
limitation, those in Senegal, India, an Saudi Arabia, and the timing of the
award of any prime contracts for such programs; and the Company's plans,
objectives, and expected future economic performance.
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,
whether there is a market for cards for homeland security in the U.S. and
abroad, and if so whether such market will utilize optical memory cards as
opposed to other technology; customer concentration and reliance on continued
U.S. and Italian government business; risks associated with doing business in
and with foreign countries; whether the Company can successfully integrate and
operate its recently acquired German subsidiaries; whether the Company will be
successful in assisting GIG with factory startup and training; whether GIG will
have the financial wherewithal to make its required payments to the Company and
to operate the facility; whether the facility will efficiently produce high
quality optical memory cards in volume; whether GIG will be able to procure and
satisfy customers so that it owes and pays royalties; and whether GIG will
encounter unexpected delays in constructing and staffing the facility;
3
lengthy sales cycles and changes in and dependence on government policy-making;
reliance on value-added resellers and system integrators to generate sales,
perform customer system integration, develop application software, integrate
optical card systems with other technologies, test products, and work with
governments to implement card programs; risks and difficulties associated with
development, manufacture, and deployment of optical cards, drives, and systems;
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; 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, implementing new manufacturing
processes, and outsourcing manufacturing; the Company's ability to produce and
sell read/write drives in volume; 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 payment schedule and/or a
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 impact of technological advances, general economic trends, and
competitive products; and the possibility that optical memory cards will not be
purchased for the full implementation of card programs in Italy, Saudi Arabia,
India, and Senegal or for DHS programs in the U.S., or will not be selected for
other government programs in the U.S. and abroad, including the US-VISIT
program; the risks set forth in the section entitled "Factors That May Affect
Future Operating Results" and elsewhere in this report; and other risks detailed
from time to time in the Company's SEC filings. 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/OpticalTM card, LaserCard(R) ConciergeCardTM, OptiChipTM, and
LaserBadgeTM 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 Corporation,
makes optical card read/write drives, develops optical card software, and
markets optical cards, read/write drives, and related systems. Challenge Card
Design Plastikkarten GmbH of Rastede, Germany (CCD), and cards & more GmbH of
Ratingen, Germany (C&M) became wholly owned subsidiaries of Drexler Technology
on March 31, 2004. CCD manufactures advanced-technology cards, and C&M markets
CCD cards and system solutions worldwide and is a representative for various
thermal card printers in Europe, the Middle East, and Africa.
Drexler Technology Corporation 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 1875 North Shoreline Boulevard, 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 using the hypertext link to the
SEC's website via the Company's website, www.drexlertechnology.com. 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 and the Company's "Code of Ethics and Business Conduct
for Employees, Officers, and Directors" are posted on the Company's website.
4
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 4.1 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 and cardholder identification.
The Company's product line primarily consists of LaserCard optical
memory cards, optical card read/write drives, optical card systems, chip-ready
hybrid Smart/Optical(TM) cards, and other advanced-technology cards. The Company
also sells optical card-related software and third-party peripherals, including
fingerprint sensor units, digital video cameras, and thermal card printers. The
Company's LaserCard products are sold mainly through value-added reseller (VAR)
companies and card-distribution licensees, with primary target markets being
domestic and foreign government programs, particularly for secure identification
cards. Company revenues also include fees from the occasional sale of patent and
know-how 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
for U.S. Department of State "Laser Visa" Border Crossing Cards (BCCs). In June
2000, the Company was awarded a U.S. government subcontract to supply Green
Cards and Laser Visa BCCs over a period of up to five years. Under this
five-year subcontract, successive order releases totaling $41 million have been
received by the Company as of March 31, 2004. 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.
In addition, 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. Through March 31, 2004, the Company has recorded
revenues of over $81 million on LaserCard optical memory cards sold for U.S.
government programs.
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 Italian national ID card for citizens
o Saudi Arabian ID card
o Other developing programs involving banking, medical record
cards, and vehicle registration cards
On March 31, 2004, the Company successfully completed the acquisition of
two related German card companies, Challenge Card Design Plastikkarten GmbH of
Rastede, Germany, and cards & more GmbH of Ratingen, Germany, including their
sales operations in the USA and Korea. These acquisitions provide the Company
with a strong card manufacturing base to serve the European, Middle Eastern,
African, and Asian markets, supplementing the Company's newly expanded
manufacturing operations in California. While future operating results of these
German companies will be consolidated into the Company's financial statements
for future periods, the historic results of CCD and C&M have not been included
in the financial statements for fiscal 2004 and prior periods, although the
consolidated balance sheet as of March 31, 2004 reflects the acquisition of
these two companies.
5
Effective April 3, 2004, the Company sold a royalty-bearing,
second-source card-manufacturing license to the Global Investments Group, for
optical memory card manufacturing in Slovenia. This agreement provides for
payments to the Company of $29 million over the 20-year term of the license
(consisting of a five-year training support package, followed by an ongoing
support phase for an additional 15 years). Additionally, the Company is to sell
approximately $12 million worth of the required manufacturing equipment and
provide installation support for the licensee's new facility to achieve a
targeted initial manufacturing capacity of 10 million optical cards annually.
The Company has received the initial $5 million of payments called for in the
agreements, consisting of a partial payment for the equipment of $500,000 as of
March 31, 2004 and $4.5 million subsequent to March 31, 2004. Start up of the
Global Investments Group facility is planned for early 2005.
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's two reportable segments are: (1) optical memory cards and
(2) optical memory card drives, maintenance, and related accessories ("optical
card drives"). The segments were determined based on the information used by the
chief operating decision maker. The segments reported are not strategic business
units which offer unrelated products and services, rather these reportable
segments utilize compatible technology and are marketed jointly. See "Segment
Reporting" in Note 4 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 recorded
using a laser and/or prerecorded using photolithography.
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
(immediately, or even over a period of years) but data can be written in a
specific location on the medium only once (write once). After an area is
recorded, firmware prevents that same location from being overwritten with new
data. Obsolete data can be ignored by the system but remains permanently stored
on the Drexon optical card as an audit trail of all changes. New or revised
information is recorded in a new location. Through these procedures, the card is
easily updatable.
Thus, although the Drexon material is not physically erasable like
magnetic storage media, Drexon can be corrected and updated at any time and has
the important audit trail feature that magnetic media do not have. Data can
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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. Currently, 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 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 periodically.
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, has 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 The electronic national ID card application in Italy, now in
Phase 2, identifies the holder as a citizen and confers upon the
holder the rights and privileges to which a citizen is entitled.
An Italian permanent resident card for non-citizens may also be
implemented.
o In a planned program for the Kingdom of Saudi Arabia, the
LaserCard would be used as a secure personal identification
card. The Company has sold read/write drives for installation of
the infrastructure required for card issuance, and also has
shipped small quantities of optical memory cards for testing and
sample purposes.
o For a secure banking project under the auspices of Societe
Nationale La Poste, the national Post Office of Senegal, Africa,
the LaserCard is planned to be issued to transient workers who
often bank at remote branches which are not on-line in real time
with each other.
o In a newly launched motor vehicle registration program in the
State of Delhi, India, the Smart/Optical LaserCard would be used
for storing the payment of road tax, vehicle registration,
insurance, violations, and vehicle fitness. The State of Gujarat
has reportedly issued up to 200,000 such optical cards based
registrations to date, and the State of Maharastra has a planned
Smart/Optical card program as well.
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.
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READING AND WRITING OPTICAL MEMORY 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 read/write drive is connected to a personal computer as an external data
storage peripheral. Information is recorded when the read/write drive pulses 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, which can be read by the computer system using an
optical card reader or reader/writer peripheral.
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 itself is the size of a
conventional credit card.
A significant portion of the LaserCard's total data capacity is used for
an error detection and correction, or EDAC, algorithm. EDAC is routinely used in
various data storage and transfer methods to compensate for data errors
resulting from transmission errors, surface scratches above the recording
material, or contamination such as dust or fingerprints. EDAC is automatically
added to data written onto the LaserCard, to achieve written data error rates of
less than one in a trillion.
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.
LASERCARD 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.
LASERCARD DURABILITY
Unlike most other types of digital storage media, the LaserCard can be
manufactured to withstand temperatures of 100 degrees Centigrade (212 degrees
Fahrenheit) 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.
8
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 program is the U.S. Department of Defense
"Automated Manifest" card (since 1993).
LASERCARD SECURITY FEATURES AND CAPABILITIES
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 high storage capacity accommodates the use
of multiple, nonerasable, security safeguards in addition to holding all of the
user data and an audit trail. These security measures include eye readable and
computer readable security features to enhance data security, confidentiality,
and resistance to counterfeiting and data tampering.
The LaserCard is a multiple-security-feature, digital identity card
solution that offers customers the capability of utilizing all or any
combination of the following security features on the same card:
o It can be upgraded time and again to deter data tampering and
high-tech counterfeiters.
o It can store PC-readable (digitized) 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
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 card's 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 (NIST)
February 11, 2003 requirements for two fingerprints (10
kilobytes each) and a 10-kilobyte facial image (total of 30
kilobytes) of data storage.
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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.
RADIO FREQUENCY (RF) CAPABILITY ON OPTICAL CARDS. The Company has
co-developed and markets a new type of smart card that combines a contactless RF
chip and optical memory technology to support biometric identification. The
contactless portion of the new hybrid card contains a computer chip and radio
antenna; the hybrid card is read automatically-no touching or inserting of the
card is needed. The contactless technology permits the card to be read in
approximately 100 milliseconds, allowing people and/or cars to approach a gate,
having their status verified against border security databases. The LaserCard's
optical memory stripe provides counterfeit resistance, automatic card
authentication, and high capacity secure storage for multiple biometric images.
The LaserCard system allows the rapid off-line verification of biometrics. For
facilitation applications, such as land border entry or registered traveler
programs, data from the optical memory can be downloaded to the contactless chip
to activate specific services and privileges for local use.
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 card-with a microprocessor and over 1 megabyte of
updatable optical memory-can be used to store digital signatures, digital
certificates, and cryptographic keys such as public key infrastructure for
Internet e-commerce, as well as multi-application programs and software
upgrades.
AUDIT TRAIL. Because the LaserCard contains an updatable, nonvolatile
WORM memory (write-once, read-many times) that is recorded permanently, the card
can hold a complete audit trail of data, changes, updates, and deletions. This
can be achieved using software--to allow access to previously recorded files
and, if desired, to record all attempts to access data from the LaserCard.
MATCHING, EYE READABLE IMAGES. The LaserCard uniquely offers this key
security feature for maximum counterfeit-resistance. Cardholder-specific
information (typically, the cardholder's face photograph, name, signature,
number, or other identifying information) can be laser-engraved onto the card's
reflective stripe (through the card's protective transparent polycarbonate
layer). These "embedded hologram" 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 U.S. Department of Homeland Security, U.S. Department of
State, and the governments of Canada, Italy, and Saudi Arabia all 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.
OPTICALLY VARIABLE DEVICES (OVDS). An OVD is a security feature that has
the characteristic of a changeable optical appearance depending on angle or
wavelength of reflected light. OVDs are key elements of many secure document
designs. The LaserCard optical media can contain OVD features integrated into
the media itself, which raises the counterfeit deterrence of the card.
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.
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INTERNATIONAL STANDARDS FOR OPTICAL MEMORY CARDS
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 base
design 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, based upon the DELA Standard format, complies with
all of the documents listed.
o ISO/IEC 11693 (2000) describes the general characteristics of
optical memory cards. This approved international standard was
first published in 1994.
o ISO/IEC 11694-1 (2000) describes the physical characteristics of
the card, such as height, width, thickness, etc. This approved
international standard was first published in 1994.
o ISO/IEC 11694-2 (2000) describes the dimensions and location of
the accessible area--the area on the card where data
writing/reading occurs. This approved international standard was
first published in 1995.
o ISO/IEC 11694-3 (2001) describes the optical properties and
characteristics of the card and provides the technical
specifications which allow interchange. This approved
international standard was published in 1995.
o ISO/IEC 11694-4 (2001) describes the logical data structure on
the card and defines the method of writing and reading card
data. This approved international standard was published in
1996.
o In the United States, ANSI has adopted all of the above ISO
Standards as ANSI/ISO Standards.
LASERCARD MANUFACTURING
The Company's LaserCard optical memory card manufacturing operations are
located in Mountain View, California, and Rastede, Germany. The Company produces
optical memory cards using its established, roll-lamination process or a newer,
sheet-lamination process. The sheet-lamination process is currently more labor
intensive than its roll-lamination process but allows the use of high security
offset printing and other special features, resulting in a premium card. The
Company has an annual production capacity of 10 to 12 million roll-process cards
and approximately 5 million sheet-process cards. 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.
In addition, the fiscal 2004 acquisition of Challenge Card Design
Plastikkarten GmbH of Rastede, Germany, provides the Company with a card
manufacturing base to serve the European, Middle Eastern, African, and Asian
markets, supplementing the Company's card manufacturing operations in
California, which were recently expanded by moving certain operations to a newly
leased facility. CCD has a manufacturing capacity of up to 20 million of its
non-optical cards per year. The Company is in the process of enhancing the
existing CCD factory in order that finished optical cards may be manufactured in
Germany. This will enable CCD to manufacture cards featuring four of the key ID
card technologies (optical memory, contact IC chip, contactless RF ID, and
magnetic stripe) either singly or in combination, along with other high-security
features.
RAW MATERIALS
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
11
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. No assurance can be given that
Kodak will continue to supply such photographic films on a satisfactory basis
and in sufficient quantities, especially in light of its recent announcement
that it is reducing its emphasis on emulsion-based photographic films. If Kodak
were to discontinue manufacturing the film from which the Drexon optical stripe
is made, the Company would endeavor to establish an alternate supplier for such
film, although the purchase price could increase and reliability and quality
could decrease from a new supplier. Considering that the U.S. government is a
major end-user of optical memory cards, the Company anticipates that an
alternate supplier of such film could be established and qualified; however, no
assurance can be given that there will be adequate demand to attract a second
source for such film. In addition, an alternate supplier could encounter
technical issues in producing the film as there may be know-how and
manufacturing expertise which Kodak has developed over the years which an
alternate supplier may have difficulty to replicate. 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 currently has an order which Kodak has accepted with
deliveries scheduled through December, 2004. If Kodak announced that it was no
longer going to sell film, the Company would request that Kodak provide a
last-buy opportunity, which the Company would plan to take maximum advantage of,
although no assurance can be given that Kodak would provide such an opportunity.
The Company has film on hand plus on order that it believes would provide an
adequate supply to meet anticipated demand until the Company could locate and
begin volume purchases of film from a second source.
SUBSIDIARIES AND MARKETING ORGANIZATION
LASERCARD SYSTEMS CORPORATION (LSC). 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 2004, the Company sold LaserCard products to approximately 26
direct customers in 4 states and 16 foreign countries. Revenues by geographic
region are shown in Note 4 of the "Notes to Consolidated Financial Statements"
in Item 8, "Consolidated Financial Statements and Supplementary Data."
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 now in Germany. In addition, the LaserCard
Systems website (www.lasercard.com) 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.
EUROPEAN OPERATIONS. The Company's newly acquired Germany subsidiaries,
Challenge Card Design and cards & more, will provide the marketing base for most
of Europe, Middle East, and Africa (EMEA), and also maintain a sales office in
Korea. These acquisitions give the Company an established position in the
European Union in the advanced-technology card market. CCD and C&M have become
recognized leaders in Europe as providers of advanced contactless card
solutions, primarily in the consumer, event, and access control sectors. C&M
will be heading the Company's European marketing effort in coordination with
LaserCard Systems Corporation.
12
The addition of the CCD card manufacturing plant in Rastede will add
significant capacity and product flexibility to the Company's product line. With
expertise in contactless IC technology and high resolution security printing,
the European factory base will position the Company to move into new market
areas. The European marketing base, along with the optical card manufacturing
capability planned for the new operation in Germany, are intended to accelerate
European acceptance of the use of optical memory products in EU government and
business solutions.
The cards & more subsidiary will continue to serve and support its
existing customer base for advanced-technology cards and thermal printers, while
adding new resources to build the optical memory card business throughout the
EMEA region. In expanding its European presence, the Company intends to focus
principally on biometric ID solutions for national and regional governments, as
well as promoting optical cards in commercial and industrial markets which can
benefit from the large data capacity and robust security that optical cards
offer.
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, Canadian Permanent Resident Cards, and the
electronic national ID card for citizens of Italy, the Company's marketing
objectives include card applications in the United States and abroad, such as:
o US-VISIT system (previously called the U.S. Entry-Exit system)
o Canadian Citizens' ID card
o Italian permanent resident card for non-citizens
o Identification card for Saudi Arabia
o Motor vehicle registration card for several states in India
o Multi-application cards plus other ID and banking card
applications
CARD 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 provide special
features, if specified; for example: security printing, sequential serial
numbers, bar coded data, laser-engraved eye-readable images, signature panels,
magnetic stripes, OVD (optically variable device) security diffraction pattern,
and OptiChip small form factor optical media. In addition, "chip ready" optical
memory cards can be purchased from the Company, for insertion of IC chips to
create hybrid Smart/Optical 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 advanced-technology cards.
In addition, Company personnel and the newly acquired CCD-C&M European
operations have worked together for the past four years to co-develop advanced
secure optical card solutions for customers such as the Canadian and Italian
government optical card programs.
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.
13
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).
LASERCARD 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. The Company maintains read/write drive manufacturing operations
in its Mountain View, California facilities. The Company has introduced a new
version of a read/write drive and is targeting design changes to allowing
further reductions in the drive selling price.
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.
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. Since fiscal 2002, there has
not been a further reduced selling price for these read/write drives. However,
in fiscal 2004, the Company introduced a new drive with a 25% reduction in price
for typical quantities as compared with the previous model. 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.
During the fiscal 2004 third quarter, the Company received an order for
and delivered 1,000 optical memory card read/write drives and biometric
verification system software for a Department of Homeland Security program.
These 1,000 drives and software systems are being deployed by the DHS at U.S.
borders, to enable the DHS to read the encoded data on more than 16 million
Green Cards and Border Crossing Cards previously manufactured by the Company and
issued by the U.S. government since 1998.
LSC also 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.
14
OTHER ADVANCED-TECHNOLOGY CARDS
Acquired by the Company on March 31, 2004, Challenge Card Design
Plastikkarten GmbH and cards & more GmbH are recognized leaders in Europe as
providers of advanced contactless card solutions, primarily in the consumer,
event, and access control sectors. CCD has the production capacity to
manufacture up to 20 million advanced-technology cards per year--including
contact IC chip cards, contactless RF ID cards, and magnetic stripe cards--while
C&M markets CCD cards and system solutions worldwide.
PERIPHERAL EQUIPMENT
The sale of third-party peripheral equipment and systems has not
contributed materially to the Company's revenues to date. However, the following
peripherals are purchased and re-sold by the Company to facilitate customer
application development:
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.
o Thermal printers for printing on plastic cards.
LICENSING
From 1983 through March 31, 2004, the Company generated a total of
approximately $40 million in license fee revenues under 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. These licenses included two $10 million,
nonexclusive, royalty bearing, patent licenses for optical memory card
manufacture, although the Company believes that the licensees are not
manufacturing or selling such cards at this time. The first such license was
sold in fiscal 1989 to Canon Inc. The second was sold 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, the joint venture's license
was fully assumed by Dai Nippon Printing.
Effective April 3, 2004, the Company sold a third card-manufacturing
license to the Global Investments Group, based in Auckland, New Zealand, for
card manufacturing in Slovenia. This agreement provides for payments to the
Company of $29 million for the license over the 20-year term of the license
(including a five-year training support package, followed by an ongoing support
phase for an additional 15 years). Additionally, the Company is to sell
approximately $12 million worth of the required manufacturing equipment and
installation support for the new facility to provide a targeted initial
manufacturing capacity of 10 million optical cards annually. Options to increase
capacity to 30 million cards per year are provided. The Company has received the
initial $5 million of payments called for in the agreements, consisting of a
partial payment for the equipment of $500,000 as of March 31, 2004 and $4.5
million subsequent to March 31, 2004. In addition to the $41 million from the
GIG transaction, Global Investments Group is to pay the Company royalties for
each card produced under the license. The territories covered by the license
include most of the European Union and eastern European regions. The Global
Investments Group has exclusive marketing rights in certain territories, with
performance goals to maintain these rights. The Company will assign personnel on
site during the license term to assist with quality, security, and operational
procedures, with a mutual goal that the facility and the cards made there
conform to the Company's standards. Start up of the Global Investments Group
facility is planned for early 2005. Payments under this license will be
recognized as revenue over the term of the arrangement beginning when operation
of the factory commences. The Company also retains rights to utilize up to 20%
of the new facility capacity as backup and capacity buffer to augment its own
card manufacturing facilities. The granting of this license to GIG is expected
to create a second source supplier of optical memory cards for existing and
prospective customers who may request multiple sources for cards.
15
Also from time to time, the Company has offered 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. 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.
License revenues for fiscal 2004, 2003, and 2002 are detailed in the
"Management's Discussion and Analysis" section of this report, under the heading
"License Fees and Other Revenues."
COMPETITION
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
optical memory 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, especially when the very high cost of Public Key encryption is factored
into the cost of an IC card system.
Other card technologies that compete with optical memory cards include
integrated circuit (IC) cards, 2-dimensional bar code cards and symbology cards,
CD-read only cards and recordable cards, and RF (radio frequency) cards. 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.
In addition, centralized on-line databases combined with wide-area
networks may limit the penetration of optical memory cards in certain
applications, and are a form of competition.
IC CARDS. The LaserCard competes primarily with cards that contain an
integrated circuit (IC) microprocessor and memory. Known as "smart cards," "IC
cards," or "chip cards," their prices and performance vary widely. The IC card
uses a much lower cost read/write drive than is currently used with an optical
card, whereas a typical smart card containing a 32-kilobyte IC and a
microprocessor is typically more than the cost of the Company's 2,800 kilobyte
optical memory card. 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. 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. 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 frequency (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
16
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 OPTICAL MEMORY CARDS AND EQUIPMENT. As described in the
"Licensing," section, the Company previously 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. In addition,
in April 2004, the Company sold a card manufacturing license to a New Zealand
company for the manufacture of optical memory cards in Slovenia. Under these
royalty-bearing licenses, the licensees have the right to manufacture and sell
optical memory cards in competition with the LaserCard. Dai Nippon Printing Co.,
Ltd., did not report any optical card sales for calendar year 2002, and Canon
Inc. has not reported any such sales since 1999. The newly licensed Slovenian
operation under the Global Investments Group license is not yet capable of
manufacturing optical cards, but is expected to become a second-source for the
Company's cards over time. Global Investments Group could become a competitor in
certain Western European countries; however, exclusivity provisions of the
license preclude competition in certain markets. For example, the Company is
prohibited from competing in certain Eastern European countries, and Global
Investments Group is prohibited from competing in certain Western European
countries and in some other territories.
As to optical card drives, 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.
Canon and Olympus have not reported any optical card drive sales since mid-2000.
A United States company, BSI2000 (a LaserCard VAR), has unveiled a proprietary
low-cost reader for optical cards, according to an April 28, 2004 news release
published by BSI 2000. It is described as a small, wall-mounted unit able to
scan and identify fingerprints that match biometric data embedded in optical
identity cards. BSI said it expects to have the unit ready for the marketplace
by early fall 2004. The Company cannot verify the actual status of this
announced product.
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.
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. In 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 $2,620,000 for fiscal 2004;
$2,818,000 for fiscal 2003; and $3,045,000 for fiscal 2002. 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
17
drives (readers), OptiChip small form factor optical media, 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, 2004, the Company owned
approximately 30 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 40 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. Also, 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 2004 to
2020, with the majority expiring during the first part 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 cards ceased 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. Dai Nippon Printing Co.,
Ltd., did not report any optical card sales for calendar year 2002, and Canon
Inc. has not reported any such sales since 1999. Other read/write equipment
licenses sold by the Company provide for royalty payments to cease on the last
expiration date of the licensed patents. The license sold to the Global
Investments Group provides for royalty payments on optical memory card sales;
however, the Slovenian card manufacturing operation is not expected to commence
manufacturing cards until calendar year 2005. Royalty payments to the Company
from its licensees have not been significant to date.
The Company cannot predict whether the expiration or invalidation of its
patents would result in the introduction of competitive products which would
affect its future revenues adversely. The Company presently intends to pursue
any infringement of its patents either by litigation, arbitration, or
negotiation. However, there can be no assurance that any of the Company's
patents will be sufficiently broad in scope to afford protection from products
with comparable characteristics that may be sold by competitors in the future.
There also can be no assurance that the validity of any patents actually granted
will not be challenged.
LaserCard(R) and Drexon(R) are federally registered trademarks of
Drexler Technology Corporation. The Company believes that its LaserCard brand
name, trade name, and other trademarks are important assets in marketing optical
memory card products.
EMPLOYEES
As of March 31, 2004, the Company and its U.S. subsidiaries employed 128
persons (including four executive officers). This workforce consisted of 103
persons in administration, marketing/sales, manufacturing, and research and
engineering, plus 25 temporary personnel mainly for quality assurance inspection
of cards. In addition, the two German subsidiaries acquired by the Company on
March 31, 2004 employed 76 personnel as of that date. None of the Company's
employees is represented by a labor union.
18
DEPENDENCE ON GOVERNMENT SUBCONTRACTS THROUGH SOLE CONTRACTORS
The largest purchaser of LaserCard products is Anteon International
Corporation, a value-added reseller (VAR) of the Company. Anteon is the
government contractor for LaserCard product sales to the U.S. Department of
Homeland Security (DHS), U.S. Department of State (DOS), U.S. Department of
Defense (DOD), and the government of Canada. Under government contracts with
Anteon, the DHS purchases U.S. Permanent Resident Cards (Green Cards) and DOS
"Laser Visa" Border Crossing Cards (BCCs); the DOD purchases Automated Manifest
System cards; and the Canadian government purchases Permanent Resident Cards.
Encompassing all of these programs, the Company's product sales to Anteon
represented 72% of total revenues for fiscal 2004; 94% of total revenues for
fiscal 2003; and 81% of total revenues for fiscal 2002. However, since the
ultimate customers are national governments, the Company is not dependent upon
any one specific contractor for continued revenues from these programs. Although
not anticipated, if Anteon 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.
U.S. government subcontract release orders for DHS Green Cards and DOS
Laser Visa BCCs represented approximately 44% of the Company's revenue for
fiscal 2004; 82% of revenues for fiscal year 2003; and 75% of revenues for
fiscal 2002. The percentage declined during fiscal 2004 as U.S. government
orders decreased more than the Company had anticipated due to delays in the
government approving artwork reflecting the advent of the Department of Homeland
Security, and the U.S. governments' desire to reduce inventory levels, while at
the same time orders of cards from foreign governments increased as planned over
prior years' levels. The U.S. government's agreement with the above VAR expires
on May 25, 2005. There can be no assurance that the U.S. government will enter
into a new contract with the VAR to continue to purchase the Company's cards, in
which case one of the Company's major sources of revenues would be eliminated.
During fiscal 2004, 22% of the Company's revenues were derived from
sales of cards for the government of Italy for its national ID card program,
Carta d'Identita Elettronica (CIE), now in Phase 2, early-stage implementation.
Card orders under this program are channeled to the Company through a
value-added reseller, Laser Memory Card SRL, of Rome, Italy. The most recent CIE
card order was in May 2004, for $3.3 million. According to Italian government
sources, the distribution of this new national ID card has started in a number
of the 56 Italian communities scheduled to be activated under the program during
2004. The government's publicly stated plan to issue up to two million cards
this year would put Italy at the forefront of European countries in terms of
providing citizens with secure, durable ID documents. However, if this program
were to be discontinued or interrupted by the Italian government, the Company
would lose one of its significant sources of optical memory card revenues.
BACKLOG
As of March 31, 2004, the backlog for LaserCard optical memory cards
totaled $4.1 million, compared with a backlog of approximately $1.9 million for
fiscal 2003 and $16.4 million for fiscal 2002. Order backlog as of March 31,
2004 includes orders for the following programs: Green Cards for the U.S.
Department of Homeland Security, Italian government national ID cards (CIE
cards), and Canadian government Permanent Resident Cards. Backlog is subject to
fluctuation due to having few customers and the timing of orders. The Company
has no backlog for read/write drives.
In addition, the backlog for Challenge Card Design Plastikkarten GmbH
and cards & more GmbH products and services totaled 2.1 million euros
(approximately $2.6 million) as of March 31, 2004.
FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS
Financial information about geographic areas is described in Note 4 to
Item 8, "Consolidated Financial Statements and Supplementary Data."
19
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
OUR CURRENT AND FUTURE EXPECTED REVENUES ARE DERIVED FROM A SMALL NUMBER
OF ULTIMATE CUSTOMERS SO THAT THE LOSS OF OR REDUCTIONS IN PURCHASES BY ANY ONE
ULTIMATE CUSTOMER COULD MATERIALLY REDUCE OUR REVENUES AND LEAD TO LOSSES.
During fiscal 2004 and each of the previous two fiscal years, we have derived
more than 90% of our revenues from four programs-two U.S. government programs
and two foreign government programs. Due to the lengthy sales cycles, we believe
that these programs, with perhaps the addition of one or two other foreign
programs, will be the basis for a substantial majority of our revenues in the
near-term. The loss of or reductions in purchases by any one customer due to
program cutbacks, competition, or other reasons would materially reduce our
revenue base. Our U.S. government subcontract expires on May 25, 2005. There is
no assurance that a follow-on contract will be issued by the U.S. government
upon expiration of the current contract. Annual or quarterly losses would occur
if there are material reductions, gaps or delays in card orders from our largest
U.S. or foreign government programs or if such programs were to be reduced in
scope, delayed, canceled, or not extended and not replaced by other card orders
or other sources of income.
WE HAVE INCURRED NET LOSSES DURING THE PAST FIVE QUARTERS AND MAY NOT BE
ABLE TO GENERATE SUFFICIENT REVENUE IN THE FUTURE TO ACHIEVE OR SUSTAIN
PROFITABILITY. As of March 31, 2004, we had an accumulated deficit of
$18,244,000. Although we operated profitably for the previous five years (fiscal
1999 through fiscal 2003), we have incurred significant losses in the past,
including in fiscal 1997 and 1998, and we incurred losses in fiscal 2004 due
primarily to delays in orders for our cards, and in the third fiscal quarter of
2004, by the increase in the valuation allowance we recorded against our
deferred tax assets. There can be no assurance that we will generate enough card
revenues in the near term or ever to become profitable. We are relying upon our
optical memory card technology to generate future product revenues, earnings,
and cash flows. If alternative technologies emerge or if we are otherwise unable
to compete, we may not be able to achieve or sustain profitability on a
quarterly or annual basis. Annual or quarterly losses would also occur if
increases in product revenues or license revenues do not keep pace with
increased marketing, research and engineering expenses and the depreciation and
amortization associated with capital expenditures.
OUR PRODUCT REVENUES WILL NOT GROW IF WE DO NOT WIN NEW BUSINESS IN THE
U.S. AND ABROAD. Revenues during fiscal 2003 included sales of approximately
$21.5 million of U.S. government Green Cards and Laser Visa BCCs. Fiscal 2004
revenues included sales of approximately $5 million of cards for these
government programs, with annual sales in the near-term after fiscal 2005
expected to approximate the card personalization rate of the U.S. government,
which currently is approximately $9 million of cards per year ($6.6 million for
Green Cards and $2.4 million for Laser Visa BCCs). During fiscal 2005, we expect
our revenue from these programs to be less as we anticipate that the U.S.
government will draw down its excess inventory; and, as a worst case, we could
have almost no revenue if the inventory levels are drawn down substantially.
These revenue levels are less than the approximately $13 million level of
revenues we had previously expected to receive from these programs on an annual
basis. We believe that in order for our overall card revenues during fiscal 2005
to return to their fiscal 2003 levels, we will need significant additional
orders from new and other existing programs to supplement the revenue, currently
expected to be less than $6 million, from the U.S. Green Cards and Laser Visa
BCCs. Optical memory card digital governance programs that are emerging programs
or prospective applications in various countries include identification cards
for Italy and Saudi Arabia; 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 US-VISIT program, the
TWIC (Transportation Worker Identification Credential) program, and the proposed
Registered Flier program are possible market opportunities for secure
identification using optical memory cards. However, there is no assurance that
our products will be selected for any of these programs. In particular, we are
uncertain whether we will be chosen as a US-VISIT subcontractor directly or
through a VAR teaming partner with Accenture, which was announced as the prime
contractor for the full implementation of this program on June 1, 2004. Since
governmental card programs typically rely on government policy-making, which in
turn is subject to technical requirements, budget approvals, and political
considerations, there is no assurance that the US-VISIT program will be
implemented as expected or that it will include optical cards in its solution.
From Italy, we received orders in July 2003, December 2003, and May 2004
valued at $2.4 million, $3.8 million, and $3.3 million, respectively, for Phase
2 of the Italian CIE card program and we anticipate receiving orders during
20
FY 2005 for one of Italy's new programs, the Permesso di Soggiorno Elettronico
(PSE) card. 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.
ONE VALUE ADDED RESELLER IS THE CONTRACTOR FOR OUR U.S. AND CANADIAN
GOVERNMENT CUSTOMERS AND ANOTHER VAR PURCHASES CARDS FROM US FOR THE ITALIAN
NATIONAL ID CARD PROGRAM. HAVING TO REPLACE EITHER OF THESE VARS COULD INTERRUPT
OUR U.S., CANADIAN, OR ITALIAN GOVERNMENT BUSINESS. AND, IF OUR VARS LOSE THEIR
GOVERNMENT BUSINESS, OUR REVENUES WOULD LIKEWISE DECLINE MATERIALLY. The largest
purchaser of LaserCard products is Anteon International Corporation, one of our
value-added resellers (VARs). Anteon is the government contractor for LaserCard
product sales to the U.S. Department of Homeland Security, U.S. Department of
State, U.S. Department of Defense, and the government of Canada. Under
government contracts with Anteon, the DHS purchases U.S. Green Cards and DOS
Laser Visa BCCs; the DOD purchases Automated Manifest System cards; and the
Canadian government purchases Permanent Resident Cards. Encompassing all of
these programs, our product sales to Anteon represented 72% of total revenues
for fiscal 2004 ended March 31, 2004; 94% of total revenues for fiscal 2003
ended March 31, 2003; and 81% of total revenues for fiscal 2002 ended March 31,
2002. However, since the ultimate customers are national governments, we are not
dependent upon any one specific contractor for continued revenues from these
programs. Although not anticipated, if Anteon 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. Concerning Italy, during fiscal 2004, 22% of the
Company's revenues were derived from sales of cards and read/write drives for
the government of Italy for its CIE card program. Card orders under this program
are channeled to the Company through a value-added reseller, Laser Memory Card
SRL, of Rome, Italy. According to Italian government sources, the distribution
of this new national ID card has started in a number of the 56 Italian
communities scheduled to be activated under the program during 2004. The
government's publicly stated plan is to issue up to two million CIE cards this
year. However, if this program were to be discontinued or interrupted by the
Italian government, the Company would lose one of its significant sources of
optical memory card revenues.
ONE OF OUR LARGER ULTIMATE CUSTOMERS, THE U.S. GOVERNMENT, HAS THE RIGHT
TO DELAY ITS ORDERS OR COULD CHANGE ITS TECHNOLOGY DECISIONS, WHICH WOULD RESULT
IN ORDER DELAYS OR LOSSES. Under U.S. government procurement 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 unfulfilled purchase 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
depreciation on capital equipment. For example, the latest order of cards under
our U.S. government subcontract, $2.6 million worth of optical memory cards for
the newly enhanced Green Cards, called for deliveries from December 2003 through
May 2004. As a result, we experienced a gap in production of several months,
which significantly affected operating results for fiscal 2004. The delay in the
U.S. government's order was the result of waiting for a change to the design of
the DHS artwork that is included on the cards as a result of the formation of
the Department of Homeland Security, and was exacerbated by its desire to reduce
its inventory levels. Any future excess inventory held by the U.S. government
for example due to delayed funding or a slower than anticipated program rollout,
or any future changes to the design of the cards may result in future gaps in
orders or production which may negatively impact our operating results.
U.S. government subcontract release orders for DHS Green Cards and DOS
Laser Visa BCCs represented approximately 44% of the Company's revenue for
fiscal 2004; 82% of revenues for fiscal year 2003; and 75% of revenues for
fiscal 2002 The percentage declined during the first nine months of fiscal 2004
as U.S. government orders decreased more than we had anticipated, due to delays
in the government approving artwork reflecting the advent of the Department of
Homeland Security, and the U.S. governments' desire to reduce inventory levels,
while at the same time orders of cards from foreign governments increased as
planned over prior years' levels. The U.S. government's agreement with our VAR
expires on May 25, 2005. There can be no assurance that the U.S. government
21
will enter into a new contract with our VAR or renew its current contract to
purchase our cards, in which case one of our major sources of revenues would be
eliminated.
There is no assurance of continuing read/write drive orders from the
U.S. government. The recent order of 1,000 drive units for use by the U.S.
government with our Biometric Verification System application software may not
result in similar orders in the future. The system performance, including
biometric verification speed, accuracy, and card reading performance may not
meet government objectives for further system expansion. There is no assurance
that the government will have budgeted sufficient funds to expand the system to
its full potential or that the Company will be successful in winning any new
U.S. government procurements for similar systems or application software.
SINCE THE SALES CYCLE FOR OUR PRODUCTS IS TYPICALLY LONG AND
UNPREDICTABLE, WE HAVE DIFFICULTY PREDICTING FUTURE REVENUE GROWTH. Initial
product sales to VARs 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.
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.
THE TIMING OF OUR U.S. GOVERNMENT REVENUES IS NOT UNDER OUR CONTROL AND
CANNOT BE PREDICTED BECAUSE WE DO NOT RECOGNIZE REVENUE UNTIL CARDS ARE SHIPPED
OUT OF A VAULT OR WE RECEIVE A FIXED SHIPMENT SCHEDULE FROM THE GOVERNMENT. We
recognize revenue from product sales when the following criteria are met: (a)
persuasive evidence of an arrangement exists; (b) delivery has occurred; (c) the
fee is fixed or determinable; and (d) 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 government or one of its specified
agents. When the cards are delivered to the vault, all title and risks of
ownership are transferred to the government. At the time of delivery, the prime
contractor is invoiced, with payment due within thirty days. The contract does
not provide for any return provisions other than for warranty. We recognize
revenue when the cards are delivered into the vault because we have fulfilled
our contractual obligations and the earnings process is complete. However, if we
do not receive such a shipment schedule, revenue is not recognized until the
cards are shipped from the vault. In addition, revenue recognition for future
deliveries into the vault would be affected if the U.S. government cancels the
shipment schedule. As a result, our revenues may fluctuate from period to period
if we do not continue to obtain shipment schedules under this subcontract or if
the shipment schedules are cancelled. We would no longer recognize revenue when
cards are delivered to the vault, but instead such revenue recognition would be
delayed until the cards are shipped from the vault to the U.S. government.
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. We may experience manufacturing complications associated with
increasing our manufacturing capacity of cards and drives, including the
adequate production capacity for sheet-lamination process cards to meet order
requirements and delivery schedules. We may also experience difficulties
implementing new manufacturing processes or outsourcing some of our
manufacturing. 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.
22
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. No assurance can be
given that Kodak will continue to supply such photographic films on a
satisfactory basis and in sufficient quantities, especially in light of its
announcement that it is reducing its emphasis on emulsion-based films. If Kodak
were to discontinue manufacturing the film from which the Drexon optical stripe
is made, we would endeavor to establish an alternate supplier for such film,
although the purchase price could increase and reliability and quality could
decrease from a new supplier. Considering that the U.S. government is a major
end-user of our optical memory cards, we anticipate that an alternate supplier
of these films could be established and qualified; however, no assurance can be
given that there will be adequate demand to attract a second source. In
addition, an alternate supplier could encounter technical issues in producing
the film as there may be know-how and manufacturing expertise which Kodak has
developed over the years which an alternate supplier may have difficulty to
replicate. We have 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, we currently have an order which Kodak has
accepted with deliveries scheduled through September, 2004. If Kodak announced
that it was no longer going to sell film, we would request that Kodak provide us
with a last-buy opportunity which we would plan to take maximum advantage of,
although no assurance can be given that Kodak would provide us with such an
opportunity. We have film on hand plus on order that we believe would provide us
with an adequate supply to meet anticipated demand until we could locate and
begin volume purchases from a second source.
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.
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. Since fiscal 2002, there has not been a
further reduced selling price for these read/write drives. However, in fiscal
2004, we introduced a new drive with a 25% reduction in price for typical
quantities as compared with the previous model. 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 undertaken a product development program for a hand-held read-only drive,
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.
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
23
require the ability to maintain and enhance the technological capabilities of
the LaserCard product line. There can be no assurance that the Company's
products currently sold or under development will remain competitive or provide
sustained revenue growth.
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 our
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.
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
three of our licensees (although none 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; radio frequency,
or RF, chip 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.
THE PRICE OF OUR COMMON STOCK IS SUBJECT TO SIGNIFICANT VOLATILITY. The
price of our common stock is subject to significant volatility, which 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
11 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. Furthermore, our trading
volume is often small, meaning that a few trades may have disproportionate
influence on our stock price. In addition, someone seeking to liquidate a
sizeable position in our stock may have difficulty doing so except over an
extended period or privately at a discount. Thus, if one or more of the selling
stockholders were to sell or attempt to sell a large number of its shares within
a short period of time, such sale or attempt could cause our stock price to
decline. There can be no guarantee that the selling stockholders will be able to
sell the shares that they acquired at a price per share equal to the price they
paid for the stock.
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WE ARE SUBJECT TO RISKS ASSOCIATED WITH CHANGES IN FOREIGN CURRENCY
EXCHANGE RATES. Most of the manufacturing process of the LaserCard products that
we sell in Italy takes place in Europe. The prices charged to us by the European
manufacturer for products are denominated in euros, the currency used in much of
Europe. However, when we sell our finished products to the Italian government,
the prices that we charge are denominated in United States dollars. Also, as of
March 31, 2004, the Company had debt relating to the acquisition of Challenge
Card Design Plastikkarten GmbH and cards & more GmbH, of Germany, in the amount
of 2.9 million euros. Accordingly, we are subject to exposure if the exchange
rate for euros increases in relation to the United States dollar. As of March
31, 2004, we had not entered into a forward exchange contract to hedge against
or potentially minimize the foreign currency exchange risk.
WE HAVE RECENTLY ACQUIRED TWO CARD COMPANIES LOCATED IN GERMANY AND MAY
ENCOUNTER DIFFICULTIES IN INTEGRATING THEM INTO OUR BUSINESS. We may encounter
unforeseen difficulties in managing Challenge Card Design GmbH and cards & more
GmbH, in which case we may not obtain some of the hoped-for benefits of these
acquisitions, such as expanded manufacturing capacity and establishment of a
significant European presence. Integration of these acquired companies