UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

(Mark one)

 

 

SPHERIX INCORPORATED

(Exact name of Registrant as specified in its Charter)

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o 
No  ý

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes  o
No ý

 

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.  Yes  ý  No  o

 

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.  ý

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer
(as defined in Rule 12b-2 of the Act). 
Large Accelerated Filer o  Accelerated Filer o  Non-accelerated Filer ý

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o 
No ý

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter (for purposes of this determination, only our Directors and Executive Officers have been deemed affiliates):

 

Common Stock (Par Value $.005) – $16,092,004

 

There were 13,578,356 shares of the Registrant’s Common Stock outstanding as of March 10, 2006.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Spherix Incorporated definitive Proxy Statement, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934 not later than 120 days after the end of the fiscal year to which this report relates, are incorporated by reference into Part III of this Form 10-K.

 

 

PART I

 

Certain statements contained in this Form 10-K, including without limitation, statements containing the words “believes,” “estimates,” “expects” and words of similar import, constitute “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  Such words and expressions are intended to identify such forward looking statements, but are not intended to constitute the exclusive means of identifying such statements.  Such forward looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward looking statements.  Given these uncertainties, prospective investors are cautioned not to place undue reliance on such forward looking statements.  The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward looking statements contained herein to reflect any events or developments.  See the Company’s Form 8-K filing dated March 26, 1999, for a more detailed statement concerning forward looking statements.

 

Item 1.  DESCRIPTION OF BUSINESS

 

General

 

Spherix Incorporated (the “Company” or “Registrant”), a Delaware corporation, was founded in 1967.  The Company consists of a biotechnology division (“BioSpherix”) and an information services division (“InfoSpherix”).  At the May 2005 annual meeting shareholders approved the establishment of InfoSpherix as a wholly-owned subsidiary of Spherix, which took effect January 2006.

 

The principal executive offices of the Company are located at 12051 Indian Creek Court, Beltsville, Maryland 20705, and its telephone number is (301) 419-3900.  The Company’s Common Stock trades on the NASDAQ National Market System under the symbol SPEX.

 

Available Information

 

Our principal Internet address is www.spherix.com.  We make available free of charge on www.spherix.com our annual, quarterly and current reports, and amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (“SEC”).

 

BioSpherix Division

 

The BioSpherix Division is located at 304A Harry S. Truman Parkway, Annapolis, MD 21401, and its telephone number is 1-877-SPHERIX.  This division is the Company’s biotechnology research and development arm, dedicated to developing proprietary products with a view toward commercial applications.  The Company has accumulated a number of patents on the products and processes developed by the BioSpherix Division.

 

Tagatose as a Low-Calorie, Full-Bulk Sweetener.  Spherix has patented the use of a naturally occurring sugar, tagatose, as a low-calorie, full-bulk sweetener.  It is a true sugar that looks, feels, and tastes like table sugar.  Tagatose occurs in nature in amounts too small for economic recovery.  The Company has developed and patented an economic method for making tagatose from whey or lactose.  Whey is a waste product from cheese manufacturing.

 

The Firm has been developing its sweetener since receiving a U.S. patent for its use and manufacture as a low-calorie sweetener in 1988, which patent expires August 29, 2006.  Tagatose has also been found to be a pre-biotic, a substance that improves the digestion of food and is beneficial to health.  Pre-biotics are widely sold in Europe and Asia and are increasingly appearing in the U.S.  The Company received two U.S. patents for its tagatose production process in 1991 and 1992, which expire July 19, 2009, and March 25, 2011, respectively.  It has received a number of foreign patents corresponding to these three and other U.S. patents.  These countries include Canada and Japan, both large potential markets.

 

In January 1997, the Company completed a license agreement with Arla Foods Ingredients amba (“Arla”) (formerly MD Foods Ingredients amba, “MDFI”) of Denmark for the exclusive worldwide rights to manufacture, market, and distribute tagatose as a food and beverage ingredient in return for a non-refundable up-front payment and fees on net sales of the sugar for these purposes.  Arla manufactures a wide variety of dairy products, foods and food

 

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ingredients; it ranks as one of the largest dairy products manufacturers in the world.  Arla operates cheese plants producing large amounts of whey as a by-product.  The License Agreement and an amendment thereto provide Arla the exclusive, world-wide right to manufacture and sell tagatose for food uses, and the exclusive right to manufacture tagatose for all uses.  Spherix retains all rights to sell tagatose for drug use, and use in drugs, including rights to the use of tagatose as a sweetener or other functional ingredient in drugs and cosmetics such as toothpaste, cough syrup, fiber laxative, and mouthwash.  To distinguish these non-food uses from the licensed food uses, Spherix has coined the name Naturlose®.  A supply agreement with Arla provides for the amount of Naturlose required by Spherix.

 

A panel of experts retained by Arla declared tagatose as Generally Recognized As Safe (“GRAS”) on April 11, 2001, permitting sale of tagatose as a food ingredient in the U.S.  The U.S. Food and Drug Administration (“FDA”) issued a “no objection” letter on October 25, 2001.  Tagatose was recommended by the Joint FAO/WHO Expert Committee on Food Additives (JECFA) panel in June 2001 to its many member countries for use in foods, and in June 2004, JECFA removed its former limit on daily consumption of tagatose.  In 2003, approval was obtained in South Korea.  In April 2004, tagatose was approved by the Food Standards Australia New Zealand (“FSANZ”), the food health and safety agency for Australia and New Zealand.  In December 2005, tagatose was approved in the European Union.  Arla has begun the approval process for tagatose in Canada, Japan and Mexico.

 

The U.S. FDA approved Arla’s recommended caloric value of 1.5 kilocalories per gram, permitting labeling of products containing it as “reduced calorie” in the U.S.  At Spherix’s request, the right to request a smaller reduced calorie rating in the future has been reserved.  Spherix believes that test data support a lower value.

 

In 2002, Arla formed a 50/50 joint venture with Nordzucker, a German sugar producer, for the manufacture and sale of tagatose.  Production from the joint venture factory, capable of producing 1,200 metric tons per year, permitted sales of tagatose to the U.S. sweetener market to begin in 2003 when the 7-Eleven chain introduced Diet Pepsi Slurpees containing tagatose.  At present Arla believes it has produced a sufficient backlog of inventory to satisfy its needs for the foreseeable future based on current demand, and accordingly has stopped production at its pilot plant until there is a sufficient increase in the demand for tagatose.  Arla is currently having discussions with potential users and Arla has stated that, if they can create enough market interest, production will be resumed and/or a larger tagatose plant will be established.  Spherix is also pursing the possibility of other production options, including recovering its technology from Arla either directly or through a third party.

 

Potential food and beverage markets for tagatose include confections, ice cream, frozen desserts, diet sodas, cereals, frosting, chocolate candy, baked goods, heat-processed foods, other dairy products, and other products in which the full bulk of sugar is required.  Tagatose may also be used in prebiotics, healthy drinks and foods, and dietary supplements.  Manufacturers have long sought a low-calorie, full-bulk substitute for table sugar; however, none has been as successful in emulating the flavor of table sugar as has tagatose.  Unlike table sugar, tagatose has been shown to cause no tooth decay, and has now won FDA approval to carry the label “does not cause tooth decay”, or “noncariogenic.”  An unexpected market for tagatose was opened up in the soft drink industry by the discovery that tagatose is synergistic with the high intensity sweeteners used in diet sodas, thereby improving the taste and mouthfeel of diet sodas.  To promote greater market interest in tagatose by food and beverage manufacturers, Arla teamed with Symrise in 2004, one of the world’s top producers of flavors and fragrances, in developing new flavor blends using tagatose.

 

In 2002, Spherix filed a Notice of Arbitration against Arla under the terms of its License Agreement with that firm, contending that it had suffered from Arla’s slow progress in bringing tagatose to market.  On November 13, 2003, the Company settled its arbitration and entered into an Amendment to the September 27, 1996 License Agreement with Arla.  The amendment extended the period under which the high-end fees on the commercial sales of tagatose are due the Company until at least March 25, 2011, and until August 25, 2016, subject to certain conditions.  In turn, the Company relinquished its rights to raise any additional delay claims against Arla.  Arla agreed to give up its right to deduct the $1 million prepayment against future royalties payable to the Company.  Arla was granted the exclusive worldwide rights to manufacture tagatose for any type of product or purpose.  Most importantly, Arla agreed to supply tagatose to Spherix for Spherix’s use in the non-food and drug markets.

 

In the year 2000, the Company achieved GRAS status for the use of Naturlose as a sweetener (excipient) in drugs for non-chronic use by adults and children.  Also in the year 2000, the Company achieved GRAS status for the uses of Naturlose in toothpaste, mouthwash, lipstick and other cosmetic products.

 

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Spherix has patented the use of Naturlose in treating Type 2 diabetes, and for other uses in health and medicine as outlined below:

 

Treatment for Type 2 Diabetes.  Phase 1 and Phase 2 clinical trials at the University of Maryland School of Medicine have found tagatose effective as an adjuvant treatment of Type 2 diabetes in humans.  In addition, over the one-year trial, all subjects lost weight at physician-approved rates along with a significant increase in the desirable type of cholesterol, HDL.  Other than for initial laxation at high doses (45 to 75 grams per capita per day), accommodated in about two weeks, no untoward effects were found in any of the research.  In addition, the studies found that tagatose produced no rise in blood glucose or insulin levels in diabetic or normal subjects.  Tagatose taken before the consumption of glucose produced a blunting effect on the otherwise normally expected rise in blood glucose.

 

On November 4, 2005, following review of pharmacological, toxicological, and efficacy data from Spherix’s completed Phase 1 and 2 clinical trials, the U.S. FDA’s Center for Drug Evaluation and Research found tagatose to be qualified for Phase 3 clinical trials.  Patient recruitment for the clinical trials is expected to begin in 2006.  The trials could last as little as two years.  More than 200 subjects, representing the demographic mix in the U.S., will receive oral doses of Naturlose to test its ability to treat Type 2 diabetes.  A Phase 3 clinical trial, which gathers evidence regarding effectiveness and safety, is needed to evaluate the overall benefit-risk relationship of new drugs proposed to the FDA.  Because Naturlose has already been established as a substance “Generally Recognized as Safe” under FDA regulations, Spherix believes the elapsed time to approval should be shorter than that for most new drugs.  A successful Phase 3 trial would permit Spherix to file a New Drug Application with the FDA, the approval of which would be the final step before marketing Naturlose as a diabetes-fighting pharmaceutical.  The FDA generally decides on such applications within one year.

 

Anti-hyperglycemic Agent.  Tagatose functions as an anti-hyperglycemic agent to prevent the formation of advanced glycosylation end-products, which is one of the major causes of aging.

 

Increasing the shelf life of stored blood, platelets and medicinal proteins.  The Company has been funding a research project at the Albert Einstein College of Medicine (AECOM) to develop the use of Naturlose to preserve hemoglobin and other blood components, including platelets and various medicinal proteins.  Under a license agreement, Spherix obtained the rights to Naturlose-containing products and processes under development at AECOM.  Spherix will pay royalties to AECOM on sales of any forthcoming patented products or processes.

 

Anti-plaque Agent:  In 2005, the Company contracted with the University of Maryland School of Dentistry to conduct human clinical trials on the oral anti-plaque efficacy of Naturlose.  The study demonstrated tagatose to be much more resistant to oral bacteria, which form plaque, than is sorbitol, a sugar substitute that is widely used in oral care products.  The study suggested ways of modifying the Naturlose product to effect desired plaque reduction.  Such modifications have been made, and a clinical trial of a Naturlose toothpaste at the University of Maryland School of Dentistry will begin in 2006 to test the effects against oral plaque and gingivitis.

 

Anemia and Hemophilia Treatment.  Naturlose has been shown to improve blood factors indicating that tagatose may be useful as a drug or drug adjuvant in the treatment of anemia and hemophilia.

 

Increased Fertility and Improved Fetal Development Drug.  Naturlose may increase the fertility of humans and other animals, to effect higher percentages of live fetuses, and to cause those fetuses to be heavier, but within normal bounds, than those of human or animal controls.

 

Preservative of Human Organs.  Naturlose has shown potential for use in the transplanting and storage of human organs to protect against cyto-oxidation and toxic chemicals.

 

The drug uses mentioned above require regulatory approval before they can be brought to market.

 

Capital for Development.  While the products under development show promise, continued progress is dependent upon many factors, including, but not limited to, the Company’s having sufficient funds and resources to pursue them.  Over its history, the Company has supported its research and development in part by using funds generated by its InfoSpherix Division; however, given the lower margin on government business, the capital needs of InfoSpherix, and bank covenants restrictions, the InfoSpherix Division may not be able to support all of the activities of the BioSpherix Division.  Funds have also been raised from private placements of Company stock and warrants, some of the proceeds of which have been used to increase the state of development, market penetration and sales of the

 

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products mentioned above.  Spherix believes it has sufficient funds to complete most, if not all, of the Phase 3 clinical trial of Naturlose as a drug against Type 2 diabetes.  If needed, the Company will seek additional funding through additional sales of stock or partnering with another Company.  In order to fully develop, manufacture, distribute and sell Naturlose for this purpose, the Company is seeking a relationship with a major pharmaceutical company.

 

BioSpherix revenue accounted for less than 1% of the Company’s total revenue in 2005.

 

InfoSpherix Division

 

InfoSpherix professionals design and operate contact centers providing information management and materials to the public on various socially beneficial subjects, as well as other information services, such as reservations and tourism.  InfoSpherix focuses on those clients who are looking to leverage technology in the ever-advancing world of information management.  InfoSpherix researches, collects, organizes and disseminates information by providing customized contact center services combining advanced data collection systems, expert decision support systems, tele-support utilizing live operators, and advanced telecommunication technologies such as Interactive Voice Response (“IVR”).  InfoSpherix answers millions of calls annually from professionals and the public nationwide.  It operates a contact center in Cumberland, Maryland and a second contact center in Rapid City, South Dakota. The South Dakota contact center will be relocating to Indiana in 2006.  All contact centers efficiently manage and track high volumes of data.  Coupling InfoSpherix’s expert staff with its advanced technologies results in an effective system to collect and disseminate large amounts of information.  The Company also provides reservation services for campgrounds and other parks via its ReserveWorld business line.  Since 1998, InfoSpherix has grown its government park reservation business from one contract to seventeen government reservation contracts, and six new state reservation contracts will be available for InfoSpherix to bid on in 2006.  InfoSpherix’s reservation business accounted for over 60% of the Company’s revenue in 2005.  InfoSpherix is now one of only two major companies in this market.

 

In 2005, Spherix won park reservation contracts for Orange County, California, the State of Pennsylvania, and the State of Michigan.  The Orange County contract consists of three base years and is valued at less than half a million.  The State of Pennsylvania contract is a five-year contract, consisting of one base year and four option years, valued at approximately $8 million.  The State of Michigan contract is a continuation of our current contract with the State.  The new contract is for five years, and consists of three base years plus two option years, valued at approximately $14 million.

 

In July 2005, Spherix filed an official protest of the U.S. Department of Agriculture’s award of the National Recreation Reservation System (“NRRS”) contract to ReserveAmerica, a TicketMaster subsidiary.  The NRRS will provide reservation services for all Federal recreation facilities, including the National Park sites currently serviced by Spherix under its ongoing National Park Reservation Service (“NPRS”) contract with the Department of Interior.  On October 20, 2005, the Government Accountability Office (“GAO”) sustained Spherix’s challenge to the USDA Forest Service award and recommended that the Department of Agriculture reopen the competition and make a new award decision.  This is the second time that GAO has found the Forest Service’s attempt to award the NRRS contract to ReserveAmerica to be flawed.  The Department of Agriculture subsequently decided not to follow GAO’s decision and is seeking to proceed with the award of the NRRS contract to ReserveAmerica.  The Department of Agriculture has agreed not to proceed while the Court of Federal Claims hears Spherix’s appeal.  Meanwhile, the Company’s NPRS contract has been formally extended through September 30, 2006.  The Company has operated the NPRS contract for eight years; revenue from such contract was $4.0 million and $3.9 million for the years ended December 31, 2005 and 2004, respectively, or 17% of total revenue for each year.

 

InfoSpherix accounted for substantially all of the Company’s revenue in 2005.  Most of InfoSpherix’s revenues traditionally have been generated by a few large government contracts.  See Note 1, “Concentrations,” of the Notes to the Financial Statements included herein pursuant to Part II of this Form 10-K.

 

In January 2006, the InfoSpherix business started operating as a wholly-owned subsidiary of Spherix Incorporated under the name “InfoSpherix Incorporated.”

 

Government Contracts

 

See Note 10, “Commitment and Contingencies – Government Contracts,” of the Notes to the Financial Statements included herein pursuant to Part II, Item 8 of this Form 10-K, which information is incorporated herein by reference.

 

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Government contracts typically have terms and conditions which, while providing annual or multi-year terms, subject them to termination upon convenience or default.

 

Industry Segments

 

See Note 13, “Information by Business Segment,” of the Notes to the Financial Statements included herein pursuant to Part II, Item 8 of this Form 10-K for industry segment information of the Company, which information is incorporated herein by reference.

 

Market Concentration

 

During 2005, 2004, and 2003, InfoSpherix contributed 100%, 99%, and 94% of total Company revenue.  The Company’s business operations are usually dependent upon substantial revenue from a select group of customers.  In 2005, 2004, and 2003, revenue from the U.S. Government, the State of Michigan and the State of Maryland each accounted for more than 10% of total Company revenues.

 

It is currently expected that revenue from the U.S. Government, State of Michigan, and the State of Maryland will each account for more than 10% of total Company revenues in 2006.

 

Patents and Trademarks

 

The Company has established a strong worldwide patent position for tagatose.  These patents and other significant Company patents are detailed in the following table:

 

Patent No.		Patent Title		Issue Date		Expiration Date
U.S. 6,585,964		Method for Preventing or Minimizing Biodegradation of a Substance		7/1/03		5/6/19
U.S. 6,355,409		Tagatose as a Cytoprotective Supplement for the Storage of Organs to Reduce Reperfusion Injury		3/12/02		9/1/20
Canada 2,077,257*		Process for Manufacturing D-Tagatose		2/19/02		1/7/11
U.S. 6,225,452		Increased Fertility and Improved Fetal Development Drug		5/1/01		4/26/19
Finland 106861*		Process for Manufacturing D-Tagatose		4/30/01		1/7/11
Japan 3,120,403*		Process for Manufacturing D-Tagatose		10/20/00		1/7/11
U.S. 6,015,793		Use of Tagatose to Enhance Key Blood Factors		1/18/00		4/26/19
Korea 190671*		Process for Manufacturing D-Tagatose		1/21/99		1/7/11
Japan 2,138,363*		D-Tagatose as a Low-Calorie Carbohydrate Sweetener and Bulking Agent		9/18/98		8/29/07
U.S. 5,690,950		Insecticidal Aliphatic Carboxylic Acid Compositions		11/25/97		10/4/16
EPO 0 518 874*		Process for Manufacturing D-Tagatose		5/15/96		1/7/11
U.S. 5,447,917		D-Tagatose as Anti-Hyperglycemic Agent		9/5/95		2/3/14
Hong Kong 127095A*		D-Tagatose as a Low-Calorie Carbohydrate Sweetener and Bulking Agent		8/18/95		8/25/07
U.S. 5,356,879		D-Tagatose an Anti-Hyperglycemic Agent		10/18/94		2/14/12
Canada 1,321,730*		D-Tagatose as a Low-Calorie Carbohydrate Sweetener and Bulking Agent		8/31/93		8/31/10
U.S. 5,166,193		Method for Killing Pests		11/24/92		11/24/09
Australia 655,166*		Process for Manufacturing D-Tagatose		1/7/92		1/7/07
U.S. 5,078,796*		Process for Manufacturing D-Tagatose (Tagatate)		1/7/92		3/25/11
U.S. 5,002,612*		Process for Manufacturing D-Tagatose		03/26/91		7/19/09
EPO 257 626*		D-Tagatose as a Low-Calorie Carbohydrate Sweetener and Bulking Agent		7/25/90		8/25/07
U.S. 4,786,722*		D-Tagatose as a Low-Calorie Carbohydrate Sweetener and Bulking Agent		11/22/88		8/29/06

 

*Licensed to Arla Foods.

 

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Patent Applications.  In addition to the above-listed issued patents, the Company has applied for patent protection as follows:

 

•                  D-Tagatose as an Anti-Biofilm Agent

•                  Use of Tagatose in Fiber Laxatives

 

Trademarks.  The Company has trademarked its name, “Spherix,” “ReserveWorld,” its reservation system and “FlyCracker,” its safe-for-humans pesticide.  It has applied for the trademark “Naturlose” for non-food uses of tagatose and for the trademark “BioSpherix.”  It retains trademarks on its original name, “Biospherics,” and a former subsidiary, “Vitalian Corp.”

 

With respect to all of its inventions, the Company has received approximately 130 patents, including foreign issues.  It has several patents pending and many additional invention disclosures.  In addition to its strong patent position, the Company relies on the common law protection of such information as trade secrets and on confidentiality agreements to protect the value of these assets.

 

Royalties.  Fees are payable to the Company from Arla under the above-described License Agreement through August 25, 2016.  Initial royalties will be used to offset approximately $195,000 in patent maintenance costs incurred by Arla Foods and future patent maintenance costs.  In late 2003, Arla began sales of tagatose and the Company has earned approximately $5,000, $4,000 and $3,000 in royalties for the years 2005, 2004 and 2003, respectively, which were credited against Arla’s patent maintenance costs.

 

Seasonality

 

Revenues from reservation and tourism services are greatest in the spring and summer when vacation planning is the heaviest.  Revenues from other sources tend to be more evenly spread throughout the year, although the fourth quarter is historically the low period of the year.

 

Sales Backlog

 

Sales backlog, consisting of both funded and unfunded amounts, at December 31, 2005 and 2004, were as follows (in $000s):

 

		December 31, 2005									December 31, 2004
		Current			Non-Current			Total			Current			Non-Current			Total
InfoSpherix - Government		$	24,100		$	48,200		$	72,300		$	22,100		$	38,900		$	61,000
InfoSpherix - Commercial		100			—			100			—			—			—
		$	24,200		$	48,200		$	72,400		$	22,100		$	38,900		$	61,000

 

The increased backlog between years is the result of winning the State of Pennsylvania reservation contract and winning the recompete of the State of Michigan reservation contract.

 

Competition

 

InfoSpherix

 

The information systems industry is subject to rapid and significant technological change.  The Company is in competition with other information services companies across the nation.  Many of these competitors have substantially greater financial and technical resources than the Company.  While acknowledging strong competition from other information services firms, the Company has developed a specialized niche by concentrating on high quality, personalized service combined with computerization for efficiency and cost-effectiveness.  The Company has established a reputation for rapidly starting up information projects to meet its clients’ critical needs, while not compromising high quality and reasonable pricing.  The Company has also established a successful niche in government campground reservation services and is now one of only two major suppliers of campground services in the U.S.  The other major supplier is IAC/InterActiveCorp’s ReserveAmerica.  Over the last five years, the Company has invested over $3 million in computer and telephony systems and over $3 million in the development of specialized computer software products to improve its competitive position.  The Company continues to upgrade and enhance those systems.

 

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BioSpherix

 

Competitors of BioSpherix are numerous and include, among others, major pharmaceutical, chemical, consumer, and biotechnology companies, specialized firms, universities and other research institutions.  Over the past several years, various sugar alcohols have been used in food products as bulk sweeteners.  However, none has the taste of table sugar and most are more caloric than tagatose.  Bulk sweeteners are used in products where the bulk of sugar is essential, such as baked goods, chocolates, and ice cream.  High intensity sweeteners, such as aspartame, saccharin, and sucralose do not provide the bulk needed for these products.  The Company’s competitors may succeed in developing technologies and products that are more effective than any that are being developed by the Company, and that could render the Company’s technology and potential products obsolete and noncompetitive.  Many of these competitors have substantially greater financial and technical resources and production and marketing capabilities than the Company.

 

Research and Development

 

BioSpherix expenditures for research and development were approximately $288,000, $196,000, and $391,000 in 2005, 2004, and 2003, respectively.  These expenditures were incurred primarily in the ongoing efforts to commercialize tagatose, including its development for drug uses and improved production processes.

 

Governmental Regulation

 

The business activities of the Company are subject to a variety of Federal and state compliance, licensing, and certification requirements.  Management believes that the Company is, and has been at all times, in full compliance with Federal and state environmental protection and worker safety laws.  The Company has not incurred significant expense in complying with such laws and does not anticipate material expense.

 

The Company is also required to comply with the Sarbanes-Oxley Act of 2002.  On September 21, 2005, the SEC announced the extension of the compliance dates of Section 404 of the Sarbanes-Oxley Act for non-accelerated filers.  Under the extension, non-accelerated filers, such as Spherix, will begin to comply with the internal control over financial reporting requirements for its first fiscal year ending on or after July 15, 2007.  The Company anticipates that the cost of implementing Section 404 over the next two years could have a material impact on the results of operations.

 

Environment

 

Compliance with current federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had, and in the opinion of management will not have, a material effect on the Company’s financial position, results of operations, capital expenditures, cash flows or competitive position.

 

Employees

 

In 2005, the Company employed an average of 570 individuals on a full- or part-time basis.  Of this total, approximately 325 were full-time employees.  The Company’s employees are not currently unionized, and management believes that its relations with the Company’s employees are harmonious.

 

Geographic Areas

 

InfoSpherix’s business is, and has been, based in the United States.  Accordingly, InfoSpherix revenues are entirely from U.S.-based operations.

 

BioSpherix’s licensee for tagatose’s food use, Arla, is located in Europe.  Arla introduced tagatose to U.S. markets first, prior to worldwide distribution.

 

Item 1A.  RISK FACTORS

 

Any of the risk factors we describe below could severely harm our business, financial condition and operating results.  The market price of our common stock could decline if one or more of these risks and uncertainties develop into actual events.

 

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RISKS RELATED TO OUR BUSINESS

 

WE CONTINUE TO BE DEPENDENT ON OUR INFORMATION SERVICES DIVISION FOR NEARLY ALL OF OUR REVENUE.  We are almost entirely dependent on the information services division for our revenue.  In each of 2005 and 2004, our information services division accounted for nearly 100% of our revenue.  Despite licensing tagatose in 1996 for food and beverage use, our principal biotechnology product, we have yet to receive any substantial royalties from the sales of tagatose by our licensee.  Thus, we have incurred substantial and continuing losses in our biotechnology division which have adversely affected our overall financial results and our stock price.  If we continue to be unsuccessful in commercializing our biotechnology products, our financial results will continue to be adversely affected to the detriment of our stock price.

 

OUR LARGEST INFORMATION SERVICES CONTRACT COULD BE AWARDED TO A COMPETITOR.  In both 2005 and 2004, our NPRS contract accounted for approximately 17% of our aggregate revenue.  This contract has been bundled with a National Forest Services contract and rebid as the National Recreation Reservation System (“NRRS”).  In 2005, the bundled NRRS contract was awarded to a competitor for the second time; we protested and our protest was again upheld.  This is the second time that GAO has found the USDA Forest Service’s attempt to award the NRRS contract to our competitor to be flawed.  The Department of Agriculture has subsequently decided not to follow GAO’s decision and is seeking to proceed with the award of the NRRS contract to our competitor.  Spherix has filed an appeal of this action with the Court of Federal Claims, but we cannot predict the outcome of the appeal.  The Department of Agriculture has agreed not to proceed while the Court of Federal Claims hears Spherix’s appeal.  Meanwhile, the Company’s NPRS contract has been formally extended through September 30, 2006.  If we lose this contract, we will need to replace it with other work or scale back our operations to avoid an adverse impact on our financial results.

 

OUR INFORMATION SERVICES BUSINESS COULD BE ADVERSELY AFFECTED BY SIGNIFICANT CHANGES IN THE CONTRACTING OR FISCAL POLICIES OF THE U.S. FEDERAL GOVERNMENT.  We derive substantial revenues from contracts with the U.S. federal government and we believe that the success and development of our business will continue to depend on our successful participation in U.S. federal government contract programs.  Accordingly, changes in U.S. federal government contracting policies could directly affect our financial performance.  Among the factors that could have a material adverse affect on our U.S. federal government contracting business are:

 

•                  budgetary constraints affecting U.S. federal government spending generally, or specific departments or agencies in particular, and changes in fiscal policies or available funding;

•                  technological developments;

•                  U.S. federal governmental shutdowns and other potential delays in the government appropriations process;

•                  delays in the payment of our invoices by government payment offices due to problems with, or upgrades to, government information systems, or for other reasons;

•                  competition and consolidation in the information services industry; and

•                  general economic conditions.

 

OUR INFORMATION SERVICES BUSINESS IS RELIANT ON TECHNOLOGY.  We have devoted significant resources to developing and acquiring specialized hardware and software in our information services business.  In order to remain competitive, we must continue to select, invest in, acquire and develop new and enhanced technology on a timely basis.  We may not be successful in these efforts or in anticipating developments in technology.  In addition, competitors could develop similar applications.  Third parties could independently develop similar technology, obtain unauthorized access to our proprietary technology or misappropriate technology to which we have granted access.  Failure to remain current with technology or misappropriation of our technology could adversely affect our ability to compete for information services business and could lead to reduced business and reduced financial results.

 

ROYALTIES FROM TAGATOSE SALES ARE UNCERTAIN.  We have developed tagatose, a full bulk, low calorie sweetener.  In September 1996, we granted an exclusive, world-wide license to a foreign entity for the manufacture and sale of tagatose for use in foods and beverages.  To date, tagatose has only been commercially introduced into a limited number of products.  We have not yet received any substantial royalties.  We initiated an arbitration proceeding against our licensee due to the delay in bringing tagatose to market.  We subsequently dismissed the arbitration in exchange for various agreements including an extension of the period during which we are entitled to

 

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receive royalties.  Our prospects for receiving royalties from tagatose food and beverage sales are uncertain due to numerous factors, most of which are out of our control, including:

 

•                  our licensee has exclusive control over the commercialization of tagatose for food and beverage uses;

•                  the delay in bringing tagatose to market results in a shortening of the time we are entitled to royalties;

•                  significant royalties are possible only if our licensee constructs a larger tagatose manufacturing facility; at present, our licensee has ceased production at its current facility due to excess inventories; and

•                  we are entitled to royalties only after reimbursing our licensee for the ongoing costs of maintaining patent protection on tagatose throughout the world.

 

WE HAVE NOT YET SUCCESSFULLY COMMERCIALIZED NATURLOSE.  We are in the process of attempting to develop other uses of tagatose, under the brand name Naturlose, in non-food products such as toothpaste, mouthwash, and over-the-counter and pharmaceutical drugs.  To date, we have yet to secure any substantial revenue from Naturlose sales.  One of the hurdles we will have to overcome is that our foreign licensee for tagatose (which has the exclusive right to manufacture tagatose) does not currently have sufficient capacity to manufacture enough tagatose to supply both food and nonfood markets if such markets mature and grow.  Failure to successfully commercialize Naturlose may adversely affect our stock price.

 

OTHER BIOTECH PRODUCTS ARE STILL IN THE DEVELOPMENT STAGE.  We are developing other biotech products.  None of these have been developed to a stage where any significant revenue has been generated.  Development of products will require significant additional research and development.  Such additional effort will require substantial funding which may not be available to us.  Further, our research and development activities may not result in any saleable products.  It is also possible that we will license or seek an affiliation with a third party to bring some products to market.  In such an event, we would likely have minimal control over the manufacture and marketing of such products.

 

DEVELOPMENT OF ANY BIOTECH PRODUCTS WILL DEPEND ON OBTAINING FDA AND FOREIGN REGULATORY APPROVALS.  Development of new products are subject to extensive regulation by governmental regulatory authorities in the United States and other countries.  These rigorous regulatory approval processes can take five to ten years or more and require the expenditure of substantial resources.  We may not be able to obtain the necessary approvals for clinical testing or for the marketing of products.  Continuing failure to commercialize biotechnology products may adversely affect our financial results and stock price.

 

OUR SUCCESS WILL DEPEND, IN PART, ON OUR ABILITY TO OBTAIN AND MAINTAIN PATENT PROTECTION FOR OUR PRODUCTS.  We have several patents for tagatose and other products under development.  We may not be able to obtain additional patents.  Further, future patents may not be held valid if subsequently challenged.  Failure to obtain and maintain patent protection for our biotechnology products may further delay or eliminate our ability to commercialize such products, which may adversely affect our financial results and stock price.

 

WE HAVE SUSTAINED LOSSES IN THE PAST AND WE MAY SUSTAIN LOSSES IN THE FUTURE.  We have incurred losses in prior years, including the last three (3) years. Our net losses for the years ended December 31, 2005, December 31, 2004 and December 31, 2003 were $2.8 million, $2.8 million and $2.3 million, respectively.  Our net accumulated losses from the date of our organization through December 31, 2005 are $15.2 million.  We may not return to profitable operations.

 

WE MAY NOT BE ABLE TO OBTAIN ADDITIONAL FINANCING THAT WE WILL NEED.  During 2005, our working capital decreased by $1.1 million, largely as a result of the incurred losses and continued investment in our business.  In recent years, we have funded our operations through private placements of our common stock and through the exercise of warrants issued in connection with such private placement transactions.  We believe that we may need to raise additional funding to continue to finance our product development operations.  We may also need to raise additional money to fund operations if the sale of tagatose as a food and beverage product continues to be delayed or is not as successful as we anticipate.  We may not be able to obtain additional financing on acceptable terms, or at all.  Failure to obtain required financing may cause us to curtail or cease our operations.

 

WE MAY NOT BE ABLE TO RETAIN OUR KEY EXECUTIVES AND PERSONNEL.  As a small company, our success depends on the services of key employees in executive and other positions.  None of our key employees have employment agreements.  Further, our Chief Science Officer, who is principally responsible for

 

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commercializing our biotechnology products, is 81 years of age.  The loss of the services of one or more of such employees could have a material adverse effect on us.

 

WE FACE INTENSE COMPETITION BY COMPETITORS IN BOTH DIVISIONS.  Our competitors in the information services business are numerous.  Many of our competitors have significantly greater financial, marketing and distribution resources than we do.  Our principal information services competitor, ReserveAmerica, is a division of Ticketmaster which is a subsidiary of IAC/InterActive Corp., a significantly larger public company than Spherix.  Our competitors may succeed in developing or marketing technologies and biotechnology products that are more effective than ours.  Alternative sweetener(s) may adversely affect sales of tagatose.  In the past year or two, the alternate sweetener Splenda has made substantial inroads into markets we expected tagatose to capture.

 

RISKS RELATED TO OWNERSHIP OF OUR COMMON STOCK

 

THE PRICE OF SPHERIX’S COMMON STOCK HAS BEEN HIGHLY VOLATILE DUE TO SEVERAL FACTORS WHICH WILL CONTINUE TO EFFECT THE PRICE OF OUR STOCK.  Our common stock has traded as low as $1.19 and as high as $5.85 between January 3, 2005 and December 30, 2005. Some of the factors leading to this volatility include:

 

•                  relatively small amounts of our stock trading on any given day;

•                  fluctuations in our operating results;

•                  announcements of technological innovations or new products which we or our competitors make;

•                  developments with respect to patents or proprietary rights; and

•                  the status of our licensee’s efforts to market tagatose.

 

CORNELL CAPITAL PARTNERS WILL PAY LESS THAN THE MARKET PRICE AND WILL HAVE AN INCENTIVE TO SELL ITS SHARES, WHICH MAY CAUSE OUR STOCK PRICE TO DECLINE.  Cornell Capital Partners will purchase shares of our common stock pursuant to the Standby Equity Distribution Agreement (SEDA) at a purchase price that is less than the then-prevailing market price of our common stock.  Cornell Capital Partners will have an incentive to immediately sell any shares of our common stock that it purchases pursuant to the SEDA to realize a gain on the difference between the purchase price and the then-prevailing market price of our common stock.  To the extent Cornell Capital Partners sells its common stock, the common stock price may decrease.

 

NEW SHAREHOLDERS WILL EXPERIENCE SIGNIFICANT DILUTION FROM OUR SALE OF SHARES UNDER THE SEDA.  The sale of shares pursuant to the SEDA will have a dilutive impact on our stockholders.  As a result, our net income per share could decrease in future periods, and the market price of our common stock could decline.  In addition, the lower our stock price, the more shares of common stock we will have to issue under the SEDA.  If our stock price is lower, then our existing stockholders would experience greater dilution.

 

OUR COMMON STOCK WILL BE DELISTED FROM NASDAQ NATIONAL MARKET SYSTEM IF WE FAIL TO COMPLY WITH CONTINUED LISTING STANDARDS.  We were previously advised that we were in danger of our common stock being delisted from the NASDAQ National Market due to our stockholders’ equity falling below the $10 million minimum requirement.  At December 31, 2005, the Company’s shareholder’s equity was $7,879,220, or $2,120,780 below the $10,000,000 required by NASDAQ; however, the Company has subsequently raised, as of March 10, 2006, an additional $2.7 million through the SEDA and warrant transactions so as to bring the Company into compliance with the NASDAQ equity requirement.  If at some point we are unable to meet the listing standards, we intend to apply to list our common stock on the NASDAQ SmallCap Market.

 

DIVIDENDS ON OUR COMMON STOCK ARE NOT LIKELY.  We intend to retain future earnings, if any, in order to provide funds for use in the operation and expansion of our business and for further research and development.  Accordingly, we do not anticipate paying cash dividends on our common stock in the foreseeable future.  Investors must look solely to appreciation in the market price of the shares of our common stock to obtain a return on their investment.

 

BECAUSE OF THE RIGHTS AGREEMENT AND “ANTI-TAKEOVER” PROVISIONS IN OUR CERTIFICATE OF INCORPORATION AND BYLAWS, A THIRD PARTY MAY BE DISCOURAGED FROM MAKING A TAKEOVER OFFER WHICH COULD BE BENEFICIAL TO OUR STOCKHOLDERS.  In 2001, we adopted a shareholder rights plan.  The effect of this rights plan and of certain provisions of our Certificate of Incorporation, By-Laws, and the anti-takeover provisions of the Delaware General Corporation Law, could delay or

 

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prevent a third party from acquiring us or replacing members of our board of directors, even if the acquisition or the replacements would be beneficial to our stockholders.  These factors could also reduce the price that certain investors might be willing to pay for shares of the common stock and result in the market price being lower than it would be without these provisions.

 

INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR STOCKHOLDERS’ ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.  As of December 31, 2005, our officers and directors and their affiliates owned approximately 20% of the outstanding shares of our common stock.  As a result, our officers and directors are able to exert considerable influence over the outcome of any matters submitted to a vote of the holders of our common stock, including the election of our Board of Directors.  The voting power of these stockholders could prevent or frustrate attempts to effect a transaction that is in the best interests of the other stockholders and could also discourage others from seeking to purchase our common stock, which might depress the price of our common stock.

 

WE EXPERIENCE QUARTERLY VARIATIONS IN OUR OPERATING RESULTS.  We have experienced and expect to continue to experience quarterly variations in revenues and operating income as a result of many factors, including the seasonality of our information services business, timing of customers’ budget processes and slowdowns or accelerations of work by customers.  General work economic conditions may result in customer deferral of projects or cancellation in planned expenditures.  These factors may adversely affect our financial results and our stock price.

 

Item 2.  PROPERTIES

 

In November 1997, the Company signed a lease agreement effective May 1, 1998, for 51,625 square feet of office, call center, research labs, and warehouse space in the same Beltsville, Maryland, facility previously occupied, under the terms of a lease that expires on February 28, 2009.  This facility contains corporate administration, human resources, accounting, sales and marketing, technical services and warehousing, for support of both InfoSpherix and BioSpherix Divisions, and through September 2005 contained call center operations for InfoSpherix.  In November 2003, the Company signed a lease agreement for 31,526 square feet of office and call center space in Cumberland, Maryland.  The lease expires on October 31, 2007.  In 2004, as part of its acquisition of certain assets of Daksoft, Inc.’s reservation business, the Company signed an agreement to lease 8,280 square feet of call center space in Rapid City, South Dakota.  The current lease, if not further extended, expires on April 30, 2006.  In 2004, the Company also signed an agreement to lease 5,000 square feet of office, research lab and warehouse space for BioSpherix in Annapolis, Maryland.  The lease expires June 30, 2009.

 

Throughout 2005, the Beltsville and Annapolis facilities had sufficient capacity.  The Cumberland and Rapid City facilities were operating at an estimated 75%-90% capacity during the peak months.

 

Item 3.  LEGAL PROCEEDINGS

 

Information required by this Item 3 is included in Note 10 “Commitments and Contingencies” of the Notes to Financial Statements, included herein pursuant to Part II of this Form 10-K.

 

Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

There were no matters submitted by the Company during the fourth quarter of 2005 to a vote of security holders through solicitation of proxies or otherwise.

 

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PART II

 

Item 5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

 

The Company’s common stock is traded in the over-the-counter market and is quoted in the NASDAQ National Market System under the symbol SPEX.  No cash dividends have been paid.  The Company’s loan agreement with its bank does not expressly restrict the payment of dividends; however, no such payments are anticipated in the near future.

 

As of March 10, 2006, the number of shareholders of record of the Company’s common stock was approximately 7,000.  The following table states the high and low sales prices of the Company’s common stock for each quarter during the two year period ended December 31, 2005, based on the daily closing prices as reported on the NASDAQ National Market System:

 

 

The Company recognized that, as of June 30, 2005, it was approximately $454,000 short of meeting NASDAQ’s National Market listing requirement of maintaining a minimum of $10,000,000 in shareholders’ equity.  NASDAQ gave the Company until September 1, 2005, to correct this situation, which the Company achieved through its third quarter results.  However, in anticipation of incurring losses due to seasonal fluctuations in the InfoSpherix business segment that occurs in the first and fourth quarters of the year, the Company, on July 22, 2005, entered into a Standby Equity Distribution Agreement (“SEDA”) with Cornell Capital Partners, L.P. (“Cornell”).  Under the SEDA, Spherix can require Cornell to purchase up to $4,000,000 of the Company’s common stock over a two-year period following the effective date, October 12, 2005, of the registration covering the shares of our common stock to be sold to Cornell.  The SEDA establishes what is sometimes termed an “equity line of credit” or an “equity draw-down facility.”  The $4,000,000 facility may be drawn down upon by us in installments, the maximum amount of each of which is limited to $350,000.  For each share of common stock purchased under the SEDA, Cornell will pay 95% of the lowest volume weighted average price (“VWAP”) of our shares during the five trading days following our draw down notice to Cornell.  The VWAP that will be used in the calculation will be that reported by Bloomberg, LLC, a third-party reporting service.  In general, the VWAP represents the sum of the value of all the sales of our common stock for a given day (the total shares sold in each trade times the sales price per share of the common stock for that trade), divided by the total number of our shares sold on that day.  We are also committed to pay to Cornell an amount equal to 5% of each purchase of our common stock made by Cornell under the SEDA.  Under the terms of the SEDA agreement, we are not obligated to draw down on the SEDA facility, but once we satisfy normal conditions for this type of transaction, we have the right to require Cornell to purchase our common shares under the SEDA.  In connection with the SEDA, we have issued to Cornell 95,000 shares of our common stock and paid a due diligence fee of $5,000.  We also paid Yorkville Advisors Management, LLC, the investment manager for Cornell, a structuring fee of $15,000, and on each sale under the SEDA we will pay an additional structuring fee of $500.  Newbridge Securities Corporation acted as our placement agent for the SEDA, and we paid that firm a fee of 5,000 shares of our common stock as compensation.  We also granted Newbridge Securities Corporation piggy-back registration rights covering these shares.  Registration of our common shares allocated to this facility was completed in October 2005.  During the term of the SEDA, our Officers and Directors have agreed not to sell any of their shares of our common stock, except to the extent permitted under Rule 144.  The number of shares of our common stock issuable to Cornell under the SEDA is subject to a 9.99% cap on the beneficial ownership that Cornell and its affiliates may have at the time of each sale (beneficial ownership is to be calculated in accordance with Section 13(d) of the Exchange Act).  Further, we may not issue more than 19.99% of our currently outstanding shares under the SEDA unless shareholder approval is received.  In 2005, the Company sold

 

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310,076 shares under the SEDA agreement for total proceeds of $376,500.  Subsequent to December 31, 2005, the Company has sold an additional 624,365 shares under the SEDA for an additional $1.5 million in proceeds.

 

On February 18, 2004, warrants for 500,000 shares of Common Stock were exercised at $6.91 per share, compared to the then current market price of $6.76 per share, by an institutional investor, and the expiration date of the remaining 585,973 warrants was extended until February 25, 2008, at an exercise price of $7.00 per share of common stock.  The remaining warrants were assigned and transferred to another institutional investor in 2004.  On March 9, 2006, in exchange for the Company’s agreement to reduce the exercise price to $2.04 per share, the Investor agreed to exercise the warrants for the full 585,973 shares for total proceeds of approximately $1.2 million.  In connection with these warrants, the Investor agreed that it would not exercise any of the warrants to the extent that it would acquire shares of Common Stock exceeding 9.9% of the outstanding Common Stock, nor would it knowingly sell shares to anyone to the extent that their holdings in the Company would exceed 4.9% of the outstanding Common Stock.  The warrants and shares of Common Stock were issued in transactions exempt from Registration pursuant to Section 4(2) of the Securities Act.  The Company has registered the shares issuable upon exercise of the warrants for resale by the institutional Investor.

 

At December 31, 2005, the Company’s shareholder’s equity was $7,879,220, or $2,120,780 below the $10,000,000 required by NASDAQ; however, as noted above, the Company has subsequently raised an additional $2.7 million through the SEDA and warrant transactions so as to bring the Company into compliance with the NASDAQ equity requirement.

 

Information concerning the Company’s equity compensation plans is incorporated by reference from the Proxy Statement for the Annual Meeting of Stockholders for the fiscal year ended December 31, 2005, which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the 2005 fiscal year.

 

The Company has a share repurchase program in place that initially authorized the purchase of up to $1,000,000 of the Company’s shares in the open market.  To date, only 34,750 shares aggregating $160,000 of the Company’s shares have been repurchased.  There was no repurchase activity during 2005.

 

Item 6.    SELECTED FINANCIAL DATA

 

		2005			2004			2003			2002			2001
Revenue		$	23,045,657		$	22,348,418		$	18,086,711		$	15,131,855		$	19,937,461
Net (loss) income		$	(2,848,748	)	$	(2,822,046	)	$	(2,256,770	)	$	(2,921,926	)	$	567,823
Net (loss) income per share, diluted		$	(0.24	)	$	(0.24	)	$	(0.20	)	$	(0.26	)	$	0.05
Total assets		$	13,118,263		$	15,243,949		$	14,167,257		$	15,453,140		$	13,240,928
Long-term debt obligations		$	27,455		$	45,580		$	63,310		$	90,530		$	104,190
Cash dividends declared per common share		$	—		$	—		$	—		$	—		$	—
Stockholders equity		$	7,879,220		$	10,367,690		$	9,489,236		$	11,261,458		$	9,522,930
Working capital		$	3,139,711		$	4,215,573		$	5,043,672		$	8,787,502		$	7,139,196

 

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Item 7.           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

The Company operates via two principal segments, BioSpherix and InfoSpherix.  BioSpherix develops proprietary products for commercial applications.  InfoSpherix provides contact center information and reservations services for government and industry.

 

InfoSpherix generates substantially all of the Company’s revenue.  In 2005, 2004, and 2003, InfoSpherix generated substantially all of its revenue from government customers.  The Company has developed a niche in providing campground and other reservation services via its ReserveWorld business line, which accounted for approximately 60%, 58%, and 49% of the Company’s revenue in 2005, 2004, and 2003.  During 2005, the company won reservation contracts from Orange County (California), the State of Pennsylvania, and the recompete of the State of Michigan contract.

 

In July 2005, Spherix filed an official protest of the U.S. Department of Agriculture’s award of the National Recreation Reservation System (“NRRS”) contract to ReserveAmerica, a TicketMaster subsidiary.  The NRRS will provide reservation services for all Federal recreation facilities, including the National Park sites currently serviced by Spherix under its ongoing National Park Reservation Service (“NPRS”) contract with the Department of Interior.  On October 20, 2005, the Government Accountability Office (“GAO”) sustained Spherix’s challenge to the USDA Forest Service award and recommended that the Department of Agriculture reopen the competition and make a new award decision.  This is the second time that GAO has found the Forest Service’s attempt to award the NRRS contract to ReserveAmerica to be flawed.  The Department of Agriculture subsequently decided not to follow GAO’s decision and is seeking to proceed with the award of the NRRS contract to ReserveAmerica.  The Department of Agriculture has agreed not to proceed while the Court of Federal Claims hears Spherix’s appeal.  Meanwhile, the Company’s NPRS contract has been formally extended through September 30, 2006.  The Company has operated the NPRS contract for eight years; revenue recognized was $4.0 million, $3.9 million and $4.2 million for the years ended December 31, 2005, 2004 and 2003, respectively, or 17%, 17% and 23% of total revenue for each year.

 

BioSpherix engages in product development, notably tagatose.  The exclusive rights to manufacture tagatose have been licensed to a foreign entity along with the exclusive rights to sell tagatose for food and beverage uses.  Tagatose was first introduced in commercial products in 2003.  Beginning July 2003, the Company has earned approximately $5,000, $4,000, and $3,000 in royalty revenue for the years 2005, 2004, and 2003, respectively, which have been credited against Arla’s patent maintenance costs.  The royalties rates payable under the licensing agreement with Arla vary based on a complex matrix that is dependent on such factors as quantity, price and intended use.  The royalty rates under the original agreement with Arla contained rates payable during the patent term (referred to hereafter as “high-end royalties”) and lower rates payable after the patent term that continue for another five years after the last to expire patents.  The precise royalty rates have not been disclosed as they are proprietary and confidential.  As part of the fall 2003 settlement of the arbitration proceeding with its licensee, the parties agreed to extend the date through which the Company shall be entitled to high-end royalties for tagatose sales until at least March 25, 2011, and until August 25, 2016, subject to certain conditions.  Future royalties will depend on increased sales of this product by the licensee, which are outside of the control of the Company.  Development of sales for non-food uses of tagatose (“Naturlose”) retained by the Company may be further limited by the lack of adequate and continuing supply from Arla.

 

Results of Operations¾2005 Compared with 2004

 

In 2005, the Company reported a net loss of $2.8 million ($0.24 per diluted share) on revenues of $23.0 million for the year, compared with a net loss of $2.8 million ($0.24 per diluted share) on revenues of $22.3 million in 2004.

 

Revenue

 

Revenue between years increased $697,000 (3%).  Revenue from the InfoSpherix Division increased $802,000 (4%) and the BioSpherix Division’s revenue decreased by $104,000 (82%).  The increased revenue from the InfoSpherix Division was less than anticipated as a result of an unexpected temporary funding shortage on one of our major Federal contracts that lasted for a period of four months until the Federal Government’s fiscal year ended September 2005, and from hurricanes and the rise in gasoline prices that impacted reservation sales on our park reservation contracts during the third quarter of 2005.  The Division also saw a decrease in revenue of approximately

 

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$2.9 million between years as a result of the decrease in revenue under the new State of Maryland contract that started November 2004 and the IRS contract that ended in April 2004.  However, these set-backs were more than off-set by the division’s continued overall growth from the award of new contracts.  The revenue growth was primarily driven by contracts such as the Federal Retirement Thrift Investment Board that started in May 2004, the Georgia contract that started in March 2004, and from increases under existing contracts with the state of Ohio and the Office of Personnel Management.  The decrease in BioSpherix revenue was related to the discontinuance of the sale of FlyCracker in 2004.

 

Direct Contract and Operating Costs

 

Direct contract and operating costs increased $566,000 (3%) between years.  This increase included the recognition of a forward loss provision of $135,000 on one of the Company’s contracts.  The increase is also attributed to approximately $100,000 in start-up costs related to the new State of Pennsylvania contract that began in January 2006.  South Dakota operations operated at a break-even for 2005, up $100,000 from 2004.

 

Selling, General and Administrative

 

Selling, general and administrative expense (“S,G&A”) for 2005 decreased by $216,000 (4%) from that of the prior year.  In 2005, the Company cut its consulting costs by approximately $265,000, most of which were related to marketing.  The Company plans to increase its marketing staff in 2006 with the addition of two to three more sales persons for the purpose of pursuing government contact center opportunities.

 

Research and Development

 

Research and development costs increased $92,000 between years.  In 2004, the BioSpherix Division began a program of outsourcing development of its patented drug uses of Naturlose.  A research project was funded at the Albert Einstein College of Medicine to follow up on that institution’s discovery that Naturlose may lengthen shelf life of stored blood fractions and medicinal proteins.  In 2005, the Company contracted with the University of Maryland School of Dentistry to conduct human clinical trials on the oral anti-plaque efficacy of Naturlose.  The study demonstrated tagatose to be much more resistant to oral bacteria, which form plaque, than is sorbitol, a sugar substitute that is widely used in oral care products.  Contrary to earlier laboratory findings by Spherix, however, a human study at the University of Maryland School of Dentistry did not show anti-plaque activity.  Conditions in the mouth may have prevented the desired effect, according to the University researchers.  Spherix is currently following up on corrective suggestions made by the University, and may conduct new human trials if results warrant.

 

Depreciation and Amortization

 

Depreciation and amortization costs increased $297,000 (13%) between years as a result of investments of approximately $3 million in property and equipment added in the prior year, compared to investments of approximately $1.5 million in 2005.  The fixed asset investment in 2004 included approximately $900,000 used to upgrade computer software and hardware at our Cumberland call center facility and approximately $1 million in intangibles related to the March 1, 2004, purchase from Daksoft Inc.

 

InfoSpherix Operations

 

The following schedule summarizes the breakdown of InfoSpherix revenue between government and commercial contracts (in $000s):

 

 

As noted above, InfoSpherix revenue for 2005 increased $802,000 (4%) over that of the prior year.  The increased revenue from the InfoSpherix Division was less than anticipated as a result of an unexpected temporary funding shortage on one of our major Federal contracts that lasted for a period of four months until the Federal Government’s fiscal year ended September 2005, and from hurricanes and the rise in gasoline prices that impacted

 

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reservation sales on our park reservation contracts during the third quarter of 2005.  The Division also saw a decrease in revenue of approximately $2.9 million between years from the decrease in revenue under the new State of Maryland contract that started November 2004, and the IRS contract that ended in April 2004.  However, these set-backs were more than off-set by the division’s continued overall growth.  This revenue growth was primarily driven by contracts such as the Federal Retirement Thrift Investment Board that started in May 2004, Georgia that started in March 2004, and from increases under existing contracts such as Ohio and the Office of Personnel Management.  The fourth quarter in particular saw a significant improvement over the prior year, with an increase in revenue of $399,000 as a result of increased revenue in the Federal Retirement Thrift Investment Board contract and a general growth across the board on our existing reservation contracts.  This combined with a reduction in direct costs of $139,000 between the fourth quarter of 2005 and 2004, contributed to the $472,000 improvement in operations between quarters.

 

In 2005, Spherix won park reservation contracts for Orange County, California, the State of Pennsylvania, and the State of Michigan.  The Orange County contract consists of three base years and is valued at less than half a million.  The State of Pennsylvania contract is a five-year contract, consisting of one base year and four option years, valued at approximately $8 million.  The State of Michigan contract is a continuation of our current contract with the State.  The new contract is for five years, and consists of three base years plus two option years, valued at approximately $14 million.

 

In March 2004, the Company won a one-year, multi-million dollar Federal Retirement Thrift Investment Board (“FRTIB”) contract with four option years.  Also, on March 1, 2004, the Company purchased certain assets of Daksoft, Inc. related to its reservation business, which operates under the name “ReserveIt.”  The purchase included the acquisition of six additional government reservation contracts and the intellectual property rights to the name “ReserveIt,” as well as other assets of the division.  Spherix purchased the assets for $700,000 plus 43,029 shares of the Company’s common stock, then trading at $6.699 per share.

 

Park reservation contracts now make up approximately 60% of the Company’s revenue and the Company is now one of only two major suppliers of campground reservation services in the U.S.

 

In July 2005, Spherix filed an official protest of the U.S. Department of Agriculture’s award of the National Recreation Reservation System (“NRRS”) contract to ReserveAmerica, a TicketMaster subsidiary.  The NRRS will provide reservation services for all Federal recreation facilities, including the National Park sites currently serviced by Spherix under its ongoing National Park Reservation Service (“NPRS”) contract with the Department of Interior.  On October 20, 2005, the Government Accountability Office (“GAO”) sustained Spherix’s challenge to the USDA Forest Service award and recommended that the Department of Agriculture reopen the competition and make a new award decision.  This is the second time that GAO has found the Forest Service’s attempt to award the NRRS contract to ReserveAmerica to be flawed.  The Department of Agriculture subsequently decided not to follow GAO’s decision and is seeking to proceed with the award of the NRRS contract to ReserveAmerica.  The Department of Agriculture has agreed not to proceed while the Court of Federal Claims hears Spherix’s appeal.  Meanwhile, the Company’s NPRS contract has been formally extended through September 30, 2006.  The Company has operated the NPRS contract for eight years; revenue recognized was $4.0 million, $3.9 million and $4.2 million for the years ended December 31, 2005, 2004 and 2003, respectively, or 17%, 17% and 23% of total revenue for each year.

 

In 2004, the Company won the re-procurement of the Maryland information center contracts, which the company has operated since 1998.  The new contracts are for three years plus two additional option years.  The combined Maryland contracts contributed 12% to the Company’s revenues in 2005 and 22% in 2004.  The new contract started on November 1, 2004, and is subject to a more competitive pricing structure, which was necessary to win the recompete.  While Spherix was not the lowest bidder, the Company’s higher technical scoring resulted in the Company achieving an overall higher score than the competition.  Management is uncertain as to the long-term financial impact the price reduction will have over the course of the contract and believes that the lower rates may encourage the state to outsource more of its call center needs to Spherix under this contract.  The previous contract initially operated at a loss during its first year and had matured to a respectable contribution margin by the time the contract ended in late 2004.  This increase was gained through the continued outsourcing of more of the state’s call center needs to Spherix under the contract.  The new contract, which was bid at a lower contribution margin, is the principal cause for the decrease in operating income between years.  The Company hopes to increase the contribution margin over the next four years through continued expansion of services to the state and through cost reductions and other efficiency gains.  The Company is working to increase the amount of business performed under this contract as well as other contracts.  Starting October 1, 2005, as part of the cost reduction efforts, the Maryland contract began operating exclusively out of

 

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the Company’s Cumberland office instead of the Beltsville office, and its margins for the fourth quarter were now consistent with our other contracts.

 

Revenue from commercial contracts decreased between years.  Commercial contracts are typically for shorter terms than government contracts and that can result in substantial variations in commercial revenues.  Commercial contracts are being pursued by the Company, but the Company’s recent history has been that contracts have been received on a sporadic basis.

 

The Company’s business development group is targeting the government contact center and technology markets, and the ReserveWorld product and services market for continued growth.  Currently, the Company is bidding on several contracts and expects to bid on more contracts throughout the coming year, although no assurance can be given at this time that these efforts will result in new business for the Company.

 

BioSpherix Operations

 

The $104,000 decrease in the BioSpherix revenue from $127,000 to $23,000 between years was related to the discontinuance of the sale of FlyCracker in 2004.

 

BioSpherix is entitled to high end royalties from Arla’s sales of tagatose until at least 2011, and, depending upon certain conditions, until 2016.  The payments are net of accumulated and continuing foreign patent maintenance costs.  Accumulated patent maintenance costs were approximately $195,000 at year-end.

 

We have received minimal royalties from Arla in 2005, 2004, and 2003.  While tagatose has been introduced into several food and beverage products, Arla currently has insufficient sales volume and manufacturing capacity to produce tagatose at the rate necessary to generate meaningful royalties.  At present, Arla believes it has produced a sufficient backlog of inventory to satisfy its needs for the foreseeable future based on current demand, and accordingly has stopped production at its plant until there is a sufficient increase in the demand for tagatose.  Arla is currently having discussions with potential users and Arla has stated that any decision to construct a larger tagatose plant will depend on the ability to create greater market interest in tagatose.  Spherix is also pursing the possibility of other production options.

 

Commercialization of Naturlose will focus on its use as a sweetener or flavor enhancer in toothpaste, mouthwash, over-the-counter drugs, pharmaceuticals and other products to which the Company retains rights.

 

Sales Backlog

 

The Company’s funded and unfunded backlog as of December 31, 2005, was $72 million, compared to $61 million as of December 31, 2004.  In 2005, the Company won five year contracts with the States of Pennsylvania and Michigan.  In addition, the NPRS contract has been extended through September 30, 2006.

 

Results of Operations¾2004 Compared with 2003

 

In 2004, the Company reported a net loss of $2.8 million ($0.24 per diluted share) on sales of $22.3 million for the year, compared with a net loss of $2.3 million ($0.20 per diluted share) on sales of $18.1 million in 2003.

 

Revenue

 

Revenue between the years 2004 and 2003 increased $4.3 million (24%).  Revenue from the InfoSpherix Division increased $5.2 million, and the BioSpherix Division’s revenue decreased approximately $900,000.  The increased revenue from the InfoSpherix Division was from the addition of five new government contracts that the Company won late in 2003 and early 2004, and from the purchase of six other state and county government reservation contracts in March 2004.  The decrease in the BioSpherix revenue was the result of $1 million that was recognized in 2003 as part of the Arbitration settlement with Arla Foods (see “BioSpherix Operations” below).

 

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Direct Contract and Operating Costs

 

Direct contract and operating costs increased $5.1 million (42%) between years as a result of the new contracts noted above and the increase in overhead costs related to the larger facility in Cumberland, Maryland, the addition of a Rapid City, South Dakota contact center, and the new BioSpherix facility in Annapolis, Maryland.

 

Additional overhead costs of approximately $600,000 related to operating a larger facility in Cumberland was offset by the benefit gained from the new FRTIB, Ohio and Georgia contracts in 2004.

 

For 2004, the South Dakota operation’s direct contract and operating costs of $1.5 million (inclusive of $116,000 in amortization expense related to the purchase of the six contracts from Daksoft) exceeded their revenues by approximately $100,000.

 

Selling, General and Administrative

 

Selling, general and administrative expense (“S,G&A”) for 2004 decreased by $885,000 (14%) from that of the prior year.  In 2004, the Company increased its InfoSpherix marketing activity by approximately $500,000, with a strong focus on telecommunications business.  The increase in marketing costs, however, was more than offset by the decrease in legal expenses between years.  Legal expenses accounted for $1.5 million of the decrease between years, from $1.6 million in 2003 to approximately $110,000 in 2004.  The 2004 legal costs were net of a $250,000 credit related to legal fees incurred in 2003.  Included in the 2003 legal costs were $981,000 related to the Arla arbitration, $331,000 related to the NPS re-procurement cancellation, and $127,000 related to other legal matters.

 

Research and Development

 

Research and development costs decreased $195,000 (50%) between years.  The reduction is primarily related to independent studies that we conducted in 2003 and a reduction in overhead costs attributed to R&D activities.

 

Net Loss

 

The Company incurred a $2.8 million loss in 2004 compared to a $2.3 million loss in 2003.  The loss incurred by InfoSpherix increased by approximately $1.3 million in 2004 due to the relocation of the Cumberland operations to a larger facility and to the addition of a Rapid City, South Dakota, contact center.  The loss incurred by BioSpherix decreased by approximately $700,000 between years due to the settlement of the Arla arbitration in late 2003, a $250,000 credit in 2004 against legal fees incurred in 2003, and the reduction in research and development activity.

 

InfoSpherix Operations

 

The following schedule summarizes the breakdown of InfoSpherix revenue between government and commercial contracts (in $000s):

 

 

InfoSpherix revenue for 2004 increased $5.2 million (30%) over that of the prior year as a result of the addition of five new government contracts that the Company won in late 2003 and early 2004, and the purchase of six other government reservation contracts.

 

In March 2004, the Company also won a one-year, multi-million dollar Federal Retirement Thrift Investment Board (“FRTIB”) contract with four option years.  In addition, in early 2004, the Company acquired six additional government reservation contracts.  In that acquisition, the Company purchased certain assets of Daksoft, Inc. related to its reservation business, which operates under the name “ReserveIt.”  The purchase includes the intellectual property rights to the name “ReserveIt” and the related contracts, as well as other assets of the division.  The company also won reservation contracts for the states of Georgia and New Mexico.

 

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Revenue from commercial contracts decreased between years.  Commercial contracts are typically for shorter terms than government contracts and that can result in substantial variations in commercial revenues.  Commercial contracts are being pursued by the Company, but the Company’s recent history has been that contracts have been received on a sporadic basis.

 

BioSpherix Operations

 

The arbitration action initiated in 2002 against Arla, the Company’s tagatose licensee for food and beverage uses, was settled in November 2003.  The arbitration was initiated as a result of the delay in tagatose commercialization by Arla Foods.  As a part of the settlement, Arla Foods agreed that $1 million previously paid to the Company would no longer be required to offset future royalties.  As a result, $1 million, previously classified as deferred revenue, was recognized as revenue in 2003 and is directly related to the decrease in revenue between 2003 and 2004.

 

Sales of FlyCracker began in 2000 and while feedback from users remained positive, sales remained below expectations and were insufficient to cover the related operating and marketing efforts of the Company.  As a result the Company decided to scale back active efforts to sell and promote the product in 2003, and in January of 2004 the Company discontinued its remaining sales activities.

 

In July 2004, the BioSpherix Division relocated to a new laboratory and offices in 5,000 square feet of rented space in Annapolis, Maryland.

 

Critical Accounting Policies

 

The preparation of 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 and liabilities and the disclosure of the contingent assets and liabilities at the date of the financial statements and revenue and expenses for the period reported.  Estimates are based upon historical experience and various other assumptions that are believed to be reasonable under the circumstances.  These estimates are evaluated periodically and form the basis for making judgments regarding the carrying values of assets and liabilities and the reported amount of revenue and expenses.  Actual results may differ substantially from these estimates.

 

Spherix’s critical accounting policies are those it believes are the most important in determining its financial condition and results, and require significant subjective judgment by management as a result of inherent uncertainties.  A summary of the Company’s significant accounting policies is set out in the notes to the consolidated financial statements.  Such policies are discussed below.

 

Accounting for Taxes and Valuation Allowances

 

We currently have significant deferred tax assets, resulting from net operating loss carry forwards.  These deferred tax assets may reduce taxable income in future periods.  Based on the Company’s losses and its accumulated deficit, the Company has provided a full valuation allowance against the net deferred tax asset.  A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized.  Cumulative losses weigh heavily in the overall assessment of valuation allowances.

 

We expect to continue to maintain a full valuation allowance on future tax benefits until an appropriate level of profitability is sustained, or we are able to develop tax strategies that would enable us to conclude that it is more likely than not that a portion of our deferred tax assets would be realizable.

 

Long-Lived Assets and Other Intangible Assets

 

Long-lived assets and other intangible assets are reviewed for impairment whenever the carrying amount of the asset may not be recoverable. An impairment loss is recognized when the carrying amount of a long-lived asset exceeds the sum of the undiscounted cash flows expected to result from the asset’s use and eventual disposition.

 

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Allowances for Doubtful Accounts

 

We are required to estimate the collectibility of our trade receivables.  A considerable amount of judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and the related aging of past due balances. We evaluate specific accounts when we become aware of information indicating that a customer may not be able to meet its financial obligations.

 

New Accounting Pronouncements

 

Share-Based Payment

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards 123-revised 2004 (“SFAS 123R”), “Share-Based Payment” which replaces Statement of Financial Accounting Standards No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees and Related Interpretations.” SFAS 123R requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of operations. In April 2005, the SEC announced that the accounting provisions of
SFAS 123R are to be applied in the first quarter of the fiscal year beginning after June 15, 2005. As a result, we are now required to adopt SFAS 123R in the first quarter of fiscal 2006 and will recognize stock-based compensation expense using the modified prospective method. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. See “Accounting for Stock-Based Compensation” above for the pro forma net loss and net loss per share amounts as if we had used a fair-value-based method similar to the methods required under SFAS 123R to measure compensation expense for employee stock incentive awards. We are evaluating the requirements under SFAS 123R and expect the adoption could have a significant impact on our consolidated statements of operations and net loss per share related to any future stock option compensation grants.

 

Accounting changes and error corrections

 

In May 2005, the Financial Accounting Standards Board issued Statement 154, Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3.  Statement 154 requires that all voluntary changes in accounting principles and changes required by a new accounting pronouncement that do not include specific transition provisions be applied retrospectively to prior periods’ financial statements, unless it is impracticable to do so.  This Statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.  The Company does not believe that the adoption of Statement 154 will have a significant effect on its financial statements.

 

Liquidity and Capital Resources

 

Working capital as of December 31, 2005, was $3.1 million, which represents a $1.1 million decrease from working capital of $4.2 million at December 31, 2004.  The decrease in working capital is related to operating losses and continued investment in our business.

 

Spherix renewed its Line-of-Credit (the “Agreement”) with Bank of America (the “Bank”) on December 29, 2005, which provides for borrowing up to $2 million.  Outstanding borrowings under the Agreement aggregated $1.4 million at December 31, 2005, and are collateralized by a restricted $2.0 million certificate of deposit.  The interest rate under the agreement is based on the LIBOR rate, which was 6.29% at year-end.  The total amount available for further advance to the Company was $551,000 under the Agreement at December 31, 2005.  As a result of the creation of InfoSpherix as a wholly-owned subsidiary, management no longer considers maintaining a bank line of credit for the parent company, Spherix, necessary, and, therefore has decided not to renew the above Agreement when it matures on March 31, 2006.  On March 31, 2006, the Company entered into a new agreement with the Bank to establish a bank Line-of-Credit (“New Agreement”) for the subsidiary, InfoSpherix Incorporated.  Management considers the creation of this credit facility for the subsidiary necessary to ensure timely cash flow for the subsidiary’s operations.  The New Agreement provides for borrowings up to $1.5 million, is collateralized by the subsidiary’s assets, contains covenants on tangible net worth and funded debt to EBITDA ratios, and matures on March 31, 2007.  Such covenants could have a limiting effect on the amount of cash that the subsidiary can transfer to Spherix.  The interest rate under the New Agreement is based on the LIBOR rate plus 300 basis points.

 

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InfoSpherix Incorporated intends to finance its furniture and equipment needs through financing or leasing arrangements where practicable, including those for a new call center facility in Indiana as well as those related to the start-up costs of new contracts.

 

Cash flow for the year ended December 31, 2005, reflects a net cash outflow of $808,000, consisting of $526,000 used in operating activities, $659,000 used in investing activities, and $377,000 provided by financing activities.  The $140,000 increase in cash used in operating activities in 2005 from that of the prior year was primarily due to funding issues on one of our contracts and the lower margins on the Maryland contract during the first nine months of the year.  The $3.3 million decrease in investing activities is directly related to the 2004 purchase of certain assets of Daksoft, Inc., and to the 2004 property and equipment and leasehold improvements related to the new Cumberland and Annapolis leases.  The 2004 investing activities were primarily financed through the proceeds of $3.5 million from the February 18, 2004 exercise of warrants by an institutional investor.

 

Trends and Outlooks

 

The InfoSpherix business continues to enjoy many successes, including:

 

•                  On October 20, 2005, the GAO sustained our challenge to the USDA Forest Service award of the NRRS contract to a competitor.  The Department of Agriculture has subsequently decided not to follow GAO’s decision and is seeking to go ahead and award the NRRS contract to ReserveAmerica.  Spherix has filed an appeal of this action with the Court of Federal Claims.  This action has resulted in an extension of our current National Park Service Reservation contract through September 30, 2006.

 

•                  In January 2006, the InfoSpherix business started operating as a wholly-owned subsidiary of Spherix Incorporated under the name “InfoSpherix Incorporated”.

 

•                  In 2005, the Company won a new five-year contract with the State of Pennsylvania for park reservations.  Revenue on the contract will begin to be realized starting in 2006.

 

•                  The Company recently won the State of Michigan park reservation contract for another five years.  Under the new contract, the call center operations are required to be located in the State of Michigan; accordingly, Spherix has partnered with an in-state subcontractor.  Spherix has noticed an increasing trend among states to include such requirements in their contracts.

 

•                  The InfoSpherix Division was successful in increasing its sales backlog between December 31, 2004 and December 31, 2005, to a record level of $72 million.  The extension of the National Park Service Reservation contract through September 30, 2006 accounted for $3.8 million of the increase in the sales backlog; the rest of the increase was from the award of new government contracts, including the renewal of the Michigan reservation contract and the contracts acquired from Daksoft, Inc.

 

•                  Since 1998, InfoSpherix has grown its government park reservation business from one contract to seventeen government reservation contracts, and six new state reservation contracts will be available for InfoSpherix to bid on in 2006.  InfoSpherix’s reservation business accounted for over 60% of the Company’s revenue in 2005.  InfoSpherix is now one of only two major suppliers of Government campground reservation services in the U.S.

 

•                  In October 2005, the operations of the State of Maryland contract were moved from the Beltsville facility to the Cumberland facility, where the Company will be able to operate the contract more cost efficiently.

 

•                  On February 8, 2006, the Company signed an agreement to lease 12,805 square feet of facility space in Indiana effective March 15, 2006, plus an additional 5,796 square feet starting January 1, 2007, for use as a call center to replace the current operation in South Dakota and to provide the InfoSpherix Division with additional space for growth.  The current facility lease in South Dakota ends April 30, 2006; however, the Company is negotiating to extend this through December 31, 2006, so as to avoid a transition during the Company’s peak reservation months.  Some of the furniture and equipment for the Indiana facility will be relocated from the Beltsville call center and the rest will be purchased or leased.

 

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•                  The newly-formed InfoSpherix Incorporated subsidiary has entered into its own bank line of credit.  The line contains covenants on tangible net worth and funded debt to EBITDA ratios.  Such covenants could have a limiting effect on the amount of cash that can be transferred to Spherix.  The InfoSpherix subsidiary will also be pursuing financing arrangement for purchases of property and equipment.

 

Our BioSpherix business continues in its development stage:

 

•                  Our entitlement to royalties for tagatose food and beverage use is totally dependent on the success of Arla, our licensee.  At present, Arla believes it has produced a sufficient backlog of inventory to satisfy its needs for the foreseeable future based on current demand, and accordingly has stopped production at its pilot plant until there is a sufficient increase in the demand for tagatose.  Arla continues to state that it must see greater demand for the product before it could commit to building a larger manufacturing facility.  To date, Arla has not decided to build a larger manufacturing facility, which is key to any significant royalties payable to us.  The construction of such a plant is estimated to take 18 to 24 months, during which time royalties from Arla will remain limited.  Spherix is also pursuing the possibility of other production options.

 

•                  BioSpherix has purchased limited quantities of tagatose from Arla for use as Naturlose in selling for non-food uses by such product manufacturers, including uses in toothpaste, mouthwash, cough syrup, and a fiber digestive aid, for which Spherix has developed prototypes.  We are exploring licensing opportunities for BioSpherix prototypes with some oral care manufacturers.

 

•                  The BioSpherix Division’s emphasis is being directed toward clinical trials to promote the non-food benefits of Naturlose, with the focus on Naturlose’s potential use for diabetics, providing increased shelf life for blood, blood products and other medicinal proteins, and for its use as an anti-plaque agent.  Patient recruitment for the diabetes clinical trials is expected to begin in 2006.  The trials could last as little as two years.  More than 200 subjects from the United States and abroad, representing the demographic mix in the U.S., will receive oral doses of Naturlose to test its ability to treat Type 2 diabetes.  A Phase 3 clinical trial, which gathers evidence regarding effectiveness and safety, is needed to evaluate the overall benefit-risk relationship of new drugs proposed to the FDA.  Because Naturlose has already been established as a substance “Generally Recognized as Safe” under FDA regulations, Spherix believes the elapsed time to approval should be shorter than that for most new drugs.  A successful Phase 3 trial would permit Spherix to file a New Drug Application with the FDA, the approval of which would be the final step before marketing Naturlose as a diabetes-fighting pharmaceutical.  The FDA generally decides on such applications within one year.

 

On June 8, 2005, the NASDAQ National Market advised the Company that the Company’s stockholders’ equity had decreased below the $10 million minimum requirement.  NASDAQ gave the Company until September 1, 2005, to correct this situation, which the Company achieved through its third quarter earnings.  However, anticipating the normal seasonal losses that the company incurs in the first and fourth quarters, the Company entered into the SEDA on July 22, 2005, with a view to selling additional shares of common stock as necessary to maintain compliance with NASDAQ listing requirements.  At December 31, 2005, the Company’s shareholder’s equity was $7,879,220, or $2,120,780 below the $10,000,000 required by NASDAQ; however, through March 10, 2006, the Company has subsequently raised an additional $2.7 million through the SEDA and warrant transactions in order to bring the Company into compliance with the NASDAQ equity requirement.  If the Company is unsuccessful in maintaining the required equity balance in future periods, then the Company will apply to register its shares of common stock on the NASDAQ Small Cap exchange.

 

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Contractual Obligations

 

The following table summarizes the Company’s known contractual obligations at December 31, 2005, and indicates the year payments are due.  In some cases estimates have been used where the exact amount and/or timing of the obligation is not presently known.  The table does not include ordinary accounts payable and payroll type obligations and does not include estimates for future interest obligation payments under the Company’s bank line of credit noted above in the Liquidity and Capital Resources sections.  The Company’s Debt Obligation, as of December 31, 2005, consisted solely of the bank line of credit noted above.

 

(numbers in 000’s)

 

								2007 -			2009 -
		Total			2006			2008			2010			Thereafter
Debt Obligations		$	1,449		$	1,449		$	—		$	—		$	—
Capital Lease Obligations		44			27			17			—			—
Operating Lease Obligations		3,351			1,204			1,977			170			—
Purchase Obligations		1,151			1,151			—			—			—
Post-retirement Obligations		747			116			199			245			187
Total		$	6,742		$	3,947		$	2,193		$	415		$	187

 

No dividends were paid in 2005 and none are anticipated in 2006.

 

Item 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company manages its debt and its available cash by considering available investment opportunities, risks, tax consequences and overall financing strategies.

 

At December 31, 2005, the Company did not have any fixed-rate indebtedness and had approximately $1.4 million of variable-rate indebtedness.  The Company has not entered into any interest rate swaps or other derivatives with respect to its indebtedness.

 

Cash available for investment is typically invested in short term funds, which generally mature in 30 days, or money-market funds.  In general, such funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate.  The carrying amounts approximate market value.  It is the Company’s practice to hold these investments to maturity.

 

Assuming year-end 2005 variable rate debt and cash available for investment, a one percent change in interest rates would impact net interest income by less than $10,000.

 

Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Financial statements and supplementary data required by this Item 8 follow.

 

Index to Financial Statements
Report of Independent Registered Public Accounting Firm
Statements of Operations for the years ended December 31, 2005, 2004, and 2003
Balance Sheets as of December 31, 2005 and 2004
Statements of Changes in Stockholders’ Equity for the years ended December 31, 2005, 2004, and 2003
Statements of Cash Flows for the years ended December 31, 2005, 2004, and 2003
Notes to Financial Statements

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and

 

Shareholders of Spherix Incorporated

 

We have audited the accompanying balance sheets of Spherix Incorporated (a Delaware corporation) (the Company) as of December 31, 2005 and 2004, and the related statements of operations, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Spherix Incorporated as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

 

 

/s/ Grant Thornton LLP

 

Vienna, Virginia

March 10, 2006 (except for Note 6, as to which the date is March 31, 2006)

 

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Spherix Incorporated

Statements of Operations

For the years ended December 31, 2005, 2004, and 2003

 

		2005			2004			2003
Revenue		$	23,045,657		$	22,348,418		$	18,086,711
Operating expense
Direct contract and operating costs		17,928,018			17,362,430			12,224,650
Selling, general and administrative expense		5,141,173			5,357,435			6,242,811
Research and development expense		288,112			196,364			390,893
Depreciation and amortization expense		2,574,247			2,277,682			1,503,003
Total operating expense		25,931,550			25,193,911			20,361,357
Loss from operations		(2,885,893		)	(2,845,493		)	(2,274,646		)
Interest income (expense), net		37,145			23,447			17,876
Loss before taxes		(2,848,748		)	(2,822,046		)	(2,256,770		)
Income tax expense		—			—			—
Net loss		$	(2,848,748	)	$	(2,822,046	)	$	(2,256,770	)
Net loss per share, basic		$	(0.24	)	$	(0.24	)	$	(0.20	)
Net loss per share, diluted		$	(0.24	)	$	(0.24	)	$	(0.20	)
Weighted average shares outstanding, basic		12,037,479			11,890,470			11,378,309
Weighted average shares outstanding, diluted		12,037,479			11,890,470			11,378,309

 

The accompanying notes to financial statements are an integral part of these financial statements.

 

26

 

Spherix Incorporated

Balance Sheets

As of December 31, 2005 and 2004

 

		2005			2004
ASSETS
Current assets
Cash and cash equivalents		$	2,667,733		$	3,475,846
Restricted investments		2,000,000			2,700,000
Trade accounts receivable, net of allowance for doubtful accounts of $15,000		2,139,061			1,742,699
Other receivables		271,287			140,314
Prepaid expenses and other assets		582,279			638,983
Total current assets		7,660,360			8,697,842
Property and equipment, net of accumulated depreciation of $6,077,074 and $5,172,785		4,603,032			5,517,279
Patents, net of accumulated amortization of $402,026 and $247,374		854,871			1,028,828
Total assets		$	13,118,263		$	15,243,949
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Bank line of credit		$	1,449,318		$	1,966,784
Accounts payable and accrued expenses		1,950,584			1,493,683
Accrued salaries and benefits		1,104,102			969,046
Capital lease obligations		16,645			18,124
Deferred revenue		—			34,632
Total current liabilities		4,520,649			4,482,269
Capital lease obligations, net of current position		10,810			27,456
Deferred compensation		511,325			125,959
Deferred rent		196,259			240,575
Total liabilities		5,239,043			4,876,259
Commitments and contingencies		—			—
Stockholders’ equity
Preferred stock, $0.01 par value, 2,000,000 shares authorized; none issued and outstanding		—			—
Common stock, $0.005 par value, 50,000,000 shares authorized; 12,448,456 and 12,031,395 issued, 12,368,018 and 11,950,957 outstanding at December 31, 2005 and 2004, respectively		62,242			60,157
Paid-in capital in excess of par value		23,521,109			23,162,916
Treasury stock, 80,438 shares, at cost at December 31, 2005 and 2004, respectively		(464,786		)	(464,786		)
Accumulated deficit		(15,239,345		)	(12,390,597		)
Total stockholders’ equity		7,879,220			10,367,690
Total liabilities and stockholders’ equity		$	13,118,263		$	15,243,949

 

The accompanying notes to financial statements are an integral part of these financial statements.

 

27

 

Spherix Incorporated

Statements of Changes in Stockholders’ Equity

For the years ended December 31, 2005, 2004 and 2003

 

							Paid-in								Retained Earnings
		Common Stock					Capital in Excess of Par			Treasury Stock					(Accumulated Deficit)			Stockholders’ Equity
		Shares		Amount						Shares		Amount
Balance, December 31, 2002		11,412,545		$	57,063		$	18,906,610		61,488		$	(390,434	)	$	(7,311,781	)	$	11,261,458
Issuance of common stock
Exercise of employee stock options		74,025		370			455,127			—		—			—			455,497
Cost of stock issuance		—		—			(2,000		)	—		—			—			(2,000		)
Stock-based compensation		—		—			31,050			—		—			—			31,050
Net loss		—		—			—			—		—			(2,256,770		)	(2,256,770		)
Balance, December 31, 2003		11,486,570		57,433			19,390,787			61,488		(390,434		)	(9,568,551		)	9,489,235
Issuance of common stock
Sale of common stock in private placement, net		43,029		215			282,715			—		—			—			282,930
Proceeds from Employee Stock Purchase Plan		1,796		9			7,739			—		—			—			7,748
Exercise of stock warrants		500,000		2,500			3,450,625			—		—			—			3,453,125
Purchase of treasury stock		—		—			—			18,950		(74,352		)	—			(74,352		)
Stock-based compensation		—		—			31,050			—		—			—			31,050
Net loss		—		—			—			—		—			(2,822,046		)	(2,822,046		)
Balance, December 31, 2004		12,031,395		60,157			23,162,916			80,438		(464,786		)	(12,390,597		)	10,367,690
Issuance of common stock
Sale of common stock in private placement, net		410,076		2,050			312,428			—		—			—			314,478
Proceeds from Employee Stock Purchase Plan		6,985		35			14,715			—		—			—			14,750
Stock-based compensation		—		—			31,050			—		—			—			31,050
Net loss		—		—			—			—		—			(2,848,748		)	(2,848,748		)
Balance, December 31, 2005		12,448,456		$	62,242		$	23,521,109		80,438		$	(464,786	)	$	(15,239,345	)	$	7,879,220

 

The accompanying notes to financial statements are an integral part of these financial statements.

 

28

 

Spherix Incorporated

Statements of Cash Flows

For the years ended December 31, 2005, 2004 and 2003

 

		2005			2004			2003
Cash flows from operating activities
Net loss		$	(2,848,748	)	$	(2,822,046	)	$	(2,256,770	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		2,574,247			2,277,682			1,503,002
Provision for uncollectible accounts receivable		—			(5,000		)	(51,000		)
Loss on disposal or write-down of assets		8,576			11,426			30,896
Loss on write-down of patents		13,254			—			28,572
Stock-based compensation		31,050			31,050			31,050
Changes in assets and liabilities:
Trade accounts receivable		(396,362		)	(245,972		)	728,744
Other receivables		(130,973		)	(123,131		)	(3,839		)
Prepaid expenses and other assets		56,704			214,320			(104,076		)
Accounts payable and accrued expenses		(139,906		)	221,503			499,728
Deferred rent		(44,316		)	16,330			9,369
Deferred compensation		385,366			3,304			9,768
Deferred revenue		(34,632		)	34,632			(1,103,662		)
Net cash used in operating activities		(525,740		)	(385,902		)	(678,218		)
Cash flows from investing activities
Purchase of property and equipment		(1,359,283		)	(3,212,340		)	(2,246,219		)
Restricted cash		700,000			—			(2,700,000		)
Proceeds from the sale of property and equipement		—			1,093			—
Additions to patent costs		—			(7,736		)	(18,386		)
Purchase of certain assets of Daksoft, Inc.		—			(700,000		)	—
Net cash used in investing activities		(659,283		)	(3,918,983		)	(4,964,605		)
Cash flows from financing activities
Net change on bank line of credit		(517,466		)	250,041			994,359
Net change in book overdraft		583,273			(99,780		)	(166,882		)
Payments on capital lease obligations		(18,125		)	(17,730		)	(27,220		)
Proceeds from issuance of common stock, net		329,228			3,455,551			453,498
Purchase of treasury stock		—			(74,352		)	—
Net cash provided by financing activities		376,910			3,513,730			1,253,755
Net decrease in cash and cash equivalents		(808,113		)	(791,155		)	(4,389,068		)
Cash and cash equivalents, beginning of year		3,475,846			4,267,001			8,656,069
Cash and cash equivalents, end of year		$	2,667,733		$	3,475,846		$	4,267,001
Supplemental cash flow information
Interest paid		$	75,802		$	60,550		$	34,763
Property and equipment financed by accounts payable		$	214,721		$	66,131		$	276,193

 

The accompanying notes to financial statements are an integral part of these financial statements.

 

29