ANDREA ELECTRONICS CORP - Quarter Report: 2011 March (Form 10-Q)

ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

likely than not that some portion or all of the deferred tax assets will not be realized. Accordingly, and after considering changes in previously existing positive evidence, the Company reduced its valuation allowance to recognize a deferred tax asset of approximately $174,000 for the year ended December 31, 2010. In addition, Andrea expects it will reduce its valuation in future periods to the extent that it can demonstrate its ability to utilize the assets. Management makes judgments as to the interpretation of the tax laws that might be challenged upon an audit and cause changes to previous estimates of tax liability. In management’s opinion, adequate provisions for income taxes have been made for all years. If actual taxable income by tax jurisdiction varies from estimates, additional allowances or reversals of reserves may be necessary. Income tax expense consists of the tax payable for the period and the change during the period in deferred tax assets and liabilities. The Company has identified its federal tax return and its state tax return in New York as "major" tax jurisdictions. Based on the Company's evaluation, it has been concluded that there are no significant uncertain tax positions requiring recognition in the Company's condensed consolidated interim financial statements.  The Company's evaluation was performed for tax years ended 2007 through 2010. The Company believes that its income tax positions and deductions will be sustained on audit and does not anticipate any adjustments that will result in a material change to its financial position.

Stock-Based Compensation -At March 31, 2011, Andrea had two stock-based employee compensation plans, which are described more fully in Note 8. Andrea accounts for stock-based compensation in accordance with ASC 718, “Compensation – Stock Compensation” (“ASC 718”). ASC 718 establishes accounting for stock-based awards exchanged for employee services. Under the provisions of ASC 718, stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the equity grant). The fair value of the Company’s common stock options are estimated using the Black Scholes option-pricing model with the following assumptions: expected volatility, dividend rate, risk free interest rate and the expected life. The Company expenses stock-based compensation by using the straight-line method. In accordance with ASC 718, excess tax benefits realized from the exercise of stock-based awards are classified in cash flows from financing activities. The future realization of the reserved deferred tax assets related to these tax benefits associated with the exercise of stock options will result in a credit to additional paid in capital if the related tax deduction reduces taxes payable. The Company has elected the “with and without approach” regarding ordering of windfall tax benefits to determine whether the windfall tax benefit did reduce taxes payable in the current year.  Under this approach, the windfall tax benefit would be recognized in additional paid-in-capital only if an incremental tax benefit is realized after considering all other benefits presently available.

Use of Estimates

The preparation of condensed consolidated interim financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and disclosures of contingent assets and liabilities at the date of the condensed consolidated interim financial statements and the reported amounts of revenues and expenses during the reporting period.

Management bases its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. The most significant estimates, among other things, are used in accounting for allowances for bad debts, inventory valuation and obsolescence, product warranty, depreciation, deferred income taxes, expected realizable values for assets (primarily intangible assets), contingencies, revenue recognition as well as the recording and presentation of the Company’s convertible preferred stock. Estimates and assumptions are periodically reviewed and the effects of any material revisions are reflected in the condensed consolidated interim financial statements in the period that they are determined to be necessary. Actual results could differ from those estimates and assumptions.

Subsequent Events - The Company evaluates events that occurred after the balance sheet date but before the condensed consolidated interim financial statements are issued. Based upon the evaluation, the Company did not identify any recognized or non-recognized subsequent events that would have required adjustment or disclosure in the condensed consolidated interim financial statements.

Note 3.

Series C Redeemable Convertible Preferred Stock

On October 10, 2000, Andrea issued and sold in a private placement $7,500,000 of Series C Redeemable Convertible Preferred Stock (the “Series C Preferred Stock”). Each of these shares of Series C Preferred Stock had a stated value of $10,000 plus a $1,671 increase in the stated value, which sum is convertible into Common Stock at a conversion price of $0.2551. On February 17, 2004, Andrea announced that it had entered into an Exchange and Termination Agreement and an Acknowledgment and Waiver Agreement, which eliminated the dividend of 5% per annum on the stated value. The additional amount of $1,671 represents the 5% per annum from October 10, 2000 through February 17, 2004. The shares of Series C Preferred Stock are subject to antidilution provisions, which are triggered in the event of certain stock splits, recapitalizations, or other dilutive transactions.  In addition,

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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

issuances of common stock at a price below the conversion price then in effect (currently $0.2551), or the issuance of warrants, options, rights, or convertible securities which have an exercise price or conversion price less than that conversion price, other than for certain previously outstanding securities and certain “excluded securities” (as defined in the certificate of amendment), require the adjustment of the conversion price to that lower price at which shares of common stock have been issued or may be acquired. In the event that Andrea issues securities in the future which have a conversion price or exercise price which varies with the market price and the terms of such variable price are more favorable than the conversion price in the Series C Preferred Stock, the purchasers may elect to substitute the more favorable variable price when making conversions of the Series C Preferred Stock.

In accordance with Sub Topic 815-40, Andrea evaluated the Series C Preferred Stock and concluded that it is not indexed to the Company’s stock because of the conversion price adjustment feature described above. Accordingly, under the provisions of ASC 815, “Derivatives and Hedging” (“ASC 815”), Andrea evaluated the Series C Preferred Stock embedded conversion feature. The Company has concluded that the embedded conversion feature would be classified in shareholders’ equity if it were a freestanding instrument as the Series C Preferred Stock is more akin to equity and as such it should not be bifurcated from the Series C instrument and accounted for separately.

As of March 31, 2011, there were 44.231432 shares of Series C Preferred Stock outstanding, which were convertible into 2,023,658 shares of Common Stock and remaining accrued dividends of $73,921.

Note 4.

Series D Redeemable Convertible Preferred Stock

On February 17, 2004, Andrea entered into a Securities Purchase Agreement (including a Registration Rights Agreement) with certain holders of the Series C Preferred Stock and other investors (collectively, the “Buyers”) pursuant to which the Buyers agreed to invest a total of $2,500,000. In connection with this agreement, on February 23, 2004, the Buyers purchased, for a purchase price of $1,250,000, an aggregate of 1,250,000 shares of a new class of preferred stock, the Series D Preferred Stock, convertible into 5,000,000 shares of Common Stock (an effective conversion price of $0.25 per share) and Common Stock warrants exercisable for an aggregate of 2,500,000 shares of Common Stock. These warrants were exercisable at any time after August 17, 2004, at an exercise price of $0.38 per share. On February 23, 2009, these warrants expired without being exercised.

In addition, on June 4, 2004, the Buyers purchased for an additional $1,250,000, an additional 1,250,000 shares of Series D Preferred Stock convertible into 5,000,000 shares of Common Stock (an effective conversion price of $0.25 per share) and Common Stock warrants exercisable for an aggregate of 2,500,000 shares of Common Stock. The warrants were exercisable at any time after December 4, 2004 and before June 4, 2009 at an exercise price of $0.17 per share. On June 4, 2009, these warrants expired without being exercised.

The shares of Series D Preferred Stock are also subject to antidilution provisions, which are triggered in the event of certain stock splits, recapitalizations, or other dilutive transactions. In addition, issuances of common stock at a price below the conversion price then in effect (currently $0.25), or the issuance of warrants, options, rights, or convertible securities which have an exercise price or conversion price less than that conversion price, other than for certain previously outstanding securities and certain “excluded securities” (as defined in the certificate of amendment), require the adjustment of the conversion price to that lower price at which shares of common stock have been issued or may be acquired. In the event that Andrea issues securities in the future which have a conversion price or exercise price which varies with the market price and the terms of such variable price are more favorable than the conversion price in the Series D Preferred Stock, the purchasers may elect to substitute the more favorable variable price when making conversions of the Series D Preferred Stock. In addition, the Company is required to use its best efforts to secure the inclusion for quotation on the Over the Counter Bulletin Board for the common stock issuable under the Series D Preferred Stock and to arrange for at least two market makers to register with the Financial Industry Regulatory Authority. In the event that the holder of the Series D Preferred Stock and related warrants is unable to convert these securities into Andrea Common Stock, the Company shall pay to each such holder a Registration Delay Payment. This payment is to be paid in cash and is equal to the product of (i) the stated value of such Preferred Shares multiplied by (ii) the product of (1) .0005 multiplied by (2) the number of days that sales cannot be made pursuant to the Registration Statement (excluding any days during that may be considered grace periods as defined by the Registration Rights Agreement).

In accordance with Sub Topic 815-40, Andrea evaluated the Series D Preferred Stock and concluded that it is not considered to be indexed to the Company’s stock because of the conversion price adjustment feature described above. Accordingly, under the provisions of ASC 815, Andrea evaluated the Series D Preferred Stock embedded conversion feature. The Company has concluded that the embedded conversion feature would be classified in shareholders’ equity if it were a freestanding instrument as the Series D Preferred Stock is more akin to equity and as such it should not be bifurcated from the Series D instrument and accounted for separately.

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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Additionally, Andrea reviewed the Series D Preferred Stock warrants and concluded that they are considered to be indexed to the Company’s stock within the provisions of ASC 815-40 and were properly classified.

As of March 31, 2011, there were 907,144 shares of Series D Preferred Stock outstanding which were convertible into 3,628,576 shares of Common Stock.

Note 5.

Licensing Agreements

The Company has entered into various licensing, production and distribution agreements with manufacturers of PC and related components. These agreements provide for revenues based on the terms of each individual agreement. The Company's two largest licensing customers accounted for $298,008 and $53,835 of revenues for the three months ended March 31, 2011 and $383,199 and $40,528 of revenues for the three months ended March 31, 2010.

Note 6.

Long Term Debt

Long-term debt consists of the following:

				March 31, 2011				December 31, 2010
HSBC unsecured bank loan, dated December 9, 2009, is due in 60 monthly installments of $2,362 including principal and interest at 6.4%.				$	33,479			$	39,673
Less: Current Portion of Long-Term Debt					26,982				26,268
Long-Term Debt, net of Current Portion				$	6,497			$	13,405
As of March 31, 2011, maturities of long term debt are as follows:
April 1 , 2011 — March 31, 2012				$	26,982
April 1 , 2011 — March 31, 2013					6,497
Total				$	33,479

Note 7.

Commitments And Contingencies

Leases

Andrea leases its corporate headquarters located in Bohemia, New York. The lease from an unrelated party, which currently expires in April 2015, is for approximately 11,000 square feet and houses Andrea’s warehousing, sales and executive offices. Rent expense under this operating lease was approximately $22,367 and $21,715 for the three months ended March 31, 2011 and 2010, respectively.

As of March 31, 2011, the minimum annual future lease payments, under this lease and all other noncancellable operating leases, are as follows:

2011 (April 1 — December 31)				$	82,178
2012					105,728
2013					96,814
2014					99,718
2015					33,565
Total				$	418,003

Employment Agreements

In July 2010, the Company entered into an employment agreement with the President, Chief Executive Officer and Chairman of the Board, Douglas J. Andrea. The effective date of the employment agreement was August 1, 2010. The employment agreement expires July 31, 2012 and is subject to renewal as approved by the Compensation Committee of the Board of Directors. Pursuant to his employment agreement, Mr. Andrea will receive an annual base salary of $337,500 for the period of August 1, 2010 through

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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

July 31, 2011 and for the period of August 1, 2011 through July 31, 2012 Mr. Andrea will receive an annual base salary of $350,000. The employment agreement provides for quarterly bonuses equal to 25% of the Company’s pre-bonus net after tax quarterly earnings in excess of $25,000 for a total quarterly bonus amount not to exceed $12,500; and annual bonuses equal to 10% of the Company’s annual pre-bonus net after tax earnings in excess of $300,000. All bonuses shall be payable as soon as the Company's cash flow permits. All bonus determinations or any additional bonus in excess of the above will be made in the sole discretion of the Compensation Committee. On August 1, 2010, the Board granted Mr. Andrea 1,000,000 stock options with an aggregate fair value of $130,000 (fair value was estimated using the Black-Scholes option-pricing model). The 1,000,000 stock option grant vests in three equal annual installments over a three year period commencing August 1, 2011. These 1,000,000 stock options have an exercise price of $0.13 per share, which was the fair market value of the Company’s common stock at the date of grant, and a term of 10 years.  Pursuant to the employment agreement and subject to the approval of the Board of Directors, the Compensation Committee will recommend a second grant of 1,000,000 stock options as soon as practical after August 1, 2011, with an exercise price equal to the per share fair market value of the Company’s common stock on the date of grant. Mr. Andrea is also entitled to a change in control payment equal to two times his salary with continuation of health and medical benefits for two years in the event of a change in control, as defined in the agreement. At March 31, 2011, the future minimum cash commitments under this agreement aggregate $462,500.

In November 1999, as amended August 2008, the Company entered into a change in control agreement with the Chief Financial Officer, Corisa L. Guiffre. This agreement provides for a change in control payment equal to three times her average annual compensation for the five preceding taxable years, with continuation of health and medical benefits for three years in the event of a change in control of the Company, as defined in the agreement, and subsequent termination of employment other than for cause.

Legal Proceedings

Andrea is involved in routine litigation incidental to the normal course of business. While it is not feasible to predict or determine the final outcome of the claims, Andrea believes any resolution of these matters will not have a material adverse effect on Andrea’s consolidated financial position, results of operations or liquidity.

In addition, in December 2010, Audrey Edwards, Executrix of the Estate of Leon Leroy Edwards, filed a law suit in the Superior Court of Providence County, Rhode Island, against 3M Company and over 90 other defendants, including the Company, alleging that the Company processed, manufactured, designed, tested, packaged, distributed, marketed or sold asbestos containing products that contributed to the death of Leon Leroy Edwards. The Company received service of process in April 2011. The Company has retained legal counsel and has filed a response to the compliant.  The Company believes the lawsuit is without merit. Accordingly, the Company does not believe the lawsuit will have a material adverse effect on the Company’s financial position or results of operations.

Note 8.

Stock Plans and Stock Based Compensation

In 1998, the Board adopted the 1998 Stock Option Plan (“1998 Plan”), which was subsequently approved by the shareholders. The 1998 Plan, as amended, authorizes the granting of awards, the exercise of which would allow up to an aggregate of 6,375,000 shares of Andrea’s Common Stock to be acquired by the holders of those awards. The awards can take the form of stock options, stock appreciation rights, restricted stock, deferred stock, stock reload options or other stock-based awards. Awards may be granted to key employees, officers, directors and consultants.  No further awards will be granted under the 1998 Plan.

In October 2006, the Board adopted the Andrea Electronics Corporation 2006 Equity Compensation Plan (“2006 Plan”), which was subsequently approved by the shareholders. The 2006 Plan authorizes the granting of awards, the exercise of which would allow up to an aggregate of 10,000,000 shares of Andrea’s Common Stock to be acquired by the holders of those awards. On July 24, 2009, shareholders approved an amendment to the 2006 Plan to increase the number of shares issuable under the 2006 Plan to 18,000,000. The awards can take the form of stock options, stock appreciation rights, restricted stock or other stock-based awards. Awards may be granted to key employees, officers, directors and consultants. At March 31, 2011, there were 4,225,283 shares available for further issuance under the 2006 Plan.

The stock option awards granted under these plans have been granted with an exercise price equal to the market price of the Company’s stock at the date of grant; with vesting periods of up to four years and 10-year contractual terms.

The fair values of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model that uses weighted-average assumptions. Expected volatilities are based on implied volatilities from historical volatility of the Company’s stock. The expected term of options granted represents the period of time that options granted are expected to be outstanding. The

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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

There were no options granted during the three months ended March 31, 2011 and 2010.

Option activity during 2011 is summarized as follows:

					Options Outstanding														Options Exercisable
					Options Outstanding		Weighted Average Exercise Price				Weighted Average Fair Value				Weighted Average Remaining Contractual Life				Options Exercisable				Weighted Average Exercise Price				Weighted Average Fair Value				Weighted Average Remaining Contractual Life
At January 1, 2011					17,940,821		$  0.10				$  0.10				6.80 years				12,701,641				$  0.11				$  0.10				6.03 years
Expired					(55,000	)	$  1.78				$  1.37
Forfeitures					(11,347	)	$  0.06				$  0.06
At March 31, 2011					17,874,474		$  0.10				$  0.09				6.57 years				12,714,479				$  0.11				$  0.09				5.83 years

During the three months ended March 31, 2011, 79,185 options vested with a weighted average exercise price and a weighted average fair value of $0.09 per option. Based on the March 31, 2011 fair market value of the Company’s common stock of $0.07, the aggregate intrinsic value for the 17,874,474 options outstanding and 12,714,479 shares exercisable is $198,250 and $140,898, respectively.

Total compensation expense recognized related to stock option awards was $51,788 and $50,835 for the three months ended March 31, 2011 and 2010, respectively. In the accompanying condensed consolidated statement of operations for the three months ended March 31, 2011, $42,044 of expense is included in general, administrative and selling expenses, $6,966 is included in research and development expenses and $2,778 is included in cost of revenues. In the accompanying condensed consolidated statement of operations for the three months ended March 31, 2010, $37,920 of expense is included in general, administrative and selling expenses, $8,805 is included in research and development expenses and $4,110 is included in cost of revenues.  

As of March 31, 2011, there was $178,947 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the 1998 and 2006 Plans. This unrecognized compensation cost is expected to be recognized over the next three years ($105,220 in 2011, $59,041 in 2012 and $14,686 in 2013).

Note 9.

Segment Information

Andrea follows the provisions of ASC 280 “Segment Reporting” (“ASC 280”). Reportable operating segments are determined based on Andrea’s management approach. The management approach, as defined by ASC 280, is based on the way that the chief operating decision-maker organizes the segments within an enterprise for making operating decisions and assessing performance. While Andrea’s results of operations are primarily reviewed on a consolidated basis, the chief operating decision-maker also manages the enterprise in two segments: (i) Andrea DSP Microphone and Audio Software Products and (ii) Andrea Anti-Noise Products. Andrea DSP Microphone and Audio Software Products primarily include products based on the use of some, or all, of the following technologies: Andrea Digital Super Directional Array microphone technology (DSDA), Andrea Direction Finding and Tracking Array microphone technology (DFTA), Andrea PureAudio noise filtering technology, and Andrea EchoStop, an advanced acoustic echo cancellation technology. Andrea Anti-Noise Products include noise cancellation and active noise cancellation computer headset products and related computer peripheral products.

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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The following represents selected condensed consolidated financial information for Andrea’s segments for the three-month periods ended March 31, 2011 and 2010.

2011 Three Month Segment Data				Andrea DSP Microphone and Audio Software Products				Andrea Anti- Noise Products				2011 Three Month Segment Data
Net revenues from external customers				$	77,786			$	524,420			$	602,206
License Revenues					396,807				—				396,807
Income (loss) from operations					63,625				(197,613	)			(133,988	)
Depreciation and amortization					119,133				13,704				132,837
Purchases of property and equipments					6,631				3,149				9,780
Purchases of patents and trademarks					9,969				53				10,022
Assets					3,325,881				2,151,379				5,477,260
Property and equipment and intangibles					1,490,776				294,079				1,784,855
2010 Three Month Segment Data				Andrea DSP Microphone and Audio Software Products				Andrea Anti- Noise Products				2010 Three Month Segment Data
Net revenues from external customers				$	204,434			$	604,554			$	808,988
License Revenues					433,252				—				433,252
Income (loss) from operations					152,854				(167,518	)			(14,664	)
Depreciation and amortization					117,486				18,568				136,054
Capital expenditures					9,019				17,227				26,246
Purchases of patents and trademarks					—				151				151
December 31, 2010 Year End Segment Data				Andrea DSP Microphone and Audio Software Products				Andrea Anti- Noise Products				2010 Year End Segment Data
Assets				$	3,635,905			$	2,151,748			$	5,787,653
Property and equipment and intangibles					1,593,309				304,581				1,897,890

Management assesses non-operating income statement data on a consolidated basis only. International revenues are based on the country in which the end-user is located. For the three-month periods ended March 31, 2011 and 2010, and as of each respective period-end, net revenues and accounts receivable by geographic area were as follows:

Geographic Data				March 31, 2011				March 31, 2010
Net revenues:
United States				$	833,214			$	1,096,698
Foreign(1)					165,799				145,542
				$	999,013			$	1,242,240

(1)

Net revenues to any one foreign country did not exceed 10% of total net revenues for the three months ended March 31, 2011 and March 31, 2010.

As of March 31, 2011 and December 31, 2010, accounts receivable by geographic area were as follows:

Geographic Data				March 31, 2011				December 31, 2010
Accounts receivable:
United States				$	553,998			$	427,552
Foreign(1)					83,613				77,580
				$	637,611			$	505,132

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Our mission is to provide the emerging “voice interface” markets with state-of-the-art communications products that facilitate natural language, human/machine interfaces.

Examples of the applications and interfaces for which Andrea DSP Microphone and Audio Software Products and Andrea Anti-Noise Products provide benefits include: Internet and other computer-based speech; telephony communications; multi-point conferencing; speech recognition; multimedia; multi-player Internet and CD ROM interactive games; and other applications and interfaces that incorporate natural language processing. We believe that end users of these applications and interfaces will require high quality microphone and earphone products that enhance voice transmission, particularly in noisy environments, for use with personal computers, mobile personal computing devices, cellular and other wireless communication devices and automotive communication systems. Our Andrea DSP Microphone and Audio Software Products use “far-field” digital signal processing technology to provide high quality transmission of voice where the user is at a distance from the microphone. High quality audio communication technologies will be required for emerging far-field voice applications, ranging from continuous speech dictation, to Internet telephony and multiparty video teleconferencing and collaboration, to natural language-driven interfaces for automobiles, home and office automation and other machines and devices into which voice-controlled microprocessors are expected to be introduced during the next several years.

 

Our Critical Accounting Policies

Our unaudited condensed consolidated interim financial statements and the notes to our unaudited condensed consolidated interim financial statements contain information that is pertinent to management's discussion and analysis. The preparation of unaudited condensed consolidated interim financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. On a continual basis, management reviews its estimates utilizing currently available information, changes in facts and circumstances, historical experience and reasonable assumptions. After such reviews, and if deemed appropriate, those estimates are adjusted accordingly. Actual results may vary from these estimates and assumptions under different and/or future circumstances. Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2010. A discussion of our critical accounting policies and estimates are included in Management’s Discussion and Analysis or Plan of Operation in our Annual Report on Form 10-K for the year ended December 31, 2010. Management has discussed the development and selection of these policies with the Audit Committee of the Company’s Board of Directors, and the Audit Committee of the Board of Directors has reviewed the Company’s disclosures of these policies. There have been no material changes to the critical accounting policies or estimates reported in the Management’s Discussion and Analysis section of the Annual Report on Form 10-K for the year ended December 31, 2010.

Cautionary Statement Regarding Forward-Looking Statements

This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of the Company. These forward-looking statements are generally identified by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project” or similar expressions. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in economic, competitive, governmental, technological and other factors that may affect our business and prospects. Additional factors are discussed below under “Risk Factors” and in Part I, “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

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Risk Factors

Our operating results are subject to significant fluctuation, period-to-period comparisons of our operating results may not necessarily be meaningful and you should not rely on them as indications of our future performance.

Our results of operations have historically been and are subject to continued substantial annual and quarterly fluctuations. The causes of these fluctuations include, among other things:

 

–

the volume of sales of our products under our collaborative marketing arrangements;

–

the cost of development of our products;

–

the mix of products we sell;

–

the mix of distribution channels we use;

–

the timing of our new product releases and those of our competitors;

–

fluctuations in the computer and communications hardware and software marketplace; and

–

general economic conditions.

 

We cannot assure that the level of revenues and gross profit, if any, that we achieve in any particular fiscal period will not be significantly lower than in other fiscal periods. Our net revenues for the three months ended March 31, 2011 were $999,013 compared to $1,242,240 for the three months ended March 31, 2010. Net loss for the three months ended March 31, 2011 was $137,623, or $0.00 per share on a basic and diluted basis, and $21,143, or $0.00 per share on a basic and diluted basis for the three months ended March 31, 2010. We continue to explore opportunities to grow sales in other business areas; we are also examining additional opportunities for cost reduction, production efficiencies and further diversification of our business.

Shares Eligible For Future Sale May Have An Adverse Effect On Market Price and Andrea Shareholders May Experience Substantial Dilution.

Sales of a substantial number of shares of our common stock in the public market could have the effect of depressing the prevailing market price of our common stock. Of the 200,000,000 shares of common stock presently authorized, 63,721,035 were outstanding as of May 11, 2011. The number of shares outstanding does not include an aggregate of 27,751,991 shares of common stock that are issuable. This number of issuable common shares is equal to approximately 44% of the 63,721,035 outstanding shares. These issuable common shares are comprised of: a) 17,874,474 shares of our common stock reserved for issuance upon exercise of outstanding awards granted under our 1998 Stock Plan and 2006 Stock Plan; b) 4,225,283 shares reserved for future grants under our 2006 Stock Plan; c) 2,023,658 shares of common stock that are issuable upon conversion of the Series C Preferred Stock; and d) 3,628,576 shares of common stock issuable upon conversion of the Series D Preferred Stock.

In addition to the risk factors set forth above and the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition or future results. The risks described in this report and in our Annual Report on Form 10-K are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

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Results Of Operations

Three Months ended March 31, 2011 compared to Three Months ended March 31, 2010

Net Revenues

				For the Three Months Ended March 31,
				2011				2010				% Change
Andrea Anti-Noise Products net Product revenues
Sales of products to OEM customers for use with educational software				$	68,273			$	44,817				52				(a)
All other Andrea Anti-Noise net product revenues					456,147				559,737				(19	)			(b)
Total Andrea Anti-Noise Products net Product revenues				$	524,420			$	604,554				(13	)
Andrea DSP Microphone and Audio Software Products revenues
Sales of automotive array microphone products					14,789				167,742				(91	)			(c)
All other Andrea DSP Microphone and Audio product revenues					62,997				36,692				72				(d)
License revenues					396,807				433,252				(8	)			(e)
Total Andrea DSP Microphone and Audio Software Products revenues					474,593				637,686				(26	)
Total Revenues				$	999,013			$	1,242,240				(20	)

(a)

This increase of approximately $24,000 represents increased product sales to our educational customers for use with their distance learning products as compared to the three months ended March 31, 2010. We believe that this increase in product sales relates to the timing of the customers purchases.

(b)

The decrease of approximately $104,000 in all other Andrea Anti-noise product revenues is related to decreased demand from corporate distance learning customers. Approximately $30,000 of this decrease relates to a decrease in sales as a result of one of our customers changing to distance learning utilizing telephones instead of VoIP. The remaining decrease of approximately $74,000 relates to decreased demand when compared to the same period in 2010.

(c)

The approximate $153,000 decrease in sales of automotive array microphone products is primarily the result of decreased product sales to integrators of public safety vehicle solutions. The decrease is related to our fulfillment of a contract in 2010.

(d)

The approximate $26,000 increase in all other Andrea DSP Microphone and Audio product revenues is related to timing of shipments to some of our OEM customers.

(e)

The 8% decrease in license revenues is a result of decreased royalties reported for the three months ended March 31, 2011 as compared to the same period last year. We believe this decrease is related to timing of revenues reported of PC models which feature our technology.

Cost of Revenues

Cost of revenues as a percentage of net revenues for the three months ended March 31, 2011 decreased to 33% from 36% for the three months ended March 31, 2010. The cost of revenues as a percentage of net revenues for the three months ended March 31, 2011 for Andrea Anti-Noise Products was 59% compared to 56% for the three months ended March 31, 2010. The cost of revenues as a percentage of net revenues for the three months ended March 31, 2011 for the Andrea DSP Microphone and Audio Software Products was 5% compared to 17% for the three months ended March 31, 2010.  The increase in cost of revenues as a percentage of sales for the Andrea Anti-Noise Products for the three months ended March 31, 2011 was a result of a decrease in revenues related to this segment. The decrease in cost of revenues as a percentage of sales for Andrea DSP Microphone and Audio Software Products for the three months ended March 31, 2011 was a result of the decreased revenues of automotive array products.

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Research and Development

Research and development expenses for the three months ended March 31, 2011 increased 21% to $208,312 from $171,655 for the three months ended March 31, 2010. For the three months ended March 31, 2011, the increase in research and development expenses reflects a 29% increase in our Andrea DSP Microphone and Audio Software Technology efforts to $122,090, or 59% of total research and development expenses, and a 12% increase in our Andrea Anti-Noise Headset Product efforts to $86,222, or 41% of total research and development expenses. These increases are related to ongoing development of new products. With respect to DSP Microphone and Audio Software technologies, research efforts are primarily focused on the pursuit of commercializing a natural language-driven human/machine interface by developing optimal far-field microphone solutions for various voice-driven interfaces, incorporating Andrea’s digital super directional array microphone technology, and certain other related technologies such as noise suppression and stereo acoustic echo cancellation. We believe that continued research and development spending should provide Andrea with a competitive advantage.

General, Administrative and Selling Expenses

General, administrative and selling expenses decreased approximately 7% to $591,522 for the three months ended March 31, 2011 from $638,265 for the three months ended March 31, 2010. For the three months ended March 31, 2011, the decrease reflects a 5% decrease in our Andrea DSP Microphone and Audio Software Technology efforts to $267,370, or 45% of total general, administrative and selling expenses and a 10% decrease in our Andrea Anti-Noise Headset Product efforts to $324,152, or 55% of total general, administrative and selling expenses. These decreases are the result of decreased professional and legal expenses during the three months ended March 31, 2011 as compared to same period in 2010.

Interest Income, net

Interest income, net for the three months ended March 31, 2011 was $1,701 compared to $1,806 for the three months ended March 31, 2010. The year to date decrease in interest income, net was the result of less net interest income.

Provision for Income Taxes

The provision for income taxes for the three months ended March 31, 2011 was $5,336 compared to a provision for income taxes of $8,285 for the three months ended March 31, 2010. The decrease was a result of decreased estimated taxable income.

Net loss

Net loss for the three months ended March 31, 2011 was $137,623 compared to net loss of $21,143 for the three months ended March 31, 2010. The net loss for the three months ended March 31, 2011 and March 31, 2010 principally reflects the factors described above.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Liquidity And Capital Resources

Andrea’s principal sources of funds are and are expected to continue to be gross cash flows from operations.  At March 31, 2011, we had cash of $1,978,681 compared with $2,220,994 at December 31, 2010. The decrease in our cash balance at March 31, 2011 was primarily a result of our cash used in operations.

Our working capital balance at March 31, 2011 was $3,059,600 compared to working capital of $3,039,308 at December 31, 2010. The increase in working capital reflects a decrease in total current assets of $197,358 and a decrease in total current liabilities of $217,650. The decrease in total current assets reflects a decrease in cash of $242,313, an increase in accounts receivable of $132,479, a decrease in inventory of $85,819, a decrease in deferred income tax assets of $5,291, and an increase in prepaid expenses of $3,586. The decrease in total current liabilities reflects a decrease in trade accounts payable of $164,580, an increase in the current portion in long-term debt of $714, and a decrease of $53,784 in other current liabilities.

The decrease in cash of $242,313 reflects $216,317 of net cash used in operating activities, $19,802 of net cash used in investing activities and $6,194 of cash used in financing activities.

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The cash used in operating activities of $216,317, excluding non-cash charges for the three months ended March 31, 2011, was attributable to a $133,172 increase in accounts receivable, a $97,655 decrease in inventories, a $3,586 increase in prepaid expenses and other current assets, a $164,580 decrease in accounts payable, and a $53,784 decrease in other current liabilities. The changes in receivables, inventory, prepaid expenses and accounts payable primarily reflect differences in the timing related to both the payments for and the acquisition of inventory as well as for other services in connection with ongoing efforts related to Andrea’s various product lines.

The cash used in investing activities of $19,802 reflects purchases of property and equipment of $9,780 and an increase in patents and trademarks of $10,022. The increase in property and equipment reflects capital expenditures associated with information technology purchases including and, to a lesser extent, molds associated with our Andrea Anti-Noise Headset Products. The increase in patents and trademarks reflects capital expenditures associated with our intellectual property.

 

The cash used in financing activities of $6,194, reflects repayments on our loan from HSBC. We obtained this loan to finance a significant upgrade to our information technologies systems.

We plan to improve our cash flows in 2011 by aggressively pursuing additional licensing opportunities related to our Andrea DSP Audio Software and increasing the sales of our Andrea Anti-Noise Headset Products through the introduction of new products as well as the increased efforts we are putting into our sales and marketing efforts. However, there can be no assurance that we will be able to successfully execute the aforementioned plans. As of May 11, 2011, Andrea has approximately $2,200,000 of cash deposits. We believe that we have sufficient liquidity available to continue in operation through at least March 2012. To the extent that we do not generate sufficient cash flows from our operations in the next twelve months, additional financing might be required. Although we have improved cash flows by reducing overall expenses, if our revenues decline, these reductions may impede our ability to be cash flow positive and our net income or loss may be disproportionately affected. We have no commitment for additional financing and may experience difficulty in obtaining additional financing on favorable terms, if at all. Any financing we obtain may contain covenants that restrict our freedom to operate our business or may have rights, preferences or privileges senior to our common stock and may dilute our current shareholders’ ownership interest in Andrea. We cannot assure that demand will continue for any of our products, including future products related to our Andrea DSP Microphone and Audio Software technologies, or, that if such demand does exist, that we will be able to obtain the necessary working capital to increase production and provide marketing resources to meet such demand on favorable terms, or at all.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 4.

CONTROLS AND PROCEDURES

Andrea’s management, including its principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, Andrea’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that it files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to Andrea’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that all control issues and instances of fraud, if any, within a company have been detected. Andrea’s disclosure controls and procedures are designed to provide reasonable assurance of achieving its objectives.

There have been no changes in the Company’s internal controls over financial reporting that have materially affected, or are reasonable likely to materially affect the Company’s internal controls over financial reporting during the period covered by this Quarterly Report.

PART II

OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

Andrea is involved in routine litigation incidental to the normal course of business. While it is not feasible to predict or determine the final outcome of the claims, Andrea believes any resolution of these matters will not have a material adverse effect on Andrea’s consolidated financial position, results of operations or liquidity.

In addition, in December 2010, Audrey Edwards, Executrix of the Estate of Leon Leroy Edwards, filed a law suit in the Superior Court of Providence County, Rhode Island, against 3M Company and over 90 other defendants, including the Company, alleging

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that the Company processed, manufactured, designed, tested, packaged, distributed, marketed or sold asbestos containing products that contributed to the death of Leon Leroy Edwards. The Company received service of process in April 2011.  The Company has retained legal counsel and has filed a response to the compliant. The Company believes the lawsuit is without merit.  Accordingly, the Company does not believe the lawsuit will have a material adverse effect on the Company’s financial position or results of operations.

ITEM 1A.

RISK FACTORS

Not applicable.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITY AND USE OF PROCEEDS

None.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.

(REMOVED AND RESERVED)

ITEM 5.

OTHER INFORMATION

None.

ITEM 6.

EXHIBITS

a)

Exhibits

Exhibit 31 – Rule 13a-14(a)/15d-14(a) Certifications*

Exhibit 32 – Section 1350 Certifications*

* Filed herewith

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

ANDREA ELECTRONICS CORPORATION
By:	/s/   DOUGLAS J. ANDREA
	Name: Douglas J. Andrea
	Title: Chairman of the Board, President, Chief Executive Officer and Corporate Secretary

Date: May 13, 2011
/s/   DOUGLAS J. ANDREA	Chairman of the Board, President, Chief	May 13, 2011
Douglas J. Andrea	Executive Officer and Corporate Secretary
/s/   CORISA L. GUIFFRE	Vice President, Chief Financial Officer and	May 13, 2011
Corisa L. Guiffre	Assistant Corporate Secretary

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